Session 1

Introduction to Financial Accounting

Accounting is termed as the language of the business. It is associated with recording, classifying
and summarizing financial transactions and preparing statements relating to the business according
to generally accepted accounting concepts and conventions. It is mainly intended to aid all parties
external to the operating responsibility of company such as shareholders and creditors besides
providing information about the overall operational results of the business.
Concept of financial accounting: In general way, financial accounting is the statement of
information about a business or other type of organization so that executives or staff can assess its
financial growth and future results. The purpose of financial accounting is to ascertain the results
(profit or loss) of business operations during the particular period and to state the financial position
(balance sheet) as on a date at the end of the period.
Financial accounting is based upon the equation: Assets = Liabilities + Owners' Equity
This is a mathematical equation which must balance. In this, assets are valuable resources that are
owned by firm. They represent probable future economic benefit and arise as result of past
transactions or events. Liabilities are present obligations of the firm. They are probable future
sacrifices of economic remunerations which arise as the result of past transactions or events.
Owners' equity signifies the owners' residual interest in the assets of the business.

Basic features of financial accounting are as under:

Relevance: Financial accounting is decision-specific. It must be possible for accounting information
to influence decisions. This trait is important for developing statements.
Materiality: Information is material if its error or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.
Reliability: Accounting must be precise or unbiased. It should be capable to be relied upon by
managers. Often information that is highly relevant isn't very reliable, and vice versa.
Understandability: Accounting reports should be clearly understood to accountant and by those at
whom the information is aimed.
Comparability: Financial reports from different periods should be comparable with one another in
order to derive meaningful conclusions about the trends in an entity's financial performance and
position over time. It can be ensured by applying the same accounting policies over time.

Users of Financial Accounting

1. The equity investor group, including existing and potential shareholders. They want to know
how effectively management is performing and how much profit they can withdraw from the
business for their own use.
2. The lender group, including existing and potential holders of debentures and loan stock, banks
providing long term loans, and providers of short-term secured and unsecured loans and
finance. They want to know if the company is earning adequately to pay them back
3. The employee group, including existing, potential and past employees. They want to know their
growth prospects, increments. Bonuses, promotion etc.
4. The analyst-adviser group, including financial analysts and journalists, economists, statisticians,
researchers, trade unions, stockbrokers and other providers of advisory services such as credit
rating agencies. They need information for their clients. For eg, credit agencies want
information to advise potential suppliers of goods to the company, journalists need information
for their reading public, researchers need the information for their research etc
5. The business contact group, including customers, trade creditors and suppliers and, in a
different sense, competitors, business rivals and those interested in mergers, amalgamations and
takeover. For eg., Suppliers want to know about the company’s ability to pay its debts.
6. The government, including tax authorities, departments and agencies concerned with the
supervision of commerce and industry, and local authorities. Regulators like Registrar of the
company, Company Law Board; SEBI studies company books of accounts to ensure the
compliance of various Acts. The Tax authorities, ED require the information for ensuring
accuracy of tax returns.
7. The public, including taxpayers, ratepayers, consumers and other community and special
interest groups such as political parties, consumer and environmental protection societies and
regional pressure groups. They want accounting information because enterprises affect them in
many ways, for e.g. by providing jobs and using local suppliers, or by affecting the environment
(e.g. pollution)
8. The auditor group including internal auditors as well as external auditors (statutory)need the
accounting information for the audit, i.e., for checking the accuracy of the books of accounts
and reporting compliance to the Companies Act.

Drawbacks of Finance Accounting

1. It allows subjective treatment of transactions. Although, accounting is based on concepts and it

follows "generally accepted accounting principles", but there exists more than one principle for
the treatment of any one item.
2. Financial accounting is impacted by personal judgments in spite of the fact that convention of
objectivity is respected in accounting. To record certain events, estimates have to be made
which requires personal judgment.
3. It overlooks important non-monetary information. Financial accounting takes into consideration
only those transactions and events which can be translated into money.
4. Financial accounting does not give information on time, i.e., at the end of the year through
Balance Sheet and P/L a/c. So the information is of historical interest and only post-mortem
analysis of the past can be conducted.
5. Financial accounting does not offer comprehensive analysis. The information supplied by the
financial accounting is in reality aggregate of the financial transactions during the year.
6. Financial accounting does not reveal the present value of the business. In financial accounting,
the assets in the balance sheet are shown on the basis of going concern concept.
To summarize, financial accounting are basically, financial statements means of communicating
financial information to parties outside the business organization. Financial accounting includes the
monitoring and controlling of the flow of money into and out of a company. Those flows are
documented on financial statements such as the balance sheet, income statement and cash flow
statement which provide insightful information to external parties who have a vested interest in the
company's performance.
 Session 2: Generally Accepted Accounting Principle

Accounting Principles are the guidelines that assist the companies to record business
activities/transactions. Although these principles are not mandatory by law however, they are
generally accepted by accounting bodies world over. These guidelines are intended to promote
consistency in recording process and therefore help the accountants in tackling the dilemmas that
can arise while preparing financial statements.

Financial accountancy is directed by both local and international accounting standards. Generally
Accepted Accounting Principles is the standard framework for guidelines for financial accounting
used in any given jurisdiction. It encompasses the standards, conventions and rules that accountants
follow in recording and summarizing and in the preparation of financial statements. Conversely,
International Financial Reporting Standards is a set of international accounting standards stating
how particular types of transactions and other events should be reported in financial statements.

Accounting Principles (GAAP) are classified into:

A. Accounting Concepts; and

B. Accounting Conventions

A. Accounting Concepts are the basic assumptions that an accountant makes in order to record a
business transaction. These concepts are:

1. Separate Business Entity concept- It assumes that the owner and the business are two different
accounting entities and therefore there should be a careful separation for the owner’s personal
transactions with the business transaction. For example, if the owner invest capital in the business,
it is considered as liability of the business.

