ASIC CoNCEPTS AND CONVENTIONS IN AccoUNTING

B A 'Concept' ordinarily means a mental idea about anything.

Eric L. Kohler in "ADictionary for Accountants" defines it as "Any abstract idea serving
systematizing function." In accountancy we consider it as an idea related with some
accounting procedure. For example, creation of reserves, provision of depreciation, etc.,
some ideas involving certain accounting procedures.
A Convention' according to Eric L. Kohler is "A statement or rule of practice which, by
common consent, express or implied, is employed in the solution of' a given class of' problems
or guides behavior in a certain kind of situation." On the basis of a standing custom, all
concerned in the accounting world, follow certain accounting procedures. These are called
conventions.
At present "Principle" has become a common term that covers concepts, conventions and
postulates (axioms or assumptions ].
In 1965, Paul Grady, appointed by the AICPA,
published
Accepted Accounting Principles for Business Enterprises". It*Inventory
of Generally
clearly enlightened the
Contemporary accounting practices.
Accounting principles are now broadly classified as (1) Accounting Concepts and (2)
Accounting Conventions.
D Accounting Concepts
Some important accounting concepts are :
(i) Business entity concepts : This concept emerged with the
Companies in the ninetecnth century. According to it any formintroduetion
of Joint Stock
as an entity separate frOm its owners, of business is considered
employees and other partics associated with it.
Transactions of the business with such individuals are recorded by the
This concept helps to give a true and correct Accountant.
view of the financial condition of a
busines. It does not mix up the business affairs with the
etc. From this concept thc idea of private aflairs of the owners.
ascertain the operating results of eachresponsibility accounting has emerged. It helps t0
effectiveness at each point of operations. department or division separately and ensures
(ii) Fund concept : Under this
an entity. The collection of concept the basis of accounting is an "operational unit within
assets
If a college wants to develop its belonging to the operational unit is known as "Fuho
buildings and creates a Building Fund. such Fund
 Introducton - Part m A 53
collection will be spent for thc
be represented by some investmcnts or cash, Any relatcd
development of the building only. This concept is usually applicd in non-prolit secking
concerns, trusts, ctc.
is cxpected to continuc for a
(1) Going concern concept :Except terminable ventures, a business
that benefits Iikely to
rcasonably long time. So, transactions are to be recorded in such a way
of current cvents are taken
acCruc in uture out of moncy spcnt at present or the future results and
into consideration. The business is considered as a going concern. Undcr it assets
thcir
liabilitics are valucd on the basis of their productivity. Assets are held for re-use. So,
cxpccted realisable valucs arc ignored) For exanmple, any prepaid expense is considered as an
and cnjoy thec bcnefit of the
asset. Because it is assumed that the busincss wilcontinue
eNpense in future.
cxpected to continue or a
(iv) Periodicity conccpt : The opcrations of a business are busincss is divided into
rcasonably long period. For eflective accounting the life of the
accounting period
different periods or time spans of equal duration, conmonly nown as
ascertaincd. It helps to
or year. The accounting results of cach period are separately
extremely uselul for (a)
compare among the said results of different periods. It is of profits and (c) the
measurement of assets and liabilities, (b) correct calculation
segregation of capital expenditure from revenue expenditurc.
carned during an accournting
(v) Deferred concept : The expenses incurred or thc revenucs
expenses or incomes of the
period may not be related fully to that period only. Similarly
years. Thus it becomes necessary
current accounting period may be paid or realised in future
coming accounting periods. This
to set aside some portions of expenses or incomes for the
the periodicity concept.
is commonly known as deferral concept. It is an offshoot of
art of recording, classifying and
(vi) Money measUrement concept : Accounting is the those facts of' a concern
summarising events and transactions in terms of money. So only
their place in Accounting.
which can be expressed or interpreted in terms of money find
denominator. Events or items having
Money is amedium of exchange. Itacts as the common
Accounting. If the principal of a
a value in exchange in terms of money are considered in benefits payable to him on
college retires, the accountant should calculate the retirement monetary value attached
retircment. He cannot measure the loss in the academic field. The
external to man.
to an assct or item should be transferable and
and take". If there is a giver,
(vii) Dual aspect concept : The world runs on the principle of *"give
and receiving
there shall be a receiver. For any transaction two aspects namely giving a benefit
transaction
a benefit should be recorded. No one side can be dispensed with. Rather for each
one side is debited and the other side is credited. The principle of recording both sides is the
on assCts
result of the dual aspect concept. It presumes that any transaction will have an ellect
on one hand and either on the claims of creditors or on owner's equity on the other.
or revenues over
(viii) Mutching cost concept: Income or surplus is the excess of inflows
of
outlay or cost. Where costs are more, the result is a loss or a deficit. For the purpose
measuring the periodical income, etc., the expired costs have to be matehed against the
revenues emerging during accounting period. This is known as matching cost concept.
Revenues may be recognised (a) at the point of sale (b) during the process of produIetion
(c) on completion of production or (d) only on receipt of selling price.
For matching expired costs against such revenues the Accountant may consider
(a) direct costs which cause the carning of revenue, (b) periodical costs like olice rent,
(c) allocated costs of lixcd assets like depreciation, (d) other revenue expendture Iike
donations and (c) the cost of materials consumed, ete.
 that the
be
sure buyer
must
54 A only if an order
Financial Accounting - I soldthe
Accountant recognised
notbe concept demands that
are shoutd realisation from a legal
(iN) Realization conccpt : AfMer the R0cds
Revenne goodsor
Is now price of the of
legally liable to pay the sale
pprinciple legal
has been received The nderlying only freom concept.
matching when
TvChue is to be treated ns realised
accounting
peeriod with the and not actually
rendering of sevice during an associated realised point of
when actual
(N) 4ccrnal concept :It is a concept closely recognised and not at the
shouldbe incurred Income & Expenditure
According to this concept revenue recogniscd when Account or
reccived. Similarly costs slhould be Loss receiptfor the next year
the Profit & revenucs, any ycar should be
payment So at the time of prepar1ng Regarding withinthe current
Account some adjustments haveto be made. butnot rcccived paidin the current
recognised incurred but not when
should be deducted but revenuc
be
costs
excludedand revenuesarerecognised actually
added. Similarly prepaid costs should faccounting against revenues
year should be added, Under cash basis of the matching of costsincome
As a result An causes an
roccived and costs are recogniscd when paid. incones andcxpenses. equity. If due to a
detine owner's
cannot bc pertect. This concept helps us to a decrcase of the
causes any income or expense
increasc of the o ners cquity. An cxpense there cannot be
oCcurs,
transaction, no change of the owners cquity deercase ofanother assct or cqual increase
there. Rather one asset has increased causing cqual
of external liabilities.

Broad Classification of Concepts and Conventions

of significance and substantial
(0) Materiality convention : Accounts should convey matters matters involving
importance. The doctrine of materiality demands that only significant
recorded. The
1inancial implications and expressable in monetary terms should be
Accountant has to decide the relative importance of matters or events to be recorded and
reported in accounts. It implics that unimportant matters may be kept out of
consideration. The Accountant should decide the areas on which he should give more
emphasis and the aspects which he should consider relativcly significant and important.
Paul Grady thought that, *a statement or a fact is material if its disclosure makes any
difference in the judgement of a reasonable person."
(ii) Convention of disclosure : It is the convention of presenting
financial statements in such
a way that none is misled by the information supplicd. There
cf material facts, ambiguity or distortion. The relevant should be no concealment
clearly in the financial data should be presentcd
final accounts prepared.
notes from the management, etc., shouldMoreover,
foot notes, supplementary schedules.
be
disclosure does not mean disclosure of tradeappended wvherever nccessary. A complete
secrets. I implies that preparation and
presentation f accounts should consider the needs of all potential users cqually.
(i) Conventivn of consistency : I
practices should be consistentlyimplies that the same accounting
followed in a concern over prineiples, rules and
demand otherwise, unilormity should be vears, Unless situations
valuation of inventory or depreciation of assetsmaintained. For example, the method o!
application of same accounting should not undergo regular changes. The
all items within a procedures for the
period is necessary for a busincss from period to period or 101
performances of differcnt years. It
any uncertainty about the
comparative analysis of accounie
eleninates any personal whims of the Accountanl 2
accounting procedures to be applicd.
 Introduction - Part II A 55
However, this convention does not permanently rule out any change desircd for the better.
Eric L. Kohler obscrvcd threc types of consistency :
vertical consistency within an interrelated group of inancial statements bearing the same date.
horizontal consistency between financial statements from period to period and a kind of
third-dimensional consistancy, at a single date, as comparcd with organizations of the
same type or organizations generally.
(iv) Couvention of conservatism : The Accountant should be conservative in
applying all the
established and traditional rules, practices or customs. He should not bring frequent
changes there. He should be careful to take into account only realised revenues. He
should ignore contingent or 'might be' incomes. He should anticipate loss, but never
anticipate profits. He should provide for future expected losses.
The convention teaches the Accountant to be prudent. The scope of over
statcment of
profits or net assets is safely avoided under it. It leads to correct measurement of
incomes,
correct valuation of assets and prevention of capital erosion. Fixed assets are valued at
historical cost less depreciation and current assets are valued at cost or markct price
whichever is lower. Thus assets are valued truely to project the purpose for which those are
owned by a business.
(v) Convention of Full Disclosure: Following this convention, all relevant and material
information should be disclosed in the financial statements. The users of accounting
information should be provided with such information that might becomc useful to them.
The information provided should be full in nature and sufficient or adequate for
their
purposes.
 7
Accouning Concepts
and Conventions
Generally Accepted Accounting Principles (GAAP)
Generally accepted accounting principles are the conventions, rules and procedures necessary to define
accepted accounting practice at a particular time. These principles provide a foundation for measuring and
disclosing the results of business transactions and events. They include both conventions, bases and presenta
tion practices.
Generally accepted accounting principles are conventional that is, they become generally accepted by
agreement rather than by formal derivation from a set of postulates or basic concepts. The principles have
daveloped on the basis of experience, reason, custom, usage., and, to asignifícant extent, practical necessity.
Ihse principles are so widely used and accepted that may be produced to underlie all accouning statements.
from the above, it can be comprehended that generally accepted accounting principles instruct an
dCountant what to do in the usual case when he has no reason to doubt that the affairs of the organisation are
0eng honcstly conducted. Since he has reason to believe that this basic assumption is false, an entirely different
Situation confronts him.

Accounting Concepts and Conventions

A
andgeneral y accepted set of rules can provide unifomity in the accounting sy stem, the accounting procedure
t0 itspresentationtheofaccounting results. In devvelopingthe structureof accounting theory and to relate thetheory
practice, accounting profession totake for
assumptions sare those broad concepts that hasdevelop
agreedgenerally granted
accepled certain basic
accounting concepts.
principles, Accounting
i.e., upon which
accounting is based. Certain ideas are: assumed or acceptedin account in orderto provide aunifying theoretical
structure and internal logic of accounting. These assumptions are rules of the game and they have been
develoned from commonbetteraccount1ng practices. These assumptions help accounting statements to become
cOparable. leading to analysis and comparison of performances.
7.2Accounting Concepts and Conventions
Basic Concepts and Conventions
1. Business Entity Concept
According to cntity concept, business is considered separate and distinct from the owners of the
This concept starts
the purposes of
with tlhe fact thatthe business unit is aseparate entity with its own identity. We
which affect the bookkecping. kecp the owner and his business quite separate. Only those e must, for enterprise
business unit are
records are kept only from the pointrecorded.)
economc events
Assuming that the business unit is a separate entity,:
a business, stvled X& of view of the business unit and not the owners. For example, M: X
Co.': acounts are to
was a different person from the owner. If the be prepared
only from the point of view of X& accountintg
staifrtsit
owner invests capital into the business, this is
owner is lending cash to the business. If a part of the capital is taken back by the owner, thistreated
Co.as
as if the
is
repayment of loan. For accounting purposes, a
partnership firm has a separate entity apart from itstreated as a
Likewise, the existence of a company does not depend on the life span of any of the shareholders.
This concept is appliedto all forms of business organisations for the following reasons :
partners.
(a) It gives a solution to the
(b) To ascertain the return on problem of separating out business transactions from personal transactione
(c) capital employed.
To ensure the proper use of funds
(d) To ho<d title to provided by the owners.
(e)
property in the name of the firm.
Toenter into transactions with
outsiders in the name of the firm.
Advantages
This concept stresses the importance of the
This concept can be applied to any form of business unit.
It is the basis of the
4) lt helps in double entry system of business organisation.
(5) This conceptseparating out the business book-keeping.
transactions
can be applicd along with proprietary from the personal
fund concepts.transactions of the owner(s).
(6) it is
possible to measure how successful or and
Disagvartages otherwise the business has been in
M
Accounting is done terms of profit or loss.
(2) This concept from the viewpoint of the business
(3) Io sOme someimes coincides with the legal fact. unit, which is an
(4) The owhersexlent, present accounting
cannot be identified withpractice is not
artificial
person.
16) Ths based on this concept.
6 J s colcepl does not stress the the
existence of the
hot
concerned mportance
with increase of of the business unit.
2. Money
Measurement Concept weath of the proprietor(s).
owner(s).
Money is what
 Financial Accounting 7.3
3. Going Concern Concept
Accounting is based on the assumption that the accounting unit is to remnain in operation into the foreseeable
future in pursuit of ts goals and objcctives. When a busincss is inauguratcd, cxcept for terminable ventures,
it is assumed that the termination of the busincss is not certain.)Bascd on this idea, this concept assumes that
the business will continue in operation for as long as possible and will not be dissolved in the foreseeable
future. unless we have some strong cvidence to suggest that this is not the case. From the accountant's
standpoint., Profit and Loss Account and Balance Shect arc drawn up on the assumption that the business unit
willcontinue functioning in the forcsceable future. This concept can be regarded as supporting the valuation
of assets at historical cost or replacement cost. If this method is not adopted, the assets of the business unit
would have to be shown at the net realisable valuc, i.c. at the amount they would sell for in the market at the
Balance Sheet date. This concept is the basis of the conventional classification scheme, for instance, fixed/
current assets, long tem/ current liabilities.
This concept assumes that theentity will continue operating under the same economic conditions and in
the same general environment, but does not assume that the business will be profitable as long as it exists. This
concept also doesnot imply that the business will continue for ever.
This concept relates to the future which is, by definition, uncertain. Therefore, many factors can be used to
determine whether a business unit is a going concern. They include the following:
(a) Liquidity : The business unit must have sufficient liquid assets (assets which can be in the form of
cash or can be easily converted into cash, i.e. current assets other than stock) to pay its current
liabilities at present or in the future. Ashortage of liquid assets may lead to the risk of insolvency.
Various ratios can be formulated and applied to ascertain the liquidity of a business unit
(b) Capital structure : A 'going concem' business unit must have a sound capital structure (the
composition of an enterprise's sources of funds, e[specially long-term) to overcome any short-term or
long-term difficulties. Capital structure of abusiness unit is influenced by several factors such as cost
of various sources of capital, dividend policy, the risk of insolvency, stability of earnings, and the like.
(cf Market : Abusiness enterprise cannot continue as agoing concern without acontinuing demand for
the goods it deals in and/or the services it supplies.
(d) Management ability : Abusiness enterprise should be managed efficiently and effectively to produce
a competitive product and to see that the objectives of the enterprise are achieved. To keep the business
unit going, the plans, policies, procedures and practices are to be used properly and attention
concentrated on those areas that are not going according to plan.
4. Historical Cost Concept
Historical cost refers to the cost at the time of acquisition. Since accounting is basically the recording of past
inasmuch as it is
happenings, accountants use the acquisition price as the most objective measurement
on the
upported by the evidence of a transaction. It is a fundamental concept of accounting which is based
historical record of the transactions, i.e., an asset is ordinarily recorded at its cost and this cost becomes the
will appear in
basis for subsequent accounting for the asset. If aplot of land is purchased, say for 10,000,ofittime. follows
he books at that figure without considering the market value of the asset at any other pointall. Let usIt take the
it will not be recorded at
rom this concept, that if nothing is paid for acquiring an asset, is modified
xample of Goodwillit should be recorded in the books only when it is purchased. This concept value whichever
cost or market
npractice by applying the concept of conservatism (valuing closing stock at time, for various reasons,
s less). Furthermore, when the real worth of an asset changes with the passage of
of assets.
ccounting records are changed to reflect changes in market value by revaluations stable prices. Historical cost
This concept provides uniformity in accounting records under conditions of
alues can well be retained in view of their familiarity to accountants.
The major drawback ofhistorical cost concept stems from rapid inflation, which leads to seious distortions
n the measurement of income. Since historical costs are matched against current incomes, there is an
overstatement of the
inderstatement of the real-value of the non-monetary assets of the business unit and an
net incone.
 1.4 Introducton to Accounlng

0feouse. foracon1derable time,the Double Entry System remained ignored in E.

contimued tollowing what is called Stewardship Accounting, the method of n
Cpenses followed by stewards. (In ou country, it may be called the.
the mumims who kept accounts of big households). munimsystem ofkeepingEuraccount
ope, hepernle
s
When, with the advent of joint stock conmpanies,
of financial accounting based on the Double Entryownership was separated from the managernent,
Principle came to
principle of action. The shareholders' and others' interests were to be be recognised and
with the perfonance of the companies. The need was safeguarded
statutorily
information systenm for the investors and others such statements as Balance recognised. and they were
ctc. By and by. the dimension of this financial Sheet there
information system expanded and it
Since business and other concerns opcrate in the social setting, and
evolution of. came to be
Profit eLossrmergl
ahalt just at providing information to the
investors and managers alone. Social cost as
had to be assessed. This brought into being social
accounting,
and assessing. Economic activities, which in economic an important adjunct to
accounting
well coulas s0cid al
the
making a living", and which again, in money-cconomy parlance,
are described as activities
are nothing other than system
spending activities.
money-earningperiandorned l
mea
Subfields of Accounting
1. Financial Accounting
Financial accounting is that part of accounting which is mainly
concerned with the
stewardship aspects of external reporting
tion outside the business entity. to shareholders, government and other users hiofstorical, custodial an
Financial accounting emphasizes the stewardship aspects of
making aspects of accounting. accounting
It is the recording and processing of rather than the control
faccounting
or
intoma:
dern
which relates to the past and is generally financial data affecing the business i
and Loss Account for the period ended for one year. The end-product of financial accounting is the D
Sheet as on the last day of the accounting(which
period
shows the profit earned or losses incurred) and the Ralan
financial accounting is based on generally accepted (which shows the financial position). The preparation of the
profession and is heavily constrained by legal regulationsaccounting principles enunciated by the accountin
and accounting standards.
2. Cost Accounting
Cost Accounting is primarily concerned with the cost to
produce goods and services. Cost accounting applies
the principles of accounting in such amanner that it is possible to have a detailed recording and analysis of
expenditures incurred in connection with the operation of any business, e.g., manufacturing, administranon or
selling, or the production of an article so that it is able to measure
Cost accounting is made up of the following: performance and control activities.
(1) Mechanics of cost keeping, i.e.,routines followed in
(2) Analysis of costs to measure managerial efficiency. reducing and classifying expenitures.
(3) Installation and supervision of cost systems.
3. Management Accounting
Any form of accounting which enables a business unit to be conducted more efficiently can be
management accounting. Management accounting is that part of accounting which is concerned, manly regreuW
internal reporting to the managers of a business unit. It relates to planning. control and
is usefultothei managementinthe discharge of its functions. Thus, it emphasizes the controldecision-making "
lofdecision-making
aspects of accounting, which is tailor-made to suit the needs of the management of aspecific enterprise,rather
than stewardship aspects of accounting, Management accountingis forward-looking'and generallyincludes
cost accounting and budgeting. The preparation of management accounting is not based on generally accepted
accounting principles and is relatively free of constraints imposed by legal regulations and accounting
standards. Therefore, management accounting is the presentation of accounting information in such away as
 USt be Collected from non-acCounting sources.
Distinction between Financial Accounting and
Management Accounting
1. It
Financial Accounting Management Accounting
is primarily for external
purposes. 1. It is
2. It records what has happened based on past 2. It primarily for internal purposes.
provides information which is used to take
transactions in a true and fair manner. decisions about the future.
3. It is heavily constrained by legal regulation and 3. It is relatively free of
accounting standard. constraintsimposed by legal
regulation and accounting standards.
4. It must comply with statute and generally 4. It is tailored to suit the needs of the users.
accepted accounting principles.
5. It emphasizes on the type of expenses. 5. It emphasizes on the products, processes and
departments.
6. It emphasizes the stewardship aspect of 6. It enphasizes the control or decision-making
accounting. aspects of accounting.
7. It provides an overall view of the business 7. It gives a detailed analysis of all aspects of the
enterprise. business unit.
 1.6 Introduction to Accounting

Internal Users External Users

Management Financing Group
"Investors
Group
"Lenders
"Suppliers
" Board of Directors

Partners Financial
Statements
" Managers Public Group
.Government Agencies
" Labour Union
"Officers "Employees
" Customers

Investors : They supply the risk capital to the business unit. Ownership is separated from management in
joint stock companies, hence, investors need to know how their money is being spent by the managers
Financial information helps them to decide about (a) making investments, (b) quantum of investmenl. and
(c) holding on to the equities they own.
Lenders : Accounting information provides them with reasonable assurance as to the payment of intcrest
and repayment of the principal.
Suppliers: They normally sellon credit and they must have reasonable assurance that their credit will be
honoured. Financial information helps them to decide about the credib1li1y of the fim, and whether they should
continue supplying on credit.
Customers: They are a composite group. consisting of (a) producers at every stage of processing,(b)
wholesalers and retailers and (c) the final consumers. Producer at the next stage of processing must be assurcd
of the input which they obtain from the concem in question. The wholesalers and retailers must also be sure
about the uninterrupted supply of materials. Otherwise, they will be hesitant to stock it. The ultimate consumer
is interested in the continuous availability of the product. Should he come to think that the availability may be
disrupted or stopped., he will shift his preference for another variety or brand. In allthese kindred decisions,
accounting information has a signiñcant role to play.
Government agencies: Any economy of the day is, in a way, controlled and regulated by the political
authorities, i.e., the govemment. Consequently. government agencies rely on the financial information for
permitting expansion or contraction of business, for import and export of products and/or materials, tor
allocation of essential resources for regulating labour or taxation. etc.
Public : For members of the public the financial information is of the nature of a health examination repor
-ittells them about employment opporunities and general growth in the individualconcern and the economy
as a whole.

