ACCOUNTING

financial
accounting

1.
Theoretical Framework in
Accounting

(a) Accounting as an Information System

Accounting is considered an information system because it collects, processes, and communicates
financial information about an entity to various stakeholders. It helps businesses make informed
decisions, manage resources, and track their financial performance.

Users of Financial Accounting Information and Their Needs:

1. Internal Users:
• Management: Uses accounting information for planning, controlling, and decision-
making.
• Employees: Need information about the company's profitability and stability for job
security.
2. External Users:
• Investors and Shareholders: Require financial information to evaluate the return on
their investments.
• Creditors and Lenders: Need to assess the company's ability to repay loans.
 • Government and Regulatory Authorities: Use accounting data to determine taxes and
ensure compliance with regulations.
• Customers and Suppliers: Interested in the company’s long-term stability to maintain
relationships.

Qualitative Characteristics of Accounting Information:

1. Relevance: Information should be useful for decision-making.
2. Reliability: Information must be accurate and free from errors.
3. Comparability: Users should be able to compare the financial statements of different
companies.
4. Understandability: Information should be presented clearly and understandably.

Functions of Accounting:
1. Recording Transactions: Documenting all financial transactions systematically.
2. Classifying and Summarizing: Organizing transactions into categories and summarizing
them in financial statements.
3. Communicating Financial Information: Providing stakeholders with financial reports
like balance sheets and income statements.
4. Ensuring Compliance: Helping companies adhere to legal requirements and accounting
standards.

Advantages of Accounting:
1. Provides detailed financial information for decision-making.
2. Facilitates resource management.
3. Helps in compliance with laws and regulations.
4. Aids in financial planning and performance evaluation.

Limitations of Accounting:
1. Relies heavily on estimates and judgments.
2. Does not account for qualitative factors like employee morale.
3. Historical in nature, as it reflects past transactions.
4. May not always reflect current market conditions or fair values.
Branches of Accounting:
1. Financial Accounting: Prepares financial statements for external users.
2. Management Accounting: Provides information for internal decision-making.
3. Cost Accounting: Focuses on determining the cost of production.
4. Tax Accounting: Involves tax planning, compliance, and preparation of tax returns.
5. Auditing: Involves the independent examination of financial statements.

Bases of Accounting:
1. Cash Basis Accounting: Records revenues and expenses when cash is received or paid. It
is simple but may not reflect the actual financial performance of a business.
2. Accrual Basis Accounting: Recognizes revenues when they are earned and expenses when
they are incurred, regardless of cash flow. It provides a more accurate picture of financial
health.

Meaning, Characteristics, and Scope of Accounting:

• Meaning: Accounting is the systematic process of recording, classifying, and summarizing
financial transactions.
• Characteristics: It is reliable, consistent, and governed by accounting principles.
• Scope: Includes financial, cost, management, and tax accounting and extends to reporting,
auditing, and budgeting.

(b) Basic Concepts and Conventions of

Accounting
1. Entity Concept: Business is separate from its owners.
2. Going Concern Concept: Business will continue to operate in the foreseeable future.
3. Monetary Unit Concept: Transactions are recorded in a stable currency.
4. Cost Concept: Assets are recorded at their original purchase price.
5. Dual Aspect Concept: Every transaction has two effects—debit and credit.
6. Revenue Recognition Concept: Revenue is recognized when it is earned.
7. Matching Concept: Expenses are matched with revenues.
 8. Conventions: Include conservatism, consistency, materiality, and full disclosure.

(c) Accounting Standards

Concept: Accounting standards are guidelines that govern how financial statements are prepared
and presented. They ensure consistency, reliability, and comparability across businesses.

Benefits:
1. Uniformity in Reporting: Ensures that financial statements are prepared consistently
across companies.
2. Comparability: Investors can compare the financial performance of different companies.
3. Transparency: Enhances the clarity and reliability of financial reports.
4. Compliance: Helps companies meet regulatory requirements.

Process of Formulation of Accounting Standards:

1. Research: Studying existing practices and identifying areas for improvement.
2. Drafting: Developing an initial draft of the standard.
3. Exposure Draft: Publishing the draft for public and professional feedback.
4. Finalization: Incorporating feedback and issuing the final standard.

Indian Accounting Standards (Ind AS) and IFRSs:

• Indian AS: These are accounting standards issued by the Institute of Chartered Accountants
of India (ICAI) and are aligned with the International Financial Reporting Standards (IFRS) to
bring global uniformity.
• IFRSs: International standards developed by the International Accounting Standards Board
(IASB).

Convergence vs. Adoption:

• Convergence: Modifying local accounting standards to bring them closer to IFRS.
• Adoption: Fully implementing IFRS without modifications.
Application of Accounting Standards in India:
• AS: Traditional Indian Accounting Standards for smaller entities.
• Ind AS: Converged standards, mandatory for listed and large companies.

International Financial Reporting Standards (IFRS):

• Meaning: Globally accepted accounting standards issued by the IASB.
• Need: To bring uniformity in global financial reporting.
• Scope: Applies to financial statements across borders.
• Process of Issuing IFRS: The IASB follows a due process involving research, exposure
drafts, public consultation, and the finalization of standards.
2.
Accounting For Depreciation,
Inventory Valuation & Business
Entities

(a) Depreciation
Definition and Nature of Depreciation: Depreciation is the gradual reduction in
the value of a tangible fixed asset over its useful life due to wear and tear, obsolescence, or usage. For
example, machinery, vehicles, and buildings lose their value over time. Depreciation ensures that the
cost of these assets is spread out over the years they are used to generate revenue for the business.

Factors in the Measurement of Depreciation:

1. Cost of the Asset: This includes the purchase price, installation, and any additional costs
required to make the asset operational.
2. Residual Value (Scrap Value): The estimated amount the asset will be worth at the end of
its useful life. It’s the value expected after the asset is no longer useful for business purposes.
3. Useful Life: The period during which the asset is expected to be used effectively. For
example, a machine might have a useful life of 10 years.
4. Depreciation Method: How the asset’s cost will be allocated over its useful life. This can
vary by asset and company policy.
5. Obsolescence: Technological changes or shifts in industry trends may reduce the asset’s
usefulness even before its physical wear and tear.

Methods of Charging Depreciation:

1. Straight-Line Method (SLM):
• This method assumes the asset’s value decreases uniformly over time. Depreciation is
calculated by dividing the difference between the asset's cost and its residual value by its
useful life.
 • Depreciation = cost of assets-residual value
• useful life
2. Diminishing (Reducing) Balance Method (DRM):
• In this method, depreciation is charged on the asset’s reducing balance (its book value
after subtracting accumulated depreciation). This results in higher depreciation expenses
in the early years and lower expenses in the later years.

(b) Inventory Valuation

Meaning of Inventory Valuation: Inventory valuation is the process of assigning a
monetary value to a company's unsold stock at the end of an accounting period. This is important
because the value of inventory affects both the cost of goods sold (COGS) and the profit reported on
financial statements. If inventory is undervalued or overvalued, it can distort financial reports, affecting
decision-making and tax liability.

Significance of Inventory Valuation:

1. