MMPC-004

ACCOUNTING FOR
MANAGERS
School of Management Studies

BLOCK 1 ACCOUNTING: AN OVERVIEW 5

Unit 1 Introduction to Accounting 7
Unit 2 Preparation of Books of Accounting 39
Unit 3 Financial Statements 69
Unit 4 Preparation of Final Accounts of Companies 107
Unit 5 Cash Flow Statement 127
BLOCK 2 COST ACCOUNTING 153
Unit6 Understanding and Classifying Costs 155
Unit 7 Absorption and Marginal Costing 175
Unit 8 Activity Based Costing 204
BLOCK 3 APPLICATION OF COST ACCOUNTING 223
Unit 9 Cost-Volume-Profit Analysis 225
Unit 10 Budgeting and Budgetary Control 253
Unit 11 Variance Analysis 288
BLOCK 4 FINANCIAL STATEMENT ANALYSIS 319
Unit 12 Understanding Annual Reports 321
Unit13 Comparative, Common Size and Trend Statements 344
Unit14 Ratio Analysis 365
BLOCK 5 EMERGING ISSUES IN ACCOUNTING 377
Unit15 Human Resource Accounting 379
Unit 16 Forensic Accounting 398
COURSE DESIGN AND PREPARATION TEAM
Prof. K. Ravi Sankar, Prof. Braj Kishor* Prof. V.N. Hukk *
Director, SOMS, Department of Business Faculty of Commerce
IGNOU, New Delhi Managemetn University of Jodhpur, Jodhpur
Osmania University, Hyderabad

Prof. N. Ramchandran* Shri S.N. Maheshwari* Dr. Lalit M. Johri*

Indian Institute of Management Department of Commerce Faculty of Management of
Calcutta Sri Ram College of Commerce Studie
University of Delhi, Delhi University of Delhi, Delhi

Prof. K.V. Rao Prof. Madhu Vij Prof. C.P. Gupta

Former Vice-Chancellor Faculty of Management Department of Financial
Acharya Nagarjuna Univervisty, University of Delhi, Delhi Studies
Guntur University of Delhi, Delhi
Prof. Pankaj Gupta Prof. G.V. Chalam Dr. Jayant Kumar Seal
Centre of Management Studies Former Dean,Deptt. Of Indian Institute of Foreign
Jamia Milia Islamia, New Delhi Commerce and Business Trade
Administration, Qutub Insititution Area
Acharya Nagarjuna University, New Delhi
Guntur

Prof. Shital Jhunjhunwala Dr. Ritu Sapra Prof. Anjali C. Ramteke

Department of Commerce Department of Commerce SOMS, IGNOU
University of Delhi, Delhi University of Delhi, Delhi New Delhi

Prof. Kamal Vagrecha

(Course Coordinator)
SOMS, IGNOU,
New Delhi

Course Editor:
Prof. Varadraj Bapat
Indian Institute of Technology
Bombay
Acknowledgement: Parts of this course is adapted from the earlier MS-04: Accounting for Managers
course and the persons marked with (*) were the original contributors and the profiles are as it was on
the date of initial print.

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Assistant Registrar
MPDD, IGNOU, New Delhi
September, 2021
© Indira Gandhi National Open University, 2021
ISBN:
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COURSE INTRODUCTION
To understand the dynamics of business and analyse its operations one needs
to be aware of various domains of knowledge and skill sets. When executives
move to managerial roles they should be equipped with multidisciplinary
skill sets and accountancy is one of them. This course is designed in a way
that even learners with no prior knowledge of accountancy will be able to
prepare and analyse various accounting statements after completing this
course.

The first part of this course “Accounting an Overview” consists of five units.

Unit 1 discusses the scope of accounting along with the conceptual

framework of accounting.

Unit 2 explains the basic accounting process along with the rules for making
entry into primary books of accounts viz. Journal and Ledger. Any
discrepancy in the accounting statements can be traced back to these primary
books, therefore it is of utmost importance for you to understand this process
of making entries into Journal and posting them into ledger

Unit 3 deals with the preparation of financial statements viz. Trading and
Profit& Loss account and Balance Sheet. Preparation of financial statement is
the culmination of accounting process and these financial statements give an
fair idea about the profitability and cost structure of the business.

Unit 4&5 deals with preparation of final accounts of companies and cash
flow statement. Companies are more complex entities as compared to
proprietorship and partnership firms and in addition they are also governed
by the companies act 2013. Keeping in view the requirements of the
Companies Act, 2013, we discuss the preparation of final account of
companies and cash flow statement. Cash flow statement is a tool through
which we can analyse the source of cash and application of cash for the
business activities. Profit/loss calculated from profit and loss account does
not give an idea about the liquidity position of the firm; therefore cash flow
statement is prepared.

The second and third part of this course deals with some aspects of cost
management. Cost management has gained significance in recent years due to
emergence of global value chains and dismantling of trade and non trade
barriers.

Unit 6 deals with classification of costs. The various elements of cost are first
explained followed by discussion on its various components which will help
you to understand the application of these concepts to managerial decisions.

Unit 7 discusses two well known techniques of costing: Absorption Costing

and Marginal Costing. Absorption costing takes into consideration both fixed
and variable cost for determining the cost of the product whereas marginal
cost only considers variable cost while charging fixed cost to the revenue of
that particular period. These techniques provide inputs for managerial
decisions like volume of production, procure r produce and many other.
In unit 8 we discuss about Activity Based Costing (ABC). In this system of
costing the costs are first traced to the activity involved and then to the
product. This method of costing provides a better way to trace the costs and
subsequently control it.

The third part of this course discusses the application of cost accounting
techniques.

Unit 9 deals with Cost Volume Profit (CVP) analysis, wherein we discuss the
impact of various variables on profit.

Unit 10 deals with budgeting and budgetary control. Cost and time over run
is a serious managerial challenge. To tackle this awell defined budget is
required and to monitor progress and avoid cost and time overrun budgetary
control techniques are used.

Unit 11 deals with variance analysis. Production planning is based on certain

pre defined cost and performance standards .During the production process
these pre defined standards may be violated. To measure the impact of
deviation from pre defined standards we use the technique of variance
analysis.

The fourth part of this course deals with financial statement analysis.

Unit 12 deals with understanding annual report. Annual report contains

wealth of information about the company and is also indicative of the future
plans of the company. We discuss the contents of annual report and how to
interpret these contents.

Unit 13&14 deals with various techniques used to analyse the various aspects
of business. The techniques discussed are comparative, common size and
trend analysis along with ratio analysis.

The fifth part of this course discusses few of the recent trends emerging in
accounting.

Unit 15 discusses human resource accounting. This concept of accounting

envisages that the expenses on development of human resources shall be
treated as capital expense instead of revenue expense and shown in the
balance sheet as an asset. This concept of accounting is yet to gain
acceptance so as to appear in the balance sheet, but many companies have
started valuing their human resources and same is shown in separate
statement in annual report.

Unit 16 discusses Forensic Accounting. Recent decades have witnessed

variety of financial scams and frauds. Forensic accounting is a technique to
investigate frauds and collect evidence which are sustainable in court of law.
On completion of this course you would be able to prepare the financial
statements and will have the ability to comprehend complex financial
transactions along with the analysis of annual reports. You would also be
aware of the some of the recent trends in accounting.
 BLOCK 1
ACCOUNTING: AN OVERVIEW
 Introduction to
UNIT 1 INTRODUCTION TO ACCOUNTING Accounting

Objective
After studying this unit, you should be able to appreciate:

 Nature and role of accounting;

 Meaning and objectives of accounting

 Different branches of accounting

 Users of Accounting information

 The basic accounting concepts, principles and conventions

Structure
1.1 Introduction
1.2 Scope and Objectives of Accounting
1.3 Definition of Accounting
1.3.1 Steps in Accounting Cycle
1.3.2 Book Keeping vsAccounting
1.3.3 Systems of Accounting
1.3.4 Applications of Accounting
1.3.5 Qualitative Characteristics of Accounting
1.4 Accounting as an Information System of Accounting
1.4.1 Nature of Accounting Function
1.5 Emerging role of Accounting
1.6 Accounting Personnel
1.7 Accounting Framework
1.7.1 Accounting Concepts
1.8 Summary
1.9 Answers to Check Your Progress

1.1 INTRODUCTION
Accounting is often called the language of business. The basic function of
any language is to serve as a means of communication. In this context, the
purpose of ac-counting is to communicate or report the results of business
operations and its various aspects. Accounting has been defined in various
ways. According to one commonly accepted definition, "Accounting is the art
of recording, classifying and summarising in a significant manner and in
terms of money, transactions and events which are; in part at least, of
financial character and interpreting the results thereof'. Another definition
which is less restrictive interprets accounting as "The process of identifying,
measuring and communicating economic information to permit informed
judgements and decisions by the users of information".
7
Accounting: An
Overview
1.2 OBJECTIVESAND SCOPE OF ACCOUNTING
The main objectives of accounting are:

To maintain a systematic record of business transactions

 Accounting is prepared to maintain a systematic record of all the
financial transactions or monetary transaction in a book of accounts
 For this purpose, all the transactions are recorded in chronological order
in Journal and then posted to principal book i.e. Ledger, Trial balance.
To ascertain profit and loss
 Every businessman is curious to know the net results of business
operations periodically.
 In order to find out whether the business has earned profits or incurred
losses, we prepare a “Profit & Loss Account”.
To determine the financial position
 Another important objective is to determine the financial position of the
business to check the value of assets and liabilities.
 For this purpose, we prepare a “Balance Sheet”.
To provide information to various users
 The most important objectives of accounting. Is to provide information
to the various interested parties or stakeholders
 The information provided by accounts helps them in making good
financial decisions.
To assist the management
 By analysing financial data and providing interpretations in the form of
reports, accounting assists management in handling business operations
effectively.
SCOPE OF ACCOUNTING
The scope of accounting can be presented in a diagrammatic form as shown
in Figure 1.1.

Source: Adapted from R.J. Bull, Accounting in Business, Butterworths, London, 1969,p.2.
8
Data creation and collection is the area which provides raw material for Introduction to
Accounting
accounting. The data collected is `historic' in the sense that it refers to events
which have already taken place. Earlier, accounting was largely concerned
with what had happened, rather than making any attempt to predict and
prepare for future.

After the historic data has been collected, it is recorded in accordance with
generally accepted accounting theory. A large number of transactions or
events have to be entered in the books of original entry (journals) and ledgers
in accordance with the classification scheme already decided upon. The
recording and processing of information usually accounts for a substantial
part of total accounting work. This type of activity of accounting may be
called recordative. The processing method employed for recording may be
manual, mechanical or electronic. Computers are also used widely in modern
business for doing this job.

Data evaluation is regarded as the most important activity in accounting

these days. Evaluation of data includes controlling the activities of business
with the help of budgets and standard costs (budgetary control), evaluating
the performance of business, analysing the flow of funds, and analysing the
accounting information for decision-making purposes by choosing among
alternative courses of action.

The analytical and interpretative work of counting may be for internal or

external uses and may range from snap answers to elaborate reports produced
by extensive research. Capital project analysis, financial forecasts, budgetary
projections and analysis for reorganisation, takeover or merger often lead to
research-based reports.

Data evaluation has another dimension and this can be known as the auditive
work which focuses on verification of transactions as entered in the books of
account and authentication of financial statements. This work is done by
public professional accountants. However, it has become common these days
for even medium-sized organisations to engage internal auditors to keep a
continuous watch over financial flows and review the operation of the
financial system.

Data reporting consists of two parts-external and internal. External reporting

refers to the communication of financial information (viz., earnings, financial
and funds position) about the business to outside parties, e.g., shareholders,
government agencies and regulatory bodies of the government. Internal
reporting is concerned with the communication of results of financial analysis
and evaluation to management for decision-making purposes.

You will note that accounting theory has been shown in the centre of the
diagram.

The central purpose of accounting is to make possible the periodic matching

of costs (efforts) and revenues (accomplishments). This concept is the
nucleus of accounting theory. However, accounting is moving away from its
traditional procedure-based record -keeping function to the adoption of a role
which emphasises its social importance.
9
Accounting: An
Overview
1.3 DEFINITION OF ACCOUNTING
Accounting can be defined as a process of reporting, recording, interpreting
and summarising economic data. The introduction of accounting helps the
decision-makers of a company to make effective choices, by providing
information on the financial status of the business

Accounting is a system which identify the transaction, record those

transaction of a business organisation in a way that can be compared with the
other business as well as within the business with the past performance..
Accounting is a part of our daily life a person most common use of
accounting is to check accounts, Tax forms, Pay roll any credit taken all these
experience focus on record keeping part of accounting. Now days due to
advancement of technology the recording part is done with the help of
technology still the analysis is done by human minds thus understanding the
various concept of accounting is important

The American Institute of Certified Public Accountants (AICPA) had defined

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

As per Robert N. Anthony – “Accounting system is a means of collecting,

summarizing, analyzing and reporting, in monetary terms, information about
the business”.

To understand accounting efficiently, it is important to understand the

following aspects of accounting.

Economic Events- Economic events are those which are a result of a

consequence of a monetary transaction which company has to undergo during
its lifetime. Such as purchasing new machinery, transportation, machine
installation on-site, etc.

Identification, Measurement, Recording, and Communication- The

purpose of accounting system should be elaborated in such a way that the
right data is identified, measured, recorded and communicated to the right
individual and at the right time.

Organization-It refers to the size of business and the types of activities.

Assets –Assets are those resources owned by organization which helps the
company to earn profit. The economic value of an item which is possessed by
the enterprise is referred to as Assets. e.g. Plant and Machinery, Furniture and
Fittings, Land and Buildings, Books, Computers, Motor Vehicles, etc Assets
can Tangible which can be seen or touched and Intangible for example
Goodwill, Patent etc,

Liabilities - The economic value of an obligation or debt that is payable by

the enterprise to other establishment or individual is referred to as liability. In
other words, liabilities are the obligations or responsibility that are arise out
of previous transactions, which is payable by the enterprise, through the
10 assets possessed by the enterprise. Liabilities can be classified as Fixed and
current. For example outstanding expenses , Debentures , Loans from banks Introduction to
Accounting
and financial institutions

Owner’s Equity - Owner‟s equity is one of the 3 vital segments of a sole

proprietorship‟s balance sheet and one of the main aspects of the accounting
equation:

Assets = Liabilities + Owner’s Equity.

It represents the owner‟s investment (Capital) in the trade minus the owner‟s
withdrawal from the trade (Drawings) + the net income since the business
concern commenced.

1.3.1 Steps in Accounting Cycle

The following attributes or characteristics can be drawn from the definition of
Accounting:

Identifying financial transactions and events

 Only those transactions and events which are of financial nature.

 Therefore, first of all, such transactions and events are identified.

Measuring the transactions

 The transactions and events are measured in terms of money which is
considered as a common unit.

Recording of transactions
 Accounting involves recording the financial transactions inappropriate
book of accounts such as Journal or Subsidiary Books.

Classifying the transactions

 Transactions recorded in the books of original entry – Journal or
Subsidiary books are classified and grouped according to nature and
posted in separate accounts known as „Ledger Accounts‟.

Summarising the transactions

 It involves presenting the classified data in a manner and in the form of
statements, which are understandable by the users.

 It includes Trial balance, Trading Account, Profit and Loss Account and
Balance Sheet.

Analysing and interpreting financial data

 Results of the business are analyzed and interpreted so that users of
financial statements can make a meaningful and sound judgment.

Communicating the financial data or reports to the users

 Communicating the financial data to the users on time is the final step of
Accounting so that they can make appropriate decisions. It not only
11
Accounting: An record classifies and summaries the business data but also analyse and
Overview
interprets the results for the future decisions.

1.3.2 Bookkeeping Vs Accounting

Bookkeeping It is a component of accounting that involves the process of

identifying the financial transactions, measuring, recording
and classifying those transactions that have occurred in the
course of business.

Accounting Accounting begins where Book Keeping ends. It is a wider

concept and includes summarizing, interpreting and
communicating the financial data to the users of financial
statements.

Accountancy Accountancy refers to systematic knowledge of the

accounting principles and the techniques.

Parameters Bookkeeping Accounting

Scope It involves identifying, In addition to bookkeeping,

measuring, recording & Accounting also involves
classifying financial summarizing, interpreting and
transactions in the ledger communicating the financial data
accounts. to the users of financial
statements.

Objective The major objective is to Its objective is to determine the

maintain systematic profitability and financial
records of financial position of the business.
transactions.

Stage It is a primary stage of Accounting starts where book

accounting keeping ends.

Nature of It is routine and It is analytical in nature.

job repetitive in nature.

Level of Bookkeeping does not It requires specialized skill and is

skills require special skills and performed by senior staff.
is performed by Junior
Staff.

1.3.3 Systems of Accounting

There are following two systems of recording transactions in the books of
accounts:

12 I. Double Entry System

II. Single Entry System Introduction to
Accounting

Double-entry system
 The double entry system is based on the Dual Aspect Principle.

 Every transaction has two aspects, „a Debit‟ and „a credit‟ of an equal

amount.

 This system of accounting recognises and records both aspects of the

transaction.

 Minimum two accounts are involved.

 The accounting equation should not be violated.

Single entry system

 Under this system, both aspects are not recorded for all the transactions.

 Either only one aspect is recorded or both the aspects are not recorded
for all the transactions.

Advantages of the Double-entry System of Accounting

Following are the main merits of the double-entry system of accounting:

i. Scientific system
 As compared to the single-entry systems, this system is more
scientific and is useful to achieve the objective of accounting.
ii. A complete record of the transaction
 Since both the aspects of transactions are considered, thus there is a
complete recording of each and every transaction.
 Using these records one can compute profit or loss easily.

iii. Checks arithmetical accuracy of accounts

 Under this system, one can check the arithmetical accuracy of the
records by preparing a Trial Balance.
iv. Determination of profit/loss and depiction of financial position
 Under this system one get to know about the profit earned or loss
incurred by preparing „Profit & Loss A/c‟ we get
 By preparing the „Balance Sheet‟ the financial position of the
business can be ascertained, i.e., position of assets and liabilities is
depicted.
v. Helpful in decision making
 Under the double-entry system of accounting, administration and
management are able to take decisions on the basis of factual
information.

1.3.4 Applications of Accounting

13
Accounting: An The following are the main applications of accounting:
Overview

Provide information about financial performance

 Accounting provides factual information about the financial performance
of an enterprise during a given time period.
 It provides information like, profit earned or loss incurred over a period
of time (through profit and loss statement) and financial position
(through balance sheet) at a particular point of time.
Provide assistance to management
 Accounting also assists the management in business planning, decision
making and in exercising control by providing financial information in
the form of reports.
Facilitates comparative study
 Accounting helps in making a comparison by keeping a systematic
records and preparation of reports at regular intervals.
Helps in settlement of tax liability
 Systematic accounting records further help in settlement of various tax
liabilities such as – Income Tax, GST, etc.
Helpful in raising loan
 On the basis of appraisal of the financial statement of the firm, banks and
Financial Institutions grant a loan to the firm.
Helpful in decision making
 Accounting also provides useful information to the management for
taking vital decisions.
Substitute of human memory:
 Since it is difficult for a human to remember all the transactions of the
business, accounting serve as a substitute of human memory by
recording all the transaction and keep all information handy as and one
require.
Helps in the valuation of business:
 In case of the shut down and dissolution of business , accounting helps
the businessman to determine the value of business otherwise it is not
possible to determine value of business

A. Limitations
Following are the limitations of accounting:

Accounting is not precise: Accounting is often subjected to personal bias or

judgment.
Accounting is done on historic values of assets: Accounting records assets
at their historical cost less depreciation and does not reflect their current
14 market value.
Ignore the effect of price level changes: Accounting statements are Introduction to
Accounting
prepared at historical cost and thus ignores the changes in the value of
money.

Ignore the qualitative information: Accounting ignores the qualitative

aspects as it records only monetary transactions.

Affected by window dressing: Window dressing means manipulation in

accounting, in order to present a more favourable position of the business
than the actual position.

1.3.5 Qualitative Characteristics of Accounting Information

Qualitative characteristics are the attributes of accounting information, which
enhance its understand ability and usefulness:
Reliability: Reliability means that the information must be free from material
error and personal bias. Unless the information is reliable the accounting
records cannot be prepared accurate.

Relevance: To be useful: accounting information must be relevant to the

decision-making requirements of the users.

Understand ability: Information should be disclosed in financial statements

in such a manner that these are easily understandable.

Comparability: Both intra-firm and inter-firm comparison must be possible

over different time periods. That is the performance of company can be
compared with its previous performance and with other companies also.

1.4 ACCOUNTING AS AN INFORMATION

SYSTEM
While discussing the scope of accounting you must have observed that
accounting involves a series of activities linked with each other, beginning
with the collecting, recording, analysing and evaluating the data, and finally
communicating information to its users. Information has no meaning unless it
is linked with a certain purpose. Accounting as a social science can be
viewed as an information system since it has all the features of a system. It
has its inputs (raw data), processes (men and equipment), and outputs (reports
and information). If we consider accounting as an information system, then
we are in a position to make some important observations. First, the goal of
the system is to provide information which meets the needs of its users. If we
can correctly identify the needs of the users, we are then able to specify the
nature and character of the outputs of the system. Secondly, it is the output
requirements that .determine the type of data which would be selected as the
inputs for processing into information output.

There are several groups of people who have a stake in a business

organisation-managers, shareholders, creditors, employees, customers, etc.
Additionally, the community at large has economic and social interest in the
activities of such organisations. This interest is expressed at the national level
by the concern of government in various aspects of the firms' activities, such
15
Accounting: An as their economic well-being, their contribution to welfare, their part in the
Overview
growth of the national product, to mention only a few examples.

We shall now briefly discuss what the information needs of various users are.

Shareholders and Investors: Since shareholders and other investors have

invested their wealth in a business enterprise, they are interested in knowing
periodically about the profitability of the enterprise, the soundness of their
investment and the growth prospects of the enterprise. Historically, business
accounting was developed to supply information to those who had invested
their funds in business enterprises.

Creditors: Creditors may be short-term or long -term lenders. Short-term

creditors include suppliers of materials, goods or services. They are normally
known as trade creditors. Long-term creditors are those who' have lent money
for a long period, usually in the form of secured loans. The main concern of
the creditors is focused on the credit worthiness of the firms and its ability to
meet its financial obligations. They are therefore concerned with the liquidity
of the firms, its profitability and financial soundness. In other words, it can
also be stated that creditors are interested mainly in information which deals
with solvency, liquidity and profitability so that they could assess the
financial standing of the firms.

Employees: The view that business organisations exist to maximise the

return to shareholders has been undergoing change as a result of social
changes. A broader view is taken today of economic and social role of
management. The importance of harmonious industrial relations between
management and employees cannot be over-emphasised. That the employees
have a stake in the outcomes of several managerial decisions is recognised.
Greater emphasis on industrial democracy through employee participation in
management decisions has important implications for the supply of
information to employees. Matters like settlement of wages, bonus, and profit
sharing rest on adequate disclosure of relevant facts.

Government: In a mixed economy it is considered to be the responsibility of

the Government to direct the operation of the economic system in such a
manner that it sub serves the common good. Controls and regulations on the
operations of private sector enterprises are the hallmark of mixed economy.
Several government agencies collect information about various aspects of the
activities of business organisations. Much of this information is a direct
output of the accounting system, for example, levels of outputs, profits,
investments, costs, and taxes, etc. All this information is very important in
evolving policies for managing the economy. The task of the Government in
managing the industrial economy of the country is facilitated if accounting
information is presented, as far as possible, in a uniform manner. It is clear
that if accounting information is distorted due to manipulations and window-
dressing in the presentation of annual accounts, it will have ill-effects on the
measures the government intends to take and the policies it wishes to adopt.
Management: Organisations may or may not exist for the sole purpose of
profit. However, information needs of the managers of both kinds of
16 organisations are almost the same, because the managerial process i.e.,
planning, organising and controlling is the same. All these functions have one Introduction to
Accounting
thing in common and it is that they are all concerned with making decisions
which have their own specific information requirements. The emphasis on
efficient and effective management of organisations has considerably
extended the demand for accounting information. The role of accounting as
far as management is concerned was highlighted earlier when we discussed
about management accounting.

Consumers and others: Consumers' organisations, media, welfare

organisations and public at large are also interested in condensed accounting
information in order to appraise the efficiency and social role of the
enterprises in different sectors of the economy, that is, what levels of profits
and outputs are being achieved, in what way the social responsibility is being
discharged and in what manner the growth is being planned by the enterprises
in-accordance with the national priorities etc.

The above discussion perhaps has indicated to you that the information needs
of the various users may not necessarily be the same. Sometimes, they may
even conflict and compete with each other. In any case, the objective of
accounting information is to enable information users to make optimum
decisions.

1.4.1 Nature of Accounting Function

Accounting is a service function. The chief accounting executive (by
whatever name he is called) holds a staff position except within his own
department where he exerts authority. This is in contradistinction to the roles
played by production or marketing executives who hold line authority: The
role of the accountant is advisory in character. He works through the
authority of the chief executive. The accounts and or finance department(s)
don‟t exercise direct authority over line departments. In decentralised
structure with a number of units and divisions, the accounting executive
however exercises what is known as the functional authority over all the
accounting staff deployed in different segments.

There are two facets to the role of the accountant. For the top managers he
works as a watchdog and for middle and lower level managers he acts as
`
helper'. The watchdog role is usually performed through `score-keeping' task
of accounting and reporting to all levels of management. The `helper' role is
usually performed through the task of directing managers' attention to
problems and assisting them in solving problems.

Mutual understanding and rapport between the accountant and the manager,
in the tasks of attention-directing and problem-solving can be enhanced if
accountant and his staff frequently interact with the line managers and guide
them in matters concerned with preparation of budgets and control
documents with which they might not be conversant. This will instil
confidence among line managers regarding the reliability of reports.

17
Accounting: An
Overview
1.5 EMERGING ROLE OF ACCOUNTING
The history of accounting indicates the evolutionary pattern which reflects
changing socio-economic conditions and the enlarged purposes to which
accounting is applied. In the present context four phases in the evolution of
accounting can be distinguished.

Stewardship Accounting
In earlier times in history, wealthy people employed `stewards' to manage
their property. These stewards rendered an account of their stewardship to
their owners periodically. This notion lies at the root of financial reporting
even today which essentially involves the orderly recording of business
transactions, commonly known as 'book-keeping'. Indeed the accounting
concepts and procedures, in use today for systematic recording of business
transactions have their origin in the practices employed by merchants in Italy
during the 15th century. The Italian method which specifically began to be
known as `double entry book-keeping' was adopted by other European
countries during the 19th century. Stewardship accounting, in a sense, is
associated with the need of business owners to keep records of their
transactions, the property and tools they owned debts they owed, and the
debts others owed them.

Financial Accounting
Financial accounting dates from the development of large-scale business and
the advent of Joint Stock Company (a form of business which enables the
public to participate in providing capital in return for `shares' in the assets and
the profits of the company). This form of business organisation permits a
limit to the liability of their members to the nominal value of their shares.
This means that the liability of a shareholder for the financial debts of the
company is limited to the amount he had agreed to pay on the shares he
bought. He is into liable to make any further contribution in the event of the
company's failure or liquidation. As a matter of fact, the law governing the
operations (or functioning) of a company in any country (for instance the
Companies Act in India) gives a legal form to the doctrine of stewardship
which requires that information be disclosed to the shareholders in the form
of annual income statement and balance sheet.

Briefly speaking, the income statement is a statement of profit and loss made
during the year of the report; and the balance sheet indicates the assets held
by the firm and the monetary claims against the firm. The general
unwillingness of the company directors to disclose more than the minimum
information required by law and the growing public awareness have forced
the governments in various countries of the• world to extend the disclosure
(of information) requirements

The importance attached to financial accounting statements can be traced to

the need of the society to mobilise the savings and channel them into
profitable investments. Investors, whether they are large or small, must be
provided with reliable and sufficient information in order to be able to make
18
efficient investment decisions. This is the most significant social purpose of Introduction to
Accounting
financial accounting.

Cost Accounting
The industrial revolution in England presented a challenge to the
development of accounting as a tool of industrial management. Costing
techniques were developed as guides to management actions. The increasing
awareness on the part of entrepreneurs and industrial managers for using
scientific principles of management in the wake of scientific management
movement led to the development of cost accounting. Cost accounting is
concerned with the application of costing principles, methods and techniques
for ascertaining the costs with a view to controlling them and assessing the
profitability and efficiency of the enterprise.

Management Accounting
The advent of management accounting was the next logical step in the
developmental process.-The practice of using accounting information as a
direct aid to management is a phenomenon of the 20th century, particularly
the last 30-40 years. The genesis of modern management with its emphasis
on detailed information for decision- making provide a tremendous impetus
to the development of management accounting.

Management accounting is concerned with the preparation and presentation

of ac-counting and controlling information in a form which assists
management in the 'formulation of policies and in decision-making on
various matters connected with routine or non-routine operations of business
enterprise. It is through the techniques of management accounting that the
managers are supplied with information which they need for achieving
objectives for which they are accountable. Management accounting has thus
shifted the focus of accounting from recording and analysing financial;
transactions to using information for decisions affecting the future. In this
sense, management accounting has a vital role to play in extending the
horizons of modern business. While the reports emanating from financial
accounting are subject to the conceptual framework of accounting, internal
reports-routine or non-routine are free from such constraints.

Social Responsibility Accounting

Social responsibility accounting is a new phase in the development of
accounting and owes its birth to increasing social awareness which has been
particularly noticeable over the last two decades or so. Social responsibility
accounting widens the scope of accounting by considering the social effects
of business decisions; in addition to the economic effects. Several social
scientists, statesmen and social workers all over the world have been drawing
the attention of their governments and the people in their countries to the
dangers posed to environment and ecology by the unbridled industrial
growth. The role of business in society is increasingly coming under greater
scrutiny\ The management is being held responsible not only for efficient
conduct of business as expressed in profitability, but also for what it
contributes to social well being and progress. There is a growing feeling that
19
Accounting: An the concepts of growth and profit as measured in traditional balance sheets
Overview
and income statements are too narrow to reflect the social responsibility
aspects of a business.

Human Resource Accounting

Way back in 1964 the first attempt to include figures on human capital in the
balance sheet was made by Hermansson which later came to be known as
Human Resource Accounting. However there had been a great socio-
economic shift in the 1990's with the emergence of "Knowledge economy", a
distinctive shift towards recognition of human and intellectual capital in
contrast to physical capital. Human Resource Accounting is a branch of
accounting which seeks to report and emphasise the importance of human
resources (knowledgeable, trained, loyal and committed employees) in a
company's earning process and total assets. It is concerned with "the process
of identifying and measuring data about human resources and communicating
this information to interested parties". In simple words it involves accounting
for investment in people and replacement costs as well as accounting for the
economic values of people to an organisation. Generally the methods used for
valuing and accounting of human resources are either based on costs or on
economic value of human resources., However providing adequate and valid
information on human assets (capital), which are outside the concept of
ownership, in figures is very difficult. Nevertheless HRA is a managerial tool
providing valuable information to the top management to take decisions
regarding adequacy of human resources and thus encouraging managers to
consider investment in manpower in a more positive way.

Inflation Accounting
Inflation Accounting is concerned with the adjustment in the value of assets
(current and fixed) and of profit in the light of changes in the price level. In a
way, it is concerned with the overcoming of limitations that arise in financial
statements on account of the cost assumption (that is recording of the assets
at their historical or original cost) and the assumption of stable monetary unit
(these are discussed in detail in the next unit). It thus aims at correcting the
distortions in the reported results caused by price level changes. Generally,
rising prices during inflation have the distorting influence of overstating the
profit. Various approaches have been suggested to deal with this problem.

