Ch 2 and Ch. 3 Basic Theory and Final Accounts

Ch. 1 Accounting Concepts and ConventionsCh.2 Basic accounting terminologies, Classification of accounts Journal, Subsidiary books, Ledger.Ch.3 Secondary books-Ledger, Trial balance, Final accounts of Sole traders

Book-keepingThe term book keeping refers to maintaining of books of accounts. A transaction means an act of exchange of things or services between the two parties. Book keeping is concerned only with monetary transactions. Books of accounts is a book which is maintained to record day to day business transactions.

Definitions:According to J. R. Batliboy “Book keeping is the art of recording business dealings in a set of books”.Book keeping is a systematic method of recording the financial transactions in the books of accounts.

Objectives:1. Book keeping is a permanent record and provides the necessary and reliable

information. 2. In enables a trader to ascertain what he owes to others and what others owe

to him, the value of various classes of property and the profit earned and the loss sustained in business.

3. Book keeping is essential to meet the requirements of the certain laws like the Bankruptcy Act, Income Tax Act, Sales tax etc.

4. To know the profits or loss suffered by the business.5. To know the cash in hand and cash at bank at any time.

Accountancy:Definition: The American Institute of Certified Public Accounts has defined accounting as “the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the results thereof”.

Distinction between Book keeping and Accountancy:Book Keeping AccountancyConcerned with only recording of business transactions in the

Concerned with the preparations of the financial statements from the

subsidiary books book keeping records.Includes journalizing, posting, totaling and balancing of various accounts

Includes making of adjustments, rectification of errors, preparation of trading and profit and loss account and balance sheet, etc.

Repetitive type of work Needs sufficient knowledge of accounting principles and imaginations.

Basic Accounting Terminologies:

1. Transactions: An act of exchange the things or services between two parties is called transaction. The transactions are classified as Monetary and Non-monetary. The transactions in which money (Cash/Cheque ) is used as a medium of exchange of goods and services are called monetary transactions. Only monetary transactions are recorded in the books of accounts.The transactions which are not using money as a medium of exchange are called non monetary transactions. Eg. Barter system.The transaction relating to business are called Business transactions which are divided as cash and credit transactions.

2. Cash Transactions: Cash transactions are those transactions in which payment or receipt of cash/cheque is involved at the time of effecting transactions.

3. Credit Transaction: In case of credit transaction cash/cheque is not paid at the time of effecting the transaction but for payment some time is allowed. If in a transaction, the name of person/trader is given and no mention is made, whether it is a cash or credit transaction, it is to be treated as credit transaction.

4. Debit: The receiving aspect is known as Debit. It is abbreviated as Dr. Debit is derived from the Latin word Debitur which means Debtor. The left hand side of an account is called as debit side. The amount recorded on the left hand side is called debit (Dr). Debit balance means the total of Debit side is greater than the total of Credit side of an account.5. Credit: The giving aspect is known as Credit. It is abbreviated as Cr. Credit is derived from the Latin word Credere which means Creditor. The right hand side of an account is called as credit side. The amount recorded on the right hand side is called credits (Cr). Credit balance means the total of Credit side is greater than the total of Debit side of an account.6. Goods: The term goods mean the things, articles, products, merchandise, etc in

which a trader trades. The term purchases , sales, purchase return and sales return are related to goods.

7. Stock: The balance of unsold/unused goods lying in the business is called stock or inventory. The stock at the beginning of certain period is called opening stock and the stock at the closing of certain period is called closing stock. The

last years closing stock is a next years opening stock. Stock is having debit balance. Closing stock is always valued at cost or market price whichever is less.

8. Assets: The term assets mean the total possessions of business. An asset is any right or thing that is owned by a business. It is valuable resources owned by a business which have been acquired at measurable money cost. Assets include land, buildings, equipment and anything else a business owns that can be given a value in money terms for the purpose of financial reporting. All the assets are having debit balance. The assets are classified as Fixed assets, Current assets, Investment and Other assets.

Fixed Assets/ Long Term Assets: The assets which are purchased or acquired by the business to increase the productivity and not for resale such as building, plant and machinery, land etc are termed as fixed assets. A fixed asset is an asset of a business intended for continuing use. A "fixed asset" is an asset which is intended to be of a permanent nature and which is used by the business to provide the capability to conduct its trade. Fixed assets must be classified in a company's balance sheet as Tangible and Intangible,

"Tangible Fixed Assets" means the assets which have a physical existence and generate goods and services and are shown net of depreciation. It include plant & machinery, land & buildings, furniture, fixtures and fittings, motor vehicles and IT equipment. They are shown in the balance sheet in accordance with the cost concept , at the cost at what they are purchased. The cost of these assets is allocated divided over their useful life. On these assets yearly depreciation is charged i.e. reduction in the value of the assets due to its wear and tear which is shown by way of deduction from the respective cost of the asset in the balance sheet. Salvage or residual value means the amount realized by the sale of the discarded asset at the end of its useful life.

"Intangible Fixed Assets" reflect the exclusive rights of the firm. Intangible fixed assets do not generate goods and services directly. Intangible assets are those fixed assets which cannot be seen or touched or felt. They are not necessarily valueless. These assets confer certain exclusive rights on their owners. Intangible assets are also written off over a period of time. The written off balance is transferred to profit and loss account debit side. It

include goodwill, patents, trademarks, copyrights and brands - although they may only be included if they have been "acquired". Goodwill is the reputation, brand, image of the company/firm. Patents confer exclusive rights to use an invention; Copyrights relate to production and sale of literary, music and artistic works; Trade mark represent exclusive rights to use certain name , symbols, labels, designs etc.

Fictitious Assets: are valueless assets (useless trade marks) or expenses treated as assets like preliminary expenses.

Preliminary expenses means the expenses which are incurred to establish a company/ expenses incurred at the time of formation of company.Investments: Investment represents funds in the securities of another company. The investment may be short term (less than a year) and long term marketable securities. The purpose of investment is either to earn a return/interest/profit or and to control another company. Investments are shown in the balance sheet at lower of the cost or the market price. Market value is shown in the parenthesis.

Current Assets/ Short Term Assets/ Floating Assets: Current assets are short term in nature. It refers to the assets which either held in the form of cash or are expected to be realized in cash within one year. Current assets are also called as liquid assets (except stock). Current assets are those that form part of the circulating capital of a business. They are replaced frequently or converted into cash during the course of trading in a short period. The most common current assets are inventory/ stock, trade debtors, bills receivable, short term marketable securities and cash. Liquid assets are those current assets which are already in cash form or which can be readily converted into cash such as government securities etc.

9. Liabilities: The term represents the total amount payable by business to others. It is defined as the claims of outsiders against the firm. All the liabilities are having credit balance. of the firm. The liability may short term and long term. Long term liability means borrowings in the from banks, financial institutions or through bonds/debentures/mortgages for more than a year. Current or Short term liability means short term borrowing in the form of purchase of goods or services on credit for less than one year period. It includes

creditors, bills payable, tax payable, outstanding expenses, accounts payable, accured expenses and deferred income..

10.Contingent Liability: It is the liability which can not be treated as actual liability at present because it depends upon happening or not happening of certain events in future, whether it is a liability or not. It is shown by way of foot note to balance sheet on the liabilities simply as information.

11.Capital: What ever money or money’s worth a proprietor brings into his business from his private property is called capital in the business. Capital is a personal account. Capital is always have credit balance as owner is the giver of the capital.Assets – Liabilities = Capital

12.Drawings: If a proprietor uses business cash or business assets for his personal use, it is termed as drawings of the proprietor. Drawing is amount or goods withdrawn by the proprietor from the business for his personal use. It is always having debit balance as it is personal account and owner is the receiver.

13.Debtor: A person who owes something to the business is a debtor. Debtor is a person who receives services /purchases goods on credit from the business. Debtor is a current asset. Debtor account always has a debit balance as debtor is the receiver.

