accounting formanagers notes ( unit - i )

7/31/2019 Accounting ForManagers Notes ( Unit - I )

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Chapter 1: Introduction to Financial Accounting

Accounting is the language of business. It requires the systematic record keeping of

all that happens on a day to day basis in business and analyzing this information

to aid business decision making. The primary intension of financial accounting is thepreparation of the statement revealing the income and financial position of the

business on the basis of the events. The major financial statements are Profit and

Loss A/c, Balance Sheet, Cash Flow Statement etc

I. UNDERSTANDING BUSINESS ORGANIZATIONS:

Business organizations offer goods and services in order to earn a profit.

Receiving and paying cash are central to the activities of business organizations.

Business organizations that provide goods are of two kinds:

Merchandising (Trading) Organizations: buy and sell goods withoutany processing.

Manufacturing Organizations: buy materials, process them intofinished products, and sell them.

Service Organizations: are businesses that provide services.Unlike goods, services do not have either form or substance, and, therefore,the recipient of a service can only experience them and can not transferthem to another person.

Book-Keeping is mainly concerned with recording of financial data relating to the business operations in a

significant and orderly manner. A book keeper may be responsible for keeping all the records of a business

or only of a minor segment such as position of a customers accounts in a departmental store. A substantial

portion of the book keeper work is of a clerical in nature and is increasingly being accomplished through the

use of mechanical and electronical devices.

II. What is Accounting?

Accounting is often called the language of Business. Accounting, as an information system, is the process of identifying, measuring,

and communicating the economic information of an organization to its userswho need the information for decision making.

The American Institute of Certified Public Accountants defines accounting as "the art

of recording, classifying and summarizing in a significant manner and in terms ofmoney transactions and events which are, in part at least, of a financial character,

and interpreting the results thereof.

This definition brings out the following as attributes of accounting:

Events and transactions of a financial nature are recorded while the events of anon-financial nature cannot be recorded.


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The record should reflect the importance of the transactions so recorded bothindividually and collectively, which includes summarization, thereby making itamenable to analysis.

The users of the financial statements should be able to obtain the messageencompassed in such financial statements, and it is the knowledge of accountancy,which enables the user to understand the contents of the financial statements.

The Accounting Information System

Accounting Process:

Recording: Recording commences when a business transaction occurs and it has

been quantified. A record of all these transactions is maintained in the order in which

they occur in the Journal Book.

Classifying: It refers to the rational segregation of the recorded information into

related groups so as to make the record useful. The book containing such classified

information is called the Ledger Book consisting of a number of accounts each

complete in its own way. For example, all the receipts forming inflows and the

payments forming outflows are grouped to ascertain the net cash position of the firm.

The arrangement in this case is better known as the Cash Book.

Summarizing: After the Recording and Classification phases are complete the

accounts containing relevant information in the Ledger Book are to be balanced and

the balances listed. The Statement giving names of these accounts and their

respective balances is called the Trial Balance. On the basis of the Trial Balance the

summaries are generated to provide information about the Profit / Loss and the

INPUT PROCESS OUTPUT

RecordingClassifyingSummarizingAnalyzingInterpreting

Communicatin

g information

to users ( P&L

A/c, B/S, CFS,

etc)

Economic

events

measured in

financial

terms


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Position of the firm. The reporting of these summaries is done through Financial

Statements.

Financial Statements can be defined to include the Balance Sheet, the Profit and

Loss Account, Notes to the Accounts and other incidental statements and explanatory

material which are identified as part of financial statements.

Information and the Accounting Process

Identificationwhats relevant? Measurementwhich yardstick? Classification and accumulationhow do you organize the results of thousands

of events? Summarizationhow much information is enough, but not too much? Communicationhow often, when, and to whom?

Qualities of Accounting Information

Information should be useful, but what does that mean? The two primary qualities of

useful information are:

1) Relevance--the information must pertain to the decision at hand. That suggests

it will havepredictive and feedback value and should be timely.

2) Reliability--the information must reasonably reflect the real-world situation that

it represents. To do so, it must be free of bias and verifiable.

Other Qualities of Useful Information

Understandability--the information must be understood to be useful. Users are

assumed to have a general knowledge of business and a very basic knowledgeof accounting. Comparability--the information must be reported so that comparisons between

similar entities can be made. Consistency--the same accounting methods must be used from period to

period to evaluate results over time.


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S T E P 1

S T E P 2

S T E P 3

S T E P 4

S T E P 5

S T E P 6

S T E P 7

I d e n t i f i c a t i o n o f

T r a n s a c t i o n

P r e p a r a t i o n o f

B u s i n e s s D o c u m e n t s

R e c o r d i n g o f

T r a n s a c t i o n i n J o u r n a l

P o s t i n g t o L e d g e r

P r e p a r a t i o n o f

U n a d j u s t e d T r a i l B a l a n c e

P a s s i n g o f A d j u s t i n g E n t r i e s

P r e p a r a t i o n o f A d j u s t e d

T r a i l B a l a n c e

P r o f i t & L o s s A c c o u n t

B a l a n c e S h e e t

F u n d F l o w S t a t e m e n t

Figure 1.1: The Accounting Process

III. ACCOUNTING INFORMATION AND ECONOMIC DECISIONS:

Accounting information is useful in making a number of decisions that affect the

income or wealth of individuals and organizations. Accounting reports are designed to

meet the common information needs of most decision makers. Examples of decisions

that are based on accounting information include the following:

1. Decide when to buy, hold or sell an equity investment.2. Assess the stewardship or accountability of mgt.3. Assess the ability of the enterprise to pay and provide other benefits to its

employees.4. Assess the security for amounts lent to the enterprise.

5. Determine distributable profits and dividends.6. Determine taxation policies.7. Prepare and use national income statistics.8. Regulate the activities of enterprises.

The decision maker who intends to use accounting information should have a

reasonable understanding of business and economic activities and be willing to study


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the information with reasonable diligence. A sophisticated understanding of

accounting is an indispensable part of the tool-kit for most decision makers.

IV. CLASSIFICATION OF ACCOUNTING:

In order to satisfy needs of different people interested in the accounting

information, different branches of accounting have developed.

Accounting is generally classified into three different disciplines as shown

in Figure.

A c c o u n t i n g

F i n a n c i a lA c c o u n t i n g

C o s tA c c o u n t i n g

M a n a gA c c o u n

Figure 1.2 Classification of Accounting

Financial Accounting: Its primary intention is to prepare the Statements revealing

the Income / Loss and financial position of the business on the basis of events, which

have happened in the period being reckoned.

But this information, though of immense vitality does not adequately aid the

management in planning, controlling, organizing and efficiently conducting the courseof the business as a result of which Cost Accounting and Management Accounting are

in place.

Cost Accounting: It shows classification and analysis of costs on the basis of

functions, processes, products, centers etc. It also deals with cost computation, cost

saving, cost reduction, etc.

Management Accounting: Management Accounting begins where Financial

Accounting and Cost Accounting ends.It deals with the processing of data generated

in financial accounting and cost accounting for managerial decision-making. It also

deals with application of managerial economic concepts for decision-making.

V. OBJECTIVES OF ACCOUNTANCY:

1. Maintaining Accounting records: Systematic recording of the monetarytransactions of the firm is the initial step leading to the creation of the financialstatements. Once recording is complete, the records are classified andsummarized to depict the financial performance of the enterprise.2. Calculating the results of Operations: The Income Statement also known


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as the Profit and Loss Account is prepared to reflect the profits earned or lossesincurred. All the expenses incurred in the course of conducting the business areaggregated and deducted from the total revenues to arrive at the profit earned orloss incurred during the relevant period.3. Ascertaining the financial position: Financial health or position isascertained with the help of the Balance Sheet. On the right hand side of the

Balance Sheet are the Assets or the resources owned by the firm. On the left handside are the Liabilities or the obligations of the business to the outsiders and theowners. The owners' portion is called the Capital and is to be distinguished fromthat of the other liabilities such as loans and creditors. All of them are grouped inthe respective heads under the Liabilities. This information on the assets andliabilities, with the help of accountancy, provides control over the resources of thefirm.4. Accounting is the precursor to financial reporting: The vital liquidity /solvency position is comprehended through the Cash and Funds Flow Statementelucidating the capital transactions, obtaining of cash and the way it has beenexpended, loans and their repayment, cash dividends, etc.5. Communicating the information to the users: Financial statements so

compiled are of great use to a variety of users including the provision of a firmbase for the computation of the statutory tax liability and the consequent filing ofreturn of income.

VI. ADVANTAGES OF ACCOUNTING:

It facilitates:

to replace memory.

to comply with legal requirements.

to ascertain Net results of operations.

to ascertain Financial position.

the users to take decisions.

a compliance study. control over assets.

the settlement of tax liability.

the ascertainment of value of business.

raising of funds.

Acts as legal evidence

VII. USERS OF FINANCIAL STATEMENTS:

Investors and lenders are the most obvious users of accounting information. Their

decisions and their uses of information have been studied and described to a much

greater extent than those of other user groups. However, financial reports are also

extensively used by other individuals and groups who have to rely on them as their

major source of financial information. Potential users of accounting information

include:

Internal Users: They include Board of Directors, Partners, Managers, and Officers.


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They need information for planning and controlling operations, formaking special decisions, and for formulating major plans and policies.

Managers use accounting information to evaluate potential investmentprojects.

Management examines the competition in the industry and makesfinancial comparisons of its performance against competitorsperformance.

II. External Users:A). Financing Group:

a) Investors: Accounting information enables investors to identifypromising investment opportunities. They need information to decidewhich investments to buy, retain, or sell, as well as the timing of thepurchases or sales of those investments. They also need informationto monitor management performance and to assess the ability of theenterprise to pay dividends.

b) Lenders: Lenders such as banks and denture-holders need to knowabout the financial stability of a business that approaches them forfunds. They are interested in information that enables them todetermine whether their loans, and the related interest will be paidwhen due.

c) Suppliers: Present and potential suppliers are interested in theenterprise as an outlet for their products or services and, if theenterprise is a major customer, they will be interested in assessingthe likelihood of the situation continuing. They are interested ininformation that enables them to determine whether amounts owedto them will be paid when due.

B). Public Group:

a) Government Agencies: The three levels of government in India central, state and local - are interested in the allocation of resourcesand, therefore, in the activities of enterprises. They also requireinformation in order to regulate the business practices of enterprises,determine taxation policies, and provide a basis for national incomeand similar statistics.

b) Employees: They are interested in information about the enterpriseabout the enterprise as well as its general operations, stability andprofitability.

c) Customers: Present, potential and past customers are interested inthe financial affairs of an enterprise in deciding how much businessto do with it, and in assessing the likely ability of the enterprise toservice to the product or to honor warranty agreements.

d) Security Analysts and Advisers: They serve the needs ofinvestors by providing them with skilled analyses and interpretationof financial reports. Securities firms to recommend to their clientswhether to buy, sell or hold their investments use Analysts reports.

Basic Terms


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Assets - resources owned by a business Liabilities - debts and obligations of the business Common stock - stock representing the primary ownership interest in a

corporation Expenses: Expenses are the costs of assets consumed or services used to

generate revenues

Examples... Store operating expenses, General and administrative expenses,Interest expense

Auditor's ReportGeneral Guide for Financial Accounting

Generally Accepted Accounting Principles

Accounts Provide the the most useful financial information forDecision Making

Primary Accounting Setting Body in the U.S.

1. Financial Accounting Standards BoardGAAP Are the Rules, The FASB makes the rules.

Accounting Concepts Basic assumptions or conditions upon which the science of accounting is

based. Accounting Conventions

Principles or theories based on which accounting is done.

Money Measurement Concept: In financial accountancy, an event is recorded, only if itcan be expressed in monetary terms. Recording, classification and summarization of

business transactions requires a common unit of measurement, which is taken as money.

Hence, all transactions are recorded through a common denominator money. Thus, if acertain event, no matter how significant for the health or even existence of the business,

cannot be measured in monetary terms, that event is not recorded in accounting. Money is

expressed in terms of its value at the time an event is recorded in the accounts.

Business Entity Concept: The business is distinctly different and separate from its owner.A business entity or a company is an artificial company created by law, who has a common

seal, which has a perpetual existence and does not die natural death. Hence for accountingpurpose, the owner and his business should be kept separate. Accounting records are kept

from the point of view of the business unit and not the owner. So, if the owner contributesfund to the business, it will be treated as a liability of the business say the business owesthis much to the owner.

Going Concern Concept: A business entity is having a perpetual existence, which doesnot die a natural death. It is assumed to carry on its operations forever. It implies that the


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resources of the concern would continue to be used for the purposes for which they are

meant to be used.

For instance, in a manufacturing concern, the land, buildings, machinery etc., are primarily

required for carrying out the production and selling of certain products. This concept

implies that these land, buildings, machinery etc., would continue to be used for thispurpose.

Cost Concept: Cost Concept implies that in accounting, all transactions are generallyrecorded at cost, and not at market value. For example, if a piece of land is acquired for

Rs.1 lakh, it would continue to be shown in the balance sheet at Rs.1 lakh, even when themarket value of the land rises to say Rs.10 lakhs. Why should this be so? This is because

cost concept is in fact closely related to the going concern concept.

Duality concept: This is the fundamental accounting equation, which is the formalexpression of the dual aspect concept. To reflect the two types of equities, the equation ismore commonly expressed as

ASSETS =LIABILITIES + OWNERSEQUITY

OR

TOTAL ASSETS =TOTAL LIABILITIES

ASSETS

Debit for

Increase

Credit for

Decrease

LIABILITIES

Debit

for

Decrease

Credit for

Increase

EQUITIES

Debit

for

Decrease

Credit for

Increase

Each of the permanent accounts areaffected by debits and credits.

A = L + OE

The Accounting Identity

Period Concept: A business entity is an artificial person having a perpetual existence. Tomeasure income generated by the business or loss incurred by the business, the infinite life

of the business is broken into small pieces called accounting periods. End of each such


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period it is ascertained what income the business generated or what loss the business

incurred and what the financial position of the business is? These small periods are known

as accounting period. Generally accounting period is one year January 01 to December31 as in US and April 01 to March 31 as in India.

Matching Concept: In order to ascertain profit or incurred some loss in an accountingperiod, the expenses related to this period must be compared or matched with the revenuesgenerated during this period.

Realization Concept: Realization concept deals with the point in time at which revenue maybe deemed to be realized or when a sale can be said to have taken place. Normally revenue is

recognized at the time of transfer of goods or services when a return consideration is eitherobtained immediately or there exists a reasonable certainty of receiving a return consideration

in future.

For example: If a customer buys Rs 500 worth of the items at grocery stores,

paying cash, the stores realizes Rs 500 from sale. If a department stores sells asuit for Rs 3000 the purchaser agreeing to pay within 30 days, the store realizes

Rs 3000(in receivables)from the sale, provided that the purchaser has a good

credit record so that payment is reasonably certain.

Accrual Concept: The accrual basis of accounting recognizes revenues when sales are

made or services are preformed, regardless of when cash is received. Expenses are

recognized as incurred, that is, when goods are used or services are received, whetheror not cash has been paid out. Net profit equals the revenues earned less expenses

incurred during a period.

B) Accounting Conventions:

The term convention denotes circumstances or traditions which guide the

accountant while preparing the accounting statements. The following are the

important accounting concepts:

1. Consistency

2. Full Disclosure

3. Conservatism

4. Materiality


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Conservatism Concept: This principle emphasizes that revenues and profits should beaccounted only when there is a reasonable surety of recognizing it but any anticipated loss or

expense should be immediately accounted for.

Materiality Concept: It states that insignificant events may be disregarded, but there mustbe full disclosure of all important information.

Consistency Concept: The consistency concept requires that once an entity has decided onone method, it will treat all subsequent events of the same character in the same fashionunless it has a sound reason to change the method of treatment of that transaction. For

example, if a concern is valuing its inventory by a particular method in one year it is

expected to value its inventory in the subsequent years also in the same method unlessthere is a strong reason to change the same.

Full Disclosure: According to this convention all accounting statements should behonestly prepared and to that end full disclosure of all significant information should be

made. On the other hand, if there is no detailed disclosure in the profit and loss account

undisclosed reserves accumulated in the past periods may be used to swell the profits in theyear when the company is failing badly and the shareholders may be misled into thinking

that company is making profit.

FORMS OF BUSINESS ORGANISATION:

1. Sole Proprietorship: A single individual carries on a business. All the profits

the business might earn go to him. The sole proprietors liability is unlimited, that

is, shall the business fall into debt, and he is personally liable for paying off the

debts.

2.Partnership: It comprises between two and twenty persons trading togetheras one firm and sharing in the profits. As well as sharing the profits, each partner

shares unlimited liability for all the debts and obligations of the firm.

3. Limited Company: It is a legal entity and is treated by the law like a natural

person. It must be run according to the rules laid down by the company law.

Systems of Accounting

Cash Basis: Revenue recorded only when cash is received.Expense recordedonly when cash is paid. Cash Basis in not GAAP

Accrual Basis: Adheres to the: Revenue Recognition Principle, Matching principle Revenue recorded only when earned not when cash is receivedExpense

recorded only when incurred not when cash paid Accrual Basis adheres to...Generally Accepted Accounting Principles

ACCOUNTING MECHANISM:

1. Recording


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Journalizing: The daily business transactions are recorded in the order of their

occurrence in a book called Journal. Recording of entries in the journal is known as

journalizing. Journals aid the recording process by

Disclosing in one place the complete effect of a transaction; Providing a chronological record of transactions; Helping prevent or locate errors because debit and credit amounts can be

easily compared.2. Classifying

Ledger preparation: The process of transferring entries from thejournal to the ledger is called ledger posting. Ledger contains a classifiedsummery of all transactions recorded in journal.

