Contents

Study Note 1 : Fundamentals of Accounting

1.1 Basics 1
1.2 Generally Accepted Accounting Principles 11
1.3 Accounting Concepts and Conventions 11
1.4 Capital & Revenue Transactions 26
1.5 Accounting for Depreciation 56
1.6 Rectification of Errors 71

Study Note 2 : Accounting for Special Transactions

2.1 Bills of Exchange 93

2.2 Consignment Accounting 112
2.3 Joint Venture Accounts 133
2.4 Insurance Claim (Loss of Stock and Loss of Profit) 151

Study Note 3 : Preparation of Financial Statments of Profit Oriented Organizations

3.1 Introduction 169

3.2 Bad Debts 169
3.3 Preparation of Financial Statements 180

Study Note 4 : Preparation of Financial Statments of Non-Profit Organizations

4.1 Preparation of Financial Statements of Non-Profit Organization 213

Study Note 5 : Preparation of Financial Statements from Incomplete Records

5.1 Preparation of Financial Statements from Incomplete Records 249

Study Note 6 : Partnership

6.1 Admission of Partner 275
6.2 Retirement of Partner 303
6.3 Death of Partner 327
6.4 Dissolution of a Partnership Firm 330
6.5 Insolvency of a Partner 338
6.6 Amalgamation of Firms and Conversion to a Company 363
6.7 Conversion or Sale of a Partnership Firm to a Company 377

Study Note 7 : Self Balancing Ledger

7.1 Self Balancing Ledger 389

Study Note 8 : Royalties

8.1 Royalties 407

Study Note 9 : Hire-Purchase and Installment System

9.1 Hire-Purchase and Installment System 423

Study Note 10 : Branch and Departmental Accounts

10.1 Branch Accounts 451
10.2 Departmental Accounts 491

Study Note 11 : Computarised Accounting System

11.1 Computerised Accounting System 523

Study Note 12 : Accounting Standards

12.1 AS – 1: Disclosure of Accounting Policies 528
12.2 AS – 2: Valuation of Inventories 531
12.3 AS – 7: Construction Contracts 539
12.4 AS – 9: Revenue Recognition 545
12.5 AS – 10: Property, Plant and Equipment 550
12.6 IND AS 558
Study Note - 1
FUNDAMENTALS OF ACCOUNTING

This Study Note includes

1.1 Basics
1.2 Generally Accepted Accounting Principles
1.3 Accounting Concepts and Conventions
1.4 Capital & Revenue Transactions
1.5 Accounting for Depreciation
1.6 Rectification of Errors

1.1 BASICS

Business is an economic activity undertaken with the motive of earning profits and to maximize the wealth for the
owners. Business cannot run in isolation. Largely, the business activity is carried out by people coming together with
a purpose to serve a common cause. This team is often referred to as an organization, which could be in different
forms such as sole proprietorship, partnership, body corporate etc. The rules of business are based on general
principles of trade, social values, and statutory framework encompassing national or international boundaries.
While these variables could be different for different businesses, different countries etc., the basic purpose is to
add value to a product or service to satisfy customer demand.
The business activities require resources (which are limited & have multiple uses) primarily in terms of material,
labour, machineries, factories and other services. The success of business depends on how efficiently and
effectively these resources are managed. Therefore, there is a need to ensure that the businessman tracks the use
of these resources. The resources are not free and thus one must be careful to keep an eye on cost of acquiring
them as well.
As the basic purpose of business is to make profit, one must keep an ongoing track of the activities undertaken in
course of business. Two basic questions would have to be answered:
(a) What is the result of business operations? This will be answered by finding out whether it has made profit or
loss.
(b) What is the position of the resources acquired and used for business purpose? How are these resources
financed? Where the funds come from?
The answers to these questions are to be found continuously and the best way to find them is to record all the
business activities. Recording of business activities has to be done in a scientific manner so that they reveal correct
outcome. The science of book-keeping and accounting provides an effective solution. It is a branch of social
science. This study material aims at giving a platform to the students to understand basic principles and concepts,
which can be applied to accurately measure performance of business. After studying the various chapters
included herein, the student should be able to apply the principles, rules, conventions and practices to different
business situations like trading, manufacturing or service.
Over years, the art and science of accounting has evolved together with progress of trade and commerce at
national and global levels. Professional accounting bodies have been doing intensive research to come up with
accounting rules that will be applicable. Modern business is certainly more complex and continuous updating
of these rules is required. Every stakeholder of the business is interested in a particular facet of information about
the business. The art and science of accounting helps to put together these requirements of information as per
universally accepted principles and also to interpret the results. It is interesting to note that each one of us has
an accountant hidden in us. We do see our parents keep track of monthly expenses. We make a distinction
between payment done for monthly grocery and that for buying a house or a car. We understand that while
grocery is a monthly expense and buying a house is like creating a resource that has indefinite future use. The
most common accounting record that each one of us knows is our bank passbook or a bank statement, which

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the bank maintains for us. It tracks each rupee that we deposit or withdraw from our account. When we go to
supermarket to buy something, the cashier at the counter will record things we buy and give us a ‘bill’ or ‘cash
memo’. These are source documents prepared for the transaction between the supermarket and us. While these
are simple examples, there could be more complex business activities. A good working knowledge of keeping
records is therefore necessary. Professional accounting bodies all over the world have been functioning with the
objective of providing this body of knowledge. These institutions are engaged in imparting training in the field of
accounting. Let us start with some basic definitions, concepts, conventions and practices used in development of
this art as well as science.
Definitions
In order to understand the subject matter with clarity, let us study some of the definitions which depict the scope,
content and purpose of Accounting. The field of accounting is generally sub-divided into:
(a) Book-keeping
(b) Financial Accounting
(c) Cost Accounting and
(d) Management Accounting
Let us understand each of these concepts.
(a) Book-keeping
The most common definition of book-keeping as given by J. R. Batliboi is “Book-keeping is an art of recording
business transactions in a set of books.”
As can be seen, it is basically a record keeping function. One must understand that not all dealings are, however,
recorded. Only transactions expressed in terms of money will find place in books of accounts. These are the
transactions which will ultimately result in transfer of economic value from one person to the other. Book-keeping
is a continuous activity, the records being maintained as transactions are entered into. This being a routine and
repetitive work, in today’s world, it is taken over by the computer systems. Many accounting packages are
available to suit different business organizations.
It is also referred to as a set of primary records. These records form the basis for accounting. It is an art because, the
record is to be kept in such a manner that it will facilitate further processing and reporting of financial information
which will be useful to all stakeholders of the business.
(b) Financial Accounting
It is commonly termed as Accounting. The American Institute of Certified Public Accountants defines Accounting
as “an art of recoding, classifying and summarizing in a significant manner and in terms of money, transactions
and events which are in part at least of a financial character, and interpreting the results thereof.”
The first step in the cycle of accounting is to identify transactions that will find place in books of accounts.
Transactions having financial impact only are to be recorded. E.g. if a businessman negotiates with the customer
regarding supply of products, this will not be recorded. The negotiation is a deal which will potentially create a
transaction and will have exchange of money or money’s worth. But unless this transaction is finally entered into,
it will not be recorded in the books of accounts.
Secondly, the recording of the business transactions is done based on the Golden Rules of accounting (which
are explained later) in a systematic manner. Transaction of similar nature are grouped together and recorded
accordingly. e.g. Sales Transactions, Purchase Transactions, Cash Transactions etc. One has to interpret the
transaction and then apply the relevant Golden Rule to make a correct entry thereof.
Thirdly, as the transactions increase in number, it will be difficult to understand the combined effect of the same
by referring to individual records. Hence, the art of accounting also involves the step of summarizing them. With
the aid of computers, this task is simplified in today’s accounting world. The summarization will help users of the
business information to understand and interpret business results.
Lastly, the accounting process provides the users with statements which will describe what has happened to the
business. Remember the two basic questions we talked about, one to know whether business has made profit or
loss and the other to know the position of resources that are used by the business.
It can be noted that although accounting is often referred to as an art, it is a science also. This is because it is
based on universally applicable set of rules. However, it is not a pure science as there is a possibility of different
interpretation.

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(c) Cost Accounting

According to the Chartered Institute of Management Accountants (CIMA), Cost Accountancy is defined as
“application of costing and cost accounting principles, methods and techniques to the science, art and practice
of cost control and the ascertainment of profitability as well as the presentation of information for the purpose of
managerial decision-making.”
It is a branch of accounting dealing with the classification, recording, allocation, summarization and reporting
of current and prospective costs and analyzing their behaviours. Cost Accounting is frequently used to facilitate
internal decision making and provides tools with which management can appraise performance and control costs
of doing business. It primarily involves relating the costs to the different products produced and sold or services
rendered by the business. While Financial Accounting deals with business transactions at a broader level, Cost
Accounting aims at further breaking it up to the last possible level to indentify costs with products and services. It
uses the same Financial Accounting documents and records. Modern computerized accounting packages like
ERP systems provide for processing Financial as well as Cost Accounting records simultaneously.
This branch of accounting deals with the process of ascertainment of costs. The concept of cost is always applied
with reference to a context. Knowledge of cost concepts and their application provide a very sound platform for
decision making. Cost Accounting aims at equipping management with information that can be used for control
on business activities.
(d) Management Accounting
Management Accounting is concerned with the use of Financial and Cost Accounting information to managers
within organizations, to provide them with the basis in making informed business decisions that would allow them to
be better equipped in their management and control functions. Unlike Financial Accounting information (which,
for public companies, is public information), Management Accounting information is used within an organization
(typically for decision-making) and is usually confidential and its access available only to a selected few.
According to the Chartered Institute of Management Accountants (CIMA), Management Accounting is “the
process of identification, measurement, accumulation, analysis, preparation, interpretation and communication
of information used by management to plan, evaluate and control within an entity and to assure appropriate
use of and accountability for its resources. Management Accounting also comprises the preparation of financial
reports for non management groups such as shareholders, creditors, regulatory authorities and tax authorities”.
Basically, Management Accounting aims to facilitate management in formulating strategies, planning and
constructing business activities, making decisions, optimal use of resources, and safeguarding assets of business.
These branches of accounting have evolved over years of research and are basically synchronized with the
requirements of business organizations and all entities associated with them. We will now see what are they and
how accounting satisfies various needs of different stakeholders.
Difference between Book-keeping and Accountancy:
The Significant difference between Book-keeping and Accountancy are:

Sl Points of Book Keeping Accountancy

No. difference
1. Meaning Book-keeping is considered as end. Accountancy is considered as
beginning.
2. Functions The primary stage of accounting function is The overall accounting functions are
called Book-keeping. guided by accountancy.
3 Depends Book-keeping can provide the base of Accountancy depends on Book-
Accounting. keeping for its complete functions.
4. Data The necessary data about financial Accountancy can take its decisions,
performances and financial positions are prepare reports and statements from the
taken from Book-keeping. data taken from Book-keeping.
5. Recording of Financial transactions are recorded on the Accountancy does not take any principles,
Transactions basis of accounting principles, concepts concepts and conventions from Book-
and conventions. keeping.

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Difference between Management Accounting and Financial Accounting:

The significant difference between Management Accounting and Financial Accounting are:

Management Accounting Financial Accounting

1. Management Accounting is primarily based on 1. Financial Accounting is based on
the data available from Financial Accounting. the monetary transactions of the enterprise.
2. It provides necessary information to the 2. Its main focus is on recording and classifying
management to assist them in the process of monetary transactions in the books of accounts
planning, controlling, performance evaluation and preparation of financial statements at the end
and decision making. of every accounting period.
3. Reports prepared in Management Accounting are 3. Reports as per Financial Accounting are meant for
meant for management and as per management the management as well as for shareholders and
requirement. creditors of the concern.
4. Reports may contain both subjective and objective 4. Reports should always be supported by relevant
figures. figures and it emphasizes on the objectivity of data.
5. Reports are not subject to statutory audit. 5. Reports are always subject to statutory audit.
6. It evaluates the sectional as well as the entire 6. It ascertains, evaluates and exhibits the financial
performance of the business. strength of the whole business.

Accounting Cycle
When complete sequence of accounting procedure is done which happens frequently and repeated in same
directions during an accounting period, the same is called an accounting cycle.

Recording of
Transaction

Financial
Journal
Statement

Closing
Ledger
Entries

Adjusted Trial Trial

Balance Balance

Adjustment
Entries

Accounting Cycle

Steps/Phases of Accounting Cycle

The steps or phases of accounting cycle can be developed as under:
(a) Recording of Transaction: As soon as a transaction happens it is at first recorded in subsidiary book.
(b) Journal: The transactions are recorded in Journal chronologically.

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(c) Ledger: All journals are posted into ledger chronologically and in a classified manner.
(d) Trial Balance: After taking all the ledger account’s closing balances, a Trial Balance is prepared at the end
of the period for the preparations of financial statements.
(e) Adjustment Entries: All the adjustments entries are to be recorded properly and adjusted accordingly
before preparing financial statements.
(f) Adjusted Trial Balance: An adjusted Trail Balance may also be prepared.
(g) Closing Entries: All the nominal accounts are to be closed by the transferring to Trading Account and Profit
and Loss Account.
Financial Statements: Financial statement can now be easily prepared which will exhibit the true financial position
and operating results.
Objectives of Accounting
The main objective of Accounting is to provide financial information to stakeholders. This financial information
is normally given via financial statements, which are prepared on the basis of Generally Accepted Accounting
Principles (GAAP). There are various accounting standards developed by professional accounting bodies all
over the world. In India, these are governed by The Institute of Chartered Accountants of India, (ICAI). In the
US, the American Institute of Certified Public Accountants (AICPA) is responsible to lay down the standards. The
Financial Accounting Standards Board (FASB) is the body that sets up the International Accounting Standards.
These standards basically deal with accounting treatment of business transactions and disclosing the same in
financial statements.
The following objectives of accounting will explain the width of the application of this knowledge stream:
(a) To ascertain the amount of profit or loss made by the business i.e. to compare the income earned versus the
expenses incurred and the net result thereof.
(b) To know the financial position of the business i.e. to assess what the business owns and what it owes.
(c) To provide a record for compliance with statutes and laws applicable.
(d) To enable the readers to assess progress made by the business over a period of time.
(e) To disclose information needed by different stakeholders.
Let us now see which are different stakeholders of the business and what do they seek from the accounting
information. This is shown in the following table.

Stakeholder Interest in business Accounting Information

O wners / Inv es tors / Profits or losses Financial statements, Cost Accounting
existing and potential records, Management Accounting reports
Lenders Assessment of capability of the business Financial statement and analysis thereof,
to pay interest and principal of money reports forming part of accounts, valuation
lent. Basically, they monitor the of assets given as security
solvency of business
Customers and suppliers Stability and growth of the business Financial and Cash flow statements to
assess ability of the business to offer better
business terms and ability to supply the
products and services
Government Whether the business is complying with Accounting documents such as vouchers,
various legal requirements extracts of books, information of purchase,
sales, employee obligations etc. and
financial statements
Employees and trade Growth and profitability Financial statements for negotiating pay
unions packages
Competitors Performance and possible tie-ups in the Accounting information to find out possible
era of mergers and acquisitions synergies

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Users of Accounting Information

Accounting provides information both to internal users and the external users. The internal users are all the
organizational participants at all levels of management (i.e. top, middle and lower). Generally top level
management requires information for planning, middle level management which requires information for
controlling the operations. For internal use, the information is usually provided in the form of reports, for instance
Cash Budget Reports, Production Reports, Idle Time Reports, Feedback Reports, whether to retain or replace an
equipment decision reports, project appraisal report, and the like.
There are also the external users (e.g. Banks, Creditors). They do not have direct access to all the records of an
enterprise, they have to rely on financial statements as the source of information. External users are basically,
interested in the solvency and profitability of an enterprise.
Types of Accounting Information
Accounting information may be categorized in number of ways on the basis of purpose of accounting information,
on the basis of measurement criteria and so on. The various types of accounting information are given below:
I. Accounting information relating to financial transactions and events.
(a) Financial Position- Information about financial position is primarily provided in a Balance Sheet. The
financial position of an enterprise is affected by different factors, like -
(i) Information about the economic resources controlled by the enterprise and its capacity in the
past to alter these resources is useful in predicting the ability of the enterprise to generate cash
and cash equivalents in the future.
(ii) Information about financial structure is useful in predicting future borrowing needs and how future
profits and cash flows will be distributed among those with an interest in the enterprise; it is also
useful in predicting how successful the enterprise is likely to be in raising further finance.
(iii) Information about liquidity and solvency is useful in predicting the ability of the enterprise to meet
its financial commitments as they fall due. Liquidity refers to the availability of cash in the near
future to meet financial commitments over this period. Solvency refers to the availability of cash
over the longer term to meet financial commitments as they fall due.
(b) Financial Performance- Information about financial performance is primarily provided in a Statement of
Profit and Loss which is also known as Income Statement.
Information about the performance of an enterprise and its profitability, is required in order to assess
potential changes taking place in the economic resources that it is likely to control in the future.
Information about variability of performance is also important in this regard. Information about
performance is necessary in predicting the capacity to generate cash flows from its available resource.
It is an important input in forming judgments about the effectiveness of an enterprise to utilize resources.
(c) Cash Flows—Information about cash flows is provided in the financial statements by means of a cash
flow statement.
Information concerning cash flows is useful in providing the users with a basis to assess the ability of the
enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise those cash
and cash equivalent.
These information may be classified as follows:
(i) on the basis of Historical Cost,
(ii) on the basis of Current Cost,
(iii) on the basis of Realizable Value,
(iv) on the basis of Present Value

II. Accounting information relating to cost of a product, operation or function.

III. Accounting information relating to planning and controlling the activities of an enterprise for internal reporting.

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This information may further be classified as follows:

(i) Information relating to Finance Area
(ii) Information relating to Production Area
(iii) Information relating to Marketing Area
(iv) Information relating to Personnel Area
(v) Information relating to Other Areas (such as Research & Development).
IV. Accounting information relating to Social Effects of business decisions.
V. Accounting information relating to Environment and Ecology.
VI. Accounting information relating to Human Resources.

Basic Accounting Terms

In order to understand the subject matter clearly, one must grasp the following common expressions always used
in business accounting. The aim here is to enable the student to understand with these often used concepts
before we embark on accounting procedures and rules. You may note that these terms can be applied to any
business activity with the same connotation.
(i) Transaction: It means an event or a business activity which involves exchange of money or money’s worth
between parties. The event can be measured in terms of money and changes the financial position of a person
e.g. purchase of goods would involve receiving material and making payment or creating an obligation to
pay to the supplier at a future date. Transaction could be a cash transaction or credit transaction. When
the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash
transaction. In credit transaction, the payment is settled at a future date as per agreement between the
parties.
(ii) Goods/Services : These are tangible article or commodity in which a business deals. These articles or
commodities are either bought and sold or produced and sold. At times, what may be classified as ‘goods’
to one business firm may not be ‘goods’ to the other firm. e.g. for a machine manufacturing company,
the machines are ‘goods’ as they are frequently made and sold. But for the buying firm, it is not ‘goods’ as
the intention is to use it as a long term resource and not sell it. Services are intangible in nature which are
rendered with or without the object of earning profits.
(iii) Profit: The excess of Revenue Income over expense is called profit. It could be calculated for each transaction
or for business as a whole.
(iv) Loss: The excess of expense over income is called loss. It could be calculated for each transaction or for
business as a whole.
(v) Asset: Asset is a resource owned by the business with the purpose of using it for generating future profits.
Assets can be Tangible and Intangible. Tangible Assets are the Capital assets which have some physical
existence. They can, therefore, be seen, touched and felt, e.g. Plant and Machinery, Furniture and Fittings,
Land and Buildings, Books, Computers, Vehicles, etc. The capital assets which have no physical existence
and whose value is limited by the rights and anticipated benefits that possession confers upon the owner are
known as lntangible Assets. They cannot be seen or felt although they help to generate revenue in future,
e.g. Goodwill, Patents, Trade-marks, Copyrights, Brand Equity, Designs, Intellectual Property, etc.
Assets can also be classified into Current Assets and Non-Current Assets.
Current Assets – An asset shall be classified as Current when it satisfies any of the following :
(a) It is expected to be realised in, or is intended for sale or consumption in the Company’s normal Operating
Cycle,
(b) It is held primarily for the purpose of being traded ,
(c) It is due to be realised within 12 months after the Reporting Date, or
(d) It is Cash or Cash Equivalent unless it is restricted from being exchanged or used to settle a Liability for
at least 12 months after the Reporting Date.

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Non-Current Assets – All other Assets shall be classified as Non-Current Assets. e.g. Machinery held for long
term etc.
(vi) Liability: It is an obligation of financial nature to be settled at a future date. It represents amount of money
that the business owes to the other parties. E.g. when goods are bought on credit, the firm will create an
obligation to pay to the supplier the price of goods on an agreed future date or when a loan is taken from
bank, an obligation to pay interest and principal amount is created. Depending upon the period of holding,
these obligations could be further classified into Long Term on non-current liabilities and Short Term or current
liabilities.
Current Liabilities – A liability shall be classified as Current when it satisfies any of the following :
(a) It is expected to be settled in the Company’s normal Operating Cycle,
(b) It is held primarily for the purpose of being traded,
(c) It is due to be settled within 12 months after the Reporting Date, or
(d) The Company does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting date (Terms of a Liability that could, at the option of the counterparty, result
in its settlement by the issue of Equity Instruments do not affect its classification)
Non-Current Liabilities – All other Liabilities shall be classified as Non-Current Liabilities. E.g. Loan taken for 5 years,
Debentures issued etc.
(vii) Internal Liability : These represent proprietor’s equity, i.e. all those amount which are entitled to the proprietor,
e.g., Capital, Reserves, Undistributed Profits, etc.
(viii) Working Capital : In order to maintain flows of revenue from operation, every firm needs certain amount
of current assets. For example, cash is required either to pay for expenses or to meet obligation for service
received or goods purchased, etc. by a firm. On identical reason, inventories are required to provide the
link between production and sale. Similarly, Accounts Receivable generate when goods are sold on credit.
Cash, Bank, Debtors, Bills Receivable, Closing Stock, Prepayments etc. represent current assets of firm. The
whole of these current assets form the working capital of a firm which is termed as Gross Working Capital.
Gross Working Capital = Total Current Assets
= Long term internal liabilities plus long term debts plus the current liabilities
minus the amount blocked in the fixed assets.
There is another concept of working capital. Working capital is the excess of current assets over current
liabilities. That is the amount of current assets that remain in a firm if all its current liabilities are paid. This
concept of working capital is known as Net Working Capital which is a more realistic concept.
Working Capital (Net) = Current Assets – Currents Liabilities.
(ix) Contingent Liability : It represents a potential obligation that could be created depending on the outcome
of an event. E.g. if supplier of the business files a legal suit, it will not be treated as a liability because no
obligation is created immediately. If the verdict of the case is given in favour of the supplier then only the
obligation is created. Till that it is treated as a contingent liability. Please note that contingent liability is not
recorded in books of account, but disclosed by way of a note to the financial statements.
(x) Capital : It is amount invested in the business by its owners. It may be in the form of cash, goods, or any other
asset which the proprietor or partners of business invest in the business activity. From business point of view,
capital of owners is a liability which is to be settled only in the event of closure or transfer of the business.
Hence, it is not classified as a normal liability. For corporate bodies, capital is normally represented as share
capital.
(xi) Drawings : It represents an amount of cash, goods or any other assets which the owner withdraws from
business for his or her personal use. e.g. if the life insurance premium of proprietor or a partner of business is
paid from the business cash, it is called drawings. Drawings will result in reduction in the owners’ capital. The
concept of drawing is not applicable to the corporate bodies like limited companies.
(xii) Net worth : It represents excess of total assets over total liabilities of the business. Technically, this amount is
available to be distributed to owners in the event of closure of the business after payment of all liabilities.

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That is why it is also termed as Owner’s Equity. A profit making business will result in increase in the owner’s
equity whereas losses will reduce it.
(xiii) Non-current Investments : Non-current Investments are investments which are held beyond the current
period as to sale or disposal. e. g. Fixed Deposit for 5 years.
(xiv) Current Investments : Current investments are investments that are by their nature readily realizable and are
intended to be held for not more than one year from the date on which such investment is made. e. g. 11
months Commercial Paper.
(xv) Debtor : The sum total or aggregate of the amounts which the customer owe to the business for purchasing
goods on credit or services rendered or in respect of other contractual obligations, is known as Sundry
Debtors or Trade Debtors, or Trade Receivable, or Book-Debts or Debtors. In other words, Debtors are those
persons from whom a business has to recover money on account of goods sold or service rendered on
credit. These debtors may again be classified as under:

(i) Good debts : The debts which are sure to be realized are called good debts.

(ii) Doubtful Debts : The debts which may or may not be realized are called doubtful debts.

(iii) Bad debts : The debts which cannot be realized at all are called bad debts.

It must be remembered that while ascertaining the debtors balance at the end of the period certain
adjustments may have to be made e.g. Bad Debts, Discount Allowed, Returns Inwards, etc.
(xvi) Creditor : A creditor is a person to whom the business owes money or money’s worth. e.g. money payable
to supplier of goods or provider of service. Creditors are generally classified as Current Liabilities.

(xvii) Capital Expenditure: This represents expenditure incurred for the purpose of acquiring a fixed asset which
is intended to be used over long term for earning profits there from. e. g. amount paid to buy a computer
for office use is a capital expenditure. At times expenditure may be incurred for enhancing the production
capacity of the machine. This also will be a capital expenditure. Capital expenditure forms part of the
Balance Sheet.

(xviii) Revenue expenditure: This represents expenditure incurred to earn revenue of the current period. The
benefits of revenue expenses get exhausted in the year of the incurrence. e.g. repairs, insurance, salary &
wages to employees, travel etc. The revenue expenditure results in reduction in profit or surplus. It forms part
of the Income Statement.

(xix) Balance Sheet: It is the statement of financial position of the business entity on a particular date. It lists all
assets, liabilities and capital. It is important to note that this statement exhibits the state of affairs of the
business as on a particular date only. It describes what the business owns and what the business owes to
outsiders (this denotes liabilities) and to the owners (this denotes capital). It is prepared after incorporating
the resulting profit/losses of Income Statement.

(xx) Profit and Loss Account or Income Statement: This account shows the revenue earned by the business
and the expenses incurred by the business to earn that revenue. This is prepared usually for a particular
accounting period, which could be a month, quarter, a half year or a year. The net result of the Profit and
Loss Account will show profit earned or loss suffered by the business entity.

(xxi) Trade Discount: It is the discount usually allowed by the wholesaler to the retailer computed on the list price
or invoice price. e.g. the list price of a TV set could be ` 15000. The wholesaler may allow 20% discount
thereof to the retailer. This means the retailer will get it for ` 12000 and is expected to sale it to final customer
at the list price. Thus the trade discount enables the retailer to make profit by selling at the list price. Trade
discount is not recorded in the books of accounts. The transactions are recorded at net values only. In
above example, the transaction will be recorded at ` 12000 only.

