BOOK KEEPING & ACCOUNTANCY

CHAPTER – 1
THEORETICAL FOUNDATIONS OF FINANCIAL ACCOUNTING

Objective of Accounting: The main objectives of Accounting are

1. To maintain systematic records.
2. To ascertain net profits or net loss of the business.
3. To ascertain the financial position of the business.
4. To provide accounting information to interested parties.

Parties Interested in Accounting Informations: Accounting informations are needed by the owners, managers, lenders,
creditors, prospective investors, tax authorities, employees and researchers of the business to study the present position of
business and to compare the performance with past years and with the similar enterprises.

Advantage of Accounting:
1. Replacement of Memory
2. Provide Control over Assets
3. Facilitate preparation of Financial Statements
4. Meets the information requirement
5. Facilitate a comparative study
6. Assist the Management in other ways
7. Held in tax matters

Introduction:
The purpose of accounting is to provide information that is needed for sound economic decision making. The main purpose
of financial accounting is to prepare financial reports that provide information about a firm’s performance to external parties
such as investors, creditors and tax authorities. Managerial accounting contrasts with financial accounting in that managerial
accounting is for internal decision making and does not have to follow any rules issued by standard-setting bodies. Financial
accounting, on the other hand, is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.
Cost Accounting is concerned with ascertainment and control of costs.

Definition of Accounting:
According to the American Marketing Association, ”Accounting is the process of identifying, measuring and
communicating economic information to permit informed judgements and decision by users of the information.”

According to American Institute of Certified Public Accountants, “Accounting is the art of recording, classifying and
summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a
financing character and interpreting the results thereof.”

Accounting Standards
In order that financial statements report financial performance fairly and consistently, they are prepared according to widely
accepted accounting standards. These standards are referred to as Generally Accepted Accounting Principles, or simply
GAAP. Generally Accepted Accounting Principles are those that have “substantial authoritative support”.

Accrual vs. Cash Method

Many small businesses utilize an accounting system that recognizes revenue and expenses on a cash basis; meaning that
neither revenue nor expenses are recognized until the cash associated with them actually is received. Most larger businesses,
however, use the accrual method.

Under the accrual method, revenues and expenses are recorded according to when they are earned and incurred, not
necessarily when the cash is received or paid. For example, under the accrual method revenue is recognized when customers
are invoiced, regardless of when payment is received. Similarly, an expense is recognized when the bill is received, not
when payment is made.

Under accrual accounting, even though employees may be paid in the next accounting period of work performed near the
end of the present accounting period, the expense still is recorded in the current period since the current period is when the
expense was incurred.

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Underlying Assumptions, Principles, and Conventions
Financial accounting relies on the following underlying concepts:

 Assumptions: Separate entity assumption, going-concern assumption, stable monetary unit assumption, fixed time
period assumption.
 Principles: Historical cost principle, matching principle, revenue recognition principle, full disclosure principle.
 Modifying conventions: Materiality, cost-benefit, conversation convention, industry practices convention.

Financial Statements
Businesses have two primary objectives:

 Earn a profit
 Remain solvent

Solvency represents the ability of the business to pay its bills and service its debt.

The four financial statements are reports that allow interested parties to evaluate the profitability and solvency of a business.
These reports include the following financial statements:

 Balance Sheet
 Income Statement
 Statement of Owner’s Equity
 Statement of Cash Flows

These four financial statements are the final product of the accountant’s analysis of the transactions of a business. A large
amount of effort goes into the preparation of the financial statements. The process begins with bookkeeping, which is just
one step in the accounting process. Bookkeeping is the actual recording of the company’s transactions, without any analysis
of the information. Accountants evaluate and analyze the information, making sense out of the numbers.

For the reports to useful, they must be:

 Understandable
 Timely
 Relevant
 Fair and Objective (free from bias)

Double Entry Accounting

Financial accounting is based on double-entry bookkeeping procedures in which each transaction is recorded in opposite
columns of the accounts affected by the exchange. Double entry accounting is a significant improvement over simple and
more error-prone single-entry bookkeeping systems.

Fundamental Accounting Model

The balance sheet is based on the following fundamental accounting equation:

Assets = Liabilities + Equity

This model has been used since the 18th century. It essentially states that a business owes all of its assets to either creditors
or owners, where the assets of a business are its resources, and the creditors and owners are the sources of those resources.

Transactions:
To record transactions, one must:

1. Identify an event that affects the entity financially.

2. Measure the event in monetary terms.
3. Determine which accounts the transaction affects.
4. Determine whether the transaction increases or decreases the balances in those accounts.
5. Record the transaction in the ledgers.

Most larger business accounting systems utilize the double entry method. Under double entry, instead of recording a
transaction in only a single account, the transaction is recorded in two accounts.

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The Accounting Process
Once a business transaction occurs, a sequence of activities begins to identify and analyze the transaction, make the journal
entries, etc. Because this process repeats over transactions and accounting periods; it is referred to as the accounting cycle.

THE ACCOUNTING CYCLE

The sequence of activities beginning with the occurrence of a transaction is known as the accounting cycle. This process is
shown in the following diagram:

Steps in the Accounting Cycle

Identify the Transaction

Identify the event as a transaction and
generate the source document.

Analyse the Transaction

Determine the transaction amount,
which accounts are affected, and in
which direction.

Journal Entries
The transaction is recorded in the
journal as a debit and a credit.

Post to Ledger
The journal entries are transferred to
the appropriate T-accounts in the
ledger.

Trial Balance
A trial balance is calculated to verify
that the sum of the debits is equal to
the sum of the credits.

Adjusting Entries
Adjusting entries are made for
accrued and deferred items. The
entries are journalized and posted to
the T-accounts in the ledger.

Adjusted Trial Balance

A new trial balance is calculated after
making the adjustment

Financial Statements
The financial statements are
prepared.
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 Closing Entries
Transfer the balances of the
temporary accounts (e.g. revenues
and expenses) to owner’s equity.

After-Closing Trial Balance

A final trial balance is calculated
after the closing entries are made.

The above diagram shows the financial statements as being prepared after the adjusting entries and adjusted trial balance.
The financial statements also can be prepared before the adjusting entries with the help of a worksheet that calculates the
impact of the adjusting entries before they actually are posted.

THE SOURCE DOCUMENT

When a business transaction occurs, a document known as the source document captures the key data of the transaction.
The source document describes the basic facts of the transaction such as its date, purpose, and amount.

Some examples of source documents:

 Cash receipt
 Cancelled cheque
 Invoice sent or received
 Credit memo for a customer refund
 Employee time sheet

The source document is the initial input to the accounting process and serves as objective evidence of the transaction,
serving as part of the audit trail should the firm need to prove that a transaction occurred.

To facilitate referencing, each source document should have a unique identifier, usually a number or alphanumeric code.
Prenumbering of commonly-used forms helps to enforce numbering, to classify transactions, and to identify and locate
missing source documents. A well-designed source document form can minimize errors and improve the efficiency of
transaction recording.

The source document may be created in either paper or electronic format. For example, automated accounting systems may
generate the source document electronically or allow paper source documents to be scanned and converted into electronic
images. Accounting software often provides on-screen entry forms for different types of transactions to capture the data and
generate the source document.

The source document is an early document in the accounting cycle. It provides the information required to analyze and
classify the transaction and to create the journal entries.

ACCOUNTING CONCEPTS

Underlying Assumptions, Principles, and Conventions

Financial accounting relies on several underlying concepts that have a significant impact on the practice of accounting.

Assumptions:
The following are basic financial accounting assumptions:

 Separate entity assumption – the business is an entity that is separate and distinct from its owners, so that the
finances of the firm are not co-mingled with the finances of the owners.
 Going concern assumption – the business is going to be operating for the foreseeable future.
 Stable monetary unit assumption – e.g. the U.S. dollar
 Fixed time period assumption – info prepared and reported periodically (quarterly, annually, etc.)

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Principles:
The basic assumptions of accounting result in the following accounting principles:

 Historical cost principles – assets are reported and presented at their original cost and no adjustment is made for
changes in market value. One never writes up the cost of an asset. Accountants are very conservative in this sense.
Sometimes costs are written down, for example, for some short-term investments and marketable securities, but
costs never are written up.
 Matching principle – matching of revenues and expenses in the period earned and incurred.
 Revenue recognition principle – revenue is realized (reported on the books as earned) when everything that is
necessary to earn the revenue has been completed.
 Full disclosure principle – all of the information about the business entity that is needed by users is disclosed in
understandable form.

Modifying Conventions
Due to practical constraints and industry practice, GAAP principles are not always applied strictly but are modified as
necessary. The following are some commonly observed modifying conventions:

 Materiality convention – a modifying convention that relaxes certain GAAP requirements if the impact is not large
enough to influence decisions. Users of the information should not be overburdened with information overload.
 Cost-benefit convention – a modifying convention that relaxes GAAP requirements if the expected cost of
reporting something exceeds the benefits of reporting it.
 Conservation convention – when there is a choice of equally acceptable accounting methods, the firm should use
the one that is least likely to overstate income or assets.
 Industry practices convention – accepted industry practices should be followed even if they differ from GAAP.
THE ACCOUNTING EQUATION

The resources controlled by a business are referred to as its assets. For a new business, those assets originate from t wo
possible sources:

 Investors who buy ownership in the business

 Creditors who extend loans to the business

Those who contribute assets to a business have legal claims on those assets. Since the total assets of the business are equal
to the sum of the assets contributed by investors and the assets contributed by creditors, the following relationship holds and
is referred to as the accounting equation:

Assets = Liabilities + Owners’ Equity

Resources Claims on the Resources

Initially, owner equity is affected by capital contributions such as the issuance of stock. Once business operations
commence, there will be income (revenues minus expenses, and gains minus losses) and perhaps additional capital
contributions and withdrawals such as dividends. At the end of a reporting period, these items will impact the owners’
equity as follows:

Assets = Liabilities + Owners’ Equity

+ Revenues
- Expenses
+ Gains
- Losses
+ Contributions
- Withdrawals

These additional items under owners’ equity are tracked in temporary accounts until the end of the accounting period, at
which time they are closed to owners’ equity.

The accounting equation holds at all times over the life of the business when a transaction occurs, the total assets of the
business may change, but the equation will remain in balance. The accounting equation serves as the basis for the balance
sheet, as illustrated in the following example.

The Accounting Equation – A Practical Example

To better understand the accounting equation, consider the following example. Mike Peddler decides to open a bicycle
repair shop. To get started he rents some shop space, purchases an initial inventory of bike parts, and opens the shop for
business. Here is a listing of the transactions that occurred during the first month:
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Date Transaction
Sep 1 Owner contributes Rs. 7,500 in cash to capitalize the business.
Sep 8 Purchased Rs. 2,500 in bike parts on account, payable in 30 days.
Sep 15 Paid first month’s shop rent of Rs. 1,000.
Sep 17 Repaired bikes for Rs. 1,100; collected Rs. 400 cash; billed customers
for the Rs. 700 balance.
Sep 18 Rs.275 in bike parts were used.
Sep 28 Paid Rs.500 to suppliers for parts purchased earlier in the month.
These transactions affect the accounting equation as shown below:

Assets = Liabilities + Owner’s Equity

Bike Accounts Accounts Peddler Revenue

Cash + + = + +
Parts Receivables Payable Capital (Expenses)

Sep 1 7,500 = 7,500

Sep 8 2,500 = 2,500

Sep 15 (1000) = (1000)

Sep 17 400 700 = 1100

Sep 18 (275) = (275)

Sep 25 425 (425) =

Sep 28 (500) = (500)

Totals: 6825 + 2225 + 275 = 2000 + 7500 + (175)

Rs. 9325 = Rs. 9325

Note that for each date in the above example, the sum of entries under the “Assets” heading is equal to the sum of entries
under the “Liabilities + Owner’s Equity” heading. In most of these cases, the transaction affected only the asset side with an
increase in cash and an equal but opposite decrease in accounts receivable.

At the end of the month of September, the net income (revenues minus expenses) is closed to capital and the balance sheet
for the business would appear as follows:

Peddler’s Bikes
Balance Sheet
September 30, 20xx
Assets Liabilities & Owner’s Equity
Cash 6,825 Accounts Payable 2,000
Accounts Receivables 275 Peddler, Capital 7,325
Bike Parts 2,225
Total Assets Rs. 9,325 Total Liabilities Rs. 9,325

The bike parts are considered to be inventory, which appears as an asset on the balance sheet. The owner’s equity is
modified according to the difference between revenues and expenses. In this case, the difference is a loss of Rs. 175, so the
owner’s equity has decreased from Rs.7,500 at the beginning of the month to Rs.7,325 at the end of the month.

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Debits and Credits

The above example illustrates how the accounting equation remains in balance for each transaction. Note that negative
amounts were portrayed as negative numbers. In practice, negative numbers are not used; in a double-entry bookkeeping
system the recording of each transaction is made via debits and credits in the appropriate accounts.

DEBITS AND CREDITS

In double entry accounting, rather than using a single column for each account and entering some numbers as positive and
others as negative, we use two columns for each account and enter only positive numbers. Whether the entry increases or
decreases the account is determined by choice of the column in which it is entered. Entries in the left column are referred to
as debits, and entries in the right column are referred to as credits.

Two accounts always are affected by each transaction, and one of those entries must be a debit and the other must be a
credit of equal amount. Actually, more than two accounts can be used if the transaction is spread among them, just as long
as the sum of debits for the transaction equals the sum of credits for it.

The double entry accounting system provides a system of checks and balances. By summing up all of the debits and
summing up all of the credits and comparing the two totals, one can detect and have the opportunity to correct many
common types of bookkeeping errors.

To avoid confusion over debits and credits, avoid thinking of them in the way that they are used in everyday language,
which often refers to a credit as increasing an account and a debit as decreasing an account. For example, if our bank credits
our checking account, money is added to it and the balance increases. In accounting terms, however, if a transaction causes
a company’s checking account to be credited, its balance decreases. Moreover, crediting another company account such as
accounts payable will increase its balance. Without further explanation, it is no wonder that there often is confusion between
debits and credits.

The confusion can be eliminated by remembering one thing. In accounting, the verbs “debits” and “credit” have the
following meanings:

Debit Credit

“Enter in the left column of” “Enter in the right column of”

That’s all. Debit refers to the left column; credit refers to the right column. To debit the cash account simply means to enter
the value in the left column of the cash account. There are no deeper meanings with which to be concerned.

The reason for the apparent inconsistency when comparing everyday language to accounting language is that from the bank
customer’s perspective, a checking account is an asset account. From the bank’s perspective, the customer’s account appears
on the balance sheet as a liability account, and a liability account’s balance is increased by crediting it. In common use, we
use the terminology from the perspective of the bank’s books, hence the apparent inconsistency.

Whether a debit or a credit increases or decreases an account balance depends on the type of account. Asset and expenses
accounts are increased on the debit side, and liability, equity, and revenue accounts are increased on the credit side. The
following chart serves as a graphical reference for increasing and decreasing account balances:

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 Assets = Liabilities + Owner’s Equity

Cash A/P Retained Earnings

Debit Credit Debit Credit Debit Credit

+ - - + - +

Expense Revenue

Debit Credit Debit Credit

+ - - +

The whole Double Entry Book keeping system is based on the fundamental rules of debit and credit. The accounts are
classified into three categories, viz. Personal Accounts, Real Accounts, & Nominal Accounts.

Personal Accounts: The Accounts of Persons whether natural or artificial e.g. Capital A/c, Ram A/c. Mohan A/c, Creditors
A/c, Debtors A/c, ABC Ltd. A/c etc.
Real Accounts: Real Accounts are the A/c of Assets and other real things of the enterprise viz, Cash A/c, Plant
A/c, Building A/c, Land A/c, Furniture A/c, Goodwill A/c etc.
Nominal Accounts: Nominal accounts are the A/c of nominal things such as income, Expenses, profits & losses; e.g.
Wage A/c, Bad debt A/c, Salaries A/c, commission A/c, Internal A/c etc.

Rules of Debit & Credit of different Accounts:-

Personal A/c
 Debit the receiver.
 Credit the giver.

Real A/c
 Debit what comes in the business.
 Credit what goes out of the business.

Nominal A/c
 Debit all the losses and expenses.
 Credit all the gains and incomes.

Note: The Journal Entries are recorded on the basis of the values of debit & credit of different accounts.

DOUBLE ENTRY BOOKKEEPING

A business transaction involves an exchange between two accounts. For example, for every asset there exists a claim on that
asset, either by those who won the business or those who loan money to the business. Similarly, the sale of a product affects
both the amount of cash ( or cash receivable) held by the business and the inventory held.

Recognizing this fundamental dual nature of transactions, merchants in medieval Venice began using a double-entry
bookkeeping system that records each transaction in the two accounts affected by the exchange. In the late 1400s,
Franciscan monk and mathematician Luca Pacioli documented the procedure for double-entry bookkeeping as part of his
famous Summa work, which described a significant portion of the accounting cycle. Double-entry bookkeeping spread
throughout Europe and become the foundation of modern accounting.

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Two notable characteristics of double-entry systems are that 1) each transaction is recorded in two accounts, and 2) each
account has two columns.

In a double-entry system, two entries are made for each transaction – one entry as a debit in one account and the other entry
as a credit in another account. The two entries keep the accounting equation in balance so that:

Assets = Liabilities + Owners’ Equity

To illustrate, consider a repair shop with a transaction involving repair service performed on Jan 4 for a cash payment of Rs.
275.00. In a single-entry bookkeeping system, the transaction would be recorded as follows:

Single Entry Example

Date Description Revenues Expenses
Jan 4 Performed repair service 275.00

In a double-entry system, the transaction would be recorded as follows:

Double Entry Example

Date Accounts Debit Credit
Jan 4 Cash 275.00
Revenue 275.00

A notation may be added to this journal entry to indicate that the revenue was from repair services.

Note that two accounts (revenue and cash) are affected by the transaction. If the customer did not pay cash but instead was
extended credit, then “accounts receivable” would have been used instead of “cash”.

In the system, the double entries take the form of debits and credits, with debits in the left column and credits in the right.
For each debit there is an equal and opposite credit and the sum of all debits therefore must equal the sum of all credits. This
principle is useful for identifying errors in the transaction recording process.

Double-entry accounting has the following advantages over single-entry:

 Accurate calculation of profit and loss in complex organizations.

 Inclusion of assets and liabilities in the bookkeeping accounts.
 Preparation of financial statements directly from the account.
 Easier detection of errors and fraud

To appreciate the importance of double-entry bookkeeping, it is interesting to note that the industrial revolution might not
have been possible without it. At all time, businesses increased in size and complexity. Accurate bookkeeping was required
for managers to understand the financial status of their businesses in order to keep them solvent and offer a degree of
transparency to investors. While a single-entry system can be adapted by a skilled bookkeeper to meet some of these needs,
only a double-entry system provides the required detail systematically and by design.

JOURNAL ENTRIES

After a transaction occurs and a source document is generated, the transaction is analyzed and entries are made in the
general journal. A journal is a chronological listing of the firm’s transactions, including the amounts, accounts that are
affected, and in which direction the accounts are affected. A journal entry takes the following format:

Format of a General Journal Entry

Date Accounts Debit Credit

mm/dd Account to be debited xxxx.xx
Account to be credited xxxx.xx

In addition to this information, a journal entry may include a short notation that describes the transaction. There also may be
a column for a reference number so that the transaction can be tracked through the accounting system.

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The above format shows the journal entry for a single transaction. Additional transactions would be recorded in the same
format directly below the first one, resulting in a time-oriented record. The journal format provides the benefit that all of the
transactions are listed in chronological order, and all parts (debits and credits) of each transaction are listed together.

Because the journal is where the information from the source document first enters the accounting system, it is known as the
book of original entry.

Compound Journal Entries

The format shown above has a single entry for the debit and a single entry for the credit. This type of entry is known as a
simple journal entry. Sometimes, more than two accounts are affected by a transaction so more than two lines are required.
Such a journal entry is known as a compound journal entry and takes the following format:

Format of a Compound Journal Entry

Date Accounts Debit Credit

mm/dd Account to be debited xxxx.xx
Account to be credited xxxx.xx
Account to be credited xxxx.xx

For example, if an expense is incurred in which part of the expense is paid with cash and the remainder placed in accounts
payable, then two lines would be used for the credit – one for the cash portion and one for the accounts payable portion. The
total of the two credits must be equal to the debit amount.

As many account as are necessary can be used in this manner, and multiple accounts also can be used for the debit side if
needed.

Special Journals
The general journal is the main journal for a wide range of transactions. Of these, a business usually finds itself performed
some types much more frequently than others. By grouping specific types of transaction into their own specific journal, the
efficiency and organization of the accounting system can be improved.

Some commonly-used special journals:

 Sales journal
 Purchases journal
 Cash receipts journal
 Cash disbursements journal

While a special journal may be organized differently from the general journal, it still provides the core transaction
information such as date, debits and credits, and the relevant accounts.

From Journal Entry to Ledger Posting

Once the source document is generated and the appropriate journal entry is made, the next step in the accounting cycle is to
post the entry to general ledger.

ADJUSTING ENTRIES

In the accounting process, there may be economic events that do not immediately trigger the recording of the transaction.
These are addressed via adjusting entries, which serve to match expenses to revenues in the accounting period in which
they occur. There are two general classes of adjustments:

 Accruals – revenues or expenses that have accrued but have not yet been recorded. An example of an accrual is
interest revenue that has been earned in one period even though the actual cash payment will not be received until
early in the next period. An adjusting entry is made to recognize the revenue in the period in which it was earned.

 Deferrals – revenues or expenses that have been recorded but need to be deferred to a later date. An example of a
deferral is an insurance premium that was paid at the end of one accounting period for insurance coverage in the
next period. A deferred entry is made to show the insurance expense in the period in which the insurance coverage
is in effect.

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How to Make Adjusting Entries

Like regular transactions, adjusting entries are recorded as journal entries. The following illustrates adjustments for accrued
and deferred items.

Accrued Items

As an example of an accrued item, consider the accrual of interest revenue. The journal entry would be similar to the
following:

Adjusting Entry for Interest Accrual

Date Accounts Debit Credit

mm/dd Interest Receivables xxxx.xx
Interest Revenue xxxx.xx

The date of the above entry would be at the end of the period in which the interest was earned. The adjusting entry is needed
because the interest was accrued during that period but is not payable until sometime in the next period. The adjusting entry
is posted to the general ledger in the same manner as other journal entries.

In the next period when the cash is actually received, one makes the following journal entry:

Journal Entry for Interest Received

Date Accounts Debit Credit

mm/dd Cash xxxx.xx
Interest Receivables xxxx.xx

Deferred Items

For deferrals, a journal entry already has been made in asset or liability accounts and an adjusting entry is needed to move
the balances to expense or revenue accounts in the next accounting period. Consider the case in which the firm prepays
insurance premiums in one period for insurance coverage in the next period. The journal entry made at the time of payment
would be similar to the following:

Journal Entry for Prepaid Insurance

Date Accounts Debit Credit

mm/dd Prepaid Insurance xxxx.xx
Cash xxxx.xx

In the next period when the insurance coverage is in effect, one makes the following adjusting entry:

Adjusting Entry for Period Insurance

Date Accounts Debit Credit

mm/dd Insurance Expense xxxx.xx
Prepaid Insurance xxxx.xx

For a single deferred item, there may be several adjusting entries over subsequent accounting periods as the expense or
revenue for the item is recognized over time.

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 CLOSING ENTRIES

Revenue, expense, and capital withdrawal (dividend) accounts are temporary accounts that are reset at the end of the
accounting period so that they will have zero balances at the start of the next period. Closing Entries are the journal entries
used to transfer the balances of these temporary accounts to permanent accounts.

After the closing entries have been made, the temporary account balances will be reflected in the Retained Earnings (a
capital account). However, an intermediate account called Income Summary usually is created. Revenues and expenses are
transferred to the income Summary account, the balance of which clearly shows the firm’s income for the period. Then,
Income Summary is closed to Retained Earnings.

The sequence of the closing process is as follows:

1. Close the revenue accounts to Income Summary.

2. Close the expenses accounts to Income Summary.
3. Close Income Summary to Retained Earnings.
4. Close Dividends to Retained Earnings.

The closing journal entries associated with these steps are demonstrated below. The closing entries may be in the form of a
compound journal entry if there are several accounts to close. For example, there may be dozen or more of expense accounts
to close to Income Summary.

1. Close Revenue to Income Summary

The balance of the revenue account is the total revenue for the accounting period. Since revenue is one of the components of
the income calculation (the other component being expenses), in the last day of the accounting period it is closed to the
Income Summary account as follows:
Closing Entry: Revenue to Income Summary
Date Accounts Debit Credit
mm/dd Revenue xxxx.xx
Income Summary xxxx.xx

Once this closing entry is made, the revenue account balance will be zero and the account will be ready to accumulate
revenue at the beginning of the next accounting period.

2. Close Expenses to Income Summary

Expenses are the other component of the income calculation and like revenue, are closed to the Income Summary account:

Closing Entry: Expenses to Income Summary

Date Accounts Debit Credit
mm/dd Income Summary xxxx.xx
Expenses xxxx.xx

After closing, the balance of Expenses will be zero and the account will be ready for the expenses of the next accounting
period. At this point, the credit column of the Income Summary represents the firm’s income for the period.

3. Close Income Summary to Retained Earnings

The Income or loss for the period ultimately adds to or subtracts from the firm’s capital. The Retained Earnings account is a
capital account that accumulates the income from each accounting period. The Income Summary account is closed to
Retained Earnings as follows:

Closing Entry: Income Summary to Retained Earnings

Date Accounts Debit Credit

mm/dd Income Summary xxxx.xx
Retained Earnings xxxx.xx

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4. Close Dividends to Retained Earnings

Any capital withdrawals (e.g. dividends paid) during the period will reduce the capital account balance, so the withdrawal
is closed to Retained Earnings:

Closing Entry: Dividends to Retained Earnings

Date Accounts Debit Credit

mm/dd Retained Earnings xxxx.xx
Dividends xxxx.xx

After closing, the dividend account will have zero balance and be ready for the next period’s dividend payments.

Posting of the Closing Entries

As with other journal entries, the closing entries are posted to the appropriate general ledger accounts in the ledger will
have non-zero balances.

Post-closing Trial Balance

Once the closing entries have been posted, the trial balance calculation is performed to help detect any errors that may
have occurred in the closing process.

THE LEDGER

While the journal lists transactions in chronological order, its format does not facilitate the tracking of individual account
balances. The general ledger is used for this purpose.

The general ledger is a collection of T-accounts to which debits and credits are transferred. The action of recording a debit
or credit in the general ledger is referred to as posting. The posting of a journal entry to the general ledger accounts is a
purely mechanical process using information already in the journal entry and requiring no additional analysis.

To understand the posting process, consider a journal entry in the following format:

Journal Entry

Date Accounts Debit Credit

mm/dd Account 1 xxxx.xx
Account 2 xxxx.xx

There are two ledger accounts affected by the above journal entry (Account 1 and Account 2). Each of these accounts is
represented by a T-account in the general ledger. To post the entry to the ledger, simply transfer the information to the T-
accounts:

Ledger Accounts

Account 1 Account 2

Mm/dd xxxx.xx Mm/dd xxxx.xx

Bal. xxxx.xx Bal. xxxx.xx

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 Note: The debit portion of the journal entry is posted to the left side of its associated T-account, and the credit portion is
portion is posted to the left side of its T-account. The date helps to identify the transactions with the journal entries.
Additionally, a reference number may be added to further facilitate cross-referencing. Because the General Ledger is
organized by account, it allows one to review the activity and balance of any account at a glance.

PREPARATION OF TRIAL BALANCE

“Trial Balance is a list of the balances of Debit and credit taken out from the ledger and Cash and Bank balances are also
included from cash book in it.” – Carler

“At the end of the accounting period, balancing of the accounts which are opened in the ledger, the list prepared for
verifying the various journals is Trial Balance by which it may be known that the total of Debit and Credit side are equal.”
– Pickles

Characteristics of Trial Balance

1. It is a list of Balance of accounts.

2. The total and balances of accounts are written in it.
3. It is prepared after the completing of account of all the accounts.
4. It is a basis for making of final accounts.
5. It includes all types of accounts.
6. It is prepared with the help of ledger and the cash books.

Objects, Utility and Importance

1. Checking of Mathematical Accuracy.

2. Basis of Final Accounts.
3. Summary of Accounts.

Format of Trial Balance

Sl No. Name of Ledger Accounts L. F. Amount

Dr. Cr.

Total

Method of preparing Trial Balance:

There are two method:-

A) Total Method
B) Balance Method

A) Total Method:- In this method, the total of the debit and credits of all the opened accounts of ledger are done.

B) Balancing Method:- To prepare the trial balance by this method the balance of every account is found out. If the
total of Debit side of any account is greater than the Credit side, then by making minus the total of Credit side from
the total of Debit side, the balance amount will be written in the debit side of the trial balance. In the same way the
total of Credit side being greater than debit side, the difference will be written in the Credit side of the trial balance
in this method such accounts will not be written in the trial balance whose total of both side are equal.

Practical Problem on Journal Entries, Ledger Positng and there Balancing:-

It is very important to understand the practical implication as to how a Journal Entry is passed, how ledger accounts are
made and how to balance them for the purpose of preparing Trial Balance.

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ILLUSTRATION:-

Journalise the following transactions, post them into ledger and balance the accounts.

1987 Rs.

Dec. 1 Anil commenced business with cash 1,00,000

“ 2 Purchased goods from Prakash 30,000
“ 2 Purchased furniture for cash 7,000
“ 3 Goods sold to Prem 6,000
“ 4 Sold goods to Ramlal 5,000
“ 5 Goods purchased from Ramesh for cash 5,000
“ 7 Paid wages 100
“ 11 Sold goods to Ashok 8,000
“ 13 Ashok returned goods 500
“ 14 Received from Ram Lal in full settlement 4,950
“ 15 Stationery purchased for cash 400
“ 17 Goods sold to Arun for cash 4,000
“ 20 Withdrew for personal use 1,000
“ 22 Paid to Prakash 20,000
“ 23 Sold goods to Prem 2,000
“ 25 Received from Prem 5,000
“ 26 Cash sales 8,000
“ 27 Paid for interest 500
“ 28 Received from Ashok 7,000
“ 29 Paid rent 2,000
“ 30 Paid salaries for the month 3,000
“ 31 Prem becomes insolvent and a dividend of 50
paid in the rupee is received.

Solution:

Journal

Dr. Cr.
Date Particulars L.F. Amount Amount
1987 Rs. Rs.
Dec. Cash A/c Dr. 1,00,00
1 To Capital A/c 0 1,00,0
(Being capital brought in) 00
" Purchases A/c Dr. 30,000
2 To Prakash A/c 30,00
(Being goods purchased on credit) 0
" Furniture A/c Dr. 7,000
2 To Cash A/c
(Being furniture purchased for cash) 7,000
" Prem A/c Dr. 6,000
3 To Sales A/c
(Being goods sold on credit) 6,000
" Ram Lal A/c Dr. 5,000
4 To Sales A/c
(Being goods sold on credit) 5,000
" Purchases A/c Dr. 5,000
5 To Cash A/c
(Being goods purchased for cash) 5,000
" Wages A/c Dr. 100
7 To Cash A/c
(Being wages paid) 100
" Ashok A/c Dr. 8,000
11 To Sales A/c
(Being goods sold on credit) 8,000

316
 " Returns Inwards A/c Dr. 500
13 To Ashok A/c
(Being goods returned by him) 500
" Cash A/c Dr. 4950
14 Discount A/c Dr. 50
To Ram Lal A/c
(Being cash received in full settlement of his
account) 5,000
" Stationery A/c Dr. 400
15 To Cash A/c
(Being stationery purchased) 400
" Cash A/c Dr. 4,000
17 To Sales A/c
(Being goods sold for cash) 4,000
" Drawings A/c Dr. 1,000
20 To Cash A/c
(Being cash withdrawn for personal use) 1,000
" Prakash A/c Dr. 20,000
22 To Cash A/c 20,00
(Being cash paid to Prakash) 0
" Prem A/c Dr. 2,000
23 To Sales A/c
(Being goods sold on credit) 2,000
" Cash A/c Dr. 5,000
25 To Prem A/c
(Being cash received from Prem) 5,000
" Cash A/c Dr. 7,000
28 To Ashok A/c
(Being cash received) 7,000
" Rent A/c Dr. 2,000
29 To Cash A/c
(Being rent paid) 2,000
" Salaries A/c Dr. 3,000
30 To Cash A/c
(Being salaries paid) 3,000
" Cash A/c Dr. 1,500
31 Bad debts A/c Dr. 1,500
To Prem
(Being a dividend of 50 paise received from
Prem) 3,000

Notes:
1. Transaction on December 14: Ram Lal paid Rs. 4,950 in full settlement of Rs. 5,000 due from him on account of
the goods sold to him on December 4. It implies that Rs. 50 (Rs. 5,000-Rs.4,950) was allowed to him as cash
discount.

