Professional Documents
Culture Documents
Financial Accounting
Financial Accounting
Developed By
Mr. Yogesh Ashar
&
Prof. Rajesh Haldipur Under
Prof. Kanu Doshi, Dean – Finance, Welingkar
Advisory Board
Chairman
Prof. Dr. V.S. Prasad
Former Director (NAAC)
Former Vice-Chancellor
(Dr. B.R. Ambedkar Open University)
Board Members
1. Prof. Dr. Uday Salunkhe 2. Dr. B.P. Sabale 3. Prof. Dr. Vijay Khole 4. Prof. Anuradha Deshmukh
Group Director Chancellor, D.Y. Patil University, Former Vice-Chancellor Former Director
Welingkar Institute of Navi Mumbai (Mumbai University) (YCMOU)
Management Ex Vice-Chancellor (YCMOU)
ALL RIGHTS RESERVED. No part of this work covered by the copyright here on may be reproduced or used in any form or by any means – graphic, electronic or mechanical,
including photocopying, recording, taping, web distribution or information storage and retrieval systems – without the written permission of the publisher.
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1
Introduction to Financial
Accounting
Objectives :
After completing this chapter, you will be able to understand:
• Principles of Accounting.
• Financial Statements.
• GAAP
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Introduction to Financial Accounting
Structure
1.1 Introduction
1.2 Limitations of Accounting
1.3 Scope and Importance
1.4 Concepts and Conventions
1.5 GAAP
1.6 Forms of Organisation
1.7 Summary
1.8 Self Assessment Questions
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Introduction to Financial Accounting
1.1! INTRODUCTION
Why Financial Accounting?
What is common to all these Individuals?
i) Ms. Sudha Narayan Murthy (Infosys) - The Wealthiest Woman in India
ii)Mr. K P Singh (DLF Group) - The Wealthiest Man in India
iii)Ms. Perween Warsi (S&A Foods – Samosa Queen) - The Wealthiest Indian
Woman Outside India
iv)Mr. Laxmi N. Mittal (Mittal Steel) - The Wealthiest Indian Outside India
v) Mr. Bill Gates (Microsoft) - The Wealthiest Man in USA
vi)Mr. Warren Buffett (Berkshire Hathaway) - The Second Wealthiest Man in USA
They are all very Rich & Famous. But above all, they hold Equity Shares in
companies indicated against their names and which are listed on recognized
stock exchanges.
How do we determine that they are Wealthy?
We can determine their wealth by counting, by accounting, by recording, by
valuing all their worldly wealth, their assets, their estates, their properties,
possessions and financial liabilities, if any.
Accounting all incomes, expenses, assets & liabilities in Monetary Terms (in
Rupees) is the sole determinant of all economic activities of all businesses,
industry, trade, commerce, also of fashion designers; software giants, media
moghuls and even NGOs (CRY, Lijjat Papad).
Accounting helps recording all financial transactions enabling preparation
of:
I. Trial Balance
II. Profit and Loss Account
III. Balance Sheet
IV. Cash flow Statement
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Introduction to Financial Accounting
Financial statements have their use to several segments of the society who
are called Stakeholders:
1. Shareholders
2. Investment Advisors, Analysts
3. Creditors, Vendors, Suppliers
4. Labour (Workers & Employees)
5. Government (Local, State, Central)
6. Researchers (Faculty)
7. Students of Finance
In any business, there are Purchases, Production, Sales, Loans, Stocks, Debtors,
Creditors, Bank Balance, Profits & Losses. Unless you produce goods or
services, you can’t sell and unless you sell, you can’t have profit. But not all sales
can be made at a profit all the time. There can be sales at a loss also. So what is
important for a business? Sales or Profit? Ideally Profitable Sales!
Basic Principles of Accounting:
Accounting is a Science (Recording) as well as an Art (Interpreting). It records
only financial transactions and records only Historical Costs (Not Market value).
These are recorded and prepared as an ongoing concern basis (not winding up)
(Capital & Revenue) (Matching concept). It expects on a year to year basis
Consistency (depreciation, stock valuation). Accounting is governed by principles
of Conservative basis (provide for unrealized losses; but ignore unrealized
profits). Accounts are prepared in a manner that the Business is separate from
the owner (hence owner’s capital is liability) (Business entity).
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Introduction to Financial Accounting
• Is the available cash sufficient to pay bills? (A company can survive a long time
without profits, but not too long without cash.)
• What is the cost of manufacturing each unit of product?
• Can we afford to give employee payraises this year?
• What product line is most profitable?
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Introduction to Financial Accounting
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Introduction to Financial Accounting
1 ENTITY CONCEPT.
2 GOING CONCERN CONCEPT.
3 MONEY MEASUREMENT CONCEPT.
4 HISTORICAL COST CONCEPT.
5 ACCRUAL CONCEPT.
6 ACCOUNTING PERIOD CONCEPT.
7 MATCHING COST AND REVENUE CONCEPT.
8 DUAL ASPECT CONCEPT.
9 COST ATTACH CONCEPT
10 VERIFIABLE OBJECTIVE EVIDENCE CONCEPT.
1 ENTITY CONCEPT:
According to this concept, the business is different from the person doing the
business. The business has a separate identity or personality which is different
from the persons or entities in the business such as proprietors, partners,
managers or the employees. Therefore, we find that all accounting records take
note of the transactions between the owner and the business. The owners are
treated as outsiders for the purpose of recording transactions. The entity concept
is applicable to all forms of business such as sole trader, partnership, Joint Stock
Company, Co-operative societies.
The transactions relating to the business only are recorded. The personal
transactions of the proprietor are not recorded in business. Similarly, the
transaction between the organisation and the proprietor is also recorded.
The Capital is shown as a liability in accounts according to the concept. It means
the capital is the money the business has to refund to the proprietor.
This concept is applicable to all forms of business organisations. In the eyes of
law, the sole trader and his business are one and the same. But for accounting
purposes they regarded as separate entities. The same is applicable in case of
Partnership firm as well.
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Introduction to Financial Accounting
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Introduction to Financial Accounting
It does not mean that the asset will always be shown at cost. It only means that
cost becomes the basis for all subsequent accounting for the asset. So the asset
may be depreciated at the end of each year and the value may be reduced.
The cost concept brings objectivity in the preparation and presentation of financial
statements.
For example: if a plot of land is purchased for Rs.200,000, it will be recorded in
the books as Rs.200,000 only even though the present market value of the land
may be Rs.500,000.
5 ACCRUAL CONCEPT:
This concept is the recognition of income and cost as they are earned or incurred.
It is not as money is received or expenses are paid. In simple words, according to
this concept we have to record the expenses for the given period say one year
even if the said expense is paid or not.
For example: we record outstanding expenses at the end of the year. It means we
have not paid the expense. But it has accrued. In the same way we also provide
for income accrued, even though it is not received.
Thus under this concept, revenues and expenses relating to a particular period is
considered. Therefore, expenses paid in advance is excluded, but expenses
outstanding is included. Similarly, income received in advance is excluded, and
income receivable is included in the books of accounts.
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Introduction to Financial Accounting
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Introduction to Financial Accounting
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Introduction to Financial Accounting
1 CONVENTION OF DISCLOSURE:
This means that accounts must be prepared honestly. They must give all material
information.The accounting statements must give full and fair information to the
proprietors, creditors, investors and others. This convention is more important in
case of a big business like the Joint Stock Companies. This is because the
owners and the managers are different. The shares of the companies are also
traded in the stock exchanges. So the investors must get full information. The
Companies' Act, 1956 requires that the accounts of the company must give a true
and fair view of the state of affairs of the company and it must be certified by the
auditors. The Act also prescribes the form in which the profit and loss account
and the Balance Sheet must be presented.
2 CONVENTION OF MATERIALITY:
The accountant must give importance to material details and ignore unimportant
details. If this is not done, the accountants will be over burdened with minute
details.An item is material if the knowledge of it will influence decision making or
to help decide on matters of investment. Therefore, while preparing accounts only
important matters are kept and the unimportant matters are left out or they are
merged with other items.
For example : an amount of Rs.1,000 is material in a total amount of Rs.10,000.
But the same amount of Rs.1,000 is not material in a total amount of Rs
10,00,000.
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Introduction to Financial Accounting
3 CONVENTION OF CONSISTENCY:
This convention indicates that the procedure selected by the company must be
followed consistently every year. The financial statements will be comparable only
if the procedure is followed consistently.
There are several methods of charging depreciation, such as Straight Line
Method or Written Down Value Method etc. Once the company decides to follow
one particular method, then it must follow the same method year after year. In the
same way, there are different methods of valuation of stock such as FIFO or LIFO
or Average price etc. The company may adopt any of the methods of valuation of
stock, but it must be followed consistently.
However, this convention does not mean the company must be very rigid.
Whenever it is desirable, the company may change the accounting procedure.
This should be done only when there is an improvement in procedure or to
introduce a new procedure. When a change is introduced, the company must
make a disclosure of the changes made. Similarly, the procedure should not be
changed very often.
4 CONVENTION OF CONSERVATISM:
This is one of the oldest conventions of accountancy.In olden days, the Balance
Sheet was considered as one of the most important documents. It established the
valuation of assets.
Conservatism in short means the policy of playing safe. According to this
convention while preparing accounts we must not take into account any profits
unless they are realised. However, we must provide for all anticipated losses.
Sometimes, this convention is criticised on the grounds that it provides scope for
creation of secret reserves and it is against the convention of disclosure. As a
result of this convention, the profit and loss account shows lesser profit and the
Balance Sheet overstates the liability.
1.5! GAAP
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Introduction to Financial Accounting
The primary agency responsible for GAAP in India is the Accounting Standards
Board of The Institute of Chartered Accountants of India (www.icai.org). In the
US, the equivalent is the Financial Accounting Standards Board (FASB). The
Securities Exchange Board of India (SEBI) oversees companies whose shares
are publicly traded, while the Company Law Board (CLB) oversees disclosure
norms in general for all companies in India. In the US, there is a single agency
called the Securities Exchange Commission (SEC). In short, the GAAP are the
rules; the ICAI makes the rules and SEBI and CLB enforce the rules.
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Introduction to Financial Accounting
• Owner's Equity is the owner's interest in the net assets of the enterprise.
Obligations to the Owners are called ‘Equities’ and include Capital and
Reserves.
• Shareholders' Equity is the collective interest of all Shareholders in the net
assets. Equity in this sense is the residual interest in the entity’s assets
remaining after liabilities are met.
• Net assets means (Assets – Liabilities)
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Introduction to Financial Accounting
• Balance Sheet
• Statement of Cash Flows
To provide greater credibility (or believability) to its financial statements for both
internal and outside users, companies utilize objective third parties to examine its
transactions and the financial statements themselves. These third parties are
called Auditors. CAs and CPAs not only (as employees) help in drawing up of the
financial statements of various enterprises they work for, but (as independent
professionals providing audit services) monopolise the work of “auditing” them –
which means checking on behalf of the shareholders (called statutory audit as it is
mandated by the Companies Act), or as external (or sometimes in-house)
advisors to the management team (called Internal Audit, which is generally
discretionary but is encouraged by the Companies Act), to ascertain whether the
financial statements truly and fairly represent the underlying accounting records,
and also comply with the relevant GAAP.
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Introduction to Financial Accounting
1 PROPRIETORSHIP FIRM:
A slightly more advanced form of organisation is called a Partnership Firm. In
India, a partnership firm is governed by the provisions of the Indian Partnership
Act, 1932. The rules thereunder and also some special rules that may be made to
govern them in the state in which they are based. The basic features of a
partnership firm are coming together of more than one “person” to do business
together and to share its fruits (be it profits or losses). However, one major
characteristic – the key ingredient of a partnership firm – is mutual agency – any
partner can and does bind all other partners in any deal or transaction struck or
carried out in the name of the firm, whether or not it was with the consent and
agreement of the other partners. For this reason, a partnership is a relationship
much like a marriage. Partners have unlimited liability, much like sole
proprietorships. In a very limited way, limited liability partnerships in large
professional firms have been introduced in India. In India, partnership firms are
taxed separately, though under the general commercial law, a partnership firm
does not enjoy recognition separate from that of its partners. In law, a partnership
is just a compendious name for all or any of the partners.
The form of organisation, which interests us the most, however, is the company. A
company in India is one, which is registered under the Companies Act, 1956, or
any earlier Act. Companies may be either public or private. Private companies
restrict the number of shareholders to 50 and restrict free transferability of its
shares, by usually incorporating a clause in its Articles of Association (which are
the mandatory rules which it agrees to adhere to in the running of its affairs) to
the effect that the shares cannot be transferred to any non-shareholder without
the consent of all the other shareholders. It can be incorporated with a minimum
of 2 directors who need not be its shareholders. Public companies are companies
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Introduction to Financial Accounting
which do not have the two restrictions as above, and they need to have at least 3
directors and at least 7 shareholders at all times. All these conditions are as laid
down by the Companies Act and/or in the Memorandum of Association of a
company, which is like the Charter under which the company is established.
Companies are treated as legal entities separate from its shareholders, who are
co-owners of the undivided fruits of the company’s assets and operations. This
means that it enjoys a continuance of existence beyond that of its shareholders.
Since it is a separate entity, it is also taxed separately. Public companies are also
classified as widely held and closely held. Widely held companies are those
whose shares are listed on a recognised stock exchange. Listed means that
shares can be publicly traded on stock exchanges openly and without restriction.
All public companies other than these are considered closely held.
4 BANKING COMPANIES:
Banking Companies are similar to Joint Stock Companies. But the maintenance
of Books of Accounts and preparation of Balance Sheet etc. are governed by
Banking Regulation Act.
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Introduction to Financial Accounting
5 INSURANCE COMPANIES:
In case of Insurance Companies, the main source of revenue is the premium
collected by the Insurance Company. But the entire premium collected cannot be
treated as income because there is a contingency of claim. There are provisions
in the Insurance Act regarding how much portion of the premium can be taken to
revenue and how much must be kept in reserve.
1.7 SUMMARY
Accounting covers recording of all financial transactions to prepare meaningful
summary statements in the form of trial balance, profit and loss statement,
balance sheet and cash flow statements. These are very useful to shareholders,
investment advisors / analysts, creditors / suppliers, employees, Government,
researchers and student community.
It is based on principles of use of historical costs, recording on a going concern
basis, consistency, conservatism in accounting unrealized losses but ignoring
unrealized profits and treating owner as a different entity than the business. The
important principles are included in universal guidelines known as Generally
Accepted Accounting Principles (GAAP). The primary agency responsible for
GAAP in India is the Institute of Chartered Accountants of India. These are
enforced by Company Law Board and SEBI.
For collecting and presenting financial data, a summary device called an ‘account’
is used.
To establish credibility in financial statements companies arrange to have them
verified by independent qualified experts called Auditors.
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Introduction to Financial Accounting
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Introduction to Financial Accounting
REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video1
Video2
Video3
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Accounting Mechanics: Processing
Accounting Information
Objectives:
• Accounting Cycle
• Trial Balance
• Financial Statements
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Accounting Mechanics: Processing Accounting Information
Structure :
2.1 Introduction
2.11 Summary
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Accounting Mechanics: Processing Accounting Information
2.1 INTRODUCTION
In actual practice, accountants (and computers) use a summary device called an
account to record transactions in the company’s books and records. An account
can be defined as a label used by accountants to record changes in assets,
liabilities, and Shareholders’ (Owners’) equity. A listing of common types of
accounts and account types appears in Annexure 1.
Throughout this course we will use accrual accounting as it usually does a much
better job in evaluating business performance, and is the only method approved
by the GAAP. Indeed, following accrual accounting is a Fundamental
Accounting Assumption – which means that GAAP requires any business,
which does not follow accrual accounting to state in what respect and why it has
not followed accrual accounting, and what would the impact on its results be if
accrual accounting had been followed.
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Accounting Mechanics: Processing Accounting Information
name from the letter T. The T Account has a heading, a left side, and a right side.
The left side is known as the debit side and the right side is known as the credit
side. There is no reason why it should not be the other way around, except that
debit on the left and credit on the right has become a very common practice.
Usually computerised ledgers follow a “vertical” format where there are two
columns, one for debits and the other for credits, and the tallying of the totals of
each column proves the basic accounting accuracy of each account. The balance
in an account is the difference between the totals of debit and credit columns.
Account may be classified from another perspective. Thus accounts are classified
as:
• Personal Accounts
• Real Accounts
• Nominal Accounts
(a) Real Accounts: Accounts, which relate to assets of the fi rm but not its debt.
Instances of real account are:
• Land
• Building
• Investment
• Fixed deposits
• Cash balance
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Accounting Mechanics: Processing Accounting Information
• Bank balance
(b) Nominal Accounts: These relate to expenses, losses, gains, revenue, etc.
Instances of these are:
• Salary account
• Interest paid account
• Commission received account
The net result of all the nominal accounts is reflected as profit or loss for the
accounting year and is transferred to the capital Account or to appropriation
account. Thus at the end of the year, the Nominal accounts have nil balance. As
we stated above, the accountant uses a double entry system in analyzing and
processing transactions. Each transaction requires at least one debit and one
credit entry. In making these entries, the accountant uses the rules of debit and
credit (which are abbreviated to Dr. and Cr. respectively). These rules can be
summarized as follows:
Shareholders’ Equity
(Reserves)
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Accounting Mechanics: Processing Accounting Information
These three Golden Rules are briefly encapsulated in the following table:
2. In this, determine whether the accounts affected by the given transaction are
‘Real’ account, ‘Personal’ account or ‘Nominal’ account.
3. Depending upon the nature of the account, apply the “golden rules” of debit
and credit.
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Accounting Mechanics: Processing Accounting Information
original entry called the Journal, in a chronological order. The Journal is therefore
called as the Book of Prime Entry. Later, they are transferred (posted) to the
General Ledger where details of each account are maintained. However, in a
computerised environment, these two stages get rolled into one. There could be
different journals maintained for administrative convenience, depending on the
type of transactions. For example, there could be journals to record only Cash
receipts, or Cash disbursements, Sales, Purchases, or another omnibus journal
called General Journal help because they are invaluable in:
• Helping prevent or locate errors because debit and credit amounts can be easily
compared
• And “Credit” Cash A/c (Golden Rule 1: Credit what goes out)
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Accounting Mechanics: Processing Accounting Information
• And “Credit” Accounts Payable A/c (Golden Rule 2: Credit the giver)
3. You introduce capital into the business (or a company issues new shares at
par) for Rs.200,000
• And “Credit” Capital A/c (Golden Rule 2: Credit Income and Liabilities)
• And “credit” Bank A/c (Golden Rule 1: Credit what goes out)
5. You bought from Rohan goods worth (at MRP) Rs. 10,000 at 20% Trade
Discount on credit;
6. You received confirmation that a large company has selected you for a major
consulting assignment. The work will start on January 1 of next year.
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Accounting Mechanics: Processing Accounting Information
Example:
Accou
nts Type of Reason for
Transaction Debit
affecte accounts Debit of Credit
d
Shri Ganesh
Real Debit what
started Cash
Cash & Account comes in (Rule 1)
business Capita
Capital Personal Credit the giver
with capital of l
Account (Rule 2)
Rs. 50.000
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Accounting Mechanics: Processing Accounting Information
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Accounting Mechanics: Processing Accounting Information
Trade discount is the normal reduction from the Maximum Retail Price or Market
Price given to a trader. Note that the market price is not relevant, and is hence
ignored. Cash Discount on the other hand, is an extra discount given as a reward
for early cash settlement of the account, and hence is recorded in the books and
reflected as a cost.
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Accounting Mechanics: Processing Accounting Information
3. Analyze and classify the transaction. This step involves quantifying the
transaction in monetary terms (rupees and paise), identifying the accounts that
are affected and whether those accounts are to be debited or credited, and by
how much.
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Accounting Mechanics: Processing Accounting Information
5. Post general journal entries to the ledger accounts. This is the manual
equivalent of indexing the journal entries in order of account name and then date,
rather than in order of date (i.e., chronological order). In a computerised
environment, the computer does this work at great speed and with perfect
accuracy, and simultaneously with the authorisation of the transaction. In a
manual system, it is an exact duplication of the work of making entries in the
journal. It requires no fresh decision-making. However, this duplication serves an
important purpose: it enables one to view the activity and balance in any single
account at a glance. In manual systems, the journal and the ledger are
completely cross-referenced: every journal page is numbered, and the page
number on which it appears is written against the entry in the ledger, in a column
titled JF (for Journal Folio, where Folio means page number). Similarly, the page
number on which a particular account appears in the Ledger is entered against
each Debit and Credit entry in the Journal, in a special column titled LF (for
Ledger Folio). The cross-referencing is an invaluable tool in error diagnosis and
rectification in manual accounting systems.
All the above steps are performed throughout the accounting period as
transactions occur, or in batches processes. The steps that follow are performed
at the end of the accounting period. These steps are required in both, a
computerised and manual system of accounting. However, in a computerised
accounting system, generally debits will equal credits at all times; hence some of
the types of errors listed may not be encountered. Further, in computerised
accounting environments, preparing financial statements are simply a question of
generating updated reports.
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Accounting Mechanics: Processing Accounting Information
Eg. 1. Purchased machinery Rs. 50,000 and paid by cheque on May 30, 2009
The journal entry will be:
Machinery Account
• Cash receipts
• Credit card receipts
• Cash register tapes
• Cancelled checks
• Customer invoices
• Supplier invoices
• Purchase orders
• Time cards
• Deposit slips
• Notes for loans
• Payment stubs for interest
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Accounting Mechanics: Processing Accounting Information
Bank Account
The Trial Balance is simply a list of all the accounts and their balances at a given
time. At this point no adjusting entries have been made. The actual sum of each
column is not meaningful; what is important is that the sums be equal.
7. Correct any discrepancies or errors in the trial balance. If the columns are not
in balance, look for math errors, posting errors, and recording errors. If the
columns are balanced, look for unusual balances – which may point to erroneous
classification of transactions, or posting to the inappropriate accounts. Posting
errors include:
Each voucher must include at least the following: date, amount, and description of the
transaction. When practical, source documents should contain name and address of
the other party of the transaction.
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Accounting Mechanics: Processing Accounting Information
When a voucher does not exist, for example, when a cash receipt is not provided by a
vendor or is misplaced, an internal voucher should be generated as soon as possible
after the transaction, using other documents such as bank statements to support the
information on the generated source document.
Once a transaction has been journalised, the voucher is usually filed in such a way
that it is easily retrievable to verify the transaction, should the need arise at a later
date.
Deferral: An adjustment for which the business paid or received cash in advance.
This signifies that at the end of each accounting year, the accounts which are
maintained need to be finalized and in doing so, various relevant information
need to be factored in.
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Accounting Mechanics: Processing Accounting Information
! ! !
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Accounting Mechanics: Processing Accounting Information
The word To is not necessary, but has very often been used by accountants to
designate the account to which an entry is credited.
Deferrals: It goes for deferrals over a time period. When a Company has paid for
certain rights which need to be expensed out but, in all fairness, these right can
be availed over more than one year like, say, right to avail the use patent over the
current year and next three years. The amount spent in this respect has to be
expensed over four years. The write off has to be deferred over four years.
! ! ! ! Depreciation Expense
! ! ! ! ! ! To Accumulated Depreciation
Note that the credit is to Accumulated Depreciation not to the asset. The
Accumulated Depreciation account accumulates all depreciation charged off to
date and its normal balance is a credit. Accumulated Depreciation is a contra
asset account meaning it has a matching pair, Equipment for example, and it has
the opposite balance of its matching pair.
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Note that book or carrying value is defined as cost less accumulated depreciation.
Balance sheets reflect the book value of plant assets.
! ! ! ! ! Expense
! ! ! ! ! ! ! To Payable
Accrued revenue is revenue earned, but not yet recorded in the books and
records. The adjusting entry takes the following form:
! ! ! ! ! Accounts Receivable
! ! ! ! ! ! ! To Revenue
Unearned revenue arises when a business receives cash before earning the
revenue. For accounting purposes, it is categorized as a liability since the firm is
liable for future performance and cash has been paid in advance. The adjusting
entry takes the following form:
! ! ! ! ! Revenue
! ! ! ! ! ! ! To Unearned Revenue
Note that every adjusting entry involves both an income statement account and a
balance sheet account.
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Accounting Mechanics: Processing Accounting Information
10. Prepare the adjusted trial balance. This step is similar to the preparation of
the unadjusted trial balance, but this time the adjusting entries are included.
Correct any errors that may be found.
After the adjusting entries have been journalized and posted, an adjusted trial
balance is prepared by listing the ending balances of all the accounts. Some of
the balances in the Adjusted Trial Balance may change from their balances in the
Unadjusted Trial Balance and some may remain the same, i.e. Cash. In fact,
Cash is never adjusted. From the adjusted trial balance, it is a simple matter to
prepare correct financial statements.
At the end of the period, the accountant must close certain accounts so that their
balances are zero as the company begins a new accounting period. There are
two broad types of accounts as follows:
! All temporary accounts must be closed out at year-end and set back to a zero
! balance for the start of the new period. Permanent accounts (balance sheet ! !
accounts) are not closed out. In other words, if the company has a balance of !
Rs.50,000 in the Cash Account at midnight on December 31, it has the same !
balance on January 1 and this account should not be closed out. However, ! !
temporary accounts must be closed out so that the accountant can begin ! !
accumulating revenues and expenses for the new period.
The closing entries transfer the revenue, expense, and dividends balances to
Retained Earnings (or Reserves and Surplus or Profit and Loss Account). The
three steps involved are as follows:
1. Debit each revenue account for the amount of its credit balance. Credit
Retained Earnings for the sum of the revenues.
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Accounting Mechanics: Processing Accounting Information
2. Credit each expense account for the amount of its debit balance. Debit
Retained Earnings for the sum of the expenses.
3. Credit the Dividends account for the amount of its debit balance. Debit
Retained Earnings.
After posting the closing entries the revenue, expense, and dividend accounts are
set back to zero, so that the accounting period can begin anew. Now only
permanent accounts have balances.
• Income statement: prepared from the revenue, expenses, gains, and losses.
• Balance sheet: prepared from the assets, liabilities, and equity accounts.
• Cash flow statement: derived from the other financial statements using either
the direct or indirect method (we shall learn about these methods in detail later).
12. Prepare closing journal entries that close temporary accounts such as
revenues, expenses, gains, and losses. These accounts are closed to a
temporary income summary account, from which the balance is transferred to the
retained earnings account (capital). Any dividend or withdrawal accounts also are
closed to capital account (in companies, it is closed to the Reserves or Profit &
Loss Account).
14. Prepare the after-closing trial balance to make sure that debits equal credits.
At this point, only the permanent accounts appear since the temporary ones have
been closed. Correct any errors.
15. Prepare reversing journal entries (optional). Reversing journal entries often
are used when there has been an accrual or deferral that was recorded as an
adjusting entry on the last day of the accounting period. By reversing the
adjusting entry, one avoids double counting the amount when the transaction
45
Accounting Mechanics: Processing Accounting Information
occurs in the next period. A reversing journal entry is recorded on the first day of
the new period.
This site provides an introduction on how to read and interpret the financial
statements in a company’s annual report. Of course, it deals with US reporting
requirements, but the general principles are very lucidly laid out and are worth a
read.
3. What is the normal balance in the capital or owner’s equity account? Debit or
Credit?
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Accounting Mechanics: Processing Accounting Information
12. What is the normal balance in the office equipment account? Debit or Credit?
1Please Note: Most websites that we point you to are constantly being updated.
Please check to see that the information requested in this exercise is available.
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Accounting Mechanics: Processing Accounting Information
Answers
2. All asset accounts have a normal balance of debit. That means that cash must
have a debit balance. A liability is something that you owe such as an invoice you
received from a vendor. If you answered Liability, you need to spend more time
working on definitions of assets, liabilities and owner's equity as well as the rules of
Debits and Credits.
5. Debit is correct. Owner withdrawals reduce the balance in the capital account.
Since the capital account has a normal balance of credit, withdrawals must have a
normal balance of debit.
6. If you answered Revenue, you just committed one of the most common mistakes
that fresh accounting students make. Revenues are recognized on the date of sale
and not on the date the cash is received. If you credit revenues on the date cash is
received, the revenue is entered twice. The correct answer is that Accounts
Receivable is credited or reduced when the cash is received.
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Accounting Mechanics: Processing Accounting Information
7. When a purchase is made on account, the liability, accounts payable will increase.
Cash is not affected until you actually pay the bill at a later date. Hence the correct
answer is Accounts Payable.
8. Remember that anything with the word payable in the account title is a liability.
The normal balance in liability accounts is credit.
9. Debit is correct, because revenues are credits while expenses are debits.
10. Prepaid Expense is an asset. The normal balance in an asset account is debit.
Hence the correct answer is Debit.
11. If you answered Revenue, remember that revenues are not debited when a sale
is made on account. Revenues are credited. Cash has not been received, hence
Cash Account also does not enter the picture. The correct answer is Accounts
Receivable.
12. Office Equipment is an asset account. The normal balance must be a debit. If
you answered credit, you still need a bit more practice.
Transaction
Opened bank account and deposited Rs. 30,000
Withdrew cash from bank Rs. 10,000 office use
Rohan supplied goods to Ganesh for Rs. 20,000
Sold goods to Vijay Rs. 30,000
Sold goods fro cash Rs. 5,000
Purchased machinery from HMT Ltd. For Rs. 50,000
Paid office expenses in cash Rs. 3,000
Deposited cash in bank Rs. 10,000
Shri Ganesh withdrew for personal use from Bank Rs. 2,000
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Accounting Mechanics: Processing Accounting Information
Solved Example 1
Journalise the following transactions in the books of Abhay and Company, sole
proprietary concern of Mr. Abhay.
1. Purchased a running business for Rs. 3,00,000/- with the following Assets and
Liabilities:
! ! ! ! ! ! ! Rs.! ! ! ! ! ! ! ! Rs.
Stock of goods ! ! ! 12,000.00 Rohan (Cr.) ! ! ! 5,000.00
Plant and Machinery ! 2,00,000.00 Loan taken ! ! ! 12,000.00
Bank balance ! ! ! 75,000.00
Furniture ! ! ! ! 30,000.00
3. Rohan supplied goods to Abhay market price Rs. 10,000 at 20% Trade
Discount;
4. Paid life insurance premium for Abhay Rs. 4,000/- and insurance for machinery
Rs.2, 000 both by cheque.
5. Goods Purchased form Rohan sold to Mohan at market price and paid freight
on his behalf Rs. 200 cash;
6. Issued a cheque of Rs. 6,000 to Rohan and earned a discount of Rs. 500;
7. Purchased goods from Mr. Memon Rs. 24,000, 1/3 against a cheque, 1/3 for
cash and balance on credit;
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Accounting Mechanics: Processing Accounting Information
11.Expenses for the year paid in cash : Conveyance Rs. 700, Stationery Rs. 450,
Salary Rs. 3,000, Wages Rs. 800. Interest of Rs. 500 was paid by cheque.
Solution
Dat Credit
Particulars L/F Debit Rs.
e Rs.
Purchase Account Dr. 12,000
Plant & Machinery Account Dr. 2,00,000
Bank Account Dr. 75,000
Furniture Account Dr. 30,000 5,000
! To Rohan Account 12,000
! To Loan (Taken) Account 3,00,000
! To Capital Account
(Being running business taken
over)
Cash Account Dr. 10,000
! To Bank Account
10,000
(Being Cash withdrawn for
office use)
Purchase Account Dr. 8,000
! To Rohan Account
8,000
(Being goods purchased at
20% Trade Discount)
Drawings Account Dr. 4,000
Insurance Premium Account Dr. 2,000
! To Bank Account
6,000
(Being Personal life insurance
premium and for machinery
paid)
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Accounting Mechanics: Processing Accounting Information
Dat Credit
Particulars L/F Debit Rs.
e Rs.
Rohan Account Dr. 6,500
! To Bank Account
6,000
! To Discount received Account
500
(Being cheque issued and
discount received)
Purchase Account Dr. 24,000
! To Bank Account 8,000
! To Cash Account 8,000
! To Memon’s Account 8,000
(Being goods purchased)
Meena's Account Dr. 12,000
! To Sales Account 12,000
(Being goods invoiced)
Cash Account Dr. 19,600
Discount allowed Account 400
! To Sales Account 20,000
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Accounting Mechanics: Processing Accounting Information
Dat Credit
Particulars L/F Debit Rs.
e Rs.
Cash A/c 26,500 -
Capital A/c - 3,00,00
Purchase A/c 44,000 0
Plant & Machinery A/c 2,00,000 -
Bank A/c 44,500 -
Furniture A/c 30,000 -
Rohan’s A/c - -
Loan (Taken) A/c - 6,500
Drawing A/c 4,000 12,000
Insurance Premium A/c 2,000 -
Memon’s A/c - -
Meena’s A/c 12,000 8,000
Discount Allowed A/c 550 -
Discount received A/c - -
Conveyance A/c 700 500
Stationery A/c 450 -
Salary A/c 3,000 -
Wages A/c 800 -
Interest A/c 500 -
Interest (paid) A/c - -
Sales A/c -
42,000
3,69,000 4E+05
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Accounting Mechanics: Processing Accounting Information
2.11 SUMMARY
Financial accounting is based on an accrual basis and not on cash basis, hence
expenses are accounted as they are incurred ( not paid ) and income when it is
earned ( and not received ).
The accounts maintained in Accounts are personal or impersonal. The latter class
of impersonal accounts is further classified into real and nominal.
Whole accounting is based on three golden rules; for real accounts what comes
in is debited and what goes out is credited. Incase of personal accounts, receiver
is debited and the giver credited. For nominal accounts, expenses and assets are
debited and income and liabilities credited.
All accounting entries are first recorded in a journal. All entries in the journal are
then posted or transferred to the general ledger. The number of accounts that a
company wishes to maintain are described in what is known as ‘chart of
accounts’.
All balances of ledger are tabulated in trial balance at the end of period for which
accounts are to be prepared. This trial balance needs to be adjusted for deferral –
an adjustment for which the firm paid or received cash in advance, depreciation -
an allocation of cost for use of an asset like machinery, accrual – an expense or
income occurring before cash is paid or received by the firm.
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Accounting Mechanics: Processing Accounting Information
Retail Paradise operates a retail chain store. The Trial Balance as on January 1
200X I.e. the beginning of the month is as under:
Cash 5,000
Sundry Debtors 40,000
Inventory of Merchandise 85,000
Prepaid Expenses 2,000
Delivery Van 1,15,000
Sundry Creditors 45,000
Owners' Capital 1E+05
Retained Income 72,000
2,47,000 2E+05
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Accounting Mechanics: Processing Accounting Information
10. Entry for rent expense (Rent was paid quarterly in advance, Rs.6,000 per
quarter. Payments were due on February 1, May 1, August 1, and November 1.)
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Accounting Mechanics: Processing Accounting Information
Transaction
Received half the amount due from, ONGC by Cheque and deposited in bank
Withdrew from Bank Rs.2000 for office use and Rs.1,000 for personal use
57
Accounting Mechanics: Processing Accounting Information
58
Accounting Mechanics: Processing Accounting Information
59
Accounting Mechanics: Processing Accounting Information
Cash Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
By Bal 19,000
70,000 70,000
Bank Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
By Drawings 1,000
By Bal 22,000
55,000 55,000
L & T Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
50,000 50,000
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Accounting Mechanics: Processing Accounting Information
Purchases Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
To Cash 10,000
60,000 60,000
Sales Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
By Cash 15,000
By ONGC 40,000
58,000 58,000
ONGC Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
40,000 40,000
HMT Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
Machinery Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
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Accounting Mechanics: Processing Accounting Information
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
62
Accounting Mechanics: Processing Accounting Information
Furniture Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
Parmar Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
Salary Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
Office Expenses
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
Drawings Account
Dr.! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Cr.
Dat Dat
Particulars J/F Amount Particulars J/F Amount
e e
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Accounting Mechanics: Processing Accounting Information
Annexure 1
• Assets
• Cash on Hand
• Savings and/or Current Account
• Fixed Deposits/ Certificates of Deposit
• Fixed Assets
• Office Premises
• Furniture
• Computers
• Vehicles
• Tools, Machinery
• Investments
• Shares
• Debentures/ Bonds
• Mutual Fund Units
• Real Estate
• Liabilities
• Accounts Payable
• Sundry Creditors (Payments due to Suppliers for Purchases on Credit)
• Bills of Exchange
• MasterCard/ Visa/ American Express/ Diner’s Club Dues
• Taxes
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Accounting Mechanics: Processing Accounting Information
• Income Tax
• Service Tax
• Loans
• Debentures
• Unsecured Loans from Friends and Relatives
• Equity
• Retained Earnings (Accumulated Profits)
• Current Year’s Profits
• Adjustments
• Income
• Interest Income
• Bank Account Interest
• Fixed Deposit Interest
• Interest on Debentures/ Bonds
• Dividends
• On Shares
• On Mutual Fund Units
• Consulting
• ABC Design
• LMN Software
• Salary
• My Job
• Commissions
• Royalties
• Sales
• Products
• Services
• Expenses
• Rent and Utilities
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Accounting Mechanics: Processing Accounting Information
• Rent
• Electricity
• Gas
• Phone
• Internet
• Cable TV
• Office Expenses
• Accounting
• Legal
• Software
• Postage
• Bank Charges
• Credit Card Charges
• Printing
• Toner, Paper, Paper Clips
• Vehicle Expenses
• Petrol/ Diesel
• Insurance
• Repair
• Rentals/ Taxi fare
• Interest on Car Loan
• Taxes
• Income Tax
• Interest and penalties
• Wages and Salaries
• Consulting
• Wages
• Travel
• Air fare
66
• Hotel
• Meals
• Taxi fare, etc
• Marketing
• Advertising
• Trade Shows
• Promotional Gifts
67
Annexure II electronically linked to the bank’s
central server.
Account Types
While initially, an ATM Card could only
Different Account types are explained be used at the ATMs set up by the
in simple, layman terms, as they apply issuing bank, now, several banks are
to the accounts of an individual who collaborating to allow each others’
does not carry on a business. customers to withdraw money from
However, businesses and companies their accounts using the other banks’
have account types in much the same ATMs. Debit Cards allow you to pay
way, except that there may be some for purchase just like you would with
other account types (a result of their your credit card, except that there is
global reach and a concession to no free credit period, and no rollover.
greater levels of complexity). The money is simultaneously taken
away from your account, which is the
Cash
closest equivalent of paying cash.
The cash account type is used to
Credit Card
denote the cash that you store,
whether in your wallet, office safe, The Credit Card account type is used
piggybank, or mattress. to denote credit card accounts, both
for cards that allow floating lines of
Bank
credit (e.g. VISA, MasterCard, or
The Bank account type denotes Diners Club) and with cards that do
savings or current accounts held at a not permit continuing balances (e.g.
bank or other financial institution. American Express). The last type is
Some of these accounts may bear not very popular in India yet, and are
interest. This is also the appropriate called Charge Cards.
account type for debit cards, which
directly withdraw payments from a
current or savings account. In India, a
debit card often doubles up as an ATM
Card, which allows you to withdraw
cash from your bank account from a
conveniently located automated
money dispensing machine, which is
68
Asset, Liability interest, or Capital Gains. There are
securities markets around the world,
Asset and Liability accounts are used and widely traded securities with
for tracking things that are of value, transparent values may be analyzed
but that are not directly translatable on a dayto- day (or even minute-to-
into cash. For instance, as an minute) basis.
individual, you might collect the costs
of purchasing a house into an asset Shares and Mutual Fund accounts are
account entitled My House, or the cost typically tracked in registers having
of a car into My Car, or collect together three main columns:
the value of your Computer
Equipment. The home loan or car loan • Price
would be represented by liability • Number of shares
accounts called Home Loan and Car • Cost
Loan, to be drawn down as you make
payments on these loans. In order to get useful information out of
the register, it is necessary to have
If you hold assets for business multiple “views” on the data so that
purposes, their decline in value over you may assess such things as:
time might be treated as a deduction
for tax purposes, that deduction being • Total Values by security
called Depreciation. On the other • Gains/Losses by security
hand, if you own assets that usually, or • Return on Investment rates by
often, appreciate in value over time, security
such as real estate, paintings, and Today, many websites (example:
investments like shares in companies, www.moneycontrol.com,
you may see them appreciate in value, www.myiris.com,
and have to recognize, for tax www.kotakstreet.com) allow registered
purposes, what are called Capital users (registration free) to track their
Gains when they are sold. portfolios (a collective name for all the
shares and mutual fund units you may
Shares, Mutual Fund Units own) on a daily basis, with software,
which shows the portfolio at current
Securities that you invest in are a form prices, and also permits several of the
of asset that are normally acquired above “views”.
with the express purpose of receiving
income either in the form of dividends, Income, Expense
69
Income and Expense account types have income and expenses. At the
are used to record income and end of the year, your net worth will be
expenses. For example, if you deposit the equity at the beginning of the year,
a salary cheque in your bank account, plus all income minus all expense.
you should mark it as a transfer from This value then becomes the equity for
an ‘income’ account. Marking income the next accounting period.
in this way helps balance the books:
the change in your net worth in the
course of a few weeks, a few months,
or a year, should exactly equal your
income (minus expenses) for the
same period. The value stored in the
bank account contributes to your ‘net
worth’, whereas the income
contributes to your ‘profits’.
Equity
70
REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video1
Video2
Video3
Video4
71
3
Accrual Accounting and the
Balance Sheet
Objectives:
• Net Worth.
• Contingent Liabilities.
72
Accrual Accounting and the Balance Sheet
Structure:
3.1 Introduction
3.4 Assets
3.5 Investments
3.7 Liabilities
3.8 Equity
3.9 Summary
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Accrual Accounting and the Balance Sheet
3.1 INTRODUCTION
At this point it is a good idea to differentiate between accrual and cash
accounting.
Accrual Accounting
Cash Accounting
The operating cycle, which is also known as the cash-to-cash cycle, is the
process of using cash to purchase current assets that are to be sold at a profit
and collected as cash. As an example, a company uses funds to purchase raw
material inventory that is produced into finished goods inventory, sold at a profit to
create a receivable and collected to become cash once again, then used to pay
the supplier, with the profits left in the business.
74
Accrual Accounting and the Balance Sheet
So far in the course we have defined GAAP, and discussed the entity concept, the
reliability principle, the cost principle, the going-concern concept, and the stable
monetary unit concept. Now we’ll consider additional GAAP concepts including:
Time Period concept: Even though the business will continue indefi nitely,
operating results need to be reported at regular intervals. All business activity is
divided into time periods for purpose of reporting. The commonest time period is
a year, though companies whose shares are traded on stock exchanges report
more often – once every quarter.
75
Accrual Accounting and the Balance Sheet
Revenue Principle: Record revenue when it is earned – usually this is when the
business has delivered a good or service to a customer.
Matching principle: Match the expense of a period against the revenue earned
during that same period.
Accrual accounting does a good job of complying with the matching principle but
using accrual accounting necessitates making adjusting entries to properly match
expenses with revenue.
Before we proceed, let us take a brief look at what the Balance Sheet and Profit &
Loss Account (also called an Income Statement) of a business looks like.
Generally, the first, preliminary step in preparation of Balance Sheet and Profit
and Loss Account is drawing up the Trial Balance. As we saw earlier in Chapter 2,
the Trial Balance is intended to check the arithmetical accuracy of all entries in
the ledger. If all entries are accurate, then the sum total of all debit and credit
balances in all accounts put together should be equal. This is technically called
an Unadjusted Trial Balance, because entries for “adjustments” necessary to
recognise the principle of accrual, like taking account of prepayments and dues
as on the balance sheet date happens after this stage.
Analyzing how the balance sheet changes over time will reveal important
information about the company’s business trends. We'll attempt to learn how, with
the Balance Sheet, you can monitor the ability of the business to collect
revenues, how well inventory is managed, and even assessment of the
business’s ability to satisfy its creditors and shareholders.
76
Accrual Accounting and the Balance Sheet
The liabilities and net worth on the balance sheet represent the company's
sources of funds. Liabilities and net worth are composed of creditors and
investors who have provided cash or its equivalent to the company in the past. As
a source of funds, they enable the company to continue in business or expand
operations. If creditors and investors are unhappy and distrustful, the company's
chances of survival are limited.
Assets, on the other hand, represent the company's use of funds. The company
uses cash or other funds provided by the creditor/ investor to acquire assets.
Assets include all the things of value that are owned or due to the business.
Presently, we will learn about the elements of the Balance Sheet and how they
either use or provide “funds”. For example, when a supplier sends you inventory
on credit, he or she in essence is providing "funds" that you may use to operate
your business. Recall that you record both an asset (inventory) and a liability
(accounts payable) when you purchase goods on credit. Of course, you must be
able to pay your supplier in cash in a timely manner. Otherwise, your ability to
continue to do business with that creditor, at least, will stand compromised.
An example of a company’s Balance Sheet is given below. Note that there are
two Balance Sheets as on two different dates. Note also that the figures are in
Rs. Millions. This makes it possible to appreciate the figures much more easily.
3.4 ASSETS
As noted previously, anything of value that is owned or due to the business is
included under the Asset section of the Balance Sheet. Assets are shown at net
book value or net realizable value (more on this later), but appreciated values are
not generally considered.
77
Accrual Accounting and the Balance Sheet
Non-Current Assets are defi ned as those that will not mature into cash within
the next 12 months. They can consist of the following asset categories:
Fixed Assets are those assets that are long term investments which enables the
business to carry on its operations. Fixed assets represent the use of cash to
purchase physical assets whose life exceeds one year. They include assets such
as:
o Land
o Building
o Machinery and Equipment
o Furniture and Fixtures
o Leasehold Land
o Vehicles etc.
Calculating Net Fixed Assets When a fi xed asset is purchased for use in
operations of the business it is recorded at cost. As the asset wears out, an
amount is charged to expense and accumulated annually in a contra-account
known as accumulated depreciation. Accumulated depreciation is the cumulative
sum of all the years' worth of wearing out that has occurred in the asset. The
gross fi xed asset (purchase price) less the accumulated depreciation equals the
Net Fixed Asset Value (also known as book value).
78
Accrual Accounting and the Balance Sheet
o Patents
o Market Research
o Goodwill
o Organizational Expenses
In several respects, intangibles are similar to prepaid expenses; the use of cash
to purchase a benefit which will be expensed at a future date. Intangibles are
recouped, like fixed assets, through incremental annual charges (amortization)
against income. Standard accounting procedures require most intangibles to be
expensed as purchased and never capitalized (i.e. put on the balance sheet). An
exception to this is purchased patents that may be amortized over the life of the
patent.
