Module 4 - Accounting & Audit - 2021-22

Certified Professional in Cooperative
Banking (CPCB)-Level-I Certification Course

2021-22 Batch
Module 4: Accounting and

Audit
2021-22
Centre for Professional Excellence in Cooperatives (C-PEC),
Bankers Institute of Rural Development (BIRD)
An autonomous institute established by NABARD.
Sector-H, LDA Colony, Kanpur Road, Lucknow – 226 012, INDIA
Phone +91-522-2421799
Email cpecforccs@gmail.com
Homepage https://bird-cpec.nabard.org/
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Contents
Unit-1: Accounting System ............................................................................................................ 13
Lesson No. 1.1: Concepts, conventions and principles .................................................................. 14
1.1.1 Objectives ............................................................................................................................... 15
1.1.2 The meaning and purpose of accountancy ............................................................................ 15
1.1.3 Basic terms in accounting ...................................................................................................... 16
1.1.4. Accounting Principles ...........................................................................................................18
1.1.5. Accounting Concepts ............................................................................................................18
1.1.6. Accounting Conventions ...................................................................................................... 20
1.1.7 Let’s sum up .......................................................................................................................... 22
1.1.8 Key words ............................................................................................................................. 23
1.1.9 Multiple Choice Questions.................................................................................................... 23
1.1.10 Answer keys ........................................................................................................................ 26
Lesson No. 1.2: System of accounting........................................................................................... 27
1.2.1 Objectives.............................................................................................................................. 28
1.2.2 Different accounting systems ............................................................................................... 28
1.2.3 Flow of an accounting transaction ....................................................................................... 29
1.2.4 Source documents ................................................................................................................ 30
1.2.5 Types of vouchers ................................................................................................................. 30
1.2.6 Identifying two accounts in a transaction ............................................................................. 31
1.2.7 Three Golden Rules of Accounting ....................................................................................... 32
1.2.8 Five Golden Rules of Accounting ......................................................................................... 33
1.2.9 Let’s sum up ......................................................................................................................... 37
1.2.10 Key words: .......................................................................................................................... 37
1.2.11 Multiple Choices Questions ................................................................................................ 38
1.2.12 Answer keys ........................................................................................................................ 40
Lesson No. 1.3: Books of accounts to be maintained .................................................................... 41
1.3.1 Objectives .............................................................................................................................. 42
1.3.2 Background .......................................................................................................................... 42
1.3.3 Journal format...................................................................................................................... 42
1.3.4 Subsidiary books/ Special journals ...................................................................................... 46
1.3.5 Various types of subsidiary journals .................................................................................... 46
1.3.6 Adjustment entry.................................................................................................................. 49
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1.3.7 Ledger ................................................................................................................................... 52
1.3.8 Balancing of Ledger.............................................................................................................. 53
1.3.9 Difference between Journal & Ledger .................................................................................. 54
1.3.10 let’s sum up .......................................................................................................................... 61
1.3.11Key words: ............................................................................................................................ 62
1.3.12 Multiple Choices Questions ................................................................................................ 62
1.3.13 Answer Keys ........................................................................................................................ 65
Lesson No 1.4: Bank reconciliation statement ............................................................................. 66
1.4.1 Objectives.............................................................................................................................. 67
1.4.2 Introduction ......................................................................................................................... 67
1.4.3 Need for bank reconciliation statement ............................................................................... 67
1.4.4 Possible reasons for the difference....................................................................................... 68
1.4.5 Steps for preparing bank reconciliation statement .............................................................. 70
1.4.6 Let’s sum up ......................................................................................................................... 74
1.4.7 Key words ..............................................................................................................................75
1.4.8 Multiple Choice Questions ....................................................................................................75
1.4.9 Answer keys ........................................................................................................................... 77
Lesson No 1. 5: Trial balance, Profit & loss account and Balance sheet ...................................... 78
1.5.1 Objectives .............................................................................................................................. 79
1.5.2 Preparation of trial balance .................................................................................................. 79
1.5.3 Error not disclosed by Trial balance......................................................................................81
1.5.4 Preparation Of financial statements .....................................................................................81
1.5.5 Income statement ................................................................................................................. 84
1.5.6 Balance Sheet ....................................................................................................................... 86
1.5.7 Horizontal presentation of the Profit and Loss Account and Balance Sheet ....................... 87
1.5.8 Vertical presentation of the Profit and Loss Account and Balance Sheet ............................ 88
1.5.9 Adjustment entries ................................................................................................................ 91
1.5.10 let's sum up ......................................................................................................................... 95
1.5.11 Key words ............................................................................................................................ 96
1.5.12 Multiple of choice questions ............................................................................................... 96
1.5.13 Answer Key ......................................................................................................................... 99
Unit-2: Analysis and Interpretation of Financial Statement ...................................................... 100
Lesson no. 2.1: Analysis and interpretation ................................................................................ 101
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2.1.1 Objectives............................................................................................................................ 102
2.1.2 Introduction ....................................................................................................................... 102
2.1.3 Financial statement analysis .............................................................................................. 102
2.1.4 Interpretation of the key terms of the financial statements ...............................................103
2.1.5 Tools & Techniques of Financial Statement Analysis ........................................................ 108
2.1.5.1 Comparative financial statements analysis .................................................................. 108
2.1.5.2 Common size financial statements analysis ................................................................. 112
2.1.5.3 Trend analysis ............................................................................................................... 116
2.1. 5.4 Funds flow statement analysis .................................................................................... 120
2.1.5.5 Cash flow statement analysis ........................................................................................ 122
2.1.5.6 Ratio analysis ................................................................................................................ 129
2.1.6 Let's sum up ........................................................................................................................ 143
2.1.7 Key words: ........................................................................................................................... 144
2.1.8 Multiple choice Questions ................................................................................................... 144
2.1.9 Answer Keys ........................................................................................................................150
Unit-3: Audit, Inspection and Control......................................................................................... 151
Lesson No. 3.1 Internal Control and Checks ............................................................................ 152
3.1.1 Objectives ............................................................................................................................. 153
3.1.2 Introduction ........................................................................................................................ 153
3.1.3 Meaning and need of internal controls ............................................................................... 153
3.1.4 Essentials of Good Internal Controls .................................................................................. 155
3.1.5 Nature of internal controls .................................................................................................. 155
3.1.6 Roles and responsibilities in internal control ..................................................................... 158
3.1.7 Limitations of Internal Control ........................................................................................... 158
3.1.8 Setting up of the internal control system ............................................................................ 158
3.1.9 Internal check ...................................................................................................................... 159
3.1.10 Objectives of internal check.............................................................................................. 160
3.1.11 Points that are taken into consideration while framing a System of Internal Control ..... 160
3.1.12 Let’s us sum up .................................................................................................................. 161
3.1.13 Key words........................................................................................................................... 161
3.1.14 Multiple choice Questions ................................................................................................. 162
3.1.15 Answer keys ....................................................................................................................... 164
Lesson No 3.2 Preparatory works for audit and inspection .................................................. 165
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3.2.1 Objectives ............................................................................................................................ 166
3.2.2 Introduction ........................................................................................................................ 166
3.2.3 Audit process in brief .......................................................................................................... 166
3.2.4 Audit preparation from the Auditee’s ( bank’s/company’s or firm’s) side .........................168
3.2.5 Let us sum up ...................................................................................................................... 170
3.2.6 Key words............................................................................................................................ 170
3.2.7 Multiple choice questions ................................................................................................... 171
3.2.8 Answer keys ........................................................................................................................ 172
Lesson No. 3.3 Audit and inspection ........................................................................................... 173
3.3.1 Objectives ............................................................................................................................ 174
3.3.2 Introduction ....................................................................................................................... 174

3.3.3 Definition of Audit ............................................................................................................. 174
3.3.4 Main features of audit ....................................................................................................... 175
3.3.5 Objectives of an audit ....................................................................................................... 175
3.3.6 Advantages of audit ........................................................................................................... 177
3.3.7 Audit types ......................................................................................................................... 177
3.3.8 CAMELSC ......................................................................................................................... 179
3.3.9 Let’s us sum up ................................................................................................................ 180
3.3.10 Key words ...................................................................................................................... 180
3.3.11 Multiple choice questions ................................................................................................ 181
3.3.12 Answer keys .......................................................................................................................182
Lesson No. 3.4 Role of an Auditor& areas to be covered .............................................................183
3.4.1 Objectives ............................................................................................................................184
3.4.2 Role of an Auditor ...............................................................................................................184
3.4.3 Items to be checked on first day of audit ............................................................................186
3.4.4 Areas to be covered .............................................................................................................186
3.4.4.1 Credit Area ....................................................................................................................186
3.4.4.2 Non credit Area ........................................................................................................... 188
3.4.4.3 Computer Area .............................................................................................................189
3.4.4.4 Branch Management ....................................................................................................189
3.4.4.5 Compliance ...................................................................................................................189
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3.4.5 Key words ........................................................................................................................... 190
3.4.6 Let's sum up ....................................................................................................................... 190
3.4.7 Multiple choice questions .................................................................................................. 190
3.4.8 Answer keys ........................................................................................................................ 192
Lesson No. 3.5: Frauds- Classification, Reporting and Monitoring ........................................... 193
3.5.1 Introduction ........................................................................................................................ 194
3.5.2 Classification of Frauds....................................................................................................... 194
3.5.3 Reporting to NABARD ........................................................................................................ 195
3.5.4 Reporting to Board ............................................................................................................. 195
3.5.5 Quarterly return .................................................................................................................. 196
3.5.6 Cases of attempted fraud .................................................................................................... 196
3.5.7 Closure of fraud cases ......................................................................................................... 196
3.5.8 Cases to be referred to Local Police: ................................................................................... 197
3.5.9 Preventive measures to be taken in Cheque related Frauds. .............................................. 199
3.5.10 Reporting Cases of Theft, Burglary, Dacoity and Bank Robberies .................................. 200
3.5.11 Legal Audit of Title Documents in respect of Large Value Loan Accounts ...................... 200
3.5.12 Key words ......................................................................................................................... 200
3.5.13 Let's sum up...................................................................................................................... 200
3.5.14 Multiple choice questions................................................................................................. 201
3.5.15 Answer keys ...................................................................................................................... 203
Additional Reading ..................................................................................................................... 204
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Abbreviations
ACB Audit Committee of Board

ALM Asset liability management
AOF Account opening form
ATM Automated teller Machine
B/D Brought down
B/F Brought forward
BDDR Bad & doubtful Reserve
C/D Carried down
C/F Carried forward
CA Current asset
CC Cash credit
CIBIL Credit information bureau (India) limited
CL Current liability
COGS Cost of goods sold
COO Chief operating officer
CP Commercial paper
CR Current ratio
Cr Credit
CR Confidential report
CTS Cheque truncation system
Dr Debit
DSCR Debt Service Coverage ratio
DTL Demand and Time Liabilities
DTO Debtor turnover
EBIT Earnings before interest & tax
EBITDA: Earnings before Interest, Tax, Depreciation &
Amortization
ECS Electronic clearing system
GAAR General anti-avoidance rule
GP Gross profit
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ICAI The Institute of Chartered Accountants of India
ICR: Interest coverage ratio
IMPS Immediate payment service
IP Immoveable property
JF Journal folio
KYC Know your customer
LF Ledger folio
LFAR Long form audit report
LLC Limited liability company
LLP Limited liability Partnership
LTL Long term liability
LTU Long Term Use
MPBF Maximum permissible bank finance
NABARD National Bank for Agriculture and Rural Development

NCA Noncurrent asset
NCL Normal credit limits
NCL Noncurrent liability
NEFT National electronic fund transfer
NGO Non-governmental organisation
NOI Non operating income
NP Net profit
NPA Non-performing asset
NPA Nonperforming asset
NPAT Net profit after tax
NPBT Net profit before tax
NW Net worth
NWC Net working capital
OD Over draft
OE Operating expenses
OI Operating income
OP Operating profit
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RBI Reserve Bank of India
ROCE Return on capital employed
RTGS Real time gross settlement
SFF Safe, Furniture & Fixture
STL Short term liability/Loan
STS Short Term Source
STU Short Term Use
TNW Tangible net worth
UPI Unified payments interface
USP Unique selling proposition
UV Ultra Violet
WC Working capital
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Syllabus
UNIT 01 ACCOUNTING SYSTEM
Concepts, Conventions Accounting -Definition - Accounting concepts
1
and Principles and conventions
Accounting systems - Double entry –
2 System of accounting
Principles
Voucher, Cash Book, Subsidiary Books, Day
Books of accounts to be
3 Book, General Ledger, Balancing of books
maintained
etc.
Bank Reconciliation Bank reconciliation statement - Procedure
4
Statement (Case exercise)
Trial Balance and
Trial Balance - Profit and Loss account and
5 Preparation of financial
Balance Sheet (Case exercise)
statements
UNIT ANALYSIS AND INTERPRETATION OF FINANCIAL

02 STATEMENT
Analysis and
1 Importance to top management
interpretation
Trend Analysis, Ratio analysis, Fund Flow ,
2 Techniques Cash Flow Statement, Factor Separation
Analysis, Interpretation and use of Ratios
UNIT
AUDIT, INSPECTION AND COMPLIANCE
03
Objectives - prevention of errors and
Internal checks and
1 frauds/embezzlements/misappropriations
control
etc.- Internal checks and controls
Preparatory work for Updation of records - Preparation of
2
audit and inspection audit/inspection statements
11
Objective, Statutory audit - internal audit -
3 Audit and inspection concurrent audit, Statutory Inspection.,
Concept of CAMELS
Spot rectification of bonafide errors-
Reporting of important observations to
Rectification of defects Board -Steps taken to improve functioning of
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and compliance the bank - Rectification of defects-
Preparation of compliance report- Need for
adhering to prescribed time schedule
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Unit-1: Accounting System
Lesson No. 1.1 Concepts, Conventions and Principles

Lesson No. 1.2 System of Accounting
Lesson No. 1.3 Books of accounts to be maintained
Lesson No. 1.4 Bank Reconciliation Statement
Lesson No. 1.5 Trial Balance, Profit & Loss and Balance Sheet
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Lesson No. 1.1: Concepts, conventions and principles
1.1.1 Objectives
1.1.2Meaning and Purpose of Accountancy
1.1.3 Basic Terms in Accountancy
1.1.4 Accounting Principles
1.1.5 Accounting Concepts
1.1.6 Accounting Conventions
1.1.7 Let us sum up
1.1.8 Key words
1.1.9 Multiple choice questions
1.1.10 Answer keys
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1.1.1 Objectives
The objectives of this lesson are to understand:
 The meaning and purpose of accountancy

 Basic terms in accounting
 Accounting principles
 Accounting concepts
 Accounting conventions and principles
1.1.2 The meaning and purpose of accountancy

Business involves transactions for exchange of goods or services against cash or credit.
These transactions take place throughout the year. As the business volumes increases, it
is beyond the capacity of the owner to remember all the transactions. This necessitates
recording of the business transactions in systematic and orderly manner. The recording
of business transactions has to be systematic, so that it will provide useful information
to the owner about the financial position of the business entity.
Book keeping is the system of recording the business transactions in a set of books. The
recording of transactions has to be based on some documents which evidence the nature
and the amount of such transactions. From book keeping the owner might ascertain
details such as total purchases, total sales, total expenses, cash, etc.
The term ‘Book keeping’ and ‘Accounting’ are often used interchangeably. However
accounting is a much wider concept and it starts where book keeping ends. In other
words, book keeping is concerned with the recording of transactions in the books, the
original entry, based on the documentary evidence, whereas, accounting is concerned
with grouping of the transactions, interpreting them and presenting them in a specific
manner to communicate the results of the entity. Together, these are called “Book of
Accounts”.
Book keeping is the art of identifying & recording all such business transactions
which can be recorded and measured in money terms, in the book of accounts.
Accounting is the process of classifying, summarizing and analyzing all
monetary transactions and communicating the required information relating to
the organization to the interested users of such information.
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1.1.3 Basic terms in accounting
Purchases: Purchases indicate the money value of goods which the owner purchases as
raw material for the process of manufacture or for the purpose of trading in goods. It
includes both cash and credit purchases.
Creditors: When goods are purchased against the assurance to pay in future, such
goods are said to be purchased on credit and the suppliers of those goods are called
creditors and purchasers of goods are called debtor.
Sales: Sales are revenues generated from sale of goods. It includes both cash sales and
credit sales.
Assets: Properties/resources owned by the enterprise are called assets. Assets can be
classified into current assets, fixed assets and non-current assets. Current assets are
those assets, which are held for a short period of time, say up to one year e.g. cash, stock,
debtors etc.
Fixed assets are of long term in nature and they are acquired for increasing the
income/profit generating capacity of the enterprise e.g. land and building, plant and
machinery etc.
Non- current assets can include investments, long term loans given to parties, etc.
Tangible assets are those assets which are physically visible and can be touched
and felt; like Building, Machine etc.
Intangible assets are those assets which cannot be seen and touched. They are
non-visible, like Goodwill, patent, Trade Mark etc.
Liabilities: These refer to the amounts owed by the business to others. These are the
obligations that the enterprise must repay in future.
Capital: This is the amount invested by the owner in the business. The amount
introduced in the business by the owner is a liability for the business entity (entity
means either a Company or a Proprietary Firm or a Partnership firm).
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Capital= Assets- Liabilities
Drawings: Drawings occur in the case of sole proprietor and partnerships. It is the
amount withdrawn by the ownerr from the business. Any drawings from the business,
reduces the net-worth of the enterprise.
Net-worth: It is also the owners’ fund. It includes the capital plus reserves.
Net-Worth
=
Total Assets - Total outside liabilities
=
Share Capital + Reserves + Profits + Retained Earnings
Contingent liabilities: These are liabilities, which might arise in future depending on
the happening or non- happening of any future event.
Profit and loss account: It is statement of total revenues and total expenses (which
would include purchases, cost of running business, etc.) of the enterprise over a period
of time. A firm/company is said to be in profit, when the revenues are more than
expenses and in loss, when expenses are more than revenues.
Balance Sheet: It is a statement of total assets and total liabilities of the enterprise on
a particular date say, at the end of a financial year.
Capital expenditure: It refers to funds that are used by a company for the purchase,
improvement, or maintenance of long-term assets, benefit of which is received over a
longer period, to improve the efficiency or capacity of the company.For example,
expenditure incurred, on purchase of plant and machinery, land and building etc.
Revenue expenditure: It is the expenditure, the benefit of which is received within

an accounting year and is incurred for running the business on a day to day basis. For
example, expenses for rent payment, electricity expenses etc.
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Deferred revenue expenditure: It is revenue in nature, the benefit of which is
however extended beyond a period of one year. These expenses are written off over a
period of time. Example: Preliminary Expenses, advertising expenses etc.
1.1.4. Accounting Principles

Financial statements such as Profit and Loss Account and Balance Sheet are used by
different stakeholders such as owners, bankers, investors etc for different purposes. In
order to maintain the consistency and uniformity in recording and maintaining of the
books of accounts, certain principles have evolved over a period of time, called
accounting principles. The principles, which are followed in maintaining the books of
accounts, are classified as
 Accounting Concepts and

 Accounting Conventions.
1.1.5. Accounting Concepts

Accounting concepts are the necessary assumptions, conditions or postulates upon
which the accounting is based.
Separate Entity Concept
This concept differentiates the identity of the owner or proprietor from the enterprise.
According to this concept, capital brought in to the business by the proprietor is
considered as a liability of the enterprise. Any drawings from business for personal use
of proprietor, results in, bringing down the capital of the enterprise.
For example, if Mr. ABC purchases plant and machinery of ₹. 100,000, for the
enterprise, these would be assets of the enterprise and not of Mr. ABC and ₹. 1, 00,000
would be shown as capital introduced by Mr. ABC.
Money Measurement Concept
This concept implies that only those transactions, which can be measured in terms of
money only, are recorded in the books of the enterprise. Therefore assets of the
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company should not be measured in the terms of the physical units (10 machineries;
20office cabinets etc., but have to be recorded in terms of money. Further, events such
as death of the partner, existence of very loyal committed employees, etc. cannot be
recorded in the books of the company
Accounting Cost Concept
This concept assumes that the assets are recorded in the books of the firm at acquisition
cost in the first year of accounting and thereafter at ‘book value’ (Acquisition cost-
*Depreciation) and not of market value or realisable value.
For example, if an asset is purchased by the firm at ₹. 1, 00,000, its value would be
recorded in the books at ₹. 1, 00,000 in the first year of accounting and book value in
subsequent accounting yea₹ even if the market price of the same is something else.
 Depreciation is defined as the reduction of recorded cost of a fixed asset, as

prescribed by income tax department, in a systematic manner until the value of
the asset becomes zero or negligible
Accrual Concept
This concept assumes recording the revenues in the accounting year when they are
earned and not when they are received in cash, and recording the expenses in the
accounting year when they are incurred and not when they are paid.
For example, if salaries of the employees for the month of March 21 are paid on the 7th
of April 21, the expenses shall be booked for FY 20-21 not for FY 21-22.
Dual Aspect Concept
In accounting concept, every transaction has a dual effect i.e. both debit & credit. When
one head is debited the proceeds are credited to another head.
For example, if Mr. ABC pays salaries of ₹. 500000 to his employees "Salaries” head is
debited for the amount & individual staff accounts are credited aggregating to the same
amount.
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Realization Concept
This concept assumes recording the revenues in the accounting year when they are
received and not when they are earned, and recording the expenses in the accounting
year when they are paid and not when they are incurred.
For example, if salaries of the employees for the month of March 21 are paid on the 7th
of April 21, the expenses shall be booked for FY 21-22 not for FY 20-21.
Going Concern Concept
This concept implies that in accounting, a business is expected to continue for a fairly
long time and carry out its commitments and obligations and also assumes that the
business will not be forced to stop functioning in near future and liquidate its
assets at “fire-sale” prices.
Accounting Period Concept
According to this concept, all the transactions are recorded in the books with the
assumption that profit/loss is to be ascertained for specific period say a year, six
months, three month etc, called accounting period Accounting period for the enterprise
can be a calendar year or financial year.
Matching Concept
This concept states that income of a certain period has to match with the expenses of
that period. This concept has its base in the ‘Accounting period’ concept. In other words,
this concept states that the revenue earned and the expenses incurred to earn the
revenues must belong to the same accounting period. This concept helps in
determining the exact profit or loss for a particular period.
1.1.6. Accounting Conventions

Accounting conventions refer to the common practices which are universally
followed in recording and presenting accounting information of the business entity.
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Following are the most important conventions which have been practiced over a long
period:
Consistency
This convention means that same accounting principles should be used for
preparing financial statements year after year and whenever it is necessary to change,
the impact of such change must be given separately.
For example a company may adopt a straight line method, written down value method
or any other method for providing depreciation on fixed assets. However it is expected
that a company follows a particular method of depreciation for long yea₹.
Materiality
According to this convention, all material details are to be reported and insignificant
details can be ignored. An item can be considered as material, if there is a reason to
believe that knowledge of it would influence the decision of the informed investor.
Thus the materiality of the fact depends on the nature and the amount involved.
For example, a businessman sets up the plant for manufacturing of plastic goods. He
purchases plant and machinery, office furniture, raw materials etc. These items are
significant items; thus they should be recorded in books of accounts in detail. At the
same time, he also purchases pens, pencils, papers, registers, etc. to maintain day to day
office work where he will use a small amount of his capital. Now here, maintaining the
details of every pen, pencil, match box or other small items is not considered of much
significance and these should not be recorded separately.
An item may be material for one concern but immaterial for another concern or material
for one year or immaterial for another year. The accountant has to judge relative
importance of each item and its significance.
Conservatism
This states that an enterprise must take into account all possible losses but do not take
into account expected future gains. As per this convention, revenues or gains should be
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recognised only when they are realised. However provision for all known liabilities,
expenses and losses must be made. It is based on the premise that profit should not be
overstated.
For example, valuing closing stock at cost or market price whichever is lower, creating
provision for doubtful debts, discount on debtors, writing off intangible assets like
goodwill, patent, etc.
Full disclosure
It requires that all relevant and material details of the financial statements are
disclosed. This implies that accounts must be honestly prepared and all material
information must be disclosed therein. There are many disclosures required by the
Accounting Standard rules prescribed by the Companies Act, 2013.
1.1.7 Let’s sum up

The term ‘Book keeping’ and ‘Accounting’ are often used interchangeably. However
accounting is a much wider concept and it starts where book keeping ends.
Further, basic accounting terms such as Sales, purchases, creditors, debtors, assets,
liabilities, capital, net-worth, contingent liabilities, depreciation, profit and loss account,
balance sheet, capital expenditure, revenue expenditure, deferred revenue expenditure
are explained in this module.
In order to maintain the consistency and uniformity in recording and maintaining of the
books of accounts, certain principles have evolved over a period of time, called
accounting principles. The principles, which are followed in maintaining the books of
accounts, are classified as concepts and conventions
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GAAP
Accounting Concepts Accounting Conventions
Consistency Materiality Conservatism Full Disclosure
Accounting Cost
Money Measurement Separate entity
Accrual
Dual Aspect Realization
Matching Accounting period Going Concern
1.1.8 Key words

Book keeping, Accounting, Accounting concepts, Depreciation
1.1.9 Multiple Choice Questions

1. According to accrual concept of accounting, financial or business transaction is
recorded
a. When cash is received or c. When profit is computed

paid d. When balance sheet is
b. When transaction occurs prepared
2. M/S ABC Company provides advertising services to an investment company in
the month of March 20 but receives advertising fee in the month of April 20. M/S
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ABC recognizes this revenue in financial year 19-20. This action of M/S ABC is
justified by
a. Business entity concept c. Economic entity concept

b. Revenue recognition d. Going concern concept
principle
3. A company is a going concern if
a. Its balance sheet shows a c. There is no evidence that it
strong financial position will or will have to cease
b. Its income statement for operations within
the current year shows foreseeable future.
huge profit d. It is a public limited
company
4. Which accounting concept or principle states that the transactions of a business
must be recorded separately from those of its owners or other businesses?
a. Materiality concept of c. Matching principle of
accounting accounting
b. Time period concept of d. Business or economic
accounting entity concept of
accounting
5. The business or economic entity concept is applicable to:
a. Sole proprietorship form c. Corporate form of

of business business
b. Partnership form of d. All of the above
business
6. The revenue is not recognized until it is earned and realized or at least realizable.
To which accounting principle/concept this statement belongs?
a. Separate entity concept c. Going concern concept
d. Conservatism concept
b. Revenue recognition
principle
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7. In certain situations, companies might recognize losses but not gains. This action
belongs to:
a. Revenue recognition c. Conservatism principle
principle d. Matching principle
b. Monetary unit assumption
8. Which accounting principle/concept allows accountants to ignore other

accounting principle/concept if the amount in question is immaterial?
a. Materiality concept c. Conservatism principle
b. Monetary unit assumption d. Matching principle
9. The art of recording, classifying and summarizing is called:

a. Journalizing c. Bookkeeping
b. Accounting d. Record Keeping
10. The position of assets and liabilities during an accounting period is shown in
a. Balance sheet c. Cash flow statement
b. Profit and loss account d. None of the above.
11. The position of income and expenditure as on particular date can be depicted
from
12. The position of income and expenditure during an accounting period can be
depicted from
b. Profit and loss account d. None of the above
13. The position of assets and liabilities on particular date is shown in
14. What the company owns is called?
a. Asset c. Capital
b. Liability d. Capital expenditure
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15. What the company owes is called?
a. Asset c. Capital
b. Liability d. Capital expenditure
16. Benefits if expenditure is received over a long period is called
a. Asset c. Capital
b. Revenue expenditure d. Capital expenditure
17. The person to whom goods are sold on credit and owe money to the organisation
a. Debtor c. Prepaid expenses
b. Creditor d. Advance payment
18. The person to whom organisation owes money:
a. Debtor c. Prepaid expenses

b. Creditor d. Advance payment
19. Debtor is
a. Current asset c. Contingent liability
b. Current liability d. Fixed asset
20. Creditor is
b. Current liability d. Fixed asset
21. Plant & Machinery is
b. Intangible asset d. Fixed asset
1.1.10 Answer keys
1-b 2-b 3-c 4-d 5 6-b 7-c 8-a 9-b 10-d

11-d 12-b 13-a 14-a 15-b 16-d 17-a 18-b 19-a 20-b
21-d
26
Lesson No. 1.2: System of accounting
1.2.1 Objectives
1.2.2 Different accounting systems
1.2.3 Flow of an accounting transaction
1.2.4 Source documents
1.2.5 Types of vouchers
1.2.6 Identifying two accounts in a transaction
1.2.7 Three golden rules of accounting
1.2.8 Five golden rules of accounting
1.2.10 Key words
1.2.12 Answer keys
27
1.2.1 Objectives
 Different accounting systems
 Double entry accounting system
 Different types of accounts
1.2.2 Different accounting systems

There are many systems followed for maintaining books of accounts. It depends on the
nature of business, volume of business, and the regulatory requirement for the same.
Following are the various systems of accounting
Single Entry system:
A single entry system of accounting is a form of bookkeeping in which each of a

company’s financial transactions is recorded as a single entry in a log. This process does
not require formal training and is usually used by new small businesses because of its
simplicity and cost effectiveness. It records the date, description, the value of the
transaction and whether it’s an income or expense, and then the balance.
Double entry system
Every business transaction has two fold effects with the same amount i.e. Debit and
Credit. The number of accounts in both sides i.e. debit and credit side, may be more
than one but the total amount of both sides shall remain equal.
Example:
 A borrows from bank.₹100000
✓ Cash/bank account will increase by ₹ 100000.
✓Liability to pay will also increase by₹ 100000
Therefore, under double entry accounting system, the arithmetical accuracy of the
records is automatically checked.
28
1.2.3 Flow of an accounting transaction
Business transaction
Generation of source documents like

bill,invoice,reciept etc.
Identifying two accounts of the

transaction .Generating a voucher
Journal Entry
Effect into Ledger
Trial Balance
Preparation of Profit and Loss

Account and Balance Sheet
Source documents and voucher are explained below. Other components are explained in
subsequent paragraphs and chapter.
29
1.2.4 Source documents
As shown above, accounting transactions starts from business transaction and a

document which provides evidence of the transactions is called the ‘Source Document’.
This source documents may be cash memo, sales invoice, expenses invoice etc.
Based on such supporting source documents, accounting vouchers are prepared.