1.6 ACCOUNTING PERSONNEL

There is hardly any organisation which does not have an accountant. His role
is all pervasive and he is involved in a wide range of activities, particularly in
a large and complex organisation. The exact duties of an accountant might
differ in different organisations. However, a broad spectrum of
responsibilities can be identified.

The accountants can be broadly divided into two categories, those who are in
public practice and those who are in private employment. The accountants in
public practice offer their services for conducting financial and or cost audit.
As such, they are known as auditors. The auditor examines the books of
20
account and reports on the balance sheet and profit and loss account of the Introduction to
Accounting
company as to whether they give a true and fair view of the state of affairs of
the company and its profit respectively. The auditor in a company is
appointed by the shareholders to whom he reports. Public accountants are
generally members of professional bodies like the Institute of Chartered
Accountants of India or the Institute of Cost and Works Accountants of India.
In addition to conducting financial or cost audit (in accordance with the
requirements of the Companies Act), as the case may be, they may also
provide consultancy services for design Qing or improving accounting and
management control systems.

Accountants in employment may be in various business or non-business

organisations to perform a variety of accounting and management control
functions. Accountants at higher levels generally belong to professional
accounting bodies but those who are at

lower levels need not be so. Accounting chiefs in different organisations,

depending upon their nature of work, are variously designated as finance
officers or internal auditors or chiefs accounts officers, etc. The term
`controller' as the head of the accounting and finance function is not very
popular in India but of late it has been catching up. Several large
organisations, both in the public and private sectors, have now controllers.
Let us have an idea of who these people are and what they do.

Internal Auditor: Internal Auditor is an employee of the organisation in

contrast to an external auditor who is paid a fee for his services. The internal
auditor is responsible for performing monitoring activities and other services,
including designing and operating the system of internal control, auditing the
data reported to the directors of the company, and assisting external auditors.
The head of the internal audit function and reports directly either to the chief
executive or to the audit committee of the Board of Directors.

Internal audit includes continuous verification of entries appearing in the

books of account with the original vouchers and proper accounting of assets.
Further, it at-tempts to ensure that the policies and procedures regarding
financial matters are being complied with. Internal auditing is also concerned
with administering the system of internal check so that mistakes, innocent or
intentional, are prevented from taking place.

We should distinguish an internal auditor from an external auditor. While an

internal auditor devotes his entire time and energy to the needs of one
company (i.e., his employer), an external auditor serves many clients. The
primary function of the external auditor, as pointed out earlier, is to safeguard
the interests of the shareholders (by whom he is appointed) by an
independent and impartial appraisal of the financial transactions of the
company so that he could report on the net profit earned by the company and
its financial position. His role is that of an objective outsider, expressing
expert opinions to the financial condition and operating results of the client's
business.

A part from shareholders, other parties such as banks, lending institutions,

government agencies, etc. reply on the fairness of such financial reports in 21
Accounting: An making certain decision about a given company. An auditor is bound by a set
Overview
of professional regulations which include an examination on technical
competence and adherence to a code of ethical conduct.

Controller : Controller- the other name for Chief Accountant- is usually the
head of the whole area of accounting, including internal audit. He is overall
in - charge of all the activities comprising financial accounting, cost
accounting, management accounting, tax accounting etc. He exercises
authority both for accounting within the organisation and for external
reporting. The external reports include reports to government revenue
collecting and regulatory bodies, such as Company Law Board and Income
Tax. Department He may also supervise the company's internal audit and
control systems. In addition to processing historical data, he is expected to
supply a good deal of accounting information to top management concerning
future operations, in line with the management's planning and control needs.
Besides, he is also expected to supply detailed information to managers in
different functional areas ( like production, marketing, etc.) and at different
levels of the organisation.

We may enumerate the functions of the controller as follows:

a) Designing and operating the accounting system

b) Preparing financial statements and reports
c) Establishing and maintaining systems and procedures
d) Supervising internal auditing and arranging for external audit
e) Supervising computer applications
f) Overseeing cost control
g) Preparing budgets
h) Making forecasts and analytical reports
i) Reporting financial information to top management
j) Handling tax matters.

Treasurer: He is the custodian arid manager of all the cash and near-cash
resources of the firm. The treasurer handles credit reviews and sets policy for
collecting receivables (debtors of the firm to whom the firm has sold goods or
services) He also handles relationships with banks and other lending or
financial institutions.

The Financial Executive Institute (of United States of America) makes the
following distinction between controllership and treasurer ship functions:
Controllership Treasurership
Planning and Control Provision of Capital
Reporting and Interpreting Investor Relations
Evaluating and Consulting Short-term Financing
Tax Administration Banking and Custody
Government Reporting Credit and Collections
Protection of Assets Investments
22 Economic Appraisal Insurance
Finance Officer: Finance is the life blood of business. Procuring financial Introduction to
Accounting
resources and their judicious utilisation are the two important activities of
financial management. Financial management includes three major decisions:
investment decision, financing decision and dividend decision. Investment
decision is perhaps the most important decision because it involves allocation
of resources. It is concerned with future which being uncertain involves risk.
How the firm is allocating its scarce resources and is planning growth will
largely determine its value in the market place. Financing decision is
concerned with determining the optimum financing mix or capital structure.
It examines the various methods by which a firm obtains short-term and long
- term finances through various alternative sources. The dividend decision is
concerned with question like how much of the profit is to be retained and
how much is to be distributed as dividends. The finance manager has to strike
a balance between the current needs of the enterprise for cash and the needs
of the shareholders for an adequate return. The financial management of a
large company is usually the responsibility of the finance director who may
be in place of, or in addition to the controller. Often finance manager and
controller are inter-changeable terms and only one of these two positions may
be found in a company. The finance manager when there is a controller also
in the organisation, is concerned with implementing the financial policy of
the board of directors, managing liquidity, preparation of budgets and
administration of budgetary control system, managing profitability, etc.

Though financial management is regarded as a separate area, this function is

per-formed in several countries, including India, by the Accountant ( or the
Financial Controller) several large organisations however have a financial
executive besides the chief accountant. Often, finance and accounting
functions are clubbed together in one person in small organisations.

1.7 ACCOUNTING FRAMEWORK

The rules and conventions of accounting are commonly referred to as the
conceptual framework of accounting. As with any discipline or body of
knowledge, some underlying theoretical structure is required if a logical and
useful set off practices and procedures are to be developed for reaching the
goals of the profession and for expanding knowledge in that field. Such a
body of principles is needed to help answer new questions that arise. No
profession can thrive in the absence of a theoretical frame-work. According
to Hendriksen (1977), Accounting theory may be defined as logical reasoning
in the form of a set of broad principles that

(i) provide a general frame of reference by which accounting practice

can be evaluated, and

(ii) guide the development of new practices and procedures. Accounting

theory may also be used to explain existing practices to obtain a
better understanding of them. But the most important goal of
accounting theory should be to provide a coherent set of logical
principles that form the general frame of reference for the evaluation
and development of sound accounting practices.
23
Accounting: An The American Institute of Certified Public Accountants (AICPA) discusses
Overview
financial accounting theory and generally accepted accounting principles as
follows.

Financial statements are the product of process in which a large volume of

data about aspects of the economic activities of an enterprise are
accumulated, analysed, and reported. This process should be carried out in
accordance with generally accepted accounting principles. Generally
accepted accounting principle incorporate the consensus at a particular time
as to which economic resources and obligations should be recorded as assets
and liabilities by financial accounting, which changes in assets and liabilities
should be recorded, when these changes should be recorded, how the assets
and liabilities and changes in them should be measured, what information
should be disclosed and how it should be disclosed, and which financial
statements should be prepared.

Generally accepted accounting principles encompass the conventions, rules

and procedures necessary to define accepted accounting practice at a
particular time generally accepted accounting principles include not only
broad guidelines of general application, but also detailed practices and
procedures.

(Source: AICPA Statements of the Accounting Principles Board No.4 "Basic

Concept and Accounting Principles Underlying Financial Statement of
Business Enterprises", October, 1970, pp.54-55)

The word `principles' is used to mean a "general law or rule adopted or

professed as a guide to action, a settled ground or basis of conduct or
practice". You will note that this definition describes a principle as a general
law or rule that is to be used as a guide to action. This implies that
accounting principles do not prescribe exactly how each detailed event
occurring in business should be recorded. Consequently, there are several
matters in accounting practice that may differ from one company to another.

Accounting principles are man-made. They are accepted because they are
believed to be useful. The general acceptance of an accounting principle (or
for that matter any principle) usually depends on how well it meets the three
criteria of relevance, objectivity, and feasibility. A principle is relevant to
the extent that it results in meaningful or useful information to those who
need to know about a certain business. A principle is objective to the extent
that the information is not influenced by the personal bias or judgment of
those who furnished it. Objectivity connotes reliability or trustworthiness
which also means that the correctness of-the information reported can be
verified. A principle is feasible to the extent that it can be implemented
without undue complexity or cost.

1.7.1 Accounting Concepts

Earlier, we had described accounting as the language of business. As with
language, accounting has many dialects. There are differences in
24
terminology. In dealing with the framework of accounting theory, one is Introduction to
Accounting
confronted with a serious problem arising from differences in terminology. A
number of words and terms have been used by different writers to express
and explain the same idea or notion. Thus, confusion abounds in the literature
in so far as the theoretical framework is concerned. The various terms used
for describing the basic ideas are: concepts, postulates, propositions, basic
assumptions, underlying principles, fundamentals, conventions, doctrines,
rules, etc. Although each of these terms is capable of precise definition,
general usage by the profession of accounting has served to give them loose
and overlapping meanings. The same idea has been described by one author
as a concept and by another as a convention. To take another instance, the
idea implied in Conservatism has been labelled by one author as a
(modifying) convention, by another as a principle and yet by another as a
doctrine. The wide diversity in terminology to express the basic framework
can only serve to confuse the learner

Without falling into the trap of this terminological maze, we are explaining
below some widely recognised ideas and we call all of these concepts. We do
feel, however, that some of these ideas have a better claim to be called
`concepts', while the rest should be called `conventions'. Fundamental
accounting concepts are broad general assumptions with underlie the periodic
financial accounts of business enterprises. The reason why some of these
ideas should be called concepts is that they are basic assumptions and have a
direct bearing on the quality of financial accounting information. The
alteration of any of the basic concepts (or postulates) would change the entire
nature of financial accounting.

Business Entity Concept

In accounting we make a distinction between business and the owner. All the
records are kept from the viewpoint of the business rather than from that of
the owner. An enterprise is an economic unit separate and apart from the
owner or owners. As such, transactions of the business and those of the
owners should be accounted for and reported separately. In recording a
transaction the important question is how does it affect the business? For
example, if the owner of a shop were to take cash from the cash box for
meeting certain personal expenditure, the accounts would show that cash had
been reduced even though it does not make any difference to the owner
himself. Similarly, if the owner puts cash into the business, he has a claim
against the business for capital brought in.

This distinction can be easily maintained in the case of a limited company

because a company has a legal entity (or personality) of its own. Like a
natural person it can engage itself in economic activities of producing,
owning, managing, storing, transferring, lending, borrowing and consuming
commodities and services. Distinction, however, is difficult in the case of
partnership, and even more so in the case of one-man business, accounting
still maintains separation of business and owner. This implies that owner's
personal and household expenses or obligations (e.g., expenditure on food,
clothing, entertainment, debts, mortgages, etc.) will not appear in the books
of account. It may be clarified that it is only for accounting purposes that
25
Accounting: An partnerships and sole proprietorships are treated as separate and apart from
Overview
the owners though law does not make such distinction. A creditor would be
justified in looking to both the business assets and the private estate of the
owner for satisfaction of his claim. One reason for this distinction is to make
it possible for the owners to have an account of the performance from those
who manage the enterprise. The managers are entrusted with funds supplied
by owners, banks and others; they are responsible for the proper use of the
funds. The financial accounting reports are designed to show how well this
responsibility has been discharged.

Activity 1.1
Apart from the reason mentioned above, can you think of any other reason
for justification of Business Entity Concept?

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Activity 1.2
The proprietor of a firm withdrew Rs. 50,000 for his personal use. This was
shown as an expense of the firm. Profits were reduced to pay a lower tax. Is
this right from accounting point of view?

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Money Measurement Concepts

In accounting, only those facts which can be expressed in terms of money are
recorded. As money is accepted not only as a medium of exchange but also as
a store of value, it has a very important advantage since a number of widely
different assets and equities can be expressed in terms of a common
denominator. Without these adding heterogeneous factors like five buildings,
ten machines, six trucks will not have much meaning.

While money is probably the only practical common denominator and a

yardstick, we must realise that this concept imposes two sever limitations. In
the first place, there are several facts which, though vital to the business,
cannot be recorded in the books of account because they cannot be expressed
26
in money terms. For example, the state of health of the Managing Director of Introduction to
Accounting
a company who has been the key contributor to the success of business is not
recorded in the books. Similarly, the fact that the Production Manager and the
Chief Internal Auditor are not on speaking terms, or that a strike is about to
begin because labour is dissatisfied with the poor working conditions in the
factory, or that a competitor has recently taken over the best customer, or that
it has developed a better product and so on will not be recorded even though
all these events are of great concern to the business.

From this standpoint, one could say that accounting does not give a complete
account of the happenings in the business. You will appreciate that all these
have a bearing on the future profitability of the company.

Secondly, use of money implies that a rupee today is of equal value to a

rupee ten years back or ten years later. In other words, we assume stable or
constant value of rupee. In the accounts, money is expressed in terms of its
value at the time an event is recorded. Subsequent changes in the purchasing
power of money do not affect this amount. You are perhaps aware that most
economies today are in inflationary conditions with rising prices. The value
of a rupee of 1980's has depreciated to an unbelievably low level in the 90s.
Most accountants know fully well that purchasing power of rupee does
change but very few recognise this fact in accounting books and make
allowance for changing price level. This is so despite the fact that accounting
profession has devoted considerable attention to this problem and numerous
suggestions have been made to account for the effects of changes in the
purchasing power of money. In fact, one of the major problems of accounting
today is to find means of solving the measurement problem, that is, how to
extend the quality and the coverage of meaningful information. It will be
desirable to present in a supplementary analysis the effect of price level
changes on the reported income of the business and the financial position.

Activity 1.3
Suppose the Managing Director of a company is killed in a plane crash. To
the extent "an organisation is the lengthened shadow of a man", the real value
of the company will change immediately and this will be reflected in the
market price of the company shares. Will this have any effect as far as the
accounts of the company are concerned?

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27
Accounting: An ............................................................................................................................
Overview
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Continuity Concept
Accounting assumes that the business (an accounting entity) will continue to
operate for a long time in the future unless there is good evidence to the
contrary. The enterprise is viewed as a going concern, that is, as continuing
in operation, at least in the foreseeable future. The owners have no intention
nor have they the necessity to windup or liquidate its operations.

This assumption is of considerable importance for it means that the business

is viewed as a mechanism for adding value to resources it uses. The success
of the business can be measured by the difference between output values
(sales or revenues) and input values (expenses). Therefore, all unused
resources can be reported at cost rather than at market values.

The assumption that the business is not expected to be liquidated in the

foreseeable future, in fact, establishes the basis for many of the valuations
and allocations in accounting. For example, depreciation (or amortisation)
procedures rest upon this concept. It is this assumption which underlies the
decision of investors to commit capital to enterprise. The concept holds that
continuity of business activity is the reasonable expectation for the business
unit for which the accounting function is being performed. Only on the basis
of this assumption can the accounting process remain stable and achieve the
objective of correctly recording and reporting on the capital invested, the
efficiency of management, and the position of the enterprise as a going
concern. Under this assumption neither higher current market values nor
liquidation values are of particular importance in accounting. This
assumption provides a basis for the application of cost in accounting for
assets.

However, if the accountant has good reasons to believe that the business, or
some part of it, is going to be liquidated or that it will cease to operate (say
within a year or two), then the resources could be reported at their current
values (or liquidation values).

Activity 1.4
A company revalue‟s its buildings which were purchased at a cost of Rs.
5,00,000 in 2005 to Rs. 50,00,000 in 2021 and records the difference of Rs.
45,00,000 as profit for the year 2021. Is this practice right?

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28 ............................................................................................................................
............................................................................................................................ Introduction to
Accounting
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Cost Concept
The resources (land, buildings, machinery, property rights, etc.) that a
business owns are called assets. The money values that are assigned to assets
are derived from the cost concept. This concept states that an asset is worth
the price paid for or cost incurred to acquire it. Thus, assets are recorded at
their original purchase price and this cost is the basis for all subsequent
accounting for the assets. The assets shown on the financial statements do not
necessarily indicate their present market worth (or market values). This is
contrary to what is often believed by an uninformed person reading the
statement or report. The term `book value' is used for amount shown in the
accounting records.

In case of certain assets the accounting values and market values may be
similar; cash is an obvious example. In general, the longer an asset has been
owned by the company the lesser, are the chances that the accounting value
will correspond to the market value.

The cost concept does not mean that all assets remain on the accounting
records at their original cost for all time to come. The cost of an asset that has
a long but limited life is systematically reduced during its life by a process
called `depreciation' which will be discussed at some length in a subsequent
unit. Suffice it to say at this point that deprecation is a process by which the
cost of the asset is gradually reduced (or written off) by allocating a part of it
to expense in each accounting period. This will have the effect of reducing
the profit of each period. In charging depreciation the intention is not to
change depreciation equal to the fall in the market value of the asset. As such,
there is no relationship between depreciation and changes in market value of
the assets. The purpose of depreciation is to allocate the cost of an asset over
its useful life and not to adjust its cost so as to bring it closer to the market
value.

You must be wondering as to why assets are shown at cost even when there
are wide differences between their costs and market values. The main
argument is that the cost concept meets all the three basic criteria of
relevance, objectivity and feasibility.

Accrual Concept
The accrual concept makes a distinction between the receipt of cash and the
right to receive it, and the payment of cash and the legal obligation to pay it.
In actual business operations, the obligation to pay and the actual movement
of cash may not coincide. The accrual concept recognises this distinction. In
connection with the sale of goods, revenue may be received
(i)before the right to receive arises, or

(ii) after the right to receive has been created.

The accrual concept provides a guideline to the accountant as to how he 29

Accounting: An should treat the cash receipt and the rights related thereto. In the former case
Overview
the receipt will not be recognised as the revenue of the period for the reason
that the right to receive the same has not yet arisen. In the latter case the
revenue will be recognised even though the amount is received in the
subsequent period.

Similar treatment would be given to expenses incurred by the firm. Cash

payments for expenses may be made before or after they are due for payment.
Only those sums which are due and, payable would be treated as expenses. If
a payment is made in advance (i.e. it does not belong to the accounting period
in question) it will not be treated as an expense, and the person who received
the cash will be treated as a debtor until his right to receive the cash has
matured. Where an expense has been incurred during the accounting period
but no payment has been made, the expense must be recorded and the person
to whom the payment should have-been made is shown as a creditor.

Activity 1.5
The accounting year of a firm closes on 31st December each year. The rent
for business premises of Rs 50,000 for the last quarter could not be paid to
the owner on account of his being away in a foreign country. Should the rent
payable be taken into account for computing the firm's income for the
accounting year?

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Activity 1.6
A government contractor supplies stationery to various government offices.
Some bills amounting to Rs. 10,000 were still pending with various offices at
the close of the accounting year on 31st March. Should the businessman take
the revenue of Rs.10,000 into account for computing the net profit of the
period?

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30
Concept of Conservatism Introduction to
Accounting
The concept of conservatism, also known as the concept of prudence, is often
stated as" anticipate no profit, provide for all possible losses". This means an
accountant should follow a cautious approach. He should record lowest
possible value for assets and revenues, and the highest possible value for
liabilities and expenses. According to this concept, revenues or gains should
be recognised only when they are realised in the form of cash or assets
(usually legally enforceable debts)the ultimate cash realisation of which can
be assessed with reasonable certainty. Further, provision must be made for all
known liabilities, expenses and losses whether the amount of these is known
with certainty or is at best an estimate in the light of the information
available. Probable losses in respect of all contingencies should also be
provided for. A contingency is a condition or a situation, the ultimate
outcome of which –gain or loss-cannot be determined accurately at present. It
will be known only after the event has occurred (or has not occurred). For
example, a customer has filed a suit for damage against the company in a
court of law. Whether the judgment will be favourable or unfavourable to the
company cannot be determined for sure. Hence, it will be prudent to provide
for likely loss in the financial statements. As a consequence of the application
of this concept, net assets are more likely to be understated than overstated,
and income is more likely to be overstated than understated. Based on this
concept is the widely advocated practice of valuing inventory (stock of goods
left unsold) at cost or market price whichever is lower? You will note that
this convention, in a way, modifies the earlier cost concept. It should be
stated that the logic of this convention has been under stress recently; it has
been challenged by many writers on the ground that it stands in the way of
fair determination of profit and the disclosure of true ad fair financial position
of the business enterprise. The concept is not applied as strongly today as .it
used to be in the past. In any case, conservatism must be applied rational Y as
over-conservatism may result in misrepresentation.

Materiality Concept
There are many events in business which are trivial or insignificant in nature.
The cost of recording and reporting such events will not be justified by the
usefulness of the information derived. Materiality concept holds that items of
small significance need not be given strict theoretically correct treatment. For
example, a paper stapler costing Rs. 30 may last for three years. However, the
effort involved in allocating its cost over the three-year period is not worth
the benefit than can be derived from this operation. Since the item obviously
is immaterial when related to overall operations, the cost incurred on it may
be treated as the expense of the period in which it is acquired. Some of the
stationery purchased for office use in any accounting period may remain
unused at the end of that period. In accounting, the amount spent on entire
stationery would be treated as expense of the period in which the stationery
was purchased, notwithstanding the fact that a small part of it still lies in
stock. The value (or cost) of the stationery lying in stock would not be treated
as an asset and carried forward as a resource to the next period. The
accountant would regard the stock lying unused as immaterial. Hence, the
31
Accounting: An entire amount spent on stationery would be taken as the expense of the period
Overview
in which such expense was incurred.

Where to draw the line between material and immaterial events is a matter of
judgment and common sense. There are no hard and fast rules in this respect.
Whether a particular item or occurrence is material or not, should be
determined by considering its relationship to other items and the surrounding
circumstances. It is desirable to establish and follow uniform policies
governing such matters.

Consistency Concept
In practice, there are several ways to record an event or a transaction in the
books of account. For example, the trade discount on raw material purchased
may be deducted from the cost of goods and net amount entered in the books,
or alternatively trade discount maybe shown as the income with full cost of
raw material purchased entered in the books. Similarly, there are several
methods to charge depreciation (which is a decrease in the value of assets
caused by wear and tear, and passage of time) on an asset or of valuing
inventory. The consistency concept requires that once a company has decided
on one method and has used it for some time, it should continue to follow the
same method or procedure for all subsequent events of the same character
unless it has a sound reason to do otherwise. If for valid reasons the company
makes any departure from the method it has been following so far, then the
effect of the change must be clearly stated in the financial statements in the
year of change.

You will appreciate that much of the utility of accounting information lies in
the fact that one could draw valid conclusions from the comparison of data
drawn
fromfinancialstatementsofoneyearwithdataoftheotheryear.Comparabilityisess
ential so that trends or differences may be identified and evaluated.
Inconsistency in the application of accounting methods might significantly
affect the reported profit and the financial position. Further, inconsistency
also opens the door for manipulation of reported income and assets. The
comparability of financial information depends largely upon the consistency
with which a given class of events are handled in ac-counting records year
after year.

Activity 1.7
A company had been charging depreciation on a machine at Rs. 10,000 per
year for the first 3 years. Then it began charging Rs. 9,000 for 4th year and
Rs. 7,800 for 5thyearand so on. Is this practice justified? Give reasons for
your answer.

............................................................................................................................
............................................................................................................................

............................................................................................................................
32
............................................................................................................................ Introduction to
Accounting
Periodicity Concept
Although the results of operations of a specific enterprise can be known
precisely only after the business has ceased to operate, its assets have been
sold off and liabilities paid off, the knowledge of the results periodically is
also necessary. Those who are interested in the operating results of business
obviously cannot wait till the end. The requirements of these parties therefore
force the accountant to report for the changes in the wealth of a firm for short
time periods. These time periods in actual, practice vary, though a year is the
most common interval as a result of established business practice, tradition
and government requirements. Some firms adopt calendar year, some others
financial year of the government. But more and more firms are changing to
the `natural' business year the end of which is marked by relatively lower or
lowest volume of business activity in the twelve-month period. The custom
of using twelve-month period is applied only for external reporting. The
firms usually adopt a shorter span of interval, say one month or three months,
for internal reporting purposes.

The allocation of long-term costs and the difficulties associated with this
process directly stem from this concept. While matching the earnings and the
cost of those earnings for any accounting period, all the revenues and all the
costs relating to the year in question have to be taken into account
irrespective of whether or not they have been
receivedincashorpaidcash.Despitethedifficultiesthatariseinallocationsand
adjustments, short-term reports (i.e., yearly reports) are of such importance to
owners, management, creditors, and other interested parties that the
accountant has no option but to resolve such difficulties. Obviously, the
utility of the periodic financial statements outweighs the difficulties.

While going through all these concepts, probably you have developed a
feeling that they come in conflict with each other. You are right. We illustrate
this by considering some of these concepts in the context of valuation of
business properties. Suppose, a firm acquired a piece of land in 2017 for a
price of Rs.6,00,000. Factory premises were constructed in 2018 and
operations commenced in2019. The firm has been successful in achieving
desired profit for the past year. The Balance Sheet (a statement of assets and
liabilities) for the year 2019 is being prepared and `Land' is required to be
valued. The estimated current market price of this land is Rs. 60,00,000.

Should you recommend that the land be valued at Rs. 60 lakhs? The answer
is `no' obviously. Land would be carried on the Balance Sheet at its original
cost of Rs,6,00,000 only. This decision is supported by several of the
concepts discussed in this section. In the first place, the stability of
purchasing power of money implied in the money measurement concept
prevents us from recognising accretion in values as
aresultofchangingpricelevels.Then,therealisationconceptwillnotallowunreali
sed profits to be included as long as land is held by the company and not
soldaway.Youmaynotethatthecontinuityorgoingconcernconceptmakesanypo
ssible market value of land irrelevant for balance sheet because the firm has
33
Accounting: An to continue in business and land will be needed by it for its own use. In this
Overview
connection,itcouldbearguedthatiflandwereshownonthebalancesheetatitsestima
tedcurrentmarketvalue,theownermightdecidetodiscontinuethebusiness,sellthel
and and retire. The principle of objectivity is now introduced into the
argument. It can be easily seen that in a situation like this the cost of
acquisition of land at Rs.6,00,000 in 2000 is the objective fact because it is
based on a transaction that actually took place and this objective evidence is
capable of being verified. In contrast, the estimate of current market value
figure may be suspect. It raises many questions. Do you have a market
quotation for an identical plot of land? Has a similar plot of land been sold
recently and can we pick it up as verifiable evidence of the current market
price? It may be said that even if market price for an identical plot of land is
not available, estimates by an accredited valuer may be accepted as verifiable
evidence of the market price. Further complications may be noticed if
buildings and facilities have been erected on the plot of land. Is it possible to
estimate the value of land without factory buildings and other facilities
constructed on it? The answer is a flat `no' and the conservatism concept will
then deter you from accepting an estimate of market value since it cannot be
ascertained with reasonable accuracy.

1.7.2 Accounting Standards

The basic concepts discussed in the foregoing paragraphs are the core
elements in the theory of accounting. These concepts (postulates or
conventions), however, permit a variety of alternative practices to co-exist.
As a result, the financial results of different companies cannot be compared
and evaluated unless full information is available about the accounting
methods which have been used. The varieties of accounting practices have
made it difficult to compare the financial results of different companies.
Further, the alternative accounting methods have also enabled the reporting
of different results, even by the same company.

Need for Standards: The information contained in published financial

statements is of particular importance to external users, such as shareholders
and investors. Without such information they would not be able to take right
decisions about their investments. As in several other countries, Parliament in
India has specified in the Companies Act the type and minimum level of
information which companies should disclose in financial statements. It is the
responsibility of the accounting profession to ensure that the required
information is properly presented. It is evident that there should not be too
much discretion to companies and their accountants to present financial
information the way they like. In other words, the information contained in
financial statements should conform to carefully considered standards. Public
confidence in accounting information contained in financial statements will
grow if they are satisfied as to the logic, consistency and fairness of the
figures shown there in. For instance, a company could incur a loss and still
pay dividends by manipulating the loss into a profit. In the long run this
course may have a disastrous effect on the company and its investors. You
would be better able to appreciate the function of accounting standards by
relating them to the basic purpose of financial statements which is the
34
communication of information affecting the allocation of resources. Ideally, Introduction to
Accounting
such information should make it possible for investors to evaluate the
investment opportunities offered by different firms and allocate scarce
resource to the most efficient ones. In theory, this process should result in the
capital distribution of resources within the economy and should maximise the
potential benefit to society

In this context unless there are reasonably appropriate standards, neither the
purpose of the individual investor nor that of the nation as a whole can be
served. The purpose is likely to be served if the accounting methods used by
different firms for presenting information to investors allow correct
comparisons to be made. For example, they should not permit a company to
report profits which result simply from a change in accounting methods
rather than from increase in efficiency. If companies were free to choose their
accounting methods in this way, the consequences might be that deliberate
distortions are introduced, leading eventually to misapplication of resources
in the economy. The relatively less efficient companies will be able to report
fictitious profits, and as a result scarce capital of society will be diverted
away from the more efficient companies which have adopted stricter and
consistent accounting methods.

1.7.3 Changing Nature of Generally Accepted Accounting

Principles (GAAP)
Generally accepted accounting principles are usually developed by
professional accounting bodies like American Institute of Certified Public
Accountants (AICPA)and Institute of Chartered Accountants of India (ICAI).
In developing such principles, however, the accounting profession has to
reflect the realities of social, economic, legal and political environment in
which it operates. Besides academic research, regulatory and tax laws of the
government e.g., Companies Act, 1956, income Tax Act, 1961 etc., in a large
measure, influence the formulation of acceptable accounting principles. Stock
exchanges and other regulatory agencies like Securities and Exchange Board
of India (SEBI) have laid down rules for disclosure and extent of accounting
information.

Since the environment in which business operates, undergoes constant

changes as result of changes in economic and financial policies of the
Government and changes in the structure of business, continued evaluation of
the relevance of generally accepted accounting principles is required. In this
sense, the principles of accounting are not ever-lasting truths. You will
appreciate that it is the development of relevant accounting principles in tune
with the present day needs of the society that would make it possible for the
business enterprises to develop financial statements which would be
acceptable and of value to the end users.

