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UG B.com Commerce (English) 102 14 Financial Accounting

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172 views364 pages

UG B.com Commerce (English) 102 14 Financial Accounting

Uploaded by

prince862400
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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ALAGAPPA UNIVERSITY

[Accredited with ‘A+’ Grade by NAAC (CGPA:3.64) in the Third Cycle


and Graded as Category–I University by MHRD-UGC]
(A State University Established by the Government of Tamil Nadu)

KARAIKUDI – 630 003

Directorate of Distance Education

B.Com.
I - Semester
102 14

FINANCIAL ACCOUNTING
Reviewer

Assistant Professor,
Dr. R. Ganapathi
Directorate of Distance Education,
Alagappa University, Karaikudi

Authors:
Dr. S.N. Maheshwari, Professor Emeritus and Academic Advisor Delhi Institute of Advanced Studies, Delhi
Dr. Suneel K. Maheshwari, Professor of Accounting, Eberly College of Business and Information Technology,
Indiana University of Pennsylvania, USA
CA Sharad K. Maheshwari, Maheshwari Sharad & Co. Chartered Accountants, Gurugram, Haryana

"The copyright shall be vested with Alagappa University"

All rights reserved. No part of this publication which is material protected by this copyright notice
may be reproduced or transmitted or utilized or stored in any form or by any means now known or
hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording
or by any information storage or retrieval system, without prior written permission from the Alagappa
University, Karaikudi, Tamil Nadu.

Information contained in this book has been published by VIKAS® Publishing House Pvt. Ltd. and has
been obtained by its Authors from sources believed to be reliable and are correct to the best of their
knowledge. However, the Alagappa University, Publisher and its Authors shall in no event be liable for
any errors, omissions or damages arising out of use of this information and specifically disclaim any
implied warranties or merchantability or fitness for any particular use.

Vikas® is the registered trademark of Vikas® Publishing House Pvt. Ltd.


VIKAS® PUBLISHING HOUSE PVT. LTD.
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Work Order No. AU/DDE/DE1-238/Preparation and Printing of Course Materials/2018 Dated 30.08.2018 Copies - 500
SYLLABI-BOOK MAPPING TABLE
Financial Accounting
Syllabi Mapping in Book

BLOCK I: BASIC FINANCIAL ACCOUNTING AND CONCEPTS


Unit 1: Basic Concepts of Financial
UNIT – I: Financial Accounting – Meaning of Book Keeping, Accounting
Accounting and Accountancy - Distinction between Book Keeping and (Pages 1-20)
Accounting, Accounting Process - Objectives of Accounting - Various Unit 2: Accounting Concepts:
users of Accounting Information, Limitations of Accounting - Accounting Principles and Conventions
Terminologies. (Pages 21-39)
Unit 3: Recording of Transactions
UNIT – II: Accounting Concepts - Principles and Conventions – Meaning
(Pages 40-56)
of Accounting Concepts – Principles – Conventions - Types of Accounting
Unit 4: Secondary Books
Concepts - Types of Accounting Principles - Types of Accounting
(Subsidiary Books)
Conventions - Accounting standards - International Financial Reporting
(Pages 57-88)
Standards [IFRS].

UNIT – III: Recording of Transactions - Meaning of Assets – Liabilities


– Equity - Accounting Equation and Effects of Financial Transaction on
Accounting Equation - Classification of Accounts under Modern Approach
Method - Double Entry System and Rules of Debit and Credit Entries.

UNIT – IV: Secondary Books – Cash Book - Petty Cash Book - Ledger.

BLOCK II: FINAL ACCOUNTS AND ADJUSTMENTS Unit 5: Trial Balance and Rectification
of Errors
UNIT – V: Trial Balance and Rectification of Errors - Error in Accounting. (Pages 89-111)
Unit 6: Final Accounts- I
UNIT – VI: Final Accounts – 1 – Meaning - Objectives and Characteristics (Pages 112-139)
of Final Accounts - Adjustments before Preparing Final Accounts - Closing Unit 7: Final Accounts- II
Entries.
(Pages 140-174)
Unit 8: Bank Reconciliation Statement
UNIT – VII: Final Accounts – 2 – Trading Account - Profit and Loss
(Pages 175-190)
Account - Balance Sheet - Treatment of Adjustments - Practical Problems.

UNIT – VIII: Bank Reconciliation Statement - Meaning of Bank


Reconciliation Statement - Importance of Bank Reconciliation Statement
- Reasons for Difference - Procedure for Reconciliation.

BLOCK III: PARTNERSHIP ACCOUNTS Unit 9: Bills of Exchange


(Pages 191-210)
UNIT – IX: Bills of Exchange - Acceptance of a Bill - Due Date - Recording Unit 10: Partnership Accounts
of Bill of Exchange in the books of Accounts. (Pages 211-234)
Unit 11: Retirement and Death
UNIT – X: Partnership Accounts - Admission of a Partner - Partnership - of a Partner
Meaning and Features - Partnership Deed and Contents - Admission of a (Pages 235-254)
Partner - Good will-Meaning - Accounting Treatment of Goodwill at the
Time of Admission - Revaluation of Assets and Liabilities - Adjustments of
Reserves and Accumulated Profits or Losses.
UNIT – XI: Retirement and Death of a Partner – Meaning of Retirement
of Partner - Calculation of New Profit Sharing Ratio and Gaining Ratio
- Adjustments with Regard to Goodwill - Revaluation of Assets and Unit 12: Depreciation Accounting
Liabilities - Settling the Claim of Retiring Partner - Death of Partner. (Pages 255-280)
Unit 13: Company Accounts-I
BLOCK IV: COMPANY ACCOUNTS (Pages 281-320)
Unit 14: Company Accounts-II
UNIT – XII: Depreciation Accounting: Meaning of Depreciation - Causes
(Pages 321-354)
for Depreciation, Need for Depreciation - Computation of the Amount of
Depreciation - Depreciation on Additions to Fixed Assets - Methods of
Depreciation, Revised AS 6.

UNIT – XIII: Company Accounts – Kinds of Companies - Formation


of Companies - Share Capital - Issue of Shares - Under Subscription &
Oversubscription - Issue of Shares at Premium & Discount - Buyback of
Shares and Treasury Stock - Accounting Treatments and Ledger Preparation.

UNIT – XIV: Company Accounts – Forfeiture of Shares - Reissue of Shares


- Issue of Bonus Shares - Rights Issue - Share Split - Buy Back of Shares
- Redemption of Preference Shares - Debentures.
CONTENTS
INTRODUCTION
BLOCK I: BASIC FINANCIAL ACCOUNTING AND CONCEPTS
UNIT 1 BASIC CONCEPTS OF FINANCIAL ACCOUNTING 1-20
1.0 Introduction
1.1 Objectives
1.2 Meaning of Book-Keeping and Accounting and Distinction Between Them
1.2.1 Accounting and Accountancy
1.2.2 Various Users of Accounting Information
1.2.3 Objectives of Accounting
1.2.4 Limitations of Accounting
1.3 Accounting system and Process
1.3.1 Accounting Equation
1.3.2 Double Entry System and Single Entry System
1.3.3 Systems of Accounting
1.4 Accounting Terminologies
1.5 Answers to Check Your Progress Questions
1.6 Summary
1.7 Key Words
1.8 Self Assessment Questions and Exercises
1.9 Further Readings

UNIT 2 ACCOUNTING CONCEPTS: PRINCIPLES AND CONVENTIONS 21-39


2.0 Introduction
2.1 Objectives
2.2 Meaning and Types of Accounting Concepts
2.3 Accounting Convention and Its Types
2.4 Accounting Principles
2.5 Accounting Standards
2.5.1 International Accounting Standards Committee and IAS/IFRS
2.6 Answers to Check Your Progress Questions
2.7 Summary
2.8 Key Words
2.9 Self Assessment Questions and Exercises
2.10 Further Readings

UNIT 3 RECORDING OF TRANSACTIONS 40-56


3.0 Introduction
3.1 Objectives
3.2 Meaning of Assets, Liabilities and Equity, and Modern Approach to Classify Accounts
3.2.1 Classification of Accounts under Modern Approach Method
3.3 Journal
3.3.1 Rules of Debit and Credit
3.3.2 Compound Journal Entry
3.3.3 Opening Entry
3.4 Answers to Check Your Progress Questions
3.5 Summary
3.6 Key Words
3.7 Self Assessment Questions and Exercises
3.8 Further Readings

UNIT 4 SECONDARY BOOKS (SUBSIDIARY BOOKS) 57-88


4.0 Introduction
4.1 Objectives
4.2 Different Types of Journals
4.3 Ledger
4.4 Answers to Check Your Progress Questions
4.5 Summary
4.6 Key Words
4.7 Self Assessment Questions and Exercises
4.8 Further Readings

BLOCK II: FINAL ACCOUNTS AND ADJUSTMENTS


UNIT 5 TRIAL BALANCE AND RECTIFICATION OF ERRORS 89-111
5.0 Introduction
5.1 Objectives
5.2 Trial Balance
5.3 Errors in Accounting and Its Rectification
5.3.1 Location of Errors
5.3.2 Rectifying Accounting Entries
5.4 Answers to Check Your Progress Questions
5.5 Summary
5.6 Key words
5.7 Self Assessment Questions and Exercises
5.8 Further Readings

UNIT 6 FINAL ACCOUNTS- I 112-139


6.0 Introduction
6.1 Objectives
6.2 Meaning, Objectives and Characteristics of Final Accounts
6.2.1 Characteristics of Final Accounts
6.2.2 Objectives of Final Accounts
6.3 Adjustments Before Preparing Final Accounts
6.4 Answers to Check Your Progress Questions
6.5 Summary
6.6 Key Words
6.7 Self Assessment Questions and Exercises
6.8 Further Readings
UNIT 7 FINAL ACCOUNTS- II 140-174
7.0 Introduction
7.1 Objectives
7.2 Trading Account
7.3 Profit and Loss Account
7.4 Balance Sheet
7.4.1 Treatment of Adjustments
7.5 Practical Problems
7.6 Answers to Check Your Progress Questions
7.7 Summary
7.8 Key Words
7.9 Self Assessment Questions and Exercises
7.10 Further Readings

UNIT 8 BANK RECONCILIATION STATEMENT 175-190


8.0 Introduction
8.1 Objectives
8.2 Meaning, Importance and Procedure of Reconciliation
8.2.1 Reasons for Difference
8.2.2 Meaning and Importance of Bank Reconciliation Statement
8.2.3 Technique or Procedure of Preparing Bank Reconciliation Statement
8.3 Answers to Check Your Progress Questions
8.4 Summary
8.5 Key Words
8.6 Self Assessment Questions and Exercises
8.7 Further Readings

BLOCK III: PARTNERSHIP ACCOUNTS


UNIT 9 BILLS OF EXCHANGE 191-210
9.0 Introduction
9.1 Objectives
9.2 Bills of Exchange: Fundamental Concepts
9.3 Recording of Bill of Exchange in the Books of Account
9.4 Answers to Check Your Progress Questions
9.5 Summary
9.6 Key Words
9.7 Self Assessment Questions and Exercises
9.8 Further Readings

UNIT 10 PARTNERSHIP ACCOUNTS 211-234


10.0 Introduction
10.1 Objectives
10.2 Partnership: Meaning, Features, Deed and Contents
10.3 Admission of a Partner
10.4 Answers to Check Your Progress Questions
10.5 Summary
10.6 Key Words
10.7 Self Assessment Questions and Exercises
10.8 Further Readings

UNIT 11 RETIREMENT AND DEATH OF A PARTNER 235-254


11.0 Introduction
11.1 Objectives
11.2 Retirement of a Partner
11.3 Death of a Partner
11.4 Answers to Check Your Progress Questions
11.5 Summary
11.6 Key Words
11.7 Self Assessment Questions and Exercises
11.8 Further Readings

BLOCK IV: COMPANY ACCOUNTS


UNIT 12 DEPRECIATION ACCOUNTING 255-280
12.0 Introduction
12.1 Objectives
12.2 Depreciation: Meaning, Need and Cause
12.2.1 Causes of Depreciation
12.2.2 Basic Features of Depreciation
12.2.3 Meaning of Depreciation Accounting
12.2.4 Objectives of Providing Depreciation
12.2.5 Fixation of Depreciation Amount
12.2.6 Methods of Recording Depreciation
12.3 Methods for Providing Depreciation
12.4 Answers to Check Your Progress Questions
12.5 Summary
12.6 Key Words
12.7 Self Assessment Questions and Exercises
12.8 Further Readings

UNIT 13 COMPANY ACCOUNTS-I 281-320


13.0 Introduction
13.1 Objectives
13.2 Meaning and Characteristics of Companies
13.3 Kinds of Companies
13.4 Formation of Companies
13.5 Share Capital
13.6 Undersubscription, Oversubscription and Issue of Shares at Premium and Discount
13.7 Buyback of Shares and Treasury Stock
13.8 Answers to Check Your Progress Questions
13.9 Summary
13.10 Key Words
13.11 Self Assessment Questions and Exercises
13.12 Further Readings
UNIT 14 COMPANY ACCOUNTS-II 321-354
14.0 Introduction
14.1 Objectives
14.2 Forfeiture of Shares
14.3 Redemption of Preference Shares
14.4 Right Issue
14.5 Debentures
14.6 Answers to Check Your Progress Questions
14.7 Summary
14.8 Key Words
14.9 Self Assessment Questions and Exercises
14.10 Further Readings
Introduction
INTRODUCTION
Good accountants make good finance managers. This is wholly true since
NOTES accounting is one of the important tools for modern managers providing
quantitative information, primarily of financial nature, necessary for
making vital economic decisions. Both accounting and finance are growing
and developing subjects and as such, accounting and financial concepts,
procedures and techniques are also constantly being reviewed and revised.
A clear exposition of these concepts, procedures and techniques is a must
for every business executive. The universities and professional institutions
which prepare young men and women for careers in business and industry
have, therefore, a solemn duty to perform. Their courses must be constantly
updated so that they meet the growing and dynamic demands of business
and industry.
Keeping in mind the requirement of financial accounting, we will
discuss in this book, the basic financial accounting concepts, the accounting
entries related to final accounts and adjustments, the accounting treatment
of partnership accounts and the provisions related to maintaining company
accounts.
This book, Financial Accounting, is written with the distance learning
student in mind. It is presented in a user-friendly format using a clear, lucid
language. Each unit contains an Introduction and a list of Objectives to
prepare the student for what to expect in the text. At the end of each unit are
a Summary and a list of Key Words, to aid in recollection of concepts learnt.
All units contain Self Assessment Questions and Exercises, and strategically
placed Check Your Progress questions so the student can keep track of what
has been discussed.

Self-Instructional
10 Material
Basic Concepts of
Financial Accounting
BLOCK - I
BASIC FINANCIAL ACCOUNTING AND CONCEPTS
NOTES
UNIT 1 BASIC CONCEPTS OF
FINANCIAL ACCOUNTING
Structure
1.0 Introduction
1.1 Objectives
1.2 Meaning of Book-Keeping and Accounting and Distinction Between Them
1.2.1 Accounting and Accountancy
1.2.2 Various Users of Accounting Information
1.2.3 Objectives of Accounting
1.2.4 Limitations of Accounting
1.3 Accounting system and Process
1.3.1 Accounting Equation
1.3.2 Double Entry System and Single Entry System
1.3.3 Systems of Accounting
1.4 Accounting Terminologies
1.5 Answers to Check Your Progress Questions
1.6 Summary
1.7 Key Words
1.8 Self Assessment Questions and Exercises
1.9 Further Readings

1.0 INTRODUCTION
Accounting has rightly been termed as the language of the business. The basic
function of a language is to serve as a means of communication. Accounting
also serves this function. It communicates the result of business operations
to various parties who have some stake in the business, viz., the proprietor,
creditors, investors, Government and other agencies. Though accounting is
generally associated with business but it is not only business which makes use
of accounting. Persons like housewives, Government and other individuals
also make use of accounting. For example, a housewife has to keep a record
of the money received and spent by her during a particular period. She can
record here receipts of money on one page of her “household diary”, while
payments for different items such as milk, food, clothing, house, education,
etc., on some other page or pages of her diary in a chronological order. Such
a record will help her in knowing about:
(i) The sources from which she received cash and the purposes for which
it was utilised.
Self-Instructional
Material 1
Basic Concepts of (ii) Whether her receipts are more than her payments or vice versa?
Financial Accounting
(iii) The balance of cash in hand or deficit, if any, at the end of a period.
In case the housewife records her transactions regularly, she can
NOTES collect valuable information about the nature of her receipts and payments.
For example, she can find out the total amount spent by her during a period
(say, a year) on different items, say milk, food, education, entertainment,
etc. Similarly, she can find the sources of her receipts such as salary of her
husband, rent from property, cash gifts from her near relations, etc. Thus, at
the end of a period (say, a year) she can see for herself about her financial
position, i.e., what she owns and what she owes. This will help her in planning
her future income and expenses (or making out a budget) to a great extent.
The need for accounting is all the more greater for a person who
is running a business. He knows: (i) What he owns? (ii) What he owes?
(iii) Whether he has earned a profit or suffered a loss on account of running
a business? (iv) What is his financial position, i.e., whether he will be in a
position to meet all his commitments in the near future or he is in the process
of becoming a bankrupt.

1.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss the meaning and differences between Book-Keeping and
accounting
• Describe the concepts of accounting and accountancy
• Explain the various users of accounting information
• Identify the objectives of accounting
• Examine the accounting system and process
• Explain the limitation of accounting
• Discuss the accounting terminologies

1.2 MEANING OF BOOK-KEEPING AND


ACCOUNTING AND DISTINCTION BETWEEN
THEM
Some people take book-keeping and accounting as synonymous terms, but
they are different from each other. Book-keeping is mainly concerned with
recording of financial data relating to the business operations in a significant
and orderly manner. A book-keeper may be responsible for keeping all
the records of a business or only of a minor segment, such as a position of
the Customers’ accounts in a departmental store. A substantial portion of the

Self-Instructional
2 Material
book-keeper’s work is of a clerical nature and is increasingly being Basic Concepts of
Financial Accounting
accomplished through the use of mechanical and electronical devices.
Accounting is primarily concerned with designing the systems for
recording, classifying and summarizing the recorded data and interpreting
NOTES
them for internal and external endusers. Accountants often direct and
review the work of the book-keepers. The larger the firm, the greater is the
responsibility of the accountant. The work of an accountant in the beginning
may include some book-keeping. An accountant is required to have a much
higher level of knowledge, conceptual understanding and analytical skill
than what is required for a book-keeper.
The difference between book-keeping and accounting can be well
understood with the help of the following example:
If A sells goods to B on credit, the only fundamental principle involved
is of “dual aspect” and to give a true picture of the transaction, both the
aspects must be considered. On the one hand, A has lost one asset, i.e., good
and on the other hand, he has obtained another asset, i.e., a “debt due from
B”. The book-keeper should debit B’s account in A’s books and credit the
sales account. However, if at the end of a year, A has got some stock of goods
with him, they should be properly valued in order to ascertain the true profit
of the business. The principle to be followed in valuing the stock and many
adjustment that will have to be made before the books of account can be
closed and true profit or loss can be ascertained, are all matters of accounting.
Thus, book-keeping is more of a routine work and a book-keeper, if instructed
properly, can record the routine transactions quite efficiently even if he does
not know much of accounting principles.
Is Accounting A ‘Science’ or An ‘Art’?
Any organized knowledge based on certain basic principles is a ‘science’.
Accounting is also a science. It is a organized knowledge based on scientific
principles which have been developed as result of study and experience. Of
course, accounting cannot be termed as a “perfect science” like Physics or
Chemistry where experiments can be carried and perfect conclusions can be
drawn. It is a social science depending much on human behaviour and other
social and economic factors. Thus, perfect conclusions cannot be drawn.
Some people, therefore, though not very correctly, do not take accounting
as a science.
Art is the technique which helps us in achieving our desired objective.
Accounting is definitely an art. The American Institute of Certified Public
Accountants also defines accounting as “the art of recording, classifying and
summarizing the financial transactions”. Accounting helps in achieving our
desired objective of maintaining proper accounts, i.e., to know the profitability
and the financial position of the business, by maintaining proper accounts.
Self-Instructional
Material 3
Basic Concepts of 1.2.1 Accounting and Accountancy
Financial Accounting
Honestly speaking, in today’s world, there is not much difference between
accounting and accountancy. The terms have become pretty much
NOTES interchangeable. Accounting is traditionally one of the three principles
of accountancy (the others were bookkeeping and auditing), which was
the application of reading and maintaining the financial records of said
company. Traditionally, accountancy is the parent term for the entire field
and accounting was a specific duty of an accountant. Accountancy is referred
to as the actual process of communicating information about the financial
state of a company to its shareholders, usually in the form of financial
statements, which show the assets and resources under the company’s control
in monetary terms.
1.2.2 Various Users of Accounting Information
Accounting is of primary importance to the proprietors and the managers.
However, other persons such as creditors, prospective investors, employees,
etc., are also interested in the accounting information.
1. Proprietors A business is done with the objective of making profit.
Its profitability and financial soundness are, therefore, matters of prime
importance to the proprietors who have invested their money in the
business.
2. Managers In a sole proprietary business, usually the proprietor is the
manager. In case of a partnership business either some or all the partners
participate in the management of the business. They, therefore, act
both as managers as well as owners. In case of joint stock companies,
the relationship between ownership and management becomes all the
more remote. In most cases the shareholders act merely as rentiers
of capital and the management of the company passes into the hands
of professional managers. The accounting disclosures greatly help
them in knowing about what has happened and what should be done
to improve the profitability and financial position of the enterprise in
the period to come.
3. Creditors Creditors are the persons who have extended credit to the
company. They are also interested in the financial statements because
these will help them in ascertaining whether the enterprise will be in a
position to meet its commitment towards them both regarding payment
of interest and principal.
4. Prospective Investors A person who is contemplating an investment
in a business will like to know about its profitability and financial
position. A study of the financial statements will help him in this
respect.

Self-Instructional
4 Material
5. Government The Government is interested in the financial statements Basic Concepts of
Financial Accounting
of business enterprise on account of taxation, labour and corporate
laws. If necessary, the Government may ask its officials to examine
the accounting records of a business.
NOTES
6. Employees The employees are interested in the financial statements
on account of various profit sharing and bonus schemes. Their interest
may further increase in case they purchase shares of the companies in
which they are employed.
7. Citizen An ordinary citizen may be interested in the accounting records
of the institutions with which he comes in contact in his daily life,
e.g., bank, temple, public utilities such as gas, transport and electricity
companies. In a broader sense, he is also interested in the accounts of
a government company, a public utility concern etc., as a voter and a
tax-payer.
1.2.3 Objectives of Accounting
The following are the main objectives of accounting:
1. To keep systematic records Accounting is done to keep a systematic
record of financial transactions. In the absence of accounting there
would have been terrific burden on human memory which is most
cases would have been impossible to bear.
2. To protect business properties Accounting provides protection to
business properties from unjustified and unwarranted use. This is
possible on account of accounting supplying the following information
to the manager or the proprietor.
(i) The amount of the propreitor’s funds invested in the business.
(ii) How much the business has to pay to others?
(iii) How much the business has to recover from others?
(iv) How much the business has in the form of (a) fixed assets, (b), cash
in hand, (c) cash at bank, (d) stock of raw materials, work-in-
progress and finished goods?
Information about the above matters helps the proprietor in
assuming that the funds of the business are not unnecessarily kept
idle or under-utilised.
3. To ascertain the operational profit or loss Accounting helps in
ascertaining the net profit earned or loss suffered on account of carrying
the business. This is done by keeping a proper record of revenues and
expenses of a particular period. The Profit and Loss Account is prepared
at the end of a period and if the amount of revenue for the period is
more than the expenditure incurred in earning that revenue, there is

Self-Instructional
Material 5
Basic Concepts of said to be a profit. In case the expenditure exceeds the revenue, there
Financial Accounting
is said to be a loss.
Profit and Loss Account will help the management, investors, creditors,
etc., in knowing whether running of the business has proved to be
NOTES
remunerative or not. In case it has not proved to be remunerative or
profitable, the cause of such a state of affairs will be investigated and
necessary remedial steps will be taken.
4. To ascertain the financial position of business The profit and Loss
Account gives the amount of profit or loss made by the business during
a particular period. However, it is not enough. The businessman must
know about his financial position, i.e., where he stands what he owes
and what he owns? This objective is served by the Balance Sheet or
Position Statement. The Balance Sheet is a statement of assets and
liabilities of the business on a particular date. It serves as barometer
for ascertaining the financial health of the business.
5. To facilitate rational decision making Accounting these days has
taken upon itself the task of collection, analysis and reporting of
information at the required points of time to the required levels of
authority in order to facilitate rational decision making. The American
Accounting Association has also stressed this point while defining
the term ‘accounting’ when it says that accounting is, “the process of
identifying, measuring and communicating economic information to
permit informed judgments and decisions by users of the information.”
Of course, this is by no means an easy task. However, the accounting
bodies all over the world and particularly the International Accounting
Standards Committee, have been trying to grapple with this problem
and have achieved success in laying down some basic postulates on
the basis of which the accounting statements have to be prepared.
1.2.4 Limitations of Accounting
Financial accounting well answered the needs of business in the initial stages
when the business was not so complex. The growth and complexities of
modern business brought out the following limitations of financial accounting:
1. Provides only limited information There are now no set patterns
of business on account of radical changes in business activities. An
expenditure may not bring an immediate advantage to the business
but it may have to be incurred because it may bring advantage to the
business in the long run or may be necessary simply to sell the name
of the business. The management needs a lot of varied information to
decide whether on the whole it will be justifiable to incur a particular
expenditure or not. Financial accounting fails to provide such
information.
Self-Instructional
6 Material
2. Treats figures as single, simple and silent items Financial accounting Basic Concepts of
Financial Accounting
fails to make the people realize that accounting figures are not mere
isolated phenomena but they represent a chain of purposeful and
pertinent events. The role of accountant these days is not only of a
book-keeper and auditor, but also that of a financial adviser. Recording NOTES
of transactions is now the secondary function of the accountant. His
primary function now is to analyse and interpret the results.
3. Provides only a post-mortem record of business transactions Financial
accounting provides only a post-mortem record of business transactions
since it records transactions only on historical basis. These days
business decisions are made on the basis of estimates and projections
rather than historical facts. Of course, past records are helpful in
making future projections but they alone are not sufficient. Thus, needs
of modern management demand a break-up from the principles and
practice of traditional accounting.
4. Considers only quantifiable information Financial accounting
considers only those factors which are capable of being quantitatively
expressed. In modern times, the concept of welfare state has resulted in
increased government interference in all sectors of the national economy.
The management has, therefore, to take into account government
decisions over and above purely commercial considerations. Some
of these factors are not capable of being quantitatively expressed and
hence their impact is not reflected in financial statements.
5. Fails to provide informational needs of different levels of
management The shareholders are only rentiers of capital. The
business is run in reality by different executives, each an expert in his
area. These executives have powers based on the level of management
to which they belong. There are usually three levels of management—
top management, middle management and lower management. The type
of information required by each level of management is different. The
top management is mainly concerned with the policy decisions. They,
therefore, are interested in knowing about the soundness of the plans,
proper structuring of the organization, proper delegation of authority
and its effectiveness. The middle management executives function
as coordinators. They must know: (i) What happened? (ii) Where
it happened? and (iii) Who is responsible? The lower management
people function as operating supervisors. They should get information
regarding effectiveness of their operations. The reports submitted
to them should give details about the planned performance, actual
performance and the deviations with their reasons. Financial accounting
does not have a built-in system to provide all such information.

Self-Instructional
Material 7
Basic Concepts of
Financial Accounting
Check Your Progress
1. List some of the users of accounting information.
NOTES 2. Which accounting tool helps to ascertain the financial position of a
business??

1.3 ACCOUNTING SYSTEM AND PROCESS


Book-keeping, as explained earlier, is the art of recording pecuniary or
business transactions in a regular and systematic manner. This recording of
transactions may be done according to any of the following two systems:
1. Single entry system An incomplete double entry system can be termed
as a single entry system. According to Kohler, “it is a system of book-
keeping in which as a rule only records of cash and personal accounts
are maintained, it is always incomplete double entry, varying with
circumstances”. This system has been developed by some business
houses, who for their convenience, keep only some essential records.
Since all records are not kept, the system is not reliable and can be
used only by small firms.
2. Double entry system The system of ‘double entry’ book-keeping
which is believed to have originated with the Venetian merchants of the
fifteenth century, is the only system of recording the two-fold aspect
of the transaction. This has been, to some extent, explained while
discussing the ‘dual aspect concept’ earlier in this unit. The system
recognises that every transaction has a two-fold effect. If some one
receives something then either some other person must have given it,
or the first mentioned person must have lost something, or some service
etc., must have been rendered by him.
1.3.1 Accounting Equation
The double entry system of book-keeping can very well be explained by the
“accounting equation” given below:
Assets = Equities
The properties owned by business are called ‘assets’. The rights to
the properties are called ‘Equities’. Equities may be sub-divided into two
principal types: the rights of the creditors and the rights of the owners.
The equity of creditors representing debts of the business and are called
“liabilities”. The equity of owners is called “capital”, or proprietorship or
owner’s equity. Thus:
Assets = Liabilities + Capital
or Capital = Assets – Liabilities
Self-Instructional
8 Material
The accounting equation can be understood with the help of the Basic Concepts of
Financial Accounting
following transactions:
Transaction 1. A starts business with a capital of `10,000
There are two aspects of the transaction. The business has received cash of NOTES
`10,000. It is its asset but on the other hand it has to pay a sum of `10,000
to A, the Proprietor.
Thus:
Capital and Liabilities ` Assets `
Capital 10,000 Cash 10,000

Transaction 2. A purchases furniture for cash worth `2,000. The position of


his business will be as follows:
Capital and Liabilities ` Assets `
Capital 10,000 Cash 8,000
Furniture 2,000
10,000 10,000
Transaction 3. A purchases cotton bales from B for `5,000 on credit. He
sells for cash cotton bales costing `3,000 for `4,000 and `1,000 for `1,500
on credit to P.
As a result of these transactions the business makes a profit of `1,500
(i.e. `5,500 –`4,000) this will increase A’s Capital from `10,000 to `11,500.
The business will have a liability of `5,000 to B and two more assets in the
form of a debtor P for `1,500 and stock of cotton bales of `1,000. The position
of his business will now be as follows:
Capital and Liabilities ` Assets `
Creditor (B) 5,000 Cash (`8,000 + 4,000) 12,000
Capital 11,500 Stock of Cotton Bales 1,000
Debtor (P) 1,500
Furniture 2,000
16,500 16,500
Transaction 4. A withdraws cash of `1,000 and cotton bales of `200 for his
personal use. The amount and the goods withdrawn will decrease relevant
assets and A’s capital. The position will be now as follows:
Capital and Liabilities ` Assets    `
Creditor (B) 5,000 Cash (`12,000 – 1,000) 11,000
Capital (`11,500 – 1,200) 10,300 Stock of Cotton Bales 800
Debtor (P) 1,500
Furniture 2,000
15,300 15,300
The above type of statement showing the financial position of a business
on a certain date is termed as balance sheet.

Self-Instructional
Material 9
Basic Concepts of The result of applying the system of double entry system may be
Financial Accounting
summarised in the form of following rule:
“For every debit there must be equivalent credit and vice versa.”
NOTES The rules of Debit and Credit have been explained in the succeeding
chapter.
Illustration 1.1. Anil had the following transactions. Use accounting equation
to show their effect on his assets, liabilities and capital:
1. Started business with cash ` 5,000
2. Purchased goods on credit 400
3. Purchased goods for cash 100
4. Purchased furniture 50
5. Withdrew for personal use 70
6. Paid rent 20
7. Received Interest 10
8. Sold goods costing `50 on credit for 70
9. Paid to creditors 40
10. Paid for salaries 20
11. Further capital invested 1,000
12. Borrowed from P 1,000

Solution:
Accounting Equation: Assets = Liabilities + Capital
No. Transaction Assets = Liabilities + Capital
` ` `
1. Anil started business with cash `5,000 5,000 = 0 + 5,000
2. Purchased goods on credit for `400 400 = 400 + 0
New Equation 5,400 = 400 + 5,000
3. Purchase goods for cash `100 + 100
– 100 = 0 + 0
New Equation 5,400 = 400 + 5,000
4. Purchased furniture `50 + 50
– 50 = 0 + 0
New Equation 5,400 = 400 + 5,000
5. Withdrew for personal use `70 – 70 = 0 – 70
New Equation 5,330 = 400 + 4,930
6. Paid rent – 20 = 0 + – 20
New Equation 5,310 = 400 + 4,910
7. Received interest `10 + 10 = 0 + 10
New Equation 5,320 = 400 + 4,920
8. Sold goods consisting `50 on credit + 70
for `70
– 50 = 0 + 20
New Equation 5,340 = 400 + 4,940
9. Paid to creditors `40 – 40 = – 40 + 0
New Equation 5,300 = 360 + 4,940
10. Paid for salaries `20 – 20 = 0 – – 20
Self-Instructional
10 Material
No. Transaction Assets = Liabilities + Capital Basic Concepts of
Financial Accounting
New Equation 5,280 = 360 + 4,920
11. Further capital Invested 1,000 = 0 + 1,000
New Equation 6,280 = 360 + 5,920
12. Borrowed from P `1,000 1,000 = 1,000 + 0 NOTES
New Equation 7,280 = 1,360 + 5,920

1.3.2 Double Entry System and Single Entry System


The difference between the double entry system and single entry system can
be put as follows:
(a) Recording of transactions: In case of double entry system, the
dual aspect concept is completely followed while recording business
transactions. In case of single entry system, the dual aspect concept
is not followed for all transactions. In case of some transactions both
the aspects are recorded, while for some only one aspect is recorded,
while in case of some other transactions no recording is at all done.
(b) Maintenance of books: In case of double entry system, various
subsidiary books viz., sales book, purchases book, returns book, cash
book etc., are maintained. While in case of single entry system, no
subsidiary books except cash book is maintained.
(c) Maintenance of books of account: In case of double entry system, all
major accounts real, nominal and personal are maintained. However,
in case of single entry system, only personal accounts are maintained.
(d) Preparation of trial balance: In case of double entry system, trial
balance is prepared to check arithmetical accuracy of the books of
account. While in case of single entry system trial balance cannot be
prepared. Hence, it is not possible to check the accuracy of books of
account.
(e) Accuracy of profits and financial position: In case of double entry
system, Trading and Profit and Loss Account gives the true profit of
the business while Balance Sheet shows the true and fair financial
position of the business. While in case of single entry system only a
rough estimate of profit or loss can be made. The Statement of Affairs
prepared in single entry system also does not show the true financial
position of the business.
(f) Utility: Single entry system is used only by very small business units.
It has no utility for large business units. As a matter of fact, they have
to compulsorily adopt double entry system.
1.3.3 Systems of Accounting
There are basically two systems of accounting:
1. Cash system of accounting It is a system in which accounting entries
are made only when cash is received or paid. No entry is made when a Self-Instructional
Material 11
Basic Concepts of payment or receipts is merely due. Government system of accounting
Financial Accounting
is mostly on the cash system. Certain professional people record their
income on cash basis, but while recording expenses they take into
account the outstanding expenses also. In such a case, the financial
NOTES statement prepared by them for determination of their income is termed
as Receipts and Expenditure Account.
2. Mercantile or accrual system of accounting It is a system in which
accounting entries are made on the basis of amounts having become
due for payment or receipt. This system recognises the fact that if
a transaction or an event has occurred; its consequences cannot be
avoided and, therefore, should be brought into books in order to present
a meaningful picture of profit earned or loss suffered and also of the
financial position of the firm concerned.
The difference between Cash System and Mercantile System of
accounting will be clear with the help of the following example:
A firm closes its books on 31st December each year. A sum of `500 has
become due for payment on account of rent for the year 2015. The amount
has, however, been paid in January, 2016.
In this case, if the firm is following cash system of accounting, no
entry will be made for the rent having become due in the books of accounts
of the firm in 2015. The entry will be made only in January 2016 when the
rent is actually paid. However, if the firm is following mercantile system of
accounting, two entries will made: (i) on 31st December, 2015, rent account
will be debited while the landlord’s account will be credited by the amount
of outstanding rent; (ii) In January, 2016 landlord’s account will be debited
while the cash account will be credited with the amount of the rent actually
paid. (This has been discussed in detail later while dealing with adjustments
relating to final accounts.)
The ‘mercantile system’ is considered to be better since it takes into
account the effects of all transactions already entered into. This system is
followed by most of the industrial and commercial firms.

1.4 ACCOUNTING TERMINOLOGIES


It will be appropriate to get familiarised with certain basic terms which
are used in accounting before proceeding with the technique of recording
of business transactions. It is necessary for the readers to go through these
basic terms and understand them clearly, since it will be then convenient for
them to understand clearly the contents of the chapters which are to follow:
1. Assets The terms ‘assets’ include the resources acquired by a business
from the funds made available either by the owners or by others. They are
“tangible objects or intangible rights owned by an enterprise and carrying
Self-Instructional
12 Material
probable future benefits”1 In other words, property of all kinds owned by a Basic Concepts of
Financial Accounting
business comes within the category of the term ‘assets’.
Assets may be classified into the following categories:
(i) Fixed assets These are assets which are acquired for relatively long NOTES
period for carrying on the business of the enterprise. They are not
meant for resale. The examples of such assets are land, buildings, plant,
machinery, etc.
(ii) Current assets These are assets which are acquired with the intention
of converting them into cash during the normal business operations of
the company. They include ‘‘cash and other assets that are expected
to be converted into cash or consumed in the production of goods or
rendering of services in the normal course of business’’2 The essential
difference between current assets and fixed assets is that the current
assets are held essentially for a short period and they are meant for
converting into cash. Examples of such assets are cash, inventories
(i.e., stocks of raw material, work-in-progress and finished goods), bills
receivable, debtors, etc. These assets are also termed as ‘Floating’ or
‘Circulating’ Assets.
(iii) Liquid assets These are assets which are immediately convertible into
cash without much loss. As a matter of fact, all current assets excluding
prepaid expenses and inventories are included in the definition of liquid
assets.
(iv) Fictitious assets These are assets which have no real value but are
shown in the books of accounts only for technical reasons. Examples
of such assets are preliminary expenses incurred in connection with
the establishment of a business or discount allowed on issue of shares
by a company, etc.
(v) Wasting assets These are the assets which are exhausted with, or which
lose themselves in the goods they produce. Mines and quarries are
common examples of such assets. The term is also used for describing
such assets which get exhausted with the lapse of time, e.g., copyrights,
patents, trademark, etc.
2. Liabilities The term ‘Liabilities’ is used to denote amounts which a
business owes and has to return or account for. They are present obligations
whose amounts can be ascertained with substantial accuracy. They can be
divided into two categories:
(i) Current liabilities The term ‘Current Liabilities’ is used to denote
liabilities which will be due within a short time (usually one year or
1&2 The Institute of Chartered Accountants of India (ICAI), ‘Guidance Note on Terms
used in Financial Statements, 1983’. Most of the terms in this unit have been defined as per
the above guidelines.
2
Self-Instructional
Material 13
Basic Concepts of less) and that are to be paid out of current assets or by creation of
Financial Accounting
other current liabilities. Creditors for goods, bills payable, outstanding
expenses are some of the examples of current liabilities.
(ii) Fixed liabilities Liabilities that will not be due for a comparatively long
NOTES
time (usually more than one year) are termed as ‘Fixed Liabilities’ or
‘Long-term Liabilities’. These liabilities would continue to be treated
as Fixed Liabilities if they are renewed rather than paid at maturity.
3. Capital The term ‘Capital’ is used to denote the owners’ equity in the
business. It is a residual claim against the assets of the business after the total
liabilities are deducted. Owners’ Equity, Proprietorship and Net-Worth are
some of the other terms which are also used to denote Capital.
Capital may be classified into the following categories:
(i) Fixed Capital It is the capital invested in or represented by Fixed
Assets.
 (ii) Circulating Capital It is the capital in the form of Current or Floating
Assets.
(iii) Working Capital It is the excess of Current Assets over Current
Liabilities.
4. Contingent Asset An asset, the existence, ownership value of which
may be known or determined only on the occurrence or non-occurrence of
one more future uncertain events. It usually arises from unexpected events
that give rise to possibility of inflow of economic benefits to the business
enterprise. For example, a claim that the firm is pursuing the outcome of
which is uncertain, is a contingent asset.
A contingent asset is not recognised in the books of an enterprise. It
also does not require any disclosure in the financial statements. Such an
asset is assessed continuously and when it becomes virtually certain that it
will result in inflow to economic benefits to the enterprise, the asset and the
related income may be recognised in the financial statements of the firm in
which such change occurs.
5. Contingent Liability It is an obligation relating to existing condition or
situation which may arise in future depending upon the occurrence or non-
occurrence of one or more uncertain future events. It is a possible obligation
which may or may not arise depending upon the situation.
Following are the examples of contingent liabilities:
1. A claim against the enterprise not acknowledged as debt.
2. Uncalled liability on shares partly paid.
3. Arrears of fixed cumulative dividends.
4. Estimated amount of contracts remaining to be executed on capital
account and not provided for.
Self-Instructional
14 Material
An enterprise should not recognise a contingent liability. However, it may be Basic Concepts of
Financial Accounting
disclosed as a note to the financial statements. Such liabilities are assessed on
a continuing basis to determine whether an outflow of economic resources has
become probable, if so to the extent of the probable amount, the liability will
have to be recognised in the books and a provision will have to be created. NOTES
6. Provision An amount written off or retained by way of providing for
depreciation or diminution in value of assets or for providing any known
liability, the amount of which cannot determined with substantial accuracy.
Examples of a provision are provision for bad and doubtful debts, a provision
for discount on debtors, etc.
Difference between a Contingent Liability, a Provision and a Liability
This can be understood with the following example:
A lawsuit has been filed against a firm claiming damages of `1,00,000. The
firm feels that the case against the firm may or may not be dismissed by the
court. Such a liability is a contingent liability and may be disclosed by way
of a note to the financial statements. However, if the firm feels that it may be
required to pay the damages of around `20,000 in the suit in all probabilities,
the provision to the extent of `20,000 for the lawsuit will be created. Finally
if the court fixes the damages payable of `25,000 against the firms, a liability
of `25,000 will be recognised in the books of the firm.
7. Transaction and Event Every economic activity is performed through
transactions and events. A transaction may be a business, performance of an
act or an agreement. While an event is the happening, consequence or result
of a transaction.
8. Revenue The term ‘Revenue’ means income of a recurring nature from
any source. The source may be sale of goods, performance of services for a
customer or a client, the rental of a property, the lending of money and any
other business or professional activity carried on for the purpose of earning
income.
9. Expenditure The term includes incurring a liability disbursement of cases
or transfer of property for the purpose of obtaining assets goods or services.
It may be of three types:
(i) Capital expenditure An expenditure incurred for obtaining a long-term
advantage for the business.
(ii) Revenue expenditure An expenditure where benefits expire within a
year or which has been incurred merely to maintain the business or
keep the assets in good working condition.
(iii) Deferred expenditure An expenditure or liability for which payment has
been made or incurred but which is carried forward on the presumption
that it will be of benefit over a subsequent period or periods. This is
also referred to as deferred revenue expenditure. Self-Instructional
Material 15
Basic Concepts of 10. Expense The term ‘Expense’ denotes the cost of services and things
Financial Accounting
used for generating revenue.
An ‘Expense’ is to be distinguished from a Loss. An Expense is supposed to
bring some benefit to the firm, whereas a Loss brings no benefit to the firm,
NOTES
e.g., loss by theft, loss by fire, etc.
10A. Expired Cost That portion of an expenditure from which no further
benefit is expected. Also termed as expense.
11. Goods The term ‘Goods’ means the property in which the business deals.
In other words, ‘Goods’ are properties for resale. For example, if a furniture
dealer purchases furniture for sale, the furniture so purchased will come
within the definition of the term ‘Goods’. However, if the furniture has been
purchased by a furniture dealer for using it in his business, such furniture
will come within the definition of the term ‘Fixed Assets’.
12. Debtor The person who owes money to the business is called a ‘Debtor’.
13. Creditor A person who has a claim for money against the business is
termed as ‘Creditor’.
14. Bill of Exchange It is a document in writing directing a certain person
to pay a certain sum of money to the order of a certain person or to the
bearer of the instrument. For example, if A, a creditor by a document in
writing asks his debtor B to pay a sum of `10,000 (owed by B on account
of purchase of certain goods) after 3 months, such a document is termed as
‘Bill of Exchange’.
The document will be termed as ‘Bill Receivable’ for A (i.e., the person
entitled to get the payment) and a ‘Bill Payable’ for B (i.e., the person who
is liable to pay the money under the document).
15. Accounts Receivable The term includes both Debtors and Bills
Receivable
16. Accounts Payable The term included both Creditors and Bills Payable.
17. Discount An allowance or a deduction allowed from an amount due is
termed as ‘Discount’. It may be of three types:
(i) Trade discount A deduction allowed to the buyers from the gross or
catalogue price is termed as ‘Trade Discount’.
(ii) Quantity discount A deduction allowed to the buyers from the gross
catalogue price on making bulk purchases is termed as ‘Quantity
Discount’.
(iii) Cash discount A discount allowed to a debtor on prompt payment of
cash is termed as ‘Cash Discount’.
Trade or quantity discount is not taken into account evolute recording
accounting transactions. The transactions are recorded at ‘net’ while cash
discount is recorded in the books of account.
Self-Instructional
16 Material
18. Commission Commission may be termed as remuneration payable to an Basic Concepts of
Financial Accounting
employee for his services to the firm or to the agent for purchasing or selling
goods, collection of debtors on behalf of the firm, etc. The commission is
computed as a percentage of the amount involved. The commission earned
is considered as an income while commission allowed is considered as an NOTES
expense for the business.
Following are examples of persons to whom commission may be
allowed:
(1) Selling or buying agents.
(2) Brokers and bankers.
(3) Property dealers for helping in renting out or purchase or sale of
properties.
(4) Import-export agent in foreign trade.
19. Merchandise Cost It is the same as cost of goods sold. It is computed
as follows:
Opening Inventory .................
Add: Net Purchases (i.e., purchases less returns) .................
Direct Expenses (i.e., expenses incurred for
acquiring the goods and making them fit for sale) .................
Less: Closing Inventory .................
Cost of goods sold .................

20. Gross profit It is the excess of the selling price over the cost of goods
sold (without deducting any expenses incurred in selling the goods).
21. Net profit/income It is the profit left after deducting all business expenses
from the Gross Profit made by the business.
21A. Cash Profit The net profit as increased by non-cash costs such as
depreciation, amortisation etc. when the result of computation is negative,
and termed as cash loss.
22. Drawings The withdrawal of goods or cash from the business by the
owner for personal use is called ‘Drawings’.
23. Entry Recording of a transaction in any book of account is called an
‘Entry’.
24. Insolvent A person who is not in a position to pay his debts in full. It
means that the liabilities of such a person are more than his assets.
25. Solvent A person who is in a position to pay his debts as they become due.
26. Bad debts The amount lost from a debtor on account of his inability to
pay his debts.

Self-Instructional
Material 17
Basic Concepts of 27. Net Assets The excess of the book value of assets (other than fictitious
Financial Accounting
assets) of an enterprise over its liabilities. This is also referred to as Net
Worth or Shareholders’ Funds.
NOTES 28. Working Capital The funds available for day-to-day operations of an
enterprise. Also represented by the excess of current assets over current
liabilities including short-term loans.

Check Your Progress


3. List the types of accounts which are maintained under double entry
and single entry system.
4. What is contingent liability?

1.5 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. Some of the users of accounting information are proprietors, managers,
creditors, prospective investors, government, employees and citizen.
2. The Balance Sheet or the Position Statement of a business is the
accounting tool which helps to ascertain the financial position of a
business.
3. In case of double entry system, all major accounts real, nominal and
personal are maintained. However, in case of single entry system, only
personal accounts are maintained.
4. Contingent liability is an obligation relating to existing condition or
situation which may arise in future depending upon the occurrence or
non-occurrence of one or more uncertain future events.

1.6 SUMMARY
• Earlier, accounting was considered simply as a process of recording
business transactions and the role of accountant as that of record-
keeper. However, accounting is now considered to be a tool of
management providing vital information concerning the organisation’s
future. Accounting today is thus more of an information system rather
than a mere recording system.
• Some people take book-keeping and accounting as synonymous
terms, but they are different from each other. Book-keeping is mainly
concerned with recording of financial data relating to the business
operations in a significant and orderly manner.
• Accounting is primarily concerned with designing the systems
for recording, classifying and summarizing the recorded data and
Self-Instructional
18 Material
interpreting them for internal and external end users. Accountants often Basic Concepts of
Financial Accounting
direct and review the work of the book-keepers.
• Accounting is of primary importance to the proprietors and the
managers. However, other persons such as creditors, prospective
NOTES
investors, employees, etc., are also interested in the accounting
information.
• The objectives of accounting are: to keep systematic records, to protect
business properties, to ascertain the financial position of business, to
facilitate rational decision making, etc.
• Limitations of accounting are: provides only limited information,
provides only a post-mortem record of business transactions, considers
only quantifiable information, etc.
• An incomplete double entry system can be termed as a single entry
system. According to Kohler, “it is a system of book-keeping in which
as a rule only records of cash and personal accounts are maintained, it
is always incomplete double entry, varying with circumstances”. This
system has been developed by some business houses, who for their
convenience, keep only some essential records.
• The system of ‘double entry’ book-keeping which is believed to have
originated with the Venetian merchants of the fifteenth century, is the
only system of recording the two-fold aspect of the transaction.
• Cash system of accounting is a system in which accounting entries are
made only when cash is received or paid. Mercantile or accrual system
of accounting is a system in which accounting entries are made on the
basis of amounts having become due for payment or receipt.

1.7 KEY WORDS


· Accounting: The process of identifying, measuring and communicating
economic information to permit informed judgements and decisions
by the users of information.
· Financial Accounting: The art of recording, classifying and
summarizing in a significant manner and in terms of money,
transactions and events which are at least in part of a financial character
and interpreting the results.
· Asset: A tangible object or an intangible right owned by an enterprise
and carrying probable future benefits.
· Capital: Owners’ equity in the business.
· Capital Expenditure: An expenditure incurred for the purpose of
obtaining a long-term advantages for the business.

Self-Instructional
Material 19
Basic Concepts of · Goods: The property in which the business deals.
Financial Accounting
· Liability: An amount which business owes and has to return or account
for.
NOTES · Revenue: An income of a recurring nature from any source.
· Revenue Expenditure: An expenditure whose benefit expires within
a year or which is incurred merely to maintain the business or keeping
the assets in good working condition.

1.8 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. Define Accounting. State its functions. How does it differ from Book-
keeping?
2. State the persons who should be interested in accounting information.
Long Answer Questions
1. Define the term ‘Assets’. Explain the different types of ‘Assets’ with
suitable examples.
2. What do you understand by the term ‘Liabilities of a business’? How
they can be classified? Explain with suitable examples.
3. Explain the concepts of: Merchandise Cost, Gross Profit and Net
Income.

1.9 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

Self-Instructional
20 Material
Accounting Concepts:

UNIT 2 ACCOUNTING CONCEPTS:


Principles and Conventions

PRINCIPLES AND
NOTES
CONVENTIONS
Structure
2.0 Introduction
2.1 Objectives
2.2 Meaning and Types of Accounting Concepts
2.3 Accounting Convention and Its Types
2.4 Accounting Principles
2.5 Accounting Standards
2.5.1 International Accounting Standards Committee and IAS/IFRS
2.6 Answers to Check Your Progress Questions
2.7 Summary
2.8 Key Words
2.9 Self Assessment Questions and Exercises
2.10 Further Readings

2.0 INTRODUCTION
It has already been stated in Unit 1 that accounting is the language of business
through which normally a business house communicates with the outside
world. In order to make this language intelligible and commonly understood
by all, it is necessary that it should be based on certain uniform scientifically
laid down standards. These standards are termed as accounting principles.
Accounting principles1 may be defined as those rules of action adopted
by the accountants universally while recording accounting transaction. “They
are a body of doctrines commonly associated with the theory and procedures
of accounting, serving as an explanation of current practices and as a guide
for selection of conventions or procedures where alternatives exist”. These
principles can be classified into two categories:
(i) Accounting Concepts2
(ii) Accounting Conventions
Accounting Concepts
The term ‘concepts’ includes those basic assumptions or conditions upon
which the science of accounting is based. The following are the important
accounting concepts:
1
. also termed as ‘Accounting Standards’.
2
. also termed as ‘Accounting Postulates’.

Self-Instructional
Material 21
Accounting Concepts: (i) Separate Entity Concept
Principles and Conventions
(ii) Going Concern Concept
(iii) Money Measurement Concept
NOTES (iv) Cost Concept
(v) Dual Aspect Concept
(vi) Accounting Period Concept
(vii) Periodic Matching of Cost and Revenue Concept
(viii) Realisation Concept
Accounting Conventions
The term ‘conventions’ includes those customs or traditions which guide the
accountant while preparing the accounting statements. The following are the
important accounting conventions.
(i) Convention of Conservatism (ii) Convention of Full Disclosure
(iii) Convention of Consistency (iv) Convention of Materiality

2.1 OBJECTIVES
After going through this unit, you will be able to:
• Explain the meaning and types of accounting concepts
• Discuss the accounting convention and its types
• Examine the accounting principles
• Identify the accounting standards

2.2 MEANING AND TYPES OF ACCOUNTING


CONCEPTS
Let’s study the different accounting concepts.
1. Separate Entity Concept In accounting business is considered to be
a separate entity from the proprietor(s). It may appear to be ludicrous that
one person can sell goods to himself but this concept is extremely helpful in
keeping business affairs strictly free from the effect of private affairs of the
proprietor(s). Thus, when one person invests `10,000 into business, it will
be deemed that the proprietor has given that much of money to the business
which will be shown as a ‘liability’ in the books of the business. In case the
proprietor withdraws `2,000 from the business, it will be charged to him
and the net amount payable by the business will be shown only as `8,000.
The concept of separate entity is applicable to all forms of business
organisations. For example, in case of a partnership business or sole

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22 Material
proprietorship business, though the partners or sole proprietor are not Accounting Concepts:
Principles and Conventions
considered as separate entities in the eyes of law, but for accounting purposes
they will be considered as separate entities.
2. Going Concern Concept According to this concept it is assumed that
NOTES
the business will continue for a fairly long time to come. There is neither the
intention nor the necessity to liquidate the particular business venture in the
foreseeable future. On account of this concept, the accountant while valuing
the assets does not take into account forced sale value of assets. Moreover,
he charges depreciation on fixed assets on the basis of their expected lives
rather than on their market value.
It should be noted that the ‘going concern concept’ does not imply
permanent continuance of the enterprise. It rather presumes that the enterprise
will continue in operation long enough to charge against income, the cost of
fixed assets over their useful lives, to amortise over appropriate period other
costs which have been deferred under the actual or matching concept, to pay
liabilities when they become due and to meet the contractual commitments.
Moreover, the concept applies to the business as a whole. When an enterprise
liquidates a branch or one segment of its operations, the ability of the
enterprise to continue as a going concern is normally not impaired.
The enterprise will not be considered as a going concern when it has
gone into liquidation or it has become insolvent. Of course, the receiver or
the liquidator may endeavour to carry on business operations for some period
pending arrangement with the creditors or the final buyer for the sale of the
business as a going concern, the going concern status of the concern will
stand terminated from the date of his appointment or will be at least regarded
as suspended, pending the results of his efforts.
3. Money Measurement Concept Accounting records only monetary
transactions. Events or transactions which cannot be expressed in money do
not find place in the books of accounts though they may be very useful for the
business. For example, if a business has got a team of dedicated and trusted
employees, it is definitely an asset to the business but since their monetary
measurement is not possible, they are not shown in the books of the business.
Measurement of business event in money helps in understanding
the state of affairs of the business in a much better way. For example, if a
business owns `10,000 of cash, 600 kg of raw materials, two trucks, 1,000
square feet of building space etc., these amounts cannot be added together
to produce a meaningful total of what the business owns. However, if these
items are expressed in monetary terms such as `10,000 of cash, `12,000 of
raw materials, `2,00,000 of trucks and `50,000 of building, all such items
can be added and much more intelligible and precise estimate about the assets
of the business will be available.

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Material 23
Accounting Concepts: 4. Cost Concept The concept is closely related to going concern concept.
Principles and Conventions
According to this concept:
(a) an asset is ordinarily entered in the accounting records at the price
paid to acquire it, and
NOTES
(b) this cost is the basis for all subsequent accounting for the assets.
If a business buys a plot of land for `50,000, the asset would be
recorded in the books at `50,000 even if its market value at that time happens
to be `60,000. In case a year later the market value of this assets comes
down to `40,000, it will ordinarily continue to be shown at `50,000 and not
at `40,000.
The cost concept does not mean that the asset will always be shown at
cost. It has also been stated above that cost becomes the basis for all future
accounting for the asset. It means that asset is recorded at cost at the time of
its purchase, but it may systematically be reduced in its value by charging
depreciation.
Cost concept has the advantage of bringing objectivity in the
preparation and presentation of financial statements. In the absence of this
concept the figures shown in the accounting records would have depended
on the subjective views of a person. However, on account of continued
inflationary tendencies the preparation of financial statements on the basis
of historical costs, has become largely irrelevant for judging the financial
position of the business. This is the reason for the growing importance of
inflation accounting.
5. Dual Aspect Concept This is the basic concept of accounting. According
to this concept every business transaction has a dual effect. For example,
if A starts a business with a capital of `10,000, there are two aspects of the
transaction. On the one hand, the business has asset of `10,000 while on the
other hand the business has to pay to the proprietor a sum of `10,000 which
is taken as proprietor’s capital. This expression can be shown in the form
of following equation:
Capital (Equities) = Cash (Assets)
10,000 = 10,000
The term ‘assets’ denotes the resources owned by a business while the
term “Equities” denotes the claims of various parties against the assets. As
we have learned before, equities are of two types. They are: owners’ equity
and outsiders’ equity. Owners’ equity (or capital) is the claim of owners
against the assets of the business while outsiders’ equity (for liabilities) is
the claim of outside parties, such as creditors, debenture-holders etc., against
the assets of the business. Since all assets of the business are claimed by
some one (either owners or outsiders), the total of assets will be equal to
total of liabilities, Thus:
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24 Material
Equities = Assets Accounting Concepts:
Principles and Conventions
or Liabilities + Capital = Assets
In the example given above, if the business purchases furniture worth
`5,000 out of the money provided by A, the situation will be as follows: NOTES
Equities = Assets
Capital `10,000 = Cash `5,000 + Furniture `5,000
Subsequently, if the business borrows `30,000 from a bank, the new
position would be as follows:
Equities = Assets
Capital `10,000 + Bank Loan `30,000 = Cash `35,000 + Furniture `5,000
The term ‘accounting equation’ is also used to denote the relationship
of equities to assets. The equation can be technically stated as “for each debit,
there is an equivalent credit”. As a matter of fact the entire system of double
entry book-keeping is based on this concept.
6. Accounting Period Concept According to this concept, the life of the
business is divided into appropriate segments for studying the results shown
by the business after each segment. This is because though the life of the
business is considered to be indefinite (according to going concern concept),
the measurement of income and studying the financial position of the business
after a very long period would not be helpful in taking proper corrective
steps at the appropriate time. It is, therefore, absolutely necessary that after
each segment or time interval the businessman must ‘stop’ and ‘see back’,
how things are going. In accounting such a segment or time interval is called
‘accounting period’. It is usually of a year.
At the end of each accounting period an Income Statement and a
Balance Sheet are prepared. The Income Statement discloses the profit or
loss made by the business during the accounting period while the Balance
Sheet depicts the financial position of the business as on the last day of the
accounting period. While preparing these statements a proper distinction has
to be made between capital and revenue expenditure.
7. Periodic Matching of Costs and Revenue Concept This is based on the
accounting period concept. The paramount objective of running a business is
to earn profit. In order to ascertain the profit made by the business during a
period, it is necessary that ‘revenues’ of the period should be matched with
the costs (expenses) of the period. The term matching, means appropriate
association of related revenues and expenses. In other words, income made by
the business during a period can be measured only when the revenue earned
during a period is compared with the expenditure incurred for earning that
revenue. The question when the payment was received or made is ‘irrelevant’.
For example, if a salesman is paid commission in January, 2011, for sales
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Material 25
Accounting Concepts: made by him in December, 2010, the commission paid to the salesman in
Principles and Conventions
January, 2011 should be taken as the cost for sales made by him in December,
2010. This means that revenues of December, 2010 (i.e., sales) should be
matched with the costs incurred for earning that revenue (i.e., salesman’s
NOTES commission) in December, 2010 (though paid in January, 2011). On account
of this concept, adjustments are made for all outstanding expenses, accrued
incomes, prepaid expenses and unearned incomes, etc., while preparing the
final accounts at the end of the accounting period.
8. Realisation Concept According to this concept revenue is recognised
when a sale is made. Sale is considered to be made at the point when the
property in goods passes to the buyer and he becomes legally liable to pay.
This can be well understood with the help of the following example:
A places an order with B for supply of certain goods yet to be
manufactured. On receipt of order, B purchases raw materials, employs
workers, produces the goods and delivers them to A. A makes payment on
receipt of goods. In this case the sale will be presumed to have been made
not at the time of receipt of the order for the goods but at the time when
goods are delivered to A.
However, there are certain exceptions to this concept:
(i) In case of hire purchase the ownership of the goods passes to the
buyer only when the last instalment is paid, but sales are presumed to
have been made to the extent of instalments received and instalments
outstanding (i.e. instalments due but not received).
(ii) In case of contracts accounts, though the contractor is liable to pay only
when the whole contract is completed as per terms of the contract, the
profit is calculated on the basis of work certified year after year as per
certain accepted accounting norms.

2.3 ACCOUNTING CONVENTION AND ITS TYPES


In this section, we will discuss the accounting conventions.
1. Conservatism In the initial stages of accounting, certain anticipated profits
which were recorded, did not materialise. This resulted in less acceptability of
accounting figures by the end-users. On account of this reason, the accountants
follow the rule ‘anticipate no profit but provide for all possible losses’ while
recording business transactions. In other words, the accountant follows the
policy of “playing safe”. On account of this convention, the inventory is
valued ‘at cost or market price whichever is less’. Similarly, a provision is
made for possible bad and doubtful debts out of current year’s profits. This
concept affects principally the category of current assets.
The convention of conservatism has become the target of serious
criticism these days especially on the ground that it goes against the convention
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26 Material
of full disclosure. It encourages the accountant to create secret reserves (e.g., Accounting Concepts:
Principles and Conventions
by creating excess provision for bad and doubtful debts, depreciation etc.),
and the financial statements do not depict a true and fair view of the state of
affairs of the business. The Income Statement shows a lower net income, the
Balance Sheet understates assets and overstates liabilities. NOTES
The research studies conducted by the American Institute of Certified
Public Accountants have indicated that conservatism concept needs to be
applied with much more caution and care if the results reported are not to
be distorted.
2. Full disclosure According to this convention accounting reports should
disclose fully and fairly the information they purport to represent. They
should be honestly prepared and sufficiently disclose information which
is of material interest to proprietors, present and potential creditors and
investors. The convention is gaining more importance because most of big
businesses are run by joint stock companies where ownership is divorced
from management. The Companies Act, 1956 not only requires that Income
Statement and Balance Sheet of a company must give a true and fair view
of the state of affairs of the company but it also gives the prescribed forms in
which these statements are to be prepared.3 The practice of appending notes
to the accounting statements (such as about contingent liabilities or market
value of investments) is in pursuance to the convention of full disclosure.
3. Consistency According to this convention, accounting practices should
remain unchanged from one period to another. For example, if stock is valued
at “cost or market price whichever is less”, this principle should by followed
year after year. Similarly, if depreciation is charged on fixed assets according
to diminishing balance method, it should be done year after year. This is
necessary for the purposes of comparison. However, consistency does not
mean inflexibility. It does not forbid introduction of improved accounting
techniques. However, if adoption of such a technique results in inflating or
deflating the figures of profit as compared to the previous period, a note to
that effect should be given in the financial statements.
4. Materiality According to this convention the accountant should attach
importance to material details and ignore insignificant details. This is because
otherwise accounting will be unnecessarily overburdened with minute details.
The question what constitutes a material detail, is left to the discretion of
the accountant. Moreover, an item may be material for one purpose while
immaterial for another. For example, while sending each debtor “a statement
of his account”, complete details upto paise have to be given. However, when
a statement of outstanding debtors is prepared for sending to top management,
figures may be rounded to the nearest ten or hundred. The Companies Act also
3
 American Institute of Certified Public Accountants, ‘‘Inventuory of Generally Accepted Principles for Business
Enterprises’’.

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Material 27
Accounting Concepts: permits ignoring of ‘paise’ while preparing financial statements. Similarly,
Principles and Conventions
for tax purposes, the income has to be rounded to nearest ten.
Thus, the term ‘materiality’ is a subjective term. The accountant should
NOTES regard an item as material if there is reason to believe that knowledge of it
would influence the decision of the informed investor. According to Kohler,
“materiality means the characteristic attaching to a statement, fact or item
whereby its disclosure or method of giving it expression would be likely to
influence the judgement of a reasonable person.”
It should be noted that accounting is a man-made art designed to help
man in achieving certain objectives. “The accounting principles, therefore,
cannot be derived from or proven by laws of nature. They are rather in the
category of conventions or rules developed by man from experience to fulfil
the essential and useful needs and proposes in establishing reliable financial
and operating information control for business entities. In this respect, they
are similar to the principles of commercial and other social disciplines.”4

Check Your Progress


1. Define going concern concept.
2. Why has the convention of conservatism become the target of criticism
these days?

2.4 ACCOUNTING PRINCIPLES


Accounting practices follow certain guidelines. The rules that govern how
accountants measure progress and communicate financial information fall
under the heading “Generally Accepted Accounting Principles” (GAAP).
GAAP comprises of conventions, rules and procedures that constitute
accepted accounting practices at any given time. They are like the law or
rules for conducting behaviour in a way acceptable to majority of the people.
They may readily be defined as rules of action or conduct which are adopted
by the accountants universally while recording accounting transactions. They
are a body of doctrines commonly associated with the theory and procedures
of accounting, serving as an explanation of current practices and as a guide
for selection of conventions or procedures where alternatives exist.
It should be noted that GAAP differ from country to country because
of the legislative requirements of each country, local accounting practices,
customs, usage and business environment peculiar to each country. Each
country has set up its own professional accounting body/regulatory authority
to frame, implement and regulate the application of the GAAPs in the
country. For example, in USA the Financial Accounting Standard Board
4
 American Institute of Certified Public Accountants, ‘‘Inventuory of Generally Accepted Principles for Business
Enterprises’’.
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28 Material
(FASB) set up in 1973 makes major pronouncements called Statements of Accounting Concepts:
Principles and Conventions
Financial Accounting Standards (SFAS) from time to time. Similarly, in
UK the Accounting Standard Board set up in 1990 issues financial reporting
standards. The Board has replaced the Accounting Standards Committee
which was responsible for issuing Statements of Standard Account Practices NOTES
(SSAPs) earlier from time to time. In India, the Accounting Standard Board
set up by the Institute of Chartered Accountants of India issues the accounting
standards to be observed by all business entities. However, the Ministry of
Corporate Affairs (MCA) has also notified presently 40 Indian Accounting
Standards (Ind AS), as a step towards convergence of International Financial
Reporting Standards (IFRS) in India. It may be noted that Ind AS would be
applicable to various classes of entities as may be prescribed by the relevant
authorities such as Ministry of Corporate Affairs for the companies governed
under the Companies Act, 2013 from the notified date(s). The existing
Accounting Standards (AS) would continue to apply to entities other than
those to which Ind AS would apply. In case of differences between the two
standards i.e. AS issued by the Institute of Chartered Accountants of India
and Ind AS notified by the Ministry of Corporate Affairs, Government of
India, the Institute of Chartered Accountants of India would harmonise their
differences. This, in some cases, has already been done e.g. withdrawal of
AS 6: Depreciation Accounting and replacement of AS 10: Fixed Assets by
AS 10: Property, Plant and Equipment.

2.5 ACCOUNTING STANDARDS


In the preceding section we have discussed the accounting principles. They
are basically the rules that govern current accounting practices and are used
as references to determine application of appropriate treatment of complex
transactions. In order to ensure that the application of these rules/principles is
uniform in different enterprises, and the financial statements are comparable,
the accounting regulatory bodies in different countries have codified these
principles/rules in the form of accounting standards. Thus, accounting
standards are basically accounting principles which have been codified and
formalised by concerned regulatory bodies.
In simple words, accounting standards are rules according to which
accounting statements have to be prepared. They can be termed as statements
of code of practice of the regulatory accounting bodies that are to be observed
in the preparation and presentation of financial statements. Accounting
Standards may vary from country to country or industry to industry depending
upon specific requirements. According to Institute of Chartered Accountants
of India “Accounting Standards act as pillars of financial reporting structure of
the country as they lay down sound principles for recognition, measurement,

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Material 29
Accounting Concepts: presentation and disclosures of information in the financial statements, which
Principles and Conventions
substantially improve the quality of financial statements.”
Objectives of Accounting Standards Financial statements provide
useful financial information about an enterprise to various stakeholders to
NOTES
base their economic and financial decisions. The comparison of the financial
statements of various reporting enterprises poses some difficulties because of
the divergence in the methods and principles adopted by these enterprises in
preparing their financial statements Accounting Standards have been evolved
to bring uniformity to the extent possible in the accounting methods and
principles adopted by the various enterprises.
Thus, accounting standards rationally harmonize the diverse accounting
policies followed in the preparation and presentation of financial statements
by different reporting enterprises so as to facilitate intra-firm and inter-firm
comparison by the stakeholders to take informed economic decisions.
2.5.1 International Accounting Standards Committee and IAS/IFRS
History and Structure International Accounting Standards Committee
(IASC) came into existence on 29th June, 1973 when 16 accounting bodies
from nine nations (called founder-members)5 signed the agreement and
constitution for its formation. The Committee has its headquarters at London.
Its interpretative arm was known as Standard Interpretation Committee (SIC).
The objective of the committee was “to formulate and publish
in the public interest standards to be observed in the presentation
of audited financial statements and to promote their world-wide
acceptance and observance.” The formulation of such standards will bring
uniformity in terminology, approach and presentation of results. This will not
only help in a correct understanding and exchange of economic and financial
information but also in facilitating a smooth flow of international investment.
Between 1973 and 2000, the IASC issued several Accounting Standards,
known as International Accounting Standards (IASs) Since 2001, the IASC
was renamed as the International Accounting Standard Board (IASB). The
IASB has now taken over the work of IASC. Its members (currently 15 full
time members) are responsible for the development and publication of IFRSs
and approving interpretations as developed by IFRIC.
The IASB has issued a new series of pronouncements known as
International Financial Reporting Standards (IFRSs) on topics on which
there was no previous IAS. Besides this, the IASB has replaced some lASs
with new IFRSs. Thus, now the lASs issued by the IASC and IFRSs issued
by the IASB all come within the purview of IASB. An International Financial
Reporting Interpretation Committee (IFRIC) has also been formed to provide
interpretations of the standards similar to previous SIC.
5
 The nine nations are: United States of America, Canada, United Kingdom and lreland, Australia, France, Germany,
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30 Material
The IASB works closely with stakeholders around the world, including Accounting Concepts:
Principles and Conventions
investors, analysts, regulators, business leaders, accounting standard-setters
and the accountancy profession.
Objectives of IASB The broad objectives of IASB as per the IFRS
NOTES
Foundation, (not for profit private sector organisation) can be summarised
as under.
(a) To develop, in the public interest, a single set of high quality,
understandable, enforceable and globally accepted financial reporting
standards based upon clearly articulated principles. These standards
should require high quality, transparent and comparable information
in financial statements and other financial reporting to help investors,
other participants in the world’s capital markets and other users of
financial information to make economic decisions;
(b) To promote the use and rigorous application of those standards;
(c) To pay attention to the needs of medium and small scale enterprises and
emerging economies in tunc with (a) and (b) objectives stated above;
and
(d) To promote and facilitate adoption of IFRSs, being the standards and
interpretations issued by the IASB, through the convergence of national
accounting standards and IFRSs.
Meaning of IFRS It is a set of international accounting standards developed
by the International Accounting Standards Board (IASB) providing the
mode of reporting particular type of transactions and events in the financial
statements. They include standards and interpretations issued by the
International Accounting Standards Board (IASB) and its predecessor body,
viz., International Accounting Standards Committee (IASC). They comprise:
(a) International Financial Reporting Standards;
(b) International Accounting Standards, and
(c) Interpretations developed by the International Financial Reporting
Interpretations Committee (IFRIC) or the former Standing Interpretations
Committee (SIC).
Objective of IFRS The basic objective of IFRSs is to make international
comparison of financial statements of business enterprises as easy as possible.
At present it is difficult since each country has its own set of rules. IFRSs
have been designed as a common global language for business affairs to
synchronize accounting standards across the globe. They are progressively
replacing the many different national accounting standards. They require
the accountants to maintain books of account in a manner that the financial
statements based on them are comparable, understandable, reliable and
relevant as per the requirements of users—both internal and external.

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Accounting Concepts: Scope of IFRS The scope of IFRS is as under.
Principles and Conventions
(i) IFRS apply to the general purpose financial statements and other
financial reporting by profit-oriented entities— those engaged in
commercial, industrial, financial, and similar activities, regardless of
NOTES
their legal form.
Explanations:

(a) G
 eneral purpose financial statements are intended to meet the
common needs of shareholders, creditors, employees, and the
public at large for information about an entity’s financial position,
performance, and cash flows.
(b) O
 ther financial reporting includes information provided outside
financial statements that assists in the interpretation of a complete
set of financial statements or improves users’ ability to make
efficient economic decisions.
(ii) Entities other than profit-oriented business entities may also find IFRSs
appropriate.
(iii) IFRSs apply to individual company and consolidated financial
statements.
IFRS Assumptions There are four underlying assumptions in IFRS as
detailed below.
1. Accrual basis: The assumption that the financial effect of transactions
and events are recognised as they occur, not when cash is received or
paid.
2. Going concern: The assumption that a business entity will be in
operation for the foreseeable future.
3. Measuring unit: Measuring unit for valuation of capital is the current
purchasing power. In other words assets should be reflected in the
financial statements at their fair value.
4. Unit of constant purchasing power: The value of capital should
be adjusted at end of the financial year to inflation prevailing in the
economy.
IFRS Around the World
IFRS is a globally accepted financial reporting framework. It is used over 110
countries but in both the US and the UK, the Generally Accepted Accounting
Principles (GAAP) is the more widely used set of guidelines for accountants.
Currently the Financial Accounting Standards Board (FASB) of USA
and the IASB are working on numerous joint projects designed to improve
the GAAP and the IFRS with the goal to ultimately make the standards fully
compatible.
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32 Material
In India also we are following GAAP i.e., accounting standards as Accounting Concepts:
Principles and Conventions
prescribed by Institute of Chartered Accountants of India. Of course steps
are being taken for converging the Indian Accounting Standards with IFRS,
as discussed later in the unit.
NOTES
IFRS Main Financial Statements
Types : The IFRS financial statements include the following.
• A Statement of Financial Position. It comprises Assets, Liabilities and
Equity
• A Statement of Comprehensive Income. It includes two separate
statements (i) an Income Statement and (ii) a Statement of
Comprehensive Income. The Statement of Comprehensive Income
reconciles the Profit or Loss as per Income Statement to total
comprehensive income
• A Statement of Changes in Equity
• A Cash Flow Statement or Statement of Cash Flows
• Notes, comprising a summary of the significant accounting policies
Objective: A financial statement should present true and fair picture of the
business affairs of an organisation. Since these statements are used by different
constituents of the regulators/society, they are required to present the true
view of financial position of the organisation.
Qualitative characteristics: As per IFRS, the main characteristics required in
its main financial statement include:
• Understandability
• Relevance
• Reliability
• Comparability
Current Status of IAS/IFRS and Interpretations The current status of
International Accounting Standards (IAS), International Financial Reporting
Standards (IFRS), and Interpretations issued by Standing Interpretation
Committee (SIC), International Financial Reporting Interpretation Committee
(IFRIC) is as under.
International Accounting Standards (IASs) All 41 IASs have been
issued out of which 12 have been withdrawn. Thus, at present 29 IAS are in
operation. They are as under.
IAS 1. Presentation of Financial Statements.
IAS 2. Inventories.
IAS 7. Cash Flow Statements.