14.Creditor: A person from whom the business owes something is a creditor. He/she is a person who sells goods on credit or provides services on credit. Creditor is a current liability. It is always has credit balance as creditor is the giver.

15.Expenditure: means spending of money or incurred an obligation to pay at a later date. For expenses paid in cash or a promise to pay the money in the future.Expense means an expenditure whose benefit is enjoyed and finished immediately. For eg. Payment of wages , rent , salaries, lighting etc.

16.Capital Expenditure: Expenditure incurred in acquiring fixed assets like land, building, etc. for using them in business and not for resale. The cost of fixed assets includes all expenditure necessary up to the time the asset is ready for use. The capital expenditure signifies expenditure which increases quantity of fixed assets, results in the replacement of fixed assets and increase productivity. For example : purchase of long term /fixed assets, cost of stand by and servicing equipment, legal charges and stamp duty for acquisition of a property etc.

17.Revenue Expenditure: Any expenditure incurred for maintaining fixed assets in good working condition and for meeting the day to day expenses to carry the business is treated as revenue expenditure. Revenue expenditure are expenses which benefit one accounting year. Revenue expenses are occur in one accounting year and expensed/written off against the revenues of the same year.

They are recurring nature. For example: salaries, wages, rent, lighting, postage, stationery, obsolescence cost , depreciation , interest on loan etc.

18.Deferred Revenue Expenditure: The expenditure which provides benefits more than one accounting year know as deferred revenue expenditure. For example research and development expenditure, advertisement for launching new product etc.

19.Income: means receipt of cash or equivalent without it having to be returned to any one. Eg. Sales , commission received, interest received.

20.Voucher: is the written record and evidence of a transaction. 21.Cash Discount: Discount is nothing but the concession .In any business

purchases and sales of goods are required to be made on credit terms therefore to recover the amount from debtors in time cash discount is given. Cash discount is an allowance given on sales price to encourage prompt payment of cash. Cash discount appears in the books of account.

22.Trade discount: This discount is given by wholesaler to retailer. It is given on catalogue price/invoice price/price list. As this discount is allowed at the time of purchase or sale the value of good purchased or sold is recorded in the books after deducting the amount of trade discount from the invoice price. Therefore trade discount does not appear in the books of account.

23.Goodwill: Goodwill is defined as the benefit arising from reputation and named earned in the market. It is an extra value attached to an established business over and above the value of its tangible assets. It is an intangible asset. It is recorded on the asset side in the balance sheet.

24.Solvent person: A person whose assets are more than or equal to liabilities is called solvent person.

25.Insolvent person: A person whose liabilities are more than his assets are called insolvent.

26.Account: An account is a systematic and summarized record of all day to day business transactions relating to persons, items or things and income and expenses of the business. It is also called as ‘T’ form of account as it is divided into two parts the left hand side is called debit and right hand side is called credit side, the two sides are divided by a vertical line in between which looks alphabet ‘T’. An account is book keeping device to record increase and decrease in each specific asset or liability item.

27.Bad Debts: The amount which is not recoverable from debtors is called bad debts. It is a loss and has debit balance. It is debited to profit and loss account as it is a loss.

Accounting Concepts and Conventions:

Accounting concepts are basic assumptions or conditions on which the science of accounting is based. Accounting conventions includes those customs and traditions which guide the accountant while preparing the accounting statement.

1. Separate Entity Concept: This concept implies that a business unit is separate and distinct from the persons who are owners of business. This concept is necessary to know the effect of the each business transaction on the operation of business and not on the owners of business. According to this concept personal transactions cannot be mixed with business transactions.

2. Money Measurement Concept: If the results of operations of a business entity are to be properly accounted for, they need to be expressed and recorded in common units of measurement. For the purpose of accounting the common economic value of assets and liabilities is expressed in monetary terms rather than in any other physical dimension. Only monetary transactions are recorded in the books at the time they takes place.

3. Cost Concept: Under this concept the fixed assets are shown at cost price less depreciation and not at the realizable value. Due to this concept there remains consistency. If it is decided to record fixed assets at their present value it would become necessary to change the value practically every day and this would affect financial position and would introduce degree of instability in the accounts. In the case of current assets, the question of cost concept does not crop up as they are to be converted to cash with in a short period- their cost and present worth are nearly the same.

4. Consistency: According this convention, the policy once adopted should not generally be changed- it should be consistently, followed from one period to another. If there is inconsistency in the policies followed or the methods adopted in would render comparison of figures difficult and meaningless.

5. Conservatism: While recording business transactions the accountants follow the rule ‘Anticipate no profit but provide for all possible losses’. On this basis the stock is valued at cost or market price which ever is lower.

6. Going Concern Concept: According to this concept it is always presumed that the business is having a perpetual succession. It assumes that the business entity would continue to operate indefinitely. It has uninterrupted existence with continuing activity till such time it is legally liquidated. In the absence of this concept it would not be possible for anybody to enter into the contracts with the business organization.

7. Realization Concept: The concept answers the question as to when and how the revenue is recognized. Sales revenue is considered as recognized when sales are effected during the accounting period irrespective of the fact

whether cash is received or not. The realization concept revolves around the determination of the point of time when revenues are earned.

8. Accrual Concept: According to this concept the expenses accrued but not paid in cash as also revenues earned but not received in cash are also to be taken in to account. Only those revenues and those expenses are to be considered which relate to the period under consideration irrespective of the fact whether they are received or paid in cash or not.

9. Dual Aspect Concept: In each transaction there are two concepts, i.e. two fold effects are required to be recorded. Modern or double entry system of accounting is based on two aspects of every transaction. There is two fold effect for every transaction .In other words ‘every debit has corresponding credit and every credit has corresponding debit’.

10.Disclosure Convention: According to this convention, accounting report should fully and fairly disclose the information they intend to represent. They should be honestly prepared and should disclose all material information to proprietors, present and potential creditors and investors.

11.Materiality Convention: Materiality means ‘relative importance’. Materiality refers to what is significant and what is insignificant. It will not be worthwhile to record every minute detail in accounting as it will be cumbersome and uneconomical. The material concept essentially relates to the time, effort and cost of accounting in relation to usefulness of the data generated whether it would influence the decision of informed investors. Materiality of an item depends upon the amount and the nature of item.

Double Entry System:Every business transaction has two aspects i.e. receiving & giving. Thus for each transaction minimum two entries are required to be made and hence this system is termed as Double Entry System. The principle of double entry system is ‘Every Debit has a corresponding Credit & Every Credit has corresponding Debit.’Advantages of Double Entry System:1. From the balances of personal accounts it can be easily ascertained as to how

much a trader owes to others and how much others owe to him.2. The balances of real accounts show the value of properties possessed.3. The balances of nominal accounts indicate incomes, gains, expenses and

losses.4. A trial balance can be prepared by taking debit balances under one column

and credit balances under the other.5. From trial balance a trader can prepare a Trading and Profit & Loss A/c to

find out profit or loss and a Balance Sheet showing the financial position.6. Comparison of various items like purchases, sales etc. of the two different

years can be done to know the trends.7. Any errors made in recording the transaction can be easily traced.8. A possibility of fraud is reduced.

The manner of recording transactions in an account is

Asset Account Liability Account Capital Account Debit CreditIncrease Decrease

Expense Account Income Account Debit CreditIncrease Decrease

JOURNAL

Debit CreditDecrease IncreaseDebit Credit

Decrease Increase

Debit CreditDecrease Increase

JOURNAL is a book of prime entry/ Basic entry/ Original entry/ Trial entry/

Primary entry. This means that as soon as a transaction takes place, it is recorded

in the Journal. The transactions are first recorded in the journal in a chronological

(serial) order and then they are posted into the ledger. Journal is derived from

French word ‘Jour’ means Day. Journal serves the purpose of permanent

accounting record. However, to reduce the pressure on Journal, it is sub divided

into several subsidiary books which are also books of prime entry.

Journalising refers to the process of recording the transactions.

The following steps are involved in recording a transaction in Journal.

