The transactions of a business enterprise for the accounting period are first recorded in the books of original entry, then posted therefrom into the ledger and lastly tested as to their arithmetical accuracy with the help of trial balance. After the preparation of the trial balance, every businessman is interested in knowing about two more facts. They are : (i) Whether he has earned a profit or suffered a loss during the period covered by the trial balance, and (ii) Where does he stand now? In other words, what is his financial position?
For the above said purposes, the businessman prepares financial statements for his business i.e. he prepares the Trading and Profit and Loss Account and Balance Sheet at the end of the accounting period. These financial statements are popularly known as final accounts. The preparation of financial statements depends upon whether the business concern is a trading concern or manufacturing concern. If the business concern is a trading concern, it has to prepare the following accounts along with the Balance Sheet :
- Trading Account; and
- Profit and Loss Account.
But, if the business concern is a manufacturing concern, it has to prepare the following accounts along with the Balance Sheet:
- Manufacturing Account;
- Trading Account ; and
- Profit and Loss Account.
Basically, two types of statements are prepared namely “Income Statement” and ‘Position Statement”. The Income Statement is generally known as Profit and Loss Account. This Profit and Loss Account is further sub-divided either into three parts or two parts according to the nature of the business. As stated above, if the concern is a manufacturing one, the Profit and Loss Account is divided into three sub-sections viz, Manufacturing Account, Trading Account and Profit and Loss Account. On the other hand, if it is a trading concern, then this account is divided into two sub-sections, namely Trading Account and Profit and Loss Account.
The second statement i.e. the “Position Statement” which is popularly known as the “Balance Sheet” is prepared by every type of business concern.
The Balance Sheet is a statement which shows the position of the assets, liabilities and capital in money terms, of an accounting entity as on a given date. A Balance Sheet is a formal representation of the accounting equation indicating that the assets are always equal, in value, to the liabilities plus capital.
Trading Account is prepared to know the Gross Profit or Gross Loss. Profit and Loss Account discloses net profit or net loss of the business. Balance sheet shows the financial position of the business on a given date. For preparing final accounts, certain accounts representing incomes or expenses are closed either by transferring to Trading Account or Profit and Loss Account. Any Account which cannot find a place in any of these two accounts goes to the Balance Sheet.
8.2 TRADING ACCOUNT
After the preparation of trial balance, the next step is to prepare Trading Account. Trading Account is one of the financial statements which shows the result of buying and selling of goods and/or services during an accounting period. The main objective of preparing the Trading Account is to ascertain gross profit or gross loss during the accounting period. Gross Profit is said to have been made when the sale proceeds exceed the cost of goods sold. Conversely, when sale proceeds are less than the cost of goods sold, gross loss is incurred. For the purpose of calculating cost of goods sold, we have to take into consideration opening stock, purchases, direct expenses on purchasing or manufacturing the goods and closing stock. The balance of this account i.e. gross profit or gross loss is transferred to the Profit and Loss Account.
Format of Trading Account
A Trading Account is prepared in “T” form just like every other
account. Though it is an account, yet it is not exactly an ordinary ledger account. It is one of the accounts which are prepared only once in an accounting period to ascertain the gross profit or gross loss of the business. As it is prepared once in a year, columns for date and journal folio are not provided. While preparing a Trading Account, an important point that must be kept in mind is that a closing journal entry is to be recorded in the journal proper. At the end of every accounting period, items of revenue and direct expenses are closed by transferring their respective balances to the Trading Account.
After recording the relevant items of various accounts in the
respective sides of the Trading Account, the balance is calculated to ascertain Gross Profit or Gross Loss. If the total of the credit side is more than that of the debit side, the excess represents Gross Profit. Conversely, if the total the debit side is more than that of the credit side, the excess represents Gross Loss. Gross Profit is transferred to the credit side of the Profit and Loss Account and Gross loss to the debit side of the Profit and Loss Account.
Closing Entries for Trading Account
The journal entries necessary to transfer opening stock,
purchases, sales and returns to the Trading Account are called closing entries, as they serve to close these accounts. These are as follows: 1. For transfer of opening stock, purchases and direct expenses to Trading A/c
Trading A/c Dr.
To Stock (Opening) A/c To Purchases A/c
To Direct Expenses A/c
(Being opening stock, purchases and direct expenses transferred to Trading Account)
- For transfer of sales and closing stock to Trading A/c
Sales A/c Dr.
Stock (Closing) A/c Dr.
To Trading A/c
(Being sales, closing stock transferred to Trading Account)
3.(a) For Gross Profit Trading A/c Dr.
To Profit & Loss A/c
(Being gross profit transferred to Profit and Loss Account)
(b) For Gross Loss
Profit & Loss A/c Dr.
To Trading A/c
(Being gross loss transferred to Profit and Loss Account)
Important Points Regarding Trading Account
- Stock
The term ‘stock’ includes goods lying unsold on a particular date.
The stock may be of two types:
- Opening stock
- Closing stock
Opening stock refers to the closing stock of unsold goods at the
end of previous accounting period which has been brought forward in the current accounting period. This is shown on the debit side of the Trading Account.
Closing stock refers to the stock of unsold goods at the end of
the current accounting period. Closing stock is valued either at cost price or at market price whichever is less. Such valuation of stock is based on the principle of conservatism which lays down that the expected profit should not be taken into account but all possible losses should be duly provided for.
Closing stock is an item which is not generally available in the
trial balance. If it is given in Trial Balance, it is not to be shown on the credit side of Trading Account but appears only in the Balance Sheet as an asset. But if it is given outside the trial balance, it is to be shown on the credit side of the Trading Account as well as on the asset side of the Balance Sheet.
- Purchases
Purchases refer to those goods which have been bought for resale. It includes both cash and credit purchases of goods. The following items are shown by way of deduction from the amount of purchases:
- Purchases Returns or Return Outwards.
- Goods withdrawn by proprietor for his personal use.
- Goods received on consignment basis or on approval basis or on hirepurchase.
- Goods distributed by way of free samples.
- Goods given as charity.
- Direct Expenses
Direct expenses are those expenses which are directly attributable
to the purchase of goods or to bring the goods in saleable condition. Some example of direct expenses are as under:
- Carriage Inward
Carriage paid for bringing the goods to the godown is treated as
carriage inward and it is debited to Trading Account.
- Freight and insurance
Freight and insurance paid for acquiring goods or making them
saleable is debited to Trading Account. If it is paid for the sale of goods, then it is to be charged (debited) to Profit and Loss Account.
- Wages
Wages incurred in a business are direct expenses, when they are
incurred on manufacturing or merchandise or on making it saleable. Other wages are indirect wages. Only direct wages are debited to the Trading Account. Other wages are debited to the Profit and Loss Account. If it is not mentioned whether wages are direct or indirect, it should be assumed as direct and should appear in the Trading Account.
- Fuel, Power and Lighting Expenses
Fuel and power expenses are incurred for running the machines. Being directly related to production, these are considered as direct expenses and debited to Trading Account. Lighting expenses of factory are also charged to Trading Account, but lighting expenses of administrative office or sales office are charged to Profit and Loss Account.
- Octroi
When goods are purchased within municipality limits, generally
octroi duty has to be paid on it. It is debited to Trading Account.
- Packing Charges
There are certain types of goods which cannot be sold without a
container or proper packing. These form a part of the finished product. One example is ink, which cannot be sold without a bottle. These type of packing charges are debited to Trading Account. But if the goods are packed for their safe despatch to customers, i.e. packing meant for transportation or fancy packing meant for advertisement, will appear in the Profit and Loss Account.
- Manufacturing Expenses
All expenses incurred in manufacturing the goods in the factory
such as factory rent, factory insurance etc. are debited to Trading Account.
- Royalties
These are the payments made to a patentee, author or landlord
for the right to use his patent, copyright or land. If royalty is paid on the basis of production, it is debited to Trading Account and if it is paid on the basis of sales, it is debited to Profit and Loss Account.
- Sales
Sales include both cash and credit sales of those goods which
were purchased for resale purposes. Some customers might return the goods sold to them (called sales return) which are deducted from the sales in the inner column and net amount is shown in the outer column. While ascertaining the amount of sales, the following points need attention:
- If a fixed asset such as furniture, machinery etc. is sold, it should
not be included in sales.
- Goods sold on consignment or on hire purchase or on sale or
return basis should be recorded separately.
- If goods have been sold but not yet despatched, these should not
be shown under sales but are to be included in closing stock.
- Sales of goods on behalf of others and forward sales should also
be excluded from sales.
MANUFACTURING ACCOUNT
Manufacturing Account is prepared by an enterprise engaged
in manufacturing activities. It is prepared to ascertain the cost of goods manufactured during an accounting period. This account is closed by transferring its balance to the debit of the Trading Account
DIFFERENCE BETWEEN TRADING ACCOUNT AND
MANUFACTURING ACCOUNT
| Trading Account | Manufacturing Account |
| 1. Trading Account is prepared tofind out the Gross Profit/Gross Loss.
2. The balance of the Tradingaccount is transferred to the Profit and Loss Account. 3. Sale of scrap is not shown in theTrading Account. 4. Stocks of finished goods areshown in the Trading Account. 5. Trading Account is a part of theProfit and Loss Account. |
Manufacturing account is prepared to find out the cost of goods produced.
The balance of the Manufacturing Account is transferred to the Trading Account. Sale of crap is shown in the Manufacturing Account. Stocks of raw materials and workin-progress are shown in the Manufacturing Account. Manufacturing Account is a part of the Trading Account. |
PROFIT AND LOSS ACCOUNT
Trading Account results in the gross profit/loss made by a
businessman on purchasing and selling of goods. It does not take into consideration the other operating expenses incurred by him during the course of running the business. Besides this, a businessman may have other sources of income. In order to ascertain the true profit or loss which the business has made during a particular period, it is necessary that all such expenses and incomes should be considered. Profit and Loss Account considers all such expenses and incomes and gives the net profit made or net loss suffered by a business during a particular period. All the indirect revenue expenses and losses are shown on the debit side of the Profit and Loss Account, where as all indirect revenue incomes are shown on the credit side of the Profit and Loss Account.
Profit and Loss Account measures net income by matching
revenues and expenses according to the accounting principles. Net income is the difference between total revenues and total expenses. In this connection, we must remember that all the expenses, for the period are to be debited to this account – whether paid or not. If it is paid in advance or outstanding, proper adjustments are to be made (Discussed later). Likewise all revenues, whether received or not are to be credited. Revenue if received in advance or accrued but not received, proper adjustment is required.
A proforma of the Profit and Loss Account showing probable items therein is as follows :
PROFIT AND LOSS ACCOUNT
For the year ended ……………
| Particulars | Rs. | Particulars | Rs. | |
| To Gross Loss b/d | By Gross Profit b/d | |||
| To Management Expenses: | By Other Income : | |||
| Rent, Rates and Taxes | Discount received | |||
| Heating and Lighting | Commission received | |||
| Office Salaries | By Non-trading Interest : | |||
| Printing & Stationary | Bank Interest | |||
| Postage & Telegrams | Rent of property let-out | |||
| Telephone Charges | Dividend from shares | |||
| Legal Charges | By Abnormal Gains : | |||
| Audit Fees | Profit on sale of machinery | |||
| Insurance | Profit on sale of investment | |||
| General Expenses | By Net Loss transferred to | |||
| To Selling and Distribution Expenses : Advertisement Tavellers’ Salaries Expenses & Commission Godown Rent Export Expenses Carriage Outwards Bank Charges Agent’s Commission Upkeep of Motor Lorries To Depreciation and Maintenance : Depreciation Repairs & Maintenance To Financial Expenses : Discount Allowed Interest on Loans Discount on Bills To Abnormal Losses: Loss by fire (not covered by Insurance) Loss on Sale of Fixed Assets Loss on Sale of Investments To Net profit transferred to Capital A/c |
Capital Account | |||
Important Points in Profit and Loss Account
- These include salaries paid to office, godowns and warehouse staff and should be shown in Profit and Loss Account being indirect expenses. Salaries to partners must be debited separately.
If salaries are paid after deduction of Income tax or Provident Fund then these should be added back to the salaries in order to have gross figure of salaries to be shown in Profit and Loss Account. If salaries are paid in kind by providing certain facilities to the employees such as house free of rent, meals or cloth or washing facility free of charge, then the value of such facilities should be regarded as salaries.
- Rent, Rates and Taxes. These include offices and warehouse rent, municipal rates and taxes. Factory rent, rates and taxes should be debited to Trading Account and others to Profit and Loss Account. If any rent is received on subletting of the building, the same should be shown separately on the credit side of the Profit and Loss Account. If rent is paid after deduction of some taxes then these should be added back to know the correct amount of rent payable.
- Interest paid on loans, overdrafts and bills overdue is an expense and is taken to the debit side of Profit and Loss Account. Interest received on loans advanced by the firm, on deposits and on securities is a gain and is shown on the credit side of Profit and Loss Account. Interest on capital should be shown separately on the debit side and interest on drawing on the credit side of Profit and Loss Account.
- Commission received for doing the work of other firms may be credited to Profit and Loss Account as a gain and commission payable to the agents employed to sell the firm’s goods is debited to Profit and Loss Account as an expense.
- Repairs and small renewals or replacements relating to the plant and machinery, fixtures, fittings and utensils etc. are generally included under this heading and such expenditure, being as expense, is debited to Profit and Loss Account.