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Material 33
Accounting Concepts: IAS 8. Accounting Policies, Changes in Accounting Estimates and
Principles and Conventions
Errors.
IAS 10. Events after the Balance Sheet Date.
NOTES IAS 11. Construction Contracts.
IAS 12. Income Taxes.
IAS 16. Property, Plant and Equipment.
IAS 17. Leases.
IAS 18. Revenue.
IAS 19. Employee Benefits.
IAS 20. A ccounting for Government Grants and Disclosure of
Government Assistance.
IAS 21. The Effects of Changes in Foreign Exchange Rates.
IAS 23. Borrowing Costs
IAS 24. Related Party Disclosures.
IAS 26. Accounting and Reporting by Retirement Benefit Plans.
IAS 27. Consolidated and Separate Financial Statements.
IAS 28. Investments in Associates.
IAS 29. Financial Reporting in Hyperinflationary Economies.
IAS 31. Interests in Joint Ventures.
IAS 32. Financial Instruments: Presentation
IAS 33. Earnings per share.
IAS 34. Interim Financial Reporting.
IAS 36. Impairment of Assets.
IAS 37. Provisions, Contingent Liabilities and Contingent Assets.
IAS 38. Intangible Assets.
IAS 39. Financial Instruments: Recognition and Measurement.
IAS 40. Investment Property.
IAS 41. Agriculture.
International Financial Reporting Standards (IFRSs) In all 15 IFRSs
have been issued out of which one is under reconsideration. The list is as
under.

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34 Material
No. Title Originally Effective Accounting Concepts:
Principles and Conventions
issued
IFRS I First-time Adoption of International Financial 2003 Jan. 1, 2004
Reporting Standard
IFRS 2 Share-based Payment 2004 Jan. 1, 2005
IFRS 3 Business Combinations 2004 Apr. l, 2004
NOTES
IFRS 4 Insurance Contracts 2004 Jan. 1, 2005
IFRS 5 Non-current Assets held for Sale and Discontinued 2004 Jan. 1,2005
Operations
IFRS 6 Exploration for and Evaluation of Mineral 2004 Jan. 1, 2006
Resources
IFRS 7 Financial instrument: Disclosures 2005 Jan. 1, 2007
IFRS 8 Operating Segments 2006 Jan. 1, 2009
IFRS 9 Financial instruments 2009 Jan. 1, 2018
(updated 2014)
IFRS 10 Consolidated Financial Statements 2011 Jan. 1, 2013
IFRS 11 Joint Arrangements 2011 Jan. 1, 2013
IFRS 12 Disclosure of Interests in Other Entities 2011 Jan. 1, 2013
IFRS 13 For Value Measurement 2011 Jan. 1, 2013
IFRS 14 Regulatory Deferral Accounts 2014 Jan. 1, 2016
IFRS 15 Revenue from Contracts with Customers 2014 Jan. 1, 2017
Interpretations Issued by SIC/IFRIC In all 26 interpretations have been
issued as given under.
SIC 7 Introduction of the Euro
SIC 10 Government Assistance - No Specific Relation to Operating
Activities
SIC 12 Consolidation - Special-Purpose Entities
SIC 13 Jointly Controlled Entities - Non-monetary Contributions
by Ventures
SIC 15 Operating Leases - Incentives
SIC 21 Income Taxes - Recovery of Revalued Non-Depreciable
Assets
SIC 25 Income Taxes - Changes in the Tax Status of an Enterprise
or its Shareholders.
SIC 27 Evaluating the Substance of Transactions Involving the
Legal Form of a Lease
SIC 29 Service Concession Arrangements: Disclosures
SIC 31 Revenue - Barter Transactions lnvolving Advertising
Services
SIC 32 Intangible Assets - Web Site Costs
IFRIC 1 Changes in Existing Decommissioning, Restoration and
Similar Liabilities

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Material 35
Accounting Concepts: IFR1C 2 Members’ Shares in Co-operative Entities and Similar
Principles and Conventions
Liabilities
IFRIC 4 Determining Whether an Arrangement contains a Lease
NOTES IFRIC 5 Rights to Interests arising from Decommissioning,
Restoration and Environmental Rehabilitation Funds.
IFRIC 6  iabililies arising from Participating in a Specific Market
L
- Waste Electrical and Electronic Equipment
IFRIC 7 Applying the Restatement Approach under IAS 29,
Financial Reporting in Hyperinflationary Economies
IFRIC 8 Scopc of IFRS 2
IFRIC 9 Reassessment of Embedded Derivatives
IFRIC 10 Interim Financial Reporting and Impairment
IFRIC 11 IFRS 2: Group and Treasury Share Transactions
IFRIC 12 Service Concession Arrangements
IFRIC 13 Customer Loyalty Programmes
IFRIC 14 I AS 19 - The Limit on a Defined Benefit Asset, Minimum
Funding Requirements, and their Interaction
IFRIC 15 Agreements for the Construction of Real Estate
IFRIC 16 Hedges of a Net Investment in a Foreign Operation

Check Your Progress


3. What is GAAP?
4. State the objective of IFRS.
5. Which International Accounting Standard deals with employee
benefits?

2.6 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. According to the going concern concept, it is assumed that the business
will continue for a fairly long time to come. There is neither the
intention nor the necessity to liquidate the particular business venture
in the foreseeable future.
2. The convention of conservatism become the target of criticism these
days because it goes against the convention of full disclosure. It
encourages the accountant to create separate reserves and the financial
statements do not depict a true and fair view of the state of affairs of
the business.

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36 Material
3. GAAP or Generally Accepted Accounting Principles are a set of Accounting Concepts:
Principles and Conventions
conventions, rules and procedures that constitute accepted accounting
principles at any given time.
4. The basic objective of IFRSs is to make international comparison of
NOTES
financial statements of business enterprises as easy as possible.
5. The International Accounting Standard 19 or IAS 19 deals with
employee benefits.

2.7 SUMMARY
• Accounting principles may be defined as those rules of action adopted
by the accountants universally while recording accounting transaction.
• The term ‘concepts’ includes those basic assumptions or conditions
upon which the science of accounting is based. The following are
the important accounting concepts: (i) Separate Entity Concept,
(ii) Going Concern Concept, (iii) Money Measurement Concept,
(iv) Cost Concept, (v) Dual Aspect Concept and (vi) Accounting Period
Concept.
• The term ‘conventions’ includes those customs or traditions which
guide the accountant while preparing the accounting statements. The
following are the important accounting conventions. (i) Convention
of Conservatism, (ii) Convention of Full Disclosure, (iii) Convention
of Consistency and (iv) Convention of Materiality.
• There are several accounting concepts like: separate entity concept,
going concern concept, money measurement concept, cost concept,
dual aspect concept, accounting period concept, periodic matching of
costs and revenue concept, and realization concept.
• Accounting practices follow certain guidelines. The rules that govern
how accountants measure progress and communicate financial
information fall under the heading “Generally Accepted Accounting
Principles” (GAAP). GAAP comprises of conventions, rules and
procedures that constitute accepted accounting practices at any given
time.
• Accounting standards are basically accounting principles which have
been codified and formalised by concerned regulatory bodies.
• Accounting standards rationally harmonize the diverse accounting
policies followed in the preparation and presentation of financial
statements by different reporting enterprises so as to facilitate intra-
firm and inter-firm comparison by the stakeholders to take informed
economic decisions.

Self-Instructional
Material 37
Accounting Concepts: • International Accounting Standards Committee (IASC) came into
Principles and Conventions
existence on 29th June, 1973 when 16 accounting bodies from
nine nations (called founder-members) signed the agreement and
constitution for its formation. The Committee has its headquarters at
NOTES London. Its interpretative arm was known as Standard Interpretation
Committee (SIC).
• Between 1973 and 2000, the IASC issued several Accounting
Standards, known as International Accounting Standards (IASs) Since
2001, the IASC was renamed as the International Accounting Standard
Board (IASB). The IASB has now taken over the work of IASC.
• The IASB has issued a new series of pronouncements known as
International Financial Reporting Standards (IFRSs) on topics on
which there was no previous IAS. Besides this, the IASB has replaced
some lASs with new IFRSs. Thus, now the lASs issued by the IASC
and IFRSs issued by the IASB all come within the purview of IASB.
• All 41 IASs have been issued out of which 12 have been withdrawn.
Thus, at present 29 IAS are in operation. In all 15 IFRSs have been
issued out of which one is under reconsideration.

2.8 KEY WORDS


· Accounting Concepts: Basic assumptions or conditions upon which
the science of accounting is based.
· Accounting Conventions: Customs and traditions which guide the
accountants while preparing the accounting statements.
· Accounting Principles: Rules of action or conduct adopted by the
accountants universally while recording accounting transactions.
· Cash System of Accounting: A system in which accounting entries
are made only when cash is received or paid.
· Mercantile System of Accounting: A system in which accounting
entries are made on the basis of amounts having become due for
payment or receipt. It is also termed as Accrual System of Accounting.

2.9 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. Define the term Convention of Conservations.
2. Define the term Convention of Materiality.
3. Define the term Convention of Disclosure.
Self-Instructional
38 Material
Long Answer Questions Accounting Concepts:
Principles and Conventions
1. Discuss briefly the basic accounting concepts and fundamental
accounting assumptions.
2. What are the accounting concepts and conventions? Name them and NOTES
explain any two accounting concepts in detail.
3. Explain any three of the following accounting concepts:
(i) Money measurement concept (ii) Business entity concept
(iii) Going concern concept (iv) Realisation concept
(v) Cost concept.
4. What is meant by the term, ‘Generally Accepted Accounting
Principles’? Explain the meaning and significance of any two of the
following:
(i) The Going concern principle (ii) Convention of consistency
(iii) Matching principle (iv) Substance over form

2.10 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi:
Kalyani Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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Material 39
Recording of Transactions

UNIT 3 RECORDING OF
TRANSACTIONS
NOTES
Structure
3.0 Introduction
3.1 Objectives
3.2 Meaning of Assets, Liabilities and Equity, and Modern Approach to Classify
Accounts
3.2.1 Classification of Accounts under Modern Approach Method
3.3 Journal
3.3.1 Rules of Debit and Credit
3.3.2 Compound Journal Entry
3.3.3 Opening Entry
3.4 Answers to Check Your Progress Questions
3.5 Summary
3.6 Key Words
3.7 Self Assessment Questions and Exercises
3.8 Further Readings

3.0 INTRODUCTION
In this unit, you will learn about the classification of accounts and recording
of transactions. It has been explained in Unit 1 that Accounting is the art
of recording, classifying and summarising the financial transactions and
interpreting the results therefore. Thus, accounting cycle involves the
following stages:
1. Recording of transactions This is done in the book termed as
‘Journal’.
2. Classifying the transactions This is done in the book termed as
‘Ledger’.
3. Summarising the transactions This includes preparation of the trial
balance, profit and loss account and balance sheet of the business.
4. Interpreting the results This involves computation of various
accounting ratios, etc., to know about the liquidity, solvency and
profitability of business. The recording of transactions in the Journal
is being explained in this unit.

3.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss the classification of accounts under Modern Approach Method
• Describe the meaning and rules of journal
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40 Material
• Explain the different types of accounts in journal Recording of Transactions

• Recall the concepts of compounding and opening journal entries

3.2 MEANING OF ASSETS, LIABILITIES AND


NOTES
EQUITY, AND MODERN APPROACH TO
CLASSIFY ACCOUNTS
The meaning of assets and liabilities has already been discussed under
Accounting Terminologies in Unit 1. The meaning of equity is also stated
while describing the concept of Accounting Equation in the same unit. You
have also learned in Unit 1 how financial transactions affect an accounting
equation. In this section, you will learn about the modern approach to
classification of accounts.
3.2.1 Classification of Accounts under Modern Approach Method
According to modern approach, the accounts are classified as asset accounts,
liability accounts, capital or owner’s equity accounts, withdrawal accounts,
revenue/income accounts and expense accounts.
• Asset accounts: Assets are things or items of value owned by a
business and are usually divided into tangible or intangible. Tangible
assets are physical items such as building, machinery, inventories,
receivables, cash, prepaid expenses and advance payments to other
parties. Intangible assets normally include non-physical items and
rights. Examples of intangible assets include goodwill, trademarks,
copyrights, patent rights and brand recognition etc.
A separate account for each tangible and intangible asset is maintained
by the business to record any increase or decrease in that account.
• Liability accounts: Liabilities are obligations or debts payable to
outsiders or creditors. The title of a liability account usually ends with
the word “payable”. Examples include accounts payable, bills payable,
wages payable, interest payable, rent payable and loan payable etc.
Besides these, any revenue received in advance is also a liability of the
business and is known as unearned revenue. For example, a marketing
firm may receive marketing fee from its client for the forthcoming
quarter in advance. Such unearned revenue would be recorded as a
liability as long as the related marketing services against it are not
provided to the client who has made the advance payment.
• Capital or owner’s equity accounts: Capital is the owner’s claim
against the assets of the business and is equal to total assets less all
liabilities to external parties. The balance in capital account increases
with the introduction of new capital and profits earned by the business
and decreases as a result of withdrawals and losses sustained by the
business. Self-Instructional
Material 41
Recording of Transactions In sole proprietorship, a single capital account titled as owner’s capital
account or simply capital account is used. In partnership or firm, each
partner has a separate capital account like John’s capital account,
Peter’s capital account etc. In corporate form of business there are
NOTES many owners known as stockholders or shareholders and the title
capital stock account is used to record any change in the capital.
• Withdrawal accounts: Withdrawals are cash or assets taken by
a business owner for his personal use. In sole proprietorship and
partnership, an account titled as drawings account is used to account
for all withdrawals. In corporate form of business withdrawals are
more systematic and usually termed as distributions to stockholders.
The account used for recording such distributions is known as dividend
account.
• Revenue or income accounts: Revenue is the inflow of cash as a
result of primary activities such as provision of services or sale of
goods. The term income usually refers to the net profit of the business
derived by deducting all expenses from revenue generated during a
particular period of time. However, in accounting and finance, the term
is also used to denote all inflows of cash resulted by those activities
that are not primary revenue generating activities of the business. For
example, a merchandising company may have some investment in an
oil company. Any dividend received from oil company would be termed
as dividend income rather than dividend revenue. Other examples of
income include interest income, rent income and commission income
etc. The businesses usually maintain separate accounts for revenues
and all incomes earned by them.
• Expense accounts: Any resource expended or service consumed to
generate revenue is known as expense. Examples of expenses include
salaries expense, rent expense, wages expense, supplies expense,
electricity expense, telephone expense, depreciation expense and
miscellaneous expense.

3.3 JOURNAL
The Journal records all daily transactions of a business into the order in
which they occur. A Journal may, therefore, be defined as a book containing
a chronological record of transactions. It is the book in which the transactions
are recorded first of all under the double entry system. Thus, Journal is the
book of original record. A Journal does not replace but precedes the Ledger.
The process of recording transaction in a Journal, is termed as Journalising.
A proforma of journal is given as:

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42 Material
JOURNAL Recording of Transactions

Date Particulars L.F. Debit Credit


` `
(1) (2) (3) (4) (5)
NOTES
1. Date The date on which the transaction was entered is recorded here.
2. Particulars The two aspects of transaction are recorded in this
column, i.e., the details regarding accounts which have to be debited
and credited.
3. L.F. It means Ledger Folio. The transactions entered in the Journal are
later on posted to the ledger. The relevant ledger folio is entered here.
Procedure regarding posting the transactions in the Ledger has been
explained in the next unit.
4. Debit In this column, the amount to be debited is entered.
5. Credit In this column, the amount to be credited is shown.
3.3.1 Rules of Debit and Credit
The transactions in the Journal are recorded on the basis of the rules of debit
and credit. For this purpose business transactions have been classified into
three categories:
(i) Transactions relating to persons.
(ii) Transactions relating to properties and assets.
(iii) Transactions relating to incomes and expenses.
On this basis, it becomes necessary for the business to keep an account of:
(i) Each person with whom it deals.
(ii) Each property or asset which the business owns.
(iii) Each item of income or expense.
The accounts falling under the first heading are called as ‘Personal
Accounts’. The accounts falling under the second heading are termed as
‘Real Accounts’. The accounts falling under the third heading are termed as
‘Nominal Accounts’. The classification of the accounts, as explained above,
can be put in the form of the following chart:

Self-Instructional
Material 43
Recording of Transactions Each of the above categories of accounts and the relevant rule for ‘debit
and credit’ have been explained in detail in the following pages:
Personal accounts Personal accounts include the accounts of persons
with whom the business deals. These accounts can be classified into the three
NOTES
categories.
1. Natural Personal Accounts The term ‘Natural Persons’ means
persons who are creation of God. For example, Mohan’s Account, Sohan’s
Account, Abha’s Account etc.
2. Artificial Personal Accounts These accounts include accounts of
corporate bodies or institutions which are recognised as persons in business
dealings. For example, the account of a Limited Company, the account of
a Co-operative Society, the account of a Club, the account of Government,
the account of an Insurance Company etc.
3. Representative Personal Accounts These are accounts which
represent a certain person or group of persons. For example, if the rent is
due to the landlord, an outstanding rent account will be opened in the books.
Similarly, for salaries due to the employees (not paid), an outstanding salaries
account will be opened. The outstanding rent account represents the account
of the landlord to whom the rent is to be paid while the outstanding salaries
account represents the accounts of the persons to whom the salaries have to
be paid. All such accounts are, therefore, termed as ‘Representative Personal
Accounts’.
The rule is:
· Debit the Receiver
· Credit the Giver
For example, if cash has been paid to Ram, the account of Ram will
have to be debited. Similarly, if cash has been received from Keshav, the
account of Keshav will have to be credited.
Real accounts Real accounts may be of the following types:
1. Tangible real accounts Tangible Real Accounts are those which
relate to such things which can be touched, felt, measured etc. Examples of
such accounts are cash account, building account, furniture account, stock
account, etc. It should be noted that bank account is a personal account;
since it represents the account of the banking company—an artificial person.
2. Intangible real accounts These accounts represent such things
which cannot be touched. Of course, they can be measured in terms of
money. For example, patents account, goodwill account, etc.
The rule is:
· Debit What Comes In
· Credit What Goes Out
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44 Material
For example, if building has been purchased for cash, building account Recording of Transactions
should be debited (since it is coming into the business) while cash account
should be credited (since cash is going out of the business). Similarly when
furniture in purchased for cash, furniture account should be debited while
the cash account should be credited. NOTES
Nominal accounts These accounts are opened in the books to simply explain
the nature of the transactions. They do not really exist. For example, in a
business, salary is paid to the manager, rent is paid to the landlord, commission
is paid to the salesman—cash goes out of the business and it is something
real; while salary, rent or commission as such do not exist. The accounts of
these items are opened simply to explain how the cash has been spent. In the
absence of such information, it may be difficult for the person concerned to
explain how the cash at his disposal was utilised.
Nominal Accounts include accounts of all expenses, losses, incomes
and gains. The examples of such accounts are rent, rates lighting, insurance,
dividends, loss by fire, etc.
The rule is:
· Debit All Expenses And Losses
· Credit All Gains And Incomes
Tutorial Note. Both Real Accounts and Nominal Accounts come in
the category of Impersonal Accounts. The student should note that when
some prefix or suffix is added to a Nominal Account, it becomes a Personal
Account. A table is being given to explain the above rule:
Nominal Account Personal Account
1. Rent account Rent prepaid account, Outstanding rent account.
2. Interest account Outstanding interest account, Interest received in advance account,
Prepaid interest account.
3. Salary account Outstanding salaries account, Prepaid salaries account.
4. Insurance account Outstanding insurance account, Prepaid insurance account.
5. Commission account Outstanding commission account, Prepaid commission account.
Illustration 3.1. From the following transactions find out the nature of
account and also state which account should be debited and which account
should be credited.
(a) Rent paid. (b) Salaries paid.
(c) Interest received. (d) Dividends received.
(e) Furniture purchased for cash. (f) Machinery sold.
(g) Outstanding for salaries. (h) Telephone charges paid.
(i) Paid to Suresh. (j) Received from Mohan (the proprietor).
(k) Lighting.

Self-Instructional
Material 45
Recording of Transactions Solution:
Transaction Accounts involved Nature of Accounts Debit/Credit
(a) Rent paid Rent A/c Nominal A/c Debit
Cash A/c Real A/c Credit
NOTES (b) Salaries paid Salaries A/c Nominal A/c Debit
Cash A/c Real A/c Credit
(c) Interest received Cash A/c Real A/c Debit
Interest A/c Nominal A/c Credit
(d) Dividends received Cash A/c Real A/c Debit
Interest A/c Nominal A/c Credit
(e) Furniture purchased Furniture A/c Real A/c Debit
Cash A/c Real A/c Credit
(f) Machinery sold Cash A/c Real A/c Debit
Interest A/c Real A/c Credit
(g) Outstanding for salaries Salaries A/c Nominal A/c Debit
Outstanding Personal A/c Credit
Salaries A/c
(h) Telephone charges paid Telephone Charges A/c Nominal A/c Debit
Cash A/c Real A/c Credit
(i) Paid to Suresh Suresh Personal A/c Debit
Cash A/c Real A/c Credit
(j) Received from Mohan Cash A/c Real A/c Debit
(the proprietor)
Capital A/c Personal A/c Credit
(k) Lighting Lighting A/c Nominal A/c Debit
Cash A/c Real A/c Credit
The journalising of the various transactions is explained now with the
help of the following illustration:
Illustration 3.2. Ram starts a business with capital of `20,000 on January
1, 2011.
In this case there are two accounts involved. They are:
(i) The account of Ram. (ii) Cash Account.
Solution: 1. Ram is natural person and, therefore, his account is a Personal
Account. Cash Account is a tangible asset and, therefore, it is a Real Account.
As per the rules of Debit and Credit, applicable to Personal Accounts, Ram is
the giver and, therefore, his account, i.e., Capital Account should be credited.
Cash is coming in the business and, therefore, as per the rules applicable to
Real Accounts, it should be debited. The transaction will now be entered in
the Journal as follows:
JOURNAL
Date Particulars L.F. Debit Credit
` `
2011
Jan. 1 Cash Account Dr. 20,000
To Capital Account 20,000
(Being commencement of business)
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46 Material
The words put within brackets “Being commencement of business” Recording of Transactions
constitute the narration for the entry passed, since, they narrate the transaction.
2. He purchased furniture for cash for `5,000 on January 5, 2011.
The two accounts involved in this transaction are the Furniture Account NOTES
and the Cash Account. Both are Real Accounts. Furniture is coming in and,
therefore, it should be debited while cash is going out and, therefore, it should
be credited. The Journal entry will, therefore, be as follows:
JOURNAL
Date Particulars L.F. ` `
2011
Jan. 5 Furniture Account Dr. 5,000
To Cash Account 5,000
(Being purchase of furniture)
3. He paid rent for business premises `2,000 on January 10, 2011.
In this transaction, two accounts involved are the Rent Account and
the Cash Account. Rent Account is Nominal Account. It is an expense and,
therefore, it should be debited. Cash Account is a Real Account. It is going
out of the business and, therefore, it should be credited. The journal entry
will, therefore, be as follows:
JOURNAL
Date Particulars L.F. ` `
2011
Jan. 10 Rent Account Dr. 2,000
To Cash Account 2,000
(Being payment of rent)

4. He purchased goods on credit of `2,000 from Suresh on January 20, 2011.


The two accounts involved in the transaction are those of Suresh and
Goods. The account of Suresh is a Personal Account while that of Goods
is a Real Account. Suresh is the giver of goods and, therefore, his account
should be credited while Goods are coming in the business and, therefore,
Goods Account should be debited.
JOURNAL
Date Particulars L.F. ` `
2011
Jan. 20 Goods Account Dr. 2,000
To Suresh 2,000
(Being purchase of goods on credit)
Classification of Goods Account The term goods include articles purchased
by the business for resale. Goods purchased by the business may be returned
back to the supplier. Similarly, goods sold by the business to its customers
can also be returned by the customers back to the business due to certain
reasons. In business, it is desired that a separate record be kept of all sale,

Self-Instructional
Material 47
Recording of Transactions purchase and return of goods. Hence, Goods Accounts can be classified into
the following categories:
(i) Purchases Account The account is meant for recording all purchases
of goods. Goods “come in” on purchasing of goods and, therefore, the
NOTES
Purchases Account is debited on purchase of goods.
(ii) Sales Account The account is meant for recording of selling of goods.
The goods “go out” on selling of goods, and therefore, on sale of goods,
the Sales Account is credited.
(iii) Purchases Returns Account The account is meant for recording return
of goods purchased. The goods “go out” on returning of goods to the
suppliers and, therefore, the account should be credited on returning
goods purchased.
(iv) Sales Returns Account The account is meant for recording return of
goods sold, by the customers. The goods “come in” and, therefore, the
Sales Returns Account should be debited on return of goods.
The above classification of Goods Account can be shown in the form
of the following chart:
GOODS ACCOUNT

Purchases A/c Sales A/c Purchases Returns Sales Returns A/c


Goods come in Goods go out A/c Goods go out Goods come in
(Dr.) (Cr.) (Cr.) (Dr.)

3.3.2 Compound Journal Entry


Sometimes there are a number of transactions on the same date relating to
one particular account or of one particular nature. Such transactions may
be recorded by means of a single journal entry instead of passing several
journal entries. Such entry regarding recording a number of transactions is
termed as a “Compound Journal Entry”. It may be recorded in any of the
following three ways:
(i) One particular account may be debited while several other accounts
may be credited.
(ii) One particular account may be credited while several other accounts
may be debited.
(iii) Several accounts may be debited and several other accounts may also
be credited.
This has been explained in the following illustration:
Illustration 3.3. Pass a compound journal entry in each of the following cases:
1. Payment made to Ram `1,000. He allowed a cash discount of `50.
2. Cash received from Suresh `800 and allowed him `50 as discount.
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48 Material
3. A running business was purchased by Mohan with the following assets Recording of Transactions
and liabilities:
Cash `2,000; Land `4,000; Furniture `1,000; Stock `2,000; Creditors
`1,000; Bank Overdraft `2,000.
NOTES
Solution:
JOURNAL
Sl. No. Particulars L.F. Debit Credit
` `
1. Ram Dr. 1,050
To Cash A/c 1,000
To Discount A/c 50
(Being payment made to Ram `1,000, and he
allowed `50 as discount)
2. Cash A/c Dr. 800
Discount A/c Dr. 50
To Suresh 850
(Being cash received from Suresh `800 and
discount allowed `50)
3. Cash A/c Dr. 2,000
Land A/c Dr. 4,000
Furniture A/c Dr. 1,000
Stock A/c Dr. 2,000
To Creditors 1,000
To Bank Overdraft 2,000
To Capital A/c 6,000
(Being commencement of business by Mohan
by taking over a running business)
Notes:
1. The total of payment due to Ram was `1,050. A payment of `1,000 has
been made to him and he allowed a discount of `50. This means by
paying `1,000, a full credit for `1,050 has been obtained. The account
of Ram is a Personal Account, and therefore, it has been debited as he is
the receiver. The cash has gone out of the business and, therefore, Cash
Account being a Real Account, has been credited. Discount Account
is a Nominal Account; getting discount is a gain to the business and,
therefore, it has been credited.
2. Suresh was to pay sum of `850. He paid `800 and he was allowed a
discount of `50. It means by paying `800 only, Suresh could get a full
credit of `850. The Cash Account is a Real Account and, therefore,
it has been debited since cash is coming in. Discount Account is a
Nominal Account; it has been debited since it is a loss to the business.
Suresh is the giver. His account being a Personal Account, it has been
credited by `850.

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Material 49
Recording of Transactions 3. It is not necessary that a person should start business only with cash.
He may bring the assets into the business or he may purchase a running
business. Mohan in the present case has purchased the assets of some
other business. The net assets (i.e. assets–liabilities taken over) will
NOTES be the capital of Mohan. The business is getting various assets and,
therefore, the assets accounts have been debited. The business creates
certain liabilities in the form of creditors, bank overdraft, and, therefore,
these accounts have been credited. Mohan’s Account, i.e., his Capital
Account has been credited by the balance since it represents the capital
brought in by him.
3.3.3 Opening Entry
In case of a running business, the assets and liabilities appearing in the
previous year’s balance sheet will have to be brought forward to the current
year. This is done by means of a journal entry which is termed as “Opening
Entry”. All Assets Accounts are debited while all Liabilities Accounts are
credited. The excess of assets over liabilities is the proprietor’s capital and
is credited to his Capital Account. This will be clear with the help of the
following illustration:
Illustration 3.4. Pass the Opening Entry on January 1, 2016 on the basis of
the following information taken from the business of Mr. Sunil:
`
(i) Cash in Hand 2,000
(ii) Sundry Debtors 6,000
(iii) Stock of Goods 4,000
(iv) Plant 5,000
(v) Land and Buildings 10,000
(vi) Sundry Creditors 10,000
Solution:
JOURNAL
Date Particulars L.F. ` `
2016 Cash A/c Dr. 2,000
Jan.1 Sundry Debtors A/c Dr. 6,000
Stock A/c Dr. 4,000
Plant A/c Dr. 5,000
Land & Buildings A/c Dr. 10,000
To Sundry Creditors 10,000
To Capital A/c (balancing figure) 17,000
(Being balances brought forward from the last year)
27,000 27,000

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50 Material
Debit Balances on Jan. 1, 2016: Recording of Transactions

1. Jan. 01 Cash in hand `8,000


Cash at Bank `25,000
Stock of Goods `20,000 NOTES
Furniture `2,000
Building `10,000
Sundry Debtors:
Vijay `2,000
Anil `1,000
Madhu `2,000
Credit Balances on Jan. 1, 2016:
Sundry Creditors
Anand `5,000
Loan from Bablu `10,000
Following were further transactions in the month of January, 2016:
2. Jan. 01 Purchased goods worth `5,000 for cash less
20% trade discount and 5% cash discount.
3. Jan. 04 Received `1,980 from Vijay and allowed him
`20 as discount.
4. Jan. 06 Purchased goods from Bharat `5,000.
5. Jan. 08 Purchased plant from Mukesh for `5,000 and
paid `100 as cartage for bringing the plant to
the factory and another `200 as installation
charges.
6. Jan. 12 Sold goods to Rahim on credit `600.
7. Jan. 15 Rahim became an insolvent and could pay only
50 paise in a rupee.
8. Jan. 18 Sold goods to Ram for cash `1,000.
9. Jan. 20 Paid salary to Ratan `2,000.
10. Jan. 21 Paid Anand `4,800 in full settlement.
11. Jan. 26 Interest received from Madhu `200.
12. Jan. 28 Paid to Bablu interest on loan `500.
13. Jan. 31 Sold Goods for cash `500.
14. Jan. 31 Withdrew goods from business for personal
use `200.

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Material 51
Recording of Transactions Solution:
JOURNAL
Sl. Date Particulars L.F. Debit Credit
No. ` `
NOTES
1. 2016
Jan. 1 Cash A/c Dr. 8,000
Bank A/c Dr. 25,000
Stock A/c Dr. 20,000
Furniture A/c Dr. 2,000
Building A/c Dr. 10,000
Vijay Dr. 2,000
Anil Dr. 1,000
Madhu Dr. 2,000
To Anand 5,000
To Bablu’s Loan A/c 10,000
To Capital A/c 55,000
(Being balances brought forward from last year)
2. Jan. 1 Purchases A/c Dr. 4,000
To Cash A/c 3,800
To Discount A/c 200
(Being purchase of goods for cash worth `5,000
allowed 20% trade discount and 5% cash discount
on `4,000)
3. Jan. 4 Cash A/c Dr. 1,980
Discount A/c Dr. 20
To Vijay 2,000
(Being cash received from Vijay, allowed `20 as
cash discount)
4. Jan. 4 Purchases A/c Dr. 5,000
To Bharat 5,000
(Being purchases of goods from Bharat)
5. Jan. 8 Plant A/c Dr. 5,300
To Mukesh 5,000
To Cash 300
(Being purchase of plant for `5,000 and payment
of `100 as cartage and `200 as installation
charges)
6. Jan. 12 Rahim Dr. 600
To Sales A/c 600
(Being sale of goods to Rahim)
7. Jan. 15 Cash A/c Dr. 300
Bad Debts A/c Dr. 300
To Rahim 600
(Being cash received from Rahim after his being
declared as an insolvent. 50% of the amount due
has been received and the rest has been taken as
a bad debt)
8. Jan. 18 Cash A/c Dr. 1,000
To Sales A/c 1,000
(Being cash sales)
9. Jan. 20 Salary A/c Dr. 2,000
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52 Material
Sl. Date Particulars L.F. Debit Credit Recording of Transactions

No. ` `
To Cash 2,000
(Being salary paid)
10. Jan. 21 Anand Dr. 5,000 NOTES
To Cash 4,800
To Discount 200
(Being cash paid to Anand and he allowed `200
as discount)
11. Jan. 26 Cash A/c Dr. 200
To Interest 200
(Being receipt of interest)
12. Jan. 28 Interest on Loan Dr. 500
To Cash 500
(Being payment of interest on loan)
13. Jan. 31 Cash A/c Dr. 500
To Sales A/c 500
(Being goods sold for cash)
14. Jan. 31 Drawings A/c Dr. 200
To Purchases A/c 200
(Being goods withdrawn for personal use)
Total 96,900 96,900

Check Your Progress


1. How is income defined in accounting and finance?
2. How are withdrawal accounts used in sole proprietorship, partnership,
and corporate firms?
3. What are the categories of personal accounts?
4. State the rule for recording transactions in the nominal accounts.
5. What comes under the opening entry?

3.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. The term income usually refers to the net profit of the business derived
by deducting all expenses from revenue generated during a particular
period of time. However, in accounting and finance, the term is also
used to denote all inflows of cash resulted by those activities that are
not primary revenue generating activities of the business.
2. In sole proprietorship and partnership, an account titled as drawings
account is used to account for all withdrawals. In corporate form
of business withdrawals are more systematic and usually termed as
distributions to stockholders. The account used for recording such
distributions is known as dividend account.
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Material 53
Recording of Transactions 3. The categories of personal accounts are: natural personal accounts,
artificial personal accounts and representative personal accounts.
4. The rule for recording transactions in the nominal accounts is: Debit
all the expenses and credit all gains and incomes.
NOTES
5. The opening entry comprises of an entry in which all assets accounts
are debited while all liabilities accounts are credited. The excess of
assets over liabilities is the proprietor’s capital and is credited to his
Capital Account.

3.5 SUMMARY
• The accounting cycle involves the following stages: recording of
transactions, classifying the transactions, summarising the transactions
and interpreting the results.
• According to modern approach, the accounts are classified as asset
accounts, liability accounts, capital or owner’s equity accounts,
withdrawal accounts, revenue/income accounts and expense accounts.
• The Journal records all daily transactions of a business into the order
in which they occur. It is a book containing a chronological record of
transactions.
• The transactions in the Journal are recorded on the basis of the rules
of debit and credit. For this purpose, business transactions have been
classified into three categories: transactions relating to persons, relating
to properties and assets and relating to incomes and expenses. Thus
three types of accounts which are prepared are personal, real and
nominal accounts.
• The term goods include articles purchased by the business for resale. In
business, it is desired that a separate record be kept of all sale, purchase
and return of goods. Hence, Goods Accounts can be classified into:
purchases account, sales account, purchases returns account and sales
returns account.
• Sometimes there are a number of transactions on the same date relating
to one particular account or of one particular nature. Such transactions
may be recorded by means of a single journal entry instead of passing
several journal entries. Such entry regarding recording a number of
transactions is termed as a “Compound Journal Entry”.
• In case of a running business, the assets and liabilities appearing in the
previous year’s balance sheet will have to be brought forward to the
current year. This is done by means of a journal entry which is termed
as “Opening Entry”.

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Recording of Transactions
3.6 KEY WORDS
· Compound Journal Entry: A journal entry recording more than one
business transaction. NOTES
· Journal: A book containing a chronological record of business
transactions. It is the book of original records.
· Journalizing: The process of recording transactions in the journal.
· Nominal Accounts: These are the accounts opened in the books simply
to explain the nature of the transaction. They include accounts of all
incomes/gains and expenses/losses.
· Opening Journal Entry: A journal entry passed for bringing forward
balances of assets and liabilities of the previous period to the current
period.
· Personal Accounts: These are the accounts of persons with whom
the business deals.
· Real Accounts: These are the accounts of tangible objects or intangible
rights owned by an enterprise and carrying probable future benefits.

3.7 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. State the meaning of the term “Journal” and state its significance.
2. What is the meaning of the term “Real Accounts”?
3. What do you understand by the term Accounting Cycle.
4. What is an opening entry?
Long Answer Questions
1. Explain the different categories in which the accounting transactions
can be classified. Also state the rule of ‘debit and credit’ in this
connection.
2. Explain the different rules for journalising the transaction with
appropriate illustrations.
3. Briefly explain the difference between:
(i) Personal and Impersonal Accounts.
(ii) Real Accounts and Nominal Accounts.

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Recording of Transactions
3.8 FURTHER READINGS
Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
NOTES Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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56 Material
Secondary Books

UNIT 4 SECONDARY BOOKS


(Subsidiary Books)

(SUBSIDIARY BOOKS)
NOTES
Structure
4.0 Introduction
4.1 Objectives
4.2 Different Types of Journals
4.2.1 Cash Journal or Book
4.2.2 Petty Cash Book
4.2.3 Purchases Journal
4.2.4 Sales Returns Journal
4.2.5 Purchases Returns Journal
4.3 Ledger
4.3.1 Posting
4.4 Answers to Check Your Progress Questions
4.5 Summary
4.6 Key Words
4.7 Self Assessment Questions and Exercises
4.8 Further Readings

4.0 INTRODUCTION
It has already been explained in Unit 3 that Journal is the book of prime
entry. It means all business transactions are to be first recorded in the Journal.
However, in a big business recording of all transactions in one Journal will
not only be inconvenient but also cause delay in collecting information
required. The Journal is, therefore, sub-divided into many subsidiary books.
This sub-division results in the following advantages:
(i) Convenience As stated above maintenance of one Journal only will
make it quite bulky or difficult to handle. Sub-division of Journal only
will result in reducing the size of Journal and making it convenient to
handle.
(ii) Division of labour Sub-division of Journal helps in division of labour
since different persons can write different Journals.
(iii) Classified information Each Journal provides information relating to
a particular aspect of the business. For example, a Purchases Journal
gives information about the total credit purchases made by the business.
Similarly, a Sales Journal gives information about the total credit sales
made by the business. Thus, the businessman gets the information
relating to different aspects of the business in a classified form in the
shortest possible time.

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Material 57
Secondary Books
(Subsidiary Books)

NOTES

Each of the above types of Journals have been explained in this unit.

4.1 OBJECTIVES
After going through this unit, you will be able to:
• Identify the different types of journals
• Describe the concept of cash book and petty cash book
• Discuss the concept of Ledger and posting
• Examine the relationship between journal and ledger

4.2 DIFFERENT TYPES OF JOURNALS


Let’s study the different types of Journals.
1. General Journal
It is also known as Journal Proper. It is meant for recording all such
transactions for which no special journal has been kept by the business. As a
matter of fact, it is meant for recording such transactions which do not occur
frequently in the business and, therefore, do not warrant setting up of special
journals. Examples of such transactions are as follows:
(i) Opening entries When a new set of books is started, the old accounts
have to be brought forward in the beginning of the year from last year’s
books. The opening entry is meant for recording these transactions.
The entries are made from the balance sheet of the last year.
(ii) Closing entries At the end of accounting year, the nominal accounts
are closed by transferring them to trading account or profit and loss
account. The entries passed for this purpose are termed as ‘Closing
Entries’.
(iii) Adjustment entries At the end of the accounting year, adjustment
entries are to be passed for outstanding/prepaid expenses, accrued/
outstanding income etc. Entries for all these adjustment are passed in
the General Journal.
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58 Material
(iv) Transfer entries Transfer entries are required for transferring one Secondary Books
(Subsidiary Books)
account to the other. Entries for such transfer are passed in the General
Journal.
(v) Rectification entries Rectification entries are passed for rectifying
NOTES
the errors which might have been committed in the books of account.
For example, the account of Mohan might have been debited in place
of the account of Sohan. The necessary rectifying entry will be passed
in he General Journal.
(vi) Purchases of fixed assets The entries for purchases of fixed assets
such as plant, machinery, furniture, etc., on credit are also passed in
this Journal.
2. Special Journal
The term ‘Special Journal’ means a Journal which is meant for a special
purpose. The following are the various types of Special Journals.
(i) Cash Journal Cash Journal is meant for recording all cash
transactions. It may be further classified into Cash Receipts Journal
and Cash Payments Journal. Cash Receipts Journal records all cash
receipts while Cash Payments Journal records all cash payments.
(ii) Goods Journal The Journal is meant for recording all transactions
relating to goods. It may, further, be classified into the following
categories:
(a) Purchases Journal The Journal is meant for recording all credit
purchases of goods. Cash purchases are to be recorded in the Cash
Journal. Moreover, only purchases of goods is to be recorded in
this Journal. The term “goods” means articles purchased for resale.
(b) Sales Journal The Journal is meant for recording all credit sales
of goods. Cash sales of the goods are to be recorded in the Cash
Journal.
(c) Purchases Returns Journal It is meant for recording all returns
of goods purchased on credit. It is also known as Returns Outward
Journal.
(d) Sales Returns Journal It is meant for recording all return of goods
sold on credit. It is also known as Returns Inward Journal.
(iii) Bills Journal The Journal is meant for recording all bills of exchange
or promissory notes received or issued by the business. It can be
classified into two categories:
(a) Bills Receivable Journal It is meant for recording all bills of
exchange or promissory notes received by the business from its
debtors.

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Material 59
Secondary Books (b) Bills Payable Journal It is meant for recording all bills of
(Subsidiary Books)
exchange or promissory notes issued by the business in favour
of its creditors.
Transactions relating to bills of exchange and promissory notes have
NOTES
been explained later in a separate unit.
In the following pages, we are explaining the method of recording
business transactions in each Journal and their posting into the ledger.
4.2.1 Cash Journal or Book
Cash Journal or Cash book is meant for recording all cash transactions. It is
a very important Journal of business on account of the following reasons:
(i) The number of cash transactions is quite large in every business. The
business has to pay for salaries, rent, lighting, insurance, purchase of
goods and it has to receive cash for sales of goods and capital assets.
(ii) The chances of fraud being committed regarding cash are higher as
compared to other assets. A strict control is, therefore, required. A
properly maintained cash book helps in achieving this objective.
(iii) Cash is the nerve centre of the business. Timely payments to its
creditors increases the reputation of the business. Similarly timely
payments from its debtors improves the financial position of the
business.
The cash book can be of any of the following types:
(i) Simple Cash Book
(ii) Two-Columnar Cash Book
(iii) Three-Columnar Cash Book
(iv) Multi-Columnar Cash Book
(v) Cash Receipts Book
(vi) Cash Payments Book
(i) Simple (Single)-Columnar Cash Book
Simple Cash Book is like an ordinary cash account. Its proforma is given
below:
Dr. SIMPLE CASH BOOK Cr.
Date Particulars L.F. Amount Date Particulars L.F. Amount

The recording of the transactions in the Simple Cash Book and their
posting in the Ledger can be understood with the help of the following
illustration:
Self-Instructional
60 Material
Illustration 4.1. Record the following transactions in the Cash Book and Secondary Books
(Subsidiary Books)
post them in the ledger:
Jan. 01 Opening Cash balance `5,000.
Jan. 04 Rent paid `2,000
Jan. 06 Interest received `3,000.
NOTES
Jan. 15 Cash purchases `4,000.
Jan. 25 Cash sales `8,000.
Jan. 31 Salaries paid `2,000.

Solution:

It should be noted that in the ledger no separate cash account will be opened.
The Cash Book functions both as a book as well as an account as shown in
the illustration above.
(ii) Two (Double)-Columnar Cash Book
Such a Cash Book has two columns: (i) Cash Column, and (ii) Discount
Column. Cash column is meant for recording cash receipts and payments
while discount column is meant for recording discount received and the

Self-Instructional
Material 61
Secondary Books discount allowed. The discount column on the debit side represents the
(Subsidiary Books)
discount allowed while discount column on the credit side represents the
discount received.
It should be noted that while the cash column of the cash book serves
NOTES
both the functions of a book as well as an account but discount column does
not serve the function of a discount account. A separate discount account has
to be opened in the ledger in which total debits and credits from the Cash
Book are posted. Sometimes, two separate discount accounts are kept in the
ledger—one for discount allowed and the other for discount received.
Trade Discount and Cash Discount The following are the points of
distinction between trade discount and cash discount:
(i) Trade discount is a deduction granted by a supplier from the list price
of the goods due to large quantity of sales or business tradition. While
cash discount is allowed by the creditor to the debtor for either buying
in cash or for making payment before the stipulated period.
(ii) Trade discount is allowed on sale of goods while cash discount is
allowed on payment of money.
(iii) Trade discount is not recorded in the books of account. The goods are
recorded on the net price. While cash discount is shown in the books
of account.
(iv) Trade discount may vary with the quantity of goods purchased while
cash discount may vary with the time period.
The recording of transactions in a two columnar cash book will be clear with
the help of the following illustration:
Illustration 4.2. Record the following transactions in the Cash Book and
post them in the ledger:
1. Jan. 01 Cash balance `5,000.
2. Jan. 06 Sold goods to Mahesh `4,000.
3. Jan. 08 Purchased goods from Mukesh `3,000.
4. Jan. 15 Cash received from Mukesh `3,900 in full
satisfaction.
5. Jan. 20 Paid to Mukesh `2,830 in full satisfaction.
6. Jan. 25 Sold goods to Suresh `3,000.
7. Jan. 31 Received cash from Suresh `2,900 in full
satisfaction.

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62 Material
Solution: Secondary Books
(Subsidiary Books)
Dr. CASH BOOK Cr.
Date Particulars L.F. Dis- Cash ` Date Particulars L.F. Dis- Cash
count count
(`) (`) (`) NOTES
Jan. 1 To Balance b/d 5,000 Jan. 20 By Mukesh 150 2,850
Jan. 25 To Mahesh 100 3,900 Jan. 31 By Balance c/d 8,950
Jan. 31 To Suresh 100 2,900
200 11,800 150 11,800

Ledger
MAHESH
Date Particulars ` Date Particulars `
Jan. 6 To Sales A/c 4,000 Jan. 15 By Cash A/c 3,900
   Jan. 15 By Discount A/c 100

SURESH
Date Particulars ` Date Particulars `
Jan. 25 To Sales A/c 3,000 Jan. 31 By Cash 2,900
   Jan. 31 By Discount 100

MUKESH
Date Particulars ` Date Particulars `
Jan. 20 To Cash 2,850 Jan. 8 By Purchases A/c 3,000
Jan. 20 To Discount 150   

DISCOUNT ALLOWED ACCOUNT


Date Particulars ` Date Particulars `
Jan. 31 To Sundries 200

DISCOUNT RECEIVED ACCOUNT

Date Particulars ` Date Particulars `


Jan. 31 By Sundries 150

Notes:
1. Transactions 2 and 6 relate to credit sales of goods and, therefore, they have not been recorded
in the cash book. They will be recorded in the Sales Book and the posting will be done in the
personal account of Mahesh and Suresh from there as shown in the Ledger.
2. Transaction 3 relates to credit purchase of goods. It has, therefore, not been recorded in the
Cash Book. It will be recorded in the Purchases Book from where posting will be done in the
personal account of Mukesh as shown in the Ledger.
3. The total of the debit side of the discount column has been taken to the ‘Discount Allowed
Account’ in the ledger. The word ‘sundries’ has been put in the ‘particulars’ column. Any
person who is interested in knowing the person to whom the discount has been allowed can
find it out from the Cash Book.
4. The total of the discount column appearing on the credit side of the cash book has been
taken to ‘Discount Received Account’ in the ledger. The word ‘Sundries’ has been put in the
‘Particulars’ column. Any person who is interested in knowing the names of the persons form
whom the discount has been received can find it out from the cash book.

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Secondary Books (iii) Three-Columnar Cash Book
(Subsidiary Books)
This type of cash book contains the following three columns on each side:
(i) Cash column for cash received and cash paid.
NOTES (ii) Discount column for discount received and discount allowed.
(iii) Bank column for money deposited and money withdrawn from the
bank.
The proforma of such a Cash Book is as follows:
Dt. Particulars L.F. Discount Cash Bank Dt. Particulars L.F. Discount Cash Bank

The recording of transactions in three-columnar cash book will be clear


with the help of the following Illustration.
Illustration 4.3.
Jan. 01 Opening Balance : Cash `3,000
Bank `4,000
Jan. 04 Rent paid by cheque `2,000
Jan. 06 Received on account of cash sales `3,000.
Jan. 08 Paid to Mehta Bros. by cheque `2,000 and earned
`200 as cash discount.
Jan. 10 Received from Suresh by cheque `2,000 and allowed
him `100 as cash discount.
Jan. 12 Cash sales `20,000.
Jan. 20 Cash purchases `15,000.
Jan. 31 Salaries paid `5,000.
Solution:
CASH BOOK
Dt. Particulars L.F Dis- Cash (`) Bank Dt. Particulars L.F. Dis- Cash Bank
(`)
count count (`) (`)
(`) (`)
Jan. Jan.
1 To Balance b/d 3,000 4,000 6 By Rent A/c 2,000
6 To Sales A/c 3,000 8 By Mehta Bros. 200 2,000
10 To Suresh 100 2,000 20 By Purch. A/c 15,000
12 To Sales A/c 20,000 31 By Salaries A/c 5,000
31 By Balance c/d 6,000 2,000
100 26,000 6,000 200 26,000 6,000
To Balance b/d 6,000 2,000
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64 Material
Ledger Secondary Books
(Subsidiary Books)
Dr. SALES ACCOUNTCr.

Date Particulars Amount (`) Date Particulars Amount (`)


Jan. 1
Jan. 10
By Cash A/c
By Cash A/c
3,000
20,000
NOTES
SURESH
Jan. 10 By Bank A/c 2,000
By Discount A/c 100

RENT ACCOUNT
Jan. 4 To Bank A/c 2,000

MEHTA BROS

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 8 To Bank A/c 2,000
Jan. 8 To Discount A/c 100

PURCHASES ACCOUNT

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 20 To Cash A/c 15,000

SALARIES ACCOUNT

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 31 To Cash A/c 5,000

DISCOUNT ALLOWED ACCOUNT

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 31 To Sundries A/c 100

DISCOUNT RECEIVED ACCOUNT

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 31 By Sundries 200

Contra entry As explained above, a three columnar cash book contains


columns both for cash and bank transactions. An accounting transaction
involves two accounts and there may be a transaction where both Cash
Account and Bank Account are involved. Since in the ledger, there are no
separate Cash Account and Bank Account, therefore, no posting will be
done from the Cash Book to the Ledger in case of such a transaction. The
transaction will be recorded on both sides of the Cash Book. For example,
if cash is withdrawn from the bank, the two accounts involved are the Cash
Account and the Bank, Account. In the Cash Book, on the debit side, the
amount will be put in cash column against the words “To Bank” while on
the credit side of the Cash Book, the amount will be written in the bank

Self-Instructional
Material 65
Secondary Books column against the words ‘‘By Cash’’. Such an accounting entry which is
(Subsidiary Books)
recorded on both the debit and credit sides of the cash book is known as a
Contra Entry. In order to give a hint to the ledger-keeper, that no posting is
required for such an entry, the word ‘C’ is put in the ledger folio column on
NOTES both the sides of the Cash Book.
Special points regarding cheques A business may receive cheques
from its customers or it can issue cheques in favour of its customers or other
creditors. Following are some special points which should be kept in view
while making accounting entries in the Cash Book regarding such cheques
received or issued.
1. Receipt of cheques There can be two situations:
(A) A cheque may be received by the business and sent to the Bank the
same day for collection. In such a case, it will be better to put the
cheque received in the debit side of the bank column as soon as it is
received. For example, if on January 10, a cheque is received from A
for `10,000 and is sent to the Bank for collection on the same day, the
entry for receipt of the cheque will appear in the Cash Book as follows:
CASH BOOK (RECEIPTS SIDE)

Date Particulars Date Cash (`) Bank (`)


Jan. 10 To A 10,000


(B) In case a cheque received from a party is sent to the Bank at a later
date, it will be better to take the cheque as receipt of cash when it is
received and deposit of cash in the bank when the cheque is sent for
collection to the Bank. For example, if on January 10, a cheque is
received from A for `10,000 and is sent to the Bank for collection on
January 14, the entries in the Cash Book will appear as follows:
Dr. CASH BOOK (CASH AND BANK COLUMNS) Cr.
Date Particulars L.F. Cash Bank Date Particulars L.F. Cash Bank
(`) (`) (`) (`)
Jan. 10 To A 10,000 Jan. 14 By Bank C 10,000
Jan. 14 To Cash C 10,000

Tutorial Note. In the absence of any specific instructions in the


question, the students should presume that the cheque received from a party
was sent to the Bank the same day for collection.
2. Endorsement of cheques received A cheque received by the business
may not be sent by it to the Bank for collection, but may be endorsed by the
business in favour of a creditor of the business. In such a case, the cheque
received will be taken as a receipt of cash. Similarly, the cheque endorsed,
will be taken as payment of cash. For example, if on January 10, cheque was
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66 Material
received from A for `10,000 and it was endorsed on January 14 in favour of B, Secondary Books
(Subsidiary Books)
a creditor of the business, the entries in the Cash Book will appear as follows:
CASH BOOK (CASH COLUMN ONLY)
Date Particulars L.F. Amount Date Particulars L.F. Amount NOTES
Jan. 10 To A 10,000 Jan. 14 By B 10,000

3. Dishonour of cheques The term ‘dishonour of cheque’ means non-payment


of the cheque by the drawee Bank on its being presented for payment. There
can be two different situations.
(I) A cheque received by a business and sent to the Bank for collection
may be dishonoured on presentation for payment. In such a case, the
party from whom the cheque was received should be debited while
the account of the Bank should be credited. For example, if a cheque
received from, ‘A’ for `10,000 on January 10, is dishonoured by his
bankers on presentation for payment on January 14, entries in the Cash
Book will appear as follows:
Dr. CASH BOOK (BANK COLUMN) Cr.
Date Particulars L.F. Amount Date Particulars L.F. Amount
Jan. 10 To A 10,000 Jan. 14 By A 10,000

Similarly when a cheque received from customer and endorsed in


favour of a creditor is dishonoured, the entries to be passed in the Cash Book
can be well understood on the basis of the following journal entries:
(a) On receipt of cheque
 Cash A/c   Dr.
   To Customer
(b) On endorsement of cheque
 Creditor     Dr.
   To Cash
(c) On dishonour of the cheque
 Customer   Dr.
   To Creditor
Thus, it is clear that no entries will be passed in the Cash Book in the
event of dishonour of a cheque received from a customer and endorsed in
favour of a creditor. Entries (a) and (b) will be passed through the Cash Book
while entry (c) will be passed through the Journal Proper.
(II) Cheques issued by the business in favour of third parties may be
dishonoured by the Bank. In such a case, the entry to be passed on the Cash
Book can be understood by passing the following journal entries:

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Material 67
Secondary Books (a) On issue of the cheque in favour of a creditor
(Subsidiary Books)
 Creditor   Dr.
   To Bank
NOTES (b) On dishonour of the cheque issued by the Bank
 Bank   Dr.
    To Creditor
Thus, when the cheque is issued in favour of a creditor, the creditor is
debited and the Bank Account is credited. The entry will appear in the Cash
Book on the credit side in the Bank column. On return of the cheque by the
creditor on account of its non-payment, the Creditor’s Account, which was
previously debited, would now be credited while the Bank Account, which
was previously credited, would now be debited. The entry for dishonour will,
therefore, appear in the debit side of the Cash Book in the Bank column.
The recording of transactions in a three-columnar cash book and from
there posting into the ledger will be clear with the help of the following
illustration.
Illustration 4.4. Enter the following transactions in the appropriate type of
the cash books, and post the same to the relevant ledger accounts:
2016
July 01 Started business with an investment of `9,000.
July 02 Deposited in Bank of India, `7,000.
July 04 Acquired a building by issuing a cheque of `5,000.
July 10 Paid the bill of the furniture by cheque `1,000.
July 15 Purchased `800 of merchandise by cheque.
July 18 Withdrew `100 from the bank.
July 20 Sold merchandise for `1,200.
July 22 Deposited `2,000 into the bank.
July 25 Bought `1,000 merchandise.
July 26 Sold `1,500 merchandise by crossed cheque.
July 27 Paid `100 by cheque as the premium for insuring
building against fire.
July 28 Paid freight `50.
July 30 Withdrew from bank for personal use `500.
July 31 Cleared electricity bill `90.
July 31 Paid to Mahesh `1,080 in full satisfaction by cheque.
We owed to Mahesh `1,100 for goods purchased.

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68 Material
July 31 Received from Suresh a cheque for `1,480, in full Secondary Books
(Subsidiary Books)
satisfaction of the debt of `1,510.
Solution:
Dr. CASH BOOK Cr. NOTES
Dt. Particulars L.F Dis. Bank Cash Dt. Particulars L.F. Dis. Bank Cash
(`)
(`) (`) (`) (`) (`)
2016 2016
Jul. 1 To Capital 9,000 Jul. 2 By Bank C 7,000
Jul. 2 To Cash C 7,000 Jul. 4 By Building 5,000
Jul. 18 To Bank C 100 Jul. 10 By Furniture 1,000
Jul. 20 To Sales 1,200 Jul. 15 By Purchases 800
Jul. 22 To Cash C 2,000 Jul. 18 By Cash C 100
Jul. 26 To Sales 1,500 Jul. 22 By Bank C 2,000
Jul. 31 To Suresh 30 1,480 Jul. 25 By Purchases 1,000
Jul. 27 By Insurance
  Premium 100
Jul. 28 By Freight 50
Jul. 30 By Drawings 500
Jul. 31 By Electricity 90
Jul. 31 By Mahesh 20 1,080
Jul. 31 By Bal. c/d 3,400 160
30 11,980 10,300 20 11,980 10,300

Aug. 1 To Bal. b/d 3,400 160

Ledger
Dr. CAPITAL ACCOUNT Cr.

Date Particulars Amount (`) Date Particulars Amount (`)


July 1 By Cash 9,000

BUILDING ACCOUNT
July 4 To Bank 5,000

PURCHASES ACCOUNT
July 15 To Bank 800
July 25 To Cash 1,000

FREIGHT ACCOUNT
July 28 To Cash 50

ELECTRICITY ACCOUNT
July 31 To Cash 90

SALES ACCOUNT
July 20 By Cash 1,200
July 26 By Bank 1,500

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Material 69
Secondary Books FURNITURE ACCOUNT
(Subsidiary Books)
July 10 To Bank 1,000

INSURANCE PREMIUM ACCOUNT


NOTES July 27 To Bank 100

DRAWINGS ACCOUNT
July 30 To Bank 500

DISCOUNT ACCOUNT
July 31 To Sundries 35 July 31 By Sundries 20

Notes:
(i) Cash and Bank columns in the cash book serve the purpose of prime as well as final entries.
Hence, in the ledger no Cash and Bank Accounts have been opened.
(ii) Cash Account never shows a credit balance, since a person cannot spend more than what he
has. While, the Bank Account may show a credit balance, since a bank may permit a customer
to overdraw his account (i.e., withdraw more money than what he has in his account). In such
a case, it will be said that the customer has an overdraft with the Bank.
(iii) Postings to the Discount Account is done at the end of the period with Total Discount Received
and Total Discount Allowed.

Cash Receipts and Payments Journal


It is common practice these days to keep separate Cash books for receipts
and payments. Thus, the business maintains two Cash Journals: (i) Cash
Receipts Journal, and (ii) Cash Payments Journal.
(i) Cash Receipts Journal The Journal is meant for recording all cash
receipts. The posting is done daily from the Cash Receipts Book to
the Journal. The concerned accounts are all credited with amount
mentioned in the Cash Receipts Journal. The total cash received as
shown by the Cash Receipts Journal is debited to the Cash Account at
the end of a period usually at the end of a week.
(ii) Cash Payments Journal The book is meant for recording all cash
payments. The posting is done daily from this book to the ledger and
the concerned accounts are debited. At the end of a period (usually at
the end of the week), cash account is credited with the total cash paid
during the period.
4.2.2 Petty Cash Book
Petty Cash Book is maintained by the business to record petty cash expenses
of the business, such as postage, cartage, stationery, cleaning charges etc.
In every business, there are many payments like the above which are of
small amounts. In case all these transactions are recorded in the Main Cash
Book, their recording will not only be inconvenient but also consume a lot

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70 Material
of valuable time of the cashier and the Posting Clerk. A Petty Cashier is Secondary Books
(Subsidiary Books)
appointed by the business to make payments of all such petty expenses. He
works under the supervision of the Chief Cashier, who advances money in
the beginning of every month/quarter to meet petty expenses. At the end of
the month/quarter, the Petty Cashier submits a statement of account of the NOTES
expenses incurred by him during the month/quarter and gets a fresh advance.
The Petty Cash Book is usually maintained on the basis of Imprest
System. According to this system, a fixed amount is advanced to the Petty
Cashier at the beginning of the period by the Chief Cashier. He submits his
accounts at the end of the period and the Chief Cashier after examining his
accounts gives him a fresh advance equivalent to the amount spent by him
during the period. Thus, in the beginning of the each period (month or quarter
as the case may be), the Petty Cashier has a fixed balance. The amount so
advanced to him is termed as “Imprest” or “Float”.
The recording of transactions in a Petty Cash Book will be clear with
the help of the following Illustration.
Illustration 4.5. Enter the following transactions in the Petty Cash Book
(maintained on Imprest system) for the month of January, 2015.
Jan. 01 Cash received from the Chief Cashier `200
Jan. 03 Typing paper `8, Postage `4
Jan. 06 Office cleaning `4
Jan. 08 Postage `2
Jan. 10 Cartage `2
Jan. 15 Postage `6
Jan. 18 Ink `3, Typing paper `10
Jan. 20 Typewriter ribbon `10
Jan. 22 Telephone charges `7
Jan. 24 Office cleaning `2
Jan. 25 Nailpolish `27
Jan. 27 Telegrams `25
Jan. 29 Typing paper `30

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Material 71
Secondary Books
(Subsidiary Books)

NOTES

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72 Material
Postings from the Petty Cash Book Postings in the Ledger from the Secondary Books
(Subsidiary Books)
Petty Cash Book is done at the end of the period, i.e., month or quarter as
the case may be. There are two alternative ways of making postings from
the Petty Cash Book.
NOTES
1. Petty Cash Book maintained as a Memorandum Book only In such a case,
the total of the various expenses from the Petty Cash Book is debited, to the
concerned accounts at the end of the period and credit is given to the Cash
Account with the actual expenditure incurred. The amount advanced by the
Chief Cashier to the Petty Cashier is recorded by him as a memorandum by
way of a note in the Cash Book itself. This method is usually not followed.
2. Where Petty Cash Book is taken as a part of the Double Entry System This
method is quite popular. The recording is done regarding the petty cash
transactions on the basis of the following entries:
(i) When money is advanced to the Petty Cashier:
Petty Cash Account Dr.
  To Cash Account
(The Petty Cash Account is debited with the actual amount
of money advanced)
(ii) On submission of accounts by the Petty Cashier:
Expenses Accounts Dr.
  To Petty Cash Account
(Each expense is to be debited separately with the expenditure incurred
during the period as shown by the Petty Cash Book.)
Thus, in the Ledger, there is a Petty Cash Account as well as separate
Expenses Accounts for each of the expenses.
Taking the figures as given in the preceding illustration, the various
ledger accounts, according to the second method, will appear as follows:
Dr. PETTY CASH ACCOUNT    Cr.

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 1 To Cash 200 Jan. 3 By Stationery 61
By Postal Charges 44
By Cartage 2
By Cleaning 8
By Miscellaneous 27
By Balance c/d 58
200 200
Feb. 1 To Balance b/d 58

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Material 73
Secondary Books STATIONERY ACCOUNT
(Subsidiary Books)
July 31 To Petty Cash A/c 61
POSTAL CHARGES ACCOUNT
July 31 To Petty Cash A/c 71
NOTES
CARTAGE ACCOUNT
July 31 To Petty Cash A/c 2

CLEANING ACCOUNT
July 31 To Petty Cash A/c 8

MISCELLANEOUS expenses ACCOUNT


July 31 To Petty Cash A/c 27

4.2.3 Purchases Journal


The Purchases Journal is meant for recording credit purchases of goods. It is
also known as the Purchases or Bought Day Book. It has columns for date of
purchase, invoice number, name of the party, ledger folio and the amount of
purchases. It should be noted that the book records only purchase of goods
on credit. Purchases of items other than goods on credit is recorded in the
General Journal. Similarly, cash purchases are recorded in the Cash Book.
Posting The posting is done in the Personal Accounts daily from the
Purchases Book. At the end of a week/month, the total of the Purchases Book
is debited to the Purchases Account in the ledger.
The following illustration will make clear the recording of transactions
in the Purchases Journal and their subsequent posting in the ledger.
Illustration 4.6. Record the following transactions in the Purchases Journal
and post them in the Ledger.
2016
Jan. 01 Purchased from Ram & Co. on credit:
30 Heater rods @ `10
20 Philips Bulbs @ `20
Jan. 04 Purchased from Shyam & Co. on credit:
40 Heater rods @ `10
20 E.C.E. Bulbs @ `15
Jan. 08 Purchased from Bajaj & Co. on credit:
20 Electric Elements @ `40
3 Electric Mixers @ `100

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74 Material
Jan. 24 Purchased from K.C. & Co. on credit: Secondary Books
(Subsidiary Books)
30 Electric Plugs @ `20
40 Table Fans @ `200
Solution: NOTES
PURCHASES JOURNAL
Sl. Invoice Particulars L.F. Amount (`) Amount
(`)
No. No.
2016
Jan. 1 50 Ram & Co.: 4
30 Heater rods @ `10 300
400 700
20 Philips Bulbs @ `20
Jan.4 55 Shyam & Co.: 8
40 Heater rods @ `10 400
300 700
20 E.C.E. Bulbs @ `15
Jan. 8 62 Bajaj & Co.: 12
20 Electric Elements @ `40 800
300 1,100
3 Electric Mixers @ `100
Jan. 24 65 K.C. & Co.: 13
30 Electric Plugs @ `20 600
8,000 8,600
40 Table Fans @ `200
Jan. 31 Purchases Account    Dr. 14 11,100

Ledger
RAM & CO. (Folio 4)

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 1 By Purchases 700

SHYAM & CO. (Folio 8)


Jan. 4 By Purchases 700

BAJAJ & CO. (Folio 12)


Jan. 8 By Purchases 1,100

K.C. & CO. (Folio 13)


Jan. 24 By Purchases 8,600

PURCHASES ACCOUNT (Folio 14)


Jan. 31 To Sundries 11,100

Notes:
(i) Folio Nos. are all imaginary.
(ii) Purchases Account has been debited with the total purchases made during the month. This
has been done at the end of the month. A firm may make the posting in the Purchases Account
weekly also.
(iii) Posting is done in the Personal Accounts daily.

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Material 75
Secondary Books Sales Journal
(Subsidiary Books)
The Journal is meant for recording all sales of goods on credit. This is also
known as Sales or Sold Day Book. It should be noted that Cash Sales are
NOTES recorded in the Cash Book while sales of articles other than goods on credit
is to be recorded in the General Journal.
Posting is done in the Personal Accounts daily from the Sales Book.
They are debited with individual amounts. The Sales Account is credited
with the total sales made during the period (i.e., a week or month) at the end
of the period.
The recording of the transactions in the Sales Book and their posting
in the Ledger will be clear with the help of the following illustration.
Illustration 4.7. Record the following transactions in the Sales Day Book
and post them into the ledger.
2015
Jan. 01 Sold to Mukesh & Co.:
10 Heater Rods @ ` 20
10 Lamp Shades @ ` 30
Jan. 10 Sold to Suresh & Brothers:
10 Table Fans @ ` 250
20 Philips Tubelights @ ` 30
Jan. 25 Sold to Ramesh & Co.:
10 Electric Switches @ ` 50
20 E.C.E. Tubelights @ ` 30
Solution:
SALES JOURNAL
Sl. Invoice Particulars L.F. Amount (`) Amount
(`)
No. No.
Jan. 1 101 Mukesh & Co.: 4
10 Heater Rods @ `20 200
300 500
10 Lamp Shades @ `30
Jan.10 102 Suresh & Brothers: 6
10 Table Fans @ `250 2,500
20 Philips Tubelights @ `30 600 3,100
Jan. 25 103 Ramesh & Co.: 8
10 Electric Switches @ `50 500
600 1,100
20 E.C.E. Tubelights @ `30
Sales A/c         Cr. 10 4,700

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76 Material
Ledger Secondary Books
(Subsidiary Books)
MUKESH & CO. (Folio 4)

Date Particulars Amount (`) Date Particulars Amount


(`)
Jan. 1 To Sales 500 NOTES

SURESH & BROTHERS (Folio 6)


Jan. 10 To Sales 3,100

RAMESH & CO. (Folio 8)


Jan. 25 To Sales 1,100

SALES ACCOUNT (Folio 10)


Jan. 31 By Sundries 4,700

Notes:
(i) Folio Nos., Invoice Nos. are all imaginary.
(ii) Posting is done in the Personal Accounts daily. The total sales are posted at the end of the
month (or week) on the credit side of the Sales Account, against the word ‘Sundries’. Any
person interested in finding out the names of the parties to whom the sales have been made
can do so by looking to the Sales Book.

4.2.4 Sales Returns Journal


The Journal is meant for recording return of goods sold on credit. The goods
which are sold for cash, if returned, are either exchanged for new goods or
the parties are paid in respect of them depending upon the circumstances. In
case the goods returned are not immediately exchanged for the other goods
or not paid for in cash, they are recorded in a memorandum book only. Thus,
goods sold for cash and returned do not find a place in the Sales Returns
Journal. They are recorded in the Cash Book in case cash is paid for them or
no entry will be passed in case they have been recorded in a memorandum
book only. A proforma of Sales Returns Journal is as under:
SALES RETURNS JOURNAL
Date Credit Note No. Particulars L.F. Amount Amount
(`) (`)
Jan. 10 202 Ram & Co.:
5 Electric Plugs @ `20 100
3 Philips Tubelights @ `30 90 190

Sales Returns A/c     Dr. 190

The posting from the Sales Returns Journal will be done daily in the
personal accounts. For example, in the above case, the account of Ram &
Co. will be credited with a sum of `190 on Jan. 10. The total of the Sales
Returns Journal will be posted to the debit of Sales Returns Account at the
end of the period, say, a week or a month.

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Material 77
Secondary Books Credit Note The customer who returns the goods, gets credit for the
(Subsidiary Books)
value of the goods returned. A Credit Note is sent to him intimating that his
account has been credited with the value of the goods returned. The Note is
prepared in duplicate. Its Proforma is as under:
NOTES
MAHESHWARI BROTHERS
3, Strand Road, Kolkata
No. 202 Date Jan. 10, 2016
To
Ram & Co.,
21, Shri Ram Road, Delhi.
Dear Sir,
We have credited your account in respect of the following goods returned by you:
` `
(i) 5 Electric Plugs @ `20 100
(ii) 3 Philips Tubelights @ `30 90 190
For Maheshwari Brothers
Sunil
Manager

4.2.5 Purchases Returns Journal


The book is meant for recording return of goods purchased on credit. The
goods purchased for cash and returned are not recorded in this book. They
are recorded in a memorandum book only. On receipt of cash in respect of
the goods returned, the entry will be passed through cash book. In case, the
goods are exchanged for other goods of the same value, no entry will be
required. The entry in the memorandum book will be cancelled on getting
cash or goods for goods returned. A proforma of the Purchases Returns
Journal is given below:
PURCHASES RETURNS JOURNAL

Date Credit Particulars L.F. Amount Amount

Note No. ` `
Jan. 12 301 Shyam & Co.
3 Electric Rods @ `40 120
Jan. 21 302 Bajaj & Co.
3 Electric Mixers @ `300 900
Purchases Returns A/c          Cr. 1,020
Note: The entries in the Personal Accounts are done daily from the Purchases Returns Book. They are
debited with the respective amounts. The total of the Purchases Returns Book is posted to the credit
of Purchases Returns Account at the end of the period, say, a week or a month, as the case may be.

Debit Note When the goods are returned to the supplier, a debit note
is sent to him indicating that this account has been debited with the amount
mentioned in the Debit Note. Its proforma is given as under:

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78 Material
Secondary Books
MAHESHWARI BROTHERS
(Subsidiary Books)
3, Strand Road Kolkata
No. 301 Date Jan. 12, 2014
To
  Shyam & Co. NOTES
  3, Clive Road, Kolkata.
  Dear Sir.
  We have debited your account for the goods returned by us as under:
  4 Electric Rods @ `30 `120
For Maheshwari Brothers
Sunil
Manager

Thus, in case of purchases returns or sales returns of goods, the flow


of Debit Note or Credit Note can be put as follows:
(i) The Debit Note is sent by the Purchaser of goods to the Seller of goods
on return of goods by the Purchaser to the Seller.
(ii) The Credit Note is sent by the Seller of goods to the Purchaser of goods
on return of goods to the Seller by the Purchaser.

Check Your Progress


1. List the types of special journal.
2. Define trade discount.
3. Give some examples of petty cash expenses.

4.3 LEDGER
It has already been explained in the previous unit that accounting involves
recording, classifying and summarising the financial transactions. Recording
is done in the Journal. This has already been explained in the preceding
chapter. Classifying of the recorded transactions is done in the Ledger. This
is being explained in the present section.
Ledger is a book which contains various accounts. In other words,
Ledger is a set of accounts. It contains all accounts of the business enterprise
whether Real, Nominal or Personal. It may be kept in any of the following
two forms:
(i) Bound Ledger (ii) Loose-leaf Ledger.
It is common to keep the Ledger in the form of loose-leaf cards these
days. This helps in posting transactions particularly when mechanised system
of accounting is used.

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Material 79
Secondary Books 4.3.1 Posting
(Subsidiary Books)
The term “Posting” means transferring the debit and credit items from the
Journal to their respective accounts in the Ledger. It should be noted that the
NOTES exact names of accounts used in the Journal should be carried to the Ledger.
For example, if in the Journal, Expenses Account has been debited, it would
not be correct to debit the Office Expenses Account in the Ledger. Though,
in the Journal, it might have been indicated clearly in the narration that it is
an item of office expenses the correct course would have been to record the
amount to the Office Expenses Account in the Journal as well as in the Ledger.
Posting may be done at any time. However, it should be completed
before the financial statements are prepared. It is advisable to keep the more
active accounts posted to date. The examples of such accounts are the cash
account, personal accounts of various parties etc.
The posting may be done by the book-keeper from the Journal to the
Ledger by any of the following methods:
(i) He may take a particular side first. For example, he may take the debits
first and make the complete postings of all debits from the Journal to
the Ledger.
(ii) He may take a particular account and post all debits and credits relating
to that account appearing on one particular page of the Journal. He
may then take some other accounts and follow the same procedure.
(iii) He may complete postings of each journal entry before proceeding to
the next journal entry.
It is advisable to follow the last method. One should post each debit
and credit item as it appears in the Journal.
The Ledger Folio (L.F.) column in the Journal is used at the time when
debits and credits are posted to the Ledger. The page number of the Ledger
on which the posting has been done is mentioned in the L.F. column of the
Journal. Similarly, a folio column in the Ledger can also be kept where the
page from which posting has been done from the Journal may be mentioned.
Thus, there are cross references in both the Journal and the Ledger.
A proper index should be maintained in the Ledger giving the names
of the accounts and the page numbers.
Relationship between Journal and Ledger
Both Journal and Ledger are the most important books used under Double
Entry System of book-keeping. Their relationship can be expressed as follows:
(i) The transactions are recorded first of all in the Journal and then they are
posted to the Ledger. Thus, the Journal is the book of first or original
entry, while the Ledger is the book of second entry.
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80 Material
(ii) Journal records transactions in a chronological order, while the Ledger Secondary Books
(Subsidiary Books)
records transactions in an analytical order.
(iii) Journal is more reliable as compared to the Ledger since it is the book
in which the entry is passed first of all.
NOTES
(iv) The process of recording transactions is termed as “Journalising”
while the process of recording transactions in the Ledger is called as
“Posting”.
Rules Regarding Posting
The following rules should be observed while posting transactions in the
Ledger from the Journal:
(i) Separate accounts should be opened in the Ledger for posting
transactions relating to different accounts recorded in the Journal. For
example, separate accounts may be opened for sales, purchases, sales
returns, purchases returns, salaries, rent, cash, etc.
(ii) The concerned account which has been debited in the Journal should
also be debited in the Ledger. However, a reference should be made of
the other account which has been credited in the Journal. For example,
for salaries paid, the salaries account should be debited in the Ledger,
but reference should be given of the Cash Account which was has been
credited in the Journal.
(iii) The concerned account, which has been credited in the Journal should
also be credited in the Ledger, but reference should be given of the
account, which has been debited in the Journal. For example, for salaries
paid, Cash Account has been credited in the Journal. It will be credited
in the Ledger also, but reference will be given of the Salaries Account
in the Ledger.
Thus, it may be concluded that while making posting in the Ledger, the
concerned account which has been debited or credited in the Journal should
also be debited or credited in the Ledger, but reference has to be given of the
other account which has been credited or debited in the Journal, as the case
may be. This will be clear with the following example.
Suppose, salaries of `10,000 have been paid is cash; the following
entry will be passed in the Journal:
Salaries Account (i) Dr. 10,000
To Cash Account (ii) 10,000
In the Ledger two accounts will be opened, (i) Salaries Account, and (ii)
Cash Account. Since Salaries Account has been debited in the Journal, it will
also be debited in the Ledger. Similarly, Cash Account has been credited in
the Journal and, therefore, it will also be credited in the Ledger, but reference
Self-Instructional
Material 81
Secondary Books will be given of the other account involved. Thus, the accounts will appear
(Subsidiary Books)
as follows in the Ledger:
Dr. SALARIES ACCOUNT Cr.

