Essentials of FA_Chapter 6

8/3/2019 Essentials of FA_Chapter 6

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Essentials of Financial Accounting, Second Edition ASISH K. BHATTACHARYYA

ESSENTIALS OF FINANCIAL

ACCOUNTING

BYASISH K BHATTACHARYYASecond Edition

Chapter 6


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Accounting Cycle: Final Phase

The final phase in the accounting cycle is the

preparation of the profit and loss account, and

the balance sheet. The profit and loss account is

prepared by matching income and expenses. The balance sheet is prepared by listing out

assets and liabilities.

The trial balance provides the raw data that are

analysed and adjusted for preparing the profit

and loss account, and the balance sheet.

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Errors

Errors might creep in while recordingtransactions and other events.

Errors may be classified into errors of principlesand errors in book keeping.

Errors of principles are those which arise due towrong application of accounting principles inrecording transactions and other events.

y For example, expenditure that should be capitalisedhas been recorded as repair and maintenance of fixedasset.

y Examples of book keeping errors are: omission inrecording a transaction, entering a wrong amount insubsidiary books, wrong casting of a ledger anderrors of posting.

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Suspense Account

Error in only one account head results indisagreement of the trial balance.

Exampley When adding up the sales day book, a mistake occurred,

resulting in the total being Rs. 1,000 less than the correcttotal.

y This error resulted in short credit to the sales account, andas a consequence the credit side total of the trial balance islower than the debit side total of the trial balance.

y It is assumed that individual accounts of customers areopened in the general ledger and each transaction is posted

to the debit of the personal account of the concernedcustomer. Therefore, an error in the sales day book did notresult in a mistake in the debit side of the trial balance.

y The suspense account will show a credit balance, becausethe debit side total of the trial balance is higher by Rs.1,000 as compared to the credit side total.

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Errors Detected in ASubsequent Period

When errors are detected in a subsequent reportingperiod, adjustments in nominal accounts should bedebited or credited to the Prior Period Adjustmenta/c.

However, adjustments in assets or liabilities accountsshould be debited or credited to the concernedaccounts.

In case, mistakes in prior periods result indisagreement in the debit side total and credit side

total of the trial balance of the previous period, thesuspense a/c should show a debit or credit balancecarried forward from that period.

y In that situation, the suspense a/c should be closed throughrectification entries.

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Errors Detected In ASubsequent Period

(cont.)

Under the Indian GAAP, prior period adjustment

is presented as a separate line item in the profit

and loss account for the current period.

If the error occurred in the previous period, theIFRS require that assets, liabilities, general

reserve, income and expenses of that period

should be restated after incorporating the

corrections, and restated figures should be

presented as comparative figures in the financialstatements for the current period.

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Errors Detected in ASubsequent Period

(cont.)

If the error occurred in a period earlier to theimmediately previous period, IFRS require thatassets, liabilities and general reserve, at thebeginning of the previous period should be restatedafter incorporating the cumulative effects of the

corrections. Items in the balance sheet of the previous period

should be restated taking into account the restatedopening balances for the previous period.

Restated figures for previous period should bepresented as comparative figures in the financialstatements for the current period.y For example, if an error occurred in the year 20062007 is

detected in the year 20102011, balances in the generalreserve account, assets and liabilities as at 1 April, 2009 isadjusted for the prior period adjustment.

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Adjustments

In the accrual system of accounting, a firm

recognises revenue immediately on completion of

the earning process without waiting for actual

receipt of cash or other assets.

Similarly, it recognises expenditure when it is

probable that economic benefits will outflow the

enterprise, without waiting for actual cash

outflow or outflow of other economic benefits.

y Therefore, the accrual system of accounting requiresadjustments for accrued income and outstanding

expenses (accruals).

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Adjustments (cont.)

Moreover, preparation of a profit and loss

account requires matching of income and

expenses.

y

These require adjustments for income received inadvance and prepaid expenses.

Some more adjustments are required to present a

true and fair view of the operating result and the

financial position

y Adjustment entries are passed through the journalproper and an adjusted trial balance is drawn

incorporating the adjustments.

y The adjusted trial balance forms the basis of

preparing financial statements.

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Adjustments: Closing Stock

Initially, entities record purchase transactions as

an expense under the head purchases.

