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FINANCIAL ACCOUNTING

Objectives
In this lesson, you will be able to:
Appreciate the need to maintain account books
Describe the double entry method of book-keeping and use it to record
transactions

Create a trial balance, profit and loss account and balance sheet

Describe the method of providing depreciation

Appreciate the importance of accounting standards

Financial Accounting

4.1

4.2

Financial Accounting

Introducing Financial Accounting Concepts


Financial accounting involves recording, classifying, and summarising financial transactions
of an organisation (business entity), and interpreting their results. Recording involves
writing the financial transactions soon after they occur, in an orderly manner. Classifying the
data relating to transactions involves a systematic analysis of the recorded data so that
similar items are classified under appropriate heads such as all cash transactions being
recorded in Cash Account. Summarising consists of presenting the classified data in a
manner, which is useful to the internal and external end-users of accounting statements
such as the Profit and Loss Account, which shows the profit earned or loss incurred by the
business in a year.
Therefore, accounting involves:

Understanding the standard accounting principles

Applying the accounting principles while recording all transactions

Classifying the recorded data under appropriate heads or accounts

Summarising accounts into various accounting statements which help the owners,
managers and external users such as investors, stock exchanges, government
authorities such as income tax officials to understand the financial performance and
position of the organisation. At any point of time, a properly kept record of
transactions enables the owners or management of the business to understand the
financial state of affairs of the organisation. This record in turn assists the owners or
management in steering the course of the organisation so that it is in tune with the
objectives of the organisation and the laws governing the organisation.

Financial accounting information helps you to understand the following aspects of an entity:

Whether the entity has made a profit or incurred a loss during the accounting period

Whether the profitability of the entity is adequate in terms of return on capital or


profit on sales

The values of an entitys assets, which are what it owns and what is owed to it and
the entitys liabilities, which are what is owed to others

Whether the financial condition of the entity is sound in terms of the composition of
its assets and liabilities

Whether the growth of the business is reasonable or below expectations or targets

Concepts of Accounting
Financial Accounting is based on certain concepts of accounting. The most important and
frequently used concepts of accounting are:

Cash basis of accounting

Accrual basis of accounting

Financial Accounting

4.3

Cash Basis of Accounting


Under the cash basis of accounting, the entity records a transaction of income when realised
or an expense when it is incurred. For example, if the entity has to pay rent every month
that is payable on the last day of each month, the transaction is recorded in the books of
the entity only when rent is actually paid.
If the rent for the month of March is paid on April 10, 2006, then the transaction is recorded
in the books only on April 10 that is, on the date of payment, and not earlier. If the financial
statements of the entity are prepared on March 31, then the rent for the month of March
will not be reflected in the financial statements for the year ended March 31, 2006 because
the rent is paid after that date.
Similarly, only those incomes that have been actually received are recorded in the books
and reflected in the financial statements. The books do not reflect the incomes that are yet
to be received, although they might be due or might relate to the accounting period.
An income or expense pertaining to the period prior to or subsequent to the accounting
period will get reflected in the financial statement of the period if it has been actually
received or paid, respectively.

Accrual Basis of Accounting


Under the accrual basis of accounting, all the income and expenditure that has become due
and is receivable or payable is recorded in the books of accounts. It is not necessary
whether the income has been received or the expenditure has been incurred for the
transaction to be recorded in the books of account. It is enough if it is due or in other words
accrued. Accrual based accounting is also known as mercantile system.
For example, the rent for the month of March, although paid in April, will be recorded in the
books of the entity on March 31, 2006, that is, the day on which it became due and
payable. This will accordingly be reflected in the financial statements of March 31.
Similarly, all the incomes that have become due and receivable, even if not received, will be
recorded in the books of account on the date they became due and receivable. Therefore,
the entire income and expenditure pertaining to a particular period will be reflected in the
financial statements of that period irrespective of their actual receipt/payment.
Similarly, any income received in advance or any payment made in advance that pertains to
the subsequent period will be removed from the financial statements of the period for which
the statements are made.
Recording of prepaid or outstanding income and expenses are made by making provisions
for them in the books of the entity.

Accounting Conventions
There are certain internationally accepted conventions and principles that are strictly
followed while recording transactions in the books of accounts and in preparing financial
statements. The most important accounting conventions are:

4.4

Consistency
Financial Accounting

Conservatism

Disclosure

Consistency
Organisations must follow consistent accounting practices and policies over various
accounting periods. Consistency is essential to enable any financial analyst to analyse the
statements to make a meaningful comparison of the various parameters, over a series of
accounting periods. There are various parameters such as the profitability, growth, and
financial position of organisations.
Frequent changes in accounting policies tend to project a distorted image of the financial
position of the concern and make historical comparisons impossible. Therefore, such ad-hoc
changes in accounting policies are not desirable.

Conservatism
It is essential that the valuation of the financial transactions as reflected in the financial
statements is done conservatively. This ensures that the income and expenditure as well as
the value of the assets and liabilities are neither overstated nor understated. This also
envisages that all the anticipated and probable losses are provided for. A conservative
valuation, therefore presents a reasonable and fair picture of the profit or loss of the
business entity.

Disclosure
In the book, Financial Accounting: Concepts and Uses, Schattke and Jensen state, Full
disclosure has been long considered a vital aspect of reporting financial accounting
information. Full disclosure means disclosure of all the important facts that is all the facts
that might affect the decisions of an informed user of the statements. Full disclosure is
related to, and derived from a number of other objectives of financial accounting,
particularly relevance, neutrality, completeness and understandability. The requirement of
full disclosure in financial statements is influenced by many factors. Many leaders in
business enterprises have a highly developed sense of social responsibility. They feel
responsible to users of their financial statements and therefore take the initiative in fully
disclosing all facts.
In addition to the preceding conventions, financial statements must be free from subjective
bias and they should be made available early enough to enable users to take timely
decisions.

Financial Accounting

4.5

Double Entry Book Keeping System


Financial transactions are recorded as they occur. Then, they are classified in groups based
on their similarity. Records of transactions of similar nature are called accounts (A/c). For
example all cash transactions, such as receipts and payments are recorded in the Cash A/c.
Similarly, all transactions relating to purchase of stationery will be recorded in the
Stationery A/C. The following table shows the format of a cash account.
Dr.

Cash Account

Date

Particulars

Ledger
Folio

Amount
(Rs.)

Date

Cr.
Particulars

Ledger
Folio

Amount
(Rs.)

Format of a Cash Account

The account of any transaction is entered in two parts as follows:


The left side of the account is the Debit side and the right side is the Credit side. Debit and
Credit are written in short as Dr. and Cr. respectively.

Double Entry Book-Keeping


The system of double entry book-keeping is based on the fundamental principle that every
transaction involving money or moneys worth has a two-fold effect. While one entity
receives an amount of money, the other entity parts with an identical amount. The
recording of the two-fold effect of a transaction in the books of account is called double
entry book-keeping.
To understand this system, consider the following example:
A bank purchases a computer from IBM for Rs. 10000 on 1 June, 2006. To record this
transaction, the bank needs to identify its two-fold effect. The effects are:

The bank receives a computer worth Rs. 10000.

The bank needs to pay Rs. 10000 to IBM, which is the supplier of the computer.