Employees: The employees of the concen are interested in the financial information because both, thei
present and future are tied up with the company's fortunes.
Thus, financial information serves diverse interests. Hence, the information should be gahered amu
disseminated in a way that benefits each interest Information should not be biased and should not supress a
or suggestanything false
Qualitative
Accounting Characteristics of
Financial Accounting 1.7

infomation infomation must Financial

providcd in the financial qualitative
possess some Statements
characteristics.
(1)Understandability:
(2) Relevance:
(3)Reliability; and
(4) Comparability.
statements
Uscful These are the attributes that
|to users. The four main
qualitative
make the
characteristics are:

Qualitative Characteristics

Understandability Relevance Reliability Comparability

Faithful
Representation Substance
Over Form Neutrality Prudence Completeness

Understandability
Understandability is the quality of accounting
information that enables users to perceive its
to understand the content and significance of accounting statements and significance, i.e.,
reports. If a user cannot understand
the accounting infomation given to him, it is not
he wants to make. To have the characteristics of useful, even though it may be relevant to whatever decision
understandability, accounting information must be presented
in a manner that users can understand, i.e., it must be expressed in terminology that is understandable to
theusers. Now-a-days, business activities and transactions have become
always be possible to describe complex transactions in simple terms. It is, increasingly
therefore,
complex. It may not
of the accounting information must attain a minimum level of competence in necessary that the users
understanding the terminology
used in accounting statements. It is assumed that the users have a basic knowledge of business accounting,
and they will spend some time and effort in studying the accounting statements. However, the accountant has
abasic responsibility todescribe business transactions clearly and concisely. o
Relevance
Accounting information must be relevant to the user. Information is relevant if it meets the needs of the user
in decision-making. Relevance is defined in terms of the ability to affect a decision-maker's course of action.
because whether a particular set of accounting information is relevant or not depends on the specific
decision-maker's objectives. Thus, for information to be relevant, it must have some bearing on the decision
being made. Relevant accounting information should be capable of making adiference in adecision by helping
users of accounting information to form predictions about the outcomes of past, present and future events.The
decision not tomodify or corect previous actions is avery important one. Financial information which does
 2
Double Entry System
Introduction
Double entry 1s an almost
business transactions whichuniversally
recognises
used system of business record
that each transaction has a dualkeeping. It is a system of recording
principles of double entry book-keeping are aspect. It is so named because the
based upon every transaction having
twoaccounts are always affected by two aspects or two parts, 1.e.,
value from one account to another. each transaction. Under this system, each transaction
is credited. Therefore, every The receiving account is debited with the amount and is seen as a flow of
the giving account
If only two accounts are debit has an equal and offsetting credit.
and the other account, Cashaffected (as in the purchase of building for
cash), one
is credited for the
transaction, the sum of the debit entries must be equal same amount. If more than twoaccount, Building is debited
to the sum of the credit accounts are affected by a
Features of Double Entry System entries.
(1) This method records both
(2) Under this system, equal aspects of each transaction.
debit and credit entries are made for every
accounts. transaction in twO different
(3) Under this system, all
(4) Under this system, it istransactions
possible
are recorded fully.
to prepare a Trial Balanceand
books of account because it records all
transactions in full.
check the arithmeticalaccuracy of the
(5) Under this system, profit/ loss can
be found out by showing in detail the
(6) Ünder this system, Balance Sheet can be
prepared in detail. expenses and incomes.
Advantages of the Double Entry System
(|) Acomplete record of all the
(2) The financial position of the transactions relating to a
firm can be ascertained. business unit are maintained systenatically.
(3) The arithmetical accuracy of the books of
(4) Location and rectification of errors are account can be ensured.
possible.
) The system can be applied to any form of organisation.
(6) Consistency can be
maintained in the books ot account, which help make a
current year's figures with those of the previous year(s). comparative study of
 2.2 Double In Srstem ascertained.
accounting period can be
o losses sntfered for an
customers can be easily ascertained.
The profis eaned
suDphers and due from
of time can be
ascertained.
Amountdeto any point
of cash balance availabe at frauda
Ihe amount and, thereby.
(0)
00) helps take managerial decisions.
aflairs ofthe business
can be exercised and misaçppro-
control lover the
l) Greater ransactions of the owner(s)
priations can be nminimised. up with private
business transactions do nof petmixcd
(02) The
System inelastic
Disadvantages of the Double Entry mcasurcment. But money Is an yardstick for
as its basic unit of
1) This system adopts money because
mcasurement.
rccorded in the books of account simply theycannot be
evcnts cannot be
(2) Many important
Cxpressed in monctary tems.
records and not future probabilities.
(3) Iransactions are all historical
all in the books of account, it may remain undiscovered
recorded at
(4) If any transaction is not recorded inthe books of original entry, it is difficultt to detect
(5) Ifthe amount ofa transaction is wrongly
the error.
undetected.
(6) A compcnsating eror may also remain
judgement of the accountant.
0 This system requires personal smallbusinesses where the owner(s) can directly control the afairs af
(8) Thissystem is not suitable for
the business.

Accounting Equation
of the business unit are
The accounting equation is the basis for double entry system ofaccounting. Total assts business
provided by the creditors/lenders and the owners. Therefore, at any point oftime, the total assets of the
owners. in
are equal to total liabilities. Liabilities to the outsiders are known as liabilities but liability to the
accounting, is referred to as 'capital'.
The relationship that exists among,assets, liabilities and the capital can be expressed in the form of an
accounting equation which is as follows:
Total Assets = Total Liabilities
OR ts
Total Assets = Liabilities + Capital
OR:
Total Assets -Liabilities = Capital
Assets and liabilities are two independent variables and capital is the dependent variable, for it is the
difference between assets and liabilities, Atransaction may affect either both sides of the equation by the same
amount or on one side of the equation only, by both increasing or decreasing it by equal amounts and thus
netting to zero. An increase in an asset, without acorresponding increase in liability or a coresponding decrease in
another asset, must represent an increase in capital. Conversely, an increase in liability without a corresponding
increase in asset, or a corresponding decrease in another liability, will indicate a decrease in capital.
Concept of Debit, Credit and Duality
The rules of Debit and Credit are as follows :
I. Debit : Any increase on the left hand side of the
2. Credit : Any decrease on the left hand side of theequation
3. Debit : Any decrease on the right hand side of the equation.
4. Credit : Any increase on the right hand side equation
of the equation.
Illustrati
 3 TIU, WB, LIBRARY
ACC.NO..
DATE.....

Accounting Cycle
Accounting Cycle
Accounting Cycle refers to the sequence of accounting procedures used to record, classify and summarise the
business transactions. It begins with the identification ofbusiness transactions and ends with the reverse entries
for prepaid and outstanding expenses. A business enterprise has numerous
transactions every day during an
accounting period. Unless the transactions are analysed and recorded individually, it is
determine the impact of each transaction in the financial statements. The purpose of accountingnotis topossible to
ascertain
the cumulative effect of the transactions. For accounting, the following steps are
followed.
Passing of Identification Business
Reverse Entries of Documents
Transactions are prepared or
received
Passing of
Closing Entries
|
Transactions
are recorded in
Preparation of books of
Final Accounts original entry

Passing of Adjust If not last

ments Entries transaction
Transactions
are posted to
of the period Ledgers
If last
Preparation of transaction
Trial Balance
of the period
226 Accountancy

Depreciation, Provisions and Reserves 7

M atching principle requires that the revenue of

a given period is matched against the expenses
for the same period. This ensures ascertainment of
the correct amount of profit or loss. If some cost is
LEARNING OBJECTIVES incurred whose benefit extend to more than one
accounting period, it is not justified to charge the
After studying this chapter, entire cost as expense in the year in which it is
you will be able to :
incurred. In fact, such a cost must be spread over
• explain the meaning of the periods in which it provides benefits.
depreciation and
distinguish it from
Depreciation, on fixed assets, which is the main
amortisation and subject matter of the present chapter, deals with such
depletion; a situation. Further, it may not always be possible
• state the need for to ascertain with certainty the amount of some
charging depreciation particular expense. Recall the principle of
and identify its causes; conservatism (prudence) which requires that instead
• compute depreciation of ignoring such items of costs, adequate provision
using straight line and must be made and charged against profits of the
written down value current period. Moreover, a part of profit may be
methods;
retained in the business in the form of reserves to
• record transactions provide for growth, expansion or meeting certain
relating to depreciation
and disposition of
specific needs of the business in future. This chapter
assets; deals with two distinct topics and hence is being
• explain the meaning presented in two different sections. First section deals
and purpose of creating with depreciation and second section deals with
provisions and reserves; provisions and reserves.
• distinguish between
reserves and provisions;
SECTION – I
• explain the nature of
various types of 7.1 Depreciation
provisions and reserves
including secret reserve. Now you are aware that fixed assets are the assets
which are used in business for more than one

Rationalised 2023-24
Depreciation, Provisions and Reserves 227

accounting year. Fixed assets (technically referred to as “depreciable assets”)

tend to reduce their value once they are put to use. In general, the term
“Depreciation” means decline in the value of a fixed assets due to use, passage
of time or obsolescence. In other words, if a business enterprise procures a
machine and uses it in production process then the value of machine declines
with its usage. Even if the machine is not used in production process, we can
not expect it to realise the same sales price due to the passage of time or
arrival of a new model (obsolescence). It implies that fixed assets are subject
to decline in value and this decline is technically referred to as depreciation.
As an accounting term, depreciation is that part of the cost of a fixed asset
which has expired on account of its usage and/or lapse of time. Hence,
depreciation is an expired cost or expense, charged against the revenue of a
given accounting period. For example, a machine is purchased for `1,00,000
on April 01, 2017. The useful life of the machine is estimated to be 10 years. It
implies that the machine can be used in the production process for next 10
years till March 31, 2016. You know that by its very nature, ` 1,00,000 is a
capital expenditure during the year 2017-18. However, when income statement
(Statement of Profit and Loss) is prepared, the entire amount of `1,00,000 can
not be charged against the revenue for the year 2017-18, because of the reason
that the capital expenditure amounting to `1,00,000 is expected to derive benefits
(or revenue) for 10 years and not one year. Therefore, it is logical to charge only
a part of the total cost say `10,000 (one tenth of ` 1,00,000) against the revenue
for the year 2017-18. This part represents the expired cost or loss in the value
of machine on account of its use or passage of time and is referred to as
‘Depreciation’. The amount of depreciation, being a charge against profit, is
debited to Income Statement (Statement of Profit and Loss).

7.1.1 Meaning of Depreciation

Depreciation may be described as a permanent, continuing and gradual
shrinkage in the book value of fixed assets. It is based on the cost of assets
consumed in a business and not on its market value.
According to Institute of Cost and Management Accounting, London (ICMA)
terminology “The depreciation is the diminution in intrinsic value of the asset
due to use and/or lapse of time.”
Accounting Standard-6 issued by The Institute of Chartered Accountants
of India (ICAI) defines depreciation as “a measure of the wearing out, consumption
or other loss of value of depreciable asset arising from use, effluxion of time or
obsolescence through technology and market-change. Depreciation is allocated
so as to charge fair proportion of depreciable amount in each accounting period
during the expected useful life of the asset. Depreciation includes amortisation
of assets whose useful life is pre-determined”.

Rationalised 2023-24
228 Accountancy

Box 1
AS-6 (Revised): Depreciation

• Depreciation is “a measure of the wearing out, consumption or other loss of

value of depreciable asset arising from use, effluxion of time or obsolescence
through technology and market-change. Depreciation is allocated so as to charge
fair proportion of depreciable amount in each accounting period during the
expected useful life of the asset. Depreciation includes amortisation of assets
whose useful life is pre-determined”.
• Depreciation has a significant effect in determining and presenting the financial
position and results of operations of an enterprise. Depreciation is charged in
each accounting period by reference to the extent of the depreciable amount.
• The subject matter of depreciation, or its base, are ‘depreciable’ assets which.
• “are expected to be used during more than one accounting period.
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and services,
for rental to others, or for administrative purposes and not for the purpose of
sale in the ordinary course of business.”
• The amount of depreciation basically depends upon three factors, i.e. Cost, Useful
life and Net realisable value.
• Cost of a fixed asset is “the total cost spent in connection with its acquisition,
installation and commissioning as well as for add item or improvement of the
depreciable asset”.
• Useful life of an asset is the “period over which it is expected to be used by the
enterprise”.
• There are two main methods of calculating depreciation amount.
• straight line method
• written down value method
• Selection of appropriate method depends upon the following factors:
• type of the asset
• nature of the use of such asset
• circumstances prevailing in the business.
• The selected depreciation method should be applied consistently from period to
period. Change in depreciation method may be allowed only under specific
circumstances.

Depreciation has a significant effect in determining and presenting the

financial position and results of operations of an enterprise. Depreciation is
charged in each accounting period by reference to the extent of the depreciable
amount. It should be noted that the subject matter of depreciation, or its
base, are ‘depreciable’ assets which:
• “are expected to be used during more than one accounting period;
• have a limited useful life; and
• are held by an enterprise for use in production or supply of goods and
services, for rental to others, or for administrative purposes and not for
the purpose of sale in the ordinary course of business.”

Rationalised 2023-24
Depreciation, Provisions and Reserves 229

Examples of depreciable assets are machines, plants, furnitures, buildings,

computers, trucks, vans, equipments, etc. Moreover, depreciation is the
allocation of ‘depreciable amount’, which is the “historical cost”, or other
amount substituted for historical cost less estimated salvage value.
Another point in the allocation of depreciable amount is the ‘expected useful
life’ of an asset. It has been described as “either (i) the period over which a
depreciable asset is expected to the used by the enterprise, or (ii) the number
of production of similar units expected to be obtained from the use of the
asset by the enterprise.”

7.1.2 Features of Depreciation

Above mentioned discussion on depreciation highlights the following features
of depreciation:
1. It is decline in the book value of fixed assets.
2. It includes loss of value due to effluxion of time, usage or obsolescence.
For example, a business firm buys a machine for ` 1,00,000 on April 01,
2017. In the year 2017, a new version of the machine arrives in the market.
As a result, the machine bought by the business firm becomes outdated.
The resultant decline in the value of old machine is caused by obsolescence.
3. It is a continuing process.
4. It is an expired cost and hence must be deducted before calculating taxable
profits. For example, if profit before depreciation and tax is ` 50,000, and
depreciation is ` 10,000; profit before tax will be:
(`)
Profit before depreciation & tax 50,000
(-) Depreciation (10,000)
Profit before tax 40,000
5. It is a non-cash expense. It does not involve any cash outflow. It is the
process of writing-off the capital expenditure already incurred.

Do it Yourself

Look at your surroundings and identify at least five depreciable assets in your home,
school, hospital, printing press and in a bakery.

Rationalised 2023-24
230 Accountancy

7.2 Depreciation and other Similar Terms

There are some terms like ‘depletion’ and ‘amortisation’, which are also used in
connection with depreciation. This has been due to the similar treatment given
to them in accounting on the basis of similarity of their outcome, as they represent
the expiry of the usefulness of different assets.

7.2.1 Depletion
The term depletion is used in the context of extraction of natural resources like
mines, quarries, etc. that reduces the availability of the quantity of the material
or asset. For example, if a business enterprise is into mining business and
purchases a coal mine for ` 10,00,000. Then the value of coal mine declines
with the extraction of coal out of the mine. This decline in the value of mine is
termed as depletion. The main difference between depletion and depreciation is
that the former is concerned with the exhaution of economic resources, but the
latter relates to the usage of an asset. In spite of this, the result is erosion in the
volume of natural resources and expiry of the service potential. Therefore,
depletion and depreciation are given similar accounting treatment.

7.2.2 Amortisation
Amortisation refers to writing-off the cost of intangible assets like patents,
copyright, trade marks, franchises, goodwill which have utility for a specified
period of time. The procedure for amortisation or periodic write-off of a portion
of the cost of intangible assets is the same as that for the depreciation of fixed
assets. For example, if a business firm buys a patent for ` 10,00,000 and
estimates that its useful life will be 10 years then the business firm must write-
off ` 10,00,000 over 10 years. The amount so written- off is technically referred
to as amortisation.

7.3 Causes of Depreciation

These have been very clearly spelt out as part of the definition of depreciation in
the Accounting Standard 6 and are being elaborated here.

7.3.1 Wear and Tear due to Use or Passage of Time

Wear and tear means deterioration, and the consequent diminution in an assets
value, arising from its use in business operations for earning revenue. It reduces
the asset’s technical capacities to serve the purpose for, which it has been meant.
Another aspect of wear and tear is the physical deterioration. An asset
deteriorates simply with the passage of time, even though they are not being put
to any use. This happens especially when the assets are exposed to the rigours
of nature like weather, winds, rains, etc.

Rationalised 2023-24
Depreciation, Provisions and Reserves 231

7.3.2 Expiration of Legal Rights

Certain categories of assets lose their value after the agreement governing their
use in business comes to an end after the expiry of pre-determined period.
Examples of such assets are patents, copyrights, leases, etc. whose utility to
business is extinguished immediately upon the removal of legal backing to them.

7.3.3 Obsolescence
Obsolescence is another factor leading to depreciation of fixed assets. In ordinary
language, obsolescence means the fact of being “out-of-date”. Obsolescence
implies to an existing asset becoming out-of-date on account of the availability
of better type of asset. It arises from such factors as:
• Technological changes;
• Improvements in production methods;
• Change in market demand for the product or service output of the asset;
• Legal or other description.

7.3.4 Abnormal Factors

Decline in the usefulness of the asset may be caused by abnormal factors such as
accidents due to fire, earthquake, floods, etc. Accidental loss is permanent but
not continuing or gradual. For example, a car which has been repaired after an
accident will not fetch the same price in the market even if it has not been used.

7.4 Need for Depreciation

The need for providing depreciation in accounting records arises from conceptual,
legal, and practical business consideration. These considerations provide
depreciation a particular significance as a business expense.
7.4.1 Matching of Costs and Revenue
The rationale of the acquisition of fixed assets in business operations is that these
are used in the earning of revenue. Every asset is bound to undergo some wear
and tear, and hence lose value, once it is put to use in business. Therefore,
depreciation is as much the cost as any other expense incurred in the normal
course of business like salary, carriage, postage and stationary, etc. It is a charge
against the revenue of the corresponding period and must be deducted before
arriving at net profit according to ‘Generally Accepted Accounting Principles’.

7.4.2 Consideration of Tax

Depreciation is a deductible cost for tax purposes. However, tax rules for the
calculation of depreciation amount need not necessarily be similar to current
business practices,

Rationalised 2023-24
232 Accountancy

7.4.3 True and Fair Financial Position

If depreciation on assets is not provided for, then the assets will be over valued
and the balance sheet will not depict the correct financial position of the business.
Also, this is not permitted either by established accounting practices or by specific
provisions of law.

7.4.4 Compliance with Law

Apart from tax regulations, there are certain specific legislations that indirectly
compel some business organisations like corporate enterprises to provide
depreciation on fixed assets.

Test Your Understanding - I

State whether the following statements are true or false:
1. Depreciation is a non-cash expense.
2. Depreciation is also charged on current assets.
3. Depreciation is decline in the market value of tangible fixed assets.
4. The main cause of depreciation is wear and tear caused by its usage.
5. Depreciation must be charged so as to ascertain true profit or loss of the business.
6. Depletion term is used in case of intangible assets.
7. Depreciation provides fund for replacement.
8. When market value of an asset is higher than book value, depreciation is not
charged.
9. Depreciation is charged to reduce the value of asset to its market value.
10. If adequate maintenance expenditure is incurred, depreciation need not be
charged.

7.5 Factors Affecting the Amount of Depreciation

The determination of depreciation depends on three parameters, viz. cost,
estimated useful life and probable salvage value.

7.5.1 Cost of Asset

Cost (also known as original cost or historical cost) of an asset includes invoice
price and other costs, which are necessary to put the asset in use or working
condition. Besides the purchase price, it includes freight and transportation
cost, transit insurance, installation cost, registration cost, commission paid on
purchase of asset add items such as software, etc. In case of purchase of a
second hand asset it includes initial repair cost to put the asset in workable

Rationalised 2023-24
Depreciation, Provisions and Reserves 233

condition. According to Accounting Standand-6 of ICAI, cost of a fixed asset is

“the total cost spent in connection with its acquisition, installation and
commissioning as well as for addition or improvement of the depreciable asset”.
For example, a photocopy machine is purchased for ` 50,000 and ` 5,000 is
spent on its transportation and installation. In this case the original cost of the
machine is ` 55,000 (i.e. ` 50,000 + `5,000 ) which will be written-off as
depreciation over the useful life of the machine.

7.5.2 Estimated Net Residual Value

Net Residual value (also known as scrap value or salvage value for accounting
purpose) is the estimated net realisable value (or sale value) of the asset at the
end of its useful life. The net residual value is calculated after deducting the
expenses necessary for the disposal of the asset. For example, a machine is
purchased for ` 50,000 and is expected to have a useful life of 10 years. At the
end of 10th year it is expected to have a sale value of ` 6,000 but expenses
related to its disposal are estimated at ` 1,000. Then its net residual value shall
be ` 5,000 (i.e. ` 6,000 – ` 1,000).

7.5.3 Depreciable Cost

Depreciable cost of an asset is equal to its cost (as calculated in point 7.5.1
above) less net residual value (as calculated in point 7.5.2,) Hence, in the above
example, the depreciable cost of machine is ` 45,000 (i.e., ` 50,000 –
` 5,000.) It is the depreciable cost, which is distributed and charged as
depreciation expense over the estimated useful life of the asset. In the above
example, ` 45,000 shall be charged as depreciation over a period of 10 years. It
is important to mention here that total amount of depreciation charged over the
useful life of the asset must be equal to the depreciable cost. If total amount of
depreciation charged is less than the depreciable cost then the capital expenditure is
under recovered. It violates the principle of proper matching of revenue and expense.

7.5.4 Estimated Useful Life

Useful life of an asset is the estimated economic or commercial life of the asset.
Physical life is not important for this purpose because an asset may still exist
physically but may not be capable of commercially viable production. For
example, a machine is purchased and it is estimated that it can be used in
production process for 5 years. After 5 years the machine may still be in good
physical condition but can’t be used for production profitably, i.e., if it is still
used the cost of production may be very high. Therefore, the useful life of the
machine is considered as 5 years irrespective of its physical life. Estimation of
useful life of an asset is difficult as it depends upon several factors such as

Rationalised 2023-24
234 Accountancy

usage level of asset, maintenance of the asset, technological changes, market

changes, etc. As per Accounting Standard – 6 useful life of an asset is normally
the “period over which it is expected to be used by the enterprise”. Normally,
useful life is shorter than the physical life. The useful life of an asset is expressed
in number of years but it can also be expressed in other units, e.g., number of
units of output (as in case of mines) or number of working hours. Useful life
depends upon the following factors :
• Pre-determined by legal or contractual limits, e.g., in case of leasehold asset,
the useful life is the period of lease.
• The number of shifts for which asset is to be used.
• Repair and maintenance policy of the business organisation.
• Technological obsolescence.
• Innovation/improvement in production method.
• Legal or other restrictions.

7.6 Methods of Calculating Depreciation Amount

The depreciation amount to be charged for during an accounting year depends
upon depreciable amount and the method of allocation. For this, two methods
are mandated by law and enforced by professional accounting practice in India.
These methods are straight line method and written down value method. Besides
these two main methods there are other methods such as – annuity method,
depreciation fund method, insurance policy method, sum of years digit method,
double declining method, etc. which may be used for determining the amount of
depreciation. The selection of an appropriate method depends upon the following :
• Type of the asset;
• Nature of the use of such asset;
• Circumstances prevailing in the business;
As per Accounting Standard-6, the selected depreciation method should be
applied consistently from period to period. Change in depreciation method may
be allowed only under specific circumstances.

7.6.1 Straight Line Method

This is the earliest and one of the widely used methods of providing depreciation.
This method is based on the assumption of equal usage of the asset over its
entire useful life. It is called straight line for a reason that if the amount of
depreciation and corresponding time period is plotted on a graph, it will result
in a straight line (figure 7.1).

Rationalised 2023-24
Depreciation, Provisions and Reserves 235

It is also called fixed installment method because the amount of depreciation

remains constant from year to year over the useful life of the asset. According to
this method, a fixed and an equal amount is charged as depreciation in every
accounting period during the lifetime of an asset. The amount annually charged
as depreciation is such that it reduces the original cost of the asset to its scrap
value, at the end of its useful life. This method is also known as fixed percentage
on original cost method because same percentage of the original cost (infact
depreciable cost) is written off as depreciation from year to year.
The depreciation amount to be provided under this method is computed
by using the following formula:

Cost of asset - Estimated net residential value

Depreciation =
Estimated useful life of the asset

Rate of depreciation under straight line method is the percentage of the total
cost of the asset to be charged as deprecation during the useful lifetime of the
asset. Rate of depreciation is calculated as follows:

Annual depreciation amount

Rate of Depreciation = × 100
Acquisition cost

Consider the following example, the original cost of the asset is ` 2,50,000.
The useful life of the asset is 10 years and net residual value is estimated to
be ` 50,000. Now, the amount of depreciation to be charged every year will be
computed as given below:
Annual Depreciation Amount
Acqusition cost of asset − Estimated net residential value
=
Estimated life of asset

` 2, 50 , 00 0 − ` 50 , 00 0
i.e. = = ` 2 0, 00 0
10

Fig. 7.1 : Depreciation amount under straight line method

Rationalised 2023-24
236 Accountancy

The rate of depreciation will be calculated as :

Annual depreciation amount
(i) Rate of Depreciation = × 100
Acquisition cost
From point (i), the annual depreciation amounts to ` 20,000.
` 20, 000
Thus, the rate of depreciation will be = × 100 = 8%
` 2, 50, 000

7.6.1.1 Advantages of Straight Line Method

Straight Line method has certain advantages which are stated below:
• It is very simple, easy to understand and apply. Simplicity makes it a popular
method in practice;
• Asset can be depreciated upto the net scrap value or zero value. Therefore,
this method makes it possible to distribute full depreciable cost over useful
life of the asset;
• Every year, same amount is charged as depreciation in profit and loss account.
This makes comparison of profits for different years easy;
• This method is suitable for those assets whose useful life can be estimated
accurately and where the use of the asset is consistent from year to year
such as leasehold buildings.

7.6.1.2 Limitations of Straight Line Method

Although straight line method is simple and easy to apply it suffers from
certain limitations which are given below.
• This method is based on the faulty assumption of same amount of the utility
of an asset in different accounting years;
• With the passage of time, work efficiency of the asset decreases and repair
and maintenance expense increases. Hence, under this method, the total
amount charged against profit on account of depreciation and repair taken
together, will not be uniform throughout the life of the asset, rather it will
keep on increasing from year to year.

7.6.2 Written Down Value Method

Under this method, depreciation is charged on the book value of the asset. Since
book value keeps on reducing by the annual charge of depreciation, it is also
known as ‘reducing balance method’. This method involves the application of a
pre-determined proportion/percentage of the book value of the asset at the
beginning of every accounting period, so as to calculate the amount of
depreciation. The amount of depreciation reduces year after year.

Rationalised 2023-24
Depreciation, Provisions and Reserves 237

For example, the original cost of the asset is ` 2,00,000 and depreciation is
charged @ 10% p.a. at written down value, then the amount of depreciation will
be computed as follows:
10
(i) Depreciation (I year) = ` 20, 00, 00 0 × = ` 2 0, 000
100
(ii) Written down value = ` 2,00,000 – 20,000 = `1,80,000
(at the end of the I year)
10
(iii) Depreciation (II year) = ` 1, 8 0, 0 00 × = ` 1 8 , 0 00
1 00
(iv) Written down value = ` 1,80,000 – `18,000 = 1,62,000
(at the end of the II year)
10
(v) Depreciation (III year) = ` 1, 6 2, 0 00 × = ` 1 6 , 2 00
1 00
(vi) Written down value = ` 1,62,000 – ` 16,200 = ` 1,45,800
(at the end of III year)
As evident from the example, the amount of depreciation goes on reducing
year after year. For this reason, it is also known ‘reducing installment’ or
‘diminishing value’ method. This method is based upon the assumption that
the benefit accruing to business from assets keeps on diminishing as the
asset becomes old (refer figure 7.2). This is due to the reason that a pre-
determined percentage is applied to a gradually shrinking balance on the
asset account every year. Thus, large amount is recovered depreciation charge
in the earlier years than in later years.

Fig. 7.2 : Depreciation amount using written down value method

Under written down value method, the rate of depreciation is computed by using
the following formula:
 s 
R = 1 − n ×100
 c
 

Rationalised 2023-24
238 Accountancy

Where, r = Rate of depreciation

n = Expected useful life
s = Scrap value
c = Cost of an asset
For example, the original cost of a truck is ` 9,00,000 and its net salvage
value after 16 years of useful life is ` 50,000 then the appropriate rate of
depreciation will be computed as under:
 50,000 
R = 1 −16 ×100 = (1 − 0.834) ×100 = 16.6%
 9,00,000 
 

7.6.2.1 Advantages of Written Down Value Method

Written down value method has the following advantages:
• This method is based on a more realistic assumption that the benefits from
asset go on diminishing (reducing) with the passage of time. Hence, it calls
for proper allocation of cost because higher depreciation is charged in earlier
years when asset’s utility is higher as compared to later years when it becomes
less effective.
• It results into almost equal burden of depreciation and repair expenses taken
together every year on profit and loss account;
• Income Tax Act accept this method for tax purposes;
• As a large portion of cost is written-off in earlier years, loss due to obsolescence
gets reduced;
• This method is suitable for fixed assets which last for long and which require
increased repair and maintenance expenses with passage of time. It can also
be used where obsolescence rate is high.
7.6.2.2 Limitations of Written Down Value Method
Although this method is based upon a more realistic assumption it suffers from
the following limitations.
• As depreciation is calculated at fixed percentage of written down value,
depreciable cost of the asset cannot be fully written-off. The value of the
asset can never be zero;
• It is difficult to ascertain a suitable rate of depreciation.

7.7 Straight Line Method and Written Down Method: A Comparative Analysis
Straight line and written down value methods are generally used for calculating
depreciation amount in practice. Following are the points of differences between
these two methods.

Rationalised 2023-24
Depreciation, Provisions and Reserves 239

7.7.1 Basis of Charging Depreciation

In straight line method, depreciation is charged on the basis of original cost or
(historical cost). Whereas in written down value method, the basis of charging
depreciation is net book value (i.e., original cost less depreciation till date) of the
asset, in the beginning of the year.

7.7.2 Annual Charge of Depreciation

The annual amount of depreciation charged every year remains fixed or constant
under straight line method. Whereas in written down value method the annual
amount of depreciation is highest in the first year and subsequently declines in
later years. The reason for this difference, is the difference in the basis of charging
depreciation under both methods. Under straight line method depreciation is
calculated on original cost while under written down value method it is calculated
on written down value.

7.7.3 Total Charge Against Profit and Loss Account on Account of

Depreciation and Repair Expenses
It is a well-accepted phenomenon that repair and maintenance expenses
increase in later years of the useful life of the asset. Hence, total charge against
profit and loss account in respect of depreciation and repair expenses increases
in later years under straight line method. This happens because annual
depreciation charge remains fixed while repair expenses increase. On the other
hand, under written down value method, depreciation charge declines in later
years, therefore total of depreciation and repair charge remains similar or equal
year after year.

7.7.4 Recognition by Income Tax Law

Straight line method is not recognised by Income Tax Law while written down
value method is recognised by the Income Tax Law.

7.7.5 Suitability
Straight line method is suitable for assets in which repair charges are low the
possibility of obsolescence is low and scrap value depends upon the time period
involved, such as freehold land and buildings, patents, trade marks, etc. Written
down value method is suitable for assets which are affected by technological
changes and require more repair expenses with passage of time such as plant
and machinery, vehicles, etc.

Rationalised 2023-24
240 Accountancy

Basis of Difference Straight Line Method Written Down Value

Method

1. Basis of charging depre- Original cost Book Value (i.e. original

ciation cost less depreciation
charged till date)
2. Annual depreciation charge Fixed (Constant) year Declines year after year

3. Total charge against Unequal year after year. Almost equal every year.
profit and loss account in It increases in later years.
respect of depreciation
and repairs
4. Recognition by income Not recognised Recognised
tax law
5. Suitablity It is suitable for assets in It is suitable for assets,
which repair charges are which are affected by
less, the possibility of technological changes
and obsolescence is low and require more repair
scrap value depends upon expenses with passage of
the time period involved. time.

Fig. 7.3 : Comparison of straight line and written down value method

7.8 Methods of Recording Depreciation

In the books of account, there are two types of arrangements for recording
depreciation on fixed assets:
• Charging depreciation to asset account or
• Creating Provision for depreciation/Accumulated depreciation account.

7.8.1 Charging Depreciation to Asset account

According to this arrangement, depreciation is deducted from the depreciable
cost of the asset (credited to the asset account) and charged (or debited) to profit
and loss account. Journal entries under this recording method are as follows:
1. For recording purchase of asset (only in the year of purchase)
Asset A/c Dr. (with the cost of asset including
installation, freight, etc.)
To Bank/Vendor A/c
2. Following two entries are recorded at the end of every year
(a) For deducting depreciation amount from the cost of the asset.
Depreciation A/c Dr. (with the amount of depreciation)
To Asset A/c
(b) For charging depreciation to profit and loss account.
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c

Rationalised 2023-24
264 Accountancy

In order to create the provision for doubtful debts, the following journal
entries will be recorded:
Journal
Date Particulars L.F. Amount Amount
` `
2014
Mar. 31 Bad debts A/c Dr. 8,000
To Sundry debtors A/c 8,000
(Bad debts written off)
Mar. 31 Profit & Loss A/c Dr. 8,000
To Bad debts A/c 8,000
(Bad debts debited to profit and
loss account)
Mar. 31 Profit and Loss A/c Dr. 6,0001
To Provision for doubtful debts a/c 6,0001
(For creating provision for doubtful debts)

Working Notes
Provision for doubtful debts @10% of sundry debtors i.e.
` 68,000 – ` 8000 = ` 60,000
10
` 6000 × = ` 60001
100

7.12 Reserves
A part of the profit may be set aside and retained in the business to provide for
certain future needs like growth and expansion or to meet future contingencies
such as workmen compensation. Unlike provisions, reserves are the
appropriations of profit to strengthen the financial position of the business.
Reserve is not a charge against profit as it is not meant to cover any known
liability or expected loss in future. However, retention of profits in the form of
reserves reduces the amount of profits available for distribution among the
owners of the business. It is shown under the head Reserves and Surpluses on
the liabilities side of the balance sheet after capital.Examples of reserves are:
• General reserve;
• Workmen compensation fund;
• Investment fluctuation fund;
• Capital reserve;
• Dividend equalisation reserve;
• Reserve for redemption of debenture.

Rationalised 2023-24
Depreciation, Provisions and Reserves 265

7.12.1 Difference between Reserve and Provision

The points of difference between reserve and provision are explained below:
1. Basic nature : A provision is a charge against profit whereas reserve is an
appropriation of profit. Hence, net profit cannot be calculated unless all
provisions have been debited to profit and loss account, while a reserve is
created after the calculation of net profit.
2. Purpose : Provision is made for a known liability or expense pertaining to
current accounting period, the amount of which is not certain. On the
other hand reserve is created for strengthening the financial position of
the business. Some reserves are also mandatory under the law.
3. Presentation in balance sheet: Provision is shown either (i) by way of deduction
from the item on the asset side for which it is created, or (ii) on the liabilities
side along with current liabilities. On the other hand, reserve is shown on
the liabilities side after capital.
4. Effect on taxable profits : Provision is deducted before calculating taxable
profits. Hence, it reduces taxable profits. A reserve is created from profit
after tax and therefore it has no effect on taxable profit.
5. Element of compulsion : Creation of provision is necessary to ascertain true
and fair profit or loss in compliance with ‘Prudence’ or ‘Conservatism’ concept.
It has to be made even if there are no profits. Whereas creation of a reserve is
generally at the discretion of the management. However, in certain cases law
has stipulated for the creation of specific reserves such as Debenture
Redemption Reserve. Reserve cannot be created unless there are profits.
6. Use for the payment of dividend : Provision cannot be used for distribution
as dividends while general reserve can be used for dividend distribution.

Basis of Difference Provision Reserve

1. Basic nature Charge against profit. Appropriation of profit.
2. Purpose It is created for a known It is made for strengthening
liability or expense pertaining the financial position of
to current accounting period, the business.Some reserves
the amount of which is not are also mandatory under law.
certain.
3. Effect on taxable It reduces taxable profits. It has no effect on taxable
profits. profit.
4. Presentations in It is shown either (i) by way It is shown on the liabilities.
Balance sheet of deduction from the item on side after capital amount.
the asset side for which it is
created, or (ii) In the liabilities
side along with current
liabilities.

Rationalised 2023-24
266 Accountancy

5. Element of Creation of provision is Generally, creation of a Reserve

compulsion necessary to ascertain true is at the discretion of the mana-
and fair profit or loss in gement. Reserve cannot be
compliance ‘Prudence’ or created unless there are profits.
‘Conservatism’ concept. However, in certain cases law
It must be made even has stipulated for the creation
if there are no profits. of specific reserves such as
‘Debenture’ ‘Redemption ’
reserve.
6. Use for the payment It can not be used for It can be used for divided
of dividend dividend distribution. distribution.

Fig. 7.4 : Showing comparison between provisions and reserves

7.12.2 Types of Reserves

A reserve is created by retention of profit of the business can be for either a
general or a specific purpose.
1. General reserve : When the purpose for which reserve is created is not
specified, it is called General Reserve. It is also termed as free reserve because
the management can freely utilise it for any purpose. General reserve
strengthens the financial position of the business.
2. Specific reserve : Specific reserve is the reserve, which is created for some
specific purpose and can be utilised only for that purpose. Examples of
specific reserves are given below :
(i) Dividend equalisation reserve: This reserve is created to stabilise or
maintain dividend rate. In the year of high profit, amount is transferred
to Dividend Equalisation reserve. In the year of low profit, this reserve
amount is used to maintain the rate of dividend.
(ii) Workmen compensation fund: It is created to provide for claims of the
workers due to accident, etc.
(iii) Investment fluctuation fund: It is created to make for decline in the
value of investment due to market fluctuations.
(iv) Debenture redemption reserve: It is created to provide funds for
redemption of debentures.
Reserves are also classified as revenue and capital reserves according to the
nature of the profit out of which they are created.
(a) Revenue reserves : Revenue reserves are created from revenue profits which
arise out of the normal operating activities of the business and are otherwise
freely available for distribution as dividend. Examples of revenue
reserves are:
• General reserve;
• Workmen compensation fund;

Rationalised 2023-24
 13
Revenue Recognition
Introduction
Determinationof profit is influenced by the revenue recognition policy of theenterprise. principle, revenue
In
can be recognised at the point of sale or when cash is collected or at any intermediate point. The amount of
revenue arising on a transaction is usually determined by agreement between the parties involved in the
transaction. Revenue recognition is mainly concerned with the timing ofrecognition ofrevenue in the statement
of profit and loss. When uncertainties exist regarding the determination of the amount, or its
associated costs,
these uncertainties may influence the timing of revenue recognition.
Objectives of Revenue Recognition
The main objectives of revenue recognition are :
1. The determination of correct profit for the accounting period.
2. To reduce the confusion ofthe users of the accounting
of the enterpr1se.
information regarding the profit earning capacity
3. Ithelps to design proper internal control system which can prevent financial abuses by the CEOs/CFOs.
4. It bringstransparency and truthfulness in reporting transactions.
Many intermational accounting scandals in the recent past was due to revenue manipulation. Some of
are given below: those
SLNo. Name of the Company
1. Alleged Accounting Abuses
Fannie Mae Inflated income
2 AOL Time Warner Inflated revenues and income
3
4
Xerox Inflated income
Qwest Communications Inflated revenues and income.
5
6
Bristol-Myers Squibb Inflated revenues and income.
Nortel Networks Understated expenses to inflate income.
7
Halliburton Inflated revenues and income.
9
Global Crossing Inflated revenues and income.
Satyam Computers Inflated revenues and income
 13.2 Revenue Recognition
rccognition is very vital for the
It is clear from theabove list that revenue
and Loss Account. reliability of the profit
by the companies in their Profit
The Institute ofChartered Accountants of India has issucd AS -9: 'Revenue Recognition' for
his disclose
Accounting Standard [AS-9: "Revenue Recognition'] purpOse,
Scope
This Statement does: not deal with the following aspects of revenue recognition to which
apply special consideration
i) revenue arising from constructioncontracts (subject matter of AS-7);
(i) revenue arising from hire-purchase, lease agreements (subject matter of AS-19):
(iii) revenue arising fromgovenment grants and other similar subsidies (subject matter ofA I
(iv) revenueof insurance companies arising from insurance contracts.
Definitions
Revenue :Revenue is the gross inflow of cash, receivables or other consideration arising in the cour.
the ordinary activities of an enterprise from the sale of goods, from the rendering of services, andfrom the
by others of enterprise resources yielding interest, royalties anddividends. Revenue is measured by the churor
madeto customers or clients for goods supplied and services rendered to them and by the charges and rewari
arising from the use of resources by them. In an agency relationship, the revenue is the amount of commission
and not the gross inflow of cash, receivables or other consideration.
Completed Service Contract Method : Completed service contract method is a method of accounting
which recognises revenue in the statement of profit and loss only when the rendering of services under a
contract is completed or substantially completed.
Proportionate Completion Method : Proportionate completion method is a method of accounting which
recognises revenue in the statement of profitand loss proportionately with the degree of completion of services
under a contract.
This statement deals with the basis for recognition of revenue in the Profit and Loss Account of the
enterprise. It is concerned with the recognition of revenue arising in the course of the ordinary activities of the
enterprise from :
(i) the sale of goods
(ii) the rendering of services
(ii) the use by others of enterprise resources yielding interest, royalties and dividends.

Sources of Revenue

Sale of Goods Rendering of Interest, Royalty

Services and Dividends
Sale of Goods
Revenue from sale of goods is recognised when all the following conditions have been satistied:
1 theseller of goods has transferred to the buyer the
2 all significant risks and rewards of ownership have property
been
in the goods for a price;
3. the seller retains no effective control of the goods transferred to the buyers; associated with
ownership; transferred to a degree usually
4. no significant uncertainty exists regarding the amount of the derivedfrom
the sale of the goods. consideration that will be
 Example 1: Financial Accounting 13.3
credit card. Modern Furnitures (P) Ltd, sold a
Modern Furnitures (P Ltd. wil computer table to Ram for 6,000. Ram paid it
by
Example 2 : Computer Point (P) recognise 6,000as revenue imn
3.00,000 on credit. Here Ltd, sold 10 to St.mediately.
Computer Point will computers
hecause normal credit risk derived Xavier's College,
of 3,00,000 Kolkata for
from sales is notrecognise the revenue
Illustration 1
a reason to defer tevenue immediately
recognition.
Bottom Ltd. entered into a sale deed for its
Registrar subsequent to Balance Sheet date.immovable property before the end of the year. But
But before finalisation, is it
possible to recogniseregistration
Balance Sheet date ? was done
Solution the sale and gain at with
the
According to AS9 "Revenue
is clear that the
significant risk andRecognition"
merely a formality. rewards of
it is possible for Bottom
Ltd. to recognise the sale and
gain at the Balance Sheet date. It
ownership has passed before Balance Sheet date and the
registration of the property is
Transfer of Legal Title
It should be noted that the
certain cases in which riskstransfer of legal title normally passes the
and rewards do not get risks and rewards. However, there are
passing of possessions. transferred to the buyer with the transfer of legal title or
For example :
1. Ifthe sale of contractallows the
of return, the sale should not begoods be returned and you cannot reasonably estimate he probability
to
recognised until you are sure about the acceptance by the customer.
2. If installation is an important part of the sale, recognition of revenue does not
installation is complete. takes place until
3. If the sale is
contingent on the buyer deriving revènue from resale of the goods, revenue is
at the tme of resale only. recognised
Example : In January, 2015 Tata H Motors
pp Ltd.lsi e d1 10
Ltd. on consignment basis. The selling price was 4,00,000Indica cars to its agent, Lexus Motors P)
each and commission is payable @ 10%
on sales. By 31st March, 2015, Lexus Motors sold 5 cars
only.
Here, revenue of 20,06,000 only willbe rec
recognised in March 2015.
Sales commission of 2.00,000 also will be recognised as expense in March 2015.

Illustration 2
How would you deal with the following in the annual accounts of aCompany, for the year ended 31.3.2015:
Some of the transport claims, lodged in 2012-13 has been settled by the Carrier in February 2015 by paying 1.15
lakhs. These claims were not recorded in the books of the Company so far.
Solution
Since the amount has been received, the revenue is measurable. Therefore, the Conpany should recognise this as revenue in the curent
year, as part of net income. The Company was correct in not providing for the same as revenue, when the claim was lodged.
llustration 3
How will you deal with the following:
The Board of Directors decided on 31.3.2015 to increase the sale price of certain ites retrospectively trom l.1.2015.
In view ofthis price revision, w.e.f. 1.1.2015, the Company has to receive 1S lakhs trom its customers in respect of sales
made from 1.-2015 to 31.3.2015and the accountant cannot make up his mind whether to include 13 lakhs in thesales
for 2014-15.
Solution
Recognition of revenue requires that it wouldnot be unreasonable to expect ultimate collection. In other words, it may be appropriate
will be made.
to recognise revenue only when it is reasonably certain that the ultimate collection
Here, in this case, the additional revenue arising out of price revision can be recognised as revenue in the current year provided there
is certainty relating to collectibility.
 1.3.4 Rcvenue Rccognition

TSMCompany has taken a TransitInsurance Policy. Suddenly inthe year 2014-15. the percentage ot accident has pomo
IMustration 4
revenue in 201415 in accordance
msurance clain as
un fo 7n and the
Companv wants to
reCognise
wIth relea
Vou agrce?
ACOUnting standard. Do
arising in the course offthe ordinary activities
Solution
inflow of cash, receivables Or other consideration unreasonable to of an enterprse
to expect ultimate
Revenuc is the gross
that revenue is measurable and it would not be
requites
4s Der AS9 recognition of revenue ultimate collection with reasonable certainty is lacking at the time of
Where thc abilit to assess the
rewognition is postponed to the extent of uncertaintyinvolved. In clonlaimy c,ol erceiovemmi
raising
such cases, it may be appropriate to recognise revenue
any
reasonablh certain that the ultimate collection
will be made
the consideration receivable is reasonatbly
whent
Another essential criterion for the recognition of revenue is that
consideration is not determinable within reasonable limits. the recognition of
revenue is postponed. determinable When auh
uncertainties in
Therefore. in the prescnt case., the Company should postpone the revenue recognition as there are the
insurance claim set lement
Ilustration 5
Arjun Ltd. sold farm equipmentsthrough its dealers. One of the conditions at the time of sale is, paymenttof
money in 14 days and in the event of delay interest is chargeable @ 15% p.a. The company has not realised inter consideraton
the dealers in the past. However, for the year ended31.3.2015, it wants to recognise interest due on the balances h
dealers. The amount is ascertained at 9 lakhs. Decide whether the income by way of interest from dealers is elioil
recognition as per As--9?
Solution
As per AS9, recognition of revenue requires that revenue is
coliection. measurable and it would not be unreasonable to expect ultimaa
Where the ability to assess the ultimate collection with
recognition is postponed 1o the extent of uncertainty involved.reasonable certainty is lacking at the time of raising any claim, revene
In such cases, it may be appropriate to
reasonably certain that the ultimate collection will be made. recogniserevenue only when it's
Inthis case, the company should not
in respect of collection of interest. recognise ? 9 lakhs as interest income for the year ending
The company shouldpostpone the
on31.3.2015because there is uncertam
recognition until the collection of interest is made.
Rendering of Services
Revenue from rendering of services should be
Sheetdate. There are two methods for recognised by referring to the stage
i)Proportionale dealing with this situation : ofcompletion at the Balamkt
(i) ProportionateCompletion Method; and (ii) Completed Service
Revenue is recognisedCompletion Method: Performance consists ofContract Method
under this method would proportionately by
other suitable basis. For be determined onreference
to the
performance
the
of
execution of more than ote
each act. The revenue revgu
the basis of
over a practical purpoSes, when servicescontract value, associated costs, number of acs
there is specific period of ime,
evidence that some otherrevenue is are provided by an indeterminate number o as
recognised on a straight
method better represents the line basis over the specitic periodunle
pattern of
itsExampl
pertormance.
cliente
:
Your company
TotalrevenueHindustan
HCCL hasREL.ineurred of the Constructing Co. Ltd.
10.0 0,000 more will
cost up project
to 3Ist is
40,00, 000. (HCCL) 0s laying a city gas pipelinefor
Upto 31st
the balanceDecember,
be
required to March, 2015 *
?
2,5 0,0 00 2014 REL, has complete the
Rprojeet.
I5,00,000 and the
conipany is expecting
hat
inspect the work
Recognise : during the Ist
(*
15,0 0,000 --* approved 12,5be0,000 of
of12,April,
50,0 00)
(a)
(b) 12,50,000 asas expenses (the
20,00,000
week will
expenditure.
HCCL 0s confident that
2015. No approved by REL when their engineerwill
payment has
amount approved)
(accrued) revenmue been so received far.

12,25,050,0,000000 x 40,00,000
 COUnt
(i) Completed Service Contract Method
Alternatively, services are pertormed in more thanPerformance consists of the execution of a single act.
a single act, and the services yet to he performed are so
significant in relation to the transaction taken as a whole that performance cannot be deemed to have been
completed until theeexecution of those acts. The completed service contract method is relevant tothese patterns
fnerformance and accordingly revenue is recognised when the sole or final act takes place and the service
becomes chargeable.
Interest, Royalty and Dividends
Revenue arising fromthe use by others of enterprise resources yielding interest, royalties and dividends should
only be recognised vwhen no significantuncertainty as to measurability or collectibility exists. These revenues
are recognisedon the following basis:
nterest :on atime proportion basis taking into account the amount outstanding and the rate applicable:
i) Roalties :on an accrual basis in accordance with the terms of the relevant agreement:
iii) Diidends fromInvestments in shares : when the owner's right to receive payment is established.
Ilustration 6 for
SCL Lmited sells agricultural products to dealers. One of
the condition of sale is that interest is payable a 2% p.m. During
to various reasons.
only 10% on such overdue outstanding due
delaved payment. Percentage of interestrecovered is entire interest receivable. Do you agree?
recognise the
the vear 2014-15, the Company wants to
no sign1ficant
Solution interest, should only be recognised when
Revenue arising from the use byothers of enterprise resources yielding following manner:
or collectibility exists. Interest is recognised as revenue on the
uncertainty as to measurability outstanding and the rate applicable. recognise it as revenue of
time proportion basis taking into account the amount interest. The company should not
On a regarding collectibility of
uncertainty arises
Here. in this case, as the when cash willbe received.
recognise it
2014-15. However,company can
as interest and
Ilustration 7 Co. Ltd, received 10 lakhs and? 15lakhs
Ltd. In return, X
certain resources ofXCo. 2014-15.
Y Co. Ltd. used Ltd. during the year recognised by X Co. Ltd.
royalties respectively from Y Co. can be
whether and on what basis these revenues
Youare required to state enterprise resources
resources by them. The use by others of such
for the use of
Solution
measured by the charges made to customers
Revenue is
to the enterprise. appicable.
gives rise to of cash resources or amounts due amount outstanding and the rate
charges for the use determined by the copvrights.
(i) Interest
most circumnstances, on the time basis know-how, patents, trade marks and that basis unless,
having regard
Interestaccrues. in assets as recognised on
charges for the use of
such agreement and are usually systematic and rational basis.
(ii)Royalties - terms of therelevant some other
accrue in accordance with the
appropriate to recognise revenue on
Royalties transactions, it is more 2014-15.
of the as revenue for the year
to the substance Ltd. should recognise 25 lakhs
Here, X & Co. (AS-1),
Disclosure of AccountingPoiciespending
Disclosure Accounting Standard Ion recognition has been posponed
by
disclosure requiredcircumstances in which revenue
addition tothe the
In
enterprise also has to disclose
an
resolution of significant uncertainties.
the Specific Examples

and accepts billing However, the

Sale of Goods and buyer takes title been done.
request delivery has not
Delivery is delayed at buyer's though the physical
recognised
I. should be and ready for delivery
revenue satisfied : identified
niscase,
conditions must be and (ii) the item is
Tollowing hand
item must be on
(1) the
 Financial
any
Statements of a Company
Learning Objectives
each would
wouldenable youto understand:
ofthisChapter
stujr Statemnents of a Company
eby e Finanial
BalanceSheet
1.1
1.1
atks D Profit and Loss
Statementof
CashFlowStatement
Characteristicsand Nature
of Financial Statements 1.2
1.2
Financial Statements
tks O 0bjectives of 1.3
Financial Statemnents
D Essentialsof 1.3
Financial Statements
Limitationsof 1.4
Sheet and Format
Heads of Balance 1.5
ty.
D
Major Heads of Balance Sheet
Eeplanation of 1.25
and Reserve
ks] 0 Difference between Provision
D

FINANCIAL STATEMENTS
MEANING OF
ch
summarised statements of accounting data prepared by n
Statements are It is a
Financial accounting process, i.e., after preparing Trial Balance.
end of an users. A
enterprise atthe accounting information to the internal and external
medium of
communicating
2(40) of the Companies Act, 2013 includes:
statements as per Section position
St
cot of financial Equity and Liabilities, i.e., financial
s Assets,
a statemnent of as Position
Statement.
1. Balance Sheet: It is It is also known
agiven date. performance, i.e., result ot
business
of an enterprise at shows the financial
Statement of Profit and Loss: It also known as Income Statement.
6 2
during an accounting period. It is Loss are supported
by
operatiorns Statement of Profitand L0sS.
Accounts: Balance Sheet and Sheet and Statement of Protit and
t
Notes to
details of items in the Balance with AS-3, Cash
Flow
notes giving accordance
ie
is a statement prepared in Cash Equivalents.
4. Cash Flow Statement: It
inflow and outflow of Cash and prepare its tinancial
Statement, to show
requires the company to Companies Act, 2013.
129 of the Companies Act, 2013 lll of the
Section prescribed form, i.e., Schedule
statemernts every yyear in the
enterprise, the Balane
Financial Statements -Definitions of a busiess stutement showine
summary of accounts incoMe
"The provide a capital as on a certain date and
ie Financial Statements provide --John N. Myer
Sheet
the reflecting the assets, liabilities and
certain period. "
results and operations during a
of the Companies Act, 2013. Pat
Format of the Balance Sheet Bal
int
The format of Balance Sheet as prescribed in Part I of Schedule III of the Companies Aa,
2013, is as follows:

Name of the Company...

BALANCE SHEET as at..
RinA
Particulars Note Figures as at the Figures as at the
No. end of the Current end of the Previous
Reporting Period Reporting Period
(1) (2) (3) (4)
I. EQUITY AND LIABILITIES
1. Shareholders' Funds
(a) Share Capital
(b) Reserves and Surplus
(c) Money Received against Share Warrants
2. Share Application Money Pending Allotment
3. Non-Current Liabilities
(a) Long-term Borrowings
(b) Deferred Tax Liabilities (Net)
(c) Other Long-term Liabilities
(d) Long-term Provisions
4. Current Liabilities
(a) Short-term Borrowings
(b) Trade Payables
(c) Other Current Liabilities
(d) Short-term Provisions
Total
 Chapter 1 Financial Statements of aCompany 1.5
ASSETS
1. Norn-Current,Assets
(a) FixedAssets:
() Tangible Assets
(i) Intangible Assets
ii) Capital Work-in-Progress
(iv) Intangible Assets under
h) Non-current Investments Development
Assets (Net)
i) Deferred Tax
Long-termLoans and Advances
(d)
il Other Non-current Assets
2. CurrentAssets
(a) Current Investments
(b) Inventories
(c) Trade Receivables
IA Cash and Cash Equivalents
(e) Short-term Loans and Advances
0 Other Current Assets
Total

cONTENTS OF BALANCE SHEET

Balance Sheet, prescribed in Part I of Schedule Iof the Companies Act, 2013, is divided
into two parts, i.e., I. Equity and Liabilities and Il. Assets.
I. EQUITY AND LIABILITIES
Eguity is the liability towards shareholders and is termed as 'Shareholders' Funds'. It
includes Share Capital, Reserves and Surplus and Money Received against Share Warrants.
Liabilities means external liabilities of the company, i.e., liabilities towards outsiders. It
is shown as Non-current Liabilities and Current Liabilities.
In between Shareholders' Funds and Non-current Liabilities, 'Share Application Money
Pending Allotment is shown.
1. Shareholders' Funds
Shareholders' Funds comprise three items, ie., (a) Share Capital; (b) Reserves and Surplus;
id (c) Money Received against Share Warrants. Let us discuss them in detail.
la) Share Capital:Share Capital means shares issued by the company for subscription and
amount received against the issued share capital and also issued for consideration other
lan cash. The persons to whom shares are allotted are known as shareholders. Share
pital includes both Equity Share Capital and Preference Share Capital.
Schedule II of the Companies Act, 2013 requires that the Balance Sheet to disclose authorised
capital, issued capital and subscribed capital besides the amount called-up by the company and
paid-up by the shareholders. It should be kept in mind that the details required by the schedule
e given in the Notes to Accounts. The details required to be given are discussed below:
(i) Authorised Capital or Nominal Capital: Authorised Capital or Nominal Capital is the
maximum capital that a company can issue for subscription. It is stated in the
Memorandum of Association of the company under Capital Clause and is divided
 Share
into different dasses of Share Capital such as Equity a compan:
Share Capital, It isthe maxinun amount up to wmCn Capital and Iei
under cah suh daS5 of Share Capital.
shown inthe vote to Accoynt.
Cabilal is
The dhount of Authorsel
added to the liability on
lor inf0mation only. It is nof
of the
Companies Act
Share
Definition of Authorised Capital
Capital" or "
|Section
Nominal Capital" means
such
2(8)
capital as is authorised hy
share capital of
nthe 0131 Auth
maximum amount of
of a conpany to be the

(i1) Issucd Capital: Issued

l is that part of authorised capital which the
Capilal tothe date of Balance Sheet. Shares
corripary
issued for sulbscription
up
givingthenumber of issued
nas
Share Capital (Equity or Preference)
the Note to Accounts on shares
Class of value is shown in
to or less Share
their nominal face) that Issued Capital can be equal subscribed than the
keptin mind the
inthe Note to Accountscapital.
should be or more than
The amount ofitlssued
Also, can be equal istoshown
Capital on Share Cap
Capital.
It is not added o the liability.
informationonly. Companies
Capital |Section 2(50) of the Act, 2013)
frorm
Definition of Issued company issues
"Issued Capital" means such capital as the tine to
for subscription.
(i1) Subscribed Cayital: Subscribed Capital is that part of the Issued Capital which
by the company, whether in cash or in
Subscribed
been subscribed. Amount
Capital is received
shown as Share Capital kind
on the face of the Balance She.

