BBA - JNU - 101 Fundamentals of Accounting PDF

FUNDAMENTALS OF
ACCOUNTING
(BBA 101)
Jaipur National University

Directorate of Distance Education
_________________________________________________________________________________
Established by Government of Rajasthan
Approved by UGC under Sec 2(f) of UGC ACT 1956
(Recognised by Joint Committee of UGC-AICTE-DEC, Govt. of India)
FUNDAMENTALS OF ACCOUNTING
Accounting: Meaning, scope, need and objectives. Accounting Principles: Concepts and
conventions, Accounting equation.
Journal: Rules of debit and credit, compound journal entry and subsidiary books. Ledger: Rules
regarding posting..
Depreciation: Concepts of Depreciation, Methods of accounting for depreciation.
Provisions: provisions for Bad debts and discount on bad debts and
Reserves: Reserve for discount on creditors, Rectification of Errors.
Trial Balance: Meaning, objectives & preparation. Errors: Types of Errors and, rectification. Self
– Balancing and Section Balancing system
Final Accounting: Trading account, Profit & Loss account, Balance sheet and Adjustment
entries.
Book of Original Record: Journal; Rules of debit and credit; compound journal entry; Opening
entry; Relationship between journal and Ledger, Rules regarding posting.
Partnership Accounts: Problems Relating to Admission, Retirement, Death and Dissolution of a

Firm
Accounting of Non Profit Organization: Accounting for insurance, Incomplete Records –

Meaning, method of Preparation of Accounts from Incomplete Records.
Issue of Shares and Debentures: Meaning, Types, Methods of issue, forfeited of shares and
reissue of forfeited shares, treatment of interest on debentures.
Redemption of Preference Shares and Debentures: Meaning, Legal provision and methods of
redemption, preparation of balance sheet after redemption.
Financial Statements: Meaning, Capital Expenditure, Revenue expenditure and Deferred

Revenue Expenditure.
Analysis of Accounting Information: Financial statement analysis and application, Statement of

cash flow, preparation and interpretation.
Accounting for Insurance Claim: Loss of Stock and consequential loss. Accounting principles;
Accounting Standards in India.
CONTENTS
Unit-1: Accounting 1-13
1.1 Need of Accounting
1.2 Objectives of Accounting
1.3 Basics of Accounting
1.4 Accounting Terms
1.5 Conceptual Framework
1.6 Accounting Conventions
1.7 Accounting Equation
1.8 Balance Sheet
1.9 Profit and Loss Account for Non Corporate and Corporate Entities
1.10 Summary
1.11 Keywords
1.12 Self Assessment Questions
1.13 Review Questions
Unit-2 Journal 14-26

2.1 Concept of Journal
2.2 Rules of Debit And Credit
2.3 Compound Journal Entry
2.4 Ledger
2.5 Trial Balance
2.6 Summary
2.7 Keywords
Unit-3 Depreciation 27-39

3.1 Concepts of Depreciation
3.2 Methods of Accounting for Depreciation
3.3 Tax Depreciation
3.4 Summary
3.5 Keywords
Unit-4 Provisions 40-52
4.1 Provision of Bad Debts Accounting
4.2 Provision for Discount on Debtors
4.3 Summary
4.4 Keywords
Unit-5 Reserves 53-64

5.1 Types of Reserves
5.2 Reserve for Discount on Debtors
5.3 Reserves for Discount on Creditors
5.4 Rectification of Errors
5.5 Summary
5.6 Keywords
Unit-6 Trial Balance 65-77

6.1 Meaning of Trial Balance
6.2 Objectives of Trial Balance
6.3 Types of Errors
6.5 Sectional and Self Balancing System
6.6 Summary
6.7 Keywords
Unit-7 Final Accounting 78-91

7.1 Trading Account
7.2 Profit and Loss Account
7.3 Balance Sheet
7.4 Adjustment Entries
7.5 Summary
7.6 Keywords
Unit-8 Book of Original Record 92-105

8.1 Journal
8.2 Rules of debit and credit
8.4 Opening entry
8.5 Relationship between journal and Ledger
8.6 Rules regarding posting
8.7 Summary
8.8 Keywords
Unit-9 Partnership Accounts 106-117

9.1 Problems Relating to Admissions
9.2 Retirement
9.3 Death and Dissolution of a Firm
9.4 Summary
9.5 Keywords
Unit-10 Accounting of Non Profit Organization 118-130

10.1 Accounting for Insurance
10.2 Meaning of Incomplete Records
10.3 Method of Preparation of Accounts from Incomplete Records
10.4 Summary
10.5 Keywords
Unit-11 Issue of Shares and Debentures 131-143

11.1 Meaning of Share and Debenture
11.2 Types of Share and Debenture
11.3 Methods of Issues of Share and Debenture
11.4 Forfeited of Shares and Reissue of Forfeited Share
11.5 Treatment of Interest on Debenture
11.6 Summary
11.7 Keywords
Unit-12 Redemption of Preference Shares and Debentures 144-153

12.1 Meaning of Shares
12.2 Debentures
12.3 Legal Provision and Methods of Redemption
12.4 Summary
12.5 Keywords
Unit-13 Financial Statements 154-166

13.1 Meaning of Financial Statements
13.2 Capital Expenditures
13.3 Revenue Expenditure
13.4 Deferred Revenue Expenditures:
13.5 Summary
13.6 Keywords
Unit-14 Analysis of Accounting Information 167-179

14.1 Financial statement analysis and application
14.2 Statement of cash flow
14.3 Preparation and interpretation.
14.4 Summary
14.5 Keywords
Unit-15 Accounting for Insurance Cl 180-194

15.1 Loss of Stock and Consequential Loss
15.2 Accounting Principles of Insurance Accounting
15.3 Accounting Standards in India
15.4 Summary
15.5 Keywords
1
Accounting
CONTENTS
Objectives
Introduction
1.8 Balance Sheet
1.9 Profit and Loss Account for Non Corporate and Corporate Entities
1.10 Summary
1.11 Keywords
Objectives
After studying this chapter, you will be able to:
Explain the need of accounting
Understand the objectives of accounting
Understand the basics of accounting
Define the terms in accounting
Discuss conceptual framework of accounting
Understand the accounting conventions
Define accounting equation and balance sheet
Explain about the profit and loss account for non corporate and corporate entities
Introduction
Every profit or nonprofits business entity requires a reliable internal system of accountability. A business
accounting system provides this accountability by recording all activities regarding the creation of
monetary inflows of sales revenue and monetary outflows of expenses resulting from operating activities.
The accounting system provides the financial information needed to evaluate the effectiveness of current
and past operations. In addition, the accounting system maintains data required to present reports showing
the status of asset resources, creditor liabilities, and ownership equities of the business entity. In the past,
much of the work required to maintain an effective accounting system involved extensive manual effort
that was tedious, aggravating, and time consuming. Such systems relied on individual effort to continually
record transactions, to add, subtract, summarize, and check for errors.
The rapid advancement of computer technology has increased operating speed, data storage, and
reliability, accompanied by a significant cost reduction. Inexpensive microcomputers and accounting
software programs have advanced to the point where all of the posting, calculations, error checking, and
financial reports are provided quickly by the computerized system.
Financial accounting is concerned with the recording of financial transactions and analyzing the effect of
such transactions to assist in the development of business decisions. Hospitality management accounting is
concerned with providing specialized internal information to managers who are responsible for directing
and controlling operations within the hospitality industry. Internal information is the basis for planning
alternative short- or long-term courses of action and the decision as to which course of action is selected.
Specific detail is provided as to how the selected course of action will be implemented.

Accounting is very much connected with our personal lives in so far as it is in respect of every business.
We all with intent or unknowingly generate accounting ideas in a way when we plan what we will do with
money. We need to plan how much money will be spent whilst how much of it will be kept back. What is
through this activity is a budget gets prepared. And we all are familiar with this concept - which is
universally acceptable, that money must be spent cautiously.
The same is true of a business. It is therefore imperative for a business to know about the inflow and out
flow of economic resources and their results. Thus, accounting is the very need of a business to provide the
information which is useful for sound economic decision making process and owing to the diversification
between ownership and management. Being known as ―The Language of business‖, accounting is the basic
need of a business organization to find out where it stands.
It is of great essence to provide the basis for planning and budgeting while dealing with measurement of
economic activities and communicating financial information to the users for decision making. Accounting
is also meant for protecting the properties of business and communicating the results obtained from the
financial statements to the intended parties like share holders, debtors, creditors, and investors while
meeting the legal requirements.
Accounting is included in those fields that are growing faster in this era. It is dynamic at the present time
and meets the growing demands of trade, commerce and industry. It is appropriate to mention here that the
advent of industrial revolution and technological advancements have given rise to widen more business
prospects at the same time as bringing about change in the domain of accounting by which it has now
begun to be known as a tool of management for planning and controlling process. Thus, it can be rightly
said, in the present day and age, no economic activity can be carried out successfully with no thought of
accounting.
Scope of Accounting
Accounting has got a very wide scope and area of application. Its use is not confined to the business world
alone, but spread over in all the spheres of the society and in all professions. Now-a-days, in any social
institution or professional activity, whether that is profit earning or not, financial transactions must take
place. So there arises the need for recording and summarizing these transactions when they occur and the
necessity of finding out the net result of the same after the expiry of a certain fixed period. Besides, this is
also the need for interpretation and communication of that information to the appropriate persons. Only
accounting use can help overcome these problems.
Nature of Accounting
We know accounting is the systematic recording of financial transactions and presentation of the related
information of the appropriate persons.
The basic features of accounting are as follows:

1. Accounting is a Process: A process refers to the method of performing any specific job step by step
according to the objectives, or target. Accounting is identified as a process as it performs the specific task
of collecting, processing and communicating financial information. In doing so, it follows some definite
steps like collection of data recording, classification summarization, finalization and reporting.
2. Accounting is an Art: Accounting is an art of recording, classifying, summarizing and finalizing the
financial data. The word ―art‖ refers to the way of performing something. It is a behavioural knowledge
involving certain creativity and skill that may help us to attain some specific objectives.

Objectives of accounting are given below:
To Keep Systematic Records
Accounting is done to keep a systematic record of financial transactions. In the absence of accounting there
would have been terrific burden on human memory which in most cases would have been impossible to
bear.
To Protect Business Properties

Accounting provides protection to business properties from unjustified and unwarranted us. This is
possible on account of accounting supplying the information to the manager or the proprietor.
To Ascertain the Operational Profit or Loss

Accounting helps is ascertaining the net profit earned or loss suffered on account of carrying the business.
This is done by keeping a proper record of revenues and expenses of a particular period. The profit and
loss account is prepared at the end of a period and if the amount of revenue for the period is more than the
expenditure incurred in earning that revenue, there is said to be a profit. In case the expenditure exceeds
the revenue, there is said to be a loss.

Accounting is a very old science which aims at keeping records of various transactions. The accounting is
considered to be essential for keeping records of all receipts and payments as well as that of the income
and expenditures.
Accounting can be broadly divided into three categories:
1. Financial Accounting aims at finding out profit or losses of an accounting year as well as the assets
and liabilities position, by recording various transactions in a systematic manner.
2. Cost Accounting helps the business to ascertain the cost of production/services offered by the
organization and also provides valuable information for taking various decisions and also for cost control
and reduction.
3. Management Accounting helps the management to conduct the business in a more efficient manner.
1.3.1 Financial Accounting
Financial accounting aims at finding the results of an accounting year in terms of profits or losses and
assets and liabilities. In order to do this, it is essential to record various transactions in a systematic
manner. Financial accounting is defined as, ―Art and science of classifying, analyzing and recording
business transactions in a systematic manner in order to prepare a summary at the end of the year to find
out the results of the concerned accounting year.‖ The definition given above is self explanatory; however
for understanding clearly.
The following terms are explained:
Business Transactions: A transaction means an activity; a business transaction means any activity which
creates some kind of legal relationship.
For example, purchase and sale of goods, appointing an employee and paying his salary, payment of
various expenses, purchase of assets etc.
Classification of Transactions: Before recording any transaction, it is essential that it is to be classified. A

transaction can be classified as cash transaction and credit transaction. Similarly transactions of receiving
income and payment of expenditure can be segregated.
Recording of Transactions: The essence of financial accounting is recording of transaction. In accounting

language, recording of the transaction is known as entry. There are well defined rules for recording various
transactions in books of accounts.
1.3.2 Cost Accounting

It is a type of accounting process that aims to capture a company‘s costs of production by assessing the
input costs of each step of production as well as fixed costs such as depreciation of capital equipment. Cost
accounting will first measure and record these costs individually, then compare input results to output or
actual results to aid company management in measuring financial performance.
Cost accounting is often used within a company to aid in decision-making, financial accounting is what the
outside investor community typically sees. Financial accounting is a different representation of costs and
financial performance that includes a company‘s assets and liabilities. Cost accounting can be most
beneficial as a tool for management in budgeting and in setting up cost control programs, which can
improve net margins for the company in the future.
1.3.3 Management Accounting

Management accounting is the application of professional knowledge and skill in the preparation and
presentation of accounting information in such a way as to assist management in the formulation of
policies and in planning and controlling the operations of the organization.
The main purpose of management accounting is to provide information to the management team at all
levels within the organization for the following purposes:
(a) Formulating the policies––strategic planning
(b) Planning the activities of the organization––corporate planning
(c) Controlling the activities of the organization
(d) Decision-making––long-term and tactical
(e) Performance appraisal at strategic and operational level
A management accounting/cost statement provides information to allow managers to plan, control and
organize the activities of the business. The purpose of a costing/management accounting information
system is:
1. To provide information about product costing to be used in financial statements.
2. To provide information for planning, controlling and organizing.
Did You Know?
The earliest accounting records were found amongst the ruins of ancient Babylon, Assyria and Sumeria,
which date back more than 7,000 years.

Every subject has certain important basic terms, and accountancy is no exception.
1.4.1 Trading and Non-trading Business Items
One must have visited many business concerns. It might have noted the various items that are purchased
for further sale by the business concerns. It might have also noted various other items that are used in the
business concern and which are not meant for sale.
For example, in a stationery shop there are various items like books, pens, pencils, scales, note-books,
charts, gum bottles, etc. These items are purchased by the businessman in order to sell them. There are
certain other items like fan, Air-conditioner, generator, furniture, etc. in the stationery shop. These items
are purchased by the businessman for use and not for sale. From the above examples, we can classify all
the items in a business concern into two categories, viz., trading and non-trading. (See Figure 1.1)
Items
Trading Non-Trading
Figure 1.1: Trading and non-trading business items.

(a) Trading Items
Trade means purchase and sale of goods or/and services. All goods or items which are purchased by the
businessman in order to sell them thereby earn profit are called Trading items. A business concern deals m
trading items in the stationery shop, books, pens, pencils, etc are all trading Items.
(b) Non-Trading Items

Items which are purchased by the business concern in order to use them are called as non-trading items.
These items are not meant for sale. In the stationery shop, furniture, fan, generator, etc. are non-trading
items. Like the stationery shop, other business units also possess trading and non-trading items.
For example, for a cloth merchant, different varieties of cloth are trading Items and racks made to store and
display the cloth are non-trading items. For a transport company, buses are trading items because they
provide service and the sheds and tools kept to repair the buses are non-trading items.

In the conceptual framework the following concept are used:
1.5.1 Generally Accepted Accounting Principles (GAAP)
The requirements for accurate financial records are outlined in federal and provincial tax laws. In addition,
the basic rules for good accounting practice are summarized in a set of guidelines known as the Generally
Accepted Accounting Principles (GAAP).
1. Business Entity Concept (Accounting Entity)
A business is separate from its owner. It has certain rights and responsibilities that are separate from the
owner.
For example, the business must file its own income tax return and pay its debts. The owner must file his or
her own income tax return that is separate from the business return. The property or assets that a business
owns must be recorded separately from the property that the owner of the business has.
2. Going-concern Assumption
When a business is started, it is expected to last or continue operations for some time. It does not plan to go
bankrupt or to dissolve immediately. It expects to be able to carry out its commitments to its customers or
clients, either to provide goods or services. The business often continues, even when the ownership
changes.
3. Time Period Principle
Even though a business is expected to continue operations for a long time (Going-Concern Assumption), it
must report frequently and at regular time periods on its status and changes for various reasons such as
annual statements to shareholders, income statements for income tax purposes and for normal business
decisions, etc. This need for reporting changes regularly creates the need to measure various parts of the
business at different periods of time (monthly, quarterly or yearly). For assets, therefore, it is necessary to
know how long they can be expected to last so that their value can be stated at these different times.
4. Monetary Principle
In order for a business to report on its status and progress, we need to be able to measure the things that it
owns and the things that it does. It has been decided that money will be used to provide this information—
dollars in Canada, yen in Japan, etc.
Thus, all assets are recorded on the balance sheet in dollar values, while income and expenses are reported
in dollars on the income statement. This principle also assumes that the dollar is stable—it is worth as
much now as it was 20 years ago, and will be 20 years from now. Of course, with inflation, this is not true;
but for now, we have not found a better way to provide information about the business. We could measure
everything in chickens, but that might create some other problems!
5. Objectivity Principle
All estimates and measurements in the business must be fair and reasonable. Whenever possible, they
should be based on fact so that they are not biased. This is why historical costs are preferred for
determining the value of assets. Fair market value is often used as the criterion or guideline. How much
something is worth should not be determined by how much your best friend will give you for it, but by
how much a group of strangers would be willing to pay for it. Your best friend is less likely to be unbiased
or objective. You might be willing to give her a really low price because she is your best friend. Or she
might be willing to pay extra to help you out because she is your best friend. The deal with your friend
would be a non-arms-length deal, because of this potential for bias.
Caution
While preparing financial statements revenue cannot be included as income.

An accounting convention refers to common practices which are universally followed in recording and
presenting accounting information of the business entity. They are followed like customs, tradition, etc. in
a society. Accounting conventions are evolved through the regular and consistent practice over the years to
facilitate uniform recording in the books of accounts. Accounting Conventions help in comparing
accounting data of different business units or of the same unit for different periods. These have been
developed over the years. The most important conventions which have been used for a long period are:
Convention of consistency.
Convention of full disclosure.
Convention of materiality.
Convention of conservatism.
Convention of Consistency
The convention of consistency means that same accounting principles should be used for preparing
financial statements year after year. A meaningful conclusion can be drawn from financial statements of
the same enterprise when there is comparison between them over a period of time. But this can be possible
only when accounting policies and practices followed by the enterprise are uniform and consistent over a
period of time. If different accounting procedures and practices are used for preparing financial statements
of different years, then the result will not be comparable.
Convention of Full Disclosure

Convention of full disclosure requires that all material and relevant facts concerning financial statements
should be fully disclosed. Full disclosure means that there should be full, fair and adequate disclosure of
accounting information. Adequate means sufficient set of information to be disclosed. Fair indicates an
equitable treatment of users. Full refers to complete and detailed presentation of information. Thus, the
convention of full disclosure suggests that every financial statement should fully disclose all relevant
information. Let us relate it to the business. The business provides financial information to all interested
parties like investors, lenders, creditors, shareholders etc.
Convention of Materiality
The convention of materiality states that, to make financial statements meaningful, only material fact i.e.
important and relevant information should be supplied to the users of accounting information.
The question that arises here is what a material fact is. The materiality of a fact depends on its nature and
the amount involved. Material fact means the information of which will influence the decision of its user.
Convention of Conservatism
This convention is based on the principle that ―Anticipate no profit, but provide for all possible losses‖. It
provides guidance for recording transactions in the books of accounts. It is based on the policy of playing
safe in regard to showing profit. The main objective of this convention is to show minimum profit.

The recording of business transaction in books of accounts is based on a fundamental equation called
accounting equation. Whatever business possesses in the form of assets is financed by proprietor or by
outsiders. This equation expresses the equality of assets on one side and the claims of outsiders (liabilities)
and owners or proprietors on the other side.
In Mathematical form,
Assets=Liabilities + Capital
Whenever an asset is introduced in the business, a corresponding liability also emerges. A business does
not have any amount of its own.
Hence, we can say that:
Whenever an asset is introduced in the business, a corresponding liability also emerges. A business does
not have any amount of its own.
Hence, we can say that:
• Business Owns Nothing, and Owes Nothing,
• What it Owns, it Owes
Let us see the effect of business transactions on accounting equation. These transactions increase or
decrease the assets, liabilities or capital. Every business has certain assets.
For example, Sunita has started business by contributing INR2, 00,000 as Capital.
It can be said that asset in the form of Cash has been created for the business concern.
Hence, Cash INR2, 00,000 Capital INR2, 00,000
Sunita later on purchases furniture, INR.20, 000 and machinery for 60,000.
Now the position of the assets is a follows:
From the above business transactions, we find that

Capital = Assets
or
Assets = Capital
Increase or decrease in capital will result in the corresponding increase or decrease in assets.
For example, Sunita introduces INR50,000 as additional capital.
Then
Every business concern, generally borrows money from outsiders in order to carry on its activities. In other
words, every business concern owes money to outsiders. These assets are financed by the funds supplied
by proprietors and outsiders. Money borrowed from outsiders is called as liability.
Effect of Transactions on Accounting Equations

The assets, liabilities and capital are the three basic elements of every business transaction, and their
relationship is expressed in the form of accounting equation which always remains equal? At any point of
time there can be a change in the individual assets, liability or capital, but the two sides of the accounting
remains equal. Let us examine the fact by taking up some more transactions and see how these transactions
affect accounting equation
Suppose, Rajni starts her business and the following transactions take place:
1. She started business with cash INR5,00,000 introduced as capital.
This transaction means that INR5,00,000 have been introduced by Rajni in terms of cash, which is the
capital for the business concern. Hence on one hand, the asset (cash) has been created to the extent of
INR5,00,000.
2. She purchased goods from Rohit for INR40,000

In this transaction, goods have been purchased on credit from Rohit; hence there is an increase in the assets
(goods) by INR40,000 and also an increase in the liabilities by INR40,000, as the business concern now
owes money to Rohit.
Did You Know?

The American Institute of Certified Public Accountants (AICPA) defines accountancy as ―the art of
recording, classifying, and summarizing in a significant manner and in terms of money, transactions and
events which are, in part at least, of financial character, and interpreting the results thereof.‖
1.8 Balance Sheet

A company‘s financial position or health is shown on the balance sheet, also called the statement of
condition or statement of financial position. It shows the business‘s financial position on a particular date.
The typical balance sheet displays the business‘s assets on the left side of the page and liabilities and net
worth on the right side like this:
Debt = Credit
BALANCE SHEET
Assets = Liabilities + Net Worth
Assets are normally debit balances and are what a business owns. Assets are broken into two main
categories: current assets and fixed assets. Current assets usually mean anything that can be converted into
cash within one year. Fixed assets, often called long term assets, are more permanent items like buildings
and major equipment.
Liabilities are normally credit balances and are what a business owes. Liabilities are divided into two main
categories just like assets. They are shown as current liabilities (that which is owed within one year) and
long term debt. Current liabilities include bills for such items as included in accounts payable, inventory,
rent, salaries, etc. Long term debt includes items that by agreement do not need to be paid back quickly,
such as a mortgage or long term note.
The difference between assets and liabilities equals net worth, which is often called stockholders‘ equity
for publicly-traded corporations. That is, after all the bills and notes are paid, anything left over is called
net worth. Another definition is that net worth is what is due the owner(s)/stockholders of the business
once all liabilities have been paid.
Assets – Liabilities = Net Worth

or
Assets = Liabilities + Net Worth
Why is it called a “Balance Sheet”?

The key word is balance, because the total assets equal the total liabilities plus the net worth. This is true
even if the liabilities exceed the assets. In this case, net worth becomes negative and it must be subtracted
from the liabilities, instead of being added.
A balance sheet uses the principle of double entry accounting. It is called double entry because each
business action affects two or more accounts.
For example, a sale will increase cash or accounts receivable but decrease inventory. An account can be
cash, inventory, money you owe (accounts payable), or owed to you (accounts receivable), etc. Accounts
payable and accounts receivable are called accrual accounts. The balances in these accounts represent cash
that must be paid to suppliers or will be received from customers at some future time.
Accounts are organized on the balance sheet in categories with current and fixed assets on the left side of
the sheet and current and long term liabilities as well as net worth on the right side of the sheet. Remember,
assets and liabilities plus net worth must always balance.
Note that business action affected three accounts which are on the asset side of the balance sheet, one
account, Inventory, decreased because product was sold, Cash increased because the business received
cash for part of the sale, Accounts receivable was added/increased because part of the product was sold on
credit.
Current assets are listed on the balance sheet in the order of when the account will be converted to cash.
Income Statement
The income statement contains two sections that can be subdivided.
Again, the detailed account names provide a fuller portrait of the business activity.
Revenues and Expenses: Revenues are sources of income, such as revenue from the sale of merchandise,
revenue from providing services or consulting, revenue from interest on bank deposits or investments, and
so on. Expenses are the costs incurred in generating revenue or in doing business.
These may include interest charges on loans or mortgages, the costs of supplies or merchandise that is sold,
maintenance of equipment and property, rent, utilities, depreciation of equipment, losses from theft or from
customers failing to pay, labour costs, payroll benefits, advertising, and so on.
Net Income (Loss): Expenses are subtracted from revenue to determine the net income. If revenue exceeds
expenses, the company has earned a profit. If expenses exceed revenue, the business will show a net loss.
Thus, the income statement shows the economic performance of the company.
1.9 Profit and Loss Account for Non Corporate and Corporate
Entities
Whereas the balance sheet shows a snapshot at a point in time of the net worth of the business, the profit
and loss account shows the current financial year‘s net operating profits, broken down into various sales,
cost of sales and expenses ledger accounts.
Sales
Sales accounts show all sales made in the period, regardless of whether or not money has been received
yet, and are shown as a credit in the Profit and Loss accounts. Where money has not yet been received, the
debit is not to cash, but to a Debtors account (money owed from customer account).
Cost of Sales
Cost of Sales is expenses that can be directly attributed to sales items, such as purchases of stocks.
Expenses
These are all other expenses (other than purchases of assets) which cannot be attributed directly to sales
items, such as rent, electricity or advertising.
1.9.1 Reporting Period and Conversion Period

The reporting period is usually a 12 month period ending 30th June each year. At the end of each financial
year the profit and loss account balance is transferred to the Retained Earnings account in the Balance
Sheet (under Equity). A new profit and loss account is started for the new financial year.
The Balance sheet is continues, the Profit and Loss accountis justfor
the current financial year.
Case Study- Process Costing System

Accounting for Spoiled Units
The House Hold Aids Company assembles clip clothespins in three sections, and uses process costing.
Under normal operating conditions, each section has a spoilage rate of 2%. However, spoilage can go as
high as 5% and is usually discovered when a faulty pin enters process or on final completion by a section.
The spring mechanism is the only material which can be saved from a spoiled unit. The production
supervisor assigns a worker once or twice a week to remove the springs from spoiled units. The salvaged
springs are placed in bins at the assembly tables in section No1 to be used again. No accounting entry is
made of this salvage operation.
In the past, the controller has made no attempt to account for spoilage separately. Lost unit costs have been
absorbed by the units transferred out of the section and those remaining in the process. However, because
spoilage is increasing, a different method is needed.
Solution
The spoiled work should be broken into normal and abnormal spoilage. The cost of normal spoilage should
be absorbed by good completed units. All materials salvaged should be assigned a value and placed in
materials inventory. Sectional materials costs should be reduced by the value assigned to salvaged
materials.
Abnormal spoilage should be charged to factory overhead account. The cost to be included in this account
should be the amount accumulated against a clothespin up to the point of being scraped, and the total loss
in scraped clothespins should be shown in the cost of production report of the department responsible for
the loss.
Questions
1. Why accounting is required for spoiled units in House Hold Aids Company?
2. What is the process costing system? Explain.
1.10 Summary
Financial accounting, aims at finding out profit or losses of an accounting year as well as the assets and
liabilities position, by recording various transactions in a systematic manner.
Financial accounting aims at finding the results of an accounting year in terms of profits or losses and
assets and liabilities.
Trade means purchase and sale of goods or/and services.
Tangible items are those which can be touched and their presence can be noted, For example furniture,
machines, etc.
Current assets are those assets which are held for short time generally a year‘s time only.
Non-current assets are those assets which are acquired for long term use in the business.
Liabilities are the obligations or debts payable by the business unit in future.
Internal liabilities are those liabilities which business owes to the owners or proprietors.
1.11 Keywords
Accounting Equation: The basic accounting equation is the foundation for the double-entry bookkeeping
system. For each transaction, the total debits equal the total credits.
Balance Sheet: Balance Sheet is the snap shot of financial strength of any company at any point of time.
Credit: Credit is the trust which allows one party to provide resources to another party where that second
party does not reimburse the first party immediately.
Current Asset: In accounting, a current asset is an asset on the balance sheet which can either be converted
to cash or used to pay current liabilities within 12 months.
Current Liabilities: current liabilities are often understood as all liabilities of the business that are to be
settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.

1. Which of the following statements is incorrect?
(a) Liabilities + Assets = Capital (b) Assets - Capital = Liabilities
(c) Liabilities + Capital = Assets (d) Assets - Liabilities = Capital
2. Which of the following is not an asset?

(a) Cash balance (b) Loan from K Harris
(c) Buildings (d) Debtors
3. Which of the following is a liability?

(a) Motor Vehicles (b) Cash at Bank
(c) Machinery (d) Creditors for goods
4. Which of the following best describes a trial balance?

(a) Shows the financial position of a business (b) It is a list of balances on the books
(c) Shows all the entries in the books (d) It is a special account
5. Is it true that the trial balance totals should agree?

(a) No, because it is not a balance sheet
(b) No, there are sometimes good reasons why they differ
(c) Yes, except where the trial balance is extracted
d) Yes, always at the year end
6. Which of the following is correct?

(a) Capital can only come from profit (b) Profit increases capital
(c) Profit reduces capital (d) Profit does not alter capital
7. Which of the following should not be called ‗Sales‘?
(a) Goods sold for cash
(b) Office fixtures sold
(c) Sale of item previously included in ‗Purchases
(d) Goods sold on credit
8. Financial Accounting aims at finding the results of an accounting year in terms of profits or losses and
assets and liabilities.
(a) True (b) False
9. SEBI stands for….

(a) Securities and Exchange Board of India (b) Securities and Export Board of India
(c) Both a and b (d) None of these.
10. …………… aims at finding the results of an accounting year in terms of profits or losses and assets
and liabilities.
(a) Cost accounting (b) Financial accounting
(c) Management Accounting (d) Both a and b

1. Explain the major difference between cash and accrual accounting.
2. In what way business manager uses accounting information?
3. Using examples, give a short description of five accounting principles or concepts.
4. Why is the rule for debit and credit entries the same for liability and owners‘ equity accounts?
5. Define the concept of depreciation.
6. What is the purpose of an accumulated depreciation account?
7. Explain the convention of consistency with example.
8. Explain the accounting convention of conservatism with example.
9. Explains the convention of materiality.
10. Distinguish between expense and expenditure.
Answer for Self Assessment Questions

1 (a) 2 (b) 3 (d) 4 (b) 5 (d)
6 (b) 7 (b) 8 (a) 9 (a) 10 (b)
2
Journal
CONTENTS
Objectives
Introduction
2.2 Rules of Debit And Credit
2.4 Ledger
2.5 Trial Balance
2.6 Summary
2.7 Keywords
Objectives
Explain the journal
Define the rules of debit and credit
Understand the compound journal entry and subsidiary books
Discuss the ledger and the rules regarding posting
Explain the trial balance
Introduction
All business transaction is initially recorded in a journal using the double-entry method or single-entry
method of bookkeeping.
The journal records all daily transactions of a business in the order in which they occur. A journal may
therefore be defined as a book containing a chronological record of transactions. It is the book in which the
transactions are recorded first of all under the double entry system. Thus, Journal is the books of original
records. The process of recording transaction in a Journal is termed as ―Journalizing‖. A Performa of a
Journal is given in Figure 2.1:
Figure 2.1: Performa of a journal.
1. Date: The date on which the transaction was entered is recorded here.
2. Particulars: The two aspects of transaction are recorded in this column, i.e. the details regarding
accounts which have to be debited and credited.
3. L.F: It means Ledger Folio. The transactions entered in the Journal are later on posted to the Ledger.
Procedure regarding posting the transactions in the Ledger has been explained in the succeeding.
4. Debit: In this column, the amount to be debited is entered.
5. Credit: In the column, the amount to be credited is shown.

The word ―journal‖ has been derived from the French word ―jour‖. Jour means day. So journal means
daily. Transactions are recorded daily in journal and hence it has been named so. It is a book of original
entry to record chronologically (i.e. in order of date) and in detail the various transactions of a trader. It is
also known Day Book because it contains the account of every day‘s transactions.
The Journal of Financial Reporting and Accounting (JFRA) provide a valuable forum for the publication
of research that address significant issues on financial reporting and accounting. The JFRA aspires to
promote interdisciplinary and international understanding on financial reporting and accounting. The JFRA
aims to publish that bridge the gap between accounting theory and practice. The JFRA encourages
submissions of high quality manuscripts that have an impact upon academia, accounting practice and
society.
1. The journal entry must identify at least two accounts.

2. The journal entry must show at least one debit and one credit entry.
3. The sum of the debits and credits must be equal
Each business transaction must be analyzed to determine the effects of increasing or decreasing an asset,
liability, owners‘ equity item, sales revenue, or expense accounts. It is incorrect to view debits as increases
and credits as decreases in the balance of all ledger accounts. All accounts are referred to as being
normally debit or credit balanced, based on their classifications. The normal account balances for each of
the five types of accounts and their debit–credit relationships as a review are summarized in Figure 2.2:
Figure 2.2: Debit–credit relationships.
Consider the following transaction: A proprietor, Gram Disk, begins a business entity called the ABC
Restaurant on May 1, 2006. He makes an initial investment of INR100,000 cash to begin operations (See
Figure 2.3). The transaction creates the following balance sheet equation:
Date Account Titles P/R Debit(in Credit in
Rs) Rs)
05-01-2006 Cash 101 100,000
Gram Disk, Capital 502 100,000
P/R: The posting refrence identifying the number of the account posted
Dates and account numbers are used in this exhibit to clarify their use in a typical
ledger account format and will not be used in future journal entries
Figure 2.3: ABC restaurant journal entry to initiate accounting system.
Figure 2.3 shows the journal entry to record the INR1,00,000 initial cash investment. The journal entry is
posted as follows:
Cash(Asset) Gram Disk, Capital(OE)

Debit(in Credit(in Balance(in Debit(in rs) Credit(in rs) Balance(in rs)
rs) rs) rs)
100,000 100,000 100,000 100,000
On May 5, 2006, Gram Disk purchased a former restaurant building for INR1,50,000, paying INR45,000
in cash and assuming a note payable for INR1,05,000 balance owed. In addition, he purchased INR8,000
of food inventory and INR2,000 of beverage inventory for cash. He purchased equipment for INR12,000
on short credit (accounts payable). These transactions were journalized in a compound entry, which uses
more than two accounts. Then they were posted to modified T ledger accounts, as shown in Figure 2.4. As
can be seen, six new ledger accounts were created to post operating journal entry 1.
After posting the journal entry, the balance sheet equation and a balance sheet look like this:
Assets Liabilities Ownership quity

  
217 , 000 (In Rs.) 117 , 000 (In Rs.) 100, 000(In Rs.)
ABC Restaurant Balance Sheet(Interim) May 5,2006

Assets (In Rs.) Liabilities and Ownership Equity (In Rs.)
Cash 45,000 Accounts Payable 12,000
Food Inventory 8,000 Notes payable 105,000

Beverage inventory 2,000 Total liabilities 117,000
Building 150,000 Ownership equity:

Equipment 12,000 Capital. Gram Disk 100,000
Total Assets 217,000 Total Liabilities and 217,000
OE
2.1.1 Closing Journal Entries

The general ledger showing the posted operating and adjusting journal entries is shown for review. The
general ledger is the source used to prepare an adjusted trial balance that confirms the ledger accounts are
in balance. Study the updated general ledger:
2.1.2 General Ledger
Cash (Assets) Credit Card Prepaid Insurance(Asset)
Receivables(Assets)
Debit Credit Balance Debit Credit Balance Debit Credit (In Balance
(In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) Rs.) (In Rs.)
100,000 100,000 620 620 3,600 3,600
55,000 45,000 150 3,450
3,600 41,000
3,400 38,000
1,400 36,600
1,800 34,800
282 34,518
24,280 58,798
818 57,980
Food Inventory(Asset) Beverage Inventory(Asset) Building(Asset)
Debit Credit Balance Debit Credit Balance Debit Credit Balance
(In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.)
8,000 8,000 2,000 2,000 150,000 150,000
4,200 12,200 1,140 3,400
12,200 -0- 3,400 -0-
3,200 3,200 1,175 1,175
Accumulated Depr: Equipment(Asset) Accumulated Depr: Equip.

Bldg(Contra) (Contra)
Debit Credit Balance Debit Credit Balance Debit Credit Balanc
(In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) (In Rs.) e (In
Rs.)
400 400 12,000 12,000 125 125
Before determining operating income or loss, an adjusted trial balance is prepared by extracting each
ledger account by name and balance, after adjustments are posted the purpose is to verify that the ABC
Restaurant ledger is in balance. The income state is prepared for ABC Restaurant from information given
in the adjusted trial balance using the following format:
Sales revenue - Cost of sales = Gross margin - Expenses

=Operating income (before tax)
After closing entries are posted from the closing journal entry to the ledger, only permanent balance sheet
accounts remain in the ABC Restaurant ledger. The post-closing trial balance is the source of information
needed to prepare a final balance sheet.
2.1.3 Benefits
The journal covers a broad scope of areas related to financial reporting and accounting.
It provides an inter-disciplinary and international understanding of theory and practice in a variety of
fields.
It also keeps abreast with the development and advancement of accounting knowledge in financial
reporting and accounting internationally.
Characteristics of Journal
Journal has the following features:
1. Journal is the first successful step of the double entry system. A transaction is recorded first of all in
the journal. So the journal is called the book of original entry.
2. A transaction is recorded on the same day it takes place. So, journal is called Day Book.
3. Transactions are recorded chronologically, So, journal is called chronological book
4. For each transaction the names of the two concerned accounts indicating which is debited and which is
credited, are clearly written in two consecutive lines. This makes ledger-posting easy. That is why
journal is called ―Assistant to Ledger‖ or ―subsidiary book‖
5. Narration is written below each entry.
6. The amount is written in the last two columns - debit amount in debit column and credit amount in
credit column.
Advantages of Journal:
The following are the advantages of journal:
1. Each transaction is recorded as soon as it takes place. So there is no possibility of any transaction being
omitted from the books of account.
2. Since the transactions are kept recorded in journal, chronologically with narration, it can be easily
ascertained when and why a transaction has taken place.
3. For each and every transaction which of the two concerned accounts will be debited and which account
credited, are clearly written in journal. So, there is no possibility of committing any mistake in writing
the ledger.
4. Since all the debits of transaction are recorded in journal, it is not necessary to repeat them in ledger.
As a result ledger is kept tidy and brief.
5. Journal shows the complete story of a transaction in one entry.
6. Any mistake in ledger can be easily detected with the help of journal.
Did You Know?

The Accounting, Auditing and Accountability Journal (ISSN 0951-3574) is a peer-reviewed academic
journal on accounting theory and practice published by Emerald Group Publishing.
2.2 Rules of Debit and Credit

The rules of debit and credit accounts are discussed through the Figure 2.5.
Figure 2.5: The rules of debit and credit.
2.2.1 Personal Accounts

Personal accounts include the accounts of persons with whom the business has dealings. These accounts
can be classified into three categories. Natural Personal Accounts: The term ―Natural Persons‖ means
persons who are creation of God. For example, Mohan‘s account, Shan‘s account, Ahab‘s account, etc.
Artificial Personal Accounts: These Accounts include accounts of corporation bodies or institutions which
are recognized as persons in business dealings.
For example, the account of a Limited Company, the account of a Co-operative Society, the account of a
Club, the account of Government, the account of an Insurance Company, etc.
The rule is:
2.2.2 Real Accounts

Real Accounts may be of the following types:
Tangible Real Accounts Tangible Real Accounts are those which relate to such things which can be
touched, felt, measured etc. Examples of such accounts are cash account, building account, furniture
account, stock account, etc. It should be noted that bank account is a personal account, since it represents
the account of the banking company – an artificial person.
Intangible Real Account These accounts represent such things which cannot be touched. Of course, they
can be measured in terms of money.
For example, patents accounts, goodwill account, etc.
The rule is:
2.2.3 Nominal Accounts

Nominal Accounts include accounts of all expenses, losses, incomes, and gains. The examples of such
accounts are rent rates, lighting, insurance, dividends, and loss by fire, etc
The rule is:
Asset Accounts: A debit increases the balance and a credit decreases the balance.
Liability Accounts: A debit decreases the balance and a credit increases the balance.
Equity Accounts: A debit decreases the balance and a credit increases the balance.
The reason for this seeming reversal of the use of debits and credits is caused by the underlying accounting
formula upon which the entire structure of accounting transactions are built, which is:
Assets = Liabilities + Equity
Revenue Accounts: A debit decreases the balance and a credit increases the balance.
Expense Accounts: A debit increases the balance and a credit decreases the balance.
Gain Accounts: A debit decreases the balance and a credit increases the balance.
Loss Accounts: A debit increases the balance and a credit decreases the balance.
If you are really confused by these issues, then just remember that debits always go in the left column, and
credits always go in the right column.
The rules governing the use of debits and credits are as follows:
All accounts that normally contain a debit balance will increase in amount when a debit (left column)
is added to them, and reduced when a credit (right column) is added to them. The types of accounts to
which this rule applies are expenses, assets, and dividends.
All accounts that normally contain a credit balance will increase in amount when a credit (right
column) is added to them, and reduced when a debit (left column) is added to them. The types of
accounts to which this rule applies are liabilities, revenues, and equity.
The total amount of debits must equal the total amount of credits in a transaction.
In financial accounting debit and credit are simply the left and right side of a T-Account respectively.
They are used to indicate the increase or decrease in certain accounts. When there is a change in an
account, that change is indicated by either debiting or crediting that account according to following
rules:
Assets and Expenses

1. An increase is recorded as debit (left side)
2. A decrease is recorded as credit (right side)
Liabilities, Equities and Revenues

1. A decrease is recorded as debit (left side)
2. An increase is recorded as credit (right side)
Contra-accounts
1. Contra-accounts behave exactly in opposite way to the respective normal accounts.
Examples
The owner brings cash from his personal account into the business
Analysis:
1. Cash (an asset) is increased thus debit Cash
2. Owner capital (an equity) is increased thus credit Owners‘ Capital
Office supplies are purchased on account

Analysis:
1. Office Supplies (an asset) is increased thus debit Office Supplies
2. Accounts Payable (a liability) is increased thus credit Accounts Payable
Wages payable are paid
Analysis:
1. Wages Payable (a liability) is decreased thus debit Wages Payable
2. Cash (an asset) is decreased thus credit Cash
Revenue is earned but not yet received

Analysis:
1. Accounts Receivable (an asset) is increased thus debit Accounts Receivable
2. Revenue (a revenue) is increased thus credit Revenue
2.2.4 Accounting Transactions: Rules of Debits and Credits

In all fairness, debits and credits are not that difficult to understand, it is simply that due to the nature of
the material debits and credits often refer to, people instinctively shy away from explanations and
knowledge. Take just a minute, and lay aside any prejudices to accounting material that one may have, and
let me show you how truly simple, yet amazing this system can are.

A compound journal entry is an accounting entry in which there is more than one debit, more than one
credit, or more than one of both debits and credits. It is essentially a combination of several simple journal
entries; they are combined for either of these reasons:
It is more efficient from a bookkeeping perspective to aggregate the underlying business transactions
into a single entry.
Examples of aggregation that may involve compound journal entries are:
1. Depreciation for multiple classes of fixed assets
2. Accruals for multiple supplier deliveries at month-end for which no invoices have yet been received
3. Accruals for the unpaid wages of multiple employees at month-end
All of the debits and credits relate to a single accounting event. Examples of accounting events that
frequently involve compound journal entries are:
1. Record all payments and deductions related to a payroll
2. Record the account receivable and sales taxes related to a customer invoice
3. Record multiple line items in a supplier invoice that relate to different expenses
4. Record all bank deductions related to a bank reconciliation
2.3.1 Subsidiary Books

Subsidiary books are special journals or ledgers where the first, or the original, transaction entries are made
before being posted in their respective accounts. They are referred to as subsidiary books because they are
separate books which categorize income and debits into their proper areas before they are added into the
principle or main books. The journal entry made in the primary records acts as a source of information to
be used in building specific final accounts in bookkeeping. The primary records have many names that
include prime book of entry, books of original entry, primary records, and many others that depict their
function.
The important subsidiary books used in modern business world are the following:
Cash Book: It is used to record all cash receipts and payments.

Purchases Book: It is used to record all credit purchases.
Sales Book: It is used to record all credit sales
Purchases returns book: It is used to record all goods returned by us to our suppliers.
Sales Returns Book: It is used to record all goods returned to us by our customers.
Bills Receivable Book: It is used to record all accepted bills received by us.
Bills Payable Book: It is used to record all bill accepted by us to our creditors.
Journal Proper: It is used for recording those transactions for which there is no separate book.
All these subsidiary books are called books of original entry, as transactions in their original form are
entered therein.
Advantages of Different Journals

The advantages of having several books of original entry in place of one journal may be stated to as
follows:
1. It may be impossible to record each transaction into the ledger as it occurs. Subsidiary books record
the details of the transactions and therefore, help the ledger to become brief.
2. As similar transactions are recorded together in the same book, future reference to any of them
becomes easy.
3. The chance of fraudulent alteration in an account is reduced as the book of original entry keeps records
of the transactions in a chronological order.
4. The work of posting can be entrusted to several clerks at the same time and thus the ledger of a large
business can be written up much more quickly.
5. As each journal contains separately transactions of similar nature any desired analysis can be made
conveniently.
Difference between a Simple and Compound Journal Entry

Business managers and accountants commonly use double entry bookkeeping to record business
transactions and compose financial statements. Journal entries are initial records of the day-to-day
transaction that a manager records. This journal data is then, generally, used to construct general ledger
entries and more complex reports, such as quarterly or annual financial statements. How many accounts
are affected by the transactions entered determines whether the information is deemed a simple or
compound journal entry.
2.4 Ledger
After journalizing transactions, the next step in the accounting process is to post transactions to the
accounts in the general ledger. Although T accounts provide a conceptual framework for understanding
accounts, most businesses use a more informative and structured spreadsheet layout. A typical account
includes date, explanation, and reference columns to the left of the debit column and a balance column to
the right of the credit column. The reference column identifies the journal page containing the transaction.
The balance column shows the account‘s balance after every transaction (See the Figure 2.6).
Figure 2.6: The ledger account name.
Referencing the account‘s number on the journal after posting the entry ensures that every line item that
has a reference number in the journal has already been posted. This practice can be helpful if phone calls or
other distractions interrupt the posting process.
2.4.1 Posting Journal Entries to Ledger Accounts

The second step of accounting cycle is to post the journal entries to the ledger accounts.
The journal entries recorded during the first step provide information about which accounts are to be
debited and which to be credited and also the magnitude of the debit or credit (see debit-credit-rules). The
debit and credit values of journal entries are transferred to ledger accounts one by one in such a way that
debit amount of a journal entry is transferred to the debit side of the relevant ledger account and the credit
amount is transferred to the credit side of the relevant ledger account.
After posting all the journal entries, the balance of each account is calculated. The balance of an asset,
expense, contra-liability and contra-equity account is calculated by subtracting the sum of its credit side
from the sum of its debit side. The balance of a liability, equity and contra-asset account is calculated the
opposite way i.e. by subtracting the sum of its debit side from the sum of its credit side.
2.5 Trial Balance

The various debit balances and the credit balances of the different accounts are put down in a statement,
which is termed a ―Trial Balance‖. In other words, Trail Balance is a statement containing the various
ledger balances on a particular date.
A trial balance is a list and total of all the debit and credit accounts for an entity for a given period –
usually a month. The format of the trial balance is a two-column schedule with all the debit balances listed
in one column and all the credit balances listed in the other. The trial balance is prepared after all the
transactions for the period have been journalized and posted to the General Ledger.
Key to preparing a trial balance is making sure that all the account balances are listed under the correct
column.
The appropriate columns are as follows:
Assets = Debit balance
Liabilities = Credit balance
Expenses = Debit Balance
Equity = Credit balance
Revenue = Credit balance
2.5.1 Final Accounting: Use of Journal/Ledger

Final accounting deals with all the ledger account balances at the end of the accounting period in one way
or the other.
All the Nominal accounts that represent direct expenses and direct incomes are closed by transfer to
the Trading a/c.
For this at least two journal entries are recorded.
The Trading a/c is closed by transferring its balance to the Profit and Loss a/c.
For this a journal entry is recorded.
All the Nominal accounts that represent indirect expenses, losses and indirect Incomes are closed by
transfer to the Profit and Loss a/c.
The Profit and Loss a/c is closed by transferring its balance to either the Capital a/c or Profit and Loss
Appropriation a/c.
All the remaining accounts are listed out in the Balance Sheet.
A closing entry is recorded in relation to this, though it is not directly related to preparing the balance
sheet. If the final accounting is to be done in a systematic manner, then the entire journal entries mentioned
above are to be recorded and all the ledger accounts that are affected by those transactions are to be posted
to and updated. That would result in the making up of the Trading a/c and Profit and Loss a/c. The balance
sheet is prepared by drawing up a statement of ledger account balances carried forward through the closing
entry.
2.5.2 Final Accounting: Use of Trial Balance: Avoiding Journal/Ledger

In manual accounting, the Trading a/c, Profit and Loss a/c and the Balance Sheets can also be prepared
using the information in the Trial Balance avoiding the act of journalizing the transactions involved in final
accounting.This is done by showing each item in the ledger accounts (Trading, P/L a/c) or the statement
(Balance Sheet) where it would be ultimately appearing had the actual procedure been adopted. This would
have the same effect as recording the journal and posting into the ledger.
Caution
Unless and until all the balances of other ledger accounts within the organizational accounting system are
not complete, the trial balance should not be prepared.
Case Study-International Journal

Mission
The mission of the International Journal of Case Studies in Management is to ensure the widest possible
distribution of quality cases to researchers and professors interested in using the case study method as a
teaching and research tool. The Journal is a refereed publication, meaning that all cases are subject to a
rigorous peer-review process. A review committee is responsible for forwarding submissions to
anonymous evaluators, selected for their expertise in the field in question. All cases submitted must
comply with the Journal‘s official editorial policy. In addition to its regular issues, the Journal also
periodically publishes special or thematic issues on the latest management issues.
Readers
Whether you are a manager, business owner, professor or student, or whether you simply have a passion
for business, the International Journal of Case Studies in Management has something for you. The Journal
offers a broad spectrum of case studies drawing on all sectors of the economy. Readers will find cases
illustrating management situations relating to various administrative functions, cases presenting the real-
life experiences of different types of companies, cases featuring remarkable business leaders of both past
and present, as well as cases presenting women managers, entrepreneurs and leaders of cultural and
government organizations and lots more.
Format
Resolutely modern, the journal is published on-line, giving it the benefit of instant international reach, not
to mention the many other advantages offered by the Internet, including access to a search engine, links to
related sites, accompanying video clips, free downloads, etc. If you are interested in a case, simply click on
its title to download a free copy in the form of a file that can be printed for your own personal use. All we
ask is that you first register as a subscriber. If you choose to register as a professor, you will be able to use
the case in class simply by sending us an email indicating the title of the course, the semester, and the
number of students. This will also give you access to the accompanying teaching notes, which are also
subject to peer review.
Questions
1. What is the main aim of the international journal?
2. What are the services provided by international journal?
2.6 Summary
In accounting, a ―journal‖ refers to a financial record kept in the form of a book, spreadsheet, or
accounting software that contains all the recorded financial transaction information about a business.
An accounting journal is created by entering information from receipts, sales tickets, cash register
tapes, invoices, and other data sources that show financial transactions.
The Journal of Financial Reporting and Accounting (JFRA) provide a valuable forum for the
publication of research that address significant issues on financial reporting and accounting.
A journal includes all accounting transactions and is considered the historical record for a business
entity.
credit, or more than one of both debits and credits
Subsidiary books are special journals or ledgers where the first, or the original, transaction entries are
made before being posted in their respective accounts.
The various debit balances and the credit balances of the different accounts are put down in a
statement, which is termed a ―Trial Balance‖.
2.7 Keywords
Accounting: It is the process of communicating financial information about a business entity to users such
as shareholders and managers.
Gross Margin: A company‘s total sales revenue minus its cost of goods sold, divided by the total sales
revenue, expressed as a percentage.
Liabilities: A liability can mean something that is a hindrance or puts an individual or group at a
disadvantage, or something that someone is responsible for, or something that increases the chance of
something occurring
Operating Income: It is an acronym meaning operating income before depreciation and amortization. It
refers to an income calculation made by adding depreciation and amortization to operating income.
Taxation: To tax (from the Latin taxo; ―I estimate‖) is to impose a financial charge or other levy upon a
taxpayer (an individual or legal entity) by a state or the functional equivalent of a state such that failure to
pay is punishable by law.
Transactions: A transaction is an agreement, communication, or movement carried out between a buyer
and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or
more businesses or individuals.

