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AccountingUPSC EPFO APFC/AO/EO Exam 2023

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BY: CA DHANANJAY OJHA (FOUNDER DHAN TAX & FELLOW MEMBER OF ICA)
1 UPSC INTERVIEW | 02 UPSC MAINS
CONSULTANT IN VARIOUS GOVERNMENT DEPARTMENT

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Index
Chapter 1 .....................................................................................8 Consideration in selection of accounting policies 22
The Basic Accounting ..........................................................8 Change in accounting policies .....................................22
Key Concept ......................................................................8 Accounting Standards (AS) issued by the Institute
Definitions ..............................................................................9 of Chartered Accountants of India (ICAI) .................22

Maintaining Records ......................................................9 Difference between AS and IAS (IFRS) ......................24

Profit and Loss..................................................................9 Institute of Chartered Accountants and

Corresponding Accounting Standards issued as
Utility of Resources.........................................................9
IFRS .........................................................................................24
Estimation of Financial Position.................................9
Double entry system ........................................................27
Helps in Decision Making ......................................... 10
Personal Account ..............................................................28
Generating financial information................................ 10
There are three types of personal accounts they
Recording transactions .............................................. 10 are.......................................................................................28
Entering journal entries ............................................. 11 Real Account .......................................................................29
Posting entries to the general ledger................... 11 Tangible Real Accounts ..............................................29
Creating an unadjusted trial balance ................... 11 Intangible Real Accounts ...........................................29
Using worksheets ......................................................... 11 Nominal Account ..............................................................29
Balancing entries .......................................................... 11 Journal entry .......................................................................30
Preparing financial statements ............................... 12 Sales Return and Purchase Return .............................32
Closing ............................................................................. 12 Discount Allowed and Discount Received ...............32
Using the Financial Information .................................. 12 Discount Allowed .........................................................32
Area of service ............................................................... 15 Discount Received........................................................33
Accounting Conventions ............................................... 16 Difference .............................................................................33
Concepts, principles and Conventions ..................... 16 Compound Entry ...............................................................34
Accounting Principles ................................................. 17 Bookkeeping Efficiency ..............................................34
Meaning ............................................................................... 19 Single Accounting Event ............................................34
Compliance of Accounting Standards (As per Outstanding Expenses/Prepaid Expenses /Accrued
Companies Act, 2013) ..................................................... 20 Income/Advance Income ...............................................34
The accounting standards cover a wide range of Outstanding Expenses ................................................34
topics, including: .......................................................... 20
Prepaid Expenses ..........................................................35
The Indian Accounting Standards Core
Outstanding Expenses ................................................35
Objectives ............................................................................ 21
Prepaid Expenses ..........................................................35
Accounting policies and their disclosures ............... 21
Accrued Income ............................................................36

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Advance Income ........................................................... 36 Errors of Duplication: ..................................................55
Introduction ........................................................................ 36 Steps to Locate Errors .....................................................55
Difference between Journal and Ledger .................. 37 Rectification of errors ......................................................56
Ledger posting .................................................................. 38 Suspense account and rectification ...........................57
Opening Entry .................................................................... 38 Rectification of errors when books have been
Balancing of account ....................................................... 38 closed (rectification in the next year) ........................57

Definition of a Cash Book.............................................. 39 A computerized accounting system typically

includes the following modules ..............................59
Types of cashbook ........................................................... 40
CHAPTER 3 ...............................................................................66
General Cash Book ...................................................... 40
Financial statements ..........................................................66
Single Column Cash Book ....................................... 40
Objective ..............................................................................66
Double Column Cash Book ...................................... 41
Difference .............................................................................68
Triple Column Cash Book.......................................... 41
Cost of goods sold and gross profit ..........................69
Petty Cash Book............................................................ 42
The formula for calculating gross profit is ..........70
Advantages of Cash Book ............................................. 42
Need of Trading Account...............................................70
Objective of accounting ................................................. 45
Opening Stock ...............................................................71
Chapter II .................................................................................. 48
Purchases and Purchases Returns ..........................71
Trial balance .......................................................................... 48
Carriage or Freight .......................................................71
Purpose of Trial Balance................................................. 49
Wages ...............................................................................71
Features of Trial Balance ................................................ 49
Fuel and Power ..............................................................72
Objective .............................................................................. 49
Lighting ............................................................................72
Balances of Ledger Accounts ....................................... 49
Rent and Rates ..............................................................72
Gross Trial Balance ........................................................... 50
Depreciation ...................................................................73
Net Trial Balance ............................................................... 50
Sales and Sales Returns..............................................73
Specimen of trial balance.......................................... 51
Closing Stock or Inventories ....................................73
Difference between net and gross trial balance
sheet ...................................................................................... 52 Some important items of profit and loss account 74

Error of Principle ............................................................... 53 Debit items......................................................................74

Clerical Errors ..................................................................... 53 Credit items ....................................................................75

Complete omission ..................................................... 54 Transfer entries of profit and loss account .............75

Errors of Commission ................................................. 54 Net profit is earned for the year .............................75

Compensating Errors: ................................................. 54 Net loss is incurred for the year..............................75

Errors of Principle: ........................................................ 54 Company has a dividend payout for the year ...75

Errors of Original Entry: ............................................. 55 Position statement/balance sheet ..............................76

Errors of Reversal: ........................................................ 55 Assets ................................................................................76

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Liabilities and Equity ................................................... 76 Preparation of income and expenditure account .91
Balance sheet ..................................................................... 77 Receipts and payments account and cash book...91
Income statement ............................................................ 77 Receipt and Payment A/c...............................................92
Cash flow statement ........................................................ 80 Income and Expenditure A/c ........................................93
Statement of retained earnings .................................. 80 Balance Sheet .....................................................................93
Marshalling of Assets and Liabilities ......................... 81 Need of preparing Income and Expenditure
Classification of assets .................................................... 82 Account .................................................................................94

Fixed Assets .................................................................... 82 Relevant Items of Income and Expenditure ............94

Floating Assets .............................................................. 83 Items of Revenue Expenses ...........................................94

Current Assets ............................................................... 83 Preparation of income and expenditure account .95

Classification of Liabilities ............................................. 83 Subscription Received ................................................95

Fixed Liabilities .............................................................. 83 Subscription outstanding for current year..........96

Long-Term Liabilities .................................................. 83 Subscription due in the previous year but

received during the current year ............................96
Current Liabilities ......................................................... 84
Rent Paid ..............................................................................96
Contingent Liabilities .................................................. 84
Difference between Receipts and Payments A/c
Preparation of balance sheet ....................................... 84
and Income and Expenditure A/c ...............................97
Determine the Reporting Date and Period ........ 84
Preparation of balance sheet........................................97
Identify Your Assets .................................................... 84
Chapter 4 ............................................................................... 102
Identify Your Liabilities............................................... 85
Accounting for share capital ...................................... 102
Current Liabilities ......................................................... 85
Meaning of a Company .......................................... 102
Add Total Liabilities to Total Shareholders’
Characteristics of a Company ............................... 102
Equity and Compare to Assets ................................ 85
Nature of a Company .............................................. 102
Need for accounting adjustments ............................. 85
Meaning of Share Capital ....................................... 103
Here are some reasons why accounting
adjustments are needed............................................ 86 Categories of Share Capital ................................... 103

Adjustments and their incorporation........................ 86 Types of Share Capital.................................................. 103

Types of adjustments ................................................. 86 Equity Share Capital ................................................. 103

Characteristics of Not-for-Profit Organizations .... 88 Preference Share Capital......................................... 103

Accounting for Non-Profit Organisations ............... 89 Disclosure of Share Capital ........................................ 104

Need for preparing Receipts and Payments Issue of Shares For Cash.............................................. 105
Accounts of NPO .............................................................. 89 Receipt of Share Money in One Instalment: ... 105
Relevant Items of income and Expenditure............ 90 Share Money Received in Two or More
Items of Income ............................................................ 90 Instalments:.................................................................. 105

Items of Expenditure................................................... 90 On Receipt of Application Money ....................... 105

On Allotment of Shares........................................... 105

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Allotment money becoming due .........................106 Meaning Forfeiture of Shares .................................... 116
Receipt of allotment money ..................................106 Immediate Impact of Forfeiture of Shares............ 116
Over-subscription ...........................................................106 Accounting Entries for Forfeiture of Shares ......... 117
Alternatives Available in Case of Over- When the shares are issued at par .......................... 117
subscription ..................................................................106 When the shares are issued at a premium ........... 117
When shares are issued at par and are payable in Effect of Forfeiture of Shares ..................................... 118
full in a lump sum ...........................................................107
Re-issue of shares .......................................................... 119
Cash Book (Bank Columns) ....................................108
Share Forfeiture and Reissue Entry ......................... 119
When shares are issued at par and the amount is
On the Forfeiture of Shares ................................... 119
payable in instalments ..................................................108
On Reissue of Shares ............................................... 119
Accounting Entries for the Amount of Premium 110
The Profit on Reissue of Forfeited Shares is
When the Premium amount is received or
transferred to .............................................................. 120
receivable along with Allotment Money................111
Meaning of Right Shares............................................. 120
When the allotment money is due including
premium ........................................................................111 Exceptions [Sec. 81(1A)] .............................................. 121
When the allotment money is received along Journal entries for the issue of fully paid-up
with premium ..............................................................111 bonus shares ............................................................... 122
If the Premium is received or receivable with Call Source of Issue of Bonus Shares .............................. 123
Money: ................................................................................111 Authorization of Bonus Issue in General
When the call money is due along with Meeting ......................................................................... 123
premium ........................................................................111 Bonus Shares are not allowed in case of partly
When the call money is received along with paid shares ................................................................... 123
premium ........................................................................111 Prohibition on issue of Bonus Shares ................ 123
Introduction ......................................................................112 Bonus shares in lieu of Dividend ......................... 123
Meaning .............................................................................112 Bonus issue cannot be withdrawn ...................... 124
Conditions for Issue of Shares at Discount...........112 Important issues relating to issue of bonus
When a Company can't Issue Shares at shares.................................................................................. 124
Discount? ...........................................................................113 Quantum of Bonus Shares ..................................... 124
When a Company can Issue Shares at a Where authorized capital was exhausted ........ 124
Discount? ...........................................................................113
Entitlement of Bonus Shares ................................. 124
Sweat Equity Shares ..................................................113
Procedure & Practice .................................................... 124
Issue of Shares to Creditors ...................................113
Procedure for Bonus Shares .................................. 124
Rights Issue at Discount ..........................................113
Sources of Buyback ....................................................... 126
Initial Public Offering (IPO).....................................114
Conditions of Buy Back Of Shares ........................... 126
Offer for Sale (OFS) ...................................................114
Objectives of Buy Back of Shares ............................. 126
Accounting Treatment for Shares Issued at
Procedure for Buy Back of Shares............................ 127
Discount .............................................................................114

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Chapter 5 ................................................................................128 Average Collection Period .......................................... 137
Ratio analysis ......................................................................128 Creditors Turnover Ratio ............................................. 137
Introduction ......................................................................128 Average Payment Period............................................. 137
Sources of Financial Data for Analysis ....................128 Working Capital Turnover Ratio ............................... 137
Importance of Ratio Analysis .................................128 Gross Profit Ratio ........................................................... 138
Types of Ratios ................................................................129 Net Profit Ratio ............................................................... 138
Long-term Solvency and Leverage Ratios.............130 Operating Profit Ratio .................................................. 138
Activity Ratios ..................................................................130 Expense Ratio .................................................................. 138
Profitability Ratios ..........................................................131 Return on Investment ................................................... 139
Contribution Margin Ratio .....................................131 Return on Assets ............................................................ 139
Gross Profit Ratio .......................................................131 Return on Capital Employed ...................................... 139
Net Profit Ratio ...........................................................131 Return on Equity (ROE) ................................................ 139
Return on Assets ........................................................131 Equity Multiplier ............................................................. 140
Return on Equity.........................................................131 Earnings per Share......................................................... 140
Current Ratio ....................................................................132 Dividend per Share ........................................................ 140
Components of Current Ratio ...............................132 Dividend Pay-out Ratio................................................ 140
Calculating the Current Ratio ................................132 Price- Earnings Ratio..................................................... 141
Acid Test Ratio .................................................................132 Chapter VI.............................................................................. 142
Cash Ratio..........................................................................133 Cash flow statement ....................................................... 142
Formula ..........................................................................133 Importance of a cash flow statement ..................... 142
Defensive interval ration ..............................................133 Definitions......................................................................... 142
Formula ..........................................................................134 Cash and Cash Equivalents ......................................... 143
Debt equity ratio .............................................................134 Activities for the Preparation of Cash Flow
Equity Ratio .......................................................................134 Statement ..................................................................... 143

Capital Gearing Ratio ....................................................134 Investing Activities .................................................... 144

Proprietary Ratio .............................................................134 Financing Activities .................................................. 144

Debt Ratio .........................................................................135 Cash flow from operating activities (CFO) ....... 145

Debt Service Coverage Ratio (DSCR) ......................135 Cash from Investing Activities ................................... 145

Interest Coverage Ratio................................................135 Calculation using direct method ......................... 146

The preferred dividend coverage ratio ..................136 Indirect Method .............................................................. 147

Fixed Charges Coverage Ratio...................................136 Chapter VII ............................................................................ 149

Net Assets or Capital Employed Turnover Ratio 136 Partnership accounts ......................................................... 149
Inventory Turnover Ratio .............................................136 Features or Characteristics of Partnership ............ 149

Debtors Turnover Ratio ................................................136 Minimum and maximum numbers of partners .. 149

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Importance of a Partnership Deed...........................150 Distribution of Reserves, Accumulated Profits and
Types of Partnership Deeds ........................................150 Losses ................................................................................. 161

Contents of a Partnership Deed................................151 For transferring accumulated profit and

reserves ......................................................................... 162
Name of the firm ........................................................151
For transferring accumulated loss....................... 162
Details of the partners..............................................151
Adjustment for goodwill ............................................. 162
Business of the firm...................................................151
Accounting treatment for goodwill .................... 162
Duration of firm ..........................................................151
When new partner brings cash towards
Place of business ........................................................151
goodwill ........................................................................ 162
Capital contribution ..................................................151
Different methods of valuation of goodwill ........ 163
Sharing of profit/loss ................................................151
Years’ Purchase of Average Profit Method .......... 163
Salary and commission ............................................151
Profit Basis Method .................................................. 164
Partner’s drawings .....................................................151
Years’ Purchase of Weighted Average
Partner’s loan ...............................................................151 Method .......................................................................... 165
Duties and obligations of partners......................151 Capitalisation Method ............................................. 166
Admission, death and retirement of partners .152 Annuity Method ......................................................... 168
Accounts and audit ...................................................152 Super-Profit Method ................................................ 169
Provisions Affecting Accounting Treatment in Capitalisation of Super-Profit Method .............. 173
Partnership Business......................................................152
Sliding Scale Valuation Method ........................... 174
Fluctuating Capital method ........................................153
Adjustment for life policy............................................ 175
Fixed Capital method ....................................................153
Adjustments require on retirement of a partner
Distinction between fixed and fluctuating capital from the firm ............................................................... 175
accounts .............................................................................153
New Profit Sharing Ratio ............................................. 175
Profit and loss appropriation account ....................154
Gaining Ratio ................................................................... 175
Interest on capital...........................................................156
Adjustment for Revaluation of Assets and
When Capital is fixed ..................................................156 Liabilities ............................................................................ 176
When Capital is Fluctuating .......................................156 Adjustment of Partners Capital and Death of a
Accounting Treatment of Interest on Capital .........157 Partner ................................................................................ 177

Interest on Drawings ........................................................157 Methods to calculate the profit of a deceased

partner ........................................................................... 178
Only when agreed upon..........................................157
Dissolution of firm ......................................................... 180
Partners’ salary.................................................................158
The dissolution of partnership takes place in any
Partner’s Loan account ..........................................158
of the following ways ............................................... 180
Computation of New Profit-Sharing Ratio............159
Ways in which dissolution of a partnership firm
Revaluation of Assets and Liabilities .......................159 takes place ................................................................... 180
Dissolution by Agreement ....................................... 180

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When certain contingencies happen ....................181 Functional Classification of Cost .......................... 192
Dissolution by Notice ................................................181 Cost Classification by Relation to Cost Centre193
Dissolution by Court ..................................................181 Cost Classification by Behaviour .......................... 193
Accounting Treatment ..................................................182 Cost Classification by Management Decision
Realisation Account...................................................182 Making........................................................................... 193

Browse more Topics under Dissolution of Cost Classification by Production Process ....... 194
Partnership Firm .........................................................182 Cost Classification by Time .................................... 194
Realisation account ...................................................182 Cost Sheet – Definitions .............................................. 195
Partner’s Loan Account ............................................183 Importance and objectives of cost sheet .............. 196
Following entry is the entry on payment of Functional classification of elements of cost ....... 196
Partner’s loan ...............................................................183 Cost heads in a cost sheet .......................................... 196
Partners’ Capital Accounts ......................................183 Prime Cost .................................................................... 196
On transfer of undistributed profits/losses and Works Cost or Factory Cost ................................... 197
reserves ..........................................................................183
Cost of Production .................................................... 197
Transfer of Realisation profit/ loss ......................184
Total Cost ..................................................................... 198
For final settlement with partners........................184
Formulas ...................................................................... 199
Bank or Cash Account ..............................................185
CHAPTER 9 ............................................................................ 202
Questions ......................................................................185
Insurance claim for loss of stock and loss of profit 202
Chapter 8 ................................................................................189
Loss of stock .................................................................... 202
Nature and scope of cost accounting.....................189
Loss of profit .................................................................... 202
Functions of accounting ..............................................190
Value of Salvaged Stock ......................................... 204
Objections to Cost Accounting .................................190
Other Important Points ........................................... 204
It is Unnecessary .........................................................190
Consequential Loss Insurance ................................... 204
It is Expensive ..............................................................191
Computation of Claim .................................................. 205
Scope of Cost Accounting ...........................................191
Cost Classification by Nature.................................192

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Chapter 1
The Basic Accounting
Introduction
Accounting is the process of recording financial transactions pertaining to a business. The accounting
process includes summarizing, analyzing, and reporting these transactions to oversight agencies, regulators,
and tax collection entities. The financial statements used in accounting are a concise summary of financial
transactions over an accounting period, summarizing a company's operations, financial position, and cash
flows.

Key Concept
 Regardless of the size of a business, accounting is a necessary function for decision making, cost
planning, and measurement of economic performance.
 A bookkeeper can handle basic accounting needs, but a Certified Public Accountant (CPA) should be
utilized for larger or more advanced accounting tasks.
 Two important types of accounting for businesses are managerial accounting and cost accounting.
Managerial accounting helps management teams make business decisions, while cost accounting
helps business owners decide how much a product should cost.
 Professional accountants follow a set of standards known as the Generally Accepted Accounting
Principles (GAAP) when preparing financial statements.
 Accounting is an important function of strategic planning, external compliance, fundraising, and
operations management.

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Definitions
 American Accounting Association: "Accounting is the process of identifying, measuring, and
communicating economic information to permit informed judgments and decisions by users of the
information."
 R. J. Chambers: "Accounting is a social science concerned with the measurement of economic
activity."
 Warren Buffet: "Accounting is the language of business."
 Robert Anthony: "Accounting is the process of recording, classifying, and summarizing economic
events to provide information that is useful in making decisions."
 AICPA (American Institute of Certified Public Accountants): "Accounting is 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."
 Sidney Davidson: "Accounting is the process of collecting, recording, and reporting financial
information to enable informed decision-making."
 Charles T. Horngren: "Accounting is the process of identifying, measuring, and communicating
economic information

Objectives of Accounting
Maintaining Records
As we mentioned, accounting is the spoken language of transactions. The human brain cannot store
endless information. And so accounting takes the charge of keeping the records of all the transactions
made within a firm.

Profit and Loss

Business is directly proportional to profits. It is all about earning profits. The accounting chart of profit and
loss determines whether there is a profit or loss made in the business. The income and expenditure decide
profit and loss.

Utility of Resources
Resources are a very crucial part of any organization and for a firm to function smoothly, they play a
significant role. The records hold the responsibility to report to the firm about the different activities along
with its timing. Hence, it becomes easy for the management to take note of the details before putting in the
money.

Estimation of Financial Position

A business person is not only interested in knowing the Profit and Losses of his business but he also wants
to know how much he owes to his creditors and how much he has to pay to his debtors. For this purpose,
he prepares a statement in which all such details are recorded. This statement is known as Balance sheet.
With the help of Balance sheet Financial position of the business can be Understood.

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Helps in Decision Making
With the help of all the records that have been maintained by following Accounting Procedures, Decisions
can be made with all those information which eventually helps in the smooth functioning of the
organisation.

Procedural aspects of accounting

On the basis of the above definitions, procedure of accounting can be basically divided into two parts

 Generating financial information and

 Using the financial information

Generating financial information

Recording transactions
The first step in the accounting procedure is to identify and record all business transactions. Organisations
have many transactions throughout the fiscal year and it is crucial to record individual transactions
accurately. Organisations use automated point of sale algorithms and software to record sales. Apart from
sales, transactions may include debt payments, employee payroll, purchases and reimbursements.
Transactions do not include creating purchase orders and signing contracts. Bookkeepers record exact

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amounts during this step of the accounting cycle. Transactions are the first requirements for the upcoming
accounting procedure.

Entering journal entries

The second step in the accounting method is the establishment of journal entries for every transaction in a
paper or electronic journal. Many organisations use point of sale technology to combine steps one and two.
They also keep a record of the expenses of the organisation. Bookkeepers record transactions
chronologically, with the oldest transaction at the top and the newest at the end. Single-entry bookkeeping
is equivalent to maintaining a chequebook.

Double-entry bookkeeping requires you to record two entries for every transaction under two accounts that
have equal credits and debits. This is further classified into two types, accrual accounting, which involves
matching revenues with expenses, and cash accounting, for which you require documenting transactions
when the organisation receives cash for the transaction.

Posting entries to the general ledger

Once you have listed every transaction in a journal, the third step is to record the transactions in the general
ledger. A business's general ledger keeps a record of all financial activities, organising every account by
category. This allows accountants and bookkeepers to gauge the business's economic position through one
centralised document. The general ledger aids authorities to monitor the influence of expenses and income
of every individual account on the business's finances. It is a bookkeeper's responsibility to post the journal
entries in the general ledger to provide uniformity and efficiency.

Creating an unadjusted trial balance

Accounting professionals of a company enter the data from the general ledger to a trial balance at the end
of an accounting period. Accountants create a trial balance to identify and correct any errors that might
have occurred during the initial stages of accounting proceedings. This trial balance is unadjusted because
of the difference between the total debit and credit of a company's account. A trial balance is successful
when the debit is equal to the credit section of the ledger.

The accountant requires identifying inconsistencies in the ledger and rectifying them to maintain parity to
ensure both sections of the ledger are equal.

Using worksheets
Creating and analysing a worksheet is the fifth step of the accounting cycle. Accountants draft worksheets
to ensure a balance between debits and credits and make adjustments if there are any differences. In
addition, bookkeepers use worksheets as a visual aid to recognise typing errors, inconsistencies and entry
mistakes in the ledger and identify the adjustments to make. The bookkeeper makes adjustments and
explains the adjustments made in the ledger by using the worksheet.

Balancing entries
Bookkeepers adjust all ledger and journal entries based on accruals and deferrals in the sixth step of the
accounting procedure. Some financial transactions may take several days to process most times. So this
step helps accountants identify sales or expenditures that were not recorded in the journals. The
bookkeeper also adjusts the trial balance by reviewing past journal entries. It is a bookkeeper's job to
recognise unusual account activity and unaccounted balances and fix existing errors. This step also involves

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a calculation of depreciation of assets, prepayments, loans, among other accruals and deferrals that affect
the accuracy of the ledger.

Preparing financial statements

The seventh step involves bookkeepers to create a financial statement report which summarises all
transactions in an accounting period. During this step of the accounting cycle, accountants classify financial
statements into categories like income statements, statements of retained earnings, balance sheets and
cash flow statements in the respective order.

It is important that an accountant prepares these financial documents in this order because they use gross
income from the income statement to prepare a statement of retained earnings. Accountants use the final
balance of the statement of retained earnings to prepare the balance sheet. Professionals prepare the cash
flow statement at the end, as it utilises data from the first three statements.

Closing
The last step of the accounting process includes the closing of temporary accounts and producing a closing
statement which delivers the analysis of the business's financial performance during the accounting period.
Accounts in the income statement are temporary accounts. The bookkeeper closes out or zeroes out these
accounts at the end of the fiscal year, meaning they transfer balances from these accounts to permanent
accounts on the balance sheets. The aim of this step is to reset debit and credit balances to zero and
document and organise data systematically.

Using the Financial Information

Accounting provides the art of presenting information systematically to the users of accounts. Accounting
data is more useful if it stresses economic substance rather than technical form. Information is useless and
meaningless unless it is relevant and material to a user's decision. The information should also be free of
any biases. The users should understand not only the financial results depicted by the accounting figures,
but also should be able to assess its reliability and compare it with information about alternative
opportunities and the past experience.

Book Keeping
Bookkeeping is the process of recording and maintaining accurate financial transactions of a business. It
involves recording all transactions, classifying them into appropriate categories, and summarizing them in a
way that can be easily understood by stakeholders.

Bookkeeping begins with the identification of all financial transactions that take place within a business,
such as sales, purchases, payments, and receipts. These transactions are then recorded in a journal, which
includes the date, amount, and description of the transaction.

After transactions are recorded in the journal, they are then posted to respective ledger accounts. Each
ledger account shows the total transactions related to it, such as accounts receivable, accounts payable,
cash, and inventory.

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A trial balance is prepared by adding up all the balances of the ledger accounts to ensure that the total
debit balance equals the total credit balance. If the trial balance is not balanced, then there may be errors in
recording or posting transactions.

Adjusting entries are made to update accounts for transactions or events that occurred during the
accounting period but were not recorded. Examples of adjusting entries include depreciation of fixed assets,
accruals for expenses, and prepayments for expenses.

After adjusting entries are made, an adjusted trial balance is prepared to ensure that the debits and credits
still balance. Financial statements, such as the income statement, balance sheet, and statement of cash
flows, are then prepared using the adjusted trial balance.

Finally, closing entries are made to transfer the balances of temporary accounts to retained earnings or
capital accounts. This process resets the temporary accounts to zero balances, ready for the next accounting
period.

Book keeping vs accounting

Bookkeeping Accounting

Definition The process of recording financial The process of recording, classifying, summarizing, analyzing,
transactions. and interpreting financial transactions.

Objective To accurately record financial To provide useful financial information for decision-making.
transactions.

Focus Recording transactions and Analyzing financial information to provide insights and
maintaining accurate financial recommendations for business decisions.
records.

Scope Limited to recording and Broader, including financial statement analysis, tax planning,
classifying transactions. and financial forecasting.

Skills Attention to detail and basic Strong analytical skills and in-depth knowledge of accounting
Needed accounting knowledge. principles and practices.

Tools Used Ledgers, journals, and accounting Financial analysis software, accounting systems, and
software. databases.

Outputs Financial records, such as ledgers, Financial statements, such as the balance sheet, income
journals, and trial balances. statement, and statement of cash flows.

Role in Provides the foundation for Essential component of accounting, providing the basis for
Business accounting. financial analysis and decision-making.

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Sub-fields of Accounting
Financial accounting: This sub-field of accounting focuses on the external reporting of financial
information to stakeholders, including investors, creditors, and regulatory bodies. Financial accountants
record financial transactions using Generally Accepted Accounting Principles (GAAP) and International
Financial Reporting Standards (IFRS) to prepare financial statements, such as the balance sheet, income
statement, and statement of cash flows. These financial statements provide stakeholders with information
about a company's financial position, performance, and cash flows.

Management accounting: This sub-field of accounting focuses on providing financial information to

support internal decision-making. Management accountants work with managers to analyse financial data,
identify trends, and develop strategies to improve a company's financial performance. They provide
information about costs, revenues, profits, and cash flows to help managers make informed decisions about
pricing, product lines, investments, and other aspects of the business.

Cost accounting: This sub-field of accounting focuses on tracking and analysing costs associated with a
company's products or services. Cost accountants analyse costs of production, including materials, labour,
and overhead, to determine the cost of goods sold and make pricing decisions. They use techniques such
as job costing, process costing, and activity-based costing to allocate costs to products and services and
identify areas where costs can be reduced.

Auditing: This sub-field of accounting focuses on verifying the accuracy of financial records and reports.
Auditors examine financial records to ensure they are in compliance with accounting standards and legal
regulations. They also provide assurance to stakeholders that financial statements are free from material
misstatement and are prepared in accordance with accounting principles.

Tax accounting: This sub-field of accounting focuses on preparing tax returns and ensuring compliance
with tax laws and regulations. Tax accountants work with individuals and businesses to minimize tax
liabilities and take advantage of tax incentives. They also provide advice on tax planning, tax compliance,
and tax disputes.

Forensic accounting: This sub-field of accounting focuses on investigating financial fraud and white-collar
crimes. Forensic accountants use accounting principles and investigative techniques to analyse financial
records and identify fraudulent activity. They also provide litigation support and expert testimony in legal
disputes.

Government accounting: This sub-field of accounting focuses on managing the financial resources of
government entities, including budgeting, accounting, and financial reporting. Government accountants
work in federal, state, and local governments and provide information to policymakers and the public about
the financial performance and accountability of government programs.

Non-profit accounting: This sub-field of accounting focuses on the unique financial reporting and
compliance requirements of non-profit organizations. Non-profit accountants prepare financial statements
using the Financial Accounting Standards Board (FASB) standards and provide information about funding
sources, program expenses, and compliance with tax laws and regulations.

International accounting: This sub-field of accounting focuses on the unique financial reporting and
compliance requirements of international business operations. International accountants must understand

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the accounting standards and tax laws of different countries and ensure compliance with regulations in
each jurisdiction.

Users of accounting information

Investors: Investors use accounting information to evaluate the financial performance and stability of a
company before investing in its stock or debt securities. They use financial statements such as the balance
sheet, income statement, and statement of cash flows to analyse a company's profitability, liquidity, and
solvency.

Creditors: Creditors use accounting information to evaluate the creditworthiness of a company before
lending it money. They use financial statements to determine a company's ability to repay its debts and
assess the risk of default.

Management: Managers use accounting information to make informed decisions about the operations of a
company. They use financial statements to track revenues, expenses, and profits and to monitor the
financial position of the company.

Employees: Employees use accounting information to understand the financial performance of the
company they work for. They use financial statements to assess the stability and profitability of the
company and to evaluate the impact of their work on the company's financial position.

Regulators: Regulators use accounting information to ensure compliance with laws and regulations. They
use financial statements to monitor the financial performance of companies in their jurisdiction and to
identify areas of potential fraud or misconduct.

Tax authorities: Tax authorities use accounting information to ensure compliance with tax laws and
regulations. They use financial statements to verify the accuracy of tax returns and to identify potential
areas of tax evasion.

Suppliers and customers: Suppliers and customers use accounting information to assess the financial
stability and creditworthiness of the companies they do business with. They use financial statements to
evaluate the ability of a company to pay its bills on time and to meet its financial obligations.

Role of Accountancy in society

Area of service
 Maintenance of Books of Accounts
 Statutory Audit
 Internal Audit
 Taxation
 Management Accounting and Consultancy Services
 Financial Advice
 Other Services
Secretarial Work
Share Registration Work
Company Formation
Receiverships, Liquidations, etc.
Arbitrations
As regards the Cost Accounts

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Accountant and Information Services

Accounting Conventions and Standards

Accounting Conventions
Accounting conventions are guidelines used to help companies determine how to record certain business
transactions that have not yet been fully addressed by accounting standards. These procedures and
principles are not legally binding but are generally accepted by accounting bodies. Basically, they are
designed to promote consistency and help accountants overcome practical problems that can arise when
preparing financial statements.

 Accounting conventions are guidelines used to help companies determine how to record business
transactions not yet fully covered by accounting standards.
 They are generally accepted by accounting bodies but are not legally binding.
 If an oversight organization sets forth a guideline that addresses the same topic as the accounting
convention, the accounting convention is no longer applicable.
 There are four widely recognized accounting conventions: conservatism, consistency, full disclosure,
and materiality.

Concepts, principles and Conventions

Conservatism: In accounting, the convention of conservatism, also known as the doctrine of prudence, is a
policy of anticipating possible future losses but not future gains. This policy tends to understate rather than
overstate net assets and net income, and therefore lead companies to “play safe”.

Example: Provision for Bad Debts, Discount on Debtors, Valuation of Inventories at lower of Cost or Market
Price whichever is Lower,

Full Disclosure: This convention says that all relevant and Realistic Information must be disclosed.
Disclosure should be in such a way that information is easily accessible to the Financial Statement user.
Normally needed Information is provided as Schedules, Annexures and Notes to the Financial Statements.
Underlying concept of disclosure is that Information must be disclosed at one place and in no case it should
be scattered. Information is provided for the decision making of the Financial Statement users.

Consistency: This convention is linked with the comparability of the Financial Statements. Accounting
Principles are followed Year to Year and uniformly in one Industries to make Financial Statements
comparable. Deviation from consistency is permissible if it is required by Law or any Accounting Standard
or it may give better presentation to the Financial Statements. Consistency refers to a company’s use of
accounting principles over time. When accounting principles allow a choice between multiple methods, a
company should apply the same accounting method over time or disclose its change in accounting method
in the footnotes to the financial statements

Materiality : Materiality is an accounting principle which states that all items that are reasonably likely to
impact investors’ decision-making must be recorded or reported in detail in a business’s financial
statements using GAAP standards. Materiality is a concept that defines why and how certain issues are

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important for a company or a business sector. A material issue can have a major impact on the financial,
economic, reputational, and legal aspects of a company, as well as on the system of internal and external
stakeholders of that company. Items or events which have significant effect in decision based on Financial
Statement must be clearly disclosed. Both nature and volume of a transaction is capable to make it material.

Accounting Concepts: Accounting concepts are the basic rules, assumptions, and conditions that define
the parameters and constraints within which the accounting operates. These are the basic “Assumptions on
the basis of which Financial Statements are prepared.” Concepts are Perceived/ Assumed and Accepted by
the governing Accounting body of a country.

Some Accounting concepts are applicable in recording stage (while Journal Entry) like Separate Entity,
Going Concern, Money Measurement, Dual Aspect, Cost Concept and Periodicity. Likewise some concepts
are applicable at the time of summarization (While making Financial Statements) like Accrual, Materiality
and Realization.

Accounting Principles
Set of doctrines generally associated with theory and procedure of accounting. Accounting principles are
the rules and guidelines that companies must follow when reporting financial data. The Financial
Accounting Standards Board (FASB) issues a standardized set of accounting principles in the U.S. referred to
as generally accepted accounting principles (GAAP).

Separate Entity: This concept says business is separate and businessman is separate. Further, the separate
entity concept states that we should always separately record the transactions of a business and its owners.

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The concept is most critical in regard to a sole proprietorship, since this is the situation in which the affairs
of the owner and the business are most likely to be intermingled.

Effect: Capital A/c and Drawing A/c emerges in the account books of the organization.

Money Measurement: This concept says only events/transactions which are measurable in terms of money
are to be recorded in the account books. The monetary unit principle states that business transactions
should only be recorded if they can be expressed in terms of a currency. In other words, anything that is
non-quantifiable should not be recorded a business’ financial accounts. Over time, money has been
adopted as a measurement unit in accounting.

Example: Qualification and Experience of owner are not shown in Financial Statements and similarly value
of Human Resources are not shown in Financial Statements.

Periodicity: The periodicity concept, can be also called the time interval concept, is a period during which
business enterprises are required to prepare financial statement at specified intervals. Interim reporting
(Half yearly/Quarterly) cannot be termed as accounting period. Financial i.e. from 1st April to 31st March is
normally termed as Accounting Period for the business organizations. Accounting period is not just to know
the result (Profit/Loss) for period but it is also to conclude and not further recording should be possible for
that accounting period.

Accrual Concept: According to this concept Items and Events are recoded when they are earned/expended
and not received/paid. Because of this concept Outstanding/ Prepaid items arise in the financial statement.
The general concept of accrual accounting is that economic events are recognized by matching revenues to
expenses (the matching principle) at the time when the transaction occurs rather than when payment is
made or received.

Matching Concept: According to this concept Expenses are to be matched with the revenue to which they
pertains. The matching principle requires that revenues and any related expenses be recognized together in
the same reporting period. Thus, if there is a cause-and-effect relationship between revenue and certain
expenses, then record them at the same time.

Example: Royalty income of one period should be matched with the expenditure related with royalty
earning

Going Concern: According to this concept in accounting an enterprise is considered as Going Concern and
it is presumed that it will continue its operations for the forcible future. Further, it is also presumed that
there is no Intention/Need contrary to this concept exists.

Example: Because of this concept an asset is depreciated during the life time of asset and not business.

Cost Concept: Assets are to be recorded at their Historical Cost value and not on market value/opportunity
costs/realizable value. The cost principle is an accounting principle that records assets at their respective
cash amounts at the time the asset was purchased or acquired. The amount of the asset that is recorded
may not be increased for improvements in market value or inflation, nor can it be updated to reflect any
depreciation.

Effect: Fixed Assets are recorded at costs incurred up to the ready to put to use condition of the assets and
not on any other value.

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Dual Aspect Concept: The dual aspect concept states that every business transaction requires recordation
in two different accounts. This concept is the basis of double entry accounting, which is required by all
accounting frameworks in order to produce reliable financial statements. As the business is a separate entity
each and every transaction of the business has two aspects. In simple words, the dual aspect concept brings
into notice how every single transaction ends up affecting two accounts. For example, A takes a loan of Rs,
1 million from his bank. The two accounts getting affected here are the bank accounts of A and Bank Loan
Account (Provided Loan amount is credited in the Bank A/c).

Accounting equation

The accounting equation is the fundamental formula in accounting—it shows that assets are equal to
liabilities plus owner's equity. It's the reason why modern-day accounting uses double-entry bookkeeping
as transactions usually affect both sides of the equation. The accounting equation is an accounting
fundamental that bookkeepers need to master to be proficient.

Concepts of Accounting Standards

Meaning
Accounting standards improve financial reporting transparency in all countries. International businesses
adhere to the International Financial Reporting Standards (IFRS), which are established by the International
Accounting Standards Board and serve as a guideline for non-US GAAP companies reporting financial
statements.

In the United States, generally accepted accounting principles are widely used by both public and private
entities. The rest of the world follows IFRS. These standards must be followed by multinational
organisations. The International Accounting Standards Board (IASB) establishes and interprets accounting
standards used by international communities when preparing financial statements.

Accounting standards cover all aspects of a company’s finances, such as assets, liabilities, revenue,
expenses, and shareholders’ equity. Accounting standards involve revenue recognition, asset valuation,

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allowable depreciation methods, what is depreciable, lease categories, and outstanding share measurement.
Accounting standards dictate when and how economic events should be recognised, measured, and
displayed. Accounting standards are used by external entities such as banks, investors, and regulatory
agencies to ensure that relevant and accurate information about the entity is provided. These technical
pronouncements have increased transparency in reporting and established the parameters for financial
reporting measures.

Compliance of Accounting Standards (As per Companies Act, 2013)

As per the Companies Act, 2013, companies in India are required to comply with the accounting standards
issued by the Institute of Chartered Accountants of India (ICAI). These accounting standards provide
guidance on the preparation and presentation of financial statements, ensuring consistency and
transparency in financial reporting across companies.

