UG B.com Commerce (English) 102 14 Financial Accounting
UG B.com Commerce (English) 102 14 Financial Accounting
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
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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
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.
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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.
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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
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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.
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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.
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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
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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.
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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.
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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??
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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
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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
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.
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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.
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
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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.
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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.
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Accounting Concepts:
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’.
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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
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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.
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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
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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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Material 31
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
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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.
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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.
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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
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
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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.
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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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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)
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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
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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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Debit Balances on Jan. 1, 2016: Recording of Transactions
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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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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
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.
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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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Secondary 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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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
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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:
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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
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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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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
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
RENT ACCOUNT
Jan. 4 To Bank A/c 2,000
MEHTA BROS
PURCHASES ACCOUNT
SALARIES ACCOUNT
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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)
(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
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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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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
Ledger
Dr. CAPITAL ACCOUNT Cr.
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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Secondary Books FURNITURE ACCOUNT
(Subsidiary Books)
July 10 To Bank 1,000
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.
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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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Secondary Books
(Subsidiary Books)
NOTES
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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.
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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
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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)
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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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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Ledger Secondary Books
(Subsidiary Books)
MUKESH & CO. (Folio 4)
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.
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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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
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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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
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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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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(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
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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
Particulars ` Particulars `
Salaries A/c (i) 10,000
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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
FURNITURE ACCOUNT
PURCHASES ACCOUNT
3 To Mohan 2,000
MOHAN
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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Secondary Books 8. He further sold goods to Suresh `2,000.
(Subsidiary Books)
9. He received cash from Suresh `1,000.
Solution:
NOTES JOURNAL
Ledger
Dr. CASH ACCOUNT Cr.
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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
SURESH
SALES ACCOUNT
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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.
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• 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.’
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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.
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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.
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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
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.
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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
BANK ACCOUNT
STOCK ACCOUNT
BUILDING ACCOUNT
VIJAY
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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
ANAND
CAPITAL ACCOUNT
PURCHASES ACCOUNT
DISCOUNT ACCOUNT
BHARAT
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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
SALES ACCOUNT
SALARY ACCOUNT
DRAWINGS ACCOUNT
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(b) (i) Total Method Trial Balance and
Rectification of Errors
TRIAL BALANCE
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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
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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
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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
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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.
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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)
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
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
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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)
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.
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
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.
Self-Instructional
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.
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110 Material
Trial Balance and
5.7 SELF ASSESSMENT QUESTIONS AND Rectification of Errors
EXERCISES
Self-Instructional
Material 111
Final Accounts- I
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.
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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
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
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
RENT ACCOUNT
Particulars ` Particulars `
To Bank 5,000 By Balance c/d 6,000
To Outstanding Rent 1,000
6,000 6,000
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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
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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
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)
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
Self-Instructional
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
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)
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)
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
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
Self-Instructional
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.
Self-Instructional
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.
Self-Instructional
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
Self-Instructional
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
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,
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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.
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Final Accounts- I
6.7 SELF ASSESSMENT QUESTIONS AND
EXERCISES
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Material 139
Final Accounts- II
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
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
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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
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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
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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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
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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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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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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).
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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* ........
........ ........
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
(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
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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.
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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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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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(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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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
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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
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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)
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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
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
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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
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
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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
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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.
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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]
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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.
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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.
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
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
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
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
Self-Instructional
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
Self-Instructional
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
Self-Instructional
Material 181
Bank Reconciliation Solution:
Statement
BANK RECONCILIATION STATEMENT
(as on 31st December, 2017)
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
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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
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
Self-Instructional
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
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
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
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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.
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.
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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
Self-Instructional
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
Bill of Exchange
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’.
Self-Instructional
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.
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
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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
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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
Self-Instructional
Material 199
Bills of Exchange (ii) When Interest is paid in cash:
Interest A/c Dr.
To Cash 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.)
Self-Instructional
200 Material
In the Books of the Drawer Bills of Exchange
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.
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)
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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 9.4. 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
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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
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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.
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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.
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Partnership Accounts
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
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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.
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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
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 93 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)
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in which they sacrifice on account of admission of C. The amount of `1,000 Partnership Accounts
NOTES
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:
NOTES
(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)
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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
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Material 225
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
NOTES
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Partnership Accounts BALANCE SHEET
as on January 1, 2017
NOTES
Working Notes:
P & L ADJUSTMENT ACCOUNT
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PARTNERS’ CAPITAL ACCOUNTS Partnership Accounts
NOTES
BALANCE SHEET
as on January 1, 2017
Working Notes:
MEMORANDUM P & L ADJUSTMENT ACCOUNT
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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
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
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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Material 231
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.
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Retirement and Death
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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Material 235
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
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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)
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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
NOTES
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Material 239
Retirement and Death BALANCE SHEET
of a Partner
Dr. as on 1st January, 2017 Cr.
NOTES
BALANCE SHEET
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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:
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
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Material 243
Retirement and Death Solution:
of a Partner
JOURNAL
NOTES
Working Notes:
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
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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.
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:
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Material 247
Retirement and Death BALANCE SHEET
of a Partner
as on January 1, 2016
NOTES
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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
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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.
11.5 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
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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
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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.
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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
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256 Material
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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Material 257
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
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Material 261
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:
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:
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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Material 263
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.
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:
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
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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
(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
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The declining charge methods of depreciation are preferred over Depreciation Accounting
JOURNAL
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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
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Material 271
Depreciation Accounting Solution:
Dr. LEASEHOLD PROPERTY ACCOUNT Cr.
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
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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
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
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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
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Company Accounts-I
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
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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.
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Material 285
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
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Material 287
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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Material 289
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.
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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.
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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
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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)
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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
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
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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
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Material 307
Company Accounts-I Share Application Account
Particulars ` Particulars `
To Share capital A/c 16,000 By Bank 16,000
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
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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
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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
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
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:
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320 Material
Company Accounts-II
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
Self-Instructional
· 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
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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
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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
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)
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
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
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)
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
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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
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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
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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
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336 Material
Solution: Company Accounts-II
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)
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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.
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.
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342 Material
From the Point of View of Convertibility Company Accounts-II
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.
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.
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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)].
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348 Material
· Bonds are a form of long term debt and can be referred as a debt security. Company Accounts-II
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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
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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:
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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
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.
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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.
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354 Material