II. MECHANICS OF ACCOUNTING_ CONCEPT NOTES_ Prof. Bhavana Raj

Distinction between Tangible Assets and Intangible Assets:

Basis of distinction Tangible Assets Intangible Assets

1 Physical Identity These assets have physical identity.

These assets do not have physical identity.

2 Depreciation or Amortization

Fixed assets are depreciated. Intangible assets are amortized.

3 Fixed Assets Vs. Current Assets

Tangible assets can be fixed assets or current assets.

Intangible assets usually fall in the category of fixed assets.

4 Acceptance as Security

Lender accepts such assets as security for a loan given.

Lenders usually don’t accept such assets as security for a loan given.

5 Risk of loss due to fire

The assets may be lost due to fire. These assets can’t be lost due to fire.

Distinction between Fixed Assets and Current Assets:

Basis of distinction Fixed Assets Current Assets

1 Purpose of holding These are the assets which are held for the purpose of providing or producing goods or services and those which are not held for resale in the normal course of business.

These are the assets which are held:

a) in the form of cash b) for their conversion into cash c) for their consumption in the

production of goods or rendering of services in the normal course of business.

2 Valuation Fixed assets are valued at Cost – Depreciation.

These assets are valued at Cost Price or Market Price whichever is lower.

3 Subject to change These assets are usually not subject to change.

These assets are usually subject to change.

4 Fixed Charges Vs. Floating Charges

Fixed charge can be created on these assets.

Floating charge can be created on these assets.

5 Nature of Profit on Sale

Profit on sale of these assets is of capital nature.

Profit on sale of these assets of revenue nature.

6 Revaluation Reserve in case of appreciation in the value

In case of appreciation in the value of such assets, revaluation reserve can be created.

In case of appreciation in the value of such assets, revaluation reserve cannot be created.

7 Sources of Finance These assets are financed out of long-term funds.

These assets are mainly financed out of short-term funds.

LIMITATIONS OF A JOURNAL: Journal in spite of its above advantages suffers from the following limitations: 1. Huge and bulky size: A single journal for the entire business will be bulky and difficult to operate and handle. 2. Balance of accounts at a glance not available: The actual position of ledger balances as purchases, sales, returns, bills etc. is not known on a particular date from journal. 3. Difficulty in reconciling cash balance: In case all transactions including cash transactions are recorded in the journal and no cash book is maintained, it will be very difficult to reconcile daily cash balance. In order to overcome the limitations of Journal, business units sub-divide the journal into

convenient parts and prepare subsidiary books i.e., Purchases book, Sales book1 Returns Inward and Outward book, Bills receivable and Payable book.

Distinction between Journal and Ledger:

Basis of distinction Journal Ledger

1 Nature of the book It is book of original or prime entry. It is book of final or secondary entry.

2 Basis for preparation It is prepared on the basis of source documents of transactions.

It is prepared on the basis of journal.

3 Stage of recording Recording in the journal in the first stage.

Recording in the ledger is the second stage.

4 Object It is prepared to record all transactions in chronological order.

It is prepared to know the net effect of various transactions affecting a particular account.

5 Format In Journal, there are 5 columns: 1. Date 2. Particulars 3. Ledger Folio 4. Debit Amount 5. Credit Amount

In Ledger, there are identical 4 columns on debit side and credit side:

1. Date 2. Particulars 3. Folio 4. Amount

6 Balancing Journal is not balanced. All ledger accounts (except nominal account) are balanced in the ledger.

7 Narration Narration is written for each entry. No narration is given.

8 Name of the process of recording entries

The process of recording in journal is called ‘Journalizing’.

The process of recording in the ledger is called ‘Posting’.

9 Basis for preparation of final accounts

Journal directly does not serve as basis for the preparation of final accounts.

Ledger serves the basis for the preparation of final accounts.

Distinction between Manufacturing Account and Trading Account:

Basis of distinction Manufacturing Account Trading Account

1 Purpose It is prepared to ascertain the cost of goods manufactured.

It is prepared to ascertain the gross profit or gross loss.

2 Closure It is closed by transferring its balance to the debit side of the Trading Account.

It is closed by transferring its balance to the debit side (in case of gross loss) or credit side (in case of gross profit) of the Profit and Loss Account.

3 Opening & Closing Stock of Finished Goods

It does not show the opening and closing stock of Finished Goods.

It shows the opening and closing stock of Finished Goods.

4 Who Prepares? It is prepared by a manufacturing concern only.

It is prepared by every business concern.

Distinction between Capital Expenditure and Revenue Expenditure:

Capital Expenditure Revenue Expenditure

1 Its effect is long term i.e., it is not exhausted within the current account year. Its benefit is enjoyed in future year or years also. In a word, its effect is reduces gradually.

Its effect is temporary, i.e., it is exhausted within the current accounting year.

2 An asset is acquired or the value of an asset is increased as a result of this expenditure.

Neither an asset is acquired nor is the value of an asset increased.

3 It does not occur again and again - it is non-recurring and irregular.

It occurs repeatedly - It is recurring and regular.

4 Generally, it has physical existence i.e., it can be seen with eyes.

It has no physical existence, i.e., it cannot be seen with eyes.

5 This expenditure improves the position of the concern.

This expenditure helps to maintain the concern.

6 A portion of this expenditure is shown in the trading and profit and loss account or income and expenditure account as depreciation.

The whole amount of this expenditure is shown in trading and profit and loss account or income and expense account. But deferred revenue expenditures and prepaid expenses are not shown.

7 It appears in balance sheet until its benefit is fully exhausted.

It does not appear in balance sheet. Deferred revenue expenditure, outstanding expenditure, outstanding expenses and prepaid expenses, however, temporarily shown in the balance sheet.

8 It does not reduce the revenue of the concern. Purchase of fixed assets does not affect revenue.

It reduces revenue. Payment of salaries to employees decreases revenue.

Distinction between Trade Discount and Cash Discount:

Basis of distinction Trade Discount Cash Discount

1 Meaning It is a reduction granted by a supplier from the list price of goods or services on business considerations (such as quantity bought, trade practices, etc. ) other than for prompt payment.

A reduction granted by a supplier from the invoice price in consideration of immediate payment or payment within a stipulated period.

2 Purpose It is allowed to promote the sales or as a trade practices.

It is allowed to encourage the prompt payment.

3 Time when allowed

It is allowed on purchase of goods. It is allowed on immediate payment or payment or within a specified period.

4 Disclosure in the Invoice

It is shown by way of deduction in the invoice itself.

It is not shown in the invoice.

5 Ledger Account Trade Discount Account is not opened in the ledger.

Cash Discount Account is opened in the ledger.

6 Variation It may vary with the quantity purchased.

It may vary with the period within which the payment is made.

PREPERATION OF FINAL ACCOUNTS

Preparation of Final Accounts involves the following: (a)Preparation of a Trading A/c: It is prepared to know the gross profit / loss or overall profit / loss. (b) Preparation of a Profit & Loss Account: It discloses net profit or clear profit of the business. (c) Preparation of a Balance Sheet: It shows the financial position of the business on a given date – generally on the last date of the accounting period.

Note:

(1)The trial balance contains all of the account balances from the ledger. It includes assets, liabilities, expenses, income, capital and drawings. (2)The Debit balances usually represent assets, expenses or drawings & these are always shown in the left hand column of the Trial Balance. (3)The Credit balances are usually income, liabilities or capital & these are always shown in the right hand column of the Trial Balance. (4)The expenses and income are shown in the Trading Account & Profit and Loss Account. (5)Assets, liabilities, capital & drawings are shown in the Balance Sheet.

Trading Account: Gross Profit = Sales proceeds of a particular period – Cost of the goods actually sold. Since, gross profit means overall profit, no deduction of any sort is made, i.e., general, administrative or selling & distribution expenses. Gross Profit is said to be made when the sale proceeds exceed the cost of goods sold. Conversely, when sale proceeds are less than the cost of the goods sold, gross loss is incurred. PREPERATION OF A TRADING ACCOUNT:

Trading Account Items: Debit Side: (1)Opening Stock: In case of a merchandising business, the opening stock consists of different types of finished goods. In case of a manufacturing concern, opening stock consists of raw materials, work-in-progress & finishes goods. Where a separate manufacturing account is prepared, opening stock consists of only finished goods. In case of a newly set up business, there will be no opening stock – at the beginning of the first year. The amount of the opening stock is available in the Trial Balance.

(2)Purchases: The balance of the Purchase Account, as appeared in the Trial Balance, shows the total purchases made during the accounting period which includes both cash & credit purchases. In respect of purchases, the following points must be noted: (a)Purchase of capital asset should not be added with the purchases. If it is already included in purchases, it should be deducted there from. (b) If goods purchased for personal use & added with the purchases, it should be excluded. This type of purchases should be treated as drawings & following journal entry is to be passed:

Drawings Account Dr.

To Purchases Account

(c) If some of the goods purchased are still in transit at the year end, it is better to debit Stock-in-transit Account & credit Cash Account or Supplier’s Account. (d)If the amount of purchases includes goods received on consignment, or on approval or on hire purchase, these should be excluded from purchases. (e)Cost of goods sent on consignment must be deducted from the purchases in case of a trading concern.

(3)Purchase Returns: When goods are returned to the supplier, for some reasons, in the books of account, supplier is debited & purchases returns or returns outwards is credited. In the Trial Balance,

it appears in the credit side. There are two ways of showing the purchases returns in the Trading Account. It may be shown by way of deduction from purchases in the Trading Account. An alternative way to show the purchases returns in the credit side of the Trading Account.

