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Chapter 1: Introduction to Financial Accounting

Accounting is the language of business. It requires the systematic record keeping of


all that happens on a day – to – day basis in business and analyzing this information
to aid business decision making. The primary intension of financial accounting is the
preparation of the statement revealing the income and financial position of the
business on the basis of the events. The major financial statements are Profit and
Loss A/c, Balance Sheet, Cash Flow Statement etc…

I. UNDERSTANDING BUSINESS ORGANIZATIONS:

Business organizations offer goods and services in order to earn a profit.


Receiving and paying cash are central to the activities of business organizations.
Business organizations that provide goods are of two kinds:

 Merchandising (Trading) Organizations: buy and sell goods


without any processing.
 Manufacturing Organizations: buy materials, process them into
finished products, and sell them.
 Service Organizations: are businesses that provide services.
Unlike goods, services do not have either form or substance, and, therefore,
the recipient of a service can only experience them and can not transfer
them to another person.

Book-Keeping is mainly concerned with recording of financial data relating to the business operations in
a significant and orderly manner. A book keeper may be responsible for keeping all the records of a
business or only of a minor segment such as position of a customer’s accounts in a departmental store. A
substantial portion of the book keeper work is of a clerical in nature and is increasingly being
accomplished through the use of mechanical and electronical devices.

II. What is Accounting?


• Accounting is often called the language of Business.
• Accounting, as an information system, is the process of identifying,
measuring, and communicating the economic information of an organization
to its users who need the information for decision making.
The American Institute of Certified Public Accountants defines accounting as "the
art of recording, classifying and summarizing in a significant manner and in terms of
money transactions and events which are, in part at least, of a financial character,
and interpreting the results thereof.

This definition brings out the following as attributes of accounting:

• Events and transactions of a financial nature are recorded while the events of a
non-financial nature cannot be recorded.
• The record should reflect the importance of the transactions so recorded both
individually and collectively, which includes summarization, thereby making it
amenable to analysis.
• The users of the financial statements should be able to obtain the message
encompassed in such financial statements, and it is the knowledge of
accountancy, which enables the user to understand the contents of the financial
statements.

The Accounting Information System

INPUT PROCESS OUTPUT

Economic
Recording Communicatin
events
Classifying g information
measured in
Summarizing to users ( P&L
financial Analyzing A/c, B/S, CFS,
terms Interpreting etc)

Accounting Process:
Recording: Recording commences when a business transaction occurs and it has
been quantified. A record of all these transactions is maintained in the order in
which they occur in the Journal Book.

Classifying: It refers to the rational segregation of the recorded information into


related groups so as to make the record useful. The book containing such classified
information is called the Ledger Book consisting of a number of accounts each
complete in its own way. For example, all the receipts forming inflows and the
payments forming outflows are grouped to ascertain the net cash position of the
firm. The arrangement in this case is better known as the Cash Book.

Summarizing: After the Recording and Classification phases are complete the
accounts containing relevant information in the Ledger Book are to be balanced and
the balances listed. The Statement giving names of these accounts and their
respective balances is called the Trial Balance. On the basis of the Trial Balance the
summaries are generated to provide information about the Profit / Loss and the
Position of the firm. The reporting of these summaries is done through Financial
Statements.

Financial Statements can be defined to include the Balance Sheet, the Profit
and Loss Account, Notes to the Accounts and other incidental statements and
explanatory material which are identified as part of financial statements.

Information and the Accounting Process

• Identification—what’s relevant?
• Measurement—which yardstick?
• Classification and accumulation—how do you organize the results of
thousands of events?
• Summarization—how much information is enough, but not too much?
• Communication—how often, when, and to whom?
Qualities of Accounting Information

Information should be useful, but what does that mean? The two primary qualities
of useful information are:

1) Relevance--the information must pertain to the decision at hand. That


suggests it will have predictive and feedback value and should be timely.

2) Reliability--the information must reasonably reflect the real-world situation


that it represents. To do so, it must be free of bias and verifiable.

