Fundamental of Financial Accounting: (Document Subtitle)
Fundamental of Financial Accounting: (Document Subtitle)
Fundamental of Financial Accounting: (Document Subtitle)
Accounting
[Document subtitle]
Gurudas Swain
Academic Script:
In order to add and update one’s own knowledge, we must read and
interact also with the people in Finance.
The field of Finance is also risky. Hence, before taking actual part
in financial transactions through any market or with any individual
or institution , proper study is essential.
Financial Accounting
Academic Script
Accounting
Role of Accounting
During the last few decades, the role of accounting has
undergone substantial change. It is the accounting which
communicates the business results to the different parties like
owners, creditors, employees etc. Accounting is not an end in
itself; it is a means to an end. Accounting performs the service
activity of communicating financial information to various
groups to enable them to make economic decisions. Accounting
reduces mass of data into reports and statements. Accounting
is a system because it operates within the system of a business
and industry. As accounting is concerned with measurement
and communication of financial data, environment plays an
important role in the design of the system. In the recent times,
accounting is regarded as a tool of social welfare by enabling
the users of accounting information to take correct decisions.
According to this approach, accounting information should be
beneficial to the society whole through rational decision-making
by the various sections. According to “Trueblood Report”, one
of the objectives is “to report on those activities of the
enterprise affecting society which can be determined and which
are important to the role of the enterprise in its social
environment.” According to Glantier and Underdown,
“Accounting information has a special meaning in that it is
data, organized for a special purpose, that is, decision-making.
The task of the accountant is to transform raw data into
information.” Accounting, as an information system,
communicates economic information to a wide variety of
interested groups.
Braches of Accounting
In order to satisfy information needs of different people,
different branches of accounting have developed. Following are
the main braches of accounting:
Accounting
Financial Cost Management
Financial Accounting:
Cost Accounting:
Management Accounting:
Management Accounting is concerned with accounting
information which is useful to the management in formulating
policies and controlling the business operations.
Financial Accounting:
5. Recording
6. Classifying
7. Summarizing
8. Interpreting
Academic Script
1. Accounting Principles
2. Accounting Standards
Accounting Principles
A principle may be defined as a rule of action or guide to action.
Accounting is a science and, therefore, contains a number of principles.
Accounting principles are board guidelines and rules of action to be
adopted by accountants for the preparation of accounts.
Traditionally, accounting principles have been classified as follows:
I.Accounting Concepts
II. Accounting Conventions
Accounting Concepts:
Accounting concepts are basic accounting assumptions or
conditions upon which the science of accounting is based.
Following are the important accounting concepts:
1. Separate Entity Concept
2. Money Measurement Concept
3. Going Concern Concept
4. Accounting Period Concept
5. Cost Concept
6. Dual Aspect Concept
7. Matching Concept
8. Realization Concept
9. Accrual Concept
10. Objectivity Concept
Accounting Conventions:
Accounting conventions are customs or traditions which guide
the accountant while preparing financial statements. Following
are important accounting conventions:
1. Convention of Conservatism
2. Convention of Consistency
3. Convention of Disclosure
4. Convention of Materiality
Cost Concept
Cost Concept is closely linked with “Going Concern Concept”. Cost
concept implies that all the assets of the business enterprise are to be
recorded in accounting books at their historical cost i.e. at the price paid
for it and the cost will be the basis for all subsequent accounting for the
assets in future also. Cost concept totally rules out value or worth
concept or market price concept. If a business buys a building for Rs. 12
lakhs, it would be shown in the Balance Sheet at Rs.12 lakhs even if its
market value at that time happens to be Rs. 15 lakhs or Rs. 10 lakhs.
Thus, the Balance Sheet on a particular date does not show the value at
which the assets could be sold for.
Cost of the asset may systematically be reduced by charging
depreciation.
Sometimes, it is argued that Balance Sheet based on this concept is
irrelevant for judging the present day financial position of the business.
In spite of this limitation, cost concept is still preferred by the
accountants. Fixed assets are purchased for use in production and not
held for sale. Further, cost concept brings in objectivity as in case of
market value, there is too much of subjectivity in “current worth” or
“market value” or “realizable value” approach. It is very difficult and time
consuming for an enterprise to ascertain the market value. There is
objectivity and verifiability in cost approach which is not found in other
approaches.
Asset = Equities
Or
Assets = Owners Equity (Capital) + Outsiders Equity (Liabilities)
Matching Concept
The term “Matching” means appropriate association of related revenues
and expenses. Matching Concept means that revenues and expenses
that relate to the same transactions should be recognized together. The
central idea of matching concept is that all costs applicable to the
revenue of a particular period should be charged against revenue so that
net income of the business may be ascertained correctly.
This concept is based on accounting period concept. Income made by
the business enterprise during an accounting period can be ascertained
when revenues earned during a period are compared with the
expenditure incurred for earning that revenue. That is why adjustments
are made for all outstanding expenses, accrued incomes, prepaid
expenses and unearned incomes etc. while preparing the final accounts
at the end of the accounting period.
Matching concept involves estimation of cost and revenues.
Revenue Recognition or Realization Concept:
Revenue Recognition or Realization Concept means that revenue is
considered to be earned by the business enterprise only when revenue
is realized. Revenue is considered to be realized when either cash has
been received or a legal obligation to pay has been assumed by the
customer. This is possible only when the property in goods is transferred
to the purchaser.
It means that receipt of a mere order from a customer cannot be
recognized as revenue unless the goods are dispatched to the
customer. It implies that revenue should be recognized only when a sale
is made.
Let us take an example, Deep publications receives an order form
Virendra on 15th march, 2008 for supply of certain books. Deep
Publications dispatches these books on 15th June, 2008. Virendra pays
the due amount on 15th April, 2009. In this case, revenue will be realized
on 15th June, 2008 and not on 15th March, 2008 because Virendra
becomes legally liable to pay only on 15th June, 2008. The date of
payment is not relevant. Hence, revenue will be earned during the year
2008-09 if accounting year of Deep Publications is financial year (April-
March). However, there are some exceptions to this concept.
Accrual Concept
Accrual Concept implies that the income should be measured as a
difference between revenue and expenses rather than the difference
between cash received and cash disbursements. Accrual concept is
related to Matching Concept. This concept facilitates in ascertaining
correct profit or loss for a period. Revenues should be recognized as
and when they are earned irrespective of the fact when they are
received. Similarly, costs should be recognized as and when they are
due irrespective of the fact when they are paid. This necessitates certain
adjustments like incomes accrued, outstanding expenses, prepaid
expenses and unearned incomes in the preparation of income statement
and the balance sheet. Another implication of this concept is that income
or profit arises only when there has been an increase in owner’s equity.
An increase in owner’s equity will be income if it is not caused by
addition to the capital be the proprietor himself. It means that every
increase in assets is not income. A simultaneous increase in assets as
well as owner’s equity is the income of the business enterprise.
Objectivity Concept
Objectivity Concept implies that all accounting must be based on
objective evidence. It means that transactions recorded in accounting
books should be supported by verifiable documents such as invoice,
vouchers, correspondence etc. In the absence of objective evidence,
the accounts may not be correct and manipulation in accounts may take
place. The evidence should be objective i.e. free from the bias of the
accountants. It is for this reason that fixed assets are shown in the
balance at their cost less depreciation. If the assets are shown at their
market values, objectivity is lost. This concept facilitates the auditors to
verify accounts and certify them as true or otherwise. However, it is not
possible to apply this principle altogether. In many matters such as
depreciation, provision for bad and doubtful debts, valuation of
inventories etc., accountants have to rely on estimates as objective
evidence may not be available for them. In spite of this, this principle is
very important since it reduces the scope of personal judgment. This
concept compels the accountants to take “most objective evidence
available” into account.
Convention of Conservatism
Convention of Conservation or Prudence Concept is the policy of
“Playing Safe”. This convention suggests that if a choice is available, the
accountant should anticipate all probable losses and should provide for
them but he should not anticipate probable gains and revenues.
Following are some of the examples of conservatism:
1. Making the provision for doubtful debts and discount on debtors.
2. Valuing the stock in trade at market price or cost whichever is less.
3. Creating provision against fluctuations in the price of investments.
4. Adopting written-down-value method of depreciation.
5. Amortization of intangible assets like goodwill.
6. Not providing for discount on creditors.
This convention helps to keep the human desire to be on the safe
side. In order to protect the interest of different groups, net profit and net
financial position must not be overstated but may be understated. The
application of this convention results in lower net income and
understatement of assets and overstatement of liabilities.
The convention of conservatism has become the target of serious
criticism these days. Convention of conservatism means deliberate
understatement of revenues and pessimistic picture of financial position.
Financial statements do not depict a true and fair view of the state of
affairs of the business. This convention goes against the convention of
disclosure. It encourages the accountant to create secret reserves.
Today, the emphasis is on disclosure of information. Hence, this
convention should be applied very cautiously; so that results reported
are not distorted.
Convention of Disclosure
Convention of Disclosure means that accounting reports should disclose
fully and fairly the information they intend to represent. In other words,
accounting reports should not conceal the facts and misrepresent the
facts. The basic aim of this convention is that financial statements
should sufficiently disclose information which is of material interest to
proprietors, investors and creditors. This convention is gaining more
importance because most of the businesses are run by companies
where ownership and management are separate.
The Companies Act 1956 requires that financial statements must give a
true and fair view of the state of affairs of the company. The Companies
Act gives the prescribed forms in which these statements are to be
prepared. Securities Exchange Board of India (SEBI) has also been
suggesting norms of disclosure from time to time.
AS-1 issued by Institute of Chartered Accountants of India is a
mandatory accounting standard which deals with disclosure of significant
accounting policies followed in preparing and presenting financial
statements. The practice of giving footnotes about contingent liabilities,
market value of investments etc. has been developed due to this
convention.
However, convention of disclosure does not imply that all the
information, that anyone may desire, should be disclosed in accounting
statements. The convention requires that “adequate” information should
be disclosed.
Convention of Consistency
Convention of Consistency means that as far as possible accounting
policies, rules and procedures should remain unchanged from one
period of time to another. There may be several rules, procedures and
methods of recording events in accounts and presenting them in
financial statements. Once a particular policy, rule or method is adopted,
it should be consistently applied. For example, if the enterprise has
decided that depreciation of machinery is to be ascertained by straight
line method, this method should be followed from year to year. Similarly,
if stock is valued at cost on the basis of FIFO method, this principle
should be followed every year. If company makes frequent changes in
the policies and methods, comparison of accounting data will not give
accurate results. Hence, convention of consistency makes the
accounting reports and statements comparable. This convention also
serves to eliminate bias on the part of management or accountants.
However, consistency does not mean inflexibility. Convention of
consistency does not forbid change in the existing accounting policies
and procedures. Convention of consistency implies that once a policy of
procedure is adopted, it should not be changed frequently. If a
change is considered desirable, change should be made but the change
in accounting policy or procedure has to be disclosed in the financial
statements.
It is assumed that accounting policies are consistent from one period of
time to another. When this assumption is not allowed, the fact should be
disclosed together with reasons.
Convention of Materiality
Convention of Materiality signifies that only material items should be
taken into account and insignificant items need not be shown in
accounting. However, what is material and what is not material is a
matter of subjective judgment of the accountant concerned. An item may
be material for one enterprise but may not be material for other.
According to American Accounting Association, “an item should be
regarded as material if there is reason to believe that knowledge of it
would influence the decision of informed investor.” According to IAS-1
materiality should govern the selection and application of accounting
policies. IAS-5 states that “all material information should be disclosed
that is necessary to make the financial statements clear and
understandable.” Some of the examples of material financial information
are like fall in the value of stocks, decline in production due to strike, loss
of markets due to government regulation, likely increase in wage bill.
Similarly events and contingencies occurring after the date of Balance
Sheet are disclosed. Further, amounts may be rounded off to nearest
10, 100 or 1000 as the case may be. Income Tax Act provides that
amount of income should be rounded off to nearest ten rupees. Thus,
materiality is influenced by legal provisions or customs or size of
business enterprise.
Convention of materiality is very significant in accounting. This
convention highlights material details and ignores insignificant details. If
this convention is not applied, accounting records and reports will be
unnecessarily overburdened with more details.
Accounting Standards –
Meaning & Significance
Academic Script
Accounting Principles:
A principle may be defined as a rule of action or guide to action.
Accounting is a science and, therefore, contains a number of
principles. Accounting principles are board guidelines and rules of action
to be adopted by accountants for the preparation of accounts.
Traditionally, accounting principles have been classified as follows:
i. Accounting Concepts
ii. Accounting Conventions
Accounting Concepts:
Accounting concepts are basic accounting assumptions or
conditions upon which the science of accounting is based.
Following are the important accounting concepts:
1. Separate Entity Concept
2. Money Measurement Concept
3. Going Concern Concept
4. Accounting Period Concept
5. Cost Concept
6. Dual Aspect Concept
7. Matching Concept
8. Realization Concept
9. Accrual Concept
10. Objectivity Concept
Accounting Conventions:
MEANING:
An accounting standard is a sort of law, a guide to action, a settled
practice or conduct. According to Kohler, “Accounting Standard is a
mode of conduct imposed by customs, law or professional body for the
benefit of public accountants and accountants generally”. Accounting
standards are norms of accounting policies and practices by way of
codes or guidelines. Accounting standards are different form Generally
Accepted Accounting Principles (GAAPs). GAAPs provide a number of
alternative treatments of the same item. But accounting standards
narrow down the areas of differences in accounting principles and
provide solution to specific issues. In short, accounting standards are
modified GAAPs expected to be followed by the accountants. In other
words, accounting standards are codified Generally Accepted
Accounting Principles.
PURPOSES:
Accounting standards have been developed to ensure consistency,
comparability, reliability, adequacy and accuracy of financial statements.
The main purpose of accounting standards is to provide information to
the users of financial statements as to the basis on which financial
statements have been prepared. Accounting standards are needed to
harmonize the diverse accounting policies and practices to make the
financial statements meaningful. Accounting standards serve the
following purposes:
1. To provide the norms on the basis of which financial
statements should be prepared.
2. To ensure uniformity in the preparation and presentation
of financial statements by removing the effect of diverse
accounting practices.
3. To make financial statements more meaningful and
comparable.
4. To resolve potential financial conflicts of interest between
various groups.
5. To help auditors in the audit of accounts.
AS-4 Contingencies and Events occurring after the Balance Sheet Date:
This accounting standard deals with the treatment in financial
statements of a) Contingencies and b) events occurring after the
balance sheet date.
AS-5 Net Profit or Loss of the period, Prior Period Items and Changes in
Accounting Policies:
This standard requires classification and disclosure of extraordinary
items within profit or loss from ordinary activities. Also accounting
treatment for changes in accounting estimates and the disclosures to be
made in the financial statements regarding changes in accounting
policies.
AS-6 Depreciation Accounting:
This standard deals with depreciation accounting and is applicable
to all depreciable assets. This standard requires disclosure, if any,
regarding the change in methods of calculating depreciation which is
considered as the change in accounting policy.
AS-7 Accounting for Construction Contracts:
The objective of this standard is to prescribe accounting treatment of
revenue and costs associated with construction contracts due to
changes in date of contract entry and completion for proper allocation of
contract costs and contract revenues.
Academic Script
Concept
The core principles of GAAP are basic accounting rules that rarely change and
are universally accepted. These include such fundamentals as the double-entry
method, which stipulates that all financial events must be recorded with an even
number of entries.
This rule ensures that the left and right sides of the balance sheet, containing
Assets and Liabilities plus Shareholder Equity, are always equal and what the
firm owns perfectly matches what it owes to stakeholders.
Other principles are broad in nature and relatively subjective in their application.
They include such guidelines as the principle of regularity, the principle of
consistency and the principle of sincerity
Principles of GAAP:
Measurement: How profits and losses are measured and reported on financial
statements
Presentation: How information needs to be presented on financial statements
This principles are aimed to meet certain goals of GAAP i.e. is to create a
uniform standard for financial reporting.
When financial information is made available to the public, it should serve the
purpose of helping investors make informed decisions as to where to put their
money. Similarly, it should enable lenders to properly assess the financial
condition of companies looking to borrow money.
Accounting principles:
Accounting Concepts
Business Entity Concept:– Entity is different from its owner for accounting
purposes.
Cost Concept:– Assets are normally recorded basis of historical cost i.e.
acquisition cost. Market value immaterial, except on concepts of revaluation.
Accrual Concept:- Under this concept, the effects of transactions and other
events are recognised on mercantile basis i.e. when they occur (and not as
cash received or paid).
Accounting Standards
3. Managerial Accountability:
Accounting standards help in assessing managerial skills in ensuring
profitability of the enterprise and in measuring the effectiveness of
management’s stewardship accounting standards ensures consistency,
reliability, adequacy and accuracy of financial data which permit better
comparisons in profitability, financial position, future prospects and other
performance indicators associated with different enterprises. As a result of
accounting standards, it will be very difficult for the management to
manipulate financial data.
IFRS are a principle based framework and not rule based so that there is
no language gap and barrier. The basic idea behind the IFRS is to
standardise the diverse accounting policies and practices with a view to
make financial statements globally comparable and reliable.
Benefits of IFRS
There are many interest groups who would benefit from IFRS:
2. Investors:
With the use of IFRS, it will be convenient for investors to assess the
relative merits of alternative investment opportunities by making
comparison of the financial performance of companies in different
countries.
3. Multinational Companies:
Multinational companies would benefit from IFRS as under:
a. Consolidation of overseas subsidiaries would be easier due to IFRS
since financial statements from all around the world would be
prepared on the same basis.
b. The adoption of IFRS will help multinational companies to raise
funds globally.
c. The task of preparing comparable internal information for the
appraisal of the performance of subsidiaries in different countries
would be made much easier.
d. Management control would be easy. The appraisal of foreign
countries for potential acquisition would also be facilitated.
5. Developing Countries:
Many countries do not have their domestic accounting standards. IFRS
would enable them to adopt a readymade system without spending any
time, money or efforts. The adoption on IFRS would promote foreign
investors to invest in developing countries. Developing countries can
attract more foreign capital at lower cost.
IFRS in India:
India has committed at the G-20 summit in 2009 to converge its domestic
accounting standards with IFRS in a phased manner starting 1st April 2011.