Accounting voucher give details of the transaction and are prepared and authorised by
authorised officials. While preparing the accounting voucher, short notes is being
written on voucher, called "Narration". The basic purpose of narration is to provide
short details through which an independent person can understand the flow of
cash/fund.
1.2.5 Types of vouchers
Cash voucher
These vouchers are prepared only when the business transaction is in cash i.e. business
has either paid cash or received cash. If business has received cash there will be cash
receipt voucher and if paid by business there will be cash payment voucher.
Transfer voucher
All non-cash transactions are recorded through the transfer voucher. Examples of non-
cash transactions are credit purchases, depreciation of goods, transfer from one account
to other account etc.
30
1.2.6 Identifying two accounts in a transaction
As stated earlier, in each business transaction minimum two accounts are involved and
hence it is very important to identify the affected accounts correctly.
Classification of Accounts
Personal A/c Impersonal A/c
Natural Personal A/c Artificial Personal A/c Representative

Personal A/c
Real A/c Nominal A/c
Tangible Real A/c Intangible Real A/c
Personal Accounts:
 These accounts which are related to individuals, firms, companies, etc
o Natural personal account: Personal account & God’s account eg. Kumar’s
A/C, Adam’s A/C, etc.
31
o Artificial personal account: Accounts which are created artificially by law.
Example: Pvt. Ltd companies, LLCs, LLPs, clubs, schools, etc.
o Representative personal account: Accounts which represent a certain
person or a group directly or indirectly. Example: Wage prepaid account
Real Account:
 All assets of a firm, which are tangible or intangible, fall under the category “Real
Accounts".
o Tangible Real account: Those assets which is physical in nature. Example:
Building, machinery, stock, land, etc
o Intangible Real account: Those assets that is not physical in nature.
Example: Good will, patents, trademarks, etc.
Nominal Account:
 Accounts which are related to expenses, losses, incomes or gains.
 Nominal accounts do not really exist in physical form, but behind every nominal
account money is involved. E.g. Purchase A/C, Salary A/C, Sales A/C,
Commission received A/C, etc.
 The final result of all nominal accounts is either profit or loss which is then
transferred to the capital account.
1.2.7 Three Golden Rules of Accounting

When any business transactions occur, any two or more accounts mentioned above will
either be debited or credited & shall be governed by the Three Golden Rules of
Accounting which is as under:
Types of Account Example Rules

Individual/ Artificial
Personal Debit the Receiver, Credit the
/representative giver
Real All assets Debit what comes in, Credit what

goes out
Debit the expenses or loss of the
business
Nominal Expenses/ Gains Credit the income or gain of the
business
32
1.2.8 Five Golden Rules of Accounting
For simplification there is another school of thoughts under which all the affected
accounts are classified in five categories as Asset, Liability, Owner’s equity, Revenue and
Expense and rules of accounting on this basis is called “5 Golden Rules of
Accounting”.
When any business transactions occur, any two or more accounts mentioned above will
either increase or decrease and their rules of debit & credit shall be governed by the
following rules.
Account Increase/Decrease Debit/Credit

Asset Increase Debit
Asset Decrease Credit
Liability & Owner's Equity Increase Credit
Liability & Owner's Equity Decrease Debit
Revenue/Income Increase Credit
Revenue/Income Decrease Debit
Expenses/Loss Increase Debit
Expanses/Loss Decrease Credit
Example
Nature of
Transactions Accounts involved Debit/Credit
account
Rent a/c Nominal a/c Debit
Rent paid
Bank a/c Real a/c Credit
Salary a/c Nominal a/c Debit
Salaries paid
Bank a/c Real a/c Debit
Interest received
Interest a/c Nominal a/c Credit
Dividends received
Dividend a/c Nominal a/c Credit
Furniture Furniture a/c Real a/c Debit
purchased Bank a/c Real a/c Credit
33
Nature of
Transactions Accounts involved Debit/Credit
account
A’s a/c Personal a/c Debit
Paid to Mr. A
Received from A Bank a/c Real a/c Debit
(Prop.) Capital a/c Personal a/c Credit
Machinery sold
Machinery a/c Real a/c Credit
Telephone charges Telephone charge a/c Nominal A/c Debit
paid Bank a/c Real a/c Credit
Received from Mr. Bank a/c Real a/c Debit
A (Prop.) Capital A/c Personal a/c Credit
Lighting a/c Nominal A/c Debit
Lighting expenses
Illustration no. 1
March 2021
1. Mr. A started business with cash ₹. 250,000.

2. Purchase goods for cash ₹. 15,000.
3. Sold good to Mr. B ₹. 5,000.
4. Purchase furniture for cash ₹. 30,000.
5. Bought goods from Mr. C ₹. 45,000.
6. Received from Mr. D ₹. 3,000.
7. Goods bought from Mr. E ₹. 10,000.
8. Sold goods to Mr. F ₹. 8,000.
9. Paid to Mr. G ₹. 25,000.
10. Sold goods for cash ₹. 12,000.
11. Paid rent of shop ₹. 17,000.
Please identify the affected accounts & its type of each transaction with reasons based on
golden rules.
34
Solution
Sr Name of Type of Debit/

no. Rea sons
Account Account Credit
1 Cash Real Dr. Cash comes in
Mr. A(Capital) Personal Cr. Proprietor is a giver

Purchase is an
Purchase Nominal Dr.
expense
2
Cash Real Cr. Cash going out
Cash Real Dr. Cash comes in

3
Sales Nominal Cr. Income of the business
Furniture Real Dr. Furniture comes in

4
Cash Real Cr. Cash goes out
Purchase Nominal Dr. Purchase is an expense

5
Cash Real Cr. Cash going out

6
Mr. D Personal Cr. Mr. D is a giver
Purchase Nominal Dr. Purchase is an expense

7
Cash Personal Cr. Cash goes out

8
Sales Nominal Cr. Income of a business
Mr. G Personal Dr. Mr. G is a receiver

9

10
Sales Nominal Cr. Income of the business
Rent Nominal Dr. Rent is an expense

11
35
Illustration no. 2
An entity named Stranger Ltd. has the following transactions.
1. It deposits ₹.100000 into Bank

2. It buys goods worth ₹.150 000 from RIL
3. It sells goods worth ₹.85, 000 to L & T
4. It pays ₹.15,000 as rent for its premises
5. It earns ₹.13, 000 as interest on a bank account.
Please identify the accounts involved in these transactions and classify them into the
different types of accounts
Solution
Transactions Accounts involved Type of account
Bank a/c Real a/c

Deposited in bank
Cash a/c Real a/c
Purchase a/c Nominal a/c

Bought goods from RIL
RIL a/c Personal a/c
L & T a/c Personal a/c

Sold goods to L & T
Sales a/c Nominal a/c
Rent a/c Nominal a/c

Paid rent
Bank a/c Real a/c
Bank a/c Real a/c

Earned interest
Interest a/c Nominal a/c
36
There are various methods of maintaining accounts such as Indian system, cash system,
and English system. The English system can be further classified into single entry
system and double entry system. The double entry system of book keeping is based on
the premise that every transaction has two aspects and the effect of both these aspects is
to be recorded in the books of account. The basic rule of accounting is “every debit must
have a corresponding credit and every credit must have a corresponding debit”.
Business transactions are recorded in the books based on the source documents such as
cash memo, sales invoice, purchase invoice etc. Based on the source documents
accounting voucher are prepared. There are two types of vouchers such as cash voucher
and transfer voucher. Cash voucher are used for recording cash transactions. Transfer
vouchers are used for recording non-cash transactions.
There are basically three types of accounts- Personalaccount, real account and nominal
account. Personalaccount represents natural person, legal person and even
representative grouped accounts (subsidiary ledger). Real account represents assets.
Nominal account represents accounts related to expenses, losses, income and gains.
Rule for Personalaccount is ‘Debit the Receiver and Credit the Giver.’ Rule for real
account is ‘Debit what comes in and Credit what goes out. Rule for nominal account is
‘Debit Expenses and Losses and Credit Incomes and Gains.
On the basis another school of thoughts there are five types of account- Asset, Liability,
Owner’s equity, Revenue and Expense and rules on the basis of these accounts are called
"5 Golden Rules of Accounting”
1.2.10 Key words:

Double entry system, Personal accounts, Real accounts, Nominal accounts, Narration
37
1.2.11 Multiple Choices Questions
1. Identify the affected accounts When goods are purchased on cash,
a. Stock account & Cash c. Bank account & stock
account account
b. Cash account & bank d. Supplier account & stock
account account
2. When goods are purchased on cash, which account shall be

credited
a. Stock account c. Bank account
b. Cash account d. Supplier account
3. When goods are purchased on cash, which account shall be
debited
4. When goods are sold on cash, which account shall be
credited
5. When goods are sold on cash, which account shall be debited
6. Identify real account/s
a. Insurance premium c. Commission received
b. Properties d. Drawing
7. Identify nominal account/s
a. Income tax account c. Commission received
b. Properties d. Drawing
8. Identify personal account/s
a. Income tax account c. Outstanding salaries
b. Drawing d. All of the above
38
9. Identify nominal account/s
a. Provision of depreciation c. Loans and advances
b. Investments d. All of the above
10. "Drawing" is
a. Real account c. Nominal account
b. Personal account d. Tangible account
11. Identify the affected accounts when Purchased goods from Mr X
a. Purchase account & Mr. X c. Purchase account & cash

account account
b. Sales account & Mr. X d. None of the above
account
12. Identify the affected accounts when paid shop rent
a. Rent account and bank c. Rent account and Mr. X
account account
b. Rent account & cash d. Cash account and bank
account account
13. Identify the affected accounts when goods bought from Mr. X
a. Sale account & Mr. X c. Bank account and Mr. X
account account
b. Cash account & Mr. X d. Purchase account and Mr.
account X account
14. Which accounts shall be debited when goods sold to Mr. X
a. Sales account c. Cash account
b. Mr. X account d. None of the above
15. Identify the affected accounts when ₹. 10000/ deposited in bank
a. Capital account & bank c. Capital account & cash
account account
b. Bank account & cash d. None of the above
account
16. Identify the types of affected accounts when interest earned on bank account
a. Nominal & Real account
39
b. Nominal & Personal c. Real & personal account
account d. All of the above
17. Which account shall be debited when interest earned on bank account
a. Interest received account c. Personal account
b. Bank account d. Intangible account
18. Which account shall be credited when interest earned on bank account
a. Interest received account c. Personal account
b. Bank account d. Intangible account
19. Identify the affected accounts when purchased furniture for cash from Mr. X
a. Purchase account & bank c. Furniture & cash account
account d. Any one of the above
b. Purchase account & MR X
account
20. Identify the types of affected accounts when purchased furniture for cash from
Mr. X
a. Real & Real account
b. Nominal & Personal account
c. Real & personal account
d. All of the above
1.2.12 Answer keys
1-a 2-b 3-a 4-a 5-b 6-b 7-c 8-d 9-a 10-b
11-a 12-b 13-d 14-b 15-b 16-a 17-b 18-a 19-c 20-a
40
Lesson No. 1.3: Books of accounts to be maintained
1.3.1 Objectives
1.3.2 Background
1.3.3 Journal format
1.3.4 Subsidiary books/special journals
1.3.5 Various types of subsidiary journals
1.3.6 Adjusting entry
1.3.7 Ledger
1.3.8 Balancing of ledger
1.3.9 Difference between journal & ledger
1.3.11 Key words
1.3.12 Multiple Choice questions
1.3.13 Answer keys
41
1.3.1 Objectives
 Introduction
 Journal – meaning and Format
 Subsidiary Books/ Cash Book
 Posting into Ledger
 Balancing of Books
1.3.2 Background
We have seen in earlier lesson that Business transactions are classified into five
categories of accounts such as assets, liabilities, expenses, revenue and capital/owner
equity and once a decision is taken on types of accounts and its debit or credit, its
recording in a book is required,, called Journal and the process of recording of
transactions is known as recording "Journal Entries "A journal is a book of “original
entry” or “primary entry” as it is a book of accounts in which all day to day business
transactions are recorded in a chronological order (i.e. in the order of their
occurrence).Since this is first step in accounting, hence, this is also called Original or
Prime entry.
Depending upon the volume and complexities of the transactions, business houses may
maintain only one Journal Book or many “Subsidiary books”. When transactions are
large in number and cumbersome, it is necessary to divide the whole Journal into
several subsidiary journals.
1.3.3 Journal format

It has 5/6 columns and for the sake of simplicity we have taken 6 columns.
Date Particular Nature of LF Amount

account
(1) (2) (4) Debit Credit
(3)
(5) (6)
42
Steps for recording
1. Determine the a/c and its nature before recording
2. Determine applicable rules to ascertain which a/c is to be debited &which is to be

credited.
3. Record the date of transaction in chronological order in column no .1
4. Particular (Column no. 2)
a. Extreme left---Write Name of a/c to be debited & in the same line Extreme
right….write "Dr"
b. 2nd line in the same row and same column, write Name of a/c to be credited
and prefixed by "To"
c. Below the 2nd line under bracket in the same row and same column, short
explanation of transaction, called Narration, is written.
5. Nature of account (Column no.3)
a. Name of the affected account is written.
b. Practically this columndoes not exist.
6. Ledger folio (Column no.4)
a. Respective number of Ledger folio where these entries are to be
transferred at later stage i.e. at the time of posting and hence at the time
recording it is kept blank.
7. Debited & Credited amount is recorded in respective column (Column no. 5 & 6)
Illustrations no. 1
Journalize the following transactions in the books of Mr. A

i. Jan. 1, 2021 Mr. A started a business with cash of ₹ 40000
ii. Jan. 3, 2021 He paid into bank ₹ 20000
iii. Jan. 5, 2021 Purchased goods for cash ₹ 15000
iv. Jan. 10, 2021 Sold goods for cash ₹ 6000
v. Jan. 11, 2021 Sold goods Mr. B ₹ 3000
43
vi. Jan. 31, 2021 Paid for stationery for ₹ 600, rent for ₹1000 & telephone bill
for ₹500.
Solution
Sr.no Date Particular Nature LF Dr. Cr.

of a/c
1 Jan 1 Cash a/c Dr Real 40000
2021 To capital a/c Personal 40000
(Being commencement of
business)
2 Jan 3 Bank a/c Dr Personal 20000
2021 To cash a/c Real 20000
(being cash deposited in
the bank)
3 Jan 5 Purchase a/c Dr Nominal 15000
2021 Cash a/c Real 15000
4 Jan 10 Cash a/c Dr Real 6000
2021 To sales a/c Nominal 6000
(Being goods sold for
cash)
5 Jan 11 B a/c Dr Personal 3000
(Being goods sold to B) a/c
6 Jan 31 Stationery a/c Dr Real 600
2021 Rent a/c Dr Nominal 1000
Telephone bill Dr Nominal 500
To Cash a/c Real 2100
(Being cash paid for
stationery, rent&
Telephone expenses)
Total 86100 86100
Illustrations no. 2
Journalize the following transactions in the books of Mr. B

1. May 1 2021 Mr. B started business with cash of ₹ 350000
2. May 2 2021 Purchased machinery for ₹ 200000 from M/S XYZ Pvt. Ltd
Purchased furniture for ₹ 20000 from Mr. C
3. May 8 2021 Purchased goods for ₹ 80000
4. May 12 2021 Sold goods for ₹ 10000
5. May 16 2021 Purchased goods from Mr. D for ₹5000
44
6. May 18 2021 Sold goods to Mr. E for ₹30000
7. May 31 2021 Paid for stationery for ₹.600, rent for ₹10000 & telephone bill for
₹1500.
Solution
Journal Entries
(In the books of Mr. B)
Sr.no Date Particular Nature of L Dr. Cr.
a/c F
1 May 1 Cash a/c Dr Real 350000
2021 To capital a/c Personal 350000
(Being commencement of
business)
2 May 2 Machinery a/c Dr Real 200000
2021 To M/S XYZ pvt ltd a/c Personal 200000
(Being machinery bought from
M/S XYZ pvt ltd)
2 May 2 Furniture a/c Dr Real 20000
2021 To Mr C a/c Personal 20000
(Being furniture bought from
Mr C)
3 May 8 Purchase a/c Dr Nominal 8000
2021 To Cash a/c Real 8000
(Being goods purchased for
cash)
4 May 12 Cash a/c Dr Real 10000
(Being goods sold for cash)
5 May 16 Purchase a/c Dr Nominal 5000
2021 To Mr D a/c Personal 5000
(Being goods purchased from
Mr D)
May 18 Mr E a/c Dr Personal 30000
2021 To Sales a/c Nominal 30000
(Being goods sold to Mr E)
6 May 31 Stationery a/c Dr Real 600
2021 Rent a/c Dr Nominal 10000
Telephone bill Dr Nominal 1500
To Cash a/c Real 12100
(Being cash paid for stationery,
rent & Telephone expenses)
Total 635100 635100
45
1.3.4 Subsidiary books/ Special journals
In case of small businesses, it is convenient to maintain one Journal. However for large
number of business transactions, the Journal would be very huge and it would be very
difficult to make a ready reference to such a Journal. Further it would be very difficult
for many accountants to handle the same journal. A logical solution to this problem
would be to group similar types of transactions and record them at one separate
Journal. Thus special journals are those journals, which are meant for recording
repetitive type of transactions. For example, Cash book would be maintained for cash
transactions, purchase book would be maintained to record all credit purchases of the
organization.
Thus as similar transactions are grouped together under subsidiary journal; there is no
need to record the entries in the form of ‘Journal Entry’ as described above. In other
words, instead of writing several repetitive separate entries for each credit sales as
Various Customers A/c…….. Dr.
To Sales a/c;
A Sales Journal is maintained where details of the all the customer would be mentioned
along with date and amount and thus separate ‘Journal Entry’ as shown above need not
be passed for every transaction. In the Sales Journal, the account that would be credited
would be the same for all entries i.e. Sales A/c and same procedure apply for other
subsidiary maintaining one journal or many subsidiary journals does not make any
difference in the subsequent accounting process i.e. at the time of posting, preparation
of Trial balance and financial statements
1.3.5 Various types of subsidiary journals
Subsidiary Journals Category of business transactions recorded

Sales Book All sales on credit basis
Purchase Book All purchases on credit basis
All transactions of return of goods by our customer i.e. Return
Sales return book
Inwards
46
Subsidiary Journals Category of business transactions recorded
All transactions of return of goods purchased from the
Purchase return book
supplier i.e. Return Outward
Cash Book All cash/ Bank receipts and payments
All remaining transactions, which cannot be entered in the
above mentioned journals, are entered in this book.
Journal proper
(Transactions are entered in the Journal Entry form, which is
described earlier)
Cash book with cash and bank column
Nowadays with the increase in the number of bank transactions, it is required to have a
separate bank book on similar lines of the cash book. Sometimes instead of having
separate book to record bank transactions, a column is added on to each side of the
simple cash book. This is called Bank Column Cash Book.
As recorded in the cash book, all receipts into the bank account are recorded on the
debit side of the bank book and all withdrawals/payments from the bank account are
recorded on the credit side of the bank book.
Petty cash book
In addition to above mentioned Subsidiary Journals, petty cash book is maintained for
recording small expenses such as conveyance, postage, stationery etc. Generally imprest
system is followed in the petty cash system. Under this system a specific sum is handed
over to the officials concerned at the beginning of the period and he/she meets all the
small payments through this amount. At the end of the period he/she submits all the
vouchers to the cashier and gets the amount reimbursed. Thus at any given point of
time, the cash and vouchers with the petty cashier tally with the amount specified at the
beginning of the period.
47
Illustration no.2
Prepare Bank Column Cash Book for March 2021
Date Details Amount (₹.)

2018
Mar 2 Cash in hand 15000
Mar 4 Bank Overdraft 9000
Mar 5 Paid Wages 1000
Mar 7 Cash Sales 20,000
Mar 12 Cash deposited into Bank 15,000
Mar 16 Purchased Goods and paid by cheque 8,000
Mar 22 Cash deposited into Bank 5,000
Mar 23 Paid Trade Expenses by cheque 2000
Mar 23 Rent paid 5000
Mar 25 Received Cash from ABC 9000
Mar 27 Commission paid 4,000
Mar 29 Salary paid 10,000
Mar 31 Bought Goods by cheque 7,000
Solution:
Bank Column Cash Book
Date Particular LF Cash Bank Date Particular L Cash Bank

F
Mar Mar
2 To Bal 15,000 4 By Bal b/d 9,000
b/d
7 To Sales 20,000 5 By wages 1,000
A/c A/c
12 To Cash 15000 12 By Bank 15,000
A/c A/c
22 To Cash 5000 16 By Goods 8,000
A/c A/c
48
25 To ABC 9,000 22 By Bank 5,000
A/c A/c
31 To Bal 6000 23 By Trade 2,000
c/d Exps A/c
23 By Rent 5,000
A/c
25 By 4,000
Commissio
n A/c
29 By Salary 10,000
A/c
31 By Goods 7000
A/c
31 By Bal c/d 4,000
44,000 26,000 44,000 26,000
1.3.6 Adjustment entry

To justify the principle of matching cost and revenue, amount of every expenses and
revenue should pertain to the period for which accounts are being prepared. There can
be a situation where amount received or paid is for more than one accounting year or
the amount due to be paid or received for the current year is not paid/received.
Further there are adjustment entries for charging depreciation, recording of the closing
stock entry etc.
Examples
1. Amount received is for more than one accounting year (income received in advance)
Since some income has been received in advance for next accounting period also
hence in view of principle of matching cost and revenue, income head is to be
debited and advance income received account, which is liability for next
accounting year, should be credited.
Income A/c ……………………. Dr
To advance income received account (Liability) A/c

49
2. In the same manner it is possible that we paid some expenses in advance. For
example if we got insured our stocks in the month of January 21 for 12 months and
paid ₹ 12000/ as premium. The adjustment entry shall be as under
Prepaid expenses a/c Insurance Dr

To Expenditure a/c Insurance
There may be many entries/transaction of such nature. Here we are giving some
common entries and their journal entries.
3. Outstanding Expenses: Those expenses which should be paid in last accounting year
but paid in subsequent accounting period.
Salaries (Expense) A/c ………………. Dr

To Salaries outstanding (Liability) A/c
(Salaries not paid for the month of March’21 provided for)
4. Accrued income
Income earned but not yet received is the accrued income. Accrued income is an asset as
income is already earned but not received.
Accrued income Fee A/c ………………. Dr

To Fee (Income) A/c
(Being service fee due but not yet received)
50
5. Closing Stock
At the end of the accounting period unsold stock is called closing stock. Keeping the
principles of matching cost and revenue in mind, the value of closing stock (Unsold
stock) must be account for.
Closing stock A/c (asset side of the balance sheet)………….. Dr

To closing stock (Right side of Profit and Loss account)
6. Provision for bad and doubtful debt

As per regulatory norms, certain %age of debts is provided for provision for bad and
doubtful debt in the banking industry and in the same manner in business also, loss
on credit sales are estimated and provided accordingly. Their journal entry shall be
passed as under.
Expenditure a/c Provision for bad & doubtful reserve (P & L account) Dr
To bad and doubtful reserve (Balance sheet)
7. Bad debts:
Once it is confirmed that amount would not be realized from certain debtors, it is
termed as bad debts. The amount of bad debts has to be deducted from the debtors and
the amount has to be booked as loss in the profit and loss account.
The journal entry for accounting shall be passed as under
Bad debts A/c (P & L a/c) Dr

To Debtor A/c ((Balance sheet)
(Being bad debts written off)
Bad and doubtful reserve (BDDR)
(Balance sheet) Dr
To bad debts (P & L a/c)
51
In certain business and industries, certain %age of debts has to be maintained as
reserve for bad and doubtful debts which should be maintained by debiting Expenditure
a/c provision for bad & doubtful reserve (P & L account) and crediting to Bad and
doubtful reserve by deficit amount.
For example,
i. If the opening balance of BDDR as on 01.04.2021 is ₹. 5,000. The bad debts for
the year 2021-22 are ₹. 1000 and the reserve required for the current year is ₹.
5,500. The additional provision required is ₹. 1,500 (debit to Profit and Loss
account) {5,500 – (5,000-1000)}
ii. If the opening balance of BDDR as on 01.04.2021 is ₹. 5000. The bad debts for
the year 2021-22 are ₹. 1000 and the reserve required for the current year is ₹.
3500. The provision that would be reversed to the Profit and Loss account is ₹.
500 (credit to Profit and Loss account) {3,500 – (5,000-1000)}
1.3.7 Ledger
Ledger is an accounting book which contains permanent record of all transactions in
classified & summarized manner. At the time of the recording in the Journal Entry, the
accounts are identified and are debited and credited based on rules as we discussed in
earlier lesson. Then all the accounts identified at the Journal Entry stage are opened in
the book separately, called as Ledger. Therefore a ledger is a book of account; where all
accounts related to assets, liabilities, capital, revenue, expenses are maintained
separately. The process of transferring the entries from Journal/ Subsidiary Journal to
the individual account is called Posting. In other words, the process of transferring
“Debit” & “Credit "entries from Journal (Book of prime entry)to respective a/cs in
ledger(Principal book of account) is called Ledger posting
52
Format of the Ledger
Name of Account
Dr Cr
Date Particular JF Amount Date Particular JF Amount
Ledger is a book containing many pages, each page is called "Ledger Folio" and they are
consecutively numbered, called "Ledger Folio no." All identified accounts (Assets,
Liabilities, Capital, revenue, Expenses) are opened in the folio separately.
Steps for posting
 Identify first affected a/c in first journal entry.