Other Qualities of Useful Information

• Understandability--the information must be understood to be useful. Users


are assumed to have a general knowledge of business and a very basic
knowledge of accounting.
• Comparability--the information must be reported so that comparisons
between similar entities can be made.
• Consistency--the same accounting methods must be used from period to
period to evaluate results over time.
S T E P 1
I d e n t if ic a t io n o f
T r a n s a c tio n

S T E P 2
P r e p a r a t io n o f
B u s in e s s D o c u m e n ts

S T E P 3
R e c o r d in g o f
T r a n s a c tio n in J o u r n a l

S T E P 4
P o s tin g to L e d g e r

S T E P 5
P r e p a r a tio n o f
U n a d ju s te d T r a il B a la n c e

S T E P 6
P a s s in g o f
A d ju s t in g E n t r ie s

P r o f it & L o s s A c c o u n t
S T E P 7
P r e p a r a t io n o f A d ju s t e d
B a la n c e S h e e t
T r a il B a la n c e

F u n d F lo w S ta te m e n t

Figure 1.1: The Accounting Process

III. ACCOUNTING INFORMATION AND ECONOMIC DECISIONS:

Accounting information is useful in making a number of decisions that affect


the income or wealth of individuals and organizations. Accounting reports are
designed to meet the common information needs of most decision makers.
Examples of decisions that are based on accounting information include the
following:

1. Decide when to buy, hold or sell an equity investment.


2. Assess the stewardship or accountability of mgt.
3. Assess the ability of the enterprise to pay and provide other benefits to its
employees.
4. Assess the security for amounts lent to the enterprise.
5. Determine distributable profits and dividends.
6. Determine taxation policies.
7. Prepare and use national income statistics.
8. Regulate the activities of enterprises.

The decision maker who intends to use accounting information should have a
reasonable understanding of business and economic activities and be willing to
study the information with reasonable diligence. A sophisticated understanding of
accounting is an indispensable part of the tool-kit for most decision makers.

IV. CLASSIFICATION OF ACCOUNTING:

In order to satisfy needs of different people interested in the accounting


information, different branches of accounting have developed.

Accounting is generally classified into three different disciplines as shown


in Figure.

A c c o u n t i n g

F i n a n c i a l C o s t M a n a g e m e n t
A c c o u n t i n g A c c o u n t i n g A c c o u n t i n g

Figure 1.2 Classification of Accounting

Financial Accounting: Its primary intention is to prepare the Statements revealing


the Income / Loss and financial position of the business on the basis of events,
which have happened in the period being reckoned.

But this information, though of immense vitality does not adequately aid the
management in planning, controlling, organizing and efficiently conducting the
course of the business as a result of which Cost Accounting and Management
Accounting are in place.

Cost Accounting: It shows classification and analysis of costs on the basis of


functions, processes, products, centers etc. It also deals with cost computation, cost
saving, cost reduction, etc.

Management Accounting: Management Accounting begins where Financial


Accounting and Cost Accounting ends. It deals with the processing of data
generated in financial accounting and cost accounting for managerial decision-
making. It also deals with application of managerial economic concepts for decision-
making.

V. OBJECTIVES OF ACCOUNTANCY:

1. Maintaining Accounting records: Systematic recording of the monetary


transactions of the firm is the initial step leading to the creation of the financial
statements. Once recording is complete, the records are classified and
summarized to depict the financial performance of the enterprise.
2. Calculating the results of Operations: The Income Statement also known
as the Profit and Loss Account is prepared to reflect the profits earned or losses
incurred. All the expenses incurred in the course of conducting the business are
aggregated and deducted from the total revenues to arrive at the profit earned
or loss incurred during the relevant period.
3. Ascertaining the financial position: Financial health or position is
ascertained with the help of the Balance Sheet. On the right hand side of the
Balance Sheet are the Assets or the resources owned by the firm. On the left
hand side are the Liabilities or the obligations of the business to the outsiders
and the owners. The owners' portion is called the Capital and is to be
distinguished from that of the other liabilities such as loans and creditors. All of
them are grouped in the respective heads under the Liabilities. This information
on the assets and liabilities, with the help of accountancy, provides control over
the resources of the firm.
4. Accounting is the precursor to financial reporting: The vital liquidity /
solvency position is comprehended through the Cash and Funds Flow Statement
elucidating the capital transactions, obtaining of cash and the way it has been
expended, loans and their repayment, cash dividends, etc.
5. Communicating the information to the users: Financial statements so
compiled are of great use to a variety of users including the provision of a firm
base for the computation of the statutory tax liability and the consequent filing
of return of income.
VI. ADVANTAGES OF ACCOUNTING:

 It facilitates:
 to replace memory.
 to comply with legal requirements.
 to ascertain Net results of operations.
 to ascertain Financial position.
 the users to take decisions.
 a compliance study.
 control over assets.
 the settlement of tax liability.
 the ascertainment of value of business.
 raising of funds.
 Acts as legal evidence

VII. USERS OF FINANCIAL STATEMENTS:

Investors and lenders are the most obvious users of accounting information.
Their decisions and their uses of information have been studied and described to a
much greater extent than those of other user groups. However, financial reports are
also extensively used by other individuals and groups who have to rely on them as
their major source of financial information. Potential users of accounting information
include:
Internal Users: They include Board of Directors, Partners, Managers, and
Officers.

• They need information for planning and controlling operations, for


making special decisions, and for formulating major plans and policies.
• Managers use accounting information to evaluate potential
investment projects.
• Management examines the competition in the industry and makes
financial comparisons of its performance against competitors’
performance.
II. External Users:
A). Financing Group:

a) Investors: Accounting information enables investors to identify


promising investment opportunities. They need information to
decide which investments to buy, retain, or sell, as well as the
timing of the purchases or sales of those investments. They also
need information to monitor management performance and to
assess the ability of the enterprise to pay dividends.
b) Lenders: Lenders such as banks and denture-holders need to
know about the financial stability of a business that approaches
them for funds. They are interested in information that enables
them to determine whether their loans, and the related interest will
be paid when due.
c) Suppliers: Present and potential suppliers are interested in the
enterprise as an outlet for their products or services and, if the
enterprise is a major customer, they will be interested in assessing
the likelihood of the situation continuing. They are interested in
information that enables them to determine whether amounts owed
to them will be paid when due.
B). Public Group:

a) Government Agencies: The three levels of government in India –


central, state and local - are interested in the allocation of
resources and, therefore, in the activities of enterprises. They also
require information in order to regulate the business practices of
enterprises, determine taxation policies, and provide a basis for
national income and similar statistics.
b) Employees: They are interested in information about the
enterprise about the enterprise as well as its general operations,
stability and profitability.
c) Customers: Present, potential and past customers are interested
in the financial affairs of an enterprise in deciding how much
business to do with it, and in assessing the likely ability of the
enterprise to service to the product or to honor warranty
agreements.
d) Security Analysts and Advisers: They serve the needs of
investors by providing them with skilled analyses and interpretation
of financial reports. Securities firms to recommend to their clients
whether to buy, sell or hold their investments use Analysts’ reports.
Basic Terms

• Assets - resources owned by a business


• Liabilities - debts and obligations of the business
• Common stock - stock representing the primary ownership interest in a
corporation
• Expenses: Expenses are the costs of assets consumed or services used to
generate revenues
Examples... Store operating expenses, General and administrative
expenses, Interest expense

• Auditor's Report
General Guide for Financial Accounting

• Generally
• Accepted
• Accounting
• Principles
Accounts Provide the the most useful financial information for…Decision Making

Primary Accounting Setting Body in the U.S.

1. Financial Accounting Standards Board


GAAP Are the Rules, The FASB makes the rules.

• Accounting Concepts
– Basic assumptions or conditions upon which the science of accounting
is based.
• Accounting Conventions
– Principles or theories based on which accounting is done.
• Money Measurement Concept: In financial accountancy, an event is recorded, only if it
can be expressed in monetary terms. Recording, classification and summarization of
business transactions requires a common unit of measurement, which is taken as money.
Hence, all transactions are recorded through a common denominator – money. Thus, if a
certain event, no matter how significant for the health or even existence of the business,
cannot be measured in monetary terms, that event is not recorded in accounting. Money is
expressed in terms of its value at the time an event is recorded in the accounts.

• Business Entity Concept: The business is distinctly different and separate from its
owner. A business entity or a company is an artificial company created by law, who has a
common seal, which has a perpetual existence and does not die natural death. Hence for
accounting purpose, the owner and his business should be kept separate. Accounting
records are kept from the point of view of the business unit and not the owner. So, if the
owner contributes fund to the business, it will be treated as a liability of the business –
say the business owes this much to the owner.
• Going Concern Concept: A business entity is having a perpetual existence, which does
not die a natural death. It is assumed to carry on its operations forever. It implies that the
resources of the concern would continue to be used for the purposes for which they are
meant to be used.
For instance, in a manufacturing concern, the land, buildings, machinery etc., are
primarily required for carrying out the production and selling of certain products. This
concept implies that these land, buildings, machinery etc., would continue to be used for
this purpose.
• Cost Concept: Cost Concept implies that in accounting, all transactions are generally
recorded at cost, and not at market value. For example, if a piece of land is acquired for
Rs.1 lakh, it would continue to be shown in the balance sheet at Rs.1 lakh, even when the
market value of the land rises to say Rs.10 lakhs. Why should this be so? This is because
cost concept is in fact closely related to the going concern concept.
• Duality concept: This is the fundamental accounting equation, which is the formal
expression of the dual aspect concept. To reflect the two types of equities, the equation is
more commonly expressed as

ASSETS =LIABILITIES + OWNERS’EQUITY

OR

TOTAL ASSETS =TOTAL LIABILITIES

The Accou
Each of the perm
affected by debits
• Period Concept: A business entity is an artificial person having a perpetual existence. To
measure income generated by the business or loss incurred by the business, the infinite
life of the business is broken into small pieces called accounting periods. End of each
such period it is ascertained what income the business generated or what loss the business
incurred and what the financial position of the business is? These small periods are
known as accounting period. Generally accounting period is one year – January 01 to
December 31 as in US and April 01 to March 31 as in India.
• Matching Concept: In order to ascertain profit or incurred some loss in an accounting
period, the expenses related to this period must be compared or matched with the
revenues generated during this period.
• Realization Concept: Realization concept deals with the point in time at which revenue may
be deemed to be realized or when a sale can be said to have taken place. Normally revenue is
recognized at the time of transfer of goods or services when a return consideration is either
obtained immediately or there exists a reasonable certainty of receiving a return consideration
in future.

For example: If a customer buys Rs 500 worth of the items at grocery stores,
paying cash, the stores realizes Rs 500 from sale. If a department stores sells a
suit for Rs 3000 the purchaser agreeing to pay within 30 days, the store realizes
Rs 3000(in receivables)from the sale, provided that the purchaser has a good
credit record so that payment is reasonably certain.

• Accrual Concept: The accrual basis of accounting recognizes revenues when sales
are made or services are preformed, regardless of when cash is received. Expenses are
recognized as incurred, that is, when goods are used or services are received, whether
or not cash has been paid out. Net profit equals the revenues earned less expenses
incurred during a period.

B) Accounting Conventions:

The term ‘convention’ denotes circumstances or traditions which guide the


accountant while preparing the accounting statements. The following are the
important accounting concepts:

1. Consistency

2. Full Disclosure

3. Conservatism

4. Materiality
• Conservatism Concept: This principle emphasizes that revenues and profits should be
accounted only when there is a reasonable surety of recognizing it but any anticipated loss
or expense should be immediately accounted for.
• Materiality Concept: It states that insignificant events may be disregarded, but there
must be full disclosure of all important information.
• Consistency Concept: The consistency concept requires that once an entity has decided
on one method, it will treat all subsequent events of the same character in the same
fashion unless it has a sound reason to change the method of treatment of that transaction.
For example, if a concern is valuing its inventory by a particular method in one year it is
expected to value its inventory in the subsequent years also in the same method unless
there is a strong reason to change the same.
• Full Disclosure: According to this convention all accounting statements should be
honestly prepared and to that end full disclosure of all significant information should be
made. On the other hand, if there is no detailed disclosure in the profit and loss account
undisclosed reserves accumulated in the past periods may be used to swell the profits in
the year when the company is failing badly and the shareholders may be misled into
thinking that company is making profit.

FORMS OF BUSINESS ORGANISATION:

1. Sole Proprietorship: A single individual carries on a business. All the profits


the business might earn go to him. The sole proprietor’s liability is unlimited,
that is, shall the business fall into debt, and he is personally liable for paying off
the debts.

2. Partnership: It comprises between two and twenty persons trading together


as one firm and sharing in the profits. As well as sharing the profits, each partner
shares unlimited liability for all the debts and obligations of the firm.

3. Limited Company: It is a legal entity and is treated by the law like a natural
person. It must be run according to the rules laid down by the company law.

Systems of Accounting

– Cash Basis: Revenue recorded only when cash is received.Expense recorded


only when cash is paid. Cash Basis in not GAAP
– Accrual Basis: Adheres to the: Revenue Recognition Principle, Matching principle
– Revenue recorded only when earned not when cash is receivedExpense
recorded only when incurred not when cash paid
– Accrual Basis adheres to... Generally Accepted Accounting Principles
ACCOUNTING MECHANISM:

1. Recording
Journalizing: The daily business transactions are recorded in the order of their
occurrence in a book called Journal. Recording of entries in the journal is known as
journalizing. Journals aid the recording process by

• Disclosing in one place the complete effect of a transaction;


• Providing a chronological record of transactions;
• Helping prevent or locate errors because debit and credit amounts can be
easily compared.
2. Classifying

Ledger preparation: The process of transferring entries from the



journal to the ledger is called ledger posting. Ledger contains a
classified summery of all transactions recorded in journal.
3. Summarizing:

 Balancing the ledger: means to make the total of amounts column


appearing on the debit and credit side equal to each other. If debit side
is bigger than the credit side, the difference between the two sides is
known as debit balance and vice versa.
 Preparation of Trial Balance: Trial Balance is a statement of debit
and credit totals or balances extracted from the various accounts in
the ledger with a view to test the arithmetical accuracy of the books.
 Preparation of Profit and Loss A/c: It is prepared to know the
operating efficiency of the firm in terms of profit made or loss incurred
during an accounting period.
 Preparation of Balance Sheet: It is a statement prepared with a
view to measure the financial position of a business on a certain fixed
date. It gives a true and fair view of the states of affairs of the
business.
II.DOUBLE ENTRY SYSTEM:

The method of writing every transaction in two accounts is known as Double


entry System of Accounting. Of the two accounts, one account is given debit
while the other account is given credit with an equal amount. Thus, on any date, the
total of all debits must be equal to the total of all credits because every debit has a
corresponding credit.

Total Debits = Total Credits

Rules of Double Entry System:

There are separate rules of the Double entry system in respect of Personal, real and
nominal accounts which are discussed below:
R u l e s o f D e b i t a n d C r e d it

P e r s o n a l A c c o u n t sR e a l A c c o u n t s N o m in a l A c c o u n t s

T h e r e c e i v e r W h a t c o m e s i n A l l e x p e n s e s a n d l o s s e s
D e b i t :

T h e g i v e r W h a t g o e s o u t A l l i n c o m e s a n d g a i n s

C r e d i t :

Figure 2.1 Rules of Double entry

III. CLASSIFICATION OF ACCOUNTS:

A) Personal Accounts: Personal account includes the account of persons


with whom the business deals. These account can be classified into
three categories
1. Natural personal Account –Example: Mohan’s account, Sohan’s account.
2. Artificial personal account-An account recording financial transaction with
an artificial person created by law. Example: Account of club, Government, Bank.
3. Representative Personal account-An account indirectly representing a
person is known as a representative personal account. Example: Salaries
outstanding account, prepaid Insurance account.
B) Impersonal Accounts:

1. Real Account: It represents assets like plant and machinery, land and buildings
goodwill, etc. As on a particular date, this account shows the worth of the asset.

2. Nominal Account: It consists of different types of expenses or incomes or loss


of profit. These accounts show the amount of income earned or expenses incurred
for a particular period say a month, a year, etc.

A c c o u n t s

P e r s o n a l A c c o u n t s I m p e r s o n a l A c c o u n t s

E g . I n d i v i d u a l s , F i r m s , N o m i n a l
R e a l A c c o u n t s
C o m p a n i e s , B a n k s , e t c . A c c o u n t s

A s s e t s l i k e c a s h ,R l ea ln a d t e, t o e x p e n s e s
b u i l d i n g s , p l a n t ao n r d l o s s e s o r
m a c h i n e r y , p a t i n
e n t s , c o m e s o r p r o f i t s .
g o o d w i l l m , e t c .
Figure 2.2 Types of Accounts

Opening Entry

All previous year’s assets and liabilities of B/S are brought forward to the current
year as an opening entry. All asset a/c’s are debited All liability a/c’s are
credited. The excess of assets over liabilities are credited to capital account.

Chapter 2: Final Accounts


TRIAL BALANCE

A list of all the accounts and their balances at a given time. It serves to prove the
mathematical equality of debits and credits after posting. It aids in the preparation
of financial statements.

FINANCIAL STATEMENTS:

1. Profit and Loss A/c: It summarizes the results of the operations of an


enterprise for a given time period by disclosing the revenues earned and
expenses incurred. It indicates the operating success of a business in a period by
measuring the net profit earned by it.

2. Balance Sheet: It presents an enterprise’s assets, liabilities, and owners’


equity at a particular point of time. It summarizes the resources of an enterprise
and the claims to those resources by owners and creditors of the enterprise on a
certain date.

3. Statement of Cash Flows: It reflects the major sources of cash receipts and
cash payments of an enterprise. It reports the cash effects during a period of not
only the enterprise’s operations but also its investing and financing activities.

CAPITAL AND REVENUE ITEMS

Capital Expenditure:

• The benefit of which is not fully derived in one year but spread over several
periods.
• Eg: Acquisition of assets, additions to fixed assets

Revenue Expenditure:

• The benefit of which is derived in the year in which the expenditure was
incurred.
• Eg: Raw material, Rent, wages and salaries.
FINAL ACCOUNTS OF MANUFACTURING FIRMS

• Production / Manufacturing A/c: To know the production cost


• Trading A/c: To know Gross Profit / Loss
• Profit and Loss A/c: To know the Net Profit / Loss
• Balance Sheet: To know the financial position

FINAL ACCOUNTS OF SERVICE BUSINESS ORGANISATIONS

• Receipts and Payments A/c: To know the Cash and Bank balances
• Income and Expenditure A/c: To know the Surplus made / Deficit incurred
• Balance Sheet: To know the financial position

FINAL ACCOUNTS OF A SOLE PROPRIETOR

Trading A/c: To know the Gross Profit/ Loss

• Profit and Loss A/c: To know the operating performance of the business
i.e. Net
profit / Net Loss

• Balance Sheet: To know the financial position of the firm on a particular


date.

Trading Account

• Overall Result of trading


• Gives out Gross profit
• Gross Profit = Sales - Cost of Goods Sold
• Gross Profit = (Net Sales) – (Opening stock +Net purchases+ Direct Expenses
- Closing Stock)
Trading Account

• Opening Stock
• Closing Stock – valuation
• Purchases
• Sales
• Direct Expenses –Wages,Customs & Import Duty,Freight, carriage and
cartage inwards,Royalty
– Gas, electricity, water, fuel,Packing materials
Closing Entries – Trading Account

1. Trading a/c Dr
To Opening stock a/c

To Purchases a/c

To Sales returns a/c

To Carriage a/c

To customs duty a/c

To direct expenses a/c

2. Sales A/c Dr

Purchase Returns a/c Dr

Closing stock a/c Dr

To Trading a/c

Trading Account - Importance

• Gross profit disclosed helps in controlling operating expenses


• Gross profit ratio is compared year after year to identify the fall in the figures
• Comparison of stock figures help in preventing lock-up of funds in stocks
• In case of new products, it is helpful to fix the sale price

P & L Account - Importance


Net profit/Net loss is an index of profitability of business

Comparison of profit over periods helps in assessing the business efficiency

Analysis of expenses over periods help in effective control of expenses

Profit and expense analysis helps in planning and forecasting the future
course of action.
Manufacturing Account

• Cost of production
• Stock
– Raw Materials
– Work in progress
• Raw Materials consumed
• Carriage inwards
• Direct wages
• Factory overheads
– Factory power
– Depreciation on factory machines
• Sale of scrap
Final Accounts – Adjustment Entries
Sometimes the accountant will come to know that he had not taken some
significant information into the books of accounts. This apart it not too uncommon
that certain transactions take place during or after the preparation of trial balance.
In the above cases the transactions were not recorded in the books and hence they
need to be adjusted in the books. This is done by passing some adjustment entries.

Following the double entry system every adjustment will have a two-fold effect. Put
in other words, the adjustment has to be carried out at two places. Normally the
adjustment takes palace at any two of the following three places

• In Trading a/c and Balance Sheet (B/S)


• In Trading a/c and Profit & Loss a/c (P & L)
• In P & L a/c and B/S
Adjustment Entries

1. Closing Stock
2. Outstanding expenses
3. Prepaid Expenses
4. 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

Closing Stock

• Adjustment
– Taken on credit side of trading account
Closing stock a/c Dr

To Trading a/c

– Asset side of Balance Sheet


• Given in the Trial balance
– Means that the closing stock is already adjusted in the cost of sales
and hence already accounted for
- Asset side of Balance Sheet

Outstanding expenses

• Outstanding expenses are those expenses which are due during the
accounting period but have not yet been paid
• Appears as adjustment
– Expense a/c Dr
To Outstanding expense a/c

– Addition to the concerned expense either in trading or P&L a/c


– Liabilities side of balance sheet
• Appears in trial balance
– Liabilities side of Balance sheet
Prepaid expenses

• Prepaid expenses are those expenses which have been paid in advance
during the accounting period
• Appears as adjustment
– Prepaid Expense a/c Dr
To expense a/c

– Deduction to the concerned expense either in trading or P&L a/c


– Assets side of balance sheet
• Appears in trial balance
– Assets side of Balance sheet
Outstanding Income & Accrued Income

• Outstanding income is that income which is due during the accounting period
but has not yet been received
• Outstanding income & Accrued income
• Appears as adjustment
– Outstanding Income a/c Dr
To Income a/c

– Addition to the concerned income either in trading or P&L a/c


– Assets side of balance sheet
• Appears in trial balance
– Assets side of Balance sheet
Income received in advance

• Income received in advance is that income which is received during the


accounting period but is not being earned.
• Appears as adjustment
– Income a/c Dr
To Income received in Advance a/c

– Deduction to the concerned income either in trading or P&L a/c


– Liabilities side of balance sheet
• Appears in trial balance
– Liabilities side of Balance sheet
Depreciation

• Depreciation denotes the decrease in the value of an asset due to the wear
and tear, lapse of time, obsolescence, exhaustion etc.,
• As an adjustment
Depreciation A/c Dr

To Fixed Asset A/c

– Debit side of P&L a/c



Deduction from the concerned asset account on assets side of balance
sheet
• Appears in trial balance
– Debit side of P&L a/c
Bad debts

Bad debt is a debt that cannot be recovered and is a loss

• As an adjustment
Bad debts A/c Dr

To Debtors a/c

- Debit side of P& L A/c


- Deduction from debtors on the assets side of Balance sheet
• Appears in trial balance
– Debit side of P&L a/c
Provision for Bad & doubtful debts

• Provision for the likely Bad and doubtful debts


• As an adjustment
P&L A/c Dr

To Provision for bad debts a/c

- Add to the bad debts on the debit side of P& L A/c


- Deduction from debtors on the assets side of Balance sheet
Provision for Discount on Debtors

• Provision for discount is making a provision for the good debts


• As an adjustment
P&L A/c Dr

To Provision for discount on debtors a/c

- Add to the discount a/c on the debit side of P& L A/c


- Deduction from debtors on the assets side of Balance sheet

All balance sheets are built up from 3 main categories, namely assets, liabilities and
shareholders funds. The relationship between them can be looked at either from the
point of view of shareholders (a proprietary approach) or from the point of view of
the company as a whole (an entity approach). Two forms of the fundamental
balance sheet identity can thus be derived:

Proprietary: assets – liabilities = shareholder funds

Entity: assets = liabilities + shareholder funds


Very broadly, all that is being said is that, firstly, what a company owns less
what a company owes is equal to the value of the shareholders funds invested in
it and that, secondly, what a company owns is financed partly by the owners
(the shareholders) and partly by outsiders (the liabilities). Either way, a balance
sheet must by definition, balance.

A proprietary approach balance sheet will look like the following (vertical balance
sheet).

Fixed assets
+ Current assets
- Current liabilities
=Net assets or capital employed

- Long term liabilities

= Share capital and reserves


A entity approach balance sheet will look like the following (Horizontal balance
sheet).

LIABILITIES = ASSETS

Equity capital Fixed assets


+ +
Long term liabilities Current assets
+
Current liabilities

Assets

Fixed assets & Current assets:

Assets are something of value to the business, which can either be turned into
cash or used to produce revenue.

Fixed assets
Those assets which are intended for use on a continuing basis in an undertakings
activities.

Examples are buildings, equipment, vehicles. Stocks, for example, are not
regarded as fixed assets since they are acquired either for immediate resale (for
example cigarettes as sold by a tobacconist) or as raw materials for use in
manufacturing operations.

It is intention that determines whether an asset is fixed or not.

Plant and vehicles, for example, are the current assets of a company whose
business it is to manufacture them for sale.

Concepts involved in valuation of fixed assets:


Matching
Fixed assets are an example of a good purchased for use over several periods
and are not charged entirely against profits of year of purchase but spread over
their years of use.

Cost valuation (historical value)

Going concern basis

Fixed assets are typically included at whatever proportion of cost is still


expected to yield useful benefits in the future. It is assumed that the business
will last long enough for these to be realised, which is quite different from an
approach which valued assets at scrap values.
There are different kinds of fixed assets in the balance sheet such as tangible
fixed assets, investments and intangible fixed assets.

Investments

Shares, loans, bonds and debentures held either as fixed tangible assets or
current assets. These are usually valued at cost.

Intangible fixed assets

Non-monetary fixed asset which is without physical substance. This category of


asset includes not only such “identifiable” intangibles as patents, trade marks
and copyrights, but also goodwill.

Goodwill

A company is not just a collection of tangible assets. It is, or should be, a going
concern whose total value, by reason of its proven ability to earn profits, is
greater than the sum of its parts. It is the difference between the total value and
the sum of the parts which constitutes goodwill. It should not be regarded as in
any way a fictitious asset: to be valuable, an asset does not have to be tangible.
Goodwill is, however, very difficult to value objectively and company law does
not permit it to be appear in the balance sheet unless it has been purchased,
and even then it is usually written off immediately or quite quickly. In some
group balance sheets an item appears entitled “goodwill arising on
consolidation” or “goodwill on acquisition”. This represents the excess of the
cost of shares in subsidiary companies over the book value of their net tangible
assets at the date of acquisition; that is, the parent company was willing to pay
more to purchase a company than the sum of its tangible and net current assets.

Current assets

Comprise those assets which are not intended for continuing use in the business.

Expected to be turned into cash or used in course of trading which can normally
be expected to be turned into cash within one year from the date of the balance
sheet.

Examples include bank balance, prepayments, amount owing from debtors,


cash, stocks.

Stocks are another example of matching concept - just how far to take it
depends upon the materiality concept.

Liabilities

Obligations arising from past transactions or other events and involving a


company in a probable future transfer of cash, goods or services.

Can be classified as current or long term liabilities.

Current liabilities

Obligations which have to be settled within a relatively short space of time.

Examples include amounts owing to creditors, bank overdraft, tax liability

Current assets- Current liabilities

= Net Current Assets or Working Capital (a measure of liquidity).

Fixed assets + current assets - current liabilities

= Capital Employed or Net Assets or Net Worth


Long term liabilities

Long term liabilities represent the extent to which the firm, not wishing to
borrow further long term funds from shareholders, has borrowed from outsiders.
The major parts consist of both long term loans (not wholly repayable within 5
years) and medium term loans (repayable within 5 years).

Banks are an obvious source of outside finance and many firms long term
liabilities are in the form of bank loans. These are not the only form of
borrowings. There are also debentures and debenture stocks which may be
secured by fixed or floating charges or may alternatively be unsecured
debentures.

Shareholders funds

The shareholders funds section of the group balance sheet is subdivided into
Share Capital and Reserves.

Shareholders differ from debenture holders in three important ways; they are
owners of the company, not lenders; they receive dividends (a share of the
profits), not interest; and, except in special circumstances, the cost of their
shares will not be repaid (redeemed) to them by the company.

Shares can be either ordinary or preference. The latter is usually entitled only to
a dividend at a fixed rate, but has priority of repayment in the event of the
company being wound up. Preference shares may be cumulative or non-
cumulative.

Every share has a par value but this is not necessarily the same as the issue
price of the shares or their market price. Shares can be issued at more than their
par value: this gives rise to a share premium reserve. Once a share has been
issued, its market price fluctuates from day to day, but this has no effect on the
firms balance sheet.

A company does not have to issue all its shares at once, nor does it have to
request full payment on the shares immediately. Companies normally have
authority to issue (i.e. have authorised capital of) shares even though they have
not issued them. Also shares can be partly paid. For example, a 25p share could
be payable 5p on application for the shares, a further 5p on allotment, when the
directors decide to whom the shares are going to be issued (or allotted), and the
remaining 15p in calls. Thus, in summary, one can distinguish authorised, issued,
called up and paid-up share capital.
Reserves

Reserves consist of the retained profit (or loss), the share premium account and
other reserves such as a revaluation reserve. This is created as a result of the
revaluation of fixed assets on the other side of the balance sheet.

It is very important not to confuse reserves with cash. To say that a company
has large reserves is not the same thing as saying that it has plenty of cash. If a
company has reserves it must have net assets of equal amount, but these assets
may be of any kind (e.g. machinery, stock in trade). Thus it is perfectly possible
for a company to have both large reserves and a large bank overdraft.

An example of a balance sheet


(£, 000)
FIXED ASSETS
Net fixed assets 100
Investments 50
150
CURRENT ASSETS
Stocks 25
Debtors 25
Cash 25
TOTAL ASSETS 225

CURRENT LIABILITIES
Creditors 50
TOTAL ASSETS LESS CURRENT LIABILITIES 175

Long term liabilities 50


125
CAPITAL AND RESERVES
Called up share capital 25
Share premium 75
Profit and loss account 25
SHAREHOLDERS FUNDS 125

Relation between the P&L statement and the balance sheet


It is worth looking more closely at the link between the profit and loss account
and the balance sheet. How can a company grow – that is, how can it increase
its assets? Look again at the identity

Entity: assets = liabilities + shareholder funds

It is clear that the only ways to increase the assets are to increase the liabilities
(to borrow) or to increase the shareholders funds. How can a company increase
the latter? There are two possibilities: it can issue more shares or it can plough
back profits (assuming of course that it is making some). Ploughing back profits
is the simplest but not necessarily the cheapest source of long term finance for a
company. Also the more a company ploughs back the less, in the short run at
least, there will be available for paying dividends.