Fundamental of Financial Accounting: (Document Subtitle)

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Fundamental of Financial

Accounting
[Document subtitle]

Gurudas Swain
Academic Script:

The world of Finance and Financial Management is quite vibrant. It is


applicable universally from individuals to business organizations,
Government and even to the international organizations.

In order to add and update one’s own knowledge, we must read and
interact also with the people in Finance.

 Regular reading and observations may include News papers


specially financial newspapers, magazines, Company annual
reports, Government Reports, etc.
 Observation of market trends through Stock Market quotations,
Commodity Market trends will keep you well informed.
 Visits to various forms of organizations specially Corporates will
acquaint us with their styles of operations, flow of documents and
strategies. Attending Annual General Meetings of corporate will be
another experience to know, how different commercial laws are
followed by them.
 There are offices of many leading Government organizations like
RBI, Stock Markets, SEBI, NSDL, etc. in our neighborhood. It is
essential to visit them to understand their functioning.
 There are many professionals in the field of Finance like
consultants, auditors and others. It will be useful to have
interaction with them to add to our knowledge and also to clear the
doubts.

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

Introduction to Financial Accounting:

We have notice that every individual is engaged in some kind


of financial transactions. An employee, a doctor, a teacher, a
shopkeeper an advocate, a hospital, a bank, a club, and a
company – all are busy in performing financial transactions.
Recording of the various financial transactions helps various
persons and institutions to work efficiently.

For example, a housewife keeps record of her receipts and


payments. She can plan her future income and expenses.

A business is engaged in a large number of transactions. A


systematic record of transactions is dispensable for every
business. Accounting came into practice as an aid to human
memory by maintaining a systematic record of business
transactions. It was subsequently realized that accounting is
capable of providing the kind of information for decision-
making by managers and other interested persons. This aspect
of accounting has become so important that accounting is
regarded as an information system or language of business.

Accounting

The concept of accounting has changed with the passage of


time. As a result, accounting has been defined in different ways
and there is no unanimity as to precise definition of accounting.
However, the definition given by the American Accounting
Association (AAA) is widely accepted. According to AAA
“accounting is the process of identifying, measuring and
communicating economic information to permit informed
judgments and decisions by users of the information.”
According to this definition, the function of accounting is to
provide the information about the business activities. Robert
Anthony has rightly pointed out that “Accounting has been
called the language of business”. The basic function of any
language is to serve as a means of communication. Accounting
summarizes financial transactions and enables the accountants
to convey economic information to various parties interested in
them so as to enable them to make correct judgments.
Communication is preceded by accounting process which
consists of recording, classifying, summarizing and
interpreting.

As an information system, accounting system may be shown as


under:

Input Processing Output


System
Business  Recording Financial
transactio  Classifying Statements
ns in  Summarizing for
terms of  Analyzing and Communicati
money Interpreting on

Following are the attributes of recording:

1. The input of accounting comprises the business


transactions which can be measured in terms of money.
2. Accounting is the process of recording, classifying and
summarizing the business transactions.
3. Accounting consists of interpreting the results.
4. Accounting conveys economic information to various
groups interested in them.

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:

Financial Accounting is the original form of accounting.


Financial accounting is mainly concerned with recording,
classifying and summarizing financial transactions with a view
to prepare financial statements. The main task of financial
accounting is to prepare Income Statement i.e. Profit and Loss
Account and the Statement of Financial Position i.e. Balance
Sheet.

The main objective of financial accounting is to ascertain profit


earned during a year and financial position at the end of the
year.

Cost Accounting:

Cost Accounting is a specialized branch of accounting which


involves classification, accumulation, assignment and control of
costs.

The main purpose of cost accounting is to ascertain the cost of


production, to enable the management fix the price of the
product and to ensure the cost reduction. Cost accounting is
generally adopted in the business engaged in manufacturing
activities.

Cost accounting is internal to the organization and has the


objective of assisting management in the performance of
managerial functions.

Management Accounting:
Management Accounting is concerned with accounting
information which is useful to the management in formulating
policies and controlling the business operations.

The main purpose of management accounting is to provide all


the relevant information that may be required by the
management to take decisions. It is also concerned with
evaluation of performance of the management as an
institution.

Financial Accounting:

Financial accounting is the most popular branch of Accounting.


In general, financial accounting and accounting are used
interchangeably. Kohler, in Dictionary for Accountants, has
defined financial accounting “as the accounting for revenues,
expenses, assets and liabilities that is commonly carried on in
the general office of a business”.

Objectives of Financial Accounting

Following are the objectives of financial accounting:

1. To keep systematic records: The primary objective of


financial accounting is to maintain a systematic record of
business transactions. There is a limit to human memory
and, therefore, a systematic record of all transactions is
essential for every business.
2. To calculate income: Another objective of financial
accounting is to ascertain profit or loss earned by the
business during an accounting year. This is done by
preparing Profit and Loss Account or Income Statement.
3. To ascertain financial position: every businessman desires
to know about his financial position i.e. where he stands,
what he owns and what he owes. This is served by the
Balance Sheet. Balance sheet is a statement of assets,
liabilities and capital on a particular date.
4. To communicate the information: The last but not the
least objective of the financial accounting is the
communicate the various information and facts to various
interested groups viz. owners, creditors, employees,
investors, taxation authorities etc. Financial accounting
facilitates rational decision making by providing relevant
data.

Process of Financial Accounting:

The role of financial accounting is that of a processing system


whose input is events and transactions in terms of money and
the output is in the form of financial statements. In order to
achieve its objectives, the financial accounting performs the
following functions:

5. Recording
6. Classifying
7. Summarizing
8. Interpreting

1. Recording: Financial accounting consists of recording of


business transactions and events in a systematic way.
2. Classifying: Classifying means grouping the transactions
of same nature at one place. This is done by preparing
appropriate accounts in Ledger. For example, all
transactions relating to cash would be recorded in the
Cash Account.
3. Summarizing: Summarizing involves the preparation of
financial statements i.e. Profit and Loss Account and
Balance Sheet. Summarizing helps in conveying economic
information to various parties interested in them.
4. Interpreting: Finally, the accountants are required to
interpret the contents of financial statements. For this,
accountants analyze the financial statements by
establishing relationship between the items of the
financial statements. This will enable the users to make
balanced decisions.

NATURE OF FINANCIAL ACCOUNTING

Financial accounting is regarded as information system.


Today, financial accounting is not confined only to
recording of transactions. Of late, people realized that
financial accounting is capable of providing the kind of
information that managers and other interest persons
need in order to make better decisions. As an information
system, financial accounting collects data and
communicates economic information about the
organization to a wide variety of users whose decisions
and actions are related to its performance. The
information is regularly communicated through accounting
reports and statements. Accounting reports may be daily,
weekly, monthly, quarterly or yearly depending upon the
needs of the users. Thus, primary function of financial
accounting is to provide useful information for decision
making. Financial accounting systems should be designed
in such a way that the right information is communicated
to the right person at the right time.

The input of financial accounting is business transactions


of financial nature. The output of financial accounting is
accounting reports and financial statements. The
information generated by accounting reports and financial
statements meets the information needs of various group
of people such as owners, management, employees,
creditors, government etc. That is why financial
accounting has been called the language of the business.

USERS OF FINANCIAL ACCOUNTING INFORMATAION

Financial accounting information may be useful to number


of groups. These groups may be internal or external.
External users are the outside parties who may be directly
or indirectly interested in the working of the business. The
main external users are investors, creditors , taxation
authorities and government. Internal users of accounting
information are those groups of persons who are within
the organization. The main internal user is management.
Some of the important users of accounting information
and their needs are discussed as under:

1. Owners: Owners are persons who provides funds to


the business and share the risks. Owners are directly
interested in knowing the profitability and financial
soundness of the business. According to Paton and
Dixon, the owners of a business enterprise like to seek
the answers to the following questions

 How much have we earned this year ? How much


during the past year ? Is our business improving?
 How much cash do we have? How much do our
customers owe us? Are they paying us regularly?
 How much do we owe our suppliers and other
creditors?
 How much money do we have invested in our
business? How much of it is represented by earnings
that have been retained (that is not withdrawn) for
expansion purposes?
Financial accounting information provides the
suitable answers of these questions. Owners are
interested in the value of their investment and the
return of their investment in the current year as well
in future.

2. Management: One of the important functions of


financial accounting is to keep the management
informed of various activities of the enterprise so as to
assist in the performing managerial functions viz
Planning, Organizing, Staffing, Directing and
Controlling. Accounting information act as “ Eyes and
Ears” of the management. The supply of information at
the appropriate time helps the management for sound
decision making particularly in a case of a company
where there is separation of ownership and
management. Management uses accounting information
as a means of self evaluation. Management assist its
managerial skill through the financial statements.
Management would like to seek answers to the
following questions:

 How much profit did the company make during


the last accounting period?
 Is the return to shareholders adequate? How can
it be improved?
 Does the company have enough cash on hand to
pay the debts when they fall due? What are the
projected cash needs in the next quarter?
 Which product are the most profitable ?
 What is the cost of manufacturing each product?
 Which cost exceeds the budget?
 How much money should be borrowed to expand
the business?
3. Employee: Like owner, employees of the business
enterprise are also interested in the good running of the
enterprise because their lively hood depends on the
earning of the enterprise. Employees need accounting
information for claiming increase in wages, bonus and
other benefits. Accounting information is also required
for deciding workers share in the profit and settling
wage disputes. They need accounting information to
ensure that total profit is correctly ascertained and
there share in the profit is also correctly ascertained.

4. Investors: Investors are the person who want to


invest their money in the business. Before taking any
decision to invest their money in the business
enterprise, investor would like to know how safe their
proposed investment would be. Accounting information
provides investors various indicators of past
performance and future prospects of the organization. A
study of financial statements help them in this respect.

5. Short-Term Creditors: Short-Term Creditors are the


persons who provide business enterprises raw
materials, goods and services and financial resources
that are payable within one year. Short term creditors
are interested in accounting information regarding
liquidity of the business enterprise. They want to
determine whether the business enterprise is in the
position to meet its obligations when they are due. As a
result the existing cash position, outstanding debts and
efficiency with which the liquid resources have been
employed, are of utmost concerns to short term
creditors.

6. Long-Term Creditors or Lenders: Bankers and


financial institutions are long term creditors who lend
money to a business enterprise with a view to earn
interest. Such a creditors are interested in solvency of
the company that is the financial soundness of the
company to repay the principal amount at the time of
maturity. Such a creditors are also interested from the
financial statements that the interest is well covered by
the profits so that the payment of interest will be made
through out the term of loans.

7. Government: The central and state governments have


a regulatory role to ensure a balanced industrial and
fiscal policy through collection of taxes viz sales tax,
income tax, excise duties etc. For this government
needs detail accounting information. Income tax
returns are the financial reports prepared from
accounting records of the enterprise. Accounting
information is also needed by the different government
departments for framing policies.

8. Consumers: Consumers are the persons who use the


products or services produced by the enterprise.
Consumers need accounting information to suggest the
enterprise about the reduction of prices by reducing
cost of production. Consumers can create public opinion
against the enterprise which exploit the consumer by
charging exorbitant price. For this purpose, consumer
have to watch financial statements carefully.

LIMITATIONS OF FINANCIAL ACCOUNTING

Following are the important limitations of financial accounting:

1. Quantitative Information: Financial accounting records


only that information which can be quantitatively
measured i.e. which can be measured in terms of money.
Events, which cannot be measured in terms of money, will
not find a place in the accounts even though it is
important for the business. For example, policies of the
government have a direct effect on the working of
business but financial accounts will not record its impact
because it cannot be measured in terms of money.
2. Historical in Nature: Financial accounting is historical in
the nature in the sense that accounting data are
summarized only at the end of accounting period.
Financial statements throw light on what has happened
during a particular period. The impact of future
uncertainties i.e. what will happen has no place in
financial accounting. It does not suggest what should be
done to increase the efficiency of the enterprise.
3. Recording of Actual Costs: Only actual cost figures
relating to purchase of materials, property or other assets
is recorded in the account books. The price of goods and
assets change from time-to-time. Accountants ignore the
changes in the values of assets. Present value of assets
may be absolutely different from the recorded values.
Recorded values do not provide correct information about
the assets.
4. Conflict between Accounting Principles: There is
conflict between different accounting principles. For
example, principle of prudence (conservatism) requires
that stock should be valued on the basis of cost or market
price whichever is less. This principle is in conflict with
principle of consistency which requires that either cost or
market price basis should be consistently followed.
5. Personal Judgment: Financial statements are influenced
by the personal judgment of the accountant. An
accountant uses his personal judgment with regard to the
adoption of accounting policies. Due to this, financial
statements may not be objective and comparable.
6. Not exact: Financial statements may not reflect the
realistic position as some of the information are based on
estimates which may not be accurate all the times. For
example, depreciation is an estimated figure.
7. Not suitable for Cost Control: Financial accounting fails
to provide data for comparison of costs of different
periods, jobs, departments, operations etc. Financial
accounting discloses only the net result of the collective
activities of the business as a whole. Hence, cost control is
not possible in financial accounting. There is no technique
in financial accounting which can help to distinguish
controllable costs from uncontrollable costs. There is no
procedure to assign responsibility for increase in costs, if
any.
8. Not Helpful for Decision-Making: Financial accounting
does not provide data which may be useful for decision-
making by the management. Financial accounting is not
helpful in fixing the prices of the products. It is not
possible to evaluate various policies and programmes in
financial accounting. Financial accounting does not provide
information for strategic decisions like replacement of
labor by machinery, introduction of a new product,
expansion of capacity etc.
Financial Accounting:
Basic Concepts & Conventions

Academic Script

Accounting plays a significant role in society by providing information to


various groups of persons such as owners, management, creditors,
regulatory authorities etc. Accounting is the language of business. With
a view to make the accounting language a standard language, there is a
need for accounting theory. Accounting theory ensures uniformity in the
accounting system, the accounting procedure and presentation of
accounting results. Accounting theory makes the accounting information
meaningful to its users. With the help of theory base of accounting,
everyone can understand the accounting reports and financial
statements in the correct perspective.

Theory base of accounting ensures uniformity in the preparation and


presentation of financial statements by removing the effect of diverse
accounting practices. Accounting theory makes accounting reports more
reliable, understandable, relevant and comparable.

Theory base of accounting consists of principles, concepts, rules and


guidelines developed over a period of time to bring uniformity and
consistency to the process of accounting and enhance its utility to
different users of accounting information. Besides this, accounting
standards also constitute a theory base of accounting. Hence, theory
base of accounting includes the following:

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

Accounting Entity Concept


Accounting Entity or Business Entity or Separate Entity Concept means
that business is considered as a separate and distinct entity from the
person or persons who own it. Accounts are maintained for recording the
transactions of the business as separate entity. The owners of the
business are treated as creditors of the business to the extent of capitals
invested by them in the business.
Accounting Entity Concept is applicable to all forms of business
organizations. Although for legal and practical purposes sole
proprietorship and partnership are separate from their owners, a sole
proprietor and partners are treated as separate entity. The accounting
equation Assets = Liabilities + Capital is an expression of the Accounting
Entity Concept because it shows that business itself owns the asset and,
in turn, owes to the various claimants.
Whenever a business receives cash from the proprietor, it is recorded as
capital in the liabilities side of Balance Sheet. Similarly, whenever a
proprietor withdraws some cash or goods from the business, capital is
decreased. In short, Accounting Entity Concept requires that accounting
records of the business should record the transactions of the business
only and not of the proprietor of the business.
Accounting Entity Concept is very significant because it limits the
transactions that are to be included in accounting records. If accounting
entity concept is not followed, affairs of the business will not be
available. In such a case, it would be very difficult to evaluate the
performance of the business since the private transactions introduce
bias in the results.

Money Measurement Concept


Accounting is a process of measurement and communication of the
activities of the firm. This requires a unit of measurement necessary to
record the transactions of a business enterprise in accounting books.
The unit of measurement in accounting is the monetary unit. Money
measurement concept means that only those transactions, which can be
expressed in term of money, are recorded in books of accounts. It
means that transactions or facts, which cannot be expressed in terms of
money, will not be recorded. For example, general health condition of
the managing director, working conditions, sales policy, industrial
relations, quality of products etc. are very useful facts of the business
but are not shown in the books of accounts because these cannot be
expressed in terms of money.
This concept restricts the scope of accounting to the information which
can be expressed in terms of money. In this way, the scope of personal
judgment and bias is restricted. Further, this concept makes the
accounting data homogenous and helps in understanding the affairs of
the business.
This concept has some limitations. As a result of this concept,
accounting reports do not give a complete account of the facts and
happenings in the business enterprise. The information reported by the
financial statements is essentially monetary and quantified and may not
show an accurate picture of the conditions of the enterprise. Another
serious limitation of the concept is that a transaction is recorded at its
money value on the date of occurrence and the subsequent changes in
the money value are ignored. Due to this concept, accounting treats
all monetary units as the same irrespective of their time dimension. As a
result, the utility of accounting information is doubtful.

Going Concern Concept


Going Concern Concept means that business will exist indefinitely and
business is not going to be liquidated in foreseeable future. All the
business transactions are recorded on the basis of this concept.
The role of going concern concept in the accounting may be
summarized as under:
1. On the basis of this concept, a business enterprise would be able
to meet its contractual obligations and uses its resources
according to the plans.
2. On the basis of this concept, a distinction is made between assets
and expenses i.e. capital expenditure and revenue expenditure.
3. Fixed assets are valued and recorded in the Balance Sheet at
historical cost less depreciation. The market value of fixed assets
is not taken into account. In the absence of this concept, fixed
assets would have been valued at the current market value. Fixed
assets are depreciated on the basis of estimated useful life rather
than on the basis of market value.
4. Assets are classified as current assets and fixed assets. Similarly,
liabilities are classified as current or short-term liabilities and non-
current, fixed or long-term liabilities.
5. Prepaid expenses, outstanding expenses, unearned incomes and
accrued incomes exist in the Balance Sheet and Profit and Loss
Account only due to this concept.
6. This concept compels an accountant to direct his attention to the
proper allocation of expenses and incomes to the current period.
Accounting Period Concept
This concept is linked with the going concern concept. According to
Accounting Period Concept, the economic life of an enterprise is divided
into some shorter and convenient period for the measurement of
income. An accounting period is the interval of time at the end of which
financial statements are prepared in order to show the results of the
business. Since the life of business is considered to be indefinite, the
measurement of income and studying the financial position of the
business after a very long period will not be helpful to various groups
interested in the business. Therefore, the accountants choose some
shorter and convenient time for the measurement of income. For the
purpose of external reporting, one year is the accounting period. Various
tax laws like Companies Act, Income Tax Act, Sales Tax Act etc
recognize one year as an accounting period.
This concept facilitates the preparation of financial statements.

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.

Dual Aspect Concept


Dual Aspect Concept means that every transaction has two aspects and
an account should record both the aspects of every transaction. This
concept is the foundation on which whole of accounting cycle is based.
That is why double entry system of book-keeping came into existence.
One entry consists of debit to one or more accounts and credit to one or
more accounts of the same amount. Thus, total amount debited is
always equal to the total amount credited. For example, if there is
purchase of goods, it has two aspects: one aspect is receipt of goods
and the second aspect is payment of cash or a debt. The journal entry
will be:

Purchase A/c Dr.


To Cash/Supplier A/c
This concept has given us the fundamental rule “for every debit there
is equivalent credit.” Accordingly, we have developed accounting
equation as follows:

Asset = Equities
Or
Assets = Owners Equity (Capital) + Outsiders Equity (Liabilities)

The concept is very useful in recording business transactions. If it is


ignored, accounting records will not show true financial position of the
business. This concept facilitates preparation of Trial Balance which
helps in detecting errors and having strict control over the employees.

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.

1. In case of hire purchase transaction, property in goods is


transferred to the buyer only when hire purchaser pays the last
installment. But sales are presumed to have been made to the
extent of the installments due during the year.
2. In the contract, a contractee is liable to pay when contract is
completed but the contractor calculates the profit on the basis of
the basis of work certified year after year.
3. Some goods have ready market. Revenue in case of gold,
silver, scarce goods etc. is recognized at the time of their
production i.e. even before sale.

The concept prevents the management from inflating their profits by


recording incomes which are not realized. The concept facilitates correct
estimate of income of business enterprise.

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 plays a significant role in society by providing information to


various groups of persons such as owners, management, creditors,
regulatory authorities etc. Accounting is the language of business. With
a view to make the accounting language a standard language, there is a
need for accounting theory. Accounting theory ensures uniformity in the
accounting system, the accounting procedure and presentation of
accounting results. Accounting theory makes the accounting information
meaningful to its users. With the help of theory base of accounting,
everyone can understand the accounting reports and financial
statements in the correct perspective.
Theory base of accounting ensures uniformity in the preparation and
presentation of financial statements by removing the effect of diverse
accounting practices. Accounting theory makes accounting reports more
reliable, understandable, relevant and comparable.

Theory base of accounting consists of principles, concepts, rules and


guidelines developed over a period of time to bring uniformity and
consistency to the process of accounting and enhance its utility to
different users of accounting information. Besides this, accounting
standards also constitute a theory base of accounting. Hence, theory
base of accounting includes the following:
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 the important accounting conventions:
1. Convention of Conservatism
2. Convention of Consistency
ACCOUNTING STANDARDS:
Accounting, as a language of business, communicates the financial
information of an enterprise to various groups by means of financial
statements. Financial statements should exhibit a “true and fair view” of
state of affairs of an enterprise. The various groups have different
information needs and conflict of interests may arise between them.
Hence, there is a need to regulate the accounting process properly;
otherwise financial statements will give misleading picture of the
business. Accounting standards provide a basis to resolve potential
financial conflicts, if any, between various groups. An accounting
standard is generally understood and accepted measure of the
phenomenon of the enterprise. Accounting standards are needed to
ensure uniformity in the preparation and presentation of financial
statements. Accounting standards ensure comparability of the data
published in the financial statements.

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.

SIGNIFICANCE OF ACCOUNTING STANDARDS:


Accounting standards play an important role in the field of accounting.
Accounting reports, prepared in accordance with accounting standards
are reliable, uniform and consistent. The significance of accounting
standards may be listed as under:
1. Accounting standards provide right direction for maintaining
accounting records. Accounting standards serve as guides to
action.
2. Accounting standards make accounting procedures universally
acceptable. This brings about uniformity in accounting.
3. Accounting standards facilitate uniform preparation and
reporting of financial statements. Various groups viz. investors,
creditors, employees etc. will have no problem in making
comparative study of accounts of various enterprises.
4. Accounting standards help the public accountants to deal with
the clients.
5. Accounting standards raise the standard of audit of accounts.

TYPES OF ACCOUNTING STANDARDS:


Following are two types of accounting standards:
1. International Accounting Standards
2. National Accounting Standards

INTERNATIONAL ACCOUNTING STANDARDS:

International Accounting Standards Committee (IASC) came into


existence on 29th June, 1973 when 16 accounting bodies from the
nations (called as founder members) signed an agreement and
constitution for its formation. The committee has its headquarters in
London. The objective of the committee is “to formulate and publish, in
the public interest, standards to be observed in the presentation of
audited financial statements and to promote their world-wide acceptance
and observance”. The basic idea of issuing the International Accounting
Standards is to ensure that financial statements comply with such
standards in all material respects. There are a number of International
Accounting Standards which have only a persuasive value.

NATIONAL ACCOUNTING STANDARDS:


Many countries have their own accounting standards. Where national
accounting standards are mandatory, national accounting standards
prevail over the international accounting standards. When there is no
national accounting standards, international accounting standard should
be followed by the public accountants. Normally, the local members of
IASC ensure that the national accounting standards are in line with the
international accounting standards. The presence of the international
and national accounting standards need harmonization of accounting
standards.

ACCOUNTING STANDARDS IN INDIA:


The Institute of Chartered Accountants of India and the Institute of Cost
and Works Accountants of India are both members of the International
Accounting Standards Committee. On 22nd April, 1977, the Council of
the Institute of Chartered Accountant established an Accounting
Standard Board (ASB). The main function of ASB is to formulate
accounting standards; so that such standards will be established by the
Council of the Institute of Chartered Accountants. While formulating the
accounting standards, the ASB gives due consideration to the
International Accounting Standards and tries to integrate them to the
extent possible. It also takes into consideration the applicable laws,
customs, usages and the business environment prevailing in India.

PROCEDURE OF PREPARING ACCOUNTING STANDARDS:


The procedure for formulating accounting standards in India is designed
to ensure the participation of all those who are interested in the
formulation and implementation of accounting standards. ASB
determines the areas which need formulation of accounting standards.
Then, ASB prepares Exposure Draft (ED) which is published in the
professional journals and circulated to receive comments from the
professional bodies, securities markets, regulatory agencies etc. After
obtaining the views, suggestions and comments, Exposure Draft is
suitably revised and is reissued as Accounting Standard. Accounting
standards are recommendatory in the initial years. Later on, these
standards may become mandatory depending upon the circumstances.
By now, the Institute of Chartered Accountants of India has issued 31
accounting standards given below:
AS-1 Disclosure of Accounting Policies
AS-2 Valuation of Inventories
AS-3 Cash Flow Statements
AS-4 Contingencies and Events occurring after the Balance Sheet Date
AS-5 Prior Period and Extraordinary Items and Changes in Accounting
Policies
AS-6 Depreciation of Accounting
AS-7 Accounting for Construction Contracts
AS-8 Accounting for Research and Development
AS-9 Revenue Recognition
AS-10 Accounting for Fixed Assets
AS-11 Accounting for Effects of Changes in Foreign Exchange Rates
AS-12 Accounting for Government Grants
AS-13 Accounting for Investments
AS-14 Accounting for Amalgamation
AS-15 Accounting for Retirement Benefits in the Financial Statements
of Employers
AS-16 Borrowing Costs
AS-17 Segment Reporting
AS-18 Related Party Disclosures
AS-19 Leases
AS-20 Earning per Share
AS-21 Consolidated Financial Statements
AS-22 Accounting for Taxes on Income
AS-23 Accounting for Investments in Consolidated Financial Statements
AS-24 Discontinuing Operations
AS-25 Interim Financial Reporting
AS-26 Intangible Assets
AS-27 Financial Reporting of Interests in Joint Venture
AS-28 Asset Impairment
AS-29 Provisions, Contingent Liabilities and Contingent Assets
AS-30 Financial Instruments: Recognition and Measurement
AS-31 Financial Instruments: Presentation

COMPLIANCE OF ACCOUNTING STANDARDS:


The compliance of accounting standards ensures uniformity in the
preparation and presentation of financial statements. International
Accounting Standards have only a persuasive value and have no
statutory force. However, Indian Accounting Standards, in the initial
years, are recommendatory. During this period, Institute of Chartered
Accountants gives wide publicity among the users and educate its
members about utility of accounting standards and the need for
compliance with the disclosure requirements. Once the accounting
standards become mandatory, it will be the duty of members of the
Institute to ensure that accounting standards are implemented in the
presentation of financial statements. In the event of any deviation from
the accounting standards, they have to disclose in their reports so that
the users of the financial statements may be aware of such deviations.
According to Section 211 of Companies (Amendment) Act 1999, Profit
and Loss Account and Balance Sheet (a) Deviation from the accounting
standards, (b) reasons for such deviation and (c) financial effect arising
due to such deviation.
Thus, it is the auditors who, while discharging their attest functions, have
to ensure that the accounting standards are implemented in the
presentation of the financial statements covered by the auditor’s report.
The auditors are required to disclose any deviations from the standards
or non-compliance of such standards.
AS-1 Disclosure of Accounting Policies:
This accounting standard deals with the disclosure of significant
accounting policies followed in preparing and presenting financial
statements. The purpose of this standard is to promote better
understanding of financial statements by the manner in which
accounting policies are disclosed in the financial statements facilitating
more meaningful comparison between financial statements of different
enterprises.

AS-2 Valuation of Inventories:


This standard deals with the determination of values of
inventories reflected in financial statements. It also includes
ascertainment of cost of inventories and write down thereof to net
realizable value.
AS-3 Cash Flow Statements:
This Standard deals with the provision of information about the
historical changes in cash and cash equivalents of an enterprise by
means of a cash flow statement which classifies cash flows during the
period from operating, investing and financing activities.

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.

AS-8 Accounting Policies, Changes in Accounting Estimates and Errors:


The objective of this Standard is to prescribe the criteria for
selecting and changing accounting policies, together with the accounting
treatment and disclosure of changes in accounting policies, changes in
accounting estimates and corrections of errors. The Standard is
intended to enhance the relevance and reliability of an entity’s financial
statements and the comparability of those financial statements over time
and with the financial statements of other entities.
AS-9 Revenue Recognition:
This standard is concerned with the recognition of revenue arising in
the course of the ordinary activities of the enterprise from a) Sale of
Goods, b) Rendering of Services c) Income from Royalties, Dividends
and Interest.
AS-10 Accounting for Fixed Assets:
This accounting standard deals with accounting for fixed assets like
land, building, vehicles, furniture, goodwill, patents, trademarks, design.
AS-11 Accounting for Effects of Changes in Foreign Exchange Rates:
This standard deals with accounting for transactions in foreign
currencies, translating the financial statements of foreign operations,
also forward exchange contracts.
AS-12 Accounting for Government Grants:
This standard deals with accounting for government grants, many a
times called by other names as subsidies, cash incentives, duty
drawbacks etc.
AS-13 Accounting for Investments:
This standard deals with accounting for investments in the financial
statements of enterprises and related disclosure requirements.
AS-14 Accounting for Amalgamation:
This standard as said deals with amalgamation and treatment of
goodwill or reserves.
AS-15 Accounting for Employee Benefits:
This standards aims to prescribe accounting and disclosure of
various employee benefits recognizing liabilities and expenses.
AS-16 Borrowing Costs:
This standard, as the name goes, deals with accounting procedures
for borrowing costs. However it doesn’t deal with imputed or actual cost
of owner’s equity, including preference shares.
AS-17 Segment Reporting:
The objective of this standard is to establish principles for reporting
financial information, about different types of products and services an
enterprise produces and the different geographical areas in which it
operates. Such information helps users of financial statements to
a) Better understand the performance of an enterprise
b) Better assess the risk and return of an enterprise
c) Make more informed judgments and about enterprise as a whole.
AS-18 Related Party Disclosures:
This standard requires reporting of related party relationships and
transactions between them in consolidated financial statements.
AS-19 Leases:
This standard deals with accounting for all leases (other than lease
agreements for exploration of oil, gas, timber, metals, licensing
agreements for films, plays, manuscripts, patents, copyrights and use of
land).
AS-20 Earning per Share:
The objective of this standard is to prescribe principles for the
determination and presentation of earnings per share which will improve
comparison of performance to enhance quality of financial reporting.
AS-21 Consolidated Financial Statements:
The objective of this standard is to lay down principles and procedures
for preparation and presentation of consolidated financial statements.
Consolidated financial statements are presented by a parent (also
known as holding enterprise) to provide financial information about the
economic activities of its group. These statements are intended to
present financial information about a parent and its subsidiary(ies) as a
single economic entity to show the economic resources controlled by the
group, the obligations of the group and results the group achieves with
its resources.
AS-22 Accounting for Taxes on Income:
The objective of this standard is to prescribe accounting treatment for
taxes on income, it being a significant item in Profit and loss for an
enterprise owing to various differences in accounting and taxable
income.
AS-23 Accounting for Investments in Consolidated Financial Statements:
The objective of this standard is to set out principles and procedures
for recognizing, in the consolidated financial statements, the effects of
the investments in associates on the financial position and operating
results of a group.
AS-24 Discontinuing Operations:
This standard deals with establishing principles for reporting information
about discontinued operations, helping users of financial information to
take better decisions.
AS-25 Interim Financial Reporting:
This standard prescribes minimum content of interim financial reports,
helping timely and reliable reporting to various stakeholders about
organizations financial condition.
AS-26 Intangible Assets:
This standard prescribes guidelines for accounting treatment for
intangible assets helping organizations deciding on what comprises of
intangible assets with necessary conditions and disclosures.
AS-27 Financial Reporting of Interests in Joint Venture:
The objective of this standard is to set out principles and procedures for
accounting for interests in joint ventures and reporting of joint venture
assets, liabilities, income and expenses in the financial statements of
ventures and investors.
AS-28 Impairment of Assets:
The objective of this standard is to prescribe the procedures that an
enterprise applies to ensure that its assets are carried at no more than
their recoverable amount. This requires organizations to indentify such
assets and probable impairment loss.

AS-29 Provisions, Contingent Liabilities and Contingent Assets:


The objective of this standard is to ensure that appropriate recognition
criteria and measurement bases are applied to provisions and
contingent liabilities and that sufficient information is disclosed in the
notes to the financial statements to enable users to understand their
nature, timing and amount.
All these 1 to 29 accounting standards are mandatory, those
listed below are not, as in September,2014.
AS-30 Financial Instruments: Recognition and Measurement:
The objective of this standard is to establish principles for recognizing
and measuring financial assets, liabilities and some contracts to buy or
sell non financial items.
AS-31 Financial Instruments: Presentation:
This standard aims at establishing principles for presenting financial
instruments as liabilities or equity and for offsetting financial assets and
liabilities and classification of financial instruments from the perspective
of the issuer.
AS-32 Financial Instruments: Disclosures:
This standard prescribes entities to provide disclosures with respect to
significance of financial instruments for entity’s financial position and
performance, nature and extent of risks arising exposed and
management of these risks in financial statements.
GAAP and IFRS

(Generally Accepted Accounting Principles & International Financial Reporting


Standards)

Academic Script

Accounting, as a language of business, communicates the financial information


of an enterprise to various groups by means of financial statements. The
various groups have different information needs and conflict of interests may
arise between them. Hence, there is a need to regulate the accounting process
properly otherwise financial statements will give misleading picture of the
business.

Concept

Students, as we are aware that financial statements are end products of


accounting process. Accounting Process is of critical importance and any
deviation in implementing it will lead to financial statements that would not
reveal true of fair view of business organisation. This is where GAAP (Generally
Accepted Accounting Principles) comes in picture.

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

Public companies, nonprofit organisations, and government entities are required


to prepare financial statements in accordance with GAAP. These guidelines
were developed over time by the Financial Accounting Standards Board
(FASB), and the American Institute of Certified Public Accountants (AICPA).

In short we can summarise that -

 GAAPs are the backbone of the accounting information system, without


which whole system cannot function.
 Financial statements can’t be told as showing true and fair view, unless
these statements are drawn upon GAAPs.
 To avoid any confusion and maintain uniformity, accounting process is
applied within the conceptual framework of “Generally Accepted
Accounting Principles” (GAAP).

Principles of GAAP:

GAAP encompasses a wide range of accounting practices and philosophies.


Some key areas covered by GAAP include:

 Recognition: How assets, liabilities, revenues, and expenses are recognised


on financial statements

 Measurement: How profits and losses are measured and reported on financial
statements
 Presentation: How information needs to be presented on financial statements

 Disclosure: What information needs to be shared 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.

When applied to non-profits and government organisations, the goal of GAAP is


to ensure complete transparency on the part of the reporting entities.
Information provided under GAAP needs to be not only clear, comprehensive,
and easily understood, but verifiable by auditors and other outside parties.

In short we can say that

GAAP consists of four components

 The requirements of law


 The judgments by court of law.
 Pronouncement by the governing bodies (FASB in US, ICAI in India)
 Requirements by regulatory authorities (RBI, SEBI etc)

GAAP guides on Accounting Principles, Accounting Concept and Accounting


standards.

Accounting principles:

“A general law or rule, adopted or professed as a guide to action, a settled


ground or basis of conduct or practice.”
These are adopted by accountants universally while recording the accounting
transactions to ensure uniformity, clarity and understanding while recording
transactions.

Accounting principles facilitates communicating the results of business to


outside world, based on certain uniform and scientifically laid down principles
and postulates.

Accounting Concepts

Accounting Concepts are those basic assumptions or conditions upon which


accounting is based. Important accounting concepts are:

Business Entity Concept:– Entity is different from its owner for accounting
purposes.

Dual Aspect Concept:– Recording simultaneously debits credits. Equity+


Liabilities = Assets

Cost Concept:– Assets are normally recorded basis of historical cost i.e.
acquisition cost. Market value immaterial, except on concepts of revaluation.

Going Concern Concept:– Always on anticipation that a business will continue


for long and will not be liquidated.

Accounting Period Concept: – Though business continues indefinitely, life of


business sub-divided into accounting periods (generally of 1 year).

Money Measurement Concept: – Those transactions which are expressed in


money terms are only recorded.
Realisation Concept:- Revenue is recognised only when, an agreement is
reached or sale is made. Exceptions may be on certain businesses such on
HP/sale on contract etc.

Constant Value Concept: Assumption of constant value of currency e.g.


rupee.

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).

Consistency: – In order to achieve comparability of the financial statements of


an enterprise through time, the accounting policies are followed consistently
from the one period to another. A change in accounting policy is made only in
certain exceptional circumstances.

Accounting Standards

Accounting standards provide a basis to resolve potential financial conflicts


between various groups. Accounting standards are needed to ensure uniformity
in the preparation and presentation financial statements. Accounting standards
ensure comparability of the data published in the financial statement.

Meaning of Accounting Standards

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 issued from time to time by institutions of the accounting
profession, government or regulatory authorities.

Accounting standards are different from 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 covering various aspects of recognition,
measurement, treatment, preparation and disclosure of transactions in financial
statements.

Purposes of Accounting Standards

Accounting standards have been developed to ensure consistency,


comparability, reliability, adequacy and accuracy of financial statements.
Accounting standards are needed to harmonise the diverse accounting policies
and practices to make the financial statements meaningful. Accounting
standards serve the listed 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.

Benefits of Accounting Standards

1. Creditability and Reliability of Financial Statements:


Accounting standards standardise the diverse accounting policies and
practices and eliminate the non-comparability of financial statements.
Thus, accounting standards enhance creditability and reliability of financial
statements. Various groups viz., investors, creditors, employees etc. will
have no problem in making comparative study of financial statements of
various enterprises. Accounting standards create a sense of confidence
among various users of the financial statements.

2. Beneficial to Accountants and Auditors:


Accounting standards narrow down the areas of differences in accounting
principles and provide solution to various complex issues. Accounting
standards help the auditors in the audit of accounts.

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.

4. Development of Accounting Theory:


Accounting standards provide a rational and conceptual framework for
accounting measurements, financial reportings and usefulness of
accounting data. This has helped in developing accounting theories and
improving existing practices. Accounting standards are not ends in
themselves but a means for promoting sound financial fundamentals.

Type of Accounting Standards

Two types of accounting standards:

1. International Accounting Standards


2. National Accounting Standards

1. International Accounting Standards:


The basic idea of issuing the International Accounting Standards is to
ensure that financial statements comply with such standards in all material
respects.

2. National Accounting Standards:


Many countries have their own accounting standards. When national
accounting standards are mandatory national accounting standards
prevail over the international accounting standards. When there is no
national accounting standard, international accounting standard should be
followed by the public accountants. The presence of international and
national accounting standards need harmonisation of accounting
standards.

Harmonisation of Accounting Standards


Accounting standards differ from country to country due to various factors
like economic and business development, tax requirements, statutory
provisions, level of professional accounting etc. Therefore, harmonisation
of accounting standards is needed. The need to harmonise accounting
standards arise due to following reasons:

1. Accounting policies and practices are different in different countries.


2. Financial statements of multinational companies should be reliable and
easily understood throughout the world. This is possible only by
harmonisation of accounting standards.
3. There is widespread diversity of accounting practices in different
countries. Harmonisation facilitates in evolving uniform accounting
standards for their worldwide application.
4. Harmonisation ensures standardisation of accounting practices even
with in a particular country,

Harmonisation of accounting standards is the urgent need of the hour.


Harmonisation of accounting standards will save time and money that is
involved in analysing financial statements. Further, harmonisation of accounting
standards will make international financial information user-friendly as
accounting information will be comparable.
IFRS (International Financial Reporting Standards)

International Financial Reporting Standards

Globalisation has undoubtedly changed various businesses today around the


globe, accounting is not an exception to it making a large room for development
for national accounting standards and reporting standards to be harmonised as
per international standards.

This development resulted in the formation of International Accounting


Standards Board (IASB).

IASB is an independent privately funded standards body based in London.


Since 2001, the IASB was expected to create a set of principles, guidelines,
financial reporting standards that may be used globally throughout the world’s
capital markets. IASB proposed some guidelines on topics for which there was
no clear cut International Accounting Standards (IAS). These proposals are
known as IFRS.

International Financial Reporting Standards refers to the pronouncements made


by IASB as distinct from IAS to achieve standardisation in financial reporting.

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.

Need for IFRS


As a result of increasing globalisation, there is increasing cross-border flow of
goods, services, capital and technology and the role of International Corporation
is increasing.

Multinational corporations operate in different geographies through their


branches and subsidiaries. As a result of this, financial statements produced in
one country are used in other countries more and more frequently. Hence, it is
necessary that financial statements of a company have worldwide acceptance
and observance. Hence, there is need of a set of uniform and consistent
accounting norms to ensure transparency and comparability in financial
statements across the globe.

Benefits of IFRS

There are many interest groups who would benefit from IFRS:

1. Growth in International Business:


IFRS will make accounting reports as an universal means of
communication among businessmen, entrepreneurs and investors. IFRS
will ensure the reliability and comparability of financial statements by
meeting the needs of international users.

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.

4. International Audit Firms:


The adoption of IFRS is in interest of international audit firms as it would
facilitate sale of their services in different parts of the world.

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.

According to Institute of Chartered Accountants of India (ICAI), about 300


companies would switch over to IFRS from April 2011.

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.

On 25th February 2011, the Ministry of Corporate Affairs notified 35 accounting


standards also known as Ind-AS. There are new accounting standards
convergent with IFRS or very close to the corresponding IFRS standard. This
would require changes in existing taxation laws and company law provisions.

As part of its convergence strategy, the ICAI has classified into four categories:

Category I: IFRS which can be adopted immediately

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

The first and foremost function of accounting is to keep a systematic


record of financial transactions. A business firm has to record the
transactions in such a way that a correct picture of the financial state of
affairs of the firm can be obtained whenever needed. The ultimate
objective of recording transactions is to prepare two basic financial
statements: Income Statement i.e. Profit and Loss Account and Balance
Sheet. The recording of series of transactions occurring during an
accounting period is termed as ‘accounting process’ or ‘accounting
cycle’. An accounting cycle may be defined as a complete sequence of
accounting procedures which are repeated in the same order during
each accounting period. An accounting cycle consists of the following
phases:

a. Recording business transactions in the books.


b. Classifying data by posting them from books to the accounts.
c. Preparation of final accounts i.e. the Profits and Loss Account and
the Balance Sheet.

DOUBLE ENTRY SYSTEM:

A business transaction involves the exchange of money and goods or


services for money or for a right to claim money in future. Each business
transaction involves two parties i.e. two aspects. There cannot be a
business transaction with one aspect. A transaction is just like a scale
which must have equal weight on each of the two sides in order to
balance the scale. Following are some examples which emphasis the
two aspects of a transaction:

1 If a business firm acquires an asset for cash, it has to give up


some other asset, say, cash or the obligation to pay for it in future.
Thus, a giver necessarily implies a receiver and a receiver
necessarily implies a giver.
2 If goods of Rs. 30,000 are sold to Jitendra on credit, the business
firm gives goods and acquires an obligation to receive payment in
future. Thus, goods and Jitendra are two aspects of this
transaction.

Double entry system recognizes both the aspects of a business


transaction. Double entry may be defined as a system of accounting in
which both the aspects of a transaction are recorded. Every transaction
affects at least two accounts and, thus, requires a debit and a credit
simultaneously. For every debit there must be a corresponding credit
and vice-versa. Double entry system is based on Dual Aspect Concept
of accounting.

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:

Assets = Capital + Liabilities

OR
Assets = Equities

At any point of time, the total assets of a business enterprise will be


equal to the total claims or equities (internal as well as external). Any
claim that can be enforced against the assets of the business entity is
termed as “equity”. There are two types of equities, namely, creditors’
equities or liabilities and owners’ equities comprising capital and retained
earnings i.e. reserves and surplus. Every transaction has two aspects. A
transaction is just like a scale to be balanced. There can be no increase
in an item without a decrease in other item. If there is a change in
assets, there will be a change in liabilities or owners’ equity.

Development of an accounting equation requires following steps:


1. First of all, variables of an equation affected by a transaction
are ascertained.
2. The next step is to find out the effect i.e. increase or decrease
of variables of an equation.
3. Finally, the effect is put on the concerned side of equation. After
recording of every transaction, there will be a new equation.

ILLUSTRATION 1

Anil had the following transactions. Use accounting equation to show


their effect on his assets, liabilities and capital.
1. 1.Commenced business with cash Rs. 50000
2. Purchased goods for cash Rs. 20000 and credit Rs. 30000
3. Sold goods for cash Rs. 40000, costing Rs. 30000
4. Rent paid Rs. 500
5. Rent outstanding Rs. 100
6. Bought furniture for Rs. 5000 on credit
7. Bought refrigerator for personal use Rs. 5000
1. Purchased building for cash Rs. 20000.
[please check the serial numbers marked in green]

Solution:

Transactions Assets = Liabilities + Capital


Rs. Rs. Rs.

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 =

New Equation 80000 = 30000 + 50000


3. Sold goods for cash (+)40000
Rs. 40000, costing Rs. (-)30000 = 0 + 10000
30000
New Equation 90000 = 30000 + 60000

4. Rent paid Rs. 500 (-)500 = 0 + (-)500

New Equation 89500 = 30000 + 59500

5. Rent outstanding Rs. 0 = (+)100 + (-


100 )100

New Equation 89500 = 30100 + 59400

6. Bought furniture for Rs. (+)5000 = (+)0 + 5000


5000 on credit
New Equation 94500 = 35100 + 59400

7. Bought refrigerator for (-)5000 = 0 + (-)5000


personal use Rs. 5000
New Equation 89500 = 35100 + 54400

8. Purchased building for (+)20000


cash Rs. 20000 (-)20000 = 0 + 0

Last Equation 89500 = 35100 + 54400

Assets, liabilities and capital are three basic elements of every


transaction. The relationship between them remains unchanged. No
business transaction can upset the relationship between these terms.
Accounting equation approach gives a true picture of financial position of
a business concern. Following points reveal the importance of
accounting equation:

1. Accounting equation emphasizes that business and its owner


are two distinct entities. Accounting equation treats owners’
claims as different from creditors’ claims. In this way, it gives a
better perspective about the business.
2. Accounting equation facilitates even a layman to understand
and apply accounting rules. Accounting equation makes us
understand the effect of business transactions on the financial
position of the business.
3. Accounting equation provides the details of assets, liabilities
and capital and, thus, helps in preparing Balance Sheet.

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

External or exchange transactions involve transactions between an


outsider and the business organization e.g. sale of goods, payment of
salaries, purchase of raw materials etc. Internal transactions occur
entirely between the internal wings of an enterprise e.g. supply of raw-
material by stores department to the manufacturing department,
depreciation of fixed asset etc.

