Year: 2020

Management Notes

Book of original Journal

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According to double entry system of bookkeeping, transactions are recorded in the books of accounts in two stages:

First stage: Journal

Second stage: Ledger

The flow of accounting information from the time a transaction takes place to its recording in the ledger may be illustrated as follows:

Business Transaction

↓

Business Document Prepared

↓

Entry Recorded in Journal

↓

Entry Posted to Ledger

The initial record of each transaction is evidenced by a business document such as invoice, cash, voucher

Narration:

A short explanation of each transaction is written under each entry which is called narration. The subject matter of the transaction can be ascertained through narration. Besides this, if there be any mistake in determining debit or credit aspect of a transaction, it can be easily detected from narration. “A journal entry is not complete without narration”.

Characteristics:

Journal has the following features:

  1. Journal is the first successful step of the double entry system. A transaction is recorded first of all in the journal. So, journal is called the book of original entry.
  2. A transaction is recorded on the same day it takes place. So, journal is also called a day book.
  3. Transactions are recorded chronologically. So, journal is called chronological book.
  4. For each transaction the names of the two concerned accounts indicating which is debited and which is credited, are clearly written into consecutive lines. This makes ledger – posting easy. That is why journal is called “assistant to ledger” or “subsidiary book”.
  5. Narration is written below each entry.
  6. The amount is written in the last two columns – debit amount in debit column and credit amount in credit column.

Advantages of Journal:

The following are the advantages of journal:

  1. Each transaction is recorded as soon as it takes place. So there is no possibility of any transaction being omitted from the books of account.
  2. Since the transactions are kept recorded in journal chronologically with narration, it can be easily ascertained when and why a transaction has taken place.
  3. For each and every transaction which of the two concerned accounts will be debited and which account credited, are clearly written in journal. So, there is no possibility of committing any mistake in writing the ledger.
  4. Since all the details of transactions are recorded in journal, it is not necessary to repeat them in ledger. As a result ledger is kept tidy and brief.
  5. Journal shows the complete story of a transaction in one entry.
  6. Any mistake in ledger can be easily detected with the help of journal.

Format of Journal:

Date Particulars L.F Amount Amount
  Account to be debited ………………………..Dr.
     Account to be credited
(Narration)		   XXX XXX

Management Notes

Book of Original Subsidiary Books

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Subsidiary books, also known as special journals, are specialized accounting records used to record specific types of transactions in detail before they are posted to the general ledger. Common types of subsidiary books include the cash book, sales book, purchase book, and journal proper. These books help streamline the recording process by categorizing transactions, making it easier to track and manage financial activities. They enhance accuracy, reduce errors, and provide a detailed breakdown of specific transactions, ultimately aiding in the preparation of financial statements and reports.

Significance of Subsidiary Books:

Subsidiary books, also known as special journals, play a vital role in the accounting system by providing detailed records of specific types of transactions. These books enhance the efficiency of the accounting process and contribute to accurate financial reporting.

  1. Efficient Record-Keeping

Subsidiary books streamline the recording of transactions by categorizing them into specific types, such as sales, purchases, cash transactions, and returns. This organization facilitates quicker data entry, reducing the time spent on bookkeeping and improving overall efficiency.

  1. Detailed Transaction Records

Each subsidiary book provides a detailed account of specific transactions, capturing essential information such as dates, amounts, and parties involved. This level of detail helps businesses track financial activities accurately and supports effective decision-making.

  1. Error Reduction

By using subsidiary books, accountants can minimize errors in recording transactions. The structured format of these books reduces the chances of omitting or misclassifying transactions, leading to more accurate financial records.

  1. Simplified Posting to the Ledger

Transactions recorded in subsidiary books can be summarized and periodically posted to the general ledger, reducing the workload for accountants. This process simplifies the transfer of information, allowing for faster preparation of financial statements while ensuring accuracy.

  1. Facilitates Control and Monitoring

Subsidiary books enable businesses to monitor specific areas of their financial operations effectively. For instance, a cash book allows businesses to track cash inflows and outflows, while a sales book provides insights into sales performance. This monitoring capability aids in identifying trends and potential issues.

  1. Enhanced Analysis and Reporting

With detailed transaction data available in subsidiary books, businesses can perform in-depth analysis and generate reports specific to various aspects of their operations. This analysis supports management in making informed decisions, identifying profitable areas, and optimizing resources.

  1. Audit Trail Creation

The systematic nature of subsidiary books creates a clear audit trail for financial transactions. Auditors can easily trace transactions back to their source documents, enhancing transparency and accountability. This is crucial for compliance with regulatory standards and for maintaining trust with stakeholders.