Under each head of fixed asset, the following details is separately given:
It may so happen that a particular fixed asset was purchased from a foreign
country. As a result of a change in the exchange rate after such purchase, there is
an increase or reduction in the liability of the company in terms of rupees, for
making payment towards cost of the asset. The amount by which the liability has
so increased or reduced must be added to or deducted from the cost of the asset.
The resultant figure will be treated as the cost of the asset.
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Accrual Accounting and the Balance Sheet
Similarly, to reflect the current enhanced value of fixed assets, some entities tend
to add up certain sums by writing up / revaluing the asset. Each subsequent
balance sheet should show the increased figures with the fact of revaluation
prominently displayed on the face of the balance sheet.
Depreciation in value of fixed assets is a charge against profit for the year. On
one hand it is reduced from the income, as well as it is also reduced from the
value of the fixed asset. The accounting entry for the same would be as under:
! Depreciation!! Dr.
! ! To! ! Fixed Asset
3.5 INVESTMENTS
A Company may invest its surplus funds in different ways. The surplus may be
temporary or a long term basis. Often the exigencies of business may require the
Company to invest funds in a particular venture or investment.
80
Accrual Accounting and the Balance Sheet
When the investment is acquired, the Investment account (real a/c) gets some
thing and is debited. The cash or cheque is paid for the acquisition. It is credited.
The suitable book entry can be:
! Investment ! Dr.
! Cash/ Bank
For better presentation of information, the Investments are also classified into
trade investments and other investments. Trade investment would mean an
investment by a company in the shares or debentures of another company, not
being its subsidiary, for promoting its own trade or business.
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Accrual Accounting and the Balance Sheet
Current Assets are those, which mature in less than one year. They are the sum
of the following categories:
• Cash
• Accounts Receivable (A/R)
• Inventory (Inv)
• Notes Receivable (N/R)
• Prepaid Expenses
• Other Current Assets
Cash is the only game in town. In Hindi, they call it, Sabse bada Rupaiah! (Cash
is the biggest of them all!) Cash pays bills and obligations. Inventory, receivables,
land, building, machinery and equipment do not pay obligations even though they
can be sold for cash, which can then be used to pay bills. If cash is inadequate or
improperly managed, the company may become insolvent and be forced into
bankruptcy. Include all bank accounts, money market and short-term savings
accounts under Cash. Cash management is discussed more in detail in Chapter
4.
Receivables are money due from customers. They arise as a result of the
process of selling inventory or services on credit, i.e., on terms that allow delivery
before collection of cash. Inventory is sold and shipped, an invoice is sent to the
customer, and later cash is collected. The receivable exists for the time period
between the selling of the inventory and the receipt of cash.
Receivables are the third most liquid asset after cash and short-term investments.
Receivables are commonly divided into three categories:
Bills of Exchange (or Notes Receivable) – Written promises to pay a defi nite
sum at a future date
82
Accrual Accounting and the Balance Sheet
o Allowance Method
o Direct Write Off Method
At time of sale
! Accounts Receivable
! ! To Sales Revenue
83
Accrual Accounting and the Balance Sheet
The Aging of Receivables Method considers the age and amount of the Closing
Accounts Receivable balance. This method assumes that longer an account goes
uncollected, the more likely it is to go bad. The prior balance in the Allowance
Account must be considered when recording the amount of expense under this
method.
Firms often use the Percentage of Sales Method on interim statements and use
the more precise Aging of Receivables Method on year-end statements.
At time of sale
! Accounts Receivable
! ! To Sales Revenue
This method usually does not comply very well with the matching principle as the
sale typically takes place in one period and the write-off in another period.
Receivables are proportional to sales. As sales rise, the investment you must
make in receivables also rises.
Example: Receivables vary with sales. ABC Company gives net 30 Day terms to
its customers. Any sale made today will be collected one month from today. ABC's
customers are prompt payers and all receivables are collected on the 30th day.
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Accrual Accounting and the Balance Sheet
On an average, ABC will have one month's worth of sales always invested in
receivables.
In 20X5, sales are Rs.1,200,000. Receivables, which are equal to one month's
sales, total Rs.100,000. In 20X6, sales rise to Rs.2,400,000. Receivables, which
remain at one month's worth of sales, rise to Rs.200,000.
Due to the growth in sales, the company is forced to increase its investments in
accounts receivable by Rs.100,000. This investment in receivables is automatic
and unavoidable. It does not indicate the company's terms have been lengthened
or that management of collections has decayed or become looser.
2 A report where all receivable accounts are classified into how many days have
elapsed since delivery of goods has been made. Typically, aging of A/R is divided
for analysis into under 30 days, 31-60 days, 61-90 days, and 91 days and above,
if the normal credit terms are 60 days.
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Accrual Accounting and the Balance Sheet
Allowance for doubtful debts: At some point in time you may have customers
that are unable to pay for the goods or services they received from you. When
you determine that you will be unable to collect these amounts, you will (albeit
reluctantly) write off the receivable and record a "write-off" loss. As your business
matures, you will be able to estimate the amount of such losses. Many
businesses calculate this expense on a monthly basis based on sales or a
percentage of past due accounts. The allowance for doubtful accounts is
subtracted from gross receivables on the Balance Sheet to show the net
receivable balance.
For a company that sells a product, inventory is often the first use of cash.
Purchasing inventory to be sold at a profit is the first step in the profit-making
cycle (operating cycle) as illustrated previously. Selling inventory does not bring
cash back into the company – it creates a receivable. Only after a time lag equal
to the receivable's collection period will cash return to the company. Thus, it is
very important that the level of inventory be well managed so that the business
does not keep too much cash tied up in inventory, as this will reduce profits. At
the same time, a company must keep sufficient inventory on hand to prevent
stockouts (having nothing to sell) because this too will erode profits and may
result in the loss of customers.
The ordering phase is the time it takes a company to order and receive raw
materials. The production phase is the time it takes to produce finished goods
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Accrual Accounting and the Balance Sheet
from raw materials. The finished goods/delivery phase is the amount of time
finished goods remains in stock and the delivery time to a customer.
Now let's look at an example of how a small business might use this information
to plan its purchases and manage inventories.
ABC Company produces special clay pots and vases. The company buys clay
from Sticky Clay and Co and receipt of the clay generally takes 14 days. If the
company orders clay today, it will receive the clay in 14 days. To prevent
stockouts (i.e., situations where there is no stock of clay, resulting in stoppage of
production), the company reorders whenever clay inventories drop to 14 days.
Once in the shop, the clay base is mixed with water and rests 1 day to set up to
the proper texture. It takes 1 day to spin the vase, 3 days to dry, 1 day to paint
and 1 more day to dry. The production cycle from wetting clay to drying the paint
is thus 7 days. Because it takes 7 days to produce 7 days worth of sales, the
company never lets its stock of pots and vases shrink to less than 7 days worth of
sales. The delivery phase is very short because most of the product will be
delivered in the immediate area. Management estimates that delivery takes one
day at the most.
If clay is ordered today, a vase made of that clay can be delivered to a customer
no sooner than 22 days from now. Now let us also assume that ABC Company’s
management likes to keep an additional 5 days of inventory on hand as a cushion
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Accrual Accounting and the Balance Sheet
to cover any delays in receipt of the clay and production of the vases. Therefore,
the company's total inventory cycle is 27 days. To keep the cycle running
smoothly, the company must keep its investment in inventory equal to 27 days
worth of sales.
The company must keep an investment in inventory equal to its inventory cycle. If
ABC keeps only 15 days' worth of investment in inventory, it eventually will run
out of stock because clay ordered today cannot be delivered as a vase for 22
days.
This investment requires the use of cash. Thus, in the above example, ABC must
have sufficient cash to acquire at least 22 days of inventory, and that
management operates more comfortably with 27 days' sales in inventory.
Knowing this, we can estimate the rupee amount of inventory as follows:
The investment in inventory will vary according to both the sales per day and the
length of the inventory cycle in days. As sales rise, the amount of inventory sold
daily rises and the investment in a day's worth of inventory must increase or
stockouts will eventually occur. As the inventory cycle lengthens more inventory
must be kept in hand to produce the same level of sales and the investment in
inventory increases.
Ideally, inventory will be at a level slightly greater than the inventory cycle.
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Accrual Accounting and the Balance Sheet
Notes receivable are notes due usually from one of the following sources:
Customers, Employees, or Officers of the company. Bills of Exchange are
invariably from customers.
Customer notes receivable is when the customer who borrowed from the
company probably borrowed because he could not meet the accounts receivable
terms. When the customer failed to pay the invoice according to the agreed upon
payment terms. The customer's obligation may have been converted to a
promissory note. This happens fairly rarely in India, not because payment
defaults don’t happen often, but because persons defaulting on payments are
often so blasé about the default, that they don’t usually bother to document it in
the form of a promissory note.
An officer or owner borrowing from the company is the worst form of note
receivable. If an officer takes money from the company, it should be treated as a
dividend or withdrawal and reflected as a reduction in net worth. Treating it in any
other way leads to possible manipulation of the company's stated net worth, and
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Accrual Accounting and the Balance Sheet
banks and other lending institutions frown greatly upon it. The Income Tax Act in
India mandates this treatment, by treating such a withdrawal as a dividend
declared, and taxing it in the recipient’s hands.
Days’ Sales in Receivables indicates how long it takes to the collect the average
level of receivables. Companies strive to reduce this ratio and lower the number
of days it takes to collect receivables. The ultimate ”champion” in this fi eld
undoubtedly is Dell Computers, which has built a huge business of selling
computers and associated items directly to customers without a chain of middle-
men. If you wish to buy a computer from Dell, it will recover the money in
someway or the other (usually via EFT or credit card). The ratio can be calculated
using a two-step approach.
Other Current Assets consist of prepaid expenses and other miscellaneous and
current assets. Prepaid expenses are uses of cash to purchase in full a good or
service, the benefi t of which will be received within the next 12 months. Insurance
is the most common form of prepaid expense. The premium is paid prior to the
receipt of the benefi t. Paying a bill before the benefi t from the purchase has been
received has depleted cash. Miscellaneous and other current assets generally
consist of small deposits or receivables.
Total Assets is the sum of all the assets owned by or due to the business.
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Accrual Accounting and the Balance Sheet
balance sheets, report format balance sheets, and account format balance
sheets. Giving a listing of balance sheet accounts, you should be able to prepare
a classified balance sheet.
3.7 LIABILITIES
Liabilities and Net Worth are sources of cash listed in descending order from
the most nervous creditors and soonest to mature obligations (current liabilities),
to the least nervous and never due obligations (net worth). There are two sources
of funds: lender-investor and owner-investor. Lender- investor consists of trade
suppliers, employees, tax authorities and fi nancial institutions. Owner-investor
consists of stockholders and principals who loan cash to the business. Both
lender-investor and owner-investors have invested cash or it’s equivalent into the
company. The only difference between the investors is the maturity date of their
obligations and the degree of their nervousness.
Current Liabilities: are those obligations that will mature and must be paid within
12 months. These are liabilities that can create a company's insolvency if cash is
inadequate. A happy and satisfi ed set of current creditors is a healthy and
important source of credit for short term uses of cash (inventory and receivables).
An unhappy and dissatisfi ed set of current creditors can threaten the survival of
the company. The best way to keep these creditors happy is to keep their
obligations current.
• Accrued Expenses
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Accrual Accounting and the Balance Sheet
Proper matching of sources and uses of funds require that short term (current)
liabilities must be used only to purchase short-term assets (inventory and
receivables).
Notes Payable (N/P): are obligations in the form of promissory notes with short-
term maturity dates of less than 12 months. Often, they are demand notes
(payable upon demand). Other times they have specifi c maturity dates (30, 60,
90, 180, 270, 360 days maturities are typical). The notes payable always include
only the principal amount of the debt. Any interest owed is listed under accruals.
Accounts Payable are obligations due to trade suppliers who have provided
inventory or goods and services used in operating the business. Suppliers
generally offer terms (just like you do for your customers), since the supplier's
competition offers payment terms. Whenever possible you should take advantage
of payment terms as this will help keep your costs down.
If the company is paying its suppliers in a timely fashion, days payable will not
exceed the terms of payment.
Accrued Expenses are obligations owed but not billed such as wages and payroll
taxes, or obligations accruing, but not yet due, such as interest on a loan.
Accruals consist chiefly of wages, payroll taxes, interest payable and employee
benefits accruals such as pension funds. As a labor related category, it should
vary in accordance with payroll policy (i.e., if wages are paid weekly, the accrual
category should seldom exceed one week's payroll and payroll taxes).
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Accrual Accounting and the Balance Sheet
Current Portion of Long Term Debt (CLTD): is the portion of term loans due
within the next 12 months. A term loan is a loan that carries a maturity that
exceeds one year. It is divided into two segments; the portion due within 12
months (CLTD) and the portion due beyond one year (LTD). This bifurcation of
Long-term Debt is not mandated by the Companies Act for Indian companies, but
is generally insisted upon by bankers and other fi nancers to the company,
because this fi gure gives a partial indication as to how much loan-servicing
burden the company carries in the year immediately following the date of the
Balance Sheet.
The non-current portion is listed separately from the current liability section. Any
interest due is listed as an accrual, and is added to the amount of the loan due.
Term loans are fundamentally different from notes payable. As sources of funds
that are repaid over a period longer than 12 months, they can be used to acquire
longer-term assets (assets that mature to cash beyond 12 months).
• Fixed Assets
Non-current Liabilities: are those obligations that will not become due and
payable in the coming year. There are three types of non-current liabilities, only
two of which are listed in the balance sheet:
• Contingent Liabilities
Non-current portion of long-term debt is the principal portion of a term loan not
payable in the coming year.
Non-Current Portion of Long Term Debt (LTD) is the portion of a term loan that
is not due within the next 12 months. It is listed below the current liability section
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Accrual Accounting and the Balance Sheet
to demonstrate that the loan does not have to be fully liquidated in the coming
year. Long-term debt (LTD) provides cash to be used for a long-term asset
purchase, either as permanent working capital or as fi xed assets.
Contingent Liabilities are potential liabilities that are not listed in the balance
sheet. They are listed in the footnotes because they may never become due and
payable. Contingent liabilities include:
• Lawsuits
• Warranties
• Cross Guarantees
If the company has been sued, but the litigation has not been initiated, there is no
way of knowing whether or not the suit will result in a liability to the company. It
will be listed in the footnotes because while not a real liability, it does represent a
potential liability, which may impair the ability of the company to meet future
obligations. Alternatively, if the company guarantees a loan made by a third party
to an affiliate, the liability is contingent because it will never become due as long
as the affiliate remains healthy and meets its obligations.
Total Liabilities represents the sum of all monetary obligations of a business and
all claims creditors have on its assets.
3.8 EQUITY
Equity or Net Worth is the most patient and last to mature source of funds. It
represents the owners' share in the financing of all the assets. It consists of two
types of equity; Purchased Equity, and Earned Equity. Purchased equity consists
of:
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Accrual Accounting and the Balance Sheet
• Earned equity consists of retained earnings (also called Reserves and Surplus
or Earned Surplus).
Purchased Equity represents the cash the owners have invested in the company
in the form of shares. Stock comes in several forms:
Preference Shares are shares that have some preferences to equity shares.
Generally, Preference Shareholders receive a dividend before equity
shareholders, and if the company is ever liquidated, they will receive a share in
liquidation proceeds prior to equity shareholders.