I. Identify the two aspects involved in a transaction: According to the

principle of double entry, every transaction has minimum two aspects. These

two aspects are the two accounts involved in the transaction. The first step in

recording a transaction in Journal is to identify these two aspects. The

following examples will clarify the point.

Goods purchased for cash: This transaction involves two aspects, i.e.

goods come in and cash goes out.

Goods sold for cash: The two aspects involved are goods are going

out and cash is coming in.

Goods purchased for credit: Here goods come in and the supplier from

whom they are purchased becomes a creditor as there is no outflow of

cash.

Deposited cash in the bank: Cash going out i.e. cash balance reduces

and bank balance increases are the two aspects of this transaction.

Business commenced with cash: In this transaction, cash comes in and

the proprietor who has invested the money becomes the creditor of the

business.

II] Identify the ‘Accounts’ affected in a transaction: As mentioned above, in

each and every transaction, there are minimum two aspects involved as per the

principle of the double entry. These aspects are called as ‘Accounts’. It is

necessary to identify the accounts involved in a transaction and thereafter the type

of accounts affected so that passing of a journal entry will be possible. The

identification of accounts affected in a transaction is illustrated in the following

illustration.

Illustration 1: From the following transactions, prepare a statement showing the

two aspects of each transaction and also the accounts affected in them.

i. A commenced business with his own cash.

ii. Opened an account in a bank and deposited amount in the same.

iii. Goods purchased for cash

iv. Purchased office furniture and paid the amount by cheque.

v. Paid for office expenses

vi. Paid for stationery

vii. Sold goods on credit to B

viii. Purchased goods on credit from C

ix. Withdrawn from bank for office use

x. Sold goods for cash

The following chart is made to show the aspects involved and the accounts affected

in each of the above transaction.

Sr.

No.

Transaction Aspects Involved Accounts

Affected

01 A commenced

business with his own

Cash comes in the Cash A/c

cash. business

Proprietor is the giver of

the cash

Capital

Account

of the

Proprietor

02 Opened an account in

a bank and deposited

amount in the same.

Bank balance increases

Cash balance decreases as

the cash goes out

Bank A/c

Cash A/c

03 Goods purchased for

cash

Goods come in

Cash goes out

Purchases

A/c *

Cash A/c

04 Purchased office

furniture and paid the

amount by cheque.

Furniture comes in

Bank balance is reduced

as the payment is made by

cheque

Furniture

A/c

Bank A/c

05 Paid for office

expenses

Office Expenses are

incurred

Cash is paid

Office

Expenses

A/c

Cash goes

out

06 Paid for stationery Stationery expenses are

incurred

Cash is paid

Stationery

A/c

Cash A/c

07 Sold goods on credit

to B

Goods go out

B becomes the debtor as

the amount is recoverable

from him in the future

Sales A/c

#

B’s A/c

08 Purchased goods on

credit from C

Goods come in

C becomes the creditor as

the amount is payable to

him

Purchases

A/c *

C’s A/c

09 Withdrawn from

bank for office use

Cash comes in

Balance at bank is reduced

Cash A/c

Bank A/c

10 Sold goods for cash Cash comes in

Goods go out

Cash A/c

Sales A/c

#

* In accounting, whenever any trading goods are purchased, the Purchases Account

is affected rather than Goods A/c. In fact the Purchases Account is for the

decentralization of the Goods Account. There are several transactions in a

business, which affect the goods. There are purchases, sales, purchases returns and

sales returns. If all these transactions are recorded through the Goods Account, it

will be extremely difficult to find out Purchases, Sales, Purchase Returns and Sales

Returns as all transactions connected with the goods account will be clubbed in this

account. Hence due to decentralization the burden on the Goods Account will be

reduced and so in case of trading goods purchases, the Purchases Account will be

affected. [Trading goods mean the goods in which the proprietor is trading, for

example, if a person is trading in stationery, purchase of stationery will be the

purchases of trading goods. On the other hand, if a stationery merchant is

purchasing furniture for his own shop, it will not be the purchases of trading goods

and hence in such cases the purchases account will not be affected.

# In case of sale of trading goods, the Sales Account is affected due to the reason

mentioned above.

III] Classification of Accounts/ Types of Accounts: For recording a journal

entry, it is necessary to decide the account to be debited and account to be credited.

For doing this, it is necessary to classify the accounts and then apply the rule for

debit and credit. Accounts are classified as shown in the following chart.

Account (A/C)

Personal Impersonal /Non – Personal

_______________________

Real & Nominal

Rules:1. For personal Accounts: Debit the receiver

Credit the giver2. For Real Accounts: Debit what comes in

Credit what goes out3. For Nominal Accounts: Debit Expenses and losses

Credit incomes and gains

A] Personal Accounts: These accounts include accounts of individuals, firms,

limited companies, banks, insurance companies, co-operative societies, educational

institutions etc.

Personal accounts deals with

a. Natural persons: means dealing with alive /real persons. Eg. Ram, Sunita,

Kamala, Bosh etc.

b. Artificial persons: It relates to corporate bodies, firms, companies,

institutions which have legal existence. Eg. Bajaj, Sinhgad institute, Tata,

KEM hospital , ABC firm etc.

c. Representative persons: It represents outstanding expenses (unpaid) and

accrued or prepaid expenses or income relating to persons. Eg. Outstanding

salaries, Outstanding rent, Prepaid insurance etc.

The Rule for debit and credit for a personal account is as follows.

“ Debit the Receiver and Credit the Giver”.

This means that the personal account which is receiving benefit should be debited

while the personal account which is giving the benefit should be credited.

Thus if cash is paid to A by a proprietor, A’s Account will be debited in the books

of the Proprietor while is cash is received from B, B’s account will be credited in

the books of the Proprietor.

B] Impersonal /Non Personal Accounts: It is not personal but related to goods, articles , expenses and incomes and profits or losses. As shown in the chart, these accounts are further sub divided into Real and Nominal. Both these types of accounts are discussed in the following paragraphs.

I] Real Account: Accounts relating to various classes of properties or things such as building, furniture, machinery, cash etc are called real accounts. The accounts of ‘Assets’ are included in this category. For example, accounts of assets like Land and Building, Plant and Machinery, Furniture, Vehicles, Electrical Fittings are included in the category of Real Accounts. Similarly accounts of intangible assets like Goodwill, Patents and Copyrights, Trade Marks also come in this category. The rule for debit and credit in this type of account is as follows.

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

This means that the asset coming in the business should be debited while the asset

going out should be credited. This if furniture is purchased by paying cash, the

furniture account will be debited as the furniture is coming in and cash account

should be credited as the cash is going out.

II] Nominal Account: All accounts other than Personal and Real are included in

this type. In other words, accounts of expenses and losses as well as accounts of

incomes and gains are included in the category of nominal accounts. For example,

accounts of salary, wages, printing and stationery, rent, discount allowed, trade

expenses, carriage inwards and outwards etc are nominal accounts as all of them

are expenses. On the other hand accounts like discount received, rent received,

interest received are also nominal accounts as they are transactions of income.

Similarly accounts of losses like loss on fire, loss due to fraud etc are also nominal

accounts. The rule of debit and credit in case of the nominal accounts is as follows.

“ Debit all expenses and losses and credit all incomes and gains.”

The classification of accounts and the application of rule of debit and credit is

shown in the following illustration.

Illustration: 2: From the following transactions, prepare a table showing the

accounts affected, the type of the account and the account to be debited and

credited with the reasons thereof.

i. B started business with own cash and also with furniture.

ii. Purchased goods and paid cash for the same.

iii. Opened an account with bank and deposited cash in the same.

iv. Paid for stationery.

v. Wages paid

vi. Sold goods to C on credit

vii. Purchased goods from Z on credit.

viii. Paid for carriage inwards

ix. Paid for sundry expenses

x. Sold goods for cash.

Solution: The following chart is prepared to show the required things in the same.

Sr.

No.