Business transactions are recorded on the basis of source documents


i.e. vouchers. Source documents provide documentary evidence of the
transactions. These documents are preserved till the audit of the
accounts and tax assessments for the relevant period are completed.

ACCOUNT:

In accounting, all the transactions of like nature pertaining to a particular


type of item are recorded at one place so as to know their cumulative
effect at the end of the accounting period. Such a record of individual
items is called an account. In other words, recording of all the
transactions of the similar nature concerning a particular item at the
same place is called an account. An account is a basic unit of recording
business transactions. According to Kohler, “An account is a normal
record of a particular type of transaction expressed in money.” An
account has two sides: debit and credit. Debit is left side of an account
while credit is the right side of an account. The book, in which all
accounts are maintained, is known as Ledger.

Under traditional approach, accounts are grouped under the following


heads:

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:

1 Natural Personal Accounts: Natural Personal Accounts are the


personal accounts of individuals. For example, Ashok’s A/c,
Ajay’s A/c, Nitin’s A/c.
2 Artificial Personal Accounts: Artificial Personal Accounts are the
personal accounts of artificial persons. For example, Bank A/c,
Gaurav & Co. A/c, Ahaan Ltd. A/c.
3 Representative Personal Accounts: Representative Personal
Accounts are the personal accounts which represent a person
or persons. For example, Salaries Outstanding Account,
Interest Received in Advance Account, Accrued Interest A/c.
Salaries Outstanding A/c represents amount due to an
employee or employees.

REAL ACCOUNTS:
Real accounts are the accounts which record dealings in or with assets.
Real accounts may be of two types:

1. Tangible Real Accounts: Tangible Real Accounts are the


accounts related to assets having physical existence. Tangible
assets can be felt and measured directly. Its examples are Land
A/c, Building A/c, Cash A/c, Stock A/c etc.
2. Intangible Real Accounts: Intangible Real Accounts are the
accounts related to assets having no physical existence.
Tangible assets can be felt and measured indirectly. Its
examples are Goodwill, Trademarks, Patent Rights, and
Copyrights.

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:

1. Profit and Gain: Discount received, Interest Received,


Rent Received, Dividends Received, and Commission
Received.
2. Expenses: Discount allowed, Interest Paid,
Commission Paid, Rent Paid, Insurance Premium Paid.
3. Loss: Loss by fire, Bad Debts, Loss by theft.

Under modern approach, accounts are grouped under the following


heads:
1. Assets Accounts
2. Liabilities Accounts
3. Capital Accounts
4. Revenue Accounts
5. Expenses Accounts

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:

1. Date: The date of the transaction is recorded here.


2. Particulars: The two aspects of transactions are recorded in
this column. It means that details regarding accounts to be
debited and credited are written here.
3. L.F.: It means Ledger Folio. The transactions entered in the
Journal are later on posted to the ledger. In this column, the
page numbers on which the various accounts appear in the
ledger are recorded.
4. Debit: In this column, the amount to be debited is entered.
5. Credit: In this column, the amount to be credited is shown.

RULES FOR DEBITING AND CREDITING


Following are the rules for recording transactions in Journal

Rule No 1: For Personal Account


“Debit the receiver and credit the giver.”

Interpretation: When any transaction involves a personal account, either


the person involved will be the receiver or giver. If the person involved is
the receiver, he should be debited but in case the person involved is the
giver, he should be credited.
Example, Cash received from Ashok
In this transaction, Ashok’s account is a personal account, therefore,
Ashok’s account should be credited.

Rule No 2: For Real Accounts


“Debit what comes in and credit what goes out.”

Interpretation: Whenever any transaction involves a real account, either


the asset involved will be coming in or going out. If the asset involved is
coming in, it should be debited but in case the asset involved is going
out, it should be credited.
Example: Cash paid to Mohan
In this transaction, cash account is a real account. Since the cash is
going out, it should be credited.

Rule No 3: For Nominal Accounts


“Debit all expenses and losses and credit all gains and profits.”
Interpretation: Whenever any transaction involves a nominal account,
either the nominal account involved will represent an expense/loss or
gain/profit. If the nominal account involved represents expense/loss, it
should be debited. On the other hand, if there is gain/profit, it should be
credited.
Example: Profit on sale of furniture Rs. 2000
In this transaction, profit on sale of furniture account is a nominal
account. Since the profit on sale of furniture is a profit, it should be
credited.

The process of recording transactions in a journal is termed as


journalizing. The first step of journalizing is to ascertain what accounts
are affected by the transaction. Name of the account to be debited and
name of the account to be credited are written in particulars column. The
word “To” is written before the account to be credited. Date of
transaction and the amount are written in their respective columns.
Sometimes, two or more transactions of a similar nature occur on the
same day. Instead of making a separate entry for each such transaction,
we combine them and pass a compound journal entry. In compound
entry, there will be more than one account in debit side or credit side for
one or more accounts in its opposite side. In the beginning, the closing
balances of the accounts relating to the previous accounting period
are recorded in the new set of books. Such an entry is called an
opening entry. Opening entry is the first journal entry in an accounting
period. The opening entry is given as follows:

Sundry Assets A/c Dr.


To Sundry Liabilities A/c
To Capital A/c
Journal Entries

Academic Script

Students, as we have already discussed that every transaction has two


fold effects and this effect is first entered in primary books of accounts
called as Journal. These entries are backbone of which the entire
preparation of financial statements rest.
These entries are the basic entries which we have to keep in mind while
solving the question. We shall learn its implication, the rules used for
making these entries and passing on these entries.
The objective of this lecture is to understand all those journal entries
which are passed in the books of account so that the information which
is required for the transaction is to be understood and each transaction
whether it is related to person, property or asset; income and
expenditure should be recorded properly and appropriately.

ENTRIES RELATING TO COMMENCEMENT OF BUSINESS


Now students we shall understand the very first entry which is passed
when business is commenced.
Imagining that we have commenced the business and we have brought
cash into business.
1. The first entry which we are required to pass for bring cash into
business.
2. Capital account which is the representative of owner’s account is
credited.
The Rule Used here is
Cash- Real Account- What comes in – Dr.
Capital – Personal Account- proprietor’s account- the proprietor is
giver- Cr. (Credit the Giver)
Date Particulars Debit (Rs) Credit
(Rs)
- Cash A/C 10,000
To Capital
A/C 10,000

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.

So the entry will be as

Date Particulars Debit (Rs) Credit


(Rs)
- Bank A/C 10,000
To Cash
A/C 10,000

Such entry is also called contra entry


3. ENTRIES RELATED TO GOODS
Goods are often called as inventories, stock in the business when goods
are related to the business purpose they are called inventories, stock,
merchandise. Wherever the transactions related to goods occur, we will
classify them under appropriate head.
When we have purchased the goods we will use the account as
Purchases.
When we have sold the goods or disposed of them, we will use the
account as Sales.
Purchase and sales are primary accounts for goods. When purchases
are returned from our end (not meeting expectations/specification), it
would be represented in Purchases return account.
By purchase return we mean that whatever we have purchased either
some portion of it or any quantity of it can be returned from our side to
the supplier. Now we are going to use Purchase return account
whenever goods are returned back to the suppliers.
Similarly for sales they can be sales return our customer can send back
us the goods so sold in that case we have to pass on the entry of the
sales return.
Their features will be just reverse of purchase account and sales
account. Purchase account has a feature of being debited. The
characteristic of purchase account is of debit.

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.

4. USE OF GOODS FOR VARIOUS – JOURNAL ENTRIES


1. Goods are purchases- Goods can be purchased either in cash or on
credit. When goods are purchased for cash then the cash account is
affected or we can make payment by cheque also at that time bank
account will be used for payment.

Date Particulars Debit (Rs) Credit


(Rs)
- Purchases 5000
A/c 5000
To Cash
A/c
(Being
goods
purchased
on Cash)

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.

Date Particulars Debit Credit


(Rs) (Rs)
- Purchases 5000
A/c 5000
To Ashish
A/c
(Being goods
purchased on
Credit)

Now we shall learn how the credit purchase will be passed


We have purchased goods from Ashish worth Rs 5,000/-. Now it is not
mentioned over here that we have made payment. So it is assumed that
it is made on credit.
Students, some piece of advice
Where ever the name of any party (vendor/supplier) is not given or
a simple narration is given as goods purchased it is assumed that
goods are purchased on cash and if suppliers name is given we will
assume that credit purchases are being made.
So the question will specify clearly whether it is cash purchase or
credit purchases and according we have to make the journal entry.
If a wrong entry is passed it will affect the cash position of the
company and its going to present the true financial position of the
organization through its balance sheet.

Students, lets now learn about journal entries related to sales


Sales turnover is decided by the help of the sales entry because sales
will be represent the total sales turnover.
Let us now see how the entries relating to sales are being passed.
1. Good are sold to Ramesh on Cash worth 6000
The Journal entry will be
Date Particulars Debit (Rs) Credit
(Rs)
- Cash A/c 6000
To Sales
A/c 6000
(Being
goods sold
on Cash)

Interpretation: Here goods are being sold to Ramesh on cash. So what


is coming into the business is cash. So cash account is debited. And the
credit what goes out. Since our goods are going out and we know where
goods are going it is sales so we are using the account Sales for
crediting. Sales have a feature that it is shown as credit balance while
purchases accounts are always debited.

2. If the sales are made on credit to Ramesh worth Rs 6000. The journal
entry will be:

Date Particulars Debit (Rs) Credit


(Rs)
- Ramesh 6000
A/c
To Sales 6000
A/c
(Being
goods sold
on Credit)
nterpretation: Since sales are on credit basis to Ramesh. Ramesh is a
debtor to the business and is a personal account. So the personal
account rules are debit the receiver and credit the giver here the receiver
are the debtors or third party hence debtor’s account is debited. Here if
we do not know the name of the person we are selling good on credit
then the general term is used as debtor. And if the name of the debtor is
given we will use his name.
5. ENTRIES RELATED TO PURCHASE RETURN and SALES
RETURN
Students, now we will discuss the entries relating to Purchase return and
sales return.
First of all let us learn about purchases return. Purchase return has the
feature which is reverse of purchase account. We know that purchase
account is always debited. Purchase return will always be credited
because its characteristics are opposite of that of purchase account.
Look at the following entry
Purchase Account Dr. 10,000
To Creditors 10,000
(Being goods purchased on credit)

It is the basic entry for credit purchase which we have passed. If we


have purchased goods worth Rs.10,000
In certain situation we would have to send back some goods which don’t
meet our requirements. It would be purchases return. In this situation we
would have to pass a reverse entry. For example the goods returns are
worth Rs. 100, the entry would be

Creditors Account Dr. 100


To Purchase Return account 100
(Being Purchases return)

Here creditor will be debited because he is receiving the goods back.


And credit the purchase return account. When we will prepare the final
account this purchase return will be subtracted from the purchases and
net purchases that is Rs.10000- Rs. 100 that is Rs.9900 will be shown in
the financial statements of the company but the account for purchase
return will have to be prepared separately.

Let us now look journal entries for Sales return


Sales Return- Sales return are goods returned to us by our
customers/debtors
If we sold goods to our customer on credit, the entry would be

Debtors Account Dr.


To sales A/C
(Goods sold on credit)

When our customers returns certain goods back to us the entry would
be

Sales Return A/c Dr.


To debtors A/C

Students, many a times it is observed that goods in business are also


used by owners for personal use (other than sales, purchases, sales
returns or purchases returns). We will be learning about passing journal
entries about this type of transactions

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.

Drawings Account Dr.


To Purchases

Instead of goods we will use the account as purchases because the


goods are going out of the business. Drawings will represent the amount
of the goods which are used by the proprietor for his personal use rather
than business use Drawings will be subtracted from the capital account
of the proprietor.
One more thing which we need to keep in mind is that when proprietor
takes goods at home he will not take it at selling price and the cost
price of the goods shall be used in the amount column.
Similarly if goods are distributed as free sample it is the form of
advertisement. So Advertisement account will be debited and purchases
account will be credited.

Advertisement Account Dr.


To Purchases

So these are the two important entries related to the use of goods.

Students, let’s now learn about compound entries


COMPOUND ENTRIES
Now students let us understand one more important feature which is
called compound entry.
Compound entries are used where the transactions are more than one
and we use single entry rather than too many entries. In order to pass
the relevant entries together we pass the compound entry.
When compound entries are passed
1. One account can be debited and several accounts can be credited.
2. Several accounts can be debited and one account can be credited.
3. There can be several debit accounts and several credit accounts.
This is the way by which compound entries are being passé. We will
illustrate the compound entries with the help of example. Such entries
are generally related to discounts.
When the discounts are availed or given to customers such compound
entries are passed.
Discount can be of two types- trade discounts and cash discount.
There are no entries for trade discount.
The net amount is being used but for cash discount the journal entries
are passed in the books of account.
1. A debtor of our to whom we have sold goods on credit he has to
give us Rs. 1000. Now we want him to give us money early so
we are giving him some discount and it is known as cash discount.
For example, cash is to be received Rs.1000 and discount allowed
is 10% so the entry will be

Date Particulars Debit Credit


Cash 900
Account..Dr
Discount 100
A/C..Dr
To
Debtors..Cr 1000
(Being
cash
received
from debtor
in full
settlement)

Cash is received hence cash is debited, discount is allowed so it is a


charge on the profit so we will also be debited.
We need to collect from debtor an amount of Rs.1000 but we are
allowing him discount of 10% . So the actual cash received by us is Rs
900 and 100 is the discount. this way the compound entry is passed
where several accounts are debited and one account is credited.
This is the form of the entry which is having multiple debit accounts and
one credit only.
Now we will learn another entry where we have multiple credit and single
debit account. It is also entry related to discount now here we are getting
the discount.
We have purchased certain goods on credit and now we are required to
make the payment of the same. Our supplier has given us some
discount and that discount is our gain in that case we are required to
pass the entry in this manner.
Date Particulars Debit Credit
Creditor 1000
A/C…Dr
To Cash 900
A/C...Cr
To 100
Discount
(Being
cash paid
to supplier
in full
settlement)

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

Prepaid Rent A/c Dr.


To Rent

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

Expenses Account dr.


To Outstanding expenses account.

Expense is a nominal account and it is debited. And the outstanding


expense is a personal account and is credited.
Similarly when the prepaid expenses are there prepaid expense has a
nature of that of debtor and it is a personal account so we have to debit
it.
These are the two important entries which we need to keep in mind
when we finalize the books of account
Academic Script

Accounting, as a language of business, communicates the financial


information of an enterprise to various groups by means of financial
statements.

Financial statements should display a “true and fair view” of state of


affairs of an enterprise.

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.

Let’s quickly understand about profit.

In general meaning, Profit is a difference between sales price and


purchase price.

However, speaking in terms of accounting language it can be seen with


two perspectives.

Perspective 1:

The change in wealth over an accounting period between the beginning


and end of the accounting period is the profit or loss for the period
reflected in the retained earnings category in the balance sheet.
Profit (or loss) considered in this way can be represented in the
equation.

Total Assets – Total Liabilities = Equity + Profit

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 -

Profit = Total Revenue – Total Cost

The diagrammatic representation here reflects the main elements of


profit and loss account.
Revenues, Sales
or Income

Profit and Loss Account

Expenses, Cost
or Expenditure

Structure of Profit and Loss Account:

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.

The total revenue of a business is generated from the provision of goods


or services and may be, for example, in the form of:

 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:

 Costs of goods purchased for resale


 Costs of manufacturing goods for sale
 Transport and distribution costs
 Advertising
 Promotion
 Insurance
 Costs of the ‘consumption’ of fixed assets over their useful lives
(depreciation)
 Wages, Salaries
 Interest Paid
 Telegram and Postages
 Water, Telephone and Electricity expenses
 Travel Expenses

Each of the listed examples of expenses or costs incurred in the


generation of revenue by a business appears itself as a separate
heading, or is grouped within one or other of the other main headings
within the profit and loss account.

Trading Account simply tells about gross profit or loss made by


businessmen on purchasing and selling of goods. It doesn’t take into
account the other operating expenses incurred by him during the course
of running the business.
Let take this example:

A person needs to maintain a office for getting orders and executing


them, taking decisions and implementing them. All such expenses are
charged to profit and loss account. Besides this a businessmen may
have different sources of income from businesses like from renting a
business premises. This income should be recorded as a business
income.

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.

It is generally prepared in the form represented herewith:


Profit and Loss Account

Dr. For the year ending…….


Cr.

Particulars Rs Particulars Rs

To Gross Loss b/d … By Gross Profit b/d …

To Salaries … By Commission …

To Rent … By Discount Received …

To Commission … By Interest Received …

To Advertisement … By Net Loss Transferred to ..


Capital Account

To Bad Debts …

To Discount

To Depreciation

To Net Profit
Transferred to Capital
Account

Total xxx Total xxx

Dr. – Debit, Cr- Credit , b/d: Brought down

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

1. Gross Profit or Gross Loss:

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:

Salaries are payable to the employees for the services rendered


by them in running the business being of indirect nature are
charged to profit and loss account.

In Case of a partnership firm, salaries may be allowed to the


partners. Such salaries will also be charged to the profit and loss
account.

3. Salaries less Tax:

In case of employees earning salaries beyond a certain limit, the


employer has to deduct the tax at source from the salaries of
employees popularly known as TDS. In such case, the amount of
gross salaries should be charged to the debit side of profit and
loss account, while the tax deducted by the employer will be
shown as a liability in the Balance sheet of business till the time it
is deposited with Tax authorities.

4. Salaries after deducting provident fund contribution etc:

In-order to provide for old age of the employees, employers


contribute a certain percentage of salaries of the employees to the
provident fund. The employee is also required generally to
contribute an equivalent amount. The share of the employee’s
contribution to provident fund is deducted from the salary due to
him and the net amount is paid to him. The amount of salaries to
be charged to the profit and loss account will be gross salary
payable to the employees i.e. including the employee’s
contribution to the provident fund.

While the contribution by the employer will be charged as an


expense to the profit and loss account. Both employers and
employees contribution to provident fund will also be shown as
liability in the balance sheet under the heading as “Employees
Provident Fund”.

5. Interest:

Interest paid on loans whether of short term or long term nature is


an expense of indirect nature and , therefore is charged to the
debit side of profit and loss account. However, interest earned on
loans advanced by a firm to third parties is an item of income, and,
therefore will be charged to credit side of profit and loss account.

6. Commission:

Commission may be both an item of income as well as an item of


expense, commission on business paid to agents is an item of
expenses while commission earned by the business for giving
business to others is an item of income.
Commission paid to agents is therefore debited to profit and loss
account while commission received is credited to profit and loss
account.

7. Trade Expenses

Trade expenses are expenses of miscellaneous nature. They are


of small amount and varied in nature and, therefore it is not
considered worthwhile to open separate account for each such
expenses. The term “Sundry Expenses” , “ Miscellaneous
Expenses” or “ Petty Expenses” have the same meaning. They all
are charged to the debit side of profit and loss account.

8. Printing and Stationery:

This item of expense includes expenses on printing of bills,


invoices, registers, files and other stationery items etc. It is an
expense of indirect nature and hence debited to the profit and loss
account to account for business expenses.

9. Advertisements:

Advertisement expenses are done for attracting the new


customers to the shop, and therefore they are taken as selling
expenses being indirect in nature, they are debited to profit and
loss account. However ideally advertisement expenses done for
procurement of goods should be charged to the Trading Account,
while an advertisement expense incurred for purchase of a capital
assets (Purchase of a new car for business etc) should be taken
as a capital expenditure and should be debited to concerned
assets account. Similarly advertisement expenditure incurred for
sale of a capital assets should be deducted out of the sales
proceeds of the assets concerned.

10. Bad Debts:

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:

Depreciation denotes decrease in the value of an assets due to


wear and tear, lapse of time, obsolescence , exhaustion and
accident.

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.

Students, Please note actual sale of car is not necessary,


Depreciation of various assets are already prescribed by various
authorities.
Taking the same example: Say I purchased the car for Rs.
5,00,000 and the rate of depreciation for car as per authorities is
10% per annum. The valuation of car is listed herewith year wise.

Year Amount of Depreciation New Value of Car

( 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%)

Students, depreciation is allowed expenditure for business. Since


it allows companies to create a separate reserve pool of cash
which can be used to purchase new assets which can be used to
business once, the life of old is completed.

This is necessary because assets may be destroyed by fire or any


other calamities and loses its value. It is necessary that
depreciation on account of all these factors is charged to the profit
and loss account to ascertain the true profit or loss made by the
business.
12. Discounts:

It is reduction from a list price, quoted price or invoice price.


Discount may be three types :

a) Trade Discount: It is reduction from the list price. It is reduction


granted by a suppler from the list price of goods and services.

b) Quantity Discount: It is similar to trade discount with the


difference that it is given in case of purchasing goods in bulk
quantities.

c) Cash Discount: It is reduction granted by suppliers from the


invoice price in consideration of immediate payment or payment
done in stipulated time period.

Nominal Account -

The rule of nominal account is

“Debit all expenses & losses while Credit all gains and profits”

Students, components on debit side of profit and loss account are


indirect in nature which are further classified into

a) Operating Expenses &

b) Non-Operating Expenses

a) Operating Expenses refer to those expenses as to day to day


expenses of operating a business which includes office and
administrative expenses, selling and distribution expenses etc.
b) Non-Operating Expenses refer to those expenses incurred other
than operating expenses. Non-Operating expenses which are
related to a financial nature.

Eg: Interest payment on loans and overdrafts, loss on sale of fixed


assets, writing off fictitious assets such as preliminary expenses
under writing commission etc.

Students,

Let us now see the components that are reflected on credit side of
Profit and Loss Account

The components are as listed herewith:

a) Gross Profit brought down from trading account

b) Operating Income: It refers to the income earned from the


operations of business.

c) Non-Operating Income: Non Operating income refers to income


that are received from other sources of business than normal
operations. Eg: Interest on investments of outside business,
dividend received etc.

Let’s quickly learn about importance of Profit and Loss Account

Importance 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.

c) An analysis of various expenses included in the profit and loss


account and their comparison with the expenses of the previous
period or periods helps in taking steps for effective control of
various expenses in future.

d) Allocation of profit among the different periods or setting aside a


part of profit for future contingencies can be done. Moreover, on
the basis for profit figures of the current and the previous period
estimates about the profit in the year to come can be made. These
projections will help the business in planning the future course of
action.
Academic script

Balance Sheet

Introduction:

As we are aware that the purpose of financial statements is to


communicate the state of business at any given point of time.

Three important financial statements are prepared by


companies which include the Income statement, Cash flow
statement and the Balance sheet. Each of the statement has its
own relevance and method of preparation.

Concept:

Organisation works with profit motive which facilitates smooth


functioning of organisations. Profit earned is expended on
various expenses and also set aside reserves to meet any
contingent situations.

In a financial year a company is involved in many monetary


transactions, with different parties, leading to the development
of cash flows, profit generation, loss, capital expansion etc.

All this transactions are to be recorded from time to time and


presented at the end of the financial year in the form of final
accounts.

The provision for the preparation of the final accounts was


earlier prescribed under the Companies Act 1956. But with the
recent amendment in the act and incorporation of the new
“Companies Act 2013” the companies now need to follow the
provision laid down by the new act and prepare the accounts
accordingly.

Financial Statements as per Companies Act 2013

Financial statement is the record of the company’s transaction


throughout the year. It comprises of a set of accounts that
need to be presented at the end of the financial year for the
use of internal as well as external users.

Section 128 to 138 under Chapter IX of the Companies


Act 2013 deal with the preparation of accounts of
companies.

The definition of financial statement was not mentioned under


Companies Act 1956. But Section 2(40) of the Companies Act
2013 has defined financial statement as -

Financial Statement in relation to company includes -

a) Balance Sheet at the end of financial year.

b) Statement of profit and loss for the financial year.

c) Cash flow statement (not mandatory for small scale


companies, OPC’s & dormant companies) for the financial year.

d) Statement of changes in equity, if applicable.

e) Explanatory statements.

These financial statements need to be prepared for every


financial year. Section 2(41) of the Companies Act 2013,
defines financial year in relation to any company as the period
ending 31st day of the March every year. Now the financial
year can only be from April to March. And the companies
following a different financial year need to align with the new
provision within a period of two years.

Financial statements need to be prepared in the form as


provided in Schedule III. It shall be laid in the AGM within 6
months from the end of financial year.

Balance sheet is a statement of assets, liabilities and capital of


an organisation.

As per schedule III of the Companies Act 2013, balance sheet


is prepared by the companies.

Key Fundamentals of Balance Sheet

Students, before we go ahead and understand the


formats of balance sheet. It’s right time to explore
certain other key fundamentals of balance sheet.

A Balance sheet is also known as statement of financial


position. It is a formal document that follows standard
accounting guidelines showing the same categories of assests
and liabilities regardless of the size or nature of the business.

Now naturally you would ask a question

Why do we create/make balance sheet?

A balance sheet provides a snapshot of a business’ health at a


point in time. It is a summary of what the business owns
(assets) and owes (liabilities). Over a period of time, a
comparison of balance sheets can give a good picture of the
financial health of a business.

In combination with other financial statements, it forms the


basis for more refined analysis of the business. The balance
sheet is also a tool to evaluate a company’s flexibility and
liquidity.

The main concept of a balance sheet is that total assets must


equal the liabilities plus the equity of the company at a
specified time. When we describe assets in this way, it shows
how they were financed. This is either by borrowing money
(liability) or by using the owner’s money (equity).

A Balance Sheet –

 Shows what tools are available to the organisation


to remain profitable.

 Is the only financial statement that relates to


specific point in time and not a period of time

 Can be represented in report of account format

A balance sheet is three part financial statement that


summarises an organizations-

a) Assets (presented in order of liquidity)

b) Liabilities and

c) Equity – at a specific period of time.

An organisation’s balance sheet can take one of two forms:

 Report Form: Uses a vertical format to show assets are


followed by liabilities and then equity

 Account Form: lists liabilities to the left side while assets


on right side
Students, let us now go through the financial statements as
mandated by Companies Act, 2013

Particulars , Amount (Rs.) Previous Year, Amount (Rs.)


Current Year

Particulars –

I. Equity and Liabilities

1)Shareholders Fund

a) Share Capital

b) Reserve and Surplus

c) Money Received against share warrants

2) Share application money or pending allotment

3) Non Current Liabilities

a) Long term borrowings

b) Deferred tax liabilities

c) Other long term liabilities

d) Long term provisions.

4) Current Liabilities

a) Short term borrowings

b) Trade Payables

c) Other Current Liabilities

d) Short term provisions

Total –

II. Assets
1) Non Current Assets

a) Fixed Assets

i) Tangible assets

ii) Intangible assets

iii)Capital work in progress

iv) Intangible assets under development

b) Non-current investments

c) Deferred tax assets

d) Long term loans and advances

e) Other non-current assets

2)Current Assets

a) Current Investments

b) Inventories

c) Trade receivables

d) Cash or Cash equivalents

e) Short term loans and advances

f) Other Current Assets

Total –

Students, as we have already discussed that components in


balance sheet can be either written in permanency order or
liquidity order.
Liquidity order when we follow we need to mention those
assets first which are liquid in nature. For example we shall
start our balance sheet with

 Cash

 Bank

 Bills Receivables

 Debtors

 Stock

 Fixed Assets

And if it is prepared on the basis of permanency then the first


items which will be written over under asset will be –

 Fixed assets – under fixed assets we are going to write


Goodwill, land, building, plant and machinery then
furniture.

This is the order of permanency, the permanent assets are in


its nature, and firstly they will be written.

The land will be fixed in comparison to furniture because its


liquidity is lesser. So lesser the liquidity the higher will be
the position of the asset in the balance sheet when we
prepare it on the basis of permanency order.

So first heading will come as fixed assets.

 Current Assets- Under current assets we will write the


assets as –

 Stock
 Debtors

 Bills Receivables

 Cash at bank

 Cash in hand

It is not an exhaustive list, it is an inclusive list and other items


can be included in it as per the usage of the business.
Similarly, when we talk about liability side under liquidity order
we would write it as –

 Bank Overdraft

 Outstanding expenses

 Creditors

 Long term loans

 Capital

But when we prepare the Balance sheet on the permanency


order first of all it shall start with capital as the first item of
liabilities then this reversal order of liquidity will follow but you
cannot prepare a balance sheet where assets are prepared on
the permanency order and liabilities are written by liquidity
order.

One method is to be followed for preparation of entire balance


sheet.

Various Components of Balance Sheet

Students, let us now focus our discussion towards the various


components which form the part of balance sheet.

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.

● Section 49 states that call on shares of the same class should


be made on uniform basis. These classes may differ due to
different issue dates, different voting rights etc.

● Section 50 allows the company to accept from any member,


the whole or part of amount remaining unpaid on his shares,
even if company has not called up that amount.

● Under section 51 a company may pay dividend in proportion


to the amount paid up on each share.

● Section 52 states that when a company receives premium


amount (in cash or otherwise) on shares issued at premium, a
sum equal to the aggregate amount shall be transferred to
“security premium account”.

● Section 53 lays down that company cannot issue shares at


discount and any share issued at discount shall be treated as
void. If a company violated the section, it shall be punishable
with a fine of not less than one lakh rupees or imprisonment.

● Any company can issue Sweat Equity Shares (Sec 54), if it


fulfills the listed conditions –

1) Special resolution should be passed by the company


before issuing the Sweat Equity Shares.

2) The resolution must specify the number of shares, current


market price, class of directors to whom such shares are
issued.
3) Not less than one year has elapsed since the date of the
issue, since the company has started the business.

4) Regulations laid down by Security & Exchange Board of


India (SEBI) shall be followed by listed companies, and rules by
Ministry of Corporate Affairs (MCA) by others.

● Section 55 states that no company (limited by shares) is


allowed to issue irredeemable preference shares.

All such shares shall be redeemable within a period not


exceeding 20 years (from their issue date).

2) Reserves and Surplus:

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:

● Capital Reserve ● Capital Redemption Reserve ● Debenture


Redemption Reserve ● Revaluation Reserve ● Securities
Premium Reserve ● Share Options Outstanding Account ●
Surplus ● Other Reserves.

3) Long Term Borrowings:

Companies borrow funds from outside the business for long


term investments, for a longer period of time. The amount so
borrowed is termed as long term borrowings.

● Long term borrowings include bonds/ debentures, term loans


from banks or other parties, deferred payment liabilities and
loans and advances from related parties.

● Borrowings shall further be classified into secured and


unsecured and disclosed separately.
● Bonds/ debentures shall be stated in descending order of
maturity or conversion (along with the rate of interest and
particulars of redemption).

● Any redeemed debentures that the company can reissue shall


be disclosed.

4) Current Liabilities:

A liability is considered as current when it specifies any of the


listed criteria’s:

● It is held specially for the purpose of being traded.

● It is due to be settled within 12 months after the reporting


date.

● It is expected to be consumed/realised in the company’s


normal operating cycle.

Balance Sheet shall include short term borrowings, trade


payables, short term provisions and other current liabilities
under the head current liabilities.

5) Current Assets:

An asset shall be classified as current when it specifies any of


the listed criteria’s:

● It is expected to be realised for sale or consumption in the


company’s normal operating cycle or financial year.

● The purpose for its acquisition is primarily for trade.

● It is expected to be realised within twelve months after the


reporting date.

● It is cash/cash-equivalent unless it is restricted from being


exchanged.
Current assets comprise of inventories, trade receivables, cash
and cash equivalents, short term loans and advances and other
current assets.

 Inventories refer to raw materials, work in progress,


finished goods, stock in trade, loose tools and stores and
spares.

 Trade receivables mean the amounts billed by business to


its customers when it delivers goods and services to them.

 Short term loans and advances refer to the amount


borrowed for a short period of time from lenders or bank.

6) Non 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.

 Fixed assets include land, building, plant and equipment,


vehicles, office equipment etc. In the balance sheet fixed
asset is categorised as tangible, intangible, capital work in
progress and intangible assets under development. The
assets under lease shall be separately specified under
each class of asset.

Non - current investments shall be classified as trade


investments and other investments and further classified
as investment property, investment in preference shares,
investment in bonds/debentures, investment in
government securities etc.
 Long term loan and advances shall be classified as capital
advances, security deposits, loans and advances to
related parties etc.

The above can also be sub classified into secured


(considered good), unsecured (Non considered good) and
doubtful. Other non-current assets consist of long term
trade receivables (including trade receivables on deferred
credit terms).

The assets and liabilities side of the balance sheet are totaled
up and both the sides tally with equal amounts.

Balance Sheet

Students, let us now quickly understand what balance


sheet tells

Balance sheet highlights critical financial information which


facilitates analysis and decision making. It tells

 How much it owns—i.e. assets

 How much it owes— i.e. liabilities.

 How much equity owners have— i.e. shareholder equity


account.

An Organisations Balance sheet shows –

 Liquidity and Solvency

 Tangible Vs Intangible Assets

 Key Ratios

Liquidity – Short Term Commitments


Solvency – Sustain in future

 Liquidity: It highlights the organisations ability to meet its


short term obligations. This includes requirements of
working capital and debt obligations for the organisation.

 Solvency: It highlights the ability of an organisation to


sustain its activities in the future.

Tangible Vs Intangible Assets

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.

 Tangible Assets are items that are physical in nature and


includes cash, inventory, buildings, equipments and
accounts receivables.

 Intangible Assets are items like patents and trademarks.

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.

The listed financial ratios that can be computed from balance


sheet primarily are:

 Current Ratio

 Quick Ratio
 Working Capital

 Debt/Capital Ratio

Since Balance sheet presents the health of a company as of


one point in time, valuable information will be lost if decision-
makers do not take this opportunity to compare the progress
and trend of business by regularly evaluating and comparing
balance sheet of past time periods.

The information that is generated from preparation and


analysis of balance sheet is one financial management tool that
may mean the difference between success and failure for
organisations.
Lecture Title: Tally System - Introduction and Importance

Academic Script

Introduction to financial accounting system:

Business is a profit making activity. Basically, these are the efforts of


people which are connected with the production of wealth with an
intention to earn profit. Business is a form of activity which involves
production & purchase of goods with the objective of selling it at a profit.
Business also includes the performance of services for others on
payment. For example : Doctors’ services, Lawyers’ services,
Management Consultancy services etc. Thus business includes tangible
products as well as intangible products.

In every business organization, (whether it is manufacturing industry,


service industry, or nonprofit organization) finance plays a vital role.
Similar to other activities in business such as production, marketing,
sales, advertisement, promotion etc, accounting is also a major activity.
It is the life blood of a business.

A business organization needs finance for its day to day activity.


Financial accounting plays a major role in keeping the record of all
financial matters (Business transactions) known as book keeping.

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.

Recording Classification Summarizations


Conclude Result (Net profit or Loss)

Communicate result to various parties

Recording of transactions under the following system:

 Indian system: It is a traditional system of accounting, also known as


Marwari system or Mahajani system. Under this system, records are
maintained in Indian languages. Transactions are recorded in long
books known as Bahi khata.

 Single entry system : Small scale entrepreneurs maintain their


business transactions under single entry system. Their volume of
operations are very small, so they maintain the record of cash
transactions in the form of income and expenses. They also maintain
the personal accounts of debtors and creditors.
 Double entry system of book keeping: This is the most scientific way
of recording transactions. Double entry system denotes that every
business transaction has two fold effects and it affects two accounts
i.e. ‘one account is debited and another account is credited’.

Methods of Accounting:

❖ Mercantile system

❖ Cash system

❖ Mercantile system (Accrual method);

It is a method of accounting under which revenue is recognized when


it is earned. Transactions are recorded on the basis of income earned
or expenses incurred, rather than income received or expenses paid.

❖ 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:

1. Business entity concept : Under this concept, the business is


considered as a separate entity and it is separated from its owner.
According to this concept, only business transactions are recorded in
the books of accounts. Proprietor’s personal transactions are not
recorded in the books of accounts.

2. Money measurement concept: Under this concept, only those


things which can be expressed in terms of money are recorded.
According to this concept, amounts are to be expressed in some
common unit of measurement. For example : In India all the
transaction values are expressed in Indian ‘Rupees’.

3. Going concern concept : Under this concept, the business should


continue for a longer period of time to carry out its commitment and
will not be liquidated in the near future. This concept helps many
investors (to invest their money in the business), many suppliers (to
give credit to businesses) and to many employees (to work) .

4. Cost Concept : According to this concept, while recording the


resources of a business, it is to be recorded at their original cost. An
asset is recorded in the books of accounts at the price actually paid at
the time of its purchase. The said asset may have a different value in
the future, whether it is lesser or more than a purchase price.

5. Accrual concept: Under this concept, Revenue is to recognized


when it is earned and expenses are recorded when they are incurred.
All the income and expenses related to one accounting are to be recorded,
whether or not the income is received in cash and expenses paid or not.

6. Conservatism: It is a doctrine of prudence. According to this


doctrine, the business should have an accounting policy for
anticipating possible future losses, not for future gains. E.g. provision
for bad and doubtful debts.
7. Periodicity concept: Accounting activities can be divided up and
reported on annual basis or quarterly basis or monthly basis in its
financial statements. Generally financial statements are prepared for
the accounting year that starts on 1st April and ends on 31st march.

8. Dual aspect Concept : Each transaction has a two fold effect: one is
debited and another is credited.

Classification of accounts:

Classification of accounts means arranging various types of accounts


into personal, real and nominal accounts.

Accounts

Impersonal Personal

Real Nominal

Personal Real Account Nominal Account


Account
It includes the The account It is the account of
accounts of denotes any expenses, losses,
persons and property which incomes and gains
group of persons may be tangible
with whom the or intangible.
business deals.
Accounts .Natural person All types of .All Expenses
belongs to .Artificial person Assets: .All Losses
.Representative . Fixed Asset .All incomes
Account .Current Asset .All Gains
.Intangible
Asset
Examples Anil’s capital A/C Plant A/C Salary A/c
Anil’s Drawings Machinery A/c Bad debts A/c
A/C Building A/c Commission paid A/C
Sunil’s loan A/c Land A/c Commission received
Bharat’s A/c Furniture A/C A/C
Audit fees A/C
ICICI bank A/c Cash A/C Royalty A/C
Rotary Club A/C
University’s A/c Goodwill A/C
Copyright A/C
Prepaid salary Patent A/C
A/c Trade mark A/C
Accrued rent A/c

Rules
The What Comes in All Expenses and
Debit Receiver/Debtor Losses
The What goes out All Incomes and Gains
Credit Giver/Creditor

Manual accounting system: .

I. Record the transactions in a journal.

II. Post them into a ledger.

III. Extract the balances from the ledger and prepare a trial balance.

IV. Rectify the errors if any.

V. Prepare trading account, profit and loss account.


VI. Prepare balance sheet.

VII. Analyze the result with the help of ratio analysis, income statements,
cash flow, and fund flow statement.

VIII. Communicate the information to management for decision making.

Disadvantages of manual system of accounting:

 There is a duplication of work.

 It is time consuming.

 It is expensive, it requires more staff to work or the company has to


pay overtime to the employees.

 It takes more time to find out the errors, if there are any in accounting
work.

Reasons for changing from manual to computerized accounting


system:

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.

2. Faster growth of an organization with new regulation such as VAT


(Value added tax), Central excise tax necessitates for an
improvement in existing accounting system.

3. With the advent of new technology, accountants can easily generate


voucher, purchase order, sales order etc. They can spend their
valuable time in analyzing accounting reports rather than preparing it.

Computerized Accounting System:

Manual accounting systems have certain drawbacks; there is a need to


change to computerized accounting system. As an organization grows,
maintaining accounts manually becomes a time consuming and costly
task. Organizations 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 delayed.

Computerized accounting software solves these problems and results


into timely and quick accounting reports, statements, ratios etc. and
enables a more rapid decision making. It also facilitates knowledge
sharing.

Challenges for computerized accounting system:

1. The process of implementing an accounting system on the computer


is a time consuming and costly task.

2. Upgrading computerized accounting system.

3. Protection of Data against physical and ethical threats.

4. Adaptability to changing environment of business.

Tally:

Bharat Goenka, being a mathematics graduate, innovated an


accounting software ’The Accountant’ with ‘No Accounting Codes
Concept’ for accounting entities. In 1986 he started a company named
as Peutronics pvt. Ltd. It has changed its name to Tally Solutions Pvt.
Ltd.

Tally is a leading and versatile accounting software. The first version of


tally was introduced in 1988, and through its continuous development it
is globally recognized as one of the leading softwares. It is multi
lingual and simple to use.
Its journey started as a very basic version but now has released
with more advance features like ERP i.e. Enterprise Resource Planning.

Journey from its first version Tally 4.5 to Tally ERP 9

Tally 4.5: It was a DOS based programme.


Tally 5.4: It was a Graphic interface version.
Tally 6.3: It was a Windows based version and supports fast printing and
with VAT implementation. It had come with water tight security in terms of
piracy.
Tally 7.2: It was a statutory compliant version. Different VAT rules for
different states were introduced with this version.
Tally 8.1
It was developed with new data structure of Tally. Point of sale and
Payroll features were added to it.
Tally 9
This is the latest version of Tally which has maximum features. All other
versions have been declared end of life period by Tally company. Tally 9
has advance features like Excise for Dealers, Payroll, FBT, TDS, e-TDS
filing facility etc along with its regular features related to accounting and
inventory management.
Tally ERP 9: It is introduced with enterprise resource planning. It is the
complete solution to accounting problems. It is the world’s first concurrent
multi-lingual business accounting and inventory software.
Tally is a complete business solution with “a power of simplicity”. Tally
software comprises, record keeping function (book keeping), financial
accounting, inventory accounting and helpful to management in decision
making by extracting, interpreting and presenting the data.

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

Tally keeps the records of all economic events, it classifies, summarizes


the monetary transaction. It maintains various groupwise ledgers and
displays it with net debit and credit balance for a ledger. It also prepares
a trial balance in a summarized form.
With the help of data it prepares profit and loss account, balance sheet,
and concludes net profit or net loss.

Complete accounting system

I Inbuilt groups for a proper

classification of accounts
Accounting
Features A Audit trail and drill down display

Display reports
Cheque Printing

Payroll

1. A Complete Accounting System:


Tally is a complete Accounting system. It has various types of vouchers
such as Contra Payments, Receipts, Journals, Sales, Purchase, Debit
Notes, Credit notes.
Tally provides complete bill wise information of amounts of Debtors and
Creditors. We can extract groupwise and individual details of Debtors
and Suppliers.
2. 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 detailed categorization of account heads.
Tally offers 28 predefined groups, out of which 15 groups are
primary groups and 13 groups are subgroups. Out of 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.
Ledgers are to be created under the above mentioned groups.
Tally has various inbuilt groups for a
proper classification of accounts.
Predefined 28 Groups
groups

15 primary 13 Sub groups


Groups

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.

3. AUDIT TRAIL AND DRILL DOWN DISPLAY:


Tally allows the user to zoom in into any reports till vouchers level and it
can make necessary changes to it.
Example: The user can view a trial balance and then select a group in
the trial balance and has a detailed look till vouchers or can make the
changes in it, and it is reflected immediately at all levels.

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.

5. Cheque printing Facility:


Tally allows the user the cheque printing facility.

6. Payroll –Tally automatically calculates salaries and it also generates pay slips of
the employees.

II) Inventory Features


Inventory is the stock of goods contained in a store or in a godown.
Inventory is the total amount of goods contained in a store or factory at
any given time. Inventory includes stock of raw Material, process goods
and finished goods.

Multi location stock order Complete tracking of stock movement

Determine Re order level

Create stock item, stock group, and stock


category
Actual bill quantity

Tracking of stock Inventory


Features
Multiple godowns

Through receipts
And delivery notes.

Price list Point of sale

1. Multi-location Stock Control: Tally keeps track of the stock at a single


or multiple locations.
2. Complete tracking of Stock Movement: Tally can keep record of
inventory transactions by using Goods Receipt Notes, Delivery
Notes, Stock Transfer Journals, Manufacturing Journals as well as
Physical Stock Journals.

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.

4. Stock categories, stock groups, stock items :


Tally allows the user to create stock groups and stock categories for
various stock items. Stock items are of various types. Similar items
can be put into one group and similar groups have one category.
5. MultipleGodowns: Tally allows the user to create any number of
Godowns. Godowns are places where stock items are stored. The
user can observe the location-wise movement of stock by creating
multiple Godowns.

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.

7. Tracking of stock through receipts and delivery notes: Many a times,


in a business, goods are delivered first and invoices are sent later, or
invoices are sent first and goods are delivered later. In such cases,
stocks should not be updated. Tally tracks the tracking document and
updates the inventory and displays it in the trading, profit and loss
account as a part of purchases or sales as the case may be.
8. Actual bill quantity: Sometimes the business gives various offers such
as ‘buy two get one free’. It means delivering 3 packets, but billing for
2 packets only. The user can enter both the quantities, to update the
stock and billed for computation of invoice.

I. III ) Technical features

Easy installation
Multi user support
Multilingual capability
Multiple platforms
Technical
Features
Tally audit
Backup and
restore Tally on the web

Data management Data security Data migration

1. Easy Installation: Tally software is easy to install as it is characterized


as a menu driven installation procedure and it takes just a few
seconds to install. The user can install its programme files on any
drive of the hard disc. It uses minimum hard disc space.
2. Unlimited multi user support: Tally supports the multi user
functionality. If multiuser version of tally is installed on network, many
users can work on tally simultaneously.
3. Available on multiple platforms: Tally runs on multiple platforms such
as windows, Linux, Macintosh operating system with its various
versions.
4. Internal backup and restore: Tally has an inbuilt ‘backup’ and ‘restore’
button. By using this option the user can take backup of companies
and restore it in the local hard disc or in an external memory. The
user can also store data by creating multiple directories. The user can
access this data by specifying a path.
5. Data Management :

a. Import–Export of data: Tally allows the user to import or export the


data from tally software to another software or vice versa after
making certain changes in current structure to accept Tally data
structure.
To import the data to tally software the user needs to write a
TDL programme (Tally Definition Language) and to export the data
from tally software to other software, it converts the data to XML,
HTML, ASCII format.
b. Extract data from Tally: Tally allows other programmes to use Tally
data directly. E.g. Microsoft excel or oracle has an in built ODBC
compliant component, hence can use data directly from Tally. In
case there is any change or update in Tally data, it can be
reflected in real time in other ODBC compliant software.
c. Data Synchronization: In synchronization process Tally enables a
branch office to send its data to head office.
d. Split data: Tally also has in built feature to split data. The user
has to specify the date and Tally will automatically split the
company to form two separate companies as per the period
specified by the user. Once the user splits the data, closing
balance of the first company becomes the opening balance for the
new company.
e. Graphical analysis: Tally allows the user to generate graphical
analysis for sales register, purchase register, ledgers, fund flow
statement, cash flow statement etc.