Listed companies are required to converge with IFRS form April 2011 in the first
phase:
1. Companies listed in India or outside.
2. Companies not listed but have net worth of Rs. 1000 crore or more.
The second phase will begin in April 2013 and will include companies, whether
listed or not, having a net worth of at least Rs 500 crore but not exceeding Rs.
1000 crore
The third phase will begin in April 2014 and include listed companies with net
worth less than Rs 500 crore.
As part of its convergence strategy, the ICAI has classified into four categories:
Category II: IFRS which may require sometime to reach a level of technical
preparedness say a short period of two years.
Category III: IFRS which require dialogues with IASB due to conceptual
difference, hence, demand time par with category II
Category IV: IFRS the adoption of which would require changes in law.
In India, there is a multiplicity of standard setting authorities (ASB, NACAS,
SEBI, Companies Act, Central Government and the tax laws) and all will get
involved in enforcing IFRS.
This hampers the process of adoption of IFRS. IFRS, once implemented, would
overrule not only the management requirement but also the law. This requires
major changes in the present system.
Accounting Process
Academic Script
ACCOUNTING EQUATION:
The literal meaning of the word “equation” is a formula affirming
equivalence or two expressions by = (sign of “is equal to”). Accounting
equation is, thus, an accounting formula expressing equibalance of total
assets and equities of an enterprise. Accounting equation shows the
equality of assets i.e. resources and enterprise. Accounting equation
shows the equality of assets i.e. resources and liabilities i.e. sources of
financing the resources. It may be expressed as under:
OR
Assets = Equities
ILLUSTRATION 1
Solution:
1. Commenced business
with cash Rs. 50000 50000 = 0 + 50000
2. Purchased goods for
cash Rs. 20000 and
(+)50000 = 30000 + 0
credit Rs. 30000
(-) 20000 =
RECORDING OF TRANSACTIONS:
The recording of transactions starts with identification of transactions.
Transactions are the events which result in the change in the value of
assets and equity. Transactions may be classified into two groups:
1. External transactions
2. Internal transactions
ACCOUNT:
1. Personal Accounts
2. Real Accounts
3. Nominal Accounts.
PERSONAL ACCOUNTS:
Personal Accounts are the accounts which record dealings of business
with persons. Personal Accounts may be of three types:
REAL ACCOUNTS:
Real accounts are the accounts which record dealings in or with assets.
Real accounts may be of two types:
NOMINAL ACCOUNTS:
Nominal Accounts are the accounts which record dealings of to profit,
gains, expenses and losses. Nominal accounts are in name only.
Examples of nominal accounts are as under:
JOURNAL:
Journal records all daily transactions of a business in the order in which
they occur. A journal may be defined as a book containing a
chronological record of transactions. It is the book in which the
transactions are recorded first of all under double entry system. Thus,
journal is called the book of original record.
There are five columns in the journal:
Academic Script
2. Cash deposited into Bank. Cash and bank are two terms in this entry.
So there are two parties- one is cash and other is bank. Bank we know is
the personal account as it is the representative of banking company. So
wherever the personal account is there.
Remember the rule of debit and credit for personal account. (Debit the
receiver, credit the giver).
So banking company is the receiver over here because the cash is going
from our hand to the bank so will debit the bank account. And cash is the
real account here it will go out of the business hence it will be credit.
They all are sub-division of goods accounts. Goods are a real account
hence these all the sub division of this account will be real account.
So goods are coming in we have debited purchases. Purchase return
will be reversal of it and it will always be credited.
So when we have to find out the net purchases we will subtract
purchase return from the purchases.
Goods can also be purchased on credit. Credit here means that at the
very time of purchases we are not making payment. The payments are
made when due date comes or after the expiry of the credit period
allowed to us by our suppliers. Instead of cash we will use the supplier’s
name, or creditors, or account payable. Now let us see its entry:
This way the entry will be passed.
2. If the sales are made on credit to Ramesh worth Rs 6000. The journal
entry will be:
When our customers returns certain goods back to us the entry would
be
If goods are used for personal purpose that means that the proprietor is
using for his own use rather than business purpose in that case an
account named Drawings will be used.
So these are the two important entries related to the use of goods.
Our liability was to pay Rs.1000 but we are required him to pay Rs.900
and the discount of Rs.100 is received.
Now we are discussing the third type of compound entry where there are
several debits and several credits.
When a business is started a proprietor may bring cash with him or
some liability may be associated with him so a compound entry is being
passed where assets are debited, liabilities are credited and balancing
figure arrived as capital.
Similarly when opening entries are passed (opening entries are those
entries which are carrying the previous year’s balances in the books of
account) in that case also the assets are debited, liabilities are credited
and the excess of assets over liabilities is capital.
For example,
Cash A/c Dr. 2000
Debtors Dr. 4000
Stock Dr. 6000
Land and building Dr. 2000
To Sundry Creditors 4000
To Capital (B.F) 10,000
The balancing amount will represent the capital account Rs. 10,000.
So this way the composite entries can be passed in the books of
account.
When the business is small all the transactions relating to person,
property, assets, income and expenditures, losses or gains all are
recording in journal but as the business expands so the books of
account will expand.
7. ADJUSTMENT ENTRIES
There are certain additional entries or adjustment entries which we need
to pass at the end of the year. Sometimes what happens that the
expenditure is paid in the advance. Expenditure is recorded in the books
of account for 12 months. That is from the period beginning from
financial year and ending where financial year is ending. If we are going
to pay rent we are going to record the rent for 12 months that is for the
particular accounting year. If it is paid in advance that is for say 15
months, hence 3 months’ rent would be considered as advance rent. So
the accounting entry will be
The prepaid expenses account is the personal account and would be the
part of current assets.
Next is outstanding expenses account:
We have to pay the expenses for the entire period of 12 months. Taking
the same example of rent, If have not paid the rent for entire 12 months
but we have paid the for the 6 months only so remaining 6 months’ rent
would be considered as outstanding rent in the books of account. The
transaction would be recorded as
Concept:
Profit and Loss account is one very important financial statement that
reflects the results of the activities of company over a period of time. It
shows what revenues have been generated and what costs incurred in
generating those revenues, and therefore the increase or decrease in
wealth of the business during the period.
Perspective 1:
Perspective 2:
It considers the the profit and loss account by summarizing all the
trading and non-trading transactions that have occurred during an
accounting period. This is the method used in practice to calculate the
profit or loss for an accounting period. This summary, or profit and loss
account, gives the same result as that derived by simply looking at the
change in wealth between the beginning and end of the accounting
period.
Profit (or loss) considered in this way can be represented in the equation
as -
Expenses, Cost
or Expenditure
The profit and loss account measures whether or not the company has
made a profit or loss on its operations during the period, through
producing or buying and selling its goods or services. It measures
whether total sales or revenues are higher than the total costs or profit,
or whether total costs are higher than total sales or revenues loss.
Sales (goods)
Interest received (on loans)
Rents (from property)
Fees (professions)
Sales of Assets
Royalties (books, CDs, Patents, Trademarks). etc
The total costs of a business include the expenditure incurred as a result
of the generation of revenue. The total costs of a business includes, for
example:
In-order to ascertain the true profit or loss which the business has made
during the particular period, it is necessary that all such expenses and
incomes should be considered.
Profit and Loss Account considers all such expenses and incomes and
gives the net profit made or loss suffered by the business during a
particular period.
Particulars Rs Particulars Rs
To Salaries … By Commission …
To Bad Debts …
To Discount
To Depreciation
To Net Profit
Transferred to Capital
Account
It’s important to understand some of the basic terms also that are
reflected in the profit and loss account.
Let’s learn more about them
The figure of gross profit or gross loss is brought down from the
trading account. Of Course, there will be only one figure, i.e. either
gross profit or gross loss.
2. Salaries:
5. Interest:
6. Commission:
7. Trade Expenses
9. Advertisements:
Bad debts denote the amount lost from debtors to whom the
goods were sold on credit and those who have defaulted the
payments that were due to the them. It is a loss for business and
therefore should be debited to profit and loss account.
11. Depreciation:
Let’s take this example which will further clear the concept.
A motor car is purchased for Rs. 5,00,000 in the first year. So very
next year a seller who have purchased the car will not be able to
sell the car for the same price. There will be some decrease in
value this may due to use of car and there may be various other
variables for less amount that can be fetched for car in second
year. The difference between the old (purchase amount) less the
new amount (selling amount) is often termed as depreciation.
( in rupees) ( in rupees)
1 -- 5,00,000
2 50,000 4,50,000
(5,00,000*10%)
3 45,000 4,05,000
(4,50,000*10%)
Nominal Account -
“Debit all expenses & losses while Credit all gains and profits”
b) Non-Operating Expenses
Students,
Let us now see the components that are reflected on credit side of
Profit and Loss Account
The profit and loss account provides information regarding the listed
matters:
a) It provides information about the net profit or net loss earned or
suffered by the business during a particular period (normally a
financial year). Thus, it is an index of profitability or otherwise of
the business.
b) The profit figures disclosed by the profit and loss account for a
particular period can be compared with that of the other period.
Thus, it helps in ascertaining whether the business is being run
efficiently or not.
Balance Sheet
Introduction:
Concept:
e) Explanatory statements.
A Balance Sheet –
b) Liabilities and
Particulars –
1)Shareholders Fund
a) Share Capital
4) Current Liabilities
b) Trade Payables
Total –
II. Assets
1) Non Current Assets
a) Fixed Assets
i) Tangible assets
b) Non-current investments
2)Current Assets
a) Current Investments
b) Inventories
c) Trade receivables
Total –
Cash
Bank
Bills Receivables
Debtors
Stock
Fixed Assets
Stock
Debtors
Bills Receivables
Cash at bank
Cash in hand
Bank Overdraft
Outstanding expenses
Creditors
Capital
1) Share Capital:
Share capital of a company means arranging the funds
required for its operations. Company issues its shares to
raise capital. The financial treatment related to share capital
is grouped under various sections.
Reserves and surplus are the balance that is kept aside out of
the profits and retained back with the company for future use.
Reserve and surplus shall be classified as:
4) Current Liabilities:
5) Current Assets:
The head Non Current Assets is sub classified into Fixed assets,
Non-current investments, Deferred tax assets, Long term loans
and advances and Other non-current assets.
The assets and liabilities side of the balance sheet are totaled
up and both the sides tally with equal amounts.
Balance Sheet
Key Ratios
The next aspect of the balance sheet you need to assess is the
ability of an organisation to liquidate an asset. This is achieved
by looking at whether or not assets are tangible or intangible.
Key Ratios:
Financial ratios convert the raw financial data from the balance
sheet into information that helps decision makers. A ratio
shows the relationship between two numbers.
Current Ratio
Quick Ratio
Working Capital
Debt/Capital Ratio
Academic Script
Book keeping has its limited role “Only Record Keeping”; But Financial
Accounting has a wide role to play. It keeps the record of business
transactions, classifying, summarizing, concluding the net profit or loss,
and communicating the result to various stakeholders such as the
management, employees, suppliers, banks,Government authorities, tax
authorities, society..etc.
Methods of Accounting:
❖ Mercantile system
❖ Cash system
❖ Cash system:
It is a method under which revenue is recognized only when it is
received. Transactions are recorded on the basis of income
received or expenses paid, rather than income earned or expenses
incurred.
Accounting Concepts:
8. Dual aspect Concept : Each transaction has a two fold effect: one is
debited and another is credited.
Classification of accounts:
Accounts
Impersonal Personal
Real Nominal
Rules
The What Comes in All Expenses and
Debit Receiver/Debtor Losses
The What goes out All Incomes and Gains
Credit Giver/Creditor
III. Extract the balances from the ledger and prepare a trial balance.
VII. Analyze the result with the help of ratio analysis, income statements,
cash flow, and fund flow statement.
It is time consuming.
It takes more time to find out the errors, if there are any in accounting
work.
1. The business grows from its small scale to large scale business
operations. Previously businesses used to operate in one city only but
now the scope has changed from one city to many cities, which
requires the sharing of accounting information for quick decision
making. Computerized accounting facilitates sharing of accounting
information across different locations of an organization.
Tally:
Tally Features:
Tally has some dominant, in-built features that are designed to meet the
needs of businesses. These features will help the user to expedite
business processes, to take quick decisions, adaptable to various
regulations etc. Tally includes the following features.
I) II) III) Iv)
Accounting Inventory Statutory
Technical
features features features
features
Accounting Features
classification of accounts
Accounting
Features A Audit trail and drill down display
Display reports
Cheque Printing
Payroll
6Groups
9 groups(capital ( revenue nature)
nature)
Primary groups which are of capital nature, show under balance sheet
include Branches/ Divisions, Capital Account, Current Assets, Fixed Assets,
Investment, Loans [Liability], MISC. Expenses[Assets], Suspense Account.
Primary groups which are of revenue nature include Direct Expenses, Direct
Income, Indirect Expenses, Indirect Income, Purchase Accounts, Sales Account
13 subgroups are classified under balance sheet include Bank Account, Bank
OCC/ Bank O/D, Cash- in- hand, Deposits (Assets), Duties and Taxes, Loans and
Advances, Provisions, Reserves and surplus ,Secured Loans, Stock in hand,
Sundry Creditors, Sundry Debtors, Unsecured Loans.
4. Display Reports:
Tally software allows the user to view reports on particular date or any
range of date. Users can view balance sheet, profit and loss account,
stock summary, ratio analysis, trial balance, day book, cash flow, fund
flow statement, receipt and payment …etc. Once the user specified
the date range, tally automatically displays these reports. The user can
compare data for any two selected years.
6. Payroll –Tally automatically calculates salaries and it also generates pay slips of
the employees.
Through receipts
And delivery notes.
3. Re-Order Levels: Tally provides the user order status reports. Based
on previous quantity consumed tally helps the user to define reorder
quantity of stock from the supplier.
6. Price lists: Tally allows the user to create multiple price lists for
multiple groups of customers. The user can generate quantity based
pricing with discount structure for various groups of customers.
Easy installation
Multi user support
Multilingual capability
Multiple platforms
Technical
Features
Tally audit
Backup and
restore Tally on the web
7. Tally Audit :Audit means to check and verify the transactions written
by the accountant. Tally also has an ‘Audit’ facility to verify and
correct the transactions entered by the user. This feature provides the
user with admin rights to check and alter the entries made by
authorized users.
8. Data migration: Tally provides a data migration tool, which helps
the user to migrate data into a latest version and continue its day to
day transactions without discontinuing the Tally.
Tally enables the user to enter data in one language and interpret
it in another language. The user can enter the data in one language
and generate the receipts, delivery notes, purchase order in any other
language.
Academic script
Manual accounting system have certain drawbacks such as it is time
consuming and a costly task, it can’t maintain the accuracy in it. It
requires employing several people to handle the accounts at different
locations. By using manual accounting system it takes a long time to
extract the data, interpret it and present it. Information that is required for
quick decisions is usually not available on time or it may be delayed.
To overcome these drawbacks Tally accounting system has been
introduced.
Tally provides accurate and timely data. It generates invoices, credit
notes and debit notes, purchase and sales order automatically. It
automatically calculates VAT figures. It supports multi currency.
It is a user friendly computerized accounting system. It is very easy to
operate and it saves time.
For learning purposes first you need to install Tally ERP 9 in educational
version. After installing Tally click on Tally icon and selection Tally in
education mode and select silver edition mode single user.
Educational version is for learning purposes only, we cannot enter all the
dates there, we can enter only 1st, 2nd, 30th,31st of the month.
Horizontal button bar: This bar includes Various short keys to print, to
language configuration, to email, to help etc.
MAILING ADDRESS : Tally allows the user to enter mailing name and
address of the company.
Once user put the mailing name and address , Tally can pick up it
and display it in any report which needs to have a company name and
address.
Ledger Creation
Voucher Creation
Display Reports
I. Create ledgers under various groups
Classification of Accounts
Tally allows the user to define account heads under various inbuilt groups
as per his requirements. Tally also offers to create new groups for more
detail categorization of account heads.
Tally offers 28 predefined groups, out of which 15 groups are primary
groups and 13 groups are subgroups. Amongst these 15 primary groups,9
groups are capital in nature show in balance sheet and 6 groups are
revenue in nature show in profit & loss account. All 13 Subgroups are
classified under 9 primary groups show under balance sheet.
Sr. Primary
No. Nature Purpose of the Group
Group
Sr. Sub
No. Nature Purpose of the Group
Group
Ledgers:
Ledgers are actual heads of Accounts. According to type of the
transaction various ledgers are to be created. Ledgers are very important
for voucher entries. In Tally, two ledgers are by default created when
user creates new company that is Profit and Loss A/c and Cash A/c.
After creating the ledger, the next step is to record the transactions in a
voucher.
VOUCHERS IN TALLY
Vouchers are used to record various day to day business transactions.
Tally has some pre-defined accounting and inventory vouchers for
different types of transactions. Each voucher is preprogrammed with
specific function. Tally allows the user to modify the vouchers as per their
business requirement.
A) Accounting vouchers
Contra Voucher : Contra voucher is used to transfer funds from one
source to another source. Example: transfer funds from one bank
account to another bank account .
Cash deposited into bank.
Cash withdrawn from bank.
Journal voucher
First you need to activate Debit Note and Credit Note Vouchers in Tally
Gateway of Tally>F11: Features>Accounting Features> Use debit not
and credit note – Yes
When our customer return some goods , it enters in Debit note voucher.
Gateway of Tally> accounting Vouchers> ctrl F8
Credit note voucher
Inventory vouchers :
Receipt note voucher: Records receipt of new stock from
suppliers
Rejections-in voucher (F8:Sales): Records return of goods
from customers.
Rejections-out voucher (F9:Purchase) Records return of
goods to suppliers
Delivery note voucher (F8:Sales)Records the delivery of
goods to customers
Stock journal voucher (F7)Records the transfer of stock from
one Location to another
Physical stock voucher (F10)Records the physical stock
count as the new stock balance.
After entering the transactions in Tally next step is to display various
reports
Reports includes:
Trial balance , press Alt+F1, will give more detail look.
Alt + F1: Details : It displays the trial balance as per sub groups
or ledger
Profit and Loss A/C: it is prepared to conclude net profit or net loss after
considering all other income and expenses incurred over a period of
time.