- It is an expense due to wear and tear, lapse of time and exhaustion of assets used in business. This is loss sustained by fixed assets and should be charged to Profit and Loss Account.
- Advertising . All sums spent on advertising should be charged to Profit and Loss Account. If a large amount is paid under a contract covering two or three years, proportionate part should be charged to Profit and Loss Account and the balance appears as an asset in the Balance Sheet.
Expenses not to be shown in Profit and Loss Account
- Domestic and Household Expenses. These expenses are not shown in Profit and Loss Account, as these are personal expenses of the proprietor and should be treated as drawings.
- Income tax. It should be treated as a personal expense of the proprietor and added to It should not be shown as an expense in Profit and Loss Account. (iii) Life Insurance Premium. Premium paid on the life police of the proprietor should be charged to the Drawings Account.
Closing Entries for Profit and Loss Account
- For transfer of various expenses to Profit & Loss A/c
Profit and Loss A/c Dr.
To Various Expenses A/c
(Being various indirect expenses transferred to Profit and Loss Account)
- For transfer of various incomes and gains to Profit & Loss A/c Various Incomes & Gains A/c Dr.
To Profit & Loss A/c
(Being various incomes & gains transferred to Profit and Loss
Account)
(iii)(a) For Net Profit
Profit & Loss A/c Dr.
To Capital A/c
(Being Net Profit transferred to capital
(b) For Net Loss
Capital A/c Dr.
To Profit & Loss A/c
(Being Net Loss transferred to Capital Account)
DISTINCTION BETWEEN TRADING ACCOUNT AND
PROFIT AND LOSS ACCOUNT
| Trading Account | Profit and Loss Account |
| 1. Trading Account is prepared asa part or section of the Profit and Loss Account. 2. Direct Expenses are taken inTrading Account. 3. Gross Profit or Gross Loss isascertained from Trading Account. 4. The Balance of the TradingAccount i.e. Gross Profit or Gross Loss is transferred to the Profit and Loss Account. 5. Items of account written in theTrading Account are few as compared the Profit and Loss Account. |
Profit and Loss Account is prepared as a main account.
Indirect expenses are taken in Profit and Loss Account. Net Profit or Net Loss is ascertained from the Profit and Loss Account. The balance of the Profit and Loss Account i.e. Net Profit or Net Loss is transferred to proprietor’s Capital Account. Items of accounts written in the Profit and Loss Account are much more as compared to the Trading Account. |
8.5 BALANCE SHEET
A Balance Sheet is a statement of financial position of a
business concern at a given date. It is called a Balance Sheet because it is a sheet of balances of those ledger accounts which have not been closed till the preparation of Trading and Profit and Loss Account. After the preparation of Trading and Profit and Loss Account the balances left in the trial balance represent either personal or real accounts. In other words, they either represent assets or liabilities existing on a particular date. Excess of assets over liabilities represent the capital and is indicative of the financial soundness of a company.
A Balance Sheet is also described as a “Statement showing
the Sources and Applications of Capital”. It is a statement and not an account and prepared from real and personal accounts. The left hand side of the Balance Sheet may be viewed as description of the sources from which the business has obtained the capital with which it currently operates and the right hand side as a description of the form in which that capital is invested on a specified date.
Characteristics
The characteristics of a Balance Sheet are summarised as under:
- A Balance Sheet is only a statement and not an account. It has no debit side or credit side. The headings of the two sides are ‘Assets’ and ‘Liabilities’.
- A Balance Sheet is prepared at a particular point of time and not for a particular period. The information contained in the Balance Sheet is true only at that particular point of time at which it is prepared.
- A Balance Sheet is a summary of balances of those ledger accounts which have not been closed by transfer to Trading and Profit and Loss Account.
- A Balance Sheet shows the nature and value of assets and the nature and the amount of liabilities at a given date.
8.5.1 Classification of Assets and Liabilities
Assets
Assets are the properties possessed by a business and the
amount due to it from others. The various types of assets are :
(a) Fixed Assets
All assets which are acquired for the purpose of using them in the conduct of business operations and not for reselling to earn profit are called fixed assets. These assets are not readily convertible into cash in the normal course of business operations. Examples are land and building, furniture, machinery, etc.
(b)Current Assets
All assets which are acquired for reselling during the course of business are to be treated as current assets. Examples are cash and bank balances, inventory, accounts receivables, etc.
(c) Tangible Assets
These are definite assets which can be seen, touched and have volume such as machinery, cash, stock, etc.
