Module II Preparation of Financial Statements

Preparation of Companies Financial Statements: as per Revised Schedule III Income Statement Balance
Sheet Accounting for Depreciation.

Final Accounts

The profit and loss account and the balance sheet are together known as Final Accounts.

This is because these are the last or the final steps in accounting trail.

The profit and loss account is prepared to show the financial results of a business – the profit
or loss- during an accounting period.

The balance sheet is prepared to show the financial position- position of assets and liabilities
of a business as on a particular date.

The profit and loss account consists of elements of income and expenses. It has two sides –
debit and credit. The debit side reflects all expenses and losses, and the credit side all income
and gains.

The excess of credit over debit is known as net profit, and the excess of debit over credit is
known as net loss for the period.

For a corporate entity profit and loss account and the balance sheet are the final accounts.
A non- corporate entity, however, prepare an additional account called trading account to show
gross profit earned or gross loss incurred during a particular period.

Gross profit is arrived at by deducting the direct cost of goods sold from the sales proceeds.

If the difference is positive, there is gross profit, and if the difference is negative, there is gross
loss.

From the gross profit if we deduct indirect administrative and selling expenses and add other
income we get net profit.

From the following trial balance, let us prepare the final accounts of the trader.

Trial Balance as on 31stMarch 2020

Dr. Cr.
S. No. Particulars Amount Rs. Amount Rs.
1. Capital A/c 13,450
2 Cash in hand A\c 1,400
3 Bank overdraft 9,320
4 Sales 2,36,400
5 Purchases 1,06,400
6 Returns inward 13,400
7 Returns outward 2,960
8 Carriage outward 2,360
9 Carriage inward 14,260

1
10 Salaries 9,600
11 Wages 3,660
12 Sundry Debtors 16,300
13 Sundry Creditors 37,360
14 Stock as on Ist April 2015 94,120
15 Land and Buildings 15,000
16 Plant & Machinery 20,900
17 Trade expenses 2,090
2,99,490 2,99,490

Closing stock as on 31stMarch 2016was valued at Rs.1,92, 100.

Trading account
For the year ended 31stMarch 2020
Dr. Cr.
Particulars Particulars Amount
Amount
To Opening stock 94,120 By Sales 2,36,400
Less: Return Inward 13,400 2,23,000
To Purchases 1,06,400 By closing stock 1,92,100
Less: Return Outward 2,960 1,03,440
14,260
To Carriage Inward
To Wages 3,660
To Gross Profit 1,99,620
(transferred to P/L account)
4,15,100 4,15,100

Profit and Loss Account

For the year ended 31stMarch 20120 Cr.
Particulars Amount Particulars Amount
Rs. Rs.
9,600 By Trading 1,99,620
To Salaries Account/Gross
Profit
To Carriage outward 2,360

To Trade expenses 2,090

To Net Profit 1,85,570

(Net profit transferred to Capital
Account)

1,99,620 1,99,620

2
 Balance Sheet
As on 31stMarch 2020

Amount Assets Amount

Liabilities Rs. Rs.
Capital Land and Buildings 15,000
Account 13,450 1,99,020
Add: net Plant and Machinery 20,900
profit 1,85,570

Sundry Creditors 37,360 Stock-in-trade 1,92,100

Bank Overdraft 9,320 Sundry Debtors 16,300

Cash in hand 1,400

2,45,700 2,45,700

As a general rule if an item appears in the Trial Balance it will find its place only once in any
final accounts, i.e., Trading Account or Profit and Loss Account or the balance Sheet.

On the other hand if an item is considered from outside the trial balance, the same will find its
place twice in the final accounts.

For example: opening stock figure appears in trial balance, and hence it is shown only once (in
the Trading Account).

Whereas closing stock, which is taken from outside the Trial Balance, has found its place twice-
once in the credit side of the Trading Account and second time in the asset side of the Balance
Sheet.

This is because of double accounting concept.

However, the closing stock can, in exceptional cases, form part of the Trial Balance e.g., if it is
adjusted against purchases or if the trial balance is prepared after the profit and loss account.

In that situation the closing stock will appear only once in the asset side of the Balance Sheet.

In actual practice the stock lying with the firm is valued at the end of the accounting period.

The valuation principle is cost or market price whichever is less.

