Financial and Management Accounting

Unit 7

Unit 7
Structure: 7.1 7.2 Final Accounts – Introduction Adjustments before preparing final accounts 7.2.1 7.2.2 7.2.3 7.2.4 7.2.5 7.2.6 7.2.7 7.2.8 7.2.9 Outstanding expenses Prepaid expenses Accured Income Income received in advance Depreciation Bad Debts Provision for doubtful debts Reserve for Discount on Debtors Reserve for discount on creditors

Final Accounts

7.2.10 Closing Stock 7.3 7.4 7.5 7.6 7.7 7.8 Trading Account Preparation of Trading Account Profit and Loss Account Preparation of Profit and Loss Account Balance Sheet – Meaning Preparation of Balance Sheet

Learning Objectives: After studying this unit, you should be able to understand the following: 1. To understand the process of preparing the final accounts of a business organization from Trial balance. 2. To incorporate such transactions left out and various adjustments with regard to transactions taking place after the trial balance but relating to the current period.

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7.1 Final Accounts – Introduction
The last step of accounting process is preparation of final accounts. Final accounts are Trading account and Profit and Loss Account with respect to any trading organization. If it is non trading organization like a club or an Educational Institution, Receipt and Payment Account and Income and Expenditure Account are the final accounts. In case of a manufacturing unit, a Manufacturing account is prepared in addition to Trading Account. Profit and Loss Account is prepared by all trading and manufacturing units. Balance Sheet is closely associated with these final accounts. But Balance Sheet is not an account. It is a statement of assets and liabilities of business organization prepared at the final stage of the accounting process. Therefore balance sheet is regarded as a part of final accounts. The purpose of preparing final accounts is to find out the end result of business at the end of an accounting period, may it be profit or loss. The basis for preparing final accounts is the Trial Balance. For Trial Balance, the ledger balances are the root. For ledger accounts, the journal entries or entries in the subsidiary books (Books of original entry) are the roots. Hence the final accounts reflect the original business transactions, which are systematically and scientifically recorded, classified, and analyzed. Final accounts provide bundle of information for decision making activities. Objectives: 1. To know the meaning and purpose of final accounts 2. To identify the items of Trading Account 3. To identify the items of Profit and Loss Account 4. To identify the items of assets and liabilities of a Balance Sheet and modes of preparing it.
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5. To know the adjustments such as Reserve for bad debts, Reserve for discounts on Debtors, Reserve for discount on Creditors, bad debts out side the trial balance. 6. To understand the adjustments like depreciation on assets, closing stock, stock lost in fire, goods given as samples, goods used for personal purpose etc., 7. To know the adjustments of prepaid expenses, outstanding expenses, pre-received incomes, outstand incomes etc. 8. To prepare Balance Sheet without any adjustments from trial balance. 9. To prepare Balance Sheet with adjustments.

7.2 Adjustments before preparing final accounts
The Generally Accepted Accounting Principles (GAAP) supports the accrual basis of accounting, according to which revenue is recognized when it is earned and expenses are recognized when they are incurred, irrespective of their actual receipt or actual payment. If the accrual basis of accounting is used, adjusting entries are required at the end of the period to record any changes in assets, liabilities, revenue incomes, revenue expenses, previously unrecognized. Adjusting entries are regarded as internal transactions. For instance, salaries are paid in advance to a few employees and the excess paid in the current period, should be adjusted to the coming period and what is paid in advance now should not be charged against the revenues relating to the current period. Similarly, insurance paid in advance, rent paid in advance etc., Like wise incomes received in advance should not be considered for the current period. On the other hand, expenses yet to be paid for the current period should be charged against the current period’s income. On the same lines, incomes yet to be received for the current period should be considered as incomes
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for the current period whether actually received in cash or not. Every asset is subject to wear and tear and the value of the asset gets reduced even if the loss on account of this is not recorded by means of a journal entry. Some stock of goods at the end of the period is left over and it has to be valued and be taken to accounts for fair computation of profit. Such internal adjustments have to be made and recorded before preparing Trading Account, Profit and Loss Account and Balance Sheet. The adjustments to be incorporated are briefly described in the following paragraphs. Self Assessment Questions 1: 1. Final account are prepared from trial balance, trial balance from ledger accounts and ledger account from books of original entry. So final accounts are reflection of original transaction (state True / False ). 2. Final accounts speak about profit or loss as on a particular day ( state True and False ) 3. Balance sheet tells the value of assets and liability as standing an a the last day of accounting period ? ( True / False ). 4. Adjustment in final accounts is necessitated because of accrual basis of accounting (state True / False ). 5. Adjusting entries are also regarded as ______ . 6. Adjustments such as outstanding and prepaid / received items are needed to find out _____________. 7. Adjustment entries are made before preparing tracking and P & L and balance sheet (True/False ). 7.2.1 Outstanding expenses Expenses due but not yet paid are known as outstanding expenses. Wages, salaries, rent, commission etc payable in the current month are paid in the following month. If final accounts are prepared for year ending 31st December, then the expenses payable for December will be paid in January of next year. The extent to which the amount belongs to the current year but
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payable in the next year is called outstanding expenses. To record that aspect, the journal entry drawn in the Journal proper is: Concerned Expenses account Dr To outstanding Expenses account. Outstanding expenses account indicates liability for the current year and it will appear in the balance sheet. Example: Advertisement expenses for year 31-12-2003 outstanding is Dr 5000 5000

Rs.5000. The journal entry is Advertisement expenses account To Outstanding expenses account Self Assessment Questions 2: 1. Expenses due but not yet paid are known as ___________. 2. What is the entry if salaries are outstanding ? 3. If ‘outstanding expenses’ appear in trial balance, what does it mean ? 4. Outstanding expenses appear an assets side of balance sheet ( state True / False ). 7.2.2 Prepaid Expenses Expenses paid in advance are regarded as prepaid expenses. Prepaid expenses form an asset and therefore prepaid expenses account is debited. For example, insurance premium is paid from April, 2004 to March, 2005 and the amount is Rs.3600. The financial year ends by 31st December, 2004. Therefore the premium relating to Jan, Feb and Mar of 2005 Rs.900 is said to have been paid in advance. To record this internal adjustment, the entry is Prepaid Expenses account To Insurance account Dr 900 900

Note that outstanding or prepaid expenses accounts are regarded as personal accounts.