  1. Facilitates Budgeting and Forecasting

By maintaining detailed records in subsidiary books, businesses can analyze past financial performance and make more accurate forecasts. This data aids in the budgeting process, allowing management to allocate resources effectively and set realistic financial goals.

  1. Support for Internal Controls

Subsidiary books can enhance internal controls within an organization by segregating duties and responsibilities related to different types of transactions. This segregation reduces the risk of fraud and errors, ensuring that transactions are recorded and reviewed systematically.

Types of Subsidiary Books:

  1. Cash Book

The cash book records all cash transactions, including cash receipts and cash payments. It serves as both a journal and a ledger and typically contains columns for cash sales, cash purchases, and bank transactions. The cash book helps businesses monitor their cash flow effectively.

  1. Sales Book

The sales book is used to record all credit sales of goods or services. It captures details such as the date of sale, customer name, invoice number, and amount. This book helps track sales performance and provides data for preparing the sales ledger.

  1. Purchase Book

The purchase book records all credit purchases of goods or services. Similar to the sales book, it includes details such as the date of purchase, supplier name, invoice number, and amount. This book helps businesses manage inventory and monitor purchasing trends.

  1. Sales Returns Book

The sales returns book, also known as the returns inward book, records all goods returned by customers. It captures information regarding the date of return, customer name, invoice number, and amount. This book helps businesses track returns and adjust sales figures accordingly.

  1. Purchase Returns Book

The purchase returns book, or returns outward book, records all goods returned to suppliers. It includes details such as the date of return, supplier name, invoice number, and amount. This book aids in managing inventory and ensuring accurate accounts payable.

  1. Journal Proper

The journal proper is used to record transactions that do not fit into the other subsidiary books. This includes non-recurring transactions, adjustments, and any other entries that require special attention. The journal proper provides a catch-all for unique transactions.

  1. Bills Receivable Book

The bills receivable book records all bills of exchange received from customers. It includes details such as the date, amount, and due date of each bill. This book helps businesses manage their receivables and track payment schedules.

  1. Bills Payable Book

The bills payable book records all bills of exchange that the business has issued to suppliers. It contains information such as the date, amount, and due date of each bill. This book helps businesses manage their obligations and payment schedules.

  1. Inventory Book

The inventory book records details related to the inventory held by the business, including purchases, sales, and stock levels. This book aids in inventory management, ensuring that stock levels are monitored and maintained accurately.

Management Notes

Trial Balance, Functions, Components, Example

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Trial Balance is a summary of all the general ledger accounts of a business at a specific point in time. It lists the balances of each account, separating them into debit and credit columns. The primary purpose of preparing a trial balance is to check the mathematical accuracy of the bookkeeping system, ensuring that total debits equal total credits. If the trial balance is balanced, it indicates that the double-entry accounting system has been followed correctly. However, a balanced trial balance does not guarantee the absence of errors, as some types of mistakes may not affect the overall balance.

Functions of Trial Balance:

  • Verification of Mathematical Accuracy

The main function of a trial balance is to ensure that the double-entry accounting system has been followed correctly. In this system, every transaction affects two or more accounts, with debits equaling credits. The trial balance checks the mathematical accuracy of these entries by listing all debit and credit balances. If the total debits equal the total credits, the bookkeeping entries are presumed correct.

  • Detecting Errors

The trial balance helps in identifying certain types of errors in the accounting records. For example, if debits and credits do not match, it indicates that there has been a mistake in the recording process. Errors such as omission, reversal of entries, or incorrect postings can be traced and corrected through the trial balance. However, it’s important to note that it won’t detect all types of errors, like compensating errors or incorrect amounts in both debit and credit sides.

  • Facilitating the Preparation of Financial Statements

One of the critical functions of the trial balance is to simplify the preparation of financial statements such as the balance sheet and income statement. Once the trial balance is complete and balanced, accountants can use the information to prepare these financial reports, ensuring the financial position and performance of the business are accurately reflected.

  • Summarizing Financial Data

The trial balance acts as a summary of all the financial data for a specific period. It compiles the ending balances of all the ledger accounts, providing a snapshot of the company’s financial standing. This summary allows management and auditors to review the overall status of the accounts in one place.

  • Checking for Completeness

By listing all the balances from the general ledger, a trial balance helps to check if any accounts have been omitted during the posting process. This function ensures that all financial transactions have been properly accounted for and included in the company’s records.