1. A journal is not an academic magazine published on a regular schedule.
(a) True (b) False
2. The accounting equation can be expressed as Liabilities + Assets = Owner‘s Equity.

(a) True (b) False
3. A debit may signify a (n):

(a) Decrease in asset accounts (b) Decrease in liability accounts
(c) Increase in the capital account (d) Decrease in expense accounts
4. Every controlling account must have its own:

(a) Revenue ledger (b) General ledger
(c) Subsidiary ledger (d) Journal
5. Net income is shown on the work sheet in the Income Statement debit column and the Balance Sheet
credit column.
(a)True (b) False
6. The process of transferring data from the journal to the ledger is known as:
(a) balancing (b) journalizing
(c) ledgering (d) posting
7. A compound entry is:

(a) violates the fundamental accounting equation
(b) is a journal entry with more than one debit or credit.
(c) is composed of more than two debits or more than two credits.
(d) is used to record the business transactions of a single day in a single journal entry.
8. When an entry is made in the general journal,

(a) assets should be listed first
(b) accounts to be debited should be listed first
(c) accounts to be increased should be listed first
(d)accounts may be listed in any order
9. The journal entry to record the sale of services on credit should include a:
(a) debit to Accounts Receivable and a credit to Capital
(b) debit to Cash and a credit to Accounts Receivable
(c) debit to Fees Income and a credit to Accounts Receivable
(d) debit to Accounts Receivable and a credit to Fees Incomes
10. The journal entry to record the receipt of cash from clients on account would include a:
(a) debit to Cash and a credit to Fees Income
(b) debit to Fees Income and a credit to Cash
(c) debit to Cash and a credit to Accounts Receivable
(d) debit to Accounts Receivable and a credit to Cash

1. What is the journal in financial accounting?
2. Describe the rules of debit and credit.
3. Explain the compound journal entry and subsidiary books.
4. What is the ledger and rules regarding posting?
5. What is the trial balance sheet?
6. Write the difference between a simple and compound journal entry.
7. What are the personal accounts and nominal accounts?
8. Explain the general ledger and write the example of general ledger.
9. Why important subsidiary books used in modern business world?
10. Describe the posting journal entries to ledger accounts.
Answers for Self Assessment Questions

1 (b) 2. (b) 3. (a) 4. (c) 5. (a)
6. (d) 7. (b) 8. (b) 9. (d) 10. (c)
3
Depreciation
CONTENTS
Objectives
Introduction
3.4 Summary
3.5 Keywords
Objectives
Explain the concepts of depreciation
Discuss the methods of accounting for depreciation
Describe the tax depreciation
Introduction
Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset
arising from use, efflux ion of time or obsolescence through technology and market changes. Depreciation
is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during
the expected useful life of the asset. Depreciation includes amortization of assets whose useful life is
predetermined.
Depreciation is defined as an accounting methodology which allows an organization to spread the cost of a
fixed asset over the expected useful life of that asset. The cost of the fixed asset immediately comes out of
the cash account of the organization and is entered as an asset for the organization. At the end of each
period of the useful life of the asset a part of the cost is expensed. This amount is added to the accumulated
depreciation for the asset. The net value of the asset on the books of the organization is the asset account
less the accumulated depreciation account.
A fixed asset is considered depreciable if it will wear out or become obsolete over a period of years. The
period of years is called the life or the useful life of the item. The life that is assigned to an item will
depend on industry standards, management standards, and governmental regulations. Generally,
depreciable items include buildings, manufacturing equipment, office equipment, and vehicles. Land is not
considered a depreciable item as it does not wear out or become obsolete. Some fixed assets may be
expected to have a market value at the end of their useful life. This expected value is called the salvage
value. Some organizations set this value on a per asset basis, some use a percentage of the purchase price,
some assume that all assets will have zero salvage value, and some use a combination of these methods.

The value of assets gradually reduces on account of use. Such reduction in value is known as depreciation.
Different researcher has given different definitions of depreciation, such as:
According to Pickles ―Depreciation may be defined as the permanent continuous diminution in the quality,
quantity or value on an asset.‖
According to Carter ―Depreciation is the gradual permanent decrease in the value of an asset from any
cause.‖
According to Spicer and Pegler ―Depreciation may be defined as a measure of the exhaustion of the
effective life of an asset from any cause during a given period.‖According to Northcott and Forsyth
―Depreciation is the reduction in the value of a fixed asset occasioned by physical wear and tear,
obsolescence or the passage of time.‖
From the above definitions, it follows that an asset gradually declines on account of use and passage of
time and this causes permanent reduction in the value and utility of asset. Such reduction in the value or
utility of asset is called depreciation. In other words, expired cost or utility of asset is depreciation.
The concept of depreciation is related to the fixed assets. Fixed assets like land, building, machines and
equipment etc are acquired for their long term use in business operations rather the short term resale like
current assets. The expenditure incurred for the acquisition of the fixed assets is treated as capital
expenditure. The benefits of such expenditure are deferred over long life of such assets. The value of such
assets diminishes with efflux ion of time and their use in the business.
For the purpose of depreciation the fixed assets should be classified into two groups:
(1) Tangible assets
(2) Intangible assets
3.1.1 Tangible Assets

Tangible assets are those fixed assets which are visible and enjoy physical existence e.g. land, building,
machines, mines etc.
Tangible assets are those holdings of an individual or business that are real and actual, instead of being
hypothetical. They are contrasted to things an individual or business may hold that are not tangible.
Examples of intangible assets include things like copyrighted ideas, patents, or intellectual property.
Though these things possibly have a chance of being financially beneficial at a future point, they are not
currently something that can be sold for great profit in most cases.
Wasting Assets
Wasting assets are the fixed asset consisting of natural resources like mines, oil wells, quarry etc. Like
other tangible assets, they are recorded initially at the acquisition cost. Their value depletes according to
their residual service potential.
3.1.2 Valuation of Tangible Fixed Asset

Valuation of Fixed Assets is a Valuation of PPE (property, plant, and equipment), or tangible assets, these
are purchased for continued and long-term use in earning profit in a business.
Fixed assets valuation includes plant and machinery, furniture, tools, land, buildings, real estate valuation,
etc.
Real Estate Valuation Services are supported by market evidence which is thoroughly researched, proper
documented and well communicated. Providing a complete end-to-end real estate valuation service that de-
risks the real estate valuation outsourcing decision for clients.
They are written off against profits over their anticipated life by charging depreciation (with exception of
land). Accumulated depreciation is shown in the face of the balance sheet or in the notes. These are also
called capital assets in management accounting.
According to Reserve bank of India different banks follow different policies for valuation of properties and
appointment of values for the purpose. The issue of correct and realistic valuation of fixed assets owned by
banks and that accepted by them as collateral for a sizable portion of their advances portfolio assumes
significance in view of its implications for correct measurement of capital adequacy position of banks.
There is a need for putting in place a system/procedure for realistic valuation of fixed assets and also for
empanelment of values for the purpose. Valuation of tangible assets is for setting up new fixed assets
records in an allocation of purchase price or for determining the value of assets for insurable value
purposes; it provides the client with the maximum detail to accomplish the established goals.
Valuing tangible fixed assets is a time-consuming and research-extensive process. While some assets are
general purpose in nature, many assets have unique values and unique lives relative to very specific
industries and uses within the industry. Operating conditions, maintenance, repairs, obsolescence, market
values, and estimated useful lives play a key role in valuing tangible fixed assets. Identical assets used in
different industries may have a wide range of value based upon any one of the aforementioned situations.
The staffs at maintain a close watch on the markets and values of thousands of unique assets. Whether the
valuation is of a state-of-the-art phone system, a stamping press, a computer, or a theme park ride,
monitors the pulse of the market.
Some firms base their studies on trend factors without actually looking at the assets. Oftentimes non-
engineering-type personnel are used to value machinery and equipment based upon this trending approach.
Trend factors are reasonably accurate over a very short time period only. And, trend factors do not
accurately take into account maintenance, repairs, wear and tear, and obsolescence. If the asset is not
actually observed in place, the values may not take into account assets that have been retired but not
disposed of, or assets that are cannibalized or even self-constructed.
The Accounting Standards Board (ASB) today published Financial Reporting Standard (FRS) 15
―Tangible Fixed Assets‖. The FRS sets out the accounting requirements in respect of the initial
measurement, valuation and depreciation of tangible fixed assets, with the exception of investment
properties. FRS 15 comes into force for financial periods ending on or after March.
3.1.3 Intangible Assets

Intangible assets are those assets which are characterized line existence e.g. patent, trademark, copyright,
good will etc. The service potential of such assets is uncertain and difficult to measure. The cost of such
assets is amortized over their useful life. Due to the high degree of uncertainty about their service potential
it is considered as business prudence to write them off as early as possible.
Intangible assets are the non-physical things of value that a company owns. These assets have no set
monetary value and no physical measurement. They cannot be seen or touched, but are nonetheless
important to the company‘s success.
Competitive Assets
Competitive intangible assets are a bit more difficult to define. These assets are usually gained by
experience. They are things like know-how, human capital, reputation, leveraging, and collaboration. If
naming them is a difficult task, valuation is a science of best guesses.
Intangible assets can also be divided into those that are definite or indefinite. Definite assets are those that
last for a particular amount of time, like contract agreements. Indefinite assets go on for an unspecified
amount of time, like a brand name that will continue on for as long as the company chooses to produce the
product.
3.1.4 Causes of Depreciation

The main causes of depreciation may be divided into two categories, namely:
1. Internal Cause
2. External Causes
Internal Causes
Depreciation which occurs for certain inherent normal causes is known as internal depreciation. The main
causes of internal depreciation are:
Wear and Tear

Some assets physically deteriorate due to wear and tear in use. More and more use of an asset, the greater
would be the wear and tear. Physical deterioration of an asset is caused from movement, strain, friction,
erosion etc. An obvious example of this is motor car which rapidly wears out. Other assets like this are
building, plant, machinery, furniture, etc. The wear and tear is general but primary cause of depreciation.
External Causes
Depreciation caused by some external reasons is called external depreciation. The main external causes are
as follows:
Efflux of Time
Some assets diminish in value on account of sheer passage of time, even though they are not used e.g.,
leasehold property, patent right, copyright etc. Suppose we take a lease of a house for 10 years for
INR5,00,000. Its annual depreciation will be INR50,000 (5,00,000/10), irrespective of the whether the
house has been used or not, because with the end of lease after 10 years, the house will go out of
possession.
3.1.5 Need for Depreciation

Ascertainment of True Profit or Loss
Depreciation is a loss. So unless it is considered like all other expenses and losses, true profit or loss
cannot be ascertained. In other words, depreciation must be considered in order to into out true profit or
loss of a business.
Ascertainment of True Cost of Production

Goods are produced with the help of plant and machinery which incurs depreciation in the process of
production. This depreciation must be considered as a part of the cost of production of goods. Otherwise,
the cost of production would be shown less than the true cost. Sales price is fixed normally on the basis of
cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will
also be fixed at low level resulting in a loss to the business.
True Valuation of Assets
Value of assets gradually decreases on account of depreciation, if depreciation is not taken into account,
the value of asset will be shown in the books at a figure higher than its true value and hence the true
financial position of the business will not be disclosed through balance sheet.
Difference among Depreciation, Depletion, and Amortization

The term depreciation, depletion, and amortization can be discussed as follows:
Depreciation
The term depreciation is used with reference to tangible fixed assets because the permanent continuing and
gradual fall in book value is possible only in the case of fixed asset.
Depletion
The term depletion is used for the depreciation of wasting assets such as mines, oil wells, timber trees etc.
Amortization
The term amortization is used in respect of intangible assets like patents, copyrights, leasehold and
goodwill which are recorded at cost. Some intangible assets have limited useful life and are, therefore,
written off. The process of their writing off is called amortization.
3.1.6 Role of Depreciation in Financial Accounting

Depreciation plays an important role in financial accounting. This approach helps managers monitor their
fixed assets over a period of time.
To understand the role of depreciation in financial accounting, it is important to grasp what fixed assets are
and how they relate to a business from an operational standpoint. Essentially fixed assets are necessary to
keep operations going.
Fixed assets are valuable to a business because these are the types of assets which an organization will
likely own for a period of years. These assets, sometimes referred to as Property, Plant and Equipment, are
the ones that are significant investments and are used to serve or produce the items which keep the
business selling.
Examples of fixed assets which depreciate may be airplanes, factory equipment or other heavy equipment.
This is nowhere near an exhaustive list, but outlines the kinds of assets that companies need to depreciate
because without them, a company would lose the capacity to produce for or serve consumers.
Decision Making
In every aspect of life people are faced with all kinds of decisions. There are relationship decisions,
business decisions, education decisions and many other kinds of choices people are faced with daily.
3.1.7 Importance of Depreciation

Depreciation as a concept and in practice plays a very important role in a company‘s cash flow hence in
funding. The reason‘s are basically two, firstly because depreciation is a way of self finance for an
organization and secondly because is a way of decreasing taxes that the government claims as the company
does not have to pay taxes on depreciation which consequently enlarges the cash flow of the company.
Did You Know?

Depreciation methods that provide for a higher depreciation charge in the first year of an asset‘s life and
gradually decreasing charges in subsequent years are called accelerated depreciation methods.

There are several methods for calculating depreciation, generally based on either the passage of time or the
level of activity (or use) of the asset.
3.2.1 Prime Cost

This method is also known as the flat rate method and is normally available to both accounting and tax
depreciation books.
Calculations using this method have a cost base equal to the original cost unless there is a depreciation
limit, residual value or some other factor which reduces the depreciable cost base. All periodic
depreciation values are pro-rata and calculated daily according to the number of days in the period.
Depreciation will be accrued until the written down value is equal to zero or a nominated residual value. If
a depreciation limit has been applied, the accumulated depreciation will not exceed this value.
If a residual value has been applied then the asset will only be depreciated until the written down value is
equal to the residual value.
Annual % Rate = 100%/Effective Life in Years
3.2.2 Declining Balance

This method is also known as the Reducing Balance, Diminishing Balance or the Diminishing Value
method [150%]. The rate for any effective life is determined by dividing 150% by the effective life in
years.
Declining balance is calculated pro-rata from the date of acquisition using the original cost base in the year
of acquisition and then, using the carried forward written down value (adjusted value) in all subsequent
years. This depreciation cost base is reduced in both cases if a residual value or some other factor is
applied that reduces the initial depreciable cost base. All calculations are calculated daily rounded to the
nearest cent for any depreciation period.
3.2.3 Units of Production

This methodology is available for bulk and single units of use and can apply to individual assets in
isolation, or multiple discrete projects involving possibly, many thousands of assets.
Essentially, it is used where a utility or resource has a finite life and where the rate of consumption of this
resource and the resultant benefits of one or more associated assets are subject to variation from time to
time, or are not sufficiently well known, to determine a normal effective life.
The algorithm is entirely dependent upon an estimate of the total life resource at any time and an accurate
knowledge of the actual production over time.
Period depreciation expense = (period units/(total reserves – previously used units)) x ((depreciable cost) –
total depreciation)
International Accounting Standard IAS16 implies that deprecation charges should not exceed, or lag
behind the depletion of the resource.
3.2.4 Double Declining Balance

This is similar to the declining balance method but uses an accelerated depreciation rate equal to double
the prime cost rate for the same effective life. The rate for any effective life is therefore determined by
dividing 200% by the effective life in years.
Double Declining Balance is calculated pro-rata from the date of acquisition using the original cost base as
the depreciation cost base in the year of acquisition. In all subsequent years the carried forward written
down value (adjusted value) is used as the depreciation cost base.
This depreciation cost base is reduced, in both cases, if a residual value or some other factor is applied that
reduces the initial recoverable amount. All calculations are calculated daily rounded to the nearest cent for
any depreciation period.
3.2.5 Straight Line
The ―Straight Line‖ method implied here is based on Useful Life. The annual depreciation charge for any
year is determined by dividing the adjusted cost base by the remaining useful life at the beginning of the
year. In year 1 this charge is calculated pro-rata based on the number of days in service expressed as a
proportion of the number of days in the year. If the remaining useful life at the beginning of the year is less
than 1 then the calculated daily charge is applied until the net book value is 0.
3.2.6 Sum of the Year Digits

This is an accelerated depreciation method in which the year depreciation charge decreases proportionately
as the remaining useful life. For each successive year, the depreciable amount is multiplied by a fraction
comprising the remaining useful life of the asset divided by the sum of the consecutive digits comprising
those useful life years.
This works well when assets are purchased on the first day of the year. However, Year 1 is invariably a
part year such that the actual remaining useful life at the beginning of each successive year is not an
integer and the annualized rate from the formula would therefore effectively be an average of the standard
previous and current year‘s rates as if these were applied pro-rata to determine the depreciation charge. In
the last year, the remaining useful life for any asset is also the period over which the depreciation charge is
made (less than 1 year). Therefore the numerator in the formula is always equal to 1 so that the remaining
value is fully written off over the remaining useful life.
An example of non-standard averaged rates is shown below except for the final part year where the rate in
this case would be 6.67%.
Year 1 Year 2 Year 3 Year 4 Year 5
Standard 33.33% 26.67% 20.00% 13.00% 6.67%
Non-standard 33.33% 29.47% 22.80% 16.13% 9.47%
For n years, the formula for summing the years is n(n + 1)/2. In an example where an asset cost 1000, has a
residual value of 100 and has an effective life of 5 years the depreciation year rate for year 3 is calculated
as follows;
Remaining useful life / (n(n+1)/2)

= 3/(5(5+1)/2)
= 3/(30/2)
= 20%
3.2.7 Economic Depreciation

This is generally utilised as an internal KPI reporting method only and is backed out for statutory reporting
and replaced by standard depreciation charges. It supplements standard depreciation charges by generating
a periodic charge to the P&L related to the economic cost of owning the assets; the cost of capital or
economic financial cost.
This algorithm utilises the net present value of the capital funds invested in the asset to calculate an
economic depreciation charge leaving an economic residual value. It would also be subject to a further
economic financial cost charge based on the current cost of the capital funds employed and therefore the
interest on capital foregone.
Economic Depreciation = [Cost × IRR] / [(1+IRR) UL-1]

Cost of Capital = Cost × IRR
Where IRR = Required Internal Rate of Return on funds
And UL = Useful Life in years
With the Economic Depreciation always being less than the cost of each asset, it follows that every asset
has an Economic Residual Value on disposal. Economic Residual Value has a negative impact on the
future value contribution if an asset is disposed earlier than the end of its economic (useful) life. This is
because the business misses out on the income that would otherwise have been generated by the asset
despite making future expense savings on capital costs.
ERV = Cost X 1 – ((1+IRR)t – 1)/((1+IRR)UL – 1)
3.2.8 Proportional Useful Life

The proportional useful life method is a US accounting methodology that utilises the prime cost method
and the useful life of the asset in deriving proportional accelerated depreciation rates. An asset depreciates
over a specific time period on the basis of three separate rates in three equal time periods.
3.2.9 How to Calculate Depreciation
Depreciation expense is calculated utilizing either a straight line depreciation method or an accelerated
depreciation method. The straight line method calculates depreciation by spreading the cost evenly over
the life of the fixed asset. Accelerated depreciation methods such as declining balance and sum of year‘s
digits calculate depreciation by expensing a large part of the cost at the beginning of the life of the fixed
asset.
Straight Line Depreciation Method

The straight line depreciation method divides the cost by the life.
SL = Cost / Life
Example: A desk is purchased for INR24,382.5. The expected life is 5 years. Calculate the annual
depreciation as follows:
24382.5/5 = 4876.5
Each year for 5 years INR4,876.5 would be expensed.
Depreciation Calculation with Salvage Value

To calculate depreciation expense on a fixed asset with a salvage value, the depreciable value of the fixed
asset is divided by the life of that asset. The depreciable basis is the cost less the salvage value.
SL = (Cost - Salvage Value)/Life
Example: A table is purchased for INR28,382.5. The expected life is 5 years. There is INR2500.00 salvage
value.
Calculate the Annual Depreciation As Follows:

(28382.5-2500.00)/5 = 5176 5
Each year for 5 years INR5176 5 would be expensed. At the end of 5 years the book value of the asset
would be INR2500.00. (The cost of INR28382.5 less 5 years of depreciation expense at INR5176 5 per
year.)
3.2.10 Depreciation Schemes

A depreciation scheme is a mathematical model of how an asset will be expensed over time. For every
asset which undergoes depreciation, one will need to decide on a depreciation scheme. An important point
to keep in mind is that, for tax purposes, he will need to depreciate assets at a certain rate. This is called tax
depreciation. For financial statement purposes he is free to choose whatever method he wants. Most small
businesses use the same rate for tax and book depreciation. This way there is less of a difference between
net income on the financial statements and taxable income.
This wills 3% of the more popular depreciation schemes: linear, geometric, and sum of digits. To simplify
the examples, we will assume the salvage value of the asset being depreciated is zero.
If choose to use a salvage value, it would stop depreciating the asset once the net book value equals the
salvage value.
1. Linear depreciation diminishes the value of an asset by a fixed amount each period until the net value
is zero. This is the simplest calculation, as estimate a useful lifetime, and simply divide the cost
equally across that lifetime.
2. Geometric depreciation is depreciated by a fixed percentage of the asset value in the previous period.
This is a front-weighted depreciation scheme, more depreciation being applied early in the period. In
this scheme the value of an asset decreases exponentially leaving a value at the end that is larger than
zero (i.e.: a resale value).
3. Sum of digits is a front-weighted depreciation scheme similar to the geometric depreciation, except
that the value of the asset reaches zero at the end of the period. This is a front-weighted depreciation
scheme, more depreciation being applied early in the period. This method is most often employed in
Anglo/Saxon countries.
Caution
Depreciation is non-cash expense that must be added because over time, fixed assets are likely to break,
wear out or become otherwise used up and unable to produce to capacity.

Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for
the production of income. Such deductions are allowed for individuals and companies. Where the assets
are consumed currently, the cost may be deducted currently as an expense or treated as part of cost of
goods sold. The cost of assets not currently consumed generally must be deferred and recovered over time,
such as through depreciation. Some systems permit full deduction of the cost, at least in part, in the year
the assets are acquired. Other systems allow depreciation expense over some life using some depreciation
method or percentage. Rules vary highly by country, and may vary within a country based on type of asset
or type of taxpayer. Many systems that specify depreciation lives and methods for financial reporting
require the same lives and methods be used for tax purposes.
Capital Allowances
A common system is to allow a fixed percentage of the cost of depreciable assets to be deducted each year.
This is often referred to as a capital allowance, Deductions are permitted to individuals and businesses
based on assets placed in service during or before the assessment year. Example of Canada‘s Capital Cost
Allowance is fixed percentages of assets within a class or type of asset. Fixed percentage rates are
specified by type of asset.
Tax Lives and Methods

Some systems specify lives based on classes of property defined by the tax authority.
Additional Depreciation
Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the
current tax year.
Real Property
Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may
vary by type of use. Many such systems, including the United States and Canada, permit depreciation for
real property using only the straight line method, or a small fixed percentage of cost. Generally, no
depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are
depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land
improvements over a 15 or 20 year life, all using the straight line method.
Averaging Conventions
Depreciation calculations can become complex if done for each asset a business owns. Many systems
therefore permit combining assets of a similar type acquired in the same year into a ―pool.‖ Depreciation is
then computed for all assets in the pool as a single calculation. Calculations for such pool must make
assumptions regarding the date of acquisition. The United States system allows a taxpayer to use a half
year convention for personal property or mid-month convention for real property. Under such a
convention, all property of a particular type is considered acquired at the midpoint of the acquisition
period. One half of a full period depreciation is allowed in the acquisition period and in the final
depreciation period. United States rules require a mid-quarter convention for personal property if more
than 40% of the acquisitions for the year are in the final quarter.
Home Depreciation
Home depreciation is a general decrease in the value of a home in comparison to what the home was
valued. This is usually viewed not only in terms of the value of a home when compared from one year to
the next, but is also considered with relation to the value of a home when it was purchased. ―Depreciation‖
in financial terms usually refers to a decrease in value, while ―appreciation‖ is the term used for an
increase in value. Home depreciation can be caused by a number of different factors, including the
condition of the home, the neighbourhood around the home, and the current housing market.
There are typically two primary ways in which home depreciation is viewed: with regard to a previous year
or years and in comparison to when the home was purchased. For someone who wishes to sell a home, the
comparison with previous years may be more important since this indicates a loss of value due to a home
not being sold earlier. Someone still living in a home might compare the change in value with when he or
she purchased the home, and this would indicate how matters have changed since the purchase was made.
This analysis of home depreciation can also be important for a homeowner who is able to use depreciation
as a tax deduction.
Home depreciation can be caused by a wide range of factors, and to fully understand why a home has
depreciated, these factors must often be considered together. The condition of a home is one of the major
elements when considering the value of a home. If a home was purchased new and has received little repair
work over a decade, despite requiring such work, then this will typically depreciate the value of a home.
Most people considering the purchase of a home see any costs for repairs as a deduction from what a home
might have otherwise been worth.
Tax deduction
A tax deduction is a reduction of a taxpayer‘s total income that decreases the amount of money used in
calculating the tax due. Essentially, a tax deduction is a break granted by the government. It reduces taxes
by a percentage that is dependent upon the income bracket of the taxpayer.
Did You Know?

National Advisory Committee on Accounting Standards (NACAS) is a body set up under section 210A of
the Companies Act, 1956 by the Government of India.
Case Study-Measuring Intangible assets of ROLTA India Pvt. Ltd.

ROLTA India limited is an Indian company operating in India and overseas. It provides
software/information technology based engineering and geospatial solutions and services to customers
across the world and has executed projects in more than 35 countries. ROLTA is headquartered in Mumbai
and operates through a network of twelve regional/branch offices in India and seven subsidiaries located in
USA, Canada, UK, The Netherlands, Germany, Saudi Arabia and UAE. It is listed on the Bombay Stock
Exchange and National Stock Exchange in India.
ROLTA is India‘s leading provider of GIS/Geo Engineering solutions and services and one of the major
AM/FM/GIS photogrammetric service providers in the world for segments such as defence, environment,
electric, telecom, gas, emergency services, Municipalities and Airports. The company‘s customer base for
GIS projects is spread across 17 countries with multimillion dollar projects executed in various parts of the
world. ROLTA is also leading provider of plant design automation solutions and services in India and one
of the major plant information management services providers worldwide.
The company‘s customer base for such business is spread across 22 countries with over 500 projects
executed in various parts of the world. To move up the value chain in the engineering domain, the
company has established a joint venture with Stone and Webster Inc., USA, namely SWRL- Stone and
Webster ROLTA Limited. SWRL has access to Stone and Webster‘s proprietary technology. This joint
venture provides high quality engineering services worldwide and undertakes selective refinery,
petrochemicals and power projects in India.
The company provides e-security implementation services, rapid application development and software
testing services to its customers worldwide. In on-going partnership with CA‘s, the company has executed
over 350 projects globally in 18 countries. ROLTA globally has around 2500 employees. Nearly 75% of
the company‘s workforce has engineering qualifications, including significant numbers with master‘s
degrees or doctorates and ROLTA ensures constant ongoing training to its professionals. The annual IDC-
DQ best Employers Survey has consistently ranked the company as one of the top employers in the IT
industry in India.
The ROLTA quality standards are benchmarked to world class levels, with top quality certifications such
as ISO 9001:2000, BS 7799, and SEI CMM level 5. The British Standards Institution (BSI) has awarded
ROLTA the BS15000 certification for its entire range of IT service management processes. This unique
accreditation has been bestowed on less than 25 companies globally.
Measuring the Intangibles

A company‘s balance sheet discloses the financial position or rather health of the company. The financial
position of an enterprise is influenced by the economic resources, financial structure, liquidity, solvency
and its capacity to adapt to changes in the environment. However, it is becoming increasingly clear that
intangible assets have a significant role in defining the growth of a company. So often, the search for the
added value invariably leads us to calculating and evaluating the intangible assets of the business.
Concept of Economic Value Added (EVA)

Economic Value Added (EVA) is the financial performance measure that aims to capture the true
economic profit of an enterprise. EVA is developed to be a measure more directly linked to creation
shareholder wealth over time. Hence, it focuses on maximizing the shareholders wealth and helps company
management to create value for shareholders. EVA refers to the net operating profits of the company
which is opportunity cost.
EVA is calculated as Net operating Profit after tax (NOPAT) – (Capital*Cost of Capital)
Generally, all intangible assets are being measured in terms of economic value added by those particular
intangible assets.
Questions
1. What is EVA?
2. What do you understand by measuring the intangibles summary?
3.4 Summary
Depreciation is defined as an accounting methodology which allows an organization to spread the cost
of a fixed asset over the expected useful life of that asset.
Tangible assets are those fixed assets which are visible and enjoy physical existence e.g. land,
building, machines, mines etc.
Valuation of Fixed Assets is a Valuation of PPE (property, plant, and equipment), or tangible assets,
these are purchased for continued and long-term use in earning profit in a business.
Intangible assets are those assets which are characterized line existence e.g. patent, trademark,
copyright, good will etc.
Declining balance is calculated pro-rata from the date of acquisition using the original cost base in the
year of acquisition and then, using the carried forward written down value (adjusted value) in all
subsequent years.
The proportional useful life method is a US accounting methodology that utilises the prime cost
method and the useful life of the asset in deriving proportional accelerated depreciation rates.
The straight line method calculates depreciation by spreading the cost evenly over the life of the fixed
asset.
3.5 Keywords
Amortization: It is the expired service cost of intangible assets.
Asset Valuation: It is a procedure in which the value of an asset is determined.
Depletion: It is used for the depreciation of wasting assets such as mines, oil wells, timber trees etc.
Depreciation: It is the systematic allocation of the depreciable amount of an asset over its useful life.
Depreciation Scheme: It is a mathematical model of how an asset will be expensed over time.

1. Depreciation is defined as...............methodology which allows an organization to spread the cost of a
fixed asset over the expected useful life of that asset.
(a) accounting (b) human recourse
(c) marketing (d) All of these.
2. Depreciation is a process of.....................

(a) valuation (b) allocation
(c) Both a and b (d) None of these.
3. .....................are the fixed asset consisting of natural resources like mines, oil wells, quarry.
(a) Intangible assets (b) Wasting assets
(c) Tangible assets (d) Other tangible assets
4. Valuation of Fixed Assets is a Valuation of............

(a) PPE (b) EPP
(c) PEP (d) EEP
5. Depreciation which occurs for certain inherent normal causes is known as internal depreciation.
(a) external (b) intra
(c) inter (d) internal
6. The..............is used in respect of intangible assets like patents, copyrights, leasehold and goodwill
which are recorded at cost.
(a) depreciation (b) depletion
(c) amortization (d) Valuation of intangible assets
7. Declining Balance method is also known as................method.

(a) Reducing Balance (b) Diminishing Balance
(c) Diminishing Value (d) All of these.
8. The proportional useful life method is.................accounting methodology.

(a) US (b) Indian
(c) UK (d) France
9. ................is a mathematical model of how an asset will be expensed over time.

(a) Depreciation (b) Depreciation scheme
(c) Amortization (d) depletion
10. Depreciation expense is calculated utilizing either a straight line depreciation method
or.............................
(a) accelerated depreciation method (b) units of production method
(c) reducing balance method (d) prime cost method

1. What is the depreciation?
2. Why do companies depreciate long-term assets?
3. Why are there so many different methods of depreciation?
4. What are the basic factors of depreciation determination?
5. Define and explain the basis of use system of depreciation.
6. Why should depreciation on fixed assets be brought into account? Discuss in detail the several
methods of providing for depreciation.
7. What is the difference among depreciation, depletion, and amortization?
8. What do you understand by depreciation scheme?
9. Explain tax depreciation.
10. A desk is purchased for INR24,382.5 and expected life is 4 years. Calculate the annual depreciation.
1. (a) 2 (b) 3 (b) 4 (a) 5 (d)
6 (c) 7 (d) 8 (a) 9 (b) 10 (a)
4
Provisions
CONTENTS
Objectives
Introduction
4.3 Summary
4.4 Keywords
Objectives
Describe the bad debts accounting
Explain the bad and doubtful debts
Define the bad debts
Describe the provision for bad debts
Explain the provision for discount on debtors
Explain the provision for discount on creditors
Introduction
An amount from profits that has been put aside in a company‘s accounts to cover a future liability is called
a provision. A provisions main purpose is to allow a current year‘s balance to become more accurate. This
is because there may be costs that could be accounted for in either the previous financial, or the current
financial year. Costs that belong to one specific year could be quite misleading if accounted for in the
future or in the past, depending on the circumstances.
A Few Facts about Provisions
Though it may seem to be, a provision is in fact not a form of saving.
During accounting, provisions will be recognized on the balance sheet and also expensed on the income
statement, and the resulting impact of a provision is a reduction in the firm‘s equity.
Setting Aside a Provision

There are a number of factors that could prompt provisions for liabilities, however there are certain
criterions that must be fulfilled before one may view an obligation as a provision, such as:
The company must perform a reliable amount of regulatory measurement of that obligation. The
measurement must be made by company management.
It must be probable that obligation results in a financial drag on economic resources.
An obligation must be a result of events that will advance the balance sheet date, and could result in a
legal or constructive obligation.
An obligation must have been determined to be probable, but not certain. It must be estimated to have
a probability of occurring of more than 50%.

The term bad debts usually refer to accounts receivable (or trade accounts receivable) that will not be
collected. However, bad debts can also refer to notes receivable that will not be collected.
The bad debts associated with accounts receivable is reported on the income statement as bad debts
expense or uncollectible accounts expense.
When the allowance method is used, the journal entry to bad debts expense will include a credit to
allowance for doubtful accounts, a contra account and valuation account to the asset accounts receivable.
The allowance method anticipates the losses and therefore requires the use of estimates.
Under the direct write-off method, the allowance for doubtful accounts is not used. Rather, bad debts
expense will be debited when an account receivable is actually written off. The credit in this entry will be
to the asset accounts receivable.
A bad debt is an amount that is written off by the business as a loss to the business and classified as an
expense because the debt owed to the business is unable to be collected, and all reasonable efforts have
been exhausted to collect the amount owed. This usually occurs when the debtor has declared bankruptcy
or the cost of pursuing further action in an attempt to collect the debt exceeds the debt itself.
The debt is immediately written off by crediting the debtor‘s account and therefore eliminating any balance
remaining in that account. A bad debt represents money lost by a business which is why it is regarded as an
expense.
Doubtful debts are those debts which a business or individual is unlikely to be able to collect. The reasons
for potential non payment can include disputes over supply, delivery and conditions of goods, the
appearance of financial stress within customers operation.
When such a dispute occurs it is prudent s add this debt or portion thereof to the doubtful debt reserve.
This is done to avoid over stating the assets of the business as trade debtors are reported net of doubtful
debt. When there is no longer any doubt that a debt in uncollectable the debt becomes bad.
Because of the matching principle of accounting, revenues and expenses should be recorded in the period
in which they are incurred. When a sale is made on account, revenue is recorded along with account
receivable. Because there is an inherent risk that clients might default on payment, accounts receivable
have to be recorded at net realizable value. The portion of the account receivable that is estimated to be not
collectible is set aside in a contra asset account called allowance for doubtful Accounts.
At the end of each accounting cycle, adjusting entries are made to charge uncollectible receivable as
expense. The actual amount of uncollectible receivable is written off as an expense from Allowance for
doubtful accounts.
4.1.1 Bad and Doubtful Debts

One of the aims of any efficient credit department is the minimization of bad debts, but credit as we know
is not an exact science. There is always an element of subjectivity involved and given the granting of credit
in any commercial undertaking, bad debts are inevitable.
But why do we provide for them or write them off, apart from their effect on our DSO‘s? Principally
because the recognition and accounting for bad and doubtful debts has its foundations in two generally
accepted accounting principles:
1. Matching Principle
This principle involves the matching of all expenses incurred in generating the income derived. Hence one
have accrual accounting which attempts to acknowledge and bring to account expenses, wherever possible,
in the same accounting period that the income was generated, not being reliant on the actual timing of cash
flows.
2. Objectivity
The value of balance sheet items should reflect their expected realizable value. Whilst there may be some
degree of subjectivity in the collectability of accounts receivable, there must be an element of objectivity
involved usually supported by some documentary evidence.
4.1.2 Bad Debts Meaning

There is no specific definition of a bad debt, but it can be generally categorized as either a not collectable
debt or one that is uneconomical to pursue.
Ageing of a debt is generally a good indicator of bad or doubtful debts, however it is not conclusive. As a
general rule of thumb, any debt greater than 6 months must be carefully considered as a bad debt.
However, a debt can become bad any time within its life cycle, including when it is still current. It all
depends on the circumstances.
There are no specific rules in identifying a bad debt and like some many other issues in credit; it must be
done on an account-by-account basis, but as general guidelines:
(1) The debt is uneconomical pursue, In other words the costs of recovery out way the benefits.
(2) The debt cannot be proven. It could be fraud or simply that there is no proof of delivery, and so on.
(3) The debtor cannot be located.
(4) Upon advice from a solicitor, collection agent or insolvency practitioner.
(5) It may also be the result of the credit policy, For example, all debts greater than 1 year may not be
considered collectable.
(6) Any other documentary evidences that indicates that the debt cannot be collected.
Bear in mind that bad debts are generally the result of objective evidence. When claiming against the ATO
for bad debts, it is preferable to have some written confirmation/advice from an independent third party,
For example, external administrator, solicitor, collection agent of the likely loss to be sustained.
Bad Debt Write-off

The timing of the bad debt write-off in private entities is usually a matter of accounting methods, they can
be written off in the month the debt is recognized as bad debt or they may be written off quarterly, half
yearly or annually. For publicly listed companies, they are usually written off on a 6 monthly cycle,
coinciding with their ASX reporting requirements.
Depending on accounting preferences the entries may be expressed as follows:
Dr: Bad Debts Expenses 2,500,000 INR
Cr: Trade Debtors 2,500,000 INR
Being bad debts written off for the period.
From a tax perspective they must be physically written off in the year that they are identified as a bad debt,
within the ATO‘s overall guidelines.
In the case of commercial debts the value of the GST content may be claimed back against the ATO.
Bearing in mind that the GST content of any subsequent bad debt recovered must be repaid to the ATO.
The following comments are guidelines only and formal tax advice should be sought for the specific
requirements, however as a general guide Bad Debts will normally be allowable deductions for tax
purposes if the following applies:
(1) The debt must exist at the time and not have been settled, forgiven, compromised, assigned or
otherwise extinguished.
NB: This has particular potential consequences with relation to voting on Deeds of Arrangements.
(2) The must have become ―bad‖ where, at the time of write off, there is little or no chance of recovery
(3) The decision to write off the debt must be made before the end of the financial period and the entries
posted in the accounts for that period.
(4) The debt must have been treated as ―assessable income‖.
Avoiding Bad Debts

Unfortunately bad debts are a resultant act of granting credit, there is no wonder cure. The best that we can
strive for is to minimize the costs thereof. The level of bad debts may also bear a direct correlation to the
lending practices of the entity involved and the competitive nature of the business sector they operate in.
In cases where corporations deliberately set out to ―buy the business‖, they generally have very relaxed
credit policies and quite often factor in a higher level of bad debts in their forward budgets or in the case of
lenders, increase their interest rates to cover the anticipated costs. These businesses are frequently new
entrants into the marketplace. They look upon bad debts as a ―cost of business‖, he same way credit
managers might look at the cost of credit information.
For small and medium size enterprises in competitive industries, it can be driven by the standards adopted
by their competitors the price of ―doing business‖, if they do not take the deal their competitor will.
Whether someone is in consumer lending or a commercial credit provider, the basics of good credit
practice still prevail:
(1) Know who you are dealing with
(2) Apply the 4 C‘s of Credit
(3) Seek full financial disclosure
(4) Seek additional securities/sureties where possible
(5) Be vigilant
Remember bad debts are largely the result of poor decisions and lack of procedures and monitoring in the
first place.
4.1.3 Doubtful Debts

Doubtful debts, as the name implies, are debts about which there is some element of doubt as to their
collectability. Similarly to bad debts, ageing can be a fairly good indicator that a debt should be considered
doubtful, but not conclusive. As a general rule of thumb, any debt aged 90 days or more should be
investigated to decide whether it is doubtful or not.
Again, there are no prescriptive rules in identifying doubtful debts. It is a case-by-case basis, but there are
some guidelines not that dissimilar to identifying bad debts. Essentially the only difference is the degree of
collectability.
1. The debtor cannot be located.
2. Upon advice from a solicitor, collection agent or insolvency practitioner.
3. It may also be the result of the credit policy,
For example, all debts greater than 3 months may be considered doubtful.
4. Any other documentary evidences that indicates that the debt may not be collected.
It is entirely possible to have a debt that is part bad and part doubtful. Take the case of liquidation where
the expected return is less than 100% of the debt. The percentage not recoverable would be written off as
bad, whilst a decision on the classification of the remainder as either doubtful, unclassified or a
combination of both, based on the degree of certainty of the recovery.
Provision for Doubtful Debts

The rules for creating a provision for doubtful debts may vary from enterprise to enterprise. The basic
concept is to allow for debts that may potentially be written off in the future, to match the cost of it (for
accounting and not tax reasons).
Generally the method of calculating the relevant provision is contained in the credit policy. It may be based
on a number of criteria. For established firms it is quite often driven by past history and trend analysis.
Examples of various methods include:
1. Percentage of annual turnover
2. Percentage of total debtors
3. Specifically identified debtors
4. Percentage of debtors by ageing analysis
5. Set value based on past claims under trade debtor insurance
When providing for doubtful debts, the aggregate value of the debtor Percentage thereof is made including
such items as unearned income in the case of consumer debts or GST in the case of commercial sales.
The assessment is usually made at the end of each financial reporting cycle, For example, yearly for
private enterprises or half yearly for publicly listed companies. The assessment made at the end of each
financial year is sometimes referred to as the ―Fixed‖ Provision, whilst the monthly adjustment may be
made to the ―Interim‖ Provision again; it is a matter of individual accounting methods.
Each enterprise makes their adjustments according to their own accounting practices. It may be made
monthly, quarterly, half yearly or annually. It is wise practice to budget for bad debts for the year and then
take up an interim provision on a monthly basis, equivalent to one twelve of the annual budget, the
matching principle in practice and to avoid large cumulative adjustment at the end of the financial period.
The journal entries may be expressed as:
Dr: Doubtful Debts Expense INR25, 00,000
Cr: Interim Provision for Doubtful Debts INR25, 00,000
Being interim provision for doubtful debts for the period
The provision for doubtful debts account is treated as a negative asset and offset against the value of the
debtors in the balance sheet. It is usually expressed as follows:
Trade Debtors INR50, 000,000
Less: Provision for Doubtful Debts INR25, 00,000
INR47, 500,000
From an accounting perspective, adjustments to doubtful debts expense have an effect on the Profit and
Loss of the enterprise, but are not a tax deduction.
4.1.4 Difference between Bad Debit and Doubtful Debit

A bad debt is an account receivable that has been clearly identified as not being collectible. This means
that you remove that specific account receivable from the accounts receivable account, usually by creating
a credit memo in the billing software and then matching the credit memo against the original invoice,
which removes both the credit memo and the invoice from the accounts receivable report.
When one create the credit memo, he credit the accounts receivable account and debit either the bad debt
expense account (if there is no reserve set up for bad debts) or the allowance for doubtful accounts (which
is a reserve account that is set up in anticipation of bad debts). The first alternative for creating a credit
memo is called the direct write off method, while the second alternative is called the allowance method for
doubtful accounts.
A doubtful debt is an account receivable that might become a bad debt at some point in the future. One
may not even be able to specifically identify which open invoice to a customer might be so classified. In
this case, he create a reserve account for accounts receivable that may eventually become bad debts,
estimate the amount of accounts receivable that may become bad debts in any given period, and create a
credit to enter the amount of his estimate in this reserve account, which is known as the allowance for
doubtful accounts. The debit in the transaction is to the bad debt expense. When he eventually identifies an
actual bad debt, he writes it off (as described above for a bad debt) by debiting the allowance for doubtful
accounts and crediting the accounts receivable account.
For example, ABC International has INR1, 00,000 of accounts receivable, of which it estimates that
INR5,000 will eventually become bad debts. It therefore charges INR5,000 to the bad debt expense (which
appears in the income statement) and a credit to the allowance for doubtful accounts (which appears just
below the accounts receivable line in the balance sheet). A month later, ABC knows that INR1, 500
invoices is indeed a bad debt. It creates a credit memo for INR1, 500, which reduces the accounts
receivable account by INR1, 500 and the allowance for doubtful accounts by INR1, 500. Thus, when ABC
recognizes the actual bad debt, there is no impact on the income statement - only a reduction of the
accounts receivable and allowance for doubtful accounts line items in the balance sheet (which offset each
other).
4.1.5 Depreciation Provision of Bad Debts

When goods are sold on credit, the personal account of the buyer is debited and so he becomes a debtor to
the business. Later, when he pays the amount due from him, his personal account is credited. His account
thus stands closed.
Sometimes, a debtor fails to pay his debt either partially or completely. The amount of debt which cannot
be recovered from the debtor is called ―Bad Debt‖. It is a loss to the business and so must be charged to
Profit and Loss Account. The following journal entry is passed when a debt becomes bad.
Bad Debts Account Dr.
To Concerned Debtor‘s Account (Being bad debts)
The effect of this entry will be:
(i) Debtor‘s personal account stands closed, and
(ii) A new account called Bad Debts Account.
The total amount of bad debts incurred during the year appears as a separate item in the Trial Balance and
the Sundry Debtors appear at reduced amount. The bad debts account, like any other account of expenses
on losses, is transferred to the profit and loss account by means of the following closing entry.
Profit and Loss Account Dr
To Bad Debts Account
(Being bad debts transferred to Profit and Loss Account)
4.1.6 A Rationale of Accounting for the Debts

Before considering the consequences of these differences in scope and accounting treatment, the rationale
of the customary provisions for bad debts is briefly presented. In commercial enterprises, the most
commonly used and ordinarily the most justifiable basis for determining charges or credits to income is the
completed transaction. Income is generally deemed to arise when a sale is made. Except for accruals of
items such as interest or rent, no credit is taken for profits except when and to the extent that they are
received or at least reasonably assured.
Thus, sales are commonly recognized as producing income at the time of sale on the assumption that the
receivables taken in exchange for goods or services are the equivalent of cash, collection of which will be
made in due course. But an element of risk inheres in most sales on credit. The taking up of income at the
moment of sale therefore constitutes a departure from the strict theory of recognizing profits only when
realized. Such recognition will prove to have been in error to the extent that receivables are not collected.
The provision for loss on bad debts is thus essentially a correction of income estimates previously or
currently made. From the viewpoint of the balance sheet, it is intended to reduce the receivables due from
customers to the net amount estimated to be realizable. Rigid adherence to the completed transaction as the
basis of income recognition might be considered to imply that no provision for failure to collect the
proceeds of a sale should be made until the loss is definitively ascertained.
When two accounting periods are involved, however, as may often be the case, to take up income in one
period and to cancel it in another would hardly be satisfactory. It would obviously distort the comparability
of results of operations as between the two pentodes. The ―charge-off‖ method doubtless has this effect in
direct ratio to the rigidity of insistence upon the date of ascertainment as the time for taking the deduction.
In contrast, the reserve method, by far the more common accounting practice, has the merit of allocating
the approximate loss to the year in which the sale, the proceeds of. Which were never realized, was made?
The receivable arising from a sale of goods or services may be regarded as containing two parts: that which
represents a cost and that which represents a gain. A case could be made in principle, although probably
not in practice, for treating these parts separately. As far as the cost element is concerned, the sale may be
regarded as a conversion of an asset from one form to another.
To the extent that the value of the asset created exceeds its cost, there is a present or prospective accretion
to assets and a gain. In the ordinary case of a corporation making its return of income on an accrual basis, a
gain will be taken up unless there is a high degree of uncertainty concerning the collectability of the debt
arising from it. In accounting as well as in tax practice, the measure of the gain is the excess of the cash
equivalent of the receivable over the cost of the goods or services sold. In measuring the cash equivalent it
is necessary to consider the interest element arising from delay in payment, the cost of collection, and the
credit risk.
Tax Treatment
The Internal Revenue Code provides for the deduction of bad debts in Section 23 as follows: In computing
net income there shall be allowed as deductions in bad debts:
(1) General rule Debts: which become worthless within the taxable year; or (in the discretion of the
Commissioner) a reasonable allowance to a reserve for bad debts; and when satisfied that a debt is
recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part
charged off within the taxable year, as a deduction.
(2) Securities becoming worthless: if any securities become worthless within the taxable year and are
capital assets, the loss resulting there from shall, in the case of a taxpayer other than a bank, be
considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets.
Accounting Treatment
The restriction of bad debt loss or expense in business accounting to losses on trade accounts and notes
receivable is necessary to obtain adequate information about a company‘s operations. These receivables
have presumably been passed on by the company‘s own credit department, or have come under the general
or discretionary rules by which the sales department operates. The losses are, in a sense, part of the cost of
doing business under the customary credit terms and with the class of customers actually dealt with. This
bad debt loss is a significant operating figure, changes in which may indicate the relative desirability of
modifying credit terms to different classes of customers. It is properly segregated as an internal check on a
company‘s operations, and to give comparable figures between companies in an industry or trade.
Losses from debts other than trade receivables arise from entirely different business situations and, if
appreciable, must be handled separately to reveal the nature of the company‘s operations. Ordinarily they
are not regular recurring charges. They arise irregularly, if at all, when investments or nontrade debts
owing a company are liquidated. Since they often represent the realization of a loss that has been
developing over a series of years, they are sometimes charged directly to surplus, on the ground that a
charge to the income account would distort income in the year of realization.
The foregoing differences in the definition of bad debt loss for tax purposes and public reports may involve
no more than different listings of the various loss items. But even though shown separately, two or more
distinct loss items may be grouped together, and all included as part of ―general and administrative
expenses‖. One item, however, may be classified separately to indicate its peculiar nature, as when a loss
on a debt arising from an investment is shown as an extraordinary charge in an income statement because it
is held to be nonrecurring, and ―income before special loss‖ is deemed to be a significant intermediate
figure.
Likewise, losses on loans to officers and employees should be shown as charges distinct from general bad
debt expense. The final net income figure for tax and business purposes would be the same if similar loss
items were included in the same year regardless of their designation. This balancing within a single year
will not always occur. Because of the differences in definition, certain losses on debts may be taken in
different years for the two types of report or they may be treated differently when taken, as when a large
nonrecurring loss is charged to surplus.
4.1.7 Reserve Method

Tax Treatment
Until 1921 the tax law did not permit the deduction of a bad debt loss until the loss had been definitely
ascertained. The Act of 1921, by sanctioning the reserve method for tax purposes, authorized a well-
established trade practice.
It thereby took a step towards implementing the general principle laid down in the Act of 1918 that net
income should be computed in accordance with the method of accounting regularly employed by the
taxpayer. Under the amendment it became permissible, at the discretion of the Commissioner, to take as a
deduction a reasonable addition to a reserve for bad debts.
The reserve alternative had been recommended by the Ways and Means Committee as ―a method of
providing for bad debts much less subject to abuse‖ than that available under the existing statute. As T. S.
Adams pointed out to the Senate Finance Committee, the reserve method affords the authorities far better
control over bad debt deductions than does the direct charge method. ―You cannot,‖ Mr. Adams
maintained, ―go through a taxpayer‘s debts and actually check off each one and make up the mind whether
it is a good or a bad debt. Business is usually so well established that the normal debt loss is pretty well
known. If the taxpayer charges off more than the ordinary percentage, the situation is flagged. But when
the taxpayer writes off a lot of bad notes (or accounts), we have no positive check.‖
The use of the reserve method for tax purposes is subject to the following conditions: the taxpayer must
choose either the specific debt or the reserve method and stick to his choice except as .the Commissioner
permits him to change it. Furthermore, he may employ only one method: he cannot use the reserve method
for part of his accounts and the specific debt.
4.1.8 Method for Other Debts

Not all taxpayers are allowed the option; for example, a taxpayer reporting sales on the instalment basis
may not use the reserve method. This is merely an illustration of the basic rule that a bad debt deduction
cannot be taken unless the amount represented by the debt has entered gross income.
The essential criterion from the tax viewpoint is that the addition to the reserve is reasonable. The fact that
the addition to the reserve is computed as a percentage of either gross sales or of bad debts outstanding
does not necessarily mean that it is ―reasonable‖. When additions over a period of years computed as a
percentage of gross sales have made the balance in the reserve unnecessarily large, an addition for the
current year, computed in the same manner, has been disallowed.
4.1.9 Accounting Treatment

As already pointed out, the reserve method of handling bad debts has important business advantages,
particularly as it facilitates the allocation of losses to the periods in which the sales giving rise to income
are made. The same objective could, of course, be achieved by anticipatory write-downs of individual
receivables, but a reserve is especially useful when a company holds a large number of receivables. The
aggregate of bad debt losses can be estimated much more precisely than the specific receivables that will
not be paid. Experience gives a reasonably accurate basis for an estimate of the total amount that will be
uncollectible, while a detailed appraisal of the prospects of payment from each individual account would
be both costly and unsatisfactory.
Also, if specific accounts were written down in anticipation of loss, inevitable unexpected losses and
unexpected payments or recoveries would have to be accounted for. An over-all account, reserve for bad
debts, makes such adjustments unnecessary because the anticipated loss is conceived of as applying against
the aggregate of receivables, not against individual receivables to varying degrees.
The amounts to be credited or charged to reserves for bad debts may be estimated by two methods, each of
which has several adaptations. The required balance in the reserve may be computed at the end of each
accounting period, on the basis of experience. Accounts receivable are classified by age, and a percentage
of probable loss is applied to each age group.
The required reserve thus estimated is compared with the existing reserve after allowing for all necessary
charge-offs of specific accounts that have been determined to be uncollectible. The difference, which
constitutes the bad debt expense of the period, is then set up on the books. Such a reserve will presumably
be appropriate for balance sheet purposes in the sense that it will indicate net receivables or the amount
that will actually prove collectible.
7The bad debt expense figure may, of course, vary greatly from period to period, and will be determined
by the age classification of receivables, bad debts actually charged off, and recoveries, if they are credited
to the reserve. If primary emphasis is on the age rather than the amount of receivables, the bad debt
expense charge will lag behind the period of expanding sales but precede the period of actual charge-offs.
Under another method,
Caution
Doubtful debts may be the result of either objective evidence (as in the case of Bad Debts) or it may be
subjective, based on current information received or conduct of the account, that may not yet warrant the
account be classified as Bad.