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Self Assessment Questions 3: 1. Expenses paid even before incurred. They are know as _____. 2. Prepaid expenses appear on the asset side of balance sheet. ( state True / False). 3. Opening balance of prepaid insurance is Rs 1000; insurance paid during the year Rs. 5600; Insurance paid in advance include in the above is Rs 800: Find out actual expenditure for insurance for the current year. 4. Prepaid expenses account is a personal account ( True / False). 7.2.3 Accrued Income Accrued income is also called outstanding income. Outstanding income account is a personal account and it represents an asset. This account is credited and the concerned income account is debited in the journal proper as an adjusting entry. The entry is Outstanding incomes account Dr To Concerned income account Example Interest accrued on Fixed Deposit of Rs 200000 at 12% simple interest on 31-12-2006, not yet received. The entry is Outstanding incomes account Dr To interest on FD account 24,000 24,000

Outstanding Income account appears as an asset in the balance sheet. Self Assessment Questions 4: 1. Income earned but not received is called ____________. 2. Outstanding income is an asset ( state True / False ). 3. Outstanding income is a personal account. (True / False ).

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7.2.4 Income received in advance Just as income is accrued, there are instances where income is received in advance. The amount is shown as liability in the balance sheet and it shows a credit balance. The adjusting entry to record the income received in advance is Concerned item of income account Dr To Income received in advance account Example Rent received for one year from 1-4-2005 to 31-3-2006 Rs.48000. Accounts are finalized on 31-12-2005. Therefore rent received for January, February and March of 2006 is said to have been received in advance Rs.12000. The entry is Rent received account Dr To Income received in advance a/c Self Assessment Questions 5: 1. Any income received in advance is a liability (state True / False ). 2. What is the adjusting entry for rent received in advance ? 3. Income received in advance in the current year is ________ from the unearned item of income received. 7.2.5 Depreciation Depreciation is reduction in the value of an asset due to constant use of the same, which is called wear and tear. Fixed assets like, buildings, plant, machinery, furniture etc., are subject to depreciation. Whenever, an asset is depreciated, its value goes down and therefore it is a loss to the organization. Depreciation account is debited and the concerned asset account is credited. The item of depreciation may appear in the trial balance, which means that already the concerned asset is reduced by the amount of depreciation. If depreciation is given as an additional adjustment,
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then the depreciation amount should be charged against profit and loss account on one hand and the concerned asset account is reduced on the other hand in the balance sheet. There are two popular methods of depreciation, namely fixed installment method and reducing balance method. In fixed installment method, depreciation is calculated on cost of the asset. In case of reducing balance method (Diminishing balance method), the depreciation is charged on the reducing balance of the book value of the asset. Reducing balance method is more popular and well recognized. Example Building is of the book value of Rs.400000. It is depreciated at 10% on fixed installment method. Show the journal entry and how does it appear in the balance sheet? Solution The entry for depreciation is Depreciation account Dr 40,000 To Building account 40,000

Depreciation being a loss is transferred to profit and loss account and in the balance sheet, the value of Building is shown as Rs.400000 – 40000 = 360000. Note: For the second year the depreciation will be Rs.40000 if the asset is depreciated under fixed installment method. If it is depreciated under reducing balance method, the depreciation for the second year is Rs.36000 (10% of 360000). Self Assessment Questions 6: 1. Depreciation is for __________ of an asset. 2. What entry is drawn if depreciation is provided ?
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3. When depreciation account is transferred to P & L A/c , what entry do you draw ? 4. If depreciation to be provided in the adjustments, what do you understand by this ? 5. What is the method of depreciation recognized by Indian Income Tax Act? 6. If depreciation appears in the trial balance, what does it indicate ? 7.2.6 Bad Debts Bad debts are those debts which are not recovered. Bad debts form loss to the business and reduce the amount of debtors. Since bad debts are losses, they are debited and the debtor’s account is credited because the outstanding amount of debtors comes down. If bad debts are identified well before preparing trial balance, then bad debts appear in the trial balance and they should be taken to the debit side of profit and loss account. Since debtors account is already reduced by the amount of bad debts, it does not require any further adjustment in the balance sheet. If bad debts are shown outside the trial balance, which means that they are identified after the preparation of Trial Balance, then two adjustments should be incorporated. One – bad debts should be charged against profits in P & L A/C and the second – the debtor’s account should be reduced by the amount of bad debts in the balance sheet on the asset side. Example The sundry debtors for the year 2005 are Rs.50000. The bad debts amounted to Rs.4000 as on 31-12-2005 already shown in the trail balance. Write off further bad debts Rs5000. Show how the above internal adjustments appear in the final accounts.
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Solution  There are bad debts shown in the trial balance Rs4000 and not shown in the trial balance Rs.5000. To incorporate those bad debts not yet shown in the trial balance, the adjusting entry is Bad debts account   Dr 5000 5000 To Debtor’s account

In the profit and loss account of 2005, the total bad debts appearing on the debit side are Rs. 9000(4000 + 5000) In the balance sheet, on the asset side, the amount of debtors is Rs45000(50000 -5000).