Equity Share is the general ownership tool. It is the least nervous, last to be paid
source of funds.
Paid up Capital arises if the share is quoted at an arbitrary par value (called face
value). In India there is a concept of face value, but in many countries, the
concept of face (or par) value simply does not exist.
Total Liabilities and Net Worth represent the sources of funds that fi nance the
assets and are an indicator of the company's ability to survive in the future. A
happy, satisfi ed set of creditors is a harbinger of future prosperity and continued
success.
3.9 SUMMARY
The operating cycle of business is also known as ‘cash to cash’ cycle. It starts
with funds collected by the owners. These are used to arrange purchases and
build materials inventory. This inventory used to produce finished products for
sale. When they are sold to customers they become Sundry Debtors. Then
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Accrual Accounting and the Balance Sheet
Even though this cycle goes on and on, it is necessary to report operating results
at regular intervals; normally a year. Listed companies are required to prepare
reports every quarter.
Assets shown in the balance sheet are classified based on their liquidity.
Noncurrent assets are those which will not mature into cash within a year. They
include net fixed assets, investments in subsidiaries, intangibles etc. Fixed assets
are long term investments which enable the business to carry operations and
include Land, Buildings, Machinery and Equipment, Furniture and Fixtures and
Vehicles etc. When the amount of accumulated depreciation is reduced from the
original value of the fixed assets we arrive at net fixed assets.
Current assets are those, which mature into cash in less than a year. Cash,
accounts receivables, inventory, pre-paid expenses are all current assets.
Accounts receivables and Inventory are controlled by monitoring how fast they
are turned over in a year.
Liabilities and net worth are sources of cash and are listed in the balance sheet in
that order. Current liabilities are that which will mature and must be paid within 12
months. Portion of a long term loan that is payable in the current year is due in
less than 12 months and has to be shown separately for Bankers. Contingent
liabilities are potential liabilities and are shown as foot notes to the balance sheet.
Equity or net worth represents owners’ share in financing all the assets.
Purchased equity consists of paid up share capital, while earned equity consists
of retained earnings called as reserves.
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Accrual Accounting and the Balance Sheet
2. Operating cycle of a business can be observed from the Balance Sheet of the
business. Do you agree to this? Explain.
5. What are Contingent liabilities? How are they reflected in Balance Sheet?
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Accrual Accounting and the Balance Sheet
1. Accrual Accounting records Revenue as earned ignoring whether the cash is paid
for the same. It records expense as incurred ignoring whether and when the expense
is paid in cash. Cash Accounting records revenue as cash is received and records
expense when it is paid ignoring when the cost is incurred.
2. Operating cycle of a business involves the process of converting the raw material
to cash i.e. the cash-to-cash cycle. It includes components such as purchase of raw
material inventory, converting it into finished goods inventory, sale thereof at profit to
create a receivable and collection to convert into cash once again which is used to
pay the supplier and the profits left in the business.
3. Matching principle matches the expense of a period against the revenue earned
during that same period. Accrual accounting aims to match the expenses with
income of the relevant accounting period. But it calls for making adjusting entries to
properly match expenses with revenue.
4. Non-Current Assets are those assets that will not mature into cash within the next
12 months. They include Net Fixed Assets, Investment in Subsidiaries and Joint
Ventures, Intangibles and Other Assets. The Current Assets are those assets of
business, which mature in less than one year. They include the broad groups of
Cash, Accounts Receivable, Inventory, Notes Receivable, Prepaid Expenses and
Other Current Assets.
5. Contingent liabilities are potential liabilities and not actual ones as of the date.
They have as yet not become due. These are listed by way of footnotes to the
Balance Sheet and not as part of the Balance Sheet as they have not accrued.
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Accrual Accounting and the Balance Sheet
REFERENCE MATERIAL
Click on the links below to view additional reference material for this chapter.
Summary
PPT
MCQ
Video1
Video2
99
4
The Profit and Loss Account or The
Income Statement
Objectives:
100
The Profit and Loss Account or The Income Statement
Structure:
4.1 Introduction
4.3 Revenue
4.4 Expenses
4.9 Summary
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The Profit and Loss Account or The Income Statement
4.1 INTRODUCTION
The Profit and Loss Account is the summary of all transactions, which the
company has entered into a revenue account during the accounting period.
An accounting time period that is one year long is called a fiscal year. In India,
normally, fiscal years begin on 1st April and end on 31st March. However,
companies are free to adopt any other 12-month period as their fiscal year,
provided they also draw up for tax purposes a set of accounts as on 31st March
every year as well. In the US, the Profit and Loss Account is called the Income
Statement. For understanding what “revenue account” is, we need to
understand the distinction between Revenue and Capital.
There is a principle called the Revenue Recognition principle that dictates that
revenue be recognized in the accounting period in which it is earned.
All revenue receipts and expenses are part of the Profit and Loss Account, the
net balance of which is transferred to Owners’ Equities (Reserves) in the Balance
Sheet. The Profit and Loss Account is also called an Income Statement, and is
usually presented in a format that is now globally accepted, known as the
Vertical format. We give on page 82 a sample Profit and Loss Account in this
format.
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The Profit and Loss Account or The Income Statement
4.3 REVENUE
Companies earn revenue in one or more of the following ways:
Some companies have only one source of revenue; some others have several
sources. For example, Hindustan Lever Limited, a large marketer of Fast- Moving
Consumer Goods (FMCG) reports revenue from its products, such as food and
personal care products. Infosys Technologies Ltd, a large software company, on
the other hand reports revenue from software services. Some other companies,
like Wipro Ltd, report revenues from software and IT-enabled services, as well as
from sale of products such as lighting fixtures and vegetable oils. Financial
analysts often refer to Revenues as the “top line” because, often, this is the first
line in the Income Statement.
4.4 EXPENSES
The Matching Principle requires that expenses be recorded in the same period in
which the revenues they helped produce are recorded. In the Cash basis of
accounting, expenses are recorded only when they are paid for, whereas in the
accrual basis of accounting, expenses are recorded when they are incurred.
Cash basis is not in accordance with GAAP.
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The Profit and Loss Account or The Income Statement
A company deducts these costs (cost of sales, cost of goods sold) from its
revenue, showing the resultant gross profit (or loss).
104
The Profit and Loss Account or The Income Statement
EXPENDITURE
Raw Materials, Packing Materials 1,10,312 1E+05
Conversion Charges - -
Excise Duty - -
Employee Costs 8,213 8,036
Sales, General and Admin Expenses 10,869 11,640
R & D Expenses
Depreciation 15,291 13,784
Provisions 5,555 1,836
Deferred Revenue Exp w/off - -
Interest and Finance Charges 9,916 8,677
Total 1,60,156 1E+05
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The Profit and Loss Account or The Income Statement
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The Profit and Loss Account or The Income Statement
Earnings per share (EPS) show how much money the shareholders would receive
for each share of the company, if the company distributed all its net earnings to
its shareholders. For example, if the net earnings are Rs.1 crore and 500,000
shares have been issued, the earnings per share are Rs.20 (Rs.10,00,000 ÷
500,000 = Rs.20).
Although all net earnings really belong to the shareholders, companies rarely
distribute the full amount as dividends. This is because they need the money to
grow and to expand their business, by reinvesting this money in its own
business. The total amount of a company's net earnings since its inception,
minus any payments made to shareholders by way of dividends, are called
Retained Earnings.
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The Profit and Loss Account or The Income Statement
1. What is the first thing you see in the Financial Reports? Do the Reports you
are seeing pertain to the same accounting year?
2. Who are the auditors? Where has the Audit Report been signed?
4. What does currently each company unit in express the figures of their financial
statements?
5. Would you consider Net of Excise Sales, or Sales including Excise for
comparability? Where does Excise duty figure in Sun Pharmaceuticals’ Profit
and Loss Account?
6. What was the cost of goods sold for each company? How would you deduce
the same from the Profit and Loss Account?
8. How much was the profit after tax for each company?
11.What was the amount of the current assets for each company? What are
some of the items included in current assets?
12.What was the amount of total assets for each company? What are some of
the items are included in fixed assets?
13.What was the amount of the current liabilities for each company? What are
some of the items included in current liabilities?
14.What was the amount of total liabilities for each company? What are some of
the items included in long-term liabilities?
108
The Profit and Loss Account or The Income Statement
a. Working Capital
b. Current Ratio
c. Quick Ratio
16.Based on the liquidity ratios, which company, Sun or Dr Reddy’s is better able
to meet its current obligations?
Note: This website, and most other websites that we point you to, are constantly
being updated. Please check to see that the information requested in this
exercise is available. It might be useful for you to print out the pages of the
financial statements alone (if not all pages) and keep the hard copies handy while
doing this exercise.
Dell Computer Corporation's activities run the full range from design and
development to manufacturing, marketing, and servicing many types of
computer systems. In addition to laptops and desktops, the company also
manufactures enterprise systems. In order to accomplish all of these business
functions, the company needs to have a fairly significant investment in operating
assets. In this exercise, you will look at what types of long-term assets the
company has and how they are reported in the financial statements. The
company's most recent filing can be found on the Dell Web site, by clicking on
About Dell, Investors, Annual Reports.
3. The first footnote to the financial statements indicates that the property, plant
and equipment are carried at depreciated cost. What does that mean? Is that
allowed under GAAP? What accounting concepts apply to this method?
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The Profit and Loss Account or The Income Statement
5. How much did the company spend for capital expenditures in the latest year?
Where do you find this information? Do you think this amount of expenditure is
good or bad? Why?
6. What is their inventory? How many days of sale does it represent? How does
this compare with other companies in the same or other industries?
Note: The Dell Annual Report is a largish download of nearly 5 MB. So it might
be a good idea for one of you to download it on to a CD and circulate the CD to
your co-students.
With nearly 25,000 restaurants in over 100 countries, McDonald's is the largest
and best-known global food service retailer. Go to www.mcdonalds.com under
Corporate, Investor Info, and select Financial Reports.
Based on the "Letter to Shareholders," how did management portray the annual
performance of the corporation?
4.9 SUMMARY
The profit and loss account is the summary of all transactions, which the
company has entered into a revenue account during the accounting period.
Capital expense is that which is laid out for investment / purchase not intended
to be sold at a profit in the normal course of business. Anything which is
intended for to be sold in the normal course of business is revenue expenditure.
Capital and revenue receipts are also distinguished similarly.
When expenses for producing goods sold are deducted from revenue generated
by their sale you arrive at gross profit (or loss). From this, company deducts
operating expenses like advertising, salaries, rent, research and development,
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The Profit and Loss Account or The Income Statement
Cost of debt financing i.e. interest is deducted from EBIT to arrive at net earnings
or profit. If all these earnings were to be distributed to shareholders one gets
earnings per share. A part of net earnings is actually distributed as dividends and
remaining part is called retained earnings. Retained earnings denote
shareholders equity and that part of the assets that is not financed through issue
of shares or long term loans.
a. Computers
b. Patents
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The Profit and Loss Account or The Income Statement
c. Finished goods
d. Buildings
a. Cost
a. Land
b. Goodwill
c. Inventories
d. Patents
c. Unpaid taxes
d. Debentures
a. Balance Sheet
c. Directors Report
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The Profit and Loss Account or The Income Statement
d. Income Statement
a. Patents
b. Goodwill
c. Dematerialized shares
d. Brand names
c. sale of investments
d. share buyback
c. repayment of loan
d. share buybacks
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The Profit and Loss Account or The Income Statement
SOLVED EXAMPLE
1. Continuing with the solved example No.1 at the end of Chapter 2, post the
entries of Abhay & Co to the respective ledger accounts and prepare a Trial
Balance (assuming manual, T-form of accounts and Financial Statements are
adopted.
After preparing the Trial Balance, prepare the final accounts (i.e. Profit & Loss
Account and Balance Sheet) of Abhay and Company taking into consideration
the following further adjustments.
114
The Profit and Loss Account or The Income Statement
ii)Depreciation on Plant and Machinery @ 10% per annum and Furniture @15%
per annum.
Ledger Posting
Cash Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
By Conveyance
To Mohan’s A/c 10,050 700
A/c
By Stationery A/
450
c
39,650 39,650
Capital Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
115
The Profit and Loss Account or The Income Statement
Purchase Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
44,000 44,000
Furniture Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
Bank Account
Dat J. Amount Dat J. Amount
Particulars Particulars
e F Rs. e F Rs.
By Insurance
2,000
Premium A/c
116
The Profit and Loss Account or The Income Statement
Rohan’s Account
Da J. Amount Dat Amount
Particulars Particulars J.F
te F Rs. e Rs.
To Discount
500 By Purchase A/c 8,000
Received A/c
13,000 13,000
Drawing Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
2,000 2,000
Mohan’s Account
Da J. Amount Dat J. Amount
Particulars Particulars
te F Rs. e F Rs.
117
The Profit and Loss Account or The Income Statement
Memon’s Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
Meena’s Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
550 550
500 500
Conveyance Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
118
The Profit and Loss Account or The Income Statement
Stationery Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
450 450
119
The Profit and Loss Account or The Income Statement
Salary Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
3,000 3,000
Wages Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
800 800
Interest Account
Dat Amount Dat Amount
Particulars J.F Particulars J.F
e Rs. e Rs.
500 500
Sales Account
Dat Amount Dat J. Amount
Particulars J.F Particulars
e Rs. e F Rs.
By Discount
400
Allowed A/c
42,000 42,000
120
The Profit and Loss Account or The Income Statement
Dat Credit
Particulars L/F Debit Rs.
e Rs.
Cash A/c 26,500 -
Capital A/c - 3,00,00
Purchase A/c 44,000 0
Plant & Machinery A/c 2,00,000 -
Bank A/c 44,500 -
Furniture A/c 30,000 -
Rohan’s A/c - -
Loan (Taken) A/c - 6,500
Drawing A/c 4,000 12,000
Insurance Premium A/c 2,000 -
Memon’s A/c - -
Meena’s A/c 12,000 8,000
Discount Allowed A/c 550 -
Discount received A/c - -
Conveyance A/c 700 500
Stationery A/c 450 -
Salary A/c 3,000 -
Wages A/c 800 -
Interest A/c - -
Interest (paid) A/c 42,000 500
Sales A/c -
83,000
4,10,500 4E+05
121
The Profit and Loss Account or The Income Statement
Profit & Loss Account of Abhay and Company for year ending on ____________
122
The Profit and Loss Account or The Income Statement
123
The Profit and Loss Account or The Income Statement
Problems to Solve
124
The Profit and Loss Account or The Income Statement
125
The Profit and Loss Account or The Income Statement
5. Interest on Long term Investments due but not received Rs. 300
6. Interest on Short term Loan due but not paid Rs. 600
9. Inventories on March 31, 200X (year end date) are valued as follows
Prepare an Income statement for the year ending March 31st, 200X and a
Balance Sheet as on March 31, 200X.
126
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5
The Statement of Cash Flows
Objectives:
128
The Statement of Cash Flows
Structure:
5.1 Introduction
5.4 Summary
129
The Statement of Cash Flows
5.1 INTRODUCTION
The statement of cash flows is one of the principal financial statements required
by GAAP. Let’s consider these financial statements in terms of what information
they provide, what accounts they include, what time period they cover, etc.