2. Transaction on December 30: Prem becomes insolvent. The firm could recover only 50 paise in a rupee i.e., 50%
of the amount due. Goods worth Rs. 8,000 were sold to him (Rs. 6,000 on December 3 and Rs. 2,000 on December
23). He paid Rs. 5,000 on December 25 leaving a balance of Rs. 3,000. Of this, the firm could recover Rs. 1,500
(50% of Rs. 3,000). The remaining amount of Rs. 1,500 has been treated as bad debts.

317
 Cash Account
Dr. Cr.
1987 Rs. 1987 Rs.
Dec. 1 To capital A/c 100,000Dec. 2 By Furniture A/c 7,000
" 14 To Ram Lal A/c 4,950 " 5 By Purchases A/c 5,000
" 17 To Sales A/c 4,000 " 7 By Wages A/c 100
" 25 To Prem 5,000 " 15 By Stationery A/c 400
" 26 To Sales A/c 8,000 " 20 By Drawings A/c 1,000
" 28 To Ashok 7,000 " 22 By Prakash 20,000
" 30 To Prem 1,500 " 27 By Interest A/c 500
" 29 By Rent A/c 2,000
" 30 By Salaries A/c 3,000
" 31 By Balance c/d 91,450
130,450 130,450

1988
Jan. 1 To Balance b/d 91,450

Purchases Account

1987 Rs. 1987 Rs.

Dec. 2 To Prakash 30,000 Dec. 31 By Balance c/d 35,000
" 5 To Cash A/c 5,000
35,000 35,000
1988
Jan. 1 To Balance b/d 35,000

Furniture Account

1987 Rs. 1987 Rs.

Dec. 2 To Cash 7,000 Dec. 31 By Balance c/d 7,000

1988
Jan. 1 To Balance b/d 7,000

Wages Account

1987 Rs. 1987 Rs.

Dec. 7 To Cash 100 Dec. 31 By Balance c/d 100

1988
Jan. 1 To Balance b/d 100

Return Inwards Account

1987 Rs. 1987 Rs.

Dec. 7 To Ashok 500 Dec. 31 By Balance c/d 500

1988
Jan. 1 To Balance b/d 500

318
 Prem’s Account

1987 Rs. 1987 Rs.

Dec. 3 To Sales A/c 6,000Dec. 25 By Cash A/c 5,000
" 5 To Sales A/c 2,000 “ 31 By Cash A/c 1,500
“ 31 By Bad Debts A/c 1,500
8,000 8,000

Sales Account
1987 Rs. 1987 Rs.
Dec. 31 To Balance c/d 33,000 Dec. 3 By Prem 6,000
" 4 By Ram Lal 5,000
" 11 By Ashok A/c 8,000
" 17 By Cash A/c 4,000
" 23 By Prem A/c 2,000
" 26 By Cash A/c 8,000
33,000 33,000
1988
Jan. 1 By Balance b/d 33,000

Capital Account

1987 Rs. 1987 Rs.

Dec. 31 To Balance c/d 100,000Dec. 25 By Cash A/c 100,000

100,000 100,000
By Balance b/d 100,000

Prakash’s Account

1987 Rs. 1987 Rs.

Dec. 22 To Cash A/c 20,000Dec. 2 By Purchases A/c 30,000
“ 31 To Balance c/d 10,000

30,000 30,000
1988
Jan. 1 By Balance b/d 10,000

Ram Lal’s Account

1987 Rs. 1987 Rs.
Dec. 22 To Sales A/c 5,000 Dec. 14 By Cash A/c 4,950
By Discount Allowed Ac 50

5,000 5,000

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 Ashok's Account

1987 Rs. 1987 Rs.

Dec. 11 To Sales A/c 8,000Dec. 13 By Returns Inwards A/c 500
" 28 By Cash A/c 7,000
" 31 By Balance C/d 500
8,000 8,000
1988
Jan. 1 To Balance b/d 500

Discount Allowed A/c

1987 Rs. 1987 Rs.

Dec. 7 To Ram Lal 50Dec. 31 By Balance c/d 50

1988
Jan. 1 To Balance b/d 50

Stationery Account

1987 Rs. 1987 Rs.

Dec. 15 To Cash 400 Dec. 31 By Balance c/d 400

1988
Jan. 1 To Balance b/d 400

Drawings Account

1987 Rs. 1987 Rs.

Dec. 20 To Cash 1,000Dec. 31 By Balance c/d 1,000

1988
Jan. 1 To Balance b/d 1,000

Interest Account

1987 Rs. 1987 Rs.

Dec. 27 To Cash A/c 500 Dec. 31 By Balance c/d 500

1988
Jan. 1 To Balance b/d 500 500

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 Rent Account

1987 Rs. 1987 Rs.

Dec. 29 To Cash 2,000Dec. 31 By Balance c/d 2,000

1988
Jan. 1 To Balance b/d 2,000

Salaries Account

1987 Rs. 1987 Rs.

Dec. 30 To Cash 3,000Dec. 31 By Balance c/d 3,000

1988
Jan. 1 To Balance b/d 3,000

Bad Debts Account

1987 Rs. 1987 Rs.

Dec. 30 To Prem 1,500Dec. 31 By Balance c/d 1,500

1988
Jan. 1 To Balance b/d 1,500

Notes: Nominal accounts like Wages Account, Discount Account, Stationery Account, etc. and the accounts relating to
purchases, sales and returns of goods are not to be balanced. As per rules, they are simply closed by transfer to the Trading
and Profit and Loss Account at the time of preparing the final accounts. In the above illustration, however, they have been
balanced for the purpose of preparing the Trial Balance which is being discussed in the next section.

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 Trial Balance as on December 31, 1987

Trial Balance

Dr. Dr.
S. No. Name of Account L.F. Balance Balance
Rs. Rs.
1 Cash Account 91,450
2 Capital Account 100,000
3 Furniture Account 7,000
4 Purchases Account 35,000
5 Sales Account 33,000
6 Prakash's Account 10,000
7 Wages Account 100
8 Returns Inwards Account 500
9 Ashok's Account 500
10 Discount Account 50
11 Stationery Account 400
12 Drawings Account 1,000
13 Interest Account 500
14 Rent Account 2,000
15 Salaries Account 3,000
16 Bad Debts Account 1,500

Total 143,000 143,000

2. SUBSIDIARY BOOKS

Meaning,

When the number of transactions in a business are too large, it becomes difficult to record all of them in the journal. Hence,
it is sub divided into number of special journal called Subsidiary Books. Each subsidiary book is used for the recording only
one category of transactions.

Kinds of Subsidiary Books

Generally a businessman keeps the following Subsidiary Books: -

A) Purchase Book: - In this book the recording of all such goods purchased on credit is done of the thing in which the
organization transacts.
B) Sales Book: - In this book, the recording of all such goods sold on credit is done of the thing in which the
organization transacts.
C) Purchase Return Book: - In this book the recording of such goods on credit is done which is returned by the
businessman.
D) Sales Return Book: - In this book recording of such goods on credit is done which is returned due to some reasons
after sales returned by customers.
E) Cash Book: - In this book all such transactions are recorded.
F) Bill Receivable Book: - In this book the recording of those bills are done which were given by the debtors or
accepted by them.
G) Bill Payable Book: - In this book the transaction are recorded of those bills done which were given by the
creditors and accepted by them.
H) Journal Proper: - In this book those transactions are recorded where recording has not been done in any of the
above books.

Advantages of keeping Subsidiary Books: -

By keeping subsidiary books of the businessman is benefited in the following manner: -

1. Division of Work: - The work can be divided among many persons by which the proficiency and expertise is
maintained in the work and the chances of error are minimized.

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 2. Saving of time and labour: - It takes lesser time in the recording of subsidiary books and there is saving of labour
and time.
3. Internal check system: - The Accounting work of the transactions is divided in a way that the checking of the
work of one person is automatically done by the work of another person so that chances of irregularities and fraud
are minimized.
4. Use of Specialized Skill: - In records of accounts skill and expertise are necessary. When a person works in a
particular trade for a long time, he attains proficiency and works with expertness.
5. Comprehensive Knowledge: - Comprehensive recording of the transactions are done in the Subsidiary Books that
provides complete knowledge.
6. Responsibility can be fixed: - The work of maintaining a particular book can be entrusted to a particular person.

Illustration:

Enter the following transactions in proper subsidiary books of Radhika Enterprises and show their postings into ledger.

1987 Rs.
Aug. 1 Sold goods to Ram Singh 2,550
“ 2 Bought goods from Dhillon 1,200
“ 3 Sold goods to Gopinath 2,500
“ 4 Purchased goods from Habeeb 3,600
“ 5 Ram Singh returned goods 350
“ 6 Goods return toed to Dhillon 200
“ 9 Gopinath returned goods 150
“ 10 Returned goods to Habeeb 260
“ 12 Bought goods from Sanyal 4,750
“ 13 Sold goods to Saila 6,200
“ 14 Sold goods to Michael 4,850
“ 15 Purchased goods from Anthony 3,940
“ 18 Returned goods to Sanyal 320
“ 19 Sailo returned goods 230
“ 22 Michael returned goods 150
“ 25 Returned goods to Anthony 250
“ 27 Sold goods to Solanki 5,340
“ 28 Purchased goods from Gopalan 4,670
“ 29 Sold goods to Harbinder Singh subject to a trade discount of 5% 2,000
“ 30 Purchased goods from Bhandari subject to a trade discount of 10% 1,000
Solution:

PURCHASES JOURNAL

Date Name of the supplier Invoice No. L.F. Amount Remarks

1987 Rs.
Aug. 2 Dhillon 1,200
“ 4 Habeeb 3,600
“ 12 Sanyal 4,750
“ 15 Anthony 3,940
“ 15 Gopalan 4,670
“ 15 Bhandari 900
“ 31 Total 19,060

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 PURCHASES RETURNS JOURNAL

Date Name of the supplier Debit Note L.F. Amount Remarks

No.
1987 Rs.
Aug. 6 Dhillon 200
“ 10 Habeeb 260
“ 18 Sanyal 320
“ 25 Anthony 250
“ 31 Total 1,030

SALES JOURNAL

Date Name of the supplier Invoice No. L.F. Amount Remarks

1987 Rs.
Aug. 1 Ram Singh 2,550
“ 3 Gopinath 2,500
“ 13 Sailo 6,200
“ 14 Michael 4,850
“ 27 Solanki 5,340
“ 29 Harbinder Singh 1,900
“ 31 Total 23,340

SALES RETURNS JOURNAL

Date Name of the Customer Credit Note L.F. Amount Remarks

No.
1987 Rs.
Aug. 5 Ram Singh 350
“ 9 Gopinath 150
“ 19 Sailo 230
“ 22 Michael 150
“ 31 Total 880

Purchases Account
Dr, Cr.
1987 Rs. Rs.
Aug. To Sundries 19,060
31 as per Purchases Journal

Dhillon's Account

1987 Rs. 1987 Rs.

Aug. 6 To Purchases Returns 200 Aug. 2 By Purchases A/c 1,200

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 Habeeb's Account

1987 Rs. 1987 Rs.

Aug. Aug. By Purchases A/c
10 To Purchases Returns 260 4 3,600

Sanyal's Account

1987 Rs. 1987 Rs.

Aug. Aug. By Purchases A/c
18 To Purchased Returns 320 12 4,750

Anthony's Account

1987 Rs. 1987 Rs.

Aug. Aug. By Purchases A/c
25 To Purchased Returns 250 15 3,940

Gopalan's Account

1987 Rs.
Aug. By Purchases A/c
28 4,670

Bhandari’s Account

1987 Rs.
Aug. By Purchases A/c
30 900

Purchases Returns Account

. 1987 Rs.
Aug.
31 By Sundries-as per 1,030
Purchases Return Journal

Sales Account

1987 Rs.
Aug.
31 By Sundries-as per 23,340
Sales Journal

325
 Ram Singh’s Account

1987 Rs. 1987 Rs.

Aug. Aug.
1 To Sales A/c 2,550 5 By Sales Returns A/c 350

Gopinath’s Account

1987 Rs. 1987 Rs.

Aug. Aug.
3 To Sales A/c 2,500 9 By Sales Returns A/c 150

Sailo’s Account

1987 Rs. 1987 Rs.

Aug. Aug.
13 To Sales A/c 6,200 19 By Sales Returns A/c 230

Michael’s Account

1987 Rs. 1987 Rs.

Aug. Aug.
14 To Sales A/c 4,850 22 By Sales Returns A/c 150

Solanki’s Account

1987 Rs.
Aug.
27 To Sales A/c 5,340

Harbinder Singh's Account

1987 Rs.
Aug.
29 To Sales A/c 1,900

Sales Returns Account

1987 Rs.
Aug. To Sundries-as per Sales 880
31 Journal

Journal Proper

The transaction, the recording of is not done in Purchase Book, Sales Book, P/R, S/R, B/R, Cash Book, their recording is
done in the journal proper.

For example: -

A) Opening Entries
B) Closing Entries
C) Transfer Entries
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 D) Adjustment Entries
E) Rectification Entries
F) Miscellaneous Entries

For example:

1. Except cash, the assets being brought in business as capital

2. Purchase and sales of assets on credit
3. Endorsement of bill to creditors
4. Dishonour of the endorsed bill
5. Write off of the bad debts.
6. Goods given in charity.
7. Goods destroyed by fire
8. Goods drawn out for domestic purposes.
9. Loss of particular goods

Give the examplePage No. 86

Cash Book
Cash Book is the most important Subsidiary Book. All the cash transactions of business are entered in it.

Types of Cash Book:

There are three types of Cash Books:
I. Simple Cash Book
II. Two columnar Cash Book
III. Three columnar Cash Book

Format of Cash Books

I. Simple Cash Book

Dr. Cr.
Date Particulars Ki L.F. Rs. Date Particulars Ki L.F. Rs.

Rules for making entries in the Cash Book.

As Cash Account is a real account, the rules for making entries in real account applicable for making entries in the Cash
Book. When cash is received Debit and when cash is given credit.

Give the examplePage No. 49

II. Two columnar Cash Book

Dr. Cr.
Date Particulars L.F. Discount Amount Date Particulars L.F. Discount Amount
Allowed Received

Rules: Discount allowed to debtors as recorded on the Debit side and Discount received from creditors on the credit sides.

327
III. Three columnar Cash Book

Format of three column Cash Book:

Dr. Cr.
Date V.N. L.F. Amount Date V.N. L.F. Amount
Discount Cash Bank Discount Cash Bank

Rules of making entries in three columnar Cash Book:

1) Cash, cheque and bill receives are entered on the debit side.
2) If the cheques and bill received have been deposited into bank on the same date then it will be entered direct in the
Bank column on debit side of Cash Book. Direct deposit in the bank by customer also entered on the same day.
3) Cash payments are entered on the credit side in cash column.
4) Discount allowed on receipts of cash or cheques is entered in the discount column on the debit side.
5) Payments made by cheques are entered on credit side in bank column.
6) Discount received on payment is entered in the discount column on the credit side with the amount paid.
7) When it is not clear from the language of the question, where the amount received is kept in the office or bank, it
should be entered in cash column.

CONTRA ENTRIES

a) When cash deposit into Bank

Bank A/c Dr.

To Cash

b) When withdrawn from Bank for office use.

Cash A/c Dr.

To Bank

Illustration:
From the following particulars, prepare a Three Column Cash Book and post it into ledger.

1987 Rs.
Dec. 11 Cash in hand 10,000
“ 11 Balance in bank account 40,000
“ 13 Bought goods for cash 5,000
“ 15 Bought furniture and paid by cheque 7,000
“ 17 Cash Sales 6,000
“ 19 Bought goods and issued cheque 15,000
“ 20 Deposited cash in bank 5,000
“ 22 Received cash from Suresh 2,450
Discount allowed 50
“ 23 Paid sundry expenses 500
“ 24 Cash withdrawn for office use 5,000

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 “ 25 Paid for stationery 500
“ 26 Received cheque from Vikas 540
Allowed him discount 10
“ 26 Cheque received from Satish and deposited in bank 2,000
“ 27 Endorsed the cheque received from Vikas in favour of Rakesh 540
“ 27 Paid Roshan Lal by cheque 4,960
Received discount 40
“ 28 Cheque received from Harish 1,000
“ 29 Cheque of Harish deposited in bank 1,000
“ 30 Paid Rent by cheque 2,000
“ 31 Paid Salary by cheque 5,000
“ 31 Withdrew from bank for personal use 2,000
“ 31 Cheque received from Harish dishonoured 1,000
“ 31 Bought machinery from Singh & Co. for cash 10,000

Solution:
CASH BOOK
(With Cash, Discount and Bank columns)
Dr. Cr.
Date Particulars L. Discount Cash Bank Date Particulars L.F. Discount Cash Bank
F. Allowed Receive
d
1987 Rs. Rs. Rs. 1987 Rs. Rs. Rs.
Dec. To Balance 10,000 40,00 Dec. 13 By Purchase A/c 5,000
11 b/d 0
" To Sales A/c 6,000 " 15 By Furniture A/c 7,000
17
" To Cash A/c C 5,000 " 19 By Purchase A/c 15,00
20 0
" To Suresh 50 2,450 " 20 By Bank A/c C 5,000
22
" To Bank A/c C 5,000 " 23 By Sundry 500
24 Expenses
" 24 By Cash A/c C 5,000
" To Vikas 10 540 " 25 By Stationery 500
26 A/c
" To Satish 2,000 " 27 By Rakesh 540
26
" To Harish 1,000 " 27 By Roshan Lal 40 4,960
28
" To Cash A/c C 1,000 " 29 By Bank A/c C 1,000
29
" 30 By Rent A/c 2,000
" 31 By Salary A/c 5,000
" 31 By Drawings A/c 2,000
" 31 By Harish 1,000
" 31 By Machinery 10,00
A/c 0
329
 " 31 By Balance c/d 2,450 6,040
60 24,990 48,00 40 24,99 48,00
0 0 0
1987
Jan. To Balance 2,450 6,040
1 b/d

Notes:
1. Transaction on December 20
Cash deposited in the bank has been entered on both sides, in the bank column on the debit side and in cash column on the
credit side. It is a contra entry, so ‘C’ has been written in L. F. column on both the sides. These entries have not been posted
in the ledger.

2. Transaction on December 26
A cheque for Rs. 540 was received from Vikas on December 26. It had not been deposited in the bank but endorsed in
favour of Rakesh on December 27. It has been entered first in the cash column on the debit side on December 26 against the
name of Vikas, and then in the cash column on the credit side on December 27 against the name of Rakesh. In the ledger,
Vikas’s Account gets the credit and Rakesh’s Account gets the debit.

BANKING TRANSACTIONS

Banks have great importance in the modern economic and business world. The business does not take the risk of keeping
cash with them and keep their money with banks. Mostly payments are made by cheques. It saves the businessman from
keeping the risk of money with them and the banks also give interest on term deposit.

Entries of Banking Transactions: -

The account, which a businessman open in the bank for depositing cash and cheques is called Current Account.

The entries in connection with current account are made as under: -

1. On depositing money into Bank:

Bank A/c Dr.
To Cash

2. On direct deposit of cash or cheques and bank draft by Debtors.

Bank A/c Dr.
To Debtors

3. When cheques or draft are received from debtors:

Cash A/c Dr.
To Debtors

4. On depositing cheques or draft are received from debtors into bank.

Bank A/c Dr.
To Cash

Note: - If the cheques and drafts received from debtors are deposited on the same day into bank then the entry will be
passed.
Bank A/c Dr.
To Debtors
5. On withdrawing money from bank for office use:
Cash A/c Dr.
To Bank

6. On issuing cheques to creditors:

Creditors A/c Dr.
To Bank

7.On payment of expenses by cheques:

Expenses A/c Dr.
To Bank

330
8.On withdrawing money for personal use:

Drawings A/c Dr.

To Bank

9. On dishonour of cheques:

Debtors A/c Dr.

To Bank

10. On interest on overdraft charged by bank:

11. On interest credited by bank on deposit

Bank A/c Dr.
To Interest

12. On charging bank charges for service:

Bank Charges A/c Dr.
To Bank

13. On transfer of Amount from current A/c

Fixed Deposit A/c Dr.

To Bank

14. On receiving of interest on fixed deposit on maturity:

Cash A/c Dr.
OR
Bank A/c Dr.
To Fixed Deposit
To Interest

15. On taking loan from bank

Bank A/c Dr.
To Bank Loan A/c

16. For payment of interest on loan:

Interest on loan A/c Dr.
To Bank

17. On repayment of loan:

Bank Loan A/c Dr.

To Bank
BANK RECONCILIATION STATEMENT

Meaning: -

The services of Banks are very important for a businessman in modern time. Banks have become a part of business. The
businessman kept their current accounts in the banks. The bank keeps separate account for each customer in their ledger and
give a copy of that account in a form of statement of book to the concerned customer for his knowledge. This book is called
Pass Book. In the same way each customer with the bank in his Cash Book or in a Bank Account kept in his ledger.

Thus, both the parties enter the banking transactions in their relative books of accounts. Ordinarily the balance of accounts
kept by both the parties should be the same. In other words, the balance shown in the Pass Book given by the bank should
tally with the balance of Bank Account Kept in his ledger or Cash Book (Bank Column). But sometimes the balances of the
accounts kept by both the parties do not tally on account of many reasons. This does not mean that there are mistakes in
writing these accounts but the differences may be due to the reason that some items have been entered in the Cash Book but
not entered in the bank Pass Book or same items might have been entered in the Cash Book. The customer should compare
the account given in the bank Pass Book with his Cash Book from time to time and complete the entries which have not
been done. If still the balances of the Cash Book and bank Pass Book does not tally then it should be understood that there is
any mistakes in any side and for knowing this a statement is prepared which is called a Bank Reconciliation Statement.

331
BRS is prepared by customer on a particular date.

Reasons for differences in the Bank Balance shown by Cash Book and the Pass Book:

1. Cheques issued but not yet presented for payment.

2. Cheques, Bill and Hundies deposite into Bank but not yet collected and credited.
3. Interest allowed by the bank.
4. Bank charges.
5. Standing Orders.
6. Direct deposited into the bank.
7. Interest on Bank overdraft.
8. Dishonoured cheques, Bill and Hundies.

METHODS OF PREPARING A BANK RECONCILIATION STATEMENT

There are two methods prepare a BRS:

A) Preparing BRS from Cash Book Balance.

I. If Bank Column of Cash Book shows a Debit Balances:
Add a) Chequed issued but not yet been presented for payment.
Add b) Interest credited by the bank but not yet considered in Cash Book.
Add c) Amount directly deposited by the customer or income directly received by the bank but not yet considered in
Cash Book.

Less a) Cheques, Bill & Hundies, deposited into the bank but not yet collected.

Less b) Bank charges and interest on overdraft charged by the bank but not yet accounted for in Cash Book.

Less c) Expenses directly paid by the bank but not yet considered in the Cash Book.

Less d) Amount of Cheques, Bill & Hundies deposited into bank and dishonoured but not yet considered in Cash Book.

II If Bank column of Cash Book shown a Credit Balance under this case, all the items added as given in 1) above will
be deducted and all items deducted as given in 1) above well added.
2. Preparing BRS from Pass Book balance.

I. When there is Credit Balance of Pass Book:-

Less a) Amount of cheques issued to customers but not yet presented for payment.
Less b) Interest allowed by bank on deposits.
Less c) The amount of dividend and interest collected by bank on the standing orders of the customer.
Less d) Direct deposits by customers into Bank.

Add e) Amount of Cheques, Bills and Hundies deposited into Bank but not yet collected and credited.
Add f) Amount of Cheques, bills and hundies deposited into bank but dishonoured and not entered in Cash Book.
Add g) Amount of Bank Charges and interest on Bank Overdraft by bank.

II. When there is a Debit Balance as per Pass Book.

Less No. –2 (i) e, f, g

Add No. –2 (i) a, b, c, and d

In Summary by Table

Cash Book Dr.

Given to find out bal. Pass Book Cr. Cash Book Cr. Pass Book Dr.
Pass Book Bal. Cash Book Bal. Pass Book Bal. Cash Book Bal.
1. Cheque issued
but not yet + - - +
presented for
payment

332
 2. Cheque, bill, or
hundies deposited - + + -
into bank but not
yet collected
3. Interest allowed + - - +
by bank
4. Bank charges - + + -
5. Collection of + - - +
dividend by bank
6. Direct payment - + + -
by bank
7. Dish. Cheques - + + -
or bill
8. Interest charged - + + -
by the bank on BO
9. Any wrong entry
on the debit side - + + -
of the Pass Book
10. Any wrong
entry on the credit
+ - - +
side of the Pass
Book
11. Drawing made
by cheque not - + + -
entered in Cash
Book

Illustration:
From the following particulars, prepare a Bank Reconciliation Statement as on December 31, 1987:

On December 31, 2008 Mohan’s cash book showed a debit balance of Rs. 7,800. The balance as per pass book was Rs.
10,300. On comparing the cash book with the pass book, the following discrepancies were found:

1) Two cheques for Rs. 1,600 and Rs. 2,000 issued on December 23 have not been presented to the bank for payment.
2) A cheque for Rs. 1,200 was deposited in the bank on December 29, but it was credited by the bank on January 5,
2009.
3) There was a credit entry in the pass book for Rs. 520 in respect of dividend received by the bank on behalf of
Mohan. This had not been recorded in the cash book.
4) Rs. 300 was deposited by a customer directly into the bank.
5) The bank charged Rs. 60 as their commission for collecting an outstanding cheque. No entry for this appeared in
the cash book.
6) A cheque for Rs. 500 received from Gopi and deposited in the bank was dishonourd, but no entry was recorded in
the cash book for the dishonour.
7) A cheque for Rs. 160 was entered in the cash book but it was not sent to the bank for collection.

Solution:

Rs. Rs.

Balance as per Cash Book 7,800

Add: Cheques issued but not yet presented for payment 3,600
Dividends collected by bank but not yet recorded in the 520
Cash Book
Amount deposited by a customer directly in the bank 300
4,420
12,220

Less: Cheque deposited but not yet collected by bank 1,200

Bank charges debited by bank but not yet recorded in the 60
333
 cash book
Cheque dishonoured but no entry made in cash book for the 500
dishonour
Cheque received from a customer entered in the cash book 160
but not sent to the bank for collection
1,920
Balance as per Pass Book 10,300

Note: The statement bears a heading ‘Bank Reconciliation Statement’ and mentions the date for which reconciliation is
done. So, whenever you prepare a Bank Reconciliation Statement, make sure that it bears this heading along with the date of
reconciliation.
3. FINAL STATEMENTS OR ACCOUNTS

Business report information in the form of financial statements issued on a periodic basis. GAAP requires the following four
financial statements.

 Balance Sheet – statement of financial position at a given point in time. It has two sides. Assets side and liability
side. The two side total will be the same. It is not an Account.
 Income Statement – revenues minus expenses for a given time period ending at a specified date. It is prepared in
two parts, namely Trading A/c and P & L A/c. Trading A/c will show gross profit or gross loss whereas P & L A/c
will show Net Profit or Net Loss of the business.
 Statement of Owner’s Equity – also known as Statement of Retained Earnings or Equity Statement.
 Statement of Cash Flows – summarizes sources and uses of cash; indicates whether enough cash is available to
carry on routine operations.

Balance Sheet

The balance sheet is based on the following fundamental accounting model:

Assets = Liabilities + Equity

Assets can be classed as either current assets or fixed assets. Current assets are assets that quickly and easily can be
converted into cash, sometimes at a discount to the purchase price. Current assets include cash, accounts receivable,
marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed asset include land,
buildings, and equipment. Such assets are recorded at historical cost, which often is much lower than the market value.

Liabilities represent the portion of a firm’s assets that are owed to creditors. Liabilities can be classed as short-term
liabilities (current) and long-term (non-current) liabilities. Current liabilities include accounts payable, notes payable,
interest payable, wages payable, and tax payable. Long-term liabilities include mortgages payable and bonds payable. The
portion of a mortgage long-term bond that is due within the next 12 months is classed as a current liability, and usually is
referred to as the current portion of long-term debt. The creditors of a business are the primary claimants, getting paid
before the owners should the business cease to exist.

Equity is referred to as owner’s equity or shareholders’ equity in a corporation. The equity owners of a business are residual
claimants, having a right to what remains only after the creditors have been paid. For a sole proprietorship or a partnership,
the equity would be listed as the owner or owners’ names followed by the word “capital”. For Example:

Sole Proprietorship: John Doe, Capital

Partnership: John Doe, Capital

Josephine Smith, Capital

In the case of a corporation, equity would be listed as common stock, preferred stock, and retained earnings.

The balance sheet reports the resources of the entity. It is useful when evaluating the ability of the company to meet its long-
term obligations. Comparative balance sheets are the most useful; for example, for the years ending December 31, 2000 and
December 31, 2001.

Income Statement

The income statement presents the results of the entity’s operations during a period of time, such as one year. The simplest
equation to describe income is:

334
 Net Income = Revenue - Expenses

Revenue refers to inflows from the delivery or manufacture of a product or from the rendering of a service. Expenses are
outflows incurred to produce revenue.

Income from operations can be separated from other forms of income. In this case, the income can be described by:

Net Income = Revenue – Expenses + Gains – Losses

Where gains refer to items such as capital gains, and losses refer to capital losses, losses from natural disasters, etc.

Statement of Owners’ Equity (Statement of Retained Earnings)

The equity statement explains the changes in retained earnings. Retained earnings appear on the balance sheet and most
commonly are influenced by income and dividends. The statement of Retained Earnings therefore uses information from the
Income Statement and provides information to the Balance Sheet.

The following equation describes the equity statement for a sole proprietorship:

Ending Equity = Beginning Equity + Investment – Withdrawals + Income

For a corporation substitute “Dividends Paid” for “Withdrawals”. The stockholders’ equity in a corporation is calculated as
follows:

Common Stock (recorded at par value)

+ Premium on Common Stock (issue price minus par value)
+ Preferred Stock (recorded at par value)
+ Premium on Preferred Stock (issue price minus par value)
+ Retained Earnings
-----------------------------------------------------------------------------
= Stockholders’ Equity

Note that the premium on the issuance of stock is based on the price at which the corporation actually sold the stock on the
market. Afterwards, market trading does not affect this part of the equity calculation. Stockholders’ equity does not change
when the stock price changes!

Form of Trading Account

Trading Account of ………..
(Day, Month and Year)

Dr. Cr.
Particulars Amount Amount Amount Amount
Rs. Rs. Rs. Rs.
To Opening Stock ----- ----- By Sales -----
Less Sales
To Purchases ----- ----- Returns -----
Less Purchases
Returns
By Closing Stock ------
To Direct Expenses ------ ------
(Specify individually)
To Gross Profit ------
(Transferred to Profit and
Loss Account) -----
----- -----

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Form of P & L A/c
Profit and Loss Account…………..
For the period ended ………..

Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Gross Loss, if any, (transferred By Gross Profit
from Trading Account) (transferred from Trading Account)
To Salaries By Interest Received
To Rent, Rates and Taxes By Discount Received
To Postage and Telegrams By Rent Received
To Telephone Charges By Commission Received
To Printing and Stationery By Dividend Received
To Legal Expenses By Other Incomes and Gains
To Insurance By Net Loss
To Office Lighting (Transferred to Capital Account)
To Bad Debts
To Depreciation
To Advertising
To Travelling Expenses
To Carriage Outwards
To Trade Expenses
To Discount Allowed
To Interest Paid
To Repairs and Renewals
To Loss by Fire
To Loss by Theft
To Other Expenses and Losses, if any
To Net Profit
(Transferred to Capital Account)

Balance Sheet of ……….

as on ………..