 Open folio of respective account
 Write date and amount of transaction in respective side i.e. Dr/Cr of ledger folio.
 Particular Column
o Debit side write name of a/c credited prefixed by "To"
o Credit side write name of a/c debited prefixed by "By"
 Write respective folio no. of journal under column "JF" of ledger and write
respective folio no. of ledger under column "LF" of journal which was kept blank
at the time recording in journal.
 Similar procedure is followed for posting all entries of journal
 Periodicity of posting may vary from one day to one month depending upon
number of business transaction per day.
1.3.8 Balancing of Ledger

After all entries are posted in the ledger, next step is the balancing of the ledger
accounts.
Balance of any account is the difference between the total of the debits and total of
credits of an account. If the debit side is more than the credit side, the balance
calculated is the debit balance. Similarly when the credit side is more than the debit
side, the balance calculated is the credit balance. At the end of the financial year of the
organization, all ledger accounts are closed by taking out the balance of each account.
53
Then the balances are carried over to next accounting period. (Examples are given
above)
Steps of balancing
 Total both sides (Debit/Credit side) of the ledger and find the larger total.
 Put the larger total in the total box on the debit / credit side.
 Insert a balancing figure to the side of the account which does not currently add
up to the amount in the total box.
 Call this balancing figure either ‘To/ By balance c/f’" (carried forward) or ‘To/By
balance c/d" (carried down).
 Carry the balance down diagonally and call it ‘balance b/f’' (brought forward) or
‘balance b/d’ (brought down) prefixed by "To or By" appropriately.
1.3.9 Difference between Journal & Ledger
 Journal is called the original book of entry because the transaction is recorded
first in the journal. Ledger, on the other hand, is called the second book of entry
because the transaction in the ledger is transferred from journal to ledger.
 In a journal, the entry is recorded sequentially, i.e., as per the happening of the
transaction. In the ledger, the entry is recorded account wise.
 The act of recording into the journal is called journaling. The act of recording into
the ledger is called posting.
 In a journal, the narration is a must because otherwise, the entry would lose its
value. In the ledger, the description is optional.
 In a journal, there is no need for balancing. In the ledger, balancing is a must at
the end of the period.
54
Illustration no. 3
From following journal entries prepare ledger account.
Particular L.F. Debit Credit

Date Amount ₹. Amount ₹.
2020 Cash A/c …………… Dr 100,000
Apr 1 To Capital A/c 100,000
(Being capital brought in the
business)
Apr 1 Bank A/c …………… Dr 90,000
To Cash A/c 90,000
(Being cash deposited in the
bank)
Apr 4 Plant and Machinery A/c …….. 75,000
Dr 75,000
To Bank A/c
(Being Plant and machinery
purchased)
Apr 4 Office Furniture A/c …………… 5,000
Dr
5,000
To Bank A/c
(Being office furniture
purchased)
Apr 5 Bank A/c …………… Dr 100,000
To Loan A/c 100,000
(Being bank loan availed)
Apr 6 Stationery A/c …………… 5,000
Dr 5,000
To Cash A/c
(Being stationery purchased for
the office)
Apr 12 Cash A/c …………… Dr 9,000
To Sales A/c
(Being goods sold on cash ) 9000
55
Apr 14 ABC A/c …………… Dr 30,000
To Sales A/c 30,000
(Being goods sold on credit to
ABC)
Apr 20 Insurance A/c …………… 2,000
Dr 2,000
To Bank A/c
(Being insurance premium
paid.)
Apr 20 Sales Return A/c ………… 3000
Dr 3,000
To ABC A/c
(Being goods returned by ABC)
Apr 25 Bank A/c …………… Dr 26,500
Bad debts A/c ………. Dr 500
To ABC A/c 27,000
(Being amount received from
ABC in full and final settlement)
2021
Mar 31 Depreciation on Plant and 22,500
Machinery A/c …………… 22,500
Dr
To Plant and Machinery A/c
(Being provision for
depreciation made for the year
ended March’12)
Mar 31 Salaries A/c …………… 10,000
Dr 10,000
To Outstanding salaries A/c
(Being salary outstanding for
the month of March provided
for.)
56
Solution i.e. Ledger Posting
Dr Cash A/c Cr
Date Particular J.F Amount Date Particular J.F. Amount
2020 2020
Apr 1 To Capital A/c 100,000 Apr 1 By Bank A/c 90,000
Apr 12 To Sales A/c 10,000 Apr 6 By Stationery A/c 5,000
2021
March
By balance c/d 15000
31
110000 110000
2021
Apr 1 To balance b/d 15000
Dr Bank A/c Cr

2020 2020
Apr 1 To Cash A/c 90,000 Apr 4 By Plant and 75,000
Machinery A/c
Apr 5 To Loan A/c 100,000
By Office Fur. A/c
Apr To ABC A/c 26,500 Apr 4 5,000
25 By Insurance A/c
Apr 2,000
20
2021
March By balance c/d 134500
31
2165000 216500
2021
Apr 1 To balance 134500
b/d
57
Dr Capital A/c Cr

2021 2020
March To balance c/d 100000 Apr 1 By Cash A/c 100,000
31
100000 100000
2021 By balance b/d 100000
Apr 1
Dr Plant and Machinery A/c Cr

2020 2021
Apr To Bank A/c 75,000 Mar By Depreciation 22,500
4 31 A/c
By balance c/d
2021 52500
Mar
31
75000 75000
2021 To balance 52500
b/d
Apr 1
Dr Office Furniture A/c Cr

2020 2021
Apr 4 To Bank A/c 5,000 Mar 31 By balance c/d 5000
5000 5000
2021 To balance b/d 5000
Apr 1
58
Dr Loan A/c Cr

2021 2020
Mar 31 To balance c/d 100000 Apr 5 By Bank A/c 100,000
100000 100000
Apr 1
Dr Stationery A/c Cr

2020 To Cash A/c 5,000 2021 By balance c/d 5000
Apr 6 Mar 31
5000 5000
Apr 1
Dr Sales A/c Cr

2021 2020 By Cash A/c 10,000
Mar 31 Apr 12
By balance c/d 40000 Apr 14 By ABC A/c 30,000
40000 40000
Apr 1
Dr ABC A/c Cr
Date Particular J.F Amount Date Particular J.F Amount

2020 2020
Apr To Sales 30,000 Apr By Sales Return 3,000
14 A/c 20 A/c 26,500
59
Apr 25 By Bank A/c 500
Apr 25 By Bad debts A/c
30000 30000
Dr Insurance A/c Cr

2020 2021
Apr 20 To Bank A/c 2,000 Mar 31 By balance c/d 2000
2000 2000
Apr 1
Dr Sales Return A/c Cr

2020 2021
Apr 20 To ABC A/c 3,000 Mar 31 By balance c/d 3000
3000 3000
Apr 1
Dr Bad debts A/c Cr

2020 2021
Apr 25 To ABC A/c 500 Mar 31 By balance c/d 500
500 500
Apr 1
Dr Depreciation A/c Cr
Date Particular J.F Amount Date Particular J.F Amount

2021 2021
Mar By balance
60
Mar To Plant and 22,500 31 c/d 22500
31 Machinery A/c
22500 22500
Apr 1
Dr Salaries A/c Cr

2021 2021
Mar To Outstanding 10,000 Mar By balance 10000
31 Salaries A/c 31 c/d
10000 10000
Apr 1
Dr Outstanding Salaries A/c Cr

2021 2021
Mar 31 To balance c/d 10000 Mar 31 By Salaries A/c 10,000
10000 10000
Apr 1
1.3.10 let’s sum up

After accounts involved in the transactions and their types are identified they are
recorded in the books of “original entry” called Journal. Thus all business transactions
are recorded in the journal and the process of recording transactions is known as
“Journal Entries”
At the time of finalization of the accounts, few entries are to be passed based on the
matching and accrual concepts. These are called adjustment entries. Thus adjustments
entries are to be passed at the year-end such as depreciation on the fixed assets,
61
recording of the entry of closing stock, provision for doubtful debts, outstanding
expenses, prepaid expenses, income received in advance and income earned but not
received.
Subsidiary journals are prepared in order to manage huge volume of business

transactions and also to bunch repetitive type of transactions at separate journals.
Various types of subsidiary journals are cash book, sales book, purchases book, sales
return book, purchases return book, journal proper.
Separate ledger accounts are opened for all accounts mentioned in the journal. Thus all
journal entries are posted in the respective ledger accounts. At the end of the year, all
ledger accounts are balanced. Nominal accounts are closed and transferred to Profit and
Loss account. Personal and real accounts are not closed, they are reflected in the balance
sheet and their balances are carried forward in the next year.
1.3.11Key words:
Journal, Subsidiary journal, Ledger, Narration
1.3.12 Multiple Choices Questions

1. A book where business transactions are recorded on the basis of source documents
a. Ledger c. P & L a/c
b. Journal d. Balance sheet
2. Brief description of the transaction is called

a. Source document c. Narration
b. Evidence d. Banker
3. Mr. ABC’s account would be _____________ for the loan given by him.
a. Credited c. Nullified
b. Debited d. Netted off
62
4. When goods are sold on cash basis to XYZ ltd. ___________ account would be
debited.
a. Goods c. Cash
b. XYZ ltd. d. Creditor
5. When shares of Infosys are sold ___________ account is credited.
a. Fixed asset c. Purchases
b. Sales d. Investments
6. Transfer of transaction entry from journal to ledger is called
a. Accounting c. Transfer
b. Book keeping d. Posting
7. First entry of financial transaction is recorded in
a. Cash book c. Journal
b. Sales book d. Ledger
8. Which book of accounts are more important
a. Journal c. Purchase book
b. Ledger d. Sales book
9. The format of ledger is
a. T shape c. M shape
b. I shape d. N shape
10. Ledger is called
a. Book of original entry c. Book of tertiary entry
b. Book of secondary entry d. Book of intermediate entry
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11. Recording in journal is in
a. In the order of account c. Chronological order
b. In the order of entries d. As per convenience
12. Narration is mandatory in
a. Journal c. Both a & b
b. Ledger d. All of the above
13. Balancing is mandatory in
a. Journal c. Both a & b
b. Ledger d. All of the above
14. The ledger column that links the entry with the journal is called as.
a. J.F column c. Credit column
b. L.F column d. Debit column
15. The left hand side of the ledger account is referred to as.
a. Footing c. Debit side
b. Credit side d. Balance
16. Accounts that have credit balance are closed by using the statement.
a. By balance b/d c. To balance b/d
b. By balance c/d d. To balance c/d
17. The book maintained for recording small expenses such as conveyance, postage etc
is called
a. Journal c. Cash book
b. Ledger d. Petty cash book
18. To justify the principle of match cost and revenue------------------ is made.
64
a. Journal entry c. Ledger entry
b. Adjustment entry d. All of the above
19. In journal
a. The entry is recorded c. The entry recorded account

sequentially wise
b. The entry is recorded in d. Both a & b

chronological order
20. In ledger
a. Balancing at the end of the c. Narration is necessary

period is necessary
d. All of the above
b. Description of entry is
optional
1.3.13 Answer Keys
1-b 2-c 3-a 4-c 5-d 6-d 7-c 8-a 9-a 10-b
11-c 12-a 13-b 14-a 15-c 16-d 17-d 18-b 19-d 20-a
65
Lesson No 1.4: Bank Reconciliation Statement
1.4.1 Objectives
1.4.2 Introduction
1.4.3 Need for bank reconciliation statement
1.4.4 Possible reasons for difference
1.4.5 Steps for preparing bank reconciliation statement
1.4.6 Lets sum up
1.4.7 Key words
1.4.8Multiple choice questions
1.4.9 Answer keys
66
1.4.1 Objectives
 Need for preparation of Bank Reconciliation Statement
 Reasons for difference between the balances of bank book and pass book
 Preparation of Bank Reconciliation Statement
1.4.2 Introduction
In order to curb money laundering activities, Government agencies and Regulator
imposed many restrictions in handling of cash and insist on increased use of banking
channels in the business and otherwise also. Further, Reserve Bank of India has also
introduced many digital channels for transfer of funds such as Real Time Gross
Settlement (RTGS), National Electronic Fund Transfer (NEFT), and Electronic Clearing
System (ECS), UPI/IMPS etc. All these have resulted in gradual increase in use of bank
channels.
1.4.3 Need for bank reconciliation statement

The way a bank account is maintained in the books of an organization, each depositor’s
account is also maintained in the books of the bank. The entries in the depositor’s
account in the bank are the exact mirror replica of the bank account in the books of the
organization. In view of this, generally bank account in the books of the organization
shows debit balance (unless overdraft facility is availed from the bank), while it is
reflected as credit balance in the depositor’s account in the bank.
Thus, in the depositor’s account in the bank, all deposits by the customer are recorded
on the credit side of the account and all withdrawals are recorded on the debit side of
the account. A copy of the account is regularly sent to the account holder by the bank.
This is called ‘Pass book’ or ‘Bank statement’.
Bank statement of the depositor, being the mirror replica of the bank account in the
books of the organization, both the balances must theoretically tally. However in
practice, this does not happen (possible reasons for the same are discussed subsequently
67
in this chapter). Bank balance as shown by Bank column of the cash book may not tally
with the balance as shown in the Pass book on a particular given date. Therefore the
organization has to identify the causes for such differences and reconcile them. The
statement explaining the causes of disagreement between the two balances is prepared
and is called ‘Bank Reconciliation Statement’.
It is not statutorily required to prepare the Bank Reconciliation Statement. Also, there is
no set frequency for the reconciliation of the balances. However, in order to avoid
mistakes, if any, bank reconciliation statement is an important part of internal controls.
The frequency of preparation of Bank reconciliation statement is normally monthly but
its frequency may also be fortnightly, weekly or even daily depending upon the volume
of business...
1.4.4 Possible reasons for the difference

The basic reason behind the difference in both these balances is the time lag in the
recording of the transaction in both the books as the time period of recording of
transaction in the bank book of the organization does not correspond with the
organization’s account in the Bank. The reasons for the difference are as follows:
1. Cheques deposited in the bank but not yet cleared
The cheques received from the customer are recorded in the books and deposited
in the bank account. However, the bank gives credit in the firm’s account only
when the cheque is cleared and the amount is collected from the paying bank.
2. Amount directly deposited by the customer through RTGS, NEFT, ECS etc./cash,
not reflected in our books
With the advent of new methods of fund transfer such as RTGS, NEFT, ECS, etc.
funds are transferred by the payer or cash are deposited, directly into the firm's
account. Sometimes it may happen that funds are received in the bank account
but the intimation of the same is not received. As a result of which corresponding
entry of the same may not be recorded in the cash/ Bank book.
68
3. Amount directly debited due to standing instructions given to the bank or ECS
debit instructions
The bank accepts the standing instructions from the depositor for payment of
monthly instalments towards recurring deposit or term loan. Similarly ECS
debits are accepted for payment of utility bills, insurance etc. In these cases,
amount is directly debited by the bank. However the firm will record the same on
receiving information from the bank in the pass book or the account statement.
4. Bank charges debited by the bank
Bank debits the account of the depositor for various charges such as cheque book
issuance charges, folio charges, cheque return charges, minimum balance
charges, locker charges or any fees or commission charged, etc. The firm can
record these transactions only after receiving intimation from the bank.
5. Interest credited by the bank
Bank might credit the account of the firm for the interest on the deposits, if any
kept by the firm. The firm may not be able to record these entries until it gets
intimation for the same.
6. Dishonour of cheques
The cheques deposited by the firm may not be honoured by the paying bank for a
variety of reasons. Similarly cheque issued by the firm may also be dishonoured
by the bank. Firm may not be able to record these transactions unless it gets
intimation for the same.
7. Cheques deposited into bank for collection but not entered in the cash/ bank
book
Sometimes the firm may have received the cheque and deposited in the bank
account without recording the same in the bank book. This causes the difference
in the balances.
8. Cheques received and entered in the cash/ bank book but not yet deposited into
the bank for collection
69
Sometimes it may so happen that receipt of cheque is recorded in the bank book,
but inadvertently not deposited in the bank. The same may cause difference in
the balances.
9. Error committed in recording of the transaction either by bank or by the

organization
There may be some error either by the bank or the firm as regards omission or
wrong posting of the entries. In such circumstances there may be difference in
the balances.
1.4.5 Steps for preparing bank reconciliation statement

1. A date for which the statement is to be prepared is decided say a fortnight end,
month end or quarter endand cash book should be completed accordingly &
balance as per bank column should be arrived for.
2. The bank should be requested to send up to date passbook up to the date on

which bank reconciliation statement should be prepared.
3. The balance, either of bank columns of cash book or passbook should be taken as
base.
4. Now compare the entries of both the books and identify the cause of differences
as discussed in earlier paragraph.
5. In case, the cause has resulted in increase in the balance shown by the other
book say cash book, the amount of such an increase should be added in former
book, say passbook which has been taken as base and vice versa i.e. if we have
taken cash book as base and the cause has resulted in decrease in the balance
shown by passbook, the amount of such an increase should be deducted from
cash book.
6. In case, the cause has resulted in decrease in the balance shown by the other
book say cash book, the amount of such an decrease should be deducted in
former book, say passbook which has been taken as base and vice versa i.e. if we
have taken cash book as base and the cause has resulted in increase in the
70
balance shown by passbook, the amount of such an increase should be added to
cash book.
7. In case of overdraft (where the bank Pass Book shows a debit balance and the
Bank column of the Cash Book shows a credit balance), the step would be just
reverse.
8. The resultant figure must be equal to the balance as per the other book i.e. we
have taken the balance of cash book as base the resultant figure must be equal to
the balance as per passbook.
It can be summarized as under
Balance as per Balance as per Pass

Cash Book Book
Cr balance Dr Dr balance
Causes of difference Cr balance
(OD) balance (OD)
Check issued but not cleared/presented (-) (+) (+) (-)

or dishonoured & similar cause
Check deposited but not realized & (+) (-) (-) (+)
similar cause
Bank charges debited& similar cause (+) (-) (-) (+)
Interest credited & similar cause (-) (+) (+) (-)
Amt. directly deposited by customer & (-) (+) (+) (-)

similar cause
Balance as per Balance as per cash

passbook book
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Illustrations no.1
ABC pvt. Ltd Co. has a difference in the balance as per Cash Book and bank passbook as
on 31st March 2021. You are advised to prepare a Bank Reconciliation Statement as on
31.03.2021 with the following information:
1. Balance as per Bank passbook as on 31st March 2021 is ₹40000. Balance as per
Cash Book is ₹14000.
2. Cheque of ₹10000 and ₹5000 issued as on 30th March 2021, but not yet cleared
3. An insurance premium paid by bank ₹2000. It is not yet recorded in Cash Book.
4. An outgoing cheque of ₹20000 recorded twice in the Cash Book. It is properly
recorded in the bank statement.
5. Payment of a cheque of ₹4000 recorded twice in Passbook.
6. Dividends received ₹5000 recorded only in the bank statements and not Cash
Book.
7. Cheque of ₹7000 deposited on 29th March 2021. But, it is not yet collected.
8. Bank charges of ₹1000 debited only in Bank Passbook.
Solutions
Particular Amt. Amt.

Balance as per passbook 40000
Add:An insurance premium paid by bank ₹2000 but not yet 2000
recorded in Cash Book
Payment of a cheque of ₹4000 recorded twice in Passbook 4000
Cheque of ₹7000 deposited on 29th March 2021. But, it is not yet 7000
collected
Bank charges of ₹1000 debited only in Bank Passbook. 1000 14000
Less:Cheque of ₹1,0000 and ₹5000 issued but not yet cleared

(10000+5000) 15000
An outgoing cheque of ₹2,0000 recorded twice in the Cash Book 20000
Dividends received ₹5000 recorded only in the bank statements 5000 40000
Balance as per cash book 14000
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OR
Particular Amt. Amt.

Balance as per cash book 14000
Add: Cheque of ₹1,0000 and ₹5000 issued but not yet cleared
(10000+5000) 15000
An outgoing cheque of ₹2,0000 recorded twice in the Cash Book 20000
Dividends received ₹5000 recorded only in the bank statements 5000 40000
Less:An insurance premium paid by bank ₹2000 but not yet 2000
recorded in Cash Book
Payment of a cheque of ₹4000 recorded twice in Passbook 4000
Cheque of ₹7000 deposited on 29th March 2021. But, it is not yet 7000
collected
Bank charges of ₹1000 debited only in Bank Passbook. 1000 14000
Balance as per passbook 40000
Illustration no. 2
Prepare the bank reconciliation statement of XYZ ltd as on 31.03.2021.
i. Bank balance as per bank statement (overdraft account) ₹. 1,00,000 (Dr)

ii. Cheques issued but not presented for payment ₹. 25000
iii. Cheques deposited into bank but not credited up to March 31, 2018
₹.10000.
iv. Bank credited ₹. 5,000 for Fixed Deposit interest
v. Bank charges debited by Bank ₹.400.
73
Solution
Bank Reconciliation Statement of ABC Ltd as on 31.03.2021
Particular ₹. ₹.
Bank Balance as per bank statement (overdraft) 100,000
Add:
Cheque issued but not presented 25,000
Bank interest not recorded in the Bank book 5,000 30,000
Less:
Cheque deposited but not credited 10,000
Cheque return charges debited by the bank 400 10,400
Balance as per bank book 119,600

Though entries in the pass book are the mirror replica of the bank book maintained at
the client’s place, practically, as on any given day, balances of the bank book and pass
book rarely match.
A Bank Reconciliation Statement is a statement prepared to reconcile the difference

between the balances as per the bank book and pass book as on any given date.
It is neither mandatory to prepare bank reconciliation statement nor there is any set
frequency for preparation of the same.
It is prepared to identify the error, if any, in recording of the transaction.
The general reasons for the difference in the bank book and pass book are
 Cheques issued by the organization but not yet presented for the payment.
 Cheques deposited in the bank but not yet cleared.
 Amount directly deposited by the customer through RTGS, NEFT, ECS etc.
 Amount directly debited due to standing instructions given to the bank or ECS
debit instructions
74
 Bank charges debited by the bank
 Interest credited by the bank
 Dishonor of cheques
 Cheques deposited into bank for collection but not entered in the cash/ bank
book
 Cheques received and entered in the cash/ bank book but not yet deposited into
the bank for collection
 Error committed in recording of the transaction either by bank or by the

organization
1.4.7 Key words

Bank Reconciliation Statement, Difference in reconciliation
1.4.8 Multiple Choice Questions

1. In case of an overdraft, the bank column of the cash book will show a
__________ balance.
a. Credit c. Positive
b. Debit d. None of the above
2. Interest on bank deposit is entered in the cash book on ____________ side.
a. Credit c. Positive
b. Debit d. None of the above
3. A debit balance in the pass book represents ____________
a. Bank over draft c. Sales turnover
b. Cash balance d. Expenses incurred
4. An entry in the credit side of the cash book would be matched with the _______
side of the pass book.
a. Credit c. Both a & b
b. Debit d. All of the above
5. On the bank statement, cash deposited by the company is known as
75
a. Credit c. Liability
b. Debit d. Expenses
6. . Bank reconciliation statement compares a bank statement with _________
a. Cash payment journal c. Financial statements
b. Cash receipt journal d. Cashbook
7. In cash book, bank charges of ₹5,000 were not recorded. Name the correct cash
book adjustment
a. It will be deducted in cash c. No adjustment needed in

book the cash book
b. It will be added in cash d. Charges will be debited to

book the cash book balance
8. A bank pass book is a copy of

a. A customer's account in c. Cash book relating to each
the bank's book column
b. Cash book relating to d. None of these
bank column
9. Debit balance as per cash book of ABC Co. on 31.03.2020 is ₹. 1500. Cheque
deposited but not cleared amounts to ₹. 100 and cheque issued but not presented
of ₹. 150. Balance as per pass book should be
a. 1750 c. 1650
b. 1550 d. None of these
10. A bank reconciliation statement is prepared with the help of
a. Bank statement and bank c. Bank column of cash book
column of cash book and cash column of cash
b. Bank statement and cash book
column of cash book d. None of these
11. Bank reconciliation statement is a
a. Part of cash book c. part of cash account
b. Part of bank account d. None of the above
76
12. In cash book, the favorable balance indicates
a. Credit balance c. Bank overdraft
b. Debit balance d. Adjusted balance
13. If cheque is issued but not cleared. The action in bank statement for the purpose
of bank reconciliation will be
a. Addition c. Either a or b
b. Subtraction d. None of the above
14. If cheque is issued but not cleared. The action in cash book for the purpose of
bank reconciliation will be
15. If Check is deposited but not realised, the action in cash book for the purpose of
bank reconciliation will be
16. If cheque is issued but not cleared. The action in bank statement (in case of
overdraft) for the purpose of bank reconciliation will be
b. Subtraction d. All of the above
1.4.9 Answer keys
1-a 2-b 3-a 4-b 5-a 6-d 7-a 8-a 9-b 10-a
12-a 13-b 14-a 15-b 16-a
11-d
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Lesson No 1. 5: Trial balance, Profit & loss account and Balance sheet
1. 5.1 Objectives
1.5.2 Preparation of Trial Balance
1.5.3 Error not disclosed by Trial balance
1.5.4 Preparation of Financial Statements
1.5.5 Income Statement
1.5.6 Balance Sheet
1.5.7 Horizontal presentation of the Profit and Loss Account and Balance Sheet
1.5.8 Vertical presentation of the Profit and Loss Account and Balance Sheet
1.5.9 Adjustment Entries
1.5.10 let's sum up
1.5.11 Key words
1.5.12Multiple choice questions
1.5.13 Answer keys
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1.5.1 Objectives
The objectives of this unit are to understand:
 Generation of trial balance
 Preparation of profit and loss account
 Balance sheet
1.5.2 Preparation of trial balance

Journals and Ledger are not sufficient to arrive at the profit and loss account and the
balance sheet. Also, there could be some error in the posting or preparation of journal
entries. Grouping of the ledger balances and trying to match the debit and credit entries
to arrive at the financial statement is known as Trial Balance. After accounts are posted
in the ledger and they are balanced, the next step is to draw a statement that shows the
list of accounts showing debit and credit balances. As double entry system is followed,
there is a corresponding credit for each debit entry and corresponding debit for each
credit entry. Therefore, the total balances of accounts showing total of debit and
credit balances must exactly match. This ensures the arithmetical accuracy of the
ledger posting & nothing else.
The Trial Balance can be defined as a statement which contains balances of all ledger
accounts on a particular day, preferably as at last day of the accounting period. Trial
balance is the list of balances of the ledger accounts as of a particular date. All the
balances of trial balance are transferred either in balance sheet a/c or
Trading/Manufacturing & PL account in due course.
Performa of Trial Balance
Particular LF Dr (₹) Cr (₹)
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Illustrations no. 1
Derive a Trial Balance from the ledger accounts mentioned in lesson no 1. 3

(Solution of illustration no. 3)
Solution
Trial Balance as on 31st March 2021
Particular LF Dr (₹) Cr (₹)
Cash 15000
Bank 134500
Capital 100000
Plant & Machinery 52500
Office Furniture 5000
Loan 100000
Stationery 5000
Sales 40000
Insurance premium 2000
Sales return 3000
Bad debts 500
Depreciation 22500
Salary 10000
Outstanding salary 10000
When the total of debit and credit columns is equal it is only

arithmetically correct and may or may not be absolutely correct,
otherwise it is incorrect.
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1.5.3 Error not disclosed by Trial Balance
1. Error of Principle:
a. An error of principle is an error which violates the fundamentals of book-
keeping. For instance, purchase of furniture is debited to Purchase
Account, instead of Furniture Account; this type of error do not affect the
total debits and total credits but affect the principle of book-keeping.
2. Error of Omission: When a transaction goes completely unrecorded in both

aspects or a transaction after being recorded in the books of primary entry is not
at all posted in the ledger, the error is an error of omission.
3. Posting to wrong account: Posting an item to wrong account, but on the correct
side. For instance, if a purchase of ₹ 200 from Ramu has been credited to Raman,
instead of Ramu, this error will not affect the agreement of Trial Balance.
4. Error of Amounts in Original Book: If an invoice for ₹ 632 is entered in Sales

Book as ₹ 623, the Trial Balance will come out correctly, since the debit and
credit have been recorded as ₹ 623. The arithmetical accuracy is there, but in fact
there is an error.
5. Compensating Error: If one account in the ledger is debited with ₹ 500 less and
another account in the ledger is also credited ₹ 500 less, these errors cancel
themselves i.e. one error is neutralized by similar error on the opposite side.
1.5.4 Preparation Of financial statements

As discussed earlier, after the preparation of trial balance financial statements are
prepared.
Why financial statements are needed?
1. To present a true and fair view of the financial performance of the

business
2. To present a true and fair view of the financial position of the business;
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3. To provide a precise idea of the financial position of the
business/organization to the various stake holders in the business so that
they can make informed decisions. And various stake holders may be
1. Internal: Owner, Manager and many more
2. External: Govt.,Bank, society and many more
There are three core financial statements:
1. Income statement
a. Also known as Trading/manufacturing and profit & Loss account
b. It shows the financial performance of a firm during an accounting period.
2. Balance sheet
a. It shows financial position in the form of assets, liabilities and capital on a
particular date.
3. Cash flow statement

a. It shows the movement of entity's cash during the period.
b. The statement helps users to understand how the cash movement in the
entity is?
Income statement & Balance sheet is collectively called Final account.
For preparation of financial statements, all balances of trial balance are being
transferred to Final account.
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Few things to remember while preparing final accounts
Transfer
1. All direct expenses balance to debit side of
Trading/Manufacturing a/c.
2. All indirect expenses balance to debit side of profit &
loss a/c.
3. Gross profit of trading/manufacturing a/c to debit side
of P & L a/c
4. Gross loss of trading/manufacturing a/c to credit side
of P & L a/c
5. Net profit of P & L a/c to liabilities side of Balance
Sheet
6. Net loss of P & L a/c to asset side of Balance Sheet
7. All revenue/gains other than sales to the credit side
of the P & L a/c
8. Sales to credit side of the Trading
9. Closing stock at two places
a. Normally at credit side of Trading a/c
b. Asset sides of balance sheet
The final accounts are prepared by transferring all balances from trial balance to either
income statement or balance sheet to find out the profit or loss from the activities of the
firm for a particular period and to know the financial position of the business. The
profit/loss and the financial position of the business cannot be ascertained from the trial
balance of the firm as trial balance is merely the listing of the balances of all ledger
accounts.
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1.5.5 Income statement
There are two parts in Income statement
1. Trading/Manufacturing account
2. Profit & Loss account
Trading/Manufacturing Account
1. It reveals Gross Profit/Loss.