Accounts

Affected

Type of

Accounts

Debit

/

Credit

Reason

1 I] Cash Account

II] Furniture Account

III] B’s Capital

Account

Real

Real

Personal

Debit

Debit

Credit

Debit what comes in

Debit what comes in

Credit the giver

2 I] Purchases Account

II] Cash Account.

Nominal

Real

Debit

Credit

Debit all expenses &

losses

Credit what goes out

3 I] Bank’s Account

II] Cash Account

Personal

Real

Debit

Credit

Debit the receiver

Credit what goes out.

4 I] Stationery Account

II] Cash Account

Nominal

Real

Debit

Credit


losses


5 I] Wages Account

II] Cash Account

Nominal

Real

Debit

Credit


losses


6 I] C’s Account

II] Sales Account

Personal

Nominal

Debit

Credit

Debit the receiver

Credit all incomes &

gains.

7 I] Purchases Account

II] Z’s Account

Nominal

Personal

Debit

Credit


losses

Credit the giver

8 I] Carriage Inwards

Account

II] Cash Account

Nominal

Real

Debit

Credit


losses


9 I] Sundry Expenses

Account

II] Cash Account

Nominal

Real

Debit

Credit


losses


10 I] Cash Account

II] Sales Account

Real

Nominal

Debit

Credit

Debit what comes in

Credit all incomes &

gains

IV] Recording a Journal Entry: After deciding the account to be debited and

credited in a transaction, the nest step is to record the Journal Entry for that

transaction. A Journal entry is recorded in the following manner. The process of

recording the transaction in the journal is called journalizing.

Transaction: Salaries paid Rs.50000

Journal Entry:

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

01 Salaries Account – Dr.

To Cash A/c

[Being the salaries paid]

- 50,000

50,000

The following features of Journal can be noted from the above illustrative entry.

There are five columns for a Journal. The first column is for date of the

transaction. The second column is for writing the details of the transaction.

When transaction is written, the account, which is debited has to come first

and so Salaries Account which is debited comes first. To indicate that it is

debited, the word Dr [Approved short form for the word Debit] is written

against the Salaries Account. The account, which is credited in the

transaction comes below the account which is debited. Since it is implied

that when one account is debited the other one is credited, the word credit is

not written against the Cash Account. The next column is of L.F., which

indicates Ledger Folio. This is the page number of the Ledger on which each

of the two accounts, i.e. Salaries and Cash, appear. In the illustration this

column is kept blank since there is no mention of the Ledger Folio. The

remaining two columns are for writing the amount and the amount is to be

written against each of the two accounts in the appropriate column. This

means that as the Salaries account is debited, the amount is shown against

the account in the debit column and Cash account is credited so that the

amount is shown against it in the credit column. Amounts in debit and credit

columns are the same. A Journal entry is not completed without narration,

which is a brief explanation of the transaction. Narration is written in the

bracket below each Journal entry so that in the future easy reference of the

transaction can be find out. Though no particular format of narration is there,

it is to be written in brief and normally started with the works as either ‘For’

or ‘Being’.

After the period for which, the Journal is maintained is over, totals of the

Debit and Credit column are taken and then the Journal for that particular

period is closed.

Journal is a book of primary entry and after recording the transaction in a

Journal, the same is taken to the Ledger, which is the book of secondary

entry.

If all the transactions are recorded in Journal, the size of the same will be

unmanageable and any future references will be extremely difficult. To

overcome this difficulty, Journal is sub-divided into several books, which

are called as ‘Subsidiary Books’ and only those transactions, which cannot

be recorded in subsidiary books are recorded in Journal. This reduces the

burden on Journal to a great extent.

SUBSIDIARY BOOKS:

1. INTRODUCTION: In the previous chapter, we have discussed about the

principles and rules for passing a journal entry. The Journal is a book of

prime entry, which means that as soon as a transaction takes place, it is

recorded in the journal. However as the number of transactions is very large,

if all these transactions are recorded in a journal, the size of this book will be

unmanageable and any future reference will be extremely difficult.

Therefore to reduce the pressure on journal, it is divided into a number of

books, which are called as subsidiary books and depending on the nature of

a transaction, it is recorded in an appropriate book. Thus considerable

number of transactions is taken out of journal and only those transactions,

which cannot be recorded anywhere else due to their nature are recorded in

the journal. These subsidiary books are also books of prime entry and after

recording transactions in them, the transaction is posted in the ledger. The

various types of subsidiary books and the method of recording of

transactions in them are discussed in the following paragraphs.

2. VARIOUS SUBSIDIARY BOOKS: The following subsidiary books are

maintained for sub-dividing a journal.

Subsidiary Books

Purchase Book Sales Book Return Books Cash Book B/R Book B/P

Book

Purchase Return Sales Return

These books are discussed in detail in the following paragraphs.

A] Purchase Book: This book is maintained to record certain type of

transactions of Purchases of goods. The type of transactions are, purchases of

trading goods made on credit basis only are recorded in this book. Trading

goods mean the goods in which the firm or the proprietor is trading. Thus a

trader who is trading in ‘furniture’ will have ‘furniture’ as trading goods.

Similarly a trader who is trading in ‘stationery’ will have ‘stationery’ as trading

goods. But if a trader in stationery purchases furniture for his shop, the furniture

purchases will not be purchases of trading goods as he is not trading in

furniture. The other condition is that the purchases made on credit basis only

are recorded in the Purchase Book. Thus if there is a purchase of trading goods

for cash, it will not find place in the Purchase Book. It will be recorded in the

‘Cash Book’, which is also a subsidiary book. The format of Purchase Book is

as follows.

PURCHASE BOOK

Date Name of

Supplier

Description of

Goods

Invoice

Number

L.F. Amount

Rs.

Total xxx

The transactions are recorded in the Purchase Book date wise and at the end of

the month, the total of Purchase Book is taken. The total is then posted to the

ledger accounts ie. Purchases account debit side as “ To, sundries as per

purchase book”

B] Sales Book: In this book, the transactions of sales of trading goods made on

credit only are recorded. Thus it has similarity with the Purchase Book in the

sense only the transactions of sales of trading goods made on credit are

recorded in the Sales Book. In other words, if a transaction of sale is of non

trading goods or a transaction of sale of trading goods made for cash is not

recorded in the Sales Book. The format of Sales Book is given below.

SALES BOOK

Date Name of

Customer

Description of

Goods

Invoice

Number

L.F. Amount

Rs.

Total xxx

Like Purchase Book, the total of the Sales Book is taken at the end of a month and

posted to the Sales Account credit side as “By sundries as per Sales book”.

C] Purchase Return Book/ Return Outward Book: Sometimes, it may so

happen that the goods purchased from supplier are required to be returned to him.

This may be due to delivery of wrong quality or quantity, late delivery, goods

received in damaged condition and so on. The details of such goods returned to the

supplier are recorded in the Purchase Return Book, which is also called as Return

Outward Book. In transactions of return, the supplier is sent a ‘debit note’, which

means that his account is debited in the books of the firm/proprietor so that the

amount payable to him is reduced. The ‘debit note number’ is shown in the

Purchase Return Book. The format of this book is as follows.

PURCHASE RETURN BOOK

Date Name of Supplier

Description of Goods

Debit Note Number

L.F. Amount Rs.

Total xxx

The total of this book at the end of the month is taken and posted in the Purchase

Return account credit side as “ By, Sundries as per purchase return book”.

D] Sales Return Book/ Return Inward Book: This book is used to record the

transactions of return of goods made by the customer by the firm/proprietor.

Customers return goods due to several reasons like quality not as per the

specifications, delivery of either excess or less quantity than ordered, late delivery

etc. Customers are sent ‘Credit Note Number’ in such cases, which indicates that

their account is credited in the books of the firm and hence the amount receivable

from them is reduced. The number of the credit note is mentioned in the Sales

Return Book, which is also called as ‘Return Inward Book’. The format of this

book is given below.

SALES RETURN BOOK

Date Name of Customer

Description of Goods

Credit Note Number

L.F. Amount Rs.