Liabilities Amount Assets Amount

Rs. Rs.
Current Liabilities Current Assets
Bank Overdraft …….. Cash in hand ……..
Bills Payable …….. Bills Receivable ……..
Sundry Creditors …….. Cash at bank ……..
Sundry Debtors ……..
Closing Stock ……..
Long-term Liabilities
Loans …….. Investments ……..
Mortgages …….. Fixed Assets ……..
Capital Vehicles ……..
Balance …….. Furniture ……..
Add Net Plant & Machinery ……..
Profit …….. Land & Buildings ……..
Less Goodwill ……..
Drawings …….. ……..
…….. ……..
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Cash Flow Statement

The nature of accrual accounting is such that a company may be profitable but nonetheless experience a shortfall in cash.
The statement of cash flows is useful in evaluating a company’s ability to pay its bills. For a given period, the cash flow
statement provides the following information:
 Sources of cash
 Uses of cash
 Change in cash balance

The cash flow statement represents an analysis of all of the transactions of the business, reporting where the firm obtained
its cash and what it did with it. It breaks the sources and uses of cash into the following categories:
 Operating activities
 Investing activities
 Financing activities

The information used to construct the cash flow statement comes from the beginning and ending balance sheets for the
period and from the income statement for the period.

FINAL ACCOUNTS WITH ADJUSTMENT

There are several items which need adjustment at the time of preparing the final accounts. Some of the important and
common adjustments are listed below:

(1) Closing Stock: Unsold stock at the end of the year, it is known as closing stock.

Closing Stock Dr.

To Trading A/c

Treatment in Final Accounts:

(a) shown in credit side in Trading A/c
(b) shown in Balance Sheet in Asset side.

(2) Outstanding expenses:

Those expenses are relating in current year but not paid in current year, is known as O/S expenses.

(a) Added to relating expenses in trading and P& L A/c

(b) Shown in liabilities side in Balance Sheet under Current Account.

(3) Prepaid expenses:

Those expenses which are related to next year but paid in the current year are called prepaid expenses.

Adj. Entry:

Prepaid Expenses A/c Dr.

To Expenses

Accounting treatment:

(a) Subtracted from relating expenses in Trading and P & L Accounts.

(b) Shown in Balance Sheet in assets side under the head Current Assets.

(4) Accrued income:

Those incomes are relating to current year but not received in current it is known as Accrued income.

Adj. Entry:
Accrued Income A/c Dr.
To Income

Accounting treatment:

(a) Added to the relating income in Profit and Loss A/c.

(b) Shown in Balance Sheet on assets side under the head Current Assets.

337
(5) Income received in advance or unearned income: Those income does not relating to current year but received in current
year. It is called unearned income.

Adj. Entry:
Income A/c Dr.
To Unearned Income

Accounting treatment:
Deducted from relating income in the P/L A/c
(a) Shown on the liabilities side under the head Current Liabilities.

(6) Depreciation:
It means decrease in the value of fixed assets due to their usage and the passage of time.

Depreciation A/c Dr.

To Particular Assets

Accounting treatment:

(a) Shown in debit side of P & L Accounts.

(b) Deducted from concerned assets in the Balance Sheet.

(7) Interest on capital

Interest on capital expenses for business. It is calculated on capital a fixed or given rate of interest.

Interest on capital A/c Dr.

To Capital A/c
Accounting treatment:

(a) Shown in debit side in Profit & Loss A/c.

(b) Added in capital in Balance Sheet in liability side.

(8) Interest on Drawing

It is income for business or firm, so will be credited.

Drawing A/c Dr.

To Interest on Drawing

Accounting treatment:
(a) Shown in credit in Profit and Loss Account
(b) Deducted from capital in the liabilities of Balance Sheet.

(9) Interest on Loan:

Interest on loan expenses for business or firm. So will be debited.

If paid, Interest on loan A/c Dr.

To Bank

P & L A/c Dr.

To Interest on Loan A/c

If not paid, O/S then, same entry.

Same adjustment of outstanding expenses.

(10) Bad debts:

When a debtor may fail to his debt either partially or completely. The amount of debt which cannot be
recovered from debtor is called bad debts. It will be a loss to the business.

Bad debts A/c Dr.

To Debtors
338
 If the Bad debts given outside the Trial Balance.

Entry passed above.

Such additional bad debts called further bad debts.

Accounting treatment

(a) Debit side in P & L A/c

(b) Deducted from Sundry Debtors.

(11) Provision for Bad debts:

Such a provision is made by debiting to the doubtful debts to the Profit and Loss A/c.

Profit and Loss A/c Dr.

To Provision for Bad Debts

(12) Provision for Discount on Debtors:

Adjustment Entry:
Profit and Loss A/c Dr.
To Provision for Discount on Debtors

Accounting treatment

(a) Shown in debit side in P & L A/c.

(b) Deducted from Debtors in Balance Sheet in Assets.

(13) Provision for Discount on Creditors:

Provision for Discount on Creditors Dr.

To Profit and Loss A/c

Accounting treatment

(a) On credit side of P & L A/c.

(b) Deducted from Creditors in liabilities of Balance Sheet.

(14) Manager’s Commission:

Sometimes, the manager may also be entitled to a commission on profit earned by the business. Such
commission is usually calculated as a fixed percentage on profit.

Commission = % Rate X Net Profit before commission

Rate + 100

(15) Drawing of Goods by the proprietor:

Drawing A/c Dr.

To Purchases

Illustration: From the following Trial Balance of Gupta & Sons, prepare Trading and Profit and Loss Account for the year
ended December 31, 1987 and a Balance Sheet as on that date.

339
 Trial Balance

Name to the Account Debit Balances Credit Balances

Rs. Rs.
Capital 500,000
Sales 1,000,000
Sales Returns 25,000
Purchases 500,000
Purchases Returns 15,000
Inventory as on1.1.87 60,000
Land & Buildings 400,000
Plant & Machinery 300,000
Furniture 100,000
Wages 50,000
Carriage Inwards 10,000
Provision for Bad Debts 7,000
Carriage Outwards 5,000
Cartage 5,000
Salaries 40,000
Loan 260,000
Debtors 150,000
Creditors 70,000
Rent 8,000
Bills Receivable 40,000
Acceptance 10,000
General Expenses 20,000
Rent & Rates 10,000
Investments 50,000
Cash in hand 50,000
Bank Overdraft 10,000
Discount 4,500
Bad Debts 5,000
Interest on Investments 5,000
Interest on Bank Overdraft 500
Goodwill 60,000
Total 18,85,000 18,85,000

Additional Information:
1. The value of inventory on December 31, 1987 was Rs. 1,00,000.
2. Depreciation is to be provided on: Land & Building @ 5% p.a. Furniture @ 10% p.a., Plant & Machinery Rs. 50,000.
3. Provision for Bad Debts is to be maintained @5% on debtors.
4. Wages are outstanding to the extent of Rs. 4,000 and Salaries to the extent of Rs. 3,000
5. Interest on Investment outstanding is Rs. 1,000.
6. Rent to the extent of Rs. 2,000 has been received in advance.

Solutions:
Trading & Profit and Loss Account
for the year ended December 31, 1987

Particulars Amount Particulars Amount

Rs. Rs. Rs. Rs.
340
To Inventory as on 1.1.87 60,000 By Sales 10,00,000
To Purchases 5,00,000 Less: Sales Returns 25,000 9,75,000
Less: Purchases Returns 15,000 4,85,000 By Inventory as on 31.12.87 1,00,000
To Wages 50,000
Add: Wages Outstanding 4,000 54,000
To Carriage Inwards 10,000
To Cartage 5,000
To Gross Profit c/d 461,000
10,75,000 10,75,000
To Carriage Outwards 5,000 By Gross Profit b/d 4,61,000
To Salaries 40,000 By Rent 8,000
Add: Outstanding 3,000 43,000 Less: Received in Advance 2,000 6,000
To General Expenses 20,000 By Interest on Investment 5,000
To Rent & Rates 10,000 Add: Outstanding 1,000 6,000
Less: Prepaid 2,500 7,500
To Discount Allowed 4,500
To Bad Debts 5,000
Add: New Provision 7,500
12,500
Less: Old Provision 7,000 5,500
To Depreciation on Plant &
Machinery 50,000
To Interest on Overdraft 500
To Depreciation
Land & Building 20,000
Furniture 10,000 30,000
To Net Profit (transferred
to Capital Account) 307,000
4,73,000 4,73,000

Balance Sheet as on December 31, 1987

Liabilities Amount Assets Amount

Rs. Rs. Rs. Rs.
Capital Fixed Assets
Balance 5,00,000 Goodwill 60,000
Add: Net Profit 3,07,000 8,07,000 Land & Building 4,00,000
Less: Depreciation 20,000 3,80,000
Long Term Liabilities Plant & Machinery 3,00,000
Loan 2,60,000 Less: Depreciation 50,000 2,50,000
Current Liabilities Furniture 1,00,000
Creditors 70,000 Less: Depreciation 10,000 90,000
Acceptances 10,000
Bank Overdraft 10,000 Investment 50,000
Wages Outstanding 4,000 Current Assets
Salaries Outstanding 3,000 Cash in hand 50,000
Rent Received in Advance 2,000 Debtors
Less: Provision for Bad
Debts
Bills Receivable 40,000

341
 Closing Stock 1,00,000
Prepaid Rent & Rates 2,500
Interest on Investment Outstanding 1,000
11,66,00
11,66,000 0

Illustration: From the following balances extracted from the book of Aristo Ltd., prepare a Trading and Profit & Loss
Account for the year ended December 31, 1987 and a Balance Sheet as on that date.

Trial Balance

Name to the Account Debit Balances Credit Balances

Rs. Rs.
Capital 2,00,000
Sales 5,00,000
Sales Returns 10,000
Purchases 2,00,000
Purchases Returns 10,000
Stock on 1.1.87 40,000
Land & Buildings 2,00,000
Plant & Machinery 1,00,000
Wages 25,000
Furniture 50,000
Provision for Bad Debts 5,000
Salaries 25,000
Debtors 82,000
Creditors 1,00,000
Bad Debts 3,000
Bills Payable 30,000
Investments 50,000
General Expenses 20,000
Cash in hand 5,000
Cash at Bank 15,000
Depreciation on Land & Buildings 20,000
8,45,000 8,45,000

Additional Information
1. The inventory on 31.12.87 has been valued at Rs. 80,000. The inventory of the value of Rs. 20,000 was destroyed
by fire on 1.12.87 and a claim of Rs. 15,000 was admitted by the insurance company.
2. Depreciation is to be provided on Plant & Machinery and furniture at 10 per anum.
3. Debtors are bad to time extent of Rs. 2,000. Provision for bad debts is to be made at 5% on debtors and a provision
for discount on debtors at 2%.
4. Wages are outstanding to the extent of Rs. 5,000.
5. Salaries are prepaid to the extent of Rs 2,000.
6. Create a provision for discount on creditors at the rate of
7. Create a provision for repairs to the extent of Rs. 4,000.

342
Solution:

Trading & Profit and Loss Account

for the year ended December 31,1987

Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs. Rs.
To Opening Stock 40,000 By Sales 5,00,000
To Purchases 2,00,000 Less: Sales Returns 10,000 4,90,000
Less: Purchases Returns 10,000 1,90,000
By Closing Stock 80,000
To Wages 25,000 By Loss by Fire 20,000
Add: Outstanding 5,000 30,000
To Gross Profit c/d 3,30,000
5,90,000 5,90,000
To Salaries 25,000
Less: Prepaid 2,000 23,000 By Gross Profit b/d 3,30,000
By Provision for Discount on 1,000
Creditors
To Bad Debts 3,000
Add: Further Bad Debts 2,000
Add: New Provision 4,000
9,000
Less: Old Provision 5,000 4,000
To General Expenses 20,000
To Depreciation on Land & 20,000
Buildings
To Loss by Fire 5,000
To Depreciation on Plant & 10,000
Machinery
To Depreciation on Furniture 5,000
To Provision for Discount on 1,520
Debtors
To Provision for Repairs 4,000
To Net Profit (transferred to 2,38,480
Balance Sheet)
3,31,000 3,31,000

Balance Sheet as on December 31, 1987

Liabilities Amount Assets Amount

Rs. Rs. Rs. Rs.
Capital 2,00,000 Land & Buildings 2,00,000
Add: Net Profit 2,38,000
4,38,480 Plant & Machinery 1,00,000
Creditor 1,00,000 Less: Depreciation 10,000 90,000
Less: Provision for Discount 1,000 99,000 Furniture 50,000
Less: Depreciation 5,000 45,000
Bills Payable 30,000
Wages Outstanding 5,000 Investments 50,000
Provision for Repairs 4,000 Cash in hand 5,000
Cash at bank 15,000
343
 Closing Stock 80,000
Debtors 82,000
Less: Further Bad Debts 2,000
80,000
Less: Provision for Bad debts 4,000
76,000
Less: Provision for Discount 1,520 74,480
Insurance Claim 15,000
Salaries Prepaid 2,000
576,480 576,480

Notes:
1. Depreciation on land & Buildings is given in the Trial Balance. Hence, it is shown in the Profit and Loss
Account only.
2. Provision for Bad Debts has been calculated at 5% on debtors after subtracting further bad debts.
3. Provision for Discount on Debtors has been calculated at 2% on debtors after subtracting further bad debts as
well as provision for bad debts.
4. Loss by fire has been charged to Profit and Loss Account after taking into consideration the claim from
insurance company.

344
 CHAPTER 4: RECTIFICATION OF ERRORS

When the Trial Balance does not tally, it means there are errors in the books of account. These errors must be detected and
rectified before preparing the Final Accounts, otherwise will not reflect a true and fair view of the state of affairs of the
business.

Types of errors:

There are four types of errors.

a) Errors of Omission: When a transaction is completely or partially omitted to be recorded in the book of account,
it is called an error of omission. The Trial Balance does not effect from errors of omission.

b) Errors of Commission: When an error is committed in recording a transaction with wrong amount or posting it to
a wrong amount or the wrong side of an account, it is called an error of commission.

c) Errors of Principle: When a transaction has not been recorded as per rules of debit and credit or Double Entry
System, it is called of principle of errors.

d) Compensating Errors: Those errors which nullify the effect of each other are called compensating errors.

Effect on Trial Balance

Errors

Errors of Principle Errors of Compensating Errors of Commission Errors of Omission

– No Effects of T. B. – No Effects of errors -(Usually effect the T. B.)

Complete Partial
– No Effects of T. B. – Effects
Detection of Errors

It is not important that the difference of the trial balance is lesser or greater. In order to find out the little difference big
errors can be detected which can change the position of the profit and financial condition of the business.

Some steps can be taken detection of errors: -

1. The totaling of trial balance should be done twice and if there is difference then the difference amount should be
traced out and it is to be seen that any account of equal amount of the difference has not been left in writing in the
trial balance. If it is not so, it should be seen by making half of the difference that account of that equal amount has
not been written the opposite side by omission.

2. It is to be seen that such and balance of bank column from the cash book have seen written in trial balance. Before
writing the balance of discount a/c in the trial balance the full posting of the discount column of the columnar cash
book has been done.

3. It is to be seen by dividing the difference of trial balance by 9 and if it is divided fully then there is change of error
by change of figures.

4. After examining the totals of Sub. Books, those books total are to be verified by the posting in the ledger.

5. The accounts written from ledger in the trial balance should be re-examined that no a/c has been missed in writing
anywhere.

345
 6. By reconciliation of the list of creditors and debtors with ledger their total should be examined. It is to be seen also
that their total have been written at proper place in the trial balance with correct amount.

7. The heads of the trial balance of last year and current year are to be checked up fully and if some head has
decreased or increased then it should be examined.

8. It is also to be seen that the balance of all account of last year have seen written in the ledger with correct amount
in the proper side.

9. In spite of this activity if the trial balance does not reconcile the every entry of posting of subsidiary books will be
checked again. All the total and balance are to be reexamined. This work may be done by a person who has not
given his services in the making of trial balance until now.

SUSPENSE ACCOUNT

If after many efforts the trial balance does not reconcile and due to some reasons the preparation of final accounts, by the
business becomes essential then the accounts in which by transferring the difference amount, the trial balance is reconciled,
that is called Suspense Account. This account is opened for a short period with the aim of preparation of final accounts.
Next year with the improvement in the corrective attitude towards the errors. The account is closed spontaneously. If there is
debit balance of this account, it is shown in the assets side of the balance sheet and if there is credit balance of this account,
it is shown in the liabilities side of balance sheet.

Illustration:
How would you rectify the following errors?
1. Rs. 3,000 received for the sale of old machinery has been wrongly posted to Sales Account.
2. Rs. 600, the cost of repairing the machinery has been wrongly charged to Machinery Account.
3. Goods purchased for Rs. 500 from Sanjay has been wrongly debited to Furniture Account.
4. A sale of Rs. 600 has been wrongly credited to the customer’s account.
5. A payment of Rs. 400 on account of rent has been posted twice to the Rent Account.
6. An item of Rs. 197 has been debited to a personal account as Rs. 179.

Solution:

1. The following journal entry is required for rectification:

Rs. Rs.
Sales A/c Dr. 3,000
To Machinery A/c 3,000
(Being rectifying entry for sale of machinery credited
to Sales A/c)

2. The following journal entry is required for rectification:

Repairs A/c Dr. 600

To Machinery A/c 600

3. The following journal entry is required for rectification

Purchases A/c Dr. 500

To Furniture A/c 500
(Being rectifying entry for purchase wrongly
debited to Furniture A/c)

4. This error will be rectifying by debiting the customer’s account with Rs. 1,200 (double of Rs. 600) by writing “To
Wrong from Sales Book on the credit side on…………..Rs. 1,200.”

5. This error will be rectified by entering Rs. 400 on the credit side of the Rent Account by writing “By Double
posting from Cash Book on ……….Rs. 400”

6. The personal A/c has been debited Rs. 18 Short (Rs. 197-179). To rectify this error the personal A/c will be debited
with difference by writing “To Difference in amount posted on …….., Rs. 18.”
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 5. BILL OF EXCHANGE

Definition of Bill of Exchange:-

Bill of exchange is an unconditional written order in which the writer order a particular person to pay a certain amount
of money on demand or after a definite period to writer or another person ordered by him or the bearer.

Features of Bill of Exchange

1. Bill has an order and not a request.

2. The order is unconditional.
3. It is in writing.]
4. This order is given to a particular person whose name is written there in.
5. The order is for the payment of a definite amount on demand or after definite period.
6. It must be signed by the maker of the instrument.
7. It is made by the creditor,
8. It should be duly accepted by the debtor.

Kind of Bill

There are two types of bills.

1. Trade Bill: This bill is written for business transaction if their payment is not made in time, then the drawer
can get payment with the help of the court.

2. Accommodation Bill: Those bills drawn to accommodate or help a fellow businessman.

Difference between a Trade Bill and Accommodation Bill

Basis of Difference Trade Bill Accommodation Bill

a) Objective This is written for business transaction. This is written for mutual
financial help.
b)Proper Consideration Proper consideration is given by the This is no proper consideration.
drawer to acceptor.
c) Proof of debts. It is a proof of debts It is written only for financial
help.
d) Discounting with At the time of need it can be discounted It is discounted and the money
Bank with the bank and money received is kept received is distributed between
by Drawer. both the parties.
e) Help of the Court In case of dishonour of the bill the The amount of bill can not be
amount can be recovered with the help of recovered with the help of court.
the court.

Parties of Bill of Exchange

There are three parties relating to a bill of exchange:-

A) Drawer:-The seller of goods is the drawer of bill of exchange. He is the creditor of the buyer and orders
the buyer to make payment after a specified period.
B) Drawee OR Acceptor:- The purchase of the goods is the drawee or acceptor of the bill of exchange. He is
the debtor and accepts the bill drawn by the seller.
C) Payee:- A person who has the right to receive the payment against the bill.

Accounting for Bill of Exchange

There are three parties relating to bills, the drawers, the acceptor and the payee. The bill transaction affect all these parties,
hence the bill transaction are recorded in the books of all the parties.

In making entries of bill transactions, the rules of Double Entry System should be followed. Taking the bill account as real
account the entries should be made accordingly.

1. On drawing & accepting a Bill

347
 a) In the books of Drawer
B/R A/c Dr.
To Acceptor’s A/c
(Acceptance received)
b) In the books of Drawee
Drawer’s A/c Dr.
To B/P
(Acceptance given)
2. On Payment of the bill

a) In the Books of Drawers

Cash A/c Dr.
To B/R
(Payment received on due date)

b) In the Books of Drawee

B/P A/c Dr.
To Cash
(Payment made on due date)

3. Discounting of the Bill before maturity

a) In the Books of Drawer

Bank A/c Dr.(Cash received)
Discount A/c Dr.(Discount)
To B/R ( Full Amount)

(B/R discounted with the bank)

Note: In the books of acceptor

No entry in the Book.

4. Endorsing a Bill:
Bill is a negotiable instrument, hence the drawer can transfer it in favour of his credits for the payment of debts. In
such case, the bill will go to the endorsee. It’s entry will be as follow:

a) In the books of Endorser

Endorsee A/c Dr.

To B/R A/c
(Bill endorsed to …..)

b) In the books of Endorsee

B/R A/c Dr.

To Endorser’s A/c

Note: There will be no entry of endorsement in the book of acceptor because he is not affected by
endorsement. He has to make payment of the bill to the holder on maturity.

5. Retiring a bill under rebate

a) In the books of Drawer

Cash A/c Dr.

To Rebate A/c
(Payment received under rebate)

b) In the books of Drawee

B/P A/c Dr.

To Cash
To Rebate
(Bill retired under rebate)
348
6. Sending the bill to bank for collection

a) In the books of Drawer

i) When the bill deposited into Bank

Bill for collection A/c Dr.

To B/R
(Bill deposited into Bank for collection)

ii) When the bill is collected and bank inform for bank charges.

Bank A/c Dr.

Bank Charges A/c Dr.
To Bill for collection

iii) When the bill is dishonoured

Acceptor’s Personal A/c Dr.

To Bill for collection
To Bank (N. Charges)
(Bill dishonoured)

Note: There will be no entry in the book of Drawee because he does not affect. He is only one entry passed.

B/P A/c Dr.

To Cash
(Bill paid on due date)

7. Dishonour of the bill:

When due to some reason the drawee is not in a position to make the payment of the bill on the due date the bill is
said to be dishonoured.

a) In the books of holder

i) If he himself is the drawer
Acceptor’s A/c Dr.
To B/R A/c (with amount of bills)
To Cash A/c (with amount noting charges)
(Bill dishonourd on due date and noting charge paid)
ii) If he has endorsed the bill

Acceptor’s A/c Dr.

To Endorsee’s
(Bill dishonoured and noting charged paid)
b) In the books of Acceptor

Bills Payable A/c Dr.

Noting charges A/c Dr.
To Drawer
(Bill dishonoured and noting charge
paid by drawer.)

8. Renewal of the bill:

When the acceptor is unable to make payment of the bill on maturity and the bill is dishonoured he can request the
drawer to cancel the old bill and until as new bill for further period and add interest for the period for which the
new bill is drawn. If the drawer agrees with this proposal, the old bill is cancelled and a new bill is written which is
an accepted by the debtor. Thus canceling the old bill and writing a new bill is called renewed of the bill.
1) In the books of Drawer
a) For cancellation of the old bill

Acceptor’s A/c Dr.

To Bill receivable
349
 (Old bill cancelled)

b) If some amount has been received from the old bill

Cash A/c Dr.
To Acceptors
(Part payment received)

c) For the interest on new bill

(If received in cash)

Cash A/c Dr.

To Interest A/c

(Interest on renewal received in cash)

(If interest is not received in cash)

Acceptors A/c Dr.
To Interest A/c

(Interest on renewal debited to acceptor)

d) On writing a new bill

B/R A/c Dr.
To Acceptors
(Acceptance received for the new bill together with interest)

2. In the books of the acceptor

a) On cancellation on old bill
B/P A/c Dr.
To Drawer’s
(The old bill cancelled)

b) If part payment is made from the old bill:

Drawer’s A/c Dr.

To Cash
(Part payment made)

c) For the interest to be changed on the new bill

I. When interest is paid in cash
Interest A/c Dr.
To Cash A/c
(Intt. Paid in cash)

II. When interest is not paid in cash

Interest A/c Dr.
To Drawer’s A/c
(Intt. on renewal)

d) On acceptance of the new bill

Drawer’s A/c Dr.
To Bill payable
(Acceptance given to a new bill with interest)

350
 ACCOMODATION BILL

Bill drawn to accommodate or help a fellow businessman.

Accounting of accommodation Bill

1. When the drawer of accommodation bill after discounting the bill, remits the acceptor, the entries in Books of
both the parties.

A) In the book of Drawer:

Acceptor A/c Dr.

To Cash
To Discount
(Amount remitted to Mr…)

B) In the books of Acceptor:

Cash A/c Dr.

Discount A/c Dr.
To Drawer’s A/c
(Share received account)

2. When the drawer send his share of amount to the acceptor before maturity, then the entries in the books.

a) In the book of the drawer

Acceptors A/c Dr.

To Cash
b) In the book of the Acceptor

Cash A/c Dr.

To Drawer’s A/c

Illustration

Sohan drew on Mohan a bill for Rs. 1,500 for 3 months on June1, 1987. The bill was endorsed to Rohan. On July
15, Mohan approaches Sohan to renew the bill for a period of three months and charges Rs. 25 as interest. Sohan
agrees to renew the bill. Mohan pays the amount of interest in cash and accepts a new bill for Rs. 1,500. The bill is
honoured on the due date. Record these transactions in the books of various parties.

351
 Solution:
Sohan’s Journal

Particulars Dr. Cr.

Date L.F. Amount Amount
1987 Rs. Rs.
June. Bills Receivable A/c Dr. 1,500
1 To Mohan 1,500
(Being bill received for three months)
" 1 Rohan Dr. 1,500
To Bills Receivable A/c 1,500
(Being bill endorsed to Rohan)
July Mohan Dr. 1,500
15 To Rohan
1,500
(Being bill dishonoured on account of
renewal)
" Mohan Dr. 25
15 To Interest A/c 25
(Being interest due from Mohan)
" Cash A/c Dr. 25
15 To Mohan 25
(Being interest due from Mohan)
" Bills Receivable A/c Dr. 1,500
15 To Mohan 1,500
(Being bill renewed for three months)
Oct. Bank A/c Dr. 1,500
18 To Bills Receivable A/c 1,500
(Being bill honoured on due date)

Mohan’s Journal

Particulars Dr. Cr.

Date L.F. Amount Amount
1987 Rs. Rs.
June. Sohan Dr. 1,500
1 To Bills Payable A/c 1,500
(Being bill accepted for three months)
Bills Payable A/c Dr. 1,500
July 15 To Sohan
8,000
(Being bill dishonoured on account of
renewal)
" Interest A/c Dr. 25
15 To Sohan 25
(Being interest due to Sohan)
" Sohan Dr. 25
15 To Cash A/c 25
(Being cash paid for interest)
" Sohan Dr. 1,500
15 To Bills Payable A/c 1,500
(Being new bill accepted for three months)
Oct Bills payable A/c Dr. 1,500
18 To Bank A/c 1,500
(Being bill payable honoured)

352
 Rohan’s Journal

Particulars Dr. Cr.

Date L.F. Amount Amount
1987 Rs. Rs.
June. Bills Receivable A/c Dr. 1,500
1 To Sohan 1,500
(Being bill received from Sohan)
July Sohan Dr. 1,500
1 To Bill Receivable A/c 1,500
(Being bill dishonoured)

Illustration:
On January 1, 1988 B owes to A Rs. 1,000. A draws on him a bill for Rs. 1,000 for three months. The bill is discounted for
Rs. 980. On the date of maturity B requests A for renewal of the bill. A agrees to his request and the following arrangement
is made.

B pays Rs. 400 in cash and requests for the renewal of the balance for two months, charging interest @ 6 % p.a. to be
included in the new bill.

B becomes insolvent on June 2, 1988 and only one third of the amount could be recovered from his estate.

Record the above transaction in the books of A and B.

A’s Journal

Particulars Dr. Cr.

Date L.F. Amount Amount
1987 Rs. Rs.
Jan. Bills Receivable A/c Dr. 1,000
1 To B 1,000
(Being bill received)
" 1 Bank A/c Dr. 980
Discount A/c Dr. 20
To Bills Receivable A/c
1000
(Being bill discounted)
Apr B Dr. 1,000
4 To Bank A/c 1,000
(Being bill cancelled)
" 4 B Dr. 6
To Interest A/c 6
(Being Interest due from B)
" 4 Cash A/c Dr. 400
To B A/c
400
(Being part payment received in respect of
the cancelled bill)
" 4 Bills Receivable A/c Dr. 606
To B
606
(Being renewal of the bill for three
months)
June B Dr. 606
2 To Bill receivable A/c
606
(Being B become insolvent and bill treated
as dishonoured)
" 2 Cash A/c Dr. 202
Bad debts A/c Dr. 404
To B 606
(Being recovery of one third of the amount
due)

B’s Journal

353
 Particulars Dr. Cr.
Date L.F. Amount Amount
1988 Rs. Rs.
Jan. A Dr. 1,000
1 To Bills Payable A/c 1,000
(Being bill accepted)
Apr Bills Payable A/c 1,000
4 To A Dr.
(Being bill cancelled)
1000
" 4 A Dr. 400
To Cash A/c
400
(Being part payment made in respect of
cancelled bill)
" 4 Interest A/c Dr. 6
To A 6
(Being interest due @ 6% p.a. on Rs. 600)
" 4 A Dr. 606
To Bills Payable A/c
(Being acceptance for the renewed bill for 606
three months)

June Bills Payable Dr. 606

2 To A
606
(Being bill treated as dishonoured at the
time of insolvency)
" 2 A Dr. 606
To Cash A/c Dr.
202
To Deficiency A/c
404
(Being 1/3rd payment made for the
amount due

354
 CHAPTER 6:
DEPRECIATION, RESERVES, PROVISIONS

Meaning

Depreciation means decrease in the value of fixed assets due to their usage and the passage of time.

“Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the value of an asset.”

Characteristics of Depreciation

1. Depreciation is decline in the value of Fixed Assets.

2. Such fall is of a permanent nature. Once an asset is reduced due to depreciation, it cannot be restored to it original
cost.
3. It decreases only the book value of the asset, not the market value.
4. It is non-cash expenses. It does not involve any cash outflow.

Causes of Depreciation

1. By constant use.
2. By expiry of time.
3. By expiry of legal right.
4. By obsolescence
5. By accident.
6. By depletion.
7. By permanent fall of market price.

Method of Depreciation

There are eight method of depreciation.

1. Fixed method/ Original cost method/ Straight line method

Depreciation are calculated under this method:

Yearly Depreciation = Asset Cost – Scrap Value

Life of the Assets

Accounting treatment

a) When purchase assets.

Asset A/c Dr.
To Bank/Vendor

b) When depreciation charged.

Depreciation A/c Dr.
To Assets
c) Amount received on sales of assets.

Bank A/c Dr.

To Assets
d) When loss on sales of assets
P&L A/c Dr.
To Asset
e) When profit on sales of Assets
Asset A/c Dr.
To P & L A/c

2. Diminishing Balance Method: Under this method, as the value of assets goes an diminishing year after year, the
amount of charged every year, also goes on declining.
For example: Rs. 20,000 depreciation is to be charged at 10%

1st Year 20,000 X 10 = 2000

100

355
 2nd Year 18,000 X 10 = 1800
100

Another name is Written Down Value method.

3. Annuity Method
4. Depreciation Fund Method
5. Insurance Policy
6. Revaluation Method
7. Depletion Method
8. Machine Hour Rate Method

Different business organisation adopts different types of method of charging depreciation, but the popular methods are
Straight Line Method (SLM) and the Written Down Value Method (WDV).

Illustration: M/s Ram & Co. purchased a Plant & Machinery will its value being Rs. 1,50,000. Its working life is 5
years. They change depreciation @ 20% p.a.

Prepare Plant & Machinery A/c under the SLM & WDV methods.

Solution:

Plant & Machinery A/c

SLM WDV SLM WDV

To Bank A/c 150000 150000 By Depreciation 30000 30000
By Balance c/d 120000 120000
150000 150000 150000 150000

To Balance b/d 120000 120000 By Depreciation 30000 24000

By Balance c/d 90000 96000
120000 120000 120000 120000

To Balance b/d 90000 90000 By Depreciation 30000 19200

By Balance c/d 60000 76800
90000 90000 90000 96000

To Balance b/d 60000 60000 By Depreciation 30000 15360

By Balance c/d 30000 61440
60000 60000 60000 76800

To Balance b/d 30000 30000 By Depreciation 30000 12288

By Balance c/d NIL 49152
30000 30000 30000 61440

To Balance b/d - 49152

RESERVES1

Reserves: A reserve is an appropriation of profits to strengthen the liquid resources of the business in the sense that profits
to the extent of reserves are not withdrawn by the proprietor or partners or shareholders in the case of a limited company.
Reserves are generally classified as general reserve, specific reserve and capital reserve.