  • Simplifying Adjustments

Trial balances are typically prepared before making adjusting entries at the end of the accounting period. It helps in identifying which accounts require adjustments, such as accruals, depreciation, or prepaid expenses. Once the necessary adjustments are made, a new trial balance, known as the adjusted trial balance, is prepared.

  • Monitoring Financial Health

A well-maintained trial balance helps monitor the financial health of a business. By reviewing the balances in various accounts, management can assess liquidity, solvency, profitability, and other key financial metrics. The trial balance also highlights the balances of assets, liabilities, and equity accounts, offering insights into the overall financial condition of the company.

  • Supporting Auditing

The trial balance is an important tool for auditors during the auditing process. It provides a basis for auditors to verify the accuracy of financial records, trace transactions back to their original entries, and assess the reliability of the company’s financial statements. It also helps in ensuring that financial statements are prepared according to accounting standards and regulations.

Components of Trial Balance:

Trial Balance consists of several key components that help summarize the financial data of a business at a specific point in time. These components ensure that the double-entry accounting system has been followed correctly, and they aid in the preparation of financial statements.

1. Account Title

  • This is the name of each account in the general ledger. It includes all types of accounts such as assets, liabilities, equity, revenues, and expenses.
  • Examples of account titles are “Cash,” “Accounts Receivable,” “Inventory,” “Sales Revenue,” and “Salaries Expense.”

2. Debit Column

  • The debit column lists all the amounts that have been debited to the various accounts.
  • It includes the total debits recorded during the accounting period, and it helps track the value of transactions that increase assets or expenses.
  • For example, cash receipts and expenses like rent or utilities are recorded on the debit side.

3. Credit Column

  • The credit column contains all the amounts credited to the various accounts.
  • It represents the transactions that reduce assets or expenses or increase liabilities, equity, and revenues.
  • For example, income from sales and amounts owed to suppliers are typically recorded in the credit column.

4. Account Balances

  • The trial balance includes the closing balances of each account from the general ledger.
  • Each account will have either a debit or a credit balance depending on its nature (e.g., assets normally have debit balances, while liabilities have credit balances).
  • The trial balance displays these balances in the respective debit and credit columns.

5. Total of Debit and Credit Columns

  • At the bottom of the trial balance, the total of all debit and credit columns is shown.
  • The total debits and total credits should match (be equal), ensuring that the accounting records are mathematically correct and balanced.

6. Date

  • The trial balance is usually prepared at the end of an accounting period (monthly, quarterly, or annually).
  • The date helps to define the period for which the financial data is summarized, making it clear which transactions are included in the trial balance.

Example of Trial Balance:

Here is an example of a trial balance in table format:

Account Title Debit ($) Credit ($)
Cash 10,000
Accounts Receivable 5,000
Inventory 7,500
Equipment 15,000
Accounts Payable 3,500
Notes Payable 12,000
Capital 10,000
Sales Revenue 25,000
Salaries Expense 8,000
Rent Expense 2,000
Utilities Expense 1,000
Total 48,500 48,500

Explanation:

  • Debit Column:

This lists all the accounts with debit balances, such as assets (Cash, Accounts Receivable, Inventory, Equipment) and expenses (Salaries Expense, Rent Expense, Utilities Expense).

  • Credit Column:

This lists all the accounts with credit balances, such as liabilities (Accounts Payable, Notes Payable), owner’s equity (Capital), and revenues (Sales Revenue).

  • Total:

The total of the debit and credit columns must be equal (48,500), confirming that the ledger is balanced.

Management Notes

Depreciation in an Accounting

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Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value. Businesses depreciate long-term assets for both tax and accounting purposes. For tax purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however, businesses must depreciate these assets according to IRS rules about how and when the company can take the deduction.

Depreciation is often a difficult concept for accounting students as it does not represent real cash flow. Depreciation is an accounting convention that allows a company to write off an asset’s value over time, but it is considered a non-cash transaction.

Depreciation Example

For accounting purposes, depreciation expense does not represent a cash transaction, but it shows how much of an asset’s value the business has used over a period. For example, if a company buys a piece of equipment for $50,000, it can either write the entire cost of the asset off in year one or write the value of the asset off over the assets 10-year life. This is why business owners like depreciation. Most business owners prefer to expense only a portion of the cost, which artificially boosts net income. In addition, the company can scrap the equipment for $10,000, which means it has a salvage value of $10,000. Using these variables, the analyst calculates depreciation expense as the difference between the cost of the asset and the salvage value, divided by the useful life of the asset. The calculation in this example is ($50,000 – $10,000) / 10, which is $4,000.

