Accounting For Business Unit I Financial Accounting

ST.
JOSEPH'S DEGREE & PG COLLEGE
Accounting for Business

UNIT I
Financial Accounting:
Meaning & Definition of financial accounting–Scope of accounting science–Accounting as a business
information system; Accounting concepts and conventions, their implications on accounting system;
Double entry system–recording business transactions–Classification of accounts–accounting process -
Accounting cycle– accounting equation Primary entry (Journal proper)–Ledger posting .Preparation of
trial balance- Suspense account(Problems )
INTRODUCTION
Accounting is a system meant for measuring business activities, processing of information into reports
and making the findings available to decision-makers. The documents, which communicate these
findings about the performance of an organisation in monetary terms, are called
financialstatements.Usually, accounting is understood as the Language of Business. However, a business
may have a lot of aspects which may not be of financial nature. As such, a better way to understand
accounting could be to call it The Language of Financial Decisions. The better the understanding of the
language, the better is the management of financial aspects of living. Many aspects of our lives are based
on accounting, personal financial planning, investments, income-tax, loans, etc. We have different roles
to perform in life-the role of a student, of a family head, of a manager, of an investor, etc. The
knowledge of accounting is an added advantage in performing different roles. However, we shall limit
our scope of discussion to a business organisation and the various financial aspects of such
anorganisation.
When we focus our thoughts on a business organisation, many questions (is our business profitable,
should a new product line be introduced, are the sales sufficient, etc.) strike our mind. To answer
questions of such nature, we need to have information generated through the accounting process. The
people who take policy decisions and frame business plans use such information.
All business organisations work in an ever-changing dynamic environment. Any new programme of the
organisation or of its competitor will affect the business. Accounting serves as an effective tool for
measuring the financial pulse rate of the company. It is acontinuous
MBA-ACCOUNTING FOR MANAGEMENT

ST.JOSEPH'S DEGREE & PG COLLEGE
cycle of measurement of results and reporting of results to decision- makers.
Just like arithmetic is a procedural element of mathematics, book keeping is

the procedural element of accounting. Figure 1 shows how an accounting system
operates in business and how the flow of information occurs.
People make decision
Business transactions occur
Accountants prepare
reportstoshowtheresults of
businessoperations
FIG 1: THE ACCOUNTING SYSTEM

Source: Liorngren, Harrison and Robinson, Financial and Management
Accounting, Prentice Hall, New Jersey,1994.
Meaning
Accounting is the language of finance. It conveys the financial position of the firm or
business to anyone who wants to know. It helps to translate the workings of a firm into
tangible reports that can be compared. So it is essential that we know the meaning of
accounting.
DEFINITIONS OF FINANCIAL ACCOUNTING
1. According to Smith andAshburn,
“Accounting is the science of recording and classifying business

transactions and events, primarily of financial character and art of
making significant summaries, analysis and interpretations of those
transactions and events and communicating the results to persons
who must make decisions or form judgments”.
2. According to committee on terminology of American

Institute ofCertified Public Accountants (AICPA),
“Accounting is the art of recording, classifying and summarizing in a
significant manner andin terms of money transactions and events
which are in part, at least of financial character and interpreting the
resultsthereof.”
3. Another definition given by the same professional body, namely,

AICPA stated that “Accounting is the collection, measurement,

recording, classification and communication
ofeconomicdatarelatingtoanenterpriseforthepurposeofreporting,decisi
onmakingand control.
4. In 1966, the American Accounting Association defined accounting

asfollows:
“Accounting is the process of identifying, measuring and
communicating economic information to permit informed judgments
and decisions by the users of the information.”
DEVELOPMENT OF ACCOUNTINGDISCIPLINE
The history of accounting can be traced back to ancient times. According to

some beliefs, the very art of writing originated in order to record accounting
information. Though this may seem to be an exaggeration, but there is no denying
the fact that accounting has a long history. Accounting records can be traced back to
the ancient civilizations of China, Babylonia, Greece and Egypt. Accounting was
used to keep records regarding the cost of labour and materials used in building
great structures like thePyramids.
During 1400s, accounting grew further because the needs for information of
merchants in the Venis City of Italy increased. The first knowndescriptionof
doubleentrybook keepingwasfirstpublished in

1994 by Lucas Pacioli. He was a mathematician and a friend of Leonardo Ileda

Vinci.
The onset of the industrial revolution necessitated the development of more

sophisticated accounting system, rather than pricing the goods based on guesses
about the costs. The increase in competition and mass production of goods led to the
rise of accounting as a formal branch of study.
With the passage of time, the corporate world grew. In the nineteenth
century, companies came up in many areas of infrastructure like the railways, steel,
communication, etc. It led to a rapid growth in accounting. As the complexities of
business grew, ownership and management of business was divorced. As such,
managers had to come up with well-defined, structured systems of accounting to
report the performance of the business to itsowners.
Government also has had a lot to do with more accounting developments.

The Income Tax brought about the concept of ‘income’. Government takes a host of
other decisions, relating to education, health, economic planning, for which it needs
accurate and reliable information. As such, the government demands stringent
accountability in the corporate sector, which forces the accounting process to be as
objective and formal aspossible.
UTILITY OFACCOUNTING
The preceing section has just brought out the importance of information. Effective
decisions require accurate, reliable and timely information. The need for quantity and
quality of information varies with the importance of the decision that has to be taken on
the basis of that information. The following paragraphs throw light on the various users
of accounting information and what do they do with that information.
Individuals may use accounting information to manage their routine affairs like
operating and managing their bank accounts, to evaluate the worthwhileness of a job in

an organization, to invest money, to rent a house,etc.
Business Managers have to set goals, evaluate progress and initiate corrective action in
case of unfavourable deviation from the planned course of action. Accounting
information is required for many such decisions—purchasing equipment, maintenance of
inventory, borrowing and lending,etc.

Investors and creditors are keen to evaluate the profitability and solvency of a
company before they decide to provide money to the organisation. Therefore, they
are interested to obtain financial information about the company in which they are
contemplating an investment. Financial statements are the principal source of
information to them which are published in annual reports of a company and
various financial dailies andperiodicals.
Government and Regulatory agencies are charged with the responsibility of

guiding the socio-economic system of a country in such a way that it promotes
common good. For example, the Securities and Exchange Board of India (SEBI)
makes it mandatory for a company to disclose certain financial information to the
investing public. The government’s task of managing the industrial economy
becomes simplify if the accounting information such as profits, costs, taxes, etc. is
presented in a uniform manner without any manipulation or ‘window- dressing’.
Central and State governments levy various taxes. The taxation authorities,
therefore, need to know the income of a company to calculate the amount of tax that
the company would have to pay. The information generated by accounting helps
them in such computations and also to detect any attempts of tax evasion.
Employees and trade unions use the accounting information to settle various
issues related to wages, bonus, profit sharing, etc. Consumers and general public are
also interested in knowing the amount of income earned by various business houses.
Accounting information helps in finding whether or not a company is over charging
or exploiting the customers, whether or not companies are showing improved
business performance, whether or not the country is emerging from theeconomic

recession, etc. All such aspects draw heavily on accounting information and are
closely related to our standard ofliving.
TYPES OF ACCOUNTING
The financial literature classifies accounting into two broad categories, viz,
Financial Accounting and Management Accounting. Financial accounting is
primarily concerned with the preparation of financial statements whereas
management accounting covers areas such as interpretation of financial statements,
cost accounting, etc. Both these types of accounting are examined in the
followingparagraphs.
Financialaccounting
As mentioned earlier, financial accounting deals with the preparation of

financial statements for the basic purpose of providing information to various
interested groups like creditors, banks, shareholders, financial institutions,
government, consumers, etc. Financial statements, i.e. the income statement and the
balance sheet indicate the way in which the activities of the business have been
conducted during a given period oftime.
Financial accounting is charged with the primary responsibility of external

reporting. The users of information generated by financial accounting, like bankers,
financial institutions, regulatory authorities, government, investors, etc. want the
accounting information to be consistent so as to facilitate comparison. Therefore,
financial accounting is based on certain concepts and conventions which include
separate business entity, going concern concept, money measurement concept, cost
concept, dual aspect concept, accounting period concept, matching concept,
realization concept and conventions of conservatism, disclosure, consistency, etc.
All such concepts and conventions would be dealt with detail in subsequentlessons.

The significance of financial accounting lies in the fact that it aids the
management in directing and controlling the activities of the firm and to frame
relevant managerial policies related to areas like production, sales, financing, etc.
However, it suffers from certain drawbacks which are discussed in the
followingparagraphs.
• The information provided by financial accounting is consolidated in
nature. It does not indicate a break-up for different departments,
processes, products and jobs. As such, it becomes difficult to
evaluate the performance of different sub-units of theorganisation.
• Financial accounting does not help in knowing the cost behaviour as it
does not distinguish between fixed and variablecosts.
• The information provided by financial accounting is historical in
nature and as such the predictability of such information islimited.
The management of a company has to solve certain ticklish questions like

expansion of business, making or buying a component, adding or deleting a product
line, deciding on alternative methods of production, etc. The financial accounting
information is of little help in answering thesequestions.
The limitations of financial accounting, however, should not lead one to

believe that it is of no use. It is the basic foundation on which other branches and
tools of accounting analysis are based. It is the source of information, which can be
further analysed and interpreted according to the tailor-made requirements
ofdecision-makers.
ManagementAccounting
Management accounting is ‘tailor-made’ accounting. It facilitates the

management by providing accounting information in such a wayso

that it is conducive for policy making and running the day-to-day operations of the
business. Its basic purpose is to communicate the facts according to the specific
needs of decision-makers by presenting the information in a systematic and
meaningful manner. Management accounting, therefore, specifically helps in
planning and control. It helps in setting standards and in case of variances between
planned and actual performances, it helps in deciding the correctiveaction.
An important characteristic of management accounting is that it is forward

looking. Its basic focus is one future activity to be performed and not what has
already happened in the past.
Since management accounting caters to the specific decision needs, it does

not rest upon any well-defined and set principles. The reports generated by a
management accountant can be of any duration– short or long, depending on
purpose. Further, the reports can be prepared for the organisation as awhole as well
as its segments.
Costaccounting
One important variant of management accounting is the cost analysis. Cost

accounting makes elaborate cost records regarding various products, operations and
functions. It is the process of determining and accumulating the cost of a particular
product or activity. Any product, function, job or process for which costs are
determined and accumulated, are called cost centres.
The basic purpose of cost accounting is to provide a detailed break- up of

cost of different departments, processes, jobs, products, sales territories, etc., so that
effective cost control can be exercised.
Cost accounting also helps in making revenue decisions such as those related
to pricing, product-mix, profit-volume decisions, expansion of business,
replacement decisions,etc.

The objectives of cost accounting, therefore, can be summarized in the form

of three important statements, viz, to determine costs, to facilitate planning and
control of business activities and to supply information for short- and long-term
decision. Cost accounting has certain distinct advantages over financial accounting.
Some of them have been discussed succeedingly. The cost accounting system
provides data about profitable and non-profitable products and activities, thus
prompting corrective measures. It is easier to segregate and analyse individual cost
items and to minimize losses and wastages arising from the manufacturing process.
Production methods can be varied so as to minimize costs and increase profits. Cost
accounting helps in making realistic pricing decisions in times of low demand,
competitive conditions, technology changes,etc.
Various alternative courses of action can be properly evaluated with the

help of data generated by cost accounting. It would not be an exaggeration if it is
said that a cost accounting system ensures maximum utilization of physical and
human resources. It checks frauds and manipulations and directs the employer and
employees towards achieving the organisationalgoal.
Distinction between financial and management accounting
Financial and management accounting can be distinguished on a variety of

basis like, users of information, criterion for decision making, behavioural
implications, time frame, type of reports.
Table 1 presents a summary of distinctions between financial and

management accounting.

TABLE 1: FINANCIAL ACCOUNTING VS MANAGEMENT ACCOUNTING
Basis of Financial accounting Management

distinction accounting
1. Primary user Outside parties and manager Business managers
of the business
2. Decision criterion Accounts are based on Comparison of costs
generally accepted accounting and benefits of proposed
principles action
3. Behavioural Concern about adequacy of Concern about how
implications disclosure. Behavioural reports will affect
implications are secondary employee
behaviour
4. Time focus Past orientation Future orientation
5. Reports Summary reports regarding Detailed reports on
the whole entity the parts of the entity
Source: Horngren, Harrison and Robinson, Financial and Management
Accounting, Prentice Hall, New Jersey,1994.
Accounting Terminology
Accrual: Recognition of revenues and costs as they are earned or incurred. It

includes recognition of transaction relating to assets and liabilities as they occur
irrespective of the actual receipts or payment.
Cost: The amount of expenditure incurred on or attributable to a specified

article, product or activity.
Expenses: A cot relating to the operations of an accounting period.
Revenue: Total amount received from sales ofgoods/services.
Income: Excess of revenue over expenses.

Loss: Excess of expenses over revenue.
Capital: Generally refers to the amount invested in an enterprise by

itsowner.
Fund: An account usually of the nature of a reserve or provision which is

represented by specifically Ear Market Assets.
Gain: A monetary benefit, profit or advantage resulting from a transaction or

group of transactions.
Investment: Expenditure on assets held to earn interest, income, profit or

other benefits.
Liability: The financial obligation of an enterprise other than owners’

funds.
Net Profit: The excess of revenue over expenses during a particular accounting
period.
CHARACTERISTICS / NATURE OF FINANCIAL ACCOUNTING
1.It is a Science and anArt:
Accounting is a science because it has some objects. In other words

Accounting is a science because every business transaction is recorded
in a systematic manner. This is done first in the Journal which is the
primary book of Accounting/ Business. Accounting is anart because it
prescribes the process through which the objects can beachieved.
2.It is the art of recording businesstransactions:
First, all transactions should be recorded in the journal or the books of

original entry known as subsidiary books as and when they take place
so that a complete record of financial transactions is available.
3.It is the art of classifying businesstransactions
All entries in the journal or subsidiary books should be classified by

posting them to the appropriate ledger accounts to find out at a glance
the total effect of all such transactions in a particularaccount.
For example, all transactions relating to Shyam Sundar’s Account in

the journal or various subsidiary books will be posted to Shyam
Sundar’s Account. I t may be noted that business transactions are
recorded and classified in such a way that it may be possible to
determine profit or loss made by the business and its financial
position on a specified date.
4.Recording of Transactions of FinancialNature:
Transactions or events which are of financial or economic nature are

only recorded in accounting. Transactions or Events which cannot be
measured in terms of money are not at all recorded in financial
accounting. For example, a quarrel between production manager and
financial manager may be affecting the business but it cannot be
measured in terms of money and thus will not be recorded in the
books of accounts. Another example is efficiency or honesty of the
employees cannot be recorded because it cannot be measured interms
of money though it affects the total profits ofbusiness.
5. It is the art of summarizing financialtransactions:
After recording and classifying financial transactions next stage is to

prepare the trial balance and final accounts with a view to ascertaining
the profit or loss made during a trading period and financial position
of the business on a particular date.
6.It is an art of analysis and interpretation of these

financialtransactions:
The accounting information must be analyzed and interpreted by

calculating various ratios and percentages or other relationship in
order to evaluate the past performance of the business and to make
sound plans for the future. As we know that the purpose of accounting
is not only recording of transactions but also of analyzing and
interpreting data for taking certain important future decisions. This is
also known as future forecasting. Thus we see the definition of
accounting is changing rapidly because of increase in its functions.
i.e., recording of transactions to interpreting of economicevents.
7. The results of such analysis must be communicated to the persons who

are to make decisions or form judgments. All information must be
provided in timeandpresented to the different categories of the persons
so that appropriate decisions may be taken at the right time.
OBJECTIVES OF FINANCIAL ACCOUNTING
1. Maintaining proper/systematic record of BusinessTransactions:

Accounting replaces the limitations of human memory. The main
purpose of accounting is to identify business transactions of financial
nature and enter them into appropriate books of accounts. Accounting
helps to keep record of all financial transactions and events
systematically in proper books ofaccounts.
2. To ascertain the financial results of theenterprise:
One of the main objects of accounting is to ascertain or calculate the
profit or loss of the business enterprise. Income statements are
prepared with the help of trial balance (prepared with the balances of
ledger accounts). At the end of the accounting period, we prepare
trading account and ascertain gross profit or gross loss. Afterwards
profit and loss account is prepared to ascertain net profit or net loss.
3. To ascertain financial position or financial health of thebusiness:
At the end of the accounting period, we prepare position statement.
Balance sheet is a statement of assets and liabilities of the business on
a particular date and serves as a parameter to measure the financial
health of the business.
4. To help in decisionmaking:
Accounting serves as an information system for helping to arrive at
rational decisions. American Accounting Association also stresses
upon this point while defining the term accounting as “the process of
identifying, measuring and communicating economic information to
permit informed judgments and decisions by the users of the
information. Accounting keeps systematic record of all transactions
and events which are used to assist the management in its function of
decision making and control.
5. Providing Effective Control over theBusiness:
Accounting reveals the actual performance of the business in terms of
production, sales, profit, loss, cost of production and the book value of
the sundry assets. The actual performance can be compared with the
planned and or desired performance of the business. I t can also be
compared with the previous performance. Comparison reveals
deviation in terms of weaknesses and pluspoints.
6. Making Information to variousgroups:

Accounting makes information available to all these interested parties.
Proprietors have interest in profit or dividend, debenture holders,
lenders and investors are concerned with the safety of money advanced
by them to the business and interest thereon. The object of the

accounting is to provide meaningful information to all these
interestedparties.
Meaning of an Account:
An account is a classified summary of business transactions relating

to a particular person or property or an income or an expense.
It is vertically divided into two halves/parts. It is prepared in the form

of alphabet T. The left side of this account is known as Debit side
and right side of the account is known as Credit side.The word Dr
should be written at the top left hand corner side of the account. The
word Cr should be written at the top right hand corner side of the
account. The title or name of the account should be written at the top
in the middle of the account. The word ‘To” should be written on the
debit side of an account in the particulars column. The word ‘By’
should be written on the credit side in the particulars column of an
account. All the receiving aspects are entered on the debit side and
all the giving aspects are entered on the credit side of the account in
the particulars column. All accounts are maintained in Ledger. So
they are called “Ledger accounts”.
Accounting is often called the language of business because the purpose of

accounting is to communicate or report the results of business operations and its
various aspects to various users of accounting information. In fact, today,
accounting statements or reports are needed by various groups such as shareholders,
creditors, potential investors, columnist of financial newspapers, proprietors and
others. In view of the utility of accounting reports to various interested parties, it
becomes imperative to make this language capable of commonly understood by all.
Accounting could become an intelligible and commonly understood language if it is
based on generally accepted accounting principles. Hence, you must be familiar with

the accounting principles behind financial statements to understand and usethem

properly.
Accounting as a Business Information System
An accounting as an information system (AIS) is a system of
collecting, storing and processing financial and accounting data that are used
by decision makers. An accounting information system is generally a computer-
based method for tracking accounting activity in conjunction with information
technology resources. The resulting financial reports can be used internally by
management or externally by other interested parties
including investors, creditors and tax authorities. Accounting information systems
are designed to support all accounting functions and activities
including auditing, financial accounting & reporting, -managerial/ management
accounting and tax. The most widely adopted accounting information systems are
auditing and financial reporting modules.
MEANING AND FEATURES OF ACCOUNTINGPRINCIPLES
For searching the goals of the accounting profession and for expanding
knowledge in this field, a logical and useful set of principles and procedures are to
be developed. We know that while driving our vehicles, follow a standard traffic
rules. Without adhering traffic rules, there would be much chaos on the road.
Similarly, some principles apply to accounting. Thus, the accounting profession
cannot reach its goals in the absence of a set rules to guide the efforts of
accountants and auditors. The rules and principles of accounting are commonly
referred to as the conceptual framework ofaccounting.
Accounting principles have been defined by the Canadian Institute of

