BOARD OF STUDIES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA (ICAI)

(SET UP BY AN ACT OF PARLIAMENT)

(Modules 1 to 2)
FOUNDATION COURSE Paper–1, Module–1

PRINCIPLES AND
PRACTICE OF
ACCOUNTING
MODULE – 1

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 Committee/ : Board of Studies
Department

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 BEFORE WE BEGIN …
SKILL REQUIREMENTS AT FOUNDATION LEVEL

The Board of Studies, ICAI presents the study material for Foundation (Entry Level Exam to the
Chartered Accountancy Course). The contents have been designed and developed with an objective
to synchronize the syllabus with the guidelines prescribed by IAESB (International Accounting
Education Standards Board), IFAC (International Federation of Accountants), to instill and enhance
the necessary pre-requisites for becoming a well-rounded, competent and globally competitive
Accounting Professional.
The level of complexity of the study material is as per standards accorded by IAESB comprising an
ideal mix of subjective and objective examination pattern to ensure discerning students get through
and seek admission to the CA Course.
The paper of 'Principles and Practice of Accounting' at Foundation level concentrates on
conceptual understanding of fundamentals of accounting. The objective of this paper is to develop
an understanding of the basic concepts and principles of Accounting and apply the same in
preparing financial statements of Non-corporate entities, computing accounting ratios and simple
problem solving.
This Study Material endeavouring towards accounting education, is committed to provide a
framework for understanding accounting discipline and describing the fundamental accounting
concepts and conventions of the basic accounting system. An attempt has been made to provide a
solid foundation on which students can successfully build and enhance their studies.

KNOW YOUR SYLLABUS AND STUDY MATERIAL

The Study Material of Principles and Practice of Accounting has been designed having regard to
the needs of home study and distance learning students. The Study Material has been divided into
eleven chapters, each addressing to a special aspect of accounting. Chapters 1 to 5 lay emphasis on
bookkeeping aspect of accounting whereas chapter 7 deals with preparation of financial statements
of sole proprietors. Chapter 6 covers accounting for special transactions like consignment, joint
ventures, bills of exchange, sale of goods on approval basis, royalty accounts and average due date
which are useful for different business entities. Chapter 8 discusses accounting of partnership firms
and chapter 9 deals with financial statements of Not-for-profit organizations. Chapter 10 explains
basic concepts of company accounts and Chapter 11 is on basic accounting ratios which are used
as a tool used in analysing financial statements and performance of a business entity.
The study material has been bifurcated into two modules (Module I : chapters 1 to 6 and Module
II: Chapters 7 to 11) for the easy handling and convenience of students. It is important to read the
Study Material thoroughly for understanding the coverage of syllabus in the paper of Advanced
Accounting.
FRAMEWORK OF CHAPTERS – UNIFORM STRUCTURE COMPRISING OF SPECIFIC
COMPONENTS
Efforts have been made to present each topic of the syllabus in a lucid manner. Care has been
taken to present the chapters in a logical sequence to facilitate easy understanding by the students.
Sincere efforts have been taken to updated the study material so that it reflects the current position.

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 The content for each chapter/unit of the study Material has been structured in the following manner
–

Components of each Chapter About the component

1 Learning Outcomes Learning outcomes which you need to
demonstrate after learning each topic have
been detailed in the first page of each chap-
ter/unit. Demonstration of these learning
outcomes would help you to achieve the de-
sired level of technical competence
2 Chapter/Unit Overview As the name suggests, the flow chart/table/
diagram given at the beginning of each chap-
ter would give a broad outline of the contents
covered in the chapter
3 Content of each unit/ chapter The concepts and provisions of each topic is
explained in student-friendly manner with
the aid of Examples/ illustrations/ diagrams/
flow charts. These value additions would
help you develop conceptual clarity and get a
good grasp of the topic. Diagrams and Flow
charts would help you understand the con-
cept/application of topic in a better manner.
4 Illustrations involving conceptual Illustrations would help the students to un-
understanding derstand the application of concepts. In ef-
fect, it would test understanding of concepts
as well as ability to apply the concepts learnt
in solving problems and addressing issues.
5 Summary A summary of the chapter is given at the end
to help you revise what you have learnt. It
would especially facilitate quick revision of
the chapter the day before the examination.
6 Test Your Knowledge This section comprises of number of multiple
choice questions, theoretical questions and
practical questions which would help stu-
dents to evaluate what they have understood
after studying the chapter. The questions giv-
en in this section have also been supplement-
ed with the answers to help the students in
evaluating their solutions so that they can
know about their grey areas.
We hope that these student-friendly features in the Study Material makes your learning process
more enjoyable, enriches your knowledge and sharpens your application skills.
Happy Reading and Best Wishes!

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 PAPER – 1 : PRINCIPLES AND PRACTICE OF ACCOUNTING
(One paper – Three hours – 100 Marks)

OBJECTIVE:

To develop an understanding of the basic concepts and principles of Accounting and apply
the same in preparing financial statements, computing accounting ratios and simple problem
solving.

CONTENTS:

1. Theoretical Framework
(i) Meaning and Scope of accounting
(ii) Accounting Concepts, Principles and Conventions
(iii) Accounting terminology - Glossary
(iv) Capital and revenue expenditure, Capital and revenue receipts, Contingent assets and
contingent liabilities
(v) Accounting Policies
(vi) Accounting as a Measurement Discipline – Valuation Principles, Accounting Estimates.
(vii) Accounting Standards – Concepts and Objectives.
(viii) Indian Accounting Standards – Concepts and Objectives.
2. Accounting Process
(i) Books of Accounts
(ii) Preparation of Trial Balance
(iii) Rectification of Errors.
3. Bank Reconciliation Statement
Introduction, reasons, preparation of bank reconciliation statement.
4. Inventories
Cost of inventory, Net realizable value, Basis and technique of inventory valuation and record
keeping.
5. Concept and Accounting of Depreciation
Concepts, Methods of computation and accounting treatment of depreciation, Change in
depreciation methods.
6. Accounting for Special Transactions
(i) Bills of exchange and promissory notes
Meaning of Bills of Exchange and Promissory Notes and their Accounting Treatment;
Accommodation bills.

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 (ii) Sale of goods on approval or return basis
Meaning of goods sent on approval or return basis and accounting treatment.
(iii) Consignments
Meaning and Features of consignment business, Difference between sale and consignment,
Accounting treatments for consignment transactions and events in the books of consignor and
consignee.
(iv) Joint Ventures for non-corporate entities
Meaning and Features of joint venture transactions, Distinction between joint venture and
partnership, Methods of maintaining joint venture accounts.
(v) Royalty accounts
Meaning of the term “Royalty” and Accounting Treatment thereof.
(vi) Average due Date
Meaning, Calculation of average due date in various situations.
(vii) Account Current
Meaning of Account Current, Methods of preparing Account Current.
7. Final Accounts of Sole Proprietors
Elements of financial statements, Closing Adjustment Entries, Trading Account, Profit and Loss
Account and Balance Sheet of Manufacturing and Non-manufacturing entities.
8. Partnership Accounts
(i) Final Accounts of Partnership Firms
(ii) Admission, Retirement and Death of a Partner including Treatment of Goodwill
(iii) Introduction to LLPs and Distinction of LLPs from Partnership.
9. Financial Statements of Not-for-Profit Organizations
Significance of Receipt and Payment Account, Income and Expenditure Account and Balance
Sheet, Difference between Profit and Loss Account and Income and Expenditure Account.
Preparation of Receipt and Payment Account, Income and Expenditure Account and Balance
Sheet.
10. Introduction to Company Accounts
(i) Definition of shares and debentures
(ii) Issue of shares and debentures, forfeiture of shares, re-issue of forfeited shares
(iii) Statement of Profit and Loss and Balance Sheet as per Schedule III to the Companies Act,
2013.
11. Basic Accounting Ratios (profitability, solvency, liquidity and turnover)

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 CONTENTS

MODULE 1
CHAPTER 1 : Theoretical Framework
CHAPTER 2 : Accounting Process
CHAPTER 3 : Bank Reconciliation Statement
CHAPTER 4 : Inventories
CHAPTER 5 : Concept and Accounting of Depreciation
CHAPTER 6 : Accounting for Special Transactions

MODULE 2
CHAPTER 7 : Preparation of Final Accounts of Sole Proprietors
CHAPTER 8 : Partnership Accounts
CHAPTER 9 : Financial Statements of Not-For-Profit Organizations
CHAPTER 10 : Company Accounts
CHAPTER 11 : Basic Accounting Ratios

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 DETAILED CONTENTS : MODULE–1
Pages
CHAPTER 1: THEORETICAL FRAMEWORK .........................................................................1.1–1.96
Unit 1: Meaning And Scope Of Accounting
Learning Outcomes ...................................................................................................................................................... 1.1
Unit overview.................................................................................................................................................................. 1.2
1.1 Introduction ................................................................................................................................................ 1.2
1.2 Meaning of Accounting........................................................................................................................... 1.3
1.3 Evolution of Accounting as a Social Science ................................................................................... 1.6
1.4 Objectives of Accounting ....................................................................................................................... 1.7
1.5 Functions of Accounting......................................................................................................................... 1.8
1.6 Book-Keeping ............................................................................................................................................. 1.8
1.7 Distinction Between Book-Keeping and Accounting................................................................... 1.9
1.8 Sub-Fields of Accounting......................................................................................................................1.10
1.9 Users of Accounting Information.......................................................................................................1.10
1.10 Relationship of Accounting with other Disciplines .....................................................................1.11
1.11 Limitations of Accounting ....................................................................................................................1.14
1.12 Role of Accountant in the Society .....................................................................................................1.14
Summary ........................................................................................................................................................................1.18
Test Your Knowledge..................................................................................................................................................1.19
Unit 2 : Accounting Concepts, Principles And Conventions
Learning Outcomes ....................................................................................................................................................1.22
Unit Overview ...............................................................................................................................................................1.23
2.1 Introduction ..............................................................................................................................................1.23
2.2 Accounting Concepts.............................................................................................................................1.24
2.3 Accounting Principles ............................................................................................................................1.24
2.4 Accounting Conventions ......................................................................................................................1.24
2.5 Concepts, Principles and Conventions - An Overview ...............................................................1.25
2.6 Fundamental Accounting Assumptions..........................................................................................1.35
2.7 Financial Statements ..............................................................................................................................1.35
Summary ........................................................................................................................................................................1.39
Test Your Knowledge..................................................................................................................................................1.39

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 Unit 3 : Accounting Terminology – Glossary
Learning Outcomes ...................................................................................................................................................1.43
Accounting Terminology - Glossary..................................................................................................................... 1.43
Test Your Knowledge................................................................................................................................................. 1.57
Unit 4 : Capital And Revenue Expenditures And Receipts
Learning Outcomes ...................................................................................................................................................1.58
Unit Overview ...............................................................................................................................................................1.58
4.1 Introduction ............................................................................................................................................. 1.58
4.2 Considerations in Determining Capital and Revenue Expenditures ................................... 1.59
4.3 Capital Expenditures and Revenue Expenditures....................................................................... 1.59
4.4 Capital Receipts and Revenue Receipts ......................................................................................... 1.61
Summary .......................................................................................................................................................................1.64
Test Your Knowledge .................................................................................................................................................1.64
Unit 5 : Contingent Assets And Contingent Liabilities
Learning Outcomes ...................................................................................................................................................1.66
Unit Overview ..............................................................................................................................................................1.66
5.1 Contingent Asset .................................................................................................................................... 1.66
5.2 Contingent Liabilities ............................................................................................................................ 1.67
5.3 Distinction Between Contingent Liabilities and Liabilities ..................................................... 1.67
5.4 Distinction Between Contingent Liabilities and Provisions .....................................................1.67
Test Your Knowledge..................................................................................................................................................1.68
Unit 6 : Accounting Policies
Learning Outcomes ...................................................................................................................................................1.70
Unit Overview ...............................................................................................................................................................1.70
6.1 Meaning ..................................................................................................................................................... 1.70
6.2 Selection of Accounting Policies ....................................................................................................... 1.71
6.3 Change in Accounting Policies .......................................................................................................... 1.71
Summary .......................................................................................................................................................................1.72
Test Your Knowledge .................................................................................................................................................1.72
Unit 7 : Accounting As A Measurement Discipline – Valuation Principles, Accounting Estimates
Learning Outcomes ...................................................................................................................................................1.74
Unit Overview ..............................................................................................................................................................1.74
7.1 Meaning of Measurement ................................................................................................................... 1.75

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 7.2 Objects or Events to be Measured ................................................................................................... 1.75
7.3 Standard or Scale of Measurement ...................................................................................................1.75
7.4 Dimension of Measurement Scale ................................................................................................... 1.76
7.5 Accounting as a Measurement Discipline ..................................................................................... 1.76
7.6 Valuation Principles ............................................................................................................................... 1.77
7.7 Measurement and Valuation .............................................................................................................. 1.80
7.8 Accounting Estimates ........................................................................................................................... 1.80
Summary ........................................................................................................................................................................1.81
Test Your Knowledge..................................................................................................................................................1.81
Unit 8 : Accounting Standards
Learning Outcomes ....................................................................................................................................................1.84
Unit Overview ...............................................................................................................................................................1.84
8.1 Introduction of Accounting Standards ............................................................................................1.85
8.2 Objectives of Accounting Standards ................................................................................................1.85
8.3 Benefits and Limitations of Accounting Standards .....................................................................1.85
8.4 Process of Formulation of Accounting Standards in India .......................................................1.87
8.5 List of Accounting Standards in India ..............................................................................................1.87
Test Your Knowledge..................................................................................................................................................1.89
Unit 9 : Indian Accounting Standards
Learning Outcomes ....................................................................................................................................................1.91
Unit overview................................................................................................................................................................1.91
9.1 Need for Convergence towards Global Standards ......................................................................1.91
9.2 International Financial Reporting Standards as Global Standards ........................................1.92
9.3 Benefits of Convergence with IFRSS .................................................................................................1.93
9.4 Development in Indian Accounting Standards (Ind AS) ...........................................................1.93
9.5 List of IND AS .............................................................................................................................................1.94
Test Your Knowledge..................................................................................................................................................1.95
CHAPTER 2 : ACCOUNTING PROCESS ............................................................................. 2.1–2.116
Unit 1 : Basic Accounting Procedures - Journal Entries
Learning Outcomes ...................................................................................................................................................... 2.1
Unit overview.................................................................................................................................................................. 2.1
1.1 Double Entry System ................................................................................................................................ 2.2
1.2 Advantages of Double Entry System .................................................................................................. 2.2

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 1.3 Account ......................................................................................................................................................... 2.2
1.4 Debit and Credit......................................................................................................................................... 2.4
1.5 Transactions................................................................................................................................................. 2.7
1.6 Accounting Equation Approach........................................................................................................... 2.8
1.7 Traditional Approach..............................................................................................................................2.12
1.8 Modern Classification of Accounts ....................................................................................................2.14
1.9 Journal .........................................................................................................................................................2.14
Summary ........................................................................................................................................................................2.24
Test Your Knowledge..................................................................................................................................................2.24
Unit 2 : Ledgers
Learning Outcomes ....................................................................................................................................................2.31
Unit Overview ...............................................................................................................................................................2.31
2.1 Introduction ..............................................................................................................................................2.32
2.2 Specimen of Ledger Accounts ............................................................................................................2.32
2.3 Posting.........................................................................................................................................................2.32
2.4 Balancing an Account ............................................................................................................................2.32
Summary ........................................................................................................................................................................2.37
Test Your Knowledge..................................................................................................................................................2.38
Unit 3 : Trial Balance
Learning Outcomes ...................................................................................................................................................2.41
Unit Overview ..............................................................................................................................................................2.41
3.1 Introduction ............................................................................................................................................. 2.41
3.2. Objectives of Preparing the Trial Balance ...................................................................................... 2.42
3.3 Limitations of Trial Balance ................................................................................................................. 2.43
3.4 Methods of Preparation of Trial Balance ........................................................................................ 2.43
3.5 Adjusted Trial Balance (Through Suspense Account)................................................................ 2.47
3.6 Rules of Preparing the Trial Balance................................................................................................. 2.47
Summary .......................................................................................................................................................................2.49
Test Your Knowledge..................................................................................................................................................2.50
Unit 4 : Subsidiary Books
Learning Outcomes ...................................................................................................................................................2.53
Unit Overview ...............................................................................................................................................................2.53
4.1 Introduction ............................................................................................................................................. 2.53

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 4.2 Distinction between Subsidiary Books and Principal books .................................................. 2.54
4.3 Purchases Book ....................................................................................................................................... 2.56
4.4 Sales Book ................................................................................................................................................. 2.60
4.5 Sales Returns Book or Returns Inward Book ................................................................................. 2.61
4.6 Purchase Returns or Returns Outward Book ................................................................................ 2.61
4.7 Importance of Journal .......................................................................................................................... 2.63
Summary .......................................................................................................................................................................2.65
Test Your Knowledge .................................................................................................................................................2.65
Unit 5 : Cash Book
Learning Outcomes ...................................................................................................................................................2.69
Unit Overview ...............................................................................................................................................................2.69
5.1 Cash Book - A Subsidiary Book and a Principal Book ................................................................ 2.70
5.2 Kinds of Cash Book................................................................................................................................. 2.70
5.3 Posting the Cash Book Entries ........................................................................................................... 2.76
5.4 Petty Cash Book ...................................................................................................................................... 2.76
5.5 Entries for Sale Through Credit/Debit Cards ................................................................................. 2.79
Summary .......................................................................................................................................................................2.81
Test Your Knowledge .................................................................................................................................................2.82
Unit 6: Rectification Of Errors
Learning Outcomes ...................................................................................................................................................2.85
Unit Overview ...............................................................................................................................................................2.85
6.1 Introduction ............................................................................................................................................. 2.85
6.2 Stages of Errors........................................................................................................................................ 2.88
6.3 Types of Errors ......................................................................................................................................... 2.89
6.4 Steps to Locate Errors ........................................................................................................................... 2.90
6.5 Rectification of Errors ............................................................................................................................ 2.91
Summary .................................................................................................................................................................... 2.106
Test Your Knowledge .............................................................................................................................................. 2.107
CHAPTER 3: BANK RECONCILIATION STATEMENT ............................................................3.1–3.33
Learning Outcomes ..................................................................................................................................................... 3.1
Chapter Overview ......................................................................................................................................................... 3.1
1. Introduction ............................................................................................................................................... 3.2
2. Bank Pass Book .......................................................................................................................................... 3.2

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 3. Bank Reconciliation Statement ........................................................................................................... 3.3
4. Importance of Bank Reconciliation Statement .............................................................................. 3.3
5. Procedure for Reconciling the Cash Book Balance with the Pass Book Balance.............. 3.11
6. Methods of Bank Reconciliation ....................................................................................................... 3.13
Summary .......................................................................................................................................................................3.28
Test Your Knowledge .................................................................................................................................................3.29
CHAPTER 4: INVENTORIES..................................................................................................4.1–4.27
Learning Outcomes ..................................................................................................................................................... 4.1
Chapter Overview ......................................................................................................................................................... 4.1
1. Meaning ....................................................................................................................................................... 4.2
2. Inventory Valuation.................................................................................................................................. 4.3
3. Basis of Inventory Valuation ................................................................................................................. 4.4
4. Inventory Record Systems ..................................................................................................................... 4.5
5. Formulae/Methods to Determine Cost of Inventory .................................................................... 4.6
6. Inventories Taking .................................................................................................................................. 4.14
Summary .......................................................................................................................................................................4.18
Test Your Knowledge .................................................................................................................................................4.19
CHAPTER 5: CONCEPT AND ACCOUNTING OF DEPRECIATION .......................................5.1–5.36
Learning Outcomes ..................................................................................................................................................... 5.1
Chapter Overview ......................................................................................................................................................... 5.1
1. Introduction ............................................................................................................................................... 5.2
2. Factors in the Measurement of Depreciation ................................................................................. 5.4
3. Methods for Providing Depreciation ................................................................................................. 5.7
4. Profit or Loss on The Sale/Disposal of Property, Plant and Equipment............................... 5.20
5. Change in the Method of Depreciation ..........................................................................................5.22
6. Revision of the Estimated Useful Life of Property, Plant and Equipment .......................... 5.24
7. Revaluation of Property, Plant and Equipment ........................................................................... 5.24
8. Provision for Repairs and Renewals ................................................................................................. 5.26
Summary .......................................................................................................................................................................5.27
Test Your Knowledge .................................................................................................................................................5.28

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 CHAPTER 6: ACCOUNTING FOR SPECIAL TRANSACTIONS ............................................ 6.1–6.163
Unit 1: Bill Of Exchange And Promissory Notes
Learning Outcomes ...................................................................................................................................................... 6.1
Unit Overview ................................................................................................................................................................. 6.1
1.1 Bills of Exchange ........................................................................................................................................ 6.2
1.2 Promissory Notes ....................................................................................................................................... 6.3
1.3 Differences - Bill of Exchange and Promissory Note ..................................................................... 6.4
1.4 Record of Bills of Exchange and Promissory Notes ....................................................................... 6.5
1.5 Term of a Bill ................................................................................................................................................ 6.6
1.6 Expiry / Due Date of a Bill ....................................................................................................................... 6.6
1.7 Days of Grace .............................................................................................................................................. 6.6
1.8 Date of Maturity of Bill ............................................................................................................................. 6.6
1.9 Bill at Sight ................................................................................................................................................... 6.7
1.10 Bill after Date .............................................................................................................................................. 6.7
1.11 How to Calculate Due Date of a Bill .................................................................................................... 6.8
1.12 Noting Charges .......................................................................................................................................... 6.8
1.13 Renewal of Bill ............................................................................................................................................ 6.9
1.14 Retirement of Bills of Exchange & Rebate......................................................................................... 6.9
1.15 Insolvency ..................................................................................................................................................6.16
1.16 Accommodation Bills .............................................................................................................................6.19
1.17 Bills of Collection .....................................................................................................................................6.21
1.18 Bills Receivable and Bills Payable Books..........................................................................................6.22
Summary ........................................................................................................................................................................6.23
Test Your Knowledge..................................................................................................................................................6.23
Unit 2 : Sale Of Goods On Approval Or Return Basis
Learning Outcomes ....................................................................................................................................................6.30
Unit Overview ...............................................................................................................................................................6.30
2.1 Introduction ..............................................................................................................................................6.30
2.2 Accounting Records................................................................................................................................6.31
Summary ........................................................................................................................................................................6.38
Test Your Knowledge..................................................................................................................................................6.39
Unit 3 : Consignment
Learning Outcomes ...................................................................................................................................................6.44
Unit Overview ...............................................................................................................................................................6.44

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 3.1 Meaning of Consignment Account .................................................................................................. 6.45
3.2 Distinctions ................................................................................................................................................6.45
3.3 Accounting for Consignment Transactions and Events in the Books of the Consignor 6.46
3.4 Valuation of Inventories ....................................................................................................................... 6.51
3.5 Goods Invoiced above Cost ................................................................................................................ 6.51
3.6 Normal Loss ...............................................................................................................................................6.54
3.7 Abnormal Loss ......................................................................................................................................... 6.54
3.8 Commission ...............................................................................................................................................6.55
3.9 Return of Goods from the Consignee ..............................................................................................6.56
3.10 Account Sales ........................................................................................................................................... 6.56
3.11 Accounting in the Books of the Consignee....................................................................................6.57
3.12 Advance by the Consignee Vs Security against the Consignment ........................................6.58
Summary .......................................................................................................................................................................6.65
Test Your Knowledge................................................................................................................................................. 6.66
Unit 4: Joint Ventures
Learning Outcomes ...................................................................................................................................................6.75
Unit Overview ...............................................................................................................................................................6.75
4.1 Meaning of Joint Venture .................................................................................................................... 6.76
4.2 Features of Joint Venture ..................................................................................................................... 6.77
4.3 Distinction of Joint Venture with Partnership .............................................................................. 6.77
4.4 Distinction of Joint Venture with Consignment .......................................................................... 6.78
4.5 Methods of Maintaining Joint Venture Accounts ....................................................................... 6.78
Summary .................................................................................................................................................................... 6.103
Test Your Knowledge .............................................................................................................................................. 6.103
Unit 5: Royalty Accounts
Learning Outcomes ................................................................................................................................................ 6.110
Unit Overview ........................................................................................................................................................... 6.110
5.1 Introduction of Royalty and Related Terminologies ............................................................... 6.111
5.2 Accounting Treatment in the Books of Lessee .......................................................................... 6.113
5.3 Accounting Treatment in the Books of Lessor .......................................................................... 6.113
Summary ..................................................................................................................................................................... 6.124
Test Your Knowledge............................................................................................................................................... 6.124

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 Unit 6 : Average Due Date
Learning Outcomes ................................................................................................................................................ 6.129
Unit Overview ............................................................................................................................................................ 6.129
6.1 Introduction .......................................................................................................................................... 6.130
6.2 Concept of due date (Date of Maturity) ...................................................................................... 6.131
6.3 Types of Problems ............................................................................................................................... 6.133
Summary .................................................................................................................................................................... 6.146
Test Your Knowledge .............................................................................................................................................. 6.146
Unit 7 : Account Current
Learning Outcomes ................................................................................................................................................ 6.150
Unit Overview ........................................................................................................................................................... 6.150
7.1 Introduction .......................................................................................................................................... 6.150
7.2 Preparation of Account Current ..................................................................................................... 6.151
Summary ..................................................................................................................................................................... 6.160
Test Your Knowledge............................................................................................................................................... 6.161

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 CHAPTER 1
THEORETICAL FRAMEWORK
UNIT 1: MEANING AND SCOPE OF ACCOUNTING
LEARNING OUTCOMES
After studying this unit, you will be able to:

w Understand the meaning and significance of accounting.

w Understand the meaning of book-keeping and the distinction of accounting with book-keeping.

w Appreciate the evolutionary process of accounting as a social science.

w Explain sub-fields of accounting.

w Identify the various user groups for whom accounting information is to be generated.

w Understand the relationship of accounting with Economics, Statistics, Mathematics, Law and
Management.

w Explain the limitations of accounting.

w Appreciate the enlarged boundary of accounting profession and the areas where in a chartered
accountant plays an important role of rendering useful services to the society.

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 1.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT Procedure of Accounting

OVERVIEW
Generating Using the financial
Financial Information Information

Recording Classifying Summarising Analyzing Interpreting Communicating

Input Identification of
transaction

Economic
events and Accounting Cycle Output
transactions
measured
in financial
terms

Preparation Preparation Communicating

Recording of Posting to
of trial of final Information to
transactions ledger
in the books balance accounts users
of original
entry

Internal users External users

• Board of • Investors
Directors • Lenders
• Partners • Suppliers
• Managers • Govt. agencies
• Officers • Customers

1.1 INTRODUCTION
Every individual performs some kind of economic activity. A salaried person gets salary and spends to
buy provisions and clothing, for children’s education, construction of house, etc. A sports club formed
by a group of individuals, a business run by an individual or a group of individuals, a local authority like
Calcutta Municipal Corporation, Delhi Development Authority, Governments, either Central or State, all
are carrying some kind of economic activities. Not necessarily all the economic activities are run for any
individual benefit; such economic activities may create social benefit i.e. benefit for the public, at large.
Anyway such economic activities are performed through ‘transactions and events’. Transaction is used
to mean ‘a business, performance of an act, an agreement’ while event is used to mean ‘a happening, as a
consequence of transaction(s), a result.’
An individual invests `2,00,000 for running a stationery business. On 1st January, he purchases goods for
` 1,15,000 and sells for ` 1,47,000 during the month of January. He pays shop rent for the month ` 5,000
and finds that still he has goods worth ` 15,000 in hand. The individual performs an economic activity.
He carries on a few transactions and encounters with some events. Is it not logical that he will want to
know the result of his activity?

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 THEORETICAL FRAMEWORK 1.3

We see that the individual, who runs the stationery business, earns a surplus of ` 42,000.

`
Goods sold 1,47,000
Goods in hand 15,000
1,62,000
Less : Goods purchased 1,15,000
Shop rent paid 5,000 (1,20,000)
Surplus 42,000
Earning of ` 42,000 surplus is an event; also having the inventories in hand is another event, while purchase
and sale of goods, investment of money and payment of rent are transactions.
Similarly, a municipal corporation got government grant ` 500 lakhs for adult education; it spent ` 250 lakhs
for purchasing literacy kits, paid ` 200 lakhs to the tutors and is left with a balance of ` 50 lakhs. These are
also transactions and events.
Similarly, the Central Government raised money through taxes, paid salaries to the employees, and spent
on various developmental activities. Whenever receipts of the Government are more than expenses it has
surplus, but if expenses are more than receipts it runs in deficit. Here raising money through various sources
can be termed as transaction and surplus or deficit at the end of the accounting year can be termed as an
event.
So, everybody wants to keep records of all transactions and events and to have adequate information about
the economic activity as an aid to decision-making. Accounting discipline has been developed to serve this
purpose as it deals with the measurement of economic activities involving inflow and outflow of economic
resources, which helps to develop useful information for decision-making process.
Accounting has universal application for recording transactions and events and presenting suitable
information to aid decision-making regarding any type of economic activity ranging from a family function
to functions of the national government. But hereinafter we shall concentrate only on business activities
and their accounting because the objective of this study material is to provide a basic understanding on
accounting for business activities. Nevertheless, it will give adequate knowledge to think coherently of
accounting as a field of study for universal application.
The growth of accounting discipline is closely associated with the development of the business world. Thus,
to understand accounting as a field of study for universal application, it is best identified with recording of
business transactions and communication of financial information about business enterprise to facilitate
decision-making. The aim of accounting is to meet the information needs of the rational and sound decision-
makers, and thus, called the language of business.

1.2 MEANING OF ACCOUNTING

The Committee on Terminology set up by the American Institute of Certified Public Accountants formulated
the following definition of accounting in 1961:
“Accounting is the art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and interpreting the result
thereof.”

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As per this definition, accounting is simply an art of record keeping. The process of accounting starts by
first identifying the events and transactions which are of financial character and then be recorded in the
books of account. This recording is done in Journal or subsidiary books, also known as primary books. Every
good record keeping system includes suitable classification of transactions and events as well as their
summarisation for ready reference. After the transactions and events are recorded, they are transferred to
secondary books i.e. Ledger. In ledger, transactions and events are classified in terms of income, expense,
assets and liabilities according to their characteristics and summarised in profit and loss account and balance
sheet. Essentially the transactions and events are to be measured in terms of money. Measurement in terms
of money means measuring at the ruling currency of a country, for example, rupee in India, dollar in U.S.A.
and like. The transactions and events must have at least in part, financial characteristics. The inauguration
of a new branch of a bank is an event without having financial character, while the business disposed of by
the branch is an event having financial character. Accounting also interprets the recorded, classified and
summarised transactions and events.
However, the above-mentioned definition does not reflect the present day accounting function. The
dimension of accounting is much broader than that described in the above definition. According to the
above definition, accounting ends with interpretation of the results of the financial transactions and events
but in the modern world with the diversification of management and ownership, globalisation of business
and society gaining more interest in the functioning of the enterprises, the importance of communicating
the accounting results has increased and therefore, this requirement of communicating and motivating
informed judgement has also become the part of accounting as defined in the widely accepted definition
of accounting, given by the American Accounting Association in 1966 which treated accounting as
“The process of identifying, measuring and communicating economic information to permit informed
judgments and decisions by the users of accounts.”
In 1970, the Accounting Principles Board (APB) of American Institute of Certified Public Accountants (AICPA)
enumerated the functions of accounting as follows:
“The function of accounting is to provide quantitative information, primarily of financial nature, about
economic entities, that is needed to be useful in making economic decisions.”
Thus, accounting may be defined as the process of recording, classifying, summarising, analysing and
interpreting the financial transactions and communicating the results thereof to the persons interested in
such information.
1.2.1 Procedural aspects of Accounting
On the basis of the above definitions, procedure of accounting can be basically divided into two parts:
(i) Generating financial information and
(ii) Using the financial information.
Generating Financial Information
1. Recording – This is the basic function of accounting. All business transactions of a financial character,
as evidenced by some documents such as sales bill, pass book, salary slip etc. are recorded in the books
of account. Recording is done in a book called “Journal.” This book may further be divided into several
subsidiary books according to the nature and size of the business. Students will learn how to prepare
journal and various subsidiary books in chapter 2.
2. Classifying – Classification is concerned with the systematic analysis of the recorded data, with a
view to group transactions or entries of one nature at one place so as to put information in compact

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 THEORETICAL FRAMEWORK 1.5

and usable form. The book containing classified information is called “Ledger”. This book contains
on different pages, individual account heads under which, all financial transactions of similar nature
are collected. For example, there may be separate account heads for Salaries, Rent, Printing and
Stationeries, Advertisement etc. All expenses under these heads, after being recorded in the Journal,
will be classified under separate heads in the Ledger. This will help in finding out the total expenditure
incurred under each of the above heads. Students will learn how to prepare ledger books in chapter 2.
3. Summarising – It is concerned with the preparation and presentation of the classified data in a manner
useful to the internal as well as the external users of financial statements. This process leads to the
preparation of the following financial statements:(a) Trial Balance (b) Profit and Loss Account (c) Balance
Sheet (d) Cash-flow Statement.
4. Analysing – The term ‘Analysis’ means methodical classification of the data given in the financial
statements. The figures given in the financial statements will not help anyone unless they are in a
simplified form. For example, all items relating to fixed assets are put at one place while all items relating
to current assets are put at another place. It is concerned with the establishment of relationship between
the items of the Profit and Loss Account and Balance Sheet i.e. it provides the basis for interpretation.
Students will learn this aspect of financial statements in the later stages of the Chartered Accountancy
Course.
5. Interpreting – This is the final function of accounting. It is concerned with explaining the meaning and
significance of the relationship as established by the analysis of accounting data. The recorded financial
data is analysed and interpreted in a manner that will enable the end-users to make a meaningful
judgement about the financial condition and profitability of the business operations. The financial
statement should explain not only what had happened but also why it happened and what is likely to
happen under specified conditions.
6. Communicating – It is concerned with the transmission of summarised, analysed and interpreted
information to the end-users to enable them to make rational decisions. This is done through preparation
and distribution of accounting reports, which include besides the usual profit and loss account and
the balance sheet, additional information in the form of accounting ratios, graphs, diagrams, fund
flow statements etc. Students will learn this aspect of financial statements in the later stages of the
Chartered Accountancy Course.
The first two procedural stages of the process of generating financial information along with the preparation
of trial balance are covered under book-keeping while the preparation of financial statements and its
analysis, interpretation and also its communication to the various users are considered as accounting stages.
Students will learn the term book-keeping and its distinction with accounting, in the coming topics of this
unit.
Using the Financial Information
There are certain users of accounts. Earlier it was viewed that accounting is meant for the proprietor or
owner of the business, but changing social relationships diluted the earlier thinking. It is now believed
that besides the owner or the management of the business enterprise, users of accounts include the
investors, employees, lenders, suppliers, customers, government and other agencies and the public at large.
Accounting provides the art of presenting information systematically to the users of accounts. Accounting
data is more useful if it stresses economic substance rather than technical form. Information is useless and
meaningless unless it is relevant and material to a user’s decision. The information should also be free of any
biases. The users should understand not only the financial results depicted by the accounting figures, but
also should be able to assess its reliability and compare it with information about alternative opportunities
and the past experience. The owners or the management of the enterprise, commonly known as internal

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 1.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

users, use the accounting information in an analytical manner to take the valuable decisions for the business.
So the information served to them is presented in a manner different to the information presented to the
external users. Even the small details which can affect the internal working of the business are given in the
management report while financial statements presented to the external users contains key information
regarding assets, liabilities and capital which are summarised in a logical manner that helps them in their
respective decision-making.

1.3 EVOLUTION OF ACCOUNTING AS A SOCIAL SCIENCE

In its oldest form, accounting aided the stewards to discharge their stewardship function. The wealthy men
employed stewards to manage their property; the stewards in turn rendered an account periodically of
their stewardship. This ‘Stewardship Accounting’ was the root of financial accounting system. The presently
followed system of double-entry book-keeping has been developed only in the 15th Century. However,
historians found records of debit and credit dating back to the 12th Century. Although double-entry system
was followed, ‘stewardship accounting’ served the purpose of businessmen and wealthy persons at that
time. In most of the countries, stewardship accounting was prevalent till the emergence of large-scale
enterprises in the form of public limited companies.
In the second phase, the idea of financial accounting emerged with the concept of joint stock company
and divorce of ownership from the management. To safeguard the interest of the shareholders and
investors, disclosure of financial statements (mainly, profit and loss account and balance sheet) and other
accounting information was moulded by law. Financial statements give periodic performance report by
way of profit and loss account and financial position at the end of the period by way of Balance Sheet.
It got the legal status due to changing relationships between the owners, economic entity and the
managers. With the democratisation of society, the relationships between the enterprise on the one hand,
the investors, employees, managers and governments on the other, have also undergone a sea-change.
Also the prospective investors and other business contact groups want to know a lot about the business
before entering into transactions. Thus, financial accounting emerged as an information system to identify,
measure and communicate useful information for informed judgements and decisions by a broad group
of users. In the third phase, accounting information was generated to aid management decision- making
in particular. It contributed a lot to improve the quality of management decisions. This new dimension of
accounting is called Management Accounting and it is the development of 20th Century only. It is pervasive
enough to cover all spheres of management decisions.
Lastly, Social Responsibility Accounting is in the formative process, which aims at accounting for the social
cost incurred by business as well as the social benefit, created by it. It emerges from the growing social
awareness about the undesirable by-products of economic activities. While earning profit, an enterprise
incurs numerous social costs like pollution, using the resources of society like materials, land, labour etc. To
compensate for this social cost, in today’s world, an enterprise is expected to generate some social benefits
also like employment opportunities, recreation activities, more choice to customers at reasonable price,
better quality products etc. Therefore it is demanded that the accounting system should produce a report
measuring the social cost incurred and social benefits generated.
Social Science study man as a member of society; they concern about social processes and the results and
consequences of social relationships. The usefulness of accounting to society as a whole is the fundamental
criterion to treat it as a social science. Although individuals may benefit from the availability of accounting
information, the accounting system generates information for social good. It serves social purposes, it
contributes for social progress; also it is being adapted to keep pace with social progress. So, accounting is
treated as a social science.

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1.4 OBJECTIVES OF ACCOUNTING

The objectives of accounting can be given as follows:

1. Systematic recording of transactions – Basic objective of accounting is to systematically record the

financial aspects of business transactions i.e. book-keeping. These recorded transactions are later on
classified and summarized logically for the preparation of financial statements and for their analysis and
interpretation.

2. Ascertainment of results of above recorded transactions – Accountant prepares profit and loss
account to know the results of business operations for a particular period of time. If revenue exceed
expenses then it is said that business is running profitably but if expenses exceed revenue then it
can be said that business is running under loss. The profit and loss account helps the management
and different stakeholders in taking rational decisions. For example, if business is not proved to be
remunerative or profitable, the cause of such a state of affair can be investigated by the management
for taking remedial steps.

3. Ascertainment of the financial position of the business – Businessman is not only interested in
knowing the results of the business in terms of profits or loss for a particular period but is also anxious
to know that what he owes (liability) to the outsiders and what he owns (assets) on a certain date. To
know this, accountant prepares a financial position statement popularly known as Balance Sheet. The
balance sheet is a statement of assets and liabilities of the business at a particular point of time and
helps in ascertaining the financial health of the business.

4. Providing information to the users for rational decision-making – Accounting as a ‘language of

business’ communicates the financial results of an enterprise to various stakeholders by means of
financial statements. Accounting aims to meet the information needs of the decision-makers and helps
them in rational decision-making.

5. To know the solvency position – By preparing the balance sheet, management not only reveals what
is owned and owed by the enterprise, but also it gives the information regarding concern’s ability to
meet its liabilities in the short run (liquidity position) and also in the long-run (solvency position) as and
when they fall due.

An overview of objectives of accounting is depicted in the chart given below:

Objectives of Accounting

Systematic Communicating
Recording of Ascertainment of Ascertainment of
Information to
Transactions Results Financial Position
various Users

Book-keeping: Manufacturing,
Journal, Leader and Trading, Profit and Balance Sheet Financial Reports
Trial Balance Loss Account

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 1.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.5 FUNCTIONS OF ACCOUNTING

The main functions of accounting are as follows:
(a) Measurement: Accounting measures past performance of the business entity and depicts its current
financial position.
(b) Forecasting: Accounting helps in forecasting future performance and financial position of the
enterprise using past data.
(c) Decision-making: Accounting provides relevant information to the users of accounts to aid rational
decision-making.
(d) Comparison & Evaluation: Accounting assesses performance achieved in relation to targets and
discloses information regarding accounting policies and contingent liabilities which play an important
role in predicting, comparing and evaluating the financial results.
(e) Control: Accounting also identifies weaknesses of the operational system and provides feedbacks
regarding effectiveness of measures adopted to check such weaknesses.
(f) Government Regulation and Taxation: Accounting provides necessary information to the government
to exercise control on the entity as well as in collection of tax revenues.

1.6 BOOK-KEEPING
Book-keeping is an activity concerned with the recording of financial data relating to business operations
in a significant and orderly manner. It covers procedural aspects of accounting work and embraces record
keeping function. Obviously, book-keeping procedures are governed by the end product, the financial
statements. The term ‘financial statements’ means Profit and Loss Account and Balance Sheet including
Schedules and Notes forming part of Accounts. As discussed earlier, Profit and Loss Account gives result
of economic activities for a period and Balance Sheet states the financial position at the end of the period.
Book-keeping also requires suitable classification of transactions and events. This is also determined with
reference to the requirement of financial statements. A book-keeper may be responsible for keeping all
the records of a business or only of a minor segment, such as position of the customers’ accounts in a
departmental store. Accounting is based on a careful and efficient book-keeping system.
The essential idea behind maintaining book-keeping records is to show correct position regarding each
head of income and expenditure. A business may purchase goods on credit as well as in cash. When the
goods are bought on credit, a record must be kept of the person to whom money is owed. The proprietor of
the business may like to know, from time to time, what amount is due on credit purchase and to whom. If
proper record is not maintained, it is not possible to get details of the transactions in regard to the expenses.
At the end of the accounting period, the proprietor wants to know how much profit has been earned or
loss has been incurred during the course of the period. For this lot of information is needed which can be
gathered from a proper record of the transactions. Therefore, in book-keeping, the proper maintenance of
books of account is indispensable for any business.
At this level, the major concern of the curriculum is with book-keeping and preparation of financial
statements. It seems important to mention at this point that book-keeping and preparation of financial
statements have legal implications also. Maintenance of books of accounts and the preparation of financial
statements of a company are guided by the Companies Act, banks and insurance companies by special Acts
governing these institutions and so on. However, for sole-proprietorship and partnership business, there is
no specific legislation regarding maintenance of books of accounts and preparation of financial statements.

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 THEORETICAL FRAMEWORK 1.9

1.6.1 Objectives of Book-keeping

1. Complete Recording of Transactions – It is concerned with complete and permanent record of all
transactions in a systematic and logical manner to show its financial effect on the business.
2. Ascertainment of Financial Effect on the Business – It is concerned with the combined effect of all the
transactions made during the accounting period upon the financial position of the business as a whole.

1.7 DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING

Some people mistake book-keeping and accounting to be synonymous terms, but in fact they are different
from each other. Accounting is a broad subject. It calls for a greater understanding of records obtained from
book-keeping and an ability to analyse and interpret the information provided by book-keeping records.
Book-keeping is the recording phase while accounting is concerned with the summarising phase of an
accounting system. Book-keeping provides necessary data for accounting and accounting starts where
book-keeping ends.

S. No. Book-keeping Accounting

1. It is a process concerned with recording of It is a process concerned with summarising of
transactions. the recorded transactions.
2. It constitutes as a base for accounting. It is considered as a language of the business.
3. Financial statements do not form part of this Financial statements are prepared in this process
process. on the basis of book-keeping records.
4. Managerial decisions cannot be taken with the Management takes decisions on the basis of
help of these records. these records.
5. There is no sub-field of book-keeping. It has several sub-fields like financial accounting,
management accounting etc.
6. Financial position of the business cannot be Financial position of the business is ascertained
ascertained through book-keeping records. on the basis of the accounting reports.

Relationship of Accounting and Book-keeping can be depicted in the following chart as

Accountancy

Accounting

Book Keeping

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1.8 SUB-FIELDS OF ACCOUNTING

The various sub-fields of accounting are:
(i) Financial Accounting – It covers the preparation and interpretation of financial statements and
communication to the users of accounts. It is historical in nature as it records transactions which had
already been occurred. The final step of financial accounting is the preparation of Profit and Loss
Account and the Balance Sheet. It primarily helps in determination of the net result for an accounting
period and the financial position as on the given date.
(ii) Management Accounting – It is concerned with internal reporting to the managers of a business unit.
To discharge the functions of stewardship, planning, control and decision- making, the management
needs variety of information. The different ways of grouping information and preparing reports as
desired by managers for discharging their functions are referred to as management accounting. A
very important component of the management accounting is cost accounting which deals with cost
ascertainment and cost control. Management Accounting will be dealt with at higher levels of the
Chartered Accountancy Course.
(iii) Cost Accounting – The terminology of Cost Accounting published by the Institute of Cost and
Management Accountants of England defines cost accounting as:
“the process of accounting for cost which begins with the recording of income and expenditure or the
bases on which they are calculated and ends with the preparation of periodical statements and reports
for ascertaining and controlling costs.”
(iv) Social Responsibility Accounting – The demand for social responsibility accounting stems from
increasing social awareness about the undesirable by-products of economic activities. As already
discussed earlier, social responsibility accounting is concerned with accounting for social costs incurred
by the enterprise and social benefits created.
(v) Human Resource Accounting – Human resource accounting is an attempt to identify, quantify and
report investments made in human resources of an organisation that are not presently accounted for
under conventional accounting practice.

1.9 USERS OF ACCOUNTING INFORMATION

Generally users of accounts are classified into two categories, (a) internal management and owners; and (b)
external users or outsiders. Management accounting is concerned with identifying information requirements
as well as methods of providing such information to management while information requirements of the
outside users are generally served by financial statements. Following are the various users of accounting
information:
(i) Investors: They provide risk capital to the business. They need information to assess whether to buy,
hold or sell their investment. Also they are interested to know the ability of the business to survive,
prosper and to pay dividend. In non-corporate sector, where ownership and management are not
essentially separated, the owners still need information about performance of the business and its
financial position to decide whether to continue or shut down.
(ii) Employees: Growth of the employees is directly related to the growth of the organisation and therefore,
they are interested to know the stability, continuity and growth of the enterprise and its ability to
provide remuneration, retirement and other benefits and to enhance employment opportunities.

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(iii) Lenders: They are interested to know whether their loan-principal and interest will be paid when due.
(iv) Suppliers and Creditors: They are also interested to know the ability of the enterprise to pay their
dues, that helps them to decide the credit policy for the relevant concern, rates to be charged and
so on. Sometimes, they also become interested in long-term continuation of the enterprise if their
existence becomes dependent on the survival of that business. Suppose, small ancillary units supply
their products to a big enterprise, if the big enterprise collapses, the fate of the small units also becomes
sealed.
(v) Customers: Customers are also concerned with the stability and profitability of the enterprise because
their functioning is more or less dependent on the supply of goods, suppose, a company produces
some chemicals used by pharmaceutical companies and supplies chemicals on three month’s credit. If
all of a sudden it faces some trouble and is unable to supply the chemical, the customers will also be in
trouble.
(vi) Government and their agencies: They regulate the functioning of business enterprises for public
good, allocate scarce resources among competing enterprises, control prices, charge excise duties and
taxes, and so they have continued interest in the business enterprise.
(vii) Public: The public at large is interested in the functioning of the enterprise because it may make a
substantial contribution to the local economy in many ways including the number of people employed
and their patronage to local suppliers.
(viii) Management : Management as whole is also interested in the accounts for various managerial
decisions. On the basis of the accounts, management determines the effects of their various decisions
on the functioning of the organisation. This helps them to make further managerial decisions.

1.10 RELATIONSHIP OF ACCOUNTING WITH OTHER DISCIPLINES

Accounting is closely related with several other disciplines and thus to acquire a good knowledge in
accounting one should be conversant with the relevant portions of such disciplines. In many cases they
overlap accounting. The Accountant should have a working knowledge of the related disciplines so that
he can understand such overlapping areas and apply the knowledge of other disciplines in his own work
wherever possible, or he can take the expert advice.
(a) Accounting and Economics: Economics is viewed as a science of rational decision-making about the
use of scarce resources. It is concerned with the analysis of efficient use of scarce resources for satisfying
human wants. This may be viewed either from the perspective of a single firm or of the country as a
whole.
Accounting is viewed as a system, which provides data to the users to permit informed judgement and
decisions. Some non-accounting data are also relevant for decision-making. Still, accounting provides a
major database.
Accounting overlaps economics in many respects. It contributed a lot in improving the management
decision-making process. But, economic theories influenced the development of the decision-making
tools used in accounting.
However, there exists a wide gulf between economists’ and accountants’ concepts of income and
capital. Accountants got the ideas of value, income and capital maintenance from economists, but
brushed suitably to make them usable in practical circumstances. Accountants developed the valuation,
measurement and decision-making techniques which may owe to the economic theorems for origin

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but these are moulded in the work environment and suitably tempered with reference to relevance,
verifiability, freedom from bias, timeliness, comparability, reliability and understand ability.
An example may be given to explain the nexus between accounting and economics. Economists think
that value of an asset is the present value of all future earnings which can be derived from such assets.
Now think about a plant whose working life is more than one hundred years. How can you estimate
future stream of earnings? So accountants developed the workable valuation base – the acquisition
cost i.e., the price paid to acquire the assets.
At the macro-level, accounting provides the database over which the economic decision models have
been developed; micro-level data arranged by the accounting system is summed up to get macro-level
database.
Non-overlapping zones of accounting are not negligible. Development of the systems of recording,
classifying and summarising transactions and events, harmonising the systems by uniform rules and
communicating the data is essentially a non-overlapping area of accounting.
(b) Accounting and Statistics: The use of statistics in accounting can be appreciated better in the context of
the nature of accounting records. Accounting information is very precise; it is exact to the last paisa. But,
for decision-making purposes such precision is not necessary and hence, the statistical approximations
are sought.
In accounts, all values are important individually because they relate to business transactions. As
against this, statistics is concerned with the typical value, behaviour or trend over a period of time or
the degree of variation over a series of observations. Therefore, wherever a need arises for only broad
generalisations or the average of relationships, statistical methods have to be applied in accounting
data.
Further, in accountancy, the classification of assets and liabilities as well as the heads of income and
expenditure has been done as per the needs of financial recording to ascertain financial results of
various operations. Other types of classification like the geographical and historical ones and ad hoc
classification are done depending on the purpose to make such classification meaningful.
Accounting records generally take a short-term view of events and are confined to a year while statistical
analysis is more useful if a longer view is taken for the purpose. For example, to fit the trend line a longer
period will be required. However, statistical methods do use past accounting records maintained on a
consistent basis.
The functional relations showing mathematical relations of one variable with one or more other
variables are based on statistical work. These relations are used widely in making cost or price estimates
for some estimated future values assigned to the given independent variables. For example, given the
functional relation of total cost to the price of an input, the effect of changes in future prices on the cost
of production can be calculated.
In accountancy, a number of financial and other ratios are based on statistical methods, which help
in averaging them over a period of time. Several accounting and financial calculations are based on
statistical formulae.
Statistical methods are helpful in developing accounting data and in their interpretation. For example,
time series and cross-sectional comparison of accounting data is based on statistical techniques. Now-
a-days multiple discriminate analysis is popularly used to identify symptoms of sickness of a business
firm. Therefore, the study and application of statistical methods would add extra edge to the accounting
data.

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(c) Accounting and Mathematics: Double Entry book-keeping can be converted in algebraic form; in fact
the first known book on this subject was part of a treatise on algebra. The fundamental accounting
equation will be discussed in detail under ‘Dual Aspect Concept’ of this chapter.
Knowledge of arithmetic and algebra is a pre-requisite for accounting computations and measurements.
Calculations of interest and annuity are the examples of such fundamental uses. While computing
depreciation, finding out installments in hire-purchase and instalments payment transactions,
calculating amount to be set aside for repayment of loan and replacement of assets and calculating
lease rentals, mathematical techniques are frequently used. Accounting data are also presented in ratio
form.
With the advent of the computer, mathematics is becoming a vital part of accounting. Instead of writing
accounts in traditional fashion, the transactions and events can be recorded in the matrix form and the
rules of matrix algebra can be applied for classifying and summarising data.
Now-a-days statistics and econometric models are largely used for developing decision models for
the users of accounts. Also, Operations Research Techniques provide lot of decision models. Since
accounting is meant for providing information to the users, to be effective, accounting data should
feed the information requirements of such statistical, econometric and operations research models.
Understanding mathematics has become a must to grasp the decision models framed by statisticians,
econometricians and the O.R. experts.
Presently graphs and charts are being extensively used for communicating accounting information. In
addition to statistical knowledge, knowledge in geometry and trigonometry seems to be essential to
have a better understanding about the accounting communications system.
(d) Accounting and Law: An economic entity operates within a legal environment. All transactions with
suppliers and customers are governed by the Contract Act, the Sale of Goods Act, the Negotiable
Instruments Act, etc. The entity itself is created and controlled by laws. For example, a company is
created by the Companies Act and also controlled by Companies Act.
Similarly, every country has a set of economic, fiscal and labour laws. Transactions and events are always
guided by laws of the land. Very often the accounting system to be followed has been prescribed by the
law. For example, the Companies Act has prescribed the format of financial statements for companies.
Banking, insurance and electric supply undertakings may also have to produce financial statements as
prescribed by the respective legislations controlling such entities.
However, legal prescription about the accounting system is the product of developments in accounting
knowledge. That is to say, legislation about accounting system cannot be enacted unless there is a
corresponding development in the accounting discipline. In that way accounting influences law and is
also influenced by law.
(e) Accounting and Management: Management is a broad occupational field, which comprises many
functions and encompasses application of many disciplines including those mentioned above.
Accountants are well placed in the management and play a key role in the management team. A
large portion of accounting information is prepared for management decision-making. Although
management relies on other data sources, accounting data are used as basic source documents. In the
management team, an accountant is in a better position to understand and use such data. In other
words, since an accountant plays an active role in management, he understands the data requirements.
So the accounting system can be moulded to serve the management purpose.

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 1.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.11 LIMITATIONS OF ACCOUNTING

There are certain misconceptions regarding financial statements. A common man presumes that an income
statement shows the correct income or loss of the enterprise and that a balance sheet depicts a perfectly
true and fair picture of financial standing of that enterprise. It must be recognised that the accounting as
a language has its own limitations. The figures of profit or loss generated by the accounting process are
subject to various constraints within which the accounting works. The assumptions and conventions, on
which the accounting is based, become the limitations of accounting. The financial statements are never
free from subjectivity factor as these are largely the outcome of personal judgement of the accountant with
regard to the adoption of the accounting policies. Following are certain instances:
1. The factors which may be relevant in assessing the worth of the enterprise don’t find place in the
accounts as they cannot be measured in terms of money. The Balance sheet cannot reflect the value
of certain factors like loyalty and skill of the personnel which may be the most valuable asset of an
enterprise these days.
2. Balance Sheet shows the position of the business on the day of its preparation and not on the future
date while the users of the accounts are interested in knowing the position of the business in the near
future and also in long run and not for the past date. Business dynamics change within the time annual
reports reach to the ultimate users. To resolve this, auditors disclose the events occurring after the
balance sheet date but before approval of financial statements in the financial reports.
3. Accounting ignores changes in some money factors like inflation etc.
4. There are occasions when accounting principles conflict with each other.
5. Certain accounting estimates depend on the sheer personal judgement of the accountant, e.g., provision
for doubtful debts, method of depreciation adopted, recording certain expenditure as revenue expenditure
or capital expenditure, selection of method of valuation of inventories and the list is quite long.
6. Financial statements consider those assets which can be expressed in monetary terms. Human resources
although the very important asset of the enterprise are not shown in the balance sheet. There is no
generally accepted formula for the valuation of human resources in money terms.
7. Different accounting policies for the treatment of same item adds to the probability of manipulations.
Though through various laws and Accounting Standards, efforts are made to reduce these options to
minimum but certainly could not be reduced to one.
In nutshell, it can be said that the language of accounting has certain practical limitations and, therefore,
the financial statements should be interpreted carefully keeping in mind all various factors influencing the
true picture.

1.12 ROLE OF ACCOUNTANT IN THE SOCIETY

There are only a few types of profession in the world which are held in high esteem in public eyes and there
is no denying the fact that the accounting profession is one of them. Goethe had called the accountant’s
profession as ‘the fairest invention of the human mind’. At the core of all types of learned profession, there is
the desire of public good and of finding the best way to serve society. By the use of the science of accountancy
and under the spell of its art, a dynamic pattern which assists business in planning its future is woven by
accountants out of the inert mass of non-speaking silent figures. This is what makes their profession an
instrument of socio-economic change and welfare of the society.

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An accountant with his education, training, analytical mind and experience is best qualified to provide
multiple need-based services to the ever growing society. The accountants of today can do full justice not
only to matters relating to taxation, costing, management accounting, financial lay-out, company legislation
and procedures but they can delve deep into the fields relating to financial policies, budgetary policies and
even economic principles. The area of activities which can be undertaken by the accountants is not limited
but it can also cover many additional facets.
1.12.1 Areas of Service
The practice of accountancy has crossed its usual domain of preparation of financial statements, interpretation
of such statements and audit thereof. Accountants are presently taking active role in company laws and other
corporate legislation matters, in taxation laws matters (both direct and indirect) and in general management
problems. Some of the services rendered by accountants to the society are briefly mentioned hereunder:
(i) Maintenance of Books of Accounts: An accountant is able to maintain a systematic record of financial
transactions in order to establish the net result of the transactions entered into during a period and to
state the financial position of the concern as at a particular date.
For the fulfillment of the twin objective of ascertaining the profit earned or loss suffered and the financial
position, it is necessary that all transactions be recorded in a systematic manner, which can be done
only by an accountant. Proper maintenance of books of accounts assists management in planning,
decision-making, controlling functions.
(ii) Statutory Audit: Every limited company is required to appoint a chartered accountant or a firm of
chartered accountants as their auditor who are statutorily required to report each year whether in their
opinion the balance sheet shows a true and fair view of the state of affairs on the balance sheet date,
and the profit and loss account shows a true and fair view of the profit or loss for the year.
Auditing is not confined to the accounts of companies; other organisations may also have their accounts
audited, either because the law so requires (for example, the Co-operative Societies Act, the Income-tax
Act, etc.) or because the proprietors wisely decided so (for example, a partnership firm or an individual
trader).
(iii) Internal Audit: It is a management tool whereby an internal auditor thoroughly examines the
accounting transactions and also the system, according to which these have been recorded with a view
to ensure the management that the accounts are being properly maintained and the system contains
adequate safeguards to check any leakage of revenue or misappropriation of property or assets and the
operations have been carried out in conformity with the plans of management.
Now-a-days internal auditing has developed as a service to management. The internal auditor
constructively contributes in improving the operational efficiency of the business through an
independent review and appraisal of all business operations.
(iv) Taxation: An accountant can handle taxation matters of a business or a person and he can represent
that business or person before the tax authorities and settle the tax liability under the statute prevailing.
He can also assist in avoiding or reducing tax burden by proper planning of tax affairs.
Accountants also have a social obligation to express their views on broad tax policy, on the effect of tax
rate on business and the economy in general and on all other aspects of taxation in which they have
knowledge superior to that of the general public.
(v) Management Accounting and Consultancy Services: Management accountant performs an
advisory function. He is largely responsible for internal reporting to the management for planning and

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 1.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

controlling current operations, decision-making on special matters and for formulating long-range
plans. His job is to collect, analyse, interpret and present all accounting information which is useful to
the management. Accountant provides management consultancy services in the areas of management
information system, expenditure control and evaluation of appraisal techniques for new investments
and divestments, working capital management, corporate planning etc.
(vi) Financial Advice: Many people need help and guidance in planning their personal financial affairs. An
accountant who knows about finances, taxation and family problems is well placed to give such advice.
Some of the areas in which an accountant can render financial advice are:
(a) Investments: An accountant can explain the significance of the formidable documents which
shareholders receive from companies and help in making decisions relating to their investments.
(b) Insurance: An accountant can provide information to his clients on various insurance policies and
helps in choosing appropriate policy.
(c) Business Expansion: As businesses grow in size and complexity and mergers are being considered,
accountants are in the forefront in interpreting accounts, making suggestions as to the form of
schemes and the fairness of proposals considering cost and financial consequences and generally
advising their clients. They also advise on how to set about the problem of borrowing money or
whether this is an appropriate method of finance. Accountants can render extremely useful service
in connection of negotiations with foreign collaborators.
(d) Investigations: Financial investigations are required for a variety of purposes. Examples are:
(i) To ascertain the financial position of a business, for the information of interested parties in
connection with an issue of capital, the purchase or sale of the business or a reconstruction or
amalgamation.
(ii) To help the management to decide whether it is cheaper to manufacture an article or to buy
out.
(iii) To ascertain why profits have fallen.
(iv) To achieve greater efficiency in management.
(v) To ascertain whether fraud has occurred and if so, its nature and extent and to make suggestions
which will help to prevent a recurrence.
(vi) To value businesses and shares in private companies for purposes such as purchase, sale, estate
duty or wealth tax etc.
For such problems requiring financial investigation, you need an accountant. His task as an
independent professional is to establish the facts fairly and clearly for the benefit of those who have
to make decisions and to give advice in many areas in which he has competence and experience.
(e) Pension schemes: Specialist advice from actuaries, insurance agents or insurance company is
needed before launching or amending a provident fund or pension scheme in a business. But
before making a final decision, an accountant has to be consulted. Later on, his help may be needed
for managing the scheme or obtaining tax relief.
(vii) Other Services
(a) Secretarial Work: Companies, clubs, and associations indeed, virtually all organisations involve
secretarial work. Accountants frequently do this work.

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(b) Share Registration Work: Accountants are often used by many companies to undertake the work
involved in registering share transfers and new issues.
(c) Company Formation: In conjunction with legal advisers, accountants help in the formation of a
company or advise against doing so.
(d) Receiverships, Liquidations, etc.: An accountant has to sometimes take on the onerous duties of
liquidator when a company is being wound up or receiver when a debenture holder exercises a
right to recover a loan on which the borrower has defaulted. Accountant is just the man for the job.
He is also just the man to help you to keep insolvency away if you consult him in time.
(e) Arbitrations: At times, accountants are invited by parties to act as arbitrators in a dispute or settle
disputes of various kinds.
(f ) As regards the Cost Accounts: A cost accountant’s job is to continuously report cost data and related
information at frequent intervals to the management.
(g) Accountant and Information Services: An accountant will be effective in his role if he supplies the
information promptly and in an unambiguous language. He should develop a system by which
there is a regular flow of information both horizontally and vertically.
The information system should be such that comparability of financial statement is possible both
business-wise and year-wise so that it benefits both the management and the investors. Dependence
on data from the computerised information system will put new responsibilities on an accountant but
his product will command greater attention and respect.
1.12.2 Chartered Accountant in Industry
An accountant, though he is a part of the highest planning team is not a planner in an industry. He works
with the functional departments and translates the organisation’s aims in terms of financial expectations.
Therefore, he has to make a thorough study of the business and of individuals in the functional departments,
whether they are engineers or salesmen. A qualified accountant will be able to play an important role
in performing important functions of a business relating to accounting, costing and budgetary control,
estimating and treasury.
1.12.3 Chartered Accountant in Public Sector Enterprises
Both in the developed and developing countries, public sector enterprises have become a special feature of the
national economy. The system of financial and budgetary control and of accounting, auditing and reporting
has, therefore, become a matter of interest and concern to the nation, and does not remain confined merely
to a limited number of shareholders. The form of accounting followed by these corporations or companies
is different from that of ordinary government accounting. It is the duty of the accountants to prepare the
accounts and reports of these public corporations in such a way that they enable the general public to know
how far the items appearing in the various types of records and financial statements justify their existence.
1.12.4 Chartered Accountant in Framing Fiscal Policies
Accountants have a positive role to play in the determination of proper fiscal policies and advancement of
trade, commerce and industry. They should develop new techniques and prepare themselves for new fields
of service towards their commitment to the concept of the public goods and services. A business enterprise
can be successful in the commercial sense only if accounting and business knowledge are pooled together.
It is a social obligation for both accountants in industry and in practice to disclose greater information
regarding the corporate results. The state of affairs of the economy can be ascertained only when such
consolidated corporate information is disclosed.

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 1.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.12.5 Chartered Accountant and Economic Growth

In the present times accountants should conceive their duties as broadly as the conditions might require
and do not restrict them to only literal compliance of the law. Their aim should be not to allow any individual
to gain at the cost of the nation. Accountants have to accept a positive role and do their best to encourage
efficiency in individual business units and encourage those social objectives which form the main foundation
of a welfare state.

SUMMARY
w “Accounting is the art of recording, classifying, and summarising in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character, and interpreting the
result thereof.”
w Accounting procedure can be basically divided into two parts:
(i) Generating financial information and
(ii) Using the financial information.
w The objectives of accounting can be given as follows:
(i) Systematic recording of transactions
(ii) Ascertainment of results of above recorded transactions
(iii) Ascertainment of the financial position of the business
(iv) Providing information to the users for rational decision-making
(v) To know the solvency position
w The main functions of accounting are as follows:
(i) Measurement (ii) Forecasting
(iii) Decision-making (iv) Comparison & Evaluation
(v) Control (vi) Government Regulation and Taxation
w Objectives of Book-keeping:
(i) Complete Recording of Transactions and
(ii) Ascertainment of Financial Effect on the Business
w The various sub-fields of accounting are:
(i) Financial Accounting (ii) Management Accounting
(iii) Cost Accounting (iv) Social Responsibility Accounting
(v) Human Resource Accounting
w The various users of accounting information:
(i) Investors (ii) Employees
(iii) Lenders (iv) Suppliers and Creditors
(v) Customers (vi) Government and their agencies
(vii) Public (viii) Management

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 THEORETICAL FRAMEWORK 1.19

w Accounting is closely related with several other disciplines and thus to acquire a good knowledge in
accounting one should be conversant with the relevant portions of such disciplines.
An accountant with his education, training, analytical mind and experience is best qualified to provide
multiple need-based services to the ever growing society. The accountants of today can do full justice not
only to matters relating to taxation, costing, management accounting, financial lay-out, company legislation
and procedures but they can delve deep into the fields relating to financial policies, budgetary policies and
even economic principles.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Which of the following is not a subfield of accounting?
(a) Management accounting.
(b) Cost accounting.
(c) Book-keeping
2. Purposes of an accounting system include all the following except
(a) Interpret and record the effects of business transaction.
(b) Classify the effects of transactions to facilitate the preparation of reports.
(c) Dictate the specific types of business enterprise transactions that the enterprises may engage in.
3. Book-keeping is mainly concerned with

(a) Recording of financial data.

(b) Designing the systems in recording, classifying and summarising the recorded data.
(c) Interpreting the data for internal and external users.

4. All of the following are functions of Accounting except

(a) Decision making.

(b) Ledger posting.
(c) Forecasting.

5. Financial statements are part of

(a) Accounting.
(b) Book-keeping.
(c) Management Accounting.

6. Financial position of the business is ascertained on the basis of

(a) Records prepared under book-keeping process.

(b) Trial balance.
(c) Balance Sheet.

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 1.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

7. Users of accounting information include

(a) Creditors/Suppliers
(b) Lenders/ Customers
(c) Both (a) and (b)

8. Financial statements do not consider

(a) Assets expressed in monetary terms.

(b) Liabilities expressed in monetary terms.
(c) Assets and liabilities expressed in non-monetary terms

9. On January 1, Sohan paid rent of ` 5,000. This can be classified as

(a) An event.
(b) A transaction.
(c) A transaction as well as an event.

10. On March 31, 2015 after sale of goods worth ` 2,000, he is left with the closing inventory of ` 10,000.
This is

(a) An event.
(b) A transaction.
(c) A transaction as well as an event.

Theoretical Questions
1. Define accounting. What are the sub-fields of accounting?

2. Who are the users of accounts?

3. Discuss briefly the relationship of accounting with

(i) Economics (ii) Statistics (iii) Law

4. Discuss the limitations which must be kept in mind while evaluating the Financial Statements.

5. What services can a Chartered Accountant provide to the society?

ANSWER/HINTS
MCQs

1. (c) 2. (c) 3. (a) 4. (b) 5. (a) 6 (c)

7. (c) 8. (c) 9. (b) 10. (a)

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 THEORETICAL FRAMEWORK 1.21

Theoretical Questions
1. Accounting is the art of recording, classifying, and summarising in a significant manner and in terms
of money, transactions and events which are, in part at least, of a financial character, and interpreting
the result thereof. Various subfields of accounting are listed as: Financial Accounting; Management
Accounting; Cost Accounting; Social Responsibility Accounting and Human Resource Accounting.

2. Users of accounts can be listed as Investors, Employees, Lenders, Suppliers and Creditors, Customers,
Govt. and their agencies, public and Management.
3. Refer para 1.10 for understanding the relationship of Accounting with Economics, Statistics and Law.
4. Limitations which must be kept in mind while evaluating the Financial Statements are as follows:
w The factors which may be relevant in assessing the worth of the enterprise don’t find place in the
accounts as they cannot be measured in terms of money.
w Balance Sheet shows the position of the business on the day of its preparation and not on the
future date while the users of the accounts are interested in knowing the position of the business
in the near future and also in long run and not for the past date.
w Accounting ignores changes in some money factors like inflation etc.
w There are occasions when accounting principles conflict with each other.
w Certain accounting estimates depend on the sheer personal judgement of the accountant.
w Different accounting policies for the treatment of same item adds to the probability of manipulations.
5. The practice of accountancy has crossed its usual domain of preparation of financial statements,
interpretation of such statements and audit thereof. Accountants are presently taking active role
in company laws and other corporate legislation matters, in taxation laws matters (both direct and
indirect) and in general management problems. For details, refer Para 1.12.

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 1.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 2 : ACCOUNTING CONCEPTS, PRINCIPLES

AND CONVENTIONS
LEARNING OUTCOMES

After studying this unit, you will be able to :

w Grasp the basic accounting concepts, principles and conventions and observe their implications while
recording transactions and events.

w Identify the three fundamental accounting assumptions:

ª Going Concern
ª Consistency
ª Accrual

w Understand the qualitative characteristics that will help to develop the skill in course of time to prepare
financial statements.

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 THEORETICAL FRAMEWORK 1.23

Entity concept

Money measurement concept

Periodicity concept

Concepts, Principles, Conventions

Accrual concept

Matching concept

Going Concern concept

UNIT OVERVIEW
Cost concept

Realisation concept

Dual aspect concept

Conservatism

Consistency

Materiality

2.1 INTRODUCTION
Let us imagine a situation where you are a proprietor and you take copies of your books of account to five
different accountants. You ask them to prepare the financial statements on the basis of the above records
and to calculate the profits of the business for the year. After few days, they are ready with the financial
statements and all the five accountants have calculated five different amounts of profits and that too with
very wide variations among them. Guess in such a situation what impact would it leave on you about
accounting profession. To avoid this, a generally accepted set of rules have been developed. This generally
accepted set of rules provides unity of understanding and unity of approach in the practice of accounting
and also in better preparation and presentation of the financial statements.
Accounting is a language of the business. Financial statements prepared by the accountant communicate
financial information to the various stakeholders for decision-making purpose. Therefore, it is important
that financial statements prepared by different organizations should be prepared on uniform basis. Also
there should be consistency over a period of time in the preparation of these financial statements. If every
accountant starts following his own norms and notions for accounting of different items then there will be
an utter confusion.

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 1.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

To avoid confusion and to achieve uniformity, accounting process is applied within the conceptual
framework of ‘Generally Accepted Accounting Principles’ (GAAPs). The term GAAPs is used to describe rules
developed for the preparation of the financial statements and are called concepts, conventions, postulates,
principles etc. These GAAPs are the backbone of the accounting information system, without which the
whole system cannot even stand erectly. These principles are the ground rules, which define the parameters
and constraints within which accounting reports are generated. Accounting principles are basic norms and
assumptions on which the whole accounting system has been developed and established. Accountant
also adheres to various accounting standards issued by the regulatory authority for the standardization of
accounting policies to be followed under specific circumstances. These conceptual frameworks, GAAPs and
accounting standards are considered as the theory base of accounting.

2.2 ACCOUNTING CONCEPTS

Accounting concepts define the assumptions on the basis of which financial statements of a business
entity are prepared. Certain concepts are perceived, assumed and accepted in accounting to provide a
unifying structure and internal logic to accounting process. The word concept means idea or notion, which
has universal application. Financial transactions are interpreted in the light of the concepts, which govern
accounting methods. Concepts are those basic assumptions and conditions, which form the basis upon
which the accountancy has been laid. Unlike physical science, accounting concepts are only result of broad
consensus. These accounting concepts lay the foundation on the basis of which the accounting principles
are formulated.

2.3 ACCOUNTING PRINCIPLES

“Accounting principles are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practices and as a guide for selection of conventions or
procedures where alternatives exist.”
Accounting principles must satisfy the following conditions:
1. They should be based on real assumptions;
2. They must be simple, understandable and explanatory;
3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.

2.4 ACCOUNTING CONVENTIONS

Accounting conventions emerge out of accounting practices, commonly known as accounting principles,
adopted by various organizations over a period of time. These conventions are derived by usage and
practice. The accountancy bodies of the world may change any of the convention to improve the quality of
accounting information. Accounting conventions need not have universal application.
In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting conventions’
have been used interchangeably to mean those basic points of agreement on which financial accounting
theory and practice are founded.

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 THEORETICAL FRAMEWORK 1.25

2.5 CONCEPTS, PRINCIPLES AND CONVENTIONS - AN OVERVIEW

Now we shall study in detail the various accounting concepts on which accounting is based. The following
are the widely accepted accounting concepts:
(a) Entity concept: Entity concept states that business enterprise is a separate identity apart from its owner.
Accountants should treat a business as distinct from its owner. Business transactions are recorded in the
business books of accounts and owner’s transactions in his personal books of accounts. The practice of
distinguishing the affairs of the business from the personal affairs of the owners originated only in the
early days of the double-entry book-keeping. This concept helps in keeping business affairs free from
the influence of the personal affairs of the owner. This basic concept is applied to all the organizations
whether sole proprietorship or partnership or corporate entities.
Entity concept means that the enterprise is liable to the owner for capital investment made by the
owner. Since the owner invested capital, which is also called risk capital, he has claim on the profit
of the enterprise. A portion of profit which is apportioned to the owner and is immediately payable
becomes current liability in the case of corporate entities.
Example: Mr. X started business investing ` 7,00,000 with which he purchased machinery for ` 5,00,000
and maintained the balance in hand. The financial position of the will be as follows:

`
Capital 7,00,000
Machinery 5,00,000
Cash 2,00,000
This means that the enterprise owes to Mr. X ` 7,00,000. Now if Mr. X spends ` 5,000 to meet his family
expenses from the business fund, then it should not be taken as business expenses and would be
charged to his capital account (i.e., his investment would be reduced by ` 5,000). Following the entity
concept the revised financial position would be

Liability ` `
Capital 7,00,000
Less : Drawings (5,000) 6,95,000
Machinery 5,00,000
Cash 1,95,000
(b) Money measurement concept: As per this concept, only those transactions, which can be measured in
terms of money are recorded. Since money is the medium of exchange and the standard of economic
value, this concept requires that those transactions alone that are capable of being measured in terms
of money be only to be recorded in the books of accounts. Transactions, even if, they affect the results of
the business materially, are not recorded if they are not convertible in monetary terms. Transactions and
events that cannot be expressed in terms of money are not recorded in the business books. For example;
employees of the organization are, no doubt, the assets of the organizations but their measurement in
monetary terms is not possible therefore, not included in the books of account of the organization.
Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency of a
country provides a common denomination for the value of material objects. The monetary unit though
an inelastic yardstick, remains indispensable tool of accounting.
It may be mentioned that when transactions occur across the boundary of a country, one may see many
currencies. Suppose a businessman sells goods worth ` 50 lakhs at home and he also sells goods worth

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 1.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

of 1 lakh Euro in the United States. What is his total sales? ` 50 lakhs plus 1 lakh Euro.
These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform
monetary unit i.e. in one currency. Suppose EURO 1 = ` 71.
Total Sales = ` 50 lakhs plus 71 lakhs = ` 121 lakhs. Money Measurement Concept imparts the essential
flexibility for measurement and interpretation of accounting data.
This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit
assumption that purchasing power of the money is not of sufficient importance as to require adjustment.
Also, many material transactions and events are not recorded in the books of accounts just because
theycannot be measured in monetary terms. Therefore it is recognized by all the accountants that this
concept has its own limitations and inadequacies. Yet it is used for accounting purposes because it is
not possible to adopt a better measurement scale.
Entity and money measurement are viewed as the basic concepts on which other procedural concepts
hinge.
(c) Periodicity concept: This is also called the concept of definite accounting period. As per ‘going concern’
concept an indefinite life of the entity is assumed. For a business entity it causes inconvenience to
measure performance achieved by the entity in the ordinary course of business.
If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as financial
position only at the end of its life.
So a small but workable fraction of time is chosen out of infinite life cycle of the business entity for
measuring performance and looking at the financial position. Generally one year period is taken up for
performance measurement and appraisal of financial position. However, it may also be 6 months or 9
months or 15 months.
According to this concept accounts should be prepared after every period & not at the end of the life of
the entity. Usually this period is one calendar year. We generally follow from 1st April of a year to 31st
March of the immediately following year.
Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an unduly
long time-frame. This concept makes the accounting system workable and the term ‘accrual’ meaningful.
If one thinks of indefinite time-frame, nothing will accrue. There cannot be unpaid expenses and non-
receipt of revenue. Accrued expenses or accrued revenue is only with reference to a finite time-frame
which is called accounting period.
Thus, the periodicity concept facilitates in:
(i) Comparing of financial statements of different periods
(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the business
(iii) Matching periodic revenues with expenses for getting correct results of the business operations
(d) Accrual concept: Under accrual concept, the effects of transactions and other events are recognised
on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and
they are recorded in the accounting records and reported in the financial statements of the periods
to which they relate. Financial statements prepared on the accrual basis inform users not only of past
events involving the payment and receipt of cash but also of obligations to pay cash in the future and
of resources that represent cash to be received in the future.
To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the
gross inflow of cash, receivables and other consideration arising in the course of the ordinary activities

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 THEORETICAL FRAMEWORK 1.27

of an enterprise from sale of goods, from rendering services and from the use by others of enterprise’s
resources yielding interest, royalties and dividends. For example, (1) Mr. X started a cloth merchandising.
He invested ` 50,000, bought merchandise worth ` 50,000. He sold such merchandise for ` 60,000.
Customers paid him ` 50,000 cash and assure him to pay ` 10,000 shortly. His revenue is ` 60,000. It
arose in the ordinary course of cloth business; Mr. X received ` 50,000 in cash and ` 10,000 by way of
receivables.
Take another example; (2) an electricity supply undertaking supplies electricity spending ` 16,00,000
for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricity charges.
This is also revenue which arose from rendering services.
Lastly, (3) Mr. A invested ` 1,00,000 in a business. He purchased a machine paying ` 1,00,000. He hired
it out for ` 20,000 annually to Mr. B. ` 20,000 is the revenue of Mr. A; it arose from the use by others of
the enterprise’s resources.
Expense is a cost relating to the operations of an accounting period or to the revenue earned during the
period or the benefits of which do not extend beyond that period.
In the first example, Mr. X spent ` 50,000 to buy the merchandise; it is the expense of generating revenue
of ` 60,000. In the second instance ` 16,00,000 are the expenses. Also whenever any asset is used it has
a finite life to generate benefit. Suppose, the machine purchased by Mr. A in the third example will last
for 10 years only. Then ` 10,000 is the expense every year relating to the cost of machinery. For the time
being, ignore the idea of accounting period.
Accrual means recognition of revenue and costs as they are earned or incurred and not as money is
received or paid. The accrual concept relates to measurement of income, identifying assets and liabilities.
Example: Mr. J D buys clothing of ` 50,000 paying cash ` 20,000 and sells at ` 60,000 of which customers
paid only ` 50,000.
His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred for the revenue) is
` 50,000, not ` 20,000 cash paid. So the accrual concept based profit is ` 10,000 (Revenue – Expenses).
As per Accrual Concept : Revenue – Expenses = Profit
Accrual Concept provides the foundation on which the structure of present day accounting has been
developed.
Alternative as per Cash basis
Cash received in ordinary course of business – Cash paid in ordinary course of business = profit.
Revenue may not be realised in cash. Cash may be received simultaneously or
(i) before revenue is created (A. 1)
(ii) after revenue is created (A. 2)
Expenses may not be paid in cash. Cash may be paid simultaneously or
(i) before expense is made (B. 1) (ii) after expense is made (B. 2)
A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Trade receivables.
B.1 creates an asset called Trade Advance when cash is paid in advance while B. 2 creates a liability
called payables or Trade payables or outstanding liabilities. If the expenses remain unpaid in respect of
goods, it is called Trade payables, if it remains unpaid for other expenses, it is called Expense payables.

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 1.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

(e) Matching concept: In this concept, all expenses matched with the revenue of that period should only
be taken into consideration. In the financial statements of the organization if any revenue is recognized
then expenses related to earn that revenue should also be recognized.
This concept is based on accrual concept as it considers the occurrence of expenses and income and
do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain items like
prepaid and outstanding expenses, unearned or accrued incomes.
It is not necessary that every expense identify every income. Some expenses are directly related to the
revenue and some are time bound. For example:- selling expenses are directly related to sales but rent,
salaries etc are recorded on accrual basis for a particular accounting period. In other words periodicity
concept has also been followed while applying matching concept.
Mr. P K started cloth business. He purchased 10,000 pcs. garments @ ` 100 per piece and sold 8,000 pcs.
@ ` 150 per piece during the accounting period of 12 months 1st January to 31st December, 2015. He
paid shop rent @ ` 3,000 per month for 11 months and paid ` 8,00,000 to the suppliers of garments and
received ` 10,00,000 from the customers.
Let us see how the accrual and periodicity concepts operate.
Periodicity Concept fixes up the time-frame for which the performance is to be measured and financial
position is to be appraised. Here, it is January 2015 - December, 2015. So revenues and expenses are
to be measured for the year 2015 and assets and liabilities are to be ascertained as on 31st December,
2015.
Accrual Concept operates to measure revenue of ` 12,00,000 (arising out of sale of garments 8,000 Pcs
× ` 150) which accrued during 2015, not the cash received ` 10,00,000 and also the expenses correctly.
Shop rent for 12 months is an expense item amounting to ` 36,000, not ` 33,000 the cash paid.
Should the accountant treat ` 10,00,000 as expenses for purchase of merchandise ? And should he treat
` 1,64,000 as profit? (Revenue ` 12,00,000-Merchandise ` 10,00,000. Shop Rent ` 36,000). Obviously the
answer is No. Matching links revenue with expenses.
Revenue – Expenses = Profit
But this unqualified equation may create misconception. It should be defined as :
Periodic Profit = Periodic Revenue – Matched Expenses
From the revenue of an accounting period such expenses are deducted which are expended to generate
the revenue to determine profit of that period.
In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000 pcs of
garments should be treated as expenses.
Thus, Profit = Revenue ` 12,00,000
Less: Expenses:
Merchandise ` 8,00,000
Shop Rent ` 36,000 (` 8,36,000)
` 3,64,000
Assets:
Inventory (2,000 pcs × ` 100) ` 2,00,000
Trade receivables ` 2,00,000

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 THEORETICAL FRAMEWORK 1.29

Cash (Cash Receipts ` 10,00,000 – cash payments ` 1,67,000

` 8,33,000)
` 5,67,000
Liabilities:
Trade Payables ` 2,00,000
Expense Payables ` 3,000
Capital (for Profit) ` 3,64,000
` 5,67,000
Thus, accrual, matching and periodicity concepts work together for income measurement and
recognition of assets and liabilities.
(f) Going Concern concept: The financial statements are normally prepared on the assumption that an
enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is
assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially
the scale of its operations; if such an intention or need exists, the financial statements may have to be
prepared on a different basis and, if so, the basis used is disclosed.
The valuation of assets of a business entity is dependent on this assumption. Traditionally, accountants
follow historical cost in majority of the cases.
Suppose Mr. X purchased a machine for his business paying ` 5,00,000 out of ` 7,00,000 invested by
him. He also paid transportation expenses and installation charges amounting to ` 70,000. If he is still
willing to continue the business, his financial position will be as follows:
Balance Sheet

Liability ` Assets `
Capital 7,00,000 Machinery 5,70,000
Cash 1,30,000
7,00,000 7,00,000
Now if he decides to back out and desires to sell the machine, it may fetch more than or less than
` 5,70,000. So his financial position should be different. If going concern concept is taken, increase/
decrease in the value of assets in the short-run is ignored. The concept indicates that assets are kept for
generating benefit in future, not for immediate sale; current change in the asset value is not realisable
and so it should not be counted.
(g) Cost concept: By this concept, the value of an asset is to be determined on the basis of historical cost, in
other words, acquisition cost. Although there are various measurement bases, accountants traditionally
prefer this concept in the interests of objectivity. When a machine is acquired by paying ` 5,00,000,
following cost concept the value of the machine is taken as ` 5,00,000. It is highly objective and free
from all bias. Other measurement bases are not so objective. Current cost of an asset is not easily
determinable. If the asset is purchased on 1.1.1995 and such model is not available in the market, it
becomes difficult to determine which model is the appropriate equivalent to the existing one. Similarly,
unless the machine is actually sold, realisable value will give only a hypothetical figure. Lastly, present
value base is highly subjective because to know the value of the asset one has to chase the uncertain
future.

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 1.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

However, the cost concept creates a lot of distortion too as outlined below :
(a) In an inflationary situation when prices of all commodities go up on an average, acquisition cost
loses its relevance. For example, a piece of land purchased on 1.1.1995 for ` 2,000 may cost `
1,00,000 as on 1.1.2015. So if the accountant makes valuation of asset at historical cost, the accounts
will not reflect the true position.
(b) Historical cost-based accounts may lose comparability. Mr. X invested ` 1,00,000 in a machine on
1.1.1995 which produces ` 50,000 cash inflow during the year 2015, while Mr. Y invested ` 5,00,000
in a machine on 1.1.2005 which produced ` 50,000 cash inflows during the year. Mr. X earned at the
rate 50% while Mr. Y earned at the rate 10%. Who is more efficient? Since the assets are recorded at
the historical cost, the results are not comparable. Obviously it is a corollary to (a).
(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example. The cost
concept fails to recognise such asset although it is a very important asset of any organization.
Many other controversial issues have arisen in financial accounting that revolves around the cost
concept which will be discussed at the advanced stage. However, later on we shall see that in many
circumstances, the cost convention is not followed. See conservatism concept for an example, which
will be discussed later on in this unit.
(h) Realisation concept: It closely follows the cost concept. Any change in value of an asset is to be
recorded only when the business realises it. When an asset is recorded at its historical cost of ` 5,00,000
and even if its current cost is ` 15,00,000 such change is not counted unless there is certainty that such
change will materialize.
However, accountants follow a more conservative path. They try to cover all probable losses but do
not count any probable gain. That is to say, if accountants anticipate decrease in value they count it,
but if there is increase in value they ignore it until it is realised. Economists are highly critical about the
realisation concept. According to them, this concept creates value distortion and makes accounting
meaningless.
Example: Mr. X purchased a piece of land on 1.1.1995 paying `2,000. Its current market value is
` 1,02,000 on 31.12.2015. Should the accountant show the land at `2,000 following cost concept and
ignoring `1,00,000 value increase since it is not realised? If he does so, the financial position would be:
Balance Sheet

Liability ` Asset `
Capital 2,000 Land 2,000
2,000 2,000
Is it not proper to show it in the following manner?
Balance Sheet

Liabilities ` Asset `
Capital 2,000 Land 1,02,000
Unrealised Gain 1,00,000
1,02,000 1,02,000

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 THEORETICAL FRAMEWORK 1.31

Now-a-days the revaluation of assets has become a widely accepted practice when the change in value
is of permanent nature. Accountants adjust such value change through creation of revaluation (capital)
reserve.
Thus the going concern, cost concept and realization concept gives the valuation criteria.
(i) Dual aspect concept: This concept is the core of double entry book-keeping. Every transaction or event
has two aspects:
(1) It increases one Asset and decreases other Asset;
(2) It increases an Asset and simultaneously increases Liability;
(3) It decreases one Asset, increases another Asset;
(4) It decreases one Asset, decreases a Liability.
Alternatively:
(5) It increases one Liability, decreases other Liability;
(6) It increases a Liability, increases an Asset;
(7) It decreases Liability, increases other Liability;
(8) It decreases Liability, decreases an Asset.
Example:
Balance Sheet

Liabilities ` Assets `
Capital 1,50,000 Machinery 2,00,000
Bank Loan 75,000 Cash 1,00,000
Other Loan 75,000
3,00,000 3,00,000
Transactions:
(a) A new machine is purchased paying ` 50,000 in cash.
(b) A new machine is purchased for ` 50,000 on credit, cash is to be paid later on.
(c) Cash paid to repay bank loan to the extent of ` 50,000.
(d) Raised bank loan of ` 50,000 to pay off other loan.
Effect of the Transactions:
(a) Increase in machine value and decrease in cash balance by ` 50,000.

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 1.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

Balance Sheet (1 & 3)

Liabilities ` Assets `
Capital 1,50,000 Machinery 2,50,000
Bank Loan 75,000 Cash 50,000
Other Loan 75,000
3,00,000 3,00,000
(b) Increase in machine value and increase in Creditors by ` 50,000.
Balance Sheet (2 & 6)

Liabilities ` Assets `
Capital 1,50,000 Machinery 2,50,000
Creditors for machinery 50,000 Cash 1,00,000
Bank Loan 75,000
Other Loan 75,000
3,50,000 3,50,000

(c) Decrease in bank loan and decrease in cash by ` 50,000.

Balance Sheet (4 & 8)

Liabilities ` Assets `
Capital 1,50,000 Machinery 2,00,000
Bank Loan 25,000 Cash 50,000
Other Loan 75,000
2,50,000 2,50,000

(d) Increase in bank loan and decrease in other loan by ` 50,000.

Balance Sheet (5 & 7)

Liabilities ` Assets `
Capital 1,50,000 Machinery 2,00,000
Bank Loan 1,25,000 Cash 1,00,000
Other Loan 25,000
3,00,000 3,00,000

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 THEORETICAL FRAMEWORK 1.33

So every transaction and event has two aspects.

This gives basic accounting equation :
Equity (E) + Liabilities (L) = Assets (A)
or
Equity (E)= Assets (A) – Liabilities(L)
Or, Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets
Or, Equity + Long Term Liabilities = Fixed Assets + (Current Assets – Current Liabilities)
Or, Equity = Fixed Assets + Working Capital – Long Term Liabilities

? ILLUSTRATION
Develop the accounting equation from the following information: -

Particulars April 1, 2016 March 31, 2017

(`) (`)
Capital 1,00,000 ?
12% Bank Loan 1,00,000 1,00,000
Trade Payables 75,000 70,000
Fixed Assets 1,25,000 1,10,000
Trade Receivables 75,000 80,000
Inventory 70,000 80,000
Cash & Bank 5,000 6,000
Required
Find the profit for the year & the Balance sheet as on 31/3/2017.

SOLUTION
For the year ended April 1, 2016:
Equity = Capital ` 1,00,000
Liabilities = Bank Loan + Trade Payables
` 1,00,000 + ` 75,000 = ` 1,75,000
Assets = Fixed Assets + Trade Receivables + Inventory + Cash & Bank
` 1,25,000 + ` 75,000 + ` 70,000 + ` 5,000 = ` 2,75,000
Equity + Liabilities = Assets
` 1,00,000 + ` 1,75,000 = 2,75,000

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 1.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

For the year ended April 1, 2017:

Assets = ` 1,10,000 + ` 80,000 + ` 80,000 + ` 6,000 = ` 2,76,000
Liabilities = ` 1,00,000 + ` 70,000 = ` 1,70,000
Equity = Assets – Liabilities = ` 2,76,000 – ` 1,70,000 = ` 1,06,000
Profits = New Equity – Old Equity = ` 1,06,000 – `1,00,000 = ` 6,000
(j) Conservatism: Conservatism states that the accountant should not anticipate income and should
provide for all possible losses. When there are many alternative values of an asset, an accountant should
choose the method which leads to the lesser value. Later on we shall see that the golden rule of current
assets valuation - ‘cost or market price whichever is lower’ originated from this concept.
The Realisation Concept also states that no change should be counted unless it has materialised. The
Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain but it is
desirable to guard against all possible losses.
For this concept there should be at least three qualitative characteristics of financial statements, namely,
(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as well as gains
which are uncertain.
(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as well as to
exclude uncertain gains,
(iii) Faithful representation of alternative values.
Many accounting authors, however, are of the view that conservatism essentially leads to understatement
of income and wealth and it should not be the basis for the preparation of financial statements.
(k) Consistency: In order to achieve comparability of the financial statements of an enterprise through
time, the accounting policies are followed consistently from one period to another; a change in an
accounting policy is made only in certain exceptional circumstances.
The concept of consistency is applied particularly when alternative methods of accounting are equally
acceptable. For example a company may adopt any of several methods of depreciation such as
written-down-value method, straight-line method, etc. Likewise there are many methods for valuation
of inventories. But following the principle of consistency it is advisable that the company should
follow consistently over years the same method of depreciation or the same method of valuation of
Inventories which is chosen. However in some cases though there is no inconsistency, they may seem
to be inconsistent apparently. In case of valuation of Inventories if the company applies the principle
‘at cost or market price whichever is lower’ and if this principle accordingly results in the valuation of
Inventories in one year at cost price and the market price in the other year, there is no inconsistency
here. It is only an application of the principle.
But the concept of consistency does not imply non-flexibility as not to allow the introduction of
improved method of accounting.
An enterprise should change its accounting policy in any of the following circumstances only:
a. To bring the books of accounts in accordance with the issued Accounting Standards.
b. To comply with the provision of law.
c. When under changed circumstances it is felt that new method will reflect more true and fair picture

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 THEORETICAL FRAMEWORK 1.35

in the financial statement.

(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is not considered
material. This principle is an exception to full disclosure principle. According to materiality principle, all
the items having significant economic effect on the business of the enterprise should be disclosed in
the financial statements and any insignificant item which will only increase the work of the accountant
but will not be relevant to the users’ need should not be disclosed in the financial statements.
The term materiality is the subjective term. It is on the judgement, common sense and discretion of
the accountant that which item is material and which is not. For example stationary purchased by the
organization though not used fully in the accounting year purchased still shown as an expense of that
year because of the materiality concept. Similarly depreciation on small items like books, calculators
etc. is taken as 100% in the year of purchase though used by the entity for more than a year. This is
because the amount of books or calculator is very small to be shown in the balance sheet though it is
the asset of the company.
The materiality depends not only upon the amount of the item but also upon the size of the business,
nature and level of information, level of the person making the decision etc. Moreover an item
material to one person may be immaterial to another person. What is important is that omission of any
information should not impair the decision-making of various users.

2.6 FUNDAMENTAL ACCOUNTING ASSUMPTIONS

There are three fundamental accounting assumptions :
(i) Going Concern
(ii) Consistency
(iii) Accrual
All the above three fundamental accounting assumptions have already been explained in this para 2.5.
If nothing has been written about the fundamental accounting assumption in the financial statements then
it is assumed that they have already been followed in their preparation of financial statements. However, if
any of the above mentioned fundamental accounting assumption is not followed then this fact should be
specifically disclosed.

2.7 FINANCIAL STATEMENTS

The aim of accounting is to keep systematic records to ascertain financial performance and financial
position of an entity and to communicate the relevant financial information to the interested user groups.
The financial statements are basic means through which the management of an entity makes public
communication of the financial information along with selected quantitative details. They are structured
financial representations of the financial position and the performance of an enterprise. To have a record
of all business transactions and also to determine whether all these transactions resulted in either ‘profit
or loss’ for the period, all the entities will prepare financial statements viz., balance sheet, profit and loss
account, cash flow statement etc. by following various accounting concepts, principles, and conventions
which have been already discussed in detail.

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 1.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

2.7.1 Qualitative Characteristics of Financial Statements

Qualitative characteristics are the attributes that make the information provided in financial statements
useful to users. The following are the important qualitative characteristics of the financial statements:
1. Understandability: An essential quality of the information provided in financial statements is that it
must be readily understandable by users. For this purpose, it is assumed that users have a reasonable
knowledge of business and economic activities and accounting and study the information with
reasonable diligence. Information about complex matters that should be included in the financial
statements because of its relevance to the economic decision-making needs of users should not be
excluded merely on the ground that it may be too difficult for certain users to understand.
2. Relevance: To be useful, information must be relevant to the decision-making needs of users.
Information has the quality of relevance when it influences the economic decisions of users by helping
them evaluate past, present or future events or confirming, or correcting, their past evaluations.
The predictive and confirmatory roles of information are interrelated. For example, information about
the current level and structure of asset holdings has value to users when they endeavour to predict the
ability of the enterprise to take advantage of opportunities and its ability to react to adverse situations.
The same information plays a confirmatory role in respect of past predictions about, for example, the
way in which the enterprise would be structured or the outcome of planned operations.
Information about financial position and past performance is frequently used as the basis for predicting
future financial position and performance and other matters in which users are directly interested, such
as dividend and wage payments, share price movements and the ability of the enterprise to meet its
commitments as they fall due. To have predictive value, information need not be in the form of an
explicit forecast. The ability to make predictions from financial statements is enhanced, however, by the
manner in which information on past transactions and events is displayed. For example, the predictive
value of the statement of profit and loss is enhanced if unusual, abnormal and infrequent items of
income and expense are separately disclosed.
3. Reliability: To be useful, information must also be reliable, Information has the quality of reliability
when it is free from material error and bias and can be depended upon by users to represent faithfully
that which it either purports to represent or could reasonably be expected to represent.
Information may be relevant but so unreliable in nature or representation that its recognition may
be potentially misleading. For example, if the validity and amount of a claim for damages under a
legal action against the enterprise are highly uncertain, it may be inappropriate for the enterprise to
recognise the amount of the claim in the balance sheet, although it may be appropriate to disclose the
amount and circumstances of the claim.
4. Comparability: Users must be able to compare the financial statements of an enterprise through time
in order to identify trends in its financial position, performance and cash flows. Users must also be able
to compare the financial statements of different enterprises in order to evaluate their relative financial
position, performance and cash flows. Hence, the measurement and display of the financial effects of
like transactions and other events must be carried out in a consistent way throughout an enterprise and
over time for that enterprise and in a consistent way for different enterprises.
An important implication of the qualitative characteristic of comparability is that users be informed of
the accounting policies employed in the preparation of the financial statements, any changes in those
polices and the effects of such changes. Users need to be able to identify differences between the
accounting policies for like transactions and other events used by the same enterprise from period to
period and by different enterprises. Compliance with Accounting Standards, including the disclosure of
the accounting policies used by the enterprise, helps to achieve comparability.

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 THEORETICAL FRAMEWORK 1.37

The need for comparability should not be confused with mere uniformity and should not be allowed
to become an impediment to the introduction of improved accounting standards. It is not appropriate
for an enterprise to continue accounting in the same manner for a transaction or other event if the
policy adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also
inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and
reliable alternatives exist.
Users wish to compare the financial position, performance and cash flows of an enterprise over time.
Hence, it is important that the financial statements show corresponding information for the preceding
period(s).
The four principal qualitative characteristics are understandability, relevance, reliability and
comparability.
5. Materiality: The relevance of information is affected by its materiality. Information is material if its
misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users
taken on the basis of the financial information. Materiality depends on the size and nature of the item
or error, judged in the particular circumstances of its misstatement. Materiality provides a threshold or
cut-off point rather than being a primary qualitative characteristic which the information must have if
it is to be useful.
4. Faithful Representation: To be reliable, information must represent faithfully the transactions and
other events it either purports to represent or could reasonably be expected to represent. Thus, for
example, a balance sheet should represent faithfully the transactions and other events that result in
assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria.
Most financial information is subject to some risk of being less than a faithful representation of
that which it purports to portray. This is not due to bias, but rather to inherent difficulties either in
identifying the transactions and other events to be measured or in devising and applying measurement
and presentation techniques that can convey messages that correspond with those transactions and
events. In certain cases, the measurement of the financial effects of items could be so uncertain that
enterprises generally would not recognise them in the financial statements; for example, although
most enterprises generate goodwill internally over time, it is usually difficult to identify or measure that
goodwill reliably. In other cases, however, it may be relevant to recognise items and to disclose the risk
of error surrounding their recognition and measurement.
7. Substance Over Form: If information is to represent faithfully the transactions and other events that
it purports to represent, it is necessary that they are accounted for and presented in accordance with
their substance and economic reality and not merely their legal form. The substance of transactions
or other events is not always consistent with that which is apparent from their legal or contrived
form. For example, where rights and beneficial interest in an immovable property are transferred but
the documentations and legal formalities are pending, the recording of acquisition/disposal (by the
transferee and transferor respectively) would in substance represent the transaction entered into.
8. Neutrality: To be reliable, the information contained in financial statements must be neutral, that is,
free from bias. Financial statements are not neutral if, by the selection or presentation of information,
they influence the making of a decision or judgement in order to achieve a predetermined result or
outcome.
9. Prudence: The preparers of financial statements have to contend with the uncertainties that inevitably
surround many events and circumstances, such as the collectability of receivables, the probable useful
life of plant and machinery, and the warranty claims that may occur. Such uncertainties are recognised

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 1.38 PRINCIPLES AND PRACTICE OF ACCOUNTING

by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the
financial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgments
needed in making the estimates required under conditions of uncertainty, such that assets or income
are not overstated and liabilities or expenses are not understated. However, the exercise of prudence
does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate
understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because
the financial statements would then not be neutral and, therefore, not have the quality of reliability.
10. Full, fair and adequate disclosure: The financial statement must disclose all the reliable and relevant
information about the business enterprise to the management and also to their external users for
which they are meant, which in turn will help them to take a reasonable and rational decision. For it, it
is necessary that financial statements are prepared in conformity with generally accepted accounting
principles i.e the information is accounted for and presented in accordance with its substance and
economic reality and not merely with its legal form. The disclosure should be full and final so that users
can correctly assess the financial position of the enterprise.
The principle of full disclosure implies that nothing should be omitted while principle of fair disclosure
implies that all the transactions recorded should be accounted in a manner that financial statement
purports true and fair view of the results of the business of the enterprise and adequate disclosure
implies that the information influencing the decision of the users should be disclosed in detail and
should make sense.
This principle is widely used in corporate organizations because of separation in management and
ownership. The Companies Act in pursuant of this principle has came out with the format of balance
sheet and profit and loss account. The disclosures of all the major accounting policies and other
information are to be provided in the form of footnotes, annexures etc. The practice of appending
notes to the financial statements is the outcome of this principle.
11. Completeness: To be reliable, the information in financial statements must be complete within the
bounds of materiality and cost. An omission can cause information to be false or misleading and thus
unreliable and deficient in terms of its relevance.
Thus, if accounting information is to present faithfully the transactions and other events that it purports to
represent, it is necessary that they are accounted for and presented in accordance with their substance and
economic reality, not by their legal form. For example, if a business enterprise sells its assets to others but
still uses the assets as usual for the purpose of the business by making some arrangement with the seller,
it simply becomes a legal transaction. The economic reality is that the business is using the assets as usual
for deriving the benefit. Financial statement information should contain the substance of this transaction
and should not only record going by legality. In order to be reliable the financial statements information
should be neutral i.e., free from bias. The prepares of financial statements however, have to contend with
the uncertainties that inevitably surround many events and circumstances, such as the collectability of
doubtful receivables, the probable useful life of plant and equipment and the number of warranty claims
that many occur. Such uncertainties are recognised by the disclosure of their nature and extent and by
exercise of prudence in the preparation of financial statements. Prudence is the inclusion of a degree
of caution in the exercise of judgement needed in making the estimates required under condition of
uncertainty such that assets and income are not overstated and loss and liability are not understated.

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 THEORETICAL FRAMEWORK 1.39

SUMMARY
w Accounting concepts define the assumptions on the basis of which financial statements of a business
entity are prepared.
The following are the widely accepted accounting concepts:
(a) Entity concept (b) Money measurement concept
(c) Periodicity concept (d) Accrual concept
(e) Matching concept (f ) Going Concern concept
(g) Cost concept (h) Realisation concept
(i) Dual aspect concept (j) Conservatism
(k) Materiality
w Accounting principles are a body of doctrines commonly associated with the theory and procedures of
accounting serving as an explanation of current practices and as a guide for selection of conventions or
procedures where alternatives exist.”
w Accounting conventions emerge out of accounting practices, commonly known as accounting
principles, adopted by various organizations over a period of time.
w There are three fundamental accounting assumptions:
(i) Going Concern (ii) Consistency (iii) Accrual
w Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users. Understandability, Relevance, Reliability, Comparability, Materiality, Faithful
Representation, Substance over Form, Neutrality, Prudence, Full, fair and adequate disclosure and
Completeness are the important qualitative characteristics of the financial statements.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. (i) All the following items are classified as fundamental accounting assumptions except
(a) Consistency. (b) Business entity.
(c) Going concern.
(ii) Two primary qualitative characteristics of financial statements are
(a) Understandability and materiality. (b) Relevance and reliability.
(c) Neutrality and understandability.
(iii) Kanika Enterprises follows the written down value method of depreciating machinery year after
year due to
(a) Comparability. (b) Convenience.
(c) Consistency.

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 1.40 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iv) A purchased a car for ` 5,00,000, making a down payment of ` 1,00,000 and signing a ` 4,00,000 bill
payable due in 60 days. As a result of this transaction
(a) Total assets increased by ` 5,00,000.
(b) Total liabilities increased by ` 4,00,000.
(c) Total assets increased by ` 4,00,000 with corresponding increase in liabilities by ` 4,00,000.
(v) Mohan purchased goods for `15,00,000 and sold 4/5th of the goods amounting `18,00,000 and
met expenses amounting ` 2,50,000 during the year, 2015. He counted net profit as ` 3,50,000.
Which of the accounting concept was followed by him?
(a) Entity. (b) Periodicity.
(c) Matching.
(vi) A businessman purchased goods for ` 25,00,000 and sold 80% of such goods during the accounting
year ended 31st March, 2017. The market value of the remaining goods was ` 4,00,000. He valued
the closing Inventory at cost. He violated the concept of
(a) Money measurement. (b) Conservatism.
(c) Cost.
(vii) Capital brought in by the proprietor is an example of
(a) Increase in asset and increase in liability.
(b) Increase in liability and decrease in asset.
(c) Increase in asset and decrease in liability.
2. (i) Assets are held in the business for the purpose of
(a) Resale. (b) Conversion into cash.
(c) Earning revenue.
(ii) Revenue from sale of products, is generally, realized in the period in which
(a) Cash is collected. (b) Sale is made.
(c) Products are manufactured.
(iii) The concept of conservatism when applied to the balance sheet results in
(a) Understatement of assets. (b) Overstatement of assets.
(c) Overstatement of capital.
(iv) Decrease in the amount of trade payables results in
(a) Increase in cash. (b) Decrease in bank over draft account.
(c) Decrease in assets.

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 THEORETICAL FRAMEWORK 1.41

(v) The determination of expenses for an accounting period is based on the principle of
(a) Objectivity. (b) Materiality.
(c) Matching.
(vi) Economic life of an enterprise is split into the periodic interval to measure its performance is as per
(a) Entity. (b) Matching.
(c) Periodicity.
3. (i) If an individual asset is increased, there will be a corresponding
(a) Increase of another asset or increase of capital.
(b) Decrease of another asset or increase of liability.
(c) Decrease of specific liability or decrease of capital.
(ii) Purchase of machinery for cash
(a) Decreases total assets. (b) Increases total assets.
(c) Retains total assets unchanged.
(iii) Consider the following data pertaining to Alpha Ltd.:
Particulars
`
Cost of machinery purchased on 1st April, 2016 10,00,000
Installation charges 1,00,000
Market value as on 31st March, 2017 12,00,000
While finalizing the annual accounts, if the company values the machinery at ` 12,00,000. Which of
the following concepts is violated by the Alpha Ltd.?
(a) Cost. (b) Matching.
(c) Accrual.
Theoretical Questions
1. Write short notes on:
(i) Fundamental accounting assumptions.
(ii) Periodicity concept.
(iii) Accounting conventions.
2. Distinguish between:
(i) Money measurement concept and matching concept
(ii) Going concern and cost concept
3. Briefly explain the qualitative characteristics of the financial statements:

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 1.42 PRINCIPLES AND PRACTICE OF ACCOUNTING

ANSWERS / HINTS
Multiple Choice Questions

1.(i) (b) (ii) (b) (iii) (c) (iv) (c) (v) (c) (vi) (b)
(vii) (a) 2.(i) (c) (ii) (b) (iii) (a) (iv) (c) (v) (c)
(vi) (c) 3.(i) (b) (ii) (c) (iii) (a)

Theoretical Questions
1. (i) Fundamental accounting assumptions: There are three fundamental accounting assumptions:
Going Concern; Consistency and Accrual. If nothing has been written about the fundamental
accounting assumption in the financial statements then it is assumed that they have already been
followed in their preparation of financial statements.
(ii) Periodicity concept: According to this concept accounts should be prepared after every period &
not at the end of the life of the entity. For details, refer para 2.5.
(iii) Accounting conventions: Accounting conventions emerge out of accounting practices, commonly
known as accounting principles, adopted by various organizations over a period of time. For details,
refer para 2.4.
2. (i) Distinction between Money measurement concept and matching concept
As per Money Measurement concept, only those transactions, which can be measured in terms of
money are recorded. Since money is the medium of exchange and the standard of economic value,
this concept requires that those transactions alone that are capable of being measured in terms of
money be only to be recorded in the books of accounts. Transactions and events that cannot be
expressed in terms of money are not recorded in the business books.
In Matching concept, all expenses matched with the revenue of that period should only be taken
into consideration. In the financial statements of the organization if any revenue is recognized then
expenses related to earn that revenue should also be recognized.
(ii) Distinction between Going concern and cost concept
Going Concern Concept
The financial statements are normally prepared on the assumption that an enterprise is a going
concern and will continue in operation for the foreseeable future.
Cost Concept
By this concept, the value of an asset is to be determined on the basis of historical cost, in other
words, acquisition cost. For details refer para 2.5.
3. Qualitative characteristics are the attributes that make the information provided in financial statements
useful to users. For details, refer para 2.7.

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 THEORETICAL FRAMEWORK 1.43

UNIT 3 : ACCOUNTING TERMINOLOGY - GLOSSARY

LEARNING OUTCOMES
After studying this unit, you will be able to:

w Define basic accounting terms; and

w Understand the application of these accounting terms while recording transactions and events.

ACCOUNTING TERMINOLOGY - GLOSSARY

Acceptance
The drawee’s signed assent on bill of exchange, to the order of the drawer. This term is also used to describe
a bill of exchange that has been accepted.
Accounting policies
Accounting policies are the specific accounting principles and the methods of applying those principles
adopted by an enterprise in the preparation and presentation of financial statements.
Accrual
Recognition of revenues and costs as they are earned or incurred (and not as money is received or paid). It
includes recognition of transactions relating to assets and liabilities as they occur irrespective of the actual
receipts or payments.
Accrual/Mercantile Basis of Accounting
The method of recording transactions by which revenues, costs, assets and liabilities are reflected in the
accounts in the period in which they accrue. The ‘accrual basis of accounting’ includes considerations
relating to deferrals, allocations, depreciation and amortisation. This basis is also referred to as mercantile
basis of accounting.
Accrued Asset
A developing but not yet enforceable claim against another person which accumulates with the passage of
time or the rendering of service or otherwise. It may arise from the rendering of services (including the use
of money) which at the date of accounting have been partly performed, and are not yet billable.
Accrued Expense
An expense which has been incurred in an accounting period but for which no enforceable claim has
become due in that period against the enterprise. It may arise from the purchase of services (including the
use of money) which at the date of accounting have been only partly performed, and are not yet billable.
Accrued Liability
A developing but not yet enforceable claim by another person which accumulates with the passage of time
or the receipt of service or otherwise. It may arise from the purchase of services (including the use of money)
which at the date of accounting have.

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 1.44 PRINCIPLES AND PRACTICE OF ACCOUNTING

Accrued Revenue
Revenue which has been earned in an accounting period but in respect of which no enforceable claim has
become due in that period by the enterprise. It may arise from the rendering of services (including the use
of money) which at the date of accounting have been partly performed, and are not yet billable.
Accumulated Depletion
The total to date of the periodic depletion charges on wasting assets.
Accumulated Depreciation
The total to date of the periodic depreciation charges on depreciable assets.
Advance
Payment made on account of, but before completion of, a contract, or before acquisition of goods or receipt
of services.
Amortised Value
The amortizable amount less any portion already provided by way of amortization.
Annual Report
The information provided annually by the management of an enterprise to the owners and other interested
persons concerning its operations and financial position. It includes the information statutorily required,
e.g., in the case of a company, the balance sheet, profit and loss statement and notes on accounts, the auditor’s
report thereon, and the report of the Board of Directors. It also includes other information voluntarily
provided e.g., value added statement, graphs, charts, etc.
Appropriation Account
An account sometimes included as a separate section of the profit and loss statement showing application of
profits towards dividends, reserves, etc.
Assets
Tangible objects or intangible rights owned by an enterprise and carrying probable future benefits.
Authorised Share Capital
The number and par value, of each class of shares that an enterprise may issue in accordance with its
instrument of incorporation. This is sometimes referred to as nominal share capital.
Average Cost
The cost of an item at a point of time as determined by applying an average of the cost of all items of the
same nature over a period. When weightages are also applied in the computation, it is termed as weighted
average cost.
Bad Debts
Debts owed to an enterprise which are considered to be irrecoverable.
Balance Sheet
A statement of the financial position of an enterprise as at a given date, which exhibits its assets, liabilities,
capital, reserves and other account balances at their respective book values.

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 THEORETICAL FRAMEWORK 1.45

Bill of Exchange
An instrument in writing containing an unconditional order, signed by the maker, directing a certain person
to pay a certain sum of money only, to or to the order of a certain person or to the bearer of the instrument.
Bonus Shares
Shares allotted by capitalization of the reserves or surplus of a corporate enterprise.
Book Value
The amount at which an item appears in the books of account or financial statements. It does not refer to
any particular basis on which the amount is determined e.g., cost, replacement value, etc.
Borrowing costs
Borrowing costs are interest and other costs incurred by an enterprise in connection with the borrowing of
funds.
Bond/Debenture
A formal document constituting acknowledgment of a debt by an enterprise usually given under its common
seal and normally containing provisions regarding payment of interest, repayment of principal and security,
if any. It is transferable in the appropriate manner.
Call
A demand pursuant to terms of issue to pay a part or whole of the balance remaining payable on shares or
debentures after allotment.
Called-up Share Capital
That part of the subscribed share capital which shareholders have been required to pay.
Capital
Generally refers to the amount invested in an enterprise by its owners e.g. paid-up share capital in a corporate
enterprise. It is also used to refer to the interest of owners in the assets of an enterprise.
Capital Assets
Assets, including investments not held for sale, conversion or consumption in the ordinary course of business.
Capital Commitment
Future liability for capital expenditure in respect of which contracts have been made.
Capital Employed
The finances deployed by an enterprise in its net fixed assets, investments and working capital. Capital
employed in an operation may, however, exclude investments made outside that operation.
Capital Profit/Capital Loss
Excess of the proceeds realised from the sale, transfer, or exchange of the whole or a part of a capital asset
over its cost. When the result of this computation is negative, it is referred to as capital loss.
Capital Reserve
A reserve of a corporate enterprise which is not available for distribution as dividend.

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 1.46 PRINCIPLES AND PRACTICE OF ACCOUNTING

Capital Work-in-progress
Expenditure on capital assets which are in the process of construction or completion.
Cash
Cash comprises cash on hand and demand deposits with banks
Cash equivalents
Cash equivalents are short term, highly liquid investments that are readily convertible into known amounts
of cash and which are subject to an insignificant risk of changes in value.
Cash Basis of Accounting
The method of recording transactions by which revenues and costs and assets and liabilities are reflected in
the accounts in the period in which actual receipts or actual payments are made.
Cash Discount
A reduction granted by a supplier from the invoiced price in consideration of immediate payment or
payment within a stipulated period.
Cash Profit
The net profit as increased by non-cash costs, such as depreciation, amortization, etc. When the result of the
computation is negative, it is termed as cash loss.
Carrying amount
Carrying amount is the amount at which an asset is recognized in the balance sheet, net of any accumulated
amortization and accumulated impairment losses thereon.
Charge
An encumbrance on an asset to secure an indebtedness or other obligations. It may be fixed or floating.
Cheque
A bill of exchange drawn upon a specified banker and not expressed to be payable otherwise than on
demand.
Collateral Security
Security which is given in addition to the principal security against the same liability or obligation.
Costs of disposal
Costs of disposal are incremental costs directly attributable to the disposal of an asset, excluding finance
costs and income tax expense.
Contingency
A contingency is a condition or situation, the ultimate outcome of which, gain or loss, will be known or
determined only on the occurrence, or non-occurrence, of one or more uncertain future events.
Contingent Asset
An asset the existence, ownership or value of which may be known or determined only on the occurrence

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 THEORETICAL FRAMEWORK 1.47

or non-occurrence of one or more uncertain future events.

Contingent Liability
An obligation relating to an existing condition or situation which may arise in future depending on the
occurrence or non-occurrence of one or more uncertain future events.
Contra Account
One or two or more accounts which partially or wholly off-set another or other accounts.
Cost
The amount of expenditure incurred on or attributable to a specified article, product or activity.
Cost of Purchase
The purchase price including duties and taxes, freight inwards and other expenditure directly attributable to
acquisition, less trade discounts, rebates, duty drawbacks, and subsidies in respect of such purchase.
Cost of Goods Sold
The cost of goods sold during an accounting period. In manufacturing operations, it includes (i) cost of
materials; (ii) labour and factory overheads; selling and administrative expenses are normally excluded.
Conversion Cost
Cost incurred to convert raw materials or components into finished or semi-finished products. This normally
includes costs which are specifically attributable to units of production, i.e., direct labour, direct expenses
and subcontracted work, and production overheads as applicable in accordance with either the direct cost or
absorption costing method. Production overheads exclude expenses which relate to general administration,
finance, selling and distribution.
Convertible Debenture
A debenture which gives the holder a right to its conversion, wholly or partly, in shares in accordance with
the terms of issue.
Cumulative Dividend
A dividend payable on cumulative preference shares which, if unpaid, accumulates as a claim against the
earnings of a corporate enterprise, before any distribution is made to the other shareholders.
Cumulative Preference Shares
A class of preference shares entitled to payment of cumulative dividends. Preference shares are always
deemed to be cumulative, unless they are expressly made non-cumulative.
Current Assets
Cash and other assets that are expected to be converted into cash or consumed in the production of goods
or rendering of services in the normal course of business.
Current Liability
Liability including loans, deposits and bank overdraft which falls due for payment in a relatively short period,
normally not more than twelve months.

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 1.48 PRINCIPLES AND PRACTICE OF ACCOUNTING

Deferral
Postponement of recognition of a revenue or expense after its related receipt or payment (or incurrence of a
liability) to a subsequent period to which it applies. Common examples of deferrals include prepaid rent and
taxes, unearned subscriptions received in advance by newspapers and magazine selling companies, etc.
Deficiency
The excess of liabilities over assets of an enterprise at a given date. The debit balance in the profit and loss
statement.
Deficit
The debit balance in the profit and loss statement.
Depletion
A measure of exhaustion of a wasting asset represented by periodic write off of cost or other substituted
value.
Depreciation
Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset
arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation
is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during
the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is
predetermined.
Depreciable amount
Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical
cost in the financial statements, less the estimated residual value.
Depreciable assets
Depreciable assets are assets which
(i) are expected to be used during more than one accounting period; and
(ii) have a limited useful life; and
(iii) are held by an enterprise for use in the production or supply of goods and services, for rental to others,
or for administrative purposes and not for the purpose of sale in the ordinary course of business.
Depreciation Method
Any method of calculating depreciation for an accounting period.
Depreciation Rate
A percentage applied to the historical cost or the substituted amount of a depreciable asset (or in case of
diminishing balance method, the historical cost or the substituted amount less accumulated depreciation).
Diminishing Balance Method
A method under which the periodic charge for depreciation of an asset is computed by applying a fixed
percentage to its historical cost or substituted amount less accumulated depreciation (net book value). This
is also referred to as written down value method.

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 THEORETICAL FRAMEWORK 1.49

Discount
A reduction from a list price, quoted price or invoiced price. It also refers to the price for obtaining payment
on a bill before its maturity.
Dividend
A distribution to shareholders out of profits or reserves available for this purpose.
Entity Concept
The view of the relationship between the accounting entity and its owners which regards the entity as a
separate person, distinct and apart from its owners.
Equity Share
A share which is not a preference share. Also sometimes called ordinary share.
Exchange difference
Exchange difference is the difference resulting from reporting the same number of units of a foreign currency
in the reporting currency at different exchange rates.
Expenditure
Incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods
or services.
Expense
A cost relating to the operations of an accounting period or to the revenue earned during the period or the
benefits of which do not extend beyond that period.
Expired Cost
That portion of an expenditure from which no further benefit is expected. Also termed as expense.
Extraordinary items
Extraordinary items are income or expenses that arise from events or transactions that are clearly distinct
from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly.
Fair value
Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable,
willing parties in an arm’s length transaction.
Fair Market Value
The price that would be agreed to in an open and unrestricted market between knowledgeable and willing
parties dealing at arm’s length who are fully informed and are not under any compulsion to transact.
First Charge
A charge having priority over other charges.
First In, First Out (FIFO)
Computation of the cost of items sold or consumed during a period as though they were sold or consumed
in order of their acquisition.

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 1.50 PRINCIPLES AND PRACTICE OF ACCOUNTING

Fixed asset
Asset held with the intention of being used for the purpose of producing or providing goods or services and
is not held for sale in the normal course of business.
Fixed Cost
That cost of production which by its very nature remains relatively unaffected in a defined period of time by
variations in the volume of production.
Fixed Deposit
Deposit for a specified period and at specified rate of interest.
Fixed or Specific Charge
A charge which attaches to a particular asset which is identified when the charge is created, and the identity
of the asset does not change during the subsistence of the charge.
Floating Charge
A general charge on some or all assets of an enterprise which are not attached to specific assets and are
given as security against a debt.
Financial Instrument
A financial instrument is any contract that gives rise to both a financial asset of one enterprise and a financial
liability or equity shares of another enterprise.
Foreign currency
Foreign currency is a currency other than the reporting currency of an enterprise.
Forfeited Share
A share to which title is lost by a member for non-payment of call money or default in fulfilling any
engagement between members or expulsion of members where the articles specifically provide therefor.
Free Reserve
A reserve the utilization of which is not restricted in any manner.
Functional Classification
A system of classification of expenses and revenues and the corresponding assets and liabilities to each
function or activity, rather than by reference to their nature.
Fund
An account usually of the nature of a reserve or a provision which is represented by specifically earmarked
assets.
Fundamental Accounting Assumptions
Basic accounting assumptions which underlie the preparation and presentation of financial statements.
They are going concern, consistency and accrual. Usually, they are not specifically stated because their
acceptance and use are assumed. Disclosure is necessary if they are not followed.
Gain
A monetary benefit, profit or advantage resulting from a transaction or group of transactions.

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 THEORETICAL FRAMEWORK 1.51

General Reserve
A revenue reserve which is not earmarked for a specific purpose.
Going Concern Assumption
An accounting assumption according to which an enterprise is viewed as continuing in operation for the
foreseeable future. It is assumed that the enterprise has neither the intention nor the necessity of liquidation
or of curtailing materially the scale of its operations.
Goodwill
An intangible asset arising from business connections or trade name or reputation of an enterprise.
Gross Margin or Gross Profit
The excess of the proceeds of goods sold and services rendered during a period over their cost, before
taking into account administration, selling, distribution and financing expenses. When the result of this
computation is negative it is referred to as gross loss.
Government
Government refers to government, government agencies and similar bodies whether local, national or
international.
Government grants
Government grants are assistance by government in cash or kind to an enterprise for past or future compliance
with certain conditions. They exclude those forms of government assistance which cannot reasonably have
a value placed upon them and transactions with government which cannot be distinguished from the
normal trading transactions of the enterprise.
Gross book value
Gross book value of a fixed asset is its historical cost or other amount substituted for historical cost in the
books of account or financial statements. When this amount is shown net of accumulated depreciation, it is
termed as net book value.
Income and Expenditure Statement
A financial statement, often prepared by non-profit making enterprises like clubs, associations etc. to present
their revenues and expenses for an accounting period and to show the excess of revenues over expenses (or
vice versa) for that period. It is similar to profit and loss statement and is also called revenue and expense
statement.
Intangible Asset
Asset which does not have a physical identity e.g. goodwill, patents, copyright etc.
Inventories are assets:
(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the rendering of
services.

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 1.52 PRINCIPLES AND PRACTICE OF ACCOUNTING

Investment
Expenditure on assets held to earn interest, income, profit or other benefits.
Investments
Assets held not for operational purposes or for rendering services i.e. assets other than fixed assets or current
assets (e.g. securities, shares, debentures, immovable properties).
Issued Share Capital
That portion of the authorized share capital which has actually been offered for subscription. This includes
any bonus shares allotted by the corporate enterprise.
Joint venture
A joint venture is a contractual arrangement whereby two or more parties undertake an economic activity,
which is subject to joint control.
Last In, First Out (LIFO)
Computation of the cost of items sold or consumed during a period on the basis that the items last acquired
were sold or consumed first.
Liability
The financial obligation of an enterprise other than owners’ funds.
Lien
Right of one person to satisfy a claim against another by holding or retaining possession of that other’s
assets/property.
Long-term Liability
Liability which does not fall due for payment in a relatively short period, i.e., normally a period not more than
twelve months.
Lease
A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of
payments the right to use an asset for an agreed period of time.
Materiality
An accounting concept according to which all relatively important and relevant items, i.e., items the
knowledge of which might influence the decisions of the user of the financial statements are disclosed in
the financial statements.
Mortgage
A transfer of interest in specific immovable property for the purpose of securing a loan advanced, or to
be advanced, an existing or future debt or the performance of an engagement which may give rise to a
pecuniary liability. The security is redeemed when the loan is repaid or the debt discharged or the obligations
performed.
Net Assets/Shareholders’ funds/Net Worth
The excess of the book value of assets (other than fictitious assets) of an enterprise over its liabilities. This is
also referred to as net worth or shareholders’ funds.

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Net Fixed Assets

Fixed assets less accumulated depreciation thereon up-to-date.
Net Profit/Net loss
The excess of revenue over expenses during a particular accounting period. When the result of this
computation is negative, it is referred to as net loss. The net profit may be shown before or after tax.
Net realizable value
Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs
of completion and the estimated costs necessary to make the sale.
Obsolescence
Diminution in the value of an asset by reason of its becoming out-of date or less useful due to technological
changes, improvement in production methods, change in market demand for the product or service output
of the asset, or legal or other restrictions.
Operating Profit
The net profit arising from the normal operations and activities of an enterprise without taking account of
extraneous transactions and expenses of a purely financial nature.
Paid-up Share Capital
That part of the subscribed share capital for which consideration in cash or otherwise has been received. This
includes bonus shares allotted by the corporate enterprise.
Preference Share Capital
That part of the share capital of a corporate enterprise which enjoys preferential rights in respect of payments
of fixed dividend and repayment of capital. Preference shares may also have full or partial participating rights
in surplus profits or surplus capital.
Preliminary Expenses
Expenses relating to the formation of an enterprise. These include legal, accounting and share issue expenses
incurred for formation of the enterprise.
Prepaid Expense
Payment for expense in an accounting period, the benefit for which will accrue in the subsequent accounting
period(s).
Prime Cost
The total cost of direct materials, direct wages and other direct production expenses.
Prior Period Item
Prior period items are income or expenses which arise in the current period as a result of errors or omissions
in the preparation of the financial statements of one or more prior periods.
Profit/Loss
A general term for the excess of revenue over related cost. When the result of this computation is negative it
is referred to as loss.

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 1.54 PRINCIPLES AND PRACTICE OF ACCOUNTING

Profit and Loss Account

A financial statement which presents the revenues and expenses of an enterprise for an accounting period
and shows the excess of revenues over expenses (or vice versa). It is also known as profit and loss account.
Promissory Note
An instrument in writing (not being a bank note or currency note) containing an unconditional undertaking,
signed by the maker, to pay a certain sum of money only to, or to the order of, a certain person or to the
bearer of the instrument.
Provision
An amount written off or retained by way of providing for depreciation or diminution in value of assets
or retained by way of providing for any known liability the amount of which cannot be determined with
substantial accuracy.
Provision for Doubtful Debts
A provision made for debts considered doubtful of recovery.
Prudence
A concept of care and caution used in accounting according to which (in view of the uncertainty attached to
future events) profits are not anticipated, but recognised only when realised, though not necessarily in cash.
Under this concept, provision is made for all known liabilities and losses, even though the amount cannot be
determined with certainty and represents only a best estimate in the light of available information.
Redeemable Preference Share
The preference share that is repayable either after a fixed or determinable period or at any time decided
by the management (by giving due notice), under certain conditions prescribed by the instrument of
incorporation or the terms of issue.
Redemption
Repayment as per given terms normally used in connection with preference shares and debentures.
Reserve
The portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated
by the management for a general or a specific purpose other than a provision for depreciation or diminution
in the value of assets or for a known liability. The reserves are primarily of two types: capital reserves and
revenue reserves.
Revaluation Reserve
A reserve created on the revaluation of assets or net assets of an enterprise represented by the surplus of the
estimated replacement cost or estimated market values over the book values thereof.
Residual value
Residual value is the amount which an enterprise expects to obtain for an asset at the end of its useful life
after deducting the expected costs of disposal.
Revenue/Income
Revenue is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary
activities of an enterprise from the sale of goods, from the rendering of services, and from the use by others

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 THEORETICAL FRAMEWORK 1.55

of enterprise resources yielding interest, royalties and dividends. Revenue is measured by the charges
made to customers or clients for goods supplied and services rendered to them and by the charges and
rewards arising from the use of resources by them. In an agency relationship, the revenue is the amount of
commission and not the gross inflow of cash, receivables or other consideration.
Revenue Reserve
Any reserve other than a capital reserve.
Right Share
An allotment of shares on the issue of fresh capital by a corporate enterprise to which a shareholder is
entitled on payment, by virtue of his holding certain shares in the enterprise in proportion to the number of
shares already held by him. (Shares allotted to certain categories of debenture holders pursuant to the rights
enjoyed by them are sometimes called right shares)
Sales Turnover/Gross Turnover/Gross Sales
The aggregate amount for which sales are effected or services rendered by an enterprise. The terms gross
turnover and net turnover (or gross sales and net sales) are sometimes used to distinguish the sales
aggregate before and after deduction of returns and trade discounts.
Secured Loan
Loan secured wholly or partly against an asset.
Share Capital
Aggregate amount of money paid or credited as paid on the shares and/ or stocks of a corporate enterprise.
Share Discount
The excess of the face value of shares over their issue price.
Shareholders’ Equity
The interest of the shareholders in the net assets of a corporate enterprise. However, in the case of liquidation
it is represented by the residual assets after meeting prior claims.
Share Issue Expenses
Costs incurred in connection with the issue and allotment of shares. These include legal and professional
fees, advertising expenses, printing costs, underwriting commission, brokerage, and also expenses in
connection with the issue of prospectus and allotment of shares.
Share warrants
Share warrants or options are financial instruments that give the holder the right to acquire equity shares.
Securities Premium
The excess of the issue price of shares over their face value.
Sinking Fund
A fund created for the repayment of a liability or for the replacement of an asset.
Straight Line Method
The method under which the periodic charge for depreciation is computed by dividing the depreciable
amount of a depreciable asset by the estimated number of years of its useful life.

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 1.56 PRINCIPLES AND PRACTICE OF ACCOUNTING

Subscribed Share Capital

That portion of the issued share capital which has actually been subscribed and allotted. This includes any
bonus shares allotted by the corporate enterprise.
Substance over Form
An accounting concept according to which the substance and not merely the legal form of transactions and
events governs their accounting treatment and presentation in financial statements.
Sundry Creditors / Trade Creditors/Trade payables
Amount owed by an enterprise on account of goods purchased or services received or in respect of
contractual obligations. Also termed as trade creditors or account payables or Trade payables.
Sundry Debtors / Trade Debtors/ Trade Receivables
Person from whom amounts are due for goods sold or services rendered or in respect of contractual
obligations. Also termed as debtors, trade debtors, account receivables, trade receivables.
Surplus
Credit balance in the profit and loss statement after providing for proposed appropriations, e.g., dividend or
reserves.
Trade Discount
A reduction granted by a supplier from the list price of goods or services on business considerations other
than for prompt payment.
Unexpired Cost
That portion of an expenditure whose benefit has not yet been exhausted.
Unissued Share Capital
That portion of the authorised share capital for which shares have not been offered for subscription.
Unpaid Dividend
Dividend which has been declared by a corporate enterprise but has not been paid, or the warrant or cheque
in respect whereof has not been dispatched within the prescribed period.
Useful life
Useful life is either (i) the period over which a depreciable asset is expected to be used by the enterprise;
or (ii) the number of production or similar units expected to be obtained from the use of the asset by the
enterprise

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 THEORETICAL FRAMEWORK 1.57

TEST YOUR KNOWLEDGE

QUESTION
Define following terms:
1. Accrual Basis of Accounting
2. Amortisation
3. Contingent Asset
4. Contingent Liability
ANSWER
1. Accrual Basis of Accounting
The method of recording transactions by which revenues, costs, assets and liabilities are reflected in the
accounts in the period in which they accrue.

2. Amortisation
The gradual and systematic writing off of an asset or an account over an appropriate period.

3. Contingent Asset
An asset the existence, ownership or value of which may be known or determined only on the occurrence
or non-occurrence of one or more uncertain future events.

4. Contingent Liability
An obligation relating to an existing condition or situation which may arise in future depending on the
occurrence or non-occurrence of one or more uncertain future events.

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 1.58 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 4 : CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Learn the criteria for identifying Revenue Expenditure and distinguishing from Capital Expenditure
w Learn the distinction between capital and revenue receipts.
w Understand the linkage of such distinction with the preparation of final accounts.

• Payments
Capital • Receipts

UNIT OVERVIEW

• Payments
Revenue • Receipts

4.1 INTRODUCTION
Accounting aims in ascertaining and presenting the results of the business for an accounting period. For
ascertaining the periodical business results, the nature of transactions should be analyzed whether they are
of capital or revenue nature. The Revenue Expense relates to the operations of the business of an accounting
period or to the revenue earned during the period or the items of expenditure, benefits of which do not
extend beyond that period. Capital Expenditure, on the other hand, generates enduring benefits and helps
in revenue generation over more than one accounting period. Revenue Expenses must be associated with
a physical activity of the entity. Therefore, whereas production and sales generate revenue in the earning
process, use of goods and services in support of those functions causes expenses to occur. Expenses are
recognised in the Profit & Loss Account through matching principal which tells us when and how much of
the expenses to be charged against revenue. A part of the expenditure can be capitalised only when these
can be traced directly to definable streams of future benefits.
The distinction of transaction into revenue and capital is done for the purpose of placing them in Profit
and Loss account or in the Balance Sheet. For example: revenue expenditures are shown in the profit and
loss account as their benefits are for one accounting period i.e. in which they are incurred while capital
expenditures are placed on the asset side of the balance sheet as they will generate benefits for more than
one accounting period and will be transferred to profit and loss account of the year on the basis of utilisation
of that benefit in particular accounting year. Hence, both capital and revenue expenditures are ultimately
transferred to profit and loss account.

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 THEORETICAL FRAMEWORK 1.59

Revenue expenditures are transferred to profit and loss account in the year of spending while capital
expenditures are transferred to profit and loss account of the year in which their benefits are utilised.
Therefore we can conclude that it is the time factor, which is the main determinant for transferring the
expenditure to profit and loss account. Also expenses are recognized in profit and loss account through
matching concept which tells us when and how much of the expenses to be charged against revenue.
However, distinction between capital and revenue creates a considerable difficulty. In many cases borderline
between the two is very thin.

4.2 CONSIDERATIONS IN DETERMINING CAPITAL AND REVENUE

EXPENDITURES
The basic considerations in distinction between capital and revenue expenditures are:
(a) Nature of business: For a trader dealing in furniture, purchase of furniture is revenue expenditure but
for any other trade, the purchase of furniture should be treated as capital expenditure and shown in
the balance sheet as asset. Therefore, the nature of business is a very important criteria in separating an
expenditure between capital and revenue.
(b) Recurring nature of expenditure: If the frequency of an expense is quite often in an accounting year
then it is said to be an expenditure of revenue nature while non-recurring expenditure is infrequent in
nature and do not occur often in an accounting year. Monthly salary or rent is the example of revenue
expenditure as they are incurred every month while purchase of assets is not the transaction done
regularly therefore, classified as capital expenditure unless materiality criteria defines it as revenue
expenditure.
(c) Purpose of expenses: Expenses for repairs of machine may be incurred in course of normal maintenance
of the asset. Such expenses are revenue in nature. On the other hand, expenditure incurred for major
repair of the asset so as to increase its productive capacity is capital in nature. However, determination
of the cost of maintenance and ordinary repairs which should be expensed, as opposed to a cost which
ought to be capitalised, is not always simple.
(d) Effect on revenue generating capacity of business: The expenses which help to generate income/
revenue in the current period are revenue in nature and should be matched against the revenue earned
in the current period. On the other hand, if expenditure helps to generate revenue over more than one
accounting period, it is generally called capital expenditure.
When expenditure on improvements and repair of a fixed asset is done, it has to be charged to Profit
and Loss Account if the expected future benefits from fixed assets do not change, and it will be included
in book value of fixed asset, where the expected future benefits from assets increase.
(e) Materiality of the amount involved: Relative proportion of the amount involved is another important
consideration in distinction between revenue and capital.

4.3 CAPITAL EXPENDITURES AND REVENUE EXPENDITURES

As we have already discussed, capital expenditure contributes to the revenue earning capacity of a business
over more than one accounting period whereas revenue expense is incurred to generate revenue for a
particular accounting period. The revenue expenses either occur in direct relation with the revenue or in
relation with accounting periods, for example cost of goods sold, salaries, rent, etc. Cost of goods sold
is directly related to sales revenue whereas rent is related to the particular accounting period. Capital

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 1.60 PRINCIPLES AND PRACTICE OF ACCOUNTING

expenditure may represent acquisition of any tangible or intangible fixed assets for enduring future benefits.
Therefore, the benefits arising out of capital expenditure last for more than one accounting period whereas
those arising out of revenue expenses expire in the same accounting period.

? ILLUSTRATION 1
State with reasons whether the following statements are ‘True’ or ‘False’.
(1) Overhaul expenses of second-hand machinery purchased are Revenue Expenditure.
(2) Money spent to reduce working expenses is Revenue Expenditure.
(3) Legal fees to acquire property is Capital Expenditure.
(4) Amount spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the plaintiff ’s
land is Capital Expenditure.
(5) Amount spent for replacement of worn out part of machine is Capital Expenditure.
(6) Expense incurred on the repairs and white washing for the first time on purchase of an old building are
Revenue Expenses.
(7) Expenses in connection with obtaining a license for running the cinema is Capital Expenditure.
(8) Amount spent for the construction of temporary huts, which were necessary for construction of the Cinema
House and were demolished when the cinema house was ready, is Capital Expenditure.

 SOLUTION
(1) False: Overhaul expenses are incurred to put second-hand machinery in working condition to derive
endurable long-term advantage. So it should be capitalised.
(2) False: It may be reasonably presumed that money spent for reducing revenue expenditure would have
generated long-term benefits to the entity. It becomes part of intangible fixed assets if it is in the form
of technical know-how and tangible fixed assets if it is in the form of additional replacement of any of
the existing tangible fixed assets. So this is capital expenditure.
(3) True: Legal fee paid to acquire any property is part of the cost of that property. It is incurred to possess
the ownership right of the property and hence a capital expenditure.
(4) False: Legal expenses incurred to defend a suit claiming that the firm’s factory site belongs to the
plaintiff is maintenance expenditure of the asset. By this expense, neither any endurable benefit can
be obtained in future in addition to that what is presently available nor the capacity of the asset will be
increased. Maintenance expenditure in relation to an asset is revenue expenditure.
(5) False: Amount spent for replacement of any worn out part of a machine is revenue expense since it is
part of its maintenance cost.
(6) False: Repairing and white washing expenses for the first time of an old building are incurred to put the
building in usable condition. These are the part of the cost of building. Accordingly, these are capital
expenditure.
(7) True: The Cinema Hall could not be started without license. Expenditure incurred to obtain the license
is pre-operative expense which is capitalised. Such expenses are amortised over a period of time.
(8) True: Cost of temporary huts constructed which were necessary for the construction of the cinema
house is part of the construction cost of the cinema house. Therefore such costs are to be capitalised.

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 THEORETICAL FRAMEWORK 1.61

? ILLUSTRATION 2
State with reasons whether the following are Capital or Revenue Expenditure:
(1) Expenses incurred in connection with obtaining a license for starting the factory for ` 10,000.
(2) ` 1,000 paid for removal of Inventory to a new site.
(3) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get fuel efficiency.
(4) Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) ` 8,000 for installing telephone in the office.
(5) A factory shed was constructed at a cost of ` 1,00,000. A sum of ` 5,000 had been incurred in the construction
of temporary huts for storing building material.

 SOLUTION
(1) Money paid ` 10,000 for obtaining license to start a factory is a capital expenditure. This is an item of
expenditure incurred to acquire the right to carry on business.
(2) ` 1,000 paid for removal of Inventory to a new site is revenue expenditure. This is neither bringing
enduring benefit nor enhancing the value of the asset.
(3) ` 5,000 spent in changing Rings and Pistons of an engine to get fuel efficiency is capital expenditure.
This is an expenditure on improvement of a fixed asset. It results in increasing profit-earning capacity of
the business by cost reduction.
(4) Money deposited with MTNL for installation of telephone in office is not expenditure. This is treated as
an asset and the same is adjusted over a period of time against actual telephone bills.
(5) Cost of construction of building including cost of temporary huts is capital expenditure. Building is
fixed asset which will generate enduring benefit to the business over more than one accounting period.
Construction of temporary huts is incidental to the main construction. Such cost is also capitalised with
the cost of building.

4.4 CAPITAL RECEIPTS AND REVENUE RECEIPTS

Just as a clear distinction between Capital and Revenue expenditure is necessary, in the same manner
capital receipts must be distinguished from revenue receipts.
Receipts which are obtained in course of normal business activities are revenue receipts (e.g. receipts
from sale of goods or services, interest income etc.). On the other hand, receipts which are not revenue in
nature are capital receipts (e.g. receipts from sale of fixed assets or investments, secured or unsecured loans,
owners’ contributions etc.). Revenue and capital receipts are recognised on accrual basis as soon as the right
of receipt is established. Revenue receipts should not be equated with the actual cash receipts. Revenue
receipts are credited to the Profit and Loss Account.
On the other hand, Capital receipts are not directly credited to Profit and Loss Account. For example, when
a fixed asset is sold for ` 92,000 (cost ` 90,000), the capital receipts ` 92,000 is not credited to Profit and Loss
Account. Profit/Loss on sale of fixed assets is calculated and credited to Profit and Loss Account as follows:

Sale Proceeds ` 92,000

Cost (` 90,000)
Profit ` 2,000

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 1.62 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 3

Good Pictures Ltd., constructs a cinema house and incurs the following expenditure during the first year ending
31st March, 2016.
(i) Second-hand furniture worth ` 9,000 was purchased; repainting of the furniture costs ` 1,000. The furniture
was installed by own workmen, wages for this being ` 200.
(ii) Expenses in connection with obtaining a license for running the cinema worth ` 20,000. During the course
of the year the cinema company was fined ` 1,000, for contravening rules. Renewal fee ` 2,000 for next year
also paid.
(iii) Fire insurance, ` 1,000 was paid on 1st October, 2015 for one year.
(iv) Temporary huts were constructed costing ` 1,200. They were necessary for the construction of the cinema.
They were demolished when the cinema was ready.
Point out how you would classify the above items.

 SOLUTION
1. The total cost of the furniture should be treated as ` 10,200 i.e., all the amounts mentioned should be
capitalised since without such expenditure the furniture would not be available for use. If ` 1,000 and `
200 have been respectively debited to the Repairs Account and the Wages Account, these accounts will
be credited to the Furniture Account.
2. License for running the cinema house is necessary, hence its cost should be capitalised. But the fine of `
1,000 is revenue expenditure. The renewal fee for the next year is also revenue expenditure but pertains
to the next year; hence, it is a prepaid expense.
3. Half of the insurance premium pertains to the year beginning on 1st April, 2016. Hence such amount
should be treated as prepaid expense. The remaining amount is revenue expense for the current year.
4. Since the temporary huts were necessary for the construction, their cost should be added to the cost of
the cinema hall and thus capitalised.

? ILLUSTRATION 4

State with reasons, how you would classify the following items of expenditure:
1. Overhauling expenses of ` 25,000 for the engine of a motor car to get better fuel efficiency.
2. Inauguration expenses of ` 25 lacs incurred on the opening of a new manufacturing unit in an existing
business.
3. Compensation of ` 2.5 crores paid to workers, who opted for voluntary retirement.

 SOLUTION
1. Overhauling expenses are incurred for the engine of a motor car to derive better fuel efficiency. These
expenses will reduce the running cost in future and thus the benefit is in form of endurable long-term
advantage. So this expenditure should be capitalised.

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 THEORETICAL FRAMEWORK 1.63

2. Inauguration expenses incurred on the opening of a new unit may help to explore more customers This
expenditure is in the nature of revenue expenditure, as the expenditure may not generate any enduring
benefit to the business over more than one accounting period.
3. The amount paid to workers on voluntary retirement is in the nature of revenue expenditure. Since the
magnitude of the amount of expenditure is very significant, it may be better to defer it over future years.

? ILLUSTRATION 5

Classify the following expenditures and receipts as capital or revenue:

(i) ` 10,000 spent as travelling expenses of the directors on trips abroad for purchase of capital assets.
(ii) Amount received from Trade receivables during the year.
(iii) Amount spent on demolition of building to construct a bigger building on the same site.
(iv) Insurance claim received on account of a machinery damaged by fire.

 SOLUTION
(i) Capital expenditure.
(ii) Revenue receipt.
(iii) Capital expenditure.
(iv) Capital receipt.

? ILLUSTRATION 6

Are the following expenditures capital in nature?

(i) M/s ABC & Co. run a restaurant. They renovate some of the old cabins. Because of this renovation some space
was made free and number of cabins was increased from 10 to 13. The total expenditure was ` 20,000.
(ii) M/s New Delhi Financing Co. sold certain goods on installment payment basis. Five customers did not pay
installments. To recover such outstanding installments, the firm spent ` 10,000 on account of legal expenses.
(iii) M/s Ballav & Co. of Delhi purchased a machinery from M/s Shah & Co. of Ahmedabad. M/s Ballav & Co. spent
` 40,000 for transportation of such machinery. The year ending is 31st Dec, 2015.

 SOLUTION
(i) Renovation of cabins increased the number of cabins. This has an effect on the future revenue generating
capability of the business. Thus the renovation expense is capital expenditure in nature.
(ii) Expense incurred to recover installments due from customer do not increase the revenue generating
capability in future. It is a normal recurring expense of the business. Thus the legal expenses incurred in
this case is revenue expenditure in nature.
(iii) Expenses incurred on account of transportation of fixed asset is capital expenditure in nature.

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 1.64 PRINCIPLES AND PRACTICE OF ACCOUNTING

SUMMARY
w Revenue expenditures are shown in the profit and loss account while capital expenditures are placed
on the asset side of the balance sheet since they generate benefits for more than are accounting period.
w Prepaid expenses are future expenses that have been paid in advance. These are shown in the balance
sheet as an asset.
w Receipts obtained should be classified between revenue receipts and capital receipts.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Money spent ` 10,000 as traveling expenses of the directors on trips abroad for purchase of capital
assets is
(a) Capital expenditures (b) Revenue expenditures
(c) Prepaid revenue expenditures
2. Amount of ` 5,000 spent as lawyers’ fee to defend a suit claiming that the firm’s factory site belonged to
the plaintiff ’s land is
(a) Capital expenditures (b) Revenue expenditures
(c) Prepaid revenue expenditures
3. Entrance fee of ` 2,000 received by Ram and Shyam Social Club is
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
4. Subsidy of ` 40,000 received from the government for working capital by a manufacturing concern is
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
5. Insurance claim received on account of machinery damaged completely by fire is
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
6. Interest on investments received from UTI is
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures
7. Amount received from IDBI as a medium term loan for augmenting working capital is
(a) Capital expenditures (b) Revenue expenditures
(c) Capital receipt

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 THEORETICAL FRAMEWORK 1.65

8. Revenue from sale of products, ordinarily, is reported as part of the earning in the period in which
(a) The sale is made. (b) The cash is collected.
(c) The products are manufactured.
9. If repair cost is ` 25,000, whitewash expenses are ` 5,000, (both these expenses relate to presently used
building) cost of extension of building is ` 2,50,000 and cost of improvement in electrical wiring system
is ` 19,000; the amount to be expensed is
(a) ` 2,99,000. (b) ` 44,000.
(c) ` 30,000.
Theory Questions
1. What are the basic considerations in distinguishing between capital and revenue expenditures?
2. Define revenue receipts and give examples. How are these receipts treated?
ANSWERS/HINTS
MCQs
1: (a), 2 (b), 3 (a), 4(b), 5(a), 6 (b), 7(c), 8 (a), 9 (c)
Theoretical Questions
1. The basic considerations in distinction between capital and revenue expenditures are:
(a) Nature of business.
(b) Recurring nature of expenditure.
(c) Purpose of expenses.
(d) Effect on revenue generating capacity of business.
(e) Materiality of the amount involved.
2. Receipts which are obtained in course of normal business activities are revenue receipts (e.g. receipts
from sale of goods or services, interest income etc.).
Revenue receipts should not be equated with the actual cash receipts. Revenue receipts are credited to
the Profit and Loss Account.

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 1.66 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 5 : CONTINGENT ASSETS AND CONTINGENT LIABILITIES

LEARNING OUTCOMES
After studying this unit, you will be able to:

w Understand the meaning of the terms 'Contingent Assets' and 'Contingent Liabilities'.

w Distinguish 'Contingent Liabilities' with 'Liabilities' and 'Provisions'

• A possible asset arises from past events and

Contingent their existence will be confirmed only after
occurrence or non-occurrence of one or
Asseet more uncertain future events.

UNIT OVERVIEW

• A possible obligation arising from

Contingent past events and may arise in future
depending on the occurrence or non-
Liability occurrence of one or more uncertain
future events.

5.1 CONTINGENT ASSET

A contingent asset may be defined as a possible asset that arises from past events and whose existence will
be confirmed only after occurrence or non-occurrence of one or more uncertain future events not wholly
within the control of the enterprise. It usually arises from unplanned or unexpected events that give rise
to the possibility of an inflow of economic benefits to the business entity. For example, a claim that an
enterprise is pursuing through legal process, where the outcome is uncertain, is a contingent asset.

As per the concept of prudence as well as the present accounting standards, an enterprise should not
recognise a contingent asset. These assets are uncertain and may arise from a claim which an enterprise
pursues through a legal proceeding. There is uncertainty in realisation of claim. It is possible that recognition
of contingent assets may result in recognition of income that may never be realised. However, when the
realisation of income is virtually certain, then the related asset no longer remains as contingent asset.

A contingent asset need not be disclosed in the financial statements. A contingent asset is usually disclosed
in the report of the approving authority (Board of Directors in the case of a company, and the corresponding
approving authority in the case of any other enterprise), if an inflow of economic benefits is probable.
Contingent assets are assessed continually and if it has become virtually certain that an inflow of economic
benefits will arise, the asset and the related income are recognised in the financial statements of the period
in which the change occurs.

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 THEORETICAL FRAMEWORK 1.67

5.2 CONTINGENT LIABILITIES

The term ‘Contingent liability’ can be defined as

“(a) a possible obligation1 that arises from past events and the existence of which will be confirmed only by
the occurrence or non-occurrence of one or more uncertain future events not wholly within the control
of the enterprise; or

(b) a present obligation 2 that arises from past events but is not recognised because:

(i) it is not probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; or

(ii) a reliable estimate of the amount of the obligation cannot be made.”

A contingent liability is a possible obligation arising from past events and may arise in future depending
on the occurrence or non-occurrence of one or more uncertain future events [part (a) of the definition]. A
contingent liability may also be a present obligation that arises from past events [(part (b) of the definition)].

An enterprise should not recognise a contingent liability. A Contingent liability is required to be disclosed
unless possibility of outflow of a resource embodying economic benefits is remote. These liabilities are
assessed continually to determine whether an outflow of resources embodying economic benefits has
become probable. If it becomes probable that an outflow or future economic benefits will be required for
an item previously dealt with as a contingent liability, a provision is recognised in financial statements of
the period in which the change in probability occurs except in the extremely rare circumstances where no
reliable estimate can be made.

5.3 DISTINCTION BETWEEN CONTINGENT LIABILITIES AND LIABILITIES

The distinction between a liability and a contingent liability is generally based on the judgement of the
management. A liability is defined as the present financial obligation of an enterprise, which arises from
past events. The settlement of a liability results in an outflow from the enterprises of resources embodying
economic benefits. On the other hand, in the case of contingent liability, either outflow of resources to
settle the obligation is not probable or the amount expected to be paid to settle the liability cannot be
measured with sufficient reliability. Examples of contingent liabilities are claims against the enterprise not
acknowledged as debts, guarantees given in respect of third parties, liability in respect of bills discounted
and statutory liabilities under dispute etc. In addition to present obligations that are recognized as liabilities
in the balance sheet, enterprises are required to disclose contingent liability in their balance sheets by way
of notes.

5.4 DISTINCTION BETWEEN CONTINGENT LIABILITIES AND PROVISIONS

Provision means “any amount written off or retained by way of providing for depreciation, renewal or
diminution in the value of assets or retained by way of providing for any known liability of which the amount
cannot be determined with substantial accuracy”.
It is important to know the difference between provisions and contingent liabilities. The distinction between
both of them can be explained as follows:

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 1.68 PRINCIPLES AND PRACTICE OF ACCOUNTING

Provision Contingent liability

(1) Provision is a present liability of uncertain A Contingent liability is a possible obligation
amount, which can be measured reliably by that may or may not crystallise depending on
using a substantial degree of estimation. the occurrence or non-occurrence of one or
more uncertain future events.
(2) A provision meets the recognition criteria. A contingent liability fails to meet the same.
(3) Provision is recognised when (a) an enterprise Contingent liability includes present
has a present obligation arising from past obligations that do not meet the recognition
events; an outflow of resources embodying criteria because either it is not probable that
economic benefits is probable, and (b) a settlement of those obligations will require
reliable estimate can be made of the amount of outflow of economic benefits, or the amount
the obligation. cannot be reliably estimated.
(4) If the management estimates that it is probable If the management estimates, that it is less
that the settlement of an obligation will result likely that any economic benefit will outflow
in outflow of economic benefits, it recognises a the firm to settle the obligation, it discloses the
provision in the balance sheet. obligation as a contingent liability.

Let us take an example to understand the distinction between provisions and contingent liabilities. The
Central Excise Officer imposes a penalty on Alpha Ltd. for violation of a provision in the Central Excise Act.
The company goes on an appeal. If the management of the company estimates that it is probable that the
company will have to pay the penalty, it recognises a provision for the liability. On the other hand, if the
management anticipates that the judgement of the appellate authority will be in its favour and it is less
likely that the company will have to pay the penalty, it will disclose the obligation as a contingent liability
instead of recognising a provision for the same.

TEST YOUR KNOWLEDGE

Mutiple Choice Questions
1. (i) Contingent asset usually arises from unplanned or unexpected events that give rise to
(a) The possibility of an inflow of economic benefits to the business entity.
(b) The possibility of an outflow of economic benefits to the business entity.
(c) Either (a) or (b).
(ii) If an inflow of economic benefits is probable then a contingent asset is disclosed
(a) In the financial statements.
(b) In the report of the approving authority (Board of Directors in the case of a company, and the
corresponding approving authority in the case of any other enterprise).
(c) In the cash flow statement.

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 THEORETICAL FRAMEWORK 1.69

(iii) In the case of ___________, either outflow of resources to settle the obligation is not probable or
the amount expected to be paid to settle the liability cannot be measured with sufficient reliability.
(a) Liability (b) Provision
(c) Contingent liabilities
(iv) Present liability of uncertain amount, which can be measured reliably by using a substantial degree
of estimation is termed as ________.
(a) Provision. (b) Liability.
(c) Contingent liability.
(v) In the financial statements, contingent liability is
(a) Recognised. (b) Not recognised.
(c) Adjusted.
Theoretical Questions
1. Differentiate between:
(i) Provision and Contingent Liability.
(ii) Liability and Contingent liability.
ANSWERS/HINTS
Multiple Choice Questions
(i) (a) (ii) (b) (iii) (c) (iv) (a) (v) (b)
Theoretical Questions
1. Provision is a present liability of uncertain amount, which can be measured reliably by using a substantial
degree of estimation. On the other hand, a Contingent liability is a possible obligation that may or may
not crystallize depending on the occurrence or non-occurrence of one or more uncertain future events.
2. A liability is defined as the present financial obligation of an enterprise, which arises from past events.
On the other hand, in the case of contingent liability, either outflow of resources to settle the obligation
is not probable or the amount expected to be paid to settle the liability cannot be measured with
sufficient reliability.

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 1.70 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 6 : ACCOUNTING POLICIES

LEARNING OUTCOMES
After studying this unit, you will be able to :
w Understand the meaning of ‘Accounting Policies’.
w Familiarize with the situations under which selection from different accounting policies is required.
w Grasp the conditions where change in accounting policy can be made and the consequences arising
from such changes.

Selection of Accounting Policies

UNIT OVERVIEW

Based
on

Prudence Substance over

Materiality
Form

6.1 MEANING OF ACCOUNTING POLICIES

Accounting Policies refer to specific accounting principles and methods of applying these principles adopted
by the enterprise in the preparation and presentation of financial statements. Policies are based on various
accounting concepts, principles and conventions that have already been explained in Unit 2 of Chapter 1.
There is no single list of accounting policies, which are applicable to all enterprises in all circumstances.
Enterprises operate in diverse and complex environmental situations and so they have to adopt various
policies. The choice of specific accounting policy appropriate to the specific circumstances in which the
enterprise is operating, calls for considerate judgement by the management. ICAI has been trying to reduce
the number of acceptable accounting policies through Guidance Notes and Accounting Standards in its
combined efforts with the government, other regulatory agencies and progressive managements. Already
it has achieved some progress in this respect.
The areas wherein different accounting policies are frequently encountered can be given as follows:
(1) Valuation of inventories;
(2) Valuation of investments.

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 THEORETICAL FRAMEWORK 1.71

This list should not be taken as exhaustive but is only illustrative. As the course will progress, students will
see the intricacies of the various accounting policies.
Suppose an enterprise holds some investments in the form of shares of a company at the end of an accounting
period. For valuation of shares, the enterprise may adopt FIFO, average method etc. The method selected
by that enterprise for valuation is called an accounting policy. Different enterprises may adopt different
accounting policies. Likewise, different methods of providing depreciation on fixed assets, i.e. Straight line,
written down, etc. are available to the business enterprises which will lead to different depreciation amounts.

6.2 SELECTION OF ACCOUNTING POLICIES

Choice of accounting policy is an important policy decision which affects the performance measurement
as well as financial position of the business entity. Selection of inappropriate accounting policy may lead to
understatement or overstatement of performance and financial position. Thus, accounting policy should be
selected with due care after considering its effect on the financial performance of the business enterprise
from the angle of various users of accounts.
It is believed that no unified and exhaustive list of accounting policies can be suggested which has
universal application. Three major characteristics which should be considered for the purpose of selection
and application of accounting policies. viz.,Prudence, Substance over form, and Materiality. The financial
statements should be prepared on the basis of such accounting policies, which exhibit true and fair view of
state of affairs of Balance Sheet and the Profit & Loss Account.
Examples wherein selection from a set of accounting policies is made, can be given as follows:–
1. Inventories are valued at cost except for finished goods and by-products. Finished goods are valued at
lower of cost or market value and by-products are valued at net realizable value.
2. Investments (long term) are valued at their acquisition cost. Provision for permanent diminution in
value has been made wherever necessary.
Sometimes a wrong or inappropriate treatment is adopted for items in Balance Sheet, or Profit & Loss
Account, or other statement. Disclosure of the treatment adopted is necessary in any case, but disclosure
cannot rectify a wrong or inappropriate treatment.

6.3 CHANGE IN ACCOUNTING POLICIES

A change in accounting policies should be made in the following conditions:
(a) It is required by some statute or for compliance with an Accounting Standard.
(b) Change would result in more appropriate presentation of financial statement.
Change in accounting policy may have a material effect on the items of financial statements. For example,
if depreciation method is changed from straight-line method to written-down value method, or if cost
formula used for inventory valuation is changed from weighted average to FIFO, or if interest is capitalized
which was earlier not in practice, or if proportionate amount of interest is changed to inventory which was
earlier not the practice, all these may increase or decrease the net profit. Unless the effect of such change
in accounting policy is quantified, the financial statements may not help the users of accounts. Therefore, it
is necessary to quantify the effect of change on financial statement items like assets, liabilities, profit/loss.

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 1.72 PRINCIPLES AND PRACTICE OF ACCOUNTING

The examples in this regard may be given as follows:

1. Omega Enterprises revised its accounting policy relating to valuation of inventories to include applicable
production overheads.
2. Alpha Enterprises changed the method of depreciation from straight-line method to written-down
value method which constitutes change in accounting policy.

SUMMARY
w Accounting Policies refer to specific accounting principles and methods of applying these principles
adopted by the enterprise in the preparation and presentation of financial statements. Policies are
based on various accounting concepts, principles and conventions.
w Three major characteristics which should be considered for the purpose of selection and application of
accounting policies. viz., Prudence, Substance over form, and Materiality.
w A change in accounting policies should be made in the following conditions:
(a) It is required by some statute or for compliance with an Accounting Standard.
(b) Change would result in more appropriate presentation of financial statement.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. A change in accounting policy is justified
(a) To comply with accounting standard and law.
(b) To ensure more appropriate presentation of the financial statement of the enterprise.
(c) All of the above.
2. Accounting policy for inventories of Xeta Enterprises states that inventories are valued at the lower
of cost determined on weighted average basis or net realizable value. Which accounting principle is
followed in adopting the above policy?
(a) Materiality. (b) Prudence.
(c) Substance over form.
3. The areas wherein different accounting policies can be adopted are
(a) Providing depreciation. (b) Valuation of inventories.
(c) Both the option.
4. Selection of an inappropriate accounting policy decision may
(a) Overstate the performance and financial position of a business entity.
(b) Understate/overstate the performance and financial position of a business entity.
(c) Overstate the performance of a business entity.

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 THEORETICAL FRAMEWORK 1.73

5. Accounting policies refer to specific accounting

(a) Principles. (b) Methods of applying those principles.
(c) Both (a) and (b).
Theoretical Questions
1. Define Accounting Policies in brief. Identify few areas wherein different accounting policies are
frequently encountered.
2. “Change in accounting policy may have a material effect on the items of financial statements.” Explain
the statement with the help of an example.
ANSWERS/HINTS
Multiple Choice Questions
(1) (c), (2) (b), (3) (c), (4) (b), (5) (c)
Theoretical Questions
1. Accounting Policies refer to specific accounting principles and methods of applying these principles
adopted by the enterprise in the preparation and presentation of financial statements. For details, refer
para 6.1.
2. Change in accounting policy may have a material effect on the items of financial statements. For
example, if depreciation method is changed from straight-line method to written-down value method,
or if cost formula used for inventory valuation is changed from weighted average to FIFO. Unless the
effect of such change in accounting policy is quantified, the financial statements may not help the users
of accounts.

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 1.74 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 7 : ACCOUNTING AS A MEASUREMENT DISCIPLINE –

VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

LEARNING OUTCOMES
After studying this unit, you will be able to:

w Understand the meaning of measurement and its basic elements.

w Know how far accounting is a measurement discipline if considered from the standpoint of the basic
elements of measurement.

w Distinguish measurement from valuation.

w Learn the different measurement bases namely historical cost, realizable value and present value.

w Understand the measurement bases which can give objective valuation to transactions and events.

w Understand that the traditional accounting system mostly uses historical cost as measurement base
although in some cases other measurement bases are also used.

Elements of Measurement
UNIT OVERVIEW

Evaluation of
Identification Selection of Dimension of
of Objects and Standards or Measurement
Events Scale Standards or Scale

Valuation
Principles

Historical Current Realizable Present

Cost Cost Value Value

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 THEORETICAL FRAMEWORK 1.75

7.1 MEANING OF MEASUREMENT

Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of
money. Any measurement discipline deals with three basic elements of measurement viz., identification of
objects and events to be measured, selection of standard or scale to be used, and evaluation of dimension
of measurement standards or scale.
Prof. R. J. Chambers defined ‘measurement’ as “assignment of numbers to objects and events according
to rules specifying the property to be measured, the scale to be used and the dimension of the unit”. (R.J.
Chambers, Accounting Evaluation and Economic Behaviour, Prentice Hall, Englewood Cliffs, N.J. 1966, P.10).
Kohler defined measurement as the assignment of a system of ordinal or cardinal numbers to the results
of a scheme of inquiry or apparatus of observations in accordance with logical or mathematical rules – [A
Dictionary of Accountant].
Ordinal numbers, or ordinals, are numbers used to denote the position in an ordered sequence: first, second,
third, fourth, etc., whereas a cardinal number says ‘how many there are’: one, two, three, four, etc.
Chambers’ definition has been widely used to judge how far accounting can be treated as a measurement
discipline.
According to this definition, the three elements of measurement are:
(1) Identification of objects and events to be measured;
(2) Selection of standard or scale to be used;
(3) Evaluation of dimension of measurement standard or scale.

7.2 OBJECTS OR EVENTS TO BE MEASURED

We have earlier defined Accounting as the process of identifying, measuring and communicating economic
information to permit informed judgements and decisions by the users of the information. So accounting
essentially includes measurement of ‘information’.
Decision makers need past, present and future information. For external users, generally the past information
is communicated.
There is no uniform set of events and transactions in accounting which are required for decision making. For
example, in cash management, various cash receipts and expenses are the necessary objects and events.
Obviously, the decision makers need past cash receipts and expenses data along with projected receipts and
expenses. For giving loan to a business one needs information regarding the repayment ability (popularly
called debt servicing) of principal and interest. This also includes past information, current state of affairs as
well as future projections. It may be mentioned that past and present objects and events can be measured
with some degree of accuracy but future events and objects are only predicted, not measured. Prediction
is an essential part of accounting information. Decision makers have to take decisions about the unseen
future for which they need suitable information.

7.3 STANDARD OR SCALE OF MEASUREMENT

In accounting, money is the scale of measurement (see money measurement concept), although now-a-
days quantitative information is also communicated along with monetary information.

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 1.76 PRINCIPLES AND PRACTICE OF ACCOUNTING

Money as a measurement scale has no universal denomination. It takes the shape of currency ruling in a
country. For example, in India the scale of measurement is Rupee, in the U.K. Pound-Sterling (£), in Germany
Deutschmark (DM), in the United States Dollar ($) and so on. Also there is no constant exchange relationship
among the currencies.
If one businessman in India took loan $5,000 from a businessman of the U.S.A., he would enter the transaction
in his books in terms of ` Suppose at the time of loan agreement exchange rate was US $ = ` 50. Then loan
amounted to ` 2,50,000. Afterwards the exchange rate has been changed to $ 1 = ` 55. At the changed
exchange rate the loan amount becomes` 2,75,000. So money as a unit of measurement lacks universal
applicability across the boundary of a country unless a common currency is in vogue. Since the rate of
exchange fluctuates between two currencies over the time, money as a measurement scale also becomes
volatile.

7.4 DIMENSION OF MEASUREMENT SCALE

An ideal measurement scale should be stable over time. For example, if one buys 1 kg. cabbage today,
the quantity he receives will be the same if he will buy 1 kg. cabbage one year later. Similarly the length
of 1 metre cloth will not change if it is bought a few days later. That is to say a measurement scale should
be stable in dimension. Money as a scale of measurement is not stable. There occurs continuous change
in the input output prices. The same quantity of money may not have the ability to buy same quantity
of identical goods at different dates. Thus information of one year measured in money terms may not be
comparable with that of another year. Suppose production and sales of a company in two different years
are as follows:

Year 1 Year 2
Qty. ` Qty. `
5,000 pcs 5,00,000 4,500 pcs 5,40,000
Looking at the monetary figures one may be glad for 8% sales growth. In fact there was 10% production and
sales decline. The growth envisaged through monetary figures is only due to price change. Let us suppose
further that the cost of production for the above mentioned two years is as follows:

Year 1 Year 2
Qty. ` Qty. `
5,000 pcs 4,00,000 4,500 pcs 4,50,000
Take Gross profit = Sales – Cost of Production. Then in the first year profit was ` 1,00,000 while in the second
year the profit was ` 90,000. There was 10% decline in gross profit.
So money as a unit of measurement is not stable in the dimension.
Thus Accounting measures information mostly in money terms which is not a stable scale having universal
applicability and also not stable in dimension for comparison over the time. So it is not an exact measurement
discipline.

7.5 ACCOUNTING AS A MEASUREMENT DISCIPLINE

How do you measure a transaction or an event? Unless the measurement base is settled we cannot
progress to the record keeping function of book-keeping. It has been explained that accounting is meant

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 THEORETICAL FRAMEWORK 1.77

for generating information suitable for users’ judgments and decisions. But generation of such information
is preceded by recording, classifying and summarising data. By that process it measures performance
of the business entity by way of profit or loss and shows its financial position. Thus measurement is an
important part of accounting discipline. But a set of theorems governs the whole measurement sub-
system. These theorems should be carefully understood to know how the cogs of the ‘accounting-wheel’
work. Now-a-days accounting profession earmarked three theorems namely going concern, consistency
and accrual as fundamental accounting assumptions, i.e. these assumptions are taken for granted. Also
while measuring, classifying, summarising and also presenting, various policies are adopted. Recording,
classifying summarising and communication of information are also important part of accounting, which
do not fall within the purview of measurement discipline. Therefore we cannot simply say that accounting
is a measurement discipline.
But in accounting money is the unit of measurement. So, let us take one thing for granted that all transactions
and events are to be recorded in terms of money only. Quantitative information is also required in many
cases but such information is only supplementary to monetary information.

7.6 VALUATION PRINCIPLES

There are four generally accepted measurement bases or valuation principles. These are:
(i) Historical Cost;
(ii) Current Cost;
(iii) Realizable Value;
(iv) Present Value.
Let us discuss these principles in detail.
(i) Historical Cost: It means acquisition price. For example, the businessman paid ` 7,00,000 to purchase
the machine and spend `1,00,000 on its installation, its acquisition price including installation charges
is ` 8,00,000. The historical cost of machine would be ` 8,00,000.
According to this base, assets are recorded at an amount of cash or cash equivalent paid at the time of
acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation.
In some circumstances a liability is recorded at the amount of cash or cash equivalent expected to be
paid to satisfy it in the normal course of business.
When one Mr. X a businessman, takes ` 5,00,000 loan from a bank @ 10% interest p.a., it is to be recorded
at the amount of proceeds received in exchange for the obligation. Here the obligation is the repayment
of loan as well as payment of interest at an agreed rate i.e. 10%. Proceeds received are ` 5,00,000 - it
is historical cost of the transactions. Take another case regarding payment of income tax liability. You
know every individual has to pay income tax on his income if it exceeds certain minimum limit. But the
income tax liability is not settled immediately when one earns his income. The income tax authority
settles it some time later, which is technically called assessment year. Then how does he record this
liability? As per historical cost base it is to be recorded at an amount expected to be paid to discharge
the liability.
(ii) Current Cost: Take that Mr. X purchased a machine on 1st January, 2000 at ` 7,00,000. As per historical
cost base he has to record it at ` 7,00,000 i.e. the acquisition price. As on 1.1.2011, Mr. X found that
it would cost ` 25,00,000 to purchase that machine. Take also that Mr. X took loan from a bank as on
1.1.2000 ` 5,00,000 @ 18% p.a repayable at the end of 15th year together with interest. As on 1.1.2011

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 1.78 PRINCIPLES AND PRACTICE OF ACCOUNTING

the bank announces 1% prepayment penalty on the loan amount if it is paid within 15 days starting
from that day. As per historical cost the liability is recorded at ` 5,00,000 at the amount or proceeds
received in exchange for obligation and asset is recorded at ` 7,00,000.
Current cost gives an alternative measurement base. Assets are carried out at the amount of cash or
cash equivalent that would have to be paid if the same or an equivalent asset was acquired currently.
Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required
to settle the obligation currently.
So as per current cost base, the machine value is ` 25,00,000 while the value of bank loan is ` 5,05,000.
(iii) Realisable Value: Suppose Mr. X found that he can get ` 20,00,000 if he would sell the machine purchased,
on 1.1.2000 paying ` 7,00,000 and which would cost ` 25,00,000 in case he would buy it currently. Take
also that Mr. X found that he had no money to pay off the bank loan of ` 5,00,000 currently.
As per realisable value, assets are carried at the amount of cash or cash equivalents that could currently
be obtained by selling the assets in an orderly disposal. Haphazard disposal may yield something less.
Liabilities are carried at their settlement values; i.e. the undiscounted amount of cash or cash equivalents
expressed to be paid to satisfy the liabilities in the normal course of business.
So the machine should be recorded at ` 20,00,000 the realisable value in an orderly sale while the bank
loan should be recorded at ` 5,00,000 the settlement value in the normal course of business.
(iv) Present Value: Suppose we are talking as on 1.1.2011 - take it as time for reference. Now think the machine
purchased by Mr. X can work for another 10 years and is supposed to generate cash @ ` 1,00,000 p.a.
Also take that bank loan of ` 5,00,000 taken by Mr. X is to be repaid as on 31.12.2015. Annual interest is
` 90,000.
As per present value, an asset is carried at the present discounted value of the future net cash inflows
that the item is expected to generate in the normal course of business. Liabilities are carried at the
present discounted value of future net cash outflows that are expected to be required to settle the
liabilities in the normal course of business.
The term ‘discount’, ‘cash inflow’ and ‘cash outflow’ need a little elaboration. ` 100 in hand as on 1.1.2011
is not equivalent to ` 100 in hand as on 31.12.2011. There is a time gap of one year. If Mr. X had ` 100 as
on 1.1.2011 he could use it at that time. If he received it only on 31.12.2011, he had to sacrifice his use for
a year. The value of this sacrifice is called ‘time value of money’. Mr. X would sacrifice i.e. he would agree
to take money on 31.12.2011 if he had been compensated for the sacrifice. So a rational man will never
exchange ` 100 as on 1.1.2011 with ` 100 to be received on 31.12.2011. Then ` 100 of 1.1.2011 is not
equivalent to ` 100 of 31.12.2011. To make the money receivable at a future date equal with the money
of the present date it is to be devalued. Such devaluation is called discounting of future money.
Perhaps you know the compound interest rule: A = P (1+ i)n
A = Amount
P = Principal
i = interest / 100
n = Time
This equation gives the relationship between present money, principal and the future money amount.
If A, i and n are given, to find out P, the equation is to be changed slightly.

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 THEORETICAL FRAMEWORK 1.79

A
P
(1 + i)n

Using the equation one can find out the present value if he knows the values of A, i and n.
Suppose i = 20%, now what is the present value of ` 1,00,000 to be received as on 31.12.2011 (Take
1.1.2011 as the time of reference).

P = 1,00,000 = ` 83,333
(1 + 2)1
Similarly,
Time of Receipt Money Value Present Value
` `
31.12.2012 1,00,000 69,444
31.12.2013 1,00,000 57,870
31.12.2014 1,00,000 48,225
31.12.2015 1,00,000 40,188
31.12.2016 1,00,000 33,490
31.12.2017 1,00,000 27,908
31.12.2018 1,00,000 23,257
31.12.2019 1,00,000 19,381
31.12.2020 1,00,000 16,150
Total of all these present values is ` 4,19,246. Since the machine purchased by Mr. X will produce cash
equivalent to ` 4,19,246 in terms of present value, it is to be valued at such amount as per present value
measurement basis.
Here, Mr. X will receive ` 1,00,000 at different points of time-these are cash inflows. In the other example,
he has to pay interest and principal of bank loan-these are cash outflows.
Perhaps you also know the annuity rule:
Present value of an Annuity or Re. A for n periods is

A = Annuity
i = interest
t = time 1, 2, 3, ..........n.

A 1 
1–
i  (1 + i)n 

Applying this rule one can derive the present value of ` 1,00,000 for 10 years @ 20% p.a.

1,00,000  1 
1 – (1 + 0.20)10  = `4,19,246
0.20  

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 1.80 PRINCIPLES AND PRACTICE OF ACCOUNTING

Similarly, the present value of bank loan is

90,000  1  5,00,000
1– 5 
+
0.20  (1 + 0.20)  (1 + 0.20)5

= ` 2,69,155 + ` 2,00,939= ` 4,70,094

Thus, we get the four measurements as on 1.1.2011:

Historical Current Realisable Present

cost cost value value
` ` ` `
Asset: Machine 7,00,000 25,00,000 20,00,000 4,19,246
Liability: Bank Loan 5,00,000 5,05,000 5,00,000 4,70,094
The accounting system which we shall discuss in the remaining chapters is also called historical cost
accounting. However, this need not mean that one shall follow only historical cost basis of accounting. In
the later stages of the CA course, we shall see that the accounting system uses all types of measurement
bases although under the traditional system most of the transactions and events are measured in terms of
historical cost.

7.7 MEASUREMENT AND VALUATION

Value relates to the benefits to be derived from objects, abilities or ideas. To the economist, value is the utility
(i.e.; satisfaction) of an economic resource to the person contemplating or enjoying its use. In accounting, to
mean value of an object, abilities or ideas, a monetary surrogate is used. That is to say, value is measured in
terms of money. Suppose, an individual purchased a car paying ` 2,50,000. Its value lies in the satisfaction to
be derived by that individual using the car in future. Economists often use ordinal scale to indicate the level
of satisfaction. But accountants use only cardinal scales. If the value of car is taken as ` 2,50,000 it is only one
type of value called acquisition cost or historical cost. So value is indicated by measurement. In accounting
the value is always measured in terms of money.

7.8 ACCOUNTING ESTIMATES

Earlier in this unit we have learned how to measure a transaction, which had already taken place and for
which either some value/money has been paid or some valuation principles are to be adopted for their
measurement. But there are certain items, which havenot occurred therefore cannot be measured using
valuation principles still they are necessary to record in the books of account, for example, provision for
doubtful debts. For such items, we need some value. In such a situation reasonable estimates based on the
existing situation and past experiences are made.
The measurement of certain assets and liabilities is based on estimates of uncertain future events. As a result
of the uncertainties inherent in business activities, many financial statement items cannot be measured with
precision but can only be estimated. Therefore, the management makes various estimates and assumptions
of assets, liabilities, incomes and expenses as on the date of preparation of financial statements. Such
estimates are made in connection with the computation of depreciation, amortisation and impairment
losses as well as, accruals, provisions and employee benefit obligations. Also estimates may be required in

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 THEORETICAL FRAMEWORK 1.81

determining the bad debts, useful life and residual value of an item of plant and machinery and inventory
obsolescence. The process of estimation involves judgements based on the latest information available.
An estimate may require revision if changes occur regarding circumstances on which the estimate was based,
or as a result of new information, more experience or subsequent developments. Change in accounting
estimate means difference arises between certain parameters estimated earlier and re-estimated during the
current period or actual result achieved during the current period.
Few examples of situations wherein accounting estimates are needed can be given as follows:
(1) A company incurs expenditure of ` 10,00,000 on development of patent. Now the company has to
estimate that for how many years the patent would benefit the company. This estimation should be
based on the latest information and logical judgement.
(2) A company dealing in long-term construction contracts, uses percentage of completion method for
recognizing the revenue at the end of the accounting year. Under this method the company has to make
adequate provisions for unseen contingencies, which can take place while executing the remaining
portion of the contract. Since provisioning for unseen contingencies requires estimation, there may be
excess or short provisioning, which is to be adjusted in the period when it is recognised.
(3) Company has to provide for taxes which is also based on estimation as there can be some interpretational
differences on account of which tax authorities may either accept the expenditure or refuse it. This will
ultimately lead to different tax liability.

SUMMARY
w Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of
money.
w There are three elements of measurement:
(i) Identification of objects and events to be measured;
(ii) Selection of standard or scale to be used;
(iii) Evaluation of dimension of measurement standard or scale.
w There are four generally accepted measurement bases or valuation principles. These are:
(i) Historical Cost; (ii) Current Cost;
(iii) Realizable Value; (iv) Present Value.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. (i) Measurement discipline deals with
(a) Identification of objects and events. (b) Selection of scale.
(c) Both (a) and (b)

(ii) All of the following are valuation principles except

(a) Historical cost. (b) Present value.
(c) Future value.

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 1.82 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iii) Book value of machinery on 31st March, 2016 ` 10,00,000

Market value as on 31st March, 2016 if sold ` 11,00,000
As on 31st March, 2016, if the company values the machinery at ` 11,00,000, which of the following
valuation principle is being followed?
(a) Historical Cost. (b) Present Value.
(c) Realisable Value.

2. Mohan purchased a machinery amounting ` 10,00,000 on 1st April, 2001. On 31st March, 2016, similar
machinery could be purchased for ` 20,00,000 but the realizable value of the machinery (purchased
on 1.4.2001) was estimated at ` 15,00,000. The present discounted value of the future net cash inflows
that the machinery was expected to generate in the normal course of business, was calculated as
` 12,00,000.

(i) The current cost of the machinery is

(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 15,00,000.

(ii) The present value of machinery is

(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 12,00,000.

(iii) The historical cost of machinery is

(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 15,00,000.

(iv) The realizable value of machinery is

(a) ` 10,00,000. (b) ` 20,00,000.
(c) ` 15,00,000.

Theoretical Questions

1. Define Measurement in brief. Explain the significant elements of measurement.

2. Describe in brief, the alternative measurement bases, for determining the value at which an element
can be recognized in the balance sheet or statement of profit and loss.

ANSWER/HINTS
Multiple Choice Questions

1.(i) (c) (ii) (c) (iii) (c) 2.(i) (b) (ii) (c) (iii) (a)

(iv) (c)

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 THEORETICAL FRAMEWORK 1.83

Theoretical Questions
1. Measurement is vital aspect of accounting. Primarily transactions and events are measured in terms of
money. Three elements of measurement are: (1) Identification of objects and events to be measured;
(2) Selection of standard or scale to be used;(3)Evaluation of dimension of measurement standard or
scale.
2. Alternative measurement bases are: (i)Historical Cost; (ii)Current cost (iii) Realizables (Settlement) Value
and (iv) Present Value. Refer para 7.6 for details.

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 1.84 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 8 : ACCOUNTING STANDARDS

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand the significance of issuance of Accounting Standards.
w Grasp the objectives, benefits and limitations of Accounting Standards.
w Learn the process of formulation of Accounting Standards by the Council of the Institute of Chartered
Accountants of India.
w Familiarize with the list of applicable Accounting Standards in India.

UNIT OVERVIEW Accounting Standards deal with the issues of

Recognition Measurement Presentation Disclosure

of events and of transactions of transactions requirements
transactions and events and events

Formulation of Accounting Standards

Identification of area

Constitution of study group

Preparation of draft and its circulation

Ascertainment of views of different bodies on draft

Finalisation of exposure draft (E.D.)

Comments received on exposure draft (E.D.)

Modification of the draft

Issue of AS

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 THEORETICAL FRAMEWORK 1.85

8.1 INTRODUCTION OF ACCOUNTING STANDARDS

Accounting as a ‘language of business’ communicates the financial results of an enterprise to various
stakeholders by means of financial statements. If the financial accounting process is not properly
regulated, there is possibility of financial statements being misleading, tendentious and providing a
distorted picture of the business, rather than the true. To ensure transparency, consistency, comparability,
adequacy and reliability of financial reporting, it is essential to standardize the accounting principles and
policies. Accounting Standards (ASs) provide framework and standard accounting policies for treatment of
transactions and events so that the financial statements of different enterprises become comparable.
Accounting standards are written policy documents issued by the expert accounting body or by the
government or other regulatory body covering the aspects of recognition, measurement, presentation
and disclosure of accounting transactions and events in the financial statements. The ostensible purpose
of the standard setting bodies is to promote the dissemination of timely and useful financial information
to investors and certain other parties having an interest in the company’s economic performance. The
accounting standards deal with the issues of -
(i) recognition of events and transactions in the financial statements;
(ii) measurement of these transactions and events;
(iii) presentation of these transactions and events in the financial statements in a manner that is meaningful
and understandable to the reader; and
(iv) the disclosure requirements which should be there to enable the public at large and the stakeholders
and the potential investors in particular, to get an insight into what these financial statements are trying
to reflect and thereby facilitating them to take prudent and informed business decisions.

8.2 OBJECTIVES OF ACCOUNTING STANDARDS

The whole idea of accounting standards is centered around harmonisation of accounting policies and
practices followed by different business entities so that the diverse accounting practices adopted for various
aspects of accounting can be standardised. Accounting Standards standardise diverse accounting policies
with a view to:

(i) eliminate the non-comparability of financial statements and thereby improving the reliability of
financial statements; and

(ii) provide a set of standard accounting policies, valuation norms and disclosure requirements.

Accounting standards reduce the accounting alternatives in the preparation of financial statements within
the bounds of rationality, thereby ensuring comparability of financial statements of different enterprises.

8.3 BENEFITS AND LIMITATIONS OF ACCOUNTING STANDARDS

Accounting standards seek to describe the accounting principles, the valuation techniques and the methods
of a pplying the accounting principles in the preparation and presentation of financial statements so that
they may give a true and fair view. By setting the accounting standards, the accountant has following
benefits:

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 1.86 PRINCIPLES AND PRACTICE OF ACCOUNTING

(i) Standards reduce to a reasonable extent or eliminate altogether confusing variations in the accounting
treatments used to prepare financial statements.

(ii) There are certain areas where important information are not statutorily required to be disclosed.
Standards may call for disclosure beyond that required by law.

(iii) The application of accounting standards would, to a limited extent, facilitate comparison of financial
statements of companies situated in different parts of the world and also of different companies situated
in the same country. However, it should be noted in this respect that differences in the institutions,
traditions and legal systems from one country to another give rise to differences in accounting standards
adopted in different countries.

Standardisation of
alternative accounting
treatments

Benefits of
Accounting
Standards

Comparability of Requirements for

financial statements additional disclosures

However, there are some limitations of accounting standards:

(i) Difficulties in making choice between different treatments: Alternative solutions to certain accounting
problems may each have arguments to recommend them. Therefore, the choice between different
alternative accounting treatments may become difficult.

(ii) Restricted scope: Accounting standards cannot override the statute. The standards are required to be
framed within the ambit of prevailing statutes.

Difficulties in
Limitations
making choice
of accounting Restricted scope
between different
standards
treatments

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 THEORETICAL FRAMEWORK 1.87

8.4 PROCESS OF FORMULATION OF ACCOUNTING STANDARDS IN

INDIA
The Institute of Chartered Accountants of India (ICAI), being a premier accounting body in the country,
took upon itself the leadership role by constituting the Accounting Standards Board (ASB) in 1977. The
ICAI has taken significant initiatives in the setting and issuing procedure of Accounting Standards to ensure
that the standard-setting process is fully consultative and transparent. The ASB considers International
Financial Reporting Standards (IFRSs) while framing Indian Accounting Standards (ASs) in India and try
to integrate them, in the light of the applicable laws, customs, usages and business environment in the
country. The composition of ASB includes, representatives of industries (namely, ASSOCHAM, CII, FICCI),
regulators, academicians, government departments etc. Although ASB is a body constituted by the Council
of the ICAI, it (ASB) is independent in the formulation of accounting standards and Council of the ICAI is
not empowered to make any modifications in the draft accounting standards formulated by ASB without
consulting with the ASB.
The standard-setting procedure of Accounting Standards Board (ASB) can be briefly outlined as follows:
w Identification of broad areas by ASB for formulation of AS.
w Constitution of study groups by ASB to consider specific projects and to prepare preliminary drafts of
the proposed accounting standards. The draft normally includes objective and scope of the standard,
definitions of the terms used in the standard, recognition and measurement principles wherever
applicable and presentation and disclosure requirements.
w Consideration of the preliminary draft prepared by the study group of ASB and revision, if any, of the
draft on the basis of deliberations.
w Circulation of draft of accounting standard (after revision by ASB) to the Council members of the ICAI
and specified outside bodies such as Department of Company Affairs (DCA), Securities and Exchange
Board of India (SEBI), Comptroller and Auditor General of India (C&AG), Central Board of Direct Taxes
(CBDT), Standing Conference of Public Enterprises (SCOPE), etc. for comments.
w Meeting with the representatives of the specified outside bodies to ascertain their views on the draft of
the proposed accounting standard.
w Finalisation of the exposure draft of the proposed accounting standard and its issuance inviting public
comments.
w Consideration of comments received on the exposure draft and finalisation of the draft accounting
standard by the ASB for submission to the Council of the ICAI for its consideration and approval for
issuance.
w Consideration of the final draft of the proposed standard and by the Council of the ICAI, and if found
necessary, modification of the draft in consultation with the ASB is done.
w The accounting standard on the relevant subject (for non-corporate entities) is then issued by the ICAI.
For corporate entities the accounting standards are issued by The Central Government of India.

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 1.88 PRINCIPLES AND PRACTICE OF ACCOUNTING

8.5 LIST OF ACCOUNTING STANDARDS IN INDIA

The ‘Accounting Standards’ issued by the Accounting Standards Board establish standards which have to be
complied by the business entities so that the financial statements are prepared in accordance with generally
accepted accounting principles.
Following is the list of applicable Accounting Standards:
List* of Accounting Standards
Sl. Number of the Accounting Title of the Accounting Standard
No. Standard (AS)
1. AS 1 Disclosure of Accounting Policies
2. AS 2 (Revised) Valuation of Inventories
3. AS 3 (Revised) Cash Flow Statements
4. AS 4 (Revised) Contingencies and Events Occurring after the Balance Sheet Date
5. AS 5 (Revised) Net Profit or Loss for the Period, Prior Period Items and Changes in
Accounting Policies
4. AS 6 (withdrawn pursuant Depreciation Accounting
to issuance of AS 10
on Property, Plant and
Equipment 2016)
7. AS 7 (Revised) Accounting for Construction Contracts
8. AS 8 (withdrawn Accounting for Research and Development
pursuant to AS 26
becoming mandatory)
9. AS 9 Revenue Recognition
10. AS 10 Property, Plant and Equipment
11. AS 11 (Revised) The Effects of Changes in Foreign Exchange Rates
12. AS 12 Accounting for Government Grants
13. AS 13 Accounting for Investments
14. AS 14 Accounting for Amalgamations
15. AS 15 (Revised) Employee Benefits
14. AS 16 Borrowing Costs
17. AS 17 Segment Reporting
18. AS 18 Related Party Disclosures
19. AS 19 Leases
20. AS 20 Earnings Per Share
21. AS 21 Consolidated Financial Statements
22. AS 22 Accounting for Taxes on Income
23. AS 23 Accounting for Investments in Associates in Consolidated Financial
Statements
24. AS 24 Discontinuing Operations
25. AS 25 Interim Financial Reporting
24. AS 26 Intangible Assets
27. AS 27 Financial Reporting of Interests in Joint Ventures

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 THEORETICAL FRAMEWORK 1.89

Sl. Number of the Accounting Title of the Accounting Standard

No. Standard (AS)
28. AS 28 Impairment of Assets
29 AS 29 Provisions, Contingent Liabilities & Contingent Assets
* Note: The list of accounting standards given above does not form part of syllabus. It has been given
here for the knowledge of students only.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Accounting Standards for Non-Corporate entities in India are issued by
(a) Central Govt. (b) State Govt.
(c) Institute of Chartered Accountants of India. (d) Reserve Bank of India.

2. Accounting Standards
(a) Harmonise accounting policies.
(b) Eliminate the non-comparability of financial statements.
(c) Improve the reliability of financial statements.
(d) All the three.

3. It is essential to standardize the accounting principles and policies in order to ensure

(a) Transparency. (b) Consistency.
(c) Comparability. (d) All the three.

Theoretical Questions
1. Explain the objective of “Accounting Standards” in brief.
2. State the advantages of setting Accounting Standards.

ANSWERS/HINTS
Multiple Choice Questions
1. (c), 2. (d), 3. (d),

Theoretical Questions
1. Accounting Standards are selected set of accounting policies or broad guidelines regarding the
principles and methods to be chosen out of several alternatives. The main objective of Accounting
Standards is to establish standards which have to be complied with, to ensure that financial statements
are prepared in accordance with generally accepted accounting principles. Accounting Standards seek
to suggest rules and criteria of accounting measurements. These standards harmonize the diverse
accounting policies and practices at present in use in India.

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 1.90 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. The main advantage of setting accounting standards is that the adoption and application of accounting
standards ensure uniformity, comparability and qualitative improvement in the preparation and
presentation of financial statements. The other advantages are: Reduction in variations; Disclosures
beyond that required by law and Facilitates comparison.

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 THEORETICAL FRAMEWORK 1.91

UNIT 9 : INDIAN ACCOUNTING STANDARDS

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand the significance of issuance of Indian Accounting Standards.
w Learn the need of issuance of Indian Accounting Standards.

UNIT OVERVIEW Indian Accounting Standards

Convergence Transparency Comparability Enhanced

towards Global of financial of financial Disclosure
Standards statements statements requirements

9.1 NEED FOR CONVERGENCE TOWARDS GLOBAL STANDARDS

The last decade has witnessed a sea change in the global economic scenario. The emergence of trans-
national corporations in search of money, not only for fueling growth, but to sustain on going activities has
necessitated raising of capital from all parts of the world, cutting across frontiers.
Each country has its own set of rules and regulations for accounting and financial reporting. Therefore,
when an enterprise decides to raise capital from the markets other than the country in which it is located,
the rules and regulations of that other country will apply and this in turn will require that the enterprise is
in a position to understand the differences between the rules governing financial reporting in the foreign
country as compared to its own country of origin. Therefore translation and re-instatements are of utmost
importance in a world that is rapidly globalising in all ways. In themselves also, the accounting standards
and principle need to be robust so that the larger society develops degree of confidence in the financial
statements, which are put forward by organizations.
International analysts and investors would like to compare financial statements based on similar accounting
standards, and this has led to the growing support for an internationally accepted set of accounting
standards for cross-border filings. The harmonization of financial reporting around the world will help to
raise confidence of investors generally in the information they are using to make their decisions and assess
their risks.
Also a strong need was felt by legislation to bring about uniformity, rationalization, comparability,
transparency and adaptability in financial statements. Having a multiplicity of accounting standards around
the world is against the public interest. If accounting for the same events and information produces different

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 1.92 PRINCIPLES AND PRACTICE OF ACCOUNTING

reported numbers, depending on the system of standards that are being used, then it is self-evident that
accounting will be increasingly discredited in the eyes of those using the numbers. It creates confusion,
encourages error and facilitates fraud. The cure for these ills is to have a single set of global standards, of the
highest quality, set in the interest of public. Global Standards facilitate cross border flow of money, global
listing in different bourses and comparability of financial statements.
The convergence of financial reporting and accounting standards is a valuable process that contributes to
the free flow of global investment and achieves substantial benefits for all capital market stakeholders. It
improves the ability of investors to compare investments on a global basis and thus lowers their risk of errors
of judgment. It facilitates accounting and reporting for companies with global operations and eliminates
some costly requirements say reinstatement of financial statements. It has the potential to create a new
standard of accountability and greater transparency, which are values of great significance to all market
participants including regulators. It reduces operational challenges for accounting firms and focuses their
value and expertise around an increasingly unified set of standards. It creates an unprecedented opportunity
for standard setters and other stakeholders to improve the reporting model. For the companies with joint
listings in both domestic and foreign country, the convergence is very much significant.

9.2 INTERNATIONAL FINANCIAL REPORTING STANDARDS AS

GLOBAL STANDARDS
With a view of achieving convergence towards global reporting, the London based group namely the
International Accounting Standards Committee (IASC), responsible for developing International Accounting
Standards, was established in June, 1973. It is presently known as International Accounting Standards Board
(IASB), The IASC comprises the professional accountancy bodies of over 75 countries (including the Institute
of Chartered Accountants of India). Primarily, the IASC was established, in the public interest, to formulate
and publish, International Accounting Standards to be followed in the presentation of audited financial
statements. International Accounting Standards were issued to promote acceptance and observance of
International Accounting Standards worldwide. The members of IASC have undertaken a responsibility to
support the standards promulgated by IASC and to propagate those standards in their respective countries.
Between 1973 and 2001, the International Accounting Standards Committee (IASC) released International
Accounting Standards. Between 1997 and 1999, the IASC restructured their organisation, which resulted
in formation of International Accounting Standards Board (IASB). These changes came into effect on 1st
April, 2001. Subsequently, IASB issued statements about current and future standards: IASB publishes its
Standards in a series of pronouncements called International Financial Reporting Standards (IFRS). However,
IASB has not rejected the standards issued by the ISAC. Those pronouncements continue to be designated
as “International Accounting Standards” (IAS).
The term IFRS comprises IFRS issued by IASB; IAS issued by International Accounting Standards Committee
(IASC); Interpretations issued by the Standard Interpretations Committee (SIC) and the IFRS Interpretations
Committee of the IASB.
International Financial Reporting Standards (IFRSs) are considered a "principles-based" set of standards.
In fact, they establish broad rules rather than dictating specific treatments. Every major nation is moving
toward adopting them to some extent. Large number of authorities requires public companies to use IFRS
for stock-exchange listing purposes, and in addition, banks, insurance companies and stock exchanges
may use them for their statutorily required reports. So over the next few years, thousands of companies
will adopt the international standards. This requirement will affect about 7,000 enterprises, including their
subsidiaries, equity investors and joint venture partners. The increased use of IFRS is not limited to public-

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 THEORETICAL FRAMEWORK 1.93

company listing requirements or statutory reporting. Many lenders and regulatory and government bodies
are looking to IFRS to fulfil local financial reporting obligations related to financing or licensing.

9.3 BENEFITS OF CONVERGENCE WITH IFRSs

There are many beneficiaries of convergence with IFRSs such as the economy, investors, industry etc.
The Economy: When the markets expand globally the need for convergence increases since the convergence
benefits the economy by increasing growth of its international business. It facilitates maintenance of orderly
and efficient capital markets and also helps to increase the capital formation and thereby economic growth.
It encourages international investing and thereby leads to more foreign capital flows to the country.
Investors: A strong case for convergence can be made from the viewpoint of the investors who wish to
invest outside their own country. Investors want the information that is more relevant, reliable, timely and
comparable across the jurisdictions. Financial statements prepared using a common set of accounting
standards help investors better understand investment opportunities as opposed to financial statements
prepared using a different set of national accounting standards. Investors’ confidence is strong when
accounting standards used are globally accepted. Convergence with IFRS contributes to investors’
understanding and confidence in high quality financial statements.
The Industry: A major force in the movement towards convergence has been the interest of the industry.
The industry is able to raise capital from foreign markets at lower cost if it can create confidence in the
minds of foreign investors that their financial statements comply with globally accepted accounting
standards. With the diversity in accounting standards from country to country, enterprises which operate in
different countries face a multitude of accounting requirements prevailing in the countries. The burden of
financial reporting is lessened with convergence of accounting standards because it simplifies the process
of preparing the individual and group financial statements and thereby reduces the costs of preparing the
financial statements using different sets of accounting standards.

9.4 DEVELOPMENT IN INDIAN ACCOUNTING STANDARDS (IND AS)

9.4.1 First Step towards IFRSs
The Institute of Chartered Accountants of India (ICAI) being the accounting standards-setting body in India,
way back in 2006, initiated the process of moving towards the International Financial Reporting Standards
(IFRSs) issued by the International Accounting Standards Board (IASB) with a view to enhance acceptability
and transparency of the financial information communicated by the Indian corporates through their
financial statements. This move towards IFRS was subsequently accepted by the Government of India.
The Government of India in consultation with the ICAI decided to converge and not to adopt IFRSs issued
by the IASB. The decision of convergence rather than adoption was taken after the detailed analysis of
IFRS requirements and extensive discussion with various stakeholders. Accordingly, while formulating IFRS-
converged Indian Accounting Standards (Ind AS), efforts have been made to keep these Standards, as far as
possible, in line with the corresponding IFRS and departures have been made where considered absolutely
essential. These changes have been made considering various factors, such as, various terminology related
changes have been made to make it consistent with the terminology used in law. Certain changes have
been made considering the economic environment of the country, which is different as compared to the
economic environment presumed to be in existence by IFRS.

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 1.94 PRINCIPLES AND PRACTICE OF ACCOUNTING

9.4.2 What are Indian Accounting Standards (Ind AS)?

Indian Accounting Standards (Ind-AS) are the International Financial Reporting Standards (IFRS) converged
standards issued by the Central Government of India under the supervision and control of Accounting
Standards Board (ASB) of ICAI and in consultation with National Advisory Committee on Accounting
Standards (NACAS).
National Advisory Committee on Accounting Standards (NACAS) recommend these standards to the Ministry
of Corporate Affairs (MCA). MCA has to spell out the accounting standards applicable for companies in India.
The Ind AS are named and numbered in the same way as the corresponding International Financial
Reporting Standards (IFRS).
9.4.3 Government of India - Commitment to IFRS Converged Ind AS
Initially Ind AS were expected to be implemented from the year 2011. However, keeping in view the fact
that certain issues including tax issues were still to be addressed, the Ministry of Corporate Affairs decided
to postpone the date of implementation of Ind AS.
In July 2014, the Finance Minister of India at that time, Shri Arun Jaitely ji, in his Budget Speech, announced an
urgency to converge the existing accounting standards with the International Financial Reporting Standards
(IFRS) through adoption of the new Indian Accounting Standards (Ind AS) by the Indian companies.
Pursuant to the above announcement, various steps have been taken to facilitate the implementation of
IFRS-converged Indian Accounting Standards (Ind AS). Moving in this direction, the Ministry of Corporate
Affairs (MCA) has issued the Companies (Indian Accounting Standards) Rules, 2015 vide Notification dated
February 16, 2015 covering the revised roadmap of implementation of Ind AS for companies other than
Banking companies, Insurance Companies and NBFCs and Indian Accounting Standards (Ind AS). As per
the Notification, Indian Accounting Standards (Ind AS) converged with International Financial Reporting
Standards (IFRS) shall be implemented on voluntary basis from 1st April, 2015 and mandatory from 1st
April, 2016. Later on, in 2016 MCA notified roadmap for NBFC announcing implementation date for Ind AS.
Similarly, Banking and Insurance regulatory authority have issued separate roadmaps for implementation
of Ind AS for Banking and Insurance companies respectively.

9.5 LIST OF IND AS

Ind AS Title of Ind AS
101 First Time Adoption of Indian Accounting Standards
102 Share Based Payment
103 Business Combinations
104 Insurance Contracts
105 Non-current Assets Held for Sale and Discontinued Operations
106 Exploration for and Evaluation of Mineral Resources
107 Financial Instruments: Disclosures
108 Operating Segments
109 Financial Instruments
110 Consolidated Financial Statements
111 Joint Arrangements
112 Disclosure of Interests in Other Entities

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 THEORETICAL FRAMEWORK 1.95

Ind AS Title of Ind AS

113 Fair Value Measurement
114 Regulatory Deferral Accounts
1 Presentation of Financial Statements
2 Inventories
7 Statement of Cash Flows
8 Accounting Policies, Changes in Accounting Estimates and Errors
10 Events after the Reporting Period
11 Construction Contracts
12 Income Taxes
16 Property, Plant and Equipment
17 Leases
18 Revenue
19 Employee Benefits
20 Accounting for Government Grants and Disclosure of Government Assistance
21 The Effects of Changes in Foreign Exchange Rates
23 Borrowing Costs
24 Related Party Disclosures
27 Separate Financial Statements
28 Investment in Associates and Joint Ventures
29 Financial Reporting in Hyperinflationary Economies
32 Financial Instruments: Presentation
33 Earnings per Share
34 Interim Financial Reporting
36 Impairment of Assets
37 Provisions, Contingent Liabilities and Contingent Assets
38 Intangible Assets
40 Investment Property
41 Agriculture
Note: The list of Ind AS given above does not form part of syllabus. It has been given here for the
knowledge of students only.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Global Standards facilitate
(a) Cross border flow of money. (b) Global listing in different bourses.
(c) Comparability of financial statements. (d) All the three.
2. The Government of India in consultation with the ICAI decided to
(a) Adapt with IFRS. (b) Converge with IFRS.
(c) apply IFRS in India. (d) notify IFRS in India.

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 1.96 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. Convergence with IFRSs

(a) Simplifies the process of preparing the financial statements.
(b) Reduces the costs of preparing the financial statements.
(c) Both (a) and (b).
(d) Facilitates global investors’ understanding and confidence in high quality financial statements.

Theoretical Questions
1. Explain the need of convergence rather adoption of IFRS as Global Standards.
2. What is the significance of issue of Indian Accounting Standards? Explain in brief.

ANSWERS/HINTS
Multiple Choice Questions
1. (d); 2. (b); 3. (d)
Theoretical Questions
1. The Government of India in consultation with the ICAI decided to converge and not to adopt IFRSs
issued by the IASB. The decision of convergence rather than adoption was taken after the detailed
analysis of IFRSs requirements and extensive discussion with various stakeholders. Accordingly, while
formulating IFRS-converged Indian Accounting Standards (Ind AS), efforts have been made to keep
these Standards, as far as possible, in line with the corresponding IAS/IFRS and departures have been
made where considered absolutely essential.
2. Global Standards facilitate cross border flow of money, global listing in different bourses and
comparability of financial statements. The convergence of financial reporting and accounting standards
is a valuable process that contributes to the free flow of global investment and achieves substantial
benefits for all capital market stakeholders. It improves the ability of investors to compare investments
on a global basis and thus lowers their risk of errors of judgment. It facilitates accounting and reporting
for companies with global operations and eliminates some costly requirements say reinstatement of
financial statements.

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 CHAPTER 2
ACCOUNTING PROCESS
UNIT 1 : BASIC ACCOUNTING PROCEDURES - JOURNAL ENTRIES
LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand meaning and significance of Double Entry System.
w Familiarize with the term ‘account’ and understand the classification of accounts into personal, real and
nominal.
w Note the utility of such classification and sub-classifications.
w Understand how debits and credits are determined from transactions and events.
w Observe the points to be taken care of while recording a transaction in the journal .

UNIT Source • All documents in books which contain financial records and
OVERVIEW Documents act as evidence of transactions.

• Purchase day book, Cash book, Sales day book and

Books of original Purchases return book
entry and Ledger
Accounts
• Accounts where information relating to a particular asset/
liability, capital , income and expenses are recorded.

• It contains the totals from various ledger accounts and act

Trial as preliminary check on accounts before producing final
Balance
accounts.

Accounts

Personal Impersonal
Accounts Accounts

Natural Artificial Repre-

Real Nominal
(legal) sentative

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 2.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.1 DOUBLE ENTRY SYSTEM

Double entry system of accounting is more than 500 years old. “Luca Pacioli” an Italian friar & mathematician
published Summa de Arithmetica, Geometria, Proportioni, et Proportionalita (“Everything about
Arithemetic Geometry and proportions”). The first book that described a double entry accounting system.
Double entry system of book-keeping has emerged in the process of evolution of various accounting
techniques. It is the only scientific system of accounting. According to it, every transaction has two-fold
aspects–debit and credit and both the aspects are to be recorded in the books of accounts. Therefore, in
every transaction at least two accounts are effected.
For example, on purchase of furniture either the cash balance will be reduced or a liability to the supplier
will arise. and new asset furniture is acquired . This has been made clear already, the Double Entry System
records both the aspects. It may be defined as the system which recognises and records both the aspects
of transactions. This system has proved to be systematic and has been found of great use for recording the
financial affairs for all institutions requiring use of money.

1.2 ADVANTAGES OF DOUBLE ENTRY SYSTEM

This system affords the under mentioned advantages:
(i) By the use of this system the accuracy of the accounting work can be established, through the device of
the trial balance.
(ii) The profit earned or loss suffered during a period can be ascertained together with details.
(iii) The financial position of the firm or the institution concerned can be ascertained at the end of each
period, through preparation of the balance sheet.
(iv) The system permits accounts to be kept in as much details as necessary and, therefore affords significant
information for the purposes of control etc.
(v) Result of one year may be compared with those of previous years and reasons for the change may be
ascertained.
It is because of these advantages that the system has been used extensively in all countries.

1.3 ACCOUNT
We have seen how the accounting equation becomes true in all cases. A person starts his business with
say, ` 10,00,000; capital and cash are both ` 10,00,000. Transactions entered into by the firm will alter the
cash balance in two ways, one will increase the cash balance and other will reduce it. Payment for goods
purchased, for salaries and rent, etc., will reduce it; sales of goods for cash and collection from customers
will increase it.
We can change the cash balance with every transaction but this will be cumbersome. Instead it would be
better if all the transactions that lead to an increase are recorded in one column and those that reduce
the cash balance in another column; then the net result can be ascertained. If we add all increases to the
opening balance of cash and then deduct the total of all decreases we shall know the closing balance. In this
manner, significant information will be available relating to cash.

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 ACCOUNTING PROCESS 2.3

The two columns which we referred above are put usually in the form of an account, called the ‘T’ form. This
is illustrated below by taking imaginary figures:
Cash
Increase Decrease
(Receipt) (Payment)
` `
Opening Balance (1) 10,00,000 (7) 1,00,000
(2) 2,50,000 (8) 3,00,000
(3) 2,00,000 (9) 2,00,000
(4) 5,00,000 (10) 5,00,000
(5) 1,35,000
(6) 4,00,000 (11) 12,00,000
New or Closing Balance 1,85,000
24,85,000 24,85,000
Since, each T-account shows only amounts and not transaction descriptions, we key each transaction in
some way, such as by numbering used in this illustration. However, one can use date also for this purpose.
What we have done is to put the increase of cash on the left hand side and the decrease on the right hand
side; the closing balance has been ascertained by deducting the total of payments, ` 23,00,000 from the
total of the left - hand side. Such a treatment of receipts and payments of cash is very convenient.
Here we talked about only one account namely cash, now let us see how to make T-accounts when asset as
well as liabilities are effected from a particular transaction.
Now, let us take some more examples:-
Transaction 1 :
Initial investment by owners ` 25,00,000 in cash.
This will effect two accounts namely cash and capital. The asset cash increases and the stock holders’ equity
paid up capital also increases.
CASH
Increase Decrease
(1) 25,00,000
CAPITAL
Decrease Increase
(1) 25,00,000
Transaction 2:-
Paid cash to the creditors ` 14,00,000
This will effect cash account which will decrease and creditors account which is a liability will also decrease.
CASH
Increase Decrease
(2) 14,00,000

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 2.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

CREDITORS
Decrease Increase
(2) 14,00,000

The proper form of an account is as follows:

Account
Date Particulars Ref. Amount Date Particulars Ref. Amount

The columns are self-explanatory except that the column for reference (Ref.) is meant to indicate the sources
where information about the entry is available.

1.4 DEBIT AND CREDIT

We have seen that in T-accounts increase and decrease entries are made on the left and right side of the
accounts for assets respectively and vice-versa for liabilities. But, formally accountants use the term Debit
(Dr.) to denote an entry on the left side of any account and Credit (Cr.) to denote an entry on the right side
of any account.
We know that by deducting the total of liabilities from the total of assets the amount of capital is ascertained,
as is indicated by the accounting equation.

Assets = Liabilities + Capital

or
Assets – Liabilities = Capital
To understand the equation better , let us expand it:-
Assets = Liabilities + Stockholders’ Equity

Assets = Liabilities + ( contributed capital + beginning retained earnings + revenue - expense - dividends)
Here,
Contributed capital = the original capital introduced by the owner.
Beginning retained earnings = previous earnings not distributed to the shareholders.
Revenue = generated from the ongoing activities of the business
Expenses = cost incurred for the operations of the company.
Dividends = earnings distributed to the shareholders of the company

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 ACCOUNTING PROCESS 2.5

We have also seen that if there is any change on one side of the equation, there is bound to be similar
change on the other side of the equation or amongst items covered by it or an opposite change on the same
side of the equation. This is illustrated below:

Transactions Total = Liabilities + Owner’s

Assets ` Capital
` `
(1) Started business with cash ` 10,00,000 10,00,000 10,00,000
(2) Borrowed ` 5,00,000 + 5,00,000 + 5,00,000
(3) Withdrew cash from business ` 2,00,000 - 2,00,000 - 2,00,000
(4) Loan repaid to the extent of ` 1,00,000 - 1,00,000 - 1,00,000
Balance 12,00,000 = 4,00,000 + 8,00,000
As has been seen previously, what has been given above is suitable only if the number of transactions
is small. But if the number is large, a different procedure of putting increases and decreases in different
columns will be useful and this will also yield significant information. The transactions given above are
being shown below according to this method.

Total Assets = Liabilities + Owner’s Capital

Decrease Decrease Increase Decrease Increase
` ` ` ` `

(1) 10,00,000 10,00,000

(2) 5,00,000 5,00,000
(3) 2,00,000 2,00,000
(4) 1,00,000 1,00,000
Total 15,00,000 3,00,000 1,00,000 5,00,000 2,00,000 10,00,000
Balance 12,00,000 4,00,000 + 8,00,000
It is a tradition that:
(i) increases in assets are recorded on the left-hand side and decreases in them on the right-hand side; and
(ii) in the case of liabilities and capital, increases are recorded on the right-hand side and decreases on the
left-hand side.
When two sides are put together in T form, the left-hand side is called the ‘debit side’ and the right hand
side is ‘credit side’. When in an account a record is made on the debit or left-hand side, one says that one
has debited that account; similarly to record an amount on the right-hand side is to credit it.
From the above, the following rules can be obtained:
(i) When there is an increase in the amount of an asset, its account is debited; the account will be credited
if there is a reduction in the amount of the asset concerned : Suppose a firm purchases furniture for
` 8,00,000 the furniture account will be debited by ` 8,00,000 since the asset has increased by this
amount. Suppose later the firm sells furniture to the extent of ` 3,00,000 the reduction will be recorded
by crediting the furniture account by ` 3,00,000.

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 2.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

FURNITURE
Increase Decrease
(1) 8,00,000 (2) 3,00,000
Balance 5,00,000

ii) If the amount of a liability increases, the increase will be entered on the credit side of the liability account,
i.e. the account will be credited: similarly, a liability account will be debited if there is a reduction in the
amount of the liability. Suppose a firm borrows ` 5,00,000 from Mohan; Mohan’s account will be credited
since ` 5,00,000 is now owing to him. If, later, the loan is repaid, Mohan’s account will be debited since
the liability no longer exists.

MOHAN
Decrease Increase
(2) 5,00,000 (1) 5,00,000

(iii) An increase in the owner’s capital is recorded by crediting the capital account: Suppose the proprietor
introduces additional capital, the capital account will be credited. If the owner withdraws some money,
i.e., makes a drawing, the capital account will be debited.
(iv) Profit leads to an increase in the capital and a loss to reduction: According to the rule mentioned in (iii)
above, profit & incomes may be directly credited to the capital account and losses & expenses may be
similarly debited.
However, it is more useful to record all incomes, gains, expenses and losses separately. By doing so, very
useful information will be available regarding the factors which have contributed to the year’s profits
and losses. Later the net result of all these is ascertained and adjusted in the capital account.
(v) Expenses are debited and Incomes are credited: Since incomes and gains increase capital, the rule is to
credit all gains and incomes in the accounts concerned and since expenses and losses decrease capital,
the rule is to debit all expenses and losses. Of course, if there is a reduction in any income or gain, the
account concerned will be debited; similarly, for any reduction in an expenses or loss the concerned
account will be credited.
The rules given above are summarised below:
(i) Increases in assets are debits; decreases are credits;
(ii) Increases in liabilities are credits; decreases are debits;
(iii) Increases in owner’s capital are credits; decreases are debits;
(iv) Increases in expenses are debits; decreases are credits; and
(v) Increases in revenue or incomes are credits; decreases are debits.
The terms debit and credit should not be taken to mean, respectively, favourable and unfavourable things.
They merely describe the two sides of accounts.

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 ACCOUNTING PROCESS 2.7

? ILLUSTRATION 1

Following are the transactions entered into by R after he started his business. Show how various accounts will be
affected by these transactions:

2017 (` in 000)
April
1. R started business with 5,000
2. He purchased furniture for 1,200
3. Paid salary to his clerk 1,100
4. Paid rent 1,150
5. Received interest 2,000

 SOLUTION
2017 Explanation Accounts Nature of How Debit Credit
April Involved Accounts affected (` in 000) (` in 000)
1. ` 5,000 cash Bank and R’s Asset Increased 5,000
invested in business Capital Capital Increased 5,000
2. Purchased furniture Furniture and Asset Increased 1,200
for ` 1,200 Bank Asset Decreased 1,200
3. Paid ` 1,100 to Salary & Bank Expense Increased 1,100
employee for salary Asset Decreased 1,100
4. Paid Rent ` 1,150 Rent & Bank Expense Increased 1,150
Asset Decreased 1,150
5. Received interest Cash & Interest Asset Increased 2,000
` 2,000 Income Increased 2,000

1.5 TRANSACTIONS
In the system of book-keeping, students can notice that transactions are recorded in the books of accounts. A
transaction is a type of event, which is generally external in nature and can be determined in terms of money.
In an accounting period, every business has huge number of transactions which are analysed in financial
terms and then recorded individually, followed by classification and summarisation process, to know their
impact on the financial statements. A transaction is a two way process in which value is transferred from
one party to another. In it either a party receives a value in terms of goods etc. and passes the value in terms
of money or vice versa. Therefore, one can easily make out that in a transaction, a party receives as well as
passes the value to other party. For recording transaction it is very important that they are supported by a
substantial document like purchasing invoices, bills, pay-slips, cash-memos, passbook etc.
Transactions analysed in terms of money and supported by proper documents are recorded in the books of
accounts under double entry system. To analyse the dual aspect of each transaction, two approaches can
be followed:
(1) Accounting Equation Approach.
(2) Traditional Approach.

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 2.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.6 ACCOUNTING EQUATION APPROACH

The relationship of assets with that of liabilities and owners’ equity in the equation form is known as
‘Accounting Equation’. Basic accounting equation comes into picture when sum total of capital and liabilities
equalises assets, where assets are what the business owns and capital and liabilities are what the business
owes. Under double entry system, every business transaction has two-fold effect on the business enterprise
where each transaction affects changes in assets, liabilities or capital in such a way that an accounting
equation is completed and equated. This accounting equation holds good at all points of time and for any
number of transactions and events except when there are errors in accounting process.
Let us suppose that an individual started business by contributing ` 50,00,000 and taking loan of `10,00,000
from a bank to be repayable, after 5 years. He purchased furniture costing ` 10,00,000, and merchandise
worth ` 50,00,000. For purchasing the merchandise he paid ` 40,00,000 to the suppliers and agreed to pay
balance after 3 months. Assume that all these transactions and events occurred at to, base point of time.
The contribution by the owner is termed as capital; the borrowings are termed as loans or liabilities.
Whenever the loan is repayable in the short-run, say within one year, it is called short-term loan or liability.
On the other hand, if the loan is repayable within say 4 or 5 years or more, it would be termed as long term
loan or liability.
Some other short-term liabilities relating to credit purchase of merchandise are popularly called as trade
payables, and for other purchases and services received on credit as expense payables. These short-term
liabilities are also termed as current liabilities.
On the other hand, money raised has been invested in two types of assets–fixed assets and current assets.
Furniture is a fixed asset, if it lasts long, say more than one year, and has utility to the business, while inventory
and cash balance will not remain fixed for long as soon as the business starts to roll-these are current assets.
Often the owner’s claim or fund in the business is called equity. Owner’s claim implies capital invested plus
any profit earned minus any loss sustained.
Now at to we have an equation:
Equity + Liabilities = Assets
or, Equity + Long-Term Liabilities = Fixed Assets + Current Assets - Current Liabilities
Check : L.H.S. (` in ‘000)

Equity ` 5,000
Long–term Liabilities ` 1,000
Current Liabilities ` 1,000
` 7,000
R.H.S.
Fixed Assets:
Furniture ` 1,000
Current Assets:
Inventory ` 5,000
Cash ` 1,000
` 7,000

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 ACCOUNTING PROCESS 2.9

Cash = Capital + Loan - Furniture - Payment to Trade payables (`’ 000 )

= ` 5,000 + ` 1,000 - ` 1,000 - ` 4,000 = ` 1,000
Let us use E0, L0 and A0 to mean Equity, Liabilities and Assets respectively at t0. Thus the basic accounting
equation becomes
E0 + L0 = A0
or E0 = A0 - L0 ...(Eq. 1)
(`’ 000 )
Now, let us suppose that at the end of period inventory valuing ` 2,500 is in hand, cash
` 2,000; trade payables ` 500; bank loan ` 1,000 (interest was properly paid); furniture ` 800
(` 200 is taken as loss of value due to use). So at t1 -

Assets: (`’ 000 )

Fixed assets/ Furniture ` 800
Current assets/ inventory ` 2,500
Cash ` 2,000
(A1) ` 5,300
Liabilities:
Long-term Liabilities ` 1,000
Current Liabilities ` 500
(L1) ` 1,500
Equity (A1 - L1) ` 3,800
Equity = Assets - Liabilities
i.e., E1 = A1 - L1
or E1 + L1 = A1 ...(Eq. 2)
Let us compare E1 with E0. Equity is reduced by ` 12,00,000 (50,00,000 - 38,00,000). Reduction in equity is
termed as loss.
Since the business sustained loss during the period, E1 becomes less than E0.
E1< E0 implies loss during t01
Similarly, E2< E1 implies loss during t12 and so on.
On the other hand, E1> E0 implies profit earned by business during t01, E2> E1 implies profit earned during t12
and so on.
So if En> En-1, in general terms, equity has increased, while En< En-1 implies that equity has declined.
Increase in equity is termed as profit while decrease in equity is termed as loss.

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 2.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 2
Develop the accounting equation from following information available at the beginning of accounting period:

Particulars (` in 000)
Capital 51,000
Loan 11,500
Trade payables 5,700
Fixed Assets 12,800
Inventory 22,600
Trade receivables 17,500
Cash and Bank 15,300
At the end of the accounting period the balances appear as follows:

(` in 000)
Capital ?
Loan 11,500
Trade payables 5,800
Fixed Assets 12,720
Inventory 22,900
Trade receivables 17,500
Cash at Bank 15,600
(a) Reset the equation and find out profit.
(b) Prepare Balance Sheet at the end of the accounting period.

 SOLUTION
(All the figures in solution are in ` 000)
(a) Accounting equation is given by
Equity + Liabilities = Assets
Let us use E0, L0 and A0 to mean equity, liabilities and assets respectively at the beginning of the accounting
period.
E0 = ` 51,000
L0 = Loan + Trade payables
= ` 11,500 + ` 5,700
= ` 17,200
A0 = Fixed Assets + Inventories + Trade receivables + Cash at Bank
= ` 12,800 + ` 22,600 + ` 17,500 + ` 15,300
= ` 68,200
So, at the beginning of accounting period
E0 + L0 = A0
i.e., ` 51,000 + ` 17,200 = ` 68,200

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 ACCOUNTING PROCESS 2.11

Let us use E1, L1, A1 to mean equity, liabilities and assets respectively at the end of the accounting period.
L1 = Loan + Trade payables
= ` 11,500 + ` 5,800
= ` 17,300
A1 = Fixed Assets + Inventories + Trade receivables + Cash at Bank
= ` 12,720 + ` 22,900 + ` 17,500 + ` 15,600
= ` 68,720
E1 = A1 - L1 = ` 68,720 - ` 17,300 = ` 51,420
Profit = E1 - E0 = ` 51,420 - ` 51,000 = ` 420
(b) Balance Sheet

Liabilities ` ` Assets `
Capital Fixed Assets 12,720
Balance 51,000 Inventories 22,900
Add: Profit 420 51,420 Trade receivables 17,500
Loan 11,500 Cash at Bank 15,600
Trade payables 5,800
68,720 68,720

? ILLUSTRATION 3

Mr. Dravid. has provided following details related to his financials. Find out the missing figures:

Particulars (` in’000)
Profits carved during the year 5,000
Assets at the beginning of year A
Liabilities at the beginning of year 12,000
Assets at the end of the year B
Liabilities at the end of the year C
Closing capital 35,000
Total liabilities including capital at the end of the year 50,000

 SOLUTION

Computing opening capital: (All figure in `’ 000 )

Closing capital - profits earned during the year
= 35,000 - 5,000
= 30,000
We also know:
Assets = liabilities + capital
Therefore, opening assets (A) = 12,000 + 30,000
= 42,000

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 2.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

Computation of liabilities at the end of the year:

Total liabilities including capital = 50,000
Less: closing capital = (35,000)
Liabilities at the end of the year (C) = 15,000
Also assets at the end of the year (B) = closing capital + liabilities at the end of the year
= 35,000 + 15,000
= 50,000

1.7 TRADITIONAL APPROACH

Under traditional approach of recording transactions one should first understand the term debit and credit
and their rules. The term debit and credit have already been explained in para 1.4 of this Unit.
Transactions in the journal are recorded on the basis of the rules of debit and credit only. For the purpose of
recording, these transactions are classified in three groups:
(i) Personal transactions.
(ii) Transactions related to assets and properties.
(iii) Transactions related to expenses, losses, income and gains.
1.7.1 Classification of Accounts
(i) Personal Accounts: Personal accounts relate to persons, trade receivables or trade payables. Example
would be the account of Ram & Co., a credit customer or the account of Jhaveri & Co., a supplier of goods.
The capital account is the account of the proprietor and, therefore, it is also personal but adjustment on
account of profits and losses are made in it. This account is further classified into three categories:
(a) Natural personal accounts: It relates to transactions of human beings like Ram, Rita, etc.
(b) Artificial (legal) personal accounts: For business purpose, business entities are treated to have
separate entity. They are recognised as persons in the eye of law for dealing with other persons. For
example: Government, Companies (private or limited), Clubs, Co-operative societies etc.
(c) Representative personal accounts: These are not in the name of any person or organisation
but are represented as personal accounts. For example: outstanding liability account or prepaid
account, capital account, drawings account.
(ii) Impersonal Accounts: Accounts which are not personal such as machinery account, cash account, rent
account etc. These can be further sub-divided as follows:
(a) Real Accounts: Accounts which relate to assets of the firm but not debt. For example, accounts
regarding land, building, investment, fixed deposits etc., are real accounts. Cash in hand and Cash
at the bank accounts are also real.
(b) Nominal Accounts: Accounts which relate to expenses, losses, gains, revenue, etc. like salary
account, interest paid account, commission received account. The net result of all the nominal
accounts is reflected as profit or loss which is transferred to the capital account. Nominal accounts
are, therefore, temporary.

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 ACCOUNTING PROCESS 2.13

1.7.2 Golden Rules of Accounting

All the above classified accounts have two rules each, one related to Debit and one related to Credit for
recording the transactions which are termed as golden rules of accounting, as transactions are recorded on
the basis of double entry system.

Types of Account Account to be Debited Account to be Credited

Personal Account Receiver Giver
Real Account What comes in What goes out
Nominal Account Expense and losses Income and gains
Example:-
From the following information , state the nature of account and state which account will be debited and
which will be credited.
1. Started business with a capital of ` 50,00,000.
2. Wages and salaries paid ` 50,000
3. Rent received ` 2,00,000
4. Purchased goods on credit ` 9,00,000
5. Sold goods for ` 8,16,000 and received payment in cheque.

 SOLUTION

Transaction ACCOUNTS NATURE DEBIT OR CREDIT Journal Entry

INVOLVED
Started business Bank account Personal Debit (Receiver) Bank A/c Dr.
with capital of Capital account Personal Credit (giver) To Capital A/c
` 50,00,000
Wages and salariesWages/salaries Nominal Debit (expense) Wages/ Salaries Dr.
paid Bank Personal Credit (giver) To Bank A/c
Rent received Bank Personal Debit (Receiver) Bank A/c Dr.
Rent Nominal Credit (income) To Rent A/c
Purchases made on Purchases Nominal Debit (expense) Purchases A/c Dr.
credit Creditor Personal Credit (giver) To Creditor A/c
Goods sold and Bank Personal Debit (Receiver) Bank A/c Dr.
payment received Sales Nominal Credit (gains) To Sales A/c
in cheque

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 2.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.8 MODERN CLASSIFICATION OF ACCOUNTS

Real, nominal and personal accounts is the traditional classification of accounts. Now, let us see the modern
and more acceptable classification of accounts:-
Types of account Normal balance of Account to be debited Account to be credited
account when there is: when there is:
Asset account Debit Increase Decrease
Liabilities account Credit Decrease Increase
Capital account Credit Decrease Increase
Revenue account Credit Decrease Increase
Expenditure account Debit Increase Decrease
Drawing account Debit Increase Decrease
Let us solve the same example with the modern approach now:-
Accounts involved Nature Debit/Credit Reason
Bank Asset Debit Increase
Capital Liability Credit Increase
Wages/salaries Expense Debit Increase
Bank Asset Credit Decrease
Bank Asset Debit Increase
Rent Revenue Credit Increase
Purchase Expense Debit Increase
Creditor Liability Credit Increase
Bank Asset Debit Increase
Sales Revenue Credit Increase

1.9 JOURNAL
Transactions are first entered in this book to show which accounts should be debited and which credited.
Journal is also called subsidiary book. Recording of transactions in journal is termed as journalizing the
entries. It is the book of original entry in which transactions are entered on a daily basis in a chronological
order.
1.9.1Journalising Process
All transactions may be first recorded in the journal as and when they occur; the record is chronological;
otherwise it would be difficult to maintain the records in an orderly manner. Debits and credits are listed
along with the appropriate explanations. There are basically two types of journals:-
1. General journal
2. Specialized journal
The latter is used when there are many repetitive transactions of the same nature. The form of the
journal is given below:

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 ACCOUNTING PROCESS 2.15

JOURNAL

Dr. Cr.
Date Particulars L.F. Amount Amount
` ` ` `
(1) (2) (3) (4) (5)
The columns have been numbered only to make clear the following but otherwise they are not numbered.
The following points should be noted:
(i) In the first column the date of the transaction is entered-the year is written at the top, then the month
and in the narrow part of the column the particular date is entered.
(ii) In the second column, the names of the accounts involved are written; first the account to be debited,
with the word “Dr” written towards the end of the column. In the next line, after leaving a little space,
the name of the account to be credited is written preceded by the word “To” (the modern practice
shows inclination towards omitting “Dr.” and “To”). Then in the next line the explanation for the entry
together with necessary details is given-this is called narration.
(iii) In the third column the number of the page in the ledger on which the account is written up is entered.
(iv) In the fourth column the amounts to be debited to the various accounts concerned are entered.
(v) In the fifth column, the amount to be credited to various accounts is entered.
1.9.2 Points to be taken into care while recording a Transaction in the Journal
1. Journal entries can be single entry (i.e. one debit and one credit) or compound entry (i.e. one debit and
two or more credits or two or more debits and one credit or two or more debits and credits). In such
cases, it is important to check that the total of both debits and credits are equal.
2. If journal entries are recorded in several pages then both the amount column of each page should be
totalled and the balance should be written at the end of that page and also that the same total should
be carried forward at the beginning of the next page.
An entry in the journal may appear as follows:

` `
May 5 Bank Account Dr. 14,50,000
To Mohan 14,50,000
(Being the amount received from
Mohan in payment of the amount due
from him)
We will now consider some individual transactions.
(i) Mohan commences business with ` 50,00,000 in his bank account. This means that the firm has
` 50,00,000 in bank. According to the rules given above, the increase in an asset has to be debited to it.
The firm also now owes ` 50,00,000 to the proprietor, Mohan as capital. The rule given above also shows
that the increase in capital should be credited to it. Therefore, the journal entry will be:

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 2.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

Bank Account Dr. ` 50,00,000

To Capital Account ` 50,00,000
(Being capital introduced by Shri Mohan)
(ii) Out of the above, ` 25,000 is withdrawn from the bank. By this transaction the bank balance is reduced
by ` 25,000 and another asset, cash account, comes into existence. Since increase in assets is debited
and decrease is credited, the journal entry will be:

Cash Account Dr. ` 25,000

To Bank Account ` 25,000
(Being cash withdraw in Bank)
(iii) Furniture is purchased for ` 12,00,000. Applying the same reasoning as above the entry will be:

Furniture Account Dr. ` 12,00,000

To Bank Account ` 12,00,000
(Being Furniture purchased vide CM No....)
(iv) Purchased goods for cash ` 4,00,000. The student can see that the required entry is:

Purchases Account Dr. ` 4,00,000

To Bank Account ` 4,00,000
(Being goods purchased vide CM No....)
(v) Purchased goods for ` 10,00,000 on credit from M/s Ram Narain Bros. Purchase of merchandise is
an expense item so it is to be debited. ` 10,00,000 is now owing to the supplier; his account should
therefore be credited, since the amount of liabilities has increased. The entry will be:

Purchases Account Dr. ` 10,00,000

To M/s Ram Narain Bros. ` 10,00,000
(Being goods purchased vide Bill No.....)
(vi) Sold goods to M/s Ram & Co. for ` 6,00,000. Amount is received in cheque. The amount of bank increases
and therefore, the bank amount should be debited; sale of merchandise is revenue item so it is to be
credited. The entry will be:
Bank Account Dr. ` 6,00,000
To Sales Account ` 6,00,000
(Being goods sold vide CM No....)
(vii) Sold goods to Ramesh on credit for ` 13,00,000. The Inventories of goods has decreased and therefore,
the goods account has to be credited. Ramesh now owes ` 13,00,000; that is an asset and therefore,
Ramesh should be debited. The entry is:

Ramesh Dr. ` 13,00,000

To Sales Account ` 13,00,000
(Being goods sold vide Bill No....)

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 ACCOUNTING PROCESS 2.17

Note: There are two views on classification of “Purchase Account” and “Sales Account”. One view is that
they represents “flow of goods”, so they should be classified as ‘Real A/c’. However, others are of the
opinion that only nominal a/cs are closed by transferring to ‘Trading or Profit and Loss A/c’. Therefore,
purchases and sales shall be classified as Nominal A/cs. However, in both the views, there will be debit
balance of Purchase A/c and credit balance of Sales A/c.
(viii) Received cheque from Ramesh ` 13,00,000. The amount of bank increased therefore the bank account
has to be debited. Ramesh’s liability towards firm has decreased infact in this case he no longer owes
any amount to the firm, i.e., this particular form of assets has disappeared; therefore, the account of
Ramesh should be credited. The entry is:

Bank Account Dr. ` 13,00,000

To Ramesh ` 13,00,000
(Being cheque received against Bill No....)

(x) Paid rent ` 1,00,000. The bank balance has decreased and therefore, the bank account should be
credited. No asset has come into existence because the payment is for services enjoyed and is an
expense. Expenses are debited. Therefore, the entry should be:

Rent Account Dr. ` 1,00,000

To Bank Account ` 1,00,000
(Being rent paid for the month of .......)
(xi) Paid ` 22,000 to the clerk as salary. Applying the reasons given in (x) above, the required entry is:

Salary Account Dr. ` 22,000

To Bank Account ` 22,000
(Being salary paid to Mr..... for the month of ...........)
(xii) Received ` 2,20,000 interest. The bank account should be debited since there is an increase in the bank
balance. There is no increase in any liability; since the amount is not returnable to any one, the amount
is an income, incomes are credited. The entry is :

Bank Account Dr. ` 2,20,000

To Interest Account ` 2,20,000
(Being interest received from........ for the period ............)
When transactions of similar nature take place on the same date, they may be combined while they are
journalised. For example, entries (x) and (xi) may be combined as follows:
Rent Account Dr. ` 1,00,000
Salary Account Dr. ` 22,000
To Bank Account ` 1,22,000
(Being expenses done as per detail attached)
When journal entry for two or more transactions are combined, it is called composite journal entry. Usually,
the transactions in a firm are so numerous that to record the transactions for a month will require many
pages in the journal. At the bottom of one page the totals of the two columns are written together with the
words “Carried forward” in the particulars column. The next page is started with the respective totals in the
two columns with the words “Brought forward” in the particulars column.

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 2.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 4

Analyse transactions of M/s Sahil & Co. for the month of March, 2017 on the basis of double entry system by
adopting the following approaches:
(A) Accounting Equation Approach.
(B) Traditional Approach.
Transactions for the month of March, 2017 were as follows (figures are in ‘000):
1. Sahil introduced capital through bank of ` 4,000.
2. Cash withdrawn from the City Bank ` 200.
3. Loan of ` 500 taken from Mr. Y.
4. Salaries paid for the month of March, 2017, ` 300 and ` 100 is still payable for the month of March, 2017.
5. Furniture purchased ` 500.
Required
What conclusion one can draw from the above analysis?

 SOLUTION

(A) Analysis of Business Transaction: Accounting Equation Approach

The accounting equation is
Assets = Liabilities + Capital
(` in ‘000)
ASSETS = CAPITAL + LIABILITIES
CASH + BANK + FURNITURE = CAPITAL + LIABILITIES
(a) - + 4,000 + - = 4,000 + -
(b) +200 + -200 + - = - + -
(c) - + 500 + - = - + 500
(d) - + -300 + - = -400 + 100
(e) - + -500 + 500 = - + -
Balance 200 + 3,500 + 500 = 3,600 + 600
4,200 4,200
(B) Analysis of Business Transactions: Traditional Approach
Transaction Analysis Account Affected Rule Entry
and Nature of
Account
Introduction of Bank has received Bank–Personal Debit the receiver Debit Bank
` 4,000 through the money; Owner
Capital–Personal Credit the giver Credit Capital
bank by the has given Bank
proprietor balance
Cash Withdrawn Cash comes into Cash–Real Debit what comes Debit Cash
from Bank ` 200 business; Bank in Credit the giver
Bank–Personal Credit Bank
gives out cash

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 ACCOUNTING PROCESS 2.19

Loan from Y Bank receives the Bank–Personal Debit the receiver Debit Bank
` 500 amount :Y pays
Y’s Loan–Personal Credit the giver Credit Y’s Loan
through bank
Salary paid ` 300 Cost of services Salary Nominal Debit all expenses Debit Salary (` 400)
and still payable used ` 400; Bank
Bank–Personal Credit the giver Credit Bank (`3,00)
` 100 gives out `300;
Still payable or Salary Outstanding Credit the giver Credit Salary
outstanding for Personal outstanding
services received (` 100)
` 100
Furniture Furniture is Furniture Real Debit what comes Debit Furniture
purchased purchased; in Credit the giver
Bank–Personal Credit Bank
` 500 Bank gives out
money
Conclusion:
It is evident from above analysis that procedure for analysis of transactions, classification of accounts and
rules for recording business transactions under accounting equation approach and traditional approach are
different. But the accounts affected and entries in affected accounts remain same under both approaches.
Thus, the recording of transactions in affected accounts on the basis of double entry system is independent
of the method of analysis followed by a business enterprise. In other words, accounts to be debited and
credited to record the dual aspect remain same under both the approaches.

? ILLUSTRATION 5

Journalise the following transactions. Also state the nature of each account involved in the Journal entry.
Following figures are given in (‘00)
1. December 1, 2016, Ajit started business with capital ` 4,00,000
2. December 3, he withdrew cash for business from the Bank ` 2,000.
3. December 5, he purchased goods making payment through bank` 15,000.
4. December 8, he sold goods` 16,000 and received payment through bank.
5. December 10, he purchased furniture and paid by cheque ` 2,500.
6. December 12, he sold goods to Arvind ` 2,400.
7. December 14, he purchased goods from Amrit ` 10,000.
8. December 15, he returned goods to Amrit ` 500.
9. December 16, he received from Arvind ` 2,300 in full settlement.
10. December 18, he withdrew goods for personal use ` 1,000.
11. December 20, he withdrew cash from business for personal use ` 2,000.
12. December 24, he paid telephone charges ` 110.
13. December 26, amount paid to Amrit in full settlement ` 9,450.

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 2.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

14. December 31, paid for stationery ` 200, rent `5,000 and salaries to staff ` 2,000.
15. December 31, goods distributed by way of free samples ` 2,000.

 SOLUTION

JOURNAL (` in ‘00)
Dr. Cr.
Sl. Date Particulars Nature of L.F. Debit Credit
No Account (`) (`)
1. Dec. 1 Bank Account Dr. Personal A/c 4,00,000
To Capital Account Personal A/c 4,00,000
(Being commencement
of business)
2. Dec. 3 Cash Account Dr. Real A/c 2,000
To Bank Account Personal A/c 2,000
(Being cash withdrawn
from the Bank)
3. Dec. 5 Purchases Account Dr. Real A/c 15,000
To Bank Account Personal A/c 15,000
(Being purchase of
goods for cash)
4. Dec. 8 Bank Account Dr. Personal A/c 16,000
To Sales Account Real A/c 16,000
(Being goods sold for cash)
5. Dec. 10 Furniture Account Dr. Real A/c 2,500
To Bank Account Personal A/c 2,500
(Being purchase of
furniture, paid by cheque)
6. Dec. 12 Arvind Dr. Personal A/c 2,400
To Sales Account Real A/c 2,400
(Being sale of goods)
7. Dec. 14 Purchases Account Dr. Real A/c 10,000
To Amrit Personal A/c 10,000
(Being purchase of
goods from Amrit )
8. Dec. 15 Amrit Dr. Personal A/c 500
To Purchases
Returns Account Real A/c 500
(Being goods
returned to Amrit)

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 ACCOUNTING PROCESS 2.21

9. Dec. 16 Bank Account Dr. Personal A/c 2,300

Discount Account Dr. Nominal A/c 100
To Arvind Personal A/c 2,400
(Being cash received from
Arvind in full settlement
and allowed him ` 100
as discount)
10. Dec. 18 Drawings Account Dr. Personal A/c 1,000
To Purchases Account Real A/c 1,000
(Being withdrawal of
goods for personal use)
11. Dec. 20 Drawings Account Dr. Personal A/c 2,000
To Cash Account Real A/c 2,000
(Being cash withdrawal
from the business for
personal use)
12. Dec. 24 Telephone Expenses Dr. Nominal A/c 110
Account
To Bank Account Personal A/c 110
(Being telephone
expenses paid)
13. Dec 26 Amrit Dr. Personal A/c 9,500
To Bank Account Personal A/c 9,450
To Discount Account Nominal A/c 50
(Being cash paid to
Amrit and he allowed
` 50 as discount)
14. Dec. 31 Stationery Expenses Dr. Nominal A/c 200
Rent Account Dr. Nominal A/c 5,000
Salaries Account Dr. Nominal A/c 2,000
To Bank Account Personal A/c 7,200
(Being expenses paid)
15. Dec. 31 Advertisement
Expenses Account Dr. Nominal A/c 2,000
To Purchases Account Real A/c 2,000
(Being distribution of
goods by way of
free samples)

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 2.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 6

Show the classification of the following Accounts under traditional and accounting equation approach:
(a) Building; (b) Purchases; (c) Sales; (d) Bank Fixed Deposit; (e) Rent; (f) Rent Outstanding; (g) Cash; (h) Adjusted
Purchases; (i) Closing Inventory; (j) Investments; (k) Trade receivables; (l) Sales Tax Payable, (m) Discount Allowed;
(n) Bad Debts; (o) Capital; (p) Drawings; (q) Interest Receivable account; (r) Rent received in advance account;
(s) Prepaid salary account; (t) Bad debts recovered account; (u) Depreciation account, (v) Personal income-tax
account.

 SOLUTION
Nature of Account
Sl. Title of Account Traditional Approach Accounting Equation Approach
No.
(a) Building Real Asset
(b) Purchases Real Asset
(c) Sales Real Revenue
(d) Bank Fixed Deposit Personal Asset
(e) Rent Nominal (Expense) Expense
(f ) Rent Outstanding Personal Liability
(g) Cash Real Asset
(h) Adjusted Purchases Nominal (Expense) Expense
(i) Closing Inventory Real Asset
(j) Investment Real Asset
(k) Trade receivables Personal Asset
(l) Sales Tax Payable Personal Liability
(m) Discount Allowed Nominal (Expense) Temporary Capital (Expense)
(n) Bad Debts Nominal (Expense) Temporary Capital (Expense)
(o) Capital Personal Capital
(p) Drawings Personal Temporary Capital (Drawings)
(q) Interest receivable Personal Asset
(r) Rent received in advance Personal Liability
(s) Prepaid salary Personal Asset
(t) Bad debts recovered Nominal (Gain) Temporary Capital (Gain)
(u) Depreciation Nominal (Expense) Temporary Capital (Expense)
(v) Personal Income Tax Personal (Drawing) Temporary Capital (Drawings)

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 ACCOUNTING PROCESS 2.23

? ILLUSTRATION 7

Transactions of Ramesh for April are given below. Journalise them.

2017 `
April 1 Ramesh started business with 10,00,000
“ 3 Bought goods for cash 50,000
“ 5 Drew cash from bank 10,000
“ 13 Sold to Krishna- goods on credit 1,50,000
“ 20 Bought from Shyam goods on credit 2,25,000
“ 24 Received from Krishna 1,45,000
“ Allowed him discount 5,000
“ 28 Paid Shyam cash 2,15,000
“ Discount allowed 10,000
“ 30 Cash sales for the month 8,00,000
Paid Rent 50,000
Paid Salary 1,00,000

 SOLUTION
JOURNAL

Dr. Cr.
Date Particulars L.F. Amount Amount
2017
April 1 Bank Account Dr. 1 10,00,000
To Capital Account 4 10,00,000
(Being the amount invested by Ramesh in
the business as capital)
“3 Purchases Account Dr. 7 50,000
To Bank Account 1 50,000
(Being goods purchased for cash)
“5 Cash Account Dr. 5 10,000
To Bank Account 1 10,000
(Being cash withdrawn from bank)
“ 13 Krishna Dr. 9 1,50,000
To Sales Account 11 1,50,000
(Being goods sold to Krishna on credit)
“ 20 Purchases Account Dr. 7 2,25,000
To Shyam 10 2,25,000
(Being goods bought from Shyam on credit)
“ 24 Bank Account Dr. 1 1,45,000
Discount Account Dr. 12 5,000
To Krishna 9 1,50,000
(Being cash received from Krishna and
discount allowed to him)

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 2.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

“ 28 Shyam Dr. 10 2,25,000

To Bank Account 1 2,15,000
To Discount Account 12 10,000
(Being cash paid to Shyam and discount
allowed by him)
“ 30 Bank Account Dr. 1 8,00,000
To Sales Account 11 8,00,000
(Being goods sold for cash)
“ 30 Rent Account Dr. 15 50,000
Salaries Account Dr. 14 1,00,000
To Bank Account 1 1,50,000
(Being the amount paid for rent and salary)
Total 27,60,000 27,60,000
(Ledger Folio imaginary)
1.10 ADVANTAGES OF JOURNAL
In journal, transactions recorded on the basis of double entry system, fetch following advantages:
1. As transactions are recorded on chronological order, one can get complete information about the
business transactions on time basis.
2. Entries recorded in the journal are supported by a note termed as narration, which is a precise explanation
of the transaction for the proper understanding of the entry. One can know the correctness of the entry
through these narrations.
3. Journal forms the basis for posting the entries in the ledger. This eases the accountant in their work and
reduces the chances of error.

SUMMARY
• The accounting process starts with the recording of transactions in the form of journal entries.
• The recording is based on double entry system. This book or register called journal is the book of first
or original entry.
• Next step is to post the entries in the ledger covered in the next unit.

TEST YOUR KNOWLEDGE

Multiple Choice Question
1. The rent paid to landlord is credited to
(a) Landlord’s account.
(b) Rent account.
(c) Cash account.
2. In case of a debt becoming bad, the amount should be credited to
(a) Trade receivables account.
(b) Bad debts account.
(c) Cash account.

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 ACCOUNTING PROCESS 2.25

3. A Ltd. has a ` 35,000 account receivable from Mohan. On January 20, Mohan makes a partial payment
of ` 21,000 to A Ltd. The journal entry made on January 20 by A Ltd. to record this transaction includes:
(a) A credit to the cash received account of ` 21,000.
(b) A credit to the Accounts receivable account of ` 21,000.
(c) A debit to the cash account of ` 14,000.
4. Which financial statement represents the accounting equation -
Assets = Liabilities + Owner’s equity:
(a) Income Statement
(b) Statement of Cash flows
(c) Balance Sheet.
5. Which account is the odd one out?
(a) Office furniture & Equipment.
(b) Freehold land and Buildings.
(c) Inventory of materials.
6. The debts written off as bad, if recovered subsequently are
(a) Credited to Bad Debts Recovered Account
(b) Credited to Trade receivables Account.
(c) Debited to Profit and Loss Account.
7. In Double Entry System of Book-keeping every business transaction affects:
(a) Two accounts
(b) Two sides of the same account.
(c) The same account on two different dates.
8. A sale of goods to Ram for cash should be debited to:
(a) Ram
(b) Cash
(c) Sales
Theory Questions
1. Write short note on classification of accounts.
2. Distinguish between Real account and nominal account.
Practical Questions
1. Show the classification of the following Accounts under traditional and accounting equation approach:
a Rent outstanding g Capital
b Closing Inventory h Sales Tax Payable
c Sales i Trade receivables
d Bank Fixed Deposit j Depreciation
e Cash k Drawings
f Bad Debts

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 2.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. Pass Journal Entries for the following transactions in the books of Gamma Bros.
(i) Employees had taken inventory worth ` 1,00,000 (Cost price ` 75,000) on the eve of Deepawali and
the same was deducted from their salaries in the subsequent month.
(ii) Wages paid for erection of Machinery ` 18,000.
(iii) Income tax liability of proprietor ` 1,17000 was paid out of petty cash.
(iv) Purchase of goods from Naveen of the list price of ` 2,00,000. He allowed 10% trade discount, `
5,000 cash discount was also allowed for quick payment.
3. Calculate the missing amount for the following.

Assets Liabilities Capital

(a) 15,00,000 2,50,000 ?
(b) ? 1,50,000 75,000
(c) 14,50,000 ? 13,75,000
(d) 57,00,000 - 2,80,000 ?
4. Show the effect of increase = (+), decrease = (-) and no change=(0) on the assets of the following
transactions:
a. Purchased office furniture, payment to be made next month.
b. Collected cash for repair services
c. Goods sold on credit.
d. Withdrawl of cash by the owner for personal use.
e. Hired an employee as sales manager of the north wing.
f. Returned goods worth ` 50,000.
g. One of our debtor agreed to pay his dues to Mr. C who is a creditor of the company with the same
amount being due to him.
h. Entered into an agreement with Mehta & Co. to purchase all raw materials from their company from
next year.
Also give reasons for your answers.
5. Following is the information provided by Mr. Gopi pertaining to year ended 31st March 2017. Find the
unknowns, showing computation to support your answer:

Particulars ` Particulars `
Machinery 12,00,000 Trade Receivables B
Accounts Payable 1,00,000 Loans C
Inventory 60,000 Closing Capital D
Total Liabilities including 14,15,000 Opening Capital 10,00,000
capital
Cash A Loss incurred during the 35,000
year
Bank 80,000 Capital Introduced during 1,00,000
the year

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 ACCOUNTING PROCESS 2.27

Additional Information: During the year sales of ` 15,55,000 was made of which Rs. 15,00,000 have
been received.
ANSWERS/HINTS
MCQs

1. (c) 2. (a) 3. (b) 4. (c) 5. (c) 6. (a) 7. (a) 8. (c)

Theoretical Questions
1 a. Accounts are broadly classified into assets, liabilities and capital. The basic accounting equation
specifies broad categories, which are as follows:
(i) Assets: These are resources controlled by the enterprise as a result of past events and from
which future economic benefits are expected to flow to the enterprise, namely cash, stock of
goods, land, buildings, machinery etc.
(ii) Liabilities: These are financial obligations of an enterprise other than owner’s equity namely
long term loans, creditors, outstanding expenses etc.
(iii) Capital: It generally refer to the amounts invested in an enterprise by its owner(s), the accretion
to it or a reduction in it. Since capital is affected by expenses and incomes of revenue nature,
there are two more categories of accounts, namely expenses and incomes. The difference
between incomes and expenses are taken into capital account.
Ø Expenses: These represents those accounts which show the amount spent or even lost in
carrying on operations.
Ø Incomes: These represent those accounts which show the revenue amounts earned by
the enterprise.
However, traditionally accounts are classified as follows:
(i) Personal Accounts: These accounts relate to persons, institutions, debtors or creditors.
(ii) Impersonal Accounts: These represent accounts which are not personal. These can be further
sub-divided as follows:
Ø Real Accounts: These accounts relate to assets of the firm but not debt e.g. accounts
relating to land, buildings, cash in hand etc.
Ø Nominal accounts: These accounts relate to expenses, losses, gains, revenues etc.
2. A real account is an account relating to properties and assets, other than personal accounts of the firm.
Examples are land, buildings, machinery, cash, investments etc. Nominal accounts relate to expenses
or losses, incomes and gains. Examples are: wages, salaries, rent, depreciation etc. The net result of all
the nominal accounts is reflected as profit or loss which is transferred to the capital account. Nominal
accounts are therefore, temporary. The real accounts are shown in the balance sheet along with personal
accounts.

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 2.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Problems
Answer 1
Nature of Account

Sl. Title of Account Traditional Approach Accounting Equation

No. Approach
a Rent Outstanding Personal Liability
b Closing Inventory Real Asset
c Sales Nominal Revenue
d Bank Fixed Deposit Personal Asset
e Cash Real Asset
f Bad Debts Nominal (Expense) Temporary Capital (Expense)
g Capital Personal Capital
h Sales Tax Payable Personal Liability
i Trade receivables Personal Asset
j Depreciation Nominal (Expense) Temporary Capital (Expense)
k Drawings Personal Temporary Capital (Drawings)
Answer 2
Journal Entries in the books of Gamma Bros.

Particulars Dr. Cr.

Amount Amount
` `
(i) Salaries A/c Dr. 75,000
To Purchase A/c 75,000
(Being entry made for inventory taken by employees)
(ii) Machinery A/c Dr. 18,000
To Cash A/c 18,000
(Being wages paid for erection of machinery)
(iii) Drawings A/c Dr. 1,17,000
To Petty Cash A/c 1,17,000
(Being the income tax of proprietor paid out of
business money)
(iv) Purchase A/c Dr. 1,80,000
To Cash A/c 1,75,000
To Discount Received A/c 5,000
(Being the goods purchased from Naveen for
` 2,00,000 @ 10% trade discount and cash discount
of ` 5,000)

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 ACCOUNTING PROCESS 2.29

Note:
i. Here wages paid on erection of machinery have been capitalised therefore machinery account has
been debited directly instead of wages being recorded as an expenditure.
ii. The students may also note that trade discount is allowed on the list price of goods. It is deducted
to find out the invoice amount of the goods to be recorded in the books. Cash discount is a discount
allowed in case of early payments to the seller. The entry is made in the books of accounts for cash
discount.
Answer 3
(a) 12,50,000
(b) 2,25,000
(c) 75,000
(d) 59,80,000
These have been solved using the Accounting Equation:
Assets = Capital + Liabilities
Answer 4

S.No. Increase (+) / Decrease (-) / Reasons

No Change (0) in Assets
(a) Furniture has been purchased making it an increase in assets and
also it being purchased on credit it increases liability and there is no
+
outflow of assets like cash or bank.
(b) + Cash has flowed in for services provided making it an increase in
assets.
(c) + Here with goods sold there is a decrease in inventory (assets) but
given there is an increase in debtors there will be a net increase in
assets.
Though if goods are sold at cost it will result in no change whereas
sale at below cost will result in decrease in assets.
(d) - Here cash has been withdrawn from business resulting in decrease
in assets and capital.
(e) 0 Only hiring of employee has been done resulting in no change in
assets.
(f ) - Outflow of goods has resulted in decrease in assets while money
owed to creditors reduce on the liability side.
(g) - Here both assets and liabilities reduce by same amounts meaning a
decrease in assets.
(h) 0 Only a purchase agreement has been entered into with no
transaction taking place yet.

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 2.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

Answer 5
Trade Receivable Balance (B) = Sales- Amount received during the year
= ` (15,55,000 - 15,00,000)
= ` 55,000.
Since, we know Assets = Capital + Liabilities
Therefore, balance of assets is also ` 14,15,000
So, total assets:

Particulars `
Total Assets 14,15,000
Less: Machinery (12,00,000)
Less: Inventory (60,000)
Less: Bank (80,000)
Less: Receivables (55,000)
Cash (A) 20,000

Computation of Closing Capital (D):

Particulars `
Opening Capital 10,00,000
Add: Introduced during the year 1,00,000
Less: Loss incurred during the year (35,000)
Closing Capital 10,65,000
So, Loan amount (C) = Total Liabilities and capital - Closing Capital - Trade Payables
= ` (14,15,000 - 10,65,000 - 1,00,000)
= ` 2,50,000

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 ACCOUNTING PROCESS 2.31

UNIT 2 : LEDGERS
LEARNING OUTCOMES
After studying this unit, you will be able to :

w Understand the concept of Ledgers.

w Learn the technique of ledger posting and how to balance an account.

w Learn the technique of opening accounts each year taking closing balances of the previous year. Note
also the use of ‘balance c/d’ and ‘balance b/d’.

Process of
transferring
journal entries
in the accounts

Difference
between the Ledger Remaining
totals of debits known as balances
UNIT OVERVIEW and credit sides is principle are carried
found out as the books of forward to the
balance account next year

Some of the
balances are
transferred to
the profit and
loss account

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 2.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

2.1 INTRODUCTION
After recording the transactions in the journal, recorded entries are classified and grouped into by preparation
of accounts. The book which contains all set of accounts (viz. personal, real and nominal accounts), is known
as Ledger. It is known as principal books of account in which account-wise balance of each account is
determined.

2.2 SPECIMEN OF LEDGER ACCOUNTS

A ledger account has two sides-debit (left part of the account) and credit (right part of the account). Each of
the debit and credit side has four columns. (i) Date (ii) Particulars (iii) Journal folio i.e. page from where the
entries are taken for posting and (iv) Amount.
Dr. Account Cr.
Date Particulars J.F. Amount (`) Date Particulars J.F. Amount (`)

2.3 POSTING
The process of transferring the debit and credit items from journal to classified accounts in the ledger is
known as posting.
2.1 RULES REGARDING POSTING OF ENTRIES IN THE LEDGER
1. Separate account is opened in ledger book for each account and entries from ledger posted to respective
account accordingly.
2. It is a practice to use words ‘To’ and ‘By’ while posting transactions in the ledger. The word ‘To’ is used in
the particular column with the accounts written on the debit side while ‘By’ is used with the accounts
written in the particular column of the credit side. These ‘To’ and ‘By’ do not have any meanings but are
used to the account debited and credited.
3. The concerned account debited in the journal should also be debited in the ledger but reference should
be of the respective credit account.

2.4 BALANCING AN ACCOUNT

At the end of the each month or year or any particular day it may be necessary to ascertain the balance in
an account. This is not a too difficult thing to do; suppose a person has bought goods worth `1,000 and has
paid only ` 850; he owes `150 and that is balance in his account. To ascertain the balance in any account,
what is done is to total the sides and ascertain the difference; the difference is the balance. If the credit side

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 ACCOUNTING PROCESS 2.33

is bigger than the debit side, it is a credit balance. In the other case it is a debit balance. The credit balance
is written on the debit side as, “To Balance c/d”; c/d means “carried down”. By doing this, two sides will be
equal. The totals are written on the two sides opposite one another.
Then the credit balance is written on the credit side as “By balance b/d (i.e., brought down)”. This is the
opening balance for the new period. The debit balance similarly is written on the credit side as “By Balance
c/d”, the totals then are written on the two sides as shown above as then the debit balance written on the
debit side as, “To Balance b/d”, as the opening balance of the new period.
It should be noted that nominal accounts are not balanced; the balance in the end are transferred to the
profit and loss account. Only personal and real accounts ultimately show balances. In the illustrations given,
you will have notice that the capital account, the purchases account, sales account, the discount account,
the rent account and the salary account have not been balanced. The capital account will have to be adjusted
for profit or loss and that is why it has not been balanced yet.

? ILLUSTRATION 1
Prepare the Stationery Account of a firm for the year ended 31.12.2015 duly balanced off, from the following
details:

2015 `
Jan. 1 Inventory of stationery 480
April 5 Purchase of stationery by cheque 800
Nov. 15 Purchase of stationery on credit from Five Star Stationery Mart 1,280
Dec. 31 Inventory of stationery 240

 SOLUTION

Dr. Stationery Account Cr.

Date Particulars ` Date Particulars `
1.1.2015 To Balance b/d 480 31.12.2015 By Balance c/d 2,560
5.4.2015 To Bank A/c 800
15.11.2015
To Five Star Stationery
Mart A/c 1,280
2,560 2,560
1.1.2016 To Balance b/d 2,560

? ILLUSTRATION 2
Prepare the ledger accounts on the basis of following transactions in the books of a trader.
Debit Balances on January 1, 2015:
Cash in Hand ` 8,000, Cash at Bank ` 25,000, inventory of Goods ` 20,000, Building ` 10,000. Trade receivables:
Vijay ` 2,000 and Madhu ` 2,000.
Credit Balances on January 1, 2015:

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 2.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

Trade payables: Anand ` 5,000, Capital ` 55,000

Following were further transactions in the month of January, 2015:
Jan. 1 Purchased goods worth ` 5,000 (payable at later date) for cash less 20% trade discount and 5% cash
discount.
Jan. 4 Received ` 1,980 from Vijay and allowed him ` 20 as discount.
Jan. 8 Purchased plant from Mukesh for `5,000 and paid `100 as cartage for bringing the plant to the factory
and another `200 as installation charges.
Jan. 12 Sold goods to Rahim on credit `600.
Jan. 15 Rahim became insolvent and could pay only 50 paise in a rupee.
Jan. 18 Sold goods to Ram for cash `1,000.
SOLUTION
Dr. Cash Account Cr.
Date Particulars L.F. ` Date Particulars L.F. `
2015 2015
Jan. 1 To Balance b/d 8,000 Jan. 1 By Purchases A/c 3,800
Jan. 4 To Vijay 1,980 Jan. 8 By Plant A/c 300
Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 7,180
Jan. 18 To Sales A/c 1,000
11,280 11,280
Feb. 1 To Balance b/d 7,180

Dr. Bank Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance c/d 25,000 Jan. 31 By Balance c/d 25,000
25,000 25,000
Feb. 1 To Balance b/d 25,000

Dr. Inventory Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 20,000 Jan. 31 By Balance c/d 20,000
20,000 20,000
Feb. 1 To Balance b/d 20,000

Dr. Building Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 10,000 Jan. 31 By Balance c/d 10,000
10,000 10,000
Feb. 1 To Balance b/d 10,000

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 ACCOUNTING PROCESS 2.35

Dr. Vijay Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 2,000 Jan. 4 By Cash A/c 1,980
By Discount A/c 20
2,000 2,000

Dr. Madhu Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Balance b/d 2,000 Jan. 31 By Balance c/d 2,000
2,000 2,000
Feb. 1 To Balance b/d 2,000

Dr. Capital Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 55,000 Jan. 1 By Balance b/d 55,000
55,000 55,000
Feb. 1 By Balance b/d 55,000

Dr. Purchases Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 1 To Cash 3,800
Jan. 1 To Cash Discount 200 Jan. 31 By Balance c/d 4,000
4,000 4,000
Feb. 1 To Balance b/d 4,000

Dr. Discount Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 4 To Vijay 20 Jan. 1 By Purchases A/c 200
Jan.31 To Balance c/d 180
200 200
Feb. 1 By Balance b/d 180

Dr. Plant Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 8 To Mukesh 5,000 Jan. 31 By Balance c/d 5,300
Jan. 8 To Cash A/c 300
5,300 5,300
Feb. 1 To Balance b/d 5,300

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 2.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

Dr. Mukesh Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 5,000 Jan. 8 By Plant A/c 5,000
5,000 5,000
Feb. 1 By Balance b/d 5,000

Dr. Sales Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 31 To Balance c/d 1,600 Jan. 12 By Rahim 600
Jan. 18 By Cash A/c 1,000
1,600 1,600
Feb. 1 By Balance b/d 1,600

Dr. Rahim Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 12 To Sales A/c 600 Jan. 15 By Cash A/c 300
Jan. 15 By Bad Debts A/c 300
600 600

Dr. Bad Debts Account Cr.

Date Particulars L.F. ` Date Particulars L.F. `
Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 300
300 300
Feb. 1 To Balance b/d 300

? ILLUSTRATION 3
The following data is given by Mr. S, the owner, with a request to compile only the two personal accounts of Mr. H
and Mr. R, in his ledger, for the month of April, 2015.
1 Mr. S owes Mr. R ` 15,000; Mr. H owes Mr. S ` 20,000.
4 Mr. R sold goods worth ` 60,000 @ 10% trade discount to Mr. S.
5 Mr. S sold to Mr. H goods prices at ` 30,000.
17 Record a purchase of ` 25,000 net from R, which were sold to H at a profit of `15,000.
18 Mr. S rejected 10% of Mr. R’s goods of 4th April.
19 Mr. S issued a cash memo for `10,000 to Mr. H who came personally for this consignment of goods, urgently
needed by him.
22 Mr. H cleared half his total dues to Mr. S, enjoying a ½% cash discount (of the payment received,
` 20,000 was by cheque).
26 R’s total dues (less `10,000 held back) were cleared by cheque, enjoying a cash discount of `1,000 on the
payment made.

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 ACCOUNTING PROCESS 2.37

29 Close H’s Account to record the fact that all but ` 5,000 was cleared by him, by a cheque, because he was
declared bankrupt.
30 Balance R’s Account.

 SOLUTION
In the books of Mr. S
Dr. Mr. H Account Cr.
Date Particulars ` Date Particulars `
1.4.2015 To Balance b/d 20,000 22.4.2015 By Bank A/c 20,000
5.4.2015 To Sales A/c 30,000 22.4.2015 By Cash A/c (Note 2) 24,775
17.4.2015 To Sales A/c 40,000 29.4.2015 By Discount Allowed A/c 225
29.4.2015 By Bank A/c 40,000
29.4.2015 By Bad Debts A/c 5,000
90,000 90,000

Dr. Mr. R Account Cr.

Date Particulars ` Date Particulars `
18.4.2015 To Purchase 5,400 1.4.2015 By Balance b/d 15,000
To Returns A/c 4.4.2015 By Purchases A/c 54,000
26.4.2015 To Bank A/c 77,600 17.4.2015 Purchases A/c 25,000
26.4.2015 To Discount
Received A/c 1,000
30.4.2015 To Balance c/d 10,000
94,000 94,000
1.5.2015 By Balance b/d 10,000

Working Notes:
(1) Sale of `10,000 on 19th April is a cash sales, therefore, it will not be recorded in the Personal Account of
Mr. H; and (2) On 22nd April, Mr. H owes Mr. S ` 90,000, amount paid by Mr. H ½ of ` 90,000 less ½% discount
i.e., ` 45,000– ` 225 = ` 44,775. Out of this amount, ` 20,000 paid by cheque and the balance of ` 24,775 in
cash.

SUMMARY
w Process of transferring journal entries in the accounts opened in Ledger is called posting.
w Ledger is known as principal books of accounts and it provides full information regarding all the
transactions pertaining to any individual account.
w The difference between the totals of debits and credit sides is found out as the balance. Some of these
balances are transferred to the profit and loss account and some are carried forward to the next year i.e.,
shown in the balance sheet, depending upon the nature of the account.

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 2.38 PRINCIPLES AND PRACTICE OF ACCOUNTING

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. The process of transferring the debit and credit items from a Journal to their respective accounts in the
ledger is termed as
(a) Posting
(b) Purchase
(c) Balancing of an account
2. The technique of finding the net balance of an account after considering the totals of both debits and
credits appearing in the account is known as
(a) Posting
(b) Purchase
(c) Balancing of an account
3. Journal and ledger records transactions in
(a) A chronological order and analytical order respectively.
(b) An analytical order and chronological order respectively.
(c) A chronological order only
4. Ledger book is popularly known as
(a) Secondary book of accounts
(b) Principal book of accounts
(c) Subsidiary book of accounts
5. At the end of the accounting year all the nominal accounts of the ledger book are
(a) Balanced but not transferred to profit and loss account
(b) Not balanced and also the balance is not transferred to the profit and loss account
(c) Not balanced and their balance is transferred to the profit and loss account.
Theory Questions
1 What do you mean by principal books of accounts?
2 What are the rules of posting of journal entries into the Ledger?
Practical Questions
1. Journalize the following transactions, post them in the Ledger and balance the accounts on 31st
December.
1. X started business with a capital of ` 20,000
2. He purchased goods from Y on credit ` 4,000
3. He paid cash to Y ` 2,000
4. He sold goods to Z ` 4,000
5. He received cash from Z ` 6,000
6. He further purchased goods from Y ` 4,000
7. He paid cash to Y ` 2,000
8. He further sold goods to Z ` 4,000
9 He received cash form Z ` 2,000

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 ACCOUNTING PROCESS 2.39

ANSWERS/HINTS
MCQ’s
1. (a) 2. (c) 3. (a) 4. (b) 5. (c)
Theoretical Questions
1. Ledger is known as principal books of accounts and it provides full information regarding all the
transactions pertaining to any individual account. Ledger contains all set of accounts (viz. personal,
real and nominal accounts).
2. Rules regarding posting of entries in the ledger:
a. Separate account is opened in ledger book for each account and entries from ledger posted to
respective account accordingly.
b. It is a practice to use words ‘To’ and ‘By’ while posting transactions in the ledger. The word ‘To’ is
used in the particular column with the accounts written on the debit side while ‘By’ is used with
the accounts written in the particular column of the credit side. These ‘To’ and ‘By’ do not have any
meanings but are used to the account debited and credited.
c. The concerned account debited in the journal should also be debited in the ledger but reference
should be of the respective credit account.
Practical Questions
Answer 1
Journal
Particulars L.F. Debit ` Credit `
Cash Account Dr. 20,000
To Capital Account 20,000
(Being commencement of business)
Purchase Account Dr. 4,000
To Y 4,000
(Being purchase of goods on credit)
Y 2,000
To Cash Dr. 2,000
(Being payment of cash to Y)
Z Dr. 4,000
To Sales 4,000
(Being goods sold to Z)
Cash Account Dr. 6,000
To Z 6,000
(Being cash received form Z)
Purchase Account Dr. 4,000
To Y 4,000
(Being payment of goods from Y)
Y Dr. 2,000
To Cash Account 2,000
(Being payment of cash to Y)
Z Dr. 4,000
To Sales Account 4,000
(Being goods sold to Z)

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 2.40 PRINCIPLES AND PRACTICE OF ACCOUNTING

Cash Account Dr. 2,000

To Z 2,000
(Being cash received from Z)
TOTAL 48,000 48,000

Dr. Cash Account Cr.

Date Particulars ` Date Particulars `
To Capital A/c 20,000 By Y 2,000
To Z 6,000 By Y 2,000
To Z 2,000 By Balance c/d 24,000
28,000 28,000
Feb. 1 To Balance b/d 24,000
Dr. Capital Account Cr.
Date Particulars ` Date Particulars `
Jan. 31 To Balance c/d 20,000 By Cash A/c 20,000
20,000 20,000
Feb. 1 By Balance b/d 20,000
Dr. Purchase Account Cr.
Date Particulars ` Date Particulars `
To Y 4,000 Jan 31. By Balance c/d 8,000
To Y 4,000
8,000 8,000
Feb.1 To Balance b/d 8,000
Dr. Y’s Account Cr.
Date Particulars ` Date Particulars `
To Cash 2,000 By Purchases 4,000
To Cash 2,000 By Purchases 4,000
Jan. 31 To Balance c/d 4,000
8,000 8,000
By Balance b/d 4,000
Dr. Z’s Account Cr.
Date Particulars ` Date Particulars `
To Sales 4,000 By Cash A/c 6,000
To Sales 4,000 By Cash A/c 2,000
8,000 8,000
Dr. Sales Account Cr.
Date Particulars ` Date Particulars `
Jan. 31 To Balance c/d 8,000 By Z 4,000
By Z 4,000
8,000 8,000
Feb. 1 By Balance b/d 8,000

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 ACCOUNTING PROCESS 2.41

UNIT 3 : TRIAL BALANCE

LEARNING OUTCOMES
After studying this unit, you will be able to :
w Learn the technique of taking balances from ledger accounts to prepare trial balance.
w Understand what is trial balance and what purposes it can serve.

Phase of
the accounting
process

Basis for
Ledger balances
Preparing final Trial
on a particular
UNIT OVERVIEW accounts i.e. P& L A/c Balance
date
and Balance sheet

Checks
arithmetical
accuracy of the
books

Trial balance contains various ledger balances on a particular date. It forms the basis for preparing final
statement i.e. profit and loss statement and balance sheet. If it tallies, it means that the accounts are
arithmetically accurate but certain errors may still remain undetected. Therefore, it is very important to
carefully journalise and post the entries, following the rules of accounting.

3.1 INTRODUCTION
Preparation of trial balance is the third phase in the accounting process. After posting the accounts in the
ledger, a statement is prepared to show separately the debit and credit balances. Such a statement is known
as the trial balance. It may also be prepared by listing each and every account and entering in separate
columns the totals of the debit and credit sides. Whichever way it is prepared, the totals of the two columns
should agree. An agreement indicates reasonable accuracy of the accounting work; if the two sides do not
agree, then there is simply an arithmetic error(s).

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 2.42 PRINCIPLES AND PRACTICE OF ACCOUNTING

This follows from the fact that under the Double Entry System, the amount written on the debit sides of
various accounts is always equal to the amounts entered on the credit sides of other accounts and vice
versa. Hence the totals of the debit sides must be equal to the totals of the credit sides. Also total of the
debit balances will be equal to the total of the credit balances. Once this agreement is established, there is
reasonable confidence that the accounting work is free from clerical errors, though it is not proof of cent
per cent accuracy, because some errors of principle and compensating errors may still remain. Generally,
to check the arithmetic accuracy of accounts, trial balance is prepared at monthly intervals. But because
double entry system is followed, one can prepare a trial balance any time. Though a trial balance can be
prepared any time but it is preferable to prepare it at the end of the accounting year to ensure the arithmetic
accuracy of all the accounts before the preparation of the financial statements. It may be noted that trial
balance is a statement and not an account.

3.2. OBJECTIVES OF PREPARING THE TRIAL BALANCE

The preparation of trial balance has the following objectives:
(i) Trial balance enables one to establish whether the posting and other accounting processes have been
carried out without committing arithmetical errors. In other words, the trial balance helps to establish
arithmetical accuracy of the books.
(ii) Financial statements are normally prepared on the basis of agreed trial balance; otherwise the work
may be cumbersome. Preparation of financial statements, therefore, is the second objective.
(iii) The trial balance serves as a summary of what is contained in the ledger; the ledger may have to be seen
only when details are required in respect of an account.
The form of the trial balance is simple as shown below:

Trial Balance
as at.......................

S.No Ledger Accounts L.F. Dr. Amount Cr. Amount

(Total or Balance) (Total or Balance)
` `

The under mentioned points may be noted:

(i) A trial balance is prepared as on a particular date which should be mentioned at the top.
(ii) In the second column the name of the account is written.
(iii) In the fourth column the total of the debit side of the account concerned or the debit balance, if any is
entered.
(iv) In the next column, the total of the credit side or the credit balance is written.
(v) The two columns are totalled at the end.
(vi) The first and third column needs no explanation.

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 ACCOUNTING PROCESS 2.43

3.3 LIMITATIONS OF TRIAL BALANCE

One should note that the agreement of Trial Balance is not a conclusive proof of accuracy. In other words,
in spite of the agreement of the trial balance some errors may remain. These may be of the following types:

(i) Transaction has not been entered at all in the journal.

(ii) A wrong amount has been written in both columns of the journal.

(iii) A wrong account has been mentioned in the journal.

(iv) An entry has not at all been posted in the ledger.

(v) Entry is posted twice in the ledger.

Still, the preparation of the trial balance is very useful; without it, the preparation of financial statement, the
profit and loss account and the balance sheet, would be difficult.

3.4 METHODS OF PREPARATION OF TRIAL BALANCE

1. TOTAL METHOD
Under this method, every ledger account is totalled and that total amount (both of debit side and credit
side) is transferred to trial balance. In this method, trial balance can be prepared as soon as ledger account
is totalled. Time taken to balance the ledger accounts is saved under this method as balance can be found
out in the trial balance itself. The difference of totals of each ledger account is the balance of that particular
account. This method is not commonly used as it cannot help in the preparation of the financial statements.

? ILLUSTRATION 1
Given below is a ledger extract relating to the business of X and Co. as on March, 31, 2016. You are required to
prepare the Trial Balance by the Total Amount Method.
Dr. Cash Account Cr.

Particulars ` Particulars `

To Capital A/c 10,000 By Furniture A/c 3,000

To Ram’s A/c 25,000 By Salaries A/c 2,500

To Cash Sales 500 By Shyam’s A/c 21,000

By Cash Purchases 1,000

By Capital A/c 500

By Balance c/d 7,500

35,500 35,500

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 2.44 PRINCIPLES AND PRACTICE OF ACCOUNTING

Dr. Furniture Account Cr.

Particulars ` Particulars `
To Cash A/c 3,000 By Balance c/d 3,000
3,000 3,000

Dr. Salaries Account Cr.

Particulars ` Particulars `
To Cash A/c 2,500 By Balance c/d 2,500
2,500 2,500

Dr. Shyam’s Account Cr.

Particulars ` Particulars `
To Cash A/c 21,000 By Purchases A/c 25,000
To Purchase Returns A/c 500 (Credit Purchases)
To Balance c/d 3,500 –
25,000 25,000

Dr. Purchases Account Cr.

Particulars ` Particulars `
To Cash A/c (Cash Purchases) 1,000 By Balance c/d 26,000
To Sundries as per Purchases Book
(Credit Purchases) 25,000 –
26,000 26,000

Dr. Purchases Returns Account Cr.

Particulars ` Particulars `
To Balance c/d 500 By Sundries as per Purchases Return Book 500
500 500

Dr. Ram’s Account Cr.

Particulars ` Particulars `
To Sales A/c (Credit Sales) 30,000 By Sales Returns A/c 100
By Cash A/c 25,000
By Balance c/d 4,900
30,000 30,000

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 ACCOUNTING PROCESS 2.45

Dr. Sales Account Cr.

Particulars ` Particulars `
To Balance c/d 30,500 By Cash A/c (Cash Sales) 500
By Sundries as per Sales Book
(Credit sales) 30,000
30,500 30,500

Dr. Sales Returns Account Cr.

Particulars ` Particulars `
To Sundries as per Sales By Balance c/d 100
Returns Book 100
100 100

Dr. Capital Account Cr.

Particulars ` Particulars `
To Cash A/c 500 By Cash A/c 10,000
To Balance c/d 9,500
10,000 10,000

 SOLUTION
Trial Balance of X and Co. as at 31.03.2016
Sl. Name of Account Total Debit Total
No. Items Credit Items
` `
1. Cash A/c 35,500 28,000
2. Furniture A/c 3,000
3. Salaries A/c 2,500
4. Shyam’s A/c 21,500 25,000
5. Purchases A/c 26,000
6. Purchases Returns A/c 500
7. Ram’s A/c 30,000 25,100
8. Sales A/c 30,500
9. Sales Returns A/c 100
10. Capital A/c 500 10,000
1,19,100 1,19,100
2. BALANCE METHOD
Under this method, every ledger account is balanced and those balances only are carried forward to the trial
balance. This method is used commonly by the accountants and helps in the preparation of the financial
statements. Financial statements are prepared on the basis of the balances of the ledger accounts.

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 2.46 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 2
Taking the same information as given in Illustration 1, prepare the Trial Balance by Balance Method.

 SOLUTION
Trial Balance of X and Co. as at 31.03.2016

Sl. Name of Account Debit Credit

No. Balance Balance
` `
1. Cash A/c 7,500
2. Furniture A/c 3,000
3. Salaries A/c 2,500
4. Shyam’s A/c 3,500
5. Purchases A/c 26,000
6. Purchases Returns A/c 500
7. Ram’s A/c 4,900
8. Sales A/c 30,500
9. Sales Returns A/c 100
10. Capital A/c – 9,500
44,000 44,000

3. TOTAL AND BALANCE METHOD

Under this method, the above two explained methods are combined. Under this method statement of
trial balance contains seven columns instead of five columns. This has been explained with the help of the
following example using the data given in illustration 1:
Trial Balance of X as at 31.03.2016

Sl. Heads of Account L.F. Debit Credit Debit Credit

No. Balance Balance Total Total
(`) (`) (`) (`)
1. Cash Account 7,500 35,500 28,000
2. Furniture Account 3,000 3,000
3. Salaries Account 2,500 2,500
4. Shyam’s Account 3,500 21,500 25,000
5. Purchases Account 26,000 26,000
6. Purchase Returns Account 500 500
7. Ram’s Account 4,900 30,000 25,100
8. Sales Account 30,500 30,500
9. Sale Returns Account 100 100
10. Capital Account 9,500 500 10,000
Total 44,000 44,000 1,19,100 1,19,100

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 ACCOUNTING PROCESS 2.47

3.5 ADJUSTED TRIAL BALANCE (THROUGH SUSPENSE ACCOUNT)

If the trial balance does not agree after transferring the balance of all ledger accounts including cash and
bank balance and also errors are not located timely, then the trial balance is tallied by transferring the
difference of debit and credit side to an account known as suspense account. This is a temporary account
opened to proceed further and to prepare the financial statements timely.

3.6 RULES OF PREPARING THE TRIAL BALANCE

While preparing the trial balance from the given list of ledger balances, following rules should be taken into
care:
1. The balances of all (i) assets accounts (ii) expenses accounts (iii) losses (iv) drawings (v) cash and bank
balances are placed in the debit column of the trial balance.
2. The balances of all (i) liabilities accounts (ii) income accounts (iii) profits (iv) capital are placed in the
credit column of the trial balance.

? ILLUSTRATION 3
From the following ledger balances, prepare a trial balance of Anuradha Traders as on 31st March, 2016:

Account Head `
Capital 1,00,000
Sales 1,66,000
Purchases 1,50,000
Sales return 1,000
Discount allowed 2,000
Expenses 10,000
Trade receivables 75,000
Trade payables 25,000
Investments 15,000
Cash at bank and in hand 37,000
Interest received on investments 1,500
Insurance paid 2,500

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 2.48 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Trial Balance of Anuradha Traders as on 31.03.2016

Dr. balance ` Cr. balance `

Purchases 1,50,000 Capital 1,00,000
Sales return 1,000 Sales 1,66,000
Discount allowed 2,000 Trade payables 25,000
Expenses 10,000 Interest received on investments 1,500
Trade receivables 75,000
Investments 15,000
Cash at bank and in hand 37,000
Insurance paid 2,500
Total 2,92,500 2,92,500

? ILLUSTRATION 4
One of your clients, Mr. Singhania has asked you to finalise his accounts for the year ended 31st March, 2016. Till
date, he himself has recorded the transactions in books of accounts. As a basis for audit, Mr. Singhania furnished
you with the following statement.

Dr. Balance (`) Cr. Balance (`)

Singhania’s Capital 1,556
Singhania’s Drawings 564
Leasehold premises 750
Sales 2,750
Due from customers 530
Purchases 1,259
Purchases return 264
Loan from bank 256
Trade payables 528
Trade expenses 700
Cash at bank 226
Bills payable 100
Salaries and wages 600
Inventories (1.4.2015) 264
Rent and rates 463
Sales return 98
5,454 5,454
The closing inventory on 31st March, 2016 was valued at ` 574. Mr. Singhania claims that he has recorded every
transaction correctly as the trial balance is tallied. Check the accuracy of the above trial balance.

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 ACCOUNTING PROCESS 2.49

 SOLUTION
Corrected Trial Balance of Mr. Singhania as on 31st March, 2016
Particulars Dr. Cr.
Amount Amount
` `
Singhania’s Capital 1,556
Singhania’s Drawings 564
Leasehold premises 750
Sales 2,750
Due from customers 530
Purchases 1,259
Purchases returns 264
Loan from Bank 256
Creditor/Suppliers 528
Trade expenses 700
Cash at Bank 226
Bills payable 100
Salaries and Wages 600
Inventory (1.4.2015) 264
Rent and rates 463
Sales return 98
5,454 5,454
Reasons:
1. Due from customers is an asset, so its balance will be a debit balance.
2. Purchases return account always shows a credit balance because assets go out.
3. Balance in Creditors Account is a liability, so its balance will be a credit balance.
4. Bills payable is a liability, so its balance will be a credit balance.
5. Inventory (opening) represents assets, so it will have a debit balance.
6. Sales return account always shows a debit balance because assets come.

SUMMARY
w Trial balance contains various ledger balances on a particular date.
w It forms the basis for preparing final statement i.e. profit and loss statement and balance sheet.
w If it tallies, it means that the accounts are arithmetically accurate but certain errors may still remain
undetected.
w It is very important to carefully journalize and post the entries, following the rules of accounting.

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 2.50 PRINCIPLES AND PRACTICE OF ACCOUNTING

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. A trial balance will not balance if _____________________________
(a) Correct journal entry is posted twice.
(b) The purchase on credit basis is debited to purchases and credited to cash.
(c) ` 500 cash payment to creditor is debited to Trade payables for ` 50 and credited to cash as ` 500.
2. ` 1, 500 received from sub-tenant for rent and entered correctly in the cash book is posted to the debit
of the rent account. In the trial balance _____________________________
(a) The debit total will be greater by ` 3,000 than the credit total.
(b) The debit total will be greater by ` 1,500 than the credit total.
(c) Subject to other entries being correct the total will agree.
3. After the preparation of ledgers, the next step is the preparation of _____________________________
(a) Trading accounts
(b) Trial balance
(c) Profit and loss account
4. After preparing the trial balance the accountant finds that the total of debit side is short by ` 1,500. This
difference will be _____________________________
(a) Credited to suspense account
(b) Debited to suspense account
(c) Adjusted to any of the debit balance account

5. S.No. Account heads Debit (`) Credit (`)

1. Sales 15,000
2. Purchases 10,000
3. Miscellaneous expenses 2,500
4. Salaries 2,500
Total 12,500 17,500
The difference in trial balance is due to _____________________________
(a) Wrong placing of sales account
(b) Wrong placing of salaries account
(c) Wrong placing of miscellaneous expenses account
Theory Questions
1. What is the trial balance? And how it is prepared?
2. Explain objectives of preparation of trial balance.
3. Even if the trial balance agrees, some errors may remain. Do you agree? Explain.

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 ACCOUNTING PROCESS 2.51

Practical Question
1. An inexperienced bookkeeper has drawn up a Trial Balance for the year ended 30th June, 2017.

Debit (`) Credit (`)

Provision For Doubtful Debts 200 –
Bank Overdraft 1,654 –
Capital – 4,591
Trade payables – 1,637
Trade receivables 2,983 –
Discount Received 252 –
Discount Allowed – 733
Drawings 1,200 –
Office Furniture 2,155 –
General Expenses – 829
Purchases 10,923 –
Returns Inward – 330
Rent & Rates 314 –
Salaries 2,520 –
Sales – 16,882
Inventory 2,418 –
Provision for Depreciation on Furniture 364 –
Total 24,983 25,002
Required:
Draw up a ‘Corrected’ Trial Balance, debiting or crediting any residual errors to a Suspense Account.
ANSWERS/HINTS
MCQs

1. (c) 2. (a) 3. (b) 4. (b) 5. (b)

Theoretical Questions
1. Preparation of trial balance is the third phase in the accounting process. After posting the accounts in
the ledger, a statement is prepared to show separately the debit and credit balances. Such a statement
is known as the trial balance.
Trial balance contains various ledger balances on a particular date. It forms the basis for preparing final
statement i.e. profit and loss statement and balance sheet. It is tallies, it means that the accounts are
arithmetically accurate but certain errors may still remain undetected. Therefore, it is very important to
carefully journalise and post the entries, following are rules of accounting.

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 2.52 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. The preparation of trial balance has the following objectives:

(i) Trial balance enables one to establish whether the posting and other accounting processes have
been carried out without committing arithmetical errors. In other words, the trial balance helps to
establish arithmetical accuracy of the books.
(ii) Financial statements are normally prepared on the basis of agreed trial balance; otherwise the work
may be cumbersome. Preparation of financial statements, therefore, is the second objective.
(iii) The trial balance serves as a summary of what is contained in the ledger; the ledger may have to be
seen only when details are required in respect of an account.
3. In spite of the agreement of the trial balance some errors may remain. These may be of the following
types:
(i) Transaction has not been entered at all in the journal.
(ii) A wrong amount has been written in both columns of the journal.
(iii) A wrong account has been mentioned in the journal.
(iv) An entry has not at all been posted in the ledger.
(v) Entry is posted twice in the ledger.

Practical Question
ANSWER 1
Trial Balance as on 30th June, 2017
Heads of Accounts Debit ` Credit `
Provision for Doubtful Debts – 200
Bank overdraft – 1,654
Capital – 4,591
Trade payables – 1,637
Trade receivables 2,983 –
Discount Received – 252
Discount allowed 733 –
Drawings 1,200 –
Office furniture 2,155 –
General Expenses 829 –
Purchases 10,923 –
Returns Inward 330 –
Rent & Rates 314 –
Salaries 2,520 –
Inventory 2,418 –
Provision for Depreciation on Furniture – 364
Sales – 16,882
Suspense Account (Balancing figure) 1,175 –
Total 25,580 25,580

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 ACCOUNTING PROCESS 2.53

UNIT 4 : SUBSIDIARY BOOKS

LEARNING OUTCOMES
After studying this unit, you will be able to :

w Understand the techniques of recording transactions in Purchase Book, Sales Book; Returns Inward Book
and Returns Outward Book; Bills Receivable and Bills Payable Book.

w Learn the technique of posting from Subsidiary Books to Ledger.

w Understand that even if subsidiary books are maintained, journalisation is required for many other
transactions and events.

w Learn the difference between the subsidiary books and principal books.

Principle • Ledger

books • Cash books

UNIT OVERVIEW

• Purchases and Sales book, Purchase

Subsidiary and Sales return books
• Bill payable and Bills receivable books
books • Journal Proper

4.1 INTRODUCTION
In a business, most of the transactions generally relate to receipts and payments of cash, sale of goods and
their purchase. It is convenient to keep a separate register for each such class of transactions one for receipts
and payments of cash, one for purchase of goods and one for sale of goods. A register of this type is called
a book of original entry or of prime entry. For transactions recorded in such books there will be no journal
entry. The system by which transactions of a class are first recorded in the book, specially meant for it and
on the basis of which ledger accounts are then prepared is known as the Practical System of Book keeping
or even the English System. It should be noted that in this system, there is no departure from the rules of
the double entry system.

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 2.54 PRINCIPLES AND PRACTICE OF ACCOUNTING

These books of original or prime entry are also called subsidiary books since ledger accounts are prepared on
their basis and, without the further process of ledger posting, a trial balance cannot be taken out. Normally,
the following subsidiary books are used in a business:
(i) Cash book to record receipts and payments of cash, including receipts into and payments out of the
bank.

(ii) Purchases book to record credit purchases of goods dealt in or of the materials and stores required in
the factory.

(iii) Purchase Returns Books to record the returns of goods and materials previously purchased.

(iv) Sales Book to record the sales of the goods dealt in by the firm.

(v) Sale Returns Book to record the returns made by the customers.

(vi) Bills Receivable Books to record the receipts of promissory notes or hundies from various parties.

(vii) Bills Payable Book to record the issue of the promissory notes or hundies to other parties.

(viii) Journal (proper) to record the transactions which cannot be recorded in any of the seven books
mentioned above.

It may be noted that in all the above cases the word “Journal” may be used for the word “book”
Advantages of Subsidiary Books
The use of subsidiary books affords the undermentioned advantages:
(i) Division of work: Since in the place of one journal there will be so many subsidiary books, the
accounting work may be divided amongst a number of clerks.
(ii) Specialization and efficiency: When the same work is allotted to a particular person over a period of
time, he acquires full knowledge of it and becomes efficient in handling it. Thus the accounting work
will be done efficiently.
(iii) Saving of the time: Various accounting processes can be undertaken simultaneously because of the
use of a number of books. This will lead to the work being completed quickly.
(iv) Availability of information: Since a separate register or book is kept for each class of transactions, the
information relating to each transactions will be available at one place.
(v) Facility in checking: When the trial balance does not agree, the location of the error or errors is
facilitated by the existence of separate books. Even the commission of errors and frauds will be checked
by the use of various subsidiary books.

4.2 DISTINCTION BETWEEN SUBSIDIARY BOOKS AND PRINCIPAL

BOOKS
The books in which transactions are first recorded to enable processing are called subsidiary books. The
ledger and the cash book are the principle books since they furnish information for preparation of the trial
balance and financial statements. The following table will help you in understanding the difference between
Subsidiary Books and Principal Books.

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 ACCOUNTING PROCESS 2.55

Principal Ledger
Books

Simple Cash Book

Cash book with

Discount Column

Cash Book with

Cash Bank & Dis. Column
Books

Petty Cash Book

Financial
Books For Credit
Purchase Purchase Book

For Credit
Sales Sales Book

For Credit
Purchase Return Book
Purchases
Returns
For Credit
Sales Return Book
Sales Returns

For Bills
Bill Receivable Book
Receivable
Subsidiary
Received
Books
For Bills Bill Payable Book
Accepted

For record of
transactions Journal Paper
not recorded
elsewhere

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 2.56 PRINCIPLES AND PRACTICE OF ACCOUNTING

4.3 PURCHASES BOOK

To record the credit purchases of goods dealt in or materials and stores used in the factory, a separate
register called the Purchases Book or the Purchases Journal, is usually maintained by firms. The ruling is
given below:

Date Particulars L.F. Details Amount

` `

It should be remembered that :

(i) Cash purchases are not entered in this book since these will be entered in the cash book; and
(ii) Credit purchases of things other than goods or materials, such as office furniture or typewriters are
journalised - they also are not entered in the Purchases Book.
The particulars column is meant to record the name of the supplier and name of the articles purchased
and the respective quantities. The amount in respect of each article is entered in the details column. After
totaling the various amounts included in a single purchase, the amount for packing, or other charges is
added and the amount for trade discount is deducted. The net amount is entered in the extreme right-hand
column. The total in this column shows the total purchase made in a period.

? ILLUSTRATION 1
The Rough Book of M/s. Narain & Co. contains the following :
2016
Feb. 1. Purchased from Brown & Co. on credit :
5 gross pencils @ `100 per gross,
1 gross registers @ ` 240 per doz.
Less : Trade Discount @ 10%
2. Purchased for cash from the Stationery Mart;
10 gross exercise books @ ` 300 per doz.
3. Purchased computer for office use from M/s. office
Goods Co. on credit for ` 30,000.
4. Purchased on credit from The Paper Co.
5 reams of white paper @ `100 per ream.
10 reams of ruled paper @ `150 per ream.
Less : Trade Discount @ 10%
5. Purchased one dozen gel pens @ `15 each from
M/s. Verma Bros. on credit.
Make out the Purchase Book of M/s. Narain & Co.

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 ACCOUNTING PROCESS 2.57

 SOLUTION
Purchases Book
Date Particulars L.F. Amount
2016 ` `
Feb. 1 M/s. Brown & Co.
5 gross pencils @ `100 per gross 500.00
1 gross registers @ `240 per doz. 2880.00
3380.00
Less : 10% trade discount (338) 3,042
“4 The Paper Co.
5 reams white paper @ `100 per ream 500.00
10 reams ruled paper @ `150 per ream 1500.00
2,000.00
Less : 10% trade discount (200.00) 1,800
5 M/s. Verma Bros.
1 doz. gel pens @ `15 each 180 180
Total 5022
Note : Purchases of cash and purchase of computer cannot be entered in the Purchase Book.

? ILLUSTRATION 2
Enter the following transactions in Purchase Book and post them into ledger.
2017
April 4 Purchased from Ajay Enterprises, Delhi
100 Doz. Rexona Hawai Chappal
@ `120 per doz.
200 Doz. Palki Leather Chappal
@ `300 per Doz.
Less : Trade discount @ 10%
Freight charged `150.
April 15 Purchased from Balaji Traders, Delhi
50 doz. Max Shoes
@ `400 per doz.
100 pair Sports Shoes.
@ `140 per paid.
Less : Trade discount @ 10%.
Freight charged `200.

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 2.58 PRINCIPLES AND PRACTICE OF ACCOUNTING

April 28 Purchased from Tripti Industries, Bahadurgarh

40 pair leather shoes
@ `400 per pair
100 doz. Rosy Hawai Chappal
@ `180 per doz.
Less : Trade discount @ 10%.
Freight charged `100.

 SOLUTION

Purchase Book

Date Particulars Gross Trade Net Freight Total

2017 Amount Discount Price Amount
April 4 Ajay Enterprises
100 doz chappal
@ `120 per doz - `12,000
200 doz Palki Leather Chappal @ `300
per doz -
` 60,000
Less: trade discount @ 10% 72,000 7,200 64,800 150 64,950
April 15 Balaji Traders, Delhi
50 doz max Shoes
@ `400 per doz - `20,000
100 pair Sports shoes
@ `140 per pair - `14,000
Less: Trade discount @ 10% 34,000 3,400 30,600 200 30,800
April 28 Tripti Industries, Bahadurgarh
40 pair Leather shoes
@ `400 per pair - `16,000
100 doz Rosy Hawai Chappal : @ `180
per doz - ` 18,000
Less: Trade discount @ 10% 34,000 3,400 30,600 100 30,700
1,40,000 14,000 1,26,000 450 1,26,457

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 ACCOUNTING PROCESS 2.59

Ledgers
Dr. Purchases A/c Cr.

2017 ` 2017 `
April 30 To amount as per purchase book 1,26,000

Dr. Freight A/c Cr.

2017 ` 2017 `
April 30 To amount as per purchase book 450

Dr. Ajay Enterprises Cr.

2017 ` 2017 `
April 30 By Purchase A/c 64,800
By Freight A/c 150

Dr. Balaji Traders Cr.

2017 ` 2017 `
April 15 By Purchase A/c 30,600
By Freight A/c 200

Dr. Tripti Industries Cr.

2017 ` 2017 `
April 28 By Purchase A/c 30,600
By Freight A/c 100

POSTING THE PURCHASES BOOK

The Purchases Book shows the names of the parties from whom goods have been purchased on credit.
These parties are now trade payables. Their accounts have to be credited for the respective amounts shown
in the purchase book. The total of the amounts column shows the total purchases made in a period. The
amount is debited to the Purchase Account to indicate receipt of goods. In Illustration 1, the Purchases
Account is debited by ` 5,022, M/s. Brown & Co. is credited by ` 3,042, The Paper Company by `1,800 and
M/s. Verma Bros. by `180. The total of the amounts put on the credit side equals the debit. Thus the double
entry is completed.

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 2.60 PRINCIPLES AND PRACTICE OF ACCOUNTING

4.4 SALES BOOK

The Sales Book is a register specially kept to record credit sales of goods dealt in by the firm, cash sales are
entered in the Cash Book and not in the Sales Book. Credit sales of things, other than the goods dealt in by
the firm are not entered in the Sales Book; they are journalised. The ruling is the same as for the Purchases
Book.
Entries in the Sales Book are also made in the same manner as in the Purchase Book. The particulars column
will record the name of the customers concerned together with particulars and quantities of the goods sold.
For each item, the amount is entered in the details column; after totalling the amounts for one sale, charges
for packing etc; are added and the trade discount, if any is deducted: the net amount is put in the outer
column. The total of this column will show the total credit sales for a period.

? ILLUSTRATION 3
The following are some of the transaction of M/s Kishore & Sons of the year 2017 as per their Waste Book.
Make out their Sales Book.
Sold to M/s. Gupta & Verma on credit:
30 shirts @ ` 800 per shirt.
20 trousers @ `1,000 per trouser.
Less : Trade Discount @ 10%
Sold furniture to M/s. Sehgal & Co. on credit `8,000.
Sold 50 shirts of M/s. Jain & Sons @ `800 per shirt.
Sold 13 shirts to Cheap Stores @ `750 each for cash.
Sold on credit to M/s. Mathur & Jain.
100 shirts @ `750 per shirt
10 overcoats @ `5,000 per overcoat.
Less: Trade Discount @ 10%

 SOLUTION

Sales Book

Date Particulars Details L.F. Amount

` `
2017 M/s. Gupta & Verma
30 shirts @ `800 24,000
20 Trousers @ `1,000 20,000
44,000
Less : 10% Trade discount (4,400)

Sales as per invoice no. dated ..... 39,600

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 ACCOUNTING PROCESS 2.61

M/s. Jain & Sons

50 shirts @ `800
Sale as per invoice no. dated ...... 40,000
M/s Mathur & Jain
100 shirts @ `750 75,000
10 overcoats @ `5,000 50,000
1,25,000
Less : 10% (12,500)
Sales as per invoice no. dated...... 1,12,500
Total 1,92,100
Note : Cash sale and sale of furniture are not entered in Sales Book.

POSTING THE SALES BOOK

The names appearing in the Sales Book are of those parties which have received the goods. The accounts
of the parties have to be debited with the respective amounts. The total of the Sales Book shows the credit
sales made during the period concerned; the amount is credited to the Sales Account. In the Illustration 3,
` 1,92,100 is credited to the Sales Account; `39,600 is debited to M/s. Gupta and Verma `40,000 to M/s Jain
and Sons and `1,12,500 to M/s Mathur & Jain. The amount put on the credit side is equal to the total of the
amount put on the debit side. Thus, the double entry principle is followed correctly.

4.5 SALES RETURNS BOOK OR RETURNS INWARD BOOK

If customers frequently return the goods sold to them, it would be convenient to record the returns in a
separate book, which is named as the Sales Returns Book or the Returns Inward Book. The ruling of the book
is similar to the Purchases or the Sales Book and entries are also made in the same manner. The following,
assumed figures, will illustrate this:
Returns Inward Book
Date Particulars Details L.F. Amount
2017 `
June 7 Sunil Bank & Co.
6 Copies-Double Entry
Bookkeeping by T.S. Grewal @ ` 7 42.00
Less : Trade Discount 10% (4.20) 37.80
(returns as per debit note no.......)
Kailash & Co.
1 Copy-Business Methods by R.K. Gupta 3.50
(returns as per debit note no.......) Total 41.30

4.6 PURCHASE RETURNS OR RETURNS OUTWARD BOOK

Such a book conveniently records return of goods or material purchased to the suppliers if however, the
returns are not frequent, it may be sufficient to record the transaction in the journal. The ruling of the
Purchase Returns or Returns Outward Book is similar to that of the Purchase Book; entries are also similarly

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 2.62 PRINCIPLES AND PRACTICE OF ACCOUNTING

made, as the illustration given below shows:

Returns Outward Book
Date Particulars ` Amount
2017
`
June 2 Premier Electric Co. 175.00
One 36” Usha Ceiling Fan
“ 28 Mohan Electric Co.
Ten Iron Heaters 150.00
Less : Discount (15.00) 135.00
Total 310.00

POSTING OF THE RETURN BOOKS

The Sales Return Book will show the total of the returns made by customers. Really, the total of the returns is
in reduction of the sales. Properly, therefore, the amount may be debited to the Sales Account but, usually,
a separate account called Returns Inward Account is opened and the total of the sales returns is debited to
this accounts. The customers who have returned the goods are credited with the respective amounts.
It should be noted that on goods being received and accepted back from the customers, a credit note is
issued to the customers concerned. This shows the amount to be credited to the customer’s account.
Similarly, when goods are returned to suppliers they will issue the necessary credit note; also the firm
returning the goods will issue a debit note to the supplier, indicating the amount for which the supplier is
liable on account of the return.
The total of Returns Outwards Book shows the total returns made. The amount can be credited to the
Purchase Account, but in practice, is credited to a separate account called Purchase Returns or Returns
Outward Account. The suppliers whose names appear in the Book have received the goods, so their accounts
have to be debited. This is shown in the illustration given below :

? ILLUSTRATION 5
Post the following into the ledger
Returns Outward Book

Date Particulars L.F. Details Amount

2017 ` `
Nov. 20 Rajindra Prakash & Sons
One 36” Usha Ceiling Fan 200.00
Less : Trade Discount @ 10% (20.00) 180.00
“ 30 Modern Electric Company 100.00
Total 280.00

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 ACCOUNTING PROCESS 2.63

 SOLUTION
Ledger
Dr. Rajindra Parkash & Sons Cr.
Date Particulars Folio Amount Date Particulars Folio Amount
2017

Nov. 20 To Returns Outward A/c 180.00

Dr. Modern Electric Co. Cr.

Date Particulars Folio Amount Date Particulars Folio Amount
2017

Nov. 30 To Returns Outward A/c 100.00

Dr. Returns Outward Account Cr.

Date Particulars Folio Amount Date Particulars Folio Amount
2017

Nov. 30 By Sundries as per 280.00

Returns Outward
A/c

BILLS RECEIVABLE BOOKS AND BILLS PAYABLE BOOKS

If the firm usually receives a number of promissory notes or hundies, it would be convenient to record the
transaction in a separate book called the Bills Receivable Book. Similarly, if promissory notes or hundies are
frequently issued, the Bills Payable Book will be convenient. This will be discussed later.

4.7 IMPORTANCE OF JOURNAL

Students are now familiar with the journal. They also know that :
(i) Cash transactions are recorded in the cash book;
(ii) Credit purchases of goods or materials are recorded in the purchases book;
(iii) Credit sales of goods are recorded in the sales book;
(iv) Returns from customers are recorded in the sale returns book; and
(v) Returns to suppliers are entered in the purchase returns book.
Bill transactions are entered in the bills receivable books or the bills payable books, if these are maintained.
Apart from the transactions mentioned above, there are some entries also which have to be recorded. For
them the proper place is the journal. In fact, if there is no special book meant to record a transaction, it is
recorded in the journal (proper). The role of the journal is thus restricted to the following types of entries :

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 2.64 PRINCIPLES AND PRACTICE OF ACCOUNTING

(i) Opening entries : When books are started for the new year, the opening balance of assets and liabilities
are journalised.
(ii) Closing entries : At the end of the year the profit and loss account has to be prepared. For this purpose,
the nominal accounts are transferred to this account. This is done through journal entries called closing
entries.
(iii) Rectification entries : If an error has been committed, it is rectified through a journal entry.
(iv) Transfer entries : If some amount is to be transferred from one account to another, the transfer will be
made through a journal entry.
(v) Adjusting entries : At the end of the year the amount of expenses or income may have to be adjusted
for amounts received in advance or for amounts not yet settled in cash. Such an adjustment is also
made through journal entries. Usually, the entries pertain to the following:
(a) Outstanding expenses, i.e., expenses incurred but not yet paid;
(b) Prepared expenses, i.e., expenses paid in advance for some period in the future;
(c) Interest on capital, i.e., the interest on proprietor’s investment in the business entity investment; and
(d) Depreciation, i.e., fall in the value of the assets used on account of wear and tear.
For all these, journal entries are necessary.
(vi) Entries on dishonour of Bills : If someone who accepted a promissory note (or bill) is not able to pay
in on the due date, a journal entry will be necessary to record the non-payment or dishonour.
(vii) Miscellaneous entries : The following entries will also require journalising:
(a) Credit purchase of things other than goods dealt in or materials required for production of goods
e.g. credit purchase of furniture or machinery will be journalised.
(b) An allowance to be given to the customers or a charge to be made to them after the issue of the
invoice.
(c) Receipt of promissory notes or issue to them if separate bill books have not been maintained.
(d) On an amount becoming irrecoverable, say, because, of the customer becoming insolvent.
(e) Effects of accidents such as loss of property by fire.
(f ) Transfer of net profit to capital account.

? ILLUSTRATION 6
From the following transactions, prepare the Purchases Returns Book of Alpha & Co., a saree dealer and post
them to ledger :

Date Debit Note No. Particulars

04.01.2016 101 Returned to Goyal Mills, Surat - 5 polyester sarees @ ` 1,000.
09.01.2016 Garg Mills, Kota - accepted the return of goods (which were purchased
for cash) from us - 5 Kota sarees @ ` 400.

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 ACCOUNTING PROCESS 2.65

16.01.2016 102 Returned to Mittal Mills, Bangalore - 5 silk sarees @ `2,600.

30.01.2016 Returned one computer (being defective) @ `35,000 to B & Co.

 SOLUTION

Purchase Returns Book

Date Debit Note No. Name of supplier L.F. Amount

2016
Jan. 4 101 Goyal Mills, Surat 5,000
Jan. 16 102 Mittal Mills, Bangalore 13,000
Jan. 31 Purchases Returns Account (Cr.) 18,000

SUMMARY
w Instead of recording all journal entries in one register, it is better to categorize the entries on the basis
of type of transactions.
w Various subsidiary books are maintained so as to record transactions of one type in each register. These
are also called books of original entry or prime entry.
w Example of subsidiary books are purchases book, sales book, purchase returns books, sales returns
book, bills receivable book etc. On the basis of these subsidiary books, the ledger accounts are prepared.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. In Purchases Book the record is in respect of ___________________________
(a) Cash purchase of goods.
(b) Credit purchase of goods dealt in.
(c) All purchases of goods.

2. The Sales Returns Book records ___________________________

(a) The return of goods purchased.
(b) Return of anything purchased.
(c) Return of goods sold.

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 2.66 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. The Sales Book ___________________________

(a) Is a part of journal.
(b) Is a part of the ledger.
(c) Is a part of the balance sheet.
4. The weekly or monthly total of the Purchase Book is ___________________________
(a) Posted to the debit of the Purchases Account.
(b) Posted to the debit of the Sales Account.
(c) Posted to the credit of the Purchases Account.

5. The total of the Sales Book is posted to ___________________________

(a) Credit of the Sale s Account.
(b) Credit of the Purchases Account.
(c) Credit of the Capital Account.

6. In which book of original entry, will you record an allowance of `50 was offered for an early payment of
cash of `1,050 ___________________________.
(a) Sales Book
(b) Cash Book
(c) Journal Proper (General Journal)

7. A second hand motor car was purchased on credit from B Brothers for `10,000 will be recorded in
___________________________.
(a) Journal Proper (General Journal)
(b) Sales Book
(c) Cash Book
(d) Purchase Book

8. In which book of original entry, will you record a bills receivable of `1,000, which was received from a
debtor in full settlement for a claim of `1,100, is dishonoured ____________________.
(a) Purchases Return Book
(b) Bills Receivable Book
(c) Journal Proper (General Journal)
Theory Questions
1 Which subsidiary books are normally used in a business?
2. What are the advantages of subsidiary books?

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 ACCOUNTING PROCESS 2.67

Practical Questions
1. Enter the following transactions in Sales Book of M/s. Pranat Engineers Ltd., Delhi.
2016
Jan. 2. Sold to M/s. Ajanta Electricals, Delhi 5 pieces of Ovens @ `6,000/- each less Trade discount
@ 10%.
8 Sold to M/s. Ajanta Electricals Plaza, 10 pieces of Tablets @ ` 8,000/- each less trade discount
5%.
15 Sold to M/s. Haryana Traders, 5 pieces of Juicers @ `3,500/- each less trade discount @ 10%.
2. Post into the ledger the entries of Sales Book prepared in Question1.

ANSWERS/HINTS
MCQs

1. (b) 2. (c) 3. (a) 4. (a) 5. (a) 6. (b) 7. (a) 8. (c)

Theoretical Questions
1. Normally, the following subsidiary books are used in a business:
(i) Cash Book to record receipts and payments of cash, including receipts into and payments out of
the bank.
(ii) Purchases Book to record credit purchases of goods dealt in or of the materials and stores required
in the factory.
(iii) Purchase Returns Books to record the returns of goods and materials previously purchased.
(iv) Sales Book to record the sales of the goods dealt in by the firm.
(v) Sale Returns Book to record the returns made by the customers.
(vi) Bills Receivable Books to record the receipts of promissory notes or hundies from various parties.
(vii) Bills Payable Book to record the issue of the promissory notes or hundies to other parties.
(viii) Journal (proper) to record the transactions which cannot be recorded in any of the seven books
mentioned above.
2. For advantages of Subsidiary Books, refer para 4.1.

PRACTICAL PROBLEMS
ANSWERS 1
Sales Book

Date Particulars Gross Trade Net

Amount Discount Price
2016
Jan. 2 Ajanta Electricals 5 pieces of

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 2.68 PRINCIPLES AND PRACTICE OF ACCOUNTING

Ovens @ ` 6,000 each

Less: 10% discount 30,000 3,000 27,000
8 Electronics Plaza 10 pieces of
Tablets @ ` 8,000 each,
Less: 5% trade discount 80,000 4,000 76,000
15 Haryana Traders 5 pieces of
Juicers @ ` 3,500 each,
less 10% trade discount 17,500 1,750 15,750
1,27,500 8,750 1,18,750
ANSWERS 2
Ledger
Ajanta Electricals

Date Particulars L.F. Amount Date Particulars L.F. Amount

2016 2016 (` )

Jan. 2 To Sales A/c 27,000

Electronics Plaza

Date Particulars L.F. Amount Date Particulars L.F. Amount

2016 2016 (` )
Jan. 8 To Sales A/c 76,000

Haryana Traders

Date Particulars L.F. Amount Date Particulars L.F. Amount

2016 2016 (` )
Jan. 15 To Sales A/c 15,750

Sales Account

Date Particulars L.F. Amount Date Particulars L.F. Amount

2016 2016 (` )
Jan. 31 By Sundries 1,18,750
(As per Sales Book)

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 ACCOUNTING PROCESS 2.69

UNIT 5 : CASH BOOK

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand that a Cash Book is a type of subsidiary book but treated as a principal book.
w Be familiar with various kinds of Cash Books, viz., Simple Cash Book, Two-column Cash Book and Three-
column Cash Book.
w Learn the technique of preparation of Simple Cash Book and how to balance it.
w See how Double-Column Cash Book is a prepared adding discount column alongwith cash column.
w Understand the techniques of preparing Three-column Cash Book.
w Understand what is a Petty Cash Book and the Imprest System of Petty Cash.
w Note the advantages of the Petty Cash Book.
w Learn how to maintain a Petty Cash Book and how to post the entries of the Petty Cash Book in the
ledger.
w Understand the accounting of credit/debit sales transactions

Subsidiary
book as well as
Principal book

UNIT OVERVIEW
Simple Cash Three column
cash book cash book
Book

Two column
cash book

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 2.70 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.1 CASH BOOK - A SUBSIDIARY BOOK AND A PRINCIPAL BOOK

Cash transactions are straightaway recorded in the Cash Book and on the basis of such a record, ledger
accounts are prepared. Therefore, the Cash Book is a subsidiary book. But the Cash Book itself serves as the
cash account and the bank account; the balances are entered in the trial balance directly. The Cash Book,
therefore, is part of the ledger also. Hence, it has also to be treated as the principal book. The Cash Book is
thus both a subsidiary book and a principal book.

5.2 KINDS OF CASH BOOK

The main Cash Book may be of the three types:
(i) Simple Cash Book;
(ii) Two-column Cash Book;
(iii) Three-column Cash Book.
In addition to the main Cash Book, firms also generally maintain a petty cash book but that is purely a
subsidiary book.
SIMPLE CASH BOOK
Such a cash book appears like an ordinary account, with one amount column on each side. The left-hand
side records receipts of cash and the right-hand side the payments.
Balancing of the Cash Book: The cash book is balanced like other accounts. The total of receipts column is
always greater than total of payments column. The difference is written on the credit side as ‘By balance c/d’.
The totals are then entered in the two columns opposite one another and then on the debit side the balance
is written as “To Balance b/d”, to show cash balance in hand in the beginning of next period.

? ILLUSTRATION 1
Enter the following transactions in a Simple Cash Book:

2016 `
Jan.1 Cash in hand 1,200
“5 Received from Ram 300
“7 Paid Rent 30
“8 Sold goods for cash 300
“10 Paid to Shyam 700
“27 Purchased Furniture 200
“31 Paid Salaries 100
“31 Rent due, not yet paid, for January 30

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 ACCOUNTING PROCESS 2.71

 SOLUTION
Dr. Cash Book Cr.

Date Receipts L.F. Amount Date Payments L.F. Amount

2016 ` 2016 `
Jan. 1 To Balance b/d 1,200 Jan. 07 By Rent A/c 30
“5 To Ram A/c 300 “ 10 By Shyam A/c 700
“8 To Sales A/c 300 “ 27 By Furniture A/c 200
“ 31 By Salaries A/c 100
“ 31 By Balance c/d 770
1,800 1,800
2016
Feb. 1 To Balance b/d 770
Note: One can see the following:
(i) In the simple cash book only the cash receipts and cash payments are recorded.
(ii) The total of debit side is always greater than the total of credit side since the payment cannot exceed
the available cash.
(iii) The simple cash book is like an ordinary account.

DOUBLE-COLUMN CASH BOOK

If along with columns for amounts to record cash receipts and cash payments another column is added
on each side to record the cash discount allowed or the discount received, or a column on the debit side
showing bank receipts and another column on the credit side showing payments through bank. It is a
double-column cash book.
Cash discount is an allowance which often accompanies cash payments. For example, if a customer owes
` 500 but is promised that 2% will be deducted if payment is made within a certain period, the customer
can clear his account by paying promptly ` 490. Cash received will be ` 490 and ` 10 will be the discount for
the firm receiving the payment discount is a loss; for the person making the payment it is a gain. Since cash
discount is allowed only if cash is paid, it is convenient to add a column for discount allowed on the receipt
side of the cash book and a column for discount received on the payment side of the cash book.
In the cash column on the debit side, actual cash received is entered; the amount of the discount allowed,
if any, to the customer concerned is entered in the discount column. Similarly, actual cash paid is entered in
the cash column on the payments side and discount received in the discount column. Also the bank column
on the debit side records all receipts through bank and the same column on the credit side shows payment
through bank.
Balancing: It should be noted that the discount columns are not balanced. They are merely totalled. The
total of the discount column on the receipts side shows total discount allowed to customers and is debited
to the Discount Account. The total of the column on the payments side shows total discount received and is
credited to the Discount Account. The Cash columns are balanced, as already shown. The bank columns are
also balanced and the balancing figure is called bank balance. Thus a double column cash book should have
two columns on each side comprising of either cash and discount transaction or cash and bank transactions.

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 2.72 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 2
Ganesh commenced business on 1st April, 2017 with ` 2,000 as capital. He had the following cash transactions
in the month of April 2017:

` `
April 1 Purchased furniture April 7 Paid for petty expenses 15
and paid cash 250 “ 8 Cash purchases 150
“2 Purchased goods 500
“4 Sold goods for cash 950
13 Paid for labour 1,000
“5 Paid cash to Ram Mohan 560
“6 He allowed discount 10 “” Paid Ali & Sons 400
“6 Received cash from They allowed discount 8
Krishna & Co. 600 “”
Allowed discount 20
Make out the two-column Cash Book (Cash and discount column) for the month of April, 2017.

 SOLUTION

Cash Book

Dr. Receipts L.F. Discount Amount Date Payments L.F. Discount Cr.
Date ` ` 2017 ` Amount
2017 `
April 1 To Capital A/c 2,000 April 1 By Furniture A/c 250
“ 4 To Sales A/c 950 “ 2 By Purchases A/c 500
“ 6 To Krishna A/c 20 600
“ 5 By Ram Mohan 10 560
“ 7 By Petty
Expenses A/c 15
“ 8 By Purchases A/c 150
“ 13 By wages A/c 1,000
“ 13 By Ali & Sons 8 400
“ 30 By Balance c/d 675
20 3,550 18 3,550
May 1 To Balance b/d 675

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 ACCOUNTING PROCESS 2.73

To summarise:
(i) the discount columns in the cash book are totalled;
(ii) they are not balanced; and
(iii) their totals are entered in the discount received/paid account in the ledger.
Note: The person who pays, is credited by both the cash paid by him and the discount allowed to him.
Similarly, the person to whom payment is made, is debited with both the amount paid and the discount
allowed by him.

THREE-COLUMN CASH BOOK

A firm normally keeps the bulk of its funds at a bank; money can be deposited and withdrawn at will if
it is current account. Probably payments into and out of the bank are more numerous than strict cash
transactions. There is only a little difference between cash in hand and money at bank. Therefore, it is very
convenient if, on each side in the cash book, another column is added to record cash deposited at bank (on
the receipt side of the cash book) and payments out of the bank (on the payment side of the cash book).
For writing up the three-column cash book the under mentioned points should be noted:
1. While commencing a new business, the amount is written in the cash column if cash is introduced and
in the bank column if it is directly put into the bank with the description “To Capital Account”. If a new
cash book is being started for an existing business, the opening balances are written as : “To Balance
b/d”.
2. All receipts are written on the receipts side, cash in the cash column and cheques in the bank column. If
any discount is allowed to the party paying the amount, the discount is entered in the discount column.
In the particulars column the name of the account in respect of which payment has been received is
written.
3. All payments are written on the payments side, cash payment in the cash column and payments by
cheques in the bank column. If some discount has been received from the party receiving the payment,
it is entered in the discount column.
4. Contra Entries: Often cash is withdrawn from bank for use in the office. In such a case the amount is
entered in the bank column on the payments side and also in the cash column on the receipts side.
In the reverse case of cash being sent to the bank, the amount is recorded in the bank column on the
receipts side and in cash column on payment side. Against such entries, the letter “C” should be written
in the LF. column, to indicate that these are contra transaction and no further posting is required for
them.
Note: If initially cheques received are entered in the cash column and then sent to the bank, the entry is
as if cash has been sent to the bank.
While recording contra entries, the basic but important rules should be followed -
(a) The Receiver Dr.
The Giver Cr.

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 2.74 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) All what comes in Dr.

All what goes out Cr.
e.g. where a Cash Book with separate columns for Bank Account is maintained.
(a) If cash is deposited in Bank Account, the Bank will be the Receiver, hence it will be Debited and as
the cash is going out, cash will be credited.
(b) If cash is withdrawn from the Bank Account, the Bank will be the Giver, hence it will be Credited and,
as the cash is coming in, cash will be Debited.
5. If some cheque sent to the bank is dishonoured, i.e., the bank is not able to collect the amount, it is
entered in the bank column on the credit side with the name of the related party in the particulars
column.
6. If some cheque issued by the firm is not paid on presentation, it is entered in the Bank column on the
debit side with the name of the party to whom the cheque was given.
7. In a rare case, a cheque received may be given to some other party, i.e., endorsed. On receipt, it must
have been entered in the bank column on the debit side; on endorsement the amount will be written
in the bank column on the credit side.
The advantages of such type of Cash Book are that -
(a) the Cash Account and the Bank Account are prepared simultaneously, therefore the double entry
is completed in the Cash Book itself. Thus the contra entries can be easily cross-checked in Cash
column in one side and the Bank column in the other side of the Cash Book. Also the chances of
error are reduced.
(b) the information regarding Cash in Hand and the Bank Balance can be obtained very easily and
quickly as there is no need to prepare Ledger of the Bank Account.
In case of maintaining more than one Bank Account, separate column can be add for each Bank Account.
Transactions between these two or more Bank Accounts can be recorded and tallied with a much less
effort.
Suppose, there are two Bank Accounts namely PNB Current Account and SBI-Cash Credit Account. Now,
if a cheque is deposited of PNB to SBI Account, the receiver - i.e., SBI Account will be debited and the
giver i.e. the PNB Account shall be credited.
Balancing: The discount columns are totalled but not balanced. The cash columns are balanced exactly
in the same manner as indicated for the simple cash book. The process is similar for balancing the
bank columns also. It is possible, however, that the bank may allow the firm to withdraw more than the
amount deposited i.e., to have an overdraft, In such a case, the total of the bank column on the credit
side is bigger than the one on the debit side. The difference is written on the debit side as “To Balance
c/d.” Then the totals are written on the two sides opposite one another, the balance is then entered on
the credit side as “By Balance b/d.”
However, the usual case is that payments into the bank will exceed the withdrawals or payments out of
the bank. Then the bank columns are balanced just like the cash columns.

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 ACCOUNTING PROCESS 2.75

? ILLUSTRATION 3
Enter the following transactions in Cash Book with Discount and Bank Columns. Cheques are first treated as cash
receipt.

2016 `
Jan.1 Chandrika commences business with Cash 20,000
“3 He paid into Current A/c 19,000
“4 He received cheque from Kirti & Co. on account 600
“7 He pays in bank Kirty & Co.’s cheque 600
“10 He pays Rattan & Co. by cheque and is allowed discount ` 20 330
“12 Tripathi & Co. pays into his Bank A/c 475
“15 He receives cheque from Warshi and allows him discount ` 35 450
“20 He receives cash ` 75 and cheque ` 100 for cash sale
“25 He pays into Bank, including cheques received on 15th and 20th 1,000
“27 He pays by cheque for cash purchase 275
“30 He pays sundry expenses in cash 50

 SOLUTION

Dr. Cash Book Cr.

Date Receipts L.F. Discount Cash Bank Date Payments L.F. Discount Cash Bank
` ` ` ` ` `
2016 2016
Jan. 1 To Capital A/c 20,000 Jan. 3 By Bank A/c C 19,000
3 To Cash C 19,000 7 By Bank A/c C 600
4 To Kirti & Co. 600 10 By Ratan & Co. 20 330
7 To Cash C 600 25 By Bank A/c C 1,000
12 To Tripathi & 475 27 By Purchases 275
Co. A/c
15 To Warshi 35 450 30 By S. Exp. A/c 50
20 To Sales A/c 175
25 To Cash C 1,000
31 By Balance c/d 300 20,745
35 21,225 21,075 20 21,225 21,075
Feb. 1 To Balance b/d 300 20,745

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 2.76 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.3 POSTING THE CASH BOOK ENTRIES

Students would have seen that the cash columns in the cash book is actually the cash account and the bank
column is actually bank account. Also, the discount columns are memorandum columns, meant only to
provide information about the total discount allowed and total discount received.
The debit side columns for cash and bank indicate receipts. Therefore, the amounts debited in the cash
book should be put to the credit of the account in respect of which cash or cheque has been received. For
instance, in the cash book given above we see that `175 have been received for sale of goods. For posting,
the amount is credited to the Sales Account as “By Cash `175.” We also see M/s. Warsi have paid `450 and
also they have been allowed ` 35 as discount; thus they have discharged a debt of `485. In the account of
M/s. Warsi, the posting is on the credit side as
By Cash ` 450
By Discount ` 35
or as:
By Sundries ` 485
All payments are recorded on the credit side. The particulars columns show on what account
payments have been made. In the ledger accounts concerned the amount is put on the
debit side. For example, the cash book shows that a cheque for ` 330 has been issued to
M/s. Ratan & Co. and also that they have allowed a discount of ` 20; thus an obligation of ` 350 has been
met. In the account of M/s. Ratan & Co. the posting is:
To Bank ` 330
To Discount ` 20
Or
To Sundries ` 350
The rule thus develops: From the debit side of the cash book credit the various accounts with their respective
amounts (including any discount that may have been allowed); from the credit side of cash book the posting
will be to the debit of the accounts mentioned in the particular column with their respective amounts
(including the discount which may have been received).
As has been shown already, the total of the discount columns on the debit side is debited to the discount
account; the total of the column on the credit side is credited to the discount account. From the cash book
given on the previous page ` 35 is debited and ` 20 be credited to the discount account.

5.4 PETTY CASH BOOK

In a business house a number of small payments, such as for telegrams, taxi fare, cartage, etc., have to be
made. If all these payments are recorded in the cash book, it will become unnecessarily heavy. Also, the main
cashier will be overburdened with work. Therefore, it is usual for firms to appoint a person as ‘Petty Cashier’
and to entrust the task of making small payments say below ` 200, to him. Of course he will be reimbursed
for the payments made. Later, on an analysis, the respective account may be debited.

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 ACCOUNTING PROCESS 2.77

IMPREST SYSTEM OF PETTY CASH

It is convenient to entrust a definite sum of money to the petty cashier in the beginning of a period and to
reimburse him for payments made at the end of the period. Thus, he will have again the fixed amount in the
beginning of the new period. Such a system is known as the imprest system of petty cash.
The system is very useful specially if an analytical Petty Cash Book is used. The book has one column to record
receipt of cash (which is only from the main cashier) and other columns to record payments of various types.
The total of the various columns show why payments have been made and then the relevant accounts can
be debited.
(i) The amount fixed for petty cash should be sufficient for the likely small payments for a relatively short
period, say for a week or a fortnight.
(ii) The reimbursement should be made only when petty cashier prepares a statement showing total
payments supported by vouchers, i.e., documentary evidence and should be limited to the amount of
actual disbursements.
(iii) The vouchers should be filed in order.
(iv) No payment should be made without proper authorization. Also, payments above a certain specified
limit should be made only by the main cashier.
(v) The petty cashier should not be allowed to receive any cash except for reimbursement.
In the petty cash book the extreme left-hand column records receipts of cash. The money column towards
the right hand shows total payments for various purposes; a column is usually provided for sundries to
record infrequent payments. The sundries column is analysed. At the end of the week or the fortnight the
petty cash book is balanced. The method of balancing is the same as for the simple cash book.

? ILLUSTRATION 4
Prepare a Petty Cash Book on the imprest System from the following:

2016 `
Jan. 1 Received `100 for petty cash
“ 2 Paid bus fare .50
“ 2 Paid cartage 2.50
“ 3 Paid for Postage & Telegrams 5.00
“ 3 Paid wages for casual labourers 6.00
“ 4 Paid for stationery 4.00
“ 4 Paid tonga charges 2.00
“ 5 Paid for the repairs to chairs 15.00
“ 5 Bus fare 1.00
“ 5 Cartage 4.00
“ 6 Postage and Telegrams 7.00
“ 6 Tonga charges 3.00
“ 6 Cartage 3.00
“ 6 Stationery 2.00
“ 6 Refreshments to customers 5.00

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 2.78 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Petty Cash Book
Receipts Date V. Particulars Total Con- Cartage Statio- Postage & Wages Sundries
` 2016 No. ` veyance ` nery Telegrams ` `
` ` `
100 Jan.1 To Cash
2 1 By Conveyance .50 .50
2 By Cartage 2.50 2.50
3 3 By Postage and 5.00 5.00
Telegrams
4 By Wages 6.00 6.00
4 5 By Stationery 4.00 4.00
6 By Conveyance 2.00 2.00
5 7 By Repairs to 15.00 15.00
Furniture
8 By Conveyance 1.00 1.00
9 By Cartage 4.00 4.00
6 10 By Postage and 7.00 7.00
Telegrams
“ 11 By Conveyance 3.00 3.00
“ 12 By Cartage 3.00 3.00
“ 13 By Stationery 2.00 2.00
“ 14 By General 5.00 5.00
Expenses
60.00 6.50 9.50 6.00 12.00 6.00 20.00
By Balance c/d 40.00
100 100.00
40.00 To Balance b/d
60.00 8 To Cash

ADVANTAGES OF PETTY CASH BOOK

There are mainly three advantages:
(i) Saving of time of the chief cashier;
(ii) Saving in labour in writing up the cash book and posting into the ledger; and
(iii) Control over small payments.

POSTING THE PETTY CASH BOOK

In the ledger, a petty cash account is maintained; when an amount is given to the petty cashier, the petty
cash account is debited. Each week or forthnight, the total of the payments made is credited to this account.
The petty cash account will then show the balance in the hand of the cashier; on demand he should be able
to produce it for counting. At the end of the year, the balance is shown in the balance sheet as part of cash
balance.
Of course, the payments must be debited to their respective amounts as shown by the petty cash book. For
this two methods may be used:
(i) From the petty cash book the total of the various columns may be directly debited to the concerned
accounts; or

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 ACCOUNTING PROCESS 2.79

(ii) A journal entry may first be prepared on the basis of the petty cash book, debiting the accounts shown
by the various analysis columns, and crediting the total of the payment of the petty cash accounts.
For Illustration 4 the journal entry and relevant accounts are as follows:

2016 ` `
Jan. 6 Conveyance Account Dr. 6.50
Cartage account Dr. 9.50
Stationery account Dr. 6.00
Postage and Telegrams account Dr. 12.00
Wages Account Dr. 6.00
Repairs Account Dr. 15.00
General Expenses Account Dr. 5.00
To Petty Cash Account 60.00
(Being the analysis of the Petty Cash Book for
the week ending Jan. 6)
Entry for cash handed over to the Petty Cashier
Petty Cash Account Dr. 100
To Cash Account 100
(Being Cash received)

Petty Cash Account

Date Particulars Folio Amount Date Particulars Folio Amount
2016 ` 2016 `
Jan.1 To Cash 100.00 Jan. 6 By Sundries:
“8 To Cash 60.00 Conveyance 6.50
Cartage 9.50
Stationery 6.00
Postage and 12.00
Telegrams
Wages 6.00
Repairs 15.00
General Expenses 5.00

5.5 ENTRIES FOR SALE THROUGH CREDIT/DEBIT CARDS

Now-a-days sales through Credit/Debit Cards are issued by almost every Bank in India either directly or
with collaboration of some other agencies. HSBC Card, SBI Card, BOB Card, ICICI Bank Card, HDFC Card and
Andhra Bank Card are some of the popular Cards.
The procedure for issuing Credit/Debit Cards are as follows -
1. A small Plastic Card, called Credit Card is issued by bank to a prospective customer, after verifying his
credibility, which is generally measured by his income sources. Debit Card is issued by bank to a customer
who has an account with the bank, maintaining a minimum balance. Now a days ATM Card issued by

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 2.80 PRINCIPLES AND PRACTICE OF ACCOUNTING

the bank can also be used as Debit Card. This card would contain an embossed 16 digit number and also
the name of the cardholder.
2. Generally Bank charges annual subscription fees from the credit card holder. No fee is charged in case
of Debit Card, though some banks charge a nominal fee on Debit Card.
3. When the Card holder intends to buy some goods or services through Credit or Debit Card, the seller
fills in a form, generally in triplicate, the details of the goods a with the amount of sales and uses
the embossed card with the help of the Credit Card machine to print the data on that form. Also the
customer has to countersign the form. One carbon copy of the form is given to the customer for the
record.
4. The seller sums up the different amounts sold like this and submits, generally everyday, to his bank all
the forms. The amount is credited by the bank to the seller’s account and debited to the account of the
Bank or the company issuing the Credit/Debit Card.
5. The bank issuing the Card, charges commission for each such transaction, which varies between 1% to
4% and is immediately debited to seller’s bank account.
6. The bank sends a monthly statement to the card holder. In case of Debit Card the account is immediately
debited to the card holder’s account, whereas in case of Credit Card, card holder has to pay the amount
in full or part. However, if not paid in full, the interest is charged.
ACCOUNTING FOR CREDIT/DEBIT CARD SALE
From the seller’s point of view, this type of sale is equivalent to a cash sale. Commission charged by the
bank will be treated as selling expenses. The following journal entries will be made in the seller’s books of
accounts.
1. Bank A/c Dr.
To Sales Account
(Sales made through Credit/Debit Card)

2. Commission Account Dr.

To Bank Account
(Commission charged by bank)

? ILLUSTRATION 5
Enter the following transaction in Cash Bank with Discount and Bank columns. Cheques are first treated as cash
receipts -

2016 `
March 1 Cash in Hand 15,000
Overdraft in Bank 500
2 Cash Sales 3,000
3 Paid to Sushil Bros. by cheque 3,400
Discount received 100
5 Sales through credit card 2,800
6 Received cheque from Srijan 6,200

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 ACCOUNTING PROCESS 2.81

7 Endorsed Srijan’s cheque in favour of Adit

9 Deposit into Bank 6,800
10 Received cheque from Aviral and deposited the same into Bank
by allowing discount of `50 3,600
12 Adit informed that Srijan’s cheque is dishonoured. Now cash is received from Srijan
and amount is paid to Adit through own cheque
15 Sales through Debit Card 3,200
24 Withdrawn from Bank 1,800
28 Paid to Sanchit by cheque 3,000
30 Bank charged 1% commission on sales through
Debit/Credit Cards

 SOLUTION
Dr. Cash Book Cr.

Date Particulars L.F. Discount Cash Bank Date Particulars L.F. Discount Cash Bank
` ` ` ` ` `

2016 2016
March 1 To Balance b/d 15,000 March 1 By Balance b/d 500
2 To Sales 3,000 3 By Sushil Bros. 100 3,400
5 To Sales 2,800 7 By Adit 6,200
6 To Srijan 6,200 9 By Bank C 6,800
9 To Cash A/c C 6,800 12 By Adit 6,200
10 To Aviral 50 3,600 24 By Cash A/c C 1,800
12 To Srijan 6,200 28 By Sanchit 3,000
15 To Sales A/c 3,200 30 By Commission 60
24 To Bank A/c C 1,800 31 By Balance c/d 19,200 1,440
50 32,200 16,400 100 32,200 16,400

If the received cheque is endorsed to other party on the same day then no entry is required. However in the
above case posting has been done through cash coloum as the endorsement is done on the next day.

SUMMARY
w Cash book contains cash transactions and also bank transactions, if it has a separate book column. It is
both a subsidiary book and a principal book.
w Cash book can be prepared adding discount column also.

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 2.82 PRINCIPLES AND PRACTICE OF ACCOUNTING

w For small payments, petty cash book is maintained separately recording the particulars of payment and
its amount. The fixed amount is given to the petty cashier for making small payments in the beginning
of the period. The amount spent is replenished so that he will have again the fixed sum in the beginning
of the next period. This system is known as imprest system of petty cash book.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. The total of discounts column on the debit side of the cash book, recording cash discount deducted by
customers when paying their accounts, is posted to the __________________________
(a) Credit of the discount allowed account.
(b) Debit of the discount allowed account
(c) Credit of the discount received account.
2. Cash book is a type of __________ but treated as a ____________ of accounts.
(a) Subsidiary book, principal book
(b) Principal book, subsidiary book
(c) Subsidiary book, subsidiary book
3. Which of the following is not a column of a three-column cash book?
(a) Cash column
(b) Bank column
(c) Petty cash column
4. Contra entries are passed only when __________________________
(a) Double-column cash book is prepared
(b) Three-column cash book is prepared
(c) Simple cash book is prepared
5. The Cash Book records __________________________
(a) All cash receipts
(b) All cash payments
(c) All cash receipts and payments
6. The balance in the petty cash book is __________________________
(a) An expense
(b) A profit
(c) An asset

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 ACCOUNTING PROCESS 2.83

7. If Ram has sold goods for cash, the entry will be recorded __________________________
(a) In the Cash Book
(b) In the Sales Book
(c) In the Journal
Theory Questions
1. Is cash book a subsidiary book or a principal book? Explain.
2. What are the various kinds of cash book?
3. What are the advantages of a three column cash book?
Practical Questions
1. Shri Ramaswamy maintains a Columnar Petty Cash Book on the Imprest System. The imprest amount is
` 500. From the following information, show how his Petty Cash Book would appear for the week ended
12th September, 2015:
`

7-9-2015 Balance in hand 134.90

Received Cash reimbursement to make up the imprest 365.10
Stationery 49.80
8-9-2015 Miscellaneous Expenses 20.90
9-9-2015 Repairs 156.70
10-9-2015 Travelling 68.50
11-9-2015 Stationery 71.40
12-9-2015 Miscellaneous Expenses 6.30
Repairs 48.30
ANSWERS/HINTS
MCQs

1. (b) 2. (a) 3. (c) 4. (b) 5. (c) 6. (c) 7. (a)

Theoretical Questions
1. Cash transactions are straightaway recorded in the Cash Book and on the basis of such a record, ledger
accounts are prepared. Therefore, the Cash Book is a subsidiary book. But the Cash Book itself serves as
the cash account and the bank account; the balances are entered in the trial balance directly. The Cash
Book, therefore, is part of the ledger also. Hence, it has also to be treated as the principal book. The Cash
Book is thus both a subsidiary book and a principal book.
2. The main Cash Book may be of the three types:
(i) Simple Cash Book;

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 2.84 PRINCIPLES AND PRACTICE OF ACCOUNTING

(ii) Two-column Cash Book;

(iii) Three-column Cash Book.
In addition to the main Cash Book, firms also generally maintain a petty cash book but that is purely a
subsidiary book.
3. The advantages of three column Cash Book are that -
(a) the Cash Account and the Bank Account are prepared simultaneously, therefore the double entry
is completed in the Cash Book itself. Thus the contra entries can be easily cross-checked in Cash
column in one side and the Bank column in the other side of the Cash Book. Also the chances of
error are reduced.
(b) the information regarding Cash in Hand and the Bank Balance can be obtained very easily and
quickly as there is no need to prepare Ledger of the Bank Account.

Practical Problems
Answer 1
Petty Cash Book

Date Receipts Amount Date Payments Total Stationery Travelling Misc Repairs
2015 ` 2015 Amount ` ` Exps. `
` `
Sept. 7 To Balance b/d 134.90 7 By Stationery 49.80 49.80
To Reimbursement 365.10 8 By Misc. Expenses 20.90 20.90
9 By Repairs 156.70 156.70
10 By Travelling 68.50 68.50
11 By Stationery 71.40 71.40
12 By Misc. Expenses 6.30 6.30
By Repairs 48.30 48.30
421.90 121.20 68.50 27.20 205.00
By Balance c/d 78.10
500.00 500.00
13 To Balance b/d 78.10

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 ACCOUNTING PROCESS 2.85

UNIT 6 : RECTIFICATION OF ERRORS

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand different types of errors which may occur in course of recording transactions and events.
w Be familiar with the steps involved in locating errors.
w Learn the nature of one-sided errors and two-sided errors.
w Understand why suspense account is opened for rectification of errors.
w Understand the technique of correcting errors of one period in the next accounting period.

Errors of
Principle

UNIT OVERVIEW Errors of

Omission
Types of Errors of
Commission
Errors

Compensating
Errors

6.1 INTRODUCTION
Unintentional omission or commission of amounts and accounts in the process of recording the transactions
are commonly known as errors. These various unintentional errors can be committed at the stage of
collecting financial information/data on the basis of which financial statements are drawn or at the stage of
recording this information. Also errors may occur as a result of mathematical mistakes, mistakes in applying
accounting policies, misinterpretation of facts, or oversight. To check the arithmetic accuracy of the journal
and ledger accounts, trial balance is prepared. If the trial balance does not tally, then it can be said that
there are errors in the accounts which require rectification thereof. Some of these errors may affect the Trial
Balance and some of these do not have any impact on the Trial Balance although such errors may affect the
determination of profit or loss, assets and liabilities of the business.

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 2.86 PRINCIPLES AND PRACTICE OF ACCOUNTING

Illustrative Case of Errors and their Nature

We have seen that after preparing ledger accounts a trial balance is taken out where debit and credit
balances are separately listed and totalled. If the two totals do not agree, it is definite that there have been
some errors We shall now study the types of errors which may be committed and how they may be rectified.
For this purpose, the working of the following illustrative cases should be carefully seen.
Illustrative Cases of Errors
(a) Wrong Entry: Let us start from the first phase in the accounting process. Wrong entry of the value of
transactions and events in the subsidiary books, Journal Proper and Cash Book may occur.
Example 1: Credit purchases `17,270 are entered in the Purchases Day Book as `17,720. Credit sales of
`15,000 gross less 1% trade discount are wrongly entered in Sales Day Book at `15,000. Cheque issued
`19,920 are wrongly entered in the credit of bank column in the Cash Book as `19,290.
(b) Wrong casting of subsidiary books: Subsidiary books are totalled periodically and posted to the
appropriate ledger accounts. There may arise totalling errors. Totalling errors may arise due to wrong
entry or simply these may be independent errors.
Example 2: For the month of January, 2016 total of credit sales are `1,75,700, this is wrongly totalled as
`1,76,700 and posted to sales account as `1,76,700.
(c) In case of cash book, wrong castings result in wrong calculation of the balance c/d.
Example 3: The following cash transactions of M/s. Tularam & Co. occurred:
2017

Jan. 1 Balance - cash `1,200 bank `16,000;

Jan. 2 Cheque issued to M/s. Bholaram & Co., a supplier, for `22,500;
Jan. 6 Cheque collected from M/s. Scindia & Bros. `42,240 and deposited for clearance;
Jan. 7 Cash sales `27,200 paid wages `12,400;
Jan. 8 Cash sales ` 37,730 cash deposited to bank ` 35,000.
The following Cash Book entries are passed:
Dr. Cash Book Cr.

Date Particulars Cash Bank Date Particulars Cash Bank

2017 ` ` 2017 ` `
Jan. 1 To Balance b/d 1,200 16,000 Jan. 2 By M/s Bholaram & Co. A/c 22,500

Jan. 6 To M/s. Scindia & Bros. A/c 42,420 By Wages A/c 12,200
Jan. 7 To Sales A/c 27,200 By Bank A/c 34,500
Jan. 8 To Sales A/c 37,370 By Balance c/d 19,070 71,420

Jan. 8 To Cash A/c 34,500

65,770 93,920 65,770 93,920

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 ACCOUNTING PROCESS 2.87

Wrong entries and wrong casting are shown in bold prints. However, errors of cash entries generally are not
carried. Usually cash balances are tallied daily. So errors are identified at an early stage. But bank balance
cannot be checked daily and thus errors may be carried until bank reconciliation is made. In the above
example, there are four wrong entries and one wrong casting. Bank and cash balances are affected by these
errors.
(d) Wrong posting from subsidiary books: In this case, the wrong amount may be posted to the ledger
account or the amount may posted to the wrong side or to the wrong account. For example, purchases
from A may be posted to B’s account.
(e) Wrong casting of ledger balances: Likewise Cash Book, any ledger account balance may be cast
wrongly. Obviously wrong postings make the balance wrong; but that is not wrong casting of balances.
Whenever there arises independent casting error as in the case of bank column in the Cash Book of
example (4), that is called wrong casting of ledger balances.
Example 4: The following are the credit purchases of M/s. Ballav Bros.:
2017
Jan. 1 Purchases from M/s. Saurabh & Co.- gross `1,00,000 less 1% trade discount.
Jan. 3 Purchases from M/s. Netai & Co.- gross ` 70,000 less 1% trade discount.
Jan. 6 Purchases from M/s. Saurabh & Co.- gross ` 60,000 less 1% trade discount
Let us cast M/s. Saurabh & Co.’s Account:
Dr. M/s Saurabh & Co. Account Cr.

Date Particulars Amount ` Date Particulars Amount `

2017 2017
Jan. 1 To Balance c/d 1,55,000 Jan. 1 By Purchases A/c 99,000
Jan. 6 By Purchases A/c 59,400
1,55,000 *1,55,000
*While casting the credit side an error has been committed and so the account is wrongly balanced.
Example 5: Goods are purchased on credit from M/s. Saurabh & Co. for ` 27,030 and from M/s. Karnataka
Suppliers for ` 28,050. The following Day Book is prepared:
Purchases Day Book

Date Particulars Amount

`
M/s. Saurabh & Co. 27,050
M/s. Karnataka Suppliers 28,030
55,080
In the Day Book both the transactions are entered wrongly but the first error has been compensated by the
second. Even if these errors are not rectified Trial Balance would tally.

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 2.88 PRINCIPLES AND PRACTICE OF ACCOUNTING

Trial Balance

Particulars Dr. Cr.

` `
M/s. Saurabh & Co. 27,050
M/s. Karnataka Suppliers 28,030
Purchases Account 55,080
55,080 55,080

6.2 STAGES OF ERRORS

Errors may occur at any of the following stages of the accounting process:
AT THE STAGE OF RECORDING THE TRANSACTIONS IN JOURNAL
Following types of errors may happen at this stage:
(i) Errors of principle,
(ii) Errors of omission,
(iii) Errors of commission.
AT THE STAGE OF POSTING THE ENTRIES IN LEDGER
(i) Errors of omission:
(a) Partial omission,
(b) Complete omission.
(ii) Errors of commission:
(a) Posting to wrong account,
(b) Posting on the wrong side,
(c) Posting of wrong amount.
AT THE STAGE OF BALANCING THE LEDGER ACCOUNTS
(a) Wrong Totalling of accounts,
(b) Wrong Balancing of accounts.
AT THE STAGE OF PREPARING THE TRIAL BALANCE
(a) Errors of omission,
(b) Errors of commission:
1. Taking wrong account,
2. Taking wrong amount,
3. Taking to the wrong side.

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 ACCOUNTING PROCESS 2.89

On the above basis, we can classify the errors in four broad categories:
1. Errors of Principle,
2. Errors of Omission,
3. Errors of Commission,
4. Compensating Errors.

6.3 TYPES OF ERRORS

Basically errors are of two types:
(a) Errors of principle: When a transaction is recorded in contravention of accounting principles, like
treating the purchase of an asset as an expense, it is an error of principle. In this case there is no effect on
the trial balance since the amounts are placed on the correct side, though in a wrong account. Suppose
on the purchase of a computer, the office expenses account is debited; the trial balance will still agree.
(b) Clerical errors: These errors arise because of mistake committed in the ordinary course of the accounting
work. These are of three types:
(i) Errors of Omission: If a transaction is completely or partially omitted from the books of account, it
will be a case of omission. Examples would be: not recording a credit purchase of furniture or not
posting an entry into the ledger.
(ii) Errors of Commission: If an amount is posted in the wrong account or it is written on the wrong side
or the totals are wrong or a wrong balance is struck, it will be a case of “errors of commission.”
(iii) Compensating Errors: If the effect of errors committed cancel out, the errors will be called
compensating errors. The trial balance will agree. Suppose an amount of `10 received from A is not
credited to his account and the total of the sales book is `10 in excess. The omission of credit to A’s
account will be made up by the increased credit to the Sales Account.
From another point of view, error may be divided into two categories:
(a) Those that affect the trial balance - because of these errors ,trial balance does not agree; these are the
following:
(i) Wrong casting of the subsidiary books.
(ii) Wrong balancing of an account.
(iii) Posting an amount on the wrong side.
(iv) Posting the wrong amount.
(v) Omitting to post an amount from a subsidiary book.
(vi) Omitting to post the totals of subsidiary book.
(vii) Omitting to write the cash book balances in the trial balance.
(viii) Omitting to write the balance of an account in the trial balance.
(ix) Writing a balance in wrong column of the trial balance.
(x) Totalling the trial balance wrongly.

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 2.90 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) The errors that do not affect the trial balance are the following:
(i) Omitting an entry altogether from the subsidiary book.
(ii) Making an entry with the wrong amount in the subsidiary book .
(iii) Posting an amount in a wrong account but on the correct side, e.g., an amount to be debited to A
is debited to B, the trial balance will still agree.
Errors

Errors of Principle (Treating a revenue Clerical Errors

expenses as capital expenditure or vice versa
or the sale of a fixed asset as ordinary sale).
Trial Balance will agree. Errors of Omission Errors of Commission Compensating Errors
Trial Balance will
agree.

Omitting an Entry completely Omitting to post the ledger account

from the subsidiary books. from the subsidiary books. Trial
Trial Balance will agree. Balance will not agree.

Writing the wrong Wrong casting of Posting the wrong Posting an amount on Wrong balancing of
amount in the subsidiary books. amount in the ledger. the wrong side. an account.
subsidiary books. Trial
Balance will agree.

Types Balance will not agree

6.4 STEPS TO LOCATE ERRORS

Even if there is only a very small difference in the trial balance, the errors leading to it must be located and
rectified. A small difference may be the result of a number of errors. The following steps will be useful in
locating errors :
(i) The two columns of the trial balance should be totalled again. If in place of a number of accounts,
only one amount has been written in the trial balance the list of such accounts should be checked and
totalled again. List of Trade receivables is the example from which Trade receivable balance is derived.
(ii) It should be seen that the cash and bank balances have been written in the trial balance.
(iii) The exact difference in the trial balance should be established. The ledger should be gone through; it is
possible that a balance equal to the difference has been omitted from the trial balance. The difference
should also be halved; it is possible that balance equal to half the difference has been written in the
wrong column.
(iv) The ledger accounts should be balanced again.
(v) The casting of subsidiary books should be checked again, especially if the difference is
` 1, ` 100 etc.

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 ACCOUNTING PROCESS 2.91

(vi) If the difference is very big, the balance in various accounts should be compared with the corresponding
accounts in the previous period. If the figures differ materially the cases should be seen; it is possible
that an error has been committed. Suppose the sales account for the current year shows a balance of
` 32,53,000 whereas it was ` 36,45,000 last year; it is possible that there is an error in the Sales Account.
(vii) Postings of the amounts equal to the difference or half the difference should be checked. It is possible
that an amount has been omitted to be posted or has been posted on the wrong side.
(viii) If there is still a difference in the trial balance, a complete checking will be necessary. The posting of all
the entries including the opening entry should be checked. It may be better to begin with the nominal
accounts.

6.5 RECTIFICATION OF ERRORS

Errors should never be corrected by overwriting. If immediately after making an entry it is clear that an error
has been committed, it may be corrected by neatly crossing out the wrong entry and making the correct
entry. If however the errors are located after some time, the correction should be made by making another
suitable entry, called rectification entry. In fact the rectification of an error depends on at which stage it is
detected. An error can be detected at any one of the following stages:
(a) Before preparation of Trial Balance.
(b) After Trial Balance but before the final accounts are drawn.
(c) After final accounts, i.e., in the next accounting period.

6.5.1 Before preparation of Trial Balance

There are some errors which affect one side of an account or which affect more than one account in such a
way that it is not possible to pass a complete rectification entry. In other words, there are some errors which
can be corrected, if detected at this stage, by making rectification statement in the appropriate side(s) of
concerned account(s). It is important to note here that such errors may involve only one account or more
than one account. Read the following illustrations:
(i) The sales book for November is undercast by ` 200. The effect of this error is that the Sales Account has
been credited short by ` 200. Since the account is posted by the total of the sales book, there is no error
in the accounts of the customers since they are posted with amounts of individual sales. Hence only the
Sales Accounts is to be corrected. This will be done by making an entry for ` 200 on the credit side: “By
undercasting of Sales Book for November ` 200”.
(ii) While posting the discount column on the debit side of the cash book the discount of
` 10 allowed to Ramesh has not been posted. There is no error in the cash book, the total of discount
column presumably has been posted to the discount account on the debit side. The error is in not
crediting Ramesh by ` 10. This should now be done by the entry “By omission of posting of discount on
----- `10”.
(iii) ` 200 received from Ram has been entered by mistake on the debit side of his account. Since the cash
book seems to have been correctly written, the error is only in the account of Ram - he should have
been credited and not debited by ` 200. Not only is the wrong debit to be removed but also a credit of
` 200 is to be given. This can be done now by entering ` 400 on the credit side of his account. The entry
will be “By Posting on the wrong side - ` 400”.

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 2.92 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iv) ` 50 was received from Mahesh and entered on the debit side of the cash book but was not posted to
his account. By the error, which affects only the account of Mahesh, ` 50 has been omitted from the
credit side of his account. The rectification will be by the entry. “By Omission of posting on the ` 50.”
(v) ` 51 paid to Mohan has been posted as `15 to the debit of his account. Mohan has been debited short
by ` 36. The rectifying entry is “To mistake in posting on ` 36”.
(vi) Goods sold to Ram for `1,000 was wrongly posted from sales day book to the debit of purchase account.
Ram has however been correctly debited. Here the error affects two accounts, viz., purchases account
and sales account but we cannot pass a journal entry for its rectification because both the accounts
need to be credited. The rectification will be by the entry “By wrong posting on ` 1,000” in the credit of
purchases account and also “By omission of posting on - ` 1,000” in the credit sales account.
(vii) Bills receivable from Mr. A of ` 500 was posted to the credit of Bills payable Account and also credited to
A account. Here also although two accounts are involved we cannot pass a complete journal entry for
rectification. The rectification will be by the entry “To wrong posting on ` 500” in debit of Bills payable
Account and also “To omission of posting on ` 500” in the debit of Bills Receivable Account.
(viii) Goods purchased from Vinod for ` 1,000 was wrongly credited to Vimal account by ` 100. Again we
cannot pass a complete journal entry for rectification even though two accounts are involved. The
rectification will be done by the entry “To wrong posting on `100” in the debit of Vimal account and “By
omission of posting on ` 1,000” in the credit of Vinod account.
Thus, from the above illustrations we are convinced that the general rule that errors affecting two accounts
can always be corrected by a journal entry is not always valid.

? ILLUSTRATION 1
How would you rectify the following errors in the book of Rama & Co.?
1. The total to the Purchases Book has been undercast by `100.
2. The Returns Inward Book has been undercast by ` 50.
3. A sum of ` 250 written off as depreciation on Machinery has not been debited to Depreciation Account.
4. A payment of ` 75 for salaries (to Mohan) has been posted twice to Salaries Account.
5. The total of Bills Receivable Book ` 1,500 has been posted to the credit of Bills Receivable Account.
6. An amount of `151 for a credit sale to Hari, although correctly entered in the Sales Book, has been posted as
` 115.
7. Discount allowed to Satish ` 25 has not been entered in the Discount Column of the Cash Book. the amount
has been postedcorrectly to the credit of his personal account.

 SOLUTION

1. The Purchases Account should receive another debit of `100 since it was debited short previously:
“To Undercasting of Purchases Book for the month of --- `100.”
2. Due to this error the Returns Inward Account has been posted short by ` 50 : the correct entry will be:
“To Undercasting of Returns Inward Book for the month of --- `50.”
3. The omission of the debit to the Depreciation Account will be rectified by the entry:
“To Omission of posting on ` 250”.

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 ACCOUNTING PROCESS 2.93

4. The excess debit will be removed by a credit in the Salaries Account by the entry:
“By double posting on ` 75”.
5. `1,500 should have been debited to the Bills Receivable Account and not credited. To correct the
mistake, the Bills Receivable Account should be debited by ` 3,000 by the entry:
“To Wrong posting of B/R received on ` 3,000”
6. Hari’s personal A/c is debited ` 36 short. The rectification entry will be:
“To Wrong posting ` 36”.
7. Due to this error, the discount account has been debited short by ` 25. The required entry is :
“To Omission of discount allowed to Satish on ` 25.”
So far we have discussed the correction of errors which affected only one Account or more than one account
but for which rectifying entries were not complete journal entries.We shall now take up the correction of
errors which affect more than one account in such a way that complete journal entries are possible for their
rectification. Read the following illustrations:
(i) The purchase of machinery for ` 2,000 has been entered in the purchases book. The effect of the entry
is that the account of the supplier Ram & Co. has been credited by ` 2,000 which is quite correct. But the
debit to the Purchases Account is wrong : the debit should be to Machinery Account. To rectify the error,
the debit in the purchases Account has to be transferred to the Machinery Account. The correcting
entry will be to Credit Purchases Account and debit the Machinery Account. Please see the three entries
made below: the last entry rectifies the error:
Wrong Entry: ` `
Purchases Account Dr. 2,000
To Ram & Co. 2,000
Correct Entry:
Machinery Account Dr. 2,000
To Ram & Co. 2,000
Rectifying Entry:
Machinery Account Dr. 2,000
To Purchases Account 2,000
(ii) `100 received from Kamal Kishore has been credited in the account of Krishan Kishore. The error is that
there is a wrong credit in the account of Krishan Kishore and omission of credit in the account of Kamal
Kishore; Krishan Kishore should be debited and Kamal Kishore be credited. The following three entries
make this clear:
Wrong Entry: ` `
Cash Account Dr. 100
To Krishan Kishore 100
Correct Entry:
Cash Account Dr. 100
To Kamal Kishore 100
Rectifying Entry:
Krishan Kishore Dr. 100
To Kamal Kishore 100

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.94 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iii) The sale of old machinery, `1,000 has been entered in the sales book. By this entry the account of
the buyer has been correctly debited by `1,000. But instead of crediting the Machinery Account. Sales
Account has been credited. To rectify the error this account should be debited and the Machinery
Account credited. See the three entries given below:

Wrong Entry: ` `
Buyer’s Account Dr. 1,000
To Sales Account 1,000
Correct Entry:
Buyer’s Account Dr. 1,000
To Machinery Account 1,000
Rectifying Entry:
Sales Account Dr. 1,000
To Machinery Account 1,000

? ILLUSTRATION 2
The following errors were found in the book of Ram Prasad & Sons. Give the necessary entries to correct them.
(1) ` 500 paid for furniture purchased has been charged to ordinary Purchases Account.
(2) Repairs made were debited to Building Account for ` 50.
(3) An amount of `100 withdrawn by the proprietor for his personal use has been debited to Trade Expenses
Account.
(4) `100 paid for rent debited to Landlord’s Account.
(5) Salary `125 paid to a clerk due to him has been debited to his personal account.
(6) `100 received from Shah & Co. has been wrongly entered as from Shaw & Co.
(7) ` 700 paid in cash for a typewriter was charged to Office Expenses Account.

 SOLUTION
Journal

Particulars L.F. Dr. Cr.

` `
(1) Furniture A/c Dr. 500
To Purchases A/c 500
(Correction of wrong debit to Purchases A/c for furniture
purchased)

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.95

(2) Repairs A/c Dr. 50

To Building A/c 50
(Correction of wrong debit to building A/c for repairs made)
(3) Drawings A/c. Dr. 100
To Trade Expenses A/c 100
(Correction of wrong debit to Trade Expenses A/c for cash
withdrawn by the proprietor for his personal use)
(4) Rent A/c Dr. 100
To Landlord’s Personal A/c 100
(Correction of wrong debit to landlord’s A/c for rent paid)
(5) Salaries A/c Dr. 125
To Clerk’s (Personal) A/c 125
(Correction of wrong debit to Clerk’s personal A/c for salaries paid)
(6) Shaw & Co. Dr. 100
To Shah & Co. 100
(Correction of wrong credit to Shaw & Co. Instead of Shah & Co.)
(7) Typewriter A/c Dr. 700
To Office Expenses A/c 700
(Correction of wrong debit to Office Expenses A/c for purchase of
typewriter)

? ILLUSTRATION 3
Give journal entries to rectify the following:
(1) A purchase of goods from Ram amounting to `150 has been wrongly entered through the Sales Book.
(2) A Credit sale of goods amounting `120 to Ramesh has been wrongly passed through the Purchase Book.
(3) On 31st December, 2016 goods of the value of `300 were returned by Hari Saran and were taken inventory
on the same date but no entry was passed in the books.
(4) An amount of ` 200 due from Mahesh Chand, which had been written off as a Bad Debt in a previous year,
was unexpectedly recovered, and had been posted to the personal account of Mahesh Chand.
(5) A Cheque for `100 received from Man Mohan was dishonoured and had been posted to the debit of Sales
Returns Account.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.96 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Journal
Particulars L.F. Dr. Cr.
` `
(1) Purchases A/c Dr. 150
Sales A/c Dr. 150
To Ram 300
(Correction of wrong entry in the sales Book for a purchases of
goods from Ram)
(2) Ramesh Dr. 240
To Purchases A/c 120
To Sales A/c 120
(Correction of wrong entry in the Purchases Book of a credit sale
of goods to Ram)
(3) Returns Inwards A/c Dr. 300
To Hari Saran 300
(Entry of goods returned by him and taken in inventory omitted
from records)
(4) Mahesh Chand Dr. 200
To Bad Debts Recovered A/c 200
(Correction of wrong credit to Personal A/c in respect of recovery
of previously written off bad debts)
(5) Man Mohan Dr. 100
To Sales Return A/c 100
(Correction of wrong debit to Sales Returns A/c for dishonour of
cheque received from Man Mohan)
Thus it can be said that errors detected before the preparation of trial balance can be rectified either through
rectification statements (not entries) or through rectification entries.
6.5.2 After Trial Balance but before Final Accounts
The method of correction of error indicated so far is appropriate when the errors have been located before
the end of the accounting period. After the corrections the trial balance will agree. Sometimes the trial
balance is artificially made to agree inspire of errors by opening a suspense account and putting the
difference in the trial balance to the account - the suspense account will be debited if the total of the credit
column in the trial balance exceeds the total of the debit column; it will be credited in the other case.
One must note that such agreement of the trial balance will not be real. Effort must be made to locate the
errors.
The rule of rectifying errors detected at this stage is simple. Those errors for which complete journal entries
were not possible in the earlier stage of rectification (i.e., before trial balance) can now be rectified by way
of journal entry(s) with the help of suspense account, for it these errors which gave rise to the suspense

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.97

account in the trial balance. The rectification entry for other type of error i.e. error affecting more than one
account in such a way that a complete journal entry is possible for its rectification, can be rectified in the
same way as in the earlier stage (i.e. before trial balance).
In a nutshell, it can be said that each and every error detected at this stage can only be corrected by a
complete journal entry. Those errors for which journal entries were not possible at the earlier stage will now
be rectified by a journal entry(s), the difference or the unknown side is being taken care of by suspense
account. Those errors for which entries were possible even at the first stage will now be rectified in the same
way.
Suppose, the sales book for November, 2015 is cast `100 short; as a consequence the trial balance will not
agree. The credit column of the trial balance will be `100 short and a Suspense Account will be credited by
`100. To rectify the error the Sales Account will be credited (to increase the credit to the right figure. Since
now one error remains, the Suspense Account must be closed- it will be debiting the Suspense Account. The
entry will be:
Suspense Account Dr. `100
To Sales Account `100
(Correction of error of undercasting the sales
Book for November 2015)

? ILLUSTRATION 4
Correct the following errors (i) without opening a Suspense Account and (ii) opening a Suspense Account:
(a) The Sales Book has been totalled `100 short.
(b) Goods worth `150 returned by Green & Co. have not been recorded anywhere.
(c) Goods purchased `250 have been posted to the debit of the supplier Gupta & Co.
(d) Furniture purchased from Gulab & Bros, `1,000 has been entered in Purchases Day Book.
(e) Discount received from Red & Black `15 has not been entered in the Discount Column of the Cash Book.
(f) Discount allowed to G. Mohan & Co. `18 has not been entered in the Discount Column of the Cash Book. The
account of G. Mohan & Co. has, however, been correctly posted.

 SOLUTION

If a Suspense Account is not opened.

(a) Since sales book has been cast `100 short, the Sales Account has been similarly credited `100 short. The
correcting entry is to credit the Sales Account by `100 as “By wrong totalling of the Sales Book `100”.
(b) To rectify the omission, the Returns Inwards Account has to be debited and the account of Green & Co.
credited. The entry:
Returns Inward Account Dr. `150
To Green & Co. `150
(Goods returned by the firm, previously
omitted from the Returns Inward Book)

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.98 PRINCIPLES AND PRACTICE OF ACCOUNTING

(c) Gupta & Co. have been debited `250 instead of being credited. This account should now be credited by
500 to remove the wrong debit and to give the correct debit. The entry will be on the credit side... “By
errors in posting `500”.
(d) By this error Purchases Account has to be debited by `1,000 whereas the debit should have been to the
Furniture Account. The correcting entry will be:

Furniture Account Dr. `1,000

To Purchases Account `1,000
(Correction of the mistake by which of the
Furniture Account)

(e) The discount of `15 received from Red & Black should have been entered on the credit side of the cash
book. Had this been done, the Discount Account would have been credited (through the total of the
discount column) and Red & Black would have been debited. This entry should not be made:

Red & Black Dr. `15

To Discount Account `15
(Rectification of the error by which the
discount allowed by the firm was not entered
in Cash Book)

(f ) In this case the account of the customer has been correctly posted; the Discount Account has been
debited `18 short since it has been omitted from the discount column on the debit side of the cash
book. The discount account should now be debited by the entry; “To Omission of entry in the Cash Book
`18.”
If a Suspense Account is opened :

Particulars L.F. Dr. Cr.

` `
(a) Suspense Account Dr. 100
To Sales Account 100
(Being the correction arising from under- casting of Sales Day
Book)
(b) Return Inward Account Dr. 150
To Green & Co . 150
(Being the recording of unrecorded returns)
(c) Suspense Account Dr. 500
To Gupta & Co. 500
(Being the correction of the error by which Gupta & Co. was
debited instead of being credited by ` 250).

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.99

(d) Furniture Account Dr. 1,000

To Purchases Account 1,000
(Being the correction of recording purchase of furniture as
ordinary purchases)

(e) Red & black Dr. 15

To Discount Account 15
(Being the recording of discount omitted to be recorded)
(f ) Discount Account Dr. 18
To Suspense Account 18
(Being the correction of omission of the discount allowed
from Cash Book customer’s account already posted correctly).

Suspense Account

Dr. Particulars Amount Date Particulars Cr.

Date ` Amount
`
To Sales A/c 100 By Difference in
To Gupta & Co. 500 Trial Balance 582
By Discount A/c 18
600 600
Notes:
(i) One should note that the opening balance in the Suspense Account will be equal to the difference in
the trial balance.
(ii) If the question is silent as to whether a Suspense Account has been opened, the student should make
his assumption, state it clearly and then proceed.

? ILLUSTRATION 5
Correct the following errors found in the books of Mr. Dutt. The Trial Balance was out by ` 493 excess credit. The
difference thus has been posted to a Suspense Account.
(a) An amount of `100 was received from D. Das on 31st December, 2015 but has been omitted to enter in the
Cash Book.
(b) The total of Returns Inward Book for December has been cast `100 short.
(c) The purchase of an office table costing ` 300 has been passed through the Purchases Day Book.
(d) ` 375 paid for Wages to workmen for making show-cases had been charged to “Wages Account”.
(e) A purchase of ` 67 had been posted to the trade payables’ account as ` 60.
(f) A cheque for ` 200 received from P. C. Joshi had been dishonoured and was passed to the debit of “Allowances
Account”.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.100 PRINCIPLES AND PRACTICE OF ACCOUNTING

(g) ` 1,000 paid for the purchase of a motor cycle for Mr. Dutt had been charged to “Miscellaneous Expenses
Account”.
(h) Goods amounting to `100 had been returned by customer and were taken in to inventory, but no entry in
respect there of, was made into the books.
(i) A sale of ` 200 to Singh & Co. was wrongly credited to their account. Entry was made correctly made in sales
book.

 SOLUTION

(a) Journal Entries

Particulars L.F. ` `
(a) Cash Account Dr. 100
To D. Das 100
(Being the amount received)
(b) Returns Inward Account Dr. 100
To Suspense Account 100
(Being the mistake in totalling the Returns Inward Book
corrected)
(c) Furniture Account Dr. 300
To Purchases Account 300
(Being the rectification of mistake by which purchase of
furniture was entered in Purchases book and hence debited
to Purchases Account)
(d) Furniture Account Dr. 375
To Wages Account 375
(Being the wages paid to workmen for making show-cases
which should be capitalised and not to be charged to Wages
Account)
(e) Suspense Account Dr. 7
To Creditors (personal) Account 7
(Being the mistake in crediting the Trade payables Account
less by ` 7, now corrected)
(f ) P.C. Joshi Dr. 200
To Allowances Account 200
(Being the cheque of P.C. Joshi dishonoured, previously
debited to Allowances Account)

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.101

(g) Drawings Account Dr. 1,000

To Miscellaneous Expenses 1,000
(Being the motor cycle purchased for Mr. Dutt debited to
his Drawings Account instead of Miscellaneous Expenses
Account as previously done by mistake)
(h) Returns Inward Account Dr. 100
To Debtors (Personal) Account 100
(Correction of the omission to record return of goods by
customers)
(i) Singh & Co. Dr. 400
To Suspense Account 400
(Being the correction of mistake by which the account of
Singh & Co. was credited by ` 200 instead of being debited)

Suspense Account

Dr. Cr.
Date Particulars Amount Date Particulars Amount
2015 ` 2015 `
Dec.31 To Difference in Dec. 31 By Returns
Trial Balance 493 Inwards A/c 100
““ To Trade Payables A/c 7 ““ By Singh & Co. 400
500 500

? ILLUSTRATION 6
The following errors, affecting the account for the year 2015 were detected in the books of Jain Brothers, Delhi:
(1) Sale of old Furniture `150 treated as sale of goods.
(2) Receipt of ` 500 from Ram Mohan credited to Shyam Sunder.
(3) Goods worth `100 brought from Mohan Narain have remained unrecorded so far.
(4) A return of `120 from Mukesh posted to his debit.
(5) A return of ` 90 to Shyam Sunder posted as ` 9 in his account.
(6) Rent of proprietor’s residence, ` 600 debited to rent A/c.
(7) A payment of ` 215 to Mohammad Sadiq posted to his credit as `125.
(8) Sales Book added ` 900 short.
(9) The total of Bills Receivable Book ` 1,500 left unposted.
You are required to pass the necessary rectifying entries and show how the trial balance would be affected by the
errors.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.102 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Journal

Particulars L.F. Dr. Cr.

Amount Amount
` `
(1) Sales Account Dr. 150
To Furniture Account 150
(Rectification of sales of furniture treated as sales of
goods)
(2) Shyam Sunder Dr. 500
To Rama Mohan 500
(Rectification of a receipt from Ram Mohan credited
to Shyam Sunder)
(3) Purchases Account Dr. 100
To Mohan Narain 100
(Purchases of goods from Mohan Narain unrecorded)
(6) Drawing Account Dr. 600
To Rent Account 600
(Rectification of Payment of rent of proprietor’s
residence treated as payment of office rent)
N.B. : For 4, 5, 7, 8, 9 no journal entry can be passed as they affect a single account. The correction will be as
under:
(4) Credit Mukesh’s Account with ` 240.
(5) Debit the account of Shyam Sunder by ` 81.
(7) Debit the account of Mohammad Sadiq by ` 340.
(8) Credit Sales Account by ` 900.
(9) Debit Bills Receivable Account with `1,500.
Effect of the Errors on Trial Balance
1. No effect
2. No effect
3. No effect
4. Trial Balance credit total short by ` 240.
5. Trial Balance debit total short by ` 81.
6. No effect
7. Trial Balance debit total short by ` 340.
8. Trial Balance credit total short by ` 900.
9. Trial Balance debit total short by ` 1,500.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.103

? ILLUSTRATION 7
Write out the Journal Entries to rectify the following errors, using a Suspense Account.
(1) Goods of the value of `100 returned by Mr. Sharma were entered in the Sales Day Book and posted therefrom
to the credit of his account;
(2) An amount of `150 entered in the Sales Returns Book, has been posted to the debit of Mr. Philip, who returned
the goods;
(3) A sale of ` 200 made to Mr. Ghanshyam was correctly entered in the Sales Day Book but wrongly posted to
the debit of Mr. Radheshyam as ` 20;
(4) Bad Debts aggregating `450 were written off during the year in the Sales ledger but were not adjusted in the
General Ledger; and
(5) The total of “Discount Allowed” column in the Cash Book for the month of September, 2015 amounting to
` 250 was not posted.

 SOLUTION
Journal
Particulars L.F. Dr. Cr.
` `
(1) Sales Account Dr. 100
Sales Returns Account Dr. 100
To Suspense Account 200
(The value of goods returned by Mr. Sharma
wrongly posted to Sales and omission of debit to
Sales Returns Account, now rectified)
(2) Suspense Account Dr. 300
To Mr. Philip 300
(Wrong debit to Mr. Philip for goods returned by
him, now rectified)
(3) Mr. Ghanshyam Dr. 200
To Mr. Radheshyam 20
To Suspense Account 180
(Omission of debit to Mr. Ghanshyam and wrong
credit to Mr. Radhesham for sale of ` 200, now
rectified)
(4) Bad Debts Account Dr. 450
To Suspense Account 450
(The amount of Bad Debts written off not adjusted
in General Ledger, now rectified)
(5) Discount Account Dr. 250
To Suspense Account 250
(The total of Discount allowed during September,
2015 not posted from the Cash Book; error now
rectified)

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.104 PRINCIPLES AND PRACTICE OF ACCOUNTING

6.5.3 Correction in the next Accounting Period

Rectification of errors discussed so far assumes that it was carried out before the books were closed for
the concerned year. However, sometimes, the rectification is carried out in the next year, carrying forward
the balance in the Suspense Account or even transferring it to the Capital Account. Suppose, the Purchase
Book was cast short by `1,000 in December, 2015 and a Suspense Account was opened with the difference
in the trial balance. If the error is rectified next year and the entry passed is to debit Purchase Account (and
credit Suspense Account), it will mean that the Purchases Account for year 2016 will be `1,000 more than
the amount relating to year 2016 and thus the profit that year 2016 will be less than the actual for that year.
Thus, correction of errors in this manner will ‘falsify’ the Profit and Loss Account.
To avoid this, correction of all amounts concerning nominal accounts, i.e., expenses and incomes should
be through a special account styled as “Prior Period Items” or “Profit and Loss Adjustment Account”. The
balance in the account should be transferred to the Profit and Loss Account. However, these Prior Period
Items should be charged after deriving net profit of the current year. ‘Prior Period items’ are material income
or expenses which arise in the current period as a result of errors or omissions in the preparation of the
financial statements of one or more periods. Prior Period Items should be separately disclosed in the current
statement of profit and loss together with their nature and amount in a manner that their impact on current
profit or loss can be perceived.

? ILLUSTRATION 8
Mr. Roy was unable to agree the Trial Balance last year and wrote off the difference to the Profit and Loss Account
of that year. Next Year, he appointed a Chartered Accountant who examined the old books and found the
following mistakes:
(1) Purchase of a scooter was debited to conveyance account `3,000.

(2) Purchase account was over-cast by `10,000.

(3) A credit purchase of goods from Mr. P for `2,000 entered as a sale.

(4) Receipt of cash from Mr. A was posted to the account of Mr. B `1,000.

(5) Receipt of cash from Mr. C was posted to the debit of his account, `500.

(6) ` 500 due by Mr. Q was omitted to be taken to the trial balance.

(7) Sale of goods to Mr. R for `2,000 was omitted to be recorded.

(8) Amount of `2,395 ofpurchase was wrongly posted as `2,593.

Mr. Roy used 10% depreciation on vehicles. Suggest the necessary rectification entries.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.105

 SOLUTION
Journal Entries in the books of Mr. Roy
Date Particulars Dr. Cr.
` `
(1) Motor Vehicles Account Dr. 2,700
To Profit and Loss Adjustment A/c 2,700
(Purchase of scooter wrongly debited to conveyance
account now rectified-capitalisation of ` 2,700, i.e.,
` 3,000 less 10% depreciation)
(2) Suspense Account Dr. 10,000
To Profit & Loss Adjustment A/c 10,000
(Purchase Account overcast in the previous year; error
now rectified).
(3) Profit & Loss Adjustment A/c Dr. 4,000
To P’s Account 4,000
(Credit purchase from P ` 2,000, enteredas sales last
year; now rectified)
(4) B’s Account Dr. 1,000
To A’s Account 1,000
(Amount received from A wrongly posted to the
account of B; now rectified)
(5) Suspense Account Dr. 1,000
To C’s Account 1,000
(` 500 received from C wrongly debited to his account;
now rectified)
(6) Trade receivables Dr. 500
To Suspense Account 500
(` 500 due by Q not taken into trialbalance; now
rectified)
(7) R’s Account Dr. 2,000
To Profit & Loss Adjustment A/c 2,000
(Sales to R omitted last year; now adjusted)
(8) Suspense Account Dr. 198
To Profit & Loss Adjustment A/c 198
(Excess posting to purchase account last year, ` 2,593,
instead of ` 2,395, now adjusted)
(9) Profit & Loss Adjustment A/c Dr. 10,898
To Roy’s Capital Account 10,898
(Balance of Profit & Loss Adjustment A/c transferred to
Capital Account)
(10) Roy’s Capital Account Dr. 10,698
To Suspense Account 10,698
(Balance of Suspense Account transferred to the
Capital Account)
Note : Entries No. (2) and (8) may even be omitted; but this is not advocated.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.106 PRINCIPLES AND PRACTICE OF ACCOUNTING

Profit and Loss Adjustment Account

(Prior Period Items)
` `
To P 4,000 By Motor Vehicles A/c 2,700
To Roy’s Capital (transfer) 10,898 By Suspense A/c 10,000
By R 2,000
By Suspense Account 198
14,898 14,898

Suspense Account

` `
To Profit & Loss Adjustment Account 10,000 By Trade Receivables (Q) 500
To C 1,000 By Roy’s Capital Account (Transfer) 10,698
To Profit & Loss Adjustment Account 198
11,198 11,198

SUMMARY
w Unintentional omission or commission of amounts and accounts in the process of recording the
transactions are commonly known as errors.
w Accounting errors are generally of four types-
(a) Errors of Principle;
(b) Errors of Omission;
(c) Errors of Commission;
(d) Compensating Errors.
w Some errors may affect the Trial Balance and some of these do not.
w The method of rectification of errors depends on the stage at which the errors are detected. If the error
is detected before the preparation of trial balance, rectification is carried out by making the statement
in the appropriate side of the concerned account.
w In case of the errors detected after the preparation of the trial balance, we open a suspense account
with the amount of difference in the trial balance. Then complete journal entries can be passed for
rectifying the errors.
w For rectifying the errors detected in the next accounting period, a special account ‘Profit and Loss
Adjustment Account’ is opened for correction of amounts relating to expenses and incomes.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.107

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Goods purchased from A for `10,000 passed through the sales book. The error will result in
(a) Increase in gross profit.
(b) Decrease in gross profit.
(c) No effect on gross profit.
2. If a purchase return of `1,000 has been wrongly posted to the debit of the sales returns account, but has
been correctly entered in the suppliers’ account, the total of the
(a) Trial balance would show the debit side to be `1,000 more than the credit.
(b) Trial balance would show the credit side to be `1,000 more than the debit.
(c) The debit side of the trial balance will be `2,000 more than the credit side.
3. If the amount is posted in the wrong account or it is written on the wrong side of the account, it is called
(a) Error of omission.
(b) Error of commission.
(c) Error of principle.
4. `200 paid as wages for erecting a machine should be debited to
(a) Repair account.
(b) Machine account.
(c) Capital account.
5. On purchase of old furniture, the amount of `1,000 spent on its repair should be debited to
(a) Repair account.
(b) Furniture account.
(c) Cash account.
6. Goods worth `50 given as charity should be credited to
(a) Charity account.
(b) Sales account.
(c) Purchase account.
7. Goods worth `100 taken by proprietor for domestic use should be credited to
(a) Sales account.
(b) Proprietor’s personal expenses.
(c) Purchases account.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 2.108 PRINCIPLES AND PRACTICE OF ACCOUNTING

8. Sales of office furniture should be credited to

(a) Sales Account.
(b) Furniture Account.
(c) Purchase Account.
9. The preparation of a trial balance is for:
(a) Locating errors of commission.
(b) Locating errors of principle.
(c) Locating clerical errors.
10. `200 received from Smith whose account, was written off as a bad debt should be credited to:
(a) Bad Debts Recovered account.
(b) Smith’s account.
(c) Cash account.
11. Purchase of office furniture `1,200 has been debited to General Expense Account. It is:
(a) A clerical error.
(b) An error of principle.
(c) An error of omission.

Theory Questions
1. How does errors of omission differ from errors of commission?
2. What is error of principle and how does it affect Trial Balance?
3. When and how is Suspense account used to rectify errors?
Practical Questions
1. The trial balance of Mr. W & H failed to agree and the difference `20,570 was put into suspense pending
investigation which disclosed that:
(i) Purchase returns day book had been correctly entered and totalled at `6,160, but had been posted
to the ledger.
(ii) Discounts received `1,320 had been debited to discounts allowed.
(iii) The Sales account had been under added by `10,000.
(iv) A credit sale of `1,470 had been debited to a customer account at `1,740.
(v) A vehicle bought originally for `7,000 four years ago and depreciated to `1,200 had not been sold
for `1,500 in the beginning of the year but no entries, other than in the bank account had been
passed through the books.
(vi) An accrual of `560 for telephone charges had been completely omitted.

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 ACCOUNTING PROCESS 2.109

(vii) A bad debt of `1,560 had not been written off and provision for doubtful debts should have been
maintained at 10% of Trade receivables which are shown in the trial balance at `23,390 with a credit
provision for bad debts at `2,320.
(viii) Tools bought for `1,200 had been inadvertently debited to purchases.
(ix) The proprietor had withdrawn, for personal use, goods worth `1,960. No entries had been made in
the books.
Required:
(i) Pass rectification entries without narration to correct the above errors before preparing annual accounts.
(ii) Prepare a statement showing effect of rectification on the reported net profit before correction of these
errors.
2. On going through the Trial balance of Ball Bearings Co. Ltd. you find that the debit is in excess by `150.
This was credited to “Suspense Account”. On a close scrutiny of the books the following mistakes were
noticed:
(1) The totals of debit side of “Expenses Account” have beeen cast in excess by ` 50.
(2) The “Sales Account” has been totalled in short by `100.
(3) One item of purchase of `25 has been posted from the day book to ledger as `250.
(4) The sale return of `100 from a party has not been posted to that account though the Party’s account
has been credited.
(5) A cheque of `500 issued to the Suppliers’ account (shown under Trade payables) towards his dues
has been wrongly debited to the purchases.
(6) A credit sale of `50 has been credited to the Sales and also to the Trade receivables Account.
You are required to
(i) Pass necessary journal entries for correcting the above;
(ii) Show how they affect the Profits; and
(iii) Prepare the “Suspense Account” as it would appear in the ledger.
3. Mr. A closed his books of account on September 30, 2016 in spite of a difference in the trial balance.
The difference was `830 the credits being short; it was carried forward in a Suspense Account. In 2017
following errors were located:
(i) A sale of `2,300 to Mr. Lala was posted to the credit of Mrs. Mala.
(ii) The total of the Returns Inward Book for July, 2016 `1,240 was not posted in the ledger.
(iii) Freight paid on a machine `5,600 was posted to the Freight Account as `6,500.
(iv) White carrying forward the total in the Purchases Account to the next page, `65,590 was written
instead of `56,950.
(v) A sale of machine on credit to Mr. Mehta for `9,000 on 30th sept. 2016 was not entered in the books
at all. The book value of the machine was `6,750.
Pass journal entries to rectify the errors. Have you any comments to make?

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 2.110 PRINCIPLES AND PRACTICE OF ACCOUNTING

4. A merchant’s trial balance as on June 30, 2017 did not agree. The difference was put to a Suspense
Account. During the next trading period, the following errors were discovered:
(i) The total of the Purchases Book of one page, `4,539 was carried forward to the next page as `4,593.
(ii) A sale of `573 was entered in the Sales Book as `753 and posted to the credit of the customer.
(iii) A return to a creditor, `510 was entered in the Returns Inward Book; however, the creditor’s account
was correctly posted.
(iv) Cash received from C. Dass, `620 was posted to the debit of G. Dass.
(v) Goods worth `840 were despatched to a customer before the close of the year but no invoice was
made out.
(vi) Goods worth `1,000 were sent on sale or return basis to a customer and entered in the Sales Book.
At the close of the year, the customer still had the option to return the goods. The sale price was
25% above cost.
You are required to give journal entries to rectify the errors in a way so as to show the current year’s
profit or loss correctly.
ANSWERS/HINTS
MCQs

1. (a) 2. (c) 3. (b) 4. (b) 5. (b) 6. (c)

7. (c) 8. (b) 9. (c) 10. (a) 11. (b)
Theoretical Questions
1. (i) Errors of Omission: If a transaction is completely or partially omitted from the books of account, it
will be a case of omission. Examples would be: not recording a credit purchase of furniture or not
posting an entry into the ledger.
(ii) Errors of Commission: If an amount is posted in the wrong account or it is written on the wrong side
or the totals are wrong or a wrong balance is struck, it will be a case of “errors of commission.”
2. Errors of principle: When a transaction is recorded in contravention of accounting principles, like
treating the purchase of an asset as an expense, it is an error of principle. In this case there is no effect on
the trial balance since the amounts are placed on the correct side, though in a wrong account. Suppose
on the purchase of a typewriter, the office expenses account is debited; the trial balance will still agree.
The method of correction of error indicated so far is appropriate when the errors have been located
before the end of the accounting period. After the corrections the trial balance will agree. Sometimes
the trial balance is artificially made to agree inspite of errors by opening a suspense account and
putting the difference in the trial balance to the account - the suspense account will be debited if the
total of the credit column in the trial balance exceeds the total of the debit column; it will be credited in
the other case. Each and every error detected can only be corrected by a complete journal entry. Those
errors for which journal entries were not possible at the earlier stage will now be rectified by a journal
entry(s), the difference or the unknown side is being taken care of by suspense account. Those errors for
which entries were possible even at the first stage will now be rectified in the same way.

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 ACCOUNTING PROCESS 2.111

Practical Questions
Answer 1

Particulars Dr. Cr.

(i) Suspense Account Dr. 6,160
To Return Outward A/c 6,160
(ii) Suspense Account Dr. 2,640
To Discount Allowed Account 1,320
To Discount Received Account 1,320
(iii) Suspense Account Dr. 10,000
To Sales Account 10,000
(iv) Suspense Account Dr. 270
To Customer Account 270
(v) Suspense Account Dr. 1,500
To Vehicle Account 1,200
To Profit on Sale of Vehicle Account 300
(vi) Telephone Charges Account Dr. 560
To Outstanding Expenses Account 560
(vii) Bad Debts Account Dr. 1,560
To Trade receivables Account 1,560
Provision for Doubtful Debts Account Dr. 1,642
To Profit and Loss Account 1,642
(viii) Loose Tools Account Dr. 1,200
To Purchases Account 1,200
(ix) Drawings Account Dr. 1,960
To Purchases Account 1,960
1. Bad debts will be debited in the profit and loss account.
2. Provision @ 10% of `21,560 i.e. 2,156; Excess provision `164 (2320 - 2156 = 164).
Working Notes :

(i) Trade receivables as per books 23,390

Deduction vide item (iv) 270 270

Bad Debts 1,560 1,830

21,560

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Sample output to test PDF Combine only
 2.112 PRINCIPLES AND PRACTICE OF ACCOUNTING

(ii) Suspense Account

` `
To Return outward Account 6,160 By balance b/d 20,570
To Discount allowed Account 1,320
To Discount Received Account 1,320
To Sales Account 10,000
To Customers Account 270
To Vehicles Account 1,200
To Profit on Sale of Vehicle 300
20,570 20,570
Answer 2
Journal Entries

Particulars L.F. Dr. Cr.

` `
Suspense Account Dr. 50
To Expenses Account 50
(Being the mistake in totalling of Expenses Account,
rectified)
Suspense Account Dr. 100
To Sales Account 100
(Being the mistake in totalling of Sales Accounts rectified)
Supplier Dr. 225
To Suspense Account 225
(Being the mistake in posting from Day Book to Ledger
rectified)
Sales Returns Account Dr. 100
To Suspense Account 100
(Being the sales return from a party not posted to “Sales
Returns” now rectified)
Trade payables Account Dr. 500
To Purchases Account 500
(Being the payments made to supplier wrongly posted to
purchases now rectified)

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Sample output to test PDF Combine only
 ACCOUNTING PROCESS 2.113

Trade receivables Account Dr. 100

To Suspense Account 100
(Being the sales wrongly credited to Customer’s Account
now rectified)

Suspense Account

Dr. ` Cr.
`
To Expenses Account 50 By Difference in Trial Balance 150
To Sales Account 100 By Trade payables 225
To Balance c/d 425 By Sales Returns Account 100
By Trade receivables 100
575 575
By Balance b/d 425
Since the Suspense Account does not balance, it is clear that all the errors have not been traced. As a result
of the above corrections the Net Profit will be:
Increased by Decreased by
` `
Mistake in totalling in “Expenses” 50
Mistake in totalling in “Sales” 100
Mistake in posting from day book to Ledger under
“Purchases” 500
Omission in posting under “Sales Returns” 100
650 100
Net Increase 550

As a result of these adjustments, the Profits will be increased by `550.

Answer 3
Journal of Mr. A

Date Particulars L.F. Dr. Cr.

` `
2017 (i) Mrs. Mala Dr. 2,300
Mr. Lala Dr. 2,300
To Suspense A/c 4,600
(Correction of error by which a sale of ` 2,300

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 2.114 PRINCIPLES AND PRACTICE OF ACCOUNTING

to Mr. Lala was posted to the Credit of Mrs. Mala)

(ii) Profit and Loss Adjustment A/c Dr. 1,240
To Suspense A/c 1,240
(Rectification of omission to post the total of
Returns Inward Book for July, 2016)
(iii) (a) Machinery A/c Dr. 5,600
Suspense A/c Dr. 900
To Profit & Loss Adjustment A/c 6,500
(Correction of error by which freight paid for
a machine ` 5,600 was posted to Freight
Account at ` 6,500 instead of capitalising it)
(b) Profit & Loss Adjustment A/c Dr. 560 560
To Plant and Machinery A/c
(Depreciation @ 10% charged on freight paid
on a machine capitalised)
(iv) Suspense A/c Dr. 8,640
To Profit & Loss Adjustment A/c 8,640
(Correction of wrong carry forward of total in
the purchase Account to the next page ` 65,590
instead of ` 56,950)
(v) Mr. Mehta Dr. 9,000
To Plant & Machinery A/c 6,750
To Profit & Loss Adjustment A/c 2,250
(Correction of omission of a sale of machine on
credit to Mr. Mehta for ` 9,000 )
Comments
The Suspense Account will now appear as shown below:
Suspense Account

Dr. Cr.
Date Particulars Amount Date Particulars Amount
` `
2017 To Profit and Loss 2016 By Balance b/d 830
Adjustment A/c 900 Oct. 1 By Sundries
To Profit and Loss Mrs. Mala 2,300
Adjustment A/c 8,640 Mr. Lala 2,300

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 ACCOUNTING PROCESS 2.115

By Profit and Loss

Adjustment A/c 1,240
By balance c/d 2,870
9,540 9,540
Since the Suspense Account still shows a balance, it is obvious that there are still some errors left in the
books.
Profit & Loss Adjustment A/c
(For Prior Period Items)

Dr. Cr.
Date Particulars Amount Date Particulars Amount
2017 ` 2017 `
To Suspense A/c 1,240 By Machinery A/c 5,600
To Plant and Machinery A/c 560 By Suspense A/c 900
To Balance c/d 15,590 By Suspense A/c 8,640
By Mr. Mehta 2,250
17,390 17,390

Answer 4
Journal Entries

Particulars L.F. Dr. Cr.

` `
(i) Suspense Account Dr. 54
To Profit and Loss Adjustment A/c 54
(Correction of error by which Purchase Account
was over debited last year- `4,593 carried forward
instead of `4,539)
(ii) Profit & Loss Adjustment A/c Dr. 180
Customer’s Account Dr. 1,326
To Suspense Account 1,506
(Correction of the entry by which (a) Sales A/c was
over credited by `180 (b) customer was credited
by `753 instead of being debited by `573)
(iii) Suspense Account Dr. 1,020
To Profit & Loss Adjustment A/c 1,020
(Correction of error by which Returns Inward
Account was debited by `510 instead of Returns
Outwards Account being credited by ` 510)

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 2.116 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iv) Suspense Account Dr. 1,240

To C. Dass 620
To G. Dass 620
(Removal or wrong debit to G. Dass and giving
credit to C. Dass from whom cash was received).
(v) Customer’s Account Dr. 840
To Profit & Loss Adjustment A/c 840
(Rectification of the error arising from non-
preparation of invoice for goods delivered)
(vi) Profit & Loss Adjustment A/c Dr. 200
Inventory Account Dr. 800
To Customer’s Account 1,000
(The Customer’s A/c credited with `1,000 for
goods not yet purchased by him; cost of the
goods debited to inventory and “Profit” debited
to Profit & Loss Adjustment Account)
(vii) Profit & Loss Adjustment A/c Dr. 1,534
To Capital Account 1,534
(Transfer of Profit & Loss Adjustment A/c balance
to the Capital Account)

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 CHAPTER 3
BANK RECONCILIATION STATEMENT
LEARNING OUTCOMES
After studying this chapter, you will be able to:

w Learn the design of a Bank Pass Book.

w Understand the reasons for difference between Cash Book balance and Pass Book balance and try to
ascertain the amount of such differences.

w Learn, how to resolve such difference in a systematic manner.

w Understand the purpose for preparing the bank reconciliation statement and its utility.

CHAPTER Salient Features of Bank Reconciliation Statement:

OVERVIEW
The reconciliation Any undue delay A regular
will bring out in the clearance reconciliation
any errors that of cheques will be discourages the
may have been shown up by the accountant of
committed either reconciliation the bank from
in the cash book embezzlement
or in the pass
book

Causes of difference in the balances of pass book and cash book

Timing Differences
differences arising due
to errors in
recording the
entries

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 3.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1. INTRODUCTION
Banks are essential institutions in a modern society. With the increase in volume of trade, commerce and
business, business entities faced difficulty in transacting in cash for each business activity. They discovered
that dealing through bank, on regular basis, would be the better and safer option and finally large
business entities switched over to banking transactions instead of dealing in cash. Now-a-days, most of the
transactions of the business are done through bank whether it is a receipt or a payment. Rather, it is legally
necessary to operate the transactions through bank after a certain limit.
A Bank accepts from people, in general, deposits in various forms, and lends funds to those who need; it
also invests some funds in profitable investments. Thus, money which would have been otherwise idle is
put to use and is made available to those who need it. Those who deposit the money are able to withdraw
it according to the settled terms and conditions. Apart from receiving deposits from and handling cash
transactions on behalf of its customers, the bank also renders some other useful services as indicated below:
(i) The bank discounts promissory notes or hundies, i.e., it enables a customer to receive the cash before
the due date in consideration of a small charge called discount.
(ii) The bank allows overdraft to its good customers so that they can make payments even when they do
not have sufficient balance at the bank. Of course, the overdraft must be cleared later.
(iii) The bank gives loans for a year or so, to its customers so that they can continue their operations. Such
financial assistance is of great help for business.
(iv) The bank on behalf of the customer collects the amount of dividend warrants or interest on securities
etc.
(v) On instruction of the customer, the bank makes payments of insurance premium, rent etc. on the due
dates.
(vi) The bank sells and purchases shares, debentures or government securities on behalf of its customers.
(vii) Money can be remitted to another place or persons through the bank at a low cost.
(viii) The bank in return, for a consideration, furnishes security or guarantee for its customers whose credit is
good.
(ix) The bank also issues letter of credit or travellers’ cheque to facilitate commerce or travel.

2. BANK PASS BOOK

Bank pass book is merely a copy of the customer’s account in the book of a bank. The bank either sends
periodical statements of account or gives a pass book to its customer in which all deposits and withdrawals
made by the customer during the particular period is recorded. Both represent almost a copy of the ledger
account of the customer in the books of the bank. Thus, it is the bank’s way of keeping the customers
informed of the entries made in his account. It is the customer’s duty to check the entries and immediately
inform the bank of any error that he may notice. The form of the pass book is given below:

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 BANK RECONCILIATION STATEMENT 3.3

PASS BOOK
Messers.........................................
in account with
Punjab National Bank
Daryaganj, New Delhi-110002
Date Particulars Withdrawals Deposits Dr. or Cr. Balance
Dr. Cr.
` ` `
The bank statement of account also has a similar form except that it is on loose sheets. The bank itself sends
the statements to customers but it is the customer’s duty to send the pass book to the bank periodically so
that it is written upto date. Business houses should also obtain at the end of the year a certificate from the
bank duly stamped with revenue stamps, showing the balance which the bank has in the account of firm.
The bank balance shown in the passbook is known as pass book balance for reconciliation purpose. The
credit balance as per pass book at a particular point of time is the deposit made by the customer while debit
balance as per pass book is the overdraft balance for the customer.
Students may note here that the nature of balance shown by pass book and cash book is quite different. The
debit balance in the pass book represents the credit balance as per the cash book and vice-versa because
the business enterprise treats the bank as a debtor/Trade receivable and bank treats the business enterprise
as a creditor/Trade payable.

3. BANK RECONCILIATION STATEMENT

To reconcile means to reason or find out the difference between two and eliminating that difference.
Whenever we deposit or withdraws money from banks, it is always recorded at two places:-
1. Bank column of the cash book; and
2. Bank statement (pass book)
The cash book is maintained by the person having the bank account whereas the bank statement is
prepared by the bank. Therefore, the balance in both should be equal and opposite in nature. For eg:- if
Mr. A deposited ` 1,00,000 in his bank account it will be recorded on the Dr. side of his cash book, but for the
bank it’s a receipt so it will recorded as a Cr. entry in the bank statement or the pass book.
But most of the times these two balances do not match. The reasons for difference in balances can be many
and are explained later in this chapter. It is possible to eliminate this difference by matching all the facts and
figures of the two statements. The process of eliminating this difference and bringing the two statements
in line with each other is known as “Reconciliation” , and the statement which reconciles the bank balance
as per cash book with the balance as per the pass book by showing all the causes of difference is known as
“BANK RECONCILIATION STATEMENT”.

4. IMPORTANCE OF BANK RECONCILIATION STATEMENT

Bank reconciliation statement is a very important tool for internal control of cash flows. It helps in detecting
errors, frauds and irregularities occurred, if any, at the time of passing entries in the cash book or in the pass
book, whether intentionally or unintentionally. Since frauds can be detected on the preparation of bank

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 3.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

reconciliation statement therefore accountants are careful while preparing and maintaining the records of
the business enterprise. Hence it works as an important mechanism of internal control. Following are the
salient features of bank reconciliation statement:
(i) The reconciliation will bring out any errors that may have been committed either in the cash book or in
the pass book;
(ii) Any undue delay in the clearance of cheques will be shown up by the reconciliation;
(iii) A regular reconciliation discourages the accountant of the bank from embezzlement. There have been
many cases when the cashiers merely made entries in the cash book but never deposited the cash in
the bank; they were able to get away with it only because of lack of reconciliation.
(iv) It helps in finding out the actual position of the bank balance.
CAUSES OF DIFFERENCE
The difference in the both balances (bank balance as per cash book and pass book) may arise because of the
following reasons:-
1. TIMING:- Sometimes a transaction is recorded at two different times in cash book and the pass book.
This may happen in the following cases:-
w Mr. A has issued a cheque to PQR ltd., now it will be recorded in his cash book immediately but the
bank will recognize this transaction only when the same cheque will be presented to it by PQR ltd.
w Similarly for PQR ltd. , entry in the cash book will be made immediately as the cheque is received
from Mr. A but the bank account will be credited when it collects money in respect of that cheque.
2. TRANSACTIONS:- There are various transactions which the bank carries out by itself without intimating
the customer. For e.g.:- interest received on a savings bank account, it will be credited by the bank
immediately but the entry in the cash book will be made only when the customer comes to know about
it, which is usually at a later stage. Similar is the case with Bank charges (which are debited from the
customer account by bank).
3. ERRORS:- Mistakes or errors made in preparing the accounts either by the bank or the customer can
also result in disagreement of the two statements. For this reason rectification of errors is required to be
done in both the statements before preparing any Bank Reconciliation Statement.
SOME OF THE ITEMS THAT FREQUENTLY CAUSE A DIFFERENCE:-
(i) Cheques issued but not presented for payment: The entry in the cash book is made immediately on
issue of cheque but naturally entry will be made by the bank only when the cheque is presented for
payment. There will thus be a gap of some days between the entry in the cash book and in the pass book.
Example: The balance as per Cash Book and Pass Book are `10,000. Cheque of ` 2,000 is issued but not
presented for payment. Then the balances as per cash book and pass book will be as follows:
Cash book (bank column only)
Particulars ` Particulars `
To balance b/f 10,000 By Vendor A/c (to whom cheque 2,000
is issued)
By balance c/f 8,000

10,000 10,000

© The Institute of Chartered Accountants of India

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 BANK RECONCILIATION STATEMENT 3.5

Bank statement (pass book)

Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 10,000(cr.)
On issues of cheque, the bank account in Cash Book is credited by `2,000 and so balance is reduced to
`8,000. Whereas balance in the Pass Book remains `10,000 until the cheque is presented for payment.
(ii) Cheques paid into the bank but not cleared: As soon as cheques are sent to the bank, entries are
made on the debit side of the bank column of the cash book. But usually banks credit the customer’s
account only when they have received the payment from the bank concerned- in other words, when
the cheques have been cleared. Again there will be some gap between the depositing of the cheques
and the credit given by the bank.
Example : The balance as per Cash book and Pass Book are ` 12,000. Cheque of ` 3,000 is deposited but
not cleared.
Cash book

Particulars ` Particulars `
To balance b/f 12,000 By balance c/f 15,000
To Vendor A/c 3,000
15,000 15,000

Bank statement (pass book)

Date Particulars Dr. (withdrawn) Cr. (deposited) Balance

Balance b/f 12,000 (cr.)
When cheque is deposited into bank, the bank account in Cash Book is increased to `15,000, but the
balance in the Pass Book remains ` 12,000 until the cheque is cleared.
(iii) Interest allowed by bank : If the bank has allowed interest to the customer, the entry will normally be
made in the customer’s account and later shown in the pass book. The customer usually comes to know
the amount of the interest by pursuing the pass book and only then he makes relevant entry in the cash
book.
Example: The balance as per Cash Book and Pass Book are `10,000. The bank has allowed `1,000 interest
on saving account to customer.
Cash book

Particulars ` Particulars `
To balance b/f 10,000 By balance c/f 10,000
10,000 10,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 10,000(cr.)
Interest 1,000 11,000(cr.)

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 3.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

Because of such interest balance of Pass Book is increased to `11,000. Whereas balance in the Cash Book
remains `10,000 until information reaches customer and he records such transaction.
(iv) Interest and expenses charged by the bank: Like (iii) above, the interest charged by the bank and
the amount of the bank charges are entered in the customer account and later in the pass book. The
customer makes the required entries only after he sees the pass book. These are debited to customer
account by bank therefore till such entry is passed in cash book, bank balance as per pass book is less
than bank balance as per cash book.
(v) Interest and dividends collected by the bank: Sometimes investments are left with the bank in the
safe custody; the bank itself sees to it that the interest or the dividend is collected on the due dates.
Entries are made as indicated in (iii) above.
Example: The balance as per Cash Book and Pass Book are `15,000. The bank has collected dividend of
`2,000.
Cash book

Particulars ` Particulars `
To balance b/f 15,000 By balance c/f 15,000
15,000 15,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 15,000(cr.)
Dividend 2,000(Cr.) 17,000(cr.)
On collection of dividend bank credits the amount to customer’s account, so balance in Pass Book is
increased to `17,000. Whereas balance in the Cash Book remains `15,000 until the information of such
dividend collection reaches the customer and he records such transaction.
(vi) Direct payments by the bank: The bank may be given standing instructions for certain payments such
as for insurance premium. In this case also, the customer may come to know of the payment only on
seeing the pass book. The entries in the pass book and in the cash book may thus be on different dates.
Example: The balance as per Cash Book and Pass Book of Mr. X are `20,000. The bank has instruction to
pay insurance premium of `1,500 directly to insurance company at the end of each month
Cash book

Particulars ` Particulars `
To balance b/f 20,000 By balance c/f 20,000
20,000 20,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 20,000 (cr.)
Insurance premium 1,500 18,500 (cr.)
On payment of insurance premium bank debits the customer’s account by `1,500 so balance in Pass
Book is decreased to `18,500. Whereas balance in the Cash Book remains `20,000 until the information
of such payment reaches the customer and he records such transaction.

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 BANK RECONCILIATION STATEMENT 3.7

(vii) Direct payment into the bank by a customer: If such a payment is received by the bank, it will be
entered in the customer’s account and also in the pass book; the account holder may come to know of
the amount only when he sees the pass book.
(viii) Dishonour of a bill discounted with the bank: If the bank is not able to receive payment on promissory
notes discounted by it, it will debit the customer’s account together with the charges it may have
incurred. The customer will naturally make the entry only when he sees the pass book.
Example : The balances as per Cash Book and Pass Book of Mr. X are `20,000. Mr. X deposited a cheque
of `3,000 and debited to his bank account `3,000 immediately. But bank will credit X’s account on
realization of amount. Now the cheque is dishonoured for non-payment. Bank charges `100 in this
connection.
Cash book

Particulars ` Particulars `
To balance b/f 20,000 By balance c/f 23,000
To bank a/c 3,000
23,000 23,000
Bank statement (pass book)
Date Particulars Dr. (withdrawn) Cr. (deposited) Balance
Balance b/f 20,000 (cr.)
Bank charges 100 19,900 (cr.)
Thus, balance of Mr. X’s account in Pass Book stands `19,900 after this transaction while balance as per
Cash Book stand `23,000. So Mr. X should deduct `3,000 the amount of dishonoured cheque, plus `100
the amount of bank charges for reconciliation.
(ix) Bills collected by the bank on behalf of the customer: If goods are sold, the documents may be sent
through the bank. If the bank is able to collect the amount, it will credit the customer’s account. The
customer may make the entry only on receiving the pass book.
All these timing differences will lead to difference in balances as shown by the cash book and the pass
book.
Following is the table summarising in brief the timings of different transactions:
Sl. Transaction Time of recording in cash Time of recording in pass
No. book book
1. Payment done by the account At the time of issuing the At the time presenting the
holder through issuing a cheque cheque to the bank for
cheque payment.
2. Receipt by the account holder At the time of depositing the At the time of collection of
through a cheque cheque into the bank amount from the account of
the issuing party.
3. Collection of bills/cheque When the entry is posted in When the amount is collected
directly on behalf of the the pass book. by the bank.
account holder

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

Sl. Transaction Time of recording in cash Time of recording in pass

No. book book
4. Direct payment to the third When the entry is posted in When the amount is paid by
party on behalf of the account the pass book. the bank
holder
5. Dishonour of cheque/bills When the entry is posted in When the cheque is
receivable. the pass book dishonoured.
6. Bank charges levied by the When the entry is posted in When charges are levied by
bank the pass book the bank
7. Interest and dividend credited When the entry is posted in When interest or dividend is
by the bank the pass book allowed or collected by the
bank.
8. Interest debited by the bank When the entry is posted in When interest is charged by
the pass book the bank
To illustrate this, we give below an extract from a pass book and the bank column of the cash book in
Illustration 1:

? ILLUSTRATION 1

Messer’s Tall & Short, Faiz Bazar, New Delhi-110002

in account with
Punjab National Bank, Daryaganj, New Delhi-110002
PASS-BOOK

Date Particulars Withdrawals Deposits Dr. or Cr. Balance

` ` `
2017
Jan. 2 By Cash 4,00,000 Cr. 4,00,000
“ 4 To Furniture Dealers Ltd. 60,000 Cr. 3,40,000
“ 4 To Das & Co. 1,25,000 Cr. 2,15,000
“ 10 By J. Johnson & Co.’s cheque 35,000 Cr. 2,50,000
“ 12 To Roy & James 1,00,000 Cr. 1,50,000
“ 15 By B. Babu & Co’s cheque 76,000 Cr. 2,26,000
“ 16 By Cash 30,000 Cr. 2,56,000
“ 20 To Cash 50,000 Cr. 2,06,000
“ 26 By J. Rai & Bros cheque 43,000 Cr. 2,49,000
“ 31 To Premium paid as per
standing instructions 25,000 Cr. 2,24,000
31 To Bank Charges 1,000 Cr. 2,23,000
31 By Interest collected on 20,000 Cr. 2,43,000
Government Securities

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.9

CASH-BOOK (Bank column only)

Date Particulars Amount Date Particulars Amount

` `
2017 2017
Jan. 1 To Cash 4,00,000 Jan. 2 By Furniture
Jan. 2 To J. Johnson & Co. 35,000 Dealers Ltd. 60,000
Jan. 8 To B. Babu& Co. 76,000 Jan. 2 By Roy & James 1,00,000
Jan. 10 To Cash 30,000 Jan. 2 By Das & Co. 1,25,000
Jan. 16 To J. Rai & Bros. 43,000 Jan. 4 By K. Nagpal & Co. 73,000
Jan. 20 To M. Mohan & Co. 1,05,000 Jan. 17 By Cash 50,000
Jan. 22 To N. Nandy & Sons 34,000 Jan. 20 By B. Babu & Co. 78,000
Jan. 31 By Balance c/d 2,37,000
7,23,000 7,23,000
Feb. 1 To Balance b/d 2,37,000
It will be seen that whereas the pass book shows a credit balance of `2,43,000, the cash-book shows a debit
balance of `2,37,000. We shall compare the two to establish the reasons for the difference The reconciliation of
the two statements can be done in two ways:-
1. Arrive at pass book balance from cash book.
2. Arrive at cash book balance from pass book.
Let us start with the pass book balance and arrive at the balance as per cash book.
Step: 1 Compare the debit side of cash book with the deposits column of pass book:-
We find that the following cheques are recorded in the cash book but not in the pass book. Therefore if
we enter these two cheques in the deposit side of the pass book the balance becomes:-
Existing balance 2, 43,000
Add:- M Mohan & Co. 1,05,000
N. Nandy & Sons 34,000
Total 3,82,000
Step: 2 Compare the credit side of the cash book with the withdrawal column of the pass book
We find that the following cheques are not recorded. Therefore, if we enter these two cheques on the
withdrawal side of the pass book the balance becomes: -
Existing balance 3,82,000
Less:- K Nagpal & Co. (73,000)
B Babu & Co. (78,000)
Total 2,31,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

There is an item Interest on Government Securities which appears on the deposit side of the pass book but
not in the debit side of the cash book, so this item should be deducted from pass book balance:-
Existing balance 2,31,000
Less:- Interest on govt. securities (20,000)
Total 2,11,000
Further, there are two items which appear on the withdrawal side of the pass book i.e. they have been
deducted from the bank balance but not on the credit side of the cash book, so these items should be
added in order to reconcile the balance:-
Existing balance:- 2,11,000
Add: Insurance premium 25,000
Add: Bank charges 1,000
Total 2,37,000
Therefore , we have arrived at the balance as per the cash book from the pass book.
This process shows that the difference between the two balance arise only because there are some entries made
in the cash-book but not in the pass book and some entries which are made in the pass book but not in the cash
book. A comparison of the two shows up such entries and then, on that basis, the reconciliation is prepared. To
illustrate it again, let us proceed from the cash book balance of `2,37,000. Since cheques totalling `1,39,000
have not been entered in the pass book, let us assume that they are also omitted from the cash book, this will
reduce the cash book balance to `98,000. Cheques totalling `1,51,000 have been entered on the credit side of
the cash book but not in the pass book their omission from the cash book will increase the cash book balance
to `2,49,000. Amounts totalling `26,000 have been entered in the withdrawals column of the pass book but
not in the cash book; an entry on the credit side of the cash book for these amounts will reduce the balance to
`2,23,000. The deposits column shows an entry of `20,000 not found on the debit side of the cash book; the
entry made in the cash book will increase balance to `2,43,000 as shown in the pass book.
(x) Errors: While recording the entries errors can occur both in the cash book and in the pass book. A bank
rarely makes any error but if does, the balance in the pass book will naturally differ from cash book.
Similarly if any error is committed in the cash book then it’s balance will be different from that of the
pass book.
Some of the errors include commission of entry, wrong recording of amount, recording of entry on the
wrong side of the book, wrong totalling of the account or wrong balancing of the book and recording
of transactions of other party.
Example: Mr. A’s cash book shows following transactions:
CASH-BOOK (Bank column only)

Date Particulars Amount Date Particulars Amount

` 2017 `
Mar 31 By balance c/d 1,00,000

April 7 To Wayne Ltd. 60,000 Apr 1 By balance b/d 10,000

April 11 To Cash A/c 80,000 April 29 By Cash A/c 2,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.11

By Balance c/d 1,28,000

1,40,000 1,40,000
PASS-BOOK

Date Particulars Withdrawals Deposit Balance

` ` ` (cr.)
2017
April 1 Balance b/d 1,00,000
April 7 By Wayne Ltd. 60,000 1,60,000
April 11 By Cash 80,000 2,40,000
April 13 To Vandy Ltd. 90,000 3,30,000
April 29 To Cash A/c 2,000 3,28,000
Here there are several errors made by accountant:
April 1: Balance should be have bought down in debit side as ` 1,00,000
April 13: Also a cheque issued to Vandy Ltd. has been omitted in the books of ` 90,000
So, on correcting these entries balance as per Cash Book will be:

Existing Balance ` 1,28,000

Add: Correct Opening Balance ` 1,00,000
Add: Incorrect Opening Balance ` 10,000
(Since it was bought down on credit side it will be added back)
Less: Cheque issued not recorded ` 90,000
Closing Balance as per Cash Book ` 1,48,000
Balance as per Pass Book 3,28,000
Less: Cheque to Vandy Ltd wrongly added to existing balance ` 1,48,000
instead of being subtracted 1,80,000
Difference in balances between cash book and pass book Nil

5. PROCEDURE FOR RECONCILING THE CASH BOOK BALANCE

WITH THE PASS BOOK BALANCE
Before proceeding further students must understand that ‘Dr. balance as per cash book’ means deposits
in the bank or cash at bank or Cr. balance as per pass book. Similarly ‘Cr. balance as per cash book’ means
excess amount over deposits withdrawn by the account holder or overdraft balance or Dr. balance as per
pass book.
It means that students can start bank reconciliation from any of the following four balances given in the
question:
1. Dr. balance as per cash book
2. Cr. balance as per cash book

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 3.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

3. Dr. balance as per pass book

4. Cr. balance as per pass book
While doing reconciliation, the following types of problems can be given:-

TYPES OF PROBLEMS

1. When causes 2. When causes

of difference of difference
are given are not given

a. Reconciliation b. Reconciliation b. Reconciliation b. Reconciliation

without after adjusting after adjusting after adjusting
adjusting cash cash book cash book cash book
book

When causes of differences are known then students can start reconciliation by taking any of the balance
stated above and proceed further with the causes. Given the causes of disagreement, the balance of the
other book can be either more or less on account of the said causes. If the balance of the other book is more
on account of the said causes then add the amount. If the balance of the other book is less on account of the
said causes then subtract the amount.
For example, if the reconciliation is initiated with Dr. balance as per the cash book and there is a cheque
deposited in the bank but not cleared, then on account of non-clearance of the cheque, the Cr. balance of
the pass book would be less. In this case, the amount of cheque should be subtracted from the cash book
balance to arrive at the balance as per the pass book. Similarly, after making all the adjustments the balance
as per the other book is obtained. It is necessary to note here that if a student starts from debit balance of
cash book and after all adjustments the balance arrived is positive then it is known as Cr. balance as per the
pass book and if the balance is negative then it is said to be Dr. balance as per the pass book and vice-versa.
But if causes of differences are not known then one has to compare the debit entries of cash book with the
credit entries of the pass-book and vice-versa. The entries, which do not tally in the course, are the causes of
difference in the balances of both the books. Once the causes are located their effects on both the books are
analysed and then reconciliation statement is prepared to arrive at the actual bank balance.
In this procedure students, should also take into care that whether opening balance of both the books at
particular point of time from where the books are compared, tallies or not. If opening balances are not same
then unticked items are divided into two categories i.e., one relating to reconciliation of opening balance
and other relating to reconciliation of closing balance.
Example: Jolly Ltd has following entries in its cash book and pass book:
CASH-BOOK (Bank column only)
Date Particulars Amount Date Particulars Amount
` `
May 1 To Balance b/d 70,000 May 15 By Richa Ltd. 20,000
May 9 To Avengers Ltd. 50,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.13

May13 To Cash A/c 80,000

May 30 By Balance c/d 1,80,000
2,00,000 2,00,000
PASS-BOOK

Date Particulars Withdrawals Deposits Dr. or Cr. Balance

` ` `
2017
May 1 Balance b/d Cr. 1,00,000
May 7 To Mr. A 30,000 Cr. 70,000
May 12 By Avengers Ltd. 50,000 Cr. 1,20,000
May 13 By Cash A/c 80,000 Cr. 2,00,000
May 23 To Richa Ltd. 20,000 Cr. 1,80,000
May 29 Bank Charges 2,000 Cr. 1,78,000
Here when we compare Cash Book and Pass Book we find out following 2 entries remain unticked in pass
book i.e. they don’t appear in cash book:
Cheque to Mr. A - ` 30,000
Bank Charges - ` 2,000
Excess withdrawals as per pass book - ` 32,000
However if we difference between closing balances of two books is only ` 2,000 but at the same time there
is a difference of ` 30,000 in opening balances. Thus we need to bifurcate the unticked items as:

Regarding Opening Balance Regarding Closing Balance

Cheque to Mr. A - ` 30,000 Bank Charges - ` 2,000
This is an item which must have been recorded in These have been charged by the bank but not
Cash book during previous month when cheque recorded in books.
would have been issued and would have appeared
as a reconciling item in BRS of that month. Since, it
has been presented to bank by Mr. A in April, it has
been recorded now by the bank.

6. METHODS OF BANK RECONCILIATION

There are following two methods of reconciling the bank balances:
6.1 Bank Reconciliation Statement without Preparation of adjusted Cash-Book
For reconciliation purposes students can take any of the four balances as the starting point and can proceed
further with the causes of differences.
Based on the earlier explanation the following table has been prepared for student’s ready reference when
reconciliation is done on the basis of ‘Balance’ presentation. The final balance, which will come after addition
and subtraction, will be the balance as per the other book.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

Causes of differences Favourable Unfavourable Favourable Unfavourable

balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per cash- as per cash- as per pass- as per pass-
book book book book
Cheque deposited but not cleared Subtract Add Add Subtract
Cheque issued but not presented to bank Add Subtract Subtract Add
Cheque directly deposited in bank by a Add Subtract Subtract Add
customer
Income (e.g., interest from UTI) directly Add Subtract Subtract Add
received by bank
Expenses (e.g., telephone bills, Insurance Subtract Add Add Subtract
charges) directly paid by bank on standing
instructions
Bank charges levied by bank Subtract Add Add Subtract
Locker rent levied by bank Subtract Add Add Subtract
Wrong debit in the cash book Subtract Add Add Subtract
Wrong credit in the cash book Add Subtract Subtract Add
Wrong debit in the pass book Subtract Add Add Subtract
Wrong credit in pass book Add Subtract Subtract Add
Undercasting of Dr. side of bank account in Add Subtract Subtract Add
the cash book
Overcasting of Dr. side of bank account in Subtract Add Add Subtract
cash book
Undercasting of Cr. side of bank account in Subtract Add Add Subtract
cash book
Overcasting of Cr. side of bank account Add Subtract Subtract Add
incash book
Bill receivable collected directly by bank Add Subtract Subtract Add
Interest on bank overdraft charged Subtract Add Add Subtract
Final Balance If answer is If answer is If answer is If answer is
positive then positive then positive then positive then
favourable Unfavourable favourable Unfavourable
balance (Cr.) balance (Dr.) balance (Dr.) balance (Cr.)
as per pass- as per pass- as per cash- as per cash-
book and if book and if book and if book and if
negative then negative then negative then negative then
unfavourable Favourable unfavourable Favourable
balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per pass- as per pass- as per cash- as per cash-
book. book book book

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.15

It is proper to prepare a neat statement showing the reconciliation of the two balances. Taking the example
given in the illustration 1, the statement may be prepared as follows:
1. ‘Balance’ presentation.
2. ‘Plus & Minus’ presentation.
1. As per Balance Presentation:
Bank Reconciliation Statement as on 31st January, 2017

Particulars Details Amount

` `
Balance as per Pass Book 2,43,000
Add: Cheques deposited but not yet credited:
M. Mohan & Co. 1,05,000
N. Nandy & Sons 34,000 1,39,000
Add: Premium paid and bank charges entered in the Pass Book but not 26,000
yet entered in the Cash-Book
4,08,000
Less: Cheques issued but not yet presented
K. Nagpal & Co. 73,000
B. Babu & Co. 78,000 1,51,000
2,57,000
Less: Interest credited by bank but not yet entered in the Cash Book
20,000
Balance as per Cash Book 2,37,000
OR
Balance as per Cash Book 2,37,000
Add: Cheques issued but not yet presented:
K. Nagpal & Co. 73,000
B. Babu & Co. 78,000 1,51,000
Add: Interest entered in the Pass Book, but not yet in the Cash Book
20,000
4,08,000
Less: Cheques paid in but not yet credited:
M. Mohan & Co. 1,05,000
N. Nandy & Sons 34,000 1,39,000
2,69,000
Less: Premium paid and bank charges entered in the Pass Book but not
yet in the Cash Book 26,000
Balance as per Pass Book 2,43,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. As per Plus-Minus Presentation:

Bank Reconciliation Statement as on 31st January, 2017

Particulars Plus Amount Minus
(`) Amount (`)
Balance as per Cash Book 2,37,000
Cheques issued but not yet presented:
K. Nagpal & Co. 73,000
B. Babu & Co. 78,000
Interest entered in pass book but not yet entered into cash book 20,000
Cheques paid but not yet credited:
M. Mohan & Co. 1,05,000
N. Nandy & Sons 34,000
Premium paid and bank charges entered in pass book 26,000
Balance as per pass book 2,43,000
4,08,000 4,08,000

? ILLUSTRATION 2
From the following particulars, prepare a Bank Reconciliation Statement for Jindal offset Ltd.
(1) Balance as per cash book is ` 2,40,000
(2) Cheques issued but not presented in the bank amounts to ` 1,36,000.
(3) Cheques deposited in bank but not yet cleared amounts to ` 90,000.
(4) Bank charges amounts to ` 300.
(5) Interest credited by bank amounts to ` 1,250.
(6) The balance as per pass book is ` 2,86,950.

 SOLUTION
Bank Reconciliation Statement
Particulars Amount
`
Balance as per cash book 2,40,000
Add : Cheque issued but not presented 1,36,000
Interest credited 1,250
3,77,250
Less : Cheque deposited but not yet cleared (90,000)
Bank charges (300)
Balance as per pass book 2,86,950

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.17

? ILLUSTRATION 3
On 31st March 2017, the Bank Pass Book of Namrata showed a balance of ` 1,50,000 to her credit while balance
as per cash book was ` 1,12,050. On scrutiny of the two books, she ascertained the following causes of difference:
i) She has issued cheques amounting to ` 80,000 out of which only ` 32,000 were presented for payment.
ii) She received a cheque of ` 5,000 which she recorded in her cash book but forgot to deposit in the bank.
iii) A cheque of ` 22,000 deposited by her has not been cleared yet.
iv) Mr. Gupta deposited an amount of ` 15,700 in her bank which has not been recorded by her in Cash Book yet.
v) Bank has credit an interest of ` 1,500 while charging ` 250 as bank charges.
Prepare a bank reconciliation statement.

 SOLUTION
Bank Reconciliation Statement as on 31st March 2017

Particulars Details (`) Amount (`)

Balance as per Pass Book (Cr.) 1,50,000
Add: Cheque deposited but not yet cleared 22,000
Add: Cheque recorded in Cash Book but not yet deposited 5,000
Add: Bank Charges debited by bank 250 27,250
Less: Cheque issued but not yet presented 48,000
Less: Amount deposited but not recorded in Cash Book 15,700
Less: Interest allowed by bank 1,500 65,200
Balance as per Cash Book 1,12,050

? ILLUSTRATION 4
From the following particulars ascertain the balance that would appear in the Bank Pass Book of A on
31st December, 2017.
(1) The bank overdraft as per Cash Book on 31st December, 2017 ` 6,340.
(2) Interest on overdraft for 6 months ending 31st December, 2017 ` 160 is entered in Pass Book.
(3) Bank charges of ` 400 are debited in the Pass Book only.
(4) Cheques issued but not cashed prior to 31st December, 2017, amounted to `11,68,000.
(5) Cheques paid into bank but not cleared before 31st December, 2017 were for ` 22,17,000.
(6) Interest on investments collected by the bank and credited in the Pass Book `12,00,000.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Bank Reconciliation Statement
As on 31st December, 2017

Particulars Amount
`
Overdraft as per Cash Book 6,340
Add: Interest debited in the Pass Book but not yet entered in the Cash Book 160
Add: Bank charges debited in the Pass Book but not entered in the Cash Book 400
Add : Cheques deposited but not yet credited in the Pass Book 22,17,000
22,23,900
Less: Cheques issued but not yet presented (11,68,000)
Less: Interest collected and credited by bank but not yet entered in Cash Book (12,00,000)
Overdraft as per Pass Book 1,44,100
The above illustration can also be presented with the column for “Plus” and “Minus.”

Particulars Plus Minus

Amount Amount
` `
Overdraft as per Cash Book 6,340
Interest debited in Pass Book but not yet in Cash Book 160
Cheque issued but not yet presented 11,68,000
Cheques paid in but not yet credited by the Bank 22,17,000
Bank charges 400
Interest collected and credited by the Bank in the Pass
Book but not yet entered in Cash Book 12,00,000
23,68,000
Overdraft as per Pass Book (`23,68,000 – 22,23,900) 1,44,100
Total 22,23,900 22,23,900

6.2 Bank Reconciliation Statement after the Preparation of adjusted Cash-Book

6.2.1 Meaning of adjusted cash book

When the balance in the cash book is first adjusted for certain adjustments before taking it to the bank
reconciliation statement, then it is known as adjusted cash book balance. Adjusting the cash-book before
preparing the bank reconciliation statement is completely optional, if reconciliation is done during different
months. But if reconciliation is done at the end of the accounting year or financial year, the cash-book must
be adjusted so as to reflect the correct bank balance in the balance sheet.
While adjusting the cash-book the following adjustments are considered:-
1. all the errors (like wrong amount recorded in the cash-book, entry posted twice in the cash-book, over/
undercasting of the balance etc.) and

© The Institute of Chartered Accountants of India

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 BANK RECONCILIATION STATEMENT 3.19

2. omissions (like bank charges recorded in the pass-book only, interest debited by the bank, direct receipt
or payment by the bank, dishonour of cheques/bills etc.) by the cash-book are taken into care
Only these transactions are considered for adjusting cash book, apart from this delay in recording in
the pass-book due to difference in timing (like cheque issued but not presented for payment, cheque
deposited but not collected) is taken to bank reconciliation statement. This adjusted cash-book balance
is taken to bank reconciliation statement.

Errors occurring in the pass-book are not to be adjusted in the cash book. All the adjustments
considered in the adjusted cash-book are not carried again to the bank reconciliation statement.

? ILLUSTRATION 5
On 30th September, 2017, the bank account of X, according to the bank column of the Cash- Book, was overdrawn
to the extent of `4,062. On the same date the bank statement showed a debit balance of `20,758 in favour of X.
An examination of the Cash Book and Bank Statement reveals the following:
1. A cheque for `13,14,000 deposited on 29th September, 2017 was credited by the bank only on 3rd October,
2017
2. A payment by cheque for `16,000 has been entered twice in the Cash Book.
3. On 29th September, 2017, the bank credited an amount of `1,17,400 received from a customer of X, but the
advice was not received by X until 1st October, 2017.
4. Bank charges amounting to `580 had not been entered in the Cash Book.
5. On 6th September, 2017, the bank credited `20,000 to X in error.
6. A bill of exchange for `1,40,000 was discounted by X with his bank. This bill was dishonoured on 28th
September, 2017 but no entry had been made in the books of X.
7. Cheques issued upto 30th September, 2017 but not presented for payment upto that date totalled ` 13,26,000.
You are required :
(a) to show the appropriate rectifications required in the Cash Book of X, to arrive at the correct balance on 30th
September, 2017 and
(b) to prepare a bank reconciliation statement as on that date.

 SOLUTION

(a) Cash Book (Bank Column)

Date Particulars Amount Date Particulars Amount
2017 ` 2017 `
Sept. 30 Sept. 30
To Party A/c 16,000 By Balance b/d 4,062
To Customer A/c By Bank charges 580
(Direct deposit) 1,17,400 By Customer A/c
To Balance c/d 11,242 (B/R dishonoured) 1,40,000
1,44,642 1,44,642

© The Institute of Chartered Accountants of India

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 3.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) Bank Reconciliation Statement as on 30th September, 2017

Particulars Amount
`
Overdraft as per Cash Book 11,242
Add: Cheque deposited but not collected upto 30th September, 2017 13,14,000
13,25,242
Less: Cheques issued but not presented for payment upto 30th September, 2017 (13,26,000)
Credit by Bank erroneously on 6th September (20,000)
Overdraft as per bank statement 20,758
Note: Bank has credited X by 20,000 in error on 6th September, 2017. If this mistake is rectified in the bank
statement, then this will not be deducted in the above statement along with ` 13,26,000 resulting in debit
balance of ` 758 as per pass-book.

? ILLUSTRATION 6
On 30th December, 2017 the bank column of A. Philip’s cash book showed a debit balance of ` 4,610. On
examination of the cash book and bank statement you find that:
1. Cheques amounting to ` 6,30,000 which were issued to trade payables and entered in the cash book before
30th December, 2017 were not presented for payment until that date.
2. Cheques amounting to ` 2,50,000 had been recorded in the cash book as having been paid into the bank on
30th December, 2017, but were entered in the bank statement on1st January, 2018.
3. A cheque for ` 73,000 had been dishonoured prior to 30th December, 2017, but no record of this fact
appeared in the cash book.
4. A dividend of ` 3,80,000, paid direct to the bank had not been recorded in the cash book.
5. Bank interest and charges amounting to ` 4,200 had been charged in the bank statement but not entered in
the cash book.
6. No entry had been made in the cash book for a trade subscription of ` 10,000 paid vide banker’s order in
November, 2017.
7. A cheque for ` 27,000 drawn by B. Philip had been charged to A. Philip’s bank account by mistake in December,
2017.
You are required:
(a) to make appropriate adjustments in the cash book bringing down the correct balance, and
(b) to prepare a statement reconciling the adjusted balance in the cash book with the balance shown in the
bank statement.

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Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.21

 SOLUTION
(a) A. Philip
Dr. Cash Book (Bank column) Cr.

Date Particulars Amount Date Particulars Amount

2017 ` 2017 `
Dec. 30 Dec. 30
To Balance b/d 4,610 By Trade receivables- 73,000
To Dividend received 3,80,000 Cheque dishonoured
By Bank interest and charges 4,200
By Trade Subscription 10,000
Dec. 31 By Balance c/d 2,97,410
3,84,610 3,84,610
2018
Jan. 1 To Balance b/d 2,97,410

(b) Bank Reconciliation Statement as at 30th December, 2017

Particulars Amount
`
Balance per cash book 2,97,410
Add: Cheques not yet presented 6,30,000
9,27,410
Deduct: Lodgement not yet recorded by bank (2,50,000)
6,77,410
Deduct: Cheque wrongly charged (27,000)
Balance as per the bank statement 6,50,410

? ILLUSTRATION 7
From the following information, prepare a Bank reconciliation statement as at 31st December, 2017 for Messrs
New Steel Limited :
`
(1) Bank overdraft as per Cash Book on 31st December, 2017 22,45,900
(2) Interest debited by Bank on 26th December, 2017 but no advice received 2,78,700
(3) Cheque issued before 31st December, 2017 but not yet presented to Bank 6,60,000
(4) Transport subsidy received from the State Government directly by the Bank but not
advised to the company 14,25,000
(5) Draft deposited in the Bank, but not credited till 31st December, 2017 13,50,000
(6) Bills for collection credited by the Bank till 31st December, 2017 but no advice received by
the company 8,36,000
(7) Amount wrongly debited to company account by the Bank, for which no details are
available 7,40,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
M/s. New Steel Ltd.
Bank Reconciliation Statement as on 31st Dec. 2017
Overdraft as per Cash Book 22,45,900
Add : Interest charged by the bank 2,78,700
Draft deposited in bank but not yet credited 13,50,000
Wrong debit by the bank, under verification 7,40,000 23,68,700
46,14,600
Less: Cheque issued but not yet presented (6,60,000)
Transport subsidy not yet recorded in the Cash Book (14,25,000)
Bills for collection credited in the bank not yet entered in the cash book (8,36,000) (29,21,000)
Overdraft as per bank statement 16,93,600

? ILLUSTRATION 8
The Cash Book of Mr. Gadbadwala shows ` 8,36,400 as the balance at Bank as on 31st December, 2017, but
you find that it does not agree with the balance as per the Bank Pass Book. On scrutiny, you find the following
discrepancies:
(1) On 15th December, 2017 the payment side of the Cash Book was undercast by `10,000.
(2) A cheque for `1,31,000 issued on 25th December, 2017 was not taken in the bank column.
(3) One deposit of `1,50,000 was recorded in the Cash Book as if there is no bank column therein.
(4) On 18th December, 2017 the debit balance of `15,260 as on the previous day, was brought forward as credit
balance.
(5) Of the total cheques amounting to `11,514 drawn in the last week of December, 2017, cheques aggregating
`7,815 were encashed in December.
(6) Dividends of `25,000 collected by the Bank and subscription of `1,000 paid by it were not recorded in the
Cash Book.
(7) One out-going Cheque of `3,50,000 was recorded twice in the Cash Book. Prepare a Reconciliation Statement.

 SOLUTION
(If the books are not closed on 31st December, 2017)
Bank Reconciliation Statement of Mr. Gadbadwala as on 31st Dec., 2017
Particulars Details Amount
` `
Balance as per the Cash Book 8,36,400
Add : Mistake in bringing forward `15,260 debit balance as credit 30,520
balance on 18th Dec., 2017
Cheques issued but not presented : `
Issued 11,514
Cashed 7,815 3,699

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.23

Particulars Details Amount

` `
Dividends directly collected by bank but not yet
entered in the Cash Book 25,000
Cheque recorded twice in the Cash Book 3,50,000
Deposit not recorded in the Bank column 1,50,000 5,59,219
13,95,619
Less : Wrong casting in the Cash Book on 15th Dec. 10,000
Cheques issued but not entered in the Bank column 1,31,000
Subscription paid by the bank directly not yet recorded in
the Cash Book 1,000 (1,42,000)
Balance as per the Pass Book 12,53,619
If the books are to be closed on 31st December, then adjusted cash book will be prepared as given below:
ADJUSTED CASH BOOK
Particulars Amount (`) Particulars Amount (`)
To Balance b/d 8,36,400 By wrong casting 10,000
To error for wrong posting 30,520 By cheques not entered 1,31,000
To dividends collected by bank 25,000 By subscription 1,000
To cheques recorded twice 3,50,000 By balance c/d 12,49,920
To deposit not recorded 1,50,000
13,91,920 13,91,920
Bank Reconciliation Statement
Particulars `
Balance as per the Cash Book (corrected) 12,49,920
Add: Cheques issued but not yet presented 3,699
Balance as per the Pass Book 12,53,619

? ILLUSTRATION 9
The following are the Cash Book (bank column) and Pass Book of Jain for the months of March, 2017 and April,
2017:
Cash Book (Bank Column only)
Date Particulars Amount Date Particulars Amount
Dr. ` Cr.
`
01/3/2017 To Balance b/d 60,000 03/3/2017 By Cash A/c 2,00,000
06/3/2017 To Sales A/c 3,00,000 07/3/2017 By Modi 60,000
10/3/2017 To Ram 65,000 12/3/2017 By Patil 30,000
18/3/2017 To Singhal 2,70,000 18/3/2017 By Suresh 40,000
25/3/2017 To Goyal 33,000 24/3/2017 By Ramesh 1,50,000
31/3/2017 To Patel 65,000 30/3/2017 By Balance c/d 3,13,000
7,93,000 7,93,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

Pass Book
Date Particulars Amount Amount Dr. or Cr. Balance
Dr. Cr. `
` `
1/4/2017 By Balance b/d 3,65,000 Cr. 3,65,000
3/4/2017 By Goyal 33,000 Cr. 3,98,000
5/4/2017 By Patel 65,000 Cr. 4,63,000
7/4/2017 To Naresh 2,80,000 Cr. 1,83,000
12/4/2017 To Ramesh 1,50,000 Cr. 33,000
15/4/2017 To Bank Charges 200 Cr. 32,800
20/4/2017 By Usha 17,000 Cr. 49,800
25/4/2017 By Kalpana 38,000 Cr. 87,800
30/4/2017 To Sunil 6,200 Cr. 81,600
Reconcile the balance of cash book on 31/3/2017.

 SOLUTION
1. On scrutiny of the debit side of the Cash Book of March 2017 and receipt side of the Pass Book of April,
2017 reveals that two cheques deposited in Bank (Goyal ` 33,000 and Patel ` 65,000) in March were not
credited by the Bank till 31/3/2017
2. On scrutiny of the credit side of the cash book and payment side of the Pass Book reveals that a
cheque issued to Ramesh for `1,50,000 in March 2017, had not been presented for payment in Bank till
31/3/2017. Therefore the Bank Reconciliation statement on 31/3/2017 will appear as follows :
Bank Reconciliation Statement as on 31/3/2017
Particulars Amount
`
Balance as per the Cash Book 3,13,000
Add : Cheque issued but not presented for payment 1,50,000
4,63,000
Less : Cheque deposited but not credited by Bank (98,000)
Balance as per the Pass Book 3,65,000

? ILLUSTRATION 10

When Nikki & Co. received a Bank Statement showing a favourable balance of `10,39,200 for the period ended on
30th June, 2017, this did not agree with the balance in the cash book.
An examination of the Cash Book and Bank Statement disclosed the following :
1. A deposit of `3,09,200 paid on 29th June, 2017 had not been credited by the Bank until 1st July, 2017.
2. On 30th March, 2017 the company had entered into hire purchase agreement to pay by bank order a sum
of `3,00,000 on the 10th of each month, commencing from April, 2017. No entries had been made in Cash
Book.

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Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.25

3. A customer of the firm, who received a cash discount of 4% on his account of `4,00,000 paid the firm a cheque
on 12th June. The cashier erroneously entered the gross amount in the bank column of the Cash Book.
4. Bank charges amounting to `3,000 had not been entered in Cash-Book.
5. On 28th June, a customer of the company directly deposited the amount in the bank ` 4,00,000, but no entry
had been made in the Cash Book.
6. `11,200 paid into the bank had been entered twice in the Cash Book.
7. A debit of ` 11,00,000 appeared in the Bank Statement for an unpaid cheque, which had been returned
marked ‘out of date’. The cheque had been re-dated by the customer and paid into Bank again on 5th July,
2017.
Prepare Bank Reconciliation Statement on 30 June, 2017.

 SOLUTION
Bank Reconciliation Statement on 30 June, 2017

Particulars Details Amount

` `
Balance as per the Pass Book 10,39,200
Add: Deposited with bank but not credited 3,09,200
Payment of Hire Purchase installments not entered in the Cash Book 9,00,000
(` 3,00,000 x 3)
Discount allowed wrongly entered in bank column 16,000
Bank charges not entered in the Cash Book 3,000
Deposit entered in the Cash Book twice 11,200
Cheque returned ‘out of date’ entered in the Cash Book 11,00,000 23,39,400
33,78,600
Less: Direct deposit by customer not entered in the Cash Book (4,00,000)
Balance as per the Cash Book 29,78,600

? ILLUSTRATION 11
The bank account of Mukesh was balanced on 31st March, 2017. It showed an overdraft of ` 5,000. This did not
agree with the balance shown by bank statement of Mukesh. You are required to prepare a bank reconciliation
statement taking the following into account :
(1) Cheques issued but not presented for payment till 31.3.2017 `12,00,000.
(2) Cheques deposited but not collected by bank till 31.3.2017 ` 20,00,000.
(3) Interest on term-loan ` 10,00,000 debited by bank on 31.3.2017 but not accounted in Mukesh’s book.
(4) Bank charges ` 2,500 was debited by bank during March, 2017 but accounted in the books of Mukesh on
4.4.2017.
(5) An amount of ` 30,68,000 representing collection of Mukesh’s cheque was wrongly credited to the account
of Mukesh by the bank in their bank statement.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 3.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
In the books of Mukesh
Bank Reconciliation Statement as on 31.3.2017
Particulars Details Amount
`
Overdraft as per the cash book 5,000
Add: Cheques deposited in bank but not collected and credited by bank 20,00,000
till 31.3.2017
Interest on term loan not accounted in books 10,00,000
Bank charges not accounted in books 2,500 30,02,500
30,07,500
Less: Cheques issued but not presented for payment till 31.3.2017 (12,00,000)
18,07,500
Less: Erroneous credit by bank to Mukesh’s account (30,68,000)
Balance as per the bank statement (12,60,500)

? ILLUSTRATION 12
From the following information (as on 31.3.2017), prepare a bank reconciliation statement after making
necessary amendments in the cash book:
Particulars
Bank balances as per the cash book (Dr.) 32,50,000
Cheques deposited, but not yet credited 44,75,000
Cheques issued but not yet presented for payment 35,62,000
Bank charges debited by bank but not recorded in the cash-book 12,500
Dividend directly collected by the bank 1,25,000
Insurance premium paid by bank as per standing instruction not intimated 15,900
Cash sales wrongly recorded in the Bank column of the cash-book 2,55,000
Customer’s cheque dishonoured by bank not recorded in the cash-book 1,30,000
Wrong credit given by the bank 1,50,000
Also show the bank balance that will appear in the trial balance as on 31.3.2017.

 SOLUTION
Cash Book as on 31.3.2017
(After making necessary amendments)
Dr. Cr.
Particulars Amount Particulars Amount
` `
To Balance b/d 32,50,000 By Bank charges 12,500
To Dividend 1,25,000 By Insurance premium 15,900
By Trade receivables (cheque dishonoured) 1,30,000
By Cash A/c (wrongly recorded cash sales) 2,55,000
By Balance c/d 29,61,600
33,75,000 33,75,000

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Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.27

Bank Reconciliation Statement as on 31.3.2017

Particulars Details Amount

`
Bank balance as per the cash book 29,61,600
Add: Cheques issued but not yet presented for payment 35,62,000
Wrong credit given by bank 1,50,000 37,12,000
66,73,600
Less: Cheques deposited but not yet credited by bank (44,75,000)
Balance as per the pass book 21,98,600
The bank balance of ` 29,61,600 will appear in the trial balance as on 31st March, 2017.
Note: Cash sales should have been recorded by passing the following entry:
Cash A/c Dr 2,55,000
To Sales A/c 2,55,000
But it has been wrongly debited to Bank A/c, so following rectification entry has been passed:
Cash A/c
To Bank A/c Dr 2,55,000
2,55,000

? ILLUSTRATION 13
On 31st March, 2017 the pass-book of a trader showed a credit balance of `15,65,000 but the passbook balance
was different for the following reasons from the cash book balance:
1. Cheques issued to ‘X’ for ` 60,000 and to ‘Y’ for `3,84,000 were not yet presented for payment.
2. Bank charged `350 for bank charges and ‘Z’ directly deposited `1,816 into the bank account, which
were not entered in the cash book.
3. Two cheques-one from ‘A’ for ` 5,15,000 and another from ‘B’ for ` 12,500 were collected in the first week of
April, 2017 although they were banked on 25.03.2017.
4. Interest allowed by bank ` 4,500
Prepare a bank reconciliation statement as on 31st March, 2017.

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Sample output to test PDF Combine only
 3.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Bank Reconciliation Statement as on 31st March, 2017
Particulars Details Amount
` ` `
Credit balance as per the pass book 15,65,000
Add: Cheques deposited into bank but not yet collected A: 5,15,000
B: 12,500 5,27,500
Bank charges debited by the bank 350 5,27,850
20,92,850
Less: Cheques issued but not presented for payment X: 60,000
Y: 3,84,000 4,44,000
Direct deposit of cash in bank by Z 1,816
Interest allowed by the bank 4,500 (4,50,316)
Debit balance as per the cash book 16,42,534

SUMMARY
w Bank pass book is merely a copy of the customer’s account in the book of a bank.
w Bank reconciliation statement is a statement which reconciles the bank balance as per cash book with
the balance as per bank pass book by showing all causes of difference between the two.
w The salient features of bank reconciliation statement:
ª The reconciliation will bring out any errors that may have been committed either in the cash book
or in the pass book;
ª Any undue delay in the clearance of cheques will be shown up by the reconciliation;
ª A regular reconciliation discourages the accountant of the bank from embezzlement. There have
been many cases when the cashiers merely made entries in the cash book but never deposited the
cash in the bank; they were able to get away with it only because of lack of reconciliation.
ª It helps in finding out the actual position of the bank balance.
w The difference in the balances of both the books can be because of the following reasons:
1. Timing differences,
2. Transactions;
3. Errors.
w Bank reconciliation can be start from any of the following four balances given in the question:
1. Dr. balance as per cash book
2. Cr. balance as per cash book
3. Dr. balance as per pass book
4. Cr. balance as per pass book
w There are two methods of reconciling the bank balances :
1. Bank reconciliation statement without preparation of adjusted cash-book.
2. Bank reconciliation statement after the preparation of adjusted cash-book.

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Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.29

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. When the balance as per Cash Book is the starting point, direct deposits by customers are:
(a) Added (b) Subtracted (c) Not required to be adjusted.
2. A debit balance in the depositor’s Cash Book will be shown as:
(a) A debit balance in the Bank Statement.
(b) A credit balance in the Bank Statement.
(c) An overdrawn balance in the Bank Statement.
3. When balance as per Pass Book is the starting point, interest allowed by Bank is
(a) Added (b) Subtracted (c) Not required to be adjusted.
4. A Bank Reconciliation Statement is prepared with the help of:
(a) Bank statement and bank column of the Cash Book.
(b) Bank statement and cash column of the Cash Book
(c) Bank column of the Cash Book and cash column of the Cash Book.
5. The cash book showed an overdraft of `1,50,000, but the pass book made up to the same date showed
that cheques of ` 10,000, ` 5,000 and ` 12,500 respectively had not been presented for payments; and
the cheque of ` 4,000 paid into account had not been cleared. The balance as per the pass book will be:
(a) ` 1,10,000 (b) ` 2,17,500 (c) ` 1,26,500
6. When drawing up a Bank Reconciliation Statement, if you start with a debit balance as per the Bank
Statement, the unpresented cheques should be:
(a) Added; (b) Deducted; (c) Not required to be adjusted.
7. When drawing up a BRS if you start with a Dr. Balance as per Bank Statement, the following are added:
1. Cheque issued but not presented to bank
2. B/R collected directly by bank
3. Overcasting of the Dr. Side of bank A/c in the cash book.
(a) only 1
(b) only 1& 2
(c) all of the above
(d) only 3.
Theory Questions
1. Write short note on Bank reconciliation statement.
2. State the causes of difference between the balance shown by the pass book and the cash book.

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 3.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Questions
Q1. From the following particulars prepare a bank reconciliation statement as on 31st December 2017:
(i) On 31st December, 2017 the cash-book of a firm showed a bank balance of ` 60,000 (debit balance).
(ii) Cheques had been issued for ` 15,00,000, out of which cheques worth ` 4,00,000 only were
presented for payment.
(iii) Cheques worth ` 11,40,000 were deposited in the bank on 28th December,2017 but had not been
credited by the bank. In addition to this, one cheque for ` 5,00,000 was entered in the cash book on
30th December, 2017 but was banked on 3rd January, 2018.
(iv) A cheque from Susan for ` 4,00,000 was deposited in the bank on 26th December 2017 but was
dishonoured and the advice was received on 2nd January, 2018.
(v) Pass-book showed bank charges of ` 2,000 debited by the bank.
(vi) One of the debtors deposited a sum of ` 5,00,000 in the bank account of the firm on 20th December,
2017 but the intimation in this respect was received from the bank on 2nd January, 2018.
(vii) Bank pass-book showed a credit balance of ` 3,82,000 on 31st December, 2017.
Q2. According to the cash-book of Gopi, there was a balance of ` 44,50,000 in his bank on 30th June, 2017.
On investigation you find that :
(i) Cheques amounting to ` 6,00,000 issued to creditors have not been presented for payment till the
date.
(ii) Cheques paid into bank amounting to ` 11,05,000 out of which cheques amounting to ` 5,50,000
only collected by the bank up to 30th June 2017.
(iii) A dividend of ` 40,000 and rent amounting to ` 6,00,000 received by the bank and entered in the
pass-book but not recorded in the cash book.
(iv) Insurance premium (up to 31st December, 2017) paid by the bank ` 27,000 not entered in the cash
book.
(v) The payment side of the cash book had been under casted by ` 5,000.
(vi) Bank charges ` 1,500 shown in the pass book had not been entered in the cash book.
(vii) A bill payable of ` 2,00,000 had been paid by the bank but was not entered in the cash book and
bill receivable for ` 60,000 had been discounted with the bank at a cost of ` 1,000 which had also
not been recorded in cash book.
Required:
(a) to make the appropriate adjustments in the cash book, and
(b) to prepare a statement reconciling it with the bank pass book.

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Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.31

Q3. Prepare a bank reconciliation statement as on 30th September, 2017 from the following particulars:
Particulars `
Bank balance as per pass-book 10,00,000
Cheque deposited into the bank, but no entry was passed in the cash-book 5,00,000
Cheque received, but not sent to bank 11,20,000
Credit side of the bank column cast short 2,000
Insurance premium paid directly by the bank under the standing advice 60,000
Bank charges entered twice in the cash book 2,000
Cheque issued, but not presented to the bank for payment 5,00,000
Cheque received entered twice in the cash book 10,000
Bills discounted dishonoured not recorded in the cash book. 5,00,000
Q4. Prepare a bank reconciliation statement from the following particulars on 31st March, 2017:
Particulars `
Debit balance as per bank column of the cash book 37,20,000
Cheque issued to creditors but not yet presented to the bank for payment 7,20,000
Dividend received by the bank but not yet entered in the cash book 5,00,000
Interest allowed by the bank 12,500
Cheques deposited into bank for collection but not collected by bank up to this date. 15,40,000
Bank charges 2,000
A cheque deposited into bank was dishonoured, but no intimation received 3,20,000
Bank paid house tax on our behalf, but no information received from bank in this 3,50,000
connection.
ANSWERS/HINTS
MCQs
1. (a) 2. (b) 3. (b) 4. (a) 5. (c) 6. (a) 7. (b)
Theoretical Questions
1. Bank reconciliation statement is prepared as on a particular date to reconcile and explain the causes
of difference between the bank balance as per cash book and the same as per savings bank pass book
or current account statement. At the end of each month, the bank balance as per cash book and that
as per pass book /bank statement should be compared and, if there is disagreement, these balances
should be reconciled stating exact reasons of disagreement. The reconciliation is made in a statement
called the bank reconciliation statement.
2. The difference between the balance shown by the passbook and the cashbook may arise on account of
the following:
(i) Cheques issued but not yet presented for payment.
(ii) Cheques deposited into the bank but not yet cleared.
(iii) Interest allowed by the bank.
(iv) Interest and expenses charged by the bank.

© The Institute of Chartered Accountants of India

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 3.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

(v) Interest and dividends collected by the bank.

(vi) Direct payments by the bank.
(vii) Direct deposits into the bank by a customer.
(viii) Dishonour of a bill discounted with the bank.
(ix) Bills collected by the bank on behalf of the customer.
(x) An error committed by the bank etc.

Practical Questions
Answer 1
Bank Reconciliation Statement
as on 31st December, 2017

` `
Bank balance (Dr.) as per cash book 60,000
Add: Cheques issued but not yet presented for payment 11,00,000
Cheques directly deposited by a customer not yet recorded in cash 5,00,000 16,00,000
book
16,60,000
Less: Cheques deposited but not yet credited by bank 11,40,000
Cheque received and recorded in cash book but not yet banked 5,00,000
Cheque dishonoured by the bank; the dishonour entry not yet passed 4,00,000
in cash book
Bank charges not recorded in cash book 2,000 (20,42,000)
Bank balance (Cr.) as per pass book (3,82,000)
Answer 2
Cash Book (Bank Column)
Receipts ` Payments `
To Balance b/d 44,50,000 By Insurance premium A/c 27,000
To Dividend A/c 40,000 By Correction of errors 5,000
To Rent A/c 6,00,000 By Bank charges 1,500
To Bill receivable A/c 59,000 By Bill payable 2,00,000
By Balance c/d 49,15,500
51,49,000 51,49,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 BANK RECONCILIATION STATEMENT 3.33

Bank Reconciliation Statement

as on 30th June, 2017
`
Adjusted balance as per cash book (Dr.) 49,15,500
Add: Cheques issued but not presented for payment till 30th June, 2017 6,00,000
Less: Cheques paid into bank for collection but not collected till 30th June, 2017 (5,55,000)
Balance as per pass book 49,60,500
Answer 3
Bank Reconciliation Statement as on 30th September, 2017
` `
Bank balance as per pass book 10,00,000
Add: Cheque received but not sent to the bank 11,20,000
Credit side of the bank column cast short 2,000
Insurance premium paid directly not recorded in the cash book 60,000
Cheque received entered twice in the cash book 10,000
Bills dishonoured not recorded in the cash book 5,00,000 16,92,000
26,92,000
Less: Cheque deposited into the bank but no entry was passed in the cash 5,00,000
book
Bank charges recorded twice in the cash book 2,000
Cheque issued but not presented to the bank 5,00,000 (10,02,000)
Bank balance as per cash book 16,90,000
Answer 4
Bank Reconciliation Statement
as on 31st March, 2017
` `
Debit balance as per cash book 37,20,000
Add: Cheque issued but not yet presented to bank for payment 7,20,000
Dividend received by bank not entered in cash book 5,00,000
Interest allowed by bank 12,500 12,32,500
49,52,500
Less: Cheques deposited into bank but not yet collected 15,40,000
Bank charges 2,000
A cheque deposited into bank was dishonoured 3,20,000
House tax paid by bank 3,50,000 (22,12,000)
Credit balance as per pass book 27,40,500

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 CHAPTER 4
INVENTORIES
LEARNING OUTCOMES
After studying this chapter, you will be able to:
w Understand the meaning of term 'Inventory'.
w Learn the technique of Specific identification method, FIFO, Average Price, Weighted Average Price
and Adjusted Selling Price methods of inventory valuation.
w Understand the methods of inventory record keeping and comprehend the intricacies relating to
Inventory taking.

Type of Inventory
CHAPTER
OVERVIEW
In case of
Manufacturing In case of Trading
concerns concerns

Raw Work-in- Finished Stores and Packing Traded goods

Materials progress goods Spares Material

Formulae for Determining Cost of Inventory

Inventory Valuation
Techniques

Historical cost Non-historical cost

methods methods

Inventory, Inventory
not ordinarily ordinarily Adjusted Selling
interchangeable interchangeable Price

Specific Historical cost

identification
methods
method

Weighted
FIFO LIFO Average Price

© The Institute of Chartered Accountants of India

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 4.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

Basis of Inventory Valuation

Cost Net realisation

value

Whichever is
less

1. MEANING
Inventory can be defined as assets held
w for sale in the ordinary course of business, or
w in the process of production for such sale, or
w for consumption in the production of goods or services for sale, including maintenance supplies and
consumables other than machinery spares, servicing equipment and standby equipment.
There can be different types of inventory based on nature of business of an enterprise. The inventories of
a trading concern consist primarily of products purchased for resale in their existing form. It may also have
an inventory of supplies such as wrapping paper, cartons, and stationery. The inventories of manufacturing
concern consist of several types of inventories: raw material (which will become part of the goods to
be produced), work-in-process (partially completed products in the factory) and finished products. In
manufacturing concerns inventories will also include maintenance supplies, consumables, loose tools and
spare parts. However, inventories do not include spare parts, servicing equipment and standby equipment
which can be used only in connection with an item of fixed asset and whose use is expected to be irregular;
such machinery spares are generally accounted for as fixed assets. Similarly, in an enterprise engaged in
construction business, projects under construction are also considered as inventory.

At the year-end every business entity needs to ascertain the closing balance of Inventory which comprise
of Inventory of raw material, work-in-progress, finished goods and other consumable items. Value of closing
Inventory is put at the credit side of the Trading Account and asset side of the Balance Sheet. So before
preparation of final accounts, the accountant should know the value of Inventory of the business entity.
However, we shall restrict our discussion on inventory valuation of a manufacturing concern and goods of
a trading concern.

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 INVENTORIES 4.3

2. INVENTORY VALUATION
A primary issue in accounting for inventories is the determination of the value at which inventories are
carried in the financial statements until the related revenues are recognized. Inventory is generally the
most significant component of the current assets held by a trading or manufacturing enterprise. It is widely
recognized that inventory is one of the major assets that affects efficiency of operations. Both excess of
inventory and its shortage affects the production activity, and the profitability of the enterprise whether
it is a manufacturing or a trading business. Proper valuation of inventory has a very significant bearing on
the authenticity of the financial statements. The significance of inventory valuation arises due to various
reasons as explained in the following points:

(i) Determination of Income

The valuation of inventory is necessary for determining the true income earned by a business entity
during a particular period. To determine gross profit, cost of goods sold is matched with revenue of the
accounting period. Cost of goods sold is calculated as follows:
Cost of goods sold = Opening inventory + Purchases + Direct expenses - Closing inventory.
Inventory valuation will have a major impact on the income determination if merchandise cost is large
fraction of sales price. The effect of any over or under statement of inventory may be explained as:
(a) When closing inventory is overstated, net income for the accounting period will be overstated.
(b) When opening inventory is overstated, net income for the accounting period will be understated.
(c) When closing inventory is understated, net income for the accounting period will be understated.
(d) When opening inventory is understated, net income for the accounting period will be overstated.
The effect of misstatement of inventory figure on the net income is always through cost of goods sold.
Thus, proper calculation of cost of goods sold and for that matter, proper valuation of inventory is
necessary for determination of correct income.
(ii) Ascertainment of Financial Position
Inventories are classified as current assets. The value of inventory on the date of balance sheet is
required to determine the financial position of the business. In case the inventory is not properly valued,
the balance sheet will not disclose the truthful financial position of the business.
(iii) Liquidity Analysis
Inventory is classified as a current asset, it is one of the components of net working capital which reveals
the liquidity position of the business. Current ratio which studies the relationship between current
assets and current liabilities is significantly affected by the value of inventory.
(iv) Statutory Compliance
Schedule III to the Companies Act, 2013 requires valuation of each class of goods i.e. raw material,
work-in-progress and finished goods under broad head to be disclosed in the financial statements. As
per the requirements of the Accounting Standards, the financial statements should disclose:
(a) the accounting policies adopted in measuring inventories, including the cost formula used, and
(b) the total carrying amount of inventories and its classification appropriate to the enterprise.

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 4.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

The common classification of inventories are raw materials; work-in-progress; finished goods; stores-in-
trade (in respect of goods acquired for trading) and spares and loose tools.

3. BASIS OF INVENTORY VALUATION

Inventories should be generally valued at the lower of cost or net realizable value. This principle is
governed by ‘Principle of Conservative Accounting’ under which any expenses or losses from transactions
entered or event occurred are to be recognized immediately, however, any gains or profits are recognized
until its becomes due or are actually realized. Under the principle of ‘lower of cost or net realizable value’
any loss due to decrease in sales price of the inventory below its cost is recognized immediately as it is
anticipated that the enterprise will make losses whenever it will sell.
Cost: As per Accounting Standards, Cost of inventories should comprise
1. all cost of purchase,
2. costs of conversion (primarily for finished goods and work - in progress) and
3. other costs incurred in bringing the inventories to their present location and condition.

Cost of purchase consist of 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 the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted
in determining costs of purchase. In other words, cost includes any amount paid to the seller reduced by
any discounts/rebates given by the seller. Similarly, any duties paid to the supplier will be part of cost of the
inventory unless the enterprises can recover these taxes duties from the authorities.

Costs of conversion of inventories include costs directly related to the units of production, such as direct
labour. They also include a systematic allocation of fixed and variable overheads.
Other Costs may include administrative overheads incurred to bring the inventory into present location
and condition or any cost specifically incurred on inventory of a specified customer. Interest and other
borrowing costs are generally not included in the cost of inventory. However, in some circumstances where
production process is longer and it is required to carry inventory for a long period e.g. wine, rice and timber
it may be appropriate to consider interest and other borrowing cost also part of cost of inventory.
Exclusions from cost of inventories: Following expenses are generally not included in the costs of
inventories:
(a) abnormal amounts of wasted materials, labour or other production overheads;
(b) storage costs, unless those costs are necessary in the production process prior to further production
stage;
(c) administrative overheads that do not contribute to bringing the inventories to their present location
and condition; and
(d) selling and distribution costs
Net realizable value: This is the estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale. In case of finished goods and
traded goods Net realizable value will generally mean selling price which reduced by selling and distribution
expenses. In case of work in progress, expenses and overheads required to be incurred to convert work -In
progress into finished goods and making it ready for sale will also be reduced from selling price. In case of
raw materials, replacement cost is generally considered as net realizable value.

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 INVENTORIES 4.5

An assessment is made of as at each balance sheet date. Inventories are usually written down to net realizable
value on an item-by-item basis. In some circumstances, however, it may be appropriate to group similar or
related items e.g. in case of interchangeable items it may not be possible to identify cost and net realizable
value of each item separately.

4. INVENTORY RECORD SYSTEMS

There are two principal systems of determining the physical quantities and monetary value of inventories sold
and in hand. One system is known as ‘ Periodic Inventory System’ and the other as the ‘Perpetual Inventory
System’. The periodic system is less expensive to use than the perpetual method. But the useful information
obtained from perpetual system is more than cost incurred on it. These systems are distinguished on the
basis of the actual records kept to ascertain the cost of goods sold and the closing inventory valuations.

4.1 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 inventory is valued.
It is because of actual physical count that the system is also called physical inventory system. The cost of
goods sold is determined as shown below:
Opening inventory (known) + Purchases (known) - closing inventory (physically counted) = Cost of goods
sold.
Periodic inventory system is simple and less expensive than the perpetual system. In this system, inventory
account is adjusted at the end of the accounting period to determine cost of goods sold. This system suffers
from various limitations:
(i) Physical inventory taking is required more than once a year for preparation of quarterly or half yearly
financial statements thereby making this system more expensive.
(ii) Physical count of goods requires closure of normal operations of business.
(iii) As cost of goods sold is taken as residual figure, it is not possible to identify loss of goods due to
pilferage, damage or even fraud.
(iv) Inventory control is not possible under this system.
(v) Books of accounts does not reflect inventory in hand and its value therefore, it is difficult to plan
operations e.g. how much or when to order/manufacture.
This system is used by small enterprises where is easy to control physical inventory. This system is not
considered suitable for medium or larger enterprises which generally use Perpetual Inventory system.

4.2 PERPETUAL INVENTORY SYSTEM

Perpetual inventory system is a system of recording inventory balances after each receipt and issue. In
order to ensure accuracy of perpetual inventory records, physical inventory should be checked and compared
with recorded balances. Under this system, cost of goods issued is directly determined and inventory of
goods is taken as residual figure with the help of inventory ledger in which flow of goods is recorded on
continuous basis. The basic feature of this system is the maintenance of inventory ledger to have records of
goods on continuous basis. Under perpetual inventory system, closing inventory is determined as follows:

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 4.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

Opening inventory (known) + Purchases during the period (known) – Cost of Goods Sold (known) = Closing
Inventory (balancing figure)
Perpetual inventory system helps to overcome the limitations of periodic system. As inventory is taken as
residual figure, it includes loss of goods. However, the main limiting factor is the cost of using this system.

4.3 DISTINCTION BETWEEN PERIODIC INVENTORY SYSTEM AND PERPETUAL INVENTORY

SYSTEM
Both the systems - Periodic Inventory System and Perpetual Inventory System are not mutually exclusive
and complementary in nature. Distinction between both the systems can be explained as follows:

S. No. Periodic Inventory System Perpetual Inventory System

1. This system is based on physical verification. It is based on book records.
2. This system provides information about It provides continuous information about
inventory and cost of goods sold at a particular inventory and cost of sales.
date.
3. This system determines inventory and takes cost It directly determines cost of goods sold and
of goods sold as residual figure. computes inventory as balancing figure.
4. Cost of goods sold includes loss of goods as Closing inventory includes loss of goods as all
goods not in inventory are assumed to be sold. unsold goods are assumed to be in Inventory.
5. Under this method, inventory control is not Inventory control can be exercised under this
possible. system.
6. This system is simple and less expensive. It is costlier method.
7. Periodic system requires closure of business for Inventory can be determined without affecting
counting of inventory. the operations of the business.

5. FORMULAE/METHODS TO DETERMINE COST OF INVENTORY

5.1 HISTORICAL COST METHODS
There is no unique formula for determination of historical cost of inventories. The different techniques for
valuation of inventory have been discussed below:

(i) Specific Identification Method

Pricing under this method is based on actual physical flow of goods. It attributes specific costs to identified
goods and requires keeping different lots purchased separately to identify the lot out of which units in
inventories are left. The historical costs of such specific purpose inventories may be determined on the basis
of their specific purchase price or production cost.
This method is generally used to ascertain the cost of inventories of items that are not ordinarily
interchangeable and their value is high like expensive medical equipments, otherwise it requires the use of
FIFO (First in first out) or weighted average price/average price formula.

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 INVENTORIES 4.7

(ii) FIFO (First in first out) Method

This method is based on the assumption that cost should be charged to revenue in the order in which
they are incurred, that is, it is assumed that the issue of goods is usually from the earliest lot on hand. The
inventory of goods on hand therefore, consists of the latest consignments. Thus, the closing inventory is
valued at the price paid for such consignments.
The FIFO formula assumes that the items of inventories which were purchased or produced first are
consumed or sold first and consequently items remaining in the inventory at the end of the period are
those most recently purchased or produced. This assumption is in line with the good business practice
to disposing goods in the order of their acquisition especially in the case of perishable goods and items
with frequent technological changes. It must be kept in mind that this assumption of cost flow or goods
flow need not be true as a physical fact i.e. not necessary goods are physically also sold or issued in the
chronological order of their purchase or production. It relates only to the method of accounting and not to
the actual physical movement of goods.
Now, let us take an example to understand the application of FIFO method.

? ILLUSTRATION 1

A manufacturer has the following record of purchases of a condenser, which he uses while manufacturing radio
sets:

Date Quantity (units) Price per unit

Dec. 4 900 50
Dec. 10 400 55
Dec. 11 300 55
Dec. 19 200 60
Dec. 28 800 47
2,600
1,600 units were issued during the month of December till 18th December.

 SOLUTION
The closing inventory is 1,000 units and would consist of:
800 units received on 28th December; and
200 units received on 19th December as per FIFO

`
The value of 800 units @ ` 47 37,600
The value of 200 units @ ` 60 12,000
Total 49,600

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 4.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

(iii) LIFO (Last in first out) Method

As the name suggests, the LIFO formula assigns to cost of goods sold, the cost of goods that have been
purchased last though the actual issues may be made out of the earliest lot on hand to prevent unnecessary
deterioration in value. The closing inventory then is assumed to consist of earlier consignments and its value
is then calculated according to such consignments. Under this basis, goods issued are valued at the price
paid for the latest lot of goods on hand which means inventory of goods in hand is valued at price paid
for the earlier lot of goods. In the absence of details of issue, the price paid for the earliest consignments
is used for valuing closing inventory. LIFO method is based on the principle of matching current cost with
current revenue as cost of recently purchased or produced goods are charged to cost against each sale. The
cost of goods sold under this method represents the cost of recent purchases resulting that there is better
matching of current costs with current sales.

? ILLUSTRATION 2
In the previous example assume that following issues were made during the month of December:
Record of issues

Date Quantity (units)

Dec. 5 500
Dec. 20 600
Dec. 29 500
Total 1,600

Using LIFO method, following will be stock ledger:

Date Receipts Issues Balance inventory

Dec. Qty. Rate Amount Qty Rate Amount Qty. Rate Amount
4 900 50 45,000 - - - 900 50 45,000
5 - - - 500 50 25,000 400 50 20,000
10 400 55 22,000 - - - 400 50 20,000
400 55 22,000
11 300 55 16,500 - - - 400 50 20,000
400 55 22,000
300 55 16,500
19 200 60 12,000 - - - 400 50 20,000
400 55 22,000
300 55 16,500
200 60 12,000
20 - - - 200 60 12,000
- - - 300 55 16,500
- - - 100 55 5,500 400 50 20,000

© The Institute of Chartered Accountants of India

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 INVENTORIES 4.9

300 55 16,500
28 800 47 37,600 - - - 400 50 20,000
300 55 16,500
28 800 47 37,600
29 - - - 500 47 23,500 400 50 20,000
300 55 16,500
300 47 14,100

Therefore, cost of closing inventory of 1,000 pcs will be ` 50,600.

LIFO method is based on an irrational assumption that inventories entering last in the stores are issued or
consumed first. However, the flow of goods which is generally observed in business entities is contradictory
to this assumption. It should be noted that while applying LIFO, there will be difference in cost of goods
sold and value of closing inventory, if the entity follows periodic as against perpetual method of inventory
valuation. Therefore, LIFO method is no longer adopted for valuing inventories. Accounting Standards
also does not permit the usage of LIFO Method. Generally, in practice, FIFO and Weighted Average Price
Method are popular among the business entities and both these methods are also permitted by Accounting
Standards.
Computation under periodic inventory system

In the above example, if the entity followed periodic inventory valuation, closing inventory of 1,000 pcs. will
be valued as follows:
800 pcs. @ ` 47 each (purchased on Dec. 28th) = ` 37,600
200 pcs. @ ` 60 each (purchased on Dec. 19th) = ` 12,000
Total 1,000 pcs. = ` 49,600

We can see that cost of closing inventory has changed following LIFO method based on perpetual inventory
method and periodic inventory method.
(iv) Simple Average Price Method
Simple Average price for computing value of inventory is a very simple approach. All the different prices are
added together and then divided by the number of prices. The closing inventory is then valued according
to the price ascertained. This method is generally followed by the entities using periodic inventory method
as it does not require efforts of identifying that closing inventory belongs to which consignments or lots.

? ILLUSTRATION 3
In the same example of a manufacturer of radio sets given earlier, let us calculate the value of closing inventory
using Average Price Method:

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 4.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
The simple average in this question is:

[(50 + 55 + 55 + 60 + 47)/5] = 267/5 = ` 53.4

1,000 units valued at ` 53.4 would be ` 53,400
Let us try to analyze the impact of FIFO, LIFO and Simple Average Price Method with the help of the following
chart:

Units Received Units issued

10 Jan - 500 units at ` 50
th
th
20 Jan - 500 units
15 Jan - 500 units at ` 60

FIFO LIFO Simple Average Method

500 units at ` 60 500 units at ` 50 500 units at ` 55

= ` 30,000 = ` 25,000 = ` 27,500

Thus we see that value of inventories changes based on different cost formula used.
(v) Weighted Average Price Method
Simple average price does not consider quantities purchased in various lots. However, it is more logical
to compute weighted average price using the quantities purchased in a lot as weights. Under weighted
average price method, cost of goods available for sale during the period is aggregated and then divided by
number of units available for sale during the period to calculate weighted average price per unit. Thus

Weighted average price per unit =

Closing inventory = No. of units in inventory × Weighted average price per unit
Cost of goods sold = No. of units sold × Weighted average price per unit.

? ILLUSTRATION 4
On the basis of the data given in illustration 1 and 2, calculate the weighted average price and also the value of
closing inventory by weighted average price method.

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 INVENTORIES 4.11

 SOLUTION
The computation of weighted average price in the referred example is shown below:
A new average rate would be calculated on receiving a fresh consignment. Answer on that basis would be
as under:

Date Receipts Issues Balance inventory

Qty Rate Amount Qty Rate Amount Qty Rate Amount
Dec. 4 900 50 45,000 - - - 900 50 45,000
Dec. 5 - - - 500 50 25,000 400 50 20,000
Dec. 10 400 55 22,000 - - - 800 52.5 42,000
Dec. 11 300 55 16,500 - - - 1,100 53.18 58,500
Dec. 19 200 60 12,000 - - - 1,300 54.23 70,500
Dec. 20 - - - 600 54.23 32,538 700 54.23 37,962
Dec. 28 800 47 37,600 - - - 1,500 50.37 75,562
Dec. 29 - - - 500 50.37 25,185 1,000 50.37 50,377

Perpetual and Periodic Inventory System and Average Methods of Cost of Inventory

Both Simple Average Method and Weighted Average Method are applied differently in case the entity uses
periodic inventory taking or Perpetual inventory taking. In case of periodic inventory taking inventory
available for sale during the period is considered together and an average rate is computed and closing
inventory is valued using that rate. In case perpetual inventory records are maintained average rate of
inventory is computed on each new purchase and next issue is recorded using new average rate.
Illustration 4 above is an example of Weighted average method used in perpetual inventory recording
system. In case the entity would have been using periodic inventory recording system, closing inventory
would have been valued as below:

Details of purchases/receipt during the period

Date Qty. Rate Value

Dec. 4 900 50 45,000
Dec. 10 400 55 22,000
Dec. 11 300 55 16,500
Dec. 19 200 60 12,000
Dec. 28 800 47 37,600
Total 2,600 51.19 133,100

Accordingly, closing stock of 1,000 pcs. would have been valued at 51,190 @ ` 51.19 per unit.

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 4.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.2 NON-HISTORICAL COST METHODS

Non-historical cost methods do not consider the historical cost incurred to acquire the goods. Non- historical
cost methods include Adjusted Selling Price method and Standard Cost method. Adjusted Selling Price
method can be explained as follows:
(i) Adjusted selling price method
This method is also called retail inventory method. It is used widely in retail business or in business where
the inventory comprises of items, the individual costs of which are not readily ascertainable. The use of this
method is appropriate for measuring inventories of large numbers of rapidly changing items that have
similar margins and for which it is impracticable to use other costing methods. The cost of the inventory is
determined by reducing from the sales value of the inventory an appropriate percentage of gross margin.
The percentage used takes into consideration inventory which has been marked below its original selling
price. An average percentage for each retail department is often used. The calculation of the estimated
gross margin of profit may be made for individual items or groups of items or by departments, as may be
appropriate to the circumstances.

? ILLUSTRATION 5

M/s X, Y and Z are in retail business, following information are obtained from their records for the year
ended 31st March, 2016:

Goods received from suppliers

(subject to trade discount and taxes) ` 15,75,500
Trade discount 3% and sales tax 11%
Packaging and transportation charges ` 87,500
Sales during the year ` 22,45,500
Sales price of closing inventories ` 2,35,000

Find out the historical cost of inventories using adjusted selling price method.

 SOLUTION

Determination of cost of purchases:

Goods received from suppliers ` 15,75,500

Less: Trade discount 3% ` (47,265)

15,28,235
Add: Sales Tax 11% ` 1,68,106

` 16,96,341
Add: Packaging and transportation charges ` 87,500
` (17,83,841)

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 INVENTORIES 4.13

Determination of estimated gross profit margin:

Sales during the year ` 22,45,500

Closing inventory at the selling price ` 2,35,000
24,80,500
Less: Purchases (` 17,83,841)
Gross profit ` 6,96,659
Gross profit margin 28.09%

Inventory valuation:

Selling price of closing inventories ` 2,35,000

Less: Gross profit margin 28.09% ` (66,012)

` 1,68,988

? ILLUSTRATION 6

From the following information, calculate the historical cost of inventories using adjusted selling price method:
`
Sales during the year 2,00,000
Cost of purchases 2,00,000
Opening inventory Nil
Closing inventory at selling price 50,000

 SOLUTION

Calculation of gross margin of profit:

`
Sales 2,00,000
Add: Closing inventory (at selling price) 50,000
Selling price of goods available for sale: 2,50,000
Less: Cost of goods available for sale 2,00,000
Gross margin 50,000
50,000
Rate of gross margin = × 100 = 20%
2,50,000

Cost of closing inventory = 50,000 less 20% of ` 50,000 = ` 40,000

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 4.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

(ii) Standard cost method - This method is used when there is frequent change in the price per unit of
the goods and goods are purchased frequently by the business e.g. crude oil. Based on the experience
a standard cost is determined on the basis of frequent changes in prices and inventory is valued on that
price per unit.

6. INVENTORIES TAKING
Normally all operations are suspended for one or two days during the financial year and physical
inventory is taken for everything in the godown or the store periodically. For the year-end inventory
valuation, physical inventory taking is done during the last week of the financial year or during the first
week of next financial year. If inventory taking is finished on 26th March, whereas accounting year ends
on 31st March purchases and sales between 26th and 31st March are then separately adjusted. Later,
a value is put on each item. The principle of cost or Net realizable value, whichever is lower, is applied
either for the inventory as a whole or item by item.

Normally, enterprises prefer to perform inventory taking closing day, however, sometimes inventory
taking cannot be carried out on the closing day. It is carried out a few days later or sometimes even a
few days earlier. In such a case, the actual value of the inventory must be so adjusted as to relate it to
the end of the year concerned. For doing so, it will be necessary to take into account the goods that
have come in (purchases and sales returns) and those that have gone out (sales and purchase returns)
during the interval between the close of the year and the date of actual inventory taking. Further, the
adjustment of all goods must be on the basis of cost. Suppose, a firm that closes its books on 31st
December, carried out the inventory taking on the 7th January next year and actual inventory was of
the cost of ` 7,85,000, during the period January 1 to 7 purchases were ` 1,53,000 and sales ` 2,50,000,
the mark up being 25% on cost. The inventory on 31st December would be ` 8,32,000 as shown below:

`
Inventory ascertained on January 7 7,85,000
Less: Purchases during the period Jan. 1 to 7 1,53,000
6,32,000
Add: Cost of goods sold during the period:
2,50,000 × (100/125) 2,00,000
8,32,000

? ILLUSTRATION 7

From the following particulars ascertain the value of Inventories as on 31st March, 2017:
`
Inventory as on 1.4.2016 1,42,500
Purchases 7,62,500
Manufacturing Expenses 1,50,000
Selling Expenses 60,500
Administrative Expenses 30,000
Financial Charges 21,500
Sales 12,45,000

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 INVENTORIES 4.15

At the time of valuing inventory as on 31st March, 2016, a sum of ` 17,500 was written off on a particular
item, which was originally purchased for ` 50,000 and was sold during the year for ` 45,000. Barring the
transaction relating to this item, the gross profit earned during the year was 20 percent on sales.

 SOLUTION

Statement of Inventory in trade as on 31st March, 2017

` `
Inventory as on 31st March, 2016 1,42,500
Less: Book value of abnormal inventory
(` 50,000 - ` 17,500) 32,500 1,10,000
Add: Purchases 7,62,500
Manufacturing Expenses 1,50,000
10,22,500
Less: Cost of goods sold:
Sales as per books 12,45,000
Less: Sales of abnormal item 45,000
12,00,000
Less: Gross Profit @ 20% 2,40,000 9,60,000
Inventory in trade as on 31st March, 2017 62,500

? ILLUSTRATION 8

A trader prepared his accounts on 31st March, each year. Due to some unavoidable reasons, no inventory
taking could be possible till 15th April, 2017 on which date the total cost of goods in his godown came to
` 5,00,000. The following facts were established between 31st March and 15th April, 2017.

(i) Sales ` 4,10,000 (including cash sales ` 1,00,000)

(ii) Purchases ` 50,340 (including cash purchases ` 19,900)

(iii) Sales Return ` 10,000.

Goods are sold by the trader at a profit of 20% on sales.

You are required to ascertain the value of inventory as on 31st March, 2017.

© The Institute of Chartered Accountants of India

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 4.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Statement of valuation of Inventory on 31st March, 2017

` `
Value of Inventory as on 15th April, 2017 5,00,000
Add: Cost of goods sold during the period between
31st March, 2017 to 15th April, 2017
Sales (` 4,10,000 - ` 10,000) 4,00,000
Less: Gross Profit (20% of ` 4,00,000) 80,000 3,20,000
8,20,000
Less: Purchases during the period from
31st March, 2017 to 15th April, 2017 50,340
7,69,660

? ILLUSTRATION 9
Inventory taking for the year ended 31st March, 2016 was completed by 10th April 2016, the valuation of
which showed a inventory figure of ` 16,75,000 at cost as on the completion date. After the end of the
accounting year and till the date of completion of inventory taking, sales for the next year were made for
` 68,750, profit margin being 33.33 percent on cost. Purchases for the next year included in the inventory
amounted to ` 90,000 at cost less trade discount 10 percent. During this period, goods were added to
inventory at the mark up price of ` 3,000 in respect of sales returns. After inventory taking it was found that
there were certain very old slow moving items costing ` 11,250, which should be taken at ` 5,250 to ensure
disposal to an interested customer. Due to heavy flood, certain goods costing ` 15,500 were received from
the supplier beyond the delivery date of customer. As a result, the customer refused to take delivery and net
realizable value of the goods was estimated to be ` 12,500 on 31st March. Compute the value of inventory
for inclusion in the final accounts for the year ended 30th March, 2016.

 SOLUTION

Statement showing the valuation of Inventory

as on 31st March, 2016
`
Value of Inventory as on 10th April 16,75,000
Add: Cost of goods sold after 31st March till Inventory taking 51,560
( ` 68,750 - ` 17,190)
Less: Purchases for the next period (net) (81,000)
Less: Cost of Sales Returns (2,250)
Less: Loss on revaluation of slow moving inventories (6,000)
Less: Reduction in value on account of default (3,000)
Value of Inventory on March 31 16,34,310
Note: Profit margin of 33.33 percent on cost means 25 percent on sales price.

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 INVENTORIES 4.17

? ILLUSTRATION 10

The following are the details of a spare part of Sriram mills:

1-1-2016 Opening Inventory Nil

1-1-2016 Purchases 100 units @ ` 30 per unit
15-1-2016 Issued for consumption 50 units
1-2-2016 Purchases 200 units @ ` 40 per unit
15-2-2016 Issued for consumption 100 units
20-2-2016 Issued for consumption 100 units

Find out the value of Inventory as on 31-3-2016 if the company follows First in first out basis.

 SOLUTION

First-in-First out basis

Sriram Mills
Calculation of the value of Inventory as on 31-3-2016

Receipts Issues Balance

Date Units Rate Amount Units Rate Amount Units Rate Amount
` ` ` ` ` `
1-1-2016 Balance Nil
1-1-2016 100 30 3,000 100 30 3,000
15-1-2016 50 30 1,500 50 30 1,500
1-2-2016 200 40 8,000 50 30 1,500
200 40 8,000
15-2-2016 50 30 1,500
50 40 2,000 150 40 6,000
20-2-2016 100 40 4,000 50 40 2,000

Therefore, the value of Inventory as on 31-3-2016: 50 units @ ` 40 = ` 2,000

? ILLUSTRATION 11

The following are the details of a spare part of Sriram Mills:

1-1-2016 Opening Inventory Nil

1-1-2016 Purchases 100 units @ ` 30 per unit
15-1-2016 Issued for consumption 50 units
1-2-2016 Purchases 200 units @ ` 40 per unit

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 4.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

15-2-2016 Issued for consumption 100 units

20-2-2016 Issued for consumption 100 units

Find out the value of Inventory as on 31-3-2016 if the company follows Weighted Average basis.

 SOLUTION

Weighted Average basis

Sriram Mills
Calculation of the value of Inventory as on 31-3-2016

Receipts Issues Balance

Date Units Rate Amount Units Rate Amount Units Rate Amount
` ` ` ` ` `
1-1-2016 Balance Nil
1-1-2016 100 30 3,000 100 30 3,000
15-1-2016 50 30 1,500 50 30 1,500
1-2-2016 200 40 8,000 250 38 9,500
15-2-2016 100 38 3,800 150 38 5,700
20-2-2016 100 38 3,800 50 38 1,900

Therefore, the value of Inventory as on 31-3-2016= 50 units @ ` 38 = ` 1,900

SUMMARY
• Inventory can be defined as assets held for sale in the ordinary course of business, or in the process of
production for such sale, or for consumption in the production of goods or services for sale, including
maintenance supplies and consumables other than machinery spares.
• The inventories of manufacturing concern consist of several types of inventories: raw material (which
will become part of the goods to be produced), parts and factory supplies, work-in-process (partially
completed products in the factory) and, of course, finished products.
• Proper valuation of inventory has a very significant bearing on the authenticity of the financial
statements.
• Cost of goods sold is calculated as follows:
Cost of goods sold = Opening Inventory + Purchases + Direct expenses - Closing Inventory.
• Inventories should be generally valued at the lower of cost or net realizable value.
• Inventory Valuation Techniques:

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 INVENTORIES 4.19

Historical Cost Methods

ü Specific Identification Method
ü FIFO (First in first out) Method
ü LIFO (Last in first out) Method
ü Average Price Method
ü Weighted Average Price Method

Non-Historical Cost Methods

ü Adjusted selling price method
ü Standard cost method
There are two principal systems of determining the physical quantities and monetary value of inventories
sold and in hand. One system is known as ‘Periodic Inventory System’ and the other as the ‘Perpetual
Inventory System’.

TEST YOUR KNOWLEDGE

MCQs
1. The amount of purchase if
Cost of goods sold is ` 80,700
Opening Inventory ` 5,800
Closing Inventory ` 6,000
(a) ` 80,500 (b) ` 74,900 (c) ` 80,900.
2. Average Inventory = ` 12,000. Closing Inventory is ` 3,000 more than opening Inventory. The value
of closing Inventory = ______.
(a) ` 12,000 (b) ` 24,000 (c) ` 13,500.
3. While finalizing the current year’s profit, the company realized that there was an error in the valuation
of closing Inventory of the previous year. In the previous year, closing Inventory was valued more by
` 50,000. As a result
(a) Previous year’s profit is overstated and current year’s profit is also overstated
(b) Previous year’s profit is overstated and current year’s profit is understated
(c) Previous year’s profit is understated and current year’s profit is also understated
4. Consider the following for Q Co. for the year 2015-16:
Cost of goods available for sale ` 1,00,000
Total sales ` 80,000
Opening inventory of goods ` 20,000

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 4.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

Gross profit margin on sales 25%

Closing inventory of goods for the year 2015-16 as

(a) ` 80,000 (b) ` 60,000 (c) ` 40,000

5. Average Inventory = ` 12,000. Closing Inventory is ` 3,000 more than opening Inventory. The value of
closing Inventory = ______.
(a) ` 12,000 (b) ` 24,000 (c) ` 13,500
6. If the profit is 25% of the cost price then it is
(a) 25% of the sales price
(b) 33% of the sales price
(c) 20% of the sales price
7. Goods purchased ` 1,00,000. Sales ` 90,000. Margin 20% on cost. Closing Inventory = ?
(a) ` 20,000 (b) ` 10,000 (c) ` 25,000
8. A company is following weighted average cost method for valuing its inventory. The details of its
purchase and issue of raw-materials during the week are as follows:
1.12.2015 opening Inventory 50 units value ` 2,200.
2.12.2015 purchased 100 units @ `47.
4.12.2015 issued 50 units.
5.12.2015 purchased 200 units @ ` 48.
The value of inventory at the end of the week and the unit weighted average costs is
(a) ` 14,200 – ` 47.33 (b) ` 14,300 – ` 47.67 (c) ` 14,000 – ` 46.66
9. The cost of sales is equal to
(a) Opening stock plus purchases
(b) Purchases minus Closing stock
(c) Opening stock plus purchases minus closing stock
10. Inventory is disclosed in financial statements under:
(a) Fixed Assets
(b) Current Assets
(c) Current Liabilities
11. Accounting Standards do not permit following method of inventory valuation
(a) FIFO
(b) Average cost
(c) LIFO

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 INVENTORIES 4.21

12. Which inventory costing formula calculates value of closing inventory considering that inventory most
recently purchased has not been sold?
(a) FIFO
(b) LIFO
(c) Weighted average cost
13. Valuing inventory at cost or net releasable value is based on which principle
(a) Consistency (b) Conservatism
(c) Going concern
14. Under inflationary trend, which of the methods will show highest value of inventory?
(a) FIFO
(b) Weighted average
(c) LIFO
15. Which of the following methods does not consider historical cost of inventory?
(a) Weighted average
(b) FIFO
(c) Retail price method
Theory Questions
1. Write short notes on:
(i) Adjusted Selling Price method of determining cost of stock.
(ii) Principal methods of ascertainment of cost of inventory.
2. Distinguish between:
(i) LIFO and FIFO basis of costing of stock.
(ii) FIFO and weighted average price method of stock costing.
3. Define inventory. Explain the importance of proper valuation of inventory in the preparation of statements
of the business entity.
Practical Questions
1. X who was closing his books on 31.3.2016 failed to take the actual stock which he did only on 9th
April, 2016, when it was ascertained by him to be worth ` 2,50,000.
It was found that sales are entered in the sales book on the same day of dispatch and return
inwards in the returns book as and when the goods are received back. Purchases are entered in the
purchases day book once the invoices are received.
It was found that sales between 31.3.2016 and 9.4.2016 as per the sales day book are ` 17,200.
Purchases between 31.3.2016 and 9.4.2016 as per purchases day book are ` 1,200, out of these
goods amounting to ` 500 were not received until after the stock was taken.

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 4.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

Goods invoiced during the month of March, 2016 but goods received only on 4th April, 2016
amounted to ` 1,000. Rate of gross profit is 33-1/3% on cost.
Ascertain the value of physical stock as on 31.3.2016.
2. From the following information, ascertain the value of stock as on 31.3.2017:

`
Value of stock on 1.4.2016 7,00,000
Purchases during the period from 1.4.2016 to 31.3.2017 34,60,000
Manufacturing expenses during the above period 7,00,000
Sales during the same period 52,20,000

At the time of valuing stock on 31.3.2016 a sum of ` 60,000 was written off a particular item which was
originally purchased for ` 2,00,000 and was sold for ` 1,60,000. But for the above transaction the gross
profit earned during the year was 25% on cost.
3. The Profit and loss account of Hanuman showed a net profit of ` 6,00,000, after considering the closing
stock of ` 3,75,000 on 31st March, 2016. Subsequently the following information was obtained from
scrutiny of the books:
(i) Purchases for the year included ` 15,000 paid for new electric fittings for the shop.
(ii) Hanuman gave away goods valued at ` 40,000 as free samples for which no entry was made in
the books of accounts.
(iii) Invoices for goods amounting to ` 2,50,000 have been entered on 27th March, 2016, but the
goods were not included in stock.
(iv) In March, 2016 goods of ` 2,00,000 sold and delivered were taken in the sales for April, 2016.
(v) Goods costing ` 75,000 were sent on sale or return in March, 2016 at a margin of profit of 33-1/3%
on cost. Though approval was given in April, 2016 these were taken as sales for March, 2016.
Calculate the value of stock on 31st March, 2016 and the adjusted net profit for the year ended on that
date.
4. Physical verification of stock in a business was done on 23rd June, 2016. The value of the stock was
` 48,00,000. The following transactions took place between 23rd June to 30th June, 2016:
(i) Out of the goods sent on consignment, goods at cost worth ` 2,40,000 were unsold.
(ii) Purchases of ` 4,00,000 were made out of which goods worth ` 1,60,000 were delivered on 5th
July, 2016.
(iii) Sales were ` 13,60,000, which include goods worth ` 3,20,000 sent on approval. Half of these
goods were returned before 30th June, 2016, but no information is available regarding the
remaining goods.
(iv) Goods are sold at cost plus 25%. However goods costing ` 2,40,000 had been sold for ` 1,20,000.
Determine the value of stock on 30th June, 2016.

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 INVENTORIES 4.23

5. From the following information ascertain the value of stock as on 31st March, 2016 and also the profit
for the year:
`
Stock as on 1.4.2015 1,42,500
Purchases 7,62,500
Manufacturing expenses 1,50,000
Selling expenses 60,500
Administrative expenses 30,000
Financial charges 21,500
Sales 12,45,000
At the time of valuing stock as on 31st March, 2015, a sum of ` 17,500 was written off on a particular
item, which was originally purchased for ` 50,000 and was sold during the year at ` 45,000. Barring the
transaction relating to this item, the gross profit earned during the year
ANSWERS / HINTS
MCQs

1. (c) 2. (c) 3. (b) 4. (c) 5. (c) 6 (c)

7. (c) 8. (a) 9. (c) 10. (b) 11. (c) 12. (a)
13. (b) 14. (a) 15. (c)

Theoretical Questions
1(i) Adjusted selling method is also called retails inventory method. It is used widely in retail business
or in business where the inventory comprises of items, the individual costs of which are not readily
ascertainable. The historical cost of inventory is estimated by calculating it in the first instance at selling
price and then deducting an amount equal to the estimated gross margin of profit on such stocks.
(ii) The specific identification method, First-In–First-Out (FIFO) and weighted average cost formulae are
the principal methods of ascertaining the cost of inventory. The cost of inventories of items that are not
ordinarily interchangeable and goods or services produced and segregated for specific projects should
be assigned by specific identification of their individual costs under the specific identification method.

2 (i) Under FIFO method of inventory valuation, inventories purchased first are issued first. The closing
inventories are valued at latest purchase prices and inventory issues are valued at corresponding old
purchase prices. In other words, under FIFO method, costs are assigned to the units issued in the same
order as the costs entered in the inventory. During periods of rising prices, cost of goods sold are valued
at older and lower prices if FIFO is followed and consequently reported profits rise due to lower cost of
goods sold.

On the other hand, under LIFO method of inventory valuation, units of inventories issued should
be valued at the prices paid for the latest purchases and closing inventories should be valued at
the prices paid for earlier purchases. In other words, closing inventories are valued at old purchase
prices and issues are valued at corresponding latest purchase prices.

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 4.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

2 (ii) Under the First-In-First-Out (FIFO) method of valuation of stock, the actual issue of goods is usually
the earliest lot on hand. Hence, the stock in hand will therefore consist of the latest consignments. The
closing stock is valued at the price paid for such consignments.
The weighted average price method is not a simple average price method. Under this method of
valuation of stock, a stock ledger is maintained, recording receipts and issues on daily basis. A new
average would be calculated on receiving fresh consignment. The average price thus calculated
after considering arrival of new consignment with the previous value of stock and dividing the
preceding stock value and the cost of new arrival with the total units of preceding and new arrival
will give the weighted average price.
3. Inventory can be defined as assets held
w for sale in the ordinary course of business, or
w in the process of production for such sale, or
w for consumption in the production of goods or services for sale, including maintenance
supplies and consumables other than machinery spares.
The significance of inventory valuation arises due to the following reasons:
(i) Determination of Income
(ii) Ascertainment of Financial Position
(iii) Liquidity Analysis
(iv) Statutory Compliance

Practical Questions
Answer 1
Statement of Valuation of Physical Stock as on 31st March, 2016

`
Value of stock as on 9th April, 2016 2,50,000
Add: Cost of sales during the intervening period
Sales made between 31.32016 and 9.4.2016 17,200
Less: Gross profit @25% on sales (4,300) 12,900
2,62,900
Less: Purchases actually received during the intervening period:
Purchases from 1.4.2016 to 9.4.2016 1,200
Less: Goods not received upto 9.4.2016 (500) 700
2,62,200
Less: Purchases during March, 2016 received on 4.4.2016 1,000
Value of physical stock as on 31.3.2016 2,61,200

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 INVENTORIES 4.25

Statement of Valuation of Stock as on 31st March, 2017

`
Value of stock as on 1st April, 2016 7,00,000
Add: Purchases during the period from 1.4.2016 to 31.3.2017 34,60,000
Add: Manufacturing expenses during the above period 7,00,000
48,60,000
Less: Cost of sales during the period:
Sales 52,20,000
Less: Gross profit 10,32,000 41,88,000
Value of stock as on 31.3.2017 6,72,000

Working Note:

`
Calculation of gross profit:
Gross profit on normal sales 20/100 x (52,20,000 -1,60,000) 10,12,000
Gross profit on the particular (abnormal) item 1,60,000 - (2,00,000 - 60,000) 20,000
10,32,000
Note: The value of closing stock on 31st March, 2017 may, alternatively, be found out by preparing
Trading Account for the year ended 31st March, 2017.
Answer 3
Profit and Loss Adjustment Account

Dr. Cr.
` `
To Advertisement (samples) 40,000 By Net profit 6,00,000
To Sales (goods approved in April to be 1,00,000 By Electric fittings 15,000
taken as April sales: 7,500 + 2,500)
By Samples 40,000
By Stock (purchases of 2,50,000
March
To Adjusted net profit 10,40,000 not included in stock)
By Sales (goods sold in 2,00,000
March wrongly taken
as April sales)

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 4.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

By Stock (goods sent 75,000

on approval basis not
included in stock)
_______ _______
11,80,000 11,80,000

Calculation of value of inventory on 31st March, 2016

`
Stock on 31st March, 2016 (given) 3,75,000
Add: Purchases of March, 2016 not included in the stock
2,50,000
Goods lying with customers on approval basis
75,000
7,00,000

Answer 4
Statement of Valuation of Stock on 30th June, 2016

`
Value of stock as on 23rd June, 2016 48,00,000
Add: Unsold stock out of the goods sent on consignment 2,40,000
Purchases during the period from 23rd June, 2016 to 30th June, 2,40,000
2016
Goods in transit on 30th June, 2016 1,60,000
Cost of goods sent on approval basis (80% of ` 1,60,000) 1,28,000 7,68,000
55,68,000
Less: Cost of sales during the period from 23rd June, 2016 to
30th June, 2016
Sales (` 13,60,000 - ` 1,60,000) 12,00,000
Less: Gross profit 96,000
11,04,000
Value of stock as on 30th June, 2016 44,64,000

Working Notes:

1. Calculation of normal sales:

Actual sales 13,60,000
Less: Abnormal sales 1,20,000
Return of goods sent on approval 1,60,000 2,80,000

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 INVENTORIES 4.27

10,80,000

2. Calculation of gross profit:

Gross profit or normal sales 20/100 x ` 10,80,000 2,16,000
Less: Loss on sale of particular (abnormal) goods 1,20,000
(` 2,40,000-` 1,20,000)

Gross profit 96,000

Answer 5
Statement of Valuation of Stock as on 31st March, 2016

` `
Stock as on 31st March, 2015 1,42,500
Less: Book value of abnormal stock (` 50,000 - ` 17,500) 32,500 1,10,000
Add: Purchases 7,62,500
Manufacturing expenses 1,50,000
10,22,500
Less: Cost of sales:
Sales as per book 12,45,000
Less: Sales of abnormal item 45,000
12,00,000
Less: Gross profit @ 20% stock as on 31st March, 2016 2,40,000 9,60,000
62,500
Statement showing Profit for the year ended 31st March, 2016

`
Gross profit on normal sales: 2,40,000
Add: Profit on abnormal item:
Sales value 45,000
Less: Book value on 31st March, 2015 32,500 12,500
2,52,500
Less: Overhead expenses:
Selling expenses 60,500
Administrative expenses 30,000
Financial charges 21,500 1,12,000
Net profit 1,40,500

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 CHAPTER 5
CONCEPT AND ACCOUNTING
OF DEPRECIATION
LEARNING OUTCOMES
After studying this chapter, you will be able to:
w Understand the meaning and nature of depreciation.
w Understand how to determine the amount of depreciation from the total value of Property, Plant
and Equipment and its useful life.
w Understand various methods of depreciation and learn advantages and disadvantages of such
methods.
w Understand how to calculate the amount of profit or loss resulting from the sale/disposal of Property,
Plant and Equipment.
w Familiarize with the accounting treatment for change in the method of depreciation from Straight
Line Method to Reducing Balance method.
w Familiarize with the accounting treatment for change in estimated useful life and residual value of
property, plant and equipment.

CHAPTER OVERVIEW Objectives of providing depreciation

To present To accumulate
To ascertain true and fair To ascertain
funds for the
true results view of the true cost
replacement
of operations financial of production
of assets
position

Factors affecting the amount of depreciation

Estimated
Expected
Cost of asset residual
useful life
value

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 5.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1. INTRODUCTION
1.1 Concept of Depreciation
Property, plant and equipment are tangible items that:

(a) are held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes; and
(b) are expected to be used during more than a period of twelve months.

These are also called fixed assets in common parlance. When a fixed asset is purchased, it is recorded in
books of account at it original or acquisition/purchase cost. However fixed assets are used to earn revenues
for a number of accounting periods in future with the same acquisition cost until the concerned fixed asset
is sold or discarded. It is therefore necessary that a part of the acquisition cost of the fixed assets is treated or
allocated as an expense in each of the accounting period in which the asset is utilized. The amount or value
of fixed assets allocated in such manner to respective accounting period is called depreciation. Value of such
assets decreases with passage of time mainly due to following reasons.

1. Wear and tear due to its use in business

2. Efflux of time even when it is not being used
3. Obsolescence due to technological or other changes
4. Decrease in market value
5. Depletion mainly in case of mines and other natural reserves
It is important to account for value of portion of property, plant and equipment utilized for generating
revenue during an accounting year to ascertain true income. This portion of cost of Property, Plant &
Equipment allocated to an accounting year is called depreciation.
As per Schedule II under the Companies Act, 2013, Depreciation is the systematic allocation of the
depreciable amount of an asset over its useful life. The depreciable amount of an asset is the cost
of an asset or other amount substituted for cost, less its residual value. The useful life of an asset
is the period over which an asset is expected to be available for use by an entity, or the number of
production or similar units expected to be obtained from the asset by the entity.

Thus there are 3 important factors for computing depreciation:

- Estimated useful life of the asset
- Cost of the asset
- Residual value of the asset at the end of the of its estimated useful life

Depreciation of an asset begins when it is available for use, i.e., when it is in the location and condition
necessary for it to be capable of operating in the manner intended by management. Thus it is not necessary
that an asset must be used to be depreciated. There is decrease in value of assets due to normal wear and
tear even when these are not physically used. Accordingly, value of such wear and tear should be estimated
and accounted for.

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.3

Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting
period during the expected useful life of the asset.
The loss in the value of assets employed for carrying on a business being an essential element of business
expenditure, it is necessary to calculate the amount of such loss and to make a provision, and therefore,
arrive at the amount of profit or loss made by the business.
Basically, the cost of an asset used for purpose of business has to be written off over its economic (not
physical) life which necessarily must be estimated. A point to remember is that usually, at the end of the
economic life, an asset has some value as scrap or otherwise. The amount to be written off in each year
should be as such which will reduce the book value of the asset, at the end of its economic life, to its
estimated scrap value.
A pertinent question, of course, is the price likely to prevail at the time of replacement. That is why some
people advocate the calculation of depreciation on the basis of replacement price rather than cost.

1.2 Depreciation on components of an assets

It may be noted that Accounting Standards as well as the Companies Act, 2013 requires depreciation to
be charged on a component basis. Each part of an item of Property, Plant and Equipment with a cost
that is significant in relation to the total cost of the item should be depreciated separately. An enterprise
should allocate the amount initially recognised in respect of an item of property, plant and equipment to
its significant parts/components and should depreciate each such part separately based on the useful life
and residual value of each particular component. For Example- Aircraft is a classic example of such an asset.
The airframe (i.e. the body of the aircraft), the engines and the interiors have different individual useful lives.
If the life of the airframe (being the longest of the individual lives of the three major types of components)
is taken as the life of the aircraft, it is important that other two major components i.e. engine and interiors
are depreciated over their respective useful life and not over the life of airframe. Other components (usually
small and low value) which will require replacement very frequently may be depreciated over the useful
life of airframe and their frequent replacement cost may be charged to expense as and when it is incurred.
Here it is important to note that a part of Property, Plant & Equipment to be identified as a separate
component should have both
(a) significant cost when compared to overall cost of item of property, plant and equipment and
(b) and estimated useful life or depreciation method different from rest of the parts of the property
plant and equipment.
A significant part of an item of property, plant and equipment may have a useful life and a depreciation
method that are the same as the useful life and the depreciation method of another significant part of that
same item. Such parts may be grouped in determining the depreciation charge.

1.3 Objectives for Providing Depreciation

Prime objectives for providing depreciation are:
(1) Correct income measurement: Depreciation should be charged for proper estimation of periodic profit or
loss. In case an enterprise does not account for depreciation on Property, Plant & Equipment, it will not
be considering loss in value of property, plant & equipment due to their use in production or operations
of the enterprise and will not result in true profit or loss for the period.
(2) True position statement: Value of the Property, Plant & Equipment should be adjusted for depreciation

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 5.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

charged in order to depict the actual financial position. In case depreciation is not accounted for
appropriately, the property, plant and equipment would be disclosed in financial statements at a value
higher than their true value.
(3) Funds for replacement: Generation of adequate funds in the hands of the business for replacement of
the asset at the end of its useful life. Depreciation is a good indication of the amount an enterprise
should set aside to replace a fixed asset after its economic useful life is over. However, the replacement
cost of a fixed asset may be impacted by inflation or other technological changes.
(4) Ascertainment of true cost of production: For ascertaining the cost of the production, it is necessary to
charge depreciation as an item of cost of production.
Further depreciation is a non-cash expense and unlike other normal expenditure (e.g. wages, rent, etc.) does
not result in any cash outflow. Further depreciation by itself does not create funds it merely draws attention
to the fact that out of gross revenue receipts, a certain amount should be retained for replacement of assets
used for carrying on operation.

2. FACTORS IN THE MEASUREMENT OF DEPRECIATION

Estimation of exact amount of depreciation is not easy. Generally following factors are taken into
consideration for calculation of depreciation.
1. Cost of asset including expenses for installation, commissioning, trial run etc.
2. Estimated useful life of the asset.
3. Estimated scrap value (if any) at the end of useful life of the asset.

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.5

The above mentioned factors can be explained, in detail, as follows:

Cost of a depreciable asset represents its money outlay or its
equivalent in connection with its acquisition, installation and
commissioning as well as for additions to or improvement
thereof for the purpose of increase in efficiency. We have
Cost of discussed this in more detail in coming paragraphs.
Asset
Historical ‘Useful Life’ is either (i) the period over which a depreciable
asset is expected to be used by the enterprise or (ii) the number
of production or similar units expected to be obtained from the
use of the asset by the enterprise. Determination of the useful
life is a matter of estimation and is normally based on various
Useful life of factors including experience with similar type of assets. Several
the asset other factors like estimated working hours, production capacity,
repairs and renewals, etc. are also taken into consideration on
demanding situation.
Estimated
Determination of the residual value is normally a difficult
matter. If such value is considered as insignificant, it is normally
Scrap regarded as nil. On the other hand, if the residual value is likely
(residual to be significant, it is estimated at the time of acquisition/
Estimated value)
installation, or at the time of subsequent revaluation of asset.
Depreciable amount of a depreciable asset is its historical cost,
or other amount substituted for historical cost in the financial
Depreciable statements, less the estimated residual value.
amount
For example, a machinery is purchased for ` 1,10,000. The
residual value is estimated at ` 10,000. It is estimated that the
machinery will work for 5 years. The cost to be allocated as
depreciation in the accounting periods will be calculated as:
`

Acquisition cost 1,10,000

Less: Residual value (10,000)

Depreciable amount 1,00,000

Estimated useful life of the asset 5 years

Depreciable amount
Depreciation = i.e. ` 1,00,000/ 5 = ` 20,000 per year
Estimated useful life

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 5.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

Cost of Property, Plant and Equipment comprises:

(a) its purchase price, including non-refundable import duties and purchase taxes, after deducting
trade discounts and rebates.
(b) any cost directly attributable to bring the asset to the location and condition necessary for it to be
capable of operating in a manner intended by the enterprise.
(c) the initial estimate of the costs of dismantling, removing, the item and restoring the site on which
an asset is located.

Examples of costs directly attributable costs are:

(a) cost of employee benefits arising directly from acquisition or construction of an item of property,
plant and equipment.
(b) cost of site preparation
(c) initial delivery and handling costs
(d) installation and assembly costs
(e) cost of testing whether the asset is functioning properly, after deducting the net proceeds from
selling the items produced while testing (such as samples produced while testing)
(f ) professional fees e.g. engineers hired for helping in installation of a machine

Thus all the expenses which are necessary for asset to bring it in condition and location of desired used will
become part of cost of the asset. However, following expenses should not become part of cost of asset:
(a) costs of opening new facility or business, such as inauguration costs;
(b) cost of introducing new product or service (for example cost of advertisement or promotional
activities).
(c) cost of conducting business in a new location or with a new class of customer (including cost of
staff training); and
(d) administration and other general overhead costs.

Once an asset has been brought to its intended condition and location of use, no cost should recognized as
part of cost of the asset unless there is major repair or addition which increases the useful life of the asset
or improves the production capacity of the asset. Accordingly, cost incurred while and item is capable of
operating in intended manner but it is not yet put to use or is used at less than full capacity should not be
capitalized as part of cost of the asset. Similarly, cost of relocation of an asset should not be capitalized.
Any additions made to a particular item of property, plant and equipment after it is initially put to use are
depreciated over the remaining useful life of the asset. Therefore, it is important to maintain an asset register
capturing asset wise details of cost, rate of depreciation, date of capitalization etc. All these details need to
be captured for any additions to existing assets as well. In the absence of the adequate information, it will
be very difficult to compute depreciation expense year on year. Also, at the time of disposal or discard of a
particular asset, it will not be possible to compute gain or loss on such disposal/discard.

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.7

3. METHODS FOR PROVIDING DEPRECIATION

Generally, methods for providing depreciation are based on formula, developed on a study of the behavior
of the assets over a period of years for readily computing the amount of depreciation suffered by different
forms of assets. Each of the methods, however, should be applied only after carefully considering nature of
the asset and the conditions under which it is being used.

Methods of Depreciation

Straight-line Method Diminishing Balance Units of Production

Method Method

Results in a constant
charge over the useful Results in a decreasing Results in a charge based
life if the residual value charge over the useful on the expected use or
of the asset does not life output
change

The Income Tax Rules, however, prescribe the Diminishing Balance Method except in the case of assets of an
undertaking engaged in generation and distribution of power.
3.1 Straight Line Method
According to this method, an equal amount is written off every year during the working life of an asset so
as to reduce the cost of the asset to nil or its residual value at the end of its useful life. The advantage of this
method is that it is simple to apply and gives accurate results especially in case of leases, and also in case of
plant and machinery. This method is also known as Fixed Instalment Method.
According to this method, an equal amount is written off every year during the working life of an asset so
as to reduce the cost of the asset to nil or its residual value at the end of its useful life. The advantage of this
method is that it is simple to apply and gives accurate results especially in case of leases, and also in case of
plant and machinery. This method is also known as Fixed Instalment Method.
Cost of Asset – Scrap Value
Straight Line Depreciation =
Useful life

Straight Line Depreciation

Straight Line Depreciation Rate = x 100
Cost of Asset

The underlying assumption of this method is that the particular tangible asset generates equal utility
during its lifetime. But this cannot be true under all circumstances. The expenditure incurred on repairs and
maintenance will be low in earlier years, whereas the same will be high as the asset becomes old. Apart
from this the asset may also have varying capacities over the years, indicating logic for unequal depreciation
provision. However, many assets have insignificant repairs and maintenance expenditures for which straight
line method can be applied.

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 5.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

While using this method the period of use of an asset in a particular year should also be considered. In
the year of purchase of an asset it may have been available for use for part of the year only, accordingly
depreciation should be proportioned to reflect the period for which it was available for use. For example,
if an asset was purchased on March 1, 2017 and the enterprise prepares financial statements for the year
ending on March 31, 2017 depreciation will be provided for a period of 1 month only. Similar situation
will arise in the year in which an asset is retired from its intended used or is sold. However, under income
tax rules depreciation is provided for full year if the asset was used for more than 180 days in a particular
financial year.

3.2 Reducing or Diminishing Balance Method

Under this system, a fixed percentage of the diminishing value of the asset is written off each year so as
to reduce the asset to its residual value at the end of its life. Repairs and small renewals are charged to
revenue. This method is commonly used for plant, fixtures, etc. Under this method, the annual charge for
depreciation decreases from year to year, so that the earlier years suffer to the benefit of the later years.
Also, under this method, the value of asset can never be completely extinguished, which happens in the
earlier explained Straight Line Method. However, it is very simple to operate. This method is based on the
assumption that cost of repairs will increase as the asset get old, therefore, depreciation in earlier years
should be high when the repair cost is expected to be low and depreciation in later years should be low
when the repair cost is expected to be high. Therefore, this method will result in almost equal burden in all
the years of use of the asset as depreciation will reduce with increase in repair costs will increase with every
passing year. On the other hand, under the Straight Line Method, the charge for depreciation is constant,
while repairs tend to increase with the life of the asset. Among the disadvantages of this method is the
danger that too low a percentage may be adopted as depreciation with the result that over the life of the
asset full depreciation may not be provided; also if assets are grouped in such a way that individual assets
are difficult to identify, the residue of an asset may lie in the asset account even after the asset has been
scrapped. The last mentioned difficulty could be, however, over come if a Plant register is maintained.
The rate of depreciation under this method may be determined by the following formula:
Residual Value
1– n × 100
Cost of asset

where, n = useful life

Similar to straight line method, in this method also period of use in a particular year e.g. year of purchase or
sale an item of property plant and equipment needs to be considered while computing the depreciation
amount.
Accounting Entries under Straight Line and Reducing Balance Methods:
There are two alternative approaches for recording accounting entries for depreciation.
First Alternative
A provision for depreciation account is opened to accumulate the balance of depreciation and the assets
are carried at historical cost.
Accounting entry
Depreciation Account Dr.
To Provision for Depreciation Account

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.9

Profit and Loss Account Dr.

To Depreciation Account

Second Alternative

Amount of Depreciation is credited to the Asset Account every year and the Asset Account is carried at
historical cost less depreciation.
Accounting entries:
Depreciation Account Dr.
To Asset Account
Profit and Loss Account Dr.
To Depreciation Account

? ILLUSTRATION 1

Jain Bros. acquired a machine on 1st July, 2015 at a cost of ` 14,00,000 and spent ` 1,00,000 on its installation.
The firm writes off depreciation at 10% p.a. of the original cost every year. The books are closed on 31st December
every year.
Required

Show the Machinery Account and Depreciation Account for the year 2015 and 2016.
Machinery Account
` `
2015 2015
July 1 To Bank A/c 14,00,000 Dec. 31 By Depreciation A/c
July 1 To Bank A/c - 10% on ` 15,00,000 for 75,000
Installation 1,00,000 6 months
Expenses Dec. 31 By Balance c/d 14,25,000
15,00,000 15,00,000
2016 2016
Jan. 1 To Balance b/d 14,25,000 Dec. 31 By Depreciation A/c
10% on ` 15,00,000 1,50,000
Dec. 31 By Balance c/d 12,75,000
14,25,000 14,25,000

Depreciation Account
` `
2015 2015
Dec. 31 To Machinery A/c 75,000 Dec. 31 By Profit & Loss A/c 75,000
2016 2016
Dec. 31 To Machinery A/c 1,50,000 Dec. 31 By Profit & Loss A/c 1,50,000

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 5.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 2

Jain Bros. acquired a machine on 1st July, 2015 at a cost of ` 14,00,000 and spent ` 1,00,000 on its installation.
The firm writes off depreciation at 10% p.a. every year. The books are closed on 31st December every year.
Required
Show the Machinery Account on diminishing balance method for the year 2015 and 2016.

 SOLUTION

As per Reducing Balance Method

Machinery Account
` `
2015 2015
July 1 To Bank A/c 14,00,000 Dec. 31 By Depreciation A/c 75,000
July 1 To Bank A/c - 1,00,000 (` 15,00,000 x 10% x 6/12) for
6 months
Dec. 31 By Balance c/d 14,25,000
15,00,000 15,00,000
2016 2016
Jan. 1 To Balance b/d 14,25,000 Dec. 31 By Depreciation A/c 1,42,500
(` 14,25,000 x 10%)
Dec. 31 By Balance c/d 12,82,500
14,25,000 14,25,000

3.3 Sum of Years of Digits Method

It is variation of the “Reducing Balance Method”. In this case, the ansnual depreciation is calculated by
multiplying the original cost of the asset less its estimated scrap value by the fraction represented by:

The number of years (including the present year) of remaining life of the asset
Total of all digits of the life of the asset (in years)

Suppose the estimated life of an asset is 10 years; the total of all the digits from 1 to 10 is 55 i.e.,10 + 9 + 8 +
7 + 6 + 5 + 4 + 3 + 2 + 1, or by the formula:
n (n + 1) 10 × 11
= = 55
2 2
The depreciation to be written off in the first year will be 10/55 of the cost of the asset less estimated scrap
value; and the depreciation for the second year will be 9/55 of the cost of asset less estimated scrap value
and so on.
The method is not yet in vogue; and its advantages are the same as those of the Reducing Balance Method.

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.11

? ILLUSTRATION 3

M/s Akash purchased a machine for ` 10,00,000. Estimated useful life and scrap value were 10 years and `
1,20,000 respectively. The machine was put to use on 1.1.2010.

Required
Show Machinery Account and Depreciation Account in their books for 2015 by using sum of years digits method.