Academic Script:
All balances of the accounts are listed in a statement, called trial balance. It
is a summary statement of all balances. This summary of balances enables
us to check the arithmetical accuracy of the transactions recorded in the
ledger accounts. Since every debit has a corresponding credit, the total of
debits should be equal to the total of credits in the trial balance. Thus if the
trial balance agrees or tallies then the recording posting and balancing of
the accounts is said to be accurate [Tallying trial balance ensures only
arithmetical accuracy], but if it does not then it is said that there are some
errors or mistakes committed by the accountant. There can be some errors
which do not affect the Trial Balance i.e. trial balance still tallies. These
errors should be located and corrected as soon as possible so that
accounts give true and fair results of the operations of the business
enterprise.
The errors are caused while recording and posting transactions. These are
called ‘Accounting Errors’. So accounting errors are the errors committed
by persons responsible for recording and maintaining accounts of a
business firm in the course of accounting process. These errors may be in
the form of omitting the transactions to record, recording in wrong books, or
wrong account or wrong totaling and so on.
Thus Accounting errors can be defined as follows:
‘Errors mean mistakes made by an accountant or clerk while recording
business transactions in the books of accounts’.
The accounting errors can affect the trial balance in two ways-
(i) That cause the disagreement of trial balance,
(ii) That do not affect the agreement of Trial Balance.
Classification of Errors
Errors of Errors of Errors of
Compensating
Principle Omission Commission Errors
Errors of Principle:-
Items of income and expenditure are divided into capital and revenue
categories. This is the basic principle of accounting that the capital income
and capital expenditure should be recorded as capital item and revenue
income and revenue expenditure should be recorded as revenue item. If
transactions are recorded in violation of this principle, it is called error of
principle. As both the sides i.e. credit as well as debit remains affected, the
trial Balance is also not affected by such errors.
Eg.
Rs. 5000 spent on the repairs of building is debited to Building A/c while it
should have been debited to Repair to Building A/c. It is a case of error of
principle because expenditure on repairs of building is a revenue
expenditure, while it has been debited to Building A/c taking it as an item of
capital expenditure.
Thus the entries passed for the above transaction are as follow:
Wrong entry
Error of Omission:-
As a rule, a transaction is first recorded in books of accounts. However,
accountant may not record it at all or record it partially. It is called an error
of omission. There are two types of omission errors –
✓ Error of complete omission – When the transaction is totally
ignored from the original books of accounts, it is called as an error of
complete omission. Thus the error does not affect the agreement of
the trial balance.
✓ Error of partial omission – When the transaction is partially
recorded and partially omitted in the original books of accounts, it is
called as an error of partial omission. This error affects the agreement
of the trial balance.
E.g.
✓ Goods of Rs.8000 purchased on credit form Mr. Anil are not
recorded in Purchases Book.
In this case it is a complete omission. Therefore, both debit and
credit are affected by the same amount. Therefore, it does not affect
the Trial Balance.
Rectification entry
Error of Commission –
When the transaction has been recorded but an error is committed in the
process of recording, it is called an error of commission. Error of
commission can be of the following 5 types:
Types of Errors of
Commission
Wrong Recording –
Errors committed while recording a transaction in the Special Purpose
books are called as wrong recording.
Eg. –
✓ Purchase of goods from Mr. Rakesh on credit for Rs.10,000 is
recorded in the Sales Book and not in the Purchases Book.(it is a
recording error.)
It is a two sided error. So the same amount is debited and credited
so the trial balance will not be affected.
Wrong entry
Cancellation entry
Rectification entry
Wrong entry
Wrong Totaling –
There may be a mistake in totaling Special Purpose Book or accounts. The
totaled amounts may be less than the actual amount or more than the
actual amount. The former is a case of under-casting and the latter of over-
casting. It is a case of an error affecting one account; hence it affects the
trial balance.
Eg.
✓ The total of Purchases Book is written as Rs.44800 while the actual
total is Rs. 44300.
As the total of the Purchase Book has overcast by Rs. 500 so it
should be shown less. No journal is required just the purchase
account should be credited by Rs.500.[Please note that journal
entry is required in this case, please refer to standard book and
give the correct entry]
Wrong Balancing –
While closing the books of accounts at the end of the accounting
period, the ledger accounts are balanced. Balance is calculated of the
totals of the two sides of the account. It may be wrongly calculated. This
error is called as wrong balancing error. It affects one account only;
therefore the Trial Balance gets affected.
Eg.
✓ The total of the debit column of Mohan’s A/c is Rs.8600 and that of
the credit column is Rs.6800. The balance calculated is Rs.1600
while the actual balance is Rs.1800.
No journal entry is required as the balance of Mohan’s A/c is
under-cast so, Mohan’s A/c will be credited by Rs.200 to rectify
the error.
Wrong Posting –
Transactions from the journal or special purpose books are posted to the
respective accounts in the ledger. Error may be committed while carrying
out posting. It may take various forms such as, posting to wrong account, to
the wrong side of the account or posted twice to the same account. Such
error is called as wrong posting error. In the above examples, only one
account is affected because of the error; therefore ,the Trial Balance
is also affected.
Eg.
Goods purchased of Rs.5400 from Rajesh Mohanti was posted
to the debit of Rajesh Mohanti’s A/c.
No journal entry is required. The debit entry is the wrong entry,
so the debit entry needs to be cleared and then the actual credit
needs to be given. Thus Rajesh Mohanti’s A/c will be given a
double credit of the amount of Rs.5400 (i.e. 10,800).
Compensating Errors –
Two or more errors when committed in such a way that there is an
increase or decrease in the debit side due to an error, also there is
corresponding decrease or increase in the credit side due to another error
by the same amount. Thus, the effect on the account is cancelled out. Such
errors are called compensating errors.
As the debit amount and the credit amount are equalized, such errors do
not affect the agreement of Trial Balance, but the fact remains that there is
still an error.
Eg.
Sohan’s A/c is debited by Rs 2500 while it was to be debited by
Rs 3500 and Mohan’s A/c is debited by Rs 3500 while the
same was to be debited by Rs 2500. Thus excess debit of
Mohan’s A/c by Rs.1000 is compensated by short credit of
Sohan’s A/c by Rs.1000.
As the debit amount and the credit amount are equalized,
such errors do not affect the agreement of the Trial Balance,
but the fact remains that there is still an error.
No journal entry is required; thus for the rectification of the error
Sohan’s A/c will be debited by Rs.1000 and Mohan’s A/c
credited with Rs.1000.
Rectification entry
The suspense account will disappear after the preparation of the final
accounts.
Illustrations –
1. Pass journal entries to rectify the errors –
a) Sales book is over-cast by Rs.500.
b) Factory light bill Rs. 9000 paid but recorded twice in the books.
c) Rent paid of Rs.725 was wrongly recorded as Rs.275 in the
rent account.
d) Total of purchase book under-cast by Rs.850.
e) Wages paid for the extension of the building Rs.8900 was
charged to wages account.
f) Cash received from Manali Rs.1800 was recorded on the
payment side of the cash book.
g) Carriage paid for the purchase of machinery Rs.3100 was
charged to the carriage account.
h) LIC premium of the proprietor paid Rs.1650 debited to
insurance account.
Solution –
Sr. Particulars L.f. Debit Credit
no amount amount
Dr. represents the debit side of the bank pass book. It is the
side where all the payments are recorded while Cr. represents
the credit side. It is the receipt side.
20,000 20,000
20,000 20,,000
18000 18000
22,000 22,000
10,000 10,000
8000 8000
8000 8000
The bank charges are debited by the bank from the Bank
Pass Book of the company but the company is not
intimated about the same on the date of the transaction.
Thus the company does not credit the bank charges
amount till the month end. So there is a difference in the
balances of the two bank books.
90000 90000
80000 80000
Eg:- The opening balance of the Bank Cash book and the
Bank pass book of a company on 1st March 2015 was Rs.
80,000. The company’s bank account is debited with Rs.
15,000 on 12th March 2015 according to the standing
instructions given by the company to the bank for the
payment of insurance premium.
If this is a situation then its reflection in the two bank
books at the month end will be as follows:-
Bank Pass Book
Dr.
Cr.
Date Payment Amount Date Receipts Amount
80,000 80,000
80,000 80,000
30,000 30,000
30,000 30,000
The cheque deposited by the debtor is shown as a receipt
by the company in the Bank cash book, but as it is
dishonored the Bank Pass book balance does not increase.
The bank nullifies the transaction by passing a debit as
well as a credit transaction. The company gets the
intimation and then nullifies the transaction, till then there
is a difference in the balances of the two Bank books.
25,000 25,000
25,000 25,000
15,000 15,000
25,000 25,000
15,000 15,000
The actual balance in the bank is Rs. 15,000 but the bank
accountant has wrongly deposited a cheque of Rs.10,000.
This transaction is not related to the company and thus
the balance seems to be on a higher side. Thus, till the
bank rectifies the wrongly credited entry, there will be a
difference in the balances of the two bank books.
Academic Script
Preparation of Bank Reconciliation statement
The cash book and the pass book have two types of balances.
The favourable balance of the cash book is on the debit side
and indicates excess cash over the expenses. But an overdrawn
balance is indicated on the credit side of the cash book and
indicated that the company has overdrawn cash form bank as
its expenses are exceeding its receipts. Similarly the pass book
also has a favourable balance which is indicated on the credit
side, indicating excess cash over the expenses. The overdrawn
balance is written on the debit side which shows the overdraft
taken by the client i.e. expenses are exceeding its receipts.
These balances help in the preparation of the BRS.
The BRS is prepared in a specific format.
If the BRS starts with the balance from the bank pass book, it
ends with balance from the cash book and if the statement
starts with the balance from the cash book, it ends with the
balance from the pass book.
When the starting balance is positive and the ending balance
comes negative, it is termed as an overdrawn balance, but if
the statement starts with an overdrawn balance and the
residual balance is negative, it will be termed as the favourable
balance.
Thus we may have four different situations while preparing the
bank reconciliation statement. These are:
1. When debit balance (favourable balance) as per cash book
is given and the balance as per passbook is to be
ascertained.
2. When credit balance (favourable balance) as per passbook
is given and the balance as per cash book is to be
ascertained.
3. When credit balance as per cash book (unfavourable
balance/overdraft balance) is given and the balance as per
passbook is to be ascertained.
4. When debit balance as per passbook (unfavourable
balance/overdraft balance) is given and the cash book
balance as per cashbook is to be ascertained.
Solution :-
Bank Reconciliation Statement as on 31st March 2015
Particular Amount
Add :-
Less :-
Working notes:-
Bank Cash Book
Ch. issued but not 60,000 Ch. Deposited but not 60,000
collected en-cashed
Illustration 2
From the following particulars of Anil & Co. prepare a bank
reconciliation statement as on August 31, 2014.
1. Balance as per the cash book Rs. 54,000.
2. Rs. 100 bank incidental charges debited to Anil & Co.
account, which is not recorded in cash book.
3. Cheques for Rs. 5,400 is deposited in the bank but not yet
collected by the bank.
4. A cheque for Rs. 20,000 is issued by Anil & Co. not
presented for payment.
5. A direct payment of Rs.3500 made by the bank for insurance
premium, which is not recorded in the cash book.
6. Bank credited Rs. 7500 as interest on investment.
Solution :-
Bank Reconciliation Statement as on 31st March 2015
Particular Amount
Add :-
Working notes :-
Bank Cash Book
Ch. issued but not 20,000 Ch. Deposited but not 5400
collected collected
Illustration 3
From the following particulars of Anil & Co. prepare a bank
reconciliation statement as on April 30, 2015.
1. Balance as per Pass Book is Rs.9214.
2. Bank credited a sum of Rs.1650 by mistake.
3. Cheque of Rs.4500 issued on 26th April 2015 presented for
payment on 4th May 2015.
4. As per the standing instructions the bank transferred
Rs.1700 for the loan installment.
5. A cheque of Rs.6000 received, deposited and credited in
the bank was wrongly recorded in the cash column of the
cash book.
6. Cheques of Rs.9500 were deposited in the month of April
but only cheques of Rs.6000 were cleared till the month
end.
Solution :-
Bank Reconciliation Statement as on 30th April 2015
Particular Amount
Add :-
Less :-
Illustration 4
On 31st Dec 2014 the Pass book had a credit balance of
Rs.10,000. From the following find out the balance as per cash
book.
1. The cheques of Rs.4000 were deposited with the bank on
27th December but were en-cashed on 5th January.
2. Bank directly paid the electricity bill of Rs.950.
3. The cheque of Rs.1500 was issued but not collected.
4. The dividend of Rs.4500 was directly deposited in the
bank account.
5. Bank charges of Rs.150 have been charged by the bank.
6. The debit side of cash book was under cast by Rs. 100
Solution :-
Bank Reconciliation Statement as on 31st December 2014
Particular Amount
Add :-
Less :-
Working notes:-
Bank Cash Book
Solution:-
Bank Reconciliation Statement as on 30th April 2015
Particular Amount
Add:
Working notes:-
Bank Cash Book
Illustration 6
The cash book showed an overdrawn balance of Rs.32750 on
30th November. Prepare a bank reconciliation statement on the
date.
1. On 22nd November cheques of Rs.6500 were sent to bank
for collection, but till date only a cheque of Rs.1300 was
credited in the bank.
2. On 25th November cheque of Rs.4,000 was issued but
was collected form bank on 5th December.
3. The bank has charged Rs.2,000 towards interest on bank
overdraft and also has charged Rs.600 towards bank
charges.
4. Credit side of Bank cash book is under cast by Rs.100
5. Cheque for office expenses of Rs.2,000 issued but not
collected till date.
6. Cheque of Rs.1000 was issued to a creditor and was
collected before 30th November, was omitted from the
bank cash book.
7. Dividend of Rs. 5000 was directly collected in the bank.
Solution:-
Bank Reconciliation Statement as on 30th April 2015
Particular Amount
Add:-
Less:-
Working notes:-
Bank Cash Book
Academic Script
Consignment
Commission
Academic Script:
VI. Amount received from debtors when the goods are sold
on credit
Date Particulars L.F. Debit Credit
Bank Account -------------Dr
To Consignment Debtors
Account
[Being the amount received
from consignment debtors ]
Total Total
ii. Consignee’s Account: This is personal account and is opened
as given below.
Consignee’s Account
Dr Cr.
Particulars Amount Particulars Amount
To consignment A/C By Bank/Bills
– Sales Receivable A/c –
advance
By Consignment A/c
– expenses
By Consignment A/c
– commission
By Bank A/c or
Balance c/d
Total Total
Consignor’s Account
Dr. Cr.
Particulars Amount Particulars Amount
To Bank A/c/Bills By Bank – Cash
Payable A/c - sales
Advance By Consignment
To Bank A/c – Debtors A/c – Credit
expenses sales
To Commission A/c – By Bank –
commission on Settlement of
consignment account
Or
By Balance c/d [In
case the account is
not settled, the
balance will be
carried forward
Total Total
Illustration 1
Shri Mahendra of Chennai consigned 300 kg of raw material at
Rs.2000 per kg to Shri Chakravarti of Kanpur paying freignt of
Rs.4000 and other expenses Rs.2000. Shri Chakravarti sold 250
kg at Rs.2500 per kg on credit and 25 kg at Rs.2200 per kg for
cash. Shri Chakravarti spent for freight Rs.3000 and other
expenses [godown rent] of Rs.1000. Shri Chakravarti remitted the
amount due to Shri Mahendra after deducting his commission at
5% [normal], 2.5% overriding and ½% del credere. [del credere
commission is to be given on total sales] Shri Chakravarti found
that one customer to whom credit of 40 days was allowed paid
only Rs.4800 out of the total amount due from him Rs.5000 in full
settlement of account. Other customers paid the amount on due
dates.
You are required to pass journal entries in the books of the
Consignor and Consignee. Also show Consignment Account in the
books of the Consignor.
Journal Entries in the books of Mahendra: [Consignor]
Date Particulars L.F. Debit [Rs.] Credit [Rs.]
2016
01 Consignment A/c --------------Dr 6,00,000
To Goods sent on Consignment 6,00,000
A/c
[Being 300 kg of raw material sent
to Kolkatta @ Rs.2000 per kg]
02 Consignment A/c ---------- Dr 6,000
To Bank A/c 6,000
[Being the expenses, i.e. freight
Rs.4000 and other expenses
Rs.2000 paid by the consignor]
03 Consignment A/c ---------Dr 4,000
To Chakravarty’s A/c 4,000
[Being the expenses, i.e freight
Rs.3000 and other expenses, i.e.
godown rent Rs.1000 paid by the
consignee, i.e. Chakravarty]
04 Chakravarty’s A/c ---------Dr 6,80,000
To Consignment A/c 6,80,000
[Being the sales of the material by
the consignee, i.e. Chakravarty]
05 Consignment A/c ------------Dr 54,400
To Chakravarty’s A/c 54,400
[Being commission payable to
Chakravarty as per following
details]
5% on Rs.6,80,000= Rs.34,000
2.5% on Rs.6,80,000 = Rs.17,000
½% on Rs.6,80,000 = Rs. 3,400
Total: Rs.54,400
To D’s A/c-
Commission
Ordinary: 10,125
3% of
Rs.225000
=
6750 12,032
Del credere
1.5%
Rs.225000
=
3350
Academic Script
Illustration:
Aditya and Amit entered into a joint venture to buy and sell goods for
festival purpose. They opened a Joint Bank Account. Aditya deposited
Rs.2,00000 and Amit Rs.1,50,000 in the joint bank account. Aditya supplied
goods worth Rs.25000 and Amit supplied decoration material worth
Rs.15000.
Dr Amit’s A/c Cr
II. When separate books are not kept: In this method, there are no separate
books maintained. Each co-venturer maintains books of accounts in his
own books. The following accounts will be maintained by each co-venturer
in his books.
i. Joint Venture Account: The main objective of this account is to find out the
profit or loss arising out of the joint venture business. This account is a
nominal account and the profit or loss is ultimately transferred to the Profit
and Loss Account.
ii. Each Co-venturer’s Account: Each co-venturer opens personal account of
the other co-venturer in his books. Thus, if there are two co-venturers i.e. A
and B, A will open B’s Account in his books while B will open A’s Account in
his books. The objective of opening this account is to find out the amount
receivable from or payable to the concerned co-venturer.