6. Data security and Data reliability:

 Data reliability: If there is power failure or if the computer is


electronically shut down, data is safe.
 Data security: Tally uses binary encoding format to store the data.
Binary encoding is a format which prevents devious changes in
information. Tally ensures that there are no external changes in its
data.
 Tally provides multiple levels of security at hierarchical levels.
Every authorized user can have his/her own password and can
use only specific features of Tally. But the administrator level user
has full access and can set control for other users.
 Tally Vault: Tally vault is a data encryption option. Without Tally
vault password data cannot be accessed.

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.

9. Multilingual capability: Tally software provides multilingual


capabilities. Tally’s multilingual capability is in its 9 Indian languages
and 3 foreign languages( Hindi, Guajarati, Punjabi, Tamil,Telugu,
Marathi, kannada, Malayalam,Bangali, English, Bahasa Melayu and
Bahasa Indonesia)

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.

10. Tally on the web:

i. Protocol Support: Tally provides the protocol support for HTTP,


HTTPS, ODBC, FTP etc.
ii. Web browser access: The user can directly log on to tally website
and refer the list of all the facilities offered by Tally. Tally
representative can assist the user with the help of ‘Tally chat’.
iii. E-mail facility: Tally allows the user to mail any document.

III. Statutory Features:


Tally provides statutory reporting for:
o VAT (Value Added Tax). CST(Central Sales Tax) State wise VAT
and CST returns.
o TCS and TDS with e-TDS/e-TCS capabilities for Printing
Certificates and Challans.
o Return and Challans for service tax.
o Filling of Fringe Benefit Tax.
o Generation of reports as per Central Excise Statutory
Requirements.
o Point of sale: Point of Sale (POS):It is a computerized Cash
Register which adds the sales total, calculate the sales tax or VAT.
Lecture Name: Tally operations

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.

Tally Accounting System


Install Tally ERP 9
After installing Tally, select the Tally version. And Start.
 Create Company :
 Create Various Ledgers under predefined groups
 Enter the Transaction in respective Vouchers.
 Generate the reports.

Getting started with Tally:


In Tally start up screen once you click on Work in Education Mode; Silver
or Gold Edition Mode, the next screen is of Gateway of Tally.
To enter the transactions in Tally, first you need to create company.
Press Alt +F3, you will get company information menu.
Title Horizo Mini
Langu Keyb
Bar ntal age mize
oard
Button Butto
Butto Butto
Bar n
n n

Botto Gateway of Calculator/


m Tally ODBC Butto
Pane server area n
Toolb
ar
Tally screen components

Title Bar: It displays the Tally version. Example :Tally ERP 9

Horizontal button bar: This bar includes Various short keys to print, to
language configuration, to email, to help etc.

Gateway of Tally: It is the actual work area. It displays menus,


screens, and generates reports.

Buttons Toolbar: Displays Various buttons, which are helpful for


quick interaction with Tally.

Calculator /ODBC serve: Use for calculations and ODBC server


compliances.

Bottom Pane: it displays Tally’s version no., serial, license type,


single user or multi user.

Language Button: this button is useful to configure language. This


button allows the user to select output language for reports.

Keyboard button: This button allows to configure language for


phonetic keyboard.

In company information screen press ‘C’ or Click on Create company


option, it shows company creation screen.
DIRECTORY: it is the data path where user wants to create a company.
By default it is C:\TALLY\DATA.But Tally allows the user to change it to
D:\Tally \Data.

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.

Statutory Compliance for : In this field users have to select the


appropriate country from the list of the countries.
State: User can select the state from the list of state.
Pin Code number, telephone number and E-mail id should be enter.
Back up data: Tally asks user to enable auto back up.
Company details : It includes currency symbol, maintain books, financial
year beginning for.
By default Currency symbol is rupees.
Tally ask the user in which type accounts books are to be maintain ------
Accounts only or accounts with inventory. Former describes the financial
accounts of the company later describes financial accounts and inventory
records of the company.
Financial year field is used to specify the financial year or
accounting year of the company and also ask the user to enter books
beginning from the date.
Data security. : In data security Tally asks the user to use security
control and ask user to set Tally vault password. Tally Vault password is
facility to keep the data protected in a encrypted form.

Base Currency information : It contains the information of base currency


symbol, it’s formal name, symbol is suffix to amounts etc.
The completed company creation screen is displays as follows

To complete the action of company creation , Press Y to accept. You will


get back to Gateway of Tally screen.

In gateway of Tally screen button bar also displays Features(F11) and


configuration(F12) buttons.
F11: Company Features
It helps to modify various features of a company. It is divided into
Accounting features(F1), inventory features(F2) (in case of books are
maintain with inventory) and statutory features(F3) .

Press enter or Hotkey A , it will open Accounting Features Screen


Screen displays as shown
Select yes or no as desired and accept Y to save the changes.

Press enter or Hotkey S , it will open Statutory and taxation Features


Screen . Screen displays as shown. Select yes or no as desired and
accept Y to save the changes.

Select yes or no as desired and accept Y to save the changes.


Press esc, Go to gateway of Tally screen .press F12 to configure
Configuration click on Accounts /inventory info

Click on button ‘voucher entry ’ to configure.


After completing the various configurations the next step is Actual
Accounting process
I) Create ledgers under predefined 28 groups.
II) Use accounting vouchers to enter the transactions in Tally.
III) Display various Reports .

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

Branche It covers all the accounts of


1 s/ Balance company’s sister concern,
Capital
Divisions sheet branches and divisions.
Capital Balance It holds capital and reserves
2 Account Capital of the company.
sheet
Current It holds subgroups like cash,
Assets Balance bank, deposits etc. It also
3 Capital
sheet holds pre-paid expenses and
outstanding incomes.
Current It covers outstanding
4 Liabilities Balance Capital liabilities, Statutory liabilities
sheet and other minor liabilities.
Direct It holds all the factory
Profit
Expense expenses like wages, factory
&
5 s rent, etc.
loss Revenue
[Expense
A/C
s Direct]
Direct It holds all incomes related to
Profit
Income non-trading company like
&
6 [Income fees received by doctors,
loss Revenue
Direct] commission received by
A/C
transport agents etc.
Indirect It holds all administrative
Expense Profit expenses like salary, rent,
s & etc.
7
[Expense loss Revenue
s A/C
Indirect]
Indirect Profit It holds the accounts of non-
Income & sale indirect incomes like
8
[Income loss Revenue commission received,
Indirect] A/C dividend received, etc.
Fixed It covers all fixed assets like
9 Balance
Assets Capital land, building, furniture, etc.
sheet

Investme It holds the accounts of


nt Balance overall investment of the
10 Capital
sheet company like investment in
shares, Govt. securities etc.
Loans It holds all loans taken by the
11 Balance
[Liability] Capital company.
sheet

MISC. It includes legal cost,


Expense accounting and valuation
s[Assets] Balance charges in connection with
12 Capital
sheet formation of the company
like preliminary expenses,
etc.
Purchas Profit It holds the accounts related
e & to purchase returns.
13
Accounts loss Revenue
A/C
Sales Profit It holds the Accounts related
Account & to sales and sales return.
14
loss Revenue
A/C
Suspens This is mainly for
e A/c Balance discrepancy in the balance
15 Capital
sheet sheet and trial balance like
difference in trial balance.

Sr. Sub
No. Nature Purpose of the Group
Group

Bank Current It holds all bank balances in


1
Account Asset current A/c And saving A/c.
Bank It covers all bank Overdraft
OCC/ Loans A/c.
2
Bank (Liability)
O/D
Cash- in- Current It holds balances of cash A/c
3 hand and petty cash A/c.
Assets
Deposits It holds all short deposits like
4 (Assets) Current telephone deposits, rental
Assets deposits, etc.
Duties It holds the accounts of
5 Current
and excise duty , local sales tax
Liabilities
Taxes and central sale tax.

Loans It holds all loans given by the


and company.
6 Advance Current
s Assets
[Assets]
Provision It covers all provisions like
7 s Current provision for depreciation,
Liabilities provision for taxes, etc.
Reserve Capital It holds all reserves like
s and Accoun Capital Reserve, General
surplus t Reserve, etc.
8 [Retaine
d
Earnings
]
Secured It holds the accounts of the
Loans Loans loan taken by the company
9
(Liability) against security like land and
building, etc.
Stock in Current It holds opening stock and
10 hand closing stock.
Assets
Sundry It holds the account of the
11 Creditors Current trade creditors of the
Liabilities company.
Sundry It holds the account of the
12 Debtors Current debtors who owe money to
Assets the company.
Unsecur It holds the account of the
13 ed Loans Loans Loan taken by company
(Liability) without any security.

Procedure to display Groups:


Gateway of Tally > Accounts Info > Groups> Single Group or Multiple
Group >Display Option>
Press Enter Key to Display the Pre-defined groups.

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.

Procedure to create Ledger:


Gateway of Tally > Accounts Info > Ledgers>Single Ledger > Create
Type a Unique Name for the Ledger. Duplicate Ledger name is not
allowed.
Select under-list groups which are applicable for particular ledger.
Press ‘Enter’ Key to create the Ledger.

Procedure to display Ledger:


Gateway of Tally > Accounts Info > Ledgers > multiple Ledgers> display
Select all items from list.
Press ‘Enter’ key.

Procedure to Alter Ledger:


Gateway of Tally > Accounts Info > Ledgers > Single Ledgers> Alter
Select particular Ledger from List
Modify the Information about the Ledger.
Press ‘Enter’ key.
Procedure to Delete Ledger:
Gateway of Tally > Accounts Info > Ledgers > Single Ledgers> Alter
Select particular Ledger from List, which user wants to delete.
Press Alt + D.
It displays a Box ‘Delete?’ Press ‘Y’ or ‘Enter’ from Keyboard.
----

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.

Gateway of Tally >accounting vouchers>contra(f4)


Payment voucher : All Payments made through cash or bank are
recorded in payment Voucher.

Gateway of Tally >accounting vouchers>Payment(F5)


Example : Paid salary by Cheque.
Purchased Machinery worth Rs.10,000 for Cash.
Purchased Goods worth Rs. 2000 for Cash.
 Receipt voucher:
Gateway of Tally >accounting vouchers>Receipt(F6)

It records all the transactions received in cash or through bank mode.


Example : Received commission .
Sold Machinery worth Rs.10,000 for Cash.
Sold Goods worth Rs. 2000 for Cash.
 Purchase voucher

Press Ctrl + V button to create voucher. To create the invoice press


again Ctrl+ V button, displays invoice in particular , Rate and in amount
column.
This voucher records all credit purchases of goods
Gateway of Tally >accounting vouchers>Purchases(F9)
Example:
Purchased goods worth Rs. 2000 from M/s ABC on credit.
 Sales voucher
Press Ctrl + V button to create voucher. To create the invoice press
again Ctrl+ V button, displays invoice in particular , Rate and in
amount column.
This voucher records all credit sales of goods
Gateway of Tally >accounting vouchers> Sales (F8)
Example:
Sold goods worth Rs. 2000 to M/s XYZ on credit.

 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

 Debit note voucher

When our customer return some goods , it enters in Debit note voucher.
Gateway of Tally> accounting Vouchers> ctrl F8
 Credit note voucher

When we return some goods to our supplier, it enters in Debit note


voucher.
Gateway of Tally> accounting Vouchers> ctrl F9
B) Inventory vouchers:’

If the user wants to maintain accounts records with inventory then


only inventory vouchers get activated.

Inventory vouchers record the receipt and issue of goods/stock, the


transfer of stock between locations and physical stock adjustments.

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.

 Profit and loss account


 Balancesheet

Trial balance is a list of balances extract from all ledger accounts


with their debit and credit balances on particular date.
Procedure to display trial balance:
Gateway of Tally > display > trial balance
Trial balance screen gets displayed. To configure the trial balance
, click on various buttons.

Alt + F1: Details : It displays the trial balance as per sub groups
or ledger

Again if you press the same button , displays only groups .


Alt + F2: Period

Profit and loss account:


Trading A/C : it is prepared to conclude gross profit or loss from it’s core
activities and calculates direct profit from it’s core activities.

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.

Balance sheet : it is a statement showing a frozen picture of asset and


liabilities on particular date. It summarises the assets and liabilities of
the business .
Lecture Name : Rectification of Errors

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’.

Accounting errors can take the following forms:


✓ Omission of recording a business transaction in the Journal or
Special purpose Books.
✓ Not posting the recorded transactions in various books of accounts to
the respective accounts in ledger.
✓ Mistakes in totaling or in carrying forward the totals to the next page.
✓ Mistakes in recording amount wrongly, writing it in a wrong
account or on the wrong side of the account.

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.

Errors affecting the trial balance (one sided errors):

✓ Errors of additions and subtractions:- wrong totaling and balancing of


ledger, wrong totaling of trial balance.
✓ Posting at the wrong side of an account:- Instead of debiting amounts
are by mistake written in credit.
✓ Entering incorrect amount:- Incorrect copying ,Transposing
figure(Writing 56 in place of 65), sliding figure (8000 in place of 800),
doubling the wrong figure and duplicate posting.
✓ Errors of omission:- Not posted in subsidiary accounts, accounts are
not opened in the ledger.
✓ Wrong posting in the trial balance:- Instead of writing debit side
accounts are posted in credit side.

Errors not affecting the trail balance (Two sided errors):

✓ Errors of omission:- Transactions are not recorded in books. E.g.


goods returned to supplier are not recorded.
✓ Errors of principle:-Disobey of accounting principles, (salary paid to
manager) managers’ accounts are debited.
✓ Compensating errors: - Sales of goods to Rani for Rs.100
debited to Rani’s account with Rs.10 and Rs.100 cash received for
Ajay was credited to Ajay with Rs.10.
✓ Incorrect account in the original book: - Instead of B.Babu‟s account,
N.babu’s account is affected by writer.
✓ Posting to wrong account: - Instead of writing in purchases book,
sales books are opened.

Steps to be taken to locate the accounting errors can be stated as


follows:
A. When the Trial Balance does not agree:
1) Check the columnar totals of Trial Balance.
2) Check that the balances of all accounts (including cash and bank
balances) in the ledger have been written and written in the correct
column of trial balance i.e. debit balance in the debit column and
credit balance in the credit column.
3) Find the exact figure of difference with trial balance and see that
no account of a similar balance has been omitted to be shown in
the Trial Balance.
4) A balance amount which is half of the amount of difference
amount but is written on the wrong side of the trial Balance.
[Please re check it as the sentence appears to be wrong]
5) Recheck the totals of Special Purpose Books.[What is special
purpose books? Please clarify]
6) Check the balancing of the various accounts in the ledger.
7) If difference is still not traced, check each and every posting from
the Journal and various Special Purpose Books, one by one in the
ledger.
B. When the Trial Balance agrees:
You have already learnt that if the totals of the two amount
columns of trial balance tally, it is no conclusive proof of the
accuracy of accounts. There may still be some accounting errors.
These errors may not be immediately traced but may be detected
at a much later stage. These are rectified as and when detected.
Following are the errors which don’t affect the trial balance:
1) Omitting a transaction in a journal or in a Special Purpose
Book totally. For example, goods purchased on credit but
are not recorded in the Purchases Book at all.
2) Recording a wrong amount of an item in journal or in a
Special Purpose Book. For example, sale of Rs. 2550 on
credit entered in the Sales Book as Rs.5250.
3) Posting the correct amount on the correct side but in the
wrong account. For example, cash received from
Jagannathan was credited to Vishvanathan.
4) An item of Capital Expenditure recorded as an item of
Revenue Expenditure and vice-a-versa. For example,
Repairs to Building was debited to Building A/c.
Why does the trial balance still agree though there may be above
stated errors? The reason is that in the above cases the debits and
credits are affected simultaneously by the same amounts.

Types of Accounting Errors :


All the errors whether they affect the trial balance or not are classified into
four different parts:

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

Building A/c Dr. 5000


To Cash A/c 5000
Correct entry
Repair & Maintenance A/c Dr. 5000
To Cash A/c 5000
Rectification entry

Repair & Maintenance A/c Dr. 5000


To Building A/c 5000

(Rectification is made of wrong debit given to building a/c instead of repairs


& maintenance a/c)

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

Purchases A/c Dr. 8000


To Mr. Anil’s A/c 8000
(Rectification is made of Purchases made from Mr. Anil not recorded
in the book)[Please include the narration properly in the journal]
✓ Discount allowed to a customer of Rs. 500 was not posted to
Discount A/c in the ledger.
In this example it is a partial omission. It affects only one account i.e.
Discount A/c. Therefore it affects the Trial Balance.
Rectification journal entry is not passed as only Discount A/c is not debited,
thus only Discount A/c is debited with Rs.500.(Please clarify.)

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 Wrong Wrong Wrong Wrong


recordin totaling Balancing caring Posting
g forward

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

Mr. Rakesh A/c Dr. 10,000


To Sales A/c 10,000

Cancellation entry

Sales A/c Dr. 10,000


To Mr. Rakesh A/c 10,000

Rectification entry

Purchases A/c Dr. 10,000


To Mr. Rakesh A/c 10,000

✓ Recording in the book correctly but wrong amount is written. For


example, goods sold to Shalini of Rs.4200 was recorded in the Sales
Book as Rs.2400.
It is a two sided error. So the same amount is debited and credited so
the trial balance will not be affected.

Wrong entry

Shalini A/c Dr. 2,400


To Sales A/c 2,400
Rectification entry

Shalini A/c Dr. 1,800


To Sales A/c 1,800

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]

✓ The total of Sales Day Book is written as Rs.52500 while it is


Rs.52900.
As the total of the Sales Book has under-cast by Rs. 400 so it
should be increased by the amount. No journal entry is
required, just the sales account should be credited by Rs.400.
.[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 carrying forward :


When the totals or balances which are carried forward to the next page are
carried forward incorrect, they are called as wrong carrying forward errors.
This error affects one account only. Therefore, Trial Balance gets affected.
Eg.
The total of page end of the Purchases Book of Rs.35,600 is carried to next
page as Rs.36,500.
No journal entry is required as the total of the purchase book is
taken on a higher side by Rs.900. Thus the total has to be
reduced. Thus the purchase account will be credited by Rs.900
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).

Goods purchased of Rs.5400 from Rajesh Mohanti was posted


twice to his account.
No journal entry is required, as the ledger account of Rakesh
Mohanti has been credited twice. To rectify the transaction the
account has to be debited once with the amount of Rs.5400.

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.

Preparation of Suspense Account –


The Trial Balance prepared at the end of a period by the business concern
must agree. It means the sum of its debit column and the sum of the credit
column should agree. But if the totals do not agree, the difference in
amount is written in a new account. This account is called Suspense
Account. If the total of the debit side of the Trial Balance is more than the
total of its credit side, the difference amount will be written in Suspense A/c
on its credit side i.e. Suspense A/c is credited and vice-versa. You have
also learnt that the two sides of the Trial Balance do not agree because
there is some error or errors in the accounts, which is reflected in the
Suspense Account. Thus, Suspense A/c is a summarized account of
errors.
Opening of a Suspense Account is a temporary arrangement. As soon as
the error that has led to Suspense Account is rectified, this account will
disappear. The suspense account is prepared only when the errors are one
sided.
Eg.
✓ Sales day book of November, was overcast by Rs.5,000.
No entry is required as only by debiting the sales account by the
amount will rectify the error. So a temporary account will help in the
agreement of the trial balance.
Rectification entry

Sales A/c Dr. 5,000


To Suspense A/c 5,000
The suspense account will disappear after the preparation of the final
accounts.
✓ A second hand computer purchased for office use for Rs.4,050 was
recorded in the office equipment account asRs.405.
a) No entry is required as only by debiting the office equipment
account by Rs.3645 the error will be rectified. So a temporary
account will help in the agreement of the trial balance.

Rectification entry

Office equipment A/c Dr. 3,645


To Suspense A/c 3,645

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

Sales A/c Dr. 500


To Suspense A/c 500
(Being over-cast of sales book
rectified)
Cash A/c Dr. 9000
To Factory lighting A/c 9000
(Being double entry recording
rectified)
Rent A/c Dr. 450
To Suspense A/c 450
(Being under-cast of rent a/c rectified)

Purchase A/c Dr. 850


To Suspense a/c 850
(Being under-cast of purchase a/c
rectified)
Building A/c Dr. 8900
To Wages A/c 8900
(Being wrong debit to wages instead
of building rectified)
Cash A/c Dr. 3600
To Manali A/c 3600
(Being receipt from Manali wrongly
shown as payment rectified)
Machinery A/c Dr. 3100
To Carriage A/c 3100
(Being wrong debit to carriage a/c
instead of machinery a/c rectified)
Drawing’s A/c Dr. 1650
To Insurance A/c 1650
(Being wrong debit to insurance a/c
instead of drawings a/c rectified)
TOTAL 28050 28050
Academic Script

Banking Reconciliation Statement – Introduction &


Importance

Business concern maintains the cash book for recording cash


and bank transactions. The Cash book serves the purpose of
both the cash account and the bank account. It shows the
balance of both at the end of a period. The Bank also maintains
an account for each customer in its book. All deposits by the
customer are recorded on the credit side of the respective
account and all withdrawals are recorded on the debit side of
the respective account. A copy of this account is regularly sent
to the customer by the bank. This is called ‘Pass Book’ or Bank
statement. It is usual to tally the firm’s bank transactions as
recorded by the bank with the cash book. But sometimes the
bank balances as shown by the cash book and that shown by
the pass book/bank statement do not match. If the balance
shown by the pass book is different from the balance shown by
bank column of cash book, the business firm will identify the
causes for such difference. It becomes necessary to reconcile
them. To reconcile the balances of Cash Book and Pass Book a
statement is prepared. If there is a difference between the cash
book balance and the pass book balance then only a statement
is prepared. It is called the ‘Bank Reconciliation Statement. It
can be said that:
“Bank Reconciliation Statement is a statement prepared to
reconcile the difference between the balances as per the bank
column of the cash book and pass book on any given date.”

Need to prepare Bank Reconciliation Statement:


It is neither compulsory to prepare Bank Reconciliation
Statement nor is a date fixed on which it is to be prepared. It is
prepared from time to time to check that all transactions
relating to the bank are properly recorded by the businessman
in the bank column of the cash book and by the bank in its
ledger account. Thus, it is prepared to reconcile the bank
balances shown by the cash book and by the bank statement.
It helps in detecting, if there is any error in recording the
transactions and ascertaining the correct bank balance on a
particular date.

When a businessman compares the Bank balance of its cash


book with the balance shown by the bank pass book, there is
often a difference. As the time period of posting the
transactions in the bank column of cash book does not
correspond with the time period of posting in the bank pass
book of the firm, the difference arises.

Importance of a Bank Reconciliation statement:

 It certifies the exact amount of cash in the bank account


at the end of the month.

 It helps to identify the undue delay in clearance of


cheques.

 The company identifies the amount of bank charges being


levied on the current account.
 The company can keep a check on the payments directly
made from the current account according to their standing
instructions.

 It detects the mistakes, errors and omissions made either


in the pass book or the cash book.

 The statement helps in keeping a moral check on the staff


of the company to keep the bank records always up-to-
date.

Format of a Bank pass book:

Specimen Pass Book


Name ________
Address __________ Account
no._____
Current Account with ____ Bank
Date Particulars Withdrawals Deposits Balance Initials
Dr. Cr.

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.

Format of a Bank Cash book:


Dr.
Cr.
Date Receipts Amount Date Payment Amount
Dr. or the debit side of the bank cash book is the side where all
the receipts are recorded while Cr. or the credit side is the
payment side.
The companies consider a monthly statement for reconciliation
and compares the opposite sides i.e. debit side of the cash
book with the credit side of the pass book.

The reasons for difference in balance of the cash book


and pass book are as under:

➢ Cheques issued by the firm but not yet


presented for payment –

When cheques are issued by the firm, these are


immediately entered on the credit side of the bank column
of the cash book. Sometimes, receiving person may
present these cheques to the bank for payment on some
later date. The bank will debit the firm’s account when
these cheques are presented for payment. There is a time
period between the issue of cheque and being presented
in the bank for payment. This may cause difference to the
balance of the cash book and the pass book.
Eg. The opening balance of the Bank Cash book and the
Bank Pass book of a company on 1st November 2015 is
Rs. 20,000. The company issues a cheque of Rs.8000 to
its vendor Mr. Shekhar on 26th November 2015, but Mr.
Shekhar could not deposit the cheque in his bank account
before 2nd December.
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

30\11\2015 To bal c/d 20,000 1\11\2015 By Bal b/d 20,000

20,000 20,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\11\2015 By Bal b/d 20,000 26\11\2015 ByMr.Shekhar 8000

31\11\2015 By Bal c/d 12,000

20,000 20,,000

As Mr. Shekhar deposited the cheque in the month of


December, the balance of the Bank Pass book and the
Bank Cash book for the month of November are different.

➢ Cheques deposited into bank but not yet


collected
When cheques are deposited into bank, the firm
immediately enters it on the debit side of the bank column
of the cash book. It increases the bank balance as per the
cash book. But, the bank credits the firm’s account after
these cheques are actually realised. A few days are taken
in clearing of local cheques and in case of outstation
cheques, few more days are taken. This may cause the
difference between the cash book and the pass book
balance.
Eg:- The opening balance of the Bank Cash book and the
Bank Pass Book of a company on 1st March 2015 was Rs.
18000. The company received a cheque of Rs.5000 from
Mr. Suresh on 27th March 2015, which was immediately
deposited in the bank account. The amount was credited
by the bank in the company’s account on 3rd April 2015.
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

31\3\2015 To bal c/d 18000 1\3\2015 By Bal b/d 18000

18000 18000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 18000

27\3\2015 ByMr.Suresh 5000 31\3\2015 By Bal c/d 23000


23000 23000

The company shows the cheque as deposited in the Bank


Cash book and so increases the balance but the bank shall
credit the Bank Pass book only when the cheque is cleared
on 3rd April 2015 so at the month end there is a difference
in the balances of both the Bank books.

➢ Amount directly deposited in the bank account:


Sometimes, the debtors or the customers deposit the
money directly into the firm’s bank account, but the firm
gets the information only when it receives the bank
statement. In this case, the bank credits the firm’s
account with the amount received but the same amount is
not recorded in the cash book. As a result the balance in
the cash book will be less than the balance shown in the
pass book.
Eg:- The opening balance of the Bank Cash book and
Bank Pass book of a company on 1st March 2015 was
Rs.12000. ABC Ltd. directly deposited a cheque of
Rs.10000 in the company’s bank account on 28th March
2015. The company got the information about the
transaction after receiving the month end statement.
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

1\3\2015 By Bal b/d 12,000

31\3\2015 To bal c/d 22,000 28\3\2015 By ABC Ltd. 10,000

22,000 22,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 10,000 31\3\2015 By Bal c/d 10,000

10,000 10,000

Sometimes the debtors or customers deposit the cheques


directly in the bank account of the company. If they give
an intimation to the company then the balances in both
the bank books would be the same, but if the company
has not been intimated then the amount will be deposited
in the bank pass book but would not be debited in the
Bank cash book. Thus there is a difference in the balances
of both the bank books.

➢ Bank Charges Charged

The bank charges i.e. fees or commission is charged from


time to time for various services provided by the bank
(Interest on overdraft balance, credit card fees, outstation
cheques, collection charges, etc.) The customer’s account
is debited by the bank without giving any intimation to the
company. The company records these charges after
receiving the bank statement. As a result, the balance in
the cash book will be more than the balance in the pass
book.

Eg:- The opening balance of the Bank Cash book and


Bank Pass book of a company on 1st March 2015 was Rs.
8000. On 20th March 2015 the bank debited charges of Rs.
200 for providing various services. The company got the
intimation about the charges from the bank statement.
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

20\3\2015 To bank charges 200 1\3\2015 By Bal b/d 8000

31\3\2015 To bal c/d 7800

8000 8000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 8000 31\3\2015 By Bal c/d 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.

➢ Interest and dividend received by the bank


Sometimes, the interest on debentures or dividends on
shares held by the account holder is directly deposited by
the company through Electronic Clearing System (ECS).
But the firm or the person does not get the information till
it receives the bank statement. As a consequence, the
firm enters it in its cash book on a date later than the
date it is recorded by the bank. As a result, the balance as
per cash book and pass book will differ.
Eg:- The opening balance of the Bank Cash book and
Bank Pass book of a company on 1st March 2015 was Rs.
80,000. The interest on the investments made by the
company of Rs. 10,000 was received through ECS on 15th
March 2015, and was credited in the bank pass book of
the company.
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

1\3\2015 By Bal b/d 80000

31\3\2015 To bal c/d 90000 15\3\2015 By Interest 10000

90000 90000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 80000 31\3\2015 By Bal c/d 80000

80000 80000

In the current times, interest and dividend warrants are


directly deposited through NEFT. The company gets the
intimation about such deposits directly from the bank
statements. So there is a difference between the two Bank
books.

➢ Direct payments made by the bank on behalf of


the customers.

Sometimes, the bank makes certain payments on behalf


of the customer as per their standing instructions.
Telephone bills, rent, insurance premium, taxes, etc. are
some of the expenses. These expenses are directly paid
by the bank and debited to the firm’s account immediately
after their payment. But the firm will record the same on
receiving information from the bank in the form of Pass
Book or bank statement. As a result, the balance of the
pass book is less than that of the balance shown in the
bank column of the cash book.

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

12\3\2015 To Insurance 15,000 1\3\2015 By Bal b/d 80,000

31\3\2015 To bal c/d 65,000

80,000 80,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 80,000 31\3\2015 By Bal c/d 80,000

80,000 80,000

The company is aware of the given instructions but can


check the actual debit entry in the Bank Pass book and
then charge the Bank Cash Book only after checking the
bank statement at the end of the month. So there is a
difference in the two Bank books.

➢ Dishonor of Cheques/Bill discounted


If a cheque deposited by the firm or bill receivable
discounted with the bank is dishonored, the same is
debited to the firm’s account by the bank. But the firm
records the same when it receives the information from
the bank. As a result, the balance as per the cash book
and that of the pass book will differ.
Eg:-
Dishonor of a cheque:-
The opening balance of the Bank Cash book and the
Bank pass book of a company on 1st March 2015 was
Rs. 25,000. A cheque received (form a debtor Mr.
Anil) by the company of Rs 5000 on 17th March 2015
was deposited in the Bank. On 29th March 2015 the
cheque was returned as dishonored to the Bank.
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

29\3\2015 To Mr. Anil 5000 1\3\2015 By Bal b/d 25,000


(ch. Dishonored) 17\3\2015 By Mr. Anil 5000

31\3\2015 To bal c/d 25,000

30,000 30,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 25,000 31\3\2015 By Bal c/d 30,000

17\3\2015 By Mr. Anil 5000

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.

Dishonour of a Bill of Exchange:-


The opening balance of the Bank Cash book and the
Bank pass book of a company on 1st March 2015 was
Rs. 25,000. A bill discounted by the company for Rs.
10,000 with the bank has been dishonoured and the
bank charges Rs.500 for the same on 21st March
2015.
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

21\3\2015 To Bills receivables 10,000 1\3\2015 By Bal b/d 25,,000

21\3\2015 To Bank Charges 500

31\3\2015 To bal c/d 14,500

25,000 25,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 25,000 31\3\2015 By Bal c/d 25,000

25,000 25,000

The company has discounted the BOE, but in case of


dishonouring the bank debits the company’s Pass
book with the bill amount and the charges for the
dishonour of the bill. The bank statement at the end
of the month will intimate the company about the
transaction. Thus till the company credits the bill
amount and the bank charges, there will be a
difference in the balances of the two Bank books.

➢ Errors committed in recording transactions by


the firm:
There may be certain errors from the firm’s side, e.g.,
omission or wrong recording of transactions relating to
cheques deposited, cheques issued and wrong balancing
etc. In this case, there would be a difference between the
balances as per Cash Book and as per Pass Book.
Eg:- The opening balance of the Bank Cash book and the
Bank pass book of a company on 1st March 2015 was Rs.
15,000. The company issues a cheque to Mr. Joshi of Rs.
8000 on 8th March 2015 and is collected from the bank on
15th March 2015. But the company’s accountant records
the issue of cheque as receipt of cheque.
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
15\3\2015 To Mr. Joshi 8000 1\3\2015 By Bal b/d 15,000

31\3\2015 To bal c/d 7000

15,000 15,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 15,000

8\3\2015 To Mr. Joshi 8000 31\3\2015 By Bal c/d 23,000


23,000 23,000

The accountant of the company committed an error by


considering the issue of cheque as a receipt of cheque
thus the actual balance of Rs.7000 is reflected in the Bank
Cash Book as Rs.23,000. Thus till the company rectifies
the error in the Bank cash book, there will be a difference
in the balances of the Bank Pass book and Bank Cash
book.

➢ Errors committed in recording transactions by


the Bank:
Sometimes, the bank may also commit errors, e.g.,
omission or wrong recording of transactions relating to
cheques deposited etc. As a result, the balance of the
bank pass book and cash book will not agree.
Eg:- The opening balance of the Bank Cash book and the
Bank pass book of a company on 1st March 2015 was
Rs.15,000. On 22nd March 2015, the bank accountant
wrongly credited a cheque of Rs. 10,000 from Mrs.
Ponkshe to the company’s current account.
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

1\3\2015 By Bal b/d 15,000

31\3\2015 To bal c/d 25,000 22\3\2015 By Mrs. Ponkshe 10,000

25,000 25,000

Bank Cash book


Dr.
Cr.
Date Receipts Amount Date Payment Amount

1\3\2015 By Bal b/d 15,000 31\3\2015 By Bal c/d 15,000

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

In the current scenario the corporate avail a lot of services


from the banks, due to this and many other reasons, there are
differences in the bank pass book and bank cash book. It is
necessary to reconcile this difference and understand the
actual balance in the bank. Thus at the end of the month a
reconciliation statement is prepared. It is not a compulsory
document for the company. The corporate prepare this
statement for the benefit of the organization and to avoid the
frauds and dishonor of cheques.
For the preparation of the BRS the companies gather
information from the banks by way of Bank Pass books or
Bank Statements. These statements are tallied with the Bank
Cash book maintained by the company. The receipt and the
payment sides are compared for finding out the discrepancies.
After judging the differences the companies can prepare a BRS.

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.

Important facts to be remembered before the


preparation of a Bank reconciliation statement:
 Debiting an item to the cash book increases the balance
and crediting it decreases the balance.
 Debiting an item to the pass book decreases the balance
and crediting it increases the balance.

Preparation of a Bank Reconciliation Statement:-


 Read the problem and see which balance of Cash book or
Pass book is given and which is to be found out. E.g. if
cash book balance is given, we have to find out the pass
book balance and vice versa.
 Write the given balance in the BRS in the beginning.
 Prepare a cash book and a pass book in an account format
as a working note.
 Side on which the balance is given becomes the positive
side and the other side becomes the negative side e.g. if
the cash book balance is given, both the debit sides of the
working note cash book and pass book will be positive and
credit side will be given the negative sign.
 Read each transaction given and post the entry where the
transaction is missing due to which the difference has
been caused.
 After recording all the transactions, the records on the
debit side of the cash book and the pass book in the
working notes will be added to the BRS while records on
the credit side will be subtracted.
 The final answer will be thus calculated after adding and
subtracting.

Procedure for the preparation of a bank reconciliation


statement:
The following steps may be initiated to prepare the bank
reconciliation statement:
 The date on which the statement is prepared is written at
the top, as part of the heading.
 The first item in the statement is generally the balance as
shown by the cash book. Alternatively, the starting point
can also be the balance as per passbook.
 The cheques deposited but not yet collected are deducted.
 All the cheques issued but not yet presented for payment,
amounts directly deposited in the bank account are
added.
 All the items of charges such as interest on overdraft,
payment by bank on standing instructions and debited by
the bank in the passbook but not entered in cash book,
bills and cheques dishonored etc. are deducted.
 All the credits given by the bank such as interest on
dividends collected etc. and direct deposits in the bank are
added.
 Adjustment of errors is made according to the principles
of rectification of errors.
 Now the net balance shown by the statement should be
same as shown by the passbook or the cash book. If the
statement starts with the cash book balance then the
positive end balance will be the balance as per pass book.

Dealing with favorable or Normal balances:


Practical illustrations:-
Illustration 1
From the following particulars of Mr. Vinod, prepare bank
reconciliation statement as on March 31, 2015.
1. Bank balance as per cash book Rs. 5,00,000.
2. Cheques issued but not presented for payment Rs. 60,000.
3. The bank had directly collected dividend of Rs. 80,000 and
credited to bank account but was not entered in the cash book.
4. Bank charges of Rs. 4000 were not entered in the cash
book.
5. A cheque for Rs. 60,000 was deposited but not collected by
the bank.

Solution :-
Bank Reconciliation Statement as on 31st March 2015
Particular Amount

Bank Balance as per Cash book 5,00,000

Add :-

Cheque directly deposited in the bank but not 80,000


entered in the cash book

Cheque deposited but not en-cashed 60,000

Less :-

Bank charges charged by the bank but no entry 4,000


in the cash book

Cheque issued but not presented for payment 60,000

Balance as per Bank Pass Book 5,76,000

Working notes:-
Bank Cash Book

Receipt (+) AMOUNT PAYMENT S (-) AMOUNT

Ch. Directly deposited 80,000 Bank charges not 4,000


charged in the cash
book

Bank Pass Book


Payments (+) AMOUNT Receipts (-) AMOUNT

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

Bank Balance as per Cash book 54,000

Add :-

Cheque issued but not collected 20,000

Interest on investment directly collected by bank 7,500


Less :-

Bank charges charged by the bank directly 100

Direct payment made by the bank 3500

Balance as per Bank Pass Book 77,900

Working notes :-
Bank Cash Book

Receipt (+) AMOUNT PAYMENT S (-) AMOUNT

Bank charges not 100


charged in the cash
book

Interest on 7500 Direct payment made 3500


investment collected not recorded in Cash
by bank not recorded book
in cash book

Bank Pass Book

Payments (+) AMOUNT Receipts (-) AMOUNT

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

Bank Balance as per Pass book 9214

Add :-

Loan installment directly paid by the Bank not 1700


recorded in the cash book

Cheques deposited but not been cleared till 3500


30\4\2015

Less :-

Cheque received wrongly recorded in the cash 6000


coloum of the cash book

Bank has credited an amount by mistake 1650

Cheque issued but not cleared till 30\4\2015 4500

Bank Balance as per Cash book 2264


Working notes:-
Bank Cash Book

Receipt (-) AMOUNT PAYMENT S (+) AMOUNT

Cheque received 6000 Loan installment 1700


wrongly recorded in directly paid by the
the cash column of Bank
the cash book

Bank Pass Book

Payments (-) AMOUNT Receipts (+) AMOUNT

Bank has credited an 1650 Cheques deposited 3500


amount by mistake but not been cleared

Cheque issued but not 4500


cleared

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

Bank Balance as per Pass book 10,000

Add :-

Electricity bill paid directly through the bank 950

Bank charges charged by the bank 150

Cheque deposited but not cleared 4,000

Less :-

Dividend cheque directly deposited in the bank 4,500

Under cast of funds rectified 100

Cheque issued but not collected 1500

Bank Balance as per Cash book 9,000

Working notes:-
Bank Cash Book

Receipt (-) AMOUNT PAYMENT S (+) AMOUNT

Dividend cheque 4500 Electricity bill paid 950


directly deposited in directly through the
the bank bank

Under cast of funds 100 Bank charges 150


rectified charged by the bank

Bank Pass Book


Payments (-) AMOUNT Receipts (+) AMOUNT

Cheque issued but not 1500 Cheque deposited but 4000


collected not cleared

Dealing with the Overdrawn Balances :


Illustration 5
Prepare a bank reconciliation statement as on 31st December
2014 if the overdraft as per pass book is Rs. 12000.
1. On 27th December cheques worth Rs. 70000 were issued
but the cheques which were en-cashed till 31st December
were Rs. 3000.
2. Cheques worth Rs.3500 were deposited in the bank
account but only cheques worth Rs. 500 were credited till
the month end.
3. Interest on overdraft Rs. 500 charged.
4. The bank pass book shows a credit of Rs. 600 against the
dividend on investment and Rs. 400 deposited by the
debtor directly.
5. A cheque received of Rs.200 but by mistake was not sent
by the bank for collection.

Solution:-
Bank Reconciliation Statement as on 30th April 2015

Particular Amount

Over drawn balance as per Pass book 12,000

Add:

Cheques deposited directly in the bank 1,000

Cheques issued but not en-cashed till date 67,000


Less:

Interest on overdraft charged by the bank 500

Cheques deposited but not collected by the bank 3,000


till date

Cheque received but not collected by the bank till 200


date

Over drawn balance as per Pass book 76,300

Working notes:-
Bank Cash Book

Receipt (+) AMOUNT PAYMENT S (-) AMOUNT

Cheques deposited 1,000 Interest on overdraft 500


directly in the bank charged by the bank

Bank Pass Book

Payments (+) AMOUNT Receipts (-) AMOUNT

Cheques issued but 67000 Cheques deposited 3,000


not en-cashed till date but not collected by
the bank till date

Cheque received but 200


not collected by the
bank till date

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

Over drawn balance as per Cash book 32,750

Add:-

Interest on overdraft charged by the bank not 2,000


credited in the cash book

Bank charges charged by the bank not credited in 600


the cash book

Balance under cast in the cash book rectified 100

Cheque issued but omitted from the cash book 1,000


Cheque deposited but not collected till date 5,200

Less:-

Dividend directly credited in the bank but not 5,000


shown in the cash book

Cheque issued but not collected till date 4,000

Cheque issued but not collected till date 2,000

Overdrawn balance as per Bank Pass book 30,650

Working notes:-
Bank Cash Book

Receipt (-) AMOUNT PAYMENT S (+) AMOUNT

Dividend directly 5,000 Interest on overdraft 2,000


credited in the bank charged by the bank
but not shown in the not credited in the
cash book cash book

Bank charges 600


charged by the bank
not credited in the
cash book

Balance under cast 100


now rectified

Cheque issued but 1,000


omitted from the
cash book
Bank Pass Book

Payments (-) AMOUNT Receipts (+) AMOUNT

Cheque issued but not 4,000 Cheque deposited but 5,200


collected till date not collected till date

Cheque issued but not 2,000


collected till date
Lecture Title: Consignments - Meaning and Features

Academic Script

1. INTRODUCTION: Any business organization tries to maximize


the profits arising from its business. For achieving this goal, the
amount of sales should be increased as much as possible.
There are various ways and methods of sales promotion.
Appointing agents at various places and selling goods through
these agents is one of the ways of increasing the sales and
profitability. The person who appoints agent is called as
‘principal’. Though there is no legal definition given that of the
principal, the definition of agent is given in The Indian Contract
Act which says that, ‘an agent is a person employed to do any act
for another or represent another in dealing with third person’.
[Section 182] In other words, it can be said that a person doing
some work for another can be called as an agent of the another
person. Thus a businessman can appoint his agents at various
places to sale his goods at those places.
For example, a trader in Pune may appoint agents at various
places such as Mumbai, Ahmednagar, Kolhapur, Nagpur,
Ahmedabad etc. The agents will sale goods at their places on
behalf of the person appointing them. They charge commission
for the service given and thus help in sales promotion at the
various places.
2. Need for appointment of agent: In the modern days, the nature of
business transactions is becoming more and more comple and if
a person who is running a business insists that all the business
related work will be done by himself, it will be impossible for him.
Therefore certain tasks can be assigned to a person who can
perform these functions. Thus an agent is a person who
performs certain work for other. However, it should be kept in
mind that an agent is only a connecting a link between the
principal and third parties. His function is to bring about
contractual relations between the principal and third parties.
3. MEANING: Consignment may be defined as a shipment of goods
by a trader to an agent for sale on commission on the sole risk
and account of the former. It is the sending of a quantity of goods
by one person to another at a different place to be sold by the
latter as the agent of the former. Thus in other words, when the
goods are sent to the agent by the principal for sale on behalf of
the principal, this is called as consignment. The consignment
transaction can be explained with the help of the following
diagram.

Consignment

Consignor Goods Consignee


[Principal] [Agent]

Net Proceeds Sale of goods


After deducting
Consignee’s expenses
& commission
For example: A of Ahmedabad sent goods to B of Pune of the
value of Rs.5,00,000 on consignment basis. Thus here A is
consignor and B is the consignee. A incurred expenses including
insurance and loading charges of Rs.25000. B received the
goods and spent Rs.32000 on unloading charges and carriage.
He is entitled to a commission of 5% on the sales made by him.
All the goods were sold by B at a price of Rs.6,00,000. He
remitted the amount of sales to A after deducting his commission
and his expenses. Here the consignment transaction is complete
between A and B. Thus for A it will be treated as consignment
outward as he is sending the goods to the consignee while in
case of B, as he is receiving the goods, it will be treated as
consignment inwards.

The following points should be noted about the consignment


transactions.
a) Commission: The consignee charges commission on the goods
sold on behalf of the consignor. Hence the consignor has to pay
the agreed commission to the consignee. The following are the
types of commission payable to the consignee.
i) Ordinary Commission: This is the remuneration charged by
the consignee and payable by the consignor. This
commission is payable on the amount of the goods sold by
the consignee. For example, if the agreed commission is
5% of sales and the amount of sales is Rs.20,00,000, the
ordinary commission payable will be Rs.10,000 i.e. 5% of
Rs.20,00,000.

ii) Del-credere Commission: It is a special commission paid by


the consignor to the consignee for taking extra risk i.e. risk
of bad debt. This commission is calculated either on the
gross sales or on the credit sales. (In the absence of
information it is calculated on the gross sales)
iii) Over-riding Commission: It is a special commission allowed
by the consignor to the consignee over and above the
ordinary commission. This commission is allowed with an
object to sell goods at a higher price. It is an extra incentive
to the consignee usually allowed if the total sales exceed a
specified target. It may be calculated on the total sales or on
the excess of total sales over the invoice price.
The following chart shows various types of commission and
the amount of sales on which it is calculated.

Commission

Ordinary Del Credere Overriding

On total sales Credit sales On excess sales

b) Stock on consignment: If the consignee is able to sell the entire


quantity of goods, there will not be any unsold stock lying with
the consignee. However if all the goods are not sold, there will
be some unsold goods left at the place of the consignee. This is
called as stock on consignment. The stock needs to be valued
and necessary entry is to be made in the books to record the
stock

4. PARTIES IN CONSIGNMENT TRANSACTIONS: In consignment


transactions, the following parties are involved.
a) Consignor: Consignor is the person who appoints the agent
or consignee. Thus he is the principal.
b) Consignee: A consignee is appointed by the consignor, i.e.
he is an agent of the consignor.
5. NATURE OF CONSIGNMENT TRANSACTIONS: The
consignment transactions have the following sequence.
I. The consignor sends goods to the consignee on
consignment basis. As mentioned above, goods are not sold
to the consignee but are sent to the consignee for sale. It is
expected that the consignee will sell the goods on behalf of
the consignor.
II. Sometimes, the consignor may ask for some advance from
the consignee. This advance may be paid either through
demand draft or bank transfer or bill of exchange.
III. The consignee sells goods on behalf of the consignee. Sale
may be made for cash or on credit. In case of credit sales, if
there are bad debts, the loss will have to be borne by the
consignor. However if the consignor agrees to pay additional
commission, i.e. del credere commission to the consignee,
the loss on account of bad debts will borne by the consignee.
IV. Consignee may incur certain expenses on the goods
received.
V. Consignee will remit the amount of sales to the consignor
after deducting the amount of expenses incurred by him as
well as his commission and advance if any paid by him to
the consignor.
6. DIFFERENCE BETWEEN SALE AND CONSIGNMENT: In
consignment, goods are sent to the consignee for sale. However it
is not a sale by the consignor to the consignee. The following are
the points which distinguish between sale and consignment.
I. In consignment transactions, the ownership of the goods
remains with the consignor as goods are sent by him to the
consignee for sale. Thus possession of goods is transferred
but ownership remains with the consignor. After the
consignee sales the goods, ownership is transferred from the
consignee to the buyer of goods. On the other hand, the
essence of any sale transaction is that there is transfer of
ownership from the seller to the buyer.
II. In case sale, there are two parties called as a seller and a
buyer. On the other hand, in consignment, the two parties
are called as ‘consignor’ and ‘consignee’.