(d)Intangible Assets
Those assets which cannot be seen, touched and have no volume but have value are called intangible assets. Goodwill, patents and trade marks are examples of such assets.
- Fictitious Assets
Fictitious assets are not assets at all since they are not represented by any tangible possession. They appear on the asset side simply because of a debit balance in a particular account not yet written off e.g. provision for discount on creditors, discount on issue of shares etc.
- Wasting Assets
Such assets as mines, quarries etc. that become exhausted or reduce in value by their working are called wasting assets.
Liabilities
A liability is an amount which a business is legally bound to
pay. It is a claim by an outsider on the assets of a business. The liabilities of a business concern may be classified as :
- Fixed Liabilities
These are those liabilities which are payable only on the
termination of the business such as capital contributed by the owner.
- Long Term Liabilities
The liabilities or obligations of a business which are not payable within the next accounting period but will be payable within next five to ten years are known as long term liabilities. Public deposits, debentures, bank loan are the examples of long term liabilities.
- Current Liabilities
All short term obligations generally due and payable within one year are current liabilities. This includes trade creditors, bills payable etc.
- Contingent Liabilities
A contingent liability is one which is not an actual liability but which may become an actual one on the happening of some event which is uncertain. Thus such liabilities have two characteristics : (a) uncertainty as to whether the amount will be payable at all, and (b) uncertainty about the amount involved.
Examples of such liabilities are :
- Claims against the companies not acknowledged as debts.
- Uncalled liability on partly paid up shares.
- Arrears of fixed cumulative dividend.
- Estimated amount of contracts remaining to be executed on capital account and not provided for.
- Liability of a case pending in the court.
- Bills of exchange, guarantees given against a particular firm or person.
8.5.2 Grouping and Marshalling of Assets and Liabilities
The arrangement of assets and liabilities in certain groups and in a
particular order is called Grouping and Marshalling of the Balance Sheet of a business. Assets and liabilities can be arranged in the Balance Sheet into two ways :
- In order of liquidity.
- In order of permanence.
- In order of liquidity. When assets and liabilities are arranged according to their reliability and payment preferences, such an order is called liquidity order. Such arrangement is given in the Balance Sheet (I). Balance Sheet (I)
| Liabilities | Rs. | Assets | Rs. |
| Current Liabilities : | Liquid Assets : | ||
| Bills Payable | Cash in Hand | ||
| Sundry Creditors | Cash at Bank | ||
| Bank Overdraft | Floating Assets : | ||
| Long Term Liabilities : | Sundry Debtors | ||
| Loan from Bank | Investments | ||
| Debentures | Bill Receivable | ||
| Fixed Liabilities : | Stock in Trade | ||
| Capital | Prepaid Expenses Fixed Assets : Machinery Building Furniture & Fixtures Motor Car Fictitious Assets : Advertisement Misc. Expenses Profit & Loss A/c Intangible Assets Goodwill Patents Copyright |
||
- In order of permanence. When the order is reversed from that what is followed in case of liquidity, it is called order of permanence. This order is followed in case of joint stock companies compulsorily but can be followed in other forms of business organisations also. Fixed assets and liabilities are shown first on the assumption that these will be sold or paid only on the insolvency of a business. This order of Balance Sheet is given below in Balance Sheet (II).
Balance Sheet (II)
| Liabilities | Rs. | Assets | Rs. |
| Fixed Liabilities | Intangible Assets | ||
| Long Term Liabilities | Fictitious Assets | ||
| Current Liabilities | Fixed Assets
Floating Assets Liquid Assets |
||
ADJUSTMENT ENTRIES
While preparing Trading and Profit and Loss Account one point
that must be kept in mind is that expenses and incomes for the full trading period are to be taken into consideration. For example if an expense has been incurred but not paid during that period, liability for the unpaid amount should be created before the accounts can be said to show the profit or loss. All expenses and incomes should properly be adjusted through entries. These entries which are passed at the end of the accounting period are called adjusting entries . Some important adjustments which are to be made at the end of the accounting year are discussed in the following pages.
- Closing Stock
This is the stock which remained unsold at the end of the
accounting period. Unless it is considered while preparing the Trading Account, the gross profit shall not be correct. Adjusting entry for closing stock is as under :
Closing Stock Account Dr.
To Trading Account
(Being closing stock brought in to books)
Treatment in final accounts
(i) Closing stock is shown on the credit side of Trading Account. (ii) At same value it will be shown as an asset in the Balance Sheet.
- Outstanding Expenses
Expenses which have become due and have not been paid by the
end of financial year, are called outstanding expenses.