(4)Direct Expenses: Direct Expenses are shown separately in the Trading Account. Direct Expenses are those expenses which are directly attributable to the purchase of goods or to bring the goods in saleable condition. Some examples of direct expenses are as under: (a)Freight & Insurance: Freight & Insurance paid in connection with acquiring goods or making them saleable is debited to Trading Account. Freight & Insurance paid in connection with the sale of goods is charged to Profit & Loss Account. Freight & Insurance paid for acquisition of fixed assets must be capitalized. (b)Carriage inwards: Carriage paid for bringing the goods to the go-down is treated as carriage inwards & it is debited to Trading Account. (c)Wages: Wages incurred in a business is direct, when it is incurred on manufacturing or merchandize or on making it saleable. Other wages are indirect wages. Only direct wages are debited to the Trading Account. Other wages are debited to the Profit & Loss Account. If it is not mentioned whether wages are direct or indirect, it should be assumed as direct & should appear in the Trading Account. (d) Octroi: When goods are purchased within municipality limits, generally octroi duty has to be paid on it. It is debited to Trading Account. (e) Fuel, power, lighting & heating expenses: Fuel & power expenses are incurred for running the machines. These are considered as direct expenses since directly related with the production & debited to Trading Account. Lighting & heating expense of factory is also charged to Trading Account but lighting expenses of administrative office or sales office are charged to Profit & Loss Account. (f)Packaging charges: There are certain types of goods which cannot be sold without a container or proper packing. These form a part of the finished goods or finished products. One example is ink, which can’t be sold without a bottle. These types of packing charges are debited to Trading Account. But if the goods are packed for their safe dispatch to customers, i.e., packing meant for transportation or fancy packing meant for advertisement will appear in the Profit & Loss Account. (g)Duty on purchases: Any duty paid in connection with the purchase of goods is debited to Trading Account.

Credit Side: (1)Sales: The balance of the sales account, as appears in the Trial Balance, shows the total sales made during the accounting period which includes both cash & credit sales. In respect of sales, the following points must be noted: (a)If the goods are sold but yet to be dispatched, it shouldn’t be included in sales, but the closing stock will be increased by the cost of such goods (if the property in goods as not yet been transferred). (b)If sale of fixed asset is included in sales, it should be deducted from sales. (c)Goods sold on approval or on consignment or on hire purchase, should be recorded separately. If these are included in sales, these should be deducted.

(2)Sales Returns: When goods are retuned by the buyers, for some reasons, in the books of account “Returns Inwards Account” or “Sales Returns Account” is debited & buyer is credited. In the Trial Balance, it is appearing in the debit side. There are two ways of showing sales returns in the Trading Account. It may be shown by way of deduction from sales in the Trading Account. An alternative way to show the sales returns in the debit side of the Trading Account.

(3)Closing Stock: The last item in the credit side of the Trading Account is the closing stock – which is the value of goods which remain unsold at the end of the period. In case of a merchandising business, the closing stock consists of different types of finished goods. Where a separate manufacturing

account is prepared, closing stock consist of raw materials, work-in-progress & finished goods. Closing stock is an item which is not generally available in the Trial Balance. However, if the closing stock is adjusted against the purchases it will appear in the Trial Balance. When closing stock is shown in the Trial Balance, it will not be included in the Trading Account. It is to be shown in the Balance Sheet. Closing stock is valued at cost or net realizable value (NRV), whichever is lower.

BALANCING OF a TRADING ACCOUNT: After recording the above items, in the respective sides of the Trading Account, the balance is calculated to ascertain Gross Profit or Gross Loss. If the total of credit side is more than that of the debit side, the excess represents Gross Profit. Conversely, if the total of debit side is more than that of the credit side, the excess represents Gross Loss. Gross Profit is transferred to the credit side of the Profit & Loss Account & Gross Loss is transferred to the debit side of the Profit & Loss Account. Note: It is common for the gross profit to be expresses as a percentage of the sales value when it is known as the GROSS PROFIT MARGIN or as a percentage of cost of sales when it is known as the GROSS PROFIT MARK-UP.

CLOSING ENTRIES:

(1)For the items of debit side

Trading Account Dr.

To Opening Stock Account

To Purchases Account (Net)

To Direct Expenses Account

(2)For the items of credit side

Sales Account (Net) Dr.

Closing Stock Account Dr.

To Trading Account

(3)For gross profit

Trading Account Dr.

To Profit and Loss Account

(4)For gross loss the above entry (3) will be reverse.

Format of a Trading Account:

Dr. Trading Account of....... for the Period Ending on….. Cr.

Particulars Rs. Particulars Rs.

To Opening Stock XXX By Sales XXX

To Purchases XXX Less: Returns Inwards XXX XXX

Less: Returns Outwards XXX XXX By Closing Stock XXX

To Direct Expenses XXX By Abnormal Loss of Stock XXX

To Wages and Salaries XXX By “*Gross Loss transferred to P & L A/c” XXX

To Freight Inward XXX

To Carriage Inward XXX

To Cartage Inward XXX

To “*Gross Profit transferred to P & L A/c” XXX

XXX XXX

Note: * = Either Gross Profit or Gross Loss shall appear.

PREPERATION OF A MANUFACTURING ACCOUNT: A Trading Account is to find out the profit from trading, i.e., the buying & selling of goods. There are many firms which instead of buying saleable products from outside suppliers make the product themselves. The main objective of such a firm is to make a saleable product & to sell that product at a profit. These firms prepare a Manufacturing Account, in addition to the Trading & Profit and Loss Account, to show separately the cost of goods manufactured during the period. PRODCUTION CYCLE: The production cycle is the sequence of operations which transforms raw material into finished goods. (a)Raw materials are the basic materials that enter into the production of finished goods. (b)Work-in-Progress are partly completed products that are in the manufacturing process. (c)Finished goods are the completed products which are ready for sale.

The flow of costs through the manufacturing process is shown as below:

ELEMENTS OF COST: In the preparation of a Manufacturing Account, it is necessary to identify all the costs of manufacturing goods. The costs of manufacturing a product consist of three major elements: (1)Materials, (2) Labor and (3) Expenses. (1)Materials: Materials are classified as Direct Materials & Indirect Materials.

Direct Materials are those which can be identified with the product, that is, these are directly traceable to an article being manufactured. For example, wood, screws, and the like in a furniture factory.

Indirect Materials are those which don’t form a part of the finished product but are necessary for production. For example, sandpaper used in a furniture factory for smoothing surfaces. Discussion on the nature of a few materials:

(a)Raw Materials: The term, raw material is referred to material that has to be further worked upon for converting into a finished product. The raw materials used in production are treated as Direct Materials.

(b)Packing Materials: Primary packing materials are treated as Direct Materials where as secondary packing materials are treated as Indirect Materials. Examples of primary packing materials are bottles & plastic containers, tins, product labels & the like. Examples of secondary packing materials are wooden cases, binding wire, string, etc.

(c)Consumable Materials: These are treated Indirect Materials. Examples will include cotton waste, grease, lubricating oil and the like.

(d)Maintenance Materials: These are required for keeping plant & machinery in working condition. Examples will include gears, bushes & bearings etc. These are treated as Indirect Materials.

(2) Labor: Labor is also classified as Direct Labor and Indirect Labor.

Direct Labor is the remuneration paid to production workers who are directly associated with the manufacture of particular articles.

Indirect Labor is the remuneration paid to those workers who are not involved in the actual manufacturing of the product.

(3) Expenses: Expenses are also classified as Direct Expenses & Indirect Expenses.

Direct Expenses are those which can be directly identified with a particular product other than direct materials & direct labor. Examples are hire charges of special plant, royalties paid on production etc.

Indirect Expenses are those which can’t be identified with the product such as rent, rates & taxes, etc. TYPES OF COST IN MANUFACTURING ACCOUNT: The total cost of manufacturing is divided into two groups:

(1)Prime Cost is the aggregate of :(a)Direct Materials , (b)Direct Labor & (c) Direct Expenses. (2)Overhead Cost is the aggregate of :(a)Indirect Materials , (b) Indirect Labor & (c) Indirect Expenses. Overheads are classified into three classes: (a)Factory Overhead, (b)Administrative Overhead & (c) Selling & Distribution Overhead. In Manufacturing Account, we only consider the Factory Overhead.

Format of a Manufacturing Account: In the Manufacturing Account, all the elements of production cost, i.e., Direct Materials, Direct Labor, Direct Expenses & Factory Overhead are debited. As the Manufacturing Account is concerned with the production cost of goods finished during the year, any opening work-in-progress & closing work-in-progress must be adjusted at the time of preparing the Manufacturing Account of that year.

Dr. Manufacturing Account of....... for the Period Ending on….. Cr.

Particulars Rs. Particulars Rs.

To Opening Work-in-Progress XXX By Sale of Scrap XXX

To Raw Material Consumed: By Closing Work-in-Progress XXX

Opening Stock XXX By Trading Account (Cost of goods produced transferred)

XXX

Add: Purchases XXX

Add: Cartage Inward XXX

Add: Freight Inward XXX

Less: Closing Stock XXX XXX

To Wages XXX

To Salary of Works Manager XXX

To Power, Electricity and Water XXX

To Fuel XXX

To Postage and Telephone XXX

To Depreciation on:

Plant and Machinery XXX

Factory, Land and Buildings XXX

To Insurance:

Plant and Machinery XXX

Factory, Land and Buildings XXX

To Rent and Taxes XXX

To General Expenses XXX

To Royalty based on Production XXX

XXX XXX

Note: The amount of depreciation & expenses which has been debited to Manufacturing Account shall not again be debited to Trading or Profit and Loss Account. PREPERATION OF A PROFIT AND LOSS ACCOUNT: After preparing Trading Account, the next step is to prepare Profit and Loss Account with a view to ascertain net profit or net loss during an accounting period. The Profit & Loss Account can be defined as a report that summarizes the revenues & expenses of an accounting period to reflect the changes in various critical areas of firm’s operations.

The balance of the Trading Account (gross profit or gross loss) is transferred to the Profit & Loss Account, which is the starting point of the preparation of this account. That is why, Trading Account, is treated as a sub-section of the Profit & Loss Account. Profit & Loss Accounts shows the profit or loss on ordinary activities, profit or loss on the sale of a capital asset, other abnormal losses & gains but excludes the payment of taxation, transfer to or withdrawal from reserves or from the business & distribution of profit.

