Meaning of Accounting

Definitions of Accounting :

1. “Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money,
transactions and events, which are, in part at least, of a financial character, and interpreting the results thereof.”

2. “Accounting is the science of recording and classifying business transactions and events, primarily of a financial
character, and the art of making significant summaries, analysis and interpretations of those transactions and
events and communicating the results to persons who must make decisions or form judgement.”

Process/Characteristics of Accounting
An analysis of the above definitions brings out the following as characteristics or process/features or attributes of
accounting :

(1) Recording of Financial Transactions only :- Only those transactions and events are recorded in accounting
which are of a financial character. There are so many transactions in the business which are very important for
business but which cannot be measured and expressed in terms of money and hence such transactions will not
be recorded.

(2) Recording in terms of money :- Each transaction is recorded in the books in terms of money only. For example,
if a businessman purchases 200 Chairs and 10 Tables, their value in terms of money will be recorded in the
books.

In a small business where the number of transactions is quite small, all transactions are first of all recorded in a
book called “Journal”. But in a big business where the number of transactions is quite large, the Journal is
further sub-divided into various subsidiary books.

(3) Classifying :- After recording the transactions in journal or subsidiary books, the transactions are classified.
Classification is the process of grouping the transactions of one nature at one place, in a separate account. The
book in which various accounts are opened is called “Ledger”.

(4) Summarising :- Summarising is the art of presenting the classified data in a manner which is understandable
and useful to management and other users of such data. This involves the balancing of ledger accounts and the
preparation of Trial Balance with the help of such balances. Final Accounts are prepared wit the help of Trial
Balance which include Trading and Profit & Loss Account and a Balance Sheet.

(5) Interpretation of the results :- In Accounting, the results of the business are presented in such a manner (i.e.,
by preparing Trading and Profit & Loss Account and Balance Sheet) that the parties interested in the business
such as proprietors, managers, banks, creditors, employees etc. can have full information about the profitability
and the financial position of the business.

(6) Communicating :- Accounting attributes also include the communication of financial data to the users.
Accounting information issued by various groups of people who have contact with the business enter price. These
user may be classified into two groups.

1. Internal Users :- Internal users are the persons who have a direct interest in the business enterprise such as
owner and management.

(i) Owner :- Owner contribute capital in the business and as such want to know about the profitability and
financial soundness of the business. They also want to know whether the profit are increasing or decreasing.

(ii) Management :- Management need accounting information for the efficient and smooth running of the business
enterprise.

2. External Users :- Individual or organization who have present or future interest in the business enterprise but
are not part of the management are called external user of accounting information. The external user are new in
investors creditors lenders, employees government.

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 Book-keeping, Accounting and Accountancy

These three are sometimes considered as synonymous, i.e., having the same meaning. However, there is a
fundamental difference amongst book-keeping, accounting and accountancy.

Book-keeping :- “Book Keeping is an art of recording business dealings in a set of books. ”

Accounting :- Accounting starts where book-keeping ends. It includes the following activities :

(i) Summarising the classified transactions in the form of Profit & Loss Account and Balance Sheet etc.

(ii) Analysing and interpreting the summarized results. In other words, drawing the meaningful information from
Profit & Loss Account and Balance Sheet etc.

(iii) Communicating the information to the interested parties.

Accountancy :- It refers to a systematic knowledge of accounting concerned with the principles and techniques
which are applied in accounting. It tells us how to prepare the books of accounts, how to summarize the
accounting information and how to communicate it to the interested parties. According to Kohler, ‘accountancy
refers to the entire body of the theory and practice of accounting.’

Distinction between Book-keeping and Accounting

Book-keeping differs from accounting in the following respects :

Basis of Book-keeping Accounting

Distinction
1. Scope Book-keeping includes : Accounting in addition to Book-keeping
(a) Identifying the transactions of financial nature; includes:
(b) Measuring the identified transactions in terms of (a) Summarising the classified transactions;
money; (b) Analysing and interpreting the summarized
(c) Recording the measured transactions; and results; and
(d) Classifying them into ledger. (c) Communicating the results to parties
interested in them.

2. Stage Book-keeping is primary stage. It is the secondary stage. Accounting starts

where Book-keeping ends.

3. Objective The main objective of Book-keeping is to maintain Its main objective is to ascertain the net results
systematic records of transactions of financial and financial position of the business and to
nature. communicate them to interested parties.

4. Nature of Job The Book-keeping function is routine and clerical in The Accounting function is analytical in nature.
nature.

5. Who Performs The Book-keeping function is performed by junior The Accounting function is performed by senior
staff. staff.

6. Knowledge It can be performed by persons having limited level It is performed by persons having higher level of
Level of knowledge. knowledge than that of Book-keeper.

7. Analytical The Book-keeper is not required to possess The Accountant is required to possess analytical
Skill analytical skill. skill.

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 Distinction between Accounting and Accountancy

Basis of Accounting Accountancy

Distinction
1. Meaning It is concerned with recording, classifying and It is a body of knowledge prescribing certain
summarizing of transactions. rules or principles to be observed while
recording, classifying and summarizing of
transactions.

2. Scope It is narrow in scope. Accounting starts where It is much wider in scope and includes Book-
Book-keeping ends. keeping as well as Accounting.

3. Relation It depends on Book-keeping It depends both on Book-keeping and

Accounting.

4. Function Its main function is to ascertain the net results and It includes the decision making function also on
the financial position of the business and to the basis of information provided by Book-
communicate them to interested parties. keeping and Accounting.

Branches of Accounting :

1. Financial Accounting :- The main purpose of this branch of accounting is to record the business transaction in a
systematic manner to as certain the profit or loss of accounting period by preparing a P & C A/c and to present the
financial position of the business preparing a balance sheet.

2. Cost Accounting :- The main purpose of cost accounting is to as certain the total cost and per unit cost of goods
produced and services rendered by a business. It also estimates the cost in advance and help the management in
exercising strict control over cost.

3. Management Accounting :- The main purpose of management accounting is to present the accounting
information in such a way as to assist the management in planning and controlling the operation of a business.

4. Tax Accounting :- The branch of accounting which is used for tax purpose is called Tax Accounting

 Book keeping Defination, Accountancy, Accounting

 Distraction between Book-keeping and Accounting
 Distraction between Accounting and Accountancy

Advantage or user of Accounting :-

1. Helpful in Management of Business :- Management needs a lot of information for the efficient running of the
business :

(a) Helpful in Planning

(b) Decision Making
(c) Controlling

2. Provides complete and systematic Record

3. Information Regarding P & L

4. Information Regarding Financial Position

5. Helpful in partnership Account

Limitation of Accounting :-

1. Influenced by Personal Judgement – Accounting is as ye an exact

2. Based on Accounting Concepts and Conventions.

3. Incomplete Information

4. Omission of Qualitative Information

5. Based on Historical Costs.

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 Basic Accounting Terms

1. Capital :- Generally refer to the amount invested in an enterprise by its owners. It is also used to refer to the
interest of owners in asset of an enterprise. It is also known as owner equity or net worth.

2. Drawing :- Where, as is usual, the proprietor withdraws cash or goods from the business for his personal use,
such amount are in effect with drawal of capital.

3. Expenditure :- Expenditure means spending of money or exchange for other assets or comma ditties or promise
to make the payment at a later date. Expenditure maybe of capital nature or of revenue nature (from which the
benefit will soon be exhausted) eg. Salary, Rent wages etc. Expenditure increase the profit earning capacity of the
business.

4. Assets :- The valuable things owned by the business are known as assets. We can say it is expenditure which
result is acquiring of same property on benefit of a lasting nature assets may be classified as :-

(a) Fixed Assets :- These assets are acquired for relatively long period of time and for carrying on business of the
firm. These are not meant for resale. Exam.- Land, building, furniture & fitting plant & Machinery, car and
other vehicles.

(b) Current Assets :- Such assets are acquired with the intention of converting them into cash during normal
business operation of the firm. Unsold stock debtors, BIR, cash in hand, Bank balance, Accrued income are
same exp. Of current assets.

(c) Tangible Assets :- Tangible assets are those assets which can be seen and touched. In other word those
assets which have a physical existence such as land, building, plant, furniture stock, cash, B/R are called
tangible assets etc.

(d) Intangible Assets :- Intangible assets are those assets which do not have a physical existence and which
cannot be seen or left example of such assets are good will. patents, trade marks, copy sight and prepaid exp.

(e) Wasting Assets :- These are such assets which are consumed through being used and worked such as mines,
oil well, forest etc. As soon as all the minerals are extracted, the mines become valueless oil well thus, wasting
assets are those which get exhausted after certain period of time being worked. It may also include such
assets which get exhausted with the lapse of time, such as patents, trade marks leasehold.

(f) Fictitious Assets :- Assets which does not possess any real value but included in the balance sheet for legal
and technical reasons are called fictitious assets. Preliminary exp. Under writing commission, discount on
issue of share, debentun in cash of a company and other trade losses are some exp.

5. Liabilities :- Liabilities refer to the amount due by a business house to other. Sometimes the term is used to
include the amount due to the proprietors also. Liabilities can be classified as :

(i) Liabilities for owner equity (ii) Liabilities to outside creditor that may be for gods for exp. etc.

It can also be classified as fixed liability current liabilities and contingent liability

(a) Fixed Liabilities :- All liabilities which are not current or not payable are called long term or fixed liabilities.
exp. Mortgage, Bank loan debentures, bonds, exp. of such liabilities which are not dye in one year.

(b) Current Liabilities :- The obligations which are due and payable within one year and which are paid out of
current liabilities, Trade creditors, accrued exp. B/P or Bank overdraft.

(c) Contingent Liabilities :- The obligation which may arise on happening of an event is future is called
contingent liabilities. A bill received and discount from bankers may arise as a liabilities if it is dishonored or
liabilities may arise on losing pending case in court of low are exm. of such liabilities. These are not included
in financial statement of the firm but are shown as footnote in balance sheet liabilities side.

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 6. Debtors :- The term debtors represent the persons or parties who have purchased goods on credit from the
business from whom amount due is receivable by the firm. In simple words debtors means a person or firm who
owes money to the business for goods supplied or for services. In case, the firm is a service institution and the
payment for service still remain to be realised beneficiaries of the service will also be known debtors.

7. Creditors :- By creditors we mean only trade creditors, creditor for expenses and bill payable thus the seller of
goods on credit to the are known as its creditors of the firm so far the full payment is not made to them.

8. Stock or Inventory :- Stock or inventories are tangible property

(a) Held for sale in the ordinary course of business.

(b) Which are in the process of production for such sale.

(c) To be consumbed in the production of goods or services for sale.

9. Deferred Expenditure :- It refer to expenditure for which payment has been made or a liability incurred which is
carried toward on the presumption that it will be beneficial over a subsequent period or periods. This is also
referred to as deferred revenue expenditure.

10. Discount :- It is an allowance given by the seller to the purchaser it is two type.

(a) Trade Discount :- Trade discount is allowed by the seller to the customer for the bulk purchase. It is allowed
at a fixed percentage on the list price of the goods. Trade discount is simply deducted form gross value of
goods sold but not recorded in books of accounts.

(b) Cash Discount :- This discount is allowed to the customers for early or prompt payment of their dues. It is
recorded in the books of accounts. Discount allowed to customer’s is a loss to a businessman. Where are if
his creditors also give discoursed to him.

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 Accepted Accounting Principles Concepts and Conventions
Accounting principles are a body of doctrine commonly associated with the theory and procedure of accounting
serving as an explanation of current practices and as a guide for selection of conventions or procedures where
alternatives exist.

Kinds of Accounting Principles

1. Accounting Concept and

2. Accounting Conventions

1. Accounting Concept :- A detailed discussion of these concepts is under taken as follows :

(i) The Business Entity Concept :- For accounting purposes each business enterprise is considered as an
accounting unit independent of its owners. According to this concept the business and businessman are two
separate and distinct entities. The business entity is considered to own the assets and liable for the liabilities
to outsides, including the claims or capital of the proprietors. The accounting entity is not necessarily a
separate legal entity.

In accounting however every type of business organization, be its sole tradership or partnership is treated as
a separate accounting entity. The entity concept, therefore, establishes a clear distinction between the owners
and the business.

(ii) Money Measuremerd Concept :- In accounting only those facts, events and transaction are recorded and
reported that can be expressed in terms of money. Since money is a common measuring unit or common
denominator, it makes possible to record and compare dissimilar facts, events and transaction about a
business.

(iii) The Going Concern Concept :- This concept assumes that the business entity will continues to exist
identifinitely, it will not be dissolved in near future. Continuity of activity is trade of all business organization.
The business entities are, therefore treated as going concerns. The going concern concepts does not imply
that accounting assumes permanent or immortal existence is simply presumes stability.

(iv) The Cost Concept :- The cost is the monetary price paid for the acquisition of assets for the business
enterprise cost concept implies that an assets is recorded in the account books at a price paid to acquire it.
The original or acquisition cost related to past and therefore, it is referred to as historical cost. It is the basis
for the valuation of the assets in financial statement. Further the cost concept means original or acquisition
cost less depreciation charged on that assets.

(v) The Dual Aspect Concept :- The dual concepts is based on double entry system of book keeping which
means the record of each transaction is made in two separate accounts once on the debit side of an accounts
and second time on the credit side of another account.

Thus it is clear that an increase or decrease in the amount of assets will also increase or decrease the amount
of creditor or capital on the liabilities side of the balance sheet, there for balance sheet in just like a scale and
if height is increased or decreased on one side the same must be added to or removed from the other side.
This is the essence & the dual aspect concept.

(vi) The Accrual Concept :- In accounting for recording to transaction, accrual basis is adopted in provides more
appropriate information about the performance of business entity as compared to cash basis. This concept is
applicable equally for revenue as well as for expenses. In accrual concept revenue is recognized and recorded
when sales are effected or services are rendered when sales are effected or services are rendered whether cash
is received or not similarly expenses are recorded in that accounting period during which they assist in
earning revenue, whether cash in paid for them or not. As such to find out true profit or loss for an
accounting period and show financial position at the end of accounting period of the enter price all expenses
and income should be recorded in that accounting period for which they relate, Whether actual cash has been
paid or received or not. It is also described as matching concept.

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 (vii) Matching Concept :- This principle hold that expenses should be recognized in the same period as
associated to revenue. It is very important for correct determination of profitability which is a measure of
performance. Infect, according to this principle, expenses incurred in a accounting period should be matched
with the revenues realized in the same period. If the revenue is realised on certain goods delivered during a
particular period, all costs attributable to those goods should also be charged as expenses in the same
period.

(viii) Verifiable and Objective Evidence Concept :- Accounting data are often subject to verification by outsiders
i.e. internal and external auditors. Hence all accounting transaction must be supported by documentary
evidences. Invoid and vouchers for purchases, sales and expenses. Physical inventory verification etc.
documents can be verified. Accounting entries must be free from errors and frauds; besides, evidence factors
like personal opinion and judgement; inventory valuation, provision to bad and doubtful debts etc.

(ix) The balance sheet equation concept implies that in each transaction the amount to be debited equal the
amount to be credited.

In the form of equation : Debit = Credit According to accounting principle, all the expenses, losses and assets
are debited while all the income gains and liabilities are credited. Therefore the form of equation appears as
follows.

Expenses + Losses + Assets = Income + Gain + Liabilities or

Assets = Income + Gain + Liabilities – Expenses – Losses
Assets = Net profit or Net loss + Liabilities.

Accounting Conventions
To make the accounting information more reliable, relevant, meaningful, consistent and intelligible, accounting
concepts and principles need to be modified. For instance materiality, consistency, conservatism, timeliness,
industry’s practices, cost benefit relationship and other considerations have to be taken into account for making the
information useful and meaningful. Thus, these modifying principles know as accounting conventions which are as
under :

(1) Convention of Materiality : The term material refers to the relative importance of an item or an event.
Accounting should disclose all the material information and not to attempt to record so insignificant events
which are not justified by the usefulness of the results. In other words, materiality here means the information
which would have changed the results of the business if it would have been disclosed. Sometimes certain
information may be furnished in footnotes as below –

(a) Information regarding contingent liabilities,

(b) Information regarding market price of investments etc. Materiality will differ with the size, nature and
traditions of the business. International accounting standards-5 states that “All material information
should be disclosed which is necessary to make the financial statements clear and understandable.”

(2) Convention of Consistency : Since business is a going concern which has to continue indefinitely, so it is
necessary to make accurate comparison and that the methods and practice of recording and presentation of
accounts does not change. The procedure for determination of value of stock, the mode of charging
depreciation etc. should continue to be the same. According to International Accounting S tandard-1
consistency is a fundamental assumption and it is assumed that accounting polices are constant from one
period to another. Where this convention is not followed, the fact should be disclosed clearly along with
reasons thereof.

(3) Convention of Conservation : This convention holds that when more than one accounting or measurement
alternative is permissible for a transaction, the one having the least favourable immediate effect on profits or
capital usually should be adopted. Providing for all future possible losses and not to anticipate any future
earning is a golden rule. According to international accounting standard, “uncertainities inevitably surround
many transactions. This should be recognized by exercising prudence in financial statements. Prudence does
not, however, justify the creation of secret or hidden reserves. Hence, convention of conservatism is the policy
of ‘Playing Safe’. Based on this convention, the stock in hand is shown at ‘Lower of cost or Market Price’,

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 Provision for bad debts,. Joint life policy or policies are shown not at actual amount of premiums paid but at
surrender value etc. are few examples of conservatism. Based on this convention, the Stock in hand or certain
categories of investments are shown at “lower of cost or markes price.”

(4) Convention of Timeliness : Although information is useful which is relevant and reliable but6 it must also be
furnished timely. Timelines means having information available to decision makers before it loses its capacity
to influence decision. In this regard it is rightly said that it is always better to have less reliable information in
time, rather than furnishing more reliable information, very late.

(5) Convention of Industry Practice : There are many different accounting policies in use even in relating to the
same subject, Judgment is required in selecting and applying those which in the circumstance of the
enterprise are best suited to present properly its financial position and the results of its operation. Different
industries such as mining, banking, electricity etc. have their own peculiar features and practices that
required carefree considerations while preparing their financial statements. As accounting focuses on
usefulness and feasibility, the industry practice at principle permits, special accounting treatment for specific
items where there is a clear precedent in the industry based on uniqueness, usefulness and feasibility, may be
adopted.

(6) Convention of Cost Benefit Relationship : According to this convention it should be ensured that the cost of
applying the particular concept, principle or convention should not exceed the benefits derived from it. In other
words, the benefits to be gained from providing any accounting information should be larger than the cost of
providing it. It does not mean that to save cost. No information or very little information should be given to the
Users. Infact cost benefit analysis has to face many difficulties. As cost can be of several kinds, it is more
difficult to measure the benefits accruing to Investors and Users.

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 Accounting Equations
The entire system of recording business transactions is based on accounting equation. All business transaction are
recorded as having a having a dual aspect. Accounting equation is a statement of equality between debits and credits.
It signifies that the assets of a business are always equal to the total of liabilities and capital (owner equity). When the
relationship is shown in the equation from it is known as ‘Accounting Equation. Thus,

Assets = Liabilities + Capital

The above equation may be elaborated as under :

Capital = Assets – Liabilities

Liabilities = Assets – Capital
Assets = Capital + Liabilities

The important points to be noted are :

i) Every transaction or event has two aspects.

ii) Total assets are always equal to capital and liabilities or in other words capital is always equal to Assets –
minus liabilities.

iii) The profit belongs to the owner which shall increase his capital.

iv) The owners has to bear the losses as such his capital will be reduced by the amount of the loss.

Thus, the recording of both the aspect of transaction and events answer that account books will also show the
accuracy of the Accounting Equation.

Other Accounting Equation formula :-

1) Total Assets = Capital + Liabilities

2) Profit = Revenue – Expenses

Closing Capital – Opening Capital

3) Closing Capital = Opening Capital + Addition Capital – Drawings + Profit or (–) loss.

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 JOURNAL
“The Journal as originally used, is a book of prime entry in which transactions are copied in order of date from a
memorandum or waste book. The entries as they are copied are classified into debits and credits so as to facilitate
their being correctly posted, afterwards in the ledger.”

Thus, the Journal provides a date-wise record of all the transactions with details of the accounts debited and credited,
and the amount of each transaction. Prior to recording in Journal, the transactions may also be recorded in a rough
book called ‘Waste book’ or ‘Memorandum book’. Maintenance of waste book is not necessary but where the number
of every day transactions is so large that it is not possible for a businessman to remember all of them, the use of
waste book may prove helpful. Later on with the help of waste book recording is made in Journal.

Features or Characteristics of a Journal

The chief features of Journal may be stated as under :

(i) Journal is a book in which the transactions are recorded first of all, as and when they take place. For this
reason it is called a book of original entry.

(ii) A journal is only a book of primary (original) entry. All the transactions recorded in the journal are subsequently
transferred to ledger which is the principal book of accounts.

(iii) A journal is a daily accounting record, i.e., each day’s transactions are recorded in the journal on the same day.

(iv) In journal, transactions are recorded in a chronological order, i.e., in a date-wise order.

(v) It maintains the identity of each transaction and provides a complete picture of the same in one entry.

(vi) A journal records both debit and credit aspects of a transaction according to the double entry system of book-
keeping.

(vii) Each entry in the journal is followed by a brief explanation of the transaction which is called ‘Narration’.

(viii) A single journal entry is capable of recording more than one transaction involving more than two accounts.
Such an entry is called compound entry.

Functions of a Journal
(i) To keep a chronological (i.e., date-wise) record of all transactions.

(ii) To analyse each transaction into debit and credit aspects by using double entry system of book-keeping.

(iii) To provide a basis for posting into ledger.

(iv) To maintain the identity of each transaction by keeping a complete record of each transaction at one place on a
permanent basis.

Advantages of a Journal
Although it is not necessary to maintain a journal and the transactions can be recorded directly in the ledger
accounts, a journal, still is used for the following reasons :

(i) As transactions in journal are entered as and when they take place, the possibility of omission of a transaction
in the books of accounts is minimized.

(ii) As transactions in journal are recorded in chronological order, it is very easy to locate a particular transaction
when required.

(iii) By analyzing each transaction into debit and credit aspects, the journal facilitates the posting into ledger.

(iv) Each entry in the journal carries narration which gives a brief explanation of the transaction. Hence, postings in
the ledger can be made without explanation.

(v) Journal facilitates cross checking of ledger accounts in case a trial balance does not agree.

(vi) Since entire transaction is recorded at one place in the journal, the identity of each transaction is maintained
on a permanent basis.

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 (vii) Once the transaction is recorded in journal, posting in the ledger can be made as and when convenient.

Limitations of Journal :
(i) When the number of transactions is large, it is not possible to record all the transactions in Journal. It will
become bulky and voluminous. Hence, the usual practice is to have separate journals or books for different
classes of transactions such as purchase book, sales book etc.

(ii) Many transactions are repetitive in nature and if all transactions are recorded in journal it will involve debiting
and crediting the same accounts time and again. It will involve repetitive posting labour also.

(iii) In order to ascertain cash balance everyday, cash transactions are usually recorded in a separate book called
‘Cash book’. Thus cash transactions need not be recorded in journal.

(iv) Journal does not provide the required information on prompt basis.

Rules of Journalising
On the basis of the rules discussed in the chapter on double entry system the accounts to be debited or credited will
be determined. The same rules are again explained here in a simplified manner :-

(1) Personal Accounts :- According to the rule of ‘Debit the receiver’, the personal account of the person to whom we
give some money or goods is debited. For example, if we gate Rs. 20,000 to Gopal, the entry will be :-

Gopal Dr. 20,000

To Cash A/c 20,000
(Cash paid to Gopal)

In the same way, according to the rule of ‘Credit the giver’, the personal account of the person from whom we
receive some money or goods is credited. For example, If we received Rs. 50,000 from Govind, the entry will be :-

Cash A/c Dr. 50,000

To Govind 50,000
(Cash received from Govind)

(2) Real Accounts :- According to the rule of ‘Debit what comes in and credit what goes out’, the account of the cash
or other property which is received by the business firm is debited and in the same way, the account of the Cash
or other property which goes out of the business is credited. For example, if Machinery is bought for
Rs. 5,00,000 :-

Machinery A/c Dr. 5,00,000

To Cash A/c 5,00,000
(Machinery purchased for cash)

(3) Nominal Accounts :- According to the rule of ‘Debit all Expenses’, the accounts of all expenses and losses are
debited. For example, if Rs. 20,000 are paid for salary, the entry will be :-

Salary A/c Dr. 20,000

To Cash A/c 20,000
(Salary paid)

Similarly, according to the rule of ‘Credit all Incomes’, the accounts of all incomes and profits are credited. For
example, if Rs. 5,000 are received for commission. The entry will be :-

Cash A/c Dr. 5,000

To Commission A/c 5,000
(Commission received)

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 Meaning of Goods
Goods are those things which are purchased for resale. In other words, goods are the commodities in which the
business deals. For example, if a cloth merchant purchases cloth, the cloth will be termed as ‘purchases’. But if the
same cloth merchant purchases some furniture, say chairs and a sofa set for the seating of customers, the furniture
so purchased will not be termed as purchases, but will be an asset of his business and in this case ‘Furniture A/c’
will be debited instead of ‘Purchases A/c’. It means that the purchases of asset are not termed as purchases in
accounting terminology because these assets are not meant for sale.

Goods Account is classified into five accounts for the purpose of passing the Journal entries :-

(I) Purchases A/c :- When goods are purchased, instead of debiting Goods A/c ‘Purchases A/c’ is debited. Purchase
A/c is a nominal account and while passing a Journal entry ‘Purchases A/c’ should always be debited because of
the rule of “Debit all Expenses and Losses.”

(II) Sales A/c :- When goods are sold, instead of crediting Goods A/c ‘Sales A/c’ is credited. Sales A/c is a nominal
account and while passing a Journal entry ‘Sales A/c’ should always be credited because of the rule of “Credit all
Incomes and Gains”.

(III) Purchases Return A/c :- This account is also named as ‘Return Outward’. It is a nominal account and should
always be credited because purchases i.e. expenses are reduced.

(IV) Sales Return A/c :- This account is also named as ‘Return Inward’. It is a nominal account and should always
be debited because incomes i.e. sales are reduced.

(V) Stock A/c

Discount
Discount is of two types :

(1) Trade Discount, and

(2) Cash Discount

(1) Trade Discount :- This discount is allowed by wholesaler or manufacturer to the retailer at a fixed percentage on
the listed price of goods. It is allowed when goods are purchased in bulk, i.e., large quantity. This discount is
allowed both on credit as well as cash transactions since it is related to the purchases and not to the payment. No
separate entry is passed for the Trade discount, as it is deducted from the cash memo or invoice of the goods. For
example, if a trader sells goods of the list price of Rs. 1,00,000 at 20% trade discount for cash, the entry will be :-

Cash A/c Dr. 80,000

To Sales A/c 80,000

If the goods sold at trade discount are returned by the customer, the amount of trade discount is again deducted
from the list price of the returned goods.

(2) Cash Discount :- This discount is allowed to the customers for making prompt or early payment. In other words,
cash discount is allowed only if the customer makes the payment within a fixed period. Such discount motivates
the customer to make the payment at the earliest. As the discount is allowed at the time of making payment, so
the entry for cash discount is recorded along with the entry for payment. Discount is a nominal account and as
such, it is debited when it is allowed to a customer and credited when it is received.

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 Distinction between Trade Discount and Cash Discount
Basis of Distinction Trade Discount Cash Discount
1. Meaning Trade discount is allowed by Cash discount is allowed if the
wholesaler or manufacturer to the customer makes the payment
retailers at a fixed percentage on the immediately or within a fixed
printed price list. period.

2. When allowed ? It is allowed when goods are It is allowed when payment is made
purchased in a specified quantity. on or before a specified date.

3. Object Generally, it is allowed to the It is allowed to encourage quick or

retailers to enable them to make prompt payment.
some profit even if they sell the
goods at their catalogue price.

4. Recording in the books of It is not recorded separately in the It is recorded separately in the
account books of accounts. books of accounts.

5. Deduction from Invoice It is deducted from the invoice It is not deducted from the invoice.

Compound Journal Entries

Sometimes, two or more transactions relating to one particular account take place on the same date. In such cases,
instead of passing separate entries for all such transactions, only one entry is passed. Such a Journal entry is termed
as Compound Journal Entry. For example, on 31st March Rs. 50,000 are paid for salaries and Rs. 20,000 are paid for
rent, the entry will be :-

31st March Salary A/c Dr. 50,000

Rent A/c Dr. 20,000
To Cash A/c 70,000
(Expenses paid)

Such entries can be passed in either of the following three ways :-

1. By debiting one account and crediting two or more accounts.

2. By crediting one account and debiting two or more accounts.
3. By debiting two or more accounts and crediting two or more accounts, such as the ‘Opening Entry’.

Recording of Banking Transactions

S.No. Transaction Entry
1. When cash is deposited into the bank. Bank A/c Dr.
To Cash A/c
2. When cash is withdrawn from the bank. Cash A/c Dr.
To Bank A/c
3. When cheques, drafts etc. received from the customers Bank A/c Dr.
are deposited into the bank on the same day. To Customer’s Personal A/c
4. When cheques, drafts etc. received from the customers Cheques in Hand A/c Dr.
are not sent to bank on the same day. To Customer’s Personal A/c
5. On the date when above cheques, drafts etc. are sent to Bank A/c Dr.
the bank. To Cheques in Hand A/c
6. When a customer directly deposits the amount in our Bank A/c Dr.
bank account. To Customer’s Personal A/c
7. When a cheque previously deposited into the bank is Customer’s Personal A/c Dr.
dishonoured. To Bank A/c
8. A When a cheque is received from a customer and discount Bank A/c Dr.
is allowed to him, and if the cheque is deposited into the Discount Allowed A/c Dr.
bank on the same day.

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 To Customer’s Personal A/c
8. B In case the above cheque is dishonoured, the discount Customer’s Personal A/c Dr.
allowed to the customer will also be withdrawn. To Bank A/c
To Discount Allowed A/c
9. When payment is made by issue of a cheque. Personal A/c Dr.
To Bank A/c
10. When expenses are paid by the issue of a cheque. Expenses A/c Dr.
To Bank A/c
11. When cash is withdrawn from the bank for the personal Drawings A/c Dr.
use of the proprietor. To Bank A/c
12. A When interest is charged by the bank. Interest A/c Dr.
To Bank A/c
12. B When interest is allowed by the bank. Bank A/c Dr.
To interest Received A/c
13. When bank charges some amount for the services Bank Charges A/c Dr.
rendered by the bank. To Bank A/c

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 Provisions and Reserves
In order to strengthen the financial position of the business and with a view to meeting all eventualities – both
expected and unexpected, it is desirable that the entire profit should not be distributed among their owners. Some
portion of the profit should be kept in the business for meeting the known as well as unknown liabilities in future.
This is done, by making provisions and creating reserves out of current year’s profits at the time of preparation of final
accounts.

The terms ‘Provision’ and ‘reserve’ are quite distinct from each other and canno0t be used interchangeably. The law
has defined the two terms clearly.

PROVISIONS
Meaning :

According to the Companies Act the term ‘Provision’ refers to any of the following amounts :-

(a) The amount written off or retained by way of providing for depreciation, renewals or diminution in value of
assets; or

(b) The amount retained by way of providing for any known liability of which the amount cannot be determined with
substantial accuracy.

It should be clearly understood that if the amount of a known liability can be determined with reasonable accuracy, it
must be classified as an outright liability and not a provision. Also if any excess provision is made knowingly or
intentionally, the amount in excess of the actual need will be treated as ‘reserve’.

Examples of Provisions :

Provision are created for the fulfillment of various objectives :

1. Provision for Depreciation of Assets.

2. Provision for Taxation.
3. Provision for Bad and Doubtful Debts.
4. Provision for Discount on Debtors.
5. Provision for Repairs and Renewals of assets.

Characteristics or Features of Provisions :-

(1) Provision is made to meet a known liability.

(2) The liability is known but the amount of such liability cannot be determined with reasonable accuracy. For
example, it is almost certain that some debts will prove irrecoverable but the exact amount of bad-debts cannot be
predicted with certainty.

(3) Provision is a charge against profits and as such reduces the profits of the year in which it is created. The loss
when actually occurs will be written off against such provision and thus the profit of the year in which such loss
occurs will not be affected.

Purpose or Importance of Provisions :

(1) To ascertain the true net profit of the business :- In order to ascertain the true profit of a business it is
necessary that all expenses pertaining to that year, whether paid or outstanding, must be debited to Profit and
Loss account and a provision should also be made for expenses or liabilities the amount of which cannot be
estimated with reasonable accuracy. For example, the provision should be made for doubtful debts, because the
amount of such bad-debts cannot be estimated very accurately.

(2) To ascertain the true financial position of the business :- The Balance Sheet will depict the true and fair view
of the financial position of the business only if adequate provision is made for all the anticipated losses and
expenses.

(3) To provide for known losses in the future :- Funds will be required to meet the losses and liabilities that are
likely to occur in the near future. As such, provisions are made to provide funds for meeting those losses such as

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 provision for taxation, provision for repairs, provision for damages likely to arise from a pending suit and such
others.

(4) For the equitable distribution of expenses :- For example, if a machine is estimated to run for 10 years and the
total amount of repairs expected to be incurred during its entire life span is Rs. 10,000, a ‘provision for repairs
a/c’ will be created by debiting Rs. 1,000 to each year’s Profit & Loss Account. Actual expenses of repairs incurred
each year will be debited to this account. Hence, it will put equal burden on the Profit & Loss Account of each
year in respect of expenses of repairs which will be very light in the earlier years but definitely heavy in the later
years.

RESERVES
Meaning :

Reserves mean amounts set aside out of profits and other surpluses to meet future uncertainties. In other words, a
reserve is meant for meeting any unknown liability or loss in the future. According to William Pickles, “Reserves mean
the amounts set aside out of profits and other surpluses, which are not earmarked in any way to meet any particular
liability, known to exist on the date of the Balance Sheet”.

Examples of reserves are : (1) General Reserve, (2) Capital Reserve, (3) Dividend Equalisation Reserve, (4) Investment
Fluctuation Fund, (5) Workmen Compensation Fund, (6) Reserve for Redemption of Debentures. It should be clearly
understood that the amount of reserve does not represent any expense or loss and as such it is not debited to Profit &
Loss Account. Creation of reserve does not reduce the net profits but only reduces the divisible profits. It is an
appropriation of profits and hence after ascertaining the net profits it is debited to Profit & Loss Appropriation
Account.

Characteristics or features of ‘Reserves’ :

(1) It is created out of net profits or divisible profits. As such the reserves are also termed as ‘Retained Earnings’ or
‘Undistributed Profits’.

(2) Creation of reserves is not a legal necessity. It is created voluntarily for strengthening the general financial
position of the business and for meeting an unanticipated situation in the future.

(3) Normally, it is not created to meet any known liability or depreciation in the value of assets but for meeting an
unknown liability or loss in the future.

(4) Reserves represent accumulated or undistributed profits and as such they belong to the proprietors just as capital
does. They are available for distribution as dividends among shareholders and just as the capital is shown on the
liabilities side of the Balance Sheet, they are also shown on the liabilities side.

(5) When the amount of reserve is invested in outside securities it is known as ‘reserve fund’.

Purpose or Importance of Reserves :

(1) Helpful in meeting the unforeseen liability or loss :- If any unforeseen or abnormal loss arises in the future,
reserves can be utilised to meet such eventualities.

(2) Helpful in strengthening the financial position of the business :- Reserves are undistributed or accumulated
profits and technically known as ‘ploughing back of profit’. It is a source of internal financing of the expansion of
business. In case the reserves had not been maintained the profit would have been distributed as dividend among
shareholders.

(3) Equalisation of dividends over the years :- Goodwill of a Company depends upon maintaining a uniform rate of
dividend from year to year and also to increase the dividend steadily. Reserves help the directors to achieve this
objective because in the periods of inadequacy of profits, the amount can be withdrawn from reserves. Sometimes
a reserve known as ‘dividend equalization reserve’ is also created for the specific purpose of equalizing the rate of
dividend.

(4) To provide funds for meeting a specific liability :- Sometimes a reserve is created for a specific purpose such
as ‘Debenture Redemption Fund’ for the payment of debentures. For example, if we need Rs. 5 crore for the
repayment of debentures after 10 years, a fund is created for this purpose by transferring a fixed amount from the

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 divisible profits each year. The funds so accumulated may also be invested outside the business in such a way
that after 10 years Rs. 5 crore will become available for the payment of debentures. It will facilitate the payment of
such a big sum in one go.

Difference between Provision and Reserve

Basis of Difference Provision Reserve
1. Meaning It is created to meet a known It is created to meet an unknown
liability. liability.

2. Necessity (Charge or Creation of provision is a legal Creation of reserves is

Appropriation) necessity. Provisions have to be discretionary. It can be created only
provided for even if there are no if adequate profits have been
profits. Thus, provision is a charge earned. Thus, reserve is an
against profits. Appropriation of Profit.

3. Object The object is to provide for The object of reserves is to

depreciation, doubtful debts and strengthen the financial position of
other specific liabilities. the business.

4. Mode of Creation It is created by debiting to P & L It is created not be debiting to P & L

A/c. Hence, net profit cannot be A/c but through P & L
calculated unless all provisions appropriation A/c. As such, it is
have been debited to P & L A/c. created after the calculation of net
profit.

5. Investment outside the Provisions are never invested Reserves may be invested outside
business. outside the business. the business.

6. Presentation in Balance It is either shown on the assets side It shown on the liabilities side
Sheet. by way of deduction from the asset under the head ‘Reserves and
for which it is created or as a Surplus’.
distinct item on the liabilities side.

7. Utilisation for dividends. It cannot be utilised for distribution It can be utilised for distribution as
as dividends among shareholders. dividends among shareholders.

8. Utilisation for other It is created to provide for a specific It is not created to provide for a
purposes. loss and hence can only be used for specific loss and hence can be used
meeting that loss. for any purpose.

Types of Reserves

Reserves

Revenue Reserves Capital Reserves

General Reserves Specific Reserves

Revenue Reserves :- These reserves come into existence out of profits which have been earned in the course of day-
to-day business operations. Therefore, the revenue reserves represent undistributed profits and as such are available
for the distribution of dividends.

Kohler has defined revenue reserves as, “that portion, or any detail thereof, of the net worth or total equity of an
enterprise representing retained earnings available for withdrawal by proprietors.”

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 Revenue reserves may be of the following two types :-

(A) General Reserve :- Usually, the businessmen do not withdraw the entire profits from the business but retain a
part of it in the business to meet unforeseen future uncertainties. Profits so retained in the business for ‘a rainy
day’ are known as ‘General Reserve’. Similarly, Companies also do not distribute the entire profits as dividends
but keep aside a part of it in the form of General Reserve. Such reserves are also termed as ‘Contingency Reserves’
or ‘Free Reserves’ because these are not created for any specific purpose and can be freely used for any purpose.

Objectives :- General Reserves may be created or utilised for any of the following purposes :

1. For meeting unforeseen losses.

2. For the strengthening of financial position of business.
3. For expansion of business through internal resources or ploughing back of profits.
4. For equalization of dividends over years, in case of Companies.

It is not compulsory and binding upon the business enterprises to maintain general reserves. Such reserves
may be created in the year in which the profits are sufficient and the management thinks it advisable to do so.
General Reserves are shown on the liabilities side of the Balance Sheet under the head ‘Owner’s Equity’.

(B) Specific Reserve :- Such a reserve is created for a specific purpose and can be utilised only for that purpose.
Examples of specific reserves are :-

(I) Dividend Equalisation Reserve :- Such a reserve is created to maintain steady rate of dividend. In the years
in which the profits are sufficient, a part of the profit is transferred to such reserve and it is utilised to keep
the dividend up in the year in which the profits are insufficient.

(II) Reserve for Replacement of Asset :- Such a reserve is created to provide finances for the replacement of an
asset at the end of its serviceable life. The amount of annual depreciation charged on assets is only capable of
providing the original cost of the asset but the replacement of the asset will required a large sum of money
due to the inflationary trend of prices. As such, a ‘reserve for replacement of asset’ is created to provide for the
extra amount required for the purchase of the new asset. For example, if an asset was purchased 10 years
ago at a cost of Rs. 10 Lac and if the depreciation has been provided @ 10% on the original cost, it will provide
only a sum of Rs. 10 Lac. But, suppose, the current price of the asset is Rs. 40 Lac, an additional sum of Rs.
30 Lac will be required for purchasing a new asset. Therefore, the reserve is created for providing this
additional sum.

‘Reserve for Replacement of Asset’ is created by annually transferring a certain amount from Surplus of
Statement of Profit & Loss. Following entry is passed for this purpose :

Surplus of Statement of Profit & Loss Dr.

To Asset Replacement Reserve A/c
(Amount transferred out of divisible profits)

The amount of replacement reserve is either kept and utilised in the business itself or is invested in outside securities
bearing interest at a pre-determined rate. When this reserve is invested in outside securities it is known as ‘reserve
fund’.

Such a reserve is created out of divisible profits. In other words, instead of declaring higher dividends the amount is
transferred to replacement reserve. If such a reserve had not been created, the profit would have been distributed as
dividend and the amount would have gone outside the business. The amount thus saved is accumulated from year to
year and is utilised for the specific purpose of replacement of the asset. ‘Reserve for Replacement of Asset A/c’ is
closed by transferring it to ‘General Reserve A/c’ at the end.

(III) Investment Fluctuation Fund :- It is created to provide for decline in the value of investment due to market
fluctuations.

(IV) Workmen Compensation Fund :- It is created to meet compensation payable to workers in case of
unexpected or unknown event of an accident.

(V) Debenture Redemption Reserve :- It is created to provide funds for the redemption i.e., repayment of
debentures.

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 Capital Reserves :- In addition to the normal profits, capital profits are also earned in the business from any sources.
The reserves created out of such capital profits are known as Capital Reserves. Such reserves generally, are not
available for distribution as cash dividend among the shareholders of a Company. Profits received from the following
sources are termed as capital profits :-

1. Profits on the sale of fixed assets.

2. Profits on the revaluation of fixed assets and liabilities.
3. Premiums received on issue of Shares or Debentures.
4. Profit on the purchase of a running business.
5. Profit prior to the incorporation of a Company.
6. Profit from the reissue of forfeited shares.
7. Profit on redemption of debentures.

All the Capital profits mentioned above should be treated as Capital Reserves.

Capital reserves are used to write off Capital losses and for the issue of fully paid bonus shares. Usually, the capital
reserves are not available for distribution as cash dividends. Some capital reserves can however be utilised to
distribute dividends subject to fulfillment of the following conditions :-

1. Articles of the Company must not prohibit such dividend.

2. Capital profits must have been realized in cash.
3. Such profit remains after a fair revaluation of assets and liabilities.

All the same, it would be a prudent policy on the part of the management not to distribute such profits. They should
be kept in the business to strengthen its financial position.

Distinction between Revenue Reserves and Capital Reserves

Basis of Distinction Revenue Reserves Capital Reserves
1. Source of Creation These reserves are created out of These reserves are created out of
revenue profits which arise from the capital profits, which do not arise
normal operating activities of the from the normal operating activities
business and are otherwise of the business and are not
available for distribution of available for distribution of
dividends. dividends.

2. Usage A specific reserve can be utilised Normally, these reserves cannot be

only for the earmarked purpose utilised for distribution of dividends
while a general reserve can be to shareholders. However, some
utilised for any purpose including capital reserves can be utilised to
distribution of dividends to distribute dividends subject to
shareholders without any pre- fulfillment of certain conditions laid
conditions. down by Companies Act.

3. Purpose These reserves are created for These reserves are created to meet
meeting unforeseen losses and for Capital losses or may be used for
strengthening the financial position purposes laid down by Companies
of business. Act.

Secret Reserves :
A secret reserve is one which is not disclosed by the Balance Sheet. These reserves are created by showing profit at
figure much lower than actual and by showing the assets at a lower figure and liabilities at a higher figure. When
secret reserves exist, the actual position of the firm is much better than what is disclosed by the Balance Sheet.
Secret reserves may be created in the following ways :

(i) Writing off excessive depreciation;

(ii) Charging Capital expenditure (such as addition to assets) to Profit & Loss Account;
(iii) Treating a revenue receipt as a capital receipt (such as rent received credited to Building Account);
(iv) Undervaluation of assets (such as undervaluation of closing stock);
(v) Showing an actual asset as a contingent asset;
(vi) Showing a contingent liability as an actual liability;
(vii) Suppressing the sales;

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 (viii) Creating excessive or unnecessary provision for doubtful debts and other contingencies.

Advantages of Secret Reserves :

(i) Financial Stability : Creation of secret reserves strengthens the financial position of the enterprise without
disclosing this fact to the shareholders or the public.

(ii) Helpful in Absorbing Unforeseen Losses : The presence of secret reserves enable such concerns to absorb any
unexpected losses without any public discomfiture.