In the case of finished goods, the cost means the cost of raw material plus manufacturing wages
and other manufacturing expenses. This also applies to work in process.

Characteristics of Balance Sheet

• It is prepared at a particular date on the close of the day and not for a period.

• It is true only on that date and not later.

3
 Suppose in the above example, part of goods is sold on 1st Jan 2005.

This will mean that the value of the stock will be reduced to that extent and the
cash in hand will increase to that extent.

The capital will also increase by the amount of profit earned in the transaction.

• The Balance Sheet is prepared only after the preparation of Profit and Loss Account
(including the Trading Account)

• Since Capital always equals the difference of the assets and liabilities and since the
Capital account will independently arrive at this figure, the two sides of the Balance
Sheet must have the same totals.

If it is not, there is certainly an error somewhere.

• Balance Sheet shows the financial position of a business at going concern cost.

• Balance Sheet is not an account but only a statement of assets and liabilities on a
particular date.

• On the left side, the liabilities of the business are shown, whereas on the right hand side
the assets of the business are shown

Arrangement of assets or liabilities:

The assets and liabilities are grouped in one of the following ways:

(i) Liquidity: It means the ease with which the assets may be converted into cash i.e.,
those assets, which are difficult in this respect, are written last.

Liabilities are shown as short-term liabilities in the beginning and then long-term liabilities
and in the end the capital is written.

(ii) Permanence: The assets which are to be used permanently in the business and are not
meant to be sold are written first.

Assets which are most liquid such as cash are written last.

In this method the capital is written in the beginning and then long-term liabilities and last of
all short-term liabilities like amount due from suppliers or goods or bills payable.

Exercise:
4
 From the following trial balance prepare a trading account, profit and loss account and
Balance sheet.

Sundry debtors 1,500 Sales 17,000

Stock as on 5,000 Rents rates
1st Jan 2004 and Taxes 800
Land and Buildings 10,000 Salaries 2,000
Cash in hand 1,600 Capital 25,000
Cash at bank 4,000 Depreciation 1,000
Interest received 6,00 Drawings 2,000
Wages 3,000 Purchases 10,000
Bills receivable 2,000 Office 2,500
Interest paid 200 expenses 5,700
Bad debts 500 Plant & 7,000
Bills payable 4,000 Machinery 1,500
Repairs 300 Sundry
creditors
Furniture &
fixtures
On 31st Jan2004 the stock was valued at Rs.10, 000

Answer: GP Rs.9, 000, NP Rs.2,300 , Total of Asset Rs. 36,300

Comparison Chart
Basis for
Balance Sheet Profit and Loss Account
Comparison
Account that shows the
A statement that shows company's assets,
Meaning company's revenue and
liabilities and equity at a specific date.
expenses over a period of time.
What is it? Statement Account
Profit earned or loss suffered
Financial position of the business on a particular
Represents by business for the accounting
date.
period
Preparation Prepared on the last day of financial year. Prepared for the financial year.
Information Income, expenses, gains and
Assets, liabilities, and capital of shareholders.
Disclosed losses.
Accounts shown in the Balance Sheet do not Accounts transferred to Profit
Accounts
lose their identity, rather their balance is carry and Loss account are closed
5
 Basis for
Balance Sheet Profit and Loss Account
Comparison
forward to next year as opening balance. and cease to exist.
It is prepared after the preparation of Profit & It is prepared before the
Sequence
Loss Account. preparation of Balance Sheet.

Comparison Chart
Basis for
Trial Balance Balance Sheet
Comparison
Trial Balance is the list of all The Balance sheet is the statement which
Meaning balances of General Ledger shows the assets, equity and liabilities of
Account. the company.
Division Debit and Credit columns Assets and equity & liabilities heads
Stock Opening stock is considered. Closing stock is considered.
Part of Financial
No Yes
Statement
To check the arithmetical
To ascertain the financial position of the
Objective accuracy in recording and
company on a particular date.
posting.
Personal, real and nominal
Balances Personal and real account are shown.
account are shown.
At the end of each month,
Preparation quarter, half year or financial At the end of the financial year.
year.
Use Internal Use External Use

What are Financial Statements?

Definition

Financial Statements represent a formal record of the financial activities of an entity. These are
written reports that quantify the financial strength, performance and liquidity of a company.
Financial Statements reflect the financial effects of business transactions and events on the
entity.

Three Types of Financial Statements

The main types of financial statements are:

1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial position
of an entity at a given date. It is comprised of the following three elements:

6
 • Assets: Something a business owns or controls (e.g. cash, inventory, plant and
machinery, etc)
• Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
• Equity: What the business owes to its owners. This represents the amount of capital that
remains in the business after its assets are used to pay off its outstanding liabilities.
Equity therefore represents the difference between the assets and liabilities.

2. Income Statement

Income Statement, also known as the Profit and Loss Statement, reports the company's financial
performance in terms of net profit or loss over a specified period. Income Statement is composed
of the following two elements:

• Income: What the business has earned over a period (e.g. sales revenue, dividend income,
etc)
• Expense: The cost incurred by the business over a period (e.g. salaries and wages,
depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

3. Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period. The
movement in cash flows is classified into the following segments:

• Operating Activities: Represents the cash flow from primary activities of a business.
• Investing Activities: Represents cash flow from the purchase and sale of assets other than
inventories (e.g. purchase of a factory plant)
• Financing Activities: Represents cash flow generated or spent on raising and repaying
share capital and debt together with the payments of interest and dividends.

Nature of Financial Statements:

The financial statements are prepared on the basis of recorded facts. The recorded facts are those
which can be expressed in monetary terms. The statements are prepared for a particular period,
generally one year. The transactions are recorded in a chronological order, as and when the
events happen.

The accounting records and financial statements prepared from these records are based on
historical costs. The financial statements, by nature, are summaries of the items recorded in the
business and these statements are prepared periodically, generally for the accounting period.

7
The following points explain the nature of financial statements:

1. Recorded Facts:

The term ‘recorded facts’ refers to the data taken out from the accounting records. The records
are maintained on the basis of actual cost data. The original cost or historical cost is the basis of
recording various transactions. The figures of various accounts such as cash in hand, cash in
bank, bills receivables, sundry debtors, fixed assets etc. are taken as per the figures recorded in
the accounting books. The assets purchased at different times and at different prices are put
together and shown at cost prices. As recorded facts are not based on replacement costs, the
financial statements do not show current financial condition of the concern.

2. Accounting Conventions:

Certain accounting conventions are followed while preparing financial statements. The
convention of valuing inventory at cost or market price, whichever is lower, is followed. The
valuing of assets at cost less depreciation principle for balance sheet purposes is followed.

The convention of materiality is followed in dealing with small items like pencils, pens, postage
stamps, etc. These items are treated as expenditure in the year in which they are purchased even
though they are assets in nature. The stationery is valued at cost and not on the principle of cost
or market price whichever is less. The use of accounting conventions makes financial statements
comparable, simple and realistic.

3. Postulates (Assumptions ):

The accountant makes certain assumptions while making accounting records. One of these
assumptions is that the enterprise is treated as a going concern. The other alternative to this
postulate is that the concern is to be liquidated, this, is untenable if management shows an
intention to liquidate the concern. So the assets are shown on a going concern basis. Another
important assumption is to presume that the value of money will remain the same in different
periods.

Though there is a drastic change in purchasing power of money the assets purchased at different
times will be shown at the amount paid for them. While preparing profit and loss account, the
revenue is treated in the year in which the sale was undertaken even though the sale price may be
received in a number of years. The assumption is known as realization postulate.

4. Personal Judgments:

Even though certain standard accounting conventions are followed in preparing financial
statements but still personal judgment of the accountant plays an important part. For example, in
applying the cost or market value whichever is less to inventory valuation the accountant will
have to use his judgment in computing the cost in a particular case. There are a number of
methods for valuing stock, viz.; last in first out, first in first out, average cost method, standard
cost, base stock method, etc.

The accountant will use one of these methods for valuing materials. The selection of depreciation
method, to use one of the several methods for estimating uncollectible debts, to determine the
8
period for writing off intangible assets are some of the examples where judgment of the
accountant will play an important role in choosing the most appropriate course of action.

Objectives of Financial Statements:

Financial statements are the sources of information on the basis of which conclusions are drawn
about the profitability and financial position of a concern. They are the major means employed
by firms to present their financial situation of owners, creditors and the general public. The
primary objective of financial statements is to assist in decision making.

(i) To provide reliable financial information about economic resources and obligations of a
business firm.

(ii) To provide other needed information about changes in such economic resources and
obligations.

(iii) To provide reliable information about changes in net resources (resources less obligations)
arising out of business activities.

(iv) To provide financial information that assists in estimating the earning potentials of business.

(v) To disclose, to the extent possible, other information related to the financial statements that is
relevant to the needs of the users of these statements.

Uses of Financial Statements:

Following major uses of financial statements:

(1) As a report of Profitability for owners

(2) As a basis for making policy and strategies in the company ;

(3) To determine the legality of dividends;

(4) As guide to advise dividend action;

(5) As a basis for the granting of credit;

(6) As informative for prospective investors in an enterprise;

(7) As a guide to the value of investment already made;

(8) As an aid to government supervision;

(9) As a basis for price or rate regulation;

(10) As a basis for taxation.

9
Importance of Financial Statements:

The utility of financial statements to different parties is discussed in detail as follows:

(1) Management: The financial statements are useful for assessing the efficiency for different
cost centres. The management is able to exercise cost control through these statements. The
efficient and inefficient spots are brought to the notice of the management. The management is
able to decide the course of action to be adopted in future.
(2) Creditors: The trade creditors are to be paid in a short period. This liability is met out of
current assets. The creditors will be interested in current solvency of the concern. The calculation
of current ratio and liquid ratio will enable the creditors to assess the current financial position of
the concern in relation to their debts.
(3) Bankers: The banker is interested to see that the loan amount is secure and the customer is
also able to pay the interest regularly. The banker will analyze the balance sheet to determine
financial strength of the concern and profit and loss account will also be studied to find out the
earning position.

A banker has a large number of customers and it is not possible to supervise their business
activities. It is through the financial statements that a banker can keep a watch on the business
plans and performances of its customers. These statements also help the banker to determine the
amount of securities it will ask from the customers as a cover for the loans.

(4) Investors: The investors include both short-term and long-term investors. They are
interested in the security of the principal amount of loan and regular interest payments by
the concern. The investors will study the long-term solvency of the concern with the help of
financial statements. The investors will not only analyze the present financial position but
will also study future prospects and expansion plans of the concern. The possibility of
paying back the loan amount in the face of liquidation of the concern is also taken into
consideration.

(5) Government: The financial statements are used to assess tax liability of business
enterprises. The government studies economic situation of the country from these
statements. These statements enable the government to find out whether business is
following various rules and regulations or not. These statements also become a base for
framing and amending various laws for the regulation of business.

(6) Trade Associations: These associations provide service and protection to the members.
They may analyze the financial statements for the purpose of providing facilities to these
members. They may develop standard ratios and design uniform system of accounts.

(7) Stock Exchange: The stock exchanges deal in purchase and sale of securities of different
companies. The financial statements enable the stock brokers to judge the financial
position of different concerns. The fixation of prices for securities, etc., is also based on
these statements.

10
Major Limitations of Financial Statements |

The following points highlight the five major limitations of financial statements, i.e, (1)
Only Interim Reports, (2) Do not Give Exact Position, (3) Historical Costs, (4) Impact of
Non-Monetary Factors Ignored, and (5) No precision.

Financial Statement Limitation # 1. Only Interim Reports:

These statements do not give a final picture of the concern. The data given in these statements is
only approximate. The actual position can only be determined when the business is sold or
liquidated. However, the statements have to be prepared for different accounting periods,
generally one year, during the life time of the concern. The costs and incomes be apportioned to
different periods with a view to determine profits etc.

The allocation of expenses and incomes will depend upon the personal judgment of the
accountant. The existence of contingent assets and liabilities also makes the statements
imprecise. So financial statements do not give the final picture and they are at the most interim
reports.

Financial Statement Limitation # 2. Do not Give Exact Position:

The financial statements are expressed in monetary values, so they appear to give final and
accurate position. The value of fixed assets in the balance sheet neither represents the value for
which fixed assets can be sold nor the amount which will be required to replace these assets. The
balance sheet is prepared on the presumption of a going concern.

The concern is expected to continue in the future. So, fixed assets are shown at cost less
accumulated depreciation. There are certain assets in the balance sheet such as preliminary
expenses, goodwill, discount on issue of shares which will realize nothing at the time of
liquidation though they are shown in the balance sheet.