The cash discount is allowed to debtors as an incentive for prompt payment. When the discount is allowed,
it is recorded through the cash book and posted to the credit side of the concerned debtors‘ personal
accounts. But, in the case of debts outstanding at the end of the current year, discounts will be allowed in
the next year if the debtors make prompt payments. So, as in the case of anticipated loss on account of
doubtful debts, a provision must be made for the discount likely to be allowed to the debtors in the next
year. Such a provision is known as the ―Provision for Discount on Debtors‖. It is also calculated as a
percentage on the net sundry debtors (remaining after deducting provision for bad debts).
For example, if Sundry Debtors amount to INR40, 000 and the firm wants to create a provision for bad
debts at 5% and a provision for discount at 2% on the debtors, they will be calculated as follows:
(i) The Provision for Bad Debts will be calculated at 5% on INR40, 000. It will amount to INR2, 000.
(ii) The provision for discount at 2% will be calculated on the debtors after deducting the Provision for Bad
Debts that is, on INR38, 000 (40,000-INR2, 000). It will amount to INR760.
Note that when both Provision for Bad Debts and Provision for Discount on Debtors are to be calculated,
the Provision for Bad Debts is calculated first and then Provision for Discount is worked out on debtors
after subtracting the Provision for Bad Debts.
The adjustment entry for Provision for Discount on Debtors is as follows:
Profit and Loss Account Dr.

To Provision for Discount on
Debtors Account
(Being the provision made for discount on debtors)
The provision for discount on debtors will be shown in the final account as follows:
(i) On the debit side of Profit and Loss Account: as a separate item.
(ii) On the assets side of Balance Sheet: as a deduction from Sundry Debtors.
The balance of the Provision for Discount on Debtors Account will be carried forward to the next year and
the discounts allowed, if any, in the next year will be set off against the provision itself. The method of
dealing with discounts allowed and provision for discount on debtors in the next year is similar to the
method followed in case of bad debts and provision for bad debts.
4.2.1 Provision for Discount on Creditors

When prompt payment is received we allow cash discount to debtors. Similarly we receive discount from
the creditors when prompt payments are made by us. So the expected gain on account of discounts
receivable from creditors in the next year should also be taken into account at the time of preparing the
final accounts. Such a provision is called ―Provision for Discount on Creditors‖. It is also calculated as a
percentage on sundry creditors. The creation of such a provision however, goes against the convention of
conservatism. Hence, it is usually avoided in practice. But it must learn how it is treated in final accounts if
such a provision is required. The adjustment entry for provision for discount on creditors is passed as
follows:
Provision for Discount on Creditors Account Dr
To Profit and Loss Account
(Being the provision made for discount on creditors)
The provision for discount on creditors will appear in the final accounts as follows:
(i) On the credit side of profit and loss account: as a separate item.
(ii) On the liabilities side of the balance sheet: as a deduction from sundry creditors.
The balance of the provision for discount on creditors Account will also be carried forward to the next year
and the discounts received, if any, in the next year will be adjusted against the provision itself.
Did You Know?

In 2010 the IASB released an exposure draft of amendments to IAS 37 and invited comments on the draft.
Case Study-Keeping an Eye on Bad Debt: An FIS Case Study

When a company records a sale, if it has not yet collected the proceeds it records an account receivable on
the balance sheet. Sometimes the company is unable to collect its receivables, and they have to be written
off as a bad debt expense. To prepare for this contingency, companies create a reserve account known as
the allowance for doubtful accounts, where they estimate how much of their receivables will not be
collected and exclude that amount from being recognized on the income statement. If in fact the receivable
is not collected it is charged against the reserve account rather than appearing on the income statement at
that time. Because the amount reserved in any period is subject to management‘s discretion, it is an area
that can be used to manipulate earnings. Even when management is completely scrupulous the allowance
for doubtful accounts can be an early warning indicator for potential problems.
As noted above, management has some discretion as to how much of a reserve should be taken in a given
accounting period. We have discussed similar issues with respect to financial receivables for companies
that lease or finance sales to customers. We have also commented in several posts about companies that
may be under-reserving their allowance for doubtful accounts. Here we explain how to analyze this
account more fully.
Management‘s discretion has certain limitations. The amounts recorded in reserve accounts have to be
explained to auditors, and generally follow some guidelines. Sometimes it can be a simple percentage of
sales or gross accounts receivable that is assumed will not be collected based on prior history. Sometimes
the system may be more complicated, as described in the disclosures below, which were taken from
Fidelity National Information Systems (FIS).
However, even in these more complicated cases, the investor can compare the current allowance to past
results based on a percentage of sales or receivables to gain insight as to trends. If the allowance is rising
or falling at a significantly lower rate than sales it should tell the investor to take a closer look and figure
out why.
When the amount being reserved is falling as a percentage of sales or receivables, the result is higher net
income than there would have been using a consistent reserve percentage. It is easy to see how
management might have an incentive to post higher earnings, so frequently this is the focus of investor
concern.
However, in the case of FIS we see the opposite trend: the allowance increased 51%, compared with a 23%
increase in receivables. Sequential rise in sales cannot be determined due to the accounting treatment of the
reverse acquisition of Certegy. The higher allowance for doubtful accounts in the period resulted in EPS
being INR1.00 lower than would have been reported had the allowance stayed at a consistent percentage of
total accounts receivable.
There are several possible explanations for a significant increase in the allowance for doubtful accounts
relative to sales or receivables:
1. Something has changed. This may be the cause for the rise in FIS, as the company acquired Certegy in a
reverse merger during the quarter. Certegy‘s check guarantee business could very well have a higher
incidence of uncollectible receivables than the legacy FIS business. (Note that this may not be a bad thing
if the profitability is high enough to offset the higher incidence of bad debt.)
2. The company is actually seeing higher than normal losses from uncollectible receivables. This is also
possible in the case of FIS, as the allowance is set partially based on an estimate of current trends. Higher
than normal levels of uncollectible receivables could be due to just random luck, but could also indicate the
company is pursuing higher-risk customers. In the latter case, it would indicate a lower quality to recorded
sales and earnings.
3. The company is doing well and management wants to set aside reserves for a rainy day. This would be a
case of earnings management in which the company has perhaps done better than expected and uses the
opportunity to pad reserves in case they want to tap into them in a tougher period.
4. The company is doing poorly and wants to take all its lumps and make future performance look better.
This is known as taking a big bath. If the company has no chance to make expectations it may want to set
aside extra reserves and take a bigger hit today in order to set up easier comparisons in the future. Since
FIS has a number of restructuring and merger charges in the current period, as well as the new requirement
to expense stock options, this is yet another possible explanation of the rise in the allowance for doubtful
accounts.
Investors should call the company or otherwise try to figure out what is behind any large change in the
allowance for doubtful accounts relative to sales and/or receivables.
Questions
1. What are several possible explanations for doubtful accounts?
2. Discuss the limitations of management‘s discretion.
4.3 Summary
The bad debts associated with accounts receivable is reported on the income statement as bad debts
expense or uncollectible accounts expense.
The debt is immediately written off by crediting the debtor‘s account and therefore eliminating any
balance remaining in that account.
Doubtful debts are those debts which a business or individual is unlikely to be able to collect.
Provision for doubtful debts is also called provision for bad debts or provision for bad and doubtful
debts.
Doubtful debts, as the name implies, are debts about which there is some element of doubt as to their
collectability.
4.4 Keywords
Adjustment Entry: Adjusting entries are journal entries usually made at the end of an accounting period to
allocate income and expenditure to the period in which they actually occurred.
Prepaid Expenses: Prepaid expenses are assets that become expenses as they expire or get used up.
For example, office supplies are considered an asset until they are used in the course of doing business, at
which time they become an expense.
Provision for Bad Debts: The provision for bad debts might refer to the balance sheet account also known
as the Allowance for Bad Debts, Allowance for Doubtful Accounts, or Allowance for Uncollectible
Accounts.
Provision for Discount on Creditors: A provision made for the anticipated gains on account of discounts
receivable from creditors.
Provision for Discount on Debtors: A provision made for discounts likely to be allowed to debtors.

1. ……………………. are those debts which a business or individual is unlikely to be able to collect.
(a) Doubtful debts (b) Bad debts
(c) Debtors (d) None of these.
2. The rules for creating a ……………….may vary from enterprise to enterprise.

(a) bad debts (b) doubtful debts
(c) provision for doubtful debts (d) bad debt write-off
3. The provision for doubtful debts is usually calculated as certain percentage of the total amount due from
………………after writing off all known bad debts.
(a) Profit And Loss Account (b) Trial Balance
(c) Balance Sheet (d) Sundry Debtors
4. The provision for doubtful debts account is treated as a negative asset and offset against the value of the
debtors in the ………………..
(a) Profit And Loss Account (b) Trial Balance
(c) Balance Sheet (d) Sundry Debtors
5. Remember …………… are largely the result of poor decisions and lack of procedures and monitoring in
the first place.
(a) bad debts (b) doubtful debts
(c) provision for doubtful debts (d) bad debt write-off
(a) Bad debts (b) Doubtful debts

(c) Provision for doubtful debts (d) Bad debt write-off
7. The amount of bad debts given in the trial balance is shown only in profit and loss account.
(a) True (b) False
8. Provision for bad debts is calculated as a certain percentage on Sundry Debtors after deducting further or
additional bad debts.
(a) True (b) False
9. Provision for discount on debtors is calculated as a fixed percentage on sundry debtors after deducting
provision for doubtful debts.
(a) True (b) False
10. Provision for discount on creditors is made by crediting profit and loss account.
(a) True (b) False

1. Distinguish between:
a. Outstanding expenses and prepaid expenses
b. Interest on capital and interest on drawings
c. Outstanding income and unearned income.
2. What is meant by provision for bad debts? Explain the treatment of provision for bad debts in the final
accounts.
3. What do you mean by provision for discount on debtors and creditors? Explain their treatment in the
final accounts.
4. Give Journal entries for the following adjustments:
a. Interest at 5% on Capital of INR80, 000.
b. Interest on Drawings INR120.
c. Provision for Discount at 2% on Debtors totalling INR30, 000.
d. Provision for Discount at 1.5% on Creditors totalling INR20, 000.
5. On January 1, 1987 the provision for Bad Debts stood at INR1, 000. The total debtors on December
31, 1987 as INR20, 600 but out of which INR600 were bad and had to be written off. The provision is
to be maintained at 5% of the debtors. Give journal entries and show the bad debts account and the
provision for bad debts account. Also show how these items will appear in the final accounts.
6. Discuss about the provision for discount on debtors.
7. What are bad debts accounting?
8. Describe the bad and doubtful debts.
9. What is provision for doubtful debts?
10. Explain the bad debt write-off.
1 (a) 2 (b) 3 (d) 4 (c) 5 (a)
6 (c) 7 (a) 8 (a) 9 (b) 10 (a)
5
Reserves
CONTENTS
Objectives
Introduction
5.2 Reserve for Discount on Debtors
5.5 Summary
5.6 Keywords
Objectives
Describe the reserves
Explain the reserves for discount on creditors
Define the rectification with example
Discuss the rectification of error
Introduction
A reserve is profits that have been appropriated for a particular purpose. Reserves are sometimes set up to
purchase fixed assets, pay an expected legal settlement, pay bonuses, pay off debt, pay for repairs and
maintenance, and so forth. This is done to keep funds from being used for other purposes, such as paying
dividends. The board of directors is authorized to create a reserve. A reserve is something of an
anachronism, because there are no legal restrictions on the use of funds that have been designated as being
reserved. Reserve accounting is quite simple just debit the retained earnings account for the amount to be
segregated in a reserve account, and credit the reserve account for the same amount. When the activity has
been completed that caused the reserve to be created, just reverse the entry to shift the balance back to the
retained earnings account.
Reserves deserve special attention when analyzing a company. When a business creates a ―Reserve‖, they
are essentially setting aside a certain amount of money for a specific purpose. Often times, reserves are
monies set aside to act as a buffer against future losses. Reserve means amount set aside out of profits (as
calculated by the profit and loss account) or other surpluses which are not meant to cover any liability,
contingency, commitment or legal requirement. Thus, reserve covers the case of amount which is neither a
liability nor a provision. It is allocation of the profit and not a charge against the current revenues.

There are two main types of reserves which are explaining with following way:
1. Open Reserves
2. Secret Reserves
Open Reserves
Open reserves may be defined all reserves which shows in the balance sheet. Every person or public can
know such reserves of company. Those reserves provide full information to shareholders about which
amount has gone to reserves or why they are not getting all amount of dividend. This type can also divide
in sub parts.
(a) Capital Reserves

Capital Reserve‘ is an accounting mechanism for conserving profits. The amount so set apart as ―Capital
Reserve‖ imparts an element of stability to the overall finances of a business enterprise. Capital reserve
arises either as a gain on sale of long-term assets or a settlement of liabilities. Again of capital nature may
also arise due to the basic transaction of being of capital nature.
For example: sale of equity shares at a premium. Further, allocation of revenue reserve may be made to
capital reserve due to legal obligations. Capital reserve does not include any free balance that might be
used for the distribution of profits. It is this crucial factor alone which tends to provide the much-needed
financial stability to a corporate undertaking.
(b) Revenue Reserves

Revenue reserves are created out of revenue profit which is usually distributable profits. All distributable
profits are not always available for paying dividend since certain amount may be required to be kept aside
either by law (minimum) or as a managerial decision (higher amount) for business needs. It is only after
this that profit will be available for distribution by way of dividend.
Comparisons between Revenue Reserve and Capital Reserve:
Comparisons between revenue reserve and capital reserve is following in Table 5.1.
Table 5.1: Comparisons between revenue reserve and capital reserve
Secret Reserves
Secret reserves may be defined as that type of reserves which is not shown in final account of company.
Means it has neither been shown in profit and loss appropriation account nor in balance sheet. These
reserves can easy created by showing less value of assets and more value of liabilities in balance sheet. If a
company has created such secret reserves for the benefits of company, it will be surely strong his financial
position.
5.1.1 How to Calculate Bad Debt Reserves
In conformity with Generally Accepted Accounting Principles, accounts receivable are reported in the
financial statements at net realizable value. Net realizable value is equal to the gross amount of receivables
less an estimated allowance for uncollectible accounts. A reserve for bad debts is an estimate of
uncollectible accounts receivable. It is sometimes called an allowance for bad debts. It is a ―contra‖
account when it is listed with the current assets because it will have a credit balance instead of a debit
balance since it is a reduction of accounts receivable.
One of the responsibilities that most credit departments have is writing off accounts to bad debt. Another is
determining what the reserve or allowance for bad debt should be - in order to properly account for
potential future bad debt losses. Under this circumstance, an accrual for a loss contingency must be
charged to income, if both of the following conditions exist:
(1) It is probable that as of the date of the financial statements an asset has been impaired or a liability
incurred, based on subsequent available information prior to the issuance of the financial statements,
and
(2) The amount of the loss can be reasonably estimated. If both of the above conditions are met, an accrual
for the estimated allowance amount of uncollectible receivables must be made even if the specific
uncollectible receivables cannot be identified. A company may base its estimate of uncollectible
receivables on any number of techniques including:
Its prior experience,
An evaluation of each debtor‘s ability to pay,
An appraisal of the loss history of the industry in which the creditor company operates
A percentage of the open accounts receivable balance
A percentage of the balance over 90 days past due
Two common procedures of accounting for bad debts are:
a) The direct write-off method, and
b) The allowance method
(a) Direct Write off Method

The direct write-off method is not acceptable for the purposes of GAAP. The weaknesses of the direct
write-off method are:
Bad debt expense is not matched with the related sales.
Accounts receivable are overstated because no attempt is made to account for the unknown bad debts
included in the A/R.
(b) Allowance Method

Under the allowance method, a percentage of each period‘s sales/revenue or ending accounts receivable is
estimated to eventually prove uncollectible. Consequently, the amount estimated is charged to bad debts of
the period and the credit is made to an account such as allowance for doubtful accounts. When specific
accounts are written off, they are charged to the allowance account, which is periodically recomputed.
Caution
A bad debt exists if, at the date of its financial statements, a creditor does not expect to collect the full
amount of its accounts receivable.
5.2 Reserves for Discount on Debtors

There are two types of discounts allowed to customers in a business. One is trade discount and another is
cash discount. Trade discount is given to customers to retain the customers and it is shown in the invoice
itself. It means that trade discount does not come to accounting records at all. But cash discount is allowed
to customers to encourage them to pay cash promptly at the earliest. Normally cash discount gets recorded
in cash account. Out of experience, a businessman can guess how much of cash discount he may have to
give on customer‘s accounts. Cash discount given to debtors is always a loss and is shown as expenditure
in the Profit and Loss Account. After anticipating the amount of cash discount allowable, provision is
made in the current year itself. In the subsequent years, the actual discount allowed is set off against the
provision for discount on debtors. Every year, the amount of provision for discount on debtors is deducted
from the profits. The entry for making the provision is Profit and Loss Account Dr to Provision for
discount on debtors account.

Just as reserve is for discount on debtors is created, reserve for discount on creditors is also created.
Businessman expects that he would receive discounts from suppliers (creditors), when the businessman
remits cash to them. Anticipating some percentage of creditors being received as discounting the coming
year, the business proprietor makes a provision for the expected income in the current year itself. Discount
on creditors is an income and therefore reserve for discount on creditors is debited and profit and loss
account is credited to show it as anticipated profit. In the subsequent year, when discount on creditors is
actually received, it is first set of against provision for discount on creditors and the difference between the
new provision for discount on creditors and the balance of old provision left over is carried to P and L
Account.
Discount on creditors is income and to that extent the creditors due is reduced. So the journal entry to
record them is Creditor‘s account Dr To discount on creditors account Later if the discount received is
adjusted against reserve for discount on creditors, the entry will be Discount on creditor‘s account Dr To
Reserve for discount on creditors When provision for discount on creditors is made in and Account, the
entry will be Reserve for discount on creditors account Dr To Profit and loss account The amount of
provision for discount on creditors is calculated at a percentage on creditors.

Any error when located must be rectified. However, the rectification should not be made by overwriting or
by striking off the wrong entry. This would destroy the authenticity of the books of account. Hence, the
errors should always be corrected by making suitable entries called rectifying entries.
Errors
The trial balance is prepared to check the arithmetical accuracy of accounts. If the trial balance does not
tally, it implies that there are arithmetical errors in the accounts which require location, detection and
rectification thereof. Even if the trial balances tallies, there may still exist some errors. There are two types
of errors:
(a) Errors which are not revealed by the trial balance, and
(b) Errors which are revealed by the trial balance. Errors may happen at any of the
Errors of Commission
These errors by definition are of clerical nature. These errors may be committed at the time of recording
and/or posting. At the time of recording, the wrong amount may be recorded in journal which will be
carried throughout. Such errors will not affect the agreement of the trial balance. These errors may also be
committed at the time of posting, by way of posting wrong amount, to the wrong side of an account or in
the wrong account. The errors resulting in posting to wrong account will not affect agreement of trial
balance, whereas, other errors of posting will resulting disagreement of trial balance.
For example, an amount of INR10, 000 received from customer (Debtor) is correctly recorded on the debit
side of the cash book but while posting, the customer‘s account is credited with INR1, 000. This is an
error, which is committed at the time of posting, by posting wrong amount to the account. This will result
in disagreement of trial balance, since; the credit total of the trail balance will be short by INR9, 000.
Errors of Omission
The errors of omission may be committed at the time of recording the transaction in the books of original
entry or while posting to the ledger. An omission may be complete or partial.
Such errors are known as errors of omission.
For example, Machinery purchased for INR50, 000 by issuing a cheque is recorded first in the credit side
of cash book, in the bank column. Suppose it is not posted to the debit of machinery account, it is an error
of partial omission. The trial balance will not tally. Suppose the transaction is not entered in the cash book
and hence ignored completely, this is a case of complete omission. It means as if the transaction has not
taken place at all. It will not affect the trial balance and hence the trial balance will tally. This is true only
in case of complete omission.
5.4.1 Classification of Errors for the Purpose of Rectification

From the point of view of rectification, errors are classified into two categories:
Errors which affect the trial balance; and
Errors which do not affect the trial balance
Errors which Affect the Agreement of Trial Balance

These errors are due to the mistake having being committed on the one side of the account. They may
happen at any of the stages of the accounting process, like recording, posting, balancing, etc. such errors
can be rectified by giving an explanatory note or by passing a journal entry with the help of a special
account called suspense account.
Rectification
An error in the books of original entry if discovered before posting to the ledger, may be corrected by
crossing out the wrong amount by a single line and writing the correct amount above the struck off amount
and putting an initial at the place.
An error in an amount posted to the correct ledger account may also be corrected in a similar way or by
making an additional posting for the difference in amount and giving an explanatory note in the particulars
column provided that trial balance is not prepared..
5.4.2 Rectification of One-sided Errors

Generally errors are corrected by passing suitable journal entries. To know passing a journal entry means
debiting one account and crediting another. But in the case of one-sided error only one account is involved.
So it cannot be corrected by passing journal entry. It is rectified by noting the correction on the appropriate
side. Take the first example of one-sided error. Deshmukh‘s Account was credited short by INR90. This
will be corrected by an additional entry for INRs 90 on the credit side of his account as follows:
The wrong total in the Purchases Book will be circled with red ink and the correct total entered above or
below the circle. The person doing the rectification will also put his initials.
5.4.3 Rectification of Two-sided Errors

One-sided errors are corrected by noting the correction on the appropriate side of the account affected by
the error. They cannot be rectified by suitable journal entries because only one account was involved the
two-sided errors are mostly rectified by journal entries. It is because such errors affect two or more
accounts and in most cases the debit and credit are equally affected.
5.4.4 Suspense Account and Rectification

This method is used for rectifying the errors located before preparing the final accounts. After the
corrections have been made, a revised Trial Balance is prepared which should normally tally. But, if it does
not tally, it means there are still some errors which have not been detected.
As considerable time and effort have already been spent in locating and rectifying the errors, it may not be
possible to wait any longer because it will delay the preoperational of final accounts. Hence, in such
situation the usual practice is to place the difference to Suspense Account and tally the Trial Balance for
the time being. If the total of the debit column in the Trial Balance is more than the total of its credit
column, the difference is placed to the credit of Suspense Account and the Trial Balance will tally.
Similarly, if the credit column total is more than the debit column total, the difference is placed to the debit
of Suspense Account. The Suspense Account thus created is shown in the Balance Sheet and is carried
forward to the next year.
These errors do not affect the agreement of Trial Balance and hence do not involve the Suspense Account.
They are rectified by means of the journal entries as usual.
This is not the case in respect of one-sided errors. When one-side errors were to be corrected before
preparing the Trial Balance we did it by writing an appropriate note in the concerned account. But, when
they are to be corrected during the next year i.e. after Suspense Account has been created, the rectification
will be through an appropriate journal entry. The one-sided error usually affects only one account. So to
pass a journal entry for rectification of such error, we shall now take Suspense Account as the other
account involved.
For example, INR580 received from Shyam was posted to his account as INRs. 850. It means Shyam‘s
Account is to be debited with INR270. One can now pass the following journal entry to rectify this error:
Thus all errors, whether they are two-sided or one-sided will now be rectified by means of journal entries.
Let us assume that a businessman could not tally his trial balance. The difference of INR 1 between the
totals of the two columns was put against the suspense account on its debit side and the trial balance was
made to tally temporarily. The suspense account was carried forward to the next accounting year. The
following errors were then located:
1 An amount of INR99 was omitted to be posted to the credit of a customer‘s account from the cash book.
2 The Sales Book was overcast by INR100.
The first error involved the omission of posting to the credit of customers account. So, to rectify this error
will have to credit customer‘s account with INR99. As the Suspense Account is in existence, the
corresponding debit would be given to the Suspense Account. Thus, the journal entry will be:
The second error refers to sales book being overcast by INR100. It means that the sales account has been
credited with INR100 in excess. To rectify this error, the sales account will have to be debited with
INR100. The corresponding credit would be given to suspense account. The rectifying entry will be:
The suspense account, after posting the two rectification entries, would appear as follows Table 5.2:
Table 5.2: Suspense account
With the posting of the two rectification entries the suspense account got closed.
Note that the opening balance in suspense account simply shows the net effect of these errors. Sometimes,
the balance of suspense account is not given.
In that case it can be worked out after completing the posting of the rectification entries. Leave the first
line blank on both the debit and credit sides of the suspense account and post the rectification entries. The
difference between the totals of two sides will be considered as the balance with which the suspense
account was opened. This is based on the assumption that there are no more errors remaining undetected.
5.4.5 Effects of Rectifying Entries on Profits

The errors still remain to be detected and rectified. So, the Profit and Loss Account prepared from such
Trial Balance is subject to the undetected errors. The profit thus arrived at may be less or more than the
actual profits. Similarly, when the errors are detected and rectified during the next year, the rectifying
entries will have their effect on the profit of the next year.
The profit is affected only if the errors involve accounts which usually appear in the Trading and Profit and
Loss Account (nominal accounts) and not those which appear in the Balance Sheet (real and personal
accounts). Let us understand it with the help of an example. Suppose INR24, 000 paid for salaries during
1986 were posted to the Salaries Account as INRs. 20,400. This error has resulted in short debit of INRs.
3,600 to Salaries Account and so the salaries charged to Profit and Loss Account are short by INRs. 3,600.
This would overstate the profits of 1986.
When this error will be detected in 1987 and the rectifying entry passed, INR3, 600 will be added to
salaries of 1987 and so the profit of 1987 will be decreased by INR3,600. Thus, both the errors and the
rectifying entries affect the profit. The effect of rectifying entries will be the reverse of the effect of errors.
The effect of errors and their rectification on the profits has been presented in a summarized form in Table
5.3:
Table 5.3: Effect of errors and rectifying entries on profits
Did You Know?

Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their
seminal 1934 book, Security Analysis.
Case Study-Reserve Requirement of PTC

The Client:
Any United States based financial institution
Strategy solution accepted and implemented at 19 US financial institutions
Strategy solution has been universally accepted and implemented at all major US financial institutions
Engagement Objective
Provide a reserve requirement reduction solution that meets current Federal Reserve guidelines
Provide core platform solutions to accommodate any necessary changes to the transaction account
processing system
Provide customer disclosure language
Challenges
Ensure any system changes or modifications have zero impact on customer‘s ability to access account
funds
Ensure any system and FRB2900 reporting modifications are acceptable under Regulation D
requirements
Provide banks with written confirmation from Federal Reserve Regulators that proposed solution is
acceptable and meets all reporting criteria.
Engagement Highlights
Strategy solutions produced over INR 20,000 M in annual benefit for client base
Implementation had NO impact to customer‘s account or access to account funds
PTC secured a letter from the Federal Reserve Bank detailing compliance with Regulation D
requirements
Strategy solution has become standard operating procedure for banks in the US Project Expectations
To reduce the receivable balances banks are required to maintain per Federal Reserve Regulation D.
For the purposes of this exercise, PTC focused on two key elements contained in Regulation D:
The definition of various account products (demand deposit, time deposit, savings deposit, etc) and the
transactional restriction that are placed on each of these account types.
The computation and maintenance of reserves required based on the account balance distribution and
reporting requirements for the completion of FRB2900 weekly reports.
PTC was required to design an accounting procedure which reclassified receivable account balances as
non-receivable account balances. This requirement must meet all Regulation D requirements and function
seamlessly with the core system platform without having any negative impact on the customer‘s account
and his/her access to available funds.
Clients
The clients were major money center banks and super regional banks based in the United States.
PTC worked directly with 19 individual banks to define the scope, disclosure requirements, system
capabilities and the calculated reduction in required reserves.
Background
The program proposed by PTC was designed to reduce receivable balances banks are required to maintain
while having NO impact on the customer. The sweep function necessary to facilitate the implementation of
this solution was setup so that it is within the limitations in Regulation D regarding preauthorized transfers
from a money market account. The applicable section of Federal Reserve Regulation D which affects this
recommendation is as follows:
204.2(d) (2) (ii): A deposit or account, such as an account commonly known as a ―money market deposit
account‖ (MMDA), that otherwise meets the requirements of section 204.2(d) (1) and from which, under
the terms of the deposit contract or by practice of the depository institution, the depositor is permitted or
authorized to make no more than six transfers per calendar month or statement cycle (or similar period).
PTC Solution
The Regulation D requirement is satisfied by setting a balance or threshold level for each account over
which transfers into or out of the money market account (sub ledger account) will take place. The balance
or threshold levels set will depend on the account type and is based on the average activity and average
balance in the customer‘s checking account.
Once the two sub ledger accounts are established, one of the following would happen when debit activity
occurs, provided the debit transfer counter (from the money market account) is less than six in the
statement cycle period: • If the ending balance in the checking account is greater than or equal to the
money manager threshold amount, the threshold amount is moved into the money market sub ledger
account. The remaining balance is moved into the checking sub ledger account.
If the ending balance in the checking account is less than the threshold amount, the ending balance is
moved into the money market sub ledger account. The balance in the checking sub ledger is set to
zero.
If the account is overdrawn, the balance in the money market sub ledger account is set to zero and the
balance in the checking sub ledger account is reduced to reflect the overdraft.
Transfers out of the checking account to the money market sub ledger account can be made as often as
required, i.e. the six transfer limits in Regulation D do not apply.
Results
Implementation of PTC‘s reserve requirement reduction solution resulted in significant reductions in the
amount of reserves bank were required to maintain, freeing hundreds of millions of dollars for investments
opportunities. The following table helps to illustrate the reduction in overall reserves required:
Regulation D stipulates that savings/time deposits had no require reserve allocation. These accounts by
definition had transaction limitations and withdrawal notification periods in order to withdraw funds. By
contrast checking/demand account balances had a tiered reserve requirement with the vast majority of
checking/demand balances requiring a 10% reserve.
Implementation of PTC‘s sub ledger accounting system resulted in a reallocation of balances between
savings and checking accounts. Using the PTC solution banks were able to reallocate approximately 85%
of checking account balances as savings balances.
The example below details the balance shift:
The following graphs show the significant reduction in balances that the typical bank was able to achieve.
Conclusions
Based on the overall success of the solution PTC was able to provide the following conclusions:
PTC was able to identify a creative method to assist banks with reducing reserve requirements while
meeting all Regulation D reporting requirements
PTC assisted with the revised disclosure requirements necessary to notify the customers of the sub
ledger processing and worked with core system processors in order to facilitate the implementation of
the sub ledger processing
PTC‘s solution allowed banks to allocate additional funds for investment purposes resulting in millions
of dollars in additional investment income
Most significantly, bank customers were NOT impact with the implementation of this solution.
Question
1. Discuss the requirement of reserve.
2. Explain the current calculation methodology in case study.
5.5 Summary
The trial balance does not tally it means there are errors in the books of account. Attempts are made to
locate the errors and rectify them.
One-sided errors which affect only one account are rectified by means of a suitable note on the
relevant side in the concerned account.
Two-sided errors, involving two or more accounts, are rectified by means of journal entries.
The Suspense Account is carried forward to the next accounting year and as and when the errors are
located, they are rectified.
The errors are rectified during the next account year, the rectification entries involving nominal
accounts affect the profits of the next year. To avoid such effect, Profit and loss Adjustment Account
can be opened and its balance directly adjusted in capital.
Errors affecting only one account can be rectified by giving an explanatory note or by passing a journal
entry. Errors which affect two or more accounts are rectified by passing a journal entry.
An account in which the difference in a trial balance is put temporarily till such time that errors are
located and rectified. It facilitates the preparation of provisional financial statements even when the
trial balance does not tally.
5.6 Keywords
Balance Sheet: A balance sheet or statement of financial position is a summary of the financial balances of
a sole proprietorship, a business partnership, a corporation or other business organization, such as an LLC
or an LLP.
Current Asset: Short-term asset (items or amounts to be used or received within 12 months) e.g. stock or
cash.
Financial Statement: A financial statement is a formal record of the financial activities of a business,
person, or other entity.
Income: Amount of sales made in the current financial year, regardless of whether cash has been received
or not.
Profit and Loss Account: A profit and loss account starts with the trading account and then takes into
account all the other expenses associated with the business.
Profit and Loss Adjustment Account: An account opened for avoiding the effect of rectifying entries in
respect of previous year‘s errors on the profit or loss of the current year.
Suspense Account: An account opened to make the Trial Balance tally temporarily. It represents the net
effect of undetected one-sided errors.
Two-sided errors: An error which involves two or more accounts and both the debit and credit aspects.

1. Which of the following errors will not affect the Trial Balance?
(a) Wrong balancing of an account
(b) Writing an amount in the wrong account but on the correct side
(c) Wrong totalling of an account
(d) None of these.
2. Which of the following errors is an error of omission?

(a) Sale of INRs.500 was written in the purchases journal
(b) Wages paid to Mohan have been debited to his account.
(c) The total of the sales journal has not been posted to the Sales Account
(d) None of these.
3. Purchase of office furniture for INRs.3,400 has been debited to General Expenses Account. It is ….
(a) an error of commission (b) an error of omission
(c) an error of principle (d) None of these.
4. Which of the following errors will affect the Trial Balance Account?
(a) Repair to buildings have been debited to buildings.
(b) The total of purchases journal is INRs.1, 000 short.
(c) Freight paid on new machinery has been debited to the Freight account
(d) None of these.
5. Errors of commission do not allow:

(a) Correct totalling of the Balance Sheet (b) Correct totalling of the Trial Balance
(c) The Trial Balance to agree (d) None of these.
6. The preparation of a Trial Balance helps in:

(a) Locating errors of complete omission (b) Locating errors of principle
(c) Locating errors of commission (d) None of these.
7. The type of account with a normal credit balance is:
(a) An asset (b) A drawing
(c) A revenue (d) An expense
8. The form listing the balances and the title of the accounts in the ledger on a given date is the :
(a) Income statement (b) Balance Sheet
(c) Retained earnings statement (d) Trial Balance
9. Errors of principle …………. affect the Trial Balance.

(a) do not (b) correct
(c) Retained (d) None of these.
10. The equality of …………… and ……………. of the Trial Balance does not mean that the individual
accounts are also ………….
(a) profit, loss, trading (b) debit, credit, accurate
(c) credit, accurate, debit (d) Trial Balance

1. What are one-sided errors? Give examples.
2. Explain the method of rectifying one-sided errors.
3. What are two-sided errors? Give example and show how two-sided errors are corrected?
4. What is a suspense account? Describe with example.
5. How do you rectify the error when a suspense account has already been opened?
6. Does rectification of errors in a subsequent accounting period always affect the trading result of the
current accounting period? Explain with example.
7. What is the purpose of preparing suspense account?
8. Explain compensating errors and give two examples of such errors.
9. Explain errors of principle and give two examples of such errors.
10. Explain errors of commission and give examples of such errors with measures to rectify them.

1 (b) 2 (c) 3 (c) 4 (b) 5 (c)
6 (c) 7 (c) 8 (c) 9 (a) 10 (b)
6
Trial Balance
CONTENTS
Objectives
Introduction
6.3 Types of Errors
6.6 Summary
6.7 Keywords
Objectives
Define meaning of trial balance
Understand objectives of trial balance
Explain types of errors
Describe rectification of errors
Define sectional and self balancing system
Introduction
One of the major reasons for recording transactions in accounts is to provide the information needed for
financial reports. However, before the information can be used to prepare these reports, it is necessary to
check the accuracy of the entries that were recorded. Remember that every entry consists of a debit and a
credit. Therefore, the total of all the debits recorded in the accounts should equal the total of all the credits.
This equality is verified by taking a trial balance.
If the journal entries are error-free and were posted properly to the general ledger, the total of all of the
debit balances should equal the total of all of the credit balances. If the debits do not equal the credits, then
an error has occurred somewhere in the process. The total of the accounts on the debit and credit side is
referred to as the trial balance.
A trial balance is a list of all the general ledger accounts (both revenue and capital) contained in the ledger
of a business. This list will contain the name of the nominal ledger account and the value of that nominal
ledger account. The value of the nominal ledger will hold either a debit balance value or a credit balance
value. The debit balance values will be listed in the debit column of the trial balance and the credit value
balance will be listed in the credit column. The profit and loss statement and balance sheet and other
financial reports can then be produced using the ledger accounts listed on the trial balance.
The name comes from the purpose of a trial balance which is to prove that the value of all the debit value
balances equal the total of all the credit value balances. Trialing, by listing every nominal ledger balance,
ensures accurate reporting of the nominal ledgers for use in financial reporting of a business‘s
performance. If the total of the debit column does not equal the total value of the credit column then this
would show that there is an error in the nominal ledger accounts. This error must be found before a profit
and loss statement and balance sheet can be produced.
The trial balance is usually prepared by a bookkeeper or accountant who has used daybooks to record
financial transactions and then post them to the nominal ledgers and personal ledger accounts. The trial
balance is a part of the double-entry bookkeeping system and uses the classic ―T‖ account format for
presenting values.
The various debit balances and the credit balances of the different accounts are put down in a statement,
which is termed a ―Trial Balance‖. In other words, Trail Balance is a statement containing the various
ledger balances on a particular date.
A trial balance is a list and total of all the debit and credit accounts for an entity for a given period usually
a month. The format of the trial balance is a two-column schedule with all the debit balances listed in one
column and all the credit balances listed in the other. The trial balance is prepared after all the transactions
for the period have been journalized and posted to the general ledger.
Key to preparing a trial balance is making sure that all the account balances are listed under the correct
column.
The appropriate columns are as follows:
Assets = Debit balance
Liabilities = Credit balance
Expenses = Debit Balance
Equity = Credit balance
Revenue = Credit balance
Should an account have a negative balance, it is represented as a negative number in the appropriate
column.
For example, if the company is INR 500 into the overdraft in the checking account the balance would be
entered as INR500 or (INR 500) in the debit column. The INR 500 negative balance is not listed in the
credit column. A book keeping worksheet in which the balances of all ledgers are compiled into debit and
credit columns. A company prepares a trial balance periodically, usually at the end of every reporting
period. The general purpose of producing a trial balance is to ensure the entries in a company‘s
bookkeeping system are mathematically correct. The Trial Balance is a statement of ledger account
balances as on a particular instance as shown in Figure 6.1.
Figure 6.1: The trial balance of M/S wears all textiles as on 21st March 2006.
6.1.1 Trial Balance Prepared

The trial balance is prepared to check/ensure the arithmetical accuracy of accounting. Though not a
conclusive proof, the agreement of the trial balance is a prima facie evidence of the absence of
mathematical errors. This is the most important purpose for which the trial balance is prepared.
Is not Trial Balance made for Enabling Preparation of Final Accounts?

Preparation of trial balance is not an act that forms a part of the activities involved in the regular
accounting cycle. Since final accounting can be completed without the preparation of the trial balance, we
can say that enabling the preparation of final accounts is not the purpose of the trial balance. The trial
balance is generally prepared at a time when all the ledger accounts are balanced like at the end of the
accounting period.
Theoretically, the trial balance can be prepared as and when needed. Different ledger accounts are
balanced at different time intervals based on the information needs of the organization. Say in a typical
organization cash a/c is balanced daily, expenses, creditor and debtor accounts are balanced on a monthly
basis, asset accounts are balanced annually etc. The ledger account balances relating to all ledger accounts
would not be available ready hand at any given instance. Year ending is one such instance when the
balances are derived.
Computerized Accounting
In mechanized (computerized) accounting systems, trial balance is a statement that can be automatically
derived as and when needed. Preparation of a trial balance is not an act which forms a part of the activities
involved in the accounting cycle (See figure 6.2). The Accounting Cycle (activities involved)
Begins with opening the books of accounts for an accounting period by recording the opening entry;
Figure 6.2: Computerized accounting.

This is the journal entry that supports the posting to balance b/d and By Balance b/d in the various ledger
accounts (See Figure 6.3).
Recording the various transactions all throughout the accounting period;
Balancing the ledgers as and when needed and finally at the end of the accounting period;
Recording the transactions for making up the final accounts
1. Making the trading a/c
2. Closing the trading a/c by transferring the balance in it to profit and loss a/c
3. Making the profit and loss a/c
4. Closing the profit and loss a/c by transferring the balance in it to capital a/c (or profit and loss
appropriation a/c)
Preparing the balance sheet (A statement of balances in all the ledger accounts that remain after
making up and closing the trading and profit and loss a/c.)
The accounting cycle ends with recording the closing entry for closing the books of accounts.
Figure 6.3: Journals of books.
This is the journal entry that supports the posting To Balance C/D and By Balance C/D in the various
ledger accounts.
6.1.2 Final Accounting: Use of Journal/Ledger

Final accounting deals with all the ledger account balances at the end of the accounting period in one way
or the other.
All the Nominal accounts that represent direct expenses and direct incomes are closed by transfer to
the trading a/c.
The trading a/c is closed by transferring its balance to the profit and loss a/c.
All the nominal accounts that represent indirect expenses, losses and indirect Incomes are closed by
transfer to the profit and loss a/c.
The profit and loss a/c is closed by transferring its balance to either the capital a/c or profit and loss
appropriation a/c.
All the remaining accounts are listed out in the balance sheet.
A closing entry is recorded in relation to this, though it is not directly related to preparing the balance
sheet. If the final accounting is to be done in a systematic manner, then the entire journal entries mentioned
above are to be recorded and all the ledger accounts that are affected by those transactions are to be posted
to and updated. That would result in the making up of the trading a/c and Profit and Loss a/c. The balance
sheet is prepared by drawing up a statement of ledger account balances carried forward through the closing
entry.
6.1.3 Final Accounting: Use of Trial Balance: Avoiding Journal/Ledger
In manual accounting, the Trading a/c, Profit and Loss a/c and the balance sheets can also be prepared
using the information in the trial balance avoiding the act of journalizing the transactions involved in final
accounting.
This is done by showing each item in the ledger accounts (trading, P/L a/c) or the statement (balance sheet)
where it would be ultimately appearing had the actual procedure been adopted. This would have the same
effect as recording the journal and posting into the ledger.
Example
The balance in the Carriage Inwards a/c (direct expenditure) is transferred to the Trading a/c by recording a
Journal entry. By this, the carriage Inwards a/c would get closed (its balance becomes zero) and the
Trading a/c would get debited with that balance. In preparing the Trading a/c the balance in the carriage
inwards a/c can be ascertained from the trial balance and shown on the debit side of trading a/c.
Reduction of Work Involved in Manual Accounting

Since not recording the related journal entries makes no difference as far as final accounting is concerned,
in almost all cases in manual accounting, the process of recording the journal entries required for final
accounting and updating the ledger is bypassed to reduce the burden of the work involved.
Information in Trial Balance to be dealt with only once

In making up final accounts using the information in the Trial Balance, we should ensure that each item of
information (representing a ledger account balance) should be dealt with only once in final accounting
each piece of information can appear either on the debit or credit sides of the Trading a/c or ―profit and
loss a/c‖ or on the assets or liabilities side of the ―Balance Sheet‖.
Caution
Unless and until all the balances of other ledger accounts within the organizational accounting system are
not complete, the trial balance should not be prepared.
6.1.4 Interpreting the Items in the Trial Balance

A statement for interpretation of the various ledger account balances in the above trial balance.
6.1.5 Making up the Final Accounts
Final accounting using the information in a trial balance involves nothing more than putting the right items
in the right places i.e. on the appropriate side of trading a/c, profit and loss a/c or the balance sheet.
6.1.6 Care in dealing with Profit and Loss Appropriation a/c (or Capital a/c)
The balance in the ―Profit and Loss Appropriation a/c‖ as shown in the trial balance represents the balance
carried forward from the previous accounting period (i.e. year ending 31st March 2005). The profit and
loss a/c relating to the current period is closed by transfer its balance to the ―Profit and Loss Appropriation
a/c‖.
Therefore, while showing the information (balance) relating to the Profit and Loss Appropriation a/c in the
balance sheet, care should be taken to make appropriate adjustment to the balance on account of the
transfer of balance from the Profit and Loss a/c. The balance that appears in the balance sheet is not the
one that appears in the trial balance, but the one that takes into consideration the adjustment on account of
current periods profit or loss also. If the balance in Profit and Loss a/c is transferred to the Capital a/c, then
such a care should be taken with regard to the Capital a/c balance.

A trial balance can be defined as a statement of balances extracted from the various accounts in the ledger
with a view to test the arithmetical accuracy of the books of account. It is has two sides debit and credit
and they both should be equal. The following are the important objectives of trial balance:
To Check the Arithmetical Accuracy
Trial balance is based on the double-entry principle of debit equals credit or credit equals debit. As a result,
the debit and credit columns of trial balance must always be equal. If they do, it is assumed that the
recordings of financial transactions are accurate. Conversely, if they do not, it is assumed that they are not
arithmetically accurate. Therefore, one important purpose of preparing trial balance is to provide a check
on the arithmetical accuracy of the recordings of the financial transactions.
To Help Locate Accounting Errors

Since the trial balance indicates if there is any error committed in the journal and the ledger, it helps the
accountant to locate the error because the starting point of locating errors is trial balance itself.
To Summarize the Financial Transactions

A business performs several numbers of financial transactions during a certain period of time. The
transactions themselves cannot portray any picture of the financial affairs of the business. For that purpose,
a summary of the transactions has to be drawn. The trial balance is prepared with a view to summarize all
the financial transactions of the business.
To Provide the Basis for Preparing Final Accounts

Final accounts are prepared to show profit and loss and the financial position of the business at the end of
an accounting period. These accounts are prepared by using the debit and credit of all ledger accounts.
Therefore, since the trial balance is a statement of the debit and credit balances of the ledger accounts, it
provides the basis for the preparation of the final accounts.
6.2.1 Features of Trial Balance

1. Trial balance can be prepared anytime during the accounting period.
2. It is prepared to check the arithmetical accuracy of posting of entries from journal to ledger, in other
words it is an instrument for carrying out the job of checking and testing.
3. It is not a part of the double entry system of book keeping but only for checking the accuracy of
posting. However it does not reveal all errors.
6.2.2 Preparation of Trial Balance from the List of Accounts Balances

Sometime, we do not prepare trial balance with facilitate of ledger accounts but with the help of balances
of accounts. At that time, we have to classify the balances of accounts in debit or credit side. After this, we
write it in the trial balance. After this, we compute its total.
For preparing trial balance with the help of balances of accounts, we should remember following things:
1. Assets, expenses and losses always debit balance.
2. Liabilities, incomes and profits always have credit balance.
3. Reserves and provisions also have credit balance.
4. There is credit balance of capital and debit balance of drawing.
5. We do not include closing stock in trial balance.
6. If the total of credit side of trial balance is less, then it will be capital.
6.3 Types of Errors

Errors can be classified into two categories:
Errors not revealed by the Trial Balance
Errors revealed by the Trial Balance
Errors not Revealed by the Trial Balance

The following errors do not affect the equality of the Trial Balance totals:
Errors of Omission
A transaction is omitted completely from the books so that there is no debit and credit entry of the
transaction, e.g. Drawings of INR 2500 cash by the proprietor was not recorded.
Errors of Commission
An entry is posted to the correct side of the ledger but to the wrong account, i.e. items have been posted to
the wrong account of the same class, e.g. Payment of INR 5000 cash by a customer A. John was wrongly
posted to the account of another customer, B. Johan.
Errors of Principle
An entry is made in the wrong class of account, i.e. when an expense is treated as an asset and vice versa,
e.g. Repairs to building INR 20000 was debited to the Building Account.
Complete Reversal of Entries

An account that should be debited is credited and vice versa, e.g. a cheque INR 10000 received from Cyril
was debited to the account of Cyril and credited to the Bank Account.
Compensating Errors
Errors (or error) on one side of the ledger are compensated by an error (or errors), e.g. The Purchases
Account and Sales Account were both overcast by INR 150.
Errors of Original Entry

The original figure may be incorrectly entered although the correct double-entry principle has been
observed using this incorrect figure, e.g. Credit sales of INR 4350 to Kay was recorded in the Sales
Account and Kay‘s account as INR 3000.
Errors Revealed by the Trial Balance
Errors which are revealed by the Trial Balance are those errors which cause the trial balance totals to be in
disagreement.
Errors in Calculation
If there is any miscalculation of the trial balance totals or the net account balances, the Trial Balance will
not balance, e.g. there was an error in the calculation of the cash balance, causing the Trial Balance totals
not to balance too.
Errors in Omission of One Entry

Omission of either the debit or credit entry of a transaction will cause the totals of the Trial Balance not to
agree, e.g. a cheque INR 25000 received for commission was debited to the Bank Account only.
Posting to the Wrong Side of an Account

Entry into the wrong side of an account will cause one side of the ledger to be more than the other, e.g. A
cheque of INR 40000 paid to creditor, K. Wang was credited instead of debited to his account.
Errors in Amount
If the debit entry of a transaction differs in amount with the credit entry, the Trial Balance will not balance,
e.g. Cash INR 6700 received from Caine was debited to the Cash Account as INR 6700 and credited to the
account of Caine as INR 7150.
Identifying and Overcoming with the Errors of the Trial Balance

Divide the difference in the trial balance by two; find out if some figure equal to that (half the
difference) appears in the trial balance. It is possible that a balance might have been placed on the
wrong side thus causing double the difference.
Dividing the difference by 9. If the difference is evenly divisible by 9 the error may be a transposition
of figures. e.g. If 797 is written as 977, the difference is 180 and 180 is evenly divisible by 9.
Check the nature of the amount of the difference.
If the amount is in round figure, it is quite possible that the mistake is made in casting or in carrying
forward the totals of subsidiary books or in balancing the accounts.
If the amount is not a round figure, it is possible that mistake might have been committed in posting. If the
difference is of an amount which recurs quite often in the accounts, first check the posting of those figures.
If the difference is of a large amount, it is better to compare the trial balance of the current year with that of
the previous. Now find out if particular balance of the account has not been included in the trial balance.
Also see that the figures of accounts under the same head do not show abnormal variation and balances fall
on the same side of the trial balance. In case of heavy variation look to the account to establish the cause of
variation.
Check the total of schedule of debtors and creditors and find out that all balances have been included
in the list.
Check that cash and bank balances have been included.
Check casting and carry forward of subsidiary books.
Check thoroughly books of subsidiary records, posting to ledger and balancing of accounts.
Did You Know?

The actual origin of the terms debit and credit is unknown; the first known recorded use of the terms is
Venetian Luca Pacioli‘s 1494 work Summa de Arithmetica, Geometria, Proportioniet Proportionalita.

Rectification of errors in accounting is not so easy because first of all we have to find mistakes. Sometime
errors may be very small and hidden from our eyes. So, it is very necessary to use a very step by step
procedure for rectification of errors.
1st Step: Divide the Rectification of Errors into Sub Parts

For easily rectification of errors, we divide rectification of errors into sub parts.
(a) Errors Affecting one Account
All mistakes like errors of commission, errors of posting and errors of balancing affect the one account and
after watching ledger of account through internal auditing system, we can find the errors and correct it
without any delay.
(b) Errors Affecting Two or More Accounts

After deep review of ledger accounts and journal and subsidiary books, we can find errors which affect two
accounts. Even by making trial balance, we cannot find these errors. Errors of principles and errors of
omission are its main example. By rectify journal entry, we can correct these errors.
2nd Step: To Fix the Stages of Rectification of Errors

(a) Before Making Trial Balance
This is the first stage in which before making trial balance, we correct all our accounting mistakes.
(b) After making trial balance and before making final accounts
Before making final accounts, if we want to correct our accounting error, we have to pass such rectify
entry so, that effect of mistake will be zero on final accounts.
For example
We have written less INR. 500 the total of sale book. This error can affect trial balance. After finding this
error, we can understand that this error is affecting only sale account, so in the credit side of sale account,
we have to write INR. 500 amount by writing ―By rectification of under casting‖
(c) After Making Final Accounts

If before making final accounts, auditor did not find the errors of accounting, we have to open a new
account and its name is suspense account. This account shows the amount of error which did not find and
this account is opened for matching our trial balance and balance sheet. Now next year, if we find where is
mistake and we close our suspense account by rectification entry.
For example, in the next accounting year, we find that debit side of previous trial balance‘s debit side was
less of INR 200 and same amount was transferred to suspense account. But this year, we find its reason.
Reason is that we did not we did not debit the amount of sale in the debit of Ram‘s account. Now this is
one sided error because we had written correct amount in sale account. So we rectify this error by passing
following rectification entry.

