1

Hari was satisfied that he must switch over from Cash Basis of Accounting to Accrual Based Double Entry
System of Accounting since his business was growing rapidly and he will be in continuous need of information
about sales, purchase, expenses, creditors, debtors and stock, etc. Besides his income was increasing and, in
all probability, will be above the threshold limit of Income Tax. As a result, he will have to file his Income Tax
Returns from this year. He decided to maintain his accounts as was suggested by Amit. Considering that it was
not an easy step, he again met Amit to know if he will be able to maintain his accounts to which Amit agreed
for a monthly fee of ` 5,000.
Hari desired to know how will be the accounts maintained and what he has to do. Amit suggested that he will
require one hour of his time in which he will visit his place, understand his business and will educate him about
the accounting system, important accounting terms and whatever else he would like to know.
Amit first discussed the business nuances and later presented a note on accounting as follows:
The process of accounting is shown in the chart below:

Communication to
Transaction
Users

Journal
Analysis and .
1 Cash Book
Interpretation 2. Purchase Book Recorded
3. Sales Book (In one of the Journals)
4. Purchase Return Book
Summarising 5. Sales Return Book
(i.e., Preparing 6. Journal Proper
1. Trial Balance
2. Trading and Profit and Classifying/Posted
Loss Account (In the relevant Ledger
3. Balance Sheet) Account)

Amit explained that any business transaction entered into by Hari will be recorded in one of the six journals. For
example, cash transactions will be recorded in Cash Book, credit purchase of goods in Purchases Book, credit
sale of goods in Sales Book and so on. Transactions (which are not recorded in any of the above books) will be
recorded in Journal Proper. Such transactions are depreciation providing on assets, drawings of goods by Hari,
credit purchase of assets and so on.

He explained that the further process is to transfer (post) recorded transactions in the relevant ledger account
maintained in a ledger from where Trial Balance, Trading and Profit and Loss Account and Balance Sheet are
prepared. Trading Account shows the gross profit or gross loss while Profit and Loss Account shows the net profit
or net loss and Balance Sheet shows the financial position of the business. These statements are collectively
called financial statements. Hari was informed that personal transactions are not recorded in the books of
account since they do not relate to business.

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Thereafter, analysis of financial statements is made and the results are interpreted to know whether the business
is in the right direction and if not, corrective steps be taken.

The last step is to communicate the accounting information to the users. At present, there are no users of the
accounting information. It may be required at a later stage when the business borrows money or the number of
employees increase and information is to be supplied to Government departments. It, however, will be required
for filing the Income Tax return.

Hari was satisfied with the explanation and thanked Amit for this elaborate presentation. But his questions did
not end here and had few more questions as follows:
(i) He has often heard his friends referring to terms such as Business Transaction, Capital, Drawings, Revenue
from Operations, Income, Goods, Debtors and Creditors, etc. He would like to understand these terms or
any other term that is useful in a simple manner.
(ii) Any other information that is considered appropriate and useful.
Prepare the replies to the queries / questions of Hari.

Answers
(i) The terms were explained as follows:
(a) Business Transaction: It is a financial transaction or event entered into by the business say, purchase
of goods, sale of goods and providing depreciation on assets, etc.
(b) Capital: It is the investment in the business by the proprietor and increases by further investment and
profit earned during the year. It decreases by loss incurred or drawings made by him during the year.
(c) Drawings: It is withdrawal by the proprietor for personal use either in cash or goods.
(d) Revenue from Operations: It is the gross amount received or receivable from the goods sold and /
or services rendered during the normal course of its business. Sale of goods and commission earned
are revenue from operations while interest received on fixed deposit with bank is not revenue from
operations.
(e) Income: It means revenue from operations less expenses incurred to earn the revenue.
(f) Goods: Goods mean items of physical existence purchased either to resell or to be used for manufacture
of items to be sold.
(g) Debtors: Debtors are the persons or parties to whom goods are sold and / or services are rendered in
the normal course of business against which amount is yet to be received.
(h) Creditors: Creditors are the persons or parties from whom goods are purchased and/or services are
taken in the normal course of business against which amount is yet to be paid.
(i) Outstanding Expenses: Outstanding expenses are the expenses that have been incurred but are yet
to be paid. Under the accrual system of accounting, all expenses incurred, whether paid or not, should
be accounted to determine correct profit or loss.
( j) Prepaid Expenses: Prepaid expenses are the expenses that have been paid but its benefit spreads to
next year or year. For example, Insurance premium of ` 12,000 is paid for one year beginning 1st July,
2020. Since the accounting year closes on 31st March, 2021 and insurance will expire on 30th June,
2021, insurance premium for three months i.e., ` 3,000 are for next year. Therefore, in current year they
are prepaid expenses.
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 2
Complete the missing values or information in the following Journal entries:
JOURNAL
Date Particulars L.F. Dr. (`) Cr. (`)

2020
April 10 Cash A/c ...Dr. 2,00,000
To ... A/c ...
(Capital introduced by Bimal)
April 10 ... A/c ...Dr. ...
To ... A/c 10,00,000
(Capital introduced by Bimal by cheque)
April 15 ... ...Dr. 75,000
To ... A/c 75,000
(Purchase of Exercise Machines by cheque)
May 1 ... A/c ...Dr. 25,000
To M/s Fitness Apparels 25,000
(Apparels purchased)
May 1 Bank A/c ...Dr. 47,500
To ... A/c ...
(Sale of 2 treadmills against cheque during May)
May 1 ... ...Dr. 23,750
To ... A/c 23,750
(Sale of 1 Exercise Machine to Raman)
May 1 Cash A/c ...Dr. 27,075
To Sales A/c 27,075
(Sale of 5 Exercise Cycles, 2 Weight Bars and 2 Sets Weights
during May)
May 1 Bank A/c ...Dr. 47,500
To ... A/c 47,500
(Advance against sale of 2 treadmills)
May 1 Cash A/c ...Dr. 1,000
To ... A/c 1,000
(Advance against sale of Exercise Cycle)
May 1 ... A/c ...Dr. 28,075
To ... A/c 28,075
(Amount of Cash Sale and advance deposited in Bank)
May 1 Salaries A/c ...Dr. 15,000
To Bank A/c 15,000
(...)
May 1 ... A/c ...Dr. 10,000
To Cash A/c 10,000
(Amount withdrawn for personal use)

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May 1 Electricity Expenses A/c ...Dr. 2,000
Telephone Expenses A/c ...Dr. 1,000
To ... A/c ...
(Expenses for the month of May payable)
May 1 ... A/c ...Dr. 30
To Furniture & Fixtures A/c 30
(Depreciation for the month @ 10% p.a.)

Answer
JOURNAL
Date Particulars L.F. Dr. (`) Cr. (`)
2020
April 10 Cash A/c ...Dr. 2,00,000
To Capital A/c 2,00,000
(Capital introduced by Bimal)
April 10 Bank A/c ...Dr. 10,00,000
To Capital A/c 10,00,000
(Capital introduced by Bimal by cheque)
April 15 Purchases A/c ...Dr. 75,000
To Bank A/c 75,000
(Purchase of exercise machines by cheque)
May 1 Purchases A/c ...Dr. 25,000
To M/s Fitness Apparels 25,000
(Apparels purchased)
May 1 Bank A/c ...Dr. 47,500
To Sales A/c 47,500
(Sale of 2 treadmills against cheque during May)
Raman
May 1 ...Dr. 23,750
To Sales A/c 23,750
(Sale of 1 Exercise Machine to Raman)
May 1 Cash A/c ...Dr. 27,075
To Sales A/c 27,075
(Sale of 5 Exercise Cycles, 2 Weight Bars and 2 Sets Weights
during May)
May 1 Bank A/c ...Dr. 47,500
To Advance Against Sale A/c 47,500
(Advance against sale of 2 treadmills)
May 1 Cash A/c ...Dr. 1,000
To Advance Against Sale A/c 1,000
(Advance against sale of Exercise Cycle)
Bank A/c
May 1 ...Dr. 28,075
To Cash A/c 28,075
(Amount of Cash Sale and advance deposited in Bank)
May 1 Salaries A/c ...Dr. 15,000
To Bank A/c 15,000
(Salaries for the May month paid by cheque)

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 Drawings A/c
May 1 ...Dr. 10,000
To Cash A/c 10,000
(Amount withdrawn for personal use)
May 1 Electricity Expenses A/c ...Dr. 2,000
Telephone Expenses A/c ...Dr. 1,000
To Outstanding Expenses A/c 3,000
(Expenses for the month of May payable)
Depreciation A/c
May 1 ...Dr. 30
To Furniture & Fixtures A/c 30
(Depreciation for the month @ 10% p.a.)

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Complete the following Rectification Entries:
JOURNAL
Date Particulars L.F. Dr. (`) Cr. (`)

(i) .... ...Dr. 25,000

To ... 25,000
(Correction of wrong credit to Sales Account for sale of old furniture,
now rectified)
(ii) ... ...Dr. 5,000
To ... 5,000
(Accrued Rent not recorded, now recorded)
(iii) ... ...Dr. 2,000
To ... 2,000
(Short debit in Amit’s Account and excess debit in
Harish’s Account rectified)
(iv) ... ...Dr. 3,500
To ... 3,500
(Cash paid to Arnav recorded in Aman’s Account,
now rectified)
(v) ... ...Dr. 8,000
... ...Dr. 8,000
To ... 16,000
(Bill drawn on Rahul was passed through Bills Payable Book,
now rectified)

Note: Also mention the nature of errors involved in the above errors.

Answers

S. No. Debit Credit Nature of Error

(i) Sales A/c Furniture A/c Error of Principle

(ii) Accrued Rent A/c Rent A/c Error of Complete Omission
(iii) Amit’s A/c Harish’s A/c Compensating Errors
(iv) Arnav’s A/c Aman’s A/c Error of Posting in Wrong Account
(v) Bills Receivable A/c Rahul’s A/c Recording in Wrong
Bills Payable A/c Subsidiary Book.

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 4
Gopal had commenced business on 1st April, 2019 with capital of ` 50,000 and an interest free loan of ` 25,000
from a friend for making low priced toys to be sold at cost plus 25%, i.e., ` 40 per piece. He had employed a
salesman Pawan to whom toys were given and he sold them by going to various nearby colonies. Gopal didn’t
maintain proper accounting records, i.e., books of account but he maintained Cash Book and personal accounts
of debtors and creditors.

On 30th April, 2020, he received a notice from the Income Tax Department to file his Income Tax return for the
year ended 31st March, 2020 within 30 days from the date of notice. He had to prepare his Income Tax Return
and file it by 30th May, 2020. He rushed to an accountant Jaspal near his shop and discussed the matter with
him. He informed him that as a first step, he will have to prepare financial statements (Profit and Loss Account
and Balance Sheet) before the return can be filed.

He submitted whatever records he had to Jaspal, who started perusing the records. After few days, he was ready
with the following basic information which he placed before Gopal:

Following information was extracted from the Cash Book:

Collection from Debtors 1,00,000

Cash Sales 60,000
Payment to Suppliers 55,000
Cash Purchases 25,000
Drawings 9,000
Payment for Expenses 98,000

His assets and liabilities on 31st March, 2020 were

Loan from friend 25,000

Amount due from Customers 25,000
Amount due to Suppliers 15,000
Stock of Unsold Goods (at Cost) 35,000
(Net Realisable Value or Market Value—` 38,000)
Machineries 35,000
Cash Balance 8,000

Goods lying with customers on Approval Basis (Sales Price ` 20,000). It was not included in Stock of Unsold
Goods of ` 35,000. Gopal also informed Jaspal that amount due from customers included the amount of goods
sold on credit.

Gopal informed Jaspal that his Salesman Pawan left the job on 31st March, 2020 without depositing the amount
of sales ` 5,000, which he collected against sale. It was included in the amount due from customers.

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After discussions, Jaspal prepared following financial statements to be used for preparing Income Tax return:
Dr. PROFIT AND LOSS ACCOUNT for the year ended 31st March, 2020 Cr.
Particulars
` Particulars `

To Purchases A/c: By Sales:

Cash 25,000 Cash 60,000
Credit(A) 70,000 95,000 Credit(B) 1,05,000 1,65,000
To Gross Profit c/d 1,21,000 By Closing Stock:
In Godown 35,000
With Customers 16,000 51,000
2,16,000 2,16,000
To Expenses 98,000 By Gross Profit b/d 1,21,000
To Depreciation A/c 3,500
To Bad Debts (Loss of Cash) 5,000
To Net Profit transferred to Capital A/c 14,500
1,21,000 1,21,000

BALANCE SHEET as at 31st March, 2020

Liabilities ` Assets `

Sundry Creditors 15,000 Cash in Hand 8,000

Loan (Friend) 25,000 Closing Stock (` 35,000 + ` 16,000) 51,000
Capital A/c: Debtors 5,000
Cash 50,000 Machineries 35,000
Add:  Profit for the Year 14,500 Less: Depreciation 3,500 31,500
64,500
Less: Drawings 9,000 55,500
95,500 95,500

Gopal filed his Income Tax return declaring income at ` 33,500. Although, the return of income was filed but
he still had few simple questions in his mind about the accounts that were prepared. He decided to ask these
questions from his relative Akhil. The questions were as follows:
(i) Are the prepared financial statements reliable? Can its arithmetical accuracy be verified?
(ii) Can the financial position of the business be assessed?
(iii) Is the manner in which credit purchase or creditors and credit sales or debtors are determined correct?
(iv) Why the debtors are shown as Nil whereas amount is receivable from Pawan, Salesman? Why the amount
receivable from Pawan is shown in the Profit and Loss Account?

Answer
(i) The financial statements prepared cannot be termed as reliable and also their accuracy cannot be verified
because the accounts are not maintained following double entry system of accounting. Since, both
the aspects of transactions are not recorded trial balance cannot be prepared to verify the arithmetical
accuracy. It is also possible that credit transactions relating to purchase and sale of goods and other credit
transactions may not have been shown in the Profit and Loss Account and/or Balance Sheet.

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 (ii) Although the Balance Sheet is prepared but it cannot be held that it shows true and fair financial position
of the business. The reason being that the accounts are not maintained following Double Entry System
of accounting. As has been stated in (b) above, credit transactions may have been the part of financial
statements meaning assets and liabilities as shown in the Balance Sheet are not correct.
(iii) Credit Purchases or Creditors and Credit Sales or Debtors are ascertained by preparing “Total Creditors
Account” and “Total Debtors Account” as follows:
Dr. TOTAL OR SUNDRY CREDITORS ACCOUNT Cr.
Particulars
` Particulars `

To Cash A/c 55,000 By Purchases (Balancing Figure) 70,000

To Balance c/d 15,000
70,000 70,000

Dr. TOTAL OR SUNDRY DEBTORS ACCOUNT Cr.

Particulars
` Particulars `

To Sales (Balancing Figure) 1,05,000 By Cash A/c 1,00,000

By Balance c/d 5,000
1,05,000 1,05,000

(iv) Debtors as on 31st March, 2020 – ` 25,000 includes ` 20,000 for goods sold on approval basis. Therefore,
actual debtors on 31st March, 2020 = ` 25,000 – ` 20,000 = ` 5,000. The amount of ` 5,000 is receivable
from Pawan, Salesman who has left the job. Since, the amount will not be received from him, it is a loss for
the firm. It is therefore, written off as Bad Debts.

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Gaurav did his Economics (Hons) from Delhi University and his MBA from IIM-Ahmedabad. He got a job with an
FMCG company with a good salary. Post working there for 5 years, he started his own business of assembling
Toy Cars for Children and named his business “Smiling Toys”, on 1st April, 2019 with capital of ` 12,50,000. He
deposited ` 10,00,000 in the firm’s name in HDFC bank and remaining amount was retained as cash in hand.
He took on lease premises (having ground and first floors) for an annual rent of ` 1,80,000. Factory and shop
occupied the ground floor and he used the first floor for residence.
He purchased a Delivery Van on 1st April, 2019 for ` 2,50,000. The estimated working life of the van is 10 years
at the end of which it is likely to be sold for ` 30,000.
An imported toy making machine was also purchased for ` 2,00,000. Its estimated useful life was 10 years and at
the end of its useful life, is likely to have scrap value of ` 25,000. Installation charges of ` 15,000 for the machine,
were wrongly debited to the Wages Account.
He spent ` 25,000 on furnishing his office. 1/4th of all the expenditures on rent, electricity and insurance was
attributed to residential portion and the balance for business purpose.
At the year-end on 31st March, 2020, he prepared following financial statements showing his financial performance
and financial position as of that date:

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Dr. TRADING AND PROFIT AND LOSS ACCOUNT for the year ended 31st March, 2020 Cr.
Particulars
` Particulars `

To Purchases A/c 6,31,000 By Sales A/c 9,00,000

Less: Returns 45,000 5,86,000 Less: Returns 11,000 8,89,000
To Wages A/c 28,500 By Closing Stock 2,35,500
To Gross Profit c/d 5,10,000
11,24,500 11,24,500
To General Expenses A/c 44,000 By Gross Profit b/d 5,10,000
To Rent (1,80,000 × 3/4) 1,35,000 By Discount Received A/c 15,500
To Electricity and Insurance (50,000 × 3/4) 37,500 By Interest A/c 22,000
To Bad Debts A/c 12,500
To Provisions for Doubtful Debts 2,500
To Provision for Discount on Debtors 2,375
To Depreciation on:
Delivery Van 44,000
Toy Machine 19,000 63,000
To Salary A/c 87,000
To Discount Allowed A/c 23,500
To Delivery Van Running Expenses 72,000
To Net Profit transferred to Capital A/c 68,125
5,47,500 5,47,500

BALANCE SHEET
as at 31st March, 2020
Liabilities
` Assets `

Creditors 1,08,000 Cash in Hand 4,30,000

General Reserve 50,000 Cash at Bank 2,31,000
Capital 12,00,000 Debtors 50,000
Less: Drawings* 57,500 Less:  Provision for Doubtful Debts 2,500
11,42,500 47,500
Add: Net Profit 68,125 12,10,625 Less:  Provision for Discount 2,375 45,125
Closing Stock 2,35,500
Furniture 25,000
Toy Machine 2,15,000
Less: Depreciation 19,000 1,96,000
Delivery Van 2,50,000
Less: Depreciation 44,000 2,06,000
13,68,625 13,68,625

* Rent 45,000 plus Electricity & Insurance 12,500.

On the basis of the above financial statement, answer the following questions:
Question
Gaurav decided to create a Provision for Doubtful Debts and Provision for Discount on Debtors @ 5% on debtors.
Which account should be debited for providing for Doubtful Debts and Provision for Discount on Debtors?
Answer
Profit and Loss Account should be debited for Provision for Doubtful Debts and Provision for Discount
on Debtors.

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Question
Gaurav has charged as depreciation on Delivery Van ` 44,000 during the year instead of charging correct
depreciation of ` 22,000 (i.e., Cost of Asset – Scrap Value)/Estimated Useful life). Is it a premium or reserve? State
the type thereof.
Answer
It’s a Secret Reserve.
Question
What is a Secret Reserve?
Answer
Secret Reserve is a reserve which exists but is not shown as a separate item in the Balance Sheet.
Question
How is Secret Reserve created?
Answer
Secret Reserve is created by following methods:
(i) by providing excessive depreciation.
(ii) by creating excessive Provision for Doubtful Debts.
(iii) by showing Capital Expenditure as Revenue Expenditure.
(iv) by accounting Contingent Liability as a Liability.
Question
State two objections against secret Reserve.
Answer
(i) Accounting principle of “full disclosure” is violated.
(ii) Balance Sheet does not show a True and Fair View.
Question
What is “Depreciable Cost”?
Answer
Depreciable Cost = Cost of the Asset – Scrap Value.
Question
Gaurav decided that depreciation would not be provided in case of a loss in a financial year. Is it a correct
decision? Give reason.
Answer
No, it is not a correct decision reason being depreciation is a charge against profit. If it is not charged, it will result
in showing higher net profit or lower net loss. So, it should be charged in case of loss also.
Question
Gaurav decided that 10% of the profits would be set aside to a reserve for the purpose of strengthening the
financial position. Name the reserve which would be created for this purpose.
Answer
General Reserve.

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Question
Name the reserves that can be used in distribution of dividend.
Answer
Revenue Reserves, i.e., General Reserve and Surplus, i.e., Balance in Statement of Profit and Loss.
Question
Balance Sheet has an item termed as General Reserve. Can it also be said to be Reserve Fund? Give reason.
Answer
No, it cannot be termed as Reserve Fund because, the amount of reserve if not retained in the business but is
invested outside the business, it is termed as Reserve Fund.
Question
What is the purpose for which Gaurav has created Provision for Doubtful Debts?
Answer
It is set aside to meet the possible loss as bad debts out of the debtors. It is provided because of the Prudence
or Conservatism Concept which prescribes that anticipated expenses and losses be accounted while anticipated
incomes and gains are not. In brief, financial statements should not show better picture than real.
Question
What is the purpose for which Gaurav has created Provision for Discount for Debtors?
Answer
It is set aside to meet the possible loss on discount being allowed to debtors. It is provided because of the
Prudence or Conservatism Concept which prescribes that anticipated expenses and losses be accounted while
anticipated incomes and gains are not. In brief, financial statements should not show better picture than real.
Question
Suppose Gaurav has earned a profit of ` 10,000 on sale of fixed asset. What should be correct accounting
treatment of it?
Answer
Profit earned on sale of fixed asset being a capital profit is transferred to Capital Reserve.

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