11
Financial Statement Limitation # 3. Historical Costs:

The financial statements are prepared on the basis of historical costs or original costs. The value
of assets decreases with the passage of time current price changes are not taken into account. The
statements are not prepared keeping in view the present economic conditions.

The balance sheet loses the significance of being an index of current economic realities.
Similarly, the profitability shown by the income statement may not represent the earning
capacity of the concern. The increase in profits may be due to an increase in prices or due to
some abnormal causes and not due to increase in efficiency. The conclusions drawn from
financial statements may not give a fair picture of the concern.

Financial Statement Limitation # 4. Impact of Non-Monetary Factors Ignored:

There are certain factors which have a bearing on the financial position and operating results of
the business but they do not become a part of these statements because they cannot be measured
in monetary terms.

Such factors may include the reputation of the management, credit worthiness of the concern,
sources and commitments for purchases and sales, co-operation of the employees, etc. The
financial statements only show the position of the financial accounting for business and not the
financial position.

Financial Statement Limitation # 5. No Precision:

The precision of financial statement data is not possible because the statements deal with matters
which cannot be precisely stated. The data are recorded by conventional procedures followed
over the years. Various conventions, postulates, personal judgments etc. are used for developing
the data.

FINAL ACCOUNTS –WITH ADJUSTMENTS

• The basic accounting record is on the basis of going concern assumption.

• But the final accounts have to be prepared every year on the basis of accounting period
assumption.The purpose is to make continuous assessment of the financial affairs of the
firm.

• It is necessary that for the year for which the accounts are being prepared full account of
the expenses and incomes of the year should be taken.

Suppose, a firm closes its books on 31st March and rent for the month of March has not yet
been paid.This amount will have to be paid in any case; the expense has been incurred.

Therefore it would be proper to take the rent for this month along with the other expenses of the
year.

Take another example: Insurance premium has been paid for twelve months beginning 1stOct .It
is clear that insurance protection will be available for six months this year and for six months
next year.Half of expense therefore should be treated as expense of next year.
12
In a firm there are number of such items, both expenses and income, which will have to be
adjusted.

Journal entries are passed to effect the required adjustment.

These entries are known as adjusting entries.

We shall deal with some of the common adjustments.

1. Outstanding Expenses: (Expenses due but not paid)

These are expenses, which have been incurred during the year, and whose benefit has been
derived during the year, but payment in respect of these has not been made.

At the end of the accounting year, all such expenses must be brought into books, otherwise the
profit will overstate.

Suppose, Salaries for the month of Dec, not yet paid. The firm closes its books as on 31st
December.

The debit to the profit and loss account in respect of salaries will thus be less than the
actual amount; the profit will be more by that amount.

The adjustment entry required is given below:

Salaries Account …Dr.

To Salaries Outstanding Account

The outstanding account is a liability and has to be shown in the balance sheet. The items
will figure in the final accounts as follows:

Disclosure In Profit and Loss A/c

Dr. Cr.

To Salaries …..
Add: Outstanding …..

Disclosure InBalance Sheet

Liability Asset

Salaries Outstanding….

13
The above principle applies to all expenses.

The amount which has already been incurred but not yet paid is debited to the account of
the expense concerned and credited to the outstanding expense account.

The outstanding account is a liability and shown in the balance sheet.

The entry will increase the expense to the correct level and is line with the accrual concept
of accounting.

2. Prepaid or Unexpired Expenses (Expenses paid in Advance)

In some cases, the benefit of the amount already spent will be available in the next accounting
year also. Such a portion of the expense concerned is called prepaid expense.

Suppose insurance premium of Rs 400 is paid on Ist of July 2006 for one-year upto 30th June
2007.While paying insurance premium you have passed the following entries:

Insurance A/c……. Dr. 400

To Bank A/c 400

(Being the insurance premium paid to National Insurance Company for the period 1st July
2006 to 30 th June 2007.)

The firm closes its books on 31st Dec.

The insurance benefit for six months is available in the next accounting year.

Therefore half of the premium will be treated as an expense for this year while half of the
expense will be debited in the next year. Till then this half of the expense will be treated as
an asset.