3. Summarizing:

Balancing the ledger: means to make the total of amounts columnappearing on the debit and credit side equal to each other. If debit sideis bigger than the credit side, the difference between the two sides isknown as debit balance and vice versa.

Preparation of Trial Balance: Trial Balance is a statement of debitand credit totals or balances extracted from the various accounts in theledger with a view to test the arithmetical accuracy of the books.

Preparation of Profit and Loss A/c: It is prepared to know theoperating efficiency of the firm in terms of profit made or loss incurredduring an accounting period.

Preparation of Balance Sheet: It is a statement prepared with a viewto measure the financial position of a business on a certain fixed date. Itgives a true and fair view of the states of affairs of the business.

II.DOUBLE ENTRY SYSTEM:

The method of writing every transaction in two accounts is known as Double

entry System of Accounting. Of the two accounts, one account is given debit while

the other account is given credit with an equal amount. Thus, on any date, the total of

all debits must be equal to the total of all credits because every debit has a

corresponding credit.Total Debits = Total Credits

Rules of Double Entry System:

There are separate rules of the Double entry system in respect of Personal, real andnominal accounts which are discussed below:


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R u l e s o f D e b i t a n d C r e d i t

P e r s o n a l A c c o u n t sR e a l A c c o u n t s N o m i n a l A c c o u

T h e r e c e i v e r

T h e g i v e r

D e b i t :

C r e d i t :

W h a t c o m e s i n

W h a t g o e s o u t

A l l e x p e n s e s a n d l

A l l i n c o m e s a n d g

Figure 2.1 Rules of Double entry

III. CLASSIFICATION OF ACCOUNTS:

A) Personal Accounts: Personal account includes the account of persons withwhom the business deals. These account can be classified into threecategories

1. Natural personal Account Example: Mohans account, Sohans account.2. Artificial personal account-An account recording financial transaction withan artificial person created by law. Example: Account of club, Government, Bank.3. Representative Personal account-An account indirectly representing aperson is known as a representative personal account. Example: Salariesoutstanding account, prepaid Insurance account.

B) Impersonal Accounts:

1. Real Account: It represents assets like plant and machinery, land and buildings

goodwill, etc. As on a particular date, this account shows the worth of the asset.

2. Nominal Account: It consists of different types of expenses or incomes or loss of

profit. These accounts show the amount of income earned or expenses incurred for a

particular period say a month, a year, etc.

A c c o u n t s

P e r s o n a l A c c o u n t s

E g . I n d i v i d u a l s , F i r m s ,

C o m p a n i e s , B a n k s , e t c .R e a l A c c o u n t s

A s s e t s l i k e c a s h , l a n d ,

b u i l d i n g s , p l a n t a n d

m a c h i n e r y , p a t e n t s ,

g o o d w i l l m , e t c .

I m p e r s o n a

N o m i n a l

A c c o u n t s

R e l a t e t o e

o r l o s s e s

i n c o m e s o


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Figure 2.2 Types of Accounts

Opening Entry

All previous years assets and liabilities of B/S are brought forward to the current year

as an opening entry. All asset a/cs are debited All liability a/cs are credited.The

excess of assets over liabilities are credited to capital account.

Chapter 2: Final AccountsTRIAL BALANCE

A list of all the accounts and their balances at a given time. It serves to prove the

mathematical equality of debits and credits after posting. It aids in the preparation of

financial statements.

FINANCIAL STATEMENTS:

1. Profit and Loss A/c: It summarizes the results of the operations of an

enterprise for a given time period by disclosing the revenues earned and expenses

incurred. It indicates the operating success of a business in a period by measuring

the net profit earned by it.

2. Balance Sheet: It presents an enterprises assets, liabilities, and owners

equity at a particular point of time. It summarizes the resources of an enterprise

and the claims to those resources by owners and creditors of the enterprise on a

certain date.

3. Statement of Cash Flows: It reflects the major sources of cash receipts andcash payments of an enterprise. It reports the cash effects during a period of not

only the enterprises operations but also its investing and financing activities.

CAPITAL AND REVENUE ITEMS

Capital Expenditure:

The benefit of which is not fully derived in one year but spread over severalperiods.

Eg: Acquisition of assets, additions to fixed assets

Revenue Expenditure:

The benefit of which is derived in the year in which the expenditure wasincurred.