Subscribed Capital [Section 2(86) of the Companies

is for the Act, 2013
Definition of which
"Subscribed Capital" means such part
of the capital
time bëir;
of a company.
subscribed by the members
classified, i.e., shown under the following two heads:
Subscribed Capital is
paid-up and
(a) Subscribed and fully
(b) Subscribed but not fully paid-up.
detail.
Let us discuss it in
Subscribed and Fully Paid-up when both the following condt
and fully paid-up'
Shares are shown as 'Subscribed
value of the share: and
are met:
called the entire nominal (face)
(i) the company has
the company has received the amount called-up.
(ii)
Ltd. has issued 1,00,000 Equity Shares of 10 each and has called the ha
For example, Mist and has also received it. Since the company has calk
nominal (face) value of 10 to be paid
(face) value and has also received it, it will be shown as fully paid-up
the entire nominal der Subscribed Capia
 Ltd. has an opening balarnce of 5,00,000 in
Example 3.Casio Machines
Reserves and also debit balance of 10,00,000 in
Profit and Loss in Reserves and Surplus. During the
Surplus, ie..
year ended
Se31stcurit esStatePmrteen
Balance in (

it incurred a loss of
and Surplus?
15,00,000. How will it be shown in Note to
AccountsMaonrch,Res
Solution:

Note to Accounts
Particulars (
W
Reserves and Surplus
fa) Securities Premium Reserve d
(b) Surplus, i.e., Balance in Statement of Profit and Loss C

Opening Balance
Add: Profit/(Loss) for the year (10,00
(1500
Balance
(250n
Total (a +b) (To be shown against Reserves and Surplus under Shareholders' Funds in the
Balance Sheet) 20.00

Example 4. Premium Stores Ltd. has the following balances in

Reserves and Surplus
Debentures Redemption Reserve 5.Q0
Securities Premium Reserve
Surplus, ie., Balance in Statement of
Profit and Loss
During the year ended 31st March, 2019, it earned a profit after tax of 5,00,000. Itdexidw
to appropriate ?
General Reserve. 1,00,000 towards Debentures and 1,25,000
towank
Redemption Reserve
Show how it will be
shown in the Note to
Accounts onon Reserves and Surplus?
 Finoncinl Statements 429)

iglution:
woe
toAccounte
Chapter 1Financial
Statements of aCompany 1.15
servesandSurplus
Securities
P,
sPremium Reserve
OpeningBalance
DebenturesRedemption
QpeningBalance
Reserve
Transferredfrom
Surplus, i.e., Balance in 6,00,000
General Reserve
OoeningBalance Statement of Profit and Loss 5,00,000
1.00,000
Transferred from 6,00,000
Surplus, i.e., Balance in
WSurplus,,ie., Balance in
Opening Balance Statement of Profit andStatLoss
ement of Profit and Loss 1,25,000 1,25,000
Add: Profit for the year
(1,50,000)
Less: Appropriations:
5,00,000 3,50,000
Debentures Redemption Reserve
General Reserve 1,00,000
(To
Total(a+b +tC+ d) be shown in the Balance Sheet against Reserves and 1,25,000 2,25,000 1,25,000
Surplus) 14,50,000
(c) Money,Received against Share Warrants: Share Warrants are
hich give the the financial
 16,87 500

Illustration 43. Following balances have been extracted from the books of Rama Ltd. on
31st March, 2019:
Equity Share Capital (1,00,000 Equity Shares of 10 each) 10,00,000; Securities Premium
Reserve 2,00,000; 12% Debentures 4,00,000; Creditors 2,00,000; Provision for Tax
750,000; Surplus, i.e., Balance in Statement of Profit and Loss (Debit) 50,000; Land and
Building ?9,00,00; Government Bonds T 5,00,000; Capital Work-in-Progress (Building)
3,50,000 and Cash at Bank 50,000.
 .aMed on 1st Apil, Chapter 1 Financial
clheet of the 2017
company as perredeemable after 5years,Stateie.,mentson
s of a
Company 1.43
4pution:

BALANCE SHEET ns Srhedul

ot 31st e
II, Part I of
the
31st March, 2022

FOUITY,
ANDLIABILITIES
March. 019 Companies Act, 2013

Shareholderss' Funds Note Curront

1 ia) ShareCapital No Yoar (
A Reserves and Surplus
Non-CurrentLiabilities
Longternm Borrowings 10.00.000
t CurrentLiabilities 150,000
(a) Trade Payables
h Short-term Provisions 4,00,000

Total 2,00,000
L ASSETS 5 50,000
Non-Current Assets 18.00.000
(a) Fixed Assets:
Set (0 Tangible Assets
(ü) Capital Work-in-Progress
6
(b) Non-current Investments 9,.00,000
7 3,50,000
2 Current Assets
8 S,00,000
Cash and Cash Equivalents
Total 50,000
18,00,000
Notes to Accounts

Particulars
1.Share Capital
Authorised Capital
Equity Shares of ? 10 each
sued Capital
Equity Shares of 10each
Subscribed Capital
Subscribed and fully paid-up
1,00,000 Equity Shares of 10 each 10,00,000
2. Reserves and Surplus
Securities Premium Reserve 2,00,000
Surplus, i.e., Balance in Statement of Profit and Loss (50,000)
1.50,000
3. Long-term Borrowings
12% Debentures 4,00,000
4. Trade Payables
Creditors
5, Short-term Provisions
2,00,000

Provision for Tax 50,000

. Fixed
Assets-Tangible
Land and Building Assets 9,00,000
. Fixed Assets--Capital
Work-in-Progress
Building under Construction 3,50,000
. Non-Current Investments
5,00,000
9, Government Bonds
Cash and Cash Equivalents 50,000
Cash at Bank
 404) Chhaya Accountoncy- X

17.5 Balance Sheet

G990
It is a statement and not an account.
If is the final statement of the financial position of a
business on the closing date of the financial period.
The balances of the real accounts and personal
wealth Countries including India follow
of a Balance Sheet as prescribed by
Gomnon-
the format
the British
Companies Act, 1856. It shows all
accounts appearing in the Trial Balance are
grouped as assets or liabilities depending on their
liabilities
capital on the left hand side and all and
nature of balances. These are arranged in a sys assets
right hand side of the staterment. USA and
on tha
tematic manner and shown in the Balance Sheet
tralia prepare their Balance Sheets in the Aus-
after making necessary adjustments like depreci
ations, provisions, etc.
manner. opposite anci

tha

extr

17.5.1 Some important definitions of Balance Sheet yFin

O Eric Louis Kohler (Dictionary for American Institute of Cost and Profes. the
Accountants) : A statement of the financial sional Accountants (Accounting Terminol.
position of any economic unit, or component ogy Bulletin No. 1) "A tabular
thereof, reporting as at a given moment of summary of balances (debit
statement
and
of
time its assets (at cost, depreciated cost, or
carried forward after an actual or constructi
credit)
other indicated value), its liabilities and its alanc
ownership equities recorded under an closing of books of account kept according abilit
accounting system. principles of accounting' AONO

BSOU
17.5.2 Nature or Features of Balance Sheet Balan

It is staterment but not an account. No closing 3 It acts as buffer between the transactions a# neas
entry is required to transfer assets or liabilities two Consecutive accounting periods nd L
he in
to the Balance Sheet. It shows the stock of According to the going concern Concept, a
assets and liabilities at a particular date. business is expected to continue over an Dm
It is a summary of unallocated balances. indefinite life span. The Balance Sheets are enote
According to the matching cost concept, the interim financial reports within this span and ICom
costs allocated to any accounting period are build up the link or bridge between two fere
matched against corresponding revenues. The accounting periods. eSui.
left over portion of costs, that is, the unallo ESOUr
cated portion is carried forward to the next It acts as a resource statement, Smith & nlows
period as assets. Liabilities represent the sac Keith observed that a Balance Sheet "shows
rifices that equal to the unallocated costs. So, the economic resources of the business at a
the Balance Sheet contains unallocated costs point of time and the sources of thOse
and corresponding sacrifices. resources at the point of time." |The
Acou
17.5.3 Functions of the Balance Sheet of Need or Purposes of Preparation of a Balance Shet ks
The Balance Sheet serves Some definite assets and current liabilities. On the other
functions. It is prepared to fulfil some definite hand fixed assets and long-term loans give an The C
objects. These are idea about the long-run prospect. show
0 Disclosure of values and nature of
bilities: Assets and liabilities are assets and lia Information about liquidity: A Balance Shet SUch
shown in the clearly exhibits the liquid assets (that is cur Ihe
Balance Sheet following some
order. This gives an idea about theirsystematic rent assets other than stock) and the incom ew
whether fixed or fluctuating or current nature
or tan
plete external debts. It creates a transparency Shee
gible, etc. The valuations of regarding the liquidity position.
these
liabilities are also made following assets and 4 Information about other necessary aspects: A Ba
sistent principles. some con ance Sheet helps to know about the captal
Information theabout solvency: The Balance employed, the nature of capitalization, the risk
separates different classes of Sheet factors involved (by showing diferent debts cat
liabilities from each other. The assets and egorically), the business potential, etc. For this
position and the short-run working capital a carefulstudy of the Balance Sheet is required
ness can be easily solvency of a busi
assessed from its current By comparing a
the Balance Sheets offormed
few

Consecutive years, an idea can be

 about Fingncial Statements 405
growth
Provision
impormatnaantgeriaaspect
itability,
in a s
lyarbusdinstesicsk ofefficienCy
like the trend of prof-
ment discipline. By provicding a
AConomic resoUrces and sacrificesmeasure
and of
ing is, of a at economic on a par
ticular date, a Balance Sheet serves as a
17.5.4 present, measurement: Account
considered
measure- as A
yardstick of measurenent.

paredTradi
1he
to ng and Profit
fnd
COncern out the
Relotionship
and Loss Between Profit &loss Acount ond Balance Sheet
Vear: A during anprofit or loss Account are pre Static and dynamic view: A Balance Sheet
ihefinanCialBalance Sheet is the
made by a trad
A

date ofthat Dosition

of
that final accountconcern
period, ing onstatement
USually
its the financial affairs on a
The Profit and L0ss particular
exhib
date
of
inextricable
Final
accountpartsing ofperitheod. As such.thetheseclosiareng
of
operational result
place
of
Account discloses the net
trading activities taking
on
other. The
TI Accounts.
These process
are
of
Prepara- which
throughout the accOunting period. For
it is
generally said that
the remainsinformation
the Profit and
oneof these
pnce Of
two other. close ete convevyed
may be Theincompl
complimentary
without theby pres-any
Loss AcCCOunt is a motion
picture
Balance Sheet is a still photograph.whereas
But both
a

stockysed as refollaltoiows:
nship between of these project the
Existance of aaanal
the
end result, of course, in
Balance Sheet is aand flow
different manners The Balance Sheet
vides a static view. The pro
Liabilities at a
economic standatement
particular time.
relaoftionship: The
lt Assets and
Profit and Loss
Account records and measures the
resources. resources
By the of the
shows Balance Sheet as a link between twochanges.
comparing
Balance Sheets of the sources
net theseof Paton and Littleton felt periods:
that the Balance
measurement of two
income is resources
Consecutive periodsProfita Sheet is a connecting link that
sive income joins succeS
and Loss
Account, on the possible. The statements into a Composite
ture of income
the inflows of revenues other hand,
pic
mof and outflows records streams. The Profit and Loss
Account records those portions of
expenses and losses.
denotes income. The in the
revenues which are allocated to costs and
income. The
Thus it also result accounting period. The unallocted costsparticular
approaches of measures revenues are carried forward to the and
different but these two
result. The Balance
Sheet
measurement
provide the same
are
accounting period through Balance next
resources and the shows
Profit and the stock of Robert Sprouse felt that a Sheets.
inflows and outflows therefrom. Loss shows the
a Balance Sheet is
dumping ground for balances that
has decided should someone
income statement. not be included in the
17.5.5
Differences
between a Profit and
0The object of preparing a Profit and Loss Loss Account and Balance Sheet
Account is to find out the profit 4 The Profit and
made or net ally in the form Loss
of a AcCount Apresented usu
loss sufferred by a is
business during an Account.
accounting period. is alwayS
prepared in the form Balance
of a
Sheet
The object of preparing a
Balance
which may be horizontal or
vertical
statement
1
show the Assets Sheet is to
and Liabilities at the end of Fhe nominal accounts related to an in style.
such period. ing period are
transferred account
to Profit and
. 9The Profit and Account and are closed permanently. TheLoss Bal
Loss Account gives a ance Sheet contains balance
View of incomes and dynamic ferred to the next accounting period.which are trans
Sheet gives a static expenses. The Balance
view of resources and 6 For a trading concern
Ooligations at aparticulars point of time. (other than a company)
9The marshalling or classification of items is required
Profit and Loss Account
dCCOunt but the Balance Sheetcontains nominal
for preparing its Profit and Loss
the concept of marshalling or Account. But
containt other arranging assets
accounts. and liabilities is closely associated with the
preparation of a Balance Sheet.

A
17.5.6 Limitations of Balance Sheet
BadeprlaneccieatedSheetvaluusually
es of theishows
r histofixed
rical assets
costs, that is, the cost incurred at the time of their
acquisitions. But in a situation where the price
 406) Chhaya Accountoncy XI
©Intangible Assets: e.g
level becomes subject to freguent changes. Outstanding incomes, etc. Prepaid
Tne value depicted in the Balence Sheet D Unrealisahle Assets: having no
remain incorrect
FictitiouS, unrealisable and boguS assets iKe
"Unwritten off Expenses" also find place in the
Balance Sheet which entirely goes Against the
like preliminary expenses.
Contingent Assets: which
subject to the happening mayof
remaalitseartiialltiyag
value mechanism.
A Balance Sheet as a transitional statement
of Assets and Liabilities becomes a static
tain event, e.g. damage
receivSOrIablncome
the suit is pending a claim for
Refund etc.
me ncor.
e wherTaxa
statement of funds, fails to bring out important liabilities: Aliability may be defined
aspects like business trend, managerial effi promise to pay money or transter as any
cience. etc.
render service to a certain person
persons. In other
qoods
or
words, liabilitiesor group ot
A Balance Sheet fails to disclose human are claim
resources and efficiency of workers. It ignores transactions that have already occurrert
(lassification of Liabilities:
qualitative aspects.
Balance Sheet as an indicator of financial Fixed Liabilities: Payable after a
resources, enjoyed central attention till the able period of time like long-termConsider.
1930s. Thereafter. income statements like
Profit and Loss Accounts enjoy more attention
debenture.
Current Liabilities: Payable in near
loans,.
as they can explain how and what amount of may be within the next accounting tuture,
income have been generated duing an such as Sunday Creditors, Bil s period,
accounting period. Outstanding expenses. Payable
SOME IMPORTANT CONCEPTS OLiguid Liabilities: Which are to be paid at
Asset: It means claim or a right which will render very short notice. Management Accoun
future value to business. Any expenditure
tants consider all Current liabilities as i.
whose entire benefit has not been utilised fully, uid liabilities excluding bank overdrat.
Contingent Liabilities: Which may arise in
from which further services or opportunities will
be received in future and on which the business future depending on the happening at
Asset. some uncertain events, e.g. Bills dËs.
has got right and ownership is called an
The future service may be received in the form counted but not matured, Damages Pay
converted into money. able still under dispute, etc. These are
of money or may be shown as foot notes to the Balance Sheet
AICPA has remarked that Assets represent and not within the Balance Sheet.
to
expected future economic benefits, right Internal Liabilities: Which mean liabilities to
enterprise
which have been acquired by thetransaction."
past the owners of the business, e.g. profit and
as a result of some current or
Loss A/c, Creditors, etc.
Classification of Assets: Assets may be broadly External Liabilities: Amounts payable to
divided into (a) Fixed Assets held by a con
not for sale) external claimants or anthorities, e.g. Bills
cern over years for re-use (and Payable, Trade Creditors, etc.
(b) Current
to earn income over years and
Assets - expected to be realised or converted 6 Working Capital: Professor H.G. Dougallofcor
excess cur
sidered Working Capital as theliabilities.
into cash or consumed during the normal Thus
operating cycle of the accounting period. rent assets over current the net
Fixed Assets may be further sub-divided working capital is considered aspayment or
amount ofcurrent assets left after
into
current liabilities.
angibe Assets: whose existence can be working capital as
seen and felt, e.g. Buildings, Machinery, The economists consider assets.
Plant, Furniture, etc. the sum total of the current
Liabilities: On the bass
Intangible Assets: whose existence remains 6 Grouping of Assets andnature the assets and lia,
invisible but whose benefit is enjoyed e.g. of their similarity in shown under spectie
Goodwill, Patents, Copyrights or Trade bilities are grouped and parties selling goodsol
Marks, etc. heading. The different
are shown as creditoD
Current Assets may be sub-divided into creditto the business whom the bus
Liquid Assets: which are cash or useable Similarly, different parties to are termedand
as cash, e.g. Cash, Securities, etc. ness has sold goods on credit
© Circulating Assets: which can be easily con shown as Debtors. same
showingitems of
verted into cash, e.g. Trade Debtors, Bills Thus, grouping means
Receivable, Stock, etc. nature under a common heading.
 Format [In order of liquidity]
[Horizontal Form]
Balance Sheet
as at..s...

Liabilities Amount Assets

Amount

Sundry Creditors XXXCash in hand XXX

Bills Payable XXX\Cash at Bank XXX

Bank Loan XXX\Bills Receivable XXX

Outstanding Expenses XXxSundry Debtors XXX

Income Received in Advance XXX\Advance Payments XXX
Loan on Mortgages XXX\Stock XXX
Reserves &Surplus XXx\ Investments XXX
Capital Account XXx Furniture &Fittings XXX
Plant and Machinery XXX
Land &Buildings XXX
Trademark XXX
Copy Rights XXX
Patents XXX
Goodwill XXX
XXX
XXX
 408 Chhaya Acountoncy- XI
permanence
Format In order of
[Horizontal Form]
Balance Sheet
as at Ple
Amount giv
Assets
Liabilities and

XXx Goodwill col

Capital Account
XXX Patents 'sUS
Reserves &Surplus sid
Loan on Mortgages XXx Copy Rights
whi
Bank Loan Trademarks
Land &Buildings Try
Income Received in Advance pet
Outstanding Expenses XXx Plant &Machinery sha
Bills Payable XxxFurniture and fittings Pro
Sundry Creditors XXx Investments an
Stock of t
Sundry Debtors ass

Bills Receivable Cre

side
Cash at Bank
Cash in Hand
(b)
XXX
Th
Vertical Form of Balance Sheet 6 are
as at.ssnes.

Particulars Amount Amount Amou

Fixed Assets:
Goodwill
Patents XXX
Capital
Copy Rights XXX
A
Trademarks XXX
Land &Buldings XXX
Le
Plant &Machinery XXX
Sundry
Furniture &Fitings XXX

Current Assets: XXX

X Bills Pa
Stock
XXX
Advance Payment
XXX
Sundry Debtors
Bills Receivable XXX

Cash at Bank XXX

Cash in Hand XXX

Less Current Liabilities: XXX XXX

(Final
Sundry Creditors Preoar
Bills Payable XXX
tor the
Outstanding
Income
Expenses XXX
ance
Received in Advance XXX
iculars
XXX

Working Capital XXX XXX

Net Assets Employed XXM

Financed By:
Long-term Loans Freehc
Add:Capi
NettaProfit
l 000
000
000 Sales
 (a) in of the balances.
Proit
any and on Trial
the debit Balance are Draw ration 8
of the Lossor side up
exxpense
of
Account
Loss
o asset Balance Sheet so on the or so
(b)
of the to be 31st
far as itTrading and in theMarch,
order
the
Balance
2010, fromSheet
the ofR Limited as on
far as it rassete pre sent s of
Credi t
SO tar Bal
side of the def
a er
nces edareretovenue indic ate s side Cash
Bills
in hand
Payabl e per
11,2m anence.
00; Sundry
following in form ation
(b) on as itTrading and Profi
e Thefar it liraebiprliteysent
So the s
be
shown
anv
expenditure.
(a)
on Sundry Debtors 3,518,00;000.Bills Greditors 28,800;
t and Lossthe credit Machinery as on April 1, Receivable 5,300;
on
are tobalbearences
prshown side of theincome or Account
a gain or Depr
esentofsinReal and Balance Sheet ClandosinDeprg SteFixtures
ture e ci
and at io n provid ed for the
as on 1 year
2009, 85.000 and

Solution liabilty/provison/Reserve.
the Personal
Balance Sheet.Account
In the
Balance Sheetbooks
Nom ingsPropri
of R.Ltd
eto r'
during s
ci
o a
cktion 15,
Capital
the
400.
provided the year 21,000
Account
for

Profit and Loss year 8,000. 90,Net000; His draw

Account
8,500:{ Furni
April, 2009,

profit as
31,000.(Delhi 2011) per
2,100;

Capital Liabilities as on
31st March,
Add: Net Profit Amount 2010
90,000 Assets
Less: Drawings 31,000 Machinery Amount
Sundry Creditors 1,21,8,000
000 Less :Depreciation 85,000
Bils Payable
1,13,000 8,500 76,500
28,800 Furniture and
Fixtures
Less :Depreciation 21,000
3,500 Stock
Sundry Debtors 2,100 18,900
Bills Receivable 15,400
Cash in hand 18,000
Ollustration 9 1,45,300 5,300
11,200
Final Accounts *Carriage 1,45,300
Prepare the without
Trading and Adju st m ents) Bad debts 956
10r the year
ended 31st
Profit and LOSs
Account Wages 450
ance Sheet as on
that March, 2013, and a Bal Debtors 2,454
iculars of Tushar date from the following par Creditors 10,890
Gupta. Discount Received 4,858
Trial Balance Discount Allowed 1,526
as on 31st Furniture 1,648
March, 2013 Capital 384
Head of Accounts Debit Credit General Expenses 21,318
2,676
Heehold Machinery
Pant andland and Bank Balance
Building 5,500 Rates 3,748
376
Sock 1st April, 2,664 Drawings 3,710
Sales 2012 8,346 69,268 69,268
Purchases 25,466
41,566 [Stock on 31.3.2013 was 8,440]
Carriage is assumed as carriage inward
 410 Chhaya Actountoncy- X

nSolution In the books of Tushar Gupta

Trading and Proflt and Loss Account
2013
Dr. for the year ended 31st March, Cr,
Particulars
Amount Particulars
Amount
8,346 By Sales
To Opening Stock
25,466 By ClosingStock 41,586
To Purchases 8,840
To Carriage 956
To Wages 2,454
To Gross Profit c/d 13,184
50,406 50,406
To General Expenses 2,676 By Gross Profit b/d
376 By Discount Received
13,184
To Rates 1,526
To Discount Allowed 1,648
To Bad Debts 450