Self Assessment Questions 7: 1. Unrecovered debts are called ______. 2. Bad debts are not expenses but they form losses. (state True / false ) 3. What is the entry made in journal proper, if bad debts are recorded. 4. What entry do you make to close the bad debts ? 5. What impact bad debts have on profits ? 6. If bad debts are recovered, what entry can be drawn ? 7.2.7 Provision for Doubtful Debts Debts that can not be recovered are called bad debts but debts, the recovery of which is doubtful, are called doubtful debts. From the past experience of the business proprietor, what percentage of good debts may become bad in future, can be estimated and in the current year itself an equal amount of profit be set aside. This provision is known as Reserve for Bad Debts or Provision for Doubtful Debts or Reserve for Doubtful Debts. Since the provision for bad debts is a charge against current year profit, the adjusting entry is to debit P & L A/C and credit Provision for Bad Debts Account.
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Profit and Loss Account

Dr

To Provision for bad debts account Provision for bad debts is a liability to be incurred in future and so it should appear on the liability side of balance sheet. However, the convention is RBD (Reserve for Bad and Doubtful Debts) is deducted from the amount of good debtors. The important note here is that RBD is computed as a percentage of good debts, which means total debtors minus bad debts unadjusted. Provision for bad and doubtful debts is a running account and every year the amount keeps on changing because from the provision made in the current year, bad debts occurring in the following year have to be adjusted and additional amount of provision to be made is calculated. Every year, the amount transferred to P & L A/C is B + N – O, where B stands for bad debts; N stands for new provision and O stands for old reserve. For example, the old reserve stands at Rs.15000 and bad debts to be adjusted is Rs4000 and new reserve to be maintained is Rs18000. The amount to be charged against profits in P&L A/C is Rs.7000 (4000 + 18000 – 15000). The formula can also be shown as N - O + B = 18000 – 15000 + 4000 = 7000 Self Assessment Questions 8: 1. What is the difference between Bad debts and doubtful debts? 2. Provision is made for Debts which have become bad (state True / False). 3. Provision for Doubtful debts is a change against the profits of the firm (state True / False ) 4. Bad debts incurred in the subsequent period are written off against reserve for bad debts (state True / False ). 5. What is the entry for writing off of bad debts against RBD?
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6. If RBD is freshly to be provided, what entry can be draw? 7. RBD is calculated on debtors which are good and so any bad debts out side trial balance should be deducted out of total debtors (state True / False ). Illustration: On 1st January 2006, the RBD account stood at Rs.9000 in the books of a merchant. The bad debts written off during the year ended 31st December, 2006 amounted to Rs.4800 and Sundry Debtors stood at Rs.480000. It was desired to maintain the reserve for bad debts at 5% on Debtors. During the year 2007 bad debts written off amounted to Rs.12000 and sundry debtors on 31st December 2007 amounted to Rs.380000.As usual 5% reserve was required. Show the journal entries for recording the above transactions and write up the bad debts reserve account. Solution Journal Entries
Date 2006 Dec, 31
st

Particulars Bad debts account Dr

LF

Debit Rs. 4800

Credit Rs. 4800

To Sundry Debtors Account (Being the bad debts written off)

Dec, 31

st

Bad Debts Reserve account To Bad Debts account

Dr

4800 4800 19800 19800

Dec 31

st

(Being bad debts set off against RBD) Profit and Loss Account Dr To Bad Debts Reserve account (Being additional RBD made to bring the reserve to 5% of 480000)

2007 Dec, 31
st

Bad debts account (Being bad debts written off )

Dr

12000 12000

To Sundry Debtors account

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Bad debts Reserve account Dr Dec 31
st

To bad debts account (Being bad debts written off against RBD) Profit and loss Account Dr To Bad debts reserve account (Being additional RBD made to bring the reserve to 5% of 380000)

12000

12000

Dec 31st

7000

7000

NOTE: On January 1st 2006, the RBD account stands at Rs9000 and during the year the actual bad debts are Rs4800 and so there is unused balance of Rs.4200 (9000 -4800). It is desirable to have reserve of 5% of 480000 – Rs24000. Therefore additional reserve required to be provided in P & L A/C is Rs19800 (24000 – 4200). Similarly during 2007 the actual bad debts are Rs.12000 and the available reserve is used for writing it off. Still there is a balance left over is Rs.12000 (24000 – 12000). The additional reserve to be maintained is 5% of 380000, that comes to Rs19000. So the additional amount to be provided in P & L A/C in 2007 is Rs.7000 (19000 – 12000). Reserve for Bad Debts Account Dr
Date 2006 Dec, 31
st

Cr
Particulars J F Amount Rs. 4800 24000 28800 2007 To bad debts To balance c/d Total 12000 19000 31000 Jan 1
st

Date 2006

Particulars

J F

Amount Rs. 9000 19800 28800 24000 7000 31000

To bad debts To balance c/d Total

Jan, 1

st

By Balance b/d By P&L A/C Total By balance b/d By P&L A/C Total

Dec 31st

2007 Dec,31st

Dec 31st

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

To Provision for discount on debtors account Just as in the case of provision for bad and doubtful debts, the bad debts are first written off against provision for bad debts and later the required amount of provision is provided in the P&L A/c, similar procedure takes place in the case of provision for discount on debtors. The following guide lines may be kept in mind while dealing with the reserve for discount on debtors 1. If a reserve for discount on debtors is not existing and cash discount is allowed, then transfer the discount to P&L account. 2. Any fresh reserve for discount on debtors is to be made, debit the P&L A ccount with the amount of reserve.

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3. If provision for discount on debtors exists at the time of providing discount, then write off the discount from the provision already made for the purpose. 4. New provision should then be calculated and only as much as required to bring the existing provision to the new figure should be debited to P&L Account. 5. If the new provision required is lower than the provision already existing (old), then the difference shows profit and transfer the same to P&L Account. Self Assessment Questions 9: 1. what is the aim of giving cash discount ? 2. If discount is allowed against receivables, what entry do you draw in journal proper? 3. Provision for Discount on debtors is a charge against P & L a/c. (state True / False). 4. Provision for discount on debtors appears as a liablility in the balance sheet ( state True / False ) 5. What is the basis for calculating provision for discount an debtors? Illustration The following items are found in the trial balance of Praksh on 31st December 2000. Sundry Debtors Bad Debts written off Discount allowed to Debtors Reserve for Bad and doubtful Debts 31-12-1999 Reserve for discount on Debtors 31-12-1999 Rs. 160000 9000 1800 16500 3200

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You are required to provide for the bad and doubtful debts at 5% and for discount on debtors at 2%. Give necessary journal entries and show bad debts account, bad debts reserve account, discount account and provision for discount on debtors account. Solution
Date 2000 st Dec, 31 Particulars RBD account Dr LF Debit Rs. 9000 9000 Credit Rs.