The transaction is recorded in the Computer A/c and Cash A/c, respectively. The entries are
made in an account on the debit side and in another account on the credit side. The
Computer A/c will be debited and Cash A/c will be credited.
Similarly, if the bank gives a loan of Rs. 50000 to Sanjay, the bank needs to record the
following parts of the transaction:

Sanjay gets a loan

The bank pays cash

4.6

Financial Accounting

The transaction will be recorded in Sanjays A/c and Cash A/c as follows:
Dr. Sanjays A/c

Rs. 50000

Cr. Cash A/c

(i.e. Debit Sanjays Account)

Rs. 50000

(i.e. Credit Cash Account)

Therefore, every transaction results in a debit entry in an account and a corresponding


credit entry in another account. Every debit entry has a corresponding credit entry and
every credit entry has a corresponding debit entry. An account is to be debited and credited
by applying the principles of double entry book-keeping to the transaction.

Types of Accounts
Under the double entry book-keeping system, accounts are classified into two types. The
following figure shows the types of accounts.

Types of Accounts

Personal Accounts: All accounts that exist in the name of a person, a firm or a
company or corporate or any other organisation such as clubs, associations,
government departments etc fall under this type. Every entity, for example, a small
firm or a large organisation, a government department or a private club or association
is treated as a person. A human being is a natural person and the other entities are
legal persons. However, they are both considered persons because they can own
properties or a business, lend money or borrow money.

Financial Accounting

4.7

Real Accounts: As the name itself suggests, these are tangible or real in nature and
include assets, such as land, building, plant and machinery, fixtures, fittings,
furniture, and vehicles of an entity.

Nominal Accounts: These are accounts in which all the incomes and expenses such
as interest earned, commission received, rent, wages, salaries, taxes, travelling
expenses, depreciation, postages, and telegrams of an entity are recorded.

Golden Rules
The type of account that has to be debited or credited for recording an entry depends on
the nature of accounts involved and the applicable rules. These rules are called the Golden
Rules. The nature of accounts and their rules are:

Personal Accounts: Debit the receiver and credit the giver.

Real Accounts: Debit what comes in and credit what goes out.

Nominal Accounts: Debit all expenses and losses and credit all incomes and gains.

Accounting Process
As stated in the definition of accounting, the process of accounting involves:

Recording a transaction as and when it occurs

Classifying the transaction so that a similar transaction is recorded

Summarising or preparation of an accounting statement

As and when transactions occur, they are recorded in a book called journal. Thereafter, the
transactions are classified and recorded in Accounts. The process of recording the
transactions in accounts is called posting in accounts.

Journal
The journal constitutes the basic record in which a transaction is recorded. The process of
recording the transactions in the journal is called journalising.
For example, on 1-6-2006 an organisation purchased a computer worth Rs. 10000 from
IBM.
A journal entry is recorded as follows.
Date

Particulars

Ledger
Folio

Debit
(Rs.)

Credit
(Rs.)

2006
June 1

Computer A/c
To IBM A/c

4.8

Dr.

1
4

10000
10000

Financial Accounting

Date

Particulars

Ledger
Folio

Debit
(Rs.)

Credit
(Rs.)

(Being the cost of


computer purchased
vide invoice number)

While recording a transaction in a journal, the golden rules for


debit and credit should be followed.

Begin writing the debit entry in a transaction close to the margin


under the particulars column and end it with an abbreviation
represented by Dr.

Enter the amount of the transaction under the debit column.

The next entry (credit entry) begins indented towards the right
from the margin and begins with To followed by the account to
which it is to be credited.

Enter the amount under the credit column.

Give brief details about the nature of the transaction. This is


called Narration. Every journal entry should have a narration to
make it comprehensible to a person looking at the entry.

All journal entries are made in a chronological order of as it


takes place.

Consider the following example:


1.

Seven persons, A, B, C, D, E, F and G started a bank by bringing in capital of Rs. 1


lakh each. The total capital is Rs. 7 lakhs.
The accounts involved are:

Cash account, which is a real account

Accounts of A to G, all of which are personal accounts as they are persons

Since cash comes in, the cash account has to be debited.


Since A to G are the givers of the amount, their account should be credited.
Since A to G are the owners of the bank, to distinguish their account from the
accounts of other persons, their accounts will be prefixed with Capital.
The journal entry will be as follows:
Dr. Cash A/c
To Capital A/c (A to G)

Rs. 700000
Rs. 700000

(Being capital of Rs. 1 lakh each brought in by A to G)


Financial Accounting

4.9

2.

The bank purchased an office building for Rs. 2 lakhs from Mr. Himmatlal.
The accounts involved are:

Building A/c, which is a real account

Cash A/c, which also is a real account

Since the bank purchases a building or building comes in and cash goes out, the
journal entry will be:
Dr. Building A/c

Rs. 200000

To Cash A/c

Rs. 200000

(Being building purchased for cash from Mr. Himmatlal for housing the head office
and first branch of the bank.)
Although the amount was paid to Mr. Himmatlal, his personal account will not be
debited because he has sold the building in return for the cash paid to him. The
personal account of the receiver will be debited only when the receiver does not
give any thing in return for the cash paid. In other words, a persons account will be
debited when he becomes indebted to the bank. In short he becomes a debtor.
3.

Purchased a computer for Rs. 20000 from IBM


The two accounts involved are:

Computer account, which is a real account

Cash account, which also is a real account

The personal account of IBM is not involved because the bank has paid cash to IBM.
The journal entry will be:
Dr. Computer A/c
To Cash A/c

Rs. 20000
Rs. 20000

(Computer comes in)


(Cash goes out)

(Being computer purchased for cash from IBM)


4.

Mr. Ram opened a savings account and deposited Rs. 10000 in cash.
The accounts involved are:

Cash account, which is a real account

Mr. Rams account, which is a personal account

Rams account is involved because in return for the cash paid by him the bank has
not given him anything in return. Therefore he has a claim on the bank. The bank
owes him the amount or the bank is his creditor.
The journal entry will be:
Dr. Cash A/c
To Ram-Savings A/c
5.

Rs. 10000
Rs. 1000

(Cash comes in)


(Ram is the giver)

Mr. Lallu opens a fixed deposit account and deposits Rs. 50000 in cash.
The accounts involved are:

4.10

Financial Accounting

Cash account, which is a real account

Lallus account, which is a personal account

The journal entry will be:


Dr. Cash A/c
To Lallu-FD A/c
6.

Rs. 50000
Rs. 50000

(Cash comes in)


(Lallu is the giver)

Opened a current account of the bank with the Reserve Bank of India and deposited
Rs. 500000.
The two accounts involved are:

Cash account, which is a real account

Reserve Bank of Indias account, which is a personal account

The journal entry will be:


Dr. RBI A/c
cash)

Rs. 500000

To Cash A/c
7.

(RBI is the receiver of

Rs. 500000

(Cash goes out)

The bank borrowed Rs. 600000 from National Housing Bank (NHB) and the amount
was credited by NHB to the banks current account with RBI.
The two accounts involved are:

NHBs account, which is a personal account

RBIs account, which also is a personal account

The journal entry will be:


Dr. RBI A/c

Rs. 600000

To NHB A/c

Rs. 600000

(RBI is the receiver)


(NHB is the giver)

Both of them receive or give cash on behalf of the bank. The bank has a claim on
RBI (debtor) and owes the amount to NHB (creditor).
8.

The bank gives a Housing Loan of Rs. 400000 to Ram and credits the amount to his
Savings account.
The two accounts involved are:

Rams Housing Loan account, which is a personal account

Rams savings account, which is a personal account

The journal entry will be:


Dr. Ram-Loan A/c
To Ram-Savings A/c

Rs. 400000

(Ram is the receiver of the loan)

Rs. 400000 (Ram is the giver of the deposit)

Had the bank disbursed the loan in cash to Ram, his loan account would have been
debited and cash account would have been credited. Later, had he deposited the
entire amount into his savings account, cash account would have been debited and
Financial Accounting

4.11

savings account would have been credited. Combining the two entries, the loan
account has been debited and savings account has been credited.
9.