2. Going Concern Concept– It assumes that the business will continue for a long period of time and
will not wind up in the foreseeable future. This means that business will not have to sell its assets
any time soon and therefore the assets would be valued at cost price and not at its realizable value.

3. Money Measurement concept– This concept says that only those business transactions that can
be measured in terms of money are recorded in the books of accounts. So, an accountant cannot
record the honesty of the workers or any major change in the management.

4. Historical cost concept– It says that the assets of the business are to be recorded at its acquisition
cost and not at its market price or at its realizable value. For example, the business purchases
machinery, the MRP of which is Rs 100000, at Rs 80000. It spends another 10,000 on its transport
and installation. At the close of the accounting period, the re-sale value of the machine is Rs 85000.
The accountant would record it at Rs 90000 (Acquisition cost = Purchase price + Transport +
Installation charges) in this case due to Cost principle.
5. Duality concept– Also known as “Double Entry principle”, it says that for every transaction,
there are two impacts or in other words, for every debit there is a credit in the books of accounts.
For example, if the company purchases Furniture for Rs 20000 on credit, this means there is an
increase in the assets of the company and at the same time there is an increase in the liability of Rs
20000 to be paid back in the near future.

6. Accounting Period Concept– This concept says that a business entity needs a regular period to
determine its profit as well as its financial position. So, it chooses a specific period of time to
complete the accounting cycle. Generally, this time period is a year called as the accounting year.
For India, company follows 1st April to 31st March as an accounting (financial) year (period).

7. Matching Concept– It says that the income of an accounting period is to be matched with the
expenses of that period to determine profit or loss of the business. The matching accounting concept
follows the realization concept. First, the revenue is recognized and then it is matched with the costs
associated.

8. Accrual concept– This concept says that revenue (income) of the period is recorded irrespective
of the fact whether it has been received or not. Similarly, expenses recognized for the period is
recorded in the same period irrespective of the fact whether it is paid or not. The Companies Act
mandates the accrual basis of accounting in India.

9. Revenue realization concept– It says that in order to record an income or expense of the period,
one needs to recognize and associate it with that period, So revenue is recognized when it is earned
and expenses are recognized when it becomes due.

B. Accounting Conventions are the traditional usage or customs that the accountants world over
have been practicing since so long that they have become no less than law to be followed. These
conventions are as follows:

1. Convention of Full Disclosure – It says that all relevant information that might impact the
decision of the stakeholders of the business, should be disclosed in the financial statements. A lot of
external users (stakeholders) depend on the information provided by these financial statements for
take their investing/lending/buying/supplying decisions.

2. Convention of Materiality – It says that the material information should be included in the
financial statements but the immaterial information should be left out. The materiality of a
transaction will depend on its nature, value and its significance to the external user. It is because of
this convention that all petty expenses are clubbed together as general expenses in the P/L account.

3. Convention of Consistency - Once certain accounting policy, for example a method of

calculating depreciation or valuating inventory, is decided by the company, it should not be
frequently changed. Otherwise, the policies should be consistent for long periods of time to allow
inter-firm and inter-period comparisons and prevent manipulations.
4. Convention of Conservatism – It says “anticipate no profit but make provision for all probable
losses”. In other words, it states that states that profit should not be included until it is realized but,
losses even with the slightest possibility of happening should be included in the financial
statements. It is because of this convention that inventory is valued at cost price or market price
whichever is lower.

5. Substance over Form - It states that the that the economic substance of transactions and events
must be recorded in the financial statements rather than just their legal form in order to present a
true and fair view of the affairs of the business entity.

Session – 3: Trial Balance

At the end of the accounting period, all these ledger accounts are closed and their balances are
transferred to trial balance. Trial balance acts as bridge between these journal books and ledger
accounts, collectively known as books of accounts and, balance sheet and income statement (profit
and loss account), collectively known as final accounts of the company.
Methods of preparing Trial Balance

Totals Method – Here, the TB is prepared by taking the total of both debit and credit sides of all the
ledger accounts.
Balance Method – In this, only the accounts having closing balances are transferred to TB. The
ledgers would have either a debit or a credit closing balance. This method is widely used.
Composite Method – Also known as Total-cum-Balance method, it is a hybrid of the first two
methods where the ledgers accounts without closing balance are ignored and the total of the
remaining ledger balances are transferred to the TB in the respective sides.

The debit and credit side of the TB should always match because of the duality concept of
accounting. A tallied TB indicates that the books of accounts are maintained accurately; although it
still does not guarantee an error free TB. A non-tallied TB is a confirmation that there is an error in
the books of accounts.

Types of Errors in Accounting

A) Errors that impact Trial Balance

B) Errors that do not impact Trial Balance

A) As mentioned earlier, when the Trial Balance does not tally, it means that there are errors in the
books of account. Following are the examples of the errors which usually affect the Trial Balance
and lead to non-matching.
• Omission of posting in one account: Both the debit and credit aspects of a transaction have to be
posted in the ledger accounts. If it is posted to the debit of one account and its posting to the credit
of the other concerned is omitted, the Trial Balance would not tally.
• Double posting in one account: If by mistake an entry is posted twice to the debit or to the credit
of an account it would result in extra debit or credit and as such cause disagreement in the Trial
Balance.
• Posting on the wrong side of an account: When an entry is posted on the wrong side of an
account i.e., instead of debit side it is posted on the credit side, it would also impact the Trial
Balance.
• Posting wrong amount in an account: If an entry is posted to the correct side of an account but
there is an error in writing the amount, this would affect the Trial Balance. Suppose, in the above
example the entry is correctly posted on the credit side of Krishan’s Account but the amount is
wrongly put as Rs. 200. It would cause a difference of Rs. 100.
• Wrong totaling of the subsidiary book: If any subsidiary book is overcast or undercast, it affects
the concerned account in ledger. Suppose the correct total of Sales Journal is Rs. 5,600, but it is
actually totaled as Rs. 5,300. The total of Sales Journal is posted to the credit side of the Sales
Account. So, the Sales Account will be short by Rs. 300, and the Trial Balance will not tally.
• Omitting to post the total of a subsidiary book: If the total of a subsidiary book is not posted to the
concerned account, it would affect the Trial Balance. Such mistake relates only to the account
where posting was to be done and as such affects only one account.
• Wrong totaling or balancing of an account: When an account is wrongly totaled or wrongly
balanced, this would affect the Trial Balance. Similarly, if the totaling is correctly done but a
mistake is committed in balancing the account, it would also cause a difference in the Trial
Balance.
• Omission of an account from Trial Balance: All accounts which show some balance must be
included in the Trial Balance. If the balance of any account is omitted in the Trial Balance, it will
not tally. In practice, cash book balances are often omitted from Trial Balance.
• Writing the balance of an account on the wrong side of the Trial Balance: If the balance of an
account which is to be shown in the debit column of the Trial Balance is actually shown in the
credit column, the Trial Balances will not tally. It will be affected by double the amount.
• Wrong totaling of the Trial Balance: If a mistake is committed in totaling the Trial Balance
amount columns of the Trial Balance itself, the Trial Balance will not tally. Note that these errors
affect only one aspect (debit or credit). This upsets the debit-credit correspondence leading to the
disagreement of the Trial Balance.

B) Errors that do not impact Trial Balance: Following are the errors which do not affect the
Trial Balance at all:
1. Errors of Principle: When a transaction has not been recorded as per the rules of debit and
credit, or some other accounting principle has been ignored, the errors so arising are called
‘Errors of Principle’. For example: An expenditure incurred on repairs of machinery debited to
Machinery Account treating it as capital expenditure. However, as per rules it should have
been debited to Machinery Repair Account, as it is a revenue expenditure. It is therefore an
error of principle.
2. Errors of Omission: When a transaction is completely or partially omitted to be recorded in
books of account, it is called an ‘Error of Omission’. The errors of complete omission do not
affect the matching Trial Balance.
3. Errors of Commission: When an error is committed in recording a transaction in the subsidiary
book with a wrong amount, or is committed in posting it to a wrong account or to the wrong
side of an account, it is called an ‘Error of Commission’. If an error of commission is
committed while recording a transaction in any of the subsidiary books, it shall not affect the
Trial Balance because both the debit and the credit are equally affected.
4. Compensating Errors: Those errors which nullify the effect of each other are called
‘Compensating Errors’. Such errors do not affect the Trial Balance. For example, while posting
an entry of Rs. 400 to the debit of Shyam’s personal account, we wrongly wrote Rs: 600. Then,
while posting an entry of Rs. 700 to the debit of some other account we wrote Rs. 500. The
first error will result in a higher debit of Rs. 200 whereas the second error will result in a lower
debit of Rs. 200. Thus, the effect of the first error is nullified by the effect of the second error.

Rectification of errors:

This depends upon the stage at which the errors are detected. These stages are:
• Before preparation of the Trial Balance
• After the Trial Balance but before the preparation of the final accounts

Before preparation of the Trial Balance

Till this time the ledger accounts are not closed, therefore it is easy to rectify errors at this stage.
There can two types of such errors:

• Errors where no journal entry is possible for its rectification: we have to go to the relevant
account(s) and put the figure on the right side of the account. No journal entry is necessary.
• Complete journal entry can be passed for its rectification: In this case rectification is done with
the help of a journal entry. Such rectification entries are passed in the journal proper.
After the Trial Balance but before the preparation of the final accounts

This means the ledger a/c are already closed. To rectify such errors, journal entries are passed.
In other words if an account is to be debited for rectification, another account has to credited by
the same amount, otherwise the Trial Balance will not tally.
 In case the error is difficult to detect, the difference is put to an artificial account created
temporarily to make the Trial Balance tally. Such an artificial account is known as Suspense
account.

The existence of the ‘Suspense A/c’ in the Trial Balance means there exist an error. Once this
error is detected, it is rectified by passing journal entries. Upon rectification of all such errors,
the Suspense account is automatically eliminated from the Trial Balance.

Session – 4: Depreciation

Fixed assets wear out, are consumed or lose their value either because of use, time or obsolescence
due to technology and market change. Depreciation is viewed as a measurement of the diminution
in the value of the fixed assets. The following can be stated as causes of depreciation:
(a) Wear and Tear; (b) Exhaustion; (c) Obsolescence; (d) Efflux of time; & (e) Accidents

In other words, depreciation is the allocation of the cost of an asset to the periods that are expected
to benefit from its use. It is the gradual conversion of the cost of an asset into expense.

Accounting Standard (AS) – 6 requires that the company charge depreciation on a “systematic
basis” to each accounting period during the life of an asset. Its aim is to absorb the cost of using the
assets to different accounting periods in a way so as to give the true figure or profit or loss made by
the business. Thus, the objective of depreciation can be:

• Ascertainment of true profits

• Presentation of true financial position
• Replacement of assets
The companies are required to use a particular method of calculating depreciation consistently and
are not supposed to change the same. However, in the following cases the change is allowed:
a) If the adoption of the new method is required by statute; or
b) For compliance with an accounting standard; or
c) If it is considered that the change would result in a more appropriate preparation or
presentation of the financial statements of the enterprise.

When a change in the method of depreciation is made, depreciation is recalculated as per the new
method from the date of the asset coming into use. The deficiency or surplus arising from
retrospective re-computation of depreciation in accordance with the new method is adjusted in the
accounts in the year in which the method of depreciation is changed.
In case the change in the method results in deficiency in depreciation in respect of past years, the
deficiency is charged in the statement of profit and loss. In case the change in the method results in
surplus, the surplus is credited to the statement of profit and loss. Such a change is treated as a
change in accounting policy and its effect is quantified and disclosed.