The journal entries in the books of each co-venturer’s books are given
below:
For the sake of understanding, we assume that there are two co-venturers,
A and B undertaking a joint venture business. The journal entries shown
below are in the books of both the parties, i.e. A and B:
Sr.No Particulars A’s books B’s books
01 Goods supplied by A Joint Venture Joint Venture A/c
and expenses paid by A/c Dr Dr
A To Goods A/c To A’s A/c
To Cash/Bank [Being the goods
A/c supplied by A
[Being the goods and expenses
supplied by A paid by him]
and expenses
paid by him]
02 Goods supplied by B Joint Venture Joint Venture A/c
and expenses paid by A/c Dr Dr
B To B’s A/c To Goods A/c
[Being the goods To Cash/Bank
supplied by B A/c
and expenses [Being the goods
paid by him] supplied by us
and expenses
paid]
03 Advance given by A to B’s A/c Dr Cash/Bank A/c
B or bill accepted by A To Cash/Bank Dr
A/c B/R A/c Dr
To B/P A/c To A’s A/c
[Being advance [Being advance
given to B by us] received from A]
04 Sale proceeds received Cash/Bank A/c A’s A/c Dr
by A Dr To Joint Venture
To Joint Venture A/c
A/c [Being sale
[Being the sale proceeds
proceeds received by A]
received by us]
Illustration:
John and Smith entered into a joint venture business to buy and sell
garments to share profits or losses in the ratio of 5:3. John supplied 400
bales of shirting @ Rs.500 each and also paid Rs.18000 as carriage and
insurance. Smith supplied 500 bales of suiting @ Rs.480 each and paid
Rs.22000 as advertisement and carriage. John paid Rs.50000 as advance
to Smith. John sold 500 bales of suiting @ Rs.600 each for cash and also
all 400 bales @ Rs.650 each for cash. John is entitled to a commission of
2.5% on total sales plus an allowance of Rs.2000 for looking after the
business. The joint venture was closed and the claims were settled.
You are required to pass journal entries in the books of John and Smith.
Solution:
Dr Smith’s A/c Cr
24000
Total 286000 Total 286000
Journal Entries in the books of Smith
Academic Script
Illustration:
John and Smith entered into a joint venture business to buy and sale
garments to share profits or losses in the ratio of 5:3. John supplied 400
bales of shirting @ Rs.500 each and also paid Rs.18000 as carriage and
insurance. Smith supplied 500 bales of suiting @ Rs.480 each and paid
Rs.22000 as advertisement and carriage. John paid Rs.50000 as advance
to Smith. John sold 500 bales of suiting @ Rs.600 each for cash and also
all 400 bales @ Rs.650 each for cash. John is entitled to a commission of
2.5% on total sales plus an allowance of Rs.2000 for looking after the
business. The joint venture was closed and the claims were settled.
You are required to pass journal entries in the books of John and Smith.
Solution:
Dr Smith’s A/c Cr
24000
Total 286000 Total 286000
Books of Ram:
Dr Mohan In Joint Venture A/c Cr
Particulars Amount Particulars Amount
[Rs.] [Rs.]
To Bank: By Bills Receivable 1,00,000
Purchases: 100000 By Bank A/c
Freight: 6000 [Balancing figure] 50,000
Insurance: 2000
1,08,000
To Discount: 3,000
To Profit & Loss A/c
39,000
Total 1,50,000 Total 1,50,000
2. A and B decided to work a joint venture for the sale of electric motors. On
21st May 2007, A purchased 200 electric motors at Rs.1750 each and
dispatched 150 motors to B incurring Rs.10000 as freight and insurance
charges. Ten electric motors were damaged in transit. On 1st February
2008, Rs.5000 were received from the Insurance company by A in full
settlement of his claim. On 15th March 2008, A sold 50 electric motors at
Rs.2250 each. He received Rs.1,50,000 from B on 1st April 2008.
On 25th May 2007, B took delivery of the electric motors and incurred the
following expenses. Clearing charges Rs.1700, Repair charges for motors
damaged in transit Rs.3000, godown rent Rs.6000. He sold the electric
motors as shown below.
1/2/2008: 10 damaged motors at Rs.1700 each
1/2/2008: 40 motors at Rs.2000 each
15/3/2008: 20 motors at Rs.3150 each
1/4/2008: 80 motors at Rs.2500 each.
It is agreed that they are entitled to a commission at 10% on the respective
sales effected by them and that the profits or losses are to be shared by A
and B in the ratio of 2:1.
B remits the balance due to A on 30th April 2008
Prepare Memorandum Joint Venture Account and Joint Venture with B
Account in the books of A.
The accounts to be opened in this case are shown below.
Dr Memorandum Joint Venture A/c Cr
Particulars Amount Particulars Amount
Rs. Rs.
To A: cost of motors 350000 By A: insurance
To A: freight & company 5000
insurance 10000
To B: clearing charges By A: Sale
To B: Repair charges 1700 proceeds of 50
To B: Godown rent 3000 motors [50 X 2250] 112500
To A: Commission 6000 By B: sale
To B: Commission 11250 proceeds of 150
To profit: 36000 motors - B 360000
A: 39700
B: 19850
59550
Total 477500 Total 477500
In the books of A:
Academic Script
*The goods are sent at invoice price which is cost price plus 25%. Thus the
amount of this entry is Rs.40000 which is the invoice price.
**The loading on goods returned by the branch is calculated as under.
Invoice price of goods returned by branch Rs.5,000. The loading is
Rs.5000 X 1/5th = Rs.1000
*** Loading on Closing Stock is calculated as under.
Invoice price of closing stock = Rs.15,000. Loading Rs.15000 X 1/5th =
Rs.3000
****Loading on Opening Stock: Invoice price of opening stock Rs. 12,500.
Loading = Rs.12,500 X 1/5th = Rs.2,500
***** Loading on Goods sent to Branch: Invoice price of goods sent
Rs.40,000. Loading Rs.40000 X 1/5th = Rs.8000.
Stock and Debtors System
1. Introduction: Where there are large number of transactions, this method is
particularly maintained by the Head Office to make efficient control over the
branches. Under this method the accounts to be opened are,
a) Branch Stock A/c [At invoice price]
b) Branch Debtors A/c
c) Branch Adjustment A/c [For recording loading for goods and for
ascertaining gross profit]
d) Branch Profit and Loss A/c [For ascertaining branch net profit]
e) Goods sent to Branch.
In addition to above, there are certain accounts which may also be opened
viz. a) Branch Expenses A/c b) Branch Cash A/c. c) Branch Cash A/c
d)Abnormal loss/Lost in transit A/c
Under this method, the most important account is the Branch Adjustment
Account which helps to ascertain Gross Profit. It takes only the loading on
Opening Stock, Closing Stock, Goods sent to branch, Goods returned by
Branch, any abnormal loss, surplus of stock etc.
Illustration:
M Stores Ltd Delhi, has its branches at Lucknow and Chennai. It charges
goods to its branches at cost plus 25%. Following information is available
of the transactions of the Lucknow Branch for the year ended 31st March
2016
Show the following accounts in the books of the M Stores Ltd. a) Lucknow
Branch Stock A/c b) Lucknow Branch Debtors A/c c) Lucknow Branch
Adjustment A/c d) Lucknow Branch Profit and Loss A/c e) Stock Reserve
A/c
48,500
1,70,000
14,000
Total 1,85,000 Total 1,85,000
9,700
Total 71,000 Total 71,000
Academic Script
Introduction
Depreciation is basically accounting contentions before proceed towards
depreciation, it is must that to understand convention. The term
‘convention’ includes customs or tradition, which guides the accountant
while preparing the accounting statements.
According to Finny & Miller, “assets are future economic benefits, the
rights, which are owned or controlled by an organization or individual.
It refers to those fixed assets which can be seen & touched e.g. Land &
building, plant & machinery etc. and rest of Intangible assets.
The term depreciation is derived from the Latin words ‘do’ meaning
down and ‘pretium’ meaning price. In common use it means patting
down the value of an asset due to wear and tear, passage of time etc
AS-6 recognises both the straight line and the straight line and the
written down value method of depreciation. However, according to the
standard, the appropriate method of depreciation must be selected
based on type of assets, the nature of the use of asset and the
circumstances prevailing in the business.
AS-6 specifies that the depreciation method selected must be applied
consistently from period to period. The method of charging of
depreciation may be changed only i9f such change is required by statute
or for compliance with an accounting standard or if it is considered the
change would result in a more appropriate preparation or presentation of
financial statements of the enterprise.
1. Tangible assets:
(i) Land None
(ii) Plant, Building, equipment tools,
furniture, fixtures, vehicles. Depreciation
(iii) Natural resources such as oil, timber,
coal, mineral deposits. Depletion
2. Intangible assets such as patent, copyrights,
trademarks, goodwill Amortisation
Among the above assets, land is a tangible asset that has an
indefinite or unlimited useful life. Therefore, it is not subject to
depreciation or periodic write off to expenses.
Types of depreciation
1) Straight line method.
2) Diminishing value method.
3) Annuity method
4) Machine hour rate method.
5) Revaluation method
6) Sum-of-the year digits method
7) Insurance policy method
8) Depletion method.
3) Annuity method
Under annuity method of depreciation the cost of asset is
investment & interest at fixed rate is calculated thereon.
Proprietor had interested outside the business, an amount equal
outside the business, an amount equal to the cost of asset, he
would have earned some interest.
Annuity method is particularly applicable to those assets whose cost
is heavy and life is long & fixed.
E.g. leasehold property, land & building etc.
5) Revaluation method.
Under revaluation method of depreciation, the assets are revalued
each year. The method is normally adapted to charge depreciation
on numerous inexpensive fixed assets like small tools, live stock,
patents, copy rights and other assets of such nature which are
constantly changing and their period of life is most uncertain under
this method, where the life of the asset is uncertain depreciation
cannot be calculated ordinarily, the asset is revalued at the balance
the book of the asset and the revalued figures is considered as
depreciation (appreciated value is not taken into account) the
valuation should be under ‘going concern’ basis.
6) Sum of the year’s digits method
This method involves calculating depreciation based on the sum of
the number of years in assets useful life.
Sum of the year’s digits method, like reducing balance method, is a
type of accelerated depreciation technique that allocates higher
depreciation expense in the earlier years of an assets useful life.
Calculation of depreciation under this method can be following-4
Step-1- Calculate the sum of the years digits in an assets useful life.
Step-2- Calculate the depreciable amount
Step-3-Calculate the un- depreciated useful life.
Step-4-Calculate depreciation using the sum of year’s digits &un-
depreciated useful life.
Depreciation expense= un-depreciated useful life (step3)/sum of the
year’s digits (step1) ×depreciable amount (step2)
Or
The number of years (including the present year) of remaining life of
asset/Total of all digits of the life of the assets (In years)
7) Insurance policy method
This method is similar to sinking fund method However instead of
investing amount to the extent of depreciation in the outside
securities; an insurance policy is taken for the value of the asset. A
fixed premium is paid on such policy, the insurance of fixed asset. If
our fixed asset will become dead before its working life, we can get
full amount for buying new fixed assets.
There is no higher return on insurance sector is only disadvantage
of this method.
8) Depletion method.
Depletion is a periodic charge to expense for the use of natural
resources. Thus it is used in situations where a company has
recorded an asset for such items as oil reserves, coal, deposits, or
graves pits. The calculation of depletion involves these steps:
1) Compute a depletion base
2) Compute a unit depletion rate
3) Charge depletion based on units of usage.
The resulting net carrying amount of natural resources still on the
books of a business do not necessarily reflects the market value of
underlying natural resources. Rather, the amount simplify reflects an
ongoing reduction in the amount of the original recorded cost of the
natural resources of the natural resources.
In simple term, depreciation is that port of the original cost of a fixed
asset that is consumed during period of use by the business. The
annual charge to profit and loss account statement for depreciation
based on estimate of how much of the overall economic use fullness
of a fixed asset has been used up in that accounting period.
Causes of depreciation.
Causes of
depreciation.
B) Economic factors:-
These may be said to be the reasons for an asset being put out of
use even through it is in good physical condition. The two main
factors are usually obsolescence and inadequacy.
1) Obsolescence:-
This is the process of becoming out of date. For example,
over the years there has been great progress in the
development of synthesizers and electronic devices used by
leading commercial musicians. The old equipment will therefore
equipment and use it, possibly because they cannot afford to
buy new up- to- date equipment.
2) Inadequacy:-
This arises when an asset is no longer used because of the
growth and changes in the size of the business.
For example,
A small ferryboat that is operated by a business at a coastal
resort will become entirely inadequate when the resort becomes
more popular. Then it will be found that it would be more
efficient and economical to operate a large ferryboat, and so the
smaller boat will be put out of use by the business. In this case
also it does not mean that the ferryboat is no longer in good
working order, or that it is obsolete. In may be sold to a
business at a smaller resort.
D) Depletion:-
Other assets are of wasting character, perhaps due the extraction of
the raw materials from them. These materials are then either used
by business to make something else, or are sold in their raw state to
other businesses.
Natural resources such as mines, quarries and oil wells come under
this heading. To provide for the consumption for an asset of a
wasting character is called provision for depletion.
Objects of Providing Depreciation and Factors Affecting Depreciation
Academic script
Introduction
Depreciation is an annual deduction that businesses can claim for the cost
of fixed assets, such as vehicles, buildings, machinery, and other
equipment. According to tax law, depreciation is defined as a reasonable
deduction for the wearing down and or obsolescence of those fixed assets.
It is included on income statements as an expense for accounting
purposes.
The cost of assets that are totally consumed within an accounting period
will be recognized as an expense within that period. When an asset is not
totally consumed within a single accounting period as is typically the case
with fixed assets the cost of the asset must be allocated as an expense
over the periods in which the asset is consumed. Depreciation arises from
this attempt to assign asset cost to the periods of asset consumption. The
depreciation for an asset in a period is simply an estimate of the portion of
the original cost to be assigned as an expense to the period. A similar
concept is depletion, which is applied to the extraction of natural resources
in recognition of the fact that a certain part of the natural resource has been
consumed during a given period.
1. Historical cost
2. Expected useful life of the assets and
3. Estimated residual value of depreciable asset.
AS-6 recognises both the straight line and the straight line and the
written down value method of depreciation. However, according to the
standard, the appropriate method of depreciation must be selected based
on type of assets, the nature of the use of asset and the circumstances
prevailing in the business.
1. Tangible assets:
(i) Land None
(ii) Plant, Building, equipment tools,
furniture, fixtures, vehicles. Depreciation
(iii) Natural resources such as oil, timber,
coal, mineral deposits. Depletion
2. Intangible assets such as patent, copyrights,
trademarks, goodwill Amortisation
Among the above assets, land is a tangible asset that has an indefinite
or unlimited useful life. Therefore, it is not subject to depreciation or
periodic write off to expenses.
Problems:
Disposal
1. Measurement of cost 2. Determination and Allocation of 4. Recording of gain or
to be written off over consumed cost of assets to periods loss on disposal.
the asset’s life. benefitted.
Some costs associated with the acquisition of an assets are not added
to the cost of asset, if they are found not necessary to get the asset ready
for use and therefore, do not increase asset’s usefulness. Expenditures
resulting from carelessness or errors in installing the asset, from vandalism
or from other unusual occurrences do not increase the usefulness of the
assets and should be treated as expenses.
If a debt is incurred for the purchase of the asset, the interest charges
are not the cost of the asset but are the cost of borrowing money to
purchase the asset. They are therefore an expense for the period. But
interest incurred during the construction period of an asset are treated as
part of the cost of an asset.
The cost of land includes not only the negotiated price but also other
expenditures such as broker’s commissions, title fees, surveying fees,
Lawyer’s fees, accrued taxes paid by the purchaser, assessment for local
improvements such as streets and sewage systems, cost of draining,
clearing, leveling, and grading. Any salvage recorded from the old building
will be deducted from the cost of the land.
When a business constructs its own buildings, the cost includes all
reasonable and necessary expenditures such as those for materials,
labour, some related overhead and indirect costs, architects’ fees,
insurance during construction, interest on construction loans during the
period of construction, lawyer’s fees. If outside contractors are used in the
construction, the net contract price plus other expenditures necessary to
put the building in usable condition are included.
Factors that affect the Computation of Depreciation :
The useful life of a depreciable asset is shorter than its physical life and is:
Since the estimated useful life of the asset is determined at the time
of acquisition, it may become necessary to revise the estimate after a
period of usage. According to AS 6, when the original estimated useful life
is revised, the unamortized depreciable amount of the asset is charged to
revenue over the revised remaining useful life. Another method to be
adopted for taking into account the revised life of the asset is to recompute
the aggregate depreciation charged to date on the basis of the revised
useful life of the asset and to adjust the excess or short depreciation so
determined in the accounting period of revision.
There are several methods of allocating depreciation over the useful life
of the assets. Those most commonly employed in industrial and
commercial enterprise are the straight line method and the reducing
balance method. The management of a business selects the most
appropriate method (s) based on various important factors, e.g., (i) type of
asset, (ii) the nature of the use of such asset and (iii) circumstances
prevailing in the business. A combination of more than one method is
sometimes used. In respect of depreciable asset which do not have
material value, depreciation is often allocated fully in the accounting period
in which they are acquired.
1. Legal Provisions:
For tax purpose, the asset would be written off as quickly as possible.
Of course, a firm can deduct only the acquisition cost, less salvage value,
from otherwise taxable income over the life of the asset. Earlier deductions
are, however, worth more than later ones because a rupee of taxes saved
today is worth more than a rupee of taxes saved tomorrow. That is, the
goal of the firm in selecting a depreciation method for tax purpose should
be to maximize the present calue of the reductions in tax payments from
claiming depreciation. When tax rates remain constant over time and there
is a flat tax rate (for example, income is taxed at a 40% rate), this goal can
usually be achieved by maximizing the present value of the depreciation
deductions from otherwise taxable income.
2. Financial Reporting:
Depreciation and its financing effect take the less basic but still
realistic approach that, regardless of any effect which depreciation may
have upon the total revenue stream, the recognition of depreciation either
through the cost of product or as an element in administration and
marketing expenses, does cut down the showing of net income available
for dividends and thus restricts the outflow of cash. The actual tax saving
argument is sometimes short sighted, but the saving of interest and the
increased financial flexibility are actual and constitute the real pressure
behind depreciation accounting. Business managers consider these points,
but they have the added responsibility of protecting management against
the possible distortions of reported cost and misleading incomes which
these pressures might engender.
4. Inflation:
5. Technology:
But the critical question is, when exactly does the time for replacement
come? Life of machine, is no longer an engineering concept. Many
electronic companies in USA had to write off their assets in three years
because new technologies came in and old machines overnight became
scrap. Commercial life of machines is decided by technologies progress.