The bank buys (invests) Government Bonds Rs. 700000 from RBI, which takes the
amount from the banks current account.
The two accounts involved are:

Investment A/c, which is a real account

RBIs account, which is a personal account

The journal entry will be:


Dr. Investment A/c
To RBI A/c

Rs. 700000

(Bond comes in)

Rs. 700000
(RBI is the giver. RBI
gave the amount on behalf of the bank)

10. The bank receives cash of Rs. 50000 from Ram Rs. 10000 is towards the first
instalment and Rs. 40000 towards interest.
The accounts involved are:

Cash account, which is a real account

Rams Housing Loan account which is a personal account and

Interest account, which is a nominal account

The journal entry will be:


Dr. Cash A/c

Rs. 50000

To Ram- Housing Loan A/c

(Cash comes in)

Rs. 10000

To Interest Account A/c

(Ram is the giver)

Rs. 40000

(Income)

The preceding entry is a combination of two journal entries.


Dr. Cash / Cr. Housing Loan for Rs. 10000 and Dr. Cash / Cr. Interest for Rs. 40000.
Instead of debiting cash twice, consolidated amount is debited.
11. The bank receives interest of Rs. 56000 on the Government Bonds. The amount is
credited by RBI to the banks current account.
The two accounts involved are:

Interest account, which is a nominal account

RBI s account, which is a personal account

The journal entry will be:


Dr. RBI A/c

Rs. 56000 (RBI is the receiver. RBI has received on behalf of


the bank)

To Interest

Rs. 56000

(Income)

12. The bank pays Rs. 30000 to NHB towards interest on the loan by issuing a cheque
on the banks account with RBI.
4.12

Financial Accounting

The accounts involved are:

Interest account, which is a nominal account

RBIs account, which is a personal account

The journal entry will be:


Dr. Interest A/c
To RBI

Rs. 30000
Rs. 30000

(Expenses)
(RBI is the giver. When the cheque
is presented by NHB, RBI will pay
on behalf of the bank)

13. The bank pays interest of Rs. 3000 on the fixed deposit of Mr. Lallu, in cash.
The accounts involved are:

Interest account which is a nominal account

Cash account, which is a real account

The journal entry will be:


Dr. Interest A/c
To Cash

Rs. 3000
Rs. 3000

(Expense)
(Cash goes out)

14. Salary of Rs. 1500 is paid to Mr. Ramlal, the cleaner boy, in cash.
The two accounts involved are:

Salary account, which is a nominal account

Cash account, which is a real account

The journal entry will be:


Dr. Salary A/c

Rs. 1500

To Cash

(Expense)

Rs. 1500

(Goes out)

Ramlals account is not involved because he does not owe the amount to the bank.
He has already given value to the bank by way of service. For the bank it is an
expense.
15. Salary of Rs. 4000 is paid to Mr. Krishnan, the cashier. It is credited to his savings
account with the bank.
The two accounts involved are:

Salary account which is a nominal account and

Krishnans savings account, which is a personal account

The journal entry will be:


Dr. Salary A/c

Rs. 4000

To Krishnan- Savings A/c

Financial Accounting

(Expense)
Rs. 4000

(Giver)

4.13

This is a combination of two journal entries. If salary was paid to Krishnan in cash
and he had then deposited it into his savings account, the entries would have been
as follows:
Dr. Salary
To Cash

(Expense)
(Goes out)

Dr. Cash
To Krishnan-Savings A/c

(Comes in)
(Giver)

The debit and credit entries to Cash account is set off and the remaining two debit
and credit entries are made.
16. The bank buys computer paper and other stationery items worth Rs. 1280 from
Supreme Stationery Co. Immediate payment was not made because the bank
wanted to verify the quantities of items received.
The two accounts involved are:

Stationery account which is a nominal account and

Supreme Stationery Cos account, which is a personal account

The journal entry will be:


Dr. Stationery A/c
To Supreme Stationery Co

Rs. 1280

(Expense)

Rs. 1280 (Giver. The bank


owes them the
amount)

When writing the preceding journal entries, the dates have been omitted for the sake of
convenience. In journal entries, dates and narrations have to be written. Further, the entries
should be in chronological order.
It needs to be reiterated that applying the rules of debit/credit and correctly recording the
transaction as a journal entry is the most important step in financial accounting. If the
journal entry is incorrect, the accounts and ultimately the financial statements will not
reflect the correct financial position. Therefore utmost care has to be exercised when
recording transactions as journal entries.
In a computerised environment, it is only the journal entries that are input in to the system.
The accounts and financial statements will be automatically generated by the system.
Though computerised accounting systems do have validations to ensure that the journal
entries are correct, the system can help in the case of only routine entries such as cash
payments, cash deposits, and interest payment. For most of the non-routine transactions
and for correction of errors human intervention cannot be avoided.
Therefore, those processing transactions must have a clear understanding of the rules of
debit and credit and how each entry will impact the accounts. Since banking is transaction
intensive and all that happens in a bank is financial transactions it is imperative that bank
employees are well versed in the golden rules of accounting.
The journal entries summarise the transactions and indicate the accounts affected by the
transactions. The transactions have to be classified by posting them in to the relevant
accounts.
4.14

Financial Accounting

Posting Entries in Accounts


Postings are made by entering the transactions on the debit side (left side) or the credit
side (right side) of the accounts.
After the entries are posted, the balance in the account is arrived at by taking the total of
both sides and finding out the difference between the totals of the two sides. If the total of
the debit entries are more than that of the credit entries the account is said to have a debit
balance. If the credit side total is more than the debit side total the account is said to have
a credit balance.

Financial Accounting

4.15

For example, when the preceding journal entries are posted, the accounts will appear as
follows.
Dr
Date

Cash A/c
Particulars

Amount
(Rs.)

To Capital
A/c

700000

Date

Cr
Particulars

Amount
(Rs.)

By Building A/c

200000

To Ram
Savings A/c

10000

By Computer
A/c

20000

To Lallu FD
A/c

50000

By RBI A/c

To Ram
Loan A/c

10000

By Interest A/c
(FD Lallu)

3000

To Interest
A/c

40000

By Ramlal
Salary A/c

1500

500000

By Balance c/d

85500

810000
Dr
Date

810000

Capital A/c
Particulars
To Balance
c/d

Amount
(Rs.)

Date

700000

Cr
Particulars

Amount
(Rs.)

By Cash

700000

700000
Dr
Date

Building A/c
Particulars
To Cash A/c

Amount
(Rs.)
200000
200000

4.16

700000

Date

Cr
Particulars
By Balance c/d

Amount
(Rs.)
200000
200000

Financial Accounting

Dr
Date

Computer A/c
Particulars
To Cash A/c

Amount
(Rs.)

Date

20000

Cr
Particulars
By Balance c/d

20000
Dr
Date

To Balance
c/d

Amount
(Rs.)

Date

410000

Cr
Particulars

Amount
(Rs.)

By Cash A/c

10000

By Ram Loan A/c


410000
Dr
Date

To Balance
c/d

Amount
(Rs.)

Date

50000

Cr
Particulars
By Cash A/c

50000
Dr
Date

Amount
(Rs.)

Amount
(Rs.)
50000
50000

RBI A/c
Particulars

400000
410000

Lallus Fixed Deposit A/c


Particulars

20000
20000

Rams Savings A/c


Particulars

Amount
(Rs.)

Date

Cr
Particulars

Amount
(Rs.)

To Cash
A/c

500000

By Investments
A/c

700000

To NHB
A/c

600000

By Interest A/c
(NHB)

30000

56000

By Balance c/d

426000

To Interest
A/c (RBI
Investmen
ts)

1156000

Financial Accounting

1156000

4.17

Dr
Date

NHB A/c
Particulars
To Balance
c/d

Amount
(Rs.)

