Chapter II

Contents
2.1 The Accounting Process:
2.2 Accounting equation Static and dynamic view
2.3 Books of original entry Preparation of Journals
2.4 Books of secondary entry Ledgers
2.5 Subsidiary Books
2.5.1 Cash Book
2.5.1.1 Single Column Cash Book
2.5.1.2 Double Column Cash Book
2.5.1.3 Triple Column Cash Book
2.5.2. Purchase Book
2.5.2.1 Purchase Return Book
2.5.3 Sales Book
2.5.3.1 Sales Return Book
2.5.4 Bills Receivable Book
2.5. 5 Bills Payable Book
2.5. 6 Journal Proper
2.6 Trial Balance
2.7 Accounting for Merchandising Transactions2.8 Classification and Distinction of capital and revenue expenses
2.9 Impact of Depreciation Methods.

2.1
The Accounting Process:
Accounting Cycle:
It is the complete cycle in which each and every transaction of the business
enterprise passes through. It starts with identification of the transaction and ends
with analysis. Following figure explains the accounting cycle in detail.
It is the complete cycle in trough which each and every transaction of the business
enterprise passes through. It starts with identification of the transaction d ends with
analysis. Following figure explains the accounting cycle in

Note: This accounting cycle is explained in detail in the following chapters

Identification
Recording the
of Transaction
transaction
1. Identification of the Transaction:
The very first step in accounting is to identify the transaction. While identifying

Accounting

one has to understand the parties involved

Cycle in the transaction. Find out whether it
fulfills the very basic concept of money measurement and then identify to which
andeach party in the transacting belong to and finally apply the rule
typeAnalysis
of account
Classifying
Interpretation
of debit and credit as applicable.
Summarizing
the
transactions

2. Recording the Transaction:

Recording the transaction means, as and when the transaction takes place it has
to be recorded in chronological manner in a book called as Journal book. (Please
read the next chapter to understand it thoroughly).
3. Classification of the Transaction:
After recording of the transactions, next step is classification. Classification is
done in order to segregate the accounts in a systematic manner under the
respective heads so that the balance in terms of Debit and Credit can be easily
identified at the end of the year without wasting much time on it. (Please read
the next chapter to understand it in detail)
4. Summarizing the transactions:
The penultimate step in the accounting cycle is summarizing ,this step helps in
identifying the correctness of step number one, two and three of the accounting
cycle. In order to identify the correctness balances at the end of the year from
the ledger accounts are summarized with the help of a statement called as Trial
Balance. (Please read the next chapter to understand it in detail) on the basis of
the correctness the Financial Statements are prepared and presented to the
stakeholders.
5. Analysis and Interpretation:
The final step is to analyze the performance during the year, considering the Financial
Statements, which is prepared in step number four. There are various techniques of
analysis and interpretation which we are going to learn in its full length as we proceed in
the chapters.

2.2 Accounting Equation

In every business enterprise, financial position is measured it terms of its Assets,
Liabilities and Capital. Which means every transaction makes an impact
compulsorily on assets and either on liabilities or capital.
Assets = Liabilities + Capital
Assets:
Assets are the resources possessed by an entity which have future value. Assets
are recorded at their acquisition cost (historical cost). Further assets are
classified into Fixed Assets and Current Assets.
Fixed Assets are the assets meant for use in the operations of the business and
not intended for resale.
Current Assets are the assets which gets converted into cash during the
operating cycle

of the entity.

Liabilities:
The indebtness of the entity towards third parties (outsiders) for the resources
are known as liabilities.
The accounting equation should remain in balance at all times because of doubleentry accounting or bookkeeping. (Double-entry means that every transaction will
affect at least two accounts in the general ledger.)
Owners Equity:
Owners Equity refers to the amount invested by the owner / proprietor in the
business. This includes the amount initially invested as increased by any
additional investment and as reduced by any drawings made by the proprietor.
ASSETS = CAPITAL + LIABILITIES

It shows the relationship between the resources belonging to a business

and the claims against these resources .

Resources represent Assets & Claim represent Capital & Liabilities

The recording of every transaction must keep this equation in balance.

The entire Financial Accounting is based on the accounting equation.

The resources possessed by the firm are known as Assets and these
resources are acquired by the firm through the amount provided by the

owner of the firm ( known as Capital) and by the outsiders (known as

Liabilities).

Accounting Equation shows the relationship between the resources

belonging to a business and the claims against these resources.

Here are some examples of how the accounting equation remains in

balance.

An owner's investment into the company will increase the company's

assets and will also increase owner's equity.

When the company borrows money from its bank, the company's assets
increase and the company's liabilities increase.

When the company repays the loan, the company's assets decrease and
the company's liabilities decrease.

If the company pays cash for a new delivery van, one asset (cash) will
decrease and another asset (vehicles) will increase.

If a company provides a service to a client and immediately receives cash,

the company's assets increase and the company's owner's equity will
increase because it has earned revenue.

If the company provides a service and allows the client to pay in 30 days,
the company has increased its assets (Accounts Receivable) and has also
increased its owner's equity because it has earned service revenue.

If the company runs a radio advertisement and agrees to pay later, the
company will incur an expense that will reduce owner's equity and has
increased its liabilities.
From the above examples, you can see that owner's equity increased
when the owner made an investment in the business and also when
revenues were earned.

Conversely Owner's equity decreased when the owner withdrew assets

from the business and when expenses were incurred. This leads us to the
expanded accounting equation:

An

elaborated

accounting

equation

can

be

given

as

Assets = Liabilities + Owner's Equity + Revenues Expenses Drawings

Let us see the accounting equation with an example.

Illustration 1:
a. Commenced business with Rs. 60,000
b. Paid rent in advance Rs. 500
c. Purchased goods for cash Rs. 30,000 and Credit Rs. 20,000
d. Sold goods for cash Rs. 30,000 and credit Rs. 20,000
e. Paid salary Rs. 500 and Salary outstanding Rs 100
f.

Bought motorcycle for personal use Rs. 5,000

Solution:
S.N

Transaction

Assets Rs.

= Liabilities

+ Capital

60,000

Rs.
= 0

Rs.
+ 60,000

= 0

+ 60,000

= 0
= 0
= (+)20,000

+ 0
+ 60,000
+ 0

(-)30,000
80,000
(+) 30,000

= 20,000
= 0

+ 60,000
+ 10,000

(-)20,000
90,000
(-)500

= 20,000
= 0

+ 70,000
+ (-)500

New Equation
Bought Motorcycle for personal

0
89,500
(-)5,000

= (+)100
= 20,100
= 0

+ (-)100
+ 69,400
+ (-)5,000

use Rs. 5,000

New Equation

84,500

= 20,100

+ 64,400

1.

Commenced business with cash

2.

Rs. 60,000
New Eqution
Rent Paid in advance Rs. 500

3.

New Equation
Purchased goods for cash Rs.

60,000
(-) 500
(+)500
60,000
(+)50,000

30,000
And credit Rs. 20,000

4.

New Equation
Sold goods for cash Rs. 30,000
costing Rs. 20,000

5.

New Equation
Paid Salary Rs. 500 and Salary
outstanding Rs. 100

Illustration 2:
1. Mr. A Started Business with cash Rs. 5,00,000.
2. Purchased furniture For Rs.75,000 for cash.
3. Opened Bank Account with Rs. 10,000.
4. Purchased Goods from P Rs. 10,000 for cash.
5. Sold Cash Goods to Mr. X for Rs 20,000, received Rs. 8,000 as cash and balance
on credit.
Solution :
S.N

Transaction

Assets

= Liabilities

+ Capital

1.