` Particulars
NOTES
Cash A/c (ii) 10,000

Dr. CASH ACCOUNT Cr.

Particulars ` Particulars `
Salaries A/c (i) 10,000

Use of the words “To” and “By”


It is customary to use words ‘To’ and ‘By’ while making posting in the Ledger.
The word ‘To’ is used with the accounts which appear on the debit side of
a Ledger Account. For example, in the Salaries Account, instead of writing
only “Cash” as shown above, the words “To Cash” will appear on the debit
side of the account. Similarly, the word “By” is used with accounts which
appear on the credit side of a Ledger Account. For example, in the above
case, the words “By Salaries A/c” will appear on the credit side of the Cash
Account instead of only “Salaries A/c”. The words ‘To’ and ‘By’ do not have
any specific meanings. Modern accountants are, therefore, ignoring the use
of these words.
The procedure of posting from the Journal to the Ledger will be clear
with the help of the illustrations given in the following pages.
Illustration 4.8. Journalize the following transactions and post them into
the Ledger:
1. Ram started business with a capital of `10,000.
2. He purchased furniture for cash `4,000.
3. He purchased goods from Mohan on credit `2,000.
4. He paid cash to Mohan `1,000.
Solution:
JOURNAL

Date Particulars L.F. Dr. ` Cr. `


1 Cash Account Dr. 10,000
To Capital Account 10,000 5
2 Furniture Account Dr. 4,000
To Cash Account 4,000 6
3 Purchases Account Dr. 2,000
To Mohan 2,000 7
4 Mohan Dr. 1,000
To Cash Account 1,000 8

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82 Material
Ledger Secondary Books
(Subsidiary Books)
CASH ACCOUNT
1 To Capital A/c 10,000 By Furniture A/c 4,000 6
By Mohan 1,000 8
NOTES
CAPITAL ACCOUNT

By Cash A/c 10,000 5

FURNITURE ACCOUNT

2 To Cash A/c 4,000

PURCHASES ACCOUNT

3 To Mohan 2,000

MOHAN

4 To Cash A/c 1,000 By Purchases A/c 2,000 7

Balancing of an Account
In business, there may be several transactions relating to one particular
account. In Journal, these transactions appear on different pages in a
chronological order while they appear in a classified form under that particular
account in the Ledger. At the end of a period (say, a month, a quarter or a year),
the businessman will be interested in knowing the position of a particular
account. This means, he should total the debits and credits of the account
separately and find out the net balance. This technique of finding out the net
balance of an account, after considering the totals of both debits and credits
appearing in the account is known as ‘Balancing the Account’. The balance
is put on the side of the account which is smaller and a reference is given that
it has been carried forward or carried down (c/f or c/d) to the next period. On
the other hand, in the next period, a reference is given that the opening has
been brought forward or brought down (b/f or b/d) from the previous period.
This will be clear with the help of the following illustration.
Illustration 4.9. Journalize the following transactions, post them in the
Ledger and balance the accounts on 31st January.
1. Ram started business with a capital of `10,000.
2. He purchased goods from Mohan on credit `2,000.
3. He Paid cash to Mohan `1,000.
4. He sold goods to Suresh `2,000.
5. He received cash from Suresh `3,000.
6. He further purchased goods from Mohan `2,000.
7. He paid cash to Mohan `1,000.

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Material 83
Secondary Books 8. He further sold goods to Suresh `2,000.
(Subsidiary Books)
9. He received cash from Suresh `1,000.
Solution:
NOTES JOURNAL

Particulars L.F. Debit (`) Credit (`)


Cash Account Dr. 10,000
To Capital Account 10,000
(Being commencement of business)
Purchases Account Dr. 2,000
To Mohan 2,000
(Being purchase of goods on credit)
Mohan Dr. 1,000
To Cash 1,000
(Being payment of cash to Mohan)
Suresh Dr. 2,000
To Sales 2,000
(Being goods sold to Suresh)
Cash Account Dr. 3,000
To Mohan 3,000
(Being cash received from Suresh)
Purchases Account Dr. 2,000
To Mohan 2,000
(Being purchase of goods from Mohan)
Mohan Dr. 1,000
To Cash Account 1,000
(Being payment of cash to Mohan)
Suresh Dr. 2,000
To Sales Account 2,000
(Being goods sold to Suresh)
Cash Account Dr. 1,000
To Suresh 1,000
(Being cash received from Suresh)
Total 24,000 24,000

Ledger
Dr. CASH ACCOUNT Cr.

Date Particulars ` Date Particulars `


To Capital A/c 10,000 By Mohan 1,000
To Suresh 3,000 By Mohan 1,000
To Suresh 1,000 Jan. 31 By Balance c/d 12,000
14,000 14,000
Feb. 1 To Balance b/d 12,000

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84 Material
Dr. CAPITAL ACCOUNT Cr. Secondary Books
(Subsidiary Books)
Date Particulars ` Date Particulars `
Jan. 31 To Balance c/d 10,000 By Cash A/c 10,000
10,000 10,000
Feb. 1 By Balance b/d 10,000 NOTES
PURCHASES ACCOUNT

Date Particulars ` Date Particulars `


To Mohan 2,000 Jan. 31 By Balance c/d 4,000
To Mohan 2,000
4,000 4,000
Feb. 1 To Balance b/d 4,000
MOHAN

Date Particulars ` Date Particulars `


To Cash 1,000 By Purchases 2,000
To Cash 1,000 By Purchases 2,000
To Balance c/d 2,000
4,000 4,000
Feb. 1 By Balance b/d 2,000

SURESH

Date Particulars ` Date Particulars `


To Sales 2,000 By Cash A/c 3,000
To Sales 2,000 By Cash A/c 1,000
4,000 4,000

SALES ACCOUNT

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 4,000 By Suresh 2,000
By Suresh 2,000
4,000 4,000
Feb. 1 By Balance b/d 4,000

It is to be noted that the balance of an account is always known by


the side which is greater. For example, in the above illustration, the debit
side of the Cash Account is greater than the credit side by `12,000. It
will be, therefore, said that Cash Account is showing a debit balance of
`12,000. Similarly, the credit side of the Capital Account is greater than
debit side by `10,000. It will be, therefore, said that the Capital Account is
showing a credit balance of `10,000.

Check Your Progress


4. What is the order of books in which the transactions are recorded in
double-entry system?
5. Define the accounting term ‘Balancing the Account’.

Self-Instructional
Material 85
Secondary Books
(Subsidiary Books) 4.4 ANSWERS TO CHECK YOUR PROGRESS
QUESTIONS
NOTES 1. The types of special journal are cash journal, goods journal, bills
journal, and bills payable journal.
2. Trade discount is a deduction granted by a supplier from the list price
of the goods due to large quantity of sales or business tradition.
3. Some examples of petty cash expenses are: postage, cartage, stationary,
cleaning charges, etc.
4. In the double entry system, the transactions are recorded first of all in
the Journal and then they are posted to the Ledger. Thus, the Journal
is the book of first or original entry, while the Ledger is the book of
second entry.
5. The technique of finding out the net balance of an account, after
considering the totals of both debits and credits appearing in the account
is known as ‘Balancing the Account’.

4.5 SUMMARY
• Journal is the book of prime entry. It means all business transactions are
to be first recorded in the Journal. However, in a big business recording
of all transactions in one Journal will not only be inconvenient but
also cause delay in collecting information required. The Journal is,
therefore, sub-divided into many subsidiary books.
• The general journal is meant for recording all such transactions for
which no special journal has been kept by the business.
• The term ‘Special Journal’ means a journal which is meant for a special
purpose. It has subtypes including a cash journal, goods journal and a
bills journal.
• The Cash journal is meant for recording all cash transactions. It has
various types including a simple cash book, two-columnar cash book,
three-columnar cash book, multi-columnar cash book, cash receipts
books and cash payments books.
• Petty Cash Book is maintained by the business to record petty cash
expenses of the business, such as postage, cartage, stationery, cleaning
charges, etc. The Petty Cash Book is usually maintained on the basis
of Imprest system.
• The Purchases Journal is meant for recording credit purchases of
goods. It is also known as the Purchases or Bought Day Book. The
Sales journal is meant for recording all sales of goods on credit. This
book is also known as Sales or Sold Day Book.
Self-Instructional
86 Material
• The Classifying of the recorded transactions is done in the Ledger. Secondary Books
(Subsidiary Books)
It may be kept in any of the two forms: bound ledger and loose-leaf
ledger.
• The term posting means transferring the debit and credit items of the
NOTES
Journal to their respective accounts in the Ledger.
• The technique of finding out the net balance of an account after
considering the totals of both debits and credits appearing in the account
is known as ‘Balancing the Account.’

4.6 KEY WORDS


· Bills Journal: A journal meant for recording all transactions relating
to Bills of Exchange or Promissory Notes received or issued by the
business.
· Cash Journal: A journal meant for recording all cash transactions.
· Contra Entry: An accounting entry which is recorded on both the
debit and credit sides of the Cash Book.
· General Journal: A journal meant for recording all such transactions
for which no special journal has been kept by the business.
· Goods Journal: A journal meant for recording all credit transactions
relating to goods.
· Imprest: The amount advanced to the petty cashier in the beginning
of a period. It is also termed as float.
· Petty Cash Book: A book meant for recording all petty cash expenses
of the business.
· Special Journal: A journal meant for recording transactions of a
specific type.
· Ledger: A book containing different accounts of an entity.
· Posting: Transferring the debit and credit items from the Journal to
the respective accounts in the Ledger.
· Trial Balance: A statement containing the various ledger balances on
a particular date.
· Voucher System: A plan and method of procedure for the verifications,
recording and payment of all items (other than items to be paid from
petty cash) which require disbursement of cash.

Self-Instructional
Material 87
Secondary Books
(Subsidiary Books) 4.7 SELF ASSESSMENT QUESTIONS AND
EXERCISES
NOTES Short Answer Questions
1. Explain briefly the Imprest System of Petty Cash Book.
2. What do you understand by subsidiary books? Describe the objectives
of preparing them.
3. What do you mean by sub-division of Journal?
Long Answer Questions
1. What is a special purpose subsidiary book? Give a specimen of such
a book showing at least five entries.
2. Explain the different types of Goods Journals with suitable examples.

4.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi:
Kalyani Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

Self-Instructional
88 Material
Trial Balance and
Rectification of Errors
BLOCK - II
FINAL ACCOUNTS AND ADJUSTMENTS
NOTES
UNIT 5 TRIAL BALANCE AND
RECTIFICATION OF
ERRORS
Structure
5.0 Introduction
5.1 Objectives
5.2 Trial Balance
5.3 Errors in Accounting and Its Rectification
5.3.1 Location of Errors
5.3.2 Rectifying Accounting Entries
5.4 Answers to Check Your Progress Questions
5.5 Summary
5.6 Key words
5.7 Self Assessment Questions and Exercises
5.8 Further Readings

5.0 INTRODUCTION
The basic information for preparing final accounts (discussed in Units 6 and
7) is supplied by the Trial Balance. Thus, the accuracy of the Trial Balance
determines to a great extent the accuracy or otherwise of the information
provided by Final Accounts. However, the Trial Balance provides only proof
of the arithmetical accuracy of the books of accounts. It simply assures that
for every debit there is an equivalent credit entry. It means that in spite of an
agreed Trial Balance, it is not necessary that there are not errors in the books
of accounts. For example, if a transaction is not at all recorded in the books
of accounts, the Trial Balance will tally, but the books of accounts cannot
be termed as accurate. In any case, if the two sides of the Trial Balance do
not tally, it is a definite proof of this fact that there are certain errors in the
books of accounts. Thus, errors may be there in recording, classifying and
summarising the financial transactions whether the Trial Balance tallies or
whether it does not tally.

Self-Instructional
Material 89
Trial Balance and
Rectification of Errors 5.1 OBJECTIVES
After going through this unit, you will be able to:
NOTES • Describe the trial balance
• Explain the preparation of a trial balance
• Discuss the procedure for rectification of error in accounting
• Identifying the rectifying accounting entries

5.2 TRIAL BALANCE


In case the various debit balances and the credit balances of the different
accounts are taken down in a statement, the statement so prepared is termed
as a Trial Balance. In other words, Trial Balance is a statement containing the
various ledger balances on a particular date. For example, with the balances
of the ledger accounts prepared in Illustration 4.9 (of the previous unit), the
Trial Balance can be prepared as follows:
TRIAL BALANCE
as on 31st January
Particulars Debit Credit
(`) (`)
Cash Account 12,000
Capital Account 10,000
Purchases Account 4,000
Mohan 2,000
Sales Account 4,000
16,000 16,000

Thus, the two sides of the Trial Balance tally. It means the books of
accounts are arithmetically accurate.
Objects of Preparing a Trial Balance
1. Checking of the arithmetical accuracy of the accounting entries As
indicated above, Trial Balance helps in knowing the arithmetical
accuracy of the accounting entries. This is because according to the dual
aspect concept for every debit, there must be an equivalent credit. Trial
Balance represents a summary of all ledger balances and, therefore, if
the two sides of the Trial Balance tally, it is an indication of this fact
that the books of account are arithmetically accurate. Of course, there
may be certain errors in the books of account in spite of an agreed Trial
Balance. For example, if a transaction has been completely omitted
from the books of account, the two sides of the Trial Balance will tally,
in spite of the books of account being wrong. This has been discussed
in detail later in a separate unit.

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90 Material
2. Basis for financial statements Trial Balance forms the basis for Trial Balance and
Rectification of Errors
preparing financial statements such as the Income Statement and the
Balance Sheet. The Trial Balance represents all transactions relating
to different accounts in a summarised form for a particular period. In
case the Trial Balance is not prepared, it will be almost impossible to NOTES
prepare the financial statements as stated above to know the profit or
loss made by the business during a particular period or its financial
position on a particular date.
3. Summarised ledger It has already been stated that a Trial Balance
contains the ledger balances on a particular date. Thus, the entire
ledger is summarised in the form of a Trial Balance. The position of a
particular account can be judged simply by looking at the Trial Balance.
The Ledger may be seen only when details regarding the accounts are
required.
Methods of Preparation of a Trial Balance
A Trial Balance may be prepared according to any of the two methods:
1. Total Method In case of this method after totaling each side of the
ledger account, the respective debit and credit totals of the ledger
accounts are transferred to the respective sides of the trial balance.
Thus, in case of this method, the trial balance can be prepared soon
after totaling various accounts and the time taken in balancing the
account is saved to that extent. This method is not generally followed
since it does not help in preparation of financial statements.
2. Balance Method According to this method, every ledger account is
balanced and only the balance of the ledger account is carried forward
to the trial balance. This method is generally used since the preparation
of the financial statements where only balances are to be taken.
3. Total and Balance Method This method combines the first two
methods explained above. In case of this method, the trial balance
contains both the totals of both sides of the respective accounts as well
as their final balances. This method has the advantage that it helps in
immediate location of a mistake incurred, if any in the balancing the
account. However, it has disadvantage of increasing the workload of
the staff.
Illustration 5.1. Prepare (a) ledger accounts and (b) the trial balance
according to (i) Total method (ii) Balance method and (iii) Total and balance
method on the basis of transactions.

Self-Instructional
Material 91
Trial Balance and Solution:
Rectification of Errors
(a) Preparation of Ledger Accounts
Dr. CASH ACCOUNT Cr.
NOTES Date Particulars L.F. ` Date Particulars L.F. `
2016 2016
Jan. 1 To Balance b/d 8,000 Jan. 1 By Purchases A/c 3,800
Jan. 4 To Vijay 1,980 Jan. 8 By Plant A/c 300
Jan. 15 To Rahim 300 Jan. 20 By Salary A/c 2,000
Jan. 18 To Sales A/c 1,000 Jan. 21 By Anand 4,800
Jan. 26 To Interest A/c 200 Jan. 28 By Interest on
Jan. 31 To Sales A/c 500 Loan A/c 500
Jan. 31 By Balance c/d 580
11,980 11,980
Feb. 1 To Balance b/d 580

INTEREST ACCOUNT

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 200 Jan. 26 By Cash A/c 200
200 200
Feb. 1 By Balance b/d 200

BANK ACCOUNT

Date Particulars ` Date Particulars `


Jan. 1 To Balance b/d 25,000 Jan. 31 By Balance c/d 25,000
25,000 25,000
Feb. 1 To Balance b/d 25,000

STOCK ACCOUNT

Date Particulars ` Date Particulars `


Jan. 1 To Balance b/d 20,000 Jan. 31 By Balance c/d 20,000
20,000 20,000
Feb. 1 To Balance b/d 20,000

Dr. FURNITURE ACCOUNT Cr.

Date Particulars ` Date Particulars `


Jan. 1 To Balance b/d 2,000 Jan. 31 By Balance c/d 2,000
2,000 2,000
Feb. 1 To Balance b/d 2,000

BUILDING ACCOUNT

Date Particulars ` Date Particulars `


Jan. 1 To Balance b/d 10,000 Jan. 31 By Balance c/d 10,000
10,000 10,000
Feb. 1 To Balance b/d 10,000

VIJAY

Date Particulars ` Date Particulars `


Jan. 1 To Balance b/d 2,000 Jan. 4 By Cash A/c 1,980
By Discount A/c 20
2,000 2,000

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92 Material
ANIL Trial Balance and
Rectification of Errors
Date Particulars ` Date Particulars `
Jan. 1 To Balance b/d 1,000 Jan. 31 By Balance c/d 1,000
1,000 1,000
Feb. 1 To Balance b/d 1,000 NOTES
MADHU

Date Particulars ` Date Particulars `


Jan. 1 To Balance b/d 2,000 Jan. 31 By Balance c/d 2,000
2,000 2,000
Feb. 1 To Balance b/d 2,000

ANAND

Date Particulars ` Date Particulars `


Jan. 21 To Cash A/c 4,800 Jan. 1 By Balance b/d 5,000
Jan. 21 To Discount A/c 200
5,000 5,000

CAPITAL ACCOUNT

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 55,000 Jan. 1 By Balance b/d 55,000
55,000 55,000
Feb. 1 By Balance b/d 55,000

Dr. BABU’S LOAN ACCOUNT Cr.

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 10,000 Jan. 1 By Balance b/d 10,000
10,000 10,000
Feb. 1 By Balance b/d 10,000

PURCHASES ACCOUNT

Date Particulars ` Date Particulars `


Jan. 1 To Cash A/c 3,800 Jan. 31 By Drawings A/c 200
Jan. 1 To Discount A/c 200 Jan. 31 By Balance c/d 8,800
Jan. 6 To Bharat 5,000
9,000 9,000
Feb. 1 To Balance b/d 8,800

DISCOUNT ACCOUNT

Date Particulars ` Date Particulars `


Jan. 4 To Vijay 20 Jan. 1 By Purchases A/c 200
Jan. 31 To Balance c/d 380 Jan. 21 By Anand 200
400 400
Feb. 1 By Balance b/d 380

BHARAT

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 5,000 Jan. 6 By Purchases A/c 5,000
5,000 5,000
Feb. 1 By Balance b/d 5,000

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Material 93
Trial Balance and PLANT ACCOUNT
Rectification of Errors
Date Particulars ` Date Particulars `
Jan. 8 To Mukesh 5,000 Jan. 31 By Balance c/d 5,300
Jan. 8 To Cash A/c 300
NOTES 5,300 5,300
Feb. 1 To Balance b/d 5,300

INTEREST ON LOAN ACCOUNT

Date Particulars ` Date Particulars `


28 To Cash A/c 500 Jan. 31 By Balance c/d 500
500 500
Feb. 1 To Balance b/d 500

Dr. MUKESH Cr.

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 5,000 Jan. 8 By Plant A/c 5,000
5,000 5,000
Feb. 1 By Balance b/d 5,000

SALES ACCOUNT

Date Particulars ` Date Particulars `


Jan. 31 To Balance c/d 2,100 Jan. 21 By Rahim 600
Jan. 18 By Cash A/c 1,000
Jan. 31 By Cash A/c 500
2,100 2,100
Feb. 1 By Balance b/d 2,100

Dr. RAHIM Cr.

Date Particulars ` Date Particulars `


Jan. 12 To Sales A/c 600 Jan. 15 By Cash A/c 300
Jan. 15 By Bad Debts A/c 300
600 600

BAD DEBTS ACCOUNT

Date Particulars ` Date Particulars `

Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 300


300 300
Feb. 1 To Balance b/d 300

SALARY ACCOUNT

Date Particulars ` Date Particulars `


Jan. 20 To Cash A/c 2,000 Jan. 31 By Balance c/d 2,000
2,000 2,000
Feb. 1 To Balance b/d 2,000

DRAWINGS ACCOUNT

Date Particulars ` Date Particulars `


Jan. 31 To Purchases A/c 200 Jan. 31 By Balance c/d 200
200 200
Feb. 1 To Balance b/d 200

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94 Material
(b) (i) Total Method Trial Balance and
Rectification of Errors
TRIAL BALANCE

(as on 31st January, 2016)

Particulars Debit (`) Credit (`) NOTES


Cash Account 11,980 11,400
Interest Account 200
Bank Account 25,000
Stock Account 20,000
Furniture Account 2,000
Building Account 10,000
Vijay 2,000 2,000
Anil 1,000
Madhu 2,000
Anand 5,000 5,000
Capital Account 55,000
Babu’s Loan Account 10,000
Purchases Account 9,000 200
Discount Account 20 400
Bharat 5,000
Plant Account 5,300
Interest on Loan Account 500
Mukesh 5,000
Sales Account 2,100
Rahim 600 600
Bad Debts Account 300
Salary Account 2,000
Drawings Account 200
Total 96,900 96,900

(ii) Balance Method


TRIAL BALANCE
(as on 31st January, 2016)

Particulars Debit (`) Credit


(`)
Cash Account 580
Interest 200
Bank Account 25,000
Stock Account 20,000
Furniture Account 2,000
Building Account 10,000
Anil 1,000
Madhu 2,000
Capital Account 55,000
Babu’s Loan Account 10,000
Purchases Account 8,800
Discount Account 380
Bharat 5,000
Plant Account 5,300

Self-Instructional
Material 95
Trial Balance and
Interest on Loan Account 500
Rectification of Errors
Mukesh 5,000
Sales Account 2,100
Bad Debts Account 300
Salary Account 2,000
NOTES
Drawings Account 200
77,680 77,680

(iii) Total and Balance Method


TRIAL BALANCE

(as on 31st January, 2016)

Total Method Balance Method


Particulars
Debit ( ` ) Credit ( ` ) Debit ( ` ) Credit ( ` )
Cash Account 11,980 11400 580
Interest Account 200 200
Bank Account 25,000 25,000
Stock Account 20,000 20,000
Furniture Account 2,000 2,000
Building Account 10,000 10,000
Vijay 2,000 2,000
Anil 1,000 1,000
Madhu 2,000 2,000
Anand 5,000 5,000
Capital Account 55,000 55,000
Babu’s Loan Account 10,000 10,000
Purchases Account 9,000 200 8,800
Discount Account 20 400 380
Bharat 5,000 5,000
Plant Account 5,300 5,300
Interest on Loan Account 500 500
Mukesh 5,000 5,000
Sales Account 2,100 2,100
Rahim 600 600
Bad Debts Account 300 300
Salary Account 2,000 2,000
Drawings Account 200 200
Total 96,900 96,900 77,680 77,680

Check Your Progress


1. Which accounting tool helps in finding out if the books of accounts
are arithmetically accurate?
2. Why is the total method of preparation of a Trial Balance not generally
followed?

Self-Instructional
96 Material
Trial Balance and
5.3 ERRORS IN ACCOUNTING AND ITS Rectification of Errors

RECTIFICATION
Errors in accounting can broadly be classified as shown in the following chart: NOTES

Each of the above types of errors has been explained on the next page:
I. Clerical Errors
These include the following errors:
1. Errors of omission These errors are incurred in those cases when a
transaction is completely omitted from the books of account. It happens
when a transaction is not recorded in the books of the original entry
(i.e., various journals). For example, if a purchase of goods on credit
from Shri Ram Lal has not at all been recorded in the books of account,
such an error will be termed as an error of omission. Since, there has
been neither a debit entry nor a credit entry, therefore, the two sides
of the Trial Balance will not be at all affected on account of this error.
Such errors, therefore, cannot be located out very easily. They come to
the notice of the businessman when statement of accounts are received
from or sent to creditors or debtors, as the case might be.
2. Errors of commission Such errors include errors on account of wrong
balancing of an account, wrong posting, wrong carry forwards, wrong
totalling, etc. For example, if a sum of `50 received from Mukesh
is credited to his account as `500, this is an error of commission.
Similarly, if the total of debit side of an account is carried forward
from one page to another and the mistake is committed in such carry
forward (e.g., total of `996 is carried forward as `699) such an error
is an error of commission. Errors of commission affect the agreement
of the Trial Balance and, therefore, their location is easier.
3. Compensating errors As the name indicates, compensating errors
are those errors which compensate each other. For example, if a sale
of `500 to Ram is debited as only of `50 to his account, while a sale of

Self-Instructional
Material 97
Trial Balance and `50 to Shyam is debited as of `500 to his account, it is a compensating
Rectification of Errors
error. These errors also do not affect the agreement of the Trial Balance
and, therefore, their location is also difficult.
II. Errors of Principle
NOTES
Errors of principle are committed in those cases where a proper distinction
between revenue and capital items is not made, i.e., a capital expenditure is
taken as a revenue expenditure or vice versa. Similarly, a capital receipt may
have been taken as a revenue receipt or vice versa. For example, a sale of
old furniture of `500 should be credited to the furniture account, but if it is
credited to the Sales Account, it will be termed as an error of principle. Sale
of old furniture is a capital receipt. If it is credited to Sales Account, it has
been taken as a revenue receipt. Such errors by themselves do not affect the
agreement of the Trial Balance. Therefore, they also are difficult to be located.
Thus, errors of omission, errors of principle and compensating errors
by themselves alone do not affect the agreement of the Trial Balance. In
case these errors get combined with errors of commission, they may affect
the agreement of the Trial Balance. For example, if a sale of old furniture of
`500 is credited to the Sales Account only as of `50, the error combines in
itself both an error of principle as well as error of commission. Thus, such
an error will affect the agreement of the Trial Balance.
5.3.1 Location of Errors
Location of errors of principle, errors of compensating nature and errors
of omission is slightly difficult because of the fact that such errors do not
affect the agreement of the Trial Balance and, therefore, their location may
be considerably delayed. However, location of errors of commission is
comparatively easier because they affect the agreement of the Trial Balance.
Thus, the errors can be classified into two categories from the point of view
of locating them:
(i) Errors which do not affect the agreement of the Trial Balance.
(ii) Errors which affect the agreement of the Trial Balance.
Errors which do not affect the agreement of the Trial Balance As
stated before, errors of omission, errors of commission and errors of
compensating nature by themselves do not affect the agreement of the Trial
Balance. Their location is, therefore, a difficult process. They are usually
found out when statement of accounts are received by the business or sent to
the customers or during the course of internal or external audit and sometimes
by chance. For example, if a credit purchase of `500 from Ram has not been
recorded in the books of accounts, the error will not affect the agreement
of the Trial Balance and, therefore, at the time of finalising the accounts it
may not be traced out. However, this will be found out when a statement of

Self-Instructional
98 Material
account is sent to Ram showing the money due to him or when a statement Trial Balance and
Rectification of Errors
of account is received from Ram showing the money recoverable by him.
Errors which affect the agreement of the Trial Balance Such errors
are easy to be located since they are caught at an early stage. As soon as the
NOTES
Trial Balance does not tally, the accountant can proceed to find out these
errors. The procedure to be followed for location of such errors can be put
as follows:
(i) The difference of the two sides of the Trial Balance should be found
out. The amount should then be divided by two. The two sides of the
Trial Balance should then be checked to find out if there is an amount
equal to that figure. It is possible that the amount was placed on a
wrong side resulting in a difference in the totals of the Trial Balance.
For example, if the total of the debit side of the Trial Balance is `450
more than the credit side of the Trial Balance, `450 should be divided
by 2, thus giving a figure of 225. The debit side should then be checked
to find out if there is an amount of `225 appearing on that side. If it
is so, it should be seen whether the amount has been correctly put to
that side or it should have gone to the credit side.
(ii) If the mistake is not found out by taking step number (i), the difference
should be divided by 9. If the difference is completely divisible, it can
be error of transposition of figures. For example, if the figure of 698
is written as 986, the difference is of `198. This figure is completely
divisible by 9. Thus it can be concluded that in such cases where the
difference is divisible by 9, there can be a probability of this type of
error.
(iii) In case the difference is still not traceable, the following further
possibilities should be checked:
(a) If the difference is in a round figure, there is a possibility of wrong
casting or wrong carry forwards of the totals of a subsidiary books
or there is an error in balancing the accounts.
(b) In case the difference is not in a round figure, there is a possibility
of error being committed in posting the transactions from the
Journal to the Ledger.
(c) If the difference is of a substantial amount, it will be appropriate
to compare the Trial Balance of the current year with the Trial
Balance of the preceding year and see whether there is any
abnormal difference between the balances of important accounts
of the two Trial Balances.
(iv) Since, cash and bank account are not maintained usually in the Ledger,
it will be also advisable to check whether the balances of the cash and
bank accounts have been taken in the Trial Balance or not.
Self-Instructional
Material 99
Trial Balance and (v) The schedules of sundry debtors and sundry creditors should be checked
Rectification of Errors
to find out whether all balances of debtors and creditors have been
included in these schedules or not.
(vi) The totals of the subsidiary books such as the Sales Book, Purchases
NOTES
Book should be checked and it should be seen whether posting has
been done from these two books correctly to the Sales, Purchases or
other accounts as the case might be.
(vii) If the error is still not traceable, check thoroughly the books of original
entry and their posting into the Ledger and finally the balancing of
different accounts.
(viii) A business may keep ledgers on sectional/self-balancing system. In such
a case, there are three ledgers: (a) Sales Ledger containing personal
accounts of all trade debtors, (b) Purchases Ledger containing personal
accounts of all trade creditors, and (c) General Ledger containing all
other real, nominal and personal accounts except those of trade debtors
and trade creditors. However, there will be two total accounts in this
ledger. (i) Total Debtors Accounts, and (ii) Total Creditors Account.
The balance of the Total Debtors Account should tally with the total of
the Schedule of Debtors as prepared from the Sales Ledger. Similarly,
the balance of the Total Creditors Account should tally with the total
of the Schedule of Creditors as prepared from the Purchases Ledger.
In case the balance of Total Debtors Account does not tally with the
total of the Schedule of Debtors, the personal accounts in the Sales
Ledger should be checked and the other Ledger may not be touched.
Same is true of the Total Creditors Account and the Schedule of Total
Creditors.
Suspense Account
The accountant should take the above-mentioned steps one after the other
to locate the difference in the totals of the Trial Balance. In case he is not
in position to locate the difference and he is in hurry to close the books of
accounts, he may transfer the difference to an account known as “Suspense
Account”. Thus, Suspense Account is an account to which the difference in the
Trial Balance has been put temporarily. On locating the errors in the beginning
or during the course of the next year, suitable accounting entries are passed
(as explained later) and the Suspense Account is closed. However, it should
be noted that Suspense Account should be opened by the accountant only
when he has failed to locate the errors in spite of his best efforts. It should
not be by way of normal practice, because the very existence of the Suspense
Account creates doubt about the authenticity of the books of accounts. The
result shown by the books of accounts may not be trusted by the proprietors,
tax officials and other government authorities in such a case. This may create
complications for the business.
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100 Material
5.3.2 Rectifying Accounting Entries Trial Balance and
Rectification of Errors
The errors committed in the books of accounts when located out, have to be
corrected. However, corrections in the books of accounts should be done by
passing proper rectifying entries and not by cutting or erasing figures. Such NOTES
entries, as explained earlier, are passed in the General Journal or Journal
Proper. The passing of proper rectifying entries is being explained below
with suitable examples.
Example 1: The Sales Book overcast by `50.
Overcosting of Sales Book will result in over-credit to Sales Account by `50
since the total of the Sales Book is posted to the credit of the Sales Account
at the end of a period. There can be two situations in such a case:
(i) The error might have been located out by the accountant before
transferring the difference to the Suspense Account. In such a case,
there is mistake only in one account, i.e., the Sales Account. It has been
credited more by `50. The error can be rectified if the Sales Account
is debited by `50. Thus, the following will be the rectifying entry in
the Journal Proper:
Particulars Dr. ` Cr. `
Sales Account Dr. 50
(Being excess credit to sales account, now rectified)

No account is to be credited since the error affects only one account.


(ii) The error might have been located out by the accountant after
transferring the difference in the Trial Balance to a Suspense Account.
In such a case two accounts are involved: (a) Sales Account, and (b)
Suspense Account. Since Sales Account had been credited more by `50
the credit side of the Trial Balance must have been more than debit side
of the Trial Balance. The Suspense Account should, therefore, have
been put on the debit side of the Trial Balance in order to balance the
two sides as shown below:
TRIAL BALANCE
Particulars Dr. ` Cr. `
Excess Credit to Sales Account 50
Suspense Account 50
50 50

The Sales Account has been credited more by `50. In order to rectify
the error, the Sales Account should, therefore, be debited by `50. Suspense
Account has been debited because of this mistake which has now been
found out. It should therefore, be closed by giving credit to it. The rectifying
accounting entry should, therefore, be passed as follows:

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Material 101
Trial Balance and Particulars Dr. ` Cr. `
Rectification of Errors
Sales Account Dr. 50
To Suspense Account 50

NOTES Example 2: A credit sale of `100 to Ramesh has been entered in the Sales
Book as a sale of `1,000.
In order to pass a rectifying entry, it will be appropriate to find out the
accounts involved. In this case, the error involves two accounts: (i) Sales
Account, and (ii) The account of Ramesh. This is because the posting is done
in the individual accounts from the Sales Book and, therefore, if a transaction
is wrongly recorded in the Sales Book (which is the book of original entry)
not only the total of the Sales Book will be wrong, but also the entry in the
personal account will be wrong as shown below:
SALES BOOK
Particulars `
Sales to Ramesh (wrongly recorded in place of `100) 1,000
Sales Account Cr. 1,000

Ledger
Dr RAMESH Cr.
Particulars ` Particulars `
To Sales A/c 1,000

Dr. SALES ACCOUNT Cr.


Particulars ` Particulars `
By Sundries (incl. sales to 1,000
Ramesh)

The recording of the transactions as shown above shows that the Sales
Account has been credited by `1,000 in place of `100. Similarly, the account
of Ramesh has been debited by `1,000 in place of `100. Thus, Sales Account
has been over-credited by `900, while the account of Ramesh has been over-
debited by `900. In order to set the matters right, Sales Account should now
be debited by `900 and the account of Ramesh should be credited by `900.
The error should not have affected the agreement of the Trial Balance because
of the same amount being put to the debit as well as the credit sides. The
Suspense Account is, therefore, not at all involved.
The rectifying accounting entry will, therefore, be as follows:
Particulars Dr. ` Cr. `
Sales Account Dr. 900
To Ramesh 900

Example 3: A sale of `50 to Suresh was posted to his account as a sale of `5.
In this case, the account of Suresh has been debited by only `5, in place
of `50. His account has, therefore, been under-debited by `45. It means the
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102 Material
credit side of the Trial Balance must have been more by `45 on account of Trial Balance and
Rectification of Errors
this error. In case, the Suspense Account has been opened, it should have
been debited by `45. The rectifying entry should, therefore, give debit of
`45 to Suresh and give credit of `45 to Suspense Account. The entry will
thus be as follows: NOTES
Particulars Dr. ` Cr. `
Suresh Dr. 45
To Suspense Account 45

The Suspense Account which was showing the debit balance of `45
would now be closed on account of passing of this rectifying entry.
Example 4: A sale of `50 to Kamlesh was entered in the Sales Book as of
`500, from where he was debited by `5,000.
This is a multiple type of error. It affects more than two accounts. The
accounts involved are (i) Kamlesh, (ii) Sales Account, and (iii) Suspense
Account.
The total of the Sales Book is posted to the Sales Account. The sale
has been recorded as of `500 in the Sales book from where the posting
must have been done to the Sales Account. Thus, the Sales Account
has been credited by `500 instead of `50. It has been credited more by
`450. In order to rectify the error, it should, therefore, be debited by `450.
The account of Kamlesh should have been debited by `50 only but it has
been debited by `5,000. It has, therefore, been debited more by `4,950. In
order to rectify the matters, it should be credited by `4,950. These two errors
must have created difference in the Trial Balance which should have gone to
the Suspense Account. Sales Account comes on the credit side of the Trial
Balance. It has been credited by `450 more and, therefore, the credit side of
the Trial Balance will be more by this amount on account of this error. On
the other hand, Kamlesh is a debtor, his account has been excess debited by
`4,950. The debit side of the Trial Balance should, therefore, be more by this
amount. The net effect is that the debit side of the Trial Balance must have
been more by `4,500 which must have been put to the Suspense Account by
giving credit to it. The rectifying entry will, therefore, be as follows:
Particulars Dr. ` Cr. `
Suspense A/c Dr. 4,500
Sales A/c Dr. 450
To Kamlesh 4,950

Thus, on the basis of the above examples, the following rules can be
framed out:
(i) Find out the accounts affected by the error.
(ii) Find out what should have been and what has been done.

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Material 103
Trial Balance and (iii) Credit or Debit the respective account in order to set the matters right.
Rectification of Errors
(iv) Put the difference to Suspense Account.
The above rules will be further clear by the following example.
NOTES Example 5: A sales of `1,000 to Suresh was entered in the Purchases Book
from where the account of Suresh was debited by `100.
The above error affects the following accounts: (i) Sales Account, (ii)
Purchases Account, and (iii) Account of Suresh.
Sales Account should have been credited by a sum of `1,000. It has
not been done since it has been recorded in the Purchases Book. Thus, Sales
Account should be credited (i.e., what should have been done).
Purchases Account has been debited since the transaction has been
entered in the Purchases Book from where it must have been posted to the
Purchases Account. It has been debited by a sum of `1,000 unnecessarily. It
should, therefore, be credited to rectify what has been done wrongly.
Account of Suresh should have been debited by `1,000. In the normal
course, since the transaction has been recorded in the Purchases Book, his
account should have been credited. However, the accountant has debited his
account by `100 instead of `1,000. His account should, therefore, be debited
by `900 more in order to give full debit to his account.
The difference, if any, should be transferred to the Suspense Account
as given in rule (iv) explained above.
The rectifying journal entry will, therefore, be as follows:
Particulars Dr. ` Cr. `
Suspense A/c Dr. 1,100
Suresh Dr. 900
To Purchases A/c 1,000
To Sales A/c 1,000

The comprehensive illustrations given in the following pages will


further clarify the accounting entries required to be passed for rectification
of different types of errors.
Illustration 5.2. The Trial Balance of Arun on 31st December, 2017, showed
a difference of `580 (excess debit). It was put to a Suspense Account and
the books were closed. On going through the books in January, 2018, the
following errors were discovered. You are required to pass suitable rectifying
journal entries and prepare the Suspense Account.
1. `540 received from M. Mehta was posted to the debit of his account.
2. `100 being Purchases Returns was posted to the debit of Purchases
Account.

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104 Material
3. Discount `200 received, entered in the cash book was not posted to Trial Balance and
Rectification of Errors
the Ledger.
4. `574 paid for repairs to motor-car was debited to the motor-car account
as `174. NOTES
5. A sale of `350 to Sethi was entered in the Sales Book as of `530.
6. While carrying forward total of one page in Kalra’s Account, the
amount of `250 was written on the credit side instead of debit side.
7. The purchase of machinery on 1st January, 2017 for `6,000 was entered
in the Purchases Account.
Solution:
JOURNAL PROPER
Sl. Particulars L.F. Dr. ` Cr. `
No.
1. Suspense A/c Dr. 1,080
To M. Mehta 1,080
(Being `540 received from M. Mehta debited to his
account, the error now rectified)
2. Suspense A/c Dr. 200
To Purchases A/c 100
To Purchases Returns A/c 100
(Being purchases returns of `100 posted to the debit
of Purchases A/c, the error now rectified)
3. Suspense A/c Dr. 200
To Discount A/c 200
(Being discount received not posted to Discount
A/c, the error now rectified)
4. Repairs A/c Dr. 574
To Motor Car A/c 174
To Suspense A/c 400
(Being repairs to motor car, `574, debited to Motor Car
A/c as `174 wrongly, the error now rectified)
5. Sales A/c Dr. 180
To Sethi 180
(Being sales of `350 to Sethi entered in the Sales Book
as of `530, the error now rectified)
6. Kalra Dr. 500
To Suspense A/c 500
(Being Kalra’s A/c credited by `250 instead of being
debited by `250, the error now rectified)

7. Machinery A/c Dr. 6,000


To Purchases A/c 6,000
(Being purchases of machinery debited to Purchases
A/c instead of Machinery A/c, the error now rectified)

Notes:
1. The account of M. Mehta should have been credited by `540. It has been debited. In order to
set the matters right, it is necessary to credit his account by `1,080 (i.e., to cancel unnecessary
debit of `540 and to give him credit of `540).
2. The Purchases Returns Account should have been credited by a sum of `100 on account of
return of the goods. It has not been at all credited. It has, therefore, been credited by `100.

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Material 105
Trial Balance and The Purchases Account should not have been at all debited. It has, therefore, been credited
Rectification of Errors by `100. Suspense Account has been debited by `200, since no other account is available
and it must have been credited earlier on account of these errors.
3. The amount of discount received is credited to the Discount Account. It has not been done.
Discount Account, has therefore, been credited now. Suspense Account has been debited
NOTES because it must have been credited earlier on account of this error.
4. Repairs to motor-car is a revenue expenditure. It should have been debited to the Repairs
Account. It has not been done. The Repairs Account has, therefore, been debited by `574.
Motor Car Account has been unnecessarily debited by `174. It should, therefore, be credited
by this amount. The difference has been put to the Suspense Account.
5. The sale to Sethi was only of `350, but it has been recorded as a sale of `530. It means the
account of Sethi has been unnecessarily debited by `180. It has, therefore, been credited by
this amount. Sales Account has been credited by `530, instead of `350. It has, therefore, been
debited by `180, the excess credit.
6. The account of Kalra should have been debited by `250. It has been credited by `250. His
account should, therefore, be debited by `500 to cancel unnecessary credit of `250 and to
keep his account debited by `250. Suspense Account has been credited by `500 since no other
account is involved.
7. Purchase of Machinery of `6,000 should have been debited to the Machinery Account. It was
not done. The Machinery Account has, therefore, been debited by `6,000. Purchases Account
was unnecessarily debited by `6,000. It has, therefore, been credited by the above amount.
Tutorial Note. While passing the rectifying journal entries, the students should put the difference to
the Suspense Account, in case it has been opened and no other account is available.

Dr. SUSPENSE ACCOUNT Cr.


Particulars Amount ` Particulars Amount `
To M. Mehta 1,080 By Balance b/d 580
To Purchases 100 By Repairs Account 400
To Purchases Returns A/c 100 By Kalra 500
To Discount A/c 200
1,480 1,480

Illustration 5.3. In taking out a Trial Balance, a Book-keeper finds that debit
total exceeds the credit total by `352. The amount is placed to the credit of a
newly opened Suspense Account. Subsequently, the following mistakes were
discovered. You are required to pass the necessary entries for rectifying the
mistakes, and show the Suspense Account:
(a) Sales Day Book was overcast by `100.
(b) A sale of `50 to Shri Ram was wrongly debited to Shri Krishna.
(c) General Expenses `18 were posted as `80.
(d) Cash received from Shri Govind was debited to his account `150.
(e) While carrying forward the total of one page of the Purchases Book
to the next, the amount of `1,235 was entered as `1,325.

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106 Material
Trial Balance and
Solution: Rectification of Errors
Sl. No. Particulars Dr. ` Cr. `
(a) Sales A/c Dr. 100
To Suspense A/c 100
(Being overcosting of Sales Day book rectified)
NOTES
(b) Shri Ram Dr. 50
To Shri Krishna 50
(Being the wrong debit given to Shri Krishna rectified)
(c) Suspense A/c Dr. 62
To General Expenses A/c 62
(Being rectification of the wrong posting made in General
Expenses Account)
(d) Suspense A/c Dr. 300
To Shri Govind 300
(Being rectification of the wrong debit given to Shri
Govind)
(e) Suspense A/c Dr. 90
To Purchases A/c 90
(Being rectification of the wrong carry forward in the
Purchases Book)

SUSPENSE ACCOUNT
Particulars Amount ` Particulars Amount `
To General Expenses 62 By Balance b/d 352
To Govind 300 By Sales 100
To Purchases 90
452 452

Illustration 5.4. A trader has tallied the Trial Balance by putting the difference
of `310 to the debit of Suspense Account and has prepared a Trading and
Profit & Loss Account and the Balance Sheet. On subsequent scrutiny the
books disclosed several errors as detailed below. Rectify these errors and
prepare Suspense Account:
(i) A sale of goods to X for `350 has been credited to his account.
(ii) Goods purchased from Y amounting to `750 were entered in the
Purchases Day Book but were omitted from Y’s Account in the
Creditors’ Ledger.
(iii) An Office Typewriter purchased for `500 has been passed through the
Purchases Account.
(iv) Goods returned to S. Sen. valued `75 were debited to P. Sen’s Account.
(v) Repairs to Office Car valued `750 were debited to the Office Car
Account.
(vi) Goods sold to R. Banerjee valued `730 have been posted in his account
as `370.

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Material 107
Trial Balance and Solution:
Rectification of Errors
Sl. Particulars Dr. ` Cr. `
No.
(i) X Dr. 700
To Suspense A/c 700
NOTES
(Being amount of sale of `350 wrongly credited to Mr. X error
now rectified)
(ii) Suspense A/c Dr. 750
To Y 750
(Being amount of goods purchased from Mr. Y not credited to
his account now recorded)
(iii) Office Equipment A/c Dr. 500
To Profit & Loss Adjustment A/c 500
(Being cost of typewriter purchased wrongly debited to
purchases account, error now rectified)
(iv) S. Sen Dr. 75
To P. Sen 75
(Being amount of goods returned to S. Sen wrongly debited to
P. Sen, now rectified)
(v) Profit & Loss Adjustment Account Dr. 750
To Office Car A/c 750
(Being amount of repairs of office car wrongly capitalised,
now rectified)
R. Banerjee Dr. 360
To Suspense A/c 360
(Being goods sold to R. Banerjee for `730 debited to him as
`370, now rectified)
Capital A/c Dr. 250
To Profit & Loss Adjustment A/c 250
(Being balance of Profit & Loss Adjustment Account
transferred)

SUSPENSE ACCOUNT
Particulars Amount ` Particulars Amount
`
To Balance b/d 310 By X 700
To Y 750 By R. Banerjee 360
1,060 1,060

Check Your Progress


3. Which category of errors comprises of the compensating errors?
4. Define Suspense Account.

5.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. The Trial Balance is the accounting tool which helps in finding out if
the books of accounts are arithmetically accurate in the condition that
Self-Instructional the two sides of the Trial Balance tally.
108 Material
2. The total method of the preparation of a Trial Balance is not generally Trial Balance and
Rectification of Errors
followed since it does not help in the preparation of the financial
statements.
3. The clerical errors is the category of errors which comprises of the
NOTES
compensating errors.
4. The Suspense Account is an account to which the difference in the
Trial Balance is put temporarily until the errors are locating and the
suitable accounting entries passed.

5.5 SUMMARY
• In case the various debit balances and the credit balances of the different
accounts are taken down in a statement, the statement so prepared is
termed as a Trial Balance. In other words, Trial Balance is a statement
containing the various ledger balances on a particular date.
• Objects of Preparing a Trial Balance: Checking of the arithmetical
accuracy of the accounting entries, basis for financial statements and
summarised ledger.
• A Trial Balance may be prepared according to any of the two methods:
Total Method, Balance Method and Total and Balance Method.
• The accuracy of the Trial Balance determines to a great extent the
accuracy or otherwise of the information provided by Final Accounts.
However, the Trial Balance provides only proof of the arithmetical
accuracy of the books of accounts. It simply assures that for every debit
there is an equivalent credit entry. It means that in spite of an agreed
Trial Balance, it is not necessary that there are not errors in the books
of accounts.
• Errors can broadly be classified as: Clerical Errors and Errors of
Principle. Clerical Errors include the following errors: Errors of
omission, Errors of commission, and Compensating errors. Errors
of principle are committed in those cases where a proper distinction
between revenue and capital items is not made, i.e., a capital expenditure
is taken as a revenue expenditure or vice versa. Similarly, a capital
receipt may have been taken as a revenue receipt or vice versa.
• Location of errors of principle, errors of compensating nature and errors
of omission is slightly difficult because of the fact that such errors
do not affect the agreement of the Trial Balance and, therefore, their
location may be considerably delayed. However, location of errors of
commission is comparatively easier because they affect the agreement
of the Trial Balance.

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Material 109
Trial Balance and • The errors can be classified into two categories from the point of view
Rectification of Errors
of locating them:
(i) Errors which do not affect the agreement of the Trial Balance.
NOTES (ii) Errors which affect the agreement of the Trial Balance.
• The accountant should take the above-mentioned steps one after the
other to locate the difference in the totals of the Trial Balance. In case
he is not in position to locate the difference and he is in hurry to close
the books of accounts, he may transfer the difference to an account
known as “Suspense Account”.
• Suspense Account is an account to which the difference in the Trial
Balance has been put temporarily. On locating the errors in the
beginning or during the course of the next year, suitable accounting
entries are passed and the Suspense Account is closed.
• It should be noted that Suspense Account should be opened by the
accountant only when he has failed to locate the errors in spite of
his best efforts. It should not be by way of normal practice, because
the very existence of the Suspense Account creates doubt about the
authenticity of the books of accounts. The result shown by the books of
accounts may not be trusted by the proprietors, tax officials and other
government authorities in such a case. This may create complications
for the business.
• The errors committed in the books of accounts when located out,
have to be corrected. However, corrections in the books of accounts
should be done by passing proper rectifying entries and not by cutting
or erasing figures. Such entries, as explained earlier, are passed in the
General Journal or Journal Proper.

5.6 KEY WORDS


· Trial Balance: A statement containing the various ledger balances on
a particular date.
· Compensating Errors: Errors which compensate each other.
· Errors of Commission: Errors on account of wrong balancing of an
account, wrong posting, wrong carry forward, wrong totalling, etc.
· Errors of Omission: Errors committed because of complete omission
of a transaction from the books of accounts.
· Errors of Principle: Errors committed because of failure to make a
proper distinction between revenue and capital items.
· Suspense Account: An account to which the difference in the trial
balance has been put temporarily.

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110 Material
Trial Balance and
5.7 SELF ASSESSMENT QUESTIONS AND Rectification of Errors

EXERCISES

Short Answer Questions NOTES

1. What is a trial balance? Explain its objectives.


2. Explain the term ‘‘Compensating Errors’’.
3. Explain the term ‘‘Suspense Account’’.
Long Answer Questions
1. Explain the different types of errors with suitable example and state
how they affect the Trial Balance.
2. ‘‘A Trial Balance is only a prima facie evidence of the accuracy of the
books of accounts”. Comment.
3. In case of disagreement of the Trial Balance what steps would you take
to locate the errors?

5.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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Material 111
Final Accounts- I

UNIT 6 FINAL ACCOUNTS- I


Structure
NOTES
6.0 Introduction
6.1 Objectives
6.2 Meaning, Objectives and Characteristics of Final Accounts
6.2.1 Characteristics of Final Accounts
6.2.2 Objectives of Final Accounts
6.3 Adjustments Before Preparing Final Accounts
6.4 Answers to Check Your Progress Questions
6.5 Summary
6.6 Key Words
6.7 Self Assessment Questions and Exercises
6.8 Further Readings

6.0 INTRODUCTION
In this unit, you will learn about the meaning, objectives and characteristics of
final accounts which give an idea about the profitability and financial position
of a business to its management, owners, and other interested parties. All
business transactions are first recorded in a journal. They are then transferred
to a ledger and balanced. These final tallies are prepared for a specific period.
The preparation of a final accounting is the last stage of the accounting cycle.
It determines the financial position of the business. Under this it is compulsory
to make trading account, the profit and loss account and balance sheet. The
term ‘final accounts’ includes the trading account, the profit and loss account,
and the balance sheet, which will be discussed in the next unit.
In this unit, you will also learn about various adjustments to be
considered before final accounts are prepared.

6.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss the meaning of Final Accounts
• Identify the objectives of Final Accounts
• Describe the characteristics of Final Accounts
• Recall the adjustments made before preparing the Final Accounts

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112 Material
Final Accounts- I
6.2 MEANING, OBJECTIVES AND
CHARACTERISTICS OF FINAL ACCOUNTS
It has been explained in a preceding unit that the accuracy of the books NOTES
of accounts is determined by means of preparing a Trial Balance. Having
determined the accuracy of the books of accounts every businessman is
interested in knowing about two more facts. They are: (i) Whether he has
earned a profit or suffered a loss during the period covered by the Trial
Balance, (ii) Where does he stand now? In other words, what is his financial
position?
The determination of the Profit or Loss is done by preparing a Trading
and Profit and Loss Account (or an Income Statement). While the financial
position is judged by means of preparing a Balance Sheet of the business.
The two statements together, i.e., Income Statement and the Balance Sheet,
are termed as Final Accounts. As the term indicates, Final Accounts means
accounts which are prepared at the final stage to give the financial position
of the business.
6.2.1 Characteristics of Final Accounts
• It is the final process of accounting.
• It is prepared to show the final result of the company in a specific
period.
• It is the account, which is prepared at the end of the given year or period,
to see the profit and loss position as well as the financial position of a
going concern for the period given.
• It is also known as financial statement.
• It consists of trading account, profit and loss account and balance sheet.
• The trading account shows the gross profit or gross loss, net profit or
net loss is calculated from profit and loss account and balance sheet is
prepared to know the position of assets and liabilities.
• Profit and loss account shows the profitability achieved during the
accounting period and balance sheet reflects the composition of various
assets, liabilities, and shareholder’s equity on the accounting period.
6.2.2 Objectives of Final Accounts
The following are the main objectives of final accounts:
• To determine gross profit and net profit of the business during the year.
• To present the true financial position of the business on a given date.
• To make effective control on financial activities of the business.
• To make a summary presentation of all the financial transactions.
Self-Instructional
Material 113
Final Accounts- I • To communicate the operating results and financial position of the
users.
• To help in making a different financial decision to the users of
accounting information.
NOTES
6.3 ADJUSTMENTS BEFORE PREPARING FINAL
ACCOUNTS
In Unit 7 of this book, we will study the important equations and entries
which are required to prepare the Trading and Profit and Loss Account and
the Balance Sheet. We have presumed that the accountant has taken into
consideration all important facts before closing the books of accounts and
preparing the Final Accounts. However, it may not always happen. The
accountant may come to know of certain adjustments to be made in the
books of accounts to give a true picture of the state of affairs of the business
after closing the books of accounts and preparing the Trial Balance. These
adjustments usually relate to the following:
1. Closing stock
2. Outstanding expenses
3. Prepaid expenses
4. Outstanding or accrued income
5. Income received in advance or unearned income
6. Depreciation
7. Bad debts
8. Provision for bad debts
9. Provision for discount on debtors
10. Reserve for discount on creditors
11. Interest on capital
12. Interest on drawings
Each of these adjustments are being explained in detail in the following pages:
Closing Stock
The following journal entry is passed for the unsold stock at the end of the
accounting period:
Closing Stock A/c Dr.
To Trading Account

The stock at the end appears in the Balance Sheet and its balance at
the end of the accounting year is carried forward to the next year. It comes
as Opening Stock in the Trial Balance of the next year from where it is
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114 Material
transferred to the Trading Account on the debit side. The Trading Account Final Accounts- I
is debited and the stock in the beginning of the accounting year (which was
Closing Stock last year) is credited. Stock Account is thus closed.
Sometimes, the value of the stock at the end of the accounting year is
NOTES
given in the Trial Balance. In such a case, the Closing Stock will be shown
only in the Balance Sheet. This is because it means that the Closing Stock
has already been taken into account while computing the cost of goods sold.
This will be clear with the help of the following example:
TRIAL BALANCE
Particulars Dr ` Cr. `
Opening Stock 10,000
Purchases 30,000
Sales 40,000
Stock at the end of the accounting year is `15,000.
In this case, the Closing Stock has been given outside the Trial Balance
and, therefore, the different items will appear in the Final Accounts as follows:
Dr. TRADING ACCOUNT Cr.
Particulars ` Particulars `
To Opening Stock 10,000 By Sales 40,000
To Purchases 30,000 By Closing Stock 15,000
To Gross Profit taken to
Profit and Loss Account 15,000
55,000 55,000

BALANCE SHEET
Liabilities ` Assets `
Closing Stock 15,000

The Opening and Closing Stocks may both be adjusted with purchases
and the cost of sales may be found out separately. In such a case, the items
in the Trial Balance will appear as follows:
TRIAL BALANCE
Particulars Dr. Amount ` Cr. Amount. `
Adjusted Purchases or Cost of Sales 25,000
Sales 40,000
Closing Stock 15,000

The different items will now appear in the Final Accounts as follows:
Dr. TRADING ACCOUNT Cr.
Particulars ` Particulars `
To Adjusted Purchases 25,000 By Sales 40,000
To Gross Profit taken to Profit
and Loss Account 15,000
40,000 40,000

BALANCE SHEET
Liabilities ` Assets `
Closing Stock 40,000
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Material 115
Final Accounts- I Outstanding Expenses
Outstanding Expenses refer to those expenses which have become due during
the accounting period for which the Final Accounts have been prepared but
NOTES have not yet been paid. This happens particularly regarding those expenses
which accrue from day-to-day business but which are recorded only when they
are paid. Examples of such expenses are rent, salaries, interest, etc. Some of
these expenses may have remained unpaid at the end of the accounting period
and, therefore, no entry might have been passed in the books of accounts. For
example, if the salary for the month of December has not been paid, no entry
might have been passed in the books for the salary remaining outstanding on
31st December. However, in order to ascertain the true profit or loss made
during the accounting year ending 31st December, it is necessary that such
outstanding salaries are taken into account. The following journal entry will
be passed in case of such outstanding expenses:
Salaries A/c Dr.
To Outstanding Salaries A/c

Salaries Account is a nominal account and, therefore, it should be


charged to the Profit and Loss Account, while the Outstanding Salaries
Account is a personal account representing the persons to whom the salary has
to be paid. It is, therefore shown in the Balance Sheet on the liabilities side.
Illustration 6.1. Following are the extracts from the Trial Balance of a firm
as on 31st December, 2017:
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr ` Cr `
Salaries A/c 10,000
Rent A/c 5,000

Additional Information:
(i) Salary for the month of December `2,000 has not yet been paid.
(ii) Rent amounting to `1,000 is still outstanding.
You are required to pass the necessary adjusting entries and show how
the above items will appear in the Firm’s Accounts:
Solution:
JOURNAL PROPER
Date Particulars Dr. ` Cr. `
Salaries A/c Dr. 2,000
To Outstanding Salaries A/c 2,000
(Being salaries due but not paid)
Rent A/c Dr. 1,000
To Outstanding Rent A/c 1,000
(Being rent due but not paid)

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116 Material
The items will appear in the Final Accounts as follows: Final Accounts- I

Dr. PROFIT AND LOSS ACCOUNT Cr.


Particulars ` Particulars `
To Salaries 10,000
(as given in the T/B) NOTES
Add: Outstanding
Salaries 2,000 12,000
To Rent 5,000
(as given in the T/B)
Add: Outstanding Rent 1,000 6,000
BALANCE SHEET
Liabilities ` Assets `
Outstanding Expenses:
Outstanding Salaries  2,000
Outstanding Rent    1,000 3,000

It should be noted that any item given outside the Trial Balance will
be recorded at two places on account of Dual Aspect Concept. For example,
in the above illustration, the amount of outstanding salaries has been shown
in the Profit and Loss Account and also in the Balance Sheet.
However, if the accountant had come to know about these outstanding
expenses before closing the books of accounts, the Salaries Account and
Outstanding Salaries Account, Rent Account and Outstanding Rent Account
would have appeared in the ledger as follows:
Dr. SALARIES ACCOUNT Cr.
Particulars ` Particulars `
To Bank 10,000 By Balance c/d 12,000
To Outstanding Salaries 2,000
12,000 12,000

Dr. OUTSTANDING SALARIES ACCOUNT Cr.


Particulars ` Particulars `
To Balance c/d 2,000 By Salaries 2,000
2,000 2,000

RENT ACCOUNT
Particulars ` Particulars `
To Bank 5,000 By Balance c/d 6,000
To Outstanding Rent 1,000
6,000 6,000

OUTSTANDING RENT ACCOUNT


Particulars ` Particulars `
To Balance c/d 1,000 By Rent A/c 1,000
1,000 1,000

The above balances would have appeared in the Trial Balance as


follows:

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Material 117
Final Accounts- I TRIAL BALANCE
as on 31st December, 2017
Particulars Dr ` Cr `
Salaries A/c 12,000
NOTES Rent A/c 6,000
Outstanding Salaries A/c 2,000
Outstanding Rent A/c 1,000
The above accounts would have appeared in the Final Accounts as
follows:
PROFIT & LOSS ACCOUNT
for the year ending 31.12.2017
Particulars ` Particulars `
To Salaries 12,000
To Rent 6,000
BALANCE SHEET
as on 31.12.2017
Liabilities ` Assets `
Outstanding Salaries 2,000
Outstanding Rent 1,000

Thus, the position in both the cases is the same. The point to be noted
is that any item appearing in the Trial Balance is recorded at only one place
in the Final Accounts while any item outside the Trial Balance is recorded
at two places in the Final Accounts.
Prepaid Expenses
Prepaid Expenses are those expenses which have been paid in advance.
In other words, these are the expenses which have been paid during the
accounting period for which the Final Accounts are bring prepared but they
relate to the next period. For example, during the accounting year ending on
31st December, 2017, insurance premium for the year ending 31st March,
2017 might have been paid. It means insurance for three months has been
paid in advance. In order to ascertain true profit or loss only expenses relating
to the accounting period should be charged to the Profit and Loss Account.
Any expenses paid in advance should be carried forward to the next year.
The following journal entry is passed for an expense paid in advance:
Prepaid Expense A/c Dr.
   To Expense A/c

Expense Account is a nominal account and, therefore, the amount should be


credited to the Profit and Loss Account, preferably the amounts should be
deducted from the relevant Expense Account in respect of which the payment
has been made in advance. Prepaid Expense Account is a Personal Account;
it represents the account of the person to whom payment has been made in
advance. It is, therefore, shown on the Balance Sheet on the assets side.

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118 Material
Illustration 6.2. The following are the extracts from the Trial Balance of a Final Accounts- I
firm as on 31st Dec. 2017.
TRIAL BALANCE
as on 31st December, 2017
NOTES
Particulars Dr ` Cr `
Insurance 8,000
Rent 4,000

Additional Information:
(i) Insurance premium has been paid in advance amounting to `1,000 for
the next year.
(ii) Rent `500 has been paid for the next year.
You are required to pass the necessary adjusting entries and show how
the items will appear in the firm’s Final Accounts.
Solution:
JOURNAL PROPER
Date Particulars Dr. ` Cr. `
2017 Prepaid Insurance A/c Dr. 1,000
To Insurance A/c 1,000
(Being Insurance premium paid in advance)
Prepaid Rent A/c Dr. 500  
To Rent A/c 500
(Being rent paid in advance)
PROFIT AND LOSS ACCOUNT
as on 31st December, 2017
Particulars ` Particulars `
To Insurance     8,000
Less: Prepaid    1,000 7,000
To Rent       4,000
Less: Prepaid    500 3,500

BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Prepaid Insurance 1,000
Prepaid Rent 500

Outstanding Income
Outstanding Income means income which has become due during the
accounting year but which has not so far been received by the firm. In order
to ascertain the true profit or loss, adjustments for such income must be made
in the Final Accounts of the business. The following journal entry will be
passed:
Outstanding Income A/c Dr.
  To Income A/c

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Material 119
Final Accounts- I Accrued Income
Accrued income means income which has been earned by the business during
the accounting year but which has not yet become due and, therefore, has
NOTES not been received. Adjusting entry of such income is also on the pattern of
outstanding income as shown below:
Accrued Income A/c Dr.
  To Income A/c

A distinction has to be made between accrued income and outstanding


income. Though, both the incomes have been earned by the business and not
yet received but in case of accrued income, the income has not become due to
the business while outstanding income is an income which has become due
to the business. For example, if a loan of `10,000 has been given @ 12% p.a.
and interest is payable monthly, if interest for one month, i.e., `100 has not
been received by the business, the income will be termed as an Outstanding
Income since interest has become due but it has not yet been received by
the business. However, in case of these securities where interest is payable
on definite dates, interest may have been earned by the business, but it will
become due not earlier than the definite date. For example, if a business
has purchased 6% Government Securities of `10,000 on which interest is
payable on 31st March and 30th September, for the accounting year ending on
31st December interest for 3 months (i.e., `150 for October, November and
December) will be taken as accrued interest and not an outstanding interest.
This is because interest will become due after 30th September, only on 31st
March and not earlier.
Illustration 6.3. The following are the extracts from the Trial Balance of a
firm on 31st Dec. 2017.
Particulars Dr. ` Cr. `
6% Loan 20,000
Investments in 6% Debentures of ‘B’ Ltd. 30,000
(Interest payable on 31st March and 30th Sept.)
Interest on loan received up to 31st October, 2017 1,000
Interest on Investments 900

Solution:
In the above case, interest on loan for a period of two months is still
outstanding. The amount of such interest is `200. In case of debentures,
interest for three months has been earned by the business but it has not
become due. The amount of accrued interest, therefore, comes to `450. The
following adjusting entries will, therefore, be passed in the journal proper.

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120 Material
Date Particulars Dr. ` Cr. ` Final Accounts- I
Outstanding Interest A/c Dr. 200
To Interest A/c 200
(Being interest on loan due but not received)
Accrued Interest A/c 450  
To Interest on Investments A/c 450 NOTES
(Being interest earned, not due and not received)

Outstanding Interest Account and Interest Accrued Account are


personal accounts. They represent the accounts of the persons from whom
the interest has to be received. They will, therefore, be shown on the ‘assets
side’ in the Balance Sheet. Interest Account is a nominal account, and it has
been credited. The amount of interest will, therefore, be added to the amount
of interest already appearing in the Trial Balance.
The items will appear in the Final Accounts as follows:
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
By Interest on Loan 1,000
Add: Outstanding
Interest 200 1,200
By Interest on Investments 900
Add: Accrued
Interest 450 1,350
BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Outstanding Interest A/c 200
Accrued Interest A/c 450

Income Received in Advance


Income received in advance means income which has been received by the
business before it is earned by the business. This includes certain prepayments
which the business may receive during the course of the accounting year. In
order to ascertain the true profit or loss, it is necessary that such income is
not taken into account while preparing the Profit and Loss Account for the
year. The following adjustment entry is passed for such income:
Income A/c Dr.
   To Income Received in Advance A/c

Illustration 6.4. The following are the extracts from the Trial Balance of
a firm on 31st December, 2017. You are required to pass the necessary
adjustment entries and show how the various will appear in the firm’s Final
Accounts.

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Material 121
Final Accounts- I TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Rent received for 12 months ending 31st March, 2017 1,200
NOTES Interest on Loan 2,000

Additional Information:
Interest on Loan has been received in advance to the extent of `500.
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Rent A/c Dr. 300
To Rent received in Advance A/c 300
(Being rent received in advance for three months)
Interest A/c Dr. 500
To Interest received in Advance A/c 500
(Being interest received in advance)
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
By Interest 2,000
Less: Received in
advance 500 1,500
By Rent 1,200
Less:Received in
advance 300 900
BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Rent received in advance 300
Interest received in advance 500

Depreciation
Depreciation denotes decrease in the value of an asset due to wear and tear,
lapse of time, obsolescence, exhaustion and accident. In order to ascertain
the true profit for the business, it is necessary that depreciation is charged
on the fixed assets of the business. The following entry will be passed for
depreciation.
Depreciation A/c Dr.
To Fixed Asset A/c

Illustration 6.5. The following are the extracts from the Trial Balance of a
firm.

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122 Material
TRIAL BALANCE Final Accounts- I

as on 31st December, 2017


Particulars Dr. ` Cr. `
Plant 30,000
Buildings 50,000 NOTES
Additional Information:
(i) Charge depreciation on plant @ 10% per annum,
(ii) Charge depreciation on buildings @ 5% per annum.
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Depreciation A/c Dr. 5,500
To Plant A/c 3,000
To Buildings A/c 2,500
(Being depreciation charged on Plant and Buildings)
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
To Depreciation:
Plant 3,000
Buildings 2,500 5,500
BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Plant 30,000
Less: Depreciation 3,000 27,000
Buildings 50,000
Less: Depreciation 2,500 47,500

Depreciation on Assets acquired during the course of the year.


Sometimes, fixed assets are acquired during the course of the year. In such
a case, the problem arises whether depreciation should be charged for the
full accounting year or it should be charged only for a part of the accounting
year. In such a situation in the absence of any specific instructions in the
question, it will be appropriate to charge depreciation for the full year even
in respect of those assets which have been acquired during the course of the
year. However, where depreciation rate has been given as per annum and the
date of acquisition of the fixed assets has been given, it will be appropriate
to charge depreciation only for the remaining part of the accounting year.
Illustration 6.6. The following are the extracts from the Trial Balance of a
firm.

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Material 123
Final Accounts- I TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Furniture and Fixtures 10,000
NOTES Plant and Machinery 40,000

Additional Information:
(i) Furniture of `5,000 was purchased on 1st July, 2017. Charge
depreciation @ 10% p.a.
(ii) Plant of `10,000 was acquired on 1st July, 2017. Charge depreciation
@ 20%.
Pass the necessary journal entries and show how the items will appear
in the firm Final Accounts:
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Depreciation A/c Dr. 8,750
To Furniture & Fixtures A/c 750
To Plant and Machinery A/c 8,000
(Being depreciation charged on furniture and fixtures
and Plant and Machinery including additions)
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
To Depreciation:
Furniture and Fixtures 750
Plant and Machinery 8,000 8,750
BALANCE SHEET
as an 31st December, 2017
Particulars ` Particulars `
Furniture & Fixtures 10,000
Less: Depreciation 750 9,250
Plant & Machinery 40,000
Less: Depreciation 8,000 32,000

Notes:
(i) Since depreciation has been given on furniture at 10% p.a., depreciation
for only 6 months has been charged for furniture acquired on 1st July,
2017.
(ii) In case of plant, the rate of depreciation has been given as 20%, hence,
depreciation for the full year has been charged even on plant which
has been acquired on 1st July, 2017.
Tutorial Note. The students should give note regarding their workings. In
case the question regarding charging of depreciation on additions to fixed
Self-Instructional assets made during the year is silent, the students can also presume that no
124 Material
depreciation is to be charged on additions. However, a specific note should Final Accounts- I

be given to that effect.


Bad Debts
Credit sales have become a must these days and bad debts occur when there NOTES
are credit sales. Bad Debt is a loss to the business and a gain to the debtor.
The following journal entry should, therefore, be passed in the event of a
debt becoming bad.
Bad Debts A/c Dr.
To Debtor’s Personal A/c

Illustration 6.7. The following are the extracts from Trial Balance of a
business.
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Sundry Debtors 50,000
Bad Debtors 5,000

Additional Information:
Mahesh, one of the debtors, became insolvent and it was learnt on 31st
December, that out of the total debt of `5,000 only `2,500 will be recovered
from him. No adjustment has so far been made.
You are required to pass necessary adjusting entries and show how the
items will appear in the Final Accounts of the business.
Solution:
JOURNAL
Date Particulars Dr. ` Cr. `
Bad Debts A/c Dr. 2,500
To Mahesh 2,500
(Being `2,500 became irrecoverable)
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
To Bad Debts 5,000
(as given in the
Trial Balance)
Add: Additional
bad debts 2,500 7,500
BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Sundry Debtors 50,000
Less: Bad Debts 2,500 47,500

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Material 125
Final Accounts- I Provision for Bad Debts
In an earlier unit, we have already explained that in accounting we observe
the “convention of conservatism” while recording business transactions.
NOTES This means that we make provision for expected losses but we do not take
credit for expected profits. A firm, therefore, makes provision at the end of
the accounting year for likely bad debts which may happen during the course
of the next year. This is for the simple reason that if out of credit sales made
during a particular year some sales are likely to become bad in the course
of the next year, the proper course would be to charge the same accounting
year with such likely bad debts in which the sales have been made, since,
the profit on such sales has been considered in the year in which the sales
have been made.
The following journal entry is passed for creating a provision for bad debts.
Profit & Loss A/c Dr.
To Provision for Bad Debts
The provision for bad debts is charged to the Profit & Loss Account and is deducted
from debtors in the Balance Sheet.
Illustration 6.8. The following are the extracts from the Trial Balance of a
firm.
TRIAL BALANCE
as on 31st December, 2017
Particulars ` `
Sundry Debtors 30,000
Bad Debts 5,000

Additional Information:
(i) After preparing the Trial Balance, it is learnt that a debtor Ramesh has
become insolvent and, therefore, the entire amount of `3,000 due from
him was irrecoverable.
(ii) Create 10% provision for bad and doubtful debts.
You are required to pass necessary adjusting entries and show how the
items will appear in the firm’s Balance Sheet.
Solution:
ADJUSTING JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Bad Debts A/c Dr. 3,000
To Ramesh 3,000
(Being amount due from Ramesh proved to be bad)
Profit & Loss A/c Dr. 2,700
To Provision for Bad and Doubtful Debts 2,700
(Being bad debts provision created)

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126 Material
PROFIT AND LOSS ACCOUNT Final Accounts- I
for the year ending 31st December, 2017
Particulars ` Particulars `
To Bad Debts 5,000
(as given in th Trial Balance) NOTES
Add : Additional bad debts 3,000
Add : Provision for bad debts 2,700 10,700
BALANCE SHEET
as on 31st December, 2017
Particulars ` Particulars `
Sundry Debtors 30,000
Less: Additional
bad debts 3,000
27,000
Less: Provision for
bad debts 2,700 24,300

The provision for bad debts created at the end of the accounting year
is carried forward to the next year and the bad debts occurring during the
course of the next year are met out of this provision. At the end of the next
year, suitable adjusting entry is passed for keeping the provision for doubtful
debts at an appropriate amount to be carried forward.
Illustration 6.9. The following are the extracts from the Trial Balance of a
firm:
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Sundry Debtors 50,000
Provision for Doubtful Debts 5,000
Bad Debts 3,000

Additional Information:
(i) Additional bad debts `3,000.
(ii) Keep the provision for bad debts @ 10% on debtors.
You are required to pass the necessary journal entries and prepare
Provision for Doubtful Debts Account and show how the different items will
appear in the firm’s Final Accounts.