1
Reference: J.R. Monga, Financial Accounting
356
 (i) A general reserve is one which is created to meet a contingent liability not specifically mentioned or
for any other general purpose. Such reserve is also known as a free reserve or revenue reserve.
(ii) Specific reserve is created for a specific purpose such as Investment Fluctuation Reserve.
(iii) Capital reserve is that reserve which is not available for dividend distribution. It is generally created
out of capital profits such as pre-incorporation profits, profits resulting from the sale of fixed assets
and profits on the reissue of forfeited shares by a joint stock company. Other examples of capital
reserves are Securities Premium Account and Capital Redemption Reserve Account which are
statutory capital reserves and can be utilized within the framework of legal provisions of the
Companies Act.

DIFFERENCE BETWEEN GENERAL RESERVE AND SPECIAL RESERVE

General Reserve Special Reserve

1. It is of general purpose. 1. It is created for some specific purpose.
2. It is an appropriation and therefore is 2. It is a charge against profits and therefore
created only if profits are adequate. has to be made whether there is profit or
loss.
3. Its basic purpose is to strengthen the 3. Its main purpose is to meet out some
financial position of the concern. specific liability.
4. It is shown on the liabilities side of the 4. It is normally shown along with the item
Balance Sheet separately. with which it is connected for instance,
provision for depreciation is shown as
deduction from the relevant asset.
5. It represents undisturbed profits and hence 5. It is not distributable.
can be distributed as dividends.

PROVISIONS

A provision is any amount set aside or retained by way of providing for depreciation, renewals, or diminutions in value of
assets, or retained by way of providing for any known liability of which the amount of liability cannot be determined with
considerable accuracy. Examples of provisions are: provision for doubtful debts, provision for repairs, reserves for discount
on debtors etc. A provision may therefore be either in respect of loss in the value of an asset, as a result of ether depreciation
or in respect of a claim which is disputed but which may have to be paid if the dispute is settled against the firm. A
provision, therefore, is distinguishable from a liability in as much as that the obligation, in respect of which it has been
made, may not arise either wholly or partially. The main points of distinction between a provision and reserve are:

1) A provision is charged against the profits and thus created even if there are no profits. But a reserve is an
appropriation of the profit and can be created only when there are sufficient profits.

2) A provision is created for some specific object and can be utilized only for that object. But a reserve is meant for
any contingency and therefore can be utilized for any future liability or loss.

3) A provision cannot be utilized for dividends while unutilized reserve can be used for dividends.

4) Provision is to be transferred to provisions.

5) Provisions are never invested outside the business (and they are known as reserve funds).

6) A provision is deducted from the item for which it is created while reserves are shown in the liabilities side of the
balance sheet.

7) Provisions reduce net profits while reserves reduce only divisible profits.

RESERVE FUNDS
A reserve fund is a reserve which is represented by securities embarked for it; if the amount of reserve is invested in outside
securities, it will become reserve fund. The term reserve alone will indicate that the amount represented by the reserve
is being utilized in the business itself.

357
 SECRET RESERVES
Secret reserve means a reserve which is not disclosed by the balance sheet. It would be revealed only when a correct
valuation is made of assets and liabilities. Obviously the actual financial position of the enterprise with the secret reserves is
better than what is disclosed by the balance sheet. Secret reserves may be created in the following ways:
(i) provision of excessive depreciation (writing down assets unnecessarily) or overvaluation of a liability;
(ii) charging capital expenditure to revenue expenditure;
(iii) treating a revenue receipt as a capital receipt e.g., crediting dividends received to investment account;
(iv) elimination of a valuable asset or undervaluation of an asset. e.g., closing stock;
(v) creating excessive provision for doubtful debts;
(vi) suppression of sales

Advantages: The benefits accruing from the secret reserves are: (i) Financial Stability. Secrete reserves promote financial
stability the sense that the same can be used to meet unexpected losses. The rate of dividends can be maintained; neither the
shareholders nor the public having any knowledge of such happening; confidence in the working of company is not shaken
by losses which merely are incidental to trading. Banks usually create secret reserves by means of creating depreciation on
investment and avoiding appreciation in the values. (ii) Tax relief. The liability for payment of taxes can be postponed by
adopting a conservative basis of assets valuation. (iii) Internal financing: Secret reserves check the profits as dividends
thus enabling the company to retain assets for internal financing. (iv) Competition is warded off: By a concealing the
actual profitability of the business enterprise under inflationary conditions, competitions is warded off.

Disadvantages (i) Concealment of actual state of affairs. Since the shareholders are not aware of actual state of affairs, it
is not possible for them to decide whether they should retain their shares or sell them. (ii) Unfair presentation of final
accounts. Secret reserves are created by debiting profit and loss account with fictitious amounts in the form of excessive
provision for depreciation, bad and doubtful debts, repairs, etc. the assets are undervalued and liabilities are overvalued in
the balance sheet. The result is that the income statement fails to disclose a true and fair figure of profit.

358
 CHAPTER 7:
SINGLE ENTRY SYSTEM OR ACCOUNTING FROM INCOMPLETE RECORDS2

MEANING, REASONS AND LIMITATIONS OF INCOMPLETE RECORDS

Meaning

Incomplete accounting records are those accounting records which at present are not complete according to double entry
principles. Many authors describe it as the Single Entry System but according to the majority of accountants, it is
appropriate to describe it as Incomplete Records because incomplete records contain:
a) Both the aspects of some of the transactions;
b) Only one aspect of some of the transactions;
c) No aspect of some of the transactions.

Reasons

Accounting records may be incomplete due to any one or more of the following reasons:
a) The businessman may be ignorant of the separate legal entity assumption;
b) The businessman may be ignorant of the double entry accounting principles;
c) Business may not intentionally maintain proper accounts to evade taxation;
d) Destruction of the books of accounts due to fire, flood etc.

Limitations

Maintenance of incomplete records suffers from the following limitations:

a) Arithmetical accuracy of the accounts cannot be checked because no agreed trial balance can be prepared.
b) True profits/losses cannot be ascertained because Trading and Profit & Loss Account cannot be prepared.
c) True financial position cannot be ascertained because Balance Sheet cannot be prepared.
d) It is difficult to conduct the audit of such records.
e) It is difficult to operate internal control system.
f) It is difficult to operate internal check system.
g) It is difficult to exercise control over assets.
h) It is difficult to detect fraud.
i) Such records are not recognized by the Courts, sales tax and income tax Authorities.

2
Reference: Gupta R. L., Advance Accounting
359
DISTINCTION BETWEEN DOUBLE ENTRY SYSTEM AND INCOMPLETE RECORDS (POPULARLY
KNOWN AS SINGLE ENTRY SYSTEM)

Basis of Distinction Double Entry System Incomplete Records System

1. Assumptions and It is based on certain assumptions and It is not based on certain assumptions
principles principles. and principles.
2. Both aspects of all Both the aspects of all transactions Both the aspects of all transactions are
transactions are recorded. not recorded.
3. Nature of accounts All types of accounts-Personal, Real, Usually, Cash and Personal accounts
maintained & Nominal, are maintained. are maintained.
4. Trial Balance Arithmetical accuracy of the records Arithmetical accuracy of the records
can be checked preparing a Trial cannot be checked since Trial Balance
Balance. cannot be prepared.
5. Determination of True profits or losses can be Only estimated profit or losses can be
True Profit or determined by preparing Trading and determined since Trading & Profit and
Loss Profit & Loss Account. Loss Account cannot be prepared.
6. Financial position True financial position can be known Only estimated financial position can
by preparing a Balance Sheet. be known on the basis of Statement of
Affairs.
7. Adjustments All types of adjustments are made No special attention is given to
while preparing final accounts. adjustments.
8. Utility It is used by all types of traders. It is used by small traders.
9. Recognition Records maintained according to this Records maintained according to this
system are recognized by the system are not recognized by the
government. government.

PREPARATION OF ACCOUNTS FROM INCOMPLETE RECORDS

To ascertain the results of operations and the financial position of the business, the information available from the
incomplete records can be used in the following methods:
a) Statement of Affairs Method
b) Final Accounts Method

Statement of Affairs Method

The practical steps involved in the ascertainment of the profit or loss according to the Statement of Affairs Method is given
as follows in Exhibit.

Exhibit: Practical steps involved in the ascertainment of the profit/loss according to the Statement of Affairs Method

Step 1 Ascertain Opening Capital by preparing a Statement of Affairs at the beginning of the
accounting period.
Step 2 Ascertain Closing Capital by preparing a Statement of Affairs at the end of the accounting
period.
Step 3 Add: the amount of drawings (whether in cash or in kind) to the Closing Capital, (calculated as
per Step 2).
Step 4 Deduct the amount of additional capital introduced from the Closing Capital (calculated as per
Step 2)
Step 5 Ascertain profit/loss by deducting Opening Capital from the Adjusted Closing Capital.
Note: Adjusted Closing Capital = Closing Capital + Drawings – Additional Capital
Step 6 Deduct interest on capital and salary of the proprietor or partner(s) from the profits (Calculated
as per Step 5).

Format of Statement of Affairs

Statement of Affairs of … As at….

Liabilities Rs. Assets Rs.

Sundry Creditors xxxx Cash in Hand xxxx

Bills Payable xxxx Cash in Bank xxxx

360
Outstanding Expenses xxxx Sundry Debtors xxxx
Bank Overdraft xxxx Bills Receivable xxxx
Capital (Balancing figure) xxxx Stock in trade xxxx
Prepaid Expenses xxxx
Fixed Assets xxxx
xxxx xxxx

Statement showing Profit or Loss for the period ending… Rs.

A Capital at the end of accounting period xxxx
B Format of
Add: Drawings (whether in cash or in kind) during the accounting Period xxxx Statement
C Less: Additional Capital introduced (whether in cash or kind) showing
during the accounting period xxxx Profit or
D Adjusted Capital at the end of accounting period ( A+ B + C) xxxx Loss
E Capital at the beginning of accounting period xxxx
F Profit (if Adjusted Capital is more than the Opening Capital)
or Loss (if Adjusted Capital is less than the Opening Capital) xxxx Distinction
between Statement of Affairs and Balance Sheet

Basis of Distinction Statement of Affairs Balance Sheet

1. Basis of preparation It is prepared on the basis It is prepared on the
of some ledger accounts basis of ledger accounts.
and estimates.
2. Balance of Capital Account Balance of Capital Balance of Capital
Account is arrived at as a Account is taken from
balancing figure. the ledger.
3 Omission of Assets/Liabilities Omission of an asset or Omission of an asset or
liability cannot be easily liability can be easily
traced. traced because of non-
agreement of both the
sides of Balance Sheet
4 Estimated vs. True Financial Position It shows only the It shows the true
estimated financial financial position.
position.

Illustration: Mr. X could not keep complete records. He furnishes you the following information for the year 1995-96.
(a) Particulars of the Assets and Liabilities

1.4.95 31.3.96
Rs. Rs.
Stock-in-trade 37,400 46,800
Sundry Debtors 24,000 28,000
Sundry Creditors 18,000 3,000
Bills Receivable 8,000 10,000
Bills Payable 2,000 400
Furniture & Fixtures 1,200 1,200
Buildings 1,200 1,200
Bank Balance 8,700 1,660(Cr.)

(b) Other information-Additional Capital introduced Rs. 5,000, drawings Rs. 15,000; written off for furniture and
fixtures and buildings, Rs. 6,000 is outstanding for wages and Rs. 2,400 for salaries, prepaid insurance
amounted to Rs. 400, outstanding legal expenses are Rs. 1,400. From the above particulars, find out by
Statement of Affairs method, the Profit or Loss made by Mr. X during 1995-96. Also prepare his Balance
Sheet as at 31st March 1996.

361
 Solution:
Statement of Profit
for the year ending 31.3.96

Rs.
A Capital as 31.3.96 91,480
B Add: Drawings during the year 15,000
C
Less: Additional Capital introduced during the year 5000
D Adjusted Capital at the end ( A+ B - C) 1,01,480
E Less: Capital as at 1.4.95 83,000
F Profit for the year (D - E) 18,180

Balance Sheet of Mr. X as at 31st March 1996

Liabilities Rs. Assets Rs.
Sundry Creditors 3,000 Stock in trade 46,800
Bills Payable 400 Sundry Debtors 28,000
Bank Overdraft 1,660 Less: Provisions 2,800 25,200
Outstanding expenses: Bills Receivable 10,000
Wages 6,000 Prepaid Expenses 400
Salaries 2,400 Furniture & Fixtures 1,200
Legal 1,400 9,800 Less: Depreciation 60 1,140
Capital Balance: Buildings 24,000
Balance 83,300 Less: Depreciation 1,200 22,800
Add: Profit 18,180
Add: Additional Capital 5,000
1,06,480
Less: Drawings 15,000 91,480
1,06,340 1,06,340

Working Notes:
(i) Calculation of Opening Capital

Statement of Affairs of Mr. X as at 31.3.96

Liabilities Rs. Assets Rs.

Sundry Creditors 18,000Cash at Bank 8,700

Bills Payable 2,000Stock –in-trade 37,400
Capital (balancing figure) 83,300Sundry Debtors 24,000
Bills Receivable 8,000
Furniture & Fixtures 1,000
Buildings 24,000
1,03,300 1,03,300

(ii) Calculation of Closing Capital

Statement of Affairs of Mr. X as at 31.3.96
Liabilities Rs. Assets Rs.
Sundry Creditors 3,000Stock –in-trade 46,800
Bills Payable 400Sundry Debtors 28,000
Bank Overdraft 1,660 Less: Provision: 2,800 25,200
Wages Outstanding 6,000Bills Receivable 10,000
Salaries Outstanding 2,400Prepaid Insurance 400
Legal Expenses Outstanding 1,400Furnitures etc. 1,200

362
Capital (b/f) 91,480 Less: Depreciation 60 1,140
Buildings 24,000
Less: Depreciation 1,200 22,800
1,06,340 1,06,340

CHAPTER-8:
HIRE PURCHASE AND INSTALMENT PURCHASE ACCOUNTING 3

When a person is not in a position to acquire an asset against immediate cash payment, he may enter into a hire
purchase transaction with the seller. Under a hire purchase agreement and the balance of the amount is paid in monthly, or
quarterly or six monthly or yearly istalments for a specified period. The instalments include interest on the outstanding
balance. Thus the total amount paid (called hire purchase price) is certainly more than the cash price of the goods. Hire
purchaser is given the possession of the goods on signing the agreement. The property (ownership) in the goods does not
pass to the buyer until all the agreed instalments are paid. If the hire purchaser fails to pay any one of the instalments, the
hire vendor can seize the goods and the hire purchaser will not be entitled to any refund of the instalments already paid by
him, as the amount already paid is treated as hire charges. The hire purchaser has the option to return the goods before the
ownership is transferred, if he does not want to become the owner of the goods. Thus hire purchase agreement is bailment
coupled with an option to buy.

Distinction between hire purchase agreement and instalment purchase agreement

Under instalment purchase system, property (ownership) in goods is usually transferred to the buyer immediately,
on signing of the contract of sale. The buyer agrees to pay the purchase price by instalments. In case of default by the buyer
in payment of any instalments, the seller can sue the buyer for recovery of the amount due but the seller is not entitled to
repossess the goods for non-payment of instalments. The buyer may sell the goods and give good title to a bonafide
purchaser. The following are the points of distinction between hire purchase and instalment purchase system:

Hire Purchase System Instalment Purchase System

1 It is bailment coupled with an option to buy. 1 It is an agreement of out right sale.

2 The property in the goods passes to the hire purchaser 2 The property in the goods passes to the buyer
only when all the instalments are paid. immediately at the time of entering into the contract.

3 The position of the hire purchaser is that of a bailee, 3 The position of the buyer is that of the owner of the
till the payment of all the instalments. goods.

4 Hire purchaser has the option of returning the goods 4 Buyer cannot terminate the contract and is liable to
before the passing of property without paying the rest pay the price of the goods.
of the instalments.
5 The instalments paid are treated as hire charges and 5 The amount payable by the buyer is reduced by the
not as payments towards the price till the option to instalments paid.
purchase is exercised by the hire purchaser.

6 Hire purchaser cannot transfer a good title even to a 6 Buyer can transfer a good title even to a person who
bonafide purchaser. purchases the goods in good faith and for
consideration.
7 Hire seller (vendor) can repossess the goods if the hire 7 Seller cannot reposses the goods in case of default by
purchaser makes default in payment of instalment. the buyer in payment of any instalment; the seller can
sue the buyer for recovery of the balance amount due.

Terms used in Hire Purchase Agreement

1. Hirer or Hire Purchaser: He is the buyer in a hire purchase agreement.

3
Reference: Goyale R. N.: Financial Accounting
363
 2. Hirer Vendor or Hire Seller: Her is seller in a hire purchase agreement.
3. Cash Price: It is the amount to be paid for outright purchase in cash.
4. Down Payment: It is the amount of initial payment payable by the hire purchaser at the time of entering into a hire
purchase agreement.
5. Hire Purchase Price: It is the total amount payable by the hire purchaser to the hire vendor if goods are purchased
under the hire purchase system. It includes the cash price and interest on outstanding balances. The rate of advance
or loan since it includes a charge to cover risk that the hirer may return the goods in damaged condition.

ACCOUNTING FOR HIRE PURCHASE TRANSACTIONS

The method of accounting for hire purchase transaction depends on the sales value of the goods. If the goods have
substantial sales value then (i) cash price method or (ii) Interest suspense method is adopted. If the goods have small sales
value then (i) Hire Purchase Trading Account (Debtors method) or (ii) Stock and Debtors method is adopted.

Hire purchase transactions are recorded in the books taking into consideration the substance of the transaction rather than its
legal form.

CASH PRICE METHOD

Under this method the hire purchaser records the asset at its cash price and the seller recognize the entire profit on sale
under hire purchase agreement in the year in which the sale has taken place and interest is transferred to Profit and Loss
Account of the different accounting periods. Depreciation is charges on the cash price of the asset acquired in the books of
the hirer from the date of acquisition or possession.

Journal Entries in the books of the Hire Purchaser

(1) When the asset is acquired on hire purchase

Asset Account Dr. (For cash price)
To Hire Vendor Account

(2) When down payment is made

Hire Vendor A/c Dr. (For down payment)
To Bank A/c

(3) When an instalment becomes due

Interest Account Dr. (For interest on outstanding balance)
To Hire Vendor A/c
(4) When instalment is paid
Hire Vendor A/c Dr. (For amount of instalment paid)
To Bank A/c

(5) For depreciation on the asset

Depreciation A/c Dr. (On the basis of cash price of the asset)
To Assset A/c

(6) For closing interest account and depreciation account

Profit and Loss A/c Dr.
To Interest A/c
To Depreciation A/c

Journal Entries in the books of the Hire Vendor

(1) When goods are delivered under hire purchase

Asset Account Dr. (For cash price)

To H.P. Sales Account

(2) When the down payment is received

Bank A/c Dr. (For down payment)
To Hire Purchaser A/c

(3) When an interest becomes due

Hire Purchaser Account Dr. (For interest on outstanding balance)
To Interest A/c
(4) When the amount of instalment is received
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 Bank A/c Dr. (For amount of instalment received.)
To Hire Purchase A/c

(5) For closing sales account

H.P. Sales A/c Dr. (On the basis of cash price of the asset)
To Trading A/c

(6) For closing interest account

Interest A/c Dr.
To Profit and Loss A/c
To Depreciation A/c

Illustration:

On January 1, 1998, H. P. & Co. acquired a machine from H. V. Ltd. on hire purchase. The cash price of the machine was
Rs. 80,000, Rs. 20,000 was to be paid on the signing of the contract and the balance was at 10% per annum. Depreciation at
10% per annum is to be written off by the diminishing balance method.

You are required to pass necessary journal entries in the books of H. P. & Co. and H. V. Ltd. Accounts are closed on 31st
December every year.

Solution :

Calculation of Interest Rs.

Calculation of Interest Rs.
Cash Price 80,000
Less: Down Payment 20,000
Balance due after down payment 60,000
Add: Interest for one year to 31-12-98 on Rs. 60,000 at 10% 6,000
66,000
Less: Instalment (Rs. 20,000 + Rs. 6,000) 26,000
Balance due on Jan. 1, 1999 40,000
Add: Interest for one year to 31st Dec., 1999 4,000
On Rs. 40,000 at 10% per anum 44,000
Less: Instalment (Rs. 20,000 + Rs.4,000) 24,000
Balance due on Jan 1, Rs. 2,000 20,000
Add: Interest for one year to 31st Dec., 2000 2,000
On Rs. 20,000 at 10% per anum 22,000
Less: Instalment (Rs. 20,000 + Rs.2,000) 22,000
NIL

Journal Entries in the books of H.P. & Co.

Date Particulars L.F. Dr.(Rs.) Cr.(Rs.)

1998
Jan. 1 Machinery A/c Dr. 80,000
To H.V. Ltd. 80,000
(Being the cash price of the machinery purchased
on hire purchase system)
“ H. V. Ltd. A/c Dr. 20,000
To Bank A/c 20,000
(Being the amount of down payment paid)
Dec. 31 Interest A/c Dr. 6,000
To H.V. Ltd. A/c 6,000
(Being the interest payable @ 10% on Rs. 60,000)
“ H. V. Ltd. A/c( Rs. 20,000 + Rs. 6,000) Dr. 26,000

365
 To Bank A/c 26,000
(Being the payment of first instalment together with
interest)

“ Depreciation A/c Dr. 8,000

To Machinery A/c 8,000
(Being the depreciation charged @10%on 80,000)
“ Profit and Loss A/c Dr. 14,000
To Depreciation A/c 8,000
To Interest A/c 6,000
(Being the transfer of depreciation and interest)
1999 4,000
Dec. 31 Interest A/c Dr. 4,000
To H.V. Ltd. A/c
(Being the interest payable at 10% on Rs. 40,000)
" H.V.Ltd. A/c (Rs. 20,000 +Rs. 4,000) Dr. 24,000
To Bank A/c 24,000
(Being the second instalment paid together with
interest)
" Depreciation A/c Dr. 7,200
To Machinery A/c 7,200
(Being the depreciation charged @ 10%)
" Profit and Loss A/c Dr. 11,200
To Interest A/c 4000
To Ram Lal A/c 7200
(Being the transfer of interest and depreciation)
2000 2,000
Dec. 31 Interest A/c Dr. 2,000
To H.V.Ltd. A/c
(Being the interest payable @ 10% on Rs. 2,000)
" H.V.Ltd. A/c( Rs. 20,000 + Rs. 2,000) Dr. 22,000
To Bank A/c 22,000
(Being the final instalment paid along with interest)
" Depreciation A/c Dr. 6,400
To Machinery A/c 6,480
(Being the depreciation charges @ 10% on Rs.
64,800(Rs. 72,000 - Rs. 7,200)
" Profit and Loss A/c Dr. 8,480
To Interest A/c 2,000
To Depreciation A/c 6,480
(Being the transfer of interest and depreciation)

Journal Entries in the books of H.V.Ltd.

Date Particulars L.F. Dr.(Rs.) Cr.(Rs.)

1998
Jan 1 H.P. & Co. A/c Dr. 80,000
To H.P. Sales A/c 80,000
(Being the goods sold on hire purchase)
" Bank A/c Dr. 20,000
To H.P. & Co. A/c 20,000
(Being the receipt of down payment)
Dec.31 H.P. & Co. A/c Dr. 6,000
To Interest A/c 6000
(Being the interest charged @ 10% on Rs.
60,000)
" Bank A/c (Rs. 20,000 + Rs. 6,000) Dr. 26,000
To H.P. & Co. A/c 26,000
(Being the first instalment received along with
366
 interest)
" Interest A/c Dr. 6,000
To Profit and Loss A/c 6,000
(Being the transfer of interest)
1999
Dec. 31 H.P. & Co. A/c Dr. 4,000
To Interest A/c 4,000
(Being the interest)
" H.P. & Co. A/c (Rs.20,000 + Rs. 4,000) Dr. 24,000
To Interest A/c 24,000
(Being the receipt of second instalment together
with interest)
" Interest A/c Dr. 4,000
To Profit and Loss A/c 4,000
(Being the transfer of interest)
2000
Dec. 31 H.P. & Co. A/c Dr. 2,000
To Interest A/c 2,000
(Being the interest charged @ 10% on Rs.
20,000)
" Bank A/c ( Rs. 20,000 + Rs. 2000) Dr. 22,000
To H.P. & Co. A/c 22,000
(Being the receipt of final instalment)
" Interest A/c Dr. 2,000
To Profit and Loss A/c 2,000
(Being the transfer of interest)

CHAPTER-9:
RECEIPT & PAYMENT AND INCOME & EXPENDITURE ACCOUNT
(Accounting for Non-Profit Organisation)
There are two types of organizations, namely,
 Profit making organisation
 Non-profit making organisation
The Profit making organization prepare Trading A/c, P & L A/c and the Balance Sheet, whereas the Non-profit making
organization such as Charitable Hospitals, Schools, Sport club & other Welfare Association, prepare three statements,
namely,
 Receipt & Payment Account
 Income & Expenditure Account
 Balance Sheet

DISTINCTION BETWEEN RECEIPTS AND PAYMENTS ACCOUNT AND INCOME AND EXPENDITURE
ACCOUNT

Points of Distinction Income and Expenditure Account Receipts and Payments Account
1. Nature It is another name for profit and loss account It is a statement of cash transactions for a
of the non-trading concerns, i.e., clubs, period.
societies, hospitals, educational institutions (Real Account)
etc. (Nominal Account)
2. Commencement It does not begin with any opening balance. It commences with opening balance of cash
in hand and at bank.
3. Outstanding items It contains the whole of the expenditure and It includes only income and expenditure
income of the accounting period (i.e., based actually received and paid whether for the
on mercantile system of accounting). period covered or not (based on cash system
of accounting).
4. Period It contains income and expenditure of the It may comprise not only receipts and
current accounting period only. payments for the current year but also for
367
 the previous or/ and succeeding years.
5. Form Income is shown on the credit side and the Receipts are entered on the debit side and
expenses on the debit side. payments on the credit side.
6. Contents It contains only the items of revenue nature It records both capital and revenue items of
of the current accounting period only. any period current, previous or succeeding
years.
7. Object It represents the net result of all the activities It shows merely the cash on hand/bank at the
during the year resulting in surplus or deficit, close.
as the case may be.
8. Balance Sheet A balance sheet is usually accompanied with No balance sheet is prepared.
the account.
9. Difference between The balance of this account represents either The balance of this account shows only the
two sides surplus or deficit, as the case may be, and is cash in hand/ bank and nothing is done
not carried to the account of next period- afterwards.
instead the surplus is added to or deficit
deducted from capital fund.

(Pro-forma) Income and Expenditure Account for the year ending on ….

Expenditure Rs. Income Rs.

Expenditure Account (say salaries) Income Account (e.g. Subscriptions)
Total salaries paid during the year Total amount of subscription received during the
year
Add: Outstanding at the end Add: Outstanding at the end
Less: Outstanding in the beginning Less: Outstanding in the beginning
(or actual amount of last year
paid)
Add: Advance paid for the salaries (Or actual amount of last year received this year)
last year
Less: Advance paid for the salaries in Add: Advance received last year
the current year
Salaries for the year Less: Advance received this year
Current year's subscriptions
Expenses on consumable material Income
(e.g., Stationery) Profit on Sale of Asset
(1) Opening stock of stationery Sale Price of the asset
(2) Add: Purchases during the year Less: Book Value of the asset sold
(3) Less: Creditors for stationery in the Net Profit on sales
beginning
(4) Add: Creditors for stationery for the Receipts for specific items
current year (Cinema shows)
(5) Add: Advance payment for stationery Less: Amount spent
last year
(6) Less: Advance payment for stationery Net Income on specific items
in the current year
(7) Less: Stock of stationery at the end Other income and gains with adjustments
Value of stationery actually used Excess of expenditure over income to be
deducted from the capital fund in the Balance
Sheet (Balancing Figure)*
Loss on the sale of an asset * Either of the two
Book value of the asset sold
Less: Sale price
Net Loss on sale

Other expenses and losses after necessary

adjustments
Expenses for specific purpose
(e.g., Cinema shows)
Expenses paid

368
Less: Collection
Net expenses on specific item
Depreciation
Excess of Income over expenditure to be
added to the capital fund in the Balance Sheet
(Balancing Figure)*

(Pro-forma) Receipts and Payments Account

Receipts Capital & Revenue(Past, Present & Rs. PaymentsCapital & Revenue(Past, Present & Rs.
Future) Future)

Balance b/d (opening balance) Capital Payments (for past, present and future
periods)
Cash in hand Building construction
Cash at bank Books
Capital Receipts (for past, present and future Sports equipments
periods) Cost of leasehold and investments
Legacies Advance for purchase of buildings
Sale of office furniture Government's loan
Sale of sports equipment Furniture
Donations for special purposes Revenue Payments (for past, present and
e.g., building, prizes etc. future periods)
Membership fees Prizes paid
Sale of investments Entertainment expenses
Endowment fund receipts Printing & Stationery
Receipt on account of special funds Newspaper and periodicals
e.g., Prize fund, Tournament fund. Postages
Interest on specific fund Doctor's or Secretary's honorarium
Investments Expenses on special food to patients
Entrance fees Insurance, Rent, Salaries
Revenue Receipts (for past, present and Advertisement
future periods) Audit fees
Subscriptions Tennis Balls
General donations Telephone, Electricity charges
Proceeds from entertainment Gardening
Interest or dividends on general Bar purchases
Investments Bar expenses
Sale of old newspaper, waste papers, etc Up-keep of lawns
Municipal taxes
Miscellaneous receipts Charity
Balance c/d * (Bank Overdraft) Printing of Year-book
Balance c/d * (Closing Balance)
Cash in hand
Cash at bank*

* There will be either of the two amounts, i.e., bank overdraft or cash at bank and not both.

(Pro-forma) Balance Sheet As on …

Liabilities Rs. Assets Rs.

Capital fund Particular Assets
Opening balance (if any) Last balance b/d
Add: Excess of income over
expenditure Add: Purchases in the current year
Or Less: Book value of the asset sold
Less: Excess of expenditure over Less: Depreciation

369
 income
Capitalised income of the current year
on account of: Closing Balance
Legacies
Entrance Fees
Life Membership Fees

Accounting for Non-profit Making organization, generally we are given a Receipt and Payment Account with some
additional information and will be required to prepare the Income & Expenditure Account and the Balance Sheet.

In the process, we have to deal the following special items: -

1. Subscription: Subscription received from the members are shown on the debit side of the R & P A/c. Out of this
amount, we have to find out the amount of subscription to be shown on the credit side of the I & E A/c/ Thus, we
can find out with the help of given information in the following manner: -

Subscriptions received during the current year xxxx

Add: Subscriptions outstanding at the end of current year xxxx
Less: Subscriptions received in advance during current year xxxx
Add: Subscription received during previous year but belong
to current year xxxx
Less: Subscriptions received in advance during the current year
which belong to next year xxxx
Amount to be shown in Income & Expenditure A/c xxxx

2. Life Membership Fee (received during the year): If it is treated as Capital Receipt, it will be shown in the liability
side of the B/S. But if it is treated as Revenue Receipt then it will be shown on the credit (Income) side of the I &
E A/c.

3. Legacies: It will be shown in the liability side of the B/S from the Receipt & Payment A/c.

4. General Donation: It will be shown as income in the credit side of the I & E A/c form the R & P A/c.

5. Specific Donation: (e.g., Building fund etc..) It will be added to that fund and be shown on the liability side of the
B/S of the current year.

6. Opening Capital Fund: If the opening capital fund is not given then we have to prepare an opening B/S of the
organisation.to find out the opening capital fund.