To Bad Debts account (Being bad debts written off against existing RBD)

Dec 31st

P & L Account

Dr

500

To RBD account (Being addition to RBD to make the new RBD equal to 5% of 160000) Dec 31
st

500

Reserve for discount on debtors account Dr To Discount on Drs A/c (Being discount on debtors written off against Reserve for discount on Debtors)

1800

1800

Dec 31st

P & L Account

Dr

To Reserve for discount On debtors account ( Being additional reserve made to make the new reserve for discount on debtors to 2% of 152000)

1640 1640

NOTE: 1. The amount debited to P&L Account towards RBD is computed as follows Old RBD Less Bad debts = = Rs. 16500 9000
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Balance = New RBD @5% on160000 = RBD to be provided =

7500 8000 500 (8000-7500)

2. The amount debited to P&L Account towards Reserve for Discount on Debtors is computed as follows: Good Debtors = 160000 – 8000 (New RBD)=152000 Old Res for Dis On Drs = Rs. 3200 Less Discount on Drs = 1800 Balance Reserve = 1400 New Res for Disc at 2% On good drs 152000 = 3040 Res for Discount to be Provided now = 1640 (3040 -1400) Bad Debts Account Dr
Date 2000 Dec, 31
st

Cr
Particulars JF Amount Rs. Date 2000 To Sundry debtors account Total Dec 31st By RBD account 9000 9000 Total 9000 9000 Particulars JF Amount Rs.

Reserve for Bad Debts Account Dr
Date 2000 Dec, 31
st

Cr
Particulars JF Amount Date Rs. 2000 To bad debts To balance c/d Total 9000 Jan, 1 17000
st

Particulars

JF

Amount Rs.

By Balance b/d By P&L A/C Total

16500 500 17000

8000 Dec 31st

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Discount on Debtors Account Dr
Date 2000 Dec, 31
st

Cr
Particulars JF Amount Rs. Date 2000 To Sundry debtors account Total Dec 31st By Reserve for Discount on 1800 Debtors A/C 1800 Total 1800 1800 Particulars JF Amount Rs.

Dr
Date 2000 st Dec, 31

Reserve for Discount on Debtors Account
Particulars JF Amount Rs. Date Particulars JF

Cr
Amount Rs. 3200 1640 4840

To Discount on Debtors To balance c/d Total

2000 st 1800 Jan, 1 By Balance b/d 3040 Dec 31st By P&L A/C 4840 Total

In the balance sheet, the Sundry debtors are reduced by bad debts shown out side the trial balance, the new RBD, discount on debtors shown out side the trial balance and the new Reserve for discount on debtors. 7.2.9 Reserve for discount on creditors Just as reserve is for discount on debtors is created, reserve for discount on creditors is also created. Businessman expects that he would receive discounts from suppliers (creditors), when the businessman remits cash to them. Anticipating some percentage of creditors being received as discount in the coming year, the business proprietor makes a provision for the expected income in the current year itself. Discount on creditors is an income and therefore reserve for discount on creditors is debited and profit and loss account is credited to show it as anticipated profit. In the subsequent year, when discount on creditors is actually received, it is first set of against provision for discount on creditors and the difference between the new provision for discount on creditors and the balance of old provision left over is carried to P&L Account.
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Discount on creditors is income and to that extent the creditors due is reduced. So the journal entry to record them is Creditor’s account Dr To discount on creditors account Later if the discount received is adjusted against reserve for discount on creditors, the entry will be Discount on creditor’s account Dr To Reserve for discount on creditors When provision for discount on creditors is made in P&L Account, the entry will be Reserve for discount on creditors account Dr To Profit and loss account The amount of provision for discount on creditors is calculated at a percentage on creditors. In the balance sheet, creditors are shown after deducting reserve for discount on creditors. Self Assessment Questions 10: 1. Discount on creditors is an item of income (state True / false ). 2. Provision for discount on creditors is shown as an anticipated income (State True/False ). 3. How do you treat provision for discount an creditors in balance sheet ? 4. Discount received from creditors subsequently is changed against provision for discount on creditors. (state True / False ). 7.2.10 Closing stock Stock of goods – raw materials, semi finished goods, finished goods – at the end of the accounting year should be considered for preparing trading account and balance sheet. It is an internal adjustment. Closing stock is normally valued at cost or market price which ever is lower, even though there are several other methods to value stock. Closing stock does not appear in the trial balance because the value of it is ascertained only after the preparation of trial balance. To bring to the records, a journal entry is
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passed in journal proper by debiting closing stock account and crediting trading account. In the balance sheet, closing stock appears as an asset. Self Assessment Questions 11: 6. what is the popular valuation method of closing stock ? 7. what is the entry for adjusting the closing stock ? 8. what does happen in case closing stock is not considered for computing gross profit ? 9. Closing stock always appears as an asset in balance sheet. (state True / false).

7.3 Trading Account
Trading account shows gross profit or gross loss arising out of trading activities. Trade means buying and selling. The account mainly focuses on finding the result of goods bought and goods sold. Interestingly, goods are bought for a cost and the proprietor incurs a few items of purchase expenses and the goods are sold at a price higher or lower than the cost incurred. At the end of accounting period, some stock is left over and it should be valued so as to calculate the profit or loss from the cost of goods sold. Therefore, opening stock of goods, cost of purchases made, expenses on purchases are taken on debit side of the trading account. On the credit side of the account, the sales of goods and the value of closing stock are shown. The excess of credit over debit is gross profit and vice versa. The gross profit or gross loss is transferred to Profit and Loss Account. The format of a Trading Account is given below: Dr Trading Account for the year ending- - - Rs. Particulars By sales Less returns inwards/sales returns By Closing stock Rs.