To Capital A/c 9,560

(Net Profit transferred)
14,710 14,710
Balance Sheet
as on31st March, 2013
Amount Assets Amount
Liabilities
Freehold land and Buildíng 5,500
Capital 21,318
Add: Net Profit 9,560
30,878
27,168
Less: Drawings 3,710
4,858|Plant &Machinery 2,664
Creditors 384
Furniture
Stock 8,840
Debtors
10,890
Cash at Bank 3,748
32,026
32,026
Discounts 1,500 3.150
11,820
llustration 10 Purchase Returns
4,50,930
Neptune Trad Sales
The following is the Trial Balance of Postage and Telegram 8,640
31, 2012:
ing Company as on March Bad Debts
3,600
Deblt Credit 48,000
Head of Accounts L.F. Amount Amount Sundry Debtors
Purchases
3,71,760
Stock on 14.2011 27,600
Landand Building 10,32,000 4,200
1,22,400 Interest 12,30,000
Machinery
Investments 84,000 Capital 8,130
3,000 Sales Returns
Carriage Inwards 2,250
Cash 480 Bills Receivable 18,00,00018,00,000
Salaries 61,200
valued at 10,800
Wages 14,400 Stock on 31.3.2012 was
Bills Payable Profit and Loss AccOunt
8,100 Prepare the Trading and
Sundry Creditors March, 2012, and tne ba
96,000 tor the year ended 31st
Travelling Expenses 6,840 ance Sheet as on that date.
 Financial Statements 4t)
potion In the books of
Trading and ProfitNeptune
and
Trading Co.
Loss
for the year ended 31st Account
March, 2012 Cr.
Particulars Amount Amount
Particulars
Oreing
Stoct
27,600 By Sales 4,50,930
Less: Sales Return 8,130 4,42,800
oAchaseS
3,71,760 By Closing Stock 10,800
ASS.:PurchaseReturn
11,820 3,59,940
14,400
Wages
armiageInwards 3,000
GossProftcd 48,660
4,53,600
4,53,600
48,660
Salaries 61,200 By Gross Profit bld
PrstageandTelegram 3.150
8,640 By Discount Received
34,170
pBad
Debts 3,600 By Capital Alc
[Net Loss transterred)
TravelingExpenses 6,840
DiscountAllowed 1,500
4,200 85,980
DInterest
85,980
Balance Sheet
as on 31st March, 2012
Amount
Amount Assets
Liabilities 10,32,000
12,30,000 Land and Buildings
Capital 34,170 | 11,95,830 1,22,400
Less: Net Loss 8,100 Machinery 84,000
5 BlsPayatble 96,000 Investments 10,800
BR Sundry Creditors Stock 48,000
Sundry Debtors 2,250
Bills Receivable 480
Cash 12,99,930
12,99,930

5
Part-B

Adjustments)
17.7 Financial Statements(With
Financial Statements
17.11 Adjustments in preparation of economic life of a busi
within the year. The accounting
equal spans or
necessaryat the time of pre ness is divided intodurations. For ascertaining
Aajustments become to years with definite
for any particular year
paing Final Accountsaccounting
for each
loss of the business incomes
principles or COn the true profit or
onour three popular expenses and
ventions. These are
particular year, all year should be con
the
Principle: Which believes thatyearS. relating to that particular
remainingoutstanding to
UThe continuity continue over sidered. Any amount
Iife of a business will
on accrual basis during the year, should be
Accounting should be made be paid or received year's amount. Simi
expenses and reve- included within current
for correct exposure of
Anyexpense or prepaid or pre-received
nues of each year separately. larly, any amounts from the current year's
year Siou
income allocable for the current paid/received should be eliminated
be correctly recognized whether
 412 Chhaya Artoutoncy- X
figures and allocated to the period to which Sheet at the year end, adjustments
they actually belong. For that are made
Matching principal: According to it. expenses (0) Any expense that has been paid is
excluded if it is related to
should be recognized in the same period
as associated revenues, For correct matching accounting period. any othbeer
the expenses incurred or revenues earned
(0) Any expense for the current period
require some adjustments considering their
comparabilities.
be included whether paid in cash nlg
(1) Similar principles should be
shoutd
3 Revenve Recognition Principle: It requires that
normally revenue should be recognized in the recording incomes or revenues. applied
for
year in which the sale occurs. (iv) Outstanding and unexpired items should
be recorded in the Balance Sheet
For preparing Trading and Profit and Loss as well
Acoount for a year and drawing the Balance

17.7.1.1 Some Important Adjustment

Adjustment of Closing Stock
Closing Stock means the stock remaining unsold at the end of the current accounting year. It is carried forwad e
the next accOunting year as its opening stock. It may include (a) stock of aw materials, (b) stock of semi-inishet
goods and (C) stock of fnished goods. There may be diferent methods applied for valuation. Stock of finished
goods should be valued at cost or net realisable value, whichever is lower.
Accounting Entry needed for its adjustrnent Closing Stock A/c Dr
To Trading Alc
1. Treatment in Trading Account Shown on the credit side of Trading Alc
2. Treatment in Balance Sheet Shown as a current Asset (Asset side)
Note: Where closing Stock appears in the Trial Balance, the above Adjustment entry is not required. It has alreacy
been adjusted against purchases. It need not be shown in the Trading Account. It is to be shown only as an assetin
the Balance Sheet.

as an additional information outside his Thal

llustration 11 Balance.
Show the accounting treatments/adjustments 2. For Y, whose closing stock 6,000 appears in
1. For X, whose closing 5,000 has been given the Trial Balance.

Solution
In the books of X
Dr. Trading Account for the year ended Cr
Amount Amount
Particulars Particulars

By Closing Stock 5,000

Balance Sheet as at
Amount Amount
Liabilities Assets

Stock 5,000
2

Dr. Balance Sheet as at ......... Cr.

Amount Amount
Liabilities Assets

Stock 6,000
 Financal Statements 413

expenseis an
Adj ustm ent of
exoensethat has Outstanding Expenses
Ustancing
been incurred but not pald in
neededfor Adjustrment the current
ParticToular Expense Alc accounting year. Dr.
Treathent
in Trading Account (if direct Outstanding Expense Ac
Proftand|Loss Ac(f indirect expense)expense) or Particular Expense
Add: Outstanding Expense
TreatmentinBalance Sheet [Debit Side]
Where outstanding expense is given in the
Current liability (Liability Side]
inthe Balance Sheet, as, the
Trial Balance, it need not be shown in Tradinig /
StoWn only amount ofthe relevant expense already PLAc. It is to be
includes it.
Alstation12
Showhowthese are to be shown in account:
ulstanding wages Outstanding Rent 8,000 (given outside the Trial
9,000 [given in the Trial Balance]
lance) Rent 7000 [given in the Trial
Balance]
Solution
Trading and Profit and Loss Account Cr.
Particulars Amount Amount
Particulars
To Rent 7000
Add: outstanding 78,000 15,000
Balance Sheet
Liabilities Amount Amount
Assets

Outstanding Liabilities for

Wages 9,000
Rent 8,000 17,000

Adjustment of Prepaid Expenses

TiePrepaid expense or unexpired expense refers to an expense which has been already paid (in advance) in this year
but whose benefit has not expired out and will accrue in subsequent year.
asi Entry needed for its Adjustment Prepaid Expense Ac ...Dr.
To Particular Expense Ac
Profit and Loss Account Prepaid Amount deducted from particular expense
1. Treatment in Trading and amount.

2. Treatment in Balance Sheet Shown on the asset side [current asset)

Adjustment No. (1) is not needed.
Note : If prepaid expense is included in Tnal Balance.ltwill only be shown in the Balance Sheet on the asset side
As the prepaid amount has already been deducted.
Under the headingcurrent asset.
Wages 80,000
Additional Information:
50 llustration 13) made in the following Wages include advance payment 10,000
Showthe adjustment to be 2. Trial Balance shows-
Cases: Insurance premium paid in advance 3,000
shows
1. Trial Balance
Solution
50
Trading Account Cr.
Dr. Amount
Particulars
Amount Particulars

80,000
To Wages
Less:Prepaid 10,000 70,000
 Balance Sheet
Amount Assets
Liabilitles

Prepaid Wages
Balance Sheet

Amount Assets
Liabilities
Prepaid Insurance
Adjustment of Accrued Income
Inoome which has been earned in the current year but which has not been received is called.
Entry needed for its Adjustment Accrued Income A/c Accrued Income
To Particular Income A/c
1. Treatment in Profit and Loss Ac To be added with particular income
2. Treâtment in Balance Sheet Shown as an asset
(Current Asset)
Note: Where Accrued Income is shown in Trial Balance, Adjustment No. (1) is not needed. t will
in Balance Sheet as an asset under the heading Current Asset. only be recorde
llustration 14
1. Accounting year : 1.4.2012 -31.3.2013. Show the adjustment needed.
Loan given on 1.4.2013 20,000. 2. What would be the
Rate of interest on loan 6% per annum. Balance it is found that difference if in the Tna
Interest on loan received during the account Interest on loan 1,200 (Cr.).
ing year? 1,000. Accrued interest on loan 200 (Dr.).
Solution
Profit and Loss Account
Dr. for the year ended 31.3.2013

Particulars Amount
Particulars Amount
By Interest Received on Loan
1,000
Add: Accrued Interest 200 120
Balance Sheet
Liabilities Amount Amount
Assets
Accrued Interest 20
(2,
Dr.
Profit and Loss Account
for the year ended 31.3.2013
Particulars Amount Amount
Particulars
By
Interest Received on Loan 120
Balance Sheet
Liabilities Amount Amount
Assets
20
Accrued Interest
 Financial Statements (15)
Adjustment of Income Recelved in Advance
has
been received in the current year but it is not acualy
WT19d
ncome earned duing the vear, it is considered 2s
oritsAdjustment
Particular Income Alc D
Tealment
tin ProitandILoss AWc To Income Received in Advance Alc

inBalance Sheet Deducted from the particular income

Treatment ACurrent Liability to be shown in the liabilities side of the
Balance Sheet.
itemalready appearsin the Inal Balance, Adjustment No. 1need not be made. It will be shown as Cuf
on liabilities side of Balance Sheet
the
iabiiy
Adjustment of Depreciation
MOeoationis nnsidered as the diminution in the value of a Fixed asset due to its use and wear and tear inthe
earningrevenue.
sof
neededforthe Adjustment Dr
Depreciation Alc.
To Particular Asset Alc
A/c and
Treatment in Protit and Loss Shown as an expense on the debit side of Profit
Loss Account
Treatmentin Balance Sheet Deducted from the value of the concerned asset on the
asset side.
from
depreciation appears in the Tral Balance adjustment No. (1) is not necessary. It will only be deducted
Note:If concerned fixed
of the asset ontheasset side of Balance sheet.
hevaluee at a cost
1.10.2012 a new machine was purchased
llustration15 of 20,000
p.a.
1.4.20121 Rate of depreciation on Machinery 10 %
nthe Trial Balance Machinery Alc las on year
1.00,000 (Dr.) Show the adjustment needed. [Accounting
is said that on 1.4.2012 to 31.03.2013]
As an additional intormation it
Solution
off
Annual Depreciation to be written 10
71,00,000 x =7 10,000
100
10 6 = 1,000
20,000 x
100
72 7 11,000
Profit and Loss Account Cr.
31.3.2013
for the year ended Amount
Dr
20 Amount Particulars
Particulars
11,000
To Depreciation on Machines
Balance Sheet
as on 31.3.2013
00 Amount
Amount Assets
Liabilities
Machinery 1,00,000
Add : Purchase 20,000
1.20,000
11,000 1,09,000
Less : Depreciation

for depreciation appeared in the Trial Balance: of

Note If provision (including the depreciation on the current year's cost
the Proft and Loss Account, annual depreclation
1. In
addition) would be shown on the debit side as
1oprovision for depreciation on machinery .
 416) Chhaya Accountoncy- XI
2. In the Balance Sheet-
() On Asset Side - Machinery at cost Amt. given
Add: Cost of Addition
Depreciation on Machinery
(ii) On Liabilities side - Provision for
Opening provision Amt. given
Add: Current years depreciation
Adjustment for Bad Debts
them are called Bad
customers but could not be recovered from Debts. These
Debts which have become due from
represent a loss of revènue to the business.
Bad Debts A/c
Entry needed for its Adjustment To Debtors A/c
Dr

To be Shown on the debit side like any other expense or

1. Treatment in Profit and Loss Ac loss
To be Deducted from Debtors inthe Asset side
2. Treatment in Balance Sheet
Trial inBalance, only adjustment No. (1) is to be made.
It needIf Bad
Note: not be deducted
Debts fromin the
are found Debtors the Balance Sheet because the closing balance of Debtors must have

been arrived at, after adjusting it.

Doubtful Debts
Adjustmnent of Provision for
proved, bad are deductedA
provision made to provide for possible bad debts. From debtors, debtS already bad debts that may anev
It is a is created at a certain percentage to cover any
of the remaining debtors, a provision
sequently. Profit and Loss A/c Dr
Entry needed for Adjustment ToProvision for Doubtful Debts Alc
PL A/c.
To be Shown on the debit side of
1. Treatment in Profit and LOSs A/c
On the asset side, it is to be deducted from Net Dehtorm
Sheet
2. Treatment in Balance case. the d
Bad Debts Ac may be already existing in the Trial Balance. In that amount nfl
Note: Sometimes, a provision for If the
provision and Existing proision may be shown in Profit and Loss A/c. exisino
ference between the New debit side of P/L Ac. If the
provision is more,the difference [New- Existing] should be shown on the
new shown on the credit side of P/L Ac.
provision is more, the difference is the new provision should be
deducted from Debtors.
However, in the Balance Sheet, always
adjustedagainst provision.
Alternatively, the new bad debts may be

llustration 16 Additional Information:

Doubtful Debts
Bad Detbts, Provision for (a) Further bad debts to be written
off 10,000
The extract from the Trial Balance of a business to be maintained
are as follows (b) Provision for Doubtful Debts
as on 31st March, 2013 at 10% on Debtors
Debit Credit entries and the
Head of Accounts Show the necessary journal
adjustments to be made
Sundry Debtors 1,90,000
Provision for Doubtful Debts 13,000
Bad Debts 2,500
Debts
New Provision for Doubtful
Solution
1,90,000
1000
Debtors as per Trial Balance
Less :Unadjusted Bad Debts 180,0
18000
Net Debtors 1,620
Less: New provision @10%
 Financial Sfatements 417
JOURNAL
Bad Debts Alc
To Sundry Debtors Alc
Particulars LF.
Debit Credit
Amount Amount
[Being Further bad debts
profit and Loss A/e
To
recorded) Dr
10, 000
provision for doubtful debts Alo 10,000
1Aeing Closing Provision created
Alternatively 10% on Debtors Dr
18,000
Drovision for Doubtful Debts Ale
Bad Debts Ac ( 2,500 + 18,000
[Being Bad Debts
transferred
to 10,000)
Provision for Doubtful DebtsPrAlc
ovision for Doubttul Debts)
profit and Loss A/c Dr
12,500
(Being Net Amount charged to 12,500
maintain 10% provision on Dr
17,500

Particulars Provision for DoubtDebtful Detbts

ors 17,500

To Bad Debts A/c

To Balance c/f
Amount Account Cr.

10% of 1,90,000-10,0001 12,500 By Balance blf Particulars Amount

18,000 By Profit and Loss
Alc 13,000

To Bad Debts Etfect on Profit and 30,500 17500

Loss Account 30,500
Add: Further bad debts 2,500 (Debit Side)
To Provision for Doubtful Debts: 10,000
New
Less : Existing
18,000 12,500
13,000
Alternatively-Debit Side Effect on Profit and Loss
To Provision for
Doubtful Debts Account 5,000
(Please see the Account
prepared above]
On asset side Effect on Balance Sheet (in
any case)
17500
Sundry Debtors
Less : Further Bad 1,90,000
Debts not yet written off
10,000
Less : Provision @ 1,80,000
10%
18,000
1,62,000
Adjustment for Discount on Debtors
teinite ess may follow the
time limit. Such practice of allowingdiscounts to Debtors who pay their dues
s
some debtors to whomdiscount becomes an expense for thesuchbusiness, Itis debited to Profit promptly or within a
iscoprUormptt. aProvision for Discount on suchbeendebtors
goods have sold this year will make prompt
payment
is usually created this year. As next year
and Loss Account,
and will enjoy some
paayment, its provision is
calculated the discount will be allowed
Voutul Debtprovis sioncalculated
for
DoubtfulandDebts. Further
on good debtors only, that is after
bad debts given as adjustment are deducting further bad debts and
only

tstnEnnientng aftEnterrydeduct
Requiinreg new
provided for
provision for
Provision
bad
for
debts.)
deducted first. (Then provision for
discount and is calculated only on the balance of deblors
Profit and Loss A/c
Dr
To Provision for Discount on Debtors Alc
418 Chhaya Accountancy -XI
Treatment in Profit and Loss AcCount
@99¬
Show on the debit side of Profit and Loss Accours
Deducted from Debtors on the Asset side
Treatment in Balance Sheet Pn
Note: Further Discount allowed iven for adiustment, may be adjusted against it or may be directly debited to

lustration 17
Extracts from the Trial Balance as on 31.03.2013 Adjustment to be made
4,000
Debit Credit (a) Further bad debts
to.
Head of Accounts (b) Provision to be made for Doubtful Debts a
Bad Debts 5,400 (c) Provision to be created for Discount
Provision for Bad & Doubtful 15,000 Debtors @ 2%
Debts [as on 01.04.2012]
Sundry Debtors 4,00,000
Profit and Loss Account
Solution
for the year ended 31.3.2013 Cr.
Dr.
Amount Particulars Amount
Particulars

To Bad Debts (5,400 +4,000] 9,400

To Provision for Doubtful Debts
New 19,800
Less: Existing 15,000 4,800
To Provision for Discount on Debtors 7524
OR

To Prov. for Doubtful Debts : 19,800

New Provision 9,400
+ Bad Debts 29,200
15,000 14,200
HExisting 7524
To Prov. for Disc. on Debtors

Working notes:
2,00,000
Debtors
Less: Further Bad Debts
4,000
3,96,000
19,800
Less: Provision for Doubtful Debts @5% 3,76,200
Less: Provision for Discount@2% 7,524 3,68,676
Net Debtors shown on Asset side
Adjustment of Manager's Commission
month. Moreover, to inspire him to render most effec
The manager of a business usually gets a regular salary per the business
commission on the Net Profit earned by
tive and sincere service to his employer, he may be allowed a
should be remembered:
in an accounting year. In this respect, the followingpoints at a predetermined rate on the Net Profit of each
(i) This commission is of no fixed amount. Rather it is calculated
separate year.
(ii) ltdoes not accrue if there is losS in any year.
year, that is until ascertainment of the annual
(iüi) lts calculation cannot be made until the end of the accounting
profit is over.
commission.
(iv) The commission may be calculated on Profit before charging such
charging such commission. It is calculated in the following way:
It may be calculated on Profit after
available surplus x Rate
100+ Rate
(v) It cannot be calculated unless Profit is calculated;so it remains on outstanding expense.
 77.7.3 Some other odjustments Lgiven outside Triol Balance]
Treatmnent in Final Accounts
Adjustment of Entry Needed
Trading Alc Profit & Loss Afc Balance Sheet
Charity in the form of goods Charity A/c Dr. Deducted from Purchases Shown in the debit side as an
To Purchases A/c expense
Assets made with business Asset A/c Dr. Deducted from purchases Added with particular asset
goods To Purchases A/c
Deferred Revenue Expenditure Profit and Loss A/c Dr. To be shown as an expense Balance to be shown as an asset
(Suppose, it lasts for 4 years] To Particular Expense (Dr.) (3/4th
[Considered as revenue expense of the year] [1/4th of total expense] Unexpired portion]
[1/4th of totalexpense - expired cost
Goods-in-Transit Goods-in transit A/c .Dr. Shown in the credit side Shown as the Asset side. (t is a
To Trading A/c Current Asset)
Provident Fund Salaries Alc Dr. To Salaries Shown on the liability side
(a) Employ- er's contribution To Employers Contribution to PF. Add:Employers contribution
to Employers P.F.
Employees contribution to P.F. Salary A/c Dr To be added with Salaries Shownon the liability side.
To Employees Contribution to PF. ....A/c [lf appears in the Trial Balance
[Employee's contribution should be it need not be deducted]
deducted at source, i.e., before payment of
Wages/Salaries deduction takes place]
Interest on Capital Interest on Capital A/c Dr. Shown on the debit side of On the liabilities side, it is to be
To Capital A/c Profit and Loss Ac added with Capitai
Interest on Drawings Capital A/C eneesonsoueen ........ Dr. Shown on the credit side of On the liabilities side, it is to be
To Interest on Drawings A/c Profit and Loss Ac deducted from Capital
Goods sent on Approval (a) Sales A/c Dr (a) S.P. to be deducted from (a) S.P. to be deducted from
To Debtors A/c sales. Debtors
[Selling price] (b) Cost price of such goods to (b) C.P. to be added with stock
(b) Stock with Customers A/c.......... Dr. be added with Closing
To Trading Alc Stock StFiatenment
ancials
[Cost Price]
Sales Tax collected (a) If sales are given inclusive of SaBes tax colected but not paid
sales tax, such tax should be shouid be shown as a liability.
deducted from sales.
(b) If a separate sales tax A/c
has been shown, the deduc
tion need not be made. 421
 Opening
StockTo Dr. (ii)information:
Additional
(ü) () Cash Cash
bank
in at return
handDiscount
allowed Stationery
12% debts
SalesSalarymaintenance
Repairs Machinery
Trade
WagesPurchases Dr. a Debts Income
Bad Unearned Accrued
Income
MSolution Bad and DebtorsOpening
Rent stoFreight
ckexpenses 2012.
Following
sole Depreciation Income Outstanding
expenses Stock
PrepaidIncomeClosing ne 422)
Closing
remainingSalaryStock Loan [Appearing
llustration20
proprietary tollowing
Particulars destroyed
for stock to is received Chlhaya
Tapan the
outstanding the Items
is Particulars in
(1.1.12) trial Trial items
by
month valued concern, in Accountancy
fire balance advance Balance]
? of of
1000. 2,000 at as adiustments
for December,
Amount
Amount Trading on of -
the In 15,000 Adhunik / XI
the
31st Ac side
year (uninsured). LossShown Shown NothingNothingNothing Nothing
Nothing
as
and b0oks December,
on of
ended 2012 2,82,800 Traders, onProfit as Whatappear
8,000|By Profit 5,00027,0001,5003,00011,00010,0001,800 interest
48, Bank
000 70,000/
Sales
Amount 31st
Balance
Trial an
of 2,500|Miscellaneous
receipts received
debtsDiscount 72,000|
Capital the &
Trading
is payable
3,Bi03,000/Bad
00l s recovery
8,000/Creditors 3,6004,400| 9,000 is
31st Adhunik
and December, Loss
debit expense to in
(v) (Vi)
(iv) Interest
Provision / be the
Return
Less:Sales December, Loss ing
pare year mation On side Ac PIL done
ateWrite
Accrued Depreciation @ on
the of A/c Trial
Traders Provision 10% received for tended
heAccount the In
Particulars Account off 2012 given, basis Profit
bad Balance debit Balance
2012 interest 2,000 per on
debts 31st and you &
Particulars of
for annum. is loan ityShown
l Shown
bad
on as to 012)
(1.1.2to Sheet Profit are this
December, Shown
Liability)
ShownShown
as What
be required
further
loandebts Tapan balance as as as as
charged as and saLiability
(Current ls
a on an an to
to 2012,
on Loss liability
bad toand Asset AssetSheet be
Asset [Current
1,61,000 Amount
Amount Tapanannum.
10%per that done
1,3,508,00|000 debts on prepare
Account
and additional [Current t
date. [CurrentCurrent in
? fixed
also Balane
1000 and 1,61,000 Amount the
assets2,82,800 3,80014,000 1,800 1,20036,000 1,800 3,000 60,000 to for Asset
(Contd) cre 200 Trainfor-
d Liabil- Asset) Assefl
Cr. Cr pre- the
422) (Chhaya Accountancy- X1
Trial Balance ag