Total xxx

The total of this book, which is taken at the end of the month, is posted to the Sales

Return account on the debit side as “ To, Sundries as per Sales return book.”

E] Cash Book/Cash Account: There are several cash transactions in a

business. There are several items of cash receipts and cash payments. All these

transactions are recorded in the book called as Cash Book. It is prepared to record

all transactions in cash or by cheques. Cash book and cash account both are same

as the format of cash book is in the form of ledger. There are two sides to a Cash

Book, the left hand is the ‘Receipts’ side and the right hand side is the ‘Payment’

side. All cash receipts are recorded on the receipts side while all payments are

recorded on the payment side. The difference between the two sides is the cash

balance, i.e. available cash on hand at the end of the month. This closing cash

balance is then brought forward as opening cash balance in the subsequent month.

Petty cash book is prepared to record all cash transactions of petty expenses.

There are various types of cash book, which are discussed below.

I] Simple Cash Book: A simple cash book has only one column for amount on

each of the two sides, i.e. receipts and payments. There are no other columns for

recording discounts and bank transactions. Hence this cash book is called as a

simple cash book. The format of this cash book is as follows.

Cash Book

Receipts Payments

Date Particulars L.F. Amount

Rs.

Date Particulars L.F. Amount

Rs.

To, By,

II] Two Column Cash Book: [Cash and Discount Column]: In this type, there are

two columns for amount on Receipts and Payment sides and they are for amount

and discount. The discount column on the debit side represents the discount

allowed while the discount column on the credit side represents the discount

received. At the end of the month, while the amount column is balanced, the

discount column is not balanced and only the totals on the debit and credit side are

shown. The format of this cash books is as follows.

Cash – Book [Two Columns]

Receipts Payments

Date Particulars L.F. Discount

Rs.

Amount

Rs.

Date Particulars L.F. Discount Amount

To, By,

Note: In the two column cash book as shown above, there can be a column for

Bank Column instead of Cash Column for recording the bank transactions. Rest of

the things remain the same.

III] Cash Book with three columns, Cash, Bank and Discount: This is called as

three column cash book. The three columns are provided for recording amounts of

discount, cash receipts and payments and receipts and payments through cheque,

i.e bank transactions. The format of this type of cash book is as follows.

Cash - Book [Three Columns]

Receipts

Payments

Date Particulars L.F. Discount Cas

h

Bank Date Particulars L.F Discount Cas

h

Bank

To, By,

In this Cash Book, the discount received is recorded on the debit side while the

discount allowed is recorded on the credit side. At the end of a particular month,

the balance cash and amount column is ascertained while the discount column is

not balanced. Only the total of the debit side and credit side of the discount column

is taken without computing the balance.

F] Bills Receivable Book: This book is maintained to record various transactions

regarding the bill of exchange, i.e. Bills Receivable. Bills receivable is the part of

debtors, the amount which firm is going to receive for a bill accepted by drawee.

The bills which have been drawn by the businessman but accepted by the other

party are known as bills receivable.

G] Bills Payable Book: For recording the transactions of Bills Payable, this book

is maintained. All the transactions relating to acceptance of bills are recorded in

this book. It is part of creditors, the amount which is accepted by firm.

H] Journal Proper: Transactions, which cannot be recorded in any of the books

due to their nature, are recorded in the Journal, which is called as Journal Proper.

Some examples of such transactions are given below.

Goods distributed as free samples.

Goods withdrawn for personal use.

Purchase of non trading goods i.e. assets on credit.

Sale of non-trading goods i.e. assets on credit etc

LEDGER

LEDGER:

Ledger is a book of Secondary entry/ Principal or Final entry. This means

that before a transaction is posted to the ledger, it has already been recorded in

either the journal or any of the subsidiary books. Ledger is a book in which

several accounts are opened and all transactions concerning that account are

recorded there. Ledger shows the net effect under one particular head relating to

the similar transaction which has take place in a particular period. It is also

called as “T’ form of account as the format of ledger is like alphabet ‘T’ and the

account is divided into two parts the left hand side is called debit and the right

hand side is called credit.

For example, in ledger, Cash Account will show all the transactions involving

either cash coming in or cash going out. Similarly in Purchases Account, all

transactions relating to the purchases will be shown. Same is the case with

accounts like Sales, Personal Accounts and also accounts of assets and

properties. Thus while the objective of journal or any of the subsidiary books is

to record the transaction as soon as it takes place, the object of ledger account is

to bring together all transactions connected with that account so that at the end

of a particular accounting period, the balance can be ascertained. The concept

of ‘balance’ is discussed later in this topic.

1. FORMAT OF LEDGER ACCOUNT: A ledger is opened in the following

‘T” form. Title of the account /Ledger Account

Dr.

Cr.

Date Particulars J.F. Amount

Rs.

Date Particulars J.F. Amount

Rs.

To, By,

POSTING:

The process of transferring all the debit and credit items from the journal into

ledger is called ledger posting.

Thus, from the above format it will be clear that the ledger account has the

following features.

Each ledger account has two sides, debit and credit.

Entries are made either on the debit side or credit side depending on whether

the concerned account is debited or credited in the journal entry.

The word ‘To’ is used as connecting word while passing an entry on the

debit side while the word ‘By’ is used as connecting word while passing an

entry on the credit side of the ledger account.

After completing all the entries in a particular accounting period, a ledger

account is to be balanced for closing the same. This means totals of amounts

recorded on both sides are taken and the difference in the amounts is put on

the side, which has lesser amount than the other one. This difference is

known as ‘balance’. For closing a ledger account the wordings used is

‘To/By Balance c/d or c/f [c/d = carried forward, c/f = carried forward]’ If

there is no difference between the amounts on the debit and credit side, it is

said that the ledger account is squared up.

A ledger account, which is closed at the end of an accounting period, is to be

re-opened at the beginning of the next accounting period. Thus a ledger

account at the end of June, i.e. on 30th June, is to be re-opened on the first

day of July. For this the balance carried forward at the end of June is to be

brought forward. For example, in case of a particular account if the balance

is carried forward Rs.10000 and on the credit side is to be brought forward

on the opposite side at the commencement of the next month. [Illustrated in

the numerical example]. The wordings used for re-opening an account are

either ‘Balance b/f or Balance b/d [b/f = brought forward, b/d = brought

down]

Balancing is done in case of all ledger accounts except in case of nominal

accounts.

TRIAL BALANCE

TRIAL BALANCE: A trial balance is the list of all ledger account balances

segregated into debit and credit balances. After preparing the ledger accounts, their

balances are ascertained and they are divided into debit and credit balances. A

ledger account shows a debit balance if the debit side total amount is more than the

total amount of the credit side. On the other hand if the credit side total is more

than that of the debit side, the account shows credit balance. In other words, if the

balance of the ledger account is carried down on the credit side, it shows debit

balance and if the balance is carried down on the debit side, it shows credit

balance.

After ascertaining the balance, a list is prepared showing the accounts and the

balances shown either as debit or credit. This is the ‘Trial Balance’, which is an

important document as it is used for preparing the final accounts, i.e. Trading and

Profit and Loss Account and Balance Sheet.

A Trial Balance tallies, which means that the total of the debit side is equal to the

total credit side. If it tallies, it is an indication of mathematical accuracy. However,

even if tallies, it is not a guarantee that there are no errors. There are certain types

of errors, in spite of which the Trial Balance tallies. However tallying of the Trial

Balance is a sign of mathematical accuracy.

FINAL ACCOUNTS:

FINAL ACCOUNTS/ FINANCIAL STATEMENT:

1. INTRODUCTION: The basic objective of financial accounting is to find out the

results of an accounting year in the form of profit or loss and financial position of

the business. For this there is a need that all business transactions should be

recorded properly in the books of accounts so that at the end of the year, a

summary of them can be prepared to find out the results of the accounting year.

The accounting cycle, which is shown in the chapter number one, is shown here

again for better understanding.