This means the company’s accountant does not have to write off the entire $50,000, even though it paid out that amount in cash. Instead, the company only has to expense $4,000 against net income. The company expenses another $4,000 next year and another $4,000 the year after that, and so on, until the company writes off the value of the equipment in year 10.

Causes of Depreciation

Depreciation is a ratable reduction in the carrying amount of a fixed asset. Depreciation is intended to roughly reflect the actual consumption of the underlying asset, so that the carrying amount of the asset has been greatly reduced to its salvage value by the time its useful life is over. But why do we need depreciation at all? The causes of depreciation are:

(i) Wear and Tear

Any asset will gradually break down over a certain usage period, as parts wear out and need to be replaced. Eventually, the asset can no longer be repaired, and must be disposed of. This cause is most common for production equipment, which typically has a manufacturer’s recommended life span that is based on a certain number of units produced. Other assets, such as buildings, can be repaired and upgraded for long periods of time.

(ii) Perishability

Some assets have an extremely short life span. This condition is most applicable to inventory, rather than fixed assets.

(iii) Usage rights

A fixed asset may actually be a right to use something (such as software or a database) for a certain period of time. If so, its life span terminates when the usage rights expire, so depreciation must be completed by the end of the usage period.

(iv) Natural resource usage

If an asset is natural resources, such as an oil or gas reservoir, the depletion of the resource causes depreciation (in this case, it is called depletion, rather than depreciation). The pace of depletion may change if a company subsequently alters its estimate of reserves remaining.

(v) Inefficiency/obsolescence

Some equipment will be rendered obsolete by more efficient equipment, which reduces the usability of the original equipment.

A variation on the depreciation concept is the destruction of or damage to equipment. If this happens, the equipment must be written down or written off to reflect its reduced value and possibly shorter useful life. Another variation is asset impairment, where the carrying cost of an asset is higher than its market value. If impairment occurs, the difference is charged to expense, which reduces the carrying amount of the asset.

When there is damage to or impairment of an asset, it can be considered a cause of depreciation, since either event changes the amount of depreciation remaining to be recognized.

Inputs to Depreciation Accounting

There are three factors to consider when you calculate depreciation, which are:

  • Useful life. This is the time period over which the company expects that the asset will be productive. Past its useful life, it is no longer cost-effective to continue operating the asset, so it is expected that the company will dispose of it. Depreciation is recognized over the useful life of an asset.
  • Salvage value. When a company eventually disposes of an asset, it may be able to sell it for some reduced amount, which is the salvage value. Depreciation is calculated based on the asset cost, less any estimated salvage value. If salvage value is expected to be quite small, then it is generally ignored for the purpose of calculating depreciation.
  • Depreciation method. You can calculate depreciation expense using an accelerated depreciation method, or evenly over the useful life of the asset. The advantage of using an accelerated method is that you can recognize more depreciation early in the life of a fixed asset, which defers some income tax expense recognition into a later period. The advantage of using a steady depreciation rate is the ease of calculation. Examples of accelerated depreciation methods are the double declining balance and sum-of-the-years digits methods. The primary method for steady depreciation is the straight-line method. The units of production method is also available if you want to depreciate an asset based on its actual usage level, as is commonly done with airplane engines that have specific life spans tied to their usage levels.

If, midway through the useful life of an asset, you expect its useful life or the salvage value to change, you should incorporate the alteration into the calculation of depreciation over the remaining life of the asset; do not retrospectively change any depreciation that has already been recorded.

Depreciation Journal Entries

When you record depreciation, it is a debit to the Depreciation Expense account and a credit to the Accumulated Depreciation account. The Accumulated Depreciation account is a contra account, which means that it appears on the balance sheet as a deduction from the original purchase price of an asset.

Once you dispose of an asset, you credit the Fixed Asset account in which the asset was originally recorded, and debit the Accumulated Depreciation account, thereby flushing the asset out of the balance sheet. If an asset was not fully depreciated at the time of its disposal, it will also be necessary to record a loss on the undepreciated portion. This loss will be reduced by any proceeds from sale of the asset.

Other Depreciation Issues

Depreciation has nothing to do with the market value of a fixed asset, which may vary considerably from the net cost of the asset at any given time.

Depreciation is a major issue in the calculation of a company’s cash flows, because it is included in the calculation of net income, but does not involve any cash flow. Thus, a cash flow analysis calls for the inclusion of net income, with an add-back for any depreciation recognized as expense during the period.

Depreciation is not applied to intangible assets. Instead, amortization is used to reduce the carrying amount of these assets. Amortization is almost always calculated using the straight-line method.