Eg: Raw material, Rent, wages and salaries.


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FINAL ACCOUNTS OF MANUFACTURING FIRMS

Production / Manufacturing A/c: To know the production cost

Trading A/c: To know Gross Profit / Loss

Profit and Loss A/c: To know the Net Profit / Loss Balance Sheet: To know the financial position

FINAL ACCOUNTS OF SERVICE BUSINESS ORGANISATIONS

Receipts and Payments A/c: To know the Cash and Bank balances

Income and Expenditure A/c: To know the Surplus made / Deficit incurred

Balance Sheet: To know the financial position

FINAL ACCOUNTS OF A SOLE PROPRIETOR

Trading A/c: To know the Gross Profit/ Loss

Profit and Loss A/c: To know the operating performance of the businessi.e. Net

profit / Net Loss

Balance Sheet: To know the financial position of the firm on a particulardate.

Trading Account

Overall Result of trading Gives out Gross profit Gross Profit = Sales - Cost of Goods Sold Gross Profit = (Net Sales) (Opening stock +Net purchases+ Direct Expenses -

Closing Stock)Trading Account

Opening Stock

Closing Stock valuation Purchases Sales Direct Expenses Wages,Customs & Import Duty,Freight, carriage and cartage

inwards,Royalty Gas, electricity, water, fuel,Packing materials

Closing Entries Trading Account

1. Trading a/c Dr


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To Opening stock a/c

To Purchases a/c

To Sales returns a/c

To Carriage a/c

To customs duty a/c

To direct expenses a/c

2. Sales A/c Dr

Purchase Returns a/c Dr

Closing stock a/c Dr

To Trading a/c

Trading Account - Importance

Gross profit disclosed helps in controlling operating expenses Gross profit ratio is compared year after year to identify the fall in the figures Comparison of stock figures help in preventing lock-up of funds in stocks In case of new products, it is helpful to fix the sale price

P & L Account - Importance

Net profit/Net loss is an index of profitability of business Comparison of profit over periods helps in assessing the business efficiency Analysis of expenses over periods help in effective control of expenses Profit and expense analysis helps in planning and forecasting the future course

of action.Manufacturing Account

Cost of production Stock

Raw Materials Work in progress

Raw Materials consumed Carriage inwards Direct wages Factory overheads

Factory power Depreciation on factory machines

Sale of scrapFinal Accounts Adjustment Entries


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Sometimes the accountant will come to know that he had not taken some significantinformation into the books of accounts. This apart it not too uncommon that certaintransactions take place during or after the preparation of trial balance. In the abovecases the transactions were not recorded in the books and hence they need to beadjusted in the books. This is done by passing some adjustment entries.

Following the double entry system every adjustment will have a two-fold effect. Put

in other words, the adjustment has to be carried out at two places. Normally the

adjustment takes palace at any two of the following three places

In Trading a/c and Balance Sheet (B/S)

In Trading a/c and Profit & Loss a/c (P & L)

In P & L a/c and B/SAdjustment Entries

1. Closing Stock

2. Outstanding expenses3. Prepaid Expenses4. Accrued Income

5. Income received in advance or unearned income

6. Depreciation

7. Bad debts8. Provision for bad debts

9. Provision for discount on debtors

Closing Stock

Adjustment Taken on credit side of trading account

Closing stock a/c Dr

To Trading a/c

Asset side of Balance Sheet Given in the Trial balance

Means that the closing stock is already adjusted in the cost of sales andhence already accounted for

- Asset side of Balance Sheet

Outstanding expenses

Outstanding expenses are those expenses which are due during the accountingperiod but have not yet been paid

Appears as adjustment Expense a/c Dr

To Outstanding expense a/c

Addition to the concerned expense either in trading or P&L a/c


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Liabilities side of balance sheet Appears in trial balance

Liabilities side of Balance sheetPrepaid expenses

Prepaid expenses are those expenses which have been paid in advance during

the accounting period Appears as adjustment

Prepaid Expense a/c DrTo expense a/c

Deduction to the concerned expense either in trading or P&L a/c Assets side of balance sheet

Appears in trial balance Assets side of Balance sheet

Outstanding Income & Accrued Income

Outstanding income is that income which is due during the accounting period

but has not yet been received Outstanding income & Accrued income Appears as adjustment

Outstanding Income a/c DrTo Income a/c

Addition to the concerned income either in trading or P&L a/c Assets side of balance sheet

Appears in trial balance Assets side of Balance sheet

Income received in advance

Income received in advance is that income which is received during theaccounting period but is not being earned.