Chartered Accountants as “The body of doctrines commonly associated with the
theory and procedure of accounting serving as an explanation of current practices
and as a guide for the selection of conventions or procedures where alternatives
exists. Rules governing the formation of accounting axioms and theprinciples
derived from them have arisen

from common experience, historical precedent statements by individuals and

professional bodies and regulations of Governmental agencies”. According to
Hendriksen (1997), Accounting theory may be defined as logical reasoning in the
form of a set of broad principles that (i) provide a general frame of reference by
which accounting practice can be evaluated, and (ii) guide the development of new
practices and procedures. Theory may also be used to explain existing practices to
obtain a better understanding of them. But the most important goal of accounting
theory should be to provide a coherent set of logical principles that form the general
frame of reference for the evaluation and development of sound
accountingpractices.
The American Institute of Certified Public Accountants (AICPA) has

advocated the use of the word “Principle” in the sense in which it means “rule of
action”. It discuses the generally accepted accounting principles asfollows:
Financial statements are the product of a process in which a large volume of

data about aspects of the economic activities of an enterprise are accumulated,
analysed and reported. This process should be carried out in conformity with
generally accepted accounting principles. These principles represent the most
current consensus about how accounting information should be recorded, what
information should be disclosed, how it should be disclosed, and which financial
statement should be prepared. Thus, generally accepted principles and standards
provide a common financial language to enable informed users to read and
interpret financialstatements.
Generally accepted accounting principles encompass the conventions, rules

and procedures necessary to define accepted accounting practice at a particular
time....... generally accepted accounting principles include not only broad
guidelines ofgeneral

application, but also detailed practices and procedures (Source: AICPA Statement of
the Accounting Principles Board No. 4, “Basic Concepts and Accounting Principles
underlying Financial Statements of Business Enterprises “, October, 1970, pp 54-55)
According to ‘Dictionary of Accounting’ prepared by Prof. P.N. Abroal,

“Accounting standards refer to accounting rules and procedures which are relating to
measurement, valuation and disclosure prepared by such bodies as the Accounting
Standards Committee (ASC) of a particular country”. Thus, we may define
Accounting Principles as those rules of action or conduct which are adopted by the
accountants universally while recording accounting transactions. Accounting
principles are man-made. They are accepted because they are believed to be useful.
The general acceptance of an accounting principle usually depends on how well it
meets the following three basic norms: (a) Usefulness; (b) Objectiveness; and
(c)Feasibility.
A principle is useful to the extent that it results in meaningful or relevant

information to those who need to know about a certain business. In other words, an
accounting rule, which does not increase the utility of the records to its readers, is
not accepted as an accounting principle. A principle is objective to the extent that
the information is not influenced by the personal bias or Judgement of those who
furnished it. Accounting principle is said to be objective when it is solidly supported
by facts. Objectivity means reliability which also means that the accuracy of the
information reported can be verified. Accounting principles should be such as are
practicable. A principle is feasible when it can be implemented without undue
difficulty or cost. Although these three features are generally found in accounting
principles, an optimum balance of three is struck in some cases for adopting a
particular rule as an accounting principle. For example, the principle of making the
provision for doubtful debts is found on feasibility and usefulnessthough

it is less objective. This is because of the fact that such provisions are not supported by
any outside evidence.
KINDS OF ACCOUNTINGPRINCIPLES
In dealing with the framework of accounting theory, we are confronted with a

serious problem arising from differences in terminology. A number of words and
terms have been used by different authors to express and explain the same idea or
notion. The various terms used for describing the basic ideas are: concepts,
postulates, propositions, assumptions, underlying principles, fundamentals,
conventions, doctrines, rules, axioms, etc. Each of these terms is capable of precise
definition. But, the accounting profession has served to give them lose and
overlapping meanings. One author may describe the same idea or notion as a
concept and another as a convention and still another as postulate. For example, the
separate business entity idea has been described by one author as a concept and by
another as a convention. It is better for us not to waste our time to discuss the
precise meaning of generic terms as the wide diversity in these terms can only serve
to confuse thelearner.
We do feel, however, that some of these terms/ideas have a better claim to be

called ‘concepts’ while the rest should be called ‘conventions’. The term ‘Concept’
is used to connote the accounting postulates, i.e., necessary assumptions and ideas
which are fundamental to accounting practice. In other words, fundamental
accounting concepts are broad general assumptions which underline the periodic
financial statements of business enterprises. The reason why some of these terms
should be called concepts is that they are basic assumptions and have a direct
bearing on the quality of financial accounting information. The term ‘convention’ is
used to signify customs or tradition as a guide tothe

preparation of accounting statements. The following are the important accounting

concepts and conventions:
Accounting Concepts Accounting Conventions

Separate Business Entity Concept Convention of Materiality
Money Measurement Concept Convention of Conservatism
Dual Aspect Concept Convention of consistency
Accounting Period Concept
Cost Concept
The Matching Concept
Accrual Concept
Realisation Concept
ACCOUNTINGCONCEPTS
The more important accounting concepts are briefly described as follows:
1. Separate Business EntityConcept
In accounting we make a distinction between business and the owner. All the
books of accounts records day to day financial transactions from the view point of
the business rather than from that of the owner. The proprietor is considered as a
creditor to the extent of the capital brought in business by him. For instance, when a
person invests Rs. 10 lakh into a business, it will be treated that the business has
borrowed that much money from the owner and it will be shown as a ‘liability’ in
the books of accounts of business. Similarly, if the owner of a shop were to take
cash from the cash box for meeting certain personal expenditure, the accounts would
show that cash had been reduced even though it does not make any difference to the
owner himself. Thus, in recording a transaction the important question is how does
it affectsthe

business? For example, if the owner puts cash into the business, he has a claim
against the business for capital broughtin.
In so-far as a limited company is concerned, this distinction can be easily

maintained because a company has a legal entity like a natural person it can engage
itself in economic activities of buying, selling, producing, lending, borrowing and
consuming of goods and services. However, it is difficult to show this distinction in
the case of sole proprietorship and partnership. Nevertheless, accounting still
maintains separation of business and owner. It may be noted that it is only for
accounting purpose that partnerships and sole proprietorship are treated as separate
from the owner (s), though law does not make such distinction. In fact, the business
entity concept is applied to make it possible for the owners to assess the
performance of their business and performance of those whose manage the
enterprise. The managers are responsible for the proper use of funds supplied by
owners, banks and others.
2. Money MeasurementConcept
In accounting, only those business transactions are recorded which can be

expressed in terms of money. In other words, a fact or transaction or happening
which cannot be expressed in terms of money is not recorded in the accounting
books. As money is accepted not only as a medium of exchange but also as a store
of value, it has a very important advantage since a number of assets and equities,
which are otherwise different, can be measured and expressed in terms of a common
denominator.
We must realise that this concept imposes two severe limitations. Firstly,
there are several facts which though very important to the business, cannot be
recorded in the books of accounts because they cannot be expressed in money
terms. For example, generalhealth

condition of the Managing Director of the company, working conditions in which a

worker has to work, sales policy pursued by the enterprise, quality of product
introduced by the enterprise, though exert a great influence on the productivity and
profitability of the enterprise, are not recorded in the books. Similarly, the fact that a
strike is about to begin because employees are dissatisfied with the poor working
conditions in the factory will not be recorded even though this event is of great
concern to the business. You will agree that all these have a bearing on the future
profitability of thecompany.
Secondly, use of money implies that we assume stable or constant value of

rupee. Taking this assumption means that the changes in the money value in future
dates are conveniently ignored. For example, a piece of land purchased in 1990
for Rs. 2 lakh and another bought for the same amount in 1998 are recorded at the
same price, although the first purchased in 1990 may be worth two times higher
than the value recorded in the books because of rise in land prices. In fact, most
accountants know fully well that purchasing power of rupee does change but very
few recognise this fact in accounting books and make allowance for changing
pricelevel.
3. Dual AspectConcept
Financial accounting records all the transactions and events involving

financial element. Each of such transactions requires two aspects to be recorded.
The recognition of these two aspects of every transaction is known as a dual aspect
analysis. According to this concept every business transactions has dual effect. For
example, if a firm sells goods of Rs. 5,000 this transaction involves two aspects.
One aspect is the delivery of goods and the other aspect is immediate receipt of
cash (in the case of cash sales). In fact, the term ‘double entry’ book keeping has
come into vogue and in this system the total amount debitedalways

equals the total amount credited. It follows from ‘dual aspect concept’ that at any
point of time owners’ equity and liabilities for any accounting entity will be equal to
assets owned by that entity. This idea is fundamental to accounting and could be
expressed as the following equalities:
Assets = Liabilities +OwnersEquity …(1)
Owners Equity =Assets-Liabilities …(2)
The above relationship is known as the ‘Accounting Equation’. The term

‘Owners Equity’ denotes the resources supplied by the owners of the entity while
the term ‘liabilities’ denotes the claim of outside parties such as creditors,
debenture-holders, bank against the assets of the business. Assets are the resources
owned by a business. The total of assets will be equal to total of liabilities plus
owners capital because all assets of the business are claimed by either owners
oroutsiders.
4. Going Concern Concept
Accounting assumes that the business entity will continue to operate for a
long time in the future unless there is good evidence to the contrary. The enterprise
is viewed as a going concern, that is, as continuing in operations, at least in the
foreseeable future. In other words, there is neither the intention nor the necessity to
liquidate the particular business venture in the predictable future. Because of this
assumption, the accountant while valuing the assets does not take into account
forced sale value of them. In fact, the assumption that the business is not expected to
be liquidated in the foreseeable future establishes the basis for many of the
valuations and allocations in accounting. For example, the accountant charges
depreciation on fixed assets. It is this assumption which underlies the decision of
investors to commit capital to enterprise. Only on the basis of this assumption
accounting process can remain stable and achieve the objectiveof

correctly reporting and recording on the capital invested, the efficiency of

management, and the position of the enterprise as a going concern.
However, if the accountant has good reasons to believe that the business, or
some part of it is going to be liquidated or that it will cease to operate (say within
six-month or a year), then the resources could be reported at their current values. If
this concept is not followed, International Accounting Standard requires the
disclosure of the fact in the financial statements together withreasons.
5. Accounting PeriodConcept
This concept requires that the life of the business should be divided into
appropriate segments for studying the financial results shown by the enterprise
after each segment. Although the results of operations of a specific enterprise can be
known precisely only after the business has ceased to operate, its assets have been
sold off and liabilities paid off, the knowledge of the results periodically is also
necessary. Those who are interested in the operating results of business obviously
cannot wait till the end. The requirements of these parties force the businessman ‘to
stop’ and ‘see back’ how things are going on. Thus, the accountant must report for
the changes in the wealth of a firm for short time periods. A year is the most
common interval on account of prevailing practice, tradition and government
requirements. Some firms adopt financial year of the government, some other
calendar year. Although a twelve month period is adopted for external reporting, a
shorter span of interval, say one month or three month is applied for internal
reportingpurposes.
This concept poses difficulty for the process of allocation of long term costs.
All the revenues and all the cost relating to the year in operation have to be taken
into account while matching the earnings and the cost of those earnings for the any
accounting period. This holdsgood

irrespective of whether or not they have been received in cash or paid in cash.
Despite the difficulties which stem from this concept, short term reports are of vital
importance to owners, management, creditors and other interested parties. Hence,
the accountants have no option but to resolve suchdifficulties.
6. CostConcept
The term ‘assets’ denotes the resources land building, machinery etc. owned
by a business. The money values that are assigned to assets are derived from the
cost concept. According to this concept an asset is ordinarily entered on the
accounting records at the price paid to acquire it. For example, if a business buys a
plant for Rs. 5 lakh the asset would be recorded in the books at Rs. 5 lakh, even if
its market value at that time happens to be Rs. 6 lakh. Thus, assets are recorded at
their original purchase price and this cost is the basis for all subsequent accounting
for the business. The assets shown in the financial statements do not necessarily
indicate their present market values. The term ‘book value’ is used for amount
shown in the accountingrecords.
The cost concept does not mean that all assets remain on the accounting
records at their original cost for all times to come. The asset may systematically be
reduced in its value by charging ‘depreciation’, which will be discussed in detail in
a subsequent lesson. Depreciation has the effect of reducing profit of each period.
The prime purpose of depreciation is to allocate the cost of an asset over its useful
life and not to adjust its cost. However, a balance sheet based on this concept can be
very misleading as it shows assets at cost even when there are wide difference
between their costs and market values. Despite this limitation you will find that the
cost concept meets all the three basic norms of relevance, objectivity andfeasibility.

7. The Matchingconcept
This concept is based on the accounting period concept. In reality we match

revenues and expenses during the accounting periods. Matching is the entire
process of periodic earnings measurement, often described as a process of matching
expenses with revenues. In other words, income made by the enterprise during a
period can be measured only when the revenue earned during a period is compared
with the expenditure incurred for earning that revenue. Broadly speaking revenue is
the total amount realised from the sale of goods or provision of services together
with earnings from interest, dividend, and other items of income. Expenses are cost
incurred in connection with the earnings of revenues. Costs incurred do not become
expenses until the goods or services in question are exchanged. Cost is not
synonymous with expense since expense is sacrifice made, resource consumed in
relation to revenues earned during an accounting period. Only costs that have
expired during an accounting period are considered as expenses. For example, if a
commission is paid in January, 2002, for services enjoyed in November, 2001, that
commission should be taken as the cost for services rendered in November 2001.
On account of this concept, adjustments are made for all prepaid expenses,
outstanding expenses, accrued income, etc, while preparing periodicreports.
8. AccrualConcept
It is generally accepted in accounting that the basis of reporting income is

accrual. Accrual concept makes a distinction between the receipt of cash and the
right to receive it, and the payment of cash and the legal obligation to pay it. This
concept provides a guideline to the accountant as to how he should treat the cash
receipts and the right related thereto. Accrual principle tries to evaluate every
transaction in terms of its impact on the owner’s equity. The essence of theaccrual

concept is that net income arises from events that change the owner’s equity in a
specified period and that these are not necessarily the same as change in the cash
position of the business. Thus it helps in proper measurement ofincome.
9. RealisationConcept
Realisation is technically understood as the process of converting non-cash

resources and rights into money. As accounting principle, it is used to identify
precisely the amount of revenue to be recognised and the amount of expense to be
matched to such revenue for the purpose of income measurement. According to
realisation concept revenue is recognised when sale is made. Sale is considered to be
made at the point when the property in goods passes to the buyer and he becomes
legally liable to pay. This implies that revenue is generally realised when goods are
delivered or services are rendered. The rationale is that delivery validates a claim
against the customer. However, in case of long run construction contracts revenue is
often recognised on the basis of a proportionate or partial completion method.
Similarly, in case of long run instalment sales contracts, revenue is regarded as
realised only in proportion to the actual cash collection. In fact, both these cases are
the exceptions to the notion that an exchange is needed to justify the realisation
ofrevenue.
ACCOUNTINGCONVENTIONS
1. Convention ofMateriality
Materiality concept states that items of small significance need not be given
strict theoretically correct treatment. In fact, there are many events in business
which are insignificant in nature. The cost of recording and showing in financial
statement such events may not be well justified bythe utility derived from that
information. For example, an

ordinary calculator costing Rs. 100 may last for ten years. However, the effort
involved in allocating its cost over the ten year period is not worth the benefit that
can be derived from this operation. The cost incurred on calculator may be treated as
the expense of the period in which it is purchased. Similarly, when a statement of
outstanding debtors is prepared for sending to top management, figures may be
rounded to the nearest ten orhundred.
This convention will unnecessarily overburden an accountant with more

details in case he is unable to find an objective distinction between material and
immaterial events. It should be noted that an item material for one party may be
immaterial for another. Actually, there are no hard and fast rules to draw the line
between material and immaterial events and hence, It is a matter of judgement and
common sense. Despite this limitation, It is necessary to disclose all material
information to make the financial statements clear and understandable. This is
required as per IAS-1 and also reiterated in IAS-5. As per IAS-1, materiality
should govern the selection and application of accountingpolicies.
2. Convention ofConservatism
This concept requires that the accountants must follow the policy of
‘‘playing safe” while recording business transactions and events. That is why, the
accountant follow the rule anticipate no profit but provide for all possible losses,
while recording the business events. This rule means that an accountant should
record lowest possible value for assets and revenues, and the highest possible value
for liabilities and expenses. According to this concept, revenues or gains should be
recognised only when they are realised in the form of cash or assets (i.e. debts) the
ultimate cash realisation of which can be assessed with reasonable certainty.
Further, provision must be made for all known liabilities, expenses and losses,
Probable losses regarding all contingenciesshould

also be provided for. ‘Valuing the stock in trade at market price or cost price which
ever is less’, ‘making the provision for doubtful debts on debtors in anticipation of
actual bad debts’, ‘adopting written down value method of depreciation as against
straight line method’, not providing for discount on creditors but providing for
discount on debtors’, are some of the examples of theapplication of the convention
of conservatism.
The principle of conservatism may also invite criticism if not applied

cautiously. For example, when the accountant create secret reserves, by creating
excess provision for bad and doubtful debts, depreciation, etc. The financial
statements do not present a true and fair view of state of affairs. American Institute
of Certified Public Accountant have also indicated that this concept need to be
applied with much more caution and care as over conservatism may result
inmisrepresentation.
3. Convention ofConsistency
The convention of consistency requires that once a firm decided on certain

accounting policies and methods and has used these for some time, it should
continue to follow the same methods or procedures for all subsequent similar events
and transactions unless it has a sound reason to do otherwise. In other worlds,
accounting practices should remain unchanged from one period to another. For
example, if depreciation is charged on fixed assets according to straight line method,
this method should be followed year after year. Analogously, if stock is valued at
‘cost or market price whichever is less’, this principle should be applied in each
subsequentyear.
However, this principle does not forbid introduction of improved accounting

techniques. If for valid reasons the company makes any departure from the method
so far in use, then the effect of the change must be clearly stated in the financial
statements in the year of change.
Theapplicationoftheprincipleofconsistencyisnecessaryforthe

purpose of comparison. One could draw valid conclusions from the comparison of data
drawn from financial statements of one year with that of the other year. But the
inconsistency in the application of accounting methods might significantly affect the
reporteddata.
ACCOUNTING CYCLE
STEPS IN ACCOUNTING CYCLE:
Step 1: Journalizing: Record the transactions and events in the Journal.
Step 2: Posting: Transfer the transactions in the respective accounts opened in the
Ledger.
Step 3: Balancing: Ascertain the difference between the total of debit amount
column and the total of credit amount column of a ledger account.
Step 4: Trial Balance: Prepare a list showing the balance of each and every account
to verify whether the sum of the debit balances is equal to the sum of the credit
balances.
Step 5: Income Statement: Prepare Trading and Profit and Loss account to
ascertain the profit or loss for accounting period.
Step 6: Position Statement/Balance Sheet: Prepare the Balance Sheet to ascertain

the financial position as at the end of accounting period.
Accounting Equation
The accounting equation is considered to be the foundation of the double-entry accounting system.
On a company's balance sheet, it shows that a company's total assets are equal to the sum of the
company's liabilities and shareholders' equity.
Based on this double-entry system, the accounting equation ensures that the balance sheet remains
“balanced,” and each entry made on the debit side should have a corresponding entry (or coverage)
on the credit side.
Understanding the Accounting Equation

The financial position of any business, large or small, is assessed based on two key components of
the balance sheet: assets and liabilities. Owners’ equity, or shareholders' equity, is the third section
of the balance sheet. The accounting equation is a representation of how these three important
components are associated with each other. The accounting equation is also called the basic
accounting equation or the balance sheet equation.

While assets represent the valuable resources controlled by the company, the liabilities represent
its obligations. Both liabilities and shareholders' equity represent how the assets of a company
are financed. If it's financed through debt, it'll show as a liability, and if it's financed through
issuing equity shares to investors, it'll show in shareholders' equity.
The accounting equation helps to assess whether the business transactions carried out by the
company are being accurately reflected in its books and accounts. Below are examples of items
listed on the balance sheet:
Assets
Assets include cash and cash equivalents or liquid assets, which may include Treasury
bills and certificates of deposit. Accounts receivables are the amount of money owed to the
company by its customers for the sale of its product and service. Inventory is also considered an
asset.
Liabilities
Liabilities are what a company typically owes or needs to pay to keep the company running. Debt,
including long-term debt, is a liability, as are rent, taxes, utilities, salaries, wages,
and dividends payable.
Shareholders' Equity
Shareholders' equity is a company's total assets minus its total liabilities. Shareholders' equity
represents the amount of money that would be returned to shareholders if all of the assets were
liquidated and all of the company's debt was paid off.
Retained earnings are part of shareholders' equity and are equal to the percentage of net
earnings that were not paid to shareholders as dividends. Think of retained earnings as savings
since it represents a cumulative total of profits that have been saved and put aside or retained for
future use.
Accounting Equation Formula and Calculation

\text{Assets}=(\text{Liabilities}+\text{Owner's Equity})Assets=(Liabilities+Owner’s Equity)
The balance sheet holds the basis of the accounting equation:
1. Locate the company's total assets on the balance sheet for the period.
2. Total all liabilities, which should be a separate listing on the balance sheet.
3. Locate total shareholder's equity and add the number to total liabilities.
4. Total assets will equal the sum of liabilities and total equity.
As an example, let's say for the fiscal year, leading retailer XYZ Corporation reported the
following on its balance sheet:
• Total assets: $170 billion

• Total liabilities: $120 billion
• Total shareholders' equity: $50 billion

If we calculate the right-hand side of the accounting equation (equity + liabilities), we arrive at
($50 billion + $120 billion) = $170 billion, which matches the value of the assets reported by the
company.
Classification of Accounts:
Broadly speaking accounts are classified into two types. They are I.
Personal Accounts
II. Impersonal Accounts. Impersonal accounts are again divided into Real
Accounts and Nominal Accounts. Thus accounts are of threetypes.
1. PersonalAccounts
2. RealAccounts
3. NominalAccounts
Real and Nominal Accounts are collectively called “Impersonal Accounts”.
1. PersonalAccount:
These are accounts of persons and institutions with whom the business
deals. A separate account is kept for each person. Personal accounts can
be classified into three categories:
They are i) Natural personal accounts ii) Artificial Personal accounts iii)
Representative Personalaccounts.
I) Natural Personal Accounts: The term Natural Persons means who
are creations of Gods. For example Ravi Account, Rani Account,
Raghu account Nagarjuna Account etc., are called as Natural
PersonalAccounts.
II) Artificial Personal Accounts: These accounts include accounts of
corporate bodies or institutions which are recognized as persons
in business dealings. The account of a Limited Company, the
accounts of co-operative society, the accounts of clubs, the
account of Government, the account of insurance company, the
account of Colleges, Schools, Universities and Hotels etc., are
examples of Artificial Personal Accounts. PersonalAccounts:
III) Representative Personal Accounts: These are accounts which
represent a certain person or group of persons. For example,
Outstanding expenses A/c, Prepaid expenses A/c, Income
Receivable A/c and Income received in advance A/c, Drawings
A/c and Capital A/c are termed as RepresentativeAccounts.

Principle/ Rule of PersonalAccount:

Debit the receiver and Credit the giver.
For example, if cash has been paid to Raja, the account of Raja will
have to be debited. Similarly, if cash received from Meena, the account
of Meena will have to be credited.
2. RealAccount:
Accounts relating to properties or assets or possessions of the firm are
called Real Accounts. Every business firm needs Fixed Assets such as
Land and Buildings, Plant and Machinery, Furniture and Fixtures etc
for running its business. A separate account is maintained for each
asset. There are Four types of Assets. They are
Fixed Assets: Those assets which are acquired for long term use by the
business concern are known as fixed assets. For example Land and
Buildings, Plant and Machinery, Furniture and Fixtures etc are called as
Fixed Assets.
Current Assets: Those assets which are possible to convert into cash
are known as known as Current assets. For example cash in hand, cash
at Bank, Stock in trade, Debtors, Bills Receivable etc., are called as
current assets.
Tangible Assets: Tangible assets are those which relate to such things
which can be touched, felt, measured etc., Tangible assets have physical
existence. Hence theseassets may be transferred from one place to
another place.Fixed asset and Current assets are the examples of
Tangible assets.
Intangible Assets: These accounts represent such things which cannot

be touched. Of course, they can be measured in terms of money.
Intangible assets haven’t any physical existence. Goodwill, copy rights,
patents and trademarks are the examples of Intangible assets.
Principle of Real Account:
i) Debit what comes into the businessand

ii) Credit what goes out of thebusiness.
For example, if machinery has been purchased for cash, machinery
account should be debited since it is coming into the business, while
cash account should be credited since cash is going out of the business.
If furniture is sold for cash, cash account should be debited since cash is
coming into the business, while Furniture account should be credited
since furniture is going out of the business.
3. NominalAccount:
Nominal accounts include accounts of all expenses, losses, incomes and
gains. The examples of such accounts are salaries, wages, rent, taxes,
lighting charges, transport charges, travelling charges, coolie charges,
warehouse rent, insurance, advertisement paid, Bad debts, commission
paid, Discount allowed, interest paid, interest paid on capital, rent
received, interest received, commission received, discount received,
dividend received, interest on investment received, bad debts recovered
etc.,
These accounts are opened in the books to simply explain the nature of
the transactions. They do not really exist. For example, in a business
when salary is paid to the manager, commission is paid to the
salesmen, rent is paid to landlord, cash goes out of the business and it is
something real, while salary, commission, or rent as such does not exist.
The accounts of these items are opened simply to explain how the cash
has been spent. In the absence of such information, it may be difficult
for the cashier to explain how the cash at his disposal was utilized.
Nominal accounts are also called FictitiousAccounts.
Principle or Rule of Nominal Account:
1. Debit all expenses and lossesand

2. Credit all incomes andgains.
For example when salaries paid in cash, salaries account should be
debited since it is an expense to the business, while cash account should
be credited since cash is going out of the business. If Rent received in
cash, Cash account should be debited since cash is coming into the
business, while rent account should be credited since it is an income to
thebusiness.
The principle of Nominal account is quite opposite to the principles of

personal account and real account. As per the principle of Nominal
account receiving aspects (Incomes and profits) are credited and giving
aspects (expenses and losses) are debited. But as per the principles of
personal account and real account, receiving aspect is debited and
giving aspect is credited. Hence the rule of Nominal account is different
from the principles of Real account and Nominalaccount.
Functions / Scope of Financial Accounting:
1. Systematic record of business transactions /Recording:

Recording is the basic function of accounting. Accounting records business
transactions interms of money. It is essentially concerned with ensuring that
all business transactions of financial nature are properly recorded.
Recording is done in Journal or subsidiary books in chronological order. To
keep systematic record of transactions, post them into ledger and ultimately
to prepare the final accounts is the first function of accounting.
2. Classifying:
Accounting also facilitates classification of all business transactions
recorded in the journal. Items of similar nature are classified under
appropriated heads. It deals with classification of recorded transactions so
as to group similar transactions at one place. The work of classification is
done in a book called the Ledger, where similar transactions are recorded
at one place under individual account heads. Eg. In sales account all sale of
goods are recorded. In purchases account all purchase of goods are
recorded.
3. Summarizing:
It involves presenting classified transactions in a manner useful `to both its
internal and external users. It involves preparation of financial statements
i.e profit& loss account and Balance sheet etc., Accounting summarizes the
classified information. This process leads to the preparation of Trial
balance, Income statement and balance sheet.
4. Analyzing:
The recorded data in financial statement is analyzed to make useful
interpretation. The figures given in financial statements need to be put in a
simplified manner. Eg. All items relating to fixed assets are placed at one
place while long term liabilities are placed at one place.
5. Interpretation:
It deals with explaining the meaning and significance of the data
simplified. The accountants should interpret the statements in a manner
useful to the users. Interpretation of data helps management, outsiders and
shareholders in decision making. It aims at drawing meaningful
conclusions from the information. Different parties can make meaningful
judgments about the financial condition and profitability of business
operations.
6. Communicating Results to InterestedParties:

Accounting also serves as an information system. It is the language of the
business. It supplies the meaningful information about the financial
activities of the business to varies parties i.e., owners, creditors, investors,

employees, government, public, research scholarsand managers at the right
time. It is a service function. It is not an end itself but a means to an end. It
involves preparation and distribution of reports to the users to make
decisions.
7. Compliance with legalrequirements:

The accounting system must aim at fulfilling the requirements of law.
Under the provisions of law, the business man has to file various
statements such as income-tax returns, sales tax returns etc.
8. Protecting the property of thebusiness:

For performing this function the accountant is required to devise
such a system of recording information so that assets of the
business are not put to wrong use anda complete record of the
assets of the concern is available without anydifficulty.
ADVANTAGES/ IMPORTANCE OF FINANCIAL ACCOUNTING
1. Provides for systematicrecords:

Since all the financial transactions are recorded in the books, one need not
rely on memory. Any information required is really available from
theserecords.
2. Facilitates the preparation of financialstatements:

Profit and Loss Account and Balance Sheet can be easily prepared with the
help of the information in the records. This enables the trader to know the
net result of the business operations. During the accounting period and
financial position of the business at the end of the accounting period.
3. Provides control overassets:

Book-keeping provides information regarding cash in hand, cash at bank,
stock of goods, Accounts receivables, from various parties and the amounts
invested in various other assets. As the trader knows the values of the assets
he will have control over them.
4. Assistance to variousparties:
It provides information to various parties i.e., owners, money lenders,
creditors, investors, government, managers, research scholars, public and
employees and financial position of a business concern from their own
viewpoint.
5. Assistance to the insolventperson:

If a person is maintaining proper accounts and unfortunately he becomes
insolvent (i.e., when he is unable to pay to his creditors), he can explain
many things about the past with help of accounts and can start a fresh life.
6. Comparative study:
One can compare the present performance of the organization with that of
its past. This enables the managers to draw useful conclusions and make
proper decisions.
7. Less scope for fraud ortheft:
It is difficult to conceal fraud or theft etc., because of the balancing of the

books of accounts periodically. As the work is divided among many
persons, there will be check and countercheck.
8. Settlement of TaxationLiability:
If accounts are properly maintained, it will be of great help to the
businessman in settling the income tax and sales tax liability otherwise tax
authorities may impose any amount of tax which the businessman will have
topay.
9. Documentaryevidence:
Accounting records can also be used as evidence in the court to substantiate
the claim of the business. These records are based on documentary proof.
Every entry is supported by authentic vouchers. As such, courts accept
these records as evidence.
10. Helpful tomanagement:

Accounting is useful to the management in various ways. It enables the
management to assess the achievement of its performance. The weaknesses
of the business can be identified and corrective measures can be applied to
remove them with of the accounting.
11. Replacement ofmemory:

In a large business it is very difficult for a business man torememberallthe
transactions. Accounting provides records which will furnish information
as and when desired and thus it replaces humanmemory.
LIMITATIONS / DISADVANTAGES OF FINANCIAL ACCOUNTING
1. Records only monetarytransactions:

Accounting records only those transactions which can be measured in
monetary terms. Those transactions which cannot be measured in monetary
terms as conflict between production manager and marketing manager,
office management etc., may be very important for concern but not
recorded in the business books.
2. Effect of price level changes notconsidered:

Accounting transactions are recorded at cost in the books. The effect of
price level changes is not brought into the books with the result that
comparison of various years becomes difficult. For example, the sales to
total assets in 2007 would be much higher than in 2003 due to rising prices,
fixed assets being shown at cost and not at market price.
3. No realisticinformation:
Accounting information may not be realistic as accounting statements are
properly prepared by following basic concepts and conventions. For
example, going concern concept gives us an idea that the business will
continue and assets are to be recorded at cost but the book value which the
asset is showing may not be actually realizable. Similarly, by following the
principles of conservation the financial statements will not reflect the true
position of thebusiness.
4. No real test of managerialperformance:

Profit earned during an accounting period is the test of managerial
performance. Profit maybe shown in excess by manipulation of accounts by
suppressing such costs as depreciation, advertisement and research and
development or taking excess value of closing stock. Consequently real
idea of managerial performance may not be available by manipulatedprofit.
5. Historical innature:
Usually accounting supplies information in the form of Profit and Loss
Account and Balance Sheet at the end of the year. So, the information
provided is of historical interest and only gives post-mortem analysis of the
past accounting information. For control and planning purposes
management is interested in quick and timely information which is not
provided by financial accounting.
6. Personal bias / judgment of Accountant affect the accounting

Statements: Accounting statements are influenced by the personal judgment
of the accountant. He may select any method of depreciation, valuation of
stock, amortization of fixed assets and treatment of deferred revenue
expenditure. Such judgment based on integrity and competency of the
accountant will definitely affect the preparation of accountingstatements.
7. Permits alternative treatments:
Accounting permits alternative treatments within generally accepted

accounting concepts and conventions. For example, method of charging
depreciation may be straight line method or diminishing balance method or
some other method. Similarly, closing stock may be valued by FIFO(First-in-
First Out) or LIFO(Last in First Out) or Average Price Method. Application
of different methods may give different results and results may not be
comparable.

MEANING OF DOUBLE ENTRY SYSTEM
Double entry system is a scientific way of presenting accounts. As such all the
business concerns feel it convenient to prepare the accounts under double entry
system. The taxation authorities also compel the businessmen to prepare the
accounts under Double Entry System.
Under dual aspect the Account deals with the two aspects of business
transaction i.e., (1) receiving aspect and (2) giving aspect. Receiving aspect is
known as Debit aspect and giving aspect is known as Credit aspect. Under
which system these two aspects of transactions are recorded in chronological
manner in the books of the business concern is known as Double Entry System.
In Double Entry System these two aspects are recorded facilitating the
preparation of Trial Balance and the Final Accounts.
PRINCIPLE OF DOUBLE ENTRY SYSTEM
Every business transaction has got two accounts, where one account is debited
and the other account is credited. If one account receives a benefit, there should
be another account to impart the benefit. The principle of Double Entry is
based on the fact that there can be no
givingwithoutreceivingnorcantherebereceivingwithoutsomethinggiving.Therece
ivingaccount is debited (i.e., entered on the debit side of the account) and the
giving account iscredited (i.e., entered on the credit side of the account).
The principle under which both debit and credit aspects are recorded is known
as the principle of double entry. According to this principle every debit must
necessarily have a corresponding credit and vice versa.
ADVANTAGES OF DOUBLE ENTRY SYSTEM
1. Scientific system:
Double entry system records, classifies and summarizes business
transactions in a systematic manner and, thus, produces useful information
for decision makers. It is more scientific as compared to single entry of
book-keeping.
2. FullInformation:
Full and authentic information can be had about all transactions as the
trader maintains the ledger with all types of accounts.
3. Assessment of Profit andLoss:

The businessman/trader will be able to know correctly whether he had
earned profit or sustained loss. It facilitates the trader to take such steps so
as to increase the efficiency of the firm.
4. Knowledge ofDebtors:
The trader will be able to know exactly what amounts are owed by different
customers to the firm. If any amount is pending for a long time from any
customer, he may stop credit facility to that customer.
5. Knowledge ofCreditors:
The trader is also knows the exact amounts owed by the firm to others and
he will be able to arrange prompt payment to obtain cash discount.
6. ArithmeticalAccuracy:
The arithmetical accuracy of the books can be proved by the trial balance.
7. Assessment of FinancialPosition:
The trader will be able to prepare the Balance Sheet which will help the
interested parties to know fully about the financial position of the firm.
8. Comparison of Results:
It facilitates the comparison of current year results with those of previous
years.
9. Maintenance according to Income TaxRules:

Proper maintenance of books will satisfy the tax authorities and facilitates
accurate assessment. In India Joint stock companies should maintain
accounts under double entry system.
10. Detection ofFrauds:

The systematic and scientific recording of business transactions on the
basis of this system minimizes the chances of embezzlement and frauds or
errors. The frauds or errors can be easily detected by vouching, verification
and auditing of accounts.
DISADVANTAGES/ LIMITATIONS OF DOUBLE ENTRY SYSTEM
1. Not Practical to AllConcerns:

This system requires the maintenance of a number of books of accounts
which is not practical in small concerns.
2. Costlysystem:
This system is costly because of a number of records are to be maintained.
3. No guarantee of Absolute Accuracy of the Books ofAccount:

There is no guarantee of absolute accuracy of the books of account inspite
of agreement of the trial balance because of there are some errors like errors
of principles, errors of omission, compensating errors etc., which remain
understand in spite of agreement of trial balance.
4. Errors ofOmission:
In case the entire transaction is not recorded in the books of accounts, the
mistake cannot be detected by accounting. The Trial Balance will tally
inspite of the mistakes.
5. Errors ofPrinciple:
Double entry is based upon the fact that every debit has its corresponding
credit and vice versa. It will not be able to detect the mistake such as
debiting Ram’s account instead of Rao’s account or Building account in
place of Repairs account.
6. CompensatingErrors:
If Rahim’s account is by mistake debited with Rs. 15 lesser and Mohan’s
account is also by mistake credited with Rs.15 lesser, the Trial Balance will
tally but mistake will remain inaccounts.
THE JOURNAL
The word Journal is derived from the French word ‘Jour’ which means a day.
Journal, therefore, means a daily record of business transactions. Journal is a
book of original entry/prime entry because transaction is first written in the
journal from which it is posted to the ledger at any convenient time. The journal
is a complete and chronological record of business transactions. It is recorded
in a systematic manner. The process of recording a transaction in the journal is
called Journalizing. The entries made in the book are called JournalEntries.
Proforma of Journal
Journal Entries in the books of--------------
Date Particulars L.F Debit Credit

Amount (Rs.) Amount (Rs.)
ADVANTAGES
OF JOURNAL
1. Availability of Full information/CompleteRecord:
All business transactions date-wise will be recorded in the Journal As such the
total information for every transaction can be obtained very easily without late.
So Journal serves as a complete record. It provides a chronological record of all
transactions and hence provides permanentrecord.
2. Posting becomeseasy:
When once the transactions are entered in the Journal, recording the same in
the relevant accounts in the ledger can be made easily. The businessman can
have an understanding on debit and credit principles in the beginning itself. It
provides information of debit and credit in an entry and an explanation to make
it understandable properly.
3. Explanation of thetransaction:
Every Journal entry will be briefly explained with a narration.
Narration helps in the proper understanding of the entry.
4. Location of the errorseasy:

Journal helps to locate the errors easily. Both debit and credit aspects of a
transaction are recorded in the journal. Since the amount recorded in debit
amount column and credit amount column must be equal. Therefore, the
possibility of committing errors is reduced and the detection of errors, if any,
committed becomes easy.
5. Chronologicalorder:
Transactions are recorded in a chronological order in the Journal. Hence, when
any information is required, the information can be traced out quickly and
easily.
6. Eliminates the need for reliance on memory:

It eliminates the need for a reliance on memory of the accounts keeper. Some
transactions are of a complicated nature and without the journal; the entries
may be difficult, if not impossible.
7. Journal provides information relating to the followingaspects:
a. Credit sale and purchase of fixed assets, investment or anything else not dealt
in by the firm.
b. Special allowances received from suppliers or given to thecustomers.
c. Writing off extra-ordinary losses viz. losses due to fire, earth quakes, theft
etc., and bad debts.
d. Recording in the reduction of the assets i.e.,depreciation.

e. Receipt and issue of bills of exchange, promissory notes, hundies and their
dishonor, renewaletc.,
f. Transactions with Bank(unless bank column added to the cashbook)
g. Income earned but not received incash.
h. Expenses incurred but not yet paid for in cash and other similar adjustingentries.
i. Transfer entries viz. posting total of subsidiary books to the respective
impersonal accounts in the ledger at the end of every month, transfer of gross
profit or loss to the Profit & Loss A/c and net profit or net loss and also
drawings A/c to the Capital A/c at the end of the tradingperiod.
j. Closing entries-entries to close the books at the time of preparing trading and
profit &loss account.
LIMITATIONS OF JOURNAL
The following are the main limitations of the journal.
1. The Journal will be too long and becomes unwieldy if all transactions are
recorded in the journal.
2. The Journal is unable to ascertain daily cash balance. That is why cash
transactions are directly recorded in a separate cash book so that daily cash
balances may beavailable.
3. It becomes difficult in practice to post each and every transaction from the
Journal to the ledger. Hence in order to make the accounting easier and
systematic, transactions are recorded in total in differentbooks.
THE LEDGER
• The second stage in the accounting cycle is ledger posting it means posting
transactions entered in the journal into their respective accounts in the ledger. It
is the book of final entry. The Ledger is designed to accommodate the various
accounts maintained by a trader. It containsthefinalandpermanentrecordofall
transactionsinduly classifiedform.Aledgerisa book which contains various
accounts. The process of transferring the entries from the journal into the
ledger is called posting.
• A Ledger may be defined as a summary statement of all the transactions

relating to a person, asset, expense or income which have taken place during a
given period of time and shows their net effect. The up to date state of any
account can be easily known by referring to the ledger.
FEATURES OF LEDGER
i. Ledger contains all the accounts-personal, real and nominalaccounts.
ii. It is a permanent record of businesstransactions.
iii. It provides a means of easyreference.

iv. It provides final balance of theaccounts.
Ledger is the principal book of accounts because it helps us in achieving the

objectives of accounting. It gives answers to the following pertinent questions.
1. How much amount is due from others to thebusiness?
2. How much amount is owed toothers?
3. What are the total sales to an individual customer and

what are the total purchases from an individualsupplier?
4. What is the amount of profit or loss made during a particularperiod?
5. What is the financial position of the firm on a particulardate?
ADVANTAGES OF LEDGER
The following are the main utilities of Ledger
1. It provides complete information about all accounts in onebook.
2. It is easy to ascertain how much money is due to suppliers (trade creditors from
creditors’ ledger) and how much money is due from customers (trade debtors
from debtors’ledger).
3. It enables to ascertain, what are the main items of revenues/incomes

(Nominalaccounts).
4. It enables to ascertain, What are the main items of expenses(Nominalaccounts)
5. It enables to know the kind of assets the enterprise holds and their respective
values(Real Accounts)
6. It facilitates preparation of trial balance and thereafter preparation of financial

statements i.e., profit and loss account and balancesheet.
TRIAL BALANCE
`Trial Balance is a statement in which debit and credit balances of all ledger

accounts are shown to test the Arithmetical accuracy of the books of account.
Trial Balance is not conclusive proof of accuracy of books of accounts.
DEFINITIONS OF TRIAL BALANCE:
1. According to J.R.Batliboi, “A Trial Balance is a statement of Debit

andCreditbalances extracted from the various accounts in the ledger with a
view to test the arithmetical accuracy of the books.”
2. According to Spicer and Pegler, “A Trial Balance is a list of all
the balances standing on the ledger accounts and cash book of a
concern at any givendate.”
FEATURES OF TRIAL BALANCE
1. It is not an account;it is only a statement which is prepared to verify the

arithmetical accuracy of ledgeraccounts.
2. It contains debit and credit balances of ledgeraccount.
3. It is prepared on a particular date generally at the end o f businessyear.
4. Trial Balance helps in preparing finalaccounts.
5. As it is prepared by taking up the ledger account balances, both debit and credit
side of a Trial Balance are alwaysequal.
6. The preparation of Trial Balance is not compulsory. There is no
hard fastrule in this regard.
IMPORTANCE OF TRIAL BALANCE:
1. Proof of Arithmeticalaccuracy:
It helps in checking the arithmetical accuracy of books of accounts.
2. Preparation of financialstatements:
It helps in the preparation of final accounts i.e., Trading Account, Profit &
Loss Account and Balance Sheet.
3. Detection ofErrors:
It will help in detection of errors in the books of accounts and in their
rectification.
4. Rectification ofErrors:
It serves as instrument for carrying out the job of rectification of errors.
5. EasyChecking:

It is possible to find out the balances of various accounts at one place.
LIMITATIONS OF TRIAL BALANCE
1. Trial balance can be prepared only in those concerns where double entry
system of accounting is adopted. This system is very costly and time
consuming. It cannot be adopted by the small businessconcerns.
2. Though Trial Balance gives arithmetical accuracy of the books of accounts but
there are certain errors which are not disclosed by Trial Balance. That is why it
is said that Trial balance is not a conclusive proof of the accuracy of the books
ofaccounts.
3. If Trial Balance is not prepared correctly then the final accounts prepared will
not reflect the true and fair view of the state of the affairs/financial position of
the business. Whatever conclusions and decisions are made by the various
groups of persons will not be correct and will mislead suchpersons.
5. Trial Balance tallies even though errors are existing in the books ofaccounts.
6. Even some transactions are omitted the Trial Balancetallies.
OBJECTIVES OF TRIAL BALANCE:
The following are the main objectives of preparing the Trial Balance.
1. To have balances of all the accounts of the ledger in order to avoid the necessity
of going through the pages of the ledger to find itout.
2. To have a proof that the double entry of each transaction has been recorded
because of its agreement.
3. To have arithmetical accuracy of the books of accounts because of the

agreement of the TrialBalance.
4. To have material for preparing the profit or loss account and

balance sheet of the business.
METHODS FOR PREPARING TRIAL BALANCE:

1. TotalsMethod:
Under this method the total of debits and credits of all ledger accounts are
shown in the debit and credit side of the Trial Balance. The Trial Balance
prepared under this method is known as gross TrialBalance.
2. BalancesMethod:
Under this method all the balances of each and every account will be
shown against the debit or credit side of the Trial Balance. If an account
has no balance then it will not be shown in the Trial Balance. This method
is more convenient and commonly used.
3. Totals and Balances Method / CompoundMethod:
Under this method, the above two methods are combined. Under this
method statement of trial balance contains seven columns instead of two
columns.
4. Elimination of Equal TotalsMethod:
Under this method equal totals of accounts will be eliminated from the trial
balance.
UNIT II
Preparation and presentation of financial statements–Distinction between capital and revenue
expenditure–Measurement of business Income, profit and loss account–Preparation of balance
sheet(Problems )
Depreciation: concept–Methods of depreciation–their impact on measurement of business
income.
INTRODUCTION
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 financialposition?
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: (i) Trading Account; and (ii) Profit and LossAccount.
But, if the business concern is a manufacturing concern, it has to prepare the

following accounts along with the BalanceSheet:
(i) Manufacturing Account; (ii) Trading Account; and (iii) Profit and Loss
Account.
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 TradingAccount

or Profit and Loss Account. Any Account which cannot find a place in any of these two
accounts goes to the BalanceSheet.
TRADINGACCOUNT
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 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 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. The specimen of a Trading Account is givenbelow:
TRADING ACCOUNT
FOR THE YEAR ENDED 31ST MARCH, 2006
Particulars Amount Particulars Amount

Rs. Rs.
To OpeningStock By Sales
To Purchases Less Sales Returns
Less Purchases Returns By Closing Stock
To DirectExpenses: By Gross Loss
Carriage Inward transferred to
Wages P & L A/c
Fuel, Power and Lighting
Expenses
Manufacturing Expenses
Coal, Water and Gas
Motive Power
Octroi
Import Duty
Custom Duty
Consumable Stores
Freight and Insurance
Royalty on manufactured
Goods
Packing charges

To GrossProfittransferredtoP&LA/c
Important points regarding trading account
1. Stock
The term ‘stock’ includes goods lying unsold on a particular date.

The stock may be of two types:
(a) Opening stock
(b) Closingstock
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 BalanceSheet.

2. 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:
(a) Purchases Returns or ReturnOutwards.
(b) Goods withdrawn by proprietor for his personaluse.
(c) Goods received on consignment basis or on approval basis or on
hirepurchase.
(d) Goods distributed by way of freesamples.
(e) Goods given ascharity.
3. DirectExpenses
Direct expenses are those expenses which are directly attributable to the
purchase of goods or to bring the goods in saleable condition. Some examples of
direct expenses are asunder:
(a) Carriage Inward: Carriage paid for bringing the goods to the
godown is treated as carriage inward and it is debited to Trading Account.
(b) 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.
(c) Wages: Wages incurred in a business is direct, when it is 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
TradingAccount.

(d) 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 is also charged to Trading Account, but lighting expenses of administrative
office or sales office are charged to Profit and LossAccount.
(e) Octroi: When goods are purchased within municipality limits,

generally octroi duty has to be paid on it. It is debited to Trading Account.
(f) 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 LossAccount.
(g) Manufacturing Expenses: All expenses incurred in manufacturing

the goods in the factory such in factory rent, factory insurance etc. are debited to
TradingAccount.
(h) 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.
4. 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:
(a) If a fixed asset such as furniture, machinery etc. is sold, it should not
be included insales.
(b) Goods sold on consignment or on hire purchase or on sale or return
basis should be recordedseparately.
(c) If goods have been sold but not yet despatched, these should not be
shown under sales but are to be included in closing stock.
(d) Sales of goods on behalf of others and forward sales should also be
excluded fromsales.
Closing entries for tradingaccount
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 asfollows:
1. For transfer of opening stock, net purchases and direct expenses to

TradingA/c.
TradingA/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 TradingAccount)
2. For transfer of net sales and closing stock to Trading A/c

SalesA/c Dr.
Stock(Closing)A/c Dr.
To Trading A/c
(Being sales, closing stock transferred to Trading Account)

3. (a) For Gross Profit

TradingA/c Dr.
To Profit & Loss A/c
(Being gross profit transferred to Profit and Loss Account)
(b) For GrossLoss
Profit &LossA/c Dr.
To Trading A/c
(Being gross loss transferred to Profit and Loss
Account)
MANUFACTURINGACCOUNT
The concern which are engaged in the conversion of raw materials into
finished goods, are interested to knowing the cost of production of the goods
produced. The cost of the goods produced cannot be obtained from the Trading
Account. So, it is desirable to prepare a Manufacturing Account prior to be
preparation of the Trading account with the object of
ascertainingthecostofgoodsproducedduringtheaccountingperiod.
The proforma of Manufacturing Account is given as under:
MANUFACTURING ACCOUNT
FOR THE YEARENDING...................
Dr. Cr.
Rs. Rs.

To Work-in process (Opening) To By Work-in-process (Closing) By

Raw Materials consumed: Sale of Scrap
Opening Stock By Cost of Production of finished
Add Purchases of Raw goods during the period
Materials transferred to the Trading
Less Closing Stock of Raw Account
Materials
To Direct or Productive
Wages
To Factory Overheads:
Power & Fuel Repairs
of Plant
Depreciation on Plant

Factory Rent
The Trading Account in case of manufacturers will appear as follows:
TRADING ACCOUNT
FOR THE YEAR ENDING..............
Dr. Cr.
Rs. Rs.
To Opening Stock of Finished Goods By Sales less Returns
To Cost of Production of finished goods
By Closing Stock of Finished
transferred from Manufacturing
goods
Account
To Purchases of Finished Goods By Gross Loss transferred to
less Returns
Profit and Loss A/c
To Carriage Charges on goods
purchased
To Gross Profit transferred to
Profit and Loss A/c
The gross profit or loss shown by the Trading Account will be taken to the
Profit and Loss Account which will be prepared in the usual way as explained in the
followingpages.
Important Points Regarding Manufacturing Account
1. Raw MaterialsConsumed
The cost of raw materials consumed to be included in the debit side of the
Manufacturing Account shall be calculated asfollows:
Rs.
Opening Stock ofrawmaterials ..........
Add Purchases ofrawmaterials ........... ...........

Less Purchase return ofrawmaterials ...........

Less Closing stock ofrawmaterials ...........
Cost of raw material consumed
2. DirectExpenses
The expenses and wages that are directly incurred in the process of
manufacturing of goods are included under this head..
3. Factory Overheads
The term “overheads” includes indirect material, indirect labour and indirect
expenses. Therefore, the term “factory overheads” stands for all factory indirect
material, indirect labour and indirect expenses. Examples of factory overheads are:
rent for the factory, depreciation of the factory machines and insurance of the
factory,etc.
4. Cost ofProduction
Cost of production is computed by deducting from the total of the debit side
of the Manufacturing Account, the total of the various items appearing on the credit
side of the ManufacturingAccount.
Difference between trading account and manufacturing account
Manufacturing Account Trading Account

1. Manufacturing account is prepared to Trading Account is prepared to
find out the cost of goods produced. find out the Gross Profit/Gross
Loss.
2. The balance of the manufacturing The balance of the Trading
Account is transferred to the Trading account is transferred to the Profit
Account. and Loss Account.
3. Sale of crap is shown in the Sale of scrap is not shown in the
Manufacturing Account. Trading Account.
4. Stocks of raw materials and work-in- Stocks of finished goods are shown

progress are shown in the in the Trading Account.

Manufacturing Account.
5. Manufacturing Account is a part of the Trading Account is a part of the
Trading account. Profit and Loss Account.
PROFIT AND LOSSACCOUNT
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
LossAccount.
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
isrequired.
A proforma of the Profit and Loss Account showing probable items therein is
as follows:

PROFIT AND LOSS A/C

FOR THE YEAR ENDED .....................
Rs. Rs.
ToGrossLossb/d By Gross Profit b/d
To Selling and By Other Income:
DistributionExpenses: Discount received
Advertisement Commission received
Travellers’ Salaries By Non-trading Interest:
Expenses & Commission Bank Interest
Godown Rent Rent of property let-out
Export Expenses Dividend from shares
Carriage Outwards By Abnormal Gains:
Bank Charges Profit on sale of machinery
Agent’s Commission Profit on sale of investment
Upkeepof Motor ByNetLosstransferredtoCapitalAccount
Lorries To
ManagementExpenses:
Rent, Rates and Taxes
Heating and Lighting
Office Salaries
Printing & Stationary
Postage & Telegrams
Telephone Charges
Legal Charges
Audit Fees
Insurance
General Expenses
To Depreciation and
Maintenance: Depreciation
Repairs&Maintenance
ToFinancialExpenses:
Discount Allowed
Interest onLoans
DiscountonBills
To Abnormal Losses:
Lossbyfire(notcoveredbyInsurance)
LossonSaleofFixedAssets
Loss on Sale of Investments

ToNetprofittransferredtoCapitalA/c
Important points in Profit and Lossaccount
1. Selling and DistributionExpenses
These expenses are incurred for promoting sales and distribution of sold
goods. Example of such expenses are godown rent, carriage outwards,
advertisement, cost of after sales service, selling agents commission,etc.
2. ManagementExpenses
These are the expenses incurred for carrying out the day-to-day
administration of a business. Expenses, under this head, include office salaries,
office rent and lighting, printing and stationery and telegrams, telephone charges,
etc.
3. MaintenanceExpenses
These expenses are incurred for maintaining the fixed assets of the
administrative office in a good condition. They include repairs and renewals,etc.
4. FinancialExpenses
These expenses are incurred for arranging finance necessary for running the
business. These include interest on loans, discount on bills, etc.
5. AbnormalLosses
There are some abnormal losses that may occur during the accounting period.
All types of abnormal losses are treated as extra

ordinary expenses and debited to Profit and Loss Account. Examples are stock lost
by fire and not covered by insurance, loss on sale of fixed assets,etc.
Following are the expenses not to appear in the Profit and Loss Account:
(i) Domestic and household expenses of proprietor orpartners.
(ii) Drawings in the form of cash, goods by the proprietor or partners.
(iii) Personal income tax and life insurance premium paid by the firm on
behalf of proprietor orpartners.
6. GrossProfit
This is the balance of the Trading Account transferred to the Profit and Loss
Account. If the Trading Account shows a gross loss, it will appear on the debitside.
7. OtherIncome
During the course of the business, other than income from the sale of goods,
the business may have some other income of financial nature. The examples are
discount or commissionreceived.
8. Non-tradingIncome
Such incomes include interest on bank deposits, loans to employees and

investment in debentures of companies. Similarly, dividend on investment in
shares of companies and units of mutual funds are also known as non-trading
incomes and shown in Profit and LossAccount.

9. AbnormalGains
There may be capital gains arising during the course of the year, e.g., profit
arising out of sale of a fixed asset. Such profit is shown as a
separateincomeonthecreditsideoftheProfitandLossAccount.
Closing entries for Profit and Lossaccount
(i) For transfer of various expenses to Profit & Loss A/c Profit
andLossA/c Dr.
ToVariousExpenses A/c
(Being various indirect expenses transferred to Profit and
LossAccount)
(ii) For transfer of various incomes and gains to Profit & Loss A/c
Various Incomes&Gains A/c Dr.
(Being various incomes & gains transferred to Profit and Loss
Account)
(iii) (a) For NetProfit
Profit&Loss A/c Dr.
ToCapital A/c
(Being Net Profit transferred to capital)
(b) For NetLoss
CapitalA/c Dr
(Being Net Loss transferred to Capital Account)
Illustration II: From the following balances extracted at the close of year
ended 31 March, 2006, prepare Profit and Loss Account as at that date:
Rs. Rs.
Gross Profit 51,000 Discount (Dr.) 500
Carriage Outward 2,500 Apprentice Premium (Cr.) 1,500

Salaries 5,500 Printing & Stationary 250

Rent 1,100 Rates & Taxes 350
Fire Insurance Premium 900 Travelling Expenses 200
Bad Debts 2,100 Sundry Trade Expenses 300
Commission Received 1,000 Discount allowed by Creditors 800
Solution
PROFIT & LOSS ACCOUNT OF M/S..............................

FOR THE YEAR ENDED 31ST MARCH, 2006
Dr. Cr.
Particular Rs. Particular Rs.

To Carriage Outward 2,500 By Gross Profit b/d 51,000
To Salaries 5,500 By Apprentice Premium By 1,500
To Rent 1,100 Discount by 800
Creditors
To Fire Insurance Premium 900 By Commission 1,000
To Bad Debts 2,100
To Discount 500
To Printing & Stationary 250
To Rent & Taxes 350
To Travelling Expenses 200
To Sundry Trade Expenses 300
To Net Profit transferred to 40,600
Capital A/c
54,300 54,300
Distinction between trading account and Profit and Loss Account

Profit and Loss Account Trading Account
1. Profit and Loss Account is Trading Account is prepared asa

Profit and Loss Account Trading Account

prepared as a main account. part or section of the Profit and
Loss Account.
2. Indirect expenses are taken in Direct Expenses are taken in
Profit and Loss Account. Trading Account.
3. Net Profit or Net Loss is ascertained Gross Profit or Gross Loss is
from the Profit and ascertained from Trading
Loss Account. Account.
4. The balance of the Profit and Loss The Balance of the Trading Account
Account i.e. Net Profit or Net Loss is i.e. Gross Profit or Gross Loss is
transferred to proprietor’s transferred to theProfit
Capital Account. and Loss Account.
5. Items of accounts written in the Profit Items of account written in the Trading
and Loss Account are much more as Account are few as compared the Profit
compared to the Trading andLoss
Account. Account.
BALANCESHEET
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 acompany.
A Balance Sheet is also described as a “Statement showing the Sources and

Application 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
specifieddate.
Characteristics
The characteristics of a Balance Sheet are summarised as under:

(a) 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’.
(b) 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 isprepared.
(c) A Balance Sheet is a summary of balances of those ledger accounts
which have not been closed by transfer to Trading and Profit and
LossAccount.
(d) A Balance Sheet shows the nature and value of assets and the nature
and theamount of liabilities at a given date.
Classification of assets andliabilities
Assets
Assets are the properties possessed by a business and the amount due to it
from others. The various types of assetsare:
(a) FixedAssets
All assets that 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 convertibleinto cash in

the normal course of business operations. Examples are land and building,
furniture, machinery,etc.
(b) CurrentAssets
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) TangibleAssets
There are definite assets which can be seen, touched and have volume such
as machinery, cash, stock, etc.
(d) IntangibleAssets
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
suchassets.
(e) 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 sharesetc.
(f) WastingAssets
Such assets as mines, quarries etc. that become exhausted or reduce in value
by their working are called wastingassets.
(g) ContingentAssets
Contingent assets come into existence upon the happening of a certain event
or the expiry of a certain time. If that event happens,the

asset becomes available otherwise not, for example, sale agreement to acquire
some property, hire purchase contracts etc.
In practical no reference is made to contingent assets in the Balance Sheet.

At the most, they may form part of notes to the Balance Sheet.
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 classifiedas:
(a) Long TermLiabilities
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 termliabilities.
(b) CurrentLiabilities
All short term obligations generally due and payable within one
yeararecurrentliabilities.Thisincludestradecreditors,billspayableetc.
(c) ContingentLiabilities
A contingent liability is one which is not an actual liability. They become

actual on the happenings of some event which is uncertain. In other words, they
would become liabilities in the future provided the contemplated event occurs.
Since such a liability is not actual liability it is not shown in the Balance Sheet.
Usually it is mentioned in the form of a footnote below the BalanceSheet.

Marshalling of assets and liabilities
The arrangement of assets and liabilities in a particular order is called

marshalling of the Balance Sheet. Assets and liabilities can be arranged in the
Balance Sheet into two ways:
(a) In order ofliquidity.
(b) In order ofpermanence.
When assets and liabilities are arranged according to their reliability and
payment preferences, such an order is called liquidity order. Such arrangement is
given below in Balance Sheet (a). When the order is reversed from that what is
followed in liquidity, it is called order of permanence. In other words, assets and
liabilities are listed in order of permanence. This order of Balance Sheet is given
below in Balance Sheet(B).
BALANCE SHEET (A)

(IN ORDER OFLIQUIDITY)
Liabilities Rs. Assets Rs.
Bills payable Cash in hand
Loans Cash at bank
Sundry creditors Investments
Outstanding expenses Sundry debtors
Reserves Bills receivable
Capital Stock-in-trade
Add NetProfit Loose tools
Add Interest Fixtures and fittings
Less Drawings Plant and machinery
Building
Land
Goodwill

BALANCE SHEET (B)

(IN ORDER OF PERMANENCE)
Liabilities Rs. Assets Rs.

Capital Goodwill
Add Net Profit Land
Add Interest Building
Less Drawings Plant and machinery
Reserves Fixtures and fittings
Outstanding expenses Loose tools
Sundry creditors Stock-in-trade
Loans Bills receivable
Bills payable Sundry debtors
Investments
Cash at bank
Cash in hand
ADJUSTMENTS
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 followingpages.
1. ClosingStock
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:
ClosingstockAccount 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 Tradingaccount.
(ii) At same value it will be shown as an asset in the balance sheet.
2. OutstandingExpenses
Those expenses which have become due and have not been paid at the end of
the accounting year, are called outstanding expenses. For example, the businessman
has paid rent only for 4 months instead of one

year. This means 8 months’ rent is outstanding. In order to bring this fact into
books of accounts, the following adjustment entry will be passed at the end of
theyear:
RentA/c Dr.
TooutstandingRent A/c
(Being rent outstanding for 8months)
The two fold effect of the above adjustment will be (i) the amount of
outstanding rent will be added to the rent on the debit side of Profit and Loss
Account, and (ii) outstanding rent will be shown on the liability side of the
BalanceSheet.
3. PrepaidExpenses
There are certain expenses which have been paid in advance or paid for the
future period which is not yet over or not yet expired. The benefit of such expenses
is to be enjoyed during the next accounting period. Since, such expenses have
already been paid, they have also recorded in the books of account of that period for
which they do not relate. For example, insurance premium paid for one year
Rs.3,600 on 1st July, 1996. The final accounts are prepared on 31st March, 1997.
The benefit of the insurance premium for the period from 1st April to 30th June,
1997 is yet to expire. Therefore, the insurance premium paid for the period from
1st April 1997 to 30th June, 1997, i.e. for 3 months, shall be treated as “Prepaid
InsurancePremium”.
The adjustment entry for prepaid expenses is as under:

PrepaidExpensesAccount Dr.
To Expenses Account
(Being the adjustment entry for prepaid expenses)
The amount of prepared expenses will appear as an asset in the Balance

Sheet while amount of appropriate expense account willbe

shown in the Profit and Loss Account by way of deduction from the said expense.
4. AccruedIncome
Accrued income means income which has been earned during the current
accounting year and has become due but not received by the end of the current
accounting period. Examples of such income are income from investments, dividend
on shares etc. The adjustment entry for accrued income is asunder:
AccruedIncome A/c Dr.
ToIncome A/c
(Being the adjustment entry for accrued income)

i) The amount of accrued income is added to the relevant item of
income on the credit side of the Profit and Loss Account to increase
the amount of income for the current year.
ii) The amount of accrued income is a debt due from a third party to the
business, so it is shown on the assets side of the BalanceSheet.
5. Income Received inAdvance
Income received but not earned during the current accounting year is called
as income received in advance. For example, if building has been given to a tenant
on Rs.2,400 p.a. 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 accountingyear:
RentA/c Dr. Rs.600
To Rent Received inAdvanceA/c Rs.600

The two-fold effect of this adjustment will be:

(i) It is shown on the credit side of Profit and Loss account by way of
deduction from the income,and
(ii) It is shown on the liabilities side of the Balance Sheet as income
received inadvance.
6. 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 1.1.98, 20% p.a. is the
rate of depreciation. Then Rs.2,000 will be depreciation for the year 1998 and will
be brought into account by passing the following adjusting entry:
DepreciationA/c Dr. Rs.2,000
ToMachineryA/c Rs.2,000
The two-fold effect of depreciation will be:

(i) Depreciation is shown on the debit side of Profit and Loss
Account,and
(ii) It is shown on the asset side of the balance sheet by way of deduction
from the value of concernedasset.
7. Interest onCapital
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.
Calculation of Interest on Capital
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
oncapital:
Interest onCapitalAccount Dr.
To Capital Account
(Being the adjustment entry for interest on capital)

(i) 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 LossAccount.
(ii) 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 theBalance Sheet.
8. Interest ofDrawings
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:
DrawingsA/c Dr.Rs.500
To Interest onDrawingsA/c Rs.500

The two-fold effect of interest on drawings will be:

(i) Interest on drawings will be shown on the credit side of Profit and
Loss Account,and
(ii) Shown on the liabilities side of the Balance Sheet by way of addition
to the drawings which are ultimately deducted from thecapital.
9. BadDebts
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 adjustmententry:
BadDebtsA/c Dr.
To Sundry Debtors A/c
(Being the adjustment entry for bad debts)
The profit and Loss Account is debited with the amount of bad debts and in
the Balance Sheet, the Sundry Debtors balance will be reduced by the same amount
in the assetsside.
10. Provisions for DoubtfulDebts
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 usuallybased

upon the past experience of the business. The reasons for making provision for
doubtful debts are two as discussedbelow:
(i) Loss caused by likely bad debts must be charged to the Profit and
Loss of the period for which credit sales have been made to ascertain
correct profit of theperiod.
(ii) 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 balancesheet.
For example, sundry debtors on 31.12.1998 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 bemade:
Profit andLossA/c Dr.Rs.2,750
To Provision for DoubtfulDebtsA/c Rs.2,750
(Being Provision for Doubtful Debtsprovided)
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.

(i) The amount of provision for doubtful debts is a provision against a
possible loss so it should be debited to Profit and Lossaccount.
(ii) The amount of provision for doubtful debts is deducted from sundry
debtors on the assets side of thebalance sheet.

11. Provision for Discount onDebtors
It is a normal practice in business to allow discount to customers for prompt

payment and it constitutes a substantial sum. Some times 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 debtsi.e.
Profit andlossaccount Dr.
To provision for discount on debtors account
(Being provision for discount on debtors provided)

(i) Provision for discount on debtors is a probable loss, so it should be
shown on the debit side of Profit and Loss account.
(ii) Amount of provision for discount on debtors is deducted from
sundry debtors on the assets side of the BalanceSheet.
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 thepayment.
12. Reserve for Discount onCreditors
Prompt payments to creditors enable 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 theprofit.

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
(Being the adjustment entry for discount on creditors)

i) Reserve for discount on creditors is shown on the credit side of Profit
and Lossaccount.
ii) In the liabilities side of the Balance Sheet, the reserve for discount on
creditors is shown by way of deductions from SundryCreditors.
13. Loss of Stock byFire
In business, the loss of stock may occur due to fire. The position of the stock
may be:
(a) all the stock is fullyinsured.
(b) the stock is partlyinsured.
(c) the stock is not insured atall.
It the stock is fully insured, the whole loss will be claimed from the insurance
company. The following entry will be passed:
InsuranceCo.A/c Dr.
To Trading A/c
(Being the adjustment entry for Loss of goods charged from insuranceCo.)
The value of goods lost by fire shall be shown on the credit side of
thetradingAccountandthisisshownasanassetintheBalanceSheet.
If the stock is not fully insured, the loss of stock covered by insurance policy
will be claimed from the insurance company andthe

rest of the amount will be loss for the business which is chargeable to
ProfitandLossAccount.Inthiscase,thefollowingentrywillbepassed:
InsuranceCo.A/c Dr.
Profit andLossA/c Dr.
To Trading A/c
(Being the adjustment entry for Loss of goods)
The amount of goods lost by fire is credited to Trading Account, the

amount of claim accepted by insurance company shall be treated as an asset
in the Balance Sheet, while the amount of claim not accepted is a loss so it
will be debited to Profit and LossAccount.
If the stock is not insured at all, the whole of the loss will be borne by
the business and the adjusting entry shallbe:
To Trading A/c
(Being the adjustment entry for Loss of goods)
The double effect of this entry will be (a) it is shown on the credit
side of the Trading Account (b) it is shown on the debit side of the Profit and
Loss Account.
14. Manager’sCommission
Sometimes, in order to increase the profits of the business, manager

is given some commission on profits of the business. It can be given at a
certain percentage on the net profits but before charging such commission or
on the net profits after charging such commission. In both the cases, the
adjustment entry willbe:
To Commission PayableA/c
DEPRECIATION ACCOUNTS
Meaning of Depreciation:
The word Depreciation is derived from the Latin word ‘Depretium.’ De

means decline and premium means price. It means decline in the value
of an asset.
Depreciation is a permanent, continuing and gradual shrinkage in the

book value of a fixed asset. Depreciation is charged on the fixed assets
only.
Definitions of Depreciation:
1) According toCarter
“Depreciation is the gradual decrease in the value of asset from any cause.”
2) According to Spicer andPegler
Depreciation may be defined as “a measure of the exhaustion of the

effective life of an asset from any cause during a given period.”
3) According toPickles
“Depreciation may be defined as the permanent and continuous

diminution in the quality, quantity or value of an asset.”
4) According to International Accounting StandardCommittee
“Depreciation is the allocation of the depreciable amount of an asset

over its estimated useful life. Depreciation for the accounting period is
charged to income either directly or indirectly”.
Causes of Depreciation:
1. PhysicalDeterioration:
Depreciation is caused mainly from wear and tear when the asset
is in the use and from erosion, rust, rot and delay from being
exposed to wind, rain, sun and other elements of nature.
2. Economic Factors:
These may be said to be those that cause the asset to be put out of use
even though it is in good physical condition.
These arise due to obsolescence and inadequacy. Obsolescence means
the process of becoming obsolete or out of date.
Old machinery though in good physical condition may be rendered
obsolete by the introduction of a new model which produces more

than the old machinery.
Inadequacy refers to the termination of the use of an asset because of

growth and changes in the size of the firm. But obsolescence and
inadequacy do not necessarily mean that the asset is scrapped. It is
merely put out of use by the firm. Another firm will often buyit.
3. TimeFactors:
There are certain assets with a fixed period of legal life such as lease,
patents and copyrights. For example, a lease can be entered into for
any period while a patent’s legal life is for some years but on certain
grounds this can be extended.
Provision for the consumption of these assets is called amortization rather
than depreciation.
4.Depletion:
Some assets are of a wasting character perhaps due to the extraction of
raw materials from them.
These materials are then either used by the firm to make something
else or are sold in their raw state to other firms.
Natural resources such as mines, quarries and other oil wells come under
this head.
To provide for the consumption of an asset of a wasting character is
called provision for depletion.
5.Accident:
An asset may reduce in value because of meeting of an accident.
NEED FOR PROVIDING DEPRECIATION:
1. To know the trueprofits:

We have seen that depreciation is an expense and becomes an
important element of the cost of production.
Though it is not visible like other expenses and never paid to the
outside party yet it is desirable to charge depreciation on fixed assets
as these are used for earning purposes.
So their depreciation must be deducted out of the income earned from
their use in order to calculate true net profit or net loss.
2. To show true financialposition:

Financial position can be studied from the balance sheet and for the
preparation of the balance sheet fixed assets are required to be shown
at their true value.
If assets are shown in the balance sheet without any charge made for
their use or depreciation, then their value must have been overstated
in the balance sheet and will not reflect the true financial position of
the business.
So, for the purpose of reflecting true financial position, it is necessary
that depreciation must be deducted from the asset and then at such
reduced value these may be shown in the balance sheet.
3. To make provision for replacement ofassets:

If depreciation is not provided, the profits of the concern will be
overstated and can be distributed to the shareholders as dividend.
After the end of the working life of the asset, there will be no
provision or funds at the disposal of the concern and has to borrow for
purchasing new assets.
Provision for depreciation is a charge to profit and loss account
though depreciation is not paid.
The amount of depreciation accumulated during the working life of

the asset provides additional working capital besides providing sum at
the end of working life of the asset for its replacement.
4. To ascertain the true cost ofproduction.
5. To comply with the legalrequirements.
6. To conserve the cash resources of theconcern.
7. To save tax payable on profits.
METHODS OF PROVIDING DEPRECIATION:
1. Fixed InstallmentMethod:
Under this method a fixed percentage of the original value of the asset
is written off every year so as to reduce the asset account to nil or to its
scrap value at the end of its estimated life of an asset. To ascertain the
annual charge under this method all that is necessary is to divide the
original value of the asset (minus its scrap value, if any) by the number
of years of its estimated life i.e.,
Annual Depreciation = Cost of asset – Scrap value

Estimated Life of Asset
The amount of depreciation charged during each period of the asset’s
life is constant. If the charge of depreciation is plotted annually on a
graph paper and the points joined together, then the gap will reveal a
straight line that is why it is also called as straight line method. It is
also called as fixed percentage on original cost method.

Merits of Fixed Installment Method:

1. This method is simple to understand and easy toapply.
2. It can write down an asset to zero at the end of its working life, if
sodesired.
3. This method is very suitable for those assets which have a fixed life
e.g., furniture, fixtures, short leases and other assets of a small
intrinsicvalue.
Demerits of Fixed Installment Method:

1. The change for depreciation remains constant year after year. The
expenses of repairs and maintenance are increasing as the asset grows
older. The profit and loss account thus in the later years bears more
than its share ofvaluation.
2. It becomes difficult to calculate the depreciation on additions made during
theyear.
3. Under this method the depreciation charge remains the same from year
to year irrespective of the use of the asset. Thusit does not take into
consideration the effective utilization of the asset.
4. It does not take into consideration the interest on capital on vested in
fixedassets.
5. It does not provide funds for replacement ofassets.
6. This method tends to report an increasing rate of return on investment
in the asset amount due to the fact that the net balance of the asset
amount is taken. In-spiteof these drawbacks, this method is mostly
used by firms in U.S.A, Canada, U.K and some firms inIndia.
2. Diminishing Balance Method:
Under this method depreciation is calculated at a certain percentage

each year on the balance of the asset which is brought forward from the
previous year.
The amount of depreciation is charged in each period is not fixed but it
goes on decreasing gradually as the beginning balance of the asset in each
year will reduce.
This method is also known as Reducing Balance method or Written
Down Value Method. Merits of Diminishing Balance Method
1. It tends to give even charge of depreciation against revenue each

year. Depreciation is generally heavy during the first few years and
is counter balanced by the repairs being light and in the later years

when repairs are heavy this is counter-balanced by the decreasing

charge fordepreciation.
2. Fresh calculations of depreciation are not necessary as and when
additions aremade.
3. This method is recognized by the income tax authorities inIndia.
4. It will provide funds for the replacement of asset on the expiry of its
usefullife.
5. This method is suitable for Plant and Machinery, Buildings etc.
Where the amount of repairs and renewals increases as the asset
grows older and the possibilities of assets are more.
Demerits of Diminishing Balance Method:
1. The original cost of the asset is altogether lost sight of subsequent

years and the asset can never be reduced tozero.
2. This method does not take into consideration the asset as an
investment and interest is not taken intoconsideration.
3. As compared to the first method, it is difficult to determine the
suitable rate of depreciation.
3. AnnuityMethod:
Under this method amount spent on the purchase of an asset is

regarded as an investment which is assumed to earn interest at a
certain rate.
Every year the asset account is debited with the amount of interest
and credited with the amount of depreciation.
This interest is calculated on the debit balance of the asset account at
the beginning of the year.
This method is a great extent scientific as it treats the purchase of an
asset as an investment in the business itself and charge interest on the
same.
4. Depreciation Fund Method:
Ready cash may not be available when the time of replacement
comes because the amount of depreciation is retained in the business
itself in the form of assets not separate from other assets which
cannot be readily sold.
This method implies that the amount written off as depreciation should
be kept aside and invested in readily saleable securities.
The securities accumulate and when the life of the asset expires, the

securities are sold and with the sale proceeds a new asset is purchased.
Since the securities always earn interest, it is not necessary to
provide for the full amount of depreciation, something less will do.
How much amount is to be invested every year so that a given sum is
available at the end of a given period depends on the rate of interest
which is easily calculated from sinking fundtables.
DIFFERENCES BETWEEN STRAIGHT

LINE METHOD AND DIMINISHING
BALANCE METHOD:
Differences between Fixed Installment Method and Diminishing

Balance Method
Point of Straight Line Method Diminishing Balance Method
Difference
1. Change in Throughout the life of the Amount of depreciation is more
Depreciation asset, the amount of during earlier years of the life
amount depreciation remains to of asset than later
beequal. yearsandtherefore amount is
never equal.
2. Balance in Asset account at the expiryof The amount never becomes nil
Asset’s A/c the expected life becomes nil.
3. Overall The overall charge i.e., Overall charge remains more or
Charge depreciation and repairs less same for every year
taken together go on throughout the life of the asset.
increasing from year to Since depreciation goes on
year. In other words the decreasing and amount of
amount of depreciation and repairs goes on increasing.
repairs is relatively less
during the earlier years of
the life of the asset than
later years because repairs
go on increasing with
useofasset.
4.Profits Profits under this method Profits are less during earlier
are more during the years than the later years.
earlieryears of the life of
the asset.
DIFFERENCES BETWEEN CAPITAL AND REVENUE

EXPENDITURE
Differences between Capital and Revenue Expenditure

Capital Expenditure Revenue Expenditure

1. It results in acquisition of fixed assets 1. It does not result in acquisition of any
which are meant for use and not for sale. fixed asset. This expenditure is incurred
The assets acquired are used for earning for meeting the day-to-day expenses of
profit as long as they can serve the purpose carrying on operations of business.
of the business and sold only when
theybecome unfit or obsolete for the
business.
2. It results in improving the 2. It results in maintenance
earningcapacity of the fixed assets e.g., ofbusinessassets such as repairs and
over- hauling the machinery for improving maintenanceofmachinery. It is helpful in
thebusiness by increasing the earning maintaining the existing capacity of
capacity of the machinery. theasset.
3. It represents unexpired cost i.e., cost 3. It represents expired cost i.e., benefitof
ofbenefit to be taken in future. cost has been taken.
4. It is a non-recurring expenditure. 4. It is recurring expenditure.
5.The benefit of such expenditure will be 5. The benefit of such expenditure
for more than one year. Only a portion of expires during the year and the amount is
such expenditure known as depreciation is charged to Revenue Account (i.e.,
charged to profitand Loss Account and Trading and Profit and Loss Account) of
balance amount of such expenditure the sameyear.
unlessit is written off is shown in the
Balance Sheet as an asset.
6. All items of capital expenditure which 6. All items of revenue expenditure the
are not written off are shown in the benefit of which has exhausted during the
Balance Sheet as assets and are carried year are transferred to Trading and Profit
forward to the next year. &Loss Account and accounts
representing such items are closed by
transferring them to Trading and Profit &
Loss Account. Such items are not carried
forward to the next year because their
benefit has been taken during the year.
Only the portion of the deferred revenue
expenditure (i.e., Heavy Advertisement)
the benefit of which has not expired
duringtheyeariscarriedforwardtothenext
year.
UNIT III
Financial Statement Analysis:
Financial Statement Analysis– Common size statement analysis, Comparative Statement
Analysis & Trend Analysis- Ratio analysis–Rationale and utility of ratio analysis–
Classification of ratios–Calculation and interpretation of ratios–Liquidity ratios–Activity /
turn over ratios–Profitability ratios–leverage and structural ratios(Problems ).
MeaningofAnalysisofFinancialStatements
The process of critical evaluation of the financial
informationcontainedinthefinancialstatementsin
ordertounderstandandmakedecisionsregarding the operations of the firm is called
‘Financial Statement Analysis’. It is basically a study of relationship among
various financial facts and figuresasgiveninasetoffinancialstatements,and
theinterpretationthereoftogainaninsightintothe
profitabilityandoperationalefficiencyofthefirmto
assessitsfinancialhealthandfutureprospects.The term ‘financial analysis’ includes
both‘analysis and interpretation’. The term analysis
meanssimplificationoffinancialdatabymethodical classification given in the financial
statements. Interpretation means explaining the meaning and significance of the
data. These two are complimentary to each other. Analysis isuseless