2. It is result of buying &selling or manufacturing of goods and services in which an
organisation deals.
3. Direct expenses associated with the purchase & sales & manufacturing of
goods and services & certain other balances of respective sides of trial balance
are transferred to respective sides of this statement and then Gross profit is
ascertained as mentioned below
Gross Profit = Sales – Cost of goods sold
Sales = Sales A/c – Sales returns
Cost of goods sold =Opening stock + Purchases – Purchase returns +

Direct expenses– Closing stock.
Items on the Debit side

1. Opening stock: Stock of goods in hand at the beginning of the accounting year.
2. Purchase
3. Purchase return : To be deducted from gross purchase
4. Direct expenses
5. Gross profit (Balancing figure, if total of credit side is more than total of debit
side)
Items on the Credit side
1. Sales
2. Sales return: To be deducted from gross sales.
3. Closing stock
4. Gross Loss (Balancing figure, if total of debit side is more than total of credit side)
The closing stock is either deducted from debit

side or added to credit side. Normally, it is
added to credit side 84
What are direct & indirect expenses?
 Expenses that directly go into producing goods or providing services are direct
expenses while indirect expenses are general business expenses that keep you
operating. In other words direct expenses are completely related and assigned
to the core business operations of a company and Indirect expenses are
necessary to keep the business up and running, but they can’t be directly related
to the cost of the core revenue-generating products or services.
 In a bit more practical view, all expenditures incurred to bring the goods up to
point of sales i.e. Godown/Outlet is direct expenses and all expenses thereafter is
indirect expenses
 Examples of direct expenses
o Freight
o Carriage inward
o Wages
o Factory expenses
o Oil and fuel expense
o Royalty on production
o Clearing and port charges
o Freight and octopi
o Import duty
o Manufacturing expense / Productive expenses
o Gas, fuel and power
Format of Trading/Manufacturing a/c

Trading/Manufacturing a/c of M/S ABC co. pvt ltd for the period ending 31.03.21
Dr Cr
Particular Amt Particular Amt
After preparation of Trading/Manufacturing a/c, the gross profit/gross loss is

transferred to credit & debit side of profit and loss account respectively.
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Profit and Loss Account
It is an extension of the Trading account and prepared on similar lines.
 It ascertains the Net Profit/Net loss.
 Gross profit/ Gross loss derived from trading /manufacturing a/c is placed to
credit/debit side of P &L Account respectively.
 The indirect expenses are transferred to the debit side of the statement
 All revenue/gains other than sales are transferred to the credit side of the
profit and loss account.
 If summation of debit side > summation of credit side Net Loss -

Transferred to assets side of Balance Sheet
 Summation of debit side < summation of credit side Net Profit -

Transferred to liabilities side of Balance Sheet
1.5.6 Balance Sheet

It represents the financial position i.e. position of the assets owned by the firm and also
the liabilities owed by the business as on a date. It shows the balances of personal
accounts and real accounts - representing assets and liabilities of the firm - are
transferred to Balance Sheet and also the net profit/loss from the Profit and Loss
Account is also transferred.
The Balance Sheet can be in the vertical or horizontal format. There is no

regulatory prescribed format for presentation of Balance Sheet except for Companies
Act, 1956. In other words, schedule VI of the Companies Act, 1956 prescribes the specific
format for presentation of Profit and Loss Account and Balance Sheet.
The balances of nominal account i.e. expenses and income, are closed at the year,
transferred to Profit and Loss account and thus are not carried forward to the next year.
Instead, the profit or loss for the period concerned is worked out and net profit/ loss are
carried to the Balance Sheet. The balances shown in the Balance Sheet are carried
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forward in the ledger accounts next year. Unlike nominal accounts, ledger accounts of
assets and liabilities are not closed at the end of the year and only the balances are
disclosed in the Balance Sheet to ascertain the position as on a date.
1.5.7 Horizontal presentation of the Profit and Loss Account and Balance
Sheet
In a horizontal format of the Balance Sheet, Assets are shown on the right-hand
side of the balance sheet whereas liabilities are shown on the left-hand side of
the Balance Sheet. Total of both the sides of the Balance Sheet always match.
Though there is no specific format of balance sheet for proprietary firm and partnership
firm, generally an order is maintained for presentation of assets and liabilities. It can be
prepared in the order of liquidity or in the order of permanency. When assets and
liabilities are presented in the order of liquidity, the assets/liabilities, which are liquid,
are written first and followed by lesser liquid assets/liabilities such as cash, bank, and
investments are classified first in the assets side and then fixed assets are classified.
Similarly current asset such as bills payable, creditors are mentioned first and capital is
the last item in the balance sheet.
When assets are presented in the order of permanency, assets and liabilities which are
fixed would be classified first and are followed by shorter term assets and liabilities.
Generally assets and liabilities are presented in the balance sheet in the order of
permanency.
The typical Horizontal format of the Balance Sheet in order of permanency is as follows:
Balance Sheet of ABC Ltd as on 31st March 2021.
Liabilities Amt ₹. Assets Amt ₹.

Share Capital *** Land and Building ***
Reserves and surplus *** Plant and Machinery ***
Debentures *** Furniture and Fixture ***
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Term Loan *** Other Fixed Assets ***
Working capital *** Investments ***
Outstanding expenses *** Closing stock ***
Sundry creditor *** Debtor ***
Bills payable *** Prepaid expenses ***
Income received in *** Accrued income ***

advance
Cash in hand ***
Intangible assets ***
Total *** Total ***
1.5.8 Vertical presentation of the Profit and Loss Account and Balance
Sheet
The horizontal format of the Balance Sheet is suitable for the owner of the enterprise.
However, the analysts and investors generally prefer the financial statements into
vertical format. The basic figures remain the same, only the sequence and presentation
are changed.
In vertical presentation of the income statement, various heads of expenses are grouped
in such a way that profit at each stage can be worked out separately. This analysis helps
in comparing the performance of the company with the past performance and also with
peer companies.
Thus, when income statement is presented in the vertical format, various heads such as
Gross Profit, Administrative expenses, Selling and Distribution expenses, Operating
profit before interest, Interest expenses, Non-operating income and expenses and net
profit etc. can be assessed and analyzed separately.
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Format of vertical Balance Sheet
No Particulars ₹. ₹.
Sources of Funds
1 Owner’s Funds/ Net worth
i. Capital ***
ii. Reserves and Surplus ***
Less : P& L Debit balance ***
Misc. Expenditure not written off *** ***
Own Funds or Net worth ***
2 Loan Funds
i. Long term funds ***
ii. Short term funds ***
Loan Funds ***
Total Capital Employed ***
Application of Funds
1 Fixed Assets ***
i. Tangible assets ***
ii. Intangible assets ***
2 Investments ***
3 Working capital ***
Current assets ***
Less : Current liabilities ***
Net Working Capital ***
Total Application of Funds ***
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Format of vertical Profit & Loss account
Gross Sales (A) ***

Less: Returns ***
Net Sales ***
Less: Cost of goods sold (B)
Opening Stock ***
Purchases ***
Direct expenses ***
Depreciation on Factory ***
Depreciation on Plant and Machinery ***
Less: Closing stock *** ***
Gross Profit (C) = (A) – (B) ***
Less: Operating expenses
Administrative expenses ***
Selling and distribution expenses ***
Depreciation on Office building ***
Total operating expenses (D) ***
Operating profit before interest (C) – ***
(D)
Less : Interest ***
Net profit after interest ***
Add: Non-operating income ***
Less: Non-operating expenses ***
Net profit before tax ***
Less: Income Tax ***
Net profit after tax ***
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Major change observed in the vertical format from the other format of Balance Sheet is
that liabilities and assets are presented as the source of funds available for the business
and the way funds are deployed in the business respectively.
Capital and loan funds are considered as sources of funds and the investments in the
fixed assets, investments and net current assets are considered as application of funds.
The current liabilities are netted off against the current assets to reflect the ‘net current
assets’ as the application of funds. Similarly, the debit balance in Profit and Loss
account, if any, and the deferred expenditure is netted off against the capital to reflect
the correct position of the net worth.
1.5.9 Adjustment entries

In order for a company's financial statements to be complete and to reflect the accrual
method of accounting, adjusting entries must be processed before the financial
statements are issued
Trial balance lists ledger balances of all accounts of the organization. These accounts are
then reflected either in Profit and Loss account or in the Balance Sheet of the firm
depending on the nature of the account. However for ascertaining, true and fair position
of the firm, certain adjustment entries are passed in Journal proper.
Summary of Adjustment Entries
Entries Debit Credit

Closing stock Closing stock Trading account
Outstanding expenses Expenditure Outstanding expenses
Prepaid expenses Prepaid expenses Expenses
Accrued income Accrued income Income
Advance income Income Advanced income
Provision for depreciation Depreciation Provision on depreciation
Adjustment for bad debts Bad debts Debtor
Provision for doubtful debts Expenditure Provision for doubtful debts
Provision on discount on debtor Expenditure Debtor
Interest on capital Expenditure Capital
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Illustration no. 2
Prepare Trading account and Profit and Loss Account for the year ended 31st March
2021and a Balance sheet as on 31st March 2021
Trial Balance as on 31st March 2021

Amt ₹. Amt ₹.
Leasehold premises 48,000 Sales 102,000
Infrastructure Bonds 20,000 Sundry Creditor 50,000

(@5%)
Discount 500
Furniture and Fixture 60,000
Interest received on 500
Insurance premium 1,800
bonds
Rent 800 Reserve for Bad and
Doubtful debts 1,500
Purchases 39,000 Capital
120,000
Wages 1,600
Carriage Inward 600
Carriage outward 1,500
Sales returns 2,000
Opening stock 20,000
Salaries 2,400
Travelling expenses 500
Sundry Debtor 60,000
Bad debts 1,000
Machinery 12,000
Loose Tools 2,500
Interest 400
Discount 400
274,500 27,4500
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Adjustment entries:
 Stock on 31st March 2021 ₹. 25000 at cost and ₹. 30000 at market value.
 Outstanding rent ₹. 400. Outstanding wages ₹. 400.
 Charge 10% depreciation on Machinery and Loose tools are valued at ₹. 2000 at
the end of the year.
 Lease for premises is run for 12 years commencing from 1st April 2020.
 Bad debts to be written off are ₹. 1000. Reserve for bad and doubtful debts is to
be maintained at 5%.
Solution:
Trading and Profit and Loss Account for the year ended 31st March 2021
Amt ₹. Amt ₹.
To Opening Stock 20000 By Sales (net) 100000
To Purchases (net) 39000 By Closing Stock 25,000
To Wages- 1600
Add: outstanding wages- 400 2000
Carriage Inward 600
To Gross profit c/d 63400
125000 125000
To Insurance premium 1800 By Gross Profit 63400
To Rent 800 By Discount 500
Add: Outstanding- 400 1200 By Interest on bonds 500
To Carriage outward 1500 Add: Outstanding 500 1000
To Salaries 2400
To Travelling expenses 500
To Bad debts 1000
Add: New Bad debts 1000
New BDDR 2950
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Less: Old BDDR 1500 3450
To Interest 400
To Discount 400
To Depreciation on machinery 1200
To Depreciation on leasehold 4000
property
To Depreciation on loose tools 500
To Net Profit transferred to

47550
Balance Sheet
64900 64900
Balance Sheet as on 31st March 2021
Capital 120000 Leasehold premises 48000

44000
Less: written off 4000
Add: Net profit 47550 167550
Infrastructure bonds 20000
Sundry Creditor 50000
Furniture 60000
Outstanding Rent 400
Machinery 12000
Outstanding Wages 400 Less: Depreciation 1200
10800
Loose tools 2500
Less: Depreciation 500 2000
Sundry Debtors 60000
Less: New Bad debts 1000
New BDDR 2950 56050
Closing stock 25000
Outstanding Interest 500
218350 218350
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1.5.10 let's sum up
 After business transactions are recorded in the journal accounts are opened in
the ledger and posting is made for each and every entry recorded in the Journal.
All ledger accounts are balanced and a statement is prepared to list balances of all
ledger accounts, called trial balance. The totals of two columns (Debit & Credit)
of a trial balance must tally because for each transaction there is debit and credit
for the same amount. Trial Balance proves only the arithmetical accuracy of
posting in the ledger.
 Financial statements are of three types :
1. Income Statement i.e. Trading Account and Profit and Loss Account.
2. Position Statement i.e. Balance Sheet.
3. Cash flow statement
First two statements are collectively called Final account
 Trading account only consider the income and expenses related to the trading
activities of the business. For ascertaining the profit / loss during a particular
period, opening stock and closing stock of the business is also considered. The
profit arrived from the Trading account is called Gross profit.
Gross Profit = Sales – Cost of goods sold
Sales = Sales A/c – Sales returns
Cost of goods sold =Opening stock + Purchases – Purchase returns +

Purchase expenses – Closing stock
 Profit and Loss Account is prepared to find out Net Profit/Net Loss during a
particular period. All indirect expenses are shown on the debit side of Profit &
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Loss Account. All incomes and gains are shown on the credit side of Profit & Loss
Account.
Net Profit = Gross Profit + other incomes – Indirect

expenses
 Balance Sheet represents the financial position of the business as on a date. It

shows the position of the assets owned by the firm and also the liabilities owed by
it. Assets and liabilities can be presented in the balance sheet in the order of
liquidity or in the order of permanency.
 In order to assess the correct profit and loss and financial position of the entity
some adjustment entries are required to be accounted for.
1.5.11 Key words

Trial Balance, Financial Statements, Income Statement, Trading Account,
Profit and Loss Account, Balance Sheet, Adjustment Entries, Final account
1.5.12 Multiple of choice questions
1. On balance sheet, accruals, notes payable, and account payable are listed under
which category?
A) Current Liabilities C) Noncurrent Liabilities
B) Accumulated Liabilities D) Accrued
2. Inventories, cash and equivalents, and accounts receivables are listed as
A) Earnings on Income Statement C) Assets on the Balance Sheet
B) Payments on Income D) Liabilities on the Balance

Statement Sheet
96
3. Position of assets and liabilities are shown in
A) Balance sheet C) P & L account
B) Trial Balance D) Journal paper
4. Financial performance are shown in
B) Trial Balance D) Journal paper
5. Where is Gross profit calculated?
B) Trial Balance D) Trading account
6. Net profit is shown in
B) Trial Balance D) Trading account
7. ---------- is placed in two financial statements
A) Purchase account C) Closing stock account
B) Sales account D) Sales return account
8. Gross profit is the part of
A) Trading account C) Both a & b
B) Profit & Loss account D) Balance sheet
9. Trial balance ensures _________________ of posting of ledger accounts.

A) Arithmetical accuracy C) Absence of fraud
B) True and fair view D) Logical accuracy
10. The balance of following account is generally not reflected in the Trial balance.
A) Purchases C) Purchases returns
B) Closing stock D) Opening stock
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11. Gross loss is transferred to the _____________ side of the Profit and Loss
account.
A) Debit C) Both
B) Credit D) Right
12. Adjustment entry is passed just to
A) Comply with accruals C) Matching concept of

concept of accounting accounting
B) Comply realization D) All of the above

concept of accounting
13. liability is
A) What we owe C) Source of fund
B) What we own D) Both a & c
14. Net profit is
A) Added to the capital C) Both a & b
B) Deducted from the D) All of the above.

capital
15. Balance sheet is prepared in order of
A) Liquidity C) Both a & b
B) Permanence D) None of the above
16. The format of balance sheet is prescribed for
A) Sole proprietorship C) Company

firm
D) All of the above
B) Partnership firm
17. Wage & salary is
A) Indirect expenses B) Direct expenses
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C) Variable expenses D) Fixed expenses
18. Salary wages is
A) Indirect expenses C) Variable expenses
B) Direct expenses D) Fixed expenses
19. Carriage inward is
A) Indirect expenses C) Variable expenses
B) Direct expenses D) Fixed expenses
20. The format of balance sheet is not prescribed for
A) Sole proprietorship C) Company

firm
D) Both A & B
B) Partnership firm
1.5.13 Answer Key
1-A 2-C 3-A 4-B 5-D 6-B 7-B 8-C 9-A 10-B
11-A 12-A 13-D 14-A 15-B 16-C 17-B 18-A 19-B 20-D
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Unit-2: Analysis and Interpretation of Financial Statement
Lesson no. 2.1 Analysis and interpretation of Financial Statements
100
Lesson no. 2.1: Analysis and interpretation
2.1.1 Objectives
2.1.2 Introduction
2.1.3 Financial Statement Analysis
2.1.4 Interpretation of the key terms of the financial statements
2.1.5 Tools and techniques of financial statement analysis
2.1.5.1 Comparative financial statement analysis
2.1.5.2 Common size statements
2.1.5.3 Trend analysis
2.1.5.4 Fund flow statement analysis
2.1.5.5 Cash flow statement analysis
2.1.5.6 Ratio analysis
2.1.6 Let's sum up
2.1.7 Key Words
2.1.9 Answer keys
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2.1.1 Objectives
The objectives of this lesson are to understand
 Management accounting
 Financial statement analysis
 Interpretation of the key terms of the financial statements
 Comparative financial statements
 Common size financial statements
2.1.2 Introduction
After preparation of the financial statements, next logical step is to analyze and interpret
the data reported in the financial statements otherwise preparation of financial
statements is of no use. Financial statement analysis takes the raw financial
information from the financial statements and turns it into usable information
that can be used to make decisions by different stakeholders. Hence, analysis of the
financial statements involves the regrouping and rearranging the presentation of final
account i.e. Profit and Loss account and Balance Sheet.
Analysis means establishing a meaningful relationship between various items of the two
financial statements with each other in such a way that a logical conclusion is drawn.
Financial analysis facilitates correct interpretation of the data and helps assessing the
profitability and financial position of the enterprise in a more meaningful way. It is
gaining more importance day by day because number of stake holders in the business is
increasing and assess the data from different angles. In other words, earlier, only the
owner of the firm was interested in the performance of the firm. However, in real world,
the other stakeholders like creditors, bankers, investors, analysts, regulators etc. also get
interested in the business and are studying the financial statements in order to
understand inter alia the growth potential and financial strength of the enterprise.
2.1.3 Financial statement analysis

Financial statement analysis refers to the detail review of the financial information
presented in the financial statements mainly Profit and Loss account and Balance Sheet.
102
The figures mentioned in the statements are studied in detail and are correlated to
establish relationships between various items of the financial statements. The detailed
analysis of the financial statements helps understand the reasons for change in the
profitability/financial position of the entity.
In order to make meaningful and convenient analysis, the presentation of data is

modified and suitably rearranged. The financial statement analysis can also be
undertaken even without changing the presentation. However, the methodological
presentation of Profit and Loss account and Balance Sheet facilitate easier
interpretation of the data.
In the words of Myers, “Financial statement analysis is largely a study of relationship

among the various financial facto₹ in a business as disclosed by a single set-of
statements and a study of the trend of these facto₹ as shown in a series of statements.
2.1.4 Interpretation of the key terms of the financial statements
 Net worth/Liability towards promoter:

o Net worth represents the stake of the owners in the entity. It includes the
share capital, reserves and profit and loss account of the entity. However,
to arrive at the correct position of the net worth, any debit balance of the
Profit and Loss account [losses from current or previous years] and
deferred revenue expenditure are deducted from the net worth.
 Liability towards outsiders:

 Long Term Liability (LTL)
 Term Loan funds:
o This represents the term debt availed by the entity for capital investment.
The term loan funds include the secured as well as unsecured loans of the
entity.
 Debenture/Bonds
o A debenture is an instrument issued by debtor or borrower accepting a
debt under the general authentication of the enterprise. It comprises of an
agreement for repayment of principal after a particular period or at
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intermissions or at the option of the enterprise or at the closure of the
enterprises and for payment of interest, called coupon, at a fixed rate due
to, usually either yearly or half-yearly on fixed dates.
 Unsecured loans
o When a business firm takes loan without any security against the loan that
is called unsecured loan. The loans can be given by the persons who are
connected to the business firm directly or indirectly but outsider also can
give the loan to the business firms.
 Company Fixed Deposits
o Company Fixed Deposit (corporate FD) is a term deposit which is held
over fixed period at fixed rates of interest. This is offered by Financial and
Non-Banking financial companies (NBFCs). The maturities of various
company fixed deposits can range from a few months to a few years.
 Other long term liability
 Contingent liability
o These are usually the types of obligations which may or may not occur
for a commercial entity in the course of its operation. Guarantee for
loans, claim against product warranty and lawsuits are examples of
contingent liability. Business ventures are required to provide an
estimate of contingent liabilities as a footnote on their respective
balance sheet.
 Short term Liability (STL) :

o Those liabilities or obligation or rent of an enterprise’s that is due within a
year or within the normal functioning cycle
Examples are
o Cash Credit/Overdraft limit

 Limit availed either against stock or any security which is payable
on demand.
o Sundry creditor
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 The entity from which business has procured goods or services in
credit or does not paid the payment immediately from the business
and is liable to pay from the business in future..
o Short duration customer deposit
 The maturity of this type of Fixed deposit is within one year
o Expenses payable
 An expense that has been incurred, but for which there is not yet
any expenditure documentation. In place of the expenditure
documentation, a journal entry is created to record an accrued
expense, as well as an offsetting liability (which is usually
classified as a current liability in the balance sheet).
o Provision/Accrued
 Accruals involve recording of expenses that have been incurred
but payment for which is yet to be made by the transacting
entity. Provision involves recording of expenses or losses that
have not yet been incurred but they may be incurred on the
occurrence or non-occurrence of certain events
o Advance payment from customer
 Advance payments are amounts received before a good or
service is actually delivered and is an short term/current liability
o Other current liabilities
 Commercial paper
Fixed assets
These are the main assets contributing to the revenue generation of the company. For
manufacturing entities, the fixed assets base is more compared to the Trading units.
In case the fixed assets are purchased from the borrowed funds, banks even look at Net
Fixed Assets based on the formula below mentioned.
Examples are
Buildings
Computer Equipments
105
Fixture & furniture
Plant & Machinery
Fixed assets-Term loan

=
Net Fixed assets
Current assets
Current assets are all assets that a company expects to convert to cash within one year.
They are commonly used to measure the liquidity of a company/business firm. Within
current asset there is one more class of asset called quick asset which can easily be
converted into cash or that are already in a cash form.
Quick Asset= Inventory (Stock- pre paid expenses)
Examples are
 Cash/bank balance
 Marketable/quoted securities
 Book debts/debtors/bills receivable (outstanding up to 180 days)
 Stock
o Raw material
o Stock in trade
o Finished goods
 Advance payment of taxes
 Prepaid expenses
106
Noncurrent Asset
A non-current asset is an asset that the company acquires or invests, but the value of
that investment does not recur within an accounting year. These types of investments
last for long and cannot be easily liquidated into cash and can generate economic
benefits to the company for more than a year.
Examples are
 Investment in long term securities/shares/associate or sister concern.

 Old stock, Old/disputed book debt
 Long term security deposit
Intangible assets
Intangible assets are identifiable, non-monetary assets without physical substance. Like
all assets, intangible assets are expected to generate economic returns for the company
in the future.
Examples are
 Goodwill/patents
 Debit balance of PL account
 Pre operative expenses/preliminary expenses
Net Working Capital = Current

Assets- Current Liabilities
Net worth + Loan funds= Fixed

assets+ Investments Working capital
Net-worth
=
Net Fixed Assets +Net Investments + Net Working capital
107
2.1.5 Tools & Techniques of Financial Statement Analysis
1. Comparative Statement
2. Common Size Statement
3. Trend analysis
4. Fund flow analysis
5. Cash flow analysis
6. Ratio analysis
2.1.5.1 Comparative financial statements analysis
 This is Statements of the financial position at different periods of time.