III. Relationship between consignor and consignee in the


consignment transactions is that of principal and agent. This
relationship continues till there is a termination of the agency
by either party. In case of sale, the relationship is that of
seller and buyer and as soon as the transaction is complete,
i.e. goods sold and price received/paid, the relationship of
seller and buyer is over.
IV. In consignment transactions, as the ownership is not
transferred to the consignee, the consignor is responsible for
any loss of goods or damage of goods. In case of sale, as
the ownership is transferred, the buyer will be responsible
for any damage to the goods after sale.
V. The consignor incurs various expenses on the goods sent on
consignment. The expenses incurred by the consignee on
the goods are also reimbursed by the consignor. However in
case of sale, after the sale is complete, the buyer has to
incur any expenses required to be paid on the goods.
VI. Consignee can return the goods any time in case of
consignment as no ownership vests with him. However in
case of sale of goods, once the goods are sold, they cannot
be returned as the ownership is already been transferred.
VII. Consignee has to send a document known as ‘Account Sale’
to the consignor. This document shows the details of the
goods sold, expenses incurred by the consignee and also
the commission due to the consignee. In case of sale no
such statement is required to be sent by the buyer.
VIII. As consignee is the agent of the consignor, he charges
commission for the services provided and the consignor has
to pay it. In case of sale, the buyer has to pay the price for
the goods purchased by him.
7. FEATURES OF CONSIGNMENT: The following are the features of
consignment transactions.
I. It should be remembered that the consignee sells goods on
behalf of the consignor. Thus when the consignor sends the
goods to the consignee, it is not a sale but goods are only
transferred to the consignee. Thus the ownership of the
goods is not transferred to the consignee, only the
possession of the goods is transferred to the consignee.
II. The relationship between the consignor and consignee is
that of principal and agent and not that of buyer and seller.
III. The consignee is entitled to commission from the
consignor for selling the goods on behalf of the consignor.
Additional commission may also be given to the consignee if
he agrees to bear the risk of bad debts arising in case of
credit sales.
IV. Expenses incurred by the consignee are reimbursed by the
consignor.
V. Though the consignee can sell the goods at profit [at a price
which is more than the cost price of the goods], any amount
of profit or loss belongs to the consignor only.
VI. The consignee can return the goods to the consignor any
time if he finds that the goods cannot be sold or sold at a
considerable amount of loss. However once the goods are
sold, the buyer cannot return the goods.
VII. Books of accounts are maintained in the books of consignor
and consignee.
VIII. Any profit or loss arising in case of the consignment is
transferred to the Profit and Loss Account in the books of the
consignor.

8. IMPORTANT TERMS USED IN CONSIGNMENT


TRANSACTIONS: It is necessary to know the meaning of certain
important terms used frequently in consignment transactions.
These terms are explained below.
a) Proforma Invoice: When goods are sent by the consignor to the
consignee, they are accompanied by a document which is called
as ‘Proforma Invoice’. In this invoice, the details of the goods sent
such as quantity, physical measurements like weight etc, price,
packing, markings etc are given. The price mentioned in this
invoice is normally more than the cost price. Thus for example, if
the cost price of the goods is Rs.100 per unit, the price shown in
the proforma invoice may be 20% more than the cost price, i.e.
Rs.120 per unit. This price is known as ‘Invoice Price’. The main
objective behind charging higher price is that the consignee should
not know the profit margin of the consignor. Certain accounting
adjustments are required in case when the goods are sent at
invoice price which is more than the cost price..
b) Account Sales: This is a document prepared by the consignee and
sent to the consignor. The consignee sales the goods on behalf of
the consignor and hence he should send a detailed statement
showing the goods sold alongwith the expenses incurred by him
on the goods as well as his commission. Any advance paid by the
consignee to the consignor as well as any payment made for final
settlement is also shown in the Account Sale.
c) Normal loss of goods sent on consignment: The goods sent on
consignment may be lost. This loss is called as normal loss if such
loss is unavoidable and is due to such reasons such as,
evaporation, drying, sublimation etc. This loss is not taken into
consideration while preparing the accounts in the books of the
consignor.
This loss is to be borne by the good units by inflating their price.
For example, if 1000 units are sent at a total cost of Rs.40000
[Rs.40 per unit] and 10 units i.e. 1% is lost due to unavoidable
reasons, it is treated as normal loss. Thus the good units will be
1000 units – 10 units = 990 units and the cost of Rs.40000 will be
spread to 990 units which means the rate will be Rs.40000/990 =
Rs.40.40
d) Abnormal loss: Any loss of goods over and above the normal loss
is called as abnormal loss. In other words, this loss is avoidable.
For example, goods may be lost due to mishandling or some
damage in transit due to accidents etc. Cost of such abnormal
loss is computed and is taken into consideration while computing
the profit or loss on consignment.
9. Consignment Accounts: In case of consignment, there are two
parties, i.e. consignor and consignee. Books of accounts are to be
maintained in the books of both the parties. The following accounts
are maintained in case of consignment transactions.
I. Consignor’s Books: The consignor maintains the following
accounts.
i. Consignment Accounts: This account is prepared with the
objective of finding out the profit or loss arising out of the
consignment transactions. Amount of goods sent on
consignment as well as expenses of consignor and
consignee, commission payable to the consignee are debited
to this account. Amount of sale of goods, closing stock and
any amount of abnormal loss is credited to this account. The
difference between the amounts on the debit side and credit
side of this account is either the profit or loss and is
transferred to the Profit and Loss Account.
ii. Goods sent on consignment account: The amount of goods
sent on consignment is credited to this account. The balance
of this account is transferred either to the Trading Account or
Purchases Account.
iii. Consignee’s Account: The amount of expenses incurred by
the consignee, commission payable to the consignee and
any advance received from the consignee is credited to this
account. The amount of sales made by the consignee is
debited to this account. The difference between the amounts
on the debit side and credit side represents the balance
payable by the consignee to the consignor. This balance
may be either paid by the consignee or carried forward in
the future.
II. Consignee’s Books:
i. Consignor’s Account: The consignee maintains
consignor’s account in his books. Expenses incurred
by the consignee as well as his commission is debited
to the consignor’s account while the amount received
on sale of goods is credited to the consignor’s
accounts. The difference between the amounts on the
debit side and credit side represents the balance
payable to the consignor and may be either paid or
carried forward in the future.
10. Conclusion: Thus these are the various aspects of
consignment transactions. Accounting entries of various
transactions will be discussed in the next chapter.
Consignment: Accounting Treatment in the Books of the Consignor
and Consignee

Academic Script:

1. Introduction: In the previous lesson, we have seen the meaning


of the consignment. Just to recapitulate, in consignment, goods
are sent by the consignor [Principal] to the consignee [Agent] for
the purpose of selling them at his [Consignee] place. Thus the
consignor is the principal who appoints the consignee as his
agent. The consignee sells goods received from the consignor and
sells them at his, i.e. consignee’s place. The amount received by
selling the goods is sent back by the consignee to the consignor.
For this service, the consignee charges commission which is
payable by the consignor. The consignor may pay additional
commission which is called as ‘Del Credre’ commission to the
consignee if the consignee agrees to bear the loss on account of
bad debts. Thus consignment transactions are undertaken for
sales promotion by the consignor.
2. Accounting Treatment: The consignor wants to know the profit or
loss arising out of the consignment transactions and hence he
prepares Consignment Account in his books. This account is
opened on the lines of Profit and Loss Account and shows the
profit or loss on consignment. Additional ledger accounts are also
opened in the books of the consignor. The Consignee also opens
certain accounts in his books in order to keep a record of all the
consignment transactions at his end. The details of the journal
entries to be passed and ledger accounts to be opened in the
books of consignor and consignee are given below.
3. ACCOUNTING ENTRIES: As regards the accounting treatment in
case of consignment transactions, entries are passed in the books
of the consignor as well as in the books of consignee. In the books
of consignor, the following entries are passed for various
transactions.
A] Consignor’s Books:
I. Goods sent by consignor to the consignee:
Date Particulars L.F Debit Credit
.
Consignment Account ------Dr
To Goods Sent on
Consignment Account
[Being the goods sent on
consignment to the consignee]
Note: The amount of this entry will be the cost price of the
goods sent on consignment if the goods are sent at the cost
price. However when the goods are sent at invoice price which
is higher than the cost price, the amount of the entry will be the
invoice price. A reverse entry will have to be passed for the
amount equal to the difference between the cost price and
invoice price so as to nullify the effect of the invoice price.
II. Advance [if any ]received from the consignee
Date Particulars L.F. Debit Credit
Bank/Bills Receivable A/c -
Dr
To Consignee’s Account
[Being the amount of
advance received from the
consignee]
Note: If the amount of
advance is received through
Bills Receivable, the Bills
Receivable Account will be
debited, otherwise the bank
account will be debited.

III. Expenses incurred by the consignor


Date Particulars L.F. Debit Credit
Consignment Account -----
Dr
To Bank Account
[Being the expenses incurred
by the consignor]

IV. Expenses incurred by the consignee


Date Particulars L.F. Debit Credit
Consignment Account ---- Dr
To Consignee’s Account
[Being the expenses incurred
by the consignee]

V. Sales made by the consignee


Date Particulars L.F. Debit Credit
Consignee’s Account ------ Dr
To Consignment Account
[Being the sales made by the
consignee]

VI. Commission earned by the consignee


Date Particulars L.F. Debit Credit
Consignment Account -----
Dr
To Consignee’s Account
[Being the commission
earned by the consignee]
VII. Recording of unsold stock of goods
Date Particulars L.F. Debit Credit
Stock on Consignment
Account --- Dr
To Consignment Account
[Being the stock on
consignment valued and
recorded in the books]

VIII. Profit or loss on Consignment


Date Particulars L.F. Debit Credit
Consignment Account --- Dr
To Profit and Loss Account
[Being the profit on
consignment transferred to
the Profit and Loss Account]
Note: In case of loss, the
entry will be as follows.
Profit and Loss Account ------
Dr
To consignment Account
[Being the loss on
consignment transferred to
the Profit and Loss Account]
IX. Settlement of Account with the consignee: At the end of the
consignment transactions, the consignee remits the amount of
sales made by him on behalf of the consignor, after deducting
his expenses and commission. Consignee’s Account is opened
and the balance is settled.
Date Particulars L.F. Debit Credit
Bank Account ---------- Dr
To Consignee’s Account
[Being the settlement of
account with the consignee]

X. Closing of ‘Goods Sent on Consignment Account’


Date Particulars L.F. Debit Credit
Goods sent on Consignment
Account --- Dr
To Trading
Account/Purchases Account
[Being the balance of the
Goods Sent on Consignment
Account transferred to
Trading Account ]

B] In the books of Consignee:


As explained above, consignment is not sale and hence
consignee do not treat the consignor as his creditor. Therefore
when the goods are received by him from the consignor, he do
not pass any entry in his books, though the goods are taken
into account while valuing the stock. The various transactions
and the required entries in the books of the consignee are given
below.
I. Payment of advance [if any] to the consignor
Date Particulars L.F. Debit Credit
Consignor’s Account ------ Dr
To Bank Account/Bills
Payable Account
[Being the advance paid to
the consignor]
Note: Depending upon the
mode of payment, i.e. either
by bills payable or by
cheque/demand draft, the
credit will be given to the
appropriate account ]

II. Expenses incurred by consignee


Date Particulars L.F. Debit Credit
Consignor’s Account ------Dr
To Bank Account
[Being the expenses on
consignment goods incurred
by us]

III. Sales of goods sent on consignment basis


Date Particulars L.F. Debit Credit
For cash sales:
Bank Account ---------Dr
To Consignor’s Account
[Being the goods received on
consignment sold for cash]
For credit sales:
Debtors Account ------Dr
To Consignor’s Account
[Being the goods received on
consignment sold on credit]

IV. Commission charged to consignor


Date Particulars L.F. Debit Credit
Consignor’s Account ------Dr
To Commission Account
[Being the commission due
from the consignor]

V. Bad debts: Bad debts in consignment transactions may


arise if the consignee sales the goods on credit. The loss
on account of bad debts is to be borne by the consignor if
no additional commission, i.e. del credere commission is
paid. If the consignor allows the del credere commission,
the loss on account of bad debts is to be borne by the
consignee. Entries in both these cases are passed as
given below.
Date Particulars L.F. Debit Credit
If del credere commission is
allowed by the consignor to
the consignee
Bad Debts Account --------- Dr
To Consignment Debtors
Account
[Being the bad debts on
account of consignment
goods sold on credit]
If del credere commission is
not allowed
Consignor’s Account --------Dr
To Consignment Debtors
Account
[Being the bad debts on
consignment goods sold on
credit]

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 ]

VII. Settling the account of the consignor


Date Particulars L.F. Debit Credit
Consignor’s Account ------Dr
To Bank Account
[Being the final balance
remitted to the consignor]

4. LEDGER ACCOUNTS: The journal entries required in case of the


consignment accounts are given above. The ledger accounts
required along with their format are given below.
I. In the books of Consignor: In the books of the consignor, the
following ledger accounts are opened.
i. Consignment Account: This is the main account opened in the
books of consignor. The objective of this account is to find out
the profit or loss arising on the consignment transactions. This
account is nominal account. The format is given below.
Consignment to Aurangabad Account
Debit Credit
Particulars Amount Particulars Amount
To Goods sent on By Consignee’s A/c
Consignment – Sales
Account By Goods sent on
To Bank Account – consignment A/c –
Expenses goods returned by
To Consignee’s A/c - consignee
expenses By stock on
To Consignee’s A/c – consignment A/c
commission Unsold stock
To consignee’s A/c - By Profit & Loss A/c
bad debts Loss transferred
To Profit and Loss
A/c
Transfer of profit

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

iii. Goods sent on consignment Account is opened as given below


Goods sent on consignment Account
Dr Cr
Particulars Amount Particulars Amount
To Trading A/c: By Consignment A/c
transfer
Total Total

II. In the books of consignee: In the books of the consignee, the


personal account of consignor will be opened. This account will
be opened as shown below.

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

5. ACCOUNTING ADJUSTMENTS: There are certain accounting


adjustments required in consignment accounts. These are made in
the books of the consignor. These adjustments are given below.
a) Valuation of unsold stock on consignment: Out of the goods
sent on consignment to the consignee, some quantity of goods
may remain unsold with the consignee. This is the closing stock
on consignment and it needs to be valued for making an entry
in the consignment account. The valuation of closing stock is
made as given below.
 The cost price of the goods remained in the stock is
calculated.
 In the cost price, proportionate non recurring expenses
incurred by the consignor as well as by the consignee are
added.
 Examples of non recurring expenses are freight, carriage on
purchases, customs duties, insurance, loading and
unloading expenses etc.
 If the goods are sent at invoice price which may be more
than the cost price, the stock valuation is done firstly on the
basis of invoice price and the difference between the cost
price and invoice price is adjusted to ‘Consignment Stock
Reserve Account or Consignment Stock Suspense Account.
 The closing stock is shown on the credit side of the
consignment account while the consignment stock suspense
account is shown on the debit side of the consignment
account.
b) Goods sent on invoice price: When the goods are sent at
invoice price which may be more than the cost price, the entry
for sending the goods to the consignee is passed at the invoice
price. This means that consignment account is debited and
goods sent on consignment account is credited at the invoice
price. However the difference between the cost price and the
invoice price is adjusted by passing the reverse entry, i.e. by
debiting the goods sent on consignment account and crediting
the consignment account. Similar adjustments are made in the
valuation of closing stock as explained in (a) above.
6. Conclusion: Thus in the above paragraphs, we have seen the
journal entries and ledger accounts to be opened in the books of
the consignor and consignee. In the next lesion, we will see the
illustration of these entries in numerical problems.

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

Date Particulars L.F. Debit [Rs.] Credit [Rs.]


2016
06 Stock on Consignment A/c -------- 50,750
Dr 50,750
To Consignment A/c
[Being the unsold stock on
consignment with the consignee,
recorded in the books]
*Please see the working note no.1
for the amount of stock.
07 Consignment A/c --------- Dr 66,350
To Profit and Loss A/c 66,350
[Being the profit on consignment
transferred to the Profit and Loss
A/c]
08 Bank A/c --------- Dr 6,21,600
To Chakravarty’s A/c 6,21,600
[Being the amount received from
the consignee, i.e. Chakravarty in
settlement of his account]
09 Goods sent on Consignment A/c --- 6,00,000
Dr 6,00,000
To Trading A/c
[Being the balance of the Goods
sent on Consignment A/c
transferred to Trading A/c]
*Working Note 1: Valuation of unsold stock on consignment [Entry no6
Particulars Amount
[Rs.]
Price paid for 300 kg of raw material @
Rs.2000 6,00,000
Add: All expenses paid by Mahendra, i.e.
consignor: Rs.4000 + Rs.2000 = 6,000
Add: Freignt paid by Chakravarty, i.e.
consignee: Rs.3000 3,000
Total cost of the raw material: 300 kg 6,09,000
Cost of 25 kg remaining in stock =
25/300 X Rs.6,09,000 50,750
Journal Entries in the books of Chakravarty [Consignee]
Date Particulars L.F. Debit [Rs.] Credit
2016 [Rs.]
01 Mahendra’s A/c ------------------Dr 4,000
To Bank A/c 4,000
[Being expenses, freight Rs.3000
and godown rent Rs.1000 paid by
us on the goods received from
Mahendra on consignment ]
02 Bank A/c -----------Dr 55,000
Consignment Debtors A/c ------Dr 6,25,000
To Mahendra’s A/c 6,80,000
[Being the goods received from
Mahendra on consignment sold for
cash Rs.55000 and on credit
Rs.625000]
03 Mahendra’s A/c ---------Dr
To Commission A/c
Being commission receivable from
Mahendra 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
04 Bad Debts A/c ---------Dr 200
Bank A/c ------------ Dr 6,24,800
To Consignment Debtors A/c 6,25,000
[Being amount collected from
debtors, Rs.200 being non
recoverable treated as bad debts.]
05 Commission A/c ------------Dr 200
To Bad Debts A/c 200
[Being the loss on account of bad
debts set off against the commission
]
06 Commission A/c ------------Dr 54,200
To Profit & Loss A/c 54,200
[Being the amount of net
commission transferred to Profit and
Loss A/c]
07 Mahendra’s A/c --------Dr 6,21,600
To Bank A/c 6,21,600
[Being the balance amount remitted
to Mahendra]

Ledger Accounts: Books of Mahendra [Consignor]


Dr Consignment A/c
Cr
Date Particulars Amount Date Particulars Amount
2016 Rs. 2016 Rs.
To Goods sent on By 6,80,000
Consignment A/c 6,00,000 Chakravarty’s
To Bank A/c A/c
Freignt: 4,000 By Stock on
Other: 2,000 6,000 Consignment
To Chakravarty’s A/c A/c 50,750
Freight: 3000 [As per Working
Other: 1000 4,000 Note 1 given
above]
To Chakravarty’s A/c
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 54,400
= Rs. 3,400
To Profit & Loss A/c
Net profit on
consignment
transferred to P & L 66,350
A/c

Total 7,30,750 Total 7,30,750


2. S Oil Mills, Mumbai consigned 10,000 kg of a particular raw material
to D of Kolkatta on 1st January 2016. The cost of the raw material was
Rs.23 per kg and the S Oil Mill paid Rs. 20,000 for packing, freight
and insurance.
During transit, 250 kg were accidentally destroyed for which the
insurers paid directly to the consignors Rs.4500 in full settlement of
the claim.
D took delivery of the consignment on the 10th January. On 31st
March D reported that 7,500 kg were sold @ Rs.30, the expenses
being on godown rent Rs.3000, on advertisement Rs.4000 and on
salesmen’s salaries Rs.6400. D is entitled to a commission of 3%
plus 1.5% del credere. A party which had bought 1000 kg was able to
pay only 80% of the amount due from it.
D reported a loss of 100 kg due to natural causes. Assuming that D
paid the amount due by Bank Draft, show the accounts in the books
of the Consignor as well as Consignee. Assume that the books are
closed on 31st March every year.
In the books of S Oil Mills, Mumbai
Consignment to Kolkatta A/c
Dr. Cr.
Date Particulars Amount Date Particulars Amount
2016 2016
Jan. 1 To Goods sent Jan. By Abnormal
on 10 Loss * 6,250
Consignment
A/c 2,30,000
[10000 X Rs.23] March By D’s A/c –
31 Sales
March To Bank A/c 20,000 7500 kg X
31 Freight, Rs.30 per kg 2,25,000
insurance
By Stock on
To D’s A/c Consignment
Godown Rent: A/c – unsold 54,307
3000 stock **
Advertising: 13,400
4000
Salesmen’s
Salaries
6400

To D’s A/c-
Commission
Ordinary: 10,125
3% of
Rs.225000
=
6750 12,032
Del credere
1.5%
Rs.225000
=
3350

To Profit & Loss


A/c
Profit on
consignment

Total 2,85,557 Total 2,85,557

* The value of abnormal loss is computed as shown below.


As given in the example, 250 kg were accidently damaged in transit. The
cost price of these 250 kg will be,
250 kg X Rs.23 per kg = Rs.5,750
Add: Proportionate expenses of the consignor:
250/10,000 X 20,000 = Rs.500
Thus the total value of abnormal loss = Rs.6,250
** The unsold stock on consignment is computed as shown below.
Particulars Amount [Rs.]
The raw material that reached 10,000 kg – 250 kg =
Kolkatta 9,750 kg
Rs.2,50,000 – Rs.6,250
Cost of 9,750 kg = Rs.2,43,750

Quantity of raw material lost due to 100


normal loss [natural causes] 9,750 – 100 = 9,650 kg
Quantity available for sale Rs.2,43,750
Total cost of 9650 kg 9,650 kg – 7,500 kg
Closing or unsold stock [sale]
= 2,150 kg
Cost of 2,150 kg Rs.2,43,750 X
2,150/9,650 = Rs.54,307
as shown in the
consignment account.

Dr. Goods Sent on Consignment A/c Cr.

Date Particulars Amount Date Particulars Amount


2016 Rs. 2016 Rs.
March To Trading A/c - 2,30,000 Jan.1 By Consignment 2,30,000
to Kolkatta A/c –
31 Transfer
Goods sent
Total 2,30,000 Total 2,30,000

Dr. Abnormal Loss A/c


Cr.

Date Particulars Amount Date Particulars Amount


2016 Rs. 2016 Rs.
Jan. To Consignment 6,250 March By Bank A/c –
1 to Kolkatta A/c 31 received from
Material insurance 4,500
damaged company
By Profit & Loss 1,750
A/c - Transfer
Total 6,250 Total 6,250
Dr. D’s A/c Cr.

Date Particulars Amount Date Particulars Amount


2016 Rs. 2016 Rs.
March To Consignment March By Consignment to
31 to Kolkatta A/c - 31 Kolkatta A/c
Sales 2,25,000 Godown rent: 3000
Advertising: 4000
Salesmen’s
Salaries: 6400
13,400
By Consignment to
Kolkatta A/c
Commission
Ordinary:
3% of Rs.225000
= 6750
Del credere
1.5% Rs.225000
= 3350 10,125

By Bank A/c – Final


payment 2,01,475

Total 2,25,000 Total 2,25,000


In the books of D [Consignee]
Dr S Oil Mills A/c Cr.
Date Particulars Amount Date Particulars Amount
2016 Rs. 2016 Rs.
To Bank A/c By 2,25,000
Godown rent: Bank/Consignment
3000 Debtors A/c - Sales
Advertising:
4000 13,400
March Salesmen’s 6,750
31 Commission
6400 3,350
To Commission 2,01,475
A/c
To Del credere
Commission A/c
To Bank A/c

Total 2,25,000 Total 2,25,000


Joint Ventures Accounting Procedures - Part 1

Academic Script

1. Introduction: Joint Venture is a form of business organization. It is a


partnership but without the use of that name. Joint venture can be called as
temporary partnership as it is formed for a specific purpose by two or more
persons and after the fulfillment of the purpose for which it was formed, the
joint venture automatically comes to an end. For example, A and B may
come together and form a joint venture for consigning the goods to C. After
the transaction is complete the joint venture between A and B will be
dissolved. Similarly, persons may come together for trading goods,
construction of building or other infrastructure, underwriting of shares or
any other purpose. The profits and losses arising out of such business are
shared by the persons who come together for this business. Persons who
thus come together are called as ‘co-venturers’. The co-venturers invest
capital in the business and after the purpose of business is achieved, the
partnership comes to an end.
2. Features of Joint Venture: The joint venture has the following features:
I. Two or more persons come together and enter into an agreement to run a
business.
II. No specific name is necessary for the firm formed for a joint venture
business.
III. The objective of forming the business is limited to that specific business.
IV. The persons forming the joint venture are known as ‘co-venturers’. The co-
venturers agree to share profits or losses arising from the particular
business in the agreed proportion. The profits/losses will be shared equally
in the absence of any agreement about the proportion.
V. The joint venture comes to an end as soon as the venture, i.e. the business
for which it is formed comes to an end.
VI. The venturers are free to do any other business of their own during the
course of the venture.
3. Benefits of joint venture: The following are the benefits of joint venture
business:
I. In joint venture, as there is more than one person, the business risk is
shared by these persons. Thus there is no burden on a single person as
the profits or losses are shared by all the co-venturers in the agreed ratio.
II. The capacity of raising the necessary capital is always limited in case of a
sole proprietor. However, in case of joint venture as more than one person
come together, the ability to raise financial resources is increased.
III. In joint venture, as more co-venturers come together, they can share their
experience. The combined experience of all the co-venturers is beneficial
to the business.
4. Difference between partnership and joint venture: The following are the
points of differences between partnership and joint venture:
I. The joint venture is established for a limited objective and after the
fulfillment of that objective, the joint venture business comes to an end. On
the other hand, partnership business has a continuing nature and is not
limited to a particular purpose only.
II. The persons carrying on the partnership are called as partners while the
persons carrying on the business of joint venture are called as co-
venturers.
III. A partnership business has a firm’s name while no such name exists in
case of joint venture business.
IV. Co-venturers in a joint venture have freedom to run their own business
independently including a competing business. However, in partnership, no
such freedom exists for partners.
V. A minor can be admitted to the benefits of partnership while in case of joint
venture no such minor person can be admitted.

5. Difference between joint venture and consignment: A consignment of


goods means the sending of the goods by a manufacturer or wholesaler to
his agent for the purpose of selling them on behalf of the wholesaler or
manufacturer. The person who sends the goods is known as ‘consignor’
while the person to whom the goods are sent is known as ‘consignee’. The
goods are sold by the consignee on behalf of the consignor and the
consignee gets a commission for that. On the other hand, in joint venture,
two or more persons come together and carry on a business activity to fulfill
a particular purpose. After the purpose is fulfilled, the joint venture comes
to an end. The profits or losses arising out of the business are shared by
the persons who form the joint venture. These persons are called as ‘co-
venturers’. The main points of difference between the joint venture and
consignment are given below:
I. In consignment, the consignee who is an agent of the consignor, gets
commission for selling the goods on behalf of the consignor. On the other
hand, in case of joint venture, the co-venturers get their share of profits
arising out of the business.
II. In consignment, the parties are known as ‘consignor’ and ‘consignee’ while
in case of joint venture, the persons coming together are called as ‘co-
venturers’.
III. The relationship between the consignor and consignee is that of a principal
and an agent. In case of joint venture, the co-venturers are partners.
IV. Joint venture is established for limited purpose. For example, it may be
established for a particular activity like construction of a building. The joint
venture business is closed as soon as the activity is completed. Thus the
relationship between the co-venturer is limited and comes to an end after
the completion of the business. In consignment, the relationship between
the consignor and consignee may continue in future also.
V. In consignment, the consignee is an agent of the consignor and does not
invest any capital in the business. On the other hand, the co-venturers
invest capital in their business.
VI. The consignor is the only owner in case of consignment. However in case
of joint venture, all co-venturers are the owners.
VII. Consignment is usually limited for sale of goods. However a joint venture
business may be to carry on any activity such as purchase and sale of
goods, underwriting of shares, construction of building etc.
VIII. The consignee gets commission for the services rendered by him. In case
of joint venture, the co-venturers share the profits or losses arising in case
of joint venture business.
IX. There is only one method of recording the consignment transactions. On
the other hand, there are various methods of recording of joint venture
business activities.
6. Accounting treatment: The basic objective of the accounting procedures in
case of joint venture business is to find out profits or losses arising out of
the business. The accounting treatment in case of joint venture is of three
types as shown in the following chart:
Accounting Treatment

Separate set of books No separate books Memorandum

Maintained Maintained Joint Venture A/c

The three methods are explained below:


I. When separate books are maintained: In this method, the following
procedure is carried on:
i. A joint venture account is opened in the books of the firm and it is prepared
on the basis of Profit and Loss Account. This account shows profit or loss.
ii. A ‘Joint Bank Account’ is opened for recording the cash/bank transactions.
In this account, the initial contribution made by co-venturers is deposited in
this account along with the amount received on account of sales. The
expenses are incurred from this account and the net balance in this
account is distributed among co-venturers on the completion of the joint
venture business.
iii. In addition to the Joint Venture A/c and Joint Bank A/c, account of co-
venturers is also maintained.
The journal entries in this method are as follow:

Sr. Transaction Journal Entry


No
01 Initial contribution of the co- Joint Bank A/c – Dr
venturers To Co-venturers A/c
[Being the amount
contributed by the co-
venturers deposited in
the joint bank account
02 Goods sent by co-venturers Joint Venture A/c Dr
out of his own stock To Co-venturers A/c
[Being the goods
supplied by co-
venturers from their
own stock]
03 Expenses paid by co- Joint Venture A/c Dr
venturers To Co-venturers A/c
[Being expenses paid
by coventurers]

Sr. Transaction Journal Entry


No
04 Material purchased out of Joint Venture A/c Dr
Joint Venture funds To Joint Bank A/c
[Being the material
purchased out of joint
venture funds]
05 Expenses paid out of joint Joint Venture A/c Dr
bank account To Joint Bank A/c
[Being the expenses
paid out of joint bank
account]
06 For goods sold for cash Joint Bank A/c Dr
To Joint Venture A/c
07 Contract/sale price received Joint Bank/Shares A/c
either in cash/shares Dr
To Joint Venture A/c
[Being the contract
price received in
cash/shares]
08 Commission/salary to co- Joint Venture A/c Dr
venturers To Co-venturers A/c
09 Unsold goods taken over by Co-venturers A/c Dr
co-venturers To Joint Venture A/c
[Being the unsold
goods taken over by
the co-venturers]
10 Shares taken over by co- Co-venturers A/c Dr
venturers To Shares A/c
[Being the shares taken
over by co-venturers]
11 If shares are sold in open Joint Bank A/c Dr
market To Shares A/c
[Being the shares sold
in open market]
12 For profit on joint venture Joint Venture A/c Dr
To Co-venturers A/c
[Being the profit on joint
venture shared by the
co-venturers]
Note: If there is a loss,
the entry will be
opposite of this entry]
13 For final distribution of funds Co-venturers A/c Dr
To Joint Bank A/c
[Being the final
payment to the co-
ventures]

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.

The following payments were made by the venture:

a) Cost of goods purchased Rs.2,50,000


b) Transportation charges Rs.12,000
c) Advertising Rs.7500 and sundry expenses Rs.2500.
They sold the goods for Rs.400000 for cash. Aditya took over some goods
for Rs.30000 and Amit took remaining goods worth Rs.10000. The profits
or losses were to be shared equally between the co-venturers. Prepare
Joint Venture Account, Joint Bank Account and each Co-venturers
Account.

Dr Joint Venture Account Cr

Particulars Amount Particulars Amount


Rs. Rs.
To Aditya: materials 25000 By Joint Bank A/c: sales 400000
To Amit: materials 15000 By Aditya: goods taken
To Joint Bank: materials over
To Joint Bank: Transport 250000 By Amit: goods taken 30000
To Joint Bank: Advertising over
To Joint Bank: sundry 12000 10000
expenses
To profit on joint venture 7500
Aditya: 64000
Amit: 64000 2500
128000
Total 440000 Total 440000

Dr Joint Bank A/c Cr

Particulars Amount Particulars Amount


Rs. Rs.
To Aditya’s A/c 200000 By Joint Venture A/c –
To Amit’s A/c 150000 materials 250000
To Joint Venture A/c By Joint Venture A/c-
Sales 400000 transport 12000
By Joint Venture A/c –
advertising 7500
By Joint Venture A/c –
sundry 2500
By Aditya’s A/c – final
settlement 259000
By Amit’s A/c – final
settlement 219000
Total 750000 Total 750000
Dr Aditya’s A/c Cr

Particulars Amount Particulars Amount


Rs. Rs.
To Joint Venture A/c – 30000 By Joint Bank A/c 200000
materials By joint venture A/c 25000
To Joint Bank A/c –Final Materials
Settlement 259000 By Joint Venture A/c - 64000
profit

Total 289000 Total 289000

Dr Amit’s A/c Cr

Particulars Amount Particulars Amount


Rs. Rs.
To Joint Venture A/c – By Joint Bank A/c 150000
material 10000 By Joint Venture A/c –
To Joint Bank A/c –final materials 15000
settlement 219000 By Joint Venture A/c -
Profit 64000
Total 229000 Total 229000

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]

The following illustration will clarify the concepts further.

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:

Journal entries: John’s books

Date Particulars L.F Debit Credit [Rs.]


[Rs.]
01 Joint Venture A/c ---Dr 200000
To Goods A/c 200000
[Being 400 bales of shirting
supplied @ Rs.500 each]
02 Joint Venture A/c ---Dr 18000
To Bank A/c 18000
[Being carriage and insurance
paid on the goods]
03 Joint Venture A/c – Dr 240000
To Smith’s A/c 240000
[Being 500 bales of suiting
supplied by Smith @ Rs.480
each]
04 Smith’s A/c –Dr 50000
To Bank A/c 50000
[Being advance paid to Smith]
05 Joint Venture A/c –Dr 22000
To Smith’s A/c 22000
[Being carriage paid by Smith]
06 Bank A/c ---Dr 560000
To Joint Venture A/c 560000
[Being 500 bales of shirting and
400 bales of suiting sold by us
for cash for Rs.600 and Rs.650
respectively]
07 Joint venture A/c ---Dr 14000
To Commission A/c 14000
[Being commission @ 2.5% on
sales is charged by us]
08 Joint Venture A/c – Dr 2000
To Allowance A/c 2000
[Being the allowance of
Rs.2000 payable to us]
09 Joint venture A/c – Dr 64000
To Profit and Loss A/c 40000
To Smith’s A/c 24000
[Being the profit on joint venture
shared in the proportion of 5/8
ad 3/8]
10 Smith’s A/c – Dr * 236000
To Bank A/c 236000
[Being the final balance paid to
Smith]
*The final balance payable to Smith can be found out by preparing his
account as shown below.

Dr Smith’s A/c Cr

Date Particulars J.F. Amount Date Particulars J.F. Amount


Rs Rs.
01 To Bank A/c – By Joint
Advance Venture A/c –
To Bank A/c 50000 Suiting
Balance paid By Joint 240000
Venture A/c –
236000 Expenses
By Joint
Venture A/c- 22000
profit

24000
Total 286000 Total 286000
Journal Entries in the books of Smith

Date Particulars L.F Debit [Rs.] Credit [Rs.]


01 Joint Venture A/c –Dr 240000
To Bank A/c 240000
[Being 500 bales @ Rs.480 per
bale supplied by us]
02 Joint Venture A/c – Dr 22000
To Bank A/c 22000
[Being advertising and carriage
paid by us]
03 Bank A/c --- Dr 50000
To John’s A/c 50000
[Being advance received from
John]
04 Joint Venture A/c –Dr 200000
To John’s A/c 200000
[Being 400 bales of shirting @
Rs.500 each supplied by John]
05 Joint venture A/c –Dr 18000
To John’s A/c 18000
[Being carriage and insurance
paid by John]
06 John’s A/c ---Dr 560000
To Joint venture A/c 560000
[Being 500 bales of shirting
and 400 bales of suiting @
Rs.600 and Rs.650 each sold
by John]
07 Joint Venture A/c –Dr 14000
To John’s A/c 14000
[Being commission payable to
John]
08 Joint Venture A/c –Dr 2000
To Allowance A/c 2000
[Being allowance payable to
John for looking after the joint
venture business]
09 Joint Venture A/c –Dr 64000
To Profit and Loss A/c 40000
To John’s A/c 24000
[Being the profits on joint
venture shared in the ratio of
5:3]
10 Bank A/c Dr 236000
To John’s A/c 236000
[Being the balance received
from John]

Conclusion: We have seen two methods of the keeping accounts in joint


venture business. The third method will be covered in the next lesson.
Joint Ventures: Accounting Procedures-2

Academic Script

1. Introduction: Friends, in the previous lesson, we have seen the meaning,


features and benefits of joint venture. We have also discussed the
difference between the joint venture and consignment and joint venture and
partnership. Out of the three methods of accounting followed in the joint
venture, the first method was also discussed in the previous lesson. In this
lesson, we will see the second and third method of recording transactions
and keeping accounts in a joint venture business. These methods are
discussed in the following paragraphs.
2. When no separate books are maintained: 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 A. Similar entries will be passed in the books of
B.

Journal Entries: A’s Books

Sr. Transaction Journal Entry


No
01 For cash brought in by co- Cash/Bank A/c Dr
venturer To Co-ventuer’s A/c
[Being the cash brought in
by each co-venturer]
02 Purchase of goods for the joint Joint Venture A/c Dr
venture To Cash/Bank A/c
[Being the goods
purchased for the joint
venture business]
03 Recording the goods brought in Joint Venture A/c Dr
by A To Purchases A/c
[Being the goods brought in
joint venture by us]
04 Recording the goods brought in Joint Venture A/c Dr
by B To B’s A/c
[Being the goods brought in
by B]
05 Paying expenses by A Joint Venture A/c Dr
To cash/bank A/c
[Being the expenses on
joint venture paid by A]
06 Expenses paid by B Joint Venture A/c Dr
To B’s A/c
[Being the expenses paid
by B]
07 Sale of goods Cash/Bank/Debtors A/c Dr
To Joint Venture A/c
[Being the goods sold]
Note: in case of credit
sales, debtors’ account will
be debited, otherwise
cash/bank account will be
debited]
08 Goods taken away by B B’s A/c Dr
To Joint Venture A/c
[Being the goods taken
over by B]
09 Goods taken away by A Purchases A/c Dr
To Joint Venture A/c
[Being the goods taken
over by us]
10 Profit on joint venture Joint Venture A/c Dr
To B’s A/c
To Profit & Loss A/c
[Being the profit on joint
venture shared in the
agreed proportion]
Note:
1. In case of loss, reverse
entry will be passed.
2. In the books B, his share of
profit will be transferred to
Profit and Loss A/c and A’s
share will be credited to A’s
A/c
11 For settling account with B B’s A/c Dr
To Cash/Bank A/c
[Being the final settlement
of the account]

The illustration of this method is given below.

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:

Journal entries: John’s books

Date Particulars L.F Debit Credit [Rs.]


[Rs.]
01 Joint Venture A/c ---Dr 200000
To Goods A/c 200000
[Being 400 bales of shirting
supplied @ Rs.500 each]
02 Joint Venture A/c ---Dr 18000
To Bank A/c 18000
[Being carriage and insurance
paid on the goods]
03 Joint Venture A/c – Dr 240000
To Smith’s A/c 240000
[Being 500 bales of suiting
supplied by Smith @ Rs.480
each]
04 Smith’s A/c –Dr 50000
To Bank A/c 50000
[Being advance paid to Smith]
05 Joint Venture A/c –Dr 22000
To Smith’s A/c 22000
[Being carriage paid by Smith]
06 Bank A/c ---Dr 560000
To Joint Venture A/c 560000
[Being 500 bales of shirting
and 400 bales of suiting sold
by us for cash for Rs.600 and
Rs.650 respectively]
07 Joint venture A/c ---Dr 14000
To Commission A/c 14000
[Being commission @ 2.5%
on sales is charged by us]
08 Joint Venture A/c – Dr 2000
To Allowance A/c 2000
[Being the allowance of
Rs.2000 payable to us]
09 Joint venture A/c – Dr 64000
To Profit and Loss A/c 40000
To Smith’s A/c 24000
[Being the profit on joint
venture shared in the
proportion of 5/8 ad 3/8]
10 Smith’s A/c – Dr * 236000
To Bank A/c 236000
[Being the final balance paid
to Smith]
*The final balance payable to Smith can be found out by preparing his
account as shown below.

Dr Smith’s A/c Cr

Date Particulars J.F. Amount Date Particulars J.F. Amount


Rs Rs.
01 To Bank A/c – By Joint
Advance Venture A/c –
To Bank A/c 50000 Suiting
Balance paid By Joint 240000
Venture A/c –
236000 Expenses
By Joint
Venture A/c- 22000
profit

24000
Total 286000 Total 286000

Journal Entries in the books of Smith

Date Particulars L.F Debit [Rs.] Credit [Rs.]


01 Joint Venture A/c –Dr 240000
To Bank A/c 240000
[Being 500 bales @ Rs.480
per bale supplied by us]
02 Joint Venture A/c – Dr 22000
To Bank A/c 22000
[Being advertising and
carriage paid by us]
03 Bank A/c --- Dr 50000
To John’s A/c 50000
[Being advance received from
John]
04 Joint Venture A/c –Dr 200000
To John’s A/c 200000
[Being 400 bales of shirting @
Rs.500 each supplied by
John]
05 Joint venture A/c –Dr 18000
To John’s A/c 18000
[Being carriage and insurance
paid by John]
06 John’s A/c ---Dr 560000
To Joint venture A/c 560000
[Being 500 bales of shirting
and 400 bales of suiting @
Rs.600 and Rs.650 each sold
by John]
07 Joint Venture A/c –Dr 14000
To John’s A/c 14000
[Being commission payable to
John]
08 Joint Venture A/c –Dr 2000
To Allowance A/c 2000
[Being allowance payable to
John for looking after the joint
venture business]
09 Joint Venture A/c –Dr 64000
To Profit and Loss A/c 40000
To John’s A/c 24000
[Being the profits on joint
venture shared in the ratio of
5:3]
10 Bank A/c Dr 236000
To John’s A/c 236000
[Being the balance received
from John]

3. Memorandum Joint Venture Account: This is the third method of recording


transactions in the books account of a joint venture business.
Memorandum Joint Venture Method. The following are the features of this
method.
 Each venturer opens on account in his books in which he records
transactions relating to joint venture.
 This account is headed as ‘Joint Venture with ---- [name of co-venturer’s ]
Account’. This account is not a nominal account and must not be confused
with Joint Venture Account opened in the earlier two methods. In fact this
account is a personal account and does not disclose any profits or loss.
This account shows the balance due to or from any of the co-ventuerers.
 Each party records only those transactions which are effected by him. For
example, If X, a co-venturer purchases goods for joint venture, then this
transaction will be recorded by X only and not by other co-venturer. On the
other hand if goods are sold by Y, the transaction will be recorded by Y
only and not by X.
 When the transaction is recorded by the party, he does it with the help of
‘Joint Venture with -----Account’. Thus if X purchases goods for cash
Rs.4000, and the other venturer is Y, the entry that X will pass will be,
 Joint Venture With Y’s A/c -Dr
To Bank A/c
 Similarly, when expenses are paid by X, the entry will be,
 Joint Venture With Y’s A/c --- Dr
To Bank A/c
 If goods are sold by Y for cash, the entry will be recorded in the books of Y
as shown below
 Bank A/c ---- Dr
To Joint Venture with X’s A/c
 If Y takes some goods for his personal use, entry in his [Y] books will be,
 Purchases A/c ----Dr
To Joint Venture with X A/c
 Thus in the Joint Venture Account opened by each of the co-venturers,
entries will be passed only for those transactions which are effected by
them.
 Profits/losses are ascertained by preparing Memorandum Joint Venture
Account. This account does not form part of double entry system and
hence there is prefix of Memorandum. The method of preparing this
account is very simple. All purchases by all the co-venturers and expenses
incurred by them, are debited to this account while all the sales are credited
to this account. The difference between the debit and credit side is the
profit or loss and is divided between the co-venturers in the agreed ratio.
The illustration of this method is given below.
Illustration:
1. Ram and Mohan entered into a joint venture to purchase and sell new year
gifts. They agreed to share profits or losses equally. On 4th November
2012, Ram purchased goods worth Rs.100000 and spent Rs.6000 in
sending the goods to Mohan. He also paid Rs.2000 for insurance. On the
same date Ram drew a bill of exchange upon Mohan for Rs.100000 for two
months. He got the bill discounted @18% p.a.
Mohan spent Rs.3000 on cartage, Rs.5000 on rent and Rs.5000 on
advertisement. He sold all the gifts for Rs.200000 after retaining gifts worth
Rs.2000 for his personal use. He sent a cheque to Ram for the amount due
for the amount due on 8th January 2013. You are required to prepare
Memorandum Joint Venture Account and Joint Venture with Mohan
account in the books of Ram.
Solution: The following accounts will be opened in this case.
Dr Memorandum Joint Venture A/c Cr
Particulars Amount Particulars Amount
[Rs.] [Rs.]
To Ram: By Mohan:
Purchases:100000 Sales: 200000
Freight: 6000 Drawings:2000
Insurance: 2000 2,20,000
Discount: 3000 1,10,000
To Mohan:
Cartage: 3000
Rent: 5000
Advertisement
5000
13,000
To Profit:
Mohan: 39000
Mohan: 39000
78,000
Total 2,02,000 Total 2,02,000

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:

Dr Joint Venture with B’s Account Cr


Date Particulars Amount Date Particulars Amount
Rs. Rs.
May To bank- Feb.1 By Bank:
21 purchases 350000 2007 Insurance Co. 5000
2007 To bank – By Bank: sale
expenses 10000 March of 50 motors
2008 15 By Bank:
March To received from 1,12,500
15 Commission 11250 April B
April 1
30 1,50,000
To Profit & April By Bank: final
Loss A/c – 30 remittance
share of 39700 from B
profit
1,43,450

Total 4,10,950 Total 4,10,950

Conclusion: Thus we have seen all the methods of recording transactions


in the books of accounts in case of a joint venture business.
Inland Branches

Academic Script

1. Introduction: In the modern days, the competition in various fields is


becoming cut throat day by day. As a strategy to face competition is to
reach maximum number of customers as much as possible. One of the
ways to achieve this is to open branches at various places to cater to the
need of maximum number of customers. It should be remembered that
though opening as many branches as possible has become inevitable, it is
of paramount important to look after the accounting aspect of the branches
thus opened. It is necessary to record the various transactions which are
taking place between the branch and head office. Thus, in this lesson, we
are going to discuss the accounting methods used to record the
transactions taking place between branch and head office. We will start
with the definition of ‘branch’ as given in the Companies Act 2013.
2. Definition of branch: As per the Companies Act 2013, a branch office is,
 Any establishment described as a Branch by the Company
 Any establishment carrying on either the same or substantially the same
activity as that carried on by the Head Office of the Company, any
establishment engaged in any production, processing or manufacturing but
does not include any establishment specified in the Central Government’s
Order.
3. Classification of Branches: There are various types of branches.
Accounting systems, to a great extent depend on the type of the branch.
The classification is shown below.
A. Inland Branches: Inland branches are the branches opened in the country.
Thus a company may have head office in Mumbai and have branches at
various places in India such as Pune, Ahmednagar, Ahmedabad etc. The
inland branches are further divided into the following categories.
i. Dependent branches: These are the branches in respect of which the
whole of the accounting records are kept at Head Office only. The branch
do not maintains books of accounts.
ii. Independent branches: These branches maintain independent accounting
records.
B. Foreign Branches: These are the branches which are located in a foreign
country. [i.e. in a country other than in which the company is incorporated
and registered]
4. Methods of Accounting: The following accounting methods are used in
case of branch.
I. Debtors Method and
II. Stock and Debtors Method.
III. Final Accounts Method
These methods are discussed below.
I. Debtors Method: Under this system, the Head Office opens one Branch
Account to record various transactions with the Branch. Branch Account is
maintained in the form of Debtors Account. In the books of the Head Office,
Branch Account is debited with the goods supplied and all expenses met by
Head Office and credited with all remittances and returns, similar to
Customers’ Account. Therefore the system can be called Debtors System
or One Account System. The excess of the credit over its debit represents
a profit or vice-versa and is transferred to General Profit and Loss Account
of Head Office. Branch Account is prepared in the books of Head Office
and is a Nominal Account.
From accounting point of view, there are further three types of accounting
under Debtors Method.
a) Branches receive goods from Head Office at cost price and are authorized
to sell them for cash only.
b) Branches receive goods from Head Office at cost price and are authorized
to sell them for cash and credit
c) Branches receive goods from Head Office at cost plus certain percentage
of profit
 The journal entries in this method are given below.
Sr. No Transaction Journal Entry
01 Goods sent to branch Branch A/c -----Dr
by the Head Office To Goods sent to Branch A/c
Note: The amount of [Being the goods sent to branch]
this entry will be the
cost price if the goods
are sent at cost price.
However if the goods
are sent at invoice
price, i.e. cost plus
certain percentage of
profit, the amount of
the entry will be the
invoice price. The
difference between the
cost price and invoice
price [called as loading]
will be adjusted by
passing a reverse entry
on the credit side of
Branch Account.
Similar adjustments will
be made in opening
and closing stock
02 Direct purchases made Branch A/c ----Dr
by the Branch [if any] To Sundry Creditors A/c
[Being goods purchased by the
branch directly]
03 Various expenses Branch A/c ----Dr
incurred at the branch To Bank A/c
[Being expenses paid at branch]
04 Remittances from Cash/Bank A/c ---Dr
branch To Branch A/c
[Being the amount remitted by
the branch]
04 Goods returned by Goods sent to branch A/c Dr
branch To Head Office A/c
[Being the goods returned by
the Branch]
05 For transferring the net Branch A/c ------Dr
profit at branch To General Profit & Loss A/c
Note: In case of net [Being the profit at branch
loss, the entry will be transferred to the General Profit
reversed. and Loss A/c]

The Branch Account in this method appears as follows.