After the transactions, being recorded in the journal, are classified in the ledger. A small enterprise
normally has less number of accounts are therefore can maintain all the accounts in one ledger alone.
However, in case of a big enterprise, the number of accounts are large and, therefore, it becomes
inconvenient to maintain all accounts into one ledger alone. Hence in such a condition the ledger is sub-
divided into the following three ledgers:
Trade Debtors/Customers/Sales/Sold Ledger

This ledger contains the personal accounts of the Trade Debtors to whom credit sales are affected. Here
trade debtor‘s word stands for only those debtors to whom goods are sold.
Creditors/Suppliers/Purchase/Bought Ledger
This ledger contains the personal accounts of the trade creditors who supply the goods on credit. Here
Trade Creditors word stands for only those creditors to whom those goods are sold.
General Ledger/Nominal/Impersonal Ledger

This ledger contains all nominal accounts, real accounts and the remaining personal accounts other than
trade debtor‘s accounts and trade creditor‘s accounts.
Having sub-divided the ledger into the above categories the enterprise may record the transactions either
according to the Sectional Balancing or Self Balancing System.
Need For Sectional Balancing System

Need for Sectional Balancing arises only for those transactions which involve Trade Debtors and Trade
Creditors, which is explained by the help of the following problem:
If in any transaction Trade Debtor is involved then one aspect of that transaction will be recorded in the
Debtors Ledger and the other aspect will be recorded in the general ledger. By this the double entry is not
completed in either ledger and due to which trial balance can also not be prepared, because in any of the
ledger double entry related to trade debtor is not completed.
Example
Goods sold to Mr. X. The usual entry of this transaction will be: Now if this entry is posted in ledger then
in Debtors Ledger debit aspect will be recorded and in the General Ledger credit aspect will be recorded,
due to which Trial Balance cannot be prepared because to prepare the Trial Balance it is necessary to
record both the aspect of any transaction in one ledger, which is not possible in this case.
To overcome this problem a control accounts namely total debtor‘s account is opened in General Ledger to
complete the double entry system. This system is known as Sectional Balancing System because out of the
three sections only in general ledger the double entry system is completed and is balanced.
Checking the Accuracy

The accuracy of individual customer‘s account can be checked by comparing the total of their balance with
balances of the total debtors account in general ledger. If the total of this schedule tallies with the balance
of total debtor‘s account appearing in general ledger, the debtors‘ ledger is treated as correctly posted.
If in any transaction Trade creditor is involved then one aspect of that transaction will be recorded in the
creditor‘s ledger and the other aspect will be recorded in the general ledger. By this the double entry is not
completed in either ledger or due to which Trial Balance can also not be prepared, because in any of the
ledger double entry related to trade creditors is not completed.
Need for Self Balancing System

When ledgers are kept under sectional balancing system, the double entry is not completed in the debtors‘
ledger and creditors‘ ledger, because only one aspect related to debtors or creditors of any transaction is
recorded in these ledgers. As a result, no trial balance can be prepared from these ledgers. To overcome the
said drawback of sectional balancing system, a system of self balancing is adopted.
Under this system, accounts are kept in such a way that two aspects of each and every transaction (related
to debtors and creditors) is completed in one Debtors Ledger or in creditor‘s ledger and therefore a
separate trial balance can be prepared for each ledger which helps to detect the errors quickly. This is done
by opening control account / adjustment accounts in the entire three ledgers, namely General Ledger
Adjustment Account in Debtors Ledger, General Ledger adjustment account in creditor‘s ledger and
debtor‘s ledger adjustment account and creditor‘s ledger adjustment account in general ledger. These
adjustment accounts are opened to record the unrecorded aspect of transactions related to debtors and
creditors. It is called self balancing system because all the three ledgers are self balanced and trial balance
of each ledger can be prepared independently.

Mission
The mission of the international journal of case studies in management is to ensure the widest possible
teaching and research tool. The journal is a refereed publication, meaning that all cases are subject to a
Readers
offers a broad spectrum of case studies drawing on all sectors of the economy. Readers will find cases
illustrating management situations relating to various administrative functions, cases presenting the real-
life experiences of different types of companies, cases featuring remarkable business leaders of both past
and present, as well as cases presenting women managers, entrepreneurs and leaders of cultural and
government organizations and lots more.
Format
Questions
1. What is the main aim of the international journal?
2. What are the services provided by international journal?
6.6 Summary
A trial balance is a list of all the general ledger accounts (both revenue and capital) contained in the
ledger of a business.
The trial balance is prepared to check/ensure the arithmetical accuracy of accounting.
The general purpose of producing a trial balance is to ensure the entries in a company‘s bookkeeping
system are mathematically correct.
statement, which is termed a ―Trial Balance‖.
Final accounting deals with all the ledger account balances at the end of the accounting period in one
way or the other.
The accuracy of individual customer‘s account can be checked by comparing the total of their balance
with balances of the total debtors account in general ledger.
6.7 Keywords
Balance Sheet: A balance sheet or statement of financial position is a summary of the financial balances of
a sole proprietorship, a business partnership, a corporation or other business organization.
Creditor: A creditor is a party (e.g. person, organization, company, or government) that has a claim to the
services of a second party.
Debtor: A debtor is an entity that owes a debt to another entity.
Financial transaction: It is an agreement, communication, or movement carried out between a buyer and a
seller to exchange an asset for payment.
General Ledger: The general ledger is the main accounting record of a business which uses double-entry
bookkeeping.
Trial balance: It is a list of all the general ledger accounts (both revenue and capital) contained in the

1. Of the following account types, which would be increased by a debit?
(a) Liabilities and expenses. (b) Assets and equity.
(c) Assets and expenses. (d) Equity and revenues.
2. Identify the step in the accounting cycle that takes place during the accounting period rather than at the
end of the accounting period.
(a) Recording closing entries in the journal (b) Recording transactions in the journal
(b) Posting adjusting entries in the ledger (d) Recording adjusting entries in the journal
3. Which internal document prepared by the bookkeeper at period end summarizes business activity?
(a) Balance sheet (b) Work sheet
(c) Income statement (d) cash flow statement
4. Identify the account listed below that is not a temporary account.

(a) Wage Expense (b) Sales Revenue
(c) Dividends (d) Notes Receivable
5. On a classified balance sheet, Wages Payable would be classified as a...............

(a) current liability (b) current asset
(c) long-term asset (d) long-term liability
6. A trial balance is a list of all the general ledger accounts (both revenue and capital) contained in the
(a) True (b) False
7. Which of the following jobs check accounting in ledgers and financial statements?
(a) Financial (b) Audit
(c) Management (d) Budget Analysis
8. Which of the following highlights the correct order of the stages in the accounting cycle?
(a) Journalizing, final accounts, posting to the ledger and trial balance
(b) Journalizing, posting to the ledger, trial balance and final accounts
(c) Posting to the ledger, trial balance, final accounts and journalizing
(d) Posting to the ledger, journalizing, final accounts and trial balance
9. Final accounting does not deal with all the ledger account balances at the end of the accounting period
in one way or the other.
(a) True (b) False
10. Rectification of errors in accounting is not so easy because first of all we have to find mistakes.
(a) True (b) False

1. What do you understand by trial balance? Explain
2. How can you prepare trial balance? Give an example in favour of your answer.
3. What are the needs of trial balance in accounting?
4. Explain the objectives of trial balance.
5. What are the features of trail balance?
6. Explain the preparation of trial balance from the list of accounts balances.
7. Define the types of errors in trial balance.
8. How can rectify the errors?
9. Explain ledger account in detail.
10. Write a short not on sectional and self balancing system.
Answer for Self Assessment Questions

1 (c) 2 (b) 3 (b) 4 (d) 5 (a)
6 (a) 7 (b) 8 (b) 9 (b) 10 (a)
7
Final Accounting
CONTENTS
Objectives
Introduction
7.1 Trading Account
7.3 Balance Sheet
7.5 Summary
7.6 Keywords
Objectives
Describe the trading accounts
Explain the profit and loss accounts
Discuss the balance sheet with example
Describe the adjustment entries of Final accounts
Introduction
All business transactions are first recorded in Journal or Subsidiary Books. They are transferred to Ledger
and balanced it. The main object of keeping the books of accounts is to ascertain the profit or loss of
business and to assess the financial position of the business at the end of the year.
The object is better served if the businessman first satisfies himself that the accounts written up during the
year are correct or at least arithmetically accurate. When the transactions are recorded under double entry
system, there is a credit for every debit, when on a/c is debited; another a/c is credited with equal amount.
If a Statement is prepared with debit balances on one side and credit balances on the other side, the totals
of the two sides will be equal. Such a Statement is called Trial Balance.Preparation of final account is the
last stage of the accounting cycle. The basic objective of ever concern maintaining the book of accounts is
to find out the profit or loss in their business at the end of the year.
Every businessman wishes to ascertain the financial position of his business firm as a whole during the
particular period. In order to achieve the objectives for the firm, it is essential to prepare final accounts
which include Manufacturing and Trading, Profit and Loss Account and Balance Sheet. The determination
of profit or loss is done by preparing a Trading, Profit and Loss Account. The purpose of preparing the
Balance Sheet is to know the financial soundness of a concern as a whole during the particular period. The
following procedure and important points to be considered for preparation of trading profit and loss
Account and Balance Sheet.
Manufacturing Account
Manufacturing Account is the important part which is required to preparing Trading, Profit and Loss
Account. Accordingly, in order to calculate the Gross Profit or Gross Loss, it is essential to determine the
Cost of Goods Manufactured or Cost of Goods Sold. The main purpose of preparing Manufacturing
Account is to ascertain the cost of goods manufactured or cost of goods sold, which is transferred to the
Trading Account.
This account is debited with opening stock and all items of costs including purchases related to production
and credited with closing balance of work in progress and cost of goods produced transferred to Trading
Account. The term ―Cost of Goods Sold‖ refers to cost of raw materials consumed plus direct related
expenses.
Components of Manufacturing Account

The following are the important components to be considered for preparation of manufacturing accounts:
(1) Opening Stock of Raw Materials.
(2) Purchase of Raw Materials.
(3) Purchase Returns.
(4) Closing Stock of Raw Materials.
(5) Work in Progress (semi-finished goods).
(6) Factory Expenses.
(7) Opening Stock of Finished Goods.
(8) Closing Stock of Finished Goods.
(1) Opening Stock: The term Opening Stock refers to stock on hand at the beginning of the years which
include raw materials, work-in-progress and finished goods.
(2) Purchases: Purchases include both cash and credit purchase of goods. If any purchase is returned, the
same will be deducted from gross purchases.
(3) Direct Expenses: Direct expenses are chargeable expenses or productive expenses which include
factory rent, wages, and freight on purchases, manufacturing expenses, factory lighting, heating, fuel,
customs duty, dock duty and packing expenses.
In short, all those expenses incurred in bringing the raw materials to the factory and converting them into
finished goods will constitute the direct expenses that are to be shown on the debit side of the trading
account.
7.1 Trading Account

Trading refers buying and selling of goods. Trading A/c shows the result of buying and selling of goods.
This account is prepared to find out the difference between the Selling prices and Cost price. If the selling
price exceeds the cost price, it will bring Gross Profit.
For example, if the cost price of INRs. 50,000 worth of goods are sold for INR60, 000 that will bring in
Gross Profit of INR10, 000. If the cost price exceeds the selling price, the result will be Gross Loss.
For example, if the cost price INR 60,000 worth of goods are sold for INR50,000 that will result in Gross
Loss of INR10, 000. Thus the Gross Profit or Gross Loss is indicated in Trading Account.
7.1.1 Items Appearing in the Debit Side of Trading Account
1. Opening Stock: Stock on hand at the commencement of the year or period is termed as the Opening
Stock.
2. Purchases: It indicates total purchases both cash and credit made during the year.
3. Purchases Returns or Returns out words: Purchases Returns must be subtracted from the total purchases
to get the net purchases. Net purchases will be shown in the trading account.
4. Direct Expenses on Purchases: Some of the Direct Expenses are.
Wages: It is also known as productive wages or Manufacturing wages.
Carriage or Carriage Inwards:
Octroi Duty: Duty paid on goods for bringing them within municipal limits.
Customs duty, dock dues, clearing charges, import duty etc.
Fuel, power, lighting charges related to production. Oil, grease and waste.
Packing charges: Such expenses are incurred with a view to put the goods in the Saleable Condition.
7.1.2 Items Appearing on the Credit Side of Trading Account

1. Sales: Total Sales (Including both cash and credit) made during the year.
2. Sales Returns or Return Inwards: Sales Returns must be subtracted from the Total Sales to get Net sales.
3. Closing Stock: Generally, Closing stock does not appear in the Trial Balance. It appears outside the Trial
balance. It represents the value of goods at the end of the trading period. (See Table 7.1)
Table 7.1: Specimen form of a trading A/c
7.1.3 Equation of Trading Account

The purpose of preparing the Trading Account is to calculate the Gross profit or Gross loss of a concern
during a particular period. The following equations are highly useful for determination of Gross profit or
Gross loss:
7.1.4 Balancing of Trading Account
The difference between the two sides of the Trading Account indicates either Gross Profit or Gross Loss. If
the total on the credit side is more, the difference represents Gross Profit. On the other hand, if the total of
the debit side is high, the difference represents Gross Loss. The Gross Profit or Gross Loss is transferred to
Profit and Loss A/c.
7.1.5 Closing Entries of Trading A/c

Trading A/c is a ledger account. Hence, no direct entries should be made in the trading account. Several
items such as Purchases, Sales are first recorded in the journal and then posted to the ledger. The Same
accounts are closed by the transferring them to the trading account. Hence it is called as closing entries.
7.1.6 Advantages of Trading Account

The result of Purchases and Sales can be clearly ascertained.
Gross Profit ratio to Sales could also be easily ascertained. It helps to determine Price.
Gross Profit ratio to direct Expenses could also be easily ascertained. And so, unnecessary expenses
could be eliminated.
Comparison of trading account details with previous years details help to draw better administrative
policies.

Trading account reveals gross profit or gross loss. Gross profit is transferred to credit side of profit and loss
a/c. Gross Loss is transferred to debit side of the Profit Loss Account. Thus Profit and Loss A/c is
commenced. This Profit and Loss A/c reveals Net Profit or Net loss at a given time of accounting year.
7.2.1 Items Appearing on Debit Side of the Profit and Loss A/c
The Expenses incurred in a business is divided in two parts. i.e. one is Direct expenses are recorded in
trading A/c., and another one is Indirect expenses, which are recorded on the debit side of Profit and Loss
A/c. Indirect Expenses are grouped under four heads:
1. Selling Expenses: All expenses relating to sales such as Carriage outwards, Travelling Expenses,
Advertising etc.
2. Office Expenses: Expenses incurred on running an office such as Office Salaries, Rent, Tax,
Postage, Stationery etc,
3. Maintenance Expenses: Maintenance expenses of assets. It includes Repairs and Renewals, Depreciation
etc.
4. Financial Expenses: Interest Paid on loan, Discount allowed etc., are few examples for Financial
Expenses.
7.2.2 Item Appearing On Credit Side of Profit And Loss A/C

Gross Profit is appeared on the credit side of P and L A/c. Also other gains and incomes of the business are
shown on the credit side. Typical of such gains are items such as Interest received, Rent received,
Discounts earned, Commission earned.
7.2.3 Components Appearing On Debit Side of the P and L A/c
Those expenses incurred during the manufacturing process of conversion of raw materials into finished
goods will be treated as direct expenses which are recorded in the debit side of Trading Account.
Any expenditure incurred subsequent to that will be known as indirect expenses to be shown in the debit
side of the Profit and Loss Account. The indirect expenses may be classified into:
(1) Operating Expenses and
(2) Non-Operating Expenses.
(1) Operating Expenses

It refers to those expenses as the day-to-day expenses of operating a business include office and
administrative expenses, selling and distribution expenses.
(2) Non-Operating Expenses

Those expenses incurred other than operating expenses. Non Operating expenses which are related to a
financial nature.
For example, interest payment on loans and overdrafts, loss on sale of fixed assets, writing off fictitious
assets such as preliminary expenses, under writing commission etc.
7.2.4 Components Appearing On Credit Side of P and L A/c

The following are the components as shown on the Credit Side:
(1) Gross Profit brought down from Trading Account
(2) Operating Income: It refers to income earned from the operation of the business excluding Gross Profit
and Non-Operating incomes.
(3) Non-Operating Income: Non-Operating incomes refer to other than operating income.
For example, interest on investment of outside business, profit on sale of fixed assets and dividend
received etc.
Did You Know?

The oldest discovered record of a complete double-entry system is the Messari (Italian: Treasurer‘s)
accounts of the city of Genoa in 1340.
7.3 Balance Sheet

According to AICPC (The American Institute of Certified Public Accountants) defines Balance Sheet as a
tabular Statement of Summary of Balances (Debit and Credits) carried forward after an actual and
constructive closing of books of accounts and kept according to principles of accounting. The purpose of
preparing balance sheet is to know the true and fair view of the status of the business as a going concern
during a particular period. The balance sheet is on~ of the important statement which is used to owners or
investors to measure the financial soundness of the concern as a whole. A statement is prepared to show
the list of liabilities and capital of credit balances of the business on the left hand side and list of assets and
other debit balances are recorded on the right hand side is known as ―Balance Sheet.‖
7.3.1 Objectives of Balance Sheet

1. It shows accurate financial position of a firm.
2. It is a gist of various transactions at a given period.
3. It clearly indicates, whether the firm has sufficient assents to repay its liabilities.
4. The accuracy of final accounts is verified by this statement
5. It shows the profit or Loss arrived through Profit and Loss A/c.
Companies Act 1956 has prescribed a particular form for showing assets and liabilities in the Balance
Sheet for companies registered under this Act. There is no prescribed form of Balance Sheet for a sole
trader and partnership firm. However, the assets and liabilities can be arranged in the Balance Sheet into
(a) In the Order of Liquidity
(b) In the Order of Performance
(a) In the Order of Liquidity
When assets and liabilities are arranged according to their order of liquidity and ability to meet its short-
term obligations, such an arrangement of order is called ―Liquidity Order.‖
(b) In the order of Performance
This method is commonly used by the companies. The specimen form of Balance Sheet arranged in the
order of Performance is given in Table 7.4:
Table 7.4: Specimen form of balance sheet in order performance
7.3.2 Classification of Assets and Liabilities

Assets
Business assets are resources or items of values owned by the business and which are utilized in the normal
course of business operations to produce goods for sale in order to yield a profit. The assets are grouped
into:
(1) Fixed Assets
(2) Current Assets or Floating Assets
(3) Fictitious Assets
(4) Liquid Assets
(5) Contingent Assets
(1) Fixed Assets

These classes of assets include those of a tangible nature having a specific value and which are not
consumed during the normal course of business and trade but provide the means for producing saleable
goods or providing services.
Components of Fixed Assets:
(1) Goodwill
(2) Land and Buildings
(3) Plant and Machinery
(4) Furniture and Fixtures
(5) Patents and Copy Rights
(2) Current Assets or Floating Assets

The assets of a business of a transitory nature which are used for resale, or conversion into cash, In other
words, those assets which are easily converted into cash in normal course of business during the shorter
period say, less than one year are treated as current or floating assets.
Components of Current Assets:

(1) Cash in hand
(2) Cash at Bank
(3) Inventories:
Stock of raw materials
Stock of work-in-progress
Stock of finished goods
(4) Sundry Debtors
(5) Bills Receivable
(6) Short-Term Marketable Securities
(7) Short-Term Investments
(8) Prepaid Expenses
(3) Fictitious Assets

Fictitious Assets refer to any deferred charges. They are really not assets. Preliminary expenses, Share
issue expenses, discount on issue of shares and debentures, and debit balance of profit and loss account etc.
are the important components of fictitious assets.
(4) Contingent Assets

It refers to a right to property which may come into existence on the happening of some future event.
For example, a right to obtain for shares in another company on Favourable terms, a right to sue for
infringement of patents and copy rights etc.
(5) Liquid Assets

A liquid asset which are immediately converted into cash, In other words, these assets are easily a cashable
in the normal course of business, Cash in hand, Cash at bank, Bills Receivable Sundry debtors, Marketable
Securities, Short-term investments etc. are the important components of liquid assets.
While measuring Liquid Assets, Stock of raw materials, work-in-progress, finished goods and prepaid
expenses are excluded from the components of Current assets.
Liabilities
According to accounting principles board, define liabilities as an economic obligation of an enterprise that
are recognized and measured in conforming to generally accepted accounting principles.
The liabilities are classified into:
(1) Non-Current Liabilities
(2) Capital
(3) Current Liabilities
(1) Non-Current Liabilities

Non-current liabilities otherwise known as long-term liabilities, Liabilities which are become due for
payment beyond a period of one year say, five to ten years, are treated as Long-Term Liabilities. The
following are the examples of Non-Current Liabilities:
(a) Long-Term Debit.
(b) Debenture.
(c) Long-Term Loan from Bank.
(d) Long-Term Loan from Financial Institutions.
(e) Long-Term Loan raised by Issue of Public Deposits.
(f) Long-term debt rise by issue of securities.
(2) Capital
Capital refers to the value of assets owned by a business and which are used during the course of business
operations to generate additional Capital or Wealth. It is also known as Owner‘s Equity or Net Worth.
When a business first comes into existence the initial capital may be provided by the proprietor. The initial
influx of capital will normally be in the form of cash which need to be converted into plant and machinery,
building and stock of materials prior to commencing operations. Thus, capital is equal to the total assets.
(3) Current Liabilities

Any amounts owing by the business which are currently due for payment are referred to as current
liabilities. In other words, these liabilities which are paid within one year are treated as current liabilities.
The following are the components of current liabilities:
Bills Payable.
Sundry Creditors.
Short-Term Bank Loans.
Dividend Payable.
Provision for Taxes Payable.
Short-Term Bank Overdraft.
Trade Liabilities and Accrued Expenses.
Outstanding Expenses.

The preparation of income statements, i.e., Trading, Profit and Loss Account and Balance Sheet is the last
stage of accounting process. According to the principles of double entry system of accounting all the
expenses and incomes relating to a particular period whether incurred or not should be taken into account.
In order to give the true and fair view of the state of affairs of the business concern, it is essential to
consider various adjustments while preparing Trading, Profit and Loss Account and Balance Sheet.
The following are the various adjustments usually related to:

(1) Closing Stock
(2) Outstanding Expenses
(4) Accrued Income
(5) Income Received in Advance
(6) Depreciation
(7) Interest on Capital
(8) Interest on Drawings
(9) Bad Debts
(10) Provision for Doubtful Debts
(11) Provision for Discount on Debtors
(12) Provision for Discount on Creditors
(1) Closing Stock
The term Closing Stock refers to stock of raw materials, work in progress and finished goods at the end of
the year valued at cost price or market price whichever is less. The following adjustment entry is
The stock at the end appears in the balance sheet and the balance in the stock is carried forward to the next
year as opening stock. The opening stock account balance will appear in the Trial Balance and would be
closed and transferred to the debit of the Trading Account.
(2) Outstanding Expenses

Outstanding expenses refer to those expenses incurred and remain unpaid during the accounting period.
For example, salary, rent, interest etc. are expenses which are incurred but remain unpaid during the
accounting period. In order to ascertain the correct profit and loss made during the year, it is essential that
such related expenses are treated as Salary Outstanding, Interest Outstanding and Rent Outstanding etc.
The following necessary adjustment entry is:
As per the rules, respective expenses are nominal account therefore it be charged to profit and loss account
and also shown in the balance sheet on the liability side.

Prepaid expenses are also known as unexpired expenses, those expenses which are incurred and paid in
advance. Such expenses are actually related to a future period. In order to ascertain the correct picture of
the profit and loss accounts the following adjustment entry is required for adjusting such prepaid expenses.
The amount paid in advance will be deducted from the actual amount paid because it is related to the future
accounting period. And the net amount will be debited to profit and loss account and the balance in the
prepaid expenses account is shown the advance payment indicates as an amount due to the business
concern.
(4) Accrued Income

Accrued Income otherwise known as Outstanding Income. Such incomes are accrued during the
accounting period but not actually received in cash during that period. The adjustment entry will be as
follows:
The accrued income is added to the respective income account. And the total accrued amount will be credit
to profit and loss account and is shown on the asset side of the balance sheet.
(5) Income Received in Advance

Any income received in advance which is not earned during the accounting period. Therefore, if any
income received in advance, it should be treated as income for the subsequent year. The adjustment entry
will be:
The income received in advance is treated as a liability because an amount due to the party, therefore it
shown on the liability side of the balance sheet. The income actually earned alone will appear on the credit
side of Profit and Loss Account.
(6) Depreciation
The term depreciation refers to loss on account of reduced value of assets due to wear and tear,
obsolescence, efflux ion of time or accident. Depreciation is treated as the cost or loss arises when the asset
is used in the normal course of time. In order to ascertain the correct value of the assets in the balance
sheet, it is essential to make to following adjustment entry as:
The amount of depreciation is charged to debit side of the profit and loss account and is deducted from the
respected assets shown on the asset side of the balance sheet.
(7) Interest on Capital

In order to ascertain true profitability of the business concern, it is essential that profit is determined after
deducting interest on the capital provided by proprietor. Interest on capital is included in the capital
expenditure and thus the adjustment entry will be:
Interest on Capital is an expenditure charged to debit side of profit and loss account and it is added to
capital shown on the liability side of the balance sheet.
(8) Interest on Drawings

It is like an interest on capital provided by the proprietor. Any amount charged as interest on drawings
made by the proprietors for his personal use during the particular period is treated as interest on drawings.
Interest on drawings should be taken as an income for ascertaining the true profit for a period. The
adjustment entry will be:
Interest on drawings is charged on the credit side of the profit and loss account and it is deducted from the
capital account shown on the liability side of the Balance Sheet.
(9) Bad Debts

The term bad debts refer to any amount which are definitely irrecoverable are termed as bad debts. It may
be treated as actual loss of the business. Any amount irrecoverable due to inability of the debtors, it should
be written off from the accounts of debtors. The necessary adjustment entry will be
Being bad debts are treated as expenses is charged to debit side of profit and loss account. And the amount
deducted from debtors account shown on the assets side of the balance sheet.
(10) Provision for Doubtful Debts

It is like a bad debt but recovery is doubtful. Doubtful debts are treated as anticipated loss therefore
making suitable provisions required to be made in the books of accounts. In order to ascertain the correct
picture of the debtor‘s balance, it is essential to make an adjustment entry:
The provision for doubtful debts is an anticipated expense charged to the debit side of the profit and loss
account and it is deducted from the debtor‘s account shown on the asset side of the balance sheet.
(11) Provision for Discount on Debtor

Discount allowed to debtor is treated as expenses of a business concern. Such discounts are allowed to
encourage for prompt payment made by the debtors on credit sales. When discount allowed, an adjustment
entry is:
The provision for discount is charged to debit side of profit and loss account and it is deducted from the
debtor‘s account shown on the assets side of balance sheet.
(12) Provision for Discount on Creditors
It is like a discount on debtors, such discounts are allowed to make prompt payment due to its creditors.
The firm receives such discounts when the payment made to its creditors in time. It is an anticipated
income or profit which is required to create a suitable provision‘s in order to ascertain the correct picture of
the creditor‘s balance, to make an adjustment entry will be:
(a) For Receipt of Discount:
Case Study-Financial Report Analysis

Three Executives of a well-known multi-national company decided to form a new company, named New
Star Company Limited in 1974. These three executives were becoming close to their retirement age. Pifco-
Zen Chen Company Limited, the company that they worked for had been in business for the last 80 years.
It was their previous employer‘s policy to retire the executives with a ―golden hand-shake‖ worth
approximately US 60,00,000 each.
The three executives occupied the following position with Pifco-Zen Chen Company Limited, (1) Finance
Manager – Mr. Zu Chang, (2) Sales and Marketing Manager, Mr. Lim Lam, and (3) Risk Management
Manager, Mr. Shu Ching. In their previous position with Pifco-Zen Chen Company Limited, they were
regarded as the most respected executives because the company made significant progress in terms of
organic growth and diversification.
The Chairman of the Board of Directors, Dr. Wing Wan used to call them ―the three wise men‖. Pifco-Zen
Chen Company Limited main business activities were the manufacturing of ―twisties‖ and acted as
wholesale distributor of a special drink called ―Wysalt‖. The drink is full of calcium and protein and it is
very popular in the South East Asia. Each year‘s Annual General Meeting of Pifco-Zen Chen Company
Limited‘s gross income and net profit before taxation increased by 10%, while its main competitor‘s
performance was declining at an alarming rate. Chairman Wan always wanted to find out what is the main
reason driving its company‘s operational success.
In a nutshell, Chairman Wan always believed that the financial result was ―too good to be true‖ because
whenever he has a chance to play golf with one of the Chairman of his competitor company, he was told
that life as the head of a corporate is becoming unbearable due to competition and increased in the cost of
living. Still, Mr. Wan kept quiet while congratulating his three wise men for a fantastic job each year. Even
the external Auditors could not believe the significant progress, which the company used to, when the three
wise men were working for Pifco-Zen Chen Company Limited. The auditors knowing too well the
performance of the company before the departure of Mr. Chang, Mr. Lam, and Mr. Ching cautioned the
Chairman that it would be a great loss for the company to lose three key executives in one go. In view of
the continued pressure and perplexities of the situation, one afternoon, Chairman of Pifco-Zen Chen
Company Limited, Dr. Wan called a special Board of Directors meeting to address his concern regarding
the retirement of Mr. Chang, Mr. Lam, and Mr. Ching. One of the vocal directors Who did not get along
very well with these three managers, said ―it does not matter if all of the three men were to leave the
company today because they are not indispensable people‖. He went on to argue further that ―we can
replace them easily because there are other professionals looking for work‖.
According to the employment contract of the three wise men, they were paid a basic salary plus they also
benefited with a 2% commission on the net profit of the company each year after the accounts have been
finalized by the external auditors. The Internal Auditor, Miss Wen always queried this employment terms
that it favors mostly these three managers at the detriment of the other hard-working employees. One day
in a management meeting, Miss Wen expressed her frustration of the favorable treatment of the three
managers because she felt that they are working very close and perhaps, manipulating the figures so that
they can benefit a hefty remuneration every year. Chairman Wan felt every uneasy during this meeting and
closed the meeting earlier than expected. After the meeting, Miss Wen wrote a memo to the Chairman of
the Board of Directors to complain that the external auditors come on the premises of the company for a
very short time to perform the audit. They do not carry out an efficient audit and the Pifco-Zen Chen
Company Limited runs the risk of facing a corporate collapse, when those three managers had left.
In the financial statement there is an amount of US INR 125 million worth of over-valued stocks, which
has been in the accounts for the last 5 years. No provision has been made in the Debtors Account for non-
performing account worth US INR 450 million. Current operating expenditure to the value of USI INR 350
million has been accounted as ―prepaid expenditure‖. The bank reconciliation has not been done properly
for the last 3 years, and the external auditors have accepted the Finance Manager‘s figure of US INR1500
million.
It appears that there are 10 cheque valued to US INR 150 million has been deposited in the accounts, and
have been returned by the banks because the customers did not have funds. There has need no adjustment
made subsequently to correct the balances at banks. The exact figure for the Short-Term Debts should be
US INR 3250 million and not US INR 2750 million as disclosed. There is a mistake in the disclosure of
Overdraft Facility; the figure should appear as US INR 4250 million and not US INR 3750 million. In
addition, the Sales and Marketing Manager has entered into a financial contract for one of the raw material
suppliers to supply equipment to the value of US INR 750 million to increase production of twisters and
this contract does not reflect in the statement of accounts.
The external auditor stated that since there is only a commercial contract and the official invoice has not
been received by the company, then there is no point to account for this transaction. A review of the
quarterly report issued by the Risk Manager does not indicate any abnormality in the financial statement
from a risk management perspective. Instead, the Risk Manager would normally end his report with the
words ―I foresee that the company is operating in a very sound and successful manner. The Board of
Directors should be proud of such achievement‖. The Sales and Marketing Manager would give the
indication that the company is progressing very well and eventually, it should be able to launch a ―bid‖ to
takeover one of its competitive rivals. The Finance Manager would normally end his reports with such
phrases such as‖ good performance‖, ―we are on the right track‖ ―the Board of Directors should feel proud
of the company‘s financial performance‖.
Question
1. Who is responsible for the sad state of affairs, which the company finds itself?
2. What are the responsibilities of the external auditors?
7.5 Summary
Net income is the company‘s final profit, after deducting a charge for income tax.
The balance sheet is statement of financial condition or position.
The statement of retained earnings is the financial statement prepared after the income statement and
before the balance sheet.
Profit and Loss Account is debited with revenue expenditure and credited with revenue income.
Capital receipt is shown on the liabilities side of the balance sheet.
Corporate governance is the system by which companies are directed and controlled.
Non-current assets are those assets which are acquired for long term use in the business.
7.6 Keywords
Accounting Equation: All accounting entries made in the books of account of a business have a
relationship based on the accounting equation: Assets = Liabilities + Owner‘s Equity.
Asset: Tangible or intangible items of value owned by a business e.g. cash, stock, buildings and vehicles.
Balance Sheet: Shows a snapshot at a given point in time of the net worth of the business. It details the
assets, liabilities and owner‘s equity.
Capital Expenditure: A capital expenditure is incurred when a business spends money either to buy fixed
assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year.
Capital: Amount invested in the business (usually at start up, but may include additional funds raised).
Conversion Period: The period (month) in which the accounts are being converted, or transferred over,
from one system to another.
Cost of Sales: Expenses in the financial year which can be directly attributed to sales of those goods or
services.
Credit: Revenue in the Profit and Loss or Liability in the Balance sheet.

1. ………….. Account enables the trader to find out Gross Profit or Loss.
(a) Trading (b) Profit
(c) Journal (d) All of These.
2. Direct Expenses appears on ……….. Side of ………. account.

(a) ratio, cost (b) debit, Trading
(c) debit, Profit/Loss (d) All of These.
3. Bills payable is a long term liabilities:

(a) True (b) False
4. Assets – Liabilities = ……………….

(a) Capital (b) Fixed Assets
(c) Trading (d) All of These.
5. Assets – Capital = ………………….

(a) Balance sheet (b) Liabilities
(c)Fixed Assets (d) All of These.
6. Capital + Liabilities = …………………

(a) Assets (b) Profitability ratios
(c) Trading (d) All of these.
7. Wages and Salaries appear on ………… account

(a) Profit/loss (b) Capital
(c) Trading (d) All of these.
8. Trade Expenses will appear on ………….. side of P and L A/c.

(a) debit (b) credit
(c) final account (d) All of These.
9. Balance Sheet is a ledger A/c
(a) True (b) False
10. Land is an intangible asset

(a) True (b) False

1. What do you understand by trading account?
2. Explain the profit and loss account.
3. What do you understand by balance sheet?
4. What are the main features of final accounts?
5. What are adjusting entries? Why are these necessary for preparing final accounts?
6. Write Short notes on:
(a) Closing Stock
(b) Outstanding Expenses
(c) Prepaid Expenses
(d) Accrued Income
(e) Provision for Discount on Creditors.
7. What is the difference between profit and loss accounts?
8. Briefly explain the classification of assets and liabilities.
9. Write short notes on :
(a) Liquid Assets
(b) Current Assets
(c) Current Liabilities
(d) Fictitious Assets
(e) Capital
10. Explain briefly the equation of trading account.
1 (a) 2 (b) 3 (b) 4 (a) 5 (b)
6 (a) 7 (c) 8 (a) 9 (b) 10 (b)
8
Book of Original Record
CONTENTS
Objectives
Introduction
8.1 Journal
8.4 Opening entry
8.7 Summary
8.8 Keywords
Objectives
Define journal
Explain the rules of debit and credit
Discuss the compound journal entry
Understand the opening entry
Define journal and ledger
Explain the rules regarding posting
Introduction
A Journal is an accounting record that is used to record the different types of transactions in chronological
order or date order. Journals are often called or referred to as the books of original entry. The reason is that
this is the first place that business transactions are formally recorded. You can think of a Journal as a
Financial Diary.Specialized Journals are journals used to initially record special types of transactions such
as sales and purchases.
All these journals are designed to record special types of business transactions and post the totals
accumulated in these journals to the General Ledger periodically (usually once a month).Books of Original
Entry: In the course of business, source documents are created. The details on these source documents need
to be summarized, as otherwise the business might forget to make some payments, ask for money owed or
even accidentally pay for something twice. It is therefore imperative to keep records of source documents
of transactions. Such records are made in ―books of original entry‖. The books of original entry also called
a daybook are a descriptive and chronological (diary-like) record of day-to-day financial transactions.
The main books of original entry are:

Sales Day Book (book of original entry for credit sales)
Purchase Day Book (book of original entry for credit purchases)
Sales Return Day Book (book of original entry for goods returned from customers)
Purchases Return Day Book (book of original entry for goods returned to suppliers)
Journal (book of original entry for credit sales)
Cash Book (book of original entry for cash receipts and payments. It records all transactions that go
through the bank account)
Petty Cash Book (It records payments of small amounts of cash)
8.1 Journal
A journal is an academic magazine published on a regular schedule. It contains experts in a particular field
of study, based on research or analysis that the author, or authors, did. That research might include case
studies in the medical field, primary source research in the field of history, or literature analysis. Journal
for experts or students of that particular field who have an advanced field-specific vocabulary and
knowledge The word ―journal‖ has been derived from the French word ―jour‖. Jour means day. So journal
means daily. Transactions are recorded daily in journal and hence it has been named so.
It is a book of original entry to record chronologically (i.e. in order of date) and in detail the various
transactions of a trader. It is also known Day Book because it contains the account of every day‘s
transactions.The Journal of Financial Reporting and Accounting (JFRA) provide a valuable forum for the
publication of research that address significant issues on financial reporting and accounting. The JFRA
aspires to promote interdisciplinary and international understanding on financial reporting and accounting.
The JFRA aims to publish papers that bridge the gap between accounting theory and practice. The JFRA
encourages submissions of high quality manuscripts that have an impact upon academia, accounting
practice and society. A journal details all the financial transactions of a business and which accounts these
transactions affect. All business transaction are initially recorded in a journal using the double-entry
method or single-entry method of bookkeeping. In accounting, a ―journal‖ refers to a financial record kept
in the form of a book, spreadsheet, or accounting software that contains all the recorded financial
transaction information about a business.
An accounting journal is created by entering information from receipts, sales tickets, cash register tapes,
invoices, and other data sources that show financial transactions. Business transactions should be recorded
so that they can be presented in the journal in chronological order.
Before computers, an accounting journal was a physical log book with multiple columns to record financial
transactions for a company. Today, most businesses use soft type of financial accounting software to
record and manage their business transactions. These transactions are then assigned to a specific ledger
class using a Chart of Accounts number to prepare profit and loss statements, financial statements, and
other important financial reports.
8.1.1 Journal Entries
After a transaction occurs and a source document is generated, the transaction is analyzed and entries are
made in the general journal. A journal is a chronological listing of the firm‘s transactions, including the
amounts, accounts that are affected, and in which direction the accounts are affected. A journal entry takes
the following format:
In addition to this information, a journal entry may include a short notation that describes the transaction.
There also may be a column for a reference number so that the transaction can be tracked through the
accounting system. The above format shows the journal entry for a single transaction. Additional
transactions would be recorded in the same format directly below the first one, resulting in a time-ordered
record.
The journal format provides the benefit that all of the transactions are listed in chronological order, and all
parts (debits and credits) of each transaction are listed together. Because the journal is where the
information from the source document first enters the accounting system, it is known as the book of
original entry.
8.1.2 Compound Journal Entries

The format shown above has a single entry for the debit and a single entry for the credit. This type of entry
is known as a simple journal entry. Sometimes, more than two accounts are affected by a transaction so
more than two lines are required. Such a journal entry is know as a compound journal entry and takes the
following format:
For example, if an expense is incurred in which part of the expense is paid with cash and the remainder
placed in accounts payable, then two lines would be used for the credit - one for the cash portion and one
for the accounts payable portion. The total of the two credits must be equal to the debit amount.
As many accounts as are necessary can be used in this manner, and multiple accounts also can be used for
the debit side if needed.
8.1.3 Special Journals

The general journal is the main journal for a wide range of transactions. Of these, a business usually finds
itself performing some types much more frequently than others. By grouping specific types of transactions
into their own special journal, the efficiency and organization of the accounting system can be improved.
Some commonly-used special journals:
sales journal
purchases journal
cash receipts journal
cash disbursements journal
While a special journal may be organized differently from the general journal, it still provides the core
transaction information such as date, debits and credits, and the relevant accounts.
8.1.4 Closing Journal Entries
The general ledger showing the posted operating and adjusting journal entries is shown for review. The
general ledger is the source used to prepare an adjusted trial balance that confirms the ledger accounts are
in balance. Study the updated general ledger:
Advantages of Journal
1. Each transaction is recorded as soon as it takes place. So there is no possibility of any transaction being
omitted from the books of account.
2. Since the transactions are kept recorded in journal, chronologically with narration, it can be easily
ascertained when and why a transaction has taken place.
3. For each and every transaction which of the two concerned accounts will be debited and which account
credited, are clearly written in journal. So, there is no possibility of committing any mistake in writing
the ledger.
4. Since all the debits of transaction are recorded in journal, it is not necessary to repeat them in ledger.
As a result ledger is kept tidy and brief.
5. Journal shows the complete story of a transaction in one entry.
6. Any mistake in ledger can be easily detected with the help of journal.
Characteristics of Journal
Journal has the following features:
7. Journal is the first successful step of the double entry system. A transaction is recorded first of all in
the journal. So the journal is called the book of original entry.
8. A transaction is recorded on the same day it takes place. So, journal is called Day Book.
9. Transactions are recorded chronologically, So, journal is called chronological book
10. For each transaction the names of the two concerned accounts indicating which is debited and which is
credited, are clearly written in two consecutive lines. This makes ledger-posting easy. That is why
journal is called ―Assistant to Ledger‖ or ―subsidiary book‖
11. Narration is written below each entry.
12. The amount is written in the last two columns - debit amount in debit column and credit amount in
credit column.
Benefits:
The journal covers a broad scope of areas related to financial reporting and accounting.
It provides an inter-disciplinary and international understanding of theory and practice in a variety of
fields.
It also keeps abreast with the development and advancement of accounting knowledge in financial
reporting and accounting internationally.
Advantages of Different Journals

The advantages of having several books of original entry in place of one journal may be stated to as
follows:
6. It may be impossible to record each transaction into the ledger as it occurs. Subsidiary books record
the details of the transactions and therefore, help the ledger to become brief.
7. As similar transactions are recorded together in the same book, future reference to any of them
becomes easy.
8. The chance of fraudulent alteration in an account is reduced as the book of original entry keeps records
of the transactions in a chronological order.
9. The work of posting can be entrusted to several clerks at the same time and thus the ledger of a large
business can be written up much more quickly.
10. As each journal contains separately transactions of similar nature any desired analysis can be made
conveniently
8.1.5 Coverage
The JFRA solicits scholarly research from the following areas:
Financial reporting
Financial accounting
Forensic accounting
Financial reporting of intangible assets and intellectual capital
Public sector accounting
Accounting for human capital
Accounting for specialized industry
Accounting education and ethics
Accounting information system
Islamic accounting and reporting
Management Accounting
Social and environmental reporting
Finance
Auditing
Taxation
Interdisciplinary studies related to financial reporting and accounting.
Did You Know?

The Accounting, Auditing and Accountability Journal (ISSN 0951-3574) is a peer-reviewed academic
journal on accounting theory and practice published by Emerald Group Publishing

In financial accounting debit and credit are simply the left and right side of a T-Account respectively. They
are used to indicate the increase or decrease in certain accounts.
The rules of debit and credit accounts are discussed through the Figure 8.1.
Figure 8.1: The rules of debit and credit.
8.2.1 Personal Accounts

Personal accounts include the accounts of persons with whom the business has dealings. These accounts
can be classified into three categories.
Natural Personal Accounts: The term ―Natural Persons‖ means persons who are creation of God. For
example, Mohan‘s account, Shan‘s account, Ahab‘s account, etc.
Artificial Personal Accounts: These Accounts include accounts of corporation bodies or institutions which
are recognized as persons in business dealings.
For example, the account of a Limited Company, the account of a Co-operative Society, the account of a
Club, the account of Government, the account of an Insurance Company, etc.
The rule is:
8.2.2 Real Accounts

Real Accounts may be of the following types:
Tangible Real Accounts Tangible Real Accounts are those which relate to such things which can be
touched, felt, measured etc. Examples of such accounts are cash account, building account, furniture
account, stock account, etc. It should be noted that bank account is a personal account, since it represents
the account of the banking company – an artificial person.
Intangible Real Account These accounts represent such things which cannot be touched. Of course, they
can be measured in terms of money.
For example, patents accounts, goodwill account, etc.
The rule is:
8.2.3 Nominal Accounts

Nominal Accounts include accounts of all expenses, losses, incomes, and gains. The examples of such
accounts are rent rates, lighting, insurance, dividends, and loss by fire, etc
The rule is:
Debit and Credit Usage Whenever it create an accounting transaction, at least two accounts are always
impacted, with a debit entry being recorded against one account and a credit entry being recorded against
the other account. There is no upper limit to the number of accounts involved in a transaction - but the
minimum is no less than two accounts. The totals of the debits and credits for any transaction must always
equal each other, so that an accounting transaction is always said to be ―in balance.‖ If a transaction were
not in balance, then it would not be possible to create financial statements. Thus, the use of debits and
credits in a two-column transaction recording format is the most essential of all controls over accounting
accuracy.
There can be considerable confusion about the inherent meaning of a debit or a credit.
For example, if you debit cash account, then this means that the amount of cash on hand increases.
However, if you debit an accounts payable account, this means that the amount of accounts payable
liability decreases.
These differences arise because debits and credits have different impacts across several broad types of
accounts, which are:
Asset Accounts: A debit increases the balance and a credit decreases the balance.
Liability Accounts: A debit decreases the balance and a credit increases the balance.
Equity Accounts: A debit decreases the balance and a credit increases the balance.
The reason for this seeming reversal of the use of debits and credits is caused by the underlying accounting
formula upon which the entire structure of accounting transactions are built, which is:
Assets = Liabilities + Equity
Thus, in a sense, one can only have assets if he has paid for them with liabilities or equity, so he must have
one in order to have the other. Consequently, if he create a transaction with a debit and a credit, he is
usually increasing an asset while also increasing a liability or equity account (or vice versa). There are
some exceptions, such as increasing one asset account while decreasing another asset account.
If someone is more concerned with accounts that appear on the income statement, then these additional
rules apply:
Revenue Accounts: A debit decreases the balance and a credit increases the balance.
Expense Accounts: A debit increases the balance and a credit decreases the balance.
Gain Accounts: A debit decreases the balance and a credit increases the balance.
Loss Accounts: A debit increases the balance and a credit decreases the balance.
8.2.4 Accounting Transactions: Rules of Debits and Credits

In all fairness, debits and credits are not that difficult to understand, it is simply that due to the nature of
the material debits and credits often refer to, people instinctively shy away from explanations and
knowledge. Take just a minute, and lay aside any prejudices to accounting material that one may have, and
let me show you how truly simple, yet amazing this system can are.
Every transaction in accounting is either a debit or a credit: How simple is that concept? Everything is
record in a financial manner (in other words that has a dollar value) is either a debit or a credit. The
abbreviations for debit and credit are DR and CR, respectively. Even the abbreviations are quite simple.
The difficulty comes in determining which type of transaction is recording. Debits are a component of an
accounting transaction that will increase assets and decrease liabilities and equity. Credits are a component
of an accounting transaction that will increase liabilities and equity and decrease assets.
May be we can put this into a simpler format:
Credits increase liabilities and equity; credits decrease assets.
Debits decrease liabilities and equity; debits increase assets.
If it will simply make a chart, with the information above, it should easily be able to discern which
transactions are credits or debits for which accounts. That being said let us take a look at the basic rules
when recording debits and credits. For each transaction, there are at least two accounts affected, one with a
debit and one with a credit. Every financial transaction credits one account and debits another. It is only
because of the distaste for accounting that many individuals have, that we find it so difficult to grasp this
idea. We have no trouble understanding yin and yang, give and take, action and reaction, and credits and
debits are no different; it just so happens they apply to accounting.
Even if you fail to realize the real life application of debits and credits, we use the system in almost every
aspect of our lives: The rules are simple: for every debit, there is a credit. The concept is the same as for
actions and reactions; with an exception: actions/reactions refer to energy, and debits/credits refer to
finances. When one makes a purchase at the local grocery, he credits his cash, and debits its food supply.
He decreased his cash (always an asset); therefore the decrease is recorded as a credit; that leaves the
increase in his food supply to be recorded as a debit. If necessary, read this last paragraph once more, and
try to view his daily events in a financial light. As for the accounting professionals, every day is a debit or
credit, an exchange of value between assets and liabilities.
Caution
We must guard against the error of thinking that the terms debit and credit mean increase or decrease. In an
account where a debit is an increase, such as an asset, a credit is a decrease. But notice that in an account
where a debit is a decrease, such as a liability, a credit is an increase.

credit, or more than one of both debits and credits. It is essentially a combination of several simple journal
entries; they are combined for either of these reasons:
It is more efficient from a bookkeeping perspective to aggregate the underlying business transactions
into a single entry.
Examples of aggregation that may involve compound journal entries are:
1. Depreciation for multiple classes of fixed assets
2. Accruals for multiple supplier deliveries at month-end for which no invoices have yet been received
3. Accruals for the unpaid wages of multiple employees at month-end
All of the debits and credits relate to a single accounting event. Examples of accounting events that
frequently involve compound journal entries are:
1. Record all payments and deductions related to a payroll
2. Record the account receivable and sales taxes related to a customer invoice
3. Record multiple line items in a supplier invoice that relate to different expenses
4. Record all bank deductions related to a bank reconciliation
An example of a compound journal entry is a payroll entry, where there is a debit to salaries expense,
another debit to payroll taxes expense, and credits to cash and a variety of deduction accounts.
Sometimes there are a number of transactions on the same date relating to one particular account or of one
particular nature. Such transactions may be recorded by means of a single journal entry instead of passing
several journal entries. Such as entry is termed as a ―Compound Journal Entry‖.
Pass a Compound Journal Entry in each of the following cases:
1. Payment made to Ram INR1, 000. He allowed a cash discount of INR50.
2. Received cash from Suresh INR800 and allowed him INR50 as discount.
3. A running business was purchased by Mohan with following assets and liabilities: Cash INR2, 000,
Land INR4, 000, Furniture INR1, 000, Stock INR2, 000, Creditors INR1, 000, Bank Overdraft INR2, 000.
Solution
Journalize the following transactions. Also state the nature of each account involved in the Journal entry.
1. Dec.1, 1998, Ajit started business with Cash INR40,000.
2. Dec.3, He paid into the Bank INR2,000.
3. Dec.5, He purchased goods for cash INR15,000.
4. Dec.8, He sold goods for cash INR6,000.
5. Dec.10, He purchased furniture and paid by Cheque INR5,000.
6. Dec.12, He sold goods to Arvind INR4,000.
7. Dec.14, He purchased goods from Amrit INR10,000.
8. Dec.15, He returned goods to Amrit INR5,000.
9. Dec.16, He received from Arvind INR3,960 in full settlement.
10. Dec.18, He withdrew goods for personal use INR1,000.
11. Dec.20, He withdrew cash from business for personal use INR2,000.
12. Dec.24, He paid telephone charges INR1,000.
13. Dec.26, Cash paid to Amrit in full settlement INR4,900.
14. Dec.31, Paid for stationary INR200, Rent INR500 and salaries to staff INR2, 000.
15. Dec.31, Goods distributed by way of Free Samples INR1,000.
Journalize the following transactions in the books of a trader

Debit Balances on Jan.1, 1999:
Cash in Hand INR8,000, Cash at Bank INR25,000, Stock of Goods INR20, 000,Furniture INR2,000,
Building INR10,000, Sundry Debtors: Vijay INR2,000, Anil INR1,000, and Madhu INR2,000. Credit
Balance son Jan.1, 1999:
Sundry Creditors: Anand INR5,000, Loan from Bablu INR10,000.
Following were further transactions in the month of January, 1999:
1. Jan 1, purchased goods worth INR5,000 for cashless 20%trade discount and 5% cash discount.
2. Jan 4, Received INR1, 980 from Vijay and allowed him INR20 as discount.
3. Jan 6, purchased goods from Bharat INR5, 000.
4. Jan 8, purchased plant from Mukesh for INR5, 000 and paid INR100 as cartage for bringing the plant
to the factory and another INR200 as installation charges.
5. Jan 12, sold goods to Rahim on Credit INR600.
6. Jan 15, Rahim became insolvent and could pay only 50 paise in rupee.
7. Jan 20, Paid salary to Ratan INR2,000.
8. Jan 21, Paid Anand INR4,800 in full settlement.
9. Jan 26, Interest received from Madhu INR200.
10. Jan 28, Paid to Bablu interest on Loan INR500.
11. Jan 31, Sold Goods for cash INR500.
12. Jan 31, Withdrew goods from business for personal use INR200.
8.4 Opening entry

One or a series of entries usually undertaken upon forming a new enterprise, or new accounts, or a new
accounting period.
1. Initial bookkeeping entries of a new firm.
2. First entries of a new account or accounting period.
We all know that life of business is very long but on the end of every financial year, accountant makes
final accounts. When next financial year is started, accountant writes one journal entry in the beginning of
every financial year in which he shows all the opening balance of assets and all the liabilities include
capital. Then that journal entry is called opening journal entry. Because all assets have debit balance, so
these are debited in opening journal entry and all liabilities have credit balance, so these are credited in
opening journal entry.
If all assets are more than all liabilities, its excess will be the value of capital which is showed credit side in
the opening journal entry. If liabilities are more than the value of all assets, then this excess will be
goodwill and it will be debited in opening journal entry. Typically, different of assets and liability will be
positive and excess value of assets are showed as capital in the credit of journal entry.
8.4.1 Generating the Opening Entry
To automatically generate the opening entries based on your actual books, OpenERP provides a wizard.
Go to Accounting ‣ Periodical Processing ‣ End of Period ‣ Generate Opening Entries.
In the wizard, enter the financial year for which you want to transfer the balances (fiscal year to close).
Select the new financial year (the year in which you want to generate the opening entry). You also have to
select the journal and the period to post the opening entries. The description for the opening entry is
proposed by default, but of course you can enter your own description, such as Opening Entry for financial
year YYYY. Then you click the Create button to generate the opening entry according to the settings
defined.
To have a look at the draft opening entry that has been generated, go to Accounting ‣ Journal Entries ‣
Journal Entries. Click the Unposted button to filter only draft entries. Open the corresponding entry and
verify the data. Click the Post button to confirm the entry.