Balance Sheet
Income Statement or Profit and Loss Account
Statement of Cash Flows
Which is the most important financial statement? Remember that positive net
income on the income statement is meaningless unless the corporation can
translate earnings into cash inflows. Since most companies use accrual
accounting, the only place one can discover what has happened to cash is the
statement of cash flows. And as we have said elsewhere, cash is the only game
in town.
ii. Inflow of funds by way of additional short term or long term borrowings
requiring cash out flow in future by way of interest payment and for the
repayment of the principal, or
130
The Statement of Cash Flows
The statement of cash flows reports cash flows (cash receipts and cash
payments) in the following categories:
(3) Financing activities: Transactions which affect the equity and debt of the
Business
In preparing a statement of cash flows, the definition of cash includes both cash
(currency and bank account balances) and cash equivalents. Cash equivalents
are short-term highly liquid instruments maturing in 90 days or less, i.e. T-bills
(short for Treasury Bills), short term CDs (Certificates of Deposit), CPs
(Commercial Paper) and other short-term financial instruments.
The only difference between the two methods is how cash flows from operating
activities are calculated. Cash flows from investing and financing activities are
calculated identically in both methods. We’ll discuss the indirect method first.
131
The Statement of Cash Flows
The steps to prepare the operating activities section (indirect method) and convert
the accrual net income figure to a cash figure are as follows:
Once the operating activities section has been completed, the investing and
financing activities sections can be prepared.
The statement of cash flows prepared using the direct method converts each item
in the income statement to a cash flow, i.e., sales are converted to cash receipts
from sales, etc. Of course, the net cash inflow from operating activities is the
same whether the statement is prepared by the indirect or direct method.
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The Statement of Cash Flows
as this serves as an example of the Vertical Form Balance Sheet, Profit and Loss
Account Statement and Cash Flow Statement.
It is important to observe that the cash flow compares Balance Sheets as on two
dates and determines the cash inflow or outflow or none at all. It is, therefore,
more convenient to plot the Balance Sheets on two dates in a vertical form.
The information from the statement of profit and loss and balance sheet is
provided to show how the statements of cash flows under the direct method and
the indirect method have been derived. Note that neither the statement of profit
and loss nor the balance sheet is presented in conformity with disclosure and
presentation requirements of applicable laws and accounting standards. It is
important to understand the manner in which the various figures appearing in the
cash flow statement are derived. The working notes given do not form part of the
cash flow statement.
! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !
1 Add non-cash expenses such as depreciation back to net income
2 Since the entire cash effect of gains or losses on fixed assets will be reported in
the Investing Section of the statement of cash flows, the effect of these sales
must be removed from the Operating Activities section.
3 Changes in current asset (other than cash) and current liability accounts result
from operating activities. For example, changes in Accounts Receivable result
from Sales on Account. Thus we have to account for these changes in the
operating activities section. An increase in accounts receivable is deducted from
net income because more sales revenue has been included in the income
statement than has been collected from customers. Similarly, decrease in
Accrued Liabilities is subtracted from net income because payment of a current
liability causes both cash and the liability to decrease.! ! ! ! ! ! !
! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !
133
The Statement of Cash Flows
Based on the above example indicate whether the following transactions will
result in the inflow of cash or an outflow of cash, or it will not affect the cash flow.
There are certain transactions which will have the effect of reducing the profit but
will not affect the cash flow. Such charges are known as ‘non-cash charges’. For
eg. When we charge depreciation on the assets there is no outflow of cash but
the profit gets reduced.
Based on the above example indicate whether the following transactions will
result in an inflow of cash or an outflow of cash, or it will not affect the cash flow.
134
The Statement of Cash Flows
5.4 SUMMARY
The statement of cash flows is one of the principal financial statements required
by GAAP. It gives an opportunity to see how good is the company in realizing
adequate cash flows from its main operating business.
The statement shows cash flows from operating, investing and financing
activities.
After operating activities are completed the investing and financing sections are
prepared.
In the direct method each item on he income statement is converted into cash
flow.
135
The Statement of Cash Flows
355000 393000
Assets
Machinery 100000 116000
Debtors 120000 115000
Raw Material 80000 90000
Cash 55000 72000
355000 393000
HINT:
a. Compare the Balance Sheet as at 31.3.2006 and 31.3.2007. Note the changes
that have taken place.
b. Determine the Increase / Decrease in Working Capital. And determine thee
Cash Used For Operations.
c. Proceed to determine cash flow from investing activities.
d. Proceed to determine the cash flow from financing activities.
e. Work out the cash at beginning of year and at the beginning of year.
Amalgamate (c) and (d).
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The Statement of Cash Flows
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6
Accounting for Inventory
Objectives:
• Inventory Systems.
• Inventory Costing.
138
Accounting for Inventory
Structure:
6.1 Introduction
6.5 Summary
139
Accounting for Inventory
6.1 INTRODUCTION
The general model of an income statement of a trader takes the following form:
Sales Revenue
Beginning Inventory
+ Purchases
= Goods Available
– Ending Inventory
140
Accounting for Inventory
Qty. Value
Nos. Rs.
Inventory as on 1.4.2007 25 100000
There are two principal types of inventory systems, the periodic system and the
perpetual system. The periodic system is used by companies, which sell
relatively inexpensive goods and do not need to accurately track inventory
throughout the year. Most companies use the perpetual system because it
provides a detailed record of inventory throughout the year. The accounting
differs depending on what system of inventory a firm is using. We will
concentrate on the perpetual inventory system.
Inventory
To Accounts Payable (or Cash)
Note that two journal entries are required to record a sale as follows:
141
Accounting for Inventory
In actual practice, the accounting for Inventory may be a little more complicated
than the general model above, as we need to properly account for Freight
Inwards, Purchase Returns, Purchases Allowances, and Purchase Discounts, not
to speak of other complexities like costs incurred after receipt of goods, quality
control rejections, goods sent out to third parties for processing, spoilage,
process-waste and by-product accounting, and so on.
Gross Sales
– Sales Discounts
= Net Sales
Rs.
Gross Sales 125000
Less: Sales Returns and Allowances 9300
Sub-Total 115700
Less: Sales Discounts 5000
Net Sales 110700
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Accounting for Inventory
Average Cost
Average Cost: Here, the value of inventory is taken on average cost. All the costs
incurred to bring the inventories to their present location and conditions are
incurred. All costs incurred in respect of the stock of the inventory are added up
and are then divided by the number of units in stock. The simple average cost of
inventory of 4 units acquired each at Rs. 8.00, Rs. 8.30, Rs. 8.50 and Rs. 8.80
would go as under:
When the stock of inventory is 1200 units, the value thereof @ Rs. 8.40 would be
Rs. 10,080/-.
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Accounting for Inventory
3350 34160
There are other methods also, like LIFO (Last In, First Out). Other than the above
three methods, no other method is approved by Indian GAAP.
Under FIFO, the first units acquired are assumed to be the first units sold.
Advantages of this method in a period of rising prices include:
• Does not adjust Cost of Goods Sold for the effect of inflation.
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Accounting for Inventory
The materials were purchased in lots on various dates in different rates. These
are issued to consumption in different quantities. The rates charged on quantities
issued to consumption are different from what they were when purchased.
Issues to consumption are made on the assumption that these came from the
oldest lot in balance. Cost of such oldest lot is charged to consumption.
Assuming Opening Stock of 300 Units valued at Rs. 3.25 per Unit, observe the
following:
145
Accounting for Inventory
146
Accounting for Inventory
L1 L2 L3 L4 L5
Incl. Op. Stock 1400
550
1550
500
550
150
1400
150
550
700
50
450
100
2050
147
Accounting for Inventory
The FIFO method would value the materials issued for consumption as follows:
148
Accounting for Inventory
With this, the Value of Closing Stock under FIFO would go as under:
Units Units
Op. Stock 300
Add: Purchases 12000 12300
The balance stock at the end of 22 January will be 1850 units and under FIFO
method if will be assumed to be out of Lot no. 5. Its value will be Rs. 4810 i.e.
Rs. 2.60 per unit.
Under the LIFO method, the last units acquired are assumed to be the first units
sold. Advantages of LIFO include:
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Accounting for Inventory
1. Interest and other borrowing costs are usually considered as not relating to
bringing the inventories to their present location and condition and are, therefore,
usually not included in, the cost of inventories.
(b) Storage costs, unless those costs are necessary in the production
process prior to further production stage;
• Closing stocks of finished goods are generally valued at “cost or market value,
whichever is lower”, except when a company is in the business of mining. The
mining companies value their stocks at net realisable value.
Once the entity opts for FIFO method for one year, it is not open to it to go for
average method in the subsequent year. Change, if required, must be for valid
and compelling reasons and must be effected only with due disclosure and
indicating the effect of such change on the net results for the year. Generally,
stakeholders and analysts do not regard such changes with favor.
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Accounting for Inventory
Conservatism Principle: A company should use the least favorable figure when
preparing its financial statements.
Inventory estimation is often used for interim reports or for insurance appraisal of
loss purposes. Closing inventory can be estimated as follows:
Opening Inventory
+ Purchases
= Total Inventory Available
– Estimated Cost of Goods Sold
= Estimated Ending Inventory
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Accounting for Inventory
For instance, when the opening inventory is Rs. 50,000 and the inventory
purchased is worth Rs.1,20,000 and the estimated cost of goods sold being
Rs.1,40,000, it can be estimated that the Estimated closing Inventory shall be
Rs.30000.
6.5 SUMMARY
There are two principal types of inventory systems, periodic and perpetual.
Periodic system is used for inexpensive goods or where there is no need to track
inventory accurately throughout the year. Most companies use the Perpetual
system so that they can track inventory throughout the year.
Cost of goods sold is the largest expense in the income statement and it is
determined by the method used for inventory costing. GAAP approve specific
identification, average cost or First in, First out (FIFO) methods of inventory
costing.
While valuing inventory, interest, selling and distribution, or any abnormal costs
are not included. Also principles of consistency, disclosure, materiality and
conservatism are to be applied.
2. How would you arrive at Inventory at the end of the year on the basis of the
opening Inventory, the purchases made during the year and the cost of goods
Sold during the year.
3. Briefly explain the periodic system and the perpetual system of inventory.
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Accounting for Inventory
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7
Accounting for Fixed Assets
Objectives:
• Methods of Depreciation.
154
Accounting for Fixed Assets
Structure:
7.17 Summary
155
Accounting for Fixed Assets
At the outset, we must understand the distinction between a fixed asset and a
non-fixed asset. For this, we must first appreciate the difference between Capital
and Revenue.
The accounting concept of matching costs with revenues has made it relevant for
any business to distinguish each of the items of payments as well as receipts as
to whether it is of a capital nature or in the nature of revenue. Drawing up
accounts for a specific period (accounting period) also necessitates the distinction
between capital and revenue in respect of receipts as well as outlays.
The importance of this distinction lies in the impact the decision has on the
bottomline – the net profit reported by the business. If an expenditure is classified
as revenue, the entire amount is treated as an expense of the period in which the
expense was incurred, whereas if it was treated as a capital expenditure, then in
the current year, only the current year’s depreciation on the capitalised value of
the asset is charged as an expense; the rest of the cost is deferred over the life of
the asset. Hence, a company wishing to show higher profitability would strain the
limits of the concept of capital expenditure, to capitalise as much of its
expenditure as possible.
Conversely, the tax laws encourage exactly the opposite tendency, because
capitalising expenditure would mean that taxable income would be higher than if
the same expenditure was treated as an allowable expense.
It is logical that the expenses incurred for a given period are matched with
revenues earned for the same period through the Profit and Loss Account.
Similarly, the payments or disbursements, which are not the expenses pertaining
to that period, and receipts, which do not represent the income of that period,
should not form part of the Profit and Loss Account and are therefore carried to
the Balance Sheet for the adjustment in the next period.
Thus, to arrive at true profit earned or loss incurred by the Business during an
accounting period and to know its correct financial position, expenditure incurred
156
Accounting for Fixed Assets
A fixed asset is an asset held with the intention of being used for the purpose of
producing or providing goods or services and is not held for sale in the normal
course of business.
There is no single rule of thumb, which can decide the distinction between capital
and revenue expenditure and capital and revenue receipt. However, general
guideline of principles for distinction can be applied; with regards to the facts of
each case. In other words, treatment can vary from case to case.
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Accounting for Fixed Assets
A capital asset in the hands of one person may still be a trading asset in the
hands of another, and similarly a receipt may also vary according to the nature of
trade in connection with which it arises. For example, the land on which a
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Accounting for Fixed Assets
manufacturer has his factory is part of his fixed assets, and its sale would be a
capital receipt. However, the land for a dealer in real estate is his stock-intrade,
and its sale would be a revenue receipt.
Receipt towards sale of plant and machinery is a capital receipt and receipt
towards sale of stock-in-trade is a revenue receipt.
• import duties and other non-refundable taxes or levies paid on such purchase
price
• any directly attributable cost of bringing the asset to its working condition for its
intended use e.g. installation costs
i. Expenses directly attributable cost of bringing the asset to its working condition
for its intended use: The implementation of a project and upto the trial runs
often continue over a long period of time. Expenses incurred in the course of
incurring these expenses obviously add to the value of fixed assets in a
company’s balance sheet. However, pragmatically speaking, these expenses
may not add to the intrinsic value of the asset, in other words, while such
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Accounting for Fixed Assets
expenses can be capitalised as part of the fixed asset schedule, the resale
value of the asset is not going to be impacted by including that amount.
ii.Companies do not give the break-up of costs capitalised and added to the value
of the asset. These are not shown separately from the actual purchase price of
the assets. A conservative view is that it may be prudent to treat such intangible
expenses as “miscellaneous expenses not written off’ or “preliminary and pre-
operative expenses”, instead of being added to the value of fixed assets.
• borrowing cost of funds that finance the asset, such as interest and foreign
exchange losses
However, to the extent that borrowing such costs (financing costs (including
interest) on fixed assets purchased on a deferred credit basis or on monies
borrowed for construction or acquisition of fixed assets) relate to periods after
such assets are ready to be put to use are not capitalised.
An interesting situation can arise where a company finances the entire cost of an
asset through its share capital or internal cash accruals. Here, there would be no
addition under the head “interest capitalised”. Similarly, if full down, payment were
made in foreign currency without resorting to a foreign currency loan, addition to
the asset value towards future foreign exchange losses would not be available.
From this, one may bear in mind that the value of an asset may be dependent on
sources of its finance.
Any trade discounts and rebates are deducted in arriving at the purchase price of
the fixed assets. Similarly, any Government Grants related to specific fixed assets
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Accounting for Fixed Assets
The self-constructed assets like building which is constructed by the entity on its
own or a plant which is installed or constructed by the entity shall be capitalised at
costs that are specifically related to the asset and those which are allocable to the
specific asset.
Goodwill should be accounted in books of account only when actually paid for by
the entity.
The Gross book values and the net book values at the beginning and end of the
year showing additions, deletions and other movements, expenditure incurred in
course of construction and revalued amount if any be disclosed by the entity. The
assets should be eliminated from the books of account on disposal or sale or
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Accounting for Fixed Assets
when it has no utility value. In such a case, the profit/Loss on disposal, shall be
recognised on disposal to the Profit & Loss account.
Accounting for machinery spares would call for special treatment. Machinery
spares which are not specific to a particular item of fixed asset, but can be used
generally for various items of fixed assets should be treated as part of any other
inventory. Such general purpose machinery spares should be charged to the
statement of profit and loss as and when issued for consumption in the ordinary
course of operations.
However, the machinery spares of the following types should be capitalised being
of the nature of capital spares/insurance spares -
i. Machinery spares which are specific to a particular item of fixed asset, i.e., they
can be used only in connection with a particular item of the fixed asset, and
For most companies fixed assets (also called Plant Assets or Long Lived Assets)
are extremely important as they constitute a large percentage of total assets in
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Accounting for Fixed Assets
the balance sheet and the related expenses of depreciation and amortization
amount to a substantial expense on the income statement.