(iii) Regularity of Dividends : Such reserves help the enterprise in maintaining the rate of dividend during adverse
trading conditions without disclosing this fact to shareholders or the public.

(iv) Avoidance of Competition : Because of concealment of actual profitability of the enterprise, the entry of the
competing firms in the particular line of business is avoided.

Disadvantages of Secret Reserves :

(i) Unfair Presentation of Financial Statements : Statement of Profit & Loss fails to disclose true profit and the
Balance Sheet fails to disclose a true and fair view of the financial position of the enterprise.

(ii) Loss to Shareholders : Shareholders who wish to sell their shares may not get actual price of their shares
because of understatement of profits and financial position of the enterprise.

(iii) Misuse by Management : Fraudulent managements may take undue advantage by creating secret reserves.
Profits may be suppressed to enable them to buy the shares of the Company at a lower price and then the
profits may be enhanced by eliminating the secret reserves to enable them to sell the shares at a higher price.

(iv) Cover for Misdeeds of Management : Secret reserves may be utilised by management to cover their mistakes
or misdeeds.

The creation of secret reserves is not allowed under the Companies Act, 2013 as it requires a full disclosure of all
material facts and significant accounting policies followed in preparing financial statements.

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 Rectification of Errors
“To err is human.” Accountant, as a human being is likely to commit mistakes while recording the transactions in the
books of original entry, posting them to Ledger accounts or in preparing a trial balance itself. It is essential to locate
and rectify errors, otherwise profit and loss account will not disclose the true profit or loss of the business and the
balance sheet will not present a true and fair view of the financial position of the business.

Errors should never be corrected by overwriting or erasing because it reduces the authenticity of accounting records
and gives the impression that something is being concealed.

Method of rectification depends on the stage at which the errors are rectified. If an error is located in the books of
original entry before its posting to the Ledger, it may be corrected by neatly crossing out the wrong figure by a single
line and writing the correct figure above the crossed figure. Similarly, if a wrong figure has been posted to the correct
Ledger account, it may also be corrected in the same manner.

If, however, an error is located after some time, it should be corrected by passing a suitable Journal entry, called
rectifying entry.

From the rectification point of view, all errors can be classified into the following two categories :

(A) Errors which do not affect the Trial Balance or Two-sides Errors
(B) Errors which affect the Trial Balance or One-sided Errors

(A) Errors which do not affect the Trial Balance or Two-sided Errors :- Errors which affect two accounts
simultaneously are called two-sided errors. Such errors may include the following types of errors : (I) Omission to
pass an entry in the books of original records, (II) Wrong recording of a transaction in the books of original
records, (III) Posting to the wrong account, and (IV) Errors of principle.

All these errors are rectified by passing a Journal entry, one account being debited and the other account being
credited. Following rules should be observed while passing entries of rectify the two-sided errors :-

(I) The account showing an excess debit should be credited in the rectifying entry.
(II) The account showing a short debit should be debited in the rectifying entry.
(III) The account showing an excess credit should be debited in the rectifying entry.
(IV) The account showing a short credit should be credited in the rectifying entry.

These four rules as enumerated above can be explained by the examples given below :-

(I) When an account has wrongly been debited in place of another account.

Example : Machinery purchased for Rs. 5,000 has been debited to Purchases A/c.

Solution :- This error affects the two accounts in the following manner :-

Dr. MACHINERY A/C Cr. Dr. PURCHASES A/C Cr.

Short by Rs. 5,000 Excess by Rs. 5,000
(This account should have (This account was debited
been debited) by mistake)

While rectifying this mistake Machinery A/c will be debited because it was not debited earlier and the Purchases
A/c will be credited because it was wrongly debited.

Rectifying entry :-

Machinery A/c Dr. 5,000

To Purchases A/c 5,000
(For purchases of machinery wrongly debited to Purchases A/c)

Second Method :-

(i) Correct entry which should have been passed earlier :-

Machinery A/c Dr. 5,000

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 To Cash A/c 5,000

(ii) Wrong entry which has been actually passed :-

Purchases A/c Dr. 5,000

To Cash A/c 5,000

(iii) By comparing the correct entry and the wrong entry it will be ascertained that Machinery A/c should be
debited and the Purchases A/c should be credited, as it has been wrongly debited earlier.

Rectifying entry which must be passed now.

Machinery A/c Dr. 5,000

To Purchases A/c 5,000

(II) When an account has wrongly been credited in place of another account.

Example : Rs. 3,000 being the sale proceeds of old furniture has been credited to Sales A/c.

Solution :- This error affects the two accounts in the following manner :-

Dr. FURNITURE A/C Cr. Dr. SALES A/C Cr.

Short by Rs. 3,000 Excess by Rs. 3,000
(This account should have (This account was credited
been credited) by mistake)

While rectifying this mistake Sales A/c will be debited because it has been credited by mistake and the Furniture
A/c will be credited because it was not credited earlier.

Rectifying entry :-

Sales A/c Dr. 3,000

To Furniture A/c 3,000
(Sales of old furniture wrongly credited to Sales A/c)

Second Method :-

(i) Correct entry which should have been passed earlier :

Cash A/c Dr. 3,000

To Furniture A/c 3,000

(ii) Wrong entry which has been actually passed :-

Cash A/c Dr. 3,000

To Sales A/c 3,000

(iii) By comparing the correct entry and the wrong entry it will be ascertained that Sales A/c should be debited
because it has been wrongly credited earlier and Furniture account should be credited.

Rectifying entry which must be passed now :-

Sales A/c Dr. 3,000

To Furniture A/c 3,000

(III) When there is a short debit in one account and a short credit in another account.

Example : Goods purchased from Sanjay for Rs. 2,000 was entered in Purchase Book as Rs. 200 only.

Solution :- Effect of Error :

Dr. PURCHASES A/C Cr. Dr. SANJAY A/C Cr.

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 Short by Rs. 1,800 Short by Rs. 1,800

While rectifying this mistake Purchases A/c will be debited by Rs. 1,800 because there will be a short debit in
Purchases A/c and Sanjay’s A/c will be credited because it has been credited by a lesser amount.

Rectifying entry :-

Purchases A/c Dr. 1,800

To Sanjay 1,800
(Goods purchased from Sanjay for Rs. 2,000 wrongly entered as Rs. 200)

Second Method :-

(i) Correct entry which should have been passed earlier :

Purchases A/c Dr. 2,000

To Sanjay 2,000

(ii) Entry which has been passed from the wrong amount :-

Purchases A/c Dr. 200

To Sanjay 200

(iii) Rectifying entry which must be passed now :-

Purchases A/c Dr. 1,800

To Sanjay 1,800

(IV) When there is an excess debit in one account and an excess credit in another account.

Example : Goods sold to Mohan for Rs. 380 on credit was recorded in Sales Book as Rs. 830.

Solution :- Effect of Error :

Dr. MOHAN Cr. Dr. SALES A/C Cr.

Excess by Rs. 450 Excess by Rs. 450
(Rs. 830 – Rs. 380) (Rs. 830 – Rs. 380)

While rectifying this mistake Mohan will be credited by Rs. 450 because it has been ‘excess debited’ by a similar
amount and Sales A/c will be debited by Rs. 450 because it has been ‘excess credited’ by a similar amount.

Rectifying entry :-

Sales A/c Dr. 450

To Mohan 450
(Sales to Mohan for Rs. 380 wrongly entered as Rs. 830)

Second Method :-

(i) Correct entry which should have been passed earlier :

Mohan Dr. 380

To Sales A/c 380

(ii) Entry which has been passed from the wrong amount :-

Mohan Dr. 830

To Sales A/c 830

(iii) Rectifying entry which must be passed now :-

Sales A/c Dr. 450

To Mohan 450

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 Notes :- (1) Students can adopt any of the two methods discussed as above, because rectifying entry in both the
methods will be similar.

(2) In the examination the students should pass only the rectifying entries.

(B) Errors which affect the Trial Balance or One Sided Errors :- These errors affect only one account. If, for
example, a sum of Rs. 2,500 given to Ajay is correctly recorded in the Cash Book but omitted to be posted to the
Debit of Ajay, the error will be termed as one sided error because the error exists in the account of Ajay only.

Such type of errors occur in the following cases :-

(i) When a subsidiary book is undercast (totaled less) or Overcast (totaled in excess).
(ii) When the posting to an account is altogether omitted.
(iii) When the posting is made on the wrong side of an account.
(iv) When the posting of a wrong amount is done.

Rectification of such errors depends on the stage at which the errors are located :-

(A) When the errors are located and rectified before the closing of accounts (i.e., before preparing the Trial
Balance and before opening of Suspense A/c).

(B) When the errors are located and rectified after the closing of accounts (i.e., after preparing the Trial Balance
and after opening of Suspense A/c).

(A) When the errors are located and rectified before the closing of account (i.e., before preparing the Trial
Balance and before opening of Suspends A/c) : Rectification of errors at this stage does not required
rectification entries. Only the amount is written on the debit or credit side of the account which is affected by the
error. For example, the total of the Purchase Book for the month of October is undercast (totaled less) by Rs.
1,000. To rectify this error, the amount of Rs. 1,000 will be put on the debit side of the purchase account by
writing the words ‘To undercasting of Purchase Book for the month of October’.

(B) When the errors are located and rectified after the closing of accounts (i.e. after preparing the Trial
Balance and dafter opening of Suspends A/c) :- When one sided errors are located after the preparation of trial
balance, rectifications are carried out by passing journal entries. As only one account is to be debited or credited
for the rectification of one sided errors, suspense account is used to complete the double entry.

SUSPENSE ACCOUNT
Meaning and utility :- When inspite of the best efforts, the Trial Balance does not tally, the difference is put to a
newly opened account named ‘Suspense Account’ and the Trial Balance is thus made to tally. This is done to avoid
the delay in the preparation of Final Accounts.

In case, the debit side of the Trial Balance exceeds the credit side, the difference is put on the credit side of the trial
balance. In this case ‘Suspense Account’ will show a credit balance. Likewise, if the credit side of the Trial Balance
exceeds the debit side, the difference is put on the debit side of the trial balance. In this case ‘Suspense Account’ will
show a debit balance.

Disposal of Suspense Account :- Suspense Account is an imaginary account used as temporary measure only for the
purpose of reconciling a Trial Balance. Later, as and when the errors affecting the suspense account are located,
rectification entries are passed with the help of suspense account. Thus when all the errors are located and rectified,
the suspense account will automatically stand closed, i.e., it will not show any balance. But if Suspense Account still
shows a balance, it will indicate that certain errors are still to be discovered and rectified. In such cases, if the
suspense account shows a debit balance, it is taken to the balance sheet on the assets side and on the contrary, if it
shows a credit balance it is taken to the balance sheet on the assets side and on the contrary, if it shows a credit
balance is it taken to the balance sheet on the liabilities side.

Following points should be noted while passing rectification entries with the help of suspense account :

(1) Suspense account is used to rectify only those errors which affect the Trial Balance.

(2) I. If the account which is to be rectified is debited in the rectifying entry, suspense account will be credited to
complete the double entry.

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 II. If the account which is to be rectified is credited in the rectifying entry, suspense account will be debited to
complete the double entry.

Guiding Principles of Rectification of Errors

1. If error relates to posting from the Cash Book : The error will be related to the individual account in which
posting was to be made not to Cash/Bank Account.

2. If error relates to posting from other Subsidiary Books : The error will be related to the Individual Personal
Account only and not the Purchase A/c, Sales A/c etc. in which total of a particular subsidiary book is posted.

Example : Goods purchased from X for Rs. 20,000 posted as Rs. 2,000.
It means that X’s A/c has been credited with Rs. 2,000 and Purchases A/c was not affected.

3. If error relates to omission of posting of a transaction recorded through Journal : Assume that the
transaction has not been posted to any of the Accounts.

Example : Machinery purchased on credit from X for Rs. 50,000 was not posted.
It means that the posting has not been done to any of the accounts i.e. Machinery A/c and X’s A/c.

4. If error is related to casting (totaling) of subsidiary books : It will affect only that account where the total of
the Subsidiary Book is posted and will not affect the individual Personal Account.

Example : Sales Book was overcast by Rs. 10,000.

It means that there is excess credit of Rs. 10,000 in Sales Account.

5. If error is committed in the books of original entry, assume that all postings have been done accordingly.

Example : Purchased goods on credit from X for Rs. 20,000 recorded as Rs. 2,000.
It means that Purchases A/c has been debited and X’s A/c has been credited with Rs. 2,000.

6. If error is at the posting stage, assume that recording in subsidiary book has been done correctly.

Example : Purchased goods on credit from X for Rs. 20,000 posted as Rs. 2,000.
It means that credit purchase is correctly recorded in Purchase Book but while posting X’s A/c has been credited
with Rs. 2,000.

7. If error relates to posting to a wrong account (without mentioning side and amount of posting) then assume that
posting has been done on correct side with correct amount.

8. If error relates to posting with wrong amount (without mentioning side of posting and account) then assume that
posting has been done to a correct account and on correct side.

9. If error relates to posting on wrong side (without mentioning amount and account) then assume that posting has
been done to a correct account with correct amount.

10. Unless stated otherwise, it is presumed that errors are rectified before the preparation of financial statements.

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 Subsidiary Books
In the previous chapter the method of recording transactions in a cash book was discussed. As discussed, only the
cash transactions are recorded in the cash book whereas non-cash transactions are recorded in other special purpose
subsidiary books, which are as follows : -

1. Purchase Book
2. Sales Book
3. Purchase Return Book
4. Sales Return Book
5. Bills Receivable Book
6. Bills Payable Book
7. Journal Proper

It is not necessary for every business to maintain all the above mentioned special purpose subsidiary books but any of
the above may be kept depending upon the need of the business.

1. Purchase Book or Purchase Journal

All credit purchases of goods are recorded in the purchase book. ‘Goods’ here mean only those things in which the
firm is dealing. In other words, these are the articles which are purchased for resale. If, for example, a firm dealing in
cloth purchases cloth, it will be treated as purchase of goods and will be recorded in the Purchase Book. But if the
same firm purchases furniture, it will be treated as purchase of an ‘Asset’ and will not be recorded in purchase book.
Purchase book is also known as ‘Invoice Book’ or ‘Purchase Day Book’.

Following transactions are not recorded in the purchase book :-

(1) Cash Purchases :- Cash purchases are not recorded in this book since these will be recorded in the cash book.

(2) Purchase of Asset :- Only credit purchase of goods are recorded in this book. Purchase of assets, such as
Machinery, Furniture, Typewriters etc. are not recorded in the purchase book. Instead these are recorded in the
Journal proper if purchased on credit or in the cash book if purchased for cash.

Recording to Transactions :- The source documents on the basis of which the transactions are recorded in the
purchase book are invoices or bills received by the firm from the suppliers of the goods. An invoice contains the
quantity of the goods, rate, amount, trade discount etc.

Trade Discount :- The amount of purchase to be recorded in the purchase book is always arrived at after deducting
trade discount. If, for example, goods of the list price of Rs. 10,000 are purchased at 20% trade discount, only Rs.
8,000 will be recorded in the purchase book.

Format of Purchase Book

Date Particulars (Name of the Supplier) Invoice L.F. Details Total Amount
(Account to be Credited) No.
(1) (2) (3) (4) (5) (6)
Rs. Rs.

Explanation of the columns of the purchase book :-

(1) Date :- The date of purchase of goods on credit is recorded in this column.

(2) Particulars :- The name of the person or firm from whom the goods are purchased is written in this column. Also
it contains the description of the goods purchased, its quantity, rate, gross amount, trade discount etc.

(3) Invoice Number :- The number of the invoice or bill on the basis of which the transaction is being recorded in
the purchase book is mentioned in this column.

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 (4) Ledger Folio or L.F. :- Page number of the ledger where the transaction is posted is recorded in this column.

(5) Details :- This column is used to write the individual amount of different items purchased from a particular
supplier. This column is also used to deduct the amount of trade discount and for adding the amount of Input
CGST, Input SGST and Input IGST.

(6) Total Amount :- Total amount of each transaction is shown in this column and the amount of each transaction
is posted to the credit of the Supplier A/c in the Ledger.

2. Sales Book or Sales Journal

All credit sales of goods are recorded in the sale book. Cash sales will be recorded in the cash book and not in the
sales book. Similarly, credit sales of things other than the goods in which the firm deals in, are not entered in the Sale
Book, they are entered in the Journal. Sales Book is also called Sales Day Book. Following transactions are not
recorded in the Sales Book :-

(1) Cash Sales :- It does not record cash sales of goods, as the cash sales are recorded in the cash book.

(2) Sale of Asset :- Only the credit sale of goods is recorded in this book. If, instead of goods, some asset such as
Machinery, Furniture, Typewriter etc. is sold on Credit or for Cash, it will not be recorded in the Sale Book.
Credit sale of an asset will be recorded in Journal proper, whereas cash sale of the asset will be recorded in cash
book.

Format of Sales Book

Date Particulars (Name of the Customer) Invoice L.F. Details Total Amount
(Account to be Debited) No.
Rs. Rs.

Explanation of the Columns of the Sales book :-

(1) Date :- The date of sale of goods on credit is recorded in this column.

(2) Particulars :- In addition to the name of the customer, this column also contains the description of goods sold,
its quantity, rate, gross amount, trade discount etc.

(3) Details : This column is used to write the individual items sold less trade discount. It is also used to add the
amount of Output CGST, Output SGST and Output IGST.

(4) Total Amount :- Total amount of each transaction is shown in this column and the amount of each transaction
is posted to the debit of the Customer’s A/c in the Ledger.

3. Purchase Return Book or Purchase Return Journal

This book is used to record the return of such goods as were purchased on credit basis. The book is also known as
Return Outward Book. There may be various reasons for returning the goods to the suppliers :-

(1) When the goods delivered are not according to the sample.
(2) When the goods are not according to the order or the quality of the goods supplied is inferior.
(3) When the goods are defective or they have been damaged in transit.
(4) When the price charged in the invoice is in excess of the agreed price.
(5) When the goods have not been delivered in time.

When the goods are returned, a debit note is prepared and is sent to the supplier with the returned goods. A debit
note contains the name of the party to whom the goods have been returned, details of the goods returned and the
reason for returning the goods. Each debit note is serially numbered, dated and is prepared in duplicate. Original
copy is sent to the supplier, informing him the amount for which his account has been debited on account of return of

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 goods. It is called a debit note because the party’s account is debited with the amount written in this note. The party
to whom the goods have been returned also prepares and sends a note which is called the credit note.

Duplicate copy of the debit note becomes a source document, on the basis of which the entries are recorded in the
purchase return book.

A debit note is also sent when a sales invoice is under charged by mistake or a sales invoice is undercast or some
particular goods are omitted to be recorded in the sales invoice.

Format of Purchase Return Book

Date Particulars (Name of the Supplier) Debit L.F. Details Total Amount
(Account to be Debited) Note No.
(1) (2) (3) (4) (5) (6)
Rs. Rs.

4. Sales Return Book or Sales Return Journal

This book is used to record the return of such goods as were sold to the customers on credit basis. The book is also
known as Return Inwards Book. When the goods are received back, a credit note is prepared in duplicate and the
original copy of the same is sent to the party from whom goods were received. A credit note contains details relating to
the name of the customer, details of the goods received back and the amount of return. Each credit note is serially
numbered and dated. This note is called a credit note because the party’s account, from whom the goods are received
back, is credited with the amount written in the note. The same note is called a debit note by the party who is
returning the goods because that party will use this note for debiting the account of the party to whom it has returned
the goods.

Duplicate copy of the credit note sent to the party becomes a source document, on the basis of which the entries are
recorded in the sales return book.

A Credit note is also sent when a sales invoice is over charged by mistake or a sales invoice is overcast or some special
discount is allowed to the customer because of defective goods.

Format of Sales Return Book

Date Particulars (Name of the Customer) Credit L.F. Details Total Amount
(Account to be Credited) Note No.
(1) (2) (3) (4) (5) (6)
Rs. Rs.

5. Journal Proper or General Journal

After the sub-division of journal into various subsidiary books, journal remains only a residuary book in which only
those transactions are recorded which cannot be recorded in any other subsidiary book. In such a case journal is
called journal proper. For example, if machinery is purchased on credit, it can neither be recorded in cash book nor in
purchase book. The reason is that cash book records only the cash transactions and the purchase book records only
credit purchase of goods and not the purchase of an asset. The purchase of machinery which is an asset will thus be
recorded in the journal proper. The following types of transactions are recorded in journal proper :

(1) Opening Entry :- This entry is passed to bring the closing balances of various assets, liabilities and capital
appearing in the Balance Sheet of previous accounting period, to the books of current accounting period.

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 (2) Closing Entries :- At the end of the accounting period, a Trading and Profit and Loss Account has to be prepared
to ascertain the net profit. For this purpose, the nominal accounts have to be closed by transferring their
balances to this account. The entries passed for this purpose are called closing entries.

(3) Transfer Entries :- Transfer entries are passed for transferring an amount or the balance of one account to
another such as transferring the balance of Drawings A/c to Capital A/c.

(4) Adjustment Entries :- At the time of preparation of final accounts, entries are needed to record certain
unrecorded items such as closing stock, outstanding expenses, prepaid expenses, depreciation on fixed assets,
interest on capital etc. Entries for these are called adjustment entries.

(5) Rectifying Entries :- These entries are passed to rectify the errors while journalising, posting, totaling,
balancing etc.

(6) Miscellaneous Entries :- In addition to the above, the following entries will also be passed in the journal proper :

(i) Purchase of an asset on credit;

(ii) Sale of an asset on credit;
(iii) Writing off bad debts;
(iv) Discount allowed and discount received;
(v) Bills receivable received;
(vi) Bills Payable issued
(vii) Endorsement of Bill Receivable to a creditor;
(viii) Dishonour of Bills Receivables (not discounted with the bank);
(ix) Cancellation of Bills Payable;
(x) Goods taken by the proprietor for personal use;
(xi) Goods given away as charity or free sample;
(xii) Abnormal loss of stock or other assets by fire, accident, theft etc.

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 CASH BOOK
Meaning and Importance :- This book is used to record all transactions relating to cash receipts and cash payments.
The number of cash transactions is quite large in every business and it is quite unpracticable and inconvenient to
record all cash transactions in the journal. It is, therefore, necessary to maintain a separate book for cash
transactions. This book enables a businessman to know the balance of cash in hand and at bank at any point of time.
It also gives information about the daily receipts, payments and the closing cash balance at the end of each day.
Hence, this is a very popular book and is maintained by all the organisations – big or small.