(xxii) Cash Discount: This is allowed to encourage prompt payment by the debtor. This has to be recorded in the
books of accounts. This is calculated after deducting the trade discount. e.g. if list price is ` 15000 on which
a trade discount of 20% and cash discount of 2% apply, then first trade discount of ` 3000 (20% of ` 15000)
will be deducted and the cash discount of 2% will be calculated on ` 12000 (`15000 – ` 3000). Hence the
cash discount will be ` 240/- (2% of ` 12000) and net payment will be ` 11,760 (`12,000 - ` 240)

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Let us see if we can apply these in the following illustrations.

Illustration 1.
Fill in the blanks:
(a) The cash discount is allowed by­ to the .
(b) Profit means excess of over .
(c) Debtor is a person who to others.
(d) In a credit transaction, the buyer is given a facility.
(e) The fixed asset is generally held for .
(f) The current liabilities are obligations to be settled in period.
(g) The withdrawal of money by the owner of business is called .
(h) The amount invested by owners into business is called .
(i) Transaction means exchange of money or money’s worth for .
(j) The net result of an income statement is or .
(k) The­ shows financial position of the business as on a particular date.
(l) The discount is never entered in the books of accounts.
(m) Vehicles represent expenditure while repairs to vehicle would mean expenditure.
(n) Net worth is excess of over .
Solution:
(a) creditor, debtor
(b) income, expenditure
(c) Owes
(d) Credit
(e) Longer period
(f) Short
(g) Drawings
(h) Capital
(i) Value
(j) Profit, loss
(k) Balance sheet
(l) Trade
(m) Capital, revenue
(n) Total assets, total liabilities

Illustration 2.
Give one word or a term used to describe the following:-
(a) An exchange of benefit for value
(b) A transaction without immediate cash settlement.
(c) Commodities in which a business deals.

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(d) Excess of expenditure over income.

(e) Things of value owned by business to earn future profits.
(f) Amount owed by business to others.
(g) An obligation which may or may not materialise.
(h) An allowance by a creditor to debtor for prompt payment.
(i) Assets like brand value, copy rights, goodwill.
Solution:
(a) Transaction, (b) Credit transaction, (c) Goods, (d) Loss, (e) Assets, (f) Liability, (g) Contingent Liability, (h) Cash
Discount, (i) Intangible Asset.

1.2 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

A widely accepted set of rules, conventions, standards, and procedures for reporting financial information, as
established by the Financial Accounting Standards Board are called Generally Accepted Accounting Principles
(GAAP). These are the common set of accounting principles, standards and procedures that companies use to
compile their financial statements. GAAP are a combination of standards (set by policy boards) and simply the
commonly accepted ways of recording and reporting accounting information.
GAAP is to be followed by companies so that investors have a optimum level of consistency in the financial
statements they use when analyzing companies for investment purposes. GAAP cover such aspects like revenue
recognition, balance sheet item classification and outstanding share measurements.

1.3 ACCOUNTING CONCEPTS AND CONVENTIONS

As seen earlier, the accounting information is published in the form of financial statements. The three basic financial
statements are
(i) The Profit & Loss Account that shows net business result i.e. profit or loss for a certain periods.
(ii) The Balance Sheet that exhibits the financial strength of the business as on a particular dates.
(iii) The Cash Flow Statement that describes the movement of cash from one date to the other.
As these statements are meant to be used by different stakeholders, it is necessary that the information contained
therein is based on definite principles, concrete concepts and well accepted convention.
Accounting principles are basic guidelines that provide standards for scientific accounting practices and
procedures. They guide as to how the transactions are to be recorded and reported. They assure uniformity
and understandability. Accounting concepts lay down the foundation for accounting principles. They are ideas
essentially at mental level and are self-evident. These concepts ensure recording of financial facts on sound bases
and logical considerations. Accounting conventions are methods or procedures that are widely accepted. When
transactions are recorded or interpreted, they follow the conventions. Many times, however, the terms-principles,
concepts and conventions are used interchangeably.
Professional Accounting Bodies have published statements of these concepts. Over years, many of these concepts
are being challenged as outlived. Yet, no major deviations have been made as yet. Path breaking ideas have
emerged and the accounting standards of modern days do require companies to record and report transactions
which may not be necessarily based on concepts that are in vogue for long. It is essential to study accounting
from the basic levels and understand these concepts in entirety.

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Theory Base of Accounting

Basic Assumptions Basic Principles Modifying Principles

(a) Business Entity Concept (a) Revenue Realization Concpet (a) Materiality Concept
(b) Going Concern Concept (b) Matching Concept (b) Consistency Concept
(c) Money Measurement Concept (c) Full Disclosure Concept (c) Conservatism Concpet
(d) Accounting Period Concept (d) Dual Aspect Concept (d) Timeliness Concept
(e) Accrual Concept (e) Verifiable Objective Evidence Concpet (e) Industry Practice Concept
(f) Historical Cost Concept
(g) Balance Sheet Equation Concpet

A. BASIC ASSUMPTIONS
(a) Business Entity Concept
As per this concept, the business is treated as distinct and separate from the individuals who own or manage
it. When recording business transactions, the important question is how will it affect the business entity?
How they affect the persons who own it or run it or otherwise associated with it is irrelevant. Application of
this concept enables recording of transactions of the business entity with its owners or managers or other
stakeholders. For example, if the owner pays his personal expenses from business cash, this transaction can
be recorded in the books of business entity. This transaction will take the cash out of business and also reduce
the obligation of the business towards the owner.
At times it is difficult to separate owners from the business. Consider an individual, who runs a small retail
outlet. In the eyes of law, there is no distinction made between financial affairs of the outlet with that of
the individual. The creditors of the retail outlet can sue the individual and collect his claim from personal
resources of the individual. However, in accounting, the records are kept as distinct for the retail outlet and
the individual respectively. For certain forms of business entities, such as limited companies this distinction is
easier. The limited companies are separate legal persons in the eyes of law as well.
The entity concept requires that all the transactions are to be viewed, interpreted and recorded from
‘business entity’ point of view. An accountant steps into the shoes of the business entity and decides to
account for the transactions. The owner’s capital is the obligation of business and it has to be paid back to
the owner in the event of business closure. Also, the profit earned by the business will belong to the owner
and hence is treated as owner’s equity.
(b) Going Concern Concept
The basic principles of this concept is that business is assumed to exist for an indefinite period and is not
established with the objective of closing it down. So unless there is good evidence to the contrary, the
accountant assumes that a business entity is a ‘going concern’ - that it will continue to operate as usual for a
longer period of time. It will keep getting money from its customers, pay its creditors, buy and sell goods, use
assets to earn profits in future. If this assumption is not considered, one will have to constantly value the worth
of the assets and resource. This is not practicable. This concept enables the accountant to carry forward the
values of assets and liabilities from one accounting period to the other without asking the question about
usefulness and worth of the assets and recoverability of the receivables.
The going concern concept forms a sound basis for preparation of a Balance Sheet.
(c) Money Measurement Concept
A business transaction will always be recoded if it can be expressed in terms of money. The advantage of
this concept is that different types of transactions could be recorded as homogenous entries with money as
common denominator. A business may own ` 3 Lacs cash, 1500 kg of raw material, 10 vehicles, 3 computers
etc. Unless each of these is expressed in terms of money, we cannot find out the assets owned by the business.
When expressed in the common measure of money, transactions could be added or subtracted to find out

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the combined effect. In the above example, we could add values of different assets to find the total assets
owned.
The application of this concept has a limitation. When transactions are recorded in terms of money, we only
consider the absolute value of the money. The real value of the money may fluctuate from time to time due
to inflation, exchange rate changes, etc. This fact is not considered when recording the transaction.
(d) The Accounting Period Concept
We have seen that as per the going-concern concept the business entity is assumed to have an indefinite
life. Now if we were to assess whether the business has made profit or loss, should we wait until this indefinite
period is over? Would it mean that we will not be able to assess the business performance on an ongoing
basis? Does it deprive all stakeholders the right to the accounting information? Would it mean that the
business will not pay income tax as no income will be computed?
To circumvent this problem, the business entity is supposed to be paused after a certain time interval. This
time interval is called an accounting period. This period is usually one year, which could be a calendar year
i.e. 1st January to 31st December or it could be a fiscal year in India as 1st April to 31st March. The business
organizations have the freedom to choose their own accounting year. For certain organizations, reporting of
financial information in public domain are compulsory. In India, listed companies must report their quarterly
unaudited financial results and yearly audited financial statements. For internal control purpose, many
organizations prepare monthly financial statements. The modern computerized accounting systems enable
the companies to prepare real-time online financials at the click of button.
Businesses are living, continuous organisms. The splitting of the continuous stream of business events into
time periods is thus somewhat arbitrary. There is no significant change just because one accounting period
ends and a new one begins. This results into the most difficult problem of accounting of how to measure
the net income for an accounting period. One has to be careful in recognizing revenue and expenses for
a particular accounting period. Subsequent section on accounting procedures will explain how one goes
about it in practice.
(e) The Accrual Concept
The accrual concept is based on recognition of both cash and credit transactions. In case of a cash
transaction, owner’s equity is instantly affected as cash either is received or paid. In a credit transaction,
however, a mere obligation towards or by the business is created. When credit transactions exist (which is
generally the case), revenues are not the same as cash receipts and expenses are not same as cash paid
during the period.
When goods are sold on credit as per normally accepted trade practices, the business gets the legal right
to claim the money from the customer. Acquiring such right to claim the consideration for sale of goods or
services is called accrual of revenue. The actual collection of money from customer could be at a later date.
Similarly, when the business procures goods or services with the agreement that the payment will be made
at a future date, it does not mean that the expense effect should not be recognized. Because an obligation
to pay for goods or services is created upon the procurement thereof, the expense effect also must be
recognized.
Today’s accounting systems based on accrual concept are called as Accrual System or Mercantile System
of Accounting.

B. BASIC PRINCIPLES
(a) The Revenue Realisation Concept
While the conservatism concept states whether or not revenue should be recognized, the concept of
realisation talks about what revenue should be recognized. It says amount should be recognized only to the
tune of which it is certainly realizable. Thus, mere getting an order from the customer won’t make it eligible
to recognize as revenue. The reasonable certainty of realizing the money will come only when the goods
ordered are actually supplied to the customer and he is billed. This concept ensures that income unearned
or unrealized will not be considered as revenue and the firms will not inflate profits.
Consider that a store sales goods for ` 25 lacs during a month on credit. The experience and past data shows
that generally 2% of the amount is not realized. The revenue to be recognized will be ` 24.50 lacs. Although
conceptually the revenue to be recognized at this value, in practice the doubtful amount of ` 50 thousand
(2% of ` 25 lacs) is often considered as expense.

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(b) The Matching Concept

As we have seen the sale of goods has two effects: (i) a revenue effect, which results in increase in owner’s
equity by the sales value of the transaction and (ii) an expense effect, which reduces owner’s equity by the
cost of goods sold, as the goods go out of the business. The net effect of these two effects will reflect either
profit or loss. In order to correctly arrive at the net result, both these aspects must be recognized during the
same accounting period. One cannot recognize only the revenue effect thereby inflating the profit or only
the expense effect which will deflate the profit. Both the effects must be recognized in the same accounting
period. This is the principle of matching concept.
To generalize, when a given event has two effects – one on revenue and the other on expense, both must
be recognized in the same accounting period.
(c) Full Disclosure Concept
As per this concept, all significant information must be disclosed. Accounting data should properly be
clarified, summarized, aggregated and explained for the purpose of presenting the financial statements
which are useful for the users of accounting information. Practically, this principle emphasizes on the
materiality, objectivity and consistency of accounting data which should disclose the true and fair view of
the state of affairs of a firm. This principle is going to be popular day by day as per Companies Act, 1956
major provisions for disclosure of essential information about accounting data and as such, concealment
of material information, at present, is not very easy. Thus, full disclosure must be made for such material
information which are useful to the users of accounting information.
(d) Dual Aspect Concept
The assets represent economic resources of the business, whereas the claims of various parties on business
are called obligations. The obligations could be towards owners (called as owner’s equity) and towards
parties other than the owners (called as liabilities).
When a business transaction happens, it will involve use of one or the other resource of the business to create
or settle one or more obligations. e.g. consider Mr. Suresh starts a business with the investment of ` 25 lacs.
Here, the business has got a resource of cash worth ` 25 lacs (which is its asset), but at the same time it has
created an obligation of business towards Mr. Suresh that in the event of business closure, the money will be
paid back to him. This could be shown as:

Assets = Liabilities + Capital

In other words,
Cash brought in by Mr. Suresh (` 25 lacs) = Liability of business towards Mr. Suresh (` 25 lacs)
We know that liability of the business could be towards owners and parties other than owners, this equation
could be re-written as:

Assets = Liabilities + Owner’s equity

Cash ` 25,00,000 = Liabilities ` nil + Mr. Suresh’s equity ` 25,00,000

This is the fundamental accounting equation shown as formal expression of the dual aspect concept. This
powerful concept recognizes that every business transaction has dual impact on the financial position.
Accounting systems are set up to simultaneously record both these aspects of every transaction; that is why
it is called as Double-entry system of accounting. In its present form the double entry system of accounting
owes its existence to an Italian expert Mr. Luca Pacioli in the year 1495.
Continuing with our example of Mr. Suresh, now let us consider he borrows ` 15 lacs from bank. The dual
aspect of this transaction-on one hand the business cash will increase by ` 15 lacs and a liability towards the
bank will be created for ` 15 lacs.

Assets = Liabilities + Owner’s equity

Cash ` 40,00,000 = Liabilities ` 15,00,000 + Mr. Suresh’s equity ` 25,00,000

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The student must note that the dual aspect concept entails recognition of the two effects of each transaction.
These effects are of equal amount and reverse in nature. How to decide these two aspects?
The golden rules of accounting are used to arrive at this decision. After recording both aspects of the
transaction, the basic accounting equation will always balance or be equal.
The above concepts find the application in preparation of the Balance Sheet which is the statement of
assets and liabilities as on a particular date. We will now see some more concepts that are important for
preparation of Profit and Loss Account or Income Statement.
(e) Verifiable Objective Evidence Concept
Under this principle, accounting data must be verified. In other words, documentary evidence of transactions
must be made which are capable of verification by an independent respect. In the absence of such
verification, the data which will be available will neither be reliable nor be dependable, i.e., these should be
biased data. Verifiability and objectivity express dependability, reliability and trustworthiness that are very
useful for the purpose of displaying the accounting data and information to the users.
(f) Historical Cost Concept
Business transactions are always recorded at the actual cost at which they are actually undertaken. The
basic advantage is that it avoids an arbitrary value being attached to the transactions. Whenever an asset
is bought, it is recorded at its actual cost and the same is used as the basis for all subsequent accounting
purposes such as charging depreciation on the use of asset, e.g. if a production equipment is bought for `
1.50 crores, the asset will be shown at the same value in all future periods when disclosing the original cost.
It will obviously be reduced by the amount of depreciation, which will be calculated with reference to
the actual cost. The actual value of the equipment may rise or fall subsequent to the purchase, but that is
considered irrelevant for accounting purpose as per the historical cost concept.
The limitation of this concept is that the Balance Sheet does not show the market value of the assets owned
by the business and accordingly the owner’s equity will not reflect the real value. However, on an ongoing
basis, the assets are shown at their historical costs as reduced by depreciation.
(g) Balance Sheet Equation Concept
Under this principle, all which has been received by us must be equal to that has been given by us and
needless to say that receipts are clarified as debits and giving is clarified as credits. The basic equation,
appears as :-
Debit = Credit
Naturally every debit must have a corresponding credit and vice-e-versa. So, we can write the above in the
following form –
Expenses + Losses + Assets = Revenues + Gains + Liabilities
And if expenses and losses, and incomes and gains are set off, the equation takes the following form –
Asset = Liabilities
or, Asset = Equity + External Liabilities
i.e., the Accounting Equation.

C. MODIFYING PRINCIPLES
(a) The Concept of Materiality
This is more of a convention than a concept. It proposes that while accounting for various transactions, only
those which may have material effect on profitability or financial status of the business should have special
consideration for reporting. This does not mean that the accountant should exclude some transactions from
recording. e.g. even ` 20 worth conveyance paid must be recorded as expense. What this convention claims
is to attach importance to material details and insignificant details should be ignored while deciding certain
accounting treatment. The concept of materiality is subjective and an accountant will have to decide on
merit of each case. Generally, the effect is said to be material, if the knowledge of an event would influence
the decision of an informed stakeholder.

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The materiality could be related to information, amount, procedure and nature. Error in description of an
asset or wrong classification between capital and revenue would lead to materiality of information. Say, If
postal stamps of ` 500 remain unused at the end of accounting period, the same may not be considered for
recognizing as inventory on account of materiality of amount. Certain accounting treatments depend upon
procedures laid down by accounting standards. Some transactions are by nature material irrespective of the
amount involved. e.g. audit fees, loan to directors.

(b) The Concept of Consistency

This concept advocates that once an organization decides to adopt a particular method of revenue or
expense recognition in line with the other concepts, the same should be consistently applied year after year,
unless there is a valid reason for change in the method. Lack of consistency would result in the financial
information becoming non-comparable between the different accounting periods. The insistence of this
concept would result in avoidance of window dressing the results by choosing the accounting method by
convenience and thereby either inflating or understating net income.
Consider an example. An asset of ` 10 lacs is purchased by a business. It is estimated to have useful life of
5 years. It will follow that the asset will be depreciated over a period of 5 years at the rate of ` 2 lacs every
year. The estimate of useful life and the rate of depreciation cannot be changed from one period to the
other without a valid reason. Suppose the firm applies the same depreciation rate for the first three years and
due to change in technology the asset becomes obsolete, the whole of the remaining amount could be
expensed out in the fourth year.
However, it may be difficult to be consistent if the business entities have two factories in different countries
which have different statutory requirement for accounting treatment.

(c) The Prudence Concept

Accountants who prepare financial statements of the business, like other human being, would like to give a
favourable report on how well the business has performed during an accounting period. However, prudent
reporting based on skepticism builds confidence in the results and in the long run best serves all the divergent
interests of users of financial statements. This philosophy of prudence leads to the conservatism concept.
The concept underlines the prudence of under-stating than over-stating the net income of an entity for a
period and the net assets as on a particular date. This is because business is done in situations of uncertainty.
For years, this concept was meant to “anticipate no profits but recognize all losses”. This can be stated as
(i) Delay in recognizing income unless one is reasonably sure
(ii) Immediately recognize expenses when reasonably sure
This, of course, does not mean to overdo and create window dressing in reporting. e.g. if the business has
sold ` 20 Lacs worth goods on the last day of accounting period and also received a cheque for the same,
one cannot argue that the revenue should not be recognized as it is not certain whether the cheque will
be cleared by the bank. One cannot stretch the conservatism concept too much. But at the same time,
if the business has to receive ` 5 lacs from a customer to whom goods were sold quite some time ago and
no payments are forthcoming, then while determining the net income for the period, the accountant must
judge the likelihood of the recoverability of this money and the prudence will prevail to make a provision for
this amount as doubtful debtors.
Let us take another example. A business had purchased goods for ` 10 lacs before the end of an accounting
period. If sold at the usual selling price, the goods would fetch the price of ` 12.50 lacs. Due to innovative
product introduced by the competition, the goods are likely to be sold for ` 9 lacs only. At what value should
the goods be shown in the balance sheet? Would it be at ` 10 lacs being the actual cost of buying? Or would
it be at ` 9 lacs? Here, the conservatism principle will come in play. The stock of goods will be valued at ` 9
lacs, being the lower of cost or net realisable value, as per AS-2.
(d) Timeliness Concept
Under this principle, every transaction must be recorded in proper time. Normally, when the transaction is
made, the same must be recorded in the proper books of accounts. In short, transaction should be recorded
date-wise in the books. Delay in recording such transaction may lead to manipulation, misplacement of

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vouchers, misappropriation etc. of cash and goods. This principle is followed particularly while verifying day
to day cash balance. Principle of timeliness is also followed by banks, i.e. every bank verifies the cash balance
with their cash book and within the day, the same must be completed.
(e) Industry Practice
As there are different types of industries, each industry has its own characteristics and features. There may
be seasonal industries also. Every industry follows the principles and assumption of accounting to perform
their own activities. Some of them follow the principles, concepts and conventions in a modified way. The
accounting practice which has always prevailed in the industry is followed by it. e.g Electric supply companies,
Insurance companies maintain their accounts in a specific manner. Insurance companies prepare Revenue
Account just to ascertain the profit/loss of the company and not Profit and Loss Account. Similarly, non
trading organizations prepare Income and Expenditure Account to find out Surplus or Deficit.
Conclusion
The above paragraphs bring out essentially broad concepts and conventions that lay down principles to be
followed for accounting of business transaction. While going through the different topics, students are advised
to keep track of concepts applicable for various accounting treatment. One would have by now understood
the importance of these concepts in preparation of basic financial statements. More clarity will emerge as one
explores the ocean of different business transactions arising out of complex business situations. The legal and
professional requirements also have their say in deciding the accounting treatment. Let us see if you can apply
these concepts in the following illustrations.

Exercise:
Recognise the accounting concept in the following:

(1) The business will run for an indefinite period.

(2) The business is distinct and separate from its owners.

(3) The transactions are recorded at their original cost.

(4) The transactions recorded are those that can be expressed in money terms.

(5) Revenues will be recognized only if there is reasonable certainty that it will be paid for.

(6) Accounting treatment once decided should be followed period after period.

(7) Every transaction has two effects to be recorded in books of accounts.

(8) Transactions are recorded even if an obligation is created and actual cash is not involved.

(9) Stock of goods is valued at lower of its cost and realizable value.

(10) Effects of an event must be recognized in the same accounting period.

Events and Transactions:

Event is a transaction or change recognized on the financial statements of an accounting entity. Accounting
events can be either external or internal. An external event would occur with an outside party, such as the
purchase or sales of a good. An internal event would involve changes in the accounting entity’s records, such as
adjusting an account on the financial statements.
An accounting event is any financial event that would impact the account balances of a company’s financial
statements. Every time the company uses or receives cash, or adjusts an entry in its accounting records, an
accounting event has occurred.

Transactions vs. Events

Transaction is exchange of an asset with consideration of money value while event is anything in general purpose
which occur at specific time and particular place. All transactions are events but all events are not transactions.
This is because in order events to be called transaction an event must involve exchange of values.

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Voucher:
It is a written instrument that serves to confirm or witness (vouch) for some fact such as a transaction. Commonly, a
voucher is a document that shows goods have bought or services have been rendered, authorizes payment, and
indicates the ledger account(s) in which these transactions have to be recorded.
Types of Voucher - Normally the following types of vouchers are used. i.e.:
(i) Receipt Voucher
(ii) Payment Voucher
(iii) Non-Cash or Transfer Voucher
(iv) Supporting Voucher
(i) Receipt Voucher
Receipt voucher is used to record cash or bank receipt. Receipt vouchers are of two types. i.e.
(a) Cash receipt voucher – it denotes receipt of cash
(b) Bank receipt voucher – it indicates receipt of cheque or demand draft
(ii) Payment Voucher
Payment voucher is used to record a payment of cash or cheque. Payment vouchers are of two types. i.e.
(a) Cash Payment voucher – it denotes payment of cash
(b) Bank Payment voucher – it indicates payment by cheque or demand draft.
(iii) Non Cash Or Transfer Voucher
These vouchers are used for non-cash transactions as documentary evidence. e.g., Goods sent on credit.
(iv) Supporting Vouchers
These vouchers are the documentary evidence of transactions that have happened.

Source Documents
Vouchers are the documentary evidence of the transactions so happened. Source documents are the basis
on which transactions are recorded in subsidiary books i.e. source documents are the evidence and proof of
transactions.

Name of the Book Source document

(a) Cash Book Cash Memos, Cash Receipts and issue vouchers
(b) Purchase Books Inward invoice received from the creditors of goods
(c) Sales Book Outward Invoice issued to Debtors
(d) Return Inward Book Credit Note issued to Debtors and Debit Notes received from Debtors
(e) Returns Outward Book Debit Note issued to creditors and Credit Note received from creditors.

The Concept of “Account”, “Debit” and “Credit”:

One must get conversant with these terms before embarking to learn actual record-keeping based on the rules.
An ‘Account’ is defined as a summarised record of transactions related to a person or a thing. e.g. when the
business deals with customers and suppliers, each of the customers and supplier will be a separate account. We
must know that each one of us is identified as a separate account by the bank when we open an account with
them. The account is also related to things – both tangible and intangible.
e.g. land, building, equipment, brand value, trademarks etc. are some of the things. When a business transaction
happens, one has to identify the ‘account’ that will be affected by it and then apply the rules to decide the
accounting treatment.

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Typically, an account is expressed as a statement in form of English letter ‘T’. It has two sides. The left hand side is
called as “Debit’ side and the right hand side is called as “Credit’ side. The debit is connoted as ‘Dr’ and the credit
by ‘Cr’. The convention is to write the Dr and Cr labels on both sides as shown below. Please see the following
example:

Dr. Cash Account Cr.

Debit side Credit side

Each side of the account will show effects, so that one can easily take totals of both sides and find out the
difference between the two. Such difference in the two sides of an account is called ‘balance’. If the total of
debit side is more than the credit side, the balance is called as ‘debit balance’ and if the total of credit side is
more than the debit side, the balance is called as ‘credit balance’. If the debit and credit side are equal, the
account will show ‘nil balance’.
The balances are to be computed at the end of an accounting period. These balances are then considered for
preparation of income statement and balance sheet. Let us see the example:
Dr. Cash Account Cr.
Particulars Amount Particulars Amount
` `
Cash brought into business 1,00,000 Paid for goods purchased 50,000
Received for goods sold 25,000 Paid for rent 15,000
Balance at the end 60,000
1,25,000 1,25,000
It can be seen from the above example that the debit side of cash account shows the receipt of cash into
the business and the credit side reflects the cash that has gone out of the business. What is the meaning of the
balance at the end? Well, it shows that cash balance available in the business.
Types of Accounts:
We have seen that an account may be related to a person or a thing – tangible or intangible. While doing business
transactions (that may be large in number and complex in nature), one may come across numerous accounts
that are affected. How does one decide about accounting treatment for each of them? If common rules are to
be applied to similar type of accounts, there must be a way to classify the account on the basis of their common
characteristics.
Please take look at the following chart.
Natural Persons

Personal Accounts Artificial Persons

Representative
Accounts Persons

Real Accounts
Impersonal (tangible and intangible)
Accounts
Nominal Accounts

Let us see what each type of account means.

(1) Personal Account : As the name suggests these are accounts related to persons.
(a) These persons could be natural persons like Suresh’s A/c, Anil’s A/c, Rani’s A/c etc.
(b) The persons could also be artificial persons like companies, bodies corporate or association of persons
or partnerships etc. Accordingly, we could have Videocon Industries A/c, Infosys Technologies A/c,
Charitable Trust A/c, Ali and Sons trading A/c, ABC Bank A/c, etc.