The Companies Act, 2013 mandates that all companies, whether public or private, need to comply with the
accounting standards issued by ICAI while preparing their financial statements. The Act also empowers the
Ministry of Corporate Affairs to prescribe accounting standards that need to be followed by companies in
specific industries or sectors.

The accounting standards cover a wide range of topics, including:

 Disclosure of accounting policies
 Valuation of inventories
 Treatment of fixed assets and depreciation
 Treatment of investments
 Treatment of contingencies and events after the balance sheet date
 Treatment of revenue recognition
 Treatment of leases
 Treatment of employee benefits
 Treatment of borrowing costs
 Treatment of foreign currency transactions

Compliance with accounting standards ensures that financial statements are prepared in a consistent and
transparent manner. This helps users of financial statements, such as investors, creditors, and other
stakeholders, to make informed decisions based on accurate and reliable financial information. Non-
compliance with accounting standards can result in penalties and legal action, including fines and
imprisonment, for company directors and officers.

 By Auditor: The Auditors should report compliance of Accounting Standards.

 Constitution of National Financial Reporting Authority to advise Central Government on the
formulation of Accounting Standards.
 Every Profit and Loss account and Balance Sheet (Financial Statement) shall comply with the
Accounting Standards.
 Where Profit and Loss Account and Balance Sheet of the Company do not comply with the
Accounting Standards, such companies shall disclose in its profit and loss account and balance
sheet, the following
The deviation from accounting standards.

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The reasons for such deviation.
The financial effect, if any, arising due to such deviation
 Central Government has power to prescribe, in consultation with National Authority the Accounting
Standards as recommended by ICAI.
 Directors Report to include a statement that applicable accounting standards have been followed
along with explanation relating to material departures.

The Indian Accounting Standards Core Objectives

 The primary goal of Indian accounting standards is to increase the transparency of annual financial
statements in corporate accounts.
 Ensure that companies in India follow these guidelines in order to implement internationally
recognised best practices.
 All of the companies use the same systematic, single accounting system. Getting rid of
misunderstandings and deceptions.
 The Indian accounting standards are so simple that they can be understood anywhere in the world.
 There are a number of global requirements, and Indian accounting standards are designed to meet
those requirements.
 To improve the financial statements’ dependability.

Accounting policies and their disclosures

Accounting policies refer to the specific accounting principles, methods, and procedures adopted by a
company to prepare and present its financial statements. These policies play a crucial role in ensuring the
accuracy and reliability of financial reporting. As per the Companies Act, 2013, companies are required to
disclose their accounting policies in their financial statements, including the notes to accounts.

The disclosures related to accounting policies typically include

 Basis of preparation: This disclosure outlines the accounting framework used to prepare the
financial statements, such as Indian Accounting Standards (Ind AS) or Generally Accepted
Accounting Principles (GAAP).
 Significant accounting policies: This disclosure outlines the specific accounting policies adopted
by the company, including policies related to revenue recognition, inventory valuation, depreciation
methods, etc.
 Changes in accounting policies: If the company has changed its accounting policies during the
reporting period, the financial statements should disclose the nature and effect of such changes.
 Judgments and estimates: The financial statements should disclose any significant judgments and
estimates made by management in applying accounting policies.
 Impact of future changes in accounting policies: If there are any expected changes in accounting
policies that are likely to have a significant impact on the financial statements, the company should
disclose the nature and timing of such changes.

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 Compliance with accounting standards: The financial statements should disclose whether the
company has complied with the applicable accounting standards, including any deviations from
such standards and the reasons for such deviations.

The disclosures related to accounting policies provide important information to users of financial
statements, such as investors, creditors, and other stakeholders, about the specific accounting methods and
procedures adopted by the company. This helps users to understand the financial statements better and
make informed decisions based on accurate and reliable financial information.

Consideration in selection of accounting policies

 Prudence
 Substance over form
 Materiality

Change in accounting policies

 Due to change in Law, or
 Due to change in Accounting Standard, or
 In order to present the financial statements in a manner so as to present a true and fair view of the
state of affairs of the enterprise.

Accounting Standards (AS) issued by the Institute of Chartered Accountants of

India (ICAI)

Accounting Title
Standard (AS)

AS 1 Disclosure of Accounting Policies

AS 2 Valuation of Inventories

AS 3 Cash Flow Statements

AS 4 Contingencies and Events Occurring After the Balance Sheet Date

AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies

AS 6 Depreciation Accounting

AS 7 Construction Contracts

AS 8 Accounting for Research and Development

AS 9 Revenue Recognition

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AS 10 Accounting for Fixed Assets

AS 11 The Effects of Changes in Foreign Exchange Rates

AS 12 Accounting for Government Grants

AS 13 Accounting for Investments

AS 14 Accounting for Amalgamations

AS 15 Employee Benefits

AS 16 Borrowing Costs

AS 17 Segment Reporting

AS 18 Related Party Disclosures

AS 19 Leases

AS 20 Earnings Per Share

AS 21 Consolidated Financial Statements

AS 22 Accounting for Taxes on Income

AS 23 Accounting for Investments in Associates in Consolidated Financial Statements

AS 24 Discontinuing Operations

AS 25 Interim Financial Reporting

AS 26 Intangible Assets

AS 27 Financial Reporting of Interests in Joint Ventures

AS 28 Impairment of Assets

AS 29 Provisions, Contingent Liabilities and Contingent Assets

AS 30 Financial Instruments Recognition and Measurements

AS 31 Financial Instruments Presentation

AS 32 Financial Instruments Disclosures

International financial reporting standards (IFRS)

International Financial Reporting Standards (IFRS) are a set of accounting rules for the financial statements
of public companies that are intended to make them consistent, transparent, and easily comparable around
the world.

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IFRS currently has complete profiles for 167 jurisdictions, including those in the European Union. The United
States uses a different system, the generally accepted accounting principles (GAAP).

The IFRS is issued by the International Accounting Standards Board (IASB).

The IFRS system is sometimes confused with International Accounting Standards (IAS), which are the older
standards that IFRS replaced in 2001.

Difference between AS and IAS (IFRS)

AS (Accounting Standards) are issued by the Institute of Chartered Accountants of India (ICAI) for the
companies in India, whereas IAS (International Accounting Standards) or IFRS (International Financial
Reporting Standards) are issued by the International Accounting Standards Board (IASB) for the companies
that operate globally.

While both AS and IAS/IFRS aim to provide guidelines and principles for financial reporting, there are some
differences between them:

 Applicability: AS is applicable to the companies registered in India, while IAS/IFRS is applicable to

the companies operating globally.
 Scope: AS covers a wide range of accounting topics such as inventory valuation, revenue
recognition, and accounting for fixed assets, while IAS/IFRS has a broader scope covering a wider
range of accounting areas and principles.
 Flexibility: AS allows companies some flexibility in applying the standards, while IAS/IFRS is more
rigid in terms of its application and interpretation.
 Enforcement: AS compliance is enforced by the regulatory bodies such as the Securities and
Exchange Board of India (SEBI) and the Ministry of Corporate Affairs (MCA) in India, whereas
IAS/IFRS compliance is enforced by the regulatory bodies of the respective countries where the
company operates.
 Updating: IAS/IFRS is updated regularly to keep pace with changing business and accounting
practices, while AS is not updated as frequently.

Institute of Chartered Accountants and Corresponding Accounting Standards

issued as IFRS
Accounting Standard (AS) Corresponding IFRS

AS 1: Disclosure of Accounting Policies IAS 1: Presentation of Financial Statements

AS 2: Valuation of Inventories IAS 2: Inventories

AS 3: Cash Flow Statements IAS 7: Statement of Cash Flows

AS 4: Contingencies and Events IAS 10: Events After the Reporting Period
Occurring After the Balance Sheet
Date

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AS 5: Net Profit or Loss for the Period, IAS 8: Accounting Policies, Changes in Accounting Estimates
Prior Period Items and Changes in and Errors
Accounting Policies

AS 7: Construction Contracts IAS 11: Construction Contracts

AS 9: Revenue Recognition IAS 18: Revenue

AS 10: Accounting for Fixed Assets IAS 16: Property, Plant and Equipment

AS 11: The Effects of Changes in IAS 21: The Effects of Changes in Foreign Exchange Rates
Foreign Exchange Rates

AS 12: Accounting for Government IAS 20: Accounting for Government Grants and Disclosure of
Grants Government Assistance

AS 13: Accounting for Investments IAS 39: Financial Instruments: Recognition and Measurement

AS 14: Accounting for Amalgamations IFRS 3: Business Combinations

AS 15: Employee Benefits IAS 19: Employee Benefits

AS 16: Borrowing Costs IAS 23: Borrowing Costs

AS 17: Segment Reporting IFRS 8: Operating Segments

AS18: Related Party Disclosures IAS 24:Related Party Disclosures

AS19: Leases IAS 17:Leases

AS20: Earnings Per Share IAS 33:Earnings Per Share

AS21: Consolidated Financial IFRS 10:Consolidated Financial Statements

Statements

AS22: Accounting for Taxes on Income IAS 12:Income Taxes

AS23: Accounting for Investments in IAS 28:Investments in Associates and Joint Ventures
Associates in Consolidated Financial
Statements

AS24: Discontinuing Operations IFRS 5:Non-current Assets Held for Sale and Discontinued
Operations

AS25: Interim Financial Reporting IAS 34:Interim Financial Reporting

AS26: Intangible Assets IAS 38:Intangible Assets

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AS27: Financial Reporting of Interests IAS 31:Interests in Joint Ventures
in Joint Ventures

AS28: Impairment of Assets IAS 36:Impairment of Assets

AS29: Provisions, Contingent Liabilities IAS 37:Provisions, Contingent Liabilities and Contingent Assets
and Contingent Assets

AS30: Financial Instruments: IAS 39:Financial Instruments: Recognition and Measurement

Recognition and Measurement

AS31: Financial Instruments: IAS 32:Financial Instruments: Presentation

Presentation

AS32: Employee Benefits IAS 19:Employee Benefits

Accounting for Business Transactions

A business transaction is an economic event with a third party that is recorded in an organization's
accounting system. Such a transaction must be measurable in money. Examples of business transactions
are:

 Buying insurance from an insurer

 Buying inventory from a supplier
 Selling goods to a customer for cash
 Selling goods to a customer on credit
 Paying wages to employees
 Obtaining a loan from a lender
 Selling shares to an investor

High-volume business transactions may be recorded in a special journal, such as the purchases journal or
sales journal. Once business transactions are entered into these journals, they are periodically aggregated
and posted to the general ledger. Lower-volume transactions are posted directly to the general ledger.
These transactions are eventually summarized into the firm's financial statements.

A business transaction should always be supported by a source document. For example, the purchase of
inventory from a supplier could be supported by a purchase order, while the payment of wages to an
employee could be supported by a timesheet.

Some events are not considered business transactions, such as giving a reporter a tour of company
facilities, since there is no tangible value associated with the event.

Journal
A journal is a detailed account that records all the financial transactions of a business, to be used for the
future reconciling of accounts and the transfer of information to other official accounting records, such as

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the general ledger. A journal states the date of a transaction, which accounts were affected, and the
amounts, usually in a double-entry bookkeeping method.

 A journal is a detailed record of all the transactions done by a business.

 Reconciling accounts and transferring information to other accounting records is done using the
information recorded in a journal.
 When a transaction is recorded in a company's journal, it's usually recorded using a double-entry
method, but can also be recorded using a single-entry method of bookkeeping.
 The double-entry method records a transaction in two (or more) entries. Each entry identifies the
account affected, and whether the account is a credit or a debit. The respective totals of the credits
and debits must be equal.
 Single-entry bookkeeping is rarely used and only notes changes in one account.
 A journal is also used in the financial world to refer to a trading journal that details the trades made
by an investor and why.

Double entry system

Double-entry bookkeeping is the most common form of accounting. It directly affects the way journals are
kept and how journal entries are recorded. Every business transaction is made up of an exchange between
two accounts.

This means that each journal entry is recorded with two columns. For example, if a business owner
purchases Rs1, 00,000 worth of inventory with cash, the bookkeeper records two transactions in a journal
entry. The cash account will show a credit of Rs1, 00,000, and the inventory account, which is a current asset,
will show a debit of Rs1, 00,000.

Kinds of accounts

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Personal Account
Personal Accounts are related to individuals, firms, companies, etc.

Example: Debtor, Creditor, Banks, Outstanding account, prepaid accounts, accounts of customers, accounts
of goods suppliers, capital, drawings, etc.

The Golden rule for a Personal account is

 Debit the receiver of the benefit

 Credit the giver of the benefit

Here giver and receiver will be individuals, firms, companies, etc. Here a person may either receive the
benefit of the transaction or give the benefit of the transaction. Therefore, the account of the person who
receives the benefit of the transaction is debited and the account of the person who gives the benefit of the
transaction is credited.

There are three types of personal accounts they are

 Natural personal account

 Artificial personal account
 Representative personal account

Natural Personal Account

Natural persons are human beings. Therefore, include the accounts belonging to them under this head.

Example: Mr. Sharma’s Account, Mrs. Sita’s Account, capital a/c, drawings a/c, capital a/c, etc come under
the category of the natural personal account.

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Artificial Personal Account

The second among three types of personal accounts is “Artificial” personal accounts. These accounts do not
have a physical existence however, they are recognized as persons in business dealings. Most often they are
legal entities created by human beings.

Example: Any Public or Private Company A/C, Bank A/C, Club A/C, Insurance Company A/C, NGO A/C,
Cooperative society A/C, etc. would fall under this category.

Representative Personal Account

This account is different as compared to the other two types of a personal account as it refers to accounts
that represent a person or a group.

Example: Outstanding expense A/C, Prepaid expense A/C, Accrued Income A/C, Income received in advance
A/C, Unearned commission A/C, etc.

Real Account
All assets of a firm, which are tangible or intangible, fall under the category of ‘Real Accounts’. Real
Accounts are the ones that are related to properties, assets, or possessions. These properties can be both
physically existing as well as non-physical in nature. Thus, Real Accounts can be of two types: Tangible Real
Accounts and Intangible Real accounts.

Types of Real Account

Tangible Real Accounts

Tangible Real Accounts are accounts that have physical existence. In other words, such assets can be seen,
felt, or touched.

Example; Machinery A/c, Vehicle A/c, Building A/c, etc.

Intangible Real Accounts

These are the assets or possessions that do not have a physical existence but can be measured in terms of
money. This means that such assets have some value attached to them.

Example; trademarks, patents, goodwill, copyrights, etc.

The Golden rule for a Real account is

 Debit what comes into the business

 Credit what goes out from the business

Nominal Account
Accounts that are related to expenses, losses, incomes, or gains are called Nominal accounts.

Example – Purchase A/C, Salary A/C, Sales A/C, and Commission received A/C, Bad Debt A/C, etc. The final
result of all nominal accounts is either profit or loss which is then transferred to the capital account.

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The Golden rule for a Nominal account is

 Debit all expenses and losses

 Credit all incomes and gains

Rules of debit and credit

In accounting, there are certain rules that dictate how financial transactions are recorded in a company's
books. These rules are known as the rules of debit and credit, and they are essential to understanding how
to keep accurate records of a company's finances.

The basic principle behind the rules of debit and credit is that every financial transaction involves at least
two accounts - one account is debited (increased), and another account is credited (decreased). The total
debits must always equal the total credits for every transaction.

Here are the general rules of debit and credit

 Assets (things that the company owns) are debited when they increase and credited when they
decrease.
 Liabilities (debts or obligations the company owes) are credited when they increase and debited
when they decrease.
 Equity (the owner's stake in the company) is credited when it increases and debited when it
decreases.
 Revenue (money earned by the company) is credited when it increases and debited when it
decreases.
 Expenses (costs incurred by the company) are debited when they increase and credited when they
decrease.

To simplify things, you can remember the acronym "AID-LE" which stands for:

 A: Assets
 I: Income (Revenue)
 D: Decreases (credits)
 L: Liabilities
 E: Expenses
 I: Increases (debits)

Remember that the rules of debit and credit apply to every financial transaction, and the goal is always to
ensure that the total debits equal the total credits. By following these rules, you can maintain accurate
records of a company's finances and ensure that all financial information is properly recorded.

Journal entry
Journal entries are how you record financial transactions. To make a journal entry, you enter details of a
transaction into your company’s books. In the second step of the accounting cycle, your journal entries get
put into the general ledger.

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Every journal entry in the general ledger will include the date of the transaction, amount, and affected
accounts with account number, and description. The journal entry may also include a reference number,
such as a check number, along with a brief description of the transaction.

Date Particulars Ledger Folio Debit (INR) Credit (INR)

01/04/23 Cash 101 50,000.00

Capital 201 50,000.00

05/04/23 Purchase of goods 301 10,000.00

Cash 101 10,000.00

10/04/23 Wages 302 2,000.00

Cash 101 2,000.00

15/04/23 Sale of goods 401 20,000.00

Accounts Receivable 102 20,000.00

20/04/23 Rent 303 5,000.00

Cash 101 5,000.00

25/04/23 Electricity Expenses 304 1,000.00

Cash 101 1,000.00

30/04/23 Interest on Loan 305 1,500.00

Loan Payable 203 1,500.00

In this example, we are using the Indian accounting format, which includes the following columns:

 Date: The date on which the transaction occurred.

 Particulars: A brief description of the transaction.
 Ledger Folio: The page number in the ledger where the transaction is recorded.
 Debit: The amount debited from the account in Indian Rupees.
 Credit: The amount credited to the account in Indian Rupees.

For example, on April 1st, 2023, the company received INR 50,000 in cash, which is debited to the Cash
account and credited to the Capital account. Similarly, on April 5th, 2023, the company purchased goods
worth INR 10,000, which is debited to the Purchase of Goods account and credited to the Cash account.

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Sales Return and Purchase Return

Sales return occurs when a customer returns goods previously purchased from the company. This could be
due to various reasons such as defects in the product, dissatisfaction with the product, or wrong product
delivered. When a sales return occurs, the company must record the transaction in their books of accounts.
The entry for a sales return is as follows:

Date Account Debit Credit

<date> Sales Returns <amount>

Accounts Receivable/ Customer <amount>

In this entry, "Sales Returns" is the account that is debited and "Accounts Receivable/Customer" is the
account that is credited. The amount credited is the amount of the sales return.

Purchase return occurs when a company returns goods previously purchased from a supplier. This could
be due to various reasons such as defects in the product, non-compliance with the specifications or order,
or overstocking. When a purchase return occurs, the company must record the transaction in their books of
accounts. The entry for a purchase return is as follows:

Date Account Debit Credit

<date> Accounts Payable/Supplier <amount>

Purchase Returns <amount>

In this entry, "Accounts Payable/Supplier" is the account that is debited and "Purchase Returns" is the
account that is credited. The amount debited is the amount of the purchase return.

Recording sales return and purchase return accurately is important for a company to maintain an accurate
record of their financial transactions. It also helps the company to identify any issues with their products or
suppliers, which can be addressed to improve customer satisfaction and business efficiency.

Discount Allowed and Discount Received

Discount Allowed
 A reduction in the price of products or services that is granted by a seller to a buyer at the expense
of the seller is known as a discount authorised. It is the discount offered to consumers who pay their
accounts on time. It must be handled like an expense, so the discount is debited and the customer's
personal accounts are credited.
 For example, Mr. Singh charges ₹50,000 for a television. When a customer buys two televisions, he
offers a 10% trade discount and an additional 5% reduction on the total sales price if the buyer pays
in cash up front.

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 The merchant offers the buyer two different types of discounts in this instance. First, a 10% trade
discount to boost sales and a 5% cash discount to encourage prompt payment are offered

Discount Received
 You want to receive a decent bargain whenever you buy products, components, or accessories from
providers. For your loyalty or to encourage you to make larger purchases, suppliers may occasionally
provide discounts. Here, we're referring to discounts that were obtained.
 Consider that you are a clothing retailer and that you choose to make upfront purchases. The
vendor might give you a discount in exchange. To further lower your costs, he might possibly give
discounts on older items that he's attempting to get rid of from his inventory.
 Discounts can also be used to encourage customers to make timely payments. In some cases,
companies may offer discounts for early payments to receive a greater level of interest income.
Discount received is recorded as a reduction to Accounts Receivable on a company's balance sheet.
 For example, when a seller permits a discount, the drop in revenues is noted and is often credited to
a contra revenue account. For instance, the seller permits a ₹50 reduction from the ₹1,000 billed
price for services it has rendered to a customer. A debit of ₹950 is made to the cash account, a
credit of ₹1,000 is made to the accounts receivable account, and a debit of ₹50 is made to the sales
discount contra revenue account to reflect the cash received from the customer. As a result, the
transaction's overall result is a decrease in gross sales.

Difference

Discount Allowed Discount Received

A discount allowed is a reduction in the Discount received is a reduction in the purchase price of
selling price of goods or services that is goods or services that is offered by the supplier to the
offered by the seller to the buyer. buyer.

A discount allowed may be offered for Discount received is typically offered as a result of
various reasons, such as to generate sales negotiations between the buyer and supplier.
or clear inventory.

A discount allowed is recorded as a Discount received is recorded as a reduction in the cost of

reduction in revenue on the seller's income goods sold on the buyer's income statement.
statement

Discounts allowed are often stated as a Discounts received are often stated as a percentage of the
percentage of the original selling price. original purchase price.

Discounts allowed may be offered at any Discounts received are typically offered at the time of
time during the sales process. purchase.

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Compound Entry
A compound journal entry is an accounting entry in which there is more than one debit, more than one
credit, or more than one of both debits and credits. It is essentially a combination of several simple journal
entries; they are combined for either of the following reasons.

Bookkeeping Efficiency
It is more efficient from a bookkeeping perspective to aggregate the underlying business transactions into a
single entry. Examples of aggregation that may involve compound journal entries are:

 Depreciation for multiple classes of fixed assets

 Accruals for multiple supplier deliveries at month-end for which no invoices have yet been received
 Accruals for the unpaid wages of multiple employees at month-end

Single Accounting Event

All of the debits and credits relate to a single accounting event. Examples of accounting events that
frequently involve compound journal entries are:

 Record all payments and deductions related to a payroll

 Record the account receivable and sales taxes related to a customer invoice
 Record multiple line items in a supplier invoice that relate to different expenses
 Record all bank deductions related to a bank reconciliation

Outstanding Expenses/Prepaid Expenses /Accrued Income/Advance Income

Outstanding expenses, prepaid expenses, accrued income, and advance income are important concepts in
accounting that reflect the timing of cash inflows and outflows. Let's take a closer look at each of them with
examples:

Outstanding Expenses
Outstanding expenses refer to expenses that have been incurred but not yet paid. These expenses are
recorded as a liability in the company's balance sheet until they are paid. Examples of outstanding expenses
include rent, salaries, and utility bills.

For example, a company rents a warehouse for INR 10,000 per month. The rent for the month of March has
been incurred but has not been paid as of March 31st. The company records the outstanding rent expense
as follows:

Date Account Debit Credit

31/03/23 Rent Outstanding 10,000.00

Rent Payable 10,000.00

In this entry, "Rent Outstanding" is the account that is debited, and "Rent Payable" is the account that is
credited.

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Prepaid Expenses
Prepaid expenses refer to expenses that have been paid in advance but have not yet been incurred. These
expenses are recorded as an asset in the company's balance sheet until they are incurred. Examples of
prepaid expenses include insurance premiums and prepaid rent.

For example, a company pays for insurance coverage for one year in advance for INR 24,000. The company
records the prepaid insurance expense as follows:

Date Account Debit Credit

01/04/23 Prepaid Insurance 24,000.00

Cash 24,000.00

Outstanding expenses, prepaid expenses, accrued income, and advance income are important concepts in
accounting that reflect the timing of cash inflows and outflows. Let's take a closer look at each of them with
examples:

Outstanding Expenses
Outstanding expenses refer to expenses that have been incurred but not yet paid. These expenses are
recorded as a liability in the company's balance sheet until they are paid. Examples of outstanding expenses
include rent, salaries, and utility bills.

For example, a company rents a warehouse for INR 10,000 per month. The rent for the month of March has
been incurred but has not been paid as of March 31st. The company records the outstanding rent expense
as follows:

Date Account Debit Credit

31/03/23 Rent Outstanding 10,000.00

Rent Payable Cash 10,000.00

In this entry, "Rent Outstanding" is the account that is debited, and "Rent Payable" is the account that is
credited.

Prepaid Expenses
Prepaid expenses refer to expenses that have been paid in advance but have not yet been incurred. These
expenses are recorded as an asset in the company's balance sheet until they are incurred. Examples of
prepaid expenses include insurance premiums and prepaid rent.

For example, a company pays for insurance coverage for one year in advance for INR 24,000. The company
records the prepaid insurance expense as follows:

Date Account Debit Credit

01/04/23 Prepaid Insurance 24,000.00

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Cash 24,000.00

In this entry, "Prepaid Insurance" is the account that is debited, and "Cash" is the account that is credited.

Accrued Income
Accrued income refers to income that has been earned but not yet received. This income is recorded as an
asset in the company's balance sheet until it is received. Examples of accrued income include interest on
investments and rent receivable.

For example, a company rents out a property for INR 12,000 per month. The rent for the month of March
has been earned but not yet received as of March 31st. The company records the accrued rent income as
follows:

Date Account Debit Credit

31/03/23 Rent Receivable 12,000.00

Rent Income Accrued 12,000.00

In this entry, "Rent Receivable" is the account that is debited, and "Rent Income Accrued" is the account
that is credited.

Advance Income
Advance income refers to income that has been received in advance but has not yet been earned. This
income is recorded as a liability in the company's balance sheet until it is earned. Examples of advance
income include subscriptions and retainers.

For example, a company receives INR 30,000 in advance for a service to be provided over the next three
months. The company records the advance income as follows:

Date Account Debit Credit

01/04/23 Cash 30,000.00

Advance Income 30,000.00

In this entry, "Cash" is the account that is debited, and "Advance Income" is the account that is credited.

Ledger

Introduction
In accounting, a ledger is a book or a computerized record that contains all the transactions of a business or
an organization. It is an essential component of the double-entry accounting system and is used to record,
classify, and summarize financial transactions.

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A ledger contains various accounts, each of which represents a specific financial transaction. These accounts
can be classified as either balance sheet accounts or income statement accounts.

Balance sheet accounts include assets, liabilities, and equity accounts. These accounts show the financial
position of the business at a given point in time. For example, the cash account, accounts receivable
account, and inventory account are all balance sheet accounts.

Income statement accounts, on the other hand, include revenue and expense accounts. These accounts
show the profitability of the business over a period of time. For example, sales revenue, rent expense, and
salaries expense are all income statement accounts.

Every transaction is recorded in the appropriate account in the ledger using the double-entry accounting
system. This means that for every debit entry, there must be a corresponding credit entry. The total of all
debit entries must equal the total of all credit entries.

The ledger is used to create financial statements such as the balance sheet, income statement, and cash
flow statement. These statements provide an overview of the financial health of the business and are
essential for decision-making purposes.

Difference between Journal and Ledger

Journal Ledger

Records financial transactions in Organizes financial transactions by account

chronological order

Is the first book of original entry Is the second book of entry that contains a summary of
transactions

Includes the date, accounts affected, and Includes all the information related to a particular
amount of the transaction in a narrative transaction in a specific account
form

Records every financial transaction, Records transactions related to a specific account,

including credit and debit entries including the balance

Used to record transactions as they occur Used to classify, summarize, and prepare financial
statements based on the recorded transactions

Provides a detailed record of all Provides an overview of the financial position and
transactions performance of the business

Provides a basis for transferring information Provides a basis for preparing financial statements
to the ledger

Does not contain running balances Contains running balances for each account

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Ledger posting
Ledger posting refers to the process of transferring the information from the journal to the ledger. In
accounting, the journal is the first book of original entry where all financial transactions are initially
recorded, and the ledger is a book or a computerized record that contains all the transactions of a business
or an organization. The ledger is organized into various accounts, each of which represents a specific
financial transaction.

To post a journal entry to the ledger, the following steps are typically followed

 Identify the accounts affected: The first step in ledger posting is to identify the accounts that have
been affected by the journal entry. For example, if the journal entry involves a cash sale, the
accounts affected may include the cash account, the sales revenue account, and the cost of goods
sold account.
 Determine the type of account: Once the accounts have been identified, it is important to
determine the type of account, such as asset, liability, equity, revenue, or expense. This will help in
determining the correct debit and credit entries for each account.
 Record the debit and credit entries: After determining the type of account, the next step is to
record the debit and credit entries in the appropriate accounts in the ledger. For example, if the cash
account is debited and the sales revenue account is credited, these entries would be recorded in the
appropriate accounts in the ledger.
 Calculate the balance: Once the debit and credit entries have been recorded, the balance for each
account should be calculated. The balance is calculated by subtracting the credit entries from the
debit entries for each account.
 Verify accuracy: Finally, it is important to verify the accuracy of the ledger posting by checking that
the total debit entries equal the total credit entries for each transaction.

Opening Entry
 An opening entry, also known as an opening journal entry, is the initial entry recorded at the start of
an accounting period to reflect the beginning balances of various accounts.
 This entry is made to ensure that the ledger accounts reflect the correct balances at the start of the
accounting period.
 The opening entry is usually made on the first day of the accounting period and it is based on the
balances of the various accounts at the end of the previous accounting period.
 The opening entry is typically a summary of all the accounts and balances from the previous period
that are carried forward to the new period.

Balancing of account
Balancing of an account in accounting refers to the process of ensuring that the total debit amount and
total credit amount of an account are equal. In other words, it is the process of verifying that all the
transactions recorded in the account have been correctly posted, and that the account is in balance.

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To balance an account, the following steps are typically followed:

 Identify the account: The first step is to identify the account that needs to be balanced. This can be
done by reviewing the chart of accounts or the ledger.

 Calculate the total debit and credit amounts: The next step is to calculate the total debit and
credit amounts for the account by adding up all the debit and credit entries made in the account.

 Compare the totals: After calculating the total debit and credit amounts, the next step is to
compare the totals to ensure that they are equal. If the total debit amount is greater than the total
credit amount, it means that the account has a debit balance. Conversely, if the total credit amount
is greater than the total debit amount, it means that the account has a credit balance.

 Adjust the account: If the totals do not match, adjustments must be made to ensure that the
account is in balance. This can be done by reviewing the transactions and identifying any errors or
omissions that may have occurred during the recording or posting process. Once the errors are
identified, appropriate adjustments can be made to correct them.

 Verify accuracy: Finally, it is important to verify the accuracy of the balancing process by rechecking
the total debit and credit amounts to ensure that they are now equal.

Cash Book
Cash Book is the one in which all the cash receipts and cash payments, including the funds deposited in the
bank and funds withdrawn from the bank, are recorded according to the date of the transaction. All the
transactions recorded in the cash book have two sides, i.e., debit and credit.

Definition of a Cash Book

The easiest and simplest cash book meaning is a book that records every cash transaction of the business. It
acts as both books of original entries and a ledger. A cash book is one of the most important journals
among the books of accounts. It easily lets people know the net cash-outflow or inflow of a financial year.
All payments and receipts are recorded in chronological order, so it becomes convenient to trace a
transaction on a particular date. The organisation, which has to make many transactions, maintains a cash
book in two parts, a cash receipt journal and a cash disbursement journal. So that cash receipt and cash
payment transactions are recorded separately.

The payment side of the cash book records the following entries

 Salary paid
 Expenses paid
 Amount paid to the suppliers
 Taxes paid.

The receipt side of the cash book contains the following entries

 Cash sales
 Advance received by a customer
 Interest received

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 Payment received from customers, and so on.

Types of cashbook

There are different types of cash books for different types of needs and complexities of the business. The
two major types of cash books are: General and Petty cash books.

General cash book

 Single column cash book

 Double Column cash book
 Triple column cash book

Petty cash book

General Cash Book

It records the cash transactions and works as a book of original entries and ledger. It has further three
divisions. Each type fulfils different requirements of the users. Let’s look into the different types of general
cash books.

Single Column Cash Book

The single-column cash book only records cash transactions. On its debit and credit side, it records cash
payments and cash receipts. It does not include bank transactions.

The format of a single-column cash book will be something like this.

Debit Credit

Date Particulars R.No Lf Cash Date Particulars R.No. LF Cash

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Double Column Cash Book

Under the double-column cash book, there are two columns to record amounts. Both the debit and credit
sides have two amount columns. One is used for recording cash transactions and another one is used for
recording bank transactions. Thus, in the double-column cash book, cash and bank accounts are prepared
together. The transactions that affect both cash and bank accounts are known as contra entries. They are
separately denoted. The closing balance of the bank column is regularly cross-checked with the bank's
closing balance. In case of any difference, an adjustment entry is passed. The company regularly prepares
bank reconciliation statements.

Debit Credit

Date Particulars R.No Lf Cash Bank Date Particulars R.No. LF Cash Bank

Triple Column Cash Book

This type of cash book records transactions of three accounts. It has three columns, one for cash, one for
the bank, and another one for discounts. Thus maintaining triple column cash book substitutes, cash account,
bank account, and discount accounts.

Deb Cred
it it

Dat Particula R.N L Cas Ban Discou Date Particula R.N L Cas Ban Discou
e rs o f h k nt rs o. F h k nt
given receive
d

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Petty Cash Book

The petty cash book is a kind of record for small business expenses. They are day-to-day indirect business
expenditures that are not directly linked to the main core objective. It records transactions of photocopy,
stationery, newspaper, tea, and other miscellaneous expenses.

Advantages of Cash Book

Cash Book makes cash management easy and convenient. The following are the advantages of
maintaining a cash book:

 The most important advantage of a cash book is that it saves time and labour in maintaining the
cash ledger separately.
 Cash book makes it easy to find errors, mistakes and frauds. By cross-verifying cash in hand with the
closing balance of the cash book, one can easily detect mistakes and errors and correct them.
Sometimes the mismatch of cash in hand and closing balance might be a result of fraud.
 A cash book facilitates ascertaining cash balances of any particular date.
 It records transactions and maintains a chronological order, which helps in tracing back any
transaction at any time.

Subsidiary books
Subsidiary books are specialized accounting records used to record transactions of a specific type or source.
These books are maintained in addition to the general ledger and are used to keep track of specific types of
transactions.

There are several types of subsidiary books, including

 Sales Journal: This is a subsidiary book used to record all credit sales made by the business.
 Purchase Journal: This is a subsidiary book used to record all credit purchases made by the
business.
 Cash Receipts Journal: This is a subsidiary book used to record all cash receipts received by the
business.
 Cash Payments Journal: This is a subsidiary book used to record all cash payments made by the
business.
 General Journal: This is a subsidiary book used to record all transactions that cannot be recorded in
any of the other subsidiary books.

The use of subsidiary books provides several advantages, including

 Improved efficiency: By categorizing transactions into different subsidiary books, the recording
process becomes more efficient and streamlined.
 Improved accuracy: Because transactions are recorded in specialized books, there is less chance of
errors being made.
 Improved organization: Subsidiary books help to organize transactions by type or source, making
it easier to locate specific transactions when needed.

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 Simplified posting: By summarizing transactions in subsidiary books, it becomes easier to post
transactions to the general ledger.

Sales Book
A sales book is a specialized accounting record used to record all credit sales made by a business. This book
is also known as a sales journal or sales daybook. It is one of the subsidiary books used to keep track of
specific types of transactions.

The sales book is usually divided into columns that record different types of information, such as the date of
the sale, the name of the customer, the amount of the sale, and any taxes or discounts that apply. This
information is then used to prepare financial statements, such as the income statement and the balance
sheet.

The use of a sales book provides several advantages, including:

 Improved accuracy: By recording sales in a specialized book, there is less chance of errors being
made.
 Improved efficiency: By categorizing sales transactions into a specific book, the recording process
becomes more efficient and streamlined.
 Improved organization: The sales book helps to organize sales transactions by date, customer, and
amount, making it easier to locate specific transactions when needed.
 Simplified posting: By summarizing sales transactions in the sales book, it becomes easier to post
transactions to the general ledger.

Purchase book
A purchase book is a specialized accounting record used to record all credit purchases made by a business.
This book is also known as a purchase journal or purchase daybook. It is one of the subsidiary books used
to keep track of specific types of transactions.

The purchase book is usually divided into columns that record different types of information, such as the
date of the purchase, the name of the supplier, the amount of the purchase, and any taxes or discounts that
apply. This information is then used to prepare financial statements, such as the income statement and the
balance sheet.

The use of a purchase book provides several advantages, including

 Improved accuracy: By recording purchases in a specialized book, there is less chance of errors
being made.
 Improved efficiency: By categorizing purchase transactions into a specific book, the recording
process becomes more efficient and streamlined.
 Improved organization: The purchase book helps to organize purchase transactions by date,
supplier, and amount, making it easier to locate specific transactions when needed.
 Simplified posting: By summarizing purchase transactions in the purchase book, it becomes easier
to post transactions to the general ledger.

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Sales return book or return inward book

A sales return book or return inward book is a specialized accounting record used to record all returns
made by customers on goods previously sold on credit. It is also known as a returns inward journal or
returns inward book.

The sales return book is usually divided into columns that record different types of information, such as the
date of the return, the name of the customer, the invoice number of the original sale, the quantity and value
of the returned goods, and any taxes or discounts that apply.

The use of a sales return book provides several advantages, including

 Improved accuracy: By recording returns in a specialized book, there is less chance of errors being
made.
 Improved efficiency: By categorizing returns transactions into a specific book, the recording
process becomes more efficient and streamlined.
 Improved organization: The sales return book helps to organize returns transactions by date,
customer, and invoice number, making it easier to locate specific transactions when needed.
 Simplified posting: By summarizing returns transactions in the sales return book, it becomes easier
to post transactions to the general ledger.

Purchase return book or return outward book

A purchase return book or return outward book is a specialized accounting record used to record all returns
made to suppliers on goods previously purchased on credit. It is also known as a returns outward journal or
returns outward book.

The purchase return book is usually divided into columns that record different types of information, such as
the date of the return, the name of the supplier, the invoice number of the original purchase, the quantity
and value of the returned goods, and any taxes or discounts that apply.

The use of a purchase return book provides several advantages, including

 Improved accuracy: By recording returns in a specialized book, there is less chance of errors being
made.
 Improved efficiency: By categorizing returns transactions into a specific book, the recording
process becomes more efficient and streamlined.
 Improved organization: The purchase return book helps to organize returns transactions by date,
supplier, and invoice number, making it easier to locate specific transactions when needed.
 Simplified posting: By summarizing returns transactions in the purchase return book, it becomes
easier to post transactions to the general ledger.

Understanding accounts process in accounting

 Identification of transactions: The first step in the accounting process is to identify and analyze all
financial transactions of a business, which includes sales, purchases, expenses, and receipts.
 Recording of transactions: The second step involves recording these financial transactions in the
appropriate subsidiary books such as cash book, sales book, purchase book, and others.
 Posting to ledger accounts: The third step involves transferring the information from the subsidiary
books to the relevant ledger accounts, which are the main accounts used to record transactions.

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 Preparation of trial balance: The fourth step involves preparing a trial balance, which is a summary
of all the ledger account balances. The total debits should be equal to the total credits in the trial
balance.
 Preparation of financial statements: The fifth step involves preparing financial statements such as
the income statement, balance sheet, and cash flow statement. These statements provide a
summary of the financial performance of the business over a specific period.
 Analysis of financial statements: The sixth step involves analyzing the financial statements to
assess the financial health of the business and identify areas for improvement.
 Closing the books: The final step involves closing the books by transferring the balances of revenue
and expense accounts to the retained earnings account and preparing closing entries.