Cash Book is a Journalised Ledger

Sometimes a question arises whether Cash book is a journal or ledger ? It is a journal since the transactions are
recorded in it for the first time from the source documents and from there these are posted to the respective accounts
in the ledger. The Cash book is also a ledger in the sense that it serves the purpose of a Cash account also. When a
Cash book is prepared, no separate Cash account is opened in the ledger. As such, the Cash book is a journal as well
as a ledger and hence it may be called ‘journalised ledger’.

Similarities of Cash Book with Journal

1. Just like a journal, transactions in the Cash book are recorded for the first time from source documents.

2. Just like a journal, transactions in the Cash book are recorded datewise, i.e., in a chronological order, as and
when they take place.

3. Just like a journal, transactions from Cash book are also posted to the relevant accounts (except Cash account) in
the ledger.

4. Just like a journal, a Cash book also contains a ledger Folio Column.

Similarities of Cash Book with Ledger

1. Form of Cash book closely resembles to a ledger account. It has two equally divided sides having identical
columns. The left side (receipts side) is the debit side and the right side (payment side) is the credit side.

2. Cash book itself serves as a Cash account also and as such when a Cash book is maintained, Cash account is not
opened in the Ledger. The Cash book, hence, is a part of ledger also.

3. Just like a ledger account, the words ‘To’ and ‘By’ are used in a Cash Book also.

4. It is balanced just like a ledger account.

Advantages of Maintaining a Cash Book

1. Cash book is a journal as well as a ledger. When a Cash book is maintained, no separate ‘Cash Account’ is opened
in the ledger. Hence, it prevents duplication of work in recording Cash transactions in the journal and then
posting them into the ledger.

2. Since Cash Account is not opened in the ledger, it prevents the size of the ledger from becoming two voluminous.

3. Both Cash and Bank transactions can be entered in the Cash book.

4. It enables a businessman to know the balance of Cash in hand and at bank at any point of time without waiting
for posting from the journal.

5. It gives information about daily receipts, payments and the closing cash and bank balance at the end of each day.

6. The Cash balance, as shown in Cash Book, must be equal to the actual (physical) Cash in hand. By a regular
verification of actual Cash in hand with the balance shown by the Cash book the possibility of defalcation is
reduced to the minimum.

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 Types of Cash Book
Cash book may be of four types :-
(1) Single Column Cash Book or One Column Cash Book : for recording cash transactions only.
(2) Double Column Cash Book having
(i) Cash and Discount Columns; or
(ii) Bank and Discount Columns; or
(iii) Cash and Bank Columns.

(3) Triple Column Cash Book.

(4) Petty Cash Book.

Each business uses any one type of Cash book mentioned at serial no. (1), (2) or (3). It is called main Cash book. The
type used by any business will depend upon the nature of business and its requirements. In addition to the main
Cash book, firms also usually maintain a Petty Cash Book for recording petty expenses but it is maintained only on
memorandum basis.

(1) Single Column Cash Book

Its format is similar to an account, with one amount column on each side. The left hand side known as ‘Debit’ records
receipts of cash and the right hand side known as ‘Credit’ records payments. Its format is shown below :-

Form of Single Column Cash Book

Dr. Cr.

Date Particulars V.No. L.F. Amount Date Particulars V.No. L.F. Amount
(Receipts) Rs. (Payments) Rs.
(1) (2) (3) (4) (5) (1) (2) (3) (4) (5)
To By

It is clear from the above format that the columns on both sides of the cash book are similar to each other. These are
as follows :-

(1) Date :- Day, month and the year of the transaction is recorded in this column.

(2) Particulars :- The name of the account in respect of which cash has been received or payment has been made is
recorded in this column.

(3) Voucher Number :- The document supporting a transaction is called Voucher. The serial number of the voucher
certifying the receipt or payment is written in this column.

(4) Ledger Folio or L.F. :- This column records the page number of the ledger where the posting of this amount has
been made.

(5) Amount :- The amounts received are recorded on the Debit side and the amounts paid are recorded on the Credit
side.

Following points should be remembered while preparing a cash book :-

(1) Cash book itself is a cash account also. As such, it is a real account and the rules of debit and credit are the same
as that of a real account, i.e., “Debit What Comes In and Credit What Goes Out”.

Thus Cash received is recorded on the debit side of the cash book and cash paid is recorded on the credit side.

(2) If opening balance of cash is given, it will be written on the debit side of the cash book as “To Balance b/d”.

(3) Single Column Cash Book makes no record of (a) Cheques received and given and (b) Cash discount allowed and
received.

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 Note
Discount allowed, Discount received and cancellation of discount received or discount allowed (in case of dishonour
of cheque) will be recorded through Journal Proper.

(4) When a Cash book is maintained, Cash Account is not opened in the Ledger.

(5) When an entry is recorded in Cash Book, a corresponding entry is recorded in ledger. For example, if Rs.
2,000 are received from Gopal, the receipt (or debit) entry is passed in the Cash Book and Gopal’s Account is
credited in ledger.

Balancing of Cash Book and Carry Forward :- Cash book may be balanced daily, weekly or monthly depending on
the need of the business. Normally, it is balanced daily in order to tally the balance shown by the cash book with that
of the actual amount of cash in the cash box.

Following points should be taken into consideration while balancing the cash book :-

(1) The receipts (Debit) column will always be bigger than the payments (Credit) column.

(2) The difference will be written on the credit side as “By Balance c/d”. This will make the total of the two sides
equal and the total will be written in the two columns opposite one another.

(3) The closing balance becomes opening balance of cash in hand at the beginning of the next period and is written
on the debit side as “To Balance b/d”.

Cash Book always shows a Debit Balance

It should be noted that the total of the debit side of the cash book always exceeds the credit side. It is because a
businessman cannot pay more cash than what he has got. If the money is paid by borrowing from someone, it will
first be recorded on the receipts side and only then it will be shown on the payment side. Hence, the cash book always
shows a Debit Balance or at the most nil balance but can never show a credit balance.

(2) Double Column Cash Book or Two-Column Cash Book

(Cash Book with Cash and Bank Column)
It is a Cash Book with two column on each side; one column for recording cash transactions and the other column for
recording bank transactions.

The advantage of maintaining such a type of Cash Book is that Cash Book is that Cash Columns and Bank Columns
represent Cash A/c and Bank A/c respectively. Hence, it is not necessary to open Cash A/c and Bank A/c in the
Ledger.

Following rules are observed for preparing such a book :-

(1) A Bank Account is a Personal Account and as such that rule applicable to a personal account i.e. ‘Debit the
receiver and credit the giver’ should be followed while recording transactions in the bank column of the Cash
Book. Thus, for cash deposited into bank – the bank would be receiver and hence would be debited in the bank
column of the Cash Book. Similarly, for cash withdrawn from the bank or for cheque issued – the bank would be
giver and hence would be credited in the bank column of the Cash Book.

(2) Opening Balance :- As the cash column would always show a debit balance, it will be written as ‘To Balance b/d’
on the debit side. But the opening balance of bank column may be given as Debit or Credit. As such, if the debit
balance of bank is given in the question, it will be written as ‘To Balance b/d’ on the debit side and on the
contrary, if the credit balance of bank is given, it will be written as ‘By Balance b/d’ on the credit side. If overdraft
balance is given, it will be treated as credit balance of bank.

(3) Contra Entries :- When cash is deposited into the bank or when cash is withdrawn from the bank for use in the
office, each such transaction affects both ‘Cash Column’ as well as ‘Bank Column’ and the transaction is
therefore, recorded on both sides of the cash book. Such entries, the double entry of which is complete in the
Cash Book itself, are called “Contra entries” :-

(i) Cash deposited into Bank :- When cash is deposited into the bank, it increases the bank balance and reduces
the cash balance. Hence, it affects the Cash Column as well as the Bank Column. As such the same amount is

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 recorded on the debit side as well as on the credit side. On the Dr. side ‘To Cash A/c’ is written and the amount is
recorded in the bank column. On the Cr. side ‘By Bank A/c’ is written and the amount is recorded in the Cash
Column.

Debit Bank A/c (As bank is receiving the Cash, i.e., Debit the receiver)
Credit Cash A/c (As Cash is going out)

(ii) Cash withdrawn from Bank for office use :- In this case, the cash balance is increased and the bank balance
is reduced. On the Dr. side ‘To Bank A/c’ is written and the amount is recorded in Cash Column. On the Cr. side
‘By Cash A/c’ is written and the amount is recorded in Bank Column.

Debit Cash A/c (As cash is coming in)

Credit Bank A/c (As bank is the giver, i.e., credit the giver)

(4) Receipt of Cheque and Bank draft :-

(A) Cheques received from customers and deposited into bank the same day :- These are entered in Bank
Column on the debit side.

(B) Cheques received from customers but not deposited into bank the same day :-

Cheques not deposited into the bank on the same day are first recorded in the books of accounts by means of a
Journal entry as follows :
Cheques in Hand A/c Dr.
To Banerjee (say)
(Cheque received from Banerjee not yet deposited into bank)

In the question, sometimes there is no information as to the deposit date of the cheque. In such a case, it will
be assumed that the cheque has been deposited into the bank on the same day.

(5) Payment by Cheque :- As soon as we issue a cheque to someone, it will be immediately recorded on the credit
side in Bank Column so that we may be acquainted of the True balance at the bank.

(6) Dishonour of a Cheque :- If a cheque, received from a customer and deposited into Bank for collection is
dishonoured, an entry will be made on the credit side of the Cash Book by entering the amount of the
dishonoured cheque in the bank column. In particulars column, the name of the customer will be entered. For
example, a cheque Rs. 20,000 received from Ram Kumar is dishonoured, it will be recorded on the credit side as,
“By Ram Kumar” and the amount will be entered in Bank Column.

(7) Cash Discount :- In a Cash Book having Cash and Bank Columns, the amount of discount is recorded in
journal proper. For example, Rs. 4,800 are received from Yuvraj Singh in full settlement of his account of Rs.
5,000. In such a case Rs. 4,800 will be recorded in Cash Book and the discount of Rs. 200 will be recorded in
Journal as follows :

Discount Allowed A/c Dr. 200

To Yuvraj Singh 200
(Discount allowed to Yuvraj Singh in full settlement)

Similarly discount received by us is also recorded in Journal.

Balancing :-
(1) Debit side of cash column will always exceed the credit column and as such the balance will be shown on the
credit side by writing the words, ‘By Balance c/d’.

(2) Usually the bank columns are balanced just like the cash columns, However, the bank column may show either a
debit balance or a credit balance. If it shows a credit balance, it is called overdraft. Overdraft is a situation when
cash withdrawn from the bank exceeds the amount deposited into the bank. In such a case, the total of the credit
side of bank column will be bigger than the total of the debit side. The difference will be written on the debit side
as “To Balance c/d”. At the beginning of the next month the balance will be shown as “By Balance b/d”.

Some important transactions :-

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 (1) Amount withdrawn for personal use :- Amount withdrawn from bank for the personal use of the proprietor is
not a contra transaction. It will affect only the bank column of the cash book. As it reduces the bank balance, it
will be recorded on the credit side of cash book as ‘By Drawings A/c’ and the amount will be written in the bank
column.

(2) Endorsement of a Cheque :- Sometimes, a cheque received from a customer is not deposited into bank, but is
may be given to some other person, i.e., endorsed. The receipt as well as endorsement of Cheque is recorded
through the Journal and not Cash Book because receipt and endorsement of Cheque neither affects Cash nor
Bank account. For example, a Cheque for Rs. 20,000 is received from Arun on 2nd March, 2017 and it is endorsed
to Vishal on 5th March, 2017. In this case we shall pass two Journal entries, one for receiving Cheque from Arun
and another for endorsing Cheque to Vishal. The Journal entries shall be as follows :

Date Particulars L.F. Amount Dr. Amount Cr.

2017 Rs. Rs.
March 2 Cheques in Hand A/c Dr. 20,000
To Arun 20,000
(Cheque received from Arun not deposited into bank)

March 5 Vishal Dr. 20,000

To Cheques in Hand A/c 20,000
(Cheque received from Arun endorsed in favour of
Vishal)

(3) Bank Charges :- Bank usually charges some amount for the services rendered to its customers. Such charges will
be recorded on the credit side as ‘By Bank Charges’ and the amount will be recorded in the bank column.

(4) Bank Charges on dishonoured cheques :- Expenses charged by the bank on dishonoured cheques will be added
into the amount of dishonoured cheque itself.

(5) Amount directly deposited by a customer into our Bank A/c :- When the information of such a deposit is
received by the trader, it will be recorded on the debit side of the cash book and the amount will be entered in the
bank column.

(6) (I) Interest allowed by bank :- Interest allowed (credited) by the bank increases the balance at bank. The entry
for such interest is, therefore, recorded on the debit side in bank column.

(II) Interest charged by bank :- When interest is charged (debited) by the bank on the amount of bank overdraft,
the entry is recorded on the credit side in bank column.

(3) Cash Book with discount and Bank Columns

or Three Column Cash Book
In this type of Cash Book, there are three columns of amount i.e., Cash. Discount and Bank. It is also prepared in the
same way as we prepare simple and double column cash books. The additional point in this regard is ‘Bank Column’.
Bank column of the three column cash book at debit side records deposits of Cash and Cheques into the bank and
interest credited by the bank. On the other hand, bank column at the credit side of the three column cash book
records cash withdrawn from the bank, payments by cheques, bank charges or collection charges, interest charged by
the bank or interest on overdraft etc. A specimen format of three column cash book is given as under :

Ruling of Three Column Cash Book

Cash Book of ……
Dr. Cr.

Date Particulars L.F. Dis. Cash Bank Date Particulars L.F. Dis. Cash Bank
(Receipts) Alld. Rs. Rs. (Payments) Reced. Rs. Rs.
Rs. Rs.

To By

For writing up the three column cash book, the following points should be kept in mind :

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 (1) While commencing a new business. “To Capital Account” is written in particulars column on debit side and if cash
is introduced, the amount is written in cash column and if amount is directly deposited into the bank, it is written
in the bank column. If a new cash book is being started for an existing business, the opening balances are written
as “To Balance b/d”. If there is Bank overdraft, it will be written as “By Balance b/d and amount in bank
column.”

(2) All receipts are written on the receipts side, cash in the cash column and cheques in the bank column. If cheques
received are not deposited on the same day into Bank, they are to be shown in the cash column on the receipt of
the cheque. If any discount is allowed to the party paying the amount, the discount is entered in the discount
column (debit side). In particulars column, the name of that account is written in respect of which the payment
has been received.

(3) All payments are written on the payment side, cash payments in the cash column and payments by cheques in
the bank column. if any discount has been received from the party receiving the payment, it is entered in the
discount column (credit side). In the particulars column, the name of that account is written, in respect of which
the payment has been made.

(4) If cash is withdrawn form bank the amount is entered in the bank column on the payment side and also in the
cash column on the receipts side. Similarly, if cash is deposited into bank, the amount is recorded in the bank
column on the receipts side and in cash column on the payments side. These entries are known as “Contra
Entries”. Against such entries, on both sides of the cash book, the letter “C” must be written in the L.F. column,
to indicate that these are contra entries and for which not further ledger posting is required. In this regard, it is
also to be noted that if initially cheques received are entered in the cash column and later on deposited into bank,
the entries are shown as if cash is received or deposited into bank.

(5) If a cheque/cheques deposited into the bank is/are dishonoured, i.e., the bank is unable to collect the amount
against them, it is entered in the bank column on the credit side with the name of the concerned party in the
particular column.

(6) If any cheque issued by the firm is not paid by the bank, it should be entered in the bank column on the debit
side with the name of the concerned party in particulars column.

(7) Sometimes, a cheque received by the firm may be endorsed to some other party. On receipt side, it must be
entered in the bank column and for endorsement, it will be entered in the bank column on the payment side
(i.e., credit side).

(8) Cash account and Bank account are not opened in the ledger since the cash column serves the purpose of a cash
account and the bank column serves the purpose of a bank account.

(9) Discount Allowed Account and Discount Received Account are opened in the ledger in which postings are made
only for the totals and not for the individual transactions since the cash book does not serve the purpose of
discount account.

(10) All contra entries i.e., entries marked “C” should be ignored at the time of posting from cash book to the ledger
because both the aspect (i.e., debt and credit) are already recorded in the cash book (i.e., in the cash column and
in the bank column).

Balancing of the Three Column Cash Book : The discount columns of the Three Column Cash Book are totaled
only, but not balanced. The cash columns are balanced exactly in the same manner as we do in the simple cash book.
The process is similar for balancing the bank column also. It is possible, however, that the bank may allow the firm to
withdraw more than the amount deposited i.e., to have an overdraft, in such a case, the total of the bank column on
the credit side is larger than the one on the debit side. The difference is written on the debit side as “To balance c/d”.
Then the totals are written on the two sides opposite of one another; the balance is then entered on the credit side as
“By Balance b/d”. However, the usual case is that deposit into the bank will exceed the withdrawals or payments out
of the bank. Then the bank columns are also balanced just like the cash columns.

Petty Cash Book :

In every organization, a large number of small payments such as for conveyance, bus, taxi, fares, postage and
telegram, cartage, printing and stationary, staff welfare and entertainment and other miscellaneous expenses are

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 incurred. These are generally repetitive in nature. If all these payments are entered in the main cash book, it will
become very bulky. To avoid this, large scale organizations normally, appoint one person who makes all small
payments and records them in his cash book, which is called petty cash book. The person dealing with petty cash
book is called the petty cashier. The person dealing with these petty expenses i.e., petty cashier should have been
provided certain amount in cash so that he can make such payments immediately. At intervals, (say, week, fortnight
of month), the petty cashier produces the vouchers before the main cashier. The main cashier checks the vouchers
and hands over the necessary cash to the petty cashier again.

Imprest System of Petty Cash : The petty cashier works on the best system of petty cash which is known as the
Imprest System. The amount given to the petty cashier in advance is known as ‘Imprest’ money. The word ‘Imprest’
means payment in advance. In this system, in the beginning, a fixed sum of money is given to the petty cashier who
makes payment out of it. At the end of the week or fortnight or months, the vouchers are checked and an amount
equal to the amount spent is again given to the petty cashier. Thus, the next period is again begins with the fixed sum
of money.

The petty cash book may or may not be maintained on ‘imprest system’. Under both the system (i.e., Imprest and
Non-imprest), the petty cashier submits the petty cash book to the Head cashier, who makes the reimbursement of
the amount spent by the petty cashier but under Non-imprest system, the head cashier may handover the cash to the
petty cashier equal to/more than/less than the amount spent.

Merits – The advantages of the imprest system are as follows :

(i) It saves the time of the chief cashier.

(ii) Petty cashier is not allowed to keep idle cash with him if the imprest is found to be more than adequate, its
amount will be immediately reduced. This reduces the chances of misuse of cash by the petty cashier.

(iii) As the sum of imprest is small, it does not provoke the person in charge of it or others in the office of
misappropriate it.

(iv) The record of petty cash is checked by the cashier, periodically, so that a mistake if committed is soon rectified.

(v) It enables a great saving to be effected in the posting of small items to the ledger accounts.

(vi) The system trains young staff to handle money responsibilities.

Analytical Petty Cash Book : Normally, the petty cashier is asked to analyse the petty cash payments; amount
column of petty cash book is analysed in such a manner so that it may be known clearly, how the money has been
spent. Such type of petty cash books are analytical petty cash books. Its form may be designed accordingly to the
requirements of the business. However, the simples format of the petty cash book is illustrated as under :

Format of Petty Cash Book

Amt. Date Voucher Particulars Total Conveyance Cartage Stationery Post & Misc. Remarks
Received No. No. Amt. Tele. Exps.
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Thus, the petty cash book generally has a number of columns for the amount on the payment side beside the first
total amount column. Each of the other amount columns is allotted for items of specific payments which are most
common one. Last amount column is designated as ‘Miscelianeous’ followed by a ‘Remarks’ Column. In the
miscellaneous columns, such payments are recorded for which a separate column does not exist and in the remarks
column, the nature of payment is recorded. At the end of the period, all amount columns are totaled which shows the
total amount spent and to be reimbursed. On the receipt side, there is only one amount column. Columns for the date
voucher number and particulars are common for both receipts and payments.

Balancing Petty Cash Book : At the end of the period i.e. week or month the total of the total column, individual
expenses columns and sundries columns and obtained. It should be ascertained that the total of the petty expenses
column and sundries columns must be equal to the total of total column. The column is compared with the total of
receipts column and balance is obtained. The closing balance is shown as ‘By Balance c/d’. The Closing Balance is
carried forward to the next week or month. It shown as ‘To Balance b/d’.

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 Posting from Petty Cash Book : In the ledger, a petty cash account maintained; when an amount is given to the
petty cashier, the petty cash account is debited. Each week or fortnight, the total of the payment made is credited to
this account. The petty cash account will then show the balance in the hand of the cashier; on demand he should be
able to produce it for counting. At the end of the year, the balance is show in the balance sheet as part of cash
balance.

Ofcourse, the payments must be debited to their respective accounts as shown by the petty cash book. For this two
methods may be used :

(i) From the petty cash book the totals of the various columns may be directly debited to the concerned accounts;
or

(ii) A journal entry may first be prepared on the basis of the petty cash book debiting the accounts shown by the
various analysis columns and crediting the total of the payments of the petty cash accounts.

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 LEDGER

Meaning and Definition

Business transactions are first entered in Journal or Special Purpose Subsidiary Books. The next step is to transfer
the entries to respective accounts in Ledger. In other words, all entries recorded in Journal or Special Purpose
Subsidiary Books are classified and in order to ascertain the position of a particular account, all transactions relating
to that particular account are collected at one place in the Ledger. In short, a Ledger is a book which contains all
accounts of the business enterprise whether Personal, Real or Nominal.

According to L.C, Cropper, “The book which contains a classified and permanent record of all the transactions of a
business is called the Ledger.”

According to J.R. Batliboi, “ The Ledger is the chief book of accounts, and it is in this book that all the business
transactions would ultimately find their place under their accounts in a duly classified form.”

Performa of Ledger
Each Ledger account is divided into two equal parts. The left-hand side is known as the debit side and the right-hand
side as the credit side. As an account is in ‘T’ shape, therefore, sometimes it is called ‘T’ account. The format of an
account is as shown below :-

NAME OF ACCOUNT
Dr. Cr.

Date Particulars J.F. Amount Date Particulars J.F. Amount

Rs. Rs.

As shown above, there are four columns on each side of an account :-

(1) Date :- The date of the transaction is recorded in this column.

(2) Particulars :- Each transaction affects two accounts. The name of the other account which is affected by the
transaction is written in this column.