Calculating Depreciation

The following information are required to calculate the depreciation:

• Cost of the asset

• Estimated scrap value
• Estimated useful life; orRate of depreciation

Methods of calculating depreciation

a) Uniform Charge Methods

a. Straight line/Fixed installment
b. Depletion method
c. Machine Hour rate method
b) Declining Charge/accelerated Depreciation
a. Diminishing Balance/WDV method
b. Sum of Years Digits method
c. Double Declining method
c) Other Methods
a. Inventory system
b. Annuity method
c. Depreciation Fund

Straight line/Fixed installment- Under the SLM, the depreciable amount of the asset is distributed
equally over the life of the asset.It is based on the assumption that depreciation arises solely from
the passage of time, and the effect of usage on the service value of the asset is insignificant.

Original Cost + Installation Expenses − Salvage Value

Depreciation =
Life time in years
or
(Original Cost + Installation Expenses − Salvage Value)  0 0 of Depreciation

For example, a machine costs Rs 8,00,000 and is expected to realize Rs 80,000 at the end of its
estimated useful life of six years. To calculate the annual depreciation, the following steps would be
there: Depreciation = (Rs 8,00,000 – Rs 80,000)/ 6 years= Rs 1,20,000 p.a.

Merits of Straight-Line Method:

• Simple to understand and easy to apply/compute
• Asset value can be reduced to zero/scrap value
• Used particularly in case of leasehold properties, patents, etc..
Demerits of Straight-Line Method:
• Same amount is charged irrespective of the usage.
• Total charge for use of asset goes on increasing i.e. repairs and depreciation.

Diminishing Balance Method: Depreciation is computed at a fixed rate percentage of the book
value of the asset at the beginning of an accounting period

Thus, the depreciation expense for year 1 will be a certain % of the beginning book value
(cost).From year 2 onwards, the Depreciation charge would be related to the cost of the asset, less
accumulated Depreciation at the beginning of the year.

Since the fixed percentage rate is applied to the beginning book value, the Depreciation expense
will keep decreasing from year to year. It is also known as Written-Down Value Method (WDV).

Merits of Diminishing/Written down Value Method:

o Amount of depreciation decreases every year, so charge to asset is almost equal by

adding repairs and depreciation.
o Simple to understand and easy to follow
Demerits of Diminishing/Written down Value Method:
o Asset value cannot be brought down to zero.

Sum of Years Digits method: In this method, the amount of depreciation goes on decreasing in the
coming years.
Depreciation = No. of years (including the current year) of the remaining life of the asset *
(Original cost less scrap value) / Sum of all digits of the life of asset (in years)

Session 5: Inventory valuation

Inventory is an asset of the business entity. It is basically a reserve of all materials held by the
company for the purpose of production or sale in the course of business in the near future. In
accounting Inventory means and includes the following:
a) Stock of Raw material
b) Stock of Work in progress
c) Stock of Finished goods
d) Stores & spares
Therefore, it can be said that the inventory as assets are held for one of the following three reasons,
a) assets held for sale in the normal course of business
b) held for the purpose of production of goods
c) for the consumption in the production of such goods (any equipment or tools or materials
the company requires in the manufacturing process)
At the end of every financial year, the business entities have to make a roster of its inventory. This
is done to ascertain the value of cost of material used in the production process and the closing
stock of the inventory. This closing balance is a very important figure in preparing the final
accounts of the company. It is shown on the asset side of the balance sheet and the credit side of the
Trading Account.

Valuation of Inventory

Inventory valuation is the costs associated with inventory of the business entity at the end of an
accounting period say 31st March or 31st December. The correct inventory valuation is crucial to
have a fair representation of the company’s finances. The following are the significance of
inventory valuation:

1. It helps in ascertaining the income of the business: To determine the income (gross profit or loss)
for the year the cost of goods sold (COGS) is compared to the net revenue of an accounting period.
The formulae for calculating the cost of goods sold is as follows,

COGS = Opening Stock (Inventory) + Purchases + Direct Expenses – Closing stock (Inventory)

The value of inventory mentioned above will impact the income in the following way:

a) When closing stock is overstated, net income for the accounting period will be more.
b) When closing stock is understated, net income for the accounting period will be less.
c) When opening stock is overstated, net income for the accounting period will be less.
d) When opening stock is understated, net income for the accounting period will be more.

2. It helps in determining financial position of the business: Inventory (closing stock) are counted as
current assets of a business entity. If the value of the inventory is wrongly calculated, it will
represent a wrong financial position on the date of the balance sheet.

3. It helps in determining liquidity position of the business: As a current asset, inventory is expected
to be converted into cash by way of sales within a period of one year. If it is held for a long period
of time in the business, this means company’s funds are stuck and cash availability is less indicating
poor liquidity.

4. Inventory Valuation is required as Statutory Compliance: According to the Accounting Standard

(AS2), all firms now have to disclose the valuation of each class of inventory. The disclosure must
include: -
• Accounting policies adopted for the inventory valuation
• The total amount of the inventories along with the classifications (raw materials, WIP, finished
goods etc.)

Methods of Inventory Valuation:

Inventory is valued at cost price or market price (realizable value) whichever is less as per the
convention of conservatism. The valuation can be done through following either of the two systems
given below:

1. Periodic Inventory method

2. Perpetual inventory method

In case of Periodic system, the quantity and value of the inventory is determined only at the end of
the accounting period. In this, the inventory verification is done by an actual physical count of the
inventory on any given date. So, to determine the closing stock a physical count of the inventory
(numbers, weight etc.) is taken.

In case of perpetual system, continuous recording of the stock is done. This means the inventory is
recorded after every issue or purchase/receipt of raw materials, final goods, work in progress etc.
So, these records need updating on a daily basis. In the perpetual inventory system, the value of the
closing stock is determined by the cost of goods issued and cost of goods sold.

The following equation gives the value of the closing inventory:

Opening Stock (Value known) + Purchases during the year (known) – COGS (known) = Closing
Stock (Balancing Figure)

The valuation of the inventory/closing stock is done using one of the various inventory pricing
methods, i.e.
1. FIFO,
2. LIFO,
3. Weighted Average Cost

FIFO (First In First Out) - In this method, stock materials are issued in the order of which they
are purchased/received by the company. This means the goods that came in first will also be issued
first. So, the older stocks are considered to be issued first, before the new stock items. Thus, the
stock lying with the company at year end is the one with the latest market price.