Mr. A Started Business with cash

Rs.
5,00,000

Rs.
= 0

Rs.
+ 5,00,000

Rs.

5,00,000
- 75,000

2.

Rs. 5,00, 000

New Equation
Purchased furniture

+ 5,00,000
0

3.

75,000 for cash

New Equation
Opened Bank Account with Rs.

+75,000
5,00,000
-10,000

= 0
0

+ 5,00,000
0

4.

10,000
New Equation
Purchased goods from Mr. P Rs..

+10,000
5,00,000
-10,000

= 0
0

+ 5,00,000
-10,000

5.

10,000 for cash

New Equation
Sold Cash
Goods to Mr. X for

4,90,000
+8,000

Rs 20,000, received Rs. 8,000

+12,000

as cash and balance on credit.

New Equation

(debtors)
5,10,000

2.3

for

0
20,000

= 20,000

Books of Primary Entry : Preparation of Journal

4,90,000
0

+ 4,90,000

Journal:
With the expansion of the business enterprises in manifold, transactions are also
increasing profusely, hence recording of these transaction was a tough job, as a
result Journal was introduced. What is Journal?
Jour means a day ,Journal is a book of Primary Entry, wherein transactions
are

recorded in a chronological manner , recording of the transaction in a

journal book is called as Journalizing.

The manner of recording transaction is known as passing an entry
Let us see the requirements for passing an entry or journalizing
After Identification of the transaction ( as discussed above.) the entry is made in
the proforma as given below
Pro-forma of Journal
Date
xxx

Particulars
--------------A/c
Dr.
To -------------A/c

L.F

Dr. Amount
xxx

Cr. Amount
xxx

(Narration- Being)
Explanation :
Date: Date column consists of the date on which the transaction has taken place ,
how many ever transactions takes place each transaction has to be recorded by
putting date accordingly. This column is useful in locating the date on which the
transaction has taken place.
Particulars: In this column entry of the transaction is made indicating both the
effects of the transaction as per the dual aspect principle. This is the birds eye view
of the transaction, any person when he looks into the entry , he will be in a position
to understand the complete transaction in terms of who has received the benefit and
who has sacrificed. In other word Debit and Credit of an entry makes every
understand as to the impact of the transaction on both the parties involve.
The entry is made in the manner shown in the proforma followed by Narration,
which is a brief description of the transaction. Narration should always start with the
word Being.

L.F. stands for Ledger Folio, which helps classifying the account in the ledger book.
It is the page number of the ledger book where the entry has been classified in its
respective head/ account. It is useful in locating the page number and also it saves
time when entry and classification is being done simultaneously by the accountant.
It helps the auditor to verify the correctness at a faster pace.
Dr. Amount: in this column amount corresponding to the debit entry is made.
Cr. Amount: in this column amount corresponding to the credit entry is made.
The basic advantage of both these columns is that , as the entry is made
simultaneously in both the columns, indicating the same amount, the chances of
error are minimized.
Friends let us look at a comprehensive example:
Illustration:
From the following transactions of ABC ltd. identify the types accounts involved ,
apply the rule of debit and credit and journalize the transactions.
Date
2008 December

Amount Rs.

Started business with Cash

50,000

Paid into bank

25,000

Purchased Furniture

15,000

Sold goods for cash

65,000

Purchased Machinery

20,000

Purchased good from Mr. Kishore

6,000

Sold goods to Mr. Anand

7,000

Paid to Mr. Kishore

6,000

Paid Salaries

Paid Rent

10,000
1,000

Solution :
Let us apply the first step i.e. identification of the transaction in terms business
entity concept and dual aspect concept .

Business enterprise being the main party , and accounts are made in the books of
the business enterprise itself hence , while passing on the entries it is important
to see that what the business enterprise is getting and what it is sacrificing and
also the source form where it is getting or where it is sacrificing. ---let us look in
detail------------------------

1. Started Business With Cash Rs. 50,000

Business is being started with a capital of , i.e. proprietor is bringing in the cash
in the form of capital
Component I- Cash

Is being received in the form of capital

Cash is Tangible Real Account

As per the rules of Real account

Dr. What comes in

Component II- the proprietor

Investing money in the form of capital

He is personal Account

He is the giver

As per the rule of Personal Account Cr. the giver (Capital account)

2. Paid into Bank Rs. 25,000

Amount is being deposited into bank , hence cash is going out of the enterprise
and the destination where it is going is Bank.
Component I

Bank

Bank is an artificial Personal Account

As per the rule of Personal Account

Dr. the receiver

Component II- Cash

Cash

Cash is Tangible Real Account

As per the rules of Real account

Cr. What goes out

3. Purchased Furniture Rs. 15,000

Furniture being purchased with an amount of Rs. 15,000. i.e. business enterprise
is investing amount in order to purchase furniture.
Component I

Furniture

Furniture is Tangible Real Account

As per the rules of Real account

Dr. What comes in

Component II

Cash

Cash is Tangible Real Account

As per the rules of Real account

Cr. What goes out

3. Sold good for Cash Rs. 65,000

Goods are being sold for cash .the business enterprise is receiving cash and in
return goods are going out.
Component I

Cash

Cash is Tangible Real Account

As per the rules of Real account

Dr. What comes in

Component II

Sales (goods)

Sales is a nominal account

As per the rules of nominal account

Cr. All incomes and gains

4. Purchased Machinery Rs. 20,000

Machinery is being purchased by spending cash
Component I

Machinery

Machinery is Real Account

As per the rules of Real account

Dr. What comes in

Component II

Cash

Cash is Tangible Real Account

As per the rules of Real account

Cr. What goes out

4. Purchased good from Mr. Kishore

6,000

Goods are being purchased from Mr. Kishore , as nothing is mentioned as to whether
it is a cash transaction or credit transaction, we need to keep certain points in mind
while identifying the transaction as cash or credit

If the name of the individual/ firm is mentioned and nothing is mentioned

whether it is a cash transaction or credit, it is implied that it is a credit
transaction.

If the name of the individual / firm is mentioned and cash is also mentioned,
it is a cash transaction.

If the name of the individual / firm is not mentioned , and also nothing is
mentioned as cash or credit transaction , it is implied cash transaction.

Note: Same is applicable in case of sales transactions

Now let us see the entry of the above transaction

Component I

Purchases (goods)

Purchases is a Nominal Account

As per the rules of nominal account

Dr. All expenses and losses

Component II

Mr. Kishore

Mr. Kishore is Personal Account

As per the rule of Personal Account, MR. Kishore being the giver (supplier)

Cr. the giver

Sold goods to Mr. Anand

7,000

Goods are being sold to MR. Anand

The rules of Purchases are applicable in case of Sales. As the name of the individual
is mentioned and nothing is mentioned as to cash pr credit transaction , it is an
implied credit transaction.
Let us see the entry
Component I

Mr. Anand

Mr. Anand is Personal Account

As per the rule of Personal Account, MR. Kishore being the receiver
(customer)

Dr. the receiver

Component II

Sales

Sales is Nominal Account

As per the rules of nominal account

Cr. All incomes and Gains.