 The elements of financial position are shown in a comparative form so as to give
an idea of financial position at two or more periods.
 Comparative financial statements’ analysis is also called Horizontal Analysis.
 It shows
o Absolute figures (rupee amounts) of different periods of time.
o Absolute Changes in absolute figures in current year in comparison to
base year.
o %age change in absolute figures in current year in comparison to base
year
Types of Comparative Statements:
1. Comparative Balance sheet, and

2. Comparative Income statement.
Comparative Balance Sheet:

While interpreting Comparative Balance Sheet the interpreter is expected to study the
following aspects:
(1) Current financial position and liquidity position.
(2) Long -term financial position.
(3) Profitability of the concern.
108
Current financial position or short -term financial position of a concern,
 Financial position
o Compare the Working capital in both the years.
 If there is an increase in current assets accompanied by the increase in
current liabilities also with same amount, there is no improvement in
the short-term financial position.
 If, there is increase in working capital (CA-CL) i.e. increase in current
asset is more than the increase in current liabilities, it means there is
improvement in the current financial position of the business and vice
versa.
 Liquidity position
o Even if there is increase in current asset & current liabilities is in equal
proportion, increase in quick asset like cash in hand, cash at bank, bills
receivables, and debtors, etc. shows improvement in liquidity position &
vice versa.
o Even if increase in current asset is equal....Increase in other asset like

stock...deterioration in liquidity position
Example
Current Asset (2020) Current Asset (2021)
Stock 600 Stock 700

CR: 1.66
Debtor 200 Debtor 400 QR: 0.88
NWC:
Cash 200 Cash 400 600
CR: 1.66 Total 1000 Total 1500

QR: 0.66
NWC: 400
Current liabilities (2020) Current liabilities (2021)
Outstanding expenses 200 Outstanding expenses 300
Creditors 100 Creditors 150
OD 300 OD 450
Total 600 Total 900
109
Interpretation
 The current ratio of both the year is 1.66 but quick ratio for the year
2021 is increased to 0.88 from 0.66. It shows that there is no change so
far as short term financial position is concerned being equal current
ratio but liquidity position is increased since quick ratio is increased
from 0.66 to 0.88.
 Long -term financial position
o The long -term financial position of the concern can be ascertained by
studying the changes in fixed assets, long-term liabilities and capital.
o Under ideal financial policy of concern will be to finance fixed assets by the
issue of either long-term securities such as debentures, bonds, loans from
financial institutions or issue of fresh share capital. It means
 Fixed Assets = LTL + Share capital.
 If an increase in Fixed Asset> increase in LTL & share capital, it means
o Fixed Asset has been financed from short term source i.e. from
working capital
 If increase in Fixed Asset < increase in LTL & share capital
o Part of working capital has been financed from long term
sources.
Profitability of the concern
 If there is increase in dividend it does not mean that there is improvement in
profitability. There may be possibility that profitability is same bit there is
decrease in retained earnings, various resources and surpluses, etc.
 In the same manner if there is increase in retaining earnings it does not mean
that there is improvement in profitability. This increase in retained earnings may
be due to decrease in dividend.
Comparative Income Statement:
 Increase/Decrease in sales means there will be increase/decrease in cost of goods

sold.
110
o And if there is percentage increase in sales, higher than the percentage
increase in cost of goods sold, there will be increase in Gross profit i.e.
there is improvement in profitability & vice versa.
 Assessment of Operating Profit [GP- operating expenses (Office and
administrative expenses, selling and distribution expenses)].
o If there is an increase in operating profit this may be due to either increase
in sales position or control of operating expenses & vice versa.
 Assessment of Net profit (NP)
o NP= OP – Non operating expenses +Net Operating Income
o Non-operating expenses--- Interest paid, losses from sale of assets,
writing off of deferred expenses, and payment of tax.
o If there is decrease in NP, it means
 There is decrease in OP or increase in OE or Decrease in NOI or
combination of any & vice versa
Example
Comparative Income Statement
2020 2021 Inc/Dec %

Sales 38,500 42,000 3,500 9.09%
Less: cost of sales 29,750 31,500 1,750 5.88%
Gross profit 8,750 10,500 1,750 20%
Less: Operating expenses 7,000 8,750 1,750 25%
Net profit 1,750 1,750 0 0
Comments on the Income Statement
 There is increase in sales by around 9% as against increase in cost of sales of

around 5.88%. As % increase in sales is more than % increase in cost of sales,
there is increase in gross profit in % terms.
 However, there is sharper increase in operating expenses. So there is no

change in net profit in absolute terms (the net profit to sales ratio has declined
in 2020-21).
111
2.1.5.2 Common size financial statements analysis
 Under this type of analysis, the different items of balance sheet and income
statement are shown in percentages with reference to their respective base figure.
 The items of Balance Sheet i.e. different items of assets and liabilities are
shown with reference to total assets/total liabilities respectively.
 The items of Income Statement are shown with reference to total sales.
 These statements are also known as component percentage or 100%
statements or vertical analysis because every individual item is stated as a
percentage of the total 100.
 In other words, common size financial statement analysis displays all items as
percentages of a common base figure rather than as absolute numerical
figures.
 The analysis helps to understand the impact of each item in the financial
statement and its contribution to the resulting figure.
Formulae
% of certain item = Actual amt. of particular item *100

Actual amt. of total asset/liabilities/Sales
Types of Common-Size Statements:
(i) Common-Size Balance Sheet:

 A statement in which balance sheet items are expressed as the ratio of each
asset/liability to total assets/total liability is called common-size balance
sheet.
 The common-size balance sheet can be used to compare inter and intra firm.
(ii) Common Size Income Statement:

 The items in income statement can be shown as percentages of sales to show
the relation of each item to sales.
112
 A significant relationship can be established between items of income statement
and volume of sales.
 The increase in sales will certainly increase selling expenses and not
administrative or financial expenses.
 In case the volume of sales increases to a considerable extent, administrative
and financial expenses may go up. In case the sales are declining, the selling
expenses should be reduced at once. So, a relationship is established between
sales and other items in income statement and this relationship is helpful in
evaluating operational activities of the enterprise.
Common Size Balance Sheet

Illustration no. 1
The Balance Sheet of ABC Ltd and XYZ Ltd. are given below. Give comments based on
the common size Balance Sheet of these two companies.
Balance Sheet as on 31st March 2021
Liabilities ABC Ltd XYZ Ltd
Equity Share Capital 140,000 410,000
Preference share capital 120,000 150,000
Reserves and Surplus 24,000 28,000
Long-term loans 110,000 120,000
Bills payables 7,000 1,000
Sundry creditors 12,000 3,000
Outstanding expenses 15,000 6,000
Proposed dividend 10,000 90,000
Total 438,000 808,000
Assets
Land and Building 80,000 123,000
Plant and Machinery 334,000 600,000
Investments 11,000 60,000
Sundry debtors 4,000 13,000
Prepaid expenses 1,000 2,000
Cash and Bank balance 8,000 10,000
Total 438,000 808,000
113
Solution:
Common size Balance Sheet as on 31st March 2021 is as follows:
Liabilities ABC Ltd % XYZ Ltd %

Equity Share Capital 140,000 31.96 410,000 50.74
Preference share
120,000 27.39 150,000 19.80
capital
Reserves and Surplus 24,000 5.48 28,000 3.47
Total Capital and

284,000 64.83 588,000 74.01
Reserves
Long-term loans 110,000 25.11 120,000 14.85
Bills payables 7,000 1.60 1,000 0.12
Sundry creditors 12,000 2.74 3,000 0.37
Outstanding expenses 15,000 3.44 6,000 0.74
Proposed dividend 10,000 2.28 90,000 11.15

Current liabilities 34,000 10.06 109,000 12.38
Total 438000 100.00 808000 100.00
Assets
Land and Building 80,000 18.26 123,000 15.22
Plant and Machinery 334,000 76.26 600,000 74.62
Total Fixed Assets 414,000 94.52 723,000 89.48
Investments 11,000 2.51 60,000 7.43
Sundry debtors 4,000 0.91 13,000 1.61
Prepaid expenses 1,000 0.23 2,000 0.25
Cash and Bank balance 8,000 1.83 10,000 1.25
Current assets 24,000 5.48 85000 10.54

Total 438000 100.00 808000 100.00
114
Comments:
 In both these companies, current assets are lesser than current liabilities which
means short term loans availed for financing Current Assets is not fully utilized
for the purpose. There may be over finance of working capital or there may be
diversion of funds from working capital to long term use or elsewhere which
needs to be explored & checked.
 XYZ Ltd. is less leveraged than ABC Ltd. Term loans contribute around 14.85% of
the total liabilities of XYZ ltd as against 25.11% for ABC Ltd. Owner’s contribution
to the business is more in case of XYZ Ltd (74.01%) than ABC ltd. (64.883%)
Common Size Income Statement
Illustration No. 2
The Profit and Loss Account of ABC Ltd and XYZ Ltd. are given below. Prepare vertical
Profit and Loss account and Common Size Statement. Give comments based on the
Common Size Profit and Loss account of these two companies.
Profit and Loss account for the year ended 31st March 2021
Particulars ABC Ltd XYZ Ltd

Sales 10,00,000 12,00,000
Less: Cost of Sales 6,00,000 8,00,000
4,00,000 4,00,000
Less: Operating Expenses (including 1,40,000 2,05,000
interest)
Less: Non-cash operating expenses 10,000 20,000
(Depreciation)
2,50,000 1,75,000
Less: Taxes 1,00,000 70,000
Less: Dividend 70,000 75,000
Retained earnings 80,000 30,000
115
Solution:
Particulars ABC Ltd % XYZ Ltd %

Sales 10,00,000 100.00 12,00,000 100.00
Less: Cost of Sales 6,00,000 60.00 8,00,000 66.67
Gross Profit 4,00,000 40.00 4,00,000 33.33
Less: Operating Expenses 1,40,000 14.00 2,05,000 17.08
Less: Depreciation 10,000 1.00 20,000 1.67
Net Profit before Tax 2,50,000 25.00 1,75,000 14.58
Less: Taxes 1,00,000 10.00 70,000 5.83
Net Profit after Tax 1,50,000 15.00 105000 8.75
Less: Dividend 70,000 7.00 75,000 6.25
Retained earnings 80,000 8.00 30,000 2.50
Comments:
 Cost of sales account for around 60% and 66.67% of the ABC Ltd and XYZ Ltd
respectively. Therefore Gross Profit ratio of ABC Ltd is also more than Gross
Profit ratio of XYZ Ltd.
 % of operating expenses to total sales is also less in case of ABC Ltd (14%) than
XYZ Ltd (17.08%). This has also contributed for the higher Net profit margin for
ABC Ltd than XYZ Ltd.
 However, dividend as a proportion of sales is more for ABC Ltd than XYZ Ltd.
Retained earnings of ABC Ltd are more than retained earnings of XYZ Ltd both in
absolute and percentage terms
2.1.5.3 Trend analysis

Trend analysis involves
 Collecting the information from multiple time periods and

 Plotting the collected information on the horizontal line with the objective to find
actionable patterns from the given information.
In other words, trend analysis is a technical analysis of the movement of a stock based
on past performance.
116
Advantages of Trend Analysis
(a)Possibility of making Inter-firm Comparison:
 Trend analysis helps the analyst to make a proper comparison between the two or
more firms over a period of time.
 It can also be compared with industry average.
 That is, it helps to understand the strength or weakness of a particular firm in
comparison with other related firm in the industry.
(b) Usefulness:
 Trend analysis (in terms of percentage) is found to be more effective in

comparison with the absolutes figures/data on the basis of which the
management can take the decisions.
(c) Useful for Comparative Analysis:
 Trend analyses is very useful for comparative analysis of data in order to measure
the financial performances of firm over a period of time and which helps the
management to take decisions for the future i.e. it helps to predict the future.
(d) Measuring Liquidity and Solvency:
 Trend analysis helps the analyst/and the management to understand the short-
term liquidity position as well as the long-term solvency position of a firm over
the years with the help of related financial Trend ratios.
(e) Measuring Profitability Position:
 Trend analysis also helps to measure the profitability positions of an enterprise or

a firm over the years with the help of some related financial trend ratios (e.g.
Operating Ratio, Net Profit Ratio, Gross Profit Ratio etc.).
117
Disadvantages of Trend Analysis
(a) Selection of Base Year:
 It is not so easy to select the base year. Usually, a normal year is taken as the base
year.
 But it is very difficult to select such a base year for the purpose of ascertaining the
trend. Otherwise, comparison or trend analyses will be of no value.
(b) Consistency:
 It is also very difficult to follow a consistent accounting principle and policy

particularly when the trends of business accounting are constantly changing.
(c) Useless in Inflationary Situations:
 Analysis of trend percentage is useless at the time of price-level change (i.e. in

inflation). Trends of data which are taken for comparison will present a
misleading result.
Types of trend
 Uptrend/upward: It is the trend when pattern is an upward directions

 Downtrend/Downward: It is the trend when pattern is in downward directions.
 Sideways/Horizontal/Flat: It is the trend when pattern is neither downward nor
downward directions.
Illustrations No. 3
Calculate Trend percentage statement for the following Balance Sheet:
Balance Sheet of ABC Ltd as on 31st March 2021
Liabilities 2021 2020 2019 Assets 2021 2020 2019

Fixed
Capital 400,000 340,000 300,000 400,000 360,000 280,000
assets
General
100,000 100,000 100,000 Stock 160,000 150,000 135,000
Reserve
118
Liabilities 2021 2020 2019 Assets 2021 2020 2019
Secured
60,000 60,000 50,000 Debtors 200,000 160,000 140,000
Loans
Loans
Unsecured
160,000 180,000 140,000 and 100,000 80,000 60,000
Loans
advances
Sundry Cash and
160,000 90,000 45,000 20,000 20,000 20,000
Creditors Bank
880,000 770,000 635,000 880,000 770,000 635,000
Solution:
Balance Sheet of ABC Ltd as on 31st March 2021
2019 2020 2021 2019 2020 2021
Amount Trend analysis
Liabilities
Capital 3,00,000 3,40,000 4,00,000 100 113 133
General 1,00,000 1,00,000 1,00,000 100 100 100
Reserve
Secured 50,000 60,000 60,000 100 120 120
Loans
Unsecured 1,40,000 1,80,000 1,60,000 100 129 114
Loans
Sundry 45,000 90,000 1,60,000 100 200 356
Creditors
6,35,000 7,70,000 8,80,000 100 121 139
Assets
Fixed 2,80,000 3,60,000 4,00,000 100 129 143
assets
Stock 1,35,000 1,50,000 1,60,000 100 111 119
Debtors 1,40,000 1,60,000 2,00,000 100 114 143
Loans and 60,000 80,000 1,00,000 100 133 167
advances
Cash and 20,000 20,000 20,000 100 100 100
Bank
6,35,000 7,70,000 8,80,000 100 121 139
Working 3,10,000 3,20,000 3,20,000 100 103 103
capital
119
Illustrative Comments:
 There is a sharp increase in fixed assets year over year.
 There is not much change in net working capital (103) as increase in debtors and
stock is generally met by stretching of the creditors. Increase in debtors was up to
143 and increase in creditors is 356.
 The cash and bank balance is at the same level.
 Reserve fund is also at the same level.
2.1. 5.4 Funds Flow Statement Analysis
Revenue statement gives details of the expenses incurred, income earned and the
profit/loss generated from the business over a specified period, generally a year. Only
revenue expenditure is recorded in the profit and loss account i.e. capital expenditure is
not recorded in the revenue statement. Further provisions for expenses and income are
also recorded in the profit and loss statement on the accrual basis. Balance Sheet depicts
the position of the assets and liabilities on a specified date. Thus, the financial
statements i.e. Profit and Loss account and Balance sheet, which are prepared on an
accrual basis, are not designed to give the movement in the funds position (sources and
utilizations/application) of the entity. But the user of financial statements would like to
understand the movement in funds during a period in order to assess whether the
business was done on a sound footing and also to use such funds movement to assess
future funds requirements.
Fund flow statement is prepared to ascertain the sources and application of funds over a
certain period. The financial position as of two dates is compared to ascertain the
change in the ‘funds’ position over the two dates.
Increase in the fixed assets and current assets are application of funds whereas increase
in share capital, term liabilities and current liabilities are sources of funds. Similarly
decrease in assets is source of funds and decrease in liabilities is application of funds.
Rationale behind this is simple like increase in assets, for example, increase in the fixed
assets is the result of the application of the funds of the Entity.
120
There is no specific format for presentation of funds flow statement. However
depending on the users of data, the statement is varied accordingly. For example,
banks/financial institutions would further bifurcate, sources and application of funds
into short and long nature to ascertain whether there was diversion of funds (when the
short term funds are used for long term uses, it is called as diversion of funds and
banks/FIs financing working capital to the entity check in detail whether company has
resorted to diversion of funds).
It is to be remembered that starting point of the preparation of funds flow statement is

the comparison of the Balance Sheets of two different dates. Thus, although it cannot be
a substitute for the revenue statement and the Balance Sheet (as these are required to be
prepared as per The Companies Act, 1956 and the Income Tax Act, 1961); it provides
additional information about the sources and application of funds.
No flow of fund, if
1. Transactions which involve Current account (CA or CL) only

2. Transactions which involve Non-Current account (NCA or NCL) only
Flow of fund, if
1. Transactions which involve one current account (CA or CL) and one
Non-Current account (NCA or NCL)
Illustration No. 4
From the following balance sheet of M/s XYZ ltd, prepare a schedule of changes in
working capital and a Fund Flow statement.
Liabilities 2020 2021 Assets 2020 2021

Capital 315000 500000 Cash 75000 100000
Long term loan 250000 300000 Debtors 150000 140000
Creditor 210000 195000 Stock 275000 360000
Land &
Overdraft 175000 125000 400000 500000
Building
Outstanding expenses 25000 30000 Furniture 75000 50000
975000 1150000 975000 1150000
121
Solution:
Funds Flow Statement for 2021
Particulars 2020 2021 Changes in working capital

Increase in WC Decrease in WC
Current assets
Cash
75000 100000 25000
Debtors
150000 140000 10000
Stock
275000 360000 85000
Total current asset
500000 600000
Current liabilities
Creditors
210000 195000 15000
Overdraft
175000 125000 50000
Outstanding expenses
25000 30000
Total current liabilities
410000 350000
Working Capital (WC )
90000 150000 175000 10000
Net increase in WC
165000 165000
255000 150000 175000 175000
2.1.5.5 Cash Flow Statement Analysis

Cash flow statement is also prepared on the similar lines such that it also tries to
ascertain the changes in the cash position of the entity over two balance sheet dates or
over a period between two Balance Sheet dates. Basic difference between funds flow
statement and cash flow statement is that funds flow statement is based on the accrual
concept of accounting and cash flow statement is based on the cash basis of
accounting. The starting point of the cash flow statement is the position of the cash
and its equivalent as on the beginning of the period. Then based on the changes in the
Balance Sheet over two dates, inflows and outflows of cash are worked out. Thus, net
change in the cash position is then tallied with the closing balance of cash and its
equivalent.
122
The Accounting Standard – 3 (AS 3) issued by Institute of Chartered Accountants of
India, gives guidelines as regards preparation and presentation of the cash flow
statement. Following are the main features of AS 3:
 Cash and cash equivalent mean cash in hand, demand deposits and also short
term highly liquid investment having maturity less than three months, which can
be readily converted into cash without, decline of its value.
 Cash flow statement explains cash movement under the following three different
heads namely:
 Cash flow from operating activities
 Cash flow from investing activities
 Cash flow from financing activities
 Operating activities: It includes
o Principal revenue generating activities of the enterprise and
o Any cash flows from current assets and current liabilities
 Investing activities
o It includes the acquisition and disposal of long-term assets and other

investments not included in cash equivalents.
 Financing activities
o It includes activities that result in change in the size and composition of

the owner’s capital (including Preference share capital in the case of a
company) and borrowings of the enterprise.
Preparation of cash flow statement
 Balance Sheets of two dates are compared. Change in net profit over the period
under study would be the starting point of the statement.
 Each and every head of the Balance Sheet is compared with the previous year
figure and changes in the balances, if any, are analyzed. The ledger accounts of all
heads are to be considered and the entries in these accounts are to be understood.
123
If the entry is non-cash entry having impact on the profit and loss account, it is added
back to the net profit (such as provision for depreciation, proposed dividend etc.).
If entry is the cash entry, it is also added back to the profit. However, depending on the
nature of activity, it is disclosed under operating activities or investing activities or
financing activities.
 Thus, net change in the cash position is arrived at and the same is compared
against the cash at the beginning and the end of the period.
 The cash flow associated with extraordinary items should be classified as arising
from operating, investing or financing activities as appropriate and separately
disclosed.
 Investing and financing transactions that do not involve the use of cash and cash
equivalents should be excluded from the cash flow statement. For example,
acquisition of an enterprise by means of issue of shares, conversion of debt to
equity etc.
As per AS 3, there are two methods
1. Indirect method: More Common

2. Direct method
124
Format of cash flow statement (Indirect Method)
Cash flows from Operating activities

 Net profit as per P& L account
 Add: (Non cash & non operative items which has already been
debited)
o Depreciation
o Increase in provision of doubtful debts
o Dividend paid #
o Transfer to reserve
o Tangible assets written off
o Amortization of intangible assets
o Provision for tax
o Preliminary expenses written off
o Loss on sale of fixed asset
 Less: (Non cash & non operative items which has already been
credited)
o Profit on sale of fixed assets
o Profit on sale of Long term investment
Cash flow before working capital changes
 Add:
o Increase in CL
o Decrease CA
 Less:
o Increase in CA
o Decrease CL
Cash flow from working capital changes
Less: Income tax paid
Net cash flow from Operating activities (A)
Cash flows from Investing activities
 Add:
o Sale of investments
o Sale of fixed assets
125
 Less:
o Purchase of investment
o Purchase of Machinery
Net cash flow from Investing activities (B)
Cash flow from Financing activities
 Add:
o Issue of shares
o Issue of debentures in cash
o Proceeds from long term & short term borrowings
 Less;
o Redemption of debenture
o Repayment of loan
o Dividend paid #
Net cash flow from Financing activities (C)
Net increase/decrease in cash & cash equivalent (A+B+C)
Cash & cash equivalent at the beginning of the year
Cash & cash equivalent at the end of the year
# If committed / promised, part of operational activities else part of

Financing activities.
Changes in Working capital
If
Increase in CA or decrease in CL Decrease in cash inflow or Increase in

cash outflow
Decrease in CA or increase in CL Increase in cash inflow or Decrease in

cash outflow
126
Direct Method
There is a slight difference in calculating cash flow from operating activities in this
method. Calculation of cash flow from Investing & financing activities are same.
Format
Particulars ₹
Cash flow from operating activities
 Cash received/collected from customer

 Cash paid to suppliers and employees
 Income tax paid
Net cash flows from operating activities
Cash flow from investment activities

As discussed in
indirect method
Cash flow from financing activities
Illustration No. 5
From the following balance sheet, prepare cash flow statement using indirect method
Liabilities 2020 (₹) 2021 (₹) Assets 2020 (₹) 2021 (₹)
Equity share 2000000 2500000 Goodwill 300000 200000
capital 500000 400000 Building 1000000 800000
12% preference
share capital
350000 550000 Plant 400000 700000
General reserve
150000 170000 Debtor 1200000 1600000
P & L A/c
230000 50000 Stock 180000 200000
Creditor
Cash 150000 170000
3230000 3670000 3230000 3670000
127
Adjustments
 Depreciation charge on plant and building was ₹ 300000 & ₹ 500000
Solution
Particulars ₹
Cash flows from operating activities
Net profit (₹ 170000- ₹ 150000) 20000
Add Non-operating items
Depreciation on plant 300000
Depreciation on building 500000
Goodwill written off 100000
Transfer to general reserve 200000 1100000
Operating before working capital changes 1120000
Less Decrease in creditors (180000)
Increase in debtors (400000)
Increase in stock (20000) (600000)
Net cash flow from operating activities (A) 520000
Cash flow from investing activities: (B)
less
Purchase of building (300000)
Purchase of plant (600000) (900000)
Cash flow from financing activities ( C )
Add Issue of shares 500000
Less Redemption of preference shares (100000) 400000
Net increase in cash & cash equivalent (A+B+C ) 20000
Cash & cash equivalent at the beginning of the year 150000
Cash & cash equivalent at the end of the year 170000
Calculated cash & cash equivalent at the end of the year (as given in
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illustration) tallies with illustration
2.1.5.6 Ratio analysis
What is a Ratio?
 A ratio is a comparison of two or more number that indicates their sizes in

relation to each other.
 A ratio compares two quantities by division. The number being divided termed
the antecedent & the number that is dividing termed the consequent.
 Ratio is an arithmetic expression indicating relationship between two numbers
where one number is presented as a proportion or percentage or in terms of
number of times of other number. For example 2000 ÷ 10000 can be expressed
as 1:5 or 20% or 0.2 times
What is Ratio Analysis?
 It is a quantitative analysis of relevant information/figures contained in a

company’s financial statements & with the help of certain arithmetic calculations,
functional relationship between relevant figures are ascertained , which is used to
understand the progress or otherwise of a business undertaking.
 According to Kohler, “A ratio is the relationship of one amount to another
expressed as the ratio of or as a simple, fraction, integer, decimal fraction or
percentage.”
 According to Hunt, William and Donaldson, “Ratios are simply a means of
highlighting in arithmetical terms of the relationship between figures draw from
financial statements
As discussed earlier, various tools and techniques are used for better understanding and
analyzing the financial position of the business & ratio analysis is one of the important
and frequently used tools. Under these techniques, various ratios are used.
Financial ratios either use both the items from Balance Sheet or both the items from
revenue statement itself or one from Balance Sheet and one from revenue statement.
Further, various stakeholders are interested in various ratios depending upon their
respective needs. For example, bankers may be more interested in solvency ratio;
shareholders may be more interested in profitability ratio.
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Analysis of financial statements through various methods has their own merits and
demerits.
Example
Firm Investment Sales Profit

X 2000000 1000000 100000
Y 1000000 10000000 10000
While we go through above example it appears that both the firms are earning profit of
₹. 100000 & hence we may conclude that both the firms are operating with same
efficiency.
But if we analyze the above information, it appears as under, which is different from the
above
Particulars X Y
Return on sales 10% 01%
Return on capital 05% 10%
Hence we need the ratio analysis
Before going into detail about types of Ratios and its analysis, we must have the concept
of few terms frequently used by ratio analyst specially in banking industry.
Indicative balance sheet (Also given in earlier chapter)
Liability Asset
Liability towards Promoter (NW) Fixed Asset
 Share Capital  Plant and machinery (Book Value)
 Reserve Current Asset
Liability towards Outsiders  Cash/bank balance
 LTL  Marketable/quoted securities
o Term Loan  Book debts/debtors/bills receivable
o Debenture (outstanding up to 180 days)
o Unsecured loan  Stock
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o Fixed deposit o Raw material
o Other LTL o Stock in trade
 STL/Current liability o Finished goods
o CC/OD limit  Advance payment of taxes
o Sundry creditor  Prepaid expenses
o Short duration deposit Noncurrent asset
o Expenses payable  Investment in long term
o Provision/Accrued securities/shares/associate or sister
o Other current liabilities concern.
 CP  Old stock, Old/disputed book debt
o Advance payment from  Long term security deposit
customer Intangible Asset
 Goodwill/patents
 Debit balance of PL account
 Pre-operative expenses/preliminary
expenses
Frequently used terms
 Source of Fund
o Liability of the firm
o What the firm Owes
 Uses of fund/Application of fund
o Asset of firm
o What the firm Owns
 Contingent liability
o Also called off balance sheet item
o Shown in foot note only.
 Capital
o Equity share
o Preference share
o Reserve & Surplus
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o For correct calculation of capital, " Misc. Expenses and non-operative
expenses ' are subtracted from the total of the above i.e.
o Capital = (Equity share+ preference share+ Reserve & Surplus)- 9 Misc.
Expenses and non-operative expenses)
o Also called Long Term Outside liabilities
 Tangible net worth= Net Worth-intangible asset

 Investment:= Share capital +Reserve (excluding depreciation reserve) + LTL-
Accumulated loss
 Cash profit= NP+ Depreciation
 Quick Asset= CA- (Stock+ Prepaid expenses)
 Current liabilities: Due for payment within 12 months from date of balance sheet.
 Current Asset: Assets change their shape in to cash within 12 months.
o Also called Gross Working Capital
 Long term sources= NW+ LTL
 Long term uses= Fixed Assets
 Tangible net worth= NW-intangible asset
 Capital/investment:= Share capital +Reserve (excluding depreciation reserve) +
LTL-Accumulated loss
 Cash profit= NP+ Depreciation
 Quick Asset= CA- (Stock+ Prepaid expenses)
 Current liabilities: Due for payment within 12 months from date of balance sheet.
 Current Asset: Assets change their shape in to cash within 12 months...
o Also called Gross Working Capital
 Long term sources= NW+ LTL
 Long term uses= Fixed Asset +Non-Current asset + Intangible asset
 Loans and advances:
o If not stated as long term it is current asset
How to express Ratios?
These are expressed in following mathematical terms
1. Percentage terms
2. Number of times
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3. Proportion
Types of Ratio Analysis
1. Liquidity Ratio
2. Solvency/Leverage ratio
3. Activity/turnover ratio
4. Profitability ratio
1) Liquidity ratios
a) The ability of the business to pay the amount due to stakeholders as and when it
is due is known as liquidity, and the ratios calculated to measure it are known as
‘Liquidity Ratios’. These are essentially short-term in nature.
b) In other words, it helps the stakeholders to ascertain whether current assets of
the entity are sufficient to repay the current liabilities. It assesses the capacity of
the entity to repay its short term liabilities. It is also called short term solvency.
Two types of liquidity ratio
i) Current ratio:
 It gives us the idea of short term solvency of the firm.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡
Current Ratio=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
 Current assets and current liabilities are explicitly mentioned in the