The arrival of new machines is not governed by the depreciation policies of
government. Therefore, the shorter the period over which the enterprise is
able to recover depreciation, the better its chances to adapt to the new
technological progress, a fixed depreciation rate is the surest way to force it
into bankruptcy.
6. Capital Maintenance:
Depreciation should be charged from the date when the asset is available
for use even if the entity decides to use it later. An asset is available for use
when it is in the location and condition necessary for it to be capable of
operating in the manner intended by the management. Depreciation should
be provided on fixed assets, which were not in use during the financial
year. Idleness of a fixed asset might increase its useful life. This might
result in charging lower depreciation in subsequent years.
A suitable depreciation policy should be adopted by taking into account the
original investment recovery, rate of return of investments, funds for
replacement, tax benefits, true profits for the current year, nature of asset,
mode of recording the depreciation, government regulations, changes in
price levels etc. Depreciable assets are classified according to tangible and
intangible fixed assets. Tangible fixed assets are those assets having real
existence. Intangible fixed assets have no real existence. Tangible fixed
assets include Land and Building, Plant and Machinery, Furniture and
fixtures, Vehicles, Mines and oil fields (Natural Resources) etc. Intangible
assets include Patents, copyrights, Goodwill, Trademarks, Leasehold
property, preliminary expenses, Capital Losses etc.
Academic Script
Of all these methods first two methods are commonly used in practice.
Demerits:
Though simplest of all other methods, it is not popular because:
i) This method does not consider the effective utilization of the asset.
The same amount of depreciation is charged from year to year
irrespective of the use of the asset.
ii) The book value of the asset may appear to be zero though it may
still be existing even after the expiry of its effective life.
iii) Total burden on profit and loss account of depreciation together
with repairs and renewals is not only heavy but also
disproportionate over the effective life of the asset. The total
charge for the use of the asset i.e. depreciation and repairs goes
on increasing from year to year though the asset might have been
used uniformly from year to year.
For example, in the initial years, the amount spent on repairs and
maintenance will be quite normal. It goes on increasing in the later
years. The amount of depreciation remains the same for each
year. Thus, each subsequent year is burdened with grater charge
for the use of the asset on account of increasing cost of repairs.
iv) This method tends to report an increasing rate of return on
investment in the asset on account of the fact that the net balance
of the asset account is taken.
v) In case of any additions or extensions to the asset and in case
effective life of such additions is not the same as that of the
original asset; calculations are to be made separately and
independently.
Scope of Application:
This method can conveniently be applied in –
i) Where the life time and break-up value of the asset can be
estimated more accurately.
ii) Where the repairs and renewals are more or less uniform or
comparatively small. This is possible in case of assets like
Patents, Short Lease and Furniture etc. This method is not
appropriate for Plant and Machinery because of its heavy repairs
and uncertain life.
b) Depletion method:
This is also known as productive output method. According to this
method, the charge for depreciation with respect to the use of an
asset will be based on total amount paid, total estimated quantities of
output available an actual quantity taken out during the accounting
year. This method is suitable in case of mines, quarries etc., where it
is possible to make an estimate of the total output likely to be
available. Depreciation is calculated per unit of output. The amount
depreciation to be charged to a particular year is computed by
multiplying the units of output with the rate of depreciation per unit of
output.
For example, a mine purchased for Rs. 20,000/- with the total
quantity of mineral in the mine estimated at 40,000 tonnes, the rate of
depreciation per tonne would amount to 50 paise per tonne (Rs.
20,000/40,000 tonnes). In case the output in a year amounts to
10,000 tonnes, the amount of depreciation to be charged to the Profit
and Loss Account would be Rs. 5,000 (i.e. 10,000 tonnes × Re.0.50).
This method has the advantage of correlating the amount of
depreciation with the productive use of the asset. However, it requires
making a reasonably correct estimate of the output likely to be there.
In the absence of such a correct estimate, the amount charged by
way of depreciation will not be correct.
For example, if the cost of an asset is Rs. 20,000 and the rate of
depreciation is 10%, the amount of depreciation to be charged in the
first year will be a sum of Rs. 2,000. In the second year, depreciation
will be charged at 10% on the book value of the asset, i.e. Rs.
18,000/- (Rs.20,000- Rs.2,000), and so on.
The formula for calculating the rate of depreciation under the
diminishing balance method is
Merits
i) The method puts an equal burden for use of the asset on each
subsequent year. The amount of depreciation goes on decreasing
while the charge for repairs goes on increasing year after year.
Thus, increase in the cost of repairs is compensated by a
decrease in the amount of depreciation for each subsequent year.
This means that combined effect of depreciation and repairs on
Profit and Loss Account is more or less uniform every year due to
increasing amount of repairs but reducing amount of depreciation.
ii) The method is simple enough to understand and easy to follow.
iii) There is no need of fresh calculations in case there is an addition
to the asset unless such additions are made in the middle of the
year.
iv) Since asset cannot be reduced to its zero value under this
method, the physical presence of the asset at the end of its
lifetime even when it becomes useless is fully justified by this
method.
Demerits
i) The value of the asset cannot be brought down to zero under this
method.
ii) The determination of a suitable rate of depreciation is also difficult
under this method as compared to the Fixed Installment method.
iii) At times, it is very difficult to identify the individual asset if there
are frequent additions.
iv) The interest on capital investments in the assets is totally ignored.
v) This method is devised to equalize the burden of depreciation and
repairs taken together on Profit and Loss Account. But this may
not happen in many cases due to either low rate of depreciation or
due to excessively heavy repairs in the later stages.
Scope of Application:
This method can very well be applied to Plant and Machinery where
repairs are heavy, where additions, extensions, substitutions are
quite frequent and where asset need not be reduced to zero.
3. Other Methods
There are some of the other methods of providing depreciation such as:
a) Group depreciation method
Under this method, all homogeneous assets, generally having similar
average life expectancy, are grouped together in a single asset
category. One summary account is established for each group and
the original cost of all the assets in the group is charged to this
account. Depreciation is charged for the group in full and not item by
item. The essential features of this method are:
i) A summary account is established for each category of
homogeneous assets e.g. 10 motor vehicles owned by a company
may be put into one account while 15 typewriters owned by the
same company may be put in another account.
ii) Depreciation is charged for the group in total at a rate based on
the expected average service life and scrap value of the asset of
the group.
iii) On the purchase of an asset, the group asset account is debited
with cost.
iv) The amount of depreciation is calculated on the balance in the
group asst account. It is debited to Depreciation Account or P&L
Account and credited to the Accumulated Depreciation Account.
v) In case an asset is sold, the amount received on account of the
sale of the asset is credited to the group asset account. The
difference between the cost of the asset and the sales value is
transferred to the Accumulated Depreciation Account.
It should be noted that no single item of the group can be
considered to have a book value. Hence, no gain or loss is
recorded on the disposal of any item of the group in the normal
course of events.
c) Annuity method:
The fixed installment method and the reducing balance method of
charging depreciation ignore the interest factor. The Annuity Method
takes care of this factor. Under this method, the depreciation is
charged on the basis that besides losing the original cost of the asset,
the business also loses interest on the amount used for buying the
asset. The term ‘interest’ here means the interest which the business
could have earned otherwise if the money used in purchasing the
asset had been invested in some other form of investment. Thus,
according to this method, such an amount is charged by way of
depreciation which takes into account not only the cost of the asset
but also interest thereon at an accepted rate. The amount of interest
is calculated on the book value of the asset, in the beginning of each
year. The amount of depreciation is uniform and is determined on the
basis of the annuity table.
d) Depreciation or sinking Fund method:
One of the objectives of providing for depreciation as explained
earlier is to provide for a replacement of the asset at the end of its
useful life. In the case of the three methods discussed earlier, the
amount of depreciation charged from the Profit and Loss Account
continues to remain in the business. However, this amount may get
invested in some other assets in the course of running the business.
Therefore, it may not be possible for the business to have sufficient
liquid resources to purchase a new asset at the time when it needs
funds for replacement. Depreciation fund method takes case of such
a contingency. According to this method, the amount charged by way
of depreciation is invested in certain securities carrying a particular
rate of interest. The amount received on account of interest from
these securities is also invested from time to time together with the
annual amount charged by way of depreciation. At the end of the
useful life of the asset, when a replacement is required, the securities
are sold away and money realized on account of the sale of securities
is used for the purchase of a new asset. This method has the
advantage of providing a separate sum for the replacement of the
asset. However, the method has a disadvantage as it puts an
increasing burden on the profit and loss of each year on account of a
fixed charge for depreciation but an increasing charge for repairs.
The depreciation methods used, the total depreciation for the period for
each class of assets, the gross amount of each class of depreciable assets
and the related accumulated depreciation are disclosed in the financial
statements along with the disclosure of other accounting policies. The
depreciation rates or the useful lives of the assets are disclosed only if they
are different from the principle rates specified in the statute governing the
enterprise.
In case the depreciable assets are revalued, the provision for depreciation
is based on the revalued amount on the estimate of the remaining useful
life of such assets.
Indian Companies Act, 2013 has brought a lot of changes and challenges
for all the companies. One such challenge is change in the provisions
relating to depreciation. Part A to Schedule II of the Companies Act 2013
defines depreciation as the systematic allocation of the depreciable amount
of an asset over its useful life.
Systematic allocation means apportionment or allotment to a system or
method i.e. companies are now free to use their own method for calculation
of depreciation such as SLM or WDV or any other.
The cash price of the goods, cash price means the price at which goods
may be purchased against cash payment.
The hire-purchase price, hire purchase price means the total amount which
is payable by the hire-purchaser under the agreement.
The date on which the hire-purchase agreement will commence.
The description of the goods that will be delivered to the hire-purchaser at
the commencement of the agreement.
The number of installments to be paid by the hire-purchaser along with the
amount of each installment and the date of payment of each installment.
The down payment if any, the down payment means the amount which is
required to be paid by hire-purchaser to the hire vendor at the time of
commencement of hire-purchase agreement.
The rate of interest charged by the hire vendor (optional).
Important Terms.
1. Hire seller/Hire vendor/Owner:
The person who sells the goods to the buyer under hire purchase system is
known as hire seller.
4. Down Payment:
The initial cash payment made by the hire purchaser to the vendor at the
time of signing the hire purchase agreement is referred as down payment.
. A person has the right to terminate the agreement at any time before the
property so passes.
Students, according to section 3 and 4 of Hire Purchase Act 1972 content
of Hire purchase agreements will be highlighted as:
1. The seller is required to give notice in writing to terminate the hire purchase
agreement if there is a default in payment of hire or breach of express
conditions.
2. The right to repossess the goods will not exist unless sanctioned by the
court in certain cases.
3. The hirer has the right of receiving statement from vendor.
4. If the hirer has paid excess amount than hire purchase price, the excess
payment should be returned by the vendor.
Note: entries 3,4,5 and 6 will be repeated year after year until the
final installment is paid.
Note: entries 3,4,5 and 6 will be repeated year after year until the
final installment is paid.
Academic Script
Introduction:
In business, one requires different types of resources varying from simple tools
to big machineries, man power, land, finance etc. The tools and machinery
and such other assets may be needed for a temporary period or for a very long
period. One may have adequate finance to purchase those or may borrow
finance for fulfilling the need. However, some may neither have adequate
finance nor be in the position of borrowing the same. What alternative is left to
them?
They can acquire the asset on rent, on credit, on installment or can go for hire
purchase. They simply need to enter into an agreement.
Under this method, the purchaser does not need to spend the entire amount in
one go or borrow a large amount of money, rather can procure the right for the
immediate use of an asset. It is a financial facility that permits the use of asset
in return of regular payments without transferring the ownership. In addition,
the hirer acquires the right to buy the asset, after the use of an asset for a
particular period on paying a small or nominal amount of money.
The acquisition of asset, specifically the expensive capital asset, calls for
careful financial planning. There is no point making outright cash payment, but
prudent to adopt the ways of spreading the cost over a period of time to match
or coincide with that of generation of revenue by business. The hire purchase
system is believed to be the most common source of finance for investment in
capital assets.
The assets that are suitably financed through this method are like:
• Tools
• Cars
• Commercial vehicles
• Agricultural equipment
The system of hire purchase is governed by the Hire Purchase Act 1972. This
Act defines a hire purchase as "an agreement under which goods are let on
hire and the hirer has an option to purchase them in accordance with the
terms and conditions laid in the agreement”. The agreement defines very
clearly and specifically the terms and conditions to be followed by the hirer and
the owner:
i) The owner of the goods would pass them to the person who would pay
an agreed sum of amount in cash or by cheque as specified or agreed upon,
in the specified number of periodic installments;
ii) The ownership of such goods would pass to such person only after the
payment of last installment by the hirer in the manner as agreed upon;
iii) The hirer has the right to terminate the agreement at any time before the
transfer of such property.
Radically, it means exactly what its name suggests; a hiring of the goods until
a certain condition is met, when they become the property of the hirer. This
condition is usually the completion of all of the payments. The advantage to
the finance company is obvious; the property in the goods remains theirs until
the goods are paid for. Therefore the finance company has, at least a partial
security for their debt. In the 1950s and 1960s, it acquired a bad reputation.
This was due to the way that some finance companies were dealing with their
customers. This lead to the first Hire Purchase Acts.
These acts, in the main, established two fundamental and far-reaching legal
principles:
1) One third of the total amount payable have been paid, the finance company
cannot recover the goods without the hirers consent. Unless the finance
company first obtains a Court Order.
2) If an innocent "private buyer in good faith" purchases the goods from the
hirer, the finance company cannot take those goods from the innocent
purchaser. That is, the finance companies property in those goods is lost. To
meet those conditions the innocent buyer must:
A) Be a genuine private buyer, that is not be engaged in any way in the motor
trade.
B) Be ignorant of the fact that the person from whom the goods was purchased
was hiring them under a Hire Purchase agreement.
These principles have remained intact up to the present day. In the early 1970s
the Hire Purchase Acts and Money Lenders Acts where replaced by new piece
of legislation, The Consumer Credit Act 1974. The essential parts of the old
Hire Purchase Acts remained intact; however, there was now a requirement for
businesses engaged in the offering of credit to be licensed.
In later years, civil procedures have been the subject of two judicial reviews,
the first instigated by the then Lord Chancellor, the other (recent) following a
report by Lord Woolfe. Although neither of these has led to any legislative
changes, radical changes have been made to the County Court system. The
result of all this is that the system is now much faster, slicker, and easier to
use. Under the present system, anyone running a finance company would do
well to consider undertaking their own legal work.
Accounting Treatment:
The total payment made in case of hire purchase is always more than the
cash price because the vendor will recover the interest under hire purchase
system.
When the asset is recorded at full cash price under this method the
assumption is that asset has been bought with the intention of paying all the
installments on the due date to acquire the asset for the business.
(II) Treating the goods not becoming the property of the hirer or when
asset is recorded at the cash price actually paid:
Under this method, goods are bought under hire purchase system will not
become the property of the buyer until all the installments are paid.
Calculation of Interest
The price quoted by the seller in the hire purchase system or installment
system is higher than the price, which he would have quoted for the sale on
the cash basis. The excess of hire purchase price over the cash price is
treated as payment for interest. Calculation of Interest depends upon the
specific information given in the problem. Following are the different situations
which explain method of calculation of interest.
A) When the Rate of Interest, Cash Price and Installment are given
separately
When the cash price, rate of interest, purchase price, and number of
installments etc. are all given in that case calculation of interest is very simple.
The interest is to be calculated on the outstanding balance of the cash price at
the stipulated rate. The interest for the final period should be taken as the
difference between cash price outstanding at the end of that period and the
amount of installment.
The difference between any two successive installments represents the least
amount of interest charged in the last year.
The asset account should not be debited with more than the cash price of the
asset, so it becomes essential to find out the cash price first before solving
such type of questions. The procedure to calculate cash price is t take up the
final installments first and to deduct the interest from it. Interest can be
calculated for one year by multiplying the sum due at the end of the year by
the formula i.e. Rate of Interest/100 + Rate of Interest.
Under working backward method, the cash price may be calculated by taking
the following steps:
Step 1: Calculate the Balance due at the end after the payment of
installment
Step 2: Calculate the Balance due at the end before the payment of
installment as under: Balance due before Installment = Balance
due after Installment + Installment.
Step 3: Calculate the Interest included in the amount (as per Step 2) as
under:
A) Asset Full Value Method (Full Cash Price Method) b) Asset Accrual Method
follows a practical approach and practically treats the hire purchaser as owner
of the asset. Under this method, the asset is recorded at full cash price based
on ‘substance over form’. This method is more appropriate since the intention
all along is to buy the asset.
(B) Actual Cash Price Method-This method follows technical approach and
does not treat the hire purchaser as owner until he makes the payment of last
installment. Under this method, the asset is recorded at the cash price actually
paid.
Sometimes, business sells goods both on cash basis and hire purchase
basis. When numerous items of the small value such as cycles, fans, radios,
TV etc are sold on hire purchase basis involving many transactions during an
accounting year, it becomes very difficult to maintain separate accounts for
each customer, calculation of interest and profit & Loss. It will involve lot of
cost, efforts, and time. Under such circumstances, Hire Purchase Trading
account is adopted. For keeping records of hire purchase method transactions
a separate book called Hire Purchase Register or Hire Purchase Sales book is
maintained to record date of contract, name of hire purchaser, cost price, hire
purchase price, down payment, number of installments and amount of each
installment with dates when they become due. At the end of the year, profit or
loss on hire purchase is calculated by extracting the following information from
accounting records:
(2) Total cash received from hire purchase (down payment + Installments)
during the year,
(3) Installments due but not paid by the hire purchase customer,
(4) Installments not yet due. It is also known as stock lying with hire purchase
customers.
Academic Script-
The law relating to Partnership in India is contained in the Indian
Partnership Act, 1932. This Act has branched out of the Indian Contract
Act, 1872. A Partnership is defined as the relationship between persons
who have agreed to share profits of a business carried on by all, or any of
them acting for all.
Persons who have entered into partnership with one another are called
individually ‘partners’ and collectively ‘a firm’ and the name under which
their business is carried on is called the ‘firm name’. In law, a ‘firm’ is
only a convenient phrase for describing the two or more persons who
constitute the partnership and the firm has no legal existence apart from
those persons. The rights and obligations of the firm are in fact the rights
and obligations of the individuals composing the firm. Partners may
choose any name as their firm’s name provided it does not go against
the rules relating to trade name or goodwill.
