Month: April 2020

Opening entry

An opening entry is the initial entry used to record the transactions occurring at the start of an organization. The contents of the opening entry typically include the initial funding for the firm, as well as any initial debts incurred and assets acquired.

When next financial year begins, the accountant passes one journal entry at the beginning of every financial year in which he shows all the opening balance of assets and all the liabilities include capital. After that, the journal entry is called an opening journal entry. Because all assets have a debit balance, so these are debited in an opening journal entry and all liabilities have a credit balance, hence these are credited in an opening journal entry.

Date                                        Particulars                             Amount                   Amount

                                                   Assets A/c                       Dr.      XX      

                                                   Liabilities A/c                                                           XX

                                                   Capital A/c                                                                XX

In case all assets exceed all liabilities, the excess will be the value of capital which is showed credit side in the opening journal entry. If however, liabilities are more than the value of all assets, then the resulting excess will be goodwill and it will be debited in the opening journal entry.

Usually, different of assets and liability will be positive and the excess value of assets will be shown as capital on the credit of journal entry. Figures of opening balances can be obtained by taking a look at the balance sheet of the previous year

Closing entries

A closing entry is a journal entry that is made at the end of an accounting period to transfer balances from a temporary account to a permanent account.

Companies use closing entries to reset the balances of temporary accounts accounts that show balances over a single accounting period to zero. By doing so, the company moves these balances into permanent accounts on the balance sheet. These permanent accounts show a company’s long-standing financials.

Temporary accounts can either be closed directly to the retained earnings account or to an intermediate account called the income summary account. The income summary account is then closed to the retained earnings account. Both ways have their advantages.

Closing all temporary accounts to the income summary account leaves an audit trail for accountants to follow. The total of the income summary account after the all temporary accounts have been close should be equal to the net income for the period.

Closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step. There is no need to close temporary accounts to another temporary account (income summary account) in order to then close that again.

Both closing entries are acceptable and both result in the same outcome. All temporary accounts eventually get closed to retained earnings and are presented on the balance sheet.

Example of a Closing Entry

Below are examples of closing entries that zero the temporary accounts in the income statement and transfer the balances to the permanent retained earnings account. This is done using the income summary account.

1. Close Revenue Accounts

Clear the balance of the revenue account by debiting revenue and crediting income summary.

2. Close Expense Accounts

Clear the balance of the expense accounts by debiting income summary and crediting the corresponding expenses. 

3. Close Income Summary

Close the income summary account by debiting income summary and crediting retained earnings.

4. Close Dividends

Close the dividends account by debiting retained earnings and crediting dividends. 

Journal

Double entry system of bookkeeping says that every transaction affects two accounts. There is a proper procedure for recording each financial transaction in this system, called as accounting process. The process starts from journal followed by ledger, trial balance, and final accounts. Journal and Ledger are the two pillars which create the base for preparing final accounts. The Journal is a book where all the transactions are recorded immediately when they take place which is then classified and transferred into concerned account known as Ledger.

Journal is also known as book of primary entry, which records transactions in chronological order. On the other hand, Ledger, or otherwise known as principal book implies a set of accounts in which similar transactions, relating to person, asset, revenue, liability or expense are tracked. In this article, we have compiled all the important differences between Journal and Ledger in accounting, in tabular form.

The Journal is a subsidiary day book, where monetary transactions are recorded for the first time, whenever they arise. In this, the transactions are regularly recorded in an orderly manner, so that they can be referred in future. It highlights the two accounts which are affected by the occurrence of the transaction, one of which is debited and the other is credited with an equal amount.

A short note is given in support of each entry, which gives a brief description of the transaction, known as Narration. The complete process of recording the entries in the journal is known as Journalizing. It has five columns which are Date, Particulars, Ledger Folio, Debit, and Credit. A journal can be:

• Single Entry: Entry having one debit and a corresponding credit.
• Compound Entry: Entry having one debit and more than one credit or entry having more than one debit for a single debit or two or more debit and two or more credits. In the case of compound entry, it should be kept in mind that the total of debit and credit will tally.

Ledger

Ledger is a principal book which comprises a set of accounts, where the transactions are transferred from the Journal. Once the transactions are entered in the journal, then they are classified and posted into separate accounts. The set of real, personal and nominal accounts where account wise description is recorded, it is known as Ledger.

While posting entries in the ledger, individual accounts should be opened for each account. The format of a ledger account is ‘T’ shaped having two sides debit and credit. When the transaction is recorded on the debit side the word ‘To’ is added, however, if the transaction is to be recorded on the credit side, then the word ‘By’ is used in the particular column along with the account name.