The entries will be:

Insurance prepaid A/c …..Dr. Rs.200

To Insurance A/c Rs.200

Profit and Loss A/c

Dr. Cr.
To Insurance Premium Rs.400
Less: Prepaid Rs.200
----------
Rs.200

Balance Sheet

14
 Liabilities Assets

Prepaid Insurance Rs.200

Next year the insurance prepaid account will be transferred to the insurance account.

This principle will apply to all expenses incurred during the year and whose benefit (partially or
wholly) will be available next year.

3. Depreciation:

The value of fixed assets goes on reducing year after year because of wear and tear and of efflux
of time.This fall in the value should be treated as a loss or expense, to be considered before profit
and loss is ascertained.

The value of assets as shown in the balance sheet must be suitably reduced.To continue to show
it in the balance sheet at the old figure will be overstating the assets.Depreciation is usually
computed on the basis of life of the asset.

Suppose a machine has a life of 5 years.

Each year 1/5th of the cost i.e., Rs.2,000 should be treated as an expense;

Only the remaining amount is to be shown in the balance sheet.

The entry will be:

Depreciation Account…Dr. 2,000

To Asset (by name) Account 2,000

The depreciation is debited to profit and loss account and the entry is shown as follows.

Profit and Loss A/c

Dr. Cr.
To Depreciation Rs.2, 000
on furniture …

Balance Sheet
Liabilities Assets
Furniture Account Rs 10,000
Less: Depreciation Rs 2,000
---------------
8,000

The entry may have been passed before preparation of trial balance. In that case the depreciation
account will figure in the trial balance itself.The concerned asset will appear at the reduced value
since the amount of depreciation would have been credited to it.

15
In that case not further adjustment will be necessary.

The depreciation account will be transferred to the debit of profit and loss account like other
expenses.

4. Accrued Income

Accrued income is income which has been earned but not yet received.

Income must be recorded in the accounting period in which it is earned. Therefore, accrued
income must be recognized in the accounting period in which it arises rather than in the
subsequent period in which it will be received.

As income will be credited to record the accrued income, a corresponding receivable must be
created to account for the debit side of the transaction. The accounting entry to record accrued
income will therefore be as follows:

Debit Income Receivable or Accrued Income (Balance Sheet)

Credit Income (Income Statement)

5. Journl Entry for Income Received in Advance

Also known as unearned income, this is income which has been received in advance. The income
belongs to a future accounting period (generally the next one); however, the payment is received
in the current accounting period.

This type of income received in advance acts like a liability for the business and according to the
rules “credit the increase in liability” and “debit the decrease in income” (modern approach).

Journal entry for income received in advance will be

Income A/C Debit

To Income Received in Advance A/C Credit

Example

Let’s assume that in March 10,000 are received in advance for rent which belongs to the month
of April.

Journal entry to record this in the current accounting period is

Rent A/C 10,000

To Rent Received in Advance A/C 10,000

16
6. Bad Debt and Provision for bad debts

Bad debts often occur and they are loss.When it is certain that our debtor Mr. A who owes us Rs.
1,000 ( due to credit sales made by us ) will not pay and all our efforts to realize the amount has
failed.It is decided that we treat this as bad debt.

The amount is debited to bad debts account and credited to the debtor’s account.

We pass the following entry:

Bad Debt A/c…Dr. 1,000

To Mr. A’s A/c 1,000

(Being the amount of owed by Mr. A written off as bad debts)

Suppose during a particular year say in 2006 it is apparent that such and such debts will be bad
but actual writing off may be postponed till 2007.In such a situation the loss should be deducted
from the profit of 2006 and not of 2007.

We can say that a suitable amount should be kept aside in 2006 to meet the possible loss on
account of bad debts.

Such an amount kept aside is called ‘provision’

A provision may be created to meet any possible loss likely to occur in future in respect of
transactions already entered into, and whose amount is uncertain.The provision for bad and
doubtful debt is a good example:

The entry required for creating a provision is:

Profit and Loss Account …Dr.

To Provision for Bad and Doubtful Debts A/c

Provision for bad debt is created on debtors after reducing amount of actual bad debt.

The debit to profit and loss account will reduce the year’s profits suitably for the possible
loss.Next year when the bad debts actually occur and are written off, the bad debts accounts will
be debited to provision for bad debts account.

The amount of bad debts will not be debited to profit and loss account since debit was already
given to it last year.