 SOLUTION

In the books of M/s Akash

Machinery Account

` `
2015 2015
Jan. 1 To Balance b/d (w.n.2) 3,60,000 Dec. 31 By Depreciation A/c (w.n.3) 80,000
Dec. 31 By Balance c/d 2,80,000
3,60,000 3,60,000
2016
Jan.1 To Balance b/d 2,80,000

Depreciation Account

` `
2015 2015
Dec. 31 To Machinery A/c 80,000 Dec. 31 By Profit and Loss A/c 80,000
80,000 80,000

Working Notes:

(1) Total of sum of digit of depreciation for 2010-2014

10 + 9 + 8 +7 + 6
= (` 10,00,000 - ` 1,20,000) ×
10 (10 + 1)
40 2
= ` 8,80,000 × = ` 6,40,000
55
(2) Written down value as on 1-1-2015
` 10,00,000 – ` 6,40,000 = ` 3,60,000
(3) Depreciation for 2015
5
(` 10,00,000 – ` 1,20,000) × = ` 80,000.
55

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 5.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.4 Annuity Method

This is a method of depreciation which also takes into account the element of interest on capital outlay and
seeks to write off the value of the asset as well as the interest lost over the life of the asset. It assumes that
the amount laid out in acquiring asset, if invested elsewhere, would have earned interest which must be
reckoned as part of the cost of asset. On that basis, the amount of depreciation to be annually provided in
the accounts is ascertained from the Annuity Tables, to write off each year interest on the capital outlay as
well as part of the capital sum at a rate that the whole of the capital sum and interest accruing thereon would
be written off over the life of the asset. Though the amount written off annually is constant, the interest in
the earlier years being greater, only small amount of the capital outlay is written off. This proportion is
reversed with the passage of time. This method is eminently suitable for writing off the amounts paid for
long leases which involve a considerable capital outlay. It is not practicable to adopt this method for writing
off depreciation of plant and machinery on account of frequent changes in the value of such assets which
would necessitate the recalculation of the amount of depreciation to be written off annually.

Relevant Journal entries are:

(1) For charging interest on asset account
Asset Account Dr.
To Interest Account
(2) For charging depreciation on asset
Depreciation Account Dr.
To Asset Account or Provision for Depreciation Account
(3) For transferring depreciation to Profit and Loss Account
Profit and Loss Account Dr.
To Depreciation Account
(4) For transferring interest to Profit and Loss Account
Interest Account Dr.
To Profit and Loss Account

? ILLUSTRATION 4

A lease is purchased on 1st April, 2012 for 4 years at a cost of ` 2,00,000. It is proposed to depreciate the lease by
the annuity method charging 5 percent interest. A reference to the annuity table shows that to depreciate ` 1 by
annuity method over 4 years charging 5% interest, one must write off a sum of ` 0.282012 [To write off ` 2,00,000
one has to write off every year ` 56,402.40 i.e. 0.282012 × 2,00,000].
Required
Show the Lease Account for four years and also the relevant entries in the profit and loss account.

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Sample output to test PDF Combine only
 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.13

 SOLUTION
Lease Account
` `
2012- 13 2012-13
April. 1 To Bank A/c 2,00,000.00 Mar. 31 By Depreciation A/c 56,402.40
Mar. 31 To Interest A/c By Balance c/d 1,53,597.60
(5% on ` 2,00,000) 10,000.00
2,10,000.00 2,10,000.00
2013-14 2013-14
April. 1 To Balance b/d 1,53,597.60 Mar..31 By Depreciation A/c 56,402.40
Mar. 31 To Interest A/c By Balance c/d 1,04,875.08
(5% on ` 1,53,597.60) 7,679.88
1,61,277.48 1,61,277.48
2014-15 2014-15
April. 1 To Balance b/d 1,04,875.08 Mar. 31 By Depreciation A/c 56,402.40
Mar. 31 To Interest A/c 5,243.75 Mar. 31 By Balance c/d 53,716.43
1,10,118.83 1,10,118.83
2015-16 2015-16
April. 1 To Balance b/d 53,716.43 Mar. 31 By Depreciation A/c 56,402.25
Mar. 31 To Interest A/c 2,685.82
56,402.25 56,402.25

Profit and Loss Account

` `
2012-13 2012-13
Mar. 31 To Depreciation A/c 56,402.40 Mar. 31 By Interest A/c 10,000.00
2013-14 2013-14
mar. 31 To Depreciation A/c 56,402.40 Mar. 31 By Interest A/c 7.679.88
2014-15 2014-15
Mar. 31 To Depreciation A/c 56,402.40 Mar. 31 By Interest A/c 5,243.75
2015-16 2015-16
Mar. 31 To Depreciation A/c 56,402.40 Mar. 31 By Interest A/c 2,685.82

3.5 Sinking Fund Method

If a large sum of money is required for replacement of property, plant and equipment at the end of its
effective life, it may not be advisable to leave in the amount of depreciation set apart annually, for it may or
may not be available in the form of the readily realisable assets to the enterprise at the time it is required.
To safeguard this position, the amount annually provided for depreciation may be placed to the credit of
the Sinking Fund Account, and at the same time an equivalent amount may be invested in Government
securities. The interest on these securities, when received, would be re-invested and the amount thereof
would be credited to the Sinking Fund Account. The amount of annual provision for depreciation in such
a case is calculated after taking into account interest, that the amounts annually invested shall be earning
over the period these will remain invested. When the asset is due for replacement, the securities are sold

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 5.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

and the new asset is purchased with the proceeds of their sale. The book value of the old asset, at the time,
is transferred to the Sinking Fund Account. Any amount realised on sale of the old asset, as well as the profit
or loss on sale of securities, is transferred to the Sinking Fund Account and it is closed off by transfer of the
balance of the Profit and Loss Account or General Reserve.
The amount to be set apart annually by way of depreciation is ascertained from Sinking Fund tables. They
readily show the amount which must be invested each year to accumulate to ` 1 at a given rate of interest
within the stated period.

Relevant Journal entries are:

(1) For transfer of depreciation to Sinking Fund

Depreciation Account Dr.
To Sinking Fund (S.F. )Account
(2) For charging depreciation to profit and loss account
Profit and Loss Account Dr.
To Depreciation Account
(3) For investment of amount of depreciation
Sinking Fund Investment Account Dr.
To Bank Account
(4) In subsequent years, for interest earned on sinking fund investment and on investment of the interest
and depreciation
Bank Account Dr.
To Interest on Sinking Fund Investment Account
Interest on Sinking Fund Investment Account Dr.
To Sinking Fund Account
(In addition to these entries, entries (1) and (2) will also be passed in subsequent years for transfer of
depreciation to sinking fund and for charging it to profit and loss account)
Sinking Fund Investment Account Dr.
To Bank Account
(yearly depreciation + interest earned)
(5) For sale of sinking fund investment at the end of useful life of the asset
Bank Account Dr.
To Sinking Fund Investment Account
If sales is at a profit
Sinking Fund Investment Account Dr.
To Sinking Fund Account

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.15

If sales is at loss
Sinking Fund Account Dr.
To Sinking Fund Investment Account
(6) For transfer of the amount to the extent of book value of the asset from asset account to sinking fund
account
Sinking Fund Account Dr.
To Asset Account
(7) Any surplus in Sinking Fund Account may be transferred to General Reserve Account and if any deficit,
that may be transferred to Profit and Loss Account
Sinking Fund Account Dr.
To General Reserve Account
OR
Profit and Loss Account Dr.
To Sinking Fund Account
The aforementioned method may also be operated a little differently. The amount set apart on account of
depreciation, instead of being invested annually in the purchase of government securities may be paid out
as premium on a policy maturing at the end of the life of the asset, for an amount equal to the sum that will
be required for its replacement. In that case the amount of the premium when paid will be debited to the
Policy Account instead of the Investment Account.

? ILLUSTRATION 5

On 1st April, 2013, Z Limited purchased the lease of property for ` 10,00,000. The lease would expire on 31st March,
2016. Z Ltd., decided to set up a sinking fund. The Sinking Fund was to be credited (or debited) with an annual
contribution from profit, the interest on the investments and any profits (or losses) made on the realisation of the
sinking fund investments. The sinking fund was to be represented by specific investment, and any sums made
available to the sinking fund were to be immediately invested, except at the termination of the fund.
During the three years following transactions took place:
2014 31st March: A contribution from profits of ` 3,20,000 was made and this sum was invested.
2014 13th Oct.: Investments which originally costed ` 1,10,000 were sold for ` 1,20,000 and the proceeds of sale
were re-invested.
2015 31st March: A contribution from profits of ` 3,20,000 was made; interest on investments of ` 16,000 was
received and these amounts were reinvested.
2015 9th August: Investments which originally costed ` 2,10,000 were sold at a profit of ` 20,000 and
proceeds of sale were re-invested.
2016 31st March: Interest on investments ` 48,000 was received which was not invested. All existing investments
were sold for ` 6,60,000. A contribution from profit of an amount required to make up the sinking fund to
` 10,00,000 was made and this amount was not invested.

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 5.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

Required
Prepare Sinking Fund and Sinking Fund Investment Account for the years 2013-14, 2014-15, 2015-16.

 SOLUTION
Sinking Fund Account
` `
2014 2014
March 31 To Balance c/d 3,20,000 March 31 By Depreciation A/c 3,20,000
3,20,000 3,20,000
2015 2015
March 31 To Balance c/d 6,66,000 April 1 By Balance b/d 3,20,000
Oct. 13 By S.F. Investment A/c 10,000
March 31 By Interest on S.F 16,000
Investment A/c
By Depreciation A/c 3,20,000
6,66,000 6,66,000
2015 2015
March 31 To S.F. Investment A/c 26,000 April 1 By Balance b/d 6,66,000
To Lease A/c 10,00,000 August 9 By S.F. Investment A/c 20,000
March 31, By Interest on S.F. 48,000
2016 Investment A/c
By Depreciation A/c 2,92,000
(Balancing Figure)
10,26,000 10,26,000

Sinking Fund Investment Account

` `
2014 2014
March 31 To Bank A/c 3,20,000 March 31 By Balance c/d 3,20,000
3,20,000 3,20,000
2014 2014
April 1 To Balance b/d 3,20,000 Oct. 13 By Bank A/c (sale) 1,20,000
Oct. 13 To S.F.A/c 10,000 March 31 By Balance c/d 6,66,000
(profit on sale)
Oct. 13 To Bank A/c 1,20,000
(investment of sale
proceed)
2015 To Bank A/c 3,36,000
March 31 (investment of
depreciation amount
and interest)
7,86,000 7,86,000
2015 2015
April 1 To Balance b/d 6,66,000 August 9 By Bank A/c 2,30,000

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.17

August 9 To S.F. A/c 20,000 2016 By Bank A/c 6,60,000

(profit on sale) March 31 By S.F. A/c
August 9 To Bank A/c 2,30,000 (loss on sale) 26,000
(investment of sale
proceeds)
9,16,000 9,16,000

? ILLUSTRATION 6

On the basis of the data given in the illustration 5,

Required
Prepare Lease Account and Depreciation Account for the years 1st April, 2013 to 31st March, 2016.

 SOLUTION
Lease Account
` `
2013 2014
April 1 To Bank A/c 10,00,000 March 31 By Balance c/d 10,00,000
10,00,000 10,00,000
2014 2015
April 1 To Balance b/d 10,00,000 March 31 By Balance c/d 10,00,000
10,00,000 10,00,000
2015 2016
April 1 To Balance b/d 10,00,000 March 31 By Sinking Fund A/c 10,00,000
10,00,000 10,00,000

Depreciation Account
` `
2014 2014
March 31 To Sinking Fund A/c 3,20,000 March 31 By Profit & Loss A/c 3,20,000
3,20,000 3,20,000
2015 2015
March 31 To Sinking Fund A/c 3,20,000 March 31 By Profit & Loss A/c 3,20,000
3,20,000 3,20,000
2016 2016
March 31 To Sinking Fund A/c 2,92,000 March 31 By Profit & Loss A/c 2,92,000
2,92,000 2,92,000

3.6 Machine Hour Method

Where it is practicable to keep a record of the actual running hours of each machine, depreciation may
be calculated on the basis of hours that the concerned machine worked. The machine hour rate of the
depreciation, is calculated after estimating the total number of hours that machine would work during
its whole life; however, it may have to be varied from time to time, on a consideration of the changes in

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 5.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

the economic and technological conditions which might take place, to ensure that the amount provided
for depreciation corresponds to that considered appropriate in the changed circumstances. It would be
observed that the method is only a slight variation of the Straight Line Method under which depreciation is
calculated per year. Under this method it is calculated for each hour the machine works.
Schedule II to the Companies Act 2013, prescribes estimated useful life of different assets for companies,
also recognizes this method to some extent. It prescribes that depreciation should be charged using
estimate useful life suggested in it, however, in certain category of plant and machinery it prescribes to
charge higher amount of depreciation if these assets are used for 2 shifts or 3 shifts. In a way, schedule II
combines straight line method and machine hour method.

? ILLUSTRATION 7
A machine was purchased for ` 30,00,000 having an estimated total working of 24,000 hours. The scrap value is
expected to be ` 2,00,000 and anticipated pattern of distribution of effective hours is as follows :
Year
1–3 3,000 hours per year
4-6 2,600 hours per year
7 - 10 1,800 hours per year

Required

Determine Annual Depreciation under Machine Hour Rate Method.

 SOLUTION

Statement of Annual Depreciation under Machine Hours Rate Method

Year Annual Depreciation

1-3 3,000
× (` 30,00,000 - ` 2,00,000) = ` 3,50,000
24,000
4-6 2,600
× (` 30,00,000 - ` 2,00,000) = ` 3,03,333
24,000
7 - 10 1,800
× (` 30,00,000 - ` 2,00,000) = ` 2,10,000
24,000
3.7 Production Units Method

Under this method depreciation of the asset is determined by comparing the annual production with the
estimated total production. The amount of depreciation is computed by the use of following method:

Production during the period

Depreciation for the period = Depreciable Amount X
Estimated total production.

The method is applicable to machines producing product of uniform specifications.

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.19

? ILLUSTRATION 8
A machine is purchased for ` 20,00,000. Its estimated useful life is 10 years with a residual value of ` 2,00,000.
The machine is expected to produce 1.5 lakh units during its life time. Expected distribution pattern of
production is as follows:
Year Production
1-3 20,000 units per year
4-7 15,000 units per year
8-10 10,000 units per year

Required
Determine the value of depreciation for each year using production units method.

 SOLUTION

Statement showing Depreciation under Production Units Method

Year Annual Depreciation

1-3 20,000
× (` 20,00,000 - ` 2,00,000) = ` 2,40,000
1,50,000
4-7 15,000
× (` 20,00,000 - ` 2,00,000 ) = ` 1,80,000
1,50,000
8-10 10,000
× (` 20,00,000 - ` 2,00,000) = ` 1,20,000
1,50,000

3.8 Depletion Method

This method is used in case of mines, quarries etc. containing only a certain quantity of product. The
depreciation rate is calculated by dividing the cost of the asset by the estimated quantity of product likely
to be available. Annual depreciation will be the quantity extracted multiplied by the rate per unit.

? ILLUSTRATION 9

M/s Surya took lease of a quarry on 1-1-2013 for ` 1,00,00,000. As per technical estimate the total quantity of
mineral deposit is 2,00,000 tonnes. Depreciation was charged on the basis of depletion method. Extraction
pattern is given in the following table:
Year Quantity of Mineral extracted
2013 2,000 tonnes
2014 10,000 tonnes
2015 15,000 tonnes

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 5.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

Required
Show the Quarry Lease Account and Depreciation Account for each year from 2013 to 2015.

 SOLUTION

Quarry Lease Account

` `
2013 2013
Jan. To Bank A/c 1,00,00,000 Dec. 31 By Depreciation A/c 1,00,000
[(2,000/2,00,000) ×
` 1,00,00,000]
Dec. 31 By Balance c/d 99,00,000
1,00,00,000 1,00,00,000
2014 2014
Jan. 1 To Balance b/d 99,00,000 Dec. 31 By Depreciation A/c 5,00,000
Dec. 31 By Balance c/d 94,00,000
99,00,000 99,00,000
2015 2015
Jan. 1 To Balance b/d 94,00,000 Dec. 31 By Depreciation A/c 7,50,000
Dec. 31 By Balance c/d 86,50,000
94,00,000 94,00,000

Depreciation Account
` `
2013 2013 `
Dec. 31 To Quarry lease A/c 1,00,000 Dec. 31 By Profit & Loss A/c 1,00,000
1,00,000 1,00,000
2014 2014
Dec. 31 To Quarry lease A/c 5,00,000 Dec. 31 By Profit & Loss A/c 5,00,000
5,00,000 5,00,000
2015 2015
Dec. 31 To Quarry lease A/c 7,50,000 Dec. 31 By Profit & Loss A/c 7,50,000
7,50,000 7,50,000

4. PROFIT OR LOSS ON THE SALE/DISPOSAL OF PROPERTY, PLANT

AND EQUIPMENT
Whenever any depreciable asset is sold during the year, depreciation is charged on it for the period it has
been used in the sale year. The written down value after charging such depreciation is used for calculating
the profit or loss on the sale of that asset. The resulting profit or loss on sale of the asset is ultimately
transferred to profit and loss account.
For example: The book value of the asset as on 1st January, 2015 is ` 50,00,000. Depreciation is charged on
the asset @10%. On 1st July 2015, the asset is sold for ` 32,00,000. In such a situation, profit or loss on the
sale will be calculated as follows:

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Sample output to test PDF Combine only
 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.21

`
Book value as on 1st Jan., 2015 50,00,000
Less: Depreciation for 6 months @10% (from 1st Jan., 2015 to 30th June, 2015) (2,50,000)
Written down value as on 1st July, 2015 47,50,000
Less: Sale proceeds as on 1st July, 2015 (32,00,000)
Loss on sale of the asset 15,50,000

? ILLUSTRATION 10

A firm purchased on 1st January, 2015 certain machinery for ` 5,82,000 and spent ` 18,000 on its erection. On
July 1, 2015 another machinery for ` 2,00,000 was acquired. On 1st July, 2016 the machinery purchased on 1st
January, 2015 having become obsolete was auctioned for ` 3,86,000 and on the same date fresh machinery was
purchased at a cost of ` 4,00,000.
Depreciation was provided for annually on 31st December at the rate of 10 per cent p.a. on written down value.
Required
Prepare machinery account.

 SOLUTION

Machinery Account
` `
2015 2015 `
Jan. 1 To Bank A/c 5,82,000 Dec. 31 By Depreciation A/c 70,000
Jan. 1 To Bank A/c –
erection charges 18,000 By Balance c/d 7,30,000
July 1 To Bank A/c 2,00,000
8,00,000 8,00,000
2016 2016
Jan. 1 To Balance b/d 7,30,000 July 1 By Depreciation on
sold machine 27,000
July 1 To Bank A/c 4,00,000 By Bank A/c 3,86,000
By Profit and Loss A/c 1,27,000
Dec. 31 By Depreciation A/c 39,000
By Balance c/d 5,51,000
11,30,000 11,30,000

Working Note:
Book Value of Machines

Machine Machine Machine

I II III
` ` `
Cost 6,00,000 2,00,000 4,00,000
Depreciation for 2015 (60,000) (10,000)

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 5.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

Written down value 5,40,000 1,90,000

Depreciation for 2016 (27,000) (19,000) (20,000)
Written down value 5,13,000 1,71,000 3,80,000
Sale Proceeds (3,86,000)
Loss on Sale 1,27,000

5. CHANGE IN THE METHOD OF DEPRECIATION

The depreciation method applied to an asset should be reviewed at least at each financial year-end and, if
there has been a significant change in the expected pattern of consumption of the future economic benefits
embodied in the asset, the method should be changed to reflect the changed pattern. Whenever any change
in depreciation method is made. Such change in method is treated as change in accounting estimate as per
Accounting Standards. Its effect needs to be quantified and disclosed. A change in an accounting estimate
may affect the current period only or both the current period and future periods.

Example :
Cost of Machine ` 10,50,000
Residual Value ` 50,000
Useful life 10 years.

The company charges depreciation on straight line method for the first two years and thereafter decides to
adopt written down value method by charging depreciation @ 25%. (calculated based on useful life). You
are required to calculate depreciation for the 3rd year.
Depreciation already charged for the first 2 years as per straight line method is ` 2,00,000. Therefore, WDV
for 2nd year is ` 8,50,000
Therefore in the profit and loss account of the 3rd year, the depreciation of ` 2,12,500 (25% of ` 850,000)
should be debited.

? ILLUSTRATION 11

M/s Anshul commenced business on 1st January 2011, when they purchased plant and equipment for ` 7,00,000.
They adopted a policy of charging depreciation at 15% per annum on diminishing balance basis and over the
years, their purchases of plant have been:

Date Amount
`
1-1-2012 1,50,000
1-1-2015 2,00,000

On 1-1-2015 it was decided to change the method and rate of depreciation to straight line basis. On this date
remaining useful life was assessed as 6 years for all the assets purchased before 1.1.2015 and 10 years for the
asset purchased on 1.1.2015 with no scrap value.

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Sample output to test PDF Combine only
 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.23

Required
Calculate the difference in depreciation to be adjusted in the Plant and Equipment Account for the year ending
31st December, 2015.

 SOLUTION

Depreciation on written down value basis

Purchased on Purchased on Total
Jan. 1, 2011 Jan. 1, 2012 Depreciation
` ` `
2011 Cost 7,00,000
Depreciation (1,05,000) 1,05,000
Written Down Value (WDV) 5,95,000
2012 Cost - 1,50,000
Depreciation ( 89,250) (22,500) 1,11,750
W.D.V. 5,05,750 1,27,500
2013
Depreciation (75,863) (19,125) 94,988
W.D.V. 4,29,887 1,08,375
2014
Depreciation (64,483) (16,256) 80,739
W.D.V. 3,65,404 92,119
2015
Depreciation (60,900) (15,353) 76,253
W.D.V. 3,04,504 76,766

Plant and Equipment Account

` `
2015 2015
Jan. 1 To Balance b/d 4,57,523 Dec. 31 By Depreciation 96,253
(60,900+15,353+20,000)

By Balance c/d 5,61,270

To Bank 2,00,000
6,57,523 6,57,523
2016
Jan. 1 To Balance b/d 5,61,270

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 5.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

6. REVISION OF THE ESTIMATED USEFUL LIFE OF PROPERTY, PLANT

AND EQUIPMENT
The residual value and the useful life of an asset should be reviewed at least at each financial year-end and,
if expectations differ from previous estimates, the change(s) should be accounted for as a change in an
accounting estimate in accordance with Accounting Standards.
Whenever there is a revision in the estimated useful life of the asset, the unamortised depreciable amount
should be charged over the revised remaining estimated useful life of the asset.

? ILLUSTRATION 12

A Machine costing ` 6,00,000 is depreciated on straight line basis, assuming 10 years working life and Nil residual
value, for three years. The estimate of remaining useful life after third year was reassessed at 5 years.
Required
Calculate depreciation for the fourth year.

 SOLUTION

Depreciation per year = ` 6,00,000 / 10 = ` 60,000

Depreciation on SLM charged for three years = ` 60,000 x 3 years = ` 1,80,000
Book value of the computer at the end of third year = ` 6,00,000 – ` 1,80,000 = ` 4,20,000.
Remaining useful life as per previous estimate = 7 years
Remaining useful life as per revised estimate = 5 years
Depreciation from the fourth year onwards = ` 4,20,000 / 5 = ` 84,000 per annum
In case the entity would have continued with estimate of 7 years of remaining useful life, depreciation for
4th year would have been ` 64,000.

7. REVALUATION OF PROPERTY, PLANT AND EQUIPMENT

If there is an upward revision in the value of asset for the first time, then the amount of appreciation is
debited to Asset Account and credited to Revaluation Reserve Account. If there is downward revision in the
value of asset then Profit and Loss Account is debited and Asset Account is credited. If an asset was earlier
revalued downward and later on revalued upward then the appreciation to the extent of earlier downfall is
credited to profit and loss account. If an asset was earlier revalued upward and then later on it was revalued
downward then the downfall to the extent of earlier appreciation is debited to Revaluation Reserve Account.
In case the revaluation has a material effect on the amount of depreciation, the same should be disclosed
separately in the year in which revaluation is carried out.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.25

Revaluation

Increase Decrease

Credited Exception Charged to Exception:

directly to When it is the Statement When it is
owners’ subsequent of profit and subsequent
interests loss
Increase Decrease
under the
heading of (Initially (Initially
Revaluation Decrease) Increase)
surplus
Recognised in the Statement of Decrease should be
Profit and loss to the extent that debited directly to
it reverses a revaluation decrease owners' interests
of the same asset previously under the heading of
recognised in the Statement of Revaluation surplus to
profit and loss the extent of any credit
balance existing in the
Revaluation surplus in
respect of that asset

? ILLUSTRATION 13

A machine of cost ` 12,00,000 is depreciated straight-line assuming 10 year working life and zero residual value
for three years. At the end of third year, the machine was revalued upwards by ` 60,000 the remaining useful life
was reassessed at 9 years.
Required
Calculate depreciation for the fourth year.

 SOLUTION

Depreciation per year charged for three years = ` 12,00,000 / 10 = ` 1,20,000

WDV of the machine at the end of third year = ` 12,00,000 – ` 1,20,000 × 3 = ` 8,40,000.
Depreciable amount after revaluation = ` 8,40,000 + ` 60,000 = ` 9,00,000
Remaining useful life as per previous estimate = 7 years
Remaining useful life as per revised estimate = 9 years
Depreciation for the fourth year onwards = ` 9,00,000 / 9 = `1,00,000.

© The Institute of Chartered Accountants of India

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 5.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

8. PROVISION FOR REPAIRS AND RENEWALS

Expenditure incurred for repairs, renewals and maintenance on plant and machinery may vary over the
years during the working life. Thus, for equalising the charge of repairs and renewals, sometimes a Provision
for Repairs and Renewals Account is opened. Total of such expenses that may be incurred over the working
life is estimated beforehand. Average of this expenditure is debited to Profit and Loss Account and credited
to Provision for Repairs and Renewals Account irrespective of actual expenses incurred. Every year Provision
for Repairs and Renewals Account is debited and Repairs Account is credited for actual expenses incurred.
The balance in provision for Repairs and Renewals Account is carried forward and in the end or on sale of
the asset, the account is closed by transfer to the Asset Account for any balance left.

? ILLUSTRATION 14

The following particulars are available from the books of a public company having a large fleet of vehicles:

`
Balance in Provision for Repairs and Renewals Account as on 31.3.2016 11,50,000
Actual repairs charged/incurred during the year ended
31.3.2016 7,50,000
31.3.2017 3,20,000
The company makes an annual provision of ` 4,00,000 on repairs and renewals.

Required
Draw up the Provision for Repairs and Renewals Account for the years 2015-2016 and 2016-2017.

 SOLUTION

Provision for Repairs and Renewal Account

` `
31.3.2016 To Repairs A/c 7,50,000 1.4.2015 By Balance b/d 15,00,000
31.3.2016 To Balance c/d 11,50,000 (Balancing figure)
31.3.2016 By Profit and Loss A/c 4,00,000
19,00,000 19,00,000
31.3.2017 To Repairs A/c 3,20,000 1.4.2016 By Balance b/d 11,50,000
31.3.2017 To Balance c/d 12,30,000 31.3.2017 By Profit and Loss A/c 4,00,000
15,50,000 15,50,000
1.4.2017 By Balance b/d 12,30,000

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.27

SUMMARY
w Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.
w Objectives for providing depreciation are:
ª Correct income measurement
ª True position statement
ª Funds for replacement
ª Ascertainment of true cost of production.
w Factors in the measurement of depreciation:
ª Cost of asset
ª Estimated useful life of the asset
ª Estimated scrap value (if any) at the end of useful life of the asset.
w Methods for providing depreciation:
ª Straight line method
ª Reducing balance method
ª Sum of years of digits method
ª Annuity method
ª Sinking fund method
ª Machine hour method
ª Production units’ method
ª Depletion method

w The resulting profit or loss on sale of the tangible asset is ultimately transferred to profit and loss
account.
w The depreciation method residual value & useful life applied to an asset should be reviewed at least
at each financial year-end and, if there has been a significant change in the expected pattern of
consumption of the future economic benefits embodied in the asset, on account of the above, they
should be changed to reflect the changed pattern.
w Whenever there is a revision in the estimated useful life of the asset, the unamortised depreciable
amount should be charged to the asset over the revised remaining estimated useful life of the asset.
w Whenever the depreciable asset is revalued, the depreciation should be charged on the revalued
amount on the basis of the remaining estimated useful life of the asset.

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 5.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

TEST YOUR KNOWLEDGE

Multiple Choice Questions

1. Original cost = ` 12,60,000; Salvage value = Nil; Useful life = 6 years. Depreciation for the first year under
sum of years digits method will be
(a) ` 3,60,000 (b) ` 1,20,000 (c) ` 1,80,000

2. Obsolescence of a depreciable asset may be caused by:

I. Technological changes.
II. Improvement in production method.
III. Change in market demand for the product or service output.
IV. Legal or other restrictions.
(a) Only (I) above
(b) Both (I) and (II) above
(c) All (I), (II), (III) and (IV) above

3. The number of production of similar units expected to be obtained from the use of an asset by an
enterprise is called as
(a) Unit life (b) Useful life (c) Production life

4. If a concern proposes to discontinue its business from March 2015 and decides to dispose of all its
plants within a period of 4 months, the Balance Sheet as on March 31, 2015 should indicate the plants
at their
(a) Historical cost (b) Net realizable value (c) Cost less depreciation

5. In the case of downward revaluation of a plant which is for the first time revalued, the account to be
debited is
(a) Plant account (b) Revaluation Reserve (c) Profit & Loss account

6. The portion of the acquisition cost of the tangible asset, yet to be allocated is known as
(a) Written down value (b) Accumulated value (c) Realisable value

7. The main objective of providing depreciation is to

(a) Create secret reserve (b) Reduce the book value of assets
(c) Allocate cost of the assets

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.29

8. Original cost of a machine was ` 25,20,000 salvage value was ` 1,20,000, useful life was 6 years.
Annual depreciation under Straight Line Method
(a) ` 4,20,000 (b) ` 4,00,000 (c) ` 3,00,000

9. The cost of a machine is ` 20,00,000. Two years later the book value is ` 10,00,000. The Straight-line
percentage depreciation is
(a) 50% (b) 33-1/3% (c) 25%

10. Original cost `13,00,000, Salvage value ` 40,000, Useful life 6 years. Depreciation for the first year under
sum-of-years digit methods will be
(a) ` 60,000 (b) ` 1,20,000 (c) ` 3,60,000

11. Which of the following assets does not depreciate?

(a) Machinery and equipment
(b) Patents
(c) Land
12. A company purchased a machinery on April 01, 2010, for ` 15,00,000. It is estimated that the machinery
will have a useful life of 5 years after which it will have no salvage value. The depreciation charged
during the year 2014-15 was
(a) ` 5,00,00 (b) ` 4,00,000 (c) ` 3,00,000

13. If the equipment account has a balance of ` 22,50,000 and the accumulated depreciation account has a
balance of ` 14,00,000, the book value of the equipment is
(a) ` 36,50,000 (b) ` 8,50,000 (c) ` 14,00,000

Theory Questions
1. Distinguish between Straight line method of depreciation and Written down value method of
depreciation.
2. Write short notes on:
(i) Depletion method of depreciation
(ii) Sinking fund method.
3. What factors are considered for calculation of depreciation of a plant?

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 5.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Questions
1. A firm’s plant and machinery account at 31st December, 2015 and the corresponding depreciation
provision account, broken down by year of purchase are as follows:

Year of Purchase Plant and Machinery at cost Depreciation Provision

` `
1998 2,00,000 2,00,000
2004 3,00,000 3,00,000
2005 10,00,000 9,50,000
2006 7,00,000 5,95,000
2013 5,00,000 75,000
2014 3,00,000 15,000
30,00,000 21,35,000

Depreciation is at the rate of 10% per annum on cost. It is the Company’s policy to assume that all
purchases, sales or disposal of plant occurred on 30th June in the relevant year for the purpose of
calculating depreciation, irrespective of the precise date on which these events occurred.

During 2015 the following transactions took place:

1. Purchase of plant and machinery amounted to ` 15,00,000
2. Plant that had been bought in 2004 for ` 170,000 was scrapped.
3. Plant that had been bought in 2005 for ` 90,000 was sold for ` 5,000.
4. Plant that had been bought in 2006 for ` 2,40,000 was sold for ` 15,000.

You are required to:

Calculate the provision for depreciation of plant and machinery for the year ended 31st December,
2015. In calculating this provision you should bear in mind that it is the company’s policy to show
any profit or loss on the sale or disposal of plant as a completely separate item in the Profit and Loss
Account. You are also required to prepare the following ledger accounts during 2015.
(i) Plant and machinery at cost;
(ii) Depreciation provision;
(iii) Sales or disposal of plant and machinery.
2. The Machinery Account of a Factory showed a balance of ` 19,00,000 on 1st January, 2015. Its accounts
were made up on 31st December each year and depreciation is written off at 10% p.a. under the
Diminishing Balance Method.
On 1st June 2015, a new machinery was acquired at a cost of ` 2,80,000 and installation charges incurred
in erecting the machine works out to ` 8,920 on the same date. On 1st June, 2015 a machine which had
cost ` 4,37,400 on 1st January 2013 was sold for ` 75,000. Another machine which had cost ` 4,37,000
on 1st January, 2014 was scrapped on the same date and it realised nothing.

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.31

Write a plant and machinery account for the year 2015, allowing the same rate of depreciation as in the
past calculating depreciation to the nearest multiple of a Rupee.

3. M/s. Prabha Pharmaceuticals has imported a machine on 1st July, 2014, for Pound 8,000, paid custom
duty and freight ` 80,000 and incurred erection charges ` 60,000. Another local machinery costing
`1,00,000 was purchased on 1st Jan 2015. On 1st July, 2016, a portion of the imported machinery (value
one-third) got out of order and was sold for ` 1,34,800. Another machinery was purchased to replace
the same for ` 50,000. Depreciation is to be calculated at 20% p.a on cost. Show the machinery account
for 2014, 2015, and 2016. Exchange rate is ` 80 per pound.

4. The LG Transport company purchased 10 trucks at ` 45,00,000 each on 1st April 2014. On October
1st, 2016, one of the trucks is involved in an accident and is completely destroyed and ` 27,00,000 is
received from the insurance in full settlement. On the same date another truck is purchased by the
company for the sum of ` 50,00,000. The company write off 20% on the original cost per annum. The
company observe the calendar year as its financial year.
Give the motor truck account for two year ending 31 Dec, 2017.

ANSWERS/HINTS
MCQs
1. (a) 2. (c) 3. (b) 4. (b) 5. (c) 6. (a)
7. (c) 8. (b) 9. (c) 10. (c) 11. (c) 12. (c)
13. (b)

Theoretical Questions
1. Under straight line method an equal amount is written off each year throughout the working life of
the depreciable tangible asset so as to reduce the cost of the asset to nil or to its scarp value at the
end. Under reducing balance method, a fixed percentage is charged on the diminishing balance of the
asset each year so as to reduce the value of the asset to its scarp value at the end of useful life. The basic
distinction between these two methods are as follows:
Under straight line method, annual depreciation charge is equal throughout the life of the asset; but
under reducing balance method, depreciation charge is reduced over the years as the asset grows old.
Under straight-line method, the asset can be fully depreciated but under reducing balance method
asset can never be fully depreciated.
Under straight line method the charge for depreciation is constant while repair charges increase with
the life of the asset, so the total charge throughout the life of the asset will not be uniform. To the
contrary, under reducing balance method, depreciation charges become high in the initial years but
generally repair remains low. As the asset grows old depreciation charge reduces but repair expenses
increase. Thus under reducing balance method depreciation and repairs are more or less evenly
distributed throughout the life of the asset.

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 5.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. (i) Natural resources include physical assets like mineral deposits, oil and gas resources and timber.
These natural resources exhaust by exploitation.
Depletion per unit is calculated as
Acquisition cost-Residual value
Estimated life in terms of production units

(ii) Sinking fund method of providing depreciation is used where the aim is not only to charge depreciation
but also to replace the asset. In case a large sum of money is required for the replacement of an asset
at the end of its effective life, it may not be advisable to leave in the amount of depreciation set apart
annually, for it may or may not be available in the form of concern itself the readily realisable assets
at the time it is required. To safeguard this position, the amount annually provided for depreciation
may be placed to the credit of the Sinking Fund account, and at the same time an equivalent amount
may be invested in government securities. The book value of the old asset, at the time, is transferred
to the Sinking Fund Account. Any amount realised on sale of the old asset, as well as the profit or loss
on sale of securities, is transferred to the Sinking Fund Account and it is closed off by transfer of the
balance to the profit and loss account or general reserve.
3. The factors considered for calculation of depreciation are as: (i)Cost of asset including expenses for
installation, commissioning, trial run etc. (ii) Estimated useful life of the asset and (iii) Estimated scrap
value (if any) at the end of useful life of the asset.

Practical Questions
Answer 1
Calculation of provision for depreciation of plant and machinery for the year ended 31st
December, 2015.
Plant purchased in: ` `
1998 nil
2004 nil
2005 50,000
2006 1/2 year at 10% on ` 2,40,000 12,000
1 year at 10% on ` 4,60,000 46,000 58,000
2013 10% on ` 5,00,000 50,000
2014 10% on ` 3,00,000 30,000
2015 1/2 year at 10% on ` 15,00,000 75,000
2,63,000

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.33

Plant and Machinery Account (for 2015) at Cost

` `
To Balance b/d 30,00,000 By Disposals account:
To Purchases A/c 15,00,000 Scrapped 1,70,000
Sold 3,30,000
By Balance c/d 40,00,000
45,00,000 45,00,000

Depreciation Provision Account (for 2015)

` `
To Disposal Account : By Balance b/d 21,35,000
Scrapped - 2004 assets 1,70,000 By Profit and Loss Account 2,63,000
Sold - 2005 assets 90,000
Sold - 2006 assets 2,16,000 4,76,000
To Balance c/d 19,22,000
23,98,000 23,98,000

Sale or disposal of Plant and Machinery Account (for 2015)

` `
To Plant and Machinery : By Provision for Depreciation 4,76,000
Scrapped 1,70,000 By Cash-Sales Proceeds 20,000
Sold 3,30,000 By Loss on sales 4,000
5,00,000 5,00,000
Answer 2
Plant and Machinery Account
` `
2015 2015
Jan. 1 To Balance b/d 19,00,000 June 1 By Bank (Sales) 75,000
June. 1 To Bank (2,80,000 + 2,88,920 By Depreciation 14,762
8,920) (on sold machine)
By Loss on sale 2,64,532
By Loss on scrapping 3,76,912
the machine
By Depreciation (on 16,388
scrapped machinery)
By Depreciation (Note iii) 1,32,094
By Balance c/d 13,09,232
21,88,920 21,88,920

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 5.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

Working Note :
(i) Calculation of loss on sale of machine on 1-6-2015
`
Cost on 1-1-2013 4,37,400
Less : Depreciation @ 10% on ` 4,37,400 (43,740)
W.D.V. on 31-12-2013 3,93,660
Less : Depreciation @ 10% on ` 3,93,660 (39,366)
W.D.V. on 31-12-2014 3,54,294
Less : Depreciation @ 10% on ` 3,54,294 for 5 months (14,762)
3,39,532
Less : Sale proceeds on 1-6-2015 (75,000)
Loss 2,64,532
(ii) Calculation of loss on scrapped machine
`
Cost on 1-1-2014 4,37,000
Less : Depreciation @ 10% on ` 4,37,000 (43,700)
W.D.V. on 1-1-2015 3,93,300
Less : Depreciation @ 10% on ` 3,93,300 for 5 months (16,388)
Loss 3,76,912
(iii) Depreciation
Balance of machinery account on 1-1-2015 19,00,000
Less : W.D.Vof machinery sold 3,54,294
W.D.V. of machinery scrapped 3,93,300 (7,47,594)
W.D.V. of other machinery on 1-1-2015 11,52,406
Depreciation @ 10% on ` 11,52,406 for 12 months 1,15,240
Depreciation @ 10% on ` 2,88,920 for 7 months 16,854
1,32,094

Answer 3
Machinery A/c

Date Particulars Amount Date Particulars Amount

2014 2014
Jul-01 To Bank A/c 6,40,000 Dec-31 By Depreciation A/c for ½ yr. 78,000
Jul-01 To Bank A/c 80,000 Dec-31 By balance c/d 7,02,000
Jul-01 To Bank A/c 60,000
7,80,000 7,80,000
2015 2015
Jan-01 To balance b/d 7,02,000 Dec-31 By Depreciation A/c 1,56,000
Jan-01 To Bank A/c 1,00,000 Dec-31 By balance c/d 6,46,000
8,02,000 8,02,000

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 CONCEPT AND ACCOUNTING OF DEPRECIATION 5.35

Date Particulars Amount Date Particulars Amount

2016 2016
Jan-01 To balance b/d 6,46,000 Jul-01 By Bank A/c 1,34,800
To Bank A/c 50,000 Jul-01 By Depreciation A/c 26,000
(On machinery sold)
Jul-01 By Profit & Loss A/c 21,200
(Loss on sale of machinery)
Dec-31 By Depreciation A/c 1,24,000
Dec-31 By balance c/d 3,90,000

6,96,000 6,96,000

Working Note:

1. In the absence of information about depreciation method to be used, Straight line method of
depreciation has been used. Alternatively, written down value method of depreciation may be assumed.
2. The method of machinery sold as on 1.7.2016 may be obtained as follow:

`
Cost of machinery sold as on 1.7.2014 2,60,000
Less: Depreciation for 2014 (for ½ year) (26,000)
2,34,000
Less: Depreciation for 2015 (52,000)
1,82,000
Less: Depreciation for 2016 (for ½ year) (26,000)
1,56,600
Less: Amount received (1,34,800)
21,200

Answer 4

Date Particulars Amount Date Particulars Amount

2016 2016
Jan-01 To balance b/d 2,92,50,000 Oct-01 By bank A/c 27,00,000
To Profit & Loss A/c
Oct-01 (Profit on settlement 4,50,000 Oct-01 By Depreciation 6,75,000
of Truck) on lost assets

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 5.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

Oct-01 To Bank A/c 50,00,000 Oct-01 By Depreciation A/c 83,50,000

Dec-31 By balance c/d 2,29,75,000

3,47,00,000 3,47,00,000

2017 2017
Jan-01 To balance b/d 2,29,75,000 Dec-31 By Depreciation A/c 91,00,000
Dec-31 By balance c/d 1,38,75,000

2,29,75,000 2,29,75,000

Working Note:

1. To find out loss on Profit on settlement of truck

`
Original cost as on 1.4.2014 45,00,000
Less: Depreciation for 2014 (6,75,000)
38,25,000
Less: Depreciation for 2015 (9,00,000)
29,25,000
Less: Depreciation for 2016 (9 months) (6,75,000)
22,50,000
Less: Amount received from Insurance company (27,00,000)
4,50,000

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 CHAPTER 6
ACCOUNTING FOR
SPECIAL TRANSACTIONS
UNIT 1 : BILLS OF EXCHANGE AND PROMISSORY NOTES
LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand the meaning of Bills of Exchange and Promissory Notes and also try to grasp their underlying
features.
w Understand the accounting treatments relating to issue, acceptance, discounting, maturity and
endorsement of bills in the books of drawer and drawee.
w Learn the technique of accounting relating to accommodation bills.
w Learn the special treatment needed in case of insolvency as well as early retirement of bill.

UNIT BILLS OF EXCHNAGE

OVERVIEW
Bill of exchange Promissory Note

Normal Trading Accommodation

Date of Expiry Nature of Bill Other Aspects

Due Date Bill at sight Dishonour of bill

Days of grace Bill after date Noting Charges

Maturity Date Bill on demand Renewal of bill

Insolvency

Retirement of bills

Bills for collection

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 6.2 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.1 BILLS OF EXCHANGE

It is general practice that when goods are sold or services are provided, the seller extends a credit period
to buyer. In sometimes, the seller may not be in a position to offer credit period and the purchase is not
in a position to pay immediately. In such circumstances the seller would like that the purchaser should
give a definite promise in writing to pay the amount of the goods on a certain date which he can use
to generate immediate funds. Commercial practice has developed to treat these written promises into
valuable instruments of credit that when a written promise is made in proper form and is properly stamped,
it is expected that the buyer discharges his debt and the seller receives payment. This is because written
promises are often accepted by banks and money is advanced against them. Also they can be endorsed,
i.e., passed on from person to person. The written promise is either in the form of a Bill of Exchange or in the
form of a promissory note.
A Bill of Exchange has been defined as an “instrument in writing containing an unconditional order signed
by the maker directing certain person to pay a certain sum of money only to or to the order of a certain
person or to the bearer of the instrument”. When such an order is accepted in writing on the face of the order
itself, it becomes a valid bill of exchange. Suppose A orders B to pay `50,000 for three months after date and
B accepts this order by signing his name, then it will be a bill of exchange.
A Bill of Exchange has the following characteristics:
1. It must be in writing.
2. It must be dated.
3. It must contain an order to pay a certain sum of money.
4. The promise to pay must be unconditional.
5. The money must be payable to a definite person or to his order to the bearer.
6. The draft must be accepted for payment by the party to whom the order is made.
7. It should be properly stamped.
8. Payment must be in legal currency of the country.

The party which makes the order is known as the drawer. The party which accepts the order is known as
the acceptor and the party to whom the amount has to be paid is known as the payee. The drawer and the
payee can be the same.
A Bill of Exchange can be passed on to another person by endorsement. Endorsement on a bill of exchange
is made exactly as it is done in the case of a cheque. The primary liability on a bill of exchange is that of the
acceptor. If he does not pay, a holder can recover the amount from any of the previous endorsers or the
drawee.
Sometimes, it may happen that a bill of exchange is drawn for foreign trade operations. Such a bill is known
as “Foreign Bill of Exchange”. A foreign bill of exchange is one which is drawn in one country and is payable
in another. It is generally drawn up in triplicate wherein each copy is sent by separate post so that at least
one copy reaches the intended party. Payment will be made only on one of the copies and when such
payment is made the other copies become useless. Section 12 of the Negotiable Instruments Act provides
that all instruments, which are not inland instrument, are foreign.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.3

A specimen of foreign bill of exchange is given below:

`11,50,000 New Delhi

July, 2016
Ninety days after date of this First Bill of Exchange (Second and Third of the same tenure and date
being unpaid) pay to the order of M/s. Vencent John & Associates, London the sum of Rupees Eleven
lakh Fifty thousand only, value received.
To,
Wallis Sons Accepted
M/s. IONX (Wallis Sons) Stamp
Birmingham, UK.

Drawee

The following are examples of foreign bills:

1. A bill drawn in India on a person resident outside India and made payable outside India.
2. A bill drawn outside India on a person resident outside India.
3. A bill drawn outside India and made payable in India.
4. A bill drawn outside India and made payable outside India.

1.2 PROMISSORY NOTES

A promissory note is an instrument in writing, not being a bank note or currency note containing an
unconditional undertaking signed by the maker to pay a certain sum of money only to or to the order of
a certain person. Under Section 31(2) of the Reserve Bank of India Act a promissory note cannot be made
payable to bearer.
A promissory note has the following characteristics:
1. It must be in writing.
2. It must contain a clear promise to pay. Mere acknowledgement of a debt is not a promissory note.
3. The promise to pay must be unconditional “I promise to pay `50,000 as soon as I can” is not an
unconditional promise.
4. The promiser or maker must sign the promissory note.
5. The maker must be a certain person.
6. The payee (the person to whom the payment is promised) must also be certain.
7. The sum payable must be certain. “I promise to pay `50,000 plus all fine” is not certain.
8. Payment must be in legal currency of the country.
9. It should not be made payable to the bearer.

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 6.4 PRINCIPLES AND PRACTICE OF ACCOUNTING

10. It should be properly stamped.

11. It does not require any acceptance.
Specimen of promissory note :
Specimen of a Promissory Note
` 10,00,000/- only Rohan
77, Sector-12, Ghaziabad
March 01, 2017
Three months after date I promise to pay Priya or his order the sum of ` Ten lakh only, for value received.
To,
Priya Stamp
S-11, Rohini, Delhi. (Rohan)

Payee Maker

1.3 DIFFERENCES - BILL OF EXCHANGE AND PROMISSORY NOTE

Bill of Exchange Promissory Note

A bill contains an unconditional order to pay A promissory note contains only a promise to pay
certain sum of money
There are generally 3 parties (Drawer, Drawee There are 2 parties (Maker and Payee) in promissory
and Payee) in bill of exchange note
A bill is paid by Acceptor A promissory note is paid by maker
A bill is drawn by creditor A promissory note is made by debtor
The drawer and payee may be same person in In promissory note maker and payee can not be same
case of bill of exchange person
In a bill of exchange the liability of drawer is In a promissory note the liability of a maker is primary
secondary and conditional and absolute
A bill of exchange can be accepted conditionally A promissory note cannot be made conditionally
In a bill of exchange, notice of dishonor must be Notice of dishonor is not required in case of promissory
given note
In case of dishonor, a bill of exchange must be Noting and protest is not required in case of dishonor of
noted and protested a promissory note.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.5

1.4 RECORD OF BILLS OF EXCHANGE AND PROMISSORY NOTES

A party which receives a Promissory Note or receives an accepted Bill of Exchange will treat it as a new asset
under the name of Bills receivable. A party which issues a Promissory Note or accepts a Bill of Exchange will
treat it as new liability under the heading of Bills Payable. We shall first deal with the entries in the books of
the party which receives promissory notes or bills. (When we talk of bills, we include promissory notes also).
On receipt of Bill, the payee makes the following entry in his books of accounts:
Bills Receivable Account Dr.
To Drawee/Maker of the note
(1) A accepts a Bill of exchange drawn on him by B. In the books of B the entry will be :
Bills Receivable Account Dr.
To A
(2) A sends to B the acceptance of D. In this case also, the entry in the books of B will be :
Bills Receivable Account Dr.
To A
The person who receives the bill has three options. These are:
(i) He can hold the bill till maturity. (Naturally in this case no further entry is passed until the date of
maturity arrives).
(ii) The bill can be endorsed in favour of another party say Z. In this case, the entry will be to debit the party
which now receives the bill and to credit the Bills Receivable Account.
Z Dr.
To Bills Receivable Account
(iii) The Bill of Exchange can be discounted with bank. The bank will deduct a small sum of money as
discount and pay rest of the money.
Bank Account Dr. (with the amount actually received)
Discount Account Dr. (with the amount of loss or discount)
To Bills Receivable Account
On the date of maturity there will be two possibilities:
(a) The first is that the bill will be paid, that is to say, met or honoured. The entries for this will depend upon
what was done to the bill during the period of maturity. If the bill was kept, the cash will be received by
the party which originally received the bill. In his books, therefore, the entry will be :
Cash Account Dr.
To Bills Receivable Account
But if he has already endorsed the bill in favour of his creditor or if the bill has been discounted with
the bank he will not get the amount; it will be the creditor or the bank which will receive the money.
Therefore, in these two cases, no entry will be made in the books of the party which originally received
the bill.

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 6.6 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) The second possibility is that the bill will be dishonoured, that is to say, the bill will not be paid. If the bill
is dishonoured, the bill becomes useless and the party from whom the bill was received will be liable to
pay the amount (and also the expenses incurred by the party).
Therefore, the following entries will be made :
1. If the bill was kept till maturity then :
Drawee / Maker of the note Dr.
To Bills Receivable Account
2. If the bill was endorsed in favour of a creditor, the entry is :
Drawee / Maker of the note Dr.
To Bill payables
3. If the bill was discounted with the bank :
Drawee / Maker of the note Dr.
To Bank A/c
Thus, it will be seen that in case of dishonour, the party which gave the bill has to be debited (because he
has become liable to pay the amount). The credit entry is in Bills Receivable Account (if it was retained) or
the Creditor or the bank (if it was endorsed/discounted in their favour).

1.5 TERM OF A BILL

The term of bill of exchange may be of any duration. Usually the term does not exceed 90 days from the date
of the bill.

w When a bill is drawn after sight, the term of the bill begins to run from the date of ‘sighting’, i.e., when
the bill is accepted.

w When a bill is drawn after date, the term of the bill begins to run from the date of drawing the bill.

1.6 EXPIRY / DUE DATE OF A BILL

The date on which the term of the bill terminates is called as ‘Expiry/Due Date of the bill’.

1.7 DAYS OF GRACE

Every instrument payable otherwise than on demand is entitled to three days of grace.

1.8 DATE OF MATURITY OF BILL

The date which comes after adding three days to the expiry/due date of a bill, is called the date of maturity.
The maturity of a promissory note or bill of exchange is the date at which it falls due. Every promissory note
or bill of exchange gets matured on the third day after the day on which it is expressed to be payable, except
when it is expressed to be payable:

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.7

(i) on demand,
(ii) at sight, or
(iii) on presentment

1.9 BILL AT SIGHT

Bill at Sight means the instruments in which no time for payment is mentioned. A cheque is always payable
on demand. A promissory note or bill of exchange is payable on demand-
(a) when no time for payment is specified, or
(b) when it is expressed to be payable on demand, or at sight or on presentment.
Notes:
(i) ‘At sight’ and ‘presentment’ means on demand.
(ii) An instrument payable on demand may be presented for payment at any time.
(iii) Days of grace is not to added to calculate maturity for such types of bill.

1.10 BILL AFTER DATE

Bill after date means the instrument in which time for payment is mentioned. A promissory note or bill of
exchange is a time instrument when it is expressed to be payable-
(a) after a specified period.
(b) on a specific day
(c) after sight
(d) on the happening of event which is certain to happen

Notes:
(i) The expression ‘after sight’ means-
(a) in a promissory note, after presentment for sight
(b) in a bill of exchange, after acceptance or noting for non-acceptance or protest for non-acceptance.
(ii) A cheque cannot be a time instrument because the cheque is always payable on demand. Though a cheque
can be post dated and which can be presented on or after such date. A cheque has validity of 90 days from its
date after that it becomes void, normally termed as ‘Stale Cheque’ as bank will not honour such cheque.

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 6.8 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.11 HOW TO CALCULATE DUE DATE OF A BILL

The due date of each bill is calculated as follows:

Case Due Date

(a) When the bill is made payable on a specific (a) That specific date will be the due date.
date.
(b) When the bill is made payable at a stated (b) That date on which the term of the bill shall expire
number of months(s) after date. will be the due date.
Note: The term shall expire on that day of the month
which corresponds with the day on which the
bill is dated. If the month in which the period
terminates has no corresponding day, the period
shall be deemed to expire on the last day of such a
month. For example a bill signed on January 31st
payable after 3 months will be due on April 30th.
(c) When the bill is made payable at a stated (c) That date which comes after adding stated number
number of days after date. of days to the date of bill, shall be the due date.
Note: The date of Bill is excluded.
(d) When the due date is a public holiday. (d) The preceding business day will be the due date.
(e) When the due date is an emergency/due (e) The next following day will be the date.
unforeseen holiday.
Note: The term of a Bill after sight commences from the date of acceptance of the bill whereas the term of
a Bill after date commences from the date of drawing of bill.

1.12 NOTING CHARGES

It is necessary that the fact of dishonour and the causes of dishonour should be established. If the acceptor
can prove that the bill was not properly presented to him for payment, he may escape liability. Therefore, if
there is dishonour, or fear of dishonour, the bill will be given to a public official known as “Notary Public”.
These officials present the bill for payment and if the money is received, they will hand over the money to
the original party. But if the bill is dishonoured they will note the fact of dishonour, with the reasons and give
the bill back to their client. For this service they charge a small fee. This fee is known as noting charges. The
amount of noting charges is recoverable from the party which is responsible for dishonour.

Suppose X received from Y a bill for `1,000. On Maturity the bill is dishonoured and `10 is paid as noting
charges. The entry in this case will be
` `
Y Dr. 1,010
To Bills Receivable Account 1,000
To Bank A/c 10

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.9

Suppose X had endorsed this bill in favour of Z. In that case entry for dishonoured bill would have been
Y Dr. 1,010
To Z 1,010
This is because Z will claim `1,010 from X and X has the right of recovering `1,010 from Y. Similarly, if the
bill has been discounted with a bank, entry will be :
Y Dr. 1,010
To Bank A/c 1,010

1.13 RENEWAL OF BILL

Sometimes the acceptor is unable to pay the amount and he himself moves that he should be given
extension of time and in consideration agrees to bear interest for the extended time period (calculated
from the date of renewal till the date of expected settlement). In such a case a new bill will be drawn and
the old bill will be cancelled. If this happens entries should be passed for cancellation of the old bill. This is
done exactly as already explained for dishonour. When the new bill is received entries for the receipt of the
bill will be repeated. The amount of the new bill may represent any of the following:
(i) Where the drawee pays nothing: Total of amount of original bill as well as the interest for the extended
time period.
(ii) Where the drawee pays the interest amount at the time of renewal: Amount of the Original bill.
(iii) Where the drawee makes part payment of the original bill or interest amount or both: That part of total of
amount of original bill as well as the interest for the extended time period on unpaid amount.

1.14 RETIREMENT OF BILLS OF EXCHANGE & REBATE

We have seen that renewal of a bill of exchange is made when a person does not have sufficient fund to pay
for the bill of exchange on the due date and he requires a further period of credit. Many a time instances do
arise when the acceptor has spare funds much before the maturity date of the bill of exchange accepted
by him. In such circumstances he approaches the payee of the bill of exchange and asks him whether the
payee is prepared to accept cash before the maturity date. In such cases the acceptor gets a certain rebate
or interest or discount for premature payment. The rebate becomes the income of the acceptor and expense
of the payee. It is a consideration of premature payment.

? ILLUSTRATION 1

Vijay sold goods to Pritam on 1st September, 2016 for `1,06,000. Pritam immediately accepted a three months
bill. On due date Pritam requested that the bill be renewed for a fresh period of two months. Vijay agrees provided
interest at 9% was paid immediately in cash. To this Pritam was agreeable. The second bill was met on due date.
Give Journal entries in the books of Vijay and Pritam.

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 6.10 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Books of Vijay
Journal

2016 ` `
1-Sept. Pritam Dr. 1,06,000
To Sales Account 1,06,000
(Sales of goods to Pritam as per Invoice No...)
Bills Receivable Account Dr. 1,06,000
To Pritam 1,06,000
(3 months acceptance received from Pritam for the
amount due from him)
Dec. 4 Pritam Dr. 1,06,000
To Bills Receivable Account 1,06,000
(Pritam acceptance cancelled because of renewal)
Pritam Dr. 1,590
To interest 1,590
(Interest @ 9% on `1,06,000 due from Pritam for 2
months because of renewal)
Bills Receivable Account Dr. 1,06,000
Cash Account Dr. 1,590
To Pritam 1,07,590
[New acceptance for 2 months for `106,000 and
Cash (for interest) received from Pritam]
2017
Feb. 7 Cash Account Dr. 1,06,000
To Bills Receivable Account 1,06,000
(Cash received against Pritam’s second acceptance)

Books of Pritam
Journal

2016 ` `
1-Sept. Purchase Account Dr. 1,06,000
To Vijay A/c 1,06,000
(Purchase of goods from Vijay as per Invoice No...)
Vijay A/c Dr. 1,06,000
To Bills Payables Account 1,06,000
(3 months acceptance given to Vijay for the amount)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.11

Dec. 4 Bills Payable Account Dr. 1,06,000

To Vijay A/c 1,06,000
(Cancellation of bill because of renewal)
Interest Account Dr. 1,590
To Vijay 1,590
(Interest @ 9% on `1,06,000 due to Vijay for 2 months
because of renewal)
Vijay Account Dr. 1,07,590
To Cash Account 1,590
To Bills Payable Account 1,06,000
[New acceptance for 2 months for `106,000 and
Cash (for interest) paid to Vijay]

2017
Feb. 7 Bills Payable Account Dr. 1,06,000
To Bank Account 1,06,000
(Cash paid against second bill)

? ILLUSTRATION 2

On 1st January, 2016, Ankita sells goods for `5,00,000 to Bhavika and draws a bill at three months for the amount.
Bhavika accepts it and returns it to Ankita. On 1st March, 2016, Bhavika retires her acceptance under rebate of
12% per annum. Record these transactions in the journals of Ankita and Bhavika.

 SOLUTION
Journal Entries in the books of Ankita

Date Particulars ` `
2016
Jan. 1 Bhavika’s account Dr. 5,00,000
To Sales account 5,00,000
(Being the goods sold to Bhavika on credit)
Bills receivable account Dr. 5,00,000
To Bhavika’s account 5,00,000
(Being the acceptance of bill received)
1-Mar Bank account Dr. 4,95,000
Rebate on bills account Dr. 5,000
To Bills receivable account 5,00,000
(Being retirement of bill by Bhavika one month
before maturity, the rebate being given to her at
12% p.a.)

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 6.12 PRINCIPLES AND PRACTICE OF ACCOUNTING

Journal Entries in the books of Bhavika

Date Particulars ` `
2016
Jan. 1 Purchases account Dr. 5,00,000
To Ankita account 5,00,000
(Being the goods purchased from Ankita on credit)
Ankita Account Dr. 5,00,000
To Bills Payable Account 5,00,000
(Being the acceptance of bill)
1-Mar Bills Receivable Account Dr. 5,00,000
To Rebate Income Account 5,000
To Bills receivable account 4,95,000
(Being retirement of bill one month before maturity,
the rebate being received at 12% p.a.)

? ILLUSTRATION 3

Journalise the following transactions in K. Katrak’s books.

(i) Katrak’s acceptance to Basu for `2,500 discharged by a cash payment of `1,000 and a new bill for the
balance plus `50 for interest.
(ii) G. Gupta’s acceptance for `4,000 which was endorsed by Katrak to M. Mehta was dishonoured. Mehta paid
`20 noting charges. Bill withdrawn against cheque.
(iii) D. Dalal retires a bill for `2,000 drawn on him by Katrak for `10 discount.
(iv) Katrak’s acceptance to Patel for `5,000 discharged by Patel. Mody’s acceptance to Katrak for a similar
amount.

 SOLUTION
Books of K. Katrak
Journal Entries

` `
(i) Bills Payable Account Dr. 2,500
Interest Account Dr. 50
To Cash A/c 1,000
To Bills Payable Account 1,550
(Bills Payable to Basu discharged by cash payment
of `1,000 and a new bill for `1,550 including `50 as
interest)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.13

(ii) (a) G. Gupta Dr. 4,020

To M. Mehta 4,020
(G. Gupta’s acceptance for `4,000 endorsed to M.
Mehta dishonoured,`20 paid by M. Mehta as noting
charges)
(b) M. Mehta Dr. 4,020
To Bank Account 4,020
(Payment to M. Mehta on withdrawal of bill earlier
received from Mr. G. Gupta)
(iii) Bank Account Dr. 1,990
Discount Account Dr. 10
To Bills Receivable Account 2,000
(Payment received from D. Dalal against his
acceptance for `2,000. Allowed him a discount of
`10)
(iv) Bills Payable Account Dr. 5,000
To Bills Receivable Account 5,000
(Bills Receivable from Mody endorsed to Patel in
settlement of bills payable issued to him earlier)

? ILLUSTRATION 4

On 1st January, 2016, Vilas draws a bill of exchange for `10,000 due for payment after 3 months on Eknath.
Eknath accepts to this bill of exchange. On 4th March, 2016 Eknath retires the bill of exchange at a discount of
12% p.a. You are asked to show the journal entries in the books of Eknath.

 SOLUTION
Journal entries in the books of Eknath

Date Particulars L.F. Debit ` Credit `

Jan. 1 Vilas A/c Dr. 10,000
To Bills Payable A/c 10,000
(Being the bill draws by him accepted)
Mar. 4 Bills Payable A/c Dr. 10,000
To Bank A/c 9,900
To Interest A/c (Discount A/c) 100
(Being retirement of acceptance 1 month before
maturity, interest allowed at 12% p.a.)

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 6.14 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 5

On 1st January, 2016, Vilas draws a Bill of Exchange for `10,000 due for payment after 3 months on Eknath.
Eknath accepts to this bill of exchange. On 4th March, 2016. Eknath retires the bill of exchange at a discount of
12% p.a. You are asked to show the journal entries in the books of Vilas.

 SOLUTION

Journal entries in the books of Vilas

Date Particulars Debit ` Credit `

2016
Jan. 1 Bills Receivable A/c Dr. 10,000
To Eknath A/c 10,000
(Being bill of exchange no . . . drawn on Eknath due
for payment on 4th April 2016)
Mar. 4 Bank A/c Dr. 9,900
Interest A/c (Discount) A/c Dr. 100
To Bills Receivable A/c 10,000
(Being retirement of bill of exchange due for maturity
on 4th April, 2016 by Eknath 1 month before maturity,
the rebate being given to him at12% p.a.)

1.15 INSOLVENCY
Insolvency of a person means that he is unable to pay his liabilities. This means that bills accepted by him
will be dishonoured. Therefore, when it is known that a person has become insolvent, entry for dishonour
of his acceptance must be passed. Later on, something may be received from his estate. When and if an
amount is received, cash account will be debited and the personal account of the debtor will be credited.
The remaining amount will be irrecoverable and, therefore, should be written off as bad debt. The students
should be careful to calculate the amount actually received from an insolvent’s estate and amount to be
written off only after preparing his account.
In the books of drawee of the bill, the amount not ultimately paid by him due to insolvency, should be
credited to Deficiency Account.

? ILLUSTRATION 6

Mr. David draws two bills of exchange on 1.1.2016 for `6,000 and `10,000. The bills of exchange for `6,000 is for
two months while the bill of exchange for `10,000 is for three months. These bills are accepted by Mr. Thomas.
On 4.3.2016, Mr. Thomas requests Mr. David to renew the first bill with interest at 18% p.a. for a period of two
months. Mr. David agrees to this proposal. On 20.3.2016, Mr. Thomas retires the acceptance for `10,000, the
interest rebate i.e. discount being `100. Before the due date of the renewed bill, Mr. Thomas becomes insolvent
and only 50 paise in a rupee could be recovered from his estate.
You are to give the journal entries in the books of Mr. David.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.15

 SOLUTION

Journal Entries in the books of Mr. David

2016 (`) (`)

Jan. 1 Bills receivable (No. 1) A/c Dr. 6,000
Bills receivable (No. 2) A/c Dr. 10,000
To Mr. Thomas’s A/c 16,000
(Being drawing of bills receivable No. 1 due for
maturity on 4.3.2016 and bills receivable No. 2 due
for maturity on 4.4.2016)
4-Mar Mr. Thomas’s A/c Dr. 6,000
To Bills receivable (No.1) A/c 6,000
(Being the reversal entry for bill No.1 on agreed
renewal)
4-Mar Bills receivable (No. 3) A/c Dr. 6,180
To Interest A/c 180
To Mr. Thomas’s A/c 6,000
(Being the drawing of bill of exchange no. 3 due
for maturity on 7.5.2016 together with interest at
18%p.a. in lieu of the original acceptance of Mr.
Thomas)
20-Mar Bank A/c Dr. 9,900
Discount A/c Dr. 100
To Bills receivable (No. 2) A/c 10,000
(Being the amount received on retirement of bills
No.2 before the due date)
7-May Mr. Thomas’s A/c Dr. 6,180
To Bills receivable (No. 3) A/c 6,180
(Being the amount due from Mr. Thomas on
dishonour of his acceptance on presentation on
the due date)
7-May Bank A/c Dr. 3,090
To Mr. Thomas’s A/c 3,090
(Being the amount received from official assignee
of Mr. Thomas at 50 paise per rupee against
dishonoured bill)
May 7 Bad debts A/c Dr. 3,090
To Mr. Thomas’s A/c 3,090
(Being the balance 50% debt in Mr. Thomas’s
Account arising out of dishonoured bill written as
bad)

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 6.16 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 7

Rita owed `1,00,000 to Siriman. On 1st October, 2016, Rita accepted a bill drawn by Siriman for the amount at 3
months. Siriman got the bill discounted with his bank for `99,000 on 3rd October, 2016. Before the due date, Rita
approached Siriman for renewal of the bill. Siriman agreed on the conditions that `50,000 be paid immediately
together with interest on the remaining amount at 12% per annum for 3 months and for the balance, Rita should
accept a new bill at three months. These arrangements were carried out. But afterwards, Rita became insolvent
and 40% of the amount could be recovered from his estate.
Pass journal entries (with narration) in the books of Siriman.

 SOLUTION
In the books of Siriman
Journal Entries

Particulars L.F. ` `
Bills Receivable A/c Dr. 1,00,000
To Rita 1,00,000
(Being a 3 month’s bill drawn on Rita for the amount due)
Bank A/c Dr. 99,000
Discount A/c Dr. 1,000
To Bills Receivable A/c 1,00,000
(Being the bill discounted)
Rita Dr. 1,00,000
To Bank A/c 1,00,000
(Being the bill cancelled up due to Rita’s inability to pay it)
Rita Dr. 1,500
To Interest A/c 1,500
(Being the interest due on ` 50,000 @ 12% for 3 months)
Bank A/c Dr. 51,500
To Rita 51,500
(Being the receipt of a portion of the amount due on the bill
together with interest)
Bills Receivable A/c Dr. 50,000
To Rita 50,000
(Being the new bill drawn for the balance)
Rita Dr. 50,000
To Bills Receivable A/c 50,000
(Being the dishonour of the bill due to Rita’s insolvency)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.17

Bank A/c Dr. 20,000

Bad Debts A/c Dr. 30,000
To Rita 50,000
(Being the receipt of 40% of the amount due on the bill from
Rita’s estate)

1.16 ACCOMMODATION BILLS

Bills of Exchange are usually drawn to facilitate trade transmission, that is, bills are meant to finance actual
purchase and sale of goods. But the mechanism of bill can be utilised to raise finance also. Suppose Boss
needs finance for three months. In that case he may persuade his friend Kapoor to accept his draft. The bill of
exchange may then be taken by Boss to his bank and get it discounted there. Thus, Boss will be able to make
use of funds. When the three months period expires, Boss will send the requisite amount to Kapoor and
Kapoor will meet the bill. Thus, Boss is able to raise money for his use. If both Boss and Kapoor need money,
the same devise can be used. Either Boss accepts a bill of exchange or Kapoor does. In either case, the bill
will be discounted with the bank and the proceeds divided between the two parties according to mutual
agreement. The discounting charges must also be borne by the two parties in the same ratio in which the
proceeds are divided. On the due date the acceptor will receive from the other party his share. The bill will
then be met. When bills are used for such a purpose, they are known as accommodation bills.
However, it may so happen that the drawer is not able to remit the proceeds to drawee on the due date. In
such a case, the drawee may draw a bill on the drawer, and get it discounted with the bank to honour the
first bill. If the new drawer (drawee of the first bill) also remits some proceeds of the new bill to new drawee
(drawer of the first bill), then the proportion of discount to be borne by the new drawee will be based upon
the proceeds remitted as well as the benefit obtained by him on the first bill (i.e., by not paying the amount
due to the original drawee on due date).
Entries are passed in the books of two parties exactly in the way already pointed out for ordinary bills. The
only additional entry to be passed is for sending the remittance for one party to the other party and also
debiting the other party with the shared amount of discount.

? ILLUSTRATION 8

On 1st July, 2016 Gorge drew a bill for `1,80,000 for 3 months on Harry for mutual accommodation. Harry accepted
the bill of exchange. Gorge had purchased goods worth `1,81,000 from Jack on the same date. Gorge endorsed
Harry’s acceptance to Jack in full settlement. On 1st September, 2016, Jack purchased goods worth `1,90,000
from Harry. Jack endorsed the bill of exchange received from Gorge to Harry and paid ` 9,000 in full settlement of
the amount due to Harry. On 1st October, 2016, Harry purchased goods worth `2,00,000 from Gorge. Harry paid
the amount due to Gorge by cheque. Give the necessary Journal Entries in the books of Harry and Gorge.

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 6.18 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION

In the books of Harry

Journal Entries

Date Particulars ` `
1.7.2016 Gorge’s account Dr. 1,80,000
To Bills payable account 1,80,000
(Acceptance of bill drawn by Gorge)
1.9.2016 Jack’s account Dr. 1,90,000
To Sales account 1,90,000
(Sales made to Jack)
1.9.2016 Bills receivable account Dr. 1,80,000
Bank account Dr. 9,000
Discount account Dr. 1,000
To Jack’s account 1,90,000
(Acceptance received from Jack’s endorsement of
bill received from Gorge for ` 1,80,000 and ` 9,000
received in full settlement of the amount due)
1.9.2016 Bills payable account Dr. 1,80,000
To Bills receivable account 1,80,000
(Own acceptance received from Jack’s endorsement,
cancelled)
1.10.2016 Purchase account Dr. 2,00,000
To Gorge’s account 2,00,000
(Purchases made from Gorge)
Gorge’s account Dr. 20,000
To Bank account 20,000
(Amount paid to Gorge after adjusting `180,000
for accommodation extended to him)

In the books of Gorge

Journal Entries

Date Particulars ` `
1.7.2016 Purchases Account Dr. 1,81,000
To Jack Account 1,81,000
(Purchase of goods from Jack)
1.7.2016 Bills Receivable Account Dr. 1,80,000
To Harry Account 1,80,000
(Acceptance by Harry of bill drawn on him)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.19

1.7.2016 Jack’s account Dr. 1,81,000

To Rebate Account 1,000
To Bills Receivable Account 1,80,000
(Harry’s bill endorsed to Jack)
1.10.2016 Harry Account Dr. 2,00,000
To Sales account 2,00,000
(Sales to Harry)
1.10.2016 Bank Account Dr. 20,000
To Harry account 20,000
(Amount received from Gorge after adjusting
`180,000 for accommodation extended by him)

? ILLUSTRATION 9

For the mutual accommodation of ‘X’ and ‘Y’ on 1st April, 2016, ‘X’ drew a four months’ bill on ‘Y’ for `4,000. ‘Y’
returned the bill after acceptance of the same date. ‘X’ discounts the bill from his bankers @ 6% per annum and
remit 50% of the proceeds to ‘Y’. On due date ‘X’ is unable to send the amount due and therefore ‘Y’ draws a bill for
`7,000, which is duly accepted by ‘X’. ‘Y’ discounts the bill for `6,600 and sends `1,300 to ‘X’. Before the bill is due
for payment ‘X’ becomes insolvent. Later 25 paise in a rupee received from his estate.
Record Journal entries in the books of ‘X’.

 SOLUTION
In the books of X
Journal Entries

Date Particulars Debit Credit

2016 ` `
1-Apr Bills receivable account Dr. 4,000
To Y’s account 4,000
(Acceptance received from Y for mutual
accommodation)
1-Apr Bank account Dr. 3,920
Discount account Dr. 80
To Bills receivable account 4,000
(Bill discounted for ` 3,920)
Y’s account Dr. 2,000
To Cash account 1,960
To Discount account 40
(Half of proceeds remitted to Y)

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 6.20 PRINCIPLES AND PRACTICE OF ACCOUNTING

Aug. 4 Y’s account Dr. 7,000

To Bills payable account 7,000
(Acceptance given to Y, being unable to remit the due
amount)
Bank account Dr. 1300
 2, 000 + 1,300 
Discount account  × 400  Dr. 200
6, 600 
To Y’s account 1500
(Amount received from Y and discount amount
credited to him)
Bills payable account Dr. 7,000
To Y’s account 7,000
(Acceptance to Y dishonoured because of insolvency)
Y account Dr. 3,500
To Bank account 875
To Deficiency account 2,625
(Amount paid @ 25 paise in a rupee and balance
credited to deficiency account as being unable to pay)

? ILLUSTRATION 10

Anil draws a bill for `9,000 on Sanjay on 5th April, 2016 for 3 months, which Sanjay returns it to Anil after
accepting the same. Anil gets it discounted with the bank for ` 8,820 on 8th April, 2016 and remits one-third
amount to Sanjay. On the due date Anil fails to remit the amount due to Sanjay, but he accepts a bill for `12,600
for three months, which Sanjay discounts it for ` 12,330 and remits ` 2,220 to Anil. Before the maturity of the
renewed bill Anil becomes insolvent and only 50% was realized from his estate on 15th October, 2016.
Pass necessary Journal entries for the above transactions in the books of Anil.

 SOLUTION
In the books of Anil
Journal Entries

Date Particulars Debit Credit

Amount Amount
2016 ` `
5-Apr Bills receivable account Dr. 9,000
To Sanjay’s account 9,000
(Being acceptance received from Sanjay for mutual
accommodation)
8-Apr Bank account Dr. 8,820
Discount account Dr. 180
To Bills receivable account 9,000
(Being bill discounted with bank)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.21

8-Apr Sanjay’s account Dr. 3,000

To Bank account 2,940
To Discount account 60
(Being one-third proceeds of the bill sent to Sanjay)
8-Jul Sanjay’s account Dr. 12,600
To Bills payable account 12,600
(Being Acceptance given)
8-Jul Bank account Dr. 2,220
Discount account (270 × 2/3) Dr. 180
To Sanjay’s account 2,400
(Being proceeds of second bill received from Sanjay)
Oct.11 Bills payable account Dr. 12,600
To Sanjay’s account 12,600
(Being bill dishonoured due to insolvency)
Oct.15 Sanjay’s account (6,000+2,400) Dr. 8,400
To Bank account 4,200
To Deficiency account 4,200
(Being insolvent, only 50% amount paid to Sanjay)

1.17 BILLS OF COLLECTION

When a person receives a bill of exchange, he may decide to retain the bill till the date of maturity. But in
order to ensure safety, he may send it to bank with instructions that the bill should be retained till maturity
and should be realised on that date. This does not mean discounting because the bank will not credit the
client until the amount is actually realised. If the bill is sent to the bank with such instructions it is known as
“Bill sent for collection”.
It is better to make a record of this also in books by passing following entry:
Bills for Collection Account Dr.
To Bills Receivable Account
When the amount is realised the entry will be
Bank Account Dr.
To Bills for Collection Account
When the amount is not honoured, the entry will be
Party (from whom the bill was received) Dr.
To Bills for collections A/c

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 6.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

1.18 BILLS RECEIVABLE AND BILLS PAYABLE BOOKS

Bills receivable and bills payable books are journals (Day Books) to record in a chronological order the details
of bills receivable and bills payable. When large number of bill transactions take place in an organization, it
is convenient to maintain these books. Wherein any bill transaction takes place, the same is entered in the
Day Books in the first instance. Postings to individual Debtors or Creditors accounts are made from the Day
Books. Also totals of bills received or accepted are posted periodically to Bills Receivable Account and Bills
Payable Account respectively.
Bills receivable book and bills payable book are very useful for following up the status of outstanding bills.
When there are large number of bills and these bills fall due on different dates, some of these bills may not
be honoured on maturity due to varied reasons. It is possible from these Day Books to trace the details of
the outstanding bills and to identify the reasons for not honouring the bills. Given below are forms of Day
Books for both bills receivable and bills payable:

Bills Receivable Book (Folio No . . .)

Date of Voucher Party from whom Acceptor Date Due Place of Amt. ` L.F. Mode of Disposal
receipt No. Received of Bill Date Payment

Bills Payable Book (Folio No . . .)

Date of Drawer Payee Date of Bill Due Date Place of Amt.` L.F. Mode of Disposal
Acceptance Payment

SUMMARY
w A Bill of Exchange is defined as an “instrument in writing containing an unconditional order signed by
the maker directing a certain person to pay a certain sum of money only to or to the order of a certain
person or to the bearer of the instrument”.

w A promissory note is an instrument in writing, not being a bank note or currency note containing an
unconditional undertaking signed by the maker to pay a certain sum of money only to or to the order
of a certain person. Under Section 31(2) of the Reserve Bank of India Act a promissory note cannot be
made payable to bearer.

w A party which receives a Promissory Note or receives an accepted Bill of Exchange will treat it as a new
asset under the name of Bills receivable. A party which issues a Promissory Note or accepts a Bill of
Exchange will treat it as new liability under the heading of Bills Payable.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.23

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. On 1.1.2017, A draws a bill on B for `1,20,000 for 3 months’ maturity date of the bill will be:
(a) 1.4.2017 (b) 3.4.2017 (c) 4.4.2017

2. On 16.6.2016 P draws a bill on Q for `1,25,000 for 30 days. 19th July is a public holiday, maturity date
of the bill will be:
(a) 19th July (b) 18th July (c) 17th July

3. PQ draws a bill on XY for `130,000 on 1.1.2017. X accepts the same on 4.1.2017 for period of 3 months
after date. What will be the maturity date of the bill:
(a) 4.4.2017 (b) 3.4.2017 (c) 7.4.2017

4. A draws a bill on B. A endorsed the bill to C. The payee of the bill will be
(a) A (b) B (c) C

5. A bill of ` 120,000 was discounted by Saras with the banker for `1,18,800. At maturity, the bill returned
dishonoured, noting charges ` 200. How much amount will the bank deduct from Saras’s bank balance
at the time of such dishonour?
(a) `1,20,000 (b) `1,18,800 (c) `1,20,200

6. X draws a bill on Y for `300,000 on 1.1.2016 for 3 months after sight, date of acceptance is 6.1.2016.
Maturity date of the bill will be:
(a) 8.4.2016 (b) 9.4.2016 (c) 10.4.2016

7. X sold goods to Y for ` 5,00,000. Y paid cash `4,30,000. X will grant 2% discount on balance, and Y
request X to draw a bill for balance, the amount of bill will be:
(a) ` 98,000 (b) ` 68,000 (c) ` 68,600
8. On 1.1.2017, X draws a bill on Y for ` 5,00,000 for 3 months. X got the bill discounted 4.1.2017 at 12%
rate. The amount of discount on bill will be:
(a) ` 15,000 ( b) ` 16,000 (c) ` 18,000

9. Mr. Jay draws a bill on Mr. John for ` 3,00,000 on 1.1.2017 for 3 months. On 4.2.2017, John got the bill
discounted at 12% rate. The amount of discount will be:
(a) ` 9,000 (b) ` 6,000 (c) ` 3,000

10. XZ draws a bill on YZ for ` 2,00,000 for 3 months on 1.1.2017. The bill is discounted with banker at a
charge of `1,000. At maturity the bill return dishonoured. In the books of XZ, for dishonour, the bank
account will be credited by:
(a) `199,000 (b) ` 200,000 (c) ` 201,000

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 6.24 PRINCIPLES AND PRACTICE OF ACCOUNTING

11. On 1.1.2017, XA draws a bill on YB for ` 1,00,000. At maturity YB request XA to renew the bill for 2
month at 12% p.a. interest. Amount of interest will be:
(a) ` 2,000 (b) ` 1,500 (c) ` 1,800

12. A bill of exchange is drawn by a

(a) Creditor (b) Debtor (c) Debenture holder

13. At the time of drawing a bill, the drawer credits

(a) Bills Receivables A/c
(b) Bills Payable A/c
(c) Debtor’s A/c

14. A promissory note is made by a

(a) Seller (b) Purchaser (c) Endorsee

15. A bill of exchange contains

(a) An unconditional order
(b) A promise
(c) A request to deliver the goods

16. A promissory note contains

(a) An unconditional order
(b) A promise
(c) A request to deliver the goods

17. The rebate on the bill shows that

(a) It has been endorsed
(b) It has been paid after the date of maturity
(c) It has been paid before the date of maturity

18. Notary Public may charge his fee from the

(a) Holder of bill of exchange
(b) Drawer
(c) None

Theory Questions
Q1. Write short notes on:
(a) Accommodation bill.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.25

(b) Renewal of bill.

(c) Noting charges.
Q2. What is bill of exchange? How does it differ from Promissory Note?

Practical Questions
Q1 On 1st January, 2016, A sells goods for `10,000 to B and draws a bill at three months for the amount.
B accepts it and returns it to A. On 1st March, 2016, B retires his acceptance under rebate of 12% per
annum. Record these transactions in the journals of B.
Q2 A draws upon B three Bills of Exchange of ` 3,000, ` 2,000 and ` 1,000 respectively. A week later his
first bill was mutually cancelled, B agreeing to pay 50% of the amount in cash immediately and for the
balance plus interest `100, he accepted a fresh Bill drawn by A. This new bill was endorsed to C who
discounted the same with his bankers for `1,500. The second bill was discounted by A at 5%. This bill on
maturity was returned dishonoured (nothing charge being `30). The third bill was retained till maturity
when it was duly met.
Give the necessary journal entries recording the above transactions in the books of A.
Q3 Journalize the following in the books of Don:
(i) Bob informs Don that Ray’s acceptance for ` 3,000 has been dishonoured and noting charges are
` 40. Bob accepts ` 1,000 cash and the balance as bill at three months at interest of 10%.Don accepts
from Ray his acceptance at two months plus interest @ 12% p.a.
(ii) James owes Don ` 3,200; he sends Don’s own acceptance in favour of Ralph for ` 3,160; in full
settlement.
(iii) Don meets his acceptance in favour of Singh for ` 4,500 by endorsing John’s acceptance for ` 4,450
in full settlement.
(iv) Ray’s acceptance in favour of Don retired one month before due date, interest is taken at the rate of
6% p.a.
ANSWERS/HINTS
MCQs

1 (c) 2 (b) 3 (a) 4 (c) 5 (c) 6 (b)

7 (c) 8 (a) 9 (b) 10 (b) 11 (a) 12 (a)
13 (c) 14 (b) 15 (a) 16 (b) 17 (c) 18 (a)

Theoretical Questions
1 (a) Bills of Exchange are usually drawn to facilitate trade transmission, that is, bills are meant to finance
actual purchase and sale of goods. But the mechanism of bill can be utilised to raise finance also.
When bills are used for such a purpose, they are known as accommodation bills.
(b) When the acceptor of a bill finds himself in financial straits to honour the bill on the due date, then
he may request the drawer to cancel the original bill and draw on him a fresh bill for another period.
And if the drawer agrees, a new bill in place of the original bill may be accepted by the drawee for
another period. This is called the renewal of bill.

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 6.26 PRINCIPLES AND PRACTICE OF ACCOUNTING

(c) The charges paid to Notary public for notify the dishonour are noting charges. Refer para 1.12 for
details.
2 A bill of exchange has been defined as “an instrument in writing containing an unconditional order
signed by the maker directing a certain person to pay a certain sum of money only to or to the order
of certain person or to the bearer of the instrument”. When such an order is accepted by the drawee, it
becomes a valid bill of exchange. A promissory note is an instrument in writing (not being a bank note
or a government currency note) containing an unconditional undertaking, signed by the maker, to pay
a certain sum of money only to, or to the order of, a certain person, or to the bearer of the instrument.
A promissory note needs no acceptance, as the debtor himself writes the document promising to pay
the stated amount. Like bills of exchange, promissory notes are also negotiable instruments, and can
be transferred by endorsement. In case of bill of exchange, the drawer and the payee may be the same
person but in case of a promissory note, the maker and the payee cannot be the same person.

Practical Questions
Answer 1
Journal Entries in the books of B

Date Particulars Debit Credit

2016 ` `
Jan. 1 Purchases account Dr. 10,000
To A’s account 10,000
(Being the goods purchased from A on credit)
A’s account Dr. 10,000
To Bills payable account 10,000
(Being the acceptance of bill given to A)
1-Mar Bills payable account Dr. 10,000
To Bank account 9,900
To Rebate on bills account 100
(Being the bill discharged under rebate @ 12% p.a.)

Working Note :
Calculation of rebate:
10,000 x 12/100 x 1/12 = `100

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.27

Answer 2
Journal of A

` `
Bills Receivable A/c Dr. 6,000
To B 6,000
(Three bills for `3,000, `2,000 and `1,000 drawn on B and duly accepted
by him received)

B Dr. 3,000
To Bills Receivable A/c 3,000
(Bill received from B cancelled for renewal)
Cash Account Dr. 1,500
Bill Receivable Account Dr. 1,600
To B 3,000
To Interest Account 100
(Amount received on cancellation of the first bill,50% along with a new
bill for 50% of the amount plus interest `100)
C Dr. 1,600
To Bills Receivable A/c 1,600
(A’s acceptance endorsed in favour of C)
Bank A/c Dr. 1,900
Discount A/c Dr. 100
To Bills Receivable A/c 2,000
(Second Bill for ` 2,000 discounted with the bank @ 5%)
B Dr. 2,030
To Bank A/c 2,030
(Second Bill for `2,000 discounted with the Bank dishonoured, noting
charges `30 paid by the Bank)
Bank A/c Dr. 1,000
To Bills Receivable A/c 1,000
(Amount received on maturity of the third bill)
Note: It is assumed that the bill for `1,600 has not yet fallen due for payment.

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 6.28 PRINCIPLES AND PRACTICE OF ACCOUNTING

Answer 3
Books of Don

` `
(i)(a) Ray Dr. 3,040
To Bob 3,040
(Ray’s acceptance endorsed to Bob dishonoured on due date
nothing charges paid by Bob `40)
(b) Bob Dr. 3,040
Interest Dr. 51
To Cash 1,000
To Bills Payable A/c 2,091
(Amount payable to Bob `3,040 settled by cash payment
`1,000 and issue of new bill for `2,091 including interest ` 51
for three months on `2,040 @ 10% p.a.)
(c) Bills Receivable A/c Dr. 3,100.80
To Ray 3,040.00
To Interest 60.8
(Bill received from Ray for `3,040due against earlier acceptance
dishonoured plus ` 60.80 interest for two months @ 12% p.a.)
(ii) Bills Payable A/c Dr. 3,160
Discount A/c Dr. 40
To James 3,200
(Cancellation of bills payable to Ralph for `3,160 in settlement
of `3,200 due from James)
(iii) Bills payable A/c Dr. 4,500
To Bills Receivable A/c 4,450
To Discount A/c 50
(Settlement of acceptance issued to Mr. Singh by endorsement
of John’s Acceptance for `4,450)
(iv) Bank A/c Dr. 3,085.30
Discount A/c Dr. 15.5
Total Bills Receivable A/c 3,100.80
(Amount received from Ray in settlement of Bills Payable,
retired one month before due date)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.29

UNIT 2 : SALE OF GOODS ON APPROVAL OR RETURN BASIS

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand the nature of goods sent on approval or return basis.
w Learn the accounting treatment of sales on approval or return basis under different situations

UNIT Sale of Goods on Approval or Return Basis

OVERVIEW
Accounting treatment when the business sends goods

Casually Frequently Numerously

Sales or Sales or
Transaction Sales or
Return Return Day Return
is treated Book Ledger
Journal is
as Ordinary prepared
Sale with four
main
columns Treated as
Memorandum
Books

Goods sent Goods Goods

Balance
on Approval Returned Approved

2.1 INTRODUCTION
Under normal course of business, goods sold to customers is treated as sale immediately when the goods
are sold, with corresponding revenue from such sale being recognized in the profit and loss account.
However, when a businessman wants to increase his sales or introduce a new product in the market, he
usually faces hardship due to competition prevailing in the market. To counter it, goods are sometimes sent
to the customers on sale or return basis. Here, goods sent on ‘approval’ or ‘on return’ basis means goods are
delivered to the customers with the option to retain or return them within a specified period. Generally,
these transactions take place between a manufacturer (or a wholesaler) and a retailer. In current scenario,
this practice is prevalent in case of online sales, where the buyer is given time of few days to return the goods
if the buyer believes that the specifications of goods are different from the same mentioned on website at
the time of sale. There may be certain terms and conditions to administrate the return of goods. Following
are essentially the features of sale of goods on approval or return basis:
(a) There is a change in the possession of goods from one person to another.

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 6.30 PRINCIPLES AND PRACTICE OF ACCOUNTING

(b) It does not involve transfer of ownership of goods. The ownership is passed only when the buyer gives
his approval or if the goods are not returned within that specified period.
(c) The customer does not incur any liability when the goods are merely sent to him. In case of online
transactions, sometimes customers are given choice to pay on receipt of goods and in some cases they
are required to pay in advance and then seller ships the goods to buyer. Even in case the buyer has
paid in advance, it retains the right of refund if the goods are returned as per the terms and conditions
agreed between seller and buyer.
As per the definition given under the Sale of Goods Act, 1930, in respect of such goods, the sale will take
place or the property in the goods pass to the buyer:
(i) When he signifies his approval or acceptance to the seller;
(ii) When he does some act adopting the transaction;
(iii) If he does not signify his approval or acceptance to the seller but retains the goods without giving
notice of rejection, on the expiry of the specified time (if a time has been fixed) or on the expiry of
a reasonable time (if no time has been fixed).

2.2 ACCOUNTING RECORDS

Accounting entries depend on the fact whether the business sends goods on sale or return basis (i) casually;
(ii) frequently; and (iii) numerously.

2.2.1 WHEN THE BUSINESS SENDS GOODS CASUALLY ON SALE OR RETURN BASIS
When the transactions are few, the seller on sending the goods, treats them as an ordinary sale. If the goods
are accepted or not returned or the business receives no intimation within the specified time limit, no extra
entry is required to be passed because the entry for sale (passed at the time of sending goods) becomes the
usual entry after the expiry of the specified period. If the goods are returned within a specified time limit, a
reverse entry is passed to cancel the previous transaction. If, at the year-end, goods are still lying with the
customers and the specified time limit is yet to expire, the entry for sales made earlier is cancelled and the
value of the goods lying with the customers must be reduced from the selling price to the cost price, and
treated as ordinary Inventories for Balance Sheet purposes.
Journal Entries:
1. When goods are sent on sale or return basis:
Trade receivables / Customers Account Dr. [Invoice price]
To Sales Account
2. When goods are rejected or returned within the specified time:
Sales/Return Inwards Account Dr. [Invoice price]
To Customers/Trade receivables Account
3. When goods are accepted at invoice price:
[No entry]

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.31

4. When goods are accepted at a higher price than invoice price:

Trade receivables / Customers Account Dr.
To Sales Account [Difference in price]
5. When goods are accepted at a lower price than the invoice price:
Sales Account Dr.
To Trade receivables / Customers Account [Difference in price]
6. (i) At the year-end, when goods are lying with customers and the specified time limit is yet to expire:
Sales Account Dr. [Invoice price]
To Trade receivables / Customers Account
(ii) These goods should be considered as Inventories with customers and in addition to the above, the
following adjustment entry is to be passed:
Inventories with Customers on Sale or Return Account Dr.
To Trading Account [Cost price or market price whichever is less]

No entry is to be passed for goods returned by the customers on a subsequent date.

? ILLUSTRATION 1

CE sends goods to his customers on Sale or Return basis. The following transactions took place during 2016:

Sept. 15 Sent goods to customers on sale or return basis at cost plus 33 1/3 % ` 1,00,000
Oct. 20 Goods returned by customers ` 40,000
Nov. 25 Received letters of approval from customers ` 40,000
Dec . 31 Goods with customers awaiting approval ` 20,000
CE records sale or return transactions as ordinary sales. You are required to pass the necessary Journal Entries in
the books of CE assuming that accounting year closes on 31st December, 2016.

 SOLUTION
In the books of CE
Journal Entries

Date Particulars L.F. Dr. (in ` ) Cr. (in ` )

2016
Sept. 15 Trade receivables A/c Dr. 1,00,000
To Sales A/c 1,00,000
(Being the goods sent to customers on sale or return
basis )

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 6.32 PRINCIPLES AND PRACTICE OF ACCOUNTING

Oct. 20 Return Inward A/c (Note 1) Dr. 40,000

To Trade receivables A/c 40,000
(Being the goods returned by customers to whom
goods were sent on sale or return basis)
Dec. 31 Sales A/c Dr. 20,000
To Trade receivables A/c 20,000
(Being the cancellation of original entry of sale in
respect of goods on sale or return basis)
Dec. 31 Inventories with customers on Sale or Return A/c Dr. 15,000
To Trading A/c (Note 3) 15,000
(Being the adjustment for cost of goods lying with
customers awaiting approval)
Note: (1) Alternatively, Sales account can be debited in place of Return Inwards account.
(2) No entry is required for receiving letter of approval from customer.
` 20,000 × 100
(3) Cost of goods with customers = = `15,000
133.33
? ILLUSTRATION 2

S. Ltd. sends out its goods to dealers on Sale or Return basis. All such transactions are, however, treated as actual
sales and are passed through the Day Book. Just before the end of the accounting year on 31.03.2016, 200 such
goods have been sent to a dealer at `250 each (cost ` 200 each) on sale or return basis and debited to his account.
Of these goods, on 31.03.2016, 50 were returned and 70 were sold while for the other goods, date of return has
not yet expired.
Pass necessary adjustment entries on 31.03.2016.

 SOLUTION
In the books of S. Ltd.
Journal Entries

Date Particulars L.F. ` `

2016
March 31 Return Inwards A/c (` 250 X 50) Dr. 12,500
To Trade receivables A/c 12,500
(Being the adjustment for 50 units of goods returned by
customers to whom goods were sent on sale or return basis)
March 31 Sales A/c (` 250 X 80) (Note 1) Dr. 20,000
To Trade receivables A/c 20,000
(Being the cancellation of original entry for sale in respect of
80 units of goods not yet returned or approved by customers)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.33

March 31 Inventories with Customers on Sale or Return A/c Dr. 16,000

To Trading A/c 16,000
(Being the cost of goods sent to customers on approval or
return basis not yet approved, adjusted)
Note: (1) Quantity of goods lying with dealer as on 31.12.2016 = 200 – 50 – 70 = 80

? ILLUSTRATION 3

Caly Company sends out its gas containers to dealers on Sale or Return basis. All such transactions are, however,
treated as actual sales and are passed through the Day Book. Just before the end of the financial year, 100 gas
containers, which cost them ` 900 each have been sent to the dealer on ‘sale or return basis’ and have been
debited to his account at `1,200 each. Out of this only 20 gas containers are sold at `1,500 each.
You are required to pass necessary adjustment entries for the purpose of Profit and Loss Account and Balance
Sheet.

 SOLUTION
In the books of Caly Company
Journal Entries

Date Particulars L.F. ` `

Trade receivables A/c Dr. 6,000
To Sales A/c 6,000
(Being the adjustment for excess price of 20 gas containers @
300 each)
Sales A/c Dr. 96,000
To Trade receivables A/c 96,000
(Being the cancellation of original entry for sale in respect of 80
gas containers @ ` 1,200 each)
Inventories with Customers on Sale or Return A/c Dr. 72,000
To Trading A/c 72,000
(Being the adjustment for cost of 80 gas container lying with
customers awaiting approval)

? ILLUSTRATION 4

E Ltd. sends out its accounting machines costing ` 200 each to their customers on Sales or Return basis. All such
transactions are, however, treated like actual sales and are passed through the Day Book. Just before the end of
the financial year, i.e., on March 24, 2016, 300 such accounting machines were sent out at an invoice price of `
280 each, out of which only 90 accounting machines are accepted by the customers ` 250 each and as to the rest
no report is forthcoming. Show the Journal Entries in the books of the company for the purpose of preparing Final
Accounts for the year ended March 31, 2016.

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 6.34 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
In the books of E Ltd.
Journal Entries

Date Particulars L.F. ` `

2016
March 31 Sales A/cs (` 30x90) Dr. 2,700
To Trade receivables A/c 2,700
(Being the adj. for reduction in the selling price of 90 accounting
machines @ ` 30 each)
March 31 Sales A/c (` 280 x 210) Dr. 58,800
To Trade Receivables A/c 58,800
(Being the cancellation of original entry for sale in respect of
210 accounting machines sent to customers not yet returned or
approved)
Inventories with customers on Sale or Return A/c Dr. 42,000
To Trading A/c 42,000
(Being the cost of 210 accounting machines @ `200 each
adjusted against Trading Account)

? ILLUSTRATION 5

A sends out goods on approval to few customers and includes the same in the Sales Account. On 31.3.2016, the
Trade receivables balance stood at `1,00,000 which included `7,000 goods sent on approval against which no
intimation was received during the year. These goods were sent out at 25% over and above cost price and were
sent to-
Mr. X - ` 4,000 and Mr. Y - ` 3,000.
Mr. X sent intimation of acceptance on 30th April and Mr. Y returned the goods on 10th April, 2016.
Make the adjustment entries and show how these items will appear in the Balance Sheet on 31st March, 2016.
Show also the entries to be made during April, 2016. Value of closing Inventories as on 31st March, 2016 was
`60,000.

 SOLUTION
In the Books of A
Journal Entries

Date Particulars L.F. ` `

2016 Sales A/c Dr. 7,000
March To Trade receivables A/c 7,000
31 (Being the cancellation of original entry for sale in respect of
goods lying with customers awaiting approval)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.35

31-Mar Inventories with Customers on Sale or Return A/c Dr 5,600

To Trading A/c (Note 1) 5,600
(Being the adjustment for cost of goods lying with customers
awaiting approval)

30-Apr Trade receivables A/c Dr. 4,000

To Sales A/c 4,000
(Being goods costing ` 3,200 sent to Mr. X on sale or return basis
has been accepted by him)

Balance Sheet of A & Co. as on 31st March, 2016 (Extracts)

Liabilities ` Assets ` `
Trade receivables ( `1,00,000 - ` 7,000) 93,000
Inventories-in-trade 60,000
Add: Inventories with customers on Sale or Return
5,600 65,600
1,58,600

Notes:
(1) Cost of goods lying with customers = 100/125 x ` 7,000 = ` 5,600
(2) No entry is required on 10th April, 2016 for goods returned by Mr. Y. Goods should be included physically
in the Inventories-in-trade.

2.2.2 WHEN THE BUSINESS SENDS GOODS FREQUENTLY ON SALE OR RETURN BASIS
When a business sends goods on sale or return on a frequent basis, an immediate sale does not take place.
Only when the customer signifies his intention to purchase the goods or takes some action whereby it is
indicated that he has decided to purchase the goods, the property in the goods passes to the buyer. So long
as the property does not pass to the buyer, the seller does not record it as a sale and, therefore, does not
debit the customer with the sales price.
Under this method, record of goods sent is maintained in a specially ruled Sale or Return Journal / Day Book
instead of passing entry for sale of goods. This Day Book is divided into 4 main columns - (1) Goods sent on
Approval; (2) Goods Returned: (3) Goods Approved; and (4) Balance.

Goods sent on approval Goods returned Goods approved Balance

1 2 3 4 5 6 7 8 9 10 11 12 13
Date Particulars Fol. Amt. Date Particulars Fol. Amt. Date Particulars Fol. Amt. Amt.

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 6.36 PRINCIPLES AND PRACTICE OF ACCOUNTING

When such a Journal is kept the following procedure is adopted for recording transactions entered into on
this basis:

w When goods are sent out for sale on approval, entries are made only in column 1 to 4, the sale price of
goods being entered in column 4. The sale price is also posted to the debit of the customers’ account
in ‘Goods on Approval Ledger’, and periodically total of column 4 is posted to the credit of Goods on
Approval Total Account in the same ledger.

w If goods are returned, entries are made in columns 5 to 8, the price of goods returned being entered to
column 8. The individual amounts are credited to the Customers’ Accounts, in the ‘Goods on Approval’
Ledger and the total of this column in periodically posted to the Total Goods on Approval Account.

w If the goods are retained by the customer, entries are made in columns 9 to 12. The individual amounts
are then posted to the debit of customer’s accounts in the Sales Ledger and their total is credited to
Sales Account in the General Ledger. Further the customer’s accounts in the Goods on Approval Ledger
are credited with the individual amounts of goods sold and periodically, the total of the amount is
posted to the debit of Goods on Approval Total Account.

w The value of goods sent out but not sold or returned till the close of the year is extended to column 13.
The total of this column, afterwards, will show the value of goods with customers at the sale price.
The balance amount is calculated as follows:
Balance Value of Goods Sent on Sale or Return Less Value of Goods Returned Less Value of Goods Approved.
Information relating to goods delivered and goods returned is kept on Memorandum basis.
However, information relating to goods approved and balance is duly accounted for by passing journal
entries relating to sales and Inventories on approval basis.
The amount, after eliminating the element of profit, is included in the Trading Account representing the
value of Inventories with customers at cost price. Like an ordinary closing Inventories, such goods are
considered as Inventories lying with customers on behalf of seller and are valued at cost or net realisable
value whichever is less.
(i) At the time of approval
Customer’s A/c Dr.
To Sales A/c
(ii) At the time of preparing of Final Accounts
An adjustment entry is required for balance goods which is as follow:
Goods with Customers on Sale or Return Account Dr. [Cost or net realisable value
To Trading Account whichever is less]

2.2.3 WHEN THE BUSINESS SENDS GOODS NUMEROUSLY ON SALE OR RETURN

When transactions are numerous, a business maintains the following books: (a) Sale or Return Day Book;
and (b) Sale or Return Ledger. ‘Ledger’ contains the accounts of the customers and the ‘Sale or Return’ Total
account. ‘Day Book’ is the primary book which records all transactions, and from there these are entered in
the ‘Sale or Return’ Total account. It is important to remember that both are Memorandum Books, i.e., these
records are not a part of regular books of accounts.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.37

Following procedure is adopted for recording transactions under this method:

w When goods are sent to the customers on a sale or return basis, they are first recorded in the Sale or
Return day Book. Thereafter, in the Sale or Return Ledger, all the customers are individually debited and
the Sale or Return Account is credited with the periodical total of the Sale or Return Day Book.

w When the goods are returned by the customers within the specified time, they are recorded initially
in the Sale or Return Day Book. Thereafter, in the Sale or Return Ledger, the Sale or Return Account
is debited with the periodical total of the Sale or Return Day Book and the individual customers are
credited. The above mentioned records are all memorandum and hence cannot find a place in the
regular books.

w When the business receives information about the acceptance of the goods or no intimation is
received within the specified time, they are recognised as sales and are recorded in the Sales Day Book.
Periodically, the total of the Sales Day Book is credited to Sales Account and debited to the Individual
Customers Account. To cancel the earlier entries, individual customers are credited and the Sale or
Return Account is debited.
The entries for the approved goods are shown below:
In the Memorandum Sale or Return Ledger In the regular General ledger

Sale or Return Account Dr. Individual Customer’s Account Dr.