1.8 SUMMARY
 Accounting can be defined as a process of reporting, recording,
interpreting and summarising economic data.

35
Accounting: An  Assets are those resources owned by organization which helps the
Overview
company to earn profit.
 The economic value of an obligation or debt that is payable by the
enterprise to other establishment or individual is referred to as liability.
 Capital represents the owner‟s investment (Capital) in the trade minus
the owner‟s withdrawal from the trade (Drawings) + the net income since
the business concern commenced.
 The major objectives of accounting are –
o To maintain a systematic record of business transactions
o To ascertain profit and loss
o To determine the financial position
o To provide information to various users assist the management
 The major characteristics of accounting are –
o Identifying financial transactions and events
o Measuring the transactions
o Recording of transactions
o Classifying the transactions
o Summarising the transactions
o Analysing and interpreting financial data
o Communicating the financial data or reports to the users
 Financial, Cost and management accounting are the major branches of
accounting
 The Accounting process is the process of collecting, recording,
classifying, summarising and communicating financial information to the
users which help them in taking decisions.
 Book keeping is a component of accounting that involves the process of
identifying the financial transactions, measuring, recording and
classifying those transactions that have occurred in the course of
business.
 Accounting begins where Book Keeping ends. It is a wider concept and
includes summarizing, interpreting and communicating the financial data
to the users of financial statements.
 Accountancy refers to systematic knowledge of the accounting principles
and the techniques
 The major benefits of accounting are –
o Provide assistance to management
o Facilitates comparative study
o Helps in settlement of tax liability
o Helpful in raising loan
36
 o Helpful in decision making Introduction to
Accounting
o Substitute of human memory
o Helps in the valuation of business
 Accounting is also criticized for not being precise, uses historical
information, ignores the effect of price level changes and qualitative
information and is often affected by window dressing.
 Users of accounting information include owners, management,
employees, trade union, customer, suppliers, bank, creditors, investors
and researchers.
 Qualitative characteristics are the attributes of accounting information,
which enhance it‟s understand ability and usefulness. It includes
reliability, relevance, and comparability and understand ability.
 There are two systems of recording transactions in the books of accounts
namely single entry and double entry system.
 In order to maintain uniformity and consistency in preparing and
maintaining books of accounts, certain rules or principles have been
evolved. These rules/principles are known as concepts and conventions.

1.9 SELF-ASSESSMENT QUESTIONS

1. Confidence and trust that the reported information is a reasonable
representation of the actual items and events, that have occurred, indicate
which qualitative characteristic of accounting information.
2. State whether a large order of supply of goods received by the firm be
recorded in books.
3. Appointment of a new managing director is not recorded in the books of
accounts. Why?
4. What is a person to whom money is owed by a firm called?
5. Mr Raj, an electronic goods dealer, gifted a microwave of value Rs.
30,000 to his friend Rohan and recorded it in books as drawing. Is he
correct?
6. Distinguish between financial accounting, cost accounting, and
management accounting.
7. Distinguish between book-keeping, accounting, and accountancy.
8. Basic objective of accounting is to provide useful information to various
users. Besides these, there are many other objectives of accounting.
Explain any four of them.
9. Select an appropriate option
I. That a business may only report activities on financial statements
that are specifically related to company operations, not those
activities that affect the owner personally, is known as which of the
following?
a. separate entity concept
37
Accounting: An b. monetary measurement concept
Overview
c. going concern assumption
d. time period assumption
II. That companies can present useful information in shorter time
periods such as years, quarters, or months is known as which of the
following?
a. separate entity concept
b. monetary measurement concept
c. going concern assumption
d. time period assumption
III. The system of using a monetary unit, such as the US dollar, to value
the transaction is known as which of the following?
a. separate entity concept
b. monetary measurement concept
c. going concern assumption
d. time period assumption
IV. Which of the following terms is used when assuming a business will
continue to operate in the foreseeable future?
a. separate entity concept
b. monetary measurement concept
c. going concern assumption
d. time period assumption

38
 Preparation of Books
UNIT 2 PREPARATION OF BOOKS OF of Accounts

ACCOUNTS
OBJECTIVES
After going through this unit, you will be able to-
 Know the meaning and steps of accounting process;
 Understand the meaning and importance of journal; and
 know the rules of journalising.

STRUCTRE
2.1 Introduction
2.2 Analysis of Business transaction
2.2.1 An overview of Balance Sheet
2.2.2 Classification of Accounts

2.2.3 Dual Aspect Concept

2.2.4 Accounting Equation Approach

2.3 Journal
2.3.1 Journalizing

2.3.2 Important Considerations for Recording the Business Transactions

2.4 Ledger
2.4.1 Posting in the Ledger

2.4.2 Balancing of Ledger Accounts

2.5 Summary
2.6 Self-Assessment Questions

2.1 INTRODUCTION
A business enterprise generally prepares the following two basic financial
statements:

Profit and Loss Account to ascertain the profit earned or loss incurred
during an accounting period.

Balance Sheet to ascertain the financial position of the business as on a

particular date.

Cash Flow Statement:

Generally, a business enterprise has numerous transactions every day during
an accounting period. Unless the transactions are recorded and analysed, it is
not possible to determine the impact of each transaction in the above two
basic statements. Traditionally, accounting is a method of collecting,
recording, classifying, summarising, presenting and interpreting financial
data aspect of an economic activity. The series of business transactions 39
Accounting: An occurring during the accounting period and its recordingis referred to an
Overview
accounting process/mechanism. An accounting process is a complete
sequence of accounting procedures which are repeated in the same order
during each accounting period.

Accounting process involves the following steps or stages:

1. Identification of transaction: In accounting, only business transactions

are recorded .A transaction is an event which can be expressed in terms
of money and which brings change in the financial position of a business
enterprise. An event is an incident or a happening which may or may not
bring any change in the financial position of a business enterprise.
Therefore, all transactions are events but all events are not transactions.
A transaction is a complete action, to an expected or possible future
action. In every transaction, there is movement of value from one source
to another. Transactions may be external (between a business entity and
a second party, e.g., goods sold on credit to Hari or internal (do not
involve second party, e.g., depreciation charged on the machinery).

2. Recording the transaction: Journal is the first book of original entry in

which all transactions are recorded event wise and date-wise and
presents a historical record of all monetary transactions. It may further be
divided into sub-journals as well which are also known subsidiary books.

3. Classifying: Accounting is the art of classifying business transactions.

Classification means statement setting out for a period where all the
similar transactions relating to a person, a thing, expense, or any other
subject are grouped together under appropriate heads of accounts.
40
4. Summarising: Summarising is the art of making the activities of the Preparation of Books
of Accounts
business enterprise asclassified in the ledger for the use of management
or other user groups i.e. Sundry debtors, Sundry creditors etc.
Summarisation helps in the preparation of Profit and Loss Account and
Balance sheet for a particular fiscal year.
5. Analysis and Interpretation: The financial information or data as
recorded in the books of an account must further be analysed and
interpreted so to draw useful conclusions. Thus, analysis of accounting
information will help the management to assess in the performance of
business operation and forming future plans also
6. Presentation or reporting of financial information: The end users of
accounting statements must be benefited from analysis and interpretation
of data as some of them are the „stockholders‟ and other one the „stake
holders‟. Comparison of past and present statement and reports, use of
ratio and trend analysis are the different tools of analysis and interpretation

2.2 ANALYSIS OF BUSINESS TRANSACTION

Accounting process starts with a business transaction and is followed by
analysis of the transaction for the purpose of classification and recording of the
transaction. Once the transaction is recorded, similar type of transactions are
summarized and the net figure arrived it is taken to the financial statements.
VOUCHER
Accounting is a process which starts and includes steps right from recording
of business transactions of monetary character to the communicating or
reporting the results thereof to the various interested parties. The first step in
the accounting process is to analyse the transaction and record it on a pre
designed slip giving details of accounts to be debited and credited. Since
vouchers provide an evidence of transaction source documents are also
attached to the accounting voucher entries in the Journal are done on the basis
of vouchers and control accounts are also maintained on the basis of
vouchers. A proper voucher system ensures minimization of errors of
omission and commissions.
Each transaction is recorded in books of accounts providing all the required
information of the transaction. Since each transaction has an effect on the
financial position of the business, there should be a documentary evidence to
establish the monetary accounts at which transactions are recorded and also
the transactions are properly authorised. The common documents that are
generally used areas under:
(i) Payment voucher: A Payment voucher usually on a printed standard
form is a record of payment. When payment is made for an expense,
generally a bill is prepared to record full particulars of the claim by the
person or organisation receiving payment. From the bill, the accounting
department prepares a voucher for each payment to be made, no matter
whether the amount that is paid for the goods purchased, or to pay
employee‟s salaries, or to pay for services or to pay for any other asset
acquisition.
41
Accounting: An (ii) Receipt voucher: A Receipt voucher is a document which is issued
Overview
against cash receipts. It may also be a printed standard form. This
document shows that a certain sum of money was received from a person
or organisation and also, contains information of the purpose for which
the money is received. It is signed by a responsible employee, authorised
by the management to receive the money.
(iii) Transfer voucher: A Transfer voucher is used to record the residuary
transactions. An internal transaction or a transaction not involving any
cash payment or cash receipt is recorded in the transfer voucher.
Examples are: Goods purchased on credit; depreciation of assets,
outstanding expenses, accrued income, etc.

2.2.1 An overview of Balance Sheet

Let us understand the concept of a balance sheet with the help of an example.

Mr.Raghav is the owner of a start-up firm RT Ltd. On 1st April 2020, the
position of his business firm RT Ltd is as follows: He has invested his
personal savings worth Rs. 10,00,000 cash into the firm as Capital to start the
business. He also took a loan from bank of an amount equal to Rs. 3,50,000
for buying an Office Premises for his business firm. Further, he purchased
some Machinery worth Rs. 2,00,000 and a Motor car worth Rs. 3,00,000 for
the operations of the firm. To start the business operations, he brought in
Inventory worth Rs. 2,50,000 and kept an amount of Rs. 20,000 as Cash and
also deposited an amount of Rs. 50,000 in a Savings bank account for the
purposes of business. Apart from this, Mr.Raghav invested the remaining
amount of Rs. 1,80,000 in government bonds on behalf of his firm RT Ltd.
Now let us generate a balance sheet for RT Ltd. as on 1st April 2020 on the
basis of given information. We will classify the above information into the
resources owned by RT Ltd. and the claims against those resources.The
commonly accepted format of Balance Sheet in India shows Liabilities on the
left-hand side and Assets on the right-hand side.
As already discussed, a balance sheet is always prepared from the point of
view of a business entity and not the owner. Hence, the balance sheet or the
position statement of RT Ltd. as on 1st April 2020 would be presented as
follows:
RT Ltd.
Balance Sheet as on 1st April 2020
Liabilities (obligations Amount Assets (resources owned Amount
of the firm) (Rs.) by the firm) (Rs.)
Capital 10,00,000 Machinery 2,00,000
Loan from Bank 3,50,000 Building (Office Premise) 3,50,000
Motor Car 3,00,000
Investment in Bonds 1,80,000
Inventory 2,50,000
Cash 20,000
Savings Bank Account 50,000
Total: 13,50,000 Total: 13,50,000
42
Here, we can see that the total value of resources owned by RT Ltd. which Preparation of Books
includes building, machinery, car, cash, investments and inventory is worth of Accounts
Rs. 13,50,000. In accounting, these resources owned by the business are
referred to as assets. Further we observe that the claims against these
resources in the form of bank loan stands at Rs. 3,50,000. Such claims against
business entity‟s assets are referred to as liabilities. Now, the net worth of RT
Ltd. will be calculated by deducting the claims against its worth from its total
worth of resources which is an amount equal to Rs. 10,00,000 (*13,50,000
minus 3,50,000).
Thus, the net worth of an entity represents the claims of its owner(s) which is
also referred to as owner's equity. We also learnt that the items of monetary
value possessed by an entity are referred to as assets. Whereas, the amount
owed by an entity which represents claims against its assets by outsiders are
called as liabilities. Thus, we can say that the position statement is a
summary of the assets, liabilities and net worth of an entity at a specific point
of time.

2.2.2 Classification of Accounts

(I) Personal Accounts: Accounts which are related with accounts of

individuals, firms, companies are known as personal accounts. The
personal accounts may further be classified into three categories:

Natural Personal Accounts: Accounts of individuals relating to natural

persons such as Akhil‟sA/c, Rajesh‟sA/c, Sohan‟sA/care natural personal
accounts.

(i) Artificial Personal Accounts: Accounts of companies, institutions

such as Reliance Industries Ltd; Lions Club, M/s Sham & Sons,
National College account are artificial personal accounts. These
exist only in the eyes of law.

(ii) Representative Personal Accounts: The accounts which represent

some person such as wage outstanding account, prepaid insurance
account, and accrued interest account are considered as
representative personal accounts.
43
Accounting: An 2. Real Accounts: Real accounts are the accounts related to
Overview
assets/properties. These may beclassified into tangible real account and
intangible real account. The accounts relating to tangible assets such as
building, plant, machinery, cash, furniture etc are classified as tangible
real accounts. Intangible real accounts are the accounts related to
intangible assets such as goodwill, trademarks, copyrights, franchisees,
Patents etc.

3. Nominal Accounts: The accounts relating to income, expenses, losses

and gains are classifiedas nominal accounts. For example Wages
Account, Rent Account, Interest Account, SalaryAccount,BadDebts
Accounts.

RULES FOR DEBIT AND CREDIT

Typeof Accounts Rules for Debit Rules for Credit

(a) PersonalAccount Debit the receiver Credit the giver
(b) Real Account Debit what comes in Credit what goes out
(c) Nominal Account Debit all the expenses Credit all the incomes
and losses and gains

Learners who are studying accounting for the first time would find it difficult
to classify the accounts on the basis explained above. You would be able to
classify the account on the basis of asset, liabilities, expense and income if
you understand the Dual aspect concept and accounting equation approach
given below.

2.2.3 Dual Aspect Concept

Let us take a step further in the previous example: suppose Mr.Raghav
purchased some goods (raw material) worth Rs. 10,000 in cash. This
transaction will have a dual impact on the balance sheet of RT Ltd. First, the
inventory will increase by Rs. 10,000 and second, the cash balance will
decrease by Rs. 10,000. Similarly, if the goods were purchased by
Mr.Raghav on credit for Rs. 10,000, the inventory (asset) will go up by Rs.
10,000 whereas, the creditors will also increase by Rs. 10,000. This brings us
to a fundamental accounting concept known as dual-aspectin accounting.
This concept explains that each transaction made by a business entity impacts
the business in two different aspects which are equal and opposite in nature.
It means that every business transaction will affect at least two accounts
which imply that for every debit there is an equivalent credit and vice versa.
For example, if your company borrows money from the bank, the company‟s
asset Cash is increased (debited) and the company‟s liability Notes Payable is
also increased (credited). It is because of this feature that both sides (assets
and liabilities) of the balance sheet will always be equal.This concept forms
the basis of double-entry accounting and is used by all accounting
frameworks for generating accurate and reliable financial statements. The
dual aspect concept is also explained in the fundamental accounting equation:
44 ASSETS = LIABILITIES + OWNERS EQUITY
The above accounting equation indicates that an entity‟s assets have to be Preparation of Books
of Accounts
equal to the sum of its liabilities and owner‟s equity. This equation is
considered to be the foundation of double entry system of accounting. It
ensures that every entry made on the debit side has a corresponding entry
made on the credit side and vice versa. Hence, the double entry made will
automatically balance the accounting equation. To sum it up,

i. An increase in assets is followed by an increase in liabilities and/or

equity and vice versa.

ii. A decrease in assets is followed by a decrease in liabilities and/or equity

and vice versa.

iii. An increase in an asset is followed by a decrease in another asset and

vice versa.

iv. An increase in a liability is followed by a decrease in another liability

and vice versa.

Let‟s consider the following series of examples to explain this concept

further:

(i) Mr.Raghav further invested cash worth of Rs. 4,00,000 into his business
RT Ltd. The effect of this transaction will be as follows:
 Capital will increase by Rs. 4,00,000.(Liabilities side)
 Cash will also increase by Rs. 4,00,000.(Assets side)
(ii) Also, Mr.Raghav repaid the loan in cash, he took from bank for his
office building worth Rs. 3,50,000. This transaction will have the
following effect:
 Loan from Bank will reduce by Rs. 3,50,000. (Liabilities side)
 Cash will also reduce by Rs. 3,50,000. (Assets side)
(iii) Lastly, Mr.Raghav sold the investments he made in government bonds
for Rs. 2,00,000 cash. In this transaction, RT Ltd. made a profit of Rs.
20,000 (as the gold bonds were purchased for Rs. 1,80,000 initially). The
effect of this transaction will be shown as follows:
 Investment in Government Bonds will reduce by Rs. 1,80,000.
(Assets side)
 Cash will increase by Rs. 2,00,000. (Assets side)
 Profits of Rs. 20,000 will be shown by an increase in Capital.
(Liabilities side)

Hence, a balance sheet will always balance its two sides.The effect on one
account will be compensated by an equal and opposite effect on another
account.

2.2.4 Accounting Equation Approach

The basic accounting equation is

Assets = Liabilities + Capital

45
Accounting: An In this equation Assets refer to the resources owned by the business
Overview
enterprise (of resources owned by the owner/s of business enterprise). These
resources are expected to generate future cash flows and earnings for the
business. Liabilities are the claim of the others on the assets of the business or
in simple terms it is the debt outstanding expenses payable to various
stakeholders.

Capital means the amount which is payable by the business enterprise to the
owners of the business. In brief the assets are the resources which business
enterprise owns and capital and liabilities are what business enterprise owns
to others.

The above mentioned equation forms the basis of double entry system of
book keeping. Every transaction recorded under this method has dual effect
viz. it affects two accounts simultaneously. For example Furniture worth Rs.
5000/- is purchased is cash / credit. Now when the furniture is purchased in
cash two accounts are affected. Cash which is an asset decreases by Rs.
5000/- and Furniture A/C which is an asset increases by Rs. 5000/-. In second
case when furniture is bought on credit again two accounts are affected. First,
Furniture A/C increased by Rs. 5000/- and a new liability of Rs. 5000/- is
created, thus the increase in liability of Rs. 5000/-. Thus in nutshell every
business transaction will have a twofold effect if there is an increase in a
particular asset the counterpart of that transaction would be decrease in some
other assed or creation of decrease in some other asset or creation of new
liability. This is also known as Dual Aspect Concept.

From the above example it is clear that effect on one account will be
compensated by an equal and opposite effect on another account/s.

When we use accounting equation approach for recording business

transactions all accounts are divided into three categories namely:

1. Asset Account
2. Liability Account
3. Capital Account

Now let us understand the basic rules used for recording changes in assets
liabilities and capital

Rule no. 1: For recording changes in assets

Increase in assets is debited and decrease in assets is credited

Rule no. 2: for recording changes in liabilities and capital Increase in

Liabilities and Capital is Credited and Decrease in Liabilities and Capital is
debited

To understand this let us assume that you have started a business on

01/04/2021 with Rs. 5,00,000/- in cash through your firm M/S Myself. This
transaction is analysed and recorded as follows:

46
 Preparation of Books
Transaction Analysis Nature Rule Entry of Accounts
of
account
Introduction of Increase of Asset Debit increase in Debit cash
Rs. 5,00,000/- cash balance assets account
in the cash by by Rs.
the owner in 5,00,000/-
the business
Increase of Capital Credit increase Credit
liabilities in capital capital
(Capital) by account
Rs. 5,00,000/-

The Journal entry for this is going to be

Date Particulars L.F Dr (Rs.) Cr. (Rs.)
01/04/2021 Cash A/C 5,00,000/-
To Capital A/c 5,00,000/-

Now you are able to understand how to record transactions for change in
assets and liabilities. Now we are going to discuss how to analyse and record
changes in capital account.
The capital account increases due to introduction of new capita, revenue and
income earned. It decreases due to with drawl of goods, cash and other assets
for personal use and expenses incurred.
Recording all these transactions directly into capital account will make it
cumbersome and unwieldy. In practice all the revenue and expenses are taken
to profit & loss account and the net effect is transferred to capital account. In
the same way cumulative effect of drawings is recorded in capital account at
the end of the accounting period.
For recording the items of revenue and expenditure temporary capital
accounts are created.

The reason behind calling these accounts as temporary capital account is that
each of these accounts starts with a zero balance at the beginning of the
accounting period and at the end of the accounting period these accounts are
closed and their balance are transferred to profit and loss account and the net
balance (net profit / net loss) is transferred to capital account. The temporary
capital accounts include:

(i) Revenue Account (including other income and gains)

(ii) Expense Account (including losses)
(iii) Drawing Account
Increase in revenue leads to increase in capital therefore revenue earned is
credited to revenue account.

For example Sales of Rs. 10,000/- in cash, in this case cash account would be
47
Accounting: An debited by Rs. 10,000/- and Sales A/c would be credited by Rs. 10,000/-.
Overview
Expenses decrease capital and decrease in capital is debited therefore
expenses incurred are debited to expense account.

For example Purchase of Rs. 9,000/- in cash, in this case Purchase A/c would
be debited by Rs. 9,000/- and cash account would be credited by Rs. 9,000/-.

In nutshell if

Asset Liability Capital Drawings Expense Revenue

Increase Dr Cr Cr Dr Dr Cr
Decrease Cr Dr Dr Cr Cr Dr

Illustration 1: Analyse transactions of M/s. Sunil & Co. for the month of
March, 2021 on the basis of double entry system by adopting the following
approaches:
A) Accounting Equation Approach
B) Traditional Approach
Transactions for the month of March, 2021 were follows:
1. Sunil introduced cash Rs. 40,000.
2. Cash deposited in the City bank Rs. 20,000.
3. Cash loan of Rs. 5,000 taken from Mr. Y.
4. Salaries paid for the month of March, 2021Rs. 3,000 and Rs. 1,000 are
still payable for the month of March, 2021.
5. Furniture purchased Rs. 5000.

What conclusions one can draw from the above analysis?

(A) Analysis of Business Transaction: Accounting Equation Approach

Transaction Analysis Account Rule Entry

Affected &
Nature of
Account
Introduction Cash Cash –Asset Debit Debit Cash
of Rs. 40,000 received increase in
cash by the asset
Capital- Credit Capital
Proprietor Credit
Investment Capital
by owner increase in
capital
Cash Bank balance Bank-Asset Debit Debit Bank
deposited in increases increase in
bank Rs. Cash balance Cash-Asset asset Credit Cash
20,000 decreases Decrease in
asset
Loan from Y Cash balance Cash- Asset Debit Debit Cash
48
Rs. 5,000 increases increase in Preparation of Books
assets of Accounts
Creates an Y‟s Loan- Credit Y‟s
obligation to Liability Credit Loan
repay Y increase in
liabilities
Salaries paid Salaries for Salary- Debit Debit Salary
Rs. 3,000 and services Temporary increase in (Rs. 4,000)
outstanding received Rs. capital expenses
Rs. 1,000 4,000 (Expense) Credit Cash
Paid Rs. Cash-Asset Credit (Rs. 3,000)
3,000 Salaries decrease in Credit
Obligation to outstanding- asset
Liability Salaries
pay Rs. Credit
1,000 Outstanding
increase in (Rs. 1,000)
liabilities
Furniture Increases Furniture- Debit Debit
purchased Rs. furniture Asset increase in Furniture
5,000 owned Cash asset Credit Cash
decreases Credit
Cash-Asset
decrease in
asset

B) Analysis of Business Transaction: Tradition approach

Transaction Analysis Account Rule Entry

Affected &
Nature of
Account

Introduction Cash is Cash – Real Debit what Debit Cash

of Rs. 40,000 received by comes in
cash by the business
Credit the
Proprietor Capital- Credit
Owner has giver
Personal Capital
given cash

Cash Bank receives Bank- Debit the Debit Bank

deposited in cash Personal receiver
bank Rs.
Cash goes out Cash- Real Credit what
20,000 Credit Cash
of business goes out

Loan from Y Business gets Cash-Real Debit what Debit Cash

Rs. 5,000 cash cones in
Y‟s loan- Credit the
Y pays cash Personal giver Credit Y‟s
Loan

49
Accounting: An
Overview Salaries paid Cost of Salary- Debit all Debit Salary
Rs. 3,000 and services used Nominal expenses (Rs. 4,000)
still payable Rs. 4,000 Credit what
Rs. 1,000 Cash goes out goes out
Rs. 3,000 Cash- Real Credit the Credit Cash
Still payable giver (Rs. 3,000)
or
Outstanding Credit
Salary
for services Outstanding- Salaries
received Rs. Personal
1,000 Outstanding
(Rs. 1,000)

Furniture Furniture is Furniture – Debit-what Debit

purchased Rs. purchased Real comes in Furniture
5,000 Credit Cash
Cash is paid Cash- Real Credit-what
goes out

Illustration 2: Show the classification of the following Accounts under

traditional and accounting equation approach:

(a) Building; (b) Purchases; (c) Sales; (d) Bank Deposit; (e) Rent; (f) Rent
Outstanding; (g) Cash; (h) Adjusted Purchases; (i) Closing Stock;
(j)Investments; (k) Debtors; (l) Sales Tax Payable; (m) Discount Allowed; (n)
Bad Debts; (o) Capital; (p) Drawings; (q) Provision for depreciation account;
(r) Interest Receivable account; (s) Rent received in advance account; (t)
Prepaid salary account; (u) Provision for Bad & doubtful debts account; (y)
Stock reserve account; (z) Provision for discount on creditors account.

Nature of Account

S.No. Title of Account Traditional Approach Accounting

Equation Approach
(a) Building Real Asset
(b) Purchases Real Asset
(c) Sales Nominal (Revenue) Temporary Capital
(Revenue)
(d) Bank Deposit Personal Asset
(e) Rent Nominal (Expense) Temporary Capital
(Expense)
(f) Rent Outstanding Personal Liability
(g) Cash Real Asset
(h) Adjusted Purchases Nominal (Expense) Temporary Capital
(Expense)
(i) Closing Stock Real Asset
(j) Investment Real Asset
50
(k) Debtors Personal Asset Preparation of Books
of Accounts
(l) Sales Tax Payable Personal Liability
(m) Discount Allowed Nominal (Expense) Temporary Capital
(Expense)
(n) Bad Debts Nominal (Expense) Temporary Capital
(Expense)
(o) Capital Personal Capital
(p) Drawings Personal Temporary Capital
(Drawings)
(q) Provision for Valuation (Real) Asset
depreciation
(r) Interest receivable Personal Asset
(s) Rent received in Personal Liability
advance
(t) Prepaid salary Personal Valuation (Asset)
(u) Provision for bad & Valuation (Personal) Valuation (Asset)
doubtful debts
(v) Bad debts recovered Nominal (Gain) Temporary capital
(Gain)
(w) Depreciation Nominal (Expense) Temporary capital
(Expense)
(x) Personal Income Tax Personal (Drawing) Temporary capital
(Drawings)
(y) Stock reserve Valuation (Real) Valuation (Asset)
(z) Provision for discount Valuation (Personal) Valuation
on creditors (Liability)

2.3 JOURNAL
Journal is a historical record of business transaction or events. The word
journal comes from theFrench word “Jour” meaning “day”. It is a book of
original or prime entry. Journal is a primary bookfor recording the day-to-day
transactions in a chronological order i.e., the order in which they occur. The
journal is a form of diary for business transactions. This is called the book of
first entry since every transaction is recorded firstly in the journal.

JournalEntry
Journal entry means recording the business transactions in the journal. For
each transaction, aseparate entry is recorded. Before recording, the
transaction is analysed to determine which account is to be debited and which
account is to be credited.

51
Accounting: An The Performa of journal is shown as follows:
Overview

Column1 (Date):The date of the transaction on which it takes place is written

in this column.

Column2 (Particulars): In this column, the name of the accounts to the

debited is written first, then the names of the accounts to be credited and
lastly, the narration (i.e., a brief explanation of transaction) are entered.

Column3(L.F.): L.F stands for ledger folio which means page of the ledger.
In this column are entered the page numbers on which the various accounts
appear in the ledger.

Column4 (Dr. Amount): In this column, the amount to be debited against the
„Dr.‟ Account is written along with the nature of currency.

Column5(Cr. Amount):In this column the amount to be credited against the

„Cr.‟ Account is written along with the nature of currency.

Advantages of Using Journal

Journal is used because of the following advantages:

 A journal contains a permanent record of all the business transactions.

 The journal provides a complete chronological (in order of the time of
occurrence) history of all business transactions and the task of later
tracing of some transactions is facilitated.
 Complete information relating to one single business transaction is
available in one placewith all its aspects.
 The transaction is provided with an explanation technically called a
narration.
 Use of the journal reduces the possibility of an error when transactions
are first recorded in this book.
 The journal establishes the quality of debits and credits for a transaction
and reconciles any problems. If a business purchases a bicycle, it is
necessary to decide whether the bicycle represents ordinary goods or
machinery. Further any amount paid is debited to bicycle account and
credited to cash account.
 The use of journals avoids omission or duplication of transactions or
52 parts of transaction.Without the journal the accountant would be forced
 to go to the individual account to enterdebits and credits. Therefore, it is Preparation of Books
of Accounts
possible for accountant to miss part of a transaction,duplicate all or part
of a transaction or incorrectly record debits and credits. Even with
theJournal, it is still possible to omit transactions and make other errors.
However, the Journal reduces these problems.
 Once a transaction is recorded in the journal, it is not necessary to post it
immediately in the ledger accounts. In this, way, the journal allows the
delayed posting.
In connection with the journal, the following points are to be remembered:
 For each transaction, the exact accounts should be debited and credited.
For that, the two accounts involved must be identified to pass a proper
journal entry.
 Sometimes, a journal entry may have more than one debit or more than
one credit. This type of journal entry is called compound journal entry.
Regardless of how many debits or credits are contained in a compound
journal entry, all the debits are entered before any credits are entered.
The aggregate amount of debits should be equal to the aggregate amount
of credits.
 For a business, journal entries generally extend to several pages.
Therefore, the total are cast at the end of each page, against the debit and
credit columns, the following words and written in the particular column,
which indicates, carried forward (of the amount on the next page)“Total
c/f”.

The debits and credits totals of the page are then written on the next page in
the amount columns; and opposite to that on the left, the following words are
written in the particulars column to indicate brought forward (of the amount
of the previous page) “Total b/f”. This process is repeated on every page and
on the last page, “Grand Total” is cast.

2.3.1 Journalizing
Journalizing is the process of recording journal entries in the Journal. It is a
systematic act of entering the transaction in a day book in order of their
occurrence i.e., date-wise or event-wise. After analysing the business
transactions, the following steps in journalising are followed:
i) Find out what accounts are involved in business transaction.
ii) Ascertain what is the nature of accounts involved?
iii) Ascertain the golden rule of debit and credit is applicable for each of
the accounts involved.
iv) Find out what account is to be debited which is to be credited.
v) Record the date of transaction in the “Date Column”.
vi) Write the name of the account to be debited very near to the left-hand
side in the„Particulars Column‟ along with the word „Dr‟ on the same
line against the name of theaccount in the „Particulars Column‟ and the
amount to be debited in the „Debit Amount column against the name of
53
Accounting: An the account.
Overview
vii) Record the name of the account to be credited in the next line preceded
by the word „To‟ at a few spaces towards right in the „Particulars
Column‟ and the amount to be credited in the „Credit Amount Column‟
in front of the name of the account.
viii) Record narration (i.e., a brief explanation of the transaction)within
brackets in the following line in Particulars Column‟.
ix) A thin line is drawn all through the particulars column to separate one
Journal entry from the other and it shows that the entry of a transaction
has been completed.
Goods Account
Generally, the term goods include every type of property such as Land,
Building, Machinery, Furniture, Cloth etc. However, in accountancy its
meaning is restricted to only those articles which are purchased by a
businessman with an intention to sell it. For example, if a businessman
purchased typewriter, it will be goods for him if he deals in typewriter but if
he deals in other business say clothes then typewriter will be asset for him
and clothes will be goods.
Sub-Division of Goods Accounts
The goods account is not opened in accounting books and it is to be noted
goods includes purchases, sales, sales returns, purchases return of goods.
However, purchase account, sales account, sales return account and purchase
return account are opened in the books of account.
Purchases Account: This is opened for goods purchased on cash and credit.
Sales Account: This account is opened for the goods sold on cash and credit
Purchase Returns Account or Return Outward Account: This account is
opened for the goods returned to suppliers.
Sales Returns Account or Return Inward Account: This account is opened
for the goods returned bycustomers.
Opening Entry: In case of going concern at the beginning of the new year,
new books of accounts are opened and the balances relating to personal and
real Accounts appearing in the books at the close of the previous year are
brought forward in new books. The entry for this purpose in the books is
called opening entry.
The opening entry is passed by debiting all assets and crediting all liabilities
including capital. If the amount of capital is not given then this can be found
out with the help of the accounting equation:
Assets = Liabilities + Capital
Capital=Assets-Liabilities

54
2.3.2 Important Considerations For Recording The Business Preparation of Books
of Accounts
Transactions
1. Trade Discount: Trade discount is usually allowed on the list price of
the goods. It may be allowed by producer to wholesaler and by
wholesaler to retailer for purchase of goods in large quantity. It is not
recorded in the books of account and entry is made only with the net
amount paid or received, for example, purchased goods of list price Rs.
8,000 at 15% trade discount from X. In this case the following entry will
be passed:

2. Amount paid or received in full settlement or cash discount: Cash

discount is a concessionallowed by seller to buyer to encourage him to
make early cash payment. It is a NominalAccount. The person who
allows discount, treat it as an expenses and debits is his books andit is
called discount allowed and the person who receives discount, treat as an
income and it is called discount received and credits in his books of
account “Discount Received Account.”For example, X owes Rs. 6,000 to
Y. He pays Rs. 5,950 in full settlement against the amount due. In the
books of X the journal entry will be:

3. Goods distributed as free samples: Sometimes business distributes

goods as free samples for the purpose of advertisement. In this case
Advertisement Account is debited and Purchases Accounts is credited.
For example, goods costing Rs.8000 were distributed as free sample. To
record these transactions following entry will be passed

55
Accounting: An 4. Interest on capital: Interest paid on capital is an expense. Therefore,
Overview
interest account should be debited. On the other hand, the capital of the
business is increased so, the capital account should be credited. The entry
will be as follows:

Interest on Capital Account Dr.