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

Diminishing Balance Method

According to the Diminishing Balance Method, depreciation is charged at a fixed percentage on the book value of the asset. As the book value reduces every year, it is also known as the Reducing Balance Method or Written-down Value Method.

Since the book value reduces every year, hence the amount of depreciation also reduces every year. Under this method, the value of the asset never reduces to zero.

When the amount of depreciation charged under this method and the corresponding period are plotted on a graph it results in a line moving downwards.

This method is based on the assumption that in the earlier years the cost of repairs to the assets is low and hence more amount of depreciation should be charged. Also, in the later years, the cost of repairs will increase and therefore less amount of depreciation shall be provided. Hence, this method results in an equal burden on the profit every year during the life of the asset.

However, under this method, if the rate of depreciation applied is not appropriate it may happen that at the end of the useful life of the asset full depreciation is not provided.

Also, while applying this method, the period of use of the asset should be considered. If an asset is used only for 2 months in a year then depreciation will be charged only for 2 months.

Management Notes

Provision and Reserves

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Reserves

A reserve is an appropriation of profits for a specific purpose. The most common reserve is a capital reserve, where funds are set aside to purchase fixed assets. By setting aside a reserve, the board of directors is segregating funds from the general operating usage of a company.

There is no actual need for a reserve, since there are rarely any legal restrictions on the use of funds that have been “reserved.” Instead, management simply makes note of its future cash needs, and budgets for them appropriately. Thus, a reserve may be referred to in the financial statements, but not even be recorded within a separate account in the accounting system.

A provision is the amount of an expense or reduction in the value of an asset that an entity elects to recognize now in its accounting system, before it has precise information about the exact amount of the expense or asset reduction. For example, an entity routinely records provisions for bad debts, sales allowances, and inventory obsolescence. Less common provisions are for severance payments, asset impairments, and reorganization costs.

In short, a reserve is an appropriation of profit for a specific purpose, while a provision is a charge for an estimated expense.

Provision

The Provision means to keep aside a particular sum of money to cover up an anticipated liability which arises from the past events. It is a recognition of an expected obligation, which will result in the outflow of cash from the business. The amount of the liability should be easily estimated by the entity to provide for it.

The recognition is to be made to provide for a known liability or decrease in the value of assets over time or a disputed claim whose probability of occurrence is maximum.

If a provision is made in excess of the amount what is required, then after paying off the liability, it needs to be written back to the profit and loss account.

Examples:

  • Provision for Bad Debts
  • Provision for Depreciation
  • Provision for Tax

Reserves

The Reserve is a fraction of retained earnings, which is kept aside for any use in future. It is regarded as a part of shareholder’s fund. The sum appropriated in the name of reserves can be used for any of the given purposes:

  • For purchasing an asset in future.
  • To pay the dividends to shareholder consistently year by year.
  • For meeting out unexpected contingencies.

The reserves are mainly divided into following categories:

  1. Capital Reserve
  2. Revenue Reserve
    • General Reserve
    • Specific Reserve
Provision

Reserve
Meaning The Provision means to provide for a future expected liability. Reserves means to retain a part of profit for future use.
What is it? Charge against profit Appropriation of profit
Provides For Known liabilities and anticipated losses Increase in capital employed
Presence of profit Not necessary Profit must be present for the creation of reserves, except for some special reserves.
Appearance in Balance Sheet In case of assets it is shown as a deduction from the concerned asset while if it is a provision for liability, it is shown in the liabilities side. Shown on the liabilities side.
Compulsion Yes, as per GAAP Optional except for some reserves whose creation is obligatory.
Payment of Dividend Dividend can never be paid out of provisions. Dividend can be paid out of reserves.
Specific use Provisions can only be used, for which they are created. Reserves can be used otherwise.

Management Notes

Preparation of final Accounts with adjustments

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The reporting information will not be accurate unless we take into consideration the adjustment entries. The treatment of various common adjustments such as closing stock, outstanding expenses, accrued incomes, prepaid expenses, incomes received in advance, bad debts, reserve for bad and doubtful debts, reserve for discount on debtors, reserve for discount on creditors, interest on capital, interest on drawings, depreciation, etc., the knowledge of which should be made use of while preparing final accounts.

Special Items of Adjustments:

1. Goods Distributed as Free Samples

In order to promote a product, free samples are supplied to experts in the field. For example, free samples of books to professors, free samples of medicine to doctors.