After transferring the Gross Profit or Gross Loss from the Trading Account to the Profit & Loss Account, the sources of other incomes like commission or discount received are shown on the credit side of the Profit or Loss Account. The credit side also includes the non-trading income like interest on bank deposits or securities, dividend on shares, rent of property let-out, profit arising out of sale of fixed assets, etc. On the debit side, all other expenses appearing in the Trial Balance which can’t find a place in the Trading Account will appear. The debit side will also include the losses arising out of sale of assets & any abnormal losses.

The Profit & Loss Account measures net income by matching revenues & expenses according to the accounting principles. Net income is the difference between total revenues & total expenses. In this connection, we must remember that all the expenses, for the period are to be debited to this account – whether paid or not. If it is paid in advance or outstanding, proper adjustment are to be made. Likewise all revenues, whether received or not are to be credited. Revenue if received in advance or accrued but not received, proper adjustment is required.

After transferring all the normal accounts from the Trail Balance to the Profit & Loss Account, it is necessary to balance the Profit & Loss Account. If the credit side is more than the debit side, it indicates net profit for the period. Conversely, if the debit side is more than the credit side , it indicates net loss for the period. Like Trading Account, Profit & Loss Account can also be prepared either in horizontal format or vertical format.

PROFIT AND LOSS ACCOUNT ITEMS: THE DEBIT SIDE: The items that will appear in the debit side of a Profit & Loss Account can broadly be classified as : (1)Management Expenses, (2) Maintenance Expenses,(3) Selling & distribution Expenses ,(4)Financial Expenses & (5) Abnormal Losses. (1)Management Expenses: These are the expenses incurred for carrying out the day-to-day administration of a business. Expenses under this head include office salaries, office rent & lighting, printing & stationery & telegrams, telephone charges, etc. (2) Maintenance Expenses: These expenses are incurred for maintaining the fixed assets of the administrative office in a good condition. They include repairs & renewals, etc. (3) Selling & distribution Expenses: These expenses are incurred from promoting sales & distribution of sold goods. Example of such expenses are go-down rent, carriage outwards, advertisement, cost of after-sales service, selling agents’ commission, etc. (4)Financial Expenses: These expenses are incurred for arranging necessary finance for running the business. These include interest on loans, discount on bills, brokerage & legal expenses for raising loan, etc. (5) Abnormal Losses: There are some abnormal losses that may occur during the accounting period. All types of abnormal losses are treated as extraordinary expenses & debited to Profit & Loss Account. Examples are stock lost by fire & not covered by insurance, loss on sale of machinery, cash defalcation, etc.

FOLLOWING ARE THE EXPENSES NOT TO APPEAR IN THE PROFIT & LOSS ACCOUNT: (1)Domestic & household expenses of proprietor or partners. (2)Drawings in the form of cash, goods by the proprietor or partners. (3)Personal income tax & life insurance premium paid by the firm on behalf of proprietor or partners. The expenses of a particular accounting period include the cost of the product sold in that accounting period though these products were purchased or manufactured in an earlier period. The wages & salaries earned by the worker – whether paid or not – and rent, electricity, telephone expenses are to

be taken into consideration, whether paid during the accounting period or not. To ascertain the amount of expenses to be debited to the Profit & Loss Account, four types of events are needed to be considered & the cash payment made in connection with these events. They are as under: (1)EXPENSES INCURRED & PAID OUT IN THAT YEAR: If expenditure is incurred in one year & also paid for in the same year, the transaction becomes simplest & least troublesome. Most of the expenses for a period are generally paid before the accounting period is over. Here, when the expenses are incurred & payment is made, we debit expense account & credit cash account or bank account. At the year end, the Expense Account can’t have any balance, since closed by transferring it to the Profit & Loss Account by debiting Profit & Loss Account & crediting the Expense Account. (2)EXPENSES INCURRED BUT NOT PAID OUT, PARTLY OR FULLY, DURING THE CURRENT YEAR: There are some expenses, which are incurred in the current accounting period, but not paid for , partly or fully , by the end of the period, are called “Outstanding Expenses”.

“Outstanding Expenses” include outstanding salaries, interest, rent, wages & other expenses. These must be duly accounted for because the parties who furnished goods or service have a claim against the business for the amount due to them & these amounts, therefore, become the liabilities of the business at the end of the accounting period.

In fact, on the date of the final accounts, outstanding expenses, both an expense & a liability exist without having been recorded in the books of account. For recording it, the following entry is to be passed:

Expenses Account Dr. (Will be shown in the Profit & Loss Account)

To Outstanding Expenses Account (Will appear in the liabilities side of the Balance Sheet)

(3)EXPENSES PAID FOR DURING THE CURRENT YEAR, BUT NOT YET INCURRED, PARTLY OR FULLY: Sometimes, it happens that some expenses are paid for during the current year, but not yet incurred, partly or fully, are known as “Prepaid Expenses”.

“Prepaid Expenses” include prepaid insurance premium, rent, taxes, interest, etc. A prepaid expense is an asset & will be shown in the Balance Sheet.

The adjusting entry to be passed:

Prepaid Expenses Account Dr. (To be shown as asset in the Balance Sheet)

To Expenses Account (Balance of this account is to be debited to Profit & Loss Account)

(4)EXPENSES OF THE CURRENT YEAR LIKELY TO ARISE IN THE SUBSEQUENT PERIOD: Sometimes, an expense or a loss may arise in the future in connection with current year’s business. In such a case, we make a provision of the anticipated loss & a charge is created against the profit for the current period. This provision is shown either as a liability or as a contingent asset, i.e., it appears in the Balance Sheet as a deduction from some other asset. The best example of this anticipated expense is “provision for bad debts”. THE CREDIT SIDE: The items that appear on the credit side of a Profit & Loss Account can be broadly classified as under: (1)GROSS PROFIT, (2) OTHER INCOMES, (3) NON-TRADING INCOME & (4) ABNORMAL GAINS. (1)GROSS PROFIT: This is the balance of the Trading Account transferred to the Profit & Loss Account. If the Trading Account shows a gross loss, it will appear on the debit side. (2)OTHER INCOMES: During the course of the business, other than income from the sale of goods, the business may have some other income of financial nature. The examples are discount or commission received.

(3)NON-TRADING INCOME: The business may have various transactions with the bank. At the end of the year, the business may earn some amount of interest which will find a place in the Profit & Loss Account as non-trading income. The business may have some investment outside the business in the form of shares or debentures or units. Any incomes received from the investments are also considered as non-trading income & are treated in the same way. (4)ABNORMAL GAINS: There may be capital gains arising during the course of the year, e.g., profit arising out of sale of a fixed asset. The profit is shown as a separate income on the credit side of the Profit & Loss Account.

In this connection, we are to remember that all the other incomes or abnormal gains are to be credited to the Profit & Loss Account if they arise or accrue during the period. Similarly, income received in advance is to be deducted from the income. The following adjustments are to be considered: (1)INCOME ACCURED NUT NOT RECEIVED, PARTLY OR FULLY: Accrue means increase. Certain income such as interest on debentures, dividend on shares accrued during the accounting period but are not received. Adjusting entry is required to recognize these unrecorded increases (accruals) in income. For recording, the following entry will be passed:

Accrued Income Account Dr. (Will be shown in the Assets side of the Balance Sheet)

To Income Account (To be credited to Profit & Loss Account)

(2)INCOME RECEIVED IN ADVANCE DURING THE CURRENT PERIOD: Income received in advance is not the revenue of the current accounting period. It will be recognized as income in the coming year. Income received in advance is treated as a liability & shown in the Balance Sheet. The adjusting entry will be:

Income Account Dr. (balance to be credited to Profit & Loss Account)

To Income Received in Advance Account (to be shown in the liability side of the Balance Sheet)

CLOSING ENTRIES: Following are the journal entries to be passed in connection with the preparation of the Profit & Loss Account:

(1)For the items of debit side:

Profit and Loss Account Dr.

To Expenses / Losses Account

(2)For Gross Profit:

Trading Account Dr.

To Profit and Loss Account

(3)For Other Income / Abnormal Gain:

Other Income / Abnormal Gain Account Dr.

To Profit and Loss Account

BALANCING THE PROFIT & LOSS ACCOUNT: The balance in the Profit & Loss Account represents the net profit or net loss. If the credit side is more than the debit side, it shows the net profit, & if the debit side shows more than the credit side, it shows net loss. When the Profit & Loss Account shows a net profit, we pass the following entry:

Profit and Loss Account Dr.

To Net Profit Account

If the Profit and Loss Account shows a net loss, the entry will be reverse.

Format of a Profit and Loss Account:

Dr. Profit and Loss Account of....... for the Period Ending on……. Cr.

Particulars Rs. Particulars Rs.

To Gross Loss b/d XXX By Gross Profit b/d XXX

To Salaries and Wages XXX By Interest earned XXX

To Rent, Rates and Taxes XXX By Commission earned XXX

To Fire Insurance Premium XXX By Rent earned XXX

To Repairs and Maintenance XXX By Profit on Sale of Fixed Assets XXX

To Depreciation XXX By Income from Investments XXX

To Audit Fees XXX By Sale of Scrap XXX

To Bank Charges XXX By Miscellaneous Incomes XXX

To Legal Charges XXX By *Net Loss transferred to Capital Account XXX

To Miscellaneous Expenses XXX

To Discount Allowed XXX

To Carriage Outward XXX

To Freight Outward XXX

To Commission to Salesman XXX

To Traveling Expenses XXX

To Entertainment Expenses XXX

To Sales Promotion Expenses XXX

To Advertising and Publicity XXX

To Bad Debts XXX

To Packing Expenses XXX

To Interest on Loan XXX

To Loss by Theft XXX

To Loss by Fire XXX

To Loss by Embezzlement XXX

To * Net Profit transferred to Capital Account

XXX

XXX XXX

Note: * = Either Gross Profit or Gross Loss shall appear.

PREPERATION OF A BALANCE SHEET – A STATEMENT OF ASSETS, LIABILITIES & CAPITAL: A Balance Sheet is a statement of the assets, liabilities and capital of an organization at a particular date which gives true & fair view of the “state of affairs” of the business. The financial position of a business is indicated by its assets on a given date & its liabilities (excluding capital) on that date.

Assets & liabilities are two independent variables & the capital is the dependent variable, because capital is the resultant of these two varying factors, assets & liabilities. Excess of assets over liabilities represents capital & is indicative of the financial soundness of the business.

ASSETS & THEIR CLASSIFICATION: Assets are resources, tangible or intangible, from which probable future economic benefits are obtained & the rights to which have been acquired by a particular entity as a result of past transactions or events. An asset (other than cash) has four essential characteristics:

(1)It embodies a probable future benefit that increases a capacity, either singly or in combination with other resources, to contribute directly or indirectly to future cash inflows. (2)A particular business entity must be able to obtain the benefit from the resource & control others access to it. It must be owned by the business, i.e., an entity must have the title to the asset. (3)It is a result of past transactions or events, i.e., the transactions giving rise to the claim to or control of the benefit must already have accrued. (4)The probable future benefits must be quantifiable or measurable in monetary units.

From the above, it is clear that assets are valuable resources owned by a business which are acquired at a measurable money cost. Following are the important points of the above definition: (1)The resource must be valuable. (2)The resource must be owned by a business enterprise & (3)It must be acquired at a measurable money cost.

Assets of a business are generally classified into four groups: (1)FIXED ASSETS, (2)CURRENT ASSETS, (3)FICTITIOUS ASSETS & (4)INTANGIBLE ASSETS.

(1)FIXED ASSETS: Fixed Assets are defined by the CIMA (Chartered Institute of Management Accountants) Terminology as: “Any asset…..acquired for retention by an entity for the purpose of providing a service to the business , & not held for resale in the normal course of trading”.

These assets are tangible in nature – relatively long lived resources of a business. A business generally requires these types of assets in order to use them in the production of goods & services. If the assets are held for re-sale they are classified as inventories, even though they are long lived. Therefore, fixed assets are long lived assets whose usefulness is likely to extend beyond one accounting period in the operations of the business. Fixed assets appear in the Balance Sheet at their historical costs minus accumulated depreciation. The expression ‘accumulated depreciation” means the portion of the original cost of the asset which has already been charged as an expense in the previous years as a cost of doing business.

The examples of fixed assets are land & building, plant & machinery, furniture & fixtures, etc. Fixed assets are generally divided into “wasting assets” & “non-wasting assets”. Wasting assets lose their value by wear & tear (plant & machinery) or by the passage of time (leasehold land) or through being worked (mines). Non-wasting assets are those which don’t lose their value by any of the above reasons. A good example of non-wasting assets is freehold land.

(2)CURRENT ASSETS: Current assets are defined by the CIMA Terminology as: “Cash or other asset , e.g., stock, debtors and short-term investments, held for conversion into cash in the normal course of trading”.

These assets are reasonably expected to be realized in cash or consumed during normal operating cycle of the business. The essence of distinction between fixed assets & current assets is time.

Current assets are those that is owned by the business generally not for more than a year from the Balance Sheet date whereas fixed assets are those that are expected to be owned for more than one year. Following are the examples of the current assets:

(A)CASH: Cash consists of funds which are readily available for disbursement without restriction. Most of these funds are usually on deposit with the banker (known as bank balance) & the balance in the temporary storage facilities (known as cash box) on the business premises.

(B)INVESTMENTS: investments are easily marketable securities & are generally converted into cash within the accounting period. A business invests money, which is temporarily idle, to get some return

in cash. Investments are valued in the Balance Sheet at cost or current market value, whichever is lower. It is valued at cost only when the decline in the market value is believed to be only temporary.

(C)SUNDRY DEBTORS: Sundry Debtors are amounts owed to the business generally by its customers arising out of credit sales. Sundry debtors appear in the Balance Sheet at their net expected realizable value, i.e., at their book value less an allowance for that portion of the amount owed which is not expected to be collected.

(D) BILLS RECIEVABLE: bills receivable are acknowledgements of debts of the customers. When the amount owed by debtors are evidenced by a written acknowledgement of obligation, it would appear not under the head “Sundry Debtors” but under the head “Bills Receivable”. Generally, Bills Receivable is a method of converting Sundry Debtors into acceptor of bills.

(E) STOCK: Stock is the inventory of raw materials, work-in-progress & finished goods. Stock is needed by a business either for sale in the ordinary course of business, or for use in the process of production for such sale or are to be currently consumed in the production of goods & services to be available for sale. Stock is recorded in the Balance Sheet at its cost or current market value whichever is lower.

(F)PREPAID EXPENSES & DEFERRED CHARGES: Prepaid expenses & deferred charges represent certain kinds of assets, usually of an intangible nature, usefulness of which will expire within the near future. In fact, these are expenses which are already incurred, but the entire portion couldn’t be recognized in the current account period because the benefit is spread over to more than one accounting period.

(3)FICTITIOUS ASSETS: Fictitious assets are intangible properties which are not represented by anything concrete. The examples of fictitious assets are preliminary expense, accumulated losses, etc.

(4)INTANGIBLE ASSETS: Intangible assets are capital assets having no physical existence whose value depends on the rights & benefits that possession confers upon owner. These represent immaterial rights, privileges & competitive advantages owned by a business. Examples of intangible assets are Goodwill, Patents, Trademarks, Copyrights, etc. LIABILITIES & THEIR CLASSIFICATION: Liabilities are obligations which arise from transactions or other events that have already been occurred. It involves an enterprise in a probable future transfer of cash, goods or services or the forgoing of a future cash receipt. The amount of the liability & the date of settlement of such liabilities are the claims of the outsiders against the business or the amounts that the business owes to some person or persons other than its owners.

A liability need not be legally enforceable claim. Generally, all the liabilities are not claims against any specific asset or a group of assets. Liabilities are stated in the Balance Sheet at either the amount of cash (or its equivalent) ultimately payable including interest accumulated to that date. Interest payable subsequent to the Balance Sheet is excluded. The liability of the business may take one of the following forms: (1)Those with fixed amounts & date of payment, (2)Those with fixed amount but date of payment is estimated, (3)Those for which the amount & the date of payment are estimated & (4)Those arise from the advances made by the customers.

Liabilities of a business can be classified into: (1) FIXED LIABILITIES, (2) CURRENT LIABILTIES & (3) CONTINGENT LIABILTIES.

(1)FIXED LIABILITIES: Fixed liabilities are not defined as such by CIMA terminology but these are long-term liabilities which are generally redeemed after a long period of time. These include long-term loan, redeemable debentures of a company, etc.

(2)CURRENT LIABILTIES: Current liabilities are defined by CIMA Terminology as: “Liabilities which fall due for payment within one year. They include that part of the long-term loans due for repayment within one year”.

These are obligations of the business which are payable in the near future, usually within the next accounting period. Therefore, a liability which is expected to have been paid within one year from the date of the Balance Sheet is termed as “Current Liability”.

When a current liability is created, it increases the resources of a business in the form of current assets, e.g., buying inventory on credit. On the other hand, when the obligation for a current liability is paid for, it reduces the current assets.

Current liabilities are generally obligations for the items which are entered into the operating cycle of a business, such as sundry creditors & bills payable in the acquisition of inventory, supplies to be used in the production cycle, collection received in advance against the delivery of goods, debts which arise from operations directly relating to the operating cycle such as outstanding salaries, wages, commission, royalty, rent, and so forth. It also includes income tax & other freight & taxes.

There may be other liabilities, which also fall under this category, though not related to the production cycle. These include short-term debts arising from acquisitions of capital assets, serial maturity of long-term obligations (interest payment at regular intervals), and so forth. Some of the important components of current liabilities are:

(A)SUNDRY CREDITORS: Sundry Creditors are the claims of the suppliers against the business for the delivery of the goods on credit – which may not be evidenced by a written acknowledgement of debt.

(B)BILLS PAYABLE: Bills Payable are the claims of the suppliers which is evidenced by a note or some other written acknowledgement of debt.

(C)LIABILTYFOR TAXES: Liability for taxes are the provisions made for the estimated tax liability which is owed to the government for taxes.

(D)OUTSTANDING EXPENSES: Outstanding Expenses are expenses which are already incurred but not paid for. These are the converse of prepaid expenses. These liabilities may be intangible in nature in the sense that they are evidenced by a legal document. The examples of outstanding expenses are outstanding wages & salary, outstanding rent, etc.

(E)DEFERRED INCOME: Deferred Income represents the short-term liability of a business that arises because the business has received money in advance for a service to be rendered in future. An example is rent received in advance, which means rental payment is received by the business in advance for which the business agrees to permit the tenant to make use of a property during near future.

(3)CONTINGENT LIABILTIES: These liabilities are conditions which exist at the Balance Sheet date, the outcomes of which can only be confirmed on the occurrence or non-occurrence of one or more uncertain future events. A contingent liability may also exist when a current situation may result in a future liability, but the amount of the liability in the monetary terms can’t be reasonably anticipated as on the Balance Sheet date.

They don’t include uncertainties connected with accounting estimates, e.g., provision for doubtful debts or provision for discount on debtors. Laos, the situation must exist currently; hence, future losses from fire, floods, natural calamities or outbreak of war are not contingent liabilities.

Examples of contingent liabilities are possible penalties, discounting of bills receivable, fines & penalties payable to the government or income tax authorities, etc. By contrast, if an obligation,

whose amount can be reasonably estimated as a current liability & it is not recorded in the books of account even though the exact amount is not known now.

Contingent liabilities are not recorded in the books of account; hence it doesn’t appear on the liability side of the Balance Sheet. CAPITAL – A LIABILITY OF BUSINESS: In the accounting sense, capital is the money contributed by the owner to an organization to enable it to function. It is measured by the excess of assets over liabilities. Capital can be brought in by a person into the business in different form – cash or kind. When capital is brought in the form of cash, it is spent way on various items o assets that make the business a going concern or a running concern.

Therefore, Capital Account is the account that shows the interest of the owner in the net asset s f the business.

Format of a Balance Sheet:

Balance Sheet of....... as at …….

Liabilities Rs. Assets Rs.