Illustration:

The Receipts and Payments Account of Navkar Football Club for the year ending 31 st March 1991 was as under:

Prepare club’s income and expenditure account for the year ended 31st March 1991 and the Balance Sheet as on that date
after taking the following information in account:

Rs. Rs.
Balance b/d 48,000 Purchases of balls 80,000
Subscription received 246,000 Tournament fees 10,000
Interest 2,000 Affiliation fees 2,000
Sale of furniture 10,000 Rent of playground 5,000
(Book Value Rs. 14,000) Refreshment expenses 4,000
Donation for club building 60,000 Travelling expenses 30,000
Investment purchased at face 100,00
value 0
Salary 12,000
Miscellaneous expenses 8,000
115,00
Balance c/d 0
366,000 366,00
0
370
Prepare club’s income and expenditure account for the year ended 31 st March 1991 and the Balance Sheet as on that date
after taking the following information in account:
i. The subscription received include Rs. 10,000 outstanding subscription of the year 1989-90. Subscription for
the year 1990-91 amounting to Rs. 16,000 is still outstanding from members. Some members have paid
subscription for the year 1991-92 amounting to Rs. 8,000 which is included in the subscriptions received.
ii. Interest accrued but not received Rs. 500
iii. The rent of playground Rs. 6,000 and salary Rs. 5,000 of the year 1990-91 are still outstanding and rent of
playground of the year 1989-90 Rs. 1,000 has been paid during this year.
iv. There is stock of balls with the club Rs. 4,000 on 31st March 1991.
[B.Comp (P) Delhi 1994]

Solution:
Income and Expenditure Account
For the Year Ended 31 March 1991

Expenditure Rs. Income Rs.

246,0
Cost of balls used Subscriptions 00
80,00 Add: Outstanding for 1990- 16,00
Purchases 0 91 0
4,000 76,00 262,0
Less: Stock at the end 0 00
10,00 Less: Outstanding for 1989- 10,00
Tournament fees 0 90 0
2,000 252,0
Affiliation fees 00
Rent of playground 5,000 Less: Received in advance
6,000 8,000 244,0
Add: Outstanding for 1991-92 00
11,00
0
Less: Outstanding Interest 2,000
1,000 10,00 500 2,500
for 1989-90 0 Add: Accrued
Refreshment to players 4,000
30,00
Travelling Expenses 0
12,00
Salary 0
5,000 17,00
Add: Outstanding 0
Miscellaneous expenses 8,000
Furniture - Loss on sale 4,000
Excess of Income over
85,50
Expenditure 0
246,5 246,5
00 00

Balance Sheet As On 31 March 1990

Liabilities Rs. Assets Rs.

1,000 48,00
Outstanding rent Cash 0
10,00
Capital fund Subscriptions due 0
71,00 14,00
(Balancing figure) 0 Furniture 0
72,00 72,00
0 0

371
 Balance Sheet As On 31 March 1991

Liabilities Rs. Assets Rs.

115,0
Subscription received in Cash 00
8,000 100,0
Advance Investments 00
Outstanding rent 6,000 Accrued Interest 500
5,000 16,00
Outstanding salary Subscriptions due 0
60,00 4,000
Building fund 0 Furniture
71,00
Capital fund 0
85,50 156,5
Add: Surplus 0 00
235,5 235,5
00 00

CHAPTER-10:
ACCOUNTING FOR THE SHARE CAPITAL 4

MEANING, NATURE AND CHARACTERISTICS OF A COMPANY

With the expansion in the scale of operations, non-corporate form of organization (i.e. sole proprietor, partnership firms)
found themselves unequal to the task of meeting all the capital requirements of the present day large scale business
operation. Thus, a relatively new form of business organisation came into vogue and this is called a ‘Joint Stock Company’
or simply, a company.

A company may be defined as an artificial person created by law, having a corporate and legal personality distinct
and separate form its members, perpetual succession and a common seal. The essential characteristics of a company are as
follows:
(a) It is an incorporated (registered) association.
(b) It is an artificial person created by law.
(c) It has a separate legal entity.
(d) It has a perpetual succession, i.e. it can be created and wound up by law only.
(e) It has a common seal, i.e. official signature of the company.

Unlike a proprietary concern or partnership concern which has no existence apart from its members, a company is a
corporate and legal personality distinct and separate from its members.

MEANING AND CATEGORIES OF SHARE CAPITAL

Share Capital means the capital raised by the issue of shares. The amounts invested by the shareholders towards the face
value of shares are collectively known as ‘Share Capital’ which is quite distinct form the capital put in by individual
shareholders.

The share capital is divided under the following three heads:

(a) Authorised Capital: Authorised Capital refers to that amount which is stated in the ‘Capital Clause’ of the
Memorandum of Association as the share capital of the company. This is the maximum limit of the company which
it is authorized to raise and beyond which the company cannot raise unless the capital clause is the Memorandum is
altered in accordance with the provisions of Sec. 94 of the Companies Act, 1956.

(b) Issued Capital: Issued Capital refers to the nominal value of the part of authorized capital, which has been (i)
subscribed for by the signatories to the Memorandum of Association, (ii) allotted for cash or for consideration
other than cash and (iii) allotted as Bonus shares.
(c) Subscribed Capital: Subscribed Capital refers to the paid-up value of the issued capital.

4
Reference: Gupta R. L., Advanced Accounting
372
 Others terms used under the Companies Act 1956 are:

(i) Unissued Capital- Unissued Capital refers to that portion of the authorized capital which has not yet been
issued.

(ii) Uncalled Capital: Uncalled capital refers to that portion of the issued capital which has not been called up by
the company.

(iii) Reserve Capital: It refers to that portion of uncalled share capital which shall not be capable of being called up
except in the event and for the purposes of the company being wound up (Sec. 99).

DISTINCTION BETWEEN RESERVE CAPITAL AND CAPITAL RESERVE

Reserve Capital should not be confused with Capital Reserve which is created out of profits. Reserve Capital and
Capital Reserve can be distinguished as under:

Basis of
Reserve Capital Capital Reserve
Distinction
1 Meaning It refers to that portion of uncalled It refers to those amounts which
share capital which shall not be are not distribution by way of
capable of being called up except dividend through Profit and Loss
in the event and for the purpose Account.
of the company being wound up.
(Sec. 99)
2 Creation-Optional It is not mandatory to create It is mandatory to create Capital
Mandatory Reserve Capital. Reserve in case of profit on
forfeited shares.
3 Disclosure in It is not disclosed in the It is required to be disclosed as
Balance Sheet company's Balance Sheet. the 1st item under the head
'Reserves and Surplus' on the
liabilities side of the Balance
Sheet.
4 Time when it can It can be used only at the time It can be used during the life of
be used winding up. the company.
5 Realised vs. It refers to the amount which has It (excluding items like
Unrealised neither been called up nor been revaluation profit) refers to that
received. amount which has already been
realises.
6 Writing off or It cannot be used to write off It can be used to write off capital
capital losses capital losses. losses.
7 Source of share It cannot be used to declare a It (excluding items like
bonus share bonus. revaluation profit) can be used to
declare a share bonus.

DISTINCTION BETWEEN AUTHORISED CAPITAL AND ISSUED CAPITAL

Basis of
Authorised Capital Issued capital
Distinction
1 Meaning It refers to that amount which is It refers to the nominal value of
stated in the Memorandum of that part of authorised capital
Association as the share capital which has been (i) subscribed for
of the company. by the signatories to the
memorandum of Association and
(ii) allotted for cash or
consideration other than cash.
2 Determination Its amount is determined after Its amount is determined after
considering present and future considering the present
requirements. requirements.

373
 3 Disclosure in Its amount is required to be Its amount is not required to be
Memorandum of disclosed in the Memorandum of disclosed in the Memorandum of
Association Association. Association
4 Basis of Stamp Stamp Duty is payable on the No stamp duty is payable.
Duty basis of authorised capital.
5 Basis of Company Company registration fee is Issued capital is not the basis for
registration payable on the basis of registration fees.
authorised capital.
6 Alteration of Any change in the amount of Any change in the amount of
Memorandum authorised capital amounts to an issued capital does not amount to
alteration of the Memorandum of an alteration of the Memorandum
Association of Association.
7 Whether one can It can exceed issued capital. It cannot exceed authorised
exceed other capital.

Illustration 1 Tulsian Ltd. Was formed with a capital of Rs. 1,00,000 divided into 10,000 shares or Rs. 10 each. Out of
these 2,000 shares were issued to the vendors as fully paid as purchase consideration for a fixed asset acquired. 6,500 shares
were offered to the public and of these 6,000 shares were applied for and allotted. The directors called Rs. 6 per share and
received the entire amount except a call of Rs. 2 per share on 500 shares. How would you show the relevant items in the
Balance Sheet of Tulsian Ltd.

Balance Sheet of Tulsian Ltd. as at …

Liabilities Rs. Assets Rs.

Share Capital: Fixed Assets: 20,000
Authorised Capital: Current Assets:
10,000 shares of Rs. 10 each 1,00,000 Cash at Bank 35,000
Issued Capital
8,000 shares of Rs.10 each 80,000
Subscribed Capital
2,000 shares issued as fully paid
for consideration other than cash 20,000
6,000 shares of Rs. 10 each
Rs. 6 called up 36,000
Less: Calls unpaid
@ Rs. 2 on
500 shares 1,000 35,000
55,000 55,000

MEANING, NATURE AND CLASSES OF SHARES

Share is a fractional part of the capital and forms the basis of ownership in a company. The persons who contribute money
through shares are called ‘Shareholders’.
A share is not a sum of money but is an interest measured by a sum of money. Share is a bundle of rights and
obligation contained in the contract (i.e. Articles of Association).
Under the existing provisions of sec. 86 of the Companies Act, now only two kinds of shares may be issued viz.,
Preference shares and Equity shares.

Preference Share: According to Sec. 85, a preference share is one which carries the following two rights:
(a) A right to receive dividend at a stipulated rate or of a fixed amount before any dividend is paid on equity shares.
(b) A right to receive repayment of capital on winding up of the company, before the capital of equity shareholders is
returned.

In addition to the aforesaid two preferential rights, a preference share may carry some other rights. On the basis of
additional rights, preference shares can be classified as under:
(a) Cumulative Preference Share is that share on which arrears of dividend accumulate. Unless otherwise stated, a
preference share is always deemed to be a cumulative one.
(b) Non-Cumulative Preference Share is that share on which arrears of dividend do not accumulate as per the express
provision in the Articles of Association.
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 (c) Participating Preference Share is that share which, in addition to two basic preferential rights, also carries one or
more of the following rights as per Articles:
(i) A right to participate in the surplus profits left after paying dividend to equity shareholders.
(ii) A right to participate in the surplus assets left after the repayment of capital to equity shareholders on
the winding up of the company.

(d) Non-participating Preference Share is that share which is not a participating share. Unless otherwise stated, a
preference share is always deemed to be a non-participating preference share.
(e) Convertible Preference Share is that share which confers on its holder a right of conversion into equity share.
(f) Non-convertible Preference Share is that share which does not confer on its holder a right of conversion into equity
share. Unless otherwise stated, a preference share is always deemed to be a non-convertible one.
(g) Redeemable Preference Share is that share which is redeemable in accordance with the provisions of Sec. 80A of
the Companies Act, 1956. After the commencement of the Companies (Amendment) Act 1988, no company
limited by shares can issue any preference share which is redeemable.

Equity Share: An equity share is a share which s not a preference share.

DISTINCTION BETWEEN AN EQUITY SHARE AND PREFERENCE SHARE

An Equity Share and Preference Share can be distinguished as under: -

Basis of Equity Share Preference Share

Distinction
1 Preferencial right Payment of equity dividend is Payment of preference dividend
as to the payment made after the payment of is made before the payment of
of dividend preference dividend. equity dividend.
2 Preferencial right Repayment of equity share Repayment of preference share
as to the capital is made after the capital is made before the
repayment of repayment of preference share repayment of equity share
capital. capital. capital.
3 Fluctuations in the The rate of equity dividend may The rate of preference dividend is
rate of dividend vary from year to year depending fixed.
upon the decision of directors and
members.
4 Arrears of dividend In case of an equity share, In case of a preference share,
arrears of dividend cannot arrears of dividend may
accumulate in any case. accumulate.
5 Convertibility It is non-convertible. It may be convertible.
6 Redeemability It is non-redeemable during the It is redeemable during the
lifetime of the company. lifetime of the company.
7 Premium on It cannot carry a right to receive It may carry a right to receive
redemption premium on redemption. premium on redemption.
8 Voting Rights Equity shareholders enjoy voting Preference shareholders do not
rights. have any voting rights except at
their meeting.

ISSUE OF SHARES

A company can issue shares in two ways:

(a) for cash (b) for consideration other than cash

These shares may be issued at par or at a premium or at a discount. Such issue price may be payable either in
lumpsum alongwith application or in instalments at different stages (e.g. partly on application, partly on allotment, partly on
call). Accounting procedure for the issue of shares of cash is given below:
Exhibit: Accounting Procedure for the issue of shares for cash
Step 1 Record the receipt of application money
Step 2 Situation I -When no. of shares applied = No. of shares offered
Transfer application money on the shares allotted to ‘Share Capital A/c’
OR
Situation II - When no. of shares applied < no. of shares offered
(a) If the minimum subscription has at least been received.

375
 Transfer application money on the shares allotted to ‘Shares Capital A/c.

(b) If the minimum subscription has not been received.

Refund application money to all the applicants.
OR
Situation III - When no. of shares applied > no. of shares offered
Transfer application money on the shares allotted to 'Share Capital A/c’
And
Transfer excess application money (not exceeding the amount due on allotment) to ‘Share Allotment
Account’ in case of partially accepted applications.
And
Refund application money in case of rejected applications and excess application money over and above
the allotment money in case of partially accepted applications.

Step 3 Make due allotment money on shares allotted.

Step 4 Record the receipt of allotment money.
Step 5 Make due the First Call money on shares allotted.
Step 6 Record the receipt of First Call Money and so on.

Minimum Subscription [Sec. 69]

The minimum subscription refers to the amount which, in the opinion of directors, must be raised by issue of shares in order
to provide for the following: -

(i) The purchase price of any property purchased or to be purchased which is to be met out of the proceeds of the issue of
shares;
(ii) Any preliminary expenses payable by the company and any commission payable in connection with the issue of shares;
(iii) The repayment of any money borrowed by the company in respect of any of the above two matters;
(iv) Working capital; and
(v) Any other expenditure stating the nature and purposes thereof and the estimated amount in each case.

Note: In view of the existing guidelines for the issue of shares/debentures, the aforesaid section has become redundant. The
latest guideline is –If the company does not receive a minimum subscription of 90% of the issued amount within60 days
from the date of closure of the issue, the company shall forthwith refund the entire subscription amount.

Under-subscription: Shares are said to be under-subscribed when the number of shares applied for is less than the number
of shares applied for is loess than the number of shares offered. For example, in case a company has offered 5,000 shares to
public but the public applied for 4,500 shares only, it is called a case of under-subscription. In such a case, it must be
ensured whether the company has received the minimum subscription or not.

Over-subscription- Shares are said to be over-subscribed when the numbers of shares applied is more than the number of
shares offered. For example, in case a company has offered 5,000 shares to public but the public applied for 6,000 only, it is
called a case of over-subscription.

DISTINCTION BETWEEN OVER-SUBSCRIPTION AND UNDERSUBSCRIPTION

Over-subscription and under-subscription of shares can be distinguished as under:

Basis of Equity Share Preference Share

Distinction
1 No. of shares In case of over-subscription, In case of under-subscription,
applied as number of shares applied for is number of shares applied for is
compared to No. of more than the number of shares less than the number of shares
shares offered. offered by the company. offered by the company.
2 Acceptance of all All applications are not accepted All applications are accepted in
applications in full. full.

3 Problem of This problem does not arise at all. If the minimum subscription has
minimum not been subscribed, all
subscription when application money may be
shares are issued required to be returned.
for the first time.

376
 4 Return of money if The company returns the money The question of returning the
minimum to the applicants whose money does not arise at all.
subscription has applications have either been
not been received. rejected or have been rejected or
have either been rejected or have
been accepted partially.

ISSUE OF SHARES AT PAR

Shares are said to be issued at par when they are issued at a price equal to the face value, i.e., when the issue price is equal
to the face value. For example, if a share of Rs. 10 is issued at Rs. 10, it is said that the share has been issued at par. The
issue price of a share may be payable either in lump sum along with the application or in instalments. The accounting entries
will be as follows:

1 On Receipt of Application money (With Application money received)

Bank A/c Dr.
To Share Application A/c
2 On Acceptance of Applications (With Application money due on shares
Share Application A/c Dr. allotted)
To Share Capital A/c
3 On Making Allotment Money due (With Allotment money due)
Share Allotment A/c Dr.
To Share Capital A/c
4 On Receipt of Allotment Money (With Allotment money received)
Bank A/c Dr.
To Share Allotment A/c
5 On Making the First Call (With First Call money due)
Share First Call A/c Dr.
To Share Capital A/c
6 On Receipt of the First Call A/c (With First Call money received)
Bank A/c Dr.
To Share First Call A/c

Notes:

(i) Similar entries may be made for the second call and third call through Share Second Call Account and Share Third
Call Account, respectively. In case of last call, the word ‘final’ is also added to the concerned ‘Share Call
Account’. In case the entire balance is payable, on a single call usually, the term ‘Share Call Account’ is used.
(ii) In case the Cash Book is required to be prepared, all cash and bank transactions will be entered in the cash book
and other transactions will be entered in the ‘Journal Proper’.
(iii) In order to distinguish one type of share from the other one, the name of the share (i.e., whether Equity or
Preference) must be prefixed with the word ‘Share’ e.g. Preference Share Capital Account, Equity Share Capital
Account, Preference Share Application Account.
(iv) Instead of preparing separate Share Application A/c & Share Allotment A/c, entries relating to the application and
allotment may be passed through a combined, ‘Share Application & Allotment A/c’. In such a case, an entry for
transferring the surplus application money towards allotment on partially accepted applications is not required to
be passed.

Illustration: ABC Corporation Ltd. was registered on 1st January 1998 with a capital of Rs. 10,00,000 divided into 1,00,000
shares of Rs.10 each. The company offered 44,000 shares of which 40,000 shares were taken up by the public and Re. 1 per
share was received with application. On 1st February, these shares were allotted and Rs. 2 per share was duly received on
28th February as allotment money. A first call of Rs. 3 per share was made on 1 st March and the call money on all shares
with the exception of 100 shares was received. The final call of Rs. 4 per share was made on 1 st June and the amount due,
with the exception of 400 shares, was received by 30th June. Pass the necessary Journal entries and prepare Balance Sheet as
on 30th June, 1998.

Solution:
Journal

Date Particulars L.F. Dr.(Rs.) Cr.(Rs.)

01.01.98 Bank A/c Dr. 40,000
To Share Application A/c 40,000

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 (Being the application money received on
40,000 @ Re. 1 per share)
01.02.98 Share Application A/c Dr. 40,000
To Share Capital A/c 40,000
(Being the application money adjusted)
02.02.98 Share Allotment A/c Dr. 80,000
To Share Capital A/c 80,000
(Being the allotment money due on
40,000 shares @ Rs. 2 per share)
28.02.98 Bank A/c Dr. 80,000
To Share Allotment A/c 80,000
(Being the allotment money received)
01.03.98 Share 1st Call A/c Dr. 120,000
To Share Capital A/c 120,000
(Being the share 1st Call money due on
40,000 shares @Rs. 3 per share)
01.03.98 Bank A/c Dr. 119,700
To Share 1st Call A/c 119,700
(Being the share 1st Call money received
on 39,000 shares @Rs. 3 per share)
01.06.98 Share Second & Final Call A/c Dr. 160,000
To Share Capital A/c 160,000
(Being the share second & final call
money due on 40,000 shares @Rs. 4 per
share)
30.06.98 Bank A/c Dr. 158,400
To Share Second & Final
Call A/c 158,400
(Being the share second & final call
money received on 39,600 shares @Rs.
3 per share)

Balance Sheet as at 30th June 1998

Liabilities Rs. Assets Rs.

Share Capital Current Assets: 3,98,100
Authorised Capital: Cash at Bank
1,00,000 shares of Rs. 10 each 10,00,000
Issued Capital:
40,000 shares of Rs. 10 each 4,00,000
Subscribed Capital:
40,000 shares of Rs. 10 each 4,00,000
Less: Calls unpaid
First call @ 3 on 100
shares 300
First call @ 4 on 400
shares 1,600 1,900
3,98,100 3,98,100

Issue of share other than cash

(a) When purchased Assets

Assets A/c Dr.

To Vendor A/c

(b) Share issued to vendor

Vendor’s A/c Dr.

To Share Capital A/c
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Issue of share for promoters

Goodwill A/c Dr.

To Share Capital A/c

Forfeiture of shares

Meaning:- If a shareholder fails to pay allotment money or a call or a part thereof by the last date fixed for payment, the
Board of Directors, if articles of Association of the company permit, proceed to forfeit share on which allotment or calls
money has become arrears.

Accounting treatment

(A) If shares were issued at par:

Share Capital A/c Dr. (Called up capital)

To Forfeited Share A/c (Actual amount received)
To Share Allotment A/c
To Calls A/c (Amounts not paid)
(B) If shares were issued at discount

Share Capital A/c Dr. (Called up capital)

To Discount on issue of shares (Discount amount)
To Share Allotment A/c (Amount not paid)
To Calls ( “ )
To Share Forfeited (Actual received)

(C) If shares were issued at premium

Share Capital A/c Dr. (Called capital)

Security premium A/c (Premium amount)
To Share Allotment (Not paid amount
To Share Calls
To Share Forfeited (3 F)

Re-issue of forfeited shares

(A) Re-issue at par

(i) Bank A/c Dr.

To Share Capital A/c

(ii) Share forfeited A/c Dr.

To Capital Reserve A/c

(B) Re-issue at Discount

(i) Bank A/c Dr.

Forfeited A/c Dr.
To Share Capital A/c

(ii) Share Forfeited A/c Dr.

To Capital Reserve A/c

(C) Re-issue at premium

(i) Bank A/c Dr.

To Share Capital A/c
To Share Premium A/c
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 (ii) Share Forfeited A/c Dr.
To Capital Reserve A/c

Illustration: (Reissue of forfeited shares originally issued at premium)

The directors of Mamta Ltd. invited applications for 2,00,000 equity shares of Rs. 10 each to be issued at 20 percent
premium. The amount payable per share is as under:

On Application : Rs. 5
On Allotment : Rs. 4 (including premium of Rs. 2)
On First Call : Rs. 2
On Final Call : the balance

Application were received for 2,40,000 shares and allotment was made as follows:

a) To applicants for 1,00,000 shares - in full.

b) To applicants for 80,000 shares - 60,000 shares
c) To applicants for 60,000 shares - 40,000 shares

Applicants for 1,000 shares falling in category a) and applicants for 1,200 shares falling in category b) failed to pay
allotment money. These shares were forfeited on failure to pay first call.
Holders of 1,200 shares falling in category c) failed to pay first call and final call and these shares were forfeited after final
call.
1,300 shares [1,000 of category a) and 300 of category b)] were issued at Rs.8 per share as fully paid.
Journalise the above transactions. Show Cash Book and prepare Balance Sheet.

Solution:
Mamta Ltd.
Journal Entries
(i) Share Application A/c Dr. 12,00,000
To Equity Share Capital A/c 10,00,000
To Share Allotment A/c 2,00,000
(Transfer of application money to equity share
capital account on allotment and the balance
adjusted towards allotment money)
(ii) Share Allotment A/c Dr. 8,00,000
To Equity Share Capital A/c 4,00,000
To Securities Premium A/c 4,00,000
(Allotment money due on 2,00,000 shares @ Rs. 4
per share including securities premium of Rs. 2
per share)
(iii) Share First Call A/c Dr. 4,00,000
To Equity Share Capital A/c 4,00,000
(First call money due on 2,00,000 shares @ Rs. 2
per share)
(iv) Equity Share Capital A/c (1,900 X 9) Dr. 17,100
Securities Premium A/c (1,900 X 2) Dr. 3,800
To Share Allotment A/c 6,100
To Share First Call A/c 3,800
To Share Forfeited A/c 11,000
(Forfeiture of 1,900 shares for non-payment of
allotment and first call money)
(v) Second and Final Call A/c Dr. 1,98,100
To Equity Share Capital A/c 1,98,100
(Second and final call due on 1,98,100 shares @
Re. 1 each)
(vi) Equity Share Capital A/c (1,200 X 10) Dr. 12,000
To Share First Call A/c (1,200 X 2) 2,400
To Share Second and Final Call A/c
(1,200 X 1) 1,200
To Share Forfeited A/c (1,200 X 7) 8,400

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 (Forfeiture of 1,900 shares for non-payment of
allotment and first call money)
(vii) Share Forfeited A/c (1,300 X 2) Dr. 2,600
To Equity Share Capital A/c 2,600
(Re-issue of 1,300 forfeited shares at a loss of
Rs.2 per shares)
(viii) Share Forfeited A/c Dr. 4,400
To Capital Reserve A/c 4,400
(Profit on reissue of 1,300 shares transferred to
Capital Reserve Account)

Cash Book (Bank Column)

Rs. Rs.
Share Application Account 12,00,000 Balance c/d 23,95,000
Share Allotment Account 5,93,900
Share First Call Account 3,93,800
Share Second and Final Call 1,96,900
Account
Equity Share Capital Account 10,400
23,95,000 23,95,000

Balance Sheet of Mamta Ltd. As On…

Liabilities Rs. Assets Rs.

Share Capital Current Assets
Authorised ? Cash at Bank 23,95,000
Issued Capital:
2,00,000 Equity Shares of Rs. 10 each 20,00,000
Subscribed:
1,98,200 Equity Shares of Rs. 10 each
fully paid 19,82,000
Add: Share Forfeited Account 12,400
19,94,400
Reserves and Surplus
Securities Premium Account 3,96,000
Capital Reserve 4,400
23,95,000 23,95,000

IMPORTANT CALCULATIONS
Rs.
(i) Allotment money not received on allotment from applicants for 1,000
in category a) 1000 X 4 4,000

(ii) Allotment money not received from applicants for 1,200 shares in
category b)

Number of shares allotted = 60,000 X 1,200 = 900 Shares

80,000
Rs.
Application money received on 1,200 shares (1,200 X 5) 6,000
Less: Application money on 900 shares allotted (900 X 5) 4,500
Excess application money adjusted towards allotment 1,500

Amount payable on allotment (900 X 4) 3,600

Less: Excess application money 1,500
381
 Amount not received on allotment 2,100

(iii) Actual amount received on allotment

Amount due on 2,00 000 shares (2,00,000 X 4) 8,00,000
Less: Received along with application money 2,00,000
6,00,000
Less: Amount not paid in category a) (1000 X 4) (4,000)
Amount not paid in category b) (2,100)
Actual amount received on allotment 5,93,900

(iv) Amount received on first call

Total amount due (2,00,000 X 2) 4,00,000
Less: Not received on 1,000 shares in category a)
900 shares in category b) and 1,200 shares
in category c) (3,100 X 2) 6,200
3,93,800
(v) Amount received on second and final call
Total amount due (1,98,100 X 1) 1,98,100
Less: Not received (1,200 X 1) 1,200

(vi) Amount forfeited

(1) In category (a) 1,000 x 5 (application money) 5,000
(2) In category (a) 1,000 x 5 (application money) 6,000
(3) In category (a) 1,000 x 5 (application money) 6,000
(4) In category (a) 1,000 x 5 (application money) 2,400
19,400

(vii) Amount transferred to capital reserve

Category a) (5,000 – 2,000) 3,000
Category b)
Total amount forfeited on 900 shares: 6,000

Less: Amount to be retained in

Share Forfeited Account
6,000 x 600
900 4,000
2,000

Less: Loss on issue (300 x 2) 600 1,400

Amount transferred to capital reserve 4,400
(viii) Since none of the shares in category c) has been
reissued, the total amount forfeited on these shares,
i.e. Rs. 8,400 would remain in the share forfeited account

(ix) Total amount in Share Forfeited Account

In category b) 4,000
In category c) 8,400
12,400

ISSUE OF DEBENTURE

Meaning: Debenture is a document under the company deal which provides for the repayment of a principal sum and
interest thereon at a regular interval which is usually secured by a fixed or floating charge on the company’s property
which acknowledge loan of the company.

A debenture is a written acknowledgement by a limited company of a loan made to it.

Features of Debenture

(a) It is issued by a company and is usually in form of a certificate which is an acknowledgement of debentures.
(b) It is normally given under the seal of the company.
(c) Loan in form of debenture is normally secured by a charge on the under taking of the company.
382
(d) A debenture holder is not entitled to vote in the meetings of the company.
(e) Rate of interest payable on debenture is fixed and generally less than the rate of dividend payable on equity shares.

Kinds of Debentures

1. Secured and unsecured debentures

2. Redeemable and Irredeemable debentures
3. Convertible and non-convertible debentures.
4. Registered and bear debentures.

Accounting of issue of debentures

(a) Issued at par:

Bank A/c Dr.
To % Debenture A/c

(b) Issued at discount

Bank A/c Dr.
Discount on issue of Debenture A/c Dr.
To % Debenture

(c) Issued at premium

Bank A/c Dr.
To % Debenture
To Premium on issue of deb.

When debentures are issued for payment in instalment.

(1) When Deb. Application money received.
Bank A/c Dr.
To % Deb. Application A/c

(2) Debenture Application amount transfer to debenture A/c.

% Debentures Application A/c Dr.
To % Debenture A/c

(3) Amount due on allotment

Deb. Allotment A/c Dr.
To % Debenture A/c

(4) Amount received on Allotment.

Bank A/c Dr.
To Debenture Allotment

(5) Amount due on calls.

Debentures calls A/c Dr. I, II, III
To % Debenture A/c

(6) Bank A/c Dr.

To Debenture Call I, II, III

Illustration: (Issue of debentures at a discount)

T. V. Components Limited issued 10,000 12% debentures of Rs. 100 each at a discount of 5% payable as follows:
On application Rs. 30
On allotment Rs. 45
On first call Rs. 20

Show the journal entries including those for cash, assuming that all the instalments were duly collected.

Solution:
T. V. Components Ltd.

Journal Entries

Date Particulars Dr.(Rs.) Cr.(Rs.)

383
 (I) Bank A/c Dr. 3,00,000
To 12% Debenture Application A/c 3,00,000
(Receipt of application money on 10,000, 12%
debentures @ Rs. 30 per debenture)
(ii) 12% Debenture Application A/c Dr. 3,00,000
12% Debenture Allotment A/c Dr. 4,50,000
Discount on the issue of Debenture A/c Dr. 50,000
To 12% Debenture A/c 800,000
(Transfer of application money received and
allotment money due on 12% debentures to 12%
debentures a/c)
(iii) Bank A/c Dr. 4,50,000
To Share Capital A/c 4,50,000
(Being the allotment money due on 40,000 shares
@ Rs. 2 per share)
(iv) 12% Debenture First and Final Call A/c Dr. 2,00,000
To 12% Debenture A/c 2,00,000
(Being first and final call due on 10,000, 12%
debentures @ Rs. 20 per debenture)
(v) Bank A/c Dr. 2,00,000
To 12% Debenture A/c 2,00,000
(Receipt of allotment money)
(vi) Bank A/c Dr. 3,92,800
To Share Second and Final Call A/c 3,92,800
(Final call money @ Rs. 4 per share received on
98,200 shares)
(vii) Share Capital A/c (1800 X Rs. 10) Dr. 18,000
To Share Forfeited A/c 4,300
(1000 x Re. 1) + (500 x Rs. 3) + (300 x Rs. 6)
To Share Allotment A/c 2,000
To Share First Call A/c 4,500
To Share Second and Final Call A/c
7,200
(Forfeiture of shares for non-payment of istalments)
(viii) Bank A/c (1,800 x Rs. 9.50) Dr. 17,100
Share Forfeited A/c (1,800 x 0.50) Dr. 900
To Equity Share Capital A/c 18,000
(Reissue of forfeited shares at Rs. 9.50 per share)
(ix) Share Forfeited A/c Dr. 3,400
To Capital Reserve A/c 3,400
(Transfer of the credit balance in the share forfeited
account to the capital reserve account, being the
profit on reissue)

Illustration: (Forfeiture and reissue of forfeited shares)

Malik Limited has a subscribed capital of 2,000 equity shares or Rs. 25 each, Rs. 20 per share called up. The directors
forfeited 200 equity shares held by a shareholder who had failed to pay the first call made @ Rs. 10 per share. Later
the directors reissued these forfeited shares at Rs. 20 per share paid up at Rs. 15 per share. Pass the journal entries for
forfeiture and reissue of shares.