Both the Journal and the Ledger are the two most important books used under the Double Entry System of
―Book-Keeping‖.
The relationship between the ―Journal and Ledger‖ could be expressed as follows:
Journal is the book of first or original entry - since all the Business Transactions are recorded first of all in
the ―Journal‖.
While the ―Ledger‖ is the book of second entry - since the transactions are ―Posted‖ to the ―Ledger‖ from
the Journal.
The Journal records transactions in ―Chronological order‖, while the Ledger records the transactions in
analytical order.
The Journal is more reliable than Ledger since it is the book in which the entry is entered first.
The process of recording transitions is termed as ―Journalising‖ while the process of recording transactions
in the Ledger is called as ―Posting‖.

Here it specifies the G/L accounts in financial accounting to which the results analysis data is settled. It
assigns a results analysis cost element or a group of results analysis cost elements to two G/L accounts.
On the basis of the settlement of the results analysis data, a posting document is generated in financial
accounting.
Data is written to the balance sheet.
Data is written to the profit and loss statement.
On the basis of this posting, an additional document is generated in profit centre accounting if the order is
assigned to a profit centre.
Settlement is made by period on the basis of
The settlement structure in the settlement rule of the sales order item, WBS element or internal order
The posting rules that you define in this step
All cost elements under which results analysis data to be settled are written (such as reserves for unrealized
costs, work in process, cost of sales) must be listed in the settlement structure. They must also be assigned
to G/L accounts by the posting rules. Settlement of data to Profitability Analysis is controlled by a PA
settlement structure. In the PA transfer structure one list the results analysis cost elements for the revenues,
reserves for imminent loss and cost of sales.
Then he assigns these cost element groups to value fields
One can assign the results analysis data to the G/L accounts at the following levels:
For each results analysis category
The following results analysis categories are created on the basis of the assignment of the costs to line IDs:
WIPR - work in process with requirement to capitalize costs
WIPO - work in process with option to capitalize costs
WIPP - work in process with prohibition to capitalize costs
It is normally define a posting rule that assigns the work in process that must be capitalized to the G/L
accounts for unfinished products (balance sheet) and stock changes (P/L). Reserves for unrealized costs
can be created if the actual costs incurred to date are less than the cost of sales. If this is the case, the
following results analysis categories are created:
RUCR - Reserves for unrealized costs (group that must be capitalized)
RUCO - Reserves for unrealized costs (group with option to capitalize)
RUCP - Reserves for unrealized costs (group that cannot be capitalized)
Reserves for unrealized costs must be shown as liabilities. If you create line IDs for all three results
analysis categories through the assignment, then it must define posting rules for all three categories.
Reserves for imminent loss and reserves for the cost of complaints also must be shown as liabilities. If it
wants to transfer the results analysis data by results analysis category to Financial Accounting, it is only
need to create a Technical Results Analysis Cost Element in the results analysis version.
For each results analysis category
In this case, one assign the individual results analysis cost elements to the G/L accounts. For example, if
the work in process for the direct material costs are updated under results analysis cost element 672111 and
the work in process for the production cost under results analysis type 672131, one can pass this
information on to different G/L accounts in Financial Accounting. In this case one can assign, for example,
the reserves for unrealized costs or work in process that must be capitalized to the G/L accounts. If he want
to pass the results analysis data to Financial Accounting by results analysis cost elements, he must
apportion to different results analysis cost elements by means of Apportionment of cost elements on in the
results analysis version.
For each results analysis category and operation (creation, usage, cancellation)
Here you assign, for example, the created reserves for unrealized costs or work in process that must be
capitalized to the G/L accounts.
If someone wants to pass the results analysis data to Financial Accounting by results analysis category, he
must turn on the indicator Separate creation/usage in the extended control in the results analysis version.
If one is using the POC method, the data will be updated under the cost elements that he specified in the
results analysis version. He can either list these results analysis cost elements or specify the following
results analysis categories:
Category Meaning
POCI Inventory from which revenue can be generated
POCS Revenue surplus
POCP Calculated profit
POC Loss
POCR Realized loss
Did You Know?

The actual origin of the terms debit and credit is unknown; the first known recorded use of the terms is
Venetian Luca Pacioli‘s 1494 work Summa de Arithmetica, Geometria, Proportioni et Proportionalita.

Mission
The mission of the International Journal of Case Studies in Management is to ensure the widest possible
teaching and research tool. The Journal is a refereed publication, meaning that all cases are subject to a
Readers
offers a broad spectrum of case studies drawing on all sectors of the economy.
Readers will find cases illustrating management situations relating to various administrative functions,
cases presenting the real-life experiences of different types of companies, cases featuring remarkable
business leaders of both past and present, as well as cases presenting women managers, entrepreneurs and
leaders of cultural and government organizations and lots more.
Format
Questions
3. What is the aim of the international journal?
4. Explain the services provided by international journal?
8.7 Summary
In accounting, a ―journal‖ refers to a financial record kept in the form of a book, spreadsheet, or
accounting software that contains all the recorded financial transaction information about a business
A Journal is an accounting record that is used to record the different types of transactions in
chronological order or date order.
The Journal of Financial Reporting and Accounting (JFRA) provide a valuable forum for the
publication of research that address significant issues on financial reporting and accounting
In financial accounting debit and credit are simply the left and right side of a T-Account respectively.
A journal is an academic magazine published on a regular schedule.
statement, which is termed a ―Trial Balance‖
A journal includes all accounting transactions and is considered the historical record for a business
entity.
8.8 Keywords
Accounting: It is the process of communicating financial information about a business entity to users such
as shareholders and managers.
Gross Margin: A company‘s total sales revenue minus its cost of goods sold, divided by the total sales
revenue, expressed as a percentage.
Liabilities: A liability can mean something that is a hindrance or puts an individual or group at a
disadvantage, or something that someone is responsible for, or something that increases the chance of
something occurring
Operating Income: It is an acronym meaning operating income before depreciation and amortization. It
refers to an income calculation made by adding depreciation and amortization to operating income.
Sales Journal: A sales journal is a specialized accounting journal used in an accounting system to keep
track of the sales of items that customers have purchased on account by charging a receivable on the debit
side of an accounts receivable account and crediting revenue on the credit side. It differs from the cash
receipts journal in that the latter will serve to book sales when cash is received

1. A journal is not an academic magazine published on a regular schedule.
(a) True (b) False
2. The accounting equation can be expressed as Liabilities + Assets = Owner‘s Equity.

(a) True (b) False

(a) violates the fundamental accounting equation.
(d) is used to record the business transactions of a single day in a single journal entry.
4. When an entry is made in the general journal,

(a) assets should be listed first (b) accounts to be debited should be listed first
(c) accounts to be increased should be listed first (d)accounts may be listed in any order
5. The journal entry to record the sale of services on credit should include a:
(a) debit to Accounts Receivable and a credit to Capital
(b) debit to Cash and a credit to Accounts Receivable
(c) debit to Fees Income and a credit to Accounts Receivable
(d) debit to Accounts Receivable and a credit to Fees Incomes
6. A journal is an academic magazine published on a regular..........

(a)schedule (b)credit
(c)debit (d)none
7. The general journal is the main journal for a............ of transactions

(a)wide range (b)range
(c)cash (d)all

(a) violates the fundamental accounting equation.
(d) is used to record the business transactions of a single day in a single journal entry
9. A compound journal entry is....................... entry in which there is more than one debit, more than one
(a)debit (b)cash
(c)range (d)accounting
10. A journal details all the financial transactions of a............. and which accounts these transactions affect
(a) business (b) accounts
(c) cash (d) none

1. What do you understand by opening entry?
2. What is a ledger entry?
3. What relationship between the journal and the ledger?
4. What is the journal in financial accounting?
5. Describe the rules of debit and credit.
6. Explain the compound journal entry.
7. Difference between Journal and Opening entry.
8. Describe the Rules regarding posting.
9. What is the Journal?
10. Write the difference between a simple and compound journal entry
1. (b) 2.(b) 3.(b) 4.(b) 5.(d)
6. (a) 7.(a) 8.(b) 9.(d) 10.(a)
9
Partnership Accounts
CONTENTS
Objectives
Introduction
9.2 Retirement
9.4 Summary
9.5 Keywords
Objectives
Explain problems relating to admission
Understand the retirement.
Explain the death of a firm.
Discuss the dissolution of a firm.
Introduction
Except for the number of partners‘ equity accounts, accounting for a partnership is the same as accounting
for a sole proprietor. Each partner has a separate capital account for investments and his/her share of net
income or loss, and a separate withdrawal account. A withdrawal account is used to track the amount taken
from the business for personal use. The net income or loss is added to the capital accounts in the closing
process. The withdrawal account is also closed to the capital account in the closing process.
Asset contributions to partnerships

When a partnership is formed or a partner is added and contributes assets other than cash, the partnership
establishes the net realizable or fair market value for the assets.
For example, if the Walking Partners company adds a partner who contributes accounts receivable and
equipment from an existing business, the partnership evaluates the collectability of the accounts receivable
and records them at their net realizable value. An existing valuation reserve account (usually called
allowance for doubtful accounts) would not be transferred to the partnership as the partnership would
establish its own reserve account. Similarly, any existing accumulated depreciation accounts are not
assumed by the partnership. The partnership establishes and records the equipment at its current fair
market value and then begins depreciating the equipment over its useful life to the partnership.
Income allocations
The partnership agreement should include how the net income or loss will be allocated to the partners. If
the agreement is silent, the net income or loss is allocated equally to all partners. As partners are the
owners of the business, they do not receive a salary but each has the right to withdraw assets up to the level
of his/her capital account balance. Some partnership agreements refer to salaries or salary allowances for
partners and interest on investments. These are not expenses of the business, they are part of the formula
for splitting net income. Many partners use the components of the formula for splitting net income or loss
to determine how much they will withdraw in cash from the business during the year, in anticipation of
their share of net income. If the partnership uses the accrual basis of accounting, the partners pay federal
income taxes on their share of net income, regardless of how much cash they actually withdraw from the
partnership during the year.
Once net income is allocated to the partners, it is transferred to the individual partners‘ capital accounts
through closing entries.
For example, assume Dee‘s Consultants, Inc., a partnership, earned INR60,000 and their agreement is that
all profits are shared equally. Each of the three partners would be allocated INR20,000 (INR60,000 ÷ 3).
The journal entry to record this allocation of net income would be:
General Journal
Date Account Title and Description Ref. Debit Credit
20X0
Dec.31 Income Summary 60,000
Dee, Capital 20,000
Sue, Capital 20,000
Jeanette, Capital 20,000
Transfer net income to partners'
capital accounts
A brokerage account in which two or more individuals are equally liable. A partnership account differs
from a joint account in that the partnership account may include a written agreement defining the interest
of each partner.
Remember that allocating net income does not mean the partners receive cash. Cash is paid to a partner
only when it is withdrawn from the partnership.
In addition to sharing equally, net income may also be split according to agreed upon percentages (for
example, 50%, 40%, and 10%), ratios (2:3:1), or fractions (1/3,1/3, and1/3) Using Dee‘s Consultants net
income of INR60,000 and a partnership agreement that says net income is shared 50%, 40%, and 10% by
its partners, the portion of net income allocated to each partner is simply the INR60,000 multiplied by the
individual partner‘s ownership percentage. Using this information, the split of net income would be:
Dee 50% INR30,000

Sue 40% 24,000
Jeanette 10% 6,000
Total net income INR60,000
Using the 2:3:1 ratio, first add the numbers together to find the total shares (six in this case) and then
multiply the net income by a fraction of the individual partner‘s share to the total parts (2/6,3/6, and1/6).
Using the three ratios, the INR60,000 of Dee‘s Consultants net income would be split as follows:
2
Sue /6 20,000
3
Dee /6 INR30,000
1
Jeanette /6 10,000
Total net INR60,000
income
Using the fractions of1/3,1/3, and1/3, the net income would be split equally to all three partners, and each
partner‘s capital account balance would increase by INR20,000.
Assume the partnership agreement for Dee‘s Consultants requires net income to be allocated based on
three criteria, including: salary allowances of INR15,000, INR12,000, and INR5,000 for Dee, Sue, and
Jeanette, respectively; 10% interest on each partner‘s beginning capital balance; and any remainder to be
split equally. Using this information, the INR60,000 of net income would be allocated INR21,000 to Dee,
INR20,000 to Sue, and INR19,000 to Jeanette.
Information from the owners‘ capital accounts shows the following activity:
Beginning
Capital Additional Investments During Withdrawals
Balance Year During Year
Dee INR 20,000 INR 5,000 INR15,000
Sue 40,000 5,000 10,000
Jeanette 100,000 10,000 5,000
Allocation of Net Income of INR60,000
Dee Sue Jeanette Total
Salary Allowances INR15,000 INR12,000 INR 5,000 INR32,000
Interest (10% of beginning 2,000 4,000 10,000 16,000
capital account balance)
17,000 16,000 15,000 48,000
Remainder (equally) 4,000 4,000 4,000 12,000
Net Income INR21,000 INR20,000 INR19,000 INR60,000
The investments and withdrawal activity did not impact the calculation of net income because they are not
part of the agreed method to allocate net income.
As can be seen, once the salary and interest portions are determined, they are added together to determine
the amount of the remainder to be allocated. The remainder may be a positive or negative amount.
Assume the same facts as above except change net income to INR39,000. After allocating the salary
allowances of INR32,000 and interest of INR16,000, too much net income has been allocated. The
difference between the INR48,000 allocated and the INR39,000 net income, a decrease of INR9,000, is the
remainder to be allocated equally to each partner. These assumptions would result in allocations of net
income to Dee of INR14,000, Sue of INR13,000, and Jeanette of INR12,000. The calculations are as
shown:
Allocation of Net Income of INR39,000

Dee Sue Jeanette Total
Salary allowances INR15,000 INR12,000 INR5,000 INR32,000
Interest (10% of 2,000 4,000 10,000 16,000
beginning capital
account balance)
17,000 16,000 15,000 48,000
Remainder (equally) (3,000) (3,000) (3,000) (9,000)
Net Income INR14,000 13,000 INR12,000 INR39,000
Accounting for Partnerships

The launch of the syllabus for Foundations in Accountancy provides a good opportunity to revisit the topic
of accounting for partnerships. The syllabus for Paper FA2, Maintaining Financial Records contains an
additional outcome that was not in the Syllabus for CAT Paper 3. Also, a recurring feature of performance
in CAT Paper 3 exams was that a disappointingly low number of candidates performed well on questions
that examined the topic of partnerships. The purpose of this is to assist candidates to develop their
understanding of the topic of accounting for partnerships. As such, it covers all of the outcomes in Section
H of the Study Guide for Paper FA2. It also provides underpinning knowledge for candidates studying
Papers FFA and F3, Financial Accounting but it is not intended to comprehensively cover the Study
Guides for those papers.
What is a partnership?
There are a number of ways in which a partnership may be defined, but there are four key elements.
Two or more individuals

A partnership includes at least two individuals (partners). In certain jurisdictions, there may be an upper
limit to the number of partners but, as that is a legal point, it is not part of the Paper FA2 syllabus.
Business arrangement
A partnership exists to carry on a business.
Profit motive: As it is a business, the partners seek to generate a profit.
Unincorporated business entity

A partnership is an unincorporated business entity.
That means:
the reporting entity (business entity) principle applies to a partnership, so for
accounting purposes, the partnership is a separate entity from the partners
the partners have unlimited liability, and
if the partnership is unable to pay its liabilities, the partners may be called upon to use their personal
assets to clear unpaid liabilities of the partnership.
How is a Partnership Controlled?

It is good practice to set out the terms agreed by the partners in a partnership agreement. While this is not
mandatory, it can reduce the possibility of expensive and acrimonious disputes in the future. As a formal
agreement is not mandatory, there is no definitive list of what it should contain, but Paper FA2 exams will
not go beyond the following:
Share of residual profit

The Paper FA2 Study Guide defines this as ―the amount of profit available to be shared between the
partners in the profit and loss sharing ratio, after all other appropriations has been made‖.

The Graduate Council feels that the functions related to graduate admissions are not too highly centralized
in the Graduate Division. Indeed if coordination and uniformity are essential in the larger aspects of the
graduate program in the Northern Section of the University, it is imperative to have a centralized control in
administration.
The Graduate Council has found that much detailed technical information regarding standards in various
schools, University standards, policies, etc., is required for evaluation of admission applications. Currently
this is handled by a small staff in the Graduate Division, with addition of clerical help in rush periods.
Obviously considerable experience is needed to render competent and consistent appraisals. Continuity and
consistency would be practically unattainable in a decentralized system. The peak load of applications for
admission occurs just prior to July 15 and processing is required during the summer months. Change in
personnel, sickness, vacations, etc., could cause problems and delays.
This would be particularly serious in the case of foreign applicants. It has taken many years to assemble in
the Graduate Division all the information necessary for rapid processing of applications for admission, and
these data must be supplemented and revised continuously. The process of handling transcripts,
testimonials, and letters requires wide knowledge of foreign languages. Detailed knowledge of
immigration regulations is also necessary. Moreover, since the Graduate Division staff handling these
matters is small, it would seem that widespread departmental assumption of this function would inevitably
require an increase in personnel, added expense, and the diversion of senior faculty members from their
primary responsibilities.The Graduate Council has found little evidence of special delay inherent in the
present system due to unnecessary paper work.
9.1.1 Withdrawals
Every partner also has his own withdrawal account which tracks the owner‘s individual withdrawals for a
period. These withdrawal accounts are called nominal accounts, which means that they are temporary.
Nominal accounts simply track a series of amounts for a one-year time period. At the end of the year, the
company‘s books are closed so they can begin using them the following year starting at zero. During the
closing process, the withdrawal accounts are closed and subtracted out of each specific owner‘s capital
account. These withdrawals reduce the owner‘s individual capital accounts.
9.1.2 Income Allocation

Part of the partnership agreement is dedicated to income allocation. Income is allocated based on what the
partners agreed upon. Partners usually divide profits based on percentages. If there are four owners and the
net profit for a period is INR 5,00,000, each owner gets INR1,00,500 credited into their individual capital
account.
Often times with partnerships, certain partners agree to do work for the company, whereas other partners
agree only to contribute money to the business. If this is the case, certain percentage guidelines are drawn
up as part of the initial agreement.
Entrance requirements based on Academic Senate Regulations necessitate review and screening of all
applicants‘ qualifications. The Graduate Division sees that these requirements are met. Sixty-one of 104
departments, schools or groups have taken advantage of the privilege of reviewing and screening of
applicants. Their recommendations to the Graduate Division are nearly always accepted. As a matter of
fact the final acceptance of qualified students is a departmental responsibility, the decision being
influenced normally by limitations in staff and facilities. Those students with questionable qualifications
should be screened carefully. The Graduate Council feels that it is only by handling the primary reviews in
the Graduate Division that uniform high standards can be assured in the graduate program of the
University.
The Graduate Council‘s investigations have revealed that at the present time there are few if any
unnecessary delays in processing applications. The primary causes of unnecessary delay, in contrast to the
necessary steps of review, usually involve the mistakes or delays of the students or of the departments.
Moreover, most of the time-consuming steps on applications would seem to be more expeditiously carried
out from an office in the Administration Building than from separate offices scattered over the campuses of
the Northern Section. Action on a normal and complete application is completed within four to six days.
We see no reason why this time should be permitted to increase with the growth in enrolment if suitable
expansion of office facilities and personnel is provided. Some consideration might be given to
development of simpler admission forms and clearer instructions in the hope that applicants would comply
more adequately.
Some delay may result from applications being sent first to the department. In certain cases (e.g., some
professional schools) an additional application blank and other requirements are requested. It appears that
this is a source of delay, since the student, if applying to the Graduate Division, is told to apply also to the
school for appropriate forms and instructions. Nearly 4,000 cases were processed for admission for the fall
semester of 1955. Many of these appeared in the Graduate Division in the last ten days before the deadline.
Yet they were put through quickly except in the cases of inadequate information or questionable eligibility.
The criticism of impersonal handling of applicants could be partially answered by changing the form
letters that are sent out, but it is unreasonable to expect a Graduate Dean to write warm personal letters to
4,000 applicants. Since schools and departments have the privilege of review and submission of
recommendations on applicants, if they request the privilege, interested faculty members can be as
personal and warm as they please to applicants as long as they do not violate University regulations in
making promises they have no authority to make.
9.2 Retirement
In any partnership firm when a partner retires from a firm it is the duty of remaining partner to give him his
share because he has to spend his remaining life. So at this time accounting treatment is very necessary in
the books of firm.
Calculate new profit sharing ratio and calculate gaining ratio by deducting new profit sharing ratio
from old ratio.
Calculate profit or loss on revaluation of assets and liabilities and transfer it to retiring partner‘s capital
account.
Calculate the goodwill share of retiring partner and transfer to retiring partner‘s capital account ( credit
side with his share)
Calculate joint life policy share and transfer to retiring partner‘s capital account
Calculate General reserve share and transfer to retiring partner‘s capital account
In his debit side we will transfer his drawing and interest on his drawing after this we can give his
capital after above adjustment in cash form or after this his amount will deemed as loan to firm. Firm
will liable to give 6% interest to retiring partner. Make and retiring partner and calculate his total
amount and give him .That is called accounting treatment of retirement of a partner.
9.2.1 Retirement of Partner Introduction

When a partner retires due to illness old age of any other reason, the partnership comes to an end. But the
form may not be dissolved as the other partner continues the business. In such a case, the partnership is
reconstituted legally similarly, when one of the partners dies, the partnership comes to an end. From the
view point of accounts there is hardly any difference between retirement and death of a partner.
In case of retirement, the partner decides to retire on some convenient date, generally at the close of
the financial year, whereas death occurs on any date.
In case of the retirement, the total amount due to the retiring partner is placed to the credit of his loan
account, if it is not paid immediately.
And in the case of death, it is transferred to his Executor‘s Account. Generally, the retiring partner is paid
his, dues in cash, if however, accounts are not settled on the date of dissolution and the business is
continued, then the retiring partner has a right to get his proportionate profit or he is entitled to get interest
on these dues at 6% P.a., whichever is more beneficial to him.
9.2.2 Problems Arising On Retirement or Death
The following points arise on retirement of a partner:
1. To revalue the assets and liabilities of the firm.
2. To distribute general reserve or profit and loss balance among all partners.
3. To determine the new profit sharing ratio.
4. To fix up the value of goodwill of the firm.
5. To ascertain the profit or loss up to the date of retirement
6. To determine the new capital of the firm and make necessary adjustments
7. To make payment of the dues of retiring partner
9.2.3 Retirement of a Partner

The following adjustments are made at the time of retirement of a partner:
1. Calculations of New Profit Sharing Ratio and Gaining Ratio of remaining partners.
2. Distribution of Reserves and Undistributed Profits/Losses.
3. Revaluation of Assets and Liabilities.
4. Treatment of Goodwill.
5. Calculation of amount payable to retiring partner.
6. Adjustment of Capital.

Dissolution of partnership and Dissolution of firm are two different terms. Dissolution of partnership
means termination of existing partnership agreement and the formation of a new agreement which can be
due to any reason like admission of a new partner or death or retirement of an old partner. In the case of
dissolution of partnership the remaining partners may agree to carry on the business under a new
agreement. Whereas Dissolution of Partnership firm means that the firm is closing down its business. In
the case of dissolution of firm the Assets of the business are sold, Liabilities are paid off and the accounts
of the partners are settled out of the remaining amount.
9.3.1 Dissolution of Partnership

Partnership is dissolved in the following circumstances:
1) At the time of admission of a new partner;
2) On the retirement/death of an old partner;
3) At the time of change in profit sharing ratio among existing partners;
4) If any partner is declared insolvent;
5) On the expulsion of any partner;
6) On the expiry of the period of partnership.
Thus this is clear from the above discussion that in the case of dissolution of the partnership the firm may
continue under a new agreement whereas in the case of dissolution of partnership firm the business of the
firm comes to an end.
9.3.2 Dissolution of Firms

When the relation between all the partners of the firm comes to an end, this is called dissolution of the
firm. Section 39 of the Indian Partnership Act, provides that ―the dissolution of the partnership between all
the partners of a firm is called the dissolution of a firm.‖ It implies the complete breakdown of the relation
of partnership between all the partners.
9.3.3 Dissolution of Partnership is Different from the Dissolution of Firm.

Dissolution of a partnership firm merely involves a change in the relation of partners; whereas the
dissolution of firm amounts to a complete closure of the business. When any of the partners dies, retires or
become insolvent but if the remaining partners still agree to continue the business of the partnership firm,
then it is dissolution of partnership not the dissolution of firm. Dissolution of partnership changes the
mutual relations of the partners. But in case of dissolution of firm, all the relations and the business of the
firm comes to an end. On dissolution of the firm, the business of the firm ceases to exist since its affairs are
would up by selling the assets and by paying the liabilities and discharging the claims of the partners. The
dissolution of partnership among all partners of a firm is called dissolution of the firm.
Dissolution of a Partnership firm may be affected in the following ways:
Dissolution without the intervention of the Court.
Dissolution by Court.
9.3.4 Dissolution without the Intervention of Court

1. By Agreement (S.40)
A partnership firm can be dissolved any time with the consent of all the partners whether the partnership is
at will or for a fixed duration. A partnership can be dissolved in accordance with the terms of the
Partnership Deed or of the separate agreement.
2. Compulsory Dissolution (Sec.41)

In case, any of the following events take place then it becomes compulsory for the firm to dissolute:
(i) Insolvency of Partners
In case all the partners or all the partners except one become insolvent.
(ii) Unlawful Business
In case the firm is engaged in more than one business which may have become unlawful, the better view
appears to be that the firm will not dissolve as to the other legitimate businesses unless all of them are so
inter connected that stoppage of one would paralyze the others e.g. A and B charter a ship to go to foreign
port and receive a cargo on the joint venture.
War breaks out between England and the country where the port is situated before the ship arrives at the
port, and continues until after the time appointed for loading. The partnership between A and B is
dissolved
3. Dissolution on the happening of contingent event (S.42)

A firm may be dissolved on the happening of any of the following contingent event
(i) Expiry of Fixed Period
A firm constituted for a term is of course not exempt from dissolution by any of the other possible cause
before the expiration of the term. The contract may expressly provide that the partnership will determine in
certain circumstances but even if there is no such express term, an implied term as to when the partnership
will determine may be gathered from the contract and the nature of the business. The provision of this
section make it clear that unless some contract between the partners to the contrary is proved, the firm, if
constituted for a fixed term would be dissolved by the expiry of that term.
(ii) On achievement of specific task
A partnership constituted to carry out contracts with specified persons during a particular season would be
taken to be dissolved once the contracts are closed. In the case of Basantlal Jalan v. Chiranjilal, Where the
firm was constituted for a specific undertaking to supply certain quantity of grain and the contract was
prematurely terminated after supply of a part of the goods, it was held that the partnership did not come to
an end and was dissolved only on the final realization of the assets
(iii) Death of Partner
When the deed of partnership did not provide that the death of a partner would not dissolve the partnership,
the partnership stood dissolve on the death of a partner. Firm, stands dissolved automatically on death of
one partner. Continuance of business after such death would not tantamount to continuance of earlier
partnership.
(iv) Insolvency of Partner
In the absence of a contract to the contrary, the insolvency of any of the partner may dissolve the firm. the
rule shall apply even though the partnership has been constituted for a fixed term and the term has not yet
expired or has been constituted for particular venture and the same has yet not been completed.
(v) Resignation of partner resignation by any of the partners dissolves the partnership
4. Dissolution by notice (S.43)

In case of partnership at will, a partner can dissolve it by giving written notice of dissolution to other
partners duly signed by him. Notice must be very clear and certain. A notice once given cannot be
withdrawn without the consent of other partners was held in case of Banarsidas v. Kanshi Ram. In those
cases where a partner has given notice of dissolution at a time when dissolution will give him some
advantage over the other partners, he may be held in the firm till the pending transactions are completed.
Dissolution by Court (S 44)
The court may order for the dissolution of the firm on the following grounds:
(i) Insanity of Partner
On the application of any of the partner, court may order for the dissolution of the firm if a partner has
become of an unsound mind. Lunacy of a partner does not itself dissolve the partnership but it will be a
ground for dissolution at the instance of other partners. It is not necessary that the lunacy should be
permanent. In the case of a dormant partner the court may not order dissolution even on the ground of
permanent insanity, except in special circumstances.
(ii) Incapacity of Partner
If a partner has become permanent in capable of discharging his duties and obligations then court may
order for the dissolution of firm on the application of any of the partner. where a partner is imprisoned for
a long period of time the court may dissolve the partnership was held in case of Whitwell v. Arthur
(iii) Misconduct of Partner
If any partner other than partner suing is responsible for any loss to the firm, which amounts to misconduct
and prejudicially affects the carrying on of business then the court may order for the dissolution of the
firm.
(iv) Constant breach of Agreement by Partner
The court may order for the dissolution of the firm if the partner other than the suing partner is found guilty
for constant breach of agreement regarding the conduct of business or the management of the affairs of the
firm and it becomes impossible to continue the business with such partner.
(v) Transfer of Interest
When any of the partner other than the suing partner transfers whole of its share to the third party for
permanently.
(vi) Continuous Losses
The court may order for dissolution if the firm is continuously suffering losses and there is no more capital
available for the future growth of the firm.
Did You Know?

When a partnership is started, an agreement is drawn up. The agreement states each owner‘s name, their
partnership percentage, the partnership name, where business will take place and what is expected from
each owner.
Caution
The remaining accounting work for a partnership is handled using the normal accounting process.
Case Study-Partnership Accounting

This firm was a Sydney CBD-based practice with 2 regional offices in rural NSW. The firm had 9 Partners
(6 equity; 3 salaried) and 54 staff. But, the firm‘s WIP was out of control and one consequence was their
write-offs were running at 37.5%. In addition, the firm was a ―victim‖ of chronic under-pricing. The
regional offices were essentially cost not profit centres.
Issues
The firm was very good in its recruitment of graduates. However, there was a rapidly ―revolving door‖ at
Middle Management level, and most of the more talented people left after serving some time as either
Seniors and/or Managers. The firm did not recognise or leverage its intellectual property primarily because
it had poor knowledge management systems and processes. The Managing Partner‘s personal billings were
down by 60% over 2.5 years largely because of his time spent on ―management‖ and ―fire-fighting‖. Not
surprisingly, there was enormous pressure on drawings and a hugely diminished profit. In the midst of this,
the Directors decided to take on both a new 5-year, CBD lease (with 2 x 5-year options) and the acquisition
of another regional practice and to restore some appeal to their marketing effort by re-designing their
corporate livery.
The firm had neither strategies nor plans of its own. Tactically they were undecided as to whether they
should ―Specialise‖ or ―generalise‖. There was no succession strategy or partner development program.
The Ownership model was skewed to goodwill. There were desired Exit Timeframes established for each
Partner whose ages were:
60>: 2; 50-55: 4; 45-50: 2; 40-45: 1
The partnership was dysfunctional and characterised by extremely poor relationships and behaviours
between partners. The partnership problems were exaggerated by:
A Recalcitrant partner who had been a ―problem child for 3 years‖
A ―Specialist‖ partner who represented the office‘s equivalent of the ―big black hole‖
There were 2 potential (internal) new admissions who, it was said, qualifies on gender and time, but
failed on ability and ―fit‖
In addition, the firm had a poorly performing financial planning practice which was headed up by a former
high-profile Rugby Union player whose greatest contribution to date had been a revitalization of the office
footy tipping comp and Melbourne Cup Calcutta.
Solution
Where are they now? We have worked through the issues and developed a framework of sustainable
change at a number of levels within the firm: at the Directors‘ level, as well as at the middle-management
and operational levels. The Directors‘ initial questions were around how to manage ―succession‖ within
the firm. However, what emerged over time was the fact that there were significant cultural and operational
issues which needed to be addressed through a rigorous and structured process involving every level of the
firm. And, together with the members of the firm, we have delivered a very positive solution which has
provided a firm foundation for their future succession plans:
A set of values and a directors‘ code of behaviour
8 Partners: 1 paid out/retired; 3 resigned; 3 new partners (1 equity; 2 salaried; 1 internal; 2 external)
Leadership group of 4 each with portfolio responsibilities complemented by ongoing external advisor
Clear strategic direction with accountabilities and measurements
Partner development program
New management structure providing clear growth opportunities for future leaders including
secondment into client businesses
Pull-back from proposed regional merger
Closure of 1 regional office; restructure of the other
Accounting Practice Revenue 8.8m
Billings and wipe brought back under control
Profitability restored and enhanced
7.25% write-offs; 8% write-ones
Future successors (partners) nominated and nurtured
Pricing reviewed and increases at partner and manager level
Financial planning practice delivering 1.2m in revenue
Advisory Board:3 credible business people, 2 clients, external advisor clear and defined charter
A happy managing partner
Questions
1. What do you mean by partner development program?
2. What do you mean by Income Allocation?
9.4 Summary
Loss on realization is distributed among partners are according to profit and loss ratio
The initial capital put into the business by each partner is shown by means of a capital account for each
partner.
The net profit of the partnership is appropriated by the partners according to some previously agreed
ratio.
Partners may be charged interest on their drawings, and may receive interest on capital. If a partner
makes a loan to the business, he will receive interest on it the normal way.
Partnerships may be terminated either by closing down the business entirely or by disposing of the
business as a going concern to a limited company.
9.5 Keywords
Partnership Account: An account at a brokerage held by two or more people in which each person is
equally liable.
Partnerships: When a partnership is formed or a partner is added and contributes assets other than cash.
Income Allocations: The partnership agreement should include how the net income or loss will be
allocated.
Accounting for Partnerships: Accountancy provides a good opportunity to revisit the topic of accounting
for partnerships.
Dissolution of Partnership: It means termination of existing partnership agreement and the formation of a
new agreement which can be due to any reason

1. If partners maintain both fixed capital and current accounts, which of the following would normally be
credited to a partner‘s capital account?
(a)Profits on revaluation (b)Interest on capital
(c)Goodwill being written off (d)Losses on revaluation
2. A debit balance on a partner‘s current account must indicate that:

(a)They are insolvent
(b)They have withdrawn more than they have earned in the partnership
(c)They have a credit balance on their capital account
(d)Drawings are higher than the profit share for that year
3. Which of the following would not appear in a limited company‘s appropriation account?
(a)Proposed taxation (b)Interim dividends
(c)Transfer to general reserve (d)Transfer to revaluation reserve
4. Which of the following statement is not true?

(a)The partnership agreement will override the 1890 Partnership Act
(b)Interest on capital is a reward for the different amounts of work partners may perform
(c)Capital contributions do not have to be equal from each partner
(d)Not all partners can have limited liability in a limited partnership
5. Which of the following is not a requirement made on a firm becoming a public limited company?
(a)An authorised capital of at least INR36,00,000
(b)It must have the words ―public limited company‖ or the abbreviation ―plc‖ after its name
(c)At least two members
(d)Shares must be offered for sale on the Stock exchange
6. A company has issued 50,000, INR72 ordinary shares and 60,000 5% preference shares of INR72 each.
If profits available for dividends are INR3,60,000 and the firm wishes to give out all available profits as
dividends then the amount given out per ordinary share would be:
(a) INR 7.20 (b) INR2.88
(c) INR4.32 (d) INR2.88
7. In normal trading circumstances, which of the following would not be found in a partner‘s capital
account?
(a)Profits on revaluation (b)Drawings
(c)Losses on dissolution (d)Goodwill
8. Which of the following is not a capital reserve?

(a)Fixed asset replacement (b)Revaluation
(c)Share premium (d)Capital redemption
9.One advantage of operating as a partnership would include:

(a)limited liability for all partners
(b)being able to raise capital through share issues
(c)greater power than a sole trader for decision making
(d)access to a larger amount of initial capital
10.Which of the following would not be found in a partnership appropriation account?

(a)Salaries (b)Interest on loan by partner to partnership
(c)Interest on drawings (d)Interest on capital

1. What do you mean by partnership account?
2. What are the problems relating to Admission?
3. What is the advantage of operating as a partnership?
4. What is the partnership agreement?
5. What do you mean by dissolution?
6. How to overcome the admission problem?
7. What do you understand by Death and Dissolution of a Firm
8. How can you explain partnership profit and loss sharing?
9. How Capital of the partners is maintained?
10. What do you mean by banking partnership business?
Answers to Self Assessment
1 (a) 2 (a) 3 (b) 4 (d) 5 (d)
6 (a) 7 (a) 8 (d) 9 (b) 10 (a)
10
Accounting of Non Profit Organization
CONTENTS
Objectives
Introduction
10.4 Summary
10.5 Keywords
Objectives
Describe the accounting of insurance
Explain the incomplete records
Explain the preparation of incomplete records in account
Introduction
A nonprofits organization is formed for the purpose of serving a public or mutual benefit other than the
pursuit or accumulation of profits for owners or investors. ―The nonprofits sector is a collection of entities
that are organizations; private as opposed to governmental; non-profit distributing; self-governing;
voluntary; and of public benefit‖ The nonprofits sector is often referred to as the third sector, independent
sector, voluntary sector, philanthropic sector, social sector, tax-exempt sector, or the charitable sector.
Accounting is always done with respect to an entity. An accounting entity may be an individual such as a
sole proprietor, a doctor, a lawyer or a chartered accountant. An accounting entity may also be a group of
persons such as a Hindu Undivided Family, a Partnership Firm, a Joint Stock Company, a Cooperative
Society, a Club, a Hospital, School, etc.
On the basis of the objectives to be achieved accounting entities can be divided into two categories. These
are:
(i) Entities for profit, and
(ii)Not-for-profit entities
Entities for Profit
The objective of such entities is to conduct business and earn profit. These entities include manufacturers,
wholesalers, retailers, service providers such as transporters, bankers, insurance agencies, and
professionals such as doctor‘s lawyer, engineers, architects, professional advisors, etc.
Not-for-profit Entities
The objective of such entities is to provide services to the people without any intentions to seek profit. The
main objective of these entities may be social, educational, religious, cultural or charitable. These entities
may be in the form of sports club, social or literary club, religious institutions, libraries, hospitals,
educational institutions, professional bodies, societies and charitable institutions like orphanage homes,
and old age homes.
Some not-for-profit entities such as sports and recreation clubs exist with the primary objective of
providing services to its members. These may consists one or more sub entity, which may undertake
trading in order to add the income from memberships, subscriptions, donations and grants.
For example, a cricket club, a not-for-profit organization may run a restaurant as a sub entity of cricket
club to earn profit and the same fund may be used for the furtherance of the objectives of the club.

Around mid-2010, the IASB and FASB plan to issue a draft standard on accounting for insurance
contracts, with the objective of issuing final version in the first half of 2011. The publication of this draft is
a major milestone in a process that started more than a decade ago to develop a standard for the
measurement of insurance liabilities. Both boards have made considerable progress over the past year,
despite distractions arising from the financial crisis, and the project is now moving forward with a real
sense of urgency for several reasons:
A number of major economies including Brazil, Canada, India, Japan, Korea and Mexico have
announced plans to adopt IFRS or move their reporting standards to IFRS between 2010 and 2012.
Due to internal rotation rules, the IASB chair and all board members who have participated in the
project over many years will complete their terms by 2011. It would be unrealistic to expect a new
board to get acquainted with the specifics of the insurance business and finalize the project quickly.
The new insurance contract standard will affect more than just those companies subject to IFRS. Given
FASB involvement in the insurance contract project, current insurance-related U.S. GAAP standards
will likely be replaced by a similar standard in a similar time frame, leading to significant changes in
U.S. GAAP insurance accounting.
The insurance contract standard is not the only change that will affect reporting by insurance entities.
Following comments received during the financial crisis about the existing reporting standards for
financial instruments, the IASB and FASB are working vigorously to revise them. As a result, on the IFRS
side, IFRS 9: Financial Instruments was published in November 2009. This new standard for financial
instruments, which so far contains new classification and measurement rules for financial assets, will
replace IAS 39, the previous standard. It allows fair-value and amortized cost measurement models for
financial assets, where an entity‘s business model and the contractual terms of its assets determine
classification. Subject to adoption procedures in certain jurisdictions, these rules will become mandatory
for reporting periods beginning January 1, 2013, with the possibility of early adoption. In addition, the
classification and measurement of financial liabilities, the impairment model for assets measured under
amortized cost and the principles for hedge accounting are also being reviewed. The outstanding final
IFRS and U.S. GAAP standards are expected to be published by the end of 2010.
A number of other IASB projects in progress will lead to further changes that need to be understood and
implemented. Among these is the fair-value project, which aims to clarify the definition of fair value and
establish a single source of guidance for all fair-value measurements, and the revenue recognition project,
which will prescribe the accounting for contracts with customers in general, including pure service
contracts. Within the next few years, insurance companies preparing their financial statements under IFRS
and U.S. GAAP will face unprecedented change. This is expected to lead to significant differences in the
way that companies measure and communicate their performance, and manage their business and the
products they sell. It is imperative that insurers follow these developments closely, quantify the impact of
proposed changes and understand the business model implications before implementation
10.1.1 General Insurance Accounting

With the opening of insurance sector, the number of general insurance companies operating in the country
is increasing gradually. At present there are 13 general insurance companies out of which 8 are private
sector companies‘ viz. Royal Sunderam, Tata AIG, Reliance General, IFFCO Tokyo, ICICI Lombard,
Bajaj Allianz, HDFC Chubb, Cholamandalam, and remaining 5 companies are public sector companies
like The New India Assurance Company Ltd, National
Insurance Company Ltd, United India Insurance Company Ltd, Oriental General Insurance Company Ltd
and ECGC. At present there is one national reinsurer viz. General Insurance Corporation of India. For the
year 2003-04, the total premium completion of the general insurance business is 16118 crore with the
accretion rate of 13%. Still there is lot of untapped general insurance market and there is a huge potential
for development of general insurance business.
Normally most of the general insurance policies are annual policies with few exceptions as Erection
policies; Contractor‘s All Risk policies etc. Nowadays there is an increasing trend to issue long term
policies in personal lines of business such as Personal Accident Policies, Housing Loan Policies etc.
Legal Framework: The primary legislations which deal with the insurance business in India are the
Insurance Act, 1938 and the IRDA Act, 1999. Various aspects relating to accounts and audit are dealt with
by the following statutes and rules/ regulations made there under;
(1) The Insurance Act, 1938 (including Insurance Rules, 1939)
(2) The Insurance Regulatory and Development Authority Act, 1999;
(3) The Insurance Regulatory and Development Authority Regulations;
(4) The Companies Act, 1956; and
(5) The General Insurance Business (Nationalisation) Act, 1972 (including Rules framed there under).
S 11 of the Insurance Act, 1938 prescribes the manner in which the accounts of an insurance company
have to be maintained. With the opening of the insurance sector for private players, IRDA Act, 1999 was
passed to provide for the establishment of an Authority to protect the interests of the holders of insurance
policies, to regulate, promote and ensure orderly growth of the insurance industry and for matters
connected therewith or incidental thereto and further to amend the Insurance Act, 1938, the Life Insurance
Corporation Act, 1956 and the General Insurance Business (Nationalisation) Act, 1972. Section 114A of
The IRDA Act, 1999 empowers IRDA to make regulations consistent with the Act, to carry out the
purposes of this Act for various matters specified in said Section 114A.
In exercise of the powers conferred by section 114A of the Insurance Act, 1938 (4 of 1938), and in
supersession of The Insurance Regulatory and Development Authority (Preparation of financial Statements
and Auditors Report of Insurance Companies) Regulations, 2000, Authority, in consultation with the
Insurance Advisory Committee, has made the Insurance Regulatory and Development Authority
(Preparation of Financial Statements and Auditors Report of Insurance Companies) Regulations, 2002.
Thus the Regulations made in the year 2000 were modified and superseded by the Regulations made in the
year 2002. As per these Regulations, an insurer carrying on general insurance business has to comply with
the requirements of Schedule B.
Accounting Principles for Preparation of Financial Statements

1. Applicability of Accounting Standards: Every Balance Sheet, Receipts and Payments Account
(Cash Flow Statement) and Profit and Loss Account (Shareholders Account) of the insurer shall be in
conformity with the Accounting Standards (AS) issued by the ICAI to the extent applicable to the insurers
carrying on general insurance business. However, there are 3 exceptions viz.
(i) AS-3 Cash Flow Statement shall be prepared only under Direct Method
(ii) AS-13 Accounting for Investments, shall not be applicable and
(iii) AS-17 Segment Reporting shall apply to all insurers irrespective of the requirements regarding listing
and turnover mentioned therein.
2. Premium: Premium shall be recognised as income over the contract period or the period of risk,
whichever is appropriate. Premium received in advance, which represents premium income not relating to
the current accounting period, shall be disclosed separately under the head ―Current Liabilities‖ in the
financial statements.
A reserve for unexpired risks shall be created as the amount representing that part of premium written
which is attributable to, and to be allocated to the succeeding accounting periods and shall not be less than
as required under 64V(1)(ii)(b) of the Act.
As per the provisions of section 64V (1) (ii) (b), reserve for unexpired risks shall be created in respect of:
(i) Fire and miscellaneous business, 50%
(ii) Marine cargo business, 50%, and
(iii) Marine hull business, 100% of the premium, net of re-insurances, during the preceding twelve months.
3. Premium Deficiency: Premium deficiency shall be recognised if the sum of expected claim costs, related
expenses and maintenance costs exceed related reserve for unexpired risks.
4. Acquisition Costs: Acquisition costs, if any shall be expensed in the period in which they are incurred.
5. Claims: The ultimate cost of claims to an insurer comprises the claims under the policies and specific
claims settlement costs. Claims under policies comprise the claims made for losses incurred, and those
estimated or anticipated under the policies following a loss occurrence.
A liability for outstanding claims shall be brought to accounts in respect of both direct business and inward
reinsurance business. The liability shall include:-
(a) Future payments in relation to unpaid reported claims;
(b) Claims Incurred but Not Reported (IBNR) including inadequate reserves (sometimes referred to as
Claims Incurred but Not Enough Reported (IBNER)), which will result in future cash/asset outgo for
settling liabilities against those claims. Change in estimated liability represents the difference between the
estimated liability for outstanding claims at the beginning and at the end of the financial period.
The accounting estimates shall also include claims cost adjusted for estimated for estimated salvage value
if there is sufficient degree of certainty of its realisation.
Claims made in respect of contracts where the claims payment period exceeds four years shall be
recognised on actuarial basis.
6. Procedure to determine the value of investments: According to this sub clause of the Regulations, a
detailed procedure has been prescribed for determining value of various investments viz.
(a) Real Estate- Investment Property: To be measured at historical cost less accumulated depreciation and
impairment loss. Revaluation is not permissible. Fair value as at the balance sheet date and the basis of its
determination shall be disclosed in the financial statements as additional information.
(b) Debt Securities shall be considered as ―held to maturity‖ securities and shall be measured at historical
cost subject to amortization.
(c) Equity Securities and Derivative Instruments that are traded in active markets shall be measured at fair
value as at balance sheet date. For the purpose of calculation of fair value, the lowest of the last quoted
closing price of the stock exchanges where securities are listed shall be taken. Unrealized gains/losses
arising due to change in the fair value of listed equity shares and derivative instruments shall be taken to
equity under the head ―Fair Value Change Account‖. Profit/Loss on sale of such investments shall include
accumulated changes in the fair value previously recognized under the heading Fair Value Change
Account in respect of a particular security and being recycled to Profit and Loss Account on actual sale of
that listed security. The balance in Fair Value Change Account or any part thereof shall not be available for
distribution as dividends. Also, any debit balance in the said Fair Value Change Account shall be reduced
from the profits/free reserves while declaring dividends.
(d) Unlisted and other than actively traded Equity Securities and Derivative Instruments will be measured
at historical costs. Provision shall be made for demolition in value of such investments.
7. Loans: Loans shall be measured at historical cost subject to impairment provisions.
8. Catastrophe Reserve: Catastrophe reserve shall be created in accordance with the norms, if any,
prescribed by the Authority. Investment of funds out of catastrophe reserve shall be made in accordance
with prescription of the Authority.
Till date the Authority has not prescribed any norms for creation of such reserve.
PART II- Disclosures forming part of Financial Statements: This contains various disclosures to be made
by an insurer as per sub clause A, B and C.
PART III: General Instructions for Preparation of Financial
Statements: This part contains 8 instructions for the preparation of financial statements.
PART IV: Contents of Management Report: The management report is required to be attached to the
financial statements. This report contains various confirmations, certifications and declarations duly
authenticated by the management.
PART V: Preparation of Financial Statements: An insurer shall prepare the Revenue Account,
Profit and Loss Account (Shareholders‘ Account) and the Balance Sheet in Form B-RA, Form B-PL, and
Form B-BS, or as near thereto as the circumstances permit. An insurer shall prepare Revenue Accounts
separately for fire, marine and miscellaneous insurance business and separate schedules shall be prepared
for Marine Cargo, Marine- Other than Marine Cargo and the following classes of miscellaneous insurance
business under miscellaneous insurance and accordingly application of AS-17 Segment Reporting- shall
stand modified.
1. Motor
2. Workmen‘s Compensation
3. Employers‘ Liability
4. Public/Product Liability
5. Engineering
6. Aviation
7. Personal Accident
8. Health Insurance
1. Others
An insurer shall prepare separate Receipts and Payments Account in accordance with the Direct Method
prescribed in AS-3 ―Cash Flow Statement‖ issued by the ICAI.