Therefore the adjusting entry is as follows:

Particulars Dr Cr
Advertising A/c                Dr

To Purchasing A/c or

To Trading A/c

 ****  

****

****

The transfer entry is as follows:

Particulars Dr Cr
Profit and Loss A/c        Dr

To Advertisement A/c

 ****  

****

The net effect would be reduction in purchases and charge to profit and loss account as promotional expense.

2. Goods Sold on Sale or Approval Basis

In order to gain confidence of the customers on quality of the goods, sometimes goods are sold on approval basis. If the customer approves it, then it becomes a sale. If the customer does not approve it, then the sale is not complete and hence cannot be treated as sales. Suppose at the end of the financial year certain goods sent on approval basis are with the customers, then there is a need to pass necessary entries for adjustment.

The adjusting entries are as follows:

Particulars Dr Cr
Sales A/c                        Dr

To Debtors A/c (at sales price of the goods)

 ****  

****
Particulars Dr Cr
Stock A/c                        Dr

To Trading A/c (at cost price of the goods)

 ****  

****

The treatment is as follows:

(a) As a deduction from sales at sales price on credit side of trading account and as an addition to closing stock at cost price.

(h) As a deduction from sundry debtors on the assets side and the total stock to be shown at cost price (closing stock at cost + stock with the customers on approval) on the assets side of the balance sheet.

3. Goods Sent on Consignment

Since consignment transaction is not a sale transaction it does not affect the trading and profit and loss accounts directly. A separate consignment account is opened and the goods sent on consignment are debited to consignment account. When the account sale is received, it is treated as consignment sales and credited to consignment account and debited to consignees account.

Any consignment stock remaining with the consignee will be credited to consignment account and profit on consignment is ascertained after charging the expenses on consignment, consignee’s commission, etc. However, closing stock of consignment will be shown on the balance sheet’s assets side and the profit on consignment is credited to profit and loss account (the entry will be reversed if there is loss on consignment).

The transfer entry for profit or loss on consignment is as follows:

  • If it is a Profit
Particulars Dr Cr
Consignment A/c                Dr

To Profit and loss A/c

 ****  

****
  • If it is Loss
Particulars Dr Cr
To profit and loss A/c       Dr          

Consignment A/c

 ****  

****

Note: (i) The above transfer entry becomes necessary only where the consignor is also running a trading business

(ii) The working of consignment account is almost similar to trading account which is not shown here.

4. Loss of Stock by Fire

If the stock is destroyed by fire, then the loss incurred will be treated differently under the following three possible situations:

(a) If the stock is not insured: The entire value of the stock destroyed by fire will be treated as loss, with an entry:

Particulars Dr Cr
To profit and loss A/c       Dr          

To trading A/c

 ****  

****

Note: (i) The value of stock destroyed is credited to trading account as “stock destroyed” (had it not been destroyed, it would have appeared as closing stock).

(ii) Entire value of the stock destroyed is treated as loss and charged to profit and loss account.

(b) If stock is fully insured: When the stock which is fully insured is destroyed, the enterprise has a claim on the insurance company for the recovery of loss incurred due to goods being destroyed by fire. Therefore, the claim is preferred with an entry –

Particulars Dr Cr
Insurance Co. A/c             Dr          

To Trading A/c

 ****  

****

In effect, the claim on the insurance company is treated as ‘debtors’ and shown in the balance sheet assets side as due from the insurance company.

If the insurance company settles the dues, then the entry will be as follows:

Particulars Dr Cr
Cash/Bank A/c       Dr          

To insurance A/c

 ****  

****

In effect, the cash/bank balance in the balance sheet will increase to the extent of the claims settled and therefore, insurance company account will not appear in the balance sheet.

(c) If the stock is partly insured: In this case the total value of the stock destroyed is credited to trading account, and that part of the claim to be settled by the insurance company is debited to insurance company account and the difference between stock destroyed and insurance claim accepted is debited to profit and loss account as loss. The entry is as follows:

Particulars Dr Cr
Insurance Co. A/c             Dr          

(part of the claim accepted)

Profit and loss A/C             Dr

(loss which connot be recovered)

To trading A/c

 ****

 

****

  

 

 

 

****

5. Deferred Revenue Expenditure

Huge expenditure of revenue nature incurred at the initial stages of the business enterprise with the belief of deriving benefit from such expenditure during the subsequent years is regarded as deferred revenue expenditure provided the charging of such expenses is spread over the number of years during which the benefit is expected to be derived.

A part of such expenditure is charged as revenue in each year and the rest is capitalized based on matching concept. For example, huge expenditure on ‘advertisement’ is incurred in the initial years of business to derive the benefit over an estimated term of ten years. Then, each year one-tenth of that expenditure is charged to revenue over the term of ten years. The catch here is that the expenditure that is not charged to revenue is capitalized and shown as fictitious assets on the balance sheet.