LIFO (Last In First Out) – In this method, the goods that are received last are issued first. So, the
issue of goods is made from the latest purchase, and the previous purchases lie in stock.

While LIFO is a better method for matching the costs to the revenue, most companies used this
method to manipulate their stock valuation in the case of price-rise. Another disadvantage is that the
stock at the year-end does not reflect the market value of stocks. This is the reason why most tax
authorities do not find LIFO and acceptable method of recording inventory.

Weighted Average Method (WAC) – In this method, average of the costs in the inventory is used
in the cost of goods sold. The quantity and price of goods both are taken into account to arrive at
the average price of the inventory purchased by the company. So if the company buy 100 goods at
Rs 5/- and 200 goods at Rs 6/-, the weighted average price will be (100×5) + (200×6) / 300 =
5.667/-

Session – 6: Accounting Equation

Based on the duality concept, the accounting equation is a basic principle of accounting and a
fundamental element of the balance sheet. The equation is as follows:

Assets = Liabilities + Shareholder’s Equity

In other word, accounting equation sets the base of double-entry accounting and highlights the
formation of the balance sheet. Double-entry accounting is a system where each transaction impacts
both sides of the accounting books. For every debit there is a credit, for every change to an asset
account, there is an equal change to a related liability or shareholder’s equity account.

The balance sheet is classified into three main sections and their several basic elements, i.e., Assets,
Liabilities, and Capital (Owner’s/Shareholder’s Equity).

Assets mean and include the following:

• Fixed assets like land & Building, Plant & Machinery, Furniture & Fixture etc and
• Current assets like Inventory, Debtors, Bills Receivable, Cash etc
Liabilities mean and include the following:

• Long term liabilities like Bank loan, long term debts, advances from FIs
• Current liabilities like creditors, bills payable, bank overdraft etc
Owner’s equity includes capital, profit or loss (retained earnings for companies)

The accounting equation shows the relationship between these items.

The accounting equation can also be structured as:
Liabilities = Assets - Owner Equity
or
Owner Equity = Assets - Liabilities

The accounting equation is a simple way to view the relationship of financial activities across a
business. The balance sheet basically ascertains the filling in of each of the values in the equation,
so the equation is not meant for actual use but is instead a simplified representation of how the
financial side of a business functions.

The rules of accounting equation may be summarized as below:

1. Increases in assets are debits; decreases in assets are credits.
2. Increases in capital are credits; decreases in capital are debits.
3. Increases in liabilities are credits; decreases in liabilities are debits.
4. Increases in incomes and gains are credits; decreases in incomes and gains are debits.
5. Increases in expenses and losses are debits; decreases in expenses and losses are credits.

Accounting equation examples

The following examples are connected to the same business. Take a look at how different
transactions affect the accounting equation. Then, see the business’s balance sheet at the end of this
section.

Example 1: Aman starts a business selling printed T-shirts for IBS students and staff. He saves for a
year before opening and contributes Rs 10,000 to the new company. By doing this, he increases his
business’s assets and owner’s equity by the same amount:

Rs10,000 Assets (cash) = Liabilities + Rs10,000 Equity

Example 2: After forming his company, Aman needs to buy equipment to print the T-shirts. He
purchases Rs 2,000 of the equipment on credit. In this situation, he gains a liability (debt) and an
asset. His assets and liabilities increase by Rs 2,000, so the equation looks like:

Rs 2,000 Assets (equipment) = Rs 2,000 Liabilities (creditors) + Equity

Expanded accounting equation

The expanded accounting equation shows the relationship between the profit and loss account and
balance sheet. It highlights how equity is created from its two main sources: revenue and owner
contributions. The expanded accounting equation:

Assets = Liabilities + Owner’s Equity + Revenue – Expenses – Drawings

Revenues are what the business earns through regular operations. Expenses are what it costs to
provide the products and services for the purpose of sale.

Certain patterns occur as figures in the expanded accounting equation change:

• Revenue increases owner’s equity
• Expenses decrease owner’s equity
• Owner’s draw decreases owner’s equity
The two sides of the equation must equal each other. If the expanded accounting equation is not
balanced, the books of accounts or financial reports are inaccurate.

Importance of accounting equation:

The accounting equation gives a clear picture of the business’s financial situation. One should
calculate the accounting equation to read the balance sheet. The accounting equation helps to
understand the relationship between the financial statements i.e., balance sheet and Profit &loss
account. One can see how much money the business has in the bank and how likely it is that the
business will be able to meet all of its financial obligations. It can also tell you how much profit (or
loss) the business has retained since it started.

Session 7: Capital and Revenue Expenditure

The happening of expenditure during the course of business is very normal. Generally, expenditure
is incurred to increase the efficiency of business and further returns. Expenditure means
any payment in cash for some goods or services. It can also mean the exchange of some
valuable item in exchange for goods or services. Receipts and invoices keep the records of these
expenditures. There are two types of expenditures on the basis of time durations, given as below:
1. Capital expenditures
2. Revenue expenditures
A third type, hybrid of the first two is known as Deferred Revenue Expenditure.
The difference between the nature of capital and revenue expenditure is important as only capital
expenditure is included in the cost of fixed asset where as the revenue expenditure items are
incorporated in the profit and loss account as day to day expenses and income.

Capital Expenditure

Capital expenditure includes costs incurred on the acquisition of a fixed asset like land, building,
vehicle, plant & machinery, furniture etc. It also includes any subsequent expenditure that increases
the earning capacity of an existing fixed asset. The cost of acquisition not only includes the cost of
purchases but also any additional costs incurred in bringing the fixed asset into its present location
and condition (e.g. delivery costs).