Paid to Mr. Kishore

6,000

Business enterprise is paying to Mr. Kishore for the credit purchases made in the
earlier transaction.
Component I

Mr. Kishore

Mr. Kishore is a Personal Account

As per the rule of Personal Account

Dr. The Receiver

Component II

Cash

Cash is tangible Real Account

As per the rules of Real Account

Cr. What goes out

Paid Salaries

10,000

Salaries are being paid to the employees for the services they have rendered.
Component I

Salaries

Salaries are nominal account

As per the rule of Nominal Account

Dr. All Expenses and Losses

Component II

Cash

Cash is tangible Real Account

As per the rules of Real Account

Cr. What goes out

Paid Rent

Business enterprise is paying rent to the land lord.

Component I

Rent

Rent is a nominal account

As per the rule of Nominal Account

Dr. All Expenses and Losses

Component II

Cash

Cash is tangible Real Account

As per the rules of Real Account

1,000

Cr. What goes out

Now let us put the entries into the pro forma and see how exactly journal
entries are made.
Solution :

Journal Entries in the Books of ABC Ltd.

Date

Particulars

L.F

Dr. Amount

Cr. Amount

.
DEC
08
1
2

Cash A/c

Dr

50,000

To Capital A/c

50,000

(Being business started with a capital)

Bank A/c
Dr

25,000

To Cash A/c
3

(Being cash deposited into Bank)

Furniture A/c

25,000
Dr

15,000

To Cash A/c
3

15,000

(Being furniture purchased for cash)

Cash A/c
Dr

65,000

To Sales A/c
4

(Being goods sold for cash)

Machinery A/c

65,000
Dr

20,000

To Cash A/c
4

20,000

(Being machinery purchased for cash)

Purchases A/c
Dr

6,000

To Mr. Kishore A/c

5

6,000

(Being goods purchased on credit)

Mr. Anand A/c
Dr

7,000

To Sales A/c
6

(Being goods sold on credit )

Mr. Kishore A/c

7,000
Dr

6,000

To Cash A/c
7

(Being cash paid to Mr. Kishore)

Salary A/c
To Cash A/c

6,000
Dr

10,000
10,000

(Being Salaries Paid)

Rent A/c

Dr

1,000

To Cash A/c

1,000

(Being Rent paid to the landlord)

Note: these figures are imaginary

2.4 Classification- Ledger Posting

We have seen the importance of classification. Let us learn more about classification.
As the journal book consist of transactions that would have occurred during the span
of one month. Suppose the account is required to give the information regarding the
balance of cash at the end of the month. He has to verify each and every transaction
and find out how many time cash has been received and how many times cash has
been paid, when he identifies these two components then only he can find out the
balance, as this procedure is a time consuming one to ease out the job of an
accountant second step in the accounting cycle has been introduced i.e. Classifying
or Ledger Posting.
What is a ledger?
Ledger is a book of Secondary Entry which carries separate heads of accounts.
After recording of the transactions it is posted to ledger accounts under respective
heads, hence, it is known as Ledger Posting. At the end of the month the accounts
are closed and the balances are carried forward for the next month. Ascertaining the
balance after closing of an account is known as Balancing of an Account, and the
balance which is left at the end of the month is known as Closing Balance which is
carried forward for the next month and taken as Opening Balance. Whenever right
hand side of an account is greater than the left hand , the account is said to be
having Credit Balance and vice versa for Debit Balance.
Let us look into the Proforma:
Dr.
Date

Cash A/c
Particulars
To

J.F

Amount

Date

Cr.
Particulars
By

J.F

Amount

Explanation:
Date: Date column consists of the date of the entry recorded into the journal book
Particulars: in the particulars column the corresponding entry of the account should
be mentioned , which indicates the very reason behind debiting or crediting of an

account. While writing the corresponding entry on the debit side it should be prefixed
with To and while writing the corresponding entry on the credit side it should be
prefixed with By.
J.F: It indicates the page number of the entry in the journal book
Amount ; Amount indicates the corresponding amount of the either debit or credit
column as the case may be.
Note all the entries related to the particular account get recorded under the
broader head.
Let us continue with the same illustration of Journal;
Dr.

Cash A/c

Date
1Dec

Particulars
To Capital

J.F

Amount
50,000

08
3 Dec

To Sales

65,000

Total
To Balance B/f

1,15,000
38,000

Jan

Cr.

Date
2Dec

Particulars
By Bank

08
3 Dec
4 Dec
6 Dec
7 Dec
8 Dec
31 Dec

By
By
By
By
By
By

J.F

Furniture
Machinery
Mr. Kishore
Salary
Rent
Balance C/f

Amount
25,000
15,000
20,000
6,000
10,000
1,000
38,000
1,15,000

09
Here the cash account is having a debit balance as the debit side of an account is
greater than the credit side.

Dr.
Date
31 Dec

Capital A/c
Particulars
To Balance C/f

J.F

Amount
50,000

08

Date
1 Dec

Cr.
Particulars
By Cash

J.F

Amount
50,000

08
Total

50,000
1
09

Jan

Total
By Balance b/f

50,000
50,000

Dr.

Bank A/c

Date
2 Dec

Particulars
To cash

J.F

Amount
25,000

08
1

Date
31 Dec

Cr.
Particulars
By Balance c/f

J.F

Amount
25,000

08
Jan

Total
To Balance B/f

25,000
25,000

Total

25,000

09
Dr.

Furniture A/c

Date
3 Dec

Particulars
To cash

J.F

Amount
15,000

08
1

Date
31 Dec

Cr.
Particulars
By Balance c/f

J.F

Amount
15,000

08
Jan

Total
To Balance b/d

15,000
15,000

Total

15,000

09
Dr.

Machinery A/c

Date
3 Dec

Particulars
To Cash

J.F

Amount
20,000

08
1

Date
31 Dec

Cr.
Particulars
By Balance c/f

J.F

Amount
20,000

08
Jan

Total
To Balance B/d

20,000
20,000

Total

20,000

09

Dr.

Purchases A/c

Date
4 Dec

Particulars
To Mr Kishore

J.F

Amount
6,000

08
1

Date
31 Dec

Cr.
Particulars
By Balance c/f

J.F

Amount
6,000

08
Jan

Total
To Balance b/f

6,000
6,000

6,000

09

Dr.
Date
31 Dec
08

Sales A/c
Particulars
To Balance c/f

J.F

Amount
72,000

Cr.

Date
4 Dec

Particulars
By Cash

08
6 Dec

By Mr. Anand

J.F

Amount
65,000
7,000

08
Total

72,000
1

Jan

Total
By Balance b/f

72,000
72,000

09
Dr.

Mr. Kishore A/c

Date
5 Dec

Particulars
To Cash

J.F

Amount
6,000

08

Particulars
By Balance

J.F

Amount
6,000

08
Total

6,000

Dr.

Total

6,000

Mr. Anand A/c

Date
6 Dec

Particulars
To sales

J.F

Amount
7,000

08
1

Date
31 Dec

Cr.

Date
31 Dec

Cr.
Particulars
By balance c/f

J.F

Amount
7,000

08
Jan

Total
By Balance b/f

7,000
7,000

Total

7,000

09
Dr.

Salary A/c

Date
7 Dec

Particulars
To Cash

J.F

Amount
10,000

08
1

Date
31 Dec

Cr.
Particulars
By Balance c/f

J.F

Amount
10,000

08
Jan

Total
To Balance b/f

10,000
10,000

Total

10,000

09
.
Dr.