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without interpretation, and interpretation without analysis is difficult or even

impossible.
Significance of Analysis of FinancialStatements
Financial analysis is the process of identifying the financial strengths and
weaknessesofthefirmbyproperlyestablishingrelationshipsbetweenthevarious
itemsofthebalancesheetandthestatementofprofitandloss.Financialanalysis
canbeundertakenbymanagementofthefirm,orbypartiesoutsidethefirm, viz., owners,
trade creditors, lenders, investors, labour unions, analysts and
others.Thenatureofanalysiswilldifferdependingonthepurposeoftheanalyst.
Atechniquefrequentlyusedbyananalystneednotnecessarilyservethepurpose of other
analysts because of the difference in the interests of the analysts. Financial
analysis is useful and significant to different users in the following ways:
(a) Finance manager: Financial analysis focusses on the facts and
relationships related to managerial performance, corporate efficiency,
financialstrengthsandweaknessesandcreditworthinessofthecompany. A
finance manager must be well-equipped with the different tools of analysis
to make rational decisions for the firm. The tools for analysis
helpinstudyingaccountingdatasoastodeterminethecontinuityofthe
operatingpolicies,investmentvalueofthebusiness,creditratingsand
testingtheefficiencyofoperations.Thetechniquesareequallyimportant in the
area of financial control, enabling the finance manager to make
constantreviewsoftheactualfinancialoperationsofthefirmtoanalyse the
causes of major deviations, which may help in corrective action
whereverindicated.
(b) Topmanagement:Theimportanceoffinancialanalysisisnotlimitedto the
finance manager alone. It has a broad scope which includes top
managementingeneralandotherfunctionalmanagers.Managementof
thefirmwouldbeinterestedineveryaspectofthefinancialanalysis.Itis

178
theiroverallresponsibilitytoseethattheresourcesofthefirmareused
mostefficientlyandthatthefirm’sfinancialconditionissound.Financial
analysis helps the management in measuring the success of the
company’s operations, appraising the individual’s performance and
evaluatingthesystemofinternalcontrol.
(c) Trade payables: Trade payables, through an analysis of financial
statements, appraises not only the ability of the company to meet its short-
termobligations,butalsojudgestheprobabilityofitscontinued
abilitytomeetallitsfinancialobligationsinfuture.Tradepayablesare
particularly interested in the firm’s ability to meet their claims over a
veryshortperiodoftime.Theiranalysiswill,therefore,evaluatethefirm’s
liquidityposition.
(d) Lenders:Suppliersoflong-termdebtareconcernedwiththefirm’slong- term
solvency and survival. They analyse the firm’s profitability over a
periodoftime,itsabilitytogeneratecash,tobeabletopayinterestand
repaytheprincipalandtherelationshipbetweenvarioussourcesoffunds
(capitalstructurerelationships).Long-termlendersanalysethehistorical
financialstatementstoassessitsfuturesolvencyandprofitability.
(e) Investors:Investors,whohaveinvestedtheirmoneyinthefirm’sshares, are
interested about the firm’s earnings. As such, they concentrate on
theanalysisofthefirm’spresentandfutureprofitability.Theyarealso interested
in the firm’s capital structure to ascertain its influences on firm’s earning
and risk. They also evaluate the efficiency of the
managementanddeterminewhetherachangeisneededornot.However,
insomelargecompanies,theshareholders’interestislimitedtodecide
whethertobuy,sellorholdtheshares.
(f) Labourunions:Labourunionsanalysethefinancialstatementstoassess
whetheritcanpresentlyaffordawageincreaseandwhetheritcanabsorb
awageincreasethroughincreasedproductivityorbyraisingtheprices.
(g) Others:Theeconomists,researchers,etc.,analysethefinancialstatements
tostudythepresentbusinessandeconomicconditions.Thegovernment
agenciesneeditforpriceregulations,taxationandothersimilarpurposes.
Objectives of Analysis of FinancialStatements

Analysisoffinancialstatementsrevealsimportantfactsconcerningmanagerial
performanceandtheefficiencyofthefirm.Broadlyspeaking,theobjectivesof
theanalysisaretoapprehendtheinformationcontainedinfinancialstatements with a
view to know the weaknesses and strengths of the firm and to make a
forecastaboutthefutureprospectsofthefirmthereby,enablingtheanalyststo
takedecisionsregardingtheoperationof,andfurtherinvestmentinthefirm.To

179
be more specific, the analysis is undertaken to serve the following purposes

(objectives):
• toassessthecurrentprofitabilityandoperationalefficiencyofthefirm
asawholeaswellasitsdifferentdepartmentssoastojudgethefinancial
healthofthefirm.
• to ascertain the relative importance of different components of the
financialpositionofthefirm.
• toidentifythereasonsforchangeintheprofitability/financialposition of
thefirm.
• to judge the ability of the firm to repay its debt and assessing the short-
termaswellasthelong-termliquiditypositionofthefirm.
Throughtheanalysisoffinancialstatementsofvariousfirms,aneconomistcan
judgetheextentofconcentrationofeconomicpowerandpitfallsinthefinancial
policiespursued.Theanalysisalsoprovidesthebasisformanygovernmental
actionsrelatingtolicensing,controls,fixingofprices,ceilingonprofits,dividend
freeze,taxsubsidyandotherconcessionstothecorporatesector.
Tools of Analysis of FinancialStatements

The most commonly used techniques of financial analysis are as follows:
1. Comparative Statements: These are the statements showing the
profitabilityandfinancialpositionofafirmfordifferentperiodsoftimein
acomparativeformtogiveanideaaboutthepositionoftwoormoreperiods. It usually
applies to the two important financial statements, namely,
balancesheetandstatementofprofitandlosspreparedinacomparative
form.Thefinancialdatawillbecomparativeonlywhensameaccounting
principlesareusedinpreparingthesestatements.Ifthisisnotthecase,
thedeviationintheuseofaccountingprinciplesshouldbementionedas
afootnote.Comparativefiguresindicatethetrendanddirectionoffinancial
positionandoperatingresults.Thisanalysisisalsoknownas‘horizontal
analysis’.
2. Common Size Statements: These are the statements which indicate the
relationshipofdifferentitemsofafinancialstatementwithacommonitem by
expressing each item as a percentage of that common item. The percentage
thus calculated can be easily compared with the results of
correspondingpercentagesofthepreviousyearorofsomeotherfirms,as
thenumbersarebroughttocommonbase.Suchstatementsalsoallowan analyst to
compare the operating and financing characteristics of two companies of
different sizes in the same industry. Thus, common size
statementsareuseful,both,inintra-firmcomparisonsoverdifferentyears
andalsoinmakinginter-firmcomparisonsforthesameyearorforseveral
years.Thisanalysisisalsoknownas‘Verticalanalysis’.

180
3. TrendAnalysis:Itisatechniqueofstudyingtheoperationalresultsand
financialpositionoveraseriesofyears.Usingthepreviousyears’dataofa
businessenterprise,trendanalysiscanbedonetoobservethepercentage changes
over time in the selected data. The trend percentage is the
percentagerelationship,inwhicheachitemofdifferentyearsbeartothe
sameiteminthebaseyear.Trendanalysisisimportantbecause,withits
longrunview,itmaypointtobasicchangesinthenatureofthebusiness.
Bylookingatatrendinaparticularratio,onemayfindwhethertheratio
isfalling,risingorremainingrelativelyconstant.Fromthisobservation,a
problemisdetectedorthesignofgoodorpoormanagementisdetected.
4. Ratio Analysis: It describes the significant relationship which exists
between various items of a balance sheet and a statement of profit and
lossofafirm.Asatechniqueoffinancialanalysis,accountingratiosmeasure the
comparative significance of the individual items of the income and
positionstatements.Itispossibletoassesstheprofitability,solvencyand
efficiencyofanenterprisethroughthetechniqueofratioanalysis.
5. CashFlowAnalysis:Itreferstotheanalysisofactualmovementofcash
intoandoutofanorganisation.Theflowofcashintothebusinessiscalled
ascashinfloworpositivecashflowandtheflowofcashoutofthefirmis
calledascashoutfloworanegativecashflow.Thedifferencebetweenthe inflow
and outflow of cash is the net cash flow. Cash flow statement is
preparedtoprojectthemannerinwhichthecashhasbeenreceivedand has been
utilised during an accounting year as it shows the sources of
cashreceiptsandalsothepurposesforwhichpaymentsaremade.Thus,
itsummarisesthecausesforthechangesincashpositionofabusiness
enterprisebetweendatesoftwobalancesheets.
Inthischapter,weshallhaveabriefideaaboutthefirstthreetechniques,
viz.,comparativestatements,commonsizestatementsandtrendanalysis.The ratio
analysis and cash flow analysis is covered in detail in Chapters 5 and 6
respectively.

181
ComparativeStatements
Asstatedearlier,thesestatementsrefertothestatementofprofitandlossand the balance
sheet prepared by providing columns for the figures for both the current year as
well as for the previous year and for the changes during the
year,bothinabsoluteandrelativeterms.Asaresult,itispossibletofindout
notonlythebalancesofaccountsasondifferentdatesandsummariesofdifferent
operationalactivitiesofdifferentperiods,butalsotheextentoftheirincreaseor
decreasebetweenthesedates.Thefiguresinthecomparativestatementscanbe used for
identifying the direction of changes and also the trends in different
indicatorsofperformanceofanorganisation.
Thefollowingstepsmaybefollowedtopreparethecomparativestatements: Step 1 :
List out absolute figures in rupees relating to two points of time (as
shownincolumns2and3ofExhibit4.1).
Step2:Findoutchangeinabsolutefiguresbysubtractingthefirstyear(Col.2)
fromthesecondyear(Col.3)andindicatethechangeasincrease(+)ordecrease (–
)andputitincolumn4.
Step 3 : Preferably, also calculate the percentage change as follows and put it in
column 5.
Absolute Increase or Decrease(Col.4)

100
First year absolute figure(Col.2)
Particulars First Second Absolute Percentag

Year Year Increase (+) e Increase
or Decrease (+)
(–) or Decrease
(–)
1 2 3 4 5
Rs. Rs. Rs. %.
Exhibit. 4.1

RATIO ANALYSIS
Alexander Wall is considered to be the pioneer of Ratio Analysis. He presented

the detailed system of Ratio Analysis in 1909 and explained its usefulness in
financial analysis.
Ratio Analysis is most widely used powerful tool of financial analysis. It is an

important technique of analysis and interpretation of financial statements. It is
also used to analyze various aspects of operational efficiency and degree of
profitability.
Ratio Analysis is based on different ratios which are calculated from the
accounting information contained in the financial statements. Different ratios are
used for different purposes.
Meaning of Ratio
Ratio is a figure expressed in terms of another.

It is an expression of relationship between one figure, two figures and the
other figures which are mutually inter-dependent.
In other words a ratio is a mathematical relationship between two items
expressed in a quantitative form. Whenratio is explained with reference to
the items shown in the financial statements.
It is called as an Accounting Ratio.
The ratio analysis facilitates easy understanding of financial statements.
ADVANTAGES OF RATIO ANALYSIS
Ratio Analysis is an important technique of financial analysis.
It is used as a device to analyze and interpret the financial health of enterprises.

Its usefulness is not only confined to business managers but also extends to
various interested parties like government, creditors, employees, investors,
consumers etc.
1. Helps in Decisionmaking:
Though Financial Statements provide necessary data for decision making. It is
not possible to take appropriate decisions merely on the basis of each data.
Ratio Analysis provides a meaningful analysis and interpretation to the data
contained in Financial Statements. This ratio analysis facilitates the managers
to take correct decisions.
2. Helps in Financial Forecasting andPlanning
Ratios calculated for a number of years reveal the trends in the phenomenon.
As such, it is possible to make predictions for a future period. Thus, ratio
analysis helps in financial forecasting and planning
3. Helps in assessing the operationalefficiency:

Ratio Analysis helps in analyzing the strengths and weaknesses of a concern.

It helps in diagnosing the financial health of a concern in terms of liquidity,
solvency, profitability etc
4. Helps in controllingbusiness:
With the help of ratio analysis, it is possible to identify the weak spots with
regard to the performance of the managers. Weakness in financial structure
due to incorrect policies in the past and present is revealed by the ratios. These
weaknesses may be communicated to the people concerned and as such ratio
analysis helps in better communication, Coordination and control of
unfavorable situations.
5. Helps in comparison ofperformance:
Through accounting ratios comparison can be made between one departments

of a firm with another of the same firm in order to evaluate the performance of
various departments in the firm. This is needed for the smooth functioning of
thedepartments.
6. Ratio analysis simplifies the complex financial data. It reveals the change in
the financial position.
7. Ratio analysis may be used as instruments of management control,
particularly in the area of sales and control.
8. Ratios facilitate the function of communication and enhance the value of
financial statements.
9. Ratios are helpful in assessing the financial position and profitability of a
concern.
10. Ratio Analysis also helps in effective control of business – measuring
performance, control of costs etc., Effective control is a keystone of better
management.
11. Ratio analysis helps the investors in making investment decisions to make a
profitable Investment.
LIMITATIONS OF RATIO ANALYSIS:
1. Limited use of a SingleRatio:

A single ratio does not convey meaningful message. As such, a number of
ratios will have to be calculated for a better understanding of
particularsituation.
Thus, a series of ratios computed may create confusion.
Ratios can be useful only when they are computed in a sufficient large number.
Calculation of more ratios sometimes confuses the analysts than help him.
2. Lack of AdequateStandards:
Expecting a few situations, in majority cases, universally accepted standards
for ratios are not available.It renders interpretation of ratios difficult.

3.Lack ofcomparability:
The results of two firms are comparable with the help of accounting ratios
only if they follow the same accounting methods. Comparison becomes
difficult if they follow different methods.Similarly, utilization of facilities,
availability of facilities and scale of operation affects the Financial Statements
of different firms. Comparison of such firms would be misleading.
4. Inherent Limitations ofAccounting:

Accounting records contain historical data. As such, ratios based on data
drawn from accounting records also suffer from the inherent weaknesses of
accounting records. Thus, accounting ratios of the past may not be true
indicators of the future.
5. Changes in AccountingProcedures:
Change in accounting procedure by a firm often makes ratio analysis
misleading. E.g., a change in the valuation of methods of inventories from
FIFO to LIFIO Increase the cost of sales and reduces the value of the closing
stock which makes inventory turnover ratio to be impressive and an
unfavorable gross profit ratio.
6. Window Dressing:
Financial statements easily be window dressed to present a better picture of its
financial and profitability position to outsiders. Hence, one has tobe very
careful in making a decision from ratios calculated from such Financial
Statements. However, it may be difficult for an outsider to learn about the
window dressing made by afirm.
7. Price-LevelChanges:
Since ratios are computed for historical data, no consideration is made to the
changes in price levels and this makes the interpretation of ratios invalid
8. PersonalBias:
Ratios are only means of financial analysis and not an end in itself. They have
to be interpreted and different people may interpret the same ratio in different
ways.
9. Ignoring qualitativefactors:
Ratio analysis ignores the qualitative factors which generally influence the
conclusions derived.
10. Reliability of data:

The accuracy and correctness of ratios are totally dependent upon reliability of
data contained in financial statements. If there are any mistakes or omissions in
the financial statements, ratio analysis presents a wrong picture about the
concern.
Classification of Ratios:
I.Classification according to the nature of accounting statement from which the
ratiosare derived into threecategories.
They are
Balance sheetRatios
1.
Profit and Loss AccountRatios
2.
Combined or CompositeRatios
3.
1. BALANCE SHEETRATIOS:
These ratios deal with the relationship between two items appearing in the
Balance sheet.
Eg. Current Ratio, Liquid Ratio, Debt to Equity Ratio.
2. PROFIT AND LOSS ACCOUNTRATIOS:

This type of ratios show the relationship between two items which are in the
profit and loss account itself
Eg. Gross Profit Ratios, Net Profit Ratios and Operating Ratios.
3. COMBINED OR COMPOSITERATIOS:
These ratios show the relationship between items one of which is taken from
profit and loss account and the other from the balance sheet.
Eg. Rate of Return on capital Employed, Debtors Turnover Ratio, creditors
turnover ratio, stock/ inventory turnover ratio and capital turnover ratio etc.
II. CLASSIFICATION FROM POINT OF VIEW OF FINANCIAL

MANAGEMENTOR OBJECTIVE.
Ratios may be classified into four categories. They are
1. LiquidityRatios
2. capital structure/ gearing Ratios.(Leverage / SolvencyRatios)
3. TurnoverRatios
4. Profitability Ratios+
Current ratio:
The current ratio is also called the working capital ratio, as working capital is
the difference between current assets and current liabilities. This ratio

measures the ability of a company to pay its current obligations using current
assets. The current ratio is calculated by dividing current assets by current
liabilities
Current Ratio = Current Assets / Current Liabilities
This ratio indicates the company has more current assets than current
liabilities. Different industries have different levels of expected liquidity.
Whether the ratio is considered adequate coverage depends on the type of
business, the components of its current assets, and the ability of the company
to generate cash from its receivables and by selling inventory.
Acid‐test ratio / Quick ratio:
The acid‐test ratio is also called the quick ratio. Quick assets are defined as
cash, marketable (or short‐term) securities, and accounts receivable and notes
receivable, net of the allowances for doubtful accounts. These assets are
considered to be very liquid (easy to obtain cash from the assets) and
therefore, available for immediate use to pay obligations. The acid‐test ratio
is calculated by dividing quick assets by current liabilities.
Acid test ratio = Quick Assets / Current Liabilities
The traditional rule of thumb for this ratio has been 1:1. Anything below this
level requires further analysis of receivables to understand how often the
company turns them into cash. It may also indicate the company needs to
establish a line of credit with a financial institution to ensure the company has
access to cash when it needs to pay its obligations.
Inventory turnover ratio:
The inventory turnover ratio measures the number of times the company sells
its inventory during the period. It is calculated by dividing the cost of goods
sold by average inventory. Average inventory is calculated by adding
beginning inventory and ending inventory and dividing by 2. If the company
is cyclical, an average calculated on a reasonable basis for the company's
operations should be used such as monthly or qtly.
Inventory turnover ratio = Cost of gods sold / Average inventory
Profitability ratios
Profitability ratios measure a company's operating efficiency, including its

ability to generate income and therefore, cash flow. Cash flow affects the
company's ability to obtain debt and equity financing.
Profit margin:
The profit margin ratio, also known as the operating performance ratio,

measures the company's ability to turn its sales into net income. To evaluate
the profit margin, it must be compared to competitors and industry statistics.
It is calculated by dividing net income by net sales.
Profit margin = Net income / Net sales
Earnings per share:
An earnings per share (EPS) represents the net income earned for each share
of outstanding common stock. In a simple capital structure, it is calculated by
dividing net income by the number of weighted average common shares
outstanding.
Earnings per share = Net Income / Weighted average common shares

outstanding.
Price‐earnings ratio:
The price‐earnings ratio (P/E) is quoted in the financial press daily. It
represents the investors' expectations for the stock. A P/E ratio greater than
15 has historically been considered high.
Price Earnings ratio = Market price per common share / Earnings per share..
Solvency ratios
Solvency ratios are used to measure long‐term risk and are of interest
tolong‐term creditors andstockholders.
Debt to total assetsratio:
The debt to total assets ratio calculates the percent of assets provided by
creditors. It is calculated by dividing total debt by total assets. Total debt is the
same as the total liabilities.
Debts to total assets ratio = Total Debts / Total Assets.
UNIT IV
Funds flow analysis & Cash Flow Analysis:

Funds flow analysis–Concept of funds flow–Statement of changes in working capital–Funds

from business operations–Statement of sources and uses of funds(Problems ) –Advantages of
funds flow analysis–Preparation Cash flow statement (Problems ) According to AS3.
FUNDS FLOW STATEMENT
Meaning of Funds Flow Statement
Funds Flow Statement is a statement showing sources and uses of funds for a period
of time.
Definition of Funds Flows Statement
Fouke defines this statement as “A statement of sources and applications of funds is a

technical device designed to analyze the changes in the financial condition of a
business enterprise between two dates.”
Statement of Changes in Working Capital
The information relating to the changes in current natured accounts between two
periods of time presented in the form of a statement is what we call the
schedule/statement of changes in working capital.
Schedule/Statement of Changes in Working Capital for the period from __ to __
Balance as on 31st March Working Capital Change
Particulars/Account
2007 2008 Increase Decrease
a) CURRENT ASSETS
56,000 78,000 22,000
1) Cash Balance 5,75,000 8,25,000 2,50,000
2) Bills Receivable 9,15,000 12,25,000 3,10,000
3) Sundry Debtors 9,48,000 12,00,000 2,52,000
4) Stocks/Inventories 3,24,000 2,84,000 40,000
5) Prepaid Expenses
TOTAL 28,18,000 36,12,000 8,34,000 40,000

b) CURRENT LIABILITIES
7,40,000 11,00,000
1) Sundry Creditors 3,60,000
2,20,000 4,00,000
2) Bills Payable 1,80,000
2,81,000 2,50,000 31,000
3) Bank Overdraft
1,23,000 1,00,000 23,000
4) Outstanding Expenses
2,38,000 3,00,000
5) Provision for Taxation 62,000
1,98,000 2,50,000
6) Provision for Dividends 52,000
18,000 12,000 6,000
7) Reserve for Bad Debts
TOTAL 18,18,000 24,12,000 60,000 6,72,000
Working Capital [(a) - (b)] 10,00,000 12,00,000
TOTAL 8,94,000 6,94,000
Net Change in Working Capital 2,00,000
Identify all the Current natured accounts on the assets as well as the liabilities sides of the
two balance sheets in consideration.
Fill the statement with the data relating to those accounts, taking current assets as a group
and current liabilities as another group.
A balance sheet item may have data in only one of the balance sheets or in both. Each
item should appear only once in the statement.
Uses of Funds Flow Statement
1. It helps in the analysis of financialOperations:
• The financial statements reveal the net effect of various transactions on

the operational and financial position of a concern.
• The balance sheet gives a static view of the resources of a business and the
uses to which these resources have been put at a certain point of the time.
• But it does not disclose the causes for changes in the assets and liabilities

between two different points of time.

• The funds flow statement explains causes for such changes and also effect of
these changes on the liquidity position of the company.
• Sometimes a concern may operate profitably and yet its cash position may
become more and more worse.
• The Funds Flow Statement gives a clear answer to such a situation explaining
what has happened to the profits of the firm?
2. It throws light on many Confusing Questions of generalinterest:
• Why were the net current assets lesser in spite of higher profits and vice-
versa? Why more dividends could not be declared in spite of available profits?
• How was it possible to distribute more dividends than the present earnings?
What happened to the net profit? Where did they go?
• What happened to the proceeds of sale of fixed assets or issue of shares,
debentures etc. What are the sources of repayment of debts?
• How was the increase in working capital financed and how will it be financed
in future?
3. It helps in the formation of a realistic dividendpolicy:
• Sometimes a firm has sufficient profits available for distribution as dividend

but yet it may not be advisable to distribute dividend for lack of liquidity or
cash resources.
• In such cases, a funds flow statement helps in the formation of a realistic
dividend policy.
4. It helps in the proper allocation ofresources:
• The resources of a concern are always limited and it wants to make the best
use of these resources. A projected funds flow statement constructed for the
future helps in making managerial decisions. The firm can plan the
deployment/use of resources and allocate them among various applications.
5. It acts as futureguide:
• A projected funds flow statement also acts as a guide for future to the
management.
• The management can come to know the various problems, it is going to face
in near future for want of funds. The firm’s future needs of funds can be
projected well in advance and also the timing of these needs.The firm can
arrange to finance these needs more effectively and avoid future problems.
6. It helps in appraising the use of workingcapital:

• A funds flow statement helps in explaining how efficiently the management

has used its working capital and also suggests ways to improve working
capital position of the firm.
7. It helps knowing overall Creditworthiness of afirm:

• The financial institutions and banks such as State Financial Institutions,
Industrial Development Corporation, Industrial Finance Corporation of India,
Industrial Development Bank of India etc., all ask for funds flow statement
constructed for a number ofyears before granting loans to know the
creditworthiness and paying capacity of the firm.
• Hence a firm seeking financial assistance from these institutions has no
alternative but to prepare funds flow statements.
LIMITATIONS OF FUNDS FLOW STATEMENT

1. It should be remembered that a funds flow statement is not a substitute of an
income statement or a balance sheet. It provides only some information as regards
changes in workingcapital.
2. It cannot reveal continuouschanges.
3. It is not an original statement but simply are arrangement of data given in the
financial Statements.
4. It is essentially historic in nature and projected funds flow statement cannot be
prepared with muchaccuracy.
5. Changes in cash are more important and relevant for financial management than
theworking capital.
CASH FLOW STATEMENT
Meaning of Cash Flow Statement
Cash Flow Statement is a statement which describes the inflows(sources) and

outflows(uses) of cash and cash equivalents in an enterprise during a specified
period of time.
A Cash Flow Statement summarizes the causes of changes in the cash position of
a business enterprise between two Balance Sheets.
Advantages of Cash FlowStatement
1. Cash flow statement reveals the causes of changes in cash balances between
two dates of balance sheets.
2. This statement helps the management to evaluate its ability to meets its
obligations i.e., payments to creditors. The payment of bank loan, payment of
interest, taxes, dividendetc.
3. It throws light on causes for poor liquidity in spite of good profits and
excessive liquidity in spite of heavylosses.

4. It helps the management in understanding the past behavior of cash cycle and
in controlling the use of cash infuture.
5. Cash flow statement helps the management in planning repayment of loans,
replacement of assets etc.
6. This statement is helpful in short-term financial decisions relating toliquidity.
7. This statement helps the management in preparing cash budgetsproperly.
8. This statement helps the financial institution who led advances to business
concerns in estimating their repayingcapacities.
9. Cash flow statement helps in evaluating financial policies of themanagement.
10. Cash flow statement discloses the complete story of cash movement. The
increase in, or decrease of cash and the reason therefore can beknown.
11. Cash flow statement provides information of all activities such as operating,
investing and financialactivities.
12. Since cash flow statement provides information regarding the sources and
utilizations of cash during a particular period. It is easy for the management
to plan carefully for the cash requirements in the future, for the pose of
redeeming long-term liabilities or /and replacing some fixedassets.
LIMITATIONS OF CASH FLOW STATEMENT
1. A cash flow statement only reveals the inflow and outflow of cash. The cash
balance disclosed by the cash flow statement may not represent the real
liquid position of theconcern.
2. Cash flow statement is not suitable for judging the profitability of a firm as
non-cash changes are ignored while calculating cash flows from
operatingactivities.
3. Cash flow statement is not a substitute for income statement or funds flow
statement. Each of them has separate function to perform.
4. Net cash flow disclosed by cash flow statement does not necessarily show net
income of the business, because net income is determined by taking into
account both cash and non-cash items.
5. Cash flow statement is based on cash accounting. It ignores the basic
accounting concept of accrualbasis.
6. Cash flow statement reveals the movement of cash only. In preparation it
ignores most liquid current assets like Sundry Debtors, Bills Receivablesetc.,
7. It is difficult to precisely define the term cash. There are controversies among
accountants over
8. A number of near cash items like cheques, stamps, postal orders etc., to be
included in cash.
9. Cash flow statement does not give a complete picture of financial position of
the concern.

Applicability of AS 3 Cash Flow Statements

The applicability of Cash flow statement has been defined under the Companies Act, 2013. As
per the definition in the act, a financial statement includes the following:
i. Balance sheet
ii. Profit and loss account / Income and expenditure account
iii. Cash flow statement
iv. Statement of changes in equity
v. Explanatory notes
Thus, cash flow statements are to be prepared by all companies but the act also specifies a certain
category of companies which are exempted from preparing the same. Such companies are One
Person Company (OPC), Small Company and Dormant Company.
♦ OPC means a company which has only one single person as its member.
♦ A Small Company is a private company with a maximum paid up capital of Rs. 50 lakhs and a
maximum turnover of Rs. 2 crores.
♦ A Dormant Company is an inactive company which is formed for some future projects or only
to hold an asset and has no significant transactions.
2. Cash and Cash Equivalents

Cash equivalents are held by an enterprise for meeting its short-term cash commitments instead
of the purpose of investment or such other purposes. For investments to qualify as cash
equivalents:
1. An investment must be easily convertible into cash and
2. Must be subject to a very low level of risk with respect to changes in its value
Hence, an investment would qualify to be a cash equivalent only when such an investment has a
short maturity of three months or less from its acquisition date.
AS 3 Cash Flow Statements states that cash flows should exclude the movements between items
which forms part of cash or cash equivalents as these are part of an enterprise’s cash
management rather than its operating, financing and investing activities.
Cash management consists of the investment of excess cash in the cash equivalents.
3. Presentation of Cash Flow

A cash flow statement must depict the cash flows within the period classifying them as
A. Operating activities
B. Investing
C. Financing activities
Companies must prepare and present cash flows from operating, financing as well as investing
activities in such manner that is apt to their business.

Grouping the activities provide information which enables the users in assessing the impact of
such activities on the overall financial position of an enterprise and also assess the value of the
cash and cash equivalents.
A. Operating Activities
Cash flows from operating activities predominantly result from the main revenue-generating
activities of an enterprise.
For example:
(i) Cash received from the sale of goods and services
(ii) Cash received in form of fees, royalties, commissions and various other revenue forms
(iii) Cash paid to a supplier of goods and services
B. Investing Activities
Cash flows from investing activities represent outflows are made for resources intended for
generating cash flows and future income.
For instance:
(i) Cash paid for acquiring fixed assets
(ii) Cash received from disposal of fixed assets (including intangibles)
(iii) Cash paid for acquiring shares, warrants or debt instruments of other companies and
interests in JVs
C. Financing Activities
Financing activities are those which brings changes in composition and size of owner’s capital
and borrowings of an enterprise.
For instance:
(i) Cash received from issuing shares or other similar securities
(ii) Cash received from issuing loans, debentures, bonds, notes, and other short-term or long-
term borrowings
(iii) Cash repaid on borrowings
4. Cash flow from operating activities

A company must report its cash flows from operating activities using:
1. Direct method – Where all the major classes of cash receipts and cash payments are
presented; or
2. Indirect method – Where the net profit or net loss is adjusted for:
a) Effects of transactions that are non-cash in nature such as depreciation, deferred taxes,
provisions, etc.

b) Accruals or deferrals of future or past operating cash proceeds or payments

c) Any expense or income related to financing or investing cash flows
5. Cash Flow from Investing and Financing Activities

A company must separately record all the major classes of cash receipts and cash payments
which arises from financing and investing activities, barring the ones which need to be reported
on the net basis.
A. Cash flow on Net Basis

Cash flows which arise from below-mentioned operating, financing or investing activities might
be reported on a net basis:
(i) Proceeds and payments in cash on behalf of a client where cash flows reflect the activities of
such client rather than that of the company itself
(ii) Proceeds and payments in cash for items where the amounts are huge, turnover is quick, and
maturities are short
Cash flows which arise from each of the below-mentioned activities of any financial enterprise
might be reported on the net basis:
(i) Proceeds and payments in cash for acceptances and repayments of deposits having fixed
maturities
(ii) Placement and withdrawal of deposits from other financial enterprises
(iii) Loans and cash advances are given to clients/customers and repayment of such loans and
advances
B. Foreign Currency Cash Flows

Cash flows that arise from the transactions in the foreign currencies must be recorded in the
company’s reporting currency by using the below method:
Foreign currency amount * FX rates between the reporting and foreign currency at the date of
cash flow.
A rate which approximates actual rate might be used in case the outcome is largely the same as it
would have been if the rate at the date of cash flows was used.
The impact of changes in the exchange rate on cash and cash equivalents which is held in the
foreign currencies must be reported as a distinct and separate part of the reconciliation of
changes in the cash and cash equivalent during the relevant period.
6. Extraordinary Items, Dividends & Interests

The cash flows related to the extraordinary items must be categorized as arising from operating,
financing or investing activities as apt and disclosed distinctly.
Cash flows from dividends and interest received and paid must be separately disclosed. Cash
flows which arise from dividends and interest received and paid in the case of financial
enterprises must be categorized as cash flows from operating activities.

For other enterprises, cash flows which arise from interest paid must be categorized as cash
flows from the financing activities whereas dividends and interest received must be categorized
as cash flows from the investing activities. Any dividends paid must be categorized as cash flows
from the financing activities.
7. Taxes on Income
Cash flows which arise from taxes on income must be disclosed separately and must be reported
as cash flows from the operating activities except if they could be explicitly related to investing
and financing activities.
8. Acquisitions and Disposal of Business Units including Subsidiaries

The aggregate cash flows which arise from acquisition and from the disposal of business units
including subsidiaries must be shown as investing activities and reported separately.
Enterprises must present, in total, with respect to both the acquisitions and disposals of other
business units including subsidiaries within the period the followings:
(a) Aggregate purchase or disposal value
(b) The amount of purchase or disposal value which is discharged by way of cash and cash
equivalents
9. Non-Cash Transactions
Financing and investing transactions which don’t require cash or cash equivalents mustn’t be
included in the cash flow statement. Those transactions must be presented elsewhere in financial
statements in a way which gives relevant information about such financing and investing
activities.
10. Disclosure
Enterprises must disclose, along with management commentary, the amount of substantial cash
and cash equivalents held by an enterprise which isn’t available for use.
Commitments that may arise from discounted bills of exchange and other similar obligations that
are undertaken by an enterprise are typically disclosed in financial statements by means of notes,
even in case the probability of loss is remote.
11. Major differences between AS 3 and Ind AS 7
Particulars AS 3 Cash Flow Statements Ind AS 7 Statement of Cash Flows
Bank Overdrafts AS 3 it doesn’t have any such Ind AS 7 explicitly includes bank
requirement overdrafts as a part of cash and cash
equivalents that are repayable on
demand
Cash flow from AS 3 necessitates cash flows Ind AS 7 doesn’t contain such

extraordinary related to the extraordinary requirement

activities activities to be classified as cash
flow arising from operating,
financing and investing activities
Cash flow from AS 3 doesn’t have any such Ind AS 7 needs classification of cash
changes in requirements flows which arises from changes in the
ownership of ownership interests in the subsidiaries
interests in which does not result in the loss of
subsidiaries control as the cash flows from financing
activities
Accounting for AS 3 doesn’t have any such Ind AS 7 requires the use of Cost or
investments in a requirement Equity method when accounting for
subsidiary or an investments in a subsidiary or an
associate
associate
Disclosure AS 3 require fewer disclosure Ind AS 7 requires more disclosure

requirements requirements as compared to Ind requirements
AS 7
UNIT V
Accounting standards-
Accounting standards their rationale and growing importance in global accounting environment
– IAS-IFRS-US GAAP
Human Resource Accounting concept and importance – Valuation of human resources-
Economic value approach – non – monetary valuation methods - Human resources group value
ACCOUNTING STANDARD
Accounting is the art of recording transactions in the best manner possible, so as to enable the
reader to arrive at judgments/come to conclusions, and in this regard it is utmost necessary that
there are set guidelines. These guidelines are generally called accounting policies. The intricacies
of accounting policies permitted Companies to alter their accounting principles for their benefit.
This made it impossible to make comparisons. In order to avoid the above and to have a
harmonised accounting principle, Standards needed to be set by recognised accounting bodies.
This paved the way for Accounting Standards to come into existence.
Accounting Standards in India are issued By the Institute of Chartered Accountanst of India
(ICAI). At present there are 30 Accounting Standards issued by ICAI.

Objective of Accounting Standards

Objective of Accounting Standards is to standarize the diverse accounting policies and practices
with a view to eliminate to the extent possible the non-comparability of financial statements and
the reliability to the financial statements.
The institute of Chatered Accountants of India, recognizing the need to harmonize the diversre
accounting policies and practices, constituted at Accounting Standard Board (ASB) on 21st
April, 1977.
Compliance with Accounting Standards issued by ICAI

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. 'Accounting Standards' means
the standard of accounting recomended by the ICAI and prescribed by the Central Government
in consultation with the National Advisory Committee on Accounting Standards(NACAs)
constituted under section 210(1) of companies Act, 1956.
Accounting Standards Issued by the Institute of Chatered Accountants of India are as

below:
• Disclosure of accounting policies.
• Valuation Of Inventories.
• Cash Flow Statements.
• Contingencies and events Occurring after the Balance sheet Date
• Net Profit or loss For the period, Prior period items and Changes in accounting Policies.
• Depreciation accounting.
• Construction Contracts.
• Revenue Recognition.
• Accounting For Fixed Assets.
• The Effect of Changes In Foreign Exchange Rates.
• Accounting For Government Grants.
• Accounting For Investments.
• Accounting For Amalgamation.
• Employee Benefits.
• Borrowing Cost.
• Segment Reporting.
• Related Party Disclosures.
• Accounting For Leases.
• Earning Per Share.
• Consolidated Financial Statement.
• Accounting For Taxes on Income.
• Accounting for Investment in associates in • Consolidated Financial Statement.
• Discontinuing Operation.
• Interim Financial Reporting.
• Intangible assets.
• Financial Reporting on Interest in joint Ventures.
• Impairment Of assets.
• Provisions, Contingent, liabilities and Contingent assets.
• Financial instrument.
• Financial Instrument: presentation.