Capital expenditure, as opposed to revenue expenditure, is generally an infrequent (rare)

expenditure and its benefit is derived over several accounting periods. Capital Expenditure may
include the following:
• Purchase costs (less any discount received) of an asset
• Delivery costs
• Legal charges
• Installation costs
• Up gradation costs
• Replacement costs
Capital expenditure is shown in the assets side of the balance sheet.

Revenue expenditures
The expense for which the full benefit is received within one accounting period is termed as
revenue expenditure. These imply the routine expenditure that is incurred in the day to day business
activities. Such expenses are debited to Trading and Profit & loss Account. In other words, the
expenditure which is incurred on a regular basis for conducting the operational activities of the
business are known as Revenue expenditure like the purchase of stock, carriage, freight, etc.
Revenue Expenditures does not result in an increase in the earning capacity of the business but only
helps in maintaining the existing earning capacity. Some examples of revenue expenditures are the
cost of goods sold, salaries, rent, electricity, repairs and maintenance expense etc.
Deferred Revenue Expenditure-
There are certain expenditures which are of revenue nature but the benefit of which is likely to be
derived over a number of years. Such expenditures are termed as “Deferred Revenue Expenditures”.
The benefit of such expenditure generally lasts between 3 to 7 years. The whole expenditure is not
debited to the Profit and Loss Account of the current year but spread over the years for which the
benefit is likely to last, only a part of such expenditure is taken to Profit & Loss Account every year
and the unwritten portion is shown in the assets side of the Balance Sheet.

For Example, Amount spent of Rs. 5,00,000 on advertising to introduce a new product in the
market and it is estimated that the benefit will last for 5 years, then Rs. 1,00,000 will be charged
every year to profit & loss account and balance amount shown on the Assets side of the Balance
Sheet.
In maintaining accounting records it important to distinguish between capital and revenue
expenditure items. This is because these are treated differently in the financial statements.

Difference between Capital Expenditure and Revenue Expenditure-

Particulars Capital Expenditure Revenue Expenditure
Capital Expenditure is incurred for
Revenue Expenditure is incurred for the day
Nature the acquisition or erection of a fixed
to day running of the business.
asset.
Amount of The amount value of these The amount spend on revenue expenditure
expense expenditures is usually very high are comparatively less
These expenditures serve long term These expenditures serve short term
Term
objectives of the business requirements of the business
Frequency of These expenditures are usually non- Revenue expenditures usually occur very
occurrence recurring in nature frequently – multiple times a year
Revenue Expenditure is incurred for
Capital Expenditure is incurred for
maintenance of earning capacity i.e. for
Capacity the purpose of increasing the earning
keeping the assets in an efficient working
capacity of the business.
order.
These may add value to the existing
Adding value These do not add value to the existing assets
assets
Benefit Capital Expenditure yields benefit Revenue Expenditure yields benefit for a
 normally over a long period. maximum period of one year.
Capitalization Yes No
Depreciation is charged on Capital There is no Depreciation charged on
Depreciation
Expenditure every year. Revenue Expenditure.
The assets acquired through capital
Resale The revenue expenses cannot be sold
expenditure can be resold
Accounting Capital Expenditure is written in Revenue Expenditure is written in Trading
treatment Balance Sheet under Fixed Assets. or Profit and Loss Account.

Session 8: Final Accounts for Sole Proprietor

Introduction

The final accounts for a sole trader business are the Income Statement (Trading and Profit & loss
Account) and the Balance Sheet. The final accounts give a picture of the financial position of the
business. It shows where or not the business has made a profit or loss during the accounting period
and whether it is able to pay the debts as they become due. Let’s now have a look at the final
accounts of a sole proprietor business.

Final Accounts
After the trial balance is completed final accounts are prepared. The final accounts of a sole trader
business include the Income Statement (trading and Profit & loss account) and the balance sheet.
The trial balance is the summary of the balances in all the accounts. Some of these balances (those
from the nominal accounts) affect the profit and are transferred to the Income statement; the others
(real and personal accounts) are transferred to the balance sheet. The Income Statement and the
Balance Sheet are prepared at the end of each financial period to record how well the business
operated during that financial period.

Income Statement
One of the most important financial statements of any business is the Income Statement. It is used
to determine the following:
1. how profitable a business is being run; and
2. comparing the results received with the results expected.

The Income Statement can be divided into two sections the trading account and the Profit & loss
account. The gross profit which is the amount of profit made before the expenses are deducted is
calculated in the trading account. The purpose of the trading account is to determine the gross profit
made from sales. Therefore, the accounts that are directly related to buying and selling (trading)
will be transferred to the trading account. The accounts directly related to trading are:

• Sales and Sales Return

• Purchase and Purchases Return
 • Wages
• Opening & Closing stock
• Carriage Inwards; Power & Fuel and other direct expenses

Gross profit is calculated as: Gross Profit = Net Sales – Cost of Goods Sold (COGS)

Along with gross profit the net sales, cost of goods sold (COGS) and the cost of goods available for
sale(COGAFS) is also calculated in the trading account:

Net Sales = Sales – Sales Return (Return Inwards)

Net sales are the total sales figure after deductions have been made for sales returned.

COGS = Cost of goods available for sale (COGAFS) – Closing Stock

COGAFS = Opening Stock + (Purchases – Purchases Return) + Carriage Inwards

The net profit of the business is calculated in the Profit & loss account. Net profit is the balance of
profit after allowance is made for revenue and expenses. It is calculated as:

Net Profit = Gross profit + Revenue – expenses

The revenue and expense charged to the Profit & loss account are those that are not directly related
to trading but more to do with the running of the business. Some of these accounts are:
• Rent • Advertisements
• Telephone • Electricity
• Carriage outwards • Stationery
• Discount allowed • Depreciation of assets
• Discount received • Losses/Profit on sale of fixed assets
• Commission received • Bad debts
• Commission paid • General Expenses
• Salary

Balance Sheet

The other half of our final accounts is the Balance Sheet. The Balance Sheet is a financial statement
showing the book values of the assets, liabilities and capital at the end of the financial period as on
a particular date. It shows what the business owes and what it owns.
The assets of the business are divided into two categories and recorded as follows:

1. Non-Current Assets are assets that:

• are expected to be of use in the business for long time;
• are to be used in the business; and
• were not bought only for the purpose of resale.
Non-current assets are recorded in the balance sheet starting with those assets that will in the
business the longest down to those that will be kept for a shorter period. Example of non-current
assets and the order of record are:
• Land and Buildings.
• Fixtures and Fittings.
• Machinery.
• Motor Vehicles.