Asset Account (on Balance Sheet) Related Expense (on Income Statement)
Land None
Property, Plant, and Equipment Depreciation
Natural Resources (like oilfields, mines) Depletion
Intangibles Amortization
The acquisition cost of fixed assets, includes all expenditures reasonable and
necessary to get the asset in place and ready for use.
Note that land and building are often purchased for a single lump sum. Since land
has an unlimited life and therefore is not depreciated, the accountant must
allocate the purchase price between land and building.
Revenue expenditures are those incurred for normal wear and tear expenses and
are debited to expense accounts. Capital expenditures, on the other hand, are
those costs, which improve an asset or extend its life and are debited to the asset
account.
! ! Accumulated Depreciation
163
Accounting for Fixed Assets
In actual practice, in place of Accumulated Depreciation, the Fixed Asset a/c itself
may be credited by the amount of Depreciation.
For example, an asset which cost Rs.110,000 and has an expected residual value
of Rs.10,000 after 10 years will be depreciated at Rs.10,000 every year for 10
years, calculated as below:
Since assets are typically not purchased on the first day of the year, it is
necessary to calculate partial year depreciation as follows:
2. Multiply full year depreciation by the fraction of the year the asset was in use.
164
Accounting for Fixed Assets
Machinery Account
Date Debit Rs. Date Credit Rs.
1.9.2006 Bank 45000 31.3.2007 Depreciation A/c 2,500
1.9.2006 Bank 5000 (@10% for 6 months
(Installation Charges) on Rs.50,000)
31.3.2007 Bal. c/d 47,500
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Accounting for Fixed Assets
Depreciation Account
Date Debit Rs. Date Credit Rs.
31.3.2007 Machinery a/c 2,500 31.3.2007 Profit& Loss a/c 2,500
(Cost – Residual Value)/Life in Units = (105 – 5)/20 = Rs.5 per unit produced
166
Accounting for Fixed Assets
the end of year II – Rs.64,000); the third year’s depreciation would be Rs.12,800
(20% of Rs.64,000) and so on.
Taking the example we considered for Straight line method, when the rate of
Depreciation is 10%, the Machinery a/c and the Depreciation a/c for three years
would look as under:
Machinery Account
Date Debit Rs. Date Credit Rs.
1.9.2006 Bank 45000 31.3.2007 Depreciation A/c 2,500
1.9.2006 Bank 5000 (@10% for 6 months)
(Installation Charges) 31.3.2007 Bal. c/d 47,500
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Accounting for Fixed Assets
Depreciation Account
Date Debit Rs. Date Credit Rs.
31.3.2007 Machinery a/c 2,500 31.3.2007 Profit& Loss a/c 2,500
The WDV method is approved under the Income-tax law, while the Companies
Act in India gives a choice for companies to apply either the SL or WDV method.
The WDV method provides for large write-offs in early years of an asset’s life and
smaller write-offs in later years. Asset book value is cost minus accumulated
depreciation. Note that with the WDV method, residual value is ignored in the first
year’s depreciation computation. It is considered in the last year, however, as
residual value should not be depreciated.
If you were trying to minimize income tax expense, which of the three methods
would you select?
Since the asset’s life is an estimate made at the time of purchase, it may be
necessary to change this estimate of life in later years based on experience or
new information. At some point fixed assets are no longer useful and are either
discarded, sold, or traded in (exchanged) for another asset. When this happens,
regardless of the disposition of the asset, the old asset account must be credited
and the old accumulated depreciation account must be debited as the old asset
must be removed from the books and records.
If the asset is fully depreciated, accumulated depreciated is debited and the asset
account is credited thus removing it from the books and records. The necessary
accounting entry for this would be:
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Accounting for Fixed Assets
Similarly, if the asset is sold mid-year, the depreciation account must be updated.
If the sales price is greater than book value, a gain is realized; and if the sales
price is less than book value, a loss is realized.
In the illustration for WDV method of Depreciation, the WDV of the asset as on
31.3.2004 is Rs.38,475/-. if the asset is sold mid-year, the updating of
depreciation account is required. When the sales price is greater than its
depreciated book value, the gain is realized and is recorded as:
The surplus / gain in Fixed Asset a/c is transferred to Profit on Sale of Asset a/c.
Machinery Account
Date Debit Rs. Date Credit Rs.
1.4.2009 Bal b/d 38,475 2.5.2009 Cash / Bank 40,000
2.5.2009 Profit from Sale of Asset a/c 1,525 (Sale Proceeds of asset)
In case of the asset realizing (sales price) less than its book value, a loss is
realized. This is represented by debit balance in Fixed Asset a/c, which is sold
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Accounting for Fixed Assets
out. The loss on sale/ disposal of Fixed Asset is transferred to Loss on Sale of
Asset a/c.
Machinery Account
Date Debit Rs. Date Credit Rs.
1.4.2009 Bal b/d 38,475 2.5.2009 Cash / Bank 35,000
(Sale Proceeds of asset)
2.5.2009 Loss on Sale of Asset a/c 3,475
When an asset is sold mid-year, the Depreciation from the beginning of the year
to the date of its sale is also expensed out. However, Indian tax laws do not
favour such a treatment.
In the above example, the entire machinery has been sold. Often it may so
happen that only one of the machines is sold off and others are used for
business. In such a situation, the WDV of the unit sold/disposed off need to be
worked out from the date of its purchase/ acquisition till its disposal and that WDV
is to be removed from the asset a/c.
Continuing the above example, we note that the WDV of the Machinery a/c as on
31.3.2009 is Rs.38,475/-. We assume that the Machinery a/c consists of a
number of Machines. One of the Machines is sold for Rs.1,500 on 1.6.2009 while
the other Machines continue to remain reflected in the Machinery a/c. The
Machine, which is sold on 1.6.2009, was acquired for Rs.12,000 on 1.4.2007. The
rate of Depreciation is 10% and WDV method is followed.
It is necessary to independently work out the WDV of the machine, which is sold
since its acquisition, and work out the loss n sale of the machine.
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Accounting for Fixed Assets
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Accounting for Fixed Assets
Machinery Account
Date Debit Rs. Date Credit Rs.
1.4.2009 Bal b/d 38,475 1.6.2009 Depreciation 162
(on asset sold)
1.6.2009 Sale of Asset 9,558
(WDV of asset sold)
31.3.2010 Depreciation 2,892
( on WDV of 38475-9558)
(@ 10%)
31.3.2010 Bal c/d 25,863
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Accounting for Fixed Assets
The related expense account for natural resources like oil wells and mines is
called depletion and the depletion expense is calculated in a manner similar to
computing units of production depreciation. The journal entry takes the
following form:
! Depletion Expense
! ! Accumulated Depletion
The related expense for intangible assets is called Amortization and it is ordinarily
computed by the straight-line method. The journal entry takes the following form:
! Amortization Expense
! ! Intangible Asset
Note: This entry results in directly crediting the intangible asset thus reducing its
basis.
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Accounting for Fixed Assets
An asset is impaired when the carrying amount of the asset exceeds its
recoverable amount. “Impaired assets” are assets with a fair value or productive
value that is lower than the book value.
An enterprise should assess whether there is any indication that an asset may be
impaired. If any such indication exists, the enterprise should determine
impairment loss if any. The impairment loss, so determined, should be adjusted
against opening balance of revenue reserves being the accumulated impairment
loss relating to periods prior to the years in which impairment is determined as
having taken place.
Any impairment loss arising shall be recognized in the statement of profit and
loss, unless an asset is carried at revalued amount. An impairment loss on a
revalued asset should he treated as a revaluation decrease.
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Accounting for Fixed Assets
7.17 SUMMARY
Fixed Asset is an asset held with the intention of being used for the purpose of
producing and providing goods or services and is not held for sale.
There is no single rule of thumb, which can decide the distinction between capital
and revenue. An expenditure, which is an advantage or benefit of an enduring
nature for business ( like land, plant and machinery or patents, trademarks etc.),
is treated as capital expenditure. A payment in connection with a fixed capital, like
architect’s fees for building, is also a capital expenditure.
Any expenditure for day to day running of the business, purchase of the raw
materials, factory rent or for maintenance of a capital asset is revenue
expenditure.
One must remember that a fixed asset (plant and machinery) for one person can
be a trading asset for another (machinery manufacturer).
When any expenditure provides benefit to the business for about 3 to 5 years, but
does not bring any asset into existence, it is termed deferred revenue
expenditure. Typical example is advertising campaign for launch of a new
product.
Total cost of a fixed asset includes its purchase price, all taxes and duties paid,
finance charges paid, commissioning expenses. Expenses incurred prior to
commencement of business are not added to costs of fixed assets, but clubbed
together as pre-operative expenses and charged to profits of subsequent years.
Machinery spares are normally treated as a part of inventory and expensed when
put to use.
Excepting Land, which is a never expensed asset, other assets like plant,
machinery; vehicles are expensed through depreciation, natural assets by
depletion and intangibles by amortization.
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Accounting for Fixed Assets
6. Do you agree that the Depreciation and Amortization mean the same? Why?
• On 1st October 2004 one machine for Rs. 3,25,000 on which Rs.15,000 were
spent on installation.
On March 30, 2006, the first machine is sold for Rs. 80,000. On November
11, 2006, the second machine meets with an accident and the Company is
able to recover Rs. 45,000 from Insurance Company.
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Accounting for Fixed Assets
The company follows financial year as its accounting year. You are required
to prepare the machinery account, depreciation account, Accumulated
Depreciation account and Machinery Sale account from 2004-05 to-2007-08.
8. M/s Atlas Car Hire Company Ltd. follows financial year as its accounting year.
They charge depreciation on its cars given for hire @ 25% p.a. and follow WDV
method. The following transactions need your consideration.
On 1st April 2004 one car is purchased for Rs. 4,50,000 and 40,000 is spent
on its accessories, which are also capitalised.
On 14th April 2005 one car is purchased for RS. 7,50,000. On September 30,
2006 the first car is sold for Rs. 2,25,000 and on September 30, 2006 a new
car is purchased for As. 4,35,000. On March 15, 2007, the second car is also
sold off for Rs. 3,25,000 and another car is purchased for Rs. 6,50,000.
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8
Current and Long Term Liabilities
Objectives:
• Contingent Liabilities.
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Current and Long Term Liabilities
Structure:
8.1 Introduction
8.4 Bonds
8.6 Summary
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Current and Long Term Liabilities
8.1 INTRODUCTION
A liability can be defined as an obligation to transfer assets or to provide services
in the future. The accounting for liabilities can be extremely important as liabilities
are often a significant amount when compared to total assets or compared to total
stockholders’ equity.
By means of this entry, salaries owed but not paid in Year X1 will be expensed in
Year X1. Salary Payable will be reflected as a current liability on the 12/31/ X1
balance sheet.
• Accounts Payable
• Short Term Notes Payable
• Sales Tax Payable
• Current Portion of Long Term Debt
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Current and Long Term Liabilities
8.3 CONTINGENT LIABILITIES
8.4 BONDS
As indicated above, long-term liabilities are those obligations not due within the
forthcoming year. Bonds are an important type of long-term liability. Bonds (or
Debentures) are essentially notes payable representing money borrowed by a
corporation or governmental entity from the investing public. Bondholders/
debentureholders loan their money for a price – interest – often paid on a semi-
annual or annual basis. Investors buy and sell bonds on a daily basis through the
bond markets. However, the market for corporate bonds in India has not yet
developed as much as its equity markets have, and are nowhere near the breadth
and depth of corporate bond markets in the US. Much of the bonds traded in
Indian debt markets are Government Bonds, issued to finance the Government’s
deficit.
Since bond investors pay money now to purchase bonds in anticipation of interest
and principal payments to be received in the future, we must now consider the
time value of money.
Two interest rates, (1) the contract interest rate and (2) the market interest rate,
interact to set the price of a bond as follows:
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Current and Long Term Liabilities
• Bonds sell at par when the market interest rate = the contract interest rate
• Bonds sell at a discount when the market interest rate > contract interest rate
• Bonds sell at a premium when the market interest rate < contact interest rate
Bond discount really represents additional interest expense and bond premium
really represents a reduction in interest expense. There are two methods to
account for bond discount or bond premium, but we will not be discussing these
here as it is not part of your syllabus for this course.
Discount on Bonds Payable is a contra account for Bonds Payable. The carrying
value of a bond payable equals the face amount of the bond less the balance in
the contra account. The carrying value of a bond issued at a premium equals the
face amount of the bond plus the balance in the Premium Account.
Both, the bond carrying value and the periodic interest expense increase over the
life of bonds issued at a discount. At the maturity date, the bond carrying value
equals face value of the bond.
Both, the bond carrying value and the periodic interest expense decrease over
the life of the bonds issued at a premium. At the maturity date, the bond carrying
value equals the face value of the bond.
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Current and Long Term Liabilities
Of these, only the second method would qualify for being called long-term
liabilities of the business. The first and the third one are referred to as owners’
equity or owners’ net worth.
8.6 SUMMARY
There are two broad categories of liabilities: current and long term. Current
liabilities are obligations due within a year. All other liabilities are long term.
Current portion of long term debt is also current liability. Potential obligations are
termed ‘contingent liability’. If it can be measured, it should be shown in the
financial statement as a footnote.
Bonds are an important type of long term liability. Investors loan their money to
purchase a bond for a price – interest – often paid on semi-annual or annual
basis. Bonds are bought and sold on a regular basis. In India, markets for bonds
are not as developed as those for equity.
A corporation can raise long term funds by issue of equity, debt instruments or
reinvesting profits earned. Of these, second option can be called long term
liability.
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Current and Long Term Liabilities
3) How would you distinguish the current liabilities from Contingent liabilities?
How are the two disclosed in the Balance Sheet?
4) How would you deal with the long-term liabilities, which are due to mature
within one year?
5) What is the relation between the contract interest rate and the market interest
rate?
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Current and Long Term Liabilities
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9
Inflation Accounting
Objectives:
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Inflation Accounting
Structure:
9.5 Illustration
9.7 Summary
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Inflation Accounting
a) General,
b) Specific and
c) Relative price changes.
The profit and loss account, under historical cost accounting, does not bear
proper charges, particularly for depreciation and cost of materials consumed.
This results in a high ‘paper profit’. If this inflated ‘paper profit’ is distributed
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Inflation Accounting
b) Physical Capital.
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Inflation Accounting
The primary objective of financial statements is to give a true and fair view of
the profit or loss for the accounting period, and true and fair value of assets
and liabilities as at the end of the accounting period. These objectives are not
fully achieved from financial statements prepared under historical cost basis.
For example, fixed assets are shown in the Balance Sheet at their historical
costs (less depreciation), which are far lower than the current replacement
cost of those assets.
v) Effective composition:
The profits earned by the company over a period of time are not comparable
under historical cost accounting. If a company’ s profit was Rs. 2,00,000 in
1990 and Rs. 15,00,000 in 2000, a shareholder’s initial reaction might be that
the company has performed well. If, subsequently, the shareholder discovers
that with Rs. 2,00,000 in 1990 he could buy exactly the same goods as with
Rs. 20,00,000 in 2000, the apparent growth is not impressive. For effective
comparison we require inflation-adjusted data.
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Inflation Accounting
a) Figures for items in the balance sheet (under historical cost) at the beginning of
the year are converted into rupees of purchasing power at the beginning of the
year as below:
b) The items in the balance sheet at the beginning of the year [after considering
step (a) above] are then updated from rupees of purchasing power at the
beginning of the year to that at the end of the year.
c) Figures for items in the balance sheet at the end of the year are converted into
rupees of purchasing power, at the end of the year in the same manner as
followed in step (a) above.
d) The difference between the total equity interest in the converted balance
sheets at the beginning and end of the year (after allowing for dividends and
introduction of new capital) is the profit or loss for the year measured in current
purchasing power.
e) The profit and loss account can be prepared to get inflation-adjusted profit or
loss by expressing the relevant figures in rupees of purchasing power at the
end of the year. The converted profit and loss account should contain a figure
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Inflation Accounting
for net loss or gain in purchasing power resulting from the effect of inflation on
the company’s net monetary assets or liabilities.