Date

600000

Cr
Particulars

Amount
(Rs.)

By RBI A/c

600000

600000
Dr
Date

600000

Rams Loan A/c


Particulars
To Ram
Savings
A/c

Amount
(Rs.)

Date

400000

Cr
Particulars

Amount
(Rs.)

By Cash A/c
(Installment)

10000

By Balance
c/d

390000

400000
Dr
Date

Investments A/c
Particulars
To RBI A/c

Amount
(Rs.)
700000
700000

4.18

400000

Date

Cr
Particulars
By Balance c/d

Amount
(Rs.)
700000
700000

Financial Accounting

Dr
Date

Interest A/c
Particulars
To RBI A/c
(NHB)
To Cash
A/c (FDLallu)
To Balance
c/d

Amount
(Rs.)

Date

30000
3000

Cr
Particulars

Amount
(Rs.)

By Cash A/c

40000

By RBI A/c
(Interest on
Investments)

56000

63000
96000

Dr
Date

96000

Salary A/c
Particular
s

Amount
(Rs.)

To Cash A/c
(Ramlal
salary)

1500

To Krishnan
Savings A/c

4000

Date

Cr
Particulars
By Balance
c/d

5500
Dr
Date

To Balance
c/d

Amount
(Rs.)
4000
4000

Financial Accounting

5500

5500

Krishnans Savings A/c


Particulars

Amount
(Rs.)

Date

Cr
Particulars
By Salary A/c

Amount
(Rs.)
4000
4000

4.19

Dr
Date

Stationary A/c
Particulars
To Supreme
Stationary
A/c

Amount
(Rs.)

Date

1280

Cr
Particulars

Amount
(Rs.)

By Balance
c/d

1280

1280
Dr
Date

1280

Supreme Stationary A/c


Particulars
To Balance
c/d

Amount
(Rs.)

Date

1280
1280

Cr
Particulars
By Stationary
A/c

Amount
(Rs.)
1280
1280

It will be observed that when the postings are over, the accounts are balanced by writing
the difference between the totals of the debit side and credit side on the appropriate side to
make the total of both sides equal. When the total of the debit side is more, the account is
said to have a debit balance, which is written on the credit side with narration, Balance
c/d. C/D means carried down from one side to the other. Similarly, if the credit side total is
more, the balance will be carried down from the credit side and written on the debit side to
balance the account.

Ledger
Ledgers are books in which the accounts are maintained. The word Folio is used to refer to
the page of the ledger in which an account is written. LF or ledger folio of each of the
account is indicated in the Journal when the transaction is posted into the account. This
serves as an indication that the transaction has been posted and also makes checking of the
posting easy.

In the examples above, the ledger folios have been omitted for the sake of convenience.

In a computerized environment, LF has no relevance.

4.20

Financial Accounting

Check Your Understanding


Pass the journal entries necessary for correcting the following errors, which
occurred in a bank.
1.

A cheque for Rs. 500 drawn on A/c no. 565 was posted to A/c no. 566.

2.

A cash deposit of Rs. 1000 was posted as Rs. 10000 in A/c no. 8242.

3.

Excess interest of Rs. 100 was debited to loan A/c of Ramvilas.

4.

A customer deposited cash of Rs. 6500 in his account 9879 but wrote in the paying
in slip Rs. 6000 only. The cashier, unfortunately, did not notice this discrepancy and
posted Rs. 6000 only.

5.

A cash deposit of Rs. 1500 in account 3345 was posted twice in the account

6.

In fixed deposit account no. 113542 interest of Rs. 679 was credited at the end of
the quarter. Later the customer took premature payment of the deposit. Therefore
an amount of Rs. 246 had to be recovered from him.

7.

When settling the travel claim of an employee an excess payment of Rs. 100 was
made

8.

A customer requested that an electronic funds transfer of Rs. 1000 be made to


account no. 5478 with Pune branch. By mistake the EFT was effected twice from his
account no. 9870

9.

A customer deposited Rs. 5000 for purchase of mutual funds from Prudential ICICI.
The amount was erroneously credited to the customers account no. 8419

10. A cheque for Rs. 800 deposited by a customer (A/c no. 5923) was returned unpaid.
It was debited to A/c no. 5932.

Financial Accounting

4.21

4.22

Financial Accounting

Financial Statements
Trial Balance
In double entry accounting system, for every transaction, the amount involved is entered on
the debit side of one account and the same amount is entered on the credit side of another
account. Every debit is matched by an equivalent credit. Therefore, when the debit and
credit balances in various accounts are listed and totaled, the totals will tally.
Trial Balance is a list of closing balances in all accounts with the debit and credit balances
written separately. The total of the debit balances must tally with the total of the credit
balances. When the balances do not tally, it indicates there is some error in posting, in
calculating the balances in the account, or in totaling the two sides of the Trial Balance.
Trial Balance is a list of the closing balances in all accounts as on a particular date.
Therefore, the following table shows the title and entries in a Trial Balance.

Trial Balance As on (Date)


Particulars
Cash

Dr

Cr

Amount
(Rs.)

Amount
(Rs.)

85500

Capital
Building
Computer

700000
200000
20000

Ram Savings A/c

410000

Lallu FD A/c
RBI

50000
426000

NHB

600000

Ram Loan A/c

390000

Investments

700000

Interest
Salary

63000
5500

Krishnan Savings A/c


Stationary
Financial Accounting

4000
1280
4.23

Trial Balance As on (Date)


Particulars

Dr

Cr

Amount
(Rs.)

Amount
(Rs.)

Supreme Stationary A/c


Total

1280
1828280

1828280

Once the Trial Balance is balanced the next step is creating financial statements to
ascertain whether the business has made a profit or not after a certain period of operation,
which usually is one year. It is customary to ascertain the profit or loss at least quarterly if
not monthly to help the management of an organisation to monitor the effectiveness of
their strategies and make mid course corrections.

Trading and Profit and Loss Account


All entities prepare a Trading and profit and loss account and the related balance sheet
usually once a year or earlier depending upon the accounting practices adopted or to
comply with certain statutory needs. Whatever be the period of their publication, the
method of preparation that is followed is uniform.
A trading account is related to the trading activity that is primarily concerned with the
buying and selling of goods by an entity. This account is constructed for finding out the
gross profit. The debit side will consist of the opening stock, the purchases made during the
year, and all direct expenses related to the Trading activity. The credit side will have the
sales affected during the year and the closing stock.
The difference between the two sides could result in either gross loss or gross profit that is
carried down to the profit and loss account.

Profit and Loss Account


The profit or loss is ascertained by listing the balances in all the nominal accounts, the
expenses on the debit side and income on the credit side, and finding out the net balance.
The consolidated listing of all nominal accounts is called the Profit and Loss Account. Since
profit earned or loss incurred over a period is ascertained, the title of the P & L A/c is
written as follows:
Profit and Loss Account for the Period Ended ----(date)----If the credit side (income) total is more, the business would have made a profit and if the
debit side total is more it will indicate a loss.
Since the P & L A/c is an account in its own right, the balances in the nominal accounts are
transferred to the P & L A/c, which also is a nominal account, by passing the necessary
journal entries.
In the example worked out earlier there are three nominal accounts, namely, Interest A/c,
Salary A/c and Stationery A/c. Once the period of operation (the financial year) is over, the
balances in the nominal accounts cannot be carried forward to the next year as the income
and expenses of a new year have to be recorded afresh. Therefore, the balances in the
4.24

Financial Accounting

nominal accounts are transferred to the P & L A/c and the nominal accounts are closed so
that they start with zero balance in the new year.
To prepare the P & L A/c of the bank in the preceding example, the following journal entries
will have to be passed:
Dr. Interest A/c

Rs. 63000

To P&L

Rs. 63000

Dr. P &L A/c

Rs. 5500

To Salary

Rs. 5500

Dr. P &L A/c

Rs. 1280

To Stationery

Rs. 1280

The preceding journal entries will close the three nominal accounts and create the
consolidated nominal account, i.e. P & L A/c which will reflect the profit or loss of the entity.
The following table shows the P & L A/c of the bank of the preceding example.