(3) Journal Folio or J.F. :- In this column, the page number of the Journal or Subsidiary Book from which that
particular entry is transferred, is entered.

(4) Amount :- The amount pertaining to this account is entered in this column.

Rules of Posting
Posting is the process of transferring entries from Journal or Subsidiary Books to the Ledger. The following rules
should be observed while posting entries in the Ledger :-

(1) All transactions relating to an account should be entered at one place. In other words, two separate accounts
should not be opened for posting transactions relating to the same account. If there are two customers with
similar names, their accounts should be distinguished by writing their address against their names, say the
Accounts of Anil (of Karol Bagh) and the Account of Anil (of Chandni Chowk).

(2) The word ‘To’ is used before the accounts which appear on the debit side of an account. Similarly, the word ‘By’
is used before the accounts which appear on the credit side of an account.

(3) If an account has been debited in the Journal entry, the posting in the Ledger should also be made on the debit
side of such account. In the Particulars column, the name of the other account which has been credited in the
Journal entry should be written for reference.

(4) If an account has been credited in the Journal entry, the posting in the Ledger should also be made on the credit
side of such account. In the particulars column, the name of the other account which has been debited in the
Journal entry should be written for reference.

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 (5) Similar amount which has been posted on the debit side of an account should also be posted on the credit side
of another account.

(6) It is not necessary to write the word ‘A/c’ after the personal accounts.

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 Final Accounts
Meaning : After the preparation of trial balance the management of a business enterprise is interested in knowing as
to whether is has earned profits or incurred losses and as to what is its financial position at the end of the accounting
period. For this purpose he prepares financial statements which are also known with their traditional name as ‘Final
Accounts’. The term ‘ Financial Statements’ or ‘Final Accounts’ refer to two statements i.e., Income statement and
Position statement. The term Income statement is traditionally known as Trading & Profit & Loss Account and
Position Statement as Balance Sheet. Trading Account shows Gross Profit or Gross Loss; whereas Net Profit or Net
Loss is available from Profit and Loss Account. Similarly the Balance Sheet exhibits the position of Assets and
Liabilities at a certain date.

Preparation of Final Accounts :

The preparation of Final Accounts has been dealt within two separate parts to facilitate a proper understanding of
their methodology :

(A) Final Accounts without adjustments.

(B) Final Accounts with adjustments.

Here, we shall study about ‘Final Accounts without adjustments’. Final Accounts with adjustments are to be studied
in the next chapter.

Stages of Preparation of Final Accounts :

There are three stages of preparing final accounts of a trading concern as under :

(1) Trading Account.

(Manufacturing concerns prepare Manufacturing Account also before Trading Account)
(2) Profit and Loss Account.
(3) Balance Sheet.

Trading Account :
The first step in the preparation of final accounts is the preparation of the Trading and Profit and Loss Account. The
first part of it is Trading Account which is designed to show the gross profit arising or gross loss incurred as a result
of the trading activities of a business. Excess of sales and closing stock over opening stock, purchases and direct
expenses is known as the gross profit. Gross loss is the excess of opening stock, purchases and direct expenses over
sales and closing stock. In other words, it can be presented as under :

Gross Profit = Net Sales – Cost of goods sold

Gross Loss = Cost of goods sold – Net Sales
Net Sales = Sales – (Sales return + Sales tax, if any)
Net Purchases = Purchases – Purchases return
Cost of goods sold = Sales – Gross Profit
or
Cost of goods sold = Opening-stock + Net purchases + Direct expenses – Closing stock

Need or object of Preparing Trading Account :

The main purpose and importance of preparing a trading account may be explained as under :

(1) It provides information about gross profit. The current figure can be compared with earlier ones to find out
reasons for variations. According to this, plan can be made for future growth of the firm.

(2) Comparison of ‘stock in hand’ of the current year with those of the previous years is possible. Reasons for
variations can be ascertained and steps can be taken to adjust things more profitably.

(3) Ratio of gross profit to sales can help the trader to improve his business administration.

(4) Ratio of direct expenses to sales will help the trader to control and rationalize the expenses.

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 (5) Ratio of cost of goods sold to total sale proceeds can help the trader in fixing the prices of his products.

(6) Precautionary measures can be taken to avoid possible losses by analyzing the items of direct expenses.

(7) Ratio of direct expenses to gross profit is calculated and compared with the desired and previous performance
so as to measure the operational efficiency of the firm.

(8) Relationship between purchases and direct expenses is ascertained through trading account which indicates
how far direct expenses are reasonable and adequate.

Performa of the Trading Account

The general proforma of the Trading Account is shown as under :

Trading Account for the year ending………..

Particulars Amount Particulars Amount

To Opening Stock By Sales
To Purchase Cash
Less :- PIR Credit
Less :- Goods used to: Less :- S/R
Charity By closing stock
Drawings
Donation
Loss by fire
Loss by theft
Free sample
To Wages/Wages on Purchase
To Wages and Salaries
To Carriage Inward
To Inward Exp.
To Custom Duty
To Import Duty
To freight/freight on Purchase
To Railway freight
To Brokerage & Commission
To Cartage/Cartage on Purchase
To Royalty on Purchase
To other Direct Exp.
To Gross Profit
(transfer to P & L A/c)

Main Points to be Kept in mind :

(1) Purchases : (i) It includes both cash and credit purchases.

(ii) It includes purchases of only such goods which are purchase d for resale purpose. Purchase of assets such
as motor vans, furniture, plant and machinery are not included in purchases.

(iii) Total purchases are shown in the inner column of trading account and net purchases (after deducting
purchases returns or returns outwards from the total purchases) are shown in the outer column. It is not
correct to show returns outward on the credit side of the trading account.

(iv) If the goods purchased are in transit then it is better to record them by debiting Goods-in-transit account
and crediting the Supplier’s account. The goods-in-transit appears as an asset and supplier’s account as a
liability in the balance sheet. Trading Account remains unaffected by such purchases

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 (v) Goods purchased by the proprietor for his personal use should first recorded as usual purchases and then it
should be recorded as goods withdrawn by the proprietor. Goods withdrawn by the proprietor for his personal
use are deducted from total purchases on the debit side and net purchases are shown in trading account.

(vi) Sometimes, invoices of the goods are received in advance of goods. At such an occasion, since goods have
not been received it is better not to record it at all. Such amount will not be added to purchases account on the
debit side nor it will be added to ‘stock at the end’ on the credit side.

(vii) Goods received on consignment should be kept separate.

(2) Sales : (i) Sales will include sale of goods which are purchased for resale purpose.

(ii) Sale of old furniture, building, car, etc., which are not purchased for sale purpose must not be added to
sales but should be credited to that particular account.

(iii) Both cash and credit sales will be included in it.

(iv) Gross sales will appear in the inner column and net sales (after deducting sales returns or returns inwards)
will be shown in the outer column. It is not correct to show sales returns on the debit side of trading account.

(v) Goods sold on hire-purchase system should be recorded separately.

(vi) Goods sold on consignment should be recorded in consignment account and should not be included in
‘Sales’.

(vii) Goods sold on approval should be recorded separately.

(viii) If goods have been sold towards the end of the accounting period and have been included in sales, care
should be taken that such goods which remain undelivered should not be included in the stock at the end.

(3) Wages, or Wages and Salaries : Wages is a direct expense and is debited to trading account. Wages and
salaries when shown as one account is conventionally treated s direct expense and is charged to trading
account. But salaries and wages is charged to profit and los account on the assumption that the item includes
salaries and wages of the staff in the establishment office.

(4) Dock charges : These charges are levied on ships and their cargo when entering or leaving docks. If dock
charges are paid on goods purchased they are taken to the debit side of trading account.

(5) Duty : This includes customs duty and excise duty. Customs duty is paid on import and export of goods.
Customs duty paid on the purchase of goods is charged to trading account. Excise duty is paid on goods
manufactured and consumed in the country. This is shown on the debit side of trading account.

(6) Freight, carriage and cartage : If these are paid on the purchase of goods, they are debited to the trading
account. Freight, carriage, cartage paid on the purchase of assets are capitalized by debiting the asset account
“Freight in”, “carriage in”, and “cartage in” terms stand for payment made on purchase of goods and are charged
to trading account.

(7) Royalty : It is a payment made to the owner for using his rights or patents. They are productive expenses and
are debited to trading account. Royalty, if based on the sale price of goods sold, it is charged to profit and loss
account.

(8) Gas, electricity, water and fuel (coal, coke, wood, etc.) : They are direct expenses and are taken to trading
account.

(9) Factory expenses : Rent of the factory, insurance of the factory, salary to the works manager, and salary of the
foreman, are direct expenses and are taken to trading account.

(10) Packing material and charges : Packing charges essential to bring goods to a saleable state are treated as
direct expenses to be charged to trading account. Packing made for the sale of goods is charged to profit and
loss account. Packing of cigarettes in the packets of ten or twenty is an essential charge for bringing into
saleable condition and should be taken to trading account.

(11) Consumable stores : Consumable stores include engine-oil, cotton-waste, grease, soft soap-etc. They are
required to keep the machine in workable condition. They are essential for production and are taken to trading
account.

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 Closing Journal Entries :
The preparation of the Trading Account requires that accounts of all items due to appear therein are incorporated by
transferring their balances into the Trading Account. The entries required for such transfer are called closing entries.
The various closing journal entries are based upon the trial balance and can be summarized and grouped in two
entries as under :

1. Trading A/c Dr.

To Opening Stock
To Purchases A/c
To Wages A/c
To Carriage or Cartage or Freight A/c
To Coal, Gas and Power A/c
To Manufacturing Expenses A/c
2. Sales A/c Dr.
Closing A/c Dr.
To Trading A/c

As stated above, the trading account is prepared in ‘T’ shape. It has debit and credit sides. The excess of the credit
side over the debit side shows a gross profit, which is transferred from trading account to Profit and Loss Account.

(a) Trading A/c Dr.

To Profit and Loss A/c
(Being transfer of gross profit to profit and loss account)

If the debit side of trading account exceeds the credit side, the excess is supposed to be gross loss and transferred to
Profit and Loss Account. A reverse entry will be made for the transfer of Gross Loss.

Manufacturing Account :
A Manufacturing account is necessary to be prepared in a business where manufacturing work is carried on. Thus, a
firm engaged in a manufacturing business also, prepares, (i) Manufacturing A/c, (ii) Trading A/c, (iii) Profit and Loss
A/c. Where more than one articles are manufactured, a separate manufacturing account for each type of article will
indicate the profit or loss in manufacturing each item of production. The following proforma will illustrate this
Account :

Manufacturing Account of……….

for the year ending…….

Particulars Amount Particulars Amount

To Opening Stock of WIP By Sale of Defactive Material
To Raw Material Consumed By Closing Stock of WIP
Opening Stock By Cost of Production transferred
Add : Purchase to trading A/c (B.F.)
Less : PIR
Less : Closing Stock
To wages
To Carriage Inward
To Carriage on Purchase
To Productive/Manufacturing Exp.
To Cartage
To Salary of factory watchman
To Custom Duty
To Excise Duty
To Factory Rent

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 To Factory Exp.
To Factory Repair
To Factory Fuel f& Oil, Water and Power
To Factory Insurance
To Depreciation on Plant & Machinery
To Consumable Stores
To other Productive Exp.

Difference between Manufacturing Account and Trading Account :

A manufacturing account can be differentiated with a Trading Account as under :

(1) Purpose : A manufacturing account is prepared to ascertain the cost of goods manufactured while a Trading
Account is prepared to ascertain the amount of gross profit or gross loss.

(2) Closure : The balance of Manufacturing Account is transferred to Trading Account while the balance of Trading
Account is transferred to Profit and Loss Account.

(3) Sale of Scrap : Sale of scrap is not shown in the Trading Account but is is shown on the credit side of
Manufacturing Account.

(4) Opening and Closing Stock of Finished Goods : These stocks are not to be shown in In Manufacturing
Account, while they are to be shown in Trading Account.

(5) Size and Status : Trading Account is a part of Profit and Loss Account while Manufacturing Account is a part
of Trading, Account.

Profit and Loss Account

Profit and Loss Account is the second part of the Trading and Profit and Loss Account. After ascertaining gross profit,
management of a business will be interested in knowing the net income earned, or net loss incurred, at the end of the
accounting period. With this object in view, a Profit and Loss Account is prepared. Thus, the Profit and Loss Account
is an account which is designed to highlight the net profit earned or net loss incurred by the business entity arising
from its transactions during an accounting period. It contains all the items of revenue gains, losses and operating
expenses relating to the accounting period.

Need or objects of Preparing Profit and Loss Account :

The main purpose and importance of preparing a Profit and Loss Account is as under :

(1) Purpose : The purpose of preparing profit and loss account is to ascertain the amount of net profit or net loss.
This is the real profit available to the proprietor and credited to his Capital Account. The net profit is calculated
after charging all indirect expenses. In case of net loss proprietor’s capital account is debited or the Capital of
the owner is reduced.

(2) Comparison : It is prepared to compare net profit or net loss of the current year with that of previous year(s) to
know whether the performance of the business over the years is improving or declining.

(3) Control : It is prepared to guide in controlling expenses incurred on various items to improve profitability.

(4) Provisions and Reserves : The business has to maintain certain reserves and provisions to meet its future
uncertainties which depends upon the net profit earned by it. Thus, it is necessary to prepare Profit and Loss
Account, so the effective provision for uncertain future could be maintained.

(5) Ratio between Net Profit and Sales : By preparing Profit and Loss Account, this ratio is calculated and
compared with the desired ratio and if there is any shortcoming, that will be removed. Similarly, it can also be
compared with the ratio of previous years and may be used to improve future profitability.

(6) Ratio between Expenses and Sales : By preparing Profit and Loss Account, we can calculated ratios between
individual expenses and sales and compare these with desired rations and with the ratios of previous year(s). It
will always be in the interest of the business that such ratio(s) should be kept minimum.

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 Proforma of the Profit and Loss Account : The general proforma of the Profit and Loss Account is shown as under :

Profit and Loss Account of............

for the period ending on……….

Particulars Amount Particulars Amount

To Gross Loss By Gross Profit
To Salaries & Wages By Interest Earned
To Rent, Rates & Taxes By Commission Earned
To Fire Insurance Premium By Profit on Sale of F.A.
To Repair & Maintenance By Income from Investment
To Royalty on Sales By Sale of Scrap
To Depreciation By Miscellaneous Income
To Audit Fess By Discount Received
To Bank Charges By dividends Received
To Legal Charges By Bad-debts Recovered
To Miscellaneous Exp. By Capital A/c
To Discount Allowed (Net Loss transfer to Capital A/c.)
To Interest/Interest on Loan
To Carriage Outward
To Freight Outward
To Commission on Sale
To Trade Exp.
To Travelling Exp.
To Entertainment Expenses
To Sales Promotion Exp.
To Advertising and Publicity
To Baddebts
To Packing Exp.
To Loss on Sale of fixed Assets
To Loss by Theft
To Loss by Fire
To Printing & Stationery
To Postage & Telephone Exp.
To Office Exp.
To other Indirect Exp.
To Capital A/c
(Net Profit transfer to Ca/pital A/c.

Contents :
The starting point of the Profit and Loss Account is the gross profit/gross loss brought down from the Trading
Account. The other items shown in this account are those of expenses and losses as well as of incomes and gains. The
other items of income or gain such as rent received, commission earned, interest received, etc. are shown on the
credit side of the Profit and Loss Account. The expenses incurred in the administration of the business and in selling
the goods and other revenue losses are shown on the debit side of the Profit and Loss Account.

According to Prof. Carter, “A Profit and Loss Account is an account into which all gains and losses are collected in
order to ascertain the excess of gains over the losses or vice versa.” It must be remembered that expenses relating to
the owner or partners are not to be accounted for in the Profit and Loss Account of the firm. They are personal
expenses and hence are transferred to the Drawings Account of the owner or the partners. These expenses are usually
(i) Life Insurance Premium, (ii) Income-tax, and (iii) Household or Personal Expenses.

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 Debit Side of Profit and Loss Account :
(1) Salaries : Salaries are paid to employees of the business working in the office. The item ‘Salaries and Wages is
treated as salaries and is, debited to Profit and Loss Account. On the other hand, the item ‘Wages and Salaries’
is treated as wages and is debited to the Trading Account. The value of salaries paid in kind is also treated as
indirect expense and is debited to Profit and Loss Account. Similarly, salaries paid to partners is an indirect
expense, so it would be separately shown. As stated earlier, salaries paid to workers of the Factory. Works
Manager, Production Engineer and Foreman is direct-expense and are debited to Trading Account.

(2) Rent : Rent of the office premises, shop, showroom etc. is an indirect expense and is debited to Profit and Loss
Account. However, as stated earlier, rent of the factory building is a direct expense and is debited to Trading
Account.

(3) Interest : The business has to pay interest on loan borrowed by it and interest on capital to partners, proprietor
etc. It has also to pay interest on overdraft or bills over due. It is an indirect expense and is debited to Profit and
Loss Account.

(4) Commission : The business has to avail fo the services of the agents and brokers to sell its goods in the
market. Such commission or brokerage paid to these agents are indirect expense and hence is should be
debited to Profit and Loss Account. However, if it is paid on the purchase of goods, it will be direct expense and
should be debited to Trading Account.

(5) Carriage Outwards or Freight Outwards : This is the amount paid by way of transportation charges in respect
of goods sold. It is debited to the Profit and Loss Account. It may also be named as carriage or freight on sale. It
should be noted that carriage inward is direct expense.

(6) Bad Debts : A debt which becomes irrecoverable is known as a bad debt. This is an item of loss for the business
and appears on the debit side of the Profit and Loss Account.

(7) Discount : Discount is of two types – (a) Trade Discount; and (b) Cash Discount.

(a) Trade Discount : It is given on bulk sales. It is deducted from the amount of sales before it is recorded in
the books. There is no further treatment of trade discount. Consequently, it will not appear in the Trial
Balance. It is also known as off season discount, new year’s discount bumper sale and festival discount etc.

(b) Cash Discount : It is allowed at the time or receiving payment. If the payment is made immediately or at an
early date we may allow our debtors certain discount which is an indirect expense and should be debited to
Profit and Loss Account.

(8) Trade Expenses : In addition to above, there are a number of expenses e.g. Printing and Stationery,
Advertisement, Free samples, Insurance Premium against Fire, Marine etc., and Sundry expenses,
Miscellaneous expenses, Office expenses etc. So, all indirect expenses are also debited to Profit Loss Account.

(9) Loss on Sale of Assets : There may be loss on the sale of assets. This is a business loss and hence it should be
debited to Profit and Loss Account. However, it should be noted that loss on sale of assets is not an operating
loss. Thus, if operating net profit is to be calculated, such loss should be excluded from the debit side of Profit
and Loss Account.

(10) Other Losses : Losses are the unwanted charge on profits in any business enterprise which it may be forced to
bear. This type of losses may be loss by fire, loss by accident etc. So, such losses are also to be shown on the
debit side of Profit and Loss Account.

Credit Side of Profit and Loss Account :

In addition to Gross Profit b/d from Trading Account, following miscellaneous incomes are shown on the credit side of
Profit and Loss Account.

(1) Rent received, Rent from tenant, Rent (Credit).

(2) Interest received on fixed deposit’, investments, loan advanced by the firm, interest (Credit), etc.
(3) Discount received, Discount (Credit), Discount from Creditors.
(4) Commission received.
(5) Dividends received.

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 (6) Compensation received.
(7) Bad Debts previously written off, now recovered or bad debts recovered.
(8) Dividends received on investments.
(9) Profit from Sale of Assets.
(10) Interest on Drawings, etc.

Expenses not to be shown in Profit and Loss Account :

Following expenses are not to be shown in the Profit and Loss Account :

(1) Direct Expenses : As stated earlier, all direct expenses add to the cost of goods purchased or manufactured, so
they should be debited to Trading Account. It will be incorrect to debit these expenses to Profit and Loss
Account.

(2) Capital Expenditure : Expenses incurred on acquiring assets are capital expenditure These assets are shown
at the assets side of Balance Sheet e.g. expenses incurred for purchases of land and building, plant and
machinery, etc. or wages paid for construction of building or carriage paid for acquiring assets are capital
expenditure. Such type of expenditure should not be shown at the debit side of Profit and Loss Account.

(3) Income Tax : Income tax is levied on the personal income of the proprietor, so it is deducted from capital on
the liabilities side of Balance Sheet. Here, it is also to be noted that income tax charged from salaries of the
employees as ‘Tax deducted at source’ is neither an income nor expense. So it is neither debited nor credited to.
Profit and Loss Account.

(4) Private or Domestic Expenses : These expenses are not business expenses, so they cannot be charged to
Profit and Loss Account. These are the personal expense of the proprietor, so it will be known as drawings and
deducted from capital at the liabilities side of balance sheet.

(5) Life Insurance Premium : The insurance premium has been paid on the personal life policy of the proprietor,
so it is not a business expense. It should be treated as drawing and deducted from capital at the liabilities side
of the balance sheet.

Closing Journal Entries :

For transfer of items regarding Profit and Loss Account from Trial Balance following closing journal entries are
passed :

(1) For transfer of office, selling, distribution and financial expenses and losses to Profit & Loss Account :

Profit and Loss A/c Dr.

To Sundry Expenses A/c
To Salaries A/c
To Rent A/c
To Insurance A/c
To Stationery A/c
To Repairs A/c
To Advertising A/c
To Audit fee A/c
To Depreciation A/c
To Miscellaneous Indirect Expenses (Individually)
(Being transfer of indirect expenses to the debit side of
Profit and Loss Account)

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 (2) For transfer of sundry incomes :

Rent received A/c Dr.

Discount received A/c Dr.
Interest received A/c Dr.
Commission received A/c Dr.
Interest on drawings A/c Dr.
Miscellaneous Income A/c Dr.
(Individually)
To Profit and Loss A/c
(Being transfer of sundry income to Profit and Loss
Account)

(3) For transfer of Net Profit :

If the credit side of Profit and Loss account exceeds the debit side of profit and loss account, the excess is
assumed to be net profit and transferred to capital account.

Profit and Loss A/c Dr.

To Capital A/c
(Being transfer of net profit to capital account)

(4) For transfer of Net Loss :

Excess of the debit side of profit and loss account over the credit side is the net loss and transferred to capital
account.

Capital A/c Dr.

To Profit and Loss A/c
(Being transfer of net loss to capital account)

Closure of or Transfer of Drawings Account :

Drawings of the proprietor/partners will be transferred to Capital Account by means of the following entry :

Capital A/c Dr.

To Drawings A/c

This will close the Drawing Account. This item relates to the Balance Sheet.