Section 5 lays down that the relation of partnership arises from contract
and not from status, and in particular the members of a Hindu Undivided
Family carrying on a family business as such are not partners in such
business. However, the Act does not prohibit the members of Joint
Hindu Family to enter into partnership among them. A Joint Hindu
Family is a Hindu joint family carrying on a trade or business inherited
from the ancestors. Partnership is essentially the result of an agreement
between the parties whereas a Joint Hindu Family is the result of status.
In a partnership, new partner can be admitted only with the consent of
all the existing members, whereas in Joint Hindu Family business a
person becomes a member merely by his birth. Death of a partner
dissolves the firm, unless otherwise agreed by the partners, death of a
member of a Joint Hindu Family business leaves the firm unaffected.
Illegal Partnership
Registration of Firms
Rights of a partner
Duties of partners
Types of Partners
Nominal Partner- A partner, who lends his name to the firm, without
having any real interest in it, is called a nominal partner. He does not
invest in the business of the firm, nor does he share in the profits or take
part in the management of the business of the firm. He, along with other
partners, is liable to the outsiders for all the debts of the firm. A nominal
partner is known to the world as a partner in the firm, but he does not
share in the profits of the firm. A sleeping partner, on the other hand, is
one whose name does not appear to the world, but he shares in the
profits of the business. Both are, however, liable for all the acts of the
firm.
Before attaining majority, a minor has the right to such share of the
property and of profits of the firm as may have been agreed upon. When
he is not given his due share of profit, he has a right to file a suit for his
share of the property of the firm. But he can do so only if he wants to
sever his connection with the firm.
On attaining majority the minor partner has to decide within six
months whether he shall continue in the firm or leave it. These six
months run from the date of his attaining majority or from the date when
he first comes to know that he had been admitted to the benefits of
partnership whichever is later. Where he elects to become a partner he
becomes personally liable to third parties for all the acts of the firm done
since he was admitted to the benefits of partnership. His share in the
property and profits of the firm is the share to which he was entitled as a
minor partner.
Academic Script
Partnership: Admission and Retirement
Sec 31 to Sec 38 of The Indian partnership Act deals with the various
reasons of reconstitution of a partnership firm and the implications
thereof.
RECONSTITUTION OF A FIRM-
The above changes have far reaching implications for the partnership
firm.
In case of any of the above changes, the rights and liabilities of each
partner are determined afresh. This is called reconstitution of a firm.
Reconstitution of a partnership firm brings to an end the existing
partnership agreement.
Sec 31 of the Indian Partnership Act 1932 deals with the introduction or
admission of a partner.
In the event of retirement of an existing partner, the firm may need a new
member or partner to conduct the operations of the firm smoothly.
The admission of a new partner has far reaching implications for the
existing firm.
Adjustment of Goodwill
Adjustment in profit sharing ratio
Revaluation of existing assets and liabilities
Adjustment of partners’ capital
Distribution of accumulated profits and reserves.
All the above will require accounting treatment and will be dealt with later
in this module under accounting for partnership.
INTRODUCTION OF A PARTNER
Subject to Sec.30 (which deals with the position of minors) of the Indian
Partnership Act 1932
Adjustment of Goodwill
Adjustment in profit sharing ratio
Revaluation of existing assets and liabilities
Adjustment of partners’ capital
Distribution of accumulated profits and reserves.
A new partner cannot be held liable for acts of the firm done prior to the
date of his admission as a partner.
He can only be held responsible for the acts done after the date of his
joining partnership.
However, there are exceptions to this rule.
In the event of the following the new partner can be held liable for the
acts of the firm done before the date of his admission.
2) He can also be held liable for the old firm’s losses if the new firm
assumes the losses of the old firm and the creditors accept the new
firm as their debtor and discharge the old firm of its liabilities
towards them.
In the above example, Aditya cannot be held responsible for the acts
done or debts incurred by the partnership firm of Ram and Vinit because
the old partners i.e. Ram and Vinit were not acting as agents of Aditya at
the time when they acted.
However, if the firm incurs losses after his joining, Aditya along with Ram
and Vinit will be liable for the same.
This however, will not give the creditors of the organization a right to
recover their past debts from Aditya because he was not in existence as
a principal at a time when the act was done.
He can be held liable for the old firm’s losses only if the new firm
assumes the losses of the old firm or the creditors accept the new firm as
their debtor and discharge the old firm of its liabilities towards them.
Retirement of a Partner
The retirement of a partner has far reaching implications for the firm.
A partner may retire from the firm for several reasons. The retiring
partner may be suffering from ill health or may have become too old to
conduct the business of the firm. He may dislike the attitude of the other
partners and may not agree with them on key issues any more. Or he
may have found other interesting business opportunities. Regardless of
the reason
1) The retired partner may be held liable for the acts of the firm even
after his retirement if the third party which could be banks or
creditors deals with the firm in the belief that he is still a partner.
2) Firm is also liable if third party deals with the retired partner if he
pretends to act on behalf of the firm.
But a retired partner cannot be held liable for the acts of the firm done
after his retirement, if the third person/s dealing with the firm did not know
that he was a partner i.e. the retired partner was a sleeping or dormant
partner. This is because third party had no knowledge that he is a partner
and did not deal with the partnership firm on the belief that he is a
partner. [Proviso to Sec 32(3)]
Example -
In the above example, Vinit decides to retire from the firm. No public
notice is given by either Ram & Aditya or the retiring partner Vinit. After
retirement Vinit orders goods on firm’s old letter head from old supplier
who knew all the three partners but was not aware of Vinit’s retirement.
Ram, Aditya & Vinit can be held liable for the acts done or debts incurred
by Vinit.
Instead, if in the above example Vinit was a dormant partner and Ram
and Aditya order goods after Vinit’s retirement from a supplier who did
not know that Vinit was a partner of the firm before retirement, Vinit
cannot be held liable by the supplier for the acts of Ram & Aditya.
[Proviso to Sec 32(3)]
A retired partner need not give notice of his retirement to persons who
were ignorant of his being a partner in the firm.
Expulsion of a Partner
Even when the partnership agreement explicitly states that a partner may
be expelled on the happening of an event such as misconduct by the
partner, still the power of expulsion must be exercised by the majority in
good faith.
Regular expulsion takes place when the conditions mentioned earlier are
fulfilled. The rights and duties of an expelled partner are the same as that
of a retired partner.
Or
b) Sue for the refund of his share of capital and profits in the firm
Apart from Sec 33, the provisions of sub-sections (2), (3) and (4) of
section 32 shall apply to an expelled partner as if he were a retired
partner.
For example –
A, B, C, D & E were partners in a firm. Due to A’s misconduct the firm
suffered serious loss. B & C pass a resolution in the absence of D & E to
expel A from the partnership. A objects to his expulsion.
2) That the expulsion was carried out in the absence of D & E due to
which a majority of partners were not involved in the decision.
This is an irregular expulsion and can be declared null and void by the
court. A can sue the partners and be reinstated as a partner in the firm
Insolvency of a partner
Second, the insolvent partner’s estate is not liable for the firm’s acts done
after the date of the order of adjudication of insolvency. A public notice
that a partner has been adjudicated insolvent is not required.
Third, according to Sec 34(2), after the date of the order of adjudication,
the firm is not liable for any act of the insolvent partner.
Death of a Partner
Sec 35 and 42(c) of the Indian Partnership Act deals with the death of
partner.
Also, estate of the deceased partner is not liable for the acts of the firm
after his/her death whether the dissolution of the firm takes place or not.
Example –
Radha was a partner in a firm. She passed away but the firm was not
dissolved because the partners had entered into a contract not to
dissolve the firm in the event of death of a partner. Later, the firm could
not pay for the goods ordered after Radha’s death. The supplier claimed
that the price of the goods be recovered from all the partners including
late Radha.
In this case due to the contract between the partners not to dissolve the
partnership firm in case of death of a partner, According to Sec 35,
Radha’s estate cannot be used to pay off the supplier as there was no
debt due in respect of goods in the lifetime of Radha.
:1. Voluntary also called as ‘without the order of the Court’ and
Dissolution of
Firm
Without the
order of the By the order of
Court the Court
On happening By notice of
Compulsary
By agreement of certain partnership-
dissolution
contingencies at-will
2. Compulsory dissolution :
A firm is dissolved compulsorily in the following ways.
a)By adjudication of all the partners or all the partners except one as
insolvent.
If all or all but one partners of the firm are declared insolvent they will
cease to be a part of the business from the date on which they are
adjudicated insolvent.
b)By happening of any event which makes it unlawful for the business
of the firm to be carried on or for the partners to carry it on in
partnerships
Under the provision of section 44 of the partnership act in the event that
any of the partners filing a suit the court can dissolve the firm. Then on
what grounds can the court pass an order to dissolve the firm.
a) Insanity: Suit for dissolution can be filed on the ground that a partner has
become of unsound mind. The suit is filed by the next friend (or legal
representative) of the partner who has become of unsound mind. (as per
section 44(a))
In this case a partner can file a suit for dissolution on two grounds
One, on the ground that a partner (other than the partner suing that)
has transferred the whole of his interest in the firm to the to a party. Two,
on the ground that a partner has allowed his share to be charged under the
execution of a decree against him (under the provision of rule 49 of order
XXI of the first schedule of code of civil procedure. Three, on the ground
that a partner has allowed his share to be sold in the recovery of arrears of
recovery of land revenue or of any dues recoverable as arrears of recovery
of land revenue due from a partner. All above suits are files by any partner
other than the partner who has transferred or charged his intereset in the
firm. (section 44, subsection f)
A suit for dissolution of the firm can be filed by a partner if the business of
the firm cannot be carried on without suffering continual losses.(section 44
subsection f)
2. Right to settle the debts of the firm out of the property of the firm
(Section 49)
Section 49 of the partnership act lays down that where the firm is
dissolved the debts of the firm are settled out of the property of the firm.
And if there is any surplus it is utilized towards the payment private
debts of the partners.
As regards the private debts of the partners the private estate is first
applied in payment of the private debts and if there is any surplus is
utilized towards the settlement of the debts of the firm.
However, The partner who had paid the premium cannot claim any refund
on dissolution
Section 52 of the partnership act lays down that where the partnership
contract is canceled on the ground of fraud or misrepresentation of one
of the partners, the other partner entitled to repeal (cancel) has the
following rights namely,
Settlement of Accounts
After the firm is dissolved the counts need to be settled. The final
accounts of each of the Partners of the firm are settled according to
the accounting clause provided in the ‘Deed of partnership’. In case
such provisions are missing in the partnership deed, the provisions
made under section 48 apply.
1. Sale of Goodwill
The firm in the course of its existence has earned goodwill for its
name and it can be valued. On dissolution while settling the
accounts of the firm the goodwill can be included in the assets and
it can be sold separately or along with the property of the
firm.(refer section 55 subsection 1)
2. Application of assets
All the assets of the firm will be applied
One , in paying the debts of the firm to third parties
Two, in paying to each partner ratably what is due to him from the
firm for advances distinguished from capital.
Three, in paying to each partner ratably what is due to him on
account of capital
And the residue if any shall be divided among the partners in
proportion in which they were entitled to share profits (refer section
48, subsection b)
If the assets are sufficient to pay one and two above that is
for repayment of debts to third parties and for repayment of
advances from the partners but insufficient to repay to each
partner his share of capital, then the deficiency in the capital shall
be borne by the partners in the proportion of profit-sharing.
For example P,Q and R are partners the firm on the terms that
profit should be shared equally. The capital was contributed in
unequal shares, the capital contributed by P being more than the
capital contributed by Q. On dissolution of the firm, after satisfying
all the liabilities to creditors and advances to partners the assets
were insufficient to repay the capital in full. On the ground that all
three partners were equal profit- sharing ratio each partner is
liable to contribute an equal third share of deficiency and then to
apply assets in paying equally, i.e ratably his share of capital.
3. Losses must be paid first out of the profits of the firm then out of
the capital (that is the amount already invested by the partners in
the firm)
Limitation Period
Public Notice
Public notice should be given on dissolution of a partnership firm.
Summary
Dissolution of Partnership
Dissolution of partnership occurs when for certain reasons the partnership
relation does not continue between any two partners in the firm. According
to section 39 of Indian partnership act, the breakdown or cessation of
relation between all partners of the firm is called dissolution of partnership
firm. Dissolution of partnership is different from dissolution of partnership
firm.
Dissolution of partnership firm can occur with or without the order of the
court.
Settlement of accounts
On dissolution of the firm the final accounts of each partner are settled as
provided in the deed of partnership’ or as provided in section 48 of the
partnership act. The accounts are settled with respect to sale of Goodwill,
application of assets and distribution of Losses
Lecture Title: Accounting for Simple Dissolution
Academic Script
Accounting Procedure:
The accounting procedure for dissolution process will begin with preparation
of Realisation Account. All the tangible assets and outside liabilities need to be
closed and transferred to this account.
E.g. 1. A & B are partners in AB Ltd and decided to dissolve the firm on
31.03.2015. A decided to take over entire stock and the remaining assets were
sold at an agreed price of 1,20,000/-. The stock was valued at Rs.80000/- and
sundry assets at Rs.1,00,000/- as on 31st March.
In case of Loss:
Partner’s Capital A/c s………………….Dr.
To Realisation A/c
Formats
Realisation Account
Particulars Amount(RS) Particulars Amount(Rs)
To Sundry Assets Book Value By sundry Book value
liabilities
To Reserve for as per B/S By Reserve for as per B/S
discount on Doubtful Debts
creditors
To Cash/Bank Actual Amount By Cash/ Bank Actual Amount
(Payment of (Assets realized)
Liability and
expenses)
To Partner’s Agreed Value By Partner’s Agreed Value
cap/current A/c Cap/current A/c
(Liability taken (Asset Taken
over) Over)
To Partner’s Profit on By Partner’s Loss on
Cap/current A/C Realisation Cap/current A/c Realisation
Total Total
Cash Account
Particulars Amount(RS) Particulars Amount(Rs)
To bal b/d By bal b/d ( credit
bal.)
To Realisation A/C By Realisation A/C
(cash realized on (Cash paid for
asset sold) liabilities discharge)
To Partner’s capital By partner’s capital
A/c A/c
(Cash brought in by (Cash paid to
partner) partners)
Total Total
Note:
1. In case of absence of profit sharing ratio, it is assumed that Partners
share their Profits and losses equally.
2. If Reserve for doubtful debt is present in balance sheet of the
partnership firm, it needs to be transferred to the Realisation account
just like any other liability.
Lecture Title: Analysis of Financial Statements
Academic Script
Meaning
Definition
According to Lev,
Interpretation:
Analysis:
Analysis
External Internal
Analysis Analysis Horizont Vertical
al Analysis
Analysis
2. Internal Analysis:
This is affected by those who have access to the books of
accounts and other information relating to the business concern.
Any financial analysis is conducted with reference to a part or the
whole unit. This type of analysis meant for managerial purpose, is
conducted by executives and employees of the business concerns
as well as governmental agencies which have statutory control and
jurisdiction over such units.
2. Vertical Analysis:
This refers to an analysis of ratios developed for one date for
one accounting period. This is also known as “Static Analysis”.
But vertical analysis does not facilitate a proper analysis and
interpretation of figures in perspective and also comparisons
over a period of years. As such this type of analysis is not
resorted to by the financial analysis.
Various techniques are used in the analysis of financial data, among the
more widely used of these techniques are the following:
2. Trend Analysis:
In Trend Analysis, percentage changes are calculated for several
successive years instead of between two years. Trend analysis
uses an index number of a period of time. Trend analysis is
important because, with its long-run view it may point to basic
changes in the nature of business.
3. Ratio Analysis:
Ratio Analysis is an important means of expressing the
relationship between the two numbers. In this chapter or unit, we
are going to discuss how ratios are related to the liquidity and short
term solvency analysis of a business.
Assets:
Current Assets:
Cash
Debtors (Less
Reserve)
Stock-in-Trade
(+)
Total Current
Assets
Investments
Shares
Government
Securities
(+)
Total Investments
Fixed Assets
Buildings (Less
Depreciation)
Machinery (Less
Depreciation)
Furniture (Less
Depreciation)
(+)
Total Fixed Assets
(+)
Total Assets
Liabilities and
Capital
Current Liabilities:
Sundry Creditors
Bills Payable
Total Current
Liabilities
Fixed Liabilities:
Debentures
Long-Term
Loans
(+)
Total Fixed
Liabilities
(+)
Total Liabilities
Capital:
Equity Share
Capital
Preference
Share Capital
General Reserve
Retained
Earnings
Total Surplus
Total Capital
Total Liabilities
and Capital
Net Sales
Less: Cost of Goods
sold
Gross Margin
(or Profit)
Operating
Expenses:
Administrative
Expenses:
……..
……..
…….. (+)
Total
Administrative
Expenses
Selling Expenses:
………
……… (+)
Total Selling
Expenses:
Finance
Expenses:
…….
……. (+)
Total Finance
Expenses (+)
Total Operating
Expenses
Operating Profit
Add: Other Incomes
Less: Other
Expenses
Income or Net Profit
before Income Tax
Less: Income- Tax
Net Profit after Tax
Interpretation:
Interpretation means bringing out the meaning of the financial
statements with the help of the analysis. In other words, interpretation
means to present an explanation of financial data with the help of the
analysis.
Analysis:
Meaning of Analysis:
Not only that, he should define the end objectives of financial statement
analysis. He should also divide the process into different steps which are
shown herewith:
Methods of Analysis:
Funds Flow
Analysis
Trend Analysis
Ratio
analysis
Any financial statement that reports the comparison of data for two or
more consecutive accounting periods is known as comparative
financial statement
Under CFS mainly two statements are analyzed viz. Balance- sheet and
Profit and Loss Account or Income Statement. Let us see how these
statements are analyzed.
Example:
Official 20 25
Expenses
Selling Expenses 10 25
Official 20 25 5 +25
Expenses
Selling 10 25 15 +150
Expenses
This will give a clear picture for management that selling expenses have
increased tremendously i.e. by 150%. Management can put its concrete
efforts to bring it down and ensure increase in profitability. Likewise
these comparative statements are useful for all other stakeholders of
business enterprises.
There are two statements that are generally prepared under Fund Flow
Analysis , viz. funds flow statement and cash flow statement.