Suppose, the advertisement expenditure incurred Rs.2,00,000 is able to yield benefit over five-year term. Then, one-fifth of 2,00,000, i.e., Rs.40,000 is charged to revenue in the first year and the rest Rs.1,60,000 is shown as fictitious assets. In the second year Rs.40,000 is charged to revenue and the balance 1,20,000 is shown as fictitious assets. This process goes on for five years till the complete expenditure is written off. The entries to be passed during the first year are as follows:

Particulars Dr Cr
Advertisement A/c       Dr           

To Bank A/c

(For Advertisement Expenditure)

 2,00,000  

2,00,000
Particulars Dr Cr
Profit and loss A/c                  Dr          

Deferred Revenue expenditure A/c  Dr

  To Advertisement A/c

(For charging 1/5th of advertising expense to revenue and treating the rest as deferred revenue expenditure.)

 40,000

1,60,000

  

 

2,00,000

6. Creation of a Reserve Fund

To strengthen the financial position of the enterprise, a part of the net profit may be transferred to reserve fund account by means of appropriation. The entry for creating a reserve fund is as follows:

Particulars Dr Cr
To profit and loss Appropriation A/c           Dr          

To Reserve fund A/c

 ****  

****

Note: (i) Reserve fund will appear on the liabilities side of the balance sheet.

(ii) In the case of sole trading and partnership organizations, it is customary to change this directly to profit and loss account instead of profit and loss appropriation account.

7. Manager’s Commission

Business enterprises sometimes offer profit incentive to managers in the form of commission to motivate the person to increase the profits of the business. This commission is given as a percentage on the net profits. There are two ways of offering this percentage on net profits.

(a) Percentage of commission on net profits before charging such commission.

(b) Percentage of commission on net profits after charging such commission.

Management Notes

Rectification of errors in trial balance

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Whenever an error occurs, it should be rectified through proper rectification. Otherwise the books of accounts cannot exhibit the true and correct view of the state of affairs of a business and its financial results.

So it is very important that we identify and rectify all material errors in the books of accounts.

POINTS OF TIME AT WHICH ERRORS CAN BE DETECTED

  1. Before preparation of the trial balance;
  2. After preparation of the trial balance but before preparation of final accounts; and
  3. After preparation of final accounts.

The rectification of the errors will be guided by

  • the nature and effect of the errors and
  • the point of time at which the errors have been detected.

TYPES OF ERRORS

A. ON THE BASIS OF NATURE

1. ERROR OF OMISSION:

It results from a complete or partial omission of recording a transaction.

For example, a transaction may be recorded in the subsidiary book but omitted to be posted to any of the ledger accounts.  This is a case of partial omission.

However, if a transaction is totally omitted to be entered in the books then it is a case of complete omission.

A complete omission will not affect the agreement of the trial balance but a partial omission will affect the agreement of a trial balance.

2. ERROR OF COMMISSION:

It results from an act of commission i.e. entries wrongly made in the journal or ledger.  It may be an

  • error of posting,
  • error of casting,
  • entering wrong amounts,
  • entering a transaction in a wrong subsidiary book etc.  

Unless the effects of errors of commission counterbalance each other, the agreement of the trial balance becomes affected.

3. ERROR OF PRINCIPLE:

It Is an error occurring due to wrong application of basic Accounting Principles.  The main reason behind such an error is incorrect classification of capital and revenue items.

For example, purchase of an Asset may be recorded through the Purchase day book instead of debiting the Asset account.  Or wages paid for the installation of an asset may be debited to the wages account instead of debiting the asset account with the amount of wages.

An error of principle will not affect the agreement of a trial balance. However, it will result in misrepresentation of the state of affairs and operational results of a business.

4. COMPENSATING ERRORS:

If the effect of an error is counterbalanced or cancelled out by the effect of another error or errors then such errors are known as compensating errors.  Since the compensating errors as a whole cancel out the effect of each other, the agreement of trial balance is not affected. Thus, it becomes difficult to detect such errors.

B. ON THE BASIS OF EFFECTS:

1. ONE SIDED ERRORS:

One sided error is an error whose effect falls on only one account.  It may arise due to

  • Wrong casting of any day book;
  • Posting made to the Wrong side of the relevant account;
  • Duplicate posting of the same amount in an account.

One Sided errors cause a disagreement of the trial balance and hence are easy to detect.