Profit and Loss A/c for the period ended (Date)


Expenses

Amount
(Rs.)

To Salary

5500

To Stationary

1280

To Profit

Income
By Interest

Amount (Rs.)
63000

56220
63000

63000

It will be observed that the bank has made a profit of Rs. 56220 during the period of
assessment. This credit balance in the P & L A/c will be transferred to the Capital A/c in the
case of proprietorship and partnership entities. In the case of organisations, the balance in
the P & L A/c may be carried forward as it is or may be transferred to the Reserves A/c.
Reserves is nothing but the accumulated profits of the organisation and it rightfully belongs
to the shareholders or owners. Therefore, the net-worth of an organisation is the total of its
capital and reserves. Technically, net-worth is the amount the business owes the owners or
share holders. In case the business is wound up, this is the amount the owners should get
from the business.

Financial Accounting

4.25

Balance Sheet
When the P & L A/c is prepared, all the nominal accounts would have been closed and only
the real and personal accounts will be left. Balances in Real Accounts represent assets of
the business such as cash, furniture, computer, and building. Balances in Personal Accounts
represent amounts owed to the business by debtors (assets) and amounts owed by the
business to its creditors (liabilities).
Therefore, the balances in real and personal accounts represent the assets and liabilities of
the business. The debit balances represent the assets and the credit balances the liabilities.
These balances feature in balance sheet. The liabilities appear on the left and assets on the
right. On the other hand, debit balances are listed on the right of the Balance Sheet.
If you list the balances in the real and personal accounts in the preceding example, the
following balance sheet will emerge.

Balance Sheet As on (Date)


Liabilities
Capital
Profit and Loss
A/c
Savings A/c
(for e.g. Ram
and Krishnan)
FD A/c
NHB

Creditors A/c
(for e.g.
Supreme
Stationary)

Amount
(Rs.)
700000
56220
414000

50000
600000

1280

1821500

Assets
Cash
Building
Computers

Amount
(Rs.)
85500
200000
20000

RBI

426000

Loan A/c
(for e.g.
Ram)

390000

Investments

700000

1821500

There are regulatory requirements for presentation of Balance Sheets. Banks have to
present their balance sheets in the format prescribed in the Banking Regulations Act.
Organisations other than banks have to follow the formats given in the Companies Act.

4.26

Financial Accounting

The balance sheet of the bank in the example, if presented in the format specified in the
Banking Regulations Act, will appear as shown in the following table.

Balance Sheet As on (Date)


Liabilities
Capital

Reserves and
Surplus

Amount
(Rs.)

Assets

700000

56220

Cash and
Balance
with
Reserve
Bank of
India

Amount (Rs.)
511500

Balance
with other
Banks

-----

------

Deposits

464000

Money at
Call

Borrowings

600000

Investments

700000

Advances

390000

Fixed Assets

220000

Other Liabilities

1280

Other
Assets
1821500

------1821500

Balance Sheet

Financial Accounting

4.27

Activity: Journalise and Prepare Financial Statements


A. Write the journal entries for the following transactions:
1.

Nurul Hassan starts a fresh paneer shop with Rs. 8000 as capital.

2.

He borrows Rs. 2000 from his father-in-law Mr. Ahmed.

3.

He opens a current account with Punjab National Bank (PNB) and deposits Rs. 5000.

4.

He buys a fridge from Vijay Sales Co for Rs. 11000 with a loan of Rs. 10000 from
Citi Financials. For the margin money, he issues a cheque to Vijay Sales Co.

5.

He buys furniture for Rs. 4000 from a carpenter, Ramvilas and pays cash to him.

6.

He buys a weighing machine for Rs. 2000 from Kirloskar and issues a cheque for it.

7.

During the first month, he:


a.

Purchases a total of 690 kilos of paneer for Rs. 69000.

b.

Sells it for Rs. 86250.

Although purchase and sales happens daily, Nurul maintains only one set of entries
for convenience sake. There is no closing stock at the end of the first month.
8.

He pays cash of Rs. 800 for electricity.

9.

He pays Rs. 1500 to Vincent, a helper as salary in cash

10. He deposits Rs. 10000 in the bank.


11. He issues a cheque for Rs. 2200 in favour of Citi Financials of which Rs. 2000 is
towards instalment and Rs. 200 is towards interest.
12. He issues a cheque for Rs. 2000 to Nagarajan towards rent.
13. He gives a loan of Rs. 1000 to Prabhu, a friend in cash.
14. He gives a donation of Rs. 100 to Sai Orphanage in cash.
15. He pays cash of Rs. 2000 to his wife, Noor for household expenses.
B. Based on the preceding transactions, open all the accounts, post them and
prepare a Trial Balance.

4.28

Financial Accounting

C. Prepare the Profit and Loss A/c and Balance Sheet.

Adjustment Entries
On working out the preceding exercise, the Balance Sheet will appear, as shown in the
following table.
Balance Sheet As on (Date)
Liabilities
Capital
Profit and Loss
Loan City
Financials

Amount
(Rs.)

Assets

Amount (Rs.)

6000

Cash

850

12650

Bank

7800

8000

26650

Fridge

11000

Furniture

4000

Weighing
Machine

2000

Loan
Prabhu

1000
26650

Closing Stock
In the above example it was assumed that all the stocks purchased were sold. At the end of
the period for which the profit and loss account was prepared there were no stocks on hand.
In a running account this does not happen and invariably there will be some closing stock.
Unless the value of the closing stock is taken in to account, the profit or loss figure arrived
at will not be accurate.
For example, assume that of the 690 kilos of paneer purchased for Rs. 69000, i.e. Rs. 100
per kilo, he sold 660 kilos for Rs. 86250 and he had in stock 30 kilos worth Rs. 3000 at the
purchase price of Rs. 100 per kilo. To arrive at the correct profit, he has to add this Rs.
3000 to the profit as in addition to the cash inflow of Rs. 86250, he has 30 kilos of paneer
which he can sell for at least Rs. 3000 if not more. To bring the Rs. 3000 into the profit and
loss account, the following entry has to be passed:

Financial Accounting

4.29

A. Dr. Closing Stock

Rs. 3000

(Asset)

To Profit and Loss Account

Rs. 3000 (Notional Income)

When this entry is passed, Rs. 3000 will be reflected on the credit side of the Profit and Loss
account after Sales and the gross profit will increase by Rs. 3000. Correspondingly the Net
Profit will also increase by Rs. 3000.
The impact of this in the Balance Sheet will be:
11. On the Asset Side, Closing Stock of Rs. 3000 will be added
12. On the Liability Side, the Profit figure will increase by Rs. 3000
Therefore, the Balance Sheet will tally but the total will be more by Rs. 3000 on both sides.
The quantity of closing stock is verified and the value calculated manually. The method of
valuation of the closing stock can alter the profit and so the financial position of the
business. For example, if Nurul Hassan had chosen to value the closing stock of 30 kilos at
Rs. 130 saying that he can easily sell it at Rs. 130, the profit would have increased by Rs.
3900 instead of Rs. 3000 when it was valued at the purchase price. Going by the principle
of Conservatism, it is customary to value the closing stock at the cost price (purchase
price) or market price (possible selling price) whichever is lower. If the paneer had
become a bit stale and Nurul would have had to sell it at a discount and may not have been
able to get more than, say Rs. 70 per kilo, the closing stock should have been valued at Rs.
2100 and not the cost price of Rs. 3000.
Method of Valuation of Closing Stock Impacts the Profit
The closing stock of one year becomes the opening stock of the next year and has to be
taken on the Debit side of the Profit and Loss Account before Purchases. Therefore, a typical
Profit and Loss Account will appear, as shown in the following table.
Profit and Loss A/c for the Year ended
Expenses

Amount
(Rs.)