For example the income generated during the year plus the initial
capital invested, reserves and provisions forms the source of fund
generated by the owner i.e. liability towards the owner.
Borrowed funds in the form of loans and advances, creditors and
outstanding generates funds from outside source. Now these funds
are invested either in fixed assets, in current assets or payment of
liabilities.
However, common size statements are especially useful when data for
more than one year are used.
It can be seen and analyzed that current assets of business have grown
from 41.66 % to 47.37% from 2010 to 2011. Likewise it can be seen that
there is fall in fixed assets. This helps to identify where organizations
needs to work and capitalize on.
Trend Analysis:
Let’s take this example which will further clarify our concept on trend
analysis
The interpretation for the table is that sales of the unit has continuously
increased over a period of five years commencing from 2008. However,
a substantial increase in the amount of sales in the year 2012 is
observed when the sales rose by 39 per cent.
Ratio Analysis
The term 'ratio' refers to the mathematical relationship between any
two inter-related variables. In other words, it establishes relationship
between two items expressed in quantitative form.
(3) Rates.
2) Profitability Ratios
3) Turnover Ratios
4) Solvency Ratios
Academic Script
Concept:
Students, let us now focus our discussion first about financial analysis.
The Tools that are commonly used for Company’s financial information
includes:
Analysis done with help of financial statements serves the listed purposes.
Measuring Profitability
Students, let us focus our discussion towards parties those are interested in
financial statement analysis.
Investors:
Investors, who have invested their money in the firm’s shares, are
interested about the firm’s earnings. As such, they concentrate on the
analysis of the firm’s present and future profitability
Management
Trade Union
Lenders
Suppliers of loans are concerned with the firm’s long term solvency and
survival. They analyse the firm’s profitability over a period of time, its ability
to generate cash, to be able to pay interest and repay the principal along
with the historical financial statements to assess its future solvency and
profitability.
Suppliers (Creditors)
The suppliers and other creditors are interested to know about the solvency
of the business i.e. the ability of the company to meet the debts as and
when they fall due.
Tax Authorities
Tax authorities are interested in financial statements for determining
the tax liability.
Researchers
Employees
They are interested to know the growth of profit. As a result of which they
can demand better remuneration and congenial working environment.
Stock Exchanges
The stock exchange members take interest in financial statements for the
purpose of analysis because they provide useful financial information about
companies
Government agencies
Thus, various techniques are employed for analyzing and interpreting the
financial statements. Techniques of analysis of financial statements are
mainly classified into three categories:
1) Cross Sectional analysis
Methods of Analysis
The common size statements (Balance Sheet and Income Statement) are
shown in analytical percentages. The figures of these statements are shown
as percentages of total assets, total liabilities and total sales respectively.
Take the example of Balance Sheet.
The total assets are taken as 100 and different assets are expressed
as a percentage of the total. Similarly, various liabilities are taken as a part
of total liabilities.
A statement where balance sheet items are expressed in the ratio of each
asset to total assets and the ratio of each liability is expressed in the ratio of
total liabilities is called common size balance sheet.
Thus the common size statement may be prepared in the listed way.
Let us take this example which will further clarify our concepts on common
size balance sheet
1. Balance sheet for M/S. Kumar & Co is presented herewith for the year
end March 2014 and 2015.
2014 2015
Assets
Fixed Assets Rs % Rs %
Liabilities
Students, if you have noticed properly we have converted all the figures
considering total assets or total liabilities as a base i.e 100 and respective
items under it are calculated accordingly. Let us now do further analysis in
depth
1. An analysis of financing pattern for both the year reveals that in the
year 2015 the company is more traditionally financed i.e. (74% of its
finance is from capital and reserves) while in the last year it was
around 64.83%. This reveals that company in the second year has
more funds from its owners and it is less dependent on other sources.
Students, this is how the analysis for organisations is done using the
method of common size balance sheet method.
Analysis of balance sheet using this method gives insights into firm’s capital
structure and facilitates comparison with peers and rivals in industry. This
facilitates various decisions making. It also highlights the cash position of
organisation over a period of time. However the analysis is not limited to the
examples shared.
Friends, suppose I tell you that I scored 80% in my Unit test II and scored 89
marks in mathematics and science each. This statement will give you some
information about my academic performance. Now if I tell you that I had
score 75% during Unit test I and scored 93 marks in mathematics and 68
marks in science, than this information will give you more appropriate idea
about my academic achievements. This is because you have some base
with which you can compare my present performance. Similarly CFS is a
process of comparing financial performance of the company over the period.
This period may be of two to five years or sometimes more depending on
the policy of the organisation under consideration.
Under CFS two or more balance- sheets and/or Income statements are
presented simultaneously in columnar form. The yearly information is
presented in adjacent columns in order to facilitate periodic interpretation of
the data. Friend, nowadays most of the published Annual Reports of the
companies provide important financial information in the condensed form for
the past few years in order to show periodic panorama of financial
performance to its stakeholders.
1. The information may just show only figures of different years. For
example the sales of previous year were Rs.1000000 and current year
it is Rs.1700000.
2. The information may show the amount of change during given period.
For example the sales of current year have increased by Rs.700000
as compared to the previous year.
3. Or the information may be given in the form of percentage change in
the performance of the business. For example the sales of current
year have increased by 10% as compared to previous year.
Now the pattern or the format to be used will depend upon the
requirement of the user of this information. Friends, as already
mentioned, under CFS mainly two statements are analysed viz. Balance-
sheet and Profit and Loss Account or Income Statement. Let us see how
these statements are analysed.
Example 1
Friends, now what can we interpret from this comparative statement? One
can easily compare the performance in terms of sales as well as expenses.
The sales of 2011 have increased by Rs. 200000 or in other words there is
increase of 25% in sales of 2011 as compared to 2010. We can also see
that gross profit has increased by 25% whereas net profit by 26.7%. We can
say that though there is 25% increase in sales yet the cost of goods sold
have also increased by 25% so the effect on gross profit is only by 25%.
Here if we could control cost of goods sold than may be increase in sales
would result in significant increase in gross profit. In other words
management can interpret this analysis with different dimensions. The
management can also understand the pattern in which expenses behave at
a given sales level. The management can also bifurcate these expenses as
controllable and non- controllable or fixed and variable out- of- pocket
expenses etc.
Not only the management but also employees, customers, creditors,
vendors etc can find this analysis useful from their own point of view. Now
let us consider comparative balance- sheet.
Friends, Income statement reveals the revenue and expenditure position for
the given financial year whereas Balance-Sheet shows the asset and
liabilities of the firm on the given date. Now comparative Balance- sheet
helps to interpret the position of different assets and liabilities on two
different dates. Composition of assets in the category of current asset and
fixed asset and liabilities in the category of liability towards owner and
liability towards outsiders can be easily analysed with the help of CBS. Let
us understand this better with the help of an example.
Example 2
Comparative Balance-Sheet
(2-3)
Now friends let us interpret this statement. Pay attention on the shaded
portion of the table you will find that the Balance- sheet is analysed on the
basis of current asset, current liabilities, working capital, proprietor’s fund
etc. We can interpret following aspects from the CBS:
1. The total fixed assets have decreased by 2.5%. This can be mainly
attributed to the depreciation of 10% charged to building and plant
each. Though there is 40% increase in furniture due to new purchase,
yet the overall impact is decrease in fixed asset.
2. The current assets, on the other hand, have significantly increased by
48% which can be attributed to increase in all the assets viz. cash,
debtors and stock. This signifies increase in business activities and
sales turnover.
3. Due to increasing sales, debtors and stock amount, there is
increase in need for working capital. Working capital i.e. current asset
minus current liability signifies the liquid capital or short term capital
required by the firm. In our example working capital has increased by
57.5%, which is a significant increase. One can say that need for
working capital can be managed by quick recovery of debtors as
debtors have increased by 50% similarly the stock can be liquated
faster so as to reduce the blockage of funds in inventory.
4. Now look at the column of proprietor’s fund. This amount represents
the liability towards owner or the funds contributed by the owner in the
business. In our example we see that there is no additional investment
made by the owner, whatever nominal increase of 5% in this fund is
due to increase in reserves. The increase in reserves signifies
increase in operating surplus transferred to reserves. In other words
operating profit or surplus transferred to reserve has increased by
22.5%.
5. The firm has raised long term capital by borrowing additional secured
loan of Rs.50000. Conventionally long term capital should be used in
long term investments or assets. In our example the fixed assets in the
form of furniture has increased by Rs.40000. This means Rs.10000
i.e. Rs.50000 minus Rs.40000 is utilized in working capital or in other
words investing in current assets or paying current liabilities. This is
not an advisable decision as long term liability is raised in order to pay
current liability or invest in current asset. Ideally working capital should
be managed by raising funds from current liabilities.
6. The portion of proprietor’s fund and long term liability together forms
capital employed. This amount shows the long term capital invested in
the business. In our example this amount has increased by Rs.95000
i.e. Rs. 45000 increase in contribution of owner’s fund and Rs.50000
contributed through external fund in the form of borrowed loan.
This shows that the contribution of external source is more than that of
internal source.
7. Finally total assets and liabilities of the firm have increased by 16.9%.
We have already discussed the attributes that are responsible for this
increase in assets and liabilities. Friends, there is a possibility of
deriving some other interpretations from the given comparative
statement. The interpretations may change according to the objective
for which the analysis is undertaken.
Friends with the help of these two examples we have studied the utility or
significance of Comparative Financial Statement analysis. With this tool we
can derive meaningful interpretation of financial statement. But there are
certain limitations to this techniques, let us discuss some of them.
Academic Script
The term 'ratio' refers to the mathematical relationship between any two
inter-related variables. In other words, it establishes relationship
between two items expressed in quantitative form.
(3) Rates.
In other words,
Interpretation of Ratios:
Risk Acceptances.
Future expectations.
Future opportunities.
1. The analysis would enable the calculation of not only the present
earning capacity of the business but would also help in the estimation
of the future earning capacity.
2. The analysis would help the management to find out the overall as
well as the department – wise efficiency of the firm on the basis of the
available financial information.
3. The short term as well as the long term solvency of the firm can be
determined with the help of ratio analysis.
4. Inter – firm comparison becomes easy with the help of ratios.
Students, let’s now focus our discussion towards advantages of
ratio analysis.
(6) Ratio analysis reveals profitable and unprofitable activities. Thus, the
management is able to concentrate on unprofitable activities and
consider to improve the efficiency.
(9) Ratio analysis is an effective tool which is used for measuring the
operating the results of the enterprises.
Though ratio analysis is relevant and useful technique for the business
concern, the analysis is based on the information available in the
financial statements.
There are some situations, where ratios are misused, it may lead the
management to wrong direction. The ratio analysis suffers from the listed
limitations:
Classification of Ratios:
Basically, there are two types of such ratios viz.; those showing
current year’s figures as a percentage of last year, thus facilitating
comparison of the changes in the various profit and loss items; and
those expressing relationship among different items of the current
year.
e.g:
2010 % 2011 Change
You can easily from the example here that salaries for an
organization while comparing to sales have gone done by 0.20 %.
It can be easily related that share capital of the company has gone
up by 10%, debt by 20% and debentures by 20%. This ratios
indicate that the burden of debt is increasing which may result in
fixed burden of interest reducing the available cash for equity
shareholders, those who have contributed share capital to the
organization.
The components for computation of these ratios are drawn from both
balance-sheet and profit and loss account. These ratios deal with the
relationship between operating and balance sheet items.
Students,
Some authorities classify the ratios on the basis of time to which ratios
computed belong. On this basis, the ratio can be divided into the
following major groups:
Structural Ratios:
Structural ratios exhibit the relationship between two such items which
relate to the same financial period. Thus, the above mentioned
classification of ratio, i.e. profit and loss ratios, balance-sheet ratios and
mixed ratios are covered under structural ratios if the components for the
computation of these ratios are drawn from the financial statements that
relate to the same period.
Trend Ratios:
These ratios deal with the relationship between items over the period of
time. Trend ratios indicate the behavior of ratios for the period under
study and thus provide enough scope for the proper evaluation of the
business.
Primary Ratio:
Secondary Ratio:
Ratios other than primary ratios are known as secondary ratios.
Such ratios are treated as supporting ratio to primary ratios
because these ratios attempt to explain the primary ratios. Ratios
such as turnover ratio, expenses ratio, earning per share are
considered as secondary ratios.
Liquidity Ratios;
Leverage Ratios;
Activity Ratios
Students, as there is logic in every activity, the same is true for ratio
analysis. There are certain principles that act as a guide in effective
financial statement analysis. Let’s now learn some of the principles of
selecting the ratios.
Revenues
Gross Profit
Less: Salaries
Advertising
Depreciation
Utilities
Operating Income
Less: Interest Expense Finance
Taxable Income
Less: Taxes Government (Tax
accounting)
Net Income
Balance Sheets:
As with the income statement, the balance sheet is constructed
in a very methodical manner. On the Asset side, the assets are listed
in order, from the most liquid to the least liquid. Similarly, on the Liability
& Equity side, the accounts are listed in order from, the most
immediately due to the least.
From Operations:
Net Income
Plus: Depreciation
Plus: Amortization
FINANCIAL RATIOS:
The financial statements are often the only information upon which
to base an investment decision (as an equityholder or a lender), so it is
imperative that we be able to determine what economic information the
statements contain. Financial Ratios are used as tools to help us
squeeze as much information as possible from the financial statements.
It must be kept in mind, however, that a financial ratio is only one
number divided by another and only yields a number. The ratio takes on
meaning when compared with other firms or industry averages (a
static analysis) or when compared with previous periods for trends to
see if a firm’s position is improving or deteriorating (a dynamic analysis).
The ratios must also be taken together as a group – if a ratio appears to
be “higher” than it normally is, it can be due to the numerator being large
OR the denominator being small. By looking at other ratios we can
determine which the case is .
Liquidity Ratios:
FINANCIAL LEVERAGE:
1 2 3
=== === ===
DEBT 0 500 900
NET INCOME 84 54 30
Notice that the Return on Equity is magnified by the use of debt, and the
more the debt that is employed, the greater the magnification. The
profits of the firm can be greatly magnified through the use of debt.
1 2 3
=== === ===
DEBT 0 500 900
Total Debt
Debt / Asset Ratio =
Total Assets
Total Liabilities
Debt/Equity Ratio =
Net Worth
D/A
=
1 - D/A
EBIT
Times Interest Earned =
Interest Expense
More important to many lenders is the ability of the company not only to
make interest payments, but also to repay the principal of the loan. The
Debt Service Coverage Ratio considers both, interest and principal
payments that are required. Note that the principal portion is “grossed
up” to account for tax considerations. Why?
EBIT
Debt Service Coverage =
Principal Pymt.
Int. Exp. +
1- t
Finally, it is common for lenders (such as banks) to look more toward the
cash flow coverage of debt payments that a company can make. For
this reason, the Operating Income (EBIT) has the non-cash charges of
Depreciation and Amortization added back (just like they are in the
Operating Cash Flow section of the Statement of Cash Flows).
EBITDA
=
Interest Expense
Inventory
Average Age of Inventory =
COGS / 365
The second major category, at least of current assets for most firms, is
the amount of money that is tied-up in Accounts Receivable. The
Average Collection Period (or Days’ Sales Outstanding) tells you how
long, on average, it takes for a firm to collect the money due on a sale
made on credit:
Accounts Receivable
Average Collection Period (Days' Sales Outstanding) =
Sales / 365
Sales
Fixed Asset Turnover =
Net Fixed Assets
Sales
Total Asset Turnover =
Total Assets
Profitability Ratios:
Gross Profit
Gross Profit Margin =
Sales
Operating Income
Operating Profit Margin =
Sales
Net Income
Net Profit Margin =
Sales
If the net ROA is low, is it because we are not controlling costs (in which
case, is it in production, selling and administrative, or financing costs), or
is it because we have too many assets relative to sales (such as too
much inventory, too long a collection period, too many unutilized fixed
assets). This approach to locating the source(s) of the problems is
known as the DuPont method of analysis. Your textbook gives you an
example of its implementation.
Net Income
Net Return on Assets =
Total Assets
Finally, equity investors are concerned with the rate of return that
is being generated on their investment in the company.
Net Income
Return on Equity =
Net Worth
Net ROA
=
1- D / A
Total Assets
= Net ROA *
Total Equity
Market Ratios:
Net Income
Earnings per Share (Basic) =
Total No. of Shares Outstanding
Net Income
Earnings per Share (Fully Diluted) =
Total Possible Shares Outstanding
P Div. / Earn.
=
E kS - g
Accounts Payable
Average Age of Payables =
COGS / 365
The cash cycle looks at how long a company has money tied-up in its
operations. Money is invested in inventories, which sit in the
warehouse for a certain period of time and then are sold on credit
which takes so-long to collect; but this length of time (known as the
operating cycle) is reduced by the fact that our suppliers do not
require immediate payment for the inventories that we purchase.
Cash Cycle = Average Age of Inventory + Average Collection Period - Average Age of Payables
The firm’s cash cycle is looking at how long, and hence, how much, cash
is tied up. Decreasing the cash cycle decreases the amount of cash
investment is required. As will be seen when working capital is
addressed, cash can be free-up by accelerating inflows (shortening the
average collection period) or delaying outflows (stretching out the
average payables period) as well as by liquidating assets such as
inventory (and increasing inventory turnover which is the same as
decreasing the average age of inventory).
Industry Averages:
Industry averages are often used for comparison purposes. The
two most popular sources of industry averages are RMA’s Annual
Statement Studies and Dun & Bradstreet’s Key Business Ratios. RMA
is an association of banks that pool loan data and Dun & Bradstreet is
the well-known credit rating agency. Industry averages can also be
obtained from Standard & Poor’s and Moody’s, the two premier bond
rating agencies.
Statement and Application of Ratio Analysis
Academic Script
A very large number of accounting ratios are used for the purpose of
determining the financial position of a concern for different purposes.
Ratios may be broadly classified in to:
I. Liquidity Ratios.
Before going ahead about learning about ratios. Let us first learn about
the concept we just discussed.
1. Liquidity:
2. Solvency
Solvency is the ability of the company to meet its long term financial
obligations. Solvency is essential for staying in business. Liquidity is
the company’s ability to meet its short- term obligations whereas
solvency checks long-term stability of the firm. Here if an organisation
has taken a long term loan of tenure 10 years and it is unable to pay it
then we can say that organisation is facing solvency problem.