To Capital Account

5. Interest charged on Drawings: If the interest is charged on drawings,

then it will be an increase in the income of business, so interest on
drawings will be credited. On the other hand, therewill be increase in
Drawings or decrease in Capital. So, Drawings Account will be debited.
To record this, following entry will be passed:
Drawing Account or Dr.
Capital Account Dr.
To Interest on Drawing Account
6. Depreciation charged on Fixed Assets: Depreciation is the gradual,
permanent decrease in the value of assets due to wear and tear and many
other causes. Depreciation is an expense so the following entry will be
passed:
DepreciationAccount Dr.
To Asset Account
7. Bad Debts: Sometimes a debtor of business fails to pay the amount due
from him. Reasons may be many e.g., he may become insolvent or he
may die. Such irrecoverable amount is a loss to the business. To record
this following entry will be passed:
BadDebts Account Dr.
To Debtor‟s Account
8. Bad Debts Recovered: When any amount becomes irrecoverable from
any costumer ordebtor his account is closed in the books. If in future any
amount is recovered from him thenhis personal account will not be
credited because that does not exist in the books. So, thefollowingentry is
passed:
CashAccount Dr.
To Bad Debts Recovered Account
9. Purchase and Sale of investment: When business has some surplus
money it may invest this amount in shares, debentures or other types of
securities. When these securities are purchased, these are recorded at the
purchase price paid. At the time of sale of investmentthe sale price of an
investment is recorded in the books of accounts. The following entry is
passed to record the purchase of investment:
InvestmentAccount Dr.
56 To Cash Account
 In case of sale of these securities the entry will be:CashAccount Dr. Preparation of Books
of Accounts
To Investment Account
10. Loss of Goods by Fire/Accident/theft: A business may suffer loss of
goods on account of fire, theft or accident. It is a business loss and a
nominal account. It also reduces the goods at cost price, and increases
the loss/expenses of the business. The entry will be passed as:
Loss by fire/Accident/theft Account Dr (for loss)
InsuranceCompanyAccount Dr.(forinsuranceclaimadmitted)
To Purchases Account
11. Income Tax Paid: Income Tax paid should be debited to Capital
Account or Drawings Account and credited to cash Account in case of
sole proprietorship and partnership firms. The reason behind this is that
income tax is a personal expense for the sole trader and partners because
it is paid on income of proprietor. The entry will be as follows:
CapitalAccount Dr.
DrawingAccount Dr.
To Cash Account
12. Bank Charges: Bank provides various services to their customers. Bank
deducts some chargesby debiting the account of customers. It is an
expense for the business. To record this following entry will be passed in
the books of businessman/customer:
Bank Charges Account Dr.
To Bank Account
13. Drawings Account: It is a personal account of the proprietor. When the
businessman withdraws cash or goods form the business for his
personal/domestic use it is called as„drawings‟. Drawings reduce the
capital as well as goods/cash balance of the business. The journal entry
is:
DrawingsAccount Dr.
ToCashAccount
To Purchases Account
14. Personal expenses of the proprietor: When the private expenses such
as life insurances premium, income tax, home telephone bill, tuition fees
of the son of the proprietor etc. are paid out of the cash or bank account
of business it should be debited to the Drawing Account of the
proprietor. The journal entry is:
Capital/ Drawings Account Dr.
To Cash/Bank
15. Sale of Asset/Property: When the asset of a business is sold, there may
be a profit or loss on its sale. It should be noted carefully that sales
account is never credited on the sale of asset. The journal entry is:
57
Accounting: An a. In case there is a profit on sale of Property/Assets
Overview
Cash/Bank Account Dr.
To Asset/Property Account
To Profit on sale of Asset Account
b. In case of a loss on sale of asset
Cash/Bank Account Dr.
Loss on sale of Asset Account Dr.
To Asset Account
16. Amount paid or received on behalf of customer:
a. When the business entity pays the amount on behalf of old reputed
customers such as carriage in anticipation of recovering the same
later on, carriage account should not be opened because carriage is
not the expense of the seller. It should be debited/charged to
customer‟s Personal account. The journal entry is:
Customer/Debtor‟sAccount Dr.
To Cash/Bank Account
b. When the business entity receives the amount on behalf of
customers from the thirdparty as mutually settled between the third
party and the customer, the account of the third party/person making
the payment should not be opened in the books of the receiving
entity. The journal entry in the books of the entity is:
Cash/BankAccount Dr.
To Customer/Debtor‟s Account
17. Amount paid on behalf of creditors: When the creditors/supplier
instructs the business entity to make payment on their behalf, the amount
so paid should be debited to creditors account and liability of the
business will decrease accordingly. The journal entry is:
Suppliers/Creditors Account Dr.
To Cash/Bank Account
18. The events affecting business but they do not involve any
transfer/exchange of money for the time being, they would not be
recorded in the financial books. Examples of them are:
a. On 1stJanuary 2006 placed an order to Geeta& Sons for the supply
of goods worth Rs.1,00,000.
b. Babanjot,a B.Com. graduate has been appointed Sales Assistant on a
salary of Rs.5,000 p.m. on Jan 2006.
c. Raman, a proprietor contracted with Bahia Builders Ltd. For the
renovation of the building at an estimated cost of Rs.5,00,000.
d. A shop in Adalt Bazar Patiala contracted to be taken on a
[email protected],000pm.
58
19. Paid wages/installation charges for erection of machinery: Wages Preparation of Books
of Accounts
and installation charges are the expenses of nominal nature. But for
erection of machinery no separate account should be opened for such
expenses because these expenses are of capital nature and it will be
merged/debited to the cost of assets i.e. machinery. The journal entry is:
MachineryAccount Dr.
ToCash/BankAccount
(Being wages/installation charges paid for the erection of machinery)
Illustration 3: Journalise the following transactions of M/s Ramesh and
Co. for the month of March, 2021: Balances on March 1, 2021 (a) Cash-
Rs. 14,000 (b) Bank- Rs. 40,000 (c) Stock- Rs. 30,000 (d) Furniture –
Rs. 10,000 (e) Building- Rs. 80,000 (f) Debtors: A – Rs. 6,000. B-
Rs10,000 (g) Bank Loan- Rs. 14,000 (h) Creditors: X- Rs. 14,000. Y- Rs.
16,000.
Transactions during the month of March, 2001 were as follows:
2nd March Received Rs. 2,800 cash from Mr. A in full and final
settlement.
6thMarch Purchased goods of the list price Rs. 10,000 at 10% discount
on credit from Mr. Z.
8thMarch Sold goods to C on credit Rs. 8,000.
11th March C pays Rs. 7,200 after getting 10% discount for prompt
payment.
15th March Salaries paid in cash Rs. 2,000.
18th March Interest on bank loan Rs. 700 debited to the current account
of the business enterprise.
20th March Goods costing Rs. 1,000 distributed as free samples.
25th March Cash withdrawn by Ramesh for personal use Rs. 2,000.
30th March paid Rs. 6,000 to X in full and final settlement of his account.
31st March Cash sales at list price Rs. 5,000. Trade discount allowed Rs. 500.
Journal
Date Particulars L.F. Dr. Cr.
1-3- Cash A/c 14000
21 Bank A/c 40000
Debtors A/c 16000
Stock a/c 30000
Furniture A/c 10000
Building A/c 80000
To Creditors A/c
To Bank Loan A/c 30000
To Capital A/c 14000
(Being balances of assets and liabilities in the 146000
beginning of the period and excess of assets over
liabilities taken as capital)
2-3- Cash A/c 5600
21 Discount Allowed A/c 400
59
Accounting: An To A 6000
Overview (Being cash received from Mr. A Rs. 5600
and difference between amount due and final
settlement treated as cash discount)
2-3- Purchases A/c 18000
21 To Z 18000
(Being goods purchased for Rs. 18,000
i.e.Rs. 20,000 less 10% trade discount)
6-3- C 16000
21 To Sales A/c 16000
(Being goods sold on credit to Mr. C)
11-3- Cash A/c 14400
21 Discount Allowed A/c 1600
To C 16000
(Being payment made of full amount by C and
he gets 10% cash discount)
15-3- Salaries A/c 4000
21 To Cash A/c 4000
(Being cash payment of salaries
18-3- Interest on Loan A/c 1400
21 To Bank A/c 1400
(Being interest charged on loan by bank)
20-3- Sample A/c 2000
21 To Purchases A/c 2000
(Being cost of free sample distributed)
25-3- Drawing A/c 4000
21 To Cash A/c 4000
(Being money withdrawn for personal use)
30-3- X 14000
21 To Cash A/c 12000
To Discount Received A/c 2000
(Being payment to Mr. X Rs. 12,000 in final
settlement and difference treated as discount
received)
31-3- Cash A/c 9000
21 To Sales A/c 9000
(Being cash sales at list price less 10%)
Total: 280400 280400

Cost of samples distributed to promote sales is a sales promotion expense and

therefore, debited to samples account. Alternatively, it can be debited to sales
promotion expense account. As it reduces the goods purchased for resale,
cost of samples distributed is credited to (or subtracted from) purchases
account.

2.4 LEDGER
Meaning: After recording the business transactions in the Journal or special
purpose Subsidiary Books, the next step is to transfer the entries to the
respective accounts in the Ledger. Ledger is a book where all the transactions
related to a particular account are collected at one place.
Definition: The Ledger is the main or Principal book of accounts in which all
60 the business transactions would ultimately find their place under various
accounts in a duly classified form. Preparation of Books
of Accounts
Utility of Leader
To know the collective effect of all the transactions pertaining to one
particular account.
By this classification, we are able to know the following-
 It provides complete information about all accounts.
 It provides position of Assets and Liabilities
 It facilitates to prepare Trial Balance.
Important: Ledger is also called the Principal Book of Accounts
Performa for Ledger
Each ledger account is divided into two equal parts.
Left Hand Slide Debit side (Dr.)

RightHandSide Creditside(Cr.)

NameoftheAccount

Dr. Cr.

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

2.4.1 Posting in the Ledger

This will be dealt separately from Journal Entries and each Subsidiary
Book.

Case-I: Posting from Journal Entries

• If an account is debited in the journal entry, the posting in the

ledger should be made on the debit side of that particular
account. In the particulars column the name of the other account
(which has been credited in the Journal entry) should be written
for reference.
• For the Ac,credited in the Journal entry, the posting in the ledger
should be made on the credit side of that particular A/c.I n the
particulars column, thename of the other account that has been
debited (in the Journalentry) is written for reference.
61
Accounting: An Important
Overview
• 'To' is written before the A/c s which appear on the debit side of
Ledger
• "By" is written before the A/cs appearing on the credit side Ledger.
• Use of these words 'To' and 'By' is optional.

Illustration 4:Simple Journal Entry

On1stAugust2021goods are sold for cash Rs.12.000.

Solution:
JournalEntry
Date Particulars L.F Dr.(Rs.) Cr(Rs.)
1st Aug, CashA/cDr. 12.000
2021 To SalesA/c 12.000
{Forcashsales)

LedgeA/c
CashA/c(extract)

Dr. Cr.

Date Particulars J.F (Rs.) Date Particulars J.F (Rs.)

1st Aug, ToSalesA/c 12000

2021

SalesA/c(extract)1
Dr. Cr.

Date Particulars J.F (Rs.) Date Particulars J.F (Rs.)

1st Aug, ToCashA/c 12000

2021

Illustration 5:Compound Journal Entry

Received Rs.14.000 in full settlement of a debt of Rs.15,000 from

62 RamonAug8.2021
Solution: Preparation of Books
of Accounts
JournalEntry
Date Particulars L.F Dr.(Rs.) Cr.(Rs.)
8th Cash A/c Dr. 14,000
August,
2021
DiscountAllowedA/C Dr. 1,000
ToRam 15,000
{Cashreceivedanddiscountallowed)

Ledger

CashAccount
Dr. Cr.

Date Particulars J.F. Rs. Date Particulars J.F. Rs.

8th ToRam 14.000

August,

2021

Discount Allowed Account

Date Particulars J.F. Rs. Date Particulars J.F. Rs.

8th ToRam 1.000

August,

2021

Ram’s Account

Date Particulars J.F. Rs. Date Particulars J.F. Rs.

8th By cash a/c 14000

August,
By Discount 1000
2021 allowed a/c

2.4.2 Balancing of Ledger Accounts

Balancing of an account means to make the total of amounts columns
appearing on debit and credit side of an account equal to each other. If the
total of amount column on debit side is more than the total of the amount
column on credit side, it is said that the account has a debit balance. The
63
Accounting: An balance is termed as credit balance if total of amount column on credit side is
Overview
more than the total of amount column on debit side. Balancing is done by
writing balance carried down (c/d) on the shorter side to make total of debit
and credit side equal. The same balance is written as balance brought down
(b/d) on the opposite side as follows:
Dr. Title of Account Cr.
1-3-01 To……………… 4,000 20-3- By………… 8,000
01
4-3-01 To……………… 3,000 25-3- By………… 7,000
01
6-3-01 To……………… 5,000 31-3- By Balance c/d 5,000
01
18-3-01 To……………… 8,000
20,000 20,000
1-4-01 By Balance b/d 5,000

Accounts relating to assets, liabilities, revaluation of assets and liabilities, and

capital are balanced at the end of accounting period. Temporary Capital
Accounts relating to expenses, revenue, gains and drawings are not balanced.
Nominal accounts representing expenses, revenue and incomes are
transferred at the end of the year to trading and profit and loss account.
Drawing account is closed by transferring its balance to capital account.
Stock account showing stock in the beginning (called opening stock) and
purchases account, although real account by nature, are not balanced. These
are transferred to trading account.

Illustration 6: Name the accounts prepared in Illustration 3 which do not

require balancing. Balance remaining accounts clearly indicating the amount
and nature of balance (debit or credit) is appearing in those accounts.

Stock A/c, Discount Allowed A/c, Purchases A/c. Sales A/c, Interest on loan
A/c, Samples A/c, Drawing A/c and Discount Received A/c are closed at the
end of the period and therefore, not balanced. Other accounts which are
balanced, appear as follows in the ledger:
Dr. Cash Account Cr.
1-3-21 To Balance b/d 14,000 15-3-21 By Salaries A/c 4,000

2-3-21 To A 5,600 25-3-21 By Drawing 4,000

A/c
11-3-21 To C 14,400 30-3-21 By X 12,000

31-3-21 To Sales A/c 9,000 31-3-21 By Balance c/d 23,000

43,000 43,000
1-4-21 To Balance b/d 23,000

64
Dr. Bank Cr. Preparation of Books
Account of Accounts
1-3-21 To Balance 40,000 18-3-21 By Interest on 1400
b/d Loan A/c
31-3-21

By Balance 38,600
c/d

40000 40000
1-4-21 By Balance 38600
b/d

Dr. A‟s Account Cr.

1-3-21 To Balance 6,000 12-3-21 By Sundries 6,000

b/d

6,000 6,000

Dr. B’s Account Cr.

1-3-21 To Balance 10,000 31-3-21 By Balance 10,000

b/d c/d

10,000 10,000
1-4-21 To Balance 10,000
b/d

Dr. Furniture Cr.

Account
1-3-21 To Balance 10,000 31-3-21 By Balance 10,000
b/d c/d

10,000 10,000
1-4-21 To Balance 10,000
b/d

Dr. Building Cr.

Account
1-3-21 To Balance 80,000 31-3-21 By Balance 80,000
b/d c/d

80,000 80,000
1-4-21 To Balance 80,000
b/d
Dr. Bank Loan Cr.
Account
31-3-21 To Balance 14,000 1-3-21 By Balance 14,000
b/d c/d
14,000 1-4-21 To Balance 14,000
b/d

65
Accounting: An
Overview
Dr. X‟s Account Cr.
30-3-21 To 14,000 1-3-21 By Balance 14,000
Sundries b/d

14,000 14,000

Dr. Y‟s Account Cr.

31-3-21 To Balance 16,000 1-3-21 By Balance 16,000
c/d b/d

16,000 1-4-21 To Balance 16,000

b/d

Dr. Z‟s Account Cr.

31-3-21 To 18,000 1-3-21 To 18,000
Balance Purchases
b/d A/c

18,000 1-4-21 By 18,000

Balance
b/d

Dr. C Cr.
8-3-21 To Sales 16,000 11-3-21 By 16,000
A/c Sundries

16,000 16,000

Summary of Balances

Accounts Title Balance Amount (Rs.) Nature of Balance

Cash 23000 Debit
Bank 38600 Debit
A Nil -
B 10,000 Debit
Furniture 10,000 Debit
Building 80,000 Debit
Bank Loan 14,000 Credit
X Nil -
Y 16,000 Credit
Z 18,000 Credit
66 C Nil -
 Preparation of Books
2.5 SUMMARY of Accounts

An accounting process is a complete sequence of accounting procedures

which are repeated in the same order during each accounting period.
Accounting process involves six steps or stages i.e. identification of
transactions, recording the transaction, classifying, summarising, analysis and
interpretation and reporting of financial information. In accounting, all the
transactions are recorded on the basis of evidence/document which are
mainly three–(i)payment voucher;(ii)receipt voucher; and(iii)transfer
voucher. Recording the transaction is the first step in the process of
accounting which is performed in the book called „Journal‟. Journal is a
primary book for recording the day to daytransactions in a chronological
order, i.e., the order in which they occur. The process of recordingjournal
entries in the journal is called journalising. For the journalising, all the
accounts are classified into three categories namely personal account; real
account; and nominal account.

2.6 SELF ASSESSMENT QUESTIONS

Question1:

Journalise the following transactions, post them into Ledger, balance the
accounts andprepare aTrial Balance:
2017 (₹)
March Haldiram& Sons commenced business with cash 80,000
1
2 Purchased goods for cash 36,000
3 Machinery purchased for cash 4,000
4 Purchased goods from :
Rahul 22,000
Dilip 30,000
6 Returned goods to Rahul 4,000
8 Paid to Rahul, in full settlement of his account 17,500
10 Sold goods to Mahesh Chand & Co. for ₹ 32,000 at 5% trade
discount
13 Received cash from Mahesh Chand & Co. 19,800
Discount allowed 200
15 Paid cash to Dilip 14,850
Discount received 150
20 Sold goods for cash 25,000
24 Sold goods for cash to Sudhir Ltd. 18,000
25 Paid for Rent 1,500
26 Received for Commission 2,000
28 Withdrew by Proprietor for his personal use 5,000
28 Purchased a fan for Proprietor's house 1,200

Question 2:
Following balances appeared in the books of Ram &Shyam on January 1,
2017:−Assets: Cash in hand ₹ 30,000; Stock ₹ 36,000; Lal Chand ₹ 7,600;
MukeshKhanna₹16,200;Furniture₹ 8,000.
67
Accounting: An Liabilities: Ghanshyam ₹ 6,000; Vinod ₹ 8,000. Following transactions took
Overview
place during Jan. 2017:−
2017
Jan. 2 Purchased Typewriter for ₹ 7,500.
4 Sold goods for Cash of the list price of ₹ 25,000 at 20% trade discount
and 5%
Cash discount.
6 Sold goods to Gopal Seth for ₹ 10,000.
8 Gopal Seth returned goods for ₹ 1,500.
12 Purchased goods from Arun ₹ 12,000; and from Varun ₹ 15,000.
13 Settled Arun's account in full after deducting 5% for cash discount.
14 Paid cash to Ghanshyam in full settlement of his account.
16 Received ₹ 7,500 from Lal Chand in full settlement of his account.
17 Purchased a Scooter for office use ₹ 18,000.
20 Sold goods for cash ₹ 20,000.
22 Received from Gopal Seth ₹ 4,850 and discount allowed ₹ 150.
27 Paid for Wages ₹ 7,000 and Salaries ₹ 3,000.
28 Withdrew goods for ₹ 2,000 and Cash ₹ 1,500 for private use.
29 Paid for Life Insurance Premium of the Proprietor ₹ 1,600.

Journalise the above transactions, post them into Ledger, balance themand
prepare aTrialBalance.

Question3:
Enter the following transactions in a Double Column Cash Book and Journal
Proper andpostthem into Ledger∶
May 1 Balance of Cash in Hand ₹ 12,400; Bank Overdraft ₹ 36,000.
3 Direct deposit by Mr. Ganesh in our bank account ₹ 10,000. Discount
allowed ₹200.
5 Issued a cheque of ₹ 7,700 to Mr. Suresh in full settlement of his account of
₹8,000.
6 Received a cheque from X for ₹ 12,000. Discount allowed ₹ 500. This
cheque was deposited into bank on 7th May.
8 Received Cash ₹ 22,000 and cheque of ₹ 8,000 for cash sale.
12 Cash sale ₹ 70,000 of which ₹ 55,000 banked.
15 Cheque received on 8th May endorsed to Mr. Sunil. Discount received ₹
150.
20 Discounted a B/R of ₹ 10,000 at 1% through bank.
24 Cheque received from X dishonoured, Bank debits ₹ 20 in respect of bank
charges.
25 Purchased goods for ₹ 50,000 at a trade discount of 10%. Payment was
made incash.
26 Withdrew from bank ₹ 10,000 for office use and ₹ 2,000 for personal use.
31 Interest debited by Bank ₹ 4,500.

68
 Financial Statements
UNIT 3 FINANCIAL STATEMENTS

Learning Objectives
After reading this chapter, you will be able to:

 Explain the meaning and objectives of financial statements of a business entity

 Understand the basic concepts of a Profit & Loss account

 Classify income and expense items

 Understand the structure and components of a balance sheet

 Classify the various assets, liabilities and capital accounts in a balance sheet

 Understand the basic principles of assets valuation

 Appreciate the concept of a balance sheet equation

 Appreciate the linkage between profit and loss account and balance sheet

Structure

3.1 Introduction to Financial Statements

3.2 Objectives of Financial Statements

3.3 Income determination: Basic concepts

3.4 Revenue and Expense

3.5 Profit and Loss

3.6 Income Statement

3.7 Preparing a Trading and Profit and Loss Account

3.8 Balance Sheet

3.9 Balance Sheet contents and classification

3.9.1 Dual Aspect Concept
3.9.2 Current Assets
3.9.3 Fixed Assets
3.9.4 Intangible Assets
3.9.5 Long Term Liabilities
3.9.6 Capital or Owner’s Equity
3.10 Relationship between Income Statement and Position Statement

3.11 Summary

3.12 Key Words

3.13 Self-assessment Questions/Exercises

3.14 Further Readings

69
Accounting: An
Overview
3.1 INTRODUCTION TO FINANCIAL
STATEMENTS
The process of accounting aims at providing the financial information about
the business entity to the users with the help of financial statements. Financial
statements are the formal end reports that summarise the business operations
and transactions conducted in a financial year. These statements are prepared
as per the accounting principles to generate systematic and consistent results.
They are useful indicators of the financial health of a business entity at a
particular point of time. The various users of financial statements include
owners and external parties such as investors, tax authorities, government,
employees, etc. It is vital to present the financial statements in a proper form
with suitable contents so that the shareholders and other users of financial
statements can easily understand and use them in their economic decisions in
a meaningful way.

There are three main financial statements of a business entity: the Balance
Sheet (position statement) as at the end of accounting period, the Statement
of Profit & Loss (income statement) and the Cash Flow Statement.

3.2 OBJECTIVES OF FINANCIAL

STATEMENTS
The financial statements are prepared with the purpose to determine the
financial standing of a business entity by measuring three main variables:
profitability, liquidity, and solvency.

 Profitability is the ability of a business to make profit. After paying all

the business expenses out of the sales revenue for a particular accounting
period, is the entity still able to make a profit?

 Liquidity is the ability of a business to pay current obligations without

disrupting normal operations. It is the ability to pay regular bills without
having to sell off assets needed to operate the business. In short, being
liquid means having enough cash to pay the bills.

 Solvency is the ability of a business to pay all its debts if the business
were liquidated, or sold out. A solvent business must have more assets
than it has debt.

These variables are shown in the revenue generated by business (profit-and-

loss statement), the movement of cash in various business activities and
balance cash available (cash-flow statement), and the net worth of the
business (balance sheet).

3.3 INCOME DETERMINATION: BASIC

CONCEPTS
To be able to understand the income statement of a business, the basic
concepts of revenue recognition and income measurement must be clearly
70
understood. But before that, one must be able to distinguish between capital Financial Statements
and revenue items. The revenue items form part of the income statement
whereas the capital items are shown in the balance sheet. These basic
concepts have been discussed as follows:

3.3.1 EXPENDITURE
Expenditure represents any payment or outlay made for the purposes of
business. The expenditures are incurred with a view to provide benefits to the
business. Such benefit may extend up to one accounting year or more than
one year. If the benefit of expenditure extends up to one accounting period, it
is termed as revenue expenditure. Revenue expenditure is the outflow of
funds to meet the running expenses of a business and it will benefit the
business during the current period only. It is incurred to carry on the normal
course of business or for the repairs and maintenance of the capital assets. In
other words, revenue expenditure is incurred to maintain the earning capacity
of business. For example, salaries, rent, routine repairs of machinery, interest
paid on loan, etc. are all revenue expenditures as they will only benefit the
current accounting period. Also, revenue expenditures are of a recurring
nature. Revenue expenditures form part of the Income Statement and are also
referred to as expenses recognised during an accounting period.

If, however, the benefit of certain expenditure extends for more than one
accounting period, it is termed as capital expenditure. For example,
payment to acquire machinery for use in the business. Machinery acquired in
the current accounting period will give benefits for many accounting periods
to come. Hence, it will be treated as a capital expenditure that affects the
balance sheet by an increase in the fixed assets. In simple words, capital
expenditure is incurred to increase the earning capacity of a business and is of
a non-recurring nature. Common examples of capital expenditure can be
payment to acquire fixed assets and/or to make additions/extensions in the
fixed assets to increase their useful life.

3.3.2 Receipts
A similar distinction of capital and revenue nature is made in case of receipts
of the business. A receipt of money is treated as a capital receipt when the
contribution is made by the owners towards the capital of the business
(example: equity share capital) or, a contribution towards the capital is made
by an outsider to the business (example: debentures, long term loan) or when
a fixed asset is sold. Capital receipts do not usually have any effect on the
profits earned or losses incurred during an accounting year as they are not
shown in the Income Statement (P&L A/c). Capital receipts have an impact
on the balance sheet.

Next, a receipt is considered as a revenue receipt when it is received from

sale of goods or services, fee received for rendering technical services, or any
interest/dividend earned on investments made by business, or any receipt
from business activities done in the normal course during an accounting
period. Revenue receipts are shown in the Income statement. They are set off
71
Accounting: An against the expenses in order to ascertain the profit or loss for the accounting
Overview
period.

3.3.3 Revenue Recognition

Now that we have learnt about revenue receipts and expenditure, the next
question that arises is, when should the revenue and expense be recognised in
the books of accounts? Should we record the revenue when the transaction is
made or when the cash is received or paid? The answer lies in the
fundamental accounting concept of accrual basis and the revenue
realisation principle.

The accrual basis of accounting states that revenues should be recorded

when they are earned or accrued, and not when they are received in cash.
Similarly, expenses should be recorded when they are incurred, and not when
they are paid in cash. For example, assume RT Ltd. made a sale of goods on
12-06-2019 to a customer on credit. The cash was received on 25-08-2019.
Hence, under accrual accounting, the revenue from sale will be recorded on
12-06-2019 and not on 25-08-2019.Later, when the cash is received; no
revenue is recorded because it has already been recorded on the day of sale.
In simple terms, accrual basis requires income and expense to be recorded in
the accounting period to which they relate and not on a cash basis. Taking
another example, if any advance salary is paid to the employee, it will be
debited as an expense in the Profit and loss account in the accounting period
to which it belongs and not in the period in which it is paid. However,
advance salary paid will be shown as a current asset in the Balance sheet of
the accounting year in which it is paid.

Realisation principle, on the other hand, is the point of recognising the

revenue. It states that the revenue should be recognized only to the extent to
which it is certainly realizable. Therefore, just receiving an order of goods or
services from the customer won’t make it eligible to be recognized as
revenue. The reasonable certainty of realizing the revenue will come only
when the goods or services ordered are actually supplied to the customer and
an invoice is created for the same. This concept ensures that income unearned
or unrealized will not be considered as revenue. Further, realisation principle
also enables the recognition of costs, incurred in making available such goods
or services, as expense. Thus, the realisation principle facilitates the process
of income measurement by recognising revenues and also the expenses
incurred with respect to such revenues. This also implies, if costs are incurred
in producing the goods, such costs are not considered as expenses unless
sales are made.

3.3.4 Measurement of Income

Income is nothing but the excess of amount the business entity has earned
from its operations over what they have invested into it over its lifetime.
However, as per the going concern concept the business is expected to run
its operations for an indefinite period of time. Therefore, it is impractical to
wait till the winding up of business to measure the net income earned by it
over its lifetime. There comes the concept of accounting period.
72
Accountants choose some convenient segment of time, such as a calendar Financial Statements
year or quarter of a year, to collect, summarise and report all information on
material changes in the owners' equity (retained earnings) during that period.
This period is usually one year, which could be a calendar year i.e. 1st
January to 31st December or it could be a fiscal year, like in India it is 1st
April to 31st March. The business organizations have the freedom to choose
their own accounting year. However, generally, as a convention, most
business firms tend to have a uniform accounting period for easier
comparison of results.

The accountants measure the income of an accounting period by recognizing

the revenue and expense of that particular accounting period based on
accounting principles of realisation and accrual. Therefore, accounting period
facilitates a practical system of valuation and measurement. Accounting
periods are bounded by balance sheets at the beginning and at the end of the
period. Operations during the period are summarised by income statements.

3.3.5 Matching Concept

The determination of profit earned or loss incurred by a business during a
particular accounting period requires deduction of the expenses from the
revenue relating to that period. The matching concept emphasises exactly on
this aspect. It is an accounting principle that states that expenses incurred in
an accounting period should be matched with the revenues of that period. It
implies that both the revenues and the expenses incurred to earn these
revenues must be recognised in the same accounting period. Matching
concept ensures that the profit or loss of an accounting period is not over or
under-stated.