If the appearInthe What is to be done in

following items of adjustments
Items
done in
What is to be Alc
Trading/ PL
Sheet
Shown as an Asset|
Ba
Current
lanes gOs

[Appearing in Trial Balance] Shown as saLiability

[Current Assel
Nothing
Closing Stock Shown as an Asset [Current Sati
Nothing Shown as on Asset [Currert
Outstanding Income Fepa
Nothing Shown as a liability [Currert
Prepaid expenses
Nothing
Accrued lncome ityl
/ Nothing
Income received in advance debit Sala

Unearned Income expenseon the

Shownas an LossAle gDisc

Depreciation sideofProfit&debit side ofProfit & gPov

Shown on the balance and

Bad Debts Loss Ac
Onthe
basis of this requiredto
are prepare
additional
inte.
the Trad
you
mation given,and Profit and Loss ACCOunt for tha
ing
AccOunt December, 2012, and alsoto cDrg.Wach
llustration20 Traders, 31st
year the Balance Sheetas on that
ended dat 150Ck
trial balance of Adhunik
December, pare
Following is the concern, as on 31st tans
a sole proprietary TrialBalance CA
2012. December, 2012 Amount
as on 31st Particulars
Amount
Dr. 60,0
Particulars 72,000|Capital 1,61,00
3,000
70,000/Sales debts (1.1.2012)
Purchases 9,000/Provisionforbad loan to Tapan 200 aoial
on
Machinery 4,400 Interestreceived 1,800 Ado
3,600Discountreceived 36,000 ecitors
Wages
Trade eXpenses 8.000Creditors 1.200 s Pay
1800
recovery
Freight 3,000 Bad debts tstanc
Opening stock 48,000/Bank interest 14.000
Rent 3,000Bills payable 3,800
Debtors 2,500 Miscellaneous receipts
Stationery
Repairs and maintenance 1,800
Bad debts 10,000
(1.1.12)
12% Loan to Tapan 11,000
Salary 3,000
Sales return 1,500
Discount allowed 27,000 282,80
Cash at bank 5,000
Cash in hand 2,82,800
to be charged on fixed assetS
(iV) Depreciation is he foll
Additional information: @ 10% per annum. debts and Cre
valued at 15,000 2,000 as further bad10% per annu.
() Closing stock is fire 2,000 (uninsured). (V) Write off bad debts @
by
(ii) Stock destroyedmonth ate Provision for 1000
of December, 2012 is on loan to Tapan ?
(iii) Salary for the
remainingoutstanding 1000. (vi)Accrued interest

In the books of Adhunik

Traders ash in
n Solution
Trading and Profit and Loss Account
Dr.
for the year ended 31st December, 2012
Amount Amount
AmountAmount urchas
Particulars
00ages
Particulars
3,000 1,,58
1,61,000
To Opening Stock 8,000| By Sales (Cantl
Less: Return
 ,Ahase
Fingncigl Statements 423
72,9,000
000| ByBy Stock
ClosingdestStockroyed by Fire
Mages

2.000
Oss
Profit
c¡ 3,600 15.000
82,400
fadeExpenses 1,75,4,400
000 By 1,75,000
Rent
3,000 By Gross Profit bld
3,000 By Discount
Sationery 82,400
Maintenance
pRepairsand M Bad DebtReceived 1,800
iabi. BadDebt 1,800 2,500 By Bank Recovery 1,200
:Further Bad Debt 2,000 Interest
By Miscellaneous Receipts 1,800
3,800 3,800
Outstandingfor Dec., 12 11,000 By
DiscountAllowed
1,000 12,000 Interest on Loan to Tapan 200
Add: Accrued Interest
Povisionfor Bad Debt: 1,500 1,000 1,200
p -2,000)
into 0% on (48,000 1.1.2012 4,600
Trad. Je8S: Provision on 3,000 1,600
o the Depreciation @10% p.a.:
Wachinery
pre sSIDck destroyed by
Fire 7,000
2,000
Capital AcCount (Net Profit 51,400
ransferred)
Ount 92,200
92,200
0,00 Balance Sheet
as at 31st
S1,3,0000 December, 2012
Liabilities Amount Amount Assets Amount Amount
200
1,800 ptal 60,000 Machinery
Add:Net Profit 70,000
6,00 51,400 1,11,400 Less: Depreciation @ 10% 7,000 63,000
1,200 editors 36,000|12% Loan to Tapan 10,000
1,800 ls Payable 14,000 Add: Accrued Interest. 1,000 11,000
4,000 Otstanding Salary 1,000 Stock 15,000
3,800 Debtors 48,000
Less : Further bad debt wit 2,000
ten off
46,000
Less:Provision @10% 4,600 41,400
Cash at Bank 27,000
Cash in Hand 5,000
1,62,400 "1,62,400
2,800
 Mlastration22
PgarationofFinal Account after correction of Trial Balance
Balance of a concern as at 31st December, 2012, is given below:
n Trial Trial Balane C

Amount Amount
Particulars Particulars

8,000 Debtors 7,580

Caotal 2,750
d Debts recovered 250 Bank Deposit
40
1,250 DiscOunt Allowed
Ceditors 600
Returns Outwards 350Drawings 450
1.570 Returns Inwards
Renk Overdraft 14,690
360 Sales
Rent 1,350
850 Bills Payable
Salaries
300
Taveling Expenses
210
Cash
450 2.450
Stock on 1st January 2012 11,870
Purchases 27460
27460
year
Trial Balance and to prepare the Final Account for the
redraw the correct
- You are required to after making adjustments for the following:
ending 31st December, 2012,
December, 2012, was 4,200
() The Closing Stock on 31st
reserve for bad debts at 5% on sundry debtors.
debts and create a
() Write off 80 as bad
(i) Three months rent is
outstanding.
bankers and interest on overdraft 157 debited
deposit 135 credited byenteredthe
(v) Interest on Bank been in the books.
by them in the Pass
Book have not
of the value of 2,000. The Insurance Company
1995., a fire destroyed stock January, 2012.
(V) On 25th December,for the loss at ? 1,500only and paid the amount on 5th
admitted the claim
Redrafted Trial Balance
Cr.
Solution as on 31.12.2012
Amount
Dr.
Amount Particulars
Particulars
8,000
11,870 Capital 250
Purchases 7,580 Bad Debts Recovered
Debtors 450 Creditors 1,250
Returns Inwards 2,750 Returns Outwards 350
Bank Deposit 360 Bank Overdraft 1,570
Rent (Contd.)
 426 Chhaya Accountancy- XI
14 890
850/Sales
Salaries
300Bils Payable 1350
Traveling Expenses 210
Cash 2.450
Stock on 1st. January 2012 40
Discount Allowed 600 27,A80
Drawings 27,460 Account
Profit and Loss
12.2012 Ct.
Trading and ended31. Amount Amount
year
for the Particulars
Dr. Amount 14,690
Amount
450
Particulars 2.450 By Sales
Less:Returns Inward 14,240
To Opening Stock ByClosingStock 4,200
11,870
11,520 (Note) 2,000
To Purchases 350 Loss by Fire 20,440
Less: Returns Outward 6,470 By
6,470
20,440 b/d
To (Gross Profit c/d) Gross Profit
Recovered(Note) 250
480 By Debts 135
850 By Bad on BankDeposit age
To Rent (Note) Interest
300 By
To Salaries Bary
To Travelling Expenses 40
s P
To DiscOunt
80
To Bad Debts 375
(Note) pair
To Provision for Bad Debts 157
Overdraft 500
To Interest on tepara
[Note] 4,073.
To Loss by Fire 6,855 atior
To Capital Account
(Net profit transferred) 6,855
Balance Sheet
12.2012 Amount Amount
as on 31.
Amount Amount Assets
4,200
Liabilities
Stock
8.000
Capital Account 7125
4,073 Debtors (Note)
Add: Net Profit
12,073 1,500
600 11,473
Less: Drawing |InsuranceClaim (Note)
1,570
Bank Overdraft 1,727
157 2,750
Add:Interest 1,250 Bank Deposit 135 2,885
Creditors Add: Interest 210
1,350 Cash
Bills Payable OPu
120 15,920
Outstanding Rent O
Ca
15,920
Ad
Working Notes: o Gr
2 Bad Debts Recovered
Loss by Fire:
Balance, it has not
The total loss 2,000 credited to
Trading Ac As It appears in the Trial oSa
the income
The Net Loss 500 debited to Profit &Loss Alc been adjusted further with Cash. But Ad
shown as an asset. is to be recorded in the P/L A/c.
The Insurance claim admitted
On 5.1.13 Bank Ac Dr. 1.500
To Insurance Claim A/c 1,500 (No effect in 1995)
bRe
 INTRODUCTION TO COSTAND MANAGEMENT ACCOUNTING

 Meaning, Objectives and advantages of cost accounting

 Difference between cost and financial accounting
 Key terms, Cost concept and classifications

Key terms, Meaning and Definition

(i) Cost- As a noun-The amount of expenditure (actual or notional) incurred on or
attributable to a specified article, product or activity.
As a verb- To ascertain the cost of a specified thing or activity.

(ii) Costing- Costing is defined as “the technique and process of ascertaining costs”.
According to CIMA “an organisation’s costing system is the foundation of the internal
financial information system for managers. It provides the information that
management needs to plan and control the organisation’s activities and to make decisions
about the future.”
(iii) Cost Accounting- Cost Accounting is defined as "the process of accounting for
cost which begins with the recording of income and expenditure or the bases on which
they are calculated and ends with the preparation of periodical statements and reports
for ascertaining and controlling costs."
(iv) Cost Accountancy- Cost Accountancy has been defined as “the application of
costing and cost accounting principles, methods and techniques to the science, art and
practice of cost control and the ascertainment of profitability. It includes the
presentation of information derived there from for the purpose of managerial decision
making.”
(v) Management Accounting- As per CIMA Official Terminology “Management
accounting is the application of the principles of accounting and financial management to
create, protect, preserve and increase value for the stakeholders of for-profit and not-
for-profit enterprises in the public and private sectors.”
Management accounting is an integral part of management. It assists management by
provision of relevant information for planning, organising, controlling, decision making etc.
(vi) Cost Management- It is an application of management accounting concepts,
methods of collections, analysis and presentation of data to provide the information needed
to plan, monitor and control costs.
 Objectives of Cost Accounting
The main objectives of cost and management accounting are explained as below:
(i) Ascertainment of Cost: The main objective of cost accounting is accumulation and
ascertainment of cost. Costs are accumulated, assigned and ascertained for each cost
object.
(ii) Determination of Selling Price and Profitability: The cost accounting system helps in
determination of selling price and thus profitability of a cost object. Though in a
competitive business environment selling prices are determined by external factors but
cost accounting system provides a basis for price fixation and rate negotiation.
(iii) Cost Control: Maintaining discipline in expenditure is one of the main objective of a
good cost accounting system. It ensures that expenditures are in consonance with
predetermined set standard and any variation from these set standards is noted and
reported on continuous basis. To exercise control over cost, following steps are
followed:
(a) Determination of pre-determined standard or results: Standard cost or performance
targets for a cost object or a cost centre is set before initiation of production or
service activity. These are desired cost or result that need to be achieved.
(b) Measurement of actual performance: Actual cost or result of the cost object or cost
centre is measured. Performance should be measured in the same manner in which
the targets are set i.e. if the targets are set up operation-wise, and then the actual
costs should also be collected and measured operation-wise to have a common basis
for comparison.
(c) Comparison of actual performance with set standard or target: The actual
performance so measured is compared against the set standard and desired target.
Any deviation (variance) between the two is noted and reported to the appropriate
person or authority.
(d) Analysis of variance and action: The variance in results so noted are further analysed
to know the reasons for variance and appropriate action is taken to ensure
compliance in future. If necessary, the standards are further amended to take
developments into account.
(iv) Cost Reduction: It may be defined "as the achievement of real and permanent
reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or diminution in the
quality of the product."
Cost reduction is an approach of management where cost of an object is believed to be
further reduced. No cost is termed as lowest and every possibility of cost reduction is
explored. To do cost reduction, the following action is taken:
(a) Each activity within an entity is segmented to analyse and identify value added and
non- value added activities. All non-value added activities are eliminated without
affecting the essential characteristics of the product or process. Value chain Analysis,
a strategic tool, developed by Michael Porter, is one of the method to do value
analysis.
(b) Conducting continuous research and study to know better way to do anything.
The three-fold assumptions involved in the definition of cost reduction may be summarised
as under:
(a) There is a saving in unit cost.
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if not improved.
(v) Assisting management in decision making: Cost and Management accounting by
providing relevant information, assist management in planning, implementing, measuring,
controlling and evaluation of various activities. A robust cost and management
accounting system not only provides information internal to industry but external also.
Difference between Cost Control and Cost Reduction
Cost Control Cost Reduction
1. Cost control aims at maintaining 1. Cost reduction is concerned with reducing
the costs in accordance with the costs. It challenges all standards and
established standards. endeavours to better them continuously

2. Cost control seeks to attain lowest 2. Cost reduction recognises no condition as

possible cost under existing permanent, since a change will result in lower
conditions. cost.
3. In case of cost control, emphasisis 3. In case of cost reduction, it is on presentand
on past and present future.
4. Cost control is a preventive 4. Cost reduction is a corrective function. It
Function operates even when an efficient cost control
system exists.
5. Cost control ends when targets 5. Cost reduction has no visible end.
are achieved.

Scope of Cost Accounting

Scope of cost accounting consists of the following functions:
(i) Costing: Costing is the technique and process of ascertaining costs of products or
services. The cost ascertainment procedure is governed by some cost accounting principles
and rules. Generally, cost is ascertained using some arithmetical process.
(ii) Cost Accounting: This is a process of accounting for cost which begins with the
recording of expenditure and ends with the preparation of periodical statement and reports
for ascertaining and controlling cost. Cost Accounting is a formal mechanism of cost
ascertainment.
(iii) Cost Analysis: It involves the process of finding out the factors responsible for
variance in actual costs from the budgeted costs and accordingly fixation of responsibility
for cost differences. This also helps in better cost management and strategic decisions.
(iv) Cost Comparisons: Cost accounting also includes comparisons of cost from
alternative courses of action such as use of different technology for production, cost of
making different products and activities, and cost of same product/ service over a period of
time.
(v) Cost Control: It involves a detailed examination of each cost in the light of
advantage received from the incurrence of the cost. Thus, we can state that cost is
analyzed to know whether cost is not exceeding its budgeted cost and whether further
cost reduction is possible or not.
(vi) Cost Reports: This is the ultimate function of cost accounting. These reports are
primarily prepared for use by the management at different levels. Cost Reports helps in
planning and control, performance appraisal and managerial decision making.
(vii) Statutory Compliances: Maintaining cost accounting records as per the rules
prescribed by the statute to maintain cost records relating to utilization of
materials, labour and other items of cost as applicable to the production of goods or
provision of services as provided in the Act and these rules.

Cost Accounting with Management Accounting:

As we already studied that though Cost Accounting and Management Accounting is used
synonymously but there are few differences. Management Accounting is open ended
discipline which enables managers to take informed decision.Management Accounting takes
inputs from cost accounts, financial accounts, statistical and operation management tools
etc.
Difference between Cost Accounting and Management Accounting
Basis Cost Accounting Management Accounting
(i) Nature It records the quantitative It records both qualitative and
aspect only. quantitative aspect.
(ii) Objective It records the cost of It Provides information to
producing a product and management for planning and
providing a service. co-ordination.
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting,
taxation, planning etc.
(iv) Recording of It uses both past andpresent It is focused with the
data figures. projection of figures for future.
(v) Development Its development is relatedto It develops in accordance to the
industrial revolution. need of modern business world.

(vi) Rules and It follows certain principles It does not follow any specific
Regulation and procedures for rules and regulations.
recording costs of different
products.
 Cost Accounting with Financial Accounting:
Cost accounting accumulates and ascertain costs for goods sold and inventories.It
provides inputs to record costs in financial accounting system.
Difference between Financial Accounting and Cost Accounting

Basis Financial Accounting Cost Accounting

(i) Objective It provides information about Ascertainment of cost for

the financial performance of the purpose of cost control
an entity. and decision making.

(ii) Nature It classifies records, present It classifies, costs records,

and interprets transactions in present, and interprets it in
monetary terms. a significant manner.

(iii) Recording It records Historical data. It makes use of both

of data historical and pre-
determined costs.

(iv) Users of The users of financial The cost accounting

information accounting statements are information is generally used
shareholders, creditors, by internal management.
financial analysts and But some time regulatory
government and its agencies, authoritiesalso.
etc.

(v) Analysis of It shows profit or loss of the It provides the cost details
cost andprofit organization either segment for each cost object i.e.
wise or as a whole. product, process, job,
contracts, etc.

(vi) Time period Financial Statements are Reports and statements are
prepared usually for a year. prepared as and when
required.

(vii) Presentation A set format is used for In general, no set formats for
of information presenting financial presenting cost information
information. is followed.
 Cost and Management Accounting with Financial Management:
Cost and Management Accounting is an application of financial management. The
techniques of financial management are used for decision making.
The relationship among Cost Accounting, Management Accounting, Financial Accounting
and Financial Management can be understood with the help of the following diagram.

Financial Management
Accounting Accounting

Cost
Accounting

Financial Management

The role of a cost and management accounting system is to:

 Provide relevant information to management for decision making,
 Assist management for planning, measurement, evaluation and controlling of
business activities,
 Help in allocation of cost to products and inventories for both external and internal
users.
Though the term cost accounting and management accounting is used by various authors
synonymously but in actual, cost accounting is concerned with accumulation and allocation
of costs to different cost objects. Whereas, management accounting concerned with
provision of information to internal users for decision making.
The functions of cost and management accounting includes:
(i) Collection and accumulation of cost for each element of cost.
(ii) Assigning costs to cost objects to ascertain cost.
(iii) Cost and management accounting department (whatever nomenclature may be used
to denote the department) sets budget and standards for a particular period or activity
beforehand and these are compared with the assigned and ascertained cost. Any deviation
with the set standards are analysed and reported. All these mechanism is done to control
costs.
(iv) The main function of cost and management accounting is provision of relevant
information to the management for decision making. An Information system environment
is set up which is popularly known as management information system (MIS). The MIS
provides relevant and timely information related to both internal and external to the
organisation to enable management at all levels to take decisions. Decisions include cost
optimisation, price fixation, implementation of any plan related with product, process,
marketing etc.
(v) The performance of a responsibility centre is measured and evaluated against the
set standards. The function of cost and management accounting is to gather data like time
taken, wastages, process idleness etc., analyse the data, prepare reports and take
necessary actions.