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 FINANCIAL ACCOUNTING

(c) There could be representative personal accounts as well. Although the individual identity of persons
related to these is known, the convention is to reflect them as collective accounts. e.g. when salary is
payable to employees, we know how much is payable to each of them, but collectively the account is
called as ‘Salary Payable A/c’. Similar examples are rent payable, Insurance prepaid, commission pre-
received etc. The students should be careful to have clarity on this type and the chances of error are
more here.
(2) Real Accounts : These are accounts related to assets or properties or possessions. Depending on their physical
existence or otherwise, they are further classified as follows:
(a) Tangible Real Account – Assets that have physical existence and can be seen, and touched. e.g.
Machinery A/c, Stock A/c, Cash A/c, Vehicle A/c, and the like.
(b) Intangible Real Account – These represent possession of properties that have no physical existence but
can be measured in terms of money and have value attached to them. e.g. Goodwill A/c, Trade mark
A/c, Patents & Copy Rights A/c, Intellectual Property Rights A/c and the like.
(3) Nominal Account : These accounts are related to expenses or losses and incomes or gains e.g. Salary and
Wages A/c, Rent of Rates A/c, Travelling Expenses A/c, Commission received A/c, Loss by fire A/c etc.
The Accounting Process:
There are two approaches for deciding when to write on the debit side of an account and when to write on the
credit side of an account:
A. American Approach/ Modern Approach
B. British Approach/ Traditional Approach/Double Entry System
A. American approach : In order to understand the rules of debit and credit according to this approach
transactions are divided into five categories.

For Assets Increase in Assets Dr.

Decrease in Assets Cr.
For Liabilities Decrease in Liabilities Dr.
Increase in Liabilities Cr.
For Capital Decrease in Capital Dr.
Increase in Capital Cr.
For Incomes Decrease in Income Dr.
Increase in Income Cr.
For Expense Increase in Expense Dr.
Decrease in Expense Cr.

Illustration 4.
Ascertain the debit and credit from the following particulars under Modern Approach.
(i) Started business with capital.
(ii) Bought goods for cash.
(iii) Sold goods for cash.
(iv) Paid salary.
(v) Received Interest on Investment.
(vi) Bought goods on credit from Mr. Y
(vii) Paid Rent out of Personal cash

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Fundamentals of Accounting

Solution:

Effect of Transaction Account To be debited/Credited

(a) Increase in Cash Cash A/c Debit
Increase in Capital Capital A/c Credit
(b) Increase in Stock Purchase A/c Debit
Decrease in Cash Cash A/c Credit
(c) Increase in Cash Cash A/c Debit
Decrease in Stock Sale A/c Credit
(d) Increase in Expense Salary A/c Debit
Decrease in Cash Cash A/c Credit
(e) Increase in Cash Cash A/c Debit
Increase in Income Interest A/c Credit
(f) Increase in Stock Purchase A/c Debit
Increase in Liability Y A/c Credit
(g) Increase in Expense Rent A/c Debit
Increase in Capital Capital A/c Credit

B. British Approach or Double Entry System :

When one identifies the account that is getting affected by a transaction and type of that account, the next step
is to apply the rules to decide whether the accounting treatment is to debit or credit that account. The Golden
Rules will guide us whether the account is to be debited or credited.
There is one rule for each basic type of account i.e. personal, real and nominal. These rules are shown in the
following chart.

Debit the receiver or who owes to business

Personal Account
Credit the giver or to whom business owes

Debit what comes into business

Real Account
Credit what goes out of business

Debit all expenses or losses

Nominal Account
Credit all income or gains

Illustration 5.
Ascertain the Debit Credit under British Approach or Double Entry System. Take Previous illustration
Solution:

Step-I Step-II Step-III Step-IV

(a) Cash A/c Real Comes in Debit
Capital A/c Personal Giver Credit
(b) Purchase A/c Nominal Expenses Debit
Cash A/c Real Goes out Credit

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 FINANCIAL ACCOUNTING

(c) Cash A/c Real Comes in Debit

Sales A/c Nominal Incomes Credit
(d) Salary A/c Nominal Expenses Debit
Cash A/c Real Goes out Credit
(e) Cash A/c Real Comes in Debit
Interest A/c Nominal Incomes Credit
(f) Purchase A/c Nominal Personal Expenses Debit
Y’ A/c Giver Credit
(g) Rent A/c Nominal Personal Expenses Debit
Capital A/c Giver Credit

Accounting Equations:
The whole Financial Accounting dependes on Accounting Equation which is also known as Balance Sheet
Equation. The basic Accounting Equation is:

Assets = Liabilities + Owner’s equity

}
or A = L + P
or P = A - L Where A = Assets, L = Liabilities, P = Capital
or L = A – P

While trying to do this correlation, please note that incomes or gains will increase owner’s equity an expenses or
losses will reduce it.
Students are advised to go through the following illustration to understand this equation properly.

Illustration 6.

Prepare an Accounting Equation from the following transactions in the books of Mr. X for January, 2013:

1 Invested Capital in the firm ` 20,000

2 Purchased goods on credit from Das & Co. for ` 2,000

4 Bought plant for cash ` 8,000

8 Purchased goods for cash ` 4,000

12 Sold goods for cash (cost ` 4,000 + Profit ` 2,000) ` 6,000.

18 Paid to Das & Co. in cash ` 1,000

22 Received from B. Banerjee ` 300 (being a debtor)

25 Paid salary ` 6,000

30 Received interest ` 5,000

31 Paid wages ` 3,000

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Solution:
Effect of transaction on Assets, Liabilities and Capital

Date Transaction Assets = Liabilities + Capital

January, 2013 Invested Capital in the firm, ` 20,000 20,000 - 20,000

1

2 Purchased goods on credit from Das & Co.

` 2,000 +2,000 +2,000 -

Revised Equation 22,000 = 2,000 + 20,000

4 Bought Plant for cash ` 8,000 +8,000 - -

-8,000

Revised Equation 22,000 = 2,000 + 20,000

8 Purchased goods for cash ` 4,000 +4,000 - -

-4,000 - -

Revised Equation 22,000 = 2,000 + 20,000

12 Sold Goods for cash (Cost ` 4,000 + Profit ` +6,000

2,000) -4,000 +2,000

Revised Equation 24,000 2,000 + 22,000

18 Paid to Das & Co. for ` 1,000 -1,000 -1,000

Revised Equation 23,000 = 1,000 + 22,000

22 Received from B.Banerjee for ` 300 +300

-300

Revised Equation 23,000 = 1,000 + 22,000

25 Paid salary for ` 6,000 - 6,000 -6,000

Revised Equation 17,000 = 1,000 + 16,000

30 Received Interest for ` 5,000 +5,000 +5,000

Revised Equation 22,000 = 1,000 + 21,000

31 Paid Wages for `3,000 -3,000 -3,000

Revised Equation 19,000 = 1,000 + 18,000

Accrual Basis and Cash Basis of Accounting

(i) Accrual Basis of Accounting

Accrual Basis of Accounting is a method of recording transactions by which revenue, costs, assets and
liabilities are reflected in the accounts for the period in which they accrue. This basis includes consideration
relating to deferrals, allocations, depreciation and amortization. This basis is also referred to as mercantile
basis of accounting. Under the Companies Act 1956, all companies are required to maintain the books of
accounts according to accrual basis of accounting

(ii) Cash Basis of Accounting

Cash Basis of Accounting is a method of recording transactions by which revenues, costs, assets and liabilities
are reflected in the accounts for the period in which actual receipts or actual payments are made.

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Distinction between Accrual Basis of Accounting and Cash Basis of Accounting

Accrual basis of accounting differs from Cash basis of accounting in the following respects:

Basis of Distinction Accrual Basis of Accounting Cash Basis of Accounting

1. Prepaid/Outstanding Expenses/ Under this, there may be prepaid/ Under this, there is no
accrued/unaccrued Income in outstanding expenses and accrued/ prepaid/outstanding
Balance Sheet. unaccrued incomes in the Balance expenses or accrued/
Sheet. unaccrued incomes.
2. Higher/lower Income in case of Income Statement will show a Income Statement will
prepaid expenses and accrued relatively higher income show lower income.
income
3. Higher/lower income incase Income Statement will show a Income Statement will show
of outstanding expenses and relatively lower income. higher income.
unaccrued income
4. Recognition under the Companies This basis is recognized under the This basis is not recognized
Act. 1956. Companies Act, 1956. under the Companies Act,
1956.
5. Availability of options to an Under this, an accountant has Under this an accountant
accountant to manipulate the options. has no option to make a
accounts by way of choosing the choice as such.
most suitable method out of several
alternative methods of accounting
e.g. FIFO/LIFO/SLM/ WDV

Hybrid or Mixed Basis

Is the combination of both the basis i.e. Cash as well as Accrual basis. Incomes are recorded on Cash basis but
expenses are recorded on Accrual basis.
This is not a system of accounting on its own. It is a combination of the Cash Basis Accounting and Accrual Basis
Accounting. This system is based on the concept of conservatism.
Under the hybrid system of accounting, incomes are recognised as in Cash Basis Accounting i.e. when they are
received in cash and expenses are recognised on accrual basis i.e. during the accounting period in which they
arise irrespective of when they are paid.

Illustration 7.
Mr. Anil Roy, a junior lawyer, provides the following particulars for the year ended 31st December, 2012:
`
Fees received in cash in 2013 60,000
Salary paid to Staff in 2013 8,000
Rent of office in 2013 14,000
Magazine and Journal for 2013 1,000
Travelling and Conveyance paid in 2013 3,000
Membership Fees paid in 2013 1,600
Office Expenses paid in 2013 10,000

Additional Information:-
Fees include ` 3,000 in respect of 2012 and fees not yet received is ` 7,000. Office rent includes ` 4,000 for previous
year and rent of ` 2,000 not yet paid. Membership fees is paid for 2 years.
Compute his net income for the year 2013, under – (a) Cash Basis, (b) Accrual Basis and (c) Mixed or Hybrid Basis.

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Fundamentals of Accounting

Solution:
Statement of Income (Cash Basis)
For the year ended 31st December, 2013

Particulars Amount (`) Amount (`)

Fees received 60,000
Less :
Salary 8,000

Office Rent 14,000

Magazine & Journal 1,000
Travelling & Conveyance 3,000
Membership Fees 1,600
Office Expenses 10,000 37,600
Net Income 22,400

(ii) Mr. Anil Roy

Statement of Income (Accrual Basis)
For the year ended 31st December, 2013

Particulars Amount (`) Amount (`)

Fees received 60,000
Add: Accrued fees for 2012 7,000
67,000
Less: Fees for 2011 received in 2012 3,000 64,000
Less :
Salary 8,000
Office Rent 14,000
Add: Outstanding rent 2,000
16,000
Less: Rent for 2011 paid in 2012 4,000 12,000
Magazine & Journal 1,000
Travelling & Conveyance 3,000
Membership Fees 1,600
Less: Advance fee paid for 2013 ( ½ x 1600) 800 800
Office Expenses 10,000 34,800
Net Income 29,200

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 FINANCIAL ACCOUNTING

Mr. Anil Roy

Statement of Income (Mixed or Hybrid Basis)
For the year ended 31st December, 2013

Particulars Amount (`) Amount (`) Amount (`)

Fees received 60,000
Less :
Salary 8,000
Office Rent 14,000
Add: Outstanding rent 2,000
16,000
Less: Fees for 2011 4,000 12,000
Magazine & Journal 1,000
Travelling & Conveyance 3,000
Membership Fees 1,600
Less: Advance 800 800
Office Expenses 10,000 34,800
Net Income 25,200

1.4 CAPITAL & REVENUE TRANSACTIONS

The concepts of capital and revenue are of fundamental importance to the correct determination of accounting
profit for a period and recognition of business assets at the end of that period. The distinction affects the
measurement of profit in a number of accounting periods.
Capital has been defined by economists as those assets which are used in the production of goods and rendering
of services for further production of assets. In accounting, on the other hand, the capital of a business is increased
by that portion of the periodic income which has not been consumed by the owner.
The relationship between capital and revenue is that of between a tree and its fruits. It is the tree which produces
the fruits, and it is the fruit that can be consumed. If the tree is tendered with care, it will produce more fruits,
conversely, if the tree is destroyed, there will be no more fruits. Likewise, revenue comes out of capital and capital
is the source of revenue. Capital is invested by a person in the business so that it may produce revenue. Moreover,
as a fruit may give birth to another new tree, different revenues may also produce further new capital.
Capital can be brought in by a person into the business in different forms-cash or kind. When capital is brought in
the form of cash, it is spent away on various items of assets that make the business a running concern. Capital of
the firm is thus, represented by its inventory of assets.
Capital of a business can be increased in a two fold way:
1. When the owner brings in more capital to the business; and/or
2. When the owner does not consume the entire periodic income.
When the owner brings in further capital to his business, the amount is credited to the Capital Account. Likewise,
the net income for a period is credited to the Capital Account, and if his drawings are less than that income, the
capital is increased by the difference. Example, Capital ` 500, Profit ` 300, drawings ` 350. So the revised capital
will be ` 450 (` 500 + ` 300 - ` 350)

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The difference between the two terms ‘revenue’ and ‘receipt’ should be carefully distinguished. A receipt is the
inflow of money into business, whereas revenue is the aggregate exchange value received for goods and services
provided to the customers.
Capital and Revenue Expenditures
Capital expenditure is the outflow of funds to acquire an asset that will benefit the business for more than one
accounting period. A capital expenditure takes place when an asset or service is acquired or improvement of a
fixed asset is effected. These assets are expected to provide benefits to the business in more than one accounting
period and are not intended for resale in the ordinary course of business. In short, it is an expenditure on assets
which is not written off completely against income in the accounting period in which it is acquired.
Revenue expenditure is the outflow of funds to meet the running expenses of a business and it will be of benefit for
the current period only. A revenue expenditure is incurred to carry on the normal course of business or maintain
the capital assets in a good condition.
It may be pointed out here that an expenditure need not necessarily be a payment made to somebody in
cash - it may be made by the exchange of another asset, or by assuming a liability. Expenditure incurrence
and expenditure recognition are distinct phenomena. Expenditure incurrence refers to the receipt of goods and
services, whereas expenditure recognition is a matter to be decided whether the expenditure is of capital or
revenue nature. For example, the buying of an asset is a capital expenditure but charging depreciation against
profit is a revenue expenditure, over the entire life of that asset. On the application of periodicity, accrual and
matching concepts, accountants identify all revenue expenditures for a given period for ascertaining profit. An
expenditure which cannot be identified to a particular accounting period is considered of capital nature.
The accounting treatment of capital and revenue expenditure are as under:
Revenue expenditures are charged as an expense against profit in the year they are incurred or recognised.
Capital Expenditures are capitalised-added to an Asset Account.
The following are the points of distinction between Capital Expenditure and Revenue Expenditure:

Sl. Capital Expenditure Sl. Revenue Expenditure

No. No.
1. The economic benefits of Capital Expenditures are 1. The economic benefits of Revenue
enjoyed for more than one accounting period. Expenditures are enjoyed within a particular
accounting period.
2. Capital Expenditures are of non-recurring in 2. Revenue Expenditures are of recurring in
nature. nature.
3. All Capital Expenditures eventually become 3. Revenue Expenditures are not generally
Revenue Expenditures like depreciation capital expenditures.
4. Capital Expenditures are not matched with 4. All Revenue Expenditures are matched with
Capital Receipts. Revenue Receipts.

Rules for Determining Capital Expenditure

An expenditure can be recognised as capital if it is incurred for the following purposes:
An expenditure incurred for the purpose of acquiring long term assets (useful life is at least more than one accounting
period) for use in business to earn profits and not meant for resale, will be treated as a capital expenditure. For
example, if a second hand motor car dealer buys a piece of furniture with a view to use it in business; it will be
a capital expenditure. But if he buys second hand motor cars, for re-sale, then it will be a revenue expenditure
because he deals in second hand motor cars.
When an expenditure is incurred to improve the present condition of a machine or putting an old asset into
working condition, it is recognised as a capital expenditure. The expenditure is capitalised and added to the cost
of the asset. Likewise, any expenditure incurred to put an asset into working condition is also a capital expenditure.
For example, if one buys a machine for ` 5,00,000 and pays ` 20,000 as transportation charges and `40,000 as

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 FINANCIAL ACCOUNTING

installation charges, the total cost of the machine comes upto ` 5,60,000. Similarly, if a building is purchased for
`1,00,000 and ` 5,000 is spent on registration and stamp duty, the capital expenditure on the building stands at
`1,05,000.
If an expenditure is incurred, to increase earning capacity of a business that will be considered as of capital
nature. For example, expenditure incurred for shifting the factory for easy supply of raw materials. Here, the cost
of such shifting will be a capital expenditure.
Preliminary expenses incurred before the commencement of business is considered capital expenditure. For
example, legal charges paid for drafting the memorandum and articles of association of a company or brokerage
paid to brokers, or commission paid to underwriters for raising capital.
Thus, one useful way of recognising an expenditure as capital is to see that the business will own something which
qualifies as an asset at the end of the accounting period.

Some examples of Revenue Expenditure

(i) Salaries and wages paid to the employees;
(ii) Rent and rates for the factory or office premises;
(iii) Depreciation on plant and machinery;
(iv) Consumable stores;
(v) Inventory of raw materials, work-in-progress and finished goods;
(vi) Insurance premium;
(vii) Taxes and legal expenses; and
(viii) Miscellaneous expenses.

Replacement of Fixed Assets

The above rules of capital and revenue expenditure do not hold good when an existing asset is replaced
for another. If an asset is replaced with a similar kind of asset, the expenditure incurred is treated as Revenue
Expenditure. For example, if a set of weighing machines in a shop becomes defective and is replaced with a
similar set, the cost of replacement should be treated as revenue expenditure and it should be charged to the
Profit and Loss Account. However, if an asset is replaced with an asset which is superior than the previous one, the
expense is partly capital and partly revenue. For example, if a manual typewriter costing ` 5,000 is replaced with
an electronic typewriter costing ` 15,000, then ` 5,000 will be revenue expenditure and the excess value of the new
typewriter over the old one, ` 10,000 will be capital expenditure.

Deferred Revenue Expenditures

Deferred revenue expenditures represent certain types of assets whose usefulness does not expire in the year
of their occurrence but generally expires in the near future. These type of expenditures are carried forward and
are written off in future accounting periods. Sometimes, we make some revenue expenditure but it eventually
becomes a capital asset (generally of an intangible nature). If one undertake substantial repairs to the existing
building, the deterioration of the premises may be avoided. We may engage our own employees to do that work
and pay them at prevailing wage-rate, which is of a revenue nature. If this expenditure is treated as a revenue
expenditure and the current year’s-profit is charged with these expenses, we are making the current year to
absorb the entire expenses, though the benefit of which will be enjoyed for a number of accounting years. To
overcome this difficulty, the entire expenditure is capitalised and is added to the asset account. Another example
is an insurance policy. A business can pay insurance premium in advance, say, for a 3 year period. The right does
not expire in the accounting period in which it is paid but will expire within a fairly short period of time (3 years).
Only a portion of the total premium paid should be treated as a revenue expenditure (portion pertaining to the
current period) and the balance should be carried forward as an asset to be written off in subsequent years.
Now, Preliminary Expenses are not shown in the balance Sheet as per para 56 of AS-26, it is a part of other expenses
which is shown in the Profit and Loss A/c (Part II of Schedule III in case of a Company). It is a part of revenue
expenditure, e.g., expenditure incurred on Scientific Research is recognized as an expense when it is incurred”. In
short, the whole amount of expenditure is treated as expense for the current year only and will not proportionately
be transferred as deferred charge.

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Capital and Revenue Receipts

A receipt of money may be of a capital or revenue nature. A clear distinction, therefore, should be made between
capital receipts and revenue receipts.
A receipt of money is considered as capital receipt when a contribution is made by the proprietor towards the
capital of the business or a contribution of capital to the business by someone outside the business. Capital receipts
do not have any effect on the profits earned or losses incurred during the course of a year.
Additional capital introduced by the proprietor; by partners, in case of partnership firm, by issuing fresh shares, in
case of a company; and, by selling assets, previously not intended for resale.
A receipt of money is considered as revenue receipt when it is received from customers for goods supplied or fees
received for services rendered in the ordinary course of business, which is a result of the firm’s activity in the current
period. Receipts of money in the revenue nature increase the profits or decrease the losses of a business and must
be set against the revenue expenses in order to ascertain the profit for the period.
The following are the points of difference between capital receipts and revenue receipts:

Sl. Revenue Receipt Sl. Capital Receipt

No. No.
1. It has short-term effect. The benefit is enjoyed 1. It has long-term effect. The benefit is enjoyed
within one accounting period. for many years in future.
2. It occurs repeatedly. It is recurring and regular. 2. It does not occur again and again. It is
nonrecurring and irregular.
3. It is shown in profit and loss account on the 3. It is shown in the Balance Sheet on the liability side.
credit side, as an income for the year
4. It does not produce capital receipt. 4. Capital receipt, when invested, produces revenue
receipt e.g. when capital is invested by the owner,
business gets revenue receipt
(i.e. sale proceeds of goods etc.).
5. This does not increase or decrease the value of 5. The capital receipt decreases the value of asset or
asset or liability. increases the value of liability e.g. sale of a fixed
asset, loan from bank etc.
6. Sometimes, expenses of capital nature are to be 6. Sometimes expenses of revenue nature are to be
incurred for revenue receipt, e.g. purchase of incurred for such receipt e.g. on obtaining loan (a
shares of a company is capital expenditure but capital receipt) interest is paid until its repayment.
dividend received on shares is a revenue receipt.

Capital and Revenue Profits

While ascertaining the trading profit of a business for a particular period, a proper distinction is to be made
between capital and revenue profits. If profit arises out of an ordinary nature, being the outcome of the ordinary
function and object of the business, it is termed as ‘Revenue Profit’. But, when a profit arises out of a casual and
non-recurring transaction, it is termed as Capital Profit. Revenue profit arises out of the sale of the merchandise
that the business deals in.
Capital Profit arises from:
(a) Profit prior to incorporation;
(b) Premium received on issue of shares;
(c) Profit made on re-issue of forfeited shares;
(d) Redemption of Debenture at a discount;
(e) Profit made on sale or revaluation of a Fixed Asset.
Generally, capital profits arise out of the sale of assets other than inventory at a price more than its book value or
in connection with the raising of capital or at the time of purchasing an existing business. For example, if an asset,
whose book value is ` 5,000 on the date of sale, is sold for ` 6,000 then ` 1,000 will be considered as capital profit.

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 FINANCIAL ACCOUNTING

Likewise, issue of shares at a premium is also a capital profit. Revenue profits are distributed to the owners of the
business or transferred to General Reserve Account, being shown in the balance sheet as a retained earning.
Capital profits are generally capitalised-transferred to a capital reserve account which can only be utilised for
setting off capital losses in future. Capital profits of a small amount (arising out of selling of one asset) is taken to
the Profit and Loss Account and added with the revenue profit-applying the concept of materiality.
Capital and Revenue Losses
While ascertaining losses, revenue losses are differentiated from capital losses, just as revenue profits are distinguished
from capital profits. Revenue losses arise from the normal course of business by selling the merchantable at a price
less than its purchase price or cost of goods sold or where there is a declining in the current value of inventories.
Capital losses may result from the sale of assets, other than inventory for less than written down value or the
diminution or elimination of assets other than as the result of use or sale (flood, fire, etc.) or in connection with
raising capital of the business (issue of shares at a discount) or on the settlement of liabilities for a consideration
more than its book value (debenture issued at par but redeemed at a premium). Treatment of capital losses
are same as that of capital profits. Capital losses arising out of sale of fixed assets generally appear in the Profit
and Loss Account (being deducted from the net profit). But other capital losses are adjusted against the capital
profits. Where the capital losses are substantial, the treatment is different. These losses are generally shown on the
balance sheet as fictitious assets and the common practice is to spread that over a number of accounting years
as a charge against revenue profits till the amount is fully exhausted.
Illustration 9.
State whether the following are capital, revenue or deferred revenue expenditure.
(i) Carriage of ` 7,500 spent on machinery purchased and installed.
(ii) Heavy advertising costs of ` 20,000 spent on the launching of a company’s new product.
(iii) ` 200 paid for servicing the company vehicle, including ` 50 paid for changing the oil.
(iv) Construction of basement costing ` 1,95,000 at the factory premises.
Solution:
(i) Carriage of ` 7,500 paid for machinery purchased and installed should be treated as a Capital Expenditure.
(ii) Advertising expenses for launching a new product of the company should be treated as a Revenue
Expenditure. (As per AS-26)
(iii) ` 200 paid for servicing and oil change should be treated as a Revenue Expenditure.
(iv) Construction cost of basement should be treated as a Capital Expenditure.
Illustration 10.
Classify the following items as capital or revenue expenditure :
(i) An extension of railway tracks in the factory area;
(ii) Wages paid to machine operators;
(iii) Installation costs of new production machine;
(iv) Materials for extension to foremen’s offices in the factory;
(v) Rent paid for the factory;
(vi) Payment for computer time to operate a new stores control system,
(vii) Wages paid to own employees for building the foremen’s offices. Give reasons for your classification.
Solution :
(i) Expenses incurred for extension of railway tracks in the factory area should be treated as a Capital Expenditure
because it will yield benefit for more than one accounting period.
(ii) Wages paid to machine operators should be treated as a Revenue Expenditure as it will yield benefit for the
current period only.

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(iii) Installation costs of new production machine should be treated as a Capital Expenditure because it will
benefit the business for more than one accounting period.
(iv) Materials for extension to foremen’s offices in the factory should be treated as a Capital Expenditure because
it will benefit the business for more than one accounting period.
(v) Rent paid for the factory should be treated as a Revenue Expenditure because it will benefit only the current
period.
(vi) Payment for computer time to operate a new stores control system should be treated as Revenue Expenditure
because it has been incurred to carry on the normal business.
(vii) Wages paid for building foremen’s offices should be treated as a Capital Expenditure because it will benefit
the business for more than one accounting period.
Illustration 11.
State with reasons whether the following are Capital Expenditure or Revenue Expenditure:
(i) Expenses incurred in connection with obtaining a licence for starting the factory were ` 10,000.
(ii) ` 1,000 paid for removal of stock to a new site.
(iii) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get full efficiency.
(iv) ` 2,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site belonged to the Plaintiff. The
suit was not successful.
(v) ` 10,000 were spent on advertising the introduction of a new product in the market, the benefit of which will
be effective during four years.
(vi) A factory shed was constructed at a cost of ` 1,00,000. A sum of ` 5,000 had been incurred for the construction
of the temporary huts for storing building materials.
Solution :
(i) ` 10,000 incurred in connection with obtaining a license for starting the factory is a Capital Expenditure. It is
incurred for acquiring a right to carry on business for a long period.
(ii) ` 1,000 incurred for removal of stock to a new site is treated as a Revenue Expenditure because it is not
enhancing the value of the asset and it is also required for starting the business on the new site.
(iii) ` 5,000 incurred for changing Rings and Pistons of an engine is a Revenue Expenditure because, the change
of rings and piston will restore the efficiency of the engine only and it will not add anything to the capacity
of the engine.
(iv) ` 2,000 incurred for defending the title to the firm’s assets is a Revenue Expenditure.
(v) ` 10,000 incurred on advertising is to be treated as a Revenue Expenditure. [As per As-26]
(vi) Cost of construction of Factory shed of ` 1,00,000 is a Capital Expenditure, similarly cost of construction of
small huts for storing building materials is also a Capital Expenditure.
Illustration 12.
State clearly how you would deal with the following in the books of a Company :
(i) The redecoration expenses ` 6,000.
(ii) The installation of a new Coffee-making Machine for ` 10,000.
(iii) The building of an extension of the club dressing room for ` 15,000.
(iv) The purchase of snacks & food stuff ` 2,000.
(v) The purchase of V.C.R. and T.V. for the use in the club lounge for ` 15,000.
Solution :
(i) The redecoration expenses of ` 6,000 shall be treated as a Revenue Expenditure.
(ii) The installation of a new Coffee - Making Machine is a Capital Expenditure because it is the acquisition of an
asset.

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 FINANCIAL ACCOUNTING

(iii) ` 15,000 spent for the extension of club dressing room is a Capital Expenditure because it creates an asset of
a permanent nature.
(iv) The purchase of snacks & food stuff of ` 2,000 is a Revenue Expenditure.
(v) The purchase of V.C.R. and T.V. for ` 15,000 is a Capital Expenditure, because it is the acquisition of assets.
Double Entry System, Books of Prime Entry, Subsidiary Books:
Double Entry System -
Books of Prime Entry
A journal is often referred to as Book of Prime Entry or the book of original entry. In this book transactions are
recorded in their chronological order. The process of recording transaction in a journal is called as ‘Journalisation’.
The entry made in this book is called a ‘journal entry’.
Functions of Journal
(i) Analytical Function: Each transaction is analysed into the debit aspect and the credit aspect. This helps to
find out how each transaction will financially affect the business.
(ii) Recording Function: Accountancy is a business language which helps to record the transactions based on
the principles. Each such recording entry is supported by a narration, which explain, the transaction in simple
language. Narration means to narrate – i.e. to explain. It starts with the word – Being …
(iii) Historical Function: It contains a chronological record of the transactions for future references.
Advantages of Journal
The following are the advantages of a journal :
(i) Chronological Record : It records transactions as and when it happens. So it is possible to get a detailed day-
to-day information.
(ii) Minimising the possibility of errors : The nature of transaction and its effect on the financial position of the
business is determined by recording and analyzing into debit and credit aspect.
(iii) Narration : It means explanation of the recorded transactions.
(iv) Helps to finalise the accounts : Journal is the basis of ledger posting and the ultimate Trial Balance.
(v) The Trial balance helps to prepare the final accounts.
(vi) The specimen of a journal book is shown below.

Date Particulars Voucher Ledger folio Debit amount Credit amount

number (`) (`)
dd-mm-yy Name of A/c to be debited Reference of -----------
Name of A/c to be credited page number of -----------
----------- the A/c in ledger
(narration describing the
transaction)

Explanation of Journal
(i) Date Column: This column contains the date of the transaction.
(ii) Particulars: This column contains which account is to be debited and which account is to be credited. It is
also supported by an explanation called narration.
(iii) Voucher Number: This Column contains the number written on the voucher of the respective transaction.
(iv) Ledger Folio (L.F.): This column contains the folio (i.e. page no.) of the ledger, where the transaction is posted.
(v) Dr. Amount and Cr. Amount: This column shows the financial value of each transaction. The amount is
recorded in both the columns, since for every debit there is a corresponding and equal credit.
All the columns are filled in at the time of entering the transaction except for the column of ledger folio. This is filled
at the time of posting of the transaction to ‘ledger’. This process is explained later in this chapter.

32 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Fundamentals of Accounting

Example:
As per voucher no. 31 of Roy Brothers, on 10.05.2013 goods of ` 50000 were purchased. Cash was paid immediately.
Ledger Folios of the Purchase A/c and Cash A/c are 5 and 17 respectively. Journal entry of the above transaction
is given bellow:
In the books of Roy Brothers
Journal Entries
Dr. Cr.
Date Particulars Voucher Ledger Folio Amount Amount
No. (`) (`)
10.05.2013 Purchase A/c Dr. 31 5 50,000
To, Cash A/c 17 50,000
(Being goods purchased for Cash)

Illustration 13.
Let us illustrate the journal entries for the following transactions: 2012
April
1 Mr. Vikas and Mrs. Vaibhavi who are husband and wife start consulting business by bringing in their personal
cash of ` 5,00,000 and ` 2,50,000 respectively.
10 Bought office furniture of ` 25,000 for cash. Bill No. - 2013/F/3
11 Opened a current account with Punjab National Bank by depositing ` 1,00,000
15 Paid office rent of ` 15,000 for the month by cheque to M/s Realtors Properties. Voucher No. 3
20 Bought a motor car worth ` 4,50,000 from Millennium Motors by making a down payment of ` 50,000 by
cheque and the balance by taking a loan from HDFC Bank. Voucher No. M/13/7
25 Vikas and Vaibhavi carried out a consulting assignment for Avon Pharmaceuticals and raised a bill for `
10,00,000 as consultancy fees. Bill No. B13/4/1 raised. Avon Pharmaceuticals have immediately settled `
2,50,000 by way of cheque and the balance will be paid after 30 days. The cheque received is deposited
into Bank.
30 Salary of one receptionist @ ` 5,000 per month and one officer @ ` 10,000 per month. The salary for the current
month is payable to them.
Solution:
The entries for these transactions in a journal will look like:
In the Books of Vikash & Vaibhavi
Journal Entries Journal Folio-1

Dr. Cr.
Date Particulars Voucher L.F Amount (`) Amount (`)
number
01-04-2013 Cash A/c Dr. 1 7,50,000
To Vikas’s Capital A/c 2 5,00,000
To Vaibhavi’s Capital A/c 3 2,50,000
(Being capital brought in by the partners)
10-04-2013 Furniture A/c Dr. 2013/F/3 4 25,000
To Cash A/c 1 25,000
(Being furniture purchased in cash)
11-04-2013 Punjab National Bank A/c Dr. 5 1,00,000
To Cash A/c 1 1,00,000
(Being current account opened with Punjab
National Bank by depositing cash)

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 FINANCIAL ACCOUNTING

15-04-2013 Rent A/c Dr. 3 6 15,000

To Punjab National Bank A/c 5 15,000
(being rent paid to Realtors Properties for the
month)
20-04-2013 Motor Car A/c Dr. M/13/7 7 4,50,000
To Punjab National Bank A/c 5 50,000
To Loan from HDFC Bank A/c 8 4,00,000
(Being car purchased from Millennium
Motors by paying down payment and loan
arrangement)
25-04-2013 Punjab National Bank A/c Dr. B13/4/1 5 2,50,000
Avon Pharmaceuticals A/c Dr. 9 7,50,000
To Consultancy Fees A/c 10 10,00,000
(Being amount received and revenue
recognized for fees charged)
30-04-2013 Salary A/c Dr. 11 15,000
To Salary payable A/c 12 15,000
(Being the entry to record salary obligation for
the month)
Subsidiary Books
Although once understood, the entries are easy to be written, but if transactions are too many, it may become
difficult to manage them and retrieve. Imagine there are 25 purchase transactions in a day. Because the journal
will record all transaction chronologically, it may be possible that the purchase transactions could be scattered
i.e. they may not all come together one after the other. Now, at the end of the day if the owner wants to know
the total purchases made during the day, the accountant will spend time first to retrieve all purchase transactions
from journal and then take total. This invalve time.
This being the greatest limitation of journal, it is generally sub-divided into more than one journal. On what logic
is such a sub-division made? It is done on the basis of similar transactions which are clubbed in a single book e.g.
purchase transactions, sales transaction etc. The sub-division of journal is done as follows:
Transaction Subsidiary Book
All cash and bank transactions Cash Book - has columns for cash, bank and cash
discount
All credit purchase of goods – only those Goods that are Purchase Day Book or Purchase register
purchased for resale are covered here.
All credit sale of goods Sales Day Book or sales register
All purchase returns – i.e. return of goods back to suppliers Purchase Return Book or Return Outward Book
due to defects
All sales returns – i.e. return of goods back from customers Sales Return Book or Return Inward Book
All bill receivables – these are bills accepted by customers Bills Receivable Book
to be honoured at an agreed date. This is dealt with in
depth later in the study note
All bills payable - these are bills accepted by the business Bills Payable Book
to be honoured by paying to suppliers at an agreed
date.
For all other transactions not covered in any of the above Journal Proper
categories – i.e. purchase or sale of assets, expense
accruals, rectification entries, adjusting entries, opening
entries and closing entries.
Let us see the formats for each of these and examples as illustration.

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Recording of Cash and Bank Transactions

Cash Book
A Cash Book is a special journal which is used for recording all cash receipts and all cash payments. Cash Book is a
book of original entry since transactions are recorded for the first time from the source documents. The Cash Book
is larger in the sense that it is designed in the form of a Cash Account and records cash receipts on the debit side
and cash payments on the credit side. Thus, the Cash Book is both a journal and a ledger.
Cash Book as the only Book of Original Entry
This Cash Book records all types of transactions even if there are some credit transactions i.e. all transactions
are recorded and not like the ordinary Cash Book where only cash transactions are recorded. For non cash
transactions, that will be two entries in the cash Book, ultimately that will be no effect in Cash Balance. For example,
if goods are sold to Mr. X on credit for ` 5,000, the entries will be

Dr. Cr.
(1) Cash A/c Dr 5,000
To Sales A/c 5,000
(2) X A/c Dr 5,000
To Cash A/c 5,000

Although the original entry is

X A/c Dr 5,000
To Sales A/c 5,000

Types of Cash Book

There are different types of Cash Book as follows:
(i) Single Column Cash Book- Single Column Cash Book has one amount column on each side. All cash receipts
are recorded on the debit side and all cash payments on the payment side, this book is nothing but a Cash
Account and there is no need to open separate cash account in the ledger.
(ii) Double Column Cash Book- Cash Book with Discount Column has two amount columns, one for cash and
other for Discount on each side. All cash receipts and cash discount allowed are recorded on the debit side
and all cash payments and discount received are recorded on the credit side.
Triple Coulmn Cash Book- Triple Column Cash Book has three amount columns, one for cash, one for Bank and
one for discount, on each side. All cash receipts, deposits into book and discount allowed are recorded on debit
side and all cash payments, withdrawals from bank and discount received are recorded on the credit side. In fact,
a triple-column cash book serves the purpose of Cash Account and Bank Account both. Thus, there is no need to
create these two accounts in the ledger.

Dr. Specimen of Single Column Cash Book Cr.

Receipts Payments
Date Particulars L.F. Cash Date Particulars L.F. Cash

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 FINANCIAL ACCOUNTING

Dr. Specimen of Double Column Cash Book Cr.

Receipts Payments
Date Particulars L.F. Cash Disc. Date Particulars L.F. Cash Disc.
Allowed Received

Double Column Cash Book containing contra transaction and cheque transaction
The double column Cash book has columns on both the sides of the Cash book. This cash book can have two
columns on both the sides as under :
(a) Cash and Discount Columns,
(b) Cash and Bank columns,
(c) Bank and Discount columns.
(I) Contra Transactions
Transactions which relates to allowing discount or receiving discount in cash after the settlement of the dues are
known as Contra Transactions.
Example:
1. Cash deposited in to Bank
Bank A/c Dr.
    To  Cash A/c

2. Cash withdrawn from Bank

Cash A/c Dr.
    To  Bank A/c

(II) Cheque Transactions

When a cheque is received and no any other information at a later date about the same is given, it will be
assumed that the said cheque has already been deposited into bank on the same day when it was received.
Then the entry should be as under:
Bank A/c Dr.
To Debtors/Party A/c
But if it is found that the said cheque has been deposited into the bank at a later date, then the entry will be:
(i) When the cheque is received
Cash A/c Dr.
To Debtors/Party A/c
(ii) When the same was deposited into bank at a later date
Bank A/c Dr.
To Cash A/c
(iii) When the said cheque is dishonoured by the bank
Debtors/Party A/c Dr.
To Bank A/c

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Fundamentals of Accounting

Let us see an illustration for the following cash and bank transactions in the books of Mr. Abhishek
January 1 Opening cash balance was ` 3,800 and bank balance was ` 27,500
January 4 Wages paid in cash ` 1,500
January 5 received cheque of ` 19,800 from KBK enterprises after allowing discount of ` 200
January 7 Paid consultancy charges by cheque for ` 7,500
January 10 Cash of ` 2,500 withdrawn from bank
January 12 Received a cheque for ` 4,500 in full settlement of the account of Mr. X at a discount of 10% and
deposited the same into the Bank.
January 15 X’s cheque returned dishonoured by the Bank
In the Books of Mr. Abhishek
Dr. Cash Book Cr.
Receipts Payments
Date Particulars L.F. Cash Bank Discount Date Particulars L.F. Cash Bank Discount
(`) (`) Allowed (`) (`) received
(`) (`)
1-Jan Opening Balance 3,800 27,500 4-Jan Wages paid 1,500
5-Jan Recd from KBK 19,800 200 7-Jan Consultancy fees 7,500
10-Jan Cash withdrawn 2,500 10-Jan Cash withdrawn 2,500
12-Jan Mr. X 4,500 500 15-Jan Mr. X 4,500 500
Closing balance 4,800 37,300
6,300 51,800 700 6,300 51,800 500
Please note that the balance of discount columns is not taken and these are posted directly to the respective
ledger account separately. The balance of cash and bank columns are posted into cash and bank accounts
periodically. The posting into ledger is explained later in this chapter.
Purchase Day Book
The purchase day book records the transactions related to credit purchase of goods only. It follows that any cash
purchase or purchase of things other than goods is not recorded in the purchase day book. Periodically, the totals
of Purchase Day Book are posted to Purchase Account in the ledger. The specimen Purchase Day Book is given
below:
In the Books of .........
Purchase Day Book

Name of the Suppliers and details Invoice

Date of Goods purchased reference L. F. Amount (`) Remarks

The format for Purchase Return is exactly the same; hence separate illustration is not given.
Let us see an illustration for following transactions for a furniture shop:
1. Bought 20 tables @ ` 500 per table from Majestic Appliances on credit @ 12% trade discount as per invoice
number 22334 on 2nd March.
2. Purchased three dozen chairs @ ` 250 each from Metro chairs as per invoice number 1112 on 4th March.
3. Second hand furniture bought from Modern Furnitures on credit as per invoice number 375 for ` 1200 on 7th
March.

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 FINANCIAL ACCOUNTING

4. Purchased seven book racks from Mayur Furnitures for ` 4900 paid for in cash on 6th March.
5. Purchased Machinery for ` 30000 from Kirloskar Ltd on 9th March as per invoice number 37.

In the Books of Furniture Shop

Purchase Day Book
Date Name of the Suppliers and Details of goods purchased Invoice L. F. Amount
reference (`)
2nd March Majestic Appliances 8,800
20 tables @ ` 500 and 12% trade discount 22334
[(20 × ` 500) = ` 10000 less 12% discount i.e., ` 1,200]
4th March Metro Chairs 9,000
3 dozen chairs @ 250 per chair 1112
7th March Modern Furnitures 375 1,200
Total 19,000
Please note that the transaction for purchase of book rack will not be entered in the purchase book as it is not
purchased on credit. (Where will it go then? It will go to the cash book!). Similarly purchase of machinery will not
form part of purchase book. It will be entered in Journal Proper.
Sales Day Book
The sales day book records transaction of credit sale of goods to customers. Sale of other things, even on credit,
will not be entered in the sales day book but will be entered in Journal Proper. If goods are sold for cash, it will be
entered in cash book. Total of sales day book is periodically posted to sales account in the ledger. The specimen
of a sales day book is given below.
In the books of ...........
Sales Day Book
Date Particulars Invoice reference L. F. Amount Remarks

The format of sales return book is exactly the same as in the case of Purchase Day Book.
Let us see how will be the following transaction recorded in the books of a Cloth Merchant.
1st July Sold Tip Top clothing 50 suits of ` 2,200 each on two months credit on invoice number -2
11th July Sold to New India Woolen 100 sweaters @ ` 250 each on invoice number 55
13th July Received an order from Modern clothing for 100 trousers @ ` 500 at trade discount of 10%
17th July Sold 50 sarees to Lunkad brothers @ ` 750 each
25th July Sold T-shirts at exhibition hall for cash for ` 7,500

In the books of Cloth Merchant

Sales Day Book
Date Particulars Invoice reference L. F. Amount
1st July Tip Top Clothing
50 suits @ ` 2,200 2 1,10,000
11th July New India Woolen
100 sweaters @ ` 250 55 25,000
17th July Lunkad brother 50 sarees @ ` 750 37,500
Total 1,72,500
Here again, cash sales at exhibition hall are not recorded. Also, merely getting an order for goods is not a
transaction to be entered in sales book.

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Fundamentals of Accounting

Other Subsidiary Books – Returns Inward, Return Outward, Biils Receivable,Bills Payable.
(i) Return Inward Book- The transactions relating to goods which are returned by the customers for various reasons,
such as not according to sample, or not up to the mark etc contain in this book. It is also known as Sales Return
Book.
Generally when a customer returns good to suppliers he issues a Debit Note for the value of the goods returned by
him. Similarly the supplier who receives those goods issues a Credit Note.
Returns Inward Day Book
Date Particulars Outward L.F. Details Totals Remarks
Invoice

(ii) Return Outward Book- This book contains the transactions relating to goods that are returned by us to our
creditors e.g. goods broken in transit, not according to the sample etc. It’s also known as Purchase Return Book.
Return Outward Day Book

Date Particulars Debit Note L.F. Details Totals Remarks

(iii) Bills Receivable Book- It is such a book where all bills received are recorded and therefrom posted directly
to the credit of the respective customer’s account. The total amounts of the bills so received during the period
(either at the end of the week or month) is to be posted in one sum to the debit of Bills Receivable A/c.
Bills Receivable Day Book
No. of Date of From Name Name Name of Date of Due L.F. Amount How
Bills Receipt whom of the of Acceptor Bill Date of Bill disposed
of Bill Receiver Drawer off

(iv) Bills Payable Book- Here all the particulars relating to bills accepted are recorded and therefrom posted
directly to the debit of the respective creditor’s account. The total amounts of the bills so accepted during the
period (either at the end of the week or month) is to be posted in one sum to the credit of Bills Payable A/c.
Bills Payable Day Book
No. Date of To Name of Name Where Date Term Due L.F. Amount How
of Acceptance whom Drawer of the Payable of Bill Date of Bill disposed
Bills given Payee off

Journal Proper
We know that usual transactions are recorded in primary books of accounts. If any transaction is not recorded in
the primary books the same is recorded in Journal Proper. It includes Credit Purchase and Credit Sales of Assets;
Transfer Entries; Opening Entries; Closing Entries; Adjusting Entries and Rectification of Errors.
However, these are explained in subsequent Para.
Ledger Accounts
Ledger is the main book or principal book of account. The entries into ledger accounts travel through the route of
journal and subsidiary books. The ledger book contain all accounts viz. assets, liabilities, incomes or gains, expenses
or losses, owner’s capital and owner’s equity. The ledger is the book of final entry and hence is a permanent
record. There is a systematic way in which transactions are posted into a ledger account. Once the transactions
are posted for an accounting period, the ledger accounts are balanced (i.e. the difference between debit side
and credit side is calculated). These balances are used to ultimately prepare the financial statement like Profit

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 FINANCIAL ACCOUNTING

and Loss A/c and Balance Sheet. The ledger may also be divided as General ledger and Sub-ledgers. While the
General Ledger will have all ledger accounts, the sub-ledgers will have individual accounts of customers and
suppliers. If there are 10 customers, the general ledger will not have 10 individual accounts for each customer.
Instead, these 10 customer account will exist in what is called as ‘Receivables or Debtors Ledger’ and the general
ledger will have only one account that represents the customers. This is named as Debtors Control Account. Similar
is the case of supplier accounts. Such sub-ledgers are necessary for better control over individual accounts. Also,
this will avoid the general ledger from becoming too big, especially when number of customers and suppliers is
large.
The specimen of a typical ledger account is given below.

Dr. Ledger-Account Cr.

Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)

Ledger Posting
As and when the transaction takes place, it is recorded in the journal in the form of journal entry. This entry is posted
again in the respective ledger accounts under double entry principle from the journal. This is called ledger posting.
The rules for writing up accounts of various types are as follows:
Assets : Increases on the left hand side or the debit side and decreases on the credit side or the
right hand side.
Liabilities : Increases on the credit side and decreases on the debit side.
Capitals : The same as liabilities.
Expenses : Increases on the debit side and decreases on the credit side.
Incomes or gain : Increases on the credit side and decrease on the debit side.
To summarise
Dr. Assets Cr. Dr. Liabilities & Capital Cr.
Increase Decrease Decrease Increase
Dr. Expenses or Loses Cr. Dr. Income or Gains Cr.
Increase Decrease Decrease Increase

The student should clearly understand the nature of debit and credit.
A debit denotes:
(a) In the case of a person that he has received some benefit against which he has already rendered some
service or will render service in future. When a person becomes liable to do something in favour of the firm,
the fact is recorded by debiting that person’s account : (relating to Personal Account)
(b) In case of goods or properties, that the value and the stock of such goods or properties has increased,
(relating to Real Accounts)
(c) In case of other accounts like losses or expenses, that the firm has incurred certain expenses or has lost
money. (relating to Nominal Account)
A credit denotes:
(a) In case of a person, that some benefit has been received from him, entitling him to claim from the firm a
return benefit in the form of cash or goods or service. When a person becomes entitled to money or money’s
worth for any reason. The fact is recorded by crediting him (relating to Personal Account)
(b) In the case of goods or properties, that the stock and value of such goods or properties has decreased.
(relating to Real Accounts)

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Fundamentals of Accounting

(c) In case of other accounts like interest or dividend or commission received, or discount received, that the firm
has made a gain (relating to Nominal Account)
At a glance:

Dr. (Debit side) Cr. (Credit side)

DESTINATION Where the economic SOURCE of each economic benefits
benefit reaches / is received.
Receiver Giver
What comes in What goes out
All expense and losses All income and gains

Let us now understand the mechanism of posting transaction into the ledger account. Consider the transaction:
Rent paid in cash for ` 10,000. The journal entry for this transaction would be:
Jan 15 Rent A/c Dr. 10,000
To, Cash A/c 10,000
We will open two ledger accounts namely Rent A/c and Cash A/c. Let us see how the posting is made

Rent Account
Dr. Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
Jan15 To, Cash A/c 10,000

Cash Account
Dr. Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
Jan 15 By Rent A/c 10,000

Please observe the following conventions while posting a transaction into ledger accounts. Note that both the
effects of an entry must be recorded in the ledger accounts simultaneously.
(1) The posting in the account which is debited, is done on the debit side by writing the name of the account or
accounts that are credited with the prefix ‘To’.
(2) The posting in the account which is credited, is done on the credit side by writing the name of the account
or accounts that are debited with the prefix ‘By’.
Let us now see how we can create ledger account for the seven journal entries that we passed for Illustration 18.
Folio No. 1

Dr. Cash Account Cr.

Date Particulars J. F. Amount Date Particulars J. F. Amount
(`) (`)
1.4.2013 To Vikas’s capital A/c 1 500,000 10.4.2013 By Furniture A/c 1 25,000
1.4.2013 To Vaibhavi’s capital A/c 1 250,000 11.4.2013 By Punjab National Bank A/c 1 1,00,000
30.4.2013 By Balance c/d 6,25,000
750,000 7,50,000
1.5.2013 To Balance b/d 625,000

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 FINANCIAL ACCOUNTING

Folio No. 2
Dr. Mr. Vikas’s Capital Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
30.4.2013 To Balance c/d 5,00,000 1.4.2013 By Cash A/c 1 5,00,000
5,00,000 5,00,000
1.5.2013 By Balance b/d 5,00,000

Folio No. 3
Dr. Mrs. Vaibhavi’s Capital Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
1.4.2013 By Cash A/c 1 2,50,000
Folio No. 4
Dr. Furniture Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
10.04.2013 To Cash 25,000

Folio No. 5
Dr. Punjab National Bank Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
11.4.2013 To Cash A/c 1 1,00,000 15.4.2013 By Rent A/c 1 15,000
25.4.2013 To Consultancy Fees A/c 1 2,50,000 20.4.2013 By Motor Car A/c 1 50,000

Folio No. 6
Dr. Rent Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
15.4.2013 To Punjab National Bank A/c 1 15,000

Folio No. 7
Dr. Motor Car Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
20.4.2013 To Punjab National Bank A/c 1 50,000
“ To Loan from HDFC Bank A/c 1 4,00,000
Folio No. 8
Dr. Loan from HDFC Bank Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
20.4.2013 By Motor Car A/c 1 4,00,000

Folio No. 9
Dr. Avon Pharmaceuticals Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
25.4.2013 To Consultancy Fees A/c 1 7,50,000

Folio No. 10
Dr. Consultancy Fees Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
25.4.2013 By Punjab National Bank A/c 1 2,50,000
25.4.2013 By Avon Pharmaceuticals A/c 1 7,50,000

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Folio No. 11
Dr. Salary Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
30.4.2013 To Salary payable A/c 1 15,000

Folio No. 12
Dr. Salary Payable Account Cr.
Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
30.4.2013 By Salary A/c 1 15,000

Please carefully observe the posting of journal entries into various ledger accounts. Do you see some further
calculation in the cash A/c and Mr. Vikas’s Capital A/c? What is done is that after posting all transactions to
these accounts, the difference between the debit and credit sides is calculated. This difference is put on the
side with smaller amount in order to tally grand totals of both sides. The convention is to write “To Balance c/d” or
“By Balance c /d” as the case may be. This procedure is normally done at the end of an accounting period. This
process is called as “balancing of ledger accounts’.
Once the ledgers are balanced for one accounting period, the balance needs to be carried forward to the next
accounting period as a running balance. This is done by writing “To Balance b/d” or “By balance b/d” as the case
may be after the grand totals. This is also shown in the Cash A/c and Mr. Vikas’s Capital Account.
Could you now attempt to balance the other ledger accounts and carry the balances to the next accounting
period?
Important note : Please remember that the balances of personal and real accounts only are carried down to the
next accounting period as they represent resources and obligations of the business which will continue to be used
and settled respectively in future. Balances of nominal accounts (which represent incomes or gains and expenses
or losses) are not carried down to the next period. These balances are taken to the Profit and Loss Account (or
Income statement) prepared for the period. The net result of the P & L Account will show either net income or net
loss which will increase or decrease the owner’s equity.
In the above example, please note that the balances of Rent A/c, Consultancy Fees Account and Salary Account
will not be carried down to the next period, but to the P & L Account of that period.
Posting to Ledger Accounts from Subsidiary books
In the above section, we explained posting to ledger accounts directly on the basis of journal entries. In practice,
however, we know that use of subsidiary books is in vogue. Let us see how the posting to ledger accounts is done
based on these records.
For each of the subsidiary books, there is a ledger account e.g. for purchase book, there is Purchase Account, for
sales book there’s Sales A/c, for cash book there will be Cash A/c as well as Bank A/c and so on.
Let us continue with illustration seen in the section 1.17.3.1.3 above and post the totals into respective ledger
accounts. It considered that there was a Purchase of ` 19,000 and Sales of ` 1,72,500.

Dr. Cash Account Cr.