2. TWO SIDED ERRORS:

A Two-sided error maybe

  • Affecting two accounts at the same direction and not affecting the agreement of the trial balance.  For example Mr A’s account credited instead of Mr B account for an amount received from Mr B.
  • Affecting two accounts at opposite direction and affecting the agreement of the trial balance.  For example, Mr A’s account debited instead of Mr B account being credited for an amount received from Mr B.

3. MORE THAN TWO SIDED ERRORS:

An error which affects more than two accounts simultaneously falls in this category.  This may or may not affect the agreement of a trial balance depending on the situation in each case.

EFFECTS OF ERRORS ON TRIAL BALANCE

Depending on its effect on the trial balance, the errors may be divided into two categories-

  1. Errors affecting the agreement of trial balance; and
  2. Errors not affecting the agreement of trial balance.
Errors affecting the agreement of Trial Balance (TB will not agree) Errors not affecting the agreement of Trial Balance (TB will agree)
1. An error of Partial Omission 1. An error of complete omission
2. An error of commission whose effect is not cancelled out by a compensating error 2. Compensating Errors
3. Error in balancing an account or casting a subsidiary book 3. Error of Principles
4. An error of wrong posting unless the correct amount is posted to the right side of a wrong account. 4. An error of wrong posting of the correct amount to the right side of a wrong account.

Management Notes

Accounting of non-Profit Organization and Professional people

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Non-profit accounting refers to the unique system of recordation and reporting that is applied to the business transactions engaged in by a nonprofit organization. A nonprofit entity is one that has no ownership interests, has an operating purpose other than to earn a profit, and which receives significant contributions from third parties that do not expect to receive a return. Nonprofit accounting employs the following concepts that differ from the accounting by a for-profit entity:

  • Net assets. Net assets take the place of equity in the balance sheet, since there are no investors to take an equity position in a nonprofit.
  • Donor restrictions. Net assets are classified as being either with donor restrictions or without donor restrictions. Assets with donor restrictions can only be used in certain ways, frequently being assigned only to specific programs. Assets without donor restrictions can be used for any purpose.
  • A nonprofit exists in order to provide some kind of service, which is called a program. A nonprofit may operate a number of different programs, each of which is accounted for separately. By doing so, one can view the revenues and expenses associated with each program.
  • Management and administration. Costs may be assigned to the management and administration classification, which refers to the general overhead structure of a nonprofit. Donors want this figure to be as low as possible, which implies that the bulk of their contributions are going straight to programs.
  • Fund raising. Costs may be assigned to the fund raising classification, which refers to the sales and marketing activities of a nonprofit, such as solicitations, fund raising events, and writing grant proposals.
  • Financial statements. The financial statements produced by a nonprofit entity differ in several respects from those issued by a for-profit entity. For example, the statement of activities replaces the income statement, while the statement of financial position replaces the balance sheet. Both for-profit and nonprofit entities issue a statement of cash flows. Finally, there is no nonprofit equivalent for the statement of stockholders’ equity, since a nonprofit has no equity.

Characteristics of Not-for-Profit Organizations

  • Service Motive: These organisations have a motive to provide service to its members or a specific group or to the general public. They provide services free of cost or at a bare minimum price as their aim is not to earn the profit. They do not discriminate among people on the basis of their caste, creed or colour. Examples of services provided by them are education, food, health care, recreation, sports facility, clothing, shelter, etc.
  • Members: These organisations are formed as charitable trusts or societies. The subscribers to these organisations are their members.
  • Management: The managing committee or the executive committee manages these organisations. The members elect the committee.
  • Source of Income: The major sources of income of not-for-profit organisations are subscriptions, donations, government grants, legacies, income from investments, etc.
  • Surplus: The surplus generated in the due course is distributed among its members.
  • Reputation: These organisations earn their reputation or goodwill on the basis of the good work done for the welfare of the public.
  • Users of accounting information: The users of the accounting information of these organisations are present and potential contributors as well as the statutory bodies.

The not-for-profit organisations also require to prepare the final accounts or the financial statements at the end of the accounting year as per the accounting principles. The final accounts of these organisations consist of:

  1. Receipts and Payments A/c: It is the summary of the cash and bank It helps in the preparation of Income and Expenditure A/c and Balance Sheet. We also need to submit it to the Registrar of Societies along with Income and Expenditure A/c and Balance Sheet.
  2. Income and Expenditure A/c: It is similar to the Profit and Loss A/c and ascertains the surplus or deficit if any.
  3. Balance Sheet: We prepare it in the same manner as the Balance Sheet of concerns with a profit motive.
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