Malik Limited
Journal

Date Particulars Dr.(Rs.) Cr.(Rs.)

(I) Equity Share Capital A/c Dr. 4,000
To Share Forfeited A/c 2,000
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 To Calls-in-Arrears A/c
2,000
(Receipt of application money on 10,000, 12%
debentures @ Rs. 30 per debenture)
(ii) Bank A/c Dr. 3,000
Share Forfeited A/c Dr. 1,000
To Equity Share Capital A/c 4,000
(Reissue of 200 equity shares as Rs.20 per share
paid up @ Rs. 15 per share)
(iii) Share Forfeited A/c Dr. 1,000
To Capital Reserve A/c 1,000
(Transfer of balance of share forfeited account to
capital reserve account)

On reissue of forfeited shares should be transferred to ‘Capital Reserve Account’.

In other words, the forfeited amount in respect of shares not yet reissued must be kept intact in the ‘Share Forfeited
Account’ itself. This amount should be shown as addition to the paid up capital on the liabilities side of the balance
sheet.

Illustration: (Profit on reissue transferred to capital reserve)

Nivedita Limited issued 1,00,000 shares of Rs. 10 each payable as under:
On Application : Re. 1
On Allotment : Rs. 2
On First Call : Rs. 3
On Final Call : Rs. 4

All the moneys payable on application, allotment and calls has been received with the following exceptions: Patel who
holds 1,000 shares has not paid the money due on allotment and calls. Asha who holds 500 shares has not paid the
money due on the first and final calls. Kumar who holds 300 shares has not paid the amount due on the final call. The
shares of Patel, Asha and Kumar were, therefore, forfeited. These shares were subsequently reissued for cash at a
discount of 5 per cent. Pass journal entries recording the above transactions from the stage of receipt of application
money till the reissue of forfeited shares.

Solution:
Nivedita Limited
Journal Entries

Date Particulars Dr.(Rs.) Cr.(Rs.)

(I) Bank A/c Dr. 1,00,000
To Share Application A/c 1,00,000
(Receipt of application money on 10,000, 1000
shares @ Re. 1 per share)
(ii) Share Application A/c Dr. 1,00,000
Share Allotment A/c Dr. 2,00,000
To Equity Share Capital A/c 3,00,000
(Application money @ Re. 1 received and allotment
money @ Rs. 2 due on 1,00,000 shares transferred
to share capital account as per resolution
no…dated…..)
(iii) Bank A/c Dr. 1,98,000
To Share Allotment A/c 1,98,000
(Allotment money @ Re. 2 received on 99,000
share)
(iv) Share First Call Account Dr. 3,00,000
To Equity Share Capital A/c 3,00,000
(First call money @ Rs. 3 due on 1,00,000 shares
vide resolution no….. dated….. )
(v) Bank A/c Dr. 2,95,500
To Share First Call Account 2,95,500

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 (First call money @ Rs. 3 due on 1,00,000 shares
vide resolution no….. dated….. )
(vi) Bank A/c Dr. 4,00,000
To Share Second and Final Call A/c 4,00,000
(Final call money @ Rs. 4 per share received on
98,200 shares)

Illustration: (Reissue of forfeited shares originally issued at discount)

Babita Ltd. forfeited 100 shares of Rs. 10 each, Rs. 8 per share being called up which were issued at a discount of Re. 1
per share for non-payment of first call or Rs. 3 per share. Of these forfeited shares, 80 shares were reissued
subsequently by the company at Rs. 5 at Rs. 8 paid up share. Give journal entries for the forfeiture and reissue of
shares.

Solution:
Babita Limited
Journal Entries

Date Particulars Dr.(Rs.) Cr.(Rs.)

(i) Equity Share Capital A/c Dr. 800

To Share Forfeited A/c 400
To Discount on Issue of Shares A/c 100
To Calls-in-Arrears A/c 300
(Forfeiture of 100 shares for non-payment of first call of
Rs. 3 per share; discount of Re. 1per share written back)
(ii) Bank A/c Dr. 400
Discount on Issue of Shares A/c Dr. 80
Share Forfeited A/c Dr. 160
To Equity Share Capital A/c 640
(Reissue of 80 shares at Rs. 5 per share paid up value
being Rs. 8)
(iii) Share Forfeited A/c Dr. 160
To Capital Reserve A/c 160
(Profit on reissue of forfeited @2 per share transferred to
capital reserve a/c)

Illustration: (Forfeiture and reissue of forfeited shares only)

Give journal entries to record the forfeiture of shares and their reissue:
1. The directors of A Ltd. forfeited 500 shares of Rs. 50 each, Rs. 40 being called up, on which Radha, a
shareholder paid application and allotment moneys of Rs. 25 per share but did not pay first call money of Rs.
15 per share. Of these forfeited shares, the company subsequently reissued 350 shares as fully paid up for Rs.
40 per share.
2. B Ltd. forfeited 100 shares or Rs. 50 each, Rs. 35 per share called up on which Rs. 25 per share has been paid
by Rakesh; the amount of first call of Rs. 10 per share being unpaid. The directors reissued the forfeited shares
or Baldeo crediting Rs. 35 per share paid for a payment of Rs. 25 per share.
3. The directors of C Ltd. forfeited 100 shares of Rs. 100 each, Rs. 50 called up issued at 5% discount on which
Rs. 3,000 have been paid. These shares were reissued to one of the directors upon payment of Rs. 7,000
credited as fully paid.
4. The directors of D Ltd. forfeited 100 shares of Rs. 100 each called up for non-payment of final call money of
Rs. 50 per share. Half of these shares were subsequently reissued at Rs. 120 per share as fully paid.
5. E Ltd. forfeited 200 shares of Rs. 100 each (issued at a premium of 10%) for non-payment of first call of Rs.
25 and final call or Rs. 15. Of these shares were reissued for Rs. 90 per share.

Solution:
Journal Entries

Date Particulars Dr.(Rs.) Cr.(Rs.)

1. A Ltd. Equity Share Capital A/c (500 x Rs. 40) Dr. 20,000
To Share Forfeited A/c 12,500

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 To Share First Call A/c 7,500
(Forfeiture of 500 shares of Rs. 50 each, Rs. 40 being
called up for non-payment of first call money of Rs. 15
per share as per resolution)
Bank A/c (350 x Rs. 40) Dr. 14,000
Share Forfeited A/c (350 x Rs. 10) Dr. 3,500
To Equity Share Capital A/c 17,500
(Reissue of 350 forfeited shares of Rs. 50 fully paid at
Rs. 40 giving a discount of Rs. 10 per share)
Share Forfeited A/c Dr. 5,250
To Capital Reserve A/c 5,250
(Transfer of profit on forfeiture proportionate to forfeited
shares reissued [i.e., on 350 shares @15 each] to
capital reserve a/c)
2. B Ltd. Equity Share Capital A/c (100 x Rs. 35) Dr. 3,500
To Share Forfeited A/c (100 x Rs. 25) 2,500
To Share First Call A/c (100 x Rs. 10) 1,000
(Forfeiture of 100 shares of Rs. 50 each, Rs. 35 being
called up for non-payment of first call money of Rs. 10
per share)
Bank A/c (100 x Rs. 25) Dr. 2,500
Share Forfeited A/c (100 x Rs. 10) Dr. 1,000
To Equity Share Capital A/c 3,500
(Reissue of 100 forfeited shares of Rs. 50 each,Rs. 35
paid up at Rs. 25 per share)
3. C Ltd. Equity Share Capital A/c (100 x Rs. 50) Dr. 5,000
To Share Forfeited A/c 3,000
To Discount on Issue of Shares A/c 500
To Calls-in-Arrears A/c 1,500
(Forfeiture of 100 shares for non-payment of call @ Rs.
15 per share and discount of Rs. 5 per share)
Bank A/c (100 x Rs. 70) Dr. 7,000
Discount on Issue of Shares A/c Dr. 500
Share Forfeited A/c Dr. 2,500
To Equity Share Capital A/c 10,000
(Reissue of 100 forfeited shares of Rs. 70 per share
and balance of Rs. 2,500 debited to share forfeited
account) .
Share Forfeited A/c Dr. 500
To Capital Reserve A/c 500
(Being profit on re-issue of forfeited shares transferred
to capital reserve account)
4. D Ltd. Equity Share Capital A/c (100 x Rs. 100) Dr. 10,000
To Share Forfeited A/c 5,000
To Calls-in-Arrears A/c 5,000
(Forfeiture of 100 shares at Rs.100 called up for non-
payment of final call of Rs. 50 per share)
Bank A/c (100 x Rs. 70) Dr. 6,000
To Equity Share Capital A/c 5,000
To Securities Premium A/c 1,000
(Reissue of 50 forfeited shares of Rs. 100 each at
premium Rs. 20) .
Share Forfeited A/c Dr. 2,500
To Capital Reserve A/c 2,500
(Transfer of capital profit on reissue of 50 forfeited
shares to capital reserve account)
5. E Ltd. Equity Share Capital A/c (200 x Rs. 100) Dr. 10,000
To Share Forfeited A/c (200 x Rs. 60) 5,000
387
 To Share First Call A/c (200 x Rs. 25) 5,000
To Share Second and Final Call A/c
(200 x Rs. 15) 5,000
(Forfeiture of 200 shares at Rs.100 each issued at Rs.
110 for non-payment of first call and Second and final
call of Rs. 25 and Rs. 15 respectively)
Bank A/c (150 x Rs. 90) Dr. 2,500
Share Forfeited A/c Dr. 2,500
To Equity Share Capital A/c (150 x Rs.
100) 5,000
(Profit on reissue of shares transferred to capital
reserve account)

REDEMPTION OF PREFERENCE SHARE

Meaning:
Redemption of preference shares means re-payment of a certain period or paying back the preference
shareholders.

CONDITION OF REDEMPTION

Section 80 requires that preference share can be redeemed only if following conditions are satisfied:

1. Such shares must be fully paid up.

2. Such shares can be redeemed out of distributable profits.
3. A company has to redeem the redeemable preference share within a period of ten years. Irredeemable
preference share cannot be issued.
4. If new share are issued for the purpose of redemption, it will not be treated as increased capital.

CHAPTER-11:
COST ACCOUNTING: AN INTRODUCTION(1)

Meaning and Definition:

Cost accounting primarily deals with collection, analysis of relevant cost data for interpretation and presentation for various
problems of management.

Cost accounting is the application of accounting and costing principles, methods and techniques in the ascertainment of
costs and the analysis of savings and/ or excess as compared with previous experience or with standards.

CIMA defines Cost Accounting as “the establishment of budgets, standard costs and actual costs of operations, process,
activities or products; and the analysis of variances, profitability or the social use of funds”.

Cost accounting accounts for the costs of a product, a service or an operation. It is concerned with actual costs incurred and
the estimation of future costs.

Cost accounting is a conscious and rational procedure by accountants for accumulating cost and relating such costs to
specific products or departments for effective management action. Cost accounting establishes budgets, standard costs and
actual costs. Cost accounting is a set of procedures used in refining raw data into usable information for management
decision making, for ascertainment of cost of products and services and its profitability. Cost accounting is a management
information system which analyses past, present and future data to provide the basis for managerial decision making.

Scope and use of Cost Accounting

A company having a proper cost accounting system will help the management in the following ways:
 The analysis of profitability of individual products services or jobs.
 The analysis of profitability of different departments or operations.
 The analysis of cost behavior of various items of expenditure in the organization. This will help in future cost
estimation with reasonable accuracies.
 It locates differences between actual results and expected results. Such differences can be also traced to the
individual cost centre with the efficient cost system.
 It will assist in setting the prices so as to cover costs and generate an acceptable level of profit.
 The effect on profits of increase or decrease in output or shutdown of a product line or department can be analysed
with by adoption of efficient cost accounting system.

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  The costing records serve to analyse the final accounts of a company i.e., the Manufacturing, Trading and Profit
and Loss Accounts, in such a way as to give a detailed explanation of the sources of profit and Loss.
 Cost Accounting data generally serves as a base to which the tools and techniques of Management Accounting can
be applied to make it more purposeful and Management oriented.
 Cost ascertainment, allocation, distribution can be efficiently made under efficient costing system.
 Cost records are the base for the Management Information Systems.
 The cost system generates regular performance statements which management need for control purposes.
 Cost accounting system not only applicable to manufacturing organizations or functions but also extended to
service organizations, functions.
 Cost comparisons between different department, machines and alternative processes help management to maintain
maximum efficiency is possible with the adoption of efficient costing system.

In view of the above we can say that cost accounting is a system of foresight and not postmortem examination, it turns
losses into profits, speeds up activities and eliminate waste and losses.

Cost Centre

Cost centre is a location, person or item of equipment for which cost may be ascertained and used for the purpose of cost
control.

CIMA defines cost centre as “a production or service, function, activity or item of equipment whose costs may be attributed
to cost units. A cost centre is the smallest organizational sub-unit for which separate cost allocation is attempted.”

From functional point of a view, a cost centre may be relatively easy to establish, because a cost centre is any unit of the
organization to which costs can be separately attributed. A cost centre is an individual activity or group of similar activities
for which costs are accumulated. For example production departments, a machine or group of machine or group of machines
within a department or a work group is considered as cost centre.

The procedure of allocation of overheads involves identification of cost centre for which an item of expenditure is a direct
cost and allocation of such cost centre.

Types of Cost Centres – The cost centres are classified into the following.
 Personal and Impersonal Cost Centres
A cost centre which consists of a person or group of persons is called personal cost centre. For example Sales
Manager, Works Manager, etc.

An impersonal cost centre consists of a location or item of equipment, production department, a machine or a
group of machines.

 Production and Service Cost Centres

Production cost centres are engaged in production activity by conversion of raw material into finished production.
Service cost centre are those which are ancillary to and render service to other production and service cost centres.
For example, maintenance department is a service department provides service to other cost centre generate and
supplies power not only to production cost centres but also to other service cost centres.
 Process Cost Centre
A cost centre in which a specific process or a continuous sequence of operations is carried out.

Profit Centre

A profit centre is any sub-unit of an organization to which both revenues and costs are assigned; so that the responsibility of
a sub-unit may be measured profit centre is a segment of the business entity by expenditure being used to evaluate
segmental performance. In profit centre, both inputs and outputs are capable of measurement in financial terms and it
provides more effective assessment of the manager’s performance since both costs and revenues are measured in monetary
terms.

Cost Unit

A cost unit is a unit of product or unit of service to which costs are ascertained by means of allocation, apportionment and
absorption.
CIMA defines cost unit as “a quantitative unit of product or service in relation to which costs are ascertained”.

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It is a unit of quantity of product, service or time or a combination of these in relation to which costs are expressed or
ascertained. For example, specific job, contract, unit of product like Fabrication Job, Road Construction Contract, an
Automobile Truck, a Table, 1000 Bricks, etc.

The relation between cost centre and cost unit is that the costs of a function or activity are classified to the cost centre. The
cost units which pass through the cost centre, the direct and indirect costs of the cost centre are charged to the units of
production by means of an absorption rate. The unit of output in relation to which cost incurred by a cost centre is expressed
is called cost unit. It is useful measurement of cost for comparative purposes.

Cost Accounting vs. Financial Accounting

Financial accounting classifies an entity’s transactions in money terms, in accordance with established concepts, principles,
accounting standards and legal requirements. It aims to present ‘true and fair view’ of the overall results of those
transactions, and events for the enterprise as a whole. It does not trace the path of events within the enterprise. The financial
statements – Profit and Loss Account, Balance Sheet and Flow Statement and Flow Statements reveal the overall
performance and position of the enterprise. Financial accounting is more attached with reporting the results and position of
business
to persons and authorities other than management – Government, Creditors, Owners etc. Financial accounting data is
historical in nature and its periodicity of reporting is much wider.

Cost Accounting is an internal reporting system for an organization’s own management for decision-making. Cost
accounting primarily emphasizes on cost and it deals with collection, analysis, relevance, concerned more with the
ascertainment, allocation, distribution and accounting aspects of costs. Cost financial accounting. Cost accounting not only
deals with historic data but also futuristic in approach. Cost accounting system best suited to its individual needs. In
financial accounting the major emphasis is in cost classification based on type of transaction e.g., Salaries, Repairs,
Insurance, Stores etc. But in Cost accounting, the major emphasis on functions, activities, products, processes and on
internal planning and control and information needs of the organization.

- The management’s intention and the co-operation of workers and staff in installation of costing system.
- Implementation of proper wage system and inventory valuation, store issues.
- The cost behaviour and elementwise classification of costs and selection of equitable basis for allocation
apportionment and absorption of overheads.
- Cost accounting system should be simple and easy to operate.
- The expenses of the costing should commensurate with the benefits of installation.
-
Cost, Expense and Loss

‘Cost’ may be defined as (i) the amount of expenditure (actual or notional) incurred on or attributable to a given thing;
or (ii) to ascertain the cost of a given thing. Cost represents the resources that have been or must be sacrificed to attain a
particular objective. Sacrifice may be direct or indirect. ’Expense’ refers to cost or expenditure which appear in the
profit and loss account of a given period as deduction or matched against the revenue in order to arrive at the profit or
loss of that period. It represents sacrifice of resources for an economic benefit.

‘Loss’ refers to the amount of difference between the expenses and revenues when expenses exceed revenues for an
accounting period. Another meaning attributed to loss is that is opposite of a gain, i.e., a loss related to the net effect of
an unfavourable transaction, event or situation not arising from a normal business activity. If it can be established that
there is no matching economic benefit for expired cost, it is referred to as loss.

Cost Concepts
The clear understanding of various cost concepts is essential for the study of cost accounting and cost systems.

Product and Period Cost – The product cost is aggregate of costs that are associated with a unit of product. Such costs
may or may not include an element of overheads depending upon the type of costing system in force – absorption or
direct. Product costs are related to goods produced or purchased for resale and are initially identifiable as part of
inventory. These product or inventory is sold. Product cost is associated with unit of output. The cost of inputs in
forming the product viz, the direct material, direct labour, factory overhead constitute the product costs.

The period cost is a cost that tends to be unaffected by changes in level of activity during a given period of time. Period
cost is associated with a time period rather than manufacturing activity and these costs are deducted as expenses during
the current year without having been previously classified as product costs. Selling and distribution costs are period
costs and are deducted from the revenue without their being regarded as part of the inventory cost.

Common and Joint costs – The common cost is an indirect cost that is incurred for the general benefit of a number of
departments or for the whole enterprises and which is necessary for present and future operations. The joint costs are

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 the costs of either a single process or a series of processes that simultaneously produce two or more products of
significant relative sales value.

Short-run and Long-run Costs – The short-run costs are costs that vary with output when fixed plant and capital
equipment remain the same and become relevant when a firm has to decide whether or not to produce more in the
immediate future. The long- run costs are those which vary with output when all input factors including plant and
equipment vary and become relevant when the firm has to decide whether to set up a new plant or to expand the
existing one.

Past and Future Costs – The past costs are actual costs incurred in the past and are generally contained in the financial
accounts. These costs report past events and the time lag between event and its reporting makes the information out of
date and irrelevant for decision making. These costs will just act as a guide for future course of action.

The future costs are costs expected to be incurred at a later date and are the only costs that matter for managerial
decisions because they are subject to management control. Future costs are relevant for managerial decision making in
cost control, profit projections, appraisal of capital expenditure, introduction of new products, expansion programmes
and pricing, etc.

Controllable and Non-controllable Costs – The concept of responsibility accounting leads directly to the classification
of costs as controllable or uncontrollable. The Controllable cost is a cost chargeable to a budget or cost center, which
can be influenced by the actions of the person in whom control of the center is vested. It is always not possible to
predetermine responsibility, because the reason for deviation from expected performance may only become evident
later. For example, excessive scrap may arise form inadequate supervision or from latent defect in purchased material.
The controllable cost is a cost that can be influenced and regulated during a given time span by the actions of a
particular individual within an organization.

The controllability of cost depends upon the level of responsibility under consideration. Direct costs are generally
controllable by the shop level management. The uncontrollable cost is a cost that is beyond the control (i.e.,
uninfluenced by actions) of a given individual during a given period of time.

The distinction between controllable and uncontrollable costs are not very sharp and may be left to individual
judgement. Some expenditure which may be uncontrollable on the short-term basis can be controllable on long-term
basis. There are certain costs which are really difficult to control due to the following reasons:
 Physical hazards arising due to flood, fire, strike, lockout, etc.
 Economic risks such as increased competition, change in fashion or model, higher prices of inputs, import
restrictions, etc.
 Political risks like change in Government policy, political unrests, war, etc.
 Technological risks such as change in design, know-how, etc.

Replacement and Historical Costs – The replacement costs and Historical costs are two methods for carrying assets in the
balance sheet and establishing the amounts of costs that are used to determine income.

The Replacement Cost is a cost at which material identical to that is to be replaced could be purchased at the date of
valuation (as distinct from actual cost price at the date of purchase). The replacement cost is a cost of replacing an asset at
any given point either at present or in the future (excluding any element attributable to improvement).

The Historical cost is the actual cost, determined after the event. Historical cost valuation states cost of plant and materials,
for example, at the price originally paid for them whereas replacement cost valuation states the costs at prices that would
have to be paid currently. Costs reported by conventional financial accounts are based on historical valuations. But during
periods of changing price levels, historical costs may not be correct basis for projecting future costs. Naturally historical
costs must be adjusted to reflect current or future price levels.

Escapable and Unavoidable Costs – The escapable cost is an avoidable cost that will not be incurred if an activity is not
undertaken or discontinued. Avoidable cost will often correspond with variable costs. Avoidable cost can be identified with
an activity or sector of a business and which would be avoided if that activity or sector did not exist. The Escapable Costs
refers to costs which can be reduced due to a contraction in the activities of a business enterprise. It is the net effect on costs
that is important, not just the costs directly avoidable by the contraction. Examples:
 Closing an apparently unprofitable branch house-storage costs of other branches and transportation charges would
increase.
 Reducing credit sales – Costs estimated may be less than the benefits otherwise available.

Escapable costs are different from controllable and discretionary costs.

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Out of pocket and Book Costs – The out of pocket cost is a cost that will necessitate a corresponding outflow of cash. These
costs involve cash outlay or payments to other parties are termed as out of pocket costs. Book costs are those which do not
require current cash payment. Depreciation is a notional cost in which no cash transaction is involved. The distinction
between out of pocket cost and book costs primarily shows how costs affect the cash position. Out of pocket costs are
relevant in some decision making problems such as fluctuation of prices during recession, make or buy decisions etc. Book
costs can be converted into out of pocket costs by selling the assets and having them on hire. Rent would then replace
depreciation and interest.

Imputed and Sunk Costs – The Imputed cost which doesn’t involve actual cash outlay, which are used only for the
purpose of decision making and performance evaluation. Imputed cost is a hypothetical cost from the point of view of
financial accounting; Interest on capital is common type of imputed cost. No actual payment of interest is made but the
basic concept is that, had the funds been invested elsewhere they would have earned interest. Thus, imputed costs are a type
of opportunity costs.

The Sunk Costs are those costs that have been invested in a project and which will not be recovered if the project is
terminated. The sunk cost is one for which the expenditure has taken place in the past. This cost cannot be changed by any
decision in future. Investment is plant and machinery as soon as it is installed; its cost is sunk cost and is not relevant for
decisions. Amortisation of past expenses, e.g., depreciation is sunk cost. Sunk costs will remain the same irrespective of the
alternative selected. Thus, it need not be considered by the management in evaluating the alternatives, as it is common to all
of them. It is important to observe that an unavoidable and also out of pocket but not sunk cost. The Managing Director’s
salary is generally unavoidable and also out of pocket but not sunk cost.

Relevant and Irrelevant Costs – The Relevant cost is cost appropriate in aiding to make specific management decisions.
Business decisions involve planning for future and consideration of several alternative courses of action. In this process the
costs which are affected by the decisions are future costs. Such costs are called relevant if it helps the manage in taking a
right decision in furtherance of the company’s objectives. For example, where a company intends to rearrange production
facilities, the estimates of future costs are as under:

Item of cost Existing facilities Proposed rearrangement

Direct materials/unit 10.00 10.00
Direct labour/ unit 5.00 4.00

The material cost being constant is irrelevant to the decision. The relevant cost is labour cost.

Opportunity and Incremental (differential) Costs – The Opportunity cost is the value of a benefit sacrificed in favour of an
alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was
sold or put to the most valuable alternative use that would be practicable. The opportunity cost of a good or service is
measured in terms of revenue which could have defined as the revenue forgone by not making the best alternative use.
Opportunity cost can be defined as the revenue forgone by not making the best alternative machine process, raw materials
etc. It is the cost of opportunity lost by diversion of an input factor from use to another.

The Incremental cost is the extra cost of taking one course of action rather than another. It is also called as differential cost.
The incremental cost is the additional cost due to a change in the level or nature of business activity. The change may take
several forms e.g., changing the channel of distribution, adding a new machine, replacing a machine by a better machine,
execution of export order etc. Incremental costs will be different in case of different alternatives. Hence, incremental costs
are relevant to the management in the analysis for decision making.

Conversion cost – The Conversion cost is the cost incurred for converting the raw material into finished product. It is
referred to as the production cost excluding the cost of direct materials.

Committed cost – The Committed cost is a cost that is primarily associated with maintaining the organisation’s legal and
physical existence over which management has little discretion. The committed cost is fixed cost which results from
decisions of prior period. The amount of committed cost is fixed by decisions which are made in the past and not subject to
managerial control in the short-run. Since committed cost does not fluctuate with volume and remains unchanged until
action is taken to increase or reduce available capacity, committed cost are depreciation, insurance, premium, rent, etc.

Shutdown and Abandonment Costs – The shutdown costs are the costs incurred in relation to the temporary closing of a
department/division/enterprise. Such costs include those of closing as well as those of reopening. The shutdown costs are
defined as those costs which would be incurred in the event of suspension of the plant and equipment and construction of
sheds for storing exposed properly. Further, additional expenses may have to be incurred when operations are restored e.g.,
re-employment of workers may involve cost of recruitment and training.

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The Abandonment costs the cost incurred in closing down a department of a division or in withdrawing a product or ceasing
to operate in a particular sales territory, etc. The abandonment costs are the cost of retiring altogether a plant from servi ce.
Abandonment arises when there is a complete cessation of activities and creates a problem as to the disposal of assets.

Urgent and Postponable Costs – The urgent costs are those which must be incurred in order to continue operations of the
firm. For example, cost of material and labour must be incurred if production is to take place.

The Postponable costs that cost which can be shifted to the future with little or no effect on the efficiency of current
operations. These costs can be postponed at least for sometime, e.g., maintenance relating to building and machinery.

Marginal Cost: The marginal cost is the variable cost of one unit of a product or a service i.e., a cost which would if the unit
was not produced or provided. In this context a unit is usually either a single article or a standard measure such as litre or
kilogram, but may in certain circumstances be an operation, process or part of an organization. The marginal costing
technique is the process of ascertaining marginal costs and of the effects of changes in volume or type of output on profit by
differentiating between fixed and variable costs.

Notional Cost: The Notional cost is a hypothetical cost taken into account in a particular situation to represent the benefit
enjoyed by an entity in respect of which no actual expense is incurred.

Classification of Costs

It is important to realize that the term ’cost’ has meaning in a given context. There are different costs for different purposes
and no single cost concept is relevant in all situations. Here is an attempt made to analyse cost and its behavioural aspect.
The cost is characterized by the word ‘sacrifice’ and as such, it is very much in managements’ interest to control and reduce,
where possible, the sacrifices involved in achieving desired results. The classification of costs is studied the following
categories:

1. Classification based on financial nature of costs

2. Elementwise classification of costs
3. Functional classification of costs
4. Classification for exercising control over costs
5. Classification based on cost behaviour

Classification based on financial nature of costs – For clear understanding costs may be classified into the following based
on its financial nature:

(a) Financial Costs

 Cash costs – Cash costs are those sacrifices that are reflected in actual cash outflows. Business
transactions usually involve both reward (or revenue) and sacrifice (or cost) with the difference the
two being gain (or profit). Thus

Reward – Sacrifice = Gain

Revenue – Cost = Profit

In measuring the outcome from business activity this general concept of sacrifice must be simplified by being expressed
in numerical terms in order that it can be shown in a company’s accounting system.

 Non-cash costs – Non-cash costs are financial sacrifices that do not involve cash outlays at the time
when their cost is recognized. These costs are found in depreciation, opportunity costs etc.

(b) Non-financial Costs – Non-financial costs are those costs that are not directly traceable through a
company’s cashflow. Whilst such costs e.g., low morale of employees, certainly involve sacrifices and
they may lead eventually, in complex ways to a reduced cashflow in the future. They do not represent in
immediate cash outlays.

The above cost concepts are based on several factors like controllability, period, situation, input-output relationship,
opportunity, urgency, historical, product, etc. The clear understanding of costs concepts will help the management in
analysis of costs, reporting, cost control and decision making.

Elementwise classification of costs – The elements of cost can be studied under the classification Direct and Indirect Costs.
If the object of interests for identifying and measuring cost is to determine how much sacrifice is involved in manufacturing
a particular product, then initially one can define the three elements of total cost.

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 a. Materials, b. Labour, c. Expenses.

All these costs may be direct or indirect costs.

(a) Direct Costs (Traceable Costs) – The Direct Costs are those which can be identified easily and
indisputably with a unit of operation or costing unit or cost center. Costs of direct material, direct labour
and direct expenses can be directly allocated or identified with particular cost centers or cost units and can
be directly charged to such cost units. These costs are also called traceable costs.
(b) Indirect costs (Common Costs) – Indirect costs cannot be allocated but which can be apportionment to
cost centers or cost units. These costs are called as common costs. The indirect costs are not traceable to
any plant, department operation or to any individual final product. All overhead costs are indirect costs.
Costs of indirect material, indirect labour and indirect expenses in aggregate constitute the overhead costs
and are the indirect component of the total cost. Indirect costs cannot be directly allocated to cost units or
cost centers and have to be absorbed or recovered in cost units are termed as indirect costs.

The concepts of direct and indirect costs are meaningless without identification of the relevant cost unit or cost center.
Segregation of costs into direct and indirect costs is essential for proper accounting and control of costs and also for
managerial decision making purpose.

Advanced manufacturing technologies such as Robotics, Computer Aided Design and Manufacture, Flexible Manufacturing
Systems, Optimised Production, Technology, Just-in-Time etc., are revolutionising of manufacturing at shop-floor, quality
etc., creating areas for improved opportunities. They have dramatically changed the manufacturing cost behaviour patterns.
The direct cost component of product cost is decreasing while depreciation; engineering and information processing costs
are increasing. These changes have resulted in higher overhead rates and a shrinking base of direct cost over which to
allocate those costs.

Functional classification of cots – Based on the functions, the costs can be classified into (1) Production cost, (2)
Administration cost, (3) Selling and distribution cost, and (4) Research and development cost.

(a) Production Cost – The production cost is inclusive of all direct material, direct labour, direct expenses and
manufacturing expenses. It refers to costs concerned with manufacturing activity which starts with supply of
material and ends with primary packing of the product.
(b) Administration Cost – The Administration cost is incurred for carrying the administrative function of the
organization i.e., cost of policy formulation and its implementation to attain the objectives of the organization.
(c) Selling and Distribution Cost – The Selling cost refers to the cost of selling function i.e., the cost of activities
relating to create and stimulate demand for company’s products and to secure orders. The distribution costs will be
incurred on goods made available to customers. These costs include the cost of maintaining and creating demand of
product, making the goods available in the hands of customer.
(d) Research and Development Costs – The Research cost is the cost of searching for new products, new
manufacturing process, improvement of existing products, processes or equivalent and the development cost is the
cost of putting research result on commercial basis.

Classification based on cost behaviour – Depending on the variability behaviour, costs can be classified into variable and
fixed costs.

(a) Variable Cost – The variable cost is a cost that tends to vary in accordance with level of activity within the relevant
range and within a given period of time. The Prime Product Costs i.e., direct material, direct labour and direct
expenses tend to vary in direct proportion to the level of activity within. An increase in the volume means a
proportionate increase in the total variable costs and decrease in volume will lead to a proportionate decline in the
total variable costs. There is a linear relationship between volume and variable costs. They are constant per unit.