Therefore, assessment of the value of stock-in-

hand at the end of the reporting period andrecognition of the same as an asset in the balance

sheet is necessary to match the cost of goods sold

and the revenue for the reporting period.

Usually, closing stock of inventory is recorded in

the books of accounts through the following

entry:

y Stock a/c Dr. Rs. 50,000 Cr. Rs. 50,000

y To profit and loss a/c

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Adjustments: Closing Stock (cont.)

The closing stock is an asset, and appears as such

in the balance sheet.

The closing stock balance is carried forward to

the next reporting period as opening stock.Opening stock is added to purchases for

determining the cost of goods that were available

for sale, or the cost of materials that were

available for consumption.

y Therefore, opening stock is treated as a nominalaccount while preparing the profit and loss account.

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Adjustments: Closing Stock (cont.)

Although it is not the normal practice, it is

possible to pass the following entry before

preparing the trial balance:

y

Closing stock a/c Dr. Rs. 50,000y To purchase a/c Cr. Rs. 50,000

The result of this entry is to reduce the purchase

account and to take on record the amount of

closing stock.

y In case this entry is passed, the trial balance will

show both opening stock and closing stock.

y The purchase account in the trial balance will show

purchases adjusted for closing stock.

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Adjustments: Accruals

Accrual represents liabilities for which the

amount is not certain, e.g. services received but

not invoiced by the supplier.

In this situation, the reporting enterpriseestimates the liability and passes the following

adjustment entry:

y Appropriate expense a/c Dr. Rs. 1,00,000

y To outstanding liabilities a/c Cr. Rs. 1,00,000

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Adjustments: Accruals (cont.)

The term accrued also signifies that an expense

has been incurred or income has been earned, but

the due date for payment or receipt of the same

falls in the next reporting period.y Adjustments are to be made for accrued expenses and

accrued income.

The following adjustment entries are required to

bring these expenses and income in the books of

accounts.y Appropriate expense a/c Dr. Rs. 50,000

y To expenses accrued a/c Cr. Rs. 50,000

y Income accrued a/c Dr. Rs. 70,000

y To appropriate income a/c Cr. Rs. 70,000

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Examples of accrued expenses are rent, interest,

rates and taxes and wages outstanding at the

end of the reporting period.

Examples of accrued income are interest onsecurities, professional fees and rents earned but

not received until the end of the reporting period.

Expenses accrued is presented as a liability and

income accrued is presented as an asset in the

balance sheet.

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These adjustment entries are reversed at the

commencement of the next reporting period.

The following are the reversal entries:

y

Expenses accrued a/c Dr. Rs. 50,000y To appropriate expense a/c Cr. Rs. 50,000

y Appropriate income a/c Dr. Rs. 70,000

y To income accrued a/c Cr. Rs. 70,000

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ADJUSTMENTS: PREPAID EXPENSES

Sometimes, expenditure is incurred in the

current period to receive services or goods in a

subsequent period, the expenditure is classified

asprepaid expenses.

y An example of prepaid expenses is insurance

premium.

The following adjustment entry is passed to

record the prepaid amount:

y Prepaid expenses a/c Dr. Rs. 80,000

y To appropriate expense a/c Cr. Rs. 80,000

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Adjustments: Prepaid Expenses (cont.)

The result of this entry is to recognise an asset in

the form of a prepaid expense and to reduce the

expenditure account by the amount allocated to a

subsequent reporting period.

y The balance in the expenditure account represents

expense for the current reporting period.

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Adjustments: Deferred Revenue

The following accounting entry is passed for the

amount of income received in advance.

y Appropriate income a/c Dr. Rs. 60,000

y

To income received in advance a/c Cr. Rs. 60,000 The result of this entry is to recognise a liability in

the form of income received in advance and to

reduce the income by the amount allocated to the

next reporting period.

y The reduced balance in the income account represents

the amount that pertains to the current reporting

period.

These adjustment entries are reversed at the

commencement of the next reporting period.

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Materials Other Than Stock-in-trade

Materials purchased for expenses such as stationery,

advertisement materials and manufacturing stores

are debited directly to respective expense accounts.

Therefore, at the end of the reporting period, thefollowing adjustment entry is required to bring the

stock of materials in hand in the books:

y Stock of materials a/c Dr. Rs. 10,000

y To appropriate expense a/c Cr. Rs. 10,000

y The entry is reversed at the commencement of the next

reporting period.