9.5 ILLUSTRATION:
A Ltd. has prepared its historical cost accounts for the year ended 31 March
2006, and 31 March 2007. These are reproduced below:
Balance Sheet
As on 31.3.2006 As on 31.3.2007
(Rs. in 000) (Rs. in 000)
Non-Monetary Assets:
Fixed Assets
(At cost less depreciation) 650 725
Stocks at cost (based on FIFO) 220 250
Net Monetary Assets: 250 350
Equity (i.e. Share Capital and Reserves & Surplus) 1120 1325
Profit and Loss Account for the year ended 31st March, 2007
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Inflation Accounting
As on 31.3.2005 ! ! 115
As on 31.3.2006 ! ! 130
As on 31.3.2007 ! ! 140
Average for 2006-07 ! 135
(All indices are imaginary)
Fixed assets purchased during the year were Rs. (‘000) 140 when the general
price index was 135. Rate of depreciation on fixed assets is 10% p.a.
You have to prepare CPP accounts for A Ltd. for the year 2006-2007.
Solution:
Step (a):
(Rs. in ‘000)
Fixed Assets (650 * 130/115) 735
Stock (see note 1) 220
Net Monetary Assets 250
Equity 1205
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Inflation Accounting
Step (b)
Step (c)
Step (d)
Therefore, the profit for the year expressed in terms of purchasing power of rupee
as on 31.3.2007 (i.e. current purchasing power) is given by difference of equity as
per step (c) and (d) above. So, profit = Rs. (‘000) (1457-1298) = Rs. (‘000) 159
Step (e)
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Inflation Accounting
Note 1:
Since FIFO method is followed for determining cost of closing stock, we have
assumed that closing stock represents latest purchases. Consequently, closing
stock figures are already expressed in current purchasing power and they are not
to be converted.
Note 2:
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Inflation Accounting
The CRC refers to the cost at which an asset can be replaced in the normal
course of business at the balance sheet date or at the date of sale, whichever is
relevant. NCRC is used for conversion of fixed assets only. NCRC Conversion of
fixed assets is calculated by determining gross replacement cost at the balance
sheet date, less a proportionate deduction for accumulated depreciation.
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Inflation Accounting
Economic value method can only be applied to the business as a whole. Profit
could be determined by comparing economic values of net assets at successive
balance sheet dates and adjusting for capital introduced. The main charge
against this method is that it is based only on estimation. Estimated future cash
flows are rarely realizable and are subjective.
9.7 SUMMARY
Various systems of accounting for inflation discussed above are not free from
flaws. The CPP method was heavily criticized and modified version for accounting
for inflation in the form of CCA was introduced. But CCA has its own limitations. In
India, the Institute of Chartered Accountants of India has issued a Guidance note
on this issue, which also advocated the use of CCA. In India, leading public
sector undertakings like SAIL, BHEL, OIL, etc. are preparing inflation adjusted
financial statement under CCA as supplementary information. But the inflation-
adjusted accounts are not legally required in India. Discussion on this subject
gained momentum with the rise in the price levels and the tempo died down with
the fall in inflation.
5) Visit the websites of companies like SAIL, BHEL, and OIL and study their
inflation adjusted financial statement.
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Inflation Accounting
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10
Questionable Accounting Practices
Objectives:
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Questionable Accounting Practices
Structure:
10.1 Introduction
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Questionable Accounting Practices
10.1 INTRODUCTION
Temptation is ubiquitous in the corporate world. Especially when top
management salaries and benefits are linked to better results, and they
themselves have significant control over the policies, which can modify the
declared results materially.
To support the cash reserves in Shivam Computers, its Chief Finance Officer had
a system of presenting Fixed Deposit Receipts for several lakhs of Rupees
deposited on long term basis with its bankers. After liquidating deposits and
transferring funds, new FD Receipts were forged and presented during periodic
audits conducted by the statutory auditors.
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Questionable Accounting Practices
company’s Banks which were shown to have issued FD receipts! It was later
established that statutory auditors of Shivam Computers earned audit fees that
were much more than the industry average for companies of Shivam’s size.
Make Sure* Company Ltd. was manufacturing aluminium caps and foils for major
bottlers and pharma companies in India. Its plant was located in Kurla, a suburb
of Mumbai. Its marketing manager booked a large single order almost equal to
20% of its annual turnover with a prominent customer having automated bottling
plant in NOIDA , Delhi.
Unfortunately, this customer had miscalculated its sales forecast and, hence,
was unable to accept delivery against this order. As the financial year end was
approaching, the management of Make Sure was not willing to expose its
marketing failure nor to show the large stockpile of closing inventory in hand in
the year end balance sheet.
Nicer Pharmaceuticals* Ltd., a 100% EOU [Export Oriented Unit] owned a world
class formulations and tablet making facility in GIDC Kandla, Gujrat. Its order
books were always full. But even after operating for over 10 years, the company
was not in a position to declared dividends to its share holders spread over
India. Nicer did not have its own marketing and distribution arrangements. For
this purpose, it relied on its privately owned associates in South Africa and UAE.
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Questionable Accounting Practices
This case would not have come to limelight, but for the disputes among brothers
that led to judicial investigations by the then Foreign Exchange Regulation
Authorities in Mumbai on receipt of a complaint from an aggrieved brother.
For the first two years profits were not significant due to fierce competition in
elevators market especially from small and local companies. Performance
bonuses for these executives were negligible. To change this situation, the CEO
of Mane Elevators, compelled marketing department to introduce Price Variation
Clause into all its existing and new contracts with its builder customers. The PV
clause was introduced to vary selling prices with every change in prices of
materials and labour inputs that occurred after the contract was entered into with
the customer.
The formula was neither spelt in details by the Chief Finance Officer nor
explained to customers by the sales force. Naturally no customer would have
agreed to the clause or for payments for the PV. But after introduction of the
clause, customers were invoiced prices that were much higher than the ones
specified in the accepted contracts. The increase in prices was based on rise in
material cost and wages as interpreted by the CFO. In the third year, when these
higher prices were accounted, the company showed a handsome profit in its
published accounts.
From the third year of operation, enterprising CEO and CFO/ Marketing
President earned [?] handsome high performance bonus for a few years, before
they quit to join competition.
Raj Electricals* Ltd., was a giant player in the power industry, manufacturing and
installing transformers, switch gears, transmission towers etc. It was located in
Kolkatta since 1973. The Directors owned about 27% of the equity and shares
were traded at P/E ratio of about 18.
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Questionable Accounting Practices
In the last year in which there was a slump in infrastructure sector of the Indian
economy, directors observed that the net profits of their company for the year
were way below the guidance provided by them in the last press conference.
They feared at least 10% drop in share prices after the results would be known
to the markets.
Directors passed a resolution that year in their board meeting before the financial
year end, directing Chief Finance Officer to apply the percentage completion
method of recognizing revenue in all its ongoing projects without reference to the
size and value of the projects.
The result was a smart jump in the sales revenue of the company for that year, as
sales were recorded for the first time on all projects of up to Rs. Fifty lakhs that
were in the pipeline at the close of the year. This provided satisfaction to the
directors that they lived to the profit guidance earlier issued by them and
confidence to meet the reporters again.
The company was planning to raise equity capital in the market in 1997 for
expansion of its activities in Bangladesh, Nepal and the Gulf countries where
Indian viewers had settled. When the date for filing documents for the equity
issue approached, investment bankers advised Himalaya’s Board, that the sales
and earnings for the year were not attractive enough to ensure full subscription.
Director’s held lengthy discussions among themselves and with the auditors.
Ultimately the Board advised the Accountant that his method of charging
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Questionable Accounting Practices
advertising and publicity expenses of a year to that year’s profits was incorrect.
He was briefed that benefits from such expense accrue to the company over a
long period. The CFO of the company, therefore, capitalized its advertising and
publicity expenses in that year and decided to charge the same to profits over a
period of next five years.
Then there is another case of Learner and Turner Engineering Works Ltd.,
employing over 3000 workers in Chakan, near Pune in Maharashtra. The
engineering firm, providing auto components to original equipment
manufacturers, had a three year old wage settlement with the workers’
recognized trade union which was due for renewal in 2002. Management was
expecting a demand for huge wage increase from the Union affiliated to the left
political party.
Company’s Board held several meetings with their Chief Finance Officer on ways
and means to curtail expected wage hike. This firm followed weighted average
method to price its material issues since inception. This year, looking at double
digit inflation that was prevailing over the year, the CFO proposed to the Board
that this method of pricing issues is outdated and be replaced by Last in First
Out method used successfully by many American companies.
Material issues charged to revenue were valued in that year at the latest high
prices under the Last in First Out system, and inventory in hand at the close of
the year was valued at the last year’s low prices. This increased cost of goods
sold and decreased the value of closing inventory.
When the published audited accounts were released, the Union leaders were
astonished to observe that company’s profits for the year had declined.
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Questionable Accounting Practices
It was reported that the fresh demands from the Union for the wage increases
were toned down by 25%!
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Questionable Accounting Practices
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11
Financial Accounting in
Computerized Environment
Objectives:
• Computerized Accounting
★ Packages
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Financial Accounting in Computerized Environment
Structure:
11.1 Introduction
11.2 Benefits
11.3 Utilities
11.4 Packages
11.5 Summary
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Financial Accounting in Computerized Environment
11.1 INTRODUCTION
In the preceding chapters, we went through the entire gamut of accounting
process. The process would lead one from the basic voucher to the books of
prime entries, posting the entries from prime and secondary books to ledgers,
compiling the trial balance, treating the adjusting entries and finally preparing the
Income Statement for a particular period and preparation of Balance Sheet as at
a particular date. The cash flow of the enterprise also can be worked out from
the Balance Sheet of two periods and changes in cash position can be attributed
to any material financial activity or event. This gives a different perspective to
understanding of the financial statements.
As the electronic data processing gained ground in late sixties and seventies, the
financial accounting had been among the major systems that were
computerized. In fact, financial accounting has been the natural beneficiary of
the early spread of the EDP revolution. The computerized environment has
ideally tackled the volume and repetitive transactions of the accounting system.
It is not our aim here to go in to the nitty-gritty of the computer languages that
write the accounting programmes. There are many accounting softwares
available in the market. We shall try to appreciate the prominent common
features that can be found among different accounting packages.
11.2 BENEFITS
Different accounting software can have features that may be distinct or unique in
being more user-friendly, they all draw from the basic principles and processes
of financial accounting that we studied in the preceding chapters. In manual
accounting process, the arithmetical accuracy is of paramount concern. Any
debit that has no corresponding credit and vice versa can throw the trial balance
for a toss. Colossal man-hours must have been lost in tallying the untallied trial
balance. The errors of commission and omission in manual accounting process
are thankfully non-existent in computerized accounting.
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Financial Accounting in Computerized Environment
Some of the most common mistakes that are found in manual accounting
system are:
One need not bother about these errors in a computerized environment. The
arithmetical accuracy of computerized accounting is one of its important
benefits. The software is programmed to accept an accounting entry for equal
and opposite debits and credits. The errors in casting or totaling are given
decent burial. Another advantage of computerized accounting is its ability to
handle bulky data processing in real time across different geographical locations.
The integration of cross-functional inputs generates meaningful and cohesive
information that facilitates the decision-making in real time.
There are different accounting packages available in the market that promise a
variety of results. The volume of transactions, their frequency and repetitive
nature would determine the suitability of the programme. To gain proficiency at
using a programme and to judge its efficacy to serve business needs, one has to
be comfortable with the basic accounting principles and processes that govern
the accounting. Sound knowledge of the needs of the business to have relevant
information also helps in evaluating any accounting programme.
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Financial Accounting in Computerized Environment
the trial balance, preparing the income statement and the balance sheet, the
cash flow statement etc. Beyond this, most of the well-known software available
seek to integrate the inventory with financial accounting. While integrating the
two, the principles of inventory valuation that we saw earlier are incorporated.
The software seek to apply FIFO, LIFO, weighted average cost or other
appropriate method of stock valuation to inventory and throw the cost of
manufacture/ consumption or sale as the case may be.
11.3 UTILITIES
Most accounting software would also facilitate the utilities like:
Many enterprises also opt for their custom made software to answer to their
unique business processes that may have specific requirements for information.
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Financial Accounting in Computerized Environment
for security reasons. The ability of the software to facilitate multi-nodal data
feeding and updation in real time across distant locations would also test its
efficacy. This can be very crucial. Of course, all these features will have cost
aspect and the management will have to take a call on this.
11.4 PACKAGES
Many accounting software are available in the market: more popular among
them being Tally, Ex-NGn, Trio, ModAct and many others. In addition, there are
other industry specific or activity specific software like for Banking, Travel
Industry, Financial Portals, for Shares and Stock Brokers, for investors and so
on. When one is comfortable with the basics of financial accounting, proficiency
in these can be had with little efforts.
Most information systems available seek to span across the entire value chain of
the business. We shall call them the Enterprise Resource Planning (ERP)
systems. The objective of implementing ERP is to increase revenues and to
improve business efficiencies. They aim to integrate the order processing, the
accounting, inventory and the issue-consumption-production-dispatch systems.
They further go to integrate the vendors and customers into the company’s
intranet network, so as to facilitate the B2B operations of the Company.
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Financial Accounting in Computerized Environment
• SAP’s package
• Avalon
• JD Edwards
• MFG-Pro
• Baan
• Oracle Application
• Ramco Marshal etc.
Organizations would undertake study of their ERP needs and gauge their
requirement for information across critical functions. It would help them
determine which ERP Package would suit them best. The cost of implementing
the package can be substantial, and it would cover the cost of the software
besides the expenses for setting up the intranet and other hardware.
Many Companies have tried to solve their Information processing needs through
implementing different packages and have tried to solve issues critical to their
businesses. For instance, Marico Industries aimed to streamline their supply
chain management through ERP Solution. They aimed to have excellence in
distribution performance. ERP was used to facilitate this.
The Larsen and Toubro’s Electrical Business Group (L&TEBG) used the ERP
Solution to obviate the difficulties faced in managing mainframe-based
applications. For them, the ERP also addressed the issue of lack of integration
between manufacturing, marketing and accounts systems, which resulted in
delays in reconciliation efforts, and lack of response from different units. Their
efforts gave them the capability to allow their stockists to access the system of
L&T to view stock of finished goods and to place orders for standard products.
This B2B capability has given it an edge over competition. In addition, the multi-
locational plants posed their own problems, which were also addressed.
TVS Motors went on to gain efficiency in all their physical activities and review
performance on a weekly basis through the ERP system, instead of reviewing it
once a month. It later switched on to daily monitoring of performance, which was
christened as ‘Supporting lean manufacturing efforts’. Thus, the financial
accounting integrated with other business processes goes to influence business
strategy and efficacy.
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Financial Accounting in Computerized Environment
11.5 SUMMARY
As the electronic data processing gained ground along with many other business
processes, Financial Accounting was also computerized in the late sixties.
The utilities offered by computerized accounting start from the ability to generate
vouchers to the preparation of final financial statements and in providing reliable
audit trails.
Several software packages are available in the market on a stand alone basis or
as a part of comprehensive Enterprise Resource Planning (ERP). Certain industry
specific packages are also being released in the market.
2) When the trial balance tallies, the accounts are free from all errors. Do you
agree to this? Give reasons for your answer.
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