Balance Sheet. Current assets are those assets which can be converted into
cash within one year. Current assets typically include stock, debtors, cash
and bank balance, advance paid to the suppliers, advance tax paid, prepaid
expenses etc. Current liabilities include creditors for goods, creditors for
expenses, overdraft or cash credit facility availed from the bank,
outstanding expenses, advance received from the customers, provision for
tax etc.
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 Interpretation:
 Higher the ratio better is the liquidity of the entity. Ideal ratio is 2:1
where it indicates that current assets are twice the current liabilities of
the entity.
 Tandon Committee, appointed by Reserve Bank of India (RBI), had
recommended 1.33 as the minimum ratio for the entity as per second
method of lending i.e. Maximum Permissible Bank Finance (MPBF)
(second method of lending assumes margin at 25% of the total current
assets)
 Too high current ratio is not always good. Current assets may include
high non-moving stock or stuck up debtors etc. or it may indicate that
entity is not utilizing its current assets to the fullest capacity–
indicating under-trading of the company.
 Too low current ratio indicates the tight liquidity condition of the
company or it may indicate very quick operating cycle of the entity i.e.
over-trading of the company.
ii) Quick ratio:
 It gives us in finding the solvency for short term say about 3/6 months.
𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡
Quick Ratio=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
 The quick ratio indicates liquidity position of the company. It is also called as
acid test ratio and ratio of 1: 1 is considered satisfactory. This indicates that the
short term creditors are safer in realizing their money. Quick assets include all
current assets except stock and prepaid expenses. Current liabilities are the same
as considered above
 Interpretation:
o This ratio indicates the immediate debt paying capacity of the entity.
Higher ratio indicates better liquidity. Here it is assumed that money
would not be realized very quickly from the sale of stock and thus excluded
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from the current assets. Similarly cash cannot be generated from the
prepaid expenses and hence they are also excluded.
2. Solvency ratios / Leverage ratios
 These ratios are calculated to assess the ability of the firms to meet its long-term
liabilities as and when they become due. Long term creditors including
debenture holders are primarily interested to know whether the company has
ability to pay regularly interest due to them and to repay the principal amount
when it becomes due. Solvency ratios disclose the firm’s ability to meet the
interest costs regularly and long-term indebtedness at maturity. Solvency ratios
include the following ratios;
o Debt Equity Ratio
 Debt includes total long term liabilities of the entity such as
debentures; term loan availed by the entity from banks/financial
institutions. Equity means preference share capital, equity share
capital, reserves of the entity. However any intangible assets are
deducted while working out equity.
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑜𝑢𝑡𝑠𝑖𝑑𝑒 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑁𝑊
TNW= NW- Intangible NW
 Interpretation:
 Ideal ratio is considered as 2:1, i.e., for every Re 1 contributed by
the owner, ₹. 2 are borrowed from outside. High debt equity
ratio indicates higher dependence on the outside funds and thus
larger burden of the fixed interest payments.
 Low debt equity ratio indicates lesser dependence on the outside
funds and is good for the shareholders. However, to achieve
higher growth rate for the company in the long term, it is
sometimes beneficial to borrow from outside and thus,
sometimes Entity with higher debt tends to grow at a higher rate
than the debt-free company.
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o Proprietary Ratio
𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒐𝒓′ 𝒔 𝑭𝒖𝒏𝒅 ∗ 𝟏𝟎𝟎

𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒂𝒓𝒚𝒓𝒂𝒕𝒊𝒐 =
𝑻𝒐𝒕𝒂𝒍𝑨𝒔𝒔𝒆𝒕
 Proprietors funds= Share capital + reserves - fictitious assets.
Total assets = Fixed assets (excluding any intangible assets) + Investments + Current
assets
 Interpretation:
o It shows the proportion of the shareholders’ funds in the total assets of
the Entity. Higher ratio indicates more safety to the creditors. There is
no ideal benchmark for this ratio. However ratio below 50% is
regarded as critical. Higher ratio indicates a good solvency position of
the entity and a proper balance between own funds and borrowed
funds.
o Capital gearing ratio
𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 + 𝑹𝒆𝒔𝒆𝒓𝒗𝒆𝒔

𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝒈𝒆𝒓𝒂𝒓𝒊𝒏𝒈 𝒓𝒂𝒕𝒊𝒐 =
= 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒔𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 + 𝒍𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒍𝒐𝒂𝒏𝒔
 Capital gearing ratio establishes relationship between equity capital and

preference share and fixed interest bearing loans. As explained in the debt
equity ratio, if the return on equity is more than the total interest burden of
the entity, it is said that entity has financial leverage or it is ‘trading on equity’.
o Interest Coverage Ratio (ICR)
 The Interest Coverage Ratio (ICR) is a financial ratio that is used to determine
how well a company can pay the interest on its outstanding debts i.e. on long
term borrowing only. The ICR is commonly used by lenders, creditors, and
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investors to determine the riskiness of lending capital to a company. The
interest coverage ratio is also called the “times interest earned” ratio.
𝑬𝑩𝑰𝑻
𝑰𝑪𝑹 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
EBITDA: Earnings before Interest& Tax
Interest = Interest payable on long term borrowing
o Debt Service Coverage Ratio (DSCR)
 The Debt Service Coverage Ratio (DSCR) measures the ability of a company to
use its operating income to repay all its debt obligations, including repayment
of principal and interest on both short-term and long-term debt. This ratio is
often used when a company has any borrowings on its balance sheet such
as bonds, loans, or lines of credit.
𝐸𝐵𝐼𝑇𝐷𝐴
𝐷𝑆𝐶𝑅 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
EBITDA: Earnings before Interest, Tax, Depreciation& Amortization
Principal = Total loan amount of short-term and long-

term borrowings
Interest = Interest payable on any borrowings i.e. both short

& long term borrowing
3. Profitability ratios
Profitability ratios are financial metrics used by analysts and investors to
measure and evaluate the ability of a company to generate income (profit)
relative to revenue, balance sheet assets, operating costs, and shareholders’
equity during a specific period of time. They show how well a company utilizes its
assets to produce profit and value to shareholders
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𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 ∗ 100
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 =
. 𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 ∗ 100
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 ∗ 100
𝑂𝑝𝑒𝑟𝑡𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑁𝑒𝑡 𝑠𝑎𝑙𝑒𝑠
𝐸𝐵𝐼𝑇 ∗ 100
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Gross profit = Sales- Cost of goods sold
Operating profit= GP-Operating expenses
Net profit= OP- non operating expenses +non-operating income
 Interpretation: Gross/Net profit ratio

o There is no such benchmark for the ideal profitability ratios. However,
these ratios can be compared by the entity against its past trend and also
with peer groups.
o Gross profit/Net profit ratio indicates the control of the company over its
direct expenses. Operating profit ratio indicates the profits from the
operations of the company. Net profit indicates the net profit from all
activities of the entity during that year.
 Interpretation: Return on capital employed (ROCE)
o Profit before interest and tax is considered in the numerator. Interest
means interest paid on the long term borrowings. Capital employed
includes capital plus reserves plus preference share capital plus
debentures plus term loans availed from the financial institutions/banks.
o As debentures and term loans are included in the capital employed in the
Entity, the interest paid on them is also added back to the profit to arrive
at the actual return on the capital employed.
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o Capital employed in the business can also be calculated as the fixed assets
plus investments plus net current assets. (Asset side on the Balance Sheet)
o There is no standard benchmark for return on capital employed. However
it can be compared against the return on alternative investment (can be
considered as opportunity cost).
o ROCE can be compared against the past trend of the company, industry
average etc.
4. Turnover/Activity ratios
o The turnover ratios are used to check the efficiency of the company that
how it uses its assets to earn revenue. The sales figure is compared with
the assets (different assets) to measure how much of the assets are used
to generate the number of sales.
o Debtor's Turnover Ratio (DTO)
o This ratio indicates how many times the debtors get rolled over in a
year. This ratio is expressed as ‘number of times’. Instead of closing
debtors, average debtors can also be considered.
𝑪𝒓𝒆𝒅𝒊𝒕 𝑺𝒂𝒍𝒆𝒔
𝑫𝑻𝑶 =
𝑫𝒆𝒃𝒕𝒐𝒓𝒔
o Debtor's velocity/Debtors collection period

o This ratio indicates the average time (Days/Months) taken to recover
the debt
𝟑𝟔𝟓(𝑫𝒂𝒚𝒔)
𝑫𝒆𝒃𝒕𝒐𝒓′ 𝒔 𝒗𝒆𝒍𝒐𝒄𝒊𝒕𝒚 =
𝑫𝑻𝑶
o Higher turnover ratio indicates that debtors cycle is short and they are
quickly realized (get converted into cash quickly). Low turnover ratio
indicates higher debtors lock up indicating stuck up debtors.
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Sales to total assets
𝑺𝒂𝒍𝒆𝒔
𝑺𝒂𝒍𝒆𝒔 𝒕𝒐 𝒂𝒔𝒔𝒆𝒕 𝒓𝒂𝒕𝒊𝒐 =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕
o This ratio indicates how effectively assets of the entity are utilized to generate the
sales of the company. Further total assets can also be bifurcated into fixed assets
and working capital. For manufacturing units, fixed assets turnover ratio would
be more relevant.
o There cannot be standard benchmark for this ratio; however it is useful to
compare the performance of the Entity over the years and also with the peer
companies.
o Higher ratio indicates over trading and lower ratio indicates under trading by the
Entity.
Sales to working capital
𝑺𝒂𝒍𝒆𝒔
𝑺𝒂𝒍𝒆𝒔 𝒕𝒐 𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 =
𝒘𝒐𝒓𝒌𝒊𝒏𝒈 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒇𝒊𝒏𝒂𝒏𝒄𝒆
o This ratio is generally used by bankers to assess the working capital finance
provided by them compared to the sales generated by the entity. As a thumb rule,
20% and 15% are considered as ideal ratios for manufacturing and trading units
respectively.
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Example
Calculation of various ratios from the following information
Balance sheet items Additional Information

Cash 20 Sales 1000
Provision on expenses 20 Net profit 50
Vehicles 100 Intt. On TL 30
Unsecured loan 80 Depreciation 20
Investment in firms 30 Gross profit 300
Good will 30 Operating expenses 150
Capital 200 TL installment 40
Sundry debtor 160
TL 200
P& M 250
Pre-operative expenses 20
Sundry creditor 120
Stocks 200
Reserves 100
Prepaid expenses 20
Expenses payable 20
Security deposit 20
CC/OD 140
Land & building 150
Debenture 120
Solution
1. Current Ratio= Current Asset/Current Liabilities

=400/300 = 1.33:1
2. Quick ratio = Quick asset/Current liability
= 180/30= 0.6:1
3. NWC = CA-CL
= 400-300= 100
4. DE Ratio= Long Term Liability/Tangible Net worth= 400/250= 1.6:1
𝐸𝐵𝐼𝑇𝐷𝐴
5. 𝐷𝑆𝐶𝑅 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡+𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
=50+30+20/40+30= 1.4
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𝐸𝐵𝐼𝑇
6. 𝐼𝐶𝑅 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
= 50+30/30 = 2.66
𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍+𝑹𝒆𝒔𝒆𝒓𝒗𝒆𝒔
7. 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑒𝑎𝑟𝑖𝑛𝑔 𝑟𝑎𝑡𝑖𝑜 =
𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒔𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍+𝒍𝒐𝒏𝒈 𝒕𝒆𝒓𝒎 𝒍𝒐𝒂𝒏𝒔
= 200+100/600 = 1:2
8. Debtor turnover ratio = Credit sales/Debtor

= 1000/160 = 6.3 times
9. Debtor velocity= 360/DTO
= 360/6.33= 57 days = 1.90 months
10. Net profit ratio = NP*100/Sales

= 50*100/1000= 5%
11. Gross profit ratio = Gross profit*100/sales
= 300*100/1000 = 30%
12. Operating profit ratio = Operating profit*100/sales
= 150*100/1000 = 15%
13. Return on capital employed = EBIT/Capital employed
= (50+30)*100/700 = 11.42%
Working Notes
Net worth Fixed Asset
Capital 200 Vehicles 100
Reserves 100 P& M 250
Land & building 150
LTL Noncurrent Asset

Unsecured loan 80 Investment in firms 30
TL 200 Security deposit 20
Debenture 120
Intangible asset
Good will 30
Pre-operative expenses 20
CL Current Asset
Provision on expenses 20 Cash 20
Sundry creditor 120 Sundry debtor 160
Expenses payable 20 Stocks 200
CC/OD 140 Prepaid expenses 20
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NW 300 Intangible asset 50 TNW (300-50)=250 LTL 400 LTS 70
CL 300 STS 30 Outside liabilities 700 LTU 600 CA 400
(400+300)
WC 400 STU 400 NWC 100 Quick Asset= CA Capital=
–(Stock + PPE) 700 (TA-
= 180 CL)
2.1.6 Let's sum up
Various techniques available for financial statement analysis are comparative financial
statements, common-size financial statements, trend analysis, funds flow statement,
cash flow and ratio analysis.
In the analysis of comparative financial statements, financial statements of two or more

years are placed and presented in such a manner that it facilitates year on year
comparison and also the magnitude and direction of change in the position.
In the common size statements, the relationship of each item of a financial statement is
expressed as a percentage of the common item of the financial statement.
In trend analysis, each item of the Profit and Loss account and Balance Sheet for the
base year is taken as 100 and then the same item for other years is expressed as a
percentage of the base year. Any year can be assumed as base year.
Fund flow statement is prepared to ascertain the sources and application of funds over a
certain period. The financial position as of two dates is compared to ascertain the
change in the ‘funds’ position over the two dates.
Cash flow statement is a summary of cash receipts and disbursements during a certain
period. Cash flow statement is prepared as per AS-3 (Revised). Cash flow statement
shows three categories of cash inflows and outflows i.e. (i) Operating activities (ii)
Investing activities (iii) Financing Activities.
Ratio is an arithmetic expression indicating relationship between two numbers where

one number is presented as a proportion or percentage or in terms of number of times
of other number. Ratios can be mainly classified into five types such as liquidity ratios,
solvency ratios, profitability ratios, turnover ratios and coverage ratios.
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 Liquidity ratios are calculated to gauge the liquidity position of the entity.
Liquidity ratios are current ratio and quick ratio.
 Solvency ratios indicate the ability of the firm to pay its long term debt. Examples
of solvency ratios are debt equity ratio, proprietary ratio and capital gearing ratio.
 Profitability ratios assess the profitability of the entity with respect to the
turnover of the firm, capital employed and total investments. Examples of
profitability ratios are gross profit ratio, net profit ratio, ROCE etc.
 Turnover ratios describe how effectively firm utilizes its assets to generate sales
for the firm. Examples are debtor’s turnover ratio, sales to total assets etc.
 Coverage ratios represent the ability of the firm to repay the interest/loan
obligations. Interest service coverage ratio and the debt service coverage ratio
are the examples of the coverage ratios.
2.1.7 Key words:
Net worth, Fixed Assets, Current Asset, Term Liabilities, Current Liabilities, Working
capital, Equity Capital, Common Size Statement ,Funds Flow statement, Cash Flow
Statement, Liquidity Ratios – Current, Quick; Solvency Ratios – Debt-equity,
Proprietary, DSCR , ICR, Profitability Ratios.
2.1.8 Multiple choice Questions

1. Analysis of financial statement means
a. Classification of financial information
b. Organizing financial information
c. Segregating the financial information
d. Conversion of raw financial information into usable information
2. Cash flow statement is similar to fund flow statement except adjusting
a. Cash transaction c. Credit transaction
b. Non cash transaction d. Debit transaction
3. ---------------------activities are principal revenue producing activities of the
enterprise:
a. Day to day b. Financing
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c. Operating d. Investing
4. Analysis means
a. Establishing meaningful relationship between two relevant items
b. Establishing meaningful relationship between two irrelevant items
c. Establishing relationship between two irrelevant items
d. All of the above
5. Net worth represents the stake of the -----------in the entity
a. Long term Lender c. Owner
b. Short term lender d. All of the above
6. Liability towards outside₹ may be
a. Long term c. Term loan
b. Short term d. All of the above
7. Short term liability may be

a. CC/OD limit c. Short duration deposit
b. Sundry creditor d. All of the above
8. Expenses payable is
a. Short term liability c. Long term liability
b. Midterm liability d. None of the above
9. Recording of expenses that have been incurred but payment for which is yet to be
made by the entity is called
a. Accrual c. Expenses payable
b. Provision d. All of the above
10. Advance payment from customer is
a. Current asset c. Short term liability
b. Current liability d. Both b & c
11. Quick asset is equal to
a. Current asset- stock + b. Current asset+ stock +
prepaid expenses prepaid expenses
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c. Current asset+ stock - d. Current asset- stock -
prepaid expenses prepaid expenses
12. Cash is
a. Current asset c. Fixed asset
b. Quick asset d. Both a & b
13. Stock is
a. Current asset c. Fixed asset
b. Quick asset d. Both a & b
14. Preoperative expenses is an example of
a. Capital c. Tangible asset
b. Revenue expenses d. Intangible asset
15. Net working capital is equal to
a. Gross working capital - d. Current asset- current
expenses liability
b. Current asst- expenses
c. Working capital - expenses
16. Comparative financial statements’ analysis is also called
a. Horizontal Analysis.
b. Vertical analysis
c. Both a & b
d. Common size statement analysis
17. Horizontal Analysis. Shows

a. Absolute figures of different periods of time
b. %age change in absolute figures in current year in comparison to base
year
c. Both a & b
d. Horizontal format is prepared
18. Increase in current asset & current liabilities is in equal proportion accompanied
with increase in quick asset shows
a. Improvement in liquidity c. No change in liquidity
position position
b. Deterioration of liquidity d. Improvement in working
position capital position
19. Increase in current asset is more than increase in current liabilities , shows
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a. Improvement in working c. Both a & b
capital position d. No change in liquidity
b. Improvement in liquidity position
position
20. Fixed asset is equal to
a. Long term liability + short term liability+ equity shares
b. Long term liability + short term liability+ preference share
c. Long term liability + short term liability- equity shares
d. Long term liability + share capital
21. If an increase in Fixed Asset> increase in LTL & share capital, it means
a. Fixed Asset has been financed from short term source i.e. from working
capital
b. Fixed Asset has been financed from working capital
c. Fixed Asset has been financed from long term source
d. Both a & b
22. Net profit is equal to
a. OP – Non operating expenses +Net Operating Income
b. OP + Non operating expenses - Net Operating Income
c. OP + Non operating expenses +Net Operating Income
d. None of the above
23. In common size statement analysis
a. Different items of assets and liabilities are shown with reference to total
assets/total liabilities respectively
b. Different items of assets are shown with reference to total assets & total
liabilities respectively
c. Different items of liabilities are shown with reference to total assets&total
liabilities respectively
d. All of the above
24. Plotting the collected information on the horizontal line with the objective to find
actionable patterns is called
a. Common size statement b. Comparative size
analysis statement analysis
c. Cash flow statement d. Trend analysis
analysis
25. There is no flow of fund, if
a. Transactions which involve current account only
b. Transactions which involve Non current account only
c. Transactions which involve one current account and one Non-current
account
d. Both a & b
26. Fund flow statement is based on

a. Accrual basis of c. Both a & b
accounting d. All of the above
b. Cash basis accounting
27. Cash flow statement is based on
a. Accrual basis of c. Both a & b
accounting d. All of the above
b. Cash basis of accounting
28. Cash movement occurs in the following types of activities

a. Operating activities c. Financing activities
b. Investing activities d. All of the above
29. Cash movement from Acquisition and disposal of long-term assets belongs to
a. Operating activities c. Financing activities
b. Investing activities d. All of the above
30. Payment to creditors is an example of

a. Cash inflow c. No cash flow
b. Cash outflow d. Both a & b
31. Method/s of preparation of cash flow statement is/are
a. Indirect method c. Straight method
b. Direct method d. Both a & b
32. Starting point of Calculation the operating profit before changes in working
capital is
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a. NPBT c. EBIT
b. NPAT d. All of the above
33. Contingent liability is
a. off balance sheet item c. both a & b
b. on balance sheet item d. none of the above
34. current asset is also called
a. Net working capital c. Working capital
b. Gross working capital requirement
d. Working capital finance
35. under ratio analysis, ratio is expressed in following mathematical term/s
a. Percentage terms c. Proportions
d. All of the above
b. Number of times
36. Liquidity ratio is also called

a. Short term solvency ratio c. Leverage ratio
b. Long term solvency ratio d. Solvency ratio
37. Leverage ratio is also called
a. Short term solvency ratio c. Solvency ratio
b. Long term solvency ratio d. Both b & c
38. While calculating DSCR, interest means
a. Interest on short term c. Interest on both short &
borrowing long term borrowing
b. Interest on long term d. All of the above
borrowing
39. Debtors collection period is also called
a. Debtor turnover ratio c. Debtor velocity
b. Creditor turnover ratio d. None of the above
40. If book debt is realized in cash, there will be

a. Change in current asset c. Change in current ratio
b. Change in quick asset d. No change
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2.1.9 Answer Keys
1-d 2-b 3-c 4-a 5-c 6-d 7-d 8-a 9-a 10-d
11-d 12-d 13-a 14-d 15-d 16-a 17-c 18-a 19-c 20-d
21-d 22-a 23-a 24-d 25-d 26-a 27-b 28-d 29-b 30-b
31-d 32-a 33-a 34-b 35-d 36-a 37-d 38-c 39-c 40-d
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Unit-3: Audit, Inspection and Control
Lesson No. 3.1 Internal control and checks
Lesson No. 3.2 Preparatory work for audit and inspection
Lesson No. 3.3 Audit and Inspection
Lesson No. 3.4 Role of an auditor and areas to be covered
Lesson No. 3.5 Frauds-classification, reporting and monitoring
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Lesson No. 3.1 Internal Control and Checks
3.1.1 Objectives
3.1.2 Introduction
3.1.3 Meaning and need for Internal Controls
3.1.4 Essentials of Good Internal Controls
3.1.5 Nature of Internal Controls
3.1.6 Roles and Responsibilities in Internal Control
3.1.7 Limitations of Internal Control
3.1.8 Setting up of the Internal Control System
3.1.9 Internal Check
3.1.10 Objectives of internal Check
3.1.11 Framing a system of Internal Control
3.1.13 Key words
3.1.15 Answer keys
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3.1.1 Objectives
 Meaning, need and essentials of internal controls

 Nature of internal controls
 Limitations of internal controls
 Setting up of internal controls
 Meaning of internal checks
3.1.2 Introduction
Control is a process to ensure that the business is conducted in an orderly and prudent
manner in accordance with established policies and practices formulated by the top
management to achieve the organization’s objectives and set goals. This covers
organizational, management & operational control and evolve action plan for strategic
development. It ensures observance & compliance to rules, regulations, guidelines
issued by controlling bodies like NABARD, RBI, State Government and the Government
of India. The internal Control system is responsible for effective supervision
3.1.3 Meaning and need of Internal Controls

Depending on the nature and volume of business, there are certain set processes, and
procedures followed within the organization. These processes and procedures differ for
each organization. Internal controls are these processes and the procedures adopted in a
business to safeguard the assets, to ensure financial information is accurate and reliable
and to ensure compliance with all financial and operational requirements.
The committee on auditing procedures of the American Institute of Certified Public

Accountants has defined internal controls as the plan of the organization and all the
coordinated methods and measures adopted within a business to:
 Safeguard its assets;

 Check the accuracy and reliability of its accounting data;
 Promote operational efficiency;
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 Encourage adherence to prescribed managerial policies.

The Institute of Chartered Accountants of England and Wales defines internal control as
"internal control means not only internal check or internal audit, but the whole system
of control financial and otherwise, established by management in order to carry on the
business of the company in an orderly manner, safeguard its assets and secure as far as
possible accuracy and reliability of its records".
A system of internal control extends beyond those matter which relate directly to the
function of the accounting and financial departments.
In some business houses, there are written documents elaborating each process and
procedure of the business. Employees are made aware of the internal controls and
accordingly, systematic business environment is created. Written procedures help train
new staff by explaining why they need to do what is asked of them. Written procedures
reduce errors and help staff understand the business quickly.
Some organizations clearly discourage poor reporting, carelessness and fraud and a
clear and stern message is given by the management, whereas others may have a softer
attitude. Lack of attention to internal matters, not having code of ethics, inadequate
respect for employees, lack of audit trails, lavish expenditure and general sloppiness in a
business etc. are all likely to create an environment that can be easily manipulated for
gain.
Control procedures are the policies and procedures that have been put in place by the
management to plug possible loopholes in the system, to reduce errors, to contain
frauds, to ensure that owners and managers can take the correct action to ensure that
the business achieves its objectives. Procedures explain the exact step by step action, the
timing and also the rationale behind the same. Thus procedures explain the how, why,
what, where and when for any set of actions.
From the above discussion, we can construe that the objectives of Internal Controls are
as follows:
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 Safeguard assets- To minimize, if not completely eliminate, wastage and

inefficiencies in business operations and to safeguard the assets of the business.
 To prevent and detect frauds and errors – ensuring the systems quickly identify
errors and frauds if and when they occur
 Allow action to be taken against undesirable performance – authorizing a formal

method of dealing with frauds, dishonesty or incompetence when detected.
 To ensure high degree of accuracy and reliability of accounting data and promote
operational efficiency.
 Reduce exposure to risks – minimizing the chance of unexpected events.
3.1.4 Essentials of Good Internal Controls

The following are the requisites of a good internal control system:-
 A well-developed plan of organization with proper delegation of functional

responsibilities should be devised. No internal control system can be effective
without such plan of organization.
 A scientific system of authorization and record procedure should be developed
with a view to provide proper control over assets, liabilities, revenue and
expenses of the organization.
 A system of healthy practices and traditions should be developed with a view to
discharge the duties and functions of various departments of the organization
smoothly.
 Since internal control system is to be exercised by personnel employed in the
organization, there should be a team of people with sound character and integrity
who are properly trained and capable of discharging their responsibilities.
 Constant managerial supervision and periodical review of the system should be
introduced with a view to make the system more efficient and effective.
3.1.5 Nature of internal controls

To understand and simplify the types of internal controls followed in the organization
the same can be bifurcated based on the objectives they serve. Thus, internal controls
can be broadly classified as the internal controls ensuring financial accuracy and
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operational efficiency, controls to safeguard assets and controls to ensure compliance

with regulatory requirements.
1. Controls ensuring financial accuracy and operational efficiency
Internal controls that are set to ensure financial accuracy also directly or indirectly
ensure that frauds/ embezzlements/ misappropriations of funds do not take place and if
they still happen, the same are detected and corrected at the earliest. It also helps in
achieving operational efficiency.
Some examples of internal controls for ensuring financial accuracy are
 Segregation of duties- a clear demarcation of duties at different levels.