To Individual Customer’s Account To Sales Account

w At the year end, in the Sale or return Ledger, the sum of the debit balances of the Individual Customers’
Account must be equal to the credit balance of the Sale or return Account. It represents Inventories with
customers waiting for approval at invoice price. To adjust the cost of such goods with customers in the
Final Accounts, the following entry is passed:
Inventories with Customers on Sale or Return Account Dr. [Cost or net realisable
To Trading Account value whichever is less]
In short, under this method, entries are passed in the regular books of account only at the time of sale or a
year end, if inventory is still lying with customers (pending approval).

SUMMARY
• As per the definition given under the Sale of Goods Act, 1930, in respect of such goods, the sale will take
place or the property in the goods pass to the buyer:
(i) When he signifies his approval or acceptance to the seller;
(ii) When he does some act adopting the transaction;
(iii) If he does not signify his approval or acceptance to the seller but retains the goods without giving
notice of rejection, on the expiry of the specified time (if a time has been fixed) or on the expiry of
a reasonable time
• Accounting entries depend on the fact whether the business sends goods on sale or approval basis (i)
casually; (ii) frequently; and (iii) numerously.

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 6.38 PRINCIPLES AND PRACTICE OF ACCOUNTING

TEST YOUR KNOWLEDGE

Multiple Choice Questions

1. When a large number of articles are sent frequently on a sale or return basis, it is necessary to maintain
(a) Sale journal (b) Goods returned journal (c) Sale or return journal
2. Sale or Return Day Book and Sale or Return Ledger are known as
(a) principal books (b) subsidiary books (c) memorandum books
3. A sent some goods costing ` 3,500 at a profit of 25% on sale to B on sale or return basis. B returned
goods costing ` 800. At the end of the accounting period i.e. on 31st December, 2016, the remaining
goods were neither returned nor were approved by him. The Inventories on approval will be shown in
the balance sheet at `
(a) 2,000. (b) 2,700 (c) 2,700 less 25% of 2,700.
4. A merchant sends out his goods casually to his dealers on approval basis. All such transactions are,
however, recorded as actual sales and are passed through the sales book. On 31-12-2016, it was found
that 100 articles at a sale price of 200 each sent on approval basis were recorded as actual sales at
that price. The sale price was made at cost plus 25%. The amount of Inventories on approval will be
amounting
(a) ` 16,000. (b) ` 20,000. (c) ` 15,000.

5. Umesh sends goods on approval basis as follows:

Date Customer’s Name Sale price of Goods Accepted Goods Returned

January, 2016 Goods Sent ` `
`
8 Anna 3,500 3,000 500

10 Babu 2,800 2,800 –

15 Chandra 3,680 – 3,680

22 Desai 1,260 1,000 260

The Inventories of goods sent on approval basis on 31st January will be

(a) ` 500. (b) Nil. (c) ` 260.
6. A company sends its cars to dealers on ‘sale or return’ basis. All such transactions are however treated
like actual sales and are passed through the sales day book. Just before the end of the financial year,
two cars which had cost ` 55,000 each have been sent on ‘sale or return’ and have been debited to
customers at ` 75,000 each, cost of goods lying with the customers will be
(a) ` 1,10,000. (b) ` 55,000. (c) ` 75,000.
7. A trader has credited certain items of sales on approval aggregating ` 60,000 to Sales Account. Of these,
goods of the value of `16,000 have been returned and taken into Inventories at cost ` 8,000 though the

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.39

record of return was omitted in the accounts. In respect of another parcel of `12,000 (cost being ` 6,000)
the period of approval did not expire on the closing date. Cost of goods lying with customers should be
(a) ` 12,000. (b) ` 54,000. (c) ` 6,000.
8. Under sales on return or approval basis, the ownership of goods is passed only
(a) when the retailer gives his approval
(b) if the goods are not returned within specified period.
(c) Both (a) and (b)
9. Under sales on return or approval basis, when transactions are few, the seller, while sending the goods,
treats them as
(a) an ordinary sale but no entry is passed in the books
(b) an ordinary sale and entry for normal sale is passed in the books
(c) Approval sale and no entry is passed
10. Under sales on return or approval basis, when transactions are few and the seller at the end of the
accounting year reverse the sale entry, then what will be the accounting treatment for the goods
returned by the customers on a subsequent date?
(a) No entry will be passed for such return of goods
(b) Entry for return of goods is passed by the seller
(c) Only the Inventories account will be adjusted

Theory Questions
Q1. What are the features of sale of goods on approval or return basis? Explain in brief.
Q2. When ‘sale or return basis’ transactions are numerous, what books are maintained by the business
entity.

Practical Questions
Q1 A firm sends goods on sale or return basis. Customers having the choice of returning the goods within
a month. During May 2016, the following are the details of goods sent:

Date (May) 2 8 12 18 20 27
Customers P B Q D E R
Value (`) 15,000 20,000 28,000 3,000 1,000 26,000
Within the stipulated time, P and Q returned the goods and B, D, and E signified that they have accepted
the goods.
Show in the books of the firm, the Sale or Return Account and Customer- P for Sale or Return Account
on 15th June, 2016.

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 6.40 PRINCIPLES AND PRACTICE OF ACCOUNTING

Q2 On 31st December, 2016 goods sold at a sale price of ` 3,000 were lying with customer, Ritu to whom
these goods were sold on ‘sale or return basis’ were recorded as actual sales. Since no consent has been
received from Ritu, you are required to pass adjustment entries presuming goods were sent on approval
at a profit of cost plus 20%. Present market price is 10% less than the cost price.
Q3 X supplied goods on sale or return basis to customers, the particulars of which are as under.

Date of dispatch Party’s name Amount Remarks

`
10.12.2016 M/s. ABC 10,000 No information till 31.12.2016
12.12.2016 M/s. DEF 15,000 Returned on 16.12.2016
15.12.2016 M/s. GHI 12,000 Goods worth ` 2,000 returned on 20.12.2016
20.12.2016 M/s. DEF 16,000 Goods Retained on 24.12.2016
25.12.2016 M/s. ABC 11,000 Good Retained on 28.12.2016
30.12.2016 M/s. GHI 13,000 No information till 31.12.2016
Goods are to be returned within 15 days from the dispatch, failing which it will be treated as sales. The books
of ‘X’ are closed on the 31st December, 2016.
Prepare the following accounts in the books of ‘X’.
(a) Goods on “sales or return, sold and returned day books”.
(b) Goods on sales or return total account.

ANSWERS/HINTS
MCQs

1. (c) 2. (c) 3. (b) 4. (a) 5. (b) 6 (a)

7. (c) 8. (c) 9. (b) 10. (a)

Theoretical Questions
1. Features of sale of goods on approval or return basis: (i) There is a change in the possession of goods
from one person to another. (ii) It does not involve transfer of ownership of goods. The ownership is
passed only when the retailer gives his approval or if the goods are not returned within that specified
period. (iii) The retailer (customer) does not incur any liability when the goods are merely sent to him.
2. When transactions are numerous, a business maintains the following books: (a) Sale or Return Day Book;
and (b) Sale or Return Ledger. ‘Ledger’ contains the accounts of the customers and the ‘Sale or Return’
Total account. ‘Day Book’ is the primary book which records all transactions, and from there these are
entered in the ‘Sale or Return’ Total account. It is important to remember that both are Memorandum
Books, i.e., these records are not a part of regular books of accounts.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.41

Practical Questions

Answer 1
Sale or Return Account

Date Particulars ` Date Particulars `

2016 2016
31-May To Sundries: Sales 24,000 31-May By Sundries
15-Jun To Sundries: Returned 43,000 (Goods sent on sale or
return basis) 93,000
15-Jun To Balance c/d 26,000
93,000 93,000
By Balance b/d 26,000
P’s Account
Date Particulars ` Date Particulars `
2016 2016
May 31 To Sale or Return A/c 15,000 May 31 By Sale or Return A/c 15,000
Answer 2
Journal Entries

Date Particulars ` `
2016
31st Dec. Sales A/c Dr. 3,000
To Ritu’s A/c 3,000
(Being cancellation of entry for sale of goods, not yet
approved)
Inventories with customers A/c (Refer W.N.) Dr. 2,250
To Trading A/c 2,250
(Being Inventories with customers recorded at market
price)

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 6.42 PRINCIPLES AND PRACTICE OF ACCOUNTING

Working Note:
Calculation of cost and market price of Inventories with customer

Sale price of goods sent on approval ` 3,000

Less: Profit (3,000 x 20/120) ` 500
Cost of goods ` 2,500
Market price = 2,500 - (2,500 x 10%) = ` 2,250.

Answer 3
In the books of ‘X’
Goods on sales or return, sold and returned day book.

Date Party to whom goods L.F Amount Date Sold Returned

2016 sent ` 2016 ` `
Dec.10 M/s. ABC 10,000 Dec. 25 10,000 -
Dec.12 M/s. DEF 15,000 Dec. 16 - 15,000
Dec.15 M/s. GHI 12,000 Dec. 20 10,000 2,000
Dec.20 M/s. DEF 16,000 Dec. 24 16,000 -
Dec.25 M/s. ABC 11,000 Dec. 28 11,000 -
Dec.30 M/s. GHI 13,000 -
77,000 47,000 17,000

Goods on Sales or Return Total Account

Date Particulars Amount Date Particulars Amount

` `
2016 2016
Dec. 31 To Returns 17,000 Dec. 31 By Goods sent on
sales or return
To Sales 47,000 77,000
To Balance c/d 13,000
77,000 77,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.43

UNIT 3 : CONSIGNMENT
LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand the special features of consignment business, meaning of the terms consignor and
consignee.
w Analyse the difference between the two transactions – sale and consignment and understand that why
consignment is termed as special transaction.
w Practice the accounting treatments for consignment transactions and events in the books of consignor
and consignee.
w Note the variations in accounting when goods are sent at cost and goods are sent above the cost.
w Learn the technique of computing value of consignment inventory lying with the consignee and also
the amount of inventory reserve in it.
w Learn the technique of computing cost of abnormal loss and treatment of insurance claim in relation to
it.
w Understand the distinction between ordinary commission, del-credere commission and over-riding
commission paid to the consignee.
w See the variation of accounting treatment for bad debts when consignee is paid ordinary commission
and when consignee is paid del-credere commission in addition to it.
w Understand the reason of including/excluding various expenditures to cost while valuing the goods
returned by the consignee.

Goods Consigned

Consignor Consignee

Account Sales

Details of Sales made by the

UNIT Inventories of
consignee
consignor
OVERVIEW Expenses incurred on behalf of the
consignor

Commission earned

Unsold Inventories left with the

consignee
Advance payment or security
deposited

Balance due or remitted

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 6.44 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.1 MEANING OF CONSIGNMENT ACCOUNT

To consign means to send. In Accounting, the term “consignment account” relates to accounts dealing with
a situation where one person (or firm) sends goods to another person (or firm) on the basis that the goods
will be sold on behalf of and at the risk of the former. The following should be noted carefully:
(i) The party which sends the goods (consignor) is called principal.
(ii) The party to whom goods are sent (consignee) is called agent.
(iii) The ownership of the goods, i.e., the property in the goods, remains with the consignor or the principal
– the agent or the consignee does not become their owner even though goods are in his possession.
On sale, of course, the buyer will become the owner.
(iv) The consignor does not send an invoice to the consignee. He sends only a proforma invoice, a
statement that looks like an invoice but is really not one. The object of the proforma invoice is only to
convey information to the consignee regarding particulars of the goods sent.
(v) Usually, the consignee recovers from the consignor all expenses incurred by him on the consignment.
This however can be changed by agreement between the two parties.
(vi) It is also usual for the consignee to give an advance to the consignor in the form of cash or a bill of
exchange. It is adjusted against the sale proceeds of the goods.
(vii) For his work, the consignee receives a commission calculated on the basis of gross sale. For ordinary
commission the consignee is not responsible for any bad debt that may arise. If the agent is to be made
responsible for bad debts, he is to be paid a commission called del-credere commission. It is calculated
on total sales, not merely on credit sales until and unless agreed.
(viii) Periodically, the consignees ends to the consignor a statement called Account Sales. It sets out the sales
made by the consignee, the expenses incurred on behalf of the consignor, the commission earned by
the consignee and the balance due to the consignor.
(ix) Firms usually like to ascertain the profit or loss on each consignment or consignments to each consignee.
Consignment Account relates to accounts dealing with such business where one person sends goods to
another person on the basis that such goods will be sold on behalf of and at the risk of the former.

3.2 DISTINCTIONS
3.2.1 CONSIGNMENT AND SALE

S.No. Consignment Sale

1. Ownership of the goods rests with the consignor The ownership of the goods transfers with the
till the time they are sold by the consignee, transfer of goods from the seller to the buyer.
no matter the goods are transferred to the
consignee.
2. The consignee can return the unsold goods to Goods sold are the property of the buyer and
the consignor. can be returned only if the seller agrees.
3. Consignor bears the loss of goods held with the It is the buyer who will bear the loss if any, after
consignee. the transfer of goods.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.45

4. The relationship between the consignor and The relationship between the seller and the
the consignee is that of a principal and agent. buyer is that of a creditor and a debtor.
5. Expenses done by the consignee to receive the Expenses incurred by the buyer are to be borne
goods and to keep it safely are borne by the by the buyer itself after the transfer of goods.
consignor unless there is any other agreement.

3.2.2 DISTINCTION BETWEEN COMMISSION AND DISCOUNT

Commission Discount
Commission may be defined as remuneration The term discount refers to any reduction or
of an employee or agent relating to services rebate allowed and is used to express one of the
performed in connection with sales, following situations:
purchases, collections or other types of
An allowance given for the settlement of a debt
business transactions and is usually based on a
before it is due i.e. cash discount.
percentage of the amounts involved.
Commission earned is accounted for as An allowance given to the whole sellers or bulk
an income in the books of accounts, and buyers on the list price or retail price, known as
commission allowed or paid is accounted for as trade discount. A trade discount is not shown in
an expense in the books of the party availing the books of account separately and it is shown
such facility or service. by way of deduction from cost of purchases.

3.3 ACCOUNTING FOR CONSIGNMENT TRANSACTIONS AND

EVENTS IN THE BOOKS OF THE CONSIGNOR
For ascertaining profit or loss on any transaction (or series of transactions) there is one golden rule; open
an account for the transaction (or series of transactions) and (i) put down the cost of goods and other
expenses incurred or to be incurred on the debit side; and (ii) enter the sale proceeds as also the cost of
goods remaining unsold on the right hand side or the credit side. The difference between the total of the
two sides will reveal profit or loss. There is profit if the credit side is more.
The consignor often dispatches goods to various consignees and he would be interested to ascertain
the profit or loss from each consignment separately. Therefore, a separate consignment account has to
be prepared for each consignment. Each consignment account is a nominal-cum-personal account and
constitutes a profit an loss account in respect of the transactions to which it relates.
The consignor records the following transactions in his book of accounts:
1. When goods are consigned or dispatched: it is to be reiterated that when goods are sent to the
consignee, the transaction does not result in a sale and only the possession of the goods changes.
Therefore, the personal account of consignee is not debited and also sales account is not credited. The
following entry is recorded by the consignor:
Consignment (say to Star trading) Account Dr.
To Goods Sent on Consignment Account
2. Expenses incurred by consignor: when consignor incurs some expenses relating to the consignment

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 6.46 PRINCIPLES AND PRACTICE OF ACCOUNTING

following entry is recorded:

Consignment (say to Star trading) Account Dr.
To Supplier Account/Bank/Cash
Unlike normal practice to debiting expense accounts first and then transferring to profit and loss
account, expenses are directly debited to consignment account.
3. When advance is received from the consignee: The consignee may remit some advance to consignor.
The following entry is recorded:
Bank/Cash Account Dr.
To Consignee’s Personal Account
4. On receipt of account sales from the consignee: Account sales contains details of sales made by
consignee, expenses incurred by consignee. Following entries are recorded
For sales proceeds
Consignee’s Personal Account Dr.
To Consignment Account
For expenses incurred by consignee
Consignment Account Dr.
To Consignee’s Personal Account
5. Cash or cheque or bank draft or bill of exchange/promissory note received from the consignee as
settlement:
Cash/Bank/Bills Receivable Account Dr.
To Consignee’s Personal Account
6. For bad debts: The accounting entry for bad debts will depend on whether del-credere commission is
paid to the consignee
i. When del-credere commission is not paid to the consignee
Consignment Account Dr.
To Consignee’s Personal Account
ii. When del-credere commission is paid to the consignee
No entry is recorded as bad debts is to be borne by consignee.
7. For the goods taken over by the consignee
Consignee’s Personal Account Dr.
To Consignment Account
8. For unsold consignment stock: In case some of the goods sent on consignment are still unsold at the time
of preparing final accounts, the unsold inventory is recorded as consignment stock with followingentry:
Consignment Stock Account Dr.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.47

To Consignment Account
9. For commission payable to consignee
Consignment Account Dr.
To Consignee’s Personal Account
We shall illustrate the scheme of entries on the basis of the following information:

? ILLUSTRATION 1
Exe sent on 1st July,2016 to Wye goods costing ` 50,000 and spent ` 1,000 on packing etc. On 3rd July,2016, Wye
received the goods and sent his acceptance to Exe for ` 30,000 payable at 3 months. Wye spent ` 2,000 on freight
and cartage, ` 500 on godown rent and ` 300 on insurance. On 31st December,2016 he sent his Account Sales
(along with the amount due to Exe) showing that 4/5 of the goods had been sold for ` 55,000. Wye is entitled to
a commission of 10%. One of the customers turned insolvent and could not pay ` 600 due from him. Show the
necessary journal entries in the books of consignor. Also prepare ledger accounts.

 SOLUTION
Journal Entries in the books of Consignor

` `
1 Open Consignment Account and debit it with the cost of goods and
credit it with “Goods sent on Consignment Account”.
1/7/2016 Consignment to Wye A/c Dr. 50,000
To Goods Sent on Consignment A/c 50,000
2 For the expenses incurred by the consignor,debit Consignment
Account and credit cash or Bank, as the case may be.
1/7/2016 Consignment to Wye A/c Dr. 1,000
To Bank A/c 1,000
3 If the consignee sends an advance, debit Cash(or Bank) or Bills
Receivable and credit the consignee’s personal account
3/7/2016 Bills Receivable A/c Dr. 30,000
To Wye 30,000
(Note: Wye’s account has appeared only now, in the previous
two entries his account did not figure since he is not personally
involved)
4 Wye’s acceptance will mature on 6/10/2016
Assuming it was met, the entry will be:
6/10/2016 Bank A/c Dr. 30,000
To Bills Receivable A/c 30,000
(Note: If such bill is discounted by consignor with the bank before
maturity, pass usual entry for discounting a bill. The discount on
bills may either be treated as consignment expenses and charged to
Consignment A/c or it may be treated as general financial charges
and charged to Profit & Loss Account)

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 6.48 PRINCIPLES AND PRACTICE OF ACCOUNTING

5 On receipt of Account sale

31/12/2016 (a)   For sales made by the consignee, debit his personal account and
credit Consignment Account
Wye Dr. 55,000
To Consignment to Wye A/c 55,000
(b)  For expenses incurred by the consignee as well as bad debts
suffered by him on behalf of the consignor, debit Consignment
Account and credit Consignee Account
31/12/2016 Consignment to Wye A/c (2,000+500+300+600) Dr. 3,400
To Wye 3,400
(c)    For commission due to the consignee, debit Consignment
Account and credit the consignee.
31/12/2016 Consignment to Wye A/c(10% on ` 55,000) 5,500
To Wye 5,500
(d)   For the remittance that may accompany the Account Sales, debit
Bank and credit the consignee.
Bank A/c Dr. 16,100
To Wye 16,100
6 For the goods that may remain unsold debit the Consignment Stock
Account and credit Consignment Account.
31/12/2016 Inventories on Consignment A/c Dr. 10,600
To Consignment to Wye A/c 10,600
Note: (i) Cost of Inventories
1/5 of Cost to consignor ` 10,000
1/5 of expense incurred by the consignor ` 200
1/5 of freight (direct exp. Of consignee) ` 400
` 10,600
(ii) Inventories on Consignment Account is an asset; it will be
shown in the balance sheet of the consignor and next year it
will be transferred to the debit of the Consignment Account.
7 At this stage the Consignment Account will reveal profit or loss (see
the account given below). The profit or loss will be transferred to the
Profit and Loss Account of the consignor by debit to the Consignment
Account.
31/12/2016 Consignment to Wye A/c Dr. 5,700
To Profit and Loss A/c 5,700
8 The Goods sent on Consignment Account should be closed by transfer
to the Trading Account debit the former and credit the latter:
31/12/2016 Goods sent on Consignment Account Dr. 50,000
To Trading Account 50,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.49

Important Ledger Accounts

Consignment to Wye Account

2016 Particulars ` 2016 Particulars `

1-Jul To Goods sent on Dec. 31 By Wye-sale
Consignment A/c 50,000 Proceeds 55,000
1-Jul To Bank(expenses) 1,000 Dec. 31 By Inventories on
Dec. 31 To Wye-expenses Consignment 10,600
& bad debt 3,400 Account
Dec. 31 To Wye-commission 5,500
Dec. 31 To P&L Account-transfer of profit 5,700
65,600 65,600

Goods sent on consignment account

2016 Particulars ` 2016 Particulars `
Dec. 31 To Trading A/c 50,000 July 1 By Consignment to 50,000
Wye A/c
Inventories on Consignment account

2016 Particulars ` 2016 Particulars `

Dec. 31 To Consignment to Wye 10,600 Dec. 31 By Balance c/d 10,600
A/c
2017
Jan. 1 To Balance b/d 10,600
Wye’s account
2016 ` 2016 `
Dec. 31 To Consignment 3-Jul By Bills Receivable
Wye A/c 55,000 Account 30,000
By Consignment to
Wye A/c –
Expenses & bad debt 3,400
Commission 5,500
By Bank
(balance received) 16,100
55,000 55,000

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 6.50 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.4 VALUATION OF INVENTORIES

The principle is that inventories should be valued at cost or net realizable value whichever is lower, the same
principle as is practised for preparing final accounts. In the case of consignment, cost means not only the
cost of the goods as such to the consignor but also all expenses incurred till the goods reach the premises
of the consignee. Such expenses include packaging, freight, cartage, insurance in transit, octroi, import duty
etc. But expenses incurred after the goods have reached the consignee’s godown (such as godown rent,
insurance of godown, delivery charges,salesman salaries) are not treated as part of the cost of purchase
for valuing inventories on hand. That is why in the case given above, inventories has been valued ignoring
godown rent and insurance.

Note: Sometimes an examination problem states only that the consignor’s expenses amounted
to such amount and that consignee spent so much. If details are not available, then for valuing
inventories the expenses incurred by the consignor should be treated as part of cost while those
incurred by the consignee should be ignored.

If the expected selling price of inventories on hand is lower than the cost, the inventories should be valued
at expected net selling price only, i.e. expected selling price less delivery expenses, etc.

3.5 GOODS INVOICED ABOVE COST

Sometimes the proforma invoice is made out at a value higher than the cost and entries in the books of the
consignor are made out on that basis – even the inventories remaining unsold will initially be valued on the
basis of the invoice price. It must be remembered, however, that the profit or loss can be ascertained only
if sale proceeds (plus) inventories on hand, valued on cost basis, is compared with the cost of the goods
concerned together with expenses. Hence, if entries are first made on invoice basis, the effect of the loading
(i.e., amount added to arrive at the invoice price) must be removed by additional entries. Suppose in the
example given above, if the invoice is cost plus 20%, i.e., ` 60,000 for the goods sent to Wye. The entries will
be initially:

Particulars ` `
(i) Consignment to Wye A/c Dr. 60,000
To Goods sent on Consignment A/c 60,000
(ii) Consignment to Wye A/c Dr. 1,000
To Bank 1,000
(iii) Bills Receivable A/c Dr. 30,000
To Wye 30,000
(iv) Bank A/c Dr. 30,000
To Bills Receivable A/c 30,000
(v) Wye Dr. 55,000
To Consignment to Wye A/c 55,000
(vi) Consignment to Wye A/c Dr. 3,400
To Wye 3,400

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.51

(vii) Consignment to Wye A/c Dr. 5,500

To Wye 5,500
(viii) Bank A/c Dr. 16,100
To Wye 16,100
(ix) Inventories on Consignment A/c Dr. 12,600
To Consignment to Wye A/c 12,600
[1/5 of 60,000 + 1/5 of (1,000 + 2,000)]
[Students will see that except for difference in the amounts in entries (i) and (ix), these and other entries are
the same as those already given.]
Additional entries (before ascertaining profit) to remove the effect of loading:
(a) Goods sent on Consignment A/c Dr. 10,000
To Consignment to Wye A/c 10,000
[Entry (i) reversed to the extent of loading in order to debit the Consignment A/c on cost basis].
(b) Consignment to Wye A/c Dr. 2,000
To Inventory Reserve Account 2,000
(The amount of loading included in the value of the closing Inventories is unrealised profit – hence reserve
is created by debit to the Consignment Account).
The Consignment Account will now reveal a profit of ` 5,700 the same as before. It will be transferred to the
P&L A/c. Similarly entry given in 8 in the earlier illustration will be made to transfer the balance in the Goods
sent on Consignment Account in the earlier illustration`500,000) after entry in (a) above to the credit of
Trading Account. The accounts (except for Wye whose account will be the same as already shown) are given
below:
Consignment to Wye Account

2016 Particulars ` 2016 Particulars `

1-Jul To Goods sent on Dec. 31 By Wye
Consignment A/c 60,000 Sales proceeds 55,000
To Bank A/c – expenses 1,000 By Inventories on Consignment 12,600
A/c
Dec. 31 To Wye-expenses & bad debt 3,400 By Goods sent on Consignment 10,000
A/c(loading)
“ To Wye-commission 5,500
To Inventory Reserve A/c 2,000
“ To Profit and Loss A/c
transfer of profit 5,700

77,600 77,600

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 6.52 PRINCIPLES AND PRACTICE OF ACCOUNTING

Goods sent on Consignment Account

2016 ` 2016 `
Dec. 31 To Consignment to Wye A/c – 10,000 1-Jul By Consignment to Wye A/c 60,000
loading
To Trading A/c –transfer 50,000
(bal.fig.)

60,000 60,000
Inventories on Consignment Account

2016 ` 2016 `
Dec. 31 To Consignment to Wye A/c 12,600 Dec. 31 By Balance c/d 12,600

2017
Jan. 1 Balance b/d 12,600

Inventory Reserve Account

2016 ` 2016 `
Dec. 31 To Balance c/d 2,000 Dec. 31 By Consignment to Wye A/c 2,000
2017
Jan. 1 By Balance b/d 2,000
The last two accounts will be carried forward to the next year and their balance will then be transferred to
the Consignment Account – ` 12,600 on the debit side and ` 2,000 on the credit. This year in the balance
sheet the net amount of ` 10,600 will be shown on the assets side as shown below:

`
Inventories on consignment 12,600
Less: Inventory Reserve 2,000
10,600
What would be the situation if the commission to Wye includes del-credere commission also?
In that case Wye would not be able to charge the bad debt of ` 600 to Exe; he will have to bear the loss
himself. The student can see that then the profit on consignment will be ` 6,300.
In this regard it is to be noted that when del – credere commission is paid to the consignee, the consignee
account is debited in the books of consignor for both cash and credit sales. But if no such del – credere
commission is paid then consignee account cannot be debited for credit sales and in that case the following
entry is passed in the books of consignor for credit sales.
Consignment Trade receivables A/c Dr.
To Consignment A/c
The difference is because in case del-credere commission is paid to consignee then consignee is responsible
to bear any loss of bad debts and he will have to pay full amount of sales to consigner. Accordingly, in the

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.53

books of consignor, whole amount (cash sales plus credit sales) is shown as receivable from consignee. On
the other hand if del-credere commission is not paid than consignor is responsible to bear loss of bad debts,
therefore, till the time consignee has not received money from customers, it is not shown as receivable from
consignee.

3.6 NORMAL LOSS

If some loss is unavoidable, it would be spread over the entire consignment while valuing inventories.
The total cost plus expenses incurred should be divided by the quantity available after the normal loss to
ascertain the cost per unit. Suppose 10,000 kg of apples are consigned to a wholesaler, the cost being `30
per kg, plus ` 40,000 of freight. It is concluded that a loss of 15% is unavoidable. The cost per kg will be
`3,40,000/8,500 or ` 40. If the unsold inventory is 1,000 kg its value will be ` 40,000.
Accordingly, no entry is recorded for normal loss and same is considered as expense which is considered for
valuation of remaining inventory.

3.7 ABNORMAL LOSS

If any accidental or unnecessary loss occurs, the proper thing to do is to find out the cost of the goods thus
lost and then to credit the Consignment Account and debit the Profit and Loss Account – this will enable the
consignor to know what profit would have been earned had the loss not taken place.
Suppose 1,000 sewing machines costing ` 2,500 each are sent on consignment basis and ` 10,000 are spent
on freight etc. 20 machines are damaged beyond repair. The amount of loss will be:

Cost = 20 × 2500 ` 50,000

Expenses = (20×10,000)/1000 ` 200
` 50,200
This amount should be credited to the Consignment Account and debited to the P&L A/c. If any amount, say,
` 40,000 is received from the insurers, then debit to the P&L A/c will be only ` 10,200. But the credit to the
Consignment Account will still be ` 50,200. ` 40,000 will have been debited to the Bank Account.
Students shall note that abnormal loss is valued just like inventories in hand.
Students should be careful while valuing goods lost in transit and goods lost in consignee’s godown. Both
are abnormal loss but in case of former consignee’s non-recurring expenses are not to be included whereas
it is to be included in latter case.
Further, for the purpose of valuation of inventory in hand, it should be noted that while normal loss is
considered as part of cost of remaining goods, whereas abnormal loss is ignored. In the example given
above assume that 10,000 Kg apples were sent in 10 different trucks and out of which one truck met an
accident and 500Kg apples were destroyed. In such case cost of remaining apples will be computed as
below:

Qty. Amount (`)

Total apples shipped 10,000 3,40,000 (@ `34 per Kg including freight)
Apples lost in accident 500 17,000 (@ `34 per Kg including freight)
Remaining apples 9,500 3,23,000 (@ `34 per Kg including freight)

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 6.54 PRINCIPLES AND PRACTICE OF ACCOUNTING

Normal loss (15%) 1,425 Nil

Remaining saleable apples 8,075 3,23,000 (@ `40 per Kg)
It is clear from above example that abnormal loss will not have impact on per unit cost, however, per unit
cost will change due to normal cost as the remaining quantity will absorb cost of normal loss whereas
abnormal loss will be immediately expensed off to profit or loss.

Distinctions between normal and abnormal loss

Normal loss Abnormal loss

Normal loss occurs due to inherent nature of the Abnormal loss occurs mainly because of unforeseen
goods being shipped e.g. leakage, evaporation, loss events e.g. accident or natural calamity etc.
of perishable goods etc.
Normal loss is not accounted for immediately and is Abnormal loss is accounted for immediately in
loaded on the remaining goods. It gets accounted profit and loss account.
for as cost of remaining goods as and when they are
sold.
As normal loss is added to cost of remaining goods, Abnormal loss does not impact gross profit.
it impact gross profit.
Insurance companies generally do not cover Insurance is generally available for abnormal losses.
normal loss as it is expected to be incurred on each
consignment or storage of goods.
Normal loss is almost certain however it may vary Abnormal loss is because of unforeseen events and
from time to time. is not certain.

Following entry is recorded for abnormal loss:

Abnormal Loss Account Dr.
To Consignment Account
If abnormal loss is recoverable from the insurance company
Insurance Company’s Account Dr.
To Abnormal Loss Account
If abnormal loss is recoverable from the consignee
Consignee’s Personal Account Dr.
To Abnormal Loss Account
If abnormal loss is not recoverable, Abnormal Loss Account is transferred to Profit & Loss Account.

3.8 COMMISSION
Commission is the remuneration paid by the consignor to the consignee for the services rendered to the
former for selling the consigned goods. Three types of commission can be provided by the consignor to the
consignee, as per the agreement, either simultaneously or in isolation. They are:

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.55

3.8.1 Ordinary Commission

The term commission simply denotes ordinary commission. It is based on fixed percentage of the gross
sales proceeds made by the consignee. It is given by the consignor regardless of whether the consignee is
making credit sales or not. This type of commission does not give any protection to the consignor from bad
debts and is provided on total sales.
3.8.2 Del-credere Commission
To increase the sale and to encourage the consignee to make credit sales, the consignor provides an
additional commission generally known as del-credere commission. This additional commission when
provided to the consignee gives a protection to the consignor against bad debts. In other words, after
providing the del-credere commission, bad debts is no more the loss of the consignor. It is calculated on
total sales unless there is any agreement between the consignor and the consignee to provide it on credit
sales only.
3.8.3 Over-riding Commission
It is an extra commission allowed by the consignor to the consignee to promote sales at higher price
then specified or to encourage the consignee to put hard work in introducing new product in the market.
Depending on the agreement it is calculated on total sales or on the difference between actual sales and
sales at invoice price or any specified price. In order to encourage the consignee to earn higher margins, it
can also be in the form of share of additional profits made by consignee on sale of goods.

3.9 RETURN OF GOODS FROM THE CONSIGNEE

Consigned goods can be returned by the consignee because of many reasons like poor quality or not upto
the specimen or destroyed in transit etc. In such a situation, the question arises what is the valuation of
returned goods. Consigned goods returned by the consignee to the consignor are valued at the price at
which it was consigned to the consignee. Expenses incurred by the consignee to send those goods back to
the consignor are not taken into consideration while valuing it because the goods were already in a salable
conditions and location and changing the location back from consignee to consignor is not a cost which
must have to be incurred to sell the goods. This is generally called secondary freight in accounting terms.

3.10 ACCOUNT SALES

An account sale is the periodical summary statement sent by the consignee to the consignor. It contains
details regarding –
(a) sales made,
(b) expenses incurred on behalf of the consignor,
(c) commission earned,
(d) unsold inventories left with the consignee,
(e) advance payment or security deposited with the consignor and the extent to which it has been adjusted,
(f ) balance payment due or remitted.
It is a summary statement and is different from Sales Account.

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 6.56 PRINCIPLES AND PRACTICE OF ACCOUNTING

3.11 ACCOUNTING IN THE BOOKS OF THE CONSIGNEE

The consignee is not concerned when goods are consigned to him or when the consignor incurs expenses.
He is concerned only when he sends an advance to the consignor, makes a sale, incurs expenses on the
consignment and earns his commission. He debits or credits the consignor for all these as the case may be.
Following entries are recorded in the books of consignee:
1. On making sales
Cash/Bank Account/Debtors Dr.
To Consignor’s Personal Account
2. For expenses incurred and his commission
Consignor’s Personal Account Dr.
To Bank Account
3. For advance paid to consignor
Consignor’s Personal Account Dr.
To Bank Account
4. For recording bad debts
Bad Debts Account Dr.
To Customer’s Account
5. For writing off bad debts
(a) When del-credere commission is not allowed
Consignor’s Personal Account Dr.
To Bad Debts Account
(b) When del-credere commission is allowed
Commission Account Dr.
To Bad Debts Account

? ILLUSTRATION 2

Exe sent on 1st July, 2016 to Wye goods costing ` 50,000 and spent ` 1,000 on packing etc. On 3rd July,2016, Wye
received the goods and sent his acceptance to Exe for ` 30,000 payable at 3 months. Wye spent ` 2,000 on freight
and cartage, ` 500 on godown rent and ` 300 on insurance. On 31st December,2016 he sent his Account Sales
(along with the amount due to Exe) showing that 4/5 of the goods had been sold for ` 55,000. Wye is entitled to
a commission of 10%. One of the customers turned insolvent and could not pay ` 600 due from him. Show the
necessary journal entries in the consignee’s book.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.57

 SOLUTION
Journal Entries in the books of Consignee

Particulars ` `
1 On sending the acceptance to Exe
2016 July 3 Exe Dr. 30,000
To Bills Payable A/c 30,000
2 On meeting expenses on the consignment:
2016 July 3 Exe Dr. 2,800
To Bank 2,800
3 On meeting his acceptance:
2016 Oct. 6 Bills payable Dr. 30,000
To Bank 30,000
4 On sales being effected:
Trade receivables/Bank Dr. 55,000
To Exe 55,000
5 On there being a bad debt:
Exe Dr. 600
To Trade receivables 600
6 On earning the commission:
Exe Dr. 5,500
To Commission Earned A/c 5,500
7 On settling the account to Exe:
Exe Dr. 16,100
To Bank 16,100
If the commission includes del-credere commission also, he would not be able to debit Exe for the bad debt.
In that case the debit should be to the Commission Earned Account whose net balance will then be `4,900
and he will have to pay `16,700 to Exe.

3.12 ADVANCE BY THE CONSIGNEE VS SECURITY AGAINST THE

CONSIGNMENT
Generally the consignor insist the consignee for some advance payment for the goods consigned at the
time of delivery of goods. This advance payment is adjusted in full against the amount due by the consignee
on account of the goods sold.
But if the advance money deposited by the consignee is in the form of security against the goods consigned
then the full amount is not adjusted against the amount due by the consignee to the consignor on account
of goods sold if, there is any unsold inventory left with the consignee. In that case proportionate security
in respect of unsold goods is carried forward till the time the respective goods held with the consignee are
sold.

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 6.58 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 3

Miss Rakhi consigned 1,000 radio sets costing `900 each to Miss Geeta, her agent on 1st July,2016. Miss Rakhi
incurred the following expenditure on sending the consignment.
Freight ` 7,650
Insurance ` 3,250
Miss Geeta received the delivery of 950 radio sets. An account sale dated 30th November,2016 showed that 750
sets were sold for `9,00,000 and Miss Geeta incurred `10,500 for carriage.
Miss Geeta was entitled to commission 6% on the sales effected by her. She incurred expenses amounting to
`2,500 for repairing the damaged radio sets remaining in the inventories.
Miss Rakhi lodged a claim with the insurance company which was admitted at `35,000. Show the Consignment
Account and Miss Geeta’s Account in the books of Miss Rakhi.

 SOLUTION
In the books of Miss Rakhi
Consignment Account

Particulars ` Particulars `
To Goods sent on By Miss Geeta 9,00,000
Consignment A/c 9,00,000 By Insurance Co. 35,000
By Profit & Loss A/c
To Cash abnormal loss(net) 10,545
Freight 7,650 By Consignment
Insurance 3,250 10,900 Inventories 1,84,391
To Miss Geeta
Carriage 10,500
Repairs 2,500
Commission 54,000 67,000
To Profit & Loss A/c 1,52,036
11,29,936 11,29,936

Miss Geeta’s Account

Particulars ` Particulars ` `
To Consignment A/c 9,00,000 By Consignment A/c
(Sales) Expenses:
Carriage 10,500
Repairs 2,500
Commission 54,000 67,000
By Bank(bal. fig.) 8,33,000
9,00,000 9,00,000
Note: It is assumed that the agent has remitted the amount due from her.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.59

Working Notes:

1. Abnormal loss :
Cost to the consignor: 50 sets @ ` 900 45,000
50 × 10,900
Add: Proportionate expenses incurred by the consignor
1,000 545
Gross abnormal loss 45,545
Less: Insurance claim (35,000)
Net abnormal loss 10,545
2. Valuation of Inventories
200 sets @ ` 900 1,80,000
200 × 10,900 2,180
Add: Proportionate expenses of the consignor
1,000

Add: Carriage and customs duty paid by the consignee 200 × 10,500
2,211
950
1,84,391

? ILLUSTRATION 4
Vikram Milk Foods Co. Ltd. of Vikrampur sent to Sunder Stores, Sonepuri 5,000 kgs of baby food packed in 2,000
tins of net weight 1 kg and 6,000 packets of net weight 1/2 kg for sale on consignment basis. The consignee’s
commission was fixed at 5% of sale proceeds. The cost price and selling price of the product were as under:

1 kg. tin 1/2 kg. packet

` `
Cost Price 10 6
Selling Price 15 7
The consignment was booked on freight “To Pay” basis, and freight charges came to 2% of selling value. One case
containing 50 (1kg. tins) was lost in transit and the transport carrier admitted a claim of `450.
At the end of the first half-year, the following information is gathered from the “Account Sales” sent by the
consignee:
(i) Sale proceeds: 1,500 1 kg. tins
4,000 1/2 kg. packets
(ii) Store rent and insurance charges ` 600.
Find out the value of closing inventory on consignment.
Show the Consignment A/c and the Consignee’s A/c in the books of Vikram Milk Food Co. Ltd. assuming that the
consignee had paid the amount due from him.

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 6.60 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Vikram Milk Foods Co. Ltd.
Consignment to Sonepuri Account

Particulars ` Particulars `
To Goods sent on By Sunder Stores
Consignment A/c
2,000 1 kg. tins @ ` 10 20,000 1,500 1 kg. tins @ ` 15 22,500
6,000 1/2 kg. pkts. @ ` 6 36,000 56,000 4,000 1/2 kg. pkts. @ ` 7 28,000 50,500
To Sunder Stores: By Insurance - Claim 450
Freight 1,440 By Profit & Loss A/c -
Rent and insurance 600 abnormal loss(Net) 65
Commission 2,525 4,565 By Inventory on 16,915
consignment A/c
To Profit & Loss A/c – 7,365
Profit
67,930 67,930
Sunder Stores, Sonepuri

Particulars ` Particulars `
To Consignment to Sonepuri By Consignment to
Account - Sales Proceeds 50,500 Sonepuri Account -
Freight 1,440
Rent & Insurance 600
Commission 2,525
By Bank(Bal. fig) 45,935
50,500 50,500

Working Notes:

(i) Sale value of total consignment:

2,000 1 kg. tins @ ` 15 30,000
6,000 1/2 kg. pkts. @ ` 7 42,000
72,000
(ii) Freight @ 2% of above 1,440
(iii) Inventories at the end:
450 1 kg. tins @ ` 10 (Selling Price ` 6,750) 4,500
2,000 1/2 kg. pkts. @ ` 6 (Selling Price ` 14,000) 12,000
16,500
Add: Freight 2% of (Selling Price ` 20,750) 415
16,915

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.61

(iv) Loss in transit:

Cost of 50 1 kg. tins @ ` 10 500
Freight @ 2% of Selling Price ` 750 15
Gross abnormal Loss 515
Less : Claim (450)
Net abnormal Loss 65

? ILLUSTRATION 5

Shri Mehta of Mumbai consigns 1,000 cases of goods costing ` 1,000 each to Shri Sundaram of Chennai. Shri
Mehta pays the following expenses in connection with consignment:

`
Carriage 10,000
Freight 30,000
Loading charges 10,000
Shri Sundaram sells 700 cases at ` 1,400 per case and incurs the following expenses:
Clearing charges 8,500
Warehousing and storage 17,000
Packing and selling expenses 6,000
It is found that 50 cases have been lost in transit and 100 cases are still in transit.
Shri Sundaram is entitled to a commission of 10% on gross sales. Draw up the Consignment Account and
Sundaram’s Account in the books of Shri Mehta.

 SOLUTION
In the books of Shri Mehta
Consignment to Sundaram of Chennai Account

Particulars ` Particulars `
To Goods sent on By Sundaram (Sales) 9,80,000
Consignment 10,00,000 By Loss in Transit 50 cases 52,500
@ `1,050 each
To Bank (Expenses) 50,000 By Consignment Inventories
To Sundaram (Expenses) 31,500 In hand 150 @ ` 1,060 each 1,59,000
To Sundaram (Commission) 98,000 In transit 100 @ ` 1,050 1,05,000 2,64,000
each
To Profit on Consignment to 1,17,000
Profit & Loss A/c
12,96,500 12,96,500

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 6.62 PRINCIPLES AND PRACTICE OF ACCOUNTING

Sundaram’s Account

Particulars ` Particulars `
To Consignment to Chennai A/c 9,80,000 By Consignment A/c
(Expenses) 31,500
By Consignment A/c
(Commission) 98,000
By Balance c/d 8,50,500
9,80,000 9,80,000
Working Notes:
(i) Consignor’s expenses on 1,000 cases amounts to `50,000; it comes to `50 per case. The cost of cases lost
will be computed at `1,050 per case.
(ii) Sundaram has incurred ` 8,500 on clearing 850 cases, i.e., `10 per case; while valuing closing inventories
with the agent `10 per case has been added to cases in hand with the agent.
(iii) It has been assumed that balance of `8,50,500 is not yet paid.

? ILLUSTRATION 6

Ajay of Mumbai consigned to Vijay of Delhi, goods to be sold at invoice price which represents 125% of cost. Vijay
is entitled to a commission of 10% on sales at invoice price and 25% of any excess realised over invoice price. The
expenses on freight and insurance incurred by Ajay were `10,000. The account sales received by Ajay shows that
Vijay has effected sales amounting to `1,00,000 in respect of 75% of the consignment. His selling expenses to be
reimbursed were ` 8,000. 10% of consignment goods of the value of `12,500 were destroyed in fire at the Delhi
godown and the insurance company paid `12,000 net of salvage. Vijay remitted the balance in favour of Ajay.
Prepare consignment account and the account of Vijay in the books of Ajay along with the necessary calculations.

 SOLUTION

Books of Ajay
Consignment to Vijay Account

Particulars ` Particulars `
To Goods sent on 1,25,000 By Goods sent on 25,000
Consignment A/c Consignment A/c (Loading)
To Cash A/c 10,000 By Abnormal Loss 11,000
To Vijay(Expenses) 8,000 By Vijay (Sales) 1,00,000
To Vijay(Commission) 10,938 By Inventories on 20,250
Consignment A/c
To Inventories Reserve A/c 3,750 By General Profit & Loss A/c 1,438
1,57,688 1,57,688

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.63

Vijay’s Account

Particulars ` Particulars `
To Consignment A/c 1,00,000 By Consignment A/c 8,000
By Consignment A/c 10,938
By Bank A/c 81,062
1,00,000 1,00,000
Working Notes:
1. Calculation of value of goods sent on consignment:
Abnormal Loss at Invoice price = ` 12,500.
Abnormal Loss as a percentage of total consignment = 10%.
Hence the value of goods sent on consignment = ` 12,500 X 100/ 10 = ` 1,25,000.
Loading of goods sent on consignment = ` 1,25,000 X 25/125 = ` 25,000.

2. Calculation of abnormal loss (10%):

Abnormal Loss at Invoice price = ` 12,500.
Abnormal Loss at cost = ` 12,500 X 100/125 = ` 10,000
Proportionate expenses of Ajay (10 % of `10,000) = ` 1,000
` 11,000
3. Calculation of closing Inventories (15%):

Ajay’s Basic Invoice price of consignment = ` 1,25,000

Ajay’s expenses on consignment = ` 10,000
` 1,35,000
Value of closing Inventories = 15% of ` 1,35,000 = ` 20,250
Loading in closing Inventories = `25,000 X 15/100 = ` 3,750
Where `18,750 (15% of `1,25,000) is the basic invoice price of the goods sent on consignment remaining
unsold.
4. Calculation of commission:
Invoice price of the goods sold = 75% of ` 1,25,000 = ` 93,750
Excess of selling price over invoice price = ` 6,250 ( ` 1,00,000- ` 93,750)
Total commission = 10% of ` 93,750 + 25% of ` 6,250
= ` 9,375 + ` 1,562.50
= ` 10,937.50 OR 10,938
Note:
1. It has been assumed that final payment received from Vijay.
2. Abnormal loss is always calculated at cost even if invoice price of goods is given.
3. Value of inventories always valued at invoice price if invoice price is given.

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 6.64 PRINCIPLES AND PRACTICE OF ACCOUNTING

SUMMARY
w In Consignment one person (consignor) sends goods to another person (consignee) to be sold on
behalf of and at the risk of the former.

w In the case of consignment, cost means not only the cost of the goods as such to the consignor but
also all expenses incurred till the goods reaches the premises of the consignee. Such expenses include
packaging, freight, cartage, insurance in transit, octroi, etc.

w Expenses incurred after the goods have reached the consignee’s godown (such as godown rent,
insurance of godown, delivery charges) are not treated as part of the cost of purchase for valuing
inventories on hand.

w If the expected selling price of inventories on hand is lower than the cost, the value put on the
inventories should be expected net selling price only, i.e. expected selling price less delivery expenses,
etc.i.e. expenses necessary for sales.

w Proforma invoice is made to show the high value of goods consigned than the cost and entries in the
books of the consignor are made out on that basis. Even the inventories remaining unsold will initially
be valued on the basis of the invoice price.

w Hence, if entries are first made on invoice basis, the effect of the loading (i.e., amount added to arrive at
the invoice price) must be removed by additional entries to ascertain profit or loss.

w Abnormal loss is valued just like inventories in hand. Students should be careful while valuing goods
lost in transit and goods lost in consignee’s godown. Both are abnormal loss but in case of former
consignee’s non-recurring expenses are not to be included whereas it is to be included in case of latter.

w Normal loss, is an unavoidable loss and be spread over the entire consignment while valuing inventories.
The total cost plus expenses incurred should be divided by the quantity available after the normal loss
to ascertain the cost per unit.

w Commission is the remuneration paid by the consignor to the consignee for the services rendered to the
former for selling the consigned goods. Three types of commission can be provided by the consignor to
the consignee, as per the agreement, either simultaneously or in isolation. They are:
ª Ordinary commission
ª Del-credere commission
ª Over-riding commission

w For accounting of consignee, he is concerned only when he sends an advance to the consignor, makes a
sale, incurs expenses on the consignment and earns his commission. He debits or credits the consignor
for all these as the case may be.

w It has been assumed that final payment received from Vijay.

w Abnormal loss is always calculated at cost even if invoice price of goods is given.

w Value of inventories always valued at invoice price if invoice price is given.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.65

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1 P of Delhi sends out 1,000 boxes of toothpaste costing ` 200 each. Each box consist of 12 packets. 600
boxes were sold by consignee at ` 20 per packet. Amount of sale value will be:
(a) ` 1,44,000 (b) ` 1,20,000 (c) `1,32,000
2 X of Kolkata sends out 2,000 boxes to Y of Delhi costing ` 100 each. Consignor’s expenses ` 5,000.
1/10th of the boxes were lost in consignee’s godown and treated as normal loss. 1,200 boxes were sold
by consignee. The value of consignment Inventories will be:
(a) ` 68,333 (b) ` 61,500 (c) ` 60,000
3 Which of the following statement is not true:
(a) If del-credere commission is allowed, bad debt will not be recorded in the books of consignor
(b) If del-credere commission is allowed, bad debt will be debited in consignment account
(c) Del-credere commission is provided by consignor to consignee
4 X of Kolkata sent out 2,000 boxes costing 100 each with the instruction that sales are to be made at cost
+ 45%. X draws a bill on Y for an amount equivalent to 60% of sales value. The amount of bill will be:
(a) ` 1,74,000 (b) ` 2,00,000 (c) ` 2,90,000
5 Which of the following statement is wrong:
(a) Consignor is the owner of the consignment Inventories
(b) Del-credere commission is allowed by consignor to protect himself from bad debt
(c) All proportionate consignee’s expenses will be added up for valuation of consignment Inventories.
6 Out of the following at which point the treatment of “Sales” and “Consignment” is same:
(a) Ownership transfer.
(b) Money receive.
(c) Inventories outflow.
7 If del-credere commission is allowed for bad debt, consignee will debit the bad debt amount to:
(a) Commission Earned A/c
(b) Consignor’s A/c
(c) Trade receivables (Customers) A/c
8 A proforma invoice is sent by:
(a) Consignee to Consignor
(b) Consignor to Consignee
(c) Customer/Debtors to Consignee

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 6.66 PRINCIPLES AND PRACTICE OF ACCOUNTING

9 Which of the following statement is correct:

(a) Consignee will pass a journal entry in his books at the time of receiving goods from consignor.
(b) Consignee will not pass any journal entry in his books at the time of receiving goods from consignor.
(c) The ownership of goods will be transferred to consignee at the time of receiving the goods.
10 Consignment Inventories will be recorded in the balance sheet of consignor on asset side at:
(a) Invoice Value
(b) At Invoice value less Inventories reserve
(c) At lower than cost price
11 Which of the following expenses of consignee will be considered as non-selling expenses:
(a) Advertisement
(b) Insurance on freight inward
(c) Selling Expenses
12 The consignment accounting is made on the following basis:
(a) Accrual
(b) Realisation
(c) Cash Basis
13 Which of the following item is not credited to consignment account?
(a) Cash sales made by consignee
(b) Credit sales made by consignee
(c) Inventories Reserve on closing consignment Inventories

Theory Questions
Q1. Write short notes on:
(i) Del-credere commission.
(ii) Account sales.
(iii) Over-riding commission.
Q2. Distinguish between:
(i) Consignment sale and Normal sale.
(ii) Commission and Discount.

Practical Questions
Q1. X of Delhi purchased 10,000 metres of cloth for `2,00,000 of which 5,000 metres were sent on
consignment to Y of Agra at the selling price of ` 30 per metre. X paid ` 5,000 for freight and ` 500 for
packing etc.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.67

Y sold 4,000 metre at ` 40 per metre and incurred ` 2,000 for selling expenses. Y is entitled to a
commission of 5% on total sales proceeds plus a further 20% on any surplus price realised over ` 30
per metre. 3,000 metres were sold at Delhi at ` 30 per metre less ` 3,000 for expenses and commission.
Owing to fall in market price, the inventories of cloth in hand is to be reduced by 10%.
Prepare the Consignment Account and Trading and Profit & Loss Account in books of X.
Q2. D of Delhi appointed A of Agra as its selling agent on the following terms:
Goods to be sold at invoice price or over.
A to be entitled to a commission of 7.5% on the invoice price and 20% of any surplus price realized over
invoice price
The principals to draw on the agent a 30 days bill for 80% of the invoice price.
On 1st February, 2016, 1,000 cycles were consigned to A, each cycle costing ` 640 including freight and
invoiced at ` 800.
Before 31st March, 2016, (when the principal’s books are closed) A met his acceptance on the due date;
sold off 820 cycles at an average price of ` 930 per cycle, the sale expenses being ` 12,500; and remitted
the amount due by means of Bank draft.
Twenty of the unsold cycles were shop-spoiled and were to be valued at a depreciation of 50% of cost.
Show by means of ledger accounts how these transactions would be recorded in the books of A and
find out the value of closing inventory with A to be recorded in the books of D at cost.
Q3. Mr. Y consigned 800 packets of toothpaste, each packet containing 100 toothpastes. Cost price of each
packet was ` 900. Mr. Y Spent ` 100 per packet as cartage, freight, insurance and forwarding charges.
One packet was lost on the way and Mr. Y lodged claim with the insurance company and could get `570
as claim on average basis. Consignee took delivery of the rest of the packets and spent ` 39,950 as other
non-recurring expenses and ` 22,500 as recurring expenses. He sold 740 packets at the rate of ` 12 per
toothpaste. He was entitled to 2% commission on sales plus 1% del-credere commission.
You are required to prepare Consignment Account. Calculate the cost of inventories at the end, abnormal
loss and profit or loss on consignment.
Q4 A of Agra sent on consignment goods valued ` 1,00,000 to B of Mumbai on 1st March, 2016. He incurred
the expenditure of ` 12,000 on freight and insurance. A’s accounting year closes on 31st December. B
was entitled to a commission of 5% on gross sales plus a del-credere commission of 3%. B took delivery
of the consignment by incurring expenses of ` 3,000 for goods consigned.
On 31.12.2016, B informed on phone that he had sold all the goods for ` 1,50,000 by incurring selling
expenses of ` 2,000. He further informed that only ` 1,48,000 had been realized and rest was considered
irrecoverable, and would be sending the cheque in a day or so for the amount due along with the
accounts sale.
On 5.1.2017, A received the cheque for the amount due from B and incurred bank charges of ` 260 for
collecting the cheque. The amount was credited by the bank on 9.1.2017.
Write up the consignment account finding out the profit/loss on the consignment, B’s account, Provision
for expenses account and Bank account in the books of the consignor, recording the transactions upto
the receipt and collection of the cheque.

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 6.68 PRINCIPLES AND PRACTICE OF ACCOUNTING

ANSWERS/HINTS
MCQs

1 2 3 4 5 6 7 8 9 10 11 12 13
(a) (b) (b) (a) (c) (c) (a) (b) (b) (b) (b) (a) (c)

Theoretical Questions
1 (i) Del-credere commission is an additional commission paid by the consignor to the consignee
for undertaking responsibility of collection of debts. Generally, the consignee gets ordinary
commission for sales made by him as a percentage of gross sales, over and above, he may get del-
credere commission for the additional responsibility of debt collection. Sometimes it is agreed that
del-credere commission shall be allowed on credit sales only. However, in the absence of any such
agreement the consignor allows del-credere commission on total sales and not merely on credit
sales. If the consignee is entitled to del-credere commission, he has to bear the bad debts; if any,
arising, out of credit sale of consignment goods.
(ii) Account sales is a periodic statement furnished by the consignee to the consignor stating therein,
the quantity sold, price charged, expenses incurred on behalf of the consignee and commission
payable to him in respect of a particular consignment, and the net amount due from him and
remittance received if any. It also shows the details of quantity of goods received, destroyed, if any,
and still held as stock.
(iii) Over-riding commission is an extra commission allowed to the consignee in addition to the normal
commission. Such additional commission is generally allowed:-
To provide additional incentive to the consignee for the purpose of introducing and creating a
market for a new product.
To provide incentive for supervising the performance of other agents in a particular area.
To provide incentive for ensuring that the goods are sold by the consignee at the highest possible
price.
2. (i) In case of consignment, the property in the goods remains with the consignor until the goods are
actually sold. The consignee acts only as a custodian of goods sent by consignor. In consignment,
the ownership of goods does not pass on to the consignee in any case. In case of ordinary sale, the
ownership of goods passes to the buyer immediately after sale. In case of consignment, the risk
attached to the goods remain with the consignor even after sending the goods to the consignee.
However, in case of ordinary sale, as soon as the property in the goods passes on to the buyers, the
risk attached to the goods also passes at the same time. The relationship between consignor and
consignee is that of principal and agent. In case of credit sale, the relationship between the buyer
and the seller is that of a debtor and a creditor.
(ii) Commission may be defined as remuneration of an employee or agent relating to services
performed in connection with sales, purchases, collections or other types of business transactions
and is usually based on a percentage of the amounts involved.
Commission earned is accounted for as an income in the books of accounts, and commission
allowed or paid is accounted for as an expense in the books of the party availing such facility or
service.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.69

The term discount refers to any reduction or rebate allowed and is used to express one of the
following situations:
An allowance given for the settlement of a debt before it is due i.e. cash discount.
An allowance given to the whole sellers or bulk buyers on the list price or retail price, known as
trade discount. A trade discount is not shown in the books of account separately and it is shown by
way of deduction from cost of purchases.

Practical Questions
ANSWER 1
In the books of Mr. X
Consignment Account

Particulars Amount ` Particulars Amount `

To Goods sent on
Consignment Account 1,50,000 By Y’s account: (Sales) 1,60,000
To Bank account: Freight and 5,500 By Goods sent on consignment 50,000
packing etc. (Cancellation of loading)
To Y’s account: By Inventories on consignment 28,990
(W.N.2)
Selling expenses 2,000
Commission (W.N.1) 16,000
To Inventories Reserve (W.N.3) 10,000
To Profit and loss account (profit 55,490
on consignment transferred)
2,38,990 2,38,990

Trading and Profit and Loss Account

for the year ended……..

Particulars Amount ` Particulars Amount `

To Purchases 2,00,000 By Sales 90,000
To Gross profit c/d 26,000 By Goods sent on consignment 1,00,000
By Inventories in hand Cost ` 40,000
Less: 10% 4,000 36,000
2,26,000 2,26,000
To Expenses and commission 3,000 By Gross profit b/d 26,000
To Net profit 78,490 By Consignment A/c
(profit on consignment) 55,490
81,490 81,490

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 6.70 PRINCIPLES AND PRACTICE OF ACCOUNTING

Working Notes:

i. Calculation of commission payable to Y: `

Total sale proceeds of Y 1,60,000
Surplus proceeds realised over ` 30 per metre
[4,000 x ` (40-30)] 40,000
Commission:
5% of total sale proceeds (5% of ` 1,60,000) 8,000
20% of surplus (20% of ` 40,000) 8,000
16,000
ii. Inventories on Consignment: `
Cost of consignment Inventories (1000 mtrs@ ` 30) 30,000
Add: Expenses of consignor(5,500X1/5) 1,100
31,100
Less: Reduction of 10% in cost due to fall in market price (20,000+1,100) x 10% 2,110
28,990
iii. Loading ( `10 x 1,000 mtrs) 10,000
ANSWER 2
D’s Account

2016 ` 2016 `
Feb. 1 To Bills payable A/c 6,40,000 Mar. 31 By Cash/Bank A/c (820x `930) 7,62,600
(80% of ` 8,00,000)
Mar. 31 To Cash A/c (expenses) 12,500
To Commission earned A/c 70,520
To Bank A/c 39,580 _______
7,62,600 7,62,600

Bills Payable Account

2016 ` 2016 `
Mar. 4 To Cash/Bank A/c 6,40,000 Feb. 1 By D’s A/c 6,40,000
6,40,000 6,40,000

Value of closing inventory with A

`
160 cycles at ` 640 (cost price including freight) 1,02,400
20 cycles (shop-spoiled) at 50% of the cost i.e. at ` 320 each 6,400
Value of closing inventory with A i.e. the amount (net effect of the loading) at which D _______
will account for in his books on 31st March, 2016
1,08,800

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.71

Working Note:
CALCULATION OF COMMISSION:

`
7.5 % on the invoice price amount (820x ` 800) i.e. ` 6,56,000 49,200
20% on the surplus price amount (820 x ` 130) ` 1,06,600 21,320
70,520
2.
`
Abnormal loss:
Cost of packet lost during transit 900
Add: Expenses incurred by Y 100
Gross Abnormal loss 1,000
Less: Insurance claim received (570)
Net Abnormal loss 430

3. COST OF INVENTORIES AT THE END:

`
59 packets @ ` 900 53,100
Add: Expenses incurred by Y (59x `100) 5,900
Add: Proportionate (non-recurring) expenses incurred by the consignee
(59/799x `39,950) 2,950
61,950

4.
Closing inventories No. of packets
Packets consigned 800
Less: Packet lost in transit (1)
799
Less: Packets sold 740
59

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 6.72 PRINCIPLES AND PRACTICE OF ACCOUNTING

ANSWER 3
Consignment Account

` `
To Goods sent on consignment A/c 7,20,000 By Consignee’s A/c-Sales 8,88,000
(800x ` 900) (740x100x `12)
To Cash A/c 80,000
(expenses 800x `100) By Abnormal Loss Cash A/c 570
(insurance claim)
To Consignee’s A/c: By Profit and loss account 430
Recurring expenses 22,500 (abnormal loss)
Non-recurring expenses 39,950 By Consignment stock A/c 61,950
Commission @ 2% on ` 8,88,000 17,760
Del-credere commission @ 1% on 8,880
` 8,88,000
To Profit and loss A/c 61,860
(profit on consignment)
9,50,950 9,50,950
ANSWER 4
In the books of Mr. A
Consignment to Mumbai Account

2016 ` 2016 `
March 1 To Goods sent on consignment A/c 1,00,000 Dec. 31 By B’s A/cs 1,50,000
To Cash A/c (freight and insurance) 12,000
To B’s A/c:
Clearance expenses 3,000
Selling expenses 2,000
Commission
@ 5% on ` 1,50,000 7,500
Del-credere commission @3% on 17,000
` 1,50,000 4,500
Dec. 31 To Provision for expenses 260
(bank charges)
To Profit and loss A/c 20,740
(profit on consignment)
1,50,000 1,50,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.73

B’s Account

2016 ` 2016 `
Dec. 31 To Consignment A/c 1,50,000 Dec. 31 By Consignment A/c-
Clearance expenses 3,000
Selling expenses 2,000
Commission 7,500
Del-credere commission 4,500 17,000
By Balance c/d 1,33,000
1,50,000 1,50,000
2017 2017
Jan. 1 To Balance b/d 1,33,000 Jan. 5 By Bank A/c 1,33,000

Bank Account

2017 ` 2017 `
Jan. 5 To B’s account 1,33,000 Jan. 5 By Bank charges 260
Jan. 5 By Balance c/d 1,32,740
1,33,000 1,33,000
Provision for Expenses Account

2017 ` 2017 `
Jan. 5 To Bank charges 260 Jan. 1 By Balance b/d 260
260 260

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 6.74 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 4: JOINT VENTURES

LEARNING OUTCOMES
After studying this unit, you will be able to :
w Understand special features of joint venture transactions,
w Learn the techniques of preparing Joint Venture Account and also the settlement of accounts with the
co-venturer(s),
w Familiarise with the use of Memorandum Joint Venture Account,
w Learn the technique of deriving venture profit and its allocation among the venturers,
w Distinguish joint venture with partnership.

UNIT MAINTENANCE OF JOINT VENTURE ACCOUNTS

OVERVIEW
Separate set of books No Separate set of
are maintained books are maintained

Personal When each

Joint When each
Joint bank accounts co-venturer
venture co-venturer
account of co- keeps
account keeps
ventures record
record of all
of own
transactions
transactions
only

Joint Co- Joint

venture venturer’s Memorandum venture
account account joint venture with co-
account venturer
account

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.75

4.1 MEANING OF JOINT VENTURE

Complexities of a business such as huge funds requirements, lack of technical expertise, sometimes make
it difficult to undertake a business assignment individually like construction of a multi purpose building
complex. The alternative available is that two or more parties join hands to take up that assignment. Joining
hands may be for finance, for technical know-how, for sharing risk etc. When two or more persons join
together to carry out a specific business and share the profits or losses on predetermined basis, it is known
as a Joint Venture. As per Accounting Standard a joint venture is a contractual arrangement whereby two
or more parties undertake an economic activity, which is subject to joint control. Further, joint control is
defined as contractually agreed sharing of control over economic activity.
A Joint Venture is a specific duration “business” (generally, confined to a single transaction, like, developing
some housing project and selling the same or mining of a particular coal mine) entered into by two or more
persons jointly which comes to an end as soon as specific period elapses or the joint purpose/business
is completed. Joint Venture may be described as a temporary partnership between two or more persons
without the use of the firm name, for a limited purpose. In other words, under Joint Venture, two or more
persons agree to undertake a particular venture (e.g. Joint consignment of goods, Joint construction of a
building, Joint underwriting of a particular issue of shares or debentures) and to share the profits and losses
thereof in an agreed ratio (if agreement is silent on this point, then in equal ratio). Venture may be for the
construction of a building or a bridge, for the supply of certain quantity of materials or labour and even for
the supply of technical services.
The persons who have so agreed to undertake a Joint Venture are known as ‘Joint Venturers’ or ‘Co-Venturers’
and their liability is limited to the project or activity concerned for which they agree to contribute capital
and share profits or losses. This limited partnership automatically expires on the completion of the venture
for which it was formed. During the duration of the venture, the co-venturers are are generally engaged in
their own business as usual as well (unless agreed otherwise).If the co-venturers are in business, then they
often supply goods from their regular business for achieving objective of the venture. For instance, two or
more persons may combine their operations, resources and expertise in order to manufacture, market and
distribute, jointly, a particular product, such as an aircraft. Different parts of the manufacturing process may
be carried out by each of the persons. Each person may bear costs and take share of revenue from the sale
of the aircraft, such share being determined in accordance with the contractual arrangement.
Let us take two examples to understand the nature of joint venture business.
Example 1: A and B decided to purchase Assam Teak in Guwahati and send to Delhi. A of Guwahati purchased
Teak of ` 1,00,000, spent ` 20,000 for transportation and ` 8,000 for transit insurance. B of Delhi received the
goods. B spent ` 2,000 for unloading, ` 6,000 for godown rent and ` 4,000 for selling expenses. He sold the
entire lot for ` 1,75,000. They agreed to share profit of the venture in the ratio of A:B = 3:2.
In the above example, A and B are co-venturers. The venture was for sale of a certain quantity of Assam Teak.
The venture would be over on sale of such Teak. Obviously some accounting is necessary to find out profit/
loss of the venture and settlement of claims of the co-venturers.
Example 2: Mr. Arun and Barun entered into a joint venture for supply of 15,000 pcs. of Bengal handloom
sarees to an exporter of Delhi @ ` 520 per piece. Arun and Barun contacted handloom weavers and paid
advance to them. They collected production by lots and delivered to Delhi in a lot of 1,000 pcs.
In this example, Arun and Barun were co-venturers. The venture was for a special purpose of supplying of
15,000 pcs. of Bengal handloom sarees. The venture was over on supply of such quantity. Obviously, Arun
and Barun had to maintain accounts to book all costs relating to the venture and revenue received from the

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 6.76 PRINCIPLES AND PRACTICE OF ACCOUNTING

exporter for determining profit/loss of the venture and for settling the claims of co-venturersinter se.

4.2 FEATURES OF JOINT VENTURE

A joint venture can be in following form or structure:
1. Jointly controlled operations;
2. Jointly controlled assets; and
3. Jointly controlled entity.
Some important characteristics of joint venture business are as follows:
(i) It is specific duration special purpose partnership.
(ii) Two or more parties come together for a specific purpose and are bound by an agreement. Parties in
venture are called co-venturers.
(iii) The agreement between co-venturers establishes joint control.
(iv) The joint venture may or may not have a specific name. Joint ventures may also be created in the form
of a company where co-venturers contribute to its share capital.
(v) Co-venturers may contribute funds for running the venture or supply Inventories from their regular
business.
(vi) Co-venturers share profit/loss of the venture at an agreed ratio likewise partnership.
(vii) The co-ventures are free to continue with their own business unless agreed otherwise during the life of
joint venture.
(viii) Joint venture terminates on completion of purpose for which it was created.
(ix) Generally profit/loss of the venture is computed on completion of the venture, however, for a joint
venture which is expected to run for a long period, profit/loss is computed annually.

4.3 DISTINCTION OF JOINT VENTURE WITH PARTNERSHIP

Joint Venture differs from Partnership in the following respects:

Basis of Distinction Joint Venture Partnership

1. Scope It is limited to a specific venture, and It is not limited to a specific venture.
comes to an end on completion of such
venture.
2. Persons involved The persons carrying on business are The persons carrying on business are
called co-venturers. called partners.
3. Name of entity Joint venture does not necessarily require A partnership firm always has a distinct
a firm name. firm name.
4. Ascertainment of The profits/losses are ascertained at The profits/losses are ascertained on an
profit/loss the end of specific venture (if venture annual basis.
continues for a short period) or on interim
basis annually (if venture continues for a
longer period).

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.77

5. Separate set of There is no need for a separate set of Separate set of books have to be
Books books. The accounts can be maintained maintained.
even in one of the Co-venturer’s books
only.
6. Competition It is a rule rather than exception that Partners generally do not involve in
chances of co-venturers in the competing competing business.
business are very high.
7. Closure Joint venture will be closed automatically Partnership can be dissolved by mutual
on the completion of the venture i.e. consent of the partners or under certain
achievement of purpose for which joint circumstances
venture was formed.

4.4 DISTINCTION OF JOINT VENTURE WITH CONSIGNMENT

Joint venture and consignment are in the nature of an agreement between different parties but there are
many points of differences between the two.
Some of these are given below:

Basis of Distinction Joint Venture Consignment

1. Purpose It may be for sale of goods or for carrying It generally involves sale of movable
out any other activity like construction goods.
of building, investment in shares, etc.
2. Persons involved The persons carrying on business are The persons in the trade are called
called co-venturers. consignor and consignee.
3. Tenure Therelationship comes to an end as The arrangement may continue for a
soon as the venture is completed. long period of time.
4. Contribution of All the co-venturers contribute funds to The funds are provided by the consignor
funds a common pool. only.
5. Sharing of profit/ The profit/loss is shared by all the co- The profit/loss belongs to consignor
loss venturers in the agreed ratio (in equal only. The consignee is entitled only to
ratio if agreement is silent) commission.
6. Ownership There is joint ownership. The consignor owns the goods.
7. Relationship The relationship between co-venturers The relationship between consignor and
is as partners to common purpose consignee is as principle and agent.

4.5 METHODS OF MAINTAINING JOINT VENTURE ACCOUNTS

When the joint venture is in the form of joint control of an entity then joint venture is generally in the form
of a company or partnership firm or any other legal entity in which each venturers has some interest. The
entity operates in the same way as any other enterprise. The entity controls the assets of the joint venture,
incurs liabilities and expenses and earns income. It has its own identity and may enter into contracts in its
own name and raise finance for the purpose of the jointly controlled activity. Each co-venturer is entitled
to a share of results of the jointly controlled entity, although it may also involve a sharing of output of
the entity. An example of this kind of joint venture can be where an enterprise who has technology to

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 6.78 PRINCIPLES AND PRACTICE OF ACCOUNTING

develop a particular product and wants to enter into a new country, joins hands with another enterprise
located in target country having knowledge of behaviorof the target market. Nowadays, it is common that
co-venturers enter into this kind of arrangement and setup a separate jointly controlled entity for running
desired business operations.
In case joint venture is not in the form of joint control of an entity, then co-venturers can maintain the
accounts for joint venture in the manner that suits them in a particular situation.
Generally there are two ways to keep records of joint venture:
1. When separate set of books are maintained.
2. When no separate set of books are maintained.
4.5.1 When Separate Set of Books are maintained
When size of the venture is fairly big, the co-venturers keep separate set of books of account for the
joint venture. Joint venture is considered a separate entity for the purpose of accounting and hence, its
transactions are recorded separately from their regular business activities. This method is similar to a
partnership agreement being entered into by the partners of a firm.
In the books of Joint Venture, the following accounts are opened:
(i) Joint Bank Account.
(ii) Joint Venture Account.
(iii) Personal Accounts of the Co-venturers (or Co-venturers’ Accounts).
(i) Joint Bank Account: The co-venturers open a separate bank account for the venture transactions by
making initial contributions. The bank account is generally operated jointly. Expenses are met from
this Joint Bank Account. Also sales or collections from transactions are deposited into this account.
However, sometimes the co-venturers may make direct payments and direct collections; in such a case
they get due credit/ debit in their Personal Accounts for the transactions done. On completion of the
venture the Joint Bank Account is closed by paying the balance to co-venturers.
(ii) Joint Venture Account: This account is prepared for measurement of venture profit. This account is
debited with all venture expenses and credited with all sales or collections. If credit side of this account
is greater than the debit side, the difference represents profit on joint venture and vice versa in the
opposite case which is transferred to co-venturers’ accounts in the profit-sharing ratio.
(iii) Co-venturers’ Accounts: Personal accounts of the venturers are maintained to keep record of their
contributions of cash, goods or meeting venture expenditure directly and direct payment received by
them on venture transactions. The profit or loss so made on venture is transferred to this account in
profit sharing ratio. This account is also closed simultaneously with the closure of joint bank account.
The following journal entries are necessary in the books of joint venture:
Journal Entries
(a) For initial contribution by the co-venturers in Joint Bank Account
Joint Bank A/c Dr.
To Co-venturers’ A/c
(b) For purchases made or expenses incurred

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.79

Joint Venture A/c Dr.

To Joint Bank A/c (for cash purchase)/Creditors A/c (for credit purchase)
(c) For material supplied by venturers or direct payment made by venturers
Joint Venture A/c Dr.
To Co-venturers’ A/cs
(d) For sale made
Joint Bank A/c (for cash sales)/Debtors A/c (for credit sales) Dr.
To Joint Venture A/c
(e) For sale or payment received directly by the venturers
Co-venturers’ A/c Dr.
To Joint Venture A/c
(f) For payment made to creditors
Creditors A/c Dr.
To Joint Bank A/c
(g) For payment received from debtors
Joint Bank A/c Dr.
To Debtors’ A/c
(h) For profit on Joint Venture
Joint Venture A/c Dr.
To Co-venturers’ A/c
or For loss on Joint Venture
Co-venturers’ A/c Dr.
To Joint Venture A/c
(i) For closing the Joint Bank A/c
Co-venturers’ A/c Dr.
To Joint Bank A/c
Form above transactions, it may be noted that all sales, incomes, purchases and expenses are recorded in
Joint Venture A/c directly. Difference between total revenues and total expenses becomes profit/loss of the
joint venture and is shared by co-venturers.

? ILLUSTRATION 1
B and C enter a joint venture to prepare a film for the Government. The Government agrees to pay ` 1,00,000. B
contributes ` 10,000 and C contributes ` 15,000. These amounts are paid into a Joint Bank Account. Payments
made out of the joint bank account were:

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 6.80 PRINCIPLES AND PRACTICE OF ACCOUNTING

`
Purchase of equipment 6,000
Hire of equipment 5,000
Wages 45,000
Materials 10,000
Office expenses 5,000
B paid ` 2,000 as licensing fees. On completion, the film was found defective and Government made a deduction
of ` 10,000. The equipment was taken over by C at a valuation of ` 2,000.
Separate books were maintained for the joint venture whose profits were divided in the ratio of B-2/5 and C-3/5.
Required
Give ledger accounts.

 SOLUTION
Joint Bank Account

Date Particulars Amount (`) Date Particulars Amount (`)

?? To B 10,000 ?? By Joint Venture A/c- Equipment 6,000
?? To C 15,000 Hire of equipment 5,000
?? To Joint Venture A/c 90,000 Wages 45,000
Materials 10,000
Office expenses 5,000
?? By B 19,600
By C 24,400
1,15,000 1,15,000

Joint Venture Account

Date Particulars Amount (`) Date Particulars Amount (`)

?? To Joint Bank A/c: ?? By Joint Bank A/c
Equipment 6,000 (` 1,00,000-10,000) 90,000
Hire of equipment 5,000
Wages 45,000 ?? By C (Equipment taken) 2,000
Materials 10,000
Office Expenses 5,000
?? To B -Licensing fee 2,000
?? To Profit to:
B 2/5 7,600
C 3/5 11,400 19,000
92,000 92,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.81

B’s Account

Date Particulars Amount (`) Date Particulars Amount (`)

?? To Joint Bank A/c ?? By Joint Bank A/c 10,000
- Repayment 19,600 ?? By Joint Venture A/c- 2,000
Fees
?? By Joint Venture A/c- 7,600
Profit
19,600 19,600
C’s Account

Date Particulars Amount (`) Date Particulars Amount (`)

?? To Joint Venture A/c- 2,000 ?? By Joint Bank A/c 15,000
Equipment
?? To Joint Bank A/c - 24,400 ?? By Joint Venture A/c- 11,400
Repayment Profit
26,400 26,400

? ILLUSTRATION 2
Rajiv and Sanjiv enter into a joint venture as dealers in land and opened a Joint Bank Account with ` 75,000
towards which Rajeev contributed ` 50,000. They agree to share profits and losses in proportion to their cash
contribution. They purchased a plot of land measuring 5,000 square yards for ` 50,000. It was decided to sell the
land in smaller plots and a plan was got prepared at a cost of ` 5,700.
In the said plan 1/5th of the total area of the land was left over for public roads and the remaining land was
divided into 8 plots of equal size. Out of 8 plots, 3 plots were sold @ ` 15 per square yard and the remaining 5 plots
were sold @ ` 20 per square yard. Expenses incurred in connection with the plots were: Registration Expenses
` 6,000, Stamp Duty ` 600 and Other Expenses ` 2,500. Allow 5% on the sale proceeds as a commission to Rajiv.
Required
Journalize the above transactions and prepare the necessary ledger accounts.

 SOLUTION
JOURNAL

Date Particulars L.F. (` ) (` )

Joint Bank A/c Dr. 75,000
To Rajiv A/c 50,000
To Sanjiv A/c 25,000
(Being funds brought in by co-venturers)
Joint Venture A/c Dr. 50,000
To Joint Bank A/c 50,000
(Being a plot of land purchased)

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 6.82 PRINCIPLES AND PRACTICE OF ACCOUNTING

Joint Venture A/c Dr. 5,700

To Joint Bank A/c 5,700
(Being expenses incurred in preparation of plan)
Joint Bank A/c Dr. 72,500
To Joint Venture A/c 72,500
(Being sale proceeds of plots as follows:
3 plots of 500 sq. yards @ ` 15 = ` 22,500
5 plots of 500 sq. yards @ ` 20 = ` 50,000)
Joint Venture A/c Dr. 9,100
To Joint Bank A/c 9,100
(Being expenses incurred as: Registration Expense- ` 6,000;
Stamp Duty- ` 600; Other Expenses- ` 2,500)
Joint Venture A/c Dr. 3,625
To Rajiv A/c 3,625
(Being commission paid to Rajiv @5% of `72,500)
Joint Venture A/c Dr. 4,075
To Rajiv A/c 2,717
To Sanjiv A/c 1,358
(Being profit transferred to Rajiv and Sanjiv in the ratio of 2:1)
Joint Bank Account

Date Particulars Amount (`) Date Particulars Amount (`)

To Rajiv A/c 50,000 By Joint Venture A/c:
To Sanjiv 25,000 Plot 50,000
To Joint Venture A/c 72,500 Plan 5,700
Other Expenses 9,100 64,800
By Balance transferred:
Rajiv’s A/c 56,342
Sanjiv’s A/c 26,358 82,700
1,47,500 1,47,500

Joint Venture Account

Date Particulars Amount (`) Date Particulars Amount (`)

To Joint Bank A/c: By Joint Bank A/c(Sales) 72,500
Plot 50,000
Plan 5,700
Other Expenses 9,100 64,800
To Rajiv A/c (Commission) 3,625
To Profit to:

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.83

Rajiv 2,717
Sanjiv 1,358 4,075
72,500 72,500
Rajiv’s Account

Date Particulars Amount (`) Date Particulars Amount (`)

To Joint Bank A/c By Joint Bank A/c 50,000
- Repayment 56,342 By Joint Venture A/c 3,625
- Commission
By Joint Venture A/c 2,717
- Profit
56,342 56,342

Sanjiv’s Account

Date Particulars Amount (`) Date Particulars Amount (`)

To Joint Bank A/c By Joint Bank A/c 25,000
- Repayment 26,358 By Joint Venture A/c 1,358
26,358 26,358

4.5.2 When no separate set of Books are maintained

w When no separate set of books of accounts are maintained for joint venture, each venturer maintains
accounts independently for the venture transactions.
w Co-vernturers are generally engaged in their own business for which they have their books of accounts.
Additional accounts with respect to join venture transactions are opened in their respective books of
accounts.
w The standard practice is to keep full records of own transactions as well as transactions of the co-
venturer relating to the venture.
w But sometimes the parties to a venture keep record of their own transactions only. In that case a
Memorandum Joint Venture Account is prepared by the parties.
w Sometimes, a bill of exchange is drawn by one of the parties and is discounted. In such a case the
discount on the bill should be charged to Joint Venture Account.
w Also, since joint venture is considered separate from the business of the co-venturers, the co-venturers
are credited (or debited) for any goods or material supplied (or taken) to (or from) the joint venture out
of their own business(es).
w Usually the co-venturers invest money in Joint venture business and receive back the amounts on
different dates. It is quite usual for them to agree to calculate interest at a certain rate. Each co-venturers
is entitled to receive interest on the amounts invested by him and pay interest on the amounts received
by him. Only net interest receivable from or payable to the co-venturer is recorded in the joint venture
account. Thus, the net amount of interest is also taken into amount before ascertaining the profit or loss
on joint venture.

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 6.84 PRINCIPLES AND PRACTICE OF ACCOUNTING

4.5.2.1 When each Co-venturer keeps records of all transactions

Under this method, the following accounts are prepared by each co-venturer:
(i) Joint Venture Account.
(ii) Co-venturer’s Account.
When venturers maintain full records of joint venture, the following journal entries are necessary:

Journal Entries
(i) For supply of goods to venture out of business Inventories
Joint Venture A/c Dr.
To Purchase A/c
(ii) For meeting expenses or purchases of venture
Joint Venture A/c Dr.
To Bank A/c/Creditors A/c
(iii) When co-venturer supplies goods and incurs expenses for venture
Joint Venture A/c Dr.
To Co-venturer A/c
(iv) For venture sale
Bank A/c/Debtors A/c Dr.
To Joint Venture A/c
(v) For venture sale made by the co-venturer
Co-venturer A/c Dr.
To Joint Venture A/c
(vi) For Bill of Exchange drawn on co-venturer
Bills Receivable A/c Dr.
To Co-venturer A/c
(vii) For discounting the Bill of Exchange
Bank A/c Dr.
Joint Venture A/c Dr.
To Bills Receivable A/c
(viii) For accepting the Bill of Exchange drawn by co-venturer
Co-venturer A/c Dr.
To Bills Payable A/c
(ix) For Bill of Exchange discounted by co-venturer
Joint Venture A/c Dr.
To Co-venturer A/c
(x) For venture profit
Joint Venture A/c Dr.
To Profit and Loss A/c (for own shares)
To Co-venturer A/c (for co-venturer’s share)

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.85

(xi) For venture loss

Profit and Loss A/c Dr. (for own share)
Co-venturer A/c Dr. (for co-venturer’s share)
To Joint Venture A/c
(xii) For settlement of claims
When payment is due to co-venturer
Co-venturer A/c Dr.
To Bank A/c
(xiii) When payment is due from co-venturer
Bank A/c Dr.
To Co-venturer A/c

? ILLUSTRATION 3
A and B enter into a joint venture to sell a consignment of timber sharing profits and losses equally. A provides
timber from stock at mutually agreed value of ` 5,000. He pays expenses amounting to ` 250. B incurs further
expenses on cartage, storage, and coolie charges of ` 650 and receives cash or sales ` 3,000.
He also takes over goods to the value of ` 1,000 for his use in his own business. At the close, A takes over the
balance stock in hand which is valued at ` 1,100.
Required
Prepare joint venture account and Co-venturer’s account in the books of A.

 SOLUTION
In the books of A
Joint Venture Account

Particulars Amount (`) Particulars Amount (`)

To Purchases A/c (Goods supplied) 5,000 By B (Sales) 3,000
To Bank A/c (Expenses) 250 By B (Goods taken over) 1,000
To B (Expenses) 650 By Drawings A/c (Goods take 1,100
nover)
By Loss transferred to:
Profit & Loss A/c 400
B 400 800
5,900 5,900

B’s Account

Particulars Amount (`) Particulars Amount (`)

To Joint Venture A/c: By Joint Venture A/c (Expenses) 650
Sales 3,000 By A (Balance paid) 3,750
Goods taken over 1,000

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 6.86 PRINCIPLES AND PRACTICE OF ACCOUNTING

Loss 400 4,400

4,400 4,400

? ILLUSTRATION 4
A and B entered into a joint venture of underwriting the subscription of the entire share capital of the Copper
Mines Ltd. consisting of 1,00,000 equity shares of ` 10 each and to pay all expenses upto allotment. The profits
were to be shared by them in proportions of 3/5ths and 2/5ths. The consideration in return for this agreement
was the allotment of 12,000 other shares of ` 10 each to be issued to them as fully paid. A provided funds for
registration fees `12,000, advertising expenses of `11,000, for expenses on printing and distributing the prospectus
amounting to ` 7,500 and other printing and stationery expenses of ` 2,000. B contributed towards payment of
office rent ` 3,000, legal charges ` 13,750, salary to clerical staff ` 9,000 and other petty disbursements of `1,750.
The prospectus was issued and applications fell short by 15,000 shares. A took over these on joint account and
paid for the same in full. The venturers received the 12,000 fully paid shares as underwriting commission. They
sold their entire holding at ` 12.50 less 50 paise brokerage per share. The net proceeds were received by A for
15,000 shares and B for 12,000 shares.
Required
Write out the necessary accounts in the books of A showing the final adjustments.

 SOLUTION
In the books of A
Joint Venture Account

Particulars Amount (`) Particulars Amount (`)

To Bank A/c - Registration Fee 12,000 By Bank A/c - sale proceeds of
- Advertising 11,000 15,000 shares ` 12.50 each
- Printing & Distribution less 50 paise brokerage 1,80,000
of Prospectus 7,500 By B - sale proceeds of 12,000
- Printing & Stationery 2,000 shares ` 12.50 each less 1,44,000
To B - Office Rent 3,000 50 paise per share brokerage
- Legal Charges 13,750
- Clerical Staff 9,000
- Petty Payments 1,750
To Bank - Cost of Shares 1,50,000
To Net profit to:
- P & L A/c [3/5] 68,400
- B [2/5] 45,600
3,24,000 3,24,000

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.87

B’s Account

Particulars Amount (`) Particulars Amount (`)

To Joint Venture A/c - Sale By Joint Venture A/c
proceeds of shares 1,44,000 - Office Rent 3,000
- Legal Charges 13,750
- Clerical Staff 9,000
- Petty Payments 1,750
By Joint Venture A/c - share of profit 45,600
By Bank 70,900
1,44,000 1,44,000

? ILLUSTRATION 5
With the information given in Illustration 4,
Required
Prepare the necessary accounts in the books of B also.

 SOLUTION
In the books of B
Joint Venture Account

Particulars Amount (`) Particulars Amount (`)

To Bank - Office Rent 3,000 By Bank (Sale of Investments) 1,44,000
- Legal Charge 13,750
- Clerical Staff 9,000 By A (Sale of Investments) 1,80,000
- Petty Payments 1,750
To A - Registration Fee 12,000
- Advertisement 11,000
- Printing of Prospectus 7,500
- Printing Stationery 2,000
- Cost of Shares 1,50,000
To Net Profit to:
P&L A/c (2/5) 45,600
A (3/5) 68,400
3,24,000 3,24,000
A’s Account

Particulars Amount (`) Particulars Amount (`)

To Joint Venture A/c By Joint Venture A/c
sale proceeds 1,80,000 - Registration Fee 12,000
To Bank A/c 70,900 - Advertisement Charges 11,000

© The Institute of Chartered Accountants of India

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 6.88 PRINCIPLES AND PRACTICE OF ACCOUNTING

- Printing & Distribution of

- Prospectus 7,500
- Printing & Stationery 2,000
- Cost of Shares 1,50,000
By Joint Venture A/c -
share of profit 68,400
2,50,900 2,50,900

? ILLUSTRATION 6

A and B enter into a joint venture sharing profits and losses equally. A purchased goods for ` 5,000 for cash on
January 1, 2016. On the same day, B bought goods for `10,000 on credit and spent ` 1,000 on freight etc.

Further expenses were incurred as follows :

On 1.2.2016 ` 1,500 by B
On 12.3.2016 ` 500 by A
Sales were made by each one of them as follows :
15.1.2016 ` 3,000 by A
13.1.2016 ` 6,000 by B
15.2.2016 ` 3,000 by A
1.3.2016 ` 4,000 by B
Creditors for goods were paid as follows:
1.2.2016 ` 5,000 by A
1.3.2016 ` 5,000 by B
On March 31, 2016 the balance of stock was taken over by B at ` 9,000.
The accounts between the co-venturers were settled by cash payment on this date. The co-venturers are entitled
to interest at 12% per annum.
Required
Prepare necessary ledger accounts in the books of assuming that he maintains record of all venture
transactions.

 SOLUTION
In the books of A
Joint Venture Account

Particulars Amount (`) Particulars Amount (`)

To Cash (Goods purchased) 5,000 By Cash (sales) 6,000
To B (Goods purchased) 10,000 By B (Sales) 10,000
To B (Freight) 1,000 By B (Goods taken over) 9,000
To B (Expenses) 1,500 By B (Interest) 50

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.89

To Cash (Expenses) 500

To Profit & Loss A/c (Interest) 135
To Profit transferred to:
Profit & Loss A/c 3,457
B 3,458 6,915
25,050 25,050

B’s Account

Particulars Amount (`) Particulars Amount (`)

To Joint Venture A/c (Sales) 10,000 By Joint Venture A/c 10,000
(Goods purchased)
To Joint Venture A/c (Goods taken 9,000 By Joint Venture A/c (Freight) 1,000
over)
To Joint Venture A/c(Interest) 50 By Joint Venture A/c (Expenses) 1,500
To Bank A (Creditor paid) 5,000 By Joint Venture A/c (Profit) 3,458
By Bank A (Balance paid) 8,092
24,050 24,050

Working Note:
Calculation of Interest
Payments by A

Date Amount(A) Month(B) Product(AxB)

1.1.16 5,000 3 15,000
1.2.16 5,000 2 10,000
1.3.16 500 1 500
TOTAL 10,500 25,500
12 1
Interest = 25,500 x × = ` 255
100 12
Receipts by A

Date Amount (A) Month(B) Product(AxB)

15.1.16 3,000 2.5 7,500
15.2.16 3,000 1.5 4,500
TOTAL 6,000 12,000
12 1
Interest = 12,000 x × = ` 120
100 12
Net Interest = 255-120 = ` 135 (Due to A)

© The Institute of Chartered Accountants of India

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 6.90 PRINCIPLES AND PRACTICE OF ACCOUNTING

Payments by B

Date Amount(A) Month(B) Product(AxB)

1.1.16 1,000 3 3,000
1.2.16 1,500 2 3,000
1.3.16 5,000 1 5,000
TOTAL 11,000

12 1
Interest = 11,000 x × = ` 110
100 12
Receipts by B

Date Amount(A) Month(B) Product(AxB)

31.1.16 6,000 2 12,000
1.3.16 4,000 1 4,000
TOTAL 16,000

12 1
Interest = 16,000 x × = ` 160
100 12
Net Interest = 160-110 = ` 50 (Due fromB)

? ILLUSTRATION 7

A and B entered into a joint venture agreement to share the profits and losses in the ratio of 2:1. A supplied goods
worth ` 60,000 to B incurring expenses amounting to ` 2,000 for freight and insurance. During transit goods
costing ` 5,000 became damaged and a sum of ` 3,000 was recovered from the insurance company. B reported
that 90% of the remaining goods were sold at a profit of 30% of their original cost. Towards the end of the venture,
a fire occurred and as a result the balance Inventories lying unsold with B was damaged. The goods were not
insured and B agreed to compensate A by paying in cash 80% of the aggregate of the original cost of such goods
plus proportionate expenses incurred by A. Apart from the share of profit of the joint venture, B was also entitled
under the agreement to a commission of 5% of net profits of joint venture after charging such commission. Selling
expenses incurred by B totalled ` 1,000. B had earlier remitted an advance of ` 10,000. B duly paid the balance due
to A by Bank Draft.
You are required to prepare (i) Joint Venture Account and (ii) B’s Account in A’s books.

 SOLUTION
In the books of A
Joint Venture Account

Particulars Amount (`) Particulars Amount (`)

To Purchases (Cost of goods supplied) 60,000 By Bank (Insurance claim) 3,000
To Bank (Expenses) 2,000 By B (Sales) 64,350
To B (Expenses) 1,000 By B (agreed value 4,546
for damaged goods)

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.91

To B (Commission - 1/21 of ` 8,896) 424

To Profit transferred to:
Profit & Loss A/c 5,648
B 2,824
71,896 71,896

B’s Account

Particulars Amount (`) Particulars Amount (`)

To Joint Venture A/c (Sales) 64,350 By Bank (Advance) 10,000
To Joint Venture A/c (Claim Portion) 4,546 By Joint Venture A/c (Expenses) 1,000
By Joint Venture A/c (Commission) 424
By Joint Venture A/c (Share of Profit) 2,824
By Bank (Balance received) 54,648
68,896 68,896
Working Notes:
1. It has been assumed that the goods damaged in transit have no residual value.
2. Computation of Sales:

`
Cost of goods sent 60,000
Less: Cost of damaged goods (5,000)
55,000
Less: Cost of goods remaining unsold (5,500)
Cost of goods sold 49,500
Add: Profit @ 30% 14,850
Sales 64,350

3. Claim for loss of fire admitted by B

`
Cost of goods 5,500
Add: Proportionate expenses [(2,000 x 5,500)/60,000] 183
5,683
Less: 20% (1,137)
4,546

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 6.92 PRINCIPLES AND PRACTICE OF ACCOUNTING

? ILLUSTRATION 8
Ram and Rahim enter into a joint venture to take a building contract for ` 24,00,000. They provide the following
information regarding the expenditure incurred by them:

Ram Rahim
` `
Materials 6,80,000 5,00,000
Cement 1,30,000 1,70,000
Wages - 2,70,000
Architect’s fees 1,00,000 -
License fees - 50,000
Plant - 2,00,000
Plant was valued at ` 1,00,000 at the end of the contract and Rahim agreed to take it at that value. Contract
amount ` 24,00,000 was received by Ram. Profits or losses to be shared equally. You are asked to show:
(i) Joint Venture Account and Rahim’s Account in the books of Ram.
(ii) Joint Venture Account and Ram’s Account in the books of Rahim.

 SOLUTION
In the books of Ram
Joint Venture Account
Particulars Amount (`) Particulars Amount (`)
To Bank A/c: By Bank A/c 24,00,000
Material 6,80,000 By Rahim’s A/c (plant) 1,00,000
Cement 1,30,000
Architect’s fee 1,00,000 9,10,000
To Rahim’s A/c:
Material 5,00,000
Cement 1,70,000
Wages 2,70,000
License fees 50,000
Plant 2,00,000 11,90,000
To Net profit transferred to:
Rahim’s A/c 2,00,000
Profit & Loss A/c 2,00,000 4,00,000
25,00,000 25,00,000

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.93

Rahim’s Account
Particulars Amount (` ) Particulars Amount (`)
To Joint Venture A/c (plant) 1,00,000 By Joint Venture A/c (sundries) 11,90,000
To Bank A/c 12,90,000 By Joint Venture A/c (profit) 2,00,000
13,90,000 13,90,000
In the books of Rahim
Joint Venture Account
Particulars Amount (`) Particulars Amount (`)
To Bank A/c: By Bank A/c 24,00,000
Material 6,80,000 By Rahim’s A/c (plant) 1,00,000
Cement 1,30,000
Architect’s fee 1,00,000 9,10,000
To Rahim’s A/c:
Material 5,00,000
Cement 1,70,000
Wages 2,70,000
License fees 50,000
Plant 2,00,000 11,90,000
To Net profit transferred to:
Rahim’s A/c 2,00,000
Profit & Loss A/c 2,00,000 4,00,000
25,00,000 25,00,000

Ram’s Account
Particulars Amount (`) Particulars Amount (`)
To Joint Venture A/c (contract 24,00,000 By Joint Venture A/c (sundries) 9,10,000
amount)
By Joint Venture A/c (profit) 2,00,000
By Bank A/c 12,90,000
24,00,000 24,00,000

4.5.2.2 When each Co-venturer keeps records of their own transactions only:
Sometimes the venturers find it wasteful to keep full record of venture transactions; rather it is considered
convenient to keep record of own transactions only. For this purpose, it is necessary to open ‘Joint Venture
with Co-venturer A/c’. All expenses incurred, materials sent, etc. are debited to this account. Profit earned is
also debited to this account while the loss sustained is credited. Any receipt from joint venture or from co-
venturer is credited to this account, while any payment to the co-venturer is debited to this account.
However, profit/loss on joint venture cannot be determined from this account, for which a Memorandum
Joint Venture Account is prepared. Memorandum Joint Venture Account is statement prepared by the
venturers for determination of venture profit when they just keep record of own transactions and do not
maintain full records of venture transactions in the books of accounts. It contains cost of goods, expenses
etc. in the debit side and sales and closing stock in the credit side. Balance of Memorandum Joint Venture

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 6.94 PRINCIPLES AND PRACTICE OF ACCOUNTING

Account shows profit or loss on joint venture. Entries in Memorandum Joint Venture Account are directly
recorded without going through the process of journal.
Venturers usually pass the following journal entries:

Journal Entries
(a) For supply of material from stores:
Joint Venture with X A/c Dr.
To Purchases A/c
(b) For payment of expenses
Joint Venture with X A/c Dr.
To Bank/Cash A/c
(c) For sale on venture
Bank A/c Dr.
To Joint Venture with X A/c
(d) For profit on venture
Joint Venture with X A/c Dr.
To Profit & Loss A/c
or For loss on venture
Profit & Loss A/c Dr.
To Joint Venture with X A/c
(e) For final payment to co-venturer
Joint Venture with X A/c Dr.
To Bank A/c
or For final payment made by co-venturer
Bank A/c Dr.
To Joint Venture with X A/c
Let us now take some illustrations to understand the book keeping system of joint venture, when venturers
maintain records of their own transactions only.
Our next comprehensive example aims to perfectly establish this methodof maintenance of joint venture
accounts in your mind.
Example : Two friends Samar and Samrat decide to undertake a joint venture to manufacture and sell
a product. Samar will primarily be responsible for manufacture, and Samrat for selling, with profits to be
shared 60% to Samar and 40% to Samrat.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.95

Samar has the following transactions relating to manufacture of the product:

w Supply materials – ` 3,200
w Wages – ` 4,000
Samrat has similar transactions relating to the selling of the product:
w Selling expenses – ` 2,400
w Wages – ` 5,000
w Revenue – ` 26,000
Step-1: Both co-venturers will record their own transactions in their accounting records; in each case the
other side of the double entry bookkeeping posting will go to a joint venture control account.
To reflect its transactions, Samar makes the following entry:
Date Particulars L.F. Debit (`) Credit (`)
Joint Venture with Samrat A/c* Dr. 7,200
To Purchases A/c 3,200
To Cash A/c (wages) 4,000
(Being goods and labour supplied for joint venture business
recorded)
*Alternatively, two separate journal entries can be passed.