Appears as adjustment Income a/c Dr

To Income received in Advance a/c

Deduction to the concerned income either in trading or P&L a/c Liabilities side of balance sheet

Appears in trial balance Liabilities side of Balance sheet

Depreciation

Depreciation denotes the decrease in the value of an asset due to the wearand tear, lapse of time, obsolescence, exhaustion etc.,

As an adjustmentDepreciation A/c Dr

To Fixed Asset A/c

Debit side of P&L a/c


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Deduction from the concerned asset account on assets side of balancesheet

Appears in trial balance Debit side of P&L a/c

Bad debts

Bad debt is a debt that cannot be recovered and is a loss

As an adjustmentBad debts A/c Dr

To Debtors a/c

- Debit side of P& L A/c- Deduction from debtors on the assets side of Balance sheet

Appears in trial balance Debit side of P&L a/c

Provision for Bad & doubtful debts

Provision for the likely Bad and doubtful debts As an adjustment

P&L A/c Dr

To Provision for bad debts a/c

- Add to the bad debts on the debit side of P& L A/c- Deduction from debtors on the assets side of Balance sheet

Provision for Discount on Debtors

Provision for discount is making a provision for the good debts

As an adjustmentP&L A/c Dr

To Provision for discount on debtors a/c

- Add to the discount a/c on the debit side of P& L A/c- Deduction from debtors on the assets side of Balance sheet

All balance sheets are built up from 3 main categories, namely assets, liabilities and

shareholders funds. The relationship between them can be looked at either from the

point of view of shareholders (a proprietary approach) or from the point of view of the

company as a whole (an entity approach). Two forms of the fundamental balancesheet identity can thus be derived:

Proprietary: assets liabilities = shareholder funds

Entity: assets = liabilities + shareholder funds


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Very broadly, all that is being said is that, firstly, what a company owns less what

a company owes is equal to the value of the shareholders funds invested in it and

that, secondly, what a company owns is financed partly by the owners (the

shareholders) and partly by outsiders (the liabilities). Either way, a balance sheet

must by definition, balance.

A proprietary approach balance sheet will look like the following (vertical balance

sheet).

A entity approach balance sheet will look like the following (Horizontal balance

sheet).

Assets

Fixed assets & Current assets:

Assets are something of value to the business, which can either be turned into

cash or used to produce revenue.

Fixed assets

Fixed assets+ Current assets- Current liabilities

=Net assets or capital employed

- Long term liabilities

= Share capital and reserves

LIABILITIES = ASSETS

Equity capital Fixed assets

+ +

Long term liabilities Current assets

+

Current liabilities


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Those assets which are intended for use on a continuing basis in an undertakings

activities.

Examples are buildings, equipment, vehicles. Stocks, for example, are not

regarded as fixed assets since they are acquired either for immediate resale (for

example cigarettes as sold by a tobacconist) or as raw materials for use in

manufacturing operations.

It is intention that determines whether an asset is fixed or not.

Plant and vehicles, for example, are the current assets of a company whose

business it is to manufacture them for sale.

Concepts involved in valuation of fixed assets:Matching

Fixed assets are an example of a good purchased for use over several periods andare not charged entirely against profits of year of purchase but spread over their

years of use.

Cost valuation (historical value)

Going concern basis

Fixed assets are typically included at whatever proportion of cost is still expected

to yield useful benefits in the future. It is assumed that the business will last long

enough for these to be realised, which is quite different from an approach which

valued assets at scrap values.

There are different kinds of fixed assets in the balance sheet such as tangible

fixed assets, investments and intangible fixed assets.

Investments

Shares, loans, bonds and debentures held either as fixed tangible assets or

current assets. These are usually valued at cost.

Intangible fixed assets

Non-monetary fixed asset which is without physical substance. This category of

asset includes not only such identifiable intangibles as patents, trade marks andcopyrights, but also goodwill.

Goodwill

A company is not just a collection of tangible assets. It is, or should be, a going

concern whose total value, by reason of its proven ability to earn profits, is greater

than the sum of its parts. It is the difference between the total value and the sum


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of the parts which constitutes goodwill. It should not be regarded as in any way a

fictitious asset: to be valuable, an asset does not have to be tangible. Goodwill is,

however, very difficult to value objectively and company law does not permit it to

be appear in the balance sheet unless it has been purchased, and even then it is

usually written off immediately or quite quickly. In some group balance sheets an

item appears entitled goodwill arising on consolidation or goodwill onacquisition. This represents the excess of the cost of shares in subsidiary

companies over the book value of their net tangible assets at the date of

acquisition; that is, the parent company was willing to pay more to purchase a

company than the sum of its tangible and net current assets.