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Material 127
Final Accounts- I JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Bad Debts A/c Dr. 3,000
To Sundry Debtors 3,000
(Being additional bad debts of `3,000)
NOTES Provision for Bad Debts A/c Dr. 6,000
To Bad Debts A/c 6,000
(Being bad debts, `3,000 appearing in the Trial Balance
+ `3,000 additional bad debts, transferred to Provision
for Bad Debts A/c)
Profit and Loss A/c Dr. 5,700
To Provision for Bad Debts A/c 5,700
(Being amount charged from P & L A/c to keep
provision for bad debts @10% on debtors)

PROVISION FOR BAD DEBTS ACCOUNT


Particulars ` Particulars `
To Bad Debts A/c 6,000 By Balance b/d 5,000
To Balance c/d 4,700 By Profit & Loss A/c 5,700
10,700 10,700

PROFIT AND LOSS ACCOUNT


as on 31st December, 2017
Particulars ` Particulars `
To Bad Debts 3,000
(as given in the
Trial Balance)
Add: Additional
bad debts 3,000
6,000
Add: New provision
for bad debts 4,700
10,700
Less: Old provision for
bad debts 5,000 5,700
BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Sundry Debtors 50,000
Less : Additional
bad debts 3,000
47,000
Less : New provision
for bad debts 4,700 42,300

Provision for Discount on Debtors


Discount may have to be allowed to the debtors on account of their making
prompt payments. When discount is allowed, the following journal entry is
passed:
Discount A/c Dr.
To Debtor’s Personal A/c
At the end of the accounting year, the firm also estimates the amount of discount
which it may have to give to the debtors outstanding at the end of the accounting year in
the course of the next year. This is done by creating a provision for discount on debtors.
Self-Instructional The following journal entry is passed:
128 Material
Profit and Loss A/c Dr. Final Accounts- I
To Provision for Discount A/c
It should be noted that ‘provision for discount’ will be created only on good debtors. In
other words, provision for discount should be made after deducting bad debts and provision
for bad debts from the debtors’ balances. NOTES
Illustration 6.10. The following are the extracts from the Trial Balance of
a firm:
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Sundry Debtors 50,000
Bad Debts 3,000
Discount 2,000

Additional Information:
(i) Create a provision for doubtful debts @ 10% on debtors.
(ii) Create a provision for discount on debtors @ 5% on debtors.
(iii) Additional discount given to the debtors `1,000.
You are required to pass the necessary journal entries and show how
the different items will appear in the Final Accounts.
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Discount A/c Dr. 1,000
To Sundry Debtors A/c 1,000
(Being discount allowed to debtors)
Profit & Loss A/c Dr. 4,900
To Provision for Bad Debts A/c 4,900
(Being provision for bad debts created @10%
on debtors of `49,000)
Profit & Loss A/c Dr. 2,205
To Provision for Discount 2,205
(Being provision for discount created @5% on debtors
of `44,100 (i.e., `49,000 – `4,900)

PROFIT AND LOSS ACCOUNT


for the year ending 31st December, 2017
Particulars ` Particulars `
To Bad Debts 3,000
(as given in the
Trial Balance)
Add: Provision for
bad debts 4,900 7,900
To Discount 2,000
(as given in the
Trial Balance)
Add: Additional discount 1,000
Add: Provision for discount 2,205 5,205
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Material 129
Final Accounts- I BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Debtors 50,000
NOTES Less: Additional discount 1,000
49,000
Less: Provision for
bad debts 4,900
44,100
Less: Provision for
discount 2,205 41,895
Illustration 6.11. The following are the extracts from the Trial Balance of
a firm:
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Sundry Debtors 50,000
Provision for Bad Debts 5,000
Provision for Discount 2,000
Bad Debts 3,000
Discount 1,000

Additional Information:
(i) Additional Bad Debts `1,000.
(ii) Additional Discount `500.
(iii) Create a provision for bad debts @10% on debtors.
(iv) Create a provision for discount @5% on debtors.
Pass the necessary journal entries, prepare Provision for Bad Debts
Account and Provision for Discount on Debtors Account and show how the
different items will appear in the Firm’s Final Accounts.
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Bad Debts A/c Dr. 1,000
Discount A/c Dr. 500
To Sundry Debtors 1,500
(Being additional bad debts and additional discount
on debtors)
Provision for Bad Debts A/c Dr. 4,000
To Bad Debts A/c 4,000
(Being bad debts written off from Provision for Bad
Debts A/c)
Provision for Discount on Debtors A/c Dr. 1,500
To Discount A/c 1,500
(Being discount allowed written off from Provision
for Discount on Debtors A/c)

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130 Material
Date Particulars Dr. ` Cr. ` Final Accounts- I
Profit and Loss A/c Dr. 3,850
To Provision for Bad Debts A/c 3,850
(Being amount charged from P & L A/c to maintain
a provision of 10% for bad debts on debtors
amounting to `48,500) NOTES
Profit and Loss A/c Dr. 1,682.50
To Provision for Discount A/c 1,682.50
(Being amount charged from P & L A/c for keeping
the provision for discount @5% on good debtors
amounting to `43,650)
PROVISION FOR BAD DEBTS ACCOUNT
Particulars ` Particulars `
To Bad Debts A/c 4,000 By Balance b/d 5,000
To Balance c/d 4,850 By Profit & Loss A/c 3,850
8,850 8,850

PROVISION FOR BAD DEBTS ACCOUNT


Particulars ` Particulars `
To Discount A/c 1,500.00 By Balance b/d 2,000.00
To Balance c/d 2,182.50 By P & L A/c 1,682.50
3,682.50 3,682.50

PROFIT AND LOSS ACCOUNT


for the year ending 31st December, 2017
Particulars ` Particulars `
To Bad Debts 3,000.00
(as given in the Trial Balance)
Add: Additional
bad debts 1,000.00
Add: New provision
for bad debts 4,850.00
8,850.00
Less: Old provision
for bad debts 5,000.00 3,850
To Discount 1,000.00
(as given in the
Trial Balance)
Add: Additional discount 500.00
Add: New provision
for discount 2,182.50
3,682.50
Less: Old provision 2,000.00 1,682.50

BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Sundry Debtors 50,000
Less: Additional
bad debts and
additional discount 1,500
48,500
Less: New provision
for bad debts 4,850
43,650
Less: New provision
for discount 2,182.50 41,467.50
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Material 131
Final Accounts- I Reserve for Discount on Creditors
A firm may like to create a reserve for discount on its creditors on a similar
pattern on which a provision for discount on debtors is made. However,
NOTES creating of such a reserve is against the fundamental convention of
conservation. Such a reserve, therefore, is usually not created. However, if
this is done the accounting entries are passed on the same pattern on which
the accounting entries are passed for provision for discount on debtors.
On receipt of additional discount from creditors:
Sundry Creditors A/c Dr.
To Discount A/c
For creating a reserve for discount on creditors:
Reserve for Discount on Creditors Dr.
To Profit and Loss A/c

Illustration 6.12. The following are the extracts from the Trial Balance of
a firm.
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Sundry Creditors 30,000
Discount 1,000
Reserve for Discount on Creditors 2,000

Additional Information:
(i) Additional discount received from creditors after closing the accounts
`1,500.
(ii) Create a reserve for discount on creditors @10%.
You are required to pass the necessary journal entries, prepare Reserve
for Discount Account and show how the various items will appear in the
Firm’s Final Accounts.
Solution:
Date Particulars Dr. ` Cr. `
Sundry Creditors A/c Dr. 1,500
To Discount A/c 1,500
(Being additional discount received from Creditors)
Discount A/c Dr. 2,500
To Reserve for Discount on Creditors 2,500
(Being discount received transferred to Reserve
for Discount A/c)
Reserve for Discount A/c Dr. 3,350
To Profit and Loss A/c 3,350
(Being amount credited to Profit and Loss Account
for maintaining Reserve for Discount Account @10%
on creditors)

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132 Material
Dr. RESERVE FOR DISCOUNT ON CREDITORS ACCOUNT Cr. Final Accounts- I

Particulars ` Particulars `
To Balance b/d 2,000 By Discount A/c 2,500
To Profit and Loss Account 3,350 By Balance c/d 2,850
5,350 5,350
NOTES
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
By Discount 1,000
(as given in the
Trial Balance)
Add: Additional
discount received 1,500
Add: New Reserve
for discount 2,850
5,350
Less: Old Reserve for
discount 2,000 3,350

Interest on Capital
Funds provided by the proprietor to run the business is termed as Capital.
In order to determine the real profit made by the business, it is necessary
that the profit should be determined after deducting interest on such funds,
which the proprietor could have earned otherwise. The entry for interest on
proprietor’s funds (or capital) is passed as follows:
Interest on Capital A/c Dr.
To Capital A/c
In case of a partnership firm, interest will be allowed on the capital of each partner.
The following journal entry will be passed:
Interest on Capital A/c Dr.
To Partner’s Capital Account
Interest on capital is allowed on the balance in the Capital Account in the beginning
of the accounting year. However, in case the proprietor has introduced further capital during
the course of the accounting year, interest on such capital will also be allowed from the date
on which such further capital was introduced till the end of the accounting period.
Illustration 6.13. The following are the extracts from the Trial Balance of
a firm:
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Capital Accounts:
Ramesh 30,000
Suresh 20,000

Additional Information:
(i) Interest on capital is to be allowed @ 10% p.a.
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Material 133
Final Accounts- I (ii) Suresh introduced additional capital amounting to `5,000 on 1st July,
2017.
You are required to pass the necessary journal entries and show how
the different items will appear in the Firm’s Final Accounts.
NOTES
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Interest on Capital A/c Dr. 4,750
To Ramesh’s Capital A/c 3,000
To Suresh’s Capital A/c 1,750
(Being interest on capital allowed to Ramesh
on `30,000 for full year and to Suresh on `15,000
for full year and on `5,000 for 6 months)
BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Capital Accounts:
Ramesh 30,000
Add: Interest on capital 3,000 33,000
Suresh 20,000
Add: Interest on capital 1,750 21,750
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
To Interest on Capital:
Ramesh 3,000
Suresh 1,750 4,750

Interest on Drawings
Drawings denote the money withdrawn by the proprietor from the business
for his personal use. It is usual practice to charge interest on drawings in case
interest is allowed to the proprietor on his capital. The following journal entry
is passed for interest on drawings.
Capital A/c Dr.
   To Interest on Drawings A/c
In case of a partnership firm, interest on drawings will be charged on the drawings
made by each partner. The journal entry will be as follows:
Partners Capital/Current Accounts*1 Dr.
   To Interest on Drawings A/c
1* Partners Capital Accounts can be maintained either on a Fixed or a Fluctuating Capital System. In
case of a Fixed Capital System, two accounts are maintained for each partner. (i) Capital Account,
and (ii) Current Account. Capital Account is credited with the amount of capital introduced by the
partner or debited with the amount of capital withdrawn by the partner, while all adjustments regarding
interest on capital, share of profit, drawings, etc., are made in the Current Accounts. Thus, balance in
the Capital Account remains more or less fixed. This is the reason for calling it as a Fixed Capital
System. In case of Fluctuating Capital System all adjustments regarding capital, drawings, interest,
share or profit etc. are made only in the Capital Account. Thus, the balance of the Capital Account
goes on fluctuating. This is the reason for calling this system as Fluctuating Capital System.
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134 Material
Computation of Interest on Drawings There is a difference between the Final Accounts- I
method of computation of interest on capital and computation of interest on
drawings. In most cases, interest on capital is charged on the opening balance
in the Capital Account. However, in case of additional capital introduced
during the year by the proprietor, interest may be charged from the date NOTES
of introducing additional capital till the end of the accounting period. This
does not create much problem. However, in case of drawings, the things are
different. The proprietor does not usually make the entire amount of drawings
on a particular date for the whole accounting year.
For example, if the proprietor has withdrawn `12,000 from the business,
it cannot reasonably be pressumed that he must have withdrawn the entire
amount in the beginning of the accounting year.
Since, the interest is to be charged on the amount withdrawn by the
proprietor from the date on which he withdrew the amount from the business
till the end of the accounting period, it requires computation of interest on
each withdrawal made by the proprietor separately. In the absence of any
specific information, it can reasonably be presumed that the drawings were
made evenly throughout the year. Moreover, for computation of interest, any
of the following three presumptions can reasonably be made:
(i) The proprietor withdrew the money on the 1st of each month. In such
a case, interest should be charged for 61/2 months on the total amount
at the given rate of interest.
(ii) The proprietor withdrew the money on the 15th of each month. In such
a case, interest should be charged on the total amount of drawings for
six months.
(iii) The proprietor withdrew the money at the end of each month. In such
a case, interest should be charged on the total amount for 51/2 months.
Tutorial Note. The students may adopt the second presumption in the absence
of any specific instructions in the question.
Illustration 6.14. The following are the extracts from the Trial Balance of
a Firm.
TRIAL BALANCE
as on 31st December, 2017
Particulars Dr. ` Cr. `
Capital Accounts:
A’s Capital 30,000
B’s Capital 20,000
Drawings:
A 6,000
B 3,000

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Material 135
Final Accounts- I Additional Information:
(i) Interest on capital is to be allowed to the partners @ 10% p.a. on the
opening balances standing to the credit of their Capital Accounts.
NOTES (ii) Interest on drawings is to be charged @ 12% p.a.
You are required to pass the necessary journal entries and show how the
different items will appear in the Firm’s Final Accounts. You may presume that
the drawings were made evenly throughout the year on 15th of each month.
Solution:
JOURNAL ENTRIES
Date Particulars Dr. ` Cr. `
Interest on Capital A/c Dr. 5,000
To A’s Capital A/c 3,000
To B’s Capital A/c 2,000
(Being interest on capital @ 10% p.a.)
A’s Capital A/c Dr. 360
B’s Capital A/c Dr. 180
To Interest on Drawings A/c 540
(Being interest on drawings charged for 6 months
@ 12% p.a. on the total amount)
PROFIT AND LOSS ACCOUNT
for the year ending 31st December, 2017
Particulars ` Particulars `
To Interest on Capital: By Interest on Drawings:
A 3,000 A 360
B 2,000 5,000 B 180 540

BALANCE SHEET
as on 31st December, 2017
Liabilities ` Assets `
Capital Accounts:
A’s Capital 30,000
Add: Interest on Capital 3,000
33,000
Less: Drawings 6,000
27,000
Less: Interest on Drawings 360 26,640
B’s Capital 20,000
Add: Interest on Capital 2,000
22,000
Less: Drawings 3,000
19,000
Less: Interest on Drawings 180 18,820

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136 Material
Final Accounts- I

Check Your Progress


1. Name the two statements which are together termed as Final Accounts.
2. How is closing stock accounted for in the Trading Account? NOTES
3. Mention how Outstanding Salaries are shown in the books of accounts.
4. State the difference between accrued and outstanding income.
5. Mention the accounting entry for provision for Discount on debtors.

6.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. The two statements Income Statement and the Balance Sheet are termed
as Final Accounts.
2. The Closing appears as the stock in the beginning of the accounting
year and is credited in the Trading Account.
3. The Outstanding Salaries Account is a personal account representing
the person to whom the salary has to be paid. It is, therefore, shown
in the Balance Sheet on the liabilities side.
4. Although both accrued and outstanding incomes have been earned by
the business and not yet received but in cased of accrued income, the
income has not become due to the business while outstanding income
is an income which has become due to the business.
5. When a provision for Discount on Debtors is provided, the following
journal entry is passed:
Discount A/c Dr.
To Debtor’s Personal A/c

6.5 SUMMARY
• The accuracy of the books of accounts is determined by means of
preparing a Trial Balance. Having determined the accuracy of the
books of accounts every businessman is interested in knowing about
two more facts. They are: (i) Whether he has earned a profit or suffered
a loss during the period covered by the Trial Balance, (ii) Where does
he stand now? In other words, what is his financial position?
• The determination of the Profit or Loss is done by preparing a Trading
and Profit and Loss Account (or an Income Statement). While the
financial position is judged by means of preparing a Balance Sheet of
the business. The two statements together, i.e., Income Statement and
the Balance Sheet, are termed as Final Accounts. As the term indicates,
Self-Instructional
Material 137
Final Accounts- I Final Accounts means accounts which are prepared at the final stage
to give the financial position of the business.
• The following are the characteristics of Final Accounts: It is the final
process of accounting, It is prepared to show the final result of the
NOTES
company in a specific period, It is the account, which is prepared at the
end of the given year or period, it is also known as financial statement,
it consists of trading account, profit and loss account and balance sheet,
etc.
• The following are the main objectives of final accounts: To determine
gross profit and net profit of the business during the year, to present
the true financial position of the business on a given date, to make
effective control on financial activities of the business, to make a
summary presentation of all the financial transactions, to communicate
the operating results and financial position of the users, and to help
in making a different financial decision to the users of accounting
information.
• The accountant may come to know of certain adjustments to be made
in the books of accounts to give a true picture of the state of affairs
of the business after closing the books of accounts and preparing the
Trial Balance.
• These adjustments usually relate to the following: Closing stock,
outstanding expenses, prepaid expenses, outstanding or accrued
income, income received in advance or unearned income, depreciation,
bad debts, provision for bad debts, provision for discount on debtors,
reserve for discount on creditors, interest on capital and interest on
drawings.

6.6 KEY WORDS


· Adjustment Entry: A journal entry passed at the end of an
accounting period to record the completed portion of an incomplete
continuous event.
· Profit & Loss Account: An account presenting the revenues and
expenses of an enterprise for an accounting period and shows the excess
of revenues over expenses and vice-versa. It is also known as Income
Statement.
· Trading Account: An account giving the overall result of trading, i.e.,
purchasing and selling of goods.

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Final Accounts- I
6.7 SELF ASSESSMENT QUESTIONS AND
EXERCISES

Short Answer Questions NOTES

1. What are final accounts? What purpose do they serve?


2. Differentiate between outstanding expense and prepaid expense.
3. What are bad debts? How are they included in the Final Accounts?
4. Write a short note on provision of discount to debtors and reserve for
discount on creditors.
5. Explain the computation of interest on drawings.
Long Answer Questions
1. Discuss the characteristics and objectives of Final Accounts.
2. Why are adjustment entries required to be made at the time of preparing
Final Accounts? Give illustrative examples of any four such adjustment
entries.

6.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

Self-Instructional
Material 139
Final Accounts- II

UNIT 7 FINAL ACCOUNTS- II


Structure
NOTES
7.0 Introduction
7.1 Objectives
7.2 Trading Account
7.3 Profit and Loss Account
7.4 Balance Sheet
7.4.1 Treatment of Adjustments
7.5 Practical Problems
7.6 Answers to Check Your Progress Questions
7.7 Summary
7.8 Key Words
7.9 Self Assessment Questions and Exercises
7.10 Further Readings

7.0 INTRODUCTION
In the previous unit, we have learnt about the meaning, objectives and
characteristics of final accounts. We also learnt about some of the adjustment
entries which need to be done in the final accounts. In this unit, we will have
a look at the two most important accounting tools which need to be made
to ascertain a better picture of the financial position of an enterprise. In this
unit, we will learn the meaning and preparation of the Trading and Profit and
Loss Account and the Balance Sheet.
The Trading and Profit and Loss Account is a final summary of such
accounts which affect the profit or loss position of the business. In other
words, the account contains the items of Incomes and Expenses relating to a
particular period. The account is prepared in two parts: (i) Trading Account,
and (ii) Profit and Loss Account. The Balance Sheet shows the position of
various accounts during the accounting period.

7.1 OBJECTIVES
After going through this unit, you will be able to:
• Describe the meaning and preparation of Trading Account
• Discuss the important points regarding Profit and Loss Account
• Explain the accounting statement Balance Sheet
• Differentiate between Profit &Loss Account and Balance Sheet
• Discuss the differences between Trial Balance and Balance Sheet

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Final Accounts- II
7.2 TRADING ACCOUNT
Trading Account gives the overall result of trading, i.e., purchasing and selling
of goods. In other words, it explains whether purchasing of goods and selling NOTES
them has proved to be profitable for the business or not. It takes into account
on the one hand the cost of goods sold and on the other the value for which
they have been sold away. In case the sales value is higher than the cost of
goods sold, there will be a profit, while in a reverse case, there will be a
loss. The profit disclosed by the Trading Account is termed as Gross Profit,
similarly the loss disclosed by the Trading Account is termed as Gross Loss.
This will be clear with the help of the following illustration:
Illustration 7.1. The following figures have been taken from the Trial Balance
of a trader:
`
Purchases 30,000
Purchases Returns 5,000
Sales 40,000
Sales Returns 5,000
Calculate the amount of profit or loss made by the trader.
Solution:
The profit or loss made by the trader can be found out by comparing the cost
of goods sold with sales value. This has been done as follows:
Particulars Amount ` Amount `
Sales 40,000
Less Sales Returns 5,000 35,000
Purchases 30,000
Less Purchases Returns 5,000 25,000
Gross Profit 10,000

Opening and Closing Stocks


In Illustration 7.1, we have presumed that all goods purchased have been
sold away by the trader. However, it does not normally happen. At the end
of the accounting year, a trader may be left with certain unsold goods.
Such stock of goods with a trader unsold at the end of the accounting
period is termed as Closing Stock. Such a stock will become the opening
stock for the next period. For example, if a trader has with himself goods
amounting to `5,000 unsold at the end of the year 2017, this stock of
`5,000 will be termed as his Closing Stock. For the year 2017, this stock of
`5,000 will be termed as his Opening Stock. While calculating the amount of
profit or loss on account of trading, a trader will have to take such Opening
and Closing Stocks into consideration. This will be clear with the help of
the following illustration.
Self-Instructional
Material 141
Final Accounts- II Illustration 7.2. Taking the figures given in Illustration 7.1, calculate the
amount of Gross Profit if stock of `5,000 is left at the end of the accounting
period.
Solution:
NOTES
In case all goods purchased have not been sold away, goods of `5,000 are
still left with the trader. Stock of such goods is termed as Closing Stock.
Thus, cost of goods sold will be calculated as follows:
COST OF GOODS SOLD = NET PURCHASES – CLOSING STOCK
= `25,000 – 5,000 = `20,000

The Gross Profit now can be computed as follows:


GROSS PROFIT= NET SALES – COST OF GOODS SOLD
= `35,000 – 20,000 = `15,000

Illustration 7.3. From the following data calculate the profit made by a
trader in 2017.
`
Stock of goods on 1.1.2017 10,000
Purchases during the year 40,000
Purchases Returns during the year 3,000
Sales during the year 60,000
Sales returns during the year 10,000
Stock of goods on 31.12.2017 15,000
Solution:
Particulars Amount ` Amount `
Sales 60,000
Less: Sales Returns 10,000 50,000
Cost of goods sold:
Opening Stock 10,000
Add: Net Purchases (`40,000 – 5,000) 35,000
45,000
Less: Closing Stock 15,000 30,000
Gross Profit 20,000

Expenses on Purchases etc.


In the Illustrations given above, we have presumed that the trader has not
incurred any expenses for purchase of goods and bringing them to his
shop for sale. However, a trader has to incur various types of expenses for
purchasing of goods as well as for bringing them to his shop for sale. Such
expenses may include brokerage or commission paid to agents for purchase
of goods, cartage or carriage charges for bringing the goods to the trader’s
shop, wages paid to coolies for transportation of goods etc. All such expenses
increase the cost of the goods sold and hence they have also to be included

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142 Material
in the cost of purchasing the goods. In other words, cost of goods sold will Final Accounts- II
be calculated as follows:
COST OF GOODS SOLD = OPENING STOCK + NET PURCHASES +
EXPENSES ON PURCHASING OF GOODS –
CLOSING STOCK
NOTES

Cost of goods sold calculated as above will then be compared with the
net sales to find out the amount of profit or loss made by the business. This
will be clear with the following Illustrations.
Illustration 7.4. Calculate the amount of the profit made by the trader with
the help of data given in Illustration 7.3, if the wages, carriage charges etc.
incurred for bringing the goods to the trader’s shop amount to `5,000.
Solution:
Particulars Amount `
Net Sales 50,000
Less: Cost of goods sold (30,000 + 5,000) 35,000
Gross Profit 15,000
The term ‘merchandise’ is also used for the term ‘goods’.
Thus:
COST OF GOODS = COST OF MERCHANDISE
COST OF GOODS PURCHASED = COST OF MERCHANDISE
PURCHASED
COST OF GOODS SOLD = COST OF MERCHANDISE SOLD

Illustration 7.5. Find out the cost of merchandise purchased, cost of


merchandise sold, cost of merchandise unsold and Gross Profit from the
following transactions:
`
Purchases (3,000 articles) 25,000
Freight 1,000
Local Taxes 1,000
Salaries 2,500
Shop Rent 500
Godown Rent 500
Electrical Charges 600
Municipal Taxes 200
Stationery 250
Furniture (estimated life 5 years) 12,000
Sales (2,700 articles) 32,000

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Material 143
Final Accounts- II Solution:
Particulars Amount `
Cost of Merchandise purchased
This consists of:
NOTES Purchases 25,000
Freight 1,000
Local Taxes 1,000
27,000
Cost of Merchandise sold
Cost of 3,000 units of merchandise purchased 27,000
Cost of one unit of merchandise 9
Cost of 2,700 units of merchandise sold 24,300
Gross Profit
Sales of 2,700 units of merchandise 32,000
Less: Cost of merchandise sold 24,300
7,700
Cost of Merchandise unsold
300 units @ `9 per unit 2,700

All other expenses including annual depreciation of furniture


(amounting in all to `6,950) will be considered for computing the Net Profit of
the business. The concept of Net Profit has been explained later in the chapter.
Equation for Preparing Trading Account
On the basis of the Illustrations given in the preceding pages, the following
equation can be derived for preparing Trading Account:
Gross Profit = Sales – Cost of Goods Sold
Cost of Goods Sold = Opening Stock + Purchases
+ Direct Expenses – Closing Stock
Therefore, Gross Profit = Sales – (Opening Stock + Purchases
+ Direct Expenses – Closing Stock)
Or Gross Profit = (Sales + Closing Stock ) – (Opening
Stock + Purchases + Direct Expenses)

The term “Direct Expenses” include those expenses which have been
incurred in purchasing the goods, bringing them to the business premises and
making them fit for sale. Examples of such expenses are carriage charges,
octroi, import duty, expenses for seasoning the goods, etc.
The Trading Account can be prepared in the following form on the
basis of equation given above.

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144 Material
TRADING ACCOUNT Final Accounts- II
Dr. for the period ending ... Cr.
Particulars Amount ` Particulars Amount `
To Opening Stock ...... By Sales ......
To Purchases ...... Less: Returns ...... ...... NOTES
Less: Returns ...... ...... By Closing Stock ......
To Direct Expenses ...... By Gross Loss* ......
To Gross Profit* ...... ......
...... ......
*Only one figure will be there.

Illustration 7.6. Prepare the Trading Account of Mr. Ramesh for the year
ending 31st December, 2017 from the data as follows:
` `
Purchases 10,000 Wages 4,000
Purchases Returns 2,000 Carriage Charges 2,000
Sales 20,000 Stock on 1.1.2017 4,000
Sales Returns 5,000 Stock on 31.12.2017 6,000
Solution:
TRADING ACCOUNT
Dr. for the year ending 31-12-2017 Cr.
Particulars ` Particulars `
To Opening Stock 4,000 By Sales 20,000
To Purchases 10,000 Less: Sales
Less: Returns 2,000 8,000 Returns 5,000 15,000
To Wages 4,000 By Closing Stock 6,000
To Carriage Charges 2,000
To Gross Profit 3,000
21,000 21,000

Important Points Regarding Trading Account


1. Stock: The term ‘Stock’ includes goods lying unsold on a particular date.
The Stock may be of two types:
(i) Opening Stock (ii) Closing Stock
The term ‘Opening Stock’ means goods lying unsold with the
businessman in the beginning of the accounting year. This is shown on the
debit side of the Trading Account.
The term ‘Closing Stock’ includes goods lying unsold with the
businessman at the end of the accounting year. It should be noted that stock
at the end of the accounting year is taken after the books of accounts have
been closed. The following journal entry is passed in the Journal Proper to
record the amount of closing stock:
Closing Stock Account Dr.
To Trading Account
The amount of closing stock is shown on the credit side of the Trading
Account and as an asset in the Balance Sheet. This has been explained later. Self-Instructional
Material 145
Final Accounts- II The Closing Stock at the end of the accounting period will become the
Opening Stock for the next year. The Opening Stock is, therefore, shown on
the debit side of the Trial Balance.
NOTES The following equations can be derived for computation of stocks:
Opening Stock = Cost of Goods Sold + Closing Stock – Cost of
Purchases
Closing Stock = Opening stock + Cost of purchases – Cost of
Goods Sold
Taking the figures from Illustration 11.6 the two stocks can be
computed as under:
Opening Stock = Cost of Goods Sold + Closing stock – Cost of
purchases
= 12,000 + 6,000 – 14,000 = `4,000
Closing Stock = Opening stock + Cost of purchases – Cost of
Goods Sold
= 4,000 + 14,000 – 12,000 = `6,000
Valuation of Closing Stock: The closing stock is valued on the
basis of “cost or market price whichever is less” principle. It is, therefore,
very necessary that the cost of the goods lying unsold should be carefully
determined. The market value of such goods will also be found out on the
Balance Sheet date. The closing stock will be valued at the lower of the two
values. For example, if the goods lying unsold at the end of the accounting
period amount to `11,000, while their market price on the Balance Sheet
date amounts to `10,000, the closing stock will be valued at `10,000. This
valuation is done because of the accounting convention of conservatism,
according to which expected losses are to be taken into account but not
expected profits.
2. Purchases: The term “Purchases” includes both cash and credit purchases
of goods. The term “goods”, as already explained in an earlier chapter, means
items purchased for resale. Assets purchased for permanent use in the business
such as purchase of plant, furniture, etc., are not included in the purchase
of goods. Similarly, purchase of articles such as stationery meant for using
in the business will also not be included in the item of purchases. In case a
proprietor has himself used certain goods for his personal purposes, the value
of such goods at cost will be deducted from the purchases and included in
the drawings of the proprietor. The journal entry in such a case would be as
follows:
Drawings Account Dr.
To Purchases Account

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146 Material
Similarly, in case certain goods are given by way of free samples, Final Accounts- II
etc., the value of such goods should be charged to advertisement account
and deducted from purchases. The journal entry in such a case would be as
follows:
NOTES
Advertisement Account Dr.
To Purchases Account
The amount of purchases will be the net purchases made by the
proprietor. The term ‘net purchases’ means total purchases of goods made by
the businessman less the goods that he has returned back to the suppliers. In
other words, purchases will be taken to the Trading Account after deducting
purchases returns from the gross purchases made during the accounting
period.
3. Sales: The term ‘Sales’ includes both cash and credit sales. Gross sales
will be shown in the inner column of the Trading Account out of which “sales
returns” will be deducted. The net sales will then be shown in the outer column
of the Trading Account. Proper care should be taken in recording sale of
those goods which have been sold at the end of the financial year but have
not yet been delivered. The sales value of such goods should be included in
the sales, but care should be taken that they are not included in the closing
stock at the end of the accounting period.
Sales have to be recorded at net realisable value excluding sales tax,
i.e., Sales excluding Sales Tax – Cost incurred necessarily to make the sale.
For example, an item can be sold for `50 plus sales tax at 10% after getting
it repaired at a cost of `5. The sales should be recorded at net relisable value,
i.e., `45.
Sales of assets like plant and machinery, land and building or such other
assets which were purchased for using in the business, and not for sale, should
not be included in the figure of ‘sales’ to be taken to the Trading Account.
4. Wages: The amount of wages is taken as a direct expense and, therefore,
is debited to the Trading Account. Difficulty arises in those cases when the
Trial Balance includes a single amount for “wages and salaries”. In such
a case, the amount is taken to the Trading Account. However, if the Trial
Balance shows “salaries and wages” the amount is taken to the Profit and
Loss Account. In actual practice such difficulties do not arise because the
businessman knows for which purpose he has incurred the expenditure by
way of wages or salaries. However, in an examination problem, it will be
useful for the students to follow the principle given above, i.e., “wages and
salaries” to be charged to Trading Account while “wages and salaries” to be
charged to the Profit and Loss Account. Wages paid for purchase of an asset
for long-term use in the business, i.e., wages paid for plant and machinery
or wages paid for construction of a building should not be charged to the
Wages Account. They should be charged to the concerned Asset Account.
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Material 147
Final Accounts- II 5. Customs and Import Duty: In case the goods have been imported from
outside the country, customs and import duty may have to be paid. The amount
of such duty should be charged to the Trading Account.
6. Freight, Carriage and Cartage: Freight, Carriage and Cartage are
NOTES
taken as direct expenses incurred on purchasing of the goods. They are,
therefore, taken to the debit side of the Trading Account. The terms “Freight
In”, “Cartage In” and “Carriage In” have also the same meaning. However,
“Cartage Out”, “Freight Out” and “Carriage Out” are taken to be the expenses
incurred on selling the goods. They are, therefore, charged to the Profit and
Loss Account. The term “Inward” is also used for the term “IN”. Similarly, the
term “Outward” is also used for the term “Out”. In other words, “Carriage” or
“Carriage Inward” or ‘‘Cariage In’’ are used as synonymous terms. Similarly,
‘‘Carriage Out’’ or ‘‘Carriage Outward’’ are also synonymous terms. The
same is true for other expenses like Freight or Cartage.
7. Royalty: Royalty is the amount paid to the owner for using his rights.
For example, the royalty is paid by a “Lessee” of a coalmine to its owner
for taking out the coal from the coalmine. Similarly, royalty is paid to the
owner of a patent for using his right. It is generally taken as a direct expense
and, therefore, is charged to the Trading Account. However, where royalty
is based on sales, for example, in case of the book publishing trade, it may
be charged to the Profit and Loss Account.
8. Gas, Electricity, Water, Fuel, etc. All these expenses are direct expenses
and, therefore, they are charged to the Trading Account.
9. Packing Materials: Packing Materials used for packing the goods
purchased for bringing them to the shop or convert them into a saleable state
are direct expenses and, therefore, they are charged to the Trading Account.
However, packing expenses incurred for making the product look attractive or
packing expenses incurred after the product has been sold away are charged
to the Profit and Loss Account.
Closing Entries
Closing Entries are entries passed at the end of the accounting year to close
different accounts. These entries are passed to close the accounts relating to
incomes, expenses, gains and losses. In other words, these entries are passed
to close the different accounts which pertain to Trading and Profit and Loss
Account. The accounts relating to assets and liabilities are not closed but
they are carried forward to the next year. Hence, no closing entries are to be
passed regarding those accounts which relate to the Balance Sheet.
The principle of passing closing entry is very simple. In case an account
shows a debit balance, it has to be credited in order to close it. For example,
if the Purchases Account is to be closed, the Purchases Account will have

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148 Material
to be credited so that it may be closed because it has a debit balance. The Final Accounts- II
Trading Account will have to be debited.
The closing entries are passed in the Journal Proper. The different
closing entries to be passed by the accountant for preparing a Trading Account
NOTES
are being explained below:
(i) Trading Account Dr.
To Stock Account (Opening)
To Purchases Account
To Sales Returns Account
To Carriage Account
To Customs Duty Account
(ii) Sales Account Dr.
Purchases Returns Account Dr.
Stock Account (Closing) Dr.
To Trading Account
In case the total of the credit side of the Trading Account is greater than
the total of the debit side of the Trading Account, the difference is known as
Gross Profit. In a reverse case it will be a Gross Loss. Gross Profit or Gross
Loss disclosed by the Trading Account is transferred to the Profit and Loss
Account.
Importance of the Trading Account
Trading Account provides the following information to a businessman
regarding his business:
1. Gross Profit disclosed by the Trading Account tells him the upper limit
within which he should keep the operating expenses of the business
besides saving something for himself. The cost of purchasing and the
price at which he can sell the goods are governed largely by market
factors over which he has no control. He can control only his operating
expenses. For example, if the cost of purchasing an article is `10 and
it can be sold in the market at `15 per unit, the gross margin available
on each article is `5. In case a businessman proposes to sell 1,000 units
of that article in a year, his gross profit or gross margin will be `5,000.
His other expenses should therefore be less than `5,000 so that he can
also save something for himself.
2. He can calculate his Gross Profit Ratio1 and compare his performance
year after year. A fall in the Gross Profit Ratio means increase in the
cost of purchasing the goods or decrease in the selling price of the
goods or both. In order to maintain at least same figure of gross profit
1. Gross Profit ÷ Sales × 100
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Material 149
Final Accounts- II in absolute terms, he will have to push up the sales or make all out
efforts to obtain goods at cheaper prices. Thus, he can prevent at least
fall in the figure of his gross profit if he cannot bring any increase in
it.
NOTES
3. Comparison of stock figures of one period from another will help him
in preventing unnecessary lock-up of funds in inventories.
4. In case of new products, the businessman can easily fix up the selling
price of the products by adding to the cost of purchases, the percentage
gross profit that he would like to maintain. For example, if the trader
has been so far maintaining a rate of gross profit of 20% on sales and
he introduces a new product in the market having a cost of `100, he
should fix the selling price at `125 in order to maintain the same rate
of gross profit (i.e., 20% on sales).

Check Your Progress


1. What is the term given to profit disclosed by the Trading Account?
2. State the principle on which the valuation of closing stock is done.

7.3 PROFIT AND LOSS ACCOUNT


The Trading Account simply tells about the gross profit or loss made by
a businessman on purchasing and selling of goods. It does not take into
account the other operating expenses incurred by him during the course of
running the business. For example, he has to maintain an office for getting
orders and executing them, taking policy decisions and implementing them.
All such expenses are charged to the Profit and Loss Account. Besides this,
a businessman may have other sources of income. For example, he may
receive rent from some of his business properties. He may have invested
surplus funds of the business in some securities. He might be getting interest
or dividends from such investments. In order to ascertain the true profit or
loss which the business has made during a particular period, it is necessary
that all such expenses and incomes should be considered. Profit and Loss
Account considers all such expenses and incomes and gives the net profit
made or loss suffered by a business during a particular period. It is generally
prepared in the following form:

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150 Material
PROFIT AND LOSS ACCOUNT Final Accounts- II
Dr. for the year ending..... Cr.
Particulars ` Particulars `
To Gross Loss b/d* ....... By Gross Profit b/d* ........
To Salaries ....... By Discount received ........ NOTES
To Rent ........ By Net Loss transferred
To Commission ........ to Capital A/c* ........
To Advertisements ........
To Bad Debts ........
To Discount ........
To Net Profit Transferred
to Capital Account* ........
........ ........

* Only one figure of profit or loss will appear.

Important Points Regarding Profit and Loss Account


1. Gross Profit or Gross Loss The figure of gross profit or gross loss
is brought down from the Trading Account. Of course, there will be
only one figure, i.e., either of gross profit or gross loss.
2. Salaries Salaries payable to the employees for the services rendered
by them in running the business being of indirect nature are charged
to the Profit and Loss Account. In case of a partnership firm, salaries
may be allowed to the partners. Such salaries will also be charged to
the Profit and Loss Account.
3. Salaries less Tax In case of employees earning salaries beyond a
certain limit, the employer has to deduct at source income tax from
the salaries of such employees. In such a case, the amount of gross
salaries should be charged to the Profit and Loss Account, while the tax
deducted by the employer will be shown as a liability in the Balance
Sheet of the business till it is deposited with the Tax Authorities. For
example, if salaries paid are `2,400 after deducting income tax of `600,
the amount of salaries to be charged to the Profit and Loss Account
will be a sum of `3,000. The amount of tax-deducted at source by the
employer, i.e., `600 will be shown as a liability in the Balance Sheet.
4. Salaries after deducting Provident Fund Contribution etc. In
order to provide for old age of the employees, employers contribute a
certain percentage of salaries of the employees to the Provident Fund.
The employee is also required generally to contribute an equivalent
amount. The share of the employee’s contribution to Provident Fund is
deducted from the salary due to him and the net amount is paid to him.
The amount of salaries to be charged to the Profit and Loss Account
will be the gross salary payable to the employee, i.e., including the
employee’s contribution to the Provident Fund. The contribution by
the employer will also be charged as an expense to the Profit and
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Material 151
Final Accounts- II Loss Account. Both employer’s and employee’s contributions to the
Provident Fund will also be shown as liability in the Balance Sheet
under the heading ‘‘Employees Provident Fund’’.
5. Interest Interest on loans whether short-term or long-term is an
NOTES
expense of an indirect nature and, therefore, is charged to the Profit
and Loss Account. However, interest on loans advanced by a firm to
third-parties is an item of income and, therefore, will be credited to
the Profit and Loss Account.
6. Commission Commission may be both an item of income as well as
an item of expense. Commission on business brought by agents is an
item of expense while commission earned by the business for giving
business to others is an item of income. Commission to agents is,
therefore, debited to the Profit and Loss Account while commission
received is credited to the Profit and Loss Account.
7. Trade Expenses Trade expenses are expenses of a miscellaneous
nature. They are of small amount and varied in nature and, therefore,
it is not considered worthwhile to open separate accounts for each of
such types of expenses. The terms ‘‘Sundry Expenses’’, ‘‘Miscellaneous
Expenses’’ or ‘‘Petty Expenses’’ have also the same meaning. They are
charged to the Profit and Loss Account.
8. Printing and Stationery This item of expense includes expenses
on printing of bills, invoices, registers, files, letter heads, ink, pencil,
paper and other items of stationery, etc. It is of an indirect nature and,
therefore, charged to the Profit and Loss Account.
9. Advertisements Advertisement expenses are incurred for attracting
the customers to the shop and, therefore, they are taken as selling
expenses. They are debited to the Profit and Loss Account. However,
advertisement expenses incurred for purchasing of goods should be
charged to the Trading Account, while an advertisement expense
incurred for purchase of a capital asset (e.g., cost of insertion in a
newspaper for purchase of car) should be taken as a capital expenditure
and debited to the concerned asset account. Similarly, advertisement
expenditure incurred for sale of a capital asset should be deducted out
of the sale proceeds of the asset concerned.
10. Bad Debts Bad Debts denotes, the amount lost from debtors to whom
the goods were sold on credit. It is a loss and, therefore, should be
debited to the Profit and Loss Account.
11. Depreciation Depreciation denotes decrease in the value of an
asset due to wear and tear, lapse of time, obsolescence, exhaustion
and accident. For example, a motor car purchased gets depreciated
on account of its constant use. A property purchased on lease for
`12,000 for a period of 12 years will depreciate at the rate of `1,000
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152 Material
per year. On account of new inventions, old assets become obsolete and Final Accounts- II

they have to be replaced. Mines etc. get exhausted after the minerals
are completely taken out of them. An asset may meet an accident and
may lose its value. It is necessary that depreciation on account of all
these factors is charged to the Profit and Loss Account to ascertain the NOTES
true profit or loss made by the business.
12. Discount It is a reduction from a list price, quoted price or invoice
price. Discount may be of three types:
(a) Trade Discount It is a reduction from the list price. It is a reduction
granted by a supplier from the list price of goods or services.
(b) Quantity Discount It is similar to trade discount with the
difference that it is given in case of purchasing of goods in bulk
quantity.
(c) Cash Discount It is a reduction granted by a supplier from the
invoice price in consideration of immediate payment or payment
within a stipulated period.
Thus, quantity discount is similar to trade discount. However, cash
discount is different from trade discount.
Distinction between trade discount and cash discount can be put as
follows:
(a) Meaning A trade discount is a reduction granted by the supplier
from the list price on total amount of sales, while a cash discount
is a reduction for prompt payment or payment within a stipulated
time period.
(b) Objective The objective of trade discount is to promote sales,
while the objective of cash discount is quick collection of
payment.
(c) Time Trade discount is allowed at the time of purchasing of goods,
while cash discount is allowed at the time of making payment.
(d) Disclosure Trade discount is shown as reduction in the invoice
itself, while cash discount is not shown in the invoice. Moreover,
trade discount account is not opened in the ledger, while cash
discount account is opened in the ledger.
(e) Variation Trade discount may vary with the quantity of goods
purchased, while cash discount may vary with time period within
which payment is received.
13. Manager’s Commissions The manager of a firm may be given a
certain percentage of net profit. This percentage of commission may
be before or after charging of such commission. The computation of
commission can be understood with the following example.
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Material 153
Final Accounts- II Example:
Net Profit before charging commision: `10,000.
Manager’s Commission 10% of Net Profit before charging his
NOTES commission.
The Manager’s Commission can be computed as under:
10
= `10,000 × 100
`1,000

However, if the manager’s commission is 10% of Net profit after


charging his commission, the amount of commission will be computed as
follows:
10
= `10,000 × 100 `909

This can be verified as under:


Net Profit before charging commission = `10,000
Less: Manager’s Commission = `909
Net Profit after charging commission = 9,091

Thus, manager’ commission of `909 is 10% of firm’s net profits after


charging commisson.
Accounting (Closing) Entries for Preparing Profit and Loss Account
The following journal entries will be passed in the Journal Proper for
preparing the Profit and Loss Account.
(i) For transfer of items of expenses, losses, etc., appearing on the debit
side of the Trial Balance
Profit and Loss Account Dr.
To Salaries
To Rent
To Commission
To Advertisements
To Bad Debts
To Discount
To Printing and Stationery

(ii) For transfer of items of incomes, gains, etc., appearing on the credit
side of the Trial Balance
Interest Account Dr.
Dividends Account Dr.
Discount Account Dr.
To Profit and Loss Account

(iii) For transfer of net profit or net loss:


In case the total of the credit side of the Profit and Loss Account is
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154 Material
termed as Net Profit. In a reverse case, it will be termed as Net Loss. The Final Accounts- II
amount of Net Profit or Net Loss shown by the Profit and Loss Account will
be transferred to Capital Account in case of sole proprietary firm. In case
of a partnership firm, the amount of net profit or net loss will be transferred
to the Partners’ Capital Accounts in the agreed ratio. In the absence of any NOTES
agreement, the partners will share profits and losses equally.
For transfer of Profit
Profit and Loss Account Dr.
To Capital Account(s)
For transfer of Net Loss
Capital Account(s) Dr.
To Profit and Loss Account
Illustration 7.7. From the following balances, taken from the Trial Balance
of Shri Suresh, prepare a Trading and Profit and Loss Account for the year
ending 31st Dec., 2017:
Particulars Dr. ` Cr. `
Stock on 1.1.2017 2,000
Purchases and Sales 20,000 30,000
Returns 2,000 1,000
Carriage 1,000
Cartage 1,000
Rent 1,000
Interest Received 2,000
Salaries 2,000
General Expenses 1,000
Discount 500
Insurance 500
The Closing Stock on 31st December, 2017 is `5,000.
Solution:
TRADING AND PROFIT AND LOSS ACCOUNT
Dr. for the year ending 31st December, 2017 Cr.
Particulars ` Particulars `
To Opening Stock 2,000 BySales 30,000
To Purchases 20,000 Less: Returns 2,000 28,000
Less: Returns 1,000 19,000 By Closing Stock 5,000
To Carriage 1,000
To Cartage 1,000
To Gross Profit c/d 10,000
33,000 33,000
To Rent 1,000 By Gross Profit b/d 10,000
To Salaries 2,000 By Interest 2,000
To General Expenses 1,000 By Discount 500
To Discount 1,000
To Insurance 500
To Net Profit taken to Capital Account 8,000
12,500 12,500

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Material 155
Final Accounts- II Importance of Profit and Loss Account
The Profit and Loss Account provides information regarding the following
matters:
NOTES (i) Ascertainment of net profit (or loss) It provides information about
the net profit or net loss earned or suffered by the business during a
particular period. Thus, it is an index of the profitability or otherwise
of the business.
(ii) Comparative study The Profit figure disclosed by the Profit and
Loss Account for a particular period can be compared with that of
the other period. Thus, it helps in ascertaining whether the business is
being run efficiently or not.
(iii) Controlling expenses An analysis of the various expenses included
in the Profit and Loss Account and their comparison with the expenses
of the previous period or periods helps in taking steps for effective
control of the various expenses.
(iv) Providing for contingencies Allocation of profit among the different
periods or setting aside a part of the profit for future contingencies can
be done.
(v) Prospective planning On the basis for profit figures of the current
and the previous period estimates about the profit in the year to come
can be made. These projections will help the business in planning the
future course of action.

Check Your Progress


3. State the entry for Salaries less Tax in the Profit and Loss Account.
4. What is the difference between cash discount and trade discount on
account of disclosure?

7.4 BALANCE SHEET


Having prepared the Trading and Profit and Loss Account, a businessman
will like to know the financial position of his business. For this purpose,
he prepares a statement of his assets and liabilities as on a particular date.
Such a statement is termed as ‘‘Balance Sheet’’. Thus, Balance Sheet is not
an account but only a statement containing the assets and liabilities of a
business on a particular date. It is, as a matter of fact, a classified summary
of the various remaining accounts after accounts relating to Incomes and
Expenses have been closed by transfer to Manufacturing, Trading and Profit
and Loss Account.

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156 Material
Balance Sheet has two sides. On the left hand side, the ‘‘liabilities’’ of Final Accounts- II
the business are shown while on the right hand side the assets of the business
appear. These two terms have been explained later in the unit.
It will be useful here to quote definitions of the Balance Sheet given
NOTES
by some prominent writers. According to Palmer, ‘‘The Balance Sheet is
a statement at a given date showing on one side the trader’s property and
possessions and on the other side his liabilities.’’ According to Freeman, ‘‘A
Balance Sheet is an itemised list of the assets, liabilities and proprietorship
of the business of an individual at a certain date.’’ The definition given by
the American Institute of Certified Public Accountants makes the meaning of
Balance Sheet more clear. According to it, Balance Sheet is ‘‘a list of balances
of the asset and liability accounts. This list depicts the position of assets and
liabilities of a specific business at a specific point of time.’’
Proforma of Balance Sheet and Principle of Marshalling
Marshalling There is no prescribed form of Balance Sheet for a sole
proprietary and partnership firm.2 However, the principle of marshalling is
applied while arranging the assets and liabilities in the balance sheet of a
firm. Marshalling refers to arrangement of assets and liabilities in the balance
sheet in any of the following order:
1. Liquidity Order 2. Permanency Order
1. Liquidity Order In case a concern adopts liquidity order, the assets which
are more readily convertible into cash come first and those which cannot be
so readily converted come next and so on. Similarly, those liabilities which
are payable first come first, and those payable later, come next and so on.
A proforma of Balance Sheet according to liquidity order is given below:
BALANCE SHEET
as on .......
Liabilities ` Assets `
Bank Overdraft ....... Cash in Hand .......
Outstanding Expenses ....... Cash at Bank .......
Bills Payable ....... Prepaid Expenses .......
Sundry Creditors ....... Bills Receivable .......
Long-term Loans ....... Sundry Debtors .......
Capital ....... Closing Stock:
Raw Materials .......
Work-in-Progress .......
Finished Goods ....... .......
Plant and Machinery .......
Furniture .......
Building .......
Land .......
Goodwill .......
....... .......

2. In case of Joint Stock Companies the proforma of balance sheet has been prescribed by Schedule III (Part-I)
of the Companies Act, 2013.
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Material 157
Final Accounts- II 2. Permanency Order In case of permanency order, assets which are
more permanent come first, less permanent come next and so on. Similarly,
liabilities which are more permanent come first, less permanent come next
and so on. In other words, an asset which will be sold in the last or a liability
NOTES which will be paid in the last come first and that order is followed both for
all assets and liabilities. In case a balance sheet is to be prepared according
to permanency order, arrangement of assets and liabilities will be reversed
than what has been shown above in case of liquidity order.
Distinction between Profit & Loss Account and Balance Sheet
The points of distinction between Profit & Loss Account and Balance Sheet
are as under:
(i) A profit and loss account shows the profit or loss made by the business
during a particular period. While a balance sheet shows the financial
position of the business on a particular date.
(ii) A profit and loss account incorporates those items which are of a
revenue nature while a balance sheet incorporates those items which
are of a capital nature.
(iii) Of course, both profit and loss account and the balance sheet are
prepared from the Trial Balance. However, the accounts transferred
to the profit and loss account are finally closed while the accounts
transferred to the balance sheet represent those accounts whose balances
are to be carried forward to the next year.
Difference between Trial Balance and Balance Sheet
The difference between trial balance and balance sheet can be put as under:
(a) Meaning A trial balance is a statement containing various ledger
balances on a particular date while a balance sheet is a statement of
various assets and liabilities of the business on a particular date.
(b) Objective The objective of preparation of a trial balance is to check
the arithmetical accuracy of the books of account of the business,
while the objective of preparation of a balance sheet is to ascertain the
financial position of the business.
(c) Items covered A trial balance contains all items relating to incomes,
expenses, assets and liabilities while a balance sheet incorporates only
assets and liabilities.
(d) Preparation A trial balance is prepared before preparation of a balance
sheet. In other words, the preparation of a trial balance is independent of
the preparation of a balance sheet. While a balance sheet is prepared not
only on the basis of trial balance but also of any additional information
which may not have been incorporated in the trial balance.
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158 Material
(e) Use A trial balance is meant only for internal use while a balance is Final Accounts- II
prepared both for internal as well as external use.
Important Points Regarding Balance Sheet
1. Liabilities The term ‘‘Liabilities’’ denotes claims against the assets of a NOTES
firm, whether those of owners of the business or of the creditors. As a matter
of fact, the term “Equity” is more appropriate than the term “Liabilities”. This
is supported by the definition given by American Accounting Association.
According to this Association, Liabilities are “claims of the creditors against
the enterprise arising out of past activities that are to be satisfied by the
disbursement or utilisation of corporate resources”. While the term “Equity”
stands both for owners equity (owners claims) as well as the outsiders equity
(outsiders claims). However, for the sake of convenience, we are using the
term “Liabilities” for the purposes of this book.
Liabilities can be classified into two categories:
(i) Current Liabilities (ii) Long-Term or Fixed Liabilities.
Current liabilities The term “Current Liabilities” is used for such liabilities
which are payable within a year from the date of the Balance Sheet either out
of existing current assets or by creation of new current liabilities. The broad
categories of current liabilities are as follows:
(a) Accounts Payable, i.e., bills payable and trade creditors.
(b) Outstanding Expenses, i.e., expenses for which services have been
received by the business but for which payments have not been made.
(c) Bank Overdraft.
(d) Short-term Loans, i.e., loans from Bank which are payable within one
year from the date of the Balance Sheet.
(e) Advance payments received by the business for the services to be
rendered or goods to be supplied in future.
Fixed liabilities All liabilities other than Current Liabilities come within
this category. In other words, these are the liabilities which do not become
due for payment in one year and which do not require current assets for their
payment.
2. Assets The term ‘‘Assets’’ denotes the resources acquired by the business
from the funds made available either by the owners of the business or
others. It thus includes all rights or properties which a business owns. Cash,
investments, bills receivable, debtors, stock of raw materials, work-in-
progress and finished goods, land, buildings, machinery, trademarks, patent
rights, etc., are some examples of assets.

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Material 159
Final Accounts- II Assets may be classified into the following categories:
(a) Current assets Current Assets are those assets which are acquired with
the intention of converting them into cash during the normal business
operations of the enterprise. According to Grady, ‘‘the term Current
NOTES
Assets is used to designate cash and other assets or resources commonly
identified as those which are reasonably expected to be realised in cash
or sold during the normal operating cycle of the business.’’3 Thus,
the term “Current Assets” includes cash and bank balances, stocks
of raw materials, work-in-progress and finished goods, debtors, bills
receivable, short-term investments, prepaid expenses, etc.
(b) Liquid assets Liquid Assets are those assets which are immediately
convertible into cash without much loss. Liquid Assets are a part of
current asset. In computing liquid assets, stock of raw materials, work-
in-progress and finished goods and prepaid expenses are excluded while
all other current assets are taken.
(c) Fixed assets Fixed assets are those assets which are acquired for
relatively long periods for carrying on the business of the enterprise.
They are not meant for resale. Land and building, machinery, furniture
are some of the examples of Fixed Assets. Sometimes, the term “Block
Capital” is also used for them.
(d) Intangible assets Intangible Assets are those assets which cannot
be seen and touched. Goodwill, patents, trademarks, etc., are some
examples of Intangible Assets.
(e) Fictitious assets There are assets not represented by tangible
possession or property. Examples of such assets are formation expenses
incurred for establishing a business such as registration charge paid
to the Registrar of joint stock companies for getting a company
incorporated, discount on issue of shares, debit balance in the Profit
and Loss Account when shown on the assets side in case of a joint
stock company etc.
Valuation of Assets The following requirements of various accounting
standards (ASs) should be kept in mind while valuing assets.
(i) The cost of a fixed asset should comprise its purchase price and any
attributable costs of bringing the asset to its working condition for its
intended use. (AS 10)
(ii) Goodwill should be recorded in the books only when some consideration
in money or money’s worth has been paid for it. (AS 10)
(iii) The direct costs incurred in developing the patents should be capitalised,
and written off over their legal term of validity or over their working
life, whichever is shorter. (AS 10)
3. Paul Grady, ‘‘Inventory of Generally Accepted Accounting Principles for Business Enterprises’’, pages
Self-Instructional 234-35.
160 Material
(iv) Amount paid for knowhow for the plants, lay-out and designs of Final Accounts- II
building and/or design of the machiery should be capitalised under
the relevant asset heads, such as buildings, plants and machinery, etc.,
(AS 10)
NOTES
(v) If the recoverable amount of an asset is less than its carrying amount,
i.e., it has become an impaired asset, the carrying amount of the asset
should be reduced to its recoverable amount. That reduction is an
impairment loss. Impairment loss should be recognised as an expense in
the statement of profit and loss immediately, unless the asset is carried
at revalued amount in accordance with another Accounting Standard
(see Accounting Standard (AS) 10, Accounting for Fixed Assets), in
which case any impairment loss of a revalued asset should be treated
as a revaluation decrease under that Accounting Standard. (AS 28)
(vi) The current assets are meant for converting into cash during the normal
operating cycle of business, hence, they are valued on the principle of
‘‘cost or market price whichever is less’’.
(vii) Assets and liabilities should be adjusted for events occurring after
the balance sheet date that provide additional evidence to assist the
estimation of amounts relating to conditions existing at the balance
sheet date or that indicates that the fundamental accounting assumption
of going concern (i.e., the continuance of existence or substratum of
the enterprise) is not appropriate. (AS 4)
Illustration 7.8. From the following balance extracted from the books of M/s
Rajendra Kumar Gupta & Co., pass the necessary closing entries, prepare a
Trading and Profit and Loss Account and a Balance Sheet.
Particulars ` Particulars `
Opening Stock 1,250 Plant and Machinery 6,230
Sales 11,800 Returns Outwards 1,380
Depreciation 667 Cash in hand 895
Commission (Cr.) 211 Salaries 750
Insurance 380 Debtors 1,905
Carriage Inwards 300 Discount (Dr.) 328
Furniture 670 Bills Receivable 2,730
Printing Charges 481 Wages 1,589
Carriage Outwards 200 Returns Inwards 1,659
Capital 9,228 Bank Overdraft 4,000
Creditors 1,780 Purchases 8,679
Bills Payable 541 Petty Cash in hand 47
Bad Debts 180

The value of stock on 31st December, 2017 was `3,700.

Self-Instructional
Material 161
Final Accounts- II Solution:
JOURNAL
Date Particulars Dr. Amt ` Cr. Amt `
Trading A/c Dr. 13,477
To Opening Stock A/c 1,250
NOTES To Purchases A/c 8,679
To Wages A/c 1,589
To Returns Inward A/c 1,659
To Carriage Inward A/c 300
(For closing all accounts to be debited to Trading A/c)
Sales A/c Dr. 11,800
Returns Outward A/c Dr. 1,380
To Trading A/c 13,180
(For closing all accounts to be credited to the Trading A/c)
Trading A/c Dr. 3,403
To Profit and Loss A/c 3,403
(For transfer of Gross Profit)
Profit and Loss A/c Dr. 2,986
To Depreciation A/c 667
To Insurance A/c 380
To Printing Charges A/c 481
To Carriage Outward A/c 200
To Salaries A/c 750
To Discount A/c 328
To Bad Debts A/c 180
(For closing all indirect and selling expenses accounts)
Commission A/c Dr. 211
To Profit and Loss A/c 211
(For closing commission account)
Profit and Loss A/c Dr. 628
To Capital A/c 628
(For transferring Net Profit to Capital Account)

TRADING AND PROFIT & LOSS ACCOUNT


for the year ending 31st December, 2017
Particulars ` Particulars `
To Opening Stock 1,250 By Sales 11,800
To Purchases 8,679 Less: Returns
Less: Returns Outward 1,380 7,299 Inwards 1,659 10,141
To Wages 1,589 Closing Stock 3,700
To Carriage Inward 300
To Gross Profit c/d 3,403
13,841 13,841
To Depreciation 667 By Gross Profit b/d 3,403
To Insurance 380 By Commission 211
To Printing Charges 481
To Carriage Outwards 200
To Salaries 750
To Discount 328
To Bad Debts 180
To Net Profit 628
3,614 3,614

Self-Instructional
162 Material
BALANCE SHEET Final Accounts- II
as on 31st December, 2017
Liabilities ` Assets `
Bills Payable 541 Cash 895
Creditors 1,780 Petty Cash 47
Bank Overdraft 4,000 Bills Receivable 2,730 NOTES
Capital 9,228 Debtors 1,905
Add: Net Profit 628 9,856 Closing Stock 3,700
Plant and Machinery 6,230
Furniture 670
16,177 16,177

Illustration 7.9. From the following Trial Balance prepare the Manufacturing
Account, Trading and Profit and Loss Account for the year ending 31st March,
2017 and the Balance Sheet as on that date:
Particulars Debit ` Credit `
Shri Banker’s Capital Account 41,000
Shri Banker’s Drawing Account 6,100
Mrs Banker’s Loan Account 4,000
Sundry Creditors 45,000
Cash in Hand 250
Cash at Bank 4,000
Sundry Debtors 40,500
Patents 2,000
Plant and Machinery 20,000
Land and Buildings 26,000
Purchases of Raw Materials 35,000
Raw Material as on 1.4.2016 3,500
Work-in-process as on 1.4.2016 2,000
Finished Stock as on 1.4.2016 18,000
Carriage Inwards 1,100
Wages 27,000
Salary of Works Manager 5,600
Factory Expenses 3,400
Factory Rent and Taxes 2,500
Royalties (paid on sales) 1,200
Sales (less Returns) 1,23,400
Advertising 3,000
Office Rent and Insurance 4,800
Printing and Stationery 1,000
Office Expenses 5,800
Carriage Outwards 600
Discounts 1,400 2,100
Bad Debts 750
2,15,500 2,15,500

The Stock on 31st March, 2017 was as follows:


`4,000 Raw Materials, `4,500 Work-in-progress and `28,000 Finished
Goods.
Solution:
MANUFACTURING ACCOUNT
for the year ending March 31, 2017
Particulars ` Particulars `
To Opening Work-in-process 2,000 By Transfer to Trading Account
To Raw Materials used: (cost of finished goods pro- 71,600
duced)
Opening Stock 3,500 By Closing Work-in-process 4,500
Self-Instructional
Material 163
Final Accounts- II Particulars ` Particulars `
Add: Purchases 35,000
38,500
Less: Closing Stock 4,000 34,500
To Carriage Inwards 1,100
NOTES To Wages 27,000
To Salary of Works Manager 5,600
To Factory Expenses 3,400
To Factory Rent and Taxes 2,500
76,100 76,100

TRADING AND PROFIT & LOSS ACCOUNT


for the year ending March 31, 2017
Particulars ` Particulars `
To Opening Stock of By Sales 1,23,400
Finished Goods 18,000 By Closing Stock of
To Manufacturing A/c 71,600 Finished Goods 28,000
(Cost of goods produced)
To Gross Profit c/d 61,800
1,51,400 1,51,400
To Royalties 1,200 By Gross Profit b/d 61,800
To Advertising 3,000 By Discount received 2,100
To Office Rent and Insurance 4,800
To Printing and Stationery 1,000
To Office Expenses 5,800
To Carriage Outwards 600
To Bad Debts 750
To Discount Allowed 1,400
To Net Profit carried to
Capital Account 45,350
63,900 63,900

BALANCE SHEET
as on 31st March, 2017
Particulars ` Particulars `
Sundry Creditors 45,000 Current Assets:
Mrs. Banker’s Loan 4,000 Cash in hand 250
Capital Account Cash at Bank 4,000
Balance on Sundry Debtors 40,500
1.4.2016 41,000 Closing Stock:
Profit 45,350 Raw Materials 4,000
86,350 Work-in-process
4,500
Less: Drawings 6,100 80,250 Finished goods 36,500
28,000
Fixed Assets:
Patents 2,000
Plant and Machinery 20,000
Land and Buildings 26,000
1,29,250 1,29,250

7.4.1 Treatment of Adjustments


Information given outside the trial balance are known as adjustments. It
means journal entry of this adjustment has not been passed yet. Treatment of
adjustments will be done keeping in mind the double entry system of book
Self-Instructional
keeping .it means treatment of adjustments is done at least two places in
164 Material
final accounts to complete the double entry system of book-keeping. These Final Accounts- II
adjustments relate to closing stock, outstanding expenses, prepaid expenses,
outstanding or accrued income, etc., which have been discussed in detail in
the previous unit.
NOTES
Check Your Progress
5. Define marshalling.
6. What is the difference between Trial Balance and Balance Sheet on
account of items covered?

7.5 PRACTICAL PROBLEMS


Practical Problems on Final Accounts without Adjustments
1. Prepare Manufacturing, Trading and Profit and Loss Account from the following figures relating
for the year 2017:
1.1.2017 31.12.2017
` `
Stock:
Finished Goods 33,000 27,500
Raw Materials 16,000 18,300
Work-in-progress 11,100 9,400
Purchase of Materials 1,50,900
Carriage on Purchases 4,100
Wages 65,000
Factory Salaries 26,000
Office Salaries 18,000
Repair and Maintenance:
Machinery 8,300
Office Equipment 1,700
Depreciation :
Machinery 25,000
Office Equipment 8,100
Sundry Expenses :
Factory 5,300
Office 17,800
Sales 3,60,000
It is the firm’s practice to transfer goods from the Factory to Sales godown at cost plus 10%.
[Ans. Manufacturing Profit `28,400; Gross Profit `42,100; Net Loss `3,500]
2. From the following particulars, prepare Manufacturing Account, Trading Account, and Profit
and Loss Account:
`
Purchases of Raw Materials 13,195
Return Inward 70
Stock on 31.12.2017
Raw Materials 1,210

Self-Instructional
Material 165
Final Accounts- II Work-in-progress 1,000
Finished Goods 1,370
Productive Wages 2,000
Factory Expenses 1,840
General Office Expenses 300
NOTES Salaries 600
Distribution Expenses 100
Selling Expenses 700
Purchasing Expenses 600
Export Duty 300
Import Duty 200
Interest on Bank Loan 600
Stock on 1-1-2017
Raw Material 400
Work-in-progress 300
Finished Goods 410
Sales 19,500
Returns Outward 85
Carriage Outward 105
Carriage Inward 100
Cash Discount (allowed) 10
Sale of scrap 20
Depreciation of Machinery 500
Repairs of Machinery 100
Depreciation of Office Furniture 40
[Ans. Gross Profit `3,470; Net Profit `7,150]
3. From the following Trial Balance, prepare a Trading, Manufacturing and Profit and Loss Account
and Balance Sheet as on 31st December, 2017:
TRIAL BALANCE
as on 31st December, 2017

Particulars ` `
Stock on 1.1.2017
Raw Materials 2,000
Work-in-progress 5,000
Finished Goods 10,000
Manufacturing Wages 10,000
Purchasing of Raw Materials 30,000
Factory Rent 5,000
Carriage of Raw Materials 3,000
Salary of the Works Manager 2,000
Office Rent 2,000
Printing and Stationery 1,000
Bad Debts 1,000
Sales 60,000
Land and Buildings 30,000
Plant and Machinery 20,000
Depreciation on Plant 2,000
Sundry Debtors 5,000
Sundry Creditors 30,000
Cash in hand 5,000
Capital 43,000
1,33,000 1,33,000
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166 Material
Closing Stocks on 31st December, 2017 were as follows: Final Accounts- II
`
Raw Material 5,000
Work-in-process 4,000
Finished Goods 10,000
[Ans. Cost of Production `50,000; Gross Profit `10,000;
NOTES
Net Profit `6,000; Total of Balance Sheet `79,000]
4. Prepare Manufacturing, Trading and Profit and Loss Account for the year ended 31st March,
2017 and Balance Sheet as at the end of the year from the following Trial Balance:

Particulars ` `
Opening Stock of Raw Materials 30,000
Opening Stock of Finished Goods 16,000
Opening Stock of Work-in-progress 5,000
Capital 72,000
Purchases of Raw Materials 2,50,000
Sales 4,00,000
Purchases of Finished Goods 8,000
Carriage Inwards 4,000
Wages 50,000
Salaries (75% Factory) 26,000
Commission 3,000
Bad Debt 2,000
Insurance 4,000
Rent, Rates and Taxes (50% Factory) 12,000
Postage and Telegram 2,800
Tea and Tiffin 1,600
Travelling and Conveyance (25% Factory) 3,500
Carriage Outwards 2,600
Machinery 40,000
Furniture 5,000
Debtors 60,000
Creditors 53,500
5,25,500 5,25,500

The Closing Stocks are as follows:


Raw Materials ` 40,000
Work-in-progress ` 12,000
Finished Goods ` 8,000
[Ans.
Cost of Production `3,13,375; Gross Profit `70,625;
Net Profit `39,500; Balance Sheet Total `1,65,000]
5. From the following balances draw up a Trading and Profit and Loss Account and Balance
Sheet:

Particulars `
P. Parikh Capital 20,000
Bank Overdraft 5,000
Machinery 13,400
Cash in Hand 1,000
Fixtures & Fittings 5,500
Opening Stock 45,000
Bills Payable 7,000

Self-Instructional
Material 167
Final Accounts- II Particulars `
Creditors 40,000
Debtors 63,000
Bills Receivable 5,000
Purchases 50,000
NOTES Sales 1,29,000
Returns from Customers 1,000
Returns to Creditors 1,100
Salaries 9,000
Manufacturing Wages 4,000
Commission and T.A. 5,500
Trade Expenses 1,500
Discount (Cr.) 4,000
Rent 2,200

The Closing Stock amounted to `52,000.


[Ans. Gross Profit `82,100; Net Profit `67,900 and
Balance Sheet Total `1,39,900]
6. From the understated Trial Balance of M/s Suneel Brothers prepare (a) Manufacturing Account;
(b) Trading and Profit and Loss Account; and (c) Balance Sheet:
TRIAL BALANCE
as on 31st December, 2017
Debit Balances ` Credit Balances `
Wages 20,000 Sales 1,74,000
Stock (Raw Materials) Profit and Loss Balance 1.1.2017 12,000
1.1.2017 5,710 Capital 1,30,000
Purchases 88,274
Carriage Inward 3,686
Repairs 6,000
Salaries (Factory) 2,100
Salaries General 1,000
Rates and Taxes 2,240
Travelling Expenses 3,550
Insurance (Factory) 700
Insurance General 80
Bad Debts 410
General Expenses 2,942
Carriage Outward 9,424
Various Assets 1,13,884
Stock 1.1.2017 (Finished Goods) 56,000
3,16,000 3,16,000

Closing Stock: Raw Materials, `5,272; Finished Goods, `34,324.


[Ans. Cost of Production, `1,21,198; Gross Profit `31,126;
Net Profit `11,480; Balance Sheet Total `1,53,480]
7. The following are the Trading and Profit & Loss Account and Balance Sheet of B as on December
31, 2017. Redraw them in proper form, giving reasons for your correction.

Self-Instructional
168 Material
TRADING AND PROFIT & LOSS ACCOUNT Final Accounts- II
for the year ended 31.12.2017

Particulars ` Particulars `
Purchases 4,66,800 Sales 5,59,900
Stock 55,110 Profit on Consignment to NOTES
Salaries 11,010 A & Co., Bombay 19,080
B’s Drawings 19,170 Interest on Capital 7,500
Wages 65,590 Stock (1st Jan.) 50,310
Rent 2,250 Commission received 27,990
General Expenses 17,470 Discount received 11,250
Interest on Loan 3,000
Bad Debts 11,890
Net Profit to B/S 23,740
6,76,030 6,76,030

BALANCE SHEET
as on 31.12.2017
Liabilities ` Assets `
Creditors 1,95,070 Debtors 2,61,580
Bills Receivable 1,30,140 Cash 960
Capital (1.1.2017) 1,50,000 Bank 52,210
Net Profit from P&L A/c 23,740 Loan from Bank 75,000
Stock (31-12-2017) 55,110
Bills Payable 54,090
4,98,950 4,98,950

[Ans. Gross Profit `32,310; Net Profit `37,510; Balance Sheet Total `5,00,000]
Practical Problems on Final Accounts with Adjustments (discussed in Unit 6)
8. State how the following must be dealt with in the final accounts of a firm for the year ended
31.12.2016 giving reasons in brief:
(i) Adverstisement expenditure of `10,000 paid on 30.12.2016, the adverstisement in respect
of which has appeared in the magazines only in January, 2016.
(ii) Cost of temporary pandal erected for an exhibition on 1.7.2016, the exhibition being
expected to be over by June 2016: `17,000.
(iii) Cost of a second-hand scooter purchased on 1.10.2016 for `2,500, which was totally
destroyed in an accident on 31.11.2016, the insurance company paying `1,000 in full
settlement in January, 2016.
(iv) Petrol expenses of `420 paid for the car of one of the partners for an official visit, the car
not being an asset of the firm.
(v) Hire charges of `1,000 for a compressor, when the firm’s own compressor was under
breakdown.
[Ans. (i) Prepaid expense; (ii) Charge `8,500 to P & L in 2016 and
carry forward the balance to 2017; (iii) Write off `1,500 from P & L;
(iv) Charge P & L A/c as a travelling expense]
(v) Charge Manufacturing A/c (if prepared) or P & L A/c]
9. (a) On Ist January, 2017 the Provision for Doubtful Debts Account in the books of a firm which
maintains it at 5% had a credit balance of `1,100. During the year the Bad Debts amounted to
`800 and the debtors at the end of the year were `20,000. Show Provision for Doubtful
Debts Account and Bad Debts Account for the year 2017.
(b) At the end of an accounting year, a trader finds that no entry has been passed in the books
of accounts in respect of the following transactions:
(i) Outstanding salary at the end of the year `200.
(ii) Goods given as charity during the year `300.
(iii) Stock-in-hand at the end of the year `20,000. Journalise these transactions.
10. The following balances were taken from the records of a firm. For each account give the adjusting
journal entry which may have resulted in the change in that account balance.
Self-Instructional
Material 169
Final Accounts- II Particulars Trial Balance Adjusted Trial Balance
Advance from Customers 20,000 16,000
Prepaid Insurance 8,000 6,000
Wages Payable 3,000 5,000
Interest (Credit Balance) 1,000 1,200
NOTES Accumulated Depreciation 15,000 20,000
Assume that the final accounts were prepared from the unadjusted balances. How would the
Profit and Loss account and Balance Sheet be affected in each of the above cases?
11. The following items are found in the Trial Balance of John on 31st December, 2017:
`
Debtors 16,000
Bad Debts 300
Bad and Doubtful Debts Provision 1.1.2017 700
You are to provide for the bad and doubtful debts @ 5%. Give the necessary journal entries and
prepare the Bad Debts Account, Bad and Doubtful Debts Provision Account, Profit and Loss
Account, Sundry Debtors Account in the ledger and a Balance Sheet appearing after the final
adjustments.
12. A firm had the following Balances on Ist January, 2017:
`
(a) Provision for Bad and Doubtful Debts 2,500
(b) Provision for Discount on Debtors 1,200
(c) Provision for Discount on Creditors 1,000
During the year Bad Debts amounted to `2,000, Discounts allowed were `100 and Discounts
received were `200. During 2018 Bad Debts amounting to `1,000 were written off while
Discounts allowed and received were `2,000 and `500 respectively.
Total Debtors on December, 31, 2017 were `48,000 before writing off Bad Debts, but after
allowing Discounts. On December 31, 2018 the amount was `19,000 after writing off the Bad
Debts but before allowing Discounts. Total Creditors on these two dates were `20,000 and
`25,000 respectively.
It is the firm’s policy to maintain a provision of 5% against Bad and Doubtful Debts and 2%
for Discount on Debtors and a provision of 3% for Discount on Creditors.
Show the accounts relating to Provision on Debtors and Provision on Creditors for the year
2017 and 2018.
[Ans. Balances on 31.12.2017 Bad Debts Provision `850; Provision for
Discount on Debtors `323; and Provision for Discount on Creditors `750]

7.6 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. The profit disclosed by the Trading Account is termed as Gross Profit.
2. The closing stock is valued on the basis of ‘cost or market price which
is less’ principle.
3. In the case for Salaries less Tax entry in the Profit and Loss Account,
the amount of gross salaries should be charged to the Profit and Loss
Account, while the tax deducted by the employer will be shown as a
liability in the Balance Sheet of the business till its is deposited with
the Tax Authorities.

Self-Instructional
170 Material
4. On account of disclosure, the trade discount is shown as reduction Final Accounts- II

in the invoice itself, while cash discount is not shown in the invoice.
Moreover, trade discount account is not opened in the ledger, while
cash discount account is opened in the ledger.
NOTES
5. Marshalling refers to arrangement of assets and liabilities in the balance
sheet in any of the following order: liquidity order and permanency
order.
6. The difference between Trial Balance and Balance Sheet on account
of items covered is that a Trial Balance contains all items relating
to incomes, expenses, assets and liabilities, while a balance sheet
incorporates only assets and liabilities.