Income

Amount (Rs.)

Opening Stock

--------

Sales

--------

Purchases

--------

Closing Stock

--------

Gross Profit

--------

--------

--------

Profit and Loss Account

Generally, instead of recording Opening Stock, Purchases and Closing Stock in the Profit &
Loss Account, the Cost of Goods sold is recorded on the Debit Side and Sales is recorded
on the Credit side. The Cost of Goods Sold is arrived at as follows;
Add
Less
4.30

Opening Stock
Purchases
Closing Stock
Financial Accounting

=
Cost of Goods Sold.
The effect is the same and the Gross Profit will be the difference between Sales and the
Cost of Goods Sold.

Outstanding and Prepaid Expenses and Incomes


Under the commonly accepted Accrual Method of accounting, all incomes and expenses
relating to the period, whether paid or not, have to be included in the Profit and Loss
Account.
It is very unlikely that all expenses and incomes relating to the period has been paid or
received during the period itself.
Assume that Nurul Hassan had the following outstanding and prepaid expenses and
incomes:
B. Interest of Rs. 500 due on the loan taken from Mr. Ahmed had not been paid.
(Outstanding Expenses)
C. Vincent was paid by cheque Rs. 1500 to be adjusted against salary of next month.
(Prepaid Expenses)
D. Prabhu had not paid Rs. 100 due as interest on the loan given to him. (Outstanding
Income)
E. Issued a cheque for Rs. 2000 in favour of Kamal as a loan to him on the last day of the
financial year. (New Loan Given)
F. Kamal paid Rs. 400 in cash towards interest for two months due after the close of the
financial year. (Prepaid Income)
The journal entries for the above transactions will be:
B. Dr. Interest A/c

Rs. 500

To Provision for Expenses - Interest

(Expense)
Rs. 500 (Liability)

Being provision made for outstanding expenses


C. Dr. Prepaid Expenses Salary
To Bank

Rs. 1500

(Asset)

Rs. 1500

Being salary paid in advance


D. Dr. Outstanding Income Interest
To Interest

Rs. 100
Rs. 100

(Asset)
(Income)

Being interest due from Prabhu


E. Dr. Loan A/c Kamal
To Bank

Rs. 2000
Rs. 2000

Being Loan given to Kamal


F. Dr. Cash
Financial Accounting

Rs. 400
4.31

To Prepaid Income - Interest

Rs. 400

(Liability)

Being interest paid in advance by Kamal

Provision for Bad Debts


Most businesses sell on credit and lose a small portion of it due to default by the debtors. To
take care of such losses businesses set aside a portion of the profit as provision for Bad
Debts. The entries passed for the same are

Dr. Profit & Loss a/c


To Provision for Bad Debts.

Such provision made will reduce the profits and the amount of provision will appear on the
Liability side (Debit side) of the Balance Sheet.

Provisions may be made for meeting any anticipated or unanticipated expenses such as
Income Tax or Gratuity Payments, Pension Payments etc that may arise in future. All of
them will result in a debit to the Profit & Loss account and will appear on the Debit side of
the Balance Sheet.

Writing off Bad Debts


When a debt becomes irrecoverable and has to be written off, the Provision for Bad Debts is
utilized for the purpose. The journal entry passed is;

Dr. Provision for Bad Debts


To Debtors a/c

Similarly, expenses for which a Provision has been made, will be debited to the Provision
account. If the provision is not adequate to meet the expenses only will it be debited to the
Profit & Loss account. For instance if the Bad Debts to be written off is Rs. 8000 and the
Provision already made is only Rs. 5000, the balance Rs. 3000 will be debited to the Profit &
Loss account.

Depreciation

4.32

Financial Accounting

Consider an example where the cost of a new car is Rs. 9 lakhs. If the car is sold after two
years, the car will fetch a lower price of, say, Rs. 6 lakhs. As the car becomes older, the
price for which it can be sold will decrease. There is an inverse relationship between the age
of the car and its value. This is true of all things except articles of antique value. The value
of assets such as vehicles, equipments, and machines depreciate over time. The faster it
wears out, the greater is the depreciation. The rate of depreciation is dependent on the
useful life of the asset.
For example, if a computer is expected to last three years, its value will depreciate by 33%
every year. If it is sold after three years it may fetch a scrap value only. Rate of
depreciation will depend upon the usage also. A car that is used as a taxi will depreciate
faster than a self-driven car because the latter would have been used sparingly and will also
be better maintained.
Since the value of fixed assets depreciates over time, business entities have to provide for
the depreciation in their books. If a car is purchased for Rs. 9 lakhs and its useful life is
considered to be 5 years, its value in the books should be reduced by 20% or Rs. 1.8 lakhs
every year. The amount of depreciation will be shown as an expense and will reduce the
profit. At the end of five years, the book value of the car will be zero, though the car may
continue to exist.
Providing for depreciation of fixed assets is necessary as otherwise the assets of the
business entity will appear in their books at an inflated value and this will give a wrong
impression about the financial strength of the business entity. The Companies Act and
Income Tax Act prescribe the rates at which various types of fixed assets should
be depreciated.
In the example, Nurul Hassan has the following items of fixed assets:
Fridge

Rs. 11000

Furniture

Rs. 4000

Weighing Machine

Rs.

2000

Let us assume that if the above items are sold at the end of the year they will fetch 20%
less than the cost price. In other words, we assume that the assets have depreciated by
20%. To know the profit of the business correctly, the amount of depreciation has to be
reduced from the profit already calculated. In other words, the amount of depreciation has
to be recorded as an expense, even though no cash has gone out of the business. The
amounts of depreciation to be recoded on the Debit side of the Profit and Loss account is as
follows:
Fridge

Rs. 11000

Depreciation at 20%

Rs. 2200

Furniture

Rs. 4000

Depreciation at 10%

Rs. 400

Weighing Machine

Rs. 2000

Depreciation at 20%

Rs. 400

Total

Rs. 3000

To bring this amount into the Profit and Loss account, the following journal entries have to
be passed:
G. Dr. Depreciation A/c

Rs. 3000

(Expense)

To Fridge A/c

Rs 2200

To Furniture A/c

Rs

Financial Accounting

400
4.33

To Weighing Machine A/c

Rs

400

Being depreciation provided on fixed assets.


The above entry will result in reduction of profit by 3000 and reduction of value of fixed
assets by Rs. 3000.

4.34

Financial Accounting

Activity: Prepare Financial Statements


Post the adjustment journal entries A to G on page 4.32 to 4.35 in to the accounts of
Nurul Hassan, prepared already, and draw up the revised:
1.

Trial Balance

2.

Profit and Loss Account

3.

Balance Sheet

Financial Accounting

4.35

Methods of Depreciation
There are two methods of depreciation:

Written down value method

Fixed instalment method or Straight line method

Written Down Value Method


Consider an example where an entity had purchased machinery for Rs. 1000000 on January
1, 2000. The useful life of the machinery is estimated to be 10 years. It is decided to
provide depreciation at the rate of 10% per annum. In this case, the depreciation account
and the asset account would appear.
This example shows working for only three years. The following table shows the journal
entry to bring the depreciation on record.
Date

Particulars

1st
year

Depreciation A/c

31
Dec,
2000

4.36

Dr. Amt. (Rs.)