Cr

Particulars To opening stock To Purchases Less Purchasereturns/returns outwards To Carriage inwards To freight and octroi To wages

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Add outstanding wages Less prepaid wages To fuel and power To Gas, coal, electricity for production To Import duty and clearing charges To stores consumed To factory rent, insurance, factory expenses To other direct expenses To Royalty paid To Profit and Loss A/c (Gross Profit)

Note: For every expenditure, outstanding and prepaid aspects must be considered. From the above account, it is easy to learn the transferring entries made to close the accounts of expenses and incomes. The transferring entries are 1. Trading account To purchases a/c/ To Wages a/c To Royalty paid a/c etc (Being all expenses of trading transferred to trading account) 2. Sales account Closing stock account Dr Dr Dr To opening stock a/c

To Trading account (Being sales and closing stock transferred to trading account) 3. Trading account Dr

To Profit and Loss Account (Being gross profit carried forward to P&L A/C) 4. Profit and Loss Account To Trading account (Being gross loss transferred to P&L Account) Dr

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Self Assessment Questions 12: 1. Trading account is an account showing profit on cost of goods sold. (state True / False). 2. Cost of goods sold include opening stock + Purchase expenses – closing stock. (state True/ False ). 3. Gross profit is ______minus cost of goods sold. 4. Gross profit or loss is transferred to ___________ account.

7.4 Preparation of Trading Account
To prepare Trading Account, the following steps may be followed: a) Identify the items of expenses relating to trading and show them on the debit side of Trading Account. b) Effect the adjustments such as outstanding or prepaid to the relevant items of expenses c) Show the sales less returns and closing stock on the credit side of trading account d) The difference is gross profit if credit total is more than debit and gross loss if debit total is more than credit. e) Transfer the gross profit or gross los to Profit and Loss Account as the case may be. Self Assessment Questions 13: 1. Do you consider gross purchases or net purchases, while preparing trading account ? 2. Do trading concerns prepare manufacturing account ?

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Illustration From the following balances extracted from Trial balance, prepare Trading Account. The closing stock at the end of the period is Rs. 56000

Particulars Stock on 1-1-2004 Returns inwards Returns outwards Purchases Debtors Creditors Carriage inwards Carriage outwards Import duty abroad on materials received from

Amount in Rs. 70700 2000 3000 102000 56000 45000 5000 4000 6000 7000 12000 10000 2000 8000 10000 1000 4000 250000

Clearing charges Rent of business shop Royalty paid to extract materials Fire insurance on stock Wages paid to workers Office salaries Cash discount Gas, electricity and water Sales

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Dr

TRADING ACCOUNT FOR THE YEAR ENDING - - - Rs 70700 Particulars By sales Less Returns Inwards 3000 99000 5000 6000 7000 10000 2000 8000 4000 91300 303000 By Closing stock 3000 250000

Cr
Rs

Particulars To stock on 1-1-2004 To Purchases Less Returns Outwards 102000

247000 56000

To Carriage inwards To import duty To Clearing charges To Royalty To Fire Insurance To Wages To Gas, electricity, water To P & L Account (GP)

303000

7.5 Profit and Loss Account
Profit and los account is an important final account in the sense that the net result of the business in the form of net profit or net loss is disclosed by preparing the same. All business expenses like administrative expenses, office expenses, selling and distribution expenses are shown on the debit side of the account. Besides, all provisions made for different purposes such as reserve for bad debts, reserve for discount on debtors, reserve for repairs, depreciation etc., also picture on the debit side of the account. On the credit side of the account, all incomes of revenue in nature, reserve for discount on creditors and gross profit carried from trading account are mentioned. In this connection, it is important to note that Trading and Profit and Loss Account are regarded as revenue accounts. Any capital receipts or capital
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payments are not considered while preparing them. In brief, revenue receipts are those which are received regularly arising out of day to day activities of the business and similarly revenue payments, which are known as expenses are incurred regularly and for every day functions of the business. Capital receipts are in the form of sources of funds such as

capital received, sale of capital asset like building etc., Capital payments are those spent for acquisition of capital assets, incurring capital expenditure etc., The transferring entries are drawn to prepare Profit and loss account. They are 1. Profit and Loss Account Dr To all expenses account 2. All Incomes account Dr To Transfer all incomes To Transfer all expenses

To Profit and Loss Account 3. Profit and Loss Account To Capital account 4. Capital account Dr Dr

To Transfer Net Profit to Capital

To Profit and Loss Account Dr
Particulars To Trading Account (GL) To Salaries + Out standing – Prepaid salaries as per

To Transfer Net loss to Capital Cr Rs

Profit and Loss Account for the year ending --Rs Particulars By Trading account (GP) By Interest earned + Accrued interest as per adjustments By Commission earned By discount earned By Rent received By Bad debts recovered By Interest on drawings

adjustments To Rent of the premises To Travelling expenses To Rates and Taxes To Printing and stationery

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To Postage and Telegram To Telephone charges To Insurance –Prepaid amount as per adjustment To Interest paid To Discount allowed To Sundry expenses To Advertisement To Commission To Carriage outwards To Bad Debts To Reserve for Bad debts To Reserve for discount on Debtors To Depreciation To Legal charges To Audit fee To Interest on Capital To Capital Account (Net

By Reserve for discount on Creditors By Dividends received By Royalty Received By Capital Account( Net Loss)

Profit)

7.6 Preparation of Profit and Loss Account
The following steps may help to prepare Profit and Loss Account 1. Identify the expenses and bring them to debit side of P&L Account 2. Identify the revenue incomes and put them on the credit side of P&L Account 3. Check whether all adjustments like outstanding, prepaid, pre received expenses and incomes as the case may be are brought to the account 4. Check the transfer of reserves to the relevant sides of the account 5. Transfer the net profit / net loss to the capital account Self Assessment Questions 14: 1. What types of expenses are shown on the debit side of P & L account ?
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2. P & L account is revenue account showing the revenue net profit or loss for the accounting period(state True / False ). 3. Painting for a new building, Installation expenses paid to install a plant, amount spent for advertising for promotion of sale of a product are revenue expenses (state True / False ). 4. Net profit / loss is carried to owners equity / capital (state True / False ) Illustration The following Trial Balance is extracted from the books of a merchant on 31-12-2004.
Particulars Furniture and fittings Motor Vehicles Buildings Capital Account Bad Debts Provision for Bad debts Sundry Debtors Sundry Creditors Stock on 1-1-2004 Purchases Sales Bank Over Draft Sales Returns Purchase Returns Advertising Interest on Bank Over Draft Commission Cash Taxes and Insurance General Expenses Salaries Rs 640 6250 7500 12500 125 200 3800 2500 3460 5475 15450 2850 200 125 450 118 375 650 1250 782 3300