Rent A/c

Date
08 Dec

Particulars
To Cash

J.F

Amount
1,000

08
1

Date
31 Dec

Cr.
Particulars
By Balance c/f

J.F

Amount
1,000

08
Jan

Total
To Balance b/f

1,000

Total

1,000

09
2.5 Subsidiary Books
Friends we have discussed in the earlier chapter that Journal Book and Ledger Book
will help the accountant in finding out the required balance at the end of the month
in relatively less time. If the volume of transactions of a business is very large again
segregating from journal and posting it into the ledger is time consuming activity.

Hence, subsidiary books are introduced in order to ease out the stress of recording
and classifying the accounts.
What are subsidiary books?
Subsidiary Books are the books in which classification of transactions are done on the
basis of its repetitive nature. Usually, transactions repeatedly affecting one aspect of
an account is grouped together and recorded under the respective head . e.g. all
transactions involving cash payments will be affecting a credit to the cash account.
Hence instead of recording in the journal book directly the effect can be shown by
opening only Cash Book , wherein the corresponding entry need to be entered and at
the end of the month the account can be balanced. Same can be applied to the when
cash is received , instead debiting cash , directly the source of cash being debit can
be entered and at the end of the month finding balance will be very easy, same can
be applied to various subsidiary books.
Classification of Subsidiary Books:
1. Cash Book- Divided into Single Column , Double Column and Triple Column
Cash Book
2. Purchases Book
3. Purchases Returns Book
4. Sales Book
5. Sales Return Book
6. Bills Receivable Book
7. Bills payable Receivable
8. Journal Proper
Explanation:
2.5.1 Cash Book:
As explained earlier, entries in the cash book can be passed directly. Based on
these entries, the ledger accounts are prepared. Therefore, cash book is known
as a subsidiary book , as the cash book consists of the bank column, depicting
the cash and bank balance simultaneously which would be helpful in preparing
the Balance Sheet, it is considered as the principle book.
Cash book can be prepared in three forms.
Cash Book

Double Column
Cash Book

Single Column
Cash Book

2.5.1.1

Three Column Cash

Book

Single Column Cash Book:

Under a simple cash book, only the cash receipts and payments are recorded. All
the receipts are recorded on the left hand side, while the payments are recorded
on the right hand side. The left hand side has to be always greater than the right
hand side , because of the simple fact that the business enterprise cannot run
with a negative balance of cash.
Pro forma
M/s ABC Co. Ltd
Receipts
Date
xxxx

Particulars
To

Single Column Cash Book

L.F.

Amount
xxxx

Date
xxxx

payments
Particulars

By

L.F.

Amount
xxxx

2.5.1.2 Double Column Cash Book:

The double column cash book is similar to the simple cash book with a difference
of one more additional column on both sides indicating the entries related with
Discount. The column is known as Discount column. The discount column on the
left hand side (receipts side) indicates discount allowed. Whereas on the right
side (payment side) it indicates discount received. The advantage of double
column cash book is besides knowing the cash balance , one can understand the
volume of discount received and allowed respectively at a glance

Pro forma
M/s ABC Co. Ltd
Receipts
Date

Double column Cash Book

Particulars

L.F

Discount

Cash

xxxx

xxxx

Payments

Date

Particular

.
xxxx

L.F.

Discount

Cash

xxxx

xxxx

To

xxxx

By

2.5.1.3 Three column Cash Book

When a bank column is added to the two column cash book it becomes the three
column cash book. The bank column is added on either side of the cash book which
helps in knowing the balance in the bank.

Pro forma
M/s ABC Co. Ltd
Receipts
Date

Double column Cash Book

Particular

L.F.

s
xxxx
2.5.2

Discoun
t
xxxx

To

Cash

Bank

Payments

Date

Particular

L.F.

Discoun

Cash

Ban

t
xxxx

xxx

xxx

s
xxxx

xxxx

xxxx

By

Purchase Book

Also known as purchase journal, this book is used to record credit purchases of
goods only as the cash purchases are recorded in the cash book. The term goods
stand as discussed in the first chapter.
Pro forma
Purchase Book of ABC Co. Ltd.
Date

Name of the

Ledger Folio

Inward

Amount

Supplier

2.5.2.1

Invoice No

Rs.

Purchase Returns Books

This subsidiary book is used to record the goods that has been purchased on
credit and would have been sent back to the supplier, due to various reasons,
needs to be recorded, as the credit purchases are recorded in the purchase
book , the goods which are returned are recorded in the purchase return book.

Pro forma
Purchase Return Book of ABC Co. Ltd.
Date

Name of the

Ledger Folio

Debit Note

Amount

No.

Rs.

Supplier

2.5.3 Sales Book

It is also known as Sales Journal, this subsidiary book is used to record all credit
sale of goods.
Pro forma
Sales Book of ABC Co. Ltd.
Date

Name of the

Ledger Folio

Customer

Outward

Amount

Invoice No

Rs.

2.5.3.1 Sales Return Book

This book is used to record the transaction relating to goods sold credit and
returned by the customer due to various reasons.
Pro forma
Sales Return Book of ABC Co. Ltd.
Date

Name of the

Ledger Folio

Credit Note

Amount

Customer

No.

Rs.

2.5.4 Bills Receivable Book

The Bills Receivable of an enterprise consist of all Promissory Notes given or Bills
of Exchange accepted by the customer in respect of amount due from them. The
bills Receivable Book is used to record all the transactions of such nature.

Pro forma
Bills Receivable Book of ABC Co. Ltd.
Date

From

Acceptor

Date

Whom

of

Received

Bills

Term

Date of

Where

Amount

How

maturity

Payable

Rs.

Disposed

2.5.5 Bills Payable Book

The opposite of Bills Receivable is Bills Payable; it consists of all promissory Notes
given or Bill Exchange accepted by the business enterprise in respect of amounts
owing to its suppliers. The Bills Payable Book is used to record all such
Promissory Notes given or Bills of Exchange accepted by the enterprise.
Pro forma
Bills Receivable Book of ABC Co. Ltd.
Date

Name

Payee

of the

Date

Term

of Bills

Date of

Where

Amount

maturity

Payable

Rs.

Remarks

Drawer

2.5.6 Journal Proper

This book is used to record all transactions which cannot be recorded in the
above discussed subsidiary books. Generally , purchase and sale of fixed assets,
any investments on credit , adjusting entries, rectification etc are the transactions
that are recorded in the journal proper.
Pro forma
Journal Proper of ABC Co. Ltd.

Date
xxx

Particulars
--------------A/c
Dr.

L.F

Dr. Amount
xxx

To -------------A/c

Cr. Amount
xxx

(Narration- Being)

2.6

Trial Balance

What is Trial Balance?