The stock of materials is an asset recognised in the

balance sheet.

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Bad Debt

The loss due to non-recovery of amount due from

customers is recorded as bad debt.

Recording of bad debt reduces the balance in the

trade debtors account. The entity passes the following entry to recognise

the loss:

y Bad debt a/c Dr. Rs. 50,000

y To trade debtors a/c Cr. Rs. 50,000

Bad debt is an expense, and it appears in the

trial balance.

It is taken to the profit and loss account directly

from the trial balance.

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Provision for Doubtful Debts

Entities usually recognise a provision for doubtful

debts.

y Provision for doubtful debts is not a liability.

y

It is a reduction of trade receivables.y An entity, based on its past experience, takes a suitable

percentage on trade debtors in deciding the amount of

provision required.

y If, a provision for doubtful debts exists, the amount of bad

debt is adjusted against the provision. The provision is recognised through the following

closing entry:

y Profit and loss account Dr. Rs. 10,000

y To provision for doubtful debts a/c Cr. Rs. 10,000

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Provision for Doubtful Debts (cont.)

If the opening balance in the provision for

doubtful debt a/c after adjustment for bad debts,

is in excess of the required provision, the excess

should be credited to the profit and loss account.

Enterprises that sell industrial products or

provide services, scrutinise each customers

account to estimate doubtful debts.

y They do not apply a percentage on the amount due

from customers to estimate doubtful debts.

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Provision for Cash Discount to Debtors

Sometimes, firms create a provision for estimated

amount of cash discount to be offered to trade

debtors.

Provision for discount is calculated withreference to good debtors, that is, the amount of

trade debtors adjusted for provision for doubtful

debts.

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Depreciation

The term amortisation is used for depreciation

of intangible asset.

The provision for depreciation represents the

reduction in the carrying amount of a depreciableasset.

Depreciation is incorporated in the books through

an adjustment entry or a closing entry.

y Therefore, the depreciation account does not appear

in the trial balance.

y The balance in an asset account is not disturbed,

because the balance sheet should present the gross

amount of the asset and accumulated depreciation

separately.

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Depreciation (cont.)

Therefore, the provision for depreciation is made

by the following adjustment entry:

y Depreciation a/c Dr. Rs. 1,00,000

y To provision for depreciation a/c Cr. Rs. 1,00,000

The balance in the depreciation a/c, after the

adjustment entry, represents the depreciation for

current period.

y It is transferred to the profit and loss account

through a closing entry.

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Depreciation (cont.)

The balance in the provision for depreciation a/c,

after the adjustment entry, represents

depreciation accumulated at the end of the

current period.

y The balance represents the total of opening balance

in the trial balance and depreciation for the current

period, reduced by the accumulated depreciation for

items disposed during the current period.

y

It is presented in the balance sheet as a deductionfrom the gross amount of the asset.

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Disposal of Depreciable Assets

On sale or disposal of an item of a depreciable

asset, the cost of the asset is withdrawn from the

asset account. The following is the entry:

y Sale of PPE a/c Dr.

y To the PPE a/c Cr.

Similarly, accumulated depreciation on the item

sold or disposed of is withdrawn from the

provision for depreciation account. The following

is the entry:y Provision for depreciation a/c Dr.

y To sale of PPE a/c Cr.

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Disposal of Depreciable Assets (cont.)

The fixed asset account and the provision for

depreciation account, after these adjustments,

show the cost of assets the enterprise is holding,

and the amount of accumulated depreciation on

those assets, respectively.

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Disposal of Depreciable Assets (cont.)

On disposal of a depreciable asset, the difference

between the net disposal proceeds and the

carrying amount (net book value) of the asset

represents profit (loss) on disposal.

The profit (loss) on disposal is credited (debited)

to the profit and loss account as income (loss).

y On disposal of a previously revalued item of tangible

fixed assets, the loss, if related to an increase which

was previously recognised in equity as revaluationreserve, may be charged directly to the revaluation

reserve, to the extent that the same has not been

subsequently reversed or utilised.

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Bank Reconciliation Statement

Ideally, a debit balance in the bank account

should agree with the credit balance in the bank

statement and vice versa.

y However, in practice, rarely do these two balances

agree.

Entities periodically reconcile the balance as per

the bank statement and the balance as per the

cash book.

The statement which explains the differencesbetween these two balances is known as the bank

reconciliation statement.