Date Particulars J. F. Amount Date Particulars J. F. Amount
(`) (`)
1st Jan To Balance b/d 3,800 By Wages A/c 1,500
To Bank A/c 2,500 By Balance c/d 4,800
6,300 6,300

Dr. Purchases Account Cr.

Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
To Sundries as per purchase 19,000 By Transfer to 19,000
book P & L A/c

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Dr. Sales Account Cr.

Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)
To Transfer to P & L A/c 1,72,500 By Sundries as 1,72,500
per sales book

Typical Ledger Account Balances

We have seen how to balance various ledger accounts. It can be seen that while some accounts will show debit
balance, while the other will show credit balance. Is there any relationship between the type of account (whether
it is the account of asset, liability, capital, owner’s equity, incomes or gain, expenses or losses) and the kind of
balance (debit or credit) it should show?
The answer is generally ‘Yes’. You may test to find the following are typical relationships.

Type of Account Type of balance

All asset accounts Debit balance
All liability accounts Credit balance
Capital & Owner’s equity account Credit balance
Expenses or loss accounts Debit balance
Incomes or gain accounts Credit balance
Let us test these possibilities for confirmation. How does one go about testing this? Consider ‘Cash A/c’. Whenever
business receives cash we debit it, and whenever it is paid we credit it. Is it possible to see a situation that credits
to cash are more than debits? In other words could we have negative cash in hand? No. Cash account will
therefore always show a debit balance. So is true for all real asset accounts. After solving problems, if the contrary
is observed, there is every chance that an error has been made while passing the accounting entries.
The Structure of Ledger
In practice, for the sake of convenience and ease of operations, the ledger is subdivided as follows:
(a) General Ledger: This contains all main ledger accounts excepting individual accounts of customers, vendors
and employees. For these categories there will be only one representative account in the general ledger
e.g. for customers – Trade Debtors A/c (or Trade Receivables Control A/c), for suppliers – Trade Creditors A/c
(or Trade Payables A/c) etc.
(b) Sub-Ledgers: These are primarily, Customers’ Ledger, Suppliers Ledger, Employees ledger etc. The customer
ledger will have all individual accounts of all customers. Suppliers’ ledger will have all individual accounts of
all suppliers. Employee ledger will have individual accounts of all employees.
The balances of all individual accounts must tally with the balance reflected in the representative A/c in the
general ledger. For this a periodical reconciliation is a must.
For example, if business has 3 customers A, B, and C; then an A/c for each of them is opened in the sub-ledger
called Customers Ledger and General Ledger will have only one A/c by the name of Trade Debtors A/c. All
transactions with each of them will be recorded in the individual accounts as well as the control ledger. See the
following:

Transaction
Customers’ Sub-ledger General ledger

Credit sales to A `10,000

Credit sales to B ` 20,000 A’s A/c - Debit ` 10,000
Credit sales to C ` 15,000
B’s A/c - Debit ` 20,000
Trade Debtors A/c-
Debit ` 45,000
C’s A/c - Debit ` 15,000

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Such separation is made for better control. A person in charge of customer accounting is given responsibility of
all individual customer accounting in the Customers sub-ledger, whereas another person be given responsibility
for Suppliers’ sub-ledger. In bigger organizations this division of labour is an absolute necessity. The person looking
after General ledger is different.
Simultaneous posting of transactions into sub-ledgers A/cs and representative A/cs in general ledger may be quite
tedious in manual accounting. But computerised accounting automates this process as well.

Subdivisions of Ledger
Practically, the Ledger may be divided into two groups -
(a) Personal Ledger & (b) Impersonal Ledger. They are again sub-divided as :

LEDGER

PERSONAL LEDGER IMPERSONAL LEDGER

Debtors’ Ledger Creditors’ Ledger Cash Book General Ledger

Nominal Ledger Private Ledger

Personal Ledger: The ledger where the details of all transactions about the persons who are related to the
accounting unit, are recorded, is called the Personal Ledger.
Impersonal Ledger: The Ledger where details of all transactions about assets, incomes & expenses etc. are
recorded, is called Impersonal Ledger.
Again, Personal Ledger may be divided into two groups:
Viz. (a) Debtors’ Ledger, & (b) Creditors’ Ledger.

(a) Debtors’ Ledger: The ledger where the details of transactions about the persons to whom goods are sold,
cash is received, etc. are recorded, is called Debtors’ Ledger.

(b) Creditors’ Ledger: The ledger where the details of transactions about the persons from whom goods are
purchased on credit, pay to them etc. are recorded, is called Creditors’ Ledger.

Impersonal Ledger may, again be divided into two group, viz, (a) Cash Book; and (b) General Ledger.

(a) Cash Book: The Book where all cash & bank transactions are recorded, is called Cash Book.

(b) General Ledger: The ledger where all transactions relating to real accounts, nominal accounts, details of
Debtors’ Ledger and Creditors’ Ledger are recorded, is called General Ledger.

General Ledger may, again, be divided into two groups. Viz, Nominal Ledger; & Private Ledger.

(a) Nominal Ledger: The ledger where all transactions relating to incomes and expenses are recorded, is called
Nominal Ledger.

(b) Private Ledger: The Ledger where all transactions relating to assets and liabilities are recorded, is called
Private Ledger.

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Advantages of sub-division of Ledger.

The advantages of sub-division of ledger are:
(a) Easy to Divide work : As a result of sub-division, the division of work is possible and records can be maintained
efficiently by the concerned employee.
(b) Easy to handle : As a result of sub-division, the size and volume of ledger is reduced.
(c) Easy to collect information: From the different classes of Ledger a particular type of transactions can easily
be found out.
(d) Minimizations of mistakes: As a result of sub-division, chances of mistakes are minimized.
(e) Easy to compute: As a result of sub-division, the accounting work may be computed quickly which is very
helpful to the management.
(f) Fixation of responsibility: Due to sub-division, allotment of different types of work to different employees is
done for which concerned employee will be responsible.
Trial Balance
After the transactions are posted to various ledger accounts (either from journal or from subsidiary books) and they
are balanced, the next stage is to draw up the list of all balances. We know that some ledger accounts will show
‘debit balance’ (debit side greater than the credit side), while the other will reflect a ‘credit balance’ (credit side
being higher than debit side). All account balances are listed to ensure that the total of all debit balances equals
the total of all credit balances. Why does this happen? Remember the dual aspect concept studied earlier in this
study note?. According to this concept, every debit has equal corresponding credit. This list of balances is called
Trial Balance.
According to the Dictionary for Accountants by Eric. L. Kohler, Trial Balance is defined as “a list or abstract of the
balances or of total debits and total credits of the accounts in a ledger, the purpose being to determine the
equality of posted debits and credits and to establish a basic summary for financial statements”. According to
Rolland, “The final list of balances, totaled and combined, is called Trial Balance”.
As this is merely a listing of balances, this will always be as on a particular date. Further it must be understood
that Trial Balance does not form part of books of account, but it is a report prepared by extracting balances of
accounts maintained in the books of accounts.
When this list with tallied debit and credit balances is drawn up, the arithmetical accuracy of basic entries, ledger
posting and balancing is ensured. However, it does not guarantee that the entries are correct in all respect. This
will be explained later in this chapter.
Although it is supposed to be prepared at the end of accounting period, computerized accounting packages
are capable of providing instant Trial Balance reports even on daily basis, as the transactions are recorded almost
on line.
Let us prepare the trial balance for the ledger accounts from the illustration 18.
Trial Balance as on...
Account name Debit (`) Credit (`)
Cash A/c 6,25,000
Vikas’s capital A/c 5,00,000
Vaibhavi’s capital A/c 2,50,000
Furniture A/c 25,000
Punjab National Bank A/c 2,85,000
Rent A/c 15,000
Motor Car 4,50,000
Loan from HDFC A/c 4,00,000
Avon Pharmaceuticals 7,50,000
Consultancy fees A/c 10,00,000
Salary A/c 15,000
Salary payable A/c 15,000
Total 21,65,000 21,65,000

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It can be seen that the totals of debit and credit balances is exactly matching. This is the result of double entry
book-keeping wherein every debit has equal corresponding credit.
Feature’s of a Trial Balance
1. It is a list of debit and credit balances which are extracted from various ledger accounts.
2. It is a statement of debit and credit balances.
3. The purpose is to establish arithmetical accuracy of the transactions recorded in the Books of Accounts.
4. It does not prove arithmetical accuracy which can be determined by audit.
5. It is not an account. It is only a statement of account.
6. It is not a part of the final statements.
7. It is usually prepared at the end of the accounting year but it can also be prepared anytime as and when
required like weekly, monthly, quarterly or half-yearly.
8. It is a link between books of accounts and the Profit and Loss Account and Balance Sheet.
Preparation of Trial Balance:
1. It may be prepared on a loose sheet of paper.
2. The ledger accounts are balanced at first. They will have either “debit-balance” or “credit balance” or “nil-
balance”.
3. The accounts having debit-balance is written on the debit column and those having credit-balance are
written on the credit column.
The sum total of both the balances must be equal, for “Every debit has its corresponding and equal credit”.
Purpose of a Trial Balance
It serves the following purposes :
1. To check the arithmetical accuracy of the recorded transactions.
2. To ascertain the balance of any Ledger Account.
3. To serve as an evidence of fact that the double entry has been completed in respect of every transaction.
4. To facilitate the preparation of final accounts promptly.
Is Trial Balance indispensable?
It is a mere statement prepared by the accountants for his own convenience and if it agrees, it is assumed that at
least arithmetical accuracy has been done although there may be a lot of errors.
Trial Balance is not a process of accounts, but its preparation helps us to finalise the accounts. Since it is prepared
on a particular date, as at ........ / as on ........ is stated.
Trial Balance – Utility and Interpretation
The utility of Trial balance could be found in the following:
(1) It forms the basis for preparation of Financial Statements i.e. Profit and Loss Account and Balance Sheet.
(2) A tallied trial balance ensures the arithmetical accuracy of the entries made. If the trial balance does not
tally, the errors can be found out, rectified and then financial statements can be prepared.
(3) It acts as a quick reference. One can easily find out the balance in any ledger account without actually
referring to the ledger.
(4) If the listing of ledger accounts is systematically done in the trial balance, one can do quick time analysis.
Hence, listing is usually done in the sequence of Asset accounts, Liability accounts, Capital accounts, Owner’s
equity accounts, Income or gain accounts and Expenses or losses accounts in that order.
One can draw some quick inferences from trial balance by interpreting the same. If one plots monthly trial balances
side by side, one can analyse the movement of balances in various accounts e.g. one can see how expenses
are increasing or decreasing or showing a trend of movements. By comparing the owner’s equity balances as on
two dates, one can interpret the business result e.g. if the equity has gone up, one can interpret that business has
earned net profit and vice versa.

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Trial Balance and Errors

We have seen that a tallied Trial Balance (T. B.) ensures arithmetical accuracy. What does it mean? It means
entries have been passed as per double entry, that every debit has equal corresponding credit. If the T.B. does not
tally, there could be errors in transaction entry. Such errors are called ‘Errors affecting trial balance’. These can be:
(a) Only one effect of a transaction is posted to ledger e.g. for rent paid in cash, if entry is posted to cash but not
to rent account, then obviously the T.B. will not match.
(b) Posting of wrong amount in one of the ledger accounts e.g. rent of ` 1,000 is paid in cash. The posting to Rent
A/c is done for ` 1,000, Cash A/c is recorded at ` 10,000. The T.B. will not tally.
(c) If one of the posting is entered twice, T.B. will not match.
(d) If the balance in a ledger is not correctly taken to the T.B. e.g. the Rent A/c has a balance of `1,000, but while
taking it to the T.B. it is taken as ` 100, the T.B. will through up difference.
(e) Taking balance to the wrong side in the T.B. e.g. a debit balance of ` 5,00,000 in Debtors A/c is taken as credit
balance in the TB, then there will be a mismatch.
(f) Wrong carry forwards also will result in the T.B. mismatch.
No financial statements can be prepared if the T.B. does not tally. Hence, the errors will have to be rectified before
proceeding further. The accountants therefore endeavour to minimize errors by being more careful and by doing
periodical scrutiny of the entries.
Errors which are not disclosed by a Trial Balance
The following errors cannot be detected by a Trial Balance :
(a) Errors of Omission: When the transaction is not at all recorded in the books of accounts, i.e. neither in the
debit sider nor in the credit side of the account – trial balance will agree.
(b) Errors of Commission: Where there is any variation in figure/amount, e.g. instead of ` 800 either ` 80 or ` 8,000
is recorded, in both sides of ledger accounts – trial balance will agree.
(c) Errors of Principal: When accounts are prepared not according to double entry principle e.g. Purchase of a
Plant wrongly debited to Purchase Account – Trial balance will agree.
(d) Errors of Misposting: When wrong posting is made to a wrong account instead of a correct one although
amount is correctly recorded, e.g., sold goods to B but wrongly debited to D’s Account – trial balance will
agree.
(e) Compensating Errors: When one error is compensated by another error e.g. Discount Allowed `100 not
debited to Discount Allowed Account, whereas interest received `100, but not credit to Interest Account –
trial balance will agree.
Procedure to locate Errors:
If the Trial Balance does not agree, the following procedure should carefully be followed:
(i) At first, check all ledger account balance one by one.
(ii) Addition of both the columns (Debit and Credit) should be checked.
(iii) If any difference comes divide the same by 2 and see whether the said figure appear on the correct side or
not.
(iv) Additions of the subsidiary books, and ledger accounts to be checked up.
(v) Posting from subsidiary books to the ledger to be checked up.
(vi) Opening balance of all account whether brought forward correctly or not to be checked up.
(vii) Even if the trial balance does not agree upto this level checking should be started again from the journal and
book of original entry using tick mark.
Illustration 14.
From the following ledger account balances, prepare a Trial Balance of Mr. Sen for the year ended 31st March,2013.
Capital ` 80,000 ; Sales `10,00,000; Adjusted Purchase ` 8,00,000; Current A/c(Cr) ` 10,000; Petty Cash ` 10,000;
Sales Ledger Balance ` 1,20,000; Purchase Ledger Balance ` 60,000; Salaries `24,000; Carriage Inwards ` 4,000;
Carriage Outward ` 6,000; Discount Allowed ` 10,000; Building ` 80,000; Outstanding Expenses ` 10,000; Prepaid

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Insurance ` 2,000 ; Depreciation ` 4,000 ; Cash at Bank ` 80,000 ; Loan A/c (Cr) ` 66,000; Profit & Loss A/c(Cr) `
20,000; Bad Debts Recovered ` 2,000 ; Stock at 31.03.2013 ` 1,20,000; Interest Received ` 10,000; Accrued Interest
` 4,000; Investment ` 20,000; Provision for Bad Debts (01.04.2012) ` 6,000 ; General Reserve ` 20,000.
Solution:
Trial Balance of Mr. Sen
Dr. as on 31st March, 2013 Cr.
Heads of Accounts Amount (`) Heads of Accounts Amount (`)
Adjusted Purchase 8,00,000 Capital 80,000
Petty Cash 10,000 Sales 10,00,000
Sales Ledger Balance 1,20,000 Current A/c 10,000
Salaries 24,000 Purchase Ledger Balance 60,000
Carriage Inward 4,000 Outstanding Expenses 10,000
Discount Allowed 10,000 Loan A/c 66,000
Building 80,000 Profit & Loss A/c(cr) 20,000
Prepaid Insurance 2,000 Bad Debts Recovered 2,000
Depreciation 4,000 Interest Received 10,000
Cash at Bank 80,000 Provision for Bad debts 6,000
Stock (31.03.2013) 1,20,000 General Reserve 20,000
Accrued Interest 4,000
Investment 20,000
Carriage outward 6,000
12,84,000 12,84,000
Note: Closing Stock will appear in Trial Balance since there is adjusted purchase.
Adjusted purchase = Opening Stock + Purchase - Closing Stock.
It may be noted that if only adjusted purchase is considered then the matching concept is affected. Hence, to
satisfy the matching concept, closing stock is also considered in Trial Balance.
Measurement, Valuation and Accounting Estimates
At the end of the last section, it was stated that Trial Balance forms the basis for preparing financial statements.
However, there are certain other tasks that have to be completed before these final accounts are prepared. You
know that accounting entries are made on the basis of actual transactions carried out during an accounting
period. These are all included in the trial balance. However, there could be certain other business realities which
are to be recognized as either asset, liability, income, gain, expense, loss or a combination thereof. As we know
the matching concept necessitates the consideration of all aspects which may affect the financial result of the
business. Technically these are called as adjustments for which entries need to be passed, without which the
financial statements will not give a true and fair view of business activity. We discuss some of these entries and
adjustments in the following sections.
Before discussing these, let us understand the meaning of Income Statement and Balance Sheet.

Trial Balance based on ledger balances

Income Statement shows income & Balance Sheet shows assets and liabilities
gains and expenses & losses for an & owner’s equity. Profit or loss from income
accounting period. The net result is statement is added or deducted from
profit or loss. owner’s capital or equity.

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Depending on the nature of business, the income statement is prepared in different forms like:
(a) In case of manufacturing concern, a Manufacturing, Trading and P & L A/c is prepared.
(b) In case of a trading or service organization, a Trading and P & L A/c is prepared.
The Manufacturing or Trading Accounts show Gross margins (or gross losses) and the P & L A/c shows Net Profit or
Net Loss.
The Balance Sheet exhibits the list of assets (which indicate resources owned) and the liabilities & owners’capital
and equity (which shows how the resources are funded).
For company type of organizations, standard formats for P & L and Balance Sheet are given in the Companies Act
that is to be adhered to. The accounting should be as per the prescribed Accounting Standards.

Closing Stock
We know when goods are purchased for resale we include them in Purchases A/c, while goods sold are shown in
Sales A/c. At the end of accounting period, some of these goods may remain unsold. If we show the entire cost of
purchases in income statement, it will not be as per the matching concept. We should only show the cost of those
goods that are sold during the period. The balance cost should be carried forward to the next accounting period
through the balance sheet. How should the closing stock be valued? According to the conservative principle,
the stock is valued at lower of cost or market price. If cost of stock is ` 125000 and its realizable market price is only
` 115000, then the value considered is ` 115000 only. What it means is the difference of ` 10000 is charged off to the
current periods profits.
Students are advised to refer to Accounting Standard 2 - ‘Valuation of Inventories’ to get thorough knowledge.
Please remember the closing stock figure does not appear in the trial balance, but is valued and directly taken to
the P & L A/c. The entry passed for this is:

Closing Stock A/c Dr.

To Trading and P & L A/c

In solving the examination problem, this entry is not actually passed, but the effect of its outcome is given. Here,
one effect is “show closing stock as asset in Balance Sheet” and second effect is “show it on the credit side of
Trading A/c”.
Note : But, if the closing stock appears in the debit side of Trial Balance, it means it has already been adjusted
against purchases. In that case, the closing stock will appear only in the asset side of the Balance Sheet.
Depreciation
When the business uses its assets to earn income, there is wear and tear of the asset life. Assets will have limited
life and as we go on using it, the value diminishes. Again the question to be asked is – at what value should the
asset be shown in the balance sheet? Consider a machine was bought on 1st April 2012 for ` 2,00,000. It’s used for
production activity throughout the year. When the final accounts are being prepared, at what value should it be
shown in Balance Sheet as on 31st March 2013?
Well, according to cost principle initial entry for purchase of machine is shown at cost paid for it e.g. `2,00,000 in
this case. But the fact that the machine is used must be recognized in financials. Hence the value in the Balance
sheet must be brought down to the extent of its use. This is called as Depreciation. How is it calculated? While there
are different methods of calculating depreciation (explained in subsequently), the simple idea is to spread it over
the useful life of the asset, so that at the end of its life the value is zero. In our example, if useful life of the machine
is taken as 10 years, the depreciation will be simply ` 2,00,000 ÷ 10 i.e. ` 20,000 every year. So a depreciation of
` 20,000 will be charged to the profit of every year and value of asset will be brought down by the same value.
Students are advised to refer to Accounting Standard 6 issued by ICAI to get thorough knowledge on Depreciation
accounting.

The entry passed for this is:

Depreciation A/c Dr.
To Fixed Asset A/c

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The effect given is one – include in the P & L A/c as expense for the period and two – reduce from asset value in
the Balance Sheet.
Accrued Expenses or Outstanding Expenses
There may be expenses incurred for the current accounting period, but not actually paid for. The matching
concept, however, necessitates that this expense must be recognized as expense for the current year and should
not be deferred till its actual payment. Typically, we know salary for the month is normally paid in the 1st week of
the next month. Imagine the accounting period close on 31st March. The salary for the month of March is not paid
till 31st March. But is it is related to this month, it must be booked as expense for the current month and also as a
liability payable in the next month (which is in next accounting period). This can be shown as follows:

March salary paid in April

Mar 2013 Apr 2013

The entry for this is:

Expense A/c Dr.
To Outstanding Expense A/c or Expense payable A/c

The two effects when preparing the final accounts are:

One – add in respective expense in P & L A/c and two – show as a liability in the Balance Sheet.

Prepaid Expenses
At times we may pay for certain expenses which are period related. For example, the business has taken an
insurance policy against fire on which the annual premium payable is ` 75,000. The policy is taken on 1st January 2013
valid till 31st December 2013. But the company’s accounting period ends on 31st March 2013. When considering
the insurance expense for the accounting year, what amount should be considered? See the following.
As can be seen, out of the total premium period of 12 months, only 3 months are related to the current accounting
period and the remaining 9 months’ premium is related to the next accounting period. Hence only 3 months’
premium is to be considered as expense for the current year i.e. ` 18750 (75000 ÷ 4).
The entry for this is:

for Current Year 31st Mar 2013 Prepaid amount

9 months
3 months

1st Jan 2013 31st Dec 2013

12 months

Prepaid Insurance A/c Dr.

To Insurance A/c
The two effects while preparing final accounts are:
One – Reduce from respective expense in P & L A/c and two – show as an asset in the Balance Sheet.

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Accrued Incomes
Just as expenses accrue, there are instances of income getting accrued at the end of accounting period. The
extent to which it accrues, it must be booked as income for the current accounting period. Consider, the business
has put a One year fixed deposit of ` 1,00,000 with Citi Bank at a fixed interest of 9 % p.a. on 1st February 2013 and
the interest is credited by the bank on a semi-annual basis. Also, consider that the accounting period ends on 31st
March 2013. The Citi bank will credit the 1st semi-annual interest on 31st July 2013 and the next on 31st January
2014. Now, consider the following:

31st Mar

10 months
2 months

1st Feb 2013 31st Jan 2014

12 months

It can be noticed that interest for the 2 months will be considered as accrued as on 31st of March 2013 and must
be taken as income for the current accounting year.
The entry for this is:
Accrued Interest A/c Dr.
To Interest A/c
The two effects while preparing final accounts are:
One – Show as income in the P & L A/c and two – show as an asset in the Balance Sheet.
Income Received in Advance
If an income is received which is not related to the current accounting period, it cannot be included in the current
year’s P & L A/c. So, if it’s already included as income it must be reduced. The entry for this is:
Respective Income A/c Dr.
To Income received in advance A/c
The effects while preparing final account are:
One – Reduce from respective income and two – show it as liability in Balance Sheet.

Illustration 15.
Journalize the following transactions in the books of Gaurav, post them into ledger and prepare trial balance for
June 2013 :
June 1: Gaurav started business with ` 10,00,000 of which 25% amount was borrowed from wife.
June 4: Purchased goods from Aniket worth ` 40,000 at 20% TD and 1/5th amount paid in cash.
June 7: Cash purchases ` 25,000.
June 10: Sold goods to Vishakha ` 30,000 at 30% TD and received 30% amount in cash.
June 12: Deposited cash into bank ` 20,000.
June 15: Uninsured goods destroyed by fire ` 5,500.
June 19: Received commission ` 3,500.

52 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Fundamentals of Accounting

June 22: Paid to Aniket ` 25,500 in full settlement of A/c.

June 25: Cash stolen from cash box ` 1,000.
June 27: Received from Vishakha ` 14,500 and discount allowed ` 200.
June 30: Interest received ` 2,400 directly added in our bank account.
Solution:
In the books of Gourav
Journal Entries
Dr. Cr.
Date Particulars L.F. Amount (`) Amount (`)
2013 Cash A/c Dr. 10,00,000
1-Jun
To Capital A/c 7,50,000
To Loan from Wife A/c 2,50,000
(Being capital brought into business)
4-Jun Purchases A/c Dr. 32,000
To Cash A/c 6,400
To Aniket’s A/c 25,600
(Being goods purchased at 20% TD & 1/5th amount
paid in cash)
7-Jun Purchases A/c Dr. 25,000
To Cash A/c 25,000
(Being cash purchases)
10-Jun Cash A/c Dr. 6,300
Vishakha’s A/c Dr. 14,700
To Sales A/c 21,000
(Being goods sold at 30% TD & 30% amount received
in cash)
12-Jun Bank A/c Dr. 20,000
To Cash A/c 20,000
(Being cash deposited in bank)
15-Jun Loss by Fire A/c Dr. 5,500
To Purchases A/c 5,500
(Being uninsured goods lost by fire)
19-Jun Cash A/c Dr. 3,500
To Commission A/c 3,500
(Being commission received)
22-Jun Aniket’s A/c Dr. 25,600
To Cash A/c 25,500
To Discount A/c 100
(Being paid to Aniket in full settlement & discount
received)
25-Jun Loss by Theft A/c Dr. 1,000
To Cash A/c 1,000
(Being cash stolen)
27-Jun Cash A/c Dr. 14,500
Discount A/c 200
To Vishakha’s A/c
(Being amount received from Vishakha & discount 14,700
allowed)

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 FINANCIAL ACCOUNTING

30-Jun Bank A/c 2,400

To Interest A/c 2,400
(Being interest received directly added into bank
account)
1,150,700 1,150,700

Dr. Cash Account Cr.

Date Particulars J.F. Amount (`) Date Particulars J.F. Amont (`)
1/6/13 To Capital A/c 7,50,000 4/6/13 By PurchasesA/c 6,400
1/6/13 To Loan from Wife A/c 2,50,000 7/6/13 By Purchases A/c 25,000
10/6/13 To Sales A/c 6,300 12/6/13 By Bank A/c 20,000
19/6/13 To Commission A/c 3,500 22/6/13 By Aniket’s A/c 25,500
27/6/13 To Vishakha’s A/c 14,500 25/6/13 By Loss by Theft A/c 1,000
30/6/13 By Balance c/d 9,46,400
10,24,300 10,24,300
1/7/13 To Balance b/d 9,46,400

Dr. Capital Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
30/6/13 To Balance c/d 7,50,000 1/6/13 By Cash A/c 7,50,000
7,50,000 7,50,000
1/7/13 By Balance b/d 7,50,000

Dr. Loan from Wife Account Cr.