Capital: Current Assets:

Opening Balance: XXX Cash-in-hand XXX

Add: Net Profit XXX Cash at bank XXX

(Less: Net Loss) XXX Bills Receivable XXX

Less: Drawings XXX XXX Sundry Debtors XXX

Long-term Liabilities: Prepaid Expenses XXX

Loan XXX Accrued Income XXX

Current Liabilities: Closing Stock XXX

Income received-in-advance XXX Investments:

Sundry Creditors XXX Fixed Assets:

Outstanding Expenses XXX Furniture and Fixtures XXX

Bills Payable XXX Plant and Machinery XXX

Bank Overdraft XXX Land and Building XXX

Goodwill XXX

XXX XXX

Distinction between Trading and Profit and Loss Account and Balance Sheet:

Basis of distinction Trading and Profit and Loss Account Balance Sheet (BS)

1 Need for Preparation

The Trading & P& L A/c is prepared to ascertain the results of business operations during an accounting period.

The BS is prepared to know the financial position of an enterprise at a particular time.

2 Contents The balances of all the ledger accounts of revenue nature are shown in the Trading & P & L A/c.

The balances of only those ledger accounts which have not been closed till the preparation of Trading & P & L A/c, are shown in the Balance Sheet.

3 Format The Trading & P & L A/c is a ledger account. It has debit side and a credit side. It is closed by transferring its balance to the Capital Account.

The BS is only a stmt. & not an account. It has no debit & credit side. The headings of the 2 sides are “Liabilities” & “Assets”.

Distinction between a Trial Balance and a Balance Sheet:

Basis of distinction Trial Balance Balance Sheet

1 Need for Preparation It is prepared to check the arithmetical accuracy of the posting of transactions to the ledger.

It is prepared to know the financial position of an enterprise at particular point of time.

2 Contents All the ledger accounts are shown in the Trial Balance.

The balances of only those ledger accounts which have not been closed till the preparation of Trading & P & L A/c are shown in the BS.

3 Format The headings of the 2 columns are “debit balances” & “credit balances”, (in case of a Trial Balance by Balance Method).

The headings of the 2 sides are “Liabilities “& “Assets”.

4 Closing Stock Generally, the closing stock doesn’t appear in the Trial Balance whereas the opening stock appears.

In a BS, only the closing stock appears on the Assets side as current assets.

5 Items of Adjustments (e.g., Outstanding Expenses, Prepaid Expenses, Accrued Income/ etc.)

It can be prepared without incorporating the terms of adjustments.

It can’t be prepared without incorporating the items of adjustments.

6 Net Profit/Net Loss Information about net profit/ net loss is not provided in a Trial Balance.

Information about net profit/ net loss is provided.

7 Periodicity It can be prepared periodically (say) at the end of a month /quarter/half-year.

It is generally prepared in the end of an accounting period.

8 Can the preparation be dispensed with?

Its preparation can be dispensed with.

Its preparation can’t be dispensed with.

METHODS of PRESENTING THE FINAL ACCOUNTS (OR) PREPERATION OF COMPANY ACCOUNTS: The Trading & P & L A/c and BS can be presented either in the form of Horizontal Form or in Vertical Form:

Vertical Form of Profit and Loss Account:

Particulars Rs. Rs. Rs.

A. Net Sales

Sales (Gross) XXXXX

Less: Returns XXXXX XXXXX

B. Cost of Goods Sold

Opening Stock XXXXX

Add: Purchases XXXXX

Less: Returns XXXXX

Add: Direct Expenses:

Carriage /Cartage/Freight Inwards XXXXX

Wages and Salaries XXXXX

Cost of Goods available for sale XXXXX

Less: Closing Stock XXXXX XXXXX

C. Gross Profit (A – B) XXXXX

D. Operating Expenses:

(a)Selling Expenses XXXXX

Carriage Outward XXXXX

Discount Allowed XXXXX

Commission Allowed XXXXX

Travelling Expenses XXXXX

Entertainment Expenses XXXXX

Sales Promotion Expenses XXXXX

Bad Debts XXXXX XXXXX

(b)Office and Administration Expenses XXXXX

Salaries & Wages XXXXX

Rent/Rates & Taxes XXXXX

Repairs XXXXX

Insurance XXXXX

Printing & Stationery XXXXX

Water & Electricity XXXXX

Postage & Telegram XXXXX

Staff Welfare Expenses XXXXX

Conveyance Charges XXXXX

Miscellaneous Expenses XXXXX

Depreciation XXXXX XXXXX XXXXX

E. Net Operating Profit/Loss (C-D) XXXXX

F. Net Non-Operating Result

(a)Interest earned XXXXX

Commission earned XXXXX

Discount earned XXXXX

Miscellaneous Incomes XXXXX XXXXX

(b)Non-Operating Expenses & Losses XXXXX

Interest allowed XXXXX

Loss on sale of a fixed asset XXXXX XXXXX XXXXX

G. Net Profit XXXXX

Vertical Form of Balance Sheet:

Particulars Rs. Rs. Rs.

A. Sources of Funds

(a)Proprietor’s Funds XXXXX

(b)Long-term Debts XXXXX

XXXXX

B. Application of Funds

(a)Net Working Capital

(1)Current Assets

Cash in hand XXXXX

Cash at bank XXXXX

Bills receivables XXXXX

Accrued income XXXXX

Debtors XXXXX

Stock XXXXX

Prepaid Expenses XXXXX XXXXX

(2)Less: Current Liabilities

Bank Overdraft XXXXX

Accrued expenses XXXXX

Bills Payable XXXXX

Trade Creditors XXXXX

Income received in advance XXXXX XXXXX XXXXX

(b)Investments XXXXX

(c) Fixed Assets

Furniture & Fixtures XXXXX

Patents & Trademarks XXXXX

Plant & machinery XXXXX

Land & Building XXXXX

Goodwill XXXXX XXXXX

XXXXX

A Schedule of Proprietor’s Funds:

Particulars Rs. Rs.

A. Capital in the beginning XXXXX

B. Add: Additional Capital Introduced XXXXX

Interest on Capital XXXXX

Salary to Partner XXXXX

Profit for the current accounting period XXXXX XXXXX

C. Less: Drawings XXXXX

Interest on Drawings XXXXX

Loss for the current accounting period XXXXX XXXXX

D. Capital at the end of the year (A + B – C) XXXXX

CLASSIFICATION OF CAPITAL AND REVENUE: The Going Concern Assumption allows the accountant to classify the expenditure and receipts as Capital Expenditure, Revenue Expenditure, Deferred Revenue Expenditure, Capital Receipts and Revenue Receipts. The expenditure and receipts may be classified as follows:

(1)Capital Expenditure: Capital Expenditure is that expenditure which is incurred (a) for acquiring or bringing into existence an asset or advantage of an enduring benefit or (b) for extending or improving a fixed asset or (c) for substantial replacement of an existing fixed asset. An asset or advantage of an enduring nature doesn’t mean that it should last forever; it should not at the same time be so transitory and ephemeral that it can be terminated at any time. Basically, the capital expenditure is incurred with a view to bringing in improvements in productivity or earning capacity. The examples of capital expenditure include cost of land and building, plant and machinery, furniture and fixtures, etc. Such expenditure normally yields benefits which extend beyond the current accounting period.

(2)Revenue Expenditure: Revenue Expenditure is that expenditure which is incurred for maintain productivity or earning capacity of a business. Such expenditure yields benefits in the current accounting period. The examples of revenue expenditure include Office and Administrative expenses such as Salaries, Rent, Insurance, Telephone Expenses, and Electricity Charges etc. Selling and Distribution

Expenses such as Advertising, Travelling Expenses, Commission to Salesman, Sales Promotion Expenses etc. Non-operating expenses and losses such as interest on loan taken loss by theft, etc.

(3)Deferred Revenue Expenditure: Deferred Revenue Expenditure is that expenditure which yields benefits which extend beyond a current accounting period, but to relatively a short period as compared to the period for which a capital expenditure is expected to yield benefits. Such expenditure should normally be written-off over a period of 3 to 5 years. The examples of such expenditure include heavy Advertising Campaign, Research and Development Expenditure.

(4)Capital Receipts Vs Revenue Receipts: There is no specific test to draw a clear cut demarcation

between a capital receipt and a revenue receipt. In order to determine whether a receipt is capital or

revenue in nature, one has to look into its true nature and substance over the form in the hands of its

receipts. For example, the sale proceeds of a land in the hands of a dealer in real estate is revenue

receipt whereas the same in the hands of a dealer in cars is a capital receipt. The examples of capital

receipts include sale of fixed assets, capital contribution, and loaned receipts. The example s of revenue

receipts include sale of stock-in-trade, revenue from services rendered in the normal course of business,

revenue from permitting others to use the assets of the enterprise, such as interest, rent, royalty.

DISTINCTION BETWEEN DEFERRED REVENUE EXPENSES AND PREPAID EXPENSES: The Guidance Note on “Terms used in Financial Statement” issued by the Institute of Chartered

Accountants of India (ICAI), defines deferred revenue expenditure as that expenditure for which

payment has been made or a liability incurred, but which is carried forward on the presumption that it

will be of benefit over a subsequent period or periods. “In short, it refers to that expenditure that is, for

the time being, deferred from being charged to income. Such suspension of ‘charging off’ operation may

be due to the nature of expenses and the benefit expected there from. SO long as deferred revenue

expenditure is not written-off, this is shown on the assets side of the Balance Sheet under the head

“Miscellaneous Expenses”.

Deferred revenue expenditure should be revenue expenditure by nature in the first instance, for

example, advertisement. But its matching with revenue may be deferred considering the benefit to be

accrued in future.

A thin line of difference exists between deferred revenue expenses and prepaid expenses. The benefits

available from prepaid expenses can be precisely estimated but that is not so in case of deferred

revenue expenses. Heavy advertising to launch a new product is a deferred expense since the benefit

from it will be available over the next three to five years but one cannot say precisely how long. On the

other hand, insurance premium paid say, for the next year ending 30th June 20X2, when the accounting

year ends on 31st March 20X2, will be an example of prepaid expenses to the extent of premium relating

to three months period, i.e., from 1st April 20X2 to 30th June 20X2. Thus, the insurance protection will be

available precisely for three months after the close of the year and the amount of the premium to be

carried forward can be calculated exactly.