Balance Sheet :
After preparation of Manufacturing Account or/and Trading and Profit and Loss Account for ascertainment of the
Profit or Loss, the businessman wants to know about the financial position of his business. A Balance Sheet is a
statement which is prepared and presented for this purpose containing the assets and liabilities of a business
enterprise on a given date. It shows the financial position of the business at the close of the accounting period. It is
called a Balance Sheet because it is a sheet of balances of ledger accounts which are still open after the preparation of
the Trading and Profit and Loss Account. This is also known as a Position statement. In a Balance Sheet, the total of
all assets must be equal to the total of all liabilities and capital at a given date which is also supported by our
accounting equation. Some important definitions of Balance Sheet may be quoted here as under :

A. Palmer has defined a Balance Sheet as follows : “The Balance Sheet is Statement at a given date showing on one
side the trader’s property and on the other hand possessions and the liabilities.”

According to Freeman, “A Balance Sheet is an itemwise list of the assets, liabilities and proprietorship of a business
of an individual at a certain date.”

The Committee on Terminology of American Institute of Certified Public Accountants (AICPA) has defined the
Balance Sheet as, “a list of balances in the assets and liabilities accounts. This list depicts the position of assets and

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 liabilities of a specific business at a specific point of time. “Thus Balance Sheet is a mirror which reflects the true
position of assets and liabilities on a particular date.

Characteristics of Balance Sheet : The Balance Sheet has the following characteristics or special features :

(1) A Statement, not an Account : A Balance Sheet is only a statement of Assets and Liabilities which has no
debit side or credit side like an Account. However, it is an important part of the final accounts. The headings of
the two sides of the Balance Sheet are ‘Assets’ and ‘Liabilities’.

(2) Particular Date, not for a Period : A Balance Sheet shows the Assets and Liabilities of a business enterprise at
the particular date on which it has been prepared. Even a single transaction would cause a change in the assets
and liabilities of a business. Thus, it shows the position of assets and liabilities on. a particular date and not for
a particulars period.

(3) Proforma : As stated above, it has no debit side or credit side, nor the words ‘To’ and ‘By’ are used before the
names of accounts shown therein. The headings are ‘Liabilities’ and ‘Assets’.

(4) Summary of Balances : A Balance Sheet is a summary of balances of accounts which have not been closed by
transfer to the Trading and Profit and Loss Account.

(5) Contents : A Balance Sheet shows the nature and value of assets and the nature and amount of liabilities at a
given date. It shows what the firm owes to others and also what others owe to the firm.

(6) Verification : According to the accounting equation, the total of Assets must be equal to Liabilities i.e.
Creditors and Proprietor’s Equity. If it is not equal, there is likely to be certain mistake.

Need of or objects of Preparing a Balance Sheet :

Balance Sheet is a vital part of final accounts, it has to be compulsorily prepared as per legal provisions. The need,
purpose or importance of preparing a Balance Sheet is as under :

(1) To Assess the Financial Position : The main object of Balance Sheet is to assess the financial position of the
firm. The short term and long term financial position of the firm can be assessed from the analysis of the
Balance Sheet. A business is said to be financially sound, If its assets exceed its external liabilities.

(2) To Ascertain Proprietory Ratio : Proprietory Ratio shows the relationship between proprietor’s funds and total
assets. Proprietor’s claim against business is said to be proprietor’s fund i.e. Capital Reserves, Retained
Earnings and Accumulated Profits etc. added to Proprietor’s Capital which gives us Propreitor’s fund. Balance
Sheet provides requisite information to ascertain proprietory ratio.

(3) To Maintain Ideal Current Ratio : The ideal ratio between current assets and current liabilities is 2 : 1. If it is
lesser than that the short term financial position of the firm cannot be said to be healthy. So, the Balance Sheet
helps us in providing requisite information about the Current Assets and Current Liabilities.

(4) To Ascertain Working Capital : Working Capital is the excess of Current Assets over Current Liabilities. It
should be sufficient to meet routine requirements of the business. Balance Sheet also helps to provide requisite
information in this regard.

(5) To Ascertain Sources and Uses of Funds : For this purpose Funds Flow Statement is prepared. The total of
inflow and outflow of funds is always equal. Balance Sheet helps in ascertaining sources from where additional
funds have been obtained and where the funds have been applied.

(6) To Compute Financial Ratios : These ratio’s indicate the present and prospective financial position of the firm.
Balance Sheet helps us in providing sufficient information for computation of short term and long term financial
ratios.

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 Proforma of Balance sheet :

The general proforma of the Balance Sheet is given as under :

Balance Sheet of Mr............

as on……….

Liabilities Amount Assets Amount

Current Liabilities Current Assets
Creditors Cash in hand
Bills payable Cash at bank
Bank overdraft Sundry Debtors or Book Debts
Short term loans Stock or Inventory
Fixed Liabilities Bills Receivable
Loan Short term Investment
Mortgage Investments
Loan from financial Long term Investment
Institutions Loans granted
Debentures Fixed Assets
Capital Land and Building
Add : Net Profit Freehold Premises
Less : Drawings Plant and Machinery
Reserves and Funds Tools and Equipments
General Reserve or Loose Tools
Reserve Funds Furniture or Fixtures
Employees Compensations fund Goodwill
Patents
Trade mark
Miscellaneous Expenses
Advertisement Expenses
Discount on Issue of Shares
Discount on Issue of Debentures

Contents :
Its contents are those accounts which have not been closed till the preparation the Trading and Profit and Loss
Account i.e. accounts of assets, liabilities and owner’s equity are shown in the Balance Sheet either on the assets side
or liabilities side, depending upon their nature. In our country, the right hand side of the Balance Sheet is called the
‘Assets Side’ and the left hand side is called the ‘Liabilities Side’. It is worthwhile to note that account of Capital and
Liabilities are shown on the left hand side, known as ‘Liabilities’. Assets and other debit balances are shown on the
right hand side, known as ‘Assets’.

Assets Side of Balance Sheet :

Items which are generally shown on assets side of the Balance Sheet are explained as under :

1. Liquid Assets : These assets can be converted into cash easily e.g. Cash in Hand, Cash at Bank, Bills
Receivable etc.

2. Current Assets : Those assets which are either in the form of cash or can be converted into cash within one
year are termed as Current Assets. These assets are also called floating or circulating assets because their
values go on changing many times even in a day. Thus, all liquid assets are Current Assets also. Examples of
Current Assets are Cash in Hand, Cash at Bank, Debtors, Stock, Bills Receivable, Short Term Investments etc.

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 3. Investments : Investments represent the funds invested in Government Securities, Shares of a Company etc.
Generally, they are shown at cost price. However, if, on the date of preparation of the Balance Sheet, their
Market Price is lower than the Cost Price, a foot note to that effect may be given below the Balance Sheet.

4. Fixed Assets : Fixed Assets are those assets which are held on a long term basis to be used in the operation of
business and not intended for sale. These assets increase the profit earning capacity of the business. The major
part of Capital is blocked in these assets. Examples of those assets are Land and Building, Freehold Premises,
Plant and Machinery, Loose Tools, Furniture of Fixtures; Intangible Assets are also shown under fixed assets,
for example Goodwill, Patent. Trade mark, and Wasting Assets as Mines, Copyright and Leasehold Land, etc.

5. Fictitious Assets (Miscellaneous Expenses) : These Assets have got no real value such as Advertisement
Expenses (deferred), Preliminary Expenses, Discount on issue of Shares and Discount on Issue of Debentures,
Underwriting Commission etc.

Liabilities Side of Balance Sheet :

Items which are generally shown on Liabilities side of the Balance Sheet are explained as under :

1. Current Liabilities : Liabilities, which are expected to be paid within one year and which are usually to be paid
out of current assets are termed as Current Liabilities. Examples of Current Liabilities are Trade Creditors, Bills
Payable, Bank Overdraft and Short Term Loans, etc.

2. Fixed Liabilities or Long Term Liabilities : Those liabilities which are paid after very long period or on the
dissolution of the firm or not prior a period of one year are termed as Fixed Liabilities or Long Term Liabilities.
In fact, Fixed Liabilities means long term funds of the business. Long term funds consists of long term loans
and proprietor’s funds. Examples of long term funds are loan from Financial Institutions as loans from IDBI,
IBRD, IFC etc., Loans, Mortgages and Debentures etc. Similarly, examples of Proprietor’s Fund are Capital
Reserves and Funds and Accumulated Profits, etc.

3. Capital : It is the excess of assets over liabilities due to outsiders. It represents the amount originally
contributed by the proprietor/partners which is further increased by adding profits and decreased by
subtracting losses and drawings.

4. Drawings : Generally, proprietor withdraw money or takes away goods etc. for his personal use, which has the
effect of reducing the balance of his Capital Account As stated earlier, the balance of drawings account is
transferred to his Capital Account However, it is shown by way of deduction from Capital in the Balance Sheet
on the liabilities side.

5. Contingent Liabilities : These are not the actual liabilities of the busness on the date of preparing Balance
Sheet. The word ‘Contingent’ means doubtful. Contingent liabilities are those liabilities which will be decided in
future upon certain happenings of events. Examples of contingent liabilities are (i) cases pending in the court of
law regarding damages, (ii) amount of bills discounted, and (iii) guarantees undertaken, etc. Containgent
liabilities are not shown in the Balance Sheet, as contingent liabilities may or may not prove to be actual
liabilities, so they are mentioned in details as a footnote below the Balance Sheet. Contingent liabilities are
shown in the footnote as a matter of convention of full disclosure.

Grouping and Marshalling of Assets and Liabilities :

The term ‘grouping’ means putting together items of a similar nature under common heading such as Trade Creditors,
Sundry Debtors, Reserves and Surplus etc. and term ‘marshalling’ refers to the order in which the various assets and
liabilities are shown in the Balance sheet. Assets and liabilities can be marshaled in two ways :

(i) In the order of liquidity, and

(ii) In the order of Permanence, as under :

Order of Liquidity :
Assets can be shown in order of liquidity. order of liquidity means the order which they can be converted into cash.
The most liquid asset, i.e., cash in hand, is shown first. The least liquid asset, i.e., goodwill, is shown last. Similarly,
the liabilities of business are arranged in order of urgency of payment. The one which is most urgent to be paid, i.e.,
short-term creditors, is shown first; the least urgent to be paid i.e.

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 Order of Permanance :
Assets and liabilities can be shown in the order of permanence. Permanent assets and liabilities are shown first,
followed by current assets and liabilities. This method is exactly the reverse of the first method given above. Business
enterprises on the line of sole-proprietorship and partnership follow the first method to marshall their Balance Sheets.
Joint stock companies prepare their balance sheets in order of permanence.

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 Final Accounts with Adjustments
In the previour chapter we have studies the preparation of the final accounts without any adjustments. At that time
we have presumed that all important facts has been taken into consideration, while preparing the final accounts,
which does not always happen. Infect, to give a true picture about the financial position of the business while closing
the books of account and preparing the final accounts, the accountant may come to know about certain adjustments
to be made in the books of accounts. Usually these adjustments are related to the following :

(1) Closing Stock or Closing Inventory,

(2) Outstanding Expenses or Accrued Expenses,
(3) Prepaid Expenses or Unexpired Expenses,
(4) Accrued Income,
(5) Unearned Income,
(6) Interest on Capital and Drawings,
(7) Depreciation on Fixed Assets,
(8) Provision for Bad and Doubtful debts,
(9) Provision for Discount on Debtors and Creditors,
(10) Commission on Profits,
(11) Accidental Losses,
(12) Deduction of Income tax from Salaries of Exployees,
(13) Goods sent on ‘Sale or Return Basis’,
(14) Other Specific Provisions,
(15) Other Adjustments.

(1) Closing Stock or Closing Inventory :

After valuation of the unsold stock at the end of the accounting period the following Journal Entry is passed :

Closing Stock A/c Dr.

To Trading A/c

The stock at the end appears in the balance sheet and is carried forward to the next year. It is shown as opening stock
in the trial balance of the next year and from there it is taken to the debit side of the trading account and thus closed.

Sometimes, the value of the unsold stock at the end of accounting year is shown in the trial balance. It should be
noted that any balance appearing in the trial balance is taken to one place only. Since closing stock at the end is an
asset it should be taken to balance sheet.

(2) Outstanding Expenses or Accrued Expenses (Liability) :

Those Expenses which accrue from day to day but usually recorded only when they are actually paid are known as
Outstanding Expense. Examples of such expense are, Salaries, interest, rent etc. Some of these expenses may have
remained unpaid at the end of the accounting period and, therefore, no entry might have been passed in the books of
accounts. Amount of such items are both expenses and liabilities on the date of final accounts. The following
Adjusting entry will be passed in case of such outstanding expenses :

Expenses A/c Dr.

To Outstanding Expenses A/c

Expense account is a nominal account and, therefore, it will be transferred to Profit & Loss Account. While the
outstanding expenses account is a personal account which represents the persons to whom the expense has to be
paid. It is, therefore, shown in the balance sheet on the liability side. At the commencement of the next year the
reverse entry (Outstanding expense account debit, To Expense account) will be passed.

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 Note : If outstanding expenses have been given inside Trial Balance, these will be shown at one place only i.e., on the
liability side on the Balance Sheet.

(3) Prepaid Expenses or Unexpired Expenses (Asset) :

Those expenses which have been paid in advance are called Prepaid Expenses or Expenses paid in advance. In this
regard it is customary that payments for some services as rent of the building, salaries to staff, insurance premium
etc. are made in advance i.e., for the period relevant to the next accounting year. In order to ascertain true profit and
loss, only those expenses which are related to the accounting period should only be charged to the Prfit & Loss
Account. That part of expenses which relate to next year should be carried forward. The following journal entry will be
passed for the expenses paid in advance :

Prepaid Expenses A/c Dr.

To Expense A/c

Prepaid expense account is a representative personal account which represents the account of the person to whom
payment has been made in advance, hence it is shown in the balance sheet on the asset side. Expense account is a
nominal account and should be credited to the profit & loss account, preferably by deducting from the relevant
expense account. At the commencement of next year prepaid expense will be written off by reversing the entry. It is
necessary to correct the expenses account of the next year.

(4) Accrued Income or Income Receivable (Asset) :

Such income which has been earned by the business during an accounting year but has not been received till the end
of current year, are called Accrued Incomes or Earned or Outstanding Incomes. Adjustment entry, for it is :

Accrued Income A/c Dr.

To (Particular) Income A/c

Treatment in Final Account :

Such incomes on one hand will be shown on credit side of Profit & Loss Account (being an Income), and on the other
hand Accrued Income being the representative personal account of such person from whom income is due, will be
shown on Assets side of Balance Sheet.

(5) Unearned Income or Income Received in Advance (Liability) :

The Income which has been received by the business before it being earned is called as unearned income or income
received in advance. Examples are apprenticeship premium, insurance premium, advertisement fee etc. In order to
ascertain the true profit or loss, it is necessary that such income is not taken into account at the time of preparing the
Profit & Loss Account for the year. The following adjustment entry is passed :

Particular Income A/c Dr.

To Income Received in Advance A/c

If adjustment is not made, profits would be overstated and the liability would be understated.

(6) Interest on Capital and Drawings :

(i) Interest on Capital : In order to determine the real amount of profit earned by the Business, it is necessary to
charge business with interest on the capital employed at a normal rate. Interest so charged is a loss for the
business on the one hand and gain to the proprietors on the other hand. The entry for interest on capital will be
passed as under :

Interest on Capital A/c Dr.

To Capital A/c

Interest on capital account being loss for the business, is transferred to debit side of Profit & Loss Account.

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 (ii) Interest on Drawings : As business allows interest on Capital, it is the usual practice to charge interest on
Drawings. The following Journal entry is passed for Interest on Drawings :

Drawings A/c Dr.

To Interest on Drawings A/c

Interest on drawings is a gain for the business, thus transferred to the credit side of Profit & Loss Account.

(7) Depreciation on fixed assets :

The value of fixed assets diminishes due to wear and tear and effluction of time, which is called depreciation. There
are various methods of providing depreciation, but in adjustment entry about final accounts normally it is to be
calculated at a fixed percentage on opening balance of the assets. However, there is any addition, depreciation is also
provided for that part only for the period for which the new asset has been used. The adjustment entry will be :

Depreciation A/c Dr.

To Fixed Assets A/c

Depreciation Account will appear on the debit side of Profit & Loss Account and the book value of Asset will be
reduced by the amount of depreciation. Hence, only the balance will appear in the balance sheet.

(8) Provision for Bad and Doubtful debts :

(a) Bad debts : Debtors who are unable to make payment of their dues or debts which are not recoverable are called
Bade debts. It is a business loss and for which the following entry is passed :

Bad debts A/c Dr. To be transferred to Profit & Loss A/c

To Sundry Debtors A/c Debtor’s balance is reduced

(b) Provision for Bad and doubtful debts : The principal purpose of making this provision is to bring down the
balance of debtors to its real realizable value. The Journal Entry for making provision is :

Profit & Loss A/c Dr. To be charged to Profit & Loss A/c
To Provision for Bad debts A/c It is shown as a deduction form Debtors

(9) Provision for Discount on Debtors and Creditors :

(a) Provision for Discount on Debtors : Discount may be allowed to the debtors on account of their making prompt
payments. The following Journal Entry is passed when discount is allowed :

Discount Allowed A/c Dr.

To Sundry Debtors A/c

Provision for discount on debtors is maintained on the same lines on which provision for bad and doubtful debts
is maintained. The following Journal entry is passed :

Profit and Loss A/c Dr.

To Provision for Discount on Debtors A/c

It should be noted that provision for discount will be created only on good debtors i.e., in order to ascertain the
balance for discount on debtors on a particular date, the rate at which discount is allowed to customers be
calculated on sundry debtors which remains after deduction of new provision for bad debts. Since discount is to
be allowed for prompt payment which is possible only from good debts.

(b) Provision for Discount on Creditors : A firm may like to create a provision or reserve for discount on creditors
on a similar pattern as provision for discount on debtors is made. It is shown on the credit side of Profit and Loss
Account, and by way of deduction from Creditors on the liability side of Balance Sheet. The adjustment entries
are passed as follows :

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 (i) On receipt of additional discount from creditors :
Sundry Creditors A/c Dr.
To Discount Received A/c

(ii) For creating a reserve for discount on creditors :

Reserve for Discount on Creditor’s A/c Dr.
To Profit & Loss A/c

(10) Commission of Profit :

Payment of commission to the manager is made as a fixed percentage of profit which is calculated as under :

Profit before Commission  Rate

Manager's Commission =
100
If Computation of commission is to be done after charging such commission, it is calculated as under :

Rate
Manager's Commission = Profit before Commission 
100 + Rate

The adjustment entry for commission on profit shall be as under :

(i) Manager’s Commission A/c Dr.

To Outstanding Commission A/c

(ii) Profit & Loss A/c Dr.

To Manager’s Commission A/c

(11) Accidental Losses :

In business there may be several types of casual losses such as loss by fire, loss by theft, or flood etc. These Losses
may be of two types : (i) loss of asset, and (ii) loss of goods. The adjustment entries in this regard will be as under :

(i) For loss of on Asset (Furniture) by Fire :

Loss by Fire A/c Dr.
To Furniture A/c

(ii) For loss of Goods by Fire :

Loss by Fire A/c Dr.
To Purchases A/c

(a) If goods are insured and the insurance company accepts the claim in full :
Insurance Company’s A/c Dr.
To Loss by Fire A/c

(b) If insurance company accepts the claim in part :

Insurance Company’s A/c Dr. (amount of claim accepted)
Profit & Loss A/c (Balance cf loss) Dr.
To Loss by Fire A/c

(c) When amount of claim is received from the insurance company :

Bank A/c Dr.
To Insurance Company A/c

(12) Deduction of Income Tax from Salaries :

The adjustment entries in this regard will be as follows :

(i) On deduction of income tax from salaries :

Salaries A/c Dr. (Gross Salary)
To Cash A/c (Actual amount paid)
To Income Tax (for Employees) A/c

(ii) On deposit of tax deducted at source : (TDS)

Income Tax for Employees A/c Dr.

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 To Cash/Bank A/c

When amount of salaries is shown after deduction of tax in trial balance and amount of tax is shown as an
adjustment below the trial balance, the adjustment entry will be :

Salaries A/c Dr.

To Income Tax for employees A/c

(13) Goods, Sent to Customers on ‘Approval or Return Basis’ :

Sometimes, goods are sold to customers on the condition that if they are not approved, the same may be returned
back. In such condition if approval of the customers has not been received till the end of the accounting year, it
cannot be treated as sale. In case it has been recorded as sale in account books it has to be adjusted by making
reverse entry for it. Further the value of such goods is reduced from sales and to be added to in the value of closing
stock. The following Journal Entry is to be passed :

(i) Sales A/c Dr. with the selling price

To Debtors A/c

(ii) Closing Stock A/c Dr. with the cost price

To Trading A/c.

(14) Other Specific Provision :

As has been explained in next chapter, if any provision is required to be made for a future contingency or for some
expected expenses, the Provision/Reserve may be made by passing the following entry :

Profit & Loss A/c Dr.

To Provision for (Specific) Expense A/c

(15) Other Adjustments :

In addition to above adjustments there may be some other adjustments also as regards goods :

(i) Goods distributed as Charity and as Free Samples

Charity A/c Dr.
Free Samples A/c Dr.
To Purchases A/c

(ii) Goods taken away for personal use by the proprietor :

(a) Drawing A/c Dr.
To Purchases A/c

(b) Capital A/c Dr.

To Drawing A/c

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 Depreciation
Meaning : It every business there are certain assets of a fixed nature that are needed for the conduct of business
operations. Some examples of such assets are Building, Plant and Machinery, Motor Vehicles, Furniture, Office
equipments etc. These assets have a definite span of life after the expiry of which the assets will lose their usefulness
for the business operations. Fall in the value and utility of such assets due to their constant use and expiry of time is
termed as depreciation. In other words, the process of allocation of the cost of a fixed asset over its useful life is
known as depreciation.

Definitions : Depreciation may be defined as the permanent and continuing diminution in the quality, quantity or the
value of an asset.

Special features or Characteristics of Depreciation :

1. Depreciation is decline in the value of fixed assets (except land).
2. Such fall is of a permanent nature. Once the value of an asset is reduced due to depreciation, it cannot be
restored to its original cost.
3. Depreciation is a gradual and continuing process because the value of the assets will decline either by their
constant use or obsolescence due to expiry of time.
4. Depreciation is not the process of valuation of asset but process of allocation of the cost of an asset to its
effective span of life.
5. It decreases only the book value of the asset, not the market value.
6. The term depreciation is used only in respect of tangible fixed assets. The term is not used for wasting assets
such as mines, oil-wells etc.
7. It is a non-cash expense. It does not involve any cash outflow.