7.7 SUMMARY
• Trading Account gives the overall result of trading, i.e., purchasing
and selling of goods. In other words, it explains whether purchasing
of goods and selling them has proved to be profitable for the business
or not. It takes into account on the one hand the cost of goods sold and
on the other the value for which they have been sold away.
• At the end of the accounting year, a trader may be left with certain
unsold goods. Such stock of goods with a trader unsold at the end of
the accounting period is termed as Closing Stock. Such a stock will
become the opening stock for the next period.
• While calculating the amount of profit or loss on account of trading,
a trader will have to take such Opening and Closing Stocks into
consideration.
• A trader has to incur various types of expenses for purchasing of
goods as well as for bringing them to his shop for sale. Such expenses
may include brokerage or commission paid to agents for purchase of
goods, cartage or carriage charges for bringing the goods to the trader’s
shop, wages paid to coolies for transportation of goods etc. All such
expenses increase the cost of the goods sold and hence they have also
to be included in the cost of purchasing the goods.
• Cost of goods sold calculated as above will then be compared with the
net sales to find out the amount of profit or loss made by the business.
• The term “Direct Expenses” include those expenses which have been
incurred in purchasing the goods, bringing them to the business premises
and making them fit for sale. Examples of such expenses are carriage
charges, octroi, import duty, expenses for seasoning the goods, etc.
Self-Instructional
Material 171
Final Accounts- II • Important things to be considered while preparing Trading Account
are: stock, purchases, sales, wages, customs and import duty, freight,
carriage and cartage, royalty and packing material, etc.
NOTES • Closing Entries are entries passed at the end of the accounting year to
close different accounts. These entries are passed to close the accounts
relating to incomes, expenses, gains and losses. In other words, these
entries are passed to close the different accounts which pertain to
Trading and Profit and Loss Account.
• The Trading Account simply tells about the gross profit or loss made
by a businessman on purchasing and selling of goods. It does not take
into account the other operating expenses incurred by him during the
course of running the business.
• In order to ascertain the true profit or loss which the business has
made during a particular period, it is necessary that all such expenses
and incomes should be considered. Profit and Loss Account considers
all such expenses and incomes and gives the net profit made or loss
suffered by a business during a particular period.
• Important things to be considered while preparing Profit and Loss
Account are: gross profit and loss, salaries, salaries less tax, interest,
commission, trade expenses, bad debts, printing and stationery,
depreciation, discount, commissions, etc.
• Having prepared the Manufacturing, Trading and Profit and Loss
Account, a businessman will like to know the financial position of his
business. For this purpose, he prepares a statement of his assets and
liabilities as on a particular date. Such a statement is termed as ‘‘Balance
Sheet’’. It is a classified summary of the various remaining accounts
after accounts relating to Incomes and Expenses have been closed by
transfer to Manufacturing, Trading and Profit and Loss Account.
• There is no prescribed form of Balance Sheet for a sole proprietary
and partnership firm. However, the principle of marshalling is applied
while arranging the assets and liabilities in the balance sheet of a firm.
Marshalling refers to arrangement of assets and liabilities in the balance
sheet in any of the following order: 1. Liquidity Order 2. Permanency
Order.
• Important points to consider while preparing a Balance Sheet are the
types and valuations of liabilities and assets.

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172 Material
Final Accounts- II
7.8 KEY WORDS
• Assets: It refers to tangible objects or intangible rights owned by an
enterprise and carrying probable future benefits. NOTES
• Balance Sheet: It refers to a statement of financial position of an
enterprise as at a given period.
• Current Assets: It refers to cash and other assets that are expected
to be converted into cash or consumed in the production of goods or
rendering of services in the normal course of business.
• Current Liabilities: It refers to liabilities payable within a year from
the date of Balance Sheet either out of the existing current assets or
by creation of new current liabilities.

7.9 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions

1. What is merchandise?
2. List the equations required for preparing the Trading Account.
3. Explain the importance of Trading Account.
4. What are the important information provided by the Profit and Loss
Account?
5. Distinguish between Profit and Loss Account and Balance Sheet.
Long Answer Questions

1. Discuss the important points regarding Trading Account.


2. Examine the important points to be kept in mind while preparing a
Profit and Loss Account.
3. Illustrate the different forms of Marshalling.
4. Discuss the differences between Trial Balance and Balance Sheet.
5. What are the important points regarding the preparation of Balance
Sheet.

Self-Instructional
Material 173
Final Accounts- II
7.10 FURTHER READINGS
Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
NOTES
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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174 Material
Bank Reconciliation

UNIT 8 BANK RECONCILIATION


Statement

STATEMENT
NOTES
Structure
8.0 Introduction
8.1 Objectives
8.2 Meaning, Importance and Procedure of Reconciliation
8.2.1 Reasons for Difference
8.2.2 Meaning and Importance of Bank Reconciliation Statement
8.2.3 Technique or Procedure of Preparing Bank Reconciliation Statement
8.3 Answers to Check Your Progress Questions
8.4 Summary
8.5 Key Words
8.6 Self Assessment Questions and Exercises
8.7 Further Readings

8.0 INTRODUCTION
In this unit, you will learn about Bank Reconciliation Statement, which
is a summary of banking and business activity that reconciles an entity’s
bank account with its financial records. The statement outlines the deposits,
withdrawals and other activity affecting a bank account for a specific period.
Bank reconciliation statements ensure payments have been processed and cash
collections have been deposited into the bank. The reconciliation statement
helps identify differences between the bank balance and book balance,
in order to process necessary adjustments or corrections. An accountant
typically processes reconciliation statements once a month. Completing a
bank reconciliation statement requires using both the current and the previous
month’s statements, including the closing balance of the account.

8.1 OBJECTIVES
After going through this unit, you will be able to:
• Identify the advantages to the business firm by keeping an account
with the bank
• Describe the meaning of bank reconciliation statement
• Discuss the reasons for difference in bank reconciliation statement
• Explain the importance of bank reconciliation statement
• Examine the procedure for preparing bank reconciliation statement

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Material 175
Bank Reconciliation
Statement 8.2 MEANING, IMPORTANCE AND PROCEDURE
OF RECONCILIATION

NOTES While explaining recordings of cash transactions in an earlier chapter, it has


already been stated that a firm may keep account(s) with one or more banks.
The advantages of keeping an account with a bank are as follows:
1. Avoidance of risk Keeping large cash balances in the office is risky. In case
money is deposited from time to time in the bank such risk can be avoided.
2. Prevention of fraud and misappropriation Deposits of money into the
bank and disbursing them through the bank reduces the chances of fraudulent
activities and misappropriation of funds by the employees of the firm. All
receipts can immediately be deposited at the end of the day in the bank.
Similarly, all payments can be made by means of cheques. Thus, the quantum
of cash to be handled by the employees of the business is considerably
reduced, resulting in lesser chances of fraud and misappropriation.
3. Reduction in accounting work Depositing money into the bank and
making payments through a bank considerably reduces the firm’s accounting
work. As a matter of fact, in case of large business houses or institutions, the
banks open extension counters where all payments can be received and made.
Thus, the accounting work at the firm’s level is considerably reduced since
the firm’s cash accounting work is more or less done by the bank.
When money is deposited by the firm into the bank, the firm debits the
bank account since bank account is a personal account and, as per accounting
rule, the bank being the receiver has to be debited. Similarly, when money
is withdrawn from the bank, the firm gives credit to the bank account since
bank is the giver. On the other hand, on receipt of money from the customer
(i.e., the firm), the bank gives credit to the customer since the customer’s
account is a personal account, and he is the giver. Similarly on money being
withdrawn by the customer, the bank debits the ac­count of the customer since
he is the receiver. The above rules of accounting as regards bank transactions
can be summarised as follows:
(i) On deposits of money by the firm into the bank account, the firm debits
the bank account while the bank credits the firm’s account.
(ii) On withdrawal of money by the firm from the bank, the firm credits
the bank’s account while the bank debits the firm’s account.
Thus, the balance as shown by the firm’s books in the bank ac­count
should tally with the balance shown by the bank’s books in the account of the
firm. If the bank’s account in the books of the firm shows a debit balance, the
firm’s account in the books of the firm shows a credit balance; the vice versa
is the otherwise case. However, the two balances rarely tally on account of
the rea­sons given later in the unit.
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176 Material
All transactions relating to the bank—deposits or withdraw­als—are Bank Reconciliation
Statement
recorded by the firm in the bank column maintained on each side of the cash
book. The deposit of money into the bank account is recorded on the debit
side of the cash book in the bank column, while the withdrawal of money is
recorded on the credit side in the bank column of the cash book. The bank also NOTES
maintains the firm’s account in its books. A copy of this account is submitted
to the firm from time to time. The account so submit­ted by the bank to the
customer is known as the bank pass book or bank statement. A proforma of
one page of bank pass book is given below:
State Bank of India
SAVINGS BANK ACCOUNT
............ Branch
Name of the Depositor(s)....................................... Account No...............
Address............................................................................

Date Cheque No./ Particulars Debit ` Credit ` Balance ` Initials


Pay-in Slip

The Pass Book or the Bank Statement is submitted by the bank to the
customer for his information and verification. As already stated the balance
shown by the bank column of the cash book and the bank pass book normally
do not tally on account of certain reasons. These reasons are being explained
in the follow­ing pages.
8.2.1 Reasons for Difference
The following are the causes of difference between the balance as shown by
the bank pass book and the balance as shown by the firm’s cash book.
1. Cheques issued but not presented for payment The firm issues cheques
from time to time for making different payments. As soon as a cheque is
issued, the firm debits the party’s account in whose favour the cheque is
issued and credits the bank’s ac­count. However, the bank comes to know of
issue of such cheques only when they are presented for payment. The bank,
therefore, debits the firm’s account only when the cheque is actually pre­sented
for payment. It may, therefore, be possible that on a particular date when the
bank is submitting the firm’s statement of account, it may not include certain
cheques which have been issued by the firm because they may not have yet
been presented. Thus, the balance shown by the bank’s books in the firm’s
account will be higher than the balance shown by the firm’s books in the
bank account. For example, a firm issues a cheque in favour of a creditor
on 28th December, 2010 for a sum of `10,000. The cheque is presented by
the creditor on 3rd January, 2011 for payment. In case the bank submits a
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Material 177
Bank Reconciliation statement of account to the firm upto 31st December, 2010, there will be a
Statement
difference of `10,000 between the balance as shown by the firm’s books and
the balance as shown by the pass book.
2. Cheques sent for collection but not yet collected A firm receives from
NOTES
time to time cheques from its customers which is sent to its bankers for
collection and for crediting the pro­ceeds to its account. The firm debits the
account of the bank as soon as it sends the cheques to the bank for collection.
However, the bank gives credit to the firm only when the cheques are actually
collected. Thus, on a particular date it may be possible that certain cheques
which were sent for collection by the firm to the bank may not have been
collected by the bank and, ther­efore, not credited to the firm’s account. The
two balances—the balance as shown by the bank pass book and the firm’s cash
book—will, therefore, be different. For example, if a firm sends a cheque of
`5,000 on 25th December, 2010 to the bank for collection which is collected
by the bank on 5th January, 2011, in the statement of account which may be
submitted by the bank for the year ending 31st December, 2010, there will
be no credit to the customer for the cheque which it has not yet collected.
Thus, the balance shown by the firm’s cash book will be different from the
balance as shown by the bank pass book.
3. Bank charges The bank charges its customers for the serv­ices it renders
to them from time to time. The bank may charge its customer for remitting
funds at his instruction from one place to another. It may also charge for
collecting outstation cheques or bills of exchange of its customer. The bank
debits the customer’s account as soon as it renders such a serv­ice. However,
a customer will know of such charges only when he receives a statement of
account from the bank. Thus, on a partic­ular date, the balance shown by the
bank pass book may be dif­ferent from the balance shown by the cash book.
4. Direct collections on behalf of customers A banker may receive amounts
due to the customer directly from customer’s debtors. For example, the banker
may get dividends, rents, inter­est, etc. directly from the persons concerned
on account of standing instructions of the customer to such persons. The
bank gives credit to the customer for such collections as soon as it gets such
payments. However, the customer comes to know of such collections only
when he receives the statement of account from his banker. Thus, the balance
shown by the bank pass book and the one shown by the firm’s cash book
may not be the same on account of this reason.
5. Errors There may be errors in the account maintained by the customer
as well as the bank. A wrong credit or debit may be given by the customer
or the bank. The two balances, therefore, may not tally.
8.2.2 Meaning and Importance of Bank Reconciliation Statement
A Bank Reconciliation Statement is a statement reconciling the balance as
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shown by the bank pass book and the balance as shown by the cash book. The
178 Material
objective of preparing such a statement is to know the causes of difference Bank Reconciliation
Statement
between the two balances and pass necessary correcting or adjusting entries
in the books of the firm. It should be noted that every variation or difference
does not require an adjusting or correcting entry. Some reasons for difference
are automatically adjusted. For example, a cheque that has been sent for NOTES
collection, but not yet collected, causes a difference between the balance as
shown by the bank pass book and the balance as shown by the cash book, but
no adjusting entry is required in the cash book for such a dif­ference because,
the bank will credit the firm’s account as soon as the cheque is collected. This
is only a question of time. However, if the cheque sent for collection to the
bank has been returned by the bank on account of it being dishonoured, the
firm should pass an adjusting entry for return of this cheque if it has not already
been passed. Similarly, the firm has also to pass in its books the entries for
bank charges or direct payments received by the bank on behalf of the firm.
Importance of Bank Reconciliation Statement
The importance of Bank Reconciliation Statement can be judged on the basis
of the following facts:
(i) It highlights the causes of difference between the bank balance as
per cash book and the bank balance as per pass book. Necessary
adjustments or corrections can therefore be carried out at the earliest.
(ii) It reduces the chances of fraud by the staff handling cash . It may be
possible that the cashier may not deposit the money in the bank in
time though he might have passed the entry in the bank column of
the cash book. The Bank Reconciliation Statement will project such
discrepancies.
(iii) There is a moral check on the staff of the organisation to keep the cash
records always up-to-date.
8.2.3 Technique or Procedure of Preparing Bank Reconciliation
Statement
A Bank Reconciliation Statement is prepared usually at the end of a period,
i.e., a quarter, a half year or a year, as may be found convenient and necessary
by the firm, taking into account the number of transactions involved. The
following are the steps to be taken for preparing a Bank Reconciliation
Statement.
(i) The cash book should be completed and the balance as per the bank
column on a particular date should be arrived at for the period for
which the Bank Reconciliation Statement has to be prepared.
(ii) The Bank should be requested to complete and send to the firm the
bank pass book upto the date on which the reconciliation statement is
to be prepared.
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Material 179
Bank Reconciliation (iii) The balance as shown by either the cash book or the bank pass book
Statement
should be taken as the base. This, as a matter of fact, is the starting point
for determining the balance as shown by the other book after making
suitable adjustments taking into account the causes of difference.
NOTES
(iv) The effect of that particular cause of difference should be studied on
the balance shown by the other book.
(v) In case the cause has resulted in an increase in the balance shown by
the other book, the amount of such an increase should be added to the
balance shown in the former book which has been taken as the base.
(vi) In case the cause has resulted in a decrease in the balance shown by
the other book, the amount of such a decrease should be deducted
from the balance shown in the former book which has been taken as
the base.
In case the book shows an adverse balance (i.e., an overdraft) the
amount of the overdraft should be transferred to minus column. The
Recociliation Statement should then be prepared on the above basis assuming
a favourable balance.
The above technique will be clear with the help of the illustra­tions
given in the following pages.
Where Causes of Differences are Given
Illustration 8.1. From the following particulars, prepare a Bank Reconciliation
Statement as on 31st December, 2017.
(i) Balance as per Cash Book `5,800.
(ii) Cheques issued but not presented for payment `2,000.
(iii) Cheques sent for collection but not collected up to 31st December,
2010 `1,500.
(iv) The Bank had wrongly debited the account of the firm by `200 which
was rectified by them after 31­­st December.
Balance as per Pass Book is `6,100.
Solution:
There is a difference of `300 between the balance as shown by the cash book
and the balance as shown by the bank pass book. A reconciliation statement
can be prepared to reconcile on the following basis the balances shown by
the two books:
(i) The balance as shown by the cash book will be taken as the starting
point.
(ii) The cheques issued but not presented for payment have not been
recorded in the bank pass book. The balance as per pass book has to
be found out. The Bank has not yet passed the entry for the payment
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180 Material
of these cheques since they have not been presented for payment. The Bank Reconciliation
Statement
balance, therefore, in the pass book should be more. The amount of
`2,000 should, therefore, be added to the balance as shown by the
cash book.
NOTES
(iii) Cheques sent for collection but not yet collected must have been entered
in the cash book but must not have been credited by the Bank to the
firm’s account since they have not yet been collect­ed. The balance in
pass book should, therefore, be less as com­pared to the cash book. The
amount of `1,500 should, therefore, be deducted out of the balance as
shown by the cash book.
(iv) The Bank has wrongly debited the firm’s account. This must have
resulted in reducing balance as per the bank pass book. The amount
should, therefore, be deducted out of the balance shown as per the cash
book.
The Bank Reconciliation Statement will now appear as follows:
BANK RECONCILIATION STATEMENT
Particulars (+) ` (–) `
(i) Balance as per cash book 5,800
(ii) Add: Cheques issued but not presented for payment 2,000
(iii) Less: Cheques sent for collection but not yet collected 1,500
(iv) Less: Amount wrongly debited by the Bank 200
7,800 1,700
Balance as per Bank Pass Book 6,100

Illustration 8.2. From the following particulars, prepare a Bank Reconciliation


Statement showing the balance as per cash book as on 31st December, 2017.
(i) Out of cheques of `9,000 paid on 29th December, `4,000 appear to
have been credited in the pass book on 2nd January, 2010.
(ii) I had issued cheques in December, 2017 amounting in all to `16,000
out of which I find that cheques for `7,000 have been cashed in the
same month; a cheque of `5,000 cashed on January 3, 2018 and the
rest have not been presented at all.
(iii) My bankers have given me a wrong credit in my Joint Ac­count with my
wife, in respect of a cheque of `2,000 paid into my personal account.
(iv) `1,000 for interest on overdraft charged in the pass book on 31st
December has been entered in my cash book on 4th January, 2018.
(v) My pass book shows a credit of `1,200 to my account being interest
on my securities collected by my bankers.
(vi) The Bank balance as per my pass book showed an overdraft of `19,000.

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Material 181
Bank Reconciliation Solution:
Statement
BANK RECONCILIATION STATEMENT
(as on 31st December, 2017)

NOTES Particulars (+) ` (–) `


Overdraft as per Pass Book 19,000
Add: Cheques not yet credited 4,000
Less: Cheques not yet presented 9,000
Add: Cheques not yet credited to my personal account 2,000
Add: Interest on overdraft charged in the Pass Book on 31st 1,000
December, not entered in Cash Book
Less: Interest on securities collected by bankers not entered in 1,200
Cash Book
7,000 29,200
Overdraft as per Cash Book 22,200

Illustration 8.3. Janardan & Company have bank accounts with two banks,
viz., Dena Bank and Bank of India. On 31st December, 2017, his cash book
(bank columns) shows a balance of `5,000 with Dena Bank and an overdraft
of `2,250 with Bank of India. On further verifica­tion, the following facts
were discovered.
(a) A deposit of `1,500 made in Dena Bank on 20th December, 2017 has
been entered in the column for Bank of India.
(b) A withdrawal of `500 from Bank of India on 2nd November, 2017 has
been entered in the column for Dena Bank.
(c) Two cheques of `500 and `750 deposited in Dena Bank on 1st
December, 2017 (and entered in the Bank of India column) have been
dishonoured by the Bankers. The entries for dishonour have been made
in the Bank of India column.
(d) Cheques were issued on 29th December, 2017 on Dena Bank and Bank
of India for `10,000 and `1,000 respectively. These have not been
cashed till 31st December, 2017.
(e) Incidental charges of `10 and `25 charged by Dena Bank and Bank of
India respectively have not been entered in the books.
( f ) Dena Bank has credited an interest of `50 and Bank of India has charged
interest of `275. These have not been recorded in the books.
(g) The deposits of `5,000 and `3,500 made into Dena Bank and Bank
of India respectively have not yet been credited to by them till 31st
December, 2017.
Draw up the two Bank Reconciliation Statements.

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182 Material
Solution: Bank Reconciliation
Statement
M/s Janardan & Company
RECONCILIATION STATEMENT WITH BANK OF INDIA
(as on 31st December, 2017)
NOTES
Particulars (+) ` (–) `
Balance as per Cash Book 5,000
Add: (a) Deposit made on 20.12.2017 but wrongly debited to 1,500
Bank of India
(b) Withdrawal made on 2.11.2017 wrongly entered in the 500
above account instead of Bank of India
(c) These entries have no effect in either account –
(d) Cheque issued on 29.12.2017 but not yet encashed with 10,000
the Bank
Less: (e) Incidental charges not yet credited by us 10
Add: (f) Interest credited by Bank but not yet debited by us in 50
our books
Less: (g) Cheque deposited but the proceeds of the same not yet 5,000
credited by Bank
17,050 5,010
Balance as per Bank Pass Book (favourable) 12,040
RECONCILIATION STATEMENT WITH BANK OF INDIA
(as on 31st December, 2017)

Particulars + ` – `
Overdraft as per Cash Book 2,250
Less: (a) Deposit made into Dena Bank on 20.12.2017 but 1,500
wrongly debited to the above account
(b) Withdrawal made on 21.1.2017, but wrongly entered in 500
Dena Bank Account
(c) These entries have no effect in either Account
Add: (d) Cheque issued on 29.12.2017 but not yet encashed with 1,000
the bank
Less: (e) Incidental charges not yet credited by us 25
(f) Interest charged by Bank but not yet recorded by us in 275
the Books
(g) Cheques deposited, but the proceeds of the same not yet 3,500
credited by Bank
1,000 8,050
Overdraft as per Bank Pass Book 7,050

Where Cash Book Balance Has To Be Adjusted


Illustration 8.4. The Cash Book of Mr Gadbadwala shows `8,364 as the
balance at Bank as on 31st December, 2017 but you find that this does not
agree with the balance as per the Bank Pass Book. On scrutiny, you find the
following discrepancies:

Self-Instructional
Material 183
Bank Reconciliation (i) On 15th December, 2017, the payments side of the Cash Book was
Statement
undercast by `100.
(ii) A cheque for `131 issued on 25th December, 2017 was taken in the
Cash column.
NOTES
(iii) A deposit of `150 was recorded in the Cash Book as if there is no Bank
Column therein.
(iv) On 18th December, 2009, the debit balance of `1,526 as on the previous
day, was brought forward as credit balance.
(v) Of the total cheques amounting to `11,514 drawn in the last week
of December, 2017, cheques aggregating `7,815 were en­cashed in
December.
(vi) Dividends of `250 collected by the Bank and subscription of `100 paid
by it were not recorded in the Cash Book.
(vii) A cheque issued for `350 was recorded twice in the Cash Book.
Prepare a Reconciliation Statement when:
(a) the books are not to be closed on 31st December.
(b) the books are to be closed on 31st December.
Solution:
(a) If the books are not to be closed on 31st December, 2017.
BANK RECONCILIATION STATEMENT
(as on 31st December, 2017)

Particulars + ` – `
Balance as per Cash Book 8,364
Add: Mistake in bringing forward `1,526 debit
balance as credit balance as on 18.12.2017 3,052
Cheques issued but not presented:
  Issued 11,514
  Cashed 7,815 3,699
Dividends directly collected by bank but not
yet entered in the Cash Book 250
Cheque recorded twice in the Cash Book 350
Deposit not recorded in the Bank column 150
Less: Wrong casting in the cash book on 15.12.2017 100
Cheques issued but not entered in the Bank 131
column
Subscription paid by the Bank directly not yet
recorded in the Cash Book 100
15,865 331
Balance as per Pass Book 15,534

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184 Material
(b) If the books are to be closed on 31st December, 2017. Bank Reconciliation
Statement
In such a case necessary corrections for mistakes committed will have to be
made in the Cash Book and correct balance as per Cash Book will have to
be found out. A Bank Reconciliation Statement will then be prepared.
NOTES
ASCERTAINMENT OF CORRECT BALANCE

Particulars ` `
Balance of Cash Book as given 8,364
Add: Mistake in bringing forward the balance on 18th December 3,052
Dividends collected by the bank 250
Cheque recorded twice in the Cash Book 350
Deposit not recorded in the Bank column 150
12,166
Less: Wrong casting of the cash Book on 15th December 100
Cheques issued but not entered in the Bank column 131
Subscription paid by the Bank directly not yet recorded in 100 331
the Cash Book
Correct Balance as per Cash Book (for Balance Sheet purposes) 11,835

BANK RECONCILIATION STATEMENT


(as on 31st December, 2017)

Particulars ` `
Balance as per Cash Book (corrected) 11,835
Add: Cheques issued but not yet presented 3,699
Balance as per Pass Book 15,534

WHERE ABSTRACTS FROM CASH BOOK


AND PASS BOOK ARE GIVEN
In such a case there can be two situations:
(i) When the abstracts relate to the same period In this a case the
transactions which are not common in both the abstracts should be
found . These constitute the causes of difference (See Illustration 8.5).
(ii) When the pass book relates to the succeeding period In this case
those transactions which are common in both the abstracts should be
compared. These constitute the causes of difference (See Illustra­tion
8.6).
Illustration 8.5. The following are the Cash Book and Bank Pass Book of
Niranjan for the month of April, 2017.

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Material 185
Bank Reconciliation CASH BOOK (BANK COLUMN)
Statement
Date Particulars ` Date Particulars `
1.4.2017 To Balance b/d 12,500 1.4.2017 By Salaries A/c (Ch. No. 183) 4,000
4.4.2017 To Sales A/c 8,000 6.4.2017 By Purchases A/c (Ch.No.184) 3,200
NOTES 8.4.2017 To Parimal A/c 1,500 11.4.2017 By Machinery A/c (Ch. No. 185) 6,000
13.4.2017 To Mahim A/c 3,400 15.4.2017 By Om Prakash A/c (Ch. No. 186) 1,000
18.4.2017 To Kamal A/c 4,600 19.4.2017 By Drawings A/c (Ch. No. 187) 800
21.4.2017 To Furniture A/c 1,200 23.4.2017 By Kishore A/c (Ch. No. 188) 2,000
25.4.2017 To Sales A/c 3,800 27.4.2017 By Suresh A/c (Ch. No. 189) 1,000
30.4.2017 To Firoz A/c 3,000 30.4.2017 By Printing A/c (Ch. No. 189) 500
30.4.2017 By Balance c/d 19,500
38,000 38,000

BANK PASS BOOK


Date Particulars Deposits ` Withdrawals ` Balance `
1.4.2017 Balance 12,500
2.4.2017 Cheque 183 4,000 8,500
6.4.2017 Cash 8,000 16,500
6.4.2017 Cheque 184 3,200 13,300
10.4.2017 Cheque 1,500 14,800
16.4.2017 Cheque 3,400 18,200
17.4.2017 Cheque 187 800 17,400
20.4.2017 Cheque 4,600 22,000
24.4.2017 Cheque 3,800 25,800
28.4.2017 Cheque 185 6,000 19,800
28.4.2017 Cheque 189 1,000 18,800
30.4.2017 Interest 100 18,900
30.4.2017 Deposit (Firoz) 3,000 21,900
30.4.2017 Charges 10 21,890
You are required to prepare a Bank Reconciliation Statement as on 30th April, 2017.
Solution:
BANK RECONCILIATION STATEMENT OF NIRANJAN
(as on 30th April, 2017)
Particulars + ` – `
Balance as per Cash Book 19,500
Less: Amount deposited but not credited 1,200
Add: Cheques drawn but not presented: Cheque No. 186 1,000
Cheque No. 188 2,000
Cheque No. 190   500 3,500
Add: Interest allowed by bank but not posted in Cash Book 100
Less: Charges debited by bank but not posted in Cash Book 10
23,100 1,210
Balance as per Pass Book 21,890

Illustration 8.6. From the following entries in the Bank column of the
Cash Book of Mr. Kartak and the corresponding Bank Pass Book, prepare
Reconciliation Statement as on 31st March, 2017:

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186 Material
CASH BOOK (BANK COLUMN ONLY) Bank Reconciliation
Statement
Date Particulars ` Date Particulars `
2017 2017
March 1 To Balance b/d 3,400 March 7 By Drawings 1,500
March 10 To Madan & Sons 500 March 8 By Salary 2,200 NOTES
March 13 To Jerbai 4,000 March 15 By Ardesar & Co. 3,000
March 18 To Cawasji & Co. 1,200 March 28 By Merwan Bros. 1,550
March 28 To Dinshwa & Co. 2,200 March 29 By Raj & Sons 800
March 29 To Dhanbura Co. 5,700 March 30 By Macmillon Radios 400
March 31 To Antony 3,425 March 31 By Chandu, H. 1,600
March 31 By Balance c/d 9,375
20,425 20,425

BANK PASS BOOK


(Mr. Kartak in Current Account with Central Bank)
Date Particulars ` Date Particulars `
20017 2017
April 1 To Balance (Overdraft) 750 April 2 By Dividends 500
April 2 To Raj & Sons 800 April 2 By Dinshaw & Co. 2,200
April 4 To Macmillon Radios 400 April 2 By Hosang 200
April 8 To Salary 2,300 April 3 By Dhanbura & Co. 5,700
April 10 To Drawings 500 April 3 By Antony 3,425
April 10 To Antony (Cheque 3,425 April 5 By Romy 170
dishonoured)

Solution:
BANK RECONCILIATION STATEMENT OF MR. KARTAK
(as on 31st March, 2017)
Particulars + ` – `
Balance as per Cash Book 9,375
Less: Cheques deposited but not credited:
Dinshaw & Co. 2,200
Dhanbura Co. 5,700
Antony 3,425 11,325
Add: Cheques drawn but not presented:
Raj & Sons 800
Macmillon Radios    400 1,200
10,575 11,325
Overdraft as per Pass Book 750

Check Your Progress


1. How does a bank record withdrawal of money by the customer?
2. Give an example of a variation which does not require an adjusting
or correcting entry.
3. When is a bank reconciliation statement prepared?

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Material 187
Bank Reconciliation
Statement 8.3 ANSWERS TO CHECK YOUR PROGRESS
QUESTIONS
NOTES 1. On money being withdrawn by the customer, the bank debits the account
of the customer since he is the receiver.
2. An example of a variation which does not require an adjusting or
correcting entry is: a cheque that has been sent for collection, but not
yet collected, causes a difference between the balance as shown by
the bank pass book and the balance as shown by the cash book, but
no adjusting entry is required in the cash book for such a difference
because, the bank will credit the firm’s account as soon as the cheque
is collected.
3. A bank reconciliation statement is prepared usually at the end of a period,
i.e., a quarter, a half year or a year, as may be found convenient and
necessary by the firm, taking into account the number of transactions
involved.

8.4 SUMMARY
• The advantages of keeping an account with a bank are as follows:
avoidance of risk, prevention of fraud and misappropriation, and
reduction in accounting work.
• On deposits of money by the firm into the bank account, the firm debits
the bank account while the bank credits the firm’s account.
• On withdrawal of money by the firm from the bank, the firm credits
the bank’s account while the bank debits the firm’s account.
• All transactions relating to the bank—deposits or withdrawals—are
recorded by the firm in the bank column maintained on each side of the
cash book. The deposit of money into the bank account is recorded on
the debit side of the cash book in the bank column, while the withdrawal
of money is recorded on the credit side in the bank column of the cash
book. The bank also maintains the firm’s account in its books. A copy
of this account is submitted to the firm from time to time. The account
so submitted by the bank to the customer is known as the bank pass
book or bank statement.
• The Pass Book or the Bank Statement is submitted by the bank to the
customer for his information and verification.
• The following are the causes of difference between the balance as
shown by the bank pass book and the balance as shown by the firm’s
cash book: cheques issued but not presented for payment, cheques sent
for collection but not yet collected, bank charges, direct collections on
Self-Instructional behalf of customers and errors.
188 Material
• A Bank Reconciliation Statement is a statement reconciling the balance Bank Reconciliation
Statement
as shown by the bank pass book and the balance as shown by the cash
book. The objective of preparing such a statement is to know the causes
of difference between the two balances and pass necessary correcting
or adjusting entries in the books of the firm. NOTES
• It should be noted that every variation or difference does not require
an adjusting or correcting entry.
• The importance of Bank Reconciliation Statement can be judged on the
basis of the following facts: (i) It highlights the causes of difference
between the bank balance as per cash book and the bank balance as
per pass book, (ii) It reduces the chances of fraud by the staff handling
cash and, (iii) There is a moral check on the staff of the organisation
to keep the cash records always up-to-date.
• A Bank Reconciliation Statement is prepared usually at the end
of a period, i.e., a quarter, a half year or a year, as may be found
convenient and necessary by the firm, taking into account the number
of transactions involved.
• The following are the steps to be taken for preparing a Bank
Reconciliation Statement: cash book should be completed and balanced
as per the bank column on the particular required date, bank should be
requested to complete and send the firm bank pass book updated till
the date required, balance shown by either the cash book or bank pass
book must be used as base, the effect of particular cause of difference
should be studied, adjustments should be made on the basis of increase
or decrease in balance.

8.5 KEY WORDS


· Bank Reconciliation Statement: A statement reconciling the bal­ance
as shown by the Bank Pass Book and the balance as shown by the Cash
Book.
· Pass Book: It is a copy of the firm’s account with a bank.

8.6 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. What is a bank reconciliation statement?
2. List the advantages of keeping an account with a bank.
3. What are the rules of accounting as regards bank transactions?

Self-Instructional
Material 189
Bank Reconciliation 4. How is the cash column used by firms to record transactions relating
Statement
to the bank by the firm?
5. Explain the importance of bank reconciliation statement.
NOTES Long Answer Questions
1. Illustrate the pro-forma of a Bank Reconciliation Statement with
imaginary figures.
2. Explain the procedure for preparing a bank reconciliation statement.
3. “Balance as shown by the Bank Pass Book should tally with the balance
as shown by the Cash Book of the business.” Do you agree? If not,
explain the reasons with suitable examples of difference between the
two.

8.7 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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190 Material
Bills of Exchange

BLOCK - III
PARTNERSHIP ACCOUNTS
NOTES
UNIT 9 BILLS OF EXCHANGE
Structure
9.0 Introduction
9.1 Objectives
9.2 Bills of Exchange: Fundamental Concepts
9.3 Recording of Bill of Exchange in the Books of Account
9.4 Answers to Check Your Progress Questions
9.5 Summary
9.6 Key Words
9.7 Self Assessment Questions and Exercises
9.8 Further Readings

9.0 INTRODUCTION
There are certain documents which are freely used in commer­cial transactions
and monetary dealings. They are transferable by delivery and confer a good
title on any one who takes them bona fide and for value. Such documents
are termed as Negotiable In­struments. Bills of Exchange, Promissory Notes
and Cheques are all Negotiable Instruments. These Instruments can be made
“payable to order” or “payable to bearer.” In the former case, they are known
as “order instruments” while in the latter case they are known as “bearer
instruments.” In case of an order instrument the payment is to be made either
to the person named in the instrument or according to his order. In case of a
bearer instrument, the payment is to be made to the person who is its bearer.
The provisions of the Negotiable Instruments Act, 1881 apply to them. We
shall be discussing here only those legal provisions of the Act which shall
enable the students to have a clear understanding of the accounting aspect
of these instruments1.

9.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss the fundamental concept of Bills of Exchange
• Explain the classification of Bills of Exchange
• Recall the concepts of acceptance of a bill and due date
• Describe the recording of Bill of Exchange in the book of Accounts
1
For a detailed study of legal provision please refer to Sec IV: “A Manual of Business Laws” (6th edition) by
Dr. S.N. Maheshwari and Dr. S.K. Maheshwari, and published by Himalaya Publishing House. Self-Instructional
Material 191
Bills of Exchange
9.2 BILLS OF EXCHANGE: FUNDAMENTAL
CONCEPTS

NOTES Promissory Note


Definition Section 4 of the Negotiable Instruments Act defines a Promissory
Note as “an instrument in writing (not being a bank note and a currency
note) containing an unconditional undertaking signed by the maker, to pay
a certain sum of money only to, or to the order of a certain person or to the
bearer of the instrument.”
Essentials The following are essential features of a Promissory Note:
1. There are two parties The Promissor is termed as the Maker and the
Promissee is called as the Payee. The former is the “Debtor” while the
latter is the “Creditor”.
2. It is an instrument in writing More verbal promise will not amount to
a Promissory Note.
3. The promise to pay should be unconditional A promissory note should
go without any condition attached to it. For example, A promises to
pay a sum of money on the marriage of a particular person will not
amount to a Promissory Note.
4. The promise should be to pay money to another person If a person
promises to supply goods, it shall not be a Promissory Note.
5. The amount should be certain If interest is also to be paid, the rate of
interest should be given.
6. The payee must also be certain, either by name or by designation.
7. A Promissory Note can be made payable to the bearer. However, a
bearer Promissory Note cannot be drawn by private individuals. It can
be drawn only by the Reserve Bank of India, as per the provisions of
Section 31 of the Reserve Bank of India Act. The objective is to protect
Government’s monopoly of issuing currency notes.
8. Bank notes and currency notes, though similar to promissory notes in
every respect, have been expressly excluded. They are considered as
money and not merely securities for money. A currency note is a note
issued by the Government containing a promise to pay to the bearer a
certain sum of money on demand. A ‘bank note’ is a promissory note
issued by a bank for payment of money to the bearer on demand. The
banks now cannot issue such notes which are payable to the bearer on
demand on account of Section 31 of the Reserve Bank of India Act.
Only the Reserve Bank of India is now authorised to issue such notes.

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192 Material
Specimen of a Promissory Note2 Bills of Exchange

`10,000
Delhi
Jan. 4, 2016
On demand,2 I promise to pay Kaushal or order the sum of Ten thousand rupees, value NOTES
received.
(Stamp)
sd/-
Ramesh

Ramesh is the Maker and Kaushal is the Payee.

Bill of Exchange

Definition Section 5 of the Negotiable Instruments Act defines a Bill of


Exchange as “an instrument in writing containing an unconditional order,
signed by the maker, directing a certain person, to pay a certain sum of money
only to, or to the order of a certain person or to the bearer of the instrument.”
Essentials The essentials of a Bill of Exchange are similar to those
of a Promissory Note except that:
1. In case of a Bill of Exchange, there are three parties, the “Maker” is
termed as the “Drawer”. He is the creditor. The person liable to pay the
money is called as the “Drawee”. The person entitled to get the money
is termed as the “Payee”. It should be noted that drawer himself can
also be the payee. There are only two parties in case of a Promissory
Note.
2. In case of a Bill of Exchange, the drawer being the creditor, orders the
drawee to pay a certain sum of money; while in case of a Promissory
Note, the drawer, being the debtor, himself, he promises to pay a certain
sum of money.
3. A Time Bill of Exchange (i.e., a B/E payable after some time) can be
made payable to the bearer, while the Promissory Note cannot be made
payable to the bearer by person other than the Reserve Bank of India
or the Central Government.
Classification of Bills of Exchange
Bills of Exchange can be classified as follows:
1. Time and demand bills When payment of a Bill of Exchange is to be
made after a particular period of time, the bill is termed as a ‘Time Bill’.
In such a case, date of maturity is always calculated by adding three
2
In case of time promissory notes, the words ‘on demand’ will be instituted by words “..... months or ...... days
after date or after sight.”

Self-Instructional
Material 193
Bills of Exchange days of grace. Such bills requires the “Acceptance” of the drawee. It is
generally given by writing across the face of the instrument as shown
above:
In case of ‘Demand Bill’, payment is to be made
NOTES ted
p
on demand. Neither the acceptance of the drawee ce an
is necessary nor any days of grace are allowed in Ac oh 7
M
this case R. .201
1.1
In case of ‘Demand Bill’, payment is to be made on demand.
Neither the acceptance of the drawee is necessary nor any days
of grace are allowed in this case.
2. Trade and accommodation Bills Where a Bill of Exchange has been
drawn and accepted for a genuine trade transaction, it is termed as
a ‘Trade Bill’. For example, A sells goods worth `10,000 to B. He
draws a Bill of Exchange on B for the said amount and the same is
accepted by B. This is a Trade Bill. Where a Bill of Exchange is drawn
and accepted for providing funds to a friend in need, it is termed as
an Accommodation Bill. For example C may be in want of money.
He may approach his friends A and B, who instead of lending the
money directly to him, propose to draw an “Accommodation Bill”
for `10,000 payable three months after, in his favour. C promises to
reimburse B (the acceptor before the period of three months is up).
C can get this bill discounted from his bankers. Thus, his needs of
funds will be met.
3. Inland and foreign bills A Bill is termed as an Inland Bill, if
(a) it is drawn in India on a person residing in India whether payable
in or outside India, or
(b) it is drawn in India on a person residing outside India but payable
in India.
A Bill which is not an Inland Bill is a Foreign Bill.
A Foreign Bill is generally drawn up in triplicate and each copy is sent
by separate post, so that at least one copy reaches the concerned party. Of
course, when payment is made on one copy, the other two copies become
inoperative.
Cheque
Definition Section 6 defines a cheque as ‘A bill of exchange drawn on a
specified banker and not expressed to be payable otherwise than on demand
and it includes the electronic image of a truncated cheque and a cheque in
the electronic form’.

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194 Material
Essentials A cheque is similar to a bill of exchange with three Bills of Exchange
additional qualifications:
1. It is always drawn on a specified banker.
2. It is always payable on demand. NOTES
3. It includes the electronic image of a truncated cheque and also a cheque
in the electronic form. The two terms: ‘A truncated cheque’ and ‘A
cheque in the electronic form’ having been defined under the Act as
under:
(i) ‘A truncated cheque’ means a cheque which is truncated during
the course of a clearing cycle, either by the clearing house or by
the bank whether paying or receiving payment, immediately on
generation of an electronic image for transmission, substituting
the further physical movement of the cheque in writing.
(ii) ‘A cheque in the electronic form’ means a cheque which contains
the exact mirror image of a paper cheque, and is generated,
written and signed in a secure system ensuring the minimum
safety standards with the use of digital signature (with or without
biometrics signature) and asymmetric crypto system.
Thus, all cheques are bills of exchange but all bills of exchange are
not cheques.

Check Your Progress


1. Define a promissory note.
2. How many parties are involved in a Bill of Exchange?

9.3 RECORDING OF BILL OF EXCHANGE IN THE


BOOKS OF ACCOUNT
Bills of Exchange and Promissory Notes, being Negotiable Instruments,
are freely transferable. The transfer is made by endorsement and delivery in
case of order instrument in case of non-payment of the bill, or promissory
note can recover the money from all previous endorsers or the payee or the
maker of the instrument. Moreover, the title of a holder-in due course remains
good though the title of the transferrer may be defective. On account of these
two important reasons, i.e., negotiability and liability of the endorsers, a bill
of exchange or a promissory note is considered to be an excellent security
by the bankers. They are generally willing to advance money to a holder of
bill of exchange or promissory note at commercial rate of discount. Thus, a
person who receives a bill of exchange or promissory note has the following
alternatives with him:

Self-Instructional
Material 195
Bills of Exchange (i) He can keep the bill of exchange or promissory note with himself till the
date of maturity.
(ii) He can pass it to one of his creditors.
NOTES (iii) He can get it discounted from his bank.
In the following pages, we are explaining the accounting entries to be
made in the books of the receiver of a bill of Exchange or a Promissory Note
(i.e., the Creditor or the Drawer or the Promisee in case or a Promissory Note)
and the Acceptor (i.e., the Debtor, or the Drawee, or the Maker in case of
a Promissory Note). For the former it is a Bill Receivable (the term is also
used for a promissory note received) and for the latter, it is a Bill Payable
(the term is also used for a promissory note given).
1. When a Bill of Exchange is Kept till the Date of Maturity
In case, the receiver of a bill of exchange keeps the Bill of Exchange till the
date of maturity with him, the following accounting entries will be passed in
the books of the receiver of the Bill of Exchange (i.e., the Drawer) and the
Drawee of the Bill of Exchange.
In the Books of the Drawer:
(i) On selling goods on credit to the Drawee
Drawee Dr.
  To Sales A/c
(ii) On receipt of Bill of Exchange duly accepted by the Drawee
Bill Receivable A/c Dr.
  To Drawee
(iii) On receiving payment on maturity of the Bill
Cash A/c Dr.
  To Bills Receivable Account

In the Books of the Drawee:


(i) On purchasing goods on credit from the Drawer
Purchases A/c Dr.
  To Drawer
(ii) On acceptance of the Bill of Exchange in favour of Drawer
Drawer Dr.
  To Bills Payable Account
(iii) On payment of the Bill on maturity
Bill Payable Account Dr.
  To Cash

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196 Material
2. When the Bill of Exchange is Endorsed in Favour of a Creditor Bills of Exchange

In case the drawer of the Bill of Exchange endorses the Bill of Exchange
received in favour of a creditor and the Bill is met on maturity, the following
journal entries will be passed in the books of the Drawer as well as the Drawee
NOTES
of the Bill of Exchange.
Books of the Drawer
The entries regarding selling of goods and receiving of the Bills of Exchange
will be the same, as explained before. However, the following entry will be
passed when the Bill of Exchange is endorsed in favour of a Creditor.
Creditor A/c Dr.
  To Bills Receivable A/c

On the date of maturity, when the Bill is met, no entry is required in


the books of the Drawer. This is because in his books, the Bills Receivable
Account has already been closed and he has no liability, if the bill is met on
maturity.
Books of the Drawee
The Drawee is not at all concerned with the endorsement of the Bill by the
Drawer to a third-party. Accounting entries in his books will therefore be the
same as explained before.
3. When Bill of Exchange is Discounted with a Bank
The Drawer of a Bill of Exchange may get the Bill of Exchange discounted
from his bankers. In such a case, the following journal entries will be passed
in the books of the Drawer and the Drawee.
Books of the Drawer
The entries regarding selling of goods and receipt of Bill of Exchange will
be the same as explained before. However, the following entry will be passed
in the books of the drawer when he gets the Bill of Exchange discounted
from his bankers.
Bank Account Dr.
Discount Account Dr.
  To Bills Receivable Account

Books of the Drawee


The entries in the books of the Drawee will remain the same as explained
before. He is not at all concerned whether he keeps the Bill with him or he
gets it discounted from his bankers.
4. Dishonour of a Bill of Exchange
A Bill of Exchange is to be presented on maturity for payment. In case,
the acceptor of the Bill refuses to make payment of the Bill on the date of
Self-Instructional
Material 197
Bills of Exchange maturity, it is said that the Bill of Exchange has been dishonoured. In order
to get an authenticate proof of the fact that the Bill of Exchange was really
presented for payment and was dishonoured, the Drawer (or holder) may get
the Bill of Exchange noted and protested. The Notary Officer appointed by
NOTES the Government for this purpose issues a certificate to this effect. He charges
some fee for this work which is termed as “Noting Charges”.
The entries for dishonour of the bill in the books of the Drawer (or
holder) and the acceptor will be as follows:
Books of the Drawer
(i) If the Bill is kept by the Drawer (or the holder) with himself till the
date of maturity:
On dishonour of the Bill
Drawee/Acceptor Dr.
  To Bills Receivable A/c

To Cash A/c
(The account of the drawee or acceptor will be debited with the amount of the bill
plus noting charges. The Bills Receivable Account will be credited with the amount of the
Bill while Cash Account will be credited with the amount of the noting charges incurred.)
(ii) If the Bill is discounted with a banker and is dishonoured:
On dishonour of the Bill
Drawee/Acceptor Dr.

To Bank
(The account of the acceptor will be debited not only with the amount of the Bill but also
with the amount of Noting Charges which the Bank might have paid. The account of the bank
will be credited with the total amount.)
(iii) If the Bill is endorsed by the Drawer in favour of a Creditor and it is
dishonoured:
On dishonour:
Drawee/Acceptor Dr.

To Creditors A/c
(The account of the drawee will be debited with the amount of the Bill as well as
the amount of Noting Charges which the creditor might have incurred. The creditor will be
given credit with the total amount.)
Books of the Acceptor
The acceptor will pass the following entry irrespective of the fact whether
the Bill of Exchange is with the Drawer himself or it has been endorsed or
discounted by him. He is concerned only with the Drawer and therefore,
he is going to give him credit with the amount of the Bill plus any noting
charges that might have been incurred either by him or by any other person
who happens to be holder of the Bill of exchange.

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198 Material
Bills Payable A/c Dr. Bills of Exchange
Noting Charges Dr.
  To Drawer

5. Renewal of a Bill
NOTES
The acceptor of the Bill may not be in a position to meet the Bill on the date
of maturity. However, he may accept to meet the bill in case, he is given some
time by the drawer for making payment of the Bill. He may, therefore, request
the Drawer to cancel the old Bill and draw a new Bill on him.The Drawer
may charge some interest for the delayed payment at mutually agreed rate of
interest. The amount of interest may be paid in cash or it may be included in
the amount of the new Bill. The following journal entries will be passed in
the books of the Drawer and the Drawee on renewal of a Bill of Exchange.
Books of the Drawer
(i) Cancellation of the old Bill
Drawee’s Personal A/c Dr.
  To Bills Receivable A/c
(The entry is the same as for dishonour of a Bill of Exchange, except there will be
no need for getting the Bill noted and protested, since the Drawee himself has requested
for cancellation of the Bill.)
(ii) On receipt of amount of Interest in cash
Cash A/c Dr.
  To Interest
(The interest will be charged for the delay in payment i.e., the date by which the
payment would be made as per the new Bill and the date by which payment should have
been made as per the old Bill of Exchange.)
(iii) In case, the interest is not payable in cash
Drawee’s Personal A/c Dr.
  To Interest A/c

(iv) For receipt of the new Bill


Bills Receivable A/c Dr.
  To Drawee’s Personal A/c
(The amount will include the amount of interest also if it is not paid in cash.)
Books of the Drawee
(i) On cancellation of the old Bill:
Bills Payable A/c Dr.
     To Drawer’s Personal A/c
(The entry is similar to dishonour of the bill except that there will be no necessity for
getting the bill noted and protested and, therefore, there will be no charge for Noting Charges.)

Self-Instructional
Material 199
Bills of Exchange (ii) When Interest is paid in cash:
Interest A/c Dr.
     To Cash A/c

NOTES (iii) In case the interest is not paid in cash:


Interest A/c Dr.
     To Drawer’s Personal A/c

(iv) On acceptance of the new Bill:


Drawer’s Personal A/c Dr.
     To Bills Payable A/c

(The amount may include the amount of interest if it has not been paid
in cash.)
6. Retiring of a Bill under Rebate
The acceptor of a Bill may be in a position to meet the Bill before maturity.
He may, therefore, approach the acceptor to make the payment of the Bill
before the due date of the Bill. In such a case, usually, the Drawer gives some
rebate to the Drawer for early payment of the Bill. The following are the
journal entries to be passed in the books of the Drawer as well as the acceptor.
Retiring of a Bill of Exchange which is with the Drawer
Books of the Drawer
On receipt of payment of the Bill
Cash A/c Dr.
Rebate A/c Dr.
  To Bills Receivable A/c
(Rebate is a loss to the Drawer and, therefore, it is debited.)
Books of the Drawee
Bills Payable A/c Dr.
  To Cash A/c
  To Rebate A/c
(Rebate is a gain to Drawee and, therefore, it has been credited.)

Retiring of Bill of an Exchange Discounted or Endorsed by the Drawer


In case the acceptor requests the drawer to accept retirement of a bill which
has been endorsed or discounted by the drawer, the drawer will have to request
the bank or the creditor (endorsee) to return the bill back to him. He will
then get the payment from the drawee and allow him rebate for pre-payment.
Similarly, the bank or the creditor may also allow some rebate to the drawer
on account of his making pre-payment to the bank or the creditor, as the case
may be. The accounting entries will be as follows:

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200 Material
In the Books of the Drawer Bills of Exchange

  On return of the bill from bank/creditor


Bills Receivable A/c Dr.
    To Bank/Creditor
NOTES
On receiving payment from the drawee:
Cash A/c Dr.
Rebate Allowed A/c Dr.
   To Bills Receivable A/c
On making payment to the Bank/Creditor:
Bank/Creditor A/c Dr.
  To Cash A/c
  To Rebate A/c
In the Books of the Drawee
The Drawee is concerned only with the Drawer. Hence, on payment
of the bill under rebate, the entry will be the same as if the bill was with the
Drawer, i.e.,
Bills Payable A/c Dr.
  To Cash A/c
  To Rebate A/c
The journal entries given in the preceding pages both in the Book of
the Drawer of the Bill as well as the Acceptor of the Bill can be summarised
as follows:
BOOKS OF THE DRAWER OF THE BILL
Sl. Transaction Debit Credit
No.
1. On Selling of goods Purchaser’s A/c Sales A/c
2. On receipt of the Bill from the purchaser Bill Receivable A/c Purchaser’s A/c
3. Disposal of the Bill:
(a) When the Bill is kept by the receiver till No entry No entry
the date of maturity.
(b) When the Bill is discounted with a banker. Bank A/c
Discount A/c Bills Receivable A/c
(c) When the Bill is endorsed in favour of Creditor’s A/c Bills Receivable A/c
a creditor.
4. On maturity, if the Bill is honoured:
(a) If the Bill is kept by the receiver till the Cash A/c Bills Receivable A/c
date of maturity.
(b) If the Bill was discounted with the No entry No entry
   banker by the receiver.
(c) If the Bill was endorsed in favour of a No entry No entry
  creditor.
5. On maturity of the Bill, if dishonoured:
(a) If it is with the Drawer and he incurs Drawee’s/Purchaser’s Bills Receivable A/c
   Noting Charges. A/c (Amount of the (amount of the Bill) +
Bill + Noting charges) Cash A/c (Noting
Charges)

Self-Instructional
Material 201
Bills of Exchange Sl. Transaction Debit Credit
No.
(b) If the Bill was discounted and Drawee’s A/c Bank A/c (with the
thereafter is now in the hands of the (with the amount of the amount of the Bill
banker and noting charges are incurred Bill and Noting Charges) and Noting Charges)
NOTES (c) If the Bill was transferred to a Drawee’s A/c Creditor’s A/c (with
Creditor and thereafter it is now in (with the amount of the amount of the Bill
his hands and he incurs Noting Charges. Bill and Noting Charges) and Noting Charges)
6. Renewal of the Bill:
(i) The entries will be similar to
dishonour of the Bill except that there
will be no expense by way of noting
charges.
(ii) For interest paid in cash Cash A/c Interest A/c
(iii) If interest not paid in cash Drawee’s A/c Interest A/c
(iv) For receipts of new bill Bills Receivable A/c Drawee’s A/c
7. Retirement of the Bill
(i) When the Bill is with the Drawer Cash A/c, Rebate A/c Bills Receivable A/c
(ii) In case the Bill is with the Bank or
with a creditor
(a) On return of Bill from bank/creditor Bills Receivable A/c Bank/Creditor’s A/c

(b) On receiving payment from the Cash A/c Bills Receivable A/c
drawee Rebate Allowed A/c
(c) On making payment to Bank/Creditor A/c Cash A/c
bank/creditor Rebate Received A/c
ENTRIES IN THE BOOKS OF THE DRAWEE OR ACCEPTOR OF THE BILL
Sl. Transaction Debit Credit
No.
1. On purchases of goods Purchases A/c Seller’s or the
Drawer’s A/c
2. On acceptance of the Bill Drawer’s A/c Bills Payable A/c
3. On payment of the Bill Bills Payable A/c Cash A/c
4. On dishonour of Bill and he Bills Payable A/c Drawer’s A/c
has to bear the Noting Charges Noting Charges A/c (amount of Bill plus
Noting Charges)
5. Renewal of the Bill
(i) Entry will be similar to Bills Payable A/c Drawer’s A/c
dishonour of a Bill except
there will be Noting Charges
(ii) (a) For interest paid in cash Interest A/c Cash a/c
(b) For interest not paid in cash Interest A/c Drawer’s A/c
(c) For accepting new Bill Drawer A/c Bills Payable A/c
6. On retirement of Bill Bills Payable A/c Cash A/c, Rebate A/c

Notes:
1. No entry is passed in the Acceptor’s books for discounting or endorsing of bill of exchange
by the Drawer/Receiver of the bill.
2. If the Drawee has transferred or got discounted the bill of exchange and the Bill is dishonoured,
the Drawee will credit the account of the Drawer only and not any other account.

The comprehensive illustration given in the following pages will make


clear to the readers the entries to be passed in the books of the Drawer as
well as the Drawee of a bill of exchange.
Illustration 9.1. A sold goods to B for `5,000. B accepted two bills of `2,500
each for 2 months. A endorsed one bill to C for `2,600, on due date both the
bills were met.
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202 Material
Pass journal entries in the books of A and B. Bills of Exchange

Solution:
BOOKS OF A
Date Particulars L.F. Dr. ` Cr. ` NOTES
B Dr. 5,000
To Sales A/c 5,000
(Being sale of goods to B)
Bills Receivable A/c Dr. 5,000
To B 5,000
(Being to Bills Receivable of `2,500 each received
from B)
C Dr. 2,600
To Bills Receivable A/c 2,500
To Discount A/c 100
(Being one Bill Receivable endorsed to C)
Bank A/c Dr. 2,500
To Bills Receivable A/c 2,500
(Being payment received of another Bill Receivable)
BOOKS OF B
Date Particulars Dr. ` Cr. `
Purchase A/c Dr. 5,000
To A 5,000
(Being goods purchased from A)
A Dr. 5,000
To Bills Payable A/c 5,000
(Being two acceptances of `2,500 each given to A)
Bills Payable A/c Dr. 5,000
To Bank 5,000
(Being acceptance met on maturity)

Illustration 9.2. A owes to B `1,000. On 1st January, 2017, A accepts a three


months’ bill for `975 in full settlement. At the due date the Bill is dishnoured.
Make journal entries in the books on both A and B.
Solution:
Books of A
JOURNAL3
Date Particulars Dr. ` Cr. `
2017
Jan. 1 B Dr. 1,000
To Bills Payable A/c 975
To Discount A/c 25
(Bills Payable accepted in full settlement)
April 4 Bills Payable A/c Dr. 975
Discount A/c3 Dr. 25
To B 1,000
(Bill Payable dishonoured)

3. Please note that discount previously allowed has been disallowed.

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Bills of Exchange Books of B
JOURNAL4
Date Particulars Dr. ` Cr. `
2017
NOTES Jan. 1 Bills Receivable A/c Dr. 975
Discount A/c Dr. 25
To A 1,000
(Bills Receivable received in full settlement)
April 4 A Dr. 1,000
To Bills Receivable A/c 975
To Discount A/c4 25
(Bill Receivable dishonoured)

Illustration 9.3. Give necessary entries as would appear in A’s Books:


2017 May 5 A drew three bills on B for `500, `400 and `300 payable at 4, 3 and 2 months
respectively.
May 12 He endorsed the first bill in favour of his customer C at `475.
May 19 He discounted the second bill with his banker for `380
May 26 He was paid the proceeds of the third bill at a rebate of 5% on the total amount of
the bill.
On due dates the first and second bills were dishonoured but the third one was paid.
Solution:
JOURNAL
Date Particulars Dr. ` Cr. `
2017
May 5 Bills Receivable A/c Dr. 1,200
To B 1,200
(Three Bills for `500, `400 and `300 were received
from B)
May 12 C Dr. 475
Discount A/c Dr. 25
To Bills Receivable A/c 500
(The first bill for `500 was endorsed in favour of C
for `475)
May 19 Bank A/c Dr. 380
Discount A/c Dr. 20
To Bills Receivable A/c 400
(The second bill for `400 was discounted with Bank)
May 26 Bank A/c Dr. 285
Rebate allowed A/c Dr. 15
To Bills Receivable A/c 300
(The third bill was retired at a rebate of 5% on the
amount of the bill)
Aug. 8 B Dr. 400
To Bank A/c 400
(The second bill dishonoured on maturity)
Sept. 8 B Dr. 500
To C 500
(The first bill dishonoured on maturity)
Note: The third bill has been paid before maturity and the entry for its payment has been passed on
May 26.

Illustration 9.4. Sujesh owed money to Brijesh and hence accepted two
bills each of `5,000 at three months duration drawn on him by the latter on
4 Please note that discount previously allowed has been disallowed.
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1st January, 2017. Brijesh discounted one of the bills with his bank for net Bills of Exchange

proceeds of `4,800 and endorsed the other in favour of Mukesh to whom he


owed a like sum, on the s­ ame date.
Sujesh paid the bill held by Mukesh on the due date, but failed to
NOTES
meet the bill presented by the bank. The bank debited Brijesh’s account on
4th April, 2017 inclusive of bank charges of `10. Sujesh paid the amount
inclusive of charges to Brijesh on 10th April, 2017.
Show the Journal entries in respect of the above in the books of Sujesh
and Brijesh.
Solution:
JOURNAL OF SUJESH
Date Particulars Dr. ` Cr. `
2017
Jan. 1 Brijesh Dr. 10,000
To Bills Payable A/c 10,000
(Being acceptance of two drafts of `5,000 each for
three months)
April 4 Bills Payable A/c Dr. 5,000
To Cash A/c 5,000
(Being honour of own acceptance at maturity)
April 4 Bills Payable A/c Dr. 5,000
Sundry Charges A/c Dr. 10
To Brijesh 5,010
(Being dishonour of own acceptance at maturity and
sundry
charges at `10 recoverable from us)
April 10 Brijesh Dr. 5,010
To Cash 5,010
(Being discharge for the dishonoured acceptance)
JOURNAL OF BRIJESH
Date Particulars Dr. ` Cr. `
2017
Jan.1 Bills Receivable A/c Dr. 10,000
To Sujesh 10,000
(Being receipt of two acceptances of `5,000 each)
Jan.1 Bank A/c Dr. 4,800
Discount A/c Dr. 200
To Bills Receivable A/c 5,000
(Being discounting of one B/R with the banker)
Jan. 1 Mukesh Dr. 5,000
To Bills Receivable A/c 5,000
(Being endorsement of another bill receivable)
April 4 Sujesh Dr. 5,010
To Bank 5,010
(Being dishonour of discounted B/R and the extra
liability to bank for bank charges of `10)
April 4 Cash/Bank Dr. 5,010
To Sujesh 5,010
(Being receipt for the dishonoured acceptance)
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Bills of Exchange Illustration 9.5. Bhasker Brothers are customers of ABC Ltd. The following
are the details of invoices in respect of sales made by the latter to the former
during the month of July, 2017.
Date Invoice No. Value `
NOTES 1.7.2017 00212 20,000
4.7.2017 00224 21,412
9.7.2017 00344 14,210
17.7.2017 00433 17,230
25.7.2017 01820 21,630
ABC Ltd., drew bills of exchange for every sale payable at 30 days
sight, and discount the bills at discounting charges of 1.5% p.m. You are
required to show:-
(a) the entries in the Sales Day Book of ABC Ltd. for the above,
(b) the journal entries for drawing and discounting of bills on the respective
days in the books of ABC Ltd., and
(c) Bhasker Brothers A/c in the ledger of ABC Ltd.
Solution:
SALES DAY BOOK OF ABC LTD.
Date Particulars Outward Invoice No. L. F. `
2017
July 1 Bhaskar Brothers 00212 20,000
July 4 Bhaskar Brothers 00224 21,412
July 9 Bhaskar Brothers 00344 14,210
July 17 Bhaskar Brothers 00433 17,230
July 25 Bhaskar Brothers 01820 21,630
94,482
JOURNAL ENTRIES
Date Particulars Debit Credit
` P ` P
2017
July 1 Bill Receivable A/c Dr. 20,000 00
To Bhaskar Brothers 20,000 00
(Being receipts of bill of exchange No.1 pay-
able at 30 days’ sight for invoice No. 00212)
Bank A/c Dr. 19,700 00
Discount A/c Dr. 300 00
To Bill Receivable A/c 20,000 00
(Being discounting of B/R No. 1 with Bank
@1.5% p.m.)
July 4 Bills Receivable A/c Dr. 21,412 00
To Bhaskar Brothers 21,412 00
(Being receipt of bill of exchange No. 2 for
invoice No. 00224 payable at 30 days’ sight)
Bank A/c Dr. 21,090 82
Discount A/c Dr. 321 18
To Bill Receivable A/c 21,412 00
(Being discounting of B/R No. 2 with Bank
@ 1.5% p.m.)

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Date Particulars Debit Credit Bills of Exchange
` P ` P
July 9 Bills Receivable A/c Dr. 14,210 00
To Bhaskar Brothers 14,210 00
(Being receipt of bill of exchange No. 3 pay-
able at 30 days’ sight for invoice No. 00433) NOTES
Bank A/c Dr. 13,996 85
DiscountA/c Dr. 213 15
To Bill Receivable A/c 14,210 00
(Being discounting of B/R No. 3 with Bank
@ 1.5% p.m.)
July 17 Bills Receivable A/c Dr. 17,230 00
To Bhaskar Brothers 17,230 00
(Being receipt of bill of exchange No. 4 pay-
able at 30 days’ sight for invoice No. 00433)
Bank A/c Dr. 16,971 55
Discount A/c Dr. 258 45
To Bill Receivable A/c 17,230 00
(Being discounting of Bills Receivable No. 4
with Bank @ 1.5% p.m.)
July 25 Bill Receivable A/c Dr. 21,630 00
To Bhaskar Brothers 21,630 00
(Being receipt of bill of exchange No. 5
payable at 30 days’ sight for the invoice
No. 01820)
Bank A/c Dr. 21,305 55
Discount A/c Dr. 324 45
To Bill Receivable A/c 21,630 00
(Being discounting of Bills Receivable
No. 5 with Bank @ 1.5% p.m.)
BHASKAR BROTHERS
Date Particulars ` Date Particulars `
2017 2017
July 1 To Sales 20,000 July 1 By Bills Receivable (No.1) 20,000
July 4 To Sales 21,412 July 4 By Bills Receivable (No.2) 21,412
July 9 To Sales 14,210 July 9 By Bills Receivable (No.3) 14,210
July 17 To Sales 17,230 July 17 By Bills Receivable (No.4) 17,230
July 25 To Sales 21,630 July 25 By Bills Receivable (No.5) 21,630
94,482 94,482

Check Your Progress


3. State two reasons why a bill of exchange or a promissory note is
considered to be an excellent security by the bankers.
4. Mention the journal entries which are passed in the books of the drawer
when the bill of exchange is discounted with a Bank.

9.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. Promissory note is an instrument in writing (not being a bank note and
a currency note) containing an unconditional undertaking signed by

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Bills of Exchange the maker, to pay a certain sum of money only to, or to the order of a
certain person or to the bearer of the instrument.
2. In a Bill of Exchange, three parties are involved: the drawer, the drawee
NOTES and the payee.
3. On account of two important reasons, negotiability and liability of the
endorsers, a bill of exchange or a promissory note is considered to be
an excellent security by the bankers.
4. The journal entries which are passed in the books of the drawer when
the bill of exchange is discounted with a Bank are:
Bank Account Dr.
Discount Account Dr.
To Bills Receivable Account

9.5 SUMMARY
• There are certain documents which are freely used in commercial
transactions and monetary dealings. They are transferable by delivery
and confer a good title on any one who takes them bona fide and for
value. Such documents are termed as Negotiable Instruments. Bills
of Exchange, Promissory Notes and Cheques are all Negotiable
Instruments.
• Section 4 of the Negotiable Instruments Act defines a Promissory Note
as “an instrument in writing (not being a bank note and a currency
note) containing an unconditional undertaking signed by the maker, to
pay a certain sum of money only to, or to the order of a certain person
or to the bearer of the instrument.”
• Essential features of a Promissory Notes include: there are two parties,
it is an instrument in writing, the promise to pay is unconditional, the
promise should be to pay money to another person, the amount should
be certain, the payee must also be certain, the promissory note can be
made payable to the bearer, etc.
• Section 5 of the Negotiable Instruments Act defines a Bill of Exchange
as “an instrument in writing containing an unconditional order, signed
by the maker, directing a certain person, to pay a certain sum of
money only to, or to the order of a certain person or to the bearer of
the instrument.”
• The essentials of a Bill of Exchange are similar to that of a Promissory
Note except that in case of a Bill of Exchange, there are three parties
instead of two, the drawer is the creditor here instead of a debtor and

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that a Time Bill of Exchange can be made payable to the bearer unlike Bills of Exchange
a Promissory Note which is only ordered by the Reserve Bank of India.
• Bill of Exchange can be classified as: Time and Demand Bills, Trade
and Accommodation Bills and Inland and Foreign Bills.
NOTES
• Section 6 defines a cheque as ‘A bill of exchange drawn on a specified
banker and not expressed to be payable otherwise than on demand and
it includes the electronic image of a truncated cheque and a cheque in
the electronic form’.
• Bills of Exchange and Promissory Notes, being Negotiable Instruments,
are freely transferable. The transfer is made by endorsement and
delivery in case of order instrument in case of non-payment of the bill,
or promissory note can recover the money from all previous endorsers
or the payee or the maker of the instrument.
• A person who receives a bill of exchange or promissory note has the
following alternatives with him:
(i) He can keep the bill of exchange or promissory note with himself
till the date of maturity.
(ii) He can pass it to one of his creditors.
(iii) He can get it discounted from his bank.
There are different journal entries in the books of the receiver and the
Acceptor depending on the transaction.

9.6 KEY WORDS


· Accommodation Bill: A bill drawn and accepted for providing funds
to a friend in need.
· Bill of Exchange: An instrument in writing containing an unconditional
order signed by the maker, directing the said person to pay a certain
sum of money only to or to the order of a certain person or to the bearer
of the instrument.
· Cheque: A bill of exchange drawn on a specified banker and payable
on demand.
· Demand Bill: A bill of exchange payable on demand.
· Promissory Note: An instrument in writing, containing an unconditional
undertaking, signed by the maker, to pay a certain sum of money only
to or to the order of certain person or the bearer of the instrument.
· Time Bill: A bill of exchange payable after a particular period of time.
· Trade Bill: A bill drawn and accepted for a genuine trade transaction.

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Bills of Exchange
9.7 SELF ASSESSMENT QUESTIONS AND
EXERCISES
NOTES Short Answer Questions
1. Differentiate between a Bill of Exchange and a Promissory Note.
2. Write a short note on trade bill and accommodation bill.
3. What are time bills and demand bills?
4. Differentiate between retiring a bill and renewal of a bill.
Long Answer Questions
1. Describe the essential features of a Promissory Note.
2. How are Bills of Exchange classified?
3. Give a specimen with atleast five entries of the following:
(a) A Bills Receivable Book
(b) A Bills Payable Book
You are also required to make the posting of these entries in the ledger.
4. Explain the dishonour of a bill of exchange with the entries.

9.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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Partnership Accounts

UNIT 10 PARTNERSHIP ACCOUNTS


Structure NOTES
10.0 Introduction
10.1 Objectives
10.2 Partnership: Meaning, Features, Deed and Contents
10.3 Admission of a Partner
10.4 Answers to Check Your Progress Questions
10.5 Summary
10.6 Key Words
10.7 Self Assessment Questions and Exercises
10.8 Further Readings

10.0 INTRODUCTION
Partnership form of business organisation came into existence on account
of limitations of sole proprietary concerns. The major limitations of sole
proprietary concerns are those of shortage of funds, uncertainty about
existence, unlimited personal liability etc. In case of a partnership business
two or more persons join hands together to do a business. Thus, the risk, funds,
responsibility all are shared. The Indian Partnership Act, 1932 is applicable
to contracts of Partnership. According to Section 4 of the said Act partnership
is “the relation between persons who have agreed to share the profits of a
business carried on by all or any of them acting for all”. Persons who have
entered into partnership with one another are called individually ‘partners’
and collectively a ‘firm’ and the name under which the business is carried
on is called the ‘firm’s name’.
The term ‘firm’ is merely a commercial notion. Law does not invest
the firm with legal personality apart from its partners except for the purposes
of assessment of income-tax. A ‘firm’ cannot become a member of another
partnership firm though its partners can join any other firm as partners.
It may be noted that under the Limited Partnership Act 2008, a limited
liability partnership can be formed as a body corporate having a separate legal
entity.

10.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss the concept of partnership in financial accounting
• Describe the features of partnership
• Explain the meaning of partnership deed and related contents

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Partnership Accounts • Examine the accounting entry admission of a partner
• Identify the accounting entries in case of goodwill, revaluation of assets
and reserves
NOTES • Recall the adjustments of reserves and accumulated profits and losses
in partnership accounts

10.2 PARTNERSHIP: MEANING, FEATURES, DEED


AND CONTENTS
A partnership business must satisfy all the following essential elements.
They must exist together. Absence of any one of them may cut the roots of
partnership.
1. There must be an association of two or more persons A person
cannot become a partner with himself. Reduction in the number of
partners to one shall bring about compulsory dissolution of the firm.
The term ‘person’ does not include ‘firm’ (since it does not have a
separate legal existence) and as such only the partners of the firms
can enter into partnership provided the combined strength of partners
does not exceed the statutory limit. According to section 464 of the
Companies Act 2013, the number of partners in partnership firm
should not exceed such numbers as may be presented. At present it
has been prescribed as 50 which shall not exceed 100. An association
or a partnership firm having members more than this statutory limit
must be registered as a joint stock company, under the Companies Act
or formed in pursuance of some other Indian law, otherwise it shall
become an illegal association.
2. There must be an agreement entered into by all persons
concerned The relation of partnership arises from contract and not
from status or by operation of law. Partners must enter into an agreement
voluntarily to form a partnership. The agreement may be express or
implied. It may be for a fixed period or for a particular venture or at
will, i.e., for an uncertain duration. Co-owners of a property or heirs
of a sole proprietor who has died will not ipso facto become partners
in the business, unless there is an agreement between them to carry on
business as partners.
Partners must enter into the contract with a motive to earn and distribute
amongst themselves profits of the business. Agreement to share losses
is not essential. Agreement to share profits also implies an agreement
to share losses.
3. Business must be carried on by all or any of the persons concerned
acting for all Partners in a firm act in both the capacities of an agent

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as well as principal. Active partners act as agents and conduct the Partnership Accounts
business for all the partners under an implied authority to do so by
the latter. Partners are mutual agents for each other and principals for
themselves. A partner has an authority to bind his co-partners by his
acts done in the ordinary course of the business of the firm. Partner’s NOTES
liability is not limited to his share in the business but it extends to his
personal assets too.
Partnership Deed
Partnership is created by an agreement. It is not necessary that the agreement
should be in writing. It may be oral but to avoid future disputes it is always
better to have it in writing. The document in writing containing the important
terms of partnership as agreed by the partners between themselves is called
the Deed of Partnership. It should be properly drafted and stamped according
to the provisions of The Stamp Act.
Contents of the Deed
The deed usually contains the following information:
1. Name of the firm.
2. Names of partners.
3. Nature and place of the business of the firm.
4. Date of commencement of partnership.
5. Duration of the firm.
6. Capital employed or to be employed by different partners.
7. Rules regarding operation of bank accounts.
8. Ratios in which profits and losses are to be shared.
9. How the business is to be managed?
10. Rules to be followed in case of admission, retirement, expulsion etc.,
of a partner.
11. Salaries etc., if payable to partners.
12. Interest on partners’ capitals, loans, drawings etc. to be allowed or
charged.
13. Settlement of accounts on the dissolution of the firm.
14. Arbitration clause.
It is better if the deed is very elaborate and clear about all questions
which may arise in the course of partnership. In the absence of any agreement
the rights and duties of partners will be those which have been given in the
Partnership Act.

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Partnership Accounts Provisions Affecting Accounting Treatment
The partnership deed is usually very elaborate. It covers all matters affecting
the partnership business. However, in the absence of any provision to the
NOTES contrary in the partnership deed/agreement, the following provisions govern
the accounting treatment of certain items:
1. Right to share profits Partners are entitled to share equally in the
profits earned and to contribute equally to losses incurred.
2. 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.
3. 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.
4. 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.
5. No remuneration for firm’s work A partner is required to attend
diligently to his duties in conducting the business of the firm. He has
no right to receive remuneration or salary for taking part in the conduct
of the business.

Check Your Progress


1. What is the maximum limit of partners in a partnership firm as per
the Companies Act, 2013?
2. State the provision for interest on advances when there is no specified
provision in the partnership deed.