As previously discussed, revenue is recognised when a sale is made or

service is rendered, not when cash is received. Similarly, an expense is
recognised when an asset or service has been used to generate revenue, and
not when the cash is paid. It is worth noting that, only when a cost is
recognised or accrues during an accounting period, it becomes an expense.
Therefore, cost is not a synonym for expense. Only those costs that have
expired during an accounting period are treated as expenses. For example,
each year’s depreciation is an expired cost of an asset which is treated as an
expense during the accounting period in which the asset is used. Similarly in
a trading account, sales revenue is matched with its cost of goods sold to
ascertain the gross profit. This implies, we should only consider the cost of
goods that have been sold during that year, and not the cost of all the goods
purchased or produced during that period. For this purpose, the cost of unsold
goods should be deducted from the cost of the goods produced or purchased.
The balance amount is called as closing inventory or closing stock and
shown in the trading account.

Other examples of expenses include salaries, rent, insurance, interest on loan

etc. These are recognised in the accounting period to which they belong
irrespective of the actual payment.

73
Accounting: An
Overview
3.4 REVENUE AND EXPENSE
Let us now learn, what constitutes revenue and expense during an accounting
period. Moreover, we shall also try to answer the following questions. Does a
business only earn revenue from sales? Are there any other sources of income
for a business entity? How are expenses classified in a Trading and P&L
Account? Later we will study how these revenues and expenses are shown in
an Income Statement in order to determine the profit or loss.

3.4.1 Revenue
Revenue is simply described as the income generated by a business from the
sale of goods or provision of services during an accounting period. Revenue
is also commonly referred to as the ‘sales revenue’ or ‘gross revenue’.
However, there are certain activities which are incidental to the main
operations of the business. The revenue that accrues from such non-operating
activities is known as non-operating revenue. Examples include dividend
income from shares held in other companies, interest on investments, rental
income, gain on sale of fixed asset etc.

3.4.2 Expense
Expenses refer to the costs incurred by a business firm to generate revenue
during an accounting period. It is a revenue expenditure incurred for
running the business operations and its benefit is only limited to the current
period. Expenses are generally, of a recurring nature such as salaries, rent,
interest etc. Moreover, capital expenditure such as purchase of a fixed asset is
not treated as an expense as the benefit of a fixed asset continues for more
than one accounting period. As already discussed, a cost becomes an expense
when it is recognised. The recognition of expense occurs at a point where the
corresponding revenue is realised. Let’s take few examples to explain it
better.

i. Rent of the office building due for the current period is an expense of the
current period, even if the actual payment of rent is made during the next
accounting period. Such payments that become due during the current
period but are actually paid in the subsequent accounting period are
called as outstanding expense.

ii. Prepaid rent related to the next accounting period, paid during the
current period is not an expense of the current accounting period. It will
be recognised as an expense in the next accounting period when it
becomes due.

iii. Inventory is treated as an expense in the accounting period during which

it is sold. Thus, the remaining unsold inventory or closing stock is not
treated as an expense because it did not generate revenue during the
current accounting period. It will, however, be treated as an expense in
the year in which such inventory is sold.

74
In other words, an expense is that part of the cost that has expired and been Financial Statements
used up by activities directed at generating revenue. Therefore, all expenses
are costs, but all costs are not expenses.

Expenses can be in the form of payments due in respect of routine business

activities (e.g. wages, salaries, rent etc.) or an expired portion of an asset (e.g.
depreciation, amortization), or a decrease in owners’ equity (loss on sale of
an asset, bad debts etc.).There are two important classifications of expenses:

i. Direct and Indirect expenses

ii. Operating and non-operating expenses

Direct and Indirect Expenses

‘Direct’ as the name suggests, are those expenses which are directly related
and allocated to the core business operations. Mainly, these are the expenses
involved in purchases of inventory and manufacturing/production of goods or
services. Direct expenses are a part of the cost of goods sold by a business
entity. They are debited in the trading account. Examples of direct expenses
include carriage inwards, wages of factory workers, fuel charges, electricity
and water charges of the factory, freight inwards, etc. Direct expenses may
differ for different types of companies such as manufacturing, trading,
services, financial etc.

On the other hand, indirect expenses are not directly related and allocated to
the core business operations of a firm such as production. Indirect expenses
are incurred to run the business operations smoothly. They are not directly
involved in the revenue-generating activities. All those expenses recognised
during an accounting period which cannot be classified as direct expense,
will be treated as indirect expense. Indirect expenses are debited in the profit
and loss account. Examples of indirect expenses include rent of building,
salaries to employees, marketing expenses, legal charges, fire insurance
premium, interest on loan, depreciation, printing charges, loss on sale of a
fixed asset, bad debts etc.

Operating and Non-operating expenses

Operating expenses are the expenses incurred for running the business
operations but are not directly related to the core activities of production or
trading. Operating expenses are usually connected with generating sales. The
common examples of operating expenses include administrative expenses,
office expenses, selling and distribution expenses, marketing expenses,
depreciation, bad debts etc.

Non-operating expenses are expenses incurred on non-core activities. These

expenses are not related to production or sales, but are incidental to the
business operations. Few examples of non-operating expenses include:
interest expense, loss on sale of a fixed asset, legal fee, etc.

75
Accounting: An Activity 3.1
Overview
1. Fill in the blanks:

a) Income statement is a summary of _________ and ________ for an

accounting period.

b) Income is the excess of ________ over _________.

c) Goods worth Rs.25,000 are sold on 20th March 2020 but the actual
payment is received on 12thApril 2020. The sales revenue will be
recorded in the year ending_________. (Assume that the business entity
follows the financial year 1st April to 31st March)

d) Realisation principle in accounting is the basis of __________

recognition.

e) Prepaid expense is recognised as an expense during the ________

accounting period.

f) Loss on sale of investments is a __________ .

3.4.3 Few Important Concepts

We shall now discuss some important elements of the Income statement in
detail.

I. Cost of Goods Sold

Having studied the types of revenue and expense that form part of the trading
and profit and loss account, now we will read about the expenses that
constitute the cost of goods sold. Cost of Goods Sold (COGS) is the direct
costs incurred in the production of goods or services that are sold during an
accounting period. It includes raw material cost, direct labour cost and direct
factory overheads assigned to the goods which are sold during a particular
accounting period. The excess of sales revenue over cost of goods sold results
in gross profit. Cost of goods sold includes the expenses related to the goods
or inventory which have been converted into sales during an accounting
period. It can be depicted in an equation as follows:

COST OF GOODS SOLD = OPENING STOCK + PURCHASES + DIRECT

EXPENSES – CLOSING STOCK.

Illustration 1
Let us illustrate the idea based on a simple example for a better understanding
of the concept of COGS. A manufacturing concern First Class Ltd. has an
opening stock of inventory worth Rs. 1,20,000 on 1st April 2020. During the
fiscal year from 1st April 2020 to 31st March 2021, they made the following
transactions:

a. They purchased raw material worth Rs. 1,80,000

b. Wages paid to direct labour Rs. 40,000
c. Carriage Inwards Rs. 3,000
76
d. Factory fuel and lighting Rs. 10,000 Financial Statements

e. Sales made during the year Rs. 3,30,000

The closing stock of inventory (unsold) on the last day of the fiscal year was
Rs. 65,000.

(Please recollect the golden rule of accounting- that all expenses and losses
are debited and all incomes and gains are credited.)

Thus, the trading account of First Class Ltd. for the fiscal year ending 31st
march 2021 will appear as follows:

Trading Account of First Class Ltd. for the year ended 31st March 2021
Particulars (Debit) Amount Particulars (Credit) Amount
(Rs.) (Rs.)
Opening Stock 1,20,000 Sales Revenue 3,30,000
Purchases 1,80,000 Closing Stock 65,000
Direct Labour 40,000
Carriage Inwards 3,000
Factory Fuel & Lighting 10,000

Gross Profit 42,000

3,95,000 3,95,000

As discussed, the Cost of Goods Sold will be computed as follows:

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses –
Closing Stock
= Rs. 1,20,000 +Rs. 1,80,000 + Rs. (40,000+3,000+10,000) – Rs. 65,000
= Rs. 2,88,000
Subsequently, gross profit is the excess of sales revenue over cost of goods
sold. Hence, is computes as:
Gross Profit = Rs. 3,30,000 – Rs. 2,88,000 = Rs. 42,000

II. Inventory valuation

As discussed, assets are recorded in the balance sheet at the cost price at
which they are purchased. Similarly, inventory is also valued at cost. The
challenge here is that the cost of inventory purchased doesn’t remain constant
over an operating cycle.

Inventory used in the production of finished goods is purchased multiple

times in an operating cycle to ensure a smooth production process. Similarly,
in a trading business, inventory is purchased in multiples batches to ensure
smooth sales. However, the cost of purchasing inventory might fluctuate
during an accounting period resulting in different cost prices. It is because of
this fluctuation in the purchase price of inventory that various methods of
inventory valuation have evolved. Two of the most commonly used methods
are as follows:
77
Accounting: An  First in First out (FIFO): This method is based on the assumption those
Overview
materials/inventory purchased first are issued first for production process
or sales. Hence, they are priced at the cost of oldest materials/inventory
listed in the stores ledger until all units of the oldest batch are used up.
Alternatively, sale of goods is made in the order in which they are
purchased. Hence, inventory purchased first, will be sold first.

 Last in First out (LIFO): In contrast to FIFO, LIFO is based on the

assumption those materials/inventory purchased last in order are issued
first for production process or sales. Hence, the inventory issued for the
production process is priced at the cost of materials which were
purchased last in the order until that batch exhausts. The same process
continues when next batch of inventory is issued for production. This
also implies that goods which are purchased last, are sold first and hence
they are valued at the cost of inventory which was purchased last in
order.

Let us understand this with the help of an illustration:

Illustration 2
Date Particulars No. of units Cost per unit Amount (Rs.)
(Rs.)
January 1 Opening 500 3 1500
Inventory
January 10 Purchases 1000 4 4000
January 12 Purchases 2000 6 12000
January 18 Purchases 4000 4 16000
January 24 Purchases 2000 7 14000
9500 47500
January 11 Sales 1000
January 13 Sales 500
January 17 Sales 1200
January 21 Sales 2000
January 29 Sales 1300
6000
Under the First-in First-out method, inventory valuation will be done as
follows:

First in First out Method

Date Quantity Quantity Rate Amount Total
sold Break-up Amount
January 11 1000 500 3 1500
500 4 2000
January 13 500 500 4 2000
January 17 1200 1200 6 7200
January 21 2000 800 6 4800
1200 4 4800
January 29 1300 1300 4 5200
TOTAL 6000 27500
SALES
CLOSING 3500 1500 4 6000
INVENTORY
2000 7 14000
3500 20000
TOTAL 9500 47500
Therefore, valuation under FIFO will be:
78
Cost of goods sold 27500 Financial Statements

Closing inventory 20000

Total 47500
Now, under the Last-in First-out method, inventory valuation will be done as
follows:

Last In First Out Method

Date Quantity Quantity Rate Amount Total
sold Break-up Amount
January 11 1000 1000 4 4000
January 13 500 500 6 3000
January 17 1200 500 6 3000
700 6 4200
January 21 2000 2000 4 8000
January 29 1300 1300 7 9100
TOTAL 6000 31,300
SALES
CLOSING 3500 700 7 4900
INVENTORY
2000 4 8000
300 6 1800
500 3 1500 16,200
TOTAL 9500 47,500
Therefore, valuation under LIFO will be:
Cost of goods sold 31,300
Closing inventory 16,200
Total 47,500

Based on the illustration above, we can see how the valuation of inventory
and cost of goods sold is affected by the change in valuation method.

III. Closing Stock

Closing stock is the amount of inventory lying unsold at the end of an
accounting period. It can be in the form of raw material, work-in-progress or
finished goods. The closing stock at the end of an accounting period is
carried forward to the next accounting period. The calculation of closing
stock is done as follows:

CLOSING STOCK = OPENING STOCK + PURCHASES – COST OF

GOODS SOLD

Every business entity calculates its unsold goods at the end of the period and
puts a value against it. Various methods are used for calculating the value of
closing stock. Two of them namely, LIFO and FIFO have been discussed in
the previous point. Closing stock is a real account and therefore, it appears on
the assets side of the balance sheet.

IV. Depreciation

79
Accounting: An As already discussed, fixed assets are the ones having a useful life of more
Overview
than one year. They provide benefits to the business in the long run and thus,
are bound to suffer some wear and tear with the passage of time.
Depreciation is the gradual decline in the value of a fixed asset over its useful
life due to use, wear and tear or obsolescence. Thus, every year the
proportionate decrease in the value of the fixed asset is charged as
depreciation in the Profit and Loss (P&L) Account. It is the expired cost of a
fixed asset which is recorded as an expense during an accounting period.

Fixed assets generate revenues for the business for multiple accounting
periods. However, with each passing year, the earning capacity of the fixed
asset declines because of physical wear and tear. This is why, every year the
depreciation on fixed asset is written off against the revenues generated
during that period. It is a non-cash expense.

Now the question arises that how the depreciation of each year should be
calculated? There are various methods to calculate depreciation. The two
most commonly used methods are:

i. Straight line method

ii. Written down value method

Any of the two methods of depreciation can be used by the business entity.
However, it is important to follow the same method of depreciation every
year.

Now we shall discuss the basic terminology of depreciation:

• Original cost of the asset: This is the cost at which the fixed asset has
been purchased and made available for use in the business.
• Salvage value: It is the expected recovery or scrap value of the asset at
the end of its useful life.
• Useful life: The time period (in years) for which the asset is expected to
be used for the operations of business.
• Depreciable cost: It is the net cost after deducting the salvage value
from the original cost of the asset. This is the cost of asset to be
depreciated during its useful life. Some portion of depreciable cost will
expire and treated as an expense each year until the useful life of asset.
That expired cost is known as depreciation.
• Book Value: The original cost of the asset less its depreciation to date
(accumulated depreciation) is known as the book value of the asset. This
is also referred to as the written down value.

V. Bad Debts
Bad debts are the accounts receivable which could not be collected by the
business firm after making all reasonable efforts. We know that sales of
80 goods and services are made on both cash and credit basis by a business
entity. Also, as per the revenue recognition concept, revenue is recognised Financial Statements
when the sale is made and not when the cash is received. Now consider a
credit sale to customers of Rs. 1000. The following entries will be made in
the books of accounts:

Debtor A/c Dr. Rs.1000

To Sales A/c Rs. 1000

Thus, the sales revenue increases by Rs. 1000 and debtors also increase by
Rs. 1000. Debtors are shown as a current asset in the balance sheet as the
payment for credit sales is expected to be received within few weeks or
months. Now assume that the debtors defaulted on their payments and went
bad. The business entity will have to make the following journal entry in the
books:

Bad Debts A/c Dr. Rs.1000

To Debtors A/c Rs.1000

The debtors will be reduced by Rs. 1000 and an expense in the Profit and
Loss A/c is created in the name of Bad debts. Bad debts lead to reduction in
the amount of profits as it is recorded as an expense in the Profit and Loss
Account. Similarly, a loss in collection of a bad or doubtful debt is also
recorded as an expense in the Profit and Loss Account as well as deduced
from the accounts receivables balance is the Balance Sheet.

VI. Provision for doubtful and bad debts

The accounting principle of ‘prudence’ states that expected losses must be
provided for and expected profits must not be accounted until realised.

We know that a business entity makes both credit and cash sales during an
accounting period. However, all credit sales may not be realized in the same
year in which the sales are made. Some realizations may happen in the
succeeding year. The entity, therefore, has to make provision at the end of the
accounting year, for likely bad debts, which may happen during the course of
the next year.

VII. Income Tax/Provision for Tax

Income tax is a charge on income earned by the business, which has to be
statutorily submitted to the government’s income tax department every year.
Thus, it is recorded as an expense in the Profit and Loss A/c every year. The
amount of tax liability is computed as per the law. We have Income Tax Act,
1961 in India which governs the computation and collection of income tax.
However, the tax liability is determined on the basis of books profits
calculated as per law and not on the basis of net profit reported by business.
A business firm estimates its tax liability usually in advance and a provision
is created for the same. Provision for tax is recorded as an expense in the
profit and loss account as it is created for current year’s tax obligation. Also,
provision for tax is shown as a current liability in the balance sheet. So, when
the actual tax is paid, it is set off against the provision of tax.
81
Accounting: An
Overview
3.5 PROFIT AND LOSS
So far, we have learnt about the various revenue and expenses arising during
the course of business operations and shown in the Trading & Profit and Loss
Account. Broadly, we understand that profit is the excess of revenue over the
expenses recognised during a fiscal year (or accounting period). Conversely,
loss is the excess of expenses over revenues realised during a fiscal year.
However, the significance of dividing income statement into trading and
profit and loss account lies in the presentation of gross profit and net profit
respectively. Besides, business entities are also interested in ascertaining the
profit arising solely from business operations, referred to as operating profit.

3.5.1 Gross Profit

The excess of sales revenue over the cost of goods sold is called gross profit.
Whereas, gross loss is the excess of cost of goods sold over revenue earned
from sales. It only deducts the direct expenses related to the production of
goods. Hence, it is the net result of a trading account. Gross profit, taken as a
percentage of sales is a significant financial ratio used in financial analysis by
managers for decision making purposes. This percentage indicates the
average mark-up obtained on products sold.

Thus,

GROSS PROFIT = SALES – COST OF GOODS SOLD

GROSS PROFIT RATIO =

Gross Profit or Loss is transferred to the Profit and Loss Account.

3.5.2 Operating Profit

Operating profit is derived from gross profit. It reflects the remaining income
after deducting all the operating expenses. In addition to COGS, these
expenses include rent, insurance, salaries, administrative expenses, selling
and distribution expenses, as well as amortization and depreciation of assets.
All those expenses that are necessary to run the core business operations must
be taken into account to arrive at the operating profit. It is the profit from
core business operations before deducting interest and tax expense. It is also
referred to as EBIT i.e. earnings before interest and tax. Therefore,

OPERATING PROFIT = GROSS PROFIT – OPERATING EXPENSES

including DEPRECIATION/AMORTIZATION

The idea is to separate the income earned from production and sales from the
other non-core activities of business.

3.5.3 Net Profit Before Tax

Net profit before tax is the surplus of all business income over all expenses
including interest but excluding tax. This is the profit available to the
business entity as a result of both operating and non-operating activities. This
82
profit is usually referred to as PBT (Profit Before Tax) or EBT (Earnings Financial Statements
Before Tax).
NET PROFIT = GROSS PROFIT + OTHER BUSINESS INCOMES –
INDIRECT EXPENSES (excluding Tax)

3.5.4 Net Profit

Net profit is simply, the amount which is available to the business for
appropriation. It is the net income from both operating and non-operating
business activities after reducing both direct and indirect expenses. It is either
distributed as dividends to shareholders (owners) or retained in the business
as retained earnings, thereby increasing the owners' equity in the business.
Alternatively, it is called as PAT (Profit After Tax) or EAT (Earnings After
Tax).
After dividend distribution (if any), the remaining surplus is added to the
retained earnings. Retained earnings accumulated over the years is shown in
the Balance Sheet under the head Reserves and Surplus.
Net profit impacts the decision of various users of financial statements such
as management, investors, creditors, competitors etc. For example, creditors
refer to the net income of a company to gauge the repayment capability
before sanctioning a loan.
Activity 3.2
1. Classify each item listed in Column A under appropriate classification in
item B, assuming that the information relates to a small manufacturing
company.
A B
Raw material Operating revenue
Interest received on investments Non-operating revenue
Dividends received from shares Cost of goods sold
Wages to workers Selling and distribution expenses
Carriage outwards Administrative expenses
Carriage inwards Non-operating expense
Salary to office staff None of the above
Rent of office
Power and Fuel
Selling agents’ commission
Audit fee
Legal fee
Advertising
Municipal taxes
Interest expense on loan
Provision for Income Tax
Profit on sale of furniture
Sales revenue
Sales discount
Purchase returns
2. Fill in the blanks
a) The maximum amount of capital that can be raised by a company is
called __________.
b) All fixed assets except _________ are subject to depreciation. 83
Accounting: An c) The gross profit is transferred to_________.
Overview
d) All indirect expenses are _________ in the profit and loss account.
e) Goodwill is _______ asset.
f) Advance income received is shown on the _________ side of Balance
Sheet.
g) Depreciation is the net cost after deducting ____________ from the
original cost of the asset.
h) Under the _______ method of valuing inventory, closing stock is
valued at the oldest price.

3.6 INCOME STATEMENT

The balance sheet represents the summary of the assets, liabilities and net
worth of the business at the end of an accounting period. In a way, it
summarises the net effect of business operations and transactions made
during the accounting period. However, it does not disclose anything about
the business operations. What was the sales volume and revenue? How much
direct and indirect expenses were incurred? What was the amount of
operating and non-operating income? How many purchases of raw materials
were made? All these answers are in fact, addressed by the income statement
of the business. Income statement is also commonly referred to as Profit and
Loss Account. It discloses the business’s revenue, costs of goods sold, gross
profit/loss, selling and administrative expenses, other non-operating expenses
and income, taxes paid, and net profit/loss in a coherent and logical manner.
The profit or loss is determined by taking all income and subtracting all
expenses from both operating and non-operating activities pertaining to an
accounting period. For a systematic determination of gross profit or loss and
net profit or loss, income statement is divided in two sections namely:
Trading Account and Profit and Loss Account.

3.7 PREPARING A TRADING AND PROFIT

AND LOSS ACCOUNT
Having understood the basic concepts of income and expense as well as
revenue recognition, we shall now prepare a trading and profit and loss
account. It is also commonly referred to as Profit and Loss Account (P&L) or
Income Statement or statement of operations. It is a final account that shows
the summary of all revenue and expense recognised during the accounting
period, the net effect of which is reflected in the profit earned or loss
incurred. Thus,

REVENUE – EXPENSE = PROFIT/LOSS

Some fundamental rules must be clear while preparing a trading and profit
and loss account:

84
i. The P&L account has two sides – debit and credit. We must debit all Financial Statements
expenses and losses; and credit all income and gains. Debit balances are
shown on the left-hand side and credit balances on the right-hand side.

ii. The incomes and expenses must relate to the current accounting period.

iii. The balances of expenses, incomes, losses and gains are taken from the
trial balance. However, there might be some omissions or corrections in
the trial balance which need to be adjusted in the P&L account if they
relate to current year.

iv. Trading account represents the gross profits/loss from the core business
operations.

v. Profit and Loss account represents the net income/loss from all the
operating and non-operating activities of the business entity.

Illustration 3
Let us illustrate the preparation of profit and loss prepared from a trial
balance with the help of an example. The trial balance of XYZ Ltd. as on 31st
March 2021 is given as follows:

TRIAL BALANCEXYZ Ltd.as on 31/03/2021

Particulars Dr. (Rs.) Cr. (Rs.)
Capital 20,000
Debtors 5,400
Machinery 7,000
Creditors 2,800
Wages 10,000
Purchases 19,000
Opening stock 4,000
Cash at Bank 3,000
Carriage inwards 300
Salaries to office staff 500
Rent of building 800
Sales revenue 29,000
Drawings 1,800
51,800 51,800
Additional information to the trial balance has been provided as follows:
i) Closing Stock is valued at Rs. 1,200.
ii) Outstanding Rent of the building is Rs. 200.
iii) Depreciation is charged on machinery at 10% p.a.
iv) Prepaid wages amount to Rs. 400.

As we learnt, the P&L account takes the balances of revenues and expenses
from the trial balance and adjustments are made for any additional
information. Let’s start with the preparation of trading account. Trading
account records the sales revenue and cost of goods sold for the accounting
period, the net effect of which is represented in the gross profit or gross loss.
The gross profit or loss of the trading account is then transferred to the profit
and loss account against which all indirect expenses are set off as well as any
other non-operating income is added. All expenses are shown on the debit 85
Accounting: An side and incomes on the credit side. Hence, the income statement of XYZ
Overview
Ltd. will appear as follows.

Trading and P&L Account XYZ Ltd. for the year ending 31st March 2021

Particulars (Dr.) Amount Particulars (Cr.) Amount

To Opening Stock 4,000 By Sales 29,000
To Purchases 19,000 By Closing stock 1,200
To Wages 10,000 9,600
Less: Prepaid wages (400)
To carriage inwards 300
By Gross Loss c/d 2,700
32,900 32,900
To Gross Loss b/d 2,700 By Net Loss 4,900
To Salaries to office staff 500
To Rent of building 900
Add: Outstanding rent 200 1,000
To Depreciation on machinery 700
4,900 4,900

Activity 3.3
1. State True or False:

i) In trading and profit and loss account, opening stock appears on the
debit side because it forms the part of the cost of sales for the current
accounting year.
ii) Rent, rates and taxes is an example of direct expenses.
iii) If the total of the credit side of the profit and loss account is more
than the total of the debit side, the difference is the net loss.
iv) Discount received is an example of indirect income.
v) As per the double-entry system of accounting, when expense
increases, it is debited.
vi) Interest income from investments is a non-operating income for a
manufacturing company.
2. Indicate whether each of the following items would appear on the
income statement (IS) or the balance sheet (BS) or both. Also specify the
head under which it will be classified.

Items IS or BS or Head of
Both classification
Sale of services revenue
Office expenses
Marketing expense
Factory Fuel and water charges
Advance salary paid
Income received in Advance
Closing Stock
Outstanding rent
Office equipment
86
Accounts receivable Financial Statements
Provision for Taxes
Profit on sale of Investments
Preliminary expenses of company
(not written off)

SUMMARISING THE INCOME STATEMENT: P&L ACCOUNT

Profit and Loss account is one of the three final accounts generated by the
business at the end of an accounting period. It shows the gross and net profits
or losses generated by the business in an accounting period. Therefore, it’s a
measure of management's ability to generate income from assets. P&L
account is divided into two sections. Trading account reflects the earnings
from core business operations in the gross profit or gross loss. Whereas, the
profit and loss account summarises all the operating and non-operating
revenues and expenses in the net profit or loss. The revenues and expenses
recorded in a profit and loss account belong to the current accounting period.
P&L account is also commonly referred to as the statement of profit and loss,
income statement, statement of operations etc. Its preparation is based on the
accounting principles of revenue recognition, matching and accruals. The net
profit or loss sustained by the business as calculated by the P&L account
increases or decreases the retained earnings in the balance sheet respectively.

3.8 BALANCE SHEET

The ‘balance sheet’ as the name suggests, is the summary of the balances of
the various assets, liabilities and capital accounts of a business entity as on a
particular date. In simple terms, it is the summary of things owned by the
entity as well as the claims against those things represented in monetary
terms as on a specific date. It contains information about both the resources
and obligations of an entity. Thus, it depicts the financial position of a
business at a given point of time which is usually the close of an accounting
period. It also depicts net worth which is just one part of the balance sheet
which is also the total shareholders’ funds. Balance sheet depicts financial
position as on a particular date.

In brief, the various aspects of a balance sheet can be put as follows:

i. A Balance Sheet is a financial statement prepared from the point of view

of a business entity, firm or company, and not from the point of view of
its owners, investors, directors, creditors etc.

ii. A Balance Sheet is a statement and not an account.

iii. It is a statement showing the financial position of the business entity on a

specific date.

iv. It is a historical report showing the cumulative effect of past transactions.

v. A Balance Sheet always relates to a particular point of time or date and
not a period.
87
Accounting: An vi. A Balance Sheet depicts the resources owned (assets) on one side and
Overview
obligations (liabilities) of a business entity on the other side.

vii. All items on a Balance Sheet are represented in terms of monetary value.

viii. The total of both sides on a balance sheet are always equal.

Let us understand the concept of a balance sheet with the help of an example.

Mr. Raghav is the owner of a start-up firm RT Ltd. On 1st April 2020, the
position of his business firm RT Ltd is as follows: He has invested his
personal savings worth Rs. 10,00,000 cash into the firm as Capital to start the
business. He also took a loan from bank of an amount equal to Rs. 3,50,000
for buying Office Premises for his business firm. Further, he purchased some
Machinery worth Rs. 2,00,000 and a Motor car worth Rs. 3,00,000 for the
operations of the firm. To start the business operations, he brought in
Inventory worth Rs. 2,50,000 and kept an amount of Rs. 20,000 as Cash and
also deposited an amount of Rs. 50,000 in a bank account for the purpose of
business. Apart from this, Mr. Raghav invested the remaining amount of Rs.
1,80,000 in government bonds on behalf of his firm RT Ltd.

Now let us generate a balance sheet for RT Ltd. as on 1st April 2020 on the
basis of given information. We will classify the above information into the
resources owned by RT Ltd. and the claims against those resources. The
commonly accepted format of Balance Sheet in India shows Liabilities on the
left-hand side and Assets on the right-hand side.

As already discussed, a balance sheet is always prepared from the point of

view of a business entity and not the owner. Hence, the balance sheet or the
position statement of RT Ltd. as on 1st April 2020 would be presented as
follows:

Balance Sheet of RT Ltd.as on 1st April 2020

Liabilities (obligations Amount (in Rs.) Assets (resources Amount (in
of the firm) owned by the firm) Rs.)
Capital Rs. 10,00,000 Machinery Rs. 2,00,000
Loan from Bank Rs. 3,50,000 Building (Office Rs. 3,50,000
Premise)
Motor Car Rs. 3,00,000
Investment in Bonds Rs. 1,80,000
Inventory Rs. 2,50,000
Cash Rs. 20,000
Bank Account Rs. 50,000
Total: Rs. 13,50,000 Total: Rs. 3,50,000

Here, we can see that the total value of resources owned by RT Ltd. which
includes building, machinery, car, cash, investments and inventory is worth
Rs. 13,50,000. In accounting, these resources owned by the business are
referred to as assets. Further we observe that the claims against these
resources in the form of bank loan stands at Rs. 3,50,000. Such claims
against business entity’s assets are referred to as liabilities. Now, the net
worth of RT Ltd. will be calculated by deducting the claims against its worth
from its total worth of resources which is an amount equal to Rs. 10,00,000
88 (*13,50,000 minus 3,50,000).
Thus, the net worth of an entity represents the claims of its owner(s) which is Financial Statements
also referred to as owner's equity. We also learnt that the items of monetary
value possessed by an entity are referred to as assets. Whereas, the amount
owed by an entity which represents claims against its assets by outsiders are
called as liabilities. Thus, we can say that the position statement is a
summary of the assets, liabilities and net worth of an entity at a specific point
of time.

3.8.1 Dual Aspect Concept

Let us take a step further in the previous example: suppose Mr. Raghav
purchased some goods (raw material) worth Rs. 10,000 in cash. This
transaction will have a dual impact on the balance sheet of RT Ltd. First, the
inventory will increase by Rs. 10,000 and second, the cash balance will
decrease by Rs. 10,000. Similarly, if the goods were purchased by Mr.
Raghav on credit for Rs. 10,000, the inventory (asset) will go up by Rs.
10,000 whereas, the creditors will also increase by Rs. 10,000. This brings us
to a fundamental accounting concept known as dual-aspect in accounting.
This concept explains that each transaction made by a business entity impacts
the business in two different aspects which are equal and opposite in nature.
It means that every business transaction will affect at least two accounts
which implies that for every debit there is an equivalent credit and vice versa.
For example, if your company borrows money from the bank, the company’s
asset Cash is increased (debited) and the company’s liability Notes Payable is
also increased (credited). It is because of this feature that both sides (assets
and liabilities) of the balance sheet will always be equal. This concept forms
the basis of double-entry accounting and is used by all accounting
frameworks for generating accurate and reliable financial statements. The
dual aspect concept is also explained in the fundamental accounting equation:

ASSETS = LIABILITIES + OWNERS EQUITY

The above accounting equation indicates that an entity’s assets have to be

equal to the sum of its liabilities and owner’s equity. This equation is
considered to be the foundation of double entry system of accounting. It
ensures that every entry made on the debit side has a corresponding entry
made on the credit side and vice versa. Hence, the double entry made will
automatically balance the accounting equation. To sum it up,

 An increase in assets is followed by an increase in liabilities and/or

equity and vice versa.