• Financial Instruments, Disclosures and • Limited revision to accounting standards.
Disclosure of Accounting Policies: Accounting Policies refer to specific accounting principles

and the method of applying those principles adopted by the enterprises in preparation and
presentation of the financial statements.
Valuation of Inventories: The objective of this standard is to formulate the method of

computation of cost of inventories / stock, determine the value of closing stock / inventory at
which the inventory is to be shown in balance sheet till it is not sold and recognized as revenue.
Cash Flow Statements: Cash flow statement is additional information to user of financial
statement. This statement exhibits the flow of incoming and outgoing cash. This statement
assesses the ability of the enterprise to generate cash and to utilize the cash. This statement is one
of the tools for assessing the liquidity and solvency of the enterprise.
Contigencies and Events occuring after the balance sheet date: In preparing financial
statement of a particular enterprise, accounting is done by following accrual basis of accounting
and prudent accounting policies to calculate the profit or loss for the year and to recognize assets
and liabilities in balance sheet. While following the prudent accounting policies, the provision is
made for all known liabilities and losses even for those liabilities / events, which are probable.
Professional judgement is required to classify the likehood of the future events occuring and,
therefore, the question of contingencies and their accounting arises.
Objective of this standard is to prescribe the accounting of contigencies and the events, which
take place after the balance sheet date but before approval of balance sheet by Board of
Directors. The Accounting Standard deals with Contingencies and Events occuring after the
balance sheet date.
Net Profit or Loss for the Period, Prior Period Items and change in Accounting
Policies: The objective of this accounting standard is to prescribe the criteria for certain items in
the profit and loss account so that comparability of the financial statement can be enhanced.
Profit and loss account being a period statement covers the items of the income and expenditure
of the particular period. This accounting standard also deals with change in accounting policy,
accounting estimates and extraordinary items.
Depreciation Accounting: It is a measure of wearing out, consumption or other loss of value of

a depreciable asset arising from use, passage of time. Depreciation is nothing but distribution of
total cost of asset over its useful life.
Construction Contracts: Accounting for long term construction contracts involves question as
to when revenue should be recognized and how to measure the revenue in the books of
contractor. As the period of construction contract is long, work of construction starts in one year
and is completed in another year or after 4-5 years or so. Therefore question arises how the profit
or loss of construction contract by contractor should be determined. There may be following two
ways to determine profit or loss: On year-to-year basis based on percentage of completion or On
cpmpletion of the contract.
Revenue Recognition: The standard explains as to when the revenue should be recognized in
profit and loss account and also states the circumstances in which revenue recognition can be

postponed. Revenue means gross inflow of cash, receivable or other consideration arising in the
course of ordinary activities of an enterprise such as:- The sale of goods, Rendering of Services,
and Use of enterprises resources by other yeilding interest, dividend and royalties. In other
words, revenue is a charge made to customers / clients for goods supplied and services rendered.
Accounting for Fixed Assets: It is an asset, which is:- Held with intention of being used for the
purpose of producing or providing goods and services. Not held for sale in the normal course of
business. Expected to be used for more than one accounting period.
The Effects of changes in Foreign Exchange Rates: Effect of Changes in Foreign Exchange
Rate shall be applicable in Respect of Accounting Period commencing on or after 01-04-2004
and is mandatory in nature. This accounting Standard applicable to accounting for transaction in
Foreign currencies in translating in the Financial Statement Of foreign operation Integral as well
as non- integral and also accounting for For forward exchange.Effect of Changes in Foreign
Exchange Rate, an enterprises should disclose following aspects:
• Amount Exchange Difference included in Net profit or Loss;
• Amount accumulated in foreign exchange translation reserve;
• Reconciliation of opening and closing balance of Foreign Exchange translation reserve;
Accounting for Government Grant: Governement Grants are assistance by the Govt. in the
form of cash or kind to an enterprise in return for past or future compliance with certain
conditions. Government assistance, which cannot be valued reasonably, is excluded from Govt.
grants,. Those transactions with Governement, which cannot be distinguished from the normal
trading transactions of the enterprise, are not considered as Government grants.
Accounting for Investments: It is the assets held for earning income by way of dividend,
interest and rentals, for capital appreciation or for other benefits.
Accounting for Amalgamation: This accounting standard deals with accounting to be made in
books of Transferee company in case of amalgamtion. This accounting standard is not applicable
to cases of acquisition of shares when one company acquires / purcahses the share of another
company and the acquired company is not dissolved and its seperate entity continues to exist.
The standard is applicable when acquired company is dissolved and seperate entity ceased exist
and purchasing company continues with the business of acquired company.
Employee Benefits: Accounting Standard has been revised by ICAI and is applicable in respect
of accounting periods commencing on or after 1st April 2006. the scope of the accounting
standard has been enlarged, to include accounting for short-term employee benefits and
termination benefits.
Borrowing Cost: Enterprises are borrowing the funds to acquire, build and install the fixed
assets and other assets, these assets take time to make them useable or saleable, therefore the
enterprises incur the interest (cost on borrowing) to acquire and build these assets. The objective
of the Accounting Standard is to prescribe the treatment of borrowing cost (interest other cost) in
accounting, whether the cost of borrowing should be included in the cost of assets or not.
Segment Reporting: An enterprise needs in multiple products/services and operates in different

geographical areas. Multiple products / services and their operations in different geographical
areas are exposed to different risks and returns. Information about multiple products / services

and their operation in different geographical areas are called segment information. Such
information is used to assess the risk and return of multiple products/services and their operation
in different geographical areas. Disclosure of such information is called segment reporting.
Related Paty Disclosure: Sometimes business transactions between related parties lose the
feature and character of the arms length transactions. Related party relationship affects the
volume and decision of business of one enterprise for the benefit of the other enterprise. Hence
disclosure of related party transaction is essential for proper understanding of financial
performance and financial position of enterprise.
Accounting for leases: Lease is an arrangement by which the lesser gives the right to use an
asset for given period of time to the lessee on rent. It involves two parties, a lessor and a lessee
and an asset which is to be leased. The lessor who owns the asset agrees to allow the lessee to
use it for a specified period of time in return of periodic rent payments.
Earning Per Share: Earning per share (EPS)is a financial ratio that gives the information
regarding earning available to each equiy share. It is very important financial ratio for assessing
the state of market price of share. This accounting standard gives computational methodology for
the determination and presentation of earning per share, which will improve the comparison of
EPS. The statement is applicable to the enterprise whose equity shares or potential equity shares
are listed in stock exchange.
Consolidated Financial Statements: The objective of this statement is to present financial

statements of a parent and its subsidiary (ies) as a single economic entity. In other words the
holding company and its subsidiary (ies) are treated as one entity for the preparation of these
consolidated financial statements. Consolidated profit/loss account and consolidated balance
sheet are prepared for disclosing the total profit/loss of the group and total assets and liabilities of
the group. As per this accounting standard, the conslidated balance sheet if prepared should be
prepared in the manner prescribed by this statement.
Accounting for Taxes on Income: This accounting standard prescribes the accounting treatment
for taxes on income. Traditionally, amount of tax payable is determined on the profit/loss
computed as per income tax laws. According to this accounting standard, tax on income is
determined on the principle of accrual concept. According to this concept, tax should be
accounted in the period in which corresponding revenue and expenses are accounted. In simple
words tax shall be accounted on accrual basis; not on liability to pay basis.
Accounting for Investments in Associates in consolidated financial statements: The

accounting standard was formulated with the objective to set out the principles and procedures
for recognizing the investment in associates in the cosolidated financial statements of the
investor, so that the effect of investment in associates on the financial position of the group is
indicated.
Discontinuing Operations: The objective of this standard is to establish principles for reporting
information about discontinuing operations. This standard covers "discontinuing operations"
rather than "discontinued operation". The focus of the disclosure of the Information is about the
operations which the enterprise plans to discontinue rather than dsclosing on the operations
which are already discontinued. However, the disclosure about discontinued operation is also
covered by this standard.

Interim Financial Reporting (IFR): Interim financial reporting is the reporting for periods of
less than a year generally for a period of 3 months. As per clause 41 of listing agreement the
companies are required to publish the financial results on a quarterly basis.
Intangible Assets: An Intangible Asset is an Identifiable non-monetary Asset without physical

substance held for use in the production or supplying of goods or services for rentals to others or
for administrative purpose.
Financial Reporting of Interest in joint ventures: Joint Venture is defined as a contractual

arrangement whereby two or more parties carry on an economic activity under 'joint control'.
Control is the power to govern the financial and operating policies of an economic activity so as
to obtain benefit from it. 'Joint control' is the contractually agreed sharing of control over
economic activity.
Impairment of Assets: The dictionary meanong of 'impairment of asset' is weakening in value

of asset. In other words when the value of asset decreases, it may be called impairment of an
asset. As per AS-28 asset is said to be impaired when carrying amount of asset is more than its
recoverable amount.
Provisions, Contingent Liabilities And Contingent Assets: Objective of this standard is to

prescribe the accounting for Provisions, Contingent Liabilitites, Contingent Assets, Provision for
restructuring cost.
Provision: It is a liability, which can be measured only by using a substantial degree of

estimation.
Liability: A liability is present obligation of the enterprise arising from past events the
settlement of which is expected to result in an outflow from the enterprise of resources
embodying economic benefits.
Financial Instrument: Recognition and Measurement, issued by The Council of the Institute of
Chartered Accountants of India, comes into effect in respect of Accounting periods commencing
on or after 1-4-2009 and will be recommendatory in nature for An initial period of two years.
This Accounting Standard will become mandatory in respect of Accounting periods commencing
on or after 1-4-2011 for all commercial, industrial and business Entities except to a Small and
Medium-sized Entity. The objective of this Standard is to establish principles for recognizing and
measuring Financial assets, financial liabilities and some contracts to buy or sell non-financial
items. Requirements for presenting information about financial instruments are in Accounting
Standard.
Financial Instrument: presentation: The objective of this Standard is to establish principles for
presenting financial instruments as liabilities or equity and for offsetting financial assets and
financial liabilities. It applies to the classification of financial instruments, from the perspective
of the issuer, into financial assets, financial liabilities and equity instruments; the classification of
related interest, dividends, losses and gains; and the circumstances in which financial assets and
financial liabilities should be offset. The principles in this Standard complement the principles
for recognising and measuring financial assets and financial liabilities in Accounting Standard
Financial Instruments:

Financial Instruments, Disclosures and Limited revision to accounting standards: The

objective of this Standard is to require entities to provide disclosures in their financial statements
that enable users to evaluate:
• the significance of financial instruments for • the entity’s financial position and performance;
and
• the nature and extent of risks arising from financial instruments to which the entity is exposed
during the period and at the reporting date, and how the entity manages those risks.
Human Resource Accounting

Meaning
Human resources are considered as important assets and are different from the physical assets.
Physical assets do not have feelings and emotions, whereas human assets are subjected to various
types of feelings and emotions. In the same way, unlike physical assets human assets never gets
depreciated.
Therefore, the valuations of human resources along with other assets are also required in order to
find out the total cost of an organization. In 1960s, Rensis Likert along with other social
researchers made an attempt to define the concept of human resource accounting (HRA).
Definition:
1. The American Association of Accountants (AAA) defines HRA as follows: ‘HRA is a process
of identifying and measuring data about human resources and communicating this information to
interested parties’.
2. Flamhoitz defines HRA as ‘accounting for people as an organizational resource. It involves

measuring the costs incurred by organizations to recruit, select, hire, train, and develop human
assets. It also involves measuring the economic value of people to the organization’.
3. According to Stephen Knauf, ‘ HRA is the measurement and quantification of human

organizational inputs such as recruiting, training, experience and commitment’.
Need for HRA:

The need for human asset valuation arose as a result of growing concern for human relations
management in the industry.
Behavioural scientists concerned with management of organizations pointed out the

following reasons for HRA:
1. Under conventional accounting, no information is made available about the human resources
employed in an organization, and without people the financial and physical resources cannot be
operationally effective.

2. The expenses related to the human organization are charged to current revenue instead of
being treated as investments, to be amortized over a period of time, with the result that
magnitude of net income is significantly distorted. This makes the assessment of firm and inter-
firm comparison difficult.
3. The productivity and profitability of a firm largely depends on the contribution of human
assets. Two firms having identical physical assets and operating in the same market may have
different returns due to differences in human assets. If the value of human assets is ignored, the
total valuation of the firm becomes difficult.
4. If the value of human resources is not duly reported in profit and loss account and balance
sheet, the important act of management on human assets cannot be perceived.
5. Expenses on recruitment, training, etc. are treated as expenses and written off against revenue
under conventional accounting. All expenses on human resources are to be treated as
investments, since the benefits are accrued over a period of time.
Objectives of HRA:
Rensis Likert described the following objectives of HRA:
1. Providing cost value information about acquiring, developing, allocating and maintaining
human resources.
2. Enabling management to monitor the use of human resources.
3. Finding depreciation or appreciation among human resources.
4. Assisting in developing effective management practices.
5. Increasing managerial awareness of the value of human resources.
6. For better human resource planning.
7. For better decisions about people, based on improved information system.
8. Assisting in effective utilization of manpower.
Methods of Valuation of Human Resources:

There are certain methods advocated for valuation of human resources. These methods include
historical method, replacement cost method, present value method, opportunity cost method and
standard cost method. All methods have certain benefits as well as limitations.

Methods of Human Resource Accounting

Several methods have been in use but they all fall under 4 methods of human resource
accounting:
1. Historical Cost Method
2. Replacement Cost Method
3. Present Value Method and Economic Value Method
4. Asset Multiplier Method
Methods of Human Resource Accounting
Historical Cost Method

Under the Historical cost method
method, the sum total of all the costs related to human resources is
calculated to find out the value of a human resource. These costs include the cost of recruitment,
selection, training, placement, and development of human resources of an organization.
Historical Cost Method was introduced by Brummet, Flamholtz and Pyle. This is the oldest
method of valuation of human resource.
Types of Historical Cost Method
1. Acquisition cost: It means the cost which is incurred on acquiring the human resource in the
organization. The cost incurred at the time of recruitment, selection, and placement, etc.
2. Learning Cost: It means that cost is incurred at the time of providing training and
development to the employees and managers.
Advantage of historical cost method
1. This method is very easy to calculate the value of a human resource.
MBA-ACCOUNTING
ACCOUNTING FOR MANAGEMENT
2. Employers and employees can easily understand this method.
3. This method follows the traditional accounting concept of matching costs with revenue.
4. Return on the company’s investment in human resources can easily be calculated by this
method.
Disadvantage of historical cost method
1. Under this method it is very different to estimate the service period of an employee.
2. In this method rate of amortization is very difficult to determine.
3. As we know, the value of assets decreases with an increasing number of years or amortization.
But in the case of human resources, it is just the opposite. The utility of employees increases
with the increasing experience and training provided to them.
Replacement Cost Method
Replacement cost is that cost which is incurred on replacing the existing human resource by an
identical one i.e. human resource capable of rendering similar services.
Replacement Cost Method was introduced by Rensis Likert and Eric G. Flamholtz.
This method is different from the historical cost method.
The historical method takes into account only the sunk cost which is immaterial to calculate the
value of human resources and take a decision on that basis.
The replacement cost method is very realistic as it considers the current value of human
resources in its financial statement.
Advantage of replacement cost method
1. This method estimates the present value of human resources. This method is very logical and
representative.
2. This method can easily adjust the human value of price trends and can provide real value at the
time of the rise in prices.
Disadvantage of replacement cost method
1. The identical replacement of an employee is not always possible to find.
2. The cost of replacing the human resource is inconsistent with traditional accounting system
based on the cost concept.
Present Value Method and Economic Value Method
Present value method, the future earnings of the employees are estimated up to the retirement
period and is discounted at a discount rate which is usually the cost of capital.
Economic value method present worth of the employee is calculated on the basis of the future
service that is expected from him till his retirement.
Under this methods value of a human resource is calculated on the basis of the contribution made
by the employees in the organization till their retirement. The payment due to the employees in
the form of pay, allowance, and benefit etc. are estimated and then discounted to arrive at a
present economic value of the individual.
Advantage of economic value method

1. Employee’s career movements are taken into account under this method.
2. The possibilities of employees leaving the organization other than death or retirement are also
considered.
Disadvantage of economic value method
1. The service tenure of an employee is very difficult to estimate.
2. The value of expected services data is very difficult to find.
3. Estimation of employee’s chances of occupying various positions for each employee is not
an easy task.
4. Valuation of the contribution of services from employees is also not easy to judge.
5. To estimate the exit probabilities and changes from one position to another is an expensive
process.
Asset Multiplier Method
Asset Multiplier Methods consider that there is no direct relationship between the cost incurred
on human resource and how much value he is for the organization. The value of human resources
depends on various factors like the level of motivation and employee attitude towards work and
the organization.
Here multiplier refers to instruments that relate personal worth of human resource to the total
asset value of the organization.
Employees of the organization are divided into four categories under this method namely
• Top management
• Middle management
• Supervisor
• Clerical employees.
Asset Multiplier reflects the following factors:
1. Technical, qualification and experience of employees.
2. Experience required for the job.
3. Personal qualities and attitude.
4. Loyalty and expectation of future services.
Advantage of asset multiplier method
1. This method is simple and easy to understand.
2. Data for calculation is easily available.
3. Multipliers used in this method are different for a different group of employees.
Disadvantage of asset multiplier method
This method considers factors like motivation, employee’s attitude which are difficult to
quantify.
Benefits of HRA:

There are certain benefits for accounting of human resources, which are explained as
follows:
1. The system of HRA discloses the value of human resources, which helps in proper
interpretation of return on capital employed.
2. Managerial decision-making can be improved with the help of HRA.
3. The implementation of human resource accounting clearly identifies human resources as valu-
able assets, which helps in preventing misuse of human resources by the superiors as well as the
management.
4. It helps in efficient utilization of human resources and understanding the evil effects of labour
unrest on the quality of human resources.
5. This system can increase productivity because the human talent, devotion, and skills are
considered valuable assets, which can boost the morale of the employees.
6. It can assist the management for implementing best methods of wages and salary
administration.
Limitations of HRA:
HRA is yet to gain momentum in India due to certain difficulties:
1. The valuation methods have certain disadvantages as well as advantages; therefore, there is
always a bone of contention among the firms that which method is an ideal one.
2. There are no standardized procedures developed so far. So, firms are providing only as
additional information.
3. Under conventional accounting, certain standards are accepted commonly, which is not
possible under this method.
4. All the methods of accounting for human assets are based on certain assumptions, which can
go wrong at any time. For example, it is assumed that all workers continue to work with the same
organization till retirement, which is far from possible.
5. It is believed that human resources do not suffer depreciation, and in fact they always
appreciate, which can also prove otherwise in certain firms.
6. The lifespan of human resources cannot be estimated. So, the valuation seems to be
unrealistic.

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ST.

JOSEPH'S DEGREE & PG COLLEGE

Accounting for Business

MBA-ACCOUNTING FOR MANAGEMENT

cycle of measurement of results and reporting of results to decision- makers.

Just like arithmetic is a procedural element of mathematics, book keeping is

People make decision

Business transactions occur

FIG 1: THE ACCOUNTING SYSTEM

DEFINITIONS OF FINANCIAL ACCOUNTING

1. According to Smith andAshburn,

“Accounting is the science of recording and classifying business

2. According to committee on terminology of American

3. Another definition given by the same professional body, namely,

MBA-ACCOUNTING FOR MANAGEMENT

AICPA stated that “Accounting is the collection, measurement,

4. In 1966, the American Accounting Association defined accounting

The history of accounting can be traced back to ancient times. According to

MBA-ACCOUNTING FOR MANAGEMENT

1994 by Lucas Pacioli. He was a mathematician and a friend of Leonardo Ileda

The onset of the industrial revolution necessitated the development of more

Government also has had a lot to do with more accounting developments.

MBA-ACCOUNTING FOR MANAGEMENT

an organization, to invest money, to rent a house,etc.

MBA-ACCOUNTING FOR MANAGEMENT

Government and Regulatory agencies are charged with the responsibility of

MBA-ACCOUNTING FOR MANAGEMENT

As mentioned earlier, financial accounting deals with the preparation of

Financial accounting is charged with the primary responsibility of external

MBA-ACCOUNTING FOR MANAGEMENT

The management of a company has to solve certain ticklish questions like

The limitations of financial accounting, however, should not lead one to

Management accounting is ‘tailor-made’ accounting. It facilitates the

MBA-ACCOUNTING FOR MANAGEMENT

An important characteristic of management accounting is that it is forward

Since management accounting caters to the specific decision needs, it does

One important variant of management accounting is the cost analysis. Cost

The basic purpose of cost accounting is to provide a detailed break- up of

MBA-ACCOUNTING FOR MANAGEMENT

The objectives of cost accounting, therefore, can be summarized in the form

Various alternative courses of action can be properly evaluated with the

Distinction between financial and management accounting

Financial and management accounting can be distinguished on a variety of

Table 1 presents a summary of distinctions between financial and

MBA-ACCOUNTING FOR MANAGEMENT

TABLE 1: FINANCIAL ACCOUNTING VS MANAGEMENT ACCOUNTING

Basis of Financial accounting Management

Accrual: Recognition of revenues and costs as they are earned or incurred. It

Cost: The amount of expenditure incurred on or attributable to a specified

Expenses: A cot relating to the operations of an accounting period.

Revenue: Total amount received from sales ofgoods/services.

Income: Excess of revenue over expenses.

MBA-ACCOUNTING FOR MANAGEMENT

Loss: Excess of expenses over revenue.

Capital: Generally refers to the amount invested in an enterprise by

Fund: An account usually of the nature of a reserve or provision which is

Gain: A monetary benefit, profit or advantage resulting from a transaction or

Investment: Expenditure on assets held to earn interest, income, profit or

Liability: The financial obligation of an enterprise other than owners’