It must be clear that that customer’s account or sundry debtor’s account is not affected by
creation of the provision for bad debts.

The provision for bad and doubtful debts account is deducted from the amount of book debts in
the balance sheet but the two accounts are separate.

17
7. Provision for discount on debtors:

To motivate the debtors to make prompt payments, cash discount may be allowed to them. After
providing provision for bad and doubtful debts, the remaining debtors are called as good debtors.
They may pay their dues in time and avail themselves of the cash discount permissable. So a
provision for discount on good debtors at a certain percentage may have to be created.

Discount A/c Dr.

To Debtor’s personal Account

At the end of accounting year , the firm also estimates the amount of discount which may have to
be given to the good debtors outstanding at the end of accounting year by making provisions
for if . the following general entry is passed

Profit & Loss A/c Dr.

To provision for Discount A/c

It should be noted that provision for Discount will be created only for good debtors. In the other
words provision for Discount should be made after deducting Bad Debt and provision for Bad
Debts from the Debtor’s Balance.

Example: The Trial Balance as on 31st March 2014 shows the following:
Sundry debtors Rs. 45,000
Adjustment: Create 2% provision for discount on Debtors.

Example: The trial balance shows on 31.03.2014,

Sundry debtors Rs. 85,000
Adjustments: Bad debts written off Rs. 5,000. Provide @ 5% provision for bad and doubtful
debts and @ 2% provision for discount on debtors.

8. Journal entry of Interest on capital and Drawing

Interest on capital?

Capital is amount invested by the proprietor in a business enterprise. It is the amount which the
help of which goods and assets are purchased in the business.

It is terms as basic concepts of accounting the business entity concept – the owner and his
business are regarded as separate entities. This avoids the complication of having the owners
private transaction from those of the business in order to arrive at the profit made by the
business. Because of this distinction between the owner and the business, it is necessary to open
an account for the owner in the firm’s book.

18
Withdrawal of cash or goods by the owner from his business for his own personal use is debited
to his capital account because such drawing reduces his claim from the business.

If the business makes a profit this belongs to the owner of the business. The business owes the
profit to the owner. Therefore his capital account must be credited. If the business makes a loss,
the owner’s capital account must be debited (since his capital is reduced by the amount of the
loss)

A credit balance on the capital account indicates the amount owing by the business to the owner
whereas a debit balance indicates the amount owing by the traders to the business.

To sum up, the difference between liabilities to other and assets of the business belongs to the
owners of the business and is called capital. It is liabilities of the business Internal Liabilities.

In Accountancy Owner and Business are separate entity both have separate legal existence.

The amount which the owner invested in the business is known as Capital and business gives
owner interest on capital because if the owner does not invest in business he keeps money in
bank and bank gives interest to an owner.

Therefore interest on Capital is given to the owner by a business which is at certain percentage as
business does not go to owners house to pay interest on capital therefore he added interest on
capital in capital. capitals are liability it has a credit balance.

Example

Interest on capital Rs 100000

So entry will be

Interest on Capital A/c 1,00,000

To Capital A/c 1,00,000

(Being Interest on capital made)

Journal entry of Interest on Drawing

Interest on Drawing?

The amount which the owner withdraw from business for personal use is known as drawings.

Suppose A withdraw Rs 10000 from business for personal use hence he reduces business capital

Therefore A have to pay business interest on drawing because if this money remains in business
it will pay owner some profit.Therefore to stop owner to withdraw money from business an
interest is charged by the business known as interest on a drawing.

So Interest on the drawing is income for business so it is Credited.

Example
19
Interest on drawings Rs 1000 is charged.

Drawings A/c 1000

To Interest on drawings A/c 1000

(being interest on drawing charged)

Treatment of interest of capital and interest of drawing in Final Account

Interest on Capital:

Interest of capital is an expense for the firm, therefore, it will be shown on the debit side of
profit and loss account.

Interest on drawing:

Interest and drawing are and income for the expense, therefore, it will be shown on the credit
side of profit and loss of account.

In balance sheet:

Interest on capital is an expense for the firm and income for the owner, therefore, it will be added
to the capital account in the balance sheet similar interest on a drawing is an income for the firm,
therefore, it will be deducted from the final account in the balance sheet.

Case 1: The following is the trial balance of R. Kumar on June 30th 2005.