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The following adjustments are to be made. 1. Stock in hand on 31-12-2004 was Rs3250 2. Depreciate Buildings at the rate of 5%, Furniture and fittings @ 10% and Motor Vehicles @ 20%. 3. Rs.85 is due for interest on bank overdraft. 4. Salaries of Rs300 and taxes Rs.120 are outstanding. 5. Insurance amounting to Rs.100 is prepaid 6. One-third of the commission received is in respect of work to be done next year 7. Write off a further sum of Rs.100 as bad debts and provision for bad and doubtful debts to be made equal to 10% on sundry debtors. 8. Prepare Trading Account and Profit and Loss Account. 9. Dr Trading Account for the year ending 31-12-2004
Rs 3460 5350 9690 18500 Total 18500 Particulars By Sales 15450 Les Returns 200 By Closing Stock 15250 3250

Cr
Rs

Particulars To Stock on1-1-2004 To Purchases Less returns To P & L A/C (GP) Total 5475 125

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Dr

Profit and Loss Account for the year ending 31-12-2004
Rs 3300 300 118 85 1250 120 1370 100 1270 782 125 370 100 375 64 1689 1551 9940 Total 270 203 3600 450 Particulars By Trading Account (GP) By Commission 375

Cr
Rs 9690 250

Particulars To Salaries Add Outstanding To Advertising To Interest on OD Add Outstanding Int To Taxes and Insurance Add Out standing tax Less Prepaid Insurance To General expenses To bad debts To RBD(New) Less old RBD balance To Depreciation: On Bldgs @ 5% On FF @ 10%

Less Pre-received 125

On M Vehicles @20% 1250 To Capital Account (NP) Total

9940

Note: Sundry Debtors are Rs.3800 and there have been bad debts outside TB Rs100. The good debtors are Rs.3700. The new RBD is 10% of 3700, i.e.Rs370. The old RBD unspent is Rs100 (200 -100). Therefore RBD to be charged against profit is Rs270

7.7 Balance Sheet
Balance Sheet is the sum and substance of financial performance a business undertaking. It shows the assets and liabilities of business on a particular day. It is not an account but is a statement of affairs. The

statement of assets and liabilities is prepared, having two sides, left side
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containing capital and liabilities and on the right side, containing assets and properties. Often the statement is prepared vertically, mentioning sources of funds first and later application of funds. Sources of funds indicate capital and liabilities and application of funds indicate assets. Balance Sheet is prepared from Trial Balance. In case of sole trader organization and Partnership organization, the format of preparing Balance Sheet is arranged basing on liquidity of the assets. In case of Companies, the Companies Act, 1956 has specified a definite pattern of preparing Balance Sheet. Both the models of preparing Balance Sheet are stated here under. BALANCE SHEET FOR THE YEAR ENDING 31-12-2003 OF Mr. X
Capital and Liabilities Sundry Creditors Less Reserve for Discount on Creditors Bills Payable Bank Over Draft Loans Borrowed Outstanding Expenses Pre-received Incomes Capital (Opening) Add Additions to capital Add interest on capital if any Add Net profit as per P&L a/c Less personal drawings Less Net loss as per P&L A/C Rs Assets Cash in hand Cash at Bank Land and Building Add Additions if any Less depreciation Plant and Machinery less depreciation Furniture and Fixtures less depreciation Sundry debtors Less Bad debts out side Trial Balance Less Reserve for Bad Debts Less Reserve for discount on Debtors Bills Receivable Loans and advances given to others + Interest outstanding Investments + outstanding income on investments Other outstanding incomes Pre-paid expenses Closing stock Total Rs

Total

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The Format of Balance Sheet of a Company
Capital and Liabilities Capital: Authorised, Issued, Subscribed,Called up, Paid-Up capital with adjustments Reserves and Surplus Loans and Borrowings Long Term Loans Short Term Loans Current Liabilities: Sundry Creditors, B/P, Outstanding expenses, pre-received incomes, dividends payable, etc., Total Rs Assets Fixed Assets: Goodwill, Land Buildings,Furniture, Fixtures, Equipment, Plant, Machinery, Copy Rights, Patents Investments Loans and Advances Current Assets: Debtors, B/R, Inventory, Cash, Bank, Outstanding incomes, Prepaid expenses etc Rs

Total

Self Assessment Questions 15: 1. The two sides of a balance sheets are ____ and ___________. 2. balance sheet is prepared on the bases of trial balance. (state True / False ). 3. balance sheet portrays the financial soundness of a concern (state True / False).

7.8 Preparation of Balance Sheet
A few guide lines are given here under to prepare balance Sheet of a business concern. Balance Sheet is not an account and there is nothing like debit side and credit side. If Trial Balance tallies, naturally Balance Sheet also tallies: 1. Identify all assets from the trial balance. Assets are shown on the debit side of T.B 2. Identify all liabilities from the Trial Balance and they are on the credit side of TB.
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3. Make a mark of items with respect to which adjustments are given out side the TB 4. All adjustments should find place in two places, one either in Trading account or in Profit and Loss Account and another invariably Balance Sheet. For example, closing Stock given outside TB is first shown on the credit side of Trading Account and it is shown as an asset in the Balance Sheet. ‘Bad Debts Reserve to be provided’ appears in P&L Account and later shown as a deduction from Sundry Debtors in the Balance Sheet. Similarly depreciation is charged against profits first and later deducted from the book value of concerned asset in the balance sheet. Illustration 1 From the Trial Balance given in para 6, prepare Balance Sheet of the merchant as on 31-12-2004. Solution Balance Sheet as on 31-12-2004
Capital and Liabilities Sundry Creditors Bank Over Draft 2850 Add interest due 85 Commission received in advance Outstanding Taxes Outstanding Salaries Capital 12500 Add Net Profit 1551 Rs 2500 2935 125 120 300 14051 Assets Cash Building 7500 Less Depreciation 375 Furniture and Fixtures 640 Less Depreciation 64 Motor Vehicle 6250 Less Depreciation 1250 Sundry Debtors 3800 Less bad debts as per Adjustments 100 Balance 3700 Less Reserve for Bad Debts(New) 370 Closing Stock Pre-Paid Insurance Total Rs 650 7125 576 5000