Variable costs have an explicit physical relationship with a selected measure of activity and exists an optimum
cause and effect relationship between the input and output. Therefore variable costs are also known as engineered
costs. All variable costs are not engineered costs. Some of the variable components which are termed as
discretionary variable costs and such costs will vary with fluctuations in the levels of activity with merely because
of the policy of the management. The variable element of research and development or advertisement costs, which
are discretionary by nature, may increase with increased activity and management may decide to spend more in
periods of increased activity.

(b) Fixed Cost – The Fixed Cost is a cost that tends to be unaffected by changes in the level of activity during a given
period of time. The fixed costs remain constant in total regardless of changes in volume up to a certain level of
output. They are not affected by changes in the volume of production. There is an inverse relationship between
volume and fixed cost per unit. Fixed costs tend to remain constant for all levels of activity within a certain range.
It follows that some fixed costs will continue to be incurred even when the activity comes down to nil. Some fixed

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 costs are liable to change from one period to another. For example salaries bill may go up because of annual
increments or due to change in the pay rates and due to pay structure.

(c) Semi-variable Cost or Semi-fixed Cost – Many costs fall between these two extreme. They are called as semi-
variable cost or semi-fixed costs. They are neither perfectly variable not absolutely fixed in relation to changes in
volume. They change in the same direction as volume but not in direct proportion thereto. An example is found in
telephone charges. The rental element is a fixed cost whereas charges for calls made are a variable cost. The
distinction between fixed and variable costs is important in forecasting the effect of short-run changes in volume
upon costs and profits. This distinction has also given rise to the concepts of Marginal Costing, Direct Costing,
Flexible Budgeting. Costs which have neither a linear or curvilinear relationship with output but they move in steps
with fluctuations in activity levels. These are called stepped up costs. Basically these are fixed costs upto a certain
level of activity specified but they change as soon as new range is reached. Such costs are semi-variable in the
long-term but fixed in the short-term. Certain variable costs tend to vary during maintenance cost during periods of
low production, increased costs on air-conditioning in summer. Costs which fluctuate with volume of production
but after stage of production has reached, the fluctuation in cost is disproportionate. It changes either of retarded or
accelerated rates.

Management Accounting vs. Cost Accounting

Management Accounting primarily concerned with management, which help the management in establishing plans and
policies for attainment of organizational objectives. Management Accounting involves application of appropriate techniques
and concepts, whether it is drawn from Financial Accounting, Cost Accounting, Economics, Mathematics and Statistics. The
data used in Management Accounting will be used either in managerial decision making or problem solving.

The scope of Management Accounting is broader than the scope of Cost Accounting. In Cost Accounting, primary emphasis
is on cost and it deals with collection, analysis, relevance, interpretation and presentation for various problems of
management. Management Accounting utilizes the principles and practices of Financial Accounting and Cost Accounting in
addition to other modern management techniques for efficient operation of a company. The main thrust in Management
Accounting is towards determining policy and formulating plans to achieve deserved objective of management.
Management Accounting makes corporate planning and strategy effective and meaningful.

Both Cost Accounting and Management Accounting are internal to the organization. Both have the same objectives of
assisting management in its functions of planning, decision making, controlling and techniques like budgetary control,
standard costing, marginal costing owe their existence to cost accounting and have slipped into the kitbag of the
Management Accountant. There is a good deal of overlapping in their function. However, the two systems can be
differentiated on the following grounds:
 Cost Accounting is concerned more with the ascertainment, allocation, distribution and accounting aspects of
costs. Management Accounting is concerned more with impact and effect aspects of costs.
 Cost Accounting data generally serves as a base to which the tools and techniques of Management Accounting
can be applied to make it more purposeful and management oriented. The management Accounting data is
deprived, both, from the cost accounts and financial accounts.
 The management Accountant places the data in a wider perspective than the Cost Accountant. This accounts for
a greater degree of relevance and objectivity in Management Accounting than in Cost Accounting. It is the
Management Accountant who is supposed to have a clear idea regarding the items and types of costs required to
analyse and decide specific business problems and effect of such costs on alternative solutions. A cost
Accountant is definitely helpful in collecting such Costing data for the Management Accountant.
 In the organizational set-up, Management Accountant is generally placed at a higher hierarchy than the Cost
Accountant.
 The approach of Cost Accountants is much narrower than that of a Management Accountant, who may have to
use certain economic and statistical data along with the costing data to enable the management to be more
accurate and precise in its functions of planning, decision making and control.
 Management Accounting, in addition to the tools and techniques like marginal costing, break-even analysis,
budgetary control, standard costing, etc., available to cost accounting, also make use of other techniques like
funds flow, cash flow, ratio analysis, etc., which are not within the scope of Cost Accounting.
 Management Accounting includes both Financial Accounting as well as Cost Accounting. It also embraces tax
planning and tax accounting. Cost Accounting does not include Financial Accounting and has nothing to do with
tax accounting.
 Management Accounting is concerned equally with short-range and long-range planning and uses highly
sophisticated techniques like sensitivity analysis, probability structures, etc., in the planning and forecasting
process. Cost Accounting is more concerned with short-term planning. Evaluation of capital investment projects
is the specialty of Management Accountant.
 Management Accounting is concerned, both, with assisting management in its functions, as well as evaluating
the performance of the management as an institution. Cost Accounting is concerned merely with assisting in
management functions and does not provide for evaluation and performance of management.

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  Cost Accounting is mostly historical in its approach and it projects the past. Management Accounting is more
predictive in nature than Cost Accounting.
 Cost Accounting system can be installed without Management Accounting. While Management Accounting
cannot be installed without a proper Cost Accounting system.

ELEMENT OF COST

There are three broad elements of cost:

Material
The substance from which the product is made is known as material. It may be in a raw or a manufactured state. It
can be direct as well as indirect.

Direct Material: All material which becomes an integral part of the finished product and which can be conveniently
assigned to specific physical units is termed as “Direct Material”. Following are some of the example of direct
material:
(i) All material or components specifically purchased or requisitioned from stores.
(ii) Primary packing material (e.g. cartoon, wrapping, cardboard, boxes etc.)
(iii) Purchased or partly produced components.

Direct material is also described as raw material, process ancillary to the business and which cannot be conveniently
assigned to the specific physical units is termed as “Indirect Material”. Consumable stores, oil and waste, printing
and stationery etc. are a few example of indirect material.
Indirect material may be used in the factory, the office or the selling and distribution division.

Labour

For conversion of materials into finished goods, human effort is needed. Such human effort is called labour. Labour can
be direct as well as indirect.

Direct Labour: Labour which takes an active and direct part in the production of particular commodity is called direct
labour. Direct labour costs are, therefore, specialty and conveniently traceable to specific products.
Direct labour is also described as process labour, productive labour, operating labour, manufacturing labour, direct
wages etc.

Indirect Labour: Labour employed for the purpose of carrying out tasks incidental to goods or services provided, is
indirect labour. Such labour does not alter the construction, composition or condition of the product. It cannot be
practically traced to specific units of output. Wages of store-keepers, foremen, time-keepers, direcotors’ fees, salaries
of salesmen, etc are all examples of indirect labour costs.
Indirect labour may relate to the factory, the office or the selling and distribution divisions.

Expenses

Expenses may be direct or indirect.

Direct Expenses: These are expenses which can be directly, conveniently and wholly allocated to specific cost
centers or cost units. Examples of such expenses are: hire of some special machinery required for a particular
contract, cost of defective work incurred in connection with a particular job or contract etc.

Direct expenses are sometimes also described as “chargeable expenses”.

Indirect Expenses: These are expenses which cannot be directly, conveniently and wholly allocated to cost centers or
cost units.

Overheads

It is to be noted that the term overheads has a wider meaning than the term indirect expenses. Overheads
include the cost of indirect material, indirect labour besides indirect expenses.
Indirect expenses may be classified under the following three categories:
(a) Manufacturing (Works, factory or production) Expenses: Such indirect expenses which are incurred in the
factory and concerned with the running of the factory or plant are known as manufacturing expenses. Expenses
relating to production management and administration are included therein. Following are a few items of such
expenses:
Rent, rates and insurance of factory premises, power used in factory building, plant and machinery, etc.

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(b) Office and Administrative Expenses: These expenses are not related to factory but they pertain to the
management and administration of business. Such expenses are incurred on the direction and control of an
undertaking. Examples are:
Office rent, lighting and heating, postage and telegrams, telephones and other charges; depreciation of office
building, furniture and distribution expenses, bad debts, collection charges etc.
(c) Selling and Distribution Expenses: Expenses incurred for marketing of a commodity, for securing orders for the
articles, dispatching goods sold, and for making efforts to find and retain customers, are called selling and
distribution expenses. Examples are:
Advertisement expenses, cost of preparing tenders, traveling expenses bad debts, collection charges etc.
Warehouse charges, packing and loading charges, carriage outwards, etc.
The above classification of different elements of cost can be presented in the for of the following chart:
Elements of Cost

Material Labour Expenses

Direct Indirect Direct Indirect Direct Indirect

Factory Factory Factory

Office Office Office

Selling & Selling & Selling &

Distribution Distribution Distribution

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 ITEMS EXCLUDED FROM COST ACCOUNTS

There are certain items which are included in financial accounts but not in cost accounts. These items fall into three
categories:

Appropriation of profits
1) Appropriation to sinking funds.
i) Dividends paid.
ii) Taxes on the income and profits.
iii) Transfers to general reserves.
iv) Excess provision for depreciation of buildings, plant etc. and for bad debts.
v) Amount written off – goodwill, preliminary expenses, underwriting commission, discount on debentures issued:
expenses of capital issue, etc.
vi) Capital expenditure specifically charged to revenue.
(viii) Charitable donations.

Matters of pure finance

a) Purely financial charges
i) Losses on sale of investments, buildings, etc.
ii) Expenses on transfer of company’s office.
iii) Interest on bank loan, debentures, mortgages, etc.
iv) Damages payable.
v) Penalties and fines.
vi) Losses due to scrapping of machinery.
vii) Remuneration paid to the proprietor in excess of a fair reward for services rendered.
b) Purely financial incomes:
i) Interest received on bank deposits
ii) Profits made on the sale of investments, fixed assets, etc.
iii) Transfer fees received.
iv) Rent receivable.
v) Interest, dividends, etc., received on investments.
vi) Brokerage received
vii) Discount, commission received.

Abnormal gains and losses

I. Losses or gains on sale of fixed assets.
II. Loss to business property on account of theft, fire or other natural calamities.

In addition to above abnormal items (gains and losses) may also be excluded from cost accounts. Alternatively, these may
be taken to Costing Profit and Loss Account.

COMPONENTS OF TOTAL COST

Prime Cost
It consists of costs of direct material, direct labour and direct expenses. It is also known as basic, first or flat cost.

Factory Cost
It comprises of prime cost and, in addition, works of factory overheads which includes costs of indirect material, indirect
labour, and indirect expenses of the factory. The cost is also known as work cost, production or manufacturing cost.

Office Cost*
If office and administrative overheads are added to factory cost, office cost is arrived at. This is also termed as
administrative cost or the total cost of production.

Total Cost
Selling and distribution overheads are added to the total cost of production to get the total cost or the cost of sales.
The various components of total cost can be depicted through the help of the following chart:

Components of Total Cost

Direct Material plus

*
The term “Office Cost” is not much in use these days. Accountants prefer to use the term Total Cost after adding adding
administration overheads and selling and distribution overhead to manufacturing or Production Cost.
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Direct Labour plus Prime Cost or Direct Cost or First Cost
Direct Expenses

Prime Cost plus Works Cost or Factory Cost or Production cost or

Works Overheads cost or Manufacturing Cost

Office Cost plus Selling

and Distribution Overheads

Adjustments for inventories

The following adjustment may have to be made for inventories of Raw Materials. Work-in-progress and Finished
Goods while computing the different component of cost:
(i) Direct Opening Stock Purchase of Closing Stock
Material = of Direct + Direct - of Direct
Consumed Material Material Material

(ii) Works Gross Opening Closing

Cost = Works + Work-in- - Work-in-
Cost Progress Progress
(iii) Cost of Cost of Opening stock Closing Stock
Production of = Production + of finished - of Finished
Goods sold Goods Goods

COST SHEET

The components of cost explained above can be presented in the form of a statement. Such a statement of cost giving total
cost, cost per unit alongwith differential cost components and preparation of a cost sheet can be understood with the
following particulars:

Illustration 1.1 Calculate the Prime cost, Factory cost, Total cost, Total cost of Production and Cost of sales from the
following particulars:

Rs. Rs.
Raw Material consumed 40,000
Wages paid to labours 10,000
Directly chargeable
expenses 2,000
Oil & Waste 100
Wages of Foremen 1,000
Storekeepers' Wages 500
Electric Power 200
Lighting: Factory 500
Office 200 700
Rent Factory 2,000
Office 1,000 3,000
Repairs & Renewals:
Factory Plant 500
Machinery 1,000
Office Premises 200 1,700
Depreciation:
Office Premises 500
Plant &
Machinery 200 700
Consumable Stores 1,000
Manager's Salary 2,000
Directors' Fees 500
Office Printing & Stationery 200
Telephone Charges 50
Postage & Telegram 100
Salesmen's Commission & Salary 500
Travelling Expenses 200
Advertising 500
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 Warehouse Charges 200
Carriage Outwards 150

Solution:

Rs. Rs. Rs.

40,00
Direct Material: Raw-materials consumed 0
Wages paid to 10,00
Direct Labour: labours 0
Direct Directly chargeable
Expenses: expenses 2,000
52,00
PRIME COST 0

Factory
Add: overheads
Indirect Material: Consumable stores 1,000
Oil & Wages 100 1,100
Indirect Labour: Wages of foreman 1,000
Storekeepers' wages 500 1,500
Indirect
Expenses: Electric power 200
Factory lighting 500
Factory rent 2,000
Repairs & Renewals:
Plant 500
Machinery 1000 1,500
Depreciation:
Plant & Machinery 200 4,400 7,000
59,00
FACTORY OR WORKS COST 0

Add: Office and administration overheads:

Indirect Material: Office printing and stationery 200
Indirect Labour: Manager's Salary 2,000
Director's fees 500 2,500
Indirect
Expenses: Office lighting 200
Repairs & Renewals office premises 1,000
Dep. on office
premises 200
Telephone charges 500
Postage & telegrams 50
TOTAL COST OF PRODUCTION 100 2,050 4,750

63,75
Add: Selling & Distribution overheads: 0
Indirect Labour: Salesmen's commission and salary 500
Indirect
Expenses: Travelling expenses 200
Advertising 500
Warehouse charges 200
Carriage outward 150 1,050 1,550
65,30
COST OF SALES
0

400
 CHAPTER-12:
AUDITING: AN INTRODUCTION(I)

Meaning
The word ‘audit’ has been derived from the latin word ‘Audire’, which means ‘to hear’. In ancient days, the owners of the
business used to appoint certain persons to check the accounting records whenever they suspected any fraud or
misappropriation of funds by the persons responsible for receipts and disbursements of money on behalf of the owners.
Such persons, whose duty was to check the accounting records, came to be known as ‘Auditors’. They used to send for the
accounting parties and hear whatever they wanted to say in connection with the accounts while providing clarifications. The
auditors used to be satisfied by their oral explanations. In those days audits mostly consisted of comparison of records of
cash payments with their vouchers. The auditor considered his task to have been completed as soon as he was satisfied that
there was perfect agreement between the payment and the documentary evidence (voucher) that someone has received the
corresponding amount. That was merely a ‘cash audit’, whereas now, the auditor has to look into the facts behind the figures
and has to certify their accuracy. Today, an auditor is more concerned with real accuracy rather than the mathematical
accuracy or the systems audit rather than the routine checking. Audit, these days, implies a written report not only about the
accuracy but also the reliability of the accounting records. With the introduction of the double entry system of book keeping,
the duties of the auditor have greatly increased, as this scientific system has made possible the recording of not only cash
transactions but also all other kinds of transactions pertaining to business.

Definition
Auditing may be defined as the examination of the books of accounts and of documents, of a business by an independent
person, qualified for the job and not in any way connected with the preparation of the accounting records, in order to verify
the truth and accuracy of the financial position as disclosed in the Profit and Loss Account and the Balance Sheet for a
particular period. It is an intelligent and critical scrutiny of the books of account of a business along with the documents and
vouchers from which they have been written up. Auditing has been defined by various learned authors in different ways.

I. Montgomery: ‘Auditing is a systematic examination of books and records of a business or other organization in
order to ascertain or specify and to report upon the facts regarding its financial operations and the results thereof.’
II. W. W. Bigg: ‘An audit may be said to be such an examination of books, accounts and vouchers of a business, as
will enable the auditor to report, whether he is satisfied that the balance sheet is affairs of the business and that of
the profit or loss for the financial period, according to the best of the information and explanations given to him
and as shown by the books; and if not, to report in what respect he is not satisfied.
III. J. R. Batliboi: ‘Audit is an intelligent and critical scrutiny of books of account of a business with the documents
and vouchers from which they have been written up, for the purpose of ascertaining whether the working results of
a particular period shown by the Profit and Loss Account and also the financial position as reflected in the Balance
Sheet are truly and fairly determined a presented by those responsible for their compilation.

A careful analysis of the above definitions clearly shows that an audit is systematic examination of books,
accounts, documents vouchers of a business to ascertain actualities of business. It is not only to see the arithmetical
accuracy of the books of accounts but it also goes further and finds out whether the transactions themselves are supported by
the authority. The auditor has, ultimately, to satisfy himself that the account books have been written properly and disclose
true view of the state of affairs of the business.

Thus, the purpose of auditing lies in ascertaining, whether the working results and financial position as shown by
the Profit and Loss Account and the Balance Sheet for a particular period are truly determined and presented by those
responsible for their compilation. It does not include the preparation of the accounts. It is the verification of accounts by an
independent person, who examines and checks them and makes best use of the information supplied to him. An auditor is
required to direct his efforts towards proving and establishing the authenticity of the accuracy of accounts after proper
examination by an independent person.

In fact, audit implies the verification of the accuracy of the complete course of a business transaction, from
beginning to the end. It is an important part of an auditor’s job to check up the authority behind the transaction, the relation
of the transaction with the business, examination of the book entries, their proper and accurate recording, and lastly the
correct presentation of its results in the final accounts. An important object of auditing is to satisfy those who are interested
in the financial affairs of an undertaking that the books and accounts are accurate and reliable, that all receipts and payments
have been properly accounted for and that the balance sheet or final statement of accounts are true and are correctly drawn
up. Auditing, thus, also puts upon the auditor a responsibility to exercise professional skill and diligence to satisfy himself
that books of account contain a proper record of the transactions. This will involve a complete examination of the whole of
the business transactions and the manner in which they have been recorded. There is no limit to which such examinations
may extend. It will depend upon the individual circumstances of the case and the skill, judgment and the dexterity of the
auditor. Whatever the extent, it must be such as would satisfy the auditor in all respects.

Though auditing helps in establishing the credibility of the financial statements, it neither provides any insurance
against future errors and frauds or future viability of the entity nor guarantees the efficiency or effectiveness with which the
management has conducted the affairs of the entity.
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 The definition of auditing has undergone a fast change. Auditing has been both an independent academic discipline
as well as a useful profession. It has become more analytical. It has laid down uniform standards of reporting of the working
results to facilitate comparisons and measure progress. Development of new communication and information systems have
totally changed the concept of auditing and it has come to stay as a friend, philosopher and guide to management.

Origin of Auditing
The necessity of auditing was realized in order to put a check upon those persons whose business was to record the receipts
and payments of money on behalf of others. In ancient days, the methods of accounting were so crude and confused and the
number of transactions was so small, that each individual was able to check the transactions and then record for himself. As
soon as the organizations became coherent and consistent, and the number of checks were evolved and applied to their
accounts. The ancient accounts only, through there are indications that it was customary to get the accounts of firms, estates
and manor houses also audited.

Auditing is older than double entry system of accounting. References to auditing practices are available in
Egyptian, Greek, and Prevedic literature. For the Mahabharat, Maurya and Muslim periods, definite evidence is available
that a very senior member of the court enjoying confidence of the king, used to be responsible for the auditing of the records
of the state.

The Renaissance in Italy in the fifteenth country led to the evolution of a system of accounts which could record
completely all kinds of mercantile transactions. It was in 1494 that Lucas Pacioli double entry system of Accounting at
Venice in its present form, although the system was more or less used in different forms during the earlier part of the
century. It was then that it became possible to record all transactions, including cash involving matters of account. This
ultimately led to the increase in the duties of an auditor. The increase in the volume of trading operations resulted in the
formation of partnerships and other organizations. This development also had a material effect on the practice of auditing
but it was only in the nineteenth century that the audit of business accounts became common. The discovery of steam power
during that period and other mechanical inventions led to the formation of a large number of joint stock companies and
other corporate undertakings involving the use of large sums of capital under the management of a few individuals. Under
these circumstances it was felt advantageous to utilize the resources of the auditors. Since then auditing has become the
most important part of the professional accountants duties. The Indian Companies Act, 1913 made the auditing of the
accounts of limited companies compulsory to the further growth of the accounting profession in India. Initially, the
Provincial Governments conducted Diploma in Accountancy examination to provide for the requisite qualifications to the
auditors. In 1918, Government Diploma in Accounts (GDA) was introduced, which was later replaced by accountants or
registered with the central government i.e., Registered Accountants or R.A. Subsequently, an Indian Accountancy Board
was established in 1932 to provide for the requisite qualification for auditors. On the passing of the Chartered Accountants
Act, 1949, the required qualification for a professional auditor is now provided by the Institute of Chartered Accountants of
India set up under this Act. The institute has also been charged with the responsibility of organizing, training and
maintaining the standard of the profession of auditors. Though the Institute functions under the overall control and
supervision of the government yet it has given due freedom to manage its own affairs and evolve high standards of
competence, independence, ethics, discipline field of work and reporting. The Indian Companies Act has made
comprehensive provisions relating to the accounts and the audit of books of account of joint stock companies. The
qualifications, rights, duties, and obligations of an auditor have now been laid down by the Companies Act, 1956.

Scope of Audit
Auditing originally used to be confined to fined to finding out whether the receipts and the payments have been recorded
and accounted for properly. There were mainly the cash transactions which came under its preview. But audit has become
something more than merely an examination of cash transactions. It has grown from routine checking to verification audit
and further to systems audit.

These days auditor is not only concerned with the determination of arithmetical accuracy of the books of accounts,
but he is also required to satisfy himself about their substantial accuracy. He must also satisfy himself about their substantial
accuracy. He must also satisfy himself as to the authority of the transactions hand that they are consistent with the general
nature of the activities of the business. He must see to it that the books are correct and include all the transactions that
should be recorded therein. For this purpose, he may be required, in many cases to go behind the books. In order to achieve
the objectives of auditing, he must examine all vouchers, invoices, contracts, minutes, correspondence, and other
documentary evidence available. Checking of postings, totals and carry forwards of balances is also required to be done by
him. Audit is required t include vouching, verification and valuation of all items appearing in the financial statements.

Techniques of Auditing and the Principles of Auditing

Principles of auditing deal with the functions and concepts of auditing. They involve the main rules and principles according
to which the books of accounts of a business concern are audited. They consist of routine checking, vouching and
verification of the accuracy of the entries recorded in the books of account. They aim at securing the accuracy and reliability
of records. They help the auditor in the detection and prevention of errors and frauds. They involve independence, integrity,
secrecy and professional care of an auditor. They are primarily concerned with the true and fair presentation of the earning
capacity and the financial position of the business for the benefit of the society. Principles of auditing remain fixed and
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constant and do not change from time to time or business to business. They are not subject to situational influences. Auditor
has no option to change them at his discretion.

Techniques of auditing are concerned with the method and means usually adopted by the auditors for the collection
and evaluation of audit evidence for each individual case. Various devices used by the auditors to confirm the accuracy of
records are called techniques of auditing. Techniques of auditing are always changing according to (i) nature and size of
business, (ii) proposition to be proved, (iii) system of accounting, (iv) efficiency of internal controls, (v) experience of the
auditor, etc. Techniques of auditing may differ in an industrial or manufacturing concern from the techniques of a financial
unit. They may also be affected by the fact whether the business employs more of mechanical or manual devices.
Sometimes physical checks may have to be given preference over documentary checks. Techniques of auditing, therefore,
have to be framed to meet the requirements of individual businesses.

Techniques of auditing are adopted and drawn up subject to the following major objective: -
(i) Efficiency conduct of audit within the parameters of an illable time.
(ii) Identifying ‘risk areas’ vis a vis the nature of the nature of the client’s business.
(iii) Assuming the role as an adviser to client instead of nearly acting as a fault finder and suggesting ways and
means for the optimum utilization of the client’s resources.

Techniques of auditing are usually are concerned with the following things:
1. Establishment of the accuracy of the books and transactions recorded therein.
2. Proper allocation of the expenditure between capital and revenue.
3. Verification of the title and the physical existence of the assets and their proper valuation.
4. Investigation in the genuineness of liabilities.
5. Ensuring that the books of accounts of the business have been maintained in accordance with the provisions of law
and that the accounts have been prepared and drawn in the prescribed form.
6. Reviewing the adequacy and efficiency of the systems of internal check and the method of recording the
transactions.

Auditing Standards and Auditing Procedures

Auditing standards relate to the quality of the auditor’s performance, which may depend upon the independence and
professional skill of the auditor. For better auditing standards, auditor must be able to form an independent assessment of
the evidence and exercise proper supervision on the work of his assistants. Auditing procedures refer to the methods or
techniques adopted by the auditor in the conduct of his work. They may include methods of collecting and evaluating
evidence for the vouching of various transactions and verification of the assets and liabilities of the business. Procedure may
involve various steps such as observation, confirmation, physical examination, inspection recomputation, retracing,
scanning, correlation, testing, reviewing, etc.

Objects of Auditing
With a radical change in the scope of auditing, its objectives have also changed. Earlier, auditing was conducted with the
sole object of finding out frauds and errors committed by those incharge of reporting the business affairs. But now the
objective has changed from the detection of frauds and errors to ascertain whether the financial statements present true and
fair view of the earning capacity and the financial position of the business. Auditors should now see that the accounts of the
business do ‘not conceal any known cause of weakness in the financial position or suggest anything which cannot be
supported as fairly correct from a business point of view’. 5 Auditor now is required to express an opinion on the financial
position of a business. Thus, the main objects of auditing can be classified under these heads:
(i) Confirmation of the truth and fairness of the financial statements, i.e., verification of the position of the
business.
(ii) Detection of errors and frauds.
(iii) Prevention of errors and frauds.

In addition to its main objects, auditing may be undertaken for various special objects. Auditors may be asked to
carry out propriety audit, efficiency audit, social audit, management audit, cost audit, etc.

The main objective of audit is to confirm whether the financial statements fairly represent the actual financial
position and the working results of a firm in accordance with Section 227 of the Companies Act, 1956. The auditor has to
conduct an independent review of the financial statements and offer an independent opinion about their reliability.
Moreover, the emphasis has now shifted from a mere confirmation to evaluation of the financial statements and the systems
practiced in the business.

The Research Committee of The Institute of Chartered Accountants of India is of the view that while an audit
under the Companies Act is not intended and cannot be relied upon to disclose all defalcations and other irregularities, their
discovery may be incidental to such an audit. Similarly, the Committee on Auditing Procedure of the American Institute of
Certified Public Accountants observes that the ordinary examination directed to the expression of the opinion on financial

5
Re London and General Bank (No.2) (1895 2 ch 673)
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statement is not primarily or specifically designed and cannot be relied upon, to disclose defalcations and other similar
irregularities. However, the auditor recognized the fact that the fraud, if sufficiently material, may affect his opinion on the
financial statements as whether they show the true and fair view and he takes this factor into consideration while conducting
an audit. Thus, detection of frauds and errors is an incidental objective which follows automatically from the main objective
of confirming that the statements give a true and fair view. However, it may become an important duty of the auditor of his
suspicion about errors and frauds are aroused. Since the financial statements are prepared with the help of the books of
accounts, the auditor has to satisfy himself that the books are properly maintained and can be relied upon to confirm the
fairness and the truth of the statements.

Detection of Frauds and Errors

As stated earlier, the detection of frauds and errors is subsidiary object of auditing. In the recent computer era, detection of
errors and frauds by the auditor may be little more difficult. Auditor may not be able to locate errors and frauds in the
accounts unless he knows the details of computer programming, which itself is a very technical and complex job. A minor
deviation in the programming may change the whole course of the figures and specifically, where it is done deliberately.

Fraud may be classified as:

1. Misappropriation of cash
2. Misappropriation of goods
3. Manipulation or falsification of accounts without any misappropriation of cash or goods.

1. Misappropriation of cash: Contrary to popular belief, misappropriation of cash is not easy to operate. This
requires collision between several parties in the organization and cannot be done by one single person without
the chance of early detection. In such business houses where the proprietor does not have any direct control over
the receipts and payments of cash, the opportunities of misappropriation are quite frequent. Internal check is the
most effective antidote against frauds. Cash is misappropriated by
a) Overcharging the payments, and
b) Concealment of the receipts.

Overcharging the payments: The purchase invoices may be inflated and false payments recorded. The totals of
the wages sheets may be manipulated by adding fictitious names of workers. Frauds may also be committed by
making payments against fictitious vouchers.

Concealment of the receipts: Cash received from debtors may not be fully accounted for and amounts may be
transferred to bad debts account, while they have actually been recovered. Unauthorized discounts and
allowances may be adjusted against customer accounts. The sale of scrap and other sundry receipts like rent etc.,
may not be recorded. In addition to these, there are many other ways to under account the cash receipt.
However, the auditor can check these frauds by thorough checking of all the books of account particularly, cash-
book, cash memo books, sales vouchers and wages sheets etc. he may even go to the extent of communicating
with the customers and getting their balances confirmed.

2. Misappropriation of goods: Valuable goods of lesser bulk are very often stolen by the employees. Proper
records of goods inwards and outwards must be maintained in order to check misappropriation of goods, which
is generally more difficult to detect of stores accounts are not maintained properly. The auditor may compare the
ratio of gross profits to gross sales to detect any loss of stock. It is also necessary that an effective system of
internal check is introduced in the business. Existence of adequate internal security to see that no goods are
taken out of the premises without proper authority is also essential. In order to detect this type of fraud, the
auditor may have to go in for a thorough physical verification of stocks in hand.
3. Manipulation or falsification of accounts without any misappropriation: This type of fraud is generally
perpetrated at the managerial level. The falsifications of accounting record does not involve actual
misappropriation of cash or goods. It is a pre-determined and pre-planned fraud which is difficult to detect due
to the involvement of the top bosses of the management. The objective of the management is to boost up the
figures of profits in order to improve the image of the firm in the eyes of the public. This practice is resorted to
obtain further credit and to increase the amount of managerial commission due to them. Sometimes, the
accounts are so manipulated as to show a loss so that the payment of Income Tax and Sales Tax is avoided. The
management also manipulates the accounts in order to show false profits so that the prospective buyers of the
business are misled and are induced to pay a higher consideration and also to create favourable condition in the
stock market to unload their shareholdings. The true position even when there are sufficient profits. The
management may achieve this objective by adopting various methods such as:
(a) By over or under-valuation of closing stock.
(b) By over or under-charging the depreciation.
(c) By recording false purchases or even omitting purchases.
(d) By showing false payments and receipts.
(e) By recording fictitious sales or purchases to increase or reduce the profits.
(f) By omitting certain expenses or incomes.

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 As this type of fraud is committed by responsible persons, its detection requires an extraordinary care and vigilance
on the part of the auditor if he wants to discover such frauds. A half-hearted approach will not do. In such cases the auditor
is intentionally fed with false information. He needs to exercise considerable skills and dexterity to be true to his salt.
However, if he uses adequate skill and reasonable care in detecting such frauds, he cannot be held liable if he fails to
discover the well planned frauds.