Date Particulars J.F. Amount (`) Date Particulars J.F. Amt. (`)
30/6/13 To Balance c/d 2,50,000 1/6/13 By Cash A/c 2,50,000
2,50,000 2,50,000
1/7/13 By Balance b/d 2,50,000

Dr. Purchases Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
4/6/13 To Cash A/c 6,400 15/6/13 By Loss by fire 5,500
4/6/13 To Aniket’s A/c 25,600 30/6/13 By Balance c/d 51,500
7/6/13 To Cash A/c 25,000
57,000 57,000
1/7/13 To Balance b/d 51,500

Dr. Aniket’s Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
22/6/13 To Cash A/c 25,500 4/6/13 By Purchases A/c 25,600

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Fundamentals of Accounting

22/6/13 To Discount A/c 100

25,600 25,600

Dr. Vishakha’s Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
10/6/13 To Sales A/c 14,700 27/6/13 By Cash A/c 14,500
27/6/13 By Discount A/c 200
14,700 14,700

Dr. Sales Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
30/6/13 To Balance c/d 21,000 10/6/13 By Cash A/c 6,300
10/6/13 By Vishakha’s A/c 14,700
21,000 21,000
1/7/13 By Balance b/d 21,000

Dr. Bank Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
12/6/13 To Cash A/c 20,000 30/6/13 By Balance c/d 22,400
30/6/13 To Interest A/c 2,400
22,400 22,400
1/7/13 To Balance b/d 22,400

Dr. Loss by Fire Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
15/6/13 To Purchases A/c 5,500 30/6/13 By Balance c/d 5,500
5,500 5,500
1/7/13 To Balance b/d 5,500

Dr. Commission Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
30/6/13 To Balance c/d 3,500 19/6/13 By Cash A/c 3,500
3,500 3,500
1/7/13 By Balance b/d 3,500

Dr. Discount Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
27/6/13 To Vishakha’s A/c 200 22/6/13 By Aniket’s A/c 100
30/6/13 By Balance c/d 100
200 200

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 FINANCIAL ACCOUNTING

1/7/13 To Balance b/d 100

Dr. Loss by Theft Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
25/6/13 To Cash A/c 1,000 30/6/13 By Balance c/d 1,000
1,000 1,000
1/7/13 To Balance b/d 1,000

Dr. Interest Account Cr.

Date Particulars J.F. Amt. (`) Date Particulars J.F. Amt. (`)
30/6/13 To Balance c/d 2,400 30/6/13 By Bank A/c 2,400
2,400 2,400
1/7/13 By Balance b/d 2,400

Trial Balance as on 30.6.13

Dr. Cr.
Name of Account (`) (`)
Cash A/c 9,46,400 -----
Capital A/c ----- 7,50,000
Loan from Wife A/c ----- 2,50,000
Purchases A/c 51,500 -----
Aniket’s A/c ----- -----
Vishakha’s A/c ----- -----
Sales A/c ----- 21000
Bank A/c 22,400 -----
Loss by Fire A/c 5,500 -----
Commission A/c ----- 3500
Discount A/c 100 -----
Loss by Theft A/c 1,000 -----
Interest A/c ----- 2,400
Total 10,26,900 10,26,900

1.5 ACCOUNTING FOR DEPRECIATION

A business or concern holds fixed assets for regular use and not for resale. The capability of a fixed asset to render
service cannot be unlimited. Except land, all other fixed assets have a limited useful life. The benefit of a fixed asset
is received throughout its useful life. So its cost is the price paid for the ‘Series of Services’ to be received or enjoyed
from it over a number of years and it should be spread over such years.
Depreciation means gradual decrease in the value of an asset due to normal wear and tear, obsolescence etc. In
short, depreciation means the gradual diminution, loss or shrinkage in the utility value of an asset due to wear and
tear in use, effluxion of time or introduction of technology in the market. A certain percentage of total cost of fixed
assets which has expired and as such turned into expense during the process of its use in a particular accounting
period.
“Depreciation accounting is a system of accounting which aims to distribute the cost or other basic value of
tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of
assets) in a systematic and rational manner. It is a process of allocation, not of valuation. Depreciation for the year
is the portion of the total charge under such a system that is allocated to the year. Although the allocation may

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Fundamentals of Accounting

properly take into account occurrences during the year, it is not intended to be the measurement of the effect of
all such occurrences.”
The above definition may be criticized as under:
(i) It does not classify properly what is meant by systematic and rational manner. The word ‘rational’ may mean
that it should reasonably be related to the expected benefits in any case.
(ii) Historical cost and any other kind of cost should be allocated or not does not defined by this definition.
(iii) Some Accountants are in a belief that depreciation is nothing but an arbitrary allocation of cost. According
to them, all the conventional methods say allocation of historical cost over a number of years is arbitrary.
Certain Useful Terms
Amortization - Intangible assets such as goodwill, trademarks and patents are written off over a number of
accounting periods covering their estimated useful lives. This periodic write off is known as Amortization and that is
quite similar to depreciation of tangible assets. The term amortization is also used for writing off leasehold premises.
Amortization is normally recorded as a credit to the asset account directly or to a distinct provision for depreciation
account. Though the write off of intangibles that have no limited life is not approved by some Accountants, some
concerns do amortize such assets on the ground of conservatism.
Depletion - This method is specially suited to mines, oil wells, quarries, sandpits and similar assets of a wasting
character. In this method, the cost of the asset is divided by the total workable deposits of the mine etc. And
by following the above manner rate of depreciation can be ascertained. Depletion can be distinguishable
from depreciation in physical shrinkage or lessening of an estimated available quantity and the latter implying a
reduction in the service capacity of an asset.
Obsolescence – The term ‘Obsolescence’ refers to loss of usefulness arising from such factors as technological
changes, improvement in production methods, change in market demand for the product output of the asset or
service or legal or medical or other restrictions. It is different from depreciation or exhaustion, wear and tear and
deterioration in that these terms refer to functional loss arising out of a change in physical condition.
Dilapidation - In one sentence Dilapidation means a state of deterioration due to old age or long use. This term
refers to damage done to a building or other property during tenancy.
Nature of Depreciation
Depreciation is a term applicable in case of plant, building, equipment, machinery, furniture, fixtures, vehicles,
tools etc. These long-term or fixed assets have a limited useful life, i.e. they will provide service to the entity (in the
form of helping in the generation of revenue) over a limited number of future accounting periods. Depreciation
implies gradual decrease in the value of an asset due to normal wear and tear, obsolescence etc. In short,
depreciation means the gradual diminution, loss or shrinkage in the utility value of an asset due to wear and tear in
use, effluxion of time or introduction of technology in the market. It makes a part of the cost of assets chargeable
as an expense in profit and loss account of the accounting periods in which the assets helped in earning revenue.
Thus, International Accounting Standard (IAS)-4 provides that “Depreciation is the allocation of the depreciable
amount of an asset over its estimated useful life.”
In Accounting Research Bulletin No. 22, AICPA observed that “Depreciation for the year is the portion of the total
charge under such a system that is allocated to the year. Although the allocation may properly take into account
occurrences during the year, it is not intended to be the measurement of the effect of all such occurrences.”
Causes of Depreciation
A. Internal Causes
(i) Wear and tear : Plant & machinery, furniture, motor vehicles etc. suffer from loss of utility due to vibration,
chemical reaction, negligent handling, rusting etc.
(ii) Depletion (or exhaustion) : The utility or resources of wasting assets (like mines etc.) decreases with
regular extractions.
B. External or Economic Causes
(i) Obsolescence : Innovation of better substitutes, change in market demand, imposition of legal
restrictions may result into discarding an asset.
(ii) Inadequacy : Changes in the scale of production or volume of activities may lead to discarding an
asset.
C. Time element : With the passage of time some intangible fixed assets like lease, patents, copy-rights etc., lose
their value or effectiveness, whether used or not. The word “amortization” is a better term to speak for the
gradual fall in their values.

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 FINANCIAL ACCOUNTING

D. Abnormal occurrences : An accident, fire or natural calamity can damage the service potential of an asset
partly or fully. As a result the effectiveness of the asset is affected and reduced.

Characteristics of Depreciation
The Characteristics of Depreciation are:
(i) It is a charge against profit.
(ii) It indicates diminution in service potential.
(iii) It is an estimated loss of the value of an asset. It is not an actual loss.
(iv) It depends upon different assumptions, like effective life and residual value of an asset.
(v) It is a process of allocation and not of valuation.
(vi) It arises mainly from an internal cause like wear and tear or depletion of an asset. But it is treated as any
expense charged against profit like rent, salary, etc., which arise due to an external transaction.
(vii) Depreciation on any particular asset is restricted to the working life of the asset.
(viii) It is charged on tangible fixed assets. It is not charged on any current asset. For allocating the costs of
intangible fixed assets like goodwill. etc, a certain amount of their total costs may be charged against
periodic revenues. This is known as amortization.

Objective and Necessity for Providing Depreciation

Eric Kohler defined depreciation as “the lost usefulness, expired utility, the diminution in service yield.” Its
measurement and charging are necessary for cost recovery. It is treated as a part of the expired cost for an asset.
For determination of revenue, that part or cost should be matched against revenue. The objects or necessities of
charging depreciation are:
(i) Correct calculation of cost of production: Depreciation is an allocated cost of a fixed asset. It is to be calculated
and charged correctly against the revenue of an accounting period. It must be correctly included within the
cost of production.
(ii) Correct calculation of profits: Costs incurred for earning revenues must be charged properly for correct
calculation of profits. The consumed cost of assets (depreciation) has to be provided for correct matching of
revenues with expenses.
(iii) Correct disclosure of fixed assets at reasonable value: Unless depreciation is charged, the depreciable
asset cannot be correctly valued and presented in the Balance Sheet. Depreciation is charged so that the
Balance Sheet exhibits a true and fair view of the affairs of the business.
(iv) Provision of replacement cost: Depreciation is a non-cash expense. But net profit is calculated after charging
it. Through annual depreciation cash resources are saved and accumulated to provide replacement cost at
the end of the useful life of an asset.
(v) Maintenance of capital: A significant portion of capital has to be invested for purchasing fixed assets. The
values of such assets are gradually reduced due to their regular use and passage of time. Depreciation on
the assets is treated as an expired cost and it is matched against revenue. It is charged against profits. If it is
not charged the profits will remain inflated. This will cause capital erosion.
(vi) Compliance with technical and legal requirements: Depreciation has to be charged to comply with the
relevant provisions of the Companies Act and Income Tax Act.
Methods of Charging Depreciation
There are different concepts about the nature of depreciation. Moreover, the nature of all fixed assets cannot be
the same. As a result, different methods are found to exist for charging depreciation. A broad classification of the
methods may be summarized as follows:
Capital/Source of Fund
(i) Sinking Fund Method
(ii) Annuity Method
(iii) Insurance Policy Method
Time Base
(i) Fixed Installment Method
(ii) Reducing Balance Method
(iii) Sum of Years’ Digit Method

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Fundamentals of Accounting

(iv) Double Declining Method

Use Base
(i) Working Hours Method
(ii) Mileage Method
(iii) Depletion Service Hours Method
(iv) Unit method
Price Base
(i) Revaluation Method
(ii) Repairs Provision Method
Depreciation as per Property, Plant and Equipment (AS-10) Revised
[AS 6 has been replaced by this part of AS 10 Property Plant and Equipment]
► The Property, Plant and Equipment (PPE) are generally known as tangible fixed assets in contrast to the
intangible property (AS-26).
These tangible assets are:
• Held for use in production or supply of goods and services, for rental to others, or for administrative purposes;
• Expected to be used during more than one period;
• Not held for sale in the normal course of business.
Examples of Property, Plant and Equipment: land, building, plant and machinery, furniture and fitting and
office equipment etc.
► Once an item of property, plant and equipment qualifies for recognition as an asset, it is initially measured at
cost.
► The cost of items of PPE comprises:
• Purchase price, including import duties, non-refundable purchase taxes, less trade discounts and rebates.
• Costs directly attributable to bring the asset to the location and condition necessary for it to be used in a
manner intended by management.
• Initial estimates of cost of dismantling/decommissioning, removing, and site restoration at present value if
the entity has an obligation that it incurs on acquisition of the asset or as a result of using the asset other
than to produce inventories. AS-29 prescribes the discounting of such provisions and provision is made at
present value by applying pre-tax discount rate.
► Examples of directly attributable costs include:
• Employee benefits of those involved in the construction or acquisition of an asset
• Site preparation cost
• Initial delivery and handling costs
• Installation and assembly costs
• Costs of testing, less the net proceeds from the sale of any product arising from test production
• Borrowing costs to the extent permitted by AS-16, Borrowing Costs
• Professional fees
► Examples of costs that are not directly attributable costs and therefore must be expensed in the income
statement include:
• Costs of opening a new facility (often referred to as preoperative expenses)
• Costs of introducing a new product or service including Advertising and promotional costs
• Costs of conducting business in a new location or with a new class of customer
• Training costs
• Administration and other general overheads

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 FINANCIAL ACCOUNTING

► Depreciation as per AS 10
• Depreciable amount should be allocated on a systematic basis over useful life.
• Useful life and residual value must be reviewed at least at each financial year end. If expectations differ
from previous estimates the changes are to be accounted for as a change in an accounting estimate.
In accordance with AS-5 “Net Profit or loss for the period, Prior Period Items and Changes in Accounting
Policies” (i.e., adjusting depreciation charge for current and future periods)
• Depreciation charge for each period should be recognized as an expense unless it is included in the
carrying amount of another asset.
• AS-10 does not specify a method to be used.
• AS-10 requires that each part of an item of PPE that has a cost that is significant when compared to the
total cost of the item should be depreciated separately.
• Asset management policy may involve disposal of assets after a specified time therefore useful life may be
shorter than economic life.
• Repair and maintenance policies may also affect useful life (e.g., by extending it or increasing residual
value) but do not negate the need for depreciation.
• Residual value is estimated value of depreciable assets at the end of its useful life.
• Depreciable amount is net of residual value. Residual value is often insignificant and immaterial to the
calculation of the depreciable amount.
• Depreciation is always recognized, even if fair value exceeds carrying amount, except when residual
value is greater than carrying amount (in which case the depreciation charge is zero).
• Depreciation period
- Depreciation commences when an asset is available for use.
- Depreciation ceases at the earlier of the date the asset is:
• derecognised and
• held for disposal
• Depreciation does not cease when an asset is idle or retired from active use (unless it is fully depreciated).
However, depreciation may be zero under the “units of production method”.
• Land and buildings are separable assets and are separately accounted for, even when they are acquired
together:
- Land normally has an unlimited useful life and is therefore not depreciated.
- Buildings normally have a limited useful life and are depreciable asset.
• Where land has a limited useful life (e.g., a landfill site, mine, quarry) it is depreciated.
► Depreciation methods as per 10
- Straight line - a constant charge over useful life
- Diminishing balance - a decreasing charge over useful life
- Sum of the units - charge based on expected use or output
• The depreciation method should also be reviewed at least of each financial year end and, if there has
been a significant change in the expected pattern of consumption of the future economic benefits
from those assets, the method should be changed to suit this changed pattern. When such a change in
depreciation takes place the change should be accounted for as a change in accounting estimate and
the depreciation charge for the current and future periods should be adjusted.
• Three impertinent factors to be calculated:
- Useful Life
- Cost of Asset
- Residual value
• As per Schedule II of the Companies Act, 2013, depreciation to be charged on the basis of useful life
of asset. Revised AS-10 also prescribes the same. Provided that where a company adopts a useful life
different from what is specified in the Schedule or uses a residual value different from the limit specified
above, the financial statements shall disclose such difference and provide justification in this behalf duly
supported by technical advice.

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I. Fixed/Equal Instalment OR Straight Line Method

Features:
(i) A fixed portion of the cost of a fixed asset is allocated and charged as periodic depreciation.
(ii) Such depreciation becomes an equal amount in each period.
(iii) The formula for calculation of depreciation is : Depreciation = (V-S)/n
Where,
V = Cost of the asset
S = Residual value or the expected scrap value of the asset n = Estimated life of the asset
Illustration: 16

Machine Cost of Expenses incurred at the time of Estimated Residual Expected Useful Life
No. Machine (`) purchase to be capitalized (`) Value (`) in years
1 90,000 10,000 20,000 8
2 24,000 7,000 3,100 6
3 1,05,000 20,000 12,500 3
4 2,50,000 30,000 56,000 5

Solution:

Machine Cost of Expenses incurred at Total Cost Estimated Expected Depreciation Rate of
No Machine the time of purchase of Asset = Residual Useful Life = (d-e)/f (`) Depreciation
(`) to be capitalize (`) (b+c) (`) Value (`) in years under SLM =
(g/d)×100
a b c d e f g h
1 90,000 10,000 1,00,000 20,000 8 10,000 10%
2 24,000 7,000 31,000 3,100 6 4,650 15%
3 1,05,000 20,000 1,25,000 12,500 5 22,500 18%
4 2,50,000 30,000 2,80,000 56,000 10 22,400 8%

Illustration 17.
A machine is purchased for ` 7,00,000. Expenses incurred on its cartage and installation ` 3,00,000. Calculate the
amount of depreciation @ 20% p.a. according to Straight Line Method for the first year ending on 31st March, 2014
if this machine is purchased on:
(a) 1st April, 2013
(b) 1st July, 2013
(c) 1st October, 2013
(d) 1st January, 2014
Solution:
Here, Total Cost of Asset = Purchased Price + Cost of Cartage and Installation
=
` 7,00,000 + ` 3,00,000 = ` 10,00,000
Amount of Depreciation:
Period from the date of purchase to date of closing accounts
= Total Cost of Asset × Rate of Depreciation ×
12
(a) The machine was purchased on 1st April, 2013:
12
Amount of Depreciation = ` 10,00,000 × 20% × = ` 2,00,000
12

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 FINANCIAL ACCOUNTING

(b) 1st July, 2013

9
Amount of Depreciation = ` 10,00,000 × 20% × = ` 1,50,000
12
(c) 1st October, 2013
6
Amount of Depreciation = ` 10,00,000 × 20% × = ` 1,00,000
12
(d) 1st January, 2014
3
Amount of Depreciation = ` 10,00,000 × 20% × = ` 50,000
12
II. Reducing / Diminishing Balance Method or Written Down Value Method
Features:
(i) Depreciation is calculated at a fixed percentage on the original cost in the first year. But in subsequent years
it is calculated at the same percentage on the written down values gradually reducing during the expected
working life of the asset.
(ii) The rate of allocation is constant (usually a fixed percentage) but the amount allocated for every year
gradually decreases.
Illustration 18.
On 1.1.2011 a machine was purchased for ` 1,00,000 and ` 50,000 was paid for installation. Assuming that the rate
of depreciation was 10% on Reducing Balance Method, calculate amount of depreciation upto 31.12.2013.
Solution:

Year Opening Book Value (`) Rate Depreciation (`) Closing Book Value (`)
2011 1,50,000 10% 15,000 1,35,000
2012 1,35,000 10% 13,500 1,21,500
2013 1,21,500 10% 12,150 1,09,350
Note: Cost of the machine (i.e. Opening Book Value for the year 2011)
= Cost of Purchase + Cost of Installation
= ` 1,00,000 + ` 50,000 = ` 1,50,000

III. Sum of the Units Method:

Depreciation for the period —
Production during the year / Estimated Total Production

Illustration 19.
A machine is purchased for `60,00,000, estimated life of which is 10 years residual value is ` 4,00,000. Expected
production of the machine is 2,00,000 during its useful life.
Production pattern is as follows:

Year Units
1-2 20,000 per year
3-6 15,000 per year
7-10 25,000 per year
Compute the amount of depreciation for each year applying Sum of the Units Method.

Solution:

Year Computation Depreciation (`)

1-2 20, 000 5,60,000
×(60, 00, 000 - 4, 00, 000)
2, 00, 000

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Fundamentals of Accounting

3-6 15, 000 4,20,000

×(60, 00, 000 - 4, 00, 000)
2, 00, 000

7-10 25, 000 7,00,000

×(60, 00, 000 - 4, 00, 000)
2, 00, 000

Illustration 20.
On 1.1.11 machinery was purchased for ` 80,000. On 1.7.12 additions were made to the amount of ` 40,000. On
31.3.2013, machinery purchased on 1.7.2012, costing ` 12,000 was sold for ` 11,000 and on 30.06.2013 machinery
purchased on 1.1.2014 costing ` 32,000 was sold for ` 26,700. On 1.10.2013, additions were made to the amount of
` 20,000. Depreciation was provided at 10% p.a. on the Diminishing Balance Method.
Show the Machinery Accounts for three years from 2011-2013. (year ended 31st December)
Solution:
Statement of Depreciation
Date Particulars Machines – I Machines – II Machines – III Total
Cost = ` 80,000 Cost = ` 40,000 Cost = ` 20,000 Depreciation
` ` ` ` ` `
01.01.2011 Book Value 48,000 32,000
31.12.2011 Depreciation 4,800 3,200 8,000
01.01.2012 W.D.V. 43,200 28,800
01.07.2012 Purchase 28,000 12,000
31.12.2012 Depreciation 4,320 2,880 1,400 600 9,200
01.01.2013 W.D.V. 38,880 25,920 26,600 11,400
31.03.2013 Depreciation 285 285
W.D.V. 11,115
Sold For 11,000
Loss on sale 115
30.06.2013 Depreciation 1,296 1,296
W.D.V. 24,624
Sold For 26,700
Profit on Sale 2,076
01.10.2013 Purchase 20,000
31.12.2013 Depreciation 3,888 2,660 500 7,048
01.01.2014 W.D.V. 34,992 23,940 19,500

Dr. Machinery Account Cr.

Date Particulars Amount (`) Date Particulars Amount

(`)
01.01.11 To, Bank A/c 80,000 31.12.11 By, Depreciation A/c 8,000
,, Balance c/d 72,000
80,000 80,000
01.01.12 To, Balance b/d 72,000 31.12.12 By, Depreciation A/c 9,200
01.07.12 ,, Bank A/c 40,000 ,, Balance c/d 1,02,800
1,12,000 1,12,000

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 FINANCIAL ACCOUNTING

01.01.13 To, Balance b/d 1,02,800 31.3.13 By, Bank (Sale) A/c 11,000
30.06.13 ,, P & L A/c (Profit on Sale) 2,076 ,, Depreciation A/c 285
,, Bank A/c 20,000 30.6.13 ,, P & L A/c (Loss on Sale) 115
,, Bank A/c (Sale) 26,700
31.12.13 ,, Depreciation A/c 1,296
,, Depreciation A/c 7,048
,, Balance c/d 78,432
1,24,876 1,24,876

Provision for Depreciation Account

Provision of depreciation is the collected value of all depreciation. Provision of depreciation account is the account
of provision of depreciation. With making of this account we are not credited depreciation in asset account, but
transfer every year depreciation to provision of depreciation account. Every year we adopt this procedure and
when assets are sold we will transfer sold asset’s ‘total depreciation’ to credit side of asset account, for calculating
correct profit or loss on fixed asset. This provision uses with any method of calculating depreciation.
There are following features of provision for depreciation account:
• Fixed asset is made on its original cost and every year depreciation is not transfer to fixed asset account.
• Provision of depreciation account is Conglomerated value of all old depreciation.
• This system can be used both in straight line and diminishing method of providing depreciation.
The journal entries will be :
(i) For purchase of asset
Asset’s A/c Dr.
To Cash/Bank A/c
(ii) For providing depreciation at end of year
Depreciation A/c Dr.
To Provision for depreciation A/c
(iii) For sale of assets
Cash/Bank A/c Dr.
To Asset Sales A/c
(iv) Cost of assets sold transferred from Assets Account to Sale of Assets Account.
Assets Sales A/c Dr.
To Asset’s A/c.
(v) Total depreciation on asset sold transferred from provision for depreciation account.
Provision for depreciation A/c Dr.
To Asset Sales A/c
(vi) Profit or loss on sale of assets will be transferred from asset sale account to Profit or Loss Account.

Disposal of an Asset
When an asset is sold because of obsolescence or inadequacy or any other reason, the cost of the asset is
transferred to a separate account called “Asset Disposal Account”. The following entries are to be made:
(i) When the cost of the asset is transferred:
Asset Disposal A/c Dr.
To, Asset A/c (original cost)
(ii) When depreciation provided on the asset is transferred:
Provision for Depreciation A/c Dr.
To, Asset Disposal A/c
(iii) For charging depreciation for the year of sale:
Depreciation A/c Dr.

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To, Asset Disposal A/c

(iv) When cash received on sale of asset:
Bank/Cash A/c Dr.
To, Asset Disposal A/c
(v) When loss on disposal is transferred to Profit & Loss A/c:
Profit & Loss A/c Dr.
To, Asset Disposal A/c
(vi) When profit on disposal is transferred to Profit & Loss A/c:
Asset Disposal A/c Dr.
To, Profit & Loss A/c

Illustration 21.
S & Co. purchased a machine for ` 1,00,000 on 1.1.2011. Another machine costing ` 1,50,000 was purchased
on 1.7.2012. On 31.12.2013, the machine purchased on 1.1.2011 was sold for ` 50,000. The company provides
depreciation at 15% on Straight Line Method. The company closes its accounts on 31st December every year.
Prepare – (i) Machinery A/c, (ii) Machinery Disposal A/c and (iii) Provision for Depreciation A/c.
Solution:
S & Co.
Dr. Machinery Account Cr.

Date Particulars Amount (`) Date Particulars Amount (`)

1.1.2011 To, Bank A/c 1,00,000 31.12.2011 By, Balance c/d 1,00,000
1,00,000 1,00,000

1.1.2012 To, Balance b/d 1,00,000

1.7.2012 To, Bank A/c 1,50,000 31.12.2012 By, Balance c/d 2,50,000
2,50,000 2,50,000

1.1.2013 To, Balance b/d 2,50,000 31.12.2013 By, Machinery Disposal A/c 1,00,000
31.12.2013 By, Balance c/d 1,50,000
2,50,000 2,50,000

1.1.2014 To, Balance b/d 1,50,000

Dr. Provision for Depreciation Account Cr.
Date Particulars Amount (`) Date Particulars Amount (`)
31.12.2011 To, Balance c/d 15,000 31.12.2011 By, Depreciation A/c 15,000
15,000 15,000

31.12.2012 To, Balance c/d 41,250 1.1.2012 By, Balance b/d 15,000
31.12.2012 By, Depreciation A/c 26,250
(` 15,000 + ` 11,250)
41,250 41,250

31.12.2013 To, Machinery Disposal A/c 30,000 1.1.2013 By, Balance b/d 41,250
31.12.2013 To, Balance c/d 33,750 31.12.2013 By, Depreciation A/c 22,500
63,750 63,750
1.1.2014 By, Balance b/d 33,750

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Dr. Machinery Disposal Account Cr.