Objective of accounting
 Recording and maintaining financial transactions: The accounting process involves the recording
and maintenance of all financial transactions of a business. This includes transactions such as sales,
purchases, receipts, and expenses.
 Providing financial information: The financial information generated through accounting is used
by stakeholders to make informed decisions. This information includes financial statements such as
the income statement, balance sheet, and cash flow statement.
 Ensuring compliance with legal and regulatory requirements: Accounting helps businesses to
comply with legal and regulatory requirements such as tax laws and financial reporting
requirements.
 Facilitating planning and budgeting: Accounting information is used to develop budgets and
financial plans for the future.
 Facilitating decision-making: Accounting information is used by stakeholders to make informed
decisions about the financial health and prospects of the business.

Questions

1. What is the purpose of the accounting process?

a) To identify financial transactions

b) To record financial transactions
c) To summarize financial transactions
d) All of the above

2. What is the purpose of a trial balance?

a) To identify errors in accounting records

b) To provide a summary of all ledger account balances
c) To prepare financial statements
d) All of the above

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3. Which of the following is a type of ledger account?

a) Sales account
b) Purchase account
c) Bank account
d) All of the above

4. What is the purpose of a cash book?

a) To record cash transactions

b) To record credit transactions
c) To record purchase transactions
d) None of the above

5. Which of the following is an example of a subsidiary book?

a) Ledger book
b) Trial balance book
c) Sales book
d) Cash book

6. Which of the following financial statements provides a summary of a business's financial

position at a specific point in time?

a) Income statement
b) Balance sheet
c) Cash flow statement
d) Trial balance

Answer Keys
1. Answer: D) All of the above
Explanation: The accounting process involves identifying, recording, and summarizing
financial transactions of a business or organization.
2. Answer: D) All of the above
Explanation: The trial balance is used to identify errors in accounting records, provide a
summary of all ledger account balances, and prepare financial statements.
3. Answer: D) All of the above

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Explanation: Ledger accounts can include sales accounts, purchase accounts, bank accounts,
and many other types of accounts used to record financial transactions.
4. Answer: A) To record cash transactions
Explanation: A cash book is used to record cash transactions, such as cash receipts and cash
payments.
5. Answer: C) Sales book
Explanation: The sales book is an example of a subsidiary book used to record sales
transactions.
6. Answer: B) Balance sheet
Explanation: The balance sheet provides a summary of a business's financial position at a
specific point in time by showing its assets, liabilities, and equity.

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Chapter 2
Trial balance
Introduction
The trial balance is a bookkeeping or accounting report in which the balances of all the general ledger
accounts of the organization are listed in separate credit and debit account columns. The balances are
usually listed to achieve equal values in the credit and debit account totals. Any deviation from expected
values helps to detect errors in the accounting exercise.

Trial balance is an important Step of the accounting cycle - which is a series of steps performed during an
accounting period to analyze, record, classify, summarize, and report financial information for generating
financial statements. The trial balance itself is not a financial statement, but comprises all the information
required for creating the three main financial statements—the cash flow statement, the balance sheet, and
the income statement. In the accounting cycle, preparing the trial balance comes right after posting journal
entries to the ledger’s accounts, and just before preparing the financial statements.

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In the words of J.R Batliboi, "A trial balance is a statement, prepared with the debit and credit balances of
the ledger accounts to test the arithmetical accuracy of the books."

A trial balance gets prepared just before preparing final accounts, which includes a balance sheet, Profit and
loss statement, Cash flow, and notes to Accounts. In layman's terms, we can assume that it is the basic
structure behind preparing the final accounts. It is the third step in the road map to prepare final accounts
after the entries are passed in journal-register followed by classification and grouping of transactions to
their respective ledgers. These ledgers, i.e. the principal book containing all sets of accounts, are then
accumulated in a single place to constitute a Trial balance.

Purpose of Trial Balance

The preparation of the trial balance helps in developing financial statements. The assets and liabilities find
their place in the balance sheet. The Income and expenses appear in the profit and loss account. Based on
all these accounts, the preparation of Final accounts takes Place.

Features of Trial Balance

 Trial balance in accounting lists down all the ledgers, including the cash book.
 It does not form a part of the Double-entry System of Accounting. It serves only as a reference.
 A trial balance can be prepared any time- weekly, monthly, quarterly, and year-end.
 It serves as a vital tool to verify the arithmetical accuracy of the books.
 It forms a connecting point between the Profit and Loss Account and Balance sheet.
 It does not provide conclusive proof of the absence of error. Errors such as errors of principal may
still exist.

Objective
 Bird Eye View: The trial balance gives the summary of all the ledgers. Since the net amount gets
displayed, you can save time by not viewing the concerned ledger again.
 Pointing out Error: The trial balance aids in pointing out errors. It is also used to check the
arithmetical accuracy of books of accounts.

Balances of Ledger Accounts

 The balance of a ledger account is the amount of money or value that remains after all transactions
affecting the account have been recorded. It represents the current status of the account and can be
either a debit or credit balance.
 A debit balance means that the total debits to the account exceed the total credits. This indicates
that more money has been debited from the account than has been credited to it. Debit balances
are typically found in asset accounts, such as cash or inventory.
 A credit balance, on the other hand, means that the total credits to the account exceed the total
debits. This indicates that more money has been credited to the account than has been debited

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from it. Credit balances are typically found in liability accounts, such as accounts payable or loans
payable.
 It is important to note that some accounts may have a normal balance that is opposite to their
classification. For example, while asset accounts normally have a debit balance, contra-asset
accounts like accumulated depreciation have a credit balance. Similarly, while liability accounts
normally have a credit balance, contra-liability accounts like discount on notes payable have a debit
balance.
 Balances of ledger accounts are used to prepare financial statements such as the balance sheet and
income statement. They are also important for tracking the financial health of a business and
making informed financial decisions.

Types of trial balance and preparation of trial balance

There are two types of trial balance

 Gross Trial Balance

 Net Trial Balance

Gross Trial Balance

A Gross Trial Balance is a list of all ledger accounts and their respective balances before adjustments are
made. It is prepared by taking all the balances from the individual ledger accounts and listing them in a
table with the debit balances in one column and credit balances in another.

To prepare a Gross Trial Balance, you need to follow these steps

 List down all the ledger accounts in the order they appear in the ledger.
 Record the debit balance of each account in the debit column and the credit balance in the credit
column.
 Calculate the total of the debit and credit columns.
 Ensure that the total of the debit column is equal to the total of the credit column. If the totals do
not match, there may be an error in the ledger, and you need to identify and correct the error.

Net Trial Balance

A Net Trial Balance is a list of all ledger accounts and their respective balances after adjustments have been
made. It is prepared by taking all the balances from the individual ledger accounts, adjusting them for any
necessary entries, and listing them in a table with the debit balances in one column and credit balances in
another.

To prepare a Net Trial Balance, you need to follow these steps

 List down all the ledger accounts in the order they appear in the ledger.
 Record the debit balance of each account in the debit column and the credit balance in the credit
column.
 Adjust the balances for any necessary entries, such as accruals, prepayments, and depreciation.
 Calculate the total of the debit and credit columns.

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 Ensure that the total of the debit column is equal to the total of the credit column. If the totals do
not match, there may be an error in the ledger, and you need to identify and correct the error.

Specimen of trial balance

Account Name Debit (Rs.) - Net Credit (Rs.) - Net Debit (Rs.) - Gross Credit (Rs.) - Gross
Trial Balance Trial Balance Trial Balance Trial Balance

Cash 10,000 10,000

Bank 5,000 5,000

Accounts Receivable 20,000 20,000

Prepaid Expenses 3,000 3,000

Inventory 50,000 50,000

Land 30,000 30,000

Building 1,00,000 1,00,000

Machinery 60,000 60,000

Accumulated 10,000 10,000

Depreciation - Building

Accumulated 20,000 20,000

Depreciation -
Machinery

Accounts Payable 15,000 15,000

Salaries Payable 5,000 5,000

Unearned Revenue 8,000 8,000

Capital 1,00,000 1,00,000

Sales Revenue 50,000 50,000

Rent Revenue 2,000

Cost of Goods Sold 35,000 35,000

Salaries Expense 10,000 10,000

Rent Expense 5,000 5,000

Utilities Expense 3,000 3,000

Insurance Expense 0 1,000

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Depreciation Expense 15,000 15,000

Difference between net and gross trial balance sheet

Basis of Net Trial Balance Sheet Gross Trial Balance Sheet

Comparison

Meaning It is a trial balance that shows the net It is a trial balance that shows the gross
balances of all accounts after adjusting for balances of all accounts without
necessary adjustments. adjusting any entries.

Adjustments The balances of some accounts are adjusted There are no adjustments made to the
to their net amounts to reflect any necessary balances of any accounts.
adjustments.

Purpose It is used to prepare the financial statements It is used to prepare the financial
like the Income Statement and Balance Sheet. statements like the Income Statement
and Balance Sheet.

Types of Only nominal accounts like revenue, expenses, All accounts, including nominal, real,
Accounts gains, and losses are adjusted to their net and personal accounts, are listed with
amounts. their gross balances.

Presentation Debit balances are listed in one column and Debit balances are listed in one column,
credit balances in another column. The and credit balances are listed in another
difference between the two columns column, with no adjustments made.
represents the net balance.

Errors and It helps in identifying errors and omissions in It does not highlight any errors or
Omissions the nominal accounts because they are omissions in the trial balance because
adjusted to their net amounts. no adjustments are made.

Accounting It follows the accrual basis of accounting by It follows the cash basis of accounting
Treatment adjusting the balances of some accounts to by listing all the transactions without
their net amounts. making any adjustments.

Disagreement of trial balance

A disagreement in trial balance occurs when the total of debit balances does not equal the total of credit
balances in the trial balance. In other words, the two columns of the trial balance do not balance. This
disagreement is also known as a trial balance error or a trial balance discrepancy.

There can be several reasons for a disagreement in trial balance, such as errors in journal entries, posting to
the wrong accounts, omitting an account or transaction, recording an incorrect amount, etc.

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When a disagreement in trial balance occurs, accountants need to carefully review the accounts, journal
entries, and ledger postings to identify and correct the error. Once the error is corrected, a new trial balance
is prepared to ensure that the two columns now balance. It is important to identify and correct the error as
it can lead to inaccurate financial statements and financial reporting.

Classification of errors
Errors in accounting are broadly classified into two categories which are as follows:

 Error of principle
 Clerical errors

Error of Principle
Error of principle is said to occur when the accountant records a transaction that does not comply with the
rules of accounting. As per accounting rules, for every debit, there should be a corresponding credit.

When a transaction violates this rule, an error results from it and such an error is known as the error of
principle. Recording of such a transaction does not have an impact on the trial balance, it simply means
transactions are recorded but in incorrect accounts.

For eg: An asset is purchased and is recorded as an expense in the account.

Clerical Errors
Clerical errors are those errors that are generated from the improper recording of transactions. Clerical
errors are further of three types and are discussed below

 Errors of Omission
 Errors of Commission
 Compensating Errors

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Errors of Omission: Errors of omission are those types of errors that are generated when the accountant
forgets to record an entry. There can be two variations of such errors, one is the complete omission of
transaction in which the transaction is not recorded in books of accounts.

The second type of error is the partial omission, in which the accountant records the transaction in either
the debit or credit side and forgets to record the transaction on the opposite side.

Examples

Complete omission – Failure to record the purchase of an asset

Partial omission – Credit sales of ₹5000 to Raj, in this transaction, the sales entry is recorded, but the entry
for Raj’s Account is not done, it leads to partial omission.

Errors of Commission: These errors occur when an incorrect entry is made in the accounting records. This
can happen due to various reasons such as human error, incorrect information, or lack of knowledge. For
example, if a transaction is recorded in the wrong account, it can cause errors in the financial statements.

Errors of commission occur when an incorrect entry is made in the accounting records.

These errors can happen due to various reasons, such as human error, incorrect information, or lack of
knowledge.

Examples of errors of commission in India include

 Recording an incorrect amount for a transaction, such as recording a sale for Rs. 10,000 instead of
Rs. 1,000.
 Recording a transaction in the wrong account, such as recording a payment for rent in the salaries
account.
 Failing to record a discount given to a customer, which results in an incorrect accounts receivable
balance.
 Recording a transaction in the wrong period, such as recording a payment made in March as being
made in April.
 Recording a payment to a supplier as being made to the wrong supplier, resulting in incorrect
accounts payable balance.

Errors of commission can cause inaccuracies in financial statements, which can have serious consequences
for businesses, including legal and financial issues.

To prevent errors of commission, it is important to implement internal controls, such as regular review and
reconciliation of accounts, and to ensure that accounting staff have the necessary knowledge and training
to perform their duties accurately.

Compensating Errors: These errors occur when two or more errors are made that offset each other,
resulting in a trial balance that still balances. For example, if an expense is overstated by Rs1000 and
revenue is understated by Rs1000, the two errors offset each other and the trial balance still balances.

Errors of Principle: Errors of principle occur when a transaction is recorded in violation of generally
accepted accounting principles (GAAP). These errors are different from errors of commission, which are
caused by a mistake or oversight. Errors of principle occur when the accountant does not have the correct

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knowledge about the accounting standards or when they intentionally ignore the standards to manipulate
the financial statements.

For example, if a company records an expense as an asset, it violates the GAAP principle of matching
expenses with revenues. Similarly, if a company records an expense in the wrong period, it violates the
GAAP principle of periodicity. Errors of principle can have serious consequences for businesses, including
legal and financial issues, as well as damage to the company's reputation.

To prevent errors of principle, it is important to ensure that accounting staff have the necessary knowledge
and training to follow GAAP principles. Regular review and reconciliation of accounts can also help identify
and correct errors before they cause major issues. Additionally, implementing internal controls can help
prevent intentional manipulation of financial statements.

Errors of Original Entry: These errors occur when an incorrect amount is recorded in the original
accounting entry. This can happen if a mistake is made in recording the transaction, or if the person
entering the data types in the wrong amount. For example, if the amount of a sale is incorrectly recorded as
Rs 5000 instead of Rs 500, it can cause errors in the financial statements.

Errors of Reversal: These errors occur when the debits and credits are reversed for a transaction. For
example, if a debit entry is recorded as a credit entry, or vice versa, it can cause errors in the financial
statements.

Errors of Duplication: These errors occur when a transaction is recorded twice in the accounting records.
This can happen if a transaction is accidentally recorded twice, or if two people independently record the
same transaction without realizing it. For example, if a purchase is recorded twice, it can cause errors in the
financial statements.

Steps to Locate Errors

 Check the trial balance: The first step in locating errors is to check the trial balance. If the trial
balance does not balance, it indicates that there is an error in the accounting records.
 Check the ledger accounts: After identifying an imbalance in the trial balance, the next step is to
check the ledger accounts for errors. This involves verifying that each transaction has been recorded
in the correct account and that the amounts are accurate.
 Reconcile bank statements: If the error involves a bank transaction, it is important to reconcile the
bank statement with the accounting records. This can help identify any discrepancies between the
two and locate the error.
 Verify source documents: It is important to verify that all transactions have been accurately
recorded based on the source documents, such as receipts, invoices, and bank statements.
 Review journal entries: Journal entries can also be reviewed to identify errors. This involves
verifying that the debit and credit amounts are correct and that each transaction has been recorded
in the correct account.
 Look for mathematical errors: Math errors are a common cause of accounting errors. Double-
checking all calculations can help identify and correct these errors.

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 Seek help from others: If you are unable to locate the error, it may be helpful to seek assistance
from another accountant or supervisor. A fresh set of eyes can often identify errors that were
overlooked.

Rectification of errors
Errors should be rectified; otherwise, a business enterprise will not be transparent. It will fail to be
creditworthy and not show the correct profit or loss. In other words, it will not show the true picture.

So, errors should be rectified; but are there other reasons for doing so?

Every business is interested in finding out its true results in terms of profit or loss from the operational
activities, as well as its true financial position at the end of the financial year.

Personnel in the accounts department will try to maintain the firm’s accounts accurately, ensuring that the
true profits or losses are determined and, furthermore, that the statement of affairs paints a correct picture.

On the basis of the principle that prevention is better than the cure, the early detection of errors is needed
to help businesses be transparent, creditworthy, and show the correct profit or loss, thereby painting an
accurate picture of their financial position.

In other words, the rectification of errors is essential to ensure

 Accountability
 Reliability
 Profitability
 Manageability

Suppose that errors are left uncorrected. These errors will influence the profit and loss account and balance
sheet.

Although the trial balance is prepared to evaluate accuracy, it does not disclose every type of error.

Furthermore, it is possible that the trial balance was made to agree by entering the suspense account
balance.

In any case, if the errors are not rectified, they will have an adverse effect on the firm’s position in terms of
profits or losses and assets or liabilities.

Therefore, they must be rectified. Such rectification may be carried out with the help of the following steps:

 Before the trial balance is prepared (pre-trial balance stage)

 After the trial balance is prepared with or without the suspense account (pre-final accounts stage)
 After the final accounts are prepared (post-final accounts stage)

Across the pre-trial balance, post-trial balance, and pre-final accounts stages, rectification is carried out by
modifying entries either directly or through a suspense account.

For the post-final accounts stage, rectification is carried out through profit and loss account adjustments.

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Suspense account and rectification

A suspense account is a temporary account used to hold entries when there is an error in the accounting
records, and the correction of the error is not immediately apparent. The suspense account allows the
accounting department to continue recording transactions without causing an imbalance in the accounting
system.

When an error is identified, the amount in the suspense account is transferred to the correct account, and
the error is rectified. This process is known as rectification. Rectification involves identifying the error,
determining the correct amount, and transferring the amount from the suspense account to the correct
account. The steps involved in rectification depend on the type of error.

For example, if an error of commission is identified, the incorrect entry must be reversed, and a new entry
must be made in the correct account. If an error of principle is identified, the original entry must be
corrected to reflect the correct accounting principle.

Once the error is rectified, the suspense account is no longer needed, and the balance in the account
should be zero. The suspense account is closed by transferring the balance to the correct account.

Rectification of errors when books have been closed (rectification in

the next year)
Rectification of errors when books have been closed or when an error is discovered in a subsequent year
requires a different approach than rectifying errors in the current year. Here are the steps for rectifying
errors in the next year:

 Identify the error: The first step is to identify the error that needs to be rectified. This can be done
by comparing the opening balances of the previous year's books with the closing balances of the
current year's books.
 Make necessary adjustments: Once the error has been identified, the necessary adjustments need
to be made in the accounts. This can be done by passing journal entries to correct the error. For
example, if an expense was recorded as an asset, then the journal entry should be passed to debit
the expense account and credit the asset account.
 Prepare the suspense account: Since the books have already been closed, the error cannot be
corrected directly in the accounts. Instead, a suspense account needs to be prepared to record the
difference between the corrected balances and the balances shown in the books. The suspense
account will help maintain the balance of the books until the error is rectified.
 Carry forward the suspense account balance: The balance in the suspense account needs to be
carried forward to the next year's books. This will ensure that the books are in balance, and the error
has been taken into account.
 Correct the error in the next year's books: In the next year's books, the necessary adjustments
need to be made to correct the error. This can be done by passing adjusting journal entries.
 Close the suspense account: Once the error has been corrected in the next year's books, the
balance in the suspense account can be transferred to the appropriate accounts, and the suspense
account can be closed.

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Let's take an example to understand the rectification of errors when books have been closed.

Suppose in the year 2021, a company mistakenly recorded a payment of Rs. 10,000 as a credit sale.
However, this error was not identified until the books were closed for the year 2021. Now, in the year 2022,
the company wants to rectify this error.

The necessary steps for rectifying this error in the next year are as follows

Identify the error: The error that needs to be rectified is the recording of the payment of Rs. 10,000 as a
credit sale.

Make necessary adjustments: The journal entry to rectify this error in the year 2022 would be:

 Debit Cash/Bank account Rs. 10,000

 Credit Sales account Rs. 10,000

Prepare the suspense account: The balance in the sales account after this adjustment will be lower than
what is shown in the books. Therefore, a suspense account needs to be prepared to record the difference.
The journal entry to prepare the suspense account would be:

 Debit Suspense account Rs. 10,000

 Credit Sales account Rs. 10,000

Carry forward the suspense account balance: The balance in the suspense account (Rs. 10,000) needs to
be carried forward to the year 2022.

Correct the error in the next year's books: In the year 2022, the necessary adjustments need to be made to
correct the error. This can be done by passing the following journal entry:

 Debit Sales account Rs. 10,000

 Credit Suspense account Rs. 10,000

Close the suspense account: Once the error has been corrected, the balance in the suspense account can
be transferred to the appropriate accounts, and the suspense account can be closed.

Computerized accounting system

A computerized accounting system is a software-based system that helps businesses keep track of their
financial transactions and manage their accounts. It automates accounting processes and makes it easier to
produce accurate financial statements.

In a computerized accounting system, financial transactions are entered into the software, which then
records and processes them. The system can generate invoices, record payments, track expenses, and
produce financial reports. It can also be used to manage payroll and inventory.

One of the main benefits of a computerized accounting system is that it saves time and reduces errors. The
software automates many of the tasks that would otherwise need to be done manually, such as posting
transactions to ledgers and creating financial reports. This reduces the risk of errors and frees up staff time
for other tasks.

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Another benefit of a computerized accounting system is that it provides real-time visibility into a company's
financial position. Business owners can see their cash flow, profit and loss, and other key financial metrics at
any time. This helps them make informed decisions about the direction of their business.

A computerized accounting system typically includes the following modules

 General ledger module: This module maintains a record of all financial transactions that occur
within a company. It includes accounts for assets, liabilities, revenue, and expenses.
 Accounts payable module: This module is used to manage the company's payables. It tracks
vendor invoices and payments, and helps ensure that bills are paid on time.
 Accounts receivable module: This module is used to manage the company's receivables. It tracks
customer invoices and payments, and helps ensure that invoices are paid on time.
 Inventory module: This module is used to manage the company's inventory. It tracks inventory
levels, costs, and sales, and helps ensure that the right products are available when customers need
them.
 Payroll module: This module is used to manage the company's payroll. It calculates employee
salaries, taxes, and benefits, and helps ensure that employees are paid on time.
 Fixed assets module: This module is used to manage the company's fixed assets, such as buildings
and equipment. It tracks the value and depreciation of assets over time.
 Financial reporting module: This module is used to produce financial reports, such as balance
sheets and income statements. It pulls data from the other modules to create a comprehensive view
of the company's financial position.

Questions

1. What is a trial balance?

a) A statement of accounts payable and accounts receivable

b) A summary of all accounts in the ledger

c) A record of all transactions for a specific period

d) A report of the company's financial performance

2. Which of the following is not a purpose of a trial balance?

a) To ensure that the accounts are accurate

b) To identify errors in the ledger

c) To prepare the financial statements

d) To record all transactions for the period

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3. Which of the following errors would not be detected by a trial balance?

a) A transposition error

b) A posting error

c) A missed transaction

d) All of the above

4. If the trial balance is not in balance, what should be done first?

a) Correct the errors and prepare a new trial balance

b) Prepare the financial statements

c) Close the ledger accounts

d) Ignore the imbalance and proceed with the financial statements

5. If an account has a credit balance on the trial balance, what does this mean?

a) The account has a debit balance

b) The account has a credit balance

c) The account has been overdrawn

d) The account has been underdrawn

6. Which of the following statements is true about a post-closing trial balance?

a) It is prepared after the financial statements are completed

b) It includes all accounts in the ledger

c) It shows only the permanent accounts

d) It shows only the temporary accounts

7. The trial balance is a/an:

a) Journal

b) Ledger

c) Financial statement

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d) None of the above

8. Which of the following errors will not be detected by the trial balance?

a) Error of omission

b) Error of commission

c) Error of principle

d) All of the above will be detected by the trial balance

9. If the trial balance does not balance, what should be done first?

a) Make adjusting entries

b) Correct the errors

c) Reconstruct the accounts

d) Ignore the error and continue with the financial statements

10. What is the purpose of a post-closing trial balance?

a) To ensure that all temporary accounts have been closed

b) To ensure that all permanent accounts have been closed

c) To ensure that all accounts have been posted to the ledger

d) None of the above

11. Which accounts are included in a post-closing trial balance?

a) Only permanent accounts

b) Only temporary accounts

c) Both permanent and temporary accounts

d) None of the above

12. What is the purpose of a trial balance?

a) To record transactions

b) To prepare financial statements

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c) To identify errors in the accounting system

d) All of the above

13. Which of the following errors will cause the trial balance to be out of balance?

a) A transposition error

b) A mathematical error

c) Posting an entry to the wrong account

d) All of the above

14. What is the normal balance of an expense account?

a) Debit

b) Credit

c) It depends on the account

d) None of the above

15. What is the normal balance of a liability account?

a) Debit

b) Credit

c) It depends on the account

d) None of the above

16. Which of the following errors would cause the trial balance to be out of balance?

a) An error of principle
b) A transposition error
c) A compensating error
d) A transposition error in different accounts

17. If the total of the debit column in a trial balance is higher than the credit column, which of the
following is true?

a) The company has more assets than liabilities.

b) The company has more liabilities than assets.
c) The company has a net loss.
d) The trial balance is out of balance.

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18. Which of the following statements is true regarding a trial balance?

a) It is used to prepare financial statements.

b) It is a permanent record of transactions.
c) It is only used by small businesses.
d) It is prepared monthly.

19. When preparing a trial balance, which of the following is true?

a) All transactions are included, regardless of whether they have been posted to the general ledger.
b) Only transactions that have been posted to the general ledger are included.
c) Only transactions that have been recorded in the journal are included.
d) Only transactions that have been approved by management are included.

20. Which of the following is not a step in preparing a trial balance?

a) Totaling the debit and credit columns of the ledger accounts.

b) Verifying that the total debits equal the total credits.
c) Recording adjusting entries.
d) Listing each account in the general ledger.

21. Which of the following errors would cause the trial balance to be in balance even though an error
has occurred?

a) An error of commission
b) A transposition error
c) A compensating error
d) An error of omission

Answer Keys
1. Answer: b) A trial balance is a summary of all accounts in the ledger, showing their debit or credit
balances.
Explanation: A trial balance is prepared by listing all accounts in the ledger and their debit or credit
balances. The total of the debit balances should equal the total of the credit balances, which
indicates that the books are in balance. This serves as a preliminary step before preparing the
financial statements.
2. Answer: d) To record all transactions for the period
Explanation: A trial balance is not meant to record all transactions for the period, but rather to
summarize the ledger accounts and ensure that they are in balance. Its main purposes are to identify
errors in the ledger and to prepare the financial statements.
3. Answer: c) A missed transaction

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Explanation: A trial balance will not detect a missed transaction, as it only summarizes the ledger
accounts. A transposition error (such as reversing two digits) or a posting error (such as entering a
transaction in the wrong account) would be detected by a trial balance, as they would result in an
imbalance between the debit and credit totals.
4. Answer: a) Correct the errors and prepare a new trial balance
Explanation: If the trial balance is not in balance, the first step is to identify and correct the errors.
Once the errors have been corrected, a new trial balance should be prepared to ensure that the
accounts are now in balance.
5. Answer: b) The account has a credit balance
Explanation: A credit balance on the trial balance means that the account has more credits than
debits. This could indicate that the account is a liability or an income account.
6. Answer: c) It shows only the permanent accounts
Explanation: A post-closing trial balance is prepared after the closing entries have been made, and
shows only the permanent accounts (those that are not closed). This includes asset, liability, and
equity accounts.
7. Answer: c) Financial statement
Explanation: The trial balance is a financial statement that lists all the accounts and their balances to
ensure that the total debits equal the total credits. It is not a journal or ledger.
8. Answer: a) Error of omission
Explanation: An error of omission occurs when a transaction is completely left out of the accounting
records. Since it does not affect any account balance, it will not be detected by the trial balance.
9. Answer: b) Correct the errors
Explanation: If the trial balance does not balance, there must be an error that needs to be corrected.
The first step is to identify and correct the error before making any adjusting entries or
reconstructing the accounts.
10. Answer: a) To ensure that all temporary accounts have been closed
Explanation: The post-closing trial balance is prepared after all temporary accounts have been
closed at the end of the accounting period. Its purpose is to ensure that all temporary accounts have
been closed and the balance of the permanent accounts is correct.
11. Answer: a) Only permanent accounts
Explanation: A post-closing trial balance includes only the balances of the permanent accounts,
which are the accounts that are not closed at the end of the accounting period.
12. Answer: c) to identify errors in the accounting system
Explanation: The main purpose of a trial balance is to identify errors in the accounting system by
ensuring that the total debits equal the total credits.
13. Answer: d) All of the above
Explanation: Any error that affects the total debits and credits of the accounts will cause the trial
balance to be out of balance, including transposition errors, mathematical errors, and posting errors.
14. Answer: a) Debit
Explanation: Expense accounts normally have a debit balance, since they represent costs that reduce
the company's net income.
15. Answer: b) Credit
Explanation: Liability accounts normally have a credit balance, since they represent obligations that
the company

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16. Answer: D. A transposition error in different accounts. A transposition error occurs when the digits
within an amount are transposed, such as entering $854 as $584. If the error is made in different
accounts, the debits and credits will still balance, but the trial balance will be out of balance because
the incorrect amounts are being used.
17. Answer: A. The Company has more assets than liabilities. The trial balance is a summary of all the
account balances in the general ledger, including asset, liability, and equity accounts. If the total of
the debit column is higher than the credit column, it means that the total of all the debit balances in
the asset accounts is higher than the total of all the credit balances in the liability and equity
accounts.
18. Answer: A. It is used to prepare financial statements. The trial balance is a list of all the accounts in
the general ledger with their respective debit or credit balances. It is used to ensure that the total of
all debits equals the total of all credits, and is then used to prepare financial statements such as the
balance sheet and income statement.
19. Answer: B. Only transactions that have been posted to the general ledger are included. The trial
balance is a list of all the accounts in the general ledger with their respective debit or credit balances.
It is prepared after all transactions for the period have been posted to the general ledger.
20. Answer: C. Recording adjusting entries. Adjusting entries are made after the trial balance has been
prepared, and are used to adjust the accounts for accruals and deferrals that have not been recorded
during the accounting period.
21. Answer: C. A compensating error. A compensating error is when two or more errors offset each
other, resulting in the trial balance being in balance. For example, if a transaction is recorded twice,
but for different amounts, the debits and credits will offset each other, resulting in the trial balance
being in balance.

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CHAPTER 3
Financial statements
Introduction
Financial statements are written reports created by a company’s management to summarize the business’s
financial condition over a certain period (quarter, six-monthly, or yearly). These statements, which comprise
the balance sheet, income statement, cash flow statement, and statement of shareholders’ equity, must be
prepared by specified and standardized accounting standards to ensure that reporting is consistent.

Financial statements are credentials that ensure investors and other stakeholders have the opportunity to
learn about the current financial status of a company before they make investments or other strategic
decisions. They can compare every statement prepared to check the actual status of the entities they want
to associate with.

Objective
 Overview: The primary objective of financial statements is to provide an overview of the financial
position and performance of an entity.
 Decision Making: The financial statements should provide relevant and reliable information to
enable the stakeholders to make informed economic decisions about the entity.

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 Stakeholder Needs: The financial statements should meet the needs of various stakeholders, such
as shareholders, creditors, investors, employees, customers, and regulatory authorities.
 Transparency: The financial statements should be transparent and provide a fair and accurate
representation of the entity's financial position and performance.
 Compliance: The financial statements should comply with the generally accepted accounting
principles (GAAP) or international financial reporting standards (IFRS).
 Accrual Basis: The financial statements should be prepared using the accrual basis of accounting,
which recognizes revenues and expenses when they are earned or incurred, regardless of when the
cash is received or paid.
 Historical Perspective: The financial statements should provide a historical perspective of the
entity's financial position and performance, allowing stakeholders to compare the entity's current
financial status with its past performance.
 Timeliness: The financial statements should be prepared and presented in a timely manner, so that
stakeholders have access to the most up-to-date information.
 Comparability: The financial statements should be comparable, enabling stakeholders to compare
the entity's financial position and performance with other entities in the same industry.
 Understandability: The financial statements should be presented in a clear and understandable
manner, so that stakeholders with varying levels of financial literacy can understand the information
presented.

Capital expenditure and revenue expenditure, capital receipts and revenue receipt
Capital Expenditure: Capital expenditure refers to expenses incurred for acquiring or improving long-term
assets that will be used in the business for more than one year. These expenses are not immediately
charged to the income statement but are instead capitalized and depreciated over their useful life.
Examples of capital expenditure include the purchase of land, buildings, equipment, and vehicles.

Revenue Expenditure: Revenue expenditure refers to expenses incurred in the day-to-day operations of
the business, such as salaries, wages, rent, and utility bills. These expenses are immediately charged to the
income statement and are considered as operating expenses. Revenue expenditure does not create an asset
and is not expected to provide a long-term benefit to the business.

Capital Receipts: Capital receipts are the funds received by a business from the sale of long-term assets, or
from borrowing money. These funds are not part of the company's normal operations and are not
considered revenue. Examples of capital receipts include the sale of land, buildings, or equipment, and the
issuance of long-term debt.

Revenue Receipts: Revenue receipts are the funds received by a business from its normal operations, such
as sales, services rendered, or interest earned. These receipts are considered part of the company's revenue
and are reported on the income statement. Examples of revenue receipts include cash sales, accounts
receivable collections, and interest earned on investments.

Capital and revenue receipts

In accounting, capital receipts refer to funds received by a business or organization that are intended for
long-term use or investment. These funds may come from sources such as the sale of company shares,

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loans, or the sale of fixed assets like property or equipment. Capital receipts are not considered part of the
company's regular income and are typically used for business growth or development.

On the other hand, revenue receipts refer to funds received by a business or organization as a result of its
regular operations, such as the sale of goods or services. Revenue receipts are considered part of the
company's regular income and are used to cover day-to-day expenses and operational costs.

It is important for businesses and organizations to distinguish between capital and revenue receipts in their
financial records in order to accurately track and manage their finances

Difference

Capital Receipts Revenue Receipts

Capital receipts refer to funds received by a business Revenue receipts refer to funds received by a business
or organization that are intended for long-term use or organization as a result of its regular operations,
or investment. These funds are not considered part such as the sale of goods or services. These funds are
of the company's regular income and are typically considered part of the company's regular income and
used for business growth or development. Examples are used to cover day-to-day expenses and operational
include funds received from: costs. Examples include funds received from:

Sale of company shares Sales of goods or services

Loans Rent or lease payments

Sale of fixed assets such as property, equipment or Interest income

vehicles

Government grants for capital expenditures Dividends from investments

Proceeds from the issuance of bonds or other long- Royalties from intellectual property
term debt

Not considered part of regular income Considered part of regular income

Recorded as a liability in the company's balance Recorded as income in the company's income
sheet statement

Used for business growth or development Used to cover day-to-day expenses and operational
costs

May have tax implications Subject to taxation

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Examples of capital receipts are the funds received Examples of revenue receipts are rental income,
for a company's expansion or acquisition, while interest income, and dividend
revenue receipts are the funds received from selling
products or services to customers.

Trading account
In accounting, a trading account is a financial statement that shows a company's revenue and expenses
related to its core business operations during a specific period of time. It is also known as a profit and loss
account, income statement, or statement of operations.

The purpose of a trading account is to determine the gross profit or loss of a business by subtracting the
cost of goods sold (COGS) from the revenue earned from selling those goods. The COGS includes the direct
expenses incurred to produce or acquire the goods sold, such as raw materials, labor, and production
overheads.

The revenue in the trading account includes sales revenue, discounts received, and any other income
earned from the company's primary operations. The expenses in the trading account include indirect costs
such as salaries, rent, utilities, and other expenses related to running the business.

The net result of the trading account is the gross profit or loss, which indicates how much revenue the
business generated from its operations after deducting the direct costs of production. This information is
useful in determining the overall profitability of the business and making strategic decisions for future
growth and development.

Cost of goods sold and gross profit

The concepts of cost of goods sold (COGS) and gross profit are applicable in India as well. In fact, they are
important metrics used in Indian businesses to determine the profitability of their operations.

Indian businesses are required to maintain their books of accounts in accordance with the Indian
Accounting Standards (Ind AS) or the Generally Accepted Accounting Principles (GAAP). These standards
require companies to report their COGS and gross profit in their financial statements, which are submitted
to the regulatory authorities.

COGS in India includes the cost of raw materials, direct labor, production overheads, and any other
expenses incurred in the production or acquisition of goods sold during a specific period of time. The
method of calculating COGS may vary depending on the industry and the nature of the business.

Gross profit in India is calculated by subtracting the COGS from the revenue earned from selling the goods
during the specific period of time. It is an important metric used by businesses to determine the profitability
of their operations and make strategic decisions.

In India, the tax authorities also use COGS and gross profit to calculate the taxable income of businesses.
The income tax laws in India allow businesses to claim a deduction for the COGS while computing their

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taxable income. This is done to ensure that businesses are taxed only on their net profits, which is the gross
profit minus the indirect expenses.

The formula for calculating gross profit is

Gross Profit = Revenue - Cost of Goods Sold

For example, if a company generates Rs100,000 in revenue from selling goods and incurs Rs 60,000 in
COGS, then the gross profit would be:

Gross Profit = Rs100,000 – Rs 60,000

Gross Profit = Rs 40,000

This means that the company has earned Rs 40,000 in gross profit from its core operations during the
specific period of time.

Need of Trading Account

A trading account is a financial statement that shows the revenue and expenses related to a company's core
business operations during a specific period of time. The purpose of a trading account is to determine the
gross profit or loss of a business by subtracting the cost of goods sold (COGS) from the revenue earned
from selling those goods. Here are some of the reasons why a trading account is necessary for businesses:

 Helps in determining the profitability of the business: The trading account helps in determining
the gross profit or loss of the business. This information is useful in determining the overall
profitability of the business and making strategic decisions for future growth and development.
 Helps in identifying cost of goods sold: The trading account helps in identifying the direct
expenses incurred in producing or acquiring the goods sold by the business. This information is
useful in controlling the cost of production and improving efficiency.
 Helps in comparing performance: The trading account helps in comparing the performance of
different products, business units, or time periods. This information is useful in identifying areas of
improvement and making informed decisions.

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Important items of trading account

Opening Stock
The figure will already be available and will be found in the trial balance. The opening stock, in case of a
manufacturing business, will consist of raw materials, finished goods and work in progress (unfinished
goods). A new business will, naturally, have no opening stock in the first year.

Purchases and Purchases Returns

The student who is familiar with the trial balance will realize that the Purchases Account represents gross
value of goods purchased and that the Returns Outwards Account represents goods returned to suppliers.
Real or net purchases are the excess of the former over the latter. In the Trading Account, generally, the net
figure is shown (although there will be no effect on the gross profit if the Purchases Account is put on the
debit side of the Trading Account and the Returns Outwards Account is put on the credit side).

The figures are actually shown thus

Purchase Return Entry Sample

It may happen sometimes that goods have been purchased and received towards the close of the year and
that somehow no entry has been passed. Before making the Trading Account, an entry should be passed,
debiting Purchases Account and crediting the supplier. An alternative is to keep the goods separate and not
to include them in the closing stock. But this is recommended only when the property in the goods still
belongs to the supplier; for example, when the supplier still has to do something such as fitting a part.
Goods received from others and to be sold on their behalf and risk should not be treated as purchases.

Carriage or Freight
All expenses to bring the purchased goods or materials to the firm’s godowns should be debited to the
Trading Account; freight, customs duty or octroi paid on purchases should be debited to this account. But
freight, customs duty, etc., paid on the acquisition of a fixed asset, say, machinery should be included in the
value of that asset and not debited to the Trading Account.

Wages
Wages paid to workmen engaged in the manufacture of goods directly or indirectly should be debited to
the Trading Account. Salaries paid to foremen, etc., in the factory should also be so debited. Care should be
taken to see that the wages of the full trading period are included even if some of the wages have not yet
been paid.