Detection of Errors
Detection of errors is the primary duty of an auditor. The chances of errors are always present in all human action and more
so in figure work. Unlike frauds, errors are unintentional and are committed out of innocence. But the auditory cannot afford
to be lethargic simply because of the fact that they are committed because of the innocence of the people liable for their
commission. Sometimes, the errors appear as if committed innocently, but actually they are the result of some fraudulent
manipulations. Therefore, the auditor must pay serious attention towards the errors. Errors may be committed either due to
the ignorance of the principles of recording the transactions or due to the negligence and carelessness of those responsible to
maintain records. Mistakes may be committed in original documents such as invoices, credit notes, statements of account
etc., or in copying figures from original documents into the record booked or in the final statements prepared therefrom.
They may arise through incorrect quantities or wrong prices being stated or through incorrect quantities or wrong prices
being stated or through inaccurate arithmetical calculations. In all cases, it is not necessary that errors must cause
disagreement in the trial balance. Some of the errors will throw out the trial balance while others will not. The errors may be
broadly classified as:
(i) Clerical errors, and
a) Errors of omission
b) Error of Commission
c) Compensating errors
(ii) Errors of Principle

(i) Clerical Errors: These errors arise because of wrong posting, of a wrong amount, to a wrong account, on the wrong
side of an account. Some transactions are not recorded at all in the books of first entry. These errors are mainly of
three types:
(a) Errors of Omission: These errors are very difficult to discover because they do not affect the agreement of
the trial balance. They arise when a transaction is wholly or partly omitted from being recorded in the books.
Such errors include the omission to enter purchases invoices or sales invoices in Purchases or Sales Books and
outstanding expenses and prepaid expenses remain unadjusted. These omissions may be made deliberately to
affect the business results, and thus, constitute fraudulent manipulation of accounts. The partial (one-sided)
omission can be easily discovered as in that case the trial balance will not agree. An auditor can discover these
errors only by carrying out a thorough and efficient checking of the records such as ledgers, correspondence,
debtors’ and creditors’ statement of accounts, etc. although the detection of all omissions is a part of auditors’
duty, yet he can rely to a certain extent on the prevalence of internal audit in a big business house.

(b) Errors of Commissions: These errors include wrong posting of wrong amounts, on the wrong side, of the
wrong accounts. For example salaries of Rs. 1510 paid are posted to the credit of Sales Account as Rs. 1150/-.
Such errors normally affect the agreement of trial balance. However, if the posting is only to the wrong
account or wrong side of a correct amount, the trial balance will remain unaffected. As such these errors are
comparatively simpler and easier to discover. The routine checking of the books will disclose many of these
errors, yet the auditor should insure that they are independently checked through test checking. He should also
not ignore personal verification of the accuracy of important calculations.
(c) Compensating Errors: A compensating error is one which is counter-balances the other, yet one error does
not rectify the other. They are also difficult to discover, as they do not affect the agreement of the trial balance.
It is also possible that, in certain cases, they may also not affect the amount of profit e.g., when both errors
have been committed in the Profit and Loss Account. These errors can only be detected by thorough checking
of different books and accounts.

(ii) Errors of Principle: These errors are generally committed due to the lack of knowledge about the accounting
principles. The transactions are recorded contrary to the fundamental principles if accounting. These errors may not
affect the Profit and Loss Account directly, but may mislead the management. These errors may be committed for a
fraudulent purpose under the garb of ignorance of accounting principles so as to disclose a particular state of affairs
of the business to the satisfaction of the management. These errors arise in the following cases:

a) Valuation of stock-in-trade on the basis of wrong principles.

b) Incorrect appropriation of expenditure between capital and revenue.
c) Ignoring the outstanding liabilities and assets.
d) Posting the transactions to the wrong class of account

As these errors may affect the accounts considerably, the auditor should undertake thorough investigation of he is to
discover such errors. Routine checking alone would not serve the purpose.
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Concealed Errors: Concealed errors are always intentional. They are very much in the nature of frauds committed either to
show financial position of the business better than the real one or to conceal misappropriation of goods or cash e.g., inflation
of sales writing off goods or cash e,g,, inflation of sales, writing off good debts as bad, etc. Usually they are very substantial
and all efforts must be made to detect them otherwise the accounts may not disclose true and fair view of the financial
position of the business.

Apparent Errors: Apparent Errors: Apparent errors are unintended genuine mistakes. Mostly they include the cases of
wrong calculations, wrong carry forwards or omissions e.g., omission to record outstanding liabilities, etc. They can easily
be detected either by routine checking or comparing the figures with those of the last year.

Prevention of errors and frauds is mainly the responsibility of the management. However, the advice of the auditor
in this regard shall always be very valuable.

Location of Errors
Ordinarily, the location of errors does not form part of the auditors’ job. His duty is simply to audit the accounts and
present his free and frank opinion about their accuracy and reliability. But in many cases because of his professional
competence, the auditor is also called upon to detect the errors so as to do away with any discrepancies in the books of
accounts, when the accountant fails to do this. The auditor can apply the following checks in order to discover the errors:
1. He can get the lists of debtors and creditors prepared and then compare them with the Trial Balance.
2. He should ensure that no entry of the books of original entry remains unposted.
3. The totals of trial balance may be rechecked. Many errors which have only one-sided effect can be located in this way.
4. Totals of the books may be verified.
5. Names of accounts in the trial balance and those in the ledger may be compared. It is possible that some accounts have
not been written in the trial balance or else some accounts may have appeared twice in the trial balance.
6. Totals of cash book, purchases book and sales book should be checked and compared with those appearing in the trial
balance.
7. The auditor may resort to thorough checking of all posting into the ledger.
8. The journal entries may be compared with the transactions so that wrong journal entries are not passed.
9. He should proceed to ascertain the exact amount of difference.
10. He should see that the opening balances have been correctly brought forward in the current year’s books.
11. He should ensure that the balances of the ledger accounts are entered in the correct columns of the trial balance.
Mistakes on account of entering the balances on the wrong side of the Trial Balance can be detected by reducing the
difference to half and ascertaining if there is any balance of the same amount in the Trial Balance.
12. He should study the amount and the nature of the differences to locate the reasons for the difference. Figures for the
current year may also be compared with the figures of the previous years.

Functions of Auditing
The important functions of auditing are:
(i) to examine the system of accounting and internal controls,
(ii) to review the systems and procedures of business,
(iii) to examine documentary evidence to determine authenticity, validity and accurate recording of business
transactions,
(iv) to ensure both arithmetical as well as real and substantial accuracy.
(v) to verify title, existence and valuation of assets,
(vi) to ensure proper distinction between capital and revenue,
(vii) to report to the appropriate persons on the truth and fairness of accounts, and
(viii) to comply with all the statutory requirements.

Process of Auditing
The process of auditing involves five different stages:
(i) Recognition of the proposition to be proved.
(ii) Collection of evidence.
(iii) Evaluation of evidence.
(iv) Formation of judgment.
(v) Evaluation of the proposition to be proved.

(i) Recognition of the proposition to be proved: An auditor must identify his objectives very clearly before
commencing his work. He must be clear about the terms of reference and the nature of his obligation i.e., statutory
or contractual. He must know what is required of him. He may be concerned with the verification of existing assets
and liabilities, past events such as reserve for bad and doubtful debts, etc. Besides ensuring mathematical accuracy
of the records, he may be concerned with the qualitative condition.
(ii) Collection of evidence: Auditor should decide about the nature and the manner of collecting relevant
evidence to prove his proposition very judiciously. He should undertake review of the accounting systems of the
business and the internal controls practiced by it. He may, in some cases, resort to physical verification, while in
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 other cases; satisfy himself with confirmation of contingent liabilities or confirmation of debtors’ and creditors’
balances. Auditor may also be required to examine the documentary evidence such as payees’ receipts, purchase
invoices, insurance policies, entries in the bank pass book, etc. Reliability of most of the documentary evidences
will depend upon the system of internal control practiced in the business. Auditor can also rely on the certificates
of the responsible officers of the firm in the absence of suspicious circumstances. Auditor should collect and
examine all that evidence which would enable him to certify both the arithmetical as well as the real accuracy of
the records. All important calculations must be checked by him.

Auditor should examine the procedures and the efficiency with which they are followed to determine the reliability
of the documentary evidence. Sometimes, the auditor may have to compare the ratios of the same item at two
different periods, examine subsequent data or subsidiary records or production records, etc., to ascertain the
accuracy of the statements submitted to him for audit.

An auditor may obtain evidence relevant for his audit work by any one or more of the following methods:
1. Inspection
2. Observation
3. Enquiry and confirmation
4. Computation
5. Analytical Review

The choice of the method for collecting audit evidence will depend upon the timings when a particular
kind of evidence is available.

Inspection: It includes examination of documents and tangible assets. The reliability of this source of evidence
will depend upon the effectiveness of internal controls of the business.

Observation: It consists of looking at a process or procedure being performed by others e.g., procedure of
counting of inventories by client’s personnel, etc.

Enquiry and Confirmation: It involves seeking appropriate information from knowledgeable persons inside or
outside the entity. Enquiries may be oral or written, formal or informal, external or internal. Technique of
confirmation of the accounting entries by the parties concerned directly to the auditors sometimes proves very
useful.

Computation: It implies independent calculations to verify arithmetical accuracy of the accounting records.

Analytical Review: Comparison of data, study of significant ratios, analysis of trends and ascertaining the causes
of unusually wide fluctuations proves to be a very useful source of audit evidence to the auditor.

(iii) Evaluation of Evidence: Auditor will, after collecting evidence, evaluate it according to his professional skill
and standards on the basis of its usefulness, relevance and credibility.
(iv) Formation of Judgment: After carrying out a critical review of the entire evidence collected and obtained by
him to prove a propositition, auditor will form his opinion about the real state of affairs and give representation to
the same either through the published statements of his client or through his reports. Auditor does not ensure
absolute accuracy but reasonable and fair presentation of the position of the business.

Need for auditing-its importance

The contention that auditing is a luxury is not well founded. From the foregoing discussion, lit must have
become very clear that auditing is very necessary for a business house. It is very useful for investors, business and
the society as a whole.

1. For the society as a whole: An auditor certifies the accounts and statements to be correct and dependable.
On the basis of these statements, future planning, whose ultimate aim is social benefit. The audited
statements also help the government in assessing the performance of business in terms of the utilization of
resources. Keeping in view this assessment, suitable economic policies can be framed by the government
about business firms. Efficient and honest reporting will not only increase the goodwill of the firms, but
will also help the society through increase in the values of shares because the stock exchanges also depend
heavily on the audited accounts of the firms.
2. For the business: The audited accounts help the business in the correct assessment of the business
performance. As the auditors bring out all the weak points in the business, they provide opportunity to the
business to improve upon its weaknesses. As the audited accounts bring credibility to the financial
statements, it becomes easier for the business to arrange for finances. The business can fix a correct
consideration in case it decides to sell its undertaking. It can also be sure of correct and reasonable
assessment of certified by the qualified auditors. Above all, the reputation and certified by the qualified
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 auditors. Above all, the reputation and goodwill of the business will get a boost when the management
gets its accounts audited and places the facts before all those who are concerned.
3. For the Investors: Investor is not only interested in the safety of investment but also in higher returns. He
is happy when he is sure that his money is properly used and there is no bungling. This factor raises the
need for auditing. Interests of the shareholders and the debenture-holders are protected by the auditor as
he acts as their trustees. His work keeps a check on the honesty and efficiency of the management. The
investors can know the true value of their investment as and when they like. If the accounts of the firms
are audited properly, the investors can raise loans on the basis of their investments. These investments can
act as collateral securities.

Considering all these points, it can be said that auditing is an integral part of the entire business
reporting. Auditing cannot be brushed aside as a mere luxury. However, one thing must be kept in mind
that the cost of audit must match the benefits derived from it, particularly in a small business, which may
not be able to afford the remuneration of a professionally qualified auditor.

Advantages of Audit

Irrespective of the fact whether audit is compulsory, statutory, or voluntary, it has numerous
advantages for every person and every type of organization. In most of the cases, it is usually done on
behalf of those persons who have neither the capacity nor the opportunity of examining accounts for
themselves. It is through the audited accounts that the shareholders are assured that the funds invested by
them are safe and that they are being used for the purposes for which they were collected. Auditing is
compulsory in the case of joint stock companies and it is to be conducted by qualified chartered
accountants. Even the sole traders and the partnership firms go in for audit of their accounts, through it is
neither compulsory nor statutory for them. This is because auditing lends credibility to accounts. It serves
both as a preventive device and a cure. Following are the main advantages of audit.

1. Verification of the financial position: The most important advantage of auditing is that the
financial position as disclosed by the Balance Sheet and Profit and Loss Account, is
independently verified and the shareholders feel assured that their funds are not misused.
2. Detection and prevention of errors and frauds: Auditing helps in detecting and preventing the
errors and frauds in the accounts. Auditing acts as a check on the honesty of the employees in
cases where the proprietor cannot personally supervise the affairs of the business. The
defalcations are avoided and the errors and frauds are easily brought to light and their occurrence
in future is checked by keeping a moral pressure on the employs. The loopholes and the weak
points in the system of internal check and control can also be brought to light by the auditor and
can be suitable plugged for future safety.
3. Up-to-date recording: Auditing tends to keep the records of a business up-to-date. Any
information can be obtained from the books without any loss of time.
4. Moral check on the honesty of the employees: Moral effect of auditing keeps the employees
always keeps the accounts regular, accurate and up-to-date. Further, the employees will not
attempt to commit frauds as they are always under the continuous fear of being caught.
5. Accuracy of records: Financial position and the earnings of a business are verified and
confirmed by an independent person who certifies their correctness. People responsible for
management of business can easily draw correct conclusions from accurate audited accounts.
Audited accounts may be used to instill significance among those who enter into any type of
financial dealings with the business.
6. Reliability of records: The audited accounts are more reliable for the purposes of the
assessments of income tax and sales tax, for insurance claims, for obtaining additional capital of
borrowing money, for proposed sale of business, for computation of goodwill, for determining
the share of the retiring partner, for obtaining the patronage of the government and for
determination of bonus and wages, etc.
7. Settlement of disputes: Audited accounts tend to prevent any dispute between the partners of the
partnership firms with regard to the distribution of profits.
8. Advisory services: The auditor has the competence to render expert advice in matters of
accounting and finance. His advice is always sought, although it is no part of his duty to offer any
such advice. Now a days, the auditors are a constructive force in the conduct of the business.
They not only check the accuracy of the figures, but also try to give the business; he can serve as
the best friend of the business for consultations on all major policy decisions.
9. Tool of management: Auditing provides regular medical check up of the health of the business
to the management which can safely rely upon the audited accounts for policy decisions. The use
of accounting ratios is meaningful only if the accounts on which they are based are accurate and
reliable.
10. Valuation of the worth of a going concern: The audited accounts are mostly relied upon for the
calculation of purchase consideration in the case of amalgamation, absorption and reconstruction.
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 Besides the valuation and verification of assets, the valuation of shares and the goodwill of the
firm is also determined on the basis of audited accounts. This valuation is decidedly more
reliable.
11. Facilitating raising of further finances: The audited accounts are useful for the management in
procuring finances from the investors are approached for loan, he would like to go through the
audited accounts of the business. The investors insist on producing the audited profit and loss
account and balance sheet of the previous year so as to guage the true problem of the firm as
these statements are generally supported by the statements of the auditors.
12. Check on over-optimism of the businessmen: There is a tendency amongst the businessmen to
overestimate the value of assets of their business and to take a very optimistic view of the
liabilities of the business. An audit is of great use in disclosing to him the true and correct
financial position of his business and in maintaining the continued solvency of the business.
13. Ensuring proper business accounting and planning: Audit reveals weaknesses in the internal
control of the business and defects in the accounting methods. Suitable precautions and
preventive measure may immediately be adopted for the future.
14. Check on the improper functioning of directors: In the case of joint stock companies, the
shareholders, who are the real owners, have no hand in the actual management of the company’s
affairs. Auditing assures them that the accounts are maintained properly. It will discourage the
directors from taking an undue advantage of their position.

Book-Keeping, Accountancy, Auditing and Investigation:

Theoretically, there is a clear line of demarcation between book-keeping, accountancy and auditing. Book-keeping means
writing up of the books of original entry. Accountancy consists of compilation of final accounts and auditing means the
verification of the accuracy of the entries recorded in the books. It is also stated that accountancy begins where book-
keeping ends and auditing begins where accountancy ends. In practice, however, this distinction is not maintained and it is
not unusual to find an auditor doing the work of an accountant or a book-keeper.

Book-keeping and Audit

Book-keeping is mainly concerned with the recording of entries in the books of original entry in a systematic way
and their posting into the ledger. The entire work is of a mechanical and routine nature and is done by book-keepers in
original books of accounts and ledgers. Auditors are required to have a specialized knowledge and training of this work.
Auditors, strictly speaking, have nothing to do with the process of writing up of the books, which is the main function of the
book-keepers.

Audit and Accountancy

It is none of the duties of the auditor to prepare the accounts. He is mainly concerned with the detailed and critical
examination of the books and accounts already prepared by others. Accountancy is the work of an accountant and is
confined chiefly to the checking of arithmetical accuracy of the books of the accounts extracting the trial balance, preparing
the profit and loss account and the balance sheet in such a way that one can clearly know the state of affairs of the business.
Auditing involves a detailed and critical examination and verification of such accounts and statements by an independent
expert for the purpose of ascertaining the true and fair position of a business. Thus, an audit does not entail the preparation
of the accounts, but it denotes something much wider in concept-verification of the facts recorded. Auditing pre-supposes
the existence of the accounts and this does not involve the writing up of the accounts. Accountancy includes the supervision
and the coordination of the work of the book-keepers. The accountant also suggests improvements under and advises the
owners of the business on all important matters pertaining to accountancy and finance. If the auditor prepares the final
accounts, he is not acting or doing so as an auditor and this will never mean that he guarantees their accuracy or the
accounts disclose a true and fair view of the affairs of the business.when he is preparing the accounts he is acting as an
accountant and not as an auditor and that this work is additional and quite outside the scope of his duties as an auditor.
When he writes the accounts, he does not certify that the accounts are correct. He can give this certificate only when he has
examined the books of accounts by conducting an appropriate audit. Thus, it is necessary that the terms and the nature of his
work is clearly laid down before he undertakes a job. However, in case of joint stock companies this problem will not arise
as his appointment and terms of reference are governed by The Companies Act, 1956. If this not done, it may give rise to
disputes and he may be held liable as an auditor, though he might have acted in the capacity of an accountant.

The decisions in the cases of Apfel Vs. Annan Dexter and Co. (1926) and Leach Vs. Stockes Bros and Prim (1937)
are worth noting in this regard. In the former case, it was held that the work purpose and not that of an audit of the books of
accounts. The main contention was that the auditors were negligent and that they had failed to detect a defalcation. It was
argued by the auditors that they were employed only to prepare the income tax returns and to prepare necessary books for
this purpose. They were never employed as auditors to audit the accounts. In the latter case, it was held that the auditors
were not negligent while accepting the assurance by one of the partners that the books produced were correct. It was further
held that though it would have been better to have prepared a balance sheet in addition, this could be excused under the
circumstances. There was nothing to arouse the suspicion. The auditors were asked to prepare annual profit and loss account
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for submission to the tax authorities. It was later on discovered that the cashier of the firm had misappropriated cash. An
action was brought against before preparing the profit and loss account. It was pointed out that if the auditors had prepared
the balance sheet carefully, they would have detected the fraud. However, the auditors argued that they were appointed to
prepare a report on the profits for the inspector of Taxes and that there were no proper records available for the preparation
of balance sheet. It was finally held that the auditors were not negligent in the performance of their duties.
For an accountant, the knowledge of the principles of auditing is not at all required in the performance of his work.
He must have good knowledge of the principles of accountancy. There can be no auditing without prior existence of
accounts. The scope of the work of an auditor is definitely wider than that of accountant. An auditor is required to certify the
state of affairs of the business as disclosed by the balance sheet to be true and fair. He has to go behind the work of an
accountant, which includes lot of detailed checking.

The work of an accountant is of perennial nature and continues practically throughout the year. Audit, on the other
hand, is generally undertaken after the close of the year when final accounts have already prepared. Also, an accountant is
not required to possess any statutory qualifications as is the case with the auditors, who must be qualified Chartered
Accountants of India.

Point of difference between Accountancy and Auditing

The main points of difference between Accountancy and Auditing, therefore, can be grouped under following sub-
heads:

1. Objects: The main objective of accountancy is to prepare the final statements from the books of accounts, while in
the case of auditing the auditor has to certify the truth and fairness of these financial statements.
2. Nature: The accountant makes use of the information recorded in the books of accounts to prepare the final
accounts, whereas the auditor keeps a check on the work of both the book-keeper and accountant.
3. Scope: Accountancy is mainly concerned with the preparation of the financial statements. In case of auditing, its
scope is determined either by mutual agreement between the management and the auditor where auditing is
voluntary and by the provisions of company law where it is compulsory.
4. Qualifications: An accountant is not required to possess any formal qualifications. Knowledge of only basic
principles of accountancy is sufficient for him. In the case of auditing, an auditor must be qualified Chartered
Accountant, an Associate of Fellow member of the Institute of Chartered Accountants of India.
5. Commencement: The work of an accountant commences after the work of the book-keeper is over and the auditor
starts his work when the work of the accountant is over.
6. Liability and Reporting: There is no statutory ability of an accountant, whereas the auditor’s liabilities are statutory
and he has to submit a report and a certificate to the effect that the balance sheet presents a true and fair view of the
state of affairs of the firm. No such report is necessary from the accountant.

As a matter of fact from the practical point of view no hard and fast barriers could be laid to demarcate the area of operation
of both the accountant and auditor. An auditor during the course of his audit may come across certain transactions which
might have been left out inadvertently and may make an accounting record of these transactions.

Audit and Investigation

Investigation is different from audit as it consists of a critical examination if the books of accounts for a specific purpose. It
may be specially decided upon either by management, shareholder or the government. The purpose may be to find out the
profit earning capacity, or financial position of a concern, or to find out the extent of fraud, etc. Thus, the scope of
investigation is limited, while in case of audit; the scope is not limited to a specific purpose. It can go to any extent.
Auditing is undertaken every year as matter of course to ensure accuracy of records.

Investigation consists of collecting and analyzing such facts that the matters regarding the subject under enquiry are brought
to light, while auditing is undertaken to know whether the balance sheet is properly prepared and shows the true and fair
view of the financial position of the business.

Investigation can be undertaken on behalf of anybody interest in the affairs of the business.

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 The last decade has witnessed a rigorous change in the worldwide economic scenario. The
emergence of transnational corporations in search of money, for fuelling growth and to sustain ongoing
activities has necessitated raising of capital from all parts of the world, cutting across frontiers. Since,
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 will necessitate that the enterprise
is in a position to understand the differences between the rules governing financial reporting in both the
foreign country as well as its own country of origin.
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 decision and assess their risks.
A strong need was felt by legislation to bring about uniformity, rationalization, comparability,
transparency and adaptability in financial statements. The better way for getting rid of problems faced
by different methods of standards is to have a single set of global standards, of the highest quality, set
in the interest of public.

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.

 improves the ability of investors to compare investments on a global basis and thus lowers their
risk of errors of judgment.

 facilitates accounting and reporting for companies with global operations and eliminates some
costly requirements say restoration of financial statements.

 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.

 reduces operational challenges for accounting firms and focuses their value and expertise
standard setters and other stakeholders to improve the reporting model.

International Accounting Standard Board

With a view of achieving these objectives, 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).
International Financial Reporting Standards as Global Standards
IFRSs refers to the entire body of IASB pronouncements, including standards and interpretations
approved by the International Accounting Standard Board (IASB) & IASs and SIC interpretations
approved by the predecessor International Accounting Standards Committee (IASC)
Broadly, IFRS consist of,

1. 13 International Financial Reporting Standard (IFRS)

2. 28 International Accounting Standard (IAS)
3. 15 International Financial Reporting Interpretation committee (IFRIC) Interpretations
4. 9 Standard Interpretation Committee (SIC) Interpretation

IFRS is a set of international accounting standards stating how particular types of transaction
and other events should be reported in financial statements and are the globally accepted accounting

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standards. IFRSs (being principle - based standards) have distinctive advantage that the transactions
can't be manipulated easily to achieve a particular accounting. It is believed that IFRS, when adopted
worldwide, will benefit investors and other users of financial statements by reducing the cost of
investments and increasing the quality of the information provided. Additionally, investors will be
more willing to provide financing with greater transparency among different firms' financial statements.
Furthermore, multinational corporations serve to benefit the most from only needing to report to a
single standard and, hence, can save money. It offers the major benefit where it is used in over 120
different countries, while U.S. GAAP is used only in one country.

Objectives of IFRS
The IASB, in regards to IFRS, has four stated goals:

1. To develop global accounting standards requiring transparency, comparability and high quality
in financial statements
2. To encourage global accounting standards
3. When implementing global accounting standards, to take into account the needs of emerging
markets
4. Converge various national accounting standards with the global accounting standards

Indian Case - Convergence with IFRS

There are two easy to make the reporting structure of a country IFRS compliant; either to adopt
the IFRS in it’s entirely, or to converge the country’s standards in line with the IFRS. Convergence
with IFRS implies to achieve harmony with IFRSs and to design and maintain national accounting
standards in a way that they comply with the International Accounting Standards. Due to some
critical issues in the original standards like agricultural accounting, foreign exchange transactions,
pension accounting etc, the India has adopted the later, i.e. Converged Accounting standards. . The
transition would enable Indian entities to be fully IFRS compliant and give an "unreserved and explicit
statement of compliance with IFRS" in their financial statements Although some may argue that
convergence is better than the adoption, as it will give the right to modify the standard in accordance
with the Indian Economic Environment, it will defeat the very purpose of having a uniform reporting
language.
In its press release dated 25 th February, 2011 Ministry of Corporate Affairs (MCA) has notified
35 Indian Accounting Standards (Ind AS) which are converged with IFRS. It further states “The
Ministry of Corporate Affairs will implement the IFRS converged Indian Accounting Standards in a
phased manner after various issues including tax related issues are resolved with the concerned
Departments. It would be ensured that the implementation of the converged standards in a phased
manner is smooth for the stakeholders. "
(http://www.mca.gov.in/Ministry/press/press/Press_note_dated_25_2_2011.pdf)

Beneficiaries of convergence with IFRS

There are several beneficiaries to the convergence of Indian GAAP with IFRS. Some important ones
are discussed as below.

1. The Investors. Convergence with IFRS makes accounting information more reliable,
relevant, timely and comparable across different legal frameworks and requirements as it would
then be prepared using a common set of accounting standards thus facilitating those who want
to invest outside India. Convergence with IFRS also develops better understanding of financial
statements globally and also develops increased confidence among the investors

2. The Industry. The other important set of beneficiary as the researchers perceive is the
industry which in the event of convergence with IFRS will be benefited because of, one,
increased confidence in the minds of the foreign investors, two, decreased burden of financial
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 reporting, three, it would simplify the process of preparing the individual and group financial
statements, four, it leads to lower cost of preparing the financial statements using different sets
of accounting standards.

3. Accounting Professionals. Although there would be initial teething problems, convergence

with IFRS would definitely benefit the accounting professionals as the later would then be able
to sell their expertise in various parts of the world.

4. The corporate world. Convergence with IFRS would raise the reputation and relationship of
the Indian corporate world with the international financial community. Moreover, the corporate
houses back in India would be benefited because of ,one, achievement of higher level of
consistency between the internal and external reporting, two, because of better access to
international market, three, convergence with IFRS improves the risk rating and makes the
corporate world more competitive globally as their comparability with the international
competitors increases.

5. The Economy. All the discussions made above explains how convergence with IFRS would
help industry grow and is advantageous to the corporate houses in the country as this would
bring higher level of consistency between the internal and external reporting along with
improving the risk rating among the international investors. Moreover the international
comparability also improves benefiting the industrial and capital markets in the country.

Challenges faced for successful Implementation of IFRS

1. Awareness of international practices - The entire set of financial reporting practices needs to
undergo a drastic change after the adoption of IFRS to overcome the number of differences
between the two GAAP’s. It would be a challenge to bring about awareness of IFRS and its
impact among the users of financial statements.

2. Training: The biggest hurdle for the professionals in implementing IFRS is the lack of training
facilities and academic courses on IFRS in India. IFRS has been implemented with effect from
2011; but it is observed that there is acute shortage of trained IFRS staff. There exists a large
gap between Trained Professionals required and trained professionals available.

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3. Taxation: Currently, Indian Tax Laws do not recognize the Accounting Standards. Therefore, a
complete overhaul of Tax laws is the major challenge faced by the Indian Law Makers
immediately.

4. Fair value: IFRS which uses fair value as a measurement base for valuing most of the items of
financial statements can bring a lot of volatility and subjectivity to the financial statements. It
also involves a lot of hard work in arriving at the fair value and services of valuation experts
have to be used.

5. Management Compensation Plan: This is because the financial results under IFRS are likely
to be very different from those under the Indian GAAP. The contracts would have to be
renegotiated by changing terms and conditions relating to management compensation plans.

6. Reporting Systems: The disclosure and reporting requirements under IFRS are completely
different from the Indian reporting requirements. Companies would have to ensure that the
existing business reporting model is amended to suit the reporting requirements of IFRS. The
information systems should be designed to capture new requirements related to fixed assets,
segment disclosures, related party transactions, etc. Existence of proper internal control and
minimizing the risk of business disruption should be taken care of while modifying or changing
the information systems.

7. Complexity In Adoption: Converting to IFRS will increase the complexity with the
introduction of concepts such as present value and fair value. In IFRS framework, treatment of
expenses like premium payable on redemption of debentures, discount allowed on issue of
debentures, underwriting commission paid on issue of debentures etc is different than the
present method used. This would bring about a change in income statement leading to enormous
confusion and complexities.

8. Risk in adoption: Implementing IFRS has increased financial reporting risk due to technical
complexities, manual workarounds and management time taken up with implementation.
Another risk involved is that the IFRS do not recognize the adjustments that are prescribed
through court schemes and consequently all such items will be recorded through income
statement.

9. Cost: The IFRS transition is expected to cost Indian firms between Rs. 30 lakh and 1 crore,
with an average of 16 internal and three external full-time staff dedicated to the transition. Fifty
percent of adopters had to implement entirely new IT systems to accommodate IFRS; only 20%
of companies did not implement systems changes. Costs such as auditor fees, systems changes,
and reporting costs could be significant.

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Table 1 : List of IFRS
IFRS Particulars
IFRS 1 First-time Adoption of IFRS
IFRS 2 Share-based Payment
IFRS 3 Business Combinations
IFRS 4 Insurance Contracts
IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
IFRS 6 Exploration for and evaluation of Mineral Resources
IFRS 7 Financial Instruments: Disclosures
IFRS 8 Operating Segments
IFRS 9 Financial Instruments
IFRS 10 Consolidated Financial Statements
IFRS 11 Joint Arrangements
IFRS 12 Disclosure of Interests in Other Entities
IFRS 13 Fair Value Measurement

Table 2: List Of IndAS

IndAS No Particulars
Ind AS 101 First-time
Ind AS 102 Share Based
Ind AS 103 Business Combination
Ind AS 104 Insurance Contracts
Ind AS 105 Non-Current Assets Held for Sale and Discontinued Operations
Ind AS 106 Exploration for and Evaluation of Mineral Resources
Ind AS 107 Financial Instruments: Disclosures
Ind AS 108 Operating Segments
Ind AS 109 Financial Instruments
Ind AS 110 Consolidated Financial Statements
Ind AS 111 Joint Arrangements
Ind AS 112 Disclosure of Interests in Other Entities
Ind AS 113 Fair Value Measurement
Ind AS 114 Regulatory Deferral Accounts
Ind AS 115 Revenue from Contracts with Customers
Ind AS 1 Presentation of Financial Statements
Ind AS 2 Inventories
Ind AS 7 Statement of Cash Flows
Ind AS 8 Accounting Policies, Changes in Accounting Estimates and
Errors
Ind AS 10 Events after Reporting Period
Ind AS 11 Construction Contracts
Ind AS 12 Income Taxes
Ind AS 16 Property, Plant and Equipment
Ind AS 17 Leases
Ind AS 18 Revenue
Ind AS 19 Employee Benefits

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Ind AS 20 Accounting for Government Grants and Disclosure of
Government Assistance
Ind AS 21 The Effects of Changes in Foreign Exchange Rates
Ind AS 23 Borrowing Costs
Ind AS 24 Related Party Disclosures
Ind AS 27 Separate Financial Statements
Ind AS 28 Investments in Associates and Joint Ventures
Ind AS 29 Financial Reporting in Hyper inflationary Economies
Ind AS 32 Financial Instruments: Presentation
Ind AS 33 Earnings Per Share
Ind AS 34 Interim Financial Reporting
Ind AS 36 Impairment of Assets
Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets
Ind AS 38 Intangible Assets
Ind AS 40 Investment Property
Ind AS 41 Agriculture

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