 Proper delegation of authority- for checking and authorizing accounting records,
signing of cheques, authorizing staff expenses etc.
 Assigning proper responsibilities for each cadre
 Reconciliation of accounts at periodic intervals. Reconciliation involves verifying
accounting records to make sure that there are no errors or omissions that have
so far gone undetected.
 Document control- sequential numbering of documents
 Validation checks- concept of maker and checker
 Exception reports- reporting of exceptional transaction to the higher
management.
 Independent checks
 Rotation of duties
 Double custody of cash
 Morning checking
 Daily generation of control reports
2. Controls to safeguard assets
These controls aim to protect physical and non-physical assets and minimize losses
from both internal and external events. Physical assets include cash, stock, plant and
machinery, and non-physical assets could include debtors, property etc. Examples of
internal controls used are as follows:
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 Physical security such as locking premises, personal offices, filing cabinets and
safes, etc.
 Controls on the entry in the premises of the organization
 Using security cameras
 Restricting access to areas and databases
 Assigning and changing computer passwords, access codes and safe
combinations regularly
 Avoiding giving one employee total control over a key process
 Having firewalls and protective devices on computer systems
 Having proper system for backup of the data
 Having clear guidelines on personal use of assets
3. Controls to ensure compliance with regulatory requirements
Every organization has to deal with many regulatory obligations. Some examples of
controls used to ensure compliance include:
 Assigning responsibility to individuals for compliance with particular

requirements such as safety officer or fire warden
 Physical controls to prevent accidents
 Processing customer complaints fairly and in a timely manner
 Staff feedback processes
 Procedures that are well documented
 Conduct of regular audits
4. Controls over human resource of the organization
 Undertaking reference checks on new staff to ensure they do have essential

qualifications
 Ensuring correct training for staff has been provided
 Appropriate supervision of staff
 Police and bankruptcy checks can be undertaken when the nature of the job
requires it
 Undertake regular annual performance reviews with staff
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3.1.6 Roles and responsibilities in internal control

 Employees: These are the people who are actually going to follow the internal
controls guidelines. Therefore they should be aware of all the set internal
guidelines.
 Management: The Chief Operating Officer (COO) of the organization has
overall responsibility for designing and implementing effective internal control.
 Board of Directors: Management is accountable to the Board of Directors,
which provides governance, guidance and oversight.
 Auditors: The internal auditors and external auditors of the organization also
measure the effectiveness of internal control through their efforts. They assess
whether controls are properly designed, implemented and working effectively.
And make recommendations on how to improve internal control.
3.1.7 Limitations of Internal Control

Frauds take place even if utmost care is taken to ensure that proper internal controls are
set and are followed. This is because of the few inherent limitations of the internal
control system:
 Human error- Though there are set procedures/processes, there are always
chances of human error.
 Unusual transaction- An unusual transaction might take place, for which
procedures/ process are not properly defined.
 Collusion - It happens when two or more people come together in an attempt to
defraud.
 Manipulations- management can externally manipulate transactions.
3.1.8 Setting up of the internal control system

The nature of the control will vary with the nature and volume of the business. Some
areas of the business are more prone to risk of loss or fraud and require more stringent
controls. These areas of concern will also differ from business to business. Therefore
each business house has to go through each aspect of the business, identify the fraud
prone areas and then set the procedure manual. Following is the example of one area of
‘Payment of wages and salaries:
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Payment of salaries and wages (payroll)
Most payrolls, even small ones, are now automated, so it is easier to commit fraud or
errors if the internal controls are not tight and the procedures are not set or followed.
 A proper system in place to check records such as Time-work sheets, leave

enjoyed, calculation of incentives, allowances are properly checked.
 Where possible, segregate payroll preparation, disbursement and distribution
functions. If possible, the payroll officer must not calculate their own pay.
 If possible, the head of the respective department should authorize the payment
by signing salary sheet.
 If an electronic payroll is used, ensure supervisors change their password often.
Ensure passwords are not handed to other staff members when the person is on
holiday or sick.
 Care to be taken for payment of absentees. Authority for payment should be
checked.
 Deductions for loan, or advances should be made.
 Cheques signed but not handed over to the employees who may be absent should
be kept in safe custody. Such cheques or cash vouchers should be verified
immediately.
3.1.9 Internal Check

Internal check is a valuable part of internal control. Spicer and Pegler have defined a
system of internal check as “an arrangement of staff duties whereby no one person is
allowed to carry through and record every aspect of a transaction so that, without
collusion between any two or more persons, fraud is prevented and at the at the same
time, the possibilities of errors are reduced to the minimum”. It involves verification of
individual’s work by prescribing cross checks and cross reconciliation as a part of
operating procedure itself.
Thus, under internal check system, the staff duties are so arranged that no one person is
allowed to record every aspect of the transactions and the entire work is distributed
among the various members of the staff in such a manner that the work of one person is
automatically checked by others. It is an allocation of responsibility and division of work
among the employees.
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3.1.10 Objectives of internal check

 To reduce chance of fraud and errors that may be committed by any member of
the staff and make it more difficult. If any fraud is to be committed two or more
persons must collude together.
 To detect fraud and errors easily and correct them promptly.
 To exercise moral pressure among the members of the staff.
 To allocate duties and responsibilities of every person in such a way that he/she
can be taken to task for any lapse on his/her part.
 To increase overall efficiency of the members of the staff by assigning duties

based on the principle of division of labour.
 To have an accurate and reliable record of all business transactions.
3.1.11 Points that are taken into consideration while framing a System of
Internal Control
 No independent control: Independent control of any aspect of a transaction
will not be entrusted to any one person alone.
 Reshuffling of duties: There must be a rotation policy. Thus, duties are to be

reshuffled at periodic intervals.
 Mandatory annual leave: Employees should be encouraged to go on annual

leave. During the absence of that employee, other employees may be asked to do
the job. This is likely to unearth frauds concealed or practiced by the employees.
 No access to books: The employees who are in physical custody of the asset
shall not be given access to the books of accounts.
 Physical verification / stock taking / reconciliation: Accounts should be

physically verified at periodic intervals. Similarly, balances of accounts are to be
reconciled with external data (such as bank balance, debtors balance
confirmation etc.) at periodic intervals.
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 Planning and budgeting: Based on the past data and overall business targets
for the future, the budgeting is to be done for all expenses heads and variance to
be worked out.
3.1.12 Let’s us sum up

Internal controls are the processes and the procedures adopted in a business to
safeguard the assets, to ensure financial information is accurate and reliable and to
ensure compliance with all financial and operational requirements.
A good internal control system should a well-developed plan of organization, with

proper delegation of functional responsibilities; scientific system of authorization and
record procedure and team of people with sound character and integrity. Constant
managerial supervision with periodical review will make the system more effective.
Internal controls can be broadly classified as:
 Internal controls ensuring financial accuracy and operational efficiency,
 Controls to safeguard assets
 Controls to ensure compliance with regulatory requirements and
 Controls over human resource of the organization
Frauds take place even if utmost care is taken to ensure that proper internal controls are
set and are followed. This is because of the inherent limitations of the internal control
system, human and technological.
Internal check is a valuable part of internal control. Internal check is an allocation of

responsibility and division of work among the employees.
3.1.13 Key words

Internal control, Internal check
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3.1.14 Multiple choice Questions

1. The ultimate responsibility of ensuring proper internal controls in the
organization lies with the _______________.
a. Auditor c. Employees
b. Board of management d. Management
2. Which one is/are true
a. Internal check is part of the overall system of internal controls.
b. Internal controls are essential in all business organizations.
c. An effective internal control system helps external auditor to design

suitable audit.
d. All of the above

3. Which one is/are false
a. Internal controls do not include accounting controls.
b. Employees should be discouraged to take leave.
c. Planning and budgeting ensure good internal check

d. Both a & b
4. ___________ ensures that the work of one person is checked by other persons.
a. Internal audit c. Rotation

b. Delegation d. Internal check
5. In an organization where accounts are not reconciled/balanced at periodical

internals, it is a sign of ___________ internal control.
a. Good c. Strong
b. Weak d. Proper
6. Which of the following are the essential financial and operational internal
controls?
a. Rotation of duties b. Proper delegation of

authority
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c. Independent check d. All of the above
7. Which of the following are the objectives of the internal controls?
a. Two safeguard assets

b. To ensure proper financial reporting
c. To prevent and detect fraud and error
d. All of the above
8. While framing a System of Internal Control, following point/s should be kept in
mind
a. There should be independent control
b. Rotation of duties should not be insisted upon
c. There should be annual reconciliation of account
d. All of the above
9. The basic objective of internal check is
a. To detect fraud and errors easily and correct them promptly.
b. To exercise moral pressure among the members of the staff.
c. To have an accurate and reliable record of all business transactions.
d. All of the above
10. The purpose of Internal controls is :
a. To ensure financial accuracy and operational efficiency,
b. To safeguard assets
c. To ensure compliance with regulatory requirements and
d. All of the above

11. -----------------------------is/are Limitations of internal control
a. Human error c. Illusion
b. Usual transaction d. All of the above
12. -------------------------- is/are controls over human resource of the organization
a. Ensuring correct training for staff.
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b. Appropriate supervision of staff.
c. Undertake regular annual performance reviews with staff.
d. All of the above
3.1.15 Answer keys
1-a 2-d 3-d 4-d 5-b
6-d 7-d 8-a 9-d 10-d
11-a 12-d
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Lesson No 3.2 Preparatory works for Audit and Inspection
3.2.1 Objectives
3.2.2 Introduction
3.2.3 Audit process in brief
3.2.4 Audit preparation from the auditee’s side
3.2.5 Let us sum up
3.2.6 Key words
3.2.8 Answer keys
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3.2.1 Objectives
The objectives of this lesson are to understand
 Audit process
 Preparation by the company for the same.
3.2.2 Introduction
Audit is an examination of accounting records undertaken with a view of establishing
whether they correctly and completely reflect the transactions to which they relate.
Auditing is a systematic and independent examination of data, statements, records,
operations and performance of an enterprise for a stated purpose.
Various types of audits and inspection carried out in the organization are covered in
detail in the next chapter.
3.2.3 Audit process in brief

a. Appointment of Auditor
Auditor receives appointment letter from the client, explaining in detail the scope of the
audit. In response to the appointment letter, the auditor will issue an engagement letter,
which is governed by the standards on auditing issued by Institute of Chartered
Accountants of India, setting out his/her understanding of the audit engagement and
the roles and responsibilities of the management of the entity. Once the entity accepts
the engagement letter (setting out the terms of audit engagement), the auditor is
formally appointed and will proceed with planning for the audit process.
b. Business review by the auditor
Auditor tries getting information about the business of the client from external sources
such as business journals, rating agencies’ reports etc. and from internal sources such as
annual reports, minutes of board or internal committee meetings, discussion with the
management, and visit to various factory and office locations.
c. Audit planning
Audit planning refers to the planning by the auditor to enable them to conduct an
effective audit in an efficient and timely manner and includes planning about area,
scope, depth, of transactions to be audited, time schedule for each area and people to be
involved in the audit.
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d. Audit Programme
Audit Programme is an outline of all procedures to be followed in verification of each

item in the financial statements and giving the estimated time required. It also notes the
areas where auditor needs to focus more considering the importance of the area and /or
the probability of errors / frauds happening.
e. Audit techniques
(i) Auditors use various techniques considering following factors:
 Nature of industry in which the entity operates,
 Nature of the regulations and the regulator governing the legal territory and
industry of the entity,
 Intensity of risk due to fraud or error identified by the auditor and /or the
management in a particular area,
 Areas identified due to developments in recent past viz.: strike, raid by Tax
Departments, legal notice served by creditors or competitors,
 Areas identified due to certain changes in laws and regulations viz.: Introduction
of GAAR, Transfer pricing on domestic transactions, Point of Taxation Rules in
Service Tax Laws.
(ii) Based on above factors, auditor may follow following techniques:
 Reliance placed on Controls by testing the Internal Controls of the entity (Control
Testing):
The auditors test the internal controls of the entity, by checking handful of samples. But
for the handful of samples, auditor verifies controls from origination of a transaction till
the ultimate conclusion / settlement of the transactions. Controls can be put in place by
the Entity which are through automated system software or manual controls which
authorize transactions as well as check completeness and accuracy of the transactions.
If based on controls tested, the auditor concludes that the internal controls are effective;
he/she may decide to reduce the amount of substantive testing to be done. This also
saves the overall audit time and gives a better assurance to the auditor than the
substantive testing. Thus, in an entity with robust control environment the audit is done
in less time than in an entity where internal controls are weak.
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 Substantive Testing:
In substantive testing auditor verifies the larger number of transactions in greater detail
like - if transactions are booked in correct accounting period or not, whether they are
booked under proper accounting head, whether they are properly authorized etc. These
parameters are decided based on the factors considered in planning.
 Analytical Testing:
Analytical testing means when testing is done based on the past trend, projections and
budgets. In certain areas an auditor may get more assurance by testing the total
expenses viz.: rent, royalty, interest expense, general provisions for expenses,
contractual expenses; through analytical means. In analytical testing, auditor might not
check the documentary support such as vouchers, agreements etc.
3.2.4 Audit preparation from the Auditee’s (bank’s/company’s or firm’s)

side
Though not all, most of the organizations are now required to undergo the audit process.
At times, organizations look upon audit as unnecessary, redundant and time consuming
exercise. However, good management is aware that entire audit process is also a
learning process. Some preparation from their side ensures that the audit process is
smooth and is completed on time.
1. Pre audit preparation

i. Preparing the employees
 Senior managers should arrange the meeting to discuss the scope of audit,
likely duration, likely outcome and also if required, designate one
coordinator for the auditor
 The purpose and the scope of the audit should be communicated in detail.
 Discuss with the employees the areas of potential weaknesses
ii. Arrangements for the auditors
 Deciding on the appropriate place for the auditor and his/her team.
 Ensuring that the room is properly equipped.
 Informing security guards and / or the receptionist about the details of the
auditors
 Reserve parking and create their IDs
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 Setting up communication with the auditor asking about the exact date of
starting of the audit
 Providing information, if any, asked by the auditor
iii. Some homework by the employees concerned
 Review the findings of the last audit
 Understanding the financials of the company in detail
 Identifying the trend and variances with the projections, if any
iv. Preparing the data required by the auditor
 Sending financial statements and supporting trial balance
 Asking auditors to prepare a list of likely questions
 Proving data required only in specified format.
 Providing unasked data should be avoided.
 Providing data in an organized manner.
 Creating a separate file section for each heading on financial statements
 Wherever required, keep ready supporting documents.
2. During the visit
v. While in discussion with the auditors;
 Introduce the auditor to the coordinator and also the senior management
people.
 Brief him about the performance of the company, any new initiatives taken
etc.
 Brief about the internal controls set
 Answer questions accurately. Otherwise, make reference to the statements,
working papers etc.
 Have a formal communication.
 Avoid taking a position regarding an issue, avoid drawing the auditor’s
attention to defects and problems
 Avoid using industry jargons, slang or in-house abbreviations (auditor may
not be aware of the same)
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3. Closing of audit process

 Discuss audit queries with auditor and if possible, try solving them right away.
 Discuss with auditor the post audit process
 Fix up date of the Board meeting
 Arranging meeting of the senior management as regards discussion on audit
points.
 Preparing follow-up plan
3.2.5 Let us sum up

Auditing is a systematic and independent examination of data, statements, records,
operations and performance of an enterprise for a stated purpose. Audit process
involves:
 Appointment of auditor
 Business review by auditor
 Audit planning
 Audit programme and
 Audit techniques
Audit techniques may include control testing - auditors test the internal controls of the
entity, by checking handful of samples; substantive testing - auditor verifies the larger
number of transactions in greater detail; analytical testing - testing is done based on the
past trend, projections and budgets. Also preparation from the auditee’s side ensures
that the audit process is smooth and is completed on time.
3.2.6 Key words

Audit process, Appointment of Auditor, Auditing techniques, Audit preparation
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1. ________________ means when testing is done based on the past trend,
projections and budgets:
a. Substantive testing c. Control testing
b. Analytical testing d. Sample testing
2. Based on controls test, the Auditor concludes that the Internal Controls are
effective and he/she may decide to __________ the amount of substantive
testing to be done
a. Increase c. Skip
b. Reduce d. 100% check
3. Audit ___________ is an outline of all procedures to be followed in verification
of each item in the financial statements and giving the estimated time required.
a. Plan c. Technique
b. Programme d. Visit plan
4. Audit ___________ refers to the planning by the auditor to enable them to
conduct an effective audit in an efficient and timely manner
a. Appointment c. Testing
b. Planning d. Technique
5. Auditing is a ____________________examination of data, statements,

records, operations and performance of an enterprise for a stated purpose
a. Haphazard c. Voluntary
b. Random d. Systematic & independent
6. Techniques of auditing are
a. Control c. Analytical
b. Substantive d. All of the above
7. The audit process involves
a. Audit planning; c. Audit techniques
b. Audit programme d. All of the above
8. Before the end of the audit process
a. Discuss irregularities with auditor and try to remove it instantly.
b. Never attend the auditor's query during audit
c. Fix the board meeting to discuss audit point
d. Both a & c
9. Following is /are homework before audit on the part of official concerned
a. Review the findings of the last audit

b. Understanding the financials of the company in detail
c. Identifying the trend and variances with the projections, if any
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d. All of the above

10. Control testing is
a. Based on the past trend, projections and budgets.
b. Based on checking handful of samples.
c. Based on the present trend, projections and budgets.
d. Based on the past trend, projections and achievements.
11. Bank should provide data to auditor in
a. Specified format only. c. Convenience format

b. An unorganized manner. d. All of the above
3.2.8 Answer keys
1-b 2-b 3-b 4-b 5-d

6-d 7-d 8-d 9-d 10-a
11-a
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Lesson No. 3.3 Audit and inspection
3.3.1 Objectives
3.3.2 Introduction
3.3.3 Definition of audit
3.3.4 Main features of audit
3.3.5 Objectives of an audit
3.3.6 Advantages of audit
3.3.7 Audit types
3.3.8 CAMELSC
3.3.9 Let us sum up
3.3.10 Key words
3.3.12 Answer keys
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3.3.1 Objectives
 Definition of audit
 The objectives of an audit
 Various types of audits
 Statutory inspection
 Concept of CAMELSC
3.3.2 Introduction
Financial statements are prepared to assess the profit/loss realized from business
activities during a period of time and also to reflect the position of assets and liabilities
of the business as on a particular day. This information is used by different stakeholders
such as shareholders, bankers, creditors, prospective investors, analysts, etc. Similarly,
management of the entity also uses the financial statements for taking important
decisions. The authenticity of the financial statements is very essential for all
stakeholders of the entity and thus independent audit of the entity’s financial statements
get paramount importance.
3.3.3 Definition of Audit

The term auditing has been defined by different authorities.
1. Prof. L.R.Dicksee "Auditing is an examination of accounting records undertaken

with a view to establish whether they correctly and completely reflect the
transactions to which they relate.”
2. Spicer and Pegler: "Auditing is such an examination of books of accounts and
vouchers of business, as will enable the auditor to satisfy himself that the balance
sheet is properly drawn up, so as to give a true and fair view of the state of affairs
of the business and that the profit and loss account gives true and fair view of the
profit/loss for the financial period, according to the best of information and
explanation given to him and as shown by the books; and if not, in what respect
he is not satisfied."
3. The book "an introduction to Indian Government accounts and audit" "issued by
the Comptroller and Auditor General of India, defines audit as “an instrument of
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financial control. It acts as a safeguard on behalf of the proprietor (whether an

individual or group of persons) against extravagance, carelessness or fraud on the
part of the proprietor's agents or servants in the realization and utilization of
money or other assets and it ensures on the proprietor's behalf that the accounts
maintained truly represent facts and that the expenditure has been incurred with
due regularity and propriety. The agency employed for this purpose is called an
auditor."
3.3.4 Main features of audit

a. Systematic: Audit is a systematic and scientific examination of the books of
accounts of a business;
b. Independent: Audit is undertaken by an independent person or body of
persons who are duly qualified for the job;
c. Cover financial statements and all related records
d. Audit is a verification of the results shown by the profit and loss account and the
state of affairs as shown by the balance sheet. Audit is done with the help of
vouchers, documents, information and explanations received from the
authorities. The auditor has to inspect, compare, check, review, scrutinize the
vouchers supporting the transactions and examine correspondence, minute
books of shareholders, director, Memorandum of Association and Articles of
association etc., in order to establish correctness of the books of accounts.
e. Reviews internal controls: Audit is a critical review of the system of
accounting and internal control;
f. The auditor has to satisfy himself with the authenticity of the financial statements
and report that they exhibit a true and fair view of the state of affairs of the
concern.
3.3.5 Objectives of an audit

There are two main objectives of auditing. The primary objective and the secondary or
incidental objective:
a. Primary objective – As per Section 227 of the Companies Act, 1956, the
primary duty (objective) of the auditor is to report to the owner whether the
balance sheet gives a true and fair view of the company’s state of affair and the
Profit and Loss a/c gives a correct figure of profit or loss for the financial year.
The main object of an audit is to ascertain that the Balance sheet and the Profit
and Loss a/c of an undertaking do show true and fair view of the financial
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position of the entity. The role of the auditor is to report on the accounts
examined by him/her. He/She have to report whether or not the accounts
audited by him give a true and fair view of the state of affairs of business. To
establish whether the financial statement show a true and fair state of affair, the
auditor must carry out a process of examination and verification and, if error and
frauds exist, they would come to his/her notice in the ordinary course of
checking. But detection of error of frauds is not the primary aim of audit; the
primary aim is the establishment of a degree of reliability of the annual
statements of account.
b. Secondary objective – it is also called the incidental objective as it is
incidental to the satisfaction of the main objective. Auditor examines the
financial statements and related record so as to ascertain whether they reflect
true and fair view of the state of the affairs. While doing this duty, auditor checks
whether there are any accounting errors that can be detected. The incidental
objectives of auditing are:
 Detection and prevention of Frauds, and
 Detection and prevention of Error.
Thus, detection of material frauds and error as an incidental objective of the
independent financial auditing flows from the main objective of determining
whether or not the financial statements give a true and fair view.
The statement on auditing practices issued by the Institute of Chartered
Accountants of India states that, an auditor should bear in mind the possibility of
existence of frauds or errors in accounts under audit since they may cause the
financial position to be misstated. Errors refer to unintentional mistake in the
financial information arising on account of ignorance of accounting principles i.e.
principle errors, or errors arising out of negligence of accounting staff i.e. clerical
errors. Fraud refers to intentional misrepresentation of financial information
with intention to deceive. Frauds can take place in the form of manipulation of
accounts, misappropriation of cash and misappropriation of goods. If there
remains a deep laid fraud in the accounts, which in the normal course of
examination of accounts may not come to light, it will not be construed as failure
of audit, provided the auditor was not negligent in the carrying out his/her
normal work. It is of great importance for the auditor to detect any frauds, and
prevent their recurrence.
c. Specific objective-
Other than financial audits, audit may cover areas such as review of operations,
performance, cost record, etc. Thus, there can be specific scope for such specific
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audits. For example, in operational audit, an attempt is made to evaluate the

existing operations of the organization.
3.3.6 Advantages of audit

 It safeguards the financial interest of persons who are not associated with the
management of the entity, whether they are partners or shareholders.
 It acts as a moral check on employees from committing defalcations or
embezzlement.
 Audited statements of account are helpful in setting liability for taxes, negotiating
loans and for determining the purchase consideration for a business.
 Can be used for settling trade disputes or higher wages or bonus as well as claims
in respect of damage suffered by property, by fire or some other calamity.
 Audit ascertains whether the necessary books of accounts and allied records have
been properly kept and helps the client in making good deficiencies or
inadequacies in this respect.
 As an appraisal function, audit reviews the existence and operations of various
controls in organizations and reports weakness, inadequacy, etc., in them.
3.3.7 Audit types

Broadly, audits can be classified on the basis of authority and based on time.
Statutory Audit
Internal Audit
Types of
Bank Concurrent Audit
Audit
Forensic Audit
Statutory audit
i. Statutory Audit itself comprises the word statute, which means regulation.
Thus, it can be understood easily that the statutory audit is a mandatory
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audit defined under the law or Banking Regulation Act, 1949. Under
Statutory Audit ICAI (The Institute of Chartered Accountants of India) and
RBI altogether assigns the banks to an auditor who is generally a
practicing chartered accountant and this auditor performs accounting
year-end audit in all branches assigned to them by the ICAI.
ii. Some of the important aspects which should be covered under statutory
audit are cash verification, tax-related issues, loan accounts verification,
assets classification and provision etc. After that, an auditor prepares an
audit report defining his opinion on LFAR (Long Form Audit Report).
Internal Audit
Internal audit is an independent management function. Internal audit is described as

the verification of the operations within the business by a specially assigned staff. It is
an important tool of management to evaluate the correctness of records on a continuous
basis in an organization. The term internal audit has been defined as "an independent
appraisal of activity” within an organization for review of operations as a basis of service
to management.
According to Howard F. Stettler, "internal auditing is an independent appraisal activity

within an organization for the review of operations as a service to management.”
The overall objective of internal auditing, therefore, is to assist the management in the
effective discharge of their responsibilities by furnishing them with objective analysis,
appraisals, recommendations and pertinent comments concerning the activities
reviewed. In short internal audit assures the management that the system of internal
checks and other types of controls are effective in design and operation.
The internal audit is carried out generally in the same manner as is followed for a
professional audit. However, it varies in form from enterprise to enterprise according to
its size and specific needs. It is installed in large organizations and is carried out by the
salaried staffs that are qualified to conduct professional audit. Being the employee of the
organization, he/she has to ensure that there is no waste in the organization.
Internal auditor has to follow the provisions of law, standard auditing practices and
procedure prescribed for professional auditors and by the professional bodies
controlling the audit system in the country. At the same time, internal auditor must be
aware of the policies and programs of the enterprise. He/she should be professionally
competent to carry out a detailed examination of working of the business.
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Concurrent audit
Concurrent audit means doing the examination of the financial transactions at the time
of happening or parallel with the transaction. It is part of a bank’s early warning system
to ensure timely detection of irregularities and lapses. It helps in preventing fraudulent
transactions at
It is a system of audit which is generally prevalent in large branch of bank. The object of
this audit is to ensure adherence to prescribed systems and procedures and timely
detection of irregularities. The emphasis under concurrent audit is not on test checking
but on substantial checking of transactions.
The concurrent audit aims at reducing the gap between the occurrence of a transaction
and its examination.
Forensic Audit
The forensic audit is normally performed by a forensic accountant who has the skill in
both accounting and investigation.
Forensic Accounting is the type of engagement that undertakes the financial
investigation in response to a particular subject matter, where the findings of the
investigation normally are used as evidence in court or conflict resolution among the
shareholders.
The investigation is covering numbers of areas include fraud investigation, crime
investigation, insurance claims as well as a dispute among shareholders.
3.3.8 CAMELSC
Reserve Bank of India conducts the audit of the banks every year and grades them based
on the CAMELSC parameters. The term CAMELSC stands for Capital Adequacy, Asset
quality, Management, Earnings appraisal, Liquidity and Systems and compliance. The
marks are assigned for each parameter and accordingly based on the weights of each
parameter; the overall rating under CAMELSC is worked out. The rating under
CAMELSC is a confidential process and working is not shared with the management.
Only the CAMELSC rating is communicated to the Board of Directors of the bank.
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3.3.9 Let’s us sum up

 Auditing is a systematic and scientific examination of the books of accounts and
records of business to enable the auditor to satisfy himself that the balance sheet
and the profit and loss account are properly drawn up so as to exhibit a true and
fair view of the financial state of affairs of the business and profit or loss for the
financial period.
 The main point of distinction between accountancy and auditing is that

accountancy is concerned with the preparation of financial statements whereas
auditing is concerned with checking of these financial statements and reporting
on the financial position and result of operation of the organization.
 Objectives of audit are broadly classified into a) primary objective b) secondary

objective and c) special objective. Primary objective of audit is to give a true and
fair view of the financial statements prepared by the accountant while the
secondary objective is to detect and prevent errors and frauds. It must be borne
in mind that due to test check nature, an Audit cannot give a true and correct
view on the financial statements.
 A number of advantages can be derived from getting the accounts audited by a

qualified auditor, such as early detection of errors and frauds, reliability of
accounts, statements of various types of claims, securing loans from banks and
other financial institutions, etc.
 Audit is classified into various types like statutory audit, internal audit
concurrent audit and forensic audit.
 RBI assesses and grades banks based on the CAMELSC rating model where RBI
assesses the Capital adequacy position, Asset quality, Management, Earnings
appraisal, Liquidity position and Systems and controls of the bank before ranking
them
3.3.10 Key words