Causes of Depreciation :- Main causes of depreciation are as follows :-

(1) By Constant Use :- Due to the constant use of fixed assets in business operations wear and tear arise in them
which results in the reduction of their values.

(2) By Expiry of Time :- The value of majority of assets decreases with the passage of time even if they are not
being put to use in the business. Natural forces such as rain, winds, weather etc. contribute to the deterioration
of their values.

(3) By Expiry of Legal Rights :- There are certain assets which have a definite span of life such as Lease. For
example, if a lease has been obtained for 20 years for Rs. 5,00,000, it will lose 1/20th, i.e., Rs, 25,000 of its
value each year whether utilised or not, so that at the end of 20th year its value is reduced to zero.

(4) By Obsolescence :- Quite often, due to new inventions and improve techniques the old assets become obsolete
and may have to be discarded even if they can be put to use physically.

(5) By Accident :- Sometimes a machine may be destroyed due to fire, earthquake, flood etc. or a vehicle may be
damaged due to accident.

(6) By Depletion :- Depletion is the decrease in the value of wasting assets such as mines, oil-wells etc. due to
their constant working.

(7) By Permanent fall in Market Price :- Though, the fluctuations in the market value of fixed assets are not
recorded because such assets are not meant for resale but for use in the business, sometimes the fall in the
value of certain fixed assets is treated as depreciation such as permanent fall in the value of investments.

Need, Importance or Objects of Providing Depreciation

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 (1) For ascertaining the true profit or loss :- The true profit of a business can be ascertained only when all costs
incurred for the purpose of earning revenues have been debited to the Profit and Loss Account. As the Assets
are used in earning revenues, the depreciation in the value of an asset is as much an expense as any other,
such as wages, salary, rent etc.

(2) For showing the ‘true and fair view’ of the financial position :- If the depreciation is not charged, the assets
will be shown in the Balance Sheet at an amount which is in excess of their true values. As such, the Balance
Sheet will not present the ‘true and fair view’ of the financial position of a business.

(3) To ascertain the accurate cost of production :- As depreciation is also an item of expense, the correct cost of
production cannot be calculated unless it is also taken into account. Sale price chargeable from customers is
determined on the basis of cost of production and hence if the depreciation is not included in Cost of
Production, the sale price will be fixed at lower rates and this in turn will lead to reduced profits.

(4) To provide funds for replacement of assets :- Depreciation though debited to Profit & Loss Account, is not
paid in cash like other expenses. Hence, the amount of depreciation is retained in the business and is used for
the replacement of fixed assets after the expiry of their estimated span of life.

(5) To prevent the distribution of profits out of capital :- If the depreciation is not charged, the profit shown by
the Profit and Loss Account will be in excess of the actual profits. Such an excess profit may be wholly
withdrawn by the proprietor or may be distributed among the shareholders as dividend. Hence, the amount of
dividend distributed will also include the amount of depreciation which is actually a part of capital.

(6) For avoiding over payment of Income Tax :- Depreciation is a deductible expenses for tax purposes. If
depreciation is not debited to Profit and Loss Account, the net profit shown by it will be in excess of actual
profits. Hence, we will also have to pay more income tax.

(7) Other Objectives :- If the depreciation is not charged, the net profit shown by Profit & Loss Account will exceed
the actual profits and as a result :
(I) Employees may demand an increase in wages and bonus,
(II) It may also result in extravagance,
(III) It may lead to increase in competition in that type of business.

Factors determining the amount of Depreciation

It is impossible to calculate the actual and true amount of depreciation. It can only be estimated by keeping the
following factors into consideration :-

(1) Total Cost of the Asset :- The cost of a fixed asset is determined after adding all expenses incurred for bringing
the asset to usable condition, such as freight, transit insurance and installation costs etc.

(2) Estimated Useful Life of Asset :- Useful life of an asset is estimated in terms of number of years, it can be
effectively used for business operations. For example, if a machine can work for 25 years but is likely to
becomes obsolete in 15 years on account of availability of a better type of machine due to improved technology,
its useful life will be considered as only 15 years.

(3) Estimated Scrap Value :- It is the estimated sale value of the asset at the end of its useful life. It is also known
as residual value or break-up value. For example, a machine is purchased for Rs. 60,000 and 4,000 are spent
on its freight and Rs. 1,000 for installation. It is estimated that its serviceable life will be 10 years at the end of
which period it will have a scrap value of Rs. 8,000. Depreciation in this case will be calculated on Rs. 57,000
(i.e. Rs. 60,000 + Rs. 4,000 + Rs. 1,000 – Rs. 8,000).

57,000
Depreciation charged on this machine will be  Rs. 5,700 every year.
10

Methods of Providing or Allocating Depreciation

Various methods have been devised for providing depreciation. Different methods are suitable for different assets
depending upon the nature and type of the asset. These methods are enumerated as under :-

1. Straight Line Method

2. Written Down Value Method

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 3. Annuity Method
4. Depreciation Fund Method
5. Insurance Policy Method
6. Revaluation Method
7. Depletion Method
8. Machine Hour Rate Method

(1) Straight Line Method

This method is also termed as ‘Original Cost Method’ because under this method depreciation is charged at a fixed
percentage on the original cost of the asset. The amount of depreciation remains equal from year to year and as such
the method is also known as ‘Equal Instalment Method’ or ‘Fixed Instalment Method’. Under this method, the
amount of depreciation is calculated by deducting the scrap value from the original cost of the asset and then by
dividing the remaining balance by the number of years of its estimated life. The depreciation so calculated and
charged annually will reduce the original cost of the asset to zero, or its scrap value, as the case may be, at the end of
its estimated life. Under this method, the amount of depreciation is calculated by the following formula :-

Original Cost of the Asset  Estimated Scrap Value

Yearly Depreciation 
Estimated Life of the Asset

For example, if the original cost of the asset is Rs. 1,00,000 and its scrap value is likely to be Rs. 15,000 after its
1,00,000  15,000
estimated life of 10 years, the depreciation written off will be  Rs. 8,500 every year.
10

Merits of Straight Line Method :-

(1) Simplicity :- Calculation of depreciation under this method is very simple and as such the method is widely
popular.

(2) Equality of Depreciation Burden :- Under this method, equal amount of depreciation is debited to the Profit
and Loss Account of each year. Hence, the burden of depreciation on each year’s net profit is equal.

(3) Assets can be completely written off :- Under this method, the book value of an asset can be reduced to net
scrap value of zero value which is not possible under some other methods.

(4) Knowledge of Original Cost and Up-to-date depreciation :- Under this method, the original cost of the asset
is shown in the Balance Sheet and the up-to-date depreciation is shown as a direct deduction form it. As such,
the information of Original Cost of the asset and its up-to-date depreciation is available at any time. Various
assets also maintain their separate identity under this method.

Demerits :-
(1) Difficulty in Computation :- When there are different machines having different life-spans, the computation of
depreciation becomes complicated because the depreciation on each machine will have to be calculated
separately.

(2) Unequal charge against income :- Repair charges go on increasing year by year as the asset becomes older but
as the equal depreciation is charged under this method each year, the total burden charged to Profit and Loss
Account in respect of depreciation and repairs put together will not be equal each year. The total burden will be
lighter in earlier years and heavier during the later years.

(3) Undue pressure in later years :- It is a well-known fact that the efficiency and usefulness of a machine is more
in the earlier years in comparison to later years. As such, more depreciation should be charged in earlier years
in comparison to the later years, whereas, depreciation remains constant from year to year under this method.

(4) Omission of Interest Factor :- This method does not take into consideration the loss of interest on the amount
invested in the asset. The amount would have earned interest, had it been invested outside the business.

(5) Unrealistic to Write off the Value of asset to Zero :- Sometimes, even after the value of an asset is reduced to
zero in the books, it continues to be used in the business in actual practice.

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 (6) Difficulty in the determination of scrap value :- It is quite difficult to assess the true scrap value of the asset
after a long period, say 15 or 20 years from the date of its installation.

Suitability :- This method is suitable for those assets whose useful life can be estimated accurately and which do not
require much expenses on repairs and renewals.

(2) Written Down Value Method

Under this method, as the value of asset goes on diminishing year after year, the amount of depreciation charged
every year also goes on declining. For example, if a machine is purchased for Rs. 10,000 and depreciation is to be
charged at 10% p.a. according to ‘Written Down Value Method’, the depreciation will be charged as under :-

Rs.
1st Year on Rs. 10,000 @ 10% = 1,000
10
2nd Year on Rs. 9,000, i.e. 10,000 – 1,000 = 9,000  = 900
100
10
3rd Year on Rs. 8,100, i.e., 9,000 – 900 = 8,100  = 810
100
10
4th Year on Rs. 7,290, i.e., 8,100 – 810 = 7,290  = 729
100
and so on.

It will be observed from the above calculations that each year’s depreciation is calculated on the book value of the
asset at the beginning of that year, rather than on the original cost.

Book Value is the Written Down Value of the asset. In other words, it is that part of the original cost of the asset
which has not been depreciated so far. Hence,
Book Value = Original Cost – Total Depreciation to date.

As the value of the asset and also the depreciation charged on it goes on reducing year after year, the method is also
known as ‘Reducing Instalment Method’ or ‘Diminishing Balance Method’.

Merits :
(1) Easy Calculation :- It is easy to calculate the depreciation under this method, even if some new assets are
purchased year after year. Different assets are grouped for the purpose of providing depreciation.

(2) Equal charge against income :- In this method, the total burden on Profit & Loss Account in respect of
depreciation and repairs put together remains almost equal year after year. This is so because in the initial
years depreciation is more in comparison to repair charges whereas, in the later years, as the asset gets older,
the amount of depreciation goes on decreasing while the expenses on repairs go on increasing, thus keeping the
combined charge of depreciation and repairs almost uniform.

(3) No undue pressure in later years :- The efficiency and usefulness of a machine is more in the earlier years than
in later years. Hence, the depreciation in first few years should be more in comparison to the later years. This is
ensured by adopting the Diminishing Balance Method.

(4) Balance of asset is never written off to zero :- This method ensures that the asset is never reduced to zero so
that some depreciation, however small, is debited to Profit & Loss Account so long as the asset remains in use.

(5) Approved method by Income Tax Authorities :- This method of providing depreciation is permissible under
Income Tax regulations.

Demerits :
(1) Asset cannot be completely written off :- Under this method, the value of an asset, even if it becomes
obsolete and useless, cannot be reduced to zero and some balance, however small, would continue on Asset
Account.

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 (2) Omission of Interest Factor :- As with the original cost method, this method also does not take into
consideration the loss of interest on the amount invested in the asset.

(3) Difficulty in determining the rate of depreciation :- Under this method, the rate of providing depreciation
cannot be easily decided. The rate is generally kept higher because it takes a very long time to write an asset
down to its scrap value. If the rate of depreciation is kept lower, then asset may become obsolete earlier.

(4) Knowledge of Original Cost and upto-date depreciation not possible :- Under this method, the original cost
of various assets is not shown in the Balance Sheet. Sometimes, the assets are grouped in such a way that it
becomes difficult to know their specific identity. The residue balance of some assets may continue in the
Balance Sheet even after they have been actually scrapped.

Suitability :- This method is very suitable in case of assets having a comparatively long life and which require
considerable repairs in the later years when they become older, such as building, plant etc.

Distinction between the two methods

Basis of Distinction Straight Line or Original Cost Written Down Value Method
Method
1. Amount of depreciation. Equal depreciation is charged every Depreciation goes on decreasing year
year. after year.
2. Basis of calculation of Depreciation is charged on the Depreciation is charged on the
depreciation. original cost of the asset. reducing balance of the asset.
3. Zero level. The book value of the asset can be The book value of the asset can never
reduced to zero. be reduced to zero.
4. Combined effect of Combined burden on account of Combined burden on account of
depreciation and repairs depreciation and repairs will be depreciation and repairs will be almost
on P & L A/c. lighter in earlier years and heavier equal over different years.
during the later years.
5. Rate of depreciation. Rate of depreciation is kept low in Rate of depreciation is kept high in
comparison to diminishing balance comparison to original cost method.
method.
6. Approval of Income Tax This method is not approved by This method is approved by Income
authorities. Income Tax authorities Tax authorities.
7. Suitability It is suitable for assets in which It is suitable for assets which require
repair charges are less and the more repair expenses with passage of
possibility of obsolescence is less time and where possibility of
such as land and buildings, patents, obsolescence is more due to
trade marks etc. technological changes such as plant
and machinery, vehicles etc.

In practice, the Written Down Value Method is more widely used. This is so because the depreciation in this method
goes on reducing according to the shrinking value of the asset.

(3) Annuity Method

This method considers that the business, loses interest on amount invested besides losing the original cost of the
asset also, since the amount used for buying the Asset, which would have earned in cash the same amount would
have been invested in some other form of Investment. As such (purchase price) the Asset account is debited with the
amount of interest also which is ultimately credited to Profit and Loss Account and is credited with amount of
depreciation which remains fixed year. After year the annual amount of depreciation is determined with the help of
annuity table. The amount of total depreciation is determined by adding the cost of the asset i.e. Purchase price and
interest thereon at an expected rate. The Journal entries are as under :

(a) Asset A/c Dr. (Purchase price)

To Bank A/c
(For purchase of asset)

(b) Asset A/c Dr. (Amount of Interest)

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 To Interest A/c
(For charging interest to asset)

(c) Depreciation A/c Dr. (Fixed amount as extracted from the Annuity Table)
To Asset A/c
(For depreciation charged on asset)

Appraisal : (i) This method takes into account interest on capital invested in the asset, (ii) it is most scientific as it
considers the amount of depreciation from Annuity table. (iii) Too much calculation work makes it cumbersome,
(iv) In case the asset requires frequent additions or extensions the calculations have to be revised quite oftern which
leads to overburdening the calculation work, (v) Like the straight line method, it also has tendency to inequalise the
charge to profit and loss account in respect of depreciation and repairs put together because the amount of
depreciation remains fixed over the life of the asset.

Suitability : This method is much suited to those assets which require considerable investment and where frequent
additions are not made. It is not suited for plant and machinery where additions are usually made quite often.

(4) Sinking Fund Method

Under this method this fund is created so as to make provision of a specified amount at a future certain date for the
purpose of replacement of the Asset at the end of its useful or usable life. The working of this method in brief is as
follows :

(i) A Sinking Fund Depreciation Fund is established for the purpose which is also called accumulating sufficient
funds to replace the asset at the end of its useful life.
(ii) An amount equal to the annual depreciation of the asset is charged against the profits every year and
accumulated in the form of Depreciation Fund.
(iii) An equivalent amount of cash (or in the multiples of a specific denomination say Rs. 10 or Rs. 100 if so
required) is withdrawn from the business and is invested in the outside securities which are readily convertible
into cash.
(iv) At the time of replacement of the asset, the investments made are realized and the available money is used in
replacing the asset concerned.

The Journal entries under this method are as under :

At the end of first year :

(1) For setting aside the amount of depreciation (to be found out from Sinking Fund tables)
Depreciation A/c ….. Dr.
To Depreciation Fund or Sinking Fund A/c

(2) For transfer of Depreciation to Profit and Loss A/c

Profit and Loss A/c ….. Dr.
To Depreciation A/c

(3) For investing the amount outside the business :

Sinking Fund Investment A/c ….. Dr.
To Bank A/c

At the end of second and subsequent years :

(1) For receiving interest on investments :

Bank A/c … Dr.
To Sinking Fund A/c

(2) For setting aside the depreciation amount

Depreciation A/c … Dr.
To Sinking Fund or Depreciation Fund A/c

(3) For investing the amount of depreciation plus interest received

Sinking Fund Investment A/c … Dr.
To Bank

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 (4) For transfer of Depreciation to Profit and Loss A/c
Profit and Loss A/c … Dr.
To Depreciation A/c

At the end of Last years : The amount of interest and annual instalment not to be invested since the money will be
required to purchase new asset. However, all investments will be sold away.

(1) For sale of Investments (Actual amount realized)

Bank A/c … Dr.
To Sinking Fund Investment A/c

(2) For transfer of Profit on sale of Investments (if credit side more)
Sinking Fund Investment A/c … Dr.
To Sinking Fund A/c

or (3) For transfer of loss on sale of Investments (if debit side more)
Sinking Fund A/c … Dr.
To Sinking Fund Investment A/c

(4) The old asset is sold out and whatever is realized in credited to Asset A/c
Bank A/c … Dr.
To Asset A/c

(5) Balance of Sinking Fund or Depreciation Fund A/c is transferred to Asset Account and any balance left in the
Asset account (old) is transferred to Profit and Loss account :

(6) For transfer of Loss in Asset Account

Profit & Loss A/c … Dr.
To Asset A/c

or

(7) For transfer of Profit on Asset Account

Asset A/c … Dr.
To Profit & Loss A/c

(8) For purchasing the new asset :

(New ) Asset Account … Dr.
To Bank A/c

Appraisal : (i) The asset is shown in the Balance Sheet at its original value throughout its life. The amount of
depreciation accumulated is shown on the liabilities side under Depreciation Fund or Sinking Fund.

(ii) Under this method, due provision is made for replacement of asset at the end of its working life. This is besides
making provision for depreciation on the asset every year. This feature is not found in other methods.

(iii) The principal limitation of the Depreciation Fund method is that, as depreciation amount remains fixed
throughout the life of the asset, it has a tendency to place unequal burden on Profit and Loss Account over different
years in respect of depreciation and repairs put together. The consequence is that the burden on Profit and Loss
Account in earlier years is light while in later years, it is heavy.

Suitability : This method is suitable for Plant and Machinery and also for may Wasting Assets requiring replacement
which involve very large amount.

(5) Insurance Policy Method

Under this method the business takes a Policy from an Insurance Company. The amount of the policy is such that it
is sufficient to replace the asset when it is worn out or discarded. The amount (cash) equal to the amount of
depreciation is paid by way of premium every year. The amount goes on accumulating with te insurance company at a
certain rate of interest and it paid back to the insured at the lime of maturity of the Policy. The amount so made
available by the Insurance Company is used for purchasing a new asset. This method to a great extent is similar to

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 sinking fund method; of course, procedure is a little different. Cash, in this method, instead of being used for buying
securities, is used for paying premium on the Policy.

This method is hardly used by the business houses.

(6) Revaluation Method

This method, also called “Appraisal System” is adopted only where the Asset in represented by a large number of
small and diverse items such as Tools or Lose tools etc. In such case, it is not possible to depreciate each item
separately. As such under this method :

(a) At the end of financial year (Accounting year) all the items, which are in good and usable condition are valued at
cost.
(b) The cost under (a) above is compared with the opening balance. The difference, if any, is charged as
depreciation.
(c) Whenever, additional assets are purchased, the amount is debited to Assets Account as usual.

Note : Please note that under this method the total amount depreciation charge is written off in the Asset account
itself and not to an accumulated depreciation account.

(7) Depletion Method of Depreciation of Natural Resources

Natural resources include physical assets like mineral deposits, oil and gas resources, and timber stands. These
natural resources get exhausted by exploitation. In some cases the reduction in physical deposits is offset by growth
(accretion) of development of additional deposits. The cost of the natural resources is the price paid for its Acquisition
plus Price paid for Development of such Asset in order to bring it to a state suitable for production. The periodic
depletion is better “not calculated in terms of year. Rather it is better to calculate the cost per unit and then multiply
the cost of units produced in that particular year. Depletion for each unit extracted is determined as follows :

Acquistion Cost (C)  Residual values(S)

Depletion per unit (U) 
Estimated life in terms of production units (N)

(8) Machine Hour Rate Method

In this method, the life of a machine is estimated in hours instead of years. Proper records are maintained for running
hours of the Machine and depreciation is computed accordingly. For example the cost of a Machine is Rs. 10,00,000
and life of the machine is estimated at 50,000 hours. The hourly depreciation will be calculated as :

Cost of Machine Rs. 10,00,000

 or Rs. 20 per hour
Machine Hours 50,000

If the machine runs for say, 2,000 hours in a particular year depreciation for the period will be 2,000 hours 
Rs. 20 = Rs. 40,000.

Machine hour rate means the cost of running a machine for an hour. This is an ideal method for calculating
depreciation where costly and different machines are used in production.

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 Trial Balance and Errors
“Trial balance is a statement, prepared with the debit and credit balances of Ledger accounts to test the arithmetical
accuracy of the books”.

Meaning of Trial Balance : All the businessmen after completion of postings from Journal or Subsidiary Books to the
Ledger, want to verify accuracy of the posting, For this purpose a statement is prepared wherein the balances of all
the accounts in the Ledger are incorporated. The statement so prepared is called “Trial Balance’. Accounts showing
debit balances are put on the debit side of the trial balance and the accounts showing credit balances are put on its
credit side. If the total of the debit side of the trial balance is equal to that of its credit side, it is presumed that the
posting to the ledger is accurate.

The reason for agreement of a trial balance is that under the double entry system, each transaction is recorded two
times, once on the debit side of an account and again on the credit side of another account. Thus, the total of all the
entries on the debit side of all the accounts must be equal to the total of all the entries on the credit side of all the
accounts. If the totals of both the sides of a trial balance are equal, it is proved that the books are atleast
arithmetically correct.

Definitions of Trial Balance

According to Carter, “ Trial Balance is the list of debit and credit balances, taken out from ledger. It also includes the
balances of cash and bank taken from cash book.”

According to William Pickles, “The statement prepared with the help of ledger balances, at the end of financial year
(or at any other date) to find out whether debit total agrees with credit total is called Trial Balance.”

Features of Characteristics of a Trial Balance

1. It is a list of balances of all ledger accounts and the cash book.
2. It is just a statement, and not an account.
3. It is neither a part of double entry system, nor does it appear in the actual books of accounts. It is just a working
paper.
4. It can be prepared at any time during the accounting period, say, at the end of every month, every quarter, every
half year of every year. Usually it is prepared at the end of accounting year before preparing the final accounts.
5. It is always prepared on a particular date and not for a particular period.
6. It is prepared to check the arithmetical accuracy of the ledger accounts.
7. If the books are arithmetically accurate, the total of all debit balances of a trial balance will be equal to the total
of all credit balances.
8. A tallied Trial Balance is not a conclusive proof of the accuracy of the books of accounts since certain type of
errors remain even when the Trial Balance tallies.

Objectives or Need or Functions of Preparing Trial Balance

The following are the objects or functions of preparing a trial balance :-

(1) To ascertain the arithmetical accuracy of the ledger accounts.