As the name itself indicates Trial Balance is a statement, which is prepared to
identify the correctness of recording and posting. When all the accounts of ledger
are balanced, credit balances and debit balances are extracted from the ledger
accounts and a statement is prepared having both debit and credit columns. We
must keep in mind that the total of both debit and credit should be equal. This
gives us the fact that at each and every step of accounting the dual aspect
principle has been followed in its true form. Thus, in summary it can be said that
a Trial Balance is a summary of all the ledger balances outstanding as on
particular date.
Why Trial Balance?
The basic objective of preparing Trial Balance is to----1. Check the arithmetical accuracy of accounting entries posted in the ledgerwhen the debit column and credit column tallies, it is an indication of the fact
that the ledger accounts are arithmetically accurate.
2. To provide the basis for preparation of financial statements. In fact Trial
Balance is the first step towards preparation of financial statements of an
organization.
3. It serves as a summary of all ledger accounts.
Pro forma
Trial Balance of ABC Co. Ltd.
As on 31-12-2008
Particulars

Dr. Amount

Cr. Amount

Let us continue with the same illustration which we have discussed in the chapter
pf Journal followed by Ledger , now let us check the arithmetical accuracy of
recording and classifying

Pro forma
Trial Balance of ABC Co. Ltd.
As on 31-12-2008
Particulars
Cash
Capital
Sales
Purchases
Mr Anand (Debtors)
Furniture

Dr. Amount
38000

Bank
Machinery
Salary
Rent
Total

25000
20000
10000
1000
1,22,000

Cr. Amount
50000
72000

6000
7000
15000

1,22,000

Identification of Errors in while preparing Trial Balance.

While preparing Trial Balance we concluded that if the total of both the sides is
tallied than recording and classifications are accurate. Certain errors may not
effect the agreement of a trial balance as the erroneous entries many not violate
the basic rule of dual aspect. Hence, it is said that even if the Trial Balance
agree , steps should be taken to ensure that the records are free from errors. The
question here arises as to what are the errors that usually occur in the Trial
Balance. For the understanding of errors we can classify them into two. One type
of errors, which can be disclosed by the Trial Balance and the other one is which
cannot be disclosed by the Trial Balance.
Let us have glance of these types of errors broadly.
A Errors which can be disclosed by the Trial Balance.

1. Partial omission of an entry: if suppose only one aspect has been recorded
and the second aspect remains un recorded, it will lead to partial omission
and hence , the total of Debits and Credits will not agree with each other.
e.g. Credit sales of Rs. 7000 remains unrecorded in the sales account in that
case total debit will exceed the total credit to the extent of Rs. 7000.
2. Wrong calculation of Balances in a ledger account. Suppose in case of
Motor Car account , if the debit balance has been taken as Rs. 6500 instead of
5,600 then the Trial Balance will show the total credit exceeding the total
debits by Rs. 900
3. Dual Posting: suppose and aspect of transaction get posted twice , in that
case it reflect an error. E.g. An amount of Rs. 2000 paid ABC Ltd was posted
to the debit of ABC Ltd., twice then the debits will exceed the credits by Rd.
2000
4. Wrong totaling in a subsidiary book
Say for example if the total of purchases for a month is stuck as Rs. 26,150
instead of 26,250 , then the debit in the purchases account would be Rs.
26,150 and the total of the credit in the individual suppliers account would be
26,250 and in the Trial Balance the total credits will exceed total debits by
Rs. 100
Errors Not Disclosed By Trial Balance:
1. Total omission of the recording of the transaction in the books of accounts
2. Recoding the transaction at an amount which is totally different from the
actual amount
3. Compensating Errors: if a cash discount of Rs. 215 allowed to a customer
has been posted to the credit of his account as Rs. 251 and a cash sale of
Rs. 2,851 has been posted to sales account as Rs. 2,815 , then the excess
credit caused by the first error would be exactly compensated by the
lower credit recorded by the second error and still the Trial Balance will be
in agreement.
4. Posting the entry on the correct side of wrong account . If suppose Mr. A-debtor was due for Rs. 500 and he paid the same is wrongly posted to the
credit of Mr. X also a debtor, the Trial Balance total will match, because
both are debit accounts and the total effects the same.
5. Recording the transaction more than once in the books of accounts.

6. Errors of Principle: causing a mistake in applying the very principles of

accounting. E.g. Repairs on Machinery is an expenses and if it is debited to
machinery account , the error will not be disclosed as machinery account
and repairs account carry debit balance.

2.7

Accounting for Merchandising TransactionsDefinition of inventory

Business organizations are of many types, as discussed earlier few may fall under
the category of manufacturing few may be service oriented and so on so forth.
However, there are other types of businesses one of which is a merchandising
company. Merchandising companies create a supply of goods that are delivered to
customers. This supply is called inventory.
Inventory is a current asset on a company's balance sheet. Inventory includes
goods for resale, raw materials, spare parts, etc.
Inventory usually includes goods that are being made (in the process of being
produced) and goods that are finished and ready for sale.
Merchandise inventory is goods that are held for resale by a merchandising
company.
Inventory for resale is accounted for in the Merchandise Inventory account. This is an
asset account shown in the assets section of the balance sheet.
2.7.1 Inventory costs. Product and Period costs
All costs related to acquiring goods and making them ready for sale is accumulated
in the Merchandise Inventory account. Such costs are associated with products and
often called product costs.
Product costs are costs required to produce inventory and make it ready for sale.
Such costs are directly associated with inventory production.
Product costs are expensed in the period of inventory sale regardless of when the
goods were purchased or produced by the company.

There are a few types of expenditures that cannot be directly traced to a specific
product. Such costs include (but not limited to) advertising, administrative salaries,
insurance, etc. Such costs are called selling and administrative expenses.
Selling and administrative expenses are expenses of selling and administrative
nature that are not directly traceable to a specific product. Examples are advertising,
administrative salaries and insurance, among others.
Because selling and administrative expenditures are expensed in the period in which
they are incurred, they are labeled period costs.
Period costs are costs associated with a specific period and not a specific product.
Period costs include selling and administrative expenses.
2.7.2 Cost of goods available for sale and cost of goods sold
Total inventory cost for a given accounting period is calculated by adding the
beginning inventory account balance to the amount of inventory acquired during the
period. The result of adding these two numbers is called cost of goods available for
sale.
Cost of goods available for sale is the cost of goods acquired during a period plus
the cost of goods on hand at the beginning of the period. This cost represents all
inventories available for sale during the period.
The cost of goods available for sale is allocated between the Merchandise Inventory
account and an expense account called Cost of Goods Sold. At a period end,
inventory that has not been sold during the period is shown as an asset on the
balance sheet (Merchandise Inventory) and inventory that has been sold is shown as
an expense on the income statement (Cost of Goods Sold).
Cost of goods sold (COGS) is the difference between the cost of goods available
for sale and the cost of goods on hand at period end. This cost represents the cost of
goods sold by the company during the period.
Gross margin is the difference between the sales revenue (i.e., revenue generated
from sales) and the cost of goods sold. Gross margin shows what profit the company
made after cost of goods sold, but before any other expenses (selling and
administrative, etc.).
Operating income is the difference between the gross margin and selling and
administrative expenses.

Sales
Less: Cost of Goods Sold
Gross Margin

Less: Selling and Administrative Expenses

Operating Income

2.7.2 Perpetual and periodic inventory systems

There are two inventory accounting systems - perpetual and periodic.
Perpetual inventory system means that the inventory account is adjusted
perpetually. The inventory account is affected each time inventory is sold or
purchased.
Periodic inventory system adjusts the inventory account only at the
end of an accounting period. Purchases and sales do not affect the inventory account
during the accounting period, but do affect at the period end.
Although both systems have different approaches to inventory accounting, they
provide the same results. The amount of cost of goods sold and the amount of sales
will be the same regardless which method the company applies.
2.7.3 Illustration 1 of accounting for inventory (period 1)
In our example, we will follow the rules of the perpetual inventory system. Under the
perpetual inventory system sales and purchases of inventory are recorded directly to
the Merchandise Inventory account when they take place. The accounting events
below refer to a book store called Dhawals 's Books that was opened in 2008 fiscal
year:
1. The owner contributed Rs. 3,000 of inventory and Rs. 9,000 cash to the
business.
2. Rs. 4,000 cash was paid to purchase additional inventory.
3. Rs. 200 cash was paid for the inventory transportation (see Event No. 2) from
the vendor to the bookstore.
4. Inventory that cost Rs. 2,000 was sold for Rs. 5,500 cash.
5. Transportation expenses of Rs. 300 to deliver sold goods (see Event No. 4)
were incurred and paid with cash.
6. Rs. 400 of selling expenses were incurred and paid with cash.