If some wages are as yet unpaid, the following entry should be passed:

Wages Account …… Dr.

To Wages Outstanding Account

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Wages Outstanding is a liability and will appear in the Balance Sheet. Sometimes firm’s own workmen do
something of capital nature—for example, erect a shed or install machinery. Wages for the job concerned
should be calculated and should be deducted from the wages account and added to the cost of the asset
concerned.

The entry will be:

Asset (by name) …. … Dr.

To Wages Account

Fuel and Power

Coal used to run boilers which produce steam to run machinery is naturally debited to the Trading Account.
Electricity used to drive machinery is similarly treated. Power should be distinguished from electricity used
for lighting. “Power” is generally used to denote electricity for driving machinery.

Lighting
Electricity used for lighting factory buildings is debited to the Trading Account; if there is a common meter
to record electricity used for lighting both the factory and the office buildings, it should be suitably
apportioned, because electricity used to light office buildings will be debited to the Profit and Loss Account
and not to the Trading Account.

Rent and Rates

Rates denote municipal taxes. Rent and rates on factory buildings should be debited to the Trading
Account. If the factory and the office are situated in the same building, the rent and rates on the building
should be suitably apportioned, on the basis of floor-space occupied.

If rent for the full trading period has not been paid, the following entry for the unpaid amount should be
passed:

Rent Account ….. ….. Dr.

To Rent Outstanding Account

“Rent Outstanding” is a liability and will be shown on the liabilities side.

Taxes are often paid in advance. It may be that a particular amount may have been paid for a period which
will end after the close of the financial year. On 1st October, 2011, a municipal tax of Rs 1,000 may be paid
for one year. If accounts are made up to 31st March, 2012, taxes for six months (from 1st April, 2012 to 30th
September, 2012), Rs 500 will be treated as prepaid or paid in advance. Since the benefit of this amount will
accrue next year, this year’s accounts should not be burdened with the expense. To put matters right, the
following entry should be passed.

Prepaid Municipal Taxes Account …… …… Dr. 500

To Municipal Taxes Account 500

Municipal taxes will be now less by Rs 500, and a prepaid Municipal Taxes Account debited, which will go to
the Balance Sheet. The amount will be charged to revenue next year. This applies to all prepaid expenses.

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Depreciation
Logically, depreciation of plant and machinery used for production of goods should be debited to the
Trading Account like other manufacturing expenses. However traditionally, it is not so charged but is
debited to the Profit and Loss Account. This may be because the amount of depreciation is determined
more or less arbitrarily.

Sales and Sales Returns

Sales appear on the credit side of Trading Account. If any goods have been returned by customers, the
Returns Inwards Account will show the amount. This amount should be deducted from the Sales.
Sometimes, towards the close of the year, invoices are made out for sale to customers, but the goods are
not despatched until after the close of the trading period with the result that such goods are included in the
closing stock also. This gives rise to an inflated gross profit.

To avoid it, the goods sold but not despatched should not be included in the closing stock. An alternative,
not recommended, is that such a sale should not be treated as sale until the next trading period. The test is
whether the property in the goods has passed to the customer; if it has, the goods sold but not yet
despatched should be excluded from stock. If, however the property in the goods has not yet passed to the
customer, say because the customer has yet to inspect them, the proper course is to reverse the entry for
the sale and then include the goods into stock.

Goods sent to agents to be sold on commission basis (that is to say, where the agent does not buy the
goods but merely undertakes to try to sell them for a commission) should not be treated as sale.Sales made
on behalf of others should not be credited to Sales Account. Similarly, goods sent to customers on sale or
return basis should not be treated as sale unless the customer has agreed to purchase the goods or an
unreasonably long period has elapsed after the customer received the goods.

Goods in the hands of the customer still returnable by them should be included in stock at cost. If, at the
time of sending the goods, the customer was debited and Sales Account credited, the entry should be
reversed at the end of the year for goods still returnable by the customers.

Closing Stock or Inventories

At the close of a period, a trading firm will have a certain quantity of goods on hand—normally only a part
of the goods purchased are sold away. It is only proper that against the sales, only the cost of the goods
sold should be put (to ascertain the gross profit). This is what is sought to be achieved. The cost of the
goods still on hand is ascertained and put on the credit side of the Trading Account; the purpose can very
well be served by deducting the cost of these goods from the purchases and entering only the net balance
on the debit side of the Trading Account.

Profit & loss account

 A profit and loss account shows a company’s revenue and expenses over a particular period of time,
typically either one month or consolidated months over a year. These figures show whether your
business has made a profit or a loss over that time period.
 Profit and loss accounts show your total income and expenses, and also shows whether your
business has earned more income than it has spent on its running costs. If that is the case, then your
business has made a profit.

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 The profit and loss account represents the profitability of a business. It cannot, for example, show
you if you are running out of cash as you build stock. For this sort of insight, you’ll need a balance
sheet.
 The profit and loss account is also known as a P&L report, an income statement, a statement of
operation, a statement of financial results, or an income and expense statement.

Some important items of profit and loss account

Debit items
 Cost of Goods Sold (COGS): This is the direct cost of producing the goods or services sold during
the period. COGS includes the cost of materials, labor, and any other costs directly related to the
production of goods or services. COGS is recorded as a debit entry in the P&L account.
 Salaries and wages: The salaries and wages paid to employees are considered an expense and are
recorded as a debit entry in the P&L account.
 Rent or lease payments: The rent or lease payments made for the business premises are recorded
as a debit entry in the P&L account.
 Depreciation: Depreciation is the decrease in value of a company's fixed assets over time. The
depreciation expense is recorded as a debit entry in the P&L account.
 Advertising and marketing expenses: Any expenses related to advertising and marketing of the
company's products or services are recorded as a debit entry in the P&L account.

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 Interest expenses: Interest expenses on loans or other forms of debt are recorded as a debit entry
in the P&L account.

Credit items
 Sales: When a business makes a sale of goods or services, the amount received is recorded as a
credit entry in the sales account.
 Interest earned: When a business earns interest on investments or deposits, the amount received is
recorded as a credit entry in the interest earned account.
 Dividends received: When a business receives dividends from investments in other companies, the
amount received is recorded as a credit entry in the dividends received account.
 Commission earned: If a business earns commission on sales made by another party, the amount
earned is recorded as a credit entry in the commission earned account.
 Sale of fixed assets: When a business sells a fixed asset, the amount received is recorded as a credit
entry in the fixed asset account.

Transfer entries of profit and loss account

Net profit is earned for the year
Let's say that a company has earned a net profit of INR 5,00,000 for the year ending on March 31, 2023. The
transfer entries would be as follows:

 Debit the retained earnings account by INR 5,00,000.

 Credit the P&L account by INR 5,00,000.

The result of these entries is that the net profit is added to the retained earnings account on the balance
sheet. The P&L account is closed out for the year.

Net loss is incurred for the year

Now, let's say that the company incurred a net loss of INR 2,00,000 for the year ending on March 31, 2023.
The transfer entries would be as follows:

 Credit the retained earnings account by INR 2,00,000.

 Debit the P&L account by INR 2,00,000.

The result of these entries is that the net loss is subtracted from the retained earnings account on the
balance sheet. The P&L account is closed out for the year.

Company has a dividend payout for the year

Let's say that the company in Scenario 1 also declared and paid a dividend of INR 1,00,000 to its
shareholders. The transfer entries would be as follows:

 Debit the retained earnings account by INR 1,00,000.

 Credit the cash account by INR 1,00,000.

The result of these entries is that the retained earnings account is reduced by the amount of the dividend
payout. The cash account is increased by the same amount, reflecting the cash outflow for the dividend.

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Position statement/balance sheet

A Position Statement, also known as a Balance Sheet, is a financial statement that reports a company's
financial position at a specific point in time. It provides a snapshot of the company's assets, liabilities, and
equity.

The Balance Sheet has two sides: the assets side and the liabilities and equity side. The assets side shows
what the company owns or controls, while the liabilities and equity side shows how those assets are
financed.

Here are the key components of a typical Balance Sheet

Assets
 Current assets: Cash, accounts receivable, inventory, prepaid expenses, and other assets that are
expected to be converted into cash within one year.
 Non-current assets: Property, plant, and equipment, long-term investments, intangible assets, and
other assets that are not expected to be converted into cash within one year.

Liabilities and Equity

 Current liabilities: Accounts payable, short-term loans, and other obligations that are expected to
be paid within one year.
 Non-current liabilities: Long-term debt, deferred taxes, and other obligations that are not expected
to be paid within one year.
 Shareholders' equity: Common stock, additional paid-in capital, retained earnings, and other equity
accounts.

The Balance Sheet equation is Assets = Liabilities + Equity. This equation must always balance, meaning
that the total value of assets must equal the total value of liabilities and equity.

The Position Statement/Balance Sheet is a crucial financial statement for investors, creditors, and other
stakeholders as it provides a snapshot of a company's financial position and its ability to meet its
obligations.

Financial Statements
Financial statements are written records that convey the business activities and the financial performance of
a company. Financial statements are often audited by government agencies, accountants, firms, etc. to
ensure accuracy and for tax, financing, or investing purposes. For-profit primary financial statements include
the balance sheet, income statement, statement of cash flow, and statement of changes in equity. Non-
profit entities use a similar but different set of financial statements.

 Financial statements are written records that convey the business activities and the financial
performance of an entity.
 The balance sheet provides an overview of assets, liabilities, and shareholders' equity as a snapshot
in time.

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 The income statement primarily focuses on a company’s revenues and expenses during a particular
period. Once expenses are subtracted from revenues, the statement produces a company's profit
figure called net income.
 The cash flow statement (CFS) measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments.
 The statement of changes in equity records how profits are retained within a company for future
growth or distributed to external parties.

There are four main financial statements

 Balance sheet
 Income statement
 Cash flow statement
 Statement of retained earnings

Financial statements may be prepared for different timeframes. Annual financial statements cover the
company’s latest fiscal year. Companies may also prepare interim financial statements on a monthly,
quarterly or semi-annual basis.

Interim statements sometimes include fewer components than year-end statements. For example, they may
lack a cash flow statement and a statement of retained earnings.

Balance sheet
The balance sheet shows what the company owns and how much it owes at the end of the period. It is
based on the equation:

Assets = Liabilities + Shareholders’ Equity

Below is a sample balance sheet.

Income statement
An income statement shows the profitability of your business. It details how much money your business
earned and spent. The income statement is also sometimes referred to as a profit-loss statement or an
earnings statement.

It shows your

 revenue from selling products or services

 expenses to generate the revenue and manage your business
 net income (or profit) that remains after your expenses

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Below is an example of an income statement.

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To supplement an income statement, a business may also prepare a statement of comprehensive income.
This reports revenues and expenses that haven’t yet been realized, such as unrealized gains or losses
from:

 financial investments
 foreign currency adjustments
 pension liabilities

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Cash flow statement

The cash flow statement, sometimes called a statement of changes in financial position, shows how money
has moved through your business during the period.

Here is an example of a cash flow statement.

Statement of retained earnings

The statement of retained earnings shows the cumulative earnings of the business after any dividends or
distributions to shareholders. As well, this statement, sometimes called a statement of changes in equity,
also shows the change in the retained earnings account between the opening and closing periods on each
balance sheet.

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Sample retained earnings statement

Marshalling of Assets and Liabilities

Marshalling of assets and liabilities refers to the process of presenting the assets and liabilities of a
company in a specific order on its balance sheet or position statement. The objective of marshalling is to
provide clarity and improve the readability of financial statements.

In general, assets are listed in order of their liquidity, meaning the ease with which they can be converted
into cash. Liabilities, on the other hand, are listed in order of their maturity, or the amount of time
remaining until they must be paid.

The order of presentation may vary depending on the accounting standards used in a particular country. In
India, the general order of presentation for assets and liabilities is:

 Non-current assets
 Current assets
 Equity and liabilities

Within these categories, specific items are presented in the order of liquidity or maturity, as applicable. For
example, non-current assets may be presented in the following order:

 Fixed assets
 Investments
 Other non-current assets

Similarly, current assets may be presented in the following order:

 Inventories
 Trade receivables
 Cash and bank balances

Current liabilities may be presented in the following order:

 Trade payables
 Short-term borrowings

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 Other current liabilities

Non-current liabilities may be presented in the following order:

 Long-term borrowings
 Deferred tax liabilities
 Other non-current liabilities

Equity is usually presented last, and may be further classified into share capital, reserves, and surplus.

Marshalling of assets and liabilities is important because it helps users of financial statements to quickly and
easily understand a company's financial position and liquidity.

Classification of assets and liabilities

Classification of assets
Fixed Assets
Fixed assets can be divided into the following groups:

 Tangible
 Intangible
 Wasting
 Fictitious

Fixed assets are assets acquired for beneficial use and held permanently in the business. The business can
earn profits by using these assets.

Tangible assets (or definite assets) are fixed assets that can be seen and touched, and which have volume.

Examples of tangible assets include land, antiques, plants, buildings, fixtures, vehicles, and equipment and
tools.

Intangible assets are assets that cannot be seen or touched, and which have no volume. Examples include
goodwill, patents, trademarks, copyrights, and leaseholds.

Wasting assets are assets that get exhausted or reduce in value when used. Natural resources, oil, timber,
coal, mineral deposits, and quarries are all examples of wasting assets.

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Fictitious assets are assets that are either past accumulated losses or expenses, which are incurred once in
the lifetime of a business and are capitalized for the time being. These items are not actually assets but are
treated as assets.

Due to the intangible nature of fictitious assets, they are sometimes also categorized as intangible assets.

Examples of fictitious assets include organizational expenses, discounts on issues of shares, advertising
expenses capitalized, and research and development expenses.

Floating Assets
 Investments in short-term marketable securities that can quickly be converted into cash can be
treated as current assets, whereas investments in long-term marketable securities can be treated as
semi-fixed assets.
 Therefore, some investments cannot be categorized either as current assets or fixed assets.
 Their treatment differs depending on their nature and, hence, they are shown midway between fixed
assets and current assets, and are considered floating assets.

Current Assets
Current assets are expected to be sold or otherwise used up in the near future. These assets are readily
available for discharging an enterprise's liabilities.

Those items of assets which can be converted into cash quickly without significant loss of time and money
are called liquid assets and fall under the category of current assets.

Examples of current assets include cash, bank balance, accounts receivables (sundry debtors and bills
receivables), and stock that can be realized quickly.

Classification of Liabilities

Fixed Liabilities
Fixed liabilities are due to the owners/partners/shareholders of an enterprise, and they are payable only on
dissolution/liquidation of the enterprise.

Long-Term Liabilities
These are in the nature of long-term loans (e.g., 5-10 years) or debentures that are payable on or after the
lapse of the term consented to in the borrowing agreement/document.

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Current Liabilities
These are short-term obligations payable within the next accounting period/year or payable within a very
short period (e.g., 1-3 months).

Examples of current liabilities include accounts payable (sundry creditors and bills payable), short-term bank
overdrafts, and short-term temporary loans.

Contingent Liabilities
 Contingent liabilities arise depending on the happenings of certain events. Such liabilities may or
may not arise. However, it is important to be cautious about them.
 Consider the example of a case that is pending in a court of law concerning a disputed payment or
compensation claim.
 If the case is decided against the enterprise, then liability arises. Otherwise, there is no obligation to
pay and, as such, no liability.
 Bills discounted, as well as guarantees given against loans from another enterprise or person, may
also cause liability if the other person does not honour the commitment.
 If the person honours the commitment, then no liability arises. This means that the liability is
'probable'.

Preparation of balance sheet

Determine the Reporting Date and Period
A balance sheet is meant to depict the total assets, liabilities, and shareholders’ equity of a company on a
specific date, typically referred to as the reporting date. Often, the reporting date will be the final day of
the accounting period.

Identify Your Assets

After you’ve identified your reporting date and period, you’ll need to tally your assets as of that date.

Typically, a balance sheet will list assets in two ways: As individual line items and then as total assets.
Splitting assets into different line items will make it easier for analysts to understand exactly what your
assets are and where they came from; tallying them together will be required for final analysis.

Assets will often be split into the following line items:

Current Assets

 Cash and cash equivalents

 Short-term marketable securities
 Accounts receivable
 Inventory
 Other current assets

Non-current Assets

 Long-term marketable securities

 Property
 Goodwill
 Intangible assets

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 Other non-current assets

Current and non-current assets should both be subtotalled, and then totalled together.

Identify Your Liabilities

Similarly, you will need to identify your liabilities. Again, these should be organized into both line items and
totals, as below:

Current Liabilities
 Accounts payable
 Accrued expenses
 Deferred revenue
 Current portion of long-term debt
 Other current liabilities

Non-Current Liabilities

 Deferred revenue (non-current)

 Long-term lease obligations
 Long-term debt
 Other non-current liabilities

As with assets, these should be both subtotalled and then totalled together.

Calculate Shareholders’ Equity

If a company or organization is privately held by a single owner, then shareholders’ equity will generally be
pretty straightforward. If it’s publicly held, this calculation may become more complicated depending on
the various types of stock issued.

Common line items found in this section of the balance sheet include:

 Common stock
 Preferred stock
 Treasury stock
 Retained earnings

Add Total Liabilities to Total Shareholders’ Equity and Compare to Assets

To ensure the balance sheet is balanced, it will be necessary to compare total assets against total liabilities
plus equity. To do this, you’ll need to add liabilities and shareholders’ equity together.

Finance statement: II

Need for accounting adjustments

Accounting adjustments are necessary to ensure that financial statements accurately reflect the financial
position and performance of a company. These adjustments are made to correct errors or omissions in the
accounting records, to ensure compliance with accounting standards, and to adjust for the timing of
revenue and expenses.

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Here are some reasons why accounting adjustments are needed
 Errors or omissions: Accounting adjustments are needed to correct errors or omissions in the
accounting records. For example, if a transaction was recorded incorrectly, an adjustment must be
made to correct the error.
 Compliance with accounting standards: Accounting adjustments may be needed to ensure
compliance with accounting standards. For example, some expenses may need to be capitalized and
amortized over a period of time instead of being expensed immediately.
 Accrual accounting: Accounting adjustments are needed to ensure that revenue and expenses are
recorded in the correct period. Under accrual accounting, revenue is recognized when earned and
expenses are recognized when incurred, regardless of when cash is received or paid.
 Depreciation: Accounting adjustments are needed to record depreciation on fixed assets.
Depreciation is a non-cash expense that reduces the value of fixed assets over their useful lives.
 Inventory valuation: Accounting adjustments are needed to adjust the value of inventory to its
lower of cost or market value. This ensures that inventory is not overstated on the balance sheet.
 Bad debt expense: Accounting adjustments are needed to record bad debt expense. This is an
expense that is recorded when a customer is unlikely to pay their outstanding balance.

Adjustments and their incorporation

Accounting adjustments are company transactions that haven't been recorded yet. Supplier invoices,
customer billings, and cash receipts document most transactions. The accounting software's module for
such transactions creates an accounting record for the user.

If such transactions have not been documented by the end of an accounting period or the entry
erroneously describes the transaction's effect, the accounting staff corrects entries. Generally Accepted
Accounting Principles or International Financial Reporting Standards are used to alter the company's
financial statements. Adjustments in accounting are primarily utilized in accrual accounting.

When a corporation changes accounting principles, preceding periods may need accounting modifications.
Such a change is carried back to compare financial performance across accounting periods.

Types of adjustments
There are just five distinct sorts of adjusting entries, and the distinctions between them are straightforward,
so don't let the prospect of creating them scare you off. Below, you'll find detailed explanations of each
kind, including some illustrative examples and instructions for filling them out.

 Accrued Revenues: Accrued revenue is the amount of money earned in one accounting period that
isn't counted until a subsequent period.
 Accrued Expenses: After getting a handle on how accumulated income works, adjusting incurred
expenses should be a breeze. They are the costs you incurred in one time period but paid for in
another.
 Deferred Revenues: Deferred income occurs when a customer pays you in advance. It's essential to
report the income in the month you provide the service and incur the prepaid costs, even if you're
being paid now.

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 Prepaid Expenses: Similar to delayed income, prepaid expenses may be used in the future. Instead
of deducting the cost over the period it pertains to, and you make a one-time payment in this
situation.
 Depreciation Expenses: Depreciation is the practice of writing off the cost of an item over a more
extended period than the asset's useful life. This is generally done for expensive acquisitions like
machinery, automobiles, and structures. You will see a change to the overall cumulative depreciation
amount on your balance sheet after any accounting Period in which depreciation occurred.
Depreciation is an ongoing cost that will be shown as an expenditure each time it is paid.
 Stock valuation: The value of a company's stock at the end of an accounting period may be
different from its value at the beginning of the period. To account for this, adjustments are made to
ensure that the value of the stock on the balance sheet is accurate. The accounting treatment
involves debiting Cost of Goods Sold and crediting Inventory for any decrease in the value of stock,
and vice versa for an increase in value.
 Accrued income: Accrued income is income that has been earned but not yet received. Examples
include interest income and rent receivable. The accounting treatment involves debiting the relevant
income account and crediting Accrued Income, which is an asset account that represents the
amount of income earned but not yet received.
 Deferred income: Deferred income is income that has been received in advance but not yet earned.
Examples include subscription fees and service contracts. The accounting treatment involves
crediting the relevant income account and debiting Deferred Income, which is a liability account that
represents the amount of income received in advance but not yet earned.
 Amortization: Amortization is an adjustment made to account for the gradual reduction in value of
intangible assets over time. The accounting treatment involves debiting Amortization Expense and
crediting Accumulated Amortization, which is a contra asset account that reduces the value of the
intangible asset on the balance sheet.
 Provision for taxation: Provision for taxation is an adjustment made to account for the estimated
tax liability of a company. The accounting treatment involves debiting Provision for Taxation, which
is a liability account that represents the estimated tax liability, and crediting Profit and Loss Account,
which is an expense account that reduces the profit earned by the company.

Adjustment Accounting Explanation

Treatment

Depreciation Debit Depreciation Depreciation is the allocation of the cost of a fixed asset over
Expense, Credit its useful life. Depreciation expense is debited to reflect the
Accumulated decrease in the asset's value, while accumulated depreciation
Depreciation is credited to reflect the total depreciation charged to date.

Prepaid Debit relevant Prepaid expenses are expenses that have been paid in
Expenses expense account, advance but have not yet been incurred. The relevant expense
Credit Prepaid account is debited to reflect the expense that has been
Expense incurred, and the prepaid expense account is credited to
reflect the remaining balance of the prepaid amount.

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Accrued Debit relevant Accrued expenses are expenses that have been incurred but
Expenses expense account, have not yet been paid. The relevant expense account is
Credit Accrued debited to reflect the expense that has been incurred, and the
Expense accrued expense account is credited to reflect the amount of
the expense that is owed but not yet paid.

Unearned Debit Unearned Unearned revenues are revenues that have been received in
Revenues Revenue, Credit advance but have not yet been earned. The unearned revenue
relevant revenue account is debited to reflect the decrease in the liability, and
account the relevant revenue account is credited to reflect the revenue
that has been earned.

Stock Debit Cost of Goods Stock valuation refers to the valuation of inventory at the end
Valuation Sold, Credit Inventory of an accounting period. The cost of goods sold account is
debited to reflect the cost of goods sold during the period,
and the inventory account is credited to reflect the remaining
inventory at the end of the period.

Not for profit organisation

A not-for-profit organization, also known as a non-profit organization (NPO), is an organization that is
dedicated to achieving a particular social or environmental mission rather than making a profit. The primary
objective of a not-for-profit organization is to provide goods or services to meet the needs of a community,
promote a particular cause, or advance a common interest.

Not-for-profit organizations can take various forms, such as charities, foundations, religious organizations,
educational institutions, social clubs, and advocacy groups. These organizations rely on donations, grants,
and government funding to support their activities and achieve their objectives.

In terms of accounting, not-for-profit organizations must follow certain guidelines and principles. Unlike
for-profit organizations, not-for-profit organizations do not have owners or shareholders who are entitled
to a portion of the profits. Instead, any surplus funds are reinvested back into the organization to support
its mission.

Characteristics of Not-for-Profit Organizations

 Service Motive: These organisations have a motive to provide service to its members or a specific
group or to the general public. They provide services free of cost or at a bare minimum price as their
aim is not to earn the profit. They do not discriminate among people on the basis of their caste,
creed or colour. Examples of services provided by them are education, food, health care, recreation,
sports facility, clothing, shelter, etc.
 Members: These organisations are formed as charitable trusts or societies. The subscribers to these
organisations are their members.
 Management: The managing committee or the executive committee manages these organisations.
The members elect the committee.

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 Source of Income: The major sources of income of not-for-profit organisations are subscriptions,
donations, government grants, legacies, income from investments, etc.
 Surplus: The surplus generated in the due course is distributed among its members.
 Reputation: These organisations earn their reputation or goodwill on the basis of the good work
done for the welfare of the public.
 Users of accounting information: The users of the accounting information of these organisations
are present and potential contributors as well as the statutory bodies.

Accounting for Non-Profit Organisations

As we know that the not-for-profit organisations do not trade in goods or provide services with a profit
motive. But, they also require to keep proper records of incomes, expenses, assets, and liabilities. Their
major source of income is donations, subscriptions, grants, etc. Therefore, most of their transactions are in
cash or through the bank account.

They need to keep proper books firstly because they are accountable to the members and the contributors
and secondly because the law requires them to maintain proper books so that the government can keep
proper control over the grants. Also, proper accounting reduces the risk of fraud and embezzlement. In
addition to the ledgers and cash book, they are also required to maintain a stock register. Also, in a Stock
register, a complete record of all fixed assets and consumables is maintained.

In accounting for non-profit organizations, instead of maintaining a Capital A/c, these organizations
maintain Capital Fund or General Fund A/c. They credit this account with the surplus, life membership fees,
donations, legacies, etc.

The not-for-profit organisations also require to prepare the final accounts or the financial statements at the
end of the accounting year as per the accounting principles. The final accounts of these organisations
consist of:

 Receipts and Payments A/c: It is the summary of the cash and bank transactions. It helps in the
preparation of Income and Expenditure A/c and Balance Sheet. We also need to submit it to the
Registrar of Societies along with Income and Expenditure A/c and Balance Sheet.
 Income and Expenditure A/c: It is similar to the Profit and Loss A/c and ascertains the surplus or
deficit if any.
 Balance Sheet: We prepare it in the same manner as the Balance Sheet of concerns with a profit
motive.

Need for preparing Receipts and Payments Accounts of NPO

The receipts and payments account is a financial statement that summarizes the cash transactions of a not-
for-profit organization (NPO) during a particular period. It provides an overview of the organization's cash
inflows and outflows, which is important for managing the organization's financial resources and ensuring
its long-term sustainability.

There are several reasons why preparing a receipts and payments account is important for NPOs:

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 Budgeting: The receipts and payments account provides valuable information for budgeting and
forecasting. By analyzing past cash inflows and outflows, an NPO can make informed decisions
about how to allocate its resources in the future.
 Compliance: Many NPOs are required by law or regulation to prepare a receipts and payments
account. For example, in India, all charitable organizations are required to file an annual returns
form, which includes a receipts and payments account.
 Transparency: The receipts and payments account provides transparency into the financial
operations of an NPO. Donors and other stakeholders can use this information to evaluate the
effectiveness and efficiency of the organization's financial management.
 Accountability: The receipts and payments account is a tool for holding the NPO's management
accountable for the organization's financial performance. By providing a clear picture of the
organization's cash inflows and outflows, the account can help identify areas where improvements
can be made.

Relevant Items of income and Expenditure

Items of income and expenditure refer to the sources of money coming in and going out of a person's or
organizations financial account. Here are some examples of relevant items of income and expenditure:

Items of Income
 Salary/Wages: This refers to the money earned by an individual for the work they do in an
organization.
 Business Profits: If you are a business owner, the profits earned from your business will be your
source of income.
 Rental Income: If you own rental property, the rent paid by tenants will be a source of income for
you.
 Investment Income: Income earned from investments such as dividends, interests, and capital
gains.
 Royalties: Income earned from the use of one's creative work or intellectual property.

Items of Expenditure
 Rent/Mortgage Payment: This is the amount of money paid by a person or organization to occupy
a property.
 Utility Bills: These are bills for essential services like electricity, water, and gas.
 Insurance Premiums: Money paid regularly to an insurance company to provide coverage for an
individual or organization.
 Taxes: These are compulsory payments made to the government.
 Office/Operating Expenses: This includes expenses incurred in running an organization such as
salaries, rent, utilities, and supplies.
 Loan Repayments: Money paid regularly to repay loans and interest.
 Depreciation: The decrease in value of an asset over time, which is accounted for as an expense.

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Preparation of income and expenditure account

The Income and Expenditure Account is a summary of all items of incomes and expenses which relate to the
ongoing accounting year. It is prepared with the objective of finding out the surplus or deficit arising out of
current incomes over current expenses. It is quite similar to the Trading and Profit and Loss Account of a
trading concern and is prepared in an exact manner.

Income and Expenditure Account is prepared on an accrual basis. All incomes and expenses relating to the
accounting year, whether they are actually received and paid or not, are taken into consideration.
Expenditure is recorded on the debit side and income is recorded on the credit side. A distinction is made
between capital and revenue items and only revenue items are included in this account.

Income and Expenditure Account is a nominal account. Therefore, the rule of nominal account (debit all
expenses and losses and credit all incomes and gains) is followed while preparing it. While preparing the
account, only items of revenue nature are recorded and all items of capital nature are ignored. For example,
the profit earned or loss suffered on the sale of an asset will be recorded in it but the amount received from
the sale of an asset will not be recorded in it.

The closing balance of this account shows a surplus or deficit for the year. If the credit side exceeds the
debit side, there is surplus. On the other hand, if the debit side exceeds the credit side, there is a deficit. The
surplus is added to the Capital Fund while the deficit is deducted from the Capital Fund.

Preparation of Income and Expenditure Account

 Include all items of revenue receipts and expenses, on the respective side of the account.
 Ensure that no items of capital incomes and expenses are included in this account.
 Also, adjustment for amounts prepaid and outstanding, with respect to each item will have to be
made.
 Further, items included in receipts and payment account, depreciation, provisions, and profit or loss
on sale of assets will have to be included in this account.
 Finally, after putting down all items of revenue and expenses, you’ll get a balance. The resulting
balance will then reveal the surplus or deficit for the period.

Receipts and payments account and cash book

Receipts and Payments account and Cash book are two important financial statements that are used to
record and track the cash transactions of an organization. Here are the main differences between the two

RECEIPTS & PAYMENTS ACCOUNT CASH BOOK

It is a summary of cash receipts and payments It is a detailed record of all cash transactions
made during a specific period, usually a year. that take place during a specific period, usually
a month.

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It is a summary statement that shows the It is a ledger account that records cash and
opening and closing balances of cash and bank bank transactions chronologically.
balances.

It is a non-operational statement that only shows It is a primary book of accounts that forms the
the total receipts and payments for the period. basis of other financial statements.

It records all receipts and payments, whether It records only revenue receipts and payments.
capital or revenue in nature.

It is prepared annually for the purpose of It is prepared monthly for the purpose of
presenting a summary of cash receipts and reconciling cash transactions and preparing
payments made by an organization. other financial statements.

Financial statements (for NPOs)

Not-for-Profit Organisations maintain books of accounts following the double-entry system of accounting,
but NPOs with low-key operations are not in the position to maintain the books of accounts following the
double-entry system of accounting, therefore, prepare a Cash Book from which Receipt & Payment A/c,
Income & Expenditure A/c, and Balance sheet are prepared to show the financial report of the organisation.
The financial transactions summarized in these accounts are used by its members and government to meet
the statutory obligations and seek any financial grants.

The financial activities of NPOs are recorded in the form of

 Receipt and Payment A/c,

 Income & Expenditure A/c, and
 Balance Sheet

Receipt and Payment A/c

Receipt and Payment A/c is a classified summary of Cash Book depicting receipts and payments under
appropriate heads of accounts. Receipt and Payment A/c is a real account. It is a summary of cash receipts
and cash payments. It records the transactions and events related to cash whether it is of revenue or capital
nature. Receipt and Payment A/c is prepared for a specific period, and it is not based on the accrual system
of accounting. Receipt and Payment A/c is maintained on the cash system of accounting. It records all
events and transactions related to receipts and payments, which are settled in cash, irrespective of capital or
revenue nature.

All the receipts are written on the debit side, and all the payments made are written on the credit side of
the account. The opening balances of this account show Cash in Hand and Cash at Bank at the beginning of
the accounting period, and the closing balances of this account show Cash in Hand and Cash at Bank at the
end of the accounting period. Receipt and Payment A/c fairly depicts the cash position of the organisation.

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Income and Expenditure A/c

Income and Expenditure A/c is equivalent to Profit & Loss A/c of profit earning business. It is prepared from
the Trial Balance where complete sets of accounts are maintained or from Receipts & Payment A/c and
other information. Income and Expenditure A/c is a nominal account and records expenses and income of
revenue nature on the accrual system of accounting. It records all the income and expenses paid or not that
is related to the current accounting period.

Income and Expenditure A/c is prepared at the end of the accounting period to ascertain the surplus or
deficit. All the incomes which are of revenue nature are credited and all the expenses which are of revenue
nature are debited. Income and Expenditure A/c shows either Surplus (if the total of the credit side is more
than the total of the debit side) or Deficit (if the total of the debit side is more than the total of the credit
side). The surplus or the deficit of Income and Expenditure A/c is added or deducted, respectively from the
capital fund in the Balance Sheet.

Balance Sheet
A Balance Sheet is a statement showing the financial position of the organisation at a particular date. The
Balance Sheet of an NPO is of similar nature as business firms. A Balance Sheet shows Assets, Liabilities, and
Capital Fund. The surplus or deficit ascertained from the Income & Expenditure A/c is transferred to Capital
Fund. If the opening balance of the Capital Fund is not given, it is derived from the excess of Assets at the
beginning over the Liabilities at the beginning. (Capital = Assets – Liabilities)

While preparing the Balance Sheet following points should be considered:

 Assets appearing on the previous year’s Balance Sheet should be adjusted for sale during the
year, if any, or purchase during the year and depreciation.
 On purchase of a new asset, the payment made will be shown in Receipt & Payment A/c and then
the scrutinized value of the asset shall be shown in the asset side of the balance sheet.
 If any loan is raised, it shall be shown in the receipt side of Receipt & Payment A/c and the
value(less repayment, if any) shall be shown on the liabilities side of the balance sheet.
 Special receipts like donations for the building are directly shown on the liabilities side of the
Balance Sheet.
 The liabilities of the previous year’s Balance Sheet shall be scrutinized for any payment if made
(Information from Receipt & Payment A/c should be taken) and the net value shown in the
Balance Sheet.
 Adjustments made on the accrual basis of accounting shall also be shown in Balance Sheet, i.e.,
outstanding expenses and advance income are shown on the liability side, and prepaid expenses
and accrued income will be shown on the Asset Side of the Balance Sheet.
 The net amount of the advances shall be shown in the Balance Sheet, i.e., payment of advances
shall be shown on the Payment Side, and recovery of advances shall be shown on the Receipt
Side of Receipt & Payment A/c and the difference between them is shown in the Balance Sheet.

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Need of preparing Income and Expenditure Account

Non-profits must file 4 statements every year to comply with IRS rules. Most non-profits use these
statements in their annual or impact reports.

Organizations share these statements to be entirely transparent with their donors. By sharing what funds
they collect and how they’re spent, donors can see how their gifts support the non-profit’s programs and
beneficiaries.

Financial statements also give donors a better understanding of how the organization is doing.

Foundations require non-profits to provide financial statements when they apply for grants. Major donors
also may want to see financial statements before giving a significant gift. When a non-profit shares more
about its financial health, foundations and sponsors see that the non-profit is financially viable and feel
safer giving.

Financial statements also help non-profits determine the future of their organization. Board members can
better understand the non-profit’s capacity for growth. It also allows leadership to find potential financial
opportunities and ways to address financial concerns.

Relevant Items of Income and Expenditure

Following are the relevant items of income of a Not for Profit Organisations (NPO).

 Subscription: It is a periodic contribution by members of the organization

 Entrance fees/Admission fees: It is received from members at the time of their admission to the
organisation.
 Donations: Donation is the amount received from person, firm, company etc. by way of gift. But
only general donation that too of smaller amount and of recurring nature is treated an item of
revenue income.
 Sale of old newspapers, sports material, etc. : Sale of old newspapers or condemned books,
sports material etc. is treated as an item of revenue income.
 Interest receipt: The surplus funds may be kept in a fixed deposit account in a bank or invested
elsewhere. Interest received thereon is an item of revenue income.
 Grant-in-Aid: Local, state and central government and some government agencies give money as
grant-in-aid to Not-for-Profit Organisations (NPOs).

Apart from these, there are numerous other items like rent of hall, sale of grass, income from entertainment,
etc.

Items of Revenue Expenses

 Salaries, wages, rent, stationery, postage, telephone charges, electricity charges are some items of
revenue expenses which are common to all Not for Profit Organisations (NPOs).

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 Honorarium: It is the amount paid to the person who looks after the functioning of the
organisation but is not the employee of the company.
 Depreciation: Depreciation is provided on the fixed assets such as furniture, building and books,
etc.
 Expenses on tournament, fair, etc.
 Other items

There are numerous other items depending upon the nature of organisation. For example, upkeep of
ground if it is a sports club, medicines, laundry if it is a hospital and so on.

Preparation of income and expenditure account

This account is prepared from Receipts and Payments account and additional information if any. While
preparing an Income and Expenditure account, the following important points have to be kept in mind

Steps for Expenditure side: The payment column of Receipts and Payments Account contains both
revenue items as well as capital items. Revenue items such as rent paid salary, telephone charges etc. will be
entered on the expenditure side of Income and Expenditure Account. If necessary, adjustments will be made
in these items for expenses that are outstanding at the end of the current year and/or were outstanding at
the end of the previous year. Adjustment will also be made for prepaid expenses at the end of previous year
as well as those at the end of current year.

Steps for Income side: The receipt column contains items of revenue receipts as well as capital receipts.
Revenue receipts are entered in the income column of the Income and Expenditure Account. Example of
such items are subscription, interest on investment, entrance fees etc. These items need to be adjusted for
the amount received for the previous year or for the next year. Similarly, adjustment should be made for
outstanding income both at the current year and at the end of the previous year. There may be other
adjustments such as bad debts, depreciation, etc. will also be entered in the expenditure column.

Surplus or Deficit: Finally, this account is balanced i.e. difference of the totals of two amount columns is
worked out. If credit side is more than the debit side the difference amount is written on its debit side as
surplus and if debit side exceeds the credit side, the difference is deficit and is written on the credit side of
the account.

Adjustment of items in income and expenditure account

Income and Expenditure A/c is prepared on the basis of Receipts and Payments A/c but there may be
certain items which are not included in Receipts and Payments A/c.

However these need to be incorporated in Income and Expenditure A/c. Following are some of the most
common adjustments to be carried out:

Subscription Received
It is an item of income and is of recurring nature. It appears on the Receipts side of the Receipts and
Payments account. It may include arrears of previous years which is received in the current year and may
also include amount received for next year in advance. There may be an amount outstanding for the current
year. Some members might have paid current year’s subscription during the previous year.

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For the purpose of preparing Income and Expenditure Account, subscription for the current year only is to
be taken into account. Hence, there is a need for adjustment to be made for the above reasons.