 A decrease in assets is followed by a decrease in liabilities and/or equity

and vice versa.

 An increase in an asset is followed by a decrease in another asset and

vice versa.

 An increase in a liability is followed by a decrease in another liability

and vice versa.

Let’s consider the following series of examples to explain this concept

further: 89
Accounting: An Mr. Raghav further invested cash worth of Rs. 4,00,000 into his business RT
Overview
Ltd. The effect of this transaction will be as follows:

 Capital will increase by Rs. 4,00,000.(Liabilities side)

 Cash will also increase by Rs. 4,00,000.(Assets side)

Also, Mr. Raghav repaid the loan in cash, he took from bank for his
office building worth Rs. 3,50,000. This transaction will have the
following effect:

 Loan from Bank will reduce by Rs. 3,50,000. (Liabilities side)

 Cash will also reduce by Rs. 3,50,000. (Assets side)

Lastly, Mr. Raghav sold the investments he made in government bonds for
Rs. 2,00,000 cash. In this transaction, RT Ltd. made a profit of Rs. 20,000 (as
the gold bonds were purchased for Rs. 1,80,000 initially). The effect of this
transaction will be shown as follows:

 Investment in Government Bonds will reduce by Rs. 1,80,000. (Assets

side)

 Cash will increase by Rs. 2,00,000. (Assets side)

 Profits of Rs. 20,000 will be shown by an increase in Capital. (Liabilities

side)

Hence, a balance sheet will always balance its two sides. The effect on one
account will be compensated by an equal and opposite effect on another
account.

Activity 3.4
1. State whether the following statement is True or False:
i) An increase in asset always results in increase in owner's equity.

ii) If you own a house worth Rs. 4,00,000 and a home loan of Rs.
2,50,000, then your equity is Rs. 1,50,000.

iii) Losses result in increase in owner's equity.

iv) An increase in assets could be equalled by increase in liabilities.

v) Assets are the economic resources that are expected to produce

future benefits

vi) During an accounting period, the assets increased by Rs. 4,000 and the
equity increased by Rs. 1,000. For the accounting equation to balance,
the liabilities must increase by Rs. 5,000.

2. For the transactions given below, circle the correct effect on the
accounting equation of the business entity:

(i) The owner invests personal cash in the business.

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 Assets Increase Decrease No Effect Financial Statements

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

(ii) The business entity purchases raw materials on credit.

Assets Increase Decrease No Effect

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

(iii) The business entity repays a long-term loan to the bank.

Assets Increase Decrease No Effect

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

(iv) The owner withdraws some cash from the business for personal use.

Assets Increase Decrease No Effect

Liabilities Increase Decrease No Effect

Owner's Equity Increase Decrease No Effect

3.9 BALANCE SHEET CONTENTS &

CLASSIFICATIONS
Having understood the basic concepts and functioning of a balance sheet, let
us now study the contents of a balance sheet. We have seen that every
transaction affects the financial statements of a business but it is not feasible
to draw up the financial statements after every transaction. Thus, financial
statements such as balance sheet, P&L and cash flow statement are prepared
at the end of a specified period, usually, a year. This specified period is
referred to as an accounting period or a financial year.

As already discussed, the balance sheet prepared at the end of the accounting
period reflects upon the position of the entity’s assets, liabilities and capital
accounts on that specific date. The balance sheet is further sub-grouped in
order to facilitate a more meaningful and convenient analysis as shown in the
following illustration:

91
Accounting: An Balance Sheet of RT Ltd.as on 31st March 2019
Overview
(Rupees in thousands)

Liabilities Amount Assets Amount

(in Rs.) (in Rs.)
Capital Goodwill 700
Equity Shares of Rs. 10 2000 Fixed Assets
each
12% Preference Shares of 500 Land and Buildings 2800
Rs. 100 each
Reserves & Surplus 1000 Plant and Machinery 1500
2000
Less: Depreciation
(-) 500
Capital Reserve 500
Current Assets
Long term Liabilities Cash 200
8% Debentures 1000 Axis Bank Account 300
Secured Loan from Bank 2000 Marketable Securities 200
Bills Receivable 1200
Current Liabilities Closing Stock (Inventory) 1100
Bills Payable 1800 Prepaid Expense 500
Income Tax Provision 400
Bank Overdraft 800 Other Assets
Deferred Expenditure 1500
10000 10000
To be able to read and analyse a balance sheet, you must understand its
different elements and what they signify about the financial health of the
business. An accurate understanding of the balance sheet enables an analyst
to evaluate the liquidity, solvency, and overall financial health of a business.

A balance sheet represents the assets, liabilities and capital of the business in
such a way that the accounting equation always balances i.e. ASSETS must
always be equal to the sum of LIABILITIES and OWNERS’ EQUITY. Let
us talk about these balance sheet elements in detail.

Assets are resources of economic value that a business entity owns with the
expectation that they will provide future economic benefit to the business.
They are generally divided into two categories: current assets and non-current
assets. The liquidity of the asset determines into which category it falls.
Liquidity is the ease with which an asset can be converted or realized into
cash. Those assets that can be converted into cash within 12 months are
considered as current assets. For example, inventory, short term investments,
bills receivable, cash and bank balance, etc. Non-current assets, on the other
hand, are the assets which generally cannot be converted to cash within 12
months and are normally used to run the business. These include fixed assets,
such as equipment used in the running of the business, furniture and fixtures
and also any real estate the business owns. Non-current assets also include
long term investments made by business and intangible assets such as
goodwill etc.
Liabilities are obligations the business owes to outsiders. They are also
divided into current liabilities and non-current liabilities. Current liabilities
92 are obligations that are scheduled to be paid within a span of 12 months.
Most common current liabilities include accounts payable, business line of Financial Statements
credit, current instalment of a long-term debt, provisions etc. Non-current
liabilities are long-term liabilities that are usually paid in more than one year.
Usually, such long-term liabilities include debentures and bonds, borrowings
from financial institutions and banks. The borrowings can either be secured
or unsecured.

Owners’ Equity represents the owners’ residual interest in the assets of a

company, net of its liabilities i.e. OWNERS’ EQUITY = ASSETS –
LIABILITIES. It is also referred to as net worth of the business. In other
words, owner’s equity is everything that is left from the assets after paying all
the liabilities. It consists of the capital contributed by owners and retained
earnings of the business. We will discuss the constitution of retained
earnings later in this chapter. Hence, the amount of equity is increased by
profits earned during the year, or by the issuance of new equity. On the other
hand, equity is decreased by financial losses, dividend payments, etc.

Assets, liabilities and capital accounts are sub-categorised in a balance sheet

on the basis of their liquidity and to present a more meaningful and useful
view of the financial position of business. Whatever system of classification
is used should be applied on a consistent basis, so that balance sheet
information is comparable over multiple reporting periods. Common
classifications used in a balance sheet are discussed as follows:

3.9.1 Current Assets

A current asset is an item on an entity's balance sheet that is either cash, cash
equivalent, or an asset which can be normally converted into cash within the
operating cycle of business, or within one year. whichever is shorter. An
operating cycle is the duration of time it takes for a business to convert its
inventory into cash. It includes the time taken in acquiring inventory,
converting inventory to sales and then recovering cash from trade
receivables. The operating cycle starts with cash and ends with the collection
of cash. Length of an entity’s operating cycle is an indicator of its liquidity
position and asset-utilization. Common examples of current assets are listed
below in order of their relative liquidity:

 Cash and cash equivalents

 Short term investments (ex: Marketable Securities)
 Accounts Receivable
 Inventory
 Prepaid Expenses

Cash and cash equivalents

Cash refers to the currency, cheques or any other document that circulates as
cash. It includes the cash kept in the cash chest of business and also the
deposits made in current accounts with banks. Further, cash equivalents are
the highly liquid investments that are readily convertible into cash and are
subject to insignificant risk of change in price. Examples include Cash and
Paper Money, Treasury bills, Money Market funds, etc. Cash and cash
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Accounting: An equivalents are the most liquid form of current assets available for a firm's
Overview
day-to-day operations.

Short-term investments
It is advisable to invest excess cash held by a firm to generate additional
income. It may be invested in financial instruments that can be quickly
converted into cash like equity shares, debentures and government securities.
These assets are readily marketable and could be sold whenever cash is
required. They are classified as current assets as these investments tend to
mature within a year or less.

Accounts Receivable
Usually, a business entity sells its goods and services both in cash as well as
on credit. Accounts receivable refers to the balance of money due to a
business entity for the sales made on credit to its customers. It is also denoted
as sundry debtors in the balance sheet. It represents the amount arising out
of normal business transactions such as credit sales and the credit period
usually ranges from few days to months. In most situations these accounts are
unsecured and have only the personal security of the customer. In some
cases, customers default and the payment may not be realised. These defaults
in payment by debtors are called bad debts. Bad debts are recorded as an
expense in the Profit and Loss account.

Inventory
Inventory generally consists of raw materials required to manufacture the
products, unfinished goods at various stages of completion i.e., work in
progress and finished goods i.e., goods ready for sale. Apart from these, there
may be inventory of stores and supplies. Thus, we have raw material
inventory, work in progress inventory, finished goods inventory and stores
and supplies inventory. It is also commonly referred to as stock-in-trade. It
may be noted that the type of inventory may vary depending on the nature of
business. For example, a manufacturing firm will have a combination of raw
material, unfinished goods and finished goods as inventory, but for a trading
firm, inventory will usually include finished goods available for sale.
As a general principle, inventory is valued at cost. It implies that all normal
costs incurred to make the goods available at the place where it can be sold or
used are treated as costs of inventory.
Prepaid Expenses
Prepaid expenses are items which are usually paid in advance such as rent,
taxes, insurance etc. For example, if rent for two months of the office
building is paid in advance, then the business acquires a right to occupy the
building for two months. This right to occupy is an asset but will expire
within a fairly short period of time, therefore it is a current asset. Therefore, it
is shown on the asset side of the balance sheet.
Since these expenses are paid in advance, they become due in the next
accounting period. Hence, they are not debited in the Profit and loss account
of the current period.
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3.9.2 Fixed Assets Financial Statements

Fixed assets are tangible, long-term assets used in the business that are of a
relatively fixed nature. These include building and land, furniture, equipment,
machinery etc. Fixed assets are not expected to be consumed or converted
into cash within a year, instead they are used in running business operations
to generate income. The useful life of fixed assets is more than one year and
they are capable of repeated use. Valuation of the fixed assets is usually made
on the basis of original cost. However, the assets have a limited useful life
and their value decreases over time due to use, wear and tear or obsolescence.
Thus, valuation of the asset is reduced proportionate to the expired life of the
asset. Such decrease in cost is referred to as depreciation in accounting. The
conceptual basis could be clarified with an example.

Suppose a manufacturing business firm buys machinery at a cost of Rs.

10,00,000. It is assumed that the machinery will have a useful life of 10 years
after which it will be discarded as scrap. Therefore, the depreciation on
machinery will be spread out across its useful life of 10 years. The method of
calculating depreciation may vary. Two most commonly used methods are:
straight line and written down value.

Under straight line method, depreciation is evenly distributed across the

useful life of asset. Hence, after the end of each year the machinery will
depreciate by Rs. 1,00,000 (i.e. Rs. 10,00,000/10). And at the end of 10th
year, the book value of machinery will depreciate to 0. Now let’s assume, at
the end of its useful life of 10 years, the machinery would be sold as scrap for
approximately Rs. 50,000. Therefore, the depreciation for each year will be
calculated as follows: Rs. (10,00,000 50,000)/10 = Rs. 95,000.

Under the written down value method, depreciation is calculated each year as
a fixed percentage of the written down value of the asset. The written down
value is the remaining value of the asset at the end of each year after reducing
accumulated depreciation from original cost. For example, machinery
purchased for Rs. 10,00,000, has a useful life of 10 years and the depreciation
will be provided @10% p.a. at written down value. The depreciation will be
calculated as follows:

Cost of Machinery at the beginning of 1st year Rs. 10,00,000

Depreciation at the end of 1st year Rs. 10,00,000 * 10% i.e. Rs. 1,00,000

Cost of Machinery at the beginning of 2nd year Rs. 9,00,000

Depreciation at the end of 2nd year Rs. 9,00,000 * 10% i.e. Rs. 90,000

Cost of Machinery at the end of 2nd year Rs. 8,10,000

The process of providing depreciation for each year will continue like this till
the end of useful life of the asset. The value of fixed assets net of
depreciation is referred to as net book value.
Hence, under the written down value method, the amount of depreciation will
reduce with each passing year as the value of the fixed asset keeps decreasing
95
Accounting: An over its useful life. Whereas, under straight line method, equal amount of
Overview
depreciation is allocated to each useful year.

Fixed assets normally include assets such as land, building, plant, machinery
and motor vehicles. All these items, with the exception of land, are
depreciated. Land is not subject to depreciation and hence shown separately
from other fixed assets.

3.9.3 Intangible Assets

Intangible assets are the resources or things of value that have no physical
appearance and are valuable to the business in the long run. They cannot be
touched or seen but represent an intrinsic value without any material being.
Some common examples of intangible assets include goodwill, customer
relationships, intellectual property such as trademarks, patents, copyrights
etc. However, they are only recorded in the accounting books when they are
purchased from outside. They are shown in the assets side of the balance
sheet and have a useful life of more than one year. As they provide value to
the business in the long run, the cost of their acquisition expires over such
useful life. Hence, they are amortized over their useful life. Amortization is
similar to depreciation, with the intent of gradually reducing the book value
of the asset to zero by accounting for the gradual consumption of the asset.

Some intangible assets might have an indefinite life too, such as goodwill.
Goodwill arises when a business firm acquires another business firm and the
cost of its purchase is higher than the fair market value of the business. It
happens because the acquired business firm has established a popular brand
name, or solid customer base, good customer relations, etc. Hence, the excess
purchase price paid over the fair market value of the acquired business firm is
termed as goodwill. When the intangible asset has an indeterminate life, it is
not amortized but is periodically tested to see if the recorded cost of the asset
has been impaired.

Fictitious Assets
As the name suggests, fictitious assets are not actually assets. Yet they appear
in the asset side simply because of a debit balance in a particular account has
not been completely written off. For example, preliminary expenditure of the
company, promotional capital expenditure etc.

3.9.4 Current Liabilities

Current liabilities are the short-term financial obligations of a business entity
which are due for payment within the operating cycle of the business or
within one year, whichever is less. These are usually incurred when the raw
materials or services are purchased on credit. Current liabilities are settled
either by using current assets or by the creation of other current liabilities.
The ratio of current assets to current liabilities is known as current ratio/
liquid ratio and it helps in determining whether a business entity is able to
pay all its short-term debts. Common examples of current liabilities include
of sundry creditors, bills payable, bank overdraft, outstanding expenses,

96
income received in advance, provision for income-tax etc. Let us discuss Financial Statements
some important current liabilities of a business entity.

Accounts Payable
Accounts payable represent the sum of money owed by a business entity to
its suppliers or creditors, usually for the goods or services supplied on credit.
These are the monetary obligations of an organisation arising in a short run.
Generally, such claims are unsecured.

When the business entity gives a written promise to pay money to a creditor
for the purchase of goods or services used in the business or the money
borrowed, then the written promise is called as bills payable or notes payable.

Outstanding Expenses
Outstanding refers to ‘due but not paid’. These expenses become due during
the current accounting and hence, are shown as an expense in the Profit and
Loss account. However, as the actual cash payment of these expenses are yet
to be done, they are also shown as a current liability in the balance sheet.

For example, the rent of building becomes due for the month of March 2021
but is paid in May 2021. Assuming the accounting period ended on 31st
March 2021, the rent of building for the month of March 2021 will be shown
as an outstanding rent in the balance sheet as on 31st March 2021.

Income Received in Advance

It is the amount received in the current accounting period but which is due to
be received in the next accounting period. Since it is not recognised as
income in the current accounting period, it is treated as a current liability in
the balance sheet until it becomes due.

Provision For Taxes

Every business entity is liable to pay taxes to the government on its earnings.
However, taxes are not necessarily paid on the end date of an accounting
period. The due date for payment of taxes usually lies in the next financial
year. Hence, a business entity creates a provision for current financial year’s
taxes to be paid. The provision is reduced when the actual payment of taxes is
done out of it.

It is shown as an expense in the P&L account and as a current liability in the

balance sheet until the taxes are paid.

3.9.5 Long Term Liabilities (Non-Current Liabilities)

Long term liabilities are the financial obligations of the firm which are not
paid off in the current operating cycle or current accounting period. These
liabilities do not become due for payment within one year. The financial
obligation in case of long-term debt lasts for more than a year. They are
classified as secured loans or unsecured loans. When a long-term loan is
obtained against the security (collateral) of fixed assets owned by the entity,
it is called as secured loan. On the other hand, an unsecured loan is not
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Accounting: An secured by any collateral. Usually, long-term liabilities include debentures
Overview
and bonds, borrowings from financial institutions and banks, etc.

CONTINGENT LIABILITIES
The literal meaning of the term ‘contingent’ is ‘subject to chance’.
Contingent liabilities are those liabilities that may arise depending on an
uncertain future event. Until then, both the occurrence and amount of the
liability are uncertain. If the event happens, there is a liability, otherwise
there is no liability at all. Therefore, they are not recorded in the balance
sheet but are required to be disclosed as footnotes to the balance sheet to
provide a fair view about the affairs of the business to the users.

Contingent liability can be defined as, a possible obligation that arises from
past events and the existence of which will be confirmed only by occurrence
or non-occurrence of one or more uncertain future events not wholly within
the control of the enterprise.

A good example of contingent liability is a legal suit contested against the

business entity for financial claim. If the case is decided against the entity,
the liability arises and in the case of favourable decision, no liability will
arise. Hence, it is shown as a contingent liability in the foot-notes of the
balance sheet.

3.9.6 Capital or Owners’ Equity

Ordinarily in a sole proprietorship firm, the owners’ equity constitutes the
capital contributed by the owner into the business. However, in case of a
company the owner's equity section of the balance sheet is divided into two
parts: (1) the share capital representing contributed capital and (2) reserves
and surplus representing retained earnings. The share capital is the capital
contribution by the shareholders or owners. In case of a company, share
capital is the joint stock predetermined at the time of registration which is
known as the authorised capital. It may consist of either equity share capital
or preference share capital (having preferential right to fixed dividend and
repayment of capital at the time of liquidation), or both. The share capital is
divided into equal units or shares. The authorised capital need not all be
raised at one time. That part of authorised capital which is issued for
subscription by the company is referred to as the issued capital.

Equity Share Capital and Preference Share Capital

Equity share capital is also called as the residual capital as the equity
shareholders have the residual claims against assets of the company at the
time of liquidation, after all the claims of creditors and preference
shareholders have been met. Ordinary shares or equity shares have no
preferential rights with respect to either repayment of capital or distribution
of profits. However, equity shareholders possess the voting rights in the
decision making of the company. The dividend distribution to equity
shareholders depends upon the profits earned by the company during a
particular accounting period Equity shares are not redeemable.

98
Preference shares, on the other hand, are so called because they have some Financial Statements
preferences over the equity shares. These preferences relate to repayment of
capital and payment of dividend. In the event of liquidation of the company,
remaining assets after the payments to creditors, are first distributed to
preference shareholders and lastly to equity shareholders. Similarly, in the
event of dividend distribution, the preference shareholders are paid first at a
pre-fixed dividend rate. Preference shares could also be made redeemable
after a specified period.

Reserves and Surplus

Reserves and surplus are the accumulated earnings of a business entity
retained over a period of time and not distributed amongst shareholders as
dividends. In other words, when a firm starts its operations, it has no retained
earnings. Reserves and surplus normally arise out of profitable operations.
Loss incurred by a firm reduces its reserves and surplus. Let’s say, if a
business firm earns a profit of Rs. 1,00,000 in the first year and decides to
distribute Rs. 40,000 as dividends, the reserves and surplus at the end of the
year will be Rs. 60,000. Now, in its second year of operation, if the firm
makes a loss of Rs. 25,000 then the retained earnings at the end of the 2nd
year will be Rs. 35,000. Retained earnings (or reserves and surplus) are in the
nature of earned capital for the firm.

In some cases, some part of reserves and surplus can be allocated for specific
purposes. These are called as specific reserves. Specific reserves can neither
be distributed nor be used for any purpose other than specified. Only non-
earmarked or free reserves are available for distribution as dividends.

Activity 3.5
1. Fill in the blanks

a) Balance sheet items are classified and listed according to their

relative __________.
b) The accounting concept that requires financial statements to reflect
the assumption that the business will continue operating indefinitely,
is called the __________.
c) Individuals or organizations entitled to receive payments from a
company are called ________.
d) The residual interest in the assets of an entity that remains after
deducting its liabilities is called ___________.
e) Expiration of cost of intangible assets is referred to as __________.
f) Contingent liabilities are shown in the ___________ of Balance
sheet.

2. State three different kinds of transactions that result in decrease in capital

or owner’s equity.

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Accounting: An SUMMARISING THE POSITION STATEMENT (BALANCE SHEET)
Overview
After learning about balance sheet, we observe that it is one of the most
crucial financial statements as it reflects the financial position of the business
and aids decision making process of stakeholders. It is a periodic summary of
assets, liabilities and owners' capital as of a particular point in time. This
statement in itself does not reveal anything about the details of operations of
the business. However, a comparison of two balance sheets could reveal the
changes in financial position of the business. A holistic understanding of the
operations of the business would require an analysis of two other statements-
Income Statement (Profit and Loss) and Cash Flow Statement. We shall read
about income statement in the next section.

3.10 RELATIONSHIP BETWEEN INCOME

STATEMENT AND POSITION STATEMENT
The income statement mainly determines four elements namely revenue,
expense, income (profit) or loss. Profit is reported when revenue exceeds
expenses. Whereas, when expenses exceed revenue, loss is booked. It should
be noted that the revenue and expenses must relate to a specific accounting
period to determine the profit or loss of that particular period. Now, let us
recall the fundamental balance sheet equation discussed in the previous
section:

ASSETS = LIABILTIES + OWNERS’ EQUITY

Here, owners’ equity signifies the net worth of the business, and constitutes
of the capital contributed by the owners and earnings retained in the business
at the end of each accounting period. Hence,

OWNERS’ EQUITY = SHARE CAPITAL + RETAINED EARNINGS

The retained earnings shown in the equation above is nothing but the profits
earned by the business. These are the profits accumulated by business over
the years. Hence, each year’s profit is clubbed into retained earnings and
shown in the balance sheet as a part of owners’ equity. Similarly, if a
business incurs loss in an accounting period, retained earnings will be
negatively impacted in that year. Thus, we find that profit and loss account is
an integral part of any balance sheet in that it is an expansion of one of the
terms of the balance sheet.

3.11 SUMMARY
The process of accounting aims at providing the financial information about
the business entity to the users with the help of financial statements. Financial
statements are the formal end reports that summarise the business operations
and transactions conducted in a financial year. These statements are prepared
as per the accounting principles to generate systematic and consistent results.
They are useful indicators of the financial health of a business entity at a
particular point of time. It is vital to present the financial statements in a
100 proper form with suitable contents so that the shareholders and other users of
financial statements can easily understand and use them in their economic Financial Statements
decisions in a meaningful way.

There are three main financial statements of a business entity: the Balance
Sheet (position statement) as at the end of accounting period, the Statement
of Profit & Loss (income statement) and the Cash Flow Statement.

The profit and loss account summarises the revenues and expenses of an
accounting period and shows the net profit/loss generated by the company.
The net profit after payment of dividends shows the amount of retained
earnings and hence links the profit and loss account with balance sheet.

Balance sheet is a periodic summary of the position of business. It is the

statement of assets, liabilities and owner’s capital at a particular point of
time. This statement in itself does not reveal much about the operations of the
business, but comparison of balance sheets over a period of time could reveal
changes in business position. Realistic understanding of business operations
require reading and linking of all the three financial statements mentioned
above.

3.12 KEY WORDS

Asset: Any tangible or intangible resource of monetary value that provides
economic benefits to a business entity.

Liability: An amount owed by the business entity (the debtor) to an outsider

to the business (the creditor). It can be long-term (non-current) or short-term
(current).

Current Asset: A current asset is an asset which can be normally converted

into cash within the operating cycle of business, or within one year.
whichever is shorter.

Current Liabilities: Current liabilities are the short-term financial

obligations of a business entity which are due for payment within the
operating cycle of the business or within one year, whichever is less.

Intangible Assets: Intangible assets are the resources or things of value that
have no physical appearance but are valuable to the business in the long run.
Example: goodwill, patents, franchises, copyrights etc.

Contingent Liability: A contingent liability is a potential liability that may

occur in the future, such as pending lawsuits or honouring product warranties.
It becomes a liability only on the happening of an uncertain future event.

Fixed Assets: These are tangible long-term assets having a useful life of
more than one year. They include land, building, plant, machinery, motor
vehicles, furniture and fixtures, etc.

Owner's Equity: It is the owner's claim against the assets of a business

entity. It could be expressed as total assets of an entity less claims of
outsiders or liabilities, includes both contributed capital and retained
earnings.
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Accounting: An Balance Sheet: It is the summary of the balances of the various assets,
Overview
liabilities and capital accounts of a business entity at the end of a particular
accounting period.

Revenue: It is the income generated by a business from both the core

(example: sale of goods or services) and non-core business operations
(example: profit on sale of a fixed asset).

Expense: Expenses refer to the costs incurred by a business firm to generate

revenue during an accounting period.

Realisation: Recognition of the revenue in accounting based on the

assumption that increase in owners' equity arises at the point of sale or
provision of goods or services.

Matching: An accounting principle that states that expenses incurred in an

accounting period should be matched with the revenues of that period.

Accrual: Income measured on the realisation of revenue independent of the

timing of cash receipt and payment.

Cost of goods sold: Direct costs incurred in the production of goods or

services that are sold during an accounting period.

Depreciation: It is the expired cost of a fixed asset due to physical wear and
tear which is recorded as an expense during an accounting period.

Profit/Loss: Revenue minus expenses for a given accounting period.

However, excess of expenses over revenue is termed as loss.

Profit and Loss Account: The final summary of all revenues, gains,
expenses and losses recognised during an accounting period reflected in the
net profit or loss for that period.

3.13 SELF-ASSESSMENT
QUESTIONS/EXERCISES
1. Differentiate between expenditure and an expense. Give suitable
examples.

2. Explain the revenue recognition concept with the help of an example.

3. Write short notes on the following:

a) Operating profit
b) Earnings before interest and tax
c) Contingent liability
d) Retained earnings
e) Depreciation

4. "Fixed assets are physical assets that provide operating capacity for a
number of accounting periods". Explain with the help of suitable
102 examples. Do all fixed assets depreciate?
5. What are bad debts? What is the way to deal with the problem of Financial Statements
expected bad debts in accounting?

6. Given below is the summarised Profit and Loss Account of Athena Ltd.
for three consecutive accounting periods. You are required to fill in the
missing information:

PARTICULARS YEAR 1 YEAR 2 YEAR 3

Sales 10,000 5,000
Cost of goods sold 5,500 2,500 3,000
Gross Profit 2,700
Office and administrative expenses 600 400
Selling and distribution expenses 500 600
Operating Profit 3,500 1,000
Other incomes 2,300 500
Depreciation 300 500
Interest expense 200 100
Net profit before tax 5000 3,000 1,200
Income Tax 200
Net profit after tax 4700 1,050

7. Following are the balances extracted from the books of Pratap Clothing
House on 31st March, 2020 after the income statement for that year had
been prepared and all the relevant adjustments had been made.

Particulars Amount (in

Rs.)
Land and Buildings 1,20,000
Cash in Hand 25,000
Closing inventory 32,000
Plant and Machinery 48,000
Motor car 61,000
Investments 44,000
Accounts Receivable 5,000
Share Capital: 1200 8% Preference Shares of Rs. 100 each 1,20,000
9000 Equity Shares of Rs. 10 each 90,000
9% Debentures 50,000
Provision for Depreciation on Motor Car 3,200
Provision for Depreciation on Plant and Machinery 2,400
Retained Earnings (as on 1st April 2019) 42,000
Accounts Payable 7,500
Bank Overdraft 2,600

You are required to ascertain the net profit of the current period ending
31st March 2020 and prepare a Balance sheet of Pratap Clothing House
as on 31st March 2020. Also classify the balance sheet items under
relevant heads. 103
Accounting: An 8. The following balances are taken from the books of Athena Ltd. As on
Overview
31st March 2021. You are required to prepare a Balance sheet and Profit
and Loss account based on this information.
Depreciation 5,000
Wages 25,000
Purchases of raw material 50,000
Sales 1,00,000
Rent of Building 3,000
Purchase returns 5,000
Sales returns 1,000
Interest expense 2,000
Fire Insurance 2,000
Miscellaneous expenses 5,000
Interest received on deposits 2,000
Cash 15,000
Bank deposits 20,000
Closing stock of inventory 10,000
Buildings 90,000
Land 10,000
Advance tax paid 5,000
Accounts receivable 20,000
Accounts payable 19,500
Long term loan from bank 50,000
Share Capital 75,000
Reserves and Surplus (Net profit) ?
Tax payable @ 20% ?
Also, find the net profit of Athena Ltd for the year ending 31st March 2021
and compute the amount of tax payable @ 20% on profits before tax.

ANSWERS TO ACTIVITIES
Activity 3.4
1. (i) F; (ii) T; (iii) F; (iv) T; (v) T; (vi) F

2. Assets Liabilities Owner’s equity

(i) Increase – No effect – Increase
(ii) Increase – Increase – No effect
(iii) Decrease – Decrease – No effect
(iv) Decrease – No effect – Decrease
Activity 3.5
1. a) liquidity
b) going-concern concept
c) creditors
d) owner’s Equity
e) amortization
f) foot-notes
2. Following transactions would result in the decrease of owner’s equity:
a) Drawings of cash from the business
104
 b) Net loss incurred during an accounting period Financial Statements

c) Loss of a fixed asset because of fire.

Activity 3.1
1. a) Revenue, expenses
b) Revenue, expenses
c) 31st March 2020
d) Revenue
e) next
f) indirect/non-operating expense

Activity 3.2
1.
A B
Raw material Cost of goods sold
Interest received on investments Non-operating revenue
Dividends received from shares Non-operating revenue
Wages to workers Cost of goods sold
Carriage outwards Selling and distribution expenses
Carriage inwards Cost of goods sold
Salary to office staff Administrative expenses
Rent of office Administrative expenses
Power and Fuel Cost of goods sold
Selling agents’ commission Selling and distribution expenses
Audit fee Administrative expenses
Legal fee Non-operating expense
Advertising Selling and distribution expenses
Municipal taxes Non-operating expense
Interest expense on loan Non-operating expense
Provision for Income Tax Non-operating expense
Profit on sale of furniture Non-operating revenue
Sales revenue Operating revenue
Sales discount Selling and distribution expense
Purchase returns Cost of goods sold
2. a) authorised capital
b) land
c) profit and loss account
d) debited
e) an intangible
f) liability
g) salvage value
h) Last in first out (LIFO)
Activity 3.3
1. (i) T; (ii) F; (iii) F; (iv) T; (v) T; (vi) T

105
Accounting: An 2.
Overview
Items IS or BS or Head of classification/account
Both
Sale of services revenue IS Trading account
Office expenses IS P&L Account
Marketing expense IS P&L Account
Factory Fuel and water IS Trading account
charges
Advance salary paid BS Current Assets
Income received in BS Current liability
Advance
Closing Stock Both Trading Account; Current Assets

Outstanding rent Both P&L Account; Current liability

Office equipment BS Fixed Asset
Accounts receivable BS Current Asset
Provision for Taxes Both P&L Account; Current liability
Profit on sale of IS P&L Account
Investments
Preliminary expenses of BS Fictitious Asset
company

3.14 FURTHER READINGS

 Horngren, C.T. and Harrison, W.T., 2017, Financial Accounting,
Prentice Hall: New Delhi (Chapter 1)

 Fraser, L.M. and Ormiston, A., 2013, Understanding Financial

Statements, Prentice Hall: New Delhi (Chapter 2)

 Bhattacharya, S.K. and Dearden, J., 1984, Accounting For Management:

Text and Cases, Vani: New Delhi. (Chapter 3, 10 and 11)

 Hingorani, N.L. and Ramanathan, A.R., 1986, Management Accounting,

Sultan Chand: New Delhi. (Chapter 3).