2.7.3.1 Analysis of capital contribution transaction

Event No. 1. The owner made a combined capital contribution that consisted of cash
and inventory. Cash (Rs. 9,000), Inventory (Rs. 3,000), and Contributed Capital
(totally, Rs. 12,000) increase. This is an asset source transaction:
Effect of capital contribution (Amount Rs.)
Balance Sheet
Event
No.

Cash + Inv. =

Beg. Rs.
0
1

+ Rs.
0

Income Statement

Cont.
Ret.
Net
+
Rev. - Exp. =
Cap.
Earn.
Inc.

= Rs.

0 + Rs.

0 Rs. - Rs. = Rs. 0

0
0

9,000 + 3,000 = 12,000 + n/a

End. 9,000 + 3,000 = 12,000 +

Cash
Flows

n/a - n/a = n/a 9,000 FA

0

Analysis of inventory acquisition transaction

Event No. 2. The Merchandise Inventory account increased when the inventory purchase
was made for Rs.4, 000 cash. Inventory increases and Cash decreases. This is an asset
exchange transaction:
Effect of inventory acquisition (Amount Rs.)
Income
Statement

Balance Sheet
Event
No.
Cash + Inv. =

Cont.
Ret.
Net
+
Rev. - Exp. =
Cap.
Earn.
Inc.

Beg. 9,000 + 3,000 = 12,000 +

2

(4,000 + 4,000 =
)

n/a

+ n/a

End. 5,000 + 7,000 = 12,000 +

Cash
Flows

0 = 0

n/a - n/a = n/a (4,000) OA

0 = 0

Analysis of transportation-in costs

Event No. 3. Recall that all expenses incurred to deliver goods and make them
ready for sale are treated as part of inventory costs and recorded in the Merchandise
Inventory account. So, the transportation costs related to the delivery of inventory

from the vendor to the bookstore are recorded in the Merchandise Inventory
account. This transportation expense is called transportation-in.
Transportation-in expenditures are cost incurred to delivery inventory from the
vendor (supplier) to the company. Transportation-in costs are treated as part of the
inventory costs (product costs).
The transaction acts to increase Merchandise Inventory and to decrease cash. This is
an asset exchange transaction:
Effect of transportation-in costs (Amount Rs.)
Income
Statement

Balance Sheet
Event
No.
Cash + Inv. =

Cont.
Ret.
Net
+
Rev. - Exp. =
Cap.
Earn.
Inc.

Beg. 5,000 + 7,000 = 12,000 +

3

(200) + 200 =

n/a

+ n/a

End. 4,800 + 7,200 = 12,000 +

Cash
Flows

n/a - n/a = n/a (200) OA

Analysis of the inventory sale transaction

Event No. 4.This event is composed of two parts. The first one (4a in
the table below) is recognition of sales revenue. Cash and Retained Earnings increase
by Rs.5,500. Transaction 4a is an asset source transaction. The second part (4b) is
designed to record the cost of goods sold. Remember that goods are expensed only
at the point of sale (under perpetual system). Accordingly, Rs.2,000 should be
removed from the Merchandise Inventory account and placed to the expense account
called Cost of Goods Sold. Transaction 4b is an asset use transaction.
Effects of inventory sale (Amount Rs.)
Balance Sheet
Event
No.

Cash +

Inv.

Income Statement

Cont.
Ret.
=
+
Cap.
Earn.

Beg. 4,800 + 7,200 = 12,000 +

4a
4b

5,500 +
n/a

n/a

Rev. 0

Exp.

Net
Inc.

n/a

= 5,500

Cash Flows

n/a

+ 5,500 5,500 -

+ (2,000) =

n/a

+ (2,000) n/a - (2,000) = (2,000) (2,000) OA

End. 10,300 + 5,200 = 12,000 + 3,500 5,500 - (2,000) = 3,500

5,500 OA

Analysis of transportation-out expenses

Event No. 5. The cash payment made by the bookstore to deliver goods to the
customer is called transportation-out:
Transportation-out expenditures are expenses incurred to deliver products from
the company to the customer. Transportation-out expenditures are treated as period
costs and expensed in the period of incurrence.
The company records transportation-out expenditures as an operating expense. This
is an asset use transaction:

Effect of transportation-out expenses (Amount Rs.)

Balance Sheet
Event
No.

Income Statement

Cont.
Ret.
Cash + Inv. =
+
Rev. Cap.
Earn.

Exp.

Net
=
Inc.

Cash
Flows

Beg. 10,300 + 5,200 = 12,000 + 3,500 5,500 - (2,000) = 3,500

5

(300) + n/a =

n/a

+ (300) n/a - (300) = (300) (300) OA

End. 10,000 + 5,200 = 12,000 + 3,200 5,500 - (2,300) = 3,200

Analysis of selling expenses transaction
Event No. 6. The Rs.400 cash payment for selling expense has the same effect as
operating expenses do. Cash and Retained Earnings decrease. This is an asset use
transaction:
Effect of selling expenses (Amount Rs)
Balance Sheet
Event
No.

Income Statement

Cont.
Ret.
Cash + Inv. =
+
Rev. Cap.
Earn.

Exp.

Net
=
Inc.

Cash
Flows

Beg. 10,000 + 5,200 = 12,000 + 3,200 5,500 - (2,300) = 3,200

6

(400) + n/a =

n/a

+ (400) n/a - (400) = (400) (400) OA

End. 9,600 + 5,200 = 12,000 + 2,800 5,500 - (2,700) = 2,800

Note these entries are prepared on the basis of the events and not on the basis
of date.
Journal Entries in the Books Dhawal

Event
No
1

Account titles

Debit Credit

Cash

9,000

Merchandise Inventory

3,000

Contributed Capital
2

Merchandise Inventory

12,000
4,000

Cash
3

Merchandise Inventory
(Transportation-in)

4,000
200

Cash
4a

Cash

200
5,500

Sales Revenue
4b

Cost of Goods Sold

5,500
2,000

Merchandise Inventory
5

Transportation-out

2,000
300

Cash
6

Selling Expense

300
400

Cash
Closing Sales Revenue
entry

Cost of Goods Sold

400
5,500
2,000

Transportation-out

300

Selling Expense

400

Retained Earnings

2,800

Note the last entry that is called a closing journal entry. We zeroed the nominal
accounts (revenue and expense accounts) for use in the next accounting period. The
closing entry is combined because we include both revenue and expense accounts
into it.
2. 9 Classification and Distinction of capital and revenue expenses
We have studied the rule of debit and credit. When we take a glance at the Trial Balance it
reflects that debit represents assets and expenses and credits represents liabilities and
income. As per the going concern concept it is assumed that an enterprise will normally
continue operation for the forecasted period and foreseeable future. Hence, it is assumed
that it has neither the intention nor the need to liquidate or curtail materially the scale of its
operations. It is this concept that leads to making a distinction between capital and revenue
expenditures.
Capital Expenditure means an expenditure which benefit accrues over a long term, say
beyond, and one year. It is also due to the going concern concept that fixed assets are
generally carried in the balance sheet at their cost less depreciation and not at their current
values even if they are lower.
e.g. All the fixed assets fall under the category of Capital Expenditure
Type of Capital expenditures:
a. Expansion of existing product line
b. Expansion into new product line
c. Replacement and Modernization
d. Project for the utilization of scraps, and also of surplus installed capacity and
e. Cost reduction projects

Revenue Expenditure means an expenditure whose benefit expires within one year.
Accounts classified as expenses fall under the category of revenue expenditure.