3330 3250 100 20031

Total

20031

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NOTE: Every adjustment given outside Trial Balance finds place in two accounts –Trading account / Profit and Loss Account and invariably in Balance Sheet. Self Assessment Questions 16: 1. What is the purpose of creating Reserve for Bad debts? 2. State the purpose of creating reserve for discount on creditors. 3. Insurance paid on 1-1-2000 up to 31-12-2000 Rs.4800. If the books are closed on 31-7-2000, what is the amount of prepaid insurance? 4. Select the most appropriate answer. i) Sales are equal to a) Cost of goods sold + Profit b) Cost of goods Sold – Gross Profit c) Gross Profit – Cost of Goods sold ii) Interest on Drawings is a) Expenditure for the business b) Expensef or the business c) Gain for the business iii) Goods given as samples should be credited to account b) Sales account a) Advertisement

c) Purchases account a) an expense b) a liability

iv) Out standing salaries are shown as c) an asset

v) Income tax paid by a sole trader on his business income should be a) debited to the Trading Account b) debited to P&L Account

c) deducted from capital account in the Balance Sheet 5. Stock at the end, if appears in the Trial Balance is taken only to the Balance Sheet – Yes or No? 6. Goods taken by the proprietor for personal use are credited to sales account – Yes or No? 7. Salary paid in advance is not an expense because it neither reduces assets nor increases liabilities. – Yes or No? 8. Balance Sheet is an account because it is included in the scope of final accounts – Yes or No

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Terminal Questions 1. In taking out a Trial Balance, a Book keeper finds that debit total exceeds the credit total by Rs.611. The amount is placed to the credit of a newly opened Suspense Account. Subsequently the following mistakes were discovered. You are required to pass the necessary entries for rectifying the mistakes, and show how Suspense account. (a) (b) (c) (d) (e) Sales day book was over cast by Rs.1000 A sale of Rs.50to Sri Ram was wrongly debited to Sri Krishna General expenses Rs.180 were posted as 801 Cash received from Bhatt was debited to his account RS.450 While carrying forward the total from one page of the Purchases book to the next, the amount of Rs.1235 was entered as Rs.1325. 2. Rectify the following errors: (i) Furniture purchases for Rs.2500 was debited to Purchases account (ii) A sum of Rs.500 paid to Lalitha was debited to Shantha (iii) A bill receivable for Rs.1000 received from Kumar has been omitted to be entered. (iv) Goods worth Rs2040 taken away by the proprietor were debited to Bharath (v) An engine purchased for Rs.12500 had been posted to Purchases account 3. An accountant could not tally the Trial Balance. The difference was temporarily transferred to Suspense account for preparing the final accounts. The following errors were later discovered. (a) (b) The sales book was under cast by Rs.500 Entertainment expenses Rs.950 though entered in the cash book were omitted to be posted in the ledger.

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(c)

Discount column of the receipt side of cash book was wrongly added as Rs114 instead of Rs.144.

(d)

Commission of Rs.250 paid, was posted twice, once to discount account and once to Commission account.

(e)

A sale of Rs.169 to Rama Murthy though correctly entered in sales book, was posted wrongly to his account as Rs.196.

(f)

A purchase from Neeraj of Rs.290 though correctly entered in purchases book was wrongly debited to his personal account.

You are required to 1. Pass the necessary rectifying entries 2. Prepare Suspense account 3. State the effect of each of the rectification on the profit. What would be the correct profit originally arrived at was Rs.10000? 4. The trial balance of Raj Bahadur of Vijayanagaram as on 31-12-2005 is given below.Prepare Trading Account, Profit and Loss Account and Balance Sheet for year ending 31-12-2005 after taking into

consideration the following adjustments. (a) (b) (c) (d) (e) (f) Stock on 31-12-2005 was 15000 Debts worth Rs.2000 should be written off as bad Depreciate Machinery by 5% and Motor Van by 15% Reserve for bad and doubtful debts should be increased by Rs.600 Commission accrued and not received Rs.500 Goods worthRs.500 were used by the proprietor for his personal use (g) On September,2005, a fire broke out in the shop and goods worth Rs.2000 were completely destroyed. The insurance company accepted a claim of Rs.1500 only and paid the amount on January 1st 2006.

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TRIAL BALANCE AS ON 31-12-2005
Particulars Capital Drawings Opening Stock Purchases and Sales Returns Discounts Commission Income Tax paid Office Salaries Advertising Sundry Debtors and creditors Reserve for Doubtful Debts Manufacturing Wages Bills Receivable and Payable Carriage Machinery Motor Vans Land and Buildings Office Expenses Cash at Bank Cash in Hand 700 17300 2000 1700 85000 8600 5000 600 40000 7000 10000 1500 6000 2300 295700 Ans: Gross Profit Rs.79300; Net Profit: 52350; BS163650 295700 5000 30000 3000 7500 12000 86000 2000 500 170000 1000 700 1000 Debit in Rs Credit in Rs 85000

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5. On 31st December,2003 the following trial balance has been extracted.
Rs Drawings Sundry Debtors Interest on loan Cash in hand Stock (1-1-2003) Motor Vehicles Cash at Bank Land and buildings Purchases Salaries Carriage in Carriage out General Expenses Bills receivable 4000 20500 300 4000 6050 10000 5600 62000 97500 8600 4100 2200 5100 7050 Establishment Rent, rates and insurance Advertisement Credit Balances Capital account Sundry creditors Loan on mortgage Bad debts Provision Sales Purchase returns Discounts Bills payable Rent received 50000 12000 15700 2000 170000 1460 500 3000 600 Rs 9100 5000 4160