Subscription outstanding for current year

Journal entry

 Subscriptions outstanding A/c Dr

 To Subscriptions A/c
 (Subscription for current year due but not received)
 Adjustment in Income and Expenditure A/c

Subscription due in the previous year but received during the current year
Journal entry

 Subscription A/c Dr
 To Subscription Outstanding A/c
 (Adjustment of subscription due in last year but received in the current year)

Rent Paid
Rent paid is an item of expenditure. It may also require some adjustments in rent.

The adjustments required to made to be the amount of rent paid during the year may be as follows :

(i) Rent outstanding for the current year

(ii) Rent paid in the current year as advance for the next year

(iii) Rent paid in the current year on account of the outstanding amount in the previous year

(iv) Rent paid in the previous year on account of current year.

Journal entries in the books will be made as follows:

(i) Rent A/c Dr.

To Rent outstanding A/c (Rent due but not paid)

(ii) Rent paid in advance A/c Dr. to Bank A/c

(Rent paid in advance for the year)

(iii) Rent outstanding A/c Dr. to Bank A/c (

Amount paid for outstanding rent of the previous year)

(iv) Rent A/c Dr. to Rent paid in Advance

(Rent paid in advance last year being transferred to Rent A/c)

Calculation of Rent Amount to be shown for current year in the Income and Expenditure Account

 Rent paid in the current year

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 Add: Rent paid in advance in the previous year for current year
 Add: Rent due in current year but not paid
 Less: Outstanding Rent paid for previous year in current year
 Less: Advance rent paid for next year in current year
 Amount of rent to be debited to Income and Expenditure A/c

Difference between Receipts and Payments A/c and Income and Expenditure A/c
Receipts and Payments account (R&P A/c) and Income and Expenditure account (I&E A/c) are two
important financial statements used to record and track the financial transactions of an organization.

RECEIPTS AND PAYMENTS ACCOUNT (R&P INCOME AND EXPENDITURE ACCOUNT (I&E A/c)
A/c)

It is a summary statement of cash and bank It is a summary statement of revenue and expense
transactions during a specific period, usually a transactions during a specific period, usually a year.
year.

It records all cash and bank transactions, It records only revenue and expense transactions.
whether they are capital or revenue in nature.

It shows the opening and closing balances of It shows the net profit or loss for the period.
cash and bank balances.

It is used by organizations that follow the cash It is used by organizations that follow the accrual
basis of accounting. basis of accounting.

It does not consider outstanding expenses or It considers outstanding expenses or revenues.

revenues.

It is prepared by charitable or non-profit It is prepared by profit-making organizations to

organizations to show their cash position and show their financial performance and profitability.
cash inflows and outflows.

Preparation of balance sheet

Not for Profit Organisations (NPOs) also prepare Balance Sheet at the end of the year. The Balance Sheet
prepared by a Not for Profit Organisation (NPOs) is not different from that which is prepared by for Profit
Organisation. It has two sides (a) Assets side and (b) Liabilities side. It has only capital items i.e. Assets,
liabilities and Capital fund.

The objective of preparing a balance sheet by a Non for Profit Organisation is to show the financial stability,
strength and soundness on the last date of the accounting year

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Income and Expenditure A/c and the Balance Sheet of NPOs is prepared from the Receipts and Payments
Account and the additional information. While preparing Balance Sheet of a Not for Profit organisations
(NPOs) certain points are to be kept in mind which are as follows:

 Assets appearing in the preceding year’s balance sheet need to be adjusted for any sale or purchase
of the asset made during the year and the depreciation provided on the particular asset. Only the
adjusted amount will appear in the Balance Sheet of the current year.
 If any new asset has been purchased during the year it will appear on the payment side of Receipts
& Payments A/c, therefrom it is taken to the Balance Sheet.
 If any loan has been raised it will appear on the receipt side of Receipts and Payments A/c and
repayment on its payment side. Net amount will be shown on the liability side of the balance sheet.
In the same manner if any advance has been made to a person and some repayment has been made
by a person, it will be shown on the Asset side of the Balance sheet at the net amount.
 Any adjustments made regarding expenses and/or regarding incomes such as outstanding or
prepaid will be shown in the Balance Sheet.
 Any item of liability appearing in the previous year’s Balance Sheet will be shown at its net value i.e.
after deducting from it the amount paid against them.
 Special receipts like donations for Building etc. will not be treated as income. It will be shown as a
fund meant for a special purpose on the liability side of the Balance Sheet.
 Capital General fund taken from the last balance sheet will be shown after adjusting for the current
years ‘surplus’ or ‘deficit’.

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Questions

1. Which financial statement shows the revenue and expenses of a non-profit organization for a
specific period?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

2. Which financial statement shows the assets, liabilities, and equity of a non-profit organization at a
specific point in time?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

3. Which financial statement shows the changes in the net assets of a non-profit organization for a
specific period?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

4. Which financial statement shows the inflows and outflows of cash of a non-profit organization for
a specific period?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

5. Which financial statement shows the total assets of a non-profit organization?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

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6. Which financial statement is used to analyze the financial performance of a non-profit
organization?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

7. Which financial statement shows the changes in the equity of a non-profit organization for a
specific period?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

8. Which financial statement is used to reconcile the beginning and ending balances of cash of a
non-profit organization?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Changes in Net Assets

9. Which financial statement provides information about the non-financial assets of a non-profit
organization, such as property and equipment?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Financial Position

10. Which financial statement shows the sources and uses of funds of a non-profit organization for a
specific period?

a) Balance Sheet
b) Cash Flow Statement
c) Income and Expenditure Statement
d) Statement of Functional Expenses

Answer Keys
1. Answer: c. Income and Expenditure Statement

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Explanation: The Income and Expenditure Statement shows the revenue and expenses of a non-
profit organization for a specific period, usually a year. It is similar to the Profit and Loss Statement
of a for-profit organization.
2. Answer: a. Balance Sheet
Explanation: The Balance Sheet shows the assets, liabilities, and equity of a non-profit organization
at a specific point in time. It provides a snapshot of the financial position of the organization.
3. Answer: d. Statement of Changes in Net Assets
Explanation: The Statement of Changes in Net Assets shows the changes in the net assets of a non-
profit organization for a specific period. It summarizes the sources and uses of the organization's
funds.
4. Answer: b. Cash Flow Statement
Explanation: The Cash Flow Statement shows the inflows and outflows of cash of a non-profit
organization for a specific period. It helps to analyze the liquidity and cash position of the
organization.
5. Answer: a. Balance Sheet
Explanation: The Balance Sheet shows the total assets of a non-profit organization, along with its
liabilities and equity.
6. Answer: c. Income and Expenditure Statement
Explanation: The Income and Expenditure Statement is used to analyze the financial performance of
a non-profit organization. It shows the revenue and expenses of the organization and helps to
determine its financial sustainability.
7. Answer: d. Statement of Changes in Net Assets
Explanation: The Statement of Changes in Net Assets shows the changes in the equity of a non-
profit organization for a specific period. It summarizes the sources and uses of the organization's
funds.
8. Answer: b. Cash Flow Statement
Explanation: The Cash Flow Statement is used to reconcile the beginning and ending balances of
cash of a non-profit organization. It shows the inflows and outflows of cash during a specific period.
9. Answer: d. Statement of Financial Position
Explanation: The Statement of Financial Position provides information about the non-financial
assets of a non-profit organization, such as property and equipment. It shows the assets, liabilities,
and equity of the organization at a specific point in time.
10. Answer: d. Statement of Functional Expenses
Explanation: The Statement of Functional Expenses shows the sources and uses of funds of a non-
profit organization for a specific period. It categorizes the expenses of the organization by program,
management and general, and fundraising activities. It helps to analyze the efficiency and
effectiveness of the organization's operations.

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Chapter 4
Accounting for share capital
Meaning, characteristics and nature of a company

Meaning of a Company
A company is a legal entity formed by a group of individuals, known as shareholders, to conduct business
activities with a common goal of making a profit. It has a separate legal identity from its owners and is
recognized as a distinct entity under the law.

Characteristics of a Company
 Separate Legal Entity: A company has a separate legal identity from its shareholders. It can own
property, enter into contracts, sue and be sued in its own name.
 Limited Liability: Shareholders of a company have limited liability, which means they are only liable
for the amount of money they have invested in the company. Their personal assets are not at risk in
case the company faces financial problems.
 Perpetual Succession: A company has a perpetual succession, meaning it can continue to exist even
if its shareholders change or die.
 Transferability of Shares: The shares of a company are freely transferable, allowing shareholders to
buy or sell their shares without affecting the existence of the company.
 Common Seal: A company has a common seal that is used to authenticate important documents
such as contracts and share certificates.
 Separate Management: A company is managed by a board of directors who are elected by the
shareholders. They are responsible for making important business decisions on behalf of the
company.

Nature of a Company
 Artificial Person: A company is an artificial person created by law. It has its own legal personality,
separate from its shareholders.
 Voluntary Association: A company is a voluntary association of individuals who come together for
a common purpose of conducting business activities.
 Limited Liability: The liability of the shareholders of a company is limited to the amount of money
they have invested in the company. Their personal assets are not at risk in case the company faces
financial problems.
 Profit-Making: The main objective of a company is to make a profit for its shareholders. This means
that all business activities are conducted with the aim of generating revenue and maximizing profits.
 Perpetual Succession: A company has a perpetual succession, meaning it can continue to exist even
if its shareholders change or die.

Separation of Ownership and Management: The owners of a company are different from its managers.
Shareholders elect a board of directors who are responsible for making important business decisions on
behalf of the company.

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Meaning and Categories of Share Capital

Meaning of Share Capital
Share capital refers to the amount of money that a company raises by issuing shares to the public or to its
shareholders. It is a critical component of a company's capital structure and represents the owners' equity in
the company. Share capital is typically used to fund the growth and expansion of a company's operations.

Categories of Share Capital

 Authorized Share Capital: It is the maximum amount of share capital that a company is authorized
to issue to the public or its shareholders. The authorized share capital is mentioned in the
company's articles of association and can be increased or decreased with the approval of the
shareholders.
 Issued Share Capital: It is the portion of the authorized share capital that the company has issued
to the public or its shareholders. The issued share capital may be less than the authorized share
capital, and it can be increased by issuing additional shares.
 Subscribed Share Capital: It is the portion of the issued share capital that the shareholders have
agreed to purchase. Shareholders may choose to subscribe to all or a portion of the shares issued by
the company.
 Paid-Up Share Capital: It is the portion of the subscribed share capital that the shareholders have
paid for in cash or other assets. The paid-up share capital represents the actual amount of money
that the company has received from its shareholders.
 Equity Share Capital: It refers to the shares that represent the ownership interest of the
shareholders in the company. Equity shareholders have the right to vote in the company's annual
general meetings and receive dividends based on the company's profitability.
 Preference Share Capital: It refers to the shares that have preferential rights over equity shares.
Preference shareholders are entitled to receive a fixed rate of dividend before any dividends are paid
to equity shareholders. They also have priority over equity shareholders in case the company is
liquidated.

Types of Share Capital

There are two main types of share capital

Equity Share Capital

Equity share capital represents the ownership interest of the shareholders in the company. Equity
shareholders are the residual owners of the company and have the right to vote in the company's annual
general meetings. They also receive dividends based on the company's profitability after any fixed dividends
have been paid to preference shareholders. Equity share capital is considered riskier than preference share
capital since there is no guarantee on the dividend amount or return of investment.

Preference Share Capital

Preference share capital is a type of share capital that has preferential rights over equity shares. Preference
shareholders are entitled to receive a fixed rate of dividend before any dividends are paid to equity
shareholders. They also have priority over equity shareholders in case the company is liquidated. Preference

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share capital is considered less risky than equity share capital since there is a guarantee on the dividend
amount.

There are several types of preference share capital, including

 Cumulative Preference Shares: Cumulative preference shares are those in which the unpaid
dividends accumulate and are paid out in future years, even if the company does not make a profit
in those years.
 Non-Cumulative Preference Shares: Non-cumulative preference shares are those in which the
unpaid dividends do not accumulate and are not paid out in future years if the company does not
make a profit.
 Redeemable Preference Shares: Redeemable preference shares are those that can be redeemed by
the company after a specific period or on a specific date.
 Convertible Preference Shares: Convertible preference shares are those that can be converted into
equity shares after a specific period or on a specific date.

Disclosure of Share Capital

Disclosure of share capital refers to the requirement for companies to provide information regarding their
share capital structure in their financial statements and other regulatory filings. This information is
important for investors and other stakeholders to understand the ownership structure of the company and
the rights and privileges of its shareholders.

The disclosure of share capital typically includes the following information:

 Authorized share capital: The maximum number of shares that a company is authorized to issue as
per its memorandum of association.
 Issued share capital: The actual number of shares that the company has issued to its shareholders.
 Subscribed share capital: The portion of the issued share capital that has been subscribed by the
shareholders.
 Paid-up share capital: The portion of the subscribed share capital that has been paid by the
shareholders to the company.
 Share premium: The amount that the company receives above the face value of the shares issued.
 Details of different classes of shares: Information about the different types of shares issued by the
company, including their rights, privileges, and restrictions.
 Details of share buybacks: Information about any buybacks of shares made by the company.
 Details of any outstanding convertible securities: Information about any convertible securities
issued by the company, such as convertible preference shares or convertible debentures.
 Changes in share capital: Any changes in the share capital structure of the company, such as
issuing new shares, buying back shares, or converting convertible securities.

Disclosure of share capital is a legal requirement for companies and is typically included in their annual
reports, financial statements, and other regulatory filings. This information is critical for investors to make
informed decisions about investing in the company and understanding the risks and rewards associated
with its share capital structure.

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Issue of Shares For Cash

In general, shares are issued for cash. The company may call the share money either in one instalment or in
two or more instalments. But company always collects this money through its bankers.

Receipt of Share Money in One Instalment: The Company may receive the share money in one instalment
along with application. In this case the following journal entries are made in the books of the company 1.

1. On Receipt of Application Money Bank A/c Dr.

To Share Application A/c

(Application money received on ….shares of `…each)

2. On transferring the Application Money Share Application A/c

Dr. To Share Capital A/c
(Application money transferred to share capital A/c)

Share Money Received in Two or More Instalments: Instead of receiving payment in one instalment i.e.
at the time of application the company collects it in two or more instalments. The first, instalment which the
applicants have to pay along with the applications for shares is known as application money. On the
allotment of shares the allotted are required to pay the second instalment which is termed as allotment
money. If the company decides to call the share money in more than two instalments the other instalment
is/are termed as call money (i.e. first-call, second call or final call).

In the above case the transactions are recorded in journal as given below:

On Receipt of Application Money

Bank A/c
Dr. To Share Application A/c
(Receipt of share application money for …. Shares @ Rs.. per share)

On Allotment of Shares
After receiving the application for shares within the prescribed time, the Board of Directors of the company
proceed to allot shares. On allotment of shares the application money is transferred to Share Capital A/c.
For this the following journal entry is made

Share Application A/c Dr.

To Share Capital A/c

(Share application for ….

Shares @ Rs… per share transferred to share capital A/c)

Allotment Money Becoming Due and Received On the allotment of shares the amount receivable on the
next instalment i.e. on allotment becomes due.

The following entry is made for recording the amount due:

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Allotment money becoming due
Share Allotment A/c

Dr. To Share Capital A/c

(Share allotment money due on …. shares @`Rs... per share)

Receipt of allotment money

On the receipt of share allotment money the following journal entry is made:

Bank A/c Dr.

To Share Allotment A/c

(Receipt of the amount due on allotment of … shares)

Over-subscription
 Oversubscription occurs when the demand for shares in a company's share issue exceeds the
number of shares available for sale. This can happen when the share issue is priced too low or when
the company is experiencing high demand from investors due to its strong financial performance or
growth prospects.
 When oversubscription occurs, the company must allocate the available shares among the
interested investors. This can be done through a process known as pro-rata allocation, where each
investor is allocated a proportionate number of shares based on the number of shares they have
applied for and the total number of shares available.
 For example, if a company is issuing 1,000 shares and receives applications for 2,000 shares, it can
allocate 500 shares to each of the four investors who applied for 500 shares, or allocate shares
based on the percentage of shares applied for by each investor.
 If the oversubscription is significant, the company may choose to issue additional shares to meet the
demand. This can increase the share capital of the company and provide additional funds for its
operations or expansion.
 Oversubscription can be beneficial for a company as it indicates strong demand from investors and
can increase the company's market value and investor confidence. However, it can also result in the
dilution of the ownership and control of the existing shareholders, as new shareholders are added to
the company. Therefore, companies must carefully consider the potential benefits and risks of an
oversubscribed share issue before making a decision.

Alternatives Available in Case of Over-subscription

Alternatives Description

Pro-rata The available shares are allocated proportionally among the interested investors based
allocation on the number of shares they have applied for and the total number of shares available.

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Allotment by A lottery system is used to randomly select the investors who will be allocated shares
lottery from the pool of interested investors. This method is considered fair and unbiased.

Allotment based This method gives priority to certain investors based on their seniority or loyalty to the
on seniority company, such as existing shareholders or employees. The investors who have held
shares for a longer period or have a higher level of ownership are given priority in the
allocation of shares.

Additional issue If the oversubscription is significant, the company may choose to issue additional
of shares shares to meet the demand. This can increase the share capital of the company and
provide additional funds for its operations or expansion.

Refund of excess If none of the above alternatives are feasible, the company may choose to refund the
subscription excess subscription amount to the investors who were not allocated shares. This can be
done through a direct refund or by issuing a credit note that can be used to subscribe
to future share issues.

Issue of Shares for cash

Issue of Shares at par

Shares are said to be issued at par when the issue price is equal to the face value or nominal value of the
shares i.e. issue price is Rs.10 and face value is also Rs.10. When the shares are issued, the company may ask
the payment of the shares either in one lump sum or in instalments.

When shares are issued at par and are payable in full in a lump sum

Note:

 When the capital of the company consists of shares of different classes, a separate share application
account will be opened for each class of shares, i.e. equity share application account/preference
share application account etc.
 Unless shares are allotted by the company, the receipt of application is simply an offer and cannot
be credited to Share Capital Account.
 If the company fails to raise the minimum subscription, then no shares can be allotted and the
application money has to be returned to the applicants. For this, the entry will be as follows:

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 In actual practice, the cash transactions are not journalised but the same have to be entered in the
cash book. The entry in the Cash Book will be as follows:

Cash Book (Bank Columns)

When shares are issued at par and the amount is payable in instalments
When shares are not payable in a lump sum, the amount can be called in a number of instalments. After
allotment, whenever the need arises, the directors may demand further money from the shareholders
towards payment of the value of shares taken up by them. Such demands are termed as calls. The different
calls are distinguished from each other by their serial numbers, i.e. first call, second call, third call and so on.
The last instalment is also termed the final call along with the number of the last call.

 First instalment is called ‘application money’

 Second instalment is called ‘allotment money’
 Third instalment is called ‘first call money’ and
 The last instalment is called ‘final call money’.

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Issue of shares at a premium

Issue of Shares at Premium means to issue the shares for a value more than its face value per share. For
example, if the face value of shares is ₹20 each and they are issued at ₹25 each, then it will be the Issue of
Shares at a Premium of ₹5. There is no legal restriction on a company for the issue of shares at a premium.
There is a separate account called Securities Premium Reserve Account, in which the amount of the
premium is credited. It is so because the amount of premium received on the shares issued is not a revenue
profit but a capital profit. This amount is shown separately in the Equity and Liabilities side of the Balance
Sheet under the Reserves and Surplus head.

In accordance with the provisions of Companies (Amendment) Act, 1999, instead of using ‘Share Premium’,
the term ‘Securities Premium’ has been used.

Utilisation of Securities Premium Account under Section 52 of the Indian Companies Act, 2013:

Even though there is no legal restriction on the issue of shares at premium; however, Section 52 of the
Indian Companies Act, 2013 has laid down some specific purposes for which the amount of securities
premium can be used. These are as follows

 Writing off the preliminary expenses of the company.

 Writing off the expenses, commission or discount allowed on the issue of shares or debentures of
the company.
 For issuing fully paid bonus shares to the shareholders of the company.
 For paying premium on redemption of redeemable preference shares or debentures of the
company.
 For buying back its own shares (as per Section 68).

Presentation of Security Premium in Company’s Balance Sheet

Notes to Accounts

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Accounting Entries for the Amount of Premium

The company may charge the premium either on application or on allotment or call. Therefore, it is essential
to record premium at the time it is payable. The entries for the same will be as follows:

1. When the Premium amount is received on Application Money:

A. For receiving Application Money

B. For transferring Application Money to Share Capital A/c and Securities Premium A/c:

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When the Premium amount is received or receivable along with Allotment Money

When the allotment money is due including premium

When the allotment money is received along with premium

If the Premium is received or receivable with Call Money:

When the call money is due along with premium

When the call money is received along with premium

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Issue of shares at a discount

Introduction
In general, share means a portion of a larger thing. Similarly, in real market share is a small proportion of
the total amount of capital of the enterprise. Shares form the major source of any company’s finance in this
present world.

Shares tempt the investors also because it can give huge profits to them unlike the fixed rate of return on
debentures. There are various ways or prices at which a company issues its shares like at par, at a premium
and at discount.

Meaning
The issue of shares at a discount means the issue of the shares at a price less than the face value of the
share. For example, if a company issues share of Rs.100 at Rs.90, then Rs.10 (i.e. Rs 100—90) is the amount
of discount.

It is nothing but a loss to the company. One must remember that the issue of share below the Market Price
(MP) but above the Face Value (FV) is not termed as ‘Issue of Share at Discount’.

The issue of Share at Discount is always below the Nominal Value (NV) of the shares. The company debits it
to a separate account called ‘Discount on Issue of Share’ Account.

Conditions for Issue of Shares at Discount

 In order to issue the shares at a price less than the face value, the company has to get permission
from the relevant authority. For seeking permission, they should call and upon a general meeting
and discuss and authorize the matter in that meeting.
 There is a cap on the rate of discount. A company cannot issue any shares at more than 10%
discount.
 The company should issue the shares within 60 days of receiving permission from the relevant
authority. In certain cases, the company can extend this time frame after getting permission in the
permission.
 The company cannot issue these shares before passing of 1 year from the date of commencement
of business.
 The shares must belong to the same class of shares which are already available in the market. For
example, if the has previously issued Equity shares then this time also, the company has to issue
Equity shares only.
 Also, the company has to acquire the sanction by the Central Government after getting approval
from the general meeting.

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When a Company can't Issue Shares at Discount?

 A company is prohibited to issue equity and preference shares at a discount as per Clause 2 of
Section 53 of the Companies Act 2013.
 If a company breaks the law, then proper legal actions can be taken against such a company or
officer who is a defaulter in the form of a penalty of the amount equal to the amount that the
company has raised by issuing such shares at a discount or the five lakh rupees, whichever is less.
Other than this, the company also has to return all the money that is raised with an interest of 12%
p.a. from the date of issue of the shares to the shareholders.
 Unlike the Companies Act, 2013, the erstwhile Companies Act of 1956 allowed a company to issue
shares at discount under its Section 79. But this could be done only after getting prior approval from
the Company Law Board.

When a Company can Issue Shares at a Discount?

Issue of shares at discount is not completely prohibited in our country. There are certain cases when a
company is allowed to issue shares at discount. They include the following:

Sweat Equity Shares

 These are the shares that a company issues to its Directors or Employees. Sweat equity shares are
issued in the form of a reward or acknowledgment of the efforts and contributions given by an
employee or director in the company towards its growth and development. As per Section 2 (88) of
the Companies Act, 2013, a company can issue sweat equity shares at discount.
 These shares are fundamentally different from ESOPs. Sweat equity shares can be issued in the form
of both a reward and incentivization mechanism to motivate and appreciate the employees for their
better performance and contributions to the organization. On the other hand, ESOPs are only used
as an incentivization mechanism to appreciate them for their better work because of their ownership
in the company.

Issue of Shares to Creditors

 As per the Section 53 (2A) of the Companies Act, 2013, a company can issue shares to creditors at a
discount when its debt is converted into shares:
 In pursuance of any statutory resolution plan.
 Or in debt restructuring scheme, in accordance with guidelines or regulations of RBI Act 1934 or
the Banking Regulation Act 1949.
 It is the latest provision that was introduced by the Companies Amendment Act 2017. This
amendment is helpful for the creditors in getting flexibility so that they can convert their debt into
shares issued at a discount.

Rights Issue at Discount

 A company may require some additional capital for growth and expansion of the business or maybe
due to some other reasons. For this purpose, the company is allowed to issue the rights shares at
discount as per Section 62 of the Companies Act 2013.

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 When a company issues the right shares, then it first asks its existing shareholders and if they refuse
to buy only then the company is allowed to issue them in the market. The company issues such
shares at a discount that is applied to the market price. It also increases the stake of existing
shareholders in the company.
 The prime motive of issuing the right shares is to raise capital. But a company issues them only
when it is highly required to arrange funds for corporate expansion or a large takeover. Also, a
company may take the help of the right issue to prevent it from being conked out.
 The right issue provides a higher equity base for the organization and also provides better
leveraging opportunities. Other than this, the practice also reduces the debt-to-equity ratio of the
company.
 A real-life example of this was seen in 2019 when Vodafone Idea issued its right shares at a deep
discount to compete with Airtel's and Jio's right issues. The face value of this right issue was Rs.
25,000 crores and it was priced at Rs. 12.50 per share. It is the largest discount on the right issue
given by a company in India's history. The shares were 1.08 times oversubscribed.

Initial Public Offering (IPO)

 The first issue price of an unlisted company's share capital (which becomes a listed company after it)
is known as Initial Public Offer (IPO). A company is allowed to offer a maximum discount of 10%
to its employees or retail individuals while issuing the IPOs.
 Once the IPO is issued, the company can go for the Follow on Public Offer (FPO) refers to the
issue of shares to its existing shareholders by the company which got listed after issuing an IPO.
Here, the company is allowed to offer discounts to retail investors but only at the permissible limit.

Offer for Sale (OFS)

 When a listed company transparently issues shares so that it can dilute the stakes or holdings of the
promoters then such shares are known as OFS. This practice is done under the norms of minimum
public shareholdings as per SEBI.
 An investor can be eligible to apply for the OFS only as a retail investor for which he/she has to fulfill
certain conditions. As per the SEBI guidelines, the company can offer OFS at a discount rate to retail
investors.D
 The company has to mention the details regarding the discount that is provided on the issue of OFS
in the announcement notice. The discount on OFS is calculated either on the bid price or the final
allotment price.

Accounting Treatment for Shares Issued at Discount

Generally, the companies issue the shares at discount at the time of allotment of shares. So, all the entries
other than allotment will remain the same at that time. The accounting treatment for the shares issued at
discount is given below:

1. Share Allotment A/c Dr.

Discount on Issue of Shares A/c Dr.

To Share Capital A/c

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(Being the allotment due after providing the discount)

2. Bank A/c Dr.

To Shares Allotment A/c

(Being the amount of allotment received after deducting the discount amount)

3. P & L A/c or Securities Premium A/c Dr.

To Discount on Issue of Shares

(Being the amount of the discount is written off)

Issue of shares to vendors for consideration other than cash

When a company needs to acquire assets or services but does not have the cash available to make a
purchase, it may consider issuing shares to the vendor in exchange for the asset or service. This is known as
a non-cash consideration transaction.

In this type of transaction, the vendor receives shares of the company instead of cash payment. This can be
beneficial for both parties. For the company, it allows them to acquire the assets or services they need
without having to spend cash up front, which can be especially useful for start-ups or companies with
limited cash reserves. For the vendor, they receive equity in the company, which has the potential to
increase in value over time.

One of the challenges of non-cash consideration transactions is determining the value of the asset or
service being exchanged for the shares. This can be a complex process that requires careful analysis and
consideration. Valuation methods can include using fair market value, appraisals, or the value of similar
transactions in the market. It is important to consult with financial experts to ensure that the valuation is
accurate and fair for both parties.

Another important consideration is tax implications. Non-cash consideration transactions may be subject to
taxes, depending on the jurisdiction in which the company operates. Tax rules vary by location, so it is
important to consult with legal and financial experts to ensure that all relevant regulations are being
followed and the transaction is structured in a way that is beneficial for both parties.

When any asset is acquired by a company, the payment of purchase price may be made by the issue of
shares or in cash to the vendor. When shares are issued against the purchase price, it is called ‘Issue of
shares for consideration other than cash’. In other words cash is not received by the company against such
shares. In this case shares are not issued to the public in general.

Such shares may be issued to the vendor either

 At par or
 At a discount or
 At a premium.

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Issue of shares to promoters as remuneration

A company may allot fully paid shares to promoters or any other party for the services rendered by them by
way of furnishing technical information, engineering services, plant layout, drawing and designing, etc.
without payment. This type of issue of shares to promoters is called issue of shares for consideration other
than cash. As the amount paid to promoters for services rendered by them is supposed to be utilised by the
company over a long period of time, such expenditure should be treated as capital expenditure and debited
to Goodwill Account. The accounting entry in such a case will be as follows:

Forfeiture of Shares
Forfeiture of shares is a process of cancellation of shares by the company. In fact, sometimes, the
shareholders have to pay instalments for owning the shares. If the shareholder fails to pay these
instalments, his shares may be forfeited. However, the reasons and process of forfeiture of shares must be
included in the article of association.

Meaning Forfeiture of Shares

Shareholding is a process of ownership of a company. Forfeiture of shares is an action taken by the
board of directors of a company to cancel the ownership of a shareholder when they fail to pay the
dues for owning the shares. By owning shares, a shareholder owns a part of the company issuing the
share. The Companies Act 2013 offers the rules and regulations related to different types of shares, such as
preferential and equity shares. The shareholders must pay all dues they owe to maintain the ownership of
the company.

Shares are forfeited if a shareholder fails to meet the holding, buying, or selling criteria. There may be
numerous requirements like transfer of Shares over a restricted period, payment of call money, or even
avoiding selling. In the case of Forfeiture of Shares, neither the shareholder has any balance left on it, nor is
any profit from the share offered to him. Moreover, the forfeited share becomes an asset of the enterprise
that issued it.

Forfeiture of shares may take place for numerous reasons, such as delay in instalments, non-payment of
dues, etc. However, for a company to forfeit shares, it must allow such action under its Article of
Association.

Immediate Impact of Forfeiture of Shares

A shareholder’s shares are forfeited when he/she is unable to pay the call money owed. Call money is the
money that has to be paid by the shareholders as due on their shares. The following impacts are seen
immediately on the forfeiture of shares.

The shareholder’s personal shares and thereby, the ownership is cancelled and forfeited.

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Each entry related to a forfeited stock is converted into its respective accounting records. For shares that are
associated with premiums, this is not applicable.

Amounts called up for the relevant shares are then debited from the associated and relevant share capital
account.

Accounting Entries for Forfeiture of Shares

It is essential to understand the accounting entries while shares are forfeited. Shares may be at par or
premium for which the accounting entries differ. Here are the details of the accounting entries for the
forfeiture of shares.

When the shares are issued at par

When shares that are issued at par are forfeited, the company may take the following actions. It is due to
Forfeitures made for non-payment of call money even when making calls on Shares and stocks is done.

The called-up amounts on the shares as of the current date of Forfeiture are debited from the share capital
account of the firm. The arrears out of allotments and call accounts of these Shares are managed. The
called-up amount is credited to its relevant account.

The accounting entries for the Forfeiture of Shares issued at par are as follows.

Date Particular Amount (Dr) Amount (Cr.)

Share capital account (Called up amount) Dr. xyz

To share forfeiture account (Paid up amount) Cr. xyz

To share allotment account Cr. xyz

To share call accounts (Individual accounts) Cr. xyz

When the shares are issued at a premium

There are two possible situations in this case. The situation may differ depending on the clearance of the
security premium amount.

On receipt of the security premium amount: The called-up amount along with its share capital amount is
debited from its relevant account. It is also directly credited to every relevant account. This includes Shares
allotment which includes an amount not received during its process, First call and Final call accounts and
Forfeited Shares which have a received amount with a lower premium.

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Particular Amount Credit (Cr.)

Share capital account Dr. 10,000

To share allotment account Cr. 6,000

To Forfeiture share allotment account Cr. 2,000

To first call account Cr. 2,000

On non-receipt of security premium amount: The security premium amount is not received in this case.
This, therefore, involves an additional step of crediting the amount. The called-up and share capital amount
are debited to the First call and Final call accounts, share allotment including its related charges, and finally
Forfeited Shares with a received amount. Moreover, the security premium is debited from the share capital
account.

Particular Amount (Dr.) Amount (Cr.)

Share capital account Dr. 10,000

Share premium account Dr. 10,000

To share allotment account Cr. 6,000

To forfeiture calls account Cr. 4,000

To first call account Cr. 4,000

Effect of Forfeiture of Shares

 The first and foremost effect of forfeiture of shares is that the owner of the shares ceases to remain
the opener. His ownership gets diluted and he cannot claim any part of the income from the
company that he used to do when he held the shares. Forfeiture sachets the power of ownership
away.
 It is done due to delays in payments of the dues, but there is a set period of time to pay the dues.
When the due time is over, the power of ownership is taken away from the shareholder.

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 The shareholder is not however released from any liability he might have with the company. He is
liable to pay all the liabilities even after his ownership has been removed. So, he must pay all dues
even after the forfeiture of shares according to the law of the company.
 The process of forfeiture starts with the identification of defaulters by the company secretary, the list
of whom is sent to the board of directors. The board then sends notices to the defaulters to pay the
dues within two weeks. If the defaulters do not pay the call money within the given time, a second
and final notice is given. If the defaulters still do not pay the dues, the shares are forfeited.

Re-issue of shares
The company forfeits shares because a part of the due amount of such shares is received, and the balance
remains unpaid. On forfeiture, the allotment of the member holding shares is cancelled. Therefore, the
company can reissue the forfeited shares at any price, but it should not be less than the amount in arrears
of such shares.

For example - A paid Rs.5 as application money for a share having a nominal value of Rs.100. On his failure
to pay further allotments, the company forfeited his shares. So, the amount the company has in arrears is
Rs.6. The company can reissue the shares at a price more than Rs.6.

Share Forfeiture and Reissue Entry

On the Forfeiture of Shares
Equity Share Capital Account Dr.

To Equity Share First Call Account

To Equity Share Second Call Account

To Share Forfeiture Account

On Reissue of Shares
At Par Bank Account Dr.

To Equity Share Capital Account

At a Premium

Bank Account Dr.

To Equity Share Capital Account

To Securities Premium Reserve Account

At Discount

Bank Account Dr.

Share Forfeiture Account Dr.

To Equity Share Capital Account

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Example - XYZ Ltd. forfeits 200 equity shares of Rs.10 each issued at par for non-payment of the first call @
Rs.3 per share and the second and final call @ Rs.2 per share. The shares are reissued as fully paid-up @ Rs.
8 per share. Give the journal entries.

Equity Share Capital A/C Dr

To Equity Share First Call A/C 600

To Equity Share Second and Final 2000 400

Call A/C

To Share forfeiture A/C

1000

Bank A/C Dr
1600
Share Forfeiture A/C Dr
400
To Equity Share Capital A/C 2000

Share Forfeiture A/C Dr

600
To Capital Reserve A/C 600

The Profit on Reissue of Forfeited Shares is transferred to

Any amount of profit on the reissue of forfeited shares is a capital receipt. The amount should be
transferred to the capital reserve account because this profit is the capital gain for the company.

The company can treat the credit balance in the Share Forfeiture Account until it reissues such shares. That’s
the reason why companies reissue forfeited shares at a discount to adjust the Share Forfeiture Account.

Right shares [Sec. 81]

Meaning of Right Shares

Sec. 81(1) of the Companies Act, 1956, states that right shares are those shares which are issued after the
original issue of shares but having an inherent right of the existing shareholders to subscribe to these
shares in proportion to their holding. Such shares must be offered to the existing equity shareholders on
pro rata basis.

The offer of this type of shares shall be made in the form of a notice giving the particulars of shares offered
and within a time not less than 15 days from the date of the offer for acceptance of such offer. These shares

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can also be issued to the new members when the existing shareholders do not accept the offer within a
period of 15 days or more.

Usually, these shares are issued among the existing shareholders at a concessional rate.

Sec. 81(1) further states the provision regarding issue of Right Shares as:

 Such new shares shall be offered to the persons who, at the date of the offer, are holders of the
equity shares of the company in proportion, as nearly as circumstances admit, to the Capital paid-up
on those shares at that date.
 The offeree aforesaid shall be intimated by notice specifying the number of shares offered and
limiting a time not being less than 15 days from the date of offer within which the offer, if not
accepted, will be deemed to have been declined.
 The offers of the shares may renounce the offers in favour of any of the persons unless the Articles
of the company provide otherwise.
 After the expiry of the time specified in the notice aforesaid or on receipt of earlier intimations from
the person to whom such notice is given that he declines to accept the shares offered, the Board of
Directors may dispose of them in such manner as they think most beneficial to the company. Shares
issued under this section are called “Right” shares. But before issuing such shares the public
company must follow the SEBI Guidelines in the regard.

Exceptions [Sec. 81(1A)]

As per above section, under certain circumstances the company may offer further issue to persons other
than the existing shareholders.

Under the circumstances, the company must follow either of the following procedures:

If a special resolution is passed by the company in the general meeting;

If no special resolution is passed, then

(a) A proposal contained in the resolution is passed by a vote of majority members, and

(b) It is approved by the Board of Directors on that behalf. The Central Government has to be satisfied
before approving the proposal that it is the most beneficial to the company.

Sec. 81(3) provides that the rules contained in Sec. 81(1) shall not apply

(i) To a private company; or

(ii) Where the subscribed Capital of a Public Company is increased due to the debenture-holders or
creditors who gave an option to convert the debenture or loans into share of the company. It must be
remembered that a right is an option and not an obligation to the existing shareholders to purchase shares
at the specified price.

However, a shareholder has four following options regarding ‘Right Issues’:

(i) To exercise the Right;

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(ii) To sell their Rights;

(iii) To hold the Rights until they expire; and

(iv) To sell existing shares and, at the same time, to purchase new shares.

Bonus Shares
Bonus issue means an issue of additional shares at no cost to existing shareholders in the proportion to
their existing holding in the company. It is also known as “Capitalisation of profits”. As the company may
capitalize its reserves by issuing bonus shares to existing members. Bonus issue rules are given under
section 63 of the companies act, 2013.

Section 63(1) states that a company may issue fully paid-up bonus shares to its members, in any manner
whatsoever, out of-

 its free reserves;

 the securities premium account; or
 the capital redemption reserve account:

Provided that no issue of bonus shares shall be made by capitalizing reserves created by the revaluation of
assets.

Journal entries for the issue of fully paid-up bonus shares

Particulars Dr/Cr Debit (Rs) Credit (Rs)

Sanction of bonus issue out of various reserves

Capital Redemption Reserve Account Dr. XXXX

Securities Premium Account Dr. XXXX

General Reserve Account Dr. XXXX

Profit & Loss Account Dr. XXXX

To Bonus to Shareholders Account Cr. XXXX

Issue of bonus shares – Capitalization of profit

Bonus to Shareholders Account Dr. XXXX

To Share Capital Account Cr. XXXX

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Conditions as specified for Issue of Bonus Shares as per Section 63

Read with Rule 14 of Companies (Share Capital & Debentures) Rules, 2014
Source of Issue of Bonus Shares

A company may issue fully paid-up bonus shares to its members, in any manner whatsoever, out of—

 its free reserves;

 the securities premium account; or
 the capital redemption reserve account:

The Company cannot issue bonus shares by capitalising reserves created by the revaluation of assets.

Authorization by its Articles of Association

The Bonus issue shall be authorized by Articles of Association. In case the Articles of Association does not
authorize the Issue of bonus shares, the same is required to be amended by following the provisions of
Section 14 of the Act.