2.9.1 Impact of Depreciation Methods.

According to the cost concept we have discussed that the fixed assets should be valued
at historical cost less depreciation. The question is what is Depreciation? And how to
calculate depreciation and how to value the asset after depreciation. We are going to
answer these questions in the following discussion.
2.9.2 Definition of Deprecation:
Depreciation is called a permanent , continuing and gradual shrinkage in the
book value of a fixed asset duet o use, wear and tear, obsolescence or efflux of
time
In common usage Depreciation is defined as the reduction in the value of an
asset. But in accounting its use is restricted to the expiration of the cost of tangible
fixed assets. Except land all other fixed have a limited life which can be defined as useful
life of an asset. Hence, their cost should be properly allocated as expense to the
accounting periods in which these assets are used. The accounting for this gradual
conversion of the cost of fixed asset into expense is called Depreciation.

2.9.3 Objective of depreciation

a. To ascertain true profits
b. To show the assets at their proper values
c. To create funds for replacement of assets
d. To keep the capital in tact
e. Provision for depreciation is a statutory need
2.9.4 Computation of Depreciation
The computation of depreciation charge involves the following factors.
a. Depreciation Base
Depreciation base refers to the cost to be recovered over a period of time of use. Higher
the depreciation base, higher will be the depreciation charge. It depends up on the cost of
assets, salvage value and removal cost. In short, it is as follows.
Depreciation Base = Cost of Asset Salvage Value+ Removal Cost
*The cost of asset includes the purchase price plus installation charges.
b. Useful of Economic Life
Estimation of economic life of a fixed asset is very difficult task. The amount of depreciation
depends mainly on the useful working life of the asset. Higher the useful life, lower will be

the amount of deprecation charge. Both obsolescence and physical endurance must be
considered in estimating the useful life.
c. The Depreciation Method
The method of depreciation is a very important factor in the allocation of net cost of an
asset to each of the accounting periods in which the asset is used. There are a number of
methods, which may be used in calculating the periodic method selected in any specific
instance should be logical and based on a careful evaluation of the peculiarities of the
individual concern.
2.9.5 Methods of Deprecation
The following are the methods of providing depreciation
a. Fixed Installment or Straight Line Method
Under this method , an equal portion of the cost of the asset is allocated as
depreciation to each accounting year over a period of its effective life. This
method is useful in reducing the value of an asset to zero without any salvage
value.
The formula for computing Annual Deprecation charge ---

Cost of Asset + Erection Charges Scarp Value + Removal

Cost X 100
=

e.g. A machine
is purchased
for Rs.
50,000
Estimated
Useful Life
of the
asset Xand
CostRs. 1,000 is incurred as
erection charges . The removal cost may amount to Rs. 1,000. Compute the
annual deprecation charge

Rs 50,000 + 1,000-5,000 + 1,000 X 100

=
50,000 X 4

= 23.50%
b. Diminishing Balance or Written Down Value Method
It is also known as reducing balance or reducing installment method or
diminishing balance method. Under this method, the depreciation is calculated
at a certain fixed percentage each year on the decreasing book value
commonly known as WDV of the asset (book value less depreciation). The use
of book value (the balance brought forward from the previous year) and fixed
rate of depreciation result in decreasing depreciation charges over the life
span of the asset.

While applying the depreciation rate both salvage or scarp value and removal
cost is ignored. The objective of this method is to see that there will be some
amount of salvage left at the end of the life of an asset. Which helps in
estimating the value of the asset based on which identifying the replacement
cost would be easier.
Depreciation Rate = 100(1-n S/C)
Where
n= Number of years
S = Salvage Value
C = Cost of Asset
For example, if a plant costs Rs. 8,000 with an estimated salvage of Rs. 1,000
at the end of third year of its useful life, the rate of depreciation will be
calculated thus:
Rate of Deprecation = 100 ((1-3 1000/8000)
= 50%

c. Sum of the years Digits Method

Similar to diminishing Balance Method, sum of the digits method is also a
device for obtaining decreasing depreciation charge. This method also uses a
constant depreciation base like Straight Line Method. But it applies a
constantly reducing rate to the base. This results in decreasing depreciation
charge year by year.
The rate of depreciation in this method is a fraction having sum of the digits
representing the useful life of the asset as its denominator and the individual
year digits in descending order each year as its numerator.
For Example for an asset having 4 years of useful life. The denominator would
be the sumo the digits form 1 to 4 i.e 1+2+3+4= 10 and the numerator
would be 4 for the first year, 3 for the second year, 2 for the third year and 1
for the fourth year.
d. Annuity Method
Normally various methods of depreciation do not take into account the
interest lost on capital invested in the asset. The annuity method removes

this deficiency. Under this method, the amount spent on the purchase of an
asset is considered as an investment which is assumed to earn interest.

e. Depreciation Fund or Sinking Fund Method

The salient feature of this method is that it provides funds of the asset. It is
suitable for plant and machinery and many other waiting assets, which
requires replacement. it is designed in such a way that, apart from providing
depreciation on the asset . it provides the required funds for the replacement
of the asset when the asset is to be replaced by new asset.
Under this method, one Depreciation Fund Account is opened and the amount
of depreciation is credited to that account. The asset account year after year
stands at original cost. At the end of the year, the amount of depreciation is
debited and depreciation fund account is credited and the corresponding
amount is invested outside in some readily realizable securities in order to
provides funds for replacement. Interest received on investments is also
invested likewise. The amount that is annually set aside as depreciation is
such that this with compound interest will be a sum equal to the cost of asset
less residual value.
f.

Insurance Policy Method

This method is similar to depreciation fund method. Under this method an

Insurance policy is taken from an insurance company. The policy is taken for
such a period that it matures when the asset is to be replaced. The procedure
is same as the depreciation fund method except that the amount of
investment will be in the form premium paid on the insurance policy.
The premium is paid at the beginning of each year and debited to deprecation
fund policy account. The annual depreciation will be equal to the amount of
annual premium and is debited to Profit and Loss Account and credited to
Deprecation fund account at the end of the accounting year. Generally interest
is not recorded yearly in this method . When the policy matures, the agree
sum is received form the Insurance company and is used to purchase the new
asset. The balance in the deprecation fund policy account is transferred to
deprecation fund account and thereafter, transfer to old asset account closes
the balance of fund account. Balance of asset account is written off to profit
and loss account.

g. Revaluation Method
This method is used to depreciate small and divers items of asset such as
bottles, corks , packages, patterns, moulds, trademark, loose tools, livestock,
and etc. under this method , the asset in question is submitted to experts for
evaluation at the end of the every year and the fall in value of the asset is
treated as depreciation. This is debited to profit and loss account and credited
to asset account. However, if there is an appreciation in value of the asset, it
should either be ignored or credited a reserve account. Purchase of asset
during the year is recorded in a normal manner.
h. Activity Method
Under this method the usage of asset is given more importance than the
passage or efflux of time . the depreciable cost of the asset is spread over in
various accounting periods in accordance with the extent if sue or activity of
the asset. If an asset is not used in any one year, then no depreciation will be
charged for that year assuming that there is no decline in its service life. This
method is useful in case the asset vary from period to period. The activity
may take place in different forms and accordingly the method may be called
in different names which are explained in brief in the following discussions.

i.