Transaction

Entry

Books of Prime Entry – Journal & Subsidiary Books

Books of Secondary Entry – Ledger

Trial Balance

Final Accounts

Trading Account Profit & Loss Account Balance Sheet

As shown by the accounting cycle, the preparation of final accounts is at the end of

the accounting cycle.

2. Final Accounts include the following accounts and statement.

A] Trading Account is prepared to find out the gross profit or gross loss.

B] Profit and Loss Account is prepared to find out the net profit or net loss.

C] Balance Sheet, which is not an account, but a statement showing Assets and

Liabilities on a particular day.

All these are discussed in detail in the following paragraphs.

A] TRADING ACCOUNT: This account is prepared to find out the Gross Profit

or Gross Loss for a particular year. The gross profit or gross loss is the difference

between the Sales and the Cost Of Goods Sold. The cost of goods sold is computed

as given below.

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing

Stock

The opening and closing stocks mentioned above represent the unsold stock of

finished goods. Direct expenses includes expenses like carriage inwards, customs

duty, octoi, freight, coal, gas and water etc.

The format of this account is as follows.

TRADING ACCOUNT OF Mr.XYZ

FOR THE YEAR ENDED ----

Dr.

Cr.

Particulars Amount

Rs.

Amount

Rs.

Particulars Amount

Rs.

Amount

Rs.

To Opening

Stock

By Sales

Less: Sales

Returns

To Purchases

Less: Purchase

Returns

By Closing

Stock

To Wages By Gross

Loss

Transferred

to Profit and

Loss Account

To Carriage

Inwards

To Customs

Duty

To Octroi

To Coal, Gas

and Water

To Factory

Expenses

To Gross Profit

Transferred to

Profit and Loss

Account

Total Total

B] PROFIT AND LOSS ACCOUNT: The objective of this statement is to

find out the Net Profit or Net Loss for a particular year. The net profit or net

loss is computed by deducting from the all expenses other than those taken in

the Trading Account and adding all other income like interest received, rent

received, discount received and so on. The net profit or not loss is the final

figure of profit or loss of a business organization. The format of this account is

given below.

PROFIT AND LOSS ACCOUNT OF Mr. XYZ

FOR THE YEAR ENDED ----

Dr.

Cr.

Particulars Amount

Rs.

Amount

Rs.

Particulars Amount

Rs.

Amount

Rs.

To Gross Loss

transferred from

Trading

Account

By Gross Profit

transferred from

Trading Account

To Salaries By Interest

To Printing and

Stationery

By Dividend

To Postage and

Telephone

By Sundry

Income

To Rent By Net Loss

transferred to

Balance Sheet

To Discount

To Advertising

To Traveling

Expenses

To Bad Debts

To Carriage

Outwards

To Depreciation

on Fixed Assets

To

Miscellaneous

Expenses

To Net Profit

transferred to

Balance Sheet

Total Total

Note: The items of expenditure and income shown on the debit and credit side

of the Profit and Loss Account is not the exhaustive list of all the items of

expenditure and income. It is an indicative list given for illustrative purpose.

C] Balance Sheet: Balance Sheet is a statement showing Assets and Liabilities

of a business organization on a particular day. There is no particular format of

Balance Sheet prescribed for a proprietorship or partnership organization.

However while writing the items on the liabilities side and assets side, a

particular order is normally followed. For example, on liabilities side, the first

item is always the Capital Account of the proprietor while on the asset side,

Fixed Assets are normally taken in the beginning and then other assets. For a

limited liability company, i.e. joint stock company, the Companies Act 1956

has prescribed a format as given in the schedule Vith of the Companies Act.

According to this Act, a balance sheet can be prepared either in vertical form or

a horizontal form. Generally balance sheet and profit and loss account of a

limited liability company are shown in vertical form. The format of balance

sheet is given below.

BALANCE SHEET OF Mr. XYZ

AS ON ----------

Liabilities

Assets

Particulars Amount

Rs.

Amount

Rs.

Assets Amount

Rs.

Amount

Rs.

Capital

Add: Net Profit

OR

Less: Net Loss

Land and

Building

Less:

Depreciation

Less: Drawings

Add: Interest on

Capital

Sundry Creditors Plant and

Machinery

Less:

Depreciation

Loan Furniture

Less:

Depreciation

Bills Payable Motor Vehicles

Less:

Depreciation

Bank Overdraft Investments

Expenses Due

But Not Paid

[Outstanding

expenses]

Sundry

Debtors

Less: Further

Bad Debts

Income Received

In Advance

Bills

Receivables

Closing Stock

Patents and

Trade Marks

Cash in hand

Bank Balance

Income Due

But Not

Received

Expenses paid

in advance

[Prepaid

Expenses]

Total Total

Note: In the Trading Account, Profit and Loss Account and Balance Sheet, the list

of items shown is not exhaustive but just illustrative.

ILLUSTRATIONS:

1. From the following Trial Balance, prepare Trading Account, Profit and Loss

Account for the year ended 31st March 2009 and a Balance Sheet as on that

date of Mr. X

Trial Balance As On 31st March 2009

Trial Balance Debit Rs. Credit Rs.

Capital Account 3500000

Sales 7500000

Land and Building 2000000

Furniture 1000000

Equipments 1200000

Opening Stock 800000

Purchases 3500000

Salaries 500000

Postage and Telephone 300000

Cash and Bank Balance 900000

Sundry Creditors 500000

Sundry Debtors 1300000

Total 11500000 11500000

The closing stock as on 31st March 2009 was Rs.900000

Solution:

Trading Account of ---

For The Year Ended 31st March 2009

Dr.

Cr

Particulars Amou

nt

Rs.

Amoun

t

Rs.

Particulars Amoun

t

Rs.

Amount

Rs.

To Opening

Stock

800000

By Sales 750000

0

To Purchases 350000

0

By Closing

Stock

900000

To Gross Profit

transferred to

Profit & Loss

Account

410000

0

Total 840000

0

Total 840000

0

Profit and Loss Account of ---

For The Year Ended 31st March 2009

Dr.

Cr.

Particulars Amou

nt

Rs.

Amoun

t

Rs.

Particulars Amoun

t

Rs.

Amount

Rs.

To Salaries

500000

By Gross Profit

transferred

from Trading

Account

410000

0

To Printing &

Stationery

300000

To Net Profit

transferred to

Balance Sheet 330000

0

Total 410000

0

Total 410000

0

Balance Sheet Of ----

As On 31st March 2009

Liabilities

Assets

Particulars Amount

Rs.

Amount

Rs.

Particulars Amount

Rs.

Amount

Rs.

Capital

Add: Net

Profit

3500000

3300000 6800000

Land and

Building

2000000

Creditors 500000 Furniture 1000000

Equipments 1200000

Sundry

Debtors

900000

Closing Stock 1300000

Cash & Bank

Balance

900000

Total 7300000 Total 7300000

ADJUSTMENTS IN ACCOUNTS: Normally in preparing the final accounts of a

business organization certain adjustments are required to be made. These

adjustments are due to the following reasons.

1. Certain information, which is required for the preparation of final accounts,

may be available after the preparation of trial balance. For example,

information about any expenditure due but not paid may not be available on

the date of closing of the accounts, similarly the information regarding the

bad debts may be available after the closing the accounts. This information

is to be included in the final accounts, otherwise the financial statements will

not show a true and fair view of the financial condition of the business. For

incorporation of this information, it is necessary to pass adjustment entry

and carry on necessary adjustments in the financial statements.

2. Sometimes there can be some errors taking place while preparing the trial

balance. For example, there may be some omission of some of the

transactions or a transaction may be recorded twice. There can be some

errors of posting also when posting in the ledger is made either of the wrong

amount or on the wrong side or wrong amount on the wrong side. This needs

to be corrected and for that adjustment entry is required.

3. There are some appropriations out of profit. For example in case of limited

companies, there can be transfer to reserves or there can be proposed

dividend. These appropriations are to be recorded in the financial statements

through adjustment entries.

The common adjustments along with their treatment in the accounts are

discussed in the following paragraphs. It should be remembered that every

adjustment has minimum two effects.