Accounting records, which are not strictly kept according to double entry system, are known as incomplete
records. Many authors describe it as single entry system. However, single entry system is a misnomer
because there is no such system of maintaining accounting records. It is also not a ―short cut‖ method as an
alternative to double entry system. It is rather a mechanism of maintaining records whereby some
transactions are recorded with proper debits and credits while in case of others, either one sided or no entry
is made. Normally, under this system records of cash and personal accounts of debtors and creditors are
properly maintained, while the information relating to assets, liabilities, expenses and revenues is partially
recorded. Hence, these are usually referred as incomplete records.
Incomplete records are the term used for any system of bookkeeping which does not use full double entry.
There may be many reasons why a firm has incomplete records, but whatever the reason, accounts must be
prepared using a number of techniques. Once one has mastered these techniques, he should find
incomplete records problems more straightforward. It should be said that the techniques needed to
complete examination problems are also used in practice when a client‘s records are incomplete.
Techniques
The techniques to be mastered are:
Preparing an opening Statement of Affairs;
Preparing the main control accounts;
Preparing the Bank Account;
Calculating gross profit;
Drafting the Profit and Loss Account;
Drafting the Balance Sheet.
It is also important to ensure that the analyst has a sound knowledge of the double entry required for
transactions involving sales (both for cash and on credit), purchases (again both for cash and on credit), as
well as cash transactions for expenses and other cash received (usually capital introduced).
Solving incomplete records problems is a matter of working through each of these steps. If one use
standard workings for each, and insert the figures which are given in the question, the problem becomes
one of finding the missing figures. Let us consider each of the steps and the relevant workings.
Opening Statement of Affairs

When a Balance Sheet has to be prepared using estimated values, we refer to it as a Statement of Affairs.
The first step is to set out the main headings which are used in a Balance Sheet. We can then use the
available information to obtain the relevant values. The main headings which are needed are:
Fixed Assets
Current Assets
Stock
Debtors
Cash and Bank
Current Liabilities
Creditors
Bank overdraft
Loans
Capital
The first task is to set out these headings and then review the question for the relevant information so that
anyone can insert the values for as many figures as possible.
Usually there will be two values missing:
Fixed assets and capital

As capital is the balancing figure, it is usually necessary to work out the value for fixed assets. A
methodical approach is important here. The question will usually tell when the various assets where
acquired, as well as the depreciation policy. The task is to calculate the net book value at the date of the
Statement of Affairs by starting with the year of acquisition and applying the depreciation policy to obtain
the net book value at the end of that year. Repeat that process for each year until one has reached the date
of the Statement of Affairs. Once one has the value for fixed assets, the capital balance can be calculated:
Fixed assets + current assets – current liabilities = capital
Control Accounts
Control accounts are needed for:
debtors
creditors
cash
10.2.1 Features of Incomplete Records

In complete records may be due to partial recording of transactions as is the case with small shopkeepers
such as grocers and vendors. In case of large sized organizations, the accounting records may be rendered
to the state of incompleteness due to natural calamity, theft or fire. The features of incomplete records are
as under:
(a) It is an unsystematic method of recording transactions.
(b) Generally, records for cash transactions and personal accounts are properly maintained and there is no
information regarding revenue and/or gains, expenses and/or losses, assets and liabilities.
(c) Personal transactions of owners may also be recorded in the cash book.
(d) Different organizations maintain records according to their convenience and needs, and their accounts
are not comparable due to lack of uniformity.
(e) To ascertain profit or loss or for obtaining any other information, necessary figures can be collected
only from the original vouchers such as sales invoice or purchase invoice, etc. Thus, dependence on
original vouchers is inevitable.
(f) The profit or loss for the year cannot be ascertained under this system with high degree of accuracy as
only an estimate of the profit earned or loss incurred can be made. The balance sheet also may not reflect
the complete and true position of assets and liabilities.
10.2 2 Reasons of Incompleteness and its Limitations

It is observed, that many businessmen keep incomplete records because of the following reasons:
(a) This system can be adopted by people who do not have the proper knowledge of accounting principles;
(b) It is an inexpensive mode of maintaining records. Cost involved is low as specialised accountants are
not appointed by the organisations;
(c) Time consumed in maintaining records is less as only a few books are maintained;
(d) It is a convenient mode of maintaining records as the owner may record only important transactions
according to the need of the business.
However, the mechanism of incomplete records suffers from a number of limitations. This is due to the
basic nature of this mechanism. Broadly speaking, unless a systematic approach to maintenance of records
is followed, reliable financial statements cannot be prepared.
The limitations of incomplete records are as follows:

(a) As double entry system is not followed, a trial balance cannot be prepared and accuracy of accounts
cannot be ensured.
(b) Correct ascertainment and evaluation of financial result of business operations cannot be made.
(c) Analysis of profitability, liquidity and solvency of the business cannot be done. This may cause a
problem in raising funds from outsiders and planning future business activities.
(d) The owners face great difficulty in filing an insurance claim with an insurance company in case of loss
of inventory by fire or theft.
(e) It becomes difficult to convince the income tax authorities about the reliability of the computed income.
Did You Know?

Bartering was the dominant practice for travelling merchants during the Middle Ages of the 13th century.
It is necessary to know the result of business activities to assess the efficiency and success or failure of the
organization. This gives rise to the need for preparing the financial statements to disclose:
The profits made or loss sustained by the firm during a given period, and to disclose the amount of
assets and liabilities as at the closing date of the accounting period.
This is true even for firms which have incomplete records. The problem faced in this situation is how
to ascertain profit or loss for an accounting year and determine the financial position of the entity at the
end of that year form the incomplete records. This problem can be solved by-
Ascertaining the profit or loss by preparing the Statement of Affairs at the beginning and at end of the
accounting period, and then analyze the changes in owner‘s equity during the accounting period.
Preparing profit and loss account and balance sheet by putting the accounting records in proper order.
10.3.1 Ascertainment of Profit or Loss by preparing the Statement of Affairs

Under this method, statement of assets and liabilities at the beginning and at the end of the relevant
accounting period are prepared to ascertain the change in owner‘s equity at the end of accounting period.
This is followed by the statement showing ascertainment of profit by analyzing non operating changes in
owner‘s equity. The statements so prepared show assets on one side and the liabilities on the other just as
in case of a balance sheet. The difference between the totals of the two sides is known as owner‘s equity.
This can be also expressed in the form of accounting equation as follows:
Assets = Liabilities + Owner‘s Equity
The above equation is rearranged to ascertain the owner‘s equity as follows
Owner‘s Equity = Assets - Liabilities
Conversely, there may be a situation when the liabilities may exceed the total assets. In such a case, the
difference will indicate ‗losses carried forward from the previous year. In this case, owner‘s equity will be
negative.
Though the Statement of Affairs appears to resemble with the balance sheet, but it is not a balance sheet,
because the balances of various assets and liabilities are not derived from the ledger accounts. The
difference between owner‘s equity at two points, i.e. opening and closing represents the increase or
decrease made by the owner and the new capital introduced by him during the accounting period to
ascertain the change in owner‘s equity due to operating activities. In case, the balance is positive it will
indicate the profit earned during the year, while in case of negative balance it will be the loss sustained by
the firm. To ascertain the profit or loss, following steps are to be taken:
Step 1
Calculate owner‘s equity at the beginning (opening owner‘s equity) and at the end of the period (closing
owner‘s equity).
Step 2
Subtract the opening balance of owner‘s equity from closing balance of owner‘s equity. Here, there may be
two situations:
(i) The change in owner‘s equity may be positive, i.e., excess of closing owner‘s equity over opening
owner‘s equity.
(ii) The change in owner‘s equity may be negative, i.e., excess of opening owner‘s equity over closing
owner‘s equity.
Step 3
In case of introduction of fresh capital and/or withdrawals made by the owner the following adjustments
are required:
(i) Subtract the amount of capital introduced during the period from the amount calculated in step 2.
(ii) Add the amount of withdrawals made by the owner during the period to the amount calculated in step
2.
Step 4
If the net result is positive, it represents profit and if it is negative, it represents earned loss sustained
during the accounting year. This process of measuring profit or loss is summarized as follows:
Profit (Loss) = O1 – O0 + d – I
Where,
O0 = A0 – L0
O1 = A1 – L1
O1 = Owner Equity at the beginning
A0 = Assets at the beginning
L0 = Liability at the beginning
O1 = Owner‘s Equity at the end
A1 = Assets at the end
L1 = Liability at the end
I = Introduction or addition to the capital during the period
D = Withdrawal during the period
∆O = Change of owner‘s equity.
10.3.2 Preparation of Profit and Loss Account and Balance Sheet

Generally, the Statement of Affairs method is used where it is difficult to compile even a reasonable
summary of cash transactions. There is a need to obtain as far as much information as possible about the
assets and liabilities at the beginning as well as at the close of the year. Bank and cash book with bank
column. Value of fixed assets, may be ascertained from the purchase documents if available with the trader
or estimated by inquiring from the supplier of such an asset. In some firms detailed information may be
available about business activities. If details of accounts payable, purchases, cash received, sales, accounts
receivable, bills receivables, bills payable, cash payments, with cash summary of transactions are available,
it may be possible to work out some of the missing figures by using the logic of double entry system of
accounting. This in turn, will help in the preparation of Profit and Loss Account and Balance Sheet.
Hereunder, we demonstrate how available information can be used to prepare the accounts to ascertain
missing figures, which will help in preparation of Profit and Loss account and Balance Sheet.
Caution
While preparation of profit and loss account and balance sheet information must be obtained from the
various documents/vouchers such as invoices for sales and purchases receipts for a payment made and cash
obtained.
Ascertainment of Missing Information about Credit Purchases and Payables

Credit purchases and Accounts Payables (creditors and bill payables) are interconnected.
Therefore, missing information about the credit purchases and any item relating to creditors and bills
payables can be obtained by preparing these accounts simultaneously. Typical Accounts Payable and Bills
Payable accounts are given in Table 10.1
When available information is placed in these two accounts, one can ascertain which items are missing.
The connecting items between Bills Payable and Accounts Payable accounts are: bill accepted during the
year against credit purchases, and dishonored bills payable. By making use of connecting items, missing
information can be ascertained.
For example, to calculate missing information about purchases, the bills payable account is to be
completed/ closed. Once the bills payable account is completed with all the required items then accounts
payable account needs to be completed. The total credit purchases made during the year will be available
on the credit side of accounts payable account. By adding cash purchases (available from the cashbook
summary) to this figure we obtain total purchases made during the period. If there are purchase returns,
they have to be deducted from the total purchases to get the net purchases. This figure of net purchases can
be placed on the debit side of the Profit and Loss Account.
Table 10.1: Total creditors accounts
10.3.3 Ascertainment of Missing Information about Credit

The bills of exchange become bills receivable. It is to be noted that credit sales, Debtors and bills
receivable are interrelated. Debtors and Bills Receivable account are therefore, prepared simultaneously.
Preparing Summary Statement of Cash Transaction to Ascertain Missing Information

Summary of cash transactions record the cash receipts and cash payments. Cash receipts indicates opening
balance of cash and receipts on account of cash sales, cash received from debtors, cash collected on
maturity of bills receivable and other receipts such as interest, commission and tax refund. The cash
payment includes payment to creditors, payment on retirements of bills payables, payments of dues,
expenses and taxes. The with-drawls made by the proprietor/ partner are also shown on the payments side
along with the closing balance. While preparing cash book summary one may find a missing figure. In case
of bank transactions, a bank overdraft appears on the other side.
The balancing figure has to be carefully identified as the missing figure. To ascertain missing information
for preparation of final accounts, all the information available should be carefully recorded by
simultaneously opening relevant accounts. Then, balance those accounts, which have only one missing
information pass transfer entries by making use of connecting items. (See Table 10.3)
Table 10.3: Cash of transaction
Case Study-Optimizing a Global Insurance Company’s Procure-to-Pay Function

The Client’s Challenge
A global insurance group had already established a shared services/global in-house center (GIC), but was
concerned that the promises around savings and customer satisfaction made by its previous advisory firm
were failing to be realized. As a result, it engaged Everest Group to assist with analyzing and optimizing its
Procure-to-Pay (P2P) function.
Insight to Action
Putting its Service Improvement methodology to work, Everest Group initiated a rigorous data collection
activity to capture baseline costs and construct a comprehensive view of the current P2P environment
(FTEs, costs, application environment, and organizational structure). Everest Group also extensively
analyzed the client‘s spending distribution across all its purchases.
Leveraging its extensive knowledge of P2P best practices gained by its frequent interaction with
outsourcing providers and the marketplace in general, Everest Group quickly formulated a list of ―gaps to
best practice,‖ and built a detailed implementation plan to jump those gaps to the desired future state.
Further, Everest Group suggested a large-scale procurement enhancement project to cleanse the vendor
master file, analyze and optimize spend, dramatically reduce the number of vendors it currently used, and
employ strategic sourcing initiatives.
Impact
Via its Service Improvement methodology, Everest Group was able to rationalize the client‘s P2P
accounting resource base by more than 30%, and the client is currently realizing savings of more than 18%
on total spend. End users of the P2P process are reporting enhanced satisfaction with the management
reporting being provided and on time vendor payment percentage has risen from 68% to 98%. As a result,
millions of dollars in available discounts are now being realized as well. Consequently, the client engaged
Everest Group to optimize its ―Order to Cash‖ and ―Record to Report‖ accounting processes.
Questions
1. How Everest Group extensively analyze the client‘s spending distribution across all its purchases.
2. What are the impacts of Service Improvement methodology?
10.4 Summary
Incomplete records refer to lack of accounting records according to the double entry system. Degree of
incompleteness may vary from highly disorganized records to organized but still not complete.
A Statement of Affairs is a statement showing various assets and liabilities of a firm on date, with
difference between the two sided denoting owner‘s equity. Since the records are incomplete, the values
of assets and liabilities are normally estimates based on information available.
The statement of affairs is used to compute Profit or Loss when a firm has a highly disorganized set of
incomplete records. It may not be possible to prepare a cash summary in such a situation.
Two statements of affairs are prepared to find out opening and closing equity amounts. To the
difference between the closing and opening equity , any sum withdrawn from business are added back
and any additional capital introduced during the year are deducted. To find out Profit and Loss made
for the period.
When cash summary of a firm is available along with information about personal accounts of creditors
and customers, an attempt can be made to prepare the Profit and Loss Account and Balance Sheet.
10.5 Keywords
Creditor: Amount owed to a supplier from the business.
Current Asset: Short-term asset (items or amounts to be used or received within 12 months) e.g. stock or
cash.
Current Liability: Short-term liability (items or amounts to be paid within 12 months) e.g. supplier or bank
overdraft.
Debit: Expenses in the Profit and Loss or Asset in the Balance sheet.
Debtor: Amount owed to the business from a customer.
Deferred Revenue Expenditure (DRE): Deferred revenue expenditure is a revenue expenditure which has
been incurred during one accounting year which is applicable either wholly or in part to further accounting
years.

1. Incomplete records are generally found in use by ………………..
(a) Small Traders (b) Society
(c) Company (d) Government
2. When Closing Owner‘s Equity is greater than Opening Owner‘s Equity, it denotes......
(a) Profit (b) Loss
(c) Profit, if there is no introduction (d) No profit no loss
3. If owner‘s equity in the beginning is INR21,000. Fresh capital introduced during the year is INR7,000.
Amount withdrawn during the year is INR13,000, then the closing owner‘s equity will be:
(a) INR27, 000 (b) INR15, 000
(c) INR41, 000 (d) INR1, 000
4. Credit Sales is obtained from:

(a) Bills Receivables (b) Accounts Receivables
(c) Accounts Payable (d) Cash Summary
5. Credit purchases can be obtained from:

(a) Statement of Affair (b) Bank
(c) Bills Receivable (d) Account Payable
6. Information about bills received dishonored can also be obtained from:
(a) Summary of cash transaction (b) Profit and Loss account
(c) Accounts Payable (d) Accounts Receivable
7. Discount received from accounts payable may be obtained from:

(a) Cash statement (b) Bills Receivables
(c) Accounts Receivables (d) Accounts Payables
8. Credit purchase can be ascertained as the balancing figure in the ………………..

(a) bills payable (b) accounts Receivables
(c) accounts payable (d) All of these.
9. The amount received from debtors can be traced from ………………….. .

(a) journal (b) balance sheet
(c) accounts (d) cash Summary
10. Increase in owner‘s equity at the end of the period represents ………………
(a) profit (b) loss
(c) accounts (d) All of these.

1. What are incomplete records?
2. What are the possible reasons for maintaining incomplete records?
3. Differentiate between a statement of affairs and a balance sheet.
4. What practical difficulties are encountered by a trader due to the incompleteness of accounting
records?
5. What is meant by a ―Statement of Affairs‖? How can the Profit or Loss of a trader be ascertained with
the help of a Statement of Affairs?
6. ―Is it possible to prepare the Profit and Loss Account and the Balance Sheet from the incomplete books
of accounts kept by a trader‖ Do you agree? Explain?
7. Describe the procedure of ascertaining credit sales, collection from accounts receivables, payments to
accounts payable closing balance and bills receivable.
8. Explain how the following may be ascertained from incomplete records:
(a) Opening owner‘s equity and closing owner‘s equity
(b) Credit sales and credit purchases
(c) Payments to creditors and collection from debtors
(d) Closing balance of cash
9. Calculate value of Opening Stock
Purchases INR17, 500
Sales INR45, 000
Closing Stock INR13, 000 Gross Profits @ 33% on Sales.
10. Calculate the amount of closing stock
Opening Stock INR17, 500
Purchases INR37, 500
Sales INR60, 000
Gross Profit @ 25% on Cost/
1 (a) 2 (b) 3 (a) 4 (b) 5 (d)
6 (a) 7 (c) 8 (c) 9 (d) 10 (a)
11
Issue of Shares and Debentures
CONTENTS
Objectives
Introduction
11.6 Summary
11.7 Keywords
Objectives
After studying this chapter; you will be able to:
Understand the meaning of share and debenture
Explain the types of share and debenture
Define the methods of issues of share and debenture
Discuss the forfeited of shares and reissue of forfeited share
Explain the treatment of interest on debenture
Introduction
There are three main types of business organization:
(1) Sole proprietorship
(2) Partnership
(3) Company
Each form of business organization is required capital to carry on its business smoothly on sole
proprietorship the whole capital is contributed by sole proprietor in partnership the capital is invested by
the partners and in case of company capital is invested by the public.
Meaning of share and share capital: A share is one unit into which the total share capital is divided. Share
capital of the company can be explained as a fund or sum with which a company is formed to carry on the
business and which is raised by the issue of shares. The amount collected by the company from the public
towards its capital, collectively is known as share capital and individually is known as share. Investment in
the shares of any company is a basis of ownership in the company and the person who invest in the shares
of any company, is known as the shareholder, member and the owner of that company Share a unit of
ownership interest in a corporation or financial asset. While owning shares in a business does not mean
that the shareholder has direct control over the business's day-to-day operations, being a shareholder does
entitle the possessor to an equal distribution in any profits, if any are declared in the form of dividends.
There are the shares on which some fixed amount of dividend is paid, after working expenses taxes,
interests, etc. are paid, Sometimes, when the profit is not enough even to meet the other expenses, even the
preferred share holders do not get any dividend.
Ordinary (Or Common) Shares: these types of shareholders get dividend only after the holders of
preference shares receive their share of profit. Due to this only the rate of dividend is not fixed and keeps
on varying.
Debenture a certificate or voucher acknowledging a debt. An unsecured bond issued by a civil or
governmental corporation or agency and backed only by the credit standing of the issuer.
A debenture is an unsecured loan you offer to a company. The company does not give any collateral for the
debenture, but pays a higher rate of interest to its creditors. In case of bankruptcy or financial difficulties,
the debenture holders are paid later than bondholders.
Debentures are different from stocks and bonds, although all three are types of investment. Below are
descriptions of the different types of investment options for small investors and entrepreneurs.
Debentures and Shares When you buy shares, you become one of the owners of the company. Your
fortunes rise and fall with that of the company. If the stocks of the company soar in value, your investment
pays off high dividends, but if the shares decrease in value, the investments are low paying. The higher the
risk you take, the higher the rewards you get. Debentures are more secure than shares, in the sense that you
are guaranteed payments with high interest rates.

Shares are the marketable instruments issued by the companies in order to raise the requiredcapital. Shares
are issued by each and every company which goes public. These are verypopular investments which are
traded every day in the stock market and the value of theshare at the end of the day decides the value of the
firm.A company when it decides to raise capital from public prepares a memorandum, capitalrequired
which is written down in this is called as authorized capital and then prospectus isprepared which is
verified by SEBI. SEBI permits the company to raise the capital and as aresult company offers it to the
public this is known as Issued Capital. Part of the capital issuedwhich is subscribed by public is Subscribed
Capital.
If the number of subscriptions is more thanthe number of shares then it is called as over-subscription and
if the number of subscriptions isless then it is called as under subscription. The amount paid by the investor
is Paid up Capital.
Meaning of Debentures
The word ‗debenture‘ has been derived from a Latin word ‗debere‘ which means to borrow. Debenture is a
written instrument acknowledging a debt under the common seal of the company. It contains a contract for
repayment of principal after a specified period or at intervals or at the option of the company and for
payment of interest at a fixed rate payable usually either half-yearly or yearly on fixed dates. According, to
section 2(12) of The Companies Act,1956 ‗Debenture‘ includes Debenture Stock, Bonds and any other
securities of a company whether constituting a charge on the assets of the company or not. Also there are
multiple types of debentures a company can issue.
Bond: is also an instrument of acknowledgement of debt. Traditionally, the Government issued bonds, but
these days‘ bonds are also being issued by semi-government and non-governmental organizations. The
terms ‗debentures‘ and ‗Bonds‘ are now being used inter-changeably.
Shares vs Debentures
Ownership: A shareholder is an owner of the company whereas a debenture holder is only a loan
creditor. A share is a part of the owned capital whereas a debenture is a part of borrowed capital. Return:
The return on shares is known as dividend while the return on debentures is called interest. The rate of
return on shares may vary from year to year depending upon the profits of the company but the rate of
interest on debentures is pre-fixed. The payment of dividend is an appropriation out profits, whereas the
payment of interest is a charge on profits and is to be paid even if there is no profit.
Repayment: Normally, the amount of shares is not returned during the life of the company, while the
debentures are issued for a specified period and the amount of debentures is returned after that period.
However, an amendment in 1998 to The Companies Act, 1956 has permitted the companies to buy back its
own shares from the market, particularly, when the price of its share in the market is lower than the book
value.
Voting Rights: Shareholders enjoy voting rights whereas debenture holders do not normally enjoy any
voting right.
Issue on Discount: Both shares and debentures can be issued at a discount. However, shares can be
issued at discount in accordance with the provisions of Section 79 of The Companies Act, 1956 which
stipulates that the rate of discount must not exceed 10% of the face value.
Security: Shares are not secured by any charge whereas the debentures are generally secured and carry
a fixed or floating charge over the assets of the company.
Convertibility: Shares cannot be converted into debentures whereas debentures can be converted into
shares if the terms of issue so provide, and in that case these are known as convertible debentures.

Companies (Private and Public) need capital either to increase their productivity or to increase their market
reach or to diversify or to purchase latest modem equipments. Companies go in for IPO and if they have
already gone for IPO then they go for FPO. The only thing they do in either IPO or FPO is to sell the
shares or debentures to investors (the term investor here represents retail investors, financial institutions,
government, high net worth individuals. banks etc). Whether they issue shares or debentures totally
depends upon the concerned company.
Shares are the marketable instruments issued by the companies in order to raise the required capital. Shares
are issued by each and every company which goes public. These are very popular investments which are
traded every day in the stock market and the value of the share at the end of the day decides the value of
the firm.
A company when it decides to raise capital from public prepares a memorandum, capital required which is
written down in this is called as authorized capital and then prospectus is prepared which is verified by
SEBI. SEBI permits the company to raise the capital and as a result company offers it to the public this is
known as Issued Capital. Part of the capital issued which is subscribed by public is Subscribed Capital. If
the number of subscriptions is more than the number of shares then it is called as over-subscription and if
the number of subscriptions is less then it is called as under subscription. The amount paid by the investor
is paid up Capital.
Types of Shares
The shares which are issued by companies are of two types
Equity Shares
Preference Shares
Equity Sharps Benjamin Graham one of the most influential and respected investor from America and
author Benjamin Graham one of the most influential and respected investor from America and author of
two bestselling books "Security Analysis" and "Intelligent Investor" has said that the investor should not be
too worried about the present performance of the stocks in the market and should be bothered about long
term. The reason that he gives is that stocks behave like a voting machine in short term and like weighing
machine in long term. These sentences are definitely applicable to shares and pretty much define their
characteristics. Equity Shares are issued and are traded everyday in the stock market. The returns on the
equity shares are not at all fixed. It depends on the amount of profits made by the company. The board of
directors decides on how much of the dividends will be given to equity share holder. Share holders can
accept to it or reject the offer during the annual general meeting.
Types of Equity Shares

The Equity share is a common name, some of the types of equity shares are
Blue Chip Shares
Income Shares
Growth shares
Cyclical Shares
Defensive share
Speculative shares
Blue Chip Shares
These are the shares of some of the companies which have been doing extremely well in the past few
years. These are usually well established companies. The word blue-chip shares came into existence when
IBM Company was doing very well and shares of that company were trading at higher prices. The
companies which come under this umbrella are never fixed as the performance of some of the companies
may suddenly fall down and some of the companies which never did well start to do extremely well. Hence
it can be said that list of blue-chip companies keeps on changing each year. The companies which come
under this are market leaders and have the potential to dictate terms.
Income Shares: These are the shares of the companies which have stable operations. The companies
have a high dividend payout ratio and when the dividends paid are high it implies that the profits saved for
company is less and hence less opportunities of growth.
Growth Shares: These are the shares of companies which have secured their positions in a particular
industry. These shares have less dividend payout ratio and hence high growth potential.
Cyclical Shares: There is a definite business cycle that keeps on operating and these are the shares of
that company whose performance varies with the stages of the cycle. It means to say that the prices of the
shares are affected by the variations in the economy.
Defensive Shares: These are the shares of the company whose performance does not change with the
changes in the economy.
Speculative shares: These are the shares which are traded in the company which have a lot of
speculations. Shares cannot be put into one category strictly because the characteristics of the shares are
overlapping in the sense that the blue-chip shares which are in great demand in the market fall under blue-
chip shares and speculative shares.
Further Classification
One more classification of shares is given by one of the most successful and respected investor all around
the world Peter Lynch. According to him the shares can be classified into 6 types
Slow Growers
Fast Growers
Stalwarts
Cyclical
Turn-around
Asset plays
Slow Growers: These are large companies which have the growth rate equal to the industry growth rate
or their growth is equal or slightly faster than the GDP (Gross Domestic Product).
Fast Growers: These are shares of newly started successful companies which have a very good growth
rate (the rate is usually 10 to 25%) per year.
Stalwarts: These are shares of very large companies which have stable growth. The dividend payout
ratio is high. These companies are growing but not rapidly as in the case of fast growers.
Cyclical: These are the shares of the company which is going through the business cycle or there is
variation due to economic factors.
Turn-around: These are the shares of the companies which have started performing very well. These
companies were fairing badly in the past and all of a sudden there is a turn-around in their
performance.
The word ‗debenture‘ has been derived from a Latin word ‗debere‘ which means to borrow.
Debenture
Debenture is a written instrument acknowledging a debt under the common seal of the company. A
company may issue different types of debentures which can be classified as under (See Figure 11.1):
Figure 11.1: Types of debenture.
From the Point of view of Security

Secured Debentures: Secured debentures refer to those debentures where a charge is created on the
assets of the company for the purpose of payment in case of default. The charge may be fixed or
floating. A fixed charge is created on a specific asset whereas a floating charge is on the general assets
of the company. The fixed charge is created against those assets which are held by a company for use
in operations not meant for sale whereas floating charge involves all assets excluding those assigned to
the secured creditors.
Unsecured Debentures: Unsecured debentures do not have a specific a charge on the assets of the
company. However, a floating charge may be created on these debentures by default. Normally, these
kinds of debentures are not issued.
From the Point of view of Tenure

Redeemable Debentures: Redeemable debentures are those which are payable on the expiry of the
specific period either in lump sum or in Instalments during the life time of the company. Debentures
can be redeemed either at par or at premium.
Irredeemable Debentures: Irredeemable debentures are also known as Perpetual Debentures because
the company does not give any undertaking for the repayment of money borrowed by issuing such
debentures. These debentures are repayable on the on winding-up of a company or on the expiry of a
long period.
From the Point of view of Convertibility

Convertible Debentures: Debentures which are convertible into equity shares or in any other security
either at the option of the company or the debenture holders are called convertible debentures. These
debentures are either fully convertible or partly convertible.
Non-Convertible Debentures: The debentures which cannot be converted into shares or in any other
securities are called nonconvertible debentures. Most debentures issued by companies fell in this
category.
From Coupon Rate Point of view

Specific Coupon Rate Debentures: These debentures are issued with a specified rate of interest, which
is called the coupon rate. The specified rate may either be fixed or floating. The floating interest rate is
usually tagged with the bank rate.
Zero Coupon Rate Debentures: These debentures do not carry a specific rate of interest.
In order to compensate the investors, such debentures are issued at substantial discount and the
difference between the nominal value and the issue price is treated as the amount of interest related to
the duration of the debentures.
From the view Point of Registration

Registered Debentures: Registered debentures are those debentures in respect of which all details
including names, addresses and particulars of holding of the debenture holders are entered in a register
kept by the company. Such debentures can be transferred only by executing a regular transfer deed.
Bearer Debentures: Bearer debentures are the debentures which can be transferred by way of delivery
and the company does not keep any record of the debenture holders. Interest on debentures is paid to a
person who produces the interest coupon attached to such debentures.

According to the section 2(46) of the Company‘s Act 1956, share means a part in the share capital of the
company and it also includes stock except where a distinction between stock and share capital is made
expressed or implied.
11.3.1 Methods of Issues of Share

Offer for Sale: This is where the company which is issuing the shares will offer the shares to an issuing
house. Generally a merchant bank will act as an issuing house. The shares bought over by the issuing
house will be re issued to the general public. Under this method the company which is issuing the shares
can make use of the financial strength and the image of the issuing house to make.
Prospectus Issue: This is where the company will directly issue the shares to the general public by
preparing a document called a prospectus which will be used to invite general public to participate in the
share issue. Therefore the prospectus will carry information about the company, its past, its present and the
future expectations. This will be an expensive method of issuing shares. This is because the company
which is issuing the shares should bear the cost of preparing the prospectus, advertise, the share issue, pay
underwriting cost. If the share issue is to be underwritten and incur any legal fees necessary to make the
share issue possible such as changing and memorandum of association. In a prospectus issue the company
can make use of an issuing house for the administration of the share issue.
Placing: This is where the company which is carrying out the share issue will select large institutional
investors and offer the shares by conducting ―road shows‖. A road show is where the company will
conduct a presentation to educate the selected investors about the share issue. This will be a low cost
method of issuing the shares. Some of the institutional investors who will be interested in the share issue
will include pension funds, unit trusts, venture capital organizations, building societies.
Offer for Sale by Tender: This is where the company which is issuing the shares will call upon the
investors to bid the price at which they are willing to buy the shares. Therefore each individual investor
will indicate the quantity of shares they expect to buy and price they are willing to pay. The company
should decide upon a price at which all the shares can be issued and collect the highest possible revenue.
This price will be called the strike price.
Stock Exchange Introduction: This is where a company which already has shares in issue, wants to obtain a
listing (quotation) in a recognized stock exchange.
In a stock exchange introduction the company will not issue new shares but will obtain a facility to have
the existing shares traded in the stock exchange. This can be used by the existing shareholders as an ‗exit
rate‘ where the shareholders can convert their paper wealth (share certificate) in to cash.
Procedure for issue of shares

(a) Issue of Prospectus: Whenever shares are to be issued to the public the company must issue a
prospectus. Prospectus means an open invitation to the public to take up the shares of the company thus a
private company need not issue prospectus. Even a Public Company issuing it is shares privately need not
issue a prospectus. However, it is required to file a ―Statement in lieu of Prospectus‖ with the register of
companies. The Prospectus contains relevant information like names of Directors, terms of issue, etc. It
also states the opening date of subscription list, amount payable on application, on allotment and the
earliest closing date of the subscription list.
(b) Application of Shares: A person intending to subscribe to the share capital of a company has to submit
an application for shares in the prescribed form, to the company along with the application money before
the last date of the subscription mentioned in the prospectus. Over Subscription: If the no. of shares applied
for is more than the no. of shares offered to the public then that is called as over Subscription. Under
Subscription: If the no. of shares applied for is less than the no. of shares offered to the public then it is
called as Under Subscription.
(c) Allotment of Shares: After the last date of the receipt of applications is over, the Directors, Provide
with the allotment work. However, a company cannot allot the shares unless the minimum subscription
amount mentioned in the prospectus is collected within a stipulated period.
The Directors pass resolution in the board meeting for allotment of shares indicating clearly the class and
no. of shares allotted with the distinctive numbers. Then Letters of Allotment are sent to the concerned
applicants. Letters of Regret are sent to those who are not allotted any shares and application money is
refunded to them.
(d) Calls on Shares: The remaining amount of shares may be collected in instalments as laid down in the
prospectus. Such instalments are called calls on Shares. They may be termed as ―Allotment amount, First
Call, Second Call, etc.‖
(e) Calls–in–Arrears: some shareholders may not pay the money due from them. The outstanding amounts
are transferred to an account called up as ―Calls-in-Arrears‖ account. The Balance of calls-in-arrears
account is deducted from the Called-up capital in the Balance Sheet.
(f) Calls–in–Advance: According to sec. 92 of the Companies Act, a Company may if so authorized by it
is accept from a shareholder either the whole or part of the amount remaining unpaid on any shares held by
them, as Calls in advance. No dividend is paid on such calls in advance.

A share in a company that the owner loses (forfeits) by failing to meet the purchase requirements.
Requirements may include paying any allotment or call money owed, or avoiding selling or transferring
shares during a restricted period. When a share is forfeited, the shareholder no longer owes any remaining
balance, surrenders any potential capital gain on the shares and the shares become the property of the
issuing company. The issuing company can re-issue forfeited shares at par, a premium or a discount as
determined by the board of directors.
Forfeiture may be termed as penalty for violation of terms of contract. Forfeiture of shares means taking
back of shares by the company from the shareholders. If the shareholder makes default in payment of calls
on shares, then the company can use their option of forfeiting the shares. For a valid forfeiture, satisfaction
of following conditions is necessary:
Association must authorize the forfeiture of shares.
The shares must be forfeited according to the conditions of Association.
The forfeiture must take place in the bonfires interest of the company. All the conditions must be
satisfied. Any irregularity in the forfeiture of shares will make it invalid
In certain cases, companies allow executives and employees to receive a portion of their cash
compensation to purchase shares in the company at a discount. This is commonly referred to as an
employee stock purchase plan. Typically, there will be restrictions on the purchase (i.e. stock cannot be
sold or transferred within a set period of time after the initial purchase). If an employee remains with the
company and meets the qualifications, he or she becomes fully vested in those shares on the stated date. If
the employee leaves the company and/or violates the terms of the initial purchase he or she will most likely
forfeit those shares.
11.4.1 Re-issue of Forfeited Shares

Shares are forfeited because only a part of the due amount of such shares is received and the balance
remains unpaid. On forfeiture the membership of the original allotted is cancelled. He/she cannot be asked
to make payment of the remaining amount. Such shares become the property of the company. Therefore
company may sell these shares. Such sale of shares is called ‗reissue of shares‘. Thus reissue of shares
means issue of forfeited shares. Once the Board of directors has forfeited the shares, the defaulting share
holder is asked to return the share certificate which is cancelled thereafter.
The board of directors passes a resolution allotting the forfeited shares to the new purchaser/purchasers of
such shares. In case of reissue of shares neither a prospectus is issued nor is any offer otherwise made to
the general public. Though the amount of such shares may be called in more than one instalment but
usually the entire amount is called in one instalment i.e. lump sum. The board of directors of the company
while reissuing the shares decides the price of reissue. These shares can be reissued at par, at premium or
at discount. Generally, these shares are reissued at a discount i.e. at a price which is less than its nominal
value.
The amount of discount allowed at the time of reissue in no case should be more than the amount forfeited
on such shares. Question arises at what price the forfeited shares can be reissued? There is no limit of the
price at which it can be reissued if price charged is more than the price of issue at the time of their
forfeiture. But then there is a limit below which price cannot be charged or we can say that there is a
minimum price below which the company cannot reissue its forfeited shares. We can look at it from
another angle i.e. the company cannot give discount more than a particular amount while reissuing the
forfeited shares. The maximum permissible discount at the time of reissue of forfeited shares is ascertained
in different situations in the following manner:
(i) Shares originally issued at par: When the shares are originally issued at par, the maximum permissible
discount for reissue of shares is equal to the amount forfeited on such shares.
(ii) Shares originally issued at premium: In case of shares originally issued at premium, there can be two
situations (a) premium has not been received on the forfeited shares, and (b) premium has been received on
such shares. The amount forfeited is the amount that has been received including the amount of premium if
it has been received and the maximum discount that can be allowed on reissue of such shares is the amount
so forfeited.
(iii) Shares originally issued at discount: In this case the actual amount received becomes the forfeited
amount. But the maximum permissible discount on reissue of shares will be equal to the amount forfeited
plus the amount of discount initially allowed on these shares at the time of their original issue.
Did you know?

In United State according to the Internal Revenue Service, 77% of tax returns filed in 2004 received a
refund check, with the average refund check being INR 1,00,100.

If you have seen an advertisement in newspaper regarding issue of debentures by a company, you must
have noticed that ‗Debenture‘ is always prefixed by a certain percentage say 9% debentures or 12%
debentures. Have you ever thought what meaning this prefix carries? It is the rate of interest per annum
that will be paid to the debenture holders. Companies generally pay interest on its debentures after every
six months. Journal entries that are made in the books of the company are as follows;
(i) Payment of Interest on Debentures
Debenture Interest A/c Dr
To Bank A/c
(Interest on % Debentures paid for six months ending @ % pa)
(ii) Transfer of Debenture Interest to Profit and Loss A/c
Profit and Loss A/c Dr
To Debenture Interest A/c
(Debenture Interest transferred to Profit and Loss A/c)
Illustration
X Ltd has issued 5000 9% Debentures of Rs 1000 each, on 1st April, 2006 Interest is payable after every
six months. Make journal entries for the interest paid for the first six months after the date of issue.
Solution
Calculation of Interest payable at six monthly intervals:
Amount of Debentures 9 6
100 12
Amount of Debentures = 5000 × Rs 1000 = Rs 5000000

Interest on Debentures for six month ending 30th September, 2006
Rs 5000000 9 6
Rs 225000
100 12
Journal Entry
Interest on debentures is an expense and thus charges against profits of the company. Interest on
debentures is payable even if there are no profits. Company is required to deduct tax at source, wherever
applicable, before payment of interest on debentures. Following is the accounting treatment of interest on
debentures:
Interest accrued and due on debentures is shown along with debentures on liabilities side of the Balance
Sheet under the head 'secured loans'. However, interest accrued but not due on debentures is shown on
liabilities side of Balance Sheet under the head current liabilities. When income tax at source is not to be
deducted amount of gross interest is to be paid to the debenture holders.
Writing off Discount/Loss on Issue of Debentures

At the time of issue of debentures at discount the loss on issue of debentures A/c is debited with the
amount of discount allowed. Similarly when debentures issued at par or premium but redeemable at
premium than for the redemption premium also the provision of loss on debentures is made by debiting the
loss on issue of debentures A/c.
Loss on issue of debentures A/c = Discount on issue of debentures + premium on redemption of debentures
Following entry is passed for writing off loss on issue of debentures:
Securities Premium A/c Dr
Capital Reserve A/c Dr
Profit & Loss A/c Dr
To Discount/Loss on issue of debentures A/c
Two methods are used to write off the loss on issue debentures A/c:
1. When debentures are to be redeemed in lump sum at the end of the given period:
In this case the amount of discount or loss on issue of debentures is written off equally over each one of the
years after which debentures are to be redeemed.
Amount of discount to be written off:
Total Amount of discount/Life of Debentures in years
So when the 10% debentures of INR. 50, 0000 are to be redeemed after 5 years, the amount of discount to
be written off annually would be
500000 × 10/100 × 1/5 = INR. 10,000
2. When debentures are to be redeemed in installments:
Loss on issue of debentures on issue of debentures to be redeemed in installments or by draw of lots is
written off in the ratio of debenture outstanding at the beginning of each accounting year i.e. in the ratio of
amount of debentures used in each of the year.
Case Study-Issue of Debentures

The word ‗Debenture‘ is derived from the Latin term debars which means ―to borrow‖. Share capital is the
main source of finance of a joint stock company. Such capital is raised by issuing shares. Those who hold
the shares of the company are called the shareholders and are owners of the company. Company may need
additional amount of money for a long period. It cannot issue shares every time. It can raise loan from the
public. The amount of loan can be divided into units of small denominations and the company can sell
them to the public. Each unit is called a ‗debenture‘ and holder of such units is called Debenture holder.
The amount so raised is loan for the company. A Debenture is a unit of loan amount. When a company
intends to raise the loan amount from the public it issues debentures. A debenture is a document issued
under the seal of the company. It is an acknowledgment of the loan received by the company equal to the
nominal value of the debenture. It bears the date of redemption and rate and mode of payment of interest.
A debenture is therefore, a certificate of loan issued by a company. It is a type of security and a debenture
holder is the creditor of the company. As per section 2(12) of Companies Act 1956, ―Debenture includes
debenture stock, bond and any other securities of the company whether constituting a charge on the
company‘s assets or not‖. A Debenture is a document given by a company as evidence of a debt to the
holder usually arising out of a loan and most commonly secured by a charge.In Laxman Bharamji.
Emperor, the Bombay High Court observed that debentures normally indicate the security against the loan
taken by the company and contain the conditions of repayment, date, rate of interest payable to the holder.
They may even create a charge on the company‘s property, but it is not always necessarily so. Briefly
speaking, the debentures are the acknowledgement of debt, the promise to return it. In United Dominion
Trust Ltd. v. Kirkwood, receipt or a certificate for a deposit made with a company when the deposit was
repayable at a fixed period after it was made, was held to be debenture.
In the ordinary business sense a ‗debenture‘ is generally understood to be a document acknowledging a
debt and securing repayment thereof by mortgage or charge on the company‘s property or undertaking ,
and providing that until repayment ,interest will be paid there on at a fixed rate payable usually half yearly
or yearly on fixed dates.
By issuing debentures means issue of a certificate by the company under its seal which is an
acknowledgment of debt taken by the company. The procedure of issue of debentures by a company is
similar to that of the issue of shares.
A Prospectus is issued, applications are invited, and letters of allotment are issued. On rejection of
applications, application money is refunded. In case of partial allotment, excess application money may be
adjusted towards subsequent calls.
Questions
1. Explain the issue of debentures.
2. Discuss the applications of debentures.
11.6 Summary
A share is one unit into which the total share capital is divided. Share capital of the company can be
explained as a fund or sum with which a company is formed to carry on the business.
A debenture is an unsecured loan you offer to a company. The company does not give any collateral
for the debenture, but pays a higher rate of interest to its creditors
Companies (Private and Public) need capital either to increase their productivity or to increase their
market reach or to diversify or to purchase latest modem equipments
Debenture is a written instrument acknowledging a debt under the common seal of the company
A share in a company that the owner loses (forfeits) by failing to meet the purchase requirements
Shares are forfeited because only a part of the due amount of such shares is received and the balance
remains unpaid
11.7 Keywords
Capital Surplus: Capital surplus is a term that frequently appears as a balance sheet item as a component
of shareholders' equity. Capital surplus is used to account for that amount which a firm raises in excess of
the par value (nominal value) of the shares (common stock).
Case Discount: An incentive that a seller offers to a buyer in return for paying a bill owed before the
scheduled due date.
Debenture: A debenture is a document that either creates a debt or acknowledges it, and it is a debt without
collateral.
Preferred Stock: Preferred stock is an equity security with properties of both equity and a debt instrument,
and is generally considered a hybrid instrument.
Rebates: A rebate is an amount paid by way of reduction, return, or refund on what has already been paid
or contributed.
1. ……..is a written instrument acknowledging a debt under the common seal of the company.
(a)Share (b) Debenture
(c)Bond (d) None of these
2. A share is one unit into which the total share capital is divided.
(a)True (b) False
3. ………of the company can be explained as a fund or sum with which a company is formed to carry on
the business.
(a)Working capital (b) Fund capital
(c) Share capital (d) All of these
4. ………are the shares on which some fixed amount of dividend is paid, after working expenses taxes,
interests.
(a)Equity share (b) Preferred Shares
(c)Ordinary share (d) All of these
5. ………are these types of shareholders get dividend only after the holders of preference shares receive
their share of profit.
(a) Equity share (b) Preferred Shares
(c) Ordinary Shares (d) All of these
6. SEBI permits the company to raise the capital and as a result company offers it to the public this is
known as Issued Capital.
(a)SIDBI (b) RBI
(c)SEBI (d) All of these
7. …….is a written instrument acknowledging a debt under the common seal of the company.
(a)Share (b) Debenture
(c)Bond (d) All of these
8. Shares are forfeited because only a part of the due amount of such shares is received and the balance
remains unpaid.
(a)True (b) False
9. The board of directors passes a resolution allotting the ……..to the new purchaser/purchasers of such
shares.
(a)Equity share (b) debenture
(c) forfeited shares (d) None of these
10. Forfeiture may be termed as penalty for violation of terms of contract.

(a)True (b) False

1. Explain the meaning of share and debenture.
2. What do you mean by the Share? Explain.
3. What are the different types of equity share?
4. What do you mean by the debenture?
5. What are the different types of debenture?
6. Give an overview of methods of issues of share and debenture.
7. Discuss the forfeited of shares in detail.
8. Explain the method of reissue of forfeited share.
9. Write the treatment of interest on debenture.
10. What is the difference between share and debenture?
1. (b) 2.(a) 3.(c) 4.(b) 5.(c)
6. (c) 7.(b) 8.(a) 9.(c) 10.(a)
12
Redemption of Preference Shares and
Debentures
CONTENTS
Objectives
Introduction
12.2 Debentures
12.4 Summary
12.5 Keywords
Objectives
After studying this chapter, you will be able to
Define share
Discuss the meaning of debentures
Explain about the legal provision and methods of redemption,
Discuss the preparation of balance sheet after redemption
Introduction
The fund provided by the owners in to a business is known as capital. We know that capital of the business
depends upon the form of business organization. From ownership point of view, there are number of
business organizations like, sole proprietorship business, partnership business, cooperative societies, joint
stock companies etc. Total capital of the company is divided into a number of small units of fixed amount
and each such unit is called a share. The fixed value of a share register with the registrar of Companies is
called face/ nominal value. However, a company can issue shares at a price different from its nominal
value or face value. As the total capital of the company is divided into shares, the capital of the company is
known as share capital. A company can issue two types shares equity shares and preference shares. The
issue of preference shares is one of the important sources of capital of a company. Redemption is the
process of repaying an obligation at predetermined amounts and timings. The redeemable preference
shares are issued on the terms that share holders will at a future date be repaid amount which they invested
in the company. According to the Companies Act, 1956, a company can issue only redeemable shares i.e.
at present a company cannot issue irredeemable preference shares. Now, in this chapter we are going to
discuss about the redemption of preference shares.
As discussed in the, shares, in general, can be of two types: equity shares and preference shares. Equity
shareholders are the ultimate owner of the company whereas preference shareholders merely have a
shareholding in the company. Prior to the amendment of The Companies Act of 1988, companies could
issue both re¬deemable and irredeemable preference shares. Irredeemable preference shares are those that
are redeemed only in the event of the company being wound up; therefore, there was no difference
between equity shares and irredeemable preference shares. However, companies are now allowed to issue
only redeemable preference shares, to be redeemed not exceeding 20 years. Given the Amendment Act
1956, See 80 5(A) prohibits the issue of irredeemable preference shares, there has been an important.
modification on the irredeemable preference shares. The company and the terms of the issue, preference
shares can be redeemed within a stipulated period either at par or at a premium.

Total capital of the company is divided into a number of small indivisible units of a fixed
amount and each such unit is called a share. The fixed value of a share, printed on the share
certificate, is called nominal/ par! face value of a share. However, a company can issue shares
at a price different from the face value of a share.
12.1.1 Types of shares

Share issued by a company can be divided into
following categories:
(i) Preference Shares
They enjoy preferential rights in the matter of:
Payment of dividend, and
Repayment of capital
Those preference shares, which can be redeemed or repaid after the expiry of a fixed period or after giving
the prescribed notice as desired by the company, are known as redeemable preference shares. Terms of
redemption are announced at the time of issue of such shares. Redeemable preference shares can be
redeemed on or after a period fixed for redemption under the terms of issue or after giving a proper notice
of redemption to preference shareholders.
The Companies Act, however, imposes certain restrictions for the redemption of preference shares.
Irredeemable preference shares are those shares which cannot be redeemed during the lifetime of the
company.
When the preference shares are issued with the stipulation that these shares are to be redeemed after a
certain period of time, then such preference shares are known as redeemable preference shares.
According to section 100 of Indian Company Law, " If a company collects the money through redeemable
preference shares, this money must be returned on its maturity whether company is liquidated or not.
Section 80 describes the following provisions relating to redeemable preference shares:
1 Its repayment will be out of net profit of company or amount received through issuing of new shares.
These shares will never be redeemed by the amount of new issue of debentures of company. It means
we cannot use loan for repayment of preference share capital. Company also cannot use the sale
amount of any asset for redemption of redeemable preference shares.
2. Capital reserves from forfeiture of shares and share premium account are not available for payment to
redeemable preference shareholders.
3. No such shares shall be redeemed unless they are fully paid. Only fully redeemable shares will be
redeemed
12.1.2 Types of Preference Shares
Equity shares get dividend at a rate fixed at the Annual General Meeting (AGM) depending on the profit
available for a particular year. The rate of dividend also varies from year to year. The preference
shareholders contribute capital to the company. According to section 85 of the Companies Act, 1956,
persons holding preference shares, called preference shareholders. They are assured of a preferential
dividend at a fixed rate during the life of the company. This type share holders carry preferential right over
other shareholders to be paid first in case of liquidation of the company. Companies use this mode of
financing as it is cheaper than raising debt. The preference shares can be of various types. These are:
1. Redeemable Preference Shares: A company may issue this type of shares on the condition that the
company will repay the amount of share capital to the holders of this category of shares after the fixed
period or even earlier at the discretion of the company. Section 80 of the Companies Act, 1956 deals
with the redemption of preference shares.
2. Irredeemable Preference Shares: the preference shares, which do not carry the agreement of
redemption, are known as irredeemable preference shares.
3. Convertible Preference Shares: This type of shares enjoys the right to the holder to get them
converted into equity shares according to the terms and conditions of the issue.
4. Non-convertible Preference Shares: The holders of these shares do not enjoy the right to get the
shares converted into equity shares. Unless otherwise stated, Preference shares are non-convertible.
5. Participating Preference Shares: The holder of this type of preference shares enjoy the right to
participate in the surplus profits, if any, after the equity shareholders have been paid dividend at a rate
fixed in the AGM. So the shareholders get additional dividend with their normal dividend.
6. Non-participating Preference Shares: These shares carry only a fixed rate of dividend without any
right to get additional dividend. Unless otherwise stated, the preference shares are non-participating.
7. Cumulative Preference Shares: The cumulative preference shares carry the right to a fixed amount of
dividend. The holders of these shares are entitled to get dividend out of future profit if current year‘s
profit is insufficient for the same. So, the dividend on these shares accumulates till the final payment.
8. Non-cumulative Preference Share: In this case the dividend for the shareholders does not accumulate.
If there is no sufficient profit, this type of preference shareholders will not get any dividend. In this
case, the dividend will be lapsed and there will be no arrear dividend.
12.1.3 Conditions for Redemption of Preference Shares

Before going to redeem the preference shares as per section 80 of the Companies Act, 1956, a company
should have to follow the conditions:
There must be a provision in Association regarding the redemption of preference shares.
The redeemable preference shares must be fully paid up. If there is any partly paid share, it should be
converted in to fully paid shares before redemption.
The redeemable preference shareholders should be paid out of undistributed profit/ distributable profit
or out of fresh issue of shares for the purpose of redemption.
If the shares are redeemed at a premium, it should be should be provided out of securities premium or
profit and loss account or general reserve account.
The proceeds from fresh issue of debentures cannot be utilized for redemption.
The amount of capital reserve cannot be used for redemption of preference shares.
If the shares are redeemed out of undistributed profit, the nominal value of share capital, so redeemed
should be transferred to Capital Redemption Reserve Account. This is also known as capitalization
profit.
So, you may understand that a company must follow the above conditions for the purpose of
redemption of its redeemable preference shares.
12.2 Debentures
A Debenture is a debt security issued by a company (called the Issuer), which offers to pay interest in lieu
of the money borrowed for a certain period. In essence it represents a loan taken by the issuer who pays an
agreed rate of interest during the lifetime of the instrument and repays the principal normally, unless
otherwise agreed, on maturity.
These are long-term debt instruments issued by private sector companies. These are issued in
denominations as low as Rs 1000 and have maturities ranging between one and ten years. Long maturity
debentures are rarely issued, as investors are not comfortable with such maturities
Debentures enable investors to reap the dual benefits of adequate security and good returns. Unlike other
fixed income instruments such as Fixed Deposits, Bank Deposits they can be transferred from one party to
another by using transfer from. Debentures are normally issued in physical form. However,
corporates/PSUs have started issuing debentures in Demat form. Generally, debentures are less liquid as
compared to PSU bonds and their liquidity is inversely proportional to the residual maturity.
Debentures can be secured or unsecured.A type of debt instrument that is not secured by physical asset or
collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer. Both
corporations and governments frequently issue this type of bond in order to secure capital. Like other types
of bonds, debentures are documented in an indenture.
Debt issued by a federal agency or a government-sponsored enterprise (GSE) for financing purposes.
These types of debentures are not backed by collateral, but by the integrity and credit worthiness of the
issuer. Officially, agency debentures issued by a Federal Agency, such as the Tennessee Valley Authority,
are backed by the full faith and credit of the United States government. Agency debentures issued by a
GSE are backed only by that GSE's ability to pay. Agreement under which a firm issuing a debenture
agrees to repay the borrowed sum on a specified date or after a specified period of notice.
12.2.1 Features of Debentures

It is a document which evidences a loan made to a company.
It is a fixed interest-bearing security where interest falls due on specific dates.
Interest is payable at a predetermined fixed rate, regardless of the level of profit.
The original sum is repaid at a specified future date or it is converted into shares or other debentures
It may or may not create a charge on the assets of a company as security.
It can generally be bought or sold through the stock exchange at a rice above or below its face value..
12.2.2 Types of Debentures

Registered debentures
Bearer debentures
Secured debentures
Unsecured debentures
Convertible debentures
Non convertible debenture
Redeemable debentures
Irredeemable debentures
The different types of debentures have been explained in brief as follows:
Registered Debentures: These are those debentures which are registered in the register of the company. the
names, addresses and particulars of holdings of debenture holders are entered in a register kept by the
company. Such debentures are treated as non-negotiable instruments and interest on such debentures are
payable only to registered holders of debentures. Registered debentures are also called as Debentures
payable to Registered holders.
Bearer Debentures: These are those debentures which are not registered in the register of the company.
Bearer debentures are like a bearer check. They are payable to the bearer and are deemed to be negotiable
instruments. They are transferable by mere delivery. No formality of executing a transfer deed is
necessary. When bearer documents are transferred, stamp duty need not be paid. A person transferring a
bearer debenture need not give any notice to the company to this effect. The transferee who acquires such a
debenture in due course bonafide and for available consideration gets good title not withstanding any
defect in the title of the transfer-or. Interest coupons are attached to each debenture and are payable to
bearer.
Secured Debentures: These are those debentures which are secured against the assets of the company
which means if the company is closing down its business, the assets will be sold and the debenture holders
will be paid their money. The charge or the mortgage may be fixed or floating and they may be fixed
mortgage debentures or floating mortgage depending upon the nature of charge under the category of
secured debentures.
In case of fixed charge, the charge is created on a particular asset such as plant, machinery etc. These
assets can be utilized for payment in case of default. In case of floating charge, the charge is created on the
general assets of the company.
The assets which are available with the company at present as well as the assets in future are charged for
the purpose. A mortgage deed is executed by the company. The deed includes the term of repayment, rate
of interest, nature and value of security, dates of payment of interest, right of debenture holders in case of
default in payment by the company. The deed may give a right to the debenture holder to nominate a
director as one of the Board of Directors. If the company fails to pay the principal amount and the interest
thereon, they have the right to recover the same from the assets mortgaged.
Unsecured Debentures: These are those debentures which are not secured against the assets of the
company which means when the company is closing down its business, the assets will not be sold to pay
off the debenture holders.
These debentures do not create any charge on the assets of the company. There is no security for
repayment of principal amount and payment of interest. The only security available to such debenture
holders is the general solvency of the company. Therefore the position of these debenture holders at the
times of winding up of the company will be like that of unsecured debentures. That is they are considered
with the ordinary creditors of the company.
Convertible Debentures: These are those debentures which can be converted into equity shares. These
debentures have an option to convert them into equity or preference shares at the stated rate of exchange
after a certain period. If the holders exercises the right of conversion, they cease to be the lender to the
company and become the members. Thus convertible debentures may be referred as debentures which are
convertible into shares at the option of the holders after a specified period. The rate of exchange of
debentures into shares is also decided at the time of issue of debentures. Interest is paid on such debentures
till its conversion. Prior approval of the shareholders is necessary for the issue of convertible debentures. It
also requires sanction of the Central Government.
Non-Convertible Debentures: These are those debentures which cannot be converted either into equity
shares or preference shares. They may be secured or unsecured. Non-convertible debentures are normally
redeemed on maturity period which may be 10 or 20 years.
Redeemable Debentures: These debentures are issued by the company for a specific period only. On the
expiry of period, debenture capital is redeemed or paid back. Generally the company creates a special
reserve account known as "Debenture Redemption Reserve Fund" for the redemption of such debentures.
The company makes the payment of interest regularly. Under section 121 of the Indian Companies Act,
1956, redeemed debentures can be re-issued.
Irredeemable Debentures: These debentures are issued for an indefinite period which are also known as
perpetual debentures. The debenture capital is repaid either at the option of the company by giving prior
notice to that effect or at the winding up of the company. The interest is regularly paid on these debentures.
The principal amount is repayable only at the time of winding up of the company. however, the company
may decide to repay the principal amount during its lifetime.
From Coupon Rate Point of view

Specific Coupon Rate Debentures: These debentures are issued with a specified rate of interest, which is
called the coupon rate. The specified rate may either be fixed or floating. The floating interest rate is
usually tagged with the bank rate.
Zero Coupon Rate Debentures: These debentures do not carry a specific rate of interest. In order to
compensate the investors, such debentures are issued at substantial discount and the difference between the
nominal value and the issue price is treated as the amount of interest related to the duration of the
debentures.
Did you know?