Date Particulars Amount (`) Date Particulars Amount (`)
31.12.2013 To, Machinery A/c 1,00,000 31.12.2013 By, Provision for Depreciation A/c 30,000
By, Depreciation A/c
15,000
By, Bank A/c
50,000
By, Profit & Loss A/c(Loss on Sale)
5,000

1,00,000 1,00,000

Working Notes
1. Depreciation for the machine purchased on 1.7.2012
For the year 2012 (used for 6 months) = ` 1,50,000 × 15% × 6/12 = ` 11,250
For the year 2013 (used for full year) = ` 1,50,000 × 15% = ` 22,500
2. Depreciation for the machine purchased on 1.1.2011
Depreciation = ` 1,00,000 × 15% = ` 15,000
So, Depreciation for 2 years = ` 15,000 × 2 = ` 30,000

Profit or Loss on Sale of Assets – Method of Depreciation Calculation

Sometimes an asset is sold before the completion of its useful life for some unavoidable circumstances (due to
obsolescence etc.) including a part of the asset which is no longer required in future. If the sale price is less than
the WDV, there will be loss, and vice versa. The profit & loss on sale of asset is adjusted in the year of Sale in Profit
& Loss Account.
Accounting Treatment
a. Where no provision for depreciation account is maintained:
WDV of the amount sold will be transferred to ‘Assets Disposal Account’. The entries will be as follows:
(i) WDV of asset has been transferred to Asset Disposal A/c
Asset Disposal A/c Dr.
To Asset A/c
(ii) In case of Sale of an Asset
Cash/Bank A/c Dr.
To Asset Disposal A/c
(iii) For depreciation (if any)
Depreciation (P & L A/c) Dr.
To Asset Disposal A/c
(iv) In case of Profit on Sale of Asset
Asset Disposal A/c Dr.
To Profit & Loss A/c
(v) In case of Loss on Sale of Asset
Profit & Loss A/c Dr.
To Asset Disposal A/c
b. Alternative Approach
In this situations, all adjustments are to be prepared through the assets account. The entries are as follows:
(i) In case of Assets sold
Cash/Bank A/c Dr.
To Assets A/c

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(ii) In case of Depreciation

Depreciation (Profit & Loss ) A/c Dr.
To Assets A/c
(iii) In case of Profit on Sale
Assets A/c Dr.
To Profit & Loss
(iv) In case of Loss on Sale
Profit & Loss A/c Dr.
To Assets A/c

Illustration 22.
On 1st April, 2011, Som Ltd. purchased a machine for `66,000 and spent `5,000 on shipping and forwarding charges,
`7,000 as import duty, `1,000 for carriage and installation, `500 as brokerage and `500 for an iron pad. It was
estimated that the machine will have a scrap value of ` 5,000 at the end of its useful life which is 15 years. On 1st
January, 2012 repairs and renewals of ` 3,000 were carried out. On 1st October, 2013 this machine was sold for `
50,000. Prepare Machinery Account for the 3 years.
Solution:
In the books of Som Ltd.
Dr. Machinery Account Cr.

Date Particulars Amount (`) Date Particulars Amount (`)

01.04.2011 To, Bank A/c 66,000 31.03.2012 By, Depreciation A/c 5,000
To, Bank A/c 14,000 By, Balance c/d 75,000
80,000 80,000

01.04.2012 To, Balance b/d 75,000 31.03.2013 By, Depreciation A/c 5,000
By, Balance c/d 70,000
75,000 75,000

By, Depreciation A/c 2,500

01.04.2013 To, Balance b/d 70,000 01.10.2013
By, Bank A/c (sale) 50,000
By, Profit & Loss A/c (Loss) 17,500

70,000 70,000

Working Note :
1. Total Cost = ` 66,000 + ` 5,000 + ` 7,000 + ` 1,000 + ` 500 + ` 500 = ` 80,000

Total Cost - Scrap Value 80,000 - 5,000

Depreciation = = = ` 5,000
Expected life 15
The amount spent on repairs and renewals on 1st January, 2012 is of revenue nature and hence, does not form
part of the cost of asset.

Change of Method
As per AS-6, the depreciation method selected should be applied consistently from period to period. Change in
depreciation method should be made only in the following situations:
(i) For compliance of statute.

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(ii) For compliance of accounting standards.

(iii) For more appropriate presentation of the financial statement.
Procedure to be followed in this case:
(i) Depreciation should be recalculated applying the new method from the date of its acquisition/ installation
till the date of change of method.
(ii) Difference between the total depreciation under the new method and the accumulated depreciation
under previous method till the date of change may be surplus/ deficiency.
(iii) The said surplus is credited to Profit & Loss Account under the head “depreciation written Back”.
(iv) Deficiency is charged to Profit & Loss Account.
(v) The journal entries will be :
(a) If old value is less
Profit and Loss A/c. Dr.
To, Assets A/c.
(b) If old value is more
Asset A/c. Dr.
To, Profit and Loss A/c.
(vi) The above change of depreciation method should be treated as change in accounting policy and its post
effect should be disclosed and quantified.

Illustration 23.
Ram Ltd. which depreciates its machinery at 10% p.a. on Diminishing Balance Method, had on 1st January,
2013 ` 9,72,000 on the debit side of Machinery Account.
During the year 2013 machinery purchased on 1st January, 2011 for ` 80,000 was sold for ` 45,000 on 1st July, 2013
and a new machinery at a cost of ` 1,50,000 was purchased and installed on the same date, installation charges
being ` 8,000.
The company wanted to change the method of depreciation from Diminishing Balance Method to Straight Line
Method with effect from 1st January, 2010. Difference of depreciation up to 31st December, 2013 to be adjusted.
The rate of depreciation remains the same as before. Show Machinery Account.

Solution:
In the books of Ram Ltd.
Dr. Machinery Account Cr.

Date Particulars Amount (`) Date Particulars Amount (`)

01.01.13 To, Balance b/d 9,72,000 01.07.13 By, Depreciation A/c [W.N.3] 3,240
(9,07,200+64,800) By, Bank A/c - Sale 45,000
By, Loss on sale of Machine A/c
01.07.13 To, Bank A/c 1,58,000 [W.N.4] 16,560
(1,50,000 + 8,000)
31.12.13 By, Depreciation A/c:
- For the year 2012 1,12,000
- For ½ year [1,58,000×10%×½] 7,900
By, Profit & Loss A/c :
Adjustment 11,200
By, Balance c/d :
- M1 (9,07,200 – 1,12,000 – 11,200) 7,84,000
- M2 Nil
- M3 (1,58,000 – 7,900) 1,50,100
11,30,000 11,30,000

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Working Notes :
(1) At 10% depreciation on Diminishing Balance Method :
`
If balance of machinery in the beginning of the year is 10
Depreciation for the year is 1
Balance of Machinery at the end of the year 2
By using the formula, balance of asset on 1 January 2010 will be calculated as follows:
st

`
Balance as on 1 January, 2013
st
9,72,000
Balance as on 1st January, 2012 is 9,72,000 × 10/9 = 10,80,000
Balance as on 1st January, 2011 is 10,80,000 × 10/9 = 12,00,000
This balance, ` 12,00,000 is composed of 2 machines, one of ` 11,20,000 and another of ` 80,000.

`
Depreciation at 10% p.a. on Straight Line Method on ` 11,20,000 1,12,000
Total Depreciation for 2011 and 2012 (` 1,12,000 x 2) 2,24,000
Total Depreciation charged for 2011 and 2012 on Diminishing Balance Method (1,12,000 + 2,12,800
1,00,800)
Balance to be charged in 2013 to change from Diminishing Balance Method to Straight Line 11,200
Method
(2) Machine purchased on 1st January, 2011 for ` 80,000 shows the balance of ` 64,800 on 1st January
2013 as follows :

`
Purchase price 80,000
Less : Depreciation for 2011 8,000
72,000
Less : Depreciation for 2012 7,200
Balance as on Jan. 1, 2013 64,800

(3) On second machine (original purchase price ` 80,000), depreciation at 10% p.a. on ` 64,800 for 6 months, viz.,
` 3,240 has been charged to the machine on July 1 2013 i.e., on date of sale.

(4) Loss on sale of (ii) machine has been computed as under:

`
Balance of the machine as on 1.1.2013 64,800
Less : Depreciation for 6 months up to date of sale 3,240
Balance on date of sale 61,560
Less : Sale proceeds 45,000
Loss on sale 16,560

Illustration 24.
M/s. Hot and Cold commenced business on 01.07.2008. When they purchased a new machinery at a cost of
` 8,00,000. On 01.01.2010 they purchased another machinery for ` 6,00,000 and again on 01.10.2012 machinery
costing ` 15,00,000 was purchased. They adopted a method of charging depreciation @ 20% p.a. on diminishing
balance basis.
On 01.07.2012, they changed the method of providing depreciation and adopted the method of writing off

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the Machinery Account at 15% p.a. under straight line method with retrospective effect from 01.07.2008, the
adjustment being made in the accounts for the year ended 30.06.2013.
The depreciation has been charged on time basis. You are required to calculate the difference in depreciation
to be adjusted in the Machinery on 01.07.2012, and show the Machinery Account for the year ended 30.06.2013.

Solution:
In the books of M/s Hot and Cold
Dr. Machinery Account Cr.

Date Particulars Amount (`) Date Particulars Amount (`)

01.07.12 To, Balance b/d 6,73,280 30.6.13 By Depreciation A/c 3,78,750
To, Profit and Loss A/c 21,720 By Balance c/d 18,16,250
(Depreciation Overcharged)
01.10.12 To, Bank A/c (Purchase) 15,00,000
21,95,000 21,95,000

Workings:
1. Statement of Depreciation:

Date Particulars Machine – I (`) Machine – II (`) Total Depreciation (`)

01.07.2008 Book Value 8,00,000
30.06.2009 Depreciation @ 20% 1,60,000 1,60,000
01.07.2009 W.D.V. 6,40,000
01.01.2010 Bank (Purchase) 6,00,000
30.06.2010 Depreciation @ 20% 1,28,000 60,000 1,88,000
01.07.2010 W.D.V. 5,12,000 5,40,000
30.06.2011 Depreciation @ 20% 1,02,400 1,08,000 2,10,400
01.07.2011 W.D.V. 4,09,600 4,32,000
30.06.2012 Depreciation @ 20% 81,920 86,400 1,68,320
01.07.2012 W.D.V. 3,27,680 3,45,600
6,73,280 7,26,720

2. Depreciation Overcharged:
Now depreciation under Straight Line Method

On ` 8,00,000 @ 15% = ` 1,20,000 × 4 years (from 01.07.2008 to 30.06.2012) ` 4,80,000

On ` 6,00,000 @ 15% = ` 90,000 × 2.5 years (from 01.01.2010 to 30.06.2012) ` 2,25,000
` 7,05,000

Depreciation overcharged = Reducing Balance Basis – Straight Line Basis = ` (7,26,720 – 7,05,000) = ` 21,720

3. Depreciation for the year:

On ` 14,00,000 @ 15% for the year ` 2,10,000

On ` 15,00,000 @ 15% for the 9 months ` 1,68,750
` 3,78,750

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1.6 RECTIFICATION OF ERRORS

Opening Entries: The opening entry is an item which is passed in the Journal Proper or General Ledger. The purpose
of passing this entry is to record the opening balances of the accounts transferred from the previous year to the
new year. The accounts which are appearing on the assets side of Balance Sheet are debited in the opening entry
while which accounts are appearing in the liabilities side are credited.
At the end of each accounting period, the books of accounts need to be closed for preparation of final accounts.
Also, in the beginning of the new accounting period, new books of accounts are to be opened. For this purpose,
opening and closing entries need to be passed. These entries are passed in journal proper.
The opening entries are passed only for those ledger A/c balances which are carried forward from earlier period
to the current accounting period. In other words, the balances of assets, liabilities and owners’ capital and equity
accounts are only considered for such opening entries. The opening entry is passed with the closing balances of
assets and liabilities & capital accounts in the last year’s balance sheet.
The entry can be given as:
All Asset A/cs Dr.
To All Liabilities A/c
To Owners’ Capital A/cs
Illustration 25.
Consider the following balances in the Balance Sheet as on 31st March 2013. Pass the opening entry on 1st April 2013.
Subodh’s Capital A/c 2,75,000
Loan from HDFC Bank 4,25,000
Plant and machinery 3,30,000
Cash in hand 20,000
Balance at Citi Bank 1,75,000
Trade Debtors 3,55,000
Closing Stock 1,35,000
Trade Payables 2,95,000
Outstanding Expenses 40,000
Prepaid Insurance 20,000
Solution:
The opening entry will be as follows:
Plant and machinery A/c Dr. 3,30,000
Cash in hand A/c Dr. 20,000
Balance at Citi Bank A/c Dr. 1,75,000
Trade Debtors A/c Dr. 3,55,000
Closing Stock A/c Dr. 1,35,000
Prepaid Insurance Dr. 20,000
To Subodh’s Capital A/c 2,75,000
To Loan from HDFC Bank A/c 4,25,000
To Trade Payables A/c 2,95,000
To Outstanding Expenses A/c 40,000
Closing Entries: All the expenses and gains or income related nominal accounts must be closed at the end of
the year. In order to close them, they are transferred to either Trading A/c or Profit and Loss A/c. Journal entries
required for transferring them to such account is called a ‘closing entry’.

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The Closing Entries are passed on the basis of trial balance for transferring the balances to Trading and Profit and
Loss A/c. These entries are mainly for:
(a) Transferring purchases and direct expenses (goods related) to Trading A/c

Trading A/c Dr.

To Opening stock A/c

To Purchases A/c

To Factory expenses A/c

To Freight & carriage inward A/c

(b) Transferring sales and closing stocks

Sales A/c Dr.

Closing Stock A/c Dr.

To Trading A/c

(c) Transferring gross profit or gross loss to P & L A/c

Gross Profit

Trading A/c Dr.

To P & L A/c

Gross Loss

P & L A/c Dr.

To Trading A/c

(d) Transferring expenses

P & L A/c Dr.

To Respective expense A/c

(e) Transferring Incomes

Respective income A/cs Dr.

To P & L A/c

(f) Transferring Net profit or Net loss

Net Profit

P & L A/c Dr.

To Capital A/c

Net Loss

Capital A/c Dr.

To P & L A/c

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Illustration 26.
Pass closing entries for the following particulars as on 31st March 2013 presented by X Ltd.
Particulars Amount (`)
Opening stock 10,000
Purchases 50,000
Wages 5,000
Returns outward 5,000
Sales 1,00,000
Returns inward 10,000
Salaries 8,000
Insurance 1,000
Bad debts 3,000
Interest received 3,000
Discount allowed 4,000
Discount received 3,000
Closing stock 15,000

Solution:
In the Books of X Ltd.
Journal

Dr. Cr.
Date Particulars LF Amount (`) Amount (`)
2013 Trading A/c Dr. 75,000
31st To, Opening Stock A/c 10,000
March To, Purchases A/c 50,000
To, Wages A/c 5,000
To, Returns inward A/c 10,000
(Transfer to balances for closing the latter accounts)
Sales A/c Dr. 1,00,000
Returns outward A/c Dr. 5,000
Closing Stock A/c Dr. 15,000
To, Trading A/c 1,20,000
(Transfer of balances for closing the former accounts)
Trading A/c Dr. 45,000
To, Profit and Loss A/c 45,000
(Gross profit transferred)
Profit and Loss A/c Dr. 16,000
To, Salaries A/c 8,000
To, Insurance A/c 1,000
To, Bad Debts A/c 3,000
To, Discount allowed A/c 4,000
(Transfer of balances for closing the latter accounts)
Interest received A/c Dr. 3,000
Discount received A/c Dr. 3,000
To, Profit and Loss A/c 6,000
(Transfer of balances for closing the former accounts)
Profit and Loss A/c Dr. 35,000
To, Capital A/c 35,000
(Net profit transferred to Capital A/c)

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Rectification Entries (Rectification of errors): These entries are passed when errors or mistakes are discovered in
accounting records. These entries are also known as Correction Entries. These entries are also passed in Journal
Proper.
In this study note, you were introduced to the reasons why errors could occur and to the fact that while some errors
affect trial balance and some errors do not affect it. In this section, we will see in depth how the corrections are
made to the wrong entries.
When the errors affecting the T.B. are made, the normal practice is to put the difference to an A/c called as
‘Suspense A/c’ till the time errors are located. On identification of errors, the one effect goes to the correct A/c
and the other effect to the Suspense A/c. This is done for one sided errors e.g. if sales book total is wrongly taken,
but individual customers are correctly debited. Such error will cause difference in trial balance as only Sales A/c
is wrongly credited. In such cases the rectification entry will be passed through Suspense A/c. In all other cases
the rectification is done by debiting or crediting the correct A/c head and by crediting or debiting the wrong A/c
head.
Let us recapitulate the types of errors and the ways to rectify them in the following table

Type of error Rectification

(a) Error of principle – entering revenue expense as A journal entry is passed to give correct effect.
capital expense or vice versa or entering revenue
receipt as capital receipt or vice versa.
(b) Error of Omission – transaction forgotten to be Simply, the correct entry is passed.
entered in books of accounts.
(c) Errors of commission – entering to wrong head of Debit or credit wrong A/c head and post it to correct
account. head.
(d) Compensating errors – more than one error that Pass correcting entry
could compensate effect of each other.
(e) Wrong totaling of subsidiary books As it affects T.B., pass through Suspense A/c
(f) Posting on wrong side of an A/c Pass an entry with double effect – one to cancel wrong
side and other to give effect on correct side
(g) Posting of wrong amount Pass entry with differential amount

Rectification of Errors

Before preparing After preparing After preparing

trial balance trial balance final accounts

Double Single sided Double Single sided Double Single sided

sided errors errors sided errors errors sided errors errors

A. Before Preparation of Trail Balance

If errors are detected before the preparation of Trail Balance, the effect of each error should be known.
The errors are of two types: viz
(a) Double Sided Error; (b) Single Sided Error
(a) Double Sided Error:

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The following principles should be followed for the purpose.

(i) What was the correct entry?
(ii) What entry had been done?
(iii) Rectifying entry.
Example: Purchased a Building for ` 3,00,000 wrongly passed through purchase account.
Solutions:

(i) Building A/c Dr. 3,00,000

To Cash A/c 3,00,000
(ii) Purchase A/c Dr. 3,00,000
To Cash A/c 3,00,000
(iii) Building A/c Dr. 3,00,000
To Purchase A/c 3,00,000
(b) Single Sided Error
Under the circumstances, no separate entry is required but the affected account should be rectified by
appropriate posting.
Example: Purchase account was overcast by ` 10,000.
Solution:
The correction to be made in Purchase Account in the following manner.
Dr. Purchase Account Cr.

Particulars ` Particulars `

By Error - Wrong posting 10,000

So, purchase account should be credited by ` 10,000.

B. After Preparation of Trial Balance
If the errors are detected after the preparations of trial balance, the following procedure should be followed:
(a) Double Sided Errors; and (b) Single Sided Errors.
(a) Double Sided Errors:
- Same as method (A) above i.e., before preparation of Trial Balance.
(b) Single Sided Errors:
- In case of Single side errors, relevant account to be rectified by applying Suspense Account.

Suspense Account
If the Trial Balance does not agree we cannot prepare final accounts. In order to prepare final account, the
difference so appeared in trail balance is to be passed through Suspense Account. When the errors will be
located and rectified suspense account will automatically be Nil or closed. The suspense account will appear in
the Balance Sheet. When it appears in the debit side of trial balance, the same will appear in the assets side of
the Balance Sheet and vice-versa.
Example: Sales Day Book was overcast by ` 1,000.
` `
Sales A/c Dr. 1,000
To Suspense A/c 1,000

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 FINANCIAL ACCOUNTING

C. After Preparation of Final Accounts

If the errors are detected after the preparation of final accounts the following steps should carefully be
followed.
(a) For Double Sided Errors
(i) Same as (A) before preparation of Trial Balance or (B) after preparation of Trail Balance. But all the
nominal accounts are to be replaced by Profit and Loss Adjustment Account. And the rest one will be
same as (A) or (B) stated earlier.
(ii) Suspense Account will be carried forward to the next year; and
(iii) Real and Personal Accounts are to be carried forward to the next year.
Example: Purchase a Plant wrongly debited to Purchase Account for ` 10,000
Solution:
(i) If after Trial Balance
Plant A/c Dr.
To Purchase A/c
(ii) If after Final Account
Plant A/c Dr.
To Profit and Loss Adjustment A/c
(b) for Single Sided Errors:
Same principle is to be followed like (B) after preparation of Trial Balance and all the nominal account
are to be preplaced by Profit and Loss Adjustment Account.
Example – Discount allowed was not posted to discount Account for ` 500.
Solution:
(i) If after Trial Balance
Discount Allowed A/c Dr.
To Suspense A/c
(ii) If after Final Account
Profit and Loss Adjustment A/c Dr.
To Suspense A/c

Illustration 27.
Rectify the following errors assuming that the errors were detected (a) Before the Preparation of Trial Balance; (b)
After the preparation of Trial Balance and (c) After the preparation of Final Accounts.
(i) Purchase Plant for ` 10,000 wrongly passed through Purchase Account.
(ii) Sales Day Book was cast short by ` 1,000.
(iii) Cash paid to Mr. X for ` 1,000 was posted to his account as ` 100.
(iv) Purchase goods from Mr. T for ` 3,500 was entered in the Purchase Day Book as ` 500.
(v) Paid salary for ` 3,000 wrongly passed through wages account.

Solution:
In the Books of …………………….
Journal (without narration)

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Fundamentals of Accounting

Date Before preparation of Trial After preparation of Trial Balance After preparation of Final Accounts
Balance
(i) Plant A/c Dr. 10,000 Plant A/c Dr. 10,000 Plant A/c Dr. 10,000
To Purchase A/c 10,000 To Purchase A/c. 10,000 To P&L Adjustment A/c 10,000
(ii) Sales account will be credited Suspense A/c Dr. 1,000 Suspense A/c Dr. 1,000
with ` 1,000 To Sales A/c 1,000 To P&L Adjustment A/c 1,000
(iii) X Account will be debited when X A/c Dr. 900 X A/c Dr. 900
` 900 To Suspense A/c 900 To Suspense A/c 900
(iv) Purchase A/c Dr. 3,000 Purchase A/c Dr. 3,000 P&L Adjustment A/c Dr. 3,000
To T A/c 3,000 To T A/c 3,000 To T’s A/c. 3,000
(v) Salary A/c Dr. 3,000 Salary A/c Dr. 3,000 P&L Adjustment A/c. Dr. 3,000
To Wages A/c 3,000 To wages A/c 3,000 To P&L Adjustment A/c 3,000

llustration 28.
A merchant, while balancing his books of accounts notices that the T.B. did not tally. It showed excess credit of `
1,700. He placed the difference to Suspense A/c. Subsequently he noticed the following errors:
(a) Goods brought from Narayan for ` 5,000 were posted to the credit of Narayan’s A/c as ` 5,500
(b) An item of ` 750 entered in Purchase Returns Book was posted to the credit of Pandey to whom the goods
had been returned.
(c) Sundry items of furniture sold for ` 26,000 were entered in the sales book.
(d) Discount of ` 300 from creditors had been duly entered in creditor’s A/c but was not posted to discount A/c.
Pass necessary journal entries to rectify these errors. Also show the Suspense A/c.
Solution:
(a) Goods bought from Narayan are posted to credit of his A/c as ` 5,500 instead of ` 5,000. Here, it is correct to
credit Narayan’s A/c. But the mistake is extra credit of ` 500. This is one sided error, as posting to purchases
A/c is correctly made. So the rectification entry will affect the suspense A/c. This needs to be reversed by the
rectification entry:
Narayan’s A/c Dr. 500
To Suspense A/c 500
(b) Goods bought from Pandey were returned back to him. It should have appeared on the debit side of his A/c.
For rectifying we will need to debit his A/c with double the amount i.e. ` 1500 (` 750 to cancel the wrong credit
and another ` 750 to give effect for correct debit) and the effect will go to Suspense A/c. The correction entry
is:
Pandey A/c Dr. 1,500
To Suspense A/c 1,500
(c) Sale of furniture was recorded in sales book. What’s wrong here? Remember that sales book records sale of
goods only and nothing else. Sale of furniture will appear in either cash book (if sold for cash) or journal proper
(if sold on credit). Hence, wrong credit to Sales A/c must be removed and credit should be given to Furniture
A/c. It’s important to note that this rectification entry will not affect the Suspense A/c. The correction entry is:
Sales A/c Dr 26,000
To Furniture A/c 26,000
(d) The discount received from creditor is not entered in discount A/c but was correctly recorded in creditors’ A/c.
This is one sided error and will therefore be routed through suspense for correction. A discount is received; it
must be credited being an income.

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 FINANCIAL ACCOUNTING

Suspense A/c Dr 300

To Discount received A/c 300
Let us now see how suspense A/c will Look like. Excess credit of ` 1,700 in Trial Balance will be shown on the debit
side of suspense A/c. This will bring in total debit equal to total credit.

Dr Suspense Account Cr

Date Particulars J. F. Amount (`) Date Particulars J. F. Amount (`)

To Balance b/d 1,700 By Narayan 500

To Discount received 300 By Pandey 1,500

2,000 2,000

Please observe that after correcting passing all rectification entries, the Suspense A/c tallies automatically.

Illustration 29.
Pass necessary journal entries to rectify the following errors:
(a) An amount of ` 200 withdrawn by owner for personal use was debited to trade expenses.
(b) Purchase of goods of ` 300 from Nathan was wrongly entered in sales book.
(c) A credit sale of ` 100 to Santhanam was wrongly passed through purchase book.
(d) ` 150 received from Malhotra was credited to Mehrotra.
(e) ` 375 paid as salary to cashier Dhawan was debited to his personal A/c.
(f) A bill of ` 2,750 for extension of building was debited to building repairs A/c
(g) Goods of ` 500 returned by Akashdeep were taken into stock, but returns were not posted.
(h) Old furniture sold for ` 200 to Sethi was recorded in sales book.
(i) The period end total of sales book was under cast by ` 100.
(j) Amount of ` 80 received as interest was credited to commission.

Solution:
Sl No. Particulars Debit (`) Credit (`)
(a) Wrong Entry Trade Expenses Dr 200
To Cash 200
Correct entry Drawings Dr 200
To cash 200
Rectification entry Drawings Dr 200
To Trade Expenses 200
(b) Wrong Entry Nathan Dr 300
To Sales 300
Correct entry Purchases Dr 300
To Nathan 300
Rectification entry Purchases Dr 300
Sales Dr 300
To Nathan 600
(c) Wrong Entry Purchases Dr 100
To Santhanam 100

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Sl No. Particulars Debit (`) Credit (`)

Correct entry Santhanam Dr 100
To Sales 100
Rectification entry Santhanam Dr 200
To Sales 100
To Purchases 100
(d) Wrong Entry Cash Dr 150
To Mehrotra 150
Correct entry Cash Dr 150
To Malhotra 150
Rectification entry Mehrotra Dr 150
To Malhotra 150
(e) Wrong Entry Dhawan Dr 375
To cash 375
Correct entry Salary Dr 375
To cash 375
Rectification entry Salary Dr 375
To Dhawan 375
(f) Wrong Entry Building Repairs Dr 2,750
To Cash 2,750
Correct entry Buildings Dr 2,750
To Cash 2,750
Rectification entry Buildings Dr 2,750
To Building Repairs 2,750
(g) Wrong Entry No entry passed
Correct entry Sales Returns Dr 500
To Akashdeep 500
Rectification entry Sales Returns Dr 500
To Asashdeep 500
(h) Wrong Entry Sethi Dr 200
To Sales 200
Correct entry Sethi Dr 200
To Furniture 200
Rectification entry Sales Dr 200
To Furniture 200
(i) Wrong Entry No entry passed
Correct entry Suspense Dr 100
To Sales 100
Rectification entry Suspense Dr 100
To Sales 100
(j) Wrong Entry Cash Dr 80
To Commission 80
Correct entry Cash Dr 80
To Interest 80
Rectification entry Commission Dr 80
To Interest 80
Effect of Errors on Profit or Loss
Some errors may affect the profit or loss for the period while other won’t. How to find it out? Remember, the P & L

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 FINANCIAL ACCOUNTING

A/c reflects items of incomes, gains, expenses and losses. All these accounts are nominal accounts. When an error
occurs which affects a nominal account, it will affect profit or loss otherwise not. So, errors that affect real and
personal accounts will not affect profit or loss.