2. Current Assets are recorded next. These are assets will change within the next twelve months.
They are recorded as follows:
• Stock (goods bought for resale)
• Debtors (Customers who purchased goods from you on credit).
• Cash at Bank & Cash in Hand.

3. Current Liability - are debts that will be settled in one year or less. This includes:
• Creditors
• Bills Payable
• Bank Overdraft
• Other small loans
4. Non-current Liability –They are also referred to as long term liability and are those debts that
take more than a year to redeem (pay back). This includes large loans - secured (collateral attached)
or unsecured.

5. Capital – This is what remains after you deduct liabilities from the (owner) assets. Capital
denotes owner’s investment into the business. Any profit incurred for the year belongs to the owner
and therefore added to the Capital. Similarly, any amount/goods withdrawn by the owner is treated
as drawings and deducted from the capital.

Trading and Profit and Loss Account Format

Dr Cr
Particulars Amount Particulars Amount
Opening Stock Sales xxxxx
Purchases xxxx Less: Sales return xxx
Less: Purchase Returns xx Closing Stock
Carriage Inward Gross Loss
Excise Duty
Wages
Supervisor's Salaries
Production Manager salary
Gross Profit
XXXX XXXX
To Gross loss b/d To Gross profit b/d
Management expenses (O&A): Income:
 To salaries By Discount received
To office rent, rates, and taxes By Commission received
To printing and stationery Non-trading income:
To Telephone charges By Bank interest
To Insurance By Rent received
To Audit fees/Legal charges By Dividend received
To Electricity charges By Bad debts recovered
To Maintenance expenses Abnormal gains:
To Repairs and renewals By Profit on sale of machinery
To Depreciation By Profit on sale of investments
Selling distribution expenses: By Net Loss
To Salaries (transferred to Capital A/c)
To Advertisement
To Carriage outward
To Bad debts
To Provision for bad debts
To Selling commission
Financial expenses:
Bank charges
Interest on loan
Discount allowed
To Loss on sale of machinery
To Loss by fire
To Net Profit
TOTAL TOTAL

BALANCE SHEET
as on or as at………………….
Liabilities Amount Assets Amount
Capital: Fixed Assets:
Add: Net Profit Furniture
Less: Drawings Loose Tools
Less: Income Tax Motor Vehicle
Less: Life Insurance Prmum Long Term Investments
Fixed Liabilities: Plant and Machinery
Long Term Loans Land and Buildings
Current Liabilities: Patents
Bank Overdraft Goodwill
Bill Payable Current Assets:
Sundry Creditors Cash in Hand & at Bank
Outstanding Expenses Sundry Debtors
Unearned Income Bills Receivable
Short-Term Investments
Closing Stock
Prepaid Exp & Accrues Income
TOTAL LIABILITIES TOTAL ASSETS
 Session 9: Accounting Treatment of Adjustment Entries

Adjusting entries refers to a set of journal entries recorded at the end of the accounting period to
have updated and accurate balances of all the accounts. Adjusting entries are plain application of
the accrual basis of accounting.

The rationale of adjusting entries is to display a correct depiction of the company’s financial
position. The stakeholders can have a complete look into the financial statements knowing that
everything that occurred during the accounting period is reported even if the cash inflows or
outflows might have occurred at a later stage. A statement of finance prepared without considering
adjusting entries would misrepresent the financial health of the company.

The adjustments relate to the following:

• Closing stock • Depreciation

• Outstanding expenses • Bad debts
• Prepaid expenses • Provision for bad debts
• Outstanding or accrued income • Provision for discount on debtors
• Income received in advance or • Interest on capital
unearned income • Interest on drawings

Rule: Any item given outside the Trial Balance will be recorded at two places on account of
Dual Aspect concept.

Closing Stock: This is the inventory remaining with the company at the end of the accounting
period. It is shown in the credit side of the Trading account and also in the assets side of the
balance sheet.

Outstanding Expenses: Expenses which have become due during the accounting period but not
paid till the end of the year. Such outstanding expenses are added to the concerned account in the
debit side of the Profit and Loss account and also shown in the liabilities side of the balance
sheet.

Prepaid Expenses: Expenses of next accounting period paid in advance in the current accounting
period are known as prepaid expenses. It should be deducted from the concerned account in the
debit side of the Profit and Loss account and also shown in the assets side of the balance sheet.

Outstanding Income: Income which has become due but not received yet. (Asset) Treatment:
Added to the income received in the credit side of the Profit and Loss account and then shown as
an asset in the Balance sheet.

Accrued Income: Income which has been earned by the business but has not become due and
therefore not received yet. (Asset). Its treatment is similar to Outstanding Income.
Income Received in advance: income which has been received by the business before being
earned by it. (liability)
Treatment: Subtracted from the Income received in the Credit side of the Profit and Loss account
and then shown as a liability in the Balance sheet.

Depreciation: It is the process of allocating the cost of an asset, such as a building or a piece of
equipment, over the serviceable or economic life of the asset. It is a non-cash expenditure (loss)
for the business and therefore shown in the debit side of the profit and loss account.
Treatment: Calculate depreciation on the basis of the rate given. Charge this amount to the debit
side of the P/Loss a/c. In the Balance Sheet, reduce the value of that asset by this amount.

Bad Debts and Provision for Bad debts: Bad debt is the loss due to debtors (customers) not
paying up the due amount for their purchases from the company. Provision for bad debts is the
estimated amount of bad debt that may arise from accounts receivable (debtors) that have been
issued but not yet collected. The usual practice is to calculate such doubtful debts at a certain
percentage, based on past experience on debtors.