Ever since the first promise of redemption was spoken in Eden, the life, the character, and the mediatorial
work of Christ have been the study of human minds.

Discharge of liability on account of debentures earlier issued by the company is called redemption of
debentures. In the other words the redemption of debentures is the repayment of amount of debentures to
the debenture holders. The terms and conditions of the redemption of debentures are given in the
prospectus inviting applications for the issue of debentures. Debentures may be redeemed at par, at
premium or at a discount but the redemption of debentures at discount is not a practical reality.
12.3.1 Legal Provision
The Companies Act 1956 contain the legal provisions relating to internal reconstruction which involves in
essence an alteration of the Share Capital and adjustments in the values of assets and liabilities. An
alteration of share capital may he done in any of the ways:
Reduction in Share Capital.
Consolidation.
Sub-division.
Conversion: and
Cancellation or Surrender.
However the following conditions must be satisfied:
i) The scheme is authorised by Association and passed by a special resolution of the general meeting and
confirmed by the Court.
ii) The Scheme does not affect the creditors interest in any way. If the proposed scheme affects the
interests of the creditors, the Court/Government (Company Law Board) shall confirm the scheme only
after consulting the creditors.
iii) The Government (CLB) shall pass the order of confirmation of internal reconstruction on such terms
and conditions as it may think proper and just after consulting the creditors. If some of the creditors are
unwind the company will have to settle their claims. The court may sanction scheme if the company
secures whole of the debts or amount fixed by the court.
iv) The court may order the use of word "and reduced" after the name the company and may order the
company to publish the reason of such reduction.
v) The order of the court has to be filed with the registrar.
vi) Capital reduction may involve variation of rights of different classes of shares. In such a case the
Consent of the holders of three fourth shares should be obtained.
vii) Holders of at least one - tenth of the issued capital affected by variation may apply to court within 21
days after the consent is obtained or resolution is passed, for cancellation of such variation. However,
the decision of court shall be final
12.3.2 Methods of Redemption

Redemption of preference shares means repayment by the company of the obligation on account of shares
issued. According to the Companies Act, 1956, preference shares issued by a company must be redeemed
within the maximum period allowed under the Act. Thus, a company cannot issue irredeemable preference
shares. Section 80 of the Companies Act, 1956, deals with rules relating to redemption of preference
shares. It ensures that there is no reduction in shareholders' funds due to redemption and thus the interest of
outsiders is not impaired. For this, it requires that either fresh issue of shares is made or distributable
profits are retained and transferred to 'Capital Redemption Reserve Account.
The rationale behind these provisions is to protect the interest of outsiders to whom the amount is payable
before redemption of preference share capital. The interest of outsiders is protected if the nominal value of
capital redeemed is substituted, thus, ensuring the same amount of shareholders fund. In case of
redemption of preference shares out of proceeds of a fresh issue of shares, replacement of capital and
tangible assets is obvious. But, if redemption is done out of distributable profits, replacement of capital is
ensured in an indirect manner by retention of profit by transfer to Capital Redemption Reserve. In this
case, the amount which would have gone to shareholders in the form of dividend is retained in the business
and is used for settling the claim of preference shareholders. Thus, there is no additional claim on net
assets of the Company. The transfer of divisible profits to Capital Redemption Reserve makes them non-
distributable profits. As Capital Redemption Reserve can be used only for issue of fully paid bonus shares,
profits retained in the business ultimately get converted into share capital. Security cover available to
outside stakeholders depends upon called-up capital as well as uncalled capital to be demanded by the
company as per its requirements. To ensure that the interests of outsiders are not reduced, Section 80
provides for redemption of only fully paid-up shares
Now, it can be concluded that the 'gap' created in the company's capital by the redemption of redeemable
preference shares much be filled in by:
(a) The proceeds of a fresh issue of shares;
(b) The capitalization of undistributed profits; or
(c) A combination of (a) and (b).
Case Study-Reliance Shares

Anil Ambani, Chairman of Reliance ADA Group, had attended the meeting of Reliance Telecom Ltd in
which the board had ―noted‖ that investment of Rs 992 crore in Swan Telecom Pvt Ltd was a ―long-term
strategic investment‖, a prosecution witness in the 2G spectrum case told a Delhi court.
Sateesh Seth, non-executive Director of Reliance Telecom Ltd (RTL) and a chartered accountant, said he,
Anil Ambani, S P Shukla and Gautam Doshi, an accused in the case, had attended the April 29, 2007,
board meeting of RTL.
―I have also been shown a certified true copy of extract of the minutes of the meeting of board of directors
of Reliance Telecom Limited held on April 29, 2007.
―In this meeting, the board noted that ‗investment in 99,20,000 8% non-cumulative redeemable preference
shares (NCRPS) each of Rs 1 each at a premium of Rs 999 per preference share aggregating to Rs 992
crore of Swan Telecom (P) Limited (STPL) was in the nature of long-term strategic investment,‖ Seth told
Special CBI Judge O P Saini.
Seth, whose recording of statement concluded today, also said Anil Ambani was among the authorised
signatories of Tiger Traders (P) Ltd, Zebra Consultants (P) Ltd, Swan Consultants (P) Ltd and ADAE
Ventures (P) Ltd, all alleged associates of Reliance ADA Group, from September-October 2006.
Reliance ADA Group top executives Gautam Doshi, Surendra Pipara and Hari Nair are facing trial for
their alleged roles in the 2G case.
Besides them, RTL has also been put on trial by the court which had said Shahid Usman Balwa-promoted
Swan Telecom Pvt Ltd (STPL), also an accused in the case, was ―just a mask‖ for it. They, however, have
denied all the allegations levelled against them.
Questions
1. Write the summery of case study.
2. Write the some reliance company name.
12.4 Summary
Those preference shares, which can be redeemed or repaid after the expiry of a fixed period or after
giving the prescribed notice as desired by the company, are known as redeemable preference shares.
Redemption of preference shares means repayment by the company of the obligation on account of
shares issued
The preference shares, which do not carry the agreement of redemption, are known as irredeemable
preference shares.
The holders of these shares do not enjoy the right to get the shares converted into equity shares
These shares carry only a fixed rate of dividend without any right to get additional dividend.
The Companies Act 1956 contain the legal provisions relating to internal reconstruction which
involves in essence an alteration of the Share Capital and adjustments in the values of assets and
liabilities.
The rationale behind these provisions is to protect the interest of outsiders to whom the amount is
payable before redemption of preference share capital
12.5 Keywords
AGM: Annual General Meeting is A mandatory yearly meeting of shareholders that allows stakeholders to
stay informed and involved with company decisions and workings.
Provision: provision is a word that creates an ambiguous account title. In U.S. GAAP, provision means an
expense, while in IFRS, International Financial Reporting Standards, it means a liability. So, in the U.S.
Equity: In accounting and finance, equity is the residual claim or interest of the most junior class of
investors in assets, after all liabilities are paid
Redeemable Preference Shares: : When the preference shares are issued with the stipulation that these
shares are to be redeemed after a certain period of time, then such preference shares are known as
redeemable preference shares

1. Total capital of the company is divided into a number of small indivisible units of a..........
amount and each such unit is called a share.
(a)fixed (b)unfixed
(c)number (d) None of these
2. Those preference shares, which can be redeemed or repaid after the expiry of a fixed..........
(a) expiry (b)unperiod
(c) period (d) None of these
3. The holders of these shares do not enjoy the right to get the..........converted into equity shares.
(a)share (b) debentures
(c) balance (d)period
4. Debentures enable investors to reap the dual benefits of adequate .............and good returns
(a)fixed (b) security
(c)period (d) None of these
5. These are those debentures which are not registered in the.......... of the company.
(a) register (b) unregister
(c) security (d) None of these
6. These debentures are issued for an indefinite period which are also known as .....debentures
(a) debentures (b) perpetual
(c) mortgage debentures (d) naked debentures
7. These debentures are issued with a specified rate of interest, which is called the..............
(a) coupon rate (b)rate
(c)ratio (d) None of these
8. The rationale behind these provisions is to protect the interest of outsiders to whom the amount is
payable before redemption of preference .............
(a)capital (b) share capital
(c) preference (d) None of these
9. The transfer of divisible profits to Capital Redemption Reserve makes them............. profits
(a) non-distributable (b) distributable
(c)ratio (d)None of these
10. There is no security for repayment of principal amount and payment of interest.
(a)True (b) False

1. Write the method of preparation of balance sheet after redemption.
2. What are redemption of preference shares and debentures?
3. Give an overview of methods of redemption.
4. What is meant by legal provision?
5. Explain the methods of redemption.
6. Difference between legal provision and methods of redemption.
7. Difference between meaning and legal provision.
8. Explain the types of preference shares.
9. What is the conditions for redemption of preference shares?
10. Give a detailed note on sub-division.

1. (a) 2.(c) 3.(a) 4.(b) 5.(a)
6. (b) 7.(a) 8.(b) 9.(a) 10.(b)
13
Financial Statements
CONTENTS
Objectives
Introduction
13.5 Summary
13.6 Keywords
Objectives
Discuss the meaning of financial statements
Understand the capital expenditure
Define revenue expenditure
Explain deferred revenue expenditure.
Introduction
Financial statement is the process of understanding the risk and profitability of a firm (business, sub-
business or project) through analysis of reported financial information, particularly annual and quarterly
reports. Financial analysis is the selection, evaluation, and interpretation of financial data, along with other
pertinent information, to assist in investment and financial decision-making. Financial analysis may be
used internally to evaluate issues such as employee performance, the efficiency of operations, and credit
policies, and externally to evaluate potential investments and the credit-worthiness of borrowers, among
other things. The analyst draws the financial data needed in financial analysis from many sources. The
primary source is the data provided by the company itself in its annual report and required disclosures. The
annual report comprises the income statement, the balance sheet, and the statement of cash flows, as well
as footnotes to these statements.
Figure 13.1: Financial statement process

A written report which quantitatively describes the financial health of a company. This includes an income
statement and a balance sheet, and often also includes a cash flow statement. Financial statements are
usually compiled on a quarterly and annual basis. We know business is mainly concerned with the
financial activities. In order to ascertain the financial status of the business every enterprise prepares
certain statements, known as financial statements. Financial statements are mainly prepared for decision
making purposes. But the information as is provided in the financial statements is not adequately helpful in
drawing a meaningful conclusion. Thus, an effective analysis and interpretation of financial statements is
required.
Analysis means establishing a meaningful relationship between various items of the two financial
statements with each other in such a way that a conclusion is drawn. By financial statements we mean two
statements:
Profit and loss Account or Income Statement
Balance Sheet or Position Statement
These are prepared at the end of a given period of time. They are the indicators of profitability and
financial soundness of the business concern.
The term financial analysis is also known as analysis and interpretation of financial statements. It refers to
the establishing meaningful relationship between various items of the two financial statements i.e. Income
statement and position statement. It determines financial strength and weaknesses of the firm.
Analysis of financial statements is an attempt to assess the efficiency and performance of an enterprise.
Thus, the analysis and interpretation of financial statements is very essential to measure the efficiency,
profitability, financial soundness and future prospects of the business units.
13.1.2 Types of Financial Statements

Financial statements can be referred to as representation of the financial status of a company in a
systematically documented form.
There are different types of financial statements. Financial statements are required to be audited by
authentic, efficient audit firms to avoid manipulation of numbers. Statements are usually audited by the
accounting firms after a thorough study of the company records. The accounting and the audit firms make
sure that the company is obeying and operating as per norms laid down by the Generally Accepted
Accounting Principles or GAAP.
Basically, there are four different types of financial statements. The different types of financial statements
indicate the different activities occurring in a particular business house.
Balance Sheet
Income statement
Statement of retained earnings
Statement of cash flow or Cash flow statement
Balance Sheet:
The balance sheet provides an insight into the financial status of a company at a particular time. The
balance sheet, type of financial statement is different in comparison to the other types of financial
statements. Other financial statements are prepared by taking into account the financial health of the
company over a considerable span of time.
Income Statements:
Also known as the P&L statement or the Profit And Loss Statement. This statement, ascertains the profit
and loss of any business. This can be again of two types:
Single Step Income Statement
Multi Step Income Statement
Statements of Retained Earnings:

This financial statement denotes alterations in these rights of equities, in any business.
Cash Flow Statement:

This statement highlights flow of cash over a period of time. The cash flow may be from investment
activities, operations or financing activities.
Figure 13.2: Types of Financial statement.

Capital expenditure are those type of expenditure the benefits of which are taken in more than one years by
the business entity. So according to this all fixed assets are capital expenditures and fixed assets are shown
at asset side of balance sheet.
It is money used to purchase, upgrade, improve, or extend the life of long-term assets. Long-term assets are
typically property, infrastructure, or equipment with a useful life of more than one year.
13.2.1 How It Works/Example:

Let us assume Company XYZ wants to buy a new delivery truck for INR20,00,000. When Company XYZ
spends the 200INR0,000, the book value of the company‘s assets are increased by INR20,00,000. This
amount is also recorded as Capital expenditure, a use of cash, in the investing section of the company‘s
statement of cash flows. Company XYZ then gradually expenses the INR20,00,000 on its income
statement over time as the truck depreciates. The length of time over which the truck depreciates (and thus
the amount of annual depreciation expense) is determined by Company XYZ‘s choice of depreciation
method.
Many companies set minimum dollar thresholds for Capital expenditure, meaning that capital expenditures
below the threshold are simply expensed even though they exhibit Capital expenditure characteristics. This
is done to simplify the accounting process and avoid having to record insignificant depreciation expenses
each period for small-value assets.
13.2.2 Why It Matters

Capital expenditure generally takes two forms: maintenance expenditures, whereby the company purchases
assets that extend the useful life of existing assets, and expansion expenditures, whereby the company
purchases new assets in an effort to grow the business. It is important to understand that money spent to
repair or conduct ongoing, normal upkeep on assets is not considered Capital expenditure and should be
expensed on the income statement when it is incurred.
13.2.3 How to Calculate Capital Expenditure

Capital expenditures refer to the money spent to acquire and maintain the physical assets of a company.
These assets are most commonly referred to as plant, property and equipment (PPE) on the balance sheet.
Manufacturing companies tend to have large capital expenditure and usually spend more money on
maintenance than service firms.
For technology-rich companies, capital expenditure might also refer to the cost of developing a product or
system. Either way, it is a number the investment community uses to measure a firm‘s investment in future
revenue-generating activities. A company with low capital expenditure may have fewer expenses, but will
it be able to compete with industry peers in the future?
13.2.4 Usage
Capital expenditure is used by a company to acquire or upgrade physical assets such as equipment,
property, or industrial buildings. In the case when a capital expenditure constitutes a major financial
decision for a company, the expenditure must be formalized at an annual shareholders meeting or a special
meeting of the Board of Directors. In accounting, a capital expenditure is added to an asset account
(―capitalized‖), thus increasing the assets basis (the cost or value of an asset adjusted for tax purposes).
Capital expenditure is commonly found on the cash flow statement under ―Investment in Plant, Property,
and Equipment‖ or something similar in the Investing subsection.
13.2.5 Accounting rules

For tax purposes, Capital expenditure is a cost which cannot be deducted in the year in which it is paid or
incurred and must be capitalized. The general rule is that if the acquired property‘s useful life is longer
than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or
depreciated over the life of the asset in question. Further to the above, Capital expenditure creates or adds
basis to the asset or property, which once adjusted, will determine tax liability in the event of sale or
transfer. In the US, Internal Revenue Code 263 and 263A deal extensively with capitalization requirements
and exceptions.
Included in capital expenditures are amounts spent on:

acquiring fixed, and in some cases, intangible assets
repairing an existing asset so as to improve its useful life
upgrading an existing asset if its results in a superior fixture
preparing an asset to be used in business
restoring property or adapting it to a new or different use
starting or acquiring a new business
Figure 13.3: Financial statement model
An ongoing question for the accounting of any company is whether certain expenses should be capitalized
or expensed. Costs which are expensed in a particular month simply appear on the financial statement as a
cost incurred that month. Costs that are capitalized, however, are amortized or depreciated over multiple
years. Capitalized expenditures show up on the balance sheet. Most ordinary business expenses are clearly
either expendable or capitalizable, but some expenses could be treated either way, according to the
preference of the company. Capitalized interest if applicable is also spread out over the life of the asset.
The counterpart of capital expenditure is operational expenditure

Revenue expenditure is recorded as expenses in Income Statement. Examples of revenue expenditure are
office rentals, utilities such as water and electricity, printing and stationery and etc.. Revenue expenditure
also includes those incurred to maintain the earning capacity of non-current assets such as repairs and
maintenance. It is the expenditure on goods or services which will be used up i.e. the benefits that come
with the goods or services will be consumed. The unused goods purchased would then be recognised as
inventory on Balance Sheet i.e. part of Current Assets.
Example On 31/1/2007, Dragon Co. Ltd. issue a cheque of INR4,499 to pay its electricity bill and another
cheque of INR75,000 to pay its monthly rental of shop. The double entry to record these transactions is:
13.3.1 Explain Revenue Expenditure

Revenue Expenditure is the expenditure incurred in one accounting year and the benefits from which is
also enjoyed in the same period only. This expenditure does not increase the earning capacity of the
business but maintains the existing earning capacity of the business. It included all the expenses which are
incurred during day to day running of business. The benefits of this expenditure are for short period and
are not forwarded to the next year. This expenditure is on recurring nature. As the return on revenue
expenditure is received in the same period thus the entries relating to the revenue expenditure will affect
the profitability statements as all the entries are passed in the same accounting year, the year in which they
were incurred.
Figure 13.4: capital expenditure

Where a certain revenue expenditure incurred is of such a nature that its benefit is likely to be spread over
a certain number of years, or where it is of non-recurring and special nature and large in amount, in such
circumstances, instead of debiting the entire amount to the profit and loss account of the year in which it
has been incurred, it may be spread over a number of years, a proportionate amount being charged to each
year‘s profit and loss account.
The remaining portion of the expenditure is carried forward and is known as capital expenditure or
deferred revenue expenditure and is shown as an asset in the balance sheet. Item such as preliminary
expenses, cost of issue of debentures is examples that may be classified under this head.
13.4.1 Exceptions to General rules:

There are certain expenses which are usually of revenue in nature but under certain circumstances they
become capital expenditures. The following are the examples of expenses which are usually revenue but
under certain circumstances become capital.
13.4.2 Legal Charges:

These are, as a rule, revenue charges, but legal charges incurred in connection with the purchase of a fixed
asset are capital expenditures as they form an additional cost of the asset acquired.
13.4.3 Wages:
Wages are ordinary a revenue expenditure. But in a manufacturing business where the firm‘s own men are
employed in making of fixed asset, the wages paid for such purpose would be capitalized.
For example if the firm‘s own men are employed in making extension to the factory building or in erection
of plant or manufacturing tools for own requirements. the wages and salaries paid to the persons are not
revenue but capital expenditures.
13.4.4 Brokerage and Stamp Duty:

Normally these are revenue expenditures, but brokerage paid on acquisition of a property and stamp duty
involved thereon can be capitalized.
13.4.5 Freight and Carriage:

This is revenue charge, but freight and carriage paid on newly acquired plant or fixed assets are capital
expenditures.
13.4.6 Advertising:
Ordinarily amount expended on advertising is revenue charge but the cost of special advertising
undertaken for the purpose of introducing a new line of goods may be capitalized.
13.4.7 Development Expense:

In concern like collieries, mines, tea, rubber etc., all expenses incurred during the period of development
are treated as capital.
13.4.8 Preliminary Expenses:

These are the expenses incurred in connection with the formation of a public company. These expenses
although are revenue in nature but are allowed to be capitalized and can be shown as an asset in the
balance sheet.
Treatment of deferred revenue expenditure

A company with a turnover of Rs. 90.00 crores has commenced marketing of a new product which is quite
different from its existing products. It is estimated that the company will have a turnover of around Rs. 7
crores from this product. The brand name under which these goods are to be marketed is owned by this
company. In order to create brand image and to launch this new product the company carried out an
extensive special initial advertisement campaign at a cost of Rs. 50 lacs.
The annual budget for this product is expected to be about Rs. 5 lacs thereafter. The annual expenditure of
the company on advertisement is around Rs. 75 lacs in respect of other current products. It is expected that
the benefit of this special campaign would be available for 5 to 7 years.
The company proposes to treat this expenditure as the deferred revenue expenditure as it is of the open that
the company will have benefit of this expenditure over quite a long period.
13.4.9 The opinion of the Expert Advisory Committee has been sought on the following questions:
Whether the company is correct in considering this initial expenditure incurred on launching extensive
special advertisement campaign which has lasting benefit as deferred revenue expenditure and not
writing-off the entire expenditure to profit and loss account in the year in which it is incurred.
(ii)What should be the reasonable period-5 years or 7 years- over which this expenditure should be
written-off, if it is to be treated as deferred revenue expenditure?
Will it make any difference, if the company was altogether a new company not doing any other
business?
The Committee notes that the term ―Deferred Revenue Expenditure has been defined in para 4.5 of the
Guidance Note on terms used in the Financial Statements, issued by the Institute of Chartered Accountants
of India,
as the ―Expenditure for which payment has been made or liability incurred but which is carried forward on
the presumption that it will be of benefit over a subsequent period or periods‖.
The Committee also notes that para 10.1 of the Statement on Auditing Practices, issued by the Research
Committee of the Institute of Chartered Accountants of India has recommended the treatment of deferred
revenue expenditure.
Figure 13.5: Financial statements
The relevant extract of the said para is as below:

If a future period will receive benefit from the outlay, the proper portion of the deferred charge should
appear on the balance sheet. Unless some value can be determined as flowing into the future, there is no
justification for not writing off the item immediately. The fact that the amount spent is large, should not by
itself affect the decision.
1. Is there proper authority for the outlay and the deferral of the write off? This will be determined
through the vouching process.
2. What is reasonable period for amortising the expenditure?
In some cases the time involved will be related directly to some other account, as in the case of debenture
discounts and debenture issue expenses. In other cases, it may be influenced by tax laws, e.g., preliminary
expenses can be written off over 10 years for income-tax purposes (Section 35D of the Income-tax Act,
1961). In many instances, such as deferred advertising, plant rearrangement, research and development
costs, etc., the period has to be arbitrarily decided by the management, and the auditor should satisfy
himself that it is not unreasonable.‖
On the basis of the above, the opinion of the Committee on the issues raised by the queries in para 3 of the
query is as follows:
(i) The special advertisement expenditure incurred to launch a new product, the value of which is expected
to flow into the future, can be treated as deferred revenue expenditure.
(ii) Regarding the period of write-off of the said advertisement expenditure which is treated as deferred
revenue expenditure, the Committee is of the upon that the management of the company should exercise its
judgment and determine that period on the basis of the period expected to benefit from the said
expenditure. The auditor should satisfy himself that the period so determined is not unreasonable keeping
in view the circumstances of the case.
(iii) The Committee is of the upon that the nature of the said expenditure will not change if it is incurred by
a new company not doing any other business. Thus, in such a situation also the special advertisement
expenditure incurred to launch the product, which is expected to benefit future periods, should be treated as
deferred revenue expenditure. In this context, the Committee draws the attention of querist, to the
following relevant extracts of paras 6.1, 6.2 and 6.3 of the Guidance Note on Treatment of Expenditure
during Construction Period, issued by the Research Committee of the Institute of chartered accountants of
India.
This heading refers to various items of indirect expenditure incurred by a project during its construction
period, which are not related either directly or indirectly to the work of construction, but which are
incurred mainly in preparation for the work which will be undertaken after the project commences
commercial production.
Expenses will also be incurred in connection with the salaries of employees who are appointed ahead of
the date of production but whose work involves no connection, direct or indirect, with the work of
construction,
For example, employees of the sales department, publicity and public relations departments, etc. The
concern may also engage in advance publicity campaigns in the press and otherwise in order to popularise
itself and its products, well in advance of the date it goes into production.
Did you know?

Deferred Revenue Expenditure can comprise diverse components of expenditure and manifest itself in the
accounts in a wide variety of ways
Caution
While preparing financial statements revenue cannot be included as income.
Case Study-Financial Statements of multi-national companies

Three Executives of a well-known multi-national company decided to form a new company, named New
Star Company Limited in 1974. These three executives were becoming close to their retirement age. Pifco-
Zen Chen Company Limited, the company that they worked for had been in business for the last 80 years.
It was their employer‘s policy to retire the executives with a ―golden hand-shake‖ worth approximately
INR120,000 each. The three executives occupied the following position with Pifco-Zen Chen Company
Limited,
(1) Finance Manager Mr. Zu Chang,
(2) Sales and Marketing Manager, Mr. Lim Lam, and
(3) Risk Management Manager, Mr. Shu Ching. In their position with Pifco-Zen Chen Company Limited,
they were regarded as the most respected executives because the company made significant progress in
terms of organic growth and diversification.
The Chairman of the Board of Directors, Dr. Wing Wan used to call them ―the three wise me‖. Pifco-Zen
Chen Company Limited main business activities were the manufacturing of ―twisters‖ and acted as
wholesale distributor of a special drink called ―Wysal‖. The drink is full of calcium and protein and it is
very popular in the South East Asia.
Each year‘s Annual General Meeting of Pifco-Zen Chen Company Limited‘s gross income and net profit
before taxation increased by 10%, while its main competitor‘s performance was declining at an alarming
rate. Chairman Wan always wanted to find out what is the main reason driving its company‘s operational
success.
In a nutshell, Chairman Wan always believed that the financial result was ―too good to be true‖ because
whenever he has a chance to play golf with one of the Chairman of his competitor company, he was told
that life as the head of a corporate is becoming unbearable due to competition and increased in the cost of
living. Still, Mr. Wan kept quiet while congratulating his three wise men for a fantastic job each year. Even
the external Auditors could not believe the significant progress, which the company used to, when the three
wise men were working for Pifco-Zen Chen Company Limited.
The auditors knowing too well the performance of the company before the departure of Mr. Chang, Mr.
Lam, and Mr. Ching cautioned the Chairman that it would be a great loss for the company to lose three key
executives in one go. In view of the continued pressure and perplexities of the situation, one afternoon,
Chairman of Pifco-Zen Chen Company Limited, Dr. Wan called a special Board of Directors meeting to
address his concern regarding the retirement of Mr. Chang, Mr. Lam, and Mr. Ching, One of the vocal
directors, who did not get along very well with these three managers, said ―it does not matter if all of the
three men were to leave the company today because they are not indispensable people‖.
He went on to argue further that ―we can replace them easily because there are other professionals looking
for wor‖.According to the employment contract of the three wise men, they were paid a basic salary plus
they also benefited with a 2% commission on the net profit of the company each year after the accounts
have been finalized by the external auditors.
The Internal Auditor, Miss Wen always queried this employment terms that it favours mostly these three
managers at the detriment of the other hard-working employees. One day in a management meeting, Miss
Wen expressed her frustration of the favourable treatment of the three managers because she felt that they
are working very close and perhaps, manipulating the figures so that they can benefit a hefty remuneration
every year. Chairman Wan felt every uneasy during this meeting and closed the meeting earlier than
expected. After the meeting, Miss Wen wrote a memo to the Chairman of the Board of Directors to
complain that the external auditors come on the premises of the company for a very short time to perform
the audit.
They do not carry out an efficient audit and the Pifco-Zen Chen Company Limited runs the risk of facing a
corporate collapse, when those three managers had left. In the abridged version of the financial statement
of Pifco-Zen Chen Company Limited, the following item appears at the end of the financial year 1975.
INR
(miilion)
Net Fixed Assets 45
Investment in Subsidiaries 30
INR
Current Assets (miilion)
Stocks 125
Debtors 90
Prepaid Expenses 40
Bank Deposits (7 Day Call Account) 60
Cash at Banks 30
Petty Cash 1
346
Less: Current Liabilities
Creditors 45
Accrued Expenses 30
Short-Term Debt 55
Overdraft Balance 75
205
Net Current Assets/(Liabilities) 141
Total Net Assets 216
Financed by:
Long-term Debts 80
Capital 90
Accumulated Profit until 1975 46
136
216
In the financial statement there is an amount INR 1250 million worth of over-valued stocks, which has
been in the accounts for the last 5 years. No provision has been made in the Debtors Account for non-
performing account worth INR 450 million.
Current operating expenditure to the value of INR 350 million has been accounted as ―prepaid
expenditure‖. The bank reconciliation has not been done properly for the last 3 years, and the external
auditors have accepted the Finance Manager‘s figure of INR 30 million. It appears that there are 10
cheques valued INR3 million has been deposited in the accounts, and have been returned by the banks
because the customers did not have funds.
There has need no adjustment made subsequently to correct the balances at banks. The exact figure for the
Short-Term Debts should be 65 million and not INR 55 million as disclosed. There is a mistake in the
disclosure of Overdraft Facility; the figure should appear as INR 85 million and not INR75 million.
In addition, the Sales and Marketing Manager has entered into a financial contract for one of the raw
material suppliers to supply equipment to the value of INR15 million to increase production of twisties and
this contract does not reflect in the statement of accounts. The external auditor stated that since there is
only a commercial contract and the official invoice has not been received by the company, then there is no
point to account for this transaction. A review of the quarterly report issued by the Risk Manager does not
indicate any abnormality in the financial statement from a risk management perspective.
Instead, the Risk Manager would normally end his report with the words ―I foresee that the company is
operating in a very sound and successful manner. The Board of Directors should be proud of such
achievemen‖. The Sales and Marketing Manager would give the indication that the company is progressing
very well and eventually, it should be able to launch a bid to takeover one of its competitive rivals. The
Finance Manager would normally end his reports with such phrases such as ―good performance‖, ―we are
on the right track‖ ―the Board of Directors should feel proud of the company‘s financial performance‖.
Questions
1. In reading this case study, what is our first impression of the state of affairs with Pifco-Zen Chen
Company Limited?
2. Is the company on the right track after we have read the financial statement?
13.5 Summary
Financial statement is the process of understanding the risk and profitability of a firm (business, sub-
business or project) through analysis of reported financial information, particularly annual and
quarterly reports.
The annual report comprises the income statement, the balance sheet, and the statement of cash flows,
as well as footnotes to these statements.
Financial statements are documents or reports which have been systematically maintained to indicate
the financial health of a company.
Analysis of financial statements is an attempt to assess the efficiency and performance of an enterprise.
Capital expenditure are those type of expenditure the benefits of which are taken in more than one
years by the business entity
Financial statements can be referred to as representation of the financial status of a company in a
systematically documented form.
13.6 Keywords
Common Size Balance Sheet: A statement where balance sheet items are expressed in the ratio of each
asset to total assets and the ratio of each liability is expressed in the ratio of total liabilities is called
common size balance sheet.
Capital Expenditure: Capital expenditure are those type of expenditure the benefits of which are taken in
more than one years by the business entity.
Revenue expenditure: Revenue Expenditure is the expenditure incurred in one accounting year and the
benefits from which is also enjoyed in the same period only.
Deferred Revenue Expenditure: The remaining portion of the expenditure is carried forward and is known
as capital expenditure or deferred revenue expenditure and is shown as an asset in the balance sheet.
Cash Flow Statement: This statement highlights flow of cash over a period of time. The cash flow may be
from investment activities, operations or financing activities.

1. Following is not a capital receipt:
(a) Dividend on investment (b) Bonus shares
(c) Sale of know-how (d) Compensation received for vacating business
place.
2. Outstanding wages are classified as

(a) Capital expenditure (b) Revenue expenditure
(c) Deferred revenue expenditure (d) None of the above
3. Expenditure incurred by a publisher for acquiring copyright is a

4. Municipal taxes paid on a property constitute a

5. An expenditure is termed a capital expenditure when

(a) The amount is large (b) It figures in the balance sheet
(c) Its benefits extend over a number of years (d) Its benefits only the current year
6. Share premium is a
(a) Capital receipt (b) Revenue receipt
(c) Both (a) and (b) (d) None of the above
7. Amount spent on unsuccessful patent rights is a

(a) Capital expenditure
(b) Deferred revenue expenditure (if the amount is large)
(c) Revenue expenditure (though the amount may be large)
(d) None of the above
8. Expenses involved in a change of office the organizational and starting costs would Constitute a _____
charge.
(a) Capital (b) Revenue (c) Deferred revenue (d)
Special
9. Which item of the following Illustrates deferred revenue expenditure?

(a) Purchase of a fixed asset (b) Wages to labour
(c) Managerial remuneration (d) Discount on issue of shares and debentures
10. Expenditure incurred by a publisher for acquiring copyright is a _____ expenditure.

(a) Revenue (b) Capital (c) Deferred revenue (d)
Strategic

1. Explain the concept of Financial Statements?
2. What do you mean by Revenue expenditure?
3. What are the objectives and needs of financial statements?
4. Which parties basically interested in financial statement analysis?
5. What do you mean by Capital Expenditure?
6. Difference between Revenue expenditure and Deferred Revenue Expenditure?
7. What are the comparative financial statements?
8. What do you mean by annual report?
9. Explain Deferred Revenue Expenditure.
10. What is the advantage of financial statements?
14
Analysis of Accounting Information
CONTENTS
Objectives
Introduction
14.4 Summary
14.5 Keywords
Objectives
Financial statement analysis and application
Presentation of a cash flow statement
Reporting cash flows from operating activities
Tying the CFS with the balance sheet and income statement
Introduction
We shall study the characteristics of a system, its attributes and some basic concepts and strategies for
studying them. Our philosophy is that an accounting information system is merely a kind of an information
system which in turn is a kind of a system. Therefore, the study of basic principles of systems in general
and, information systems in particular, is important for a thorough understanding of accounting
information systems. Our approach to the study of accounting information systems, as will become clear, is
an engineering one, where one proceeds through a methodical path of specification, design, construction,
testing and evaluation, operation and maintenance. A well engineered system is easy to understand, build,
maintain, and upgrade. An information system differs from other kinds of systems in that its objective is to
monitor/document the operations of some other system, which we can call a target system. An information
system cannot exist without such a target system.
For example, production activities would be the target system for a production scheduling system, human
resources in the business operations would be the target system of a human resource information system,
and so on. It is important to recognise that within a vending machine there is a component/sub-system that
can be considered an information system. In some sense, every reactive system will have a subsystem that
can be considered an information system whose objective is to monitor and control such a reactive system.
Being an information system, an accounting information system must have a target system. It should be
obvious that the target system must be business operations in a narrow sense. Other non-accounting aspects
of business operations are covered by information systems such as Human Resources Information System,
Management Information System, Production Planning/Scheduling System, Strategic Planning System,
and so on. The target system for an accounting system has to do with the aspects of business operations
that have to do with accountability for the assets/liabilities of the enterprise, the determination of the
results of operations that ultimately leads to the computation of comprehensive income, and the financial
reporting aspects of business operations.
The main object of teaching is not to give explanations, but to knock at the doors of the mind. If any boy is
asked to give an account of what is awakened in him by such knocking, he will probably say something
silly. For what happens within is much bigger than what comes out in words. Those who pin their faith on
university examinations as the test of education take no account of this.
These notes are prepared exclusively for the benefit of the students in the course Acc 681 Accounting
Information Systems in the Department of Accounting and Law at the State University of New York at
Albany, and are not to be used by others for any purpose without the express permission of the author.

Financial statement analysis is a process which examines past and current financial data for the purpose of
evaluating performance and estimating future risks and potential. Financial statement analysis is used by
investors, creditors, security analysts, bank lending officers, managers, taxing authorities, regulatory
agencies, labour unions, customers, and many other parties who rely on financial data for making
economic decisions about a company. Emphasis of this course is placed on the needs of investors,
especially shareholders and bondholders.
Analysis of financial statements focuses primarily on data provided in external reports plus supplementary
information provided by management. The analysis should identify major changes or turning points in
trends, amounts, and relationships. Financial statements are merely summaries of detailed financial
information. Many different groups are interested in getting inside financial statements, especially
investors and creditors. Their objectives are sometimes different but often related.
However, the basic tools and techniques of financial statement analysis can be effectively applied by all of
the interested groups. Financial statement analysis can assist investors and creditors in finding the type of
information they require for making decisions relating to their interests in a particular company.
14.1.1 Assessment of Past Performance and Current Position

Past performance is often a good indicator of future performance. Therefore, an investor or creditor looks
at the trend of past sales, expenses, net income, cash flow, and return on investment not only as a means
for judging management‘s past performance but also as a possible indicator of future performance. In
addition, an analysis of current position will tell, for example, what assets the business owns and what
liabilities must be paid. It will also tell what the cash position is, how much debt the company has in
relation to equity, and what levels of inventories and receivable exist. Knowing a company‘s past
performance and current position is often important in achieving the second general objective of financial
analysis.
14.1.2 Assessment of Future Potential and Related Risk

Information about the past and present is useful only to the extent that it bears on decisions about the
future. An investor judges the potential earning ability of a company because that ability will affect the
market price of the company‘s stock and the amount of dividends the company will pay. A creditor judges
the potential debt-paying ability of the company. The riskiness of an investment or loan depends on how
easy it is to predict future profitability or liquidity. If an investor can predict with confidence that a
company‘s earnings per share will be between INR125 and INR130 in the next year, the investment is less
risky than if the earnings per share are expected to fall between INR100 and INR450.
For example, the potential associated with an investment in an established and stable electric utility, or a
loan to it, is relatively easy to predict on the basis of the company‘s past performance and current position.
The potential associated with a small high-tech firm, on the other hand, may be much harder to predict. For
this reason, the investment in or loan to the electric utility carries less risk than the investment in or loan to
the small high-tech company.
Often, in return for taking a greater risk, an investor in the information technology (IT) company will
demand a higher expected return (increase in market price plus dividends) than will an investor in the
utility company. Also, a creditor of the IT company will demand a higher interest rate and possibly more
assurance of repayment (a secured loan, for instance) than a creditor of the utility company. The higher
interest rate reimburses the creditor for assuming a higher risk.
14.1.3 Investor’s Needs

Investors and potential investors are primarily interested in evaluating the investment Characteristics of a
company. Investment characteristics of an investment include such factors as risk, return, dividend or
interest yield, safety, liquidity, growth, and others.
The relationship of the current value of a stock or bond to expectations of its future value is basically
involved in the evaluation of investment opportunities. Investors are also interested in the safety of their
investment as reflected in the financial condition of the company and its operating performance. The
dividend policy of a company is usually a major concern of investors. Investors are also interested in the
operating income of the firm in order to evaluate the normal earnings trend of the firm. Since many
investors are interested in growth potential they look for information concerning how the company
obtained its resources and how it uses them. What is the capital structure of the company? What risks and
rewards does it hold out for equity investors? Does the firm have any financial leverage? Investment
evaluation also involves predicting the timing, amounts, and uncertainties of future cash flows of the firm.
Investors are also interested in monitoring the activities and effectiveness of management. Information
about how management acquires resources and uses the resources under its control can influence
investment decisions. The track record of management is often the most critical factor in deciding whether
or not to invest in the securities of a particular firm.
Bondholders and other creditors of a company are primarily concerned with the company‘s ability to meet
its obligations. Lenders want to know the reasons for a company‘s borrowings. Are they short or long-term
needs? Are they self-liquidating? How has the company handled its debt in the past?
Investment analysts and financial advisors have a major interest in the tools and techniques of financial
statement analysis. Such persons have the same basic information needs as investors and creditors as it
relates to their clients and potential clients. Analysts frequently adjust the financial statements prepared by
accountants for items they do not consider significant or for items they consider significant but which do
not appear o the statements.
14.1.4 Objectives of Financial Reporting

Financial reporting provides information that is useful in making business and economic decisions. The
objectives of general purpose external financial reporting come primarily from the needs of external users
who must rely on information that management communicates to them. SFAC (Statement of Financial
Accounting Concepts) No. 1 describes the objectives of financial reporting.
The financial reporting has the following major objectives:
1. Financial reporting should provide information that is useful to present and potential investors and
creditors and other users in making rational investment, credit, and similar decisions. The information
should be comprehensive to those who have a reasonable understanding of business and economic
activities and are willing to study the information with reasonable diligence.
2. Financial reporting should provide information to help present and potential investors and creditors and
other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends
or interest and the proceeds from the sales, redemption, or maturity of securities or loans. Since investors‘
and creditors‘ cash flows are related to enterprise cash flows, financial reporting should provide
information to help investors, creditors, and others assess the amounts, timing, and uncertainty of
prospective net cash inflows to the related enterprise.
3. Financial reporting should provide information about the economic resources of an enterprise, the claims
to those resources (obligations of the enterprise to transfer resources to other entities and owners‘ equity),
and the effects of transactions, events, and circumstances that change its resources and claims to those
resources. The primary focus of financial reporting is ordinarily considered to be information about
earnings and its components. Earnings analysis gives clue to (a) management‘ performance, (b) long-term
earning capabilities, (c) future earnings, and (d) risks associated with lending to and investing in the
enterprise.
Financial reporting should also provide information about how management has discharged its stewardship
function to stockholders for the use of the enterprise‘s resources entrusted to it. Management is responsible
not only for the custody and safekeeping of enterprise resources but also for their efficient profitable use.
SFAC No. 2 identifies the primary and secondary qualitative characteristics of accounting information that
distinguish better (more useful) information from inferior (less useful) information decision-making
process. Qualitative characteristics of accounting information are those qualities or ingredients of
accounting information that make it useful. The diagram in outlines a hierarchy of accounting information
qualities.
The hierarchical arrangement in Exhibit 1-1 is used to show certain relationships among the qualities. The
hierarchy shows that information useful for decision making is the most important. The primary qualities
are that accounting information shall be relevant and reliable.
If either of these two qualities is completely missing, the information cannot be useful. To be relevant,
information must be timely, and it must have predictive value or feedback value or both. To be reliable,
information must have representational faithfulness, and it must be verifiable and neutral. The ingredients
of reliability are verifiability, neutrality, and representational faithfulness. Verifiability is the ability
through consensus among measurers to ensure that information represents what it purports to represent or
that the chosen method of measurement has been used without error or bias. Management‘s estimate of
market value may not be verifiable because it may not reflect a consensus and may be biased or in error.
Comparability, including relevance and reliability, contributes to the overall usefulness of information.
Two constraints are shown on the chart in benefits must exceed costs and materiality. To be useful and
worth providing, the benefits of information should exceed its cost. All of the qualities described are
subject to a materiality threshold. The hierarchy of qualitative characteristics does not rank the
characteristics. If information is to be useful, all characteristics are required to a minimum degree. At times
various qualities may conflict in particular circumstances, in which even trade-offs are often necessary or
appropriate.
For example, the most relevant information may be difficult to understand, or information that is easy to
understand may not be very relevant.

Complementing the balance sheet and income statement, the cash flow statement (CFS), a mandatory part
of a company‘s financial reports since 1987, records the amounts of cash and cash equivalents entering and
leaving a company. The CFS allows investors to understand how a company‘s operations are running,
where its money is coming from, and how it is being spent. Here you will learn how the CFS is structured
and how to use it as part of your analysis of a company.
14.2.1 The Structure of the CFS

The cash flow statement is distinct from the income statement and balance sheet because it does not
include the amount of future incoming and outgoing cash that has been recorded on credit. Therefore, cash
is not the same as net income, which, on the income statement and balance sheet, includes cash sales and
sales made on credit.
Cash flow is determined by looking at three components by which cash enters and leaves a company: core
operations, investing and financing,
Operations
Measuring the cash inflows and outflows caused by core business operations, the operations component of
cash flow reflects how much cash is generated from a company‘s products or services. Generally, changes
made in cash, accounts receivable, depreciation, inventory and accounts payable are reflected in cash from
operations.
Cash flow is calculated by making certain adjustments to net income by adding or subtracting differences
in revenue, expenses and credit transactions (appearing on the balance sheet and income statement)
resulting from transactions that occur from one period to the next. These adjustments are made because
non-cash items are calculated into net income (income statement) and total assets and liabilities (balance
sheet). So, because not all transactions involve actual cash items, many items have to be re-evaluated when
calculating cash flow from operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the total value
of an asset that has previously been accounted for. That is why it is added back into net sales for
calculating cash flow.
The only time income from an asset is accounted for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must also be
reflected in cash flow. If accounts receivable decreases, this implies that more cash has entered the
company from customers paying off their credit accounts - the amount by which AR has decreased is then
added to net sales. If accounts receivable increase from one accounting period to the next, the amount of
the increase must be deducted from net sales because, although the amounts represented in AR are
revenue, they are not cash. An increase in inventory, on the other hand, signals that a company has spent
more money to purchase more raw materials. If the inventory was paid with cash, the increase in the value
of inventory is deducted from net sales. A decrease in inventory would be added to net sales. If inventory
was purchased on credit, an increase in accounts payable would occur on the balance sheet, and the amount
of the increase from one year to the other would be added to net sales.
The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something has been
paid off, then the difference in the value owed from one year to the next has to be subtracted from net
income. If there is an amount that is still owed, then any differences will have to be added to net earnings.
(For more insight, see Operating Cash Flow: Better Than Net Income?)
Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes from
investing are a ―cash out‖ item, because cash is used to buy new equipment, buildings or short-term assets
such as marketable securities. However, when a company divests of an asset, the transaction is considered
―cash in‖ for calculating cash from investing.
Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from
financing are ―cash in‖ when capital is raised, and they are ―cash out‖ when dividends are paid. Thus, if a
company issues a bond to the public, the company receives cash financing; however, when interest is paid
to bondholders, the company is reducing its cash.
14.2.2 Analyzing an Example of a CFS

Let us take a look at this CFS sample:
From this CFS, we can see that the cash flow for FY 2003 was INR7,61,00,000. The bulk of the positive
cash flow stems from cash earned from operations, which is a good sign for investors. It means that core
operations are generating business and that there is enough money to buy new inventory. The purchasing
of new equipment shows that the company has cash to invest in inventory for growth. Finally, the amount
of cash available to the company should ease investors‘ minds regarding the notes payable, as cash is
plentiful to cover that future loan expense.
Of course, not all cash flow statements look this healthy, or exhibit a positive cash flow. But a negative
cash flow should not automatically raise a red flag without some further analysis. Sometimes, a negative
cash flow is a result of a company‘s decision to expand its business at a certain point in time, which would
be a good thing for the future. This is why analyzing changes in cash flow from one period to the next
gives the investor a better idea of how the company is performing, and whether or not a company may be
on the brink of bankruptcy or success.
14.2.3 Tying the CFS with the Balance Sheet and Income Statement
As we have already discussed, the cash flow statement is derived from the income statement and the
balance sheet. Net earnings from the income statement are the figure from which the information on the
CFS is deduced. As for the balance sheet, the net cash flow in the CFS from one year to the next should
equal the increase or decrease of cash between the two consecutive balance sheets that apply to the period
that the cash flow statement covers.
14.2.4 Conclusion
A company can use a cash flow statement to predict future cash flow, which helps with matters in
budgeting. For investors, the cash flow reflects a company‘s financial health: basically, the more cash
available for business operations, the better. However, this is not a hard and fast rule. Sometimes a
negative cash flow results from a company‘s growth strategy in the form of expanding its operations. By
adjusting earnings, revenues, assets and liabilities, the investor can get a very clear picture of what some
people consider the most important aspect of a company: how much cash it generates and, particularly,
how much of that cash stems from core operations.
14.2.5 Scope
1. An enterprise should prepare a cash flow statement and should present it for each period for which
financial statements are presented.
2. Users of an enterprise‘s financial statements are interested in how the enterprise generates and uses cash
and cash equivalents. This is the case regardless of the nature of the enterprise‘s activities and irrespective
of whether cash can be viewed as the product of the enterprise, as may be the case with a financial
enterprise. Enterprises need cash for essentially the same reasons, however different their principal
revenue-producing activities might be. They need cash to conduct their operations, to pay their obligations,
and to provide returns to their investors.
14.2.6 Benefits of Cash Flow Information

3. A cash flow statement, when used in conjunction with the other financial statements, provides
information that enables users to evaluate the changes in net assets of an enterprise, its financial structure
(including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order
to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the
ability of the enterprise to generate cash and cash equivalents and enables users to develop models to
assess and compare the present value of the future cash flows of different enterprises.
It also enhances the comparability of the reporting of operating performance by different enterprises
because it eliminates the effects of using different accounting treatments for the same transactions and
events.
4. Historical cash flow information is often used as an indicator of the amount, timing and certainty of
future cash flows. It is also useful in checking the accuracy of past assessments of future cash flows and in
examining the relationship between profitability and net cash flow and the impact of changing prices.