3. Turnover:
Turnover measures the companies speed in conducting business
functions mainly the trading function. It is barometer of
performance of management of organisation with regards to
generating revenue, sales etc from given resources.
4. Profitability
Liquidity Ratios
To measure the liquidity of a firm, the listed ratios are commonly used:
Current Ratio
The two basic components of this ratio are current assets and current
liabilities. Current asset normally means assets which can be easily
converted in to cash within a year's time. On the other hand, current
liabilities represent those liabilities which are payable within a year.
Current Assets Current Liabilities
The ideal current ratio is 2: 1. It indicates that current assets double the
current liabilities are considered to be satisfactory. Higher value of
current ratio indicates more liquid of the firm's ability to pay its current
obligation in time. On the other hand, a low value of current ratio means
that the firm may find it difficult to pay its current liabilities.
Let us take a quick example which will further clarify our concept.
Company A Company B
Quick Ratio= Current Asset- (Inventory+ Prepaid Expenses)/ Total current liabilities
This ratio established the relationship between the absolute liquid assets
and current liabilities.
The optimum value for this ratio should be one, i.e., 1: 2. It indicates that
50% worth absolute liquid assets are considered adequate to pay the
100% worth current liabilities in time.
If the ratio is relatively lower than one, it represents that the company's
day-to-day cash management is poor. If the ratio is considerably more
than one, the absolute liquid ratio represents enough funds in the form of
cash to meet its short-term obligations in time.
Absolute Liquidity Ratio= Cash+ Bank+ Marketable Securities/ Total Current
liabilities
The term profitability means the profit earning capacity of any business
activity. Thus, profit earning may be judged on the volume of profit
margin of any activity and is calculated by subtracting costs from the
total revenue accruing to a firm during a particular period.
Gross Profit Ratio established the relationship between gross profit and
net sales. This ratio is calculated by dividing the Gross Profit by Sales. It
is usually indicated as percentage.
Gross Profit Ratio= Gross Profit / Net Sales *100
Higher Gross Profit Ratio is an indication that the firm has higher
profitability. It also reflects the effective standard of performance of firm's
business. It helps in finding out efficiency of business.
Operating Ratio.
Operating Profit Ratio indicates the operational efficiency of the firm and
is a measure of the firm's ability to cover the total operating expenses.
Net Profit Ratio is also termed as Sales Margin Ratio (or) Profit Margin
Ratio (or) Net Profit to Sales Ratio. This ratio reveals the firm's overall
efficiency in operating the business. Net profit Ratio is used to measure
the relationship between net profit (either before or after taxes) and
sales. Higher Net Profit Ratio indicates the standard performance of the
business concern.
Net Profit Ratio= Net Profit after Tax / Net Sales *100
This ratio is also called as ROI. This ratio measures a return on the
owner's or shareholders' investment. This ratio establishes the
relationship between net profit after interest and taxes and the owner's
investment.
ROI= Net Profit (After Interest and Tax) / Shareholders funds * 100
Earnings Per Share Ratio (EPS) measures the earning capacity of the
concern from the owner's point of view and it is helpful in determining the
price of the equity share in the market place.
EPS = Net Profit after tax and preference dividend / No of equity shares
This ratio helps to measure the price of stock in the market place
highlighting the capacity of the organisation to pay the dividends and it is
used as a yardstick to measure the overall performance of the concern.
Dividend Payout Ratio= Equity Dividend / Net Profit after taxes *100
Or
Dividend Yield Ratio= Dividend per share /Market Value per share *100
This ratio highlights the earning per share reflected by market share.
Price earnings Ratio establishes the relationship between the market
price of an equity share and the earning per equity share. This ratio
helps to find out whether the equity shares of a company are
undervalued or not. This ratio is also useful in financial forecasting. This
ratio is calculated as :
Price Earnings Ratio= Market Price per Equity Share / Earnings Per Share
This ratio indicates the efficiency of firm's credit collection and efficiency
of credit policy. It also measures the quality of receivables highlighting
the probability of bad debts that may occur during the course of
business. It also highlights the liquidity of trader. Higher turnover ratio
and shorter debt collection period indicate prompt payment by debtors
and vice versa.
A high Creditor's Turnover Ratio signifies that the creditors are being
paid promptly. A lower ratio indicates that the payment of creditors is not
paid in time.
This ratio highlights the effective utilisation of working capital with regard
to sales. This ratio represents the firm's liquidity position. It establishes
relationship between cost of sales and networking capital.
Fixed Assets Turnover Ratio= Cost of Goods Sold / Total Fixed Assets
Or
Proprietary Ratio
Proprietary Ratio is also known as Capital Ratio or Net Worth to Total
Asset Ratio. This is one of the variant of Debt-Equity Ratio. The term
proprietary fund is called Net Worth. This ratio shows the relationship
between shareholders' fund and total assets.
Debt Service Ratio= Net Profit before Interest and Income Tax/ Fixed
Interest Charges *100
Higher the ratio the more secure the debenture holders and other
lenders would be with respect to their periodical interest income. In other
words, better is the position of long-term creditors and the company's
risk is lesser. A lower ratio indicates that the company is not in a position
to pay the interest but also to repay the principal loan on time.
An activity ratio which is also termed as turnover ratio measures
movement and indicates how frequently an account has moved or
turned over a period. It shows how effectively and efficiently the assets
of the firm are being utilised. The Activity ratios therefore, measure the
effectiveness with which the firm uses its resources. These ratios are
usually calculated with reference to sales or cost of goods sold. As the
ultimate objective of kitchen task is to cook food similarly the ultimate
objective of any business firm is to generate sales. It is therefore,
necessary to examine relationship between the assets and their
conversion into sales. Friends consider this operating cycle of a typical
manufacturing firm.
In this diagram you can see that Raw Material gets converted into work-
in- progress, which in turn gets converted into finished goods. Finished
goods get converted into sales and sales into debtors. Further debtors
pay cash which is again utilised for purchasing raw material. Now each
of these phase needs certain time lag. Say if company A completes this
cycle in 2 months and company B in 4 months, then which company
according to you is more active? Yes you are right Company A can be
termed as the one having higher turnover or activity ratio. Here we can
study the time taken by the company for converting raw material into
cash i.e. 2 months in case of Company A and 4 months in case of
Company B. Not only this, we can also analyse the time taken at each
stage and then compare performance of both the company. Say for
example if company A takes 15 days for converting finished goods into
sales and Company B takes 5 days in this conversion, then we can say
that Company B is more active than Company A in terms of conversion
of finished goods into sales. Similarly we can study how fast the
company collects its dues from the debtors. For example Company A
collects debtors within 10 days and for this Company B takes 30 days
then we can say that Company A is more efficient in terms of collection
of its dues from their debtors.
Friends, activity ratios can be calculated for all the assets, however, we
will study some of the most commonly used ratios.
Where,
Example 1:
A firm has an opening stock of Rs.400000 and the closing stock of Rs.
500000. The net sales made during the year amounted to Rs. 24 lakh to
give a gross profit of Rs. 600000. Let us calculate inventory turnover
ratio
The firm has a stock turnover ratio of 4 times this means that in a year
stock gets converted into sales for four times. There is no ideal standard
for evaluating an inventory turnover ratio of a firm. This is because every
industry has different production cycle and accordingly their standard
activity ratio would also differ. Usually the firm’s I/T ratio is compared
with other firms in the same industry. Anyhow, higher the turnover ratio
better is the position. But this is true only up to a point and a very high
I/T ratio signal problems for example a firm may have a high turnover
ratio if it is maintaining a low level of inventory. Since, the average
inventory is used as a division in the formula, there is a negative
correlation between the amount of average inventory and the I/T ratio.
So if a firm has a high turnover ratio, the firm should take it seriously as
a low level of stock of course if that is the reason for high turnover, then
it may result into frequent stock out position. This means if the I/T ratio
for a year is below the range, it may signal inactive stock while the ratio
beyond the range may indicate insufficient inventory signaling a risk of
stock outs. .
Inventory velocity= 365/ I/T ratio where 365 represents days in the year.
In our example where I/T ratio is 4 times
This means that the firm is maintaining inventory for 90 days. In other
words it takes 90 days for the inventory to get converted into sales. Our
next activity ratio is Debtors turnover ratio so let us learn more about it.
Example 2:
Suppose a firm has total sales of Rs.20 lakh in a year, out of which
80% sales were make on credit and there was no sales return. The
firm has opening and closing debtors of Rs. 3 lakh and Rs. 3.4 lakh
respectively. Now let us calculate Debtors Turnover Ratio.
This means that the debtors get converted into cash for 8 times in a
year. We can also calculate debtors velocity ratio by dividing number
of days in a year by Debtors Turnover Ratio. So DVR= 365/5 = 73
days. From this calculation we can say that it takes 73 days for
collection of dues from the debtors.
Just like Inventory Turnover Ratio, Debtors turnover ratio too does not
have any ideal standard for evaluation of efficiency. Usually the
acceptable or non- acceptable ratio is determined on the basis of
credit policy of the firm. Say for example in our case if the firm’s credit
policy is of 75 days, then 73 days can be considered as acceptable
velocity ratio. But if the policy is of 60 days then this velocity shows
negative activity ratio. This activity ratio can also be compared with
the standard credit policy followed by the respective industry. In
absolute terms, a high R/T ratio indicates good liquidity on one hand
and on the other it shows very restrictive credit policy. This means
that the firm takes risk of losing sales by not allowing credit to
customers. But if the turnover ratio is low, it may result in to blockage
of funds into debtors and thus decrease liquidity of the firm. It is
therefore essential to balance this ratio and maintain it at par with
industry standards and firm’s own credit policy. The next ratio that we
are about to study is just opposite of receivable ratio i.e. it is payable
ratio or creditors ratio.
Example 3:
In case of Debtors Turnover ratio we always try to aim for higher ratio
but in case of creditors turnover ratio we prefer lower turnover ratio.
This is because every firm looks at getting maximum credit period
from their supplier. But at the same time care should be taken that
firm’s payment mode should match with the creditor’s credit policy.
The higher the WCT, lower is the investment in the working capital and
higher is the profitability. Friends we have a separate unit that deals with
working capital management so we will confine ourselves to understand
the relationship between working capital and its impact on turnover ratio.
Now let us take an example to understand this concept:
Example 4:
Suppose, if the firm has net sales of Rs. 24 lakhs and current asset of
Rs. 6 lakhs and current liabilities of Rs. 4 lakhs. Then what would be its
WCT ratio?
Example 5:
Suppose the net sales of the firm is Rs. 18 lakhs and the total fixed
assets are worth Rs. 7 lakh and depreciation Rs. 1 lakh then Fixed Asset
Turnover ratio can be calculated as;
2. Total Asset Turnover Ratio: This ratio measures the per rupee
sales generated by per rupee of total asset being maintained by
the firm. Just like Fixed Asset turnover ratio this ratio also
establishes relation between total asset and sales. Here one factor
is to noted that when we talk of total fixed asset we ideally exclude
intangible assets like goodwill, trademark, patent etc. By now you
must have understood how this ratio is calculated? You are
absolutely right this ratio is calculated as
This ratio can be understood better with the help of some figures:
Example 6:
A firm has the net sales of Rs. 61,48,000 and total assets of 100 lakh
with goodwill worth Rs. 28,06,000. What would be total Asset Turnover
Ratio?
Friends, just like our previous ratio, this ratio also is satisfactory if it is on
higher side i.e. more the better. In order to check whether this ratio is
ideal, the firm has to compare it with its previous ratio or ratio of other
enterprise from same industry.
This was about comparing sales with the assets employed. One can also
establish relationship between sales and the total capital employed. So
our last ratio is:
LIQUIDITY RATIOS
2. Quick Ratio: This ratio is also called ‘Acid- Test Ratio’ or ‘Liquid
Ratio.’ This ratio establishes the relationship between quick current
assets and the current liabilities. A current asset is considered to
be liquid if it is convertible into cash without loss of time and value.
On the basis of this definition of liquid assets, the inventory is
singled out of the total current assets as the inventory is
considered to be potentially illiquid. The reason for keeping
inventory out is that it may become obsolete, unsalable or out of
fashion and may require time for realising into cash. Moreover, the
inventories have tendency to fluctuate in value. Another item which
is generally kept out is the prepaid expenses because by nature,
these prepaid expenses are not realisable in cash. So, the quick
ratio looks from the ready availability or convertibility into cash.
The quick ratio is therefore calculated as
Quick Ratio= Current Asset- (Inventory+ Prepaid Expenses)/ Total current liabilities
So under Quick Ratio, quick assets comprise of Bills receivable, debtors,
marketable securities, cash and bank balance.
Friends, all these three liquidity ratios focus on the short-term solvency
of the firm. Now the question arises as to who is interested in knowing
these ratios? Then, obviously owner is the one who is always conscious
about the liquidity of the firm. As well as the creditors are the one who
keep their eye on the liquidity ratio. They are interested to know how
safe their money is with the firm and what is the creditworthiness of the
firm Right? Higher the liquidity ratio safer is the creditors’ position but on
the other hand a firm is always interested in maintaining low or at the
most optimal liquidity ratio. This is because liquid assets are non
productive assets and investing more funds in these assets do not
generate any additional returns and as already mentioned higher
liquidity ratio adversely affects profitability of the firm. So it is advisable
to maintain standard liquidity ratio which would be acceptable by the
creditors as well as profitable to the firm.
,,
Introduction to Cash Flow Statement
Academic Script
INTRODUCTION
Cash:
Cash Equivalent:
Bank Overdrafts:
CLASSFICATION OF ACTIVITIES:
Classification of Activities
Taxes on income:
Cash flows arising from taxes on income should be
separately disclosed and classified as cash flows from
operating activities unless they can be specifically
identified with financing and investing activities.
Points to Remember:
1.Transactions that have no cash implications are
excluded from the cash flow statement. Therefore, the
transactions involving acquisition of assets by issue of
equity share is excluded from the cash flow statement.
Accordingly, increase in stock is calculated after excluding
the stock acquired by issue of shares. Similarly, the
machinery acquired by issue of equity share is excluded.
2. Disclosures are in accordance with AS3.
EXCHANGE DIFFERENCE:
General Principle:
Direct Method:
Indirect Method:
ANALYST’S PERSPECTIVE:
Academic Script
INTRODUCTION
A statement of cash flows, when used in conjunction with the rest of the
Financing statements, provides information that enables users to
evaluate the changes in net assets of an entity, its Financing structure
(including its liquidity and solvency), and its ability to affect the amounts
and timing of cash flows in order to adapt to changing circumstances
and opportunities. The statement of cash flows enhances the
comparability of performance of different entities. This is so because it
eliminates the effects of using different accounting policies for the same
transactions and events. It also helps one to examine the relationship
between profitability and net cash flow and the impact of changing
prices.
Cash comprises cash on hand and demand deposits, the latter being
deposits which can be withdrawn without prior notice and without
payment of any penalty. For example, term deposit with a bank is a
demand deposit. If a bank charges penalty for pre mature withdrawal of
a term deposit, that term deposit cannot be classified as demand
deposit. However, it will qualify as cash equivalent.
Cash Equivalent:
Cash equivalents are held for the purpose of meeting short-term cash
commitments rather than for investment or other purposes. An
investment normally qualifies as a cash equivalent only when it has a
short maturity of, say, three months or less from the date of acquisition.
Equity investments are excluded from cash equivalents.
Bank Overdrafts:
CLASSFICATION OF ACTIVITIES:
a. Operating activities;
b. Investing activities; and
c. Financing activities.
Classification of Activities
Points to Remember:
1. Transactions that have no cash implications are excluded from
the cash flow statement. Therefore, the transactions involving
acquisition of assets by issue of equity share is excluded from the
cash flow statement. Accordingly, increase in stock is calculated
after excluding the stock acquired by issue of shares. Similarly, the
machinery acquired by issue of equity share is excluded.
2. Disclosures are in accordance with AS3.
EXCHANGE DIFFERENCE:
General Principle:
Direct Method:
For preparing the consolidated statement of cash flows using the direct
method, cash flows of the subsidiary are measured at its functional
currency and then translated at the presentation currency of the
company (parent).
Indirect Method:
ANALYST’S PERSPECTIVE:
The starting point in the analysis is to enquire whether the company has
generated positive cash flow from operating activities. Several factors
affect a company’s ability to generate positive cash flow from operating
activities. Usually, a healthy enterprise in a steady state and operating in
a mature industry generates positive cash flow. On the other hand, a
growing enterprise that invests significantly in fixed assets, research and
development, advertising, training and working capital to support its
future growth may not be able to generate positive cash flow from
operations. Cash flow from operating activities should be analyzed from
this perspective.
The next question that an analyst asks about a company that generates
positive cash flow from operating activities is whether it is self-sufficient,
whether the surplus cash is available after working capital investment,
for distribution to debt-holders (interest and installment), long-term
investment and distribution to shareholders. If the internally generated
surplus cash is not sufficient to meet the needs of the company, it
resorts to external financing. An analyst analyzes the financing policy of
the company by examining the different sources that it has used to
mobilize additional resources.
Reconciliation of net profit and cash flow from operating activities helps
one to understand the quality of net profit reported in the profit and loss
account. An examination of the gap between the two provides an
understanding of the accounting policy of the company regarding non-
current amortizations. It also helps one to understand whether
increase/decrease in current assets and current liabilities are normal,
and whether adequate explanation is available for those changes.
A cash flow statement alone may not provide answers to all questions.
An analyst should gather information from the Board of Directors’ report
and the Management Discussion and Analysis presented in the annual
report along with annual Financing statements. Those two reports
provide management’s analysis of past performance, management
perspective of the business environment, and its projection of future
performance. Those reports, to an extent, describe the corporate
strategy. A cash flow statement should be analyzed in the context of
corporate strategy and likely changes in the business environment.
Individuals make personal decisions based in part on the amount of
cash they have and their expectations about future cash flows. Similarly,
current cash balances and forecasts of future cash flows are at the heart
of many business decisions. Managers, investors, and creditors all need
information about cash and cash flows so they can make decisions.
the numerical example which will further clear our concept on Cash
Flow Statement.
Additional Information:
Particulars Rs Particulars Rs
241600 241600
Machinery Account
Particulars Rs Particulars Rs
366000 366000
Particulars Rs Rs
(26000 + 1200)
From our Cash Flow Statement we have calculated have cash has flown
in operating activities, investing and financing activities.