For example, when Profit and Loss Account is being prepared on 31st March 31, 2002, it may be found that salaries for the month of March have become due on March 31, 2002 but have not been paid till that date. This must be shown on the debit side of Profit and Loss Account being prepared on March 31, 2002. The entry will be as under :
Salary account Dr.
To Outstanding salary account
(Being salary due but not paid)
Treatment in final accounts :
- The amount of outstanding salary shall be added to particular expenses on the debit side of Profit and Loss Account.
- In balance sheet the same amount will be shown as a liability.
- Unexpired or Prepaid Expenses
Those expenses which have been paid in advance, i.e., whose benefit
will be available in future are called unexpired or prepaid expenses. For example, if a fire insurance policy is taken for a year paying Rs. 1,000 as insurance premium on Ist July, 2000 and will expire on 30th June, 2001, the position on 31st March 2001, when accounts are closed, will be that Rs. 750, i.e., premium from Ist July, 2000 to 31st March, 2001 will be an expense but Rs. 250 i.e., premium from Ist April, 2001 to 30th June, 2001 will be unexpired expense. In order to bring this into account on 31st March, 2001, the following entry will be passed :
Prepaid Insurance Premium A/c Dr. Rs. 250
To Insurance Premium A/c Rs. 250
The two-fold effect of prepaid expenses will be :
- Prepaid expenses will be shown in the Profit and Loss Account by way of deduction from the expenses and
- These will be shown on the assets side of the Balance Sheet as prepaid expenses. In the beginning of the next year, a reverse entry will be passed to nullify the effect of adjusting entry.
- Accrued Income
That income which has been earned but not received during the accounting year is called accrued income. For example, if the business has invested Rs. 10,000 in 5% gilt edged securities on Ist April, 2001 but during the year Rs. 350 has been received as interest on securities. Then Rs. 150 interest on securities earned and due for payment on 31st March, 2002 but not received, will be accrued interest for the year 2001-2002. In order to bring accrued interest into books of account, the following adjusting entry will be passed :
Accrued Interest A/c Dr. Rs. 150
To Interest A/c Rs. 150
The two-fold effect of accrued income will be :
- It will be shown on the credit side of Profit and Loss Account by way of addition to the income, and
- It will be shown on the assets side of the Balance Sheet as Accrued Income.
Next year, in the beginning, a reverse entry will be passed in order to eliminate the effect of adjusting entry and to bring the same to the correct position.
- Income Received in Advance
Income received but not earned during the accounting year is called as income received in advance. For example, if building has been given to a tenant on Rs. 2,400 per annum but during the year Rs. 3,000 has been received, then Rs. 600 will be income received in advance. In order to bring this into books of account, the following adjusting entry will be made at the end of the accounting year :
Rent A/c Dr. Rs. 600
To Rent Received in Advance Account Rs. 600
The two-fold effect of this adjustment will be :
- It is shown on the credit side of Profit and Loss Account by way of deduction from the income, and
- It is shown on the liabilities side of the Balance sheet as income received in advance.
A reverse entry will be passed at the beginning of the next year to
nullify the effect of adjusting entry.
- Depreciation
Depreciation is the reduction in the value of fixed asset due to
its use, wear and tear or obsolescence. When an asset is used for earning purposes, it is necessary that reduction due to its use, must be charged to the Profit and Loss Account of that year in order to show correct profit or loss and to show the asset at its correct value in the Balance Sheet. There are various methods of charging depreciation on fixed assets. Suppose machinery for Rs.10,000 is purchased on 1.1.2001, 20% p.a. is the rate of depreciation. Then Rs.2,000 will be depreciation for the year 2001 and will be brought into account by passing the following adjusting entry :
Depreciation A/c Dr. Rs.2,000
To Machinery A/c Rs.2,000
The two-fold effect of depreciation will be :
- Depreciation is shown on the debit side of Profit and Loss
Account, and
- It is shown on the asset side of the Balance Sheet by way of deduction from the value of concerned asset.
- Interest on Capital
The amount of capital invested by the trader in his business is
just like a loan by the firm. Charging interest on capital is based on the argument that if the same amount of capital were invested in some securities elsewhere, the businessman would have received interest thereon. Such interest on capital is not actually paid to the businessman. Interest on capital is a gain to the businessman because it increases its capital, but it is a loss to the business concern.
Interest is calculated on the opening balance of the capital at
the given rate for the full accounting period. If some additional amount of capital has been brought in the business during the course of accounting period, interest on such additional amount of capital is calculated from the date of introduction to the end of the accounting period. The following adjustment entry is passed for allowing interest on capital :
Interest on Capital Account Dr.