Illustration 30.
Rectifying the following errors by way of journal entries and work out their effect on profit or loss of the concern:
a. Return inward book was cast short by ` 500.
b. ` 300 received from Ram has been debited to Mr. Shyam.
c. Wages paid for the installation of a machine debited to wages account for ` 1,000.
d. A purchase made for ` 1,000 was posted to purchase account as ` 100.
e. Purchase of furniture amounting to ` 3,000 debited to purchase account.
f. Goods purchased for proprietor’s use for ` 1,000 debited to purchase account.

Solution:
In the Books of …………
Journal

Dr. Cr.
Date Particulars L.F Amount (`) Amount (`)
(a) Return Inward A/c Dr. 500
To, Suspense A/c 500
(Return Inward Book was cast short, now rectified.)
(b) Suspense A/c Dr. 600
To, Ram A/c 300
To Shyam A/c 300
(Received from Mr. Ram has been debited to Mr.
Shyam A/c, now rectified.)
(c) Machinery A/c Dr. 1,000
To, Wages/c 1,000
(Wages paid for maintenance of machinery debited to
Wages A/c, now rectified.)
(d) Purchase A/c Dr. 900
To, Suspense A/c 900
(Purchase account was short by ` 900, now rectified.)
(e) Furniture A/c Dr. 3,000
To, Purchase A/c 3,000
(Furniture purchased wrongly debited to purchase
account, now rectified)
(f) Drawings A/c Dr. 1,000
To, Purchase A/c 1,000
(Goods purchased for proprietor’s use, debited to
purchase account, now rectified.)

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Effect on Profit

Items Particulars Increase (`) Decrease (`)

(a) Decrease in Profit 500
(b) No Effect in Profit - -
(c) Increase in Profit 1,000 -
(d) Decrease in Profit 900
(e) Increase in Profit 3,000 -
(f) Increase in Profit 1,000 -
Total 5,000 1,400
Increase in Profit - 3,600
5,000 5,000

llustration 31.
The books of M/s Shakti trading for the year ended 31st March 2013 were closed with a difference that was posted
to Suspense A/c. The following errors were found subsequently:
(a) Goods of ` 12,500 returned to Thick & Fast Corporation were recorded in Return Inward book as ` 21,500 and
from there it was posted to the debit of Thick & Fast Corporation.
(b) A credit sale of ` 7,600 was wrongly posted as ` 6,700 to customer’s A/c in sales ledger.
(c) Closing stock was overstated by ` 5,000 being totaling error in the schedule of inventory.
(d) ` 8900 paid to Bala was posted to the debit of Sethu as ` 9,800.
(e) Goods purchased from Evan Traders for ` 3,250 was entered in sales book as ` 3,520.
(f) ` 1,500, being the total of discount column on the payment side of the cash book was not posted.
Rectify the errors and pass necessary entries giving effects to Suspense A/c and P & L Adjustment A/c.
Solution:
(a) There are 2 errors: one – return outward is wrongly recorded as return inward and two – amount is also recorded
wrongly. First, we need to remove extra debit to Thick & Fast corporation i.e. ` 9,000 (21,500-12,500) by crediting
it. Also we need to remove wrong credit of ` 21,500 in sales return by debiting it and credit ` 12,500 to Purchase
returns A/c.
The rectification entry will be:
Suspense A/c Dr. 21,500
To Thick & Fast Corp 9,000
To P & L Adjustment A/c 12,500
(b) In this case, error has occurred only in customer’s A/c. hence, profit or loss won’t be affected and the P & L
Adjustment A/c will not be in picture. As customer’s A/c is debited for ` 6,700 instead of ` 7,600, it needs to
be corrected.
The rectification entry will be:
Sundry Debtors A/c Dr. 900
To Suspense A/c 900
(c) Over casting of closing stock had affected profit which must be reduced through P & L Adjustment A/c.
The rectification entry is:
P & L Adjustment A/c Dr. 5,000
To Suspense A/c 5,000

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(d) As only personal accounts are affected, there won’t be an effect on Profits. So rectification will be done
through Suspense A/c only. The rectification entry is:
Bala A/c Dr. 8,900
Suspense A/c Dr. 900
To Sethu A/c 9,800
(e) This transaction involves correction of purchase as well as sales, and hence will affect profit. As the purchases
were booked as sales, we will need to cancel sales by debiting and freshly debit purchase. So overall effect
on profit will be 3,250 + 3,520 i.e. 6,770. The rectification enry will be:
P & L Adjustment A/c Dr. 6,770
To Evan Traders 6,770
(f) If discount is appearing on payment side of cash book, it indicates discount received while making payment
and is an item of income. Hence, it will affect profit. The accounting entry will be:
Suspense A/c Dr. 1,500
To P & L Adjustment A/c 1,500
Illustration 32.
You are presented with a trial balance of S Ltd as on 30.06.2013 showing the credit is in excess by ` 415 which was
been carried to Suspense Account. On a close scrutiny of the books, the following errors were revealed:
a. A cheque of ` 3,456 received from Sankar after allowing him a discount of ` 46 was endorsed to Sharma in
full settlement for ` 3,500. The cheque was finally dishonored but no entries are passed in the books.
b. Goods of the value of ` 230 returned by Sen were entered in the Purchase Day Book and posted therefrom
to Das as ` 320.
c. Bad debts aggregating ` 505 written off during the year in the Sales Ledger but were not recorded in the
general ledger.
d. Bill for ` 750 received from Mukherjee for repairs to Machinery was entered in the Inward Invoice Book as `
650.
e. Goods worth ` 1,234 Purchased from Mr. Y on 28.6.2013 had been entered in Day Book and credited to him
but was not delivered till 5th June 2013. Stock being taken by the purchase on 30.06.2013. The title of the
goods was, however, passed on 28.06.2013.
f. ` 79 paid for freight on Machinery was debited to freight account as ` 97.
You are required to pass the necessary journal entries for correcting the books.
Solution:
In the books of S Ltd.
Journal
Dr. Cr.
Date Particulars L.F. Amount Amount
(`) (`)
(a) Sankar A/c Dr. 3,502
Discount Received A/c Dr. 44
To, Sharma A/c 3500
To Discount Allowed A/c 46
(Cheque received from Sankar was endorsed to Sharma after allowing
discount `46 , it was dishonored, now rectified)

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(b) Return Inward A/c Dr. 230

Das A/c Dr. 320
To, Purchase A/c 230
To, Sen A/c 230
To Suspense A/c 90
(Goods returned by sen for ` 230 wrongly recorded in Purchase Day Book as
an credit to Das as ` 320, now rectified.)
(c) Bad debts A/c Dr. 505
To Suspense A/c 505
(Bad debts written off but not recorded, now rectified)
(d) Repairs A/c Dr. 750
To, Purchase A/c 650
To, Mukherjee A/c 100
(Repairs of machinery for ` 750, wrongly recorded as ` 650 on Purchase A/c,
now rectified.)
(e) Goods- in- Transit A/c Dr. 1,234
To Trading A/c 1,234
(Goods were in Transit which were not considered, now rectified)
(f) Machinery A/c Dr 79
Suspense A/c Dr 18
To Freight A/c 97
(amount paid for freight on machinery was wrongly debited to freight
account, now rectified)

Illustration 33.
The books of accounts of A Co. Ltd. for the year ending 31.3.2013 were closed with a difference of `21,510 in books
carried forward. The following errors were detected subsequently:
(a) Return outward book was under cast by ` 100.
(b) ` 1,500 being the total of discount column on the credit side of the cash book was not posted.
(c) ` 6,000 being the cost of purchase of office furniture was debited to Purchase A/c.
(d) A credit sale of ` 760 was wrongly posted as ` 670 to the customers A/c. in the sales ledger.
(e) The Sales A/c was under casted by ` 10,000 being the carry over mistakes in the sales day book.
(f) Closing stock was over casted by ` 10,000 being casting error in the schedule or inventory.
Pass rectification entries in the next year.
Prepare suspense account and state effect of the errors in determination of net profit of last year.

Solution:
In the Books of A Co. Ltd.
Journal

Dr. Cr.
Date Particulars L/F Amount (`) Amount (`)
(a) 2013 Suspense A/c Dr. 100
April To Profit & Loss Adjustment A/c 100
1 (Returns outward book was under cast now rectified).

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 FINANCIAL ACCOUNTING

(b) Suspense A/c Dr. 1,500

To Profit & Loss Adjustment A/c 1,500
(Discount received was not recorded, now rectified).
(c) Office Furniture A/c Dr. 6,000
To Profit & Loss Adjustment A/c 6,000
(Office furniture purchased wrongly debited to Purchase A/c, now
rectified.)
(d) Debtors’ A/c Dr. 90
To Suspense A/c 90
(Debtors account was posted ` 670 in place of ` 760, now rectified.)
(e) Suspense A/c Dr. 10,000
To Profit & Loss Adjustment A/c 10,000
(Sales account was under casted, now rectified)
(f) Profit & Loss Adjustment A/c Dr. 10,000
To Closing Stock A/c 10,000
(Closing Stock was overcastted, now rectified.)

Dr. Suspense Account Cr.

Date Particulars Amount Date Particulars Amount

(`) (`)
2013 To Profit & Loss Adjustment A/c 100 2013 By Difference in Trial Balance 21,510
April To Pofit & Loss Adjustment A/c 1,500 April By Debtors A/c. 90
1 To Pofit & Loss Adjustment A/c 10,000 1
To Pofit & Loss Adjustment A/c 10,000
21,600 21,600

Effect on Profit

Increase Decrease
(+) (-)
` `
Item (a)……………………………….. - 100
(b)……………………………….. - 1,500
(c)……………………………….. - 6,000
(d) No effect - -
e)……………………………….. - 10,000
(f)……………………………….. 10,000 -
10,000 17,600
Profit will be decreased by 7,600 -
17,600 17,600

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Illustration 34.
The Trial Balance of a concern has agreed but the following mistakes were discovered after the preparation of
final Accounts.
(a) No adjustment entry was passed for an amount of ` 2,000 relating to outstanding rent.
(b) Purchase book was overcast by ` 1,000.
(c) ` 4,000 depreciation of Machinery has been omitted to be recorded in the book.
(d) ` 600 paid for purchase of stationary has been debited to Purchase A/c.
(e) Sales books was overcast by ` 1,000.
(f) ` 5,000 received in respect of Book Debt had been credited to Sales A/c.
Show the effect of the above errors in Profit and Loss Account & Balance Sheet.
Solution:
Effects of the errors in profit and loss A/c and Balance Sheet

Profit & Loss A/c. Balance Sheet

(a) Profit was overstated by ` 2,000 (a) Capital was also overstated by ` 2,000 &
outstanding Liability was understated by 2,000.
(b) Gross profit was under stated by ` 1,000 & also the (b) Capital was understated by ` 1,000.
Net Profit.
(c) Net Profit was overstated by ` 4,000. (c) Machinery was overstated by ` 4,000 & so the
(d) No effect on Net Profit. Capital A/c was also overstated by ` 4,000.
(e) Gross Profit and Net Profit were overstated by ` (d) No effect in Balance Sheet.
1,000. (e) Capital was overstated by ` 1,000.
(f) Gross Profit & Net Profit were overstated by ` 5,000. (f) Capital & Sundry Debtors were overstated by `
5,000.

Adjusting Entry
Adjusting Entries are passed in the journal to bring into the books of accounts certain unrecorded items like closing
stock, depreciation on fixed assets, etc. These are needed at the time of preparing the final accounts.
E.g. Depreciation A/c Dr.
To, Fixed Assets A/c

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SELF EXAMINATION QUESTIONS:

1. The following account has a credit balance
(A) Plant and Equipment A/c
(B) Purchase Returns A/c
(C) Purchase A/c
(D) None of the above
2. The concept that business is assumed to exist for an indefinite period and is not established with the objective
of closing down is referred to as
(A) Money Measurement concept
(B) Going Concern concept
(C) Full Disclosure concept
(D) Dual Aspect concept
3. The outflow of funds to acquire an asset that will benefit the business for more than one accounting period
is referred to as
(A) Miscellaneous Expenditure
(B) Revenue Expenditure
(C) Capital Expenditure
(D) Deferred Revenue Expenditure
4. Which of the following purpose is served from the preparation of Trial Balance?
(A) To check the arithmetical accuracy of the recorded transactions
(B) To ascertain the balance of any ledger account
(C) To facilitate the preparation of final accounts promptly
(D) All of the above.
5. An amount spent for replacement of worn out part of machine is
(A) Capital Expenditure
(B) Revenue Expenditure
(C) Deferred revenue
(D) Capital Loss
6. Sukku Limited purchased a machine on 1st July, 2013 for `8,90,000 and freight and transit insurance premium
paid `25,000 and `15,000 respectively. Installation expenses were ` 40,000 and salvage value after 5 year will
be `50,000. Under straight line method for the year ended 31st March, 2014 the amount of depreciation will
be
(A) `1,35,750
(B) `1,81,000
(C) `1,84,000
(D) `1,38,000
7. Purchase Cost of machinery `7,20,000; Carriage inwards `15,000; Transit insurance `8,000; Establishment
Charges `25,000; Workshop Rent `25,000; Salvage value `50,000 and estimated working life 8 years. On the
basis of straight line method the amount of depreciation for third year will be
(A) `96,000
(B) `89,750
(C) `88,750
(D) `91,875

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(8) The cost of a Fixed Assets of a business has to be written off over its
(A) Natural Life
(B) Accounting Life
(C) Physical Life
(D) Estimated Economic Life

Answer:
1. (B) 2. (B) 3. (C) 4. (D) 5. (B) 6. (D) 7. (B) 8. (D)

State whether the following statement is True (or) False:

1. Original cost minus scrap value is the depreciable value of asset.
2. Compensation paid to employees who are retrenched is Revenue expenditure.
3. The useful life of a depreciable asset is the period over which the asset is expected to be used by the enterprise,
which is generally greater than the physical life.
4. After the transactions are posted to various ledger accounts (either from journal or from subsidiary books),
they are balanced while preparing Trial Balance for an enterprise. (added,)
5. Depreciation is charge against profit.
6. One of the objectives achieved by providing depreciation is saving cash resources for future replacement of
assets.
7. As per concept of conservatism, the Accountant should provide for all possible losses but should not anticipate
profit.
8. Wages incurred by departmental workers of a factory in installing a new machinery7 is a revenue expenditure.
9. As per the going concern concept, the enterprise should continue to exist in the foreseeable future.
10. Trial balance would not disclose error of omission.
11. Purchase of a technical know-how is revenue expenditure
12. Inauguration expenses on opening of a new Branch of an existing business will be revenue expenditure.
13. Every debit must have its corresponding and equal …………….(benefit, credit)

QUESTIONS:
1. State whether the following items are in the nature of Capital, Revenue and/or Deferred Revenue Expenditure.
(i) Expenditure on special advertising campaign ` 66,000; suppose the advantage will be received for six
years.
(ii) An amount of ` 8,000 spent as legal charges for abuse of Trade Mark.
(iii) Legal charges of ` 15,000 incurred for raising loan.
(iv) Share issue expenses ` 5,000.
(v) Freight charges on a new machine ` 1,500 and erection charges ` 1,800 for that machine.
Answer:
(i) Revenue expenditure ` 66,000.
(ii) Revenue expenditure ` 8,000.
(iii) Capital expenditure ` 15,000.
(iv) Capital expenditure ` 5,000.
(v) Capital expenditure = ` 1,500 + ` 1,800 = ` 3,300.

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2. Classify the following Accounts into Personal, Real and Nominal Accounts. Also state whether it is recorded
as asset, liability, expenses/loss or revenue:
(i) Returns Inward Account
(ii) Bad Debt Recovered Account
(iii) Interest On Investment Account
(iv) Outstanding Rent Account and
(v) Capital Work-in-Progress Account

Answer:
(i) Nominal, Revenue
(ii) Nominal, Revenue
(iii) Nominal, Revenue
(iv) Personal, Liability
(v) Real, Asset

3. Classify the following under personal, real and nominal accounts.

(i) Patent Rights (vi) Advertisement
(ii) Outstanding Rent (vii) Export duty
(iii) Drawings (viii) Securities and Shares
(iv) Live Stock (ix) Suspense
(v) Bank Overdraft (x) Work-in-progress

Answer:
Personal Account (ii) Outstanding Rent
(iii) Drawings
(v) Bank Overdraft
Real Account (i) Patent Rights
(iv) Live Stock
(viii) Securities and Shares
(x) Work-in-progress
Nominal Account (vi) Advertisement
(vii) Export duty
(ix) Suspense

4. Mr. X is owner of a Cinema Hall. He spent a heavy amount for complete renovation of the hall, for installation
of air-condition machines and for sitting arrangement with cushion seats. As a result the revenue has been
doubled. He also spent for few more doors for emergency exit. State your opinion amount the treatment of
the entire expenditure.
Answer:
The size of the expenditure is not the criteria to decide whether subsequent expenditure should be capitalized. The
important question is whether the expenditure increases the future benefits from the asset beyond its pre-assessed
standard of performance as per AS-10. Only then it should capitalized.
In the instant case, the first part f expenditure i.e., Renovation etc., Renovation etc. should be capitalized because
it has enhanced the revenue earning capacity of the hall. The second part of expenditure for making more
emergency exists does not enhance the revenue of the asset. So it should be charged to revenue.

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5. Mr. Agarwal could not agree the Trial Balance. He transferred to the Suspense Account of ` 296, being
excess of the debit side total. The following errors were subsequently discovered.
(i) Sales Day Book was overcast by ` 300
(ii) An amount of ` 55, received from Mr. Y was posted to his account as ` 550
(iii) Purchases Return Book total on a folio was carried forward as ` 221, instead of ` 112
(v) A car sale of ` 1,235 duly entered in the Cash Book but posted to Sales A/c as ` 235
(vi) Rest of the difference was due to wrong total in Salaries A/c. Show the Journal entries to rectify the
above errors.
Answer:

Date Particulars Amount (`) Amount (`)

(i) Sales A/c Dr. 300
To, Suspense A/c 300
(Being Sales Book overcast by now rectified)
(ii) Y A/c 495
To Suspense a/c 495
(Being amount received from Mr. Agarwal for ` 55 wrongly recorded as
` 550 now rectified.
(iii) Returns Outward A/c 109
To, Suspense A/c 109
(Being the total of purchases returns book was carried forward as ` 221,
instead of ` 112 now rectified)
(iv) Suspense A/c 1,000
Sales A/c 235
To, Car A/c / Sale of Asset A/c 1,235
(Being cash sales being ` 1,235 recorded only ` 235 as Sales A/c now
rectified)
(v) Suspense A/c 200
To, Salaries A/c 200
(Being Salary A/c was overcast by ` 200 now rectified)

6. Shyama Limited purchased a second-hand plant for ` 7,50,000 on 1st July, 2011 and immediately spent `
2,50,000 in overhauling. On 1st January, 2012 an additional machinery at a cost of ` 6,50,000 was purchased.
On 1st October, 2013 the plant purchased on 1st July, 2011 became obsolete and it was sold for ` 2,50,000.
On that date a new machinery was purchased at a cost of ` 15,00,000. Depreciation was provided @ 15%
per annum on diminishing balance method. Books are closed on 31st March in every year.
You are required to prepared Plant and Machinery Account upto 31st March, 2014.
Answer:
Books of Shyama Limited
Plant & Machinery Account
Date Particulars ` Date Particulars `
1.7.11 To Bank A/c 10,00,000 31.3.12 By Depreciation A/c 1,36,875
(7,50,000 + 2,50,000)
1.1.12 To Bank A/c 6,50,000 31.3.12 By Balance c/d 15,13,125
16,50,000 16,50,000
1.4.12 To Balance b/d 15,13,125 31.3.13 By Depreciation @ 15% on ` 15,13,125 2,26,969
By Balance c/d 12,86,156
15,13,125 15,13,125
1.4.13 To Balance b/d 12,86,156 By Bank A/c (Sale) 2,50,000
1.10.13 To Bank A/c 15,00,000 By P&L A/c (Loss on Sale) 4,47,797
By Depreciation A/c 2,48,845
By Balance c/d 18,39,514
27,86,156 27,86,156

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 FINANCIAL ACCOUNTING

Working Notes:
Written down value of Machinery which is purchased on 01.07.2011.

Particulars `
On 01.07.2011 10,00,000
Less: Depreciation for 2011 – 12 of 9 months (10,00,000 × 15% × 9/12) 1,12,500
W.D.V. for 2012-13 8,87,500
Less: Depreciation for 2012-13 1,33,125
W.D.V. for 2013-14 7,54,375
Less: Depreciation for 6 months on (7,54,375 × 15% × /12)
6
56,578
W.D.V. 6,97,797
Less: Selling Price 2,50,000
Less: On Sale of Machinery 4,47,797

Total Depreciation
(a) Machinery Purchased on 01.01.2012
Particulars `
On 01.01.2012 6,50,000
Less: Depreciation for 3 months of 2011 - 12 24,375
W.D.V. 6,25,625
Less: Depreciation for 2012-13 (6,25,625 × 15%) 93,844
W.D.V. 5,31,781
Less: Depreciation for 2013-14 79,767
W.D.V. 4,52,014

(b)
Particulars `
Machinery Purchased on 01.01.2013 15,00,000
Less: Depreciation for 6 months (15,00,000 × 15% × 6/12) 1,12,500
13,87,500
∴ Total Depreciation ` (1,12,500 + 79,767 + 56,578) = ` 2,48,845.

7. On 31st December, 2011 two machines which were purchased on 1.10.2008 costing ` 50,000 and ` 20,000
respectively had to be discarded and replaced by two new machines costing ` 50,000 and ` 25,000
respectively.
One of the discarded machine was sold for ` 20,000 and other for ` 10,000. The balance of Machinery Account
on April 1, 2011 was ` 3,00,000 against which the depreciation provision stood at ` 1,50,000. Depreciation
was provided @ 10% on Reducing Balance Method.
Prepare the Machinery Account, Provision for Depreciation Account and Machinery Disposal Account.

Answer:
Machinery Account
Date Particulars ` Date Particulars `
1.4.11 To Balance b/d 3,00,000 31.12.11 By Machine Disposal A/c 70,000
To Bank A/c 75,000 31-3.12 By Balance c/d 3,25,000
3,75,000 3,75,000

90 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA

Fundamentals of Accounting

Provision for Depreciation Account

Date Particulars ` Date Particulars `
1.4.11 To Machine Disposal A/c 20,175 1.4.11 By Balance b/d 1,50,000
(16,135 + 4,040)
31.3.12 To Balance c/d 1,41,314 31.3.12 By P/L A/c 11,489
1,61,489 1,61,489
Machine Disposal Account
Date Particulars ` Date Particulars `
1.4.11 To Machine A/c 70,000 31.12.11 By Provision for Depreciation A/c 16,135
By Provision for Depreciation (on two machine 4,040
for 9 months)
By Bank A/c 30,000
By P/L A/c (Balancing Figure) 19,825
70,000 70,000

Working Note: 1. Calculation of Depreciation of Two Discarded machine till 1.4.2012

Particulars M-1 M-2 Total
Value of Machine as on 1-10-2008 50,000 20,000 70,000
Less: Depreciation for 2008-09 @ 10% (from 1.10.08 to 31.3.09) 2,500 1,000 3,500
47,500 19,000 66,500
Less: Depreciation for 2009-10 @ 10% 4,275 1,900 6,650
42,750 17,100 59,850
Less: Depreciation for 2009-10 @ 10% 4,275 1,710 5,985
38,475 15,390 53,865

Hence, Provision for Depreciation on Machine Disposal = 3,500 + 6,650 + 5,985 = 16,135.

Working Note: 2. Depreciation on Discarded Machine:

Particulars `
Book Value of machine as on 01.04.2011 53,865
Less: Depreciation @ 10% for 9 months (till 31.12.2011)(53,865 × 10% × /12)
9
4,040
Value of Discarded Machine as on selling date 49,825

Working Note: 3. Depreciation of Machine in use:

Particulars ` `
Value of Machine on 1.4.11 3,00,000
Less: Cost of Discarded Machine 70,000
2,30,000
Less: Provision for Depreciation on 1.4.11 1,50,000
Less: Depreciation on Discarded Machine 1.4.11 16,135 1,33,865
96,135
Depreciation @ 10% on ` 96,135 9,614
Add: Depreciation for 3 months on 75,000 @ 10% 1,875
Total Depreciation 11,489

THE INSTITUTE OF COST ACCOUNTANTS OF INDIA 91

 FINANCIAL ACCOUNTING

EXERCISE:
1. Classify the following Accounts into Personal, Real and Nominal Accounts:
(i) Patent Rights A/c
(ii) Drawings A/c
(iii) Purchase Return A/c
(iv) South Sports Club A/c
(vi) Prepaid Insurance A/c
(vii) Bank Overdraft A/c
(viii) Free samples A/c

Answer:
Real A/c (i)
Personal A/c (ii), (iv), (v), (vii)
Nominal A/c (iii), (vi), (vii)

2. State which of the following items are (i) Capital Expenditure; (ii) Revenue expenditure; (iii) Deferred Revenue
expenditure:
(i) Legal charges of ` 15,000 incurred for raising loan.
(ii) An amount of ` 7,500 spent as legal charges for abuse of Trade-Mark.
(iii) Carriage paid on a new machine purchased for ` 18,000.
(iv) ` 25,000 spent on construction of animal-huts.

Answer:
Capital Expenditure (i), (iii), (iv)
Revenue Expenditure (ii)

3. The total of debit side of the Trial Balance of Lotus Stores as at 31.03.2016 is ` 3,65,000 and that of the credit
side is ` 2,26,000.
After checking, the following mistakes were discovered:

Items of account Correct figures (as it should be) Figures as it appears in the Trial Balance
(`) (`)
Opening Stock 15,000 10,000
Rent and Rates 36,000 63,000
Sundry Creditors 81,000 18,000
Sundry Debtors 1,04,000 1,58,000
Ascertain the correct total of the Trial Balance.
Answer:
The correct total is — ` 2,89,000

4. On 1st April, 2010, M/s. N. R. Sons & Co. purchased four machines for ` 2,60,000 each. On 1st April, 2011, one
machine was sold for ` 2,05,000. On 1st July, 2012, the second machine was destroyed by fire and insurance
claim received ` 1,75,000 on 15th July, 2012. A new machine costing ` 4,50,000 was purchased on 1st
October, 2012. Books are closed on 31st March every year and depreciation has been charged @ 15% per
annum on diminishing balance method. You are required to prepare machinery account for 4 years still 31st
March, 2014. (Calculations to be shown in nearest rupee).
Answer:
Machinery A/c Balance as on 01.04.2014 (Dr.) `6,25,256.
Depreciation as on 31.03.2014 — `1,10,339.

92 THE INSTITUTE OF COST ACCOUNTANTS OF INDIA