Embed Size (px)
Citation preview
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.
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. Format of a Manufacturing Account:
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.
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.
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) It is generally prepared in the end
at the end of a month /quarter/half-year.
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
The accounting statements of such type of entity include: (a)a Receipts & Payments A/c, (b)a
Trading A/c, (c) a Profit & Loss A/c, (d) a Balance Sheet.
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.
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
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
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 bank balance (or bank overdraft) at the end of the accounting period.
Its closing balance represents 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 created out of profits available for distribution by way of dividend. Revenue Reserves may be classified into two categories as follows:
Capital Reserves are those reserves which are not created out of operating profits. In case of companies, the following are the examples of capital profits. (a)Profits prior to incorporation, (b)Premium on the issue of shares and debentures, (c) Profit on reissue of forfeited shares, (d)Profit on redemption of debentures, (e)Profit on Sale of Fixed Assets, (f)Profit on revaluation of fixed assets and (g)Profit on sale of the whole undertaking or a part of it.
(1)General Reserve: General Reserve is that reserve which is not created for a specific purpose. Examples of such reserves include General Reserve, Contingency Reserve etc.
(2)Specific Reserve: Specific Reserve is that reserve which is created for a specific purpose. Examples of such reserves include Dividend Equalization Reserve, Debenture Redemption Reserve, and Investment Fluctuation Reserve.
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 and can only be used for that particular purpose.
It need not necessarily be created for a particular purpose. For example, General reserve is not for any particular purpose.
2 Charge Vs. Appropriation
It is a charge against the profit and is required to be created irrespective of the amount of profit.
It is an appropriation out of profit and can be created only if profits have been earned.
3 Disclosure in Income Statement
It is shown on the debit side of the P & L A/c.
It is shown on the debit side of the P & L Appropriation A/c.
4 Disclosure in Balance Sheet
Usually a provision is shown by way of deduction from the amount of the items for which it is created. For example, Provision for Doubtful Debts.
Reserve is shown as a separate item under the head ‘Reserves and Surplus’ on the liabilities side of the Balance Sheet.
5 Investment outside business
There is no question of investment of the amount of provisions.
The amount of a reserve can be invested outside the business.
6 Utilization It cannot be utilized for distribution by way of dividends.
It can be utilized for distribution by way of dividends.
7 Legal Necessity It is made mainly because of legal necessity.
It is a matter of financial prudence.
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 are creditors of the company. Shareholders have a multi-faceted interest in the welfare of the company.
The debenture holders have a very limited interest in the company, i.e. limited to receiving interest on time.
3 A shareholder is entitled to receive dividend when there are profits. The rate of dividend varies from year to year depending upon the amount of profit.
On the other hand, the debenture holders are entitled to interest at a fixed rate which the company must pay whether or not there are profits.
4 A shareholder enjoys the rights of proprietorship of a company.
A debenture holder can enjoy the rights of a lender only.
5 A shareholder has a right of control over the working of the company by attending and voting in the general meeting. They are able to decisively influence the composition of Board of directors and other senior management positions.
The debenture holders do not have any voting right, and they are unable to exercise any such influence.
6 A shareholder gets a dividend far higher if the company earns good profits.
A debenture holder gets a fixed rate of 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 the proposal to pay dividend is passed by the shareholders at the annual general meeting of the company.
There is no need of such approval in the case of payment of interest on debentures.
9 A company can purchase its own shares from the market under certain condition.
A company can purchase its own debentures and cancel them or re issue them.
10 A shareholder has a claim on the accumulated profits of the company and is normally rewarded with bonus shares.
A debenture holder has no such claims whatsoever after he has been paid the interest amount.
11 Shareholders cannot be paid back (Except in case of redeemable preference shares) so long as the company is going concern.
Debentures are normally issued for a specified period after which they are repaid.
12 In the event of winding up, shareholders cannot claim payment unless all outside creditors have been paid in full.
In the event of winding up, debenture holders being secured creditors get priority 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
Inventory is ascertained by taking an actual physical count.
Inventory is ascertained on the basis of records.
2 Calculation of Inventory
Inventory is directly calculated by applying the method of valuation of inventories.
Inventory is calculated as a residual figure as follows: Closing Inventory = Opening Inventory + Purchases – Cost of Goods Sold (COGS).
3 Calculation of Cost of Goods Sold
Cost of Goods Sold is calculated as a residual figure as follows: Cost of Goods Sold = Opening Inventory + Purchases – Closing Inventory.
Cost of Goods Sold is directly calculated by applying the method of valuation of inventories.
4 Lost Goods Cost of Goods Sold includes cost of lost goods (if any).
The cost of closing inventory includes cost of lost goods (if any).
5 Closing Down of Work for Stock Taking
It requires, closing down of work for Stock Taking.
It doesn’t require closing down of work for Stock Taking.
6 Continuous Stock Checking
It doesn’t facilitate the Continuous Stock Checking.
It facilitates the Continuous Stock Checking.
7 Simplicity and Stock It is simple and inexpensive. It is elaborate and expensive.
8 Application of Method of Valuation
The method of valuation (e.g., FIFO (First-In-First-Out/ Weighted Average) is applied only once at the end of the accounting period to ascertain the cost of Closing Inventory.
The method of valuation (e.g., FIFO/Weighted Average) is applied on continuous basis during the accounting period to ascertain the cost of goods sold.
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 first.
Goods received last are used first.
2 Cost of Goods Sold Cost of goods sold represents cost of earlier purchases.
Cost of goods sold represents cost of recent purchases.
3 Ending Inventory Ending inventory represents cost of recent purchases.
Ending inventory represents cost of earlier purchases.
4 In case of Rising Prices
Higher income is reported since old costs (which are lower than current costs) are matched with current revenue. As a result, income tax liability is increased.
Lower income is reported since current costs ( which are higher than the old costs) are matched with current revenue. As a result, income tax liability is reduced.
5 Distortion in Balance Sheet
Balance Sheet shows the ending inventory at a value nearer the current market price.
Balance Sheet is distorted because ending inventory is understand at old costs.