To Capital Account Treatment in final accounts
- Interest allowed on capital is an expense for the business and is debited to Profit and Loss Account, i.e. it is shown on the debit side of the Profit and Loss Account.
- Such interest is not actually paid in cash to the businessman but added to his capital account. Hence, it is shown as an addition to capital on the liabilities side of the Balance Sheet.
- Interest of Drawings
It interest on capital is allowed, it is but natural that interest
on drawings should be charged from the proprietor, as drawings reduce capital. Suppose during an accounting year, drawings are Rs.10,000 and interest on drawings is Rs.500. In order to bring this into account, the following entry will be passed :
Drawings A/c Dr. Rs.500
To Interest on Drawings A/c Rs.500
The two-fold effect of interest on drawings will be :
- Interest on drawings will be shown on the credit side of Profitand Loss Account, and
- Shown on the liabilities side of the Balance Sheet by way ofaddition to the drawings which are ultimately deducted from the capital.
- Bad Debts
Debts which cannot be recovered or become irrecoverable are
called bad debts. It is a loss for the business. Such a loss is recorded in the books by making following adjustment entry :
Bad Debts A/c Dr.
To Sundry Debtors A/c
The two-fold effect of bad debts will be that bad debts will be :
- Shown on the debit side of Profit and Loss Account, and
- Shown on the assets side of the Balance Sheet by way of deduction from sundry debtors.
- Provisions for Doubtful Debts
In addition to the actual bad debts, a business unit may find on
the last day of the accounting period that certain debts are doubtful, i.e., the amount to be received from debtors may or may not be received. The amount of doubtful debts is calculated either by carefully examining the position of each debtor individually and summing up the amount of doubtful debts from various debtors or it may be computed (as is usually done) on the basis of some percentage (say 5%) of debtors at the end of the accounting period. The percentage to be adopted is usually based upon the past experience of the business. The reasons for making provision for doubtful debts are two as discussed below :
- Loss caused by likely bad debts must be charged to the Profit and Loss Account of the period for which credit sales have been made to ascertain correct profit of the period.
- For showing the true position of realisable amount of debtors in the Balance Sheet, i.e., provision for doubtful debts will be deducted from the amount of debtors to be shown in the Balance Sheet.
For example, sundry debtors on 31.03.2002 are Rs.55,200. Further bad debts are Rs.200. Provision for doubtful debts @ 5% is to be made on debtors. In order to bring the provision for doubtful debts of Rs.2,750, i.e., 5% on Rs.55,000 (55,200-200), the following entry will be made :
Profit and Loss A/c Dr. Rs.2,750
To Provision for Doubtful Debts A/c Rs.2,750
It may be carefully noted that further bad debts (if any) will be
first deducted from debtors and then a fixed percentage will be applied on the remaining debtors left after deducting further debts. It is so because percentage is for likely bad debts and not for bad debts which have been decided to be written off.
Treatment in final accounts
- The amount of provision for doubtful debts is a provision against a possible loss so it should be debited to Profit and Loss Account.
- The amount of provision for doubtful debts is deducted from sundry debtors on the assets side of the Balance Sheet.
- Provision for Discount on Debtors
It is a normal practice in business to allow discount to
customers for prompt payment and it constitutes a substantial sum. Sometimes the goods are sold on credit to customers in one accounting period whereas the payment of the same is received in the next accounting period and discount is to be allowed. It is a prudent policy to charge this expenditure (discount allowed) to the period in which sales have been made, so a provision is created in the same manner, as in case of provision for doubtful debts i.e.
Profit and Loss Account Dr.
To Provision for Discount on Debtors Account
Treatment in final accounts
- Provision for discount on debtors is a probable loss, so it should be shown on the debit side of Profit and Loss Account.
- Amount of provision for discount on debtors is deducted from sundry debtors on the assets side of the Balance Sheet.
Note : Such provision is made on debtors after deduction of further bad debts and provision for doubtful debts because discount is allowable to debtors who intend to make the payment.
- Reserve for Discount on Creditors
Prompt payments to creditors enables a businessman to earn
discount from them. When a businessman receives cash discount regularly, he can make a provision for such discount since he is likely to receive the discount from his creditors in the following years also. The discount received being a profit, the provision for discount on creditors amounts to an addition to the profit.
Accounting treatment of Reserve for Discount on Creditors is
just reverse of that in the case of Provision for Discount on Debtors. The adjustment entries for Reserve for Discount on Creditors is as follows :
Reserve for Discount on Creditors Account Dr. To Profit and Loss Account
Treatment in final accounts
- Reserve for discount on creditors is shown on the credit side of Profit and Loss Account.