 Hortagren, C.T., Sundem, G.L. and Jhon, A.E., 2002, Introduction to

Financial Accounting,Prentice Hall:New Delhi (Chapters 2-4)

 Khan M.Y. and Jain P.K., 2013, Cost Accounting and Financial
Management, Tata McGraw Hill (Chapter 3)

 Glautier M.W.E., Underdown, B. and Clark, A.C., 1979, Basic

Accounting Practice, Arnold Hieneman: New Delhi. (Chapters 2-4)

 Meigs, W.B. and Meigs, R.F., 1987, Accounting: The Basis For Business
Decisions (7th Ed.), McGraw-Hill: New York. (Chapters 3 and 4.)

 Raithatha Bapat, Financial Accounting a Managerial Perspective,

McGraw Hill, 2017.

106
 Preparation of Final
UNIT 4 PREPARATION OF FINAL Accounts of A
Company
ACCOUNTS OF A COMPANY

Objective
After studying this unit, you should be able to:

 Discuss the applicability of various provisions in the preparation of the

financial statement
 Understand the structure and preparation of Profit and Loss Statement of
a company
 Understand the presentation and disclosure of company's Balance Sheet
 Understand the structure and preparation of Cash Flow Statement

Structure
4.1 Introduction
4.2 Schedule III of the Companies Act, 2013
4.3 General Instructions for the preparation of Financial Statement
4.4 Profit and Loss Statement Part II of Schedule III
4.5 Balance Sheet Part I of Schedule III
4.6 Cash Flow Statement
4.7 Statement of changes in Equity
4.8 Self Assessment Questions

4.1 INTRODUCTION
Companies are required to prepare their final accounts are per the provisions
of the Companies Act 2013. They should prepare and keep the books of
accounts of every financial year at their' registered office which gives a true
and fair view of the state of affairs of a company. Companies should keep the
books of accounts on an accrual basis and according to the double-entry
system of accounting.

As per Section 129 of the act, at the time of the company's annual general
meeting, it is mandatory for the board of directors to lay down the financial
statements before the company. The financial statements includes –

I. Profit and loss statement

II. Balance sheet
III. Cash flow statement
IV. Statement of changes in Equity
V. Notes to accounts

Note – Cash flow statement is not a part of financial statements in case of

One Person Company. 107
Accounting: An Final accounts must give a true and fair view of a company at the end of the
Overview
financial year. Further, Special acts are applicable for insurance, banking,
electricity supply or any other class of companies to prepare the financial
statements, while in case of all other companies, balance sheet and profit &
loss statement is prepared as per Part I and Part II of Schedule III.

It is mandatory for the companies to comply with the accounting standards as

notified by the Central Government from time to time.

4.2 SCHEDULE III OF COMPANIES ACT, 2013

The companies must prepare and present their final accounts as per the
Schedule III of the Company Act, 2013. The Schedule was formulated in
order to keep pace with changing economic philosophies leading to
privatisation, globalisation and subsequent desired changes in corporate
financial reporting practices. The several new features of Schedule III are as
follows –

 Vertical format of presenting the Balance Sheet items and their

classification into current and non-current heads.
 Vertical format of profit and loss statement with classification of
expenses based on nature.
 Elimination of the concept of "Schedules" and such information is now
furnished in "Notes to accounts"
 It does not contain any specific disclosure for items included in Schedule
VI under the head, "Miscellaneous Expenditure."
 Debit balance of profit and loss statement will be disclosed as a negative
figure under "Reserves and Surplus" head.
 Preparation of cash flow statement as per AS-3.
 The Schedule gives prominence to AS in case of any conflict between
AS and Schedule.

4.3 GENERAL INSTRUCTIONS FOR THE

PREPARATION OF FINANCIAL
STATEMENTS
 Schedule III sets provides minimum requirements for disclosure on the
face of the Balance Sheet, and the Statement of Profit and Loss (herein
after referred to as "Financial Statements") and Notes.
 This implies that new line items or sub-items can be added or substituted
in the Financial Statements when such presentation is:
o Relevant to an understanding of the company's financial position
o To meet industry/sector-specific disclosure requirements
o When required for compliance when statutory changes are made
especially in case of the amendments to the Companies Act or under
the Accounting Standards.
108
 Where compliance with the requirements of the Act, including Preparation of Final
Accounts of A
Accounting Standards as applicable to the companies, require any Company
change in treatment or disclosure, including addition, amendment,
substitution or deletion in the head or sub-head or any changes, interest,
in the financial statements or statements forming part thereof, the same
shall be made, and the requirements of this Schedule shall stand
modified accordingly.
 The disclosure requirements specified in this Schedule are in addition to
and not in substitution of the disclosure requirements specified in the
Accounting Standards prescribed under the Companies Act, 2013.
Additional disclosures specified in the Accounting Standards shall be
made in the notes to accounts or by way of additional statements unless
required to be disclosed on the face of the Financial Statements.
Similarly, all other disclosures as required by the Companies Act shall be
made in the notes to accounts in addition to the requirements set out in
this Schedule.
 Notes to accounts shall contain information in addition to that presented
in the Financial Statements and shall provide where required

o Narrative descriptions or disaggregation of items recognised in those

statements; and

o Information about items that do not qualify for recognition in those

statements.

 Each item on the face of the Balance Sheet and Statement of Profit and
Loss shall be cross-referenced to any related information in the notes to
accounts. In preparing the Financial Statements, including the notes to
accounts, a balance shall be maintained between providing excessive
detail that may not assist users of financial statements and not providing
necessary information as a result of too much aggregation.
 Depending upon the turnover of the company, the figures appearing in
the Financial Statements may be rounded off as given below: –
S.No. Turnover Rounding off
1 less than one To the nearest hundreds,
hundred crore thousands, lakhs or millions, or
rupees decimals thereof.
2 one hundred crore To the nearest lakhs, millions or
rupees or more crores, or decimals thereof
 Once a unit of measurement is used, it shall be used uniformly in the
Financial Statements.
 Except in the case of the first Financial Statements laid before the
company (after its incorporation), the corresponding amounts
(comparatives) for the immediately preceding reporting period for all
items shown in the Financial Statements, including notes, shall also be
given.
 For this Schedule, the terms used herein shall be as per the applicable
Accounting Standards. 109
Accounting: An
Overview
4.4 PROFIT & LOSS STATEMENT – PART II OF
SCHEDULE-III

Note Figures Figures

Particulars No. for the for the
current previous
reporting reporting
period period
I. Revenue from operations xxx xxx
II. Other income xxx xxx
III. Total Revenue(I+II) xxx xxx
IV. Expenses: xxx xxx
Cost of materials consumed xxx xxx
Purchases of Stock-in-Trade xxx xxx
Changes in inventories of Finished xxx xxx
goods, Work-in-Progress and Stock-
in-Trade
Employee benefits expense xxx xxx
Finance costs xxx xxx
Depreciation and Amortisation xxx xxx
expense
Other expenses xxx xxx
Total expenses xxx xxx
V. Profit before exceptional and xxx xxx
extraordinary items and tax(III-IV)
VI. Exceptional items xxx xxx
VII. Profit before extraordinary items and xxx xxx
tax (V-VI)
VIII. Extraordinary Items xxx xxx
IX. Profit before tax (VII-VIII) xxx xxx
X. Tax expense:
(1)Current tax xxx Xxx
(2)Deferred tax xxx xxx Xxx xxx
XI. Profit(Loss) for the period from xxx xxx
continuing operations (VII-VIII)
XII. Profit/(Loss) from discontinuing xxx xxx
operations
XIII. Tax expense of discontinuing xxx xxx
operations

110
 Preparation of Final
4.5 BALANCE SHEET–PART I OF SCHEDULE-III Accounts of A
Company
 Assets are the resources controlled by the enterprise due to past events
from which future economic benefits are expected to flow to the
enterprise.
 Liabilities are the obligation of an enterprise arising from the past event,
the settlement of which leads to an outflow of resources embodying
economic benefits,
 Equity is the residual interest in the interest of an enterprise after
deducting all the liabilities.

Particulars Note Figures Figures

No. as at the as at the
end of end of
current the
reporting previous
period period
1 2 3 4

I. EQUITY AND LIABILITIES

(1) Shareholder’s funds
(a) Share capital
(b) Reserves and surplus
(c) Money received against
share warrants
(2) Share application money
pending allotment
(3) Non-current liabilities
(a) Long-term borrowings
(b) Deferred tax liabilities
(net)
(c) Other Long-term liabilities
(d) Long-term provisions
(4) Current liabilities
(a) Short-term borrowings
(b) Trade payables
(c) Other current liabilities
(d) Short-term provisions
TOTAL
II. ASSETS
(1) Non-current assets
(a) Fixed Assets
(i) Tangible assets
(ii) Intangible assets
(iii) Capital work-in-
progress
(iv) Intangible assets
under
development
(b) Non-current investments
(c) Deferred tax assets (net)
(d) Long-term loans and
advances
111
Accounting: An (e) Other non-current assets
Overview (2) Current assets
(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash equivalents
(e) Short-term loans and
advances
(f) Other current assets

Some items are to be explained in the Notes to Accounts as follows:

A. Share Capital
For each class of share capital following points is to be kept in mind:
i) The number and amount of shares authorised.
ii) The number of shares which are issued subscribed and fully paid and
which are issued, subscribed but not fully paid.
iii) The par value per share.
iv) Shares outstanding at the beginning and at the end of the reporting
period should be reconciled.
v) Calls unpaid.
vi) Forfeited shares.
B. Reserves and Surplus
Reserves and surplus can be distributed among the following sub-heads:
i) Capital reserves
ii) Capital redemption reserves
iii) Securities Premium
iv) Debenture Redemption reserve
v) Revaluation reserve
vi) Surplus; the balance as per profit and loss statement
vii) Other reserves(specify the nature and purpose)
C. Long term Borrowings
Long term borrowings can be classified under the following sub-heads:
i) Bonds/Debentures
ii) Term loans
iii) Deferred payment liabilities
iv) Deposits
v) Long term maturities of finance lease obligations
vi) Loans and advances from related parties
vii) Other loans and advances(specify nature)

112
 Preparation of Final
Accounts of A
D. Long Term Provisions Company

These can be classified as follows:

i) Employee benefits provision like gratuity, provident fund etc.
ii) Other provisions (specify the nature)
E. SHORT TERM BORROWINGS
Short term borrowings can be classified among the following sub-heads:
i) Loans repayable on demand
ii) Loans and advances from related parties
iii) Deposits
iv) Other loans and advances(specify the nature)
F. Other Current Liabilities
Some of the other current liabilities can be grouped asunder:
i) Interest accrued but not/ and due on borrowings
ii) Income received in advance
iii) Unpaid dividends
iv) Applicationmoneyreceivedforallotmentofsecuritiesanddueforrefunda
ndinterestaccruedthereon
v) Other current liabilities(specify the nature)
G. Tangible Assets
Tangible assets can be classified as follows:
i) Land
ii) Buildings
iii) Plant and Equipment
iv) Furniture and Fixtures
v) Vehicles
vi) Office equipment
vii) Others (specify the nature)
A detailed report showing additions, disposals, acquisitions through
business combinations and other adjustments and amounts related to
depreciation, impairment losses, revaluation etc., should be provided for
each class of asset.
H. Intangible Assets
Intangible assets can be classified as follows:
i) Goodwill
ii) Brands/trademarks
iii) Computer software 113
Accounting: An iv) Mining rights
Overview
v) Publishing titles
vi) Copyrights, patents and other intellectual property rights, services
and operating rights
vii) Licence and franchise
viii) Recipes, models, designs, formulae and prototypes
ix) Others (specify the nature)
A detailed report showing additions, disposals, acquisitions through
business combinations and other adjustments and amounts related to
depreciation, impairment losses, revaluation etc., should be provided for
each class of asset.
I. Non-Current Investments
Investments can be classified as under:
i. Investments in property
ii. Investments in equity instruments
iii. Investments in preference shares
iv. Investments in governments or trust securities
v. Investments in debentures or bonds
vi. Investments in mutual funds
vii. Investments in partnership firms
viii. Other non-current investments(specify the nature)
J. LONG TERM LOANS AND ADVANCES
It can be classified under the following sub-groups:
i. Capital advances
ii. Security deposits
iii. Loans and advances to related parties
iv. Other loans and advances(specify nature)
The above shall also be sub-classified as follows:
i. Secured, considered goods
ii. Unsecured, considered goods
iii. Doubtful
K. Current Investments
It can be classified as follows:
i. Investments in equity instruments
ii. Investments in preference shares
iii. Investments in government or trust securities
iv. Investments in bonds or debentures
114
 v. Investments in mutual funds Preparation of Final
Accounts of A
vi. Investments in partnership firms Company

vii. Other investments(specify the nature)

L. Inventories
Inventories can be classified as:
i. Raw materials
ii. Work-in-progress
iii. Stores and spares
iv. Finished goods
v. Loose tools
vi. Stock in trade
vii. Goods in transit
viii. Others(specify the nature)
M. Cash and Cash Equivalents
The following head can be classified as follows:
i. Balances with banks
ii. Cheques, drafts in hand
iii. Cash in hand
iv. Others(specify the nature)

Illustration 4.1
The following is the Trial Balance of Alpha Limited as on 31.3.20X2:

(Figures in`‘000)

Debit Credit
Land at cost 4400 Equity Capital(Shares of Rs. 6000
10each)
Plant& Machinery at 15400 10%Debentures 4000
cost
Trade Receivables 1920 General Reserve 2600
Inventories(31.3.X2) 1720 Profit& Loss A/c 1440
Bank 400 Securities Premium 800
Adjusted Purchases 6400 Sales 14000
Factory Expenses 1200 Trade Payables 1040
Administration Expenses 600 Provision for Depreciation 3440
Selling Expenses 600 Suspense Account 80
Debenture Interest 400
Interim Dividend Paid 360
Total: 33,400 Total: 33,400
115
Accounting: An Additional Information:
Overview
(i) The authorised share capital of the company is 8,00,000 shares of Rs.
10 each.
(ii) The company, on the advice of an independent valuer, wishes to revalue
the land at Rs. 72,00,000.
(iii) Declared final dividend @10% on2nd April, 20X2.
(iv) Suspense account of Rs. 80,000 represents cash received for the sale of
some of the machinery on 1.4.20X1. The cost of the machinery was
Rs.2,00,000 and the accumulated depreciation thereon being Rs.
1,60,000.
(v) Depreciation is to be provided on plant and machinery at 10% on cost.

You are required to prepare Alpha Limited's Balance Sheet as on 31.3.20X2

and Statement of Profit and Loss with notes to accounts for the year ended
31.3.20X2 as per Schedule III. Ignore previous years' figures & taxation.

Solution

Balance Sheet

As at 31st March 20X2

Particulars NoteNo. (`in000)

Equity and Liabilities
1. Shareholders' funds
a Share capital 1 6000
b Reserves and Surplus 2 10600
2. Non-Current liabilities
a Long term borrowings 3 4000
3. Current liabilities
a Trade Payables 1040
Total 21640
Assets
1. Non-current assets
A PPE(Property, Plant& Equipment) 4 17600
2. Current assets
A Inventories 1720
B Trade receivables 1920
C Cash and bank balances 400
Total 21640

116
Profit and Loss Statement Preparation of Final
Accounts of A
For the period ending 31st March, 20X2 Company

Particulars Notes (`in000)

I. Revenue from operations 14000
II. Other Income 5 40
III Total Revenue 14040
IV Expenses:
Purchases 6400
Finance costs 6 400
Depreciation (10% of 15,200) 1520

Other expenses 7 2400

Total Expenses 10720
V. Profit (Loss) for the period (III – IV) 3320

Notes to accounts

(`in000)
1. Share Capital
Equity share capital
Authorised
800,000 shares of Rs. 10each 8000
Issued& subscribed & called up
600,000sharesof Rs. 10each 6000
2. Reserves and Surplus
Securities Premium Account 800
Revaluation reserve (7200–4400) 2800
General reserve 2600
Profit& loss Balance
Opening balance 1440
Profit for the period 3320 4760
Less: Appropriations
Interim Dividend (360) 4400
10600
3. Long term borrowing
10%Debentures 4000
4. PPE
Land
117
Accounting: An Opening balance 4400
Overview
Add: Revaluation adjustment 2800
Closing balance 7200
Plant and Machinery
Opening balance 15,400
Less: Disposed off (200)
15,200
Less: Depreciation (3440-160+1520) (4800)
Closing balance 10,400
Total 17,600
5. Other Income
Profit on sale of machinery:
Sale value of machinery 80
Less: Book value of machinery (10-8) (40) 40
6. Finance costs
Debenture interest 400
7. Other expenses:
Factory expenses 1200
Selling expenses 600
Administrative expenses 600 2400

Note: Dividend declared on 2nd April 20X2 will be accounted for in the next
financial year.

4.6 CASH FLOW STATEMENT

The cash flow statement is prepared in accordance with the provisions of
AS-3. It provides information about the cash flow position of an enterprise.
Further, the statement also identifies the cash from operating, investing and
financing activities. The purpose of the statement is to explain the cash
movement between two points of time. The sources of cash include the issue
of shares, debentures, raising of long term-loan, sale of an investment, sale of
fixed assets and cash from operations. In contrast, application of cash
includes redemption of shares, debentures, repayment of a long term loan,
purchase of fixed assets or investment, payment of tax, dividend and net
operating loss.

Note – Cash includes cash in hand, demand deposits with banks, short-term
liquid investment, and securities with short-term maturity (less than three
months from the date of acquisition).

The cash flow statement includes three major elements, namely –

118
a. Cash Flow from operating activities – These are the principal revenue Preparation of Final
Accounts of A
generating activities of an enterprise. Positive cash flow from operating Company
activities helps an enterprise maintain its operating capability, pay
dividends, repay loans, make new investments, etc. It also provides
valuable information about financing through working capital.
b. Cash flow from investing activities – It deals with the acquisition and
disposal of long-term assets and other investments. In other words, it
represents the extent to which expenditures have been made for
resources intended to generate future income and cash flows.
c. Cash flow from financing activities – These are the activities that result
in changes in the size and composition of owner's and borrowed capital.
These are useful in predicting claims on future cash flows by providers
of capital to the entity. Examples include cash proceeds from the issue of
equity shares, loans, debentures, etc.

Cash Flow Statement Format

Particulars Amt. Amt.

Net profit before Tax and extraordinary Items xxx
Cash flow from Operating activities
Add: Non-cash and non-operating Items which have
already been debited to Profit and Loss Account like:
Depreciation xxx
Amortisation of intangible assets xxx
Provision for tax xxx
Loss on the sale of Long-term Investments xxx
Loss on the sale of Fixed assets xxx
Dividend paid xxx xxx
Less: Non-cash and Non-operating Items which have
already been credited to Profit and Loss Account like:
Profit on sale of fixed assets (xxx)
Profit on sale of Long-term investment (xxx) (xxx)
Operating profit before Working Capital changes (A) xxx
Changes in working capital:
Add: Increase in current liabilities xxx
Decrease in current assets xxx xxx
Less: Increase in current assets (xxx)
Decrease in current liabilities (xxx) (xxx)
Net increase/decrease in working capital (B) xxx
119
Accounting: An Cash generated from operations (C) = (A+B) xxx
Overview
Less: Income tax paid (Net tax refund received) (D) (xxx)
Cash flow from before extraordinary items (C-D) = (E) xxx
Adjusted extraordinary items (+/–) (F) xxx
Net cash flow from operating activities (E+F) = (G) xxx
Cash flow from Investing activities
Proceeds from the sale of fixed assets xxx
Proceeds from the sale of investments xxx
Purchase of shares/debentures/fixed assets (xxx)
Net cash from investing activities (H) xxx
Cash flow from Financing activities
Proceeds from the issue of shares xxx
Proceeds from issue of debentures xxx
Payment of dividend (xxx)
Net cash flow from financing activities (I) xxx
Net increase in cash and cash equivalents (G+H+I) = (J) xxx
Cash and cash equivalents and the beginning of the period xxx
(K)
Cash and cash equivalents and the end of the period (J+K) xxx

Illustration 4.2
Raymond Ltd provides the following information at the year-end, March31,
20X1:

Particulars Rs. Rs.

Sales 1,39,600
Cost of Goods Sold (1,04,000)
35,600
Operating Expenses
(including Depreciation Expense of Rs. 74,00) (29,400)
6,200
Other Income/(Expenses):
Interest Expense paid (4,600)
Interest Income received 1200
Gain on Sale of Investments 2,400
Loss on Sale of Plant (600)
(1600)
120
 4600 Preparation of Final
Accounts of A
Income tax (1400) Company

3,200

Information available:

31stMarch 31stMarch
20X1 20X0
Rs. Rs.
Plant 1,43,00 10,1000
Less: Accumulated Depreciation (20,600) (13,600)
1,22,400 87,400
Investments (Long term) 23,000 25,400
Inventory 28,800 22,000
Trade receivables 9,400 11,000
Cash 9,200 3,000
Prepaid expenses 200 1000
Share Capital 93,000 63,000
Reserves and surplus 28,000 26,400
Bonds 59,000 49,000
Trade payables 10,000 8,600
Outstanding liabilities 2400 1800
Income taxes payable 600 1000

Analysis of selected accounts and transactions during20X0-X1

1. Purchased investments for Rs. 15,600.
2. Sold investments for Rs. 20,400. These investments cost Rs. 18,000.
3. Purchased plant assets for Rs.24000.
4. Sold plant assets that cost Rs. 2000 with accumulated depreciation of Rs.
400 for Rs.1000.
5. Issued Rs. 20000 of bonds at face value in exchange for plant assets
on31st March, 20X1.
6. Repaid Rs.10000 of bonds at face value at maturity.
7. Issued 3000 shares of Rs. 10each.
8. Paid cash dividends Rs. 1600.

Prepare Cash Flow Statement as per AS-3(Revised), using the indirect method.

Solution
Raymond Ltd.

121
Accounting: An Cash Flow Statement
Overview
For the year ending 31stMarch, 20X1
Particulars Rs Rs.
Cash flows from operating activities
Net profit before taxation 4600
Adjustments for:
Depreciation 7400
Gain on sale of investments (2400)
Loss on sale of plant assets 600
Interest expense 4600
Interest income (1200)
Operating profit before working capital changes 13,600

Decrease in trade receivables 1600

Increase in inventory (6800)
Decrease in prepaid expenses 800
Increase in trade payables 1400
Increase in outstanding liabilities 600
11,200
Cash generated from operations
Income taxes paid* (1800)
Net cash generated from operating activities 94,00
Cash flows from investing activities
Purchase of plant (24000)
Sale of plant 1000
Purchase of investments (15600)
Sale of investments 20400
Interest received 1200
Net cash used in investing activities (17,000)
Cash flows from financing activities
Proceeds from issuance of share capital 30000
Repayment of bonds (10000)
Interest paid (4600)
Dividends paid (1600)
Net cash from financing activities 13,800
Net increase in cash and cash equivalents 62,00
Cash and cash equivalents at the beginning of the 3,000
period
Cash and cash equivalents at the end of the period 92,00
122
*Working Note: Preparation of Final
Accounts of A
Company
Income taxes paid:
Income tax expense for the year 1400
Add: Income tax liability at the beginning of the year 1000
2400
Less: Income tax liability at the end of the year (600)
1800

4.7 STATEMENT OF CHANGE IN EQUITY

 It is the reconciliation between the opening and closing balance of
shareholder's equity.
 The statement summarises the transactions related to the shareholder's
equity over an accounting period.
 It records movement in retained earnings, other reserves and changes in
share capital.
 Statement of changes in equity is to be presented, and it includes the
following:

o Reconciliation of the opening and closing balances of equity,

describing changes in detail.

o Details of comprehensive income for the accounting period.

o Details of changes and the impact when components of equity are

restated

o applied retrospectively in accordance with the IAS/Ind-AS 8.

o Comprehensive income is the incomes listed after the net income on
the income statement.

4.8 SELF-ASSESSMENT QUESTIONS

1. State under which head these accounts should be classified in Balance
Sheet, as per Schedule III of the Companies Act, 2013:
a. Unpaid matured debenture and interest accrued thereon.
b. Uncalled liability on shares and other partly paid investments.
c. Share option outstanding account.
d. Calls unpaid.
e. Money received against share warrant.
f. Share application money received in excess of issued share capital.
2. From the following particulars furnished by Alpha Ltd., prepare the
Balance Sheet as on 31stMarch 20X1asrequired by Part I, Schedule III to 123
Accounting: An the Companies Act, 2013.
Overview
Particulars Debit Credit
Equity Share Capital (Face value of Rs. 5,00,000
100each)
Call in Arrears 500
Land& Building 2,75,000
Plant& Machinery 2,62,500
Furniture 25,000
General Reserve 1,05000
Loan from State Financial Corporation 75,000
Inventory:
Raw Materials Finished Goods 25,000
1,00,000 1,25,000
Provision for Taxation 64,000
Trade receivables 1,00,000
Short term Advances 21,350
Profit& Loss Account 43,350
Cash in Hand 15,000
Cash at Bank 1,23,500
Unsecured Loan 60,500
Trade payables (for Goods and Expenses) 80,000
Loans & advances from related parties 20,000
9,47,850 9,47,850

The following additional information is also provided:

(i) 10,000Equity shares were issued for consideration other than cash.
(ii) Trade receivables of Rs. 26,000aredueformorethan6months.
(iii) The cost of the Assets were:
Building Rs. 30,0,000, Plant&MachineryRs.35,0,000 and Furniture Rs.
31,250
(iv) The balance of Rs. 75,000 in the Loan Account with State Finance
Corporation is inclusive of Rs.3750 for Interest Accrued but not due. The
loan is secured by hypothecation of Plant &Machinery.
(v) Balance at Bank includes Rs. 1000 with Omega Bank Ltd., which is not
a Scheduled Bank.
(vi) Transfer Rs. 2,000 to general reserve is proposed by the Board of
directors.
(vii) The Board of directors declared a dividend of 5% on the paid-up capital
on 2nd April, 20X1.

124 3. From the following Balance Sheets and information, prepare the cash
 flow statement of Ryan ltd. by indirect method for the year ended Preparation of Final
Accounts of A
31stMarch, 20X1: Company

Particulars Notes 31stMarch20X1 31stMarch20X0

Rs. Rs.

Equity and
Liabilities
1 Shareholders’
funds
A Share capital 1 60,000 70,000
B Reserves and 2 42,000 30,000
Surplus
2 Non-current
liabilities
Long term 3 20,000 -
borrowings
3 Current liabilities
A Trade Payables 11,500 11,000
B Other current 4 3,000 8,000
liabilities
C Short term
provision(provision 9,500 6,000
for tax)
Total 1,46,000 1,25,000
Assets
1 Non-current assets
A Property, plant and 5 91,500 70,000
Equipment
B Non-Current 50,000 8000
Investments
2 Current assets
A Inventories 9500 9000
B Trade receivables 25,000 22,500
C Cash and Cash 5000 9000
equivalents
D Other Current assets 10,000 6500
Total 146000 125000

Notes to Accounts

No. 31stMarch, 31stMarch,

20X1 20X0
1. Share capital
125
Accounting: An Equity share capital 60000 50000
Overview
10%RedeemablePreferencesharecapital
-- 20000
Total 60000 70000
2 Reserves and Surplus
Capital redemption reserve 10000 -
Capital reserve 7000 -
General reserve 15000 2,5000
Profit and Loss account 10000 5000
Total 42000 3,0000
3 Long term borrowings
9%Debentures 20000 --

4. Other current liabilities

Dividend payable - 6000

Liabilities for expenses 3000 2000
Total 3000 8000

5 Property, plant and equipment

Plant and machinery 7,6500 5,0000

Land and building 1,5000 2,0000
Net carrying value 9,1500 7,0000

Additional Information:
(i) A piece of land has been sold out for Rs. 15000 (Cost – Rs. 1,2000), and
the balance land was revalued. Capital Reserve consisted of profit on
revaluation of land.
(ii) On1stApril,20X0, a plant was sold for Rs.9000(Original Cost–Rs.
7000and
W.D.V. – Rs. 5000) and Debentures worth Rs. 10,000 were issued at par
as part consideration for plant of Rs. 40500acquired.
(iii) Part of the investments (Cost–Rs. 5000) was sold for Rs. 7000.
(iv) Pre-acquisition dividend received Rs. 500was adjusted against the cost of
investment.
(v) Interim dividend was declared and paid @15%during the current year.
(vi) Income-tax liability for the current year was estimated at Rs. 13500.
Depreciation@15%has been charged on Plant and Machinery, but no
depreciation has been charged on Building.

126
 Cash Flow Statement
UNIT 5 CASH FLOW STATEMENT

Objectives
After you have studied this unit, you should be able to:

 Understand the purpose and preparation of cash flow statement;

 Distinguish between operating activities, investing activities and financing activities;

 Prepare the cash flow statement using the direct method;

 Prepare the cash flow statement using the indirect method.

Structure

5.1 Introduction

5.2 Importance and objectives of cash flow statement

5.3 Cash and cash equivalent

5.4 Types of activities and cash flow classification

5.5 Preparation of cash flow statement and illustrations

5.6 Activity: Cash flow statement of NTPC Ltd

5.7 Summary

5.8 Keywords

5.9 Self-assessment questions

5.10 Further readings

5.1 INTRODUCTION
The Cash flow statement is one of the three most important financial
statements. It shows the inflows and outflows of cash and cash equivalents
over a period of time. The users of financial information give substantial
importance to this statement as it acts as a tool to study the strength and long-
term future outlook of the company. It also takes into account various
activities of an enterprise.

The cash flow statement of an enterprise provides information about the

historical changes in cash and cash equivalents by classifying all cash flows
derived from operating, investing and financing activities. The revised
Accounting Standard -3 (AS-3) made it mandatory for all listed companies to
prepare and present an annual cash flow statement along with other financial
statements.

This unit discusses and explains the method of preparing a cash flow
statement for an accounting period.

127
 Accounting: An Features of Cash Flow Statement C
Overview
Features are mentioned as follows:

1. A cash flow statement is a periodic statement.

2. It is a statement of change in the financial position on a cash basis.
3. It shows the movement of cash and explains the reasons for changes in
cash position between two balance sheet dates.
4. It does not match cost against revenue.
5. It shows the inflow and outflow of cash and cash equivalents from
various activities.
6. It helps assess the company’s capability to generate cash and cash
equivalents and channels to utilise those cash flows.
7. It provides information on inflow and outflow of cash and cash
equivalents from various activities of a company under various heads,
i.e. operating, investing and financing activities.

Preparation of Cash Flow Statement

Following basic documents or data are required to prepare the statement:

Figure 5.1: Data used for Cash Flow Statement

5.2 OBJECTIVES AND BENEFITS OF CASH

FLOW STATEMENT
Objectives of Cash Flow Statement
The objectives of the cash flow statement are as follows:

 To make future financial policies.

 To identify the extent of major expenses.

 To devise the cash requirement for a period.

 To find reasons for the net cash inflows or outflows.

 To predict the financial strength of the company.