Deferred expenses are considered fictitious assets but prepaid expenses are considered as current

assets.

DISTINCTION BETWEEN OUTSTANDING EXPENSE AND PREPAID EXPENSE:

Basis of Distinction Outstanding Expense Prepaid Expense

1 Meaning It refers to an expense incurred but not paid during the current accounting period.

It refers to an expense paid but not incurred during the current accounting period.

2 Payment It is yet to be paid. It has already been paid.

3 Incurrence It has already been incurred. It is yet to be incurred.

4 Year to which the item relates

It is an item of the current year. It is an item of the following year.

5 Treatment in Income Statement

It is shown by way of addition to the relevant item.

It is shown by way of deduction from the relevant item.

6 Treatment in Balance Sheet

It is shown on the liabilities side as a current liability.

It is shown on the assets side as a current asset.

DISTINCTION BETWEEN A PROFIT SEEKING ORGANIZATION AND A NOT-FOR-PROFIT ORGANIZATION:

Basis of Distinction Profit Seeking Organization Not-for-Profit Organization

1 Primary Motive The primary motive of such an entity is to earn profit.

The primary motive of such an entity is to provide services.

2 Owner’s Fund Vs. Capital Fund

Interest of owners is known as owner’s fund which represents the owner’s investments plus accumulated reserves and surplus.

Interest of members is known as capital fund which represents the accumulated surplus of subscriptions, donation and net profits from activities carried on by such an entity.

3 Net result of activities

The net result of the activities of such an entity is known as the profit/loss.

The net result of the activities of such an entity is known as the surplus/deficit.

4 Accounting Statements

The accounting statements of such type of entity include: (a)a Manufacturing A/c, (b)a Trading A/c, (c) a Profit & Loss A/c, (d) a Balance Sheet.

The accounting statements of such type of entity include: (a)a Receipts & Payments A/c, (b)a Trading A/c, (c) an Income and Expenditure A/c, (d) a Balance Sheet.

RECEIPTS AND PAYMENTTS ACCOUNT: The’ Receipts & Payment Account’ is an Asset Account (or Real Account) which shows the classified summary of transactions of a Cash Book along with the Cash and Bank balances in the beginning and at the end of an accounting period.

Features of Receipts and Payments Accounts: (1)It starts with the opening balance of cash in hand and cash at bank. (2)It is debited with all sums received. (3)It is credited with all sums paid out. (4)It records all receipts and payments whether they are of revenue nature or capital nature. (5)It records all receipts and payments whether they relate to the previous, current or following accounting year. (6)It does not record non-cash items (e.g., depreciation). (7)It ends with closing balance of Cash in hand and Cash at bank.

Format of Receipts and Payments Account:

Dr. Receipts and Payments Account for the period ending on…… Cr.

INCOME AND EXPENDITURE ACCOUNT: An Income and Expenditure Account is a final account like Profit and Loss Account, which shows the classified summary of revenue incomes, revenue expenses and losses for current accounting period along with surplus (i.e., the excess of income over expenditures) or deficit (i.e., excess of expenditure over income) which is transferred to the Capital Fund.

Features of Income and Expenditure Account: (1)It is debited with the expenses and losses. (2)It is credited with the incomes. (3)It records only those incomes, expenses and losses which are of revenue nature. (4)It records only those incomes, expenses and losses which relates to current accounting year. (5)It records non-cash items also (e.g., depreciation). (6)Its balance at the end which represents either the net surplus (if credit side exceeds debit side) or net deficit (if debit side exceeds credit side) is transferred to the Capital Fund in the Balance Sheet.

Format of Income and Expenditure Account:

Dr. Income and Expenditure Account for the year ending on 31st December 20X2 Cr.

Expenditure Account Rs. Income Account Rs.

To Salaries & Wages paid XXX By Subscription Received XXX

Add: Outstanding at the end XXX Add: Outstanding at the end XXX

Receipts Rs. Payments Rs.

To Balance b/d: By Balance b/d (Bank overdraft) XXX

Cash XXX By Annual Sports Expenses XXX

Bank XXX XXX By Salaries & Wages XXX

To Subscription: By Rent, Rates and Taxes XXX

for previous year XXX By Insurance XXX

for current year XXX By Furniture XXX

For next year XXX XXX By Sports Equipments XXX

To Entrance Fees XXX By Books and Periodicals XXX

To Donation for Building XXX By Audit Fees XXX

To General Donations XXX By Printing and Stationery XXX

To Life Membership Fees XXX By Honorarium XXX

To Legacy XXX By Bank Charges XXX

To Grant from Government XXX By Postage and Telegrams XXX

To Contribution for Annual Dinner XXX By Water and Electricity XXX

To Dividend XXX By Conveyance and Travelling XXX

To Interest XXX By Repairs and Maintenance XXX

To Rent XXX By Sundry Expenses XXX

To Receipt on Annual Sports XXX By Annual Dinner Expenses XXX

To Sale of Old Sports Materials XXX By 12% Investments XXX

To Sale of Old Magazines XXX By Balance c/d: XXX

To Sundry Receipts XXX Cash XXX

To Balance c/d (Bank overdraft) XXX Bank XXX XXX

XXX XXX

Less: Prepaid at the end XXX Less: Advance at the end XXX

Add: Prepaid in the beginning XXX Add: Advance in the beginning XXX

Less: Outstanding in the beginning XXX XXX Less: Outstanding in the beginning

XXX XXX

To Rent, Rates and Taxes XXX By Entrance Fees (only that portion which is to be treated as revenue)

XXX

To Insurance Premium XXX By General Donations XXX

To Depreciation on Furniture and Sports Equipments

XXX By Life membership Fees (only that portion which is to be treated as revenue)

XXX

To Books and Periodicals XXX By Profit from Annual Dinner Contribution

XXX

To Audit Fees XXX Less: Expenses XXX XXX

To Printing and Stationery XXX By Profit on Annual sports (Receipts – expenses)

XXX

To Honorarium XXX By Profit on sale of provisions (Sale + Closing stock – Purchases – Opening Stock)

XXX

To Bank Charges XXX By Rent of Club Hall XXX

To Postage and Telegram XXX By Dividend and Interest XXX

To Electricity and Water XXX By Sundry Receipts XXX

To Conveyance and Travelling XXX By* Deficit i.e., Excess of expenditure over income

XXX

To Sundry Expenses XXX XXX

To Surplus i.e., excess of income over expenditure

XXX

XXX

DISTINCTION BETWEEN RECEIPTS AND PAYMENTS ACCOUNT AND INCOME AND EXPENDITURE A/C:

Basis of Distinction Receipts & Payments Account Income & Expenditure Account

1 Nature of Account It is a real account. It is a nominal account.

2 Basic Structure It is basically a summarized Cash Book.

It is like a Profit & Loss Account.

3 Object It is prepared to present a summary of cash transactions during an accounting period.

It is prepared to ascertain the net results of all the transactions during an accounting period.

4 Opening Balance Opening balance represents cash or bank balances (or Bank Overdraft) in the beginning of the accounting period.

It has no opening balance.

5 Items of Debit side It is debited with all the sums received.

It is debited with the expenses and losses.

6 Items of Credit side It is credited with all the sums paid out.

It is credited with the incomes.

7 Closing Balance Closing balance represents cash or Its closing balance represents

bank balance (or bank overdraft) at the end of the accounting period.

either net surplus or net deficit.

8 Treatment of Closing Balance

Its closing balance is carried forward in the same account of the next period.

Its closing balance is transferred to the Capital Funds in the Balance Sheet.

9 Non-cash Items Non-cash items are not shown in this account.

Non-cash items such as depreciation, bad debts, etc., are shown.

10 Period to which items relate

It records the receipts and payments whether they relate to previous, current or following accounting period.

It records only those incomes, expenses and losses which relate to current accounting period.

11 Nature of items Recorded-Revenue Vs. Capital

It records the receipts and payments whether of capital or revenue nature.

It records the incomes, expenditures and losses of revenue nature.

DISTINCTION BETWEEN INCOME AND EXPENDITURE ACCOUNT AND PROFIT AND LOSS ACCOUNT:

Basis of Distinction Income & Expenditure Account Profit & Loss Account

1 Object The main object of Income and Expenditure Account is to ascertain excess of income over expenditure or excess of expenditure over income.

The main object of Profit & Loss Account is to ascertain net profit or net loss.

2 Who prepares? This account is prepared by non-profit organizations.

This account is prepared by trading institutions.

3 Basis of Preparation This account is prepared on the basis of Receipts and Payments Account and other information.

This account is prepared on the basis of trial balance.

4 Balance The balance of this account represents surplus or deficit.

The balance of this account represents net profit or net loss.

DISTINCTION BETWEEN STRAIGHT LINE METHOD (SLM) & WRITTEN DOWN VALUE (WDV) METHOD: .

Basis of Distinction Straight Line Method Written Down Value Method

1 Basis of Calculation Depreciation is calculated at a fixed percentage on the original cost.

Depreciation is calculated at affixed percentage on original cost (in first year) and on written down value (in subsequent years).

2 Amount of Depreciation

The amount of depreciation remains constant.

The amount of depreciation goes on decreasing.

3 Total Charge (i.e., depreciation plus repairs and renewals)

Total charge in later years is more as compared to that in earlier years since the amount of repairs and renewals goes on increasing as the asset grows older, whereas the amount of depreciation remains constant year after year.

Total charge remains almost uniform year after year, since in earlier years the amount of depreciation is more and the amount of repairs and renewals is less whereas in later years, the amount of depreciation is less and the amount of repairs and renewals is more.

4 Book Value The book value of the asset becomes zero or equal to its scrap value.

The book value of the asset does not become zero.

5 Suitability This method is suitable for those assets in relation to which (a) repair charges are less (b) the possibility of obsolescence is less.

This method is suitable for those assets in relation to which (a) the amount of repairs and renewals goes on increasing as the asset grows older and (b) the possibilities of obsolescence are more.

6 Calculation- Easy or Difficult

It is easy to calculate the rate of depreciation.