Authorization of Bonus Issue in General Meeting

The issue of bonus shares shall be previously authorized in the General meeting of the Company, by way of
passing ordinary resolution, in case Articles of Association provides for Special resolution, then by way of
passing special resolution.

The above said resolution shall be passed on the recommendation of the Board of Directors.

Bonus Shares are not allowed in case of partly paid shares

The Company cannot issue bonus shares to the Shareholders holding partly paid-up shares, however the
partly paid shares as outstanding on the date of allotment, are made fully paid-up, before issuing bonus
shares.

Prohibition on issue of Bonus Shares

The company can capitalise its profits or reserves for the purpose of issuing fully paid-up bonus shares, only
if

 it has not defaulted in payment of interest or principal in respect of fixed deposits or debt securities
issued by it;
 it has not defaulted in respect of the payment of statutory dues of the employees, such as,
contribution to provident fund, gratuity and bonus.

Bonus shares in lieu of Dividend

The bonus shares shall not be issued in lieu of dividend.

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Bonus issue cannot be withdrawn

Rule 14 of Companies (Share Capital & Debentures) Rules, 2014, provides that the Company which has once
announced the decision of its Board recommending a bonus issue, shall not subsequently withdraw the
same.

Important issues relating to issue of bonus shares

Quantum of Bonus Shares

The quantum of bonus shares or the ratio of bonus share shall depend on the Reserves and Surplus of the
Company and also the intent of the management regarding quantum of reserves and surplus to be
capitalized.

Where authorized capital was exhausted

In the case of Sanjay Paliwal v. Paliwal Hotels P. Ltd., (2007) 79 CLA 431 (CLB), it was held that where the
authorized capital was already exhausted on the date of the alleged allotment, no further allotment of
shares could take place.

Therefore, before initiating the process of the issue of shares, the Company should first increase the
authorized share capital, and then subsequently, the Company can initiate the process of issue of shares.
However, in the case of passing Shareholders resolution for increase in Authorised Share Capital and
resolution for issue of bonus shares, can be passed simultaneously in the same general meeting.

Entitlement of Bonus Shares

The entitlement of bonus shares shall be to those persons who are the members on the cut-off date as
decided by the Board of Director. A person who has transferred his shares before the cut-off date shall not
be entitled for the bonus share

Procedure & Practice

Procedure for Bonus Shares

1. Before proceeding for the decision for issue of bonus shares, the management should ensure that all
the conditions or prohibitions as specified under Section 63 of the Companies Act, 2013 and Rule 14
of Companies (Share Capital & Debentures) Rules, 2014, are duly taken care of.
2. Convene a Board Meeting, after giving seven days’ notice as per section 173(3) to all the directors of
the company, to approve the following:

 Issue of Bonus Shares to the shareholders

 Quantum of bonus shares to be issued and the ratio at which the shares are to be offered as
Bonus Shares.
 Decide the date, time and place to hold the Extraordinary General Meeting (EGM).

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3. File Form MGT-14 within 30 days of passing Board Resolution* for issue of bonus shares as per
sections 117 & 179(3)(c). The requirement to file MGT-14 is exempt in case of private companies
vide Notification No. GSR 464(E)dt. 05.06.2015 and for IFSC Public Limited Company vide
notification GSR 8(E)dated 04-01-2017.

4. Convene Extraordinary General Meeting for the following purposes:

 Pass Ordinary Resolution** (or Special Resolution, in case specified in the Articles of Association
of the Company) to approve the Bonus Issue.
 Quantum of bonus shares to be issued and the ratio at which the shares are to be offered as
Bonus Shares.
5. File Form MGT-14 with ROC within 30 days in case Company passes the Special Resolution
approving the Bonus Issue along with explanatory statement.
6. Convene a Board Meeting, after giving seven days’ notice as per section 173(3) to all the directors of
the company, for the purpose of passing resolution for allotment of Bonus Shares and issuing of
Shares Certificates.
7. File the return of allotment in Form PAS-3 within 30 days from the date of allotment made along
with the following as its attachments:

List of allottees which shall include the following information

 the full name, address, Permanent Account Number and E-mail ID of such shareholders;
 the class of shares held;
 the date of allotment of shares;

the number of shares held, nominal value.

Certified copy of the Board Resolution* passed for allotment of Bonus shares.

8. In case of allotment of shares, issue fresh shares certificates in Form SH-1 or to any other specified
format to all such persons to whom shares have been allotted within 60 days from the date of
allotment
9. Update the Register of Members on issue of share certificates to the shareholders.

Buy-back of shares
Share or stock buyback is the practice where companies decide to purchase their own share from their
existing shareholders either through a tender offer or through an open market. In such a situation, the price
of concerning shares is higher than the prevailing market price.

When companies decide to opt for the open market mechanism to repurchase shares, they can do so
through the secondary market. On the other hand, those who choose the tender offer can avail the same by
submitting or tendering a portion of their shares within a given period. Alternatively, it can be looked at as a
means to reward existing shareholders other than offering timely dividends.

However, company owners may have several reasons for repurchasing their stocks. Individuals should make
a point to find out the underlying causes to make the most of such decisions and also to benefit from them
accordingly.

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Sources of Buyback
Pursuant to section 68 (1) of Companies Act, 2013, a company whether public or private, may purchase its
own shares or other specified securities out of following sources:

 Its free reserves

 The securities premium account
 The proceeds of the issue of any shares or other specified securities.

However, buy-back of any kind of shares or other specified securities shall not be made out of the proceeds
of an earlier issue of the same kind of shares or other specified securities.

Specified Securities includes employees’ stock option or other securities as may be notified by the Central
Government from time to time.

Conditions of Buy Back Of Shares

 Buy back of shares must be authorized by its articles
 A special resolution passed at general meeting is needed to authorize buy-back. However, If buy-
back is upto 10% of the total paid up equity capital and free reserves, the Board of directors by
passing a resolution at its meeting may authorize the company For such buy-back (only one such
buy-back can be done in a year).
 Buy-back should not be more than 25% of the total paid up capital and free reserves of The
company.
 Buy-back of equity shares in any financial year must not exceed 25% of its paid up Equity capital.
 Debt-equity ratio should not fall below 2:1 after buy-back.
 The shares and the specified securities should be fully paid up.
 Company must follow the SEBI guidelines in case of listed shares and prescribed Guidelines in case
of others.
 Only one buy-back in a year is allowed.
 Shares must be physically destroyed within 7 days of completion of buy-back.
 No fresh issue is allowed within 6 months from buy-back, except by way of issue of Bonus shares,
ESOPs, sweat equity and conversion of debt/preference shares into equity.

Objectives of Buy Back of Shares

 To increase the promoters holding as the shares which are bought are cancelled
 To increase EPS, if there is no dilution in companies earnings as the buy-back reduces the
outstanding number of shares.
 To support the share price when the share price, in the opinion of the management is less than its
fair value.
 To pay surplus cash to the shareholders when the company does not need it for the business. For
e.g. TCS, Infosys, Wipro, HCL and Tech Mahindra are regularly conducting such programmes since
2014 as part of their capital allocation policies.

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 To reward shareholders by Buy-back of shares at much higher price than ruling market price.
 It safeguard against a hostile takeover by increasing promoters holding.

Procedure for Buy Back of Shares

 Notice of the meeting to be accompanied by the explanatory statement- Notice must include the
details regarding all the materials facts, the necessity of the buy back, class of the securities
intended to be bought back, amount to be invested under the buy back and the time limit for the
completion of the buy back
 Declaration of solvency- Before making the buy-back, the company is required to file with the
registrar and SEBI a declaration of solvency in prescribed form and an affidavit declaring that it is
capable of meeting its liabilities and will not be rendered insolvent within a period of one year of
the date of declaration adopted by the board.
 Completion of Buy-back- Every buy-back must be completed within 12 months from the date of
passing the special resolution or the resolution passed by the board.
 Extinguishment of securities- The Company must extinguish and physically destroy the securities
bought back within 7 days of the last date of completion of buy-back.
 Register of bought back of securities is to be maintained by the company.
 Filling of return to be made with the registrar and SEBI (in case of listed company) within 30 days of
such completion.

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Chapter 5
Ratio analysis

Introduction
Ratio analysis is a process to scrutinise and compare financial data of a company using its financial
statements. This method actively uses the data from financial statements to calculate the financial health
and performance of a company. Therefore, this process eliminates the need of analysing and comparing
line items from each financial statement.

This prevailing method primarily helps the management of a company as well as its investors to gather
information on its growth percentage. Besides, this method also clarifies the operational drawbacks of an
organisation. As a result, the management can take suggestions from the ratio analysis to take the right
course of financial action. Thereby, a company benefits largely from this widely prominent method.

For example, let’s consider that a company XYZ has had an annual income of Rs. 1,00,000. On the other
hand, the cost of XYZ is around Rs.60,000. Therefore, the margin of profit for XYZ is Rs.40,000. As a result,
the ratio analysis suggests that the gross profit is 40% of the revenue of XYZ.

Consequently, the margin of profit of XYZ is denoted by a percentage instead of line comparison of
financial statements. However, there are several types of ratio analysis that companies use to gather data on
their financial operations. Having knowledge about these types will certainly help a student understand the
advantages and limitations of ratio analysis.

Sources of Financial Data for Analysis

 Annual Reports
 Interim financial statements
 Notes to Accounts
 Statement of cash flows
 Business periodicals.
 Credit and investment advisory services

Importance of Ratio Analysis

 Test of solvency. Ratios can illuminate the solvency of a firm. For example, when the ratio of current
assets to current liabilities is increasing, this indicates sufficient working capital. Thus, creditors can
be paid easily.
 Helpful in decision-making. The main aim of financial statements is to inform users about the
financial position of the company, as well as to serve as a decision-making aid for managerial
personnel.

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 Helpful in financial forecasting and planning. Ratios are critical in financial planning and
forecasting. For example, if a firm's current ratio is 5:1, this means that capital is blocked up. As the
ideal ratio is 2:1, we have 5:1, meaning that $3 is unnecessarily blocked.
 Useful in discovering profitability. Ratios are also useful when comparing the profitability of
different companies. Present and past ratios can be compared, for example, to discover trends in the
historical and future performance of companies.
 Liquidity position. With the use of ratio analysis, meaningful conclusions can be obtained about
the sound liquidity position of the firm. A firm's liquidity position is sound if it can pay its debts
when these are due for payments.
 Useful for operating efficiency. From a management perspective, ratios enable managers to
measure the efficiency of assets. When sales and their contribution to net profit increase every year,
this is a test of higher efficiency.
 Business trends. Ratio analysis can expose trends that managers may use to take corrective actions.
 Helpful in cost control. Ratios are useful to measure performance and facilitate cost control.
 Helpful in analyzing corporate financial health. Ratio analysis can provide information about
liquidity, solvency, profitability, and capital gearing. Thus, they are valuable for learning about
financial health.

Types of Ratios

 Activity Ratio Analysis – Activity ratio analysis implies the assessment of a company’s efficiency
and scale of operations. This method helps accountants understand the pace at which companies
convert their inventories into sales. Besides, this method also helps them to understand how the
cash from sales helps them to manage their fixed capital and working capital. Activity ratio analysis
also includes inventory turnover ratio, working capital turnover ratio, and payables turnover ratio
among others.
 Profitability Ratio Analysis – This category of ratio analysis helps a business measure its profits. As
a result, accountants can use the profitability ratio analysis to determine the company’s ability to
bag profits. Besides, this works as a marker for the industry to understand which companies have
exhibited the most profits. Therefore, it duly conveys the financial health of an organisation. This

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kind of analysis takes into account the net profit margin, gross profit margin, and return on capital
employed.
 Liquidity Ratio Analysis – This method duly analyses an organisation’s liquidity of its assets.
Therefore, individuals can gather an idea about the rate at which the company can convert its assets
into cash. This procedure is mainly used to determine a company’s ability to fulfil its financial
obligations without experiencing any disruption.
 Solvency Ratio Analysis – Solvency ratio analysis takes into account the long-term financial
sustainability of a business. Therefore, it is used to analyse the ability of an organisation for paying
off its long-term financial obligations. These obligations thus include loans taken from financial
institutions to fund its capital requirement, and the bonds it has issued in the secondary market.

Long-term Solvency and Leverage Ratios

Long term solvency means the firm’s ability to meet its liabilities in the long run. Long term solvency ratios
help to determine the ability of the business to repay its debts in the long run. The ratio includes

 Debt to capital Ratio

 Debt Equity Ratio
 Debt to Total Assets Ratio
 Capital Gearing Ratio
 Proprietary Rati
 Debt-Service Coverage Ratio (DSCR)
 Interest Coverage Ratio
 Preference Dividend Coverage Ratio
 Fixed Charges Coverage Ratio

Activity Ratios
These ratios can be known as activity ratios, efficiency ratios, cash ratios or working capital ratios and can
also be included under the liquidity heading.

 Receivables collection period = receivables ÷ credit sales × 365 days

 Inventory holding period = inventory ÷ cost of sales × 365 days
 Payables payment period = payables ÷ credit purchases (or cost of sales) × 365 days

Activity ratios measure an organisation’s ability to convert statement of financial position items into cash or
sales. They measure the efficiency of the business in managing its assets.

Total Assets Turnover Ratio

 Fixed Assets Turnover Ratio

 Capital Turnover Ratio/ Net Assets Turnover Ratio
 Current Assets Turnover Ratio
 Working Capital Turnover Ratio
 Inventory/ Stock Turnover Ratio
 Receivables (Debtors) Turnover Ratio
 Payables (Creditors) Turnover Ratio

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Profitability Ratios
Profitability ratios are a set of measurements used to determine the ability of a business to create earnings.
These ratios are considered to be favourable when they improve over a trend line or are comparatively
better than the results of competitors. Profitability ratios are derived from a comparison of revenues to
difference groupings of expenses within the income statement. A different class of profitability ratios
compare the results listed on the income statement to the information on the balance sheet. The intent of
these latter measurements is to examine the efficiency with which management can produce profits, in
comparison to the amount of equity or assets at their disposal. If the outcome of these measurements is
high, it implies that resource usage has been minimized.

Contribution Margin Ratio

The contribution margin ratio subtracts all variable expenses in the income statement from sales, and then
divides the result by sales. This is used to determine the proportion of sales still available after all variable
expenses to pay for fixed costs and generate a profit. This is used for breakeven analysis. The contribution
margin is only found on a contribution margin income statement, which is rarely reported.

Gross Profit Ratio

The gross profit ratio subtracts all costs related to the cost of goods sold in the income statement from
sales, and then divides the result by sales. This is used to determine the proportion of sales still available
after goods and services have been sold to pay for selling and administrative costs and generate a profit.
This ratio includes the allocation of fixed costs to the cost of goods sold, so that the result tends to yield a
smaller percentage than the contribution margin ratio. Also, since the ratio is derived from both fixed and
variable expenses, the profit percentage tends to increase as sales go up, since the fixed expenses are
covered by initial sales.

Net Profit Ratio

The net profit ratio subtracts all expenses in the income statement from sales, and then divides the result by
sales. This is used to determine the amount of earnings generated in a reporting period, net of income
taxes. If the accrual basis of accounting is used, this can result in a figure that is different from what cash
flows would indicate, due to the accrual of expenses for which payments have not yet been made.

Return on Assets
The return on assets divides net profits by the total amount of assets on the balance sheet. The
measurement can be improved by using a tight credit policy to reduce the amount of accounts receivable, a
just-in-time production system to reduce inventory, and by selling off fixed assets that are rarely used.
These asset reduction policies can have a negative effect on profits, however, if they adversely impact
operations. The result varies by industry, since some industries require far more assets than others.

Return on Equity
The return on equity divides net profits by the total amount of equity on the balance sheet. The
measurement can be improved by funding a larger share of operations with debt, and by using debt to buy
back shares, thereby minimizing the use of equity. Doing so can be risky, if a business does not experience
sufficiently consistent cash flows to pay off the debt.

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Current Ratio
The current ratio, also known as the working capital ratio, measures the capability of a business to meet its
short-term obligations that are due within a year. The ratio considers the weight of total current assets
versus total current liabilities. It indicates the financial health of a company and how it can maximize the
liquidity of its current assets to settle debt and payables. The current ratio formula (below) can be used to
easily measure a company’s liquidity.

Components of Current Ratio

There are two primary components of the current ratio, namely, current assets and current liabilities.

Current Assets

These are essentially investments that can be readily converted into cash and cash equivalents within a year.
It includes -

 Cash
 Cash equivalents
 Accounts receivable
 Marketable securities
 Short-term deposits

Current Liabilities

They make up the financial obligations of a company that are typically paid off within a year. It includes -

 Income taxes
 Accounts payable
 Dividends declared
 Outstanding wages

Calculating the Current Ratio

To calculate the current ratio, analysts compare the business’s existing assets to its present liabilities. The
current assets mentioned on a firm’s balance sheet consist of inventory, accounts receivable, cash, as well as
OCA (other current assets) which it expects to liquidate or turn in the form of cash within the duration of 12
months.

Current liabilities incorporate the existing amount of long-term debt, short-term debts, taxes payable,
wages, and accounts payable. Thus, the formula for the current ratio is:

Current Ratio = Current Assets/Current Liabilities

Acid Test Ratio

The Acid-Test Ratio, also known as the quick ratio, is a liquidity ratio that measures how sufficient a
company’s short-term assets are to cover its current liabilities. In other words, the acid-test ratio is a
measure of how well a company can satisfy its short-term (current) financial obligations. This guide will
break down how to calculate the ratio step by step, and discuss its implications.

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Quick Ratio = Quick Assets - Quick Liabilities

Cash Ratio
The cash ratio, sometimes referred to as the cash asset ratio, is a liquidity metric that indicates a company’s
capacity to pay off short-term debt obligations with its cash and cash equivalents. Compared to other
liquidity ratios such as the current ratio and quick ratio, the cash ratio is a stricter, more conservative
measure because only cash and cash equivalents – a company’s most liquid assets – are used in the
calculation.

Formula
The formula for calculating the cash ratio is as follows:

Cash Ratio = Absolute liquid assets Current Liabilities

Defensive interval ration

The defensive interval ratio (DIR) is a financial liquidity ratio that indicates how many days a company can
operate without needing to tap into capital sources other than its current assets. It is also known as the
basic defence interval ratio (BDIR) or the defensive interval period ratio (DIPR).

Sources of capital include long-term assets such as a company’s patents or PP&E investments, which have
relatively poor liquidity. This means they might take considerably more time to sell off at their fair market
value.

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Typically, long-term assets cannot be sold in the current accounting period. They usually take upwards of
one year to liquidate. Examples of long-term, less liquid capital include a company’s external sources of
capital that would require time to see cash flows from (e.g., issuing new debt or equity).

Formula
Defensive Interval Rato = Liquid Assets Projected daily cash requirement

Projected Daily cash requirement = Projected daily operatng expenditure No. of days in a year

Debt equity ratio

The Debt to Equity ratio (also called the “debt-equity ratio”, “risk ratio”, or “gearing”), is a leverage ratio that
calculates the weight of total debt and financial liabilities against total shareholders’ equity. Unlike the debt-
assets ratio which uses total assets as a denominator, the D/E Ratio uses total equity. This ratio highlights
how a company’s capital structure is tilted either toward debt or equity financing.

Debt-ratio= Long - term Debts Shareholders Fund

Equity Ratio
The equity ratio is a financial metric that measures the amount of leverage used by a company. It uses
investments in assets and the amount of equity to determine how well a company manages its debts and
funds its asset requirements.

A low equity ratio means that the company primarily used debt to acquire assets, which is widely viewed as
an indication of greater financial risk. Equity ratios with higher value generally indicate that a company’s
effectively funded its asset requirements with a minimal amount of debt.

Equity Ratio = Shareholder’s Equity Net Assets

Capital Gearing Ratio

Capital gearing ratio is the ratio between total equity and total debt; this is a specifically important metric
when an analyst is trying to invest in a company and wants to compare whether the company is holding the
right capital structure.

Capital Gearing Ratio = Long term Debt + Preference Sh. Equity + Reserve and surplus

Proprietary Ratio
The proprietary ratio is the proportion of shareholders' equity to total assets, and as such provides a rough
estimate of the amount of capitalization currently used to support a business. If the ratio is high, this
indicates that a company has a sufficient amount of equity to support the functions of the business, and
probably has room in its financial structure to take on additional debt, if necessary. Conversely, a low ratio

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indicates that a business may be making use of too much debt or trade payables, rather than equity, to
support operations (which may place the company at risk of bankruptcy).

Proprietary Ratio = Shareholder’s Funds/Capital employed (or net assets)

Debt Ratio
The term debt ratio refers to a financial ratio that measures the extent of a company’s leverage.

 Total debt or total outside liabilities includes short and long term borrowings from financial
institutions, debentures/bonds, deferred payment arrangements for buying capital equipment, bank
borrowings, public deposits and any other interest bearing loan.
 A ratio greater than 1 would mean greater portion of company assets are funded by debt and could
be a risky scenario.

Debt Ratio = Total debt Total assets

Debt Service Coverage Ratio (DSCR)

Debt-Service Coverage Ratio (DSCR) is considered a more comprehensive and apt measure to compute
debt service capacity of a business firm.

It provides the value in terms of the number of times the total debt service obligations consisting of interest
and repayment of principal in instalments are covered by the total operating funds available after the
payment of taxes:

Earnings after taxes, EAT + Interest + Depreciation + Other non-cash expenditures like amortization

Debt Service Coverage Ratio = Earnings available for Debt services Interest + Instalment

Interest Coverage Ratio

The interest coverage ratio is a debt and profitability ratio used to determine how easily a company can pay
interest on its outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings
before interest and taxes (EBIT) by its interest expense during a given period.

The interest coverage ratio is sometimes called the times interest earned (TIE) ratio. Lenders, investors, and
creditors often use this formula to determine a company's riskiness relative to its current debt or for future
borrowing.

Interest Coverage Ratio = EBIT (Earnings available to equity shareholders) Interest

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The preferred dividend coverage ratio

It is a measure of a company's ability to pay the required amount that will be due to the owners of its
preferred stock shares. Preferred stock shares come with a dividend that is set in advance and cannot be
changed.

A healthy company will have a high preferred dividend coverage ratio, indicating that it will have little
difficulty in paying the preferred dividends it owes.

Preference Dividend Coverage Ratio = Net profit /Preference dividend

Fixed Charges Coverage Ratio

The Fixed Charge Coverage Ratio (FCCR) compares the company’s ability to generate sufficient cash flow to
meet its fixed charge obligations, such as the required principal and interest payments on debt. It may
include leases and other fixed charges. It is an important financial ratio, and when it is a debt covenant, it
also governs the company’s ability to incur or refinance debt from lenders.

As with other non-IFRS/GAAP measures, lenders and borrowers negotiate and specify the lending ratio
calculation within a credit agreement.

Fixed Charges Coverage Ratio = (EBIT + Dep.) (Interest + Repayment of loan)

Net Assets or Capital Employed Turnover Ratio

It reflects the relationship between revenue from operations and net assets (capital employed) in the
business. Higher turnover means better activity and profitability.

Net Asset Turnover Ratio = Revenue from Operation/ Capital Employed

Inventory Turnover Ratio

The inventory turnover ratio, also known as the stock turnover ratio, is an efficiency ratio that measures how
efficiently inventory is managed. The inventory turnover ratio formula is equal to the cost of goods sold
divided by total or average inventory to show how many times inventory is “turned” or sold during a period.
The ratio can be used to determine if there are excessive inventory levels compared to sales.

Inventory Turnover Ratio = (Sales or COGS) Average Inventory Average Inventory = (Opening Stock
+ Closing Stock) 2

Debtors Turnover Ratio

The Debtors Turnover Ratio is a financial ratio used to measure a company's efficiency in collecting its
accounts receivable from customers. It shows how many times a company collects its average accounts
receivable over a period of time.

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Debtors Turnover Ratio = Net Credit Sales / Average Accounts Receivable

Average Collection Period

The Average Collection Period is a financial ratio used to measure the average number of days it takes a
company to collect its accounts receivable from customers. It is also known as the Days Sales Outstanding
(DSO) ratio.

A high Average Collection Period indicates that a company is taking a longer time to collect its accounts
receivable, which could lead to cash flow problems. On the other hand, a low Average Collection Period
suggests that a company is collecting its accounts receivable quickly and efficiently. It is important to note
that the Average Collection Period can vary significantly between industries, so it is best to compare a
company's ratio to others in the same industry.

Average Collection Period = (Accounts Receivable / Net Credit Sales) x Number of Days in the Period

Creditors Turnover Ratio

The Creditors Turnover Ratio is a financial ratio used to measure a company's efficiency in paying its
accounts payable to suppliers. It shows how many times a company pays its average accounts payable over
a period of time.

Creditors Turnover Ratio = Net Credit Annual Purchases Average Trade Creditors

A high Creditors Turnover Ratio indicates that a company is paying its accounts payable quickly and
efficiently, while a low ratio may suggest that the company is taking a longer time to pay its outstanding
debts. It is important to note that the Creditors Turnover Ratio can vary significantly between industries, so
it is best to compare a company's ratio to others in the same industry.

Average Payment Period

 It represents the average number of days taken by the firm to pay its creditors.
 A higher ratio may imply that greater credit period enjoyed by the firm.
 The lower the ratio the better the liquidity positon of the firm.

Average payment period = Average Accounts Payable Average Daily Credit Purchases

OR

= 12months /52weeks /360daysCreditors/ Payables turnover ratio

Working Capital Turnover Ratio

It measures how effective a company is at generating sales for every rupee of working capital put to use.

It indicates the no. of times the working capital is turned over in a year.

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Working Capital Turnover Ratio = Sales Average Working Capital Average Working Capital =
(Opening + Closing) 2

Gross Profit Ratio

Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross
margin.
Gross Profit Ratio = Gross Profit / Net Revenue of Operations × 100

Net Profit Ratio

 Net profit margin measures the percentage of each sales rupee remaining after all costs and
expenses including interest and taxes have been deducted.
 The net profit margin is indicative of management’s ability to operate the business with sufficient
success not only to recover from revenues of the period, the cost of merchandise or services, the
expenses of operating the business (including depreciation) and the cost of the borrowed funds, but
also to leave a margin of reasonable compensation to the owners for providing their capital at risk.
 The ratio of net profit (after interest and taxes) to sales essentially expresses the cost price
effectiveness of the operation.

Net Profit Ratio = Net profit/Revenue from Operation× 100

Operating Profit Ratio

The operating profit ratio is the amount of money a company makes from its operations. It demonstrates
the financial sustainability of a company’s basic operations prior to any financial or tax-related
repercussions. As a result, it is one of the better indicators of how successfully a management team runs a
company. The operational margin ratio is a measure that determines how much profit a company makes on
a rupee of sales. Higher operating profit margin ratios are seen positively. Since they demonstrate a
company’s effectiveness in managing its operations and capacity to convert sales into profits.

Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

Expense Ratio
It is computed by dividing expenses by sales. The term ‘expenses’ includes (i) cost of goods sold, (ii)
administrative expenses, (iii) selling and distribution expenses, (iv) financial expenses but excludes taxes,
dividends and extraordinary losses due to theft of goods, good destroyed by fire and so on.

Cost of Goods Sold (COGS) Ratio = COGS Sales × 100

Operating Expenses Ratio = Administrative exp.+ Selling & Distribution OH Sales × 100

Operating Ratio = COGS + Operating expenses Sales × 100

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Financial Expenses Ratio = Financial expenses Sales × 100

Return on Investment
 Return on Investment estimates the loss and gain generated on the amount of money invested.
 ROI (Return on Investment) is generally expressed in the percentage to analyse an Organisation’s
profit or the earnings of different investments.
 In simple words, Return on Investments estimates what you receive back as compared to what you
invest.
 Return on Investment can be used in different ways to calculate the profitability of the business. It
can be used by a company to estimate inventory investments, pricing Policy, capital equipment
investments, etc.,

Return on Investment = Return /Profit /Earnings Investment ×100

Return on Assets
The profitability ratio is measured in terms of relationship between net profits and assets employed to earn
that profit. This ratio measures the profitability of the firm in terms of assets employed in the firm.

ROA = Net Profit after taxes Average Total Assets or Average Tangible Assets or Average Fixed
Assets

Return on Capital Employed

Return on Capital Employed (ROCE), a profitability ratio, measures how efficiently a company is using its
capital to generate profits. The return on capital employed metric is considered one of the best profitability
ratios and is commonly used by investors to determine whether a company is suitable to invest in or not.

ROCE (Pre-tax) = Earnings before interest and taxes (EBIT) Capital Employed × 100
ROCE (Post-tax) = EBIT(1-t) Capital Employed × 100

Return on Equity (ROE)

Return on Equity (ROE) is the measure of a company’s annual return (net income) divided by the value of its
total shareholders’ equity, expressed as a percentage (e.g., 12%). Alternatively, ROE can also be derived by
dividing the firm’s dividend growth rate by its earnings retention rate (1 – dividend payout ratio).

Return on Equity is a two-part ratio in its derivation because it brings together the income statement and
the balance sheet, where net income or profit is compared to the shareholders’ equity. The number
represents the total return on equity capital and shows the firm’s ability to turn equity investments into
profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.

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Return on Equity= Net Profit after taxes - Preference dividend (if any)Net Worth/Equity
Shareholders' Funds x 100

Equity Multiplier
 It is possible for a company with terrible sales and margins to take on excessive debt and artificially
increase its return on equity.
 The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the
return on equity is the result of debt.

Equity Multiplier = Total Assets Total Equity Shareholders

Earnings per Share

EPS is a financial ratio, which divides net earnings available to common shareholders by the average
outstanding shares over a certain period of time. The EPS formula indicates a company’s ability to produce
net profits for common shareholders. This guide breaks down the Earnings per Share formula in detail.

A single EPS value for one company is somewhat arbitrary. The number is more valuable when analyzed
against other companies in the industry, and when compared to the company’s share price (the P/E Ratio).
Between two companies in the same industry with the same number of shares outstanding, higher EPS
indicates better profitability. EPS is typically used in conjunction with a company’s share price to determine
whether it is relatively “cheap” (low P/E ratio) or “expensive” (high P/E ratio).

EPS = Earnings available to equity shareholder’s Number of equity shares outstanding

Dividend per Share

Dividend per Share (DPS) is the dividends paid to the equity shareholders on a per share basis. In other
words, DPS is the net distributed profit belonging to the ordinary

Shareholders divided by the number of ordinary shares outstanding.

DPS = Total dividend paid to Equity Shareholder Total no. of outstanding shares

Dividend Pay-out Ratio

Dividend Pay-out (D/ P) Ratio is also known as pay-out ratio. It measures the relationship between the
earnings belonging to the ordinary shareholders and the dividend paid to them.
In other words, the D/ P ratio shows what percentage share of the net profits after taxes
and preference dividend is paid out as dividend to the equity-holders.
Dividend Pay-out Ratio = Dividend per share Earnings per share

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Price- Earnings Ratio

Price/ Earnings (P/ E) ratio measures the amount, investors are willing to pay for each rupee of earnings; the
higher the ratio, the larger the investors’ confidence in the firm’s future.

Price- Earnings Ratio = Market price per share EPS

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Chapter 6
Cash flow statement
Introduction
The statement of cash flows (also referred to as the cash flow statement) is one of the three key financial
statements. The cash flow statement reports the cash generated and spent during a specific period of time
(e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement
and balance sheet by showing how cash moved in and out of the business.

Importance of a cash flow statement

For a business to be successful, it should always have sufficient cash. This enables it to pay back bank loans,
buy commodities, or invest to get profitable returns. A business is declared bankrupt if it doesn’t have
enough cash to pay its debts. Here are some of the benefits of a cash flow statement:

Gives details about spending: A cash flow statement gives a clear understanding of the principal
payments that the company makes to its creditors. It also shows transactions which are recorded in cash
and not reflected in the other financial statements. These include purchases of items for inventory,
extending credit to customers, and buying capital equipment.

Helps maintain optimum cash balance: A cash flow statement helps in maintaining the optimum level of
cash on hand. It is important for the company to determine if too much of its cash is lying idle, or if there’s
a shortage or excess of funds. If there is excess cash lying idle, then the business can use it to invest in
shares or buy inventory. If there is a shortage of funds, the company can look for sources from where they
can borrow funds to keep the business going.

Helps you focus on generating cash: Profit plays a key role in the growth of a company by generating
cash. But there are several other ways to generate cash. For instance, when a company finds a way to pay
less for equipment, it is actually generating cash. Every time it collects receivables from its customers
quicker than usual, it is gaining cash.

Useful for short-term planning: A cash flow statement is an important tool for controlling cash flow. A
successful business must always have sufficient liquid cash to fulfil short-term obligations like upcoming
payments. A financial manager can analyse incoming and outgoing cash from past transactions to make
crucial decisions. Some situations where decisions have to be made based on the cash flow include
foreseeing cash deficit to pay off debts or establishing a base to request for credit from banks.

Definitions
Cash comprises cash on hand and demand deposits with banks.

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Cash equivalents are short term, highly liquid investments that are readily convertible into known amounts
of cash and which are subject to an insignificant risk of changes in value.

Cash flows are inflows and outflows of cash and cash equivalents.

Operating activities are the principal revenue-producing activities of the enterprise and other activities
that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the owners’ capital
(including preference share capital in the case of a company) and borrowings of the enterprise.

Cash and Cash Equivalents

Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for
investment or other purposes. For an investment to qualify as a cash equivalent, it must be readily
convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore,
an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months
or less from the date of acquisition.

Investments in shares are excluded from cash equivalents unless they are, in substance, cash equivalents; for
example, preference shares of a company acquired shortly before their specified redemption date (provided
there is only an insignificant risk of failure of the company to repay the amount at maturity).

Cash flows exclude movements between items that constitute cash or cash equivalents because these
components are part of the cash management of an enterprise rather than part of its operating, investing
and financing activities. Cash management includes the investment of excess cash in cash equivalents.

Activities for the Preparation of Cash Flow Statement

 Operating Activities
 Investing Activities
 Financing Activities
 Operating Activities

The amount of cash flows arising from operating activities is a key indicator of the extent to which the
operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the
enterprise, pay dividends, repay loans and make new investments without recourse to external sources of
financing. Information about the specific components of historical operating cash flows is useful, in
conjunction with other information, in forecasting future operating cash flows.

Cash flows from operating activities are primarily derived from the principal revenue-producing activities of
the enterprise. Therefore, they generally result from the transactions and other events that enter into the
determination of net profit or loss. Examples of cash flows from operating activities are:

 cash receipts from the sale of goods and the rendering of services;

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 cash receipts from royalties, fees, commissions and other revenue;
 cash payments to suppliers for goods and services;
 cash payments to and on behalf of employees;
 cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and
other policy benefits;
 cash payments or refunds of income taxes unless they can be specifically identified with financing
and investing activities; and
 cash receipts and payments relating to futures contracts, forward contracts, option contracts and
swap contracts when the contracts are held for dealing or trading purposes.

Investing Activities
The separate disclosure of cash flows arising from investing activities is important because the cash flows
represent the extent to which expenditures have been made for resources intended to generate future
income and cash flows. Examples of cash flows arising from investing activities are:

 cash payments to acquire fixed assets (including intangibles). These payments include those relating
to capitalised research and development costs and self-constructed fixed assets;
 cash receipts from disposal of fixed assets (including intangibles);
 cash payments to acquire shares, warrants or debt instruments of other enterprises and interests in
joint ventures (other than payments for those instruments considered to be cash equivalents and
those held for dealing or trading purposes);
 cash receipts from disposal of shares, warrants or debt instruments of other enterprises and
interests in joint ventures (other than receipts from those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
 cash advances and loans made to third parties (other than advances and loans made by a financial
enterprise);
 cash receipts from the repayment of advances and loans made to third parties (other than advances
and loans of a financial enterprise);
 cash payments for futures contracts, forward contracts, option contracts and swap contracts except
when the contracts are held for dealing or trading purposes, or the payments are classified as
financing activities; and
 cash receipts from futures contracts, forward contracts, option contracts and swap contracts except
when the contracts are held for dealing or trading purposes, or the receipts are classified as
financing activities.

Financing Activities
The separate disclosure of cash flows arising from financing activities is important because it is useful in
predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:

cash proceeds from issuing shares or other similar instruments;

cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings;
and cash repayments of amounts borrowed.

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Cash flow from operating activities (CFO)
It indicates the amount of money a company brings in from its ongoing, regular business activities, such as
manufacturing and selling goods or providing a service to customers. It is the first section depicted on a
company's cash flow statement.

Cash flow from operating activities does not include long-term capital expenditures or investment revenue
and expense. CFO focuses only on the core business, and is also known as operating cash flow (OCF) or net
cash from operating activities.

Indirect Method

The first option is the indirect method, where the company begins with net income on an accrual
accounting basis and works backwards to achieve a cash basis figure for the period. Under the accrual
method of accounting, revenue is recognized when earned, not necessarily when cash is received.

Direct Method

The second option is the direct method, in which a company records all transactions on a cash basis and
displays the information on the cash flow statement using actual cash inflows and outflows during the
accounting period.

Examples of the direct method of cash flows from operating activities include:

 Salaries paid out to employees

 Cash paid to vendors and suppliers
 Cash collected from customers
 Interest income and dividends received
 Income tax paid and interest paid

Cash from Investing Activities

As per AS-3, Investing activities are the acquisition and disposal of long-term assets and other investments
not included in cash equivalents.

Investing activities relate to the purchase and sale of long-term assets or fixed assets such as machinery,
furniture, land, and building, etc.

Transactions related to long-term investment are also investing activities.

Calculation of Cash Flows from Operating Activities

An enterprise can determine cash flows from operating activities using either:

(a) Direct Method: The direct method, whereby major classes of gross cash receipts and gross cash
payments are considered; or

(b) Indirect Method: The indirect method, whereby net profit or loss is adjusted for the effects of
transactions of a non-cash nature, deferrals or accruals of past or future operating cash receipts or
payments, and items of income or expense associated with investing or financing activities.

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Calculation using direct method
The direct method of presenting the statement of cash flows presents the specific cash flows associated
with items that affect cash flow. Items that typically do so include:

 Cash collected from customers

 Interest and dividends received
 Cash paid to employees
 Cash paid to suppliers
 Interest paid
 Income taxes paid

The advantage of the direct method over the indirect method is that it reveals operating cash receipts and
payments.

The standard-setting bodies encourage the use of the direct method, but it is rarely used, for the excellent
reason that the information in it is difficult to assemble; companies simply do not collect and store
information in the manner required for this format. Using the direct method may require that the chart of
accounts be restructured in order to collect different types of information. Instead, they use the indirect
method, which can be more easily derived from existing accounting reports.

Cash flows from operating activities

Cash receipts from customers Rs 45,800,000

Cash paid to suppliers (29,800,000)

Cash paid to employees (11,200,000)

Cash generated from operations 4,800,000

Interest paid (310,000)

Income taxes paid (1,700,000)

Net cash from operating activities Rs2,790,000

Cash flows from investing activities

Purchase of property, plant, and equipment (580,000)

Proceeds from sale of equipment 110,000

Net cash used in investing activities (470,000)

Cash flows from financing activities

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Proceeds from issuance of common stock 1,000,000

Proceeds from issuance of long-term debt 500,000

Principal payments under capital lease obligation (10,000)

Dividends paid (450,000)

Net cash used in financing activities 1,040,000

Net increase in cash and cash equivalents 3,360,000

Cash and cash equivalents at beginning of period 1,640,000

Cash and cash equivalents at end of period Rs5,000,000

Reconciliation of net income to net cash provided by operating activities

Net income Rs2,665,000

Adjustments to reconcile net income to net cash provided by operating

activities:

Depreciation and amortization Rs125,000

Provision for losses on accounts receivable 15,000

Gain on sale of equipment (155,000)

Increase in interest and income taxes payable 32,000

Increase in deferred taxes 90,000

Increase in other liabilities 18,000

Total adjustments 125,000

Net cash provided by operating activities Rs2,790,000

Indirect Method
Under the indirect method, profit and loss account is adjusted for

 The effects of transactions of non-cash items such as depreciation, amortisation, deferred taxes,
loss on sale of fixed assets and unrealised foreign exchange gains and losses,
 Changes during the period in inventories and operating receivables and payables, and
 For all other items for which the cash effects are shown either in financing or investing activities.