128
Benefits of Cash Flow Statement Cash Flow Statement

Benefits are mentioned as follows:

● Highlights liquidity position

Liquidity means one’s ability to pay the obligation on time or as soon as
it becomes due. A cash flow statement helps in determining the liquidity
position of the business. It shows the cash position and gives an idea of
the cash payments made in the course of business of the company, thus,
confirming the liquidity position of the same.
● Helps in cash management
A cash flow statement helps in the management of cash flow. With the
help of cash flow statements, companies can estimate both future cash
receipts and payments. With the help of this statement, it is easier for
companies to make future plans related to cash without compromising on
liquidity.
● Maintain optimal cash balance
Another benefit of a cash flow statement is that it facilitates the company
to maintain an optimal cash balance. It enables businesses to verify the
possible idle, excess or shortage of cash. After arranging for the required
Cash position, the companies can invest the excess cash or borrow funds
in case of any deficit.
● Comparability
A cash flow statement facilitates the accurate comparison of the cash-
based performance of different companies as it uses the same accounting
treatment for the same transactions and events. Companies can,
therefore, adjust their cash flows as per the industry norms or modify
them as per the structure of the industry leaders.
● Indicates future
One of the significant benefits of the cash flow statement is that
historical cash flow information is taken as an adequate indication of
future cash flows. Past information on cash amount, their timing and
certainty of their arrival may be used for the forecasting of the future
cash flows. It helps in confirming the accuracy of past assessments too.

5.3 CASH AND CASH EQUIVALENTS

Cash and Cash Equivalents
As per AS-31, Cash comprises cash in hand and demand deposits with banks.
Cash equivalents means short-term highly liquid investments that are readily
convertible into known amounts of cash and subject to an insignificant risk of
changes in value.

Cash equivalents have the following features:

1
https://www.mca.gov.in/Ministry/notification/pdf/AS_3.pdf 129
 Accounting: An  Cash equivalents can be readily converted into cash. C
Overview
 These are held to meet short-term cash requirements rather than for investments
purposes.

 Cash equivalents have a short term maturity, normally, three months or less.

 Cash equivalents are highly liquid and easily sellable in the market.

 Buyers of cash equivalents are easily accessible.

Marketable securities and money market instruments are considered cash

equivalents. Generally, it includes commercial paper, treasury bills, short-
term government bonds etc. with a maturity date of three months or less.

Cash Flows
A company creates value for the shareholders by generating positive cash
flows for them. As per AS-31, cash flows are inflows and outflows of cash
and cash equivalents, i.e. cash flows is the amount of cash and cash
equivalents move in and out of a business. Cash flow generated in a company
adds to its cash reserves, which further accelerate reinvestment in the
company.

5.4 TYPES OF ACTIVITIES AND CASH FLOW

CLASSIFICATION
As per AS-31, these activities can be put into three categories:

 Operating activities

 Investing activities, and

 Financing activities

This classification shows the cash flows generated and used in these
activities.

Figure 5.2 Types of Activities

Cash from Operating Activities

Operating activities comprised of the primary activities of a company. These
activities create the principal revenue stream for the company. Cash flow
from operating activities is the first subdivision portrayed on a cash flow
statement. Cash from operations is an indicator of the internal solvency of the
company.

 Cash from operating activities signifies the cash a company generates from its ongoing
and regular business activities.
130
 These activities include routine acts of manufacturing and selling goods or a service to Cash Flow Statement
clients.

 It focuses only on core business activities and does not include non-core, long-
term capital expenditures or investment revenues etc.

 As it considers only the core business, cash flow from operating activities is a yardstick
to verify the financial status of a company.

There are two different methods to identify cash from operating activities: the
indirect method and the direct method.

Figure 5.3 Methods to identify Cash from Operating Activities

Cash Inflows from Operating Activities

 Cash receipts from the sale of goods and the rendering of services.

 Cash receipts from royalties, fees, commissions and other revenues.

Cash Outflows from Operating Activities

 Cash payments to suppliers for goods and services

 Cash payments to employees

 Cash payment on behalf of the employees

 Cash payments for insurance premiums and claims, annuities, and other benefits.

 Cash payments or refunds of income taxes

Non-operating cash flows are clearly different from operating cash flows. For
example, non-operating cash flows include taking a loan or issuing new
shares and are usually non-recurring.

Cash from Investing Activities

As per AS-3, investing activities are the acquisition and disposal of long-
term assets and other investments not included in cash equivalents. Investing
activities are related to the purchase and sale of long-term or fixed assets of a
company. These assets include land and building, machinery, furniture etc.
These activities signify the extent to which expenditures are made for
acquiring resources to generate future cash flows. Cash flows related to long-
term investments are also known as investing activities. 131
 Accounting: An Cash Inflows from Investing Activities C
Overview
 Cash receipt from the disposal of fixed assets, including intangibles assets.

 Cash receipt from the disposal of intangibles assets.

 Cash receipt from the repayment of advances or loans made to third parties.

 Cash receipt from the disposal of shares, warrants or debt instruments of other
enterprises other than receipts from those instruments considered as cash or cash
equivalents or held for trading purposes.

 Interest received in cash from loans and advances.

 Dividend received from investments in other companies.

 Cash receipts from futures contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing, or trading purposes, or the
receipts are classified as financing activities

Cash Outflows from Investing Activities

 Cash payments to acquire fixed assets, including intangibles and capitalised research
and development.

 Cash payments to acquire shares warrants or debt instruments of other enterprises other
than the instruments considered to be cash equivalents or held for trading purposes.

 Cash advances and loans made to a third party (other than advances and loans made by
a financial enterprise, wherein it is operating activities).

 cash payments for futures, forward, options and swap contracts except when the
contracts are held for dealing or trading purposes, or the payments are classified as
financing activities; and

Cash from Financing Activities

As per AS-3, financing activities are activities that result in changes in the
size and composition of the owners’ capital (including preference share
capital in case of a company) and borrowings of the enterprise.

It is the part of a company’s cash flow statement, which shows the flows of
cash used to fund the company that involve equity, debt and dividends. It
provides an insight into a company’s financial strength and its capital
structure. These activities are related to long-term funds or capital as cash
proceeds from issue of equity shares, debentures, bank loans etc.

Cash Inflows from Financing Activities

 Cash proceeds from issuing shares or other similar instruments.

 Cash proceeds from issuing debentures, loans, bonds and other short or long-term
borrowings.

Cash Outflows from Financing Activities

 Cash repayments of amounts borrowed.

 Interest paid on loans, debentures and advances.

132  Dividends paid on equity and preference capital.

Sometimes, one transaction may fall into more than one different Cash Flow Statement
classification. For example, the purchase of shares is an operating activity for
a share broker, while it is referred to as investing activity for another
enterprise.

Non-cash Transactions
As per AS-3, investing and financing transactions that do not require the use
of cash or cash equivalents should be excluded from a cash flow statement.
Examples of such transactions are – acquisition of machinery by the issue of
equity shares or redemption of debentures by the issue of equity shares.

5.5 PREPARATION OF CASH FLOW

STATEMENT
Basic Structure of the Cash Flow Statement
The basic structure of the cash flow statement is presented as under:

Particulars Amount
(A) Cash flows from operating activities XX
(B) Cash flows from investing activities XX
(C) Cash flows from financing activities XX
Net increase /decrease in cash and cash equivalents (A + B + C) XX
+ Cash and cash equivalents at the beginning
= Cash and cash equivalents at the end XX

Figure 5.4 Basic Structure of the Cash Flow Statement

Cash Flow from Operating Activities

Calculation of cash flow from operation is considered to be the most complex
problem area while preparing the statement. As mentioned earlier, as per AS-
3, a company reports these cash flows either by direct or indirect method.
Detailed discussion is given below:

Direct Method
Under this method, cash receipts and cash payments are arranged and
presented in the cash flow statement. The difference between cash receipts
and payments is the net cash flow from operating activities. The financial
statement provides the summarised data for revenue and expenses. The
accrual basis of revenue and expenses are to be converted to equivalent cash
receipts and payments.

Some examples of cash receipts and payments are mentioned as under:

 Cash receipts from customers/debtors

 Cash receipts of royalties, fees, commission etc

 Cash paid to suppliers

 Cash paid for purchases 133

 Accounting: An  Cash paid for wages and salaries C
Overview
 Cash paid for various taxes , interest etc

Cash receipt from Customers/debtors:

In a standard scenario, if a business is run on an only cash basis, the sales
revenue in the income statement is as same as the cash collected from the
customers. However, normally, credit sales are also made. The uncollected
amount is reflected by the closing balance of debtors. To calculate the cash
received from debtors, the opening balance (debtors/bills receivable) should
be added to the amount of credit sales, and the closing balance should be
subtracted there from.

Cash Collected from Debtors can also be calculated as follows:

Cash Collected from Debtors = Credit Sales (+) Decrease in Accounts

Receivable or

(–) Increase in Accounts Receivable.

Cash paid to suppliers / Purchases

For purchases, cash payments to suppliers consider the cost of goods sold
from the Profit & Loss account and others from the Balance Sheet, etc. The
calculations are as follows:

Purchases = Cost of Goods Sold (+) Closing Stock (-) Opening Stock

Or

Purchases = Cost of Goods Sold (+) Increase in Stock or (-) Decrease in

Stock

Or

Cash Paid to Suppliers = Purchases (+) Opening Balance of Creditors

(Bills Payable)

(-) Closing Balance of Creditors (Bills Payable)

Or

Cash Paid to Suppliers = Purchases (+) Decrease in Accounts Payable or

(–) Increase in

Accounts Payable

Cash Paid to Employees

The calculation for cash payments is presented as under:

Cash Paid for Wages and Salaries =

Wages and Salaries Expenses (+) Opening Balance of Outstanding
Wages and Salaries (-) Closing Balance of Outstanding Wages and
134 Salaries.
Or Cash Flow Statement

Cash Paid for Wages and Salaries =

Wages and Salaries Expenses (+) Decrease in Wages and Salaries

Payable or (-) Increase in Wages and Salaries Payable

The following points should be noted:

 The sale of fixed assets and investments does not require any adjustment here.

 Bad debts, sales returns, purchases returns, discount allowed, discount received etc.
require adjustment.

 Items like depreciation, amortisation of intangible assets like goodwill, debenture

discount, preliminary expenses, premium on redemption of debentures and preference
shares are ignored.
 Non-cash items are omitted from a statement of cash flows.

Cash Flows from Operating Activities (Direct Method)

Amount

Cash receipts from customers XX

xxx
(–) Cash paid to suppliers and employees XX
xxx
= cash generated from operations XX
xxx
(–) Income tax paid XX
xxx
= Cash flow before extra-ordinary items XX
xxx
(+/–) Extra-ordinary items XX
xxx
= Net cash from operating activities XX

Figure 5.5 Cash Flows from Operating Activities (Direct Method)

Indirect Method
In the indirect method, the net profit/loss forms the base to calculate net cash
flow. Non-cash and non-operating charges put in the Profit & Loss account
are added back, whereas non-cash and non-operating incomes are deducted to
calculate operating profit. Adjustments are further needed in current assets
and current liabilities to obtain net cash from operating activities.

Cash flows from Operating Activities (Indirect Method)

Amount

Net profit for the year XX

(+) Non-cash and non-operating expenses:
● Depreciation XX
● Goodwill written off XX
135
 Accounting: An ● Provision for taxation XX C
Overview
● Preliminary expenses written off XX
● Loss on sale of fixed assets, investment etc XX
(-) Non-cash and non-operating incomes
● Loss on sale of fixed assets, investment etc
Net profit after adjustment of non-cash items XX
(+) Increase in current liabilities
(+) Decrease in current assets
(-) Increase in current assets XX
(-) Decrease in current liabilities XX
(-) Income tax paid XX
Cash from operating activities XX
XX
XX

Figure 5.6 Cash Flows from Operating Activities (Indirect Method)

Illustration 5.1
From the following information, calculate the net cash flow from operating
activities for the year ended March 31, 2020, using direct method.

Amount (Rs)
Cash Sales 1,50,000
Credit Sales 75,000
Receivables collections 1,50,000
Cash Purchases 35,000
Credit Purchases 40,000
Creditors Paid 87,500
General Expenses Paid 25,000
Unpaid Expenses 30,000
Wages Paid 45,000
Outstanding Wages 15,000
Salaries Paid 55,000
Total Salaries 1,25,000
Interest Received 7,500
Income Tax Paid 14,000
Depreciation 10,000
Loss due to Fire 9,000
Insurance Claims 7,500
136
Solution: Cash Flow Statement

Amount (Rs) Amount

(Rs)
Cash Receipts:
Cash Sales 1,50,000
Receivables collections 1,50,000 3,00,000
(Less) Cash Paid to Suppliers and
Employees:
Cash Purchases 35,000
Payment to Creditors 87,500
Payment of wages 45,000
Payment of Salaries 55,000
Payment of General Expenses 25,000 2,47,500
Cash from Operations* 52,500
(Less) Payment of Income Tax 14,000
Cash Flow before Extra-ordinary items 38,500
(Add) Extra-ordinary Income:
Insurance Claim received 7,500
Net Cash Flow from Operating Activities 46,000

*Only operating income and expenses are considered.

Illustration 5.2
From the following Profit and Loss Account, calculate the Net Cash flow
from Operating Activities using the indirect method.

Profit and Loss Account for the year ended March 31st, 2020

Dr. Cr.
Rs Rs Rs Rs
To Opening Stock 22,500 By Sales:
To Purchases: Cash 42,500
Cash 25,000 Credit 1,75,000 2,17,500
Credit 90,000 1,15,000 By Closing 17,500
To Wages: Stock
Paid 26,000 By
Outstanding 5,000 31,000 Dividend 5,000
To Salaries from
Investment
Paid 15,000
Outstanding 5,000 20,000
To Rent Paid 4,000
To Depreciation 12,500
To Preliminary
Expenses
137
 Accounting: An write-off 8,000 C
Overview
To Provision of 5,000
Taxation

To Net Profit 22,000

2,40,000 2,40,000

Additional information is:

 Tax paid during the year is Rs 25,000

 The opening and closing balances of debtors are Rs 24,000 and Rs 29,000

 The opening and closing balance of creditors are Rs 22,500 and Rs 20,000

Solution:

Amount Amount
(Rs) (Rs)
Net Profit 22,000
Add: Non-operating and Non-cash items
charged to Profit &Loss A/C 12,500
Depreciation 8,000
Preliminary Expenses written off 5,000 25,500
Provision for Taxation 47,500

Less: Non-operating and Non-current items

credited to Profit &Loss
Dividend from Investment 5,000
Operating profit before working capital 42,500
changes
Add: Increase in Operating Current
Liabilities
Outstanding Wages
5,000
Outstanding Salaries
5,000
Decrease in Operating Current Assets
15,000
Stock
5,000
57,500
138 Less: Increase in Operating Current Assets
Debtors 7,500 Cash Flow Statement

Decrease in Operating Current Liabilities 10,000 50,000

Creditors 25,000
Cash Generated From Operations 5,000
Less: Payment of Income Tax 25,000

Net Cash Flow from Operating

Activities

Cash Flow Statement

There is no specific format of cash flow statement in Accounting Standard-3
(Revised). A widely accepted format under direct method and indirect
method is being provided below:

Proforma for Cash Flow Statement (under Direct Method)

Statement of .................for the period ended...................

Amount Amount
(Rs) (Rs)

A. Cash flows from Operating Activities

Cash receipts from customers
Less: Cash paid to suppliers and employees
Cash generated from operations
Less: Income taxes paid
Cash flows from operations before extra-ordinary
item
Add: Proceeds from any disaster settlement
Net Cash Flow from Operating Activities
B. Cash flows from Investing Activities
Proceeds from Sale of Fixed Assets including
Investments
Less: Purchase of Fixed Assets including Investments
Add: Interest received
Dividend received
Net Cash from Investing Activities
C. Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Less: Repayments of long-term borrowings
Redemption of Preference Shares
139
 Accounting: An Less: Interest paid C
Overview
Dividend paid
Net Cash from Financing Activities
Net Increase (Decrease) in Cash and Cash
Equivalents (A + B + C)
Add : Cash and Cash Equivalents at the Beginning
of Period

Cash and Cash Equivalents at End of Period

Proforma for Cash Flow Statement (under Indirect Method)

Statement of .................for the period ended...................

Amount Amount
(Rs) (Rs)

A. Cash flows from Operating Activities

Net profit before tax and extra-ordinary items
Add: Adjustments for Non-cash and Non-operating
items charged
to Profit and Loss A/c
Depreciation
Interest Paid
Foreign Exchange Loss
Loss on sale of fixed assets and Investments
Less: Adjustments for Non-cash and Non-operating
items credited
to Profit and Loss A/c
Interest earned
Dividend earned
Profit on sale of fixed assets and Investments
Operating profit before working capital changes
Add: Increase in Operating Current Liabilities
Decrease in Operating Current Assets
Less: Increase in Operating Current Assets
Decrease in Operating Current Liabilities
Cash generated from Operations
Less: Income Tax Paid
140
Add: Proceed from any Disaster Settlement Cash Flow Statement

Net Cash Flow from Operating Activities

B. Cash flows from Investing Activities
Proceeds from Sale of Fixed Assets including
Investments
Less: Purchase of Fixed Assets including Investments
Add: Interest received
Dividend received
Net Cash from Investing Activities
C. Cash flows from financing activities
Proceeds from issuance of share capital
Proceeds from long-term borrowings
Less: Repayments of long-term borrowings
Redemption of Preference Shares
Less: Interest paid
Dividend paid
Net Increase (Decrease) in Cash and Cash
Equivalents (A + B + C)
Add: Cash and Cash Equivalents at the Beginning of
Period Cash and Cash Equivalents at End of Period

Illustration5.3
Prepare a cash flow statement of ABC Ltd on the basis of given information:

Liabilities 2019 2020 Assets 2019 2020

(in Rs) (in Rs) (in Rs) (in Rs)
Share Capital 3,00,000 3,75,000 Land and 3,00,000 4,20,000
Building
12% Debentures 1,50,000 1,20,000 Machinery 1,50,000 1,95,000
Reserve 7,5000 1,05,000 Debtors 60,000 90,000
Bills Payables 30,000 1,50,000 Stock 1,05,000 1,35,000
Outstanding 37,500 30,000 Cash 22,500 27,000
Expenses
Creditors 60,000 90,000 Goodwill 15,000 3,000
Total 6,52,500 8,70,000 Total 6,52,500 8,70,000

141
 Accounting: An Solution C
Overview
Cash Flow Statement for the year ended March 31st 2020

(Rs) (Rs)
Cash from operating Activities
Profit during the year* 30,000
Add: Goodwill written off 12,000
Increase in creditors 30,000
Increase in bills payables 1,20,000 1,92,000

Less : Increase in debtors (30,000)

Increase in stock (30,000)
Decrease in outstanding expenses (7,500) (67,500)
1,24,500
A. Cash outflow from operating
activities

Cash from investing activities (1,20,000)

Purchase of land and building (45,000) (1,65,000)45,000
Purchase of machinery
B. Cash outflow from investing
activities 75,000 4,500
Cash from Financing Activities (30,000) 22,500
Issue of shares 27,000
Redemption of debentures

C. Cash inflow from financing

activities

Net Increase in Cash (A+B+C)

Add: Cash balance in the beginning of the
year
Cash balance at the end of the year

*Change in General Reserve

Illustration 5.4
Summary of cash transactions of XYZ Ltd is extracted from their books. You
are required to prepare a cash flow statement for the period ended 31st
March, 2020 in accordance with the Accounting Standard- 3 (Revised).

142
 (` in Rs ’000) Cash Flow Statement

Balance as on 1st April, 2019 140

Receipts from customers 11132
Issue of shares 1200
Sale of fixed assets 512
12984

Payments to suppliers 8188

Payments for fixed assets 920
Payments for overheads 460
Wages and salaries 276
Taxation 972
Dividends 320
Repayment of bank loans 1000
12136
Balance as on 31st March, 2020 848

Solution:

Cash Flow Statement for the period ending 31st March, 2020

(` in ‘000s)
A. Cash Flow from Operating Activities
Receipts from customers 11132
Payment to suppliers (8188)
Payment of Wages and Salaries (276)
Payment of Overheads (460)
Payment of Taxes (972)
Net Cash from Operating Activities(A) 1236
B Cash Flow from Investing Activities
Proceeds on sale of fixed assets 512
Acquisition of (payments) fixed assets (920)
Net Cash Used in Investing Activities (B) (408)
C Cash Flow from Financing Activities
Proceeds on issue of shares 1200
Payments of dividends (320)
Repayments of bank loans (1000)
Net Cash Used in Financing Activities (C) (120)

143
 Accounting: An Net increase in cash and cash equivalents 708 C
Overview
(A)+(B)+(C)
Cash and cash equivalents at the beginning of the 140
period
Cash and cash equivalents at the end of the period 848

Illustration 5.5
From the following information, prepare a cash flow statement using: (i)
Direct Method and (ii) Indirect Method.

Income Statement and Reconciliation of Earnings for the year ended

31.3.2020

`
Net Sales 630000
Less: Cost of sales 495000
Depreciation 15000
Salaries and wages 60000
Operating expenses 20000
Provision for taxation 22000 612000
Net operating profit Non-recurring income: 18,000
Profit on sale of equipment
3,000
21,000
Retained earnings (balance in Profit & Loss Account 37950
brought forward)
58950
Dividend declared and paid during the year 18000
Profit & Loss Account balance as on 31.3.2020 40950

Balance Sheets
As at As at
31.3.2019 31.3.2020
Capital 90,000 110000
Surplus in profit and loss A/c 37950 90950
Sundry creditors 60,000 58500
Outstanding expenses 6000 12000
Income tax payable 3000 3300
Accumulated depreciation on building and 30000 33000
equipments
22695 258750
Fixed assets Land 12000 24,000
144
Building and equipments 90000 1,44,000 Cash Flow Statement

Current assets Cash 15,000 18,000

Debtors 42,000 46,500

Stock 66000 24,000
Advances 1950 2250
22695 258750

Cost of equipment sold was 18,000.

Solution:

` `
Cash Flows from Operating Activities:
Cash receipts from customers WN1 625500
Cash paid to suppliers and employees 528800
WN2
Cash generated from operations 96700
Income tax paid WN3 (21700)
Net Cash from Operating Activities 75000
Cash Flows from Investing Activities:
Purchase of land (12,000)
Purchase of building and equipment WN6 (72000)
Sale of equipment WN5 9000
Net cash used in Investing Activities
Cash Flows from Financing Activities: (75000)
Issue of share capital 21000
Dividend paid (18000)
Net Cash from Financing Activities 3000
Net Increase in Cash and Cash Equivalents 3000
Cash and Cash Equivalents at the beginning 15,000
Cash and Cash Equivalents at the end 18000

Working Notes (WN):

1) Cash receipts from customers:WN1
`
Sales revenue 630000
Add: Debtors at the beginning 42000
672000
Less: Debtors at the end 46500
625500
2) Cash paid to suppliers and 145
 Accounting: An employees:WN2 C
Overview
Cost of goods sold 495000
Add: Operating expenses 20000
Salaries and wages 60000
575000
Add: Creditors at the beginning 60000
Stock at the end 24000
Advances at the end 2250
Outstanding expenses at the beginning 6000 92250
667250
Less: Creditors at the end 58500
Stock at the beginning 66000
Advances at the beginning 1950
Outstanding expenses at the end 12000 138450
528800

3) Income tax paidWN3

Tax payable at the beginning 3000
Add: Provision for taxation 22000
25000
Less: Tax payable at the end 3300
Tax paid during the year 21700
4) Accumulated depreciation written off
on equipments (sold)WN4

Accumulated depreciation at the beginning 30000

Add: Depreciation for the year 15,000
45000
Less: Accumulated depreciation at the end 33000
12,000
5) Sale price of equipmentWN5
Cost price 18000
Less: Accumulated depreciation WN4 12000
6000
Add: Profit on sale 3000
9000
6) Purchase of building and
equipmentsWN6
146 Balance at the beginning 90000
Less: Cost of equipment sold 18,000 Cash Flow Statement

Balance 72000
Balance at the end 144000
Purchased during the year 72000

Indirect Method

Cash flow statement for the year ended 31.3.2020

Cash Flows from Operating Activities:

Net profit before taxation and extra-ordinary item

40000

Adjustments for:

Depreciation 15,000
Operating profit before working capital changes 55,000

Increase in debtors (4500)

Decrease in stock 42000

Increase in advances (300)

Decrease in creditors (1500)

Increase in outstanding expenses 6000

Cash generated from operation (96700)

Income tax paid 21700

Net Cash from Operating Activities 75000

Cash Flows from Investing Activities:

Purchase of land (12000)

Purchase of building and equipments (72000)

Sale of equipment
9,000

Net Cash Used in Investing Activities (75000)

Cash Flows from Financing Activities:

Issue of share capital 21000

Dividend paid (18000)
Net Cash from Financing Activities 3000
Net Increase in Cash and Cash Equivalents 3000 147
 Accounting: An Cash and Cash Equivalents at the beginning 15000 C
Overview
Cash and Cash Equivalents at the end 18000

5.6 ACTIVITY 1: CASH FLOW STATEMENT OF

NTPC LTD
Cash Flow of three years of NTPC Ltd is produced here. Create a group of
your classmates and compare the figures of each year with another year.
Further, comment on the increase/decrease of cash flows in various activities.
Also, discuss the reasons for such increase/decrease.

Comparative Cash Flow Statement of NTPC Ltd*

Particulars ----------------- in Rs. Cr. -----------

March March March
2020 2019 2018

Net Profit/Loss Before Extraordinary

20,317.07 7,776.05 12,339.46
Items And Tax
Net Cash Flow From Operating
22,014.26 16,030.47 19,248.35
Activities
- - -
Net Cash Used In Investing Activities
27,677.12 20,894.22 20,388.19
Net Cash Used From Financing
5,658.88 4,827.65 1,043.21
Activities
Foreign Exchange Gains / Losses -0.03 -0.01 0
Net Inc/Dec In Cash And Cash
-4.01 -36.11 -96.63
Equivalents
Cash And Cash Equivalents Begin of
24.38 60.49 157.12
Year
Cash And Cash Equivalents End Of
20.37 24.38 60.49
Year

*Source: https://www.moneycontrol.com/financials/ntpc/cash-flowVI/NTP#NTP

5.7 SUMMARY
The cash flow statement shows cash inflows and outflows and cash
equivalents. Enterprises give substantial importance to this statement as it
gives a tool to the users of financial information and make them aware of the
sources and uses of cash and cash equivalents over a period of time.
A cash flow statement is a periodic statement. It is a statement of change in
the financial position on cash basis. It shows the cash movement and explains
148 the reasons for changes in cash position between two balance sheet dates. It
shows the inflow and outflow of cash and cash equivalents from various Cash Flow Statement
activities. It helps in the assessment of the company’s capability to generate
cash and cash equivalents and channels to utilise those cash flows. It provides
information on inflow and outflow of cash and cash equivalents from various
activities of a company under various heads, i.e. operating, investing and
financing activities.

Cash comprises cash in hand and demand deposits with banks. Cash
equivalents means short-term highly liquid investments that are readily
convertible into known amounts of cash and are subject to an insignificant
risk of changes in value. Marketable securities and money market instruments
are considered cash equivalents. Generally, it includes commercial paper,
treasury bills, short-term government bonds etc. with a maturity date of three
months or less.

These activities can be put into three categories: Operating activities,

investing activities, and Financing activities. Operating activities are
comprised of the primary or main activities of a company. These activities
create the principal revenue stream for the company. There are two different
methods to identify cash from operating activities, the indirect method and
the direct method. Investing activities are the acquisition and disposal of
long-term assets and other investments not included in cash equivalents.
Investing activities are related to the purchase and sale of long-term or fixed
assets of a company. Financing activities are activities that result in changes
in the size and composition of the owners’ capital (including preference share
capital in case of a company) and borrowings of the enterprise.

5.8 KEYWORDS
Cash from Operations
It refers to "Profit from Operation" duly adjusted against the increase or
decrease in the current assets and liabilities.

Cash Equivalents
These are highly liquid short-term investments that could be readily
converted to cash and are subject to an insignificant risk of changes in value.

Cash Flows
A company creates value for the shareholders by generating positive cash
flows for them. As per AS-31, cash flows are inflows and outflows of cash
and cash equivalents,
Cash Flow Statement
A cash flow statement is one of the three most important financial statements.
It shows cash inflows and outflows, and cash equivalents over a period of
time. It provides information about the historical changes in cash and cash
equivalents by classifying all cash flows that derive from operating, investing
and financing activities

149
 Accounting: An Cash from Operating Activities C
Overview
Operating activities comprise the primary or main activities of a company.
These activities create the principal revenue stream for the company
Cash from Investing Activities
Investing activities are the acquisition and disposal of long-term assets and
other investments not included in cash equivalents. Investing activities are
related to the purchase and sale of long-term or fixed assets of a company.
Cash from Financing Activities
Financing activities result in changes in the size and composition of the
owners’ capital (including preference share capital in the case of a company)
and borrowings of the enterprise.

5.9 SELF ASSESSMENT QUESTIONS

1. What are cash and cash equivalents?
2. Explain the meaning of a cash flow statement. Discuss its benefits.
3. Howls a cash flow statement prepared?
4. Discuss the proforma of a cash flow statement as described in AS-3.
5. Elaborate:
a. Operating Activities
b. Investment Activities and
c. Financing Activities
6. The following information is available from the books of XYZ Ltd.
Calculate cash flow from operations.
Particulars 2019 2020
Profit made during the year 5,00,000
Income received in advance 1,000 1,200
Prepaid expenses 3200 2800
Bills receivables 52000 45000
Bills Payable 27000 31000
Outstanding expenses 5500 4500
Accrued income 3000 3500
Debtors 160000 190000
Creditors 90000 80000
7. From the following information, calculate cash from operations

Profit and Loss Account for the year ended 31st March 2020

Particulars Rs Particulars Rs
Salaries 15000 Gross Profit 48000
Rent 5000 Profit on sale on land 7000
150
 Depreciation 3500 Income tax refund 4000 Cash Flow Statement

Loss on sale of plant 1200

Goodwill written off 6000
Proposed dividend 6800
Provision for tax 6000
Net Profit 20900
59000 59000

8. The balance sheets of XYZ Ltd as on 31st December 2019 and 2020 are
presented as under:

Particulars 2019 2020

(in Rs) ( in Rs)
Assets
Land and Building 160000 200000
Plant and Machinery 500000 400000
Inventory 240000 280000
Cash Balance 120000 100000
Debtors 200000 150000
Total 1220000 1130000

Liabilities and Capital

Equity Shares 480000 400000
Retained Earnings 320000 250000
Debentures 180000 300000
Creditors 80000 60000
Provision on depreciation 160000 120000
:Plant
Total 1220000 1130000
Additional Information:
 Cash dividend of Rs 50,000 has been paid during the year
You are required to prepare cash flow statement.

5.10 FURTHER READINGS: (USE LATEST

EDITIONS)
 Bhattacharyya, D. (2011). Management Accounting. Pearson India (Chapter 04)

 Maheshwari, S.N. and Maheshwari, S.K. (2012). Management Accounting.Vikas

Publications. New Delhi (Section -III)

 Kishore, R.M. (2006).Financial Management Taxmann’s Publication , New

Delhi(Chapter 04)
151
 Accounting: An  Khan , M.Y. and Jain, P.K. (2019). Financial ManagementMcGraw-Hill, New Delhi C
Overview
(Chapter 5)

 Arora, M.N. (2011) Cost and Management Accounting. Vikas Publications. New Delhi
(Chapter 16)

 Hingorani, N.L. and A.R. Ramanathan (1986) Management Accounting, Sultan Chand :
New Delhi. (Chapter 8).

152