It is difficult to calculate the rate of depreciation.

MEANING AND OBJECTIVES OF PROVISION: The term ‘Provision’ refers to any of the following amounts: (a) The amount written off or retained by way of providing for depreciation, renewals or diminution in value of assets; or (b) The amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy.

Examples of Provisions: Provision for Depreciation , Provision for Doubtful Debts, Provision for Taxation, Provision for Repairs and Renewals, Provision for Fluctuations in Investments, Provision in respect of a claim which is disputed but which may have to be paid, Provision for Discount on Debtors. It is also to be noted that, if the amount of any known liability can be determined with substantial accuracy, a definite liability should be created instead of making a provision for it, e.g., Liability for Outstanding Rent/Salary etc.

Objectives of Provision: Provision is created to cover a loss in the value of assets, or a loss or expenses, the amount of which cannot be determined with substantial accuracy.

Need for Provision for Doubtful Debts: A Provision for doubtful debts is created to cover the loss of possible bad debts by means of a predetermined percentage of net debtors (i.e., debtors bless bad debts) with a view to bring in a certain element of certainty in the amount of bad debts charged for each accounting period.

Need for Provision for Discount on Debtors: Provision for Discount on Debtors is created to provide for discount likely to be allowed on good debtors (i.e., Sundry Debtors less additional bad debts given outside the Trial Balance and the provision for doubtful debts).

Accounting Treatment: Provision is a charge against the profits and is created by debiting Profit and Loss Account.

Disclosure: Provision is shown either on assets side by way of deduction from the respective asset in relation to which it has been created (e.g., Provision for Depreciation is shown by way of deduction from the Respective Fixed Asset, Provision for Doubtful Debt is shown by way of deduction from Debtors) or on the liabilities side under the sub-head ‘Provisions’, e.g., Provision for tax. MEANING, OBJECTIVES AND TYPES OF RESERVES:

Meaning of ‘Reserve’: The term ‘reserve’ refers to the profits retained in the business not having any of the attributes of a ‘provision’. If however, the provision exceeds the amount which is required to meet the loss or the liability, the excess is to be treated as reserve. In other words, reserve means accumulated or undistributed profits.

Objectives of Reserve: (1)To strengthen the financial position of the concern. (2)To provide funds for the modernization and/or expansion of existing plant or acquisition of a new plant.

(3)To equalize the dividend during the periods of inadequate profits. (4)To comply with legal requirements e.g., Debenture Redemption Reserve, Capital Redemption Reserve under the Companies Act 1956, Investment Allowance Reserve, Development Allowance Reserve, Foreign Project Allowance Reserve under the Income Tax Act 1961. Types of Reserves: Basically there are two types of reserves viz. Revenue Reserves and Capital Reserves.

Revenue Reserves Capital Reserves

Revenue reserves are those reserves which are Capital Reserves are those reserves which are not created out of profits available for distribution by created out of operating profits. In case of way of dividend. Revenue Reserves may be companies, the following are the examples of classified into two categories as follows: capital profits.

(1)General Reserve: General Reserve is that (a)Profits prior to incorporation, reserve which is not created for a specific (b)Premium on the issue of shares and purpose. Examples of such reserves include debentures, General Reserve, Contingency Reserve etc. (c) Profit on reissue of forfeited shares,

(2)Specific Reserve: Specific Reserve is that (d)Profit on redemption of debentures, reserve which is created for a specific purpose. (e)Profit on Sale of Fixed Assets, Examples of such reserves include Dividend (f)Profit on revaluation of fixed assets and Equalization Reserve, Debenture Redemption (g)Profit on sale of the whole undertaking or a Reserve, and Investment Fluctuation Reserve. part of it.

DISTINCTION BETWEEN REVENUE RESERVE AND CAPITAL RESERVE: Revenue reserve refers to the amounts which are free for distribution by way of dividend. Capital reserve refers to the amounts which are not free for distribution by way of dividend. Profit and loss appropriation account shows the distribution of net profit amongst the shareholders in the form of dividend and transfer of profit to various reserves and issue of bonus share. Profit and loss appropriation account is prepared after the preparation of profit and loss account. Profit and loss account provides the information about adjustment relating to last year. Profit and loss appropriation account also provides the information about the appropriation of dividend out of available profit. Profit and loss appropriation account is prepared after profit and loss account and before the preparation of balance sheet. Profit and loss appropriation account is a vital item of final account.

DISTINCTION BETWEEN ‘PROVISON’ AND ‘RESERVE’: Basis of Distinction Provision Reserve

1 Purpose It is created for a particular purpose It need not necessarily be created and can only be used for that for a particular purpose. For particular purpose. example, General reserve is not for any particular purpose.

2 Charge Vs. It is a charge against the profit and is It is an appropriation out of profit Appropriation required to be created irrespective of and can be created only if profits the amount of profit. have been earned.

3 Disclosure in It is shown on the debit side of the It is shown on the debit side of the Income Statement P & L A/c. P & L Appropriation A/c.

4 Disclosure in Usually a provision is shown by way of Reserve is shown as a separate Balance Sheet deduction from the amount of the item under the head ‘Reserves and items for which it is created. For Surplus’ on the liabilities side of example, Provision for Doubtful Debts. the Balance Sheet.

5 Investment outside There is no question of investment of The amount of a reserve can be business the amount of provisions. invested outside the business.

6 Utilization It cannot be utilized for distribution by It can be utilized for distribution by way of dividends. way of dividends.

7 Legal Necessity It is made mainly because of legal It is a matter of financial prudence. necessity. Shares Vs. Debentures:

Shares Debentures

1 Shares are uniform parts of the share capital. Debentures are uniform part of the loan capital of a company.

2 Share holders are owners of the company whereas The debenture holders have a very limited the debenture holders are creditors of the interest in the company, i.e. limited to company. Shareholders have a multi-faceted receiving interest on time. interest in the welfare of the company.

3 A shareholder is entitled to receive dividend when On the other hand, the debenture holders there are profits. The rate of dividend varies from are entitled to interest at a fixed rate which

year to year depending upon the amount of profit. the company must pay whether or not there

are profits.

4 A shareholder enjoys the rights of proprietorship A debenture holder can enjoy the rights of a of a company. lender only.

5 A shareholder has a right of control over the The debenture holders do not have any working of the company by attending and voting in voting right, and they are unable to exercise

the general meeting. They are able to decisively any such influence. influence the composition of Board of directors

and other senior management positions.

6 A shareholder gets a dividend far higher if the A debenture holder gets a fixed rate of company earns good profits. interest per annum payable on fixed dates.

7 Dividend on shares is not a charge against profit. Interest on debentures, on the other hand, is a charge against profits and is deducted

from profits for the purpose of calculating

tax liability.

8 In respect of shares, dividend is payable only when There is no need of such approval in the case the proposal to pay dividend is passed by the of payment of interest on debentures. shareholders at the annual general meeting of the

company.

9 A company can purchase its own shares from the A company can purchase its own debentures market under certain condition. and cancel them or re issue them.

10 A shareholder has a claim on the accumulated A debenture holder has no such claims profits of the company and is normally rewarded whatsoever after he has been paid the with bonus shares. interest amount.

11 Shareholders cannot be paid back (Except in case Debentures are normally issued for a of redeemable preference shares) so long as the specified period after which they are repaid. company is going concern.

12 In the event of winding up, shareholders cannot In the event of winding up, debenture claim payment unless all outside creditors have holders being secured creditors get priority been paid in full. in payment over the shareholders. Definition of 'Redemption': The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units in a mutual fund. Redemption occurs, in a fixed income security at par or at a premium price, upon maturity or cancellation by the issuer. Redemptions occur with mutual funds, at the choice of the investor, however limitations by the issuer may exist, such as minimum holding periods. Redemption of mutual fund shares from a mutual fund company must occur within seven days of receiving a request for redemption from the investor. Some mutual funds may have redemption fees attached, in the place of a back-end load. It is important to note which units should be redeemed when choosing to sell mutual funds within a portfolio. What is the difference between redemption of shares and repurchase of shares? Sometimes, shares of stock offered by a company are not regular, market-driven common shares. Instead, they may be preferred shares, which are considered fixed income securities and are issued with a par value. When that par value is paid back to the purchaser of the preferred share, this is considered redemption. Redemption can also occur when issued bonds are called or matured and the principal, or par value, is paid back. When a company issues shares of common stock for the public to buy and later decides to buy some of those shares back, that's considered a repurchase rather than redemption. The major difference between the two is that the shares bought back in redemption are considered a fixed-income security that is expected to be bought back by the issuer. A repurchase of shares, however, reduces the number of outstanding shares that a company has, and can increase the company's holdings so that it remains or regains majority shareholder status. It can also increase the stock's earnings per share, since it reduces the outstanding number of shares. A repurchase may even allow the company to profit off of the resale of its own shares at a later.

The Little Book of Valuation: Asset Measurement and Valuation: When analyzing any firm, we would like to know the types of assets that it owns, the values of these assets and the degree of uncertainty about these values. Accounting statements do a reasonably good job of categorizing the assets owned by a firm, a partial job of assessing the values of these assets, and a poor job of reporting uncertainty about asset values. In this section, we will begin by looking at the accounting principles underlying asset categorization and measurement and the limitations of financial statements in providing relevant information about assets.