Adjustments 1. Depreciate land and buildings at 5% and Motor Vehicles at 15% 2. Interest on loan is at 5% taken on 1st January,2003 3. Salaries amounting to Rs.700 and Rates amounting to Rs.400 are due. 4. There has been a fire on 1st January, 2003 destroying goods worth Rs.200 5. The bad debts provision is to be brought up to 5% on Sundry debtors 6. The stock in hand on 31-12-2003 was valued at Rs16000 7. Goods costing Rs.1000 were taken away by the proprietor for his personal use, but no entry has been made in the books of accounts 8. Prepaid insurance amounted to Rs.500 9. Provide for Manager’s commission at 5% on net profit after charging such commission. Prepare Trading & P&L a/c and balance sheet.
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6. A firm had the following Balances on 1st January 2000 (a) Provision for bad debts (b) Provision for discount on debtors (c) Provision for discount on creditors Rs7500 3600 3000

During the year Bad debts amounted to Rs.6000, Discounts allowed were Rs300 and discounts received were Rs.600. During 2001, bad debts amounted to Rs.5000 and discounts allowed and received were respectively Rs.6000 and Rs1500. Total debtors on December 1st, 2000 were Rs.1,44,000 before writing off of bad debts, but after allowing discounts. On December 31st, 2000, the amount of debtors was Rs.57000 after writing off the bad debts but before allowing discounts. Total creditors on these two dates were Rs.60000 and Rs.75000 respectively. It is the firm’s policy to maintain a provision of 5% against bad and doubtful debts and 3 % for discount on debtors and a provision of 3% for discount on creditors. Show the accounts relating to provision on Debtors and provision on creditors for the year 2000 and 2001 (Ans: Provision for bad debts-2000 Rs.6900 and 2001 Rs.2850; Provision for discount on debtors – 2000 Rs.3933, 2001 Rs.1530; Provision for discount on creditors – 2000 Rs.1800, 2001 Rs2250) 7. In a business, Sundry debtors were Rs.40000 at the beginning of the year and there was 5% Reserve for Doubtful Debts and also

5%Rreserve for Discount on Debtors. During the year the actual bad debts amounted to Rs.1600 and the discount allowed were Rs.1700. At the close of the year, the debtors were Rs.50000; and the percentage of the two reserves have to be maintained as at beginning. Show ledger accounts.
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Answer for Self Assessment Questions. Self Assessment Questions 1: 1. True 2. False 3. True 4. True 5. Internal transactions 6. profit / loss for the accounting period 7. True Self Assessment Questions 2: 1. Outstanding expenses 2. Salaries account Dr To outstanding expenses account 3. It means t hat they are already considered. 4. False. Self Assessment Questions 3: 1. Prepaid expenses 2. True 3. 1000 + 5600 – 800 = 5800 4. True. Self Assessment Questions 4: 1. Accrued or outstanding income 2. True 3. True Self Assessment Questions 5: 1. True 2. Rent account Dr To Income received in advance account 3. Deducted.
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Self Assessment Questions 6: 1. Wear & tear / usage 2. Depreciation a/c Dr To asset account 3. P & L a/c Dr To Depreciation a/c 4. It means that the concerned asset is get to be depreciated 5. Diminishing(Reducing) balance method. 6. It indicates that the asset is already depreciated and depreciation should be transferred only to P & L a/c. Self Assessment Questions 7: 1. Bad debts 2. True 3. Bad debts a/c Dr To Debtor a/c 4. P & L a/c Dr To Bad debts a/c 5. Profits are reduced. 6. Cash a/c Dr. To Bad-debts recovered a/c. Self Assessment Questions 8: 1. Bad debts are totally not recoverable, doubtful debts may be recovered. 2. False 3. True 4. True 5. R.B.D a/c Dr To bad debts account. 6. P & L a/c Dr To R BD a/c 7. True
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Self Assessment Questions 9: 1. To encourage customers to make quick & prompt payment. 2. Cash discount a/c Dr To Debtors a/c 3. True 4. True

5. Good debtors (Meaning total debtors- Bad debts outside trial balanceRBD ) Self Assessment Questions 10: 1. True 2. True 3. Deduct the provision from the amount of creditors 4. True. Self Assessment Questions 11: 1. Cost on market price which ever is lower 2. Closing stock is debited and trading account is credited 3. Gross profit is reduced by not considering unsold stock 4. True. Self Assessment Questions 12: 1. True 2. True 3. Sales 4. P & L

Self Assessment Questions 13: 1. Net purchases meaning (Total purchases – purchase returns – stock destroyed – stock used for personal use ). 2. No, because they do not manufacture any product.
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Self Assessment Questions 14: 1. Indirect expenses office & administrative expenses, selling & distribution expenses etc. 2. True 3. False 4. True

Self Assessment Questions 15: 1. Assets, liabilities 2. True 3. True Self Assessment Questions 16: 1. To write off bad debts against the reserve and reduce the pressure on current profits. 2. to provide for anticipated profits. 3. Rs 2000 relating to 5 months ( 1.8.2000 to 31.12.2000) 4. i) a ii) c iii) c iv) b v) c 5. Yes 6. No 7. Yes 8. No Answer for Terminal Question: 1. Refer to unit 6.10. 2. Refer to unit 6.10. 3. Refer to unit 6.10. 4. Refer to unit 7.4, 7.6, 7.8. Ans: Gross profit Rs 79300, Net profit Rs 52350 Balance sheet Rs 163650.
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5. Refer to unit 7.4, 7.6 & 7.8 Gross Profit Rs 81010; Net Profit Rs 40706; Commission Rs 2034; Balance Sheet Total Rs 1,20,025 6. Refer to unit 7.2.7, 7.2.8, 7.2.9 Answer : Provision for Bad debts 2000 – Rs 6900 ; 2001 – Rs 2850. Provision for discount on debtors 2000 – Rs 3933; 2001- Rs 1530 Provision for discount on creditors 2000 – Rs 1800; 2001 –Rs 2,250. 7. Refer to unit 7.2.7, 7.2.8 Closing Balance of RBD Rs 2,500 Closing Balance of Reserve for Discount on Debtors Rs 2,375. RBD Transferred to P & L account Rs 2,100 Reserve for Discount Transferred to P & L account Rs 2,175

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