10.3 ADMISSION OF A PARTNER


Any change in the relations of the partners will result in the reconstitution
of a partnership firm. The firm is, therefore, said to be reconstituted when

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there is admission, retirement or death of a partner or where a partnership Partnership Accounts
firm gets amalgamated with another partnership firm. In the present section,
the accounting entries relating to admission of a partner are being explained.
Admission of a Partner NOTES
Section 31 of the Partnership Act deals with the statutory provisions regarding
admission of a new partner. These provisions are summarised below:
(i) A new partner cannot be admitted without the consent of all the partners
unless otherwise agreed upon.
(ii) A new partner admitted to an existing firm, is not liable to any debts
of the firm incurred, before he comes in as a partner. The new partner
cannot be held responsible for the acts of the old partners unless it is
proved that:
(a) the reconstituted firm has assumed the liability to pay the debt;
and
(b) that the creditor concerned has agreed to accept the reconstituted
firm as his debtor and to discharge the old firm from liability.
However, a minor admitted to the benefits of partnership, who, if he
elects to become a partner in the firm after attaining majority, shall become
personally liable for all the acts of the firm done since he was admitted to
the benefits of partnership.
A newly admitted partner shall be liable only for the debts incurred or
transactions entered into by the firm subsequent to his becoming a partner.
Accounting Problems
The accounting problems on admission of a new partner can be put as follows:
(i) Adjustment in the profit sharing ratio.
(ii) Adjustment for goodwill.
(iii) Adjustment for revaluation of assets and liabilities.
(iv) Adjustment for reserves and other accumulated profits.
(v) Adjustment for capital.
Each of the above problems are being discussed in the following pages.
Adjustment in the Profit Sharing Ratio
A newly admitted partner will be entitled to share the profits or bear the
losses with the other partners. Hence, the profit sharing ratio of the partners
will change. There can be two situations.
1. The new partner may be given a certain proportion of the total profit
or required to bear a certain proportion of the total loss and the old

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Partnership Accounts partners continue to share the balance of profit or bear the balance of
loss in the old ratio in between themselves.
Illustration 10.1. A and B are partners in a business sharing profits and losses
in the ratio of 3:2. They admit a new partner C with 1/5 share in the profits.
NOTES
Calculate the new profit sharing ratio of the partners.
Solution:
C’s share is 1/5 of the total profit. Thus, for A and B the remaining
profit is only 4/5 (i.e., 1 – 1/5).
A and B continue to share profits in old ratio.
The shares of the two partners will therefore be:
4 3 12 4 2 8
A   B  
5 5 25 5 5 25
Thus the new profit sharing ratio is
A B C
12 8 1
: :
25 25 5
or 12 : 8 : 5
Illustration 10.2. A and B share profits in the ratio of 3 : 2. They admit C
with 1/5 share in the profits, which he gets equally from A and B. Calculate
the new profit sharing ratio.
Solution:
1 1 1
C’s share is 1/5 of total profits. He gets it equally from A and B i.e.  
5 2 10
1 1 1
from A and   from B.
5 2 10
A’s share of profit will therefore be:
3 1 6 1 5
  
5 10 10 10
B’s share of profit will therefore be:
2 1 4 1 3
  
5 10 10 10
Thus, the new profit sharing ratio is:
A B C
5 3 1
: :
10 10 5
or 5 : 3 : 2
Illustration 10.3. A and B are partners sharing profits in the ratio of 7 : 3.
A surrenders1/7 of his share and B surrenders 1/3 of his share in favour of
C, the new partner. What is the new ratio and what is the sacrificing ratio?

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Solution: Partnership Accounts

Old Profit sharing ratio


A : B
7 : 3 NOTES
7 1 7
Surrender by A:  
10 7 70

3 1 3
Surrender by B:  
10 3 30
New Ratio:
7 7 49  7 42 6
A:    
10 70 70 70 10

3 3 93 6 1
B:    
10 30 30 30 5

7 3 1 1 2
C:    
10 30 10 10 10
New Ratio:

6 , B: 15 , 2 ,
A: 10 C: 10

or 12 : 4 : 4
or 3 : 1 : 1
Adjustment for Goodwill
Since the new partner gets a share in the profits of the firm, he should
compensate the old partners for sharing the earning of the firm on account
of the reputation or goodwill earned by the partnership firm so far.
The problem of goodwill on admission of a new partner can be dealt
in two different ways:
1. When the goodwill account already appears in the books.
2. When the goodwill account is not appearing in the books at the time
of admission of a partner.
If the goodwill account is already appearing in the books There can be
three situations:
(i) The goodwill account is appearing at a proper value. In such an event
no adjustment will be required for goodwill.
Illustration 10.4. A and B are sharing profits in the ratio 3 : 2. They admit
a new partner C with 1/5 share in the profits. At the time of admission of C,
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Partnership Accounts goodwill is appearing in the firm’s books at `10,000 and it is agreed by all
partners (including C) that it is properly valued. Should C pay anything for
goodwill?
NOTES Solution:
Since goodwill is already appearing in the books, it shows that the old
partners have already got credit to their capital accounts with the value of
goodwill. Moreover, it is properly valued and hence C will not be required
to pay anything for goodwill nor any further adjustment will be required.
(ii) The goodwill account is to be revalued. In such an event entry will be
made only with the difference. The amount of over or under-valued
goodwill is debited or credited to the old partners in the old ratio and
credited or debited to goodwill account.
Illustration 10.5. With the information given in Illustration 10.4, pass the
necessary journal entry if the goodwill is agreed to be valued at `15,000 on
C’s admission.
Solution:
Goodwill A/c Dr. 5,000
To A’s Capital A/c 3,000
To B’s Capital A/c 2,000
(Being value of goodwill raised by `5,000)

(iii) Sometimes adjustment may have to be made for undisclosed goodwill.


This happens when goodwill account is already appearing in the books
but the new partner is required to bring premium for sharing future
profits of the firm. In such an event the goodwill brought in by the new
partner will be utilised as basis for revaluation of goodwill.
Illustration 10.6. A and B are partners sharing profits in the ratio of 3 : 2.
Goodwill appears in the books at `4,000. C is admitted as a partner and
pays `1,000 as premium for 1/5 share of the profits of the firm. Journalise
the above transaction presuming that the profit sharing ratio between A and
B remains unchanged.
Solution:
The question can be solved by taking any of the following two presumptions:
(i) Goodwill account is not to be disturbed.
(ii) Goodwill account is to be disturbed.
Where goodwill account is not to be disturbed
As C is acquiring 1/5 share of goodwill for `1,000 the whole goodwill
is `5,000, of which `4,000 already appears in the books. Hence, the value of
undisclosed goodwill is `1,000 and C’s share, thereof is `200. This amount
should be debited to his capital account and credited to A and B in the ratio

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in which they sacrifice on account of admission of C. The amount of `1,000 Partnership Accounts

brought in by C, should then be credited to his capital account. C’s account


thus gets a credit of `800. The journal entries will be:

NOTES

In case, on dissolution of the firm the goodwill realises `5,000, C will


get `200 (i.e., 1/5 of `1,000) out of the profit on account of sale of goodwill.
Thus, he is compensated for `200 with which he was charged on his
admission.
When goodwill account is to be disturbed
There could be two alternatives:
(a) The increase or decrease in the value of the goodwill be debited or
credited to old partners capital accounts in the old ratio. The entire
premium brought in by the new partner may be credited to his capital
account.
The following journal entries will be passed in such a case on basis of
information given in Illustration 10.6.

Thus, C has not paid anything to A and B for goodwill because goodwill
has now been revalued on his admission and A and B have got due credit for it.
(b) The old goodwill may be written off and charged to old partners in the
old ratio. Cash brought in by C should be credited to the old partners in
their sacrificing ratio. Goodwill account is then raised at the new value
and credit is given to all the partners in their new ratio. The journal
entries will be as follows:

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Partnership Accounts

NOTES

The net affect of these entries is the same as given in case of alternative
(a), discussed above.
When the goodwill account is not appearing in the books There
can be several alternatives.
(i) The new partner may bring cash for his share of goodwill. The amount
so brought in by the new partner will be credited to the old partners in
the ratio in which they sacrifice on admission of the new partner.
Illustration 10.7. A and B are sharing profits equally. They admit a new
partner C with 1/5 share in profits. The new profit sharing ratio being 2 : 2 :
1. The value of firm’s goodwill is `10,000. C brings his share of goodwill
in cash. Pass the necessary journal entry.
Solution:
A and B were sharing profits in the ratio of 1/2 and 1/2.
Under the new agreement A gets 2/5 and B gets 2/5.
Thus, sacrifice made by A and B is equal:
1 2 5 4 1
A   
2 5 10 10
1 2 5 4 1
B   
2 5 10 10
The amount of goodwill `2,000 (i.e., l0,000 × 1/5) will, therefore, be
shared by A and B equally. The journal entry will be:

Alternatively, the amount brought in cash for goodwill by the new


partner be credited to the goodwill account. It may then be transferred to
old partners’ capital accounts in the sacrificing ratio. However, the method
is not preferable to the one discussed above.
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The journal entries in such a case would be: Partnership Accounts

NOTES

Another alternative could be to credit the new partner’s capital account


with the cash brought in by him for capital and goodwill. A goodwill account
is raised in the books with full value and the amount is credited to the old
partners in the old profit sharing ratio. The goodwill account is then written
off to all partners in the new profit sharing ratio.
Illustration 10.8. A and B are two partners sharing profits in the ratio of
3 : 2. They admit a new partner C. The new ratio being 2 : 2 : 1 for A, B and
C respectively. C brings `10,000 as capital and `5,000 as goodwill. Pass the
necessary journal entries.
Solution:
JOURNAL

The amount brought in by new partner for goodwill may be either


wholly or partly withdrawn by the old partners. For example, if in the
Illustration 10.7 A and B withdraw in cash 50% of the amount of goodwill
brought in by C, the accounting entry will be:

(ii) A goodwill account may be raised in the books. In such an event the
new partner will not bring any cash for his share of goodwill. The
goodwill so raised will be credited to the old partners in their old profit
sharing ratio.
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Partnership Accounts Illustration 10.9. A and B are sharing profits in a business in ratio of 3 :
2. They admit C as a partner. The new ratio being 2 : 2 : 1 for A, B and C
respectively. The value of the firm’s goodwill is estimated at `15,000. C is
not in a position to bring any cash for his share of goodwill. Pass a suitable
NOTES journal entry for adjustment of goodwill in the partners’ capital accounts.
Solution:

(iii) The new partners may not like to continue with the goodwill account
in the firm’s books. In such an event the goodwill account which was
raised on admission of a partner, will be written off among all the
partners in the new profit sharing ratio.
Illustration 10.10. With the information given in Illustration 10.9 state the
journal entries to be passed when the partners first decide to raise the goodwill
account and subsequently decide to write it off.
Solution:
JOURNAL

(iv) The partners may desire to make adjustment for goodwill without
raising the goodwill account at all. In such an event the following entry
may be passed on the basis of data given in Illustration 10.9.

C has been debited because he gets 1/5 share in the profits and the
entire sacrifice has been made by A.
(v) The new partner may be in a position to pay cash only for a part of his
share of goodwill. In such an event the amount received as premium
will be credited to the old partners in their sacrificing ratio and for the
balance of his share, a goodwill account will be raised in the firm’s
books.
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Illustration 10.11. X, Y and Z were partners sharing profits and losses as to X Partnership Accounts
one-half, Y one-third and Z one-sixth. As from January 1, 2016, they agreed
to admit A into partnership for a one-sixth share in profits and losses, which
he acquired equally from X and Y, and he agreed to bring in `20,000 for his
capital and `10,000 as premium for goodwill. A paid in his capital money NOTES
but in respect of premium for goodwill he could bring in only `5,000 and
in regard to the unpaid amount he agreed to the raising of goodwill account
in the books of the new firm as would be appropriate in the circumstances.
You are requested to:
(i) give the Journal entries to carry out the above arrangements, and
(ii) work out the new profit sharing ratio of the partners.
Solution: (i)
JOURNAL ENTRIES IN RECONSTITUTED PARTNERSHIP FIRM’S BOOKS
(as on January 1, 2016)

or X, Y, Z and A’s new profit sharing ratio is 5 : 3 : 2 : 2 respectively.


Goodwill to be inferred Sometimes the value of goodwill has to be
inferred on the basis of total capital of the firm.
Illustration 10.12. A and B are equal partners in a partnership firm with
capitals of `14,000 each. They admit a new partner C in the firm with 1/4 share
in the profits of the firm. C is to bring `12,000 as his capital. No Goodwill
account, at present, appears in the books of the firm. Pass the necessary
journal entry for Goodwill in the books of the firm.
Solution:
Since C is required to bring `12,000 as capital for 1/4 share in the profits of
the firm, the total capital of the firm would be taken as `48,000. The total
capital of the partners (including C) now stands at `40,000. It means `8,000
is hidden goodwill which should be credited to old partners in their old profit
sharing ratio. The following journal entry would therefore be passed in the
books of the firm;

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Partnership Accounts

NOTES
AS 10, AS 26, Ind AS 38 and Goodwill
We have discussed in the preceding pages the traditional methods adopted
in popular textbooks for treatment of Goodwill. However, these methods
should be adopted keeping in view the treatment of intangible Goodwill, an
intangible asset as given Accounting Standards 10, 26 and Ind AS 38.
The provisions of AS 10 and AS 26 arc as under:
1. AS 10: Accounting for Fixed Assets. Goodwill should be recorded in the
books only when some consideration in money or money’s worth has been
paid for it. Whenever a business is acquired for a price (payable in cash or
in shares or otherwise) which is in excess of the value of the net assets of
the business taken over, the excess should be termed as “goodwill” (Para
36).
2. AS 26: Intangible Assets. Internally generated goodwill should not
be recognised as an asset. (Para 35). Such goodwill is not recognised
as an asset because it is not an identifiable resource controlled by the
enterprise that can be measured reliably at cost (Para 36).
3. Ind AS 38: Intangible Assets. An intangible asset shall be recognized
if, and only if:
(a) It is probable that the expected future economic benefits that are
attributable to the asset will flow to the entity; and
(b) The cost of the asset can be measured reliably (Para 21).
Hence, Goodwill should be recorded in the books only when some
consideration in money or money’s worth has been paid for it. In other
words no goodwill account should be raised in case of internally generated
goodwill, either because of no cost being incurred or its cost is not capable
of being measured reliably.
It may, therefore, be preferable for a partnership firm to adopt the
following treatment for goodwill in case of admission of a partner.
(i) When the required amount of goodwill is brought in by the incoming
partner
In the above case, the amount of goodwill brought in by the incoming
partner is shared by the old partners in their sacrificing ratio. The Journal
entry will be as follows:

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Bank Account Dr. Partnership Accounts

   To Old Partners’ Capital A/cs


   (In the sacrificing ratio)
(ii) When the required amount of goodwill brought in by the new partner NOTES
is immediately withdrawn by the partners.
In the above case the amount of goodwill is withdrawn by the partners
in the sacrificing ratio and the entry for withdrawal will be:
Old Partners’ Capital (A/cs) Dr.
   To Bank A/c
(iii) Where the new partner pays amount of goodwill privately to the old
partners
In this case, no entry should be passed in the books of the Arm. The
amount to be paid to each partner should be calculated as per the profit-
sacrificing ratio.
(iv) Where the new partner is unable to bring anything for goodwill
In this case, the value of goodwill should not be raised in the books. It
is inherent goodwill, hence it is preferable that such value of goodwill should
be adjusted through partners’ capital accounts. The new partner’s capital
account should be debited with this share of goodwill and the amount should
be credited to old partners’ capital accounts in the ratio in which they make
sacrifice of profits. The journal entry should be:
New Partner’s Capital A/c Dr.
   To Old Partners’ Capital A/cs
In place of adjusting the value of goodwill of the firm through partners’
capital accounts, another practice is also followed without keeping goodwill
account in the books. In this case goodwill account is raised in the books
by crediting the value of goodwill to old partners’ capital accounts in old
profit sharing ratio and then writing off the value of goodwill by debiting all
partners’ capital accounts in the new profit sharing ratio.
(v) When the new partner brings a portion of the required amount of
goodwill
In such a case, the amount brought in by the new partner should be
shared by the old partners in the sacrificing ratio and the portion of amount
of goodwill not brought in by the new partner should be adjusted through
the capital accounts of partners by debiting new partner’s capital account
with the amount and crediting the old partners’ capital accounts in their
sacrificing ratio.

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Partnership Accounts Adjustment for Revaluation of Assets and Liabilities
The assets and liabilities may have to be revalued on admission of a partner
so that the profit or loss on account of improper valuation of the assets or
NOTES liabilities is shared or borne only by the old partners. The adjustment can
be done in two ways:
When assets and liabilities have to appear in the books at the revised
values
In such a case a Profit and Loss Adjustment Account or Revaluation
Account is opened in the books. The following entries are to be passed.
(i) For increase in the value of an asset or decrease in the value of a
liability.
Asset/Liability A/c Dr.
To P & L Adjustment A/c

(ii) For decrease in the value of an asset or increase in the value of a


liability.
P & L Adjustment A/c Dr.
To Asset/Liability A/c

(iii) The profit on revaluation will be transferred to old partners’ capital


accounts in the old profit sharing ratio.
P & L Adjustment A/c Dr.
To Old Partners Capital A/cs (Individually).

In the event of loss, the entry will be reversed.


When assets and liabilities have to appear at old values in the books
A Memorandum Profit and Loss Adjustment Account will be opened in the
books. The increase in the value of assets or decrease in the value of liabilities
will be credited to this account. The decrease in the value of assets or increase
in the value of liabilities will be debited to this account. However, only two
entries will be passed:
(i) For crediting as profit on revaluation to old partners’ accounts:
Memorandum P & L Adjustment A/c Dr.
To Old Partners’Capital Accounts (in old ratio)
In case of loss the entry will be reversed.
(ii) For writing off the profit on revaluation to all partners’ capital accounts (including
the new partner):
Partners’ Capital Accounts (in the new ratio) Dr.
To Memorandum P & L Adjustment A/c

In case of loss the entry will be reversed.


Illustration 10.13. Following is the Balance Sheet of Messers A and B who
are sharing profits in the ratio of 3 : 2.
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BALANCE SHEET Partnership Accounts
as on 31 December, 2016

NOTES

C is admitted as a partner with effect from 1 January, 2017, the new


profit sharing ratio being 2 : 2 : 1. The following information has been given
to you:
(i) C will bring `10,000 as capital.
(ii) The value of the firm’s goodwill is `5,000.
(iii) An amount of `2,000 owing to D for purchase of goods has been
omitted from the list of sundry creditors.
(iv) Building is to be revaluated at `30,000 and Plant at `7,000.
You are required to pass the necessary Journal entries and prepare the
Balance Sheet of the new firm when:
(a) assets and liabilities have to be shown in the books at the revised values.
(b) assets and liabilities have to continue in the books at the old values.
Solution: (a) When new values have to be recorded in the books
JOURNAL

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Partnership Accounts BALANCE SHEET
as on January 1, 2017

NOTES

Working Notes:
P & L ADJUSTMENT ACCOUNT

PARTNERS’ CAPITAL ACCOUNTS

(b) When new values have not to be recorded in the books

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PARTNERS’ CAPITAL ACCOUNTS Partnership Accounts

NOTES

BALANCE SHEET
as on January 1, 2017

Working Notes:
MEMORANDUM P & L ADJUSTMENT ACCOUNT

Adjustments for Reserves and other Accumulated Profits


The amount standing to the credit of Reserves, representing accumulated
profits or balance in the Profit & Loss Account should be distributed among
the old partners in the old profit sharing ratio. The accounting entry will be:
P & L Account (if profit) Dr.
General Reserve Dr.
To Old Partners’ Capital Accounts (in the old ratio)
In case it is desired to leave the Reserves and P & L Account undisturbed, one more
entry reversing the amount credited may be passed:
All Partners’ Capital Accounts Dr.
(in the new ratio)
To P & L A/c
To General Reserve

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Partnership Accounts In place of passing two entries only one entry may be passed crediting
or debiting the partners with the net amount.
Illustration 10.14. A and B are partners in a business sharing profits and
losses in the ratio of 3 : 2. They admit a new partner C with 1/5 share in the
NOTES
profits. The following amounts represented undistributed profits among the
partners on the date of admission of C:
`
(i) P & L A/c balance 5,000
(ii) General Reserve 10,000

You are required to pass the necessary Journal entries when:


(i) Old P & L A/c and General Reserve balances are not to appear in the
New Firm’s books:
(ii) Old P & L A/c and General Reserve balances are to appear in the New
Firm’s books.
Solution:
(i) JOURNAL ENTRIES

(ii) JOURNAL ENTRIES

OR
In place of passing the two entries one entry may be passed. The new partner may be
debited with the share in the P & L A/c and General Reserve balances and the old partners
be credited in the ratio in which they lose.

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Partnership Accounts

Check Your Progress


3. What are the conditions within which there is a reconstitution of a
partnership firm? NOTES
4. List two ways in which the problem of goodwill on admission of a
new partner can be dealt with.
5. What does AS 26 prescribe about intangible assets?

10.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. As per the Companies Act, 2013, the number of partners in a partnership
firm should not exceed such numbers as may be presented. At present,
it has been prescribed as 50 which shall not exceed 100.
2. In the absence of any provision to the interest on advances in the
partnership deed/agreement, a partner who makes an advance of money
to the firm beyond the amount of his capital for the purposes of business,
is entitled to get interest thereon at the rate of 6% per annum.
3. Any change in the relations of the partners will result in the
reconstitution of a partnership firm. The firm is, therefore, said to be
reconstituted when there is admission, retirement or death or where a
partnership firm gets amalgamated with another partnership firm.
4. The problem of goodwill on admission of a new partner can be dealt
in two different ways:
• When the goodwill account already appears in the books.
• When the goodwill account is not appearing in the books at the
time of admission of a partner.
5. In relation to intangible assets, the AS 26 prescribes that internally
generated goodwill should not be recognized as an asset. This is because
it is not an identifiable resource controlled by the enterprise that can
be measured reliably at cost.

10.5 SUMMARY
• Partnership form of business organization came into existence
on account of limitations of sole proprietary concerns. The major
limitations of sole proprietary concerns are those of shortage of funds,
uncertainty about existence, unlimited personal liability etc. In case of
a partnership business two or more persons join hands together to do
a business. Thus, the risk, funds, responsibility all are shared.

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Partnership Accounts • The Indian Partnership Act, 1932 is applicable to contracts of
Partnership. According to Section 4 of the said Act partnership is “the
relation between persons who have agreed to share the profits of a
business carried on by all or any of them acting for all”. Persons who
NOTES have entered into partnership with one another are called individually
‘partners’ and collectively a ‘firm’ and the name under which the
business is carried on is called the ‘firm’s name’.
• A partnership business must satisfy all the following essential elements.
They must exist together. Absence of any one of them may cut the
roots of partnership. These features are: there must be an association
of two or more persons, there must be an agreement entered into by
all persons concerned, business must be carried on by all or any of the
persons concerned acting for all.
• Partnership is created by an agreement. It is not necessary that the
agreement should be in writing. It may be oral but to avoid future
disputes it is always better to have it in writing. The document in
writing containing the important terms of partnership as agreed by
the partners between themselves is called the Deed of Partnership. It
should be properly drafted and stamped according to the provisions
of The Stamp Act.
• It is better if the deed is very elaborate and clear about all questions
which may arise in the course of partnership. In the absence of any
agreement the rights and duties of partners will be those which have
been given in the Partnership Act. These are right to share profits,
interest on capital, interest on advances, right to share subsequent
profits after retirement and no remuneration for firm’s work.
• Any change in the relations of the partners will result in the reconstitution
of a partnership firm. The firm is, therefore, said to be reconstituted
when there is admission, retirement or death of a partner or where a
partnership firm gets amalgamated with another partnership firm.
• Section 31 of the Partnership Act deals with the statutory provisions
regarding admission of a new partner. These provisions are summarised
below:
(i) A new partner cannot be admitted without the consent of all the
partners unless otherwise agreed upon.
(ii) A new partner admitted to an existing firm, is not liable to any
debts of the firm incurred, before he comes in as a partner. The
new partner cannot be held responsible for the acts of the old
partners unless it is proved that:
(a) the reconstituted firm has assumed the liability to pay the
debt; and

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(b) that the creditor concerned has agreed to accept the recon- Partnership Accounts
stituted firm as his debtor and to discharge the old firm
from liability.
• The accounting problems on admission of a new partner can be put as
NOTES
follows:
(i) Adjustment in the profit sharing ratio.
(ii) Adjustment for goodwill.
(iii) Adjustment for revaluation of assets and liabilities.
(iv) Adjustment for reserves and other accumulated profits.
(v) Adjustment for capital.

10.6 KEY WORDS


· Memorandum Revaluation Account: This is also known as
Memorandum Profit & Loss Adjustment Account. It is similar to
revaluation account except that it is only a memorandum record
of increase or decrease in the values of assets and liabilities on
reconstitution of a partnership firm. The assets and liabilities continue
to appear at their old values in the balance sheet and entry is passed
only with the net profit or loss made or suffered by the partners on
reconstitution of the firm.
· Revaluation Account: This is also known as Profit & Loss Adjustment
account. The account records any increase or decrease in the values
of assets and liabilities as agreed by the partners on reconstitution of
a partnership firm. The balance of the account represents profit or loss
made on revaluation to be shared by the partners.
· Sacrificing Ratio: The term is used generally in case of admission of a
partner. It is the ratio in which the existing partners lose on admission
of a new partner.

10.7 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. Why assets and liabilities are revalued on admission of a partner? Give
imaginary entries covering such revaluation.
2. What is ‘Goodwill’?
3. If there is a change in the profit sharing ratio of the existing partners,
is it necessary to revalue the assets and liabilities? Give reasons for
your answer.
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Partnership Accounts 4. Distinguish between Revaluation Account and Memorandum
Revaluation Account.
Long Answer Questions
NOTES 1. What could be the several alternatives regarding adjustment for
goodwill in the event of admission of a partner?
2. State the ratio and the Journal entry for the following adjustments in
the event of admission of a partner
(a) When goodwill account is raised.
(b) When goodwill account is written off.
(c) When the new partner brings cash for his share of goodwill.
(d) When there is profit or loss on revaluation of assets.
[Ans. (a) old, (b) new, (c) sacrificing, (d) old]
3. Explain the following methods of calculating goodwill of a partnership
firm:
(i) Purchase of a certain number of years’ average profit method.
(ii) Super-Profits method.
4. Explain the accounting treatment of ‘Goodwill’ when at the time of
admission, the new partner cannot bring his share of goodwill in cash.

10.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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Retirement and Death

UNIT 11 RETIREMENT AND DEATH


of a Partner

OF A PARTNER
NOTES
Structure
11.0 Introduction
11.1 Objectives
11.2 Retirement of a Partner
11.3 Death of a Partner
11.4 Answers to Check Your Progress Questions
11.5 Summary
11.6 Key Words
11.7 Self Assessment Questions and Exercises
11.8 Further Readings

11.0 INTRODUCTION
In the previous unit, we studied the reconstitution of partnership accounts
under the condition of admission of new partner in the partnership. In this unit,
we will take up the other conditions under which the partnership accounts go
under reconstitution. These conditions are retirement and death of a partner.
On retirement of a partner from the firm may result in the dissolution or
reconstitution of the firm. Generally, a partner retires from the firm because
he/she is too old, they have a better opportunity in their kitty or they are
unhappy with the attitude or behaviour of their partners. Death of the partner,
as the name suggests means the actual death of the partner. In both these
cases, different items like the assets and liabilities, goodwill, accumulated
reserves are to be adjusted and new calculations done with regards to the
profit sharing and loss sharing ratio and the amount due to the former partner.

11.1 OBJECTIVES
After going through this unit, you will be able to:
• Discuss the meaning of retirement of a partner
• Describe the calculation of new profit sharing ratio and gaining ratio
when a partner retires
• Explain the adjustments with regards to Goodwill in case of a retiring
partner
• Examine the revaluation of assets and liabilities in case of retiring
partners

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Retirement and Death • Recall the provisions in case of settling claims of retiring partner
of a Partner
• Describe the concept of death of a partner in a partnership

11.2 RETIREMENT OF A PARTNER


NOTES
Section 32 of the Partnership Act deals with the statutory provisions relating
to retirement of a partner from partnership firm. These provisions are
summarised below:
(i) A partner may retire from the firm:
(a) in accordance with an express agreement; or
(b) with consent of all other partners; or
(c) where the partnership is at will1, by giving a notice in writing to
all the other partners of his intention to retire.
(ii) A retiring partner may carry on business competing with that of the
firm and may advertise such business. But he has no right to:
(a) use the name of the firm,
(b) represent himself as carrying on the business of the firm, or
(c) solicit the custom of the old customers of the firm except when
he obtains these rights by an agreement with the other partners
of the firm.
(iii) A retiring partner will not be liable for liabilities incurred by the firm
after his retirement. However, he must give a public notice to that
effect. Such a public notice is not necessary in case of a sleeping or
dormant partner.2
(iv) Retirement of a partner by death or insolvency also does not require
any public notice.
Accounting Problems
The accounting problems in the event of retirement of a partner can be put
as follows:
(i) Adjustment for Goodwill.
(ii) Revaluation of assets and liabilities.
(iii) Adjustment regarding Reserves and other undistributed profits.
(iv) Adjustments regarding profit sharing ratios.
(v) Payment to the retiring partner.
1. Goodwill The retiring partner will be entitled to his share of goodwill in
the firm. The problem of goodwill can be dealt in the following two different
ways:

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236 Material
(a) Where goodwill account is already appearing in the books: Retirement and Death
of a Partner
(i) In such a case if goodwill is properly valued, no further adjustment
will be needed. The amount has already been credited to all the
partners including the retiring partner.
NOTES
(ii) In case goodwill is not properly valued, an adjustment entry will
be required only for the difference. For example A, B and C are
three partners sharing profits and losses in the ratio of 2 : 2 : 1.
The goodwill is appearing in the books at `10,000. C retires and
on the date of his retirement, the goodwill is valued at `15,000.
The following Journal entry will be passed for `5,000.
Goodwill A/c Dr. 5,000
To A’s Capital A/c 2,000
To B’s Capital A/c 2,000
To C’s Capital A/c 1,000
(Being adjustment for goodwill on retirement of C)

(b) Where goodwill account is not appearing in the books:


There could be several alternatives:
(i) Goodwill account may be raised in the books.
Goodwill A/c Dr.
  To Old Partners’ Capital A/c
(The amount of goodwill credited to old partners
including the retiring partner in their old profit sharing ratio)
(ii) In case continuing partners decide not to continue with the
goodwill account, it may be written off.
Continuing Partners Capital A/cs Dr.
  To Goodwill A/c
[Goodwill written off to the continuing partners A/c
(i.e., new partners) in the new ratio]
(iii) Entry may be made only with the share of goodwill of the retiring
partner.
Goodwill A/c Dr.
(only with the share of the retiring partner)
  To Retiring Partner’s Capital A/c
(iv) The share of goodwill of the retiring partner may be adjusted in
the accounts of the continuing partners without raising a goodwill
account.

Continuing Partners’ Capital A/c Dr.
(in the ratio in which they gain on retirement)
  To Retiring Partner’s Capital A/c

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Material 237
Retirement and Death Illustration 11.1. A, B and C are partners in business sharing profits and
of a Partner
losses in the ratio of 2 : 2 : 1. C retires from the firm and on this date the
value of firm’s goodwill (for which no account appears in the books) was
determined at `10,000.
NOTES
You are required to pass suitable Journal entries for each of the
following cases:
(i) When goodwill account is to be raised in the books.
(ii) When the goodwill account raised is subsequently written off.
(iii) When only C’s share is to be recorded.
(iv) When C’s share is to be adjusted into accounts of A and B without
raising a Goodwill account in the firm’s book.
Solution:
JOURNAL

2. Revaluation of assets and liabilities A Profit and Loss Adjustment


account will be opened in the firm’s books and profit or loss on revaluation
will be credited or debited to all the partners (including the retiring partner)
in the old ratio. The assets and liabilities will appear at the revised values in
the new balance sheet after retirement.
In case it is desired that assets and liabilities should continue to appear
at the old values, the entries for profit or loss on revaluation will be done
through Memorandum Profit and Loss Adjustment Account as explained in
the previous unit in “Admission of a Partner”.
Illustration 11.2. A, B and C are sharing profits in a business in the ratio
of 3 : 2 : 1.
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238 Material
Their Balance Sheet as on December 31, 2009 was as under: Retirement and Death
of a Partner

NOTES

C retires on this date. The following arrangement is agreed upon:


(i) The value of the Firm’s goodwill is `15,000. C’s share of the same is
to be adjusted in the accounts of A and B.
(ii) The assets are revalued as follows:
Stock 25,000
Plant 52,000

(iii) A provision for bad debts is to be created on debtors @ 10% of debtors.


(iv) The amount due to C is to be transferred to a loan account in his name.
You are required to prepare the Profit and Loss Adjustment Account,
Capital Accounts of the Partners and the Balance Sheet of the business:
(a) When assets are to be shown at new values in the books.
(b) When assets are to be shown at old values.
Solution:
(a) When assets are to be shown at new values.
Dr. P & L ADJUSTMENT ACCOUNT Cr.

Dr. CAPITAL ACCOUNTS Cr.

Self-Instructional
Material 239
Retirement and Death BALANCE SHEET
of a Partner
Dr. as on 1st January, 2017 Cr.

NOTES

(b) When assets are to be shown at old values.


Dr. MEMORANDUM P & L ADJUSTMENT ACCOUNT Cr.

Dr. PARTNERS’ CAPITAL ACCOUNTS Cr.

BALANCE SHEET

Dr. as on 1st January, 2017 Cr.

3. Reserves and other Undistributed Profits The amount standing as


reserves or undistributed profits in the books of the firm will be distributed
among all the partners in their old profit sharing ratio.

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240 Material
The journal entry will be: Retirement and Death
of a Partner
Reserves or P & L A/c Dr.
To Partners’ Capital A/c
In case it is desired that only retiring partner should be credited with NOTES
his share in reserves or undistributed profit, the following journal entry will
be passed:
Reserves or P & L A/c Dr.
To Retiring Partners’ Capital A/c
(only with his share)
The balance of Reserves or undistributed profits will continue to appear
in the Balance Sheet after such retirement.
In case it is desired that the retiring partner should be given the benefit of
Reserves or undistributed profits without in any way disturbing the Reserves
or undistributed profits, the following journal entry will be passed:
Continuing Partners’ Capital A/c Dr.
(in the ratio they gain)
   To Retiring Partner’s Capital A/c
    (only with his share)
Illustration 11.3. A, B and C are partners in a business sharing profits and
losses in the ratio of 2 : 2 : 1. C retires from the business. The General Reserve
stands at `5,000 on the date of C’s retirement. A and B agree to share the
future profits in the ratio of 3 : 2 respectively.
You are required to pass the necessary journal entry for distribution
of General Reserve if
(a) The General Reserve is not allowed to be kept in the books.
(b) The General Reserve is kept only at an amount remaining after giving
C his share.
(c) The General Reserve is allowed to be kept at the full value.
Solution:

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Material 241
Retirement and Death 4. Profit Sharing Ratio In the absence of any other agreement between the
of a Partner
partners, the continuing partners will continue to share the profits or losses
in between themselves in the same ratio in which they were sharing before
retirement of a partner.
NOTES
For example if A, B and C were sharing profits in the ratio of 3 : 2 : 1
respectively and C retires, the profit sharing ratio between A and B would
continue to be 3 : 2.
In other words it can be said that the share of the retiring partner will be
shared by the continuing partners in their old profit sharing ratio. The ratio in
which they share the retiring partner’s share is termed as their “gaining ratio”.
In the above example, the share of retiring partner is 1/6. This shall go
to A and B in the ratio of 3/5 to A and 2/5 to B which means:

A’s share

B’s share
or the ratio comes to 3 : 2.
The continuing partners may agree to share, the share of the retiring
partner in an agreed ratio. For example, if in the above example, C’s share
of 1/6 is shared by A and B equally, the new profit sharing ratio will be:

Thus, the new profit sharing ratio of A and B will be 7 : 5 respectively.


Illustration 11.4. A, B and C were partners sharing profits and losses in the
ratio of 3/6, 2/6 and 1/6.
Calculate the new and gaining ratios in each of the following cases:
(a) A retires; (b) B retires; (c) C retires.
Solution:

New Ratios
(i) When A retires. B and C will continue to share the profits in the old
ratio i.e., 2/6 and 1/6 or 2 : 1.
(ii) When B retires. A and C will continue to share the profits in the old
ratio i.e., 3/6 and 1/6 or 3 : 1.
(iii) When C retires. A and B will continue to share the profits in the old
ratio i.e., 3/6 and 2/6 or 3 : 2.

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242 Material
Gaining Ratio Retirement and Death
of a Partner
In each of the above cases, since nothing contrary has been given, the gaining
ratio will be the same as old profit sharing ratio i.e., (i) 2 : 1 (ii) 3 : 1 and (iii)
3 : 2. This can be verified as follows: NOTES
Gaining Ratio = New Ratio – Old Ratio
When A retires

Illustration 11.5. A, B and C are partners in a business, sharing profits in


the ratio of 2 : 2 : 1. A retires and he sells his share in the business for a sum
of `6,000; `4,800 is paid by B and `1,200 by C. The profit for the year after
A’s retirement amounts to `10,000.
You are required to give the necessary Journal entries.

Self-Instructional
Material 243
Retirement and Death Solution:
of a Partner
JOURNAL

NOTES

Working Notes:

The new profit sharing ratio has been calculated as under:


B pays `4,800
C pays `1,200
This means B has bought 4/5 of A’s share and C has bought 1/5.
B’s share would therefore be:

C’s share would therefore be:

Thus, the new ratio would be:

5. Payment The amount due to the retiring partner will be paid as per terms
of the partnership agreement or as otherwise mutually agreed. When the
amount payable to the retiring partner is determined, it will be transferred
to his loan account. The Journal entry will be:
Retiring Partner’s Capital A/c Dr.
To Retiring Partner’s Loan A/c
In case the continuing partners agree to bring cash to pay off the retiring
partner, the entries will be
Bank Dr.
To Continuing Partners’ Capital A/c
(For cash brought in by the partners in the agreed ratio
Self-Instructional
   to pay off the retiring partner)
244 Material
Retiring Partner’s Capital A/c Dr. Retirement and Death
of a Partner
   To Bank
(For cash paid to the retiring partner)
In case the continuing partners decide to pay the retiring partner in their NOTES
individual capacity in their profit sharing ratio, the entry will be:
Retiring Partner’s Capital Loan A/c Dr.
To Continuing Partner’s Capital A/c
Payment in Instalments
The amount due to the retiring partner may be agreed to be paid in equal
instalments together with interest at the agreed rate.
In such a case there may be two situations:
(i) Equal instalments may only be regarding ‘principal’ amount. Interest
on outstanding balance is paid in addition to the instalment amount
(See Illustration 11.6).
(ii) Equal instalment may be both as regards interest as well as principal.
In such a case the amount of instalment is calculated with the help of
Annuity Table (See Illustration 11.8).
Illustration 11.6. The total amount due to the retiring partner A is `12,000.
It is to be paid in ten equal annual instalments with interest at 10% p.a. The
first instalment to be paid after the expiry of one year after from the date of
retirement. Prepare A’s loan account for the first three years.
Solution:
A’s LOAN ACCOUNT

Illustration 11.7. Nut, Bolt and Screw are partners sharing profits and losses
in the ratio of 4 : 2 : 1.On 1st January, 2016, Screw retires. On that date, the
capital accounts of the partners showed credit balances of Nut `12,000, Bolt
`10,000 and Screw `9,000. It was provided in the Partnership Deed that in
case of retirement, the retiring partner should be entitled to a share of the
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Material 245
Retirement and Death goodwill of the firm to be calculated at two years’ purchase of the average
of a Partner
profits of the last three years, and that the payment of the capital and share
of goodwill to the retiring partner shall be made by annual instalment of
`4,000 each, for the first two years and the balance in the last year, interest
NOTES being calculated at 10% on the unpaid balances.
The Profit for the years 2013, 2014 and 2015 were `8,600, `7,600 and
`4,800 respectively.
The first instalment was paid on 31st December, 2016.
Show Screw’s Loan Account until the payment of the whole amount
due to him was made.
Solution:
Dr. SCREW’S CAPITAL ACCOUNT Cr.

Dr. SCREW’S LOAN ACCOUNT Cr.

Working Note:
Computation of Goodwill
Profits for the three years were:
`
2013 8,600
2014 7,600
2015 4,800
Total Profits for three years 21,000

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246 Material
Average Profit = 21,000/3 = `7,000 Retirement and Death
of a Partner
Value of Goodwill = `7,000 × 2 = `14,000
Screw’s Share of Goodwill = 14,000 × 1/7 = `2,000.
Illustration 11.8. A, B and C were carrying on business in partnership sharing NOTES
profit and losses in the ratio of 3 : 2 : 1 respectively. On 31st December, 2015
Balance Sheet of the firm stood as follows:

B retired on the above mentioned date on the following terms:


(i) Buildings be appreciated by `7,000.
(ii) Provision for bad debts be made @ 5% on Debtors.
(iii) Goodwill of the firm be valued at `9,000 and adjustment in this respect
be made without raising a Goodwill Account.
(iv) `5,000 be paid to B immediately and the balance due to him be treated
as a loan carrying interest @ 6% per annum. Such loan is to be paid to
three equal annual instalments including interest.
Pass Journal entries to record above mentioned transactions and show
the Balance Sheet of the firm as it would appear immediately after B’s
retirement. Prepare also B’s Loan Account till it is finally closed.
Solution:
JOURNAL

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Material 247
Retirement and Death BALANCE SHEET
of a Partner
as on January 1, 2016

NOTES

Dr. B’S LOAN ACCOUNT Cr.

Check Your Progress


1. Which section of the Partnership Act deals with the statutory provisions
relating to retirement of a partner?
2. Mention the journal entry which should be passed in case it is desired
that only retiring partner should be credited with his share in reserves
or undistributed profit.
3. Mention the journal entry for continuing partners agree to bring cash
to pay off the retiring partner.

11.3 DEATH OF A PARTNER


According to Section 35 of the Partnership Act, a partnership firm may not
be dissolved on the death of a partner.
Where under a contract between the partners the firm is not dissolved
by the death of a partner, the estate of the deceased partner is not liable for
any act done or liability incurred after his death. No public notice is required
for this purpose.

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248 Material
In the event of death of a partner, the legal representatives of the Retirement and Death
of a Partner
deceased partner will be entitled to get from the firm, amounts due on account
of following:
(i) Capital standing to the credit of the deceased partner on the date of his
NOTES
death.
(ii) Share of goodwill.
(iii) Profit on revaluation of assets and liabilities as reduced by any loss on
any such revaluation.
(iv) Share out of the proceeds of a joint life insurance policy.
In case the firm has taken insurance policies severally on the life of
each partner, the deceased’s partner’s executor’s will be entitled to get not
only a share out of the proceeds of the policy on his life but also a share out
of the surrender values of the policies on the lives of other partners. However,
the latter part will be applicable only when the entire premium paid on these
policies has been charged to Profit & Loss Account and the policies are not
appearing in the books of accounts.
For example, a Firm has taken life policies on the lives of all partners
severally for A `10,000, B `5,000 and C `5,000. A dies. The premium paid
has been charged to Profit & Loss Account each year. The surrender values
of the policies of B and C are `2,000 each. The partners share profits and
losses in the ratio of 2 : 2 : 1.
In this case, A’s executors will be entitled to:
(a) Share out of the proceeds of life
insurance policy on the life of A `

i.e., 10,000 × 2/5 4,000
(b) Share out of the surrender values of the life insurance policies
on lives of B and C i.e., 4,000 × 2/5 1,600
5,600

(v) Share out of the reserves or other undistributed profits.


(vi) Share in the profits of the firm earned by the firm from the date of
beginning of the year to the date of his death.
(vii) Interest on capital from the beginning of the year to the date of his
death.
The deceased partner’s capital account will be charged with his share
of the following amounts:
(i) Drawings and interest thereon from the beginning of the accounting
year to the date of his death.
(ii) Loss on revaluation of assets and liabilities.
(iii) Loss in the business from the beginning of the accounting year till the
date of his death.
Self-Instructional
Material 249
Retirement and Death Ascertainment of the deceased partner’s share in the profit of the
of a Partner
firm The actual share of the deceased partner in the profit of the firm till the
date of death can be calculated only by preparing the final accounts up to that
date. However, it may not be very convenient. The profit may, therefore, be
NOTES calculated according to any of the following methods:
1. Time basis The profit for the year can be divided between two periods:
(i) beginning of the accounting year to the date of death of the partner.
(ii) from the date of death of partner till the end of the accounting
year.
The deceased partner’s share can now be ascertained out of the profit
ascertained for the period (i) stated above.
Illustration 11.9. A, B and C are partners in a business sharing profits in the
ratio of 2 : 2 : 1. C dies on 1st April 2016. The profit for the accounting year
ending on 31st December, 2016 amounts to `16,000. Calculate the share of
the deceased partner in profits of the firm.
Solution:
Profit for the year is `16,000
Profit from 1st January to 1st April, 2016 i.e., for 3 months.
16,000 × 1/4 = `4,000
C’s share will be 4,000 × 1/5 = `800.
2. Sales basis The deceased partner’s share in profits up to the date of
his death can be determined on the basis of sales.
Illustration 11.10. A, B and C are sharing profits in the ratio of 2 : 2 : 1. C
dies on April 1, 2017. Sales for the year 2017 amount to `3,00,000 out of
which sales of `1,00,000 amounted between the period from January 1, 2017
to April 1, 2017. The profit for the year amounted to `30,000.
Calculate the deceased partner’s share in the profits of the firm.
Solution:
The profit up to the death on the basis of turnover:
1,00,000
30,000 × 3,00,000 = `10,000
C’s share will be:
10,000 × 1/5 = `2,000.
In both cases the share of the deceased partner can also be ascertained
on the basis of firm’s past performance instead of actual figures for the
current year.

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250 Material
Retirement and Death
of a Partner
Check Your Progress
4. What happens to the estate of a partner who is deceased?
5. State the two methods through which ascertainment of the deceased NOTES
partner’s share in the profit of the firm.

11.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. Section 32 of the Partnership Act deals with the statutory provisions
relating to retirement of a partner from partnership firm.
2. The journal entry which should be passed in case it is desired that
only retiring partner should be credited with his share in reserves or
undistributed profit is:
Reserves or P&L A/c Dr.
To Retiring Partners’ Capital A/c
(Only with his share)
3. The journal entry for continuing partners agree to bring cash to pay
off the retiring partner will be:
Bank Dr.
To Continuing Partners’ Capital A/c
(For cash brought in by the partners in the agreed ratio to
pay off the retiring partner)
4. Where under a contract between the partners the firm is not dissolved
by the death of a partner, the estate of the deceased partner is not liable
for any act done or liability incurred after his death. No public notice
is required for this purpose.
5. The two methods through which ascertainment of the deceased
partner’s share in the profit of the firm are: time basis and sales basis.

11.5 SUMMARY
• Section 32 of the Partnership Act deals with the statutory provisions
relating to retirement of a partner from partnership firm.
• A partner may retire from the firm:
(a) in accordance with an express agreement; or
(b) with consent of all other partners; or
(c) where the partnership is at will1, by giving a notice in writing to
all the other partners of his intention to retire
Self-Instructional
Material 251
Retirement and Death • The accounting problems in the event of retirement of a partner can
of a Partner
be put as follows:
(i) Adjustment for Goodwill.
NOTES (ii) Revaluation of assets and liabilities.
(iii) Adjustment regarding Reserves and other undistributed profits.
(iv) Adjustments regarding profit sharing ratios.
(v) Payment to the retiring partner.
• The retiring partner will be entitled to his share of goodwill in the firm.
The problem of goodwill can be dealt in the following two different
ways: (a) Where goodwill account is already appearing in the books
and (b) Where goodwill account is not appearing in the books.
• For revaluation of assets and liabilities in case of a retiring partner:
Profit and Loss Adjustment account will be opened in the firm’s books
and profit or loss on revaluation will be credited or debited to all the
partners (including the retiring partner) in the old ratio. The assets and
liabilities will appear at the revised values in the new balance sheet
after retirement.
• In case of Reserves and other Undistributed Profits of a retiring partner,
the amount standing as reserves or undistributed profits in the books
of the firm will be distributed among all the partners in their old profit
sharing ratio.
• In the absence of any other agreement between the partners, the
continuing partners will continue to share the profits or losses in
between themselves in the same ratio in which they were sharing
before retirement of a partner.
• The amount due to the retiring partner will be paid as per terms of
the partnership agreement or as otherwise mutually agreed. When
the amount payable to the retiring partner is determined, it will be
transferred to his loan account.
• The amount due to the retiring partner may be agreed to be paid in
equal instalments together with interest at the agreed rate. In such a
case there may be two situations:
(i) Equal instalments may only be regarding ‘principal’ amount.
Interest on outstanding balance is paid in addition to the
instalment amount
(ii) Equal instalment may be both as regards interest as well as
principal. In such a case the amount of instalment is calculated
with the help of Annuity Table

Self-Instructional
252 Material
• According to Section 35 of the Partnership Act, a partnership firm Retirement and Death
of a Partner
may not be dissolved on the death of a partner. Where under a contract
between the partners the firm is not dissolved by the death of a partner,
the estate of the deceased partner is not liable for any act done or
liability incurred after his death. No public notice is required for this NOTES
purpose.
• In the event of death of a partner, the legal representatives of the
deceased partner will be entitled to get from the firm, amounts due on
account of following:
(i) Capital standing to the credit of the deceased partner on the date
of his death.
(ii) Share of goodwill.
(iii) Profit on revaluation of assets and liabilities as reduced by any
loss on any such revaluation.
(iv) Share out of the proceeds of a joint life insurance policy.
• The actual share of the deceased partner in the profit of the firm till the
date of death can be calculated only by preparing the final accounts up
to that date. However, it may not be very convenient. The profit may,
therefore, be calculated according to any of the following methods:
Time basis and Sale basis.

11.6 KEY WORDS


· Gaining Ratio: The term is generally used in case of retirement or
death of a partner. It is the ratio in which the continuing partners gain
on retirement or death of a partner.
· Amalgamation: It refers to the merger of two or more partnership
firms to form a new partnership firm.

11.7 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. What are the conditions under which a partner retires from the firm?
2. State the rights which are not provided to the retiring partner in case
he wants to carry on business competing with that of the firm and may
advertise such business.
3. Explain the revaluation of assets and liabilities in case of a retiring
partner.
4. Explain the condition of payment in installments in case of a retiring
partner with journal entries.
Self-Instructional
Material 253
Retirement and Death 5. How can a partner retire from a partnership firm? Is a retiring partner
of a Partner
liable for liabilities incurred by the partnership firm after his retirement?
6. State the rights of an outgoing partner in case the continuing partners
do not settle his accounts and continue to carry on business.
NOTES
Long Answer Questions
1. Discuss how goodwill is settled in case of a retiring partner.
2. Explain the accounting entries which are to be made in case of the
death of a partner.
3. State the journal entries that are to be passed in the event of
amalgamation in the books of (i) the firms to be amalgamated and
(ii) New firm.

11.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel K. and Sharad K. 2018. An Introduction to
Accountancy, 12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narang, K.L. 2001. Advanced Accountancy. New Delhi: Kalyani
Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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254 Material
Depreciation Accounting

BLOCK - IV
COMPANY ACCOUNTS
NOTES
UNIT 12 DEPRECIATION
ACCOUNTING
Structure
12.0 Introduction
12.1 Objectives
12.2 Depreciation: Meaning, Need and Cause
12.2.1 Causes of Depreciation
12.2.2 Basic Features of Depreciation
12.2.3 Meaning of Depreciation Accounting
12.2.4 Objectives of Providing Depreciation
12.2.5 Fixation of Depreciation Amount
12.2.6 Methods of Recording Depreciation
12.3 Methods for Providing Depreciation
12.4 Answers to Check Your Progress Questions
12.5 Summary
12.6 Key Words
12.7 Self Assessment Questions and Exercises
12.8 Further Readings

12.0 INTRODUCTION
The concept of depreciation is closely linked to the concept of business
income. In the revenue generating process the use of long-term assets tend to
consume their economic potential. At some point of time these assets become
useless and are disposed of and possibly replaced. The economic potential so
consumed represents the expired cost of these assets and must be recovered
from the revenue of the business in order to determine the income earned by
the business. Depreciation may, therefore, be defined as that portion of the
cost of the assets that is deducted from revenue for assets services used in the
operation of a business. Depreciation is thus allocating the cost of assets to
the business over the useful life of the asset. It is thus a process of allocation
and not of valuing the assets.
In order to have a clear understanding about the concept of depreciation,
it will be useful to quote definitions given by some prominent writers.
According to Pickles, “Depreciation is the permanent and continuing
diminution in the quality, quantity or value of an asset”.
The Institute of Chartered Accountants of England and Wales defines
depreciation as “that part of the cost of a fixed asset to its owner which is not Self-Instructional
Material 255
Depreciation Accounting recoverable when the asset is finally put out of use by him. Provision against
this loss of capital is an integral cost of conducting the business during the
effective commercial life of the asset and is not dependent upon the amount
of profit earned”.
NOTES
According to Spicer and Pegler, depreciation may be defined as, “the
measure of the exhaustion of the effective life of an asset from any cause
during a given period”.
From the above definitions, it can be concluded that depreciation is
a gradual decrease in the value of an asset from any cause. In this unit, we
will learn the concept of depreciation accounting. We will study the meaning,
causes, need and computation of depreciation along with the methods of
depreciation.

12.1 OBJECTIVES
After going through this unit, you will be able to:
· Discuss the meaning of depreciation in accounting
· Describe the need and cause of depreciation
· Explain the methods for providing depreciation

12.2 DEPRECIATION: MEANING, NEED AND


CAUSE
In this section, we will study the meaning, need, features and causes of
depreciation.
12.2.1 Causes of Depreciation
The causes of depreciation are as follows:
1. Wear and tear Assets get worn or torn out on account of constant use
as is the case with plant and machinery, furniture and fixtures used in
a factory.
2. Exhaustion An asset may get exhausted through working. This is
the case with mineral mines, oil wells etc. On account of continuous
extraction of minerals or oil, a stage comes when the mine or well gets
completely exhausted and nothing is left.
3. Obsolescence Some assets are discarded before they are worn out
because of changed conditions. For example, an old machine which is
still workable may have to be replaced by a new machine because of
the latter being more efficient and economical. Such a loss on account
of new inventions or changed fashions is termed as loss on account of
obsolescence.

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4. Efflux of time Certain assets get decreased in their value with the Depreciation Accounting
passage of time. This is true in case of assets like leasehold properties,
patents or copyrights.
5. Accidents An asset may meet an accident and, therefore, it may get
NOTES
depreciated in its value.
On the basis of the above causes, it can be said that depreciation is
the decrease or depletion in the value of an asset due to wear and tear,
lapse of time, obsolescence, exhaustion and accident.
12.2.2 Basic Features of Depreciation
1. The term ‘depreciation’ is used only in respect of fixed assets. Of
course, the current assets may also lose their value. Loss on account of
fall in their value is taken care of by valuing them for Balance Sheet
purposes “at cost or market price whichever is less”.
2. Depreciation is a charge against profits. This means that true profit of
the business cannot be ascertained without charging depreciation.
3. Depreciation is different from maintenance. Maintenance expenses are
incurred for keeping the machine in a state of efficiency. However, any
degree of maintenance cannot assure that the asset will never reach
a state of scrap. Of course, good maintenance delays this stage but it
cannot absolutely prevent it.
4. All fixed assets, with certain possible exceptions, e.g., land, and
antiques etc., suffer depreciation although the process may be invisible
or gradual.
Depreciation
The term ‘depreciation’ is to be distinguished from other terms such a
depletions, amortization etc. though they are used often interchangeably.
Depletion Depletion implies removal of an available but irreplaceable
resource such as extracting coal from a coal mine or oil out of an oil well.
Amortization The process of writing off intangible assets is termed as
amortization. Some intangible assets like patents, copyrights, leaseholds have
a limited useful life. Hence, their cost must be written off over such period.
The American Institute of Certified Public Accountants (AICPA) has
put the difference between depreciation, depletion, and amortization in the
following words.
“Depreciation can be distinguished from other terms with specialised
meaning used by accountants to describe assets cost allocation procedures.
Depreciation is concerned with charging the cost of man made fixed assets
to operations (and not with determination of asset value for the balance
sheet). Depletion refers to cost allocations for natural resources such as oil
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Depreciation Accounting and mineral deposits. Amortization relates to cost allocation for intangible
assets such as patent and leaseholds. The use of the term depreciation should
also be avoided in connection with the valuation procedures for securities
and investments.”
NOTES
Dilapidations The term dilapidation refers to damage done to a
building or other property during tenancy. When a property is taken on lease,
is returned to the landlord he may ask the lessee as per agreement to put it
in as good condition as it was at the time it was leased out. In order to meet
cost of such dilapidation, a provision may be created by debiting the property
account with the estimated amount of dilapidation and crediting the provision
for dilapidations account. Depreciation may then be charged on the total cost
of the asset so arrived at. Any payment made later on dilapidation may be
debited to the provision for dilapidation account. The balance, if any, may
be transferred to profit and loss account.
12.2.3 Meaning of Depreciation Accounting
Depreciation Accounting is mainly concerned with a rational and systematic
distribution of cost over the estimated useful life of the asset. According to the
American Institute of Certified Public Accountants, Depreciation Accounting
is ‘a system of accounting which aims to distribute the cost or other basic
values of the tangible capital assets less salvage (if any) over the estimated
useful life of the unit (which may be a group of assets) in a systematic and
rational manner. It is the process of allocation and not of valuation”.
The objective of Depreciation Accounting is to absorb the cost of using
the assets to different accounting periods in a way so as to give the true figure
of profit or loss made by the business.
12.2.4 Objectives of Providing Depreciation
The following are objectives of providing depreciation:
1. Ascertainment of true profits When an asset is purchased, it is
nothing more than a payment in advance for an expense. For example,
if a building is purchased for `10,000 for business, the effect of such
a purchase will be saving in the cost of rent in the future. But, after a
certain number of years, the building will become useless. The cost
of the building is, therefore, nothing except paying rent in advance
for a period of years. If the rent had been paid, it would have been
charged as an expense for determination of the true profits, made by the
business during a particular period. The amount paid for the purchase
of building should, therefore, be charged over a period of time for
which the asset would be serviceable.
2. Presentation of true financial position The assets get depreciated
in their value over a period of time on account of various factors,
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as explained before. In order to present a true state of affairs of the
258 Material
business, the assets should be shown in the Balance Sheet, at their Depreciation Accounting
proper values.
3. Replacement of assets Assets used in the business need replacement
after the expiry of their service life. By providing depreciation a part
NOTES
of the profits of the business is kept in the business which can be used
for purchase of new assets on the old fixed assets becoming useless.
12.2.5 Fixation of Depreciation Amount
Following are the three important factors which should be considered for
determining the amount of depreciation to be charged to the Profit and Loss
Account in respect of a particular asset.
1. Cost of the asset The cost of the asset includes the invoice price of the
asset, less any trade discount plus all costs essential to bring the asset
to a usable condition. It should be noted that financial charges, such as
interest on money borrowed for the purchase of the asset, should not
be included in the cost of the asset.
2. Estimated scrap value The term scrap value means the residual or
the salvage value which is estimated to be realised on account of the
sale of the asset at the end of its useful life. In determining the scrap
value, the cost to be incurred in the disposal or removing of the asset
should be deducted out of the total realisable value.
3. Estimated useful life This is also termed as economic life of the
asset. This may be calculated in terms of years, months, hours, units
of output of other operating measures such as kilometres in case of a
taxi or a truck.
12.2.6 Methods of Recording Depreciation
Depreciation can be recorded in the books of accounts by two different
methods:
1. When a provision for depreciation account is maintained In case of
this method, the amount of depreciation to be charged in a particular year
is credited to Provision for Depreciation Account and debited to Profit and
Loss Account. The Asset Account appears in the books at original cost. In
case the asset is sold, the Provision for Depreciation Account is transferred
to the Asset Account. Any amount realised on account of sale of the asset is
also credited to the Asset Account. The balance, if any, in the Asset Account
is transferred to the Profit and Loss Account.
The following journal entries are passed in case this method is followed:
(i) For providing depreciation:
Depreciation Account Dr.
To Depreciation Account
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Material 259
Depreciation Accounting (ii) For transfer of depreciation to Profit and Loss Account:
Profit and Loss Account Dr.
To Depreciation Account
NOTES (iii) On sale of asset:
(a) Provision for Depreciation Account Dr.
   To Asset Account
(b) In case of profit or loss on sale of an asset:
If Profit: Asset Account Dr.
      To Profit and Loss Account
If Loss:  Profit and Loss Account Dr.
      To Asset Account
Alternatively, on sale of an asset, an ‘asset disposal account’ may be opened.
The following entries will be passed in such a case on sale of an asset:
Asset Disposal Account Dr.
To Asset Account
(with original cost of asset)
Bank Account Dr.
To Asset Disposal Account
(with the actual sale proceeds on account of sale of asset)
Provision for Depreciation Account Dr.
To Asset Disposal Account
(with the accumulated depreciation on the asset sold)
Profit & Loss Account Dr.
To Asset Disposal
(for transfer of loss on sale of the asset)
In case of profit, the above entry would be reversed.
2. When a provision for depreciation account is not maintained In
case a provision for Depreciation Account is not maintained, the amount
of depreciation is debited to the Depreciation Account and credited to the
Asset Account. The Asset Account thus appears in the books at a written
down value (i.e., the value remaining after deducting depreciation). The
Depreciation Account is transferred to the Profit and Loss Account like any
other item of expense.
The following journal entries are passed in case depreciation is provided
according to this method:

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260 Material
(i) For providing depreciation: Depreciation Accounting

Depreciation Account Dr.


To Asset Account
(ii) For transfer of depreciation to the Profit and Loss Account: NOTES
Profit and Loss Account Dr.
To Depreciation Account
In case the asset is sold, the amount realised is credited to the Asset
Account. Any profit or loss on the sale of the asset is transferred to the Profit
and Loss Account.

Check Your Progress


1. What is amortization?
2. What does the cost of the asset include?

12.3 METHODS FOR PROVIDING DEPRECIATION


The following are the various methods for providing depreciation:
1. Uniform charge methods
(a) Fixed instalment method
(b) Depletion method
(c) Machine hour rate method
2. Declining charge or accelerated depreciation methods:
(a) Diminishing balance method
(b) Sum of years digits method
(c) Double declining method
3. Other methods:
(a) Group depreciation method
(b) Inventory system of depreciation
(c) Annuity method
(d) Depreciation fund method
(e) Insurance policy method.
1. Uniform Charge Methods
In case of these methods depreciation is charged on uniform basis year after
year. Such methods are considered appropriate only for such assets which
are uniformly productive.

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Depreciation Accounting The following three methods fall in this category.
(a) Fixed instalment method This is also termed as Straight Line Method
(SLM). According to this method, depreciation is charged evenly
NOTES every year throughout the effective life of the asset. The amount of
depreciation is calculated as follows:

The depreciation to be charged each year can also be expressed as a


percentage of cost. This percentage (R) can be calculated as follows:

or
For example, if an asset has been purchased for `10,000 and it will have
a scrap value of `1,000 at the end of its useful life of 10 years, the amount
of depreciation to be charged every year over the effective life of the asset
will be computed as follows:

= `900 each year and Rate of Depreciation (R) 9%


Merits (i) The method is simple to understand and easy to apply.
(ii) The value of the asset can be reduced to zero (or its scrap value)
under this method.
(iii) The method is very suitable, particularly in case of those assets
which get depreciated more on account of expiry of period, e.g., leasehold
properties, patents, etc.
Demerits (i) The method does not take into account the effective
utilisation of the asset. The same amount of depreciation is charged from
year to year irrespective of the use of the asset.
(ii) The total charge for use of the asset (i.e., depreciation and repairs)
goes on increasing from year to year though the asset might have been used
uniformly from year to year. For example, in the initial years, the amount spent
on repairs is quite normal. It goes on increasing in the later years. The amount
of depreciation remains the same for each year. Thus, each subsequent year
is burdened with greater charge for the use of asset on account of increasing
cost on repairs.
(iii) The method tends to report an increasing rate of return on
investment in the asset on account of the fact that net balance of the asset
account is taken. For example, if the cost of an asset is `10,000, life 10 years,
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262 Material
net revenue before charging depreciation `2,000, the earnings for the first Depreciation Accounting

three years will be calculated as follows:


Year 1 Year 2 Year 3
` ` `
Revenue 2,000 2,000 2,000 NOTES
Less: Depreciation 1,000 1,000 1,000
Profit 1,000 1,000 1,000
Book Value of the asset .......... .......... ..........
(capital employed) 10,000 9,000 8,000
Rate of Return 10% 11.1% 12.5%

The idea of an increasing rate of return as an asset approaches retirement


does not seem to be justifiable. Reason suggests that the rate of return either
remains constant or actually decreases somewhat as the asset ages.
Illustration 12.1. A firm purchases a plant for a sum of `10,000 on Ist January,
2013. Installation charges are `2,000. Plant is estimated to have a scrap
value of `1,000 at the end of its useful life of five years. You are required
to prepare Plant Account for five years charging depreciation according to
Straight Line Method.
Solution:
PLANT ACCOUNT

Date Particulars ` Date Particulars `


2013 2013
Jan. 1. To Bank 12,000 Dec. 31 By Depreciation A/c 2,200
Dec. 31 By Balance c/d 9,800
12,000 12,000
2014 2014
Jan. 1. To Balance b/d 9,800 Dec. 31 By Depreciation A/c 2,200
Dec. 31 By Balance c/d 7,600
9,800 9,800
2015 2015
Jan. 1. To Balance b/d 7,600 Dec. 31 By Depreciation A/c 2,200
Dec. 31 By Balance c/d 5,400
7,600 7,600
2016 2016
Jan.1. To Balance b/d 5,400 Dec. 31 By Depreciation A/c 2,200
Dec. 31 By Balance c/d 3,200
5,400 5,400
2017 2017
Jan. 1. To Balance b/d 3,200 Dec. 31 By Depreciation A/c 2,200
Dec. 31 By Balance c/d 1,000
3,200 3,200

Illustration 12.2. A firm writes off 95% of the cost of machinery acquired
over a period of 10 years by the straight line method, leaving 5% as estimated
scrap value. Full depreciation is written off even if the machinery is in use
only for part of a year. On 31st March, 2015, the original cost of the machinery
was as follows:

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Depreciation Accounting `
Purchased in 2004-05 or earlier 1,20,000
Purchased in 2006-07 40,000
Purchased in 2010-11 30,000
NOTES On 30th September, 2015, a machine which had cost of `10,000 in
2003-04 was disposed of for `900; and on 28th February, 2016, a machine
acquired in 2010-11 at a cost of `15,000 was sold for `5,000. On the same
date, a new machinery was acquired for `45,000.
Prepare the machinery account for the year 2015-16, the accounts being
closed on 31st March each year.
Solution:
Dr. MACHINERY ACCOUNT Cr.

Date Particulars ` Date Particulars `


2015 2015
Apr. 1 To Balance b/d (WN1) 27,550 Sept. 30 by Bank 900
Sept. 30 To P & L A/c (Profit) 400
2016 2016
Feb. 28 To Bank 45,000 Feb. 28 By Bank 5,000
Feb. 28 By Depreciation 1,425
Feb. 28 By P & L A/c (Loss) 1,450
Mar. 31 By Depreciation A/c:
Machine purchased in
2000-01 3,800
2004-05 1,425
2009-10 4,275 9,500
By Balance c/d 54,675
72.950 72,950
2017
Apr. 1 To Balance b/d 54,675

Working Notes:
1. Computation of Opening Balance of Machinery Account on 1st April, 2015: ` `
Machinery purchased in 2004-05 or earlier:
At Scrap Value, i.e., 5% of `1,20,000 6,000
Machinery purchased in 2006-07:
Scrap Value: i.e., 5% of `40,000 2,000
Add: Balance of Depreciation for one year
`(40,000 – 2,000) × 1/10 3,800 5,800
Machinery purchased in 2010-11:
Scrap value: i.e., 5% of `30,000 1,500
Add: Balance of Depreciation for 5 years
`(30,000 – 1,500) × 5/10 14,250 15,750
Balance of Machinery A/c as on 1.4.2015 27,550
2. Computation of Machinery on 30th Sept. 2015:
Sale of Machinery on 30th Sept. 2015 900
Less: Book Value of Machinery i.e., Scrap Value: 5% of `10,000 500
Profit on sale of Machinery 400
3. Depreciation on Machinery sold on 28th Feb. 2016:
Depreciation for one year `(15,000 – 750) × 1/10 1,425
4. Loss on sale of machinery on 28th Feb., 2016:
Book Value on 1st April, 2015 `750 + (15,000 – 750) × 5/10 7,875
Less: Depreciation for the year `(15,000 – 750) × 1/10 1,425
6,450
Less: Sale Proceeds of Machine 5,000
Loss on sale of Machine 1,450
5. Depreciation on Machinery purchased on 28th Feb., 2016:

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(b) Depletion method This is also known as productive output method. Depreciation Accounting
According to this method the charge for depreciation in respect of the use
of an asset will be based on the following factors:
(i) Total amount paid.
NOTES
(ii) Total estimated quantities of the output available.
(iii) The actual quantity taken out during the accounting year.
The method is suitable in case of mines, queries, etc., where it is possible
to make an estimate of the total output likely to be available. Depreciation
is calculated per unit of output. The amount of depreciation to be charged
in a particular year is computed by multiplying the unit of output with the
rate of depreciation per unit of output. For example, if a mine is purchased
for `20,000 and it is estimated that the total quantity of mineral in the mine
is 40,000 tonnes, the rate of depreciation per tonne would amount to 50
paise per tonne (`20,000/40,000 tonnes). In case output in a year amounts
to 10,000 tonnes, the amount of depreciation to be charged to the Profit and
Loss Account would `5,000 (i.e., 10,000 tonnes × `0.50).
The method has the advantage of correlating the amount of depreciation
with the productive use of the asset. However, it requires making of a
reasonably correct estimate of the output likely to be there. In the absence
of correct estimate, the amount charged by way of depreciation will not be
correct.
(c) Machine hour rate method This is also known as Service Hours Method.
This method takes into account the running time of the asset for the purpose
of calculating depreciation. The method is particularly suitable for charging
depreciation on plant and machinery, aircraft, etc. The amount of depreciation
is calculated as follows:

For example, if a machine (having a scrap value of `1,000) is purchased


for ` 20,000 and it has an effective life of 10 years of 1,000 hours each, the
amount of depreciation per hour will be computed as follows:

This means that, there will be a depreciation of 90 paise in case


machine runs for an hour. If, in a particular year, the machine runs for 600
hours, the amount of depreciation will be `540 (i.e., `90 × 600).
The method has the advantage of correlating the charge for depreciation,
to the actual working time of the machine. However, this method can be
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Material 265
Depreciation Accounting used only in case of those assets whose life can be measured in terms of
working time.
2. Declining Charge Depreciation Methods
NOTES In case of these methods the amount charged for depreciation declines over
the asset’s expected life. These methods are suitable in those case where
(a) the receipts are expected to decline as the asset gets older and (b) it is
believed that the allocation of depreciation should be related to the pattern
of asset’s expected receipts.
The following methods fall in this category.
(a) Diminishing balance method According to this method,
depreciation is charged on the book value of the asset each year. Thus, the
amount of depreciation goes on decreasing every year. For example, if the
cost of an asset is `20,000, and the rate of depreciation is 10%, the amount
of depreciation to be charged in the first year will be a sum of `2,000. In the
second year, depreciation will be charged at 10% on the book value of the
asset, (i.e., `20,000 – `2,000) and so on.
The formula for calculating the rate of depreciation under diminishing
balance method (where ‘n’ = years of economic life of the asset) is as
follows:

For example, if the cost of an asset is `10,000, residual value `1,296,


economic life 4 years, the rate of depreciation would be 40% calculated as
follows:

Depreciation rate
Merits
(i) The method puts an equal burden for use of the asset on each
subsequent year. The amount of depreciation goes on decreasing for
each subsequent year while the charge for repairs goes on increasing
for each subsequent year. Thus, increase in the cost of repairs for
each subsequent year is compensated by decrease in the amount of
depreciation for each subsequent year.
(ii) The method is simple to understand and easy to follow.
Demerits
(i) The value of the asset cannot be brought down to zero under this
method.
(ii) The determination of a suitable rate of depreciation is also difficult
Self-Instructional under this method as compared to the Fixed Instalment Method.
266 Material
Straight Line Method and Diminishing Balance Method Depreciation Accounting

The difference between straight line method and diminishing balance method
can be put as follows:
(a) Amount on depreciation In case of straight line method, the amount NOTES
of depreciation remains same throughout the life of the asset. While
in case of diminishing balance method, the amount of depreciation is
more during the earlier years of the life of the asset as compared to
the later years. Thus, the amount of depreciation charged every year
is not the same.
(b) Value on expiry of the life of the asset In case of straight line method,
the value of the asset on expiry of its life becomes zero. While in case
of diminishing balance method, the value at the end of the life of the
asset would never become zero.
(c) Overall charge for the use of the asset In case of fixed instalment
method, the overall charge for use of the asset goes on increasing
because of fixed amount of depreciation plus increasing cost of repairs
year after year. While in case of diminishing balance method, the overall
cost for use of the asset almost remains the same year after year. This
is because of decrease in the amount of depreciation and increase in
the cost of repairs.
Illustration 12.3. A firm purchases plant and machinery on 1st January, 2015
for `10,000. Prepare the Plant Account for three years charging depreciation
@ 10% p.a. according to the Diminishing Balance Method.
Solution:
PLANT AND MACHINERY ACCOUNT

Date Particulars ` Date Particulars `


2015 2015
Jan. 1 To Bank 10,000 Dec. 31 By Depreciation 1,000
Dec. 31 By Balance c/d 9,000
10,000 10,000
2016 2016
Jan. 1 To Balance b/d 9,000 Dec. 31 By Depreciation 900
Dec. 31 By Balance c/d 8,100
9,000 9,000
2017 2017
Jan. 1 To Balance b/d 8,100 Dec. 31 By Depreciation 810
Dec. 31 By Balance c/d 7,290
8,100 8,100

(b) Sum of years digits (SYD) method This method is on the pattern
of Diminishing Balance Method. The amount of depreciation to be charged
to the Profit and Loss Account under this method goes on decreasing every
year. The depreciation is calculated according to the following formula:

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Depreciation Accounting For example, if the cost of an asset is `10,000 and it has an effective
life of 5 years, the amount of depreciation to be written off each year will
be computed as follows:

NOTES

(c) Double declining balance method This method is similar to


reducing or declining balance method explained above except that the rate
of depreciation is charged at the rate which is twice the straight line rate.
While computing this rate two things have been kept in mind :
(a) No allowance is to be made for the scrap value of the asset.
(b) The total cost should not be reduced by charging the depreciation
to an amount lower than the estimated scrap value of the asset.
The method is prevalent in USA and is permitted under the federal tax laws.
Illustration 12.4. A plant having a scrap value of `1,000 and life of 5 years
was purchased for `10,000 in January, 2015. You are required to calculate the
amount of depreciation for each of the years according to Double Declining
Method.
Solution:
According to the Fixed Instalment Method (without considering the salvage
value) the depreciation would amount to `2,000 (i.e., `10,000, 5 years) each
year. The rate of depreciation, therefore, comes to 20%. In case of Double
Declining Method the rate of depreciation would be the twice of this rate,
i.e., 40%. The amount of depreciation for each year would, therefore, be as
follows:
Book value in the beginning
Year Amount of Depreciation
of the year
1 10,000 4,000
2 6,000 2,400
3 3,600 1,440
4 2,160 860
5 1,300 300*

* The depreciation at 40% comes to `520. However, since the value of


the asset has not to be reduced below the scrap value of the asset (i.e.,
`1,000), only a sum of `300 will be charged by way of depreciation.