Production Unit Method

This method is adopted when the economic life of the asset is fixed in terms
of unit of production . Under this method the depreciation rate is determined
by dividing the net cost of the asset by the estimated number of units that
are likely to be produced during its useful economic life. The annual
depreciation charge is calculated by applying the rate to the number of units
produced during an accounting period.
Depreciation Rate Per Unit
Cost Salvage Value
= -------------------------------------------Total units produced during the assets lifetime
Depreciation for the year
= Number of units produced during the year X
j.

Machine Hour Rate Method

Depreciation Rate per unit

This method is useful when the life of machine is fixed in terms of hours.
Hourly rate is determined by dividing the total cost of the machine by total
number of hours to be used in its lifetime. The annual depreciation charge is
calculated by applying this rate to the number of hours used in an accounting
period.
Machine Hour Rate
Cost- Salvage Value
=---------------------------------------------Total estimated machine hours in machines lifetime
Deprecation for the Year
= Number of Hours used in the year X Machine Hour Rate

k.

Service Unit Method

This method is mostly useful for depreciating transport vehicle. It takes into
consideration the running time of the asset for calculating the deprecation.
Under this method the deprecation is calculated by dividing the net total cost
of the asset by its estimated service life.

l.

Depletion Method.

This method is used for allocating the cost of natural resources. E.g. mines,
quarries , oil and gas deposits etc., The life of the asset is estimated by
geographical survey methods in terms of total unit of resource deposits. The
depletion rate pre unit is computed by dividing the net total cost of natural
resource by the estimated available number of units. Then the depreciation
for a year is calculated by applying the depletion rate per unit to the total
quantity extracted during that year.

m. Repairs and Renewals Method

Under this method the total repairs and renewals costs are estimated for the
whole life of the asset and added to its capital cost less scrap value to get an
aggregate figure. This figure is then divided by its estimated life, the resultant

is the amount that has to be charged to profit and loss account each year in
respect of repairs, renewals and depreciation. The corresponding credit is
given to provision for depreciation and repairs account. Each year actual
amount or repairs and renewals are debited to this provision account and not
to profit and loss account.

The balance of provision account show the net

amount set aside for depreciation and by the time the asset becomes useless,
the balance should be equal to the difference of its cost and scrap value. At
the end of the working life of the asset, transfer to asset account closes the
provision account. If the estimation of total repairs and renewals goes wrong
and asset account shows any balance, then it will be transferred to profit and
loss account.

Question:
A try your self (short answer)
1. If capital of business is Rs. 10,000 and outside liabilities are Rs. 15,000, calculate
total assets and liabilities of the business.
2. If total assets of a business are Rs. 1,30,000 and net worth is Rs. 80,000.
Calculate creditors.
3. Give an example for each of the following types of transactions.
a. Increase in one asset, decrease in another asset
b. Increase in assets, increase in liabilities
c. Increase in assets, increase in owners capital
d. Decrease in assets, decrease in liabilities
e. Decrease in assets, decrease in owners capital

f. Increase in one liability, decrease in another liability

g. Increase in liabilities , decrease in owners capital
h. Decrease in liabilities , increase in owners capital
B. Self evaluation questions
1.

Mr. Amir Khan had the following transactions , use accounting equation to
show the effect of the transactions on his assets. Liabilities and capital

a. Started with business with cash Rs. 25,000

b. Purchased goods for cash Rs. 10,000 and Credit Rs. 15,000
c. Sold goods for cash Rs. 20,000 costing Rs. 15,000
d. Rent paid Rs. 250
e. Rent outstanding Rs. 50
f.

Bought furniture Rs. 2,500 on credit

g. Bought refrigerator for personal use Rs. 2,500

h. Purchased building for cash Rs. 10,000
2.

Work out the accounting equation on the basis of the following transactions.

a. Dhawal started business with cash

Rs. 25,000

b. Purchased goods on credit

2,000

c. Purchased goods for cash

500

d. Purchased furniture for

250

e. Paid rent

100

f. Withdrew for personal use

350

g. Received interest for

50

h. Sold goods on credit (cost Rs 250) for

350

i. Paid to creditors

200

j. Paid salaries

100

3.

Show the affect of transactions on the accounting equation.

a. Invested Rs. 15,000 in cash in the business

b. Purchased securities for Rs. 7,500 in cash
c. Purchased a home

for Rs. 15,000 and giving Rs. 5,000 in cash and the

balance through a loan

d. Sold securities costing Rs. 1,000 for 1,500

e. Purchased an old car for Rs. 2,800 in cash

f.

Received cash as salary Rs. 3,600

g. Paid Rs. 500 for loan and Rs. 300 for interest
h. Paid cash for household expenses Rs. 300
i.

Received cash for dividend on securities Rs. 200

1. Why are we not using the name of the proprietor, why capital? Which concept
is applicable?
2. Why are we not using the names of the employees, why only salary?
3. Why are we not mentioning the name of the supplier/ customer if it is cash
transaction and why if it is a credit transaction?
4. What is the difference between purchases of goods and purchases of
machinery or furniture?
5. Whenever you go for buying anything try to understand each transaction from
the sellers point of view, you will have an upper hand on the concept.
6. Journalize the following transactions in the books Ashram Ltd.
2008 Jan
1 Started business with cash Rs. 10,000
2. Deposited the same into Bank
3. Purchased machinery for Rs. 5,000 from Jawahar and gave him a cheque
for the amount
4. Furniture costing Rs. 500 was used in furnishing the office
5. Sold furniture to Sandehsh of the list price of Rs. 1000 and allowed him 5%
trade discount
6. Paid installation charges of machinery Rs. 100
7. Received a cheque form Sandesh in full settlement and sent the cheque to
the bank amount Rs. 930
7. Journalize the following transactions
2008 Jan
1. Paid rent of the building Rs. 12,000 and half of the building are used by the
proprietor for residential use.
2. Paid fire insurance of the above building in advance Rs. 1,000
3. Paid life insurance premium Rs. 2,000

4. Paid income tax Rs. 3,000

5. Paid for stationery Rs. 4,000
6. Purchased furniture , machinery, motor car and building for Rs. 100,000 with an
equal amount on all four
7. A fire broke out in the godown and insurance company admitted a clam of Rs.
5000 for a total loss of Rs. 10,000
8. Paid for miscellaneous expenses Rs. 1,000

Questions:
1. What do you mean by posting? Explain with definition
2. Define and discuss with example balancing of an account
3. Explain when the account will be holding a debit balance and credit balance?
4. With your own understanding explain the importance of ledger accounts. Give
suitable examples where ever necessary
5. From the exercise problems given in the chapter IV prepare ledger account for
each problem.

Project: Visit any shop as a customer , have as many transactions as

possible over a months time, note down each transaction and try to apply
the concept of accounting equation to find out the impact of the transaction
on the shops (companies) Balance Sheet.