The effect of the entries is to transfer the expenses relating to the materials and the wages to the joint
venture control account.
Likewise, Samrat makes the following entry to reflect its own transactions:

Date Account L.F. Debit (`) Credit (`)

Cash A/c (Sales) Dr. 26,000
To Cash A/c (Selling Expenses) 2,400
To Cash A/c (Wages) 5,000
To Joint Venture with SamarA/c* 18,600
(Being sales and expenses for joint venture business recorded)
*Alternatively, three separate journal entries can be passed.
Again the effect of the joint venture accounting is to transfer the expenses incurred and the revenue to the
joint venture control account.
Step-2: Joint Venture Accounting Memorandum Income Statement: At this point,since neither co-
venturerknows the full details of all the transactions affecting the joint venture,they now share details through
a working account called Memorandum Joint Venture Account. The memorandum income statement does

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 6.96 PRINCIPLES AND PRACTICE OF ACCOUNTING

not form part of the double entry book-keeping of either party, and is simply used to enable the outcome
of the joint venture to be calculated. Alternatively, it can also be made in the form of a statement showing
calculation of profit or loss.
Combining all the transactions, the Memorandum Joint Venture Account would be preparedas follows:
Memorandum Joint Venture A/c

Particulars Amount (`) Particulars Amount (`)

To Goods Supplied (by Samar) 3,200 By Sales proceeds 26,000
To Wages expense (of Samar) 4,000
To Wages expense (of Samrat) 5,000
To Selling Expenses (of Samrat) 2,400
To Profit transferred to:
Samar 6,840
Samrat 4,560 11,400
26,000 26,000
From the Memorandum Joint Venture A/c, we can see that the profit of the joint venture is 11,400, Business
Samar will receives 60% (6,840) and Business Samrat will receive 40% (4,560).
Step-3: Joint Venture Profit Share: Each co-venturer will now take their share of the joint venture profit
into his own accounts with the following entries:
Samar: Share of profit journal entry

Date Particulars L.F. Debit (`) Credit (`)

Joint Venture with Samrat A/c Dr. 6,840
To Profit & Loss A/c 6,840
(Being profit from joint venture business recorded)

Samrat: Share of profit journal entry

Date Particulars L.F. Debit (`) Credit (`)
Joint Venture with Samar A/c Dr. 4,560
To Profit & Loss A/c 4,560
(Being profit from joint venture business recorded)

Step-4: Reconciling the Joint Venture Control Accounts: Finally, the joint venture control accounts of
co-venturers are reconciled, and a cash settlement is made between them to balance the joint venture
accounts.
Samar – Joint venture control account summary

Particulars Amount (`)

Materials 3,200
Wages 4,000
Share of Profit 6,840

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.97

Sub-total 14,040
Less: Cash due from Samrat (14,040)
Balance NIL
Before settlement Samar has a debit balance of 14,040 which represents money due from Samrat. When
Samrat settles this amount, Samar will make the following entry to clear the joint venture account and
complete its own joint venture accounting:

Date Particulars L.F. Debit (`) Credit (`)

CashA/c Dr. 14,040
To Joint Venture with SamratA/c 14,040
(Being balance due from Samrat received)

Hence, in Samrat’s books, Joint Control with Samar A/c will look as below:
Joint Venture with Samrat A/c

Particulars Amount (`) Particulars Amount (`)

To Purchases A/c (Goods supplied) 3,200 By Cash A/c (Balance received) 14,040
To Cash A/c (Wages)
To Profit & Loss A/c 4,000
6,840
14,040 14,040

Likewise for Samrat, the joint venture control account is reconciled as follows:
Samrat – Joint venture control account summary

Particulars Amount (`)

Selling Expenses 2,400
Wages 5,000
Sales (26,000)
Share of Profit 4,560
Sub-total (14,040)
Less: Cash paid to Samar 14,040
Balance NIL

As it received all the revenue from the joint venture operation, Samrat has a credit balance of 14,040 before
settlement, which represents money due to Samar. When Samrat settles this amount, it will make the
following entry to clear the joint venture account and complete its joint venture accounting:

Date Particulars L.F. Debit (`) Credit (`)

Joint Venture with Samrat A/c Dr. 14,040
To Cash A/c 14,040
(Being balance due to Samar paid)

© The Institute of Chartered Accountants of India

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 6.98 PRINCIPLES AND PRACTICE OF ACCOUNTING

Hence, in Samrat’s books, Joint Control with Samar A/c will look as below:
Joint Venture with SamarA/c

Particulars Amount (`) Particulars Amount (`)

To Cash A/c (Selling Expenses) 2,400 By Cash A/c (Sales) 26,000
To Cash A/c (Wages) 5,000
To Profit & Loss A/c 4,560
To Cash A/c (Balance paid) 14,040
26,000 26,000

The net effect of the accounting for joint ventures in this example, is that each business has its costs
reimbursed and has received its share of the profit of the joint venture.

? ILLUSTRATION 9

Ram and Gautham entered into a joint venture to buy and sell TV sets, on 1st July, 2016.
On 1.7.2016, Ram sent a draft for ` 2,50,000 in favour of Gautham, and on 4.7.2016, the latter purchased 200
sets each at a cost of ` 2,000 each. The sets were sent to Ram by lorry under freight “to pay” for ` 2,000 and were
cleared by Ram on 15.7.2016.
Ram effected sales in the following manner:

Date No. of sets Sale price Discount on

per set sales price
16.7.2016 20 3,000 10%
31.7.2016 100 2,800 -
14.8.2016 80 2,700 5%
On 25.8.2016, Ram settled the account by sending a draft in favour of Gautham, profits being shared equally.
Gautham does not maintain any books. Show in Ram’s book:
(i) Joint Venture with Gautham A/c; and
(ii) Memorandum Joint Venture A/c.

 SOLUTION
Ram’s Books
Joint Venture with Gautham A/c

2016 Particulars Amount (`) 2016 Particulars Amount (`)

1-Jul To Bank - draft sent 16-Jul By Bank-sale proceeds 54,000
on A/c 2,50,000
15-Jul To Bank - freight 2,000 31-Jul By Bank-sale proceeds 2,80,000
25-Jul To Profit and Loss A/c
share of profit 68,600 14-Aug By Bank-sale proceeds 2,05,200

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.99

To Bank - draft sent

in settlement 2,18,600
5,39,200 5,39,200

Memorandum Joint Venture A/c

Particulars Amount (`) Particulars Amount (`)

To Cost of 200 sets 4,00,000 By Sales proceeds (net)
To Freight 2,000 20 sets @ ` 2,700 net 54,000
To Profit : 100 sets @ ` 2,800 net 2,80,000
Ram 68,600 80 sets @ ` 2,565 net 2,05,200
Gautham 68,600
1,37,200
5,39,200 5,39,200

? ILLUSTRATION 10

D of Delhi and M of Mumbai entered into a joint venture for the purpose of buying and selling second-hand
computers, M to make purchases and D to effect sales. The profit and loss was to be shared equally by D and M. A
sum of ` 1,50,000 was remitted by D to M towards the venture.
M purchased 22 old computers for ` 1,50,000 and paid ` 90,000 for their reconditioning and sent them to Delhi.
His other expenses were: Buying commission ` 10,000; Cartage ` 2,000 and Miscellaneous ` 1,000.
D took delivery of the computers and paid ` 2,700 for Octroi and ` 1,000 for Cartage. He sold 12 computers at
` 22,000 each; 4 computers at ` 21,000 each and 3 computers at ` 20,000 each. He retained remaining computers
for his personal use at an agreed value of ` 15,000. His other expenses – Insurance ` 2,500; Rent ` 4,000; Brokerage
` 12,000 and Miscellaneous ` 2,000.
Each party’s ledger contains a record of his own transactions on account of joint venture. Prepare a statement
showing the result of the venture and the account of the venturer in D’s ledger as it will finally appear, assuming
that the matter was finally settled between the parties.

 SOLUTION

Statement showing the results of the venture

Sales
` `
12 computers@ ` 22,000 each 2,64,000
4 ““ ` 21,000 each 84,000
3 ““ ` 20,000 each 60,000
Taken by D at agreed value 15,000
4,23,000
Less: Paid for purchases 1,50,000

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 6.100 PRINCIPLES AND PRACTICE OF ACCOUNTING

Repairs 90,000
Expenses – Buying Commission 10,000
Cartage (2,000 + 1,000) 3,000
Misc. Expenses (2,000 + 1,000) 3,000
Octroi 2,700
Insurance 2,500
Rent 4,000
Brokerage 12,000
(2,77,200)
Profit on Joint Venture 1,45,800

In the books of D
Joint Venture with M Account

Particulars Amount (`) Particulars Amount (`)

To Cash - remittance to M 150,000 By Cash - Sale proceeds 4,08,000
received
To Cash – expenses By Drawings (Goods taken for 15,000
personal use)
- Octroi 2,700
- Cartage 1,000
- Insurance 2,500
- Rent 4,000
- Brokerage 12,000
- Misc. 2,000 24,200
To Profit and Loss - own 72,900
share of profit (1/2)
To Cash - Balance remitted 1,75,900
4,23,000 4,23,000

? ILLUSTRATION 11

David of Mumbai and Khosla of Delhi entered into a joint venture for the purpose of buying and selling second-
hand motor cars: David to make purchases and Khosla to effect sales. The profit and loss was to be shared equally.
Khosla remitted a sum of ` 1,50,000 to David towards the venture.
David purchased 5 cars for `1,60,000 and paid ` 60,000 for their reconditioning and sent them to Delhi. He also
incurred an expense of ` 5,000 in transporting the cars to Delhi.
Khosla sold 4 cars for ` 2,40,000 and retained the fifth car for himself at an agreed value of ` 50,000. His expenses
were: Insurance ` 1,000; Garage Rent ` 2,000; Brokerage ` 2,000; and Sundry Expenses ` 400.
Each party’s ledger contains a record of his own transactions on account of joint venture.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.101

Required
Prepare a Memorandum Joint Venture Account showing the result of the venture and the joint venture account
with David in the books of Khosla as it will appear, assuming that the matter was finally settled between the
parties.

 SOLUTION
Books of Khosla
Joint Venture Account with David

Particulars Amount (`) Particulars Amount (`)

To Bank - Remittance 1,50,000 By Bank - Sales 2,40,000
To Bank - Insurance 1,000 By Vehicles A/c - Car Purchase 50,000
To Bank - Garage Rent 2,000
To Bank - Brokerage 2,000
To Bank - Sundry 400
To Profit & Loss A/c
- Share of Profit 29,800
To Bank - Final Settlement 1,04,800
2,90,000 2,90,000

Memorandum Joint Venture Account

Particulars Amount (`) Particulars Amount (`)

To David - cost of cars 1,60,000 By Khosla - Sales 2,40,000
To David - Reconditioning 60,000 By Khosla - car taken 50,000
To David - Transport charges 5,000
To Khosla - Expenses * 5,400*
To Net Profit
- David 29,800
- Khosla 29,800 59,600
2,90,000 2,90,000
* Expenses incurred by Khosla
- Insurance 1,000
- Garage Rent 2,000
- Brokerage 2,000
- Sundry Expenses 400
5,400

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 6.102 PRINCIPLES AND PRACTICE OF ACCOUNTING

SUMMARY
w Parties to joint venture usually prepare a memorandum called Memorandum Joint Venture Account
to record primarily all revenues and expenses relating to venture mentioning the party who collected
revenue or met the expenses. This memorandum is very useful to determine profit/loss of venture as
well as to prepare Joint Venture Account.

w Venturers may keep record for venture transactions in three ways:

(i) Simply a Joint Venture Investment A/c can be maintained wherein the investments made, revenue
collected, share of profit/loss and final remittance received made are recorded.
(ii) Alternatively, a venturer can prepare Joint Venture Account to record all costs and revenues relating
to venture and so balance of Joint Venture Account will show profit/loss. In such a case a separate
account of co-venturer is maintained.
(iii) Alternatively, separate books can be maintained for joint venture transactions, mainly when a
separate Joint Bank Account is opened.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. M and N enter into a Joint venture where M supplies goods worth ` 6,000 and spends ` 100 on various
expenses. N sells the entire lot for ` 7,500 meeting selling expenses amounting to ` 200. Profit sharing
ratio is equal. N remits to M the amount due. The amount of remittance will be:
(a) ` 6,700 (b) ` 7,300 (c) ` 6,400
2. A purchased goods costing ` 42,500. B sold goods costing ` 40,000 at ` 50,000. Balance goods were
taken over by A at same gross profit percentage as in case of sale. The amount of goods taken over will
be:
(a) ` 3,125 (b) ` 2,500 (c) ` 3,000
3. For material supplied from own Inventories by any of the venturer, the correct journal entry will be: (In
case of separate sets of books)
(a) Joint Venture A/c will be debited and Venturers Capital A/c will be credited
(b) Joint Venture A/c will be debited and Joint Bank A/c will be credited
(c) Joint Venture A/c will be debited and Material A/c will be credited
4. A and B enter into a joint venture to underwrite the shares of K Ltd. K Ltd. make an equity issue of
1,00,000 equity shares of `10 each. 80% of the issue was subscribed by the public. The profit sharing
ratio between A and B is 3:2. The balance shares not subscribed by the public, purchased by A and B in
profit sharing ratio. How many shares to be purchased by A.
(a) 80,000 shares (b) 72,000 shares (c) 12,000 shares

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.103

5. A and B enter into a joint venture to underwrite shares of K Ltd. K Ltd make an equity issue of 2,00,000
equity shares. 80% of the shares underwritten by the venturer. 1,60,000 shares are subscribed by the
public. How many shares are to be subscribed by the venturer?
(a) 40,000 shares (b) 36,000 shares (c) 32,000 shares
6. P and Q enter into a Joint Venture sharing profits and losses in the ratio 3:2. P purchased goods costing
`2,00,000. Other expenses of P ` 10,000. Q sold the goods for 1,80,000. Remaining goods were taken
over by Q at ` 20,000. The amount of final remittance to be paid by Q to P will be:
(a) ` 2,15,000 (b) ` 2,04,000 (c) ` 2,10,000
7. C and D entered into a Joint Venture to construct a bridge. They did not open separate set of books.
They shared profits and losses as 3:2. C contributed ` 1,50,000 for purchase of materials. D paid wages
amounting to ` 80,000. Other expenses were paid as:
C – ` 5,000 D – ` 15,000
C purchased one machine for ` 20,000. The machine was taken over by C for `10,000. Total contract
value of ` 3,00,000 was received by D. What will be the profit on venture?
(a) ` 30,000 (b) ` 40,000 (c) ` 20,000
8. R and M entered into a joint venture to purchase and sell new year gifts. They agreed to share the profit
and losses equally. R purchased goods worth ` 1,00,000 and spent ` 10,000 in sending the goods to M.
He also paid ` 5,000 for insurance. M spent ` 10,000 as selling expenses and sold goods for ` 2,00,000.
Remaining goods were taken over by him at ` 5000. What will be the amount to be remitted by M to R
as final settlement?
(a) ` 1,55,000 (b) ` 1,50,000 (c) ` 1,15,000
9. A and B enter into a joint venture sharing profit and losses in the ratio 3:2. A will purchase goods and B
will affect the sale. A purchase goods costing ` 2,00,000. B sold it for ` 3,00,000. The venture is terminated
after 3 months. A is entitled to get 10% interest on capital invested irrespective of utilization period. The
amount of interest received by A will be
(a) ` 15,000 (b) ` 10,000 (c) ` 20,000
10. If any Inventories is taken over by the venturer, it will be treated as an:
(a) Income of the joint venture, hence credited to Joint Venture Account
(b) Expenses of Joint Venture, hence debited to Joint Venture Account
(c) To be ignored as Joint Venture Transaction
Theoretical Questions
1. What do you mean by Joint Venture Account and what are the features of joint venture.
2. Distinguish between
(i) Consignment and Joint Venture.
(ii) Joint venture and partnership.

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 6.104 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Questions
1. A of Delhi and B of Bangalore entered into a joint venture for purchase and sale of one lot of mopeds.
The cost of each moped was ` 3,600 and the fixed retail selling price; ` 4,500. The following were the
recorded transactions:
2016
Jan 1 A purchased 100 mopeds paying ` 72,000 in cash on account.
A raised a loan from X Bank for ` 50,000 at 18% p.a., interest repayable with loan amount on
1.3.2016.
A forwarded 80 mopeds to B incurring ` 2,880 as forwarding and insurance charges.
Jan. 7 B received the consignment and paid ` 720 as clearing charges.
A sold 5 mopeds for cash.
B sold 20 mopeds for cash.
Feb. 1 B raised a loan of ` 1,50,000 from Y Bank, repayable with interest at 18% p.a on 1.3.2016.
B telegraphically transferred `1,50,000 to A incurring charges of `50. A paid balance due for the
mopeds.
Feb. 26 A sold the balance mopeds for cash.
B sold balance mopeds for cash.
A paid selling expenses ` 5,000.
B paid selling expenses ` 20,000.
Mar. 1 Accounts settled between the venturer and loans repaid, profit being appropriated equally.
You are required to show Memorandum Joint Venture A/c. You are also required to show
(1) Joint Venture with B A/c in A’s books; and
(2) Joint Venture with A A/c in B’s books.
Assume each venturer recorded only such transactions as concluded by him.
2. K and A of Nagpur entered into a joint venture to trade in silk goods in the ratio 2:1. On June 1, 2016, K
bought goods worth ` 7,200 and handed over half of the goods to A. On July 1, 2016, K bought another
lot of goods costing ` 2,400 and paid ` 180 as expenses. On September 1, A purchased goods for ` 4,500
and on the same day he sent to K a part of these goods costing ` 1,800 and paid ` 240 towards expenses.
On the same day K remitted ` 1,800 to A. The goods were invariably sold by the venturers at a uniform
price of 33.33% above cost price excluding expenses. Each of the venturers collected cash proceeds on
sales excepting an amount of ` 250 owing to K by a customer and this was written off as a loss relating to
the venture. In addition, goods costing ` 600 in possession of A were destroyed by fire and an amount
of ` 500 was realized by him as compensation from the Insurance Company. On December 20, unsold
goods costing ` 1,500 (at cost) were lying with K. Of these, goods costing ` 600 were taken by K for
personal use and the balance was purchased by him at an agreed value of ` 1,000. A disposed of all the
goods with him on December 31, excepting some damaged goods costing ` 300 which were written off
as unsaleable. You are required to prepare a Memorandum Joint Venture Account to find the amount of
profit or loss.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.105

ANSWER/HINTS
MCQs
1. (a) 2. (a) 3. (a) 4. (c) 5. (c) 6 (b)
7. (b) 8. (a) 9. (c) 10. (a)
Theoretical Questions
1. A joint venture account is a nominal account prepared by the co-venturers involved in the joint
ventures. The objective of preparing a joint venture account is to ascertain the profit or loss arising out
of the joint venture business. The joint venture account is debited with the value of goods or stores
bought or used on account of joint venture. It is also debited with expenses incurred. The credit will be
to the trading account or cash account or to the party which has supplied the goods or incurred the
expenses. When the sale proceeds are received, the party receiving it will debit bank account (or sundry
debtors) and credit the joint venture account. The other party will debit the party which has received
the sale proceeds and credit the joint venture account. Thus, joint venture account will reflect profit or
loss, which must be transferred to the profit and loss account and the other party’s account in agreed
proportions.

2. (i) Refer para 4.4

(ii) Refer para 4.3

Practical Questions
Answer 1
Memorandum Joint Venture Account
for the period Jan. 1 to March 1, 2016

Particulars Amount (`) Particulars Amount (`)

To A : By Sales :
Cost of Mopeds 3,60,000 B (80 × 4,500) 3,60,000
Forwarding & Insurance 2,880 A (20 × 4,500) 90,000
Interest (2 months) 1,500
Selling Expenses 5,000
To B :
Clearing Charges 720
Interest (1 month) 2,250
Sundry Expenses
(Telegraphic transfer charges) 50
Selling Expenses 20,000
To Net Profit to:
A 28,800
B 28,800 57,600
4,50,000 4,50,000

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 6.106 PRINCIPLES AND PRACTICE OF ACCOUNTING

Books of A
Joint Venture with B Account

Particulars Amount (`) Particulars Amount (`)

To Bank A/c - 72,000 By Bank A/c 22,500
(part payment of cost) (sales proceeds)
To Bank A/c - 2,880 By Bank A/c - (remittance 1,50,000
(forwarding charges) from B)
To Bank A/c - (balance cost of 2,88,000 By Bank A/c 67,500
purchases) (sales proceeds)
To Bank A/c - (selling exp.) 5,000 By Bank A/c - (cash received
To Interest A/c 1,500 in settlement) 1,58,180
To Profit & Loss A/c
(share of profit) 28,800
3,98,180 3,98,180

Books of B
Joint Venture with A Account

Particulars Amount (`) Particulars Amount (`)

To Bank A/c - (clearing charges) 720 By Bank A/c - (Sales proceeds of 20 90,000
mopeds)
To Bank A/c - (remittance including 1,50,000 By Bank A/c - (sales proceeds of 60 2,70,000
charges) mopeds)
To Bank A/c - (selling exp.) 20,000
To Bank A/c - (interest) 2,250
To Sundry Expenses 50
To P & L A/c
(share of profit) 28,800
Bank A/c - (paid in settlement) 1,58,180
3,60,000 3,60,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.107

Answer 2
Memorandum Joint Venture Account
Date Particulars ` Date Particulars `
To K: By K:
Cost of goods Sales (W.N.1) 8,400
(` 7,200 + ` 2,400) 9,600 Inventories taken over 1,600
Expenses 180 By A:
Bad Debts 250 Sales (W.N.2) 7,200
To A: Insurance claim 500
Cost of goods 4,500
Expenses 240
To Net Profit:
K - 2/3rd 1,953
A - 1/3rd 977
17,700 17,700
Working Notes:

1. Calculation of sales affected by K

`
Goods purchased in first lot ` 7,200
Less: Send to A (` 3,600) 3,600
Goods purchased in another lot 2,400
Goods received from A 1,800
7,800
Less: Unsold goods:
Taken for personal use ` 600
Purchase by K (1500-600) ` 900 (1,500)
Cost of goods sold 6,300
Add: Profit @ 33.33% on cost 2,100
Sales price of goods sold 8,400

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 6.108 PRINCIPLES AND PRACTICE OF ACCOUNTING

2. Calculation of sales affected by A

`
Goods received by K 3,600
Goods purchased ` 4,500
Less: Goods sent to K (` 1,800) 2,700
6,300
Less: Goods destroyed by fire (600)
Damaged goods (300)
Cost of goods sold 5,400
Add: Profit @ 33.33% on costs 1,800
Sales price of goods sold 7,200

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.109

UNIT 5 : ROYALTY ACCOUNTS

LEARNING OUTCOMES
After studying this unit, you will be able to:
w Understand the meaning of the term “Royalty”.
w Familiarize yourself with the Terminology related to Royalty Accounting:
ª Minimum Rent
ª Short-workings and Recoupment of Short-workings
• Fixed
• Floating
w Understand the Accounting Treatment in the books of Lessee and Lessor.

UNIT OVERVIEW ROYALTY ACCOUNTING

Made by For the

Periodic one person extraction of
By the lessee
payment (lessee) to oil, coal, and
vested in the
for using the another minerals or to
lessor
right person an author for
(lessor) his books.

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 6.110 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.1 INTRODUCTION OF ROYALTY AND RELATED TERMINOLOGIES

“Royalty” may be defined as:
w Periodic payment
w Made by one person (lessee) to another person (lessor)
w For using the right by the lessee vested in the lessor.
Examples:
1. For the extraction of oil, coal, and minerals.
2. To an author for sale of his books.
3. To a patentee for the use of patent.
4. For use of technical know how developed by a party
Thus, royalty means sum payable, generally based on output or sale, to the owner of mine, a patentee
or an author or any other such person for use of rights vested in him. The person paying the royalty will
treat this amount as an ordinary business expenditure. Royalties are generally debited to profit and loss
account. Strictly speaking, royalty based on output should be debited to Trading or manufacturing account;
royalty based on sales should be treated as selling expense and debited to profit and loss account. Before
we understand the Accounting Treatment for Royalty, let us understand certain terms used in this unit.
Lease
Lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments
the right to use an asset for an agreed period of time.
The party who conveys the rights is lessor and the one who is being granted the right to use in return for a
series of payments is lessee.
Minimum Rent/Dead Rent/Rock Rent/Fixed Rent
Amount of rent which the lessee is required to pay to the lessor whether he has derived any benefit or not
out of the right vested to him by the lessor.
Case I:
If in any year the Actual royalty is less than the Minimum rent
• Landlord will claim the minimum rent
Case II:
If in any year Actual royalty exceeds Minimum Rent
• Landlord will claim the actual royalty
Note: Minimum Rent may be the same for each year or may vary for different years according to the terms
of agreement.
Example:
X has taken a lease of mine with minimum rent of `10,000 p.a. and with a rate of royalty at ` 2 per tonne of
coal extracted. If coal extracted in the first year is 4,000 tonnes then Royalty comes to ` 8,000 (4,000 tonnes x
` 2 per tonne).

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.111

But X has to pay `10,000 as it is the minimum rent decided under the Royalty agreement.
Short Workings
It represents excess of Minimum Rent over the Actual Royalty.
Mathematically:
Short-workings = Minimum Rent – Actual Royalty
Conclusion:
Short- workings will only arise when the Actual royalty is less than the Minimum Rent. Also, short-workings
will arise only when the same are allowed to be adjusted against future royalties. If the agreement is such
that the lessee will have to pay a minimum rent irrespective of the benefits derived from the right vested
to him by the lessor, and amount short-workings (minimum rent in excess of royalty computed as per
agreement) cannot be adjusted in future years, then minimum rent will become expense of the lessee for
that particular year.
Continuing the above example:
Short-workings for the year will be ` 2,000 i.e. [10,000-8,000]
Recoupment of Short-workings
Recoupment implies that lessor allows the lessee the right to carry forward and set off the short-workings
against the excess or surplus of royalties over the Minimum Rent in the subsequent years.

This right is known as the right of Recoupment of Short-working.

Fixed Right
Right of
Recoupment
Floating Right

Case I: Fixed Right of Recoupment

If the lessor promises the lessee to compensate the loss (short working) only for a fixed time period
Example:
If lessor promises to compensate the loss only during the first 4 years, the right is said to be fixed.
Case II: Floating Right of Recoupment
If the lessor promises the lessee to compensate the short working of any year in the next two or three years
Example:
If lessor promises to compensate the (short-working) of any year in coming 2 years
Then short-workings of 3rd year can be recouped in 4th and 5th year and short-workings of 8th year in 9th
and 10th year.

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 6.112 PRINCIPLES AND PRACTICE OF ACCOUNTING

5.2 ACCOUNTING TREATMENT IN THE BOOKS OF LESSEE

Entry 1:
When Royalty is Payable:
Royalty A/c -----------------------------------Dr. Actual Royalty
Short-workings A/c ----------------------------Dr. Balancing Figure
To Landlord A/c Minimum Rent
Entry 2:
For Payment to Landlord:
Landlord A/c ---------------------------------Dr. Minimum Rent
To Bank A/c Minimum Rent
Entry 3:
For Transferring Royalty:
Trading/Profit and Loss/Manufacturing/Production A/c ----------Dr. Actual Royalty
To Royalty A/c Royalty amount
Note:
1. The Journal Entries given below assume that there is a clause on Minimum Rent and Recoupment of
Short- working subsequently:
2. Royalties based on output should be debited to Manufacturing or Production Account whereas royalty
based on sales be treated as selling expenses should be debited to Trading Account or Profit and Loss
Account.
Entry 4:

When Short-workings is recouped:

Royalty A/c ----------------------------------------Dr. Actual Royalty
To Short-workings A/c Recoupment
To Landlord A/c Actual Payment
Entry 5:
For Irrecoverable Short-workings to Trading/Profit and Loss/Manufacturing/Production A/c:
Trading/Profit and Loss/Manufacturing/Production A/c --------------Dr. Amount Lapsed
To Short-workings A/c Amount Lapsed

5.3 ACCOUNTING TREATMENT IN THE BOOKS OF LESSOR

Entry 1:
When Royalty is due:
Lessee A/c -----------------------------------------Dr. Minimum Rent
To Royalty Receivable A/c Actual Royalty

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.113

To Short-workings Allowable A/c Balancing Figure

Entry 2:
When money is received:
Bank A/c -------------------------------------------Dr. Net Amount received
To Lessee A/c Minimum Rent

Entry 3:
When short-workings is recouped:
Short-workings Allowable A/c ------------------Dr. Amount of short-workings recouped
To Lessee A/c Amount of short-workings recouped

Entry 4:
For Irrecoverable amount of Short-workings
Profit and Loss A/c ----------------------------Dr. Amount Lapsed
To Short-workings Allowable A/c Amount Lapsed

Entry 5:
For Transferring Royalty Receivable to Trading/Profit and Loss/Manufacturing/Production A/c:
Royalty Receivable A/c ------------------------Dr. Actual Royalty
To Trading/Profit and Loss/Manufacturing/Production A/c ------ Actual Royalty

Practical Illustrations

? ILLUSTRATION 1:
India Coal Ltd. got the lease of a colliery on the basis of ` 5 per tonne of coal raised subject to a Minimum Rent
of ` 2,00,000 p.a. The tenant has the right to recoup short-workings during first four years of the lease and not
afterwards.
The output in four years was:

Year Output (Tonnes)

1 18,000
2 26,000
3 50,000
4 60,000
5 1,00,000
You are required to give the Journal entries and ledger accounts in the books of India Coal Ltd.

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 6.114 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Computation of Royalty, Minimum Rent and Short-workings

Year Quantity in Rate per tonne Royalty Minimum Rent Short-

tonnes workings
1 18,000 5 90,000 2,00,000 1,10,000
2 26,000 5 1,30,000 2,00,000 70,000
3 50,000 5 2,50,000 2,00,000
4 60,000 5 3,00,000 2,00,000
5 1,00,000 5 5,00,000 2,00,000

Computation of Recoupment, Short-workings carried forward, Transferred to P&L Account

Year Recoupment Short-workings Transferred to Payment to
carried forward P&L Account Landlord
1 1,10,000 2,00,000
2 1,80,000 2,00,000
3 50,000 1,30,000 2,00,000
4 1,00,000 30,000 2,00,000
5 5,00,000
Journal Entries in the Books of India Coal Ltd
Entries for Year 1
Entry 1:
When Royalty is Payable:
Royalty A/c -----------------------------------Dr. 90,000
Short-workings A/c ----------------------------Dr. 1,10,000
To Landlord A/c 2,00,000
Entry 2:
For Payment to Landlord:
Landlord A/c ---------------------------------Dr. 2,00,000
To Bank A/c 2,00,000
Entry 3:
For Transferring Royalty:
Trading/Profit and Loss/Manufacturing/Production A/c ----------Dr. 90,000
To Royalty A/c 90,000
Entries for Year 2
Entry 1:
When Royalty is Payable:
Royalty A/c -----------------------------------Dr. 1,30,000
Short-workings A/c ----------------------------Dr. 70,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.115

To Landlord A/c 2,00,000

Entry 2:
For Payment to Landlord:
Landlord A/c ---------------------------------Dr. 2,00,000
To Bank A/c 2,00,000
Entry 3:
For Transferring Royalty:
Trading/Profit and Loss/Manufacturing/Production A/c ----------Dr. 1,30,000
To Royalty A/c 1,30,000
Entries for Year 3
Entry 1:
When Royalty is Payable:
Royalty A/c -----------------------------------Dr. 2,50,000
To Short-workings A/c ----------------------------Dr. 50,000
To Landlord A/c 2,00,000
Entry 2:
For Payment to Landlord:
Landlord A/c ---------------------------------Dr. 2,00,000
To Bank A/c 2,00,000
Entry 3:
For Transferring Royalty:
Trading/Profit and Loss/Manufacturing/Production A/c ----------Dr. 2,50,000
To Royalty A/c 2,50,000
Entries for Year 4
Entry 1:
When Royalty is Payable:
Royalty A/c -----------------------------------Dr. 3,00,000
To Short-workings A/c ----------------------------Dr. 1,00,000
To Landlord A/c 2,00,000
Entry 2:
For Payment to Landlord:
Landlord A/c ---------------------------------Dr. 2,00,000
To Bank A/c 2,00,000
Entry 3:
For Transferring Royalty:
Trading/Profit and Loss/Manufacturing/Production A/c ----------Dr. 3,00,000
To Royalty A/c 3,00,000

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 6.116 PRINCIPLES AND PRACTICE OF ACCOUNTING

Entry 4:
For Irrecoverable Short-working:
Profit and Loss A/c --------------------------------Dr. 30,000
To Short-workings A/c 30,000
Entries for Year 5
Entry 1:
When Royalty is Payable:
Royalty A/c -----------------------------------Dr. 5,00,000
To Landlord A/c 5,00,000
Entry 2:
For Payment to Landlord:
Landlord A/c ---------------------------------Dr. 5,00,000
To Bank A/c 5,00,000
Entry 3:
For Transferring Royalty:
Trading/Profit and Loss/Manufacturing/Production A/c ----------Dr. 5,00,000
To Royalty A/c 5,00,000
Ledger Accounts
Lessor Account
1st Year ` `
To Bank A/c 2,00,000 By Royalty A/c 90,000
By Short-workings 1,10,000
2,00,000 2,00,000
2nd Year
To Bank A/c 2,00,000 By Royalty A/c 1,30,000
By Short-working 70,000
2,00,000 2,00,000
3rd Year
To Bank A/c 2,00,000 By Royalty A/c 2,00,000
4th Year
To Bank A/c 2,00,000 By Royalty A/c 2,00,000
5th Year
To Bank A/c 5,00,000 By Royalty A/c 5,00,000
Short-workings Account
1st Year ` `
To Lessor A/c 1,10,000 By Balance c/d 1,10,000
2nd Year
To Balance b/d 1,10,000 By Balance c/d 1,80,000
To Lessor A/c 70,000
1,80,000 1,80,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.117

3rd Year
To Balance b/d 1,80,000 By Royalty 50,000
By Balance c/d 1,30,000
1,80,000 1,80,000
4th Year
To Balance b/d 1,30,000 By Royalty 1,00,000
By P&L 30,000
1,30,000 1,30,000

Royalty A/c
1st Year
To Lessor 90,000 By P&L 90,000
2nd Year
To Lessor 1,30,000 By P&L 1,30,000
3rd Year
To Lessor 2,00,000 By P&L 2,50,000
To Short-workings 50,000
2,50,000 2,50,000
4th Year
To Lessor 2,00,000 By P&L 3,00,000
To Short-workings 1,00,000
3,00,000 3,00,000
5th Year
To Lessor 5,00,000 By P&L 5,00,000

? ILLUSTRATION 2
Solve Illustration 1 from the point of view of Lessor.
Entries for Year 1
Entry 1:
When Royalty is due:
Lessee A/c -----------------------------------------Dr. 2,00,000
To Royalty Receivable A/c 90,000
To Short-workings Allowable A/c 1,10,000
Entry 2:
When money is received:
Bank A/c -------------------------------------------Dr. 2,00,000
To Lessee A/c 2,00,000
Entry 3:
For Transferring Royalty Receivable:
Royalty Receivable A/c ------------------------Dr. 90,000
To Profit and Loss A/c 90,000

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 6.118 PRINCIPLES AND PRACTICE OF ACCOUNTING

Entries for Year 2

Entry 1:
When Royalty is due:
Lessee A/c -----------------------------------------Dr. 2,00,000
To Royalty Receivable A/c 1,30,000
To Short-workings Allowable A/c 70,000
Entry 2:
When money is received:
Bank A/c -------------------------------------------Dr. 2,00,000
To Lessee A/c 2,00,000

Entry 3:
For Transferring Royalty Receivable:
Royalty Receivable A/c ------------------------Dr. 1,30,000
To Profit and Loss A/c 1,30,000

Entries for Year 3

Entry 1:
When Royalty is due:
Lessee A/c -----------------------------------------Dr. 2,50,000
To Royalty Receivable A/c 2,50,000

Entry 2:
When short-workings is recouped:
Short-workings Allowable A/c ------------------Dr. 50,000
To Lessee A/c 50,000

Entry 3:
When money is received:
Bank A/c -------------------------------------------Dr. 2,00,000
To Lessee A/c 2,00,000

Entry 4:
For Transferring Royalty Receivable:
Royalty Receivable A/c ------------------------Dr. 2,50,000
To Profit and Loss A/c 2,50,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.119

Entries for Year 4

Entry 1:
When Royalty is due:
Lessee A/c -----------------------------------------Dr. 3,00,000
To Royalty Receivable A/c 3,00,000

Entry 2:
When short-workings is recouped:
Short-workings Allowable (Royalty Suspense) A/c------------------Dr. 1,00,000
To Lessee A/c 1,00,000
Entry 3:
When money is received:
Bank A/c -------------------------------------------Dr. 2,00,000
To Lessee A/c 2,00,000
Entry 4:
For Transferring Royalty Receivable:
Royalty Receivable A/c ------------------------Dr. 3,00,000
To Profit and Loss A/c 3,00,000
Entry 5:
For Irrecoverable amount of Short-workings
Profit and Loss A/c ----------------------------Dr. 30,000
To Short-workings Allowable A/c 30,000
Entries for Year 5
Entry 1:
When Royalty is due:
Lessee A/c -----------------------------------------Dr. 5,00,000
To Royalty Receivable A/c 5,00,000
Entry 2:
When money is received:
Bank A/c -------------------------------------------Dr. 5,00,000
To Lessee A/c 5,00,000
Entry 3:
For Transferring Royalty Receivable:
Royalty Receivable A/c ------------------------Dr. 5,00,000
To Profit and Loss A/c 5,00,000

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 6.120 PRINCIPLES AND PRACTICE OF ACCOUNTING

Ledger Accounts
Lessee Account
1st Year
To Royalty Receivable 90,000 By Bank A/c 2,00,000
To Short-workings Allowable 1,10,000
2,00,000 2,00,000
2nd Year
To Royalty Receivable 1,30,000 By Bank A/c 2,00,000
To Short-workings Allowable 70,000
2,00,000 2,00,000
3rd Year
To Royalty Receivable 2,50,000 By Bank A/c 2,00,000
By Short-workings Allowable 50,000
2,50,000 2,50,000
4th Year
To Royalty Receivable 3,00,000 By Bank A/c 2,00,000
By Short-workings Allowable 1,00,000
3,00,000 3,00,000
5th Year
To Royalty Receivable 5,00,000 By Royalty 5,00,000
Royalty Receivable Account
1st Year
To P&L Account 90,000 By Lessee 90,000
2nd Year
To P&L Account 1,30,000 By Lessee 1,30,000
3rd Year
To P & L Account 2,50,000 By Lessee 2,50,000
4th Year
To P&L Account 3,00,000 By Lessee 3,00,000
5th Year
To P&L Account 5,00,000 By Lessee 5,00,000
Short-workings Allowable A/c
1st Year
To Balance c/d 1,10,000 By Lessor 1,10,000
2nd Year
To Balance c/d 1,80,000 By Balance b/d 1,10,000
By Lessor 70,000
1,80,000 1,80,000
3rd Year
To Lessor 50,000 By Balance b/d 1,80,000
To Balance c/d 1,30,000
1,80,000 1,80,000
4th Year
To Lessor 1,00,000 By Balance b/d 1,30,000
To P&L 30,000
1,30,000 1,30,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.121

? ILLUSTRATION 3
On 1st April, 2011 State Collieries Co. took on lease a mine from Omega Co. Under the contract, royalty was
payable @ ` 10 per tonne of coal extracted with an annual minimum rent of ` 1,00,000. Short-workings, if any
were recoverable only during the first three years of the contract. The output for the first four years is noted below:-

For the year ended 31st March 2012 6,000 tonnes

For the Year ended 31st March 2013 10,500 tonnes
For the Year ended 31st March 2014 13,000 tonnes
For the Year ended 31st March 2015 20,000 tonnes
Pass journal entries in the books of the landlord for all the four years.

 SOLUTION
Date Output (in Royalty @ ` Minimum Short- Short- Short- Amount
tones) 10 per tone Rent workings workings workings receivable
` ` allowable recouped irrecoverable from lessee
` by lessee ` `
`
31-3-12 6,000 60,000 1,00,000 40,000 1,00,000
31-3-13 10,500 1,05,000 1,00,000 5,000 1,00,000
31-3-14 13,000 1,30,000 1,00,000 30,000 5,000 1,00,000
31-3-15 20,000 2,00,000 1,00,000 2,00,000
In the books of Omega
Journal Entries

` `
2012 State Collieries Co. Dr. 1,00,000
March 31 To Royalties Receivable Account 60,000
To Short-workings allowable Account 40,000
(Minimum rent receivable from State Collieries Co.,
royalties receivable being ` 60,000; excess of the
former over the latter being credited to Short workings
allowable Account.)
” Bank A/c Dr. 1,00,000
To State Collieries Co. 1,00,000
(Receipt of amount due from State Collieries Co.)
” Royalties Receivable Account Dr. 60,000
To Profit & Loss Account 60,000
(Transfer of Royalties Account to Profit & Loss
Account)

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 6.122 PRINCIPLES AND PRACTICE OF ACCOUNTING

2013 State Collieries Co. Dr. 1,00,000

March 31 Short-workings allowable Account Dr. 5,000
To Royalties Receivable Account 1,05,000
(Minimum rent receivable from State Collieries
Co.,after adjusting ` 5,000 of short-workings allowable
against royalties receivable)
” Bank Dr. 1,00,000
To State Collieries Co. 1,00,000
(Receipt of amount due from State Collieries Co.)
” Royalties Receivable Account Dr. 1,05,000
To Profit & Loss Account 1,05,000
(Transfer of Royalties Account to Profit & Loss
Account)
2014 State Collieries Co. Dr. 1,00,000
March 31 Short-workings allowable Account Dr. 30,000
To Royalties Receivable Account 1,30,000
(Minimum rent receivable from State Collieries Co.,
after adjusting of short-workings allowable ` 30,000
against royalties receivable)
“ Bank Dr. 1,00,000
To State Collieries Co. 1,00,000
(Amount received from State Collieries Co).
” Short-workings allowable Account Dr. 5,000
To Profit & Loss Account 5,000
(Balance of Shortworkings allowable count, being
irrecoverable short-workings, transferred to Profit &
Loss Account.)
” Royalties Receivable Account Dr. 1,30,000
To Profit & Loss Account 1,30,000
(Transfer of Royalties Receivable Account to Profit &
Loss Account )
2015 State Collieries Co. Dr. 2,00,000
Mar. 31 To Royalties Receivable Account 2,00,000
(Amount due from State Collieries Co., for royalties
receivable for the year)
” Bank Dr. 2,00,000
To State Collieries Co. 2,00,000
(Amount of royalties received from State Collieries
Co.)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.123

” Royalties Receivable Account Dr. 2,00,000

To Profit & Loss Account 2,00,000
Transfer of Royalties Receivable Account to Profit &
Loss Account.

SUMMARY
w ”Royalty” may be defined as periodic payment made by one person (lessee) to another person (lessor)
for using the right by the lessee vested in the lessor.
w Minimum Rent is the amount of rent which the lessee is required to pay to the lessor whether he has
derived any benefit or not out of the right vested to him by the lessor.
w Short-workings means excess of Minimum Rent over the Actual Royalty.
w Right of Recoupment implies that lessor allows the lessee the right to carry forward and set off the
short-workings against the excess or surplus of royalties over the Minimum Rent in the subsequent
years.

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1. Short-workings means
(a) Excess of minimum rent over actual royalty amount.
(b) Excess of actual royalty amount over minimum rent.
(c) Excess of maximum rent over actual royalty amount.
2. The rent payable by the tenant to the landlord irrespective of the fact whether he has derived any
benefit or not out of the property let out to him by the landlord is termed as
(a) Dead Rent (b) Fixed Rent (c) Either (a) or (b).
3. In case the right to recoup short workings has expired, the balance in the short-workings accounts is
transferred to
(a) Landlord’s account.
(b) Profit and Loss account.
(c) Royalty account.

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 6.124 PRINCIPLES AND PRACTICE OF ACCOUNTING

Theory Questions
1. Define Royalty. Give some examples where it is paid or received.
2. Write short notes on:
(i) Minimum Rent. (ii) Recoupment of short-workings.
Practical Questions
Q1. A grants a mine on lease to B on 31.3.13 a royalty of ` 2 per tonne of the coal produced. The following
is the quantum of output for each year :
For the year ended 31stMarch, 2014 3,000 tonnes
2015 3,200 tonnes
2016 4,000 tonnes
2017 5,000 tonnes
The minimum rent is fixed at ` 7,000 and short-workings recoupment is allowable throughout the
period of lease. Compute the amount of royalty payable for the years ended 31st March, 2014, 2015,
2016 and 2017.
Q2. ABC Collieries Co. Ltd. took from M/s XYZ a lease of coal field for a period of 25 years from 1stApril, 2010
on a royalty of ` 25 per tonne of coal extracted with a Dead Rent of ` 2,20,000 a year with power to
recoup short - workings during the first five years of the lease. The company closes its books of account
on 31st March every year.
The output in the first five years of the lease was as follows:-

Year ended 31st March, 2011 2,000 tonnes

Year ended 31st March, 2012 3,600 tonnes
Year ended 31st March, 2013 9,000 tonnes
Year ended 31st March, 2014 15,000 tonnes
Year ended 31st March, 2015 20,000 tonnes
You are required to give journal entries for all the transactions relating to royalties for the five years in the
books of ABC Collieries Co. Ltd.
ANSWERS/HINTS
MCQs
1. (a ) 2. (c) 3. (b)
Theoretical Questions
1. Royalty” may be defined as periodic payment made by one person (lessee) to another person (lessor) for
using the right by the lessee vested in the lessor. Examples: For the extraction of oil, coal, and minerals
or to an author for sale of his books.
2. (i) Minimum Rent is the amount of rent which the lessee is required to pay to the lessor whether he has
derived any benefit or not out of the right vested to him by the lessor. It is also called Dead Rent or
Rock Rent or Fixed Rent.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.125

(ii) Short-Workings represents excess of Minimum Rent over the Actual Royalty. Right of Recoupment
implies that lessor allows the lessee the right to carry forward and set off the short-workings
against the excess or surplus of royalties over the Minimum Rent in the subsequent years as per the
agreement.
Practical Questions
Answer 1
Statement showing amount of royalty payable
Date Output (in Royalty @ ` 2 Minimum Short- Short- Amount
tones) per tone Rent workings workings payable
allowable recouped
2014 3,000 6,000 7,000 1,000 7,000
2015 3,200 6,400 7,000 600 7,000
2016 4,000 8,000 7,000 1,000 7,000
2017 5,000 10,000 7,000 600 9,400
Answer 2
Date Output Royalty @ Minimum Short Short- Short-workings Amount
(in ` 25 per Rent workings workings irrecoverable payable
tonnes) tonne being Landlord
recouped
31-3-11 2,000 50,000 2,20,000 1,70,000 2,20,000
31-3-12 3,600 90,000 2,20,000 1,30,000 2,20,000
31-3-13 9,000 2,25,000 2,20,000 5,000 2,20,000
31-3-14 15,000 3,75,000 2,20,000 1,55,000 2,20,000
31-3-15 20,000 5,00,000 2,20,000 1,40,000 3,60,000
Journal Entries in the books of ABC Collieries Co. Ltd.

2011, 31 Royalties Account Dr. 50,000

March Short-workings Account Dr. 1,70,000
To M/s XYZ 2,20,000
(Royalties @ ` 25 per tonne on 2,000 tonnes subject to a
minimum of ` 2,20,000)
31 M/s XYZ Dr. 2,20,000
To Bank… 2,20,000
(Payment of the sum due to the landlord)
31 Profit and Loss Account Dr 50,000
To Royalties Account 50,000
(Transfer of Royalties Account to Profit and Loss Account)

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 6.126 PRINCIPLES AND PRACTICE OF ACCOUNTING

2012, 31 Royalties Account Dr. 90,000

March Short-workings Account Dr. 1,30,000
To M/s XYZ 2,20,000
(Royalties @ ` 25 per tonne on 3,600 tonnes plus
` 1,30,000 to landlord)
31 M/s. XYZ Dr. 2,20,000
To Bank 2,20,000
(Payment of the sum due to the landlord)
31 Profit and Loss Account Dr. 90,000
To Royalties Account 90,000
(Transfer of Royalties Account to Profit and Loss
Account)
2013, 31 Royalties Account Dr. 2,25,000
March To M/s XYZ 2,20,000
To short-workings Account 5,000
(Royalties @ `25 per tonne on 9,000 tonnes less ` 5,000
recovered against short-workings payable to landlord.)
M/s XYZ Dr. 2,20,000
To Bank 2,20,000
(Payment of the sum due to landlord)
Profit and Loss Account Dr. 2,25,000
To Royalties Account 2,25,000
(Transfer of Royalties Account to Profit and Loss
Account)
2014, Royalties Account Dr. 3,75,000
March 31 To M/s XYZ 2,20,000
To Short-workings Account 1,55,000
(Royalties @ ` 25 per tonne on 15,000 tonne less
` 1,55,000 recovered against short-workings payable to
landlord.)

M/s XYZ Dr. 2,20,000

To Bank 2,20,000
(Payment of the sum due to landlord)
Profit and Loss Account Dr. 3,75,000
To Royalties Account 3,75,000
(Transfer of Royalties Account to Profit and Loss Account )

2015, Royalties Account Dr. 5,00,000

March 31 To M/s XYZ 1,40,000
To Short-workings Account 3,60,000
(Royalties @ ` 25 per tonne on 20,000 tonne less `
1,44,000, balance in Short-workings account, recouped
against amount payable to landlord)

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.127

M/s XYZ Dr. 3,60,000

To Bank 3,60,000
(Payment of the sum due to the landlord)
Profit and Loss Account Dr. 5,00,000
To Royalties Account 5,00,000
(Transfer of Royalties Account to Profit and Loss Account)

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 6.128 PRINCIPLES AND PRACTICE OF ACCOUNTING

UNIT 6 : AVERAGE DUE DATE

LEARNING OUTCOMES
After studying this chapter, you will be able to:

w Understand what is average due date and how to choose 0 (zero) day for calculating average due date.

w Learn the technique of calculating due date

w Learn calculation of average due date where amount is lent in various instalments.

w Calculate average due date for determining interest on drawings.

w Familiarize with the steps involved in calculation of average due date where amount is lent in one
instalment but repayment is done in various instalments. Also understand days of grace and learn the
technique of maturity date by counting the days of grace.

UNIT OVERVIEW

USES OF AVERAGE DUE DATE

Bill of
For calculation of Where amount
Exchnage/ Where amount
interest on drawings is lent in various is lent in one
Promissory
of partners instalments
Note instalment

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.129

CALCULATION OF DUE DATE

If Bill/Invoice
is payable

at a stated no. of
on a specific date months(s)/days
after date

Due date will be on that date

Due date will be on which comes after adding
that specific date stated number of months/
days to the date of invoice/bill
+ 3 days of grace

6.1 INTRODUCTION
In business enterprises, a large number of receipts and payments by and from a single party may occur
at different points of time. To simplify the calculation of interest involved for such transactions, the idea
of average due date has been developed. Where a person owing several amounts due on different dates,
desires to pay the total amount payable by him/her on a particular date, so that neither the debtor nor the
creditor stands to lose or gain anything by way of interest, that date is known as average due date. Average
Due Date is weighted average of due dates of various transactions where amount of each transaction is
used as weight. The unique feature f this approach is that the party making payment neither suffers any loss
nor gains anything by this arrangement of making a single payment. Average due date is generally used in
following circumstances:

i) For calculating interest on drawings of partners;

ii) For settling accounts between principle and agent;
iii) For settling contra accounts e.g. where parties sell goods to each other;
iv) For making lump sum payment against various bills drawn on different dates with different due
dates;
In this unit, we shall elaborate the underlying principle of determining average due date covering the cases
where the amount is lent in various instalments but repayment is made in a single instalment as well as
where the amount is lent in one instalment but repayment is made by various instalments. The technique of
average due date is also useful for calculating interest on drawings made by the proprietors or partners of a
business firm at several points of time.

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 6.130 PRINCIPLES AND PRACTICE OF ACCOUNTING

Average due date: It is the mean or equated date on which a single total payment may be made in lieu
of different payments on different dates without any loss to either party.

Where payment is not made on the average due date, the party receiving the amount charges interest
for as many days as the payment is delayed from the average due date.

The formula for calculating average due date is as follows:

Total of the products

Average due date = Base date ±
Total of the amounts

Points to be noted:
1. Selection of base date/ zero date: Such a date may be the due date of the first transaction or the due
date of the last transaction or any other due date between the first and the last but preferably earlier
due date may be taken.
2. While ascertaining the number of intervening days (plus or minus) between the base date and the due
date of each transaction ignore the first date and include the last day.
3. If due date is in fraction, round it off.
4. If amount is paid before due date, rebate is given.
5. If amount is paid after due date, then interest is charged.
6. Whenever there is a sale of goods by two persons to each other on different dates, the formula for
calculating average due date becomes:

Difference in products
Base date ±
Difference in amounts

6.2 CONCEPT OF DUE DATE (DATE OF MATURITY)

The due date of a bill of exchange/invoice is the date when the amount of a bill/invoice is payable by the
drawee/ creditor to drawer/ debtor.
6.2.1 Calculation of Due Date after Taking into Consideration Days of Grace
A Bill of exchange or promissory note matures on the date on which it falls due. And every promissory note
or bill of exchange (other than those payable on demand or at sight or on presentment) falls due on the
third day after on which it is expressed to be payable.
Examples
(i) A bill dated 30th September is made payable three months after date. It falls due on 2nd January.
(ii) Due Date=30 Dec
(iii) Maturity date= 30 Dec +3 =2 Jan
(ii) A note dated 1st January is payable one month after sight. It falls due on 4th February.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.131

6.2.2 Calculating Due Date of Bill or Note Payable Few Months after Date or Sight
When the bill is made payable at a stated number of months after date or after sight or after certain events,
then the period stated shall be held to terminate on the date of the month which corresponds with the day
on which the instrument is dated. If the month in which the period would terminate has no corresponding
day, the period shall be held to terminate on the last day of such month.

Example: A Bill due on 29th January, 2015 is made payable at one month after date. The due date of
instrument is 3rd day after 28th February, i.e., 3rd March (in 2015, February is of 28 days only).
6.2.3 Calculation of Due Date when the Maturity Day is a Holiday
When the day on which a promissory note or bill of exchange is at maturity (after including days of grace) is
a public holiday, the instrument shall be deemed to be due on the preceding business day. The expression
“public holiday” includes Sundays and other days declared by the Central Government by notification in the
official gazette, to be a public holiday. And now if the preceding day is also a public holiday, it will fall on the
day preceding the previous day. But if the holiday happens to be emergency or unforeseen holiday then the
date shall be the next following day.(Ref: Negotiable Instruments Act 1881).

If Maturity Day is holiday (after

including days of grace)

Public Holiday (including Sundays & other Emergency or unforeseen

days declared by Central Government by holiday
notification in the official gazette)

Due date = Next following day

Due date = Preceding Business day

If Preceding day is also Public Holiday

Due date = Day Preceding the previous day

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 6.132 PRINCIPLES AND PRACTICE OF ACCOUNTING

6.3 TYPES OF PROBLEMS

w Case 1: Learn calculation of average due date where one Party is involved
w Case 2: Learn calculation of average due date where inter transactions between 2 Parties are involved
w Case 3: Learn calculation of average due date where amount is repaid in Instalments
w Case 4: Learn Calculation of average due date for determining interest on drawings.

Case 1: Learn calculation of average due date Where one Party is involved
Calculation of average due date
Under this type of problem, average due date is calculated as follows :

a. Take the earliest due date as starting day or base date or “O” day for convenience. Any date whatsoever,
may also be taken as “O” day.
b. Consider the number of days from base date up to each due date. Calculations may also be made in
month.
c. Multiply the number of days by the corresponding amounts.
d. Add up the amount and products.
e. Divide the “Product total” by “Amount total” and get result approximately upto a whole number.
f. This number is added in the base date to find the average due date.
Thus the formula for the average due date can be under.
Total of products
Average due date = Base date ±
Total amounts
Note: For calculation of no. of days, no. of days in each respective month involved are to be considered
individually.

? ILLUSTRATION 1
The followings are the amounts due on different dates in between the same parties:
Amount Due Date
`
500 3rd July
800 2nd August
1,000 11th September
Suggest a date on which all the bills may be paid out without any loss of interest to either party.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.133

 SOLUTION

Considering 3rd July as the starting day the following table is prepared:

Due Dates Amount No. of Days from 3rd July Products

3rd July 500 0 0
2nd August 800 30 24,000
11th September 1,000 70 70,000
2,300 94,000
94,000
Average Due Date = 3rd July +
2,300
= 3rd July + 41 days = 13th August

Loss of Interest: 13th August to 11th September

Assuming 5% is interest rate, the debtor loses interest due to early payment of ` 1,000 for 29 days (from 13th
August to 11th September) i.e., ` 4. 1000 × 29/365 × 5/100

Gain of Interest: 3rd July to 13th August and 2 August to 13th August

He however, gains interest, due to late payment on ` 500 for 41 days from 3rd July to 13th August and on
` 800 for 11 days i.e. ` 2.80 + ` 1.20, i.e., ` 4.

Thus, the debtor neither loses nor gains by payment of all the amounts on 13th August.
It should be noted that in calculating the number of days only one of the dates, either the starting date or
the due date is to be counted.
In the same manner, bill due to one party may be cancelled as against bills of same amount due from the
same party after adjustment of interest for the period elapsing between the two average due dates. Instead
of payment of several bills on the same date as above, other bill starting from the average due date for
agreed period together with interest for the period may be accepted.

? ILLUSTRATION 2
The following amounts are due to X by Y. Y wants to pay off (a) on 18th March or (b) on 14th July. Interest rate of
8% p.a. is taken into consideration.

Due Dates `
10th January 500
26th January (Republic Day) 1,000
23rd March 3,000
18th August (Sunday) 4,000

Determine the amount to be paid in (a) and in (b).

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 6.134 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Taking 10th January as the base date

Due Date Due Date No. of days Amount Product

(Normal) (Actual) from 10th January. . . `
10th January 10th January 0 500 0
26th January 25th January 15 1,000 15,000
23rd March 23rd March 72 3,000 2,16,000
18th August 17th August 219 4,000 8,76,000
8,500 11,07,000

11,07,000
Average Due Date = 10th Jan. + = 10th Jan + 131 days = 21st May
8500

January 21
February 28
March 31
April 30
110
(a) If the payment is made on 18th March rebate will be allowed for unexpired time from 18th March to 21th
May i.e., 13 + 30 + 21 i.e. for 64 days. He has to pay the discounted value of the total amount.
8 64 64
Discount = 8,500 x x = 680 x = ` 119.2
100 365 365
Amount to be paid on 18th March= ` (8,500 – 119.23) = ` 8,380.77
(b) If the payment is deferred to 14th July, interest is to be paid from 21th May to 14th July i.e., for
10 + 30 + 14 = 54 days.
8 54 54
Interest = 8,500 x x = 680 x = ` 100.6
100 365 365
The amount to be paid on 14th July.
` 8,500 + 100.6 = 8600.6

? ILLUSTRATION 3

Calculate Average Due date from the following information:

Date of the bill Term Amount

`
August 10, 2015 3 months 6,000
October 23, 2015 60 days 5,000
December 4, 2015 2 months 4,000

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.135

January 14, 2016 60 days 2,000

March 08, 2016 2 months 3,000
(Assume February of 28 days)

 SOLUTION
Calculation of Average Due Date
Taking 10th August as the base date

Date of bill Term Due date- No. of days Amount Product

Maturity Date from 10th
` `
August 2015
August 10, 2015 3 months Nov. 13, 2015 95 6,000 5,70,000
October 23,2015 60 days Dec. 25, 2015 137 5,000 6,85,000
December 04, 2015 2 months Feb. 07, 2016 181 4,000 7,24,000
January 14, 2016 60 days Mar. 18, 2016 220 2,000 4,40,000
March 08, 2016 2 months May 11, 2016 274 3,000 8,22,000
20,000 32,41,000
Total of product 32,41,000
Average due date = = = 162.05=163 days
Total of amount 20,000
= 163 days after August 10, 2015 i.e. January 20, 2016.
Days of Grace added as it is case of Bills and it is Negotiable Instrument.

? ILLUSTRATION 4
A trader having accepted the following several bills falling due on different dates, now desires to have these bills
cancelled and to accept a new bill for the whole amount payable on the average due date :
Sl. No. Date of bill Amount Usance of the bill
1 1st March 2016 400 2 months
2 10th March 2016 300 3 months
3 5th April 2016 200 2 months
4 20th April 2016 375 1 month
5 10th May 2016 500 2 months
You are required to find the said average due date.

 SOLUTION

Calculation of the average due date

Taking 4th May as the base date
Sl. No. Date of bill Due Date of Amount No. of days Product
Maturity ` from starting
date (4th May)
1 1st March 2016 4th May 400 0 0

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 6.136 PRINCIPLES AND PRACTICE OF ACCOUNTING

2 10th March 2016 13th June 300 40 12,000

3 5th April 2016 8th June 200 35 7,000
4 20th April 2016 23rd May 375 19 7,125
5 10th May 2016 13th July 500 70 35,000
Total : 1,775 61,125
Average Due Date is 61,125/1,775=34.43 i.e., 35 days after the assumed due date, 4th May, 2016. The new
bill should be for ` 1,775 payable on June 8th, 2016.

? ILLUSTRATION 5

A owes B ` 890 on 1st January, 2015. From January to March, the following further transactions took place
between A and B:
January 16 A buys goods ` 910
February 2 A receives Cash loan ` 750
March 6 A buys goods ` 810
A pays the whole amount on 31st March, 2015 together with interest at 5% per annum. Calculate the interest by
the average due date method.

Due Date Amount No. of days from Jan. 1 Product

2015 `
Jan. 1 890 0 0
Jan. 16 910 15 13,650
Feb. 2 750 32 24,000
March 6 810 64 51,840
3,360 89,490

 SOLUTION
Calculation of average due date
Sum of product
Average due date = Base date + days equal to
Sum of the amount

Jan. 1 + [ [89,490
3,360
i.e., 27 days or Jan. 28

Interest therefore has been calculated on ` 3,360 from 28th Jan. to 31st March, i.e., for 63 days.
5 63
3,360 x x = ` 29
100 365

? ILLUSTRATION 6
Radheshyam purchased goods from Hariram. The due dates for payment is cash, being as follows:
March 15 ` 400 Due on 18th April
April 21 ` 300 Due on 24th May

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.137

April 27 ` 200 Due on 30th June

May 15 ` 250 Due on 18th July
Hariram agreed to draw a Bill for the total amount due on the average due date. Ascertain that date

 SOLUTION

Taking 18th April as the base date

Due Date Amount No. of days Product

` from 18th April
18th April 400 0
24th May 300 36 10,800
30th June 200 73 14,600
18th July 250 91 22,750
1,150 48,150
48,150
Average Due Date is or 42 days after the base date.
1,150
18th April, i.e. 30 May.
Case 2: Learn calculation of average due date Where inter transactions between 2 Parties are involved
When more than one party is involved where one party purchase and also sells to other party like JK Tyres
and Maruti where Maruti sells car to JK Tyres for their employees and purchases Tyres from them. In such a
case instead of paying gross amount they may go for new amount i.e. Purchase amount and sales amount
will be set off and thus here we take difference of amount and produce as Net Amount. In such cases, earliest
date of both parties is taken as the base date.

? ILLUSTRATION 7
Two traders X and Y buy goods from one another, each allowing the other one month’s credit. At the end of 3
months the accounts rendered are as follows:

Goods sold by X to Y Goods sold by Y to X

` `
April 18 60.00 April 23 52.00
May 15 70.00 May 24 50.00
June 16 80.00
Calculate the date upon which the balance should be paid so that no interest is due either to X or Y.

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 6.138 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION
Taking May 18th as the zero or base date ( April 18 +One month Credit=18 May)
For Y’s payments:

Date of Due Date Amount No. of days from Products

Transactions the base date
(1) (2) (3) (4) (5)
April 18 May 18 60 0 0
May 15 June 15 70 28 1,960
June 16 July 16 80 59 4,720
Amount Due to X 210 Sum of products 6,680
For X’s payments

The students should note that the same base date should be taken. Therefore, the base date will be May
18th in this case also.

Date of Due Date Amount No. of days from Products

Transactions the base date
(1) (2) (3) (4) (5)
April 23 May 23 52 5 260
May 24 June 24 50 37 1,850
Amount Due to Y 102 Total products 2,110

Excess of Y’s products over X’s = 6,680 – 2,110

= 4,570
Excess amount due to X ` 210 – 102 = ` 108.
Number of days from the base date to the date of settlement is
4,570
= 42.3 days i.e 43 days
108
Hence the date of settlement of the balance is 4.3 days after May 18 i.e., on June 30. On June 30, Y has to
pay X, ` 108 to clear the account.

? ILLUSTRATION 8
Manoj had the following bills receivables and bills payable against Sohan. Calculate the average due date, when
the payment can be received or made without any loss of interest.
Date Bills Receivable Tenure Date Bills Payable Tenure
` `
01/06/2016 3,000 3 month 29/05/2016 2,000 2 month
05/06/2016 2,500 3 month 03/06/2016 3,000 3 month
09/06/2016 6,000 1 month 9/06/2016 6,000 1 month
12/06/2016 1,000 2 month
20/06/2016 1,500 3 month

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.139

15 August, 2016 was a Public holiday. However, 6 September, 2016 was also declared as sudden holiday.

 SOLUTION:
Let us take 12.07.2014 as Base date.
Bills receivable
Due date No. of days from 12.07.2016 Amount Product
04/09/2016 54 3,000 1,62,000
08/09/2016 58 2,500 1,45,000
12/07/2016 0 6,000 0
14/08/2016 33 1,000 33,000
23/09/2016 73 1,500 1,09,500
14,000 4,49,500
Bills payable
Due date No. of days from 12.07.2016 Amount Product
01/08/2016 20 2,000 40,000
07/09/2016 57 3,000 1,71,000
12/07/2016 0 6,000 0
11,000 2,11,000
Excess of products of bills receivable over bills payable = 4,49,500 -2,11,000= 2,38,500
Excess of bills receivable over bills payable = 14,000 – 11,000 = 3,000
Number of days from the base date to the date of settlement is 2,38,500/3,000 = 79.5 (appox.)
Hence date of settlement of the balance amount is 80 days after 12th July i.e. 30th September.
On 30th September, 2016 Sohan has to pay Manoj ` 3,000 to settle the account.

? ILLUSTRATION 9

Mr. Green and Mr. Red had the following mutual dealings and desire to settle their account on the average due
date:

Purchases by Green from Red: `

6th January, 2016 6,000
2nd February, 2016 2,800
31st March, 2016 2,000
Sales by Green to Red:
6th January, 2016 6,600
9th March, 2016 2,400
20th March, 2016 500
You are asked to ascertain the average due date. ( 28 days in feb.)

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 6.140 PRINCIPLES AND PRACTICE OF ACCOUNTING

 SOLUTION

Calculation of Average Due Date

Taking 6th January, 2016 as base date

For Green’s payments
Due date Amount No. of days from the base date i.e. Product
6th Jan. 2016
2016 `
6th January 6,000 0 0
2nd February 2,800 27 75,600
31st March 2,000 84 1,68,000
Total 10,800 2,43,600
For Red’s payment
2016
6th January 6,600 0 0
9th March 2,400 62 1,48,800
20th March 500 73 36,500
Total 9,500 1,85,300
Excess of Green’s products over Red’s = ` 2,43,600 – ` 1,85,300 = ` 58,300
= ` 10,800 – ` 9,500 = ` 1,300
Number of days from the base date to the date of settlement is 58,300/1,300=45 days (approx.)
Hence, the date of settlement of the balance amount is 45 days after 6th January i.e. on 20th February.
On 20th February, 2016, Green has to pay Red ` 1,300 to settle the account.

w Case 3: Learn calculation of average due date where amount is repaid in Instalments

Calculation of average due date in a case where the amount is lent in one instalment and repayment is done
in various instalments (opposite to what we have done in the first case). The problem takes a different shape.
The procedure for calculating average due date can be summarized as under:

Step 1: Calculate number of days/monthly/years from the date of lending money to the date of each
repayment.
Step 2: Find the total of such days/months/years.
Step 3: Quotient will be the number of days/months/years by which average due date falls away from date
of commencement of loan.
As explained earlier, if instalment are same, we can use Simple mean concept i. Divide days by number of
items and no need for product.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.141

Thus, the formula for the average due date can be written as under:

Sum of days / months / Years from the date of Lending

Average due date = Date of Loan + to the date of repayment of each instalment
Number of instalments

? ILLUSTRATION 10

` 10,000 lent by Dass Bros. to Kumar & Sons on 1st January, 2011 is repayable in 5 equal annual instalments
commencing on 1st January, 2012. Find the average due date and calculate interest at 5% per annum, which
Dass Bros. will recover from Kumar & Sons.

 SOLUTION
Due date No. of years from 1 Jan 2011
1Jan 2011 0
1Jan 2012 1
1Jan 2013 2
1Jan 2014 3
1Jan 2015 4
1Jan 2016 5

Average=5+4+3+2+1/5=3 years

Sum of the number of years / months / days from

Average due date = Date of Loan + the date of lending to the date of repayment of each instalment
Number of instalments

1 2  3  4  5
= Jan. 1, 2011 +
5
= Jan. 1, 2011+ 3 years

= 1st Jan., 2014

Interest at a certain rate on the instalments paid from the date of payment to any fixed date will be the same
as on ` 10,000 (if lent on 1st Jan., 2014 to that fixed date). There will be no loss to either party. Supposing rate
of interest is 5% p.a. and date of settlement is 31st Dec., 2012 then calculation of interest by product method
from both parties’ point of view will be as follows:
Dass Bros. pays interest as follows:

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 6.142 PRINCIPLES AND PRACTICE OF ACCOUNTING

Amount Paid on Money used by Dass Bros upto 31st Dec. 2016 Product
` `
2,000 1st Jan. 2012 5 Years 10,000
2,000 1st Jan. 2013 4 Years 8,000
2,000 1st Jan. 2014 3 Years 6,000
2,000 1st Jan. 2015 2 Years 4,000
2,000 1st Jan. 2016 1 Year 2,000
30,000

` 30,000 x 5
Interest at 5% p.a. on ` 30,000 for one year. = = ` 1,500
100

Dass Bros. will receive interest (if given on 1st Jan., 2014 on ` 10,000 from average due date to 31st Dec.,

5 x 3 x ` 10,000
2016, i.e., for 3 years at 5% p.a. = = ` 1,500
100
From the above, it can be concluded that if the borrower pays ` 2,000 yearly from 1st Jan., 2012 for 5 years
and if the lender gives ` 10,000 on 1st Jan., 2014 then both will charge same interest from each otherThere
is no loss to any of the parties. But actually lender gives ` 10,000 on 1st Jan., 2011, therefore, he has given
loan 3 years in advance and will charge interest on ` 10,000 for 3 years.

` 10,000 x 5 x 3
Interest = = ` 1,500 (to be charged by Dass Bros.)
100
Case 4: Learn Calculation of average due date for determining interest on drawings
In the case of drawings also, amount is drawn by the owners of business on various dates but it may settled
on one day. It should be noted that, when different amounts are due on different dates, but they are
ultimately settled on one day the interest may be calculated by means of Average Due Date. When interest
is chargeable on drawings, and drawings are on different dates, interest may be calculated on the basis of
Average Due Date of drawings determined on the basis given above. An illustration is given below to help
in understanding the same:

? ILLUSTRATION 11

A and B, two partners of a firm, have drawn the following amounts from the firm in the year ending 31st March,
2015:

A Date B
Date
` `
st th
1 July 500 12 June 1,000
30th September 800 11th August 500
1st November 1,000 9th February 400
28th February 400 7th March 900

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.143

Interest at 6% p.a. is charged on all drawings. Calculate interest chargeable by using (i) ordinary system
(ii) Average due date system. (assume 1 year = 365 days)

 SOLUTION

(i) Ordinary System :

A 500 for 9 months = 4,500 for 1 month
800 for 6 months = 4,800 for 1 month
1,000 for 5 months = 5,000 for 1 month
400 for 1 month = 400 for 1 month
14,700 for 1 month
14,700 @ 6% for 1 month = 1/2% of 14,700
= ` 73.50
B 1,000 for 292 days = 2,92,000
500 for 232 days = 1,16,000
400 for 50 days = 20,000
900 for 24 days = 21,600
4,49,600

6 1
4,49,600 x x = ` 73.91
100 365

(ii) Average Due Date System:

(a) Taking 1st July as the base date (O-day)

Dates ` Months from O-day Products
1st July 500 0 0
30th September 800 3 2,400
A 1st November 1,000 4 4,000
28th February 400 8 3,200
2,700 9,600
9,600
Average Due Date = months from 1st July. i.e., 3.556 months i.e. October 17th.
2,700
Interest is chargeable from October 17 to March 31 i.e. 5.444 months

6 5.444
2,700 x x = ` 73.49
100 12

Or,

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 6.144 PRINCIPLES AND PRACTICE OF ACCOUNTING

Taking 1st April as the base date (O-day):

Dates ` Months from O-day Products
A 1st July 500 3 1,500
30th September 800 6 4,800
1st November 1,000 7 7,000
28th February 400 11 4,400
2,700 17,700
17,700
Average Due Date = months from 1st April. i.e. 6.556 months i.e. 17th October.
2,700
Interest is chargeable from October 17 to March 31 i.e. 5.444 months.
6 5.444
2,700 x x = ` 73.49
100 12

(b) Taking 12th June as the base date (Zero-day)

Dates ` Days from O-day Products
B 12th June 1,000 0 0
11th August 500 60 30,000
9th February 400 242 96,800
7th March 900 268 2,41,200
2,800 3,68,000
3,68,000
Average Due Date = days from 12th June . i.e. 131 days.
2,800

June 18
July 31
Aug. 31
Sept. 30
110
131 days -110 days i.e. 21st October
So, interest is chargeable from 21st October to 31st March i.e. for 161 days.

6 161
2,800 x x = ` 74.10
100 365
The Differences in amounts in the two systems (1) and (2) are due to approximation.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.145

SUMMARY
w Average Due Date is one on which the net amount payable can be settled without causing loss of
interest either to the borrower or the lender.
w It is used in various cases like:
(i) Calculation of interest on drawings of partners.
(ii) Cancellation of various bills of exchange due on different dates and issuance of a Single bill.
(iii) Amount lent in one instalment and repayable in various instalments.
w When the amount is lent in various instalments then average due date can be calculated as :

Total [Amount x No. of days from base date to due date

Average due date = Base date
Total amounts
w When interest is chargeable on drawings, and drawings are on different dates, interest may be calculated
on the basis of Average Due Date of drawings.
w Average due date in a case where the amount is lent in one instalment and repayment is done in various
instalments will be:
Sum of days/months/years from the date of lending to
Average due date = Date of Loan + the date of repayment of each instalments
Total amounts

Every promissory note or bill of exchange (other than those payable on demand or at sight or on
presentment) falls due on the third day after on which it is expressed to be payable. This exempted
period of three days is called days of grace.

TEST YOUR KNOWLEDGE

Multiple Choice Questions

1. If payment is made on the average due date it results in-

(a) Loss of interest to the creditor.
(b) Loss of interest to the debtor.
(c) No loss of interest to either of them.
2. A mean date is calculated
(a) In connection with the settlement of contra accounts.
(b) For a lump sum payment.
(c) For several payments on different dates.
3. If payment is made after average due date, the party entitled to interest is
(a) Creditor (b) Debtor (c) Bank

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 6.146 PRINCIPLES AND PRACTICE OF ACCOUNTING

4. When due date is a public holiday, then the due date will be.
(a) Succeeding business day
(b) Preceding business day
(c) Due date will not change and will remain same.
5. A Bill due on 29th January, 2015 is made payable at one month after date. The due date of instrument
(a) 28th February, 2015. (b) 29th February, 2015. (c) 3rd March, 2015.
Theoretical Questions
1. Define Average Due Date.
2. List out the various instances when Average Due Date can be used.
Practical Questions
Q1 Mr. Yash and Mr. Harsh are partners in a firm. They had drawn the following amounts from the firm
during the year ended 31.03.2016:
Date Amount Drawn by
` `
01.05.2015 75,000 Mr. Yash
30.06.2015 20,000 Mr. Yash
14.08.2015 60,000 Mr. Harsh
31.12.2015 50,000 Mr. Harsh
04.03.2016 75,000 Mr. Harsh
31.03.2016 15,000 Mr. Yash
Interest is charged @ 10% p.a. on all drawings. Calculate interest chargeable from each partner by using
Average due date system. (Consider 1st May as base date)
Q2 Anand purchased goods from Amirtha, the average due date for payment in cash is 10.08.2016 and the
total amount due is ` 67,500. How much amount should be paid by Anand to Amirtha, if total payment
is made on following dates and interest is to be considered at the rate of 12% p.a.
(i) On average due date.
(ii) On 25th August, 2016.
(iii) On 30th July, 2016.

ANSWERS/HINTS
MCQs
1. (c) 2. (c) 3. (a) 4. (b) 5. (c)
Theoretical Questions
1. In business enterprises, many receipts and payments by and from a single party may occur at different
points of time. To simplify the calculation of interest involved for such transactions, the idea of average
due date has been developed. Average Due Date is a break-even date on which the net amount payable
can be settled without causing loss of interest either to the borrower or the lender.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.147

2. Few instances where average due date can be used:

(i) Calculation of interest on drawings made by the proprietors or partners of a business firm at
several points of time.
(ii) Settlement of accounts between a principal and an agent.
(iii) Settlement of contra accounts, that is, A and B sell goods to each other on different dates.
Practical Questions
Answer 1
Calculation of Interest chargeable from Partners
Taking 1st May as the base date

Dates Amount (`) Days from 1st May Products (`)

Yash 1.5.2015 75,000 0 0
30.6.2015 20,000 60 12,00,000
31.3.2016 15,000 334 50,10,000
1,10,000 62,10,000

62,10,000
Average Due Date = days from 1st May. i.e 57 days
1,10,000
= 27thJune
Interest is chargeable for Yash from 27th June to March 31 i.e. 277 days
` 1,10,000 x 10% x 277/365 = ` 8,348

Dates ` Days from 1 May Products (`)

Harsh 14.8.2015 60,000 105 63,00,000
31.12.2015 50,000 244 1,22,00,000
4.3.2016 75,000 307 2,30,25,000
1,85,000 4,15,25,000
4,15,25,000
Average Due Date = days from 1 May = 225 days.
1,85,000
= 12th Dec.
Interest is chargeable for Harsh from 12 December to 31st March i.e. for 109 days.
10 109
` 1,85,000 x x = ` 5,525
100 365
Thus, interest amounting ` 8,348 will be charged from Yash and amount of ` 5,525 will be charged from
Harsh.

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 6.148 PRINCIPLES AND PRACTICE OF ACCOUNTING

Answer 2
A B C D=B C
Principal Interest from Average Due Date to Actual date of Payment Total amount
Amount to be paid
(i) Payment on average due date
` 67,500 12 0
` 67,500 x x =0
100 365 ` 67,500
th
(ii) Payment on 25 Aug. 2016
` 67,500 12 15
` 67,500 x x = 333
100 365 ` 67,833
Interest to be charged for period of 15 days from 10.8.2016 to
25th Aug. 2016
th
(iii) Payment on 30 July, 2016
` 67,500 12 (11)
` 67,500 x x = (244)
100 365 ` 67,256
Rebate has been allowed for unexpired credit period of 11
days from 30.7.2016 to 10.8.2016

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.149

UNIT 7 : ACCOUNT CURRENT

LEARNING OUTCOMES
After studying this unit, you will be able to:

a) Understand the meaning of Account Current.

b) Learn the methods of preparing Account Current, namely preparation of Account Current with the help
of interest tables, by means of product and by means of balances.

c) Understand the calculation procedure involved in the preparation of Account Current.

UNIT OVERVIEW WAY OF PREPARING ACCOUNT CURRENT

By means of
With the help of By means of
products of
interest tables products
balances

7.1 INTRODUCTION
An Account Current is a running statement of transactions between parties for a given period of time and
includes interest allowed or charged on various items. It takes the form of an ledger account.
Some of the situations when account current is prepared are:
1. It is prepared when frequent transactions regularly take place between two parties. An example is of a
manufacturer who sells goods frequently to a merchant on credit and receives payments from him in
instalments at different intervals and charges interest on the amount which remains outstanding.
2. A consignee of goods can also prepare an Account Current, if the latter is to settle the account at the
end of the consignment & interest is chargeable on outstanding balance.
3. An Account Current also is frequently prepared to set out the transactions taking place between a
banker and his customer.
4. It is prepared when two or more persons are in joint venture and each co-venture is entitled to interest
on their investment. Also, no separate set of book is maintained for it.
An Account Current has two parties - one who renders the account and the other to whom the account is
rendered. This is indicated in the heading of an Account Current, which is like the following: “A in Account
Current with B”. It implies that A is the customer, and the account is being rendered to him by B.

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 6.150 PRINCIPLES AND PRACTICE OF ACCOUNTING

7.2 PREPARATION OF ACCOUNT CURRENT

There are three ways of preparing an Account Current:
(i) With help of interest table
(ii) By means of products
(iii) By means of products of balances

7.2.1 Method 1: Preparation of Account Current with the help of Interest Tables-Individual Method
According to this method, all the transactions are arranged in the form of an account. There are two
additional columns on both the sides of such an account.
(a) One column is meant to indicate the number of days counted from the due date of each transaction to
the date of rendering the account. If no specific date is mentioned as the date on which payment is due,
the date of the transactions is presumed to be the due date.
(b) The other column is meant for writing interest.
With the help of ready made tables, interest due on different amounts at given rates for different periods of
time is found out and this is entered against each item separately.
The interest columns of both the sides are totalled up and the balance is drawn.

? ILLUSTRATION 1
Prepare Account Current for Nath Brothers in respect of the following transactions with Shyam:

2015 `

September 16 Goods sold to Shyam 200 due 1st Oct.

October 1 Cash received from Shyam 90

October 21 Good purchased from Shyam 500 due 1st Dec.

November 1 Paid to Shyam 330

December 1 Paid to Shyam 330

December 5 Goods purchased from Shyam 500 due 1st Jan.

December 10 Goods purchased from Shyam 200 due 1st Jan.

2016

January 1 Paid to Shyam 600

January 9 Goods sold to Shyam 20 due 1st Feb.

The account is to be prepared upto 1st February. Calculate interest @ 6% per annum. (1 year = 365 days)

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.151

 SOLUTION
Shyam in Account Current with Nath Brothers
(Interest to 1st February, 2016 @ 6% p.a.)
Date Particulars Due Amount Days Inter- Date Particulars Due Amount Days Interest
est
2015 date ` 2015 date `
Sept.16 To Sales 1st Oct. 200 123 4.04 Oct. 1 By Cash A/c 1st Oct. 90 123 1.82
A/c
Nov.1 To Cash A/c 1st Nov. 330 92 5 Oct. 21 By Purchase 1st Dec. 500 62 5.1
A/c
Dec. 1 To Cash A/c 1st Dec. 330 62 3.36 Dec. 5 By Purchase 1st Jan. 500 31 2.55
A/c
Dec.10 By Purchase 1st Jan. 200 31 1.02
A/c
2016 2016
Jan. 1 To Cash A/c 1st Jan. 600 31 3.06 Feb. 1 By Balance of 4.97
Interest
Jan. 9 To sales A/c 1st Feb. 20 Feb.1 By Balance c/d 194.97 -
Feb. 1 To Interest 4.97
1,484.97 15.46 1,484.97 15.46

Tutorial Notes:
(1) While counting the number of days, the date of due date is ignored and the date upto which the account
is prepared, is included.
(2) While counting the number of days, for opening balances, the opening date as well as date upto which
the account is prepared, is counted.
Calculation of days:

Transaction Due Date Oct. Nov. Dec. Jan. Feb. Total Days
2014
16th Sept. 1st Oct. 30+ 30+ 31+ 31+ 1= 123
1st Oct. 1st Oct. 30+ 30+ 31+ 31+ 1= 123
21st Oct. 1st Dec. - - 30+ 31+ 1= 62
1st Nov. 1st Nov. - 29+ 31+ 31+ 1= 92
1st Dec. 1st Dec. - - 30+ 31+ 1= 62
5th Dec. 1st Jan. - - - 30+ 1= 31
10th Dec. 1st Jan. - - - 30+ 1= 31
2015
1st Jan. 1st Feb. - - - 30+ 1= 31
9st Jan. 1st Feb. - - - - -= 0

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 6.152 PRINCIPLES AND PRACTICE OF ACCOUNTING

7.2.2 Method 2: Preparation of Account Current by means of Products; Product Method

When this method is followed, the way of preparing the Account Current remains the same. In this method
is only the method of calculating interest is different.
Under the previous method, interest columns are provided on both the sides of the Account Current, and
interest in respect of each item is found out from the ready-made interest tables. In this method, interest
columns are replaced by “product” columns. Product in this case is the amount multiplied by the number
of days for which it has been outstanding. Interest on a certain sum of money for a certain number of days
is the same thing as interest on the product for one day. In other words, with a view to reduce the period
of each transaction to one day, the amount of each transaction is multiplied by the number of days. This
product is entered against each transaction the product column.
The remaining steps are as follows:
(a) Find out the balance of the products on the two sides.
(b) Calculate interest at the given rate on the balance of the products for a single day.
(c) Enter interest on the appropriate side in the amount column. This entry is made on the side other than
that on which the balance of products appears.
Taking Illustration 1 Account Current by means of Product is explained below :
Shyam in Account Current with Nath Brothers
(Interest to 1st February, 2016 @ 6% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
2015 date ` ` ` 2015 date ` ` `
Sept. 16 To Sales A/c 1st Oct 200 123 24,600 Oct. 1 By Cash A/c Oct.1 90 123 11,070
1 Nov. To Cash A/c 1st Nov 330 92 30,360 Oct.21 By Purchase A/c Dec.1 500 62 31,000
1 Dec. To Cash A/c 1st Dec 330 62 20,460 Dec.5 By Purchase A/c Jan. 1 500 31 15,500
Dec.10 By Purchase A/c 1-Jan 200 31 6,200
2016 2016
Jan.1 To Cash A/c 1-Jan 600 31 18,600 Feb.1 By Balance of 30,250
products
Jan.9 To Sales A/c 1-Feb 20 Feb.1 By Balance c/d 194.97
Feb.1 To Interest 4.97
(30,250x6%)/365

1,484.97 94,020 1,484.97 94,020

2016
Feb To Balance b/d 194.97

7.2.3 Method of Computing the numbers of Days

Usually any of the following two methods is used for calculating the number of days.
1. Forward Method- Under this method the number of days are calculated from the due date of the
transaction to the date of closing the account.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.153

2. Backward (or Epoque Method)- Under this method, the number of the days are calculated from the
opening date of statement to the due date of transaction.
EXAMPLE
From the following particulars, make up an Account Current to be rendered by Mr. X to Mr. Y on 31st December,
2016 taking interest into account at the rate of 18% p.a.

01.07. 2016 Balance owing by Mr. Y ` 600

30.07. 2016 Goods sold to Mr. Y (Credit Period allowed 1 month) ` 300

01.08. 2016 Good purchased from Mr. Y (Credit Period received 1 month) ` 200

01.09. 2016 Cash received from Mr. Y ` 100

01.09. 2016 Mr. Y accepted Mr. X’s Draft at 3 Months date ` 400

You are required to prepare the Account Current according to interest on individual transaction under the Forward
and Backward methods.

 SOLUTION
(a) Product of individual Transaction Method (Forward Method)
Mr. Y in Account Current with Mr. X (interest to 31st Dec. 2016 @ 18% p.a.)

Date Particulars Due Amt. Days Product Date Particulars Due Amt. Days Product
` ` ` `
date date
01.07.2016 To Balance b/d 600 184 1,10,400 01.08.2016 By Sep. 1 200 121 24,200
Purchase
A/c
30.07.2016 To Sales A/c Aug 300 123 36,900 01.09.2016 By Cash A/c Sep. 1 100 121 12,100
30
31.12. 2016 To Interest on 49 01.09.2016 By B/R A/c Dec. 4 400 27 10,800
Balance
for 1 day @
18%

[ [
1,00,200 x 18 x 1
100 x 365

31.12.2017 By Balance 1,00,200

of Products
31.12.2017 By Balance 249
c/d
949 1,47,300 949 1,47,300

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 6.154 PRINCIPLES AND PRACTICE OF ACCOUNTING

b) Product of individual Transaction Method (Epoque Method)

Mr. Y in Account Current with Mr. X (interest to 31st Dec. 2016 @ 18% p.a.)
Date Particulars Due Amt. Days Product Date Particulars Due Amt. Days Product
` ` date ` `
date
01.07.2016 To Balance b/d 600 01.08.2016 By Purchase Sep. 1 200 63 12,600
A/c
30.07.2016 To Sales A/c 30- 300 61 18,300 01.09.2016 By Cash A/c Sep. 1 100 63 6,300
Aug
31.12.2016 To Balance of 1,00,200 01.09.2016 By B/R A/c Dec. 4 400 157 62,800
Product
31.12.2016 To Interest on 49 31.12.2016 By Balance 36,800
Balance for 1 of
day @ 18% Products
[200 x
[1,00,200 x 18 x 1
100 x 365 [ 184]

31.12.2016 By Balance 249

c/d
949 - 1,18,500 949 1,18,500

? ILLUSTRATION 2

From the following particulars prepare the account current to be rendered by Mr. Singh to Mr. Paul as on 31st
August, 2016. Interest must be calculated @ 10% p.a. (1 year = 365 days)

2014 `
June 11 Goods sent to Mr. Paul 1,020
June 15 Cash received from Mr. Paul 500
June 20 Goods sent to Mr. Paul 650
July 7 Goods sent to Mr. Paul 700
Aug 8 Cash received from Mr. Paul 1,100

 SOLUTION
Mr. Paul in Account Current with Mr. Singh
(Interest to 31st August, 2016 @ 10% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
2016 Date ` 2016 Date `
June 11 To Sales A/c June 11 1,020 81 82,620 June 15 By Cash A/c June 15 500 77 38,500
June 20 To Sales A/c June 20 650 72 46,800 Aug.8 By Cash A/c Aug.8 1,100 23 25,300
July 7 To Sales A/c July 7 700 55 38,500 Aug.31 By Balance of 1,04,120
product
Aug.31 To Interest A/c 28.53 Aug. 31 Balance c/d 798.53

1,04,120 10
x 100
365
2,398.53 1,67,920 2,398.53 1,67,920
Sept. To Balance b/d 798.53

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.155

? ILLUSTRATION 3
From the following particulars make up an Account Current to be rendered by S. Dasgupta to A. Halder at 31st
Dec. reckoning interest at 5% p.a. (assume 1 year = 365 days)

2016 `
June 30 Balance owing by A. Halder 520
July 17 Goods sold to A. Halder 40
Aug. 1 Cash received from A. Halder 500
Aug. 19 Goods sold to A. Halder 720
Aug. 30 Goods sold to A. Halder 50
Sept. 1 Cash received from A. Halder 400
Sept. 1 A. Halder accepted Dasgupta’s Bill at 3 month date for 300
Oct. 22 Goods bought from A. Halder 20
Nov. 12 Goods sold to A. Halder 14
Dec. 14 Cash received from A. Halder 50

 SOLUTION
A. Halder in Current Account with Mr. S. Dasgupta
(Interest to 31st December, 2016 @ 5% p.a.)

Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product

2016 Date ` 2016 Date `

June 30 To Balance b/d 520 185 96,200 Aug.1 By Cash A/c Aug.1 500 152 76,000

July 17 To Sales A/c July 17 40 167 6,680 Sep.1 By Cash A/c Sep.1 400 121 48,400

Aug.19 To Sales A/c Aug.19 720 134 96,480 Sep.1 By Bills Dec.4 300 27 8,100
Receivable

A/c (Note : 1)

Aug. 30 To Sales A/c Aug.30 50 123 6,150 Oct.22 By Purchases Oct.22 20 70 1,400
A/c

Nov.12 To Sales A/c Nov.12 14 49 686 Dec.14 By Cash A/c Dec.14 50 17 850

Dec.31 By Balance of 71,446

product

31 Dec. To Interest A/c 9.79 Dec.31 By Balance b/d

83.79 -------

71,446 x 5%
365
1,353.79 2,06,196 1,353.79 2,06,196

Note: It is assumed that the bill was honoured on due date. The due date of the bill should be treated as date
of payment and days to be calculated from the due date of account.

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 6.156 PRINCIPLES AND PRACTICE OF ACCOUNTING

Workings:
Calculation of Days
Date of Transactions : Due date June July Aug. Sept. Oct. Nov. Dec. Total
Opening Balance 1 +31 +31 +30 +31 +30 +31 = 185
July 17 July 17 - 14 +31 +30 +31 +30 +31 = 167
Aug. 1 Aug. 1 - - 30 +30 +31 +30 +31 = 152
Aug. 19 Aug. 19 - - 12 +30 +31 +30 +31 = 134
Aug. 30 Aug. 30 - - 1 +30 +31 +30 +31 = 123
Sep. 1 Sep. 1 - - - 29 +31 +30 +31 = 121
Sep. 1 Dec. 4 - - - - - - 27 = 27
Oct. 22 Oct. 22 - - - - 9 +30 +31 = 70
Nov. 12 Nov. 12 - - - - - 18 +31 = 49
Dec. 14 Dec. 14 - - - - - - 17 = 17
Note: While counting the number of days, for opening balances, the opening date as well as date upto
which the account is prepared, is counted.

? ILLUSTRATION 4
From the following prepare an account current, as sent by A to B on 30th June, 2016 by means of products method
charging interest @ 6% p.a:
2016 `
Jan. 1 Balance due from B 600
Jan.11 Sold goods to B 520
Jan. 18 B returns Goods 125
Feb 11 B Paid by cheque 400
Feb 14 B accepted a bill drawn by A for one month 300
Apr. 29 Goods sold to B 615
May 15 Received cash from B 700

 SOLUTION
B in Account Current with A
for the period ending on 30th June, 2016
Date Particulars Amount Days Products Date Particulars Amount Days Products
2016 ` 2016 `
Jan.1 To Balance b/d 600 182 1,09,200 Jan.18 By Sales Returns 125 164 20,500
Jan. 11 To Sales A/c 520 171 88,920 Feb. 11 By Bank A/c 400 140 56,000
Apr. 29 To Sales A/c 615 62 38,130 Feb. 14 By B/R A/c (due 300 105 31,500
June 30 To Interest A/c 15.75 date: March 17)
May 15 By Cash A/c 700 46 32,200
June By Balance of 96,050
30 products
By Balance c/d 225.75
1,750.75 2,36,250 1,750.75 2,36,250

Calculation of interest:
96,050 6
Interest = x = ` 15.75
366 100

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.157

Red - Ink Interest: In case the due date of a bill falls after the date of closing the account, then no interest
is allowed for that. However, interest from the date of closing to such due date is written in “Red-Ink” in
the appropriate side of the ‘Account current’. This interest is called Red-Ink interest. This Red Ink interest is
treated as negative interest. In actual practice, however the product of such bill [value of bill X (due date-
closing date) is written in ordinary ink in the opposite side on which the bill is entered]. It means interest
from future date from date of account current i.e., present date. In earlier periods, it was written in red ink;
hence it got the name of red ink interest. It implies that rebate will be allowed on interest paid/ received, if
settlement of future due transaction is done on account current date
This can also be understood in a different way. In an account current, interest is calculated on the amount
of a bill from the date of transaction to the closing date of the period concerned. In case the due date of
the bill falls after the closing date of the accounts, then no interest is allowed for that period. Such interest
is customarily written in red ink in the appropriate side of the account current. The interest is called Red-Ink
interest and is treated as negative interest.

? ILLUSTRATION 5
Following transaction took place between X and Y during the month of April, 2016.
April `
1 Amount payable by X to Y 10,000
7 Received acceptance of X to Y for 2 months 5,000
10 Bills receivable (accepted by Y) on 7.2.2016is honoured on this due date
10 X sold goods to Y (invoice dated 10.5.2016) 15,000
12 X received cheque form Y dated 15.5.2016 7,500
15 Y sold goods to X (invoice dated 15.5.2016) 6,000
20 X returned goods sold by Y on 15.4.2016 1,000
20 Bill accepted by Y is dishonoured on this due date 5,000
You are required to make out an account current by products method to be rendered by X to Y as on 30.4.2016,
taking interest into account @ 10% p.a. (assume 1 year = 365 days)

 SOLUTION
‘Y’ In Account Current with ‘X’
(Interest to 30th April, 2016 @ 10% p.a.)
Date Particulars Due Amount Days Product Date Particulars Due Amount Days Product
Date ` Date `
2016 2016 2016 2016
April 7 To Bills June 10 5,000 - - April 1 By Balance b/d 10,000 30 3,00,000
Payable
April 10 To Sales A/c May 10 15,000 - - April 12 By Bank A/c May 15 7,500 - -
(Cheque received
dated 15.5.2016)
April 20 To Purchase May 15 1,000 - - April 15 By Purchase A/c May 15 6,000 - -
Returns (invoice dated
15.5.2016)
April 20 To Bill April 20 5,000 10 50,000
Receivable
A/c

© The Institute of Chartered Accountants of India

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 6.158 PRINCIPLES AND PRACTICE OF ACCOUNTING

April 30 To Red Ink May 15 15 1,12,500 April 30 By Red Ink Product June10 - 41 2,05,000
Product as per contra
(` 7,500 x15) (5,000 x 41)
as per contra
April 30 To Red Ink May 15 15 90,000 April 30 By Red Ink May 10 - 10 1,50,000
Product Product
(` 6,000 x15) as per contra
as per contra (15,000 x 10)
April 30 To Balance 4,17,500 April 30 By Red Ink May 15 - - 15,000
of Product as per
product contra
(1,000 x 15)
April 30 By Interest A/c 114.38
10 1
4,17,500 x x
100 365
April 30 By Balance c/d 2,385.62
26,000 6,70,000 26,000 6,70,000

No entry is required for matured bill on 10th April since party is not contracted.
7.2.4 Method 3: Preparation of Account Current by Means of Product of Balances in case of Banks.
This method, also known as periodic balance method, is usually adopted in the case of banks where the
balance of account is taken out after every transaction. In this case, the number of days written against each
transaction are the days counted from its date or due date to the date of the following transaction. In the
case of the last transaction, the number of days is counted to the close of the period.
Each amount is multiplied with the number of days. If the amount represents a debit balance, the product
is entered in the Dr. Product column; and if it represents a credit balance, the product is written in the Cr.
Product column. The Dr. Product and Cr. Product columns are then totalled up. Interest is calculated on each
total at the given rate of interest; and the net interest is ascertained. If net interest is payable to the customer,
it will appear as “By Interest A/c”, and if it is due from the customer, it will appear as “To Interest A/c”.

? ILLUSTRATION 6

On 2nd January, 2016 Vinod opened a current account with the Allahabad Bank Limited; and deposited a sum of
` 30,000.

He further deposited the following amounts: `

th
15 January 12,000
12th March 8,000
th
10 May 16,000

His withdrawals were as follows :

15th February 26,000
th
10 April 30,000
th
15 June 14,000
Show Vinod’s a/c in the ledger of the Allahabad Bank. Interest is to be calculated at 5% on the debit balance and
2% on credit balance. The account to be prepared as on 30th June, 2016. Calculation may be made correct to the
nearest rupee.

© The Institute of Chartered Accountants of India

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.159

 SOLUTION
Vinod Current Account with Allahabad Bank Ltd.
Date Particular Dr. Cr. Dr. or Cr. Balance Days Dr. Product Cr. Product

2016

Jan. 2 By Cash Account - 30,000 Cr. 30,000 13 - 3,90,000

Jan. 15 By Cash Account - 12,000 Cr. 42,000 31 - 13,02,000

Feb. 15 To Self 26,000 - Cr. 16,000 25 - 4,00,000

Mar. 12 By Cash Account - 8,000 Cr. 24,000 29 - 6,96,000

April 10 To Self 30,000 - Dr. 6,000 30 1,80,000 -

May 10 By Cash Account - 16,000 Cr. 10,000 36 - 3,60,000

June 15 To Self 14,000 - Dr. 4,000 16 64,000 -

June 30 By Interest A/c - 140 Dr. 3,860 - -

June 30 By Balance c/d 3,860 -

70,000 70,000 2,44,000 31,48,000

July 1 To Balance b/d 3,860

* Interest is calculated as follows:

On ` 31,48,000 @ 2% for 1 day = ` 172.49
On ` 2,44,000 @ 5% for 1 day = ` 33.42
Net Interest = ` 139.07 (` 172.49- ` 33.42)

SUMMARY
w When interest calculation becomes an integral part of the account. The account maintained is called
“Account Current”.
Some examples where it is maintained are:
(i) Frequent transactions between two parties.
(ii) Goods sent on consignment
(iii) Frequent transactions between a banker and his customers
(iv) In case of Joint venture when no separate set of books is maintained for joint venture
w There are three ways of preparing an Account Current :
(i) With the help of interest tables
(ii) By means of products
(iii) By means of products of balances

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 6.160 PRINCIPLES AND PRACTICE OF ACCOUNTING

TEST YOUR KNOWLEDGE

Multiple Choice Questions
1 Red ink interest is
(a) really not interest
(b) negative interest
(c) used in connection with average due date.
2 An account current is a statement of mutual transactions
(a) between two parties
(b) in lieu of average due date
(c) prepared for a particular accounting period.
3 In account current, while counting the number of days, the due date is ignored and date up to
which the accounts are prepared, is
(a) included (b) excluded (c) ignored

Theoretical Questions
1. Define Account Current. Explain ways of preparing an Account Current
2. Write short note on Red-ink interest.
Practical Questions
1. Roshan has a current account with partnership firm. It has debit balance of ` 75,000 as on 01-07-2016.
He has further deposited the following amounts:
Date Amount (`)
14-07-2016 1,38,000
18-08-2016 22,000
He withdrew the following amounts :
Date Amount (`)
29-07-2016 97,000
09-09-2016 11,000
Show Roshan’s A/c in the ledger of the firm. Interest is to be calculated at 10% on debit balance and 8% on
credit balance. You are required to prepare current account as on 30th September, 2016 by means of product
of balances method.
2. From the following particulars prepare a account current, as sent by Mr. Ram to Mr. Siva as on 31st
October 2016 by means of product method charging interest @ 5% p.a.

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 ACCOUNTING FOR SPECIAL TRANSACTIONS 6.161

2016 Particulars `
1st July Balance due from Siva 750
15th August Sold goods to Siva 1250
20th August Goods returned by Siva 200
22nd Sep Siva paid by cheque 800
15th Oct Received cash from Siva 500
ANSWERS/HINTS
MCQs
1. (b) 2. (a) 3. (a)
Theoretical Questions
1. An Account Current is a running statement of transactions between parties for a given period of time
and includes interest allowed or charged on various items. It takes the form of an ledger account.
There are three ways of preparing an Account Current:
(i) With help of interest table.
(ii) By means of products.
(iii) By means of products of balances.
2. In case the due date of a bill falls after the date of closing the account, then no interest is allowed for that.
However, interest from the date of closing to such due date is written in “Red-Ink” in the appropriate
side of the ‘Account current’. This interest is called Red-Ink interest. This Red Ink interest is treated as
negative interest. In actual practice, however the product of such bill [value of bill X (due date-closing
date) is written in ordinary ink in the opposite side on which the bill is entered]. It means interest from
future date from date of account current i.e., present date. In earlier periods, it was written in red ink;
hence it got the name of red ink interest. It implies that rebate will be allowed on interest paid/ received,
if settlement of future due transaction is done on account current date

© The Institute of Chartered Accountants of India

Sample output to test PDF Combine only
 6.162 PRINCIPLES AND PRACTICE OF ACCOUNTING

Practical Questions
Answers 1
Roshan’s Current Account with Partnership firm (as on 30.9.2016)

Date Particulars Dr Cr Balance Dr. Days Dr Cr

or Product Product
(`) (`) (`) Cr. (`) (`)
01.07.16 To Bal b/d 75,000 75,000 Dr. 13 9,75,000
14.07.16 By Cash A/c 1,38,000 63,000 Cr. 15 9,45,000
29.07.16 To Self 97,000 34,000 Dr. 20 6,80,000
18.08.16 By Cash A/c 22,000 12,000 Dr. 22 2,64,000
09.09.16 To Self 11,000 23,000 Dr. 22 5,06,000
30.09.16 To Interest A/c 457 23,457 Dr.
30.09.16 By Bal. c/d 23,457
1,83,457 1,83,457 24,25,000 9,45,000
Interest Calculation:

On ` 24,25,000x 10% x 1/365 = 664

On ` 9,45,000 x 8% x 1/365 = (` 207)
Net interest to be debited = (` 457)
Answers 2
Siva in Account Current with Ram as on 31st Oct, 2016

` Days Product ` Days Product

(`) (`)
01.07.16 To Bal. b/d 750 123 92,250 20.08.16 By Sales 200 72 14,400
Returns
15.8.16 To Sales 1,250 77 96,250 22.09.16 By Bank 800 39 31,200
31.10.16 To Interest 18.48 15.10.16 By Cash 500 16 8,000
By Balance of 1,34,900
Products
31.10.16 By Bal. c/d 518.48
2018.48 1,88,500 2018.48 1,88,500

5 1
Interest = ` 1,34,900 x x = ` 18.48
100 365

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