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Some special items under AS 3

 Non-cash items: These are items that do not involve actual cash flows, such as depreciation,
amortization, and deferred taxes. They need to be adjusted for in the cash flow statement to reflect
the actual cash flows generated by the business.
 Changes in working capital: Changes in working capital, such as accounts receivable, inventory,
and accounts payable, can impact the cash flows of a business. An increase in accounts receivable or
inventory will reduce cash flows, while a decrease in accounts payable will increase cash flows.
 Foreign currency transactions: Cash flows from foreign currency transactions need to be translated
into the reporting currency using the exchange rate at the time of the transaction. Any gains or
losses from changes in exchange rates need to be reflected in the cash flow statement.
 Investing and financing activities: Investing and financing activities can also impact cash flows. For
example, the purchase or sale of property, plant, and equipment will result in cash outflows or
inflows from investing activities. Issuance of debt or equity will result in cash inflows from financing
activities.
 Acquisitions and mergers: When a company acquires or merges with another company, the cash
flows from these transactions need to be reflected in the cash flow statement. Cash outflows will
occur if the company is paying for the acquisition with cash or financing, while cash inflows will
occur if the company is receiving cash or financing.
 Income taxes: Income taxes paid or received need to be reflected in the cash flow statement. This
includes current income taxes and any changes in deferred income taxes.
 Restructuring and severance costs: These costs are considered special items and need to be
disclosed separately in the cash flow statement. This includes any cash outflows related to employee
severance or other costs associated with restructuring the business.
 Litigation settlements: Settlements related to litigation or other legal disputes can result in
significant cash outflows for a business. These need to be disclosed separately in the cash flow
statement to provide a clear picture of the company's cash flows.

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Chapter 7
Partnership accounts
Introduction
A partnership generally means a relationship among people sharing a mutual interest. In accountancy, a
partnership means a business set up together by two or more persons sharing a common interest to earn
profit. The concept of partnership is a solution to the problems of the sole proprietorship, such as a single
person bearing the risk, investing, and managing the capital alone. Hence, it can be concluded that a
partnership is an agreement where two or more people agree to conduct a business together or any one of
them acting on behalf of others, sharing risk, and investing capital together into a joint business to earn
profit. In India, the partnership business is governed by The Indian Partnership Act, 1932.

Features or Characteristics of Partnership

 Association of two or more persons: The minimum number of partners in a firm can be two.
Maximum number is guided by Companies Act. According to section 464 of the Indian Companies
Act 2013, the number of partners in any association shall not exceed 100. However, the Rules given
under the Companies (Miscellaneous) Rules, 2014 restrict the present limit to 50. If this limit is
exceed it becomes illegal association
 Agreement: There must be an agreement between all partners who are involved in that business.
 Business: The agreement should be for the purpose of carrying business between the partners.
 Profit sharing Ratio: There must be sharing of profits and loss of business between partners.
 Agency Relationship: A partner is both (an agent and the principal) of his own business .A partner
is an agent of his own business in the sense that he can bind new partners by his acts and a partner
is a principal of his own business in the sense that he can be bound by the acts of other partners of
business.
 Liability of Partners: Each partner is liable jointly and individually third party for all the acts of the
firm done while he is a partner. It means his private assets can also be used for paying off the firm’s
debts.

Minimum and maximum numbers of partners

Minimum Partners 2 persons must be required to form a partnership.

Maximum Partners as per Indian Companies Act, 2013 As per Indian Companies Act, 2013 a Partnership firm can
have maximum 100 Partners. Though, it might sound strange but upper limit on number of partners are fixed under
Companies Act and not in Partnership Act.

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Partnership deed
 The smooth and successful running of a partnership firm requires a clear understanding among its
partners regarding the various policies governing their partnership.
 The partnership deed serves this purpose. The partnership deed contains various terms such as
profit/loss sharing, salary, interest on capital, drawings, admission of a new partner, etc. in order to
bring clarity to the partners.
 A deed of partnership also known as a partnership agreement is a legal document signed by two or
more partners who come together and decide to run a business for profit.
 The partnership deed helps to resolve any disagreement or conflict which arises between the
partners regarding the partnership norms.
 The purpose of a partnership deed is to give a clear understanding of the roles of all partners,
ensuring the smooth running of the operations of the partnership firm.

Importance of a Partnership Deed

A partnership deed defines the position of the partners of the firm. Below is the importance of a partnership
deed:

 It helps partners to define the terms of their relationship.

 It regulates the nature of business and liabilities, rights and duties of all partners.
 It helps to avoid misunderstandings between the partners since all of the terms and conditions of
the partnership are specified in the deed.
 In the case of a dispute amongst the partners, it will be settled as per the terms of the partnership
deed.
 There will be no confusion between the partners regarding the profit and loss sharing ratio amongst
them.
 It mentions the role of each individual partner.
 It contains the remuneration that is to be paid to partners, thereby avoiding any dispute or
confusion.
 It ensure smooth functioning of the firm as the terms and liabilities between partners are in a written
form.

Types of Partnership Deeds

General Partnership Deed: The general partnership deed contains the terms and conditions of a general
partnership, where each partner shares equal responsibility for the management of the firm business and
are jointly liable for debts or obligations.

Limited Partnership Deed: The limited partnership deed establishes a limited partnership, which includes
general and limited partners. The general partners have unlimited liability for the debts of the partnership
firm, while the limited partners have limited liability and do not participate actively in the management of
the business.

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Contents of a Partnership Deed

Name of the firm
The partners of the firm should decide the firm’s name which adheres to the provisions of the Partnership
Act. The firm name is the name under which the business is conducted.

Details of the partners

The deed should include details of all the partners, such as their names, addresses, contact number,
designation, and other particulars.

Business of the firm

The deed should mention the business that the firm undertakes. It may be dealing with producing goods or
rendering services.

Duration of firm
The deed should mention the duration of the partnership firm, i.e. if the firm is constituted for a limited
period, for a specific project or for an unlimited period.

Place of business
The deed should contain the principal place of business where it carries on the partnership business. It
should also mention the names of any other places where it conducts business.

Capital contribution
Each partner will contribute an amount of capital to the firm. The entire capital of the firm and the share
contributed by each partner are to be mentioned in the deed.

Sharing of profit/loss
The ratio of sharing profits and losses of the firm amongst partners should be noted in the deed. It can be
shared equally amongst all partners, or according to the capital contribution ratio or any other agreed ratio.

Salary and commission

The details of the salary and commission payable to partners should be mentioned in the deed. The salary
and commission can be paid to the partners based on their role, capabilities or any other capacity.

Partner’s drawings
The drawings from the firm allowed to each partner and interest to be paid to the firm on such drawings, if
any should be mentioned in the deed.

Partner’s loan
The deed should mention whether the business can borrow loans, the interest rate of loans, properties to
be pledged, etc. It can also mention if a partner of the firm can borrow loans from the business or not.

Duties and obligations of partners

The rights, duties and obligations of all the partners of the firm should be mentioned in the deed to avoid
future disputes.

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Admission, death and retirement of partners
The deed should mention the date of admission of the partner, the regulations governing the admission of
a new partner, resignation, or changes after the death of a partner of the firm.

Accounts and audit

The deed should contain details about the audit procedure of the firm. It should mention the details of how
the partnership accounts are to be prepared and maintained.

Provisions Affecting Accounting Treatment in Partnership Business

 Right to share profits: Partners are entitled to share equally in the profits earned and to contribute
equally to losses incurred.
 Interest on capital: No interest is payable on the capitals contributed by them. Similarly no interest
is to be charged on drawings. However, where partnership agreement provides for payment of
interest on capital, such interest is payable out of profits of the business unless otherwise provided.
 Interest on advances: A partner who makes an advance of money to the firm beyond the amount
of his capital for the purpose of business, is entitled to get interest thereon at the rate of 6% p.a.
 Right to share subsequent profits after retirement: Where any member of a firm has died or
otherwise ceased to be a partner and the surviving or continuing partners carry on the business of
the firm with the property of the firm without any final settlement of accounts as between them, the
outgoing partner or his estate is entitled, at the option of himself or his representatives to such
share of the profits made since he ceased to be a partner as may be attributable to the use of his
share of the property of the firm or to interest at the rate of six per cent per annum on the amount
of his share in the property of the firm.
 No remuneration for firm’s work: A partner is required to attend diligently to his duties in
conducting the business of the finn. He has no right to receive remuneration or salary for taking part
in the conduct of the business.

Capital accounts
Partners’ Capital Accounts:

Methods of Maintaining Capital Accounts of Partners

The partner’s Capital Account may be maintained in two ways.

 Fluctuating Capital method

 Fixed Capital method

In the absence of any instructions, the partners’ capital A/c should be prepared on the basis Fluctuating
Capital Method

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Fluctuating Capital method

When capital is fluctuating a single Account is prepared that is called Partners Capital Account. In this
account amount of capital is change from opening figure to closing figure. All entries such as, Interest on
capital, Drawings, Interest on Drawings, Salary of partner, Commission of partner, Share of Profit or Loss
and additional / fresh capital introduced by partners are recorded in Partner Capital A/c

Note:- Interest on Loan and Advance to Partners are not recorded in Partners Capital A/c When Partners
Capital A/c is fluctuating. In this case it may be recorded in separate account “Accrued Interest A/c”

Fixed Capital method

When capital is fixed two Accounts are prepared

 Partners’ Capital Account

 Partners’ Current Account

Partners’ Capital Account: – In this account only additional capital introduced and withdrawn from
existing capital is shown and no other transactions are recorded.

Partners’ Current Account:- In this account all entries such as, Interest on capital, Drawings, Interest on
Drawings, Salary of partner, Commission of partner, Share of Profit or Loss are recorded.

Current Account balance of partners may be fall in both sides whether in debit side or credit side.

Distinction between fixed and fluctuating capital accounts

Parameter Fixed Capital Accounts Fluctuating Capital Accounts

Nature of Represents initial investment made by Tracks changes in ownership interest

account owners due to profits/losses

Amount Remains constant unless new Changes over time based on business
investments or withdrawals are made performance

Type of Initial investment and any subsequent Profits generated by business operations
investment additional investments

Risk Fixed and relatively low risk Fluctuates based on business

performance and may involve higher risk

Ownership Represents ownership share of the Represents the ownership share of

company profits/losses

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Profit and loss appropriation account

This account is prepared to distribute profit or loss among the partners. It is the extension of Profit and Loss
Account. This account show what amount of profit is transferred to partner’s capital Account.

Profit and Loss Appropriation A/c

For the year Ended on ………………..

Dr. Cr.

Particulars ` Particulars `

To Interest on Capital

By Profit and Loss A/c–

A xxx xxxx
Net Profit
xxxx
B xxx

C xxx By Interest on Drawings

To Partner Salary A xxx

xxxx
A xxx xxxx B xxx

B xxx C xxx

To Partners Commission – A xxxx

To Reserve Fund (Transfer) xxxx

To Profit transferred to C
apital A/c
Balancin
g Figure
A (3/6) xxx

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B (2/6) xxx

C (1/6) xxx xxxx

Total xxxx Total xxxx

Note: –

Partners Commission:- If Partners commission is allowed on Turnover (Sales) or Purchase of goods it is item of
Profit and Loss Account but when Partners allowed commission on Profit it becomes item of Profit and Loss
Appropriation A/c

Following are the items of Profit and Loss A/c

 Interest on Partner’s Loan and advance

 Manager Commission
 Rent Paid to a partner
 Profit and Loss A/c
 For the year Ended on ………………..

Particulars ` Particulars `

Dr. Cr.

Particulars ` Particulars `

To Interest on Partners’ Loan & Adva

xxxx By Profit as given xxxx
nce

To Manager Salary & Commission xxxx

To Rent paid to partner xxxx

To Net Profit – transferred to P / L Ap

xxxx
propriation A/c

xxxx xxxx

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Interest on capital
Calculation of Interest on Capital: Interest on capital is calculated at the pre-defined rate with period for
which capital has been used in the business. Interest on capital will be calculated on opening balance of
capital account. Interest on capital is also allowed if any capital is introduced during the year.

Certain times closing capital is given then for the purpose of calculating “interest on capital” opening capital
will find out

When Capital is fixed

Calculation of Capital at the Beginning

Particulars A B C

Capital at end xxxx xxxx xxxx

Add: Drawings (withdrawn from Capital) + + +

Less: Additional Capital – – –

Capital at Beginning xxxx xxxx xxxx

When Capital is Fluctuating

Calculation of Capital at the Beginning

Particulars A B C

Capital at end xxxx xxxx xxxx

Add: Drawings + + +

Add: Interest on Drawings + + +

Less: Additional Capital – – –

Less: Interest on Capital – – –

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Less: Share of Profits – – –

Capital at Beginning xxxx xxxx xxxx

Accounting Treatment of Interest on Capital

Case Rules

1. When partnership agreement is silent as to

Interest on capital is not allowed
providing Interest on Capital

2. When partnership agreement is providing

Interest on capital is allowed out of profit as well
Interest on Capital “as a Charge” it means it is
as from loss.
allowed even in case of loss

Interest on capital is allowed only in case of

sufficient profit and no Interest on capital is
allowed out of Loss.

3. When partnership agreement is providing

In case of Loss: – No Interest on Capital is allowed.
Interest on Capital but it silent as to the
treatment “as a Charge “or If there is Sufficient Profit, it means total interest
“appropriation”(only it is given in partnership on capital is allowed out of profit :- Interest on
agreement that Interest on Capital is allowed) capital is allowed

If there is no sufficient Profit, it means total

interest on capital cannot allowed out of profit :-
Interest on capital is allowed only to the extent of
profit “in the ratio of capital of each partner”

Interest on Drawings
When company Charge Interest on Drawing – Interest on Drawings will be charged from the partners if the
partnership agreement provides for the same. If partnership deed is silent about charging interest on
drawings, No interest on Drawings will charge.

Only when agreed upon

Interest on Drawing is to be charged to partners only if it is specifically agreed upon. If there is no mention
in the partnership agreement regarding this, no interest need to be charged @6% If rate is not mentioned

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Where the partnership deed provide for charging interest on drawings and it does not mention the rate of
interest to be charged it is convention to charge interest 6% p.a. For interest on drawings (Individual)

Partners’ salary
As per Section 40(b) of the Income Tax Act 1961, Interest & Salary paid to the Partners by the
Partnership Firm are allowed to be deducted as an expense only in case all the specified conditions are
being adhered to.

Payment of Salary, Bonus, Commission or Remuneration, by whatever name called (hereinafter

referred to as Remuneration in this article) is allowed only to a Working Partner. If it is paid to
be a non-working partner, the same shall be disallowed.

Moreover, the payment of remuneration should not exceed the following amounts. Any amount
in excess of the below mentioned limits will be disallowed:-

Particulars Salary Allowed

Rs. 1,50,000 or at the rate of 90% of the book
a. On the first 3,00,000 of book profits
profit
or in case of a loss
(whichever is higher)

b. On the balance of book profits at the rate of 60%

The computation of Book Profit for the purpose of Section 40b would be the net profit as shown
in the P&L A/c for the previous year and increased by the aggregate of the remuneration paid or
payable to all partners of the firm is such amount has been deducted while computing the net
profit.

Partner’s Loan account

Where a partner makes a loan to the firm in addition to his capital, he is a creditor of the firm for the
amount of the loan and hence, a separate loan account is opened for him.

The interest on loan shall be credited to his current or loan account.

➢ the rate of interest on loan would depend on the agreement between the partners. But if there is no
agreement the interest is to be paid at 6% p.a. as per the Partnership Act.

Capital ratio
Partners may agree to share profits and losses in the capital ratio. When capitals are fixed, profits will be
shared in the ratio of given capitals.

But if capitals are fluctuating and partners introduce or withdraw capitals during the year, the capitals for
the purpose of ratio would be determined with reference to time on the basis of weighted average method.

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Admission of new partner

A business firm seeks new partners with business expansion being one of the driving motives. As per the
Partnership Act, 1932, a new partner can be admitted into the firm with the consent of all the existing
partners, unless otherwise agreed upon.

With the admission of a new partner, there is a reconstitution of the partnership firm and all the partners
get into a new agreement for carrying out the business of the firm.

The following conditions led to the addition of a new partner

 When the firm is in an expansion mode and requires fresh capital.

 When the new partners possesses expertise which can be beneficial for the business expansion of
the firm.
 When the partner in question is a person of reputation and adds goodwill to the firm.

Computation of New Profit-Sharing Ratio

On the admission of the new partner, the shares of profit old partners decrease. Therefore, it is necessary to
calculate the new profit sharing ratio among the existing partners (including the new partner).

Different situations while the calculations of new profit sharing ratio are as follows

 When the question only contains the ratio of the new partner, and there is no presence of any
agreement. Then, we shall assume that the old partners continue to share their profits in the same
old profit sharing ratio only.
 When a new partner purchases the shares from the old partners of the firm equally, then the profit-
sharing ratios of old partners of the firm will be ascertained by deducting the sacrifices they made
from their existing profit-sharing ratios.
 When a new partner purchases the shares from the old partners of the firm in a specific ratio, then
the calculation of the new profit sharing ratio of the old partners of the firm is after deducing the
sacrifice made by a partner from his share of profits.
 Sometimes, the partners of the firm shall surrender some portion of their share in the favour of new
partner. Thus, the calculation of the new profit sharing ratio is by the addition of the surrendered
portion of the share of the old partners. Moreover, the calculation of the old partner’s share is by
deducing the surrendered share from their old shares.

Revaluation of Assets and Liabilities

At the time of retirement or death of a partner there may be some assets which may not have been shown
at their current values. Similarly, there may be certain liabilities which have been shown at a value different
from the obligation to be met by the firm. Not only that, there may be some unrecorded assets and
liabilities which need to be brought into books. As learnt in case of admission of a partner, a Revaluation
Account is prepared in order to ascertain net gain (loss) on revaluation of assets and/or liabilities and
bringing unrecorded items into firm’s books and the same is transferred to the capital account of all
partners including retiring/deceased partners in their old profit sharing ratio.

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A Revaluation Account is prepared in order to ascertain net gain or loss on revaluation of assets and
liabilities and bringing unrecorded items into books. The Revaluation profit or loss is transferred to
the capital account of all partners including retiring or deceased partners in their old profit sharing ratio.

The following Journal entries are passed:

For the increase in the value of Assets

Assets A/c (Individually) Dr.

To Revaluation A/c

(Being increase in the value of assets on revaluation)

For a decrease in the value of Assets

Revaluation A/c Dr.

To Assets A/c (Individually)

(Being decrease in the value of assets on revaluation)

For an increase in the value of Liabilities

Revaluation A/c Dr.

To Liabilities A/c (Individually)

(Being increase in the value of liabilities on revaluation)

For a decrease in the value amount of Liabilities

Liabilities A/c (Individually) Dr.

To Revaluation A/c

(Being decrease in the value of liabilities on revaluation)

For an unrecorded Asset

Assets A/c Dr.

To Revaluation A/c

(Being unrecorded asset recorded in books)

For an unrecorded Liability

Revaluation A/c Dr.

To Liability A/c

(Being unrecorded liability recorded in books)

For transferring Profit on Revaluation

Revaluation A/c Dr.

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To All Partners’ Capital A/c (Individually)

(Being Profit on revaluation transferred to all partner’s capital A/c in old ratio)

For transferring Loss on Revaluation

All Partners’ Capital A/c (Individually) Dr.

To Revaluation A/c

(Being Loss on revaluation transferred to partner’s capital A/c in old ratio)

The partners may decide that the revalued figures of assets and liabilities will not appear in the books of the
firm. In this case, the share of retiring or deceased partner of profit or loss from revaluation of assets and
liabilities are adjusted in the remaining partners’ capital A/cs in their gaining ratio.

The journal entries that will be passed are

In case of Revaluation Profit

Remaining Partners Capital A/c (Individually) Dr.

To Retiring Partners Capital A/c

(Being the share of retiring partner in revaluation profit adjusted in remaining partners’ capital in gaining
ratio)

In case of Revaluation Loss

Remaining Partners Capital A/c (Individually) Dr.

To Retiring Partners Capital A/c

(Being the share of retiring partner in revaluation profit adjusted in remaining partners capital in gaining
ratio)

Distribution of Reserves, Accumulated Profits and Losses

Profits and losses of previous years which are not distributed to the partners are called accumulated profits
and losses. Any reserve and accumulated profits and losses belong to the old partners and hence these
should be distributed to the old partners in the old profit sharing ratio. Reserves include general reserve,
reserve fund, workmen compensation fund and investment fluctuation fund. Incase of workmen
compensation fund, the excess amount after providing for anticipated claim is the accumulated profit to be
transferred.

Following are the journal entries to be passed

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For transferring accumulated profit and reserves

For transferring accumulated loss

Adjustment for goodwill

Reputation built up by a firm has an impact on the present profit and future profit to be earned by the firm.
At the time of admission of a partner, the existing partners sacrifice part of their share of profit in favour of
the new partner. Hence, to compensate the sacrifice made by the existing partners, goodwill of the firm has
to be valued and adjusted. In addition to capital, the new partner may contribute towards goodwill. This
goodwill is distributed in the sacrificing ratio to the old partners who sacrifice.

Accounting treatment for goodwill

 When new partner brings cash towards goodwill
 When the new partner does not bring goodwill in cash or in kind
 When the new partner brings only a part of the goodwill in cash or in kind
 Existing goodwill.

When new partner brings cash towards goodwill

When the new partner brings cash towards goodwill in addition to the amount of capital, it is distributed to
the existing partners in the sacrificing ratio. The following journal entries are to be made:

For the goodwill brought in cash credited to old partners’ capital account

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For the goodwill brought in kind (in the form of assets) credited to old partners’ capital account

For withdrawal of cash received for goodwill by the old partners

Different methods of valuation of goodwill

Years’ Purchase of Average Profit Method

Under this method, average profit of the last few years is multiplied by one or more number of years in
order to ascertain the value of goodwill of the firm. How many years’ profit should be taken for calculating

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average and the said average should be multiplied by how many number of years — both depend on the
opinions of the parties concerned. The average profit which is multiplied by the number of years for
ascertaining the value of goodwill is known as Years Purchase. It is also called Purchase of Past Profit
Method or Average Profit Basis Method.

Profit Basis Method

Value of Goodwill = Average Profit x Years’ Purchase

Illustration

Majumdar & Co. decides to purchase the business of Banerjee & Co. on 31.12.2003. Profits of Banerjee &
Co. for the last 6 years were: 1998 Rs. 10,000; 1999 Rs. 8,000; 2000 Rs. 12,000; 2001 Rs. 16,000, 2002 Rs.
25,000 and 2003 Rs. 31,000.

The following additional information about Banerjee & Co. were also supplied:

(a) A casual income of Rs. 3,000 was included in the profit of 2000 which can never be expected in future.

(b) Profit of 2001 was reduced by Rs. 1,000 as a result of an extraordinary loss by fire.

(c) After acquisition of the business, Majumdar & Co. has to pay insurance premium amounting to Rs. 1,000
which was not paid by Banerjee & Co.

(d) S. Majumdar, the proprietor of Majumdar & Co., was employed in a firm at a monthly salary of Rs. 1,000
p.m. The business of Banerjee & Co. was managed by a salaried manager who was paid a monthly salary of
Rs. 4,000. Now, Mr. Majumdar decides to manage the firm after replacing the manager.

Compute the value of Goodwill on the basis of 3 years’ purchase of the average profit for the last 4 years.

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Years’ Purchase of Weighted Average Method

This method is the modified version of Years’ Purchase of Average Profit Method. Under this method, each
and every year’s profit should be multiplied by the respective number of weights, e.g. 1, 2, 3 etc., in order to
find out the value of product which is again to be divided by the total number of weights for ascertaining
the weighted average profit. Therefore, the weighted average profit is multiplied by the years’ purchase in
order to ascertain the value of goodwill. This method is particularly applicable where the trend of profit is
rising.

Value of Goodwill = Weighted Average Profit x Years Purchase

Illustration

XYZ Co. Ltd. intends to purchase the business of ABC Co. Ltd. Goodwill for this purpose is agreed to be
valued at 3 years’ purchase of the weighted average profits of the past four years.

ADVERTISEMENTS:

The appropriate weights to be used:

1998 — 1; 1999 — 2; 2000 — 3; 2001-4.

The profits for these years were

The following information were available

 On 1.9.1999 a major repair was made in respect of a Plant at a cost of Rs. 8,000 and this was charged
to revenue. The said sum is agreed to be capitalized for Goodwill calculation subject to adjustment
of depreciation of 10% p.a. on Diminishing Balance Method.
 The Closing Stock for the year 2000 was overvalued by Rs. 3,000.
 To cover the Management cost an annual charge of Rs. 10,000 should be made for the purpose of
Goodwill valuation.

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Capitalisation Method
Under this method, the value of the entire business is determined on the basis of normal profit. Goodwill is
taken as the difference between the Values of the Business minus Net Tangible Assets.

Under this method, the following steps should be taken into consideration for ascertaining the
amount of goodwill

 Expected Average Net Profit should be ascertained;

 Capitalised value of profit is to be calculated on the basis of normal rate of return;
 Net Tangible Assets (i.e. Total Tangible Assets – Current Liabilities) should also be calculated;
 To deduct (iii) from (ii) in order to ascertain the value of Goodwill.

Capitalised Value of Profit = Profit (Adjusted)/Normal Rate of Return x 100

Value of Goodwill = Capitalised Value of Profit – Net Tangible Assets

Illustration 3

The following is the Balance Sheet of P. Ltd. as at 31.12.2009

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The profits of the past four years (before providing for taxation) were:

2006 — Rs. 20,000; 2007 — Rs. 30,000; 2008 — Rs. 36,000 and 2009 — Rs. 40,000.

Compute the value of Goodwill of the company assuming that the normal rate of return for this type of
company is 10%. Income Tax is payable @ 50% on the above profits.

Illustration

From the following Balance Sheet and other necessary information of P. Ltd. for the year ended
31.12.2001, compute the value of Goodwill by the application of Capitalisation Method

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The company commenced operation in 1997 with a paid-up capital of Rs. 2, 00,000.

Profits earned before providing for taxation have been:

1997 — Rs. 90,000; 1998 — Rs. 95,000; 1999 — Rs. 1, 05,000; 2000 — Rs. 80,000; 2001 — Rs. 1, 10,000.

Assume that Income-Tax @ 50% has been payable on these profits. Dividends have been distributed from
the profits of the first three years @ 10% and for those of the next two years @ 15% on the Paid-up Capital.

Annuity Method
Under this method, Super-profit (excess of actual profit over normal profit) is being considered as the value
of annuity over a certain number of years and, for this purpose, compound interest is calculated at a certain
respective percentage. The present value of the said annuity will be the value of goodwill.

Value of Goodwill,

V=

Where

V = Present value of Annuity

a = Annual Super Profit

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n = Number of Years

I = Rate of Interest

Illustration

From the following particulars, compute the value of goodwill under Annuity Method

Super-Profit Rs. 10,000

Number of years over which Super-Profit is to be paid 5

Rate Per cent p.a. 5%

Computation of Goodwill:

Super-Profit Method
Super-profit represents the difference between the average profit earned by the business and the normal

profit (on the basis of normal rate of return for representative firms in the industry) i.e., the firm’s

anticipated excess earnings. As such, if there is no anticipated excess earning over normal earnings, there

will be no goodwill.

This method for calculating goodwill depends on:

 Normal rate of return of the representative firms;

 Value of capital employed/Average capital employed; and
 Estimated future profit, i.e. the average profit of the last few years.

Super-Profit = Average Profit (Adjusted) – Normal Profit

Value of Goodwill = Super-Profit x Years’ Purchase

The students should remember that the number of years’ purchase of goodwill differs from firm to firm and
industry to industry. One or two years’ purchase should be taken into consideration if the retiring partner of
a business was the main source of success. It should also be remembered that three to five years’ purchase
is usually taken. Of course, a large number of years’ purchase may be considered if the super-profit itself is
found to be large. If there is a declining trend in super-profit, one or two years’ purchase may be
considered.

The following steps should carefully be followed for calculating the value of Goodwill under Super
Profit Method

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 Ascertain the amount of Capital Employed/Average Capital Employed;
 Ascertain the amount of Normal Profit (i.e. Percentage of Normal Rate of Return on Capital/Average
Capital Employed);
 Ascertain the Actual Maintainable Profit;
 Ascertain the difference between Actual Maintainable Profit minus Normal Profit. If Actual
Maintainable Profit is more than the Normal Profit, the excess is called Super-Profit and, in the
opposite case, this is no Super-Profit;

Value of Goodwill = Super-Profit x Year’s Purchase.

Illustration

The following particulars are available in respect of the business carried on by Mr. R. N. Mitra

Compute the value of Goodwill of the business on the basis of 3 years’ purchase of super-profit taking
average of last four years

Illustration

The following is the Balance Sheet of Mithu Ltd. as on 31.12.2009

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The Assets were revalued as

Plant and Machinery Rs. 50,000; Land and Building Rs. 40,000; Investments Rs. 25,000; Profit includes Rs.
1,000 income from Investment. Calculate the value of Goodwill on the basis of 3 years’ purchase of Super-
profit. Normal rate of return in this type of business is 12%.

Illustration

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From the following information, compute the Goodwill of the firm XYZ Co. Ltd. on the basis of four years’
purchase of the average Super-Profit on a 10% yield basis:

As per the Articles of Association of this private company, its Directors have declared and paid dividends to

its members in the month of December each year out of the profit of the related year. The cost of the

Goodwill to the company was Rs. 5, 00,000. Capital employed at the beginning of the year 2006 was Rs. 19,

30,000 including the cost of Goodwill and balance in Profit and Loss Account at the same time was Rs.

60,000.

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Value of Goodwill will be four years’ purchase of Average Super-Profit, i.e. Rs. 4,75,833 x 4 = Rs. 19,03,332,
or, say, Rs. 19,00,000.

Capitalisation of Super-Profit Method

Under the method, we are to consider super-profit in place of ordinary profit against the normal rate of
return.

The same is calculated as

Value of Goodwill = Super-Profit/Normal Rates of Returns x 100

Illustration

X Ltd. Presented the following information

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Normal Rate of Return @ 10%

Capital Employed Rs. 3, 00,000

Profit for last 5 years are Rs. 20,000; Rs. 25,000; Rs. 45,000; Rs. 30,000 and Rs. 50,000

Compute the value of goodwill.

Sliding Scale Valuation Method

Under this method, the distribution of profit which is related to super-profit may vary from year to year. In
other words, in order to find out the value of goodwill, sliding scale valuation may be considered relating to
super-pr8fits of an enterprise.

Illustration

Compute the value of Goodwill on the basis of Sliding Scale Method.

Amount of Super-Profit estimated at Rs. 12,000.

Sliding Scale

First Rs, 6,000 for 3 years’ purchase

Next Rs. 4,000 for 2 years’ purchase

Balance Rs. 2,000 for 1 year’s purchase

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Adjustment for life policy

 Joint Life Insurance Policy is a common Life insurance policy which covers the lives of all the partners
of the firm and the premium of which is borne by the firm.
 The Surrender Value of the Joint Life Policy as on the date of admission is to be considered for the
accounting purpose. The Maturity Value is irrelevant in these cases.

Retirement /death of a partner

One major change in the constitution of a partnership firm may occur if a partner undergoes retirement
from the firm or in the event of his death. In both cases, the partner’s account will have to be settled, and
new ratios will have to be calculated. There is also the issue of treatment of goodwill.

Adjustments require on retirement of a partner from the firm

 Calculate new gaining ratio of all remaining partners.
 Calculate new ratio of the remaining partners.
 Calculation of goodwill of the firm and its accounting treatment.
 Revaluation of assets and liabilities.
 Distribution of accumulated profit and losses and reserve among all the partners.
 Treatment of joint life policy.
 Settlement of the amount due to retiring partner.
 Adjustment of capital accounts of the remaining partners in their new profit sharing ratio.

New Profit Sharing Ratio

There are different cases when partnership can have new profit sharing ratio:

 Sometimes the partners may decide to change their existing profit sharing ratio, without any
admission or retirement of partner,
 At the time of admission of the new partner
 At the time of retirement or death of an old partner

This may result in a gain to a few partners and loss to others. The partners who are in profit due to this
change in the profit sharing ratio should compensate the sacrificing partner/partners.

 New profit sharing ratio: Ratio in which the partners decide to share profits/losses in future.
 Gaining ratio: Ratio in which the partners have agreed to gain their share of profit from other
partners.
 Sacrificing ratio: Ratio in which the partners have agreed to sacrifice their share of profit in favour of
other partners. Sacrificing ratio= Old Ratio – New Ratio
 New Profit Sharing and Gaining Ratio

Gaining Ratio
Gaining ratio is calculated at the time of retirement or death of a partner. It is the ratio in which the
remaining partners acquire the outgoing partner’s share of profit.

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When the partner retires, the profit sharing ratio of the continuing partners gets changed. Continuing
partners distribute the share of retiring partner among them.

Gaining ratio= New Ratio – Old Ratio (if positive)

Adjustment for Revaluation of Assets and Liabilities

At the time of retirement or death of a partner, there may be some assets and liabilities which are not
recorded in books at their current values. Also, there may be some unrecorded assets and liabilities which
need to be recorded in the books.

A Revaluation Account is prepared in order to ascertain net gain or loss on revaluation of assets and
liabilities and bringing unrecorded items into books. The Revaluation profit or loss is transferred to the
capital account of all partners including retiring or deceased partners in their old profit sharing ratio.

The following Journal entries are passed:

For the increase in the value of Assets

Assets A/c (Individually) Dr.

To Revaluation A/c

(Being increase in the value of assets on revaluation)

For a decrease in the value of Assets

Revaluation A/c Dr.

To Assets A/c (Individually)

(Being decrease in the value of assets on revaluation)

For an increase in the value of Liabilities

Revaluation A/c Dr.

To Liabilities A/c (Individually)

(Being increase in the value of liabilities on revaluation)

For a decrease in the value amount of Liabilities

Liabilities A/c (Individually) Dr.

To Revaluation A/c

(Being decrease in the value of liabilities on revaluation)

For an unrecorded Asset

Assets A/c Dr.

To Revaluation A/c

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(Being unrecorded asset recorded in books)

For an unrecorded Liability

Revaluation A/c Dr.

To Liability A/c

(Being unrecorded liability recorded in books)

For transferring Profit on Revaluation

Revaluation A/c Dr.

To All Partners’ Capital A/c (Individually)

(Being Profit on revaluation transferred to all partner’s capital A/c in old ratio)

For transferring Loss on Revaluation

All Partners’ Capital A/c (Individually) Dr.

To Revaluation A/c

(Being Loss on revaluation transferred to partner’s capital A/c in old ratio)

The partners may decide that the revalued figures of assets and liabilities will not appear in the books of the
firm. In this case, the share of retiring or deceased partner of profit or loss from revaluation of assets and
liabilities are adjusted in the remaining partners’ capital A/cs in their gaining ratio.

The journal entries that will be passed are:

In case of Revaluation Profit

Remaining Partners Capital A/c (Individually) Dr.

To Retiring Partners Capital A/c

(Being the share of retiring partner in revaluation profit adjusted in remaining partners capital in gaining
ratio)

In case of Revaluation Loss

Remaining Partners Capital A/c (Individually) Dr.

To Retiring Partners Capital A/c

(Being the share of retiring partner in revaluation profit adjusted in remaining partners capital in gaining
ratio)

Adjustment of Partners Capital and Death of a Partner

At the time of the death of a partner, we credit the following amounts in the Deceased Partner’s Capital
Account:

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 Reserves or Undistributed profits
 Goodwill
 Profit on Revaluation of assets and liabilities.
 Any loan is given by the partner
 The share of Joint Life Policy
 Share in subsequent Profits
 Interest on Capital

However, we need to debit the following amounts

 Drawings by the deceased partner

 Interest on Drawings
 Loss of Revaluation of assets and liabilities.
 Share in subsequent Losses.

The legal representative of a deceased partner has a right to subsequent profits. He also has a right to
choose whether he wants the share in the profit or the interest at the rate of 6 percent per annum.

There are the following two ways to ascertain the subsequent profit. It is the profit from the date of the last
Balance Sheet until the date of death of the partner.

Browse more Topics under Retirement or Death of a Partner

Methods to calculate the profit of a deceased partner

Time Basis

Under this method, we assume that the profits are earned evenly throughout the year. We estimate the
profit on the basis of the profit of the last year.

Turnover or Sales Basis

Under this method, we consider the profit as well as the total sales of the last year. Hence, we estimate the
profit up to the date of death of the partner on the basis of the sales of the last year.

After all these adjustments, the amount standing in the Deceased Partner’s Capital A/c is payable to his/her
legal representative.

The Journal Entries are

Date Particulars Amount (Dr.) Amount (Cr.)

1. General Reserve A/c Dr.

To Deceased Partner’s Capital A/c

(Being transfer of the share of reserve and

undistributed profit to deceased partner’s
capital)

2. Revaluation A/c Dr.

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To Deceased Partner’s Capital A/c

(Being transfer of the share of revaluation

profit to deceased partner’s capital)

3. Deceased Partner’s Capital A/c Dr.

To Revaluation A/c

(Being transfer of the share of revaluation

loss to deceased partner’s capital)

4. Profit and Loss Suspense A/c Dr.

To Deceased Partner’s Capital A/c

(Being transfer of the share of subsequent

profits to deceased partner’s capital A/c)

5. Deceased Partner’s Capital A/c Dr.

To Profit and Loss Suspense A/c

(Being transfer of the share of subsequent

losses to deceased partner’s capital A/c)

6. Deceased Partner’s Loan A/c Dr.

To Deceased Partner’s Capital A/c

(Being transfer of partner’s loan to deceased

partner’s capital A/c)

7. Joint Life Policy A/c Dr.

To Deceased Partner’s Capital A/c

(Being transfer of the share of the joint life

policy to deceased partner’s capital A/c)

8. Deceased Partner’s Capital A/c Dr.

To Deceased Partner’s Legal

Representative’s A/c

(Being transfer of final amount payable to

his legal representative’s A/c)

9. Deceased Partner’s Legal Representative’s Dr.

A/c

To Bank A/c

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(Being final payment to the Deceased
Partner’s Legal Representative)

Dissolution of firm
When the relation between all the partners of the firm comes to an end, this is called dissolution of the firm.
Section 39 of the Indian Partnership Act, provides that “the dissolution of the partnership between all the
partners of a firm is called the dissolution of a firm.” It implies the complete breakdown of the relation of
partnership between all the partners.

Dissolution of a partnership firm merely involves a change in the relation of partners; whereas the
dissolution of firm amounts to a complete closure of the business. When any of the partners dies, retires or
become insolvent but if the remaining partners still agree to continue the business of the partnership firm,
then it is dissolution of partnership not the dissolution of firm. Dissolution of partnership changes the
mutual relations of the partners. But in case of dissolution of firm, all the relations and the business of the
firm comes to an end. On dissolution of the firm, the business of the firm ceases to exist since its affairs are
would up by selling the assets and by paying the liabilities and discharging the claims of the partners. The
dissolution of partnership among all partners of a firm is called dissolution of the firm.