At the end of the financial year, the ledger account is balanced. For this purpose, first of all, the totals of the two sides is determined, after that, you need to calculate the difference between the two sides. If the amount on the debit side is more than the credit side, then there is a debit balance, but if the credit side is higher than the debit side, then there is a credit balance. Suppose if an account has a debit balance, then you have to write “By Balance c/d” on the credit side with the difference amount. In this way both the sides will tally.

Now, at the beginning of the new period, you have to transfer the opening balance to the opposite side (i.e. On the debit side as per our example) as “To Balance b/d”. Here c/d refers to carried down, and b/d means brought down.

Despite so many similarities, there are some differences between journal and ledger which are shown below;

Capital profit is a profit which is earned, on the sale of a fixed asset or profit earned on raising capital for a company (by issuing shares at premium). This is not a regular profit of the business and is not earned in the ordinary trade of the business. For example, if a machinery having book value of $50,000 is sold for $60,000, the profit of $10,000 will be a capital profit. In the same way, a joint stock company issues shares of $ 2,00,000 at a premium of $10,000 to raise capital, such premium of $10,000 will be a capital profit.

In this connection the distinction between capital receipt and capital profit may be noted. A machinery of $50,000 is sold for $60,000. Here capital receipt is $60,000 and capital profit is $10,000. This type of profit is not recurring and regular. It will be shown on the liability side of the Balance Sheet under the head “Capital Reserve”.

Revenue Profits:

This is a profit which is earned during the ordinary course of business e.g. profit on sale of goods, rent received, interest received etc.

Capital Loss:

This is a Joss suffered by a business on the sale of a fixed asset or it is incurred on raising capital of a joint stock company. This is not a recurring loss and is not made in the ordinary course of the business. e.g. A machinery having book value of $50,000 is sold for $45,000, the loss of $ 5,000 is a capital loss. In the same way, a company issued shares of $1,00,000 at 10% discount, the loss of $10,000 (10% of $1,00,000) is a capital loss. Capital loss is sown in the Balance Sheet on the asset side as a fictitious asset which is gradually written off out of the profits every year.

Revenue Loss:

This loss is made in the ordinary course or day to day operation of a business such as loss on sale of goods etc. Revenue loss appears in the profit and loss account or income statement in the year in which it occurs.

Posting in accounting is when the balances in subledgers and the general journal are shifted into the general ledger. Posting only transfers the total balance in a subledger into the general ledger, not the individual transactions in the subledger. An accounting manager may elect to engage in posting relatively infrequently, such as once a month, or perhaps as frequently as once a day.

Subledgers are only used when there is a large volume of transaction activity in a certain accounting area, such as inventory, accounts payable, or sales. Thus, posting only applies to these larger-volume situations. For low-volume transaction situations, entries are made directly into the general ledger, so there are no subledgers and therefore no need for posting.

For example, ABC International issues 20 invoices to its customers over a one-week period, for which the totals in the sales subledger are for sales of $300,000. ABC’s controller creates a posting entry to move the total of these sales into the general ledger with a $300,000 debit to the accounts receivable account and a $300,000 credit to the revenue account.

Posting is also used when a parent company maintains separate sets of books for each of its subsidiary companies. In this case, the accounting records for each subsidiary are essentially the same as subledgers, so the account totals from the subsidiaries are posted into those of the parent company. This may also be handled on a separate spreadsheet through a manual consolidation process.

Posting has been eliminated in some accounting systems, where subledgers are not used. Instead, all information is directly stored in the accounts listed in the general ledger.

When posting is employed, someone researching information in the general ledger must “drill down” from the account totals posted into the relevant general ledger accounts, and search in the detailed records listed in the relevant subledgers. This can entail a significant amount of additional research work.

From the perspective of closing the books, posting is one of the key procedural steps required before financial statements can be created. In this process, all adjusting entries to the various subledgers and general journal must be made, after which their contents are posted to the general ledger. It is customary at this point to set a lock-out flag in the accounting software, so that no additional changes to the subledgers and journals can be made for the accounting period being closed. Access to the subledgers and journals is then opened for the next accounting period.

If posting accidentally does not occur as part of the closing process, the totals in the general ledger will not be accurate, nor will the financial statements that are compiled from the general ledger.

Steps for Balancing Ledger Account

• First of all, calculate the totals of debit and credit columns separately on a rough sheet to avoid mistakes. Find out the difference between the heavier total and lighter total by subtracting the lower from higher. The difference is called a Balance amount.
• If the total of the debit side is heavier than that of the credit side, the balance is called as “Debit Balance” and is written on the credit side (the side with lower amount) of that particular account as “By Balance c/d” or “By Balance c/FD”. Here, c/d means carried down and c/FD means carried forward.
• Similarly, if the total of the credit side is more than that of debit side total, the balance is called “Credit Balance”. The difference amount is written on the debit side of the account as “To balance c/d” or “To balance c/fd”
• Once we get the heavier total it should be written in both the columns’ total. Draw double lines across the total below the amounts which indicates the account is closed and balanced.
• Last year’s closing balance is the opening balance of the current year. So, if there is debit it should be shown on the debit side of a particular account as “To Balance b/d” or “To Balance b/fd”. Here, b/d means brought down and b/fd means brought forward.

Note: Nominal accounts are not balanced; the balances are transferred to profit and loss account.

Posting the entries from day books to ledger is very important work. An accountant must keep in his mind the following rules while posting the entries:-

1. Entries must be posted from the day books or journal only.
2. Posting of the entries must be date wise.
3. Date of entry in day books must be the date of entry in ledger.
4. All amounts shown in debit side in journal must be posted in debit side of a particular account. In ‘particulars’ column of ledger, the name of the other account as shown in journal, relating to same entry, must be written and the account head must start with ‘To’.
5. All amounts shown in credit side in journal must be posted in credit side of a particular account. In ‘particulars’ column of ledger, the name of the other account as shown in journal, relating to same entry, must be written and the account head must start with ‘By’.
6. After the entry, page number of journal from where the entry is posted, must be written in L/F column of account and the page number of ledger account must be written in L/F column of journal or day book.
7. Then the balancing of the ledger should be done. Balancing is may be done as running or can be done after doing the totals of debit and credit side. If the total of debit side is more than credit side then the balance should be shown as debit balance in balance column and if the total of credit side is more than the total of debit side then balance should be shown as credit balance in balance column. If the totals of debit and credit sides are equal then the balance should be shown as ‘nil’ in balance column.

The income statement summarizes sales, expenses and profits for an accounting period. Expenses include cost of goods sold, operating and non-operating expenses, and unusual expenses. Operating expenses include administration and advertising, while interest and taxes are some of the non-operating expenses. Unusual expenses are extraordinary or one-time in nature. The company does not incur these expenses every period, but they may have a significant effect on profits and cash flow.

Types

Unusual items include discontinued operations, extraordinary items and changes in accounting principles. Discontinued operations refer to the sale or shutdown of a significant operating unit. For example, the costs associated with shutting down overseas manufacturing operations would count as unusual expenses. Extraordinary expenses are infrequent or one-time events, such as damages caused by natural disasters and accidents. Unusual expenses also include changes in accounting principles, such as a change from cash-basis to accrual-basis accounting.

Accounting

Income statements show unusual items in a separate section near the bottom. Items must be both unusual and infrequent to be in this section. For example, gains and losses from disposal of fixed assets or changes in inventory valuations are not part of this section. Companies may show the net income from continuing or regular operations as a separate line item, then list the extraordinary and discontinued items, and finally show the net income. The income statement shows these unusual items net of taxes. For example, if the corporate tax rate is 20 percent and the losses from flood damage are $10,000, the net loss is $8,000 — $10,000 x (1 – 0.20) = $10,000 x 0.80 = $8,000.

Impact

Unusual items affect the net income calculation on the income statement, including resulting in a loss. For example, a fire that destroys a small company’s production facilities could result in a net loss because the company would have to repurchase inventory, repair damages to the building and buy or lease new equipment. For public companies, unusual items also affect earnings per share, which is the net income divided by the number of shares outstanding. Changes in net income also affect operating cash flow.

Considerations

Investors should review the unusual items to determine whether they indicate an underlying problem. For example, if a company discontinues its Latin American operations, investors might want to know why management closed the business or could not find a buyer. Some companies may classify certain items as unusual in every accounting period to make the net income from continuing operations number look better. External stakeholders should assess whether the company management is trying to hide operational weaknesses in unusual items.

Accounting errors

Accounting errors are the mistakes committed in bookkeeping and accounting. The mistake may be one relating to routine or one relating to principle. They may occur in entering the transactions in the journal or subsidiary books or they may creep at the time of posting into the ledger.

Thus, errors may be committed while recording, classifying or summarizing the accounting transactions. The error may be the result of an act of omission or commission.

Classification of Errors:

Depending upon the nature of errors, they may be classified into the following four types:

(1) Errors of Omission

(2) Errors of Commission

(3) Errors of Principles

(4) Compensating Errors

1. Errors of Omission:

When a transaction is not recorded by mistake in the books of accounts, it is called an error of omission. The omission may be partial or complete.