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The declining charge methods of depreciation are preferred over Depreciation Accounting

uniform charge methods of depreciation on account of the following reasons:


(i) The total cost for use of the asset is evenly spreaded over the useful
life of the asset. Such cost of the use of the asset includes both
NOTES
depreciation and repairs. With the asset growing older, the repairs
cost goes on increasing while the amount of the depreciation goes on
decreasing. Thus, increase in repairs cost is compensated by decrease
in depreciation cost.
(ii) The rate of depreciation in case of declining charge methods of
depreciation is higher as compared to the rates in case of uniform
charge methods of depreciation. Thus, the charge for depreciation in
the initial years will be more and this will result in a considerable tax
advantage to the business in these years when the demand for funds
is also more. Higher depreciation in the initial years is also beneficial
because a rupee saved today is much more important than a rupee saved
in future. Thus, accelerated depreciation creates a shield that enables
the business to retain more resources in the early years than it can be
under straight line method. These resources can be reinvested for more
profits.
3. Other Methods
The following are some of the other methods of providing depreciation.
(a) Group depreciation method Under this method all homogeneous
assets, generally having similar average life expectancy are grouped
together in a single asset category. One summary account is established
for each group and original cost of all assets in the group is charged
to this account. Depreciation is charged for the group in total and not
item by item. The essential features of this method are as follows:
(i) A summary account is established for each category of
homogeneous assets, e.g.,10 motor vehicles owned by a company
may be put in one account while 15 typewriters owned by the
company may be put in another account.
(ii) Depreciation is charged for the group in total at a rate based on
expected average service life and scrap values of the assets of the
group.
(iii) On purchase of an asset the group asset account is debited with
cost.
(iv) The amount of depreciation is calculated on the balance in the
group asset account. It is debited to Depreciation Account (or P.
& L. Account) and credited to Accumulated Depreciation Account.
(v) In case an asset is sold the amount received on account of sale
of the asset is credited to group asset account. The difference
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Material 269
Depreciation Accounting between the cost of the asset and the sales value is transferred to
Accumulated Depreciation Account.
It should be noted that no single item of the group can be considered
to have a book value. Hence, no gain or loss is recorded on disposal of any
NOTES
item of the group in the normal course of events.
Illustration 12.5. A company purchased 10 identical machines on January
1st at a cost of `11,000 each. Each having a zero scrap value and an average
life of 5 years. At the end of the 2nd year the company sold one machine for
`6,000 and purchased another for `14,000 in the beginning of the 3rd year.
Journalise the above transaction in the books of the company for the
1st three years.
Solution:
COMPUTATION OF DEPRECIATION RATE
Cost of 10 machines (10 × 11,000) `1,10,000
Less. Scrap value Nil
Depreciation to be written off over 5 years 1,10,000
Yearly Depreciation 22,000
Rate of Depreciation: 20%

JOURNAL

Date Particulars Dr. ` Cr. `


1st Year Machines A/c Dr. 1,10,000
To Bank 1,10,000
(For machines purchased)
Depreciation A/c Dr. 22,000
To Accumulated Depreciation A/c 22,000
(For depreciation @ 20% on `1,10,000)
2nd Year Depreciation A/c Dr. 22,000
To Accumulated Depreciation A/c 22,000
(For depreciation on `1,10,000)
Bank A/c Dr. 6,000
Accumulated Depreciation A/c Dr. 5,000
To Machines A/c 11,000
(Being sale of machine)
3rd Year Machines A/c Dr. 14,000
To Bank 14,000
(Being purchase of Machine)
Depreciation A/c Dr. 22,600
To Accumulated Depreciation A/c 22,600
(Being depreciation of Machines on `1,13,000 @20%)

(b) Inventory system of depreciation The method is followed in case of


those assets which are of small values such as loose tools or where the life
of the asset cannot be ascertained with certainty e.g., livestock etc. In case
of these assets the depreciation is charged on the following basis:
Cost of the assets in working condition at the beginning of the accounting year .......
Add: Cost of the assets purchased during the accounting year .......
Less: Cost of the assets in working condition at the end of the accounting year .......
Depreciation to be charged .......

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For example, a firm has loose tools in working condition costing `2,000 on 1.1.2016 Depreciation Accounting
and purchased during 2015 loose tools of `3,000. The cost of the loose tools in working
condition on 31.1.2016 is `2,000. The amount of depreciation to be charged to the Profit &
Loss Account comes to `3,000 (i.e., `2,000 + 3,000 – `2,000).
The following journal entry is passed for recording the amount of depreciation: NOTES
Depreciation A/c Dr.
To Asset Account

(c) Annuity method The Fixed Instalment Method and the Reducing
Balance Method of charging depreciation ignore the interest factor. The
Annuity Method takes care of this factor. Under this method, the depreciation
is charged on the basis that besides losing the original cost of the asset, the
business also loses interest on the amount used for buying the asset. The
term “Interest” here means the interest which the business could have earned
otherwise if the money used in purchasing the asset would have been invested
in some other form of investment. Thus, according to this method, such an
amount is charged by way of depreciation which takes into account not only
the cost of the asset but also interest thereon at an accepted rate. The amount
of interest is calculated on the book value asset, in the beginning of each
year. The amount of depreciation is uniform and is determined on the basis
of annuity table.
The following journal entries are passed in case depreciation is charged
according to this method.
(i) On purchase of asset:
Asset Account Dr.
  To Bank
(ii) For charging interest:
Asset Account Dr.
    To Interest Account
(iii) For charging depreciation:
Depreciation Account Dr.
  To Asset Account

Illustration 12.6. A firm purchases a leasehold property for a period of five


years for `10,000 on 1.1.2013. It decides to write off the lease by Annuity
Method presuming the rate of interest at 5% p.a. The Annuity Table shows
that the annual amount necessary to write off `1 at 5% p.a. is `0.230976.
You are required to prepare the Lease Hold Property Account for five years
and show the net amount to be charged to the Profit & Loss Account for
these five years.

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Depreciation Accounting Solution:
Dr. LEASEHOLD PROPERTY ACCOUNT Cr.

Date Particulars ` Date Particulars `


NOTES 2013
Jan. 1 To Bank 10,000.00
2013
Dec. 31 By Depreciation 2,309.76
Dec. 31 To Interest 500.00 Dec. 31 By Balance c/d 8,190.24
10,500.00 10,500,00
2014 2014
Jan. 1 To Balance b/d 8,190.24 Dec. 31 By Depreciation A/c 2,309.76
Jan. 31 To Interest 409.52 Dec. 31 By Balance c/d 6,290.00
8,599.76 8,599.76
2015 2015
Jan. 1 To Balance b/d 6,290.00 Dec. 31 By Depreciation A/c 2,309.76
Dec. 31 To Interest 314.50 Dec. 31 By Balance c/d 4,294.74
6,604.50 6,604.50
2016 2016
Jan. 1 To Balance b/d 4,294.74 Dec. 31 By Depreciation A/c 2,309.76
Dec. 31 To Interest 214.74 Dec. 31 By Balance c/d 2,199.72
4,509.48 4,509.48
2017 2017
Jan. 1 To Balance b/d 2,199.72 Dec. 31 By Depreciation A/c 2,309.76
Dec. 31 To Interest 110.04
2,309.76 2,309.76

Statement showing the amount chargeable to the Profit & Loss Account
Year Depreciation (debited) Interest (credited) Net Charge against profits
2013 2,309.76 500.00 1,809.76
2014 2,309.76 409.52 1,900.24
2015 2,309.76 314.50 1,995.26
2016 2,309.76 214.74 2,095.02
2017 2,309.76 110.04 2,199.72
11,548.80 1,548.80 10,000.00

(d) Depreciation (or sinking) fund method One of the objectives of


providing for depreciation (as explained earlier) is to provide for replacement
of the asset at the end of its useful life. In case of the three methods discussed
earlier, the amount of depreciation charged from the Profit & Loss Account
continues to remain in the business. However, this amount may get invested
in the course of running the business is some other assets. It may, therefore,
not be possible for the business to have sufficient liquid resources to purchase
a new asset at the time when it needs funds for replacement. Depreciation
Fund Method takes care of such a contingency. According to this method,
the amount charged by way of depreciation is invested in certain securities
carrying a particular rate of interest. The amount received on account of
interest from these securities is also invested from time to time together with
the annual amount charged by way of depreciation. At the end of the useful
life of the asset, when replacement is required, the securities are sold away
and money realised on account of the sale of the securities is used for purchase
of a new asset. The method has the advantage of providing a separate sum
for replacement of the asset. However, the method has a disadvantage. It
puts an increasing burden on the profit and loss of each year on account of
a fixed charge for depreciation but increasing charge for repairs.
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The accounting entries are as follows: Depreciation Accounting

(a) At the end of the 1st accounting year


(i) On setting aside the amount for depreciation:
Depreciation Account (or Profit & Loss Account) Dr.
NOTES
   To Depreciation Fund Account
(The amount to be charged by way of depreciation
is determined on the basis of Sinking Fund Table)
(ii) For investing the money charged by way of depreciation:
Depreciation Fund Investment A/c Dr.
   To Bank

(b) At the end of each subsequent accounting year


(iii) For receipt of interest
Bank A/c Dr.
   To Depreciation Fund A/c
(Interest will be received at the specified rate
on balance of Depreciation Fund Investment
outstanding in the beginning of each year)
(iv) For setting aside the amount of depreciation:
Profit and Loss A/c Dr.
   To Depreciation Fund A/c
(v) For investing the money:
Depreciation Fund Investment A/c Dr.
   To Bank
(Annual instalment plus interest received)

(c) At the end of the last year


(vi) For receipt of interest:
Bank A/c Dr
To Depreciation Fund A/c
(vii)For setting aside the amount for depreciation:
Profit and Loss A/c
   To Depreciation Fund A/c
(No investment will be made at the end of the last year since the asset is due for replacement
and no purpose will be served by simply investing the money and then selling the investment
either on the same day or on the subsequent day.)
(viii) For the sale of investments:
 Bank A/c Dr.
   To Depreciation Fund Investment A/c
(ix) The profit or loss on sale of Depreciation Fund Investments will be transferred to
the Depreciation Fund Account.
(x) For sale of the old asset:
Bank A/c Dr.
   To Asset Account
(xi) The balance in the Depreciation Fund represents accumulated depreciation. It will
be transferred to the Old Asset Account.

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Depreciation Accounting (xii) The balance in the Old Asset Account represents profit or loss. It will be transferred
to the Profit and Loss Account.
(xiii) The proceeds realised on account of sale of the asset and investment will be utilised
for purchase of new asset.
NOTES New Asset A/c Dr.
   To Bank

Illustration 12.7. Suresh bought a plant on 1.1.2013 for a sum of `1,00,000


having a useful life of 5 years. It is estimated that the plant will have a
scrap value of `16,000 at the end of its useful life. Suresh decides to charge
depreciation according to depreciation fund method. The depreciation fund
investments are expected to earn interest @ 5% p.a. Sinking Fund table
shows that `0.180975 if invested yearly at 5% p.a. produces `1 at the end
of 5 years. The investments are sold at the end of 5th year for a sum of
`65,000. A new plant is purchased for `1,20,000 on 1.1.2018. The scrap of
the old plant realises `17,000.
You are required to prepare the necessary accounts in the books of
Suresh.
Solution:
PLANT ACCOUNT

Date Particulars ` Date Particulars `


2013 2013
Jan. 1 To Bank 1,00,000 Dec. 31 By Balance c/d 1,00,000
2014 2014
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Balance c/d 1,00,000
2015 2015
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Balance c/d 1,00,000
2016 2016
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Balance c/d 1,00,000
2017 2017
Jan. 1 To Balance b/d 1,00,000 Dec. 31 By Depreciation Fund A/c 83,478
Dec. 31 To P. & L. A/c (Profit) 478 Dec. 31 By Bank (Scrap sold) 17,000
1,00,478 1,00,478

NEW PLANT ACCOUNT

Date Particulars ` Date Particulars `


2018
Jan.1 To Bank A/c 1,20,000

DEPRECIATION FUND ACCOUNT

Date Particulars ` Date Particulars `


2013 2013
Dec. 31 To Balance c/d 15,202 Dec. 31 By P. & L. A/c 15,202
2014 2014
Dec. 31 To Balance c/d 31,164 Jan. 1 By Balance b/d 15,202
Dec. 31 By Bank (Interest) 760
Dec. 31 By P. & L. A/c 15,202
31,164 31,164
2015 2015
Dec. 31 To Balance c/d 47,924 Jan. 1 By Balance b/d 31,164
Dec. 31 By Bank (Interest) 1,558
Dec. 31 By P. & L. A/c 15,202
47,924 47,924
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2016 2016 Depreciation Accounting
Dec. 31 To Balance c/d 65,522 Jan. 1 By Balance b/d 47,924
Dec. 31 By Bank (Interest) 2,396
Dec. 31 By P. & L. A/c 15,202
65,522 65,522
2017 2017
Dec. 31 To Depreciation Jan. 1 By Balance b/d 65,522 NOTES
Fund Investment A/c 522 Dec. 31 By Bank (Interest) 3,276
(loss on sale of Dec. 31 By P. & L. A/c 15,202
investment)
Dec. 31 To Plant A/c
(accumulated 83,478
depreciation)
84,000 84,000

DEPRECIATION FUND INVESTMENT ACCOUNT

Date Particulars ` Date Particulars `


2013 2013
Dec. 31 To Bank 15,202 Dec. 31 By Balance c/d 15,202
15,202 15,202
2014 2014
Jan. 1 To Balance b/d 15,202 Dec. 31 By Balance c/d 31,164
Dec. 31 To Bank (15,202 + 760) 15,962
31,164 31,164
2015 2015
Jan. 1 To Balance b/d 31,164 Dec. 31 By Balance c/d 47,924
Dec. 31 To Bank (15,202 + 1,558) 16,760
47,924 47,924
2016 2016
Jan. 1 To Balance b/d 47,924 Dec. 31 By Balance c/d 65,522
Dec. 31 To Bank (15,202 + 2,396) 17,598
65,522 65,522
2017 2017
Jan. 1 To Balance b/d 65,522 Dec. 31 By Bank 65,000
By Depreciation Fund A/c 522
(loss on sale of
investment)
65,522 65,522

Note: The amount to be charged to the Profit and Loss Account has been
arrived as follows:
Original Cost of the Plant 1,00,000
Less: Estimated scrap value 16,000
Depreciation on the plant for its whole life 84,000
   The amount to be charged to the
Profit and Loss Account = `84,000 × 0.180975 = `15,201.90 or `15,202
(e) Insurance policy method The method is similar to the Depreciation
Fund Method as explained above. However, instead of investing the money
in securities an insurance policy for the required amount is taken. A fixed
amount as premium is paid every year. However, this amount will have to
be paid in the beginning of each year. At the end of the specified period, the
insurance company pays the agreed amount with which the new asset can
be purchased.

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Material 275
Depreciation Accounting The accounting entries can be put as follows:
(i) First and subsequent years
In the beginning of the year for insurance premium paid:
Depreciation Insurance Policy A/c Dr.
NOTES
To Bank
At the end of the year for providing depreciation:
Profit and Loss A/c Dr.
To Depreciation Provision A/c
(with the amount of premium paid)
(ii) At the end of the last year
On realisation of money from the insurance company:
  Bank A/c Dr.
   To Depreciation Policy A/c
For transfer of profit on insurance policy:
Depreciation Provision A/c Dr.
   To Depreciation Provision A/c
For transfer of accumulated depreciation to the Asset Account:
  Depreciation Provision A/c
   To Asset A/c
On purchase of new asset:
   New Asset A/c Dr.
   To Bank

Illustration 12.8. A firm purchases a lease for 3 years for `30,000 on 1.1.2014.
It decided to provide for its replacement by means of Insurance Policy for
`30,000. The annual premium is `9,500.
On 1.1.2017, the lease is renewed for a further period of 3 years for
`30,000. You are required to show the necessary Ledger Accounts.
Solution:
LEASE ACCOUNT

Date Particulars ` Date Particulars `


2014 2014
Jan. 1 To Bank 30,000 Dec. 31 By Balance c/d 30,000
2015 2015
Jan. 1 To Balance b/d 30,000 Dec. 31 By Balance c/d 30,000
2016 2016
Jan. 1 To Balance b/d 30,000 Dec. 31 By Dep. Provision A/c 30,000

DEPRECIATION PROVISION ACCOUNT

Date Particulars ` Date Particulars `


2014 2014
Dec. 31 To Balance c/d 9,500 Dec. 31 By P & L A/c 9,500
2015 2015
Dec. 31 To Balance c/d 19,000 Jan. 1 By Balance b/d 9,500
Dec. 31 By P & L A/c 9,500
19,000 19,000

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Date Particulars Date Particulars
Depreciation Accounting
` `
2016 2016
Dec. 31 To Lease Account 30,000 Jan. 1 By Balance b/d 19,000
Dec. 31 By P & L A/c 9500
Dec. 31 By Depreciation
Insurance NOTES
Policy A/c 1,500
30,000 30,000

DEPRECIATION INSURANCE POLICY ACCOUNT

Date Particulars ` Date Particulars `


2014 2014
Jan. 1 To Bank – (Premium) 9,500 Dec. 31 By Balance c/d 9,500
2015 2015
Jan. 1 To Balance b/d 9,500 Dec. 31 By Balance c/d 19,000
Jan. 1 To Bank – (Premium) 9,500
19,000 19,000
2016 2016
Jan. 1 To Balance b/d 19,000 Dec. 31 By Bank 30,000
Jan. 1 To Bank – (Premium) 9,500
Dec. 31 To Profit – (Transferred to
Depreciation Provision 1,500
A/c)
30,000 30,000

LEASE (NEW) ACCOUNT

Date Particulars ` Date Particulars `


2017
Jan. 1 To Bank 30,000

Check Your Progress


3. List the different declining charge or accelerated depreciation methods.
4. Define the sum of the years digits method.
5. State the disadvantage of the depreciating (or sinking) fund method.

12.4 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. Amortization is the process of writing off intangible assets.
2. The cost of the asset includes the invoice price of the asset, less nay
trade discount plus all costs essential to bring the asset to a usable
condition.
3. The different declining charge or accelerated depreciation methods
are: Diminishing balance method, sum of the years digits method and
double declining method.
4. The sum of the years digit method is on the pattern of diminishing
balance method. The amount of depreciation to be charged to the Profit
and Loss Account under this method goes on decreasing every year.
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Depreciation Accounting 5. The disadvantage of the depreciating (or sinking) fund method is that it
puts an increasing burden on the profit and loss of each year on account
of a fixed charge for depreciation but increasing charge for repairs.

NOTES 12.5 SUMMARY


· Depreciation may, therefore, be defined as that portion of the cost of
the assets that is deducted from revenue for assets services used in the
operation of a business. Depreciation is thus allocating the cost of assets
to the business over the useful life of the asset. It is thus a process of
allocation and not of valuing the assets.
· There are varied causes of depreciation: wear and tear, exhaustion,
obsolescence, efflux of time and accidents.
· Features of depreciation include: The term ‘depreciation’ is used only
in respect of fixed assets, Depreciation is a charge against profits,
Depreciation is different from maintenance and all fixed assets,
with certain possible exceptions, e.g., land, and antiques etc., suffer
depreciation although the process may be invisible or gradual.
· Depletion implies removal of an available but irreplaceable resource
such as extracting coal from a coal mine or oil out of an oil well.
· The process of writing off intangible assets is termed as amortization.
Some intangible assets like patents, copyrights, leaseholds have a
limited useful life. Hence, their cost must be written off over such
period.
· The term dilapidation refers to damage done to a building or other
property during tenancy. When a property is taken on lease, is returned
to the landlord he may ask the lessee as per agreement to put it in as
good condition as it was at the time it was leased out.
· Depreciation Accounting is mainly concerned with a rational and
systematic distribution of cost over the estimated useful life of the
asset. The objective of Depreciation Accounting is to absorb the cost
of using the assets to different accounting periods in a way so as to
give the true figure of profit or loss made by the business.
· The objective of depreciation accounting are: ascertainment of true
profits, presentation of true financial position, replacement of assets.
· Three important elements are considered for determining the amount of
depreciation to be charged to the Profit and Loss Account in respect of
a particular asset: cots of the asset, estimated scrap value, and estimated
useful life.
· The methods of recording depreciation include: when a provision
for depreciation account in maintained and when a provision for
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278 Material
· The major methods for providing depreciation are: Uniform charge Depreciation Accounting

methods, declining charge methods and other methods.


· Uniform charge methods include: (a) Fixed instalment method,
(b) Depletion method and (c) Machine hour rate method. NOTES
· Declining charge or accelerated depreciation methods: (a) Diminishing
balance method, (b) Sum of years digits method and (c) Double
declining method.
· Other methods: (a) Group depreciation method, (b) Inventory system
of depreciation, (c) Annuity method (d) Depreciation fund method and
(e) Insurance policy method.

12.6 KEY WORDS


· Amortization: The process of writing off the intangible assets.
· Depletion: The portion of the cost of the natural resources recognised
as an expense for each period.
· Depreciation: The portion of the cost of tangible operating assets
(other than land) recognised as an expense for each period.
· Depreciation Accounting: A system of accounting which aims to
distribute the cost or other basic values of tangible capital assets (less
salvage, if any) over the estimated useful life of the asset in a systematic
and rational manner.
· Dilapidation: Damage done to a building or other property during the
tenancy.

12.7 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answers Questions


1. Explain the need and significance of depreciation?
2. What factors should be considered for determining amount of
depreciation?
3. Write short notes on:
(a) Group Depreciation Method;
(b) Double Declining Balance Method; and
(c) Accounting Standard 6 (Revised): Depreciation Accounting.
(d) Depreciation Fund
4. What is Depreciation?
5. Discuss the merits and demerits of Sinking Fund Method of depreciation.
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Material 279
Depreciation Accounting Long Answers Questions
1. Distinguish between “straight line method” and “diminishing balance
method” of providing depreciation. Which one of the above two
NOTES methods would you recommend to provide depreciation on Plant and
Machinery?
2. Explain the circumstances under which different methods of
depreciation can be employed.
3. What do you mean by “replacement cost”? What are the difficulties
faced while providing depreciation on the basis of replacement lost.
4. Explain the salient features of accounting standard regarding dpreciation
as per AS: 10 Property, Plant and Equipment.

12.8 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel and Sharad. 2018. An Introduction to Accountancy,
12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narangjk, K.L. 2001. Advanced Accountancy. New Delhi:
Kalyani Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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Company Accounts-I

UNIT 13 COMPANY ACCOUNTS-I


Structure NOTES
13.0 Introduction
13.1 Objectives
13.2 Meaning and Characteristics of Companies
13.3 Kinds of Companies
13.4 Formation of Companies
13.5 Share Capital
13.6 Undersubscription, Oversubscription and Issue of Shares at Premium and
Discount
13.7 Buyback of Shares and Treasury Stock
13.8 Answers to Check Your Progress Questions
13.9 Summary
13.10 Key Words
13.11 Self Assessment Questions and Exercises
13.12 Further Readings

13.0 INTRODUCTION
Joint Stock Companies represent the third stage in the evolution of forms
of business organisation. Unlike sole proprietorship and partnership firms,
a company enjoys a separate legal status. The ownership is here divorced
from the management. The shareholders contribute towards the finances of
the company but all of them do not and cannot participate in the management
of the company. The company is managed by a Board of Directors elected by
shareholders. Thus, in a company form of business organisation, a shareholder
simply acts as a supplier of capital. The law applicable to companies in India
has largely been based upon the laws of companies in England. An Act for
registrations of joint stock companies in India was first passed in 1850 on
the pattern of English Companies Act of 1844. The Act was subsequently
amended in 1857 and 1860. This Act of 1850 was replaced by the Companies
Act of 1913. The Act was also amended several times between 1936 and
1956. However, all these amendments proved inadequate. As a result as per
the recommendation of C.H. Bhabha Committee, the Companies Act of 1956
was enacted to replace the Companies Act of 1913.
The Companies Act 1956 came into effect from 15th April, 1956. The
Act has been amended several times. Some of the important amendments
have been in 1960, 1963, 1966, 1969, 1974, 1977, 1981, 1988, 2000, 2001,
2002 and 2006.
However, this piecemeal re-engineering of the corporate regulatory
framework was not considered adequate to meet changes in the national and
international economic environment and the need to ensure greater autonomy
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Material 281
Company Accounts-I of operation and innovation to corporates. In the above backdrop the review
of the Companies Act 1956 and drafting of a new Companies Bill was taken
up by the Government. An Export Committee on company law under the
chairmanship of Dr. J.J. Irani was constituted on 2nd December, 2004 to
NOTES make recommendation in respect of new company law.
The process of overhauling the Company Law was taken in right
earnest in October, 2008. Finally a comprehensive Companies Bill 2009
was introduced in the Lok Sabha. After meeting several hurdles, the bill
was finally passed by both Houses of Parliament on 8th August, 2013. It
received the President’s assent on 29th August, 2013 and has now become the
Companies Act, 2013. The Act has been further amended by The Companies
(Amendment) Act, 2015 and The Companies (Amendment) Act 2017. The
relevant changes have been incorporated at proper places in the book.

13.1 OBJECTIVES
After going through this unit, you will be able to:
· Describe the meaning and characteristics of companies
· Explain the kinds of companies
· Discuss the formation of companies
· Examine the important concepts related to share capital

13.2 MEANING AND CHARACTERISTICS OF


COMPANIES
In common parlance, company means, an association of persons formed
for the economic gain of its members. However, in law, any association of
persons for any common object can be registered as a company. The object
need not be the economic gain of its members, e.g., a company can be formed
for purposes such as charity, research, advancement of knowledge, etc.
In the words of Justice Lindley, “A company is an association of many
persons who contribute money or money’s worth to a common stock and
employ it for a common purpose. The common stock so contributed is denoted
in money and is the capital of the company. The persons who contribute it or
to whom it belongs, are members.” (Late) Chief Justice Marshall of USA has
defined a company as “a person, artificial, invisible, intangible and existing
only in the eyes of the law. Being a mere creature of law, it possesses only
those properties which the charter of its creation confers upon it, either
expressly or as incidental to its very existence.”
The Companies Act 2013, defines a company as “a company
incorporated under this Act or an existing company.” ‘An existing company’
means a company formed and registered under any of the former Companies
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282 Material
Act. It is to be noted that some sole proprietorship and partnership firms use Company Accounts-I
the word ‘Company’ as a part of their names, e.g., Ram & Company, Shyam
& Company. Such firms are not companies within the meaning of the Act.
A company thus exists, only in the contemplation of law. It has no
NOTES
physical existence. Right to act as a natural being is granted to it by law.
Law creates it and law alone can dissolve it.
Essential Characteristics of a Company
Following are the essential characteristics of a company:
Voluntary association A company is a voluntary association of persons,
i.e., it can neither compel a person to become its member nor to give up its
membership. It is the personal choice of people and their objective to make
profits which leads them to become members of a company.
Independent legal entity A company is a legal entity quite distinct and
separate from its members. It can hold and deal with any type of property—
of which it is the owner—in any way it likes; can enter into contracts, open
a bank account in its own name, sue and be sued by its members as well as
outsiders.
On account of this independent corporate existence, the creditors of
a company are creditors of the company alone and their remedy lies against
the company and its property only and not against any of its members. Law
recognises the existence of the company as quite distinct, irrespective of the
motives, intentions, scheme of conduct of the individual shareholders.
Perpetual existence A company has perpetual succession. The mode of
incorporation and dissolution of a company and the right of the members
to transfer shares freely, guarantees the continuity of the existence of the
company quite independent of the life of the members. The existence of a
company can be terminated only by law. Thus, members may come and go,
but the company can go on for ever.
Common seal A company being an artificial entity, acts through other
natural persons, who are called directors. They act as agents to the company
but not to its members. All the acts of the company are authorised by its
common seal. The common seal is the official signature of the company. A
document not bearing the common seal of the company will not be binding
on the company.
The Companies (Amendment) Act, 2015 has removed the requirement
of the common seal by amending Section 9 of the Companies Act, 2013.
In case a company does not have a common seal, the authorization of any
document on behalf of the company can be executed by two directors or by
a director and the company secretary, where appointed.

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Material 283
Company Accounts-I Limited liability The liability of the members of a company is generally
limited to the extent of the unpaid value of the shares held by them. In the
case of a guarantee company, the members are liable to contribute a specified
agreed sum to the assets of the company in the event of the company being
NOTES wound up if its assets fall short of its liabilities.
Transferability of shares The shares of a joint stock company are freely
transferable. However, in the case of private companies they are transferable
subject to the restrictions put by the company’s articles.

13.3 KINDS OF COMPANIES


Let’s discuss the various kinds of companies in this section.
1. Statutory Companies
A company formed by a special Act passed either by the Central or State
Legislature is called a Statutory Company or a Statutory Corporation. Such
companies or corporations are governed by their respective Acts, and are not
required to have any Memorandum or Articles of Association. Changes in
their structure are possible only by legislative amendments. Annual Report
on the working of each such company is required to be placed on the table
of the Parliament. The audit of such companies is conducted under the
supervision, control and guidance of the Auditor-General of India. These
companies are usually formed to carry out some special public undertakings
requiring extraordinary powers and privileges. The object of such companies
is not so much to earn profit but to serve people. Though the liability of the
members of such companies is limited, yet in most of the cases, they may
not be required to use the word ‘limited’ as part of their names. Some of
the important statutory companies are Reserve Bank of India, State Bank of
India, Nationalised Banks, etc.
2. Registered Companies
Companies formed by registration under the Companies Act are known as
Registered Companies. The working of such companies is regulated by the
provisions of the Companies Act, Memorandum of Association and Articles
of Association. These companies may be limited by shares or limited by
guarantee or unlimited companies.
(i) Companies limited by shares. A company having the liability of
its members limited by the amount, if any unpaid on the shares held
by them, is called as a company limited by shares [Sec. 2(21)]. For
example, if A Ltd. has a share capital of 10,000 shares of ` 10 each
and A has purchased 100 shares on which he has paid so far ` 6 per
share, the maximum liability of A is now only ` 4 per share (the unpaid
amount).
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A large majority of companies registered in our country are of this Company Accounts-I
category.
(ii) Companies limited by guarantee. Companies whose objective is not to
earn profits are mostly registered as guarantee companies. A guarantee
NOTES
company is a company in which liability of each member is limited to
such amount as he may voluntarily undertake under the memorandum
to contribute to meet out the deficiency of the assets of the company in
the event of its being wound up [Sec. 2(21)]. The guaranteed amount
may differ from member to member. It may or may not have share
capital. If the company has share capital, the shareholders shall be
liable to pay the amount which remains unpaid on their shares plus
the amount payable under the guarantee. The amount guaranteed by
each member is in the nature of a reserve capital. It cannot be called
up except in the case of the winding up of the affairs of the company.
The articles of association of such a company shall state the number
of members with which the company is to be registered.
(iii) Unlimited companies. A company, not having any limit on the liability
of its members, is termed as an unlimited company [Sec. (92)].
The Articles of an unlimited company should state the number of
members with which the company is to be registered. If it has a share capital,
the amount of share capital with which the company is to be registered, should
also be stated in the Articles.
The members of an unlimited company are fully liable for the debts
incurred by the company like partners of a partnership firm. However, the
creditors cannot sue the members directly on account of separate legal
personality of the company. In case the company fails to pay, the creditors
will have to resort to the winding up of the company. The liquidator will
call upon members to contribute towards the assets of the company so as to
enable him to meet the debts and the cost of winding up of the company.
An unlimited company may or may not have any share capital. In
case it has any share capital, it can increase or reduce its share capital without
any restriction. It may even purchase its own shares.
Such type of companies, though permitted by the Companies Act,
are not common in the country.
A registered company (whether limited or unlimited) may be either
a private or a public company.

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Company Accounts-I (a) Private company: A private company means, a company which has
a minimum paid up capital as may be prescribed1, and which by its
Articles:2
(i) restricts the right to transfer its shares*.
NOTES
(ii) except in case of one person company limits the number of
members to 200 not including:
(a)  persons who are in the employment of the company and;
(b)  persons who having been formally in the employment of
the company who are members of the company while in
that employment and have continued to be members after
that employment ceased.
(iii) prohibits any invitation to the public to subscribe for any securities
of the company [Sec. 2(68)].
(b) Public company: A public company means a company which:
(i) is not a private company and
(ii) has a minimum paid up capital as may be prescribed.
Provided that a company which is a subsidiary of a company, not being
a private company, shall be deemed to be public company for the purposes
of this Act even where such subsidiary company continues to be a private
company in its articles; [Sec. 2(71)].
It will be noted that a private company can be registered with only
2 members (except one person company) while a public company needs at
least 7 members. Where 2 or more members hold 1 or more shares jointly,
they shall be considered as a single member.
Listed and Unlisted Companies
A public company may further be categorized into a listed and an unlisted
company. According to the Companies Act, 2013, listed company means
“a company which has any of its securities listed on any recognized stock
exchange” [Sec. 2(52)]. Alternatively, the company may be unlisted, i.e., a
company whose shares are not listed on a stock exchange. A public company
may be listed or unlisted. It will be listed if it has issued securities to public
which are listed on one or more recognized stock exchanges. It will be
As amended by The Companies (Amendment) Act, 2015. At present there is no minimum capital requirement
1&2

prescribed both for a public company and a private company.


*The right to transfer shares is generally restricted in the following manner:
· The directors are authorised under the Articles to refuse transfer of shares to those whom they disapprove.
· The shareholders may be required to offer their shares first to existing shareholders in case they intend to transfer
shares.
· The method of calculating the price at which the shares are to be sold by one shareholder to another may be
prescribed in the Articles
· It may be provided that shareholders who are the employees of the company shall offer share to specified persons
or class of persons in case they leave the company’s employment.
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unlisted if it has not offered its securities to the general public and hence not Company Accounts-I
got them listed on a recognized stock exchange. However, a private company
will always be unlisted since it cannot invite the general public to subscribe
for its securities.
NOTES
Listing of the securities on a stock exchange makes them readily
marketable since such securities can be freely purchased and sold on the
stock exchange.
The listed company has to follow guidelines of SEBI, in addition to
provisions of Companies Act, Public company which is not listed does not
have to follow SEBI guidelines.
3. Holding Company
“In relation to one or more other companies, means a company of which such
companies are subsidiary companies; [Sec. 2(46)].” The expression company
here includes any body corporate3.
In other words a holding company can be there only when it has a
subsidiary company or companies.
Subsidiary Company or Subsidiary: In relation to any other company
(that is to say the holding company); means a company in which the holding
company-
(i) controls the composition of the Board of Directors; or
(ii) exercises or controls more than one-half of the total voting power either
at its own or together with one or more of its subsidiary companies.
Provided that such class or classes of holding companies as may be
prescribed shall not have layers of subsidiaries beyond such numbers as may
be prescribed.
Explanation - For the purposes of this clause,-
(a) a company shall be deemed to be a subsidiary company of the holding
company even if the control referred to in sub-clause (i) or sub-clause
(ii) is of another subsidiary company of the holding company;
Example: Company B is a subsidiary of Company A and Company

C is a subsidiary of company B. Hence, company C is a subsidiary
of Company A. By virtue of the above provision, if company D is a
subsidiary of Company C, Company D will be subsidiary of Company
B and consequently also of Company A.
(b) the composition of a company’s Board of Directors shall be deemed to
be controlled by another company if that other company by exercise of
some power exercisable by it at its discretion can appoint or remove
all or a majority of the directors;
3
Added by The Companies (Amendment) Act, 2017.

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Company Accounts-I (c) the expression “company” includes anybody corporate;
(d) “layer” in relation to a holding company means its subsidiary or
subsidiaries; [(Sec. 2(87)].
NOTES 4. Government Company
It means any company in which not less than fifty-one per cent of the paid-up
share capital is held by the Central Government, or by any State Government
or Governments, or partly by the Central Government and partly by one or
more State Governments, and includes a company which is a subsidiary
company of such a Government company; [(Sec. 2(45)].”
5. Foreign Company
It means any company or body corporate incorporated outside India which­—
(a) has a place of business in India whether by itself or through an agent,
physically or through electronic mode; and
(b) conducts any business activity in India in any other manner [Sec. 2(42)].
A foreign company is required to register with Registrar of Companies within
30 days from the date of establishing a place of business in India.
6. One-Man Companies or Family Companies
A private company can be formed with two members and a public company
with seven. A man may take only one other person with him to constitute
the minimum number required in a private company or six other so as
to constitute the required seven in a public company. He may keep with
himself a substantial number of shares so as to have controlling power over
the company. Such a company may be regarded as One-man Company.
Sometimes, a company may be formed by a person by involving other family
members. Such a company can be regarded as a ‘Family Company’. Even in
such cases the company will be regarded to have a separate entity as distinct
from the majority shareholders (Salomon v. Salomon & Co. Ltd.).
The Companies Act, 2013 has introduced the concept of “One Person
Company” in the true sense. According to clause 2(62) of the Act “One
Person Company” (OPC) means a company which has only one person as a
member.
A one person company can be formed as a private company by one
person subscribing to the Memorandum and complying with all other usual
legal requirements.
The following are some specific requirements applicable to “One
Person Company”:
1. The words “One Person Company” shall be mentioned in brackets
below the name of such company wherever the name is printed affixed,
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288 Material
2. The memorandum of “One Person Company” shall indicate the name Company Accounts-I
of other person, with his prior written consent in the prescribed form,
who shall, in the event of the subscriber’s death become the member of
the company. The written consent of such person shall also be filed with
the Registrar at the time of incorporation of the One Person Company NOTES
along with its Memorandum and Articles.
Provided further that such other person may withdraw his consent in
such manner as may be prescribed.
Provided also that the member of “One Person Company” may at any
time change the name of such other person by giving notice in such
manner as may be prescribed.
3. It shall be the duty of the member of “One Person Company” to
intimate the company the change, if any, in the name of the other person
nominated by him by indicating in the memorandum or otherwise
within such time and in such manner as may be prescribed, and the
company shall intimate the Registrar any such change within such time
and in such manner as may be prescribed.
7. Small Company
A small company means a company other than a public company which
satisfies any of the following two conditions:
(i) Its paid-up share capital does not exceed fifty lakh rupees or such
higher amount as may be prescribed by the Central Government, not
exceeding ten crore rupees.4
(ii) Its turnover as per last profit and loss account for the immediately
preceding financial year does not exceed two crore rupees or such
higher amount as may be prescribed by the Central Govt., not exceeding
one hundred crore rupees. [Sec. 2(85)]. 5
8. Dormant Company
An inactive company is termed as a dormant company. Section 455 of the
Companies Act, 2013 makes the following provision regarding dormant
companies.
(i) Where a company is formed and registered under 2013 Act for a future
project or to hold an asset or intellectual property and has no significant
accounting transaction, such a company or an inactive company
may make an application to ROC to obtain the status as a “dormant
company”.
(ii) “Inactive Company” means a company which has not been carrying on
any business or operation, or has not made any significant accounting
4
Raised from ` 5 crore by The Companies (Amendment) Act 2017.
5
As amended by The Companies (Amendment) Act 2017.
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Company Accounts-I transaction during the last 2 financial years, or has not filed financial
statements and annual returns during the last 2 financial years.
(iii) Cash flow statement is not required for a dormant company.
NOTES (iv) Board meetings required to be held at least in each half of a calendar
year not the gap between the 2 meetings is not less than 90 days.
(v) The dormant company may become an active company by making
necessary application to ROC.
(vi) The ROC may strike off the name of a dormant company from the
register of dormant companies, if the company fails to comply with
the requirements.
9. Associate Company
In relation to another company, it means a company in which that other
company has a significant influence, but which is not a subsidiary company
of the company having such influence and includes a joint venture company.
[Sec. 2 (6)].
“Significant influence” here means control of atleast 20% of total
voting power or control of or participation in business decisions under any
agreement.
10. Global Company
A company which plans its activities on a global basis but markets its products
through the use of some co-ordinated image brand in all markets. There is
generally one corporate office that is responsible for global strategy. Such
company integrates all of its units and focuses its marketing strategy on
worldwide scale. For example, a global software company would sell the
same operating system in all countries, but makes a few changes to program
to account for foreign language speakers. It makes the product homogenous
to the maximum extent which allows the company to have the benefits from
saving on activities such as R&D, production and marketing etc.
11. Multinational Company
A company which is having its headquarters in one country but have business
operations in other countries. This means this type of organisation will have
business operations in many countries.
A multinational company technically differs from a global company. A
multinational company does not have, like a global company, co-ordinated
product offerings in each country. Its focus is more on adapting its products
or services to each individual market. For example, Toyota Motors is a
multinational company having its base in Japan. However, it assembles cars
in different countries keeping in view the local requirements and regulations.
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It may be noted that neither the political scientists nor economists have Company Accounts-I
a standard definition for a multinational company or a global company. In
practical terms, people tend to call any company that sells products or services
on the global market or has operations in several countries a multinational
or a global company. Hence, the two terms can be used interchangeably to NOTES
a large extent.
12. Charitable or Non-Profit Making Companies
A company may be formed for a charitable or non-profit making objective
under Section 8 of the Companies Act. Such a company may be registered
with a limited liability without requirement of using the words ‘limited’ or
‘private limited’ as a part of its name. The Central Government may issue a
license to that effect if it is satisfied that an association:
(i) is about to be formed as a limited company for promoting commerce,
art, science, sports, education, research, social welfare, religion, charity,
protection of environment or any such other useful object, and
(ii) intends to apply its profits if any or other income in promoting its
objects, and
(iii) intends to prohibit the payment of any dividend to its members.
Such an association can be registered as a company by complying
with all the other requirements of the Companies Act required for formation
of a company.
Of course, it may not use the word ‘limited’ or ‘private limited’ as a
part of its name because of the license so granted by the Central Government.

Check Your Progress


1. State the meaning of perpetual existence in relation to companies.
2. Define an inactive company.

13.4 FORMATION OF COMPANIES


A company may be formed either to take over an existing business or to
carry on a new business. Whatever may be the objective, the procedure for
the formation of a company, from the time the idea of forming a company is
first conceived till the company is actually formed and commences business,
may be divided into three principal stages:
(i) Promotion.
(ii) Incorporation.
(iii) Commencement of business.
Let’s discuss promotion and incorporation briefly in this section. Self-Instructional
Material 291
Company Accounts-I Promotion
The stage of conceiving an idea and its working up is termed as promotion.
The person involved in this task is termed as promoter. The promoter may
NOTES work up the idea with the help of his own resources, influence or competence
or he may, if necessary, take the help of technical experts to find out the
economics of the project he has in his mind.
Promoter
The Companies Act, 2013 defines a promotes as under:
“Promoter means a person—
(a) who has been named as such in a prospectus or is identified by the
company in the annual return referred to in Section 926; or
(b) who has control over the affairs of the company, directly or indirectly
whether as a shareholder, director or otherwise; or
(c) in accordance with whose advice, directions or instructions the Board
of Directors of the company in accustomed to act.
Provided that nothing in sub-clause (c) shall apply to a person who is
acting merely in a professional capacity. [(Sec. 2(69)].
Promoter is, as a matter of fact, a person who conceives the idea of
starting a business, plans the formation of a company and actually brings it
into existence. He opens out the opportunities for profitable investment. He
may be said to be “the father of the company who sees the prospects of gain
in a business which he wishes to set up, and believes that he can persuade
others to think as he does.” In other words the function of the promoter, may
be defined as “the discovery of business opportunities and the subsequent
organisation of funds, property and managerial ability of a business concern
for the purpose of making profits therefrom.” Palmer has defined company
promoter as “a person who originates a scheme for the formation of the
company, has the Memorandum and the Articles prepared, executed and
registered, and finds the first directors, settles the terms of preliminary
contracts and prospectus (if any) and makes arrangements for advertising
and circulation of the prospectus and placing the capital”.
Thus, a promoter discovers, formulates and assembles a business
proposition and brings about a company into existence for its development.
He plans and decides upon the nature, scope and the extent of the business
for the proposed company. He provides or secures the initial capital of the
company, negotiates the purchase of an existing business, instructs and directs
the solicitors or lawyers to prepare the necessary documents, selects and
arranges with persons to become directors, has the prospectus approved and
6
Every company has to prepare and file a Return in the prescribed form containing the particulars as they stood
on the close of the financial year giving vital details of the company.
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issued, induces persons to buy shares, finds funds for the registration fees Company Accounts-I
and executes a score of other things involved in the formation of a company.
Incorporation
It is the incorporation which brings a company into existence as a separate NOTES
corporate entity. The promoter has to take the following preliminary steps
in this connection:
(i) Ascertainment of availability of the proposed name of the company:
This has to be confirmed from the Registrar of Companies. Application
has to be made in the prescribed form with the prescribed fee. It will
be better for the promoters to select and send to the Registrar three or
four names in order of preference.
(ii) Application for licence: In case the industry to be run by the
proposed company falls within the category of those industries for
the establishment of which licence is necessary under the Industries
(Development & Regulation), Act, 1951, the application should be
made to the concerned ministry of the Central Government.
(iii) SEBI’s approval to Draft Prospectus: In case a company proposes
to raise capital by issue of shares or debentures to the general public,
a draft prospectus has to be submitted to the Securities and Exchange
Board of India (SEBI) duly certified by a merchant banker acting as a
lead banker to the issue regarding compliance of all legal formalities.
(iv) Prepare and finally get printed the company’s memorandum and
articles of association.
(v) Fixation of the underwriters, brokers, solicitors, auditors, etc.
In addition to the above preliminary steps the promoter will have to take the
following steps to get the company incorporated:
1. Filing of the necessary documents.
2. Payment of the necessary fees.
3. Obtaining the certificate of incorporation.

13.5 SHARE CAPITAL


Meaning: A share is one of the units into which the total share capital of a
company is divided. The Companies Act, 2013 defines a share as “share in
the share capital of a company and includes stock”. [Sec. 2(84)].
Essential Features: The following are the essential features of a share:
1. A share has a nominal value and bears a distinct number.
2. A share certificate issued under the common seal of the company
certifies that the person named herein is a registered holder of a
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Company Accounts-I specific number of shares bearing distinct numbers as mentioned in
the certificate.
3. A share is an ownership security. In other words, a shareholder is a
part-owner of the company.
NOTES
4. A share is said to be a bundle of rights as well as liabilities. It secures to
its owner the right to receive a proportionate part of the profits, if any,
and proportionate part of the assets of the company upon liquidation.
On the other hand the shareholder may also be required to pay the full
value in winding up.
5. Shares may be issued generally at par or premium and at discount only
in certain cases.
6. A share is considered to be a movable property transferable in the
manner provided in the articles of the company [Sec. 44].
Stocks
Fully paid up share capital may, if the Articles so permit, be converted into
stock by an ordinary resolution (a resolution by simple majority) of the
members. Stock is the aggregate consolidated holdings of the share capital of
a person. It can be divided and transferred in any fractions and sub-divisions
without regard to the original face value of the share for the purpose of
convenient holding into different parts.
Difference between a Share and a Stock
(1) A share may not be fully paid up, but a stock is always fully paid up.
(2) A share has a nominal value, whereas a stock has no nominal value.
(3) A share cannot be transferred in small fractions, while a stock can be
transferred in any fractions.
(4) All shares bear distinct numbers, while stocks disclose the consolidated
value of the share capital. Fractions of the stock do not bear any number.
(5) All shares are of equal denomination. Stock may be of unequal amounts.
(6) Unlike shares, stock cannot be directly offered by the company to the
public in the first instance. Only fully paid up shares can be converted
into stock by the company.
Types of Shares
Shares can be of different types as given in the following chart:

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Company Accounts-I

NOTES

Each of the above types of shares are being explained in the following pages.
1. Preference Shares
Preference shares are those which carry the following preferential rights over
other classes of shares:
(a) A preferential right in respect of a fixed dividend—it may consist of a
fixed amount (say ` 30,000 p.a.) or a fixed rate (say 13% p.a.)
(b) A preferential right as to repayment of the capital in the event of
company’s winding up.
Categorisation and Type of Preference Shares Preference shares can be
categorised variously. Their categories and the types under each category
are shown below:
On the Basis of Dividend
(i) Cumulative preference shares. In case of shares, arrears of dividend
go on accumulating till they are paid. The accumulated arrears of
dividend shall be paid before anything is paid out of profits to the
holders of any other class of shares. Preference shares are always
cumulative unless otherwise expressly stated in the company’s articles.
Example 1: A company has 10,000, 12% preference shares of `100
each. The company has not paid dividend to its preference shareholders
for the year 2012-13 and 2013-14. In 2014-15 the company earns
adequate profits. In this case the company shall pay dividend for 3 years
(including arrears of last 2 years) amounting to `3,60,000 (`1,20,000
per annum) before paying any dividend to the equity shareholders.
(ii) Non-cumulative preference shares. In case of these shares dividend
is not allowed to accumulate. The right to claim dividend will lapse if
there are not sufficient profits in a particular year.
Example 2: In Example 1 if the preference shares are non-cumulative
the company will pay dividend only for 2014-15 amounting to
`1,20,000 to its preference shareholders before paying any dividend
to its equity shareholders. Self-Instructional
Material 295
Company Accounts-I On the Basis of Participation
(i) Participating preference shares. The holders of these shares are
entitled to (a) a fixed dividend and (b) a share in the surplus profits,
remaining after paying dividend to the equity shareholders up to a
NOTES certain limit.
Example 3: A company has 10,000, 10% preference shares of `100
each and 1,00,000 equity shares of `10 each. The Articles provide
that after paying a dividend at 15% to the equity shareholders, the
remaining profits will be dividend in equally between Preference
Shareholders and Equity Shareholders. The company makes a profit
of `5,00,000 in the year 2014-15. The division of profit among the
preference and equity shareholders will be as under:
`
Preference Shareholders at 10% on `10,00,000 1,00,000
Equity Shareholders at 15% on `10,00,000 1,50,000
2,50,000
The balance of profit of `2,50,000 will be divided between Preference
and Equity shareholders equally. Thus, the total share of different
shareholders in the company’s profits for 2014-15 will be as under:
`
Preference Shareholders (1,00,000 + 1,25,000) 2,25,000
Equity Shareholders (1,50,000 + 1,25,000) 2,75,000
5,00,000
(ii) Non-participating preference shares. The holders of these shares
are entitled to a fixed dividend and not a share in the surplus profits.
Example 4. In Example 3 if the preference shares and non-participating
the profit of `5,00,000 made by the company during 2014-15 will be
divisible between preference shareholders and equity shareholders as
under:
`
Preference Shareholders at 10% 1,00,000
Equity Shareholders (5,00,000 – 1,00,000) 4,00,000
5,00,000
On the Basis of Convertibility
(i) Convertible preference shares. The holders of these shares to get
their preference shares converted into equity shares within a certain
period.
(ii) Non-convertible preference shares. These preference shares do not
carry the right of conversion into equity shares.
On the Basis of Redemption
(i) Redeemable preference shares. The shares which can be redeemed
after a fixed period or after giving the prescribed notice, as desired by
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the company.
(ii) Irredeemable preference shares. Shares which cannot be redeemed Company Accounts-I
during the life-time of the company.
However, as per the Companies Act, 2013 a company can issue only
such preference shares which are redeemable within 20 years from the date
of issue. However, Preference Shares which are issued for infrastructure NOTES
projects can be redeemable after a period exceeding 20 years.
Of course, in no case a company can issue irredeemable preference
shares.
It may be noted that preference shares are always taken as cumulative,
non-participating, non-convertible and redeemable, unless otherwise
specified.
2. Equity Shares
Equity shares are those shares which are not preference shares. Equity
shares can be of two types:
(i) With voting rights;
(ii) With differential right as to dividends, voting or otherwise in accordance
with the rules and subject to such conditions as may be prescribed.
[Sec. 43(a)]
Rules as to Issue of Equity Shares with Differential Rights
The following are the basic rules notified by the Ministry of Corporate
Affairs for issue of shares with differential rights:
(a) The articles of association of the company authorizes the issue of shares
with differential rights.
(b) The issue of shares is authorized by an ordinary resolution passed at
a general meeting of the shareholders.
(c) The shares with differential rights shall not exceed twenty-six percent
of the total post-issue paid up equity.
(d) The company should have consistent track record of distributable
profits for the last three years.
(e) The company has not defaulted in payment of the dividend on
preference shares or repayment of any term loan from a public financial
institution or a scheduled bank.

Check Your Progress


3. Define stock.
4. What are the two types of equity shares?

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Company Accounts-I
13.6 UNDERSUBSCRIPTION, OVERSUBSCRIPTION
AND ISSUE OF SHARES AT PREMIUM AND
DISCOUNT
NOTES
In this section, we will discuss the concepts of undersubscription,
oversubscription and issue of shares at premiums and discount.
Undersubscription
A company may not receive applications for all the shares offered by it to
the public. For example, it might have offered 8,000 shares to the public but
applications might have been received only for 6,000 shares. Such a situation
is called under subscription. In such a case entries for application, allotment
and calls will be made only for 6,000 shares.
However, if the shares are so undersubscribed that applications are
not received even for minimum subscription, the company cannot proceed
with allotment. It will have to refund to the applicants all application money.
Oversubscription
A company, making a public offer, may receive applications for a larger
number of shares than offered by it to public for subscription. Such a situation
is termed as oversubscription. The company may treat the excess applications
received in one or more of the following ways:
(i) Certain applications (either on the basis of number of shares applied
for or any other basis) may straightway be rejected. Application money
will be refunded to such applicants. The journal entry will be
Share application A/c Dr.

To Bank A/c
(Being refund of application money to applicants for…shares @
` …per share)
(ii) Partial allotment may be done. It means allotment of a smaller number
of shares than the number applied for. For example every applicant for
1,000 shares may be allotted 500 shares and every applicant for 2,000
shares be allotted 800 shares and so on.
(iii) Pro rata allotment may be done. It means allotment is made to each
applicant or some applicants on a proportionate basis. For example
a company offers 10,000 shares to the public, and applications are
received for 15,000 shares. No allotment is made to applicants for
3,000 shares and the rest are allotted shares on a pro rata basis. It means
applicants for 12,000 shares have been allotted 10,000 shares or every
applicant of this group has been allotted five shares for six applied.
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298 Material
In case the company adopts (ii) or (iii) alternative, there will be a Company Accounts-I
problem of excess application money received. Company can use the
excess application money received, for money due on allotment. For
example, A applies for 50 shares and pays ` 2 per share as application
money. He gets only 40 shares and the money due on allotment is ` 3 NOTES
per share. The following journal entry will be passed for transferring
money from “share application account” to “share allotment account”.
Share application A/c Dr. 20
  To Share allotment A/c 20
Surplus money exceeding that due on allotment should be refunded to the
allottees, within 15 days from the date of closure of issue or such lesser
time as may be specified by SEBI. In case of default, as discussed earlier,
the applicant will be entitled to interest at 15% p.a. for the delayed period
besides penalty on both the company and the directors.
Illustration 13.1. A company offers 10,000 shares of ` 10 each to the public
for subscription. The money is payable as follows:
` 2 on Application, ` 3 on Allotment, and ` 5 on First & Final Call.
The company receives application for 12,000 shares. Applicants for
9,000 shares pay the application money in cash, while the rest pay that
money through stockinvests. The shares are allotted on the prorata basis.
All allottees pay the allotment and final call moneys on due dates.
Pass the necessary journal entries.
Solution:
Journal Entries
Date Particulars Dr. ` Cr. `
Bank A/c Dr. 18,000
To share application A/c 18,000
(Being application money received in cash on 9,000 shares
@ ` 2 per share)
Share application A/c Dr. 18,000
To Share capital A/c 15,000
To Share allotment A/c 3,000
(Being transfer of application money due on 7,500 shares
from applicants who applied for 9,000 shares. Surplus
application money adjusted towards allotment)
Bank A/c Dr. 5,000
To Share capital A/c 5,000
(Being application money received on 2,500 shares @ ` 2
each from persons who applied through stockinvests)
Share allotment A/c Dr. 30,000
To Share capital A/c 30,000
(Being allotment money due on 10,000 shares @ ` 3 per
share)
Bank A/c Dr. 27,000
To Share allotment A/c 27,000
Self-Instructional
Material 299
Company Accounts-I Date Particulars Dr. ` Cr. `
(Being allotment money received on 10,000 shares)
Share first & final call A/c Dr. 50,000
To Share capital A/c 50,000
NOTES (Being 1st & final call money due on 10,000 shares @ `
5 per share)
Bank A/c Dr. 50,000
To Share first & final call A/c 50,000
(Being receipt of first & final call money)

Calls in advance
A company may, if authorised by its Articles, accept calls in advance from
its shareholders. Table F gives such a power and also provides for payment
of interest at a rate not exceeding 12% per annum. The amount received in
advance as payment of calls will be credited to a “Calls in Advance Account.”
The amount so received will be adjusted towards the payment of calls as and
when they become due.
Bank A/c Dr.
To Call in advance A/c
(with the amount of calls received in advance)
Share ...... call A/c
To Share capital A/c
(with the amount due on........call on all shares including those
on which call has been received in advance)
Bank A/c Dr.
(with the amount actually received)
Calls in advance A/c Dr.
(with the amount of the call received in advance)
To........call A/c

Calls in Arrears
A shareholder may not pay the call when it becomes due. The company may
provide in its Articles for charging interest from the defaulting shareholder.
Table F permits charging of interest on calls in arrears at 10% per annum.
The journal entries in respect of calls in arrears are as follows:
When a call becomes due:
Share........call A/c Dr.
To Share capital A/c
When money in response to calls is received
Bank A/c Dr.
To Share........call A/c
(with the amount actually received excluding the amount of a call in arrear)
At the end of the accounting year, the amount outstanding on account of a call will be
transferred to ‘Calls in Arrears A/c’.
Calls in arrears A/c Dr.
To Share........call A/c
In case a shareholder makes payment of a ‘call in arrear’ with interest, the entry will be:
Bank A/c Dr.
To Share........call A/c/Calls in arrears A/c
Self-Instructional To Interest A/c
300 Material
Illustration 13.2. A company offers 10,000 shares to the public. The amount Company Accounts-I
payable is as follows:
On Application ` 3 per share On 1st Call ` 3 per share
On Allotment ` 2 per share On Final Call ` 2 per share
Applications are received for 15,000 shares. The directors make the NOTES
allotment as follows:
(i) No allotment to applicants for 3,000 shares.
(ii) Rest allotted on a pro rata basis.
All calls were duly made and paid except:
· A, a holder of 100 shares paid the two calls with allotment.
· B, a holder of 200 shares fails to pay the 1st and the 2nd calls.
· C, a holder of 100 shares fails to pay the 2nd call.
Pass the necessary journal entries to record the above transactions in
the company’s books and show how the share capital will appear in the
company’s Balance Sheet.
Solution:
Journal Entries
Date Particulars ` Dr ` Cr
Bank A/c Dr 45,000
To Share application A/c 45,000
(Being application money received on 15,000 shares @ `
3 per share)
Share application A/c Dr 45,000
To Bank 9,000
To Share allotment A/c 6,000
To Share capital A/c 30,000
(Being transfer of application money to Share capital A/c on
10,000 shares, surplus money on pro rata allotment to share
allotment account and the balance being refunded)
Share allotment A/c Dr 20,000
To Share capital A/c 20,000
(Being money due on allotment)
Bank A/c Dr 14,500
To Share allotment A/c 14,000
To Calls in advance A/c 500
(Being receipt of allotment and calls in advance money)
Share 1st call A/c Dr 30,000
To Share capital A/c 30,000
(Being money due on 1st call)
Bank A/c Dr 29,100
Calls in advance A/c Dr 300
To Share 1st call A/c 29,400
(Being receipt of money on 1st call)
Share second & final call A/c Dr 20,000
To Share capital A/c 20,000
(Being money due on 2nd call)

Self-Instructional
Material 301
Company Accounts-I Date Particulars ` Dr ` Cr
Bank A/c Dr 19,200
Calls in advance A/c Dr 200
To Share 2nd call A/c 19,400
NOTES (Being money due on 2nd call)
Calls in arrears A/c Dr 1,200
To Share 1st call 600
To Share final call 600
(Being transfer of 1st and final call in arrear to calls in
arrears account)
......Co. Ltd.
Balance Sheet (Extracts)
as on…..
Equity & liabilities Note No. `
Share Capital:
   Shareholders’ Funds 1 98,800
    Share capital

Notes to Accounts
1. Share capital `
Authorised
  .....shares of ` 10 each
   issued and Subscribed .........
Subscribed and fully paid up
   9,700 shares of ` 10 each 97,000
Subscribed and not fully paid up
   300 shares of ` 10 each                     3000
Less Calls in Assenes                     1,200 1500
98,800

Issue of Shares at Premium


Legal provisions A company can issue its shares at a premium (i.e., for
a value higher than the face value of the shares) whether for cash of for
consideration other than cash. The power to issue shares at a premium need
not be given in the Articles of Association. However, according to recent
guidelines issued by SEBI, a new company set up by the entrepreneurs
without a track record can issue capital to the public only at par. According
to Section 52 of the Companies Act, the amount of such premium, shall have
to be transferred by the company to the Securities Premium Account. The
balance in this account is treated with the same sanctity as the paid up Share
Capital of the company.
Utilisation of Securities Premium Account
This can be studied under two heads:
(a) Companies which are not required to follow the accounting
standards [Sec. 52(2)].
These Companies can use the Securities Premium Account for the
Self-Instructional
302 Material
following purposes.
(i) towards the issue of unissued shares of the company to members Company Accounts-I
of the company as fully paid bonus shares;
(ii) in writing off the preliminary expenses of the company;
(iii) in writing off the expenses of, or the commission paid or discount
allowed on, any issue of shares or debentures of the company; NOTES
(iv) in providing for the premium payable on the redemption of any
redeemable preference shares or of any debentures of the company;
or
(v) for the purchase of its own shares or other securities under section
68.
(b) Companies which are required to follow the accounting standards
[Sec. 52(3)].
These companies can use Securities Premium Account only for the
following purposes:
(i) in paying up unissued equity shares of the company to be issued
to members of the company as fully bonus shares; or
(ii) in writing off the expenses of, or the commission paid or discount
allowed on, any issue of equity shares of the company; or
(iii) for the purchase of its own shares or other securities under Section
68.
Note: As stated above according to Section 52 of the Companies Act 2013 the amount
of premium received on shares is to be transferred to the “Securities Premium Account”.
However, in the Notes to Accounts under Proforma of Balance Sheet as per Schedule III,
under the heading “Reserves & Surplus”, there is a sub-heading of “Securities Premium
Reserve”. Hence, some accountants, while making accounting entries, for share premium
prefer the term “Securities Premium Reserve Account” in place of “Securities Premium
Account”. According to us any of the terms, i.e.,“Securities Premium Reserve Account” or
“Securities Premium Account” may be used while making entries in respect of Securities
premium.
However, in “Notes to Accounts” the Securities Premium will have to
be shown as “Securities Premium Reserve” under the heading Reserves &
Surplus as required by the Notes to Accounts given in Schedule III.
Accounting entries Generally the amount of premium is payable in a
lump sum on allotment. However, a company may require the applicants to
pay premium money with application money or with calls. The accounting
entries are made as follows:
(i) Where premium money is payable on allotment:
On amount being due:
Shares allotment A/c Dr.
To Share capital A/c
To Securities premium A/c
(Share allotment account will be debited with the amount due on account
of share capital as well as securities premium).
On receipt of allotment money:
Bank A/c Dr.
To Share allotment A/c
(With the amount actually received) Self-Instructional
Material 303
Company Accounts-I (ii) In case premium money is payable on application:
On receipt of application money:
Bank A/c Dr.
To Share application A/c
(With money received on account of share capital as well as securities
NOTES premium)
On transfer of application money:
Share application A/c Dr.
To Share capital A/c
To Securities premium A/c
(iii) In case premium is received in parts, say, on application as well as allotment or
allotment and first call, entries on the same pattern can be passed. For example, if
premium is payable in two installments—on allotment and first call, the following
accounting entries will be passed.
For premium due on allotment:
Share allotment A/c Dr.
To Share capital A/c
To Securities premium A/c
For receipt of allotment money:
Bank A/c Dr.
To Share allotment A/c
For premium due on first call:
Share 1st call A/c Dr.
To Share capital A/c
To Securities premium A/c
For receipt of first call money:
Bank A/c Dr.
To Share 1st call

Alternative Method
There is an alternative method for treatment of securities premium. No entry
is passed for securities premium when it becomes due. However, on receipt of
securities premium, the amount of securities premium is credited to Securities
Premium Account. For example, if amount is to be received on allotment of
10,000 shares @ ` 3 per share (including ` 1 per share as premium) and only
holders of 9,500 shares pay the allotment money, the following accounting
entries will be passed for recording these transactions.
Date Particulars ` Dr ` Cr
Share Allotment A/c Dr 20,000
To Share capital A/c 20,000
Being money due on allotment on account of share(
)capital
Bank A/c Dr 29,500
To Share allotment A/c 20,000
To Securities premium A/c 9,500
Being money received on account of share allotment(
)and securities premium

The advantage of this method is that the securities premium account


will not have to be debited in the event of the forfeiture of shares in case
Self-Instructional
304 Material
securities premium money has not been received. This has been explained Company Accounts-I
in detail later while explaining forfeiture of shares.
The amount of securities premium is an item of capital gain. It will
appear on the liabilities side of the balance sheet under the heading “Reserves
NOTES
and Surplus.”
Illustration 13.3. A company offers 10,000 shares of ` 10 each to the public
for subscription at` 12 per share. Money is payable as follows:
` 3 on application,
` 4 on allotment (including ` 1 as premium)
` 5 on call (including ` 1 as premium)
Applications are received for 15,000 shares. No allotment is made to
applicants for 3,000 shares and their application money is refunded. Rest are
allotted shares on a pro rata basis. All allottees pay the money due on shares
as and when called up.
Pass necessary journal entries and show how the items will appear in
the company’s balance sheet.
Solution:
Journal
Date Particulars ` Dr ` Cr
Bank A/c Dr 45,000
To Share application A/c 45,000
(Being the application money received on 15,000 shares @ ` 3 per
share)
Share Application A/c Dr 45,000
To Share capital A/c 30,000
To Bank A/c 9,000
To Share allotment A/c 6,000
(Being application money transferred to share capital on 10,000 shares,
application money on 3,000 shares refunded and rest transferred to
allotment)
Share Allotment A/c Dr 40,000
To Share capital A/c 30,000
To Securities premium A/c 10,000
(Being money due of allotment of 10,000 shares @ ` 4 per share including
` 1 as share premium)
Bank A/c Dr 34,000
To Share allotment A/c 34,000
(Being money received on allotment)
Share Call A/c Dr 50,000
To Share capital A/c 40,000
To Securities premium A/c 10,000
(Being money due to call @ ` 5 per share including ` 1 as premium)
Bank A/c Dr 50,000
To Share call A/c 50,000
(Being money received on call)

Self-Instructional
Material 305
Company Accounts-I .......... CO. Ltd.
Balance Sheet
as on .......
Particulars Note No. `
(i) Equity & Liabilities
NOTES
(a) Shareholders’ Funds 1 1,00,000
(b) Reserves & Surplus 2 20,000
1,20,000
(ii) Assets
Current Assets
Cash & Cash Equivalents 3 1,20,000
1,20,000

Notes to Accounts
Particulars `
1. Share Capital
(a) Authorised Capital
...... Shares of ` ...... each ...........
Issued Share Capital
10,000 shares of ` l0 each 1,00,000
Subscribed Capital
Subscribed but not fully paid up
10,000 shares of ` 10 each fully 1,00,000
2. Reserves & Surplus
Securities Premium Reserve 20,000
1,20,000
3. Cash & Cash Equivalents
Cash at Bank 1,20,000
1,20,000

Issue of Shares at Discount


A company now cannot issue shares at a discount (i.e., for a consideration
less than the nominal value of the shares) except sweat equity shares. As
discussed earlier, sweat equity shares are those shares which have been issued
for consideration other than cash, e.g., for intellectual rights or value additions.
Section 53 of the Companies Act, 2013 provides as under:
(1) Except as provided in Section 54 (i.e., Sweat Equity Shares), a company
shall not issue shares at a discount.
(2) Any share issued by a company at discount shall be void.
(3) Where a company contravenes the provisions of this Section, the
company shall be punishable with fine which shall not be less than one
lakh rupees but which may extend to five lakh rupees and every officer
who is in default shall be punishable with imprisonment for a term
which may extend to six months or with fine which shall not be less
than one lakh rupees but which may extend to five lakh rupees, or with
both.
Self-Instructional
306 Material
Restrictions on the issue of shares at a discount as set out above do not Company Accounts-I
apply in the case of debentures since they do not form the capital fund of the
company but are merely creditorship securities.
Accounting entries The entry for discount has to be invariably made with NOTES
allotment. The accounting entry will be as follows:
Share Allotment A/c Dr.
Discount on Issue of Shares A/c Dr.
To Share Capital A/c
“Discount on Issue of Shares” will appear on the Assets side of the
Balance Sheet as a negative item under the heading other current/non-
current assets depending on whether the amount will be amortised in next
12 month or thereafter.
It is an acceptable practice that discount on issue of shares, share issue
expenses, etc., should be written off over the period of benefit, i.e., normally
3 to 5 years from profits available for that purpose.
On writing off discount the following entry shall be
Securities Premium / P & L Statement/Account*
To Discount on Issue of Shares A/c
*Note: Schedule III to the Companies Act 2013 gives the format in which a company has to prepare
its Balance Sheet and Profit and Loss Statement. All appropriations out of profit have to be made in
the Balance Sheet itself under the heading Reserves and Surplus. Hence, for reporting purposes the
method given as per Schedule III has to be followed. However, accounting entries for appropriation
are to be made as per the traditional procedure that is debiting the P&L account and crediting the
Respective Appropriation Accounts. The illustration given below will explain this concept.

Illustration 13.4. A company offered 5,000 shares of ` 10 each, at a discount


of 10%, to the public for subscription. Money was payable as follows:
` 4 on application, ` 3 on allotment, Balance as and when called up.
Applications were received for 4,000 shares. The final call had not yet been
made. All applicants paid application and allotment moneys.
During the year the company made a net profit of ` 15,000. It decided to
write off the discount of ` 2,000 out of the profit for the year.
You are requested to prepare the necessary ledger accounts and show
how the items would appear in the company’s balance sheet.
Solution:
Bank Account
Particulars ` Particulars `
To Share application A/c 16,000 By Balance c/d 43,000
To Share allotment A/c 12,000
To Net profit for the year
(presuming that it was realised in cash) 15,000
43,000 43,000

Self-Instructional
Material 307
Company Accounts-I Share Application Account
Particulars ` Particulars `
To Share capital A/c 16,000 By Bank 16,000

Share Allotment Account


NOTES Particulars ` Particulars `
To Share capital A/c 12,000 By Bank A/c 12,000

Discount on Issue of Shares Account


Particulars ` Particulars `
To Share capital A/c 4,000 By P&L A/c 2,000
By Balance c/d 2,000
4,000 4,000

Profit & Loss Statement Account


Particulars ` Particulars `
To Discount on issue of shares A/c 2,000 By Net profit for the 15,000
year
To Balance of profit taken to
Balance sheet 13000
15,000 15,000

Share Capital Account


Particulars ` Particulars `
To Balance c/d 32,000 By Share application A/c 16,000
By Share allotment A/c 12,000
By Discount on issue of 4,000
shares A/c
32,000 32,000

Co. Ltd.
Balance Sheet
as on ...........
Particulars Note No. `
(i) Equity & Liabilities
(a) Shareholder’ Funds 1 32,000
(b) Reserves & Surplus 2 13,000
45,000
(ii) Assets
None-current Assets
Other non-current Assets 3 2,000
Current Assets 43,000
Cash & Cash Equivalents 4 45,000

Notes to Accounts
Particulars `
1. Share Capital
Authorised Capital
..... Shares of ` ..... each ...........
Issued Share Capital
4,000 shares of ` 10 each 40,000

Self-Instructional
308 Material
Subscribed Capital Company Accounts-I
Subscribed but not fully paid up
4,000 shares of ` 10 each
` 8 per share called & paid up 32,000
2. Reserves & Surplus NOTES
Surplus as per profit & loss statement 15,000
Less: Discount on issue of shares written off 2,000
13,000
3. Other Non-current Assets
Discount on issue of shares (yet to be written off) 2,000
4. Cash & Cash Equivalents
Cash at Bank 43,000

Check Your Progress


5. What is oversubscription?
6. How does the ‘discount of issue of shares’ appear on the Balance
Sheet?

13.7 BUYBACK OF SHARES AND TREASURY


STOCK
The term buy-back refers to purchase by a company of its own shares or
other specified securities. The Companies Act, 2013 makes the following
provisions for buy-back of securities.
1. Power of company to purchase its own shares [Sec. 68] A company
may purchase its own shares or other specified securities out of the following:
(a) Free reserves;
The term “free reserves” means such reserves which as per the latest
audited balance sheet of the company are available for distribution as
dividend.
(b) Securities premium account: or
(c) The proceeds of any shares or other specified securities.
However, no buy back of any kind of shares or other specified securities
shall be made out of the proceeds of an earlier issue of the same kind of shares
and other specified securities.
A company can purchase its own shares or other specified securities
subject to the following conditions:
(i) The buy-back should be authorised by its articles;
(ii) A special resolution should be passed in general meeting of the company
authorising the buy-back. The buy-back should be completed within a
period of one year from the date of passing of this special resolution. Self-Instructional
Material 309
Company Accounts-I Moreover, the company before making the buy-back has to file with the
Registrar and the Securities Exchange Board of India a declaration of
solvency in the prescribed form signed by at least two directors of the
company one of whom shall be the Managing Director.
NOTES
(iii) The buy-back should not exceed 25 per cent of the total paid capital
and free reserves of the company. Provided that the buy-back of equity
shares in any financial year shall not exceed twenty five per cent of its
total paid-up equity capital in that financial year.
(iv) The ratio of the debt owed by the company should not be more than
twice the capital and its free reserves after such buy-back. However,
the Central Government may prescribe a higher ratio of the debt than
the specified above for a class or classes of companies. The expression
“debt” for this purpose includes all amounts of secured and unsecured
debts, long as well as short-term.
(v) All the shares or other specified securities for buy-back are fully paid-
up.
(vi) The buy-back of the shares or other specified securities listed on any
recognised stock exchange should be in accordance with the regulations
made by the Securities and Exchange Board of India in this behalf.
In any other case, the buy-back should be in accordance with the
guidelines prescribed.
(vii) The buy-back may be made:
· From the existing shareholders or security holders on a
proportionate basis;
· From the open market;
· From the odd lots;
· By purchasing the securities issued to the employees of the
company pursuant to a scheme of stock option or reveal equity.
(viii) Where a company buys back its own securities, it shall extinguish and
physically destroy the securities so bought back within seven days of
the last date of completion of buy-back.
(ix) Where a company completes the buy-back of its shares or other
specified securities as above, it shall not make further issue of the same
kind of shares or other speficied securities within a period of 6 months
except in the following form—
(a) Bonus issue;
(b) Discharge of subsisting obligations such as conversion of warrants;
(c) Stock option schemes;
(d) Sweat equity shares or conversion of preference shares or
debentures into equity shares.
Self-Instructional
310 Material
A company has to maintain a separate register of the securities Company Accounts-I
so bought back with all relevant details.
(x) The company shall file a return containing details of buy-back with
the Registrar and SEBI within 30 days of completion of buy back.
NOTES
However, no return has to be filed with SEBI if the shares are not listed
on a recognised stock exchange.
In case of listed companies, SEBI: has made the following additional
provisions as per SEBI (Buy-back of Securities). Regulations
(a) The buy-back may be from the open market through
(i) book-building process
(ii) stock exchange
(b) A company listed on a stock exchange shall not buy-back its
shares of other specified securities so as to delist its shares or
other specified securities from the stock exchange.
(c) A company shall not make any offer of buy-back within a period
of one year reckoned from the date of closure of the preceding
offer of buy-back, if any.
(d) A copy of the special resolution passed at the general meeting for
buy-back or securities shall be filed with the SEBI and the stock
exchanges where the shares or other specified securities of the
company are listed, within seven days from the date of passing
of the resolution.
2. Transfer of Capital Redemption Reserve Account (69) In case a
company purchases its own shares out of free reserves or securities premium
account, a sum equal to nominal value of the shares so purchased shall be
transferred to capital redemption reserve account.
3. Prohibition for buy-back (70) No company shall directly or indirectly
purchase its own shares or other specified securities—
(a) Through any subsidiary company including its own subsidiary
companies;
(b) Through any investment company or group of investment companies;
(c) If a default is subsisting by the company in respect of any of the
following;
· any deposit or interest due thereon;
· redemption of debentures or preference shares;
· payment of dividend to any shareholder;
· repayment of any term loan or interest thereon to any financial
institution or banking company.
Moreover, the company should not have defaulted in filing
(presumably in the year in which buy-back operations are carried out) its
Self-Instructional
Material 311
Company Accounts-I annual return (Section 92), payment of dividend (Sections 123 & 124) and
preparation of balance sheet and profit and loss account to reveal the true
and fair view in accordance with the Schedule III to the Companies Act.
(Section 129).
NOTES
Accounting Treatment: The accounting entries in case of buy-back of shares
are as follows:
(i) For issue of new shares for buy-back purposes:
Bank Account Dr.
Discount on issue of shares Account* Dr.
To Share capital
To Securities premium Account*
(Only one figure will appear)
(ii) On payment of amount for buy-back
Share capital A/c Dr.
(nominal value of shares bought back)
Free reserves/Securities premium share/general reserve etc A/c Dr.
(with the extra amount paid)
To Bank A/c
(iii) For transfer to Capital Redemption Reserve
Free reserves/general reserve/securities premium etc. A/c Dr.
(with nominal value of shares bought back out of free reserves)
To Capital redemption/buy-back reserve A/c
Capital Redemption or Buy-back Reserve may be applied by the company
in paying up the unissued shares of the company to be issued to members of
the company as fully paid bonus shares.
(iv) Expenses on buy-back
Buy-back expenses A/c Dr.
To Bank
(with the actual amount of expenses paid)
The buy-back expenses may be set off against the current profit and loss account or
from reserves in the year of buy-back.
Illustration 13.5. The following is the Balance Sheet of XYZ Ltd. as on 31
March 2017:
Particulars `
A. Equity and Liabilities
1. Shareholders’ funds
(a) Share capital
Equity share capital (` 10 per share) 50,000
Preference Share Capital (` 10 per Share) 5,000 55,000
(b) Reserves & Surplus
Securities Premium Reserve 5,000
Self-Instructional
312 Material
Particulars Company Accounts-I
`
General Reserve 55,000
Surplus from Profit & Loss Statement 10,000
Less: Miscellaneous Exp. Written off 10,000 ....
Investment allowance NOTES
(available for utilization ` 10,000) 18,000
Capital redemption reserve 2,000
Debenture redemption reserve 20,000 1,00,000
2. Non-current liabilities
10% Debentures 40,000
Term loan (Secured) 15,000
Unsecured loan 25,000 80,000
3. Current liabilities & provisions 1,05,000
3,40,000
B. Assets
1. Non-Current assets
(a) Tangible assets
Fixed assets (Net) 1,50,000
Intangible 10,000
(b) non-current investments 60,000 2,20,000
2. Current assets
Loans & advances 1,20,000
3,40,000

The following additional information has been furnished to you:


(i) Investments of the cost of ` 20,000 were sold for ` 15,000.
(ii) The income tax authorities imposed an additional tax liability of `
1,000 for the year 2016.
(iii) The company intends to buy back its equity shares in the beginning
of the next financial year to the maximum extent as permissible under
law.
You are required:
(a) to compute the maximum amount of equity shares that can be purchased
by the company
(b) pass necessary journal entries assuming that such buy back has been
carried out and make out the new Balance Sheet.
Workings should form part of your answer.
Solution: Basic Workings:
1. Computation of maximum number of Equity Shares & Price per share for Buy Back:
(i ) Free Reserve for Buy-back:
` `
Securities premium 5,000
General reserve 55,000
Investment allowance reserve (available) 10,000 70,000

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Material 313
Company Accounts-I Less: Tax liability for 2016 1,000
Loss on sale of investments 5,000
Good will 10,000
16,000
54,000
NOTES
(ii ) Equity share capital 50,000
Preference share capital 5,000
55,000
(iii ) Share capital & free reserves (i) + (ii)
1,09,000
(iv) 25% of share capital & free reserves (1/4 × 1,09,000) 27,250
(v) 25% of the equity share capital 12,500
Hence maximum no. of equity shares that can be purchased
In a financial year 1,250
(vi) Maximum amount available for buy-back 27,250
(vii ) Maximum price that can be paid for buy back of a share (27,250/1,250) 21.80
(viii) Maximum premium payable per equity share (` 21.80 – ` 10) 11.80
(ix) Total premium payable on buy back (1,250 × 1.80) 14,750
(x) Amount payable as face value of equity share (1,250 ×10) 12,500

Check Your Progress


7. Define free reserves.
8. What is the maximum buy-back amount for a company in relation to
its paid up capital and free reserves?