Dr Branch A/c Cr
Particulars Amount Particulars Amount Rs.
Rs.
To Balance b/d By Cash/Bank
[Opening balance of A/c
assets at branch] [remittances from
Stock branch]
Debtors By Goods sent to
Petty cash at branch Branch
To Goods sent to [Returns]
Branch [At cost]* By Balance c/d
To Sundry Creditors [Closing balance
[Direct purchases by at branch of
branch if any] assets]
To Bank – [expenses Stock
at branch] Debtors
To General Profit & Petty cash at
Loss A/c branch
[net profit **By General
transferred] Profit & Loss A/c
[net loss
transferred ]
Total Total
*The amount of this entry is cost price whenever goods are sent at cost
price. However when the goods are sent at invoice price [cost plus certain
percentage profit], the amount of the entry will be invoice price. In this case,
the difference between cost price and invoice price [loading] will be
adjusted on the credit side of the Branch A/c by passing a reverse entry.
Adjustments will also be made in case of opening and closing stock.
** In case of net loss the entry will be passed on the credit side of the
Branch A/c. The net profit or net loss will be finally transferred to the
General Profit and Loss Account.
Illustration:
Prepare a Branch Account in the books of Head Office form the following
particulars for the year ended 31st March 2016 on the assumption that
Head Office sold goods at cost price plus 25%

Particulars Amount Rs Particulars Amount Rs.


Stock –opening at 12,500 Bad debts 2,000
invoice price
Debtors –Opening 5,000 Allowances to 1,000
customers
Petty cash-opening 1,000 Returns inwards 1,000
Goods sent to 40,000 Charges sent to
branch – invoice Bank
price Rates and taxes 3,000
Salaries
Miscellaneous 8,000
expenses
1,000
Goods sent to Head 5,000 Closing stock at
Office invoice price 15,000
Cash sales 12,000 Closing Debtors
4,000
Cash received from 30,000 Closing Petty
Debtors Cash 1,000

The Debtors Account is shown below.

In the books of the Head Office


Dr Branch A/c Cr.
Particulars Amount Amount Particulars Amount Amount
Rs. Rs. Rs. Rs.
To Balance ****By Stock
b/d Reserve
Stock 12,500 [Loading on
Debtors 5,000 opening stock]
Petty cash 1,000 18,500
2,500
*To Goods By Bank A/c
sent to Branch Cash Sales 12,000
A/c 40,000 Cash received
To Bank A/c from Debtors
Rates & Taxes
Salaries 3,000 30,000 42,000
Misc. 8,000
expenses
1,000 12,000

**To Goods By Goods sent


sent to Branch to Branch
A/c –loading [Return of
on goods goods to Head
returned] Office]
1,000 5,000
***To Stock *****By Goods
Reserve – sent to Branch
loading on A/c
closing stock Loading on
3,000 goods sent
8,000
To General By Balance c/d
Profit & Loss Stock
A/c Debtors 15,000
Net profit 3,000 Petty Cash 4,000
1,000 20,000
Total 77,500 Total 77,500

*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.

Apparent Profit and Apparent Loss: An unusual increase or decrease in the


value of stock arises at Branch Stock Account due to inaccurate prediction
of the expected selling price of the goods which are invoiced by the Head
Office. Usually Head Office sends goods after charging a certain
percentage of profit i.e. at invoice price. However, it may happen that the
said goods are sold either at a price which is higher than the invoice price
or lower than the invoice price rather than the price fixed by the Head
Office. Thus the Branch Stock Account may show the wither surplus of
stock which is known as apparent profit or a shortage of stock which is
known as apparent loss. The apparent profit or apparent loss is recorded
as shown below.

 For Apparent Profit:


Branch Stock A/c ---------Dr
To Apparent Profit A/c
Apparent Profit A/c ---Dr
To Branch Stock Adjustment A/c
 For Apparent loss, the entries will be reversed.
 The accounts to be opened alongwith their objectives under Stock and
Debtors system are as follows.
I. Branch Stock Account [Branch Trading A/c]: To ascertain gross profit or
gross loss.
II. Branch Profit and Loss Account: To ascertain net profit
III. Branch Debtors Account: To record Receivables/Credit Sales etc
IV. Branch Expenses Account: To record expenses incurred at Branch
V. Branch Cash Account: To control Branch Cash position/remittances
VI. Branch Adjustment Account: To reverse loading, i.e. unrealized profits if
any
VII. Goods sent to Branch Account: To record goods sent/returned
VIII. Branch Assets Account: To record Assets at Branch if any
 Journal Entries to be passed in this method are given below.

Sr. No Transaction Journal Entry


01 Goods sent to branch by Branch Stock A/c –Dr
Head Office To Goods Sent to Branch A/c
Note: If the goods are sent To Branch Adjustment A/c
by the Head Office at [Being the goods sent to
invoice price [cost + Branch by Head Office]
certain percentage of
profit], the debit to Branch
Stock A/c will be with
invoice price while the
Goods sent to Branch A/c
will be credited with the
cost price. The difference
between the cost price and
invoice price will be
credited to Branch
Adjustment A/c ]
02 Goods returned by Branch Goods sent to Branch A/c –Dr
to Head Office Branch Adjustment A/c Dr
Note: In this entry, the To Branch Stock A/c
Goods sent to Branch A/c [Being the goods returned by
will be debited with cost Branch to the Head Office]
price, difference between
the cost price and invoice
price [loading if any] will be
credited to Branch
Adjustment A/c and
Branch Stock A/c will be
credited with full amount,
i.e. invoice price]
03 Assets provided by Head Branch Assets A/c –Dr
Office to Branch by way of To [Main] Bank A/c/vendor
fresh purchases or by way A/c/Assets [HO] A/c
of transfer from Head [Being assets provided by
Office Head Office to Branch]
04 Cash sent to Branch for Branch Cash A/c –Dr
expenses To [Main] Cash A/c
[Being the cash sent to
branch for meeting their
expenses]
05 Cash Sales at the Branch Branch Cash A/c -Dr
To Branch Stock A/c
[Being cash sales at branch]
06 Credit sales at the Branch Branch Debtors A/c –Dr
To Branch Stock A/c
[Being credit sales at the
branch]
07 Collection from Branch Branch Cash A/c –Dr
Debtors To Branch Debtors A/c
[Being amount received from
branch debtors]
08 Sales returns at Branch Branch Stock A/c --Dr
To Branch Debtors A/c
[Being the goods returned to
branch]
09 Discounts/bad debts etc Branch Expenses A/c -Dr
To Branch Debtors A/c
[Being discount and bad
debts credited to branch
debtors account]
10 Various expenses incurred Branch Expenses A/c -Dr
at branch To Branch Cash A/c
[Being expenses incurred at
branch]
11 Branch expenses directly Branch Expenses A/c -Dr
met by Head Office To [Main] Cash/Bank A/c
[Being the branch expenses
incurred by the Head Office]
12 Remittance made by [Main] Cash A/c –Dr
Branch to Head Office To Branch Cash A/c
[Being the cash remitted by
branch to the head office]
13 Goods lost in transit/stolen Goods lost in transit A/c -Dr
etc [At cost]
Branch Adjustment A/c –Dr
[loading if any]
To Branch Stock A/c
[Being the goods lost in
transit/stolen]
At the end of the year:
Closing entries
14 (i)Recording closing stock Closing Stock at Branch A/c
at branch [including loading] Dr
To Branch Stock A/c
[Being the closing stock at
branch recorded]
(ii) Excess of sales price Branch Stock A/c --Dr
over invoice price To Branch Adjustment A/c
[Being the excess of sales
price over invoice price
recorded]
15 Recording unrealized profit Branch Adjustment A/c Dr
on closing stock i.e. Stock To Stock Reserve A/c
Reserve [Being the unrealized profit on
closing stock]
16 Recording gross profit at Branch Adjustment A/c Dr
Branch To Branch Profit & Loss A/c
[Being the gross profit at
branch recorded]
17 Depreciation of Branch Branch Expenses A/c Dr
Assets if any To Branch Assets A/c
[Being the depreciation of
branch assets provided]
18 Transfer of Branch Branch Profit & Loss A/c Dr
Expenses To Branch Expenses A/c
[Being transfer of branch
expenses to branch profit and
loss account]
19 Recording of net profit at Branch P & L A/c –Dr
branch To General P & L A/c
[Being the net profit at branch
transferred to general profit
and loss account]

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

Particulars Amount [Rs.]


Balance on 1/04/2015
Stock [at invoice price] 30,000
Debtors 10,000
Petty cash 50
Transactions during the year at Lucknow
brach
Goods sent to Lucknow branch [invoice
price] 3,25,000
Good returned to Head Office [invoice price] 10,000
Cash sales
Credit sales 1,00,000
Goods pilfered [at invoice price] 1,75,000
Goods lost by fire [at invoice price] 2,000
Insurance co. paid to Head Office for loss 5,000
by fire]
Cash sent for petty expenses 3,000
Bad debts at branch 34,000
Goods transferred to Chennai Branch under 500
Head Office advice
Insurance charges paid by Head Office 15,000
Goods returned by Debtors 500
Balance as on 31/3/2016 500
Petty cash
Debtors 230
14,000
Goods worth Rs.15000 [including above] sent by Lucknow Branch to
Chennai Branch was in transit on 31/3/2016.

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

In the books of Head Office:

Dr Lucknow Branch Stock A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2015 2016 By Branch Cash
March A/c 1,00,000
April
To Balance b/d 30,000 31 Cash Sales
1 By Branch
To Goods sent Debtors A/c 1,75,000
2016
to Branch A/c 3,25,000 Credit sales
March By Goods sent to
Branch A/c
31
To Branch Returns from 10,000
March Debtors A/c- Branch
Return inwards By Pilferage A/c
31
By Loss by Fire 2,000
500 A/c
By Chennai Brach 5,000
A/c
Goods transferred
but in transit
By Balance c/d 15,000

48,500

Total 3,55,500 Total 3,55,500

Dr Lucknow Branch Debtors A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2015 2016 By Branch Profit &
March Loss A/c –Bad
April
31 debts 500
1 To Balance b/d 10,000 By Branch Stock
A/c
2016
To Branch Returns inwards
March Stock A/c By Branch Cash 500
Credit sales A/c
31
1,75,000 Collections from
Customers –
balancing figure
By Balance c/d

1,70,000
14,000
Total 1,85,000 Total 1,85,000

Dr Lucknow Branch Stock Adjustment A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2016 2016 By Balance b/d 6,000
March March Load on opening
31 To goods sent to 31 stock
Branch A/c Rs.30000 X 1/5
Loading on By Goods sent to
goods returned Branch A/c
10,000 X 1/5 Loading
To Branch Stock 2,000 Rs.325000 X1/5
A/c
Pilferage loading 65,000
Rs.2000/1/5
To loss by fire
Loading 400
Rs.5000X 1/5
To Chennai
Branch A/c 1,000
Loading
Rs.15000X1/5
To Branch Profit 3,000
& Loss A/c
Gross profit 54,900
transferred –
balancing figure
To Balance c/d
Loading on
closing stock
Rs.48500X 1/5

9,700
Total 71,000 Total 71,000

Dr Branch Profit & Loss A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2016 To Branch 2016 By Branch Stock
March Debtors A/c March Adjustment A/c
31 Bad Debts 500 31 Gross profit 54,900
To Insurance 500
To Pilferage [at
cost] 1,600
To Stock lost by
fire 1,000
To Petty
expenses 33,820
To General P &
L A/c –Branch
profit transferred
17,480
Total 54,900 Total 54,900

Dr Stock Reserve A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2016 To Stock 2015 By Balance b/d 6,000
March Adjustment A/c April
31 –transfer 6,000 1
To Balance c/d 9,700 2016 By Branch Stock
March Adjustment A/c 9,700
31
Total 15,700 Total 15,700

Dr Stock Lost by Fire A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2015 To Lucknow 5,000 2016 By Branch Stock
March Branch Stock March Adjustment A/c
31 A/c 31 By Bank – 1,000
insurance claim
By Branch Profit & 3,000
Loss A/c –
balancing figure
1,000
Total 5,000 Total 5,000

Dr Petty Cash A/c Cr

Date Particulars Amount Date Particulars Amount


Rs. Rs.
2015 To Balance b/d 50 2016 By Branch Profit &
March March Loss A/c –
31 To Cash 31 expenses –
2016 34,000 balancing figure 33,820
March By Balance c/d
31 230
Total 34,050 Total 34,050

Conclusion: Friends, in this lesson, we have seen the meaning of branch,


types of branches and the methods of recording accounting transactions.
We have also seen the illustration under Debtors system and Stock and
Debtors System.
Lecture Name : Depreciation Accounting - Meaning and
Causes

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.

In Accounting prudence (conservatism) is important convention, which


means the tendency to maintain a state of affairs without a sudden
change.

In convention in accounting shows that there has been a practice of the


accountants to follow the policy of playing safe. In other words, they
follow the rule, “anticipate no profit but provides for all possible losses”.
This is their prudence or wisdom.

Depreciation is charged on fixed assets but appreciation is not recorded;


is the example of this convention.

Assets are things of value used by the business in its operations.

According to Finny & Miller, “assets are future economic benefits, the
rights, which are owned or controlled by an organization or individual.

For depreciation purpose here most important to understand tangible


fixed assets.

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

According to R.N. carter, “depreciation is the gradual and permanent


decrease in the value of an asset from any cause.”

The reduction in value of tangible fixed assets due to normal usage,


wear and tear, new technology or unfavorable market conditions is
called depreciation.

Assets such as plants, machinery, buildings, vehicle etc, which are


expected to last more than one year, but not for infinity are subject to
this reduction.

It is allocation of the cost of a fixed asset in each accounting period


during its expected time of use.

The accounting standard on depreciation was issued by the ICAI in


November, 1982.

According to the Accounting standard, the amount of depreciation to be


charged is decided on the basis of following three factors :
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.
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.

Before taking up depreciation, it should be understood that the costs


relating to the use of long-term assets should be properly calculated and
matched against the revenue earned (these use cost have helped in
generating) so that periodic net income can be determined.

Types of Long-term Assets Term of expense or write off


Or use costs

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.

Depletion is the name of expenses or write off in the case of natural


resources. Depletion refers to the systematic and rational allocation of
the acquisition cost of natural resources to future periods in which the
use of those natural resources contributes to revenue. Natural resources
are exhausted or used up through mining, cutting, pumping etc.

The term amortization is used in case of intangible assets. Amortization


refers to the systematic and rational allocation of the acquisition cost of
intangible assets to future periods in which the benefits contribute to
revenue. It is the periodic write off to expenses of the intangible asset’s
cost over its expected useful life.

The term depreciation refers to periodic allocation of the acquisition cost


of tangible long-term asset over its useful life.

Basically, there are two problems relating to accounting of long-term


assets. First, what is the original acquisition cost of a particular long-term
asset. Second, how should the amount of expense or period write off
should be determined and allocated against yearly revenue to reflect the
asset’s consumption.
The other related issues are how should subsequent expenditures such
as repairs, maintenance and additions be treated, how should disposal
of long term assets be recorded.

Journal Entry for depreciation (assuming no provision is maintained)


Depreciation A/C………………………….Dr
To asset a/c

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.

1) Straight line method.


Also known as original cost method, fixed installment method and
fixed percentage method.
This is most popular method for charging depreciation.
An equal amount is allocated for each accounting period.
The rate of depreciation is the reciprocal of the estimated useful life
of an asset, so for example, the useful life of an asset is 5 years, the
depreciation charged will be 1/5 =0.02%
Example:-
Asset cost=1, 00,000
Depreciation rate =20%
1st year =20/100×1, 00,000 = 20,000
2nd year = 20/100×1, 00,000 =20,000
Simple & easy to understand.
The book value of an asset can be reduced to 2ero
A fair evaluation of an asset each year in the balance sheet.
Depreciation amount = (cost of asset –salvage value)/useful life of
asset in year
Salvage value = scrap value.
Amount that expected to be received at end of a plant assets use
full life.

2) Diminishing value method.


Also known as written down value method, reducing installment
method.
In diminishing value method, depreciation is charged on reducing
balance on a fixed rate.
The percentage at which depreciation is charged, remains fixed,
however the amount of depreciation goes on diminishing year after
year.
According to DVM,
𝑟
D=1-𝑛√
𝑐
D= depreciation %
n= Useful life of asset in years
r = residual value of asset
c= cost of asset.
Ex. Asset cost = 1, 00,000
Depreciation rate= 20% (DVM)
1st year=20/100×1, 00,000=20,000
2nd year=20/100× (1, 00,000-20,000)
=16,000
More Practical & easy method to apply.
This method is applicable for income tax purposes.

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.

4) Machine hour rate method.


This method is also known as service house method. This
method takes into account the running time for the purpose of
calculating depreciation. The amount of depreciation under this
method is calculated as
Depreciation= original cost of the asset- scrap value/life of the
assets in hours
Scrap value- scrap value is the worth of physical assets individual
components when the asset itself is deemed no longer usable.
Lt is scientific method to calculate factory overhead. It is useful to
increase efficiency of machine because we can used it efficiency of
machine because we can used it efficiency of machine because we
can used it effective way and all overheads depends on it.

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.

In is an expense for services consumed in the same way as expenses


are incurred for items such as wages, rant or electricity. Because it is
charged as expenses to the profit and loss account, depreciation
reduces net profit.

Causes of depreciation.
Causes of
depreciation.

Physicy Economic The time


Depletion
deterioration factors factor

The causes of depreciation can be divided up between physical


deterioration, economic factors, the time factor and depletion.
A) Physical deterioration:-
In is factor divided in two categories.
1) Wear and tear:-
When a motor vehicle or machinery or fixtures and fittings are
used they eventually wear out some last many years, others last
only a few years this is also true of buildings, although some
may last for a long time.
2) Erosion rust rot and decay:-
Land may be eroded or wasted away by the action of wind, rain,
sun and other elements of nature. Similarly, the metals in motor
vehicles or machinery will rust away. Wood will not eventually.
Decay is a process which will also be present due to the
elements of nature and the lack of proper attention.

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.

C) The Time Factor:-


Obviously time is needed for wear and tear, erosion, and for
obsolescence and inadequacy to take place. However, there are
fixed assets to which the time factor is connected a different way.
These assets which hare a legal life fixed in terms of years. For
instance you may agree to rent some buildings for ten years.
This is normally called a lease. When the years have passed, the
lease is worth nothing to you, us it has finished whatever you paid
for the lease is now no value.
In similar way, where you buy a patent so that only you are able to
produce something when the patent’s time has finished it then has
no value.
Instead of using the term depreciation, the term amortization is often
used for these cases.

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.

The accounting standard on depreciation was issued by the ICAI in


November, 1982.
According to the Accounting standard, the amount of depreciation to be
charged is decided on the basis of following three factors:

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.

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 if 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.

Before taking up depreciation, it should be understood that the costs


relating to the use of long-term assets should be properly calculated and
matched against the revenue earned (these use cost have helped in
generating) so that periodic net income can be determined.
Types of Long-term Assets Term of expense or write off
Or use costs

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.

Depletion is the name of expenses or writes off in the case of natural


resources. Depletion refers to the systematic and rational allocation of the
acquisition cost of natural resources to future periods in which the use of
those natural resources contributes to revenue. Natural resources are
exhausted or used up through mining, cutting, pumping etc.

The term amortization is used in case of intangible assets. Amortisation


refers to the systematic and rational allocation of the acquisition cost of
intangible assets to future periods in which the benefits contribute to
revenue. It is the periodic write off to expenses of the intangible asset’s
cost over its expected useful life.

The term depreciation refers to periodic allocation of the acquisition


cost of tangible long-term asset over its useful life.
Basically, there are two problems relating to accounting of long-term
assets. First, what is the original acquisition cost of a particular long-term
asset. Second, how should the amount of expense or period write off
should be determined and allocated against yearly revenue to reflect the
asset’s consumption. The other related issues are how should subsequent
expenditures such as repairs, maintenance and additions be treated, how
should disposal of long term assets be recorded.

Acquisition Useful life or holding


period
Of long-term assets

Decline in Asset’s Economic Significance

Or Decline in Unexpired (Unused) cost

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.

3. Accounting for subsequent


expenditures such as repairs,
maintenance, additions.
For accounting purposes, the acquisition cost of a long term asset
having a limited useful life indicates the prepaid cost of a bundle of future
services or benefits that will help earn future revenues. Acquisition cost of
long term assets are like inventories and prepaid expenses. Acquisition
cost includes all expenditures necessary to get the long term assets in
place and ready for use.

Cost of a long term asset is easy to determine when the asset is


purchased for cash. In this case, cost of asset is equal to cash paid for the
asset plus expenditures for freight, insurance while in transit, sales tax,
special foundations, installation and other necessary costs. When a second
hand asset is purchased, the initial costs of getting it ready for use, such as
expenditures for new parts, repairs and painting are added to the cost of
assets.

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.

Improvements to land such as parking lots, private sidewalks,


driveways, fences are note added to the cost of land but to a separate
account, Land Improvement Account. These expenditures are depreciated
over the estimated lives of the improvements.

When an existing or old building or used machinery is purchased, its


cost includes the purchase price plus all repairs, renovation and other
expenses incurred by the purchaser prior to use of asset. Ordinary repair
costs incurred after the asset is placed in use are normal operating
expenses when incurred.

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 computation of depreciation for an accounting period is affected by the


following factors:

(1) Depreciable assets: Depreciable asset are asset which:


(i) are expected to be used during more than one accounting
period; and
(ii) have a limited useful life; and
(iii) are held by an enterprise for use in the production or supply of
goods and services,
for rental to others, or for administrative purposes and not for
the purpose of
sale in the ordinary course of business.

(2) Useful life: Useful life is either


(i) the period over which a depreciable asset is expected to be used
by the enterprises; or
(ii) the number of production or similar units expected to be
obtained from the use of the asset by the enterprise.

The useful life of a depreciable asset is shorter than its physical life and is:

(i) pre-determined by legal or contractual limits, such as the expiry


dates of related leases;
(ii) directly governed by extraction or consumption:
(iii) dependent on the extent of use and physical deterioration on
account of wear and tear which again depends on operational
factors, such as, the number of shifts for which the asset is to be
used, repair and maintenance policy of the enterprise etc., and
(iv) reduced by obsolescence arising from such factors as:
(a) technological changes;
(b) improvement in production methods;
(c) change in market demand for the product or service output of
the asset; or
(d) Legal or other restrictions.

Estimation of the useful life of a depreciable asset or a group of


similar depreciable asset is a matter of judgement ordinarily based on
experience with similar types of assets. For an asset using new technology
or used in the production of a new product or in the provision of a new
service with which there is little experience, estimation of the useful life is
more difficult but is nevertheless required.

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.

(3) Depreciable amount:


Depreciable amount of a depreciable asset is its historical cost, or
other amount substituted for historical cost in the financial statements,
less the estimated residual value.
Historical cost of a depreciable asset represents its money outlay or
its equivalent in connection with its acquisition, installation and
commissioning as well as for additions to or improvement thereof. The
historical cost of a depreciable asset may undergo subsequent changes
arising as a result of increase or decrease in long term liability on
account of exchange fluctuations, price adjustments, change in duties or
similar factors.

(4) Residual value:


The residual value of an asset is often insignificant and can be
ignored in the calculation of the depreciable amount. If the residual value
is likely to be significant, it is estimated at the date of acquisition, or the
date of any subsequent revaluation of the asset, on the basis of the
realizable value prevailing at the date for similar assets which have
reached the end of their useful lives and have operated under conditions
similar to those in which the asset will be used. The gross residual value
in all cases is reduced by the expected cost of disposal at the end of the
useful life of the asset.

According to ICAI’s AS 6 “any addition or extension to an existing


asset which is of a capital nature and which becomes an integral part of
the existing asset is depreciated over the remaining useful life of that
asset. As a practical measure, however, depreciation is sometimes
provided on such addition or extension at the rate which is applied to an
existing asset. Any addition or extension which retains separate identity
and is capable of being used after the existing asset is disposed of, is
depreciated independently on the basis of an estimate of its own useful
life.”

Factors Influencing the Selection of Depreciation Method:

Depreciation has a significant effect in determining the financial position


and result of operations of an ecterprises by calculating net income as well
as deduction from taxable income. The quantum of depreciation to be
provided in an accounting period involves the exercise of judgement by
management in the light of technical, commercial, accounting and legal
requirements and accordingly may need periodical review. If it is
considered that the original estimate of useful life of an asset requires any
revision, the unamortized depreciable amount of the asset is charged to
revenue over the revised remaining useful life. Alternatively, the aggregate
depreciation charged to date is recomputed on the basis of the revised
useul life and the excess or short depreciation so determined is adjusted 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.

The following factors influence the selection of a depreciation


method:

1. Legal Provisions:

The statute governing an enterprise may be the basis for computation


of the depreciation. In India, in the case of company, the Companies Act,
1956 provides that the provision of depreciation, unless permission to the
contrary is obtained from the Central Government, should either be based
on reducing balance method at the rate specified in the Income Tax act /
Rules or on the corresponding straight line depreciation rates which would
write off 95% of the original cost over the specified period. Where the
management’s estimate of the useful life of an asset of the enterprise is
shorter than that envisaged under the provision of the relevant statute, the
depreciation provision is appropriately computed by applying a higher rate.
If the management’s estimate of the useful life of the assets is longer than
that envisaged under the statute, depreciation rate lower than that
envisaged by statute can be applied only in accordance with the
requirements of the statute.

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.

Depreciation is a tax-deductible expense. Therefore, any profit a


business enterprise sets aside towards depreciation is free of tax. Those
enterprises, who make huge profit and choose to pay a lot of tax, should
wisely go for more depreciation rather than pay more tax. They can follow
accelerated methods of depreciation, can seek easy of increasing the
amount of depreciation and amortization on their assets so as to salt away
more tax-free funds.

2. Financial Reporting:

The goal in financial reporting for long-lived assets is to seek a


statement of income that realistically measures the expiration of those
assets. The only difficulty is that no one knows, in any satisfactory sense,
just what portion of the service potential of a long-lived assed expires in
any one period. All that can be said is that financial statements should
report depreciation charges based in reasonable estimates of assets
expiration so that the goal of fair presentation can more nearly be achieved.
U.K. Accounting standards SSAP 12 issued in December 1977 argues:

“The management of a business has a duty to allocate depreciation as


fairly as possible to the periods expected to benefit from the use of the
asset and should select the method regarded as most appropriate to the
type of asset and its use in the business.
Provision for depreciation of fixed assets having a finite useful life
should be made by allocating the cost (or revalued amount) less estimated
residual values of the assets as fairly as possible to the periods expected to
benefit from their use.”

3. Effect on Managerial Decision:

The suitability of a depreciation method should not be argued only on


the basis of correct portrayal of the objective facts but should also be
decided in terms of their various managerial effects.

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.

A depreciation method which would lead to unwise dividends,


distributing cash which was later needed to replace the asset, would be a
poor method. A depreciation method which matches the asset costs
distributed period by period against the revenues produced by the asset,
thus helping management to make correct judgments regarding operating
efficiency, would be a good method.\

4. Inflation:

Depreciation is a process to account for decline in the value of


assets and for this many methods such as straight line, different
accelerated methods are available. In recent years, inflation has been a
major consideration in selecting a method of depreciation. To take an
example, suppose one bought a car for Rs. 1,00,000 five years ago and
wrote off Rs. 20,000 every year to account for depreciation using straight
line method, expecting that a new car can be purchased after five years.
However, five years later, it is found that the same car costs Rs. 2 ,00,000
whereas only Rs. 1,00,000 has been saved through depreciation.

Why a new car or new asset cannot be purchased with the


accumulated amount of depreciation? The difficulty has been created by
the inflation. In fact, inflation has eaten into the money saved through
depreciation over the five years. This means that a business enterprise (or
the owner of car) eats into the asset faster than the rate of depreciation as
the cost of replacing the asset is increasing.

The accelerated methods of depreciation tend to write of Rs. 1,00,000


(the price of car in the above example) over the five years. But higher
amounts are written off in the beginning as depreciation, and hence, larger
amounts are accumulated through depreciation which increases the
‘replacement capability’ of a business enterprise.

The problem created by inflation in depreciation accounting has


contributed in the emergence of the concept of inflation accounting. In
inflation accounting, an attempt is made to increase the depreciation
amount in line with inflation so that enough money to replace the asset at
its current inflated cost can be accumulated.

5. Technology:

Depreciation is vital because it decides the regeneration capacity of


industry and enables enterprises to set aside an amount before submitting
profits to taxation, for replacing, machines. Realistically, the depreciation
that enterprises are eligible for and capable of accumulating should cover
the purchase price of assets, when the time comes for replacement.

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.

Accumulating depreciation enough for buying new technology does


not depend merely on a rate of depreciation. Business enterprises should
have profit to provide for depreciation resulting into adequate money for the
replacement at the proper time. An industry in which profits are likely to be
high in the initial years will have to provide more depreciation in those
years when the profit is likely to be low.
Technological progress as a dimension of depreciation has become
more important than the engineering life of machines. A constant rate of
depreciation may be followed when an enterprise is making profit at a
constant rate. It is only when profit, are fluctuating that the company in
years of high profits will provide for higher depreciation. If it is not able to do
that because of fixed rate of depreciation imposed by the government, it will
be over-taxed. As a result, it will not be able to retain enough earnings after
payment of tax and dividends to make up for its inability to provide norma
depreciation in years of adversity. At the end of the useful life of machines
the company will not have the resource to invest in new machines. It will
succumb to technological progress.

6. Capital Maintenance:

During inflation, depreciation, if based on historical cost of assets,


helps a business firm to gather an amount equivalent to the historical cost
of the asset less its salvage value. This treatment of depreciation facilitates
in maintaining only the ‘money capital’ or financial capital of business
enterprises. However, this results into matching between historical amount
of depreciation and sales in current Rupees. The result is that reported net
income is overstated and a dividend is distributed from the net income
which is not real but fictitious. This way of income measurement and
maintaining only financial capital during inflation results into erosion of real
capital of business enterprises.

However, if depreciation is provided on replacement or current value


of assets, it gives matching between current cost (depreciation) and current
revenues. This does not involve any hoarding income as is found when
depreciation is determined on historical cost. Depreciation on current value
of assets provides real operating income in the profit and loss account.
Valuation of fixed cost in terms of current cost reflects the current value of
operating capability of business enterprises.
ACADEMIC SCRIPT
Depreciation Accounting is very much useful everywhere in accounting
process to know the exact position of fixed assets over a number of year’s
utilization of the asset. After certain years, the asset loses its utility and
requires maintenance or replacement. At that time, it is required to show its
real value after charging the depreciation cost. The charge of depreciation
is on fixed assets except the Land. "DEPRECIATION" is a gradual
decrease in the value of asset from any cause. Depreciation is the
decrease or depletion in the value of an asset due to wear and tear, lapse
of time, obsolescence, exhaustion or accident, negligence, lack of
maintenance, deterioration, inadequacy etc. The definition of depreciation
states all the causes of depreciation which is as follows;-

The Institute of Chartered Accountants of England and Wales defines


Depreciation as “That part of the cost of fixed assets to its owner which is
not recoverable when the asset is finally put out of use by him. Provision
against this loss of capital is an integral cost of conducting the business
during the effective commercial life of the asset and is not dependent upon
the amount of profit earned”

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.

The depreciation is recorded in the accounts when provision for


depreciation is made is as follows
The Journal entries are as follows:-
1) For providing depreciation:-
Depreciation A/C Dr
To Provision for Depreciation A/C
2) For transfer of depreciation to Profit and Loss A/c:-
Profit and Loss A/C DR
To Depreciation A/C
3) On sale of asset:-
Provision for depreciation A/C DR
To Asset A/C
4) On Profit on sale of asset:-
Asset A/C DR
To Profit and Loss A/C
5) On loss on sale of asset:-
Profit and Loss A/C DR
To Asset A/c
When sale of an asset is made, an "Asset Disposal Account" may be
opened also. Then the entries will be passed as follows:-
1) Asset Disposal A/C DR
To Asset A/c
(Being original cost of asset)
2) Bank A/C DR
To Asset Disposal A/C
(With the actual sale proceeds on the sale of asset)
3) Provision for Depreciation A/C DR
To Asset Disposal A/c
(With the accumulated depreciation
on the assets sold)
4) Profit and Loss A/C Dr
To Asset Disposal A/C
(For transfer of profit on sale of asset)
2) When a provision for depreciation account is not maintained:-
When provision for depreciation is not maintained, the amount of
depreciation is debited to Depreciation account and credited to the Asset
Account. The asset account appears at a written down value i.e. cost less
depreciation. The depreciation account is transferred to profit and loss
account like any other item of expense.
The Journal entries in the above case are as follows:-
1) For Providing Depreciation:-
Depreciation A/C DR
To Asset A/c
2) For Transfer of Depreciation to the Profit and Loss A/C:-
Profit and Loss A/C DR
To Depreciation A/C
3) On sale of Asset:-
Cash/Bank A/C DR
To Asset A/C
4) On Profit on sale of asset:-
Asset A/C DR
To Profit and Loss A/c
5) On Loss on sale of asset:-
Profit and Loss A/C DR
To Asset A/C
It will be appropriate to provide for depreciation on the Replacement cost of
the asset rather than its historical cost but it is difficult to estimate the
replacement cost in advance. If the depreciation is charged on the
replacement cost, it is charged for the improved asset even when such
asset has not been used for generating revenue during those years.
Income tax authorities do not give recognition to replacement cost.
Depreciation is to be charged on only original cost. Any profit or loss made
on scrapping the asset over its book value should be credited or debited to
the profit and loss at the end of the year of scrap.
It is decided to provide enough funds for replacement of the asset, at the
end of its useful life, then Replacement Reserve Account should be
credited every year with interest at the current rate on the accumulated
balance appears to the credit of its account.
If asset is sold during the year, the amount realized should be credited to
asset account. Depreciation for the period for which the asset has been
used should be written off in the usual manner. Any balance in the asset
account, which shows profit and loss on sale of the asset should be
transferred to profit and loss account.
Methods of Depreciation –

Straight line Method and Diminishing Balance Method

Academic Script

Cost of a fixed asset must be charged to the income statement in a manner


that best reflects the pattern of economic use of assets. Now here we list
out various methods of depreciation for assessment and allocation.

1. Fixed Installment or Equal Installment or Straight Line Method or Fixed


Percentage on Original Cost Method (SLM).
2. Reducing Charge Methods
a) Diminishing Balance or Reducing Balance or Fixed Percentage on
Diminishing Balance or Written Down Value Method (WDV).
b) Sum-of-years’ Digit Method.
c) Double-declining Balance Method.
3. Annuity System.
4. Depreciation Provision Fund or Sinking Fund Method.
5. Insurance Policy Method.
6. Depreciation, Repairs and Renewal Provision or Fund Method.
7. Revaluation Method or Inventory System.
8. Machine Hour Rate or Running Time or Service Hours Method.
9. Depletion or Output Method.
10. Mileage Method.
11. Replacement System of Depreciation.
12. Group Depreciation.
13. Retirement Method.
14. Global Method.

Of all these methods first two methods are commonly used in practice.

Basis for selection of methods


Management selects most appropriate method based on important factors
such as:
a) Type of asset
b) Nature and use of asset and
c) Circumstances prevailing in the business
But before we go ahead, here we categorized methods for providing
depreciation.

Methods of Depreciation Accounting

Uniform Charge Method Declining charge or Other Methods


Accelerated Depreciation
Method

Fixed installment method Diminishing balance method Group depreciation


Depletion method Sum-of years digits method Inventory System
Machine hour rate method Double declining method Annuity method
Depreciation fund
Insurance policy
So students, we categorized these methods from the list we made above.
Well, now we discuss these methods, but we will discuss first two
commonly used methods in detail.

1. Uniform Charge Method:


In case of these methods, depreciation is charged on a uniform basis
year after year. Such methods are considered appropriate only for such
assets which are uniformly productive.
a) Fixed Installment method:
This is also termed as the Straight Line Method (SLM) or Equal
Installment Method. According to this method, depreciation is
charged evenly at the end of each financial year throughout the
effective life of the asset. It is so done with the sole intention of
reducing the book value of the asset to zero or to its breakup value.
The amount so written off as depreciation is calculated as:-

Original Cost of Fixed Asset –


Estimated Scrap
Value
Depreciation =
Working Life of the Asset in
number of Accounting Periods
The depreciation to be charged each year can also be expressed
as a percentage of cost. This percentage can be calculated as:
Depreciation
Rate = × 100
Cost
For example, if an asset purchased for Rs. 10,000/- will have a
scrap value of Rs. 1,000 at the end of its useful life of 10 years,
the amount of depreciation to be charged every year over the
effective life of the asset will be computed as
Rs. 10,000 – Rs. 1,000
Depreciation = = Rs. 900 per year
10 years
Therefore, Rate of depreciation = 9%

This method is also known as Fixed Percentage on Original Cost


Method because the amount of depreciation happens to be a fixed
percentage of the original cost of the asset less any scrap value. It
is call as Straight line method because of the straight calculations
of depreciation.

According to this method, repairs and renewals are to be charged


separately to Profit and Loss Account and provision for
replacement has also to be made separately. Further, depreciation
on any addition to the asset must be made independently in case
the life of such additional asset differs from that of the original
asset.
Merits:
i) This method is simple to understand, operate and easy to apply,
perhaps the simplest of all other methods.
ii) It is safer to follow because its results are certain.
iii) The value of the asset can be reduced to zero or to its scrap value
under this method.
iv) It is not misleading since depreciation is deducted from the asset
itself; the asset shows the true value in the Balance Sheet. On the
contrary like in some other methods, if the depreciation is shown
on the liability side, the reader may be confused.
v) This method is very suitable particularly in case of those assets
which get depreciated more on account of expiry of period. For
example leasehold properties, patents etc.

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.

c) Machine hour rate method:


This is also known as the Service Hours Method. This method takes
into account the running time of the asset for the purpose of
calculating depreciation.
The method is particularly suitable for charging depreciation on plant
and machinery, aircrafts etc. The amount of depreciation is calculated
as

Original Cost of Asset - Scrap Value


Depreciation =
Life of the Asset in hours
For example, if a machine having a scrap value of Rs. 1,000 is
purchased for Rs.20,000/- and it has an effective life of 10 years of
1,000 hours each, the amount of depreciation per hour will be
computed as
Rs. 10,000 – Rs. 1,000
Depreciation = = Re. 0.90 per hour
10,000 hours
This means that, there will be a depreciation of 90 paise in case the
machine runs for an hour. If in a particular year, the machine runs for
600 hours, the amount of depreciation will be Rs. 540 (i.e.
Re.0.90*600). This method has the advantage of correlating the
charge for depreciation to the actual working time of the machine.
However, this method can be used only in the case of those assets
whose life can be measured in terms of working hours.
2. Declining Charge Depreciation Methods
In these methods, the amount charged for depreciation declines over the
asset’s expected life. These methods are suitable in those cases where
(a) The receipts are expected to decline as the asset gets older and
(b) It is believed that the allocation of depreciation should be related to
the pattern of the asset’s expected receipts.

Methods fall under this category are:-


a) Diminishing balance method
This method is an improvement upon the Fixed Installment Method.
The most serious defect of the Equal Installment Method as
discussed above is the disproportionate burden on Profit and Loss
Account of depreciation together with repairs and renewals. This
system has been devised to equalize such burden over the life period
of the asset. This is the only method that tries to equalize the burden
of ‘depreciation together with repairs’ on Profit and Loss Account.

According to this method, amount of depreciation is charged as a


fixed percentage of the reducing or diminishing value of the asset
standing in the books at the beginning of the year, so as to bring
down the book value of the asset to its residual value. Since,
depreciation is based on the written down value of the asset, it is
heavier in the initial period and goes on decreasing or reducing every
year after year.
When it is considered together with repairs which are generally in
increasing order in later years, the total burden of depreciation
coupled with repairs and renewals on Profit and Loss Account is
more or less equal every year.

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

𝑁𝑒𝑡 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒


𝑛
−−−−−−−−−−−−
Depreciation rate =1 − √
𝐴𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡

For example, if the cost of an asset is Rs. 10,000/-, residual value


Rs. 1,296, economic life 4 years, then the rate of depreciation would
be 40%,
How, let’s see, put the information in above equation
Therefore,
1,296
4
−−−−−−−
Depreciation rate=1 − √ =1 – 6/10 = 40%
10,000
This method is also known as Reducing Balance Method or Fixed
Percentage on Diminishing Balance Method or Written Down-Value
Method (WDV).

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.

b) Sum of years digits method


This method is on the pattern of diminishing balance method. The
amount of depreciation to be charged to the Profit and Loss Account
goes on decreasing every year. The depreciation is calculated
according to the formula i.e.
Remaining life of the Asset (including current year)
Depreciation = × original cost
Sum of all digits of the life of the asset in years
c) Double declining balance method
This method is similar to the reducing or declining balance method
except that the rate of depreciation is charged at the rate which is
twice the straight line rate. While computing this rate, two things have
to be kept in mind:
i) No allowance is to be made for the scrap value of the asset.
ii) The total cost should not be reduced by charging the depreciation
to an amount lower than the estimated scrap value of the asset.
This method is prevalent in the USA and is permitted under the
federal tax laws. This method is preferred over the uniform charge
method of depreciation.

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.

b) Inventory system of depreciation:


This method is followed in the case of those assets which are of small
value such as loose tools, or where the life of the asset cannot be
ascertained with certainty e.g. livestock etc. in the case of these
assets, the depreciation is charged as
Cost of the assets in working condition
at the beginning of the accounting year ………..
Add
cost of the assets purchased during the accounting year .….……
Less
cost of the assets in working condition
at the end of the accounting year ……….
________
= Depreciation to be charged ……….

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.

e) Insurance policy method:


The method is similar to the depreciation fund method as explained
earlier. However, instead of investing the money in securities, an
insurance policy for the required amount is taken. A fixed amount is
paid as premium every year. However, this amount will have to be
paid in the beginning of each year. At the end of the specified period,
the insurance company pays the agreed amount with which a new
asset can be purchased.
When choosing a depreciation method for business, an entity has to
consider the tax implications. In case of having a bigger tax deduction in
the near-term, using a written down value method is more sensible. But to
just spread out the tax deduction evenly, use the straight line depreciation
method. A business even uses one method on certain items and another
on different items.

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.

New schedule by Companies Act 2013 provides the method to amortize


intangible assets which is as per the provisions of AS – 26. Instead of
method and rates of depreciation, new Act prescribed only assets useful
life. The difference between SLM and WDV will be removed. The useful life
shall not be longer than the specified life of the asset as given in Part C of
the Act and the residual value shall not exceed 5% of the cost of the asset.
95% of the original cost of asset only has to be depreciated.

The company cannot change its method of calculating depreciation form


SLM to WDV or vice-versa in the name of transitional provisions. Any
change by the company in the method of calculating depreciation will
amount to change in accounting policy as per AS – 5. The calculation of the
impact of such change on the statement of profit and loss has to be
disclosed by the company in its financial statements.
Introduction of Accounting for Hire Purchase Transactions
Academic Script:

Hire-puchase system is a special system of purchase and sale of goods.