14.3.1 Presentation of a Cash Flow Statement
1. The cash flow statement should report cash flows during the period classified by operating, investing
and financing activities.
2. An enterprise presents its cash flows from operating, investing and financing activities in a manner
which is most appropriate to its business Classification by activity provides information that allows users
to assess the impact of those activities on the financial position of the enterprise and the amount of its cash
and cash equivalents. This information may also be used to evaluate the relationships among those
activities.
3. A single transaction may include cash flows that are classified differently.
For example, when the instalment paid in respect of a fixed asset acquired on deferred payment basis
includes both interest and loan, the interest element is classified under financing activities and the loan
element is classified under investing activities.
Operating Activities
1. The amount of cash flows arising from operating activities is a key indicator of the extent to which the
operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the
enterprise, pay dividends, repay loans and make new investments without recourse to external sources of
financing. Information about the specific components of historical operating cash flows is useful, in
conjunction with other information, in forecasting future operating cash flows.
2. Cash flows from operating activities are primarily derived from the principal revenue-producing
activities of the enterprise. Therefore, they generally result from the transactions and other events that enter
into the determination of net profit or loss. Examples of cash flows from operating activities are:
(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions and other revenue;
(c) cash payments to suppliers for goods and services;
(d) cash payments to and on behalf of employees;
(e) cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and
other policy benefits;
(f) cash payments or refunds of income taxes unless they can be specifically identified with financing and
investing activities; and
(g) cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap
contracts when the contracts are held for dealing or trading purposes.
3. Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included
in the determination of net profit or loss.However, the cash flows relating to such transactions are cash
flows from investing activities.
4. An enterprise may hold securities and loans for dealing or trading purposes, in which case they are
similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase and
sale of dealing or trading securities are classified as operating activities. Similarly, cash advances and loans
made by financial enterprises are usually classified as operating activities since they relate to the main
revenue-producing activity of that enterprise.
Investing Activities
1. The separate disclosure of cash flows arising from investing activities is important because the cash
flows represent the extent to which expenditures have been made for resources intended to generate future
income and cash flows. Examples of cash flows arising from investing activities are:
(a) cash payments to acquire fixed assets (including intangibles).
These payments include those relating to capitalised research and development costs and self-constructed
fixed assets;
(b) cash receipts from disposal of fixed assets(including intangibles);
(c) cash payments to acquire shares, warrants or debt instruments of other enterprises and interests in joint
ventures (other than payments for those instruments considered to be cash equivalents and those held for
dealing or trading purposes);
(d) cash receipts from disposal of shares, warrants or debt instruments of other enterprises and interests in
joint ventures (other than receipts from those instruments considered to be cash equivalents and those held
for dealing or trading purposes);
(e) cash advances and loans made to third parties (other than advances and loans made by a financial
enterprise);
(f) cash receipts from the repayment of advances and loans made to third parties (other than advances and
loans of a financial enterprise);
(g) cash payments for futures contracts, forward contracts, option contracts and swap contracts except
when the contracts are held for dealing or trading purposes, or the payments are classified as financing
activities; and
(h) cash receipts from futures contracts, forward contracts, option contracts and swap contracts except
when the contracts are held for dealing or trading purposes, or the receipts are classified as financing
activities.
2. When a contract is accounted for as a hedge of an identifiable position, the cash flows of the contract are
classified in the same manner as the cash flows of the position being hedged.
Financing Activities
The separate disclosure of cash flows arising from financing activities is important because it is useful in
predicting claims on future cash flows by providers of funds (both capital and borrowings) to the
enterprise. Examples of cash flows arising from financing activities are:
(a) cash proceeds from issuing shares or other similar instruments;
(b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term borrowings;
and
(c) cash repayments of amounts borrowed.
14.3.2 Reporting Cash Flows from Operating Activities

1. An enterprise should report cash flows from operating activities using either:
(a) The direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed;
or
(b) the indirect method, whereby net profit or loss is adjusted for the effects of transactions of a non-cash
nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income
or expense associated with investing or financing cash flows.
2. The direct method provides information which may be useful in estimating future cash flows and which
is not available under the indirect method and is, therefore, considered more appropriate than the indirect
method. Under the direct method, information about major classes of gross cash receipts and gross cash
payments may be obtained either:
(a) From the accounting records of the enterprise; or
(b) By adjusting sales, cost of sales (interest and similar income and interest expense and similar charges
for a financial enterprise) and other items in the statement of profit and loss for:
(i) changes during the period in inventories and operating receivables and payables;
(ii) Other non-cash items; and
(iii) Other items for which the cash effects are investing or financing cash flows.
3. Under the indirect method, the net cash flow from operating activities is determined by adjusting net
profit or loss for the effects of:
(a) Changes during the period in inventories and operating receivables and payables;
(b) Non-cash items such as depreciation, provisions, deferred taxes, and unrealised foreign exchange gains
and losses; and
(c) All other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash flow from operating activities may be presented under the indirect method by
showing the operating revenues and expenses excluding non-cash items disclosed in the statement of profit
and loss and the changes during the period in inventories and operating receivables and payables.
14.3.3 Reporting Cash Flows from Investing and Financing Activities

An enterprise should report separately major classes of gross cash receipts and gross cash payments arising
from investing and financing activities,
14.3.4 Reporting Cash Flows on a Net Basis

1. Cash flows arising from the following operating, investing or financing activities may be reported on a
net basis:
(a) Cash receipts and payments on behalf of customers when the cash flows reflect the activities of the
customer rather than those of the enterprise; and
(b).cash receipts and payments for items in which the turnover is quick, the amounts are large, and the
maturities are short.
2. Examples of cash receipts and payments referred to in above are:
(a) The acceptance and repayment of demand deposits by a bank;
(b) Funds held for customers by an investment enterprise; and
(c).rents collected on behalf of, and paid over to, the owners of properties.
3. Examples of cash receipts and payments referred to in above are advances made for, and the repayments
of:
(a) Principal amounts relating to credit card customers;
(b) The purchase and sale of investments; and
(c) Other short-term borrowings, for example, those which have a maturity period of three months or less.
4. Cash flows arising from each of the following activities of a financial enterprise may be reported on a
net basis:
(a) Cash receipts and payments for the acceptance and repayment of deposits with a fixed maturity date;
(b) The placement of deposits with and withdrawal of deposits from other financial enterprises; and
(c) Cash advances and loans made to customers and the repayment of those advances and loans.
Did You Know?

1. John Grisham, famous mystery novelist, received his undergraduate degree in accounting from
Mississippi State University.
2. Walter Diemer, was an accountant for the Fleer Corporation in the 1920s. In his spare time, Diemer
tinkered with gum recipes and created a chewy, rubbery substance better known as bubble gum
Caution
Registration statements prepared during this timeframe oftentimes include capsule
financial information for the fourth quarter and/or full year notwithstanding the fact that
the year-end financial statements have not been ―issued‖.
Case Study-Accounting Information Systems

Accounting Information Systems (AIS) are a tool which, when incorporated into the field of Information
and Technology systems (IT), are designed to help in the management and control of topics related to
organization‘ economic-financial area. But the stunning advance in technology has opened up the
possibility of generating and using accounting information from a strategic viewpoint.
Accounting Information System (AIS) is vital to all organizations and perhaps, each organization either
profit or non profit-oriented need to maintain the AISs. On the other hand, an AIS is the whole of the
related components that are put together to collect information, raw data or ordinary data and transform
them into financial data for the purpose of reporting them to decision makers. To better understand the
term ―Accounting Information System‖, the three words constitute AIS would be elaborated separately.
Firstly, literature documented that accounting could be identified into three components, namely
information system, ―language of business‖ and source of financial information (Wilkinson, 1993: 6-7).
Secondly, information is a valuable data processing that provides a basis for making decisions, taking
action and fulfilling legal obligation. Finally, system is an integrated entity, where the framework is
focused on a set of objectives.
Accounting literature argues that strategic success is considered an outcome of Accounting Information
Systems (AIS) design. Several, studies have analyzed the role of AIS in strategic management, examining
the attributes of AIS under different strategic priorities. It has also been analyzing the effect on
performance of the interaction between certain types of strategies and different design of AIS (e.g.
different techniques and information). The appropriate design of AIS supports business strategies in ways
that increasing the organizational performance. Increasing AIS investment will be the leverage for
achieving a stronger, more flexible corporate culture to face persistent changes in the environment.
Innovation is the incentive with which a virtuous circle will be put in place, leading to better firm
performance and a reduction in the financial and organizational obstacles, while making it possible to
access capital markets. AIS are systems used to record the financial transactions of a business or
organization. This system combines the methodologies, controls and accounting techniques with the
technology of the IT industry to track transactions provide internal reporting data, external reporting data,
financial statements, and trend analysis capabilities to affect on organizational performance.
In managing an organization and implementing an internal control system the role of accounting
information system (AIS) is crucial. An important question in the field of accounting and management
decision-making concerns the fit of AIS with organizational requirements for information communication
and control. Benefits of accounting information system can be evaluated by its impacts on improvement of
decision-making process, quality of accounting information, performance evaluation, internal controls and
facilitating company‘s transactions.
Therefore, regarding the above five characteristics, the effectiveness of AIS is highly important for all the
organization performance. According to Adrian Downes and Nick Barclay performance management is a
quick maturing business discipline. Therefore, performance management has a key role to play in
improving the overall value of an organization. Control efficacy of financial information reliability has
affected operating performance.
Questions:
1. What do you know about Accounting Information System(AIF)?.
2. How can you say that AIF is tool which are use in Information System (IT)?.
14.4 Summary
Financial statement analysis is a process which examines past and current financial data for the
purpose of evaluating performance and estimating future risks and potential.
Past performance is often a good indicator of future performance.
Financial reporting provides information that is useful in making business and economic decisions.
Financial reporting should provide information that is useful to present and potential investors and
creditors and other users in making rational investment, credit, and similar decisions.
Management is responsible not only for the custody and safekeeping of enterprise resources but also
for their efficient profitable use.
14.5 Keywords
Accounts Payable (AP): The AP an accounting entry that represents an entity‘s obligation to pay off a
short-term debt to its creditors. The accounts payable entry is found on a balance sheet under the heading
current liabilities.
Accounts Receivable (AR): The AR Money owed by customers (individuals or corporations) to another
entity in exchange for goods or services that have been delivered or used, but not yet paid for.
Depreciation: A method of allocating the cost of a tangible asset over its useful life. Businesses depreciate
long-term assets for both tax and accounting purposes.
Inventory: The raw materials, work-in-process goods and completely finished goods that are considered to
be the portion of a business‘s assets that are ready or will be ready for sale. Inventory represents one of the
most important assets that most businesses possess, because the turnover of inventory represents one of the
primary sources of revenue generation and subsequent earnings for the company‘s shareholders/owners.
Net Income (NI): A company‘s total earnings (or profit). Net income is calculated by taking revenues and
adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. This number is
found on a company‘s income statement and is an important measure of how profitable the company is
over a period of time. The measure is also used to calculate earnings per share.

1. In proper capital budgeting analysis we evaluate incremental ......................... cash flows.
(a) accounting (b) oprating
(c) before-tax (d).financing
2. All of the following influence capital budgeting cash flows except ...........................
(a).choice of depreciation method for tax purposes
(b).economic length of the project
(c).projected sales (revenues) for the project
(d).sunk costs of the project
3. Depreciation Expense..........
(a) Operating (b).Investing
(c).Financing (d) Supplemental
4. Proceeds from the sale of equipment used in the business

5. An increase in the balance in Accounts Payable

6. Cash has been described as:

(a) the lifebuoy of the business. (b) the lifeboat of the business.
(c) the lifeline of the business. (d) the lifeblood of the business.
7. The definition of cash as used in Cash Flow Statements includes:

(a) only cash balances (b) only bank balances.
(c) bank balances and bank overdrafts (d) cash in hand plus bank balances less bank overdrafts.
8. How can a profitable business fail?

(a) Because it cannot pay its bills
(b) Because it has more current liabilities than current assets
(c) Because it has a bank overdraft
(d) Because it has too much cash
9. Which of the following is not a standard heading in a cash flow statement?
(a) Financing (b) Taxatio
(c) Equity dividends paid (d) Current expenditure
10. If a company has paid dividends on its preference shares, under which one of the cash flow statement
headings would they appear?
(a) Returns on investments and servicing of finance
(b) Financing
(c) Equity dividends paid
(d) Capital investment and financial investment

1. How can a company have a profit but not have cash?
2. Why is an increase in inventory shown as a negative amount in the statement of cash flows?
3. What is the difference between the direct method and the indirect method for the statement of cash
flows?
4. Where does the interest paid on bank loans get reported on the statement of cash flows?
5. Why is an amount in the cash flows from investing activities shown in parenthesis?
6. Where is interest on a note payable reported on the cash flow statement?
7. What do you know about Inventory needs?
8. Why is the cash flow statement identified as one of the financial statements?
9. What do you know about qualitative characteristics of accounting information?
10. What is the difference between cash flow and free cash flow?

1 (b) 2 (d) 3 (a) 4 (b) 5 (a)
6 (d) 7 (d) 8 (a) 9 (d) 10 (a)
15
Accounting for Insurance Cl
CONTENTS
Objectives
Introduction
15.4 Summary
15.5 Keywords
Objectives
Understand the loss of stock and consequential loss
Explain accounting principles
Discuss the accounting standards in India
Introduction
The major differences in accounting for life insurance as compared with other industries derive from the
long time period between receipt of premiums and the payment of claims. This gives rise to the need for
actuarial estimates of the liability in order to determine both the solvency and the profitability of life
business. UK insurance companies are structured as proprietary or mutual companies and are mostly
composites writing both non-life and life insurance. However only life insurance offers a form of
investment as well as pure insurance against risk. Life insurance products include term; whole-life;
endowment; maximum investment contracts including unit-linked policies; annuities; pensions; and
permanent health insurance. In with-profits insurance policyholders as well as shareholders participate in
the surpluses arising on the business. Premiums may be paid as single, regular or recurring single
premiums. In setting premium rates the actuary must allow for mortality, interest, expenses and
contingencies, as well target profit and market competition.
Accounting practices are needed for premiums, for claims on death, maturity and surrenders (including
bonuses), and for commissions (including deferred acquisition costs). Companies normally ‗lay-off‘ a
proportion of the risk by reinsuring with other insurance, or specialist reinsurance, companies. The
accounting for the reinsurance premiums paid, claims reimbursements received and commissions paid is
effectively the mirror image of the accounting for the direct insurance. Investment return comprises
interest and dividends and gains and losses from changes in the market value of investments. A realised
gain arises when an investment is sold for more than its cost. Unrealised gains arise when investments are
revalued to market value at the yearend but not actually sold. UK companies normally show investments at
market value in the balance sheet.
As solvency needs to be maintained over the very long periods for which policies are written it is necessary
to ensure that not only do assets currently exceed liabilities but even more importantly that future cash
inflows will match the requirements for future cash outflows. A crucial aspect of investment management
is therefore to ensure adequate ‗matching‘ of the maturities of investments against the maturities of
anticipated claims.
As there is usually a significant period between the inception of a policy and the receipt of premiums, and
the final payment of benefit, it is necessary to make provision, at the end of each accounting period, for the
future liability to pay the ultimate benefits to the policyholders, the amount of which will depend on a
range of factors. An actuarial estimate of the ‗long term business provision‘ needs to be made. In the UK
this is the responsibility of the company‘s ‗appointed actuary‘. The actuarial estimate of the long term
liabilities is part of both the accounting and the regulatory requirements for supervision of insurance
business and the calculations are required both for the insurers‘ annual accounts and for the returns made
to the supervisory authorities (in the UK, the returns to the Department of Trade and Industry (‗DTI
Returns‘)), to ensure the protection of policyholders‘ interests.
In respect of profit calculation the very conservative ‗surplus arising‘ method in the UK – the ‗statutory
solvency method‘ as modified under the EU Insurance Accounts Directive (‗IAD‘) by the deferral of
acquisition costs - is primarily designed to show the degree of solvency of the company rather than to
measure its profitability in a particular year. However, it is generally accepted that, given certain
disclosures, this basis is ‗true and fair‘ for the purpose of the annual accounts.
New approaches to more ‗realistic‘ profit measurement are currently under discussion in the UK. The
accounts required under the IAD comprise a profit and loss account (including a technical account for non-
life insurance business, a technical account for life assurance business and a non-technical account), a
balance sheet and notes thereto.

Stock Loss is simply the discrepancy/difference between actual physical stock values compared to book
value of stock.
When unknown quantity goods is lost, whether they are stolen, destroyed in a fire, or lost in any other way
such that the quantity lost cannot be counted, then the cost of the goods lost is the difference between:
The cost of goods sold
Opening stock of the goods plus purchases less closing stock of the goods
When stock is stolen, destroyed or otherwise lost, the loss must be accounted for somehow. Since the
loss is not a trading loss, the cost of the goods lost is not included in the trading account. The account
that is to be debited is one of two possibilities, depending on whether or not the lost goods were
insured against the loss.
If the lost goods were not insured, the business must bear the loss, and the loss is shown in the profit
and loss account.
Profit and loss account – Debit
Trading account – Credit
If the lost goods were insured, the business will not suffer a loss, because the insurance will pay back
the cost of the lost goods. This means that there is no charge at all in the profit and loss account, and
the appropriate double entry is:
Insurance claim account – Debit
Trading account – Credit
The insurance claim will then be a current asset, and shown in the balance sheet of the business as
such. When the claim is paid, the account is closed by,
Cash – Debit
Insurance claim account – Credit
The amount of loss incurred as a result of being unable to use business property or equipment. If the
property/equipment is damaged through a natural disaster or accident, only certain types of insurance can
cover the owner for lost business income. Consequential loss is considered an indirect loss (as compared to
losses from the direct damage). Direct damages would be covered under different types of insurance, such
as property/casual or fire insurance, but the firm still incurs the costs of lost operations.
Say, for example, that a major storm causes some property damage to a storefront. The business owner‘s
property/casualty insurance may cover the amount needed to replace the property, but what about the lost
revenue while the store is closed? All of the owner's fixed costs such as rent continue, but there's no money
coming in. These are consequential losses, and can be covered under business interruption insurance, of
which there are several types. Insurance to compensate for consequential losses can also cover situations
where no direct damage is done to property, but loss of revenue occurs because of things like a power
outage or breach of contract from a supplier or business partner. If you run or own a business then knowing
what consequential loss is can be crucial should you ever have to file and insurance claim for a large
disaster or major catastrophe like fire or flood damage? The most successful businesses have a good idea
of what they can do to minimise their disruption when something goes wrong having a plan for if you
suffer a fire or flood may sound extreme, but could save your business in the long run.
Consequential loss in layman‘s terms is essentially the loss of profit or the basic value of loss that
surrounds a property‘s use. Fire and flood are prime examples of where a property and the damage caused
to it can seriously affect how a business is run and its ability to trade as it did prior to the fire.
If a fire rips through a building and causes severe structural damage (which is incredibly common) the
business will not be able to operate for the foreseeable future in most cases until the building is brought
back to its original state. In its most basic terms, consequential loss is the basic value of loss, specifically
when it relates to the loss of a property‘s use. A good example of this loss would be when a fire damages a
building‘s structure and causes the businesses in that structure to lose income until it is finally able to
reopen after renovations and repairs. Similarly if you stock has been damaged by water damage or flood
damage you are going to be unable to trade until you have replaced said stock. In today‘s economic climate
that is not always financially viable.
Consequential loss can also relate to indirect losses caused by the disaster the example that is oft quoted is
if you have a freezer full of fresh meat and the power is cut due to indirect damage and the meat is ruined.
If you run a restaurant this can have a major impact on your ability to provide your normal level of service
which results in loss of profit. Is your business automatically covered for consequential loss? The general
answer is no – in most cases you will need business interruption insurance to be covered for consequential
loss. Having business interruption insurance can cover you for so many eventualities that it can be
surprising that so many businesses neglect to take it or are even aware of its existence.
With regards to your business planning for the future is essential for its success but more often than not
businesses tend to concentrate on the exciting and forward thinking ideas. For a business to truly succeed
you need to be thinking about the things you would rather not? Wayne Barker is the copywriter for Harris
Balcombe a claims management company whose loss assessor have been helping businesses get the
insurance claim payouts they deserve for over a hundred years. Harris Balcombe specialise in fire
insurance claims, flood insurance claims and many other types of business interruption insurance claims.
Consequential Loss and Business Interruption are two different concepts. Many businesses deal with stock
that is temperature sensitive. A prolonged change in temperature could result in damage or spoilage to
these items. Most commercial property forms exclude loss caused directly or indirectly by changes in
temperature, freezing or heating. Having a Consequential Loss Assumption clause (or something similar)
covers this type of damage.
Whatever causes the refrigerating or heating equipment to stop working has to be a covered peril under the
policy. So if the refrigerating equipment caught on fire and the equipment failed, as long as the cause of
the fire is covered then the damage to the equipment would be covered along with the spoilage of whatever
stock is being refrigerated. However if there is a blackout due to interruption of power from the local
power company, then any damage to the equipment and/or spoilage of stock would not be covered, as this
peril is a standard exclusion under any commercial property policy.
Business Interruption coverage insures the net profit that is lost because of partial or total interruption to
the business and the operating expenses which must continue during the period of the interruption. If your
business has the potential to be interrupted after a loss to your physical assets, then you need the coverage
provided by Business Interruption insurance.

Rules for insurance accounting codified by the National Association of Insurance Commissioners (NAIC)
or as promulgated by a domicile as rules to be used in reporting an insurer's results to regulators. These
rules focus on the balance sheet and solvency analysis, and differ from the generally accepted accounting
principles (GAAP) used for other types of businesses.
For example, statutory accounting rules do not allow the inclusion of certain nonadmitted assets on the
balance sheet; require that certain loss reserves be set by conservative formulas instead of the insurer's
estimates; require the insurer to immediately recognize the expenses associated with writing new business
instead of amortizing them over the policy period; and do not allow premiums for reinsurance placed with
unauthorized reinsurers to be recognized as an asset.
The insurance accounts directive (―IAD‖) does not establish a different set of standards for insurance
companies in comparison with other undertakings but rather it aims to deal with items affected by the
special characteristics of insurance business: reporting format and disclosure. Accounts of companies
based outside the EU will reflect the Home State‘s own accounting conventions. The following description
is based on UK practice.
UK GAAP accounting bases: annual and funded.
Under UK GAAP, general insurance business may be accounted for on two different bases: the annual
basis or the funded basis. These bases refer to the way in which profit is recognised:
Under the annual basis, the profits and losses of business written during the financial year are
recognised at the end of that financial year by setting up provisions for outstanding claims, unearned
premiums and unexpired risk provisions, and by deferring an appropriate portion of acquisition costs.
Under the funded basis, the recognition of profits (but not losses) is deferred for up to three years after
the end of the financial year in which the business incepts.
While there are only these two accounting bases under UK GAAP, there are also two methods of
reporting the underwriting performance of a general insurance business for regulatory return or other
statistical or management purposes - the accident year basis and the underwriting year basis:
The accident year basis measures performance in relation to the events and earnings of a financial
period, irrespective of when the relevant policies incepted.
The underwriting year basis measures performance in relation to ultimate losses and premiums written
in respect of policies incepting in the financial period, irrespective of when events (premiums, claims
and expenses) occur.
A general insurer will therefore have a basis on which it recognises profit (annual or funded) and also have
a system for reporting underwriting performance (accident year or underwriting year).
Insurance accounting rules (also known as statutory accounting) help a firm record operating transaction
and evaluate business performance levels. A state's insurance commissioner establishes rules and
guidelines by which firms abide when preparing financial statements. Statutory financial reports include
statement of financial position, statement of profit and loss, or Profit and Loss, statement of cash flows and
statement of equity.
Insurable Interest: Insurable interest means that in order for the insured to start an insurance policy, he
must have an ownership or financial interest in whatever it is he wants to insure. This keeps people
from taking insurance policies out or making claims that don't directly affect them. For example, you
cannot take out an insurance policy on the Eiffel Tower unless you have an ownership interest in it, or
are otherwise harmed, physically or monetarily, should something happen to the structure.
Indemnity: To indemnify is to compensate a person for losses sustained. Indemnity in an insurance-
sense simply means that your policy protects you from loss by covering whatever it is that you are
insuring. The best example would be car insurance. If you wreck your car, you get compensated for
your loss. This is indemnity.
Uberrimae Fidei: Uberrimae Fidei, or "good faith," means that the insurer is dependent on you, the
insured, to disclose any relevant information about yourself or whatever it is you are insuring. If you
want to get health insurance, good faith means that you will disclose any existing health conditions.
Subrogation: Subrogation is the insurance company's right to take action on parties that may have
caused the claim against your insurance. For example, if you are involved in an auto accident that you
didn't cause, the insurance company has the right to collect damages from the person that caused the
accident or his insurance company. This allows the insurance company to recoup any losses due to
claims for which the insured wasnot responsible.
Contingency Insurance: Contingency insurance is essentially a worst case scenario policy. The best
example would be exporting freight to a buyer on the other side of the country. Should the truck show
up to the buyer with lost or damaged goods, and the buyer refuses to take delivery because of this, you
can file a claim through your contingency policy. Most contingency claims are filed by retail suppliers.
Proximate Cause: Proximate cause is basically insurance that covers losses that other types of
insurance don't cover. For example, assume that a plane carrying three tons of Halloween costumes
crashes on the runway upon landing. The accident isn't severe, and the costumes aren't damaged, but
they end up arriving a week after Halloween, which costs the retailer several thousand dollars in
revenue. Since they aren't damaged and were indeed delivered, the retailer may not be able to file a
claim under most types of insurance. Policies that include proximate cause allow you to recoup your
damages when the unexpected happens.
The contribution principle of insurance states that if a risk is insured by multiple carriers and one carrier
has paid out a claim, that carrier is entitled to collect proportionate coverage from other carriers.
Example
If you had taken out INR 50 million in fire insurance on a building from two different carriers for INR 50
million each, and a fire destroyed the building, and you filed a claim with only one carrier, the carrier
would pay the claim. But it would be entitled to go to the other carrier and collect INR 25,00,000, the other
carrier's proportionate share of the claim.
Restrictions: The total amount insured should not exceed the amount of damage or loss incurred. This
is because of the insurance principle of indemnity: No one should profit from an insurance claim after
damages are taken into account.
Applicability: The doctrine applies primarily to property and casualty insurance claims, such as fire
and marine claims. It does not ordinarily apply to life insurance: When more than one company covers a
life, they underwrite that risk independently. However, the applicant must typically disclose how much
other coverage is in force or applied for.
The statutory accounting principles (SAP) forms the basis for preparing the financial statements of
insurance companies. GAAP is the set of accounting rules required to be followed by all companies,
irrespective of the industry. Broadly, SAP differs from GAAP in terms of the accounting principles used to
prepare the financial statements, governing agencies, the purpose for which the financial statements are
used, and valuation methods.
Difference 1
SAP is specific to the insurance industry, while all companies must follow GAAP rules.
Statutory Accounting Principles are accounting rules that are specific to insurance companies as
outlined by the National Association of Insurance Commissioners (NAIC). They provide the
framework to prepare the financial statements of insurance companies. Because the insurance industry
falls under state regulation, actual rules vary by state. The SAP filings are used to determine the health
of the insurance company.
Generally Accepted Accounting Principles (GAAP), on the other hand, are a set of accounting rules
and standards that are required to be followed by all companies. The GAAP rules are set and
monitored by the Financial Accounting Standards Board (FASB). The U.S. Securities and Exchange
Commission (SEC) requires all companies to follow GAAP rules when filing their financial reports.
GAAP rules are the same nationwide, allowing investors to compare companies using the same set of
standards.
Insurance companies have to file their financial statements using SAP for state filings, and GAAP for
SEC filings.
Difference 2
SAP and GAAP operate on different accounting principles to provide information that is used for
different purposes.
SAP guidelines are used to prepare financial statements that allow investors to determine the ability of
the insurance company to pay its future claims. In other words, if all customers of the insurance
company had a claim at present, SAP helps to determine if the company would be able to pay those
insurance claims. It allows investors to know the worth of the company if it ceased operations
immediately.
GAAP guidelines, however, treat a business as a going concern--as if the business would remain in
operation indefinitely. Therefore, the focus is on preparing the financial statements by matching
revenues with expenses, so an investor can gauge the underlying profitability of the business. This
allows investors to answer the question about the worth of a company in its future versus its actual
present value.
Difference 3
The value of assets using SAP is lower than when using GAAP.
This difference stems from the fundamental difference in the purpose of creating financial statements
under SAP and GAAP. Because SAP statements are used to find the value of the company at the
immediate present, the statements don't include many intangible and non-liquid assets. This includes
items such as furniture, supplies, tax credit and goodwill. GAAP, on the other hand, allows companies
to list these items under the assets category, which translates to a higher value in terms of assets.
Difference 4
The matching principle used by GAAP that matches revenues and expenses isn't followed in SAP
filings. Thus, the net income ratios as calculated by using the data from SAP and GAAP filings are
different for the same company and the same financial year.
So when a product is sold apart from recording the sales revenue, the company has to also record the
cost of making the product as an expense. Though in actuality the expense may have occurred before
the sale of the product, the matching principle allows a company to record this expense only when the
sale is made. In the case of insurance, an insurance company can record the expense over the life of the
policy using GAAP. So if the premium is due quarterly, the expense related to the sale of the policy is
divided to match the quarterly earned premiums.
In the case of SAP, this principle is broken. So the insurance company has to record its expenses as
they occur, irrespective of when the revenue is earned. So the entire expense related to the policy is
recorded when the sale is made, even though the premium may still be unearned. For a growing
company, the initial statements may thus show more expenses than revenue, thus lowering its net
income.
Difference 5
The equity values for the same company differ, using data from SAP and GAAP filing for the same
financial year.
The value of an enterprise is recorded differently using GAAP and SAP. GAAP records it as
stockholder equity; SAP records this under statutory policyholder surplus. Because SAP records assets
more conservatively and also has different standards for calculating the net income of an insurance
company than GAAP, it naturally follows that the values recorded under statutory policyholder surplus
aren't the same as stockholder equity. Generally, the valuation under SAP will tend to be lower than
that of GAAP because of the more conservative method of accounting used.
Caution:
Rules for insurance accounting should always be codified by the National Association of Insurance
Commissioners (NAIC).

The objective of this Indian accounting standard is to specify the financial reporting for insurance contracts
by any entity that issues such contracts (described in this Indian accounting standard as an insurer). In
particular, this Indian Accounting Standard requires: limited improvements to accounting by insurers for
insurance contracts disclosure that identifies and explains the amounts in an insurer‘s financial statements
arising from insurance contracts and helps users of those financial statements understand the amount,
timing and uncertainty of future cash flows from insurance contracts.
An entity shall apply this Indian Accounting Standard to: insurance contracts (including reinsurance
contracts) that it issues and reinsurance contracts that it holds financial instruments that it issues with a
discretionary participation feature. Ind AS 107 Financial Instruments: Disclosures requires disclosure
about financial instruments, including financial instruments that contain such features.
This Indian Accounting Standard does not address other aspects of accounting by insurers, such as
accounting for financial assets held by insurers and financial liabilities issued by insurers (Financial
Instruments: Presentation, Ind AS 39 Financial Instruments: Recognition and Measurement and Ind AS
107).
An entity shall not apply this Indian accounting standard to:
This Indian Accounting Standard shall come into effect for insurance companies from the date to be
separately announced. Product warranties issued directly by a manufacturer, dealer or retailer (see Ind AS
18 Revenue and Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets). Employers‘ assets
and liabilities under employee benefit plans (see Ind AS 19 Employee Benefits and Ind AS 102 Share-
based Payment) and retirement benefit obligations reported by defined benefit retirement plans. contractual
rights or contractual obligations that are contingent on the future use of, or right to use, a non-financial
item (for example, some licence fees, royalties, contingent lease payments and similar items), as well as a
lessee‘s residual value guarantee embedded in a finance lease (see Ind AS 17 Leases, Ind AS 18 Revenue
and Ind AS 38 Intangible Assets).
Financial guarantee contracts unless the issuer has previously asserted explicitly that it regards such
contracts as insurance contracts and has used accounting applicable to insurance contracts, in which case
the issuer may elect to apply Ind AS 39, Ind AS 32 and Ind AS 107 or this Standard to such financial
guarantee contracts. The issuer may make that election contract by contract, but the election for each
contract is irrevocable. Contingent consideration payable or receivable in a business combination (see Ind
AS 103 Business Combinations) direct insurance contracts that the entity holds (i.e., direct insurance
contracts in which the entity is the policyholder). However, a decant shall apply this Standard to
reinsurance contracts that it holds. For ease of reference, this Indian Accounting Standard describes any
entity that issues an insurance contract as an insurer, whether or not the issuer is regarded as an insurer for
legal or supervisory purposes.
A reinsurance contract is a type of insurance contract. Accordingly, all references in this Indian
Accounting Standard to insurance contracts also apply to reinsurance contracts.
Embedded derivatives
Ind AS 39 requires an entity to separate some embedded derivatives from their host contract, measure them
at fair value and include changes in their fair value in 4 profit or loss. Ind AS 39 applies to derivatives
embedded in an insurance contract unless the embedded derivative is itself an insurance contract.
As an exception to the requirement in Ind AS 39, an insurer need not separate, and measure at fair value, a
policyholder‘s option to surrender an insurance contract for a fixed amount (or for an amount based on a
fixed amount and an interest rate), even if the exercise price differs from the carrying amount of the host
insurance liability. However, the requirement in Ind AS 39 does apply to a put option or cash surrender
option embedded in an insurance contract if the surrender value varies in response to the change in a
financial variable (such as an equity or commodity price or index), or a non-financial variable that is not
specific to a party to the contract. Furthermore, that requirement also applies if the holder‘s ability to
exercise a put option or cash surrender option is triggered by a change in such a variable (for example, a
put option that can be exercised if a stock market index reaches a specified level). Paragraph 8 applies
equally to options to surrender a financial instrument containing a discretionary participation feature.
The paradigm shift in the economic environment in India during last few years has led to increasing
attention being devoted to accounting standards as a means towards ensuring potent and transparent
financial reporting by corporate. Further, cross-border rising of huge amount of capital has also generated
considerable interest in the generally accepted accounting principles in advanced countries such as USA.
Initiatives taken by International Organisation Securities Commission (IOSCO) towards propagating
International Accounting Standards (IASs)/ International Financial Reporting Standards (IFRSs), issued by
the International Accounting Standards Board (IASB), as the uniform language of business to protect the
interests of international investors have brought into focus the IASs/ IFRSs.
The Institute of Chartered Accountants of India, being a premier accounting body in the country, took upon
itself the leadership role by establishing Accounting Standards Board, more than twenty five years ago, to
fall in line with the international and national expectations. Today, accounting standards in India have
come a long way. Presented hereinafter are some salient features of the accounting standard-setting
endeavours in India.
Did you know?
Accounting Standards issued by the ICAI have legal recognition through the Companies Act in 1956.
15.3.1 Rationales of Accounting Standards

Accounting Standards are formulated with a view to harmonise different accounting policies and practices
in use in a country. The objective of Accounting Standards is, therefore, to reduce the accounting
alternatives in the preparation of financial statements within the bounds of rationality, thereby ensuring
comparability of financial statements of different enterprises with a view to provide meaningful
information to various users of financial statements to enable them to make informed economic decisions.
The Companies Act, 1956, as well as many other statutes in India require that the financial statements of
an enterprise should give a true and fair view of its financial position and working results. This
requirement is implicit even in the absence of a specific statutory provision to this effect. The Accounting
Standards are issued with a view to describe the accounting principles and the methods of applying these
principles in the preparation and presentation of financial statements so that they give a true and fair view.
The Accounting Standards not only prescribe appropriate accounting treatment of complex business
transactions but also foster greater transparency and market discipline. Accounting Standards also helps the
regulatory agencies in benchmarking the accounting accuracy.
15.3.2 International Harmonisation of Accounting Standards

Recognising the need for international harmonisation of accounting standards, in 1973, the International
Accounting Standards Committee (IASC) was established. It may be mentioned here that the IASC has
been reconstituted as the International Accounting Standards Board (IASB). The objectives of IASC
included promotion of the International Accounting Standards for worldwide acceptance and observance
so that the accounting standards in different countries are harmonised. In recent years, need for
international harmonisation of Accounting Standards followed in different countries has grown
considerably as the cross-border transfers of capital are becoming increasingly common.
15.3.4 Accounting Standards-setting in India

The Institute of Chartered Accountants of India (ICAI) being a member body of the IASC, constituted the
Accounting Standards Board (ASB) on 21st April, 1977, with a view to harmonise the diverse accounting
policies and practices in use in India. After the avowed adoption of liberalisation and globalisation as the
corner stone‘s of Indian economic policies in early ‗90s, and the growing concern about the need of
effective corp effective corporate governance of late, the Accounting Standards have increasingly assumed
importance.
While formulating accounting standards, the ASB takes into consideration the applicable laws, customs,
usages and business environment prevailing in the country. The ASB also gives due consideration to
International Financial Reporting Standards (IFRSs)/ International Accounting Standards (IASs) issued by
IASB and tries to integrate them, to the extent possible, in the light of conditions and practices prevailing
in India.
15.3.5 Composition of the Accounting Standards Board

The composition of the ASB is broad-based with a view to ensuring participation of all interest groups in
the standard-setting process. These interest-groups include industry, representatives of various departments
of government and regulatory authorities, financial institutions and academic and professional bodies.
Industry is represented on the ASB by their apex level associations, viz., Associated Chambers of
Commerce and Industry (ASSOCHAM), Confederation of Indian Industries (CII) and Federation of Indian
Chambers of Commerce and Industry (FICCI).
As regards government departments and regulatory authorities, Reserve Bank of India, Ministry of
Company Affairs, Comptroller and Auditor General of India, Controller General of Accounts and Central
Board of Excise and Customs are represented on the ASB. Besides these interest-groups, representatives of
academic and professional institutions such as Universities, Indian Institutes of Management, Institute of
Cost and Works Accountants of India and Institute of Company Secretaries of India are also represented on
the ASB. Apart from these interest groups, certain elected members of the Central Council of ICAI are also
on the ASB.
15.3.6 Accounting Standards-setting Process

The accounting standard setting, by its very nature, involves reaching an optimal balance of the
requirements of financial information for various interest-groups having a stake in financial reporting.
With a view to reach consensus, to the extent possible, as to the requirements of the relevant interest-
groups and thereby bringing about general acceptance of the Accounting Standards among such groups,
considerable research, consultations and discussions with the representatives of the relevant interest-groups
at different stages of standard formulation becomes necessary. The standard-setting procedure of the ASB,
as briefly outlined below, is designed in such a way so as to ensure such consultation and discussions:
Identification of the broad areas by the ASB for formulating the Accounting Standards.
Constitution of the study groups by the ASB for preparing the preliminary drafts of the proposed
Accounting Standards.
Consideration of the preliminary draft prepared by the study group by the ASB and revision, if any, of
the draft on the basis of deliberations at the ASB.
Circulation of the draft, so revised, among the Council members of the ICAI and 12 specified outside
bodies such as Standing Conference of Public Enterprises (SCOPE), Indian Banks‘
Association, Confederation of Indian Industry (CII), Securities and Exchange Board of India
(SEBI), Comptroller and Auditor General of India (Cand AG), and Department of Company
Affairs, for comments.
Meeting with the representatives of specified outside bodies to ascertain their views on the draft of the
proposed Accounting Standard.
Finalisation of the Exposure Draft of the proposed Accounting Standard on the basis of comments
received and discussion with the representatives of specified outside bodies.
Issuance of the Exposure Draft inviting public comments.
Consideration of the comments received on the Exposure Draft and finalisation of the draft Accounting
Standard by the ASB for submission to the Council of the ICAI for its consideration and approval for
issuance.
Consideration of the draft Accounting Standard by the Council of the Institute, and if found necessary,
modification of the draft in consultation with the ASB.
The Accounting Standard, so finalised, is issued under the authority of the Council.
Present status of Accounting Standards in India in harmonisation with the International Accounting
Standards
As indicated earlier, Accounting Standards are formulated on the basis of the International
Financial Reporting Standards (IFRSs)/ International Accounting Standards (IASs) issued by the IASB. Of
the 41 IASs issued so far, 29 are at present in force, the remaining standards have been withdrawn. Apart
from this, 8 IFRSs have also been issued by the IASB Corresponding to the IASs/IFRSs.
15.3.7 Compliance with Accounting Standards

Accounting Standards issued by the ICAI have legal recognition through the Companies Act, 1956,
whereby every company is required to comply with the Accounting Standards and the statutory auditors of
every company are required to report whether the Accounting Standards have been complied with or not.
Also, the Insurance Regulatory and Development Authority (IRDA) (Preparation of Financial Statements
and Auditor‘s Report of Insurance Companies)
Regulations, 2000 requires insurance companies to follow the Accounting Standards issued by the ICAI.
The Securities and Exchange Board of India (SEBI) and the Reserve Bank of India also require compliance
with the Accounting Standards issued by the ICAI from time to time. Section 211 of the Companies Act,
1956, deals with the form and contents of balance sheet and profit and loss account. The Companies
(Amendment) Act, 1999 has inserted new sub-sections 3A, 3B and 3C to Section 211, with a view to
ensure that the financial statements are prepared in accordance with the Accounting Standards. The new
sub-sections as inserted are reproduced below:
Section 211 (3A): ‗Every profit and loss account and balance sheet of the company shall comply with the
accounting standards‘
Section 211 (3B): ‗Where the profit and loss account and the balance sheet of the company do not comply
with the accounting standards, such companies shall disclose in its profit and loss account and balance
sheet, the following, namely:
The deviation from the accounting standards;
The reasons for such deviation; and
The financial effect, if any, arising due to such deviation‘
Section 211 (3C): ‗For the purposes of this section, the expression ―accounting standards‖ means the
standards of accounting recommended by the Institute of Chartered Accountants of India, constituted under
the Chartered Accountants Act, 1949 (38 of 1949), as may be prescribed by the Central Government in
consultation with the National Advisory Committee on Accounting Standards established under sub-
section (1) of section 210A:
Provided that the standards of accounting specified by the Institute of Chartered Accountants of India shall
be deemed to be the Accounting Standards until the accounting standards are prescribed by the Central
Government under this sub-section.‘
It may also be mentioned that the National Advisory Committee on Accounting Standards
NACAS) has been constituted under section 210A as referred to under section 211 (3C) to advise the
Central Government on formulation and laying down of the accounting standards for adoption by
companies or class of companies. It is of significance to note that on the recommendation of NACAS, the
Ministry of Company Affairs, has issued a Notification dated 7th December, 2006, whereby it has
prescribed Accounting Standards 1 to 7 and 9 to 29, as recommended by the Institute of Chartered
Accountants of India, which are included in the said Notification. As per the Notification, the Accounting
Standards shall come into effect in respect of accounting periods commencing on or after the publication of
these Accounting Standards, i.e., 7th December, 2006. Specific relaxations are given to particular kinds of
companies, termed as Small and Medium Sized Companies, depending upon their size and nature.
The above legal provisions have cast a duty upon the management to prepare the financial statements in
accordance with the accounting standards. The corresponding provision to report on the compliance of
accounting standards has been inserted under section 227 of the Companies Act, 1956, thereby casting a
duty upon the auditor of the company to report on such compliance. A new clause (d) under sub-section 3
of Section 227 of the Companies Act, 1956 is read as under: ‗whether, in his opinion, the profit and loss
account and balance sheet comply with the accounting standards referred to in sub-section (3C) of section
211‘
As far as the reporting of compliance with the Accounting Standards by the management is concerned,
clause (i) under the new sub-section 2AA of Section 217 of the Companies Act, 1956, (inserted by the
Companies Amendment Act, 2000) prescribes that the Board‘s report should include a Directors‘
Responsibility Statement indicating therein that in the preparation of the annual accounts, the applicable
accounting standards had been followed along with proper explanation relating to material departures.
Did you know?

The National Association of Insurance Commissioners (NAIC) is the U.S. standard-setting and regulatory
support organization created and governed by the chief insurance regulators from the 50 states, the District
of Columbia and five U.S. territories
Case Study-EMC Insurance Companies Insurance Firm Uses Business Intelligence to Improve
Financial Reserve Management
EMC Insurance Companies struggled with pinpointing the right amount of money to hold in reserve
against potential case payouts; holding back either too much or too little could be disadvantageous to the
firm‘s bottom line. After a year in which the company experienced a run-up in reserves, EMC took steps to
improve financial reserve management. The company selected PolyVista, advanced data analytics software
built on Microsoft SQL Server Analysis Services, to uncover anomalies, correlations, relationships, and
patterns hidden within the firm‘s warehouse of claim data. After deploying the solution, EMC was able to
improve financial reserve management, identify claims requiring special attention, improve data quality,
support executive decision making with improved analysis, and better manage expenses.
Situation
EMC Insurance Companies sell workers‘ compensation, property, and casualty insurance through
independent insurance agents in 16 branch offices across the United States. Founded in 1911, EMC is one
of the largest insurance companies in its home state of Iowa. With assets of approximately U.S.INR 15
billion, the insurance firm has the bulk of its volume in commercial lines of business, with the remaining
15% in personal lines.
The Challenge of Financial Reserve Management

EMC manages its loss reserves money set aside for paying future insurance claims by setting up a reserve
for every case that the company handles. ―When a claim walks in the door, we try to determine what is the
most likely outcome for that claim,‖ explains Rich Schulz, Senior Vice President of Claims for EMC
Insurance Companies. Strategic management of financial reserves can be a key contributor to the success
of any insurance firm, and they are important indicators that are looked at by both insurance regulators and
investors.
―It is a real balancing act; you do not want to under reserve or over reserve accounts. Consistency is
critical,‖ says Schulz. ―In 2004, we saw that our loss reserves were starting to creep up and yet, with all the
tools we had, we were unable to pinpoint exactly what was happening. We realized we had to get a better
handle on the way we were setting our reserves.
Schulz wanted to be able to predict the company‘s claim outcomes on an ongoing basis and, hopefully,
identify and closely monitor those cases likely to have negative outcomes such as increased costs,
additional services, or a lengthy resolution. ―We had all this claim data and not an effective way to look at
it,‖ says Schulz. ―We wanted a tool that would allow us to look at trends that the company was
experiencing and be able to figure out what was driving them.‖ He looked at a number of predictive
modelling tools available on the market, but found that initial investment costs were high and the cost of
maintaining those tools was far beyond what the company was willing to pay.
The Need to Identify Trends

EMC stored a great deal of data in its internal claim processing system, but managers needed the ability to
sift through that data more efficiently. For example, executives at EMC wanted to track and understand
company trends related to claim frequency, which is the ratio of claim volume to premium volume, and
severity, which is the ratio of claim cost to premium volume. Not only did they need to track these
measures in order to manage their business, but executives also were expected to provide explanations of
sudden trend changes to industry analysts.
Schulz also needed to be able to track expenses both across the company and by individual branch, and he
wanted the flexibility to analyze expenses in consideration with other factors. ―Currently, most claim
people are under a lot of stress about expenses,‖ Schulz says.
―The ability to understand where expenses were running high is important. All of our adjustment expenses
are open to analysis. Do we have one or two business units that are overusing certain types of vendors to
investigate claims?‖
In need of an affordable and effective solution, EMC Insurance Companies heard about PolyVista business
intelligence software, which provides two important capabilities: A business user can use it to drill up and
down on data, and it can automatically identify anomalies, correlations, relationships, and patterns that are
hidden in that data—all without requiring custom code or predefining the anticipated results.
EMC was interested in determining whether the PolyVista software, which uses Microsoft SQL Server
Analysis Services as its core engine, could help the firm with its data analysis needs. ―For the PolyVista
solution, we made the decision to use Microsoft SQL Server Analysis Services as our multidimensional
engine many years ago,‖ says Robert Potts, Vice President of Sales at PolyVista Inc. ―That selection has
proven to be prescient. Analysis Services has become the dominant multidimensional engine in the market.
It provides a robust open development environment that allows us to build and enhance our unique
sophisticated analytic product at an affordable price point.
―Plus, partnering with Microsoft just makes sense,‖ Potts adds. ―We‘re working with the best software
company in the business.‖After watching an initial demonstration of the software in March 2007, Schulz
arranged for PolyVista Inc. to do a proof of concept (POC) for key stakeholders within EMC. ―Typically,
we arrange to have the client data staged and ready for us when we walk in the door,‖ explains Potts. ―We
then load the data into SQL Server Analysis Services, do some massaging, and start presenting.‖
Questions
1. What was the problem facing EMC Insurance Companies?
2. What are the different challenges of financial reserve management?
15.4 Summary
The major differences in accounting for life insurance as compared with other industries derive from
the long time period between receipt of premiums and the payment of claims
The amount of loss incurred as a result of being unable to use business property or equipment. If the
property/equipment is damaged through a natural disaster or accident, only certain types of insurance
can cover the owner for lost business income
Rules for insurance accounting codified by the National Association of Insurance Commissioners
(NAIC) or as promulgated by a domicile as rules to be used in reporting an insurer's results to
regulators
The Insurance Accounts Directive (―IAD‖) does not establish a different set of standards for insurance
companies in comparison with other undertakings
An entity shall apply this Indian Accounting Standard to: insurance contracts (including reinsurance
contracts) that it issues and reinsurance contracts
The objective of this Indian Accounting Standard is to specify the financial reporting for insurance
contracts by any entity that issues such contracts
15.5 Keywords
Accounting Equation: All accounting entries made in the books of account of a business have a
relationship based on the accounting equation: Assets = Liabilities + Owner‘s Equity.
Asset: Tangible or intangible items of value owned by a business e.g. cash, stock, buildings and vehicles.
Consequential Loss: Consequential loss in layman‘s terms is essentially the loss of profit or the basic
value of loss that surrounds a property‘s use.
NAIC: Rules for insurance accounting codified by the National Association of Insurance Commissioners
(NAIC) or as promulgated by a domicile as rules to be used in reporting an insurer's results to regulators.
Statutory Accounting Principles: There are accounting rules that are specific to insurance companies as
outlined by the National Association of Insurance Commissioners (NAIC).
1. The amount of loss incurred as a result of being unable to use business property or equipment
(a) True (b) False
2. .........is simply the discrepancy/difference between actual physical stock values compared to book
value of stock.
(a) Stock profit (b) Stock Loss
(c) Consequential Loss (d) None of these
3. A general insurer will therefore not have a basis on which it recognises profit.
(a)True (b) False
4. Rules for insurance accounting codified by the..........

(a) SAP (b) GAAP
(c) NAIC (d) None of these
5. Insurance accounting rules
(a) financial accounting (b) statutory accounting
(c) management accounting (d) None of these
6. The ......... forms the basis for preparing the financial statements of insurance companies
(a) SAP (b) GAAP
7. ....... is the set of accounting rules required to be followed by all companies, irrespective of the industry
(a) SAP (b) GAAP
8. Accounting Standards are formulated with a view to harmonise different accounting policies and
practices in use in a country
(a) True (b)False
9. The matching principle used by GAAP that matches revenues and expenses isn't followed in .............
filing
(a) SAP (b) GAAP
10. Insurance companies have to file their financial statements using SAP for state filings, and ......... for
SEC filings
(a) SAP (b) GAAP

1. Write short note on loss of stock.
2. What do you mean by consequential loss?
3. Explain the different accounting principles of insurance accounting
4. Explain in detail accounting standards in India
5. Write the difference between the statutory accounting principles (SAP) and generally accepted
accounting principles (GAAP)
6. What are the two accounting bases under UK GAAP?
7. What are the insurance accounting rules?
8. What is the international harmonisation of accounting standards?
9. Explain the accounting standards-setting in India
10. Give an overview of compliance with accounting standards

1. (a) 2.(b) 3.(b) 4.(c) 5.(b)
6. (a) 7.(b) 8.(a) 9.(a) 10.(b)

BBA - JNU - 101 Fundamentals of Accounting PDF

Uploaded by

Copyright:

Available Formats

You might also like

BBA - JNU - 101 Fundamentals of Accounting PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BBA - JNU - 101 Fundamentals of Accounting PDF

Uploaded by

Copyright:

Available Formats

FUNDAMENTALS OF

Jaipur National University

Depreciation: Concepts of Depreciation, Methods of accounting for depreciation.

Reserves: Reserve for discount on creditors, Rectification of Errors.

Partnership Accounts: Problems Relating to Admission, Retirement, Death and Dissolution of a

Accounting of Non Profit Organization: Accounting for insurance, Incomplete Records –

Financial Statements: Meaning, Capital Expenditure, Revenue expenditure and Deferred

Analysis of Accounting Information: Financial statement analysis and application, Statement of

Unit-2 Journal 14-26

Unit-3 Depreciation 27-39

Unit-5 Reserves 53-64

Unit-6 Trial Balance 65-77

Unit-7 Final Accounting 78-91

Unit-8 Book of Original Record 92-105

Unit-9 Partnership Accounts 106-117

Unit-10 Accounting of Non Profit Organization 118-130

Unit-11 Issue of Shares and Debentures 131-143

Unit-12 Redemption of Preference Shares and Debentures 144-153

Unit-13 Financial Statements 154-166

Unit-14 Analysis of Accounting Information 167-179

Unit-15 Accounting for Insurance Cl 180-194

1.1 Need of Accounting

The basic features of accounting are as follows:

1.2 Objectives of Accounting

To Protect Business Properties

To Ascertain the Operational Profit or Loss

1.3 Basics of Accounting

Classification of Transactions: Before recording any transaction, it is essential that it is to be classified. A

Recording of Transactions: The essence of financial accounting is recording of transaction. In accounting

1.3.2 Cost Accounting

1.3.3 Management Accounting

1.4 Accounting Terms

Figure 1.1: Trading and non-trading business items.

(b) Non-Trading Items

1.5 Conceptual Framework

1.6 Accounting Conventions

Convention of Full Disclosure

1.7 Accounting Equation

From the above business transactions, we find that

Effect of Transactions on Accounting Equations

2. She purchased goods from Rohit for INR40,000

Did You Know?

1.8 Balance Sheet

Assets – Liabilities = Net Worth

Why is it called a “Balance Sheet”?

1.9.1 Reporting Period and Conversion Period

Case Study- Process Costing System

1.12 Self Assessment Questions

2. Which of the following is not an asset?

3. Which of the following is a liability?

4. Which of the following best describes a trial balance?

5. Is it true that the trial balance totals should agree?

6. Which of the following is correct?

9. SEBI stands for….

1.13 Review Questions

Answer for Self Assessment Questions

2.1 Concept of Journal

1. The journal entry must identify at least two accounts.