Auditing, statutory audit, internal audit, true and fair view, LFAR, forensic audit
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1. RBI assesses and rates banks based on the _______________ rating model
every year.
a. CAMELSC c. Both a & b
b. External d. None of the above
2. ___________ Audit is one of the important parts of the overall internal

controls system.
a. Statutory c. Continuous
b. Balance sheet d. Internal
3. Audit of companies is an example of _____________.
a. Statutory c. Continuous
b. Balance sheet d. Internal
4. "A" in the term CAMELSC stands
a. Average quality c. Asset quality
b. Adequate quality d. None of the above
5. "C" in the term CAMELSC stands
a. Capital adequacy c. Credit worthiness
b. Capability d. None of the above
6. Which one is true in respect of concurrent audit
a. It is test checking
b. It is substantial checking
c. It increases the gap between the occurrence of a transaction and its
examination.
d. All of the above
7. forensic accountant has the skill in
a. Accounting c. Auditing
b. Investigation d. Both a & b
8. Audit safeguards the financial interest of
a. Investors c. Government
b. Customers d. All of the above
9. Audit can be used for
a. Settling of trade disputes c. Settling disputes among
b. Settling dividend staff members
d. Al of the above
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10. Audit is
a. Systematic
b. independent
c. Covers financial statements and all related records
d. All of the above
11. The primary objective of an auditor is
a. To report to the owners whether the financial statements gives a true and
fair view of the company’s state of affairs
b. To report to the owners whether the balance sheet and profit and loss
statement gives a true and fair view of the company’s state of affairs
c. To report to the customers whether the financial statements gives a true
and fair view of the company’s state of affairs
d. Both a & b.
3.3.12 Answer keys
1-a 2-d 3-a 4-c 5-a

6-b 7-d 8-d 9-a 10-d
11-d
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Lesson No. 3.4 Role of an Auditor & areas to be covered
3.4.1 Objectives
3.4.2 Role of an auditor
3.4.3 Items to be checked ob first day of audit
3.4.4 Areas to be covered
3.4.4.1 Credit area
3.4.4.2 Non - credit area
3.4.4.3 Computer
3.4.4.4 Branch Management
3.4.4.5 Compliance
3.4.5 Key words
3.4.6 Let's sum up
3.4.8 Answer keys
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3.4.1 Objectives
 Role of an auditor
 Areas to be checked on the first day of audit itself
 Areas to be covered under different banking functions
3.4.2 Role of an Auditor
1. The auditor should ascertain the level of observance of prescribed systems &
procedures of the bank, adherence to statutory and regulatory requirements,
testing of accuracy/ reliability of accounting & other records and timeliness of
submission of control returns.
2. Auditor should ensure that the Bank’s assets and the assets charged to the Bank
are safeguarded, data integrity is maintained and organizational goals are
achieved.
3. While auditing a branch/office, an Auditor should act as a Friend, Philosopher

and Guide. The Auditor should possess high degree of confidence and analytical
judgment. The Auditor should have:
a. High sense of integrity;
b. Great degree of common sense;
c. Sense of thoroughness and orderliness to complete his task systematically
and efficiently;
d. Sound knowledge of both the existing and emerging commercial banking
procedures and practices as also of the working of all
departments/sections of a branch;
e. Good grasp of instructions/circulars issued by the ho to the branches
regarding various aspects of their operations, so as to be able to guide the
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branch officials in complying with them;

f. Fair idea about sampling methods to enable him to select for scrutiny a
representative cross-section of transactions and to draw meaningful
conclusions;
g. Good communication skill
4. Auditor must follow practical approach

a. The Auditor should adopt constructive, corrective and practical approach
while auditing a branch/office. The Auditor should keep in mind that the
idealistic state of affairs₹ may not be possible since the job of an
Incumbent In charge is full of complexities calling for special skills to
ensure quality business growth.
5. Before final submission of report all the irregularities should be discussed with
incumbent/section in charge
6. Auditor must avoid Value Judgment
a. Passing of value judgment is not within the purview of an Auditor. Value
judgment has to be done at HO on the basis of the facts brought out in
the Inspection Report.
b. In serious cases, where officials are involved, it is imperative that
findings are arrived at after a thorough examination of all aspects and
ensuring cent percent correctness of the minutest details.
7. Auditor must give emphasis on spot rectification of irregularities

a. To achieve this objectives, auditor must hold meetings with Incumbent In
charge & Section In charges to discuss the various weak areas and
observations in branch functioning.
b. To meet the objective of spot rectification, Auditor can suggest the
following:
i. Root cause analysis
ii. Maintenance of Diary by Section In charges to develop ‘Compliance
Culture’ for implementing laid down Systems & Procedures
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iii. Counsel and educate Section In charges by advising ‘gaps’ in their

working
iv. Compliance of various functions laid down under Risk Based
Internal Audit system on an ongoing basis
8. Update and upgrade knowledge
a. The auditors should upgrade their professional skill with latest available
audit tools and techniques, update their knowledge from various
circulars issued by different Divisions of the bank & others sources like
newspapers, internet sites of RBI, IBA etc.
3.4.3 Items to be checked on first day of audit
1. Cash
2. Petty Cash
3. Postage
4. Stamps in Hand and Stock
5. Got Securities & other securities held on Investment a/c on behalf of HO.
6. Securities held against advances (Gold & Jeweler, IVPs etc.)
7. Articles in Safe Custody
8. Parcels
9. Securities Forms e.g. Drafts, FDRS, KCCs, Non-personalized Debit Cards, Blank
Cheque Books, Non-personalized Debit Cards, Internet Banking PINs etc.
3.4.4 Areas to be covered

Auditor should cover following areas. The areas & its detail mentioned below is an
indicative only
3.4.4.1 Credit Area

1. Vouchers relating to all Loan Accounts.
2. Temporary overdrafts allowed.
3. Excess accommodation allowed
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4. Proper documents taken and got filled up, properly executed, prescribed stamp
duty on documents with adhesive stamp cancelled.
5. Documents to be verified with Documents & BC Register as well as relative loan
accounts.
6. Recovery of service charges in loans sanctioned, enhanced or renewed, if any.
7. Pre-sanction appraisal in respect of Loans sanctioned, limits enhanced or
renewed.
8. Confirmation from the competent authority on the facilities allowed beyond
vested power.
9. Encashment of securities (FDRs, NSCs, Vikas Patras etc) on due dates and credit
in respective loan account.
10. Sanction of facilities as prescribed norms & guidelines.
11. Whether operations allowed in accounts in which Stock statement is not received
12. .End use/diversion of funds in cash credit accounts
13. Custody of loan documents/title deeds – during day/overnight
14. Equitable mortgage of IPs – Title deeds, Register etc., creation formalities,
original documents and insurance
15. Interest & other charges as per norms/circulars
16. Limitation expiry and its register.
17. Insurance register & its expiry
18. NPAs - Follow up, Notices, Diary, Advocate fees etc.
19. Proper attendance on the dates fixed by Courts & progress in hearings, if any.
20. Follow up and Review of the limits.
21. Renewal of CRs.
22. Recovery in NPA, irregular / sticky a/cs : correspondence &personal follow up
23. KYC norms have been adhered to
24. CIBIL / Credit Information Companies (CICs) recordshave been verified.
25. Vehicles financed by the bank are jointly registered within one month from the
date of disbursement of the loan amount.
26. All the terms & conditions of sanction have been complied with.
27. Stocks are being checked in rotation by different officials.
28. No DP is being allowed against old, deteriorated and un saleable stocks...
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3.4.4.2 Non-credit Area

1. All accounts opened during the previous day including their AOFs, Nomination etc.
2. All vouchers, high value items to be given priority and to be examined in detail
3. Checking of important book like cash memo book and cash reserve register, cash
book, log book etc. & tallying of Day Book ensuring that all vouchers are accounted
for.
4. Whether Control Returns prescribed is being checked by branch officials.
5. Correctness of interest paid on closed deposit accounts.
6. Observance of guidelines in respect of security forms in use.
7. Unauthorized access/control available to members of staff over the
computers/records/ documents of the bank/branch
8. Updating of pass books and statement of accounts.
9. Issue of pass books and statement of accounts.
10. Execution of standing instructions.
11. Instructions for stop payment of cheques and their timely noting.
12. Ensure that vouchers of all types are being tallied, stitched, sealed, signed and
recorded.
13. Proper custody of AOFs, Registers etc., during day time & overnight.
14. Joint custody by two officials, wherever prescribed
15. Passing of all debits in Suspense by Incumbent In charge
16. Disposal of blank cheque leaves returned in accounts closed.
17. Observance of guidelines while allowing transactions in a/cs opened during last six
months.
18. Any abnormal transaction in staff accounts.
19. Balancing of impersonal accounts.
20. Payment is not allowed on withdrawal slip without passbook. If allowed, permission
of incumbent is obtained. & any other irregularity.
21. Vouchers are handed over to Daftri against proper receipt.
22. Customers are properly attended and their queries are responded to promptly.
23. Time norms for discharging different jobs/services are being followed/adhered.
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3.4.4.3 Computer Area
1. Enabling & Disabling of User/Creation & Deletion of User and checking of the
Report
2. List of Authorized Users is generated and checked.
3. Secrecy of Password is maintained
4. Signature scanning, uploading & verification are being done.
5. Internet is not available on the CBS (Core banking Solution).
6. Backups are maintained as prescribed
7. Vendor is not allowed to perform routine jobs.
8. Security/Anti-Virus/ Networking aspects.
3.4.4.4 Branch Management

1. Timely opening & closing of Branch and observance of Public Hours, including
Lunch Hour Working, as per guidelines.
2. Observance of attendance by branch staff and also ensuring of timely
commencement of counter work.
3. Sub-Staff wearing Proper uniform.
4. Upkeep of Safe, Furniture & Fixture (SFF) and cleanliness in the branch
5. Expenses incurred by cash payment.
6. Security Alarm system in working condition
7. Whether CCTV (closed-circuit television) are functional.
3.4.4.5 Compliance
1. Previous Regular inspection report dated _____has been closed within stipulated
time frame.
2. All other Inspection Reports such as statutory audit report, RBI Inspection Report
IS Audit Report etc. have been closed within reasonable time.
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3. Daily / monthly / quarterly concurrent audit reports are promptly attended and
irregularities are rectified
3.4.5 Key words

CCTV, SFF, CBS, CIBIL, KYC
3.4.6 Let's sum up
While auditing a branch/office, an Auditor should act as a Friend, Philosopher and

Guide. The Auditor should adopt constructive, corrective and practical approach while
auditing a branch/office. The Auditor should keep in mind that the idealistic state of
affairs₹ may not be possible since the job of an Incumbent In charge is full of
complexities calling for special skills to ensure quality business growth. Auditor must
avoid Value Judgment. They must have good communication and skill & regular update
of knowledge.
Auditor must check certain areas/items on the first day of audit itself like cash, stamps,
parcels and security forms etc. while auditing a branch, auditor must check entire area
of branch functioning starting from branch management to areas of credit.
1. While auditing a branch auditor should check "Cash " item on

a. Middle of the audit c. Any day during audit
b. End of the audit d. First day of audit
2. On the first day of audit auditor should check following
a. Cash c. Security forms
b. Stamps d. All of the above
3. Auditor must have
a. Autocratic approach c. Practical approach
b. Democratic approach d. All of the above
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4. Auditor should check

a. An abnormal transaction c. Whether CCTV are non-
in staff account functional
b. Untimely opening & d. All of the above
closing of Branch
5. Auditor should check
a. Whether previous c. Whether previous
inspection report is closed inspection report is closed
within prescribed time. within fortnight time.
b. Whether previous d. Whether previous
inspection report is closed inspection report is closed
within weeks’ time. within one month time.
6. Which one is true?
a. Daily / monthly / b. CCTV must be functional.
quarterly concurrent audit c. Sub-Staff should wear
reports are promptly proper uniform
attended and irregularities d. All of the above
are rectified
7. Which one is true?
a. List of Authorized Use₹ is c. Signature scanning,
not generated and uploading & verification
checked. are being done quarterly.
b. Secrecy of Password is d. Internet may available on
maintained the CBS.
8. Which one is false?
a. Backups are maintained as c. Security/Anti-Virus/
prescribed Networking aspects.
b. Vendor is not allowed to d. None of the above
perform routine jobs.
9. Which one is false?
a. List of Authorized Use₹ is weekly.
generated and checked b. Monthly updating of pass
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book. quarterly.
c. Back ups are maintained d. All of the above
10. The auditor should have
a. No sense of integrity c. Average communication
b. Great degree of common skill
sense d. Both a & c
11. Which of the following areas should be covered by auditor during Computer
Audit?
a. Back ups are maintained c. No provision of
as prescribed Security/Anti Virus
b. Vendor is allowed to d. Both a & b
perform routine jobs.
3.4.8 Answer keys
1-d 2-d 3-c 4-a 5-a

6-d 7-b 8-d 9-d 10-b
11-a
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Lesson No. 3.5: Frauds- Classification, Reporting and Monitoring
3.5.1 Introduction
3.5.2 Classification of Frauds
3.5.3 Reporting to NABARD
3.5.4 Reporting to Board
3.5.5 Quarterly return
3.5.6 Cases of attempted fraud
3.5.7 Closure of fraud cases
3.5.8 Cases to be referred to Local police
3.5.9 Preventive measures in cheque related frauds
3.5.10 Reporting cases of Theft, Burglary, Dacoity and bank robberies
3.5.11 Legal Audit of Title Documents in respect of Large Value Loan Accounts
3.5.12 Key words
3.5.13 Let's sum up
3.5.15 Answer keys
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3.5.1 Introduction
Frauds have become quite a common occurrence in the banking sector. From the
medieval crimes such as robbery, arson and other crude forms of crime, present-day use
of technology has given rise to skillfully crafted and conducted frauds. The Indian
banking sector has experienced considerable growth and changes since liberalization of
economy in 1991. Despite the fact that the banking sector has a better regulatory
framework and it is well supervised, this sector experienced a variety of challenges when
it comes to illegal practices & financial frauds. Hence it is felt necessary that cooperative
bank officials must know something about fraud, its prevention, classification, reporting
to the appropriate regulators and other aspects.
3.5.2 Classification of Frauds

a. Based on the provisions of the Indian Penal Code (IPC), frauds have been
classified as under:
i. Misappropriation and criminal breach of trust.
ii. Fraudulent encashment through forged instruments, manipulation of
books of account or through fictitious accounts and conversion of
property.
iii. Unauthorized credit facilities extended for reward or for illegal
gratification.
iv. Cheating and forgery.
v. Any other type of fraud not coming under the specific heads as above
b. Negligence and cash shortages.
i. Negligence & cash shortages will be classified as fraud only when the
intention to cheat / defraud is suspected / proved. However, there is
certain circumstance where these types of activities will be treated as
fraud even if their mala fide intentions are not suspected/proved.
These are
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1. Cases of cash shortages more than ₹ 10,000 (including ATMs)

2. Cases of cash shortages more than ₹ 5,000 if detected by
Management / Auditor / Inspecting Officer and not reported on
the day of occurrence by the persons handling.
c. In case of frauds involving forged negotiable instruments, paying banker, not
the collecting banker, will report just to avoid duplication.
d. In case negotiable instrument is genuine but being not collected by true
owner, collecting banker has to report.
3.5.3 Reporting to NABARD
 Frauds involving amounts of less than ₹ 1.00 lakh: Not to be reported

individually rather be reported to NABARD in a quarterly statement as
prescribed.
 Frauds involving amounts of ₹ 1.00 lakh and above: Report to NABARD
through ENSURE portal within three weeks from the date of detection of
fraud in DoS-FMS-1.
 Frauds in borrowal accounts involving an amount of ₹ 20.00 lakh and above:
Part B of DoS-FMS-1 should also be filled in properly in addition to the above.
 Those cases, where central investigating agencies have initiated criminal
proceedings suo-moto and/or where the NABARD / Reserve Bank of India
has directed that such cases be reported as frauds, should also be report as
fraud.
 Delays in Reporting of Fraud; Staff accountability must be fixed in respect of
either incomplete submission of reports or delays in reporting of fraud cases
to NABARD.
3.5.4 Reporting to Board

 All frauds of ₹ 1.00 lakh and above are reported to their respective Boards
promptly on their detection.
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 Such reports should also accompany the report of failure on the part of erring
officials and controlling authorities and action taken against such officials.
3.5.5 Quarterly return
 Quarterly outstanding of fraud in DoS-FMS-2 within 30 days of end of the

quarter through ENSURE should be uploaded.
 Part A of DoS-FMS-2 is related with details of frauds outstanding as at the
end of the quarter whereas Part B of the report gives category-wise and
perpetrator-wise details of frauds reported during the quarter.
 Quarterly progress report of each fraud cases involving an amount of ₹ 1.00
lakh and above should be uploaded through ENSURE portal in DoS-FMS-2.
3.5.6 Cases of attempted fraud
 Cases of attempted fraud need not be reported to NABARD.

 Cases of attempted frauds involving an amount of ₹20.00 lakh and above
should be placed before the Audit Committee of respective Board (ACB). The
report should cover following points
o The modus operandi of the attempted fraud.
o How the attempt did not materialize into fraud or how the attempt
failed/ was foiled.
o The measures taken by the bank to strengthen the existing systems
and controls.
o New systems and controls put in place in the area where fraud was
attempted.
3.5.7 Closure of fraud cases
 Report to NABARD through ENSURE regarding closed fraud cases with

reasons thereof.
 Quarterly closed cases of fraud through FMS 3.
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 Banks should report only following cases as closed after obtaining prior
approval from respective Regional office of NABARD.
o The fraud cases pending with Police/Court are finally disposed of.
o The examination of staff accountability has been completed
o The amount of fraud has been recovered or written off.
o Insurance claim wherever applicable has been settled.
o The bank has reviewed the systems and procedures, identified as the
causative facto₹ and plugged the lacunae and the fact of which has
been certified by the appropriate authority (Board / ACB)
 Banks are permitted to close following types of fraud cases where amount
involved is up to ₹1 lakh.
o The investigation is on or challan/ charge sheet has not been filed in
the Court for more than three years from the date of filing of First
Information Report (FIR) by the Police or
o The trial in the courts, after filing of charge sheet/challan by Police,
has not started or is in progress.
3.5.8 Cases to be referred to Local Police:
As a general rule, the following cases should invariably be referred to the State
Police
 Cases where amount involved is of ₹1 lakh and above committed by outside₹
on their own and / or with the connivance of bank staff / officers - Reported
by the Regional Head of the bank to a senior officer of the State
CID/Economic Offenses Wing of the State concerned.
 Cases where fraud is committed by bank employees & amount involved
exceeds ₹10000  Reported to the local police station by the bank branch
concerned.
 All fraud cases of value below ₹ 10000 involving bank officials  Referred to
the Head office of the bank, who after scrutinizing each case will direct the
bank branch whether to report to the local police station for further legal
action or not.
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3.5.9 Preventive measures to be taken in Cheque related Frauds.

The list is indicative only
 Ensuring the use of 100% “CTS – 2010” compliant cheques.
 Strengthening the infrastructure at the cheque handling Service Branches and
bestowing special attention on the quality of equipment and personnel posted
for CTS based clearing, so that it is not merely a mechanical process.
 Ensuring that the beneficiary is KYC compliant so that the bank has recourse
to him/her as long as he/she remains a customer of the bank.
 Examination under UV lamp for all cheques beyond a threshold of say, ₹2
lakh.
 Checking at multiple levels, of cheques above a threshold of say, ₹5 lakh.
 Close monitoring of credits and debits in newly opened transaction accounts
based on risk categorization.
 Sending an SMS alert to payer/drawer when cheques are received in clearing.
 The threshold limits can be reduced/ increased depending on the volume of
cheques handled by the banks or its risk appetite in due course with the
approval of the respective board of the bank.
 In case of large value and or suspicious transactions
o Alerting the customer by a phone call and getting the confirmation
from the payer/drawer.
o Contacting base branch in case of non-home cheques
 Confidential information viz., customer name / account number/signature,
cheque serial numbers and other related information are neither
compromised nor misused either from the bank or from the vendors’
(printers, couriers etc.) side.
 In case of collection of altered/fake cheque involving two or more branches of
the same bank, the branch where the altered/fake cheque has been encashed
or the branch who has released the payment (in case of CBS) should report
the fraud to the Head Office.
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3.5.10 Reporting Cases of Theft, Burglary, Dacoity and Bank Robberies
 Banks should report instances of bank robberies, dacoities, thefts and

burglaries immediately on their occurrence to NABARD through “ENSURE”
portal, in DoS – FMS-4a.
 Banks should also submit a quarterly consolidated statement in DoS-FMS-4
in “ENSURE” covering all cases pertaining to the quarter. This may be
submitted within 30 days of the end of the quarter to which it relates.
 Banks which do not have any instances of theft, burglary, dacoity and / or
robbery to report during the quarter, may submit a nil report.
3.5.11 Legal Audit of Title Documents in respect of Large Value Loan

Accounts
 There should be periodic legal audit and re- verification of title deeds and
other documents with relevant authorities in respect of all credit exposures of
₹ 1.00 crore and above to as part of regular audit exercise till the loan stand
fully repaid.
 A quarterly review notes to this effect should be furnished before the Board /
Audit Committee of the Board (ACB) on an ongoing basis.
3.5.12 Key words
IPC, NABARD, UV lamp, CTS, ACB
3.5.13 Let's sum up

Frauds have been classified on the basis of certain provisions of IPC and also on the
basis of negligence and cash shortage even if their maladies intentions are not
suspected/proved.
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All the fraud cases involving an amount of less than ₹ 1 lakh should be repotted to
NABARD quarterly and those cases where amount involved is more than ₹ 1 Lakh, it is
required to be reported within three weeks of their detection in DoS-FMS-2.
Quarterly outstanding of fraud in DoS-FMS-2 within 30 days of end of the quarter

through ENSURE should be uploaded.
Cases of attempted fraud need not be reported to NABARD &Cases of attempted frauds
involving an amount of ₹20.00 lakh and above should be placed before the Audit
Committee of respective Board (ACB).
Cases where amount involved is of ₹1 lakh and above committed by outsiders on their
own and / or with the connivance of bank staff / officers  Reported by the Regional
Head of the bank to a senior officer of the State CID/Economic Offenses Wing of the
State concerned.
Cases where fraud is committed by bank employees & amount involved exceeds ₹ 10000
 Reported to the local police station by the bank branch concerned.
There are few preventive measures in cheque related frauds like use of UV lamps, calling
to customers, use of "CTS-2010 compliant "cheques etc.
There should be periodical legal audit of documents and titles of loan exceeding ₹ 1
crore and its quarterly report should be furnished before the board/ACB.

1. Reporting of frauds to NABARD involving an amount of less than ₹ 1.00 lakh is
a. Monthly d. Within 30 days from
b. Quarterly detection
c. Half yearly
2. Reporting of frauds involving an amount of more than ₹ 1.00 lakh is
a. Monthly d. Within 30 days from
b. Quarterly detection
c. Half yearly
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3. Frauds involving an amount of more than ₹ 1.00 lakh is reporting in

a. DoS-FMS-1. c. DoS-FMS-3.
b. DoS-FMS-2. d. DoS-FMS-4.
4. Cases of cash shortages --------------is treated as fraud
a. More than ₹ 1000 c. More than ₹ 10000
b. More than ₹ 5000 d. All of the above
5. In case negotiable instrument is genuine but being not collected by true owner, --
-------------- has to report
a. Collecting banker c. Both a & b
b. Paying banker d. All of the above
6. In case of frauds involving forged negotiable instruments-----------------has to
report.
a. Collecting banker c. Both a & b
b. Paying banker d. All of the above
7. periodic legal audit and re- verification of title deeds and other documents is
done in loan accounts exceeding
a. ₹ 20 lakh c. ₹ 100 lakh
b. ₹ 50 lakh d. ₹ 10 crore
8. UV lamp should be used in passing of cheques of
a. ₹ 1 lakh & above c. ₹ 5 lakh & above
b. ₹ 2 lakh & above d. None of the above
9. There should be multiple checking in passing of cheques of
a. ₹ 1 lakh & above c. ₹ 5 lakh & above
b. ₹ 2 lakh & above d. None of the above
10. In case of large value and or suspicious transactions, there should be
a. Alerting the customer by a confirmation from the
phone call and getting the payee
confirmation from the c. Contacting base branch in
payer/drawer. case of non-home cheques
b. Alerting the customer by a d. Both a & c
phone call and getting the
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11. In case of collection of altered/fake cheque involving two or more CBS branches
of the same bank the branch --------------------- should report the fraud to the
Head Office
a. Who has released the c. Base branch
payment d. Any one of the above
b. Who has issued the cheque
12. In Case where amount involved is of ₹ 1 lakh and above, committed by outside₹
on their own and / or with the connivance of bank staff / office₹, -------------
should report to police.
a. Branch head c. General manager
b. Regional head d. Chief Executive Officer
13. In Case where amount involved is of ₹10000 to less than ₹1 lakh, committed by
bank staff -------------should report to police.
a. Branch head c. General manager
b. Regional head d. Chief Executive Officer
14. Banks are permitted to close the fraud cases (up to ₹1 lakh) where the charge
sheet has not been filed in the Court for -----------------------from the date of filing
of First Information Report (FIR) by the Police
a. More than three years c. More than two years
b. Up to three years d. Up to two years
3.5.15 Answer keys
1-b 2-d 3-b 4-c 5-a

6-b 7-c 8-b 9-c 10-d
11-a 12-b 13-a 14-a
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Additional Reading
1. Fundamentals of Accounting; Dr.N.K.Agrawal & Dr. R.K. Sharma; Franksons,
Darya Ganj, New Delhi
2. Fundamentals of Accounting; Dr. T.P. Ghosh; Sultan Chand & Sons, New Delhi.
3. Fundamentals of Accounting; Dr. S.N. Maheshwari & Dr. S.K. Maheshwari; Vikas
Publishing House
4. Double Entry Book Keeping; T.S. Grewal; Sultan Chand & Sons, New Delhi.
5. Principles and Practice of Accountancy; R.L. Gupta and V. K. Gupta; Sultan
Chand and Sons, New Delhi.
6. Introduction to Accounting; T.S, Grewal; S. Chand and Co., New Delhi
7. Analysis of Balance Sheet; N S Toor; Skylark Publications, New Delhi
8. An Introduction to Accountancy; S N Maheshwari and S K Maheshwari; Vikash
publishing House Pvt. Ltd., New Delhi
9. Financial Accounting for Managers; Dr. Saroj Kumar; Thakur Publishers,
Lucknow
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Certified Professional in Cooperative

Banking (CPCB)-Level-I Certification Course

Module 4: Accounting and

3.3.2 Introduction ....................................................................................................................... 174

ACB Audit Committee of Board

NABARD National Bank for Agriculture and Rural Development

UNIT ANALYSIS AND INTERPRETATION OF FINANCIAL

Lesson No. 1.1 Concepts, Conventions and Principles

1.1.2Meaning and Purpose of Accountancy

1.1.3 Basic Terms in Accountancy

1.1.4 Accounting Principles

1.1.5 Accounting Concepts

1.1.6 Accounting Conventions

1.1.7 Let us sum up

1.1.8 Key words

1.1.9 Multiple choice questions

1.1.10 Answer keys

 The meaning and purpose of accountancy

1.1.2 The meaning and purpose of accountancy

Revenue expenditure: It is the expenditure, the benefit of which is received within

1.1.4. Accounting Principles

 Accounting Concepts and

1.1.5. Accounting Concepts

Separate Entity Concept

Money Measurement Concept

Accounting Cost Concept

 Depreciation is defined as the reduction of recorded cost of a fixed asset, as

Dual Aspect Concept

Going Concern Concept

Accounting Period Concept

1.1.6. Accounting Conventions

1.1.7 Let’s sum up

Accounting Concepts Accounting Conventions

Consistency Materiality Conservatism Full Disclosure

Matching Accounting period Going Concern

1.1.8 Key words

1.1.9 Multiple Choice Questions

a. When cash is received or c. When profit is computed

a. Business entity concept c. Economic entity concept

a. Sole proprietorship form c. Corporate form of

8. Which accounting principle/concept allows accountants to ignore other

9. The art of recording, classifying and summarizing is called:

a. Debtor c. Prepaid expenses

1.1.10 Answer keys

1-b 2-b 3-c 4-d 5 6-b 7-c 8-a 9-b 10-d

1.2.2 Different accounting systems

1.2.3 Flow of an accounting transaction

1.2.4 Source documents

1.2.5 Types of vouchers

1.2.6 Identifying two accounts in a transaction

1.2.7 Three golden rules of accounting

1.2.8 Five golden rules of accounting

1.2.9 Let’s sum up

1.2.10 Key words

1.2.11 Multiple choice questions

1.2.12 Answer keys

The objectives of this lesson are to understand:

 Different accounting systems