Under this system the purchaser pays the price of the goods in
installments. The installments may be annual, six monthly, quarterly,
monthly, fortnightly etc. Under this system the goods are delivered to the
purchaser at the time of agreement before the payment of installments but
the title on the goods is transferred after the payment of all installments as
per the hire-purchase agreement. The special feature of a hire-purchase
transaction is that the payment of every installment is treated as the
payment of hire charges by the purchaser to the hire vendor till the
payment of the last installment. After the payment of the last installment,
the amount of various installments paid is appropriated towards the
payment of the price of the goods sold and the ownership or the goods is
transferred to the purchaser. Thus hire-purchase means a transaction
where the goods are sold by vendor to the purchaser under the following
conditions :

 The goods will be delivered to the purchaser at the time of agreement.


 The purchaser has a right to use the goods delivered.
 The price of the goods will be paid in installments.
 Every installment will be treated to be the hire charges of the goods which
are being used by the purchaser.
 If all installments are paid as per the terms of agreement , the title of the
goods is transferred by vendor to the purchaser.
 If there is a default in the payment of any of the installments, the vendor will
take away the goods from the possession of the purchaser without
refunding him any amount received earlier in the form of various
installments.

Before discussing the characteristics of hire-purchase system, we must


know what is a hire purchase agreement and what are the contents of a
hire-purchase agreement. Hire-purchase agreement means a contract
between the hire vendor and the hire purchaser regarding the sale of goods
under certain conditions. Usually every hire-purchase agreement shall
contain the following terms:

 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.

2. Hirer/Hire purchaser/Hire buyer:


The person who purchases goods from hire vendor or who obtains the
goods from an owner under hire purchase agreement is known as hirer.

3. Cash price/Cash value:


It is a value of goods at which the goods may be purchased by the hirer for
cash.

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.

5. Hire Purchase Price:


The hire purchase price includes the cash price and interest to be paid on
the future installment. It is the total sum payable by the hirer to the vendor.
6. Hire Purchase Charge:
The difference between the hire purchase price and the cash price as
stated in the hire purchase agreement is known as hire purchase charge..

Characteristics of Hire-Purchase System:


The characteristics of hire-purchase system are as under

 Hire-purchase is a credit purchase.


 The price under hire-purchase system is paid in installments.
 The goods are delivered in the possession of the purchaser at the time of
commencement of the agreement.
 Hire vendor continues to be the owner of the goods till the payment of last
installment.
 The hire-purchaser has a right to use the goods as a bailor.
 The hire-purchaser has a right to terminate the agreement at any time in
the capacity of a hirer.
 The hire-purchaser becomes the owner of the goods after the payment of
all installments as per the agreement.
 If there is a default in the payment of any installment, the hire vendor will
take away the goods from the possession of the purchaser without
refunding him any amount.

Advantages of Hire Purchase System:


(1) Convenience in Payment:
The buyer is greatly benefited as he has to make the payment in
installments. This system is greatly advantageous to the people having
limited income.

(2) Increased Volume Of Sales:


This system attracts more customers as the payment is to be made in easy
installments. This leads to increased volume of sales.
(3) Increased Profits:
Large volume of sales ensures increased profits to the seller.

(4) Encourages Savings:


It encourages thrift among the buyers who are forced to save some portion
of their income for the payment of the installments. This inculcates among
the people the habit to save.

(5) Helpful For Small Traders:


This system is a blessing for the small manufacturers and traders. They
can purchase machinery and other equipment on installment basis and in
turn sell to the buyer charging full price.

(6) Earning Of Interest:


The seller gets the installment which includes original price and interest.
The interest is calculated in advance and added in total installments to be
paid by the buyer.

(7) Lesser Risk:


From the point of view of the seller this system is greatly beneficial as he
knows that if the buyer fails to pay one installment, he can get the article
back.

Disadvantages of Hire Purchase System:


(1) Higher Price:
A buyer has to pay higher price for the article purchased which includes
cost plus interest. The rate of interest is quite high.

(2) Artificial Demand:


Hire purchase system creates artificial demand for the product. The buyer
is tempted to purchase the products, even if he does not need or afford to
buy the product.

(3) Heavy Risk:


The seller runs a heavy risk under such system, though he has the right to
take back the articles from the defaulting customers. The second hand
goods fetch little price.

(4) Difficulties in Recovery of Installments:


It has been observed that the sellers do not get the installments from the
purchasers on time. They may choose wrong buyers which may put them
in trouble. They have to waste time and incur extra expenditure for the
recovery of the installments. This sometimes leads to serious conflicts
between the buyers and the sellers.

Hire Purchase Agreement

According to section 2(c) Hire Purchase Agreement means, an agreement


under which the hirer has an option to purchase accordance with the terms
of agreement which are included in the agreement.

. Possession of goods is delivered by the owner to a person on condition


that such person pays the agreed amount in periodic installment.

. The property in goods is to pass to such a person on the payment of the


last installment

. 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. Every hire purchase agreement is written documents and signed by all


parties.

2. The date on which the agreement shall be deemed to have commenced.

3. The number of installments by which the hire purchase price is to be


paid, the amount of each of those installment and date or the mode of
determining the date, upon which it is payable and the person to whom and
the place where it is payable.

4. The goods to which the agreement relates, the manner sufficient to


identify them.

Rights of the Hirer are explained as,

The following rights are given in the Act:

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.

Termination of Hire Purchase agreement:

The Hire purchase agreement may be terminated at any time by giving 14


days notice in writing to owner. He has to redeliver the goods to the owner
along with any installment of hire which is due.

In case of termination of agreement following point should be taken into


consideration:
1. Where the sum total amount paid and the amounts due in respect of the
hire purchase price immediately before termination does not exceed one
half of the hire purchase price, the hirer shall be liable to pay the difference
between the said sum total and the said one half or the sum named in the
agreement whichever is less.

HOW THE TRANSACTION / PROCESS OF HIRE PURCHASE TAKES


PLACE STEP BY STEP?
The following info graphics will explain how the transaction takes place:

1. Seller sells goods to Financing or Hire Purchase (HP) Co.


a. HP Co. makes payment to the seller.
b. HP Co. gets the ownership of the assets.

2. HP Co. lets goods on hire to Buyer / Hirer.


a. HP Co. signs the HP Agreement with the hirer.
b. Hirer agrees to pay installments called as hire charges.
c. HP Agreement contains a purchasing option clause stating that if all
the agreed installments are paid, the ownership will be transferred to the
buyer.
3.The buyer makes down payment and takes possession.
a. The buyer pays the first installment or the down payment.
b. The buyer is permitted to take possession of goods and has the right to
use.
5.hirer makes all the agreed installments.
a. The buyer pays all the installments.
b. If the buyer stops the installment at any point, the HP co. can take back
possession of the goods and ownership will never be transferred.
5. Ownership transfers from HP co. to hirer.
a. All the installments are paid.
b. The ownership is transferred from HP co.
Difference between Hire-purchase system and Installment payment
system
Installment Payment System is a system of purchase and sale of goods in
which the title of goods is immediately transferred to the purchaser at the
time of sale of goods and the sale price of the goods is paid in installments.
In the event of default in payment of any installment, the seller has no right
to take back goods from the possession of the purchaser. He can file a suit
for the recovery of the outstanding balance of the price of goods sold. The
followings are the differences between Hire-purchase system and
Installment payment system:

 In Hire-purchase system, the transfer of ownership takes place after the


payment of all installments while in case of Installment payment system,
the ownership is transferred immediately at the time of agreement.
 In Hire-purchase system, the hire-purchase agreement is like a contract of
hire though later on it may become a purchase after the payment of the last
installment while in Installment payment system, the agreement is like a
contract of credit purchase.
 In case of default in payment , in Hire-purchase system the vendor has a
right to take back goods from the possession of the hire-purchaser while in
case of Installment payment system, the vendor has no right to take back
the goods from the possession of the purchaser; he can simply sue for the
balance due.
 In Hire-purchase system, if the purchaser sells the goods to a third party
before the payment of last installment, the third party does not get a better
title on the goods purchased. But in case of Installment payment system,
the third party gets a better title on the goods purchased.
 In Hire-purchase system the provisions of the Hire-purchase Act apply to
the transaction while in case of Installment payment system, the provisions
of Sale of Goods Act apply to the transaction.

Journal Entries In The Books Of Hire Purchaser


There are two methods of recording hire purchase transactions in the
books of the hire purchaser:
i. Under Asset Accrual Method

1. For the purchase of asset: On Delivery (Down payment due)


Asset A/C ...........Dr.
To vendor A/C

2. For the payment made for 'down payment'


Vendor A/C.............Dr.
To bank A/C

2. For installment due


Asset a/c ……Dr
Interest A/C............Dr.
To vendor A/C

4. For the payment of installment (both method)


Vendor A/C............Dr.
To Bank A/C

5. For charging depreciation( on the basis of cash value) (both methods)


Depreciation A/C...................Dr.
To Asset A/C

6. For transfer of interest and depreciation(both methods)


Profit and loss A/C............Dr.
To depreciation A/C
To interest A/C

Note: entries 3,4,5 and 6 will be repeated year after year until the
final installment is paid.

ii. Under credit purchase with Interest Method

1.On Delivery First Year


Asset A/c …………..Dr
To Vendor a/c

2. For the payment made for 'down payment'


Vendor A/c............Dr.
To Bank A/C
3. For interest due
Interest A/C……………………………Dr
To Vendor Account.

4. For the payment of installment (Including interest)


Vendor A/C............Dr.
To Bank A/C

5. For charging depreciation( on the basis of cash value) (both methods)


Depreciation A/C...................Dr.
To Asset A/C

6. For transfer of interest and depreciation(both methods)


Profit and loss A/C............Dr.
To depreciation A/C
To interest A/C

Note: entries 3,4,5 and 6 will be repeated year after year until the
final installment is paid.

Journal Entries In The Books Of Vendor

1. For selling goods on hire purchase


Hire purchase A/C...........Dr.(full cash price)
To sales/hire purchase sales A/C

2. For receiving down payment


Cash/bank A/C.................Dr.
To hire purchaser A/C

3. For interest due


Hire purchaser A/C............Dr.
To Interest A/C

4. For receiving the installment


Cash/bank A/C .............Dr.
To hire purchaser A/C

5. For transferring interest


Interest A/C............Dr.
To profit and loss A/C.

Note: * Depreciation will not charge by hire vendor.


* Entries 3,4 and 5 will be repeated year after year until the first installment
is paid.
Accounting for Hire Purchase Transactions

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.

Hire Purchase System:

Hire purchase system is a method of buying goods or assets in which the


buyer takes the possession as soon as an initial installment of the price is paid
but the ownership is obtained only after all the agreed number of subsequent
installments are paid. However in case of default, the vendor can take back
the possession of goods. It is also relevant to state that the sum paid by the
hire purchaser, prior to the repossession of
goods by the hire vendor, are treated as
hire charges for using the property and the
same are never refundable.

A hire purchase agreement differs from a credit-sale agreement and sale by


installment because under these transactions ownership passes on signing
the contract.

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

• Plants and machinery

• Cars

• Commercial vehicles

• Agricultural equipment

• Computers including software packages

• Office equipment, etc.

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.

History of Hire Purchase System:


th
The first use of hire purchase was evidenced in 19 century for enabling the
carriers to procure wagons for the use in business.

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.

Terms Used in Hire Purchase System:


There are many terms that are used in hire purchase transactions and
accounting, but only few are explained here.
a) Hirer: Also known as hire purchaser, the one who purchase goods under
hire purchase agreement
b) Hire Vendor: The person who sells goods under hire purchase agreement.
c) Cash price: It is actual price of goods charged under normal cash sale or
the price at which the goods may be purchased by hirer for cash.
d) Down Payment: Down payment means an initial payment payable by the
hirer at the time of entering into a hire purchase agreement.
e) Hire Purchase Price: The total amount payable under the terms of hire
purchase agreement in the form of down payment and installments. In other
words, the total of down payment and installments is called hire-purchase
price.

f) Hire Purchase Charges: Hire purchase charges are the difference


between hire purchase price and cash price. These charges are known as
interest.
Since, installments are spread over a longer period, the seller charges
interest and it is included in the aforesaid installments. Hence, installments
include payment towards cash price financed and interest on the amount
financed.

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.

Journal Entries in the books of purchaser:

(I) Treating the goods as outright property:

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.

B) Calculation of Interest when Cash Price is given but Rate of Interest


is not given
Mathematically speaking, the amount of interest should be allocated in the
ratio of benefit derived (i.e. outstanding cash price). Since this would be too
complicated, practically the amount of interest is allocated in the ratio of
outstanding hire purchase price. Unless otherwise stated, one may assume
that a) all the sales have been made at the beginning of the year or b) sales
have been made uniformly throughout the year. The latter assumption is
considered more appropriate as compare to the former assumption. Since in
practice, the sales will be taking place on the different dates each year not at
the beginning of the year.
C) Calculation of Interest when both Cash Price and Rate of Interest is
not given
D)

The difference between any two successive installments represents the least
amount of interest charged in the last year.

Calculation of Cash Price:

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.

Working Backward Method

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:

Interest = (Amount as per Step 1 + Amount as per Step 2) x Rate/


100+Rate.

Step 4: Calculate the Balance due in the beginning as under:

Balance due in the Beginning = Amount as per Step 2 – Amount


Step 3.

Step 5: Go to Step 1 until Balance due in the Beginning of first year is


calculated.

Step 6: Calculate Cash Price S follows:

Cash Price = Balance due in the Beginning of the first year +


Down Payment.
Accounting Methods for Hire Purchase:

Accounting for hire purchase can be recorded


under various methods of recording hire
purchase transaction as:

(1) For Goods of Considerable Value :


a) Asset Full Value Method (Full Cash Price
Method) b) Asset Accrual Method
(2) For Goods of Small Value :

a) Hire Purchase Trading A/C Method

b) Stock and Debtors Method

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.

A. Hire purchase Trading Account or Debtor System

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:

(1) Cost of goods sold on hire purchase.

(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.

B. Hire purchase Stock and Debtor System

This is an alternative method of calculating profit or loss on hire purchase


transactions. Under this method, beside the three ledger accounts namely
Shop Stock Accounts, Installment Not Due A/c and Installment Due A/c
(already been discussed),Hire Purchase Adjustment Account is prepared
(instead of Hire Purchase Trading A/c) for calculation of profit or loss on hire
purchase transactions. If goods have been repossessed, the Goods
Repossessed A/c should also be prepared.
Lecture Title : Partnership - Introduction and Types

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.

The essentials of partnership is as mentioned below-

1- Partnership is an association of two or more persons. There must be


at least two persons who should join together to constitute a
partnership. As regards to the maximum number of partners in a
partnership firm, section 11 of the Companies Act, 1956 puts the limit
at 10 in case of banking business and 20 in case of any other
business.

2- Partnership must be the result of an agreement between two or more


persons. Partnership can arise by contract only. An agreement to
constitute partnership must fulfill all the essentials of a valid contract.
An agreement between the partners may be express or implied.
Further, the partnership agreement may be to execute a particular
task or for a fixed period.
3- The agreement must be to carry on business. The term ‘business’
means any trade, occupation or profession. Unless the persons join
for the purpose of carrying on a business, it will not amount to a
partnership. Thus, partnership does not exist between members of a
charitable society or religious association or members of a club.

4- The agreement must be to share profits of the business. Carrying on


a business jointly is not enough; there must be an agreement to
share profits arising from the business. Unless otherwise so agreed,
sharing of profits also involves sharing of losses. Though, sharing of
profits is an essential feature of partnership, the mere fact that a
person is given a share in the profits of the business does not
necessarily make him a partner.

5- Business must be carried on by all or any of them acting for all.


Partnership is based upon the idea of mutual agency. Every partner
assumes the role of a principal as well as an agent. The foundation of
the law of partnership is agency, and the law of partnership is a
branch of the law of principal and agent. Each partner is an agent
binding the other partners who are his principals and each partner is
again a principal, who in turn is bound by the acts of the other
partners. It is not necessary that every partner must actively
participate in the conduct of the business. Thus, it is possible to have
a partnership, in which one or some of the partners have
management and control and some other partner/ partners are
sleeping or dormant.
Partnership deed- The agreement creating partnership may be
express( oral or written) or implied, and the latter may be inferred from
the conduct or the course of dealing of the parties or from the
circumstances of the case. It is in the interest of the parties that the
agreement should be in writing. The document which contains this
agreement is called partnership deed. The deed contains provisions
relating to the nature and the principal place of business, the name of
the firm, the name and addresses of the partners, the duration of the
firm, profit-sharing ratio, interest on capital and drawings, valuation of
goodwill on the death or retirement of a partner, management, accounts,
arbitration etc. The deed must be duly stamped as required by the
Indian Stamp Act, 1889.

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.

Test of Partnership- The question whether a particular group of


persons constitutes a partnership or not, is often a difficult one to decide.
If all the relevant facts taken together show that all the essentials of
partnership are present, the group of persons will be called partnership,
otherwise not. Of the essentials of partnership, sharing of profits is an
important criterion but is not conclusive. When two persons who jointly
own a house, let out the same to a tenant and divide the rent received,
they are co-owners and not partners. The true test of partnership is
agency, and not sharing of profits.

Partnership and Co-ownership

While partnership always arises from a contract, Co- ownership may or


may not arise from contract. Partnership always implies a business, Co-
ownership may exist without business. Partnership involves sharing of
profits and losses, Co-ownership does not involve the sharing of profits
or losses, it may exist without any business. Each partner is the agent of
other partners, a co-owner is not the agent of the other co-owners. A
partner cannot transfer his interest without the consent of all other
partners, a co-owner may transfer his interest to a third party without the
consent of other co-owners.

Partnership and Club

The objective of a club is not acquisition of profits, but the promotion of


some beneficial or social object, such as promotion of health or
providing recreation for its members. In a club, there is no motive of
earning profits and sharing them. A member of a club is not the agent of
the other members and the death or resignation of a member does not
affect its existence. A member of a club is not liable to a creditor of the
club, except to the extent to which he took part in the contract
concerned which gave rise to the liability.

Partnership and Hindu Family Business

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

A partnership may be illegal in either of the two ways-


1- By being formed to carry on an illegal business
2- Where the numbers of partners exceed the maximum limit
The maximum number of partners is a general business is 20 and in
case of banking business is 10

Registration of Firms

Section 58 lays down that a partnership firm may be registered at any


time by sending by post, or delivering to the Registrar of Firms of the
area in which any place of business of the firm is situated or proposed to
be situated, a statement in the prescribed form and accompanied by the
prescribed fee stating:

1- the firm name


2- the place or principal place of business of the firm
3- the names of any other places where the firm carries on business
4- the date when each partner joined the firm
5- the name in full and addresses of the partners
6- the duration of the firm

The statement must be signed by all the partners, or by their agents


specially authorized in their behalf, and duly verified. When the Registrar
is satisfied that the provisions of section 58 have been duly complied
with, he registers the firm by recording an entry of the statement in the
Registrar of Firms.

Registration of a partnership firm is not compulsory. There are certain


disabilities associated with the non-registration of a firm. A partner of an
unregistered firm cannot file a suit against the firm or any partner, so as
to enforce a right (a) arising from contract, or (b) conferred by the
Partnership Act. If a partner of an unregistered firm is not paid his share
of profits, he cannot claim it through a suit in the court of law. No suit
can be filed on behalf of an unregistered firm against any third party for
the purpose of enforcing a right arising from a contract. Example- An
unregistered firm supplies to X goods worth Rs 20, 000/-, X refuses to
pay the money, the firm will have no legal remedy against X.

Rights of a partner

1- Right to take part in the conduct of business


2- Right to express his opinion on any matter
3- Right to have access to and inspect and copy any books of the firm
4- Right to share to profits- In absence of any agreement, the partners
are entitled to share equally in the profits earned and are liable to
contribute equally to the losses sustained by the firm.
5- A partner is a joint owner of firm’s property
6- In an emergency, a partner has the right to do all such acts as are
reasonably necessary to protect the firm from losses
7- Right to resist the introduction of a new partner
8- Right to claim 6 percent on advances made by him to the firm
9- Right to be indemnified for liabilities incurred by him during the
ordinary course of business
10- Right not to be expelled
11- Right to retire
12- Right to carry on competing business after ceasing to be a
partner
13- In certain cases right of outgoing partner to share
subsequent profit

Duties of partners

1- To carry on the business of the firm to the greatest common


advantage
2- To be just and dutiful to each other
3- To render true accounts and full information of all things affecting the
firm
4- To indemnify for loss caused by fraud
5- To attend diligently to firm’s business without remuneration
6- To account for profits of a competing business
7- To account for secret profits
8- To not claim remuneration
9- Not to assign his share
10- Unless otherwise agreed, to contribute equally to the losses of
the firm
11- To indemnify the firm for any loss caused by his willful neglect

Types of Partners

Actual or ostensible partner- A person who becomes a partner by an


agreement and is actively engaged in the conduct of the business of the
partnership is known as actual partner. He is the agent of other partners
in the ordinary course of the business of the firm. He binds himself and
the other partners, so far as third parties are concerned, for all the acts
which he does in the ordinary course of the business and in the name
of the firm.

Sleeping or dormant partner- A sleeping partner is one who does not


take an active part in the conduct of the business of the firm. He, like
other partners, invests capital and shares in the profits of the business.
He is equally liable along with other partners for all the debts of the firm ,
even though his existence is kept a secret from the outsiders dealing
with the firm.

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.

Partner in profits only- Sometimes partners may agree that a partner


shall get a share of the profits only and that he shall not be liable to
contribute towards the losses. Such a partner is known as a partner in
profits only. He is liable for all the debts of the firm. If the firm incurs any
losses and the other partners have meager private resources, he shall
have to bear the brunt of the losses as the liability of the partners is
joint and several and at the same time unlimited.

Sub-partner- When a partner agrees to share his profits derived from


the firm with a third person, that third person is known as a sub-partner.
A sub-partner is in no way connected with the firm and cannot represent
himself as a partner of the firm. He has no rights against the firm nor is
he liable for the acts of the firm.

Partner by estoppel or holding out- Sometimes a person who is not a


partner in a firm may, under certain circumstances, be liable for its debts
as if he were a partner. Such a partner is called a partner by estoppel or
holding out.

Minor Partner- According to section 11 of the Indian Contract Act, an


agreement with a minor is void. As such, he is incapable of entering into
a contract of partnership. But with the consent of all the partners, a
minor may be admitted to the benefits of partnership (Sec. 30).A new
partnership cannot be formed with a minor partner. There cannot be
partnership of minors as they are incapable of entering into a contract.

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.

Circumstances In Which A Partnership Firm Is Reconstituted.

RECONSTITUTION OF A FIRM-

Reconstitution of a partnership firm may happen due to any of the under


mentioned reasons -

1. Introduction of a partner (Sec.31)

2. Retirement of a partner (Sec.32)

3. Expulsion of a partner (Sec.33)

4. Insolvency of a partner (Sec.34)

5. Death of a partner (Sec.35)

6. Transfer of a partner’s share (Sec. 29)

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.

A new agreement is entered into by the reconstituted partnership firm


with due consideration to the changes in membership of the firm. This
new agreement changes the relationship among the members of the
partnership firm. Hence, whenever there is a change in the partnership
agreement, the firm continues but it amounts to reconstitution of the
partnership firm.
RECONSTITUTION OF A FIRM-

1. Introduction/ Admission of a partner

Sec 31 of the Indian Partnership Act 1932 deals with the introduction or
admission of a partner.

ADMISSION OF NEW PARTNER

There are many reasons why a new partner may be admitted in a


partnership firm. For e.g.

A new partner may be admitted because of expansion or diversification


of the firm which may require additional capital or specialized skills which
a new partner can bring.

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.

Also, sometimes a new partner may be admitted due to his reputation or


because of the goodwill he commands, which may benefit the firm.

The admission of a new partner has far reaching implications for the
existing firm.

The following changes will need to be made to accommodate the


incoming partner –

 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

1) An individual can be admitted as a partner into a firm only if all


existing partners consent to the admission. Mutual trust and
confidence is of utmost importance among partners, hence consent
of all partners to admission of a new partner is essential. In other
words no partner can be admitted as a partner into a firm without the
consent of all existing partners.

2) Also, the admission of the new partner has to be in accordance with


an already existing contract for admission of new partner between
existing partners (Sec.31 (1)).

Example of Admission of a new partner

Two partners, Ram and Vinit are running a partnership firm


manufacturing toys. To keep pace with changing times they decide to
start manufacturing electronically operated toys. To successfully
implement their new venture, they need more capital as well as technical
expertise.

Aditya, an old friend of Vinit, is an electronic engineer and has funds as


well. With the consent of Ram his old partner, Vinit convinces Aditya to
join the partnership firm. Aditya agrees to join and brings in capital and
share of goodwill.

Many adjustments will be made to the existing partnership to


accommodate the entry of the new partner, Aditya like -

 Adjustment of Goodwill
 Adjustment in profit sharing ratio
 Revaluation of existing assets and liabilities
 Adjustment of partners’ capital
 Distribution of accumulated profits and reserves.

The incoming partner will have to undertake liabilities in accordance with


the law.

LIABILITY OF AN INCOMING PARTNER

Please note that -

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.

1) By mutual agreement between the three partners, the new partner


can be made liable to bear the previous losses of the firm. This
however will not give the creditors of the organization a right to
recover their past debts from the new partner because he was not
in existence as a principal at a time when the act was done.

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.

By mutual agreement between the three partners, Aditya can be made


liable to bear previous losses of the firm.

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.

Admission of a minor as a partner

At this point it is important to understand the whether a minor can be


admitted into a partnership and what are the legal implications of the
same.

According to Sec 30 of the Indian Partnership Act 1932, a minor can be


admitted to the benefit of partnership with the consent of all the existing
partners. A minor, if admitted into the partnership has the right to share
the property and profits of the firm as may be agreed upon in the
partnership deed. He is also liable for the acts of the firm from the date of
his admission but cannot be held personally liable for the same.

Retirement of a Partner

Sec 32 of the Indian Partnership Act 1932 deals with retirement of a


partner

A partner is said to retire when he decides to leave the firm voluntarily.


Such a partner is called a retiring partner. The retiring partner
extinguishes his interest in the partnership firm.

The retirement of a partner has far reaching implications for the firm.

Retirement of a partner leads to the dissolution or reconstitution of the


partnership 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

 Just as in the case of admission, retirement of a partner also requires


the consent of the existing partners. Consent of the existing partners
may be expressed or implied.

• Retirement also has to be in accordance with the agreement by the


existing partners or

• According to Sec 32(1), where the partnership is at will, by giving


notice in writing to all the other partners of his intention to retire.

Liabilities of a retiring partner before and after retirement –

Sec 32(2), (3) and (4).

Liability of the retired partner before retirement -


A retired partner will be held liable to third party for the acts of the firm
done till the time of retirement or acts which may be pending at the time
of his retirement unless he is discharged from such acts.

He may be discharged from liability towards any third party if he has


entered into an agreement with the third party and the existing partners
of the reconstituted firm to discharge him of such acts of the firm before
his retirement or according to Sec 32(2), if such agreement can be
implied by the course of dealings with the third party and the
reconstituted firm (firm consisting of remaining partners).

Liability of the retired partner after retirement –

According to Sec 32(3), the retiring partner continues to be liable towards


third parties for acts of the firm done after retirement until public notice of
retirement of the partner is given. According to Sec 32(4), notice can be
given by any partner of the reconstituted firm or by the retiring partner
himself.

Please note that giving public notice of retirement of a partner is not


mandatory. However, in the absence of such notice, the following may
happen –

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.

Rights of the Retired Partner –

According to the Indian Partnership Act 1932 the rights of a retiring


partner are as follows –

1) To carry on competing business – According to Sec 36(1) a


outgoing partner can carry on a competing business. However, he
is not allowed to use the names, represent himself as an existing
partner or approach the customers of the firm for business. This is
subject to contract to the contrary.

2) To share subsequent profits - According to Sec 37 the outgoing


partner is also allowed to share subsequent profits earned by
existing partners after his retirement which can be attributed to the
use of his share of the property in the absence of final settlement of
accounts between the retiring and continuing partners or an
interest of six percent per annum on the amount of his share in the
property of the firm.

Expulsion of a Partner

According to Sec 33 of the Indian Partnership Act a partner may be


expelled from the partnership firm if the following conditions are fulfilled-

1) The contract between the partners confers the power of expulsion of a


partner.

2) A majority of the partners should exercise this power


3) The power should be exercised in good faith. Just ensuring majority to
expel a partner is not enough.

According to Sec 33(1), to establish good faith the following have to be


considered -

a) The expulsion must be in the interest of the partnership


b) The partner to be expelled has been served a notice
c) The partner to be expelled is given an opportunity of being heard

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.

Expulsion of a partner may be either regular or irregular.

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.

An irregular expulsion takes place when the conditions mentioned earlier


are not fulfilled and the court may set aside the expulsion.

In case of an irregular expulsion the expelled partner may either

a) Claim re-instatement as a partner

Or

b) Sue for the refund of his share of capital and profits in the firm

In case of an irregular expulsion, the expelled partner does not cease to


be a partner of 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.

In this example, due to the following reasons this expulsion is irregular.

1) Absence of an express contract to confer the power of expulsion to


partners,

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.

3) Third, even if the above conditions were met, it would still be


considered an irregular expulsion since all the conditions of good faith
were not met. A was not served a notice and neither was he given an
opportunity to be heard.

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

After learning about Admission, Retirement and Expulsion, let us look at


reconstitution of partnership firm in case of Insolvency of a partner.

Insolvency of a partner

Sec 34 of the Indian Partnership Act deals with Insolvency of partners.

According to sec 34(1), in case a partner is declared insolvent, he ceases


to be a partner from the day he is declared insolvent. However, the
partnership firm may or may not be dissolved.

Following are the other implications of insolvency of a partner –

First, the firm is dissolved in case of insolvency of a partner unless there


is an agreement between the partners stating that the partnership firm
will not be dissolved on such a contingency.

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.

Death of a partner leads to dissolution of the partnership firm unless a


contract to the contrary exists.

Following are the implication in case of death of a partner -

1) According to Sec 42(c), in case a contract to the contrary does not


exist, the firm is dissolved in case of death of a partner.

2) According to Sec 35, in case under a contract the partners agree


not to dissolve the partnership firm in case of death of a partner,
the estate of the deceased partner is not liable for any act of the
firm done after his death.

Public notice in case of death of a partner is not required.

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.

Rights and Duties of existing partners after a change in the


constitution of the firm
According to Sec 17 following are the rights and duties of existing
partners after a change in the constitution of the firm –

First – where a change occurs in the constitution of a firm –

According to Sec 17(1) and subject to contract between the partners in


case of change in the constitution of a firm, the mutual rights and duties
of the partners in the reconstituted firm remain the same as they were
immediately before the change as far as they may be.

Second- After the expiry of the term of the firm –

According to Sec 17(b) and subject of contract between the partners,


where a firm is constituted for a fixed term continues to carry on business
after the expiry of that term, the mutual rights and duties of the partners
in the reconstituted firm remain the same as they were before the expiry
so far as they may be consistent with the incidents of a partnership-at-
will.

Third – Where additional undertakings or adventures are carried out –


Subject to contract between the partners, where a firm constituted to
carry out one or more adventures or undertakings, carries out other
adventures and undertakings, the mutual rights and duties of the
partners in respect of the other adventures or undertakings are the same
as those in respect of the original adventures or undertakings.
Academic Script

Dissolution of Partnership Firms: Legal Position

Dissolution of a partnership firm:

Ina partnership firm, Sometimes, there can be conflicts amongst few


partners thus affecting the relation between them This is called as
dissolution of partnership. When the Dissolution of partnership between all
members of the firm is called the ‘dissolution of the firm. Section 39 to 43
of the Indian partnership act deals with dissolution of a partnership firm

Dissolution of Partnership and Dissolution of a partnership firm:

The two terms , dissolution of partnership and dissolution of partnership


firm, though look similar but have different meaning. The Indian partnership
acts recognizes the difference between the dissolution of partnership and
dissolution of partnership firm

The breakdown or severance of relation between a few and not all


partners then amounts to dissolution of partnership and not of the firm.
Dissolution of partnership relation occurs either when a new partner is
admitted or when one of the partners retires or in the event of the death of
a partner. Under such circumstances the firm will continue to exist but
constitution of the firm changes and there will be a change in the profit
ratio.

Example one : A, B and C are three partners in a firm ‘Crystal Enterprises’ .


A, B and C. In the occurrence of the event where C retires , the
partnership between A, B and C comes to an end and a new partnership
between two partners, A and B is formed. the firm Crystal Enterprises will
continue to exist with reconstituted relation between A and B.

Similarly if a new partner D is admitted in Crystal Enterprises, the firm will


be a reconstituted firm with relation between three partners, A, B and D.
This, too does not result in dissolution of the firm.
However if the partnership between all the partners A, B,C,D in the
firm ‘Crystal Enterprises’ comes to an end, it will result in dissolution of ‘
Crystal Enterprises.

How can a partnership firm be dissolved?

There can be times when reasons uncertainities that a partnership firm


can be dissolved

Dissolution of the firm occurs in two ways :

:1. Voluntary also called as ‘without the order of the Court’ and

2. Dissolution by the order of the Court

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

Dissolution without the intervention of the court

1. Dissolution By Agreement (Section 40 of Indian partnership act )


A partnership firm can be dissolved
a) with the consent of all partners of the firm .or
b) in accordance with the contract between all the partners

In case a) a firm can be dissolved if all the partners of the firm


mutually agree to dissolve the firm. Or a firm can also be dissolved
by an agreement or a contract between all the partners. Such
contract between the partners may be expressed or implied.

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

3. Dissolution on the happening of certain contingencies:


(According to section 42 of the Indian partnership act)

Subject to contract between the partners a firm can also be dissolved


under the occurrence of certain contingencies. Which means if so
mentioned in the contract between the partners that a firm can be
dissolved on the happening of any of the following contingencies

a) A firm is dissolved on the expiry of the term for which it was


constituted.
b) A firm is dissolved on completion of a venture or ventures if it is
constituted for the execution of a particular venture
c) A firm is dissolved on the death of a partner
d) A firm is dissolved on the adjudication of a partner as an insolvent

4 ) Dissolution by notice of the partnership at-will

When a partnership is at will, a firm may be dissolved by any partner by


giving notice to all other partners of his intention to dissolve the firm .
Dissolution by the Court

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))

b) Permenent incapacity: Suit for the dissolution of a partnership firm can


be filed on the ground that a partner has become in any way of permenenty
incapable of performing. his duties as a partner. Such a suit is
mainatainable only when permanent incapability is supported by proper
medical evidence. The suit is filed by a partner who is alleged to have been
incapable.

c) Misconduct : A suit for dissolution can be filed by a partner if a partner,


other than the one who has filed a suit, is found guilty of conduct which is
likely to affect prejudicially the carrying on of the business, And the court
may dissolve the firm

d) Persistent Breach of agreement


When a partner other than the partner filing the suit, willfully or persistently
commits breach of agreements relating to the management of the affairs of
the firm or the conduct of the business or otherwise conducts himself in
such a way that it is not reasonably practicable for the other partners to
carry on the business in partnership with him, In such a case the court may
the instance of other partners dissolve the firm (Section 44(d))

e) Transfer of Interest by a partner

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)

Business working at a loss

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)

g) Any other just and equitable ground


A partner in a firm can file a suit for dissolution on any other ground which
renders it as just and equitable that a firm be dissolved. (section 44
subsection g). In this case the court should be satisfied that the reason and
situation is such that the continuation of a firm is impossible or
impracticable

Consequences of dissolution of the firm


After the partnership firm is dissolved, the business is wound up and
proceeds are distributed amongst the partners. A partnership firm conducts
business in external environment and is accountable to various
stakeholders. Although the firm has been dissolved the partners still have
the rights and have to perform duties as former partners. Now we discuss
the rights and liabilities of the partners

Rights of a partner on dissolution


On the dissolution of a partnership firm a partner has following rights

1. Right to enforce winding up (sec 46)


On dissolution of the firm every partner or his representatives have
the right to apply the property of the firm for payment of debts and
liabilities of the firm and if there is surplus if any it is distributed among
the partners or their representatives in accordance with their right. The
right of the partner is called a partner’s lein

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.

3. Right to personal profits earned after dissolution (Section 50)


Where a partner has bought the goodwill of the firm on it dissolution, he
has the right to use the firm name and earn profits by its use.

4. Right to earn premium on premature dissolution (Section 51)


Where a partner has paid premium on entering into partnership for a
fixed term and the firm is dissolved before the expiration of the term he
is entitled to repayment of the whole or part of the premium with regards
to following

1) The terms upon which he became a partner


2) The length of the time during which he was a partner

However, The partner who had paid the premium cannot claim any refund
on dissolution

i) Though prematurely is due to the death of a partner


ii) If the dissolution is mainly due to the misconduct of the partner who
as paid the premium
iii) Is on pursuance of an agreement which contains no provision
for the refund of the premium or any part thereof.

5. Right where partnership contract is rescinded or annulled for fraud


or misrepresentation (Sec 52)

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,

Right of lien on the surplus assets


He has the lien on the surplus of the assets after the debts of the firm
have been paid. For any sum paid by him for the purchase of his share
and for any capital contributed by him

Liability of partners on dissolution of firm

1. Liability for act of partners after dissolution (Section 45)


Under the provision of section 45 of the partnership act , after the
dissolution of the firm public notice must be given of the dissolution.
Public notice is necessary to absolve partners of the liability for any
act done after dissolution of the firm.
Notwithstanding the dissolution of the firm the partners continue to be
liable as such to third parties for any act done by any of them which
would have been the act of the firm if done before dissolution. Until
public notice given of the dissolution (refer section 45 subsection 1)
Public notice under subsection 1 may be given by any partner
(section 45 subsection2)
Liability for the act of the partner

2. Continuing authority of partners for the purposes of winding


up
As stipulated in section 47, after the dissolution of the firm it is
continuing authority of each partner to bind the firm. They have the
other mutual rights and obligations as partners of the erstwhile firm .
They have the right to
A to wind up the affairs of the firm
B to complete transactions began but unfinished at the time of
dissolution

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

The limitation period for filing a case in the court in regard to


settlement of firm’s accounts after dissolution is three years. So if a
partner fails to file such a case against even one partner within this
period of three years, the whole claim gets barred against the
remaining partners as well. Lay down that a public notice has to be
given
1. On the retirement or expulsion of a partner
2. On the dissolution of a registered firm
3. On the election to become or not become

Public Notice
Public notice should be given on dissolution of a partnership firm.

1. by notice to the registrar of firms


2. By official gazette
3. By publication in at least one vernacular newspaper
circulating in district where the firm has its principal place of
business
If notice of dissolution is not given the partners shall continue
to be liable to third persons for any act done any of them.

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.

Dissolution without the intervention of the court can happen by any of


the following means
a) By mutual agreement between the partners,
b) Compulsory dissolution,
c) Dissolution on the happening of certain contingencies
d) Dissolution by notice if the partnership is at-will, (as provided in the
sections 40 to 43 of the partnership act. )
Dissolution by the order of the court as stipulated in section 44 of
partnership act can take place on following grounds
a) Insanity of a partner
b) Permanent incapacity of a partner
c) Misconduct of a partner
d) Persistent breach of agreement by a partner
e) Transfer of interest by a partner
f) Business working at loss
g) Any other just and equitable ground

On dissolution, the partners have certain rights and liabilities on behalf of


the former firm.
Rights of partners are
1. Right to enforce winding up (Refer sec 46)
2. Right to settle the debts of the firm out of the property of the
firm (Section 49)
3. Right to personal profits earned after dissolution (Section 50)
4. Right to earn premium on premature dissolution (Section 51)
5. Right where partnership contract is rescinded or annulled for
fraud or misrepresentation (Sec 52)

Liability of partners on dissolution of firm


1. Liability for act of partners after dissolution (Section 45)
2. Continuing authority of partners for the purposes of winding up

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

Settling of Accounts (Sec 48)


In settling the accounts of a firm after dissolution, the following rules, subject
to agreement by the partners, shall be observed:
Treatment of Losses: Losses including the loss arising from deficiencies of
capital should be first paid out of :
Profits of the firm
Capital of the firm
Lastly, by partners in their profit sharing ratio
Applicability of assets: The assets of the firm (including any amount received
from partners to make up deficiencies) shall be applied in the following
manner and order:
• In paying the debts of the firm to third parties.
• In paying each partner, the amount that is due to him on account of
advance .
• In paying each partner, the amount that is due to him on account of
capital.
• The residue, if any, should be divided amongst the partners in their
profit sharing ratio.

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.

Entry relating to transfer of assets:


All the recorded assets (except fictitious assets/ cash and bank balances and
debit balance of partner’s capital account) need to be transferred to debit side
of realisation account at their respective book value.
Realisation A/c ……………………………………Dr (Total)
To Sundry Assets (individually)

Particulars L/F Debit Credit


Realisation A/c Dr 48,000
To Stock 16000
To Book Debts 13200
To Plant and Machinery 6000
To Land & building 6600
To Joint Life Policy 1000
To Investments 2000
To Goodwill 3000
To Prepaid Expenses 200

Entry relating to transfer of outsiders’ liabilities:


All recorded outside liabilities should be transferred to the credit side of
realisation account at their respective book value.
Sundry Liabilities A/c ………………………………Dr (Individually)
To Realisation A/C (Total)

Particulars L/F Debit Credit

Provision for doubtful debt 1000


Creditors 15000
Bills Payable 5000
Loan 6000

To Realisation A/C 27000

Entry relating to sale of all assets (recorded and unrecorded *):


There can be two possibilities here:
1. The asset is sold for Cash/ Bank:
Cash/ Bank…………………Dr.
To Realisation A/c

2. The asset is taken away by any partner:


Concerned Partner’s Capital A/c……………………….Dr.
To Realisation A/C
(* Unrecorded assets are those assets which are not appearing in the
balance sheet.
In case provision of debtors shown in liability, it needs to be transferred
separately to Realisation account without netting off from debtors).

Entry relating to discharge of outside liabilities ( recorded and unrecorded *)


Two situations can arise:
1. When liabilities are discharged in cash
Realisation A/C………………………………………….Dr.
To Cash/ Bank A/C
2. When liability is discharged by a partner.
Realisation A/C………………………………………….Dr.
To Concerned Partner’s Capital A/c

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.

So the entries will be:


Realisation A/c ………………………Dr. 1,80,000
To Stock A/c 80,000
To Sundry Assets A/C 1,00,000
(Transfer of asset to Realisation Account)

A cap A/c…………………………………Dr. 80,000


To Realisation A/c 80,000
(Stock taken over by partner A)

Cash/ Bank A/c………………………..Dr. 120,000


To Realisation A/c 120,000
(Amount realised on sale of asset)
E.g. 2. A & B are partners in AB Ltd and decided to dissolve the firm on
31.03.2015. A decided to discharge the full creditors worth Rs.60,000/- and
remaining liability for Bills payable was discharged by the firm at a discount of
Rs.5,000/-(Shown in Balance sheet at Rs.25,000/-)

Creditors A/C……………………………….Dr. 60,000


Bills Payable A/C…………………………..Dr. 25,000
To Realisation A/C 85,000
(Transfer of liabilities to realisation account)

Realisation A/C……………………………..Dr. 60,000


To A A/c 60,000
(Discharge of liability by A)

Realisation A/c………………………………Dr. 20,000


To cash/ Bank A/c 20,000
(Payment of Liability by firm)

Entry relating to payment of Realisation Expenses:


The amount spent for carrying out the procedure of dissolution is known as
‘Realisation expenses’.
The entry relating to Realisation expenses is
If settled in Cash
Realisation A/C…………………………..Dr.
To Cash/Bank A/c
If settled by Partners
Realisation A/C…………………………..Dr.
To Concerned Partner’s Capital A/c

Entries relating to transfer of profit/loss on realisation


Transfer of Profit /loss on Realisation to partner’s capital accounts
In case of Profit:
Realisation A/C………………………….Dr.
To Partner’s Capital A/c s

In case of Loss:
Partner’s Capital A/c s………………….Dr.
To Realisation A/c

Entries relating to payment of partner’s loan


Partner’s loan A/C……………………… Dr.
To cash/ Bank A/C

Closing Entries in Partner’s capital A/c


Entries relating to reserves and undistributed profit
P&L A/c………………………………………..Dr.
Reserves A/C………………………………..Dr.
To Partner’s capital A/Cs
In case of “debit balance” in partner’s capital account
Cash/Bank A/C………………………………Dr.
To Partner’s Capital A/c.
In case of “credit balance” in partner’s capital account
Partner’s Capital A/c…………………….Dr.
To Cash/Bank 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

Partner’s capital Account


Particulars A B Particulars A B
To Bal b/d(debit By Bal b/d
bal)
To Realisation a/c By Reserve A/c
(assets taken
over)
To Realisation By Realisation A/c
A/c (liability
(Loss on discharge)
realization)
To Cash/Bank By Realisation
(In case of credit (Profit on
bal) realization)
By Cash/Bank
(in case of debit
bal)
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

Financial statements contain a wealth of information which, if properly


analyzed and interpreted, provides valuable insights into firm’s
performance and position. The principal tool of Financial Statement
Analysis is ration analysis. The concerned unit explores this tool in much
detail and interprets the problems of financial statement analysis.

Meaning

Financial Statement Analysis is an analysis which highlights important


relationships in the financial statements. If focuses on evaluation of past
operations as revealed by the analysis of basic statements. Financial
Statement Analysis embraces the methods used in assessing and
interpreting the result of past performance and current financial position
as they relate to particular factors of interest in investment decisions. It is
an important means of assessing past performance and in forecasting
and planning future performance.

Definition

According to Lev,

“Financial Statement Analysis is an information processing system


designed to provide data for decision making models, such as the
portfolio selection model, bank lending decision models, and corporate
financial management models.”

“Financial Statement Analysis, according to Myres


Is largely a study of relationship among the various financial factors
in a business as disclosed by a single set of statements and a study of
the trends of these factors as shown in series of statement.”

In the words of W. B. Meig,

“Financial statements thus are organized summarizes of detailed


information and are thus a form of analysis. The type of statements
accountants prepare, the way they arrange items on these statements
and their standards of disclosure are all influenced by a desire to provide
information in a convenient form.”

The focus of Financial Analysis is on key figures contained in the


financial Statements and the significant relationship that exists between
them.

Analysis of Financial Statements, According to Metcalf and Titard,

“is a process of evaluating the relationship between component parts of


a Financial Statement to obtain a better understanding of a firm’s
position and performance.”

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:

“Analysis is the simplification of the data incorporated in the financial


statements, whereas ‘Interpretation’ is explaining the meaning and
significance of the data so simplified.”

In short, the analysis is the prerequisite to “interpretation” and analysis is


useless without interpretation.

Thus, Analysis and Interpretation both, assist the management in


measuring and maintaining efficiency at various levels.