Cr. Amt. (Rs.)

100000

To Machinery A/c

100000

(Being the depreciation


@ 10% on the value of
machinery written off)

1st
year

Profit and Loss A/c

31
Dec,
2000

A/c

To Depreciation

100000
100000

(Being the transfer of


depreciation to the
Profit and Loss
Account)

Financial Accounting

Date

Particulars

2nd
year

Depreciation A/c

31
Dec,
2001

Dr. Amt. (Rs.)

Cr. Amt. (Rs.)

90000

To Machinery A/c

90000

(Being the depreciation


@10% on the value of
machinery written off)
Note: - The
depreciation is worked
out on the book value
of the asset at the
beginning of the second
year

2nd
year
31
Dec,
2001
3rd
year
31
Dec,
2002
3rd
year
31
Dec,
2002

Financial Accounting

Profit and Loss A/c

90000

To Depreciation A/c

90000

(Being the transfer of


depreciation to the
profit and loss account)
Depreciation A/c

81000

To Machinery A/c

81000

(Being the depreciation


@10% written off)
Profit and Loss A/c
To Depreciation A/c

81000
81000

(Being the transfer of


depreciation to the
profit and Loss
account)

4.37

Therefore, every year, 10% on the reducing balance of the machinery account (book value)
is written off during the useful life of the asset concerned. Further, the amount written off
by way of depreciation will be shown as deduction from the asset concerned in the balance
sheet of each year to reflect the true value of the asset, as shown in the following table.

Liabilities

Amount
(Rs.)

Assets

Amount
(Rs.)

Balance Sheet as at 31 December, 2000


Machinery A/c 1000000
Less Depreciation
100000

900000

Balance Sheet as at 31 December, 2001


Machinery A/c 900000
Less Depreciation
90000

810000

Balance Sheet as at 31 December, 2002


Machinery A/c 810000
Less Depreciation
81000

4.38

729000

Financial Accounting

The following table shows table shows the depreciation account.


Date

Particulars

2000,

To
Machinery
A/c

December
31

Total
2001,
December
31

To
Machinery
A/c
Total

2002,
December
31

To
Machinery
A/c
Total

Financial Accounting

Dr.
Amt.
(Rs.)
100000

Date

Particulars

2000,

By P & L
A/c

December
31
100000
90000

Total
2001,
December
31

900000
81000

Total
2002,
December
31

810000

By P & L
A/c

By P & L
A/c

Total

Cr.
Amt.
(Rs.)
100000

100000
90000

90000
81000

81000

4.39

The following table shows the machinery account.


Date

Particulars

Dr. Amt.
(Rs.)

Date

Particulars

2000,

To Bank A/c

1000000

2000,

By
Depreciatio
n A/c

January
1

December
31

Cr. Amt.
(Rs.)
100000
900000

By Bal c/d
Total
2001,

To Bal b/f

1000000
900000

January
1

2001,
December
31

Total
2002,

Total

To Bal b/f

900000
810000

January
1

By
Depreciatio
n A/c

December
31

90000
810000

By Bal c/d
Total

2002,

1000000

By
Depreciatio
n A/c

900000
81000
729000

By Bal c/d
Total
2003,

To Bal b/f

810000

Total

810000

729000

January
1

Fixed Instalment Method


Under this method, a percentage on the original value of an asset is provided as
depreciation year after year during the life of the asset. This method is also known as the
straight-line method. Consider the following example. The original cost of the asset is Rs.
1000000 and if the entity decides to provide a depreciation of 10% per annum, the
depreciation and the machinery account would appear as follows:

4.40

Financial Accounting

This example shows working for only two years. The following table shows the depreciation
account.
Date

Particulars

2000,

To
Machinery
A/c

December
31

Total
2001,

To
Machinery
A/c

December
31

Total

Dr.
Amt.
(Rs.)
100000

Date

Particulars

2000,

By P & L A/c

Cr.
Amt.
(Rs.)
100000

December
31
100000
100000

Total
2001,

By P &L A/c

100000
100000

December
31
100000

Total

100000

Depreciation Account

The following table shows the machinery account.


Date

Particulars

Dr. Amt.
(Rs.)

Date

Particulars

2000,

To Bank A/c

1000000

2000,

By
Depreciation
A/c

January
1

December
31

Cr. Amt.
(Rs.)

100000

By Bal c/d
900000

Total
2001,

To Bal b/f

1000000
900000

January
1

Total
2001,
December
31

By
Depreciation
A/c

1000000

100000

By Bal c/d
800000
Total
2002,

To Bal b/f

900000

Total

900000

800000

January
1
Financial Accounting

4.41

Check Your Understanding

4.42

1.

A Ltd. had purchased a computer system valued at Rs. 800000 on January 1, 2005.
It is proposed to write off 20% as depreciation on the original cost every year. Write
the journal entries to give effect to the above decision, and show the entries in the
computer account for two years.

2.

B Ltd. had purchased some machinery worth Rs. 1000000 on January 1, 2003. It
was decided to write off 10% as depreciation on the reducing balance method.
Further, machinery worth Rs. 400000 was added on July 1, 2004. Show the working
of the depreciation account for three years along with the journal entries.

Financial Accounting

Accounting Standards
If entities were permitted absolute freedom to draw up their books of accounts without any
methods and standards, it will become difficult to compare the results. For example, an
entity may follow the straight-line method for providing 10% as depreciation on the original
cost of the machinery. The amount written off after three years would amount to 30% of
the cost of machinery.
However, under the reducing balance method, this amount would vary as the depreciation is
provided on the balance amount at the beginning of each year. Similarly, in valuing stock,
different entities may adopt different standards like First in First Out, Last in First Out.
Therefore, there arises a need to adopt certain standard accounting practices, which are
uniform and prevent ambiguity in reporting. With this end in view, the International
Accounting Standards Committee has evolved certain norms, which are adopted by the
Institute of Chartered Accountants of India (ICAI). Rules that are decided for uniform
application for reporting transactions in published accounts are made mandatory for all
entities.
The Accounting Standards Board (ASB) was formed in 1977 for formulating accounting
standards that are published by the council of ICAI. The Government of India has also
constituted a national body called the National Advisory Committee on Accounting
Standards in the year 2001. This committee advises the Government about certain
standards that are to be followed by all corporate bodies in India.
At present, there are 28 issues on which accounting standards have been evolved. These
are mandatory for all organisations, which are listed on the Stock Exchanges (SE) in India.
Further, these are also applicable for the entities whose annual turnover exceeds Rs. 50
crores. The emergence of accounting standards provides for uniform disclosure norms. The
auditors of the entities are enjoined to ensure compliance with all reporting requirements
under these standards and report deviations from the standards laid down. In addition,
these also cast an obligation on the Board of Directors of the organisation to ensure
adherence to these standards.
For a better appreciation of these standards, look at a few of the directives, which are
issued:

Accounting for depreciation: The accounting standard No. 6 deals with the
disclosure relating to the depreciation method, total depreciation and the gross
amount of depreciation provided. It also mandates that if a particular method is
chosen to provide depreciation, it should be followed consistently year after year and
what needs to be done if the method is changed.

Enterprise and related party: The reporting requirement for transactions between
the reporting enterprise and related party is covered by accounting standards No.18.
It applies to all transactions with the related party and calls for disclosure of name of
the related party, nature of relationship, volume of transactions, and amount of write
off, if any.