Accounting Principles Underlying Asset Measurement: The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset, adjusted upward for improvements made to the asset since purchase and downward for loss in value associated with the aging of the asset. This historical cost is called the book value. Although the generally accepted accounting principles for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting statements. (1)An abiding belief in book value as the best estimate of value: Accounting estimates of asset value begin with the book value. Unless a substantial reason is given to do otherwise, accountants view the historical cost as the best estimate of the value of an asset. (2)A distrust of market or estimated value: When a current market value exists for an asset that is different from the book value, accounting convention seems to view it with suspicion. The market price of an asset is often viewed as both much too volatile and too easily manipulated to be used as an estimate of value for an asset. This suspicion runs even deeper when values are estimated for an asset based on expected future cash flows. (3)A preference for underestimating value rather than overestimating it: When there is more than one approach to valuing an asset, accounting convention takes the view that the more conservative (lower) estimate of value should be used rather than the less conservative (higher) estimate of value. Measuring Asset Value: The financial statement in which accountants summarize and report asset value is the balance sheet. To examine how asset value is measured, let us begin with the way assets are categorized in the balance sheet. (1)First, there are the fixed assets, which include the long-term assets of the firm, such as plant, equipment, land, and buildings. Generally accepted accounting principles (GAAPs) in the United States require the valuation of fixed assets at historical cost, adjusted for any estimated gain and loss in value from improvements and the aging, respectively, of these assets. Although in theory the adjustments for aging should reflect the loss of earning power of the asset as it ages, in practice they are much more a product of accounting rules and convention, and these adjustments are called depreciation. Depreciation methods can very broadly be categorized into straight line (where the loss in asset value is assumed to be the same every year over its lifetime) and accelerated (where the asset loses more value in the earlier years and less in the later years). (2)Next, we have the short-term assets of the firm, including inventory (such as raw materials, works in progress, and finished goods), receivables (summarizing moneys owed to the firm), and cash; these are categorized as current assets. It is in this category accountants are most amenable to the use of market value. Accounts receivable are generally recorded as the amount owed to the firm based on the billing at the time of the credit sale. The only major valuation and accounting issue is when the firm has to recognize accounts receivable that are not collectible. There is some discretion allowed to firms in the valuation of inventory, with three commonly used approaches – First-in, first-out (FIFO), where the inventory is valued based upon the cost of material bought latest in the year, Last-in, first-out (LIFO), where inventory is valued based upon the cost of material bought earliest in the year and Weighted Average, which uses the average cost over the year. (3)In the category of investments and marketable securities, accountants consider investments made by firms in the securities or assets of other firms and other marketable securities, including Treasury bills or bonds. The way these assets are valued depends on the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority, passive investment; a minority, active investment; or a majority, active investment. If the securities or assets owned in another firm represent less than 20 percent of the overall ownership of that firm, an investment is treated as a minority, passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities,

and often a market value. For investments held to maturity, the valuation is at acquisition value, and interest or dividends from this investment are shown in the income statement under net interest expenses. Investments that are available for sale or trading investments are shown at current market value. If the securities or assets owned in another firm represent between 20 percent and 50 percent of the overall ownership of that firm, an investment is treated as a minority, active investment. Although these investments have an initial acquisition value, a proportional share (based on ownership proportion) of the net income and losses made by the firm in which the investment was made, is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach. If the securities or assets owned in another firm represent more than 50 percent of the overall ownership of that firm, an investment is treated as a majority active investment.[1] In this case, the investment is no longer shown as a financial investment but is replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet. The share of the equity in the subsidiary that is owned by other investors is shown as a minority interest on the liability side of the balance sheet. (4)Finally, we have what is loosely categorized as intangible assets. These include patents and trademarks that presumably will create future earnings and cash flows and also uniquely accounting assets, such as goodwill, that arise because of acquisitions made by the firm. Patents and trademarks are valued differently depending on whether they are generated internally or acquired. When patents and trademarks are generated from internal sources, such as research, the costs incurred in developing the asset are expensed in that period, even though the asset might have a life of several accounting periods. Thus, the intangible asset is not usually valued in the balance sheet of the firm. In contrast, when an intangible asset is acquired from an external party, it is treated as an asset. When a firm acquires another firm, the purchase price is first allocated to tangible assets and then allocated to any intangible assets, such as patents or trade names. Any residual becomes goodwill. While accounting standards in the United States gave firms latitude in how they dealt with goodwill until recently, the current requirement is much more stringent. All firms that do acquisitions and pay more than book value have to record goodwill as assets, and this goodwill has to be written off, if the accountants deem it to be impaired. Methods of Valuation of Assets: Valuation of various assets can be made by using different methods. Valuation of fixed assets can be made in different ways. Some of the major methods are as follows: 1. Cost Method: In this method, valuation of assets is made on the basis of purchase price of the assets. It is very simple method of valuation of assets. Sometimes, existence of one asset depends on the existence of another. Then it is difficult to use this method. 2. Market Value Method: Valuation of assets can be made on the basis of market price of such assets. But if same nature of assets is not available in the market, it is very difficult to determine the value of such assets. So, there are two methods related to it. They are: i. Replacement Value Method: If same asset is to be purchased then on the basis of same value, valuation of assets can be done. ii. Net Realizable Value: It refers to the price in which such asset can be sold in the market. But expenditure incurred at the sale of such asset should be deducted. 3. Base Stock Method: Under this method of valuation, company should maintain certain level of stock and valuation of stock is made on the basis of valuation of base stock. 4. Standard Cost Method: Some of the business organizations fix the standard cost on the basis of their past experience. On the basis of standard cost, they make valuation of assets and present in the balance sheet.

5. Average Cost Method: It is a simple method for the valuation of such assets which cannot be distinguished. Like petrol, petrol is kept in the tank but e cannot separate its stock on the basis of lot. So, valuation of stock is made adding to all the cost and dividing by the quantity. INVENTORY VALUATION: COST FOR INVENTORY VALUATION: For inventory valuation, cost may mean historical, current (replacement) or standard cost. Historical cost represents the cost actually incurred at the date of acquisition. Current replacement cost represents the replacement price on the date of its consumption. Standard cost represents the predetermined cost that should be incurred at a given level of efficiency and capacity utilization. But with regard to the objectivity, verifiability and effectiveness in line with the realization concept, the historical cost basis is almost universally accepted and used. Historical cost represents an appropriate combination of: (a)The cost of purchase; (b) The cost of conversion and (c) The other costs incurred in the normal course of business in bringing the inventories up to their present location and condition. (a) The cost of purchase: ’Cost of Purchase’ consists of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to acquisition, less trade discounts, rebates, duty drawbacks and subsidies in the year in which they are accounted, whether immediate or deferred, in respect of such purchase. (b) The cost of conversion: ’Cost of Conversion’ consists of: (1) Costs which are specifically attributable to units if production i.e., direct labor, direct expenses and sub-contracted work and (2)Production overheads, ascertained in accordance with adsorption costing method. Production overheads exclude expenses which relate to general administration, finance, selling and distribution. (c) Other Costs: Costs other than production overheads are sometimes incurred in bringing inventories to their present location and condition, for example, expenditure incurred in designing products for specific customers. On the other hand, selling and distribution expenses, general administration overheads, research and development costs and interest are usually considered not to relate to putting the inventories in their present location and condition. They are , therefore, excluded from determining the valuation of inventories.

INVENTORY SYSTEMS: There are 2 inventory systems , Periodic and Perpetual Inventory Systems. Meaning of Periodic Inventory System: Periodic Inventory System is a method of ascertaining inventory by taking an actual physical count (or measure or weight) of all the inventory items on hand at a particular date on which information about inventory is required. The cost of goods sold is calculated as a residual figure (which includes lost goods also) as follows: COST OF GOODS SOLD (COGS) = OPENING INVENTORY + PURCHASES – CLOSING INVENTORY Meaning of Perpetual Inventory System: Perpetual Inventory System is a method of recording inventory balances after each receipt and issue in order to ensure accuracy if perpetual inventory records, physical stocks should be checked and compared with recorded balances. The discrepancies, if any, should be investigated and adjusted in the accounts properly. The closing inventory is calculated as a residual figure (which includes lost goods sold) as follows: CLOSING INVENTORY = OPENING INVENTORY + PURCHASES - COST OF GOODS SOLD (COGS)

DISTINCTION BETWEEN PERIODIC INVENTORY SYSTEM AND PERPETUAL INVENTORY SYSTEM: Basis of Distinction PERIODIC INVENTORY SYSTEM PERPETUAL INVENTORY SYSTEM

1 Basis of Ascertaining Inventory is ascertained by taking Inventory is ascertained on the basis Inventory an actual physical count. of records.

2 Calculation of Inventory is directly calculated by Inventory is calculated as a residual Inventory applying the method of valuation figure as follows: Closing Inventory = of inventories. Opening Inventory + Purchases – Cost of Goods Sold (COGS).

3 Calculation of Cost Cost of Goods Sold is calculated as Cost of Goods Sold is directly of Goods Sold a residual figure as follows: Cost of calculated by applying the method of Goods Sold = Opening Inventory + valuation of inventories. Purchases – Closing Inventory.

4 Lost Goods Cost of Goods Sold includes cost The cost of closing inventory includes of lost goods (if any). cost of lost goods (if any).

5 Closing Down of It requires, closing down of work It doesn’t require closing down of Work for Stock for Stock Taking. work for Stock Taking. Taking

6 Continuous Stock It doesn’t facilitate the Continuous It facilitates the Continuous Stock Checking Stock Checking. Checking.

7 Simplicity and Stock It is simple and inexpensive. It is elaborate and expensive. 8 Application of The method of valuation (e.g., The method of valuation (e.g.,

Method of FIFO (First-In-First-Out/ Weighted FIFO/Weighted Average) is applied

Valuation Average) is applied only once at on continuous basis during the

the end of the accounting period accounting period to ascertain the to ascertain the cost of Closing cost of goods sold.

Inventory.

DISTINCTION BETWEEN FIFO AND LIFO METHOD OF VALUTAION OF INVENTORY: Basis of Distinction FIFO (FIRST-IN-FIRST-OUT) LIFO (LAST-IN-FIRST-OUT)

1 Basic Assumption Goods received first are used Goods received last are used first. first.

2 Cost of Goods Sold Cost of goods sold represents Cost of goods sold represents cost of cost of earlier purchases. recent purchases.

3 Ending Inventory Ending inventory represents Ending inventory represents cost of cost of recent purchases. earlier purchases.

4 In case of Rising Higher income is reported Lower income is reported since current Prices since old costs (which are lower costs ( which are higher than the old costs) than current costs) are are matched with current revenue. As a matched with current revenue. result, income tax liability is reduced. As a result, income tax liability

is increased.

5 Distortion in Balance Sheet shows the Balance Sheet is distorted because ending Balance Sheet ending inventory at a value inventory is understand at old costs. nearer the current market

price.