Treatment: Charge this amount (additional bad debts) to the Debit side of the P&L A/c. If the
Trial balance already has an entry of Bad debts, ‘additional bad debts’ should be added to this
amount. In the Balance Sheet, reduce the value of the Debtors by this ‘additional Bad debts.
Add the amount of provision (new provision for bad debts) to the ‘Bad debts’ in the Debit side of
the P&L A/c. If the Trial balance already has an entry of Provision for Bad debts, this old
provision should be subtracted from the total. In the Balance sheet, reduce the value of Debtors
by this new ‘provision for bad debts.

Discount allowed and Provision for Discount allowed: Cash discounts are allowed to debtors in
order to encourage them to make prompt payments. After providing for bad and doubtful debts,
the balance of debtors represents debts due from sound parties. They (good debtors) may try to
pay their dues on time and avail themselves of the cash discounts permissible. It is, therefore, the
usual practice in business is to provide for discount on debtors at certain percentage on good
debts. Treatment: Same as that of bad debts and provision for bad and doubtful debts

Interest on Capital: Sometimes, interest at a normal rate is allowed on the capital of the sole
proprietor invested in the business. This is necessary in order to assess the efficiency of the
business. Otherwise the profits would include the interest and appear at a higher rate. The interest
so charged is a loss to the business and gain to the proprietor. So it is debited to the Profit and
Loss a/c and added to the capital in the Balance Sheet.

Interest on Drawings: Drawings are money withdrawn by the proprietor from his capital. Just as
the business allows interest on capital, it charges interest on drawings. It is a gain to the business
and a loss to the proprietor. So, it is credited to the Profit and Loss a/c and deducted from the
capital in the Balance Sheet.
 Manager's Commission on Net Profit: Sometimes, in additional to his regular Salary, the
manager is entitled to a commission on Net Profit. This is done to induce him to take more
interest in the business. Since, the Commission is always calculated at the end of the accounting
period. So, it is treated as outstanding expenses.
Treatment in Final Accounts: It will be recorded on the debit side of profit and loss Account
because it's an expense for business firm. On the other hand, It is shown on the Liabilities side as
an outstanding expense in the Balance Sheet.

Session 10: Indian Accounting Standards (Ind AS)

Accounting Standards denotes the guidelines (standard of accounting)proposed by the ICAI and
laid down by the Central Government in consultation with the National Advisory Committee on
Accounting Standards (NACAs) constituted under section 210(1) of Companies Act, 1956.

The core purpose of Accounting Standards is to harmonize the varied accounting policies and
practices. These Accounting Standards have been applied to do away with the non-comparability of
financial statements and the reliability to the financial statements.

Before the introduction of Ind AS, financial statements were prepared on the basis of Accounting
Standards (AS) which were not in line with the standards and principles applicable globally (IFRS).
Due to this, investors were not able to assess and compare the financial position of Indian
companies with other global companies. In order to make the financial statements uniform, Ind AS
were introduced which are converged form of IFRS (global standards). Moreover, introduction of
Ind AS will bring consistency in the accounting practices and principles followed by companies in
India and other companies across world, leading to enhanced accessibility and acceptability of
financial statements by global investors.

Benefits of Ind AS

1. Global acceptability: Since Ind AS are converged form of IFRS, there is a wider acceptability
and it gives confidence to the user of financial statements.

2. Easy comparability of Financial Statements: Financial statements prepared using Ind AS are
easily comparable with the financial statements prepared by companies of other countries.

3. Changes in standards as per economic situations: Principles of Ind AS are revised/modified in

case there is any major change in economy. Ind AS 29 is ‘Financial Reporting in hyperinflationary
Economies’ which deals with situations related to inflation.

4. Attracts Foreign Investment: Adopting Ind AS may attract foreign investors to invest in Indian
Companies as that will ensure better comparability with similar companies across the globe.
5. Reduces financial statement preparation cost: For multinational companies, it will be beneficial
as it will be able to use the same accounting standards in all the global markets in which they
operate. This will save preparation costs of aligning financial statements of Indian company with
other operations.

Sub-Section (3A) to section 211 of Companies Act, 1956 requires that every Profit/Loss Account
and Balance Sheet shall comply with the Accounting Standards.

List of Indian Accounting Standards: https://www.taxmann.com/blogpost/2000001685/list-of-indian-

accounting-standards-with-explanation.aspx

Applicability of Indian Accounting Standards:

Ind AS are applicable to the following category of companies given below:

Mandatory requirement: Companies are required to follow Ind AS from Financial year 2015-2016.
For Financial year 2018-19, following is the limit for companies required to follow Ind AS:

• Companies whose equity or debt securities are listed or are in the process of being listed on any
stock exchange in India or outside India;
• Unlisted companies having net worth of Rs. 250 crore or more; and
• Holding, subsidiary, joint venture or associate companies of companies covered in point (1) and
(2) above.
• Non-Banking Financial Companies (NBFCs) having net worth of rupees five hundred crore or
more;
• Holding, subsidiary, joint venture or associate companies of companies covered under point (1)
above.

For 2019-20
• NBFCs whose equity or debt securities are listed or in the process of listing on any stock
exchange in India or outside India and having net worth less than Rs. 500 crore;
• NBFCs, that are unlisted companies, having net worth of Rs. 250 crore or more but less than Rs.
500 crore; and
• Holding, subsidiary, joint venture or associate companies of companies covered under point (1)
and (2) above.
Voluntary applicability: Company may voluntarily apply Indian accounting standards (Ind AS).

Requirement to follow AS:

Corporate entities are required to follow standard of accounting (Ind AS where applicable) while
preparing its financial statements as per Section 129 of the Companies Act, 2013.

In case of conflict between Act and Indian Accounting standards:

In case there is any conflict between provisions of any applicable Act and Indian Accounting
Standard (Ind AS), the provisions of the Act shall prevail to that extent.