Reporting requirements on economic activity controlled by parent body and


an outsider group: This issue is covered by the accounting standards No. 27. It
deals with disclosure of information where an activity is jointly organised and subject
to joint control in the matter of operations and policy decisions. It provides for

Financial Accounting

4.43

disclosure by way of statement regarding the share of assets, incomes, liabilities, and
expenses. The disclosure norms stipulated are quite elaborate and cover a wide
variety of issues that form the basis of a relationship between the parent organisation
and the outside organisation jointly controlling the activities of a organisation.
The accounting standards introduce an element of uniformity in reporting on numerous
issues so that all parties - regulators, public, investors, and shareholders are served by the
transparency it seeks to achieve.

4.44

Financial Accounting

Financial Accounting

4.45

Practice Questions
I. Fill in the blanks:
13. A Trial Balance is the summary of both the ______.
14. Trial Balance tells us that the books are ________.
15. Agreement of Trial Balance is a forerunner for preparation of ______.
16. A profit and loss account relates to ________.
17. If expenses exceed income in a Profit and Loss account, it is termed as
__________.
18. Depreciation should be charged at a percentage such that the asset is ________
within its useful life.
II. Multiple Choice Questions:
1.

To debit an account is to post the transaction on the


a.
b.
c.
d.

2.

The double entry book- keeping is represented by which of the following?


a.
b.
c.
d.

3.

Taxes
Car
Postages
Travelling expenses
A list of balances in the ledger accounts of an entity on any given date
An activity undertaken to balance an account
A trial activity to mask a mistake
None of the above

The agreement of a Trial Balance is a conclusive proof of:


a.

4.46

Depreciation
Telco Ltd
Arun & Co.
Mahnagar Gas Ltd

A Trial Balance is
a.
b.
c.
d.

6.

the cash received


both the debit and credit aspects of the same transaction
receipts and payments at one and the same side
only credit entries

Which one of the following is not a nominal account?


a.
b.
c.
d.

5.

Record
Record
Record
Record

Which one of the following is not a personal account?


a.
b.
c.
d.

4.

Right side
Both the sides
Left side
None of the above

The fact that all entries are posted


Financial Accounting

b.
c.
d.
7.

A Profit and Loss account is a:


a.
b.
c.
d.

8.

The arithmetic accuracy of the recorded transactions


The intelligence of the book-keeper
None of the above
Revenue account
Real account
Personal account
Fictitious account

Which of the following correctly describes the concept accrual basis in preparation of
the accounts?
a.
b.
c.
d.

To
To
To
To

record cash as and when received


record only losses
record all expenses and incomes relating to a period irrespective of the date
take stock of stock

Financial Accounting

4.47

Summary
In this lesson, you learned that:

Financial accounting involves recording, classifying, and summarising financial


transactions of an organisation (business entity), and interpreting their results.

Recording involves writing the financial transactions soon after they occur, in an
orderly manner.

Record keeping involves an application of the principles of accountancy at every


stage.

Accounting involves:

Applying the accounting principles while recording all transactions.


Classifying the accounts of transactions under appropriate heads of accounts.
Summarising these transactions into various accounting statements, such as Trial
Balance, Profit And Loss Account and the Balance Sheet.

The most important and frequently used concepts of accounting are:

Understanding the standard accounting principles.

Cash basis of accounting


Accrual basis of accounting

The most important internationally accepted conventions and principles, which are
strictly followed in the recording of transactions in the books of accounts and in
preparing the financial statements are:

Consistency
Conservatism
Disclosure

The left side of the account is the Debit side and the right side is the Credit side. Debit
and Credit are written in short as Dr. and Cr. respectively.

The system of double entry book- keeping (which is universally followed) is based on
the fundamental premise that every transaction involving money or moneys worth
has a two-fold effect.

Under the double entry book-keeping system, accounts are classified into two types:

Impersonal account

The accounting process involves:

4.48

Personal account

Recording a transaction as and when it occurs


Classifying the transaction so that a similar transaction is recorded

Financial Accounting

Summarising or preparation of an accounting statement

The process of recording the transactions in the journal is called journalising.

Postings are made by entering the transactions on the debit side (left side) or the
credit side (right side) of the accounts.

Trial Balance is a list of closing balances in all accounts with the debit and credit
balances written separately.

The consolidated listing of all nominal accounts is called the Profit and Loss Account.

A balance sheet is a statement drawn up at the end of each financial period, setting
forth the various assets and liabilities of the concern as on that date.

Depreciation represents the diminution in the value of an asset due to its normal use
by the entity and may become worthless after some time.

There are two methods of depreciation:

Written down value method


Fixed instalment method or Straight line method

At present, there are 28 issues on which accounting standards have been evolved.
These are mandatory for all companies, which are listed on the Stock Exchanges (SE)
in India.

The accounting standards introduce an element of uniformity in reporting on


numerous issues so that all parties - regulators, public, investors, and shareholders
are served by the transparency it seeks to achieve.

Financial Accounting

4.49

Exercises
1.

Prepare a Trading and Profit and Loss account for the year ended 31st March 2006
based on the following.

Trial balance on 31st March 2006


Particulars

Dr. Amt. (Rs.)

Capital
Opening stock as on
1.4. 2005

240000
20000

Sales

300000

Purchases

220000

Sales returns

9000

Rent

6000

Salaries and wages

8000

Carriage inward

15000

Traveling expenses on
salesmen

6000

General expenses

1000

Interest recd on
investment

4000

Sundry creditors

15000

Insurance

1200

Law charges

800

Discount recd

4.50

Cr. Amt. (Rs.)

2000

Discount paid

600

Furniture & fittings

3000

Postage & Telegrams

450

Cash in hand

9950

Cash at bank

20000
Financial Accounting

Particulars

Dr. Amt. (Rs.)

Plant & Machinery

180000

Motor car

60000

Total

561000

Cr. Amt. (Rs.)

561000

The following adjustments are to be made:


a.
b.
c.
d.
2.

The closing stock is valued at Rs. 30000.


Rent to the extent of Rs. 500 and Salary and wages to the extent of Rs.1000
remain to be paid.
Prepaid insurance amounted to Rs. 300.
Depreciate machinery @10%, motor car @ 20% and furniture @ 5%.

The following is the Trial Balance of M/S Sahakar Wire Ropes & Co as on the 31st
March 2006. You are required to prepare a Trading and Profit and loss account for
the year ended 31st March 2006 and a Balance sheet as on that date after making
necessary adjustments.
Particulars

Dr. Amt. (Rs.)

Cr. Amt. (Rs.)

Land and Building

60000

Plant & Machinery

40000

Carriage inwards
Wages (manufacturing)

4000
40000

Sundry creditors

24000

Sahakars capital
Salaries
Bank interest
Purchases

164000
5960
300
95000

Purchase returns

12920

Bills receivables

2300

Trade expenses

4000

Sundry debtors

76000

Stock as on 1.4.2005

50000

Financial Accounting

4.51

Particulars

Dr. Amt. (Rs.)

Insurance

Cr. Amt. (Rs.)


1200

Sales

203000

Cash in hand

2160

Cash at bank

15000

Furniture & Fixtures

6000

Power and fuel

2000

Total

403920

403920

Additional information:
i.

The value of closing stock as on 31.3.2006 was Rs. 35000.

ii.

Depreciation on land & building to be provided @ 5%.

iii.

Depreciation on Plant & Machinery and furniture / fixtures @ 10%.

iv.

Salaries to the extent of Rs. 2000 was outstanding on date.

v.

Insurance to the extent of Rs. 300 is prepaid.

Create a reserve of 2.5% on sundry debtors.

4.52

Financial Accounting

Financial Accounting

4.53