The dissolution of partnership takes place in any of the following ways

 Change in the existing profit sharing ratio.
 Admission of a new partner
 The retirement of an existing partner
 Death of an existing partner
 Insolvency of a partner as he becomes incompetent to contract. Thus, he can no longer be a partner
in the firm.
 On completion of a specific venture in case, the partnership was formed specifically for that
particular venture.
 On expiry of the period for which the partnership was formed.

Section 39 of the Indian Partnership Act 1932 states that the dissolution of partnership firm among all the
partners of the partnership firm is the Dissolution of the Partnership Firm. The dissolution of partnership
firm ceases the existence of the organization.

After this, the partnership firm cannot enter into any transaction with anybody. It can only sell the assets to
realize the amount, pay the liabilities of the firm and discharge the claims of the partners.

However, the dissolution of a firm may be without or with the intervention of the court. It is noteworthy
here that the dissolution of partnership may not necessarily result in the dissolution of the firm.

But, dissolution of partnership firm always results in the dissolution of the partnership.

Ways in which dissolution of a partnership firm takes place

Dissolution by Agreement

A firm may be dissolved if all the partners agree to the dissolution. Also, if there exists a contract between the
partners regarding the dissolution, the dissolution may take place in accordance with it.

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Compulsory Dissolution

In the following cases the dissolution of a firm takes place compulsorily

 Insolvency of all the partners or all but one partner as this makes them incompetent to enter into a
contract.

 When the business of the firm becomes illegal due to some reason.

 When due to some event it becomes unlawful for the partnership firm to carry its business. For
example, a partnership firm has a partner who is of another country and India declares war against
that country, then he becomes an enemy. Thus, the business becomes unlawful.
When certain contingencies happen

The dissolution of the firm takes place subject to a contract among the partners, if:

 The firm is formed for a fixed term, on the expiry of that term.

 The firm is formed to carry out specific venture, on the completion of that venture.

 A partner dies.

 A partner becomes insolvent.

Dissolution by Notice

When the partnership is at will, the dissolution of a firm may take place if any one of the partners gives
a notice in writing to the other partners stating his intention to dissolve the firm.

Dissolution by Court

When a partner files a suit in the court, the court may order the dissolution of the firm on the basis of the
following grounds:

 In the case where a partner becomes insane

 In the case where a partner becomes permanently incapable of performing his duties.
 When a partner becomes guilty of misconduct and it affects the firm’s business adversely.
 When a partner continuously commits a breach of the partnership agreement.
 In a case where a partner transfers the whole of his interest in the partnership firm to a third party.
 In a case where the business cannot be carried on except at a loss
 When the court regards the dissolution of the firm to be just and equitable on any ground.

Settlement of Accounts

In a case where the partners do not have an agreement regarding the dissolution of the firm, the following
provisions of the Indian Partnership Act 1932 will apply:

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The firm will pay the losses including the deficiency of capital firstly out of the profits, secondly out of the
partner’s capital and lastly by the partners individually in their profit sharing ratio.

The firm shall apply its assets including any contribution to make up the deficiency firstly, for paying the third
party debts, secondly for paying any loan or advance by any partner and lastly for paying back their capitals.
Any surplus left after all the above payments is shared by partners in profit sharing ratio.

Accounting Treatment
On dissolution, the books of the firm are to be closed. Dissolution process starts by opening the following
accounts in the firm’s books:

 Realisation Account,

 Partner’s Loan Account,

 Partners’ Capital Accounts,

 Bank or Cash Account.

Realisation Account
The object of preparing Realisation account is to close the books of accounts of the dissolved firm and to
determine profit or loss on the Realisation of assets and payment of liabilities. It is prepared by:

 Transferring all the assets except Cash or Bank Account to the debit side of the account.
 Transferring all the liabilities except Partner’s Loan Account and Partners’ Capital Accounts to the
credit side of the account.
 Crediting the Receipt on the sale of assets to the account.
 Debiting the payment of Liabilities to the account.
 Debiting the dissolution expenses of the firm.
 The balance in the account may be either profit or loss. We transfer this balance to the Capital
Accounts of the Partners in their profit-sharing ratio.

Browse more Topics under Dissolution of Partnership Firm

Dissolution of Partnership and Settlement of Accounts

Realisation account

Particulars Amount Particulars Amount

To Land and Building A/c By Provision for Doubtful Debts A/c

To Plant and Machinery A/c By Sundry Creditors A/c

To Furniture A/c By Bills Payable A/c

To Stock A/c By Outstanding Expenses A/c

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To Debtors A/c By Bank Loan, Overdraft A/c

To Goodwill A/c By Bank/Cash A/c ( assets realized)

To Investment A/c Land and Building

To Bank/Cash A/c (liabilities paid): Plant and Machinery

Sundry Creditors Furniture

Bills Payable Stock

Outstanding Expenses Debtors

Bank loan, overdraft Bad Debts Recovered

Bank/Cash (expenses realised) Investment

To Partners’ Capital A/c (expenses By Partners’ Capital A/c (taking over of

paid) assets )

To Partners’ Capital A/c (gain) By Partners’ Capital A/c (loss)

Partner’s Loan Account

We do not transfer the loan by a partner to firm to Realisation account, it remains in its account itself. At the
time of settlement, i.e., payment of liabilities, we pay partner’s loan after paying the outside liabilities but
before payment of capital.

Following entry is the entry on payment of Partner’s loan

Date Particulars Amount (Dr.) Amount (Cr.)

Partner’s loan A/c Dr.

To Bank/Cash A/c

(being partners’ loan paid)

Partners’ Capital Accounts

If partners take over firm’s assets, we debit it to their Capital Accounts at the agreed value being payment
against their capital. If a partner takes over the liability of the firm, we credit it to their Capital Accounts. In
addition, we also transfer undistributed profits/losses, reserves and Realisation profit/loss to capital
accounts in their profit-sharing ratio. Entries are:

On transfer of undistributed profits/losses and reserves

Date Particulars Amount (Dr.) Amount (Cr.)

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Profit and Loss A/c Dr.

General reserve A/c Dr.

To Partners’ Capital A/c

(being profit transferred to capital A/c)

Partners’ Capital A/cs Dr.

To Profit and Loss A/c

To Deferred Revenue Expenditure A/c

(being loss transferred to capital Accounts)

Transfer of Realisation profit/ loss

Date Particulars Amount (Dr.) Amount (Cr.)

Realisation A/c

To Partners’ Capital A/c

(being Realisation profit transferred)

Partners’ Capital A/cs

To Realisation A/c

(being Realisation loss transferred)

For final settlement with partners

The partner brings Cash to meet the deficiency in capital

Date Particulars Amount (Dr.) Amount (Cr.)

Bank/Cash A/c Dr.

To Partners’ Capital A/c

(being amount brought by partner)

On payment to partners or closing partners’ capital accounts

Date Particulars Amount (Dr.) Amount (Cr.)

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Partners’ Capital A/c Dr.

To Bank/Cash A/c

(being amount paid to partner)

Bank or Cash Account

On the debit side, we show opening balance, the amount received from the sale of assets and amount
brought by partners. And on the credit side, we show payment of liabilities, expenses and amount paid to
partners.

After settling the claims of the partners, there is no balance in the Bank/Cash Account.

Questions

1. Which of the following is not a type of partnership?

a) General partnership

b) Limited partnership

c) Limited liability partnership

d) Private partnership

2. What is the maximum number of partners allowed in a partnership firm in India?

a) 10

b) 20

c) 50

d) There is no maximum limit

3. What is the formula for calculating the interest on drawings of a partner?

a) Interest on drawings = Rate of interest x Drawings x Time period

b) Interest on drawings = Rate of interest x Capital x Time period

c) Interest on drawings = Rate of interest x Profit x Time period

d) Interest on drawings = Rate of interest x Fixed assets x Time period

4. Which of the following is not a method of maintaining capital accounts of partners?

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a) Fixed capital method

b) Fluctuating capital method

c) Separate capital account method

d) Combined capital account method

5. Which of the following statements is true regarding the distribution of profits in a partnership?

a) Profits must be distributed equally among all partners

b) Profits must be distributed according to the capital contributed by each partner

c) Profits must be distributed according to the drawings made by each partner

d) Profits must be distributed according to the goodwill of each partner

6. What is the treatment of interest on partner's loan in the final accounts of a partnership firm?

a) It is debited to Profit and Loss Appropriation Account

b) It is credited to Profit and Loss Appropriation Account

c) It is shown as a liability in the balance sheet

d) It is shown as an asset in the balance sheet

7. Which of the following statements is true regarding the dissolution of a partnership?

a) Dissolution of partnership leads to the termination of the firm's existence

b) Dissolution of partnership leads to the sale of the firm's assets

c) Dissolution of partnership leads to the formation of a new firm

d) Dissolution of partnership leads to the transfer of ownership of the firm

8. Which of the following is not a reason for the dissolution of a partnership?

a) Retirement of a partner

b) Insanity of a partner

c) Admission of a new partner

d) Mutual agreement of the partners

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9. What is the treatment of accumulated profits in the final accounts of a partnership firm?

a) It is distributed among the partners in their profit-sharing ratio

b) It is shown as a liability in the balance sheet

c) It is shown as an asset in the balance sheet

d) It is transferred to the capital accounts of the partners

10. Which of the following statements is true regarding the admission of a new partner in a
partnership?

a) The new partner has no liability for the firm's previous debts

b) The new partner is liable only for the capital contributed by him/her

c) The new partner is liable for the firm's previous debts to the extent of his/her share in the profits

d) The new partner is liable for the firm's previous debts to the extent of his/her share in the capital

Answer Keys

1. Answer: d) Private partnership is not a recognized type of partnership. General partnership, limited
partnership, and limited liability partnership are the most common types of partnerships.
2. Answer: c) In India, the maximum number of partners allowed in a partnership firm is 50.
3. Answer: a) The correct formula for calculating the interest on drawings of a partner is: Interest on
drawings = Rate of interest x Drawings x Time period
4. Answer: d) Combined capital account method is not a recognized method of maintaining capital
accounts of partners. Fixed capital method, fluctuating capital method, and separate capital account
method are the most common methods.
5. Answer: b) Profits in a partnership must be distributed according to the capital contributed by each
partner, unless otherwise agreed upon in the partnership deed.
6. Answer: a) Interest on partner's loan is debited to Profit and Loss Appropriation Account in the final
accounts of a partnership firm.
7. Answer: a) Dissolution of partnership leads to the termination of the firm's existence. The assets are
sold, liabilities are settled, and any surplus is distributed among the partners.
8. Answer: c) Admission of a new partner is not a reason for the dissolution of a partnership.
Retirement of a partner, insanity of a partner, and mutual agreement of the partners are some of the
common reasons for dissolution.
9. Answer: a) Accumulated profits are distributed among the partners in their profit-sharing ratio in
the final accounts of a partnership firm.

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10. Answer: c) The new partner is liable for the firm's previous debts to the extent of his/her share in
the profits in the case of admission of a new partner in a partnership. This liability can be limited by
agreement between the existing partners and the new partner.

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Chapter 8
Nature and scope of cost accounting
Introduction
Cost: Cost has been defined in the terminology given by the Chartered Institute of Management
Accountants (CIMA) as ‘the amount of expenditure incurred or attributed on a given thing’. More simply, it
can be defined as that which is given or scarified to obtain something. Thus the cost of an article is its
purchase or manufacturing price, i.e. it would consist of its direct material cost, direct labour cost, direct and
indirect expenses allocated or apportioned to it.

Cost accounting: The Chartered Institute of Management Accountants in England (CIMA) has defined Cost
Accounting as, ‘the process of accounting for cost from the point at which expenditure is incurred or
committed to establishment of its ultimate relationship with cost centres and cost units. In its widest usage,
it embraces the preparations of statistical data, the application of cost control methods and the
ascertainment of the profitability of activities carried or planned’. It is a formal mechanism by means of
which costs of products or services are ascertained and controlled.

It is concerned with accumulation, classification, analysis and interpretation of cost data for three
major purposes:

 ascertainment of cost,
 operational planning and control, and
 decision-making

Cost object: A cost object is any item, product, or service that is the focus of a cost analysis.

Direct cost: A direct cost is a cost that can be traced directly to a specific cost object, such as a product or
department.

Indirect cost: An indirect cost is a cost that cannot be traced directly to a specific cost object, but is
necessary for the production of the product or service.

Cost driver: A cost driver is a factor that causes a change in the cost of an activity or process.

Variable cost: A variable cost is a cost that varies with the level of production or activity.

Fixed cost: A fixed cost is a cost that remains constant regardless of the level of production or activity.

Semi-variable cost: A semi-variable cost is a cost that has both variable and fixed components.

Marginal cost: Marginal cost is the additional cost of producing one additional unit of a product or service.

Standard cost: Standard cost is a predetermined cost that is used as a benchmark against actual costs to
evaluate performance.

Cost behaviour: Cost behaviour refers to the way in which costs change as production or activity levels
change.

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Cost-volume-profit analysis: Cost-volume-profit (CVP) analysis is a tool used to determine how changes in
sales volume, costs, and prices affect a company's profits.

Break-even point: The break-even point is the level of sales at which total revenue equals total costs,
resulting in neither a profit nor a loss.

Overhead: Overhead refers to indirect costs that are not directly associated with the production of a
specific product or service.

Functions of accounting
According to Blocker and Weltemer, “Cost Accounting is to serve management in the execution of polices
and in comparison, of actual and estimated results in order that the value of each policy may be appraised
and changed to meet the future conditions”.

 To work out cost per unit of the different products manufactured by the organisation;
 To provide an accurate analysis of this cost;
 To maintain costs to the lowest point consistent with the most efficient operating conditions. It
requires the examination of each cost in the light of the service or benefit obtained so that the
maximum utilization of each rupee will be obtained;
 To work out the wastage in each process of manufacture and to prepare reports as may be
necessary to assist in the control of wastage;
 To provide necessary data for the fixation of selling price of commodities manufactured;
 To compute profits earned on each of the products and to advise management as to how these
profits can be improved;
 To help management in control of inventory so that there may be minimum locking up of capital in
stocks of raw materials, stores, work-in-process and finished goods
 To install and implement cost control systems like Budgetary Control and Standard Costing for the
control of expenditure on materials, labour and overheads;
 To advise management on future expansion;
 To advise management on the profitability or otherwise of new lines of products;
 To carry out special cost studies and investigations which are invaluable to management in
determining policies and formulating plans directed towards profitable operations.

Objections to Cost Accounting

Two of the principal objections against the installation of costing system in a factory are that

 it is unnecessary and
 it is expensive.

It is Unnecessary
In this age of competition in the business world, a manufacturer must know the exact cost not only of each
article made but also of each element of cost, so that his selling price may be reasonably fixed, neither too
high price which may reduce business nor to low price which may lead to loss.

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The main purpose of ascertaining costs is to provide the management with facts and information to carry
on the business in the most efficient manner, and to achieve advantages of a costing system:

 It enables the business to ascertain the exact cost of each specific unit of output and the extent to
which each element of expenditure contributes to such cost.
 It provides a reliable basis upon which tenders and estimates may be prepared.
 It facilitates the detection and prevention of waste, leakage and inefficiency.
 It provides invaluable data for purposes of comparison.
 It provides an independent and collateral check upon the accuracy of financial accounts.
 It enables unprofitable activities of the business disclosed, so that steps may be taken to eliminate
or reduce them.

In view of these advantages, the objection that a costing system is unnecessary is not quite correct.

It is Expensive
When it is desired to introduce a costing system in a manufacturing business, that business must be studied
in detail with special reference to its manufacturing technique and the advice of its technical staff must be
obtained in framing the system of costing. The system to be adopted to a particular case must be adopted
to the requirement and circumstances of that case.

A simple costing system will in many case suffice, and unnecessary elaboration must always be avoided
elaborate costing records should only be kept when their maintenance is warranted, since a system of Cost
Accounting must be profitable investment and produce a benefit commensurate with the expenditure
incurred upon it. It must be simple and it must be elastic and capable of adaptation to changing conditions.
Therefore, it cannot be said that a costing system is expensive.

A good management should be able to benefit greatly from the installation of Cost Accounting, but the
character of management is of vital importance here. Really speaking, the cost accountant can only prepare
information highlighting the points which should be studied, but action is something which is beyond the
cost accountant and is a function of management itself. Unless, therefore, the management is, firstly, willing
to study the information compiled and presented by the cost accountant, secondly, capable of doing that
and, thirdly, willing to take action on the basis of that information, installation of a Cost Accounting system
will prove of no avail.

Scope of Cost Accounting

Cost accounting is being widely applied by the production units to modify the process and maximise the
profit.

 Cost Analysis: Cost accounting determines the deviation of the actual cost as compared to
the planned expense, along with the reason for such variation.
 Cost Audit: To verify the cost sheets and ensure the efficient application of cost accounting
principles in the industries, cost audits are done.
 Cost Report: Cost reports are prepared from the data acquired through cost accounting to
be analysed by the management for strategic decision making.

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 Cost Ascertainment: To determine the price of a product or service, it is essential to know

the total cost involved in generating that product or service.
 Cost Book Keeping: Similar to financial accounting; journal entries, ledger, balance sheet
and profit and loss account is prepared in cost accounting too. Here, the different cost
incurred is debited, and income from the product or service is credited.
 Cost System: It provides for time to time monitoring and evaluation of the cost incurred in
the production of goods and services to generate cost reports for the management.
 Cost Comparison: It examines the other alternative product line or activities and the cost
involved in it, to seek a better opportunity for generating high revenue.
 Cost Control: Sometimes, the actual cost of a product or service becomes higher than its
standard cost. To eliminate the difference and control the actual cost, cost accounting is
required.
 Cost Computation: When the company is engaged in the production of bulk units of a
particular product or commodity, the actual per-unit cost is derived through cost
accounting.
 Cost Reduction: It acts as a tool in the hands of management to find out if there is any
scope of reducing the standard cost involved in the production of goods and services. Its
purpose is to obtain additional gain.

Classification of Cost
Cost Classification by Nature
The cost can be differentiated by its nature or the purpose for which it has occurred.

It can be treated as an expense under this category and the expenses so incurred is divided as follows:

Material: Material cost is the cost of the raw material and its related cost such as procurement cost, taxes,
insurance, freight inwards, etc.

Labour: Labour cost is the salary and wages paid to the employees, i.e. permanent, temporary or
contractual employees working in an organisation. It also includes PF contribution, bonus, commission,
incentives, allowances, overtime pay, etc.

Other Expenses: All the other overheads excluding material and labour comes under this head. Some of
these are packaging, promotion, job processing charges, etc.

Functional Classification of Cost

The categorisation follows the structure of the basic administrative actions of an organisation.

The accumulation of costs is done depending on the vast divisions of procedures such as selling,
production, administration, etc.

Cost of Production

Every cost is concerned with tangible manufacturing or production of the good.

Cost of Commercials

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The cumulative cost of the system of production other than manufacturing expenses. It comprises the
administration cost, distribution, selling cost, etc.

Cost Classification by Relation to Cost Centre

Another basis of differentiating the costs is categorising them by their allocation in the production process
of goods or services.

The points as mentioned earlier under the cost classification by nature are used under this category to
further sub-categorise the elements of this category.

 Direct Cost: Direct cost is the significant cost immediately associated with a production process. It
can be seen as a prime cost for any business. It is sub-divided into direct material cost, direct labour
cost and other direct expenses.
 Indirect Cost: Indirect cost is the cost which cannot be directly allocated to a particular process of
production. It is a secondary cost and is majorly seen as of three types – indirect material cost,
indirect labour cost and other indirect expenses.

Cost Classification by Behaviour

The cost involved in any business process can be differentiated on the grounds of its volatility concerning
the fluctuation in business activity in the short run.

The following classification of cost by its behaviour will give a clear illustration of the above statement

 Fixed Cost: The cost which is hardly affected by the temporary change taking place in business
activity is known as a fixed cost. It includes rent, depreciation, lease, salary, etc.
 Variable Cost: The cost which changes proportionately with the change in production quantity or
other business activity is termed under variable cost. Raw material, packaging, sales commissions,
wages, etc. are variable costs.
 Semi-Variable Cost: The cost which is moderately influenced by the change in business activity is
called semi-variable cost. It includes power consumption, maintenance cost, management cost,
supervision cost, etc.

Cost Classification by Management Decision Making

Cost is not just a price paid to generate some value, but it is also used as a tool by the management for
decision making.

Managerial decisions are framed depending upon the following types of cost involved in carrying out of
business:

 Marginal Cost: Marginal cost is the cost of producing an additional unit and its impact on the total
cost of production.
 Differential Cost: When there is an increment or decrement in the cost of bulk production, the
change in the cost of a single unit is also determined which is known as differential cost.
 Opportunity Cost: The value of one or more products given up to acquire the desired product or
service is known as opportunity cost. For instance; while choosing green tea, a person has to give up
the value he must have derived from coffee or regular tea.
 Replacement Cost: When machinery or any other asset becomes obsolete or involve high
maintenance cost, and simultaneously a better asset is available in the market which can replace it,

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then the cost involved in such substitution is known as replacement cost. For example; a
transportation company needs to replace its trucks from time to time to avoid excessive repairing
expenses.
 Sunk Cost: The cost which has been born by the organisation in the past and cannot be recovered
at any stage of the business process is termed as a sunk cost. Freight inwards paid at the time of
buying machinery has to be written off at the time of selling it.
 Normal Cost: The routine cost associated with the manufacturing of goods or services under usual
circumstances is called a normal cost. It includes all direct expenses such as salary, material, rent, etc.
 Abnormal Cost: The cost that arises suddenly and unknowingly under unfavourable situations is
known as abnormal cost. For instance; workers go on strike, theft or robbery, fire in the premises,
etc.
 Avoidable Cost: Such costs are under the control of management and can be prevented as per the
organisational need. For example; an enterprise upgrades its technology by installing self-operative
machines to avoid the labour charges it pays.
 Unavoidable Cost: The cost which is pre-determined and inevitable is called an unavoidable cost.

Cost Classification by Production Process

This basis of cost classification is significantly applicable in the manufacturing industries or factories where
goods are produced.

All production or manufacturing activities involve different types of costs.

 Batch Cost: The cost incurred while producing a whole lot comprising of identical products (batch)
is known as batch cost. Each batch differs from the other, and the units lying under a batch are
identified by their batch number. Pharmaceuticals, automobiles, electronic products are some of the
examples.
 Process Cost: The cost incurred on performing different operations in a streamlined production
process is termed as a process cost. By dividing the total cost of a process with the number of units
produced, we can derive the process cost of a single unit or product.
 Operation Cost: The cost involved in a particular business function contributing to the production
process is known as operation cost. It helps in regulating the mechanism of business activities by
monitoring the cost incurred on each business operation.
 Operating Cost: Operating cost refers to the day to day expenses incurred by an organisation to
ensure uninterrupted functioning of the business is known as an operating cost.
 Contract Cost: The cost of entering into a contract with a buyer or seller by mutually agreeing to
the terms and conditions so mentioned is called a contract cost. It includes a bidding contract, price
escalation contract, tenders, etc.
 Joint Cost: The combined cost involved in the production of two or more useful products
simultaneously is known as the joint cost. For example; the cost of processing milk to get cottage
cheese and buttermilk.

Cost Classification by Time

The nature, importance and liability of a cost vary as per the time it takes place or has been assessed.

A cost which is a priority today, may not be that important tomorrow or a cost which has been overlooked
today, may be considered as a relevant cost tomorrow.

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 Historical Cost: Any actual cost ascertained and evaluated after it has been incurred, is termed a
historical cost. It can be committed either on the production of goods and services or asset
acquisition.
 Pre-determined Cost: The cost which can be identified and calculated before the production of
goods and services based on the cost factors and data is called a pre-determined cost. It can be
either a standard cost or an estimated cost.
 Standard Cost: An actual cost which is pre-determined as per certain norms and guidelines to
provide as a base for cost control, is termed as a standard cost.
 Estimated Cost: The cost of business operation presumed on the grounds of experience is known
as an estimated cost. It is merely based on assumptions and therefore considered to be less accurate
to determine the actual cost.

Introduction to cost sheet

A cost sheet is a statement that shows the various components of total cost for a product and shows
previous data for comparison. You can deduce the ideal selling price of a product based on the cost sheet.

A cost sheet document can be prepared either by using historical cost or by referring to estimated costs. A
historical cost sheet is prepared based on the actual cost incurred for a product. An estimated cost sheet,
on the other hand, is prepared based on estimated cost just before the production begins.

Cost Sheet – Definitions

All costs incurred or expected to be incurred during a given period are presented in the form of a
statement, popularly called cost sheet or statement of cost or production statement.

The chartered Institute of Management Accountants, London defines cost sheet as “a document which
provides for the assembly of the detailed cost of a cost centre or cost unit” The cost sheet is prepared with
separate columns, one for the cost per unit and the other for the total cost.

Separate columns can also be provided for the current cost and cost of the previous periods. The cost sheet
is generally prepared periodically, say weekly, monthly, quarterly and yearly. There is no prescribed format
or form of the cost sheet. It’s from, contents and arrangement vary from firm to firm.

According to Harold J. Wheldon, “Cost sheets are prepared for the use of the management and
consequently, they must include all the essential details which will assist the management in checking the
efficiency of production.”

According to Walter W. Bigg, The expenditure, which has been incurred upon production for a period, is
extracted from the financial books and the store records, and out in a memorandum statement. If this
statement is confined to the discloser of the cost of the units production during the period, it is termed cost
sheet.

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Importance and objectives of cost sheet

Cost sheets help with a number of essential business processes:

 Determining cost: The main objective of the cost sheet is to obtain an accurate product cost. It
gives you both the total cost and cost per unit of a product.
 Fixing selling price: In order to fix the selling price of a product, you need to create a cost sheet so
you can see the details of its production cost.
 Cost comparison: It helps the management compare the current cost of a product with a previous
per unit cost for the same product. Comparing the costs helps management take corrective
measures if costs have increased.
 Cost control: The cost sheet is an important document for a manufacturing unit, as it helps in
controlling production costs. Using an estimated cost sheet aids in monitoring labour, material and
overhead costs at each step of production.
 Decision-making: Some of the most important decisions management makes are based on the cost
sheet. Whenever a business needs to produce or buy a component, or quote prices for its goods on
a tender, managers refer to the cost sheet.

Functional classification of elements of cost

Under this classification, costs are divided according to the function for which they have been incurred. The
following are the classification of costs based on functions:

 Direct Material Cost

 Direct Employee (labour) Cost
 Direct Expenses
 Production/ Manufacturing Overheads
 Administration Overheads
 Selling Overheads
 Distribution Overheads Research and Development costs etc.

Cost heads in a cost sheet

An organization needs to bear multiple types of overheads while carrying out business operations. In a cost
sheet, the following overheads or expenditure are presented systematically

Prime Cost
The initial cost made for manufacturing a product, i.e., raw material, labour wages and other production-
related expenses, is termed as prime cost.

Following is the equation for computing the prime cost:

Where direct material is calculated with the help of the following formula:

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Works Cost or Factory Cost

The works cost is calculated by summing up the prime cost with the factory overheads and simultaneously
adjusting the opening and closing stocks of work in progress. It can be denoted as:

The various indirect overheads incurred at the factory premises can be computed with the help of the
following formula:

Let us now go through each of the indirect overheads in detail below:

Indirect Material

The indirect material includes all the additional items used for manufacturing products, but not directly
contribute as a raw material for the finished goods. It can be anything like the oil, fuel, coal, stationery items
and other factory utilities.

Also, the items which are though directly used for making a product, but are inexpensive and small, are
considered as indirect material. These include thread, pins, cello tape, nails, nuts, etc.

Indirect Labour

The labour or human resource engaged in all the activities other than manufacturing of goods or services
which are essential to carry out the business and assist the production operations is called indirect labour.

It includes salary paid to managers, cleaning staff, security staff, drivers, etc.

Indirect Expenses

All the other overheads which are neither directly contributing to the production operations, nor they can
be termed as labour or material expense, are called indirect expenses.

These are the expenses made for running the business operations smoothly. These include advertisements,
depreciation, rent, electricity, insurance, taxes, repairs and maintenance, etc.

Cost of Production
The cost of production includes all the direct and indirect cost, including the material, labour and other
expenses, i.e., production cost, factory cost and office or administration cost.

The following formula denotes the computation of cost of production:

After making an adjustment of the opening finished goods and the closing finished goods to the cost of
production, we acquire the cost of production of goods sold.

Further, to calculate the cost of production of goods sold, the opening and closing stocks of finished
products are adjusted with the cost of production. Its formula is:

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Total Cost
The final value of a product or service can be determined after adding all the selling and distribution
expenses to the cost of production of goods sold. The formula to find out the total cost or cost of sales is:

If the sales price of the products or service is known, the following method can be used to determine the
profit:

Cost sheet/statement
An analysis of the total cost of production and cost of sales is carried out by preparing a cost sheet. A cost
sheet is an important document prepared by the costing department. It is prepared to analyse the
components of total cost, thereby determining prime cost, works cost, cost of production, cost of sales and
profit.

Cost sheet is a statement showing the total cost under proper classification in a logical order. It reveals the
total cost as well as the cost per unit in different stages. It shows the various elements of cost that goes to
make up the total cost. It helps in fixing up the selling price more accurately.

A specimen of cost sheet is given below

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Formulas
(1) Prime Cost is the aggregate of direct materials, Direct Labour and Direct Expenses.

Prime Cost = Direct Materials + Direct Labour + Direct Expenses

(2) Works Cost is the aggregate of prime cost and works overhead. It consists of the total of all items of cost
incurred in the manufacturing of a product.

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Works Cost = Prime Cost + Works Overhead.

(3) Cost of production includes works cost and administration overheads. Production is not deemed to be
complete without the managerial and office expenses.

Cost of production = Works Cost + Office and Administration Overheads

(4) Cost of Sales (Total Cost) is the aggregate of all expenses attributable to it. It comprises cost of
production plus selling and distribution overheads.

Cost of Sales = Cost of production + Selling and Distribution overheads

When profit is added to the cost of sales, sales can be found out. Usually selling prices are fixed on the basis
of cost of sales. It ensures that all the costs are recovered and any desired profit is also obtained.

Questions

1. Which of the following best describes cost accounting?

a) The process of identifying, measuring, and analyzing costs

b) The process of producing goods and services
c) The process of selling goods and services
d) The process of marketing goods and services

2. Which of the following is not a benefit of cost accounting?

a) Improved decision-making
b) Enhanced profitability
c) Increased efficiency
d) Increased sales

3. What is the primary purpose of cost accounting?

a) To determine the cost of producing goods and services

b) To increase sales and revenue
c) To reduce expenses
d) To manage human resources

4. Which of the following is not an element of cost?

a) Direct materials
b) Direct labor
c) Indirect labor

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d) Overhead costs

5. Which of the following is not a cost accounting technique?

a) Activity-based costing
b) Standard costing
c) Marginal costing
d) Customer relationship management

Answer Keys

1. Answer: a. Cost accounting is the process of identifying, measuring, and analyzing costs. This
involves gathering information about the costs of producing goods and services, and then using
that information to make decisions about pricing, budgeting, and other business operations.
2. Answer: d. Increased sales is not a benefit of cost accounting. While cost accounting can help a
company make better pricing decisions, it is not directly related to increasing sales.
3. Answer: a. The primary purpose of cost accounting is to determine the cost of producing goods
and services. By understanding the costs associated with each product or service, a company can
make better decisions about pricing and resource allocation.
4. Answer: c. Indirect labor is not an element of cost. Direct materials and direct labor are the costs
directly associated with producing a product or service, while overhead costs are indirect costs like
rent, utilities, and other expenses.
5. Answer: d. Customer relationship management is not a cost accounting technique. It is a business
strategy that focuses on building relationships with customers to increase loyalty and sales. Activity-
based costing, standard costing, and marginal costing are all cost accounting techniques that
involve analyzing and measuring different aspects of a company's costs.

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CHAPTER 9
Insurance claim for loss of stock and loss of
profit
Introduction

Loss of stock
It refers to the loss of inventory or goods that a business owns. This can occur due to a variety of reasons,
such as theft, damage, spoilage, obsolescence, or natural disasters. When a business experiences a loss of
stock, it can have significant financial implications, as the value of the lost goods must be written off as a
cost of doing business.

There are several ways that a loss of stock can impact a business's financial statements. First, it can reduce
the value of the company's assets, as the lost inventory must be deducted from the value of the company's
inventory account. This can also lead to a decrease in the company's net income, as the cost of the lost
inventory must be recorded as an expense.

Another potential impact of a loss of stock is a reduction in the company's profits. This is because the lost
inventory represents potential revenue that the company could have earned if the goods had not been lost.
Depending on the value of the lost inventory, this can have a significant impact on the company's
profitability and overall financial health.

Loss of profit
It refers to a decrease in revenue or an increase in expenses that results in lower profits for a business. This
can occur due to a variety of reasons, such as decreased sales, increased costs, or changes in market
conditions. When a business experiences a loss of profit, it can have significant implications for the
company's financial health and long-term viability.

One potential impact of a loss of profit is a decrease in the company's cash flow. This is because lower
profits mean that the company has less money available to invest in growth opportunities or to pay off
debts. This can also lead to a decrease in the company's stock price, as investors may be less likely to invest
in a company with lower profits.

Another potential impact of a loss of profit is a decrease in the company's ability to attract and retain
talented employees. This is because lower profits may mean that the company is unable to offer
competitive salaries or benefits, which can make it more difficult to attract and retain top talent.
Additionally, a loss of profit can make it more difficult for a company to invest in employee training and
development, which can further impact the company's long-term success.

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Determination of amount of insurance claim

When making an insurance claim, the amount of the claim will need to be determined in order to determine
how much the insurance company will pay out. The amount of the insurance claim will depend on several
factors, including the type of insurance policy, the terms of the policy, the value of the insured property, and
the extent of the damage or loss.

To determine the amount of an insurance claim, there are several steps that need to be taken:

 Review the insurance policy: The first step in determining the amount of an insurance claim is to
review the terms of the insurance policy. This will outline the coverage and limits of the policy, and
provide guidance on what is covered and how much can be claimed.
 Assess the damage or loss: Once the policy has been reviewed, the next step is to assess the
damage or loss. This may involve obtaining estimates from contractors or repair services, or
assessing the value of lost or damaged property.
 Calculate the value of the claim: Once the extent of the damage or loss has been determined, the
next step is to calculate the value of the claim. This will typically involve adding up the costs of
repairs or replacement, and subtracting any applicable deductibles or other limitations.
 Submit the claim: Once the value of the claim has been calculated, the final step is to submit the
claim to the insurance company. The insurance company will review the claim and determine
whether it is covered by the policy, and if so, how much will be paid out.

Memorandum trading account

Prepare Memorandum Trading Account up to the date of fire by collecting figures in respect of opening
stock, purchases, direct expenses and sales from the record. In case the record is destroyed by fire, the
information can be made available from the documentary evidence.

The balancing figure on the credit side of the Memorandum Trading Account is the estimated value of
stock on the date of fire. While preparing Memorandum or Pro forma Trading Account, following points
should be given proper consideration:

Period: This Account is prepared for the period from last date of accounts to the date of fire which is given
in the problem.

Stock (Opening: The basis of valuation of stock should be changed to cost.

If there is undervaluation of stock:

Cost of stock = (100\100 ñ Rate of Undervaluation) × Value of stock

If there is overvaluation of stock:

Cost of stock = (100\100 + Rate of Overvaluation) × Value of stock

Purchases

Purchases should be for the period from last date of accounts to the date of fire.

Goods included in the purchases. Goods received but not accounted should be added to purchases. If the
amount of purchases is not given, the same can be calculated by preparing

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Creditors Account.

Purchases XX

Less: Goods included in purchases but not actually received XX

Add: Unrecorded purchases XX

Less: Purchase Returns XX

Purchases to be debited to Trading A/c XX

Value of Salvaged Stock

Value of stock as calculated at step-2 will be reduced by the value of salvaged stock to arrive at the value of
Insurance Claim.

Other Important Points

In case, where stock is not valued at the cost, first it will be valued at the cost in the last year trading
account and then in the memorandum account of the current year. For example, if it is given that stock of
Rs. 80,750 is valued at 85% of the cost in the last year, then first it should be valued
as (80,75085×100)=95,000(80,75085×100)=95,000 in the last year and then in the current year memorandum
Trading account.

Cost of the sample given free of cost or withdrawal of stock by proprietor or partner of the firm for personal
use, it should be adjusted in the Trading Account of the last year as well as in the current year’s
memorandum trading account.

In case, where gross profits of the last several years are given, average gross profit should be taken to
determine the gross profit of the current year. However, in case where clear upward trend of the gross
profit or downward trend of the gross profit is identified, weighted average gross profit or reasonable trend
of upward or downward trend should be applied to determine the gross profit of the current year.

To find out the gross profit on normal sales, poor selling sale should be eliminated from the sale of the
current year. Similarly, poor selling items should be eliminated from the opening and closing stock of the
last years to prepare the trading account of the current year.

Consequential Loss Insurance

A normal fire policy only indemnifies loss of stock or assets, and fails to insure any loss of profit suffered by
the concerned business. Therefore, a consequential loss policy should be taken to cover the Loss of profit,
Loss of Fixed expenditure, etc.

Following are the important terms used in loss of profit policy −

Insured Standing Charges − Salaries to staff, Rent rates & Taxes, Wages to skilled workers, Auditors’ fees,
Directors’ fees, Advertisement Expenses, Travelling Expenses, Interest on debentures, and unspecified
expenses (not more than 5% of the specified expenses) are the charges that have to mention on the policy
form at the time of buying policy (so that all charges get insured).

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Turnover − Turnover includes sold goods or services for which amount is payable; it also needs to be
insured.

Annual Turnover − Turnover for the last 12 months, immediately preceding to the date of fire.

Standard Turnover − Standard turnover means, turnover for the period corresponding with the indemnity
period during the preceding accounting year. It also needs to be adjusted to notice the trend during the
accounting year, in which incident took place.

Gross Profit − It is calculated as

Gross profit = Net profit + Insured standing charges

Net Profit − To calculate net profit — profit (excluding tax), insured standing charges, other charges,
depreciation, and other provisions of such kind need to be adjusted.

Indemnity Period − Maximum twelve months (from the date of damage), during which the result of the
business affected due to damage. Period of indemnity is selected by the insured person.

Computation of Claim
Following steps need to be taken to compute insurance claim on the loss of the profit, which is occurred
due to dislocation of the business −

Short Sale − Short sale means loss of sale due to the incident of fire and subsequent dislocation of the
business. The difference of standard turnover and the actual turnover during the period of indemnity is
called short sale. It is illustrated in the following example.

Example

Calculate short sale according to the particulars given below –

Date of Fire occurs 01-06-2013

Period of dislocation of business 4 months

Standard Sale 500,00

Increased trend 15%

Actual Sale 300,000

Solution

Computation of Short Sale

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Standard turnover (Rs. 50,000 + 15%)(A) 575,000

Less: Actual Sale(B) 300,000

Short Sale(A-B) 275,000

Rate of Gross Profit − It is calculated as

Note − All figures given above are related to the last accounting year.

Note − All figures given above are related to the last accounting year.

In case where all the standing charges are not insured, amount of net loss need to reduce as –

Loss Due to Short Sale − It is calculated as

Increased Cost of Working − Increased cost of working means, certain additional expenses those have to
be incurred by insured person to keep the business in running condition during the indemnity period.

Least of following figures will be considered as increased cost of working –

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