(2) To help in locating errors.
(3) To obtain a summary of the ledger accounts.
(4) To help in the preparation of Final Accounts.

(1) To ascertain the arithmetical accuracy of the ledger accounts : The trial balance provides a useful check
upon the ledger postings. If a trial balance tallies, it is proved that the posting to the ledger accounts is correct.
In other words, it ensures that both the aspects of each transaction have been posted into the ledger i.e., debit
aspects have been posted on the debit side and the corresponding credit aspects on the credit side.

(2) To help in the detection or location of errors : If a trial balance does not tally, it indicates that some errors
have occurred and the accountant will then proceed to locate such errors. Even a small difference in the trial

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 balance is to be given the same importance and attention as a large difference because it may be possible that
there may be a number of errors which have offset the effect of one another, resulting in a small composite
difference.

(3) To obtain a summary of the ledger accounts : A Trial Balance serves as a summary of all the ledger accounts.
Scanning the Trial Balance enables one to know the assets, liabilities, expenses, incomes etc.

(4) For the preparation of Final Accounts : As the trial balance contains the list of all the Ledger accounts, it
provides a basis for further processing of accounting data, i.e., preparation of final accounts namely Trading
and Profit & Loss Account and a Balance Sheet.

Preparation of a Trial Balance

A trial balance may be prepared at any time, say, at the end of every month, quarter, half-year or year. Usually it is
prepared at the end of the accounting period, so as to verify the arithmetical accuracy of the ledger accounts before
the preparation of final accounts. It may be noted it is always prepared on a particular date and not for a particular
period.

In order to prepare a trial balance, all the accounts showing debit balances in the Ledger are put on the debit side of
the Trial Balance and the accounts showing credit balances are put on its credit side. If, however, an account shows
no balance, i.e., the debit and credit totals of an account are equal, the account is not included in the Trial Balance.
After this, the debit and credit columns of the Trial Balance are totaled and if the total is equal, it is said that the Trial
Balance has tallied. It may be noted that a trial balance can be prepared only when all the ledger accounts have been
balanced.

Steps to Locate or Detect the Errors :

If the Trial Balance does not tally, steps must be taken to locate the errors which are causing discrepancy. The
following steps may be taken, one after another, to locate the errors :

Step 1. Recheck the totals of both the debit and credit amount columns of the Trial Balance.

Step 2. The exact figure of difference in the Trial Balance should be ascertained. After this, the subsidiary books
should be gone through to see if any item of that amount remains unposted. For example, if the difference
is of Rs. 3,200 all the entries of Rs. 3,200 should be scanned to ensure that they have been duly posted.

Step 3. The difference should be halved to find out if some figure equal to half the difference has been posted on the
wrong side of an account thereby making the difference double. For example, if the total of debit side of the
Trial Balance exceeds by Rs. 3,200, it is possible that a credit item of Rs. 1,600 may have been posted to
the debit side of a Ledger account.

Step 4. The difference in the Trial Balance should be divided by 9. If the difference is completely divisible, it can be
a mistake of transposition of figures. For example, if the figure of 47 is written as 74, the difference is of Rs.
27. This figure is completely divisible by 9. Likewise, if ‘0’ is added against a figure, the difference will also
be divisible by 9. For example, if the figure of 13 is written 130, the difference is Rs. 117 which is completely
divisible by 9.

Step 5. In case, the difference is in a round figure, say Rs. 1, Rs. 10, Rs. 100 etc., there will be a possibility of
wrong totaling or wrong carry forwards of the totals of a subsidiary book or there will be an error in the
balancing of an account. Hence, the totaling and balancing must be checked.

Step 6. Check with the help of the Ledger whether the balance of each and every account including the balances of
Cash and Bank have been included in the Trial Balance on the correct side and with the correct amounts.

Step 7. Check whether all the closing balances from the previous year’s Balance Sheet have been correctly carried
forward and recorded in respective ledger accounts.

Step 8. Check the figures which are not clearly written.

Step 9. If the difference is of a very big amount, it is just possible that the balance of a certain Ledger account may
not have been included in the Trial Balance. This can be detected by comparing the Trial Balance of the
current year with that of the previous year. Also, if the figures of accounts under the same head show
abnormal variation, the account should be rechecked to find out the cause of variation.

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 Step 10. If, in spite of all the above efforts, there is still a difference in the Trial Balance, a complete checking of the
postings of all the entries will be necessary. A check mart () should be placed at the right of each amount
to show that the item has been checked. It should also be checked that the totals of the subsidiary books
have been posted c accounts in the Ledger.

Types of Errors :
All errors may be classified into the following two categories :

(1) Errors affecting Trial Balance (or errors disclosed by Trial Balance).
(2) Errors not affecting Trial Balance (or errors not disclosed by Trial Balance).

(1) Errors Affecting Trial Balance (or Errors Disclosed by Trial Balance) : If the Trial Balance does not tally, it
will indicate that certain errors have been committed which have affected the agreement of the Trial Balance. The
accountant will then proceed to find out the errors and ultimately the errors will be located. Such errors are
called ‘Errors Disclosed by Trial Balance’ or ‘errors which affect the agreement of Trial Balance’. Until such errors
are rectified, the Trial Balance will not agree. Some of the examples of such errors are as follows :-

(i) Wrong Casting : If the total of the Cash Book or some other Subsidiary Book is wrong, the Trial Balance will
not tally. For example, the total of the Purchase Book has been added Rs. 1,000 in excess. When this total will be
posted to the debit side of the purchase account, it will also show an excess debit of Rs. 1,000 and hence, the
Trial Balance will not tally.

(ii) Posting to the Wrong Side : If instead of posting an amount on the debit side of an account, it is posted on
the credit side, or vice versa, the Trial Balance will not tally. For example, goods for Rs. 2,000 have been
purchased from Gopal. If instead of posting the amount on the credit side of Gopal’s account it is posted to his
debit, the debit side of the Trial Balance will exceed the credit by Rs. 4,000.

(iii) Posting of Wrong Amount : The Trial Balance will not tally if the posting in an account is made with an
incorrect amount. For example, goods for Rs. 600 have been purchased from Mahendra. If, it has been correctly
entered in the Purchase Book but while posting to Mahendra’s credit, the amount posted is Rs. 60 instead of Rs.
600, the Trial Balance will not tally.

(iv) Omission of Posting of One Side of an Entry : For example, if Rs. 500 have been received from Ram and
correctly entered in the Cash Book, but if it is omitted to be posted on the credit side of Ram’s account, the Trial
Balance will not tally.

(v) Double Posting in a Single Account : For example, if Rs. 500 have been received from Shyam Lal and
correctly entered in the Cash Book, but if it is posted twice on the credit side of Shyam Lal’s account, the Trial
Balance will not tally.

(vi) Errors of Totalling and Balancing of Accounts in the Ledger : Errors may occur in the totaling of debit or
credit sides of accounts in the Ledger or in the balancing of accounts in the Ledger. Because the balances of
accounts are transferred to the Trial Balance, it will not tally.

(2) Errors not Affecting Trial Balance (or Errors Not Disclosed by Trial Balance) : Main object of preparing a
Trial Balance is to check the accuracy of the accounts. However, the equality of debits and credits of the Trial
Balance does not mean that there are absolutely no errors in the books of accounts. There may be a number of
errors which may remain undetected in spite of the agreement of a Trial Balance. As such, it is true to say that
‘Trial Balance is not a conclusive proof of the accuracy of the books of accounts.’ There are certain errors
which do not affect the agreement of the Trial Balance. Such errors are also called limitations of Trial
Balance. These may be discussed as below :-

(i) Errors of Omission : If a transaction remains altogether unrecorded either in the Journal or in Subsidiary
Books, It will be termed as an error of omission. Such an error will not affect the agreement of a Trial Balance, as
neither the transaction has been entered on the debit side of an account nor on the credit side of any other
account. For example, suppose goods for Rs. 2,000 have been sold to Ram on credit and the transaction was
omitted to be recorded in the books. The omission will not affect the Trial Balance in any way, because neither
has it been recorded on the debit side of Ram’s account nor on the credit side of sales account.

(ii) Errors of Commission : If a wrong amount is entered either in the Journal or in the Subsidiary Books, the
Trial Balance will tally because the same amount (though wrong) will be posted in both the accounts affected by

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 the transaction. For example, sale of goods to Ram on credit for Rs. 420 has been entered in the Journal as Rs.
240. When then entry is posted to Ledger, Double Entry will be completed with Rs. 240, Ram being debited with
Rs. 240, and sales account being credited with Rs. 240. In spite of the inaccuracy in both the accounts, the Trial
Balance will tally.

(iii) Compensating Errors : If the effect of one error is neutralized by the effect of some other error, such errors
are called compensating errors. For example, while posting on the debit side of Anil’s account, Rs. 50 are posted
instead of Rs. 500 and while posting on the debit side of Sunil’s account Rs. 500 are posted instead of Rs. 50.
These two mistakes will nullify the effect of each other and in spite of the errors in both the accounts, the Trial
Balance will still agree.

(iv) Errors of Principle : When some fundamental principle of Accountancy is violated while recording a
transaction, the error is termed as error of principle. These errors are committed in those cases where a proper
distinction between capital and revenue items is not made, i.e., a capital expenditure is treated as a revenue
expenditure of vice-versa. These errors may be of two types :-

(a) When a capital expenditure is treated as revenue expenditure : For example, if the purchase of furniture
is treated as an ordinary purchase and it thus debited to purchase account instead of furniture account, it will
be an error of principle. Similarly, if amount spent on the extension of building is debited to repairs account
instead of building account, it is also an error of principle.

(b) When a revenue expenditure is treated as capital expenditure : For example, if the amount spent on the
repair of an old machinery is debited to machinery account instead of repairs account.

(v) Errors of Posting in Wrong Account : If, while posting from the books of originally entry, posting is made to
a wrong account but on the correct side, the error will not affect the agreement of Trial Balance. If, for example,
goods are sold to Ram on credit by Shyam’s account is debited in place of Ram’s account in Ledger, the Trial
Balance would tally in spite of errors in both the accounts.

Suspense Account
Sometimes, in spite of best efforts of an accountant, all the errors are not located and the Trial Balance does not tally.
In such a situation, to avoid the delay in the preparation of final accounts, the difference in the Trial Balance is placed
to a newly opened account know as “Suspense Account” and the Trial Balance tallies. If the debit side of the Trial
Balance exceeds the credit side, the difference will be put on the credit side of the suspense account and if the credit
side of the Trial Balance exceeds the debit side, suspense account will be debited. After including the balance of
suspense account in the Trial Balance, it will appear to be tallied.

Later, when the errors are located, the rectification entries will be passed with the help of the suspense account.
Therefore, when all the errors have been located and rectified, the suspense account will automatically stand closed. If
suspense account still shows a balance, it will be taken to the Balance Sheet – on the assets side if it shows a debit
balance or on the liabilities side if it shows a credit balance.

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 Insurance Claims
Every business enterprise is always exposed to a number of risks, such as fire,-flood, storm, burglary, accidents etc.
So, at present, insurance has become an important necessity in business world as it safeguards from such losses. A
wise businessman secures himself against such losses by taking a proper insurance policy as ‘Fire Insurance Policy’,
‘Marine Insurance Policy’, ‘Accident Insurance Policy’, Consequential Loss Policy, and Comprehensive Policy, etc. of
course, the question of claim or amount of compensation arises on happening of certain event. Out of the above
mentioned risks, the fire risk is the most dangerous. In case it goes out of control, it may involve loss both in terms of
assets as well as human lives. The present chapter mainly deals with estimating the amount of loss of stock and profit
as a result of fire.

Fire Insurance
In fire insurance, it is an essential feature that insurable interest must be at both the times i.e., at the time of taking
the policy and at the time of making claim. The premium of fire insurance is treated as revenue expense relevant to
business and transferred to Profit and Loss Account on debit side. If assets are destroyed by fire then actual loss is
claimed from the insurance company. The main forms of fire insurance are as under :

(1) Stock Insurance; and

(2) Consequential Loss Insurance.

Loss of Stock
1. Fire Insurance

An enterprise generally gets itself insured against the loss of assets by fire. Fire insurance being a contract of
indemnity, the claim for loss is restricted to the actual loss.

Loss of Stock by Fire : In case of loss of stock by fire, the problem arises in determining the loss suffered where
either proper records are not maintained or such records are also destroyed by fire. Under such circumstances, the
following procedure is adopted to estimate the value of stock at the date of fire :

(a) Gross Profit Ratio : Gross Profit Ratio for the current year is estimated on the basis of gross profit ratio of either
preceding year or the average of past few years, depending upon the information available.

(b) Information about Opening Stock, Purchases, Sales etc. : Information about opening stock, purchases, sales,
direct expenses for the period from last accounting date upto the date of fire is collected either from accounting
records or, if accounting records are destroyed by fire, from documentary evidences such as purchases bill, sales bill,
cash vouchers, statement from customers and suppliers, copies of preceding year’s financial statements and bank
pass book etc.

(c) Preparation of Memorandum Trading Account : A memorandum trading account should be prepared with the
information collected. The balance of memorandum trading account will furnish the estimated amount of stock on
the date of fire.

(d) Salvaged Stock : The stock saved from fire is known as salvaged stock. The value of salvaged stock is determined
and adjusted for calculating the amount of claim.

(e) Loss of Stock or Amount of Claim : For determining the loss of stock by fire, the salvaged stock should be
deducted from the value of stock estimated on the date of fire by preparing memorandum trading account.

Average Clause :

If the goods are totally destroyed, the amount of claim is equal to the actual loss, provided the goods are fully insured.
However, in case of under insurance, the amount of claim is restricted to the policy amount. Generally, the insurance
companies include ‘Average Clause’ in insurance policy in order to save themselves from under insurance. If average
clause is applied, the loss of stock is proportionately reduced considering the ratio of policy amount (i.e. insured
amount) to the value of stock (i.e. insurable amount). In such a case, the amount of claim will be determined by
applying the following formula :

Sum Insured
Amount of Claim = Loss of Stock 
Insurable Amount

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 Example : Suppose the amount insured is Rs. 40,000 for total stock of Rs. 50,000. If the whole stock is destroyed by
fire, the amount of claim will be as follows :

40,000
Claim  50,000   Rs. 40,000
50,000

If stock of Rs. 30,000 is destroyed by fire, the amount of claim will be

40,000
Claim  30,000   Rs. 24,000
50,000

Valuing Stock at Cost Price : It is very important to ensure that stock (opening as well as closing) in the past years
in valued at cost, otherwise the valuation should be adjusted first at cost to determine the gross profit ratio of past
years. Again for calculating the correct estimated stock from Memorandum Trading Account, the opening stock in it
should be shown at cost price after adjustment.

Treatment of Abnormal Items :

Sometimes, there are abnormal items in a business enterprise. The gross profit ratio is to be calculated on sale of
normal items upto the date of fire. Profit (or loss) on sale of abnormal items (i.e. items of poor selling line) is
determined separately by comparing cost with the sale proceeds of abnormal items. Total gross profit is the sum of
profit (or loss) on sale of normal and abnormal items.

Treatment of Goods used for Advertisement, Loss by Theft etc. :

Goods used as samples for advertisement, theft of stock, cash sales stolen should be ascertained and adjusted to
derive a reasonable estimate of the value of stock at the date of fire.

2. Consequential Loss Insurance

In case of a fire, it destroys not only the tangible assets of the firm such as stock, building, furniture, machine and
plant etc., but it also affects the capacity of the firm for some time, which results in loss of profits otherwise that could
have been earned.

Following losses are incurred due to fire :

(i) Loss of Profit that would have been earned;

(ii) Loss of fixed expenses which are incurred even during closure period of business; and
(iii) Additional working cost incurred in bringing the business house in order, such as renting premises temporarily
for a short time.

All the above losses are not covered in an ordinary fire insurance policy. So to cover all these losses, a separate policy
may be taken which is called as “a loss of profit policy” or “consequential loss policy”. But claim under this policy is
admitted only when there is also an admission of liability for loss of property or stock. However, the amount of claim
under this policy may not depend on the value of the property or stock destroyed as a small damage may give rise to a
rather huge consequential loss if dislocation of the business is very much essential.

Difference between Consequential Loss Insurance and Fire Insurance

The points of difference between ‘consequential loss insurance’ and ‘fire insurance’ are as under :

(1) The fire insurance covers capital losses whereas consequential loss insurance covers revenue losses.
(2) The subject matter of fire insurance is tangible which covers stock, building, furniture, machine and plant, etc.
whereas under consequential loss insurance it is intangible and covers the earning capacity of the business.
(3) The fire insurance protects the insured only against the losses of stock etc. whereas the consequential loss
insurance provides protection against trading losses arising due to closure of business activities.

Some Important terms :

With reference to ‘Loss of Profits Policy’ or ‘Consequential Loss Policy’ one should know the meaning of certain terms
explained as under :

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 (i) Indemnity Period : It is the period of claim which is generally specified in the policy or actual dislocation period,
whichever is the lower.

(ii) Fixed Charges or Standing Charges : In every business, certain expenses are of fixed nature which are not
affected by increase or decrease in production or sales i.e. these are to be incurred necessarily even than business is
closed for some time. Such expenses are known as fixed expenses or period cost. For example, salary of employees,
interest on loans and capital, rent of building, audit fees, advertisement, insurance premium, municipal tax, wealth
tax, etc.

(iii) Insured Standing Expenses : The insurance company also pays the amount of fixed expenses in addition to loss
of profit so the businessmen should have insured fixed expenses also. If only a part of the fixed expenses are
insured, such part is known as insured standing expenses. If all the fixed expenses are being insured that all such
expenses will be known as insured standing expenses.

(iv) Net Profit : It is the trading profit resulting from the business of the insured person at the premises after due
provision made for all standing and other charges including the depreciation.

Computation of Claim :
Step I : Calculation of Short Sales : The term ‘Short Sale’ refers to the loss of sales on account of fire resulting in
dislocation of business. It is the difference between the ‘standard sales’ and the ‘actual sales’ during the indemnity
period. Here, the term ‘standard sales’ refers to the amount of sales for the period corresponding with the indemnity
period during the preceding accounting year duly adjusted in view of the trend (increase or decrease) noticed during
the accounting year in which the fire occurred.

Example : Date of fire in an undertaking was 1st March, 2015; period of indemnity was 3 months. Sales at normal
level started from 1st June, 2015. Sales during 1st March, 2015 to 31st May, 2015 was Rs. 3,40,000, whereas standard
turnover during the same period in the preceding year was Rs. 8,17,000. In comparison to the previous year, there is
an increase of 15% in sales of this year. Find out the amount of short sale.

Calculation of Short Sales :

Rs.
Sales from 1st March, 2014 to 31st May, 2014 8,17,000
Add : Expected increase in Sales @ 15% 1,22,550
Standard Sales 9,39,550
Less : Actual Sales during 1st March, 2015 to 31st May, 2015 3,40,000
Short Sales 5,99,550

Step II : Calculation of Rate of Gross Profit : The term ‘Gross Profit’ has got a different meaning than that which is
generally understood and shown by trading account. Here, ‘gross profit’ means : Net Profit + Insured Standing
Charges. So, the rate of gross profit is ascertained as under :

Net Profit + Insured Standing Charges

Rate of Gross Profit on Sales   100
Accounting Year's Sales (Adjusted)
All the figures relating to net profit, insured standing charges and turnover relate to the last accounting period. If in
above example, the amount of total sales of preceding accounting year was Rs. 7,00,000; fixed expenses were Rs.
2,60,000; the net profit Rs. 3,40,000 and the insured standing charges Rs. 70,000; the rate of gross profit will be :

Rs. 3,40,000 + 70,000

  100  50.93%
Rs. (7,00,000 + 1,05,000)

In Case of Net Loss : The rate of gross profit shall be determined as under :

Insured Standing Charges  Net Loss

 100
Accounting Year Sales (Adjusted)

If all the standing charges are not insured, the amount of net loss will have to be reduced as under :

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 Net Loss  Insured Standing Charges
All Standing Charges

Step III : Calculation of Loss of Profit : The loss due to short sale is calculate by applying the rate of gross profit on
short sales. Thus,

Loss of Profit = Rate of Gross Profit  Short Sale

In the above example, amount of short sales was Rs. 5,99,550 and rate of gross profit was 50.93%. So, loss of profit
would have been Rs. 3,05,351.

Step IV : Average Clause : The amount of loss of profit will be proportionately reduced if the sum insured under the
policy is less than the amount for which the policy should have been taken. As such, the amount of claim on
application of average clause would be calculated as under :

Amount of Policy
Amount of Claim  Loss of Profit 
Gross Profit on Annual Sales (Adjusted)

Adjusted Annual Sales or Insurable Amount : The amount for which the policy should have been taken is
determined by applying the rate of gross profit to the turnover for just preceding 12 months from the date of fire. Such
turnover must be adjusted in terms of trend of sales (increase or decrease) in the accounting year in which the fire
takes place.

Increased Working Expenses : The insured may have to incur certain additional expenses to keep the business in
form during the indemnity period. Such type of increased working expenses will be allowed subject to the least of the
following :

(a) Actual additional working expenses;

(b) Rate of gross profit  Short sales avoided through increased cost of working; and
(c) Amount calculated by the formula :
Net Profit + Insured Standing Charges
 Additional Working Expenses
Net Profit + All Standing Charges

Savings in Insured Standing Charges : Any savings in insured standing charges will have to be deducted from the
amount calculated as above in respect of increased working expenses.

Average Clause : In respect of increased working expenses, average clause will apply in the same manner as it applies
in case of loss of profit. The only difference in this regard will be that the average clause will apply on the basis of total
Loss of Profit and Increased of Working Cost.

Example : Rs.

Additional Working Expenses during indemnity period : 4,000

Additional Sales during indemnity period : 55,000
Net Profit + All standing charges : 35,000
Net Profit + Insured standing charges : 30,000
Savings in insured standing charges 700
Rate of gross profit : 10% on Sales
Calculate the gross amount of claim in respect of additional working expenses.

Solution :

Least of the following (Less saving in insured standing charges) shall be the gross amount of claims :

(a) Rs. 4,000;

(b) Rs. 55,000  10% = Rs. 5,500; and
Rs. 30,000
(c) Rs. 4,000   Rs. 3,429
Rs. 35,000

So, Rs. 3,429 – Rs. 700 = Rs. 2,729 would be the gross amount of claim for additional working cost.

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H.O. : B-5, Dev nagar ,opp. Kamal & company ,gopalpura ,Jaipur Tel : 0141-2708941 , Mob : 9887755436, 9413223636 Visit us at : www.fluxeducare.in