1] Outstanding Expenses / Expenses Due But Not Paid / Unpaid Expenses:

On the date of closing of the books of accounts, certain expenses may have

become due but they may not have been paid in cash. For example, on 31st

March 2009, salaries for March 2009 may not have been paid. Due to the non

payment of the salary, it is not recorded in the books and consequently do not

appear in the trial balance from which, the final accounts are prepared.

However if this salary is not taken into consideration, the profit/loss disclosed

by the Profit and Loss Account will not be true as according to the accrual

principle, an expenditure for the current year should be taken into current year’s

account even if it is not paid in cash. Therefore such outstanding expenses are

to be taken into consideration by way of the following adjustment.

A] The amount of such outstanding expenses is to be added in the concerned

item of expenditure either in the Trading Account or Profit and Loss Account,

depending on the item of the expenditure. For example, if it is wages it will be

taken in the Trading Account, while if it is salary it will be taken in the Profit

and Loss Account and so on.

B] The amount of such expenditure is to be paid in the future and till it is paid it

is to be shown as liability on the LIABILITIES side of the Balance Sheet.

The Journal entry for recording this transaction is as follows.

(Particular) Expenses A/c – Dr.

To Outstanding Expenses A/

Note: Particular Expenses means the concerned expense. For example, is it is

salary outstanding, salary account will be debited, if wages are outstanding,

wages account will be debited and so on.

2] Prepaid Expenses / Expenses Paid In Advance / Unexpired Expenses:

Exactly opposite of the outstanding expenses are the expenses paid in advance

or also called as prepaid expenses or unexpired expenses. Sometimes expenses

are to be paid in advance for the future period. For example, insurance is to be

paid in advance or sometimes rent may be paid in advance. These expenses are

actually paid and hence their entry is made in the books of accounts and hence

they are shown in the trial balance. However if they are shown in the final

accounts without any adjustments it will mean that next year’s expenses are

shown in the current year’s accounts and the profit/loss shown will be true,

though the Balance Sheet at the end will tally. Therefore the following

adjustments are to be made.

A] Deduction from the concerned expense either in the Trading Account or the

Profit and Loss Account.

B] Showing the item of expense as an asset on the asset side of the Balance

Sheet.

The journal entry for recording this adjustment is as follows.

Prepaid Expenses A/c – Dr.

To Particular Expense A/c

3] Depreciation on Fixed Assets: Fixed Assets are those assets, which are

acquired not for resale but are acquired for being used in the business and

improve the earning capacity of the business. Due to constant use and wear and

tear, the utility value of the assets is reduced and this is called as the

‘depreciation’. The depreciation is provided on the books according to one of

the several methods available for the same. The effects in the accounts are as

follows.

A] Amount of depreciation is debited to the Profit and Loss Account

B] It is deducted from the concerned asset in the Balance Sheet of the firm.

The Journal entry for this adjustment is as follows.

Profit and Loss Account – Dr.

To Depreciation Account.

4] Income Outstanding/ Income Due But Not Received: It was discussed in

the first adjustment that there can be certain expenses, which are not paid

though they have become due in the relevant accounting year. The accounting

treatment of the same has also been discussed. Now, we have to discuss the

income, which has become due but not received due to a particular reason. The

same principle that is followed for recording the outstanding expenses is

followed here. The income, which has been due but not received due to some

reason should be taken into account because it is relevant for the current year.

The two effects of this adjustment are as follow.

I] Add in the particular item on the credit side of the Profit and Loss Account

II] The amount of the outstanding income is to be shown on the asset side of the

Balance Sheet.

The journal entry for recording this adjustment is as follows.

Outstanding Income A/c –Dr.

To Particular Income A/c [For example, if it is interest receivable, it will

be outstanding interest account debited and credited to interest account]

5] Pre-received Income / Income Received In Advance: Sometimes, it so

happens that certain type of income is received in advance. Actually it is due for

the next year but it is received in advance in the current year itself. If no

adjustments are made for this, the profits for the current year will be distorted as

the next year’s income is included in the current years accounts. Therefore the

following effects are given to this adjustment.

I] Income received in advance is deducted from the concerned item of income.

Thus if rent is received in advance, the amount of rent received in advance is

deducted from the amount of rent on the credit side of the Profit and Loss Account.

II] Income received in advance is treated as a liability as any income received

without being due, is a liability and hence shown on the liability side of the

Balance Sheet of the organization.

The journal entry for this transaction is as follows.

Particular Income Account – Dr.

To Income Received In Advance Account.

6. Bad Debts: Bad Debts is the amount of irrecoverable debt. In the course of

business, as a part of the policy credit is granted to customer to pay the money.

Thus there are sales on credit basis and the amount of such sale is expected to

receive within the credit period allowed to the customer. However sometimes, the

customer to whom such sales are made, may not pay the money and in the future

he may not be able to pay the money at all. This may be due to reasons like

bankruptcy, closure of business, death of the customer and so on. The result is that

the concerned amount is written off as bad debts. The amount of bad debts known

to the proprietor during the course of business gets recorded in the books of

accounts and is carried to the trial balance through the regular accounting chain.

The amount of such bad debts is shown on the debit side of the Profit and Loss

Account and this is the only effect of this item. However, adjustment entry is

required for the bad debts which have come to the notice of the proprietor after the

trial balance is prepared. There will be two effects of this adjustment. These two

effects are as follows.

I] The amount is debited to the Profit and Loss Account. If bad debts are already

given in the trial balance, the amount will be added in the bad debts already given

in the trial balance.

II] The amount will be deducted from the Sundry Debtors in the Balance Sheet.

However the point to be noted that the above two effects are for the bad debts

given in the ADJUSTMENT and not in the trial balance. Amount of bad debts

given in the trial balance is to be recorded in the Profit and Loss Account debit side

and there will not be two effects for the same.

The Journal entry for this transaction is as follows.

Bad Debts A/c – Dr.

To Sundry Debtors A/c

7] Reserve / Provision for Bad and Doubtful Debts: The word ‘reserve’ and

‘provision’ has different meanings in accounting. However since the accounting

treatment for both is same in this case, the terms have been used interchangeably.

Creation of reserve or provision for bad and doubtful debts is according to the

principle of conservatism. Every year, it is expected that some of the amount of

debt may not be recovered by the firm. In the course of business, goods are sold on

credit. This amount is recoverable according to the credit period. But if a debtor

becomes bankrupt or closes down his business, he may be unable to pay the

amount. In such cases, there are ‘Bad Debts’, which in fact is the irrecoverable

amount of the debt. Every year some of the amount of the debtors may become bad

and hence a provision is created in the accounts. The accounting treatment of this

adjustment is as follows.

I] The amount of reserve/provision to be created on debtors at the end of the year is

added in the bad debts on the debit side of the profit and loss account. From this

amount, the amount of reserve/provision for bad and doubtful debts already given

in the profit and loss account is to be deducted.

II] The amount of provision for bad and doubtful debts created in the current year

only is to be deducted from sundry debtors in the balance sheet.

The journal entry for creating a provision/reserve for bad and doubtful debts is as

follows.

Profit and Loss Account –Dr

To Provision/Reserve for Bad and Doubtful Debts.

The accounting treatment of this adjustment is illustrated in the following

illustration.

Illustration:

The Trial Balance of a firm shows the following.

Particulars Debit Credit

Rs.

Rs.

Provision for bad and doubtful

debts

30000

Bad Debts 18000

The adjustment to the account provides that,

i. Write off additional bad debts of Rs.13000

ii. Create a provision on Sundry Debtors @ 5%. The amount of Sundry

Debtors is Rs.750000

The accounting adjustments will be as follows.

Profit and Loss Account for the year ended—

Dr.

Cr.

Particulars Amount

Rs.

Amount

Rs.

Particulars Amount Amount

To Bad Debts:

Add:

Additional Bad

Debts [New

Bad Debts]

Add: New

Provision for

Bad and

Doubtful Debts

18000

13000

36850

---------

67850

Less: Old

Provision for

Bad and

Doubtful Debts

30000 37850

In the Balance Sheet, the Sundry Debtors will be shown in the following manner.

Balance Sheet [Asset side only]

Particulars Amount

Rs.

Sundry Debtors

Less: Additional Bad

Debts

Less: New Provision for

Bad and Doubtful Debts

750000

37000

713000

36850

676150

8] Discount on Debtors: In order to encourage early payment, the debtors may be

allowed some cash discount as an incentive. The discount allowed to debtors is

actually a loss suffered by the firm. The accounting treatment for the same is as

follows.

I] The amount of discount allowed to debtors is shown on the debit side of the

Profit and Loss Account.

II] The amount is deducted from Sundry Debtors in the Balance Sheet.

It should be noted that before computing the amount of discount allowed to

debtors, the bad debts and provision/reserve for bad and doubtful debts given in the

adjustments should first be deducted from debtors.

The journal entry for the discount on debtors is as follows.

Discount on debtors A/c –Dr.

To Sundry Debtors A/c

The discount on debtors account is ultimately transferred to the Profit and Loss

Account.

9] Discount on Creditors: Creditors of the firm allow discount to the firm in order

to provide an incentive for early payment. This discount allowed by creditors is a

gain for the business and the two effects of this transaction are as follows.

I] The amount of discount allowed by creditors is credited to the profit and loss

account as it is a gain for the firm.

II] The amount of discount is deducted from creditors from the Balance Sheet of

the firm as the amount payable to them is reduced.


Sundry Creditors A/c – Dr.

To Discount on Creditors A/c

Ultimately the discount on creditors allowed to creditors is transferred to the Profit

and Loss Account.

10] Unrecorded Credit Sales: Sometimes there is an omission regarding

recording a transaction like credit sales. This may happen in the last month of the

accounting year, where the goods sold are adjusted in the stock but the entry is not

passed in the books. In such case, the following two effects are to be given for this

adjustment.

I] The amount of the unrecorded credit sales is added in the amount of sales in the

Trading Account.

II] Amount of Sundry Debtors will be increased by the amount of unrecorded

credit sales as their receivable amount will increase.


Sundry Debtors A/c – Dr.

To Sales A/c

It should be noted that the amount of provision for bad and doubtful debts as well

as the amount of discount on debtors should be computed after adding the amount

of unrecorded sales in the sundry debtors.

11] Unrecorded Credit Purchases: Credit purchases made during the year may

be omitted to be recorded in the books of accounts. Therefore an adjustment is to

be made in the accounts otherwise the profit/loss shown by the financial statements

will not be true. The two effects for this adjustment are as follows.

I] The amount will be added in the purchases on the debit side of the Trading

Account.

II] The amount will also be added in the amount of Sundry Creditors on the

liabilities side of the Balance Sheet.

The journal entry for the recording of this transaction is as follows.

Purchases A/c – Dr.

To Sundry Creditors A/c

12] Goods Destroyed By Fire: There may be loss due to fire taking place at the

office or the warehouse of the firm. If these goods are insured and the insurance

company has admitted a claim but of lesser amount than the amount of loss the

effects of this transaction will be as follows.

I] The amount of claim admitted by the Insurance Company will be shown as

receivable in the Balance Sheet on the Asset side.

II] The difference between the amount of the goods destroyed and the claim

admitted is a net loss and will be debited to the Loss By Fire Account on the debit

side of the Profit and Loss Account.

III] The amount of goods destroyed will be credited to Goods Destroyed by Fire

Account and will be shown on the credit side of the Trading Account.

The Journal entry for recording this transaction will be as follows.

Insurance Company A/c – Dr.

Loss By Fire A/c – Dr.

To Goods Destroyed by Fire A/c

13] Goods Withdrawn For Personal Use: A proprietor or a partner of a firm may

withdraw some goods from the business for his private use. The effects of this

transaction are as follows.

I] The amount is credited to the Trading Account.

II] It is added in the drawing account of the proprietor or the partner. If drawing

account is not given, the amount will be deducted from the Capital Account.

The journal entry for this is as follows.

Drawings Account – Dr.

To Goods Withdrawn For Personal Use A/c

14] Goods Distributed As Free Samples: This is part of advertising as the goods

are distributed as free samples as a part of the promotion program. The two effects

of this transaction are as follows.

I] The amount is debited to the Advertisement Account and is shown on the debit

side of the Profit and Loss Account.

II] Trading Account is credited with the amount of goods distributed as free

samples.

Journal entry for this is as follows.

Advertisement Account – Dr.

To Goods Distributed As Free Samples Account.

15] Interest on Capital: If the proprietor or partners are allowed interest on their

capital investments, this adjustment will be required. Interest on capital is paid by

the business firm to the proprietor or partners and hence it is an item of expenditure

for the firm. It is called as an appropriation out of profits. The amount of capital is

increased by the amount of interest. The two effects of this adjustment are

therefore as follows.

I] Amount of interest of capital is debited to the Profit and Loss Account

II] This amount is added in the capital account of the proprietor.

16] Interest on Drawings: While the interest on capital is allowed by a firm to its

proprietors or partners, the interest on drawings is charged from the proprietor or

partners by the firm. Drawings is the amount of goods/cash withdrawn by the

proprietor/partners for their personal use. The two effects of this adjustment are as

follows.

I] Amount of interest on drawings is credited to the Profit and Loss Account as it is

a gain for the firm.

II] This amount is added in the drawings of the proprietor/partner.

Journal entry for recording this transaction is as follows.

Drawings A/c – Dr.

To Interest on Drawings A/c

17] Installation Charges of Plant and Machinery: Purchase of Plant and

Machinery is a capital expenditure like the purchase of any other asset. Any

expenditure incurred on installation of machinery such as wages paid to the

workers for such purpose is also a capital expenditure. If there is an error of

principle and such expenditure is treated as a revenue expenditure, this adjustment

is required. For example, if wages paid for the installation of plant and machinery

is debited to the wages account instead of the plant and machinery account,

adjustment will be required. The two effects of such an adjustment are as follows.

I] Deduction from the concerned revenue expenditure. For example, if wages paid

for the installation of plant and machinery are debited to the wages account, the

amount of such wages is deducted from the wages account.

II] Amount deducted like this is added in the cost of plant and machinery account

as it is a capital expenditure.

Journal entry for this adjustment is as follows.

Plant and Machinery A/c – Dr.

To Concerned Revenue Expenditure A/c

Depreciation on plant and machinery will be computed after adding the amount of

such installation expenditure.

18] Writing off an Asset: Fixed Assets are depreciated as per the relevant rules in

various Laws. However an intangible asset is to be written off over a period of

time. The accounting treatment for such an adjustment is similar to that of the

depreciation. The adjustment has the following effects.

I] Amount written of, is debited to the Profit and Loss Account.

II] The amount is deducted from the concerned asset.

Journal entry for recording such transaction is as follows.

Profit and Loss A/c – Dr.

To Concerned Asset A/c

19] Appropriations out of profits: In case of limited companies, there are several

appropriations. Some of them are as follows.

Transfer to Reserves

Payment of Dividend

The respective amounts are debited to the Profit and Loss Account, appropriation

section and then the second effect is to show it in the Balance Sheet under

appropriate headings.

20] Hidden Adjustments/ Adjustments with in the trial balance: Some

adjustments are not given explicitly but are implicit from the information given in

the Trial Balance. For example, in the trial balance it may be mentioned that loan

of a particular amount is given by the firm. The rate of interest is given and the

date of giving the loan is also given. In such cases, the amount of interest due is to

be computed and compared to the amount of interest paid and mentioned in the

trial balance. There may have been some amount of interest due but not paid and

hence adjustment for outstanding interest payable will have to be made as

mentioned in the first adjustment.

Ch 2 and Ch. 3 Basic Theory and Final Accounts

Documents

Transcript of Ch 2 and Ch. 3 Basic Theory and Final Accounts