- In the liabilities side of the Balance Sheet, the reserve for discount on creditors is shown by way of deductions from Sundry Creditors.
- Deferred Revenue Expenditure
The expenditure done in the initial stage but the benefit of which will also be available in subsequent years is called deferred revenue expenditure. Part of such expenditure will be written off in each year and the rest will be capitalised. The entry for this expenditure (say advertisement Rs. 2,000 which will be spread over 5 years) will be :
Profit and Loss A/c Dr. Rs. 400
To Advertisement A/c Rs. 400
The two-fold effect of such expenditure will be :
- It is shown on the debit side of Profit and Loss Account, and
- It is shown on the assets side by way of deduction from capitalised expense.
- Loss of Stock by Fire
In business, the loss of stock may occur due to fire. The position of the business may be :
- All the stock is fully insured.
- The stock is partly insured.
- The stock is not insured at all.
If the stock is fully insured, the whole loss (say Rs. 15,000) will
be claimed from the insurance company. The following entry will be passed :
Insurance Co. A/c Dr. Rs. 15,000
To Trading A/c Rs. 15,000
The double effect on this entry will be :
- It will be shown on the credit side of the Trading Account, and
- It is shown on the assets side of the Balance Sheet.
If the stock is not fully insured, the loss of stock covered by
insurance policy (say Rs. 10,000) will be claimed from the insurance company and the rest of the amount (say Rs. 5,000) will be loss for the business. The following entry will be passed:
Insurance Co. A/c Dr. Rs. 10,000
Profit & Loss A/c Dr. Rs. 5,000
To Trading A/c Rs. 15,000
The two-fold effect of this entry will be :
- It will be shown on the credit side of the Trading Account with the value of stock and shown on the debit side of the Profit and Loss Account for that part of the stock which is not insured, and
- It is shown on the assets side of the Balance Sheet with the amount which is to be realised from the Insurance Co., i.e., that part of the loss which is insured.
If the stock is not insured at all, whole of the loss (say Rs. 15,000)
will be borne by the firm. The entry for this will be :
Profit and Loss A/c Dr. Rs. 15,000
To Trading A/c Rs. 15,000
The double effect of this entry will be :
- It is shown on the credit side of the Trading Account, and
- It is shown on the debit side of the Profit and Loss Account.
- Goods Distributed as Free Samples
Sometimes in order to promote the sale of goods, some of the produced goods are distributed as free samples. For example, if goods worth Rs. 2,000 are distributed as free samples then it will be an advertisement for the concern and on other hand stock will be less by such goods. In order to bring this into books of account, the following entry is passed :
Advertisement A/c Dr. Rs. 2,000 To Trading or Purchases A/c Rs. 2,000
The two-fold effect of this entry will be :
- It is shown on the credit side of the Trading Account, or deducted from the purchases, and
- It is also shown on the credit side of the Profit and Loss Account as advertisement expenses.
SUMMARY
Financial statements are the means of conveying to management, owners and interested outsiders a concise picture of profitability and financial position of the business. The preparation of the final accounts is not the first step in the accounting process but they are the end products of the accounting process which give a concise accounting information of the accounting period after the accounting period is over. In order to know the profit or loss earned by a firm, Trading and Profit and Loss Account is prepared. Balance Sheet will portray the financial condition of the firm on a particular date.
8.8 KEYWORDS
Trading account: It is an account which is prepared to ascertain the gross profit or loss of the business.
Manufacturing account: It is prepared in order to know the cost of production of goods or services manufactured.
Profit and Loss account: The object of profit and Loss Account is to reveal the net profit or loss of the business.
Balance sheet: A balance sheet is a statement which portrays the financial position of the business.
Grouping and marshalling of assets and liabilities: The arrangement of assets and liabilities in certain groups and in a particular order is called grouping and marshalling of the balance sheet of a business.
Prepaid expenses: Those expenses which have been paid in advance i.e. whose benefit will be available in future are called prepaid expenses.
8.9 SELF ASSESSMENT QUESTIONS
- Distinguish between Trading Account and Profit & Loss Account. Give a specimen of Trading and Profit & Loss Account with imaginary figures.
- What is a Balance Sheet? What do you understand by Marshalling used in the Balance Sheet ? Illustrate the different forms of marshalling.
- What are closing entries. Give the closing entries which are passed at the end of the accounting period.
- What are adjustment entries? Why are these necessary for preparing final account.