Users of Cost and Management Accounting information:

Cost and management accounting information which are generated or collected are used
by different stakeholders. The users of the information can be broadly categorized into
internal and external to the entity.
Internal Users
Internal users, which use the cost and management accounting information may include the
followings:
(a) Managers- The managers use the information
(i) to know the cost of a cost object and cost centre
(ii) to price for the product or service
(iii) to measure and evaluate performance of responsibility centres
(iv) to the know the profitability- product-wise, department-wise, customer-wiseetc.
(v) to evaluate the strategic options and to make decisions
(b) Operational level staffs- The operational level staffs like supervisors,foreman, team
leaders are requiring information
(i) to know the objectives and performance goals for them
(ii) to know product and service specifications like volume, quality and process etc.
(iii) to know the performance parameters against which their performance ismeasured
and evaluated.
(iv) to know divisional (responsibility centre) profitability etc.
(c) Employees- Employees are concerned with the information related withtime and
attendance, incentives for work, performance standards etc.
External Users
External users, which use the cost and management accounting information may
include the followings:
(a) Regulatory Authorities- Regulatory Authorities are concerned with cost accounting
data and information for different purpose which includes tariff determination, providing
subsidies, rate fixation etc. To do this the regulatory bodies require information on the
basis of some standards and format in this regard.
(b) Auditors- The auditors while conducting audit of financial accounts or for some
other special purpose audit like cost audit etc. requires information relatedwith costing
and reports reviewed by management etc.
(c) Shareholders- Shareholders are concerned with information that effect their
investment in the entity. Management communicate the shareholders through periodic
communique, annual reports etc. regarding new orders received, product expansion,
market share for products etc.
(d) Creditors and Lenders- Creditor and lenders are concerned with data and information
which affects an entity’s ability to serve lenders or creditors. For example, any financial
institutions which provides loan to an entity against book debts and stocks are more
concerned with regular reporting on net debt positionand stock balances.
Essentials of a good Cost Accounting System
The essential features, which a good cost accounting system should possess, are as
follows:
(a) Informative and simple: Cost accounting system should be tailor-made, practical,
simple and capable of meeting the requirements of a business concern. The system of
costing should not sacrifice the utility by introducing inaccurate and unnecessary
details.
(b) Accurate and authentic: The data to be used by the cost accounting system
should be accurate and authenticated; otherwise it may distort the outputof the system
and a wrong decision may be taken.
(c) Uniformity and consistency: There should be uniformity and consistency in
classification, treatment and reporting of cost data and related information. This is
required for benchmarking and comparability of the results of the system for both
horizontal and vertical analysis.
(d) Integrated and inclusive: The cost accounting system should be integrated with other
systems like financial accounting, taxation, statistics and operational research etc. to have a
complete overview and clarity in results.
(e) Flexible and adaptive: The cost accounting system should be flexible enough to
make necessary amendment and modifications in the system to incorporate changes in
technological, reporting, regulatory and other requirements.
(f) Trust on the system: Management should have trust on the system and its output.
For this, an active role of management is required for the development of such a system
that reflect a strong conviction in using information for decision making.

Installation of a good Cost Accounting System

As in the case of every other form of activity, it should be considered whether it would be
profitable to have a cost accounting system. Management of an organisation needs
complete and accurate information to make decisions. A well- established Costing system
should provide all relevant information as and when required by management as well as
various stakeholders.
verify their accuracy.
3. Duplication of Work: It involves duplication of work as organization has to maintain
two sets of accounts i.e. Financial Account and Cost Account.
4. Inefficiency: Costing system itself does not control costs but its usage does.

Classification of costs
It means the grouping of costs according to their common characteristics. Theimportant
ways of classification of costs are:
(i) By Nature or Element
(ii) By Functions
(iii) By Variability or Behaviour
(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making

By Nature or Element
This type of classification is useful to determine the total cost.
A diagram as given below shows the elements of cost described as under:

ELEMENT OF COST

Material Cost Employee (Labour) Cost Other Expenses

Direct Material Indirect Direct Indirect Direct Indirect

Cost Material Cost Employee Employee Expenses Expenses
(Labour) Cost (Labour) Cost

Overheads

Production Administration Selling and

Overheads Overheads Distribution Overheads

(i) Direct Materials: Materials which are present in the finished product (cost object) or
can be economically identified in the product are called direct materials. For example,
cloth in dress making; materials purchased for a specific job etc. However, in some
cases a material may be direct but it is treated as indirect, because it is used in small
 quantities, it is not economically feasible to identify that quantity and those materials
which are used for purposes ancillary to the business.
(ii) Direct Labour: Labour which can be economically identified or attributed wholly to a
cost object is called direct labour. For example, employee engaged on the actual
production of the product or in carrying out the necessary operations for converting
the raw materials into finished product.

(iii) Direct Expenses: It includes all expenses other than direct material or direct labour
which are specially incurred for a particular cost object and can be identified in an
economically feasible way. For example, hire charges for some special machinery, cost
of defective work.
(iv) Indirect Materials: Materials which do not normally form part of the finished product
(cost object) are known as indirect materials. These are —
 Stores used for maintaining machines and buildings (lubricants, cotton waste,
bricks etc.)
 Stores used by service departments like power house, boiler house, canteen
etc.
(v) Indirect Labour: Labour costs which cannot be allocated but can be apportioned to or
absorbed by cost units or cost centres is known as indirect labour. Examples of
indirect employees includes foreman and supervisors; maintenance workers; etc.
(vi) Indirect Expenses: Expenses other than direct expenses are known as indirect
expenses, that cannot be directly, conveniently and wholly allocated to cost centres.
Factory rent and rates, insurance of plant and machinery, power, light, heating,
repairing, telephone etc., are some examples of indirect expenses.
(vii) Overheads: It is the aggregate of indirect material costs, indirect labour costs and
indirect expenses. The main groups into which overheads may be subdivided are the
following:
 Production or Works Overheads: Indirect expenses which are incurred in
the factory and for the running of the factory. E.g.: rent, power etc.
 Administration Overheads: Indirect expenses related to management and
administration of business. E.g.: office rent, lighting, telephone etc.
 Selling Overheads: Indirect expense incurred for marketing of a commodity.
E.g.: Advertisement expenses, commission to sales persons etc.
 Distribution Overheads: Indirect expense incurred for despatch of the
goods E.g.: warehouse charges, packing(secondary) and loading charges.
 By Functions
Under this classification, costs are divided according to the function for whichthey have
been incurred. It includes the following:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.
Direct Materials
Direct Employees(Labours) Prime Cost

Direct Expenses
Factory Overheads
Indirect Material
Factory Cost or Works
Cost
Indirect Labour
Administration Overheads
Indirect Cost of Goods Sold
Expenses Selling and DistributionOverheads

Cost of Sales

By Variability or Behavior
According to this classification costs are classified into three group viz., fixed, variable and
semi-variable.
(a) Fixed costs– These are the costs which are incurred for a period, and which, within
certain output and turnover limits, tend to be unaffected by fluctuations in the
levels of activity (output or turnover). They do not tend to increase or decrease with
the changes in output. For example, rent, insurance of factory building etc. remain
same with different level of production
(b) Variable Costs– These costs tend to vary with the volume of activity. Any increase in
the activity results in an increase in the variable cost and vice- versa. For example,
cost of direct labour, etc.

Variable Cost
60000

50000

40000
Cost (`)

30000

20000

10000

0
0 100 200 300 400 500 600
Output (in units)
(c) Semi-variable costs– These costs contain both fixed and variable components and
are thus partly affected by fluctuations in the level of activity. Examples of semi
variable costs are telephone bills, gas and electricity etc. Such costs are depicted
graphically as follows:
1.13.1.1 Methods of segregating Semi-variable costs into fixed and variable costs

Semi- Variable Cost

90000
80000
70000
60000
Cost (`)

50000
40000
30000
20000
10000
0
0 100 200 300 400 500 600
Output (in units)

By Controllability
Costs here may be classified into controllable and uncontrollable costs.
(a) Controllable Costs: - Cost that can be controlled, typically by a cost, profit or
investment centre manager is called controllable cost. Controllable costs incurred in
a particular responsibility centre can be influenced by the action of the executive
heading that responsibility centre. For example, direct costs comprising direct labour,
direct material, direct expenses and some of the overheads are generally controllable
by the shop level management.
(b) Uncontrollable Costs - Costs which cannot be influenced by the action of a specified
member of an undertaking are known as uncontrollable costs. For example,
expenditure incurred by, say, the tool room is controllable by the foreman in-charge
of that section but the share of the tool-room expenditure which is apportioned
to a machine shop is not to be controlledby the machine shop foreman.
Distinction between Controllable Cost and Uncontrollable Cost: The distinction
between controllable and uncontrollable costs is not very sharp and is sometimes left to
individual judgement. In fact, no cost is uncontrollable; it is onlyin relation to a particular
individual that we may specify a particular cost to be either controllable or uncontrollable.
 P a g e | 19

2. The frequency of issue of materials, relative quantity etc.

3. Nature of cost accounting system.
4. The nature of business and type of production process.
5. Management policy relating to valuation of closing stock.
Several methods of pricing material issues have been evolved in an attempt to
satisfactorily answer the problem. These methods may be grouped and explained
as follows:
Cost Price Methods
(i) Specific Price Method: This method is useful, specially when materials are
purchased for a specific job or work order, and as such these materials are
issued subsequently to that specific job or work order at the price at which they
were purchased.
To use this method, it is necessary to store each lot of material separately and
maintain its separate account.
Advantages and Disadvantages

Advantages Disadvantages
 The cost of materials issued for  This method is difficult to operate,
production purposes to specific jobs specially when purchases and
represent actual and correct costs. issues are numerous.
 This method is best suited for non-
standard and specific products.

(ii) First-in First-out (FIFO) method: It is a method of pricing the issues of

materials, in the order in which they are purchased. In other words, the
materials are issued in the order in which they arrive in the store or the items
longest in stock are issued first. Thus each issue of material only recovers the
purchase price which does not reflect the current market price.
This method is considered suitable in times of falling price because the
material cost charged to production will be high while the replacement cost of
materials will be low. But, in the case of rising prices, if this method is adopted,
the charge to production will be low as compared to the replacement cost of
materials. Consequently, it would be difficult to purchase the same volume of
material (as in the current period) in future without having additional capital
resources.
 2.20

Advantages and disadvantages

Advantages Disadvantages
 It is simple to understand and  If the prices fluctuate frequently, this
easy to operate. method may lead to clerical error.
 Material cost charged to  Since each issue of material to production
production represents actual is related to a specific purchase price, the
cost with which the cost of costs charged to the same job are likely to
production should have been show a variation from period to period.
charged.
 In the case of falling prices,  In the case of rising prices, the real profits
the use of this method gives of the concern being low, may not be
better results. adequate to meet the materials purchase
demand at the current market price.
 Closing stock of material will
be represented very closely
at current market price.

The application of FIFO method is illustrated below:

Material Received and Issued
Lot Date Quantity Lot Rate Amount
No. Kg. No. (`) (`)
1. July 3 600 1.00 600.00
2. July 13 800 1.20 960.00
3. July 23 600 0.90 540.00
4. August 5 400 1.10 440.00
5. August 6 1200 0.80 960.00
July 8 400 Kgs. out of (1) 1.00 400.00
July 12 200 Kgs. out of (1) 1.00 200.00
July 22 600 Kgs. out of (2) 1.20 720.00
July 25 200 Kgs. out of (2) 1.20 240.00
200 Kgs. out of (3) 0.90 180.00
August 8 400 Kgs. out of (3) 0.90 360.00
400 Kgs. out of (4) 1.10 440.00
200 Kgs. out of (5) 0.80 160.00
 P a g e | 21

The stock in hand after 8th August will be 1,000 Kgs. This will be out of lot
number (5) and its value will be ` 800, i.e., @ ` 0.80 per Kg.
(iii) Last-in-First-out (LIFO) method: It is a method of pricing the issues of
materials. This method is based on the assumption that the items of the last
batch (lot) purchased are the first to be issued. Therefore, under this method
the prices of the last batch (lot) are used for pricing the issues, until it is
exhausted, and so on. If however, the quantity of issue is more than the quantity
of the latest lot than earlier (lot) and its price will also be taken into consideration.
During inflationary period or period of rising prices, the use of LIFO would
help to ensure that the cost of production determined on the above basis is
approximately the current one. This method is also useful specially when there is
a feeling that due to the use of FIFO or average methods, the profits shown and
tax paid are too high.
Advantages and Disadvantages
Advantages Disadvantages
 The cost of materials issued will be  Calculation under LIFO system
either nearer to and or will reflect the becomes complicated and
current market price. Thus, the cost cumbersome when frequent
of goods produced will be related to purchases are made at highly
the trend of the market price of fluctuating rates.
materials. Such a trend in price of
materials enables the matching of cost
of production with current sales
revenues.
 The use of the method during the period  Costs of different similar batches
of rising prices does not reflect undue of production carried on at the
high profit in the income statement as it same time may differ a great
was under the first-in-first-out or deal.
average method. In fact, the profit
shown here is relatively lower because
the cost of production takes into
account the rising trend of material
prices.
 In the case of falling prices profit  In time of falling prices, there
tends to rise due to lower material will be need for writing off stock
cost, yet the finished products appear value considerably to stick to
 2.22

to be more competitive and are at the principle of stock valuation,

market price. i.e., the cost or the market price
whichever is lower.
 Over a period, the use of LIFO helps to  This method of valuation of
iron out the fluctuations in profits. material is not acceptable to the
income tax authorities.
 In the period of inflation LIFO will tend
to show the correct profit and thus avoid
paying undue taxes to some extent.

It may be noted that Last in First out (LIFO) is not permitted under Accounting
Standard (AS)-2: Valuation of Inventories and Ind AS- 2: Inventories. However,
for the purpose of academic knowledge LIFO method is included in this Study
Material

ILLUSTRATION 12
The following transactions in respect of material Y occurred during the six months
ended 30th June, 20X8:

Month Purchase Price per unit Issued

(units) (`) Units
January 200 25 Nil
February 300 24 250
March 425 26 300
April 475 23 550
May 500 25 800
June 600 20 400
Required:
(a) The Chief Accountant argues that the value of closing stock remains the same
no matter which method of pricing of material issues is used. Do you agree?
Why or why not? EXPLAIN. Detailed stores ledgers are not required.
(b) STATE when and why would you recommend the LIFO method of pricing
material issues?
 P a g e | 23

SOLUTION
(a) The Closing Stock at the end of six months’ period i.e., on 30th June, 20X8
will be 200 units, whereas up to the end of May 20X8, total purchases coincide
with the total issues i.e., 1,900 units. It means that at the end of May 20X8, there
was no closing stock. In the month of June 20X8, 600 units were purchased out of
which 400 units were issued. Since there was only one purchase and one issue in
the month of June, 20X8 and there was no opening stock on 1st June 20X8, the
Closing Stock of 200 units is to be valued at ` 20 per unit.
In view of this, the argument of the Chief Accountant appears to be correct.
Where there is only one purchase and one issue in a month with no opening
stock, the method of pricing of material issues becomes irrelevant. Therefore, in
the given case one should agree with the argument of the Chief Accountant that
the value of Closing Stock remains the same no matter which method of pricing
the issue is used.
It may, however, be noted that the argument of Chief Accountant would not
stand if one finds the value of the Closing Stock at the end of each month.
(b) LIFO method has an edge over FIFO or any other method of pricing material
issues due to the following advantages:
(i) The cost of the materials issued will be either nearer or will reflect the
current market price. Thus, the cost of goods produced will be related to the
trend of the market price of materials. Such a trend in price of materials
enables the matching of cost of production with current sales revenues.
(ii) The use of the method during the period of rising prices does not reflect
undue high profit in the income statement, as it was under the first-in-first-
out or average method. In fact, the profit shown here is relatively lower
because the cost of production takes into account the rising trend of
material prices.
(iii) In the case of falling prices, profit tends to rise due to lower material cost,
yet the finished products appear to be more competitive and are at market
price.
(iv) During the period of inflation, LIFO will tend to show the correct profit and
thus, avoid paying undue taxes to some extent.
 2.24

ILLUSTRATION 13
The following information is provided by Sunrise Industries for the fortnight of April,
20X9:
Material Exe:
Stock on 1-4-20X9 100 units at ` 5 per unit.
Purchases
5-4-20X9, 300 units at ` 6
8-4-20X9, 500 units at ` 7
12-4-20X9, 600 units at ` 8
Issues
6-4-20X9, 250 units
10-4-20X9,400 units
14-4-20X9,500 units
Required:
(A) CALCULATE using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period
(b) the value of stock of materials on 15-4-20X9.
(B) EXPLAIN why the figures in (a) and (b) in part A of this question are different
under the two methods of pricing of material issues used. You need not draw
up the Stores Ledgers.
SOLUTION
(A) (a) Value of Material Exe consumed during the period
1-4-20X9 to 15-4-20X9 by using FIFO method.

Date Description Units Qty. (Units) Rate Amount

(`) (`)
1-4-20X9 Opening balance 100 5 500
5-4-20X9 Purchased 300 6 1,800
6-4-20X9 Issued 100 5
150 6 1,400
 P a g e | 25

8-4-20X9 Purchased 500 7 3,500

10-4-20X9 Issued 150 6
250 7 2,650
12-4-20X9 Purchased 600 8 4,800
14-4-20X9 Issued 250 7
250 8 3,750
15-4-20X9 Balance 350 8 2,800

Total value of material Exe consumed during the period under FIFO
method comes to (` 1,400 + ` 2,650 + ` 3,750) ` 7,800 and balance on
15-4-20X9 is of ` 2,800.
Value of material Exe consumed during the period 01-4-20X9 to 15-
4-20X9 by using LIFO method

Date Description Qty. Rate Amount

(Units) (`) (`)
1-4-20X9 Opening balance 100 5 500
5-4-20X9 Purchased 300 6 1,800
6-4-20X9 Issued 250 6 1,500
8-4-20X9 Purchased 500 7 3,500
10-4-20X9 Issued 400 7 2,800
12-4-20X9 Purchased 600 8 4,800
14-4-20X9 Issued 500 8 4,000
15-4-20X9 Balance 350 — 2,300*

Total value of material Exe issued under LIFO method comes to (`

1,500 + ` 2,800 + ` 4,000) ` 8,300.
*The balance 350 units on 15-4-20X9 of ` 2,300, relates to opening
balance on 1-4-20X9 and purchases made on 5-4-20X9, 8-4-20X9 and
12-4-20X9. (100 units @ ` 5, 50 units @ ` 6, 100 units @ ` 7 and 100
units @ ` 8).
(b) As shown in (a) above, the value of stock of materials on 15-4-20X9:
Under FIFO method ` 2,800
Under LIFO method ` 2,300
 2.26

(B) Total value of material Exe issued to production under FIFO and LIFO
methods comes to ` 7,800 and ` 8,300 respectively. The value of closing
stock of material Exe on 15-4-20X9 under FIFO and LIFO methods comes to
` 2,800 and ` 2,300 respectively.
The reasons for the difference of ` 500 (` 8,300 – ` 7,800) as shown by the
following table in the value of material Exe, issued to production under FIFO
and LIFO are as follows:
Date Quantity Value Total Value Total
Issued FIFO LIFO
(Units) (`) (`) (`) (`)
6 - 4-20X9 250 1,400 1,500
10-4-20X9 400 2,650 2,800
14-4-20X9 500 3,750 7,800 4,000 8,300
1. On 6-4-20X9, 250 units were issued to production. Under FIFO their
value comes to ` 1,400 (100 units × ` 5 + 150 units × ` 6) and under
LIFO ` 1,500 (250 × ` 6). Hence, ` 100 was more charged to
production under LIFO.
2. On 10-4-20X9, 400 units were issued to production. Under FIFO their
value comes to ` 2,650 (150 × ` 6 + 250 × ` 7) and under LIFO ` 2,800
(400 × ` 7). Hence, ` 150 was more charged to production under
LIFO.
3. On 14-4-20X9, 500 units were issued to production. Under FIFO their
value comes to ` 3,750 (250 × ` 7 + 250 × ` 8) and under LIFO ` 4,000
(500 × ` 8). Hence, ` 250 was more charged to production under
LIFO.
Thus the total excess amount charged to production under LIFO comes to
` 500.
The reasons for the difference of ` 500 (` 2,800 – ` 2,300) in the value of
350 units of Closing Stock of material Exe under FIFO and LIFO are as
follows:
1. In the case of FIFO, all the 350 units of the closing stock belongs to
the purchase of material made on 12-4-20X9, whereas under LIFO
these units were from opening balance and purchases made on 5-4-
20X9, 8-4-20X9 and 12-4-20X9.
 P a g e | 27

2. Due to different purchase price paid by the concern on different days

of purchase, the value of closing stock differed under FIFO and LIFO.
Under FIFO 350 units of closing stock were valued @ ` 8 p.u. Whereas
under LIFO first 100 units were valued @ ` 5 p.u., next 50 units @ ` 6
p.u., next 100 units @ ` 7 p.u. and last 100 units @ ` 8 p.u.
Thus under FIFO, the value of closing stock increased by ` 500.
Average Price Methods
(i) Simple Average Price Method: Under this method, materials issued are
valued at average price, which is calculated by dividing the total of rates at which
different lot of materials are purchased by total number of lots. In this method
quantity purchased in each lot is ignored.
Example: During the month of April, a company has made five purchases as
follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ `11 each.
The issue price under Simple Average Price Method would be calculated as below:
`10  `12  `12  `15  `11
= ` 12 each
5 lots