Objectives of Financial Statement Analysis

The major objectives of financial statement analysis is to provide


decision makers, information about a business enterprise for use in
decision-making. Users of financial statement information are the
decision makers concerned with evaluating the economic situation of
the firm and predicting its future course. The major groups of users are
management for evaluating the operational and financial efficiency of the
enterprise as a whole or of sub-units (e.g. departments); investors for
making investment decisions and portfolio decisions, lenders and
creditors for determining the creditworthiness and solvency position;
employees and labor unions for deciding economic status of the
enterprise and making sound decisions in wage and salary negotiations,
regulatory authorities for controlling the activities of the firm and making
overall corporate policy, economists, researchers and planners for
studying firm and specific data behaviour.

Financial Statement Analysis can be used by different users and


decision makers to achieve the following objectives and purposes:

1. Assessment of Past Performance and Current Position:


Past performance is often a good indicator of future performance.
Therefore, an investor or a creditor is interested in the trend of past
sales, expenses, net income, cash flow and return on investment.
These trends offer a means for judging management’s past
performance and are possible indicators of future performance.
Similarly, the analysis of current position indicates where the
business stands today. For instance, the current position analysis
will show the types of assets owned by a business enterprise and
the different liabilities due against the enterprise. It will indicate
what the cash position is, how much debts the company has in
relation to equity and how reasonable the inventories and
receivables are.

2. Credit appraisal decisions by Financial Institutions and Banks:


Financial statement analysis is used by financial institutions,
loaning agencies, banks and others to make sound loan or credit
decisions. In this way, they can make proper allocation of credit
among the different borrowers. All lenders are primarily concerned
with repayment of loan and payment of interest on the due dates.
This requires comprehensive investigation and analysis of the
financial statements submitted by the borrowers. Financial
statement analysis helps in determining credit risk, deciding
terms and conditions of loan if sanctioned, interest rate, maturity
date etc.

3. Prediction of Net Income and Growth Prospects:


Financial statement analysis helps in predicting the earning
prospects and growth rate in the earnings which are used by
investors while comparing investment alternatives and other users
interested in judging the earning potential of business enterprises.
Investors also consider the risk or uncertainty associated with the
expected return. The decision makers are futuristic and are always
concerned with the future financial statements which contain
information on past performances analyzed and interpreted as a
basis for forecasting future rates of return and for assessing the
risk. The prediction of future earnings tend to improve the financial
decisions made by the investors and financial analysis.

4. Prediction of Bankruptcy and Failure:


Financial statement analysis is a significant tool in predicting the
bankruptcy and failure probability of business enterprises.
Financial statement analysis accomplishes this through the
evaluation of solvency position. After being aware of the probable
failure, managers and investors both can take preventive
measures to avoid or minimize losses. Corporate managements
can effect changes in operating policy, reorganize financial
structure or even go for voluntary liquidation to shorten the length
of time losses.
In accounting and finance area, empirical studies conducted have
suggested a set of financial ration which can give early signal of
corporate failure. Such a prediction model based on financial
statement analysis is useful to managers, investors and creditors.
Managers may use the ratios prediction model to assess the
solvency position of their firms and thus can take appropriate
corrective actions. Investors and shareholders can use the model
to make the optimum portfolio selection and to bring changes in
the investment strategy in accordance with their investment goals.
Similarly, creditors can apply the prediction model which
evaluating the creditworthiness of business enterprises.
Method of Financial Analysis

The classification of financial analysis can be made either on the


basis of material used for the same or according to modus
operandi of the analysis. The following figure shows the Methods
of Financial Analysis:

Methods of Financial Analysis


A B

According to Material Used According to Modus Operandi


of

Analysis

External Internal
Analysis Analysis Horizont Vertical
al Analysis
Analysis

A. According to Material Used:


1. External Analysis:
This is effected by those who do not have access to the detailed
accounting records of the concern. This group comprising
investors, credit agencies, government and public, depends almost
entirely on published financial statements. With the recent
development in the Government regulations requiring business
concern to make available detailed information to the public
through audited accounts, the position of the external analysis
has been considerably improved.

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.

B. According to Modus Operandi of Analysis:


1. Horizontal Analysis:
When financial statements for a certain number of years are
examined and analyzed, the analysis is called a ‘horizontal
analysis’. It is also called “Dynamic Analysis”. This is based on
the data or information spread over a period of years rather
than on one date or period of time.

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.

Techniques of Financial Statement Analysis:

Various techniques are used in the analysis of financial data, among the
more widely used of these techniques are the following:

1. Horizontal and Vertical Analysis;


2. Trend Analysis;
3. Ratio Analysis
1. Horizontal and Vertical Analysis:
The percentage of analysis of increase or decrease in
corresponding items in comparative financial statements is called
‘Horizontal Analysis’. On the other hand, Vertical Analysis uses
percentages to show the relationship of the different parts to the
total in a single statement.

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.

STEPS INVOLVED IN FINANCIAL STATEMENT ANALYSIS:


On the basis of the above discussion, it can be said that, financial
statement analysis is investigative and thought provoking process in
nature. The basic objective of financial statement analysis is financial
planning and forecasting on the basis of meaningful interpretation of the
financial data. It is a forward look exercise, since, decisions are going to
be taken on the basis of financial statement analysis, the analyst must
understand various tools and techniques and techniques of accounting
and their application in the analysis and interpretation of data. In addition
to this, he must be careful, precise, analytical, objective and intelligent
enough to undertake the financial statement analyst in a systematic
way. 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 below:

4 Suggest Actions: To suggest actions as a remedy


to rectify the situation or to be helpful in future
financial planning

3 Comparing the Processed Data: Comparing the


processed information with the predetermined
standards and to derive conclusions

2 Processing of Data: Processing of the information by a


suitable technique (e.g. Horizontal Analysis, trend Analysis,
Ratio Analysis etc.)

1 Collection of Financial Data: Collection of as much financial


information as available and required, keeping in view the
objective of financial statement analysis.

Fig: Steps of Financial Analysis

Comparative Financial Statements i.e. Horizontal Analysis:


Joint Stock Companies are required to provide in their annual published
accounts the corresponding figures for the year immediately preceding
the current financial year so as to provide a comparative picture of their
business affairs.
The decision-makers prefer to study the picture not only for one or two
years but for few more years in the past. The Income Statement and
Balance Sheet in their usual form are not much useful from the
management point of view. Therefore, the analysis re-arrange the
information in different groups, as the group study along with the
individual items is more meaningful for the purpose if interpretation and
decision-making. If two or more companies have to be compared
(interfirm comparison), the analyst should take care that the groups are
homogenous. He should also bear in mind the size of the enterprise in
terms of capital investment and turnover. A comparative financial
statement may be presented in any one of the following forms:
1. Absolute figures for the years of comparison
2. Absolute figures along with variations (in absolute figures).
3. Absolute figures along with variation in terms of percentage or
ratio.
4. Individual items as percentage of a base year.

Comparison may be Intra-firm Comparison or Inter-firm Comparison

Intra-firm or Inter-firm Comparison:


Under this process, comparison is made of the financial statements of
the same firm. In these statements figures for two or more periods are
placed side by side to facilitate comparison and to ascertain the trend.

Comparative Income Statement:


A Comparative Income Statement shows the absolute figures for two or
more periods, the absolute change from one period to another. The
change may, if necessary, be expressed in percentages instead of in
absolute figures. However, the items of incomes and expenses should
be considered together while interpreting the increases or decreases.

Preparation of Comparative Statements:


The comparative statements for two or more years are prepared in the
horizontal form. The number of columns provided for absolute figures
depend upon the number of years of comparison. After these columns of
absolute figures, a column is provided to indicate increase or decrease.
If the increase or decrease is decided to be expressed in percentage
also, an additional column showing this percentage is provided.
A Proforma of Comparative Balance Sheet
In the books of ……..
Comparative Balance Sheet As on 31th March, 2008 and 2009
Particulars 31th 31th Amount of Percentage
March March increase or of Increase
2008 2009 decrease in or
2008-2009 decrease in
2008-2009

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

A Proforma of Comparative Income Statement


In the Books of ……
Comparative Income Statement for the year ended 31th March, 2008
and 2009
Particulars 31th 31th Amount of Percentage
March March Increase or of Increase
2008 2009 Decrease in or Decrease
2008-2009 in 2008-2009

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

Precautions before preparing Comparative Statements


Analysis of financial statement is a technical job which can be performed
properly only by a knowledgeable and experienced financial analyst. In
other to be successful in his analysis and interpretation, a financial
analyst must possess thorough knowledge of accounting theory and
practice. In addition to this, he must also understand the industry
environment in which the unit is operating. His personal qualities such as
penetrating vision and insight, tactfulness, alertness, leadership qualities
etc., help him greatly in the successful discharge of his functions as
financial analyst.
Before preparing comparative statements, it is necessary to ensure that
the following precautions are taken. If the following principles are not
followed, the comparison cannot be made, and if it is made the results
will be misleading and misinterpreting.

1. The financial statements should contain full disclosure of the


information by way of foot-notes, schedules, annexure.
2. Proper accounting procedure is to be followed every year while
preparing the accounts and the financial statements.
3. The items in the balance-sheet are to be properly classified and
uniformity is to be maintained in such classification and allocation.
4. Concept of consistency and other relevant concepts and
conventions are to be followed in preparation of financial
statements
5. Personal judgments are to be properly exercised as the accuracy
of the accounting statements depend to a large extent on the
integrity, experience and wisdom with which judgments are
exercised.
6. If there has been any change in the depreciation policy,
inventory valuation method, or any other variable affecting profit
figure and assets and liabilities, the analyst should first make the
data comparable by making necessary adjustments in the
concerning items.
7. Sometimes a percentage figure is misleading. Therefore, the
analysis of statements submitted to management should contain
absolute figures along with their percentages.

Financial statements enable a reader not only to measure business


results of an organization but also to assess its financial position; hence
they are generally predictive in nature. Such statement contains not only
sufficient but also valuable information about the organization that would
help managers in decision making.

The nature of financial statements was admirably summarized on


traditional ground number of years ago by the American Institute of
Certified Public Accountants, 1936 in the following lines

“Financial statements are prepared for the purpose of presenting a


periodical review or report by the management and deal with the
status of investment in the business and the results achieved
during the period under review”

Thus financial statements are reporting instruments that provide a


summary of the accounting data of an organization’s business pertaining
to a specific accounting period.

The main focus of analysis of financial statements is on analysis and


interpretation

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:

“Analysis is the simplification of the data incorporated in the financial


statements, whereas ‘Interpretation’ is explaining the meaning and
significance of the data so simplified.”

In short, the analysis is the prerequisite to “interpretation” and analysis is


useless without interpretation.

Thus, Analysis and Interpretation both, assist the management in


measuring and maintaining efficiency at various levels.

The objectives of financial statements are summarized as:

 To measure an organizations business results and assess its


financial position

 To present true and fair view of the business

 To reveal implications of operating profits on the financial position


of the concern.

 To provide sufficient and relevant financial information to various


parties interested in financial statement analysis and

 To serve as the basis for future planning and strategy.

Meaning of Analysis:

Like any other analysis, financial statements can be studied, puzzled


and scrutinized. The analysis of such statements provides valuable
information for managerial decisions. The utility of the statement doesn’t
lie in the amount of information it contains but in the expertise and the
skill of analyst to analyze and interpret the information in the
statement in order to get the story behind the facts i.e to read between
the lines.

Financial statement analysis involves a systematic and careful


examination of the information contained in the financial statements with
a definite purpose. It is a detailed inquiry into financial data to evaluate
an organization’s performance, future risks and potential. It attempts to
determine the significance and meaning of the business information as
depicted by financial statements so that prospects for future earnings,
ability to pay interest and other debts, dividend policies can be
forecasted.

Thus, financial statement analysis is process of analyzing the financial


data in order to judge the profitability and financial position of an
organization. It is the evaluation of the economic and financial data
presented in the financial statements for making decisions and
maintaining control.

Steps involved in financial statement analysis:

The basic objective of financial statement analysis is financial planning


and forecasting on the basis of meaningful interpretation of the financial
data. It is a forward look exercise, since, decisions are going to be taken
on the basis of financial statement analysis, the analyst must understand
various tools and techniques and techniques of accounting and their
application in the analysis and interpretation of data.
In addition to this, he must be careful, precise, analytical, objective
and intelligent enough to undertake the financial statement analyst in a
systematic way.

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:

4 Suggest Actions: To suggest actions as a


remedy to rectify the situation or to be helpful in
future financial planning

3 Comparing the Processed Data: Comparing the


processed information with the predetermined
standards and to derive conclusions

2 Processing of Data: Processing of the information by a


suitable technique (e.g. Horizontal Analysis, trend Analysis,
Ratio Analysis etc.)

1 Collection of Financial Data: Collection of as much


financial information as available and required, keeping in
view the objective of financial statement analysis.

Fig: Steps of Financial Analysis

Methods of Analysis:

Analysis of financial statements may be undertaken by different persons


for different reasons, therefore the methodology adapted may vary from
one situation to another. However following are the commonly used
techniques of analysis:
Comparative
financial
statement

Funds Flow
Analysis

Methods of Common- size


Financial financial
Statement Analysis statement

Trend Analysis

Ratio
analysis

The methods listed above bring in various insights in the financial


statements. Let us study them in detail

1. Comparative Financial Statement

Any financial statement that reports the comparison of data for two or
more consecutive accounting periods is known as comparative
financial statement

Comparative financial statement highlights trends and establishes


relationship between items that appear on the same row of the
statement. The comparative study helps to identify and examine the
key factors which have affected profitability or the financial position of
the organization.
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.

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.

Comparative Income Statement

Comparative income statement or profit and loss accounts show the


figures of different items in order to give meaningful information For
example figures of sales may be mentioned along with cost of sales and
other expenses.

This will give information about changes in revenue as well as


expenditure. From this information one can immediately understand
whether the sales have increased or decreased and what is the
percentage of this change.

As well as one can understand the changes occurred in different


expenditure items. Let us take an example in order to understand this
concept more clearly.

Example:

Simple Income Statement

Particulars 2008 2009 Particulars 2008 2009


Cost of Goods 600 700 Sales 800 1000
Sold

Official 20 25
Expenses

Selling Expenses 10 25

Profit 170 250

Total 800 1000 Total 800 1000

Comparative Income Statement

Particulars 2008 2009 Change Change (%)

Sales 800 1000 200 +25

Cost of 600 700 100 +16.67


Goods Sold

Official 20 25 5 +25
Expenses

Selling 10 25 15 +150
Expenses

Profit 170 250 80 +47.05

Friends, now what can we interpret from this comparative statement?


One can easily compare the performance in terms of sales as well as
expenses.
Sales have risen up by 25%, Cost of goods sold have raised by 16.67
% , official expenses by 25% , selling expenses by 150% while
profitability by 47% for year on year basis.

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.

Comparative Balance- Sheet (CBS)

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 analyzed with the help of CBS.

Funds Flow analysis:

Funds flow analysis has become an important technique of financial


statement analysis.
Financial managers and owners in order to study flow of funds within
different financial items do Fund Flow analysis. This analysis helps
them to understand changes in the financial position of a firm.

There are two statements that are generally prepared under Fund Flow
Analysis , viz. funds flow statement and cash flow statement.

1. Funds flow statement: Students, There is constant flow of funds in


business from various sources and means.
There is inflow as well as outflow of funds. This would mean creation
of an asset or liability for a business.

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.

Funds flow statement helps the management to understand:

1. Financial consequences of business operations


2. The pattern of allocation of resources
3. Effective or ineffective use of working capital.

2. Cash Flow Statement:

As the name suggests cash flow statement helps management to


understand flow of cash into the business and out of the business.
Cash-Flow statement may be defined as a summary of receipts and
disbursements of cash for a particular period of time. It also explains
reasons for the changes in cash position of the firm.

Cash flow statement helps in highlighting the cash generated from


operating activities. Cash flow statement helps in planning the
repayment of loan schedule and replacement of fixed assets, etc. Cash
is the centre of all financial decisions. It is used as the basis for the
projection of future investing and financing plans of the enterprise

Common Size Financial Statements:

Financial statements that depict financial data in the shape of vertical


percentage are known as common size statements. Since such
statements provide readers with a vertical analysis of the items of profit
and loss account and balance sheet, the values of items are converted
into common unit by expressing them in percentage of a key figure in the
statement. Therefore the total of financial statements is reduced to 100
and each item of the statement is shown as a component of whole.

Common Size financial statements facilitates comparison and are


recognized as valuable management tools as they reveal both
efficiencies and inefficiencies that are otherwise difficult to identify.

However, common size statements are especially useful when data for
more than one year are used.

Here is the example of a common size balance sheet

Particulars 2010 % 2011 %


Current 25,000 41.66 36,000 47.37
Assets

Fixed 35,000 58.33 40,000 52.63


Assets

Total 60,000 100 76,000 100


Assets

Current 10,000 25 12,000 28.57


Liabilities

Share 30,000 75 30,000 71.42


capital

Total 40,000 100 42,000 100


Liabilities

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:

It is a technique of studying the operational results and financial position


over a series of years. Using the previous years’ data of a business
enterprise, trend analysis can be done to observe the percentage
changes over time in the selected data.

The trend percentage is the percentage relationship, in which each item


of different years bear to the same item in the base year.
Trend analysis is important because, with its long run view, it may
point to basic changes in the nature of the business. By looking at a
trend in a particular ratio, one may find whether the ratio is falling, rising
or remaining relatively constant.

From this observation, a problem is detected or the sign of good or poor


management is detected

Let’s take this example which will further clarify our concept on trend
analysis

Year Sales (in Lakhs) Trend Percentage

2008 1881 100 (Base)

2009 2340 124

2010 2655 141

2011 3021 161

2012 3768 200

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.

Students, let us now learn another type of analysis of financial


statements

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.

According J. Batty, Ratio can be defined as "the term accounting ratio is


used to describe significant relationships which exist between figures
shown in a balance sheet and profit and loss account in a budgetary
control system or any other part of the accounting management."

Ratio can be used in the form of

(1) Percentage (20%)

(2) Quotient (say 10) and

(3) Rates.

In other words, it can be expressed as a to b; a: b (a is to b) or as a


simple fraction, integer and decimal.

A ratio is calculated by dividing one item or figure by another item or


figure.

Ratio Analysis has several advantages which helps management to


compare and take informed decisions.

Accounting Ratios are classified on the basis of the different parties


interested in making use of the ratios. A very l?rge 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:


1) Liquidity Ratios

2) Profitability Ratios

3) Turnover Ratios

4) Solvency Ratios

5) Overall Profitability Ratios


Lecture Name : Common Size Balance Sheet

Academic Script

Accounting, as a language of business, communicates the financial


information of an enterprise to various groups by means of financial
statements. Financial statements are important to comment on progress or
decline of organisations. However a detailed analysis needs to be supported
with the same to come to some decision which is facilitated by financial
analysis.

Concept:

Students, let us now focus our discussion first about financial analysis.

The financial analysis of companies is usually undertaken so that investors,


creditors, and other stakeholders can make decisions about those
companies.

Financial analysis is the selection, evaluation and interpretation of financial


data, along with other essential information, to assist in various decision
making process. It can be used internally to assess the operating efficiency,
various policies and externally to evaluate potential investments and many
other factors.

The Tools that are commonly used for Company’s financial information
includes:

i) Financial ratio analysis

ii) Cash Flow analysis

iii) Common Size analysis


But before going in further depth, let us now first learn what a financial
statement is.

A financial statement is a numerical report covering financial


information to express the financial results and financial condition of
the concern.

According to Smith and Ashburne, the financial statement is the end


product of financial accounting, prepared by the accountant of an
enterprise, the result of its represents financial position, and analysis
of worked has been done with earnings.

Analysis done with help of financial statements serves the listed purposes.

 Measuring Profitability

 Indicating the trends of performance

 Assessment of actual versus planned growth

 Assessment of growth potential for organisation

 Comparison with internal departments

 Comparison with other organisations

 Assessment of solvency and liquidity position of firm.

Students, let us focus our discussion towards parties those are interested in
financial statement analysis.

Analysis of financial statements has become very significant due to


widespread interest of various parties in the financial results of a business
unit. The various parties interested in the analysis of financial statements
are:

 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

The management is interested in the financial position and performance of


the enterprise as a whole and of its various divisions. It helps them in
preparing budgets and assessing the performance of various departmental
heads.

 Trade Union

Labour unions analyse the financial statements to assess whether it can


presently afford a wage increase and whether it can absorb a wage increase
through increased productivity or by raising the prices.

 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

They are interested in financial statements in undertaking research work in


business affairs and practices.

 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

Government and their agencies need financial information to regulate the


activities of the enterprises/ industries and determine taxation policy. They
suggest measures to formulate policies and regulations.

Students, Financial statements give complete information about assets,


liabilities, equity, reserves, expenses and profit and loss of an enterprise.
They are not readily understandable to interested parties like creditors,
shareholders, investors etc.

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

It is also known as inter-firm comparison. This analysis helps in analysing


financial characteristics of an enterprise with financial characteristics of
another similar enterprise in that accounting period.

2) Time Series analysis &

It is also called as intra-firm comparison. According to this method, the


relationship between different items of financial statement is established,
comparisons are made and results obtained. The basis of comparison may
be

: – Comparison of the financial statements of different years of the same


business unit

. – Comparison of financial statement of a particular year of different


business units.

3) Cross sectional cum time series analysis

This analysis is intended to compare the financial characteristics of


two or more enterprises for a defined accounting period. It is possible
to extend such a comparison over the year. This approach is most
effective in analyzing of financial statements.

Methods of Analysis

Analysis of financial statements may be undertaken by different persons for


different reasons, therefore the methodology adapted may vary from one
situation to another. However listed are the commonly used techniques of
analysis:
Students, today our focus is to learn more about Common Size Statement in
general and Common Size Balance sheet to be more precise.

Common Size Statements

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.

Let us focus our discussion towards Common Size Balance sheet.

Common Size Balance Sheet

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.

– The total assets or liabilities are taken as 100

– The individual assets are expressed as a percentage of total assets i.e.


100 and different liabilities are calculated in relation to total liabilities.

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.

Liabilities March, 2014 March, 2015

Preference Share Capital 1,20,000 1,50,000

Equity Share Capital 1,40,000 4,10,000

Reserve and Surpluses 24,000 28,000

Long term loans 1,10,000 1,20,000

Bills Payables 7000 1000


Creditors 12,000 3000

Outstanding Expenses 15,000 6000

Proposed Dividend 10,000 90,000

Total 4,38,000 8,08,000

Land and Building 80,000 1,23,000

Plant and Machinery 3,34,000 6,00,000

Temporary Investment 5,000 40,000

Investment 6,000 20,000

Debtors 4,000 13,000

Prepaid Expenses 1000 2000

Cash and Bank Balance 8,000 10,000

Total 4,38,000 8,08,000

Students, let us now analyse this balance sheet

2014 2015
Assets

Fixed Assets Rs % Rs %

Land and Building 80,000 18.26 1,23,000 15.22

Plant and Machinery 3,34,000 76.26 600000 74.62

Total Fixed Assets 4,14,000 94.52 723000 89.48

Temporary 5,000 1.14 40,000 4.95


Investment

Investment 6,000 1.37 20,000 2.48

Debtors 4,000 0.91 13,000 1.61

Prepaid Expenses 1000 0.23 2000 0.25

Cash and Bank 8,000 1.83 10,000 1.25


Balance

Total Current Asset 24000 5.48 85000 10.54

Total Assets 438000 100.00 808000 100.00

Liabilities

Preference Share 1,20,000 27.39 1,50,000 19.80


Capital

Equity Share Capital 1,40,000 31.96 4,10,000 50.74

Reserve and 24,000 5.48 28,000 3.47


Surpluses
Total Capital and 284000 64.83 588000 74.01
reserves

Long term loans 1,10,000 25.11 1,20,000 14.85

Bills Payables 7000 1.60 1000 0.12

Creditors 12,000 2.74 3000 0.37

Outstanding 15,000 3.44 6000 0.74


Expenses

Proposed Dividend 10,000 2.28 90,000 11.15

39000 10.06 109000 12.38

Total Liabilities 438000 100.00 808000 100.00

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.

2. An analysis of current liabilities reveals that in the year 2014 that


company was largely dependent on other sources than owners own
capital and sources than the year 2015.
3. Though the percentage of loan in total is reduced from 2014 to
2015 the company has increased its long term loan by Rs 10,000.

4. There is good improvement in total current assets portfolio for the


company which improved from 5.48% to 10.54% from 2014 to 2015
respectively.

5. Temporary investment figures reveals that the company has invested


more amount in the second year.

6. Creditors has been significantly reduced from 2.74% to 0.37% which


reveals that the company is paying its creditors on time. While debtors
position which is not so good needs improvement.

Students, this is how the analysis for organisations is done using the
method of common size balance sheet method.

Let us quickly discuss its benefits

A common-size financial statement displays line items as a percentage of


one selected or common figure. Creating common-size financial statements
makes it easier to analyse a company over time and compare it with its
peers.

Using common-size financial statements helps investor’s spot trends that a


raw financial statement may not uncover.

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.

The biggest benefit of a common-size analysis is that it can let an investor


identify large or drastic changes in a firm’s financials. Rapid increases or
decreases will be readily observable, such as a rapid drop in reported profits
during one quarter or year.
A common-size analysis can also give insight into the different strategies
that companies pursue. For instance, one company may be willing to
sacrifice margins for market share, which would tend to make overall sales
larger at the expense of gross, operating or net profit margins.

Analysis of financial statements may be undertaken by different persons for


different reasons, therefore the methodology adapted may vary from one
situation to another. However following are the commonly used techniques
of analysis:

Friends, out of these four techniques ratio analysis is the most


comprehensive, sophisticated and widely used techniques. We will be
studying ratio analysis in much more detail, but before that let us get
ourselves acquainted with remaining three methods.
I. Comparative Financial Statements (CFS)

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.

The CFS may be presented in order to show information in following pattern:

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.

II. Comparative Income Statement:

Comparative income statement or profit and loss accounts show the


figures of different items in order to give meaningful information. For
example figures of sales may be mentioned along with cost of sales and
other expenses. This will give information about changes in revenue as
well as expenditure. From this information one can immediately
understand whether the sales have increased or decreased and what is
the percentage of this change. As well as one can understand the
changes occurred in different expenditure items. Let us take an example
in order to understand this concept more clearly.

Example 1

From the Income Statement of 2010 and 2011 prepare a comparative


income statement.
Income statement for the year 2010-11

Particulars 2010 2011 Particulars 2010 2011

To cost of 600000 750000 By sales 800000 1000000


goods sold

To General 20000 20000


Expenses

To selling 15000 20000


expenses

To financial 15000 20000


expenses

To Net Profit 150000 190000

Total 800000 1000000 Total 800000 1000000

This is a simple income statement; now let us present this information in a


comparative format.

Comparative Income Statement

Particulars 2010 2011 Change in %


2011 change
Net Sales 800000 1000000 200000 +25

Less cost of goods sold 600000 750000 150000 +25

Gross Profit (1) 200000 250000 50000 +25

Less general expenses 20000 20000 Nil Nil

Selling expenses 15000 20000 5000 +33.3

Financial expenses 15000 20000 5000 +33.3

Total expenses (2) 50000 60000 10000 +20

Net Profit (1-2) 150000 190000 40000 +26.7

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.

III. Comparative Balance- Sheet (CBS)

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

From the Balance- Sheet of 2010 and 2011 prepare a comparative


Balance- Sheet.

Balance- sheet as on 31st March 2010 and 31st March 2011

Liabilities 2010 2011 Assets 2010 2011

Capital 700000 700000 Land 100000 100000

Reserves 200000 245000 Building 300000 270000

Secured loans 100000 150000 Plant 300000 270000

Creditors 200000 275000 Furniture 100000 140000

Outstanding 100000 150000 Cash 100000 140000


exp.
Debtors 200000 300000

Stock 200000 300000

Total 1300000 1520000 Total 1300000 15200000

This is a simple Balance-Sheet; now let us present this information in a


comparative format.

Comparative Balance-Sheet

Particulars 2010 2011 Change in %


2011 change

Land 100000 100000 Nil Nil

Building 300000 270000 -30000 -10

Plant 300000 270000 -30000 -10

Furniture 100000 140000 40000 +40

Total Fixed Assets (1) 800000 780000 -20000 -2.5

Cash 100000 140000 40000 40

Debtors 200000 300000 100000 50

Stock 200000 300000 100000 50

Total Current Assets (2) 500000 740000 240000 48

Creditors 200000 275000 75000 37.5


Outstanding exp. 100000 150000 50000 50

Total Current Liability(3) 300000 425000 125000 41.7

Net Working Capital 200000 315000 115000 57.5

(2-3)

Capital 700000 700000 Nil Nil

Reserves 200000 245000 45000 22.5

Proprietor’s fund(4) 900000 945000 45000 5

Secured loans(5) 100000 150000 50000 50

Capital Employed(4+5) 100000 1095000 95000 9.5

Total 1300000 1520000 220000 16.9

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.

Limitations of Comparative Financial Statement Analysis:

1. It is essential for the firm to follow uniform accounting policies and


principles. If the policies are not uniform than the results of comparative
analysis becomes useless.
2. Another limitation is that since the financial statement itself is based on
historic costs, therefore the comparative statement also shows its
analysis based on historic approach.
3. If a certain item does not appear in the base year and is introduced in
the current year, then it is not possible to have uniform comparison.
4. Friends, there is also a possibility of some abnormal financial event in
the particular year which may result into abnormal gains or loss. This
abnormal change makes the comparative statement meaningless.
5. We are also aware the there is a constant change in price level
resulting in changes in trading activity. These price changes are not
taken into consideration while preparing comparative statement.
6. Many a times, firms tend to compare its performance with that of another
firm. This is called inter- firm comparison. In such analysis, it is essential
that both the firms under consideration belong to the same business
activity, are of the same size and have similar business commencement
age. In other words inter-firm comparison is not worth if say one firm is
functioning from 10 years and the other from 2 years than the
comparison cannot be justified.
7. It is observed that companies distort and manipulate financial
statements in order to project positive picture of the financial results. In
such cases comparative statement too becomes manipulative and
therefore not of much use to the management.
Lecture Title: Introduction to Ratio Analysis

Academic Script

The fundamental, clear and definite understanding of financial


statements is recognized as a prerequisite for accurate, complete and
relevant financial decisions. However, the ability to interpret these
financial statements intelligently and accurately is essential to
understand the financial status and performance of a business.

Financial statements are reporting instruments that provide a summary


of the accounting data of an organization’s business pertaining to a
specific accounting period.

There are a number of techniques of financial statement analysis. The


selection of appropriate technique generally depends upon the purpose
of the analysis. The commonly used techniques are:

 Comparative Financial statements


 Common Size Statements
 Trend Analysis
 Ratio Analysis
 Fund Flow and Cash Flow Analysis

The analysis of the financial statements and interpretations of financial


results of a particular period of operations with the help of 'ratio' is
termed as "ratio analysis."

Ratio analysis is one of the popular tools of financial statement analysis.


This analysis aims to reduce the large number of data to relatively a
small number with relevant and meaningful information.

Ratio analysis is used to determine the financial soundness of a


business concern.

Alexander Wall designed a system of ratio analysis and presented it in a


useful form in the year 1909.

Meaning and Definition:

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.

Ratio Analysis is the relationship between two terms of financial data


expressed in the form of ratios and then interpreted with a view to
evaluating the financial condition and performance of a firm.

According to J. Batty, Ratio can be defined as "the term accounting ratio


is used to describe significant relationships which exist between figures
shown in a balance sheet and profit and loss account in a budgetary
control system or any other part of the accounting management."

Ratio can be used in the form of

(1) Percentage ( e.g.20%)


(2) Quotient (say 10) and

(3) Rates.

In other words,

It can be expressed as a to b; a: b (a is to b) or as a simple fraction,


integer and decimal.

A ratio is calculated by dividing one item or figure by another item or


figure.

Interpretation of Ratios:

One of the most difficult problems is the interpretation and analysis of


ratios. An adequate financial analysis involves more than an
understanding and interpretation of each individual ratio.

An analysis requires insights into the meaning of inter-relationships


among the ratios and financial data into the statements. Gaining such
insight and understanding requires considerable experience in the
analysis of financial statements.

The listed factors need due consideration before analyzing and


concluding on any financial ratios for any firm.

 General economic condition of the firm.

 Risk Acceptances.

 Future expectations.

 Future opportunities.

 Accounting system of the industry.


 Analysis and interpretation system.

The interpretation of the ratios can be made by comparing them


with:

 Previous figures: Trend Analysis

 Similar firms: Inter-firm comparison

 Targets: individual ratio set to meet the objectives.

Students, let’s now look into various objectives of ratio analysis.

Objective of Ratio Analysis:

The main objective of analyzing financial statement with the help of


ratios is:

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.

Advantages of Ratio Analysis:

Ratio analysis is necessary to establish the relationship between two


accounting figures to highlight the significant information to the
management or users who can analyze the business situation and to
monitor their performance in a meaningful way.
The advantages of ratio analysis are listed herewith:

(1) It facilitates the accounting information to be summarized and


simplified in a required form.

(2) It highlights the inter-relationship between the facts and figures of


various segments of business.

(3) Ratio analysis helps to remove all type of wastages and


inefficiencies.

(4) It provides necessary information to the management to take prompt


decision relating to the business.

(5) It helps to the management for effectively discharging its functions


such as planning, organizing, controlling, directing and forecasting.

(6) Ratio analysis reveals profitable and unprofitable activities. Thus, the
management is able to concentrate on unprofitable activities and
consider to improve the efficiency.

(7) Ratio analysis is used as a measuring rod for effective control of


performance of its business activities.

(8) Ratios are an effective means of communicating and informing about


financial soundness of the business concern to the proprietors,
investors, creditors and other parties.

(9) Ratio analysis is an effective tool which is used for measuring the
operating the results of the enterprises.

(10) It facilitates control over the operation as well as resources of the


business.

(11) Effective co-operation can be achieved through ratio analysis.


(12) Ratio analysis provides all assistance to the management to fix
responsibilities.

(13) Ratio analysis helps to determine the performance of liquidity,


profitability and solvency position of the business concern.

Limitations of Ratio Analysis:

Ratio analysis is one of the important techniques of determining the


performance of financial strength and weaknesses of a firm.

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:

1. Ratio analysis is used on the basis of financial statements.


Number of limitations of financial statements may affect the
accuracy or quality of ratio analysis.

2. Ratio analysis heavily depends on quantitative facts and figures


and it ignores qualitative data limiting the accuracy.

3. Ratio analysis is a poor measure of a firm's performance due to


lack of adequate standards laid for ideal ratios.
4. It is not a substitute for analysis of financial statements. It is
merely used as a tool for measuring the performance of business
activities.

5. Ratio analysis clearly has some scope for window dressing.

6. It makes comparison of ratios between companies which is


questionable due to differences in methods of accounting operation
and financing.

1. Ratio analysis does not consider the change in price level, as


such; these ratios will not help in drawing meaningful inferences.

Classification of Ratios:

Ratios have been classified by different experts differently based on their


characteristics. Some authorities classify ratios on the basis of financial
statements or statements from which the financial figures are selected.
Accordingly the classification of ratios can be formed.

 Profit and Loss Ratios:

These ratios indicate the relationship between two such variables


which have been taken from the profit and loss account.

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

Salarie 5,00,00 5% 6,00,000 4.80% Salaries decline by


s 0 0.20% (2010 to
2011)

Sales 1 Cr. 1.25 Cr. Sales increase by


25%

You can easily from the example here that salaries for an
organization while comparing to sales have gone done by 0.20 %.

 Balance Sheet Ratios:

Top management always wants to view the financial structure of


the company in terms of basic ratios of assets or liability categories
to total assets. This set of ratios attempts to express relationship
between two balance-sheet items.

eg: the ratio of owners’ equity to total equity:

Capital 2010 2011 Change


Share Capital 1,00,000 1,10,000 + 10%

Debt 50,000 60,000 + 20%

Debentures 10,000 12,000 + 20%

Total 1,60,000 1,82,000 + 13.75%

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.

 Inter-statement Ratios/Mixed Ratios:

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.

eg: Debtors’ turnover ratio, fixed assets turnover ratio.

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.

Another classification of ratios, developed by financial experts, is on the


basis of significance of ratios. Some ratios are considered more
important than others when ratios are evaluated in the light of the
objectives of the business. Accordingly listed two main groups of ratios
are covered under this classification.

 Primary Ratio:

Every commercial concern considers profit as its prime objective,


and therefore any ratio that relates to such objective is treated as a
primary ratio. The ratios covered by this category are return on
capital, gross margin to sales, etc.

 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.

Ratios are also classified according to financial characteristic they


describe. Accordingly, the listed classifications of ratio are made:

 Liquidity Ratios;

 Leverage Ratios;

 Profitability Ratios and

 Activity Ratios

The classification on the basis of characteristic is simple to calculate


and easy to understand as compared to other classifications
discussed in this session. Therefore, this classification is always
preferred by the financial analysts to evaluate the business
performance.

Students, analysis of these ratios could be also of various types. Let’s


briefly also learn about them.

Analysis or Interpretations of Ratios:

The analysis or interpretations in question may be of various types. The


approaches are listed herewith

(a) Interpretation or Analysis of an Individual (or) Single ratio.

(b) Interpretation or Analysis by referring to a group of ratios.

(c) Interpretation or Analysis of ratios by trend.


(d) Interpretations or Analysis by inter-firm comparison.

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.

Principles of Ratio Selection:

The principles listed herewith should be considered before


selecting the ratio:

(1) Ratio should be logically inter-related.

(2) Artificial ratios should be avoided.

(3) Ratio must measure a material factor of business.

(4) Cost of obtaining information should be borne in mind.

(5) Ratio should be in minimum numbers.

(6) Ratio should facilitate comparison.

FINANCIAL STATEMENT ANALYSIS

Understanding the financial statements of a firm is critical since it


is often the only source of information with which we must make
investment decisions; i.e., whether or not to loan the company money or
invest some equity. There is a rationale behind the construction of the
financial statements that help us to interpret the information that is
contained within them.
Income Statements:

Revenues

Less: Cost of Goods Sold Manufacturing

Gross Profit

Less: Salaries

Advertising

Rent Selling & Administrative

Depreciation

Utilities

Operating Income
Less: Interest Expense Finance

Taxable Income
Less: Taxes Government (Tax
accounting)

Net Income

The income statement is broken down by functional area. This


allows us to more accurately determine where our strengths or
weaknesses lie.

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.

Cash Accounts Payable


Marketable Securities Wages Payable
Accounts Receivable Bank Note Payable
Inventory Current Portion of L-T Debt
Prepaid Expenses

Total Current Assets Total Current Liabilities

Plant & Equipment Long-Term Debt

(Accumulated Depr.) Common Stock

Net Plant & Equip. Retained Earnings


Total Assets Total Liabilities & Equity

Statement of Cash Flows:

From a financial perspective, the Statement of Cash Flows is the


most important financial statement because it integrates the Income
Statement and Balance sheet while adjusting the accounting figures
based upon accrual accounting into actual cash flow.

From Operations:
Net Income

Plus: Depreciation

Plus: Amortization

Operating Cash Flow

Plus: Changes in Non-Cash Current Assets

Plus: Changes in Operations-related Current Liabilities

Total From Operations

From Investing Activities:

Changes In Gross Fixed Assets

Plus: Changes in Other Non-Current Assets

Total From Investing Activities

From Financing Activities:

Changes in Non-Operations-related current liabilities

Plus: Changes in Long-Term Debt

Plus: Changes in Other Capital Accounts

(except Retained Earnings)

Less: Dividends Paid


Total From Financing Activities

Total Change in Cash

Plus: Beginning Cash Balance

Ending Cash Balance

COMMON SIZE INCOME STATEMENTS:

All Items Expressed as a Percentage of Revenues.

COMMON SIZE BALANCE SHEETS

All Accounts Expressed as a Percentage of Total Assets.

What’s the purpose of calculating Common-Sized statements?


(Comparison purposes.)

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:

Liquidity ratios are designed to measure the extent to which our


short-term, or liquid, assets exist to cover our short-term obligations.
While most ratios have definitions that vary (and, hence, one must be
certain that the appropriate definition is being used for comparison
purposes), the definition of the Current Ratio is standard:

Total Current Assets


Current Ratio =
Total Current Liabilities

The current ratio is looking at those assets that are expected to be


converted into cash within one year, relative to those liabilities that come
due within a year. A more stringent measure is the Quick (or Acid Test)
Ratio. This ratio recognizes that some current assets are more liquid
than others.
While the book defines the quick ratio’s numerator as being the Current
Assets less Inventories, the general definition used in practice excludes
other current assets that are not liquid in nature, such as prepaid
expenses. The idea behind excluding inventories is twofold: first,
inventories are generally illiquid and can only be converted into cash by
selling at steep discounts. Secondly, most companies sell inventories on
credit, so they become an account receivable which must then be
collected. By excluding inventories, the quick ratio is therefore
recognizing the fact that they are one step further removed from
becoming cash than other current assets.
Monetary Current Assets
Quick (Acid Test ) Ratio =
Total Current Liabilities

FINANCIAL LEVERAGE:

The next set of financial ratios is designed to examine the extent to


which a company utilizes debt in the financing of its assets. The use of
debt is referred to as financial leverage. First, let’s look at the effect of
financial leverage on a firm. Consider a company that has three
different possible debt financing strategies, ranging from no debt to 90%
debt. Also, let’s assume that the interest rate on any debt employed is
10% and that the firm has a tax rate of 40%.

Interest Rate = 10%


Tax Rate = 40%

1 2 3
=== === ===
DEBT 0 500 900

EQUITY 1,000 500 100

-------- -------- --------

TOTAL ASSETS 1,000 1,000 1,000

Since the effect of financing doesn’t appear until we go below the


Operating Income (EBIT) line, we can jump straight down to the
operating income to analyze the effect of financial leverage. Assume
that the EBIT is $140 for the firm; then, the calculation of Net Income,
and the rate of return that the Net Income represents on the equity
invested, are as follows:

EBIT 140 140 140

- INT 0 (50) (90)


-------- -------- --------

TAX. INC. 140 90 50

- TAX (56) (36) (20)

-------- -------- --------

NET INCOME 84 54 30

ROE = 8.4% 10.8% 30.0%

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.

Leverage, however, is a two-edged sword. Not only are profits


magnified, but also losses. Consider the same firm when EBIT is only
$60:

1 2 3
=== === ===
DEBT 0 500 900

EQUITY 1,000 500 100

-------- -------- --------

TOTAL ASSETS 1,000 1,000 1,000


EBIT 60 60 60

- INT 0 (50) (90)

-------- -------- --------

TAX. INC. 60 10 (30)

- TAX (24) (4) 12

-------- -------- --------

NET INCOME 36 6 (18)

ROE = 3.6% 1.2% -18.0%

Now the use of debt results in lower profitability. Financial leverage


magnifies both profits and losses – in other words, it magnifies the risk of
the company. Financial leverage will be looked at in more detail later.
For now, a basic understanding of the effect of leverage is sufficient; but
let’s look at some of the ratios designed to measure the extent to which
a company utilizes debt, and just how well it can manage its debt.

Leverage (Solvency) Ratios:

The Debt-to-Assets Ratio looks at how much of a company’s


assets are financed with debt; i.e., other people’s money.

Total Debt
Debt / Asset Ratio =
Total Assets

A variation on the Debt-to-Asset Ratio that is more commonly used


in practice is the Debt-to-Equity Ratio which simply expresses the debt
as a percentage of equity rather than total assets. The two measures
are equivalent as indicated by the second part of the equation:

Total Liabilities
Debt/Equity Ratio =
Net Worth

D/A
=
1 - D/A

Sometimes it is desirable to break down the use of debt into short-term


and long-term debt. Which type of debt do you think is more risky for the
company to utilize? (To answer this, ask yourself whether you would
prefer to buy a house using a one-year note that would have to be
refinanced in twelve months, or a 30-year mortgage.)

Total Current Liabilities


Current Liabs. to Net Worth =
Net Worth

Just as in accounting where changes in current liabilities are


included as a part of operating cash flows (since accounts payable and
accruals such as wages payable arise from operations), sometimes only
the long-term portions of debt are considered. This is because
oftentimes a company is viable in the long-run but faces short-term
liquidity problems (consider when the Democrats and Republicans shut
down the federal government for a few days in 1997). The capitalization
ratio looks at the long-term debt financing that a company uses:

Long - term Debt


Capitalization Ratio =
Long - term Capital

While short-term solvency is obviously important, the long-term aspects


are relevant for long-term debt/investment considerations.

While the preceding measures of the extent to which a company


uses debt to finance its assets are important, what is probably of more
concern is the ability of the company to service its debt. The following
ratios look at the ability of the company to make debt service payments
to its creditors. The most common of these, particularly when only the
financial statements are available, is the Times Interest Earned ratio:

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).

EBIT + Depreciation & Amortization


Cash Coverage =
Interest Expense

EBITDA
=
Interest Expense

Asset Management (Utilization) Ratios:

Asset utilization ratios are designed to give insight into how


effectively a company is managing its assets. For many firms,
inventories are its largest category of assets. Why is it bad to have too
much inventory? Why is it bad to have too little? One way to look at the
amount of assets that a firm holds in relation to its level of sales is the
inventory turnover ratio:
Cost Of Goods Sold
Inventory Turnover =
Inventory

The inventory turnover ratio can, alternatively, be stated as the Average


Age of Inventory; i.e., how long on average does an inventory item sit in
the warehouse before it is sold:

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

The final major category of assets, particularly manufacturing


firms, is that of Property, Plant & Equipment, or Fixed Assets. The Fixed
Asset Turnover ratio looks at the amount of productive equipment that a
firm has, relative to the amount of sales that it is generating. In one
sense, this could be interpreted as a measure of the amount of capacity
utilization that a firm has. What problems do you see with this measure?

Sales
Fixed Asset Turnover =
Net Fixed Assets

A final measure looks at all of the firm’s investment in assets


relative to its sales level. This is the Total Asset Turnover ratio:

Sales
Total Asset Turnover =
Total Assets
Profitability Ratios:

One of the best measures for evaluating management lies in their


ability to control costs. Thus, profit margins are an important means of
assessing this ability:

Gross Profit
Gross Profit Margin =
Sales

Operating Income
Operating Profit Margin =
Sales

Net Income
Net Profit Margin =
Sales

Another important factor has to do with the amount of profit being


made relative to the investment in assets that support the operations
and sales. Note that this ratio can be decomposed into the Net Profit
Margin and the Total Asset Turnover. This has two important
implications: First, it illustrates that there are two ways to make money –
have a high profit margin and a low turnover rate, or a low profit margin
and a high turnover rate. Secondly, it provides us a means by which to
determine where problems, or strengths, reside.