Partial Omission may happen in relation to any subsidiary book. Here the transaction is entered in the subsidiary book but not posted to the ledger.

For example, goods returned by a customer has been entered in the sales returns book but not posted to the credit of customer’s account. Similarly, cash paid to the supplier has been entered in the payment side of the Cash Book but not posted to the debit of supplier’s account.

Complete omission can happen when the transaction is completely omitted from the books of accounts. For example, a bookkeeper failed to enter an invoice from the sales daybook.

2. Error of Commission:

When a transaction is entered in the books of accounts, it might be entered wrongly. It may be entered partially or incorrectly. Such error is called an error of commission. These errors arise often due to the ignorance or negligence or absent-mindedness of the accountant. It may be of different types. Examples of such errors are as follows:

(a) Errors relating to subsidiary books:

These are three types:

(i) Entering wrong amount in a subsidiary book, e.g., a purchase of Rs.430 may be entered in the Purchase Day Book as Rs.340 due to wrong transposition of figures.

(ii) Entering the transaction in a wrong subsidiary book, e.g., a purchase transaction may be entered in sales daybook and a sales transaction may be entered in the purchase daybook.

(iii) Wrong casting or carry forward of a subsidiary book. Casting refers to the process of totaling the daybooks periodically. A mistake in relation to totaling is called ‘error in casting’.

If there is excess totaling, the error is ‘over casting’ and short totaling is ‘under casting’. Sometimes, error may be the result of wrong carry forward of the total from one page of the daybook to another, e.g., the total of a page may be Rs.235 and carried forward to the next page as Rs.325.

(b) Errors relating to ledger:

These errors may be subdivided broadly into two types. They are: errors of posting and errors in balancing.

Error of posting may be further being subdivided as follows:

(i) Posting wrong amount on the right side of an account. Example. Sale of Rs.560 to Mr.Raja is entered as Rs.650 in the debit side of his account from the Sales Day Book.

(ii) Posting the same amount twice to an account. Example. A cash receipt of Rs.1000 from Mr.Ram is credited twice to his account.

(iii) Posting the correct amount to the wrong side of the right account. Example. A purchase of goods from Mr. Raj for Rs.1000 is debited to his account [instead of crediting],

(iv) Posting wrong amount to the wrong side of right account. Example. A purchase of Rs.1000 from Mr.Sam is debited to his account as Rs. 10,000.

(v) Posting the correct amount to the wrong account but on the right side. Example. A sale of goods to S.Anish for Rs.1000 is wrongly debited to G.Anish a/c.

(vi) Posting correct amount to the wrong account and on the wrong side. Example. A sale of Rs.1000 to S.Anish is wrongly credited to G.Anish a/c.

Errors in balancing:

Errors may arise in balancing the account resulting in excess or short balance of the account.

3. Errors of Principle:

These errors occur when entries are made against the principles of accounting. Example. Purchase of computer for office use is wrongly entered in the Purchases Day Book. Capital expenditure should not be treated as revenue expenditure.

These errors may be committed:

(a) Due to the inability to make a distinction between revenue and capital items;

(b) Due to inability to make a difference between business expenses and personal expenses;

(c) Due to inability to make a difference between productive expenses and non-productive expenses, e.g., wages paid for production may be debited to salaries a/c or salaries paid to office employees may be debited to wages a/c.

4. Compensating Errors:

These are the errors, which compensate themselves in the net results, i.e., over debit of one account is neutralized by an over credit in some other account to the same extent. Similarly a wrong credit might have been compensated by some wrong debit in some other account.

For example, if tax paid Rs.2, 500 is debited in Tax a/c as Rs.3, 000 and interest received Rs.3, 500 is credited in the interest a/c as Rs.4, 000, the excess debit of Rs.500 in tax a/c is compensated by an excess credit of Rs.500 in interest a/c.

This type of error may be committed in combination of different errors in different accounts. Normally the presence of this type of errors will not be revealed by the trial balance.

Impact of Errors on Trial Balance:

The agreement of the Trail balance is proof as to the arithmetical accuracy of the books of accounts. But it is a final proof of accuracy of books of accounts; it simply assures that for every debit there is a corresponding and equal credit.

If trial balance does not agree, it is a clear indication that there are certain errors in the books of accounts. Even if the trial balance agrees, there may be errors in the books of accounts.

Hence, the errors may be classified, depending upon the agreement of trial balance, as follows:

(a) Errors that do not affect the agreement of the trial balance.