Current assets

Comprise those assets which are not intended for continuing use in the business.

Expected to be turned into cash or used in course of trading which can normally

be expected to be turned into cash within one year from the date of the balance

sheet.

Examples include bank balance, prepayments, amount owing from debtors, cash,

stocks.

Stocks are another example ofmatching concept - just how far to take it depends

upon the materialityconcept.

Liabilities

Obligations arising from past transactions or other events and involving a

company in a probable future transfer of cash, goods or services.

Can be classified as current or long term liabilities.

Current liabilities

Obligations which have to be settled within a relatively short space of time.

Examples include amounts owing to creditors, bank overdraft, tax liability

Current assets- Current liabilities

= Net Current Assets or Working Capital (a measure of liquidity).

Fixed assets + current assets - current liabilities

= Capital Employed or Net Assets or Net Worth


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Long term liabilities

Long term liabilities represent the extent to which the firm, not wishing to borrow

further long term funds from shareholders, has borrowed from outsiders. The

major parts consist of both long term loans (not wholly repayable within 5 years)

and medium term loans (repayable within 5 years).

Banks are an obvious source of outside finance and many firms long term

liabilities are in the form of bank loans. These are not the only form of borrowings.

There are also debentures and debenture stocks which may be secured by fixed or

floating charges or may alternatively be unsecured debentures.

Shareholders funds

The shareholders funds section of the group balance sheet is subdivided into

Share Capital and Reserves.

Shareholders differ from debenture holders in three important ways; they areowners of the company, not lenders; they receive dividends (a share of the

profits), not interest; and, except in special circumstances, the cost of their shares

will not be repaid (redeemed) to them by the company.

Shares can be either ordinary or preference. The latter is usually entitled only to a

dividend at a fixed rate, but has priority of repayment in the event of the company

being wound up. Preference shares may be cumulative or non-cumulative.

Every share has a par value but this is not necessarily the same as the issue priceof the shares or their market price. Shares can be issued at more than their par

value: this gives rise to a share premium reserve. Once a share has been issued,

its market price fluctuates from day to day, but this has no effect on the firms

balance sheet.

A company does not have to issue all its shares at once, nor does it have to

request full payment on the shares immediately. Companies normally have

authority to issue (i.e. have authorised capital of) shares even though they have

not issued them. Also shares can be partly paid. For example, a 25p share could

be payable 5p on application for the shares, a further 5p on allotment, when the

directors decide to whom the shares are going to be issued (or allotted), and theremaining 15p in calls. Thus, in summary, one can distinguish authorised, issued,

called up and paid-up share capital.

Reserves


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Reserves consist of the retained profit (or loss), the share premium account and

other reserves such as a revaluation reserve. This is created as a result of the

revaluation of fixed assets on the other side of the balance sheet.

It is very important not to confuse reserves with cash. To say that a company has

large reserves is not the same thing as saying that it has plenty of cash. If acompany has reserves it must have net assets of equal amount, but these assets

may be of any kind (e.g. machinery, stock in trade). Thus it is perfectly possible for

a company to have both large reserves and a large bank overdraft.

An example of a balance sheet

Relation between the P&L statement and the balance sheet

It is worth looking more closely at the link between the profit and loss account and

the balance sheet. How can a company grow that is, how can it increase its

assets? Look again at the identity

(, 000)

FIXED ASSETS

Net fixed assets 100

Investments 50150

CURRENT ASSETS

Stocks 25

Debtors 25

Cash 25

TOTAL ASSETS 225

CURRENT LIABILITIES

Creditors 50

TOTAL ASSETS LESS CURRENT LIABILITIES 175

Long term liabilities 50

125

CAPITAL AND RESERVES

Called up share capital 25

Share premium 75

Profit and loss account 25

SHAREHOLDERS FUNDS 125


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Entity: assets = liabilities + shareholder funds

It is clear that the only ways to increase the assets are to increase the liabilities

(to borrow) or to increase the shareholders funds. How can a company increase

the latter? There are two possibilities: it can issue more shares or it can plough

back profits (assuming of course that it is making some). Ploughing back profits isthe simplest but not necessarily the cheapest source of long term finance for a

company. Also the more a company ploughs back the less, in the short run at

least, there will be available for paying dividends.

accounting formanagers notes ( unit - i )

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