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

= Net Profit Margin * Total Asset Turnover

Net Income Sales


= *
Sales 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:

The last group of ratios is designed to look at market-related


measures of performance:

Net Income
Earnings per Share (Basic) =
Total No. of Shares Outstanding
Net Income
Earnings per Share (Fully Diluted) =
Total Possible Shares Outstanding

Market Price/ share


Price/ Earnings Ratio =
Earnings per Share
or

P Div. / Earn.
=
E kS - g

Another Liquidity Measure:

One problem with the Current and Quick Ratios as measures of


liquidity is the fact that they are predicated upon the liquidation of the
current assets of the firm in order to satisfy the short-term liabilities.
Generally, however, one is not interested in liquidating a firm in order to
cover its short-term obligations (except in extreme cases). For this
reason, the cash cycle is often looked at in order to see the extent to
which the ongoing operations of the firm cover short-term requirements
(primarily in the area of accruals and payables). In order to calculate the
cash cycle, we need to look at a measure of the short-term liability
encompassed by the trade credit that our supplier provide to us:

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

While a short cash cycle is considered to be an efficient use of


money, what are the dangers to have:

1) A low average age of inventory


2) A short average collection period
3) A long average payables period

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

Accounting Ratios are classified on the basis of the different parties


interested in making use of the ratios.

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:

(1) Classification of Ratios on the basis of Balance Sheet.

(2) Classification of Ratios on the basis of Profit and Loss Account.

(3) Classification of Ratios on the basis of Mixed Statement (or) Balance


Sheet and Profit and Loss Account.

This classification further grouped in to:

I. Liquidity Ratios.

II. Profitability Ratios.

III. Turnover Ratios.

IV. Solvency Ratios.

Financial health of the organisation is determined basically on four


parameters viz. liquidity, solvency, profitability and turnover.

Before going ahead about learning about ratios. Let us first learn about
the concept we just discussed.

1. Liquidity:

Liquidity is the term used to describe how easily assets can be


converted into cash. It also explains how easily organisation can pay
its short- term liability with the help of its liquid assets.
Liquidity is the relationship between current asset and current liability.
Suppose you have borrowed Rs. 1000 from your friend and you are
expected to pay it within 2 months.
If you are able to pay this amount within the stipulated period from
your operational activities, then we can say that you are enjoying
good liquidity position. But if you have to sell out one of your assets to
pay the dues than you are certainly facing liquidity problem.

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

Profitability is the organisation’s ability to generate earnings as


compared to its expenses and other relevant costs incurred during a
specific period of time. It is the strength of the business to earn profit
from the given resources.
Students, let us now take our discussion towards application of
various ratios as per classification.

Liquidity Ratios

Liquidity Ratios are also termed as Short-Term Solvency Ratios. The


term liquidity means the extent of quick convertibility of assets in to
money for paying obligation of short-term nature.

Accordingly, liquidity ratios are useful in obtaining an indication of a


firm's ability to meet its current liabilities, but it does not reveal how
effectively the cash resources can be managed.

To measure the liquidity of a firm, the listed ratios are commonly used:

(1) Current Ratio.

(2) Quick Ratio (or) Acid Test or Liquid Ratio.

(3) Absolute Liquid Ratio (or) Cash Position Ratio

Current Ratio

Current Ratio establishes the relationship between current Assets and


current Liabilities. It attempts to measure the ability of a firm to meet its
current obligations. It is calculated as

Current Ratio= Total Current Assets / Total Current Liabilities

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

1. Cash in Hand 1. Sundry Creditors


2. Cash at Bank 2. Bills payable
3. Sundry Debtors 3. Short term advances
4. Bills Receivables 4. Outstanding or Accrued
5. Short term securities Expenses
6. Stock of raw material, work 5. Bank Overdraft
in progress and Finished 6. Unpaid or Unclaimed
goods dividend.

Interpretation of Current Ratio:

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

Current Assets (CA) Rs5,00,000 Rs. 2,00,000

Current Liabilities (CL) Rs. 2,50,000 Rs. 1,50,000

Current Ratio (CA/CL) 2:1 1.33:1

In this example we can see a current ratio of Company A is better than


of B. However the analysis would drastically change with change in
nature of current asset or current liabilities for organisation.

Quick Ratio (or) Acid Test or Liquid Ratio


Quick Ratio also termed as Acid Test or Liquid Ratio. It is supplementary
to the current ratio. The acid test ratio is a more severe and stringent test
of a firm's ability to pay its short-term obligations 'as and when they
become due. Quick Ratio establishes the relationship between the quick
assets and current liabilities.

In order to compute this ratio, the presented formula is used

Quick Ratio= Current Asset- (Inventory+ Prepaid Expenses)/ Total current liabilities

The ideal Quick Ratio of 1: 1 is considered to be satisfactory. High Acid


Test Ratio is an indication that the firm has relatively better position to
meet its current obligation in time. On the other hand, a low value of
quick ratio exhibiting that the firm's liquidity position is not good.

Absolute Liquid Ratio:

This ratio established the relationship between the absolute liquid assets
and current liabilities.

Absolute Liquid Assets include cash in hand, cash at bank, and


marketable securities or temporary investments.

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

Let us now discuss more about profitability ratios

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.

Profitability Ratio is used to measure the overall efficiency or


performance of a business. Generally, a large number of ratios can also
be used for determining the profitability as the same is related to sales or
investments.

The listed important profitability ratios are discussed below:

1. Gross Profit Ratio.


2. Operating Ratio.
3. Operating Profit Ratio.
4. Net Profit Ratio.
5. Return on Investment Ratio.
6. Return on Capital Employed Ratio.
7. Earning Per Share Ratio.
8. Dividend Payout Ratio.
9. Dividend Yield Ratio.
10.Price Earning Ratio.
11. Net Profit to Net Worth Ratio.

Gross Profit Ratio.

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

Gross Profit = Sales – Cost of goods sold

Net Sales= Gross Sales- Sales Return

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.

Operating Ratio= Operating Profit / Net Sales *100

Operating Profit = Net Sales – Operative Cost or Gross Profit – Operating


Expenses

Net Sales= Gross Sales- Sales Return

Net Profit Ratio.

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 measure of profitability and liquidity of business and


highlights operational efficiency facilitating decision making for
organisations. It is also an important tool for investment evaluation.

Return on Investment Ratio.

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

This ratio highlights the success of business from owners perspectives


measuring income for them against their investments in the business.

Earning Per Share Ratio.

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.

This ratio highlights the relationship between payment of dividend on


equity share capital and the profits available after meeting tax and
preference dividend. This ratio indicates the dividend policy adopted by
the top management about utilisation of divisible profit to pay dividend or
to retain or both. The ratio, thus, can be calculated as :

Dividend Payout Ratio= Equity Dividend / Net Profit after taxes *100

Or

Dividend Payout Ratio= Dividend per equity share / EPS * 100

Dividend Yield Ratio.

Dividend Yield Ratio indicates the relationship is established between


dividend per share and market value per share. This ratio is a major
factor that determines the dividend income from the investors' point of
view. It can be calculated by the listed formula :

Dividend Yield Ratio= Dividend per share /Market Value per share *100

Price Earning Ratio.

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

Let us now discuss more about Turnover ratios

Turnover Ratios highlight the different aspect of financial statement to


satisfy the requirements of different parties interested in the business. It
also indicates the effectiveness with which different assets are vitalized
in a business. Turnover means the number of times assets are
converted or turned over into sales. The activity ratios indicate the rate at
which different assets are turned over.
Depending upon the purpose, the listed turnover ratios can be
calculated:

 Inventory Ratio or Stock Turnover Ratio (Stock Velocity)

Inventory means stock of raw materials, working in progress and finished


goods. This ratio is used to measure whether the investment in stock in
trade is effectively utilised or not.
It reveals the relationship between sales and cost of goods sold Stock
Turnover Ratio indicates the number of times the stock has been turned
over in business during a particular period.

Stock Turnover Ratio = Cost of goods sold / Average Inventory at Cost

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses –


Closing Stock

Average Stock= Opening Stock + Closing Stock / 2


o This ratio indicates whether investment in stock in trade is
efficiently used or not.
o This ratio highlights the operational efficiency of the business
concern.
o This ratio is helpful in evaluating the stock utilisation.
o It measures the relationship between the sales and the stock
in trade.
o This ratio indicates the number of times the inventories have
been turned over in business during a particular period.

 Debtor's Turnover Ratio or Receivable Turnover Ratio


(Debtor's Velocity)

Receivables and Debtors represent the uncollected portion of credit


sales. Debtor's Velocity indicates the number of times the receivables
are turned over in business during a particular period. In other words, it
represents how quickly the debtors are converted into cash. It is used to
measure the liquidity position of a concern. This ratio establishes the
relationship between receivables and sales

Debtors Turnover Ratio= Net Credit Sales / Average Receivables or

Debtors Turnover Ratio= Total Sales / Accounts Receivables

Net Credit Sales= Total Sales – ( Cash Sales + Sales Return)

Accounts Receivables= Sundry Debtors + Bills Recievables

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.

Creditor's Turnover Ratio or Payable Turnover Ratio (Creditor's


Velocity)

The Term Accounts Payable or Trade Creditors include sundry creditors


and bills payable. This ratio establishes the relationship between the net
credit purchases and the average trade creditors. The ratio indicates the
number of times with which the payment is made to the supplier in
respect of ratio analysis.

Creditors Turnover Ratio= Net Credit Purchases / Average A/Cs Payable

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.

Working Capital Turnover Ratio

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.

Working Capital Turnover Ratio= Net Sales / Working Capital

Net Sales= Gross Sales – Sales Return

Working Capital= Current Assets – Current Liabilities


It is an ratio to know whether the working capital has been effectively
utilised or not in making sales. A higher working capital turnover ratio
indicates efficient utilisation of working capital and vice versa.

Fixed Assets Turnover Ratio

This ratio indicates the efficiency of assets management. Fixed Assets


Turnover Ratio is used to measure the utilisation of fixed assets. Higher
the ratio highlights a firm has successfully utilised the fixed assets. If the
ratio is depressed, it indicates the under utilisation of fixed assets.

Fixed Assets Turnover Ratio= Cost of Goods Sold / Total Fixed Assets

Or

Fixed Assets Turnover Ratio= Sales / Net Fixed Assets

Capital Turnover Ratio.

This ratio measures the efficiency of capital utilisation in the business.

Capital Turnover Ratio= Cost of Sales / Capital Employed

 Capital Employed= Shareholders Fund+ Long term loan or Total


Assets – Current Liabilities

Students, Lets now focus our discussion on Solvency Ratios

Solvency Ratio indicates the sound financial position of a concern to


S
carry on its business smoothly and meet its all obligations. The important
solvency ratios are listed herewith

Debt - Equity Ratio


This ratio is calculated to ascertain the firm's obligations to creditors in
relation to funds invested by the owners. The ideal Debt Equity Ratio is
1: 1. This ratio also indicates all external liabilities to owner recorded
claims.

Debt Equity Ratio= Outsiders Funds / Shareholders Fund

This ratio indicates the proportion of owner's stake in the business.


Excessive liabilities tend to cause insolvency. This ratio also tells the
S
extent to which the firm depends upon outsiders for its existence.

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.

Proprietary Ratio= Shareholders Fund / Total Assets

Shareholders Fund= Equity + Preference Capital + All Reserves and


Surpluses

Total Assets= Tangible Assets + Intangible Assets + Current Assets

This ratio is used to determine the financial stability of the concern in


S
general. Proprietary Ratio indicates the share of owners in the total
assets of the company. It serves as an indicator to the creditors who can
find out the proportion of shareholders' funds in the total assets
employed in the business. A higher proprietary ratio indicates relatively
little secure position in the event of solvency of a concern. A lower ratio
indicates greater risk to the creditors. A ratio below 0.5 is alarming for
the creditors.
Capital Gearing Ratio
The term capital gearing refers to describe the relationship between
fixed interest and/or fixed dividend bearing securities and the equity
shareholders' fund. It can be calculated as shown herewith:

Capital Gearing Ratio= Equity Share Capital / Fixed Interest Bearing


Securities

A high capital gearing ratio indicates a company is having large funds


bearing fixed interest and/or fixed dividend as compared to equity share
capital. A low capital gearing ratio represents preference share capital
and other fixed interest bearing loans are less than equity share capital.

Debt Service Ratio


This ratio establishes the relationship between the amount of net profit
before deduction of interest and tax and the fixed interest charges. It is
used as a yardstick for the lenders to know the business concern will be
able to pay its interest periodically. It is also known as Interest Coverage
Ratio.

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.

Types of Activity Ratios:


Now let us study these ratios one by one

1. Inventory Turnover Ratio:

Inventory turnover ratio or stock turnover ratio establishes relationship


between the cost of goods sold during the year and the average
inventory held during the year by the firm. It is calculated as:

Inventory Turnover Ratio= Cost of goods sold/ Average


inventory

Where,

Cost of Goods sold= Opening Stock+ Purchase- Closing stock

Which is also= Net sales – Gross Profit

And Average inventory= Opening stock+ Closing stock/ 2

Two points are worth discussing about this formula:


1. The denominator is the cost of goods sold i.e. net sales- gross
profit and not the net sales. This is because the inventory account
is carried at cost and it must be compared with the other figures at
cost level only. However, in case the value of cost of goods sold is
not available, then it may be replaced by the amount of net sales.
2. The average stock may be taken as the average of yearly opening
and closing stock. However, in case the firm is dealing in seasonal
goods, then the average require the monthly data which is
generally not available in usual published financial statements.

Now let us take an example to understand this ratio better:

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

Here average inventory= Opening+ closing stock/ 2

Which = 400000+500000/2 = 450000

And cost of Goods Sold= Net sales- Gross profit

Which = 2400000-600000 = 1800000

Therefore Inventory Turnover Ratio= Cost of Goods sold/ Average stock

Which= 1800000/450000 i.e. 4 times

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. .

Friends the concept of inventory turnover can be expended to find out


the number of days of inventory holding which is calculated as:

Inventory velocity= 365/ I/T ratio where 365 represents days in the year.
In our example where I/T ratio is 4 times

Inventory velocity= 365/4= Approx 90 days

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.

II. Receivables Turnover Ratio/ Debtors turnover Ratio: A firm’s


credit sales results into debtors and bills receivables. These debtors take
certain time to pay the dues. This time taken by the debtors for payment
of dues affects liquidity of the firm.
D/T ratio measures the speed with which debtors pay their dues at
the same time it also throws light on the collection policy and credit
policy of the firm. So this ratio establishes relationship between credit
sales and average debtors, hence this ratio is calculated as:

Receivable Turnover Ratio= Annual Net Credit Sales/ Average


Receivables

Now let us take a simple example to understand this ratio.

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.

Debtors Turnover Ratio= Total Credit Sales/ Avg. Debtors

Which = 1600000/320000 = 5 times

Here Avg Debtors= opening + closing debtor/2

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.

III. Payable/ Creditors Turnover Ratio: The payable ratio is


calculated on the similar lines with that of R/T ratio.
This ratio establishes relationship between total annual credit
purchases and average opening and closing balance of creditors. It is
calculated as:

Payable Turnover Ratio= Annual Net Credit Purchases/ Average


Payables

Again let us take an example to elaborate this concept.

Example 3:

Suppose a firm makes a total credit purchase of Rs. 10 lakhs in a


year and opening and closing creditors are Rs. 1 lakh and 160000
respectively. Now the

Payable turnover ratio= 1000000/ 130000 = 7.70 times approx.

Its velocity ratio in this case = 365/7.7 = 47.4 days

This means that creditors are paid within 47 days approximately or in


other words creditors are paid 7.7 times in a year.

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.

Now let us move to the next turnover ratio.

IV. Working Capital Turnover Ratio: working capital is the capital


required by the business for running its day to day business activity. It
is in the form of current asset viz. stock, debtors, bank balance and
cash. Working capital in the form of current asset is termed as gross
working capital and when current asset is deducted from current
liabilities what we get is net working capital. We will be leaning more
about working capital in out forthcoming units. Here what we need to
understand is how active the firm is in rotating its working capital in
the given period. It can be also said that WC turnover ratio calculates
how fast the firm converts its raw material into finished goods and
finished goods into sales and sales into cash. W.C. Turnover ratio is
calculated as:

W.C.T. Ratio= Annual Net Sales/ Average Working Capital

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?

Then WC= Current Asset – Current Liabilities

Which = 600000- 400000= 200000

Therefore WCT Ratio= 2400000/200000= 12 times

This means working capital turnovers 12 times in a year. To judge


whether the ratio is satisfactory or not, it should be either compared with
its own past ratios or with the ratio or similar enterprises in the same
industry or with the industry average. But generally higher the ratio
better is the turnover and profitability.

V. Other Activity ratios:


Friends, the activity ratios that we have discussed just now were
concerned with current asset and current liabilities. We can calculate
activity ratio by establishing relationship between fixed asset and sales
or total assets and sales. So these ratios are;

1. Fixed Asset Turnover Ratio: the objective behind calculating this


ratio is to determine the efficiency with which the fixed assets are
utilised. This ratio is calculated as

FATR= Net Sales/ Average Fixed Assets

Higher turnover ratio indicates efficient management and utilisation of


fixed asset. It may be noted that there is no direct relation between sales
and fixed asset. This is because sales does not just depend on the total
fixed asset invested in the business but it depends on the quality, price,
delivery terms, credit policy, after sales service, advertising etc. Yet this
ratio is calculated in order to understand how effectively the given fixed
assets are used to generate sales. Take an example to understand this:

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;

Fixed Asset= cost- depreciation

Which= 700000- 100000= 600000

FATR= 1800000/600000= 2 times.

To judge whether this ratio is satisfactory or not, it should be compared


with the own past ratios or with the ratio of similar enterprises in the
same industry or with the industry average. On this same lines we can
also establish relationship between total assets and sales. This ratio is
termed 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

TATR= Net Sales / Average tangible assets

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?

Then here total tangible asset = total asset- Goodwill

Which = 10000000-2806000= 7194000

So TATR= Net sales/ Total average tangible assets

Which= 6148000/7194000 = .85 times.

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:

3. Capital Turnover Ratio: the objective of computing this ratio is to


determine the efficiency with which the capital employed is utilised.
It is calculated as:

CTR= Net Sales/ Average Capital Employed

Where average capital employed is equal to the average of the


opening and closing balances of the capital employed. Friends, capital
employed means the total long term funds invested in the business.
Now, long term investment is made by the owner, in the form of capital
or in the form of long term borrowings. Therefore capital employed is
calculated by adding owner’s capital with long term liabilities. Again
there is no standard ratio for this turnover. The firm has to compare its
performance either on the basis of past trend or on the basis of
comparison with competitive firms belonging to the same industry.

liquidity refers to the maintenance of cash, bank balance and those


assets which are easily convertible into cash in order to meet the
short- term liabilities as and when they arise. So the liquidity ratio
studies the firm’s short term solvency and its ability to pay off the
liabilities. Suppose a firm has to pay the bills of its purchases, then
will it be an ideal situation if the firm has to sell its furniture or other
fixed asset to meet this liability? Obviously this is not a desirable
situation. The firm needs to pay its bills either from cash balance or
bank balance or by selling its inventory or by collecting cash from
debtors i.e. customers.
Friends in other words firm should have sufficient current asset to
meet its current liabilities. The Liquidity Ratios provide a quick
measure of liquidity of the firm by establishing a relationship between
the current assets and its current liabilities. If a firm does not have
sufficient liquidity, it may not be in a position to meet its commitments
and thereby may lose its credit worthiness. The liquidity ratios are
also called the ‘Balance- Sheet Ratios’ because the information
required for the calculation of liquidity ratio is available in the Balance-
Sheet only.

Friends, there are three commonly used liquidity ratios

LIQUIDITY RATIOS

Now let us study each type in detail:

1. Current Ratio: it is the most common and popular measure of


studying the liquidity of a firm it is calculated as;

Current Ratio= Total Current Assets/ Total Current Liabilities


Now let us understand what we mean by current assets or the
balance- sheet elements included in Current Assets:
Current Assets include cash, bank balance, inventory, debtors,
prepaid expenses, marketable securities and short term
investment. In short all those assets that tend to be converted into
cash within one year falls under current assets. Similarly current
liabilities include bills payable, trade creditors, unclaimed dividend,
bank overdraft, outstanding expenses, provision for tax, proposed
dividend and accrued interest etc. in other words all those liabilities
that have to be paid within one year fall under current liabilities.
Now take an example of different proportion of current assets and
current liabilities.
Example 1:
Situation 1 Situation 2

Current Assets (CA) Rs500000 Rs. 200000

Current Liabilities (CL) Rs. 250000 Rs. 150000

Current Ratio (CA/CL) 2:1 1.33:1

In this example two situations of different current ratios are given in


situation 1 the current ratio is 2: 1 whereas in situation no. 2 current ratio
is 1.33:1. What do these ratios suggest? Then it can be said that in
situation no.1 there are 2 current assets after every 1 current liability.
That is the current liabilities can be easily met from the current assets,
whereas in situation no.2 current assets and current liabilities are almost
same i.e. there is a barely difference of .33. Which situation would you
call an ideal situation? Then I am sure you would say that situation 1 is
better than situation 2. Friends ideally current ratio should be 2:1 i.e.
after every 1 part of liability there has to be 2 part of current asset.
Now there is a slight twist in this concept. We just now agreed that
situation 1 is better than situation 2. But if we go slightly in deep and
consider components of current assets in both the situations, then our
interpretation may change. In situation 1 current assets are worth Rs. 5
lakh, now if I say that out of these current assets obsolete inventory or
stock of goods is worth Rs. 3 lakh, then our results would change
drastically. This is because in current ratio we do not consider exact
composition of current assets. In order to overcome this limitation we
use our next liquidity ratio i.e. Quick Ratio.

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.

Generally a quick ratio of 1:1 is considered to be satisfactory because


this means that the quick assets of the firm are just equal to the quick
liabilities and there does not seem to be a possibility of default in
payment by the firm. The Quick Ratio is considered to be a better test of
liquidity than the Current Ratio. However, friends, quick ratio is itself not
a conclusive test of liquidity. The inventories which have been ignored in
Quick Ratio may not always be illiquid as well as the receivables and
marketable securities which are considered to be liquid may not always
be liquid. Therefore, a firm having a quick ratio of 1:1 or even more may
still face problems in meeting the commitments if the liquid assets are
consisting of slow paying or defaulting customers. In order to overcome
this limitation we use our next liquidity ratio i.e. Absolute Liquidity Ratio.

3. Absolute Liquidity Ratio: This ratio is also known as ‘Super-


Quick Ratio’ or ‘Cash Ratio’ or ‘Cash Reservoir ratio’. In Quick
Ratio we had considered debtors and bills receivable as elements
of current assets. But there is every possibility that debtors may
not fulfill their dues in time or they may be defaulters in such a
case creditors are interested in knowing Absolute Liquidity ratio of
the firm. This ratio considers only the absolute liquidity available
with the firm. The cash and bank balance are no doubt, the most
liquid assets and the marketable securities are also considered as
highly liquid asset. The absolute liquidity ratio is calculated as;

Absolute Liquidity Ratio= Cash+ Bank+ Marketable Securities/ Total Current


liabilities
Friends, the cash ratio of 1:2 may be considered as satisfactory in other
words one part of liquid asset against 2 parts of current liability is a safe
ratio. It is also essential for the firm to not maintain too much of supper
liquid assets this is because the funds would remain unnecessarily
blocked in the form of cash and bank which may adversely affect
profitability of the firm as cash and bank are most nonproductive assets.
Moreover, every firm has a reserve borrowing capacity. The firm can
borrow for a short period from the banks or other sources to meet any
contingency. Therefore, it is not the cash ratio which is relevant, but what
is more important is the total cash reservoir which includes the reserve
borrowing capacity also.

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.
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Introduction to Cash Flow Statement
Academic Script

INTRODUCTION

Users of financial statements evaluate the ability of an entity to


generate cash and cash equivalents and the timing and
certainty of their generation. Information about the cash flows
of an entity is useful in providing users with a basis to assess
the ability of the entity to generate cash and cash equivalents
and the needs of the entity to utilize those cash flows.

A statement of cash flows, when used in conjunction with the


rest of the financial statements, provides information that
enables users to evaluate the changes in net assets of an
entity, its financial 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 AND CASH EQUIVALENTS:

Cash flow statement provides an analysis of changes in cash


and cash equivalents; it is important to understand what
constitutes cash and cash equivalents.

Cash:

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 short-term, highly liquid investments,


that are readily convertible to known amounts of cash and are
subject to an insignificant risk of changes in value.

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:

Bank borrowings are generally considered to be financial


activities. However, bank overdrafts, which are repayable on
demand, form an integral part of an entity’s cash management.
In these circumstances, bank overdrafts are included as a
component of cash and cash equivalents. A characteristic of
such banking arrangements is that the bank balance often
fluctuates from being positive to overdrawn.

Cash flows exclude movements between items that constitute


cash or cash equivalents because those components are part of
the cash management of an entity rather than part of its
operating, investing and financial activities. Cash management
includes the investment of excess cash in cash equivalents.

CLASSFICATION OF ACTIVITIES:

The model prescribed in IAS 7 classifies cash flows into three


categories. Cash flow from:
,,
a. Operating activities;
b. Investing activities; and
c. Financing activities.

The classification is presented in table below:

Classification of Activities

Origin of cash flow Description

Operating Activities Principal revenue producing activities of an entity.


They generally include the transactions and other
events that enter into determination of net income.

Investing Activities Activities related to capital expenditure, inter-


corporate investments and acquisitions. Receipt of
interest and dividend are investment activities.
Disposal of non-current assets is included in
investment activities.

Financing Activities Financial activities related to transactions and


activities that change the capital structure. In
other words, they are transactions with financiers.

DIRECT AND INDIRECT METHODS:

IAS 7 prescribes two alternative formats – direct method and


indirect method –for presentation of cash flow. The key
difference in these two methods lies in their presentation of
Cash Flows from operating activities. In the direct method,
operating cash receipts and payments are reported directly. In
the indirect method, cash flows from operating activities are
reported by way of adjustments of net profit of the reporting
periods shown in the profit and loss account. Users prefer the
indirect method because it establishes linkage between the
cash flow statement, the balance sheet, and the profit and loss
account. SEBI requires companies listed in Indian Stock
Exchanges to use the indirect method to present the statement
of cash flows. A firm that uses the direct method in presenting
,,
the statement of cash flows provides reconciliation between the
reported net profit and the change in cash balance during the
reporting period.

CASH FLOWS FROM OPERATING ACTIVITIES:

1. Nature of Operating Cash Flows:


Cash flow from operating activities is primarily derived
from the principal revenue-producing activities of the firm.
Therefore, they generally result from the transactions and
the other events that enter into the determination of net
profit or loss. In other words, cash flow measures the
amount of cash generated or used by the firm in
producing and selling goods and services.
Examples of cash flows from operating activities are:
1. Cash receipts from the sale of goods and the rendering
of services.
2. Cash receipts from royalties, fees, commissions and
other revenues.
3. Cash payments to suppliers from goods and services.
4. Cash payments to and on behalf of employees.
5. Cash receipts and cash payments of an insurance
enterprise for premiums and claims, annuities and
other policy benefits.
6. Cash payments or refunds of income taxes, unless they
can be specifically identified with financial and investing
activities.
7. Cash receipts and payments relating to future
contracts, forward contacts, option contracts and swap
contracts when the contracts are held for dealing or
trading purposes.

Gain or Loss from sale of non-current assets:


Some transactions (e.g. the sale of an item of non-current
assets) give rise to a gain or loss which is included in the
determination of net profit or loss. However, the cash
,,
flows relating to such transactions are cash flows from
investing activities. An example of such a transaction is
the sale of an item of property, plant and equipment.

Purchase and sale of dealing or trading securities:


An enterprise may hold securities and loans for dealing or
trading purposes, in which case they are similar to
inventory acquired specifically for resale. Therefore, cash
flows arising from the purchase and sale of dealing or
trading securities are classified as operating activities.
Similarly, cash advances and loans made by financial
enterprises are usually classified as operating activities
since they relate to the main revenue producing activity of
that enterprise.

Interest and Dividends:


Interest paid and interest and dividends received are
usually classified as operating cash flows for a financial
institution. However, there is no consensus on the
classification of these cash flows for other entities.
Interest paid and interest received may be classified as
operating cash flows because they enter into the
determination of profit or loss. Alternatively, interest paid
may be classified as financing cash flows because it
represents the cost of obtaining debt capital (financial
resource); and interest received may be classified as
investing cash flows because it represents returns on
investments.
Dividends received may be classified as investing cash
flows because they represent returns on investments.
Alternatively, they may be classified as operating cash
flows because they enter into the determination of profit
or loss.
Dividends paid may be classified as financing cash flows
because they represent transaction with providers of
equity capital. Alternatively, dividends paid may be
,,
classified as a component of cash flows from operating
activities in order to assist users in determining the ability
of a enterprise to pay dividends out of its operating cash
flows.

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.

METHOD FOR CALCULATING OPERATING CASH FLOWS:


For calculating cash flows from operating activities, we have
considered interest and dividends received as cash flows from
investment activities and interest and dividends paid as cash
flows from financing activities.
Depreciation is non-cash expense because it is the allocation of
the cost of PP&E to the current period. Therefore, depreciation
has no cash flow implication.
Deferred tax has no cash flow implication. Cash outflow on
account of income tax is the amount actually paid to the
revenue department during the current period.
The same result should be obtained if indirect method is used
to calculate cash flows from the operating activities.

Box 1: Increase or Decrease in Working Capital.


Increase in current assets reduces the cash flow from
operations while increase in current liabilities increases the
cash flow from operations. Similarly, decrease in current assets
increases the cash flow from operations, while decrease in
current liabilities decreases the cash flow from operations.
Therefore, if a firm earns large profit, but in the process builds
large investories (in an effort to compete on speed) and
receivables (with sales to marginal customers), its cash flow
from operating activities should be much lower than the net
,,
profit reported in the profit and loss account. This creates
pressure on liquidity and adversely affects the operation of the
firm.

CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES


1. Nature of investing Cash Flows:
Investing activities are the acquisition and disposal of
long-term assets and other investments not included in
cash equivalents.
Cash flows from investing activities represent the extent
to which expenditures have been made for resources
intended to generate future income and cash flows. Only
expenditures that result in a recognized asset in the
balance sheet are eligible for classification as investing
activities. Examples of cash flows arising from investing
activities are:
1. Cash payments to acquire fixed assets and other long-
term assets.
2. Cash receipts from sales of fixed assets and other long-
term assets.
3 .Cash payments to acquire equity or debt instruments of
other entities and interests in joint ventures.
4. Cash receipts from sales of equity or debt instruments
of other entities and interests in joint ventures.
5 .Cash advances and loans made to other parties (other
than advances and loans made by a financial institution).
6. Cash receipts from the repayment of advances and
loans made to other parties (other than advances and
loans of financial institution).
1. Cash payments for future contracts, forward contracts,
option contracts and swap contracts except when the
contracts are held for dealing on trading purposes or
payments.

2. Nature of Financial Cash Flows:


,,
Financial activities are activities that result in changes in
the size and compositions of the contributed equity and
borrowings of the firm.
The separate disclosure of cash flows arising from
financial activities is useful in predicting claims on future
cash flows by providers of capital to the firm. Examples of
cash flows arising from financial activities are:
1. Cash proceeds from issuing shares or other equity
instruments.
2. Cash payments to owners to acquire or redeem the
company’s share.
3. Cash proceeds from issuing debentures, loans, bonds,
mortgages and other short-term or long-term borrowings.
4. Cash repayments of amount borrowed.
5. Cash payments by a lessee for the reduction of the
outstanding liability relating to a finance lease.

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:

Cash flows arising from transactions in a foreign currency are


recorded in a firm’s functional currency by translating the
foreign currency amount into the functional currency using the
exchange rate at the date of the cash flow. Cash flows of a
,,
foreign subsidiary should be translated using the exchange
rates prevailing at the date of the cash flows.

For practical reasons, a company may apply a rate (e.g.


weighted average rate for the period) that approximates the
actual rate.

Direct Method:

When a company enters into a transaction denominated in


foreign currency, there are no cash flow consequences until
payments are received or paid. The receipts and payments are
recorded in the accounting records of the company at the
exchange rate prevailing at the date of payment and these
amounts are reflected in the statement of cash flows.

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:

Where the exchange differences relate to operating items such


as sales or purchases of inventory by the firm, no adjustment
is to be made while calculating cash flows from operating
activities using the indirect method. For example, if a sale
transaction takes place during the period when the transaction
occurred, the net profit includes both the amount recorded at
the date of sale and the exchange difference on settlement.
Therefore, the net profit is based on the cash flow arising from
the sale transaction. If the settlement takes place in a period
subsequent to the period in which the transaction occurred, net
profit includes exchange difference arising from the transaction
of the receivables at the closing rate. However, no adjustment
is required because the increase or decrease in the amount of
,,
receivables during the period is adjusted to determine the cash
flows from operating activities for the period. The increase or
decrease in receivables includes the exchange difference.

Determining the value of non-operating cash flows:

Adjustment to net profit is required for exchange difference


arising from settlement or translation (at the closing rate) of a
transaction relating to non-operating cash flows. An example of
non-operating cash flow is cash flow relating to purchase of an
item of property, plant and equipment. The adjustment is
required because the net profit includes the exchange
difference while the amount of investment recorded initially is
not adjusted to the cash flow relating to the purchase of the
item of the PP&E. This cash flow should be included in cash
flows from investing activities.

Exchange difference relating to cash and cash equivalents:

The effect of exchange rate movements on foreign currency


cash and cash equivalents is not a cash flow. However, it is
necessary to include those exchange differences in the
statement of cash flows in order to reconcile the movement in
cash and cash equivalents to the corresponding amounts
presented in the balance sheet at the beginning and at the
close of the period. The exchange difference is presented as a
footnote to the statement of cash flows.

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.

Cash flow is analyzed from investing activities to understand


the company’s strategy for long-term growth. A company may
achieve growth either through mergers and acquisitions, or
through investment in new assets (Projects). Analysis of cash
flow from investing activities also provides an insight into the
company’s strategy for spin-off and disinvestment and its
ability to manage surplus cash.

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
financial 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.
Application of Cash Flow Statement

Academic Script

INTRODUCTION

Users of Financing statements evaluate the ability of an entity to


generate cash and cash equivalents and the timing and certainty of their
generation. Information about the cash flows of an entity is useful in
providing users with a basis to assess the ability of the entity to generate
cash and cash equivalents and the needs of the entity to utilize those
cash flows.

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 AND CASH EQUIVALENTS:

Cash flow statement provides an analysis of changes in cash and cash


equivalents; it is important to understand what constitutes cash and cash
equivalents.
Cash:

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 short-term, highly liquid investments, that are


readily convertible to known amounts of cash and are subject to an
insignificant risk of changes in value.

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:

Bank borrowings are generally considered to be Financingactivities.


However, bank overdrafts, which are repayable on demand, form an
integral part of an entity’s cash management. In these circumstances,
bank overdrafts are included as a component of cash and cash
equivalents. A characteristic of such banking arrangements is that the
bank balance often fluctuates from being positive to overdrawn.
Cash flows exclude movements between items that constitute cash or
cash equivalents because those components are part of the cash
management of an entity rather than part of its operating, investing and
Financing activities. Cash management includes the investment of
excess cash in cash equivalents.

CLASSFICATION OF ACTIVITIES:

The model prescribed in IAS 7 classifies cash flows into three


categories. Cash flow from:

a. Operating activities;
b. Investing activities; and
c. Financing activities.

The classification is presented in table below:

Classification of Activities

Origin of cash flow Description

Operating Principal revenue producing activities of an entity.


Activities They generally include the transactions and other
events that enter into determination of net
income.

Investing Activities Activities related to capital expenditure, inter-


corporate investments and acquisitions. Receipt
of interest and dividend are investment activities.
Disposal of non-current assets is included in
investment activities.
Financing Financing activities related to transactions and
Activities activities that change the capital structure. In
other words, they are transactions with financiers.

DIRECT AND INDIRECT METHODS:

IAS 3 prescribes two alternative formats – direct method and indirect


method –for presentation of cash flow. The key difference in these two
methods lies in their presentation of Cash Flows from operating
activities. In the direct method, operating cash receipts and payments
are reported directly. In the indirect method, cash flows from operating
activities are reported by way of adjustments of net profit of the reporting
periods shown in the profit and loss account. Users prefer the indirect
method because it establishes linkage between the cash flow statement,
the balance sheet, and the profit and loss account. SEBI requires
companies listed in Indian Stock Exchanges to use the indirect method
to present the statement of cash flows. A firm that uses the direct
method in presenting the statement of cash flows provides reconciliation
between the reported net profit and the change in cash balance during
the reporting period.

CASH FLOWS FROM OPERATING ACTIVITIES:

1. Nature of Operating Cash Flows:


Cash flow from operating activities is primarily derived from the
principal revenue-producing activities of the firm. Therefore, they
generally result from the transactions and the other events that
enter into the determination of net profit or loss. In other words,
cash flow measures the amount of cash generated or used by the
firm in producing and selling goods and services.
Examples of cash flows from operating activities are:
1. Cash receipts from the sale of goods and the rendering of
services.
2. Cash receipts from royalties, fees, commissions and other
revenues.
3. Cash payments to suppliers from goods and services.
4. Cash payments to and on behalf of employees.
5. Cash receipts and cash payments of an insurance enterprise
for premiums and claims, annuities and other policy benefits.
6. Cash payments or refunds of income taxes, unless they can be
specifically identified with Financing and investing activities.
7. Cash receipts and payments relating to future contracts,
forward contacts, option contracts and swap contracts when the
contracts are held for dealing or trading purposes.

Gain or Loss from sale of non-current assets:


Some transactions (e.g. the sale of an item of non-current assets)
give rise to a gain or loss which is included in the determination of
net profit or loss. However, the cash flows relating to such
transactions are cash flows from investing activities. An example
of such a transaction is the sale of an item of property, plant and
equipment.

Purchase and sale of dealing or trading securities:


An enterprise may hold securities and loans for dealing or trading
purposes, in which case they are similar to inventory acquired
specifically for resale. Therefore, cash flows arising from the
purchase and sale of dealing or trading securities are classified as
operating activities. Similarly, cash advances and loans made by
Financing enterprises are usually classified as operating activities
since they relate to the main revenue producing activity of that
enterprise.

Interest and Dividends:


Interest paid and interest and dividends received are usually
classified as operating cash flows for a Financing institution.
However, there is no consensus on the classification of these cash
flows for other entities.
Interest paid and interest received may be classified as operating
cash flows because they enter into the determination of profit or
loss. Alternatively, interest paid may be classified as financing
cash flows because it represents the cost of obtaining debt capital
(Financing resource); and interest received may be classified as
investing cash flows because it represents returns on investments.
Dividends received may be classified as investing cash flows
because they represent returns on investments. Alternatively, they
may be classified as operating cash flows because they enter into
the determination of profit or loss.
Dividends paid may be classified as financing cash flows because
they represent transaction with providers of equity capital.
Alternatively, dividends paid may be classified as a component of
cash flows from operating activities in order to assist users in
determining the ability of a enterprise to pay dividends out of its
operating cash flows.
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.

METHOD FOR CALCULATING OPERATING CASH FLOWS:


For calculating cash flows from operating activities, we have considered
interest and dividends received as cash flows from investment activities
and interest and dividends paid as cash flows from financing activities.
Depreciation is non-cash expense because it is the allocation of the cost
of PP&E to the current period. Therefore, depreciation has no cash flow
implication.
Deferred tax has no cash flow implication. Cash outflow on account of
income tax is the amount actually paid to the revenue department during
the current period.
The same result should be obtained if indirect method is used to
calculate cash flows from the operating activities.

Box 1: Increase or Decrease in Working Capital.


Increase in current assets reduces the cash flow from operations while
increase in current liabilities increases the cash flow from operations.
Similarly, decrease in current assets increases the cash flow from
operations, while decrease in current liabilities decreases the cash flow
from operations. Therefore, if a firm earns large profit, but in the process
builds large inventories (in an effort to compete on speed) and
receivables (with sales to marginal customers), its cash flow from
operating activities should be much lower than the net profit reported in
the profit and loss account. This creates pressure on liquidity and
adversely affects the operation of the firm.

CASH FLOWS FROM INVESTING AND FINANCING ACTIVITIES


1. Nature of investing Cash Flows:
Investing activities are the acquisition and disposal of long-term
assets and other investments not included in cash equivalents.
Cash flows from investing activities represent the extent to which
expenditures have been made for resources intended to generate
future income and cash flows. Only expenditures that result in a
recognized asset in the balance sheet are eligible for classification
as investing activities. Examples of cash flows arising from
investing activities are:
1. Cash payments to acquire fixed assets and other long-term
assets.
2. Cash receipts from sales of fixed assets and other long-term
assets.
3 .Cash payments to acquire equity or debt instruments of other
entities and interests in joint ventures.
4. Cash receipts from sales of equity or debt instruments of other
entities and interests in joint ventures.
5 .Cash advances and loans made to other parties (other than
advances and loans made by a Financing institution).
6. Cash receipts from the repayment of advances and loans made
to other parties (other than advances and loans of Financing
institution).
6. Cash payments for future contracts, forward contracts, option
contracts and swap contracts except when the contracts are held
for dealing on trading purposes or payments.
7. Nature of Financing Cash Flows:
Financing activities are activities that result in changes in the size
and compositions of the contributed equity and borrowings of the
firm. The separate disclosure of cash flows arising from Financing
activities is useful in predicting claims on future cash flows by
providers of capital to the firm. Examples of cash flows arising
from financing activities are:
1. Cash proceeds from issuing shares or other equity instruments.
2. Cash payments to owners to acquire or redeem the company’s share.
3. Cash proceeds from issuing debentures, loans, bonds, mortgages
and other short-term or long-term borrowings.
4. Cash repayments of amount borrowed.
5. Cash payments by a lessee for the reduction of the outstanding
liability relating to a finance lease.

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:

Cash flows arising from transactions in a foreign currency are recorded


in a firm’s functional currency by translating the foreign currency amount
into the functional currency using the exchange rate at the date of the
cash flow. Cash flows of a foreign subsidiary should be translated using
the exchange rates prevailing at the date of the cash flows.

For practical reasons, a company may apply a rate (e.g. weighted


average rate for the period) that approximates the actual rate.

Direct Method:

When a company enters into a transaction denominated in foreign


currency, there are no cash flow consequences until payments are
received or paid. The receipts and payments are recorded in the
accounting records of the company at the exchange rate prevailing at
the date of payment and these amounts are reflected in the statement of
cash flows.

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:

Where the exchange differences relate to operating items such as sales


or purchases of inventory by the firm, no adjustment is to be made while
calculating cash flows from operating activities using the indirect
method. For example, if a sale transaction takes place during the period
when the transaction occurred, the net profit includes both the amount
recorded at the date of sale and the exchange difference on settlement.
Therefore, the net profit is based on the cash flow arising from the sale
transaction. If the settlement takes place in a period subsequent to the
period in which the transaction occurred, net profit includes exchange
difference arising from the transaction of the receivables at the closing
rate. However, no adjustment is required because the increase or
decrease in the amount of receivables during the period is adjusted to
determine the cash flows from operating activities for the period. The
increase or decrease in receivables includes the exchange difference.

Determining the value of non-operating cash flows:

Adjustment to net profit is required for exchange difference arising from


settlement or translation (at the closing rate) of a transaction relating to
non-operating cash flows. An example of non-operating cash flow is
cash flow relating to purchase of an item of property, plant and
equipment. The adjustment is required because the net profit includes
the exchange difference while the amount of investment recorded
initially is not adjusted to the cash flow relating to the purchase of the
item of the PP&E. This cash flow should be included in cash flows from
investing activities.
Exchange difference relating to cash and cash equivalents:

The effect of exchange rate movements on foreign currency cash and


cash equivalents is not a cash flow. However, it is necessary to include
those exchange differences in the statement of cash flows in order to
reconcile the movement in cash and cash equivalents to the
corresponding amounts presented in the balance sheet at the beginning
and at the close of the period. The exchange difference is presented as
a footnote to the statement of cash flows.

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.

Cash flow is analyzed from investing activities to understand the


company’s strategy for long-term growth. A company may achieve
growth either through mergers and acquisitions, or through investment in
new assets (Projects). Analysis of cash flow from investing activities also
provides an insight into the company’s strategy for spin-off and
disinvestment and its ability to manage surplus cash.

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.

The summarized balance-sheet for X-ltd is giving below, we will prepare


cash flow statement using the information.

Liabilities 2015 2016 Assets 2015 2016

Share capital 400000 500000 Building 400000 380000

General 100000 120000 Machinery 300000 338000


reserve

Profit & Loss 61000 61200 Stock 200000 148000


account

Bank Loan 140000 - Debtors 160000 128400

Creditors 300000 270400 Cash 1000 1200

Provision for 60000 70000 Bank 26000


taxation

Total 1061000 1021600 Total 1061000 1021600

Additional Information:

1. Dividend of Rs. 46000 was paid during the year.


2. Machinery purchased for Rs.66000
3. Depreciation written off on machinery Rs. 24000 and building
Rs.20000
4. Loss on sale of machinery was Rs. 400
Students, firstly we will calculate funds from operations with the
help of Adjusted Profit and Loss Account. Next we will find out
hidden information with the help of respective accounts. And lastly
we will prepare cash flow statement showing cash from different
sources viz. operating activities, financing activities and investing
activities.

Adjusted Profit and Loss Account

Particulars Rs Particulars Rs

To bal c/f 61200 By bal b/d 61000

To depreciation on 24000 By fund from 180600


machinery operations(bal
figure)

To depreciation on build. 20000

To dividend paid 46000

To Loss on sale of machine 400

To Prov. For tax 70000

To Transfer to Gen. Res. 20000

241600 241600
Machinery Account

Particulars Rs Particulars Rs

To bal b/d 300000 By depreciation 24000

To purchase 66000 By loss on sale 400

By sale (bal. fig) 3600

By bal c/f 338000

366000 366000

As far as building account is concerned, it opening and closing balances


matches with the depreciation amount and therefore there is no need to
draw a separate building account. So now let us directly draw a Cash
Flow statement

Cash Flow Statement

Particulars Rs Rs

Cash flow from operating activities

Funds from operations 180600

Add decrease in Stock 52000


Add decrease in debtors 31600

Less decrease in creditors (29600)

Less tax paid (60000) (6000)

Cash from operating activities 174600

Cash Flow from Investing activities

Purchase of Machinery (66000)

Sale of machinery 3600

Cash used in investing activities (62400)

Cash flow from Financing Activities

Payment of interim dividend (46000)

Payment of Loan (140000)

Issue of Shares 100000

Cash used in financing activities (86000)

Net increase in cash/ Bank 26200

Add opening balance of cash 1000

Cash and Bank bal (Closing) 27200

(26000 + 1200)

This entire exercise is to trace the movement of cash and cash


equivalents. In our example we were interested to know how cash
moved from the financial year 2015 to 2016. In other words how did the
cash balance of Rs. 1000 in 2015 change to Rs27200 in the financial
year 2016.

From our Cash Flow Statement we have calculated have cash has flown
in operating activities, investing and financing activities.

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