(b) Errors that affect the agreement of the trial balance.

Errors that are not disclosed by Trial balance or not affect the agreement of the Trial balance are mainly the errors of principle, errors of complete omission, errors of commission and compensation errors.

Certain errors like entering a transaction in two subsidiary books or writing a wrong amount in a subsidiary book or mis-posting to the wrong account but correct side, etc. locating such errors are quite difficult and such errors can always be rectified by means of journal entries.

Errors that are disclosed by trial balance or affect the agreement of the Trial balance are mainly the errors of wrong or omission of posting, wrong totaling of subsidiary books, wrong carry-forward and wrong balancing of ledger accounts, etc.

Wrong posting may be in the forms of posting a wrong amount to a ledger account or posting to the wrong side of an account or double posting.

As these errors affect mostly only one side of ledger accounts, they will be revealed by the trial balance through disagreement of debit and credit totals.

Reducing Balance Method charges depreciation at a higher rate in the earlier years of an asset. The amount of depreciation reduces as the life of the asset progresses. Depreciation under reducing balance method may be calculated as follows:

Depreciation per annum = (Net Book Value – Residual Value) x Rate%

Where:

• Net Book Value is the asset’s net value at the start of an accounting period. It is calculated by deducting the accumulated (total) depreciation from the cost of the fixed asset.
• Residual Value is the estimated scrap value at the end of the useful life of the asset. As the residual value is expected to be recovered at the end of an asset’s useful life, there is no need to charge the portion of cost equaling the residual value.
• Rate of depreciation is defined according to the estimated pattern of an asset’s use over its life term.

Example:

An asset has a useful life of 3 years.

Cost of the asset is $3,000.

Residual Value is $500.

Rate of depreciation is 50%.

Depreciation expense for the three years will be as follows:

*Under reducing balance method, depreciation for the last year of the asset’s useful life is the difference between net book value at the start of the period and the estimated residual value. This is to ensure that depreciation is charged in full.

As you can see from the above example, depreciation expense under reducing balance method progressively declines over the asset’s useful life.

Reducing Balance Method is appropriate where an asset has a higher utility in the earlier years of its life. Computer equipment for instance has better functionality in its early years. Computer equipment also becomes obsolete in a span of few years due to technological developments. Using reducing balance method to depreciate computer equipment would ensure that higher depreciation is charged in the earlier years of its operation.

Following are the main points of difference between straight line method and reducing balance method of depreciation:

Depreciation means the decrease in the value of fixed assets due to normal wear and tear, efflux of time or obsolescence due to technology. Thus, it is important to measure the decrease in value of an asset and also account for it. There are various methods of providing depreciation. The most common method is the Straight line method (SLM).

According to the Straight line method, the cost of the asset is written off equally during its useful life. Therefore, an equal amount of depreciation is charged every year throughout the useful life of an asset. After the useful life of the asset, its value becomes nil or equal to its residual value. Thus, this method is also called Fixed Installment Method or Fixed percentage on original cost method.

When the amount of depreciation and the corresponding period are plotted on a graph it results in a straight line. Hence, it is known as the Straight line method (SLM).

This method is more suitable in case of leases and where the useful life and the residual value of the asset can be calculated accurately. However, where the repairs are low in the initial years and increase in subsequent years, this method will increase the charge on profit.

Also, while applying this method, the period of use of the asset should be considered. If an asset is used only for 3 months in a year then depreciation will be charged only for 3 months. However, for the Income Tax purposes, if an asset is used for more than 180 days full years’ depreciation will be charged.

Formulae:

Amount of Depreciation = (Cost of Asset – Net Residual Value) / Useful Life

The rate of Depreciation = (Annual Depreciation x 100) / Cost of Asset

Journal Entries for Straight Line Method of Depreciation

How to Calculate Straight Line Depreciation

The straight line calculation steps are:

1. Determine the cost of the asset.
2. Subtract the estimated salvage value of the asset from the cost of the asset to get the total depreciable amount.
3. Determine the useful life of the asset.
4. Divide the sum of step (2) by the number arrived at in step (3) to get the annual depreciation amount.

Benefits/Need of charging depreciation

1. Tax Benefit: Depreciation is allowed as an expense under Income tax and therefore it is important to consider it to save income tax.
2. Mandatory under companies act: It is compulsory to charge depreciation in profit and loss account in companies act 2013.
3. Real Profit: If it is not considered then expenditure on behalf of fixed assets is not considered and the profit may be shown as a high number especially in industries required large plant and machinery. Also, this may lead to high distribution of earnings to shareholders and thus non-availability of funds when business is in need to replace the asset.