Dr. Cr
Rs. Rs.
Cash in hand 540
Cash at Bank 2,630

Purchase account 40,675

Sales account 98,780
Returns Inward Account 680
Returns Outward Account 500
Wages Account 10,480
Fuel &Power Account 4,730
Carriage on Sales Account 3,200
Carriage on Purchase Account 2,040
Stock Account ( 1st July 2004) 5,760
Building Account 30,000
Freehold land account 10,000
Machinery Account 20,000
Patent Account 7,500
Salaries Account 15,000
General Expenses Account 3,000
Insurance Account 600
20
Drawings Account 5,245
Capital Account 71,000
Sundry Debtors Account 14,500
Sundry Creditors Account 6,300
Total 1,76,580 1,76,580

Taking account the following adjustments prepare the final accounts.

1. Stock in hand on 30th June 2005 has been valued at Rs. 6,800.

2. Machinery is to be depreciated at the rate of 10% and patents at the rate of 20%.

3. Salaries for the month of June 2005 amounting to Rs. 1,500 were unpaid.
4. Insurance includes a premium of Rs. 170 on a policy expiring on 31st December 2005.

5. Wages include a sum of Rs.2, 000 spent on erection of a cycle shed for employees and
customers.

6.A provision for bad and doubtful Debts is to be created to the extent of 5 % on debtors.

Trading Account
For the year ended 30th June 2005
Dr. Cr.
To Opening By Sales
Stock 5,760 Less: Return 98,780
Inward

680 98,100
To By Closing
Purchase A/c 40,675 Stock
Less: Returns 6,800
Outward 500 40,175
To Wages A/c
Less: Wrongly taken as wages 10,480

2,000 8,480
To Fuel& Power A/c
4,730
To Carriage on
purchases A/c

2,040
To Gross profit transferred
to Profit & Loss a/c

43,715
1,04,900 1,04,900

21
 Profit & Loss Account
For the year ended 30th June 2005.
Dr. Cr.
To Salaries A/c 15,000 By Gross profit transferred from
Add: trading A/c
Outstanding 1,500 16,500 43,715
To Carriage on Sales
3,200
To General Expenses
3,000
To Insurance A/c
Less: Prepaid 600
85 515
To provision for bad
and doubtful debts A/c

725
To Depreciation A/c
Machinery
Patents 2,000
1,500 3,500
To Net Profit – Transferred
to
Capital A/c 16,275
43,715 43,715

Balance Sheet of R. Kumar

as on 30thJune , 2005
Capital and Liabilities Assets

22
Current Current Assets
Liabilities Cash in Hand
Cash at Bank 540
Sundry creditors 6,300 Sundry Debtors 2,630
Less: Provision for bad &
Salaries Doubtful Debts 14,500
Out-
-standing Insurance
1,500 7,800 prepaid
Stock in hand
725 13,775

85
6,800

Capital Fixed Assets

Balance Freehold land 10,000
in the Building 32,000
beginning 71,000 Machinery
Add: Profit during Less: Depreciation 20,000
the year 2,000 18,000
Less: Drawings Patents
Less: Depreciation 7,500
16,275
5,245 82,030 1,500 6,000
89,830 89,830

Case 2:From the following trial balance of Mrs. Reema as on 31.03.14, prepare Trading and
Profit and Loss account and Balance sheet as on 31.03.14.
Particulars Debit Credit
Capital Accounts 1,20,000
Drawings 15,000
Bill Receivables 22,000
Machinery 20,000
Debtor and Creditor 60,000 58,000
Wages 39,000
Purchase and Sales 2,52,000 3,55,000
Commission received 5,500
Rent and taxes 6,000
Opening stock 90,000
Salaries 10,500
Travelling Expenses 2,000
Insurance 600
Repairs 3,400
Bad debts 3,500
Furniture 9,000

23
Sales and purchase Returns 5,000 2,000
Cash in Hand and Bank 2,500
5,40,500 5,40,500

Adjustments:
1. Stock on hand on 31.03.14 was Rs.1,00,000
2. Create 5% provision on debtor for doubtful debts.
3. Prepaid insurance amounted to Rs.100
4. Wages outstanding was Rs.1,000
5. Depreciate machinery by 5%and furniture by 10% p.a.

24
25
26
27