13.8 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. The meaning of perpetual existence in relation to companies means
that the mode of incorporation and dissolution of a company and the
right of the members to transfer shares freely, guarantees the continuity
of the existence of the company quite independent of the life of the
members.
2. An inactive company means a company which has not been carrying on
any business or operation or has not made any significant accounting
transactions during the last 2 financial years, or has not filed financial
statements and annual returns during the last 2 financial years.
3. A stock refers to the aggregate consolidated holdings of the share capital
of a person.
4. The two types of equity shares are: (i) with voting rights; and (ii) with
differential rights as to dividends, voting or otherwise in accordance
with the rules and subject to such conditions as may be prescribed.
5. A company, making a public offer, may receive applications for a larger
number of shares than offered by it to public for subscription. Such a
Self-Instructional
situation is termed as oversubscription.
314 Material
6. The ‘Discount of Issue of Shares’ appear on the Assets side of the Company Accounts-I
Balance Sheet as a negative item under the heading other current/non-
current assets depending on whether the amount will be amortised in
the next 12 month or thereafter.
NOTES
7. The term ‘free reserves’ means such reserves which are as per the latest
audited balance sheet of the company are available for distribution as
dividend.
8. The buy-back should not exceed 25 per cent of the total paid capital
and free reserves of the company. Provided that the buy-back of equity
shares in any financial year shall not exceed twenty five per cent of its
total paid-up equity capital in that financial year.

13.9 SUMMARY
· Joint Stock Companies represent the third stage in the evolution of forms
of business organisation. Unlike sole proprietorship and partnership
firms, a company enjoys a separate legal status. The ownership is here
divorced from the management. The shareholders contribute towards
the finances of the company but all of them do not and cannot participate
in the management of the company. The company is managed by a
Board of Directors elected by shareholders.
· In common parlance, company means, an association of persons formed
for the economic gain of its members. However, in law, any association
of persons for any common object can be registered as a company. The
object need not be the economic gain of its members, e.g., a company
can be formed for purposes such as charity, research, advancement of
knowledge, etc.
· The essential characteristics of a company include: voluntary
association, perpetual existence, common seal, limited liability, and
transferability of shares, etc.
· The kinds of companies are statutory companies, registered companies,
holding companies, government company, foreign company, one-man
companies, small company, dormant company, associate company,
global company, multinational company, and charitable or non-profit
making companies.
· A company may be formed either to take over an existing business or to
carry on a new business. Whatever may be the objective, the procedure
for the formation of a company, from the time the idea of forming a
company is first conceived till the company is actually formed and
commences business, may be divided into three principal stages: (i)
Promotion, (ii) Incorporation and (iii) Commencement of business.
· The stage of conceiving an idea and its working up is termed as
promotion. The person involved in this task is termed as promoter. The Self-Instructional
Material 315
Company Accounts-I promoter may work up the idea with the help of his own resources,
influence or competence or he may, if necessary, take the help of
technical experts to find out the economics of the project he has in his
mind.
NOTES
· It is the incorporation which brings a company into existence as a
separate corporate entity. The promoter has to take the following
preliminary steps in this connection: ascertainment of availability
of proposed name, application for licence, SEBI’s approval to Draft
prospectus. Prepare and get printed the memorandum, and article of
association and fixation of underwriters, brokers, solicitors, auditors,
etc.
· A share is one of the units into which the total share capital of a company
is divided. The Companies Act, 2013 defines a share as “share in the
share capital of a company and includes stock”. [Sec. 2(84)].
· Fully paid up share capital may, if the Articles so permit, be converted
into stock by an ordinary resolution (a resolution by simple majority) of
the members. Stock is the aggregate consolidated holdings of the share
capital of a person. It can be divided and transferred in any fractions
and sub-divisions without regard to the original face value of the share
for the purpose of convenient holding into different parts.
· There are different types of shares: preference and equity. Further
preference shares are divided on the basis of dividend, participation
redeemability and convertibility.
· A company may not receive applications for all the shares offered by
it to the public. For example, it might have offered 8,000 shares to the
public but applications might have been received only for 6,000 shares.
Such a situation is called under subscription.
· A company, making a public offer, may receive applications for a larger
number of shares than offered by it to public for subscription. Such a
situation is termed as oversubscription.
· A company can issue its shares at a premium (i.e., for a value higher
than the face value of the shares) whether for cash of for consideration
other than cash. The power to issue shares at a premium need not be
given in the Articles of Association. However, according to recent
guidelines issued by SEBI, a new company set up by the entrepreneurs
without a track record can issue capital to the public only at par.
· A company now cannot issue shares at a discount (i.e., for a
consideration less than the nominal value of the shares) except sweat
equity shares. As discussed earlier, sweat equity shares are those shares
which have been issued for consideration other than cash, e.g., for
intellectual rights or value additions.
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316 Material
· The term buy-back refers to purchase by a company of its own shares Company Accounts-I

or other specified securities. The term “free reserves” means such


reserves which as per the latest audited balance sheet of the company
are available for distribution as dividend.
NOTES
13.10 KEY WORDS
· Allotment: It is the appropriation out of previously unappropriated
share capital of the company.
· Articles of Association: A document containing rules and regulations
and bye-laws for governing the internal affairs of a company being
framed in pursuance of the Companies Act.
· Associate Company: In relation to another company, it means a
company in which that other company has a significant influence,
but which is not a subsidiary company of the company having such
influence and includes a joint venture company.
· Company: An association of persons formed and registered under the
Companies Act.
· Government Company: A company of which not less than 51% of
the paid up share capital is held by the Central Government or by the
State Government or by any two or more of them together.
· Holding & Subsidiary Companies: A company which controls another
company is known as holding company and the company so controlled
is termed as subsidiary company.
· Incorporation: The process of getting a company registered under the
Companies Act.
· Memorandum of Association: A document confining and defining
the scope of activities of the company and framed in pursuance of the
Companies Act.
· One Person Company: A company which has only one person as a
number.
· Private Company: A company which by its Articles:
(i) restricts the right of its members to transfer shares;
(ii) except in case of one person company limits the number of
members to two hundred; and
(iii) prohibits any invitation to the public to subscribe for its shares
or debentures.
· Prospectus: Any document described or issued as a prospectus and
includes any notice, circular, advertisement or other document inviting
deposits from the public or offers from the public for the subscription
or purchase of any securities of a body corporate. Self-Instructional
Material 317
Company Accounts-I · Promotion: The stage of conceiving an idea and its working up.
· Promoter: A person who conceives the idea of starting a business,
plans the formation of a company and actually brings it into existence.
NOTES · Public Company: A company which is not a private company

13.11 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. Define a company and state its essential characteristics.
2. What is a ‘share’? Discuss their different classes.
3. State the purposes for which the money received on account of share
premium can be used.
4. Write short note on Redemption of Preference Shares
5. Can share premium be distributed as dividends?
6. What is meant by sweat equity share?
Long Answer Questions
1. What is allotted of shares? Explain the statutory restrictions imposed
on allotment of shares.
2. Explain the documents that have to be filled with the Registrar of
Companies for getting a company incorporated.
3. State the conditions which are required to be satisfied by a company
for the purpose of buy-back of shares
4. Explain the conditions under which redeemable preference shares can
be redeemed.
Practical Problems
1. Following is the balance sheet of Danny Ltd. as on 31st March, 2015:
Balance Sheet
Particulars ` (000)
A. Equity and Liabilities
1. Shareholders’ Funds
(i) Share Capital 3,00,000 shares of ` 10 each 3,000
(ii) Reserves & Surplus:
(a) General Reserve 100
(b) Securities Premium reserve 5
2. Non-current Liabilities:
Long-term Borrowings
10% Debentures 1,400
3. Current Liabilities:
Accounts Payable 1,560
6,065
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318 Material
Particulars ` (000) Company Accounts-I
B. Assets
1. Non-current Assets:
Land & Building 630
Plant & Machinery 2,350
Furniture & Fittings 350 NOTES
2. Current Assets:
Current Investments 370
Inventories 1,200
Accounts Receivable 590
Cash & Bank Balance 575
6,065

On 1st April, 2015, the shareholders of the company have approved the
scheme of buy-back of equity shares as under:
(i) 15% of the equity shares would be bought-back at ` 11 per share.
(ii) Balance in the general reserve and securities premium account may
be utilised to the fullest extent for this purpose.
(iii) Issue 12% redeemable preference shares of ` 10 each as per the
requirements.
Pass the journal entries to record the above transactions and prepare
the balance sheet of the company immediately after the buy-back of
shares.(ICSI, June, 2006, adapted)
[Ans. CRR Balance ` 60,000; B/s Total ` 59,60,000]
2. Following is the Balance Sheet of M/s Competent Limited as on 31st
March, 2015:
Assets ` Assets `
Equity Shares of ` 10 each fully paid 12,50,000 Fixed Assets 46,50,000
Revenue Reserve 15,00,000 Current Assets 30,00,000
Securities Premium 2,50,000
Profit & Loss Account 1,25,000
Secured Loans:

12% Debentures 18,75,000


Unsecured Loans 10,00,000
Current Liabilities 16,50,000
Total 76,50,000 Total 76,50,000

The company wants to buy back 25,000 equity shares of ` 10 each, on


1st April. 2015 at ` 20 per share. Buy back of shares is duly authorized
by its articles and necessary resolution passed by the company towards
this. The payment for buy back of shares will be made by the company
out of sufficient bank balance available as part of Current Assets.
Comment with your calculations, whether buy back of shares by
company is within the provisions of the companies Act, 2013. If yes,
pass necessary journal entries towards buy back of shares and prepare
e-Balance Sheet after buy back of shares.  (IPCE, ICAI, May 2012,
adapted)
[Ans. Maximum buy back of shares 31,250]
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Material 319
Company Accounts-I
13.12 FURTHER READINGS
Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
NOTES Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel and Sharad. 2018. An Introduction to Accountancy,
12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narangjk, K.L. 2001. Advanced Accountancy. New Delhi:
Kalyani Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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320 Material
Company Accounts-II

UNIT 14 COMPANY ACCOUNTS-II


Structure NOTES
14.0 Introduction
14.1 Objectives
14.2 Forfeiture of Shares
14.3 Redemption of Preference Shares
14.4 Right Issue
14.5 Debentures
14.6 Answers to Check Your Progress Questions
14.7 Summary
14.8 Key Words
14.9 Self Assessment Questions and Exercises
14.10 Further Readings

14.0 INTRODUCTION
Uptill now, we have learned the company accounts in the context of meaning
of different companies, and formation of companies. We also learned about the
companies’ financial backing through the concept of share capital, particularly
the undersubscription, oversubscription as well as buy back of shares. In this
unit, we will turn our focus towards certain other kinds of securities and their
treatment in the company accounts.
Forfeiture of shares happen under situations when the owners of
the shares are unable to meet the purchase requirements of the company.
Redemption of preference shares is the condition that the preference
shareholder will be repaid the amount they have invested in the company on a
future date provided they company the set conditions. Rights issue are shares
offered to the existing shareholders at a discount for the purpose of raising
funds. The company’s requirement to raise funds is met by the company partly
by raising share capital and partly by depending on public borrowings. One
form of such public borrowings is to raise money by issue of debentures.
In this unit, we will learn about the provisions related to and the
accounting entries related to the forfeiture of shares, redemption of preference
shares, right issue and debentures.

14.1 OBJECTIVES
After going through this unit, you will be able to:
· Discuss the concept of forfeiture of shares
· Describe the redemption of preference shares
· Explain the concept of right issue in company accounts
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· Examine the treatment of debentures in company accounts Material 321
Company Accounts-II
14.2 FORFEITURE OF SHARES
Legal provisions Forfeiture of shares may be defined as termination of
NOTES membership and taking away of the shares because of default in payment
of allotment and/or call money by a shareholder. The Companies Act does
not contain any specific provision regarding forfeiture of shares. However,
Regulation, 28 to 34 of Model Articles of a company limited by shares
(as contained in Table F of Schedule I of the Companies Act, 2013) make
provision forfeiture of shares.
These provisions can be summarized as under.
(i) The power to forfeit shares must be expressly given by the company’s
Articles.
(ii) The procedure given in the Articles must be followed.
(iii) There should be a default by the shareholder in payment of a valid call.
(iv) A notice of demand, requiring the shareholder to pay calls of a specified
amount within 14 days must be given.
(v) The Board of Directors must pass a resolution for forfeiture of shares.
(vi) The power to forfeiture must be exercised in good faith and in the
interest of the company.
(vii) Forfeited shares may be sold or otherwise disposed of by the Board,
as it deems fit. Board can cancel forfeiture on such terms as it deems
fit.
The shareholder, whose shares have been forfeited, shall cease to
be the member of the company. If the articles of the company permit, the
company can sue him for unpaid calls even after the forfeiture. In such
a case the ex-shareholder will be liable as an ordinary debtor and not as
a contributory. But where the company goes into liquidation within one
year of the forfeiture of shares, the ex-shareholder can be put on “List B
contributories.”1
Accounting entries The following points should be taken into account
while passing an accounting entry for forfeiture of shares.
(i) The amount called up on the shares forfeited.
(ii) The amount unpaid on various calls (including allotment) on the shares
forfeited.
(iii) The amount received on the shares forfeited.
Forfeiture of shares results in reduction of share capital and therefore
the share capital account should be debited with the amount called up on these
A “List B Contributory” can be required to pay the unpaid calls in the event of a company's winding up if the
1 

existing shareholder is not in a position to pay such calls.

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322 Material
shares so far. The various unpaid calls account should now be cancelled and Company Accounts-II
therefore they should be credited and the balance representing the amount
received on the shares forfeited should be credited to a new account termed
as “Forfeited Shares Account.”
Share capital A/c Dr. NOTES
  To Unpaid call(s) A/c
  To Forfeited shares A/c
(Being forfeiture of…shares as per Board’s resolution no…dated…..)
Shares, as explained before, can be issued at par, at premium or at
discount. The accounting entries for forfeiture of shares in each of these cases
are being explained below:
Forfeiture of shares issued at par The journal entry will be as follows:
Share capital A/c (with the amount called up) Dr.
  To Unpaid call(s) A/c (with the amount, remaining unpaid)
  To Forfeited shares A/c (with the amount received)
Illustration 14.1. A company forfeits 100 shares of ` 10 each fully called up
on which the shareholder has failed to pay the allotment money of ` 2 per
share and call money of ` 3 per share.
Solution:
The Journal entry for forfeiture will be as follows:
Date Particulars Dr. ` Cr. `
Share Capital A/c Dr. 1,000
To Share allotment A/c 200
To Share call A/c 300
To Shares forfeited A/c 500

Forfeiture of shares issued at premium There can be two situations.


(i) The amount of share premium had not been received but it was credited
to “Securities Premium Account”, when the amount became due. The
journal entry for forfeiture will be:
Share capital A/c (with the amount called up) Dr.
Securities premium A/c (with the amount of premium called) Dr.
    To Unpaid calls A/c
  To Forfeited shares A/c
Illustration 14.2. A company forfeits 100 shares of ` 10 each issued at ` 11
per share. The premium was payable on allotment. The shareholder failed
to pay allotment money of ` 3 per share (including premium) and the call
money of ` 2 per share.
Solution:
The journal entry for forfeiture will be as follows:

Self-Instructional
Material 323
Company Accounts-II Date Particulars ` `
Share capital A/c Dr. 1,000
Securities premium A/c Dr.   100
To Share allotment A/c 300
NOTES To Share call A/c 200
To Forfeited shares A/c 600

(ii) The amount of share premium has either been received or even if
not received, the company has given credit to the securities premium
account only with the amount of premium received.
The journal entry will be:
Share capital A/c Dr.
(with the amount called up on account of share capital)
  To Unpaid calls
(with unpaid amount excluding share premium)
  To Forfeited shares A/c
(with the amount received)
Share premium once received cannot be cancelled. This is because
of Section 52 which provides for the use of share premium received, only
for certain specified purposes, as explained before.
Illustration 14.3. A company forfeits the shares held by two shareholders—A
and B.
(i) A holds 100 shares of ` 10 each on which he has paid ` 5 per share (` 3
on application and ` 2 on allotment including ` 1 as premium payable
on allotment) as application and allotment moneys but has failed to
pay the call of ` 6 per share.
(ii) B holds 200 shares of ` 10 each on which he has paid ` 3 per share, as
application money. He has failed to pay the allotment and call money.
The company gives credit to securities premium account only when
it is received.
Pass necessary journal entries.
Solution:
S.No Particulars Dr. ` Cr. `
(i) Share Capital A/c Dr. 1,000
To Share call A/c 600
To Shares forfeited A/c 400
(Being forfeiture of 100 shares held by A)
(ii) Share Capital A/c Dr. 2,000
To Share allotment A/c 200
To Share call A/c 1,200
To Shares forfeited A/c 600
(Being forfeiture of 200 shares held by B)

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324 Material
Forfeiture of shares issued at discount In such a case the discount allowed Company Accounts-II
on issue of shares will have to be cancelled. The journal entry will be:
Share Capital A/c Dr.
  To Unpaid call A/c
  To Forfeited shares A/c NOTES
  To Discount on issue of shares A/c
Illustration 14.4. A company forfeits 100 shares of ` 10 each issued at
` 9 per share on account of non-payment of final call of ` 4 per share by the
shareholder.
Solution:
The journal entry for forfeiture will be as follows:
Date Particulars Dr. ` Cr. `
Share capital A/c Dr. 1,000
To Share final call A/c 400
To Forfeited Shares A/c 500
To Discount on issue of shares A/c 100

Reissue of Forfeited Shares


Forfeited shares become the property of the company and the company can
always reissue them at its convenience. They can be reissued at par, premium
or discount. However, in case they are reissued at discount, the amount of
discount cannot exceed the amount that had been received on these shares. In
other words there cannot be any loss on account of reissue of forfeited shares.
Accounting entries While passing accounting entries regarding reissue of
forfeited shares the following points should be taken into account.
(i) The amount at which they are taken as paid up on reissue.
(ii) The amount that had already been received on the shares forfeited.
(iii) The amount allowed as discount.
The journal entry will be:
Bank A/c (with the amount recd.) Dr.
Forfeited Shares A/c (with the discount allowed) Dr.
  To Share Capital A/c (with the amount taken as paid up)
Illustration 14.5. A company forfeits 100 shares of ` 10 each on which
` 300 had been received. The company can allow a maximum discount
of ` 300 on these shares. In case these shares are reissued for ` 900 fully
paid, pass the necessary journal entries.

Self-Instructional
Material 325
Company Accounts-II Solution:
Date Particulars Dr. ` Cr. `
Bank A/c Dr. 900
Forfeited Shares A/c Dr. 100
NOTES
To Share capital A/c 1,000
(Being reissue of 100 forfeited shares)

The balance standing to the credit of “forfeited shares account”, is


a capital profit and therefore, it will be transferred to capital reserve. The
journal entry will be:
Date Particulars Dr. ` Cr. `
Forfeited Shares A/c Dr. 200
To Capital reserve 200
(Being profit on reissue of forfeited
shares transferred to capital reserve)

In case only a part of the forfeited shares have been reissued, only
the proportionate profit on reissue of forfeited shares will be transferred to
capital reserve.
For example, if in the above case only 60 shares are reissued at ` 9 per
share, the amount to be transferred to Capital Reserve will be ` 120

Reissue of forfeited shares originally issued at discount In case the


forfeited shares were originally issued at discount, the maximum permissible
reissue discount, is the sum received on forfeited shares and original discount.
For example, if a share of ` 10 was originally issued at a discount of `
1 is forfeited, and the amount received on it was ` 2, the maximum discount
on reissue of such a forfeited share can be ` 3 (i.e., original discount ` 1
+ amt. recd. ` 2). The Journal entry will be as follows in case the share is
reissued for ` 7 per share, fully paid up.
Particulars ` `
Bank A/c Dr. 7
Discount on issue of shares A/c Dr. 1
Forfeited shares A/c Dr. 2
To Share capital A/c 10

Illustration 14.6. B Ltd. forfeited 100 shares of ` 10 each, ` 8 per share being
called up, which were issued at a discount of ` 1 per share for non-payment
of first call of ` 3 per share. Of these forfeited shares, 80 shares were reissued
subsequently by the company at ` 5, as ` 8 paid up per share. Give journal
entries for the forfeiture and reissue of shares.

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326 Material
Solution: Company Accounts-II

In the Books of B Ltd.


Journal Entries
Date Particulars Dr. ` Cr. ` NOTES
Share Capital A/c (100 × ` 8) Dr. 800
To Shares forfeited A/c (100 × ` 4) 400
To Discount on issue of shares A/c (100 × ` 1) 100
To Shares first call A/c (100 × ` 3) 300
(Being forfeiture of 160 shares of ` 10 each, ` 8
called up issued at a discount of ` 1 per share for
non-payment of first call of ` 3 per share)
Bank A/c (80 × ` 5) Dr. 400
Discount on issue of shares A/c (80 × ` 1) Dr. 80
Shares Forfeited A/c (80 × ` 2) Dr. 160
To Share Capital A/c (80 × ` 8) 640
(Being reissue of 80 forfeited shares of ` 10
each,
` 8 called up, originally issued at a discount of `
1 per share, for ` 5 per share, credited as ` 8 per
share)
Shares Forfeited A/c Dr. 160
To Capital Reserve A/c 160
(Being transfer of capital profit proportionate to
forfeited shares reissued, i.e., on 80 shares, to
capital reserve account)
Reissue of forfeited shares originally issued at premium It is not
necessary that if the shares were originally issued at premium, their reissue
after forfeiture should also be at premium or that the premium should be at
the same rate. However, if any premium is received (i.e., over and above the
amount taken as paid up on account of share capital), the amount should be
credited to the “securities premium account.”
Illustration 14.7. A company forfeits 100 shares of ` 10 each, originally
issued at a premium of ` 2 per share. The shareholder paid ` 4 per share on
application but did not pay the allotment money of ` 4 per share (including
premium) and call of ` 4 per share. The company takes credit for the premium
as soon as it becomes due. The shares are subsequently reissued at ` 11 per
share fully paid up.
Pass journal entries for forfeiture and reissue of forfeited shares.

Self-Instructional
Material 327
Company Accounts-II Solution:
Journal

Date Particulars ` `
NOTES Share Capital A/c Dr. 1,000
Securities Premium A/c Dr. 200
To Share Allotment A/c 400
To Share Call A/c 400
To Shares Forfeited A/c 400
(Being forfeiture of 100 shares on account of non-
payment of allotment and call moneys)
Bank A/c Dr. 1,100
To Share Capital A/c 1,000
To Securities Premium A/c 100
(Being reissue of forfeited shares)
Shares Forfeited A/c Dr. 400
To Capital Reserve 400
(Being transfer of profit on shares forfeited to
capital reserve)

Alternative approach Some accountants are of the opinion that securities


premium account appearing in the Balance Sheet should have definite
relevance with the number of shares actually issued. Hence, in case shares
are subsequently issued at a premium at a rate lower than the rate at which
they were originally issued and the premium amount had not been received
at the time of original issue, the shortfall should be met out of the shares
forfeited account. For example, on the basis of the figures given in the previous
illustration, the journal entry will be as follows:
Date Particulars Dr. ` Cr. `
Bank A/c Dr. 1,100
Shares Forfeited A/c Dr. 100
To Share Capital A/c 1,000
To Securities premium A/c 200
(Being reissue of 100 forfeited shares)
However, such an approach may create problems in cases where
forfeited shares account does not have sufficient amount to meet the shortfall
on account of share premium. Thus, it is better to follow the first method
given before.
Illustration 14.8. A holds 100 shares of ` 10 each on which he has paid ` 1
per share as application money.
B holds 200 shares of ` 10 each on which he has paid ` 1 on application
and ` 2 on allotment.
C holds 300 shares of ` 10 each and has paid ` 1 on application, ` 2
on allotment and ` 3 for the first call.
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328 Material
They all fail to pay their arrears and the second call of ` 2 per share Company Accounts-II

and the Directors, therefore, forfeited their shares. The shares of C were then
reissued at ` 7 per share as fully paid-up.
Give the necessary journal entries to record the above transactions. NOTES
Solution:
The amount called up has been calculated as follows:
On Application `1
On Allotment `2
On First Call `3
On Second Call `2
Total Called up `8
Journal
Date Particulars Dr. ` Cr. `
Share Capital A/c Dr. 4,800
To Share Allotment A/c 200
To Share First call A/c 900
To Share Second Call A/c 1,200
To Forfeited Shares A/c 2,500
(Being forfeiture of 600 shares)
Bank A/c Dr. 2,100
Forfeited Shares A/c Dr. 900
To Share Capital A/c 3,000
(Being 300 shares reissued at ` 7 each fully
paid up)
Forfeited Shares A/c Dr. 900
To Capital Reserve A/c 900
(Being surplus on forfeiture and reissue of 300
shares transferred to capital reserve)
Working Notes:
(i) Amount not paid:
Allotment First Call Second Call
A 200 300 200
B – 600 400
C – – 600
200 900 1,200
(ii) The amount transferred to Capital Reserve has been calculated as follows:
Amount received on C’s shares (300 × 6) ` 1,800
Less: Discount allowed on reissue (300 × 3) ` 900
Net Gain ` 900

Check Your Progress


1. State the condition in which the ex-shareholder can be put on ‘List B
contributories’?
2. What is the condition for reissue of forfeited shares at discount?
Self-Instructional
Material 329
Company Accounts-II
14.3 REDEMPTION OF PREFERENCE SHARES
A company cannot return its share capital to its shareholders during its lifetime
NOTES except as provided under provisions The Companies Act (e.g. buy-back of
shares). However, a company can issue a special category of shares termed
as Redeemable Preference Shares, which the company can redeem during
its lifetime as per the provisions of Section 55 of the Companies Act, 2013.
These provisions have been framed keeping in view the fact that the interest
of the third parties are not adversely affected on account of return of share
capital to the shareholders.
The legal provisions are as follows:
(i) The issue of redeemable preference shares must be authorised by the
Articles of Association Shares already issued cannot be converted into
redeemable preference shares.
(ii) A company can issue preference shares which are liable to be redeemed
within a period not exceeding twenty years from the date of their
issue subject to such conditions as may be prescribed: Provided that a
company may issue preference shares for a period exceeding twenty
years for infrastructure projects, subject to the redemption of such
percentage of shares as may be prescribed on an annual basis at the
option of such preferential shareholders.
(iii) Such shares cannot be redeemed unless they are fully paid.
(iv) These shares can be redeemed subject to the terms and manners laid
down in the Articles and only (a) out of the profits of the company which
would otherwise be available for dividend or (b) out of the proceeds
of a fresh issue of shares made for the purpose of redemption.
It is to be noted that amount in the securities premium account or
development rebate reserve account or capital reserve etc., is not
available for distribution by way of dividend, and, therefore, such
funds cannot be used for redemption of preference shares. Similarly,
the term “proceeds of fresh issue’ does not include the amount received
by way of securities premium since Section 52 does not permit use
of securities premium for the redemption of preference share capital.
However, if the shares are issued at a discount, the net amount received
should be taken into consideration for calculating the “proceeds of the
fresh issue.”
(v) Where any such shares are redeemed otherwise than out of the proceeds
of a fresh issue, the company must out of the profits which would have
been otherwise available for dividend, transfer to ‘Capital Redemption
Reserve Account’ a sum equivalent to the nominal amount of shares

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330 Material
redeemed. ‘Capital Redemption Reserve Account’ may subsequently Company Accounts-II
be utilised for the purpose of issuing fully paid bonus shares to the
members of the company.
In the case of a capital reduction scheme, the capital redemption reserve
NOTES
account can be reduced in the same way as paid up share capital of the
company.
The effect of the provisions given in clauses (iv) and (v) above is the
replacement of redeemable preference share capital by fresh share
capital or by Capital Redemption Reserve Account. Capital Redemption
Reserve Account can be used only for issuing fully paid bonus shares.
The intention of the law, therefore, is to keep intact even redeemable
preference share capital by replacing such share capital by share capital
issued for cash or issued out of profits as bonus shares.
(vi) Where any shares are redeemed out of the proceeds of the fresh issue,
the premium, if any, payable on redemption must be provided for out
of the profits of the company or out of the balance in the Securities
Premium Account.
(vii) Where a company is not in a position to redeem any preference shares
or to pay dividend, if any, on such shares in accordance with the terms
of issue (such shares hereinafter referred to as unredeemed preference
shares), it may, with the consent of the holders of three-fourths in
value of such preference shares and with the approval of the Company
Law Tribunal on a petition made by it in this behalf, issue further
redeemable preference shares equal to the amount due, including the
dividend thereon, in respect of the unredeemed preference shares. On
the issue of such further redeemable preference shares, the unredeemed
preference shares shall be deemed to have been redeemed.
(viii) Company must notify the fact of the redemption of shares to the
Registrar of Joint Stock Companies within one month of such
redemption.
Accounting entries The following are the accounting entries to be passed in the books of
a company which wants to redeem its redeemable preference share capital.
(i ) For making partly paid up shares fully paid up:
(a) Redeemable preference share final call A/c Dr.
To Redeemable preference share capital A/c
(For final call being made)
(b) Bank A/c Dr.
To Redeemable preference share final call A/c
(For money realised on final call)

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Material 331
Company Accounts-II (ii ) For redeeming out of profits:
Profit & Loss A/c/Revenue reserves A/c Dr.
To Capital redemption reserve A/c
(iii ) For a fresh issue of shares:
NOTES
Bank A/c Dr.
To Share capital A/c
(In case of issue of shares at premium or discount, the
relevant account should be credited or debited)
(iv) Making provision for payment of premium on redemption of preference shares:
Securities premium/Profit and Loss/Revenue or Capital reserve A/c Dr.
To Premium on redemption of preference share A/c
(v) For money due to redeemable preference shareholders:
Redeemable preference share capital A/c Dr.
Premium on redemption of preference shares A/c Dr.
To Redeemable preference shareholders/preference
shares redemption A/c
(vi) For payment of redeemable preference shareholders:
Redemable preference shareholders/preference share redeemable A/c
To Bank A/c
(vii) For issue of bonus shares:
(a) redemption reserve/Share premium/Revenue reserve A/c Dr.
To Bonus payable A/c
(b) Bonus payable A/c Dr.
To Share capital A/c

Tutorial Notes: The following points are worth noting:


(i) Calls in Arrears. In case calls are in arrear in respect of certain
redeemable preference shares, such preference shares can be redeemed only
when the calls are paid by the shareholders concerned. While attempting an
examination problem, the students should not redeem these preference shares
till the calls are paid. The amount of such preference capital not redeemed
because of unpaid calls may be allowed to remain as Redeemable Preference
Share Capital. Alternatively the amount of such capital may be transferred to
Redeemable Preference Share Capital Suspense Account till a final decision
(whether to forfeit or not) is taken. the Red. Pref. Share Capital Suspense
Account may be shown under the heading Share Capital in the balance sheet.
However, if a fresh issue is to be made for redemption of the preference
shares, such issue should be made presuming that the shareholders holding
preference shares against which calls are in arrears will also make payment
of such calls.
In case preference shares are to be redeemed out of profits, an amount
equivalent to the nominal value of the preference shares against which calls
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332 Material
are in arrears should be allowed to remain in the profit and loss account or Company Accounts-II
the revenue reserve account. On redemption of these shares, such amount
should be transferred to Capital Redemption Reserve Account.
Alternatively, the amount may be transferred to Preference Shares
NOTES
Redemption Suspense Account. On redemption of these shares the amount
may be transferred to Capital Redemption Reserve Account. Any premium
payable on redemption of preference shares may also be put to Preference
Shares Redemption Suspense Account. On redemption of preference shares,
such account will be debited with the amount of premium paid.
(ii) Sale of Assets. In case certain assets are sold for raising the necessary
liquid resources, selling of such assets will not in any way affect transferring
of the amount to the capital redemption reserve account or issue of new shares
for redemption as per the requirements of law. Any profit or loss on sale of
such assets (unless it is a capital profit) should preferably be transferred to
the profit and loss account.
(iii) Unpaid Amount. In case certain Redeemable Preference shareholders
could not be paid the amount due to them due to change of their addresses or
their being untraceable, the amount due to them should be allowed to remain
in the “Redeemable Preference Shareholders Account or Preference Shares
Redemption Account.” In the Balance Sheet the amount due to them can be
shown under the heading Current Liabilities and Provisions.
The process of making necessary accounting entries, in case of
redemption of preference shares can be very well understood with the help
of the illustrations given below.
Illustration 14.9. Pioneer Construction Co. Ltd. decided to redeem their
preference shares as on31st March, 2017 on which date the position was as
under.
Pioneer Construction Ltd.
Balance Sheet as at 31 March, 2017
Particulars As at 31 March, 2017
`
A Equity and Liabilities
1. Shareholders’ Funds
(a) Share Capital
Issued Subscribed & Paid up Capital:
4,000 Equity shares of `100 each 4,00,000
4,000 Redeemable preference shares of 1,00,000
`50 each,
`25 Paid up
2,000 Redeemable preference shares of ` 2,00,000
100 each
Fully paid

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Material 333
Company Accounts-II Particulars As at 31 March, 2017
`
(b) Reserves and Surplus
Securities Premium Account 10,000
NOTES Capital Redemption Reserve 90,000
Dividend Equalisation Reserve 1,10,000
(c) money Received Against Share Warrants –
9,10,000
2. Share Application Money Pending Allotment –
3. Non-current Liabilities –
4. Current Liabilities –
(a) Short-term Borrowings –
(b) Trade Payables 90,000
90,000
Total (1) + (2) + (3) + (4) 10,00,000
B Assets
1. Non-current Assets –
2. Current Assets
(a) Current Anvestments –
(b) Inventories –
(c) Trade Receivables –
(d) Cash and Cash Equivalents 1,40,000
(e) Short-term loans and Advances –
(a) Other Current Assets 8,60,000
Total (1) + (2) 10,00,000

The redemption was to be at a premium of 5 per cent. The Capital


Redemption Reserve appearing in the balance sheet is the reserve brought
into being as a result of a redemption which took place in 2000. To enable the
redemption to be carried out the company decides to issue, after carrying
out the necessary formalities required under law, sufficient number of new
equity shares at a discount of 10 per cent. The redemption is duly carried
out. Show journal entries relating to the redemption and new issue and also
the balance sheet after redemption. Ignore the question of dividend upto the
date of redemption.
Solution:
Tutorial Notes:
(i) Amount to be paid to preference shareholders:
As Share capital ` 2,00,000
As Premium on redemption 10,000
2,10,000
Please note that only preference shares fully called and paid up are to be redeemed.
No redemption can be carried out of 4,000 redeemable preference shares which are
partly called and paid up.
(ii) Arrangement for redemption:
(a) ` 10,000 premium on redemption can be provided out of Securities Premium
Account already appearing in the Balance Sheet (See entry No. 5).
(b) Preference Capital of ` 2,00,000 has to be redeemed. The number of new shares
to be issued has not been given. However, in the absence of any specific amount
Self-Instructional
334 Material
in the question, their number has to be minimum. A sum of ` 1,10,000 is lying Company Accounts-II
in the Dividend Equalisation Reserve. Redemption can be carried out of profits
to this extent. The amount has therefore been transferred to Capital Redemption
Reserve (See entry No. 2).
The balance has been redeemed by issuing new shares. Since the new shares
NOTES
are being issued at a discount, the number of new shares required to be issued
to collect the necessary proceeds would amount to 90,000/9 = 10,000 (See entry
No. 3).
Pioneer Construction Co. Ltd
Journal
S. No. Particulars Dr. ` Cr. `
(1) Preference Share Capital A/c(fully paid) Dr. 2,00,000
Premium on redemption of pref. shares A/c Dr. 10,000
To Sundry preference shareholders A/c 2,10,000
(Being amount due to preference shareholders on
redemption, including premium at 5%)
(2) Dividend Equalisation Reserve Dr. 1,10,000
To Capital redemption reserve A/c 1,10,000
(Being transfer to the latter account as required
by law, to the extent the redemption has been from
distributable profits)
(3) Bank A/c Dr. 90,000
Discount on Issue of Share A/c Dr. 10,000
To Equity share capital A/c
(Being issue of new equity shares @ 10 per cent 1,00,000
discount for the purpose of redemption of prefer-
ence shares to the extent required)
(4) Sundry preference Shareholders A/c Dr. 2,10,000
To Bank 2,10,000
(Being payment made to preference shareholders)
(5) Securities Premium A/c Dr. 10,000
To Premium on redemption of preference 10,000
shares
(Being writing off premium on redemption of
preference shares from share premium)

Pioneer Construction Ltd.


Balance Sheet as at 31 March, 2017
(Summarised balance sheet after redemption)
Particulars `
A Equity and Liabilities
1. Shareholders’ Funds
(a) Share Capital
Issued Capital: 5,000 Equity Shares of ` 100 each 5,00,000
4,000 Redeemable Preference Shares of `50 each, `25 1,00,000
Paid up
(b) Reserves and Surplus
Capital Redemption Reserve 2,00,000
Discount on Issue of Shares (10,000)
(c) money Received against Share Warrants

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Material 335
Company Accounts-II Particulars `
7,90,000
2 Share Application Money Pending Allotment –
3. Non-current Liabilities –
NOTES 4. Current Liabilities –
(a) Short-term Borrowings –
(b) Trade Payables 90,000
90,000
Total (1) + (2) + (3) + (4) 8,80,000
B Assets
1. Non-current Assets –
2. Current Assets
(a) Current Investments –
(b) Inventories –
(c) Trade Receivables –
(d) Cash and Cash Equivalents 20,000
(e) Short-term Loans and Advances –
(f) Other Current Assets 8,60,000
Total (1) + (2) 8,80,000

Use of Mathematical Equation


Sometimes the use of a mathematical equation becomes necessary to find
out the number of new shares to be issued. This particularly happens when
a minimum new issue is to be made at premium or discount, the preference
shares are to be redeemed at premium and the existing amount of divisible
profits and share premium are not sufficient to redeem the preference shares
in full.
The algebraic equation taking the new issue as x can be put as follows:
Red. Pref. Share Capital Premium in Divisible x i.e., Premium on x
+ = Balance Sheet + Profits in + New + (or less
Premium on Redemption Balance Sheet Issue Discount)

Illustration 14.10. Prosperous Ltd. has 12% preference share capital of ` 1


lac consisting of` 100 shares fully called and paid up. The company wants
to redeem them at 10% premium. The ledger accounts show the following
balances:
Profits & loss A/c ` 20,000
Securities premium 4,000
The directors desire to make a minimum fresh issue of equity shares
of ` 10 each at 5% premium for redemption of the preference shares.
You are required to ascertain the amount of such fresh issue to be
made by the directors and pass the requisite journal entries.

Self-Instructional
336 Material
Solution: Company Accounts-II

Since, the new issue of equity shares is to be made at a premium of an amount


which is the minimum for redeeming preference shares, a mathematical
equation will have to be used. NOTES
Let the new issue be of ` x
Redeemable Preference Share Capital Share Premium as given + P. & L. A/c balance
+ = +
Premium on redemption Proceeds of fresh issue + Premium on fresh issue.
= 1,00,000 + 10,000 = 4,000 + 20,000 + x + x/20
or 1,10,000 = 24,000 + 21x/20
or –21x/20 = –1,10,000 + 24,000
or –21x/20 = –86,000
or 21x = 86,000 × 20 = 17,20,000
x = 17,20,000/21
or = 81,905

Thus, a minimum new issue of ` 81,905 will have to be made for


redemption of preference shares.
Verification In case each share is of ` 10, face value, 8,191 shares will be
issued. The amount realised would be as under:
Share Capital 8,191 × 10 = ` 81,910.00
Share Premium 8,191 × 0.50 4,095.50
86,005.50
Total amount required for redemption:
Red. Preference share capital 1,00,000
Premium on Redemption 10,000
1,10,000
Amount Available for redemption:
Share Premium (4,000 + 4,095.50) = ` 8,095.50
Profit & Loss A/c balance 20,000.00
Proceeds from new Issue 81,910.00
1,10,005.50

Journal Entries
Date Particulars Dr. ` Cr. `
Redeemable Preference Share Capital A/c Dr. 1,00,000
Premium on Redemption of Pref. Shares Dr. 10,000
To Redeemable pref. shareholders A/c 1,10,000
(Being amount due to preference shareholders includ-
ing 10% premium)
P&L A/c Dr. 1,904.50
Share premium A/c Dr. 8,095.50
To Premium on redemption of pref. shares 10,000
(Being providing for premium on redemption)
P&L A/c Dr. 18,095.50
To Capital redemptional reserve 18,095.50

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Material 337
Company Accounts-II
Date Particulars Dr. ` Cr. `
(Being transfer of balance in P. & L. A/c to Capital
redemption reserve to provide for redemption of pref-
erence shares)
NOTES Bank A/c Dr. 86,005.50
To Equity share capital A/c 81,910.00
To Securities Premium A/c 4,095.50
(Being issue of 8,191 shares of ` 10 each at 10%
premium)
Redeemable pref. shareholders A/c Dr. 1,10,000
To Bank A/c 1,10,000
(Being money paid to preference shareholders on
redemption)

Check Your Progress


3. What is the intention of the law to keep Capital Redemption Reserve
Account’s use only for issuing fully paid bonus shares?
4. Where is the unpaid amount due to Redeemable Preference
shareholders shown in the Balance Sheet?

14.4 RIGHT ISSUE


Meaning In case of joint stock companies or corporations, generally the
shareholders are given the pre-emptive right either by their Charter or by
the Act applicable to them. This pre-emptive right gives holders of common
stock (or equity shares) the first option to purchase additional issues of
common stock.2
A pre-emptive right (popularly termed simply as “right”) may
therefore be defined as an option to buy a security at a specified price during
a specified period. “Right shares” are the shares so issued to the shareholders
under such pre-emptive right.
Purpose Issue of right shares serves two purposes:
(i) It preserves the power of control of the present shareholders. In the
absence of such a right, the existing shareholders may be deprived
of their controlling power if a large number of shares are offered for
subscription to outsiders.
(ii) It prevents loss to the existing shareholders on account of dilution of
the value of their shareholdings. For example, a company has a share
capital of 1,000 equity shares of ` 100 each but having a market value
of ` 150. The company needs additional funds of ` 50,000. It offers
to outsiders 500 equity shares at ` 100 each. In such a case the total
market value of the firm after the new issue would be ` 2,00,000
(i.e., 1,50,000 + 50,000) and the value per share would come down
to ` 133 (i.e., 2,00,000/1,500) each. Thus, offering new equity shares
Self-Instructional 2
Section 62 of the Companies Act, 2013 also gives this pre-emptive right to shareholders in India.
338 Material
below market value will dilute the value of the equity shares. It will be Company Accounts-II
detrimental to the present equity shareholders but beneficial to those
who have purchased the new shares.
Valuation of rights When a company offers new shares to the existing
NOTES
shareholders, they are generally offered at a much lower price than their
market price. This is because of two reasons. First, the company wants to
give the existing shareholders some advantage because of their continued
association with the company. Secondly, the company wants to make the
right issue a success and therefore it takes into account the possible fall in
the market value of the company’s shares on account of a right issue.
On a right issue being made, the existing shareholders have the
privilege of either applying for the shares offered within a fixed period
(usually 30 days) or to renounce their right to apply for these shares in favour
of some other person. Since the right issue is being offered at a concessional
price, an existing shareholder can make a profit by selling his right to apply
for the new shares. He may sell this right with or without selling his existing
shareholding. The price of the shares may therefore be either cum-right
price or an ex-right price. The cum-right price gives the buyer, besides
the ownership of the shares already held, the right to apply for new shares
offered by the company, while the ex-right price gives the buyer only the
ownership of the existing shares held by the seller and not the right to apply
for additional shares offered by the company. Ex-right price is quoted either
after the right shares have already been allotted by the company or the time
to apply for right shares has already expired.
The cum-right price is higher than the ex-right price of the shares
since the former includes the value of the right also. The value of the right
can be calculated by applying the following formula:

where, R = Value of one right


M = Cum-right market price of a share
S = Subscription price for a new share
N = Number of old shares required to purchase one new share
Illustration 14.11. A Ltd. has a share capital of 5,000 equity shares of ` 100
each, having a market value of ` 150 per share. The company wants to raise
additional funds of ` 1,20,000 and offers to the existing shareholders the right
to apply for a new share at ` 120 for every five shares held. You are required
to calculate the value of a right.
Solution:

Self-Instructional
Material 339
Company Accounts-II The value of one right is, therefore, ` 5.
Valuation of a share ex-right The ex-right value of a share can be
determined by deducting the value of right from the cum-right market price
of the share. For example, in the illustration given above, the ex-right value
NOTES
of a share would be ` 145 (i.e., ` 150 – 5). The same result can be obtained
by applying the following formula.

where, P = Theoretical market value of a share ex-right


M = Cum-market price
N = Number of old shares entitling purchase one new share
S = Subscription price for a new share.
On the basis of the data given in the above illustration, the theoretical
ex-right value of a share will be as follows:

The value of right by this method also comes to ` 5 (i.e., 150 – 145)

14.5 DEBENTURES
Companies require money from time to time. This requirement is met by
the company partly by raising share capital and partly by depending on
public borrowings. One form of such public borrowings is to raise money
by issue of debentures. Debentures help the companies in borrowing
money from a large section of the general public. A debenture is of a small
denomination (usually of ` 100) and, therefore, can be purchased even
by persons of small means. For example, if a company needs a sum of
` 1,00,000 it can offer to the public for subscription 1,000 debentures of
` 100 each. It may be difficult for one person to lend a sum of ` 1,00,000 to
the company but he can conveniently purchase a certain number of debentures,
thus helping the company in raising the required funds.
Meaning of Debentures
Debenture may be defined as a certificate issued by a company under its seal
acknowledging debt due by it to its holder. The most essential characteristic
of a debenture is the admission or record of indebtedness.
According to the Companies Act, 2013 the term debenture includes
“debenture stock, bonds and any other securities of a company whether
constituting a charge of the assets of the company or not”. [Sec. 2(30)]

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340 Material
The term “debenture stock” is similar to “share stock”. It is the Company Accounts-II
aggregate and consolidated amount of borrowings on account of debentures
by a company. Fully paid debentures can only be converted into debenture
stock. Such stock can be divided and transferred in any convenient parts.
NOTES
A company cannot issue debentures carrying any voting rights [Sec.
71(2)].
Bonds and Debentures
Bonds are a form of long term debt and can be referred as a debt security.
Bond may be defined as a debt security in which the issuer (borrower) of the
bond owes the holder (lender), a debt and depending on the terms of the bond
is obliged to pay interest on the amount borrowed and repay the principal at
maturity. In other words, the bond is a formal contract to repay the borrowed
money with interest at fixed intervals.
A bond is similar to a debenture. A debenture, as stated before may be
defined, a certificate issued by a company acknowledging the debt due by it
to its holder. The most essential characteristic of a debenture is the admission
or record of indebtedness. Debentures may be both, secured or unsecured.
In some countries, e.g., in U.S.A., a difference is made between a
debenture and a bond. The term debenture is used for a debt instrument
which is unsecured or which does not have a charge against some specific
property of the borrower. Moreover, a bond has a longer maturity, period as
compared to a debenture.
In India, no such difference is made between a debenture and a
bond. They are used as interchangeable terms. Of course, the term bond is
generally used in India for a debt security issued by Government or a Public
Institution. Both debentures and bonds are debt securities issued for long
term borrowings, i.e., borrowings for more than a year.
Classification of debentures
A company may issue various kinds of debentures with different rights as
given below.
From the Point of View of Security
Naked debentures These are debentures which do not carry any charge
on the assets of the company. The holders of such debentures are not given
any security as to the payment of interest and repayment of capital.
Mortgage or secured debentures Debentures which are secured by a
mortgage or charge on the whole or a part of the assets of the company are
known as mortgage debentures.
The date of redemption of secured debentures should not exceed ten
years from the date of issue except debentures issued for infrastructure
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Material 341
Company Accounts-II projects where secured debentures may be issued for a period exceeding 10
years but not exceeding 30 years.
Sometimes on the same security, money is borrowed by the company by
issuing debentures in two or more instalments. Debentures so issued may be
NOTES
given priority in repayment depending upon the order in which they have been
issued, Debentures issued earlier will have priority over debentures issued
later. Mortgage debentures may, therefore, be further classified as follows:
(i) First debentures. These debentures have priority over other debentures
as regards payment out of the proceeds of the property mortgaged.
(ii) Second debentures. These debentures are repaid after the claims of
the first debentures have been met.
For example, a company has freehold property worth ` 1,00,000 against
which First debentures of ` 60,000 and Second debentures of ` 40,000 were
issued. In case the property is sold for ` 90,000, out of the sale proceeds,
First debentureholders will be paid ` 60,000 and the balance of ` 30,000 will
be used for payment to Second debentureholders.
Trust Deed In case of mortgage debentures issued to public, it becomes
essential for the company to appoint trustees who will hold the property given
by way of security in trust for the benefit of all debentureholders. This is
necessary because it is impossible to give each debentureholder title deeds
of the mortgaged property. The company acknowledges its indebtedness to
the trustees and conveys them legal and equitable interest in the property
given by way of security for the loan by handing over the relevant title deeds.
From the Point of View of Redemption
Redeemable debentures Redeemable debentures provide for the payment
of the principal amount on the expiry of a certain period. Redeemable
debentures can be reissued even after they have been redeemed until they
have been cancelled. Upon such reissue, the person entitled to the debentures
will have the same rights and priorities as if the debentures had never been
redeemed.
Irredeemable debentures In the case of irredeemable or perpetual
debentures, the company does not give any undertaking of repaying the
money borrowed by issuing debentures, after a fixed time or within a fixed
period during the continuance of business by the company. Company may
repay debentures at any time it may choose to do so, but the creditors cannot
compel the company to repay them at certain time. They shall, however, be
repaid when the company goes into liquidation or makes a default in the
payment of interest.

Self-Instructional
342 Material
From the Point of View of Convertibility Company Accounts-II

Convertible debentures These are debentures which are wholly or partly


convertible into shares of the company as per the terms of their issue.
The issue of debentures with an option to convert such debentures into NOTES
shares wholly or partly, must be approved by a special resolution passed
at a general meeting. Of course convertible debentures at discount as it is
prohibited.
Non-convertible debentures Debentures not convertible into shares of
the company are termed as non-convertible debentures.
From the Point of View of Transferability
Registered debentures Registered debentures are made out in the names of
specific persons, who are registered as a debentureholders in the books of the
company. The names of the debentureholders are recorded in the company’s
register of debentureholders. They are transferable in the same way as shares
or in accordance with the conditions endorsed on their back.
Bearer debentures Bearer debentures are treated as negotiable instruments
and are transferable by delivery alone. The names of the holders of such
debentures are not required to be registered in the register of debentureholders.
Accounting for Issue of Debentures
The entries for issue of debentures are made on the same pattern as for issue
of shares. They can also be issued at par, premium or discount. However,
the legal restrictions regarding use of premium money or issuing at discount
applicable in the case of shares, are not applicable to debentures. The
accounting entries are being given below:
Issue of debentures for consideration other than cash
(i) On acquisition of assets:
Assets A/c (with value of assets) Dr.
To Vendors (with purchase price)
In case the value of assets is more than the purchase price, the balance
is credited to Capital Reserve. In a reverse case, i.e., where the purchase price
is more than the value of assets purchased, the balance is debited to Goodwill
Account.
(ii) On allotment of debentures:
Vendors Dr.
To Debentures A/c
In case debentures are issued at a discount, the ‘Debenture Discount
Account’ will be debited with the amount of discount allowed. In case issue
of debentures is at premium, the “Debenture Premium Account” will be
credited with the amount of premium. Self-Instructional
Material 343
Company Accounts-II Issue of debentures for cash
(i) For receipt of application money:
Bank A/c Dr.
To Debenture application A/c
NOTES (ii) On allotment of debentures:
Debenture application A/c Dr.
To Debentures A/c
(For transfer of debenture application money)
Debenture allotment A/c Dr.
To Debentures A/c
(For allotment money due)
Bank A/c Dr.
To Debenture allotment A/c
(For receipt of allotment money)
In case allotment is made at premium and premium is to be received on allotment, the
entry for amount due on allotment will be:
Debenture allotment A/c Dr.
To Debentures A/c
To Debenture premium A/c
In case allotment is made at discount, the entry will be:
Debenture allotment A/c Dr.
Discount on issue of debentures A/c Dr.
To Debentures A/c
(iii) On first/second/final call:
Debentures first/second/final call A/c Dr.
To Debentures A/c
(For first/second/final call due)
Bank A/c Dr.
To Debenture first/second/final call A/c
(For first/second/final call money received)
(iv) If money is received in one instalment:
If issued at par:
Bank A/c Dr.
To Debentures A/c
If issued at discount:
Bank A/c Dr.
Discount on issue of Debentures A/c Dr.
To Debentures A/c
If issued at premium:
Bank A/c Dr.
To Debentures A/c
To Debentures Premium A/c
(v) For payment of interest of debentures:
Debenture interest A/c Dr.
To Bank
To Tax deducted at source
Notes:
(a) It is customary to prefix the rate of interest payable on debentures with the “Debentures Account”.
For example if the rate of interest payable on debentures is 10%, debentures account will be termed
as, “10% Debentures Account”.
(b) Income tax is to be deducted at source at prescribed rates by the company paying interest on
debentures. Tax so deducted is deposited by the company on behalf of debentureholders with the Central
Self-Instructional
344 Material
Government. The debentureholder can get credit for the tax deducted on the basis of Tax deduction Company Accounts-II
certificate issued by the company.

Illustration 14.12. In February 2016 A Ltd., offered for subscription 1,000


14% debentures of` 1,000 each at the issue price of 94%, payable ` 50 per
debenture on application, ` 500 on allotment and the balance on 1 May, NOTES
2016. Interest was payable half yearly on 30 June and 31 December. The first
coupon payable on 30 June 2016, being for 5%. The issue was fully taken up.
Rate of Tax Deducted at source is 10%. Journalise the transactions
and show how they would appear in the Company’s Balance Sheet as on
31st Dec. 2016.
Solution:
A Ltd.
Journal
Date Particulars Dr. ` Cr. `
2016 Bank A/c Dr.
Feb. To 14% Deb. application A/c 50,000
(Being application money received on 1,000 50,000
debentures @ ` 50 each)
14% Debenture application A/c Dr. 50,000
To 14% Debentures A/c
(Being transfer of application money to 14% 50,000
debentures account on allotment vide Board’s
Resolution No. ..... dated ......)
14% Debenture allotment A/c Dr. 5,00,000
Discount on issue of deb. A/c Dr. 60,000
To 14% Debentures A/c 5,60,000
(Being money due on allotment vide Board’s
Resolution
No......dated.....)
Bank A/c Dr. 5,00,000
To 14% Debenture allotment A/c 5,00,000
(Receipt of allotment money)
1 May 14% Debenture first & final call A/c Dr. 3,90,000
To 14% Debentures A/c 3,90,000
(Being first and final call due on 1,000 deben-
tures @
` 390 per debenture)
Bank A/c Dr. 3,90,000
To 14% Debenture first & final call A/c 3,90,000
(Being receipt of first and final call money)
30 June Debenture interest A/c* Dr. 50,000
To Bank 45,000
To Tax deducted at source 5,000
(Interest paid on debentures for half year @ 5
per cent on ` 10,00,000
after deduction of tax)

Self-Instructional
Material 345
Company Accounts-II Date Particulars Dr. ` Cr. `
31 Dec. Debenture interest A/c Dr. 70,000
To Bank 63,000
To Tax deducted at source 7,000
NOTES (Payment of debenture interest for half-year
ended 31 Dec. 2016)
31 Dec. Profit and Loss A/c Dr. 1,20,000
To Debenture interest A/c 1,20,000
(Being transfer of debenture interest to Profit &
Loss A/c)
*
The money was received on debentures on different dates. Instead of calculating interest on different
amounts received on different dates, the question provides for a flat rate of interest of 5% on the entire
amount for the first six months.

A Ltd.
Balance Sheet as on 31st Dec. 2016
Particulars `
A Equity and Liabilities
1. Shareholders’ Funds
(a) Share Capital
Issued & Paid-up Capital _ equity shares of _ each
(b) Reserves and Surplus .................
Profit and Loss A/c (1,20,000)
Discount on Issue of Debentures (60,000)
(c) Money Received Against Share Warrants –
(1,80,000)
2 Share Application money Pending Allotment –
3 Non-current Liabilities
(a) Long-term Borrowings: 14% debentures 10,00,000
(b) Deferred tax Liabilities (net)
(c) Other Long-term Liabilities
(d) Long-term Provisions
10,00,000
4 Current Liabilities
(a) Short-term Borrowings –
(b) Trade Payables –
(c) Other Current Liabilities 12,000
(d) Short-term Provisions: Tax deducted at source –
12,000
TOTAL (1) + (2) + 8,32,000
(3) + (4)
B Assets
1. Non-current Assets –
2. Current Assets
(a) Current Investments –
(b) Inventories –
(c) Trade Receivables –
(d) Cash and Cash Equivalents 8,32,000

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346 Material
Particulars Company Accounts-II
`
(e) Short-term Loans and Advances –
(f) Other Current Assets –
8,32,000
TOTAL (1) + (2) 8,32,000 NOTES
Note: Separate notes for various items of Balance Sheet have not been made in the absence of detailed
information.

Check Your Progress


5. Define pre-emptive right.
6. What are naked debentures?

14.6 ANSWERS TO CHECK YOUR PROGRESS


QUESTIONS
1. When a company goes into liquidation within one year of the forfeiture
of shares, the ex-shareholder can be put on “List B contributories’.
2. In case, the forfeited shares are reissued at discount, the amount of
discount cannot exceed the amount that had been received on these
shares.
3. The intention of the law to keep Capital Redemption Reserve Account’s
use only for issuing fully paid bonus shares is to keep intact even
redeemable preference share capital by replacing such share capital by
share capital issued for cash or issued out of profits as bonus shares.
4. The unpaid amount due to Redeemable Preference shareholders are
shown in the Balance Sheet under the heading Current Liabilities and
Provisions.
5. A pre-emptive right (popularly termed simply as ‘right’) is defined
as an option to buy a security at a specified price during a specified
period.
6. Naked debentures are debentures which do not carry any charge on
the assets of the company.

14.7 SUMMARY
· Forfeiture of shares may be defined as termination of membership and
taking away of the shares because of default in payment of allotment
and/or call money by a shareholder. The Companies Act does not
contain any specific provision regarding forfeiture of shares.

Self-Instructional
Material 347
Company Accounts-II · The following points should be taken into account while passing an
accounting entry for forfeiture of shares.
(i) The amount called up on the shares forfeited.
NOTES (ii) The amount unpaid on various calls (including allotment) on the
shares forfeited.
(iii) The amount received on the shares forfeited.
· Forfeited shares become the property of the company and the company
can always reissue them at its convenience. They can be reissued at par,
premium or discount. However, in case they are reissued at discount, the
amount of discount cannot exceed the amount that had been received
on these shares. In other words there cannot be any loss on account of
reissue of forfeited shares.
· While passing accounting entries regarding reissue of forfeited shares
the following points should be taken into account.
(i) The amount at which they are taken as paid up on reissue.
(ii) The amount that had already been received on the shares forfeited.
(iii) The amount allowed as discount.
· In case of joint stock companies or corporations, generally the
shareholders are given the pre-emptive right either by their Charter or
by the Act applicable to them. This pre-emptive right gives holders of
common stock (or equity shares) the first option to purchase additional
issues of common stock.
· Pre-emptive right (popularly termed simply as “right”) may therefore
be defined as an option to buy a security at a specified price during
a specified period. “Right shares” are the shares so issued to the
shareholders under such pre-emptive right.
· A company cannot return its share capital to its shareholders during its
lifetime except as provided under provisions The Companies Act (e.g.
buy-back of shares). However, a company can issue a special category
of shares termed as Redeemable Preference Shares, which the company
can redeem during its lifetime as per the provisions of Section 55 of
the Companies Act, 2013. These provisions have been framed keeping
in view the fact that the interest of the third parties are not adversely
affected on account of return of share capital to the shareholders.
· Debenture may be defined as a certificate issued by a company under
its seal acknowledging debt due by it to its holder. The most essential
characteristic of a debenture is the admission or record of indebtedness.
According to the Companies Act, 2013 the term debenture includes
“debenture stock, bonds and any other securities of a company whether
constituting a charge of the assets of the company or not”. [Sec. 2(30)].
Self-Instructional
348 Material
· Bonds are a form of long term debt and can be referred as a debt security. Company Accounts-II

Bond may be defined as a debt security in which the issuer (borrower)


of the bond owes the holder (lender), a debt and depending on the terms
of the bond is obliged to pay interest on the amount borrowed and repay
the principal at maturity. In other words, the bond is a formal contract NOTES
to repay the borrowed money with interest at fixed intervals.
· Debentures are classified from the point of view of security, from the
point of view of redemption, from the point of view of convertibility
and from the point of view of transferability.

14.8 KEY WORDS


· Forfeiture of shares: It is defined as termination of membership and
taking away of the shares because of default in payment of allotment
and/or call money by a shareholder. The Companies Act does not
contain any specific provision regarding forfeiture of shares.
· Pre-emptive right: It refers to as an option to buy a security at a
specified price during a specified period.
· Rights shares: It refers to the shares that are issued to the shareholders
under such pre-emptive right.
· Debentures: It is defined as a certificate issued by a company under
its seal acknowledging debt due by it to its holder.

14.9 SELF ASSESSMENT QUESTIONS AND


EXERCISES

Short Answer Questions


1. List the provisions for forfeiture of shares under the Model Articles of
a company limited by shares.
2. Write a short note on calls in arrears in case of redeemable preference
shares.
3. What is the purpose of issue of rights shares?
4. What are cum-right price and ex-right price?
5. Briefly explain the concept of bonds and debentures.
Long Answer Questions
1. Explain the accounting entries for various conditions under the
forfeiture of shares.
2. Discuss the major provisions related to the redemption of preference
shares.
Self-Instructional
Material 349
Company Accounts-II 3. Mention the accounting entries to be passed in the books of a company
which wants to redeem its redeemable preference share capital.
4. Explain the classification of debentures.
NOTES 5. Mention the accounting entries for issue of debentures in different
cases.
Practical Problems
1. X Co. Ltd. invited applications for 2,00,000 equity shares of ` 10 each on the following terms:
Payable on application on 31 Jan. 2016 – ` 5 per share.
Payable on allotment on 28 Feb. 2016 – ` 3 per share (including ` 1 per
share as premium)
Payable on final call on 30 June 2016 – ` 3 per share.
Applications for 2,50,000 shares were received. It was decided:
(i) to refuse allotment to the applicants for 10,000 shares.
(ii) to allot in full to applicants for 40,000 shares.
(iii) to allot the balance of the available shares pro rata among other applicants.
(iv) to utilise excess application moneys in part payment of allotment moneys.
One shareholder to whom shares had been allotted on pro rata basis failed to pay the amount due
on allotment and on call and his 200 shares were forfeited. 150 of these shares were reissued on
31 October, 2016 at ` 9 per share.
Give the necessary Journal entries and prepare the Cash Book to record the above transactions.
[Ans. Amount. transferred to Capital Reserve on reissue of forfeited shares ` 787.50]
2. Wye Ltd. was formed with an authorised capital of 2,00,000 equity shares of ` 10 each on 1 July
2016. 1,00,000 shares were issued as fully paid to the vendors for properties purchased.
On the same day the company offered 80,000 shares to the public. The issue was fully sub-
scribed. The amount on these shares was payable as follows:
On application ` 2.50 per share
On allotment ` 2.50 per share
On first call ` 2.50 per share (due on 1st September)
On second call ` 2.50 per share (due on 1st December)
On the shares subscribed for by the public, the following had been paid on 30 June, 2017.
On 60,000 shares the full amount called
On 18,000 shares ` 7.50 per share
On 500 shares ` 5.00 per share
On 1,500 shares ` 2.50 per share
On 30 June, 2017 the directors forfeited the shares on which less than ` 7.50 had been paid. The
calls in arrears on 18,000 shares were collected on 31 July, 2017 together with the necessary
interest. The forfeited shares were reissued on the same date at a price of ` 8 per share.
You are required to pass the necessary journal and cash book entries and show how the various
items will appear in the Company’s Balance Sheet as on 31 Dec. 2017.
[Ans. Amount. transferred to Capital Reserve on reissue of forfeited shares ` 2,250]
3. Chinubhai Chunilal Ltd. made an issue of 30,000 shares of ` 10 each, payable ` 3 on application,
` 5 on allotment and ` 2 on call. 93,200 shares were applied for and owing to this heavy over-
subscription allotments were made as under:
(a) Applicants for 21,500 (in respect of applications for 2,000 shares or more) received
10,200 shares.
(b) Applicants for 50,600 (in respect of applications for 1,000 shares or more but less than
2,000) received 12,600 shares.
(c) Applicants for 21,000 (in respect of applications for less than 1,000 shares) received
7,200 shares.

Self-Instructional
350 Material
Cash thus received after satisfying amount due on application was applied towards allotment Company Accounts-II
and call moneys and any balance was then returned. All moneys due on allotment and call were
received.
Write up the Bank Account and Ledger Accounts relating to this issue in the books of the Company.
[Ans. Bank Account Balance Dr ` 3,00,000]
4. X Co. Limited issued 60,000 equity shares of ` 10 each at a premium of ` 2.50 per share payable NOTES
on application. The amount payable on allotment was fixed at ` 4 per share and an equivalent
sum was due on a call to be made.
Total applications received were for 1,10,000 shares and after consulting the Stock Exchange,
the following scheme of allotment was decided upon.
Category A B C
Grouping of share 1–100 101–500 over 500
No. of applications received 1,200 175 5
No. of shares applied for 70,000 35,000 5,000
No. of shares allotted 42,000 14,000 4,000
It was decided that the excess amount received on applications would be utilised in payment of
allotment money and surplus, if any, would be refunded to the applicants.
Samuel, who was one of the applicants belonging to category A and had applied for 100 shares,
defaulted in payment of allotment money. Theodore who belonged to category C, and who had
been allotted 800 shares failed to pay the call money. Their shares were forfeited, after the
respective calls were made and reissued as fully paid up for ` 8 and ` 6 per share respectively.
Pass the necessary journal entries.
[Ans. Amount transferred to Capital Reserve on reissue of forfeited shares ` 1,780]
5. Nitin Co. Ltd. decided to make a rights issue in the proportion of one new share of ` 200 each at
a premium of ` 50 each to the shareholders for every three existing shares. The market value of
the shares at the time of announcement of rights issue is ` 500 each. Calculate the value of rights.
[Ans. ` 62.50]
6. Sunita Ltd. offers to its existing shareholders two shares for every seven shares held by them.
The right issue price ` 140 (including premium of ` 40) and the market value of the share at the
time of right issue is ` 190 per share. Calculate the value of rights.[Ans. Value of right-` 11.11]
[Hint. Total cost of 9 shares = ` 1,610, Values of right = Market Value–Average Price = ` 190 – `
178.89 = ` 11.11]
7. 15,000, 9% Redeemable preference shares of ` 100 each of Global Customer Care Ltd., repayable
at a premium of 12% are now due for redemption. The company has accumulated reserves the
amount of which is much in excess the sum required for redemption. In addition, there is a
large balance lying securities premium account which is available for payment of premium on
redemption.
Show the journal entries in the books of the company to give effect to above. (CS Inter, Dec.
2003)
[Ans. Amount transferred to Capital Redemption Reserve ` 15,00,000]
8. X Ltd. has the following balance sheet as on 31 March 2016.

X Ltd.
Balance Sheet as at 31 March, 2016

Particulars `
A Equity and Liabilities
1. Shareholders’ Funds
(a) Share Capital
Issued & paid up capital: 10.000 equity Shares of ` 100 each 10,00,000
5,000 Preference Shares of ` 100 each 5,00,000
(b) Reserves and Surplus

Self-Instructional
Material 351
Company Accounts-II Particulars `
Capital Reserve 1,00,000
Securities Premium A/c 1,00,000
General Reserve A/c 2,00,000
NOTES
Profit and Loss Account 1,00,000
20,00,000
2. Share application money pending allotment
3. Non-current Liabilities –
4. Current Liabilities
(a) Short-term Borrowings –
(b) Trade Payables –
(c) Other Current Liabilities 10,00,000
(d) Short-term Provisions:
10,00,000
TOTAL (1) + (2) + (3) + (4) 30,00,000
B Assets
1. Non-current Assets
(a) Fixed Assets
Tangible Assets 22,00,000
22,00,000
2. Current Assets
(a) Current Investments
(b) Inventories
(c) Trade Receivables
(d) Cash and Cash Equivalents –
(e) Short-term loans and Advances _
(f) Other Current Assets 8,00,000
8,00,000
TOTAL (1) + (2) 30,00,000

Preference shares are to be redeemed at 10% premium. Fresh issue of equity shares is to be made
to the extent required under the Companies Act for the purpose of this redemption. The shortfall
in funds for the purpose of the redemption after utilising the proceeds of the fresh issue are to be
met by taking a bank loan. Subsequently the company decides to issue bonus shares in the ratio
of one equity share for every four equity shares held. Show journal entries. (ICWA Foundation,
June 2005 adapted)
[Ans. Amount transferred to Capital Redemption Reserve ` 3,00,000]
9. Spotlight Limited has issued share capital of 60,000, 8% redeemable cumulative preference
shares of ` 20 each and 4,00,000 equity shares of ` 10 each. The preference shares are redeemable
at a premium of 5 per cent on 1st January, 2016.
As at 31 December, 2015, the company’s balance sheet showed the following position:

Self-Instructional
352 Material
Spotlight Ltd. Company Accounts-II
Balance Sheet as at 31st December, 2015
Particulars `
A Equity and Liabilities
1 Shareholders’ funds
(a) Share Capital NOTES
Issued & paid up capital: 60,000,8% redeemable cumulative
preference Shares of ` 20 each fully paid 12,00,000
4,00,000 Equity shares of ` 10 each fully paid up 40,00,000
(b) Reserves and surplus
Profit and loss account 7,00,000
59,00,000
2 Share application money pending allotment –
3 Non-current liabilities –
4 Current liabilities
(a) Short-term borrowings
(b) Trade payables 11,00,000
(c) Other current liabilities
11,00,000
TOTAL (1) + (2) + (3) + (4) 70,00,000
B Assets
1 Non-current assets
Fixed assets
Tangible assets:
Plant machinery 25,00,000
Furniture and fixture 9,00,000
34,00,000
34,00,000
2 Current Assets
(a) Current investments 3,50,000
(b) Inventories 15,00,000
(c) Trade receivables 14,00,000
(d) Cash and cash equivalents 3,50,000
(e) Short-term loans and advances –
(f) Other current assets –
36,00,000
TOTAL (1) + (2) 70,00,000

In order to facilitate the redemption of preference shares it was decided:


(a) To sell the investments for ` 3,00,000.
(b) To finance part of the redemption from company funds subject to leaving of balance in Profit
and Loss Account of ` 2,00,000.
(c) To issue sufficient equity shares of ` 10 each at a premium of ` 2 per share to raise the
balance of funds required.
The preference shares were redeemed on due date and equity shares were fully subscribed.
You are required to prepare:
(i) Journal entries to record the above transactions.
(ii) A Memorandum Balance Sheet as on completion of redemption.
[Ans. Fresh Issue of 75,000 shares, Balance Sheet Total ` 65,90,000]

10. Suman Ltd. made an issue of 2,000, 14 per cent Debentures of ` 100 each at a premium of
10 per cent. The issue was fully subscribed. Money was payable as follows:
` 10 on application; ` 40 on allotment (incl. premium); ` 30 on first call; Balance on final
call. According to the terms of issue, payment could be made in full on allotment. Interest at
a flat rate on any amounts prepaid being allowable at 7 per cent. Such interest was payable
by the company on 31 December. The allottees of one half of the debentures took advantage
of the pre-payment terms. The others paid on due dates. Journalise the transactions.

Self-Instructional
Material 353
Company Accounts-II Debentures
11. A company issues the following debentures:
(a) 1,000, 14 per cent debentures of ` 100 each at par but redeemable at a premium of 5 per
cent after 10 years; (b) 500, 14 per cent debentures of ` 100 each at a premium of 10 per cent
NOTES payable at par after 5 years; (c) 500, 13 per cent debentures of ` 100 each at a discount of 10
per cent but payable at a premium of 5 per cent after ten years; (d) 300 debentures of ` 100
each as collateral security to a creditor who advanced a loan of ` 25,000 to the company; (e)
Issue of ` 10,000 debentures at a discount of 10%.
12. Give journal entries for the following:
(i). The company allots 1,000 12% debentures of ` 100 each at an issue price of ` 96 per
debenture redeemable at a premium of ` 8 per debenture. (The liability of premium is
also to be recorded at the time of issue of debentures).
(ii) 3,000 fully convertible debentures of ` 100 each are converted into 20,000 equity shares
of ` 10 each at a premium of ` 5 per share.

14.10 FURTHER READINGS


Maheshwari, S.N., Suneel K. and Sharad K. 2017. Advanced Accountancy,
Vol I. New Delhi: Vikas Publishing House.
Maheshwari, S.N., Suneel and Sharad. 2018. An Introduction to Accountancy,
12th edition. New Delhi: Vikas Publishing House.
Jain, S.P. and Narangjk, K.L. 2001. Advanced Accountancy. New Delhi:
Kalyani Publishers.
Ahmed, N. 2008. Financial Accounting. New Delhi: Atlantic Publishers and
Distributors Pvt. Ltd.

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354 Material

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