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Bank Reconciliation Statement: Reasons

for Differences

Differences may arise on account of the following:

y Cheques issued by the enterprise but not yet

presented to the bank for payment.

y Cheques deposited with the bank but not yet

collected.

y Interest allowed by the bank but not yet recorded in

the books of the enterprise.

y Interest and expenses charged by the bank but not

yet recorded in the books of the enterprise.

y Interests and dividend collected by the bank as per

standing instruction of the enterprise but not yet

recorded in the books of the enterprise.

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for Differences (cont.)

y Direct payments by the bank as per the standing

instructions of the enterprise but not yet recorded in

the books of the enterprise.

y Direct payments received by the bank, for example,

from a customer of the enterprise, not recorded in thebooks of the enterprise.

y Dishonouring of a bill discounted with the bank, not

yet recorded in the books of the enterprise.

y Bills collected by the bank, not yet recorded in the

books of the enterprise.

y An error committed by the bank.

y An error in writing the cash book.

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for Differences (cont.)

The final bank reconciliation statement, prepared

after incorporating all transactions and

correcting errors in the cash book, should exhibit

only the following:

y Cheques issued by the enterprise but not yet

presented to the bank for payment.

y Cheques deposited with the bank but not yet

collected.

y

An error committed by the bank.

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Bank Reconciliation Statement:

Advantages

The chief advantages of preparing a bank

reconciliation statement at short intervals, say

fortnightly, are:

y It brings out any error in the banks records or in the

cash book.

y It brings out any undue delay in collection of cheques

and other instruments deposited with the bank.

y It is a control against embezzlement.

y

It summarises information that is available from thebank statement only.

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Presentation

Example: Bank reconciliation statement before

adjustments

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BANK RECONCILIATION STATEMENT OF A & CO.

As on 31st December, 2010

Balance as per cash book Rs. 5,000Add: Cheques issued not yet presented Rs. 3,000

Dividend collected not yet recorded in thecashbook 200 3,2008,200

Less: Cheques deposited not yet collected Rs. 2,000Cheque dishonoured not yet recorded in the cash book 500Bank charges not yet recorded in the cash book 50

Cheque wrongly debited by bank 800 Rs. 3,350Balance as per bank statement Rs. 4,850


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Presentation (cont.)

Example (cont.): Final bank reconciliation

statement before adjustments

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BANK RECONCILIATION STATEMENT OF A & CO.As on 31st December. 2010

Balance as per cashbook Rs. 4,650

Add: Cheques issued not yet presented 3,000

7,650

Less: Cheques deposited not yet collected Rs. 2,000Cheque wrongly debited by bank 800 2,800

Balance as per bank statement Rs. 4,850


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Deferred Tax

Tax expense for a period is the total of current tax

and deferred tax.

Current taxis the amount of income tax

determined to be payable (recoverable) in respectof the taxable income (tax loss) for a period.

Taxable income or tax loss is the amount of the

income (loss) for a period, determined in

accordance with the tax laws, based upon which

income tax payable (recoverable) is determined.

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Deferred Tax (cont.)

Deferred tax liability arises because of taxable

temporary differences.

Similarly, deferred tax asset arises because of

deductible temporary differences. Deferred taxis the difference between the closing

net deferred tax liability (net of deferred tax

asset) and the opening net deferred tax liability

(net of deferred tax asset).

y Income tax law allows deduction of past losses and

unabsorbed depreciation in computing taxable

income.

y Therefore, deferred tax asset arises from carried-

forward losses and unabsorbed depreciation.

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Deferred Tax (cont.)

Deferred tax liability is presented separately in

the balance sheet.

The Indian GAAP require that the deferred tax

liability be presented after the head unsecuredloans.

Deferred tax liability may be viewed as an

interest free credit to the entity and the

management is expected to use this credit to earn

return for equity share holders.y Therefore, for the purpose of financial analysis,

deferred tax liability is considered as quasi-equity

and is included in equity to calculate accounting

ratios.

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Deferred Tax

y On 1st January 2010 Rangachari Limited (RL)

purchased equipment for use in research activities.

y The cost of the equipment is Rs. 1,00,000. RL

estimates the useful life of the equipment at 5 years

and its residual value at zero.y RL uses the straight line method of depreciation. The

tax law allows 100% depreciation in the first year for

equipment being used for research.

y The current tax rate is 40%.

y Assume that there is no temporary difference otherthan depreciation.

y Further assume that the taxable income before

depreciation and accounting income before

depreciation are same at Rs. 1,00,000 from year 1 to 5.

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Deferred Tax: Example (cont.)

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Table showing computation of current tax and deferred taxAmount in Rs.

Particular s Year 1 Year 2 Year 3 Year 4 Year 5 Total

Accounting income before depreciation 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 5,00,000

Depreciation 20,000 20,000 20,000 20,000 20,000 1,00,000Accounting income afterdepreciation 80,000 80,000 80,000 80,000 80,000 4,00,000

Taxable income before depreciation 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 5,00,000Depreciation 1,00,000 Nil Nil Nil Nil 1,00,000

Taxable income afterdepreciation Nil 1,00,000 1,00,000 1,00,000 1,00,000 4,00,000

Tax expense as per accountingincome @0.40 32,000 32,000 32,000 32,000 32,000 1,60,000

Tax expense as per taxable income(Current tax) @0.40 Nil 40,000 40,000 40,000 40,000 1,60,000

Deferredtax 32,000 (8,000) (8,000) (8,000) (8,000) Nil

Tax expense:Current tax Nil 40,000 40,000 40,000 40,000 1,60,000Deferred tax 32,000 (8,000) (8,000) (8,000) (8,000) Nil

Total 32,000 32,000 32,000 32,000 32,000 1,60,000

Deferredtax liability:

Opening balance Nil 32,000 24,000 16,000 8,000New/(Reversal) 32,000 (8,000) (8,000) (8,000) (8,000)Closing balance (to be recognisedin the balance sheet) 32,000 24,000 16,000 8,000 Nil


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Insights:

a. Temporary difference is one that is capable of

reversal.

b. Every year the deferred tax and deferred tax liability

should be computed using the latest tax rate.

c. In practice, deferred tax for the year is calculated by

deducting the opening balance of deferred tax

liability from the closing balance of the same. This

obviates the necessity to track all reversals.

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Tax liability for year 1 is calculated as follows:

y Carrying amount of the equipment in the balance

sheet: Rs. 80,000

y Tax base (Carrying amount as per tax law): Nil

y Difference Rs. 80,000

y Therefore, a deferred tax liability of 0.40 Rs. 80,000

or Rs. 32,000 should be recognised in the balance

sheet.

y

Deferred tax expense is recognised at (Rs. 32,000 0)or Rs. 32,000.

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Year 2:

y Carrying amount of the equipment in the balance

sheet: Rs. 60,000

y Tax base (Carrying amount as per tax law): Nil

y Difference: Rs. 60,000

y Therefore, a deferred tax liability of 0.40 Rs. 60,000

or Rs. 24,000 should be recognised in the balance

sheet.

y

In year 2, deferred tax expense will be recognised at(Rs. 24,000 32,000) orRs. 8,000.

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Preparation of Profit and Loss Account

Usually, regulators do not require segmentation

of profit and loss account into manufacturing

account, trading account and profit and loss

account.

However, entities often prefer this segmentation.

y The manufacturing account shows the cost of goods

manufactured:

y The trading account shows the gross profit earned

during the reporting periody The profit and loss account shows the net profit/loss

for the period.

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(cont.)

Manufacturing Account

y The manufacturing account is debited with the cost of

raw materials and components consumed,

manufacturing wages and other manufacturing

expenses, including depreciation on factory assets.

Trading Account

y The trading account is debited with the opening stock

of finished goods, cost of goods manufactured,

purchases of finished goods and all other expenses

attributable to bringing the finished goods to the

condition and location of sale.

y The trading account is credited with the amount of

sales and the closing stock.

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(cont.)

The Profit and Loss Account

y The profit and loss account is credited with the gross

profit, other operating income and extraordinary

income.

y It is debited with operating expenses, financingcharges, tax expenses and losses incurred during the

reporting period.

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Essentials of Financial Accounting Second Edition ASISH K BHATTACHARYYA

Closing Entries

Closing entries refer to those entries that are

passed to transfer balances in nominal accounts

appearing in the adjusted trial balance to the

manufacturing account, trading account and

profit and loss account.

The closing entries close nominal accounts in the

general ledger.

The remaining account balances represent either

assets or liabilities that appear in the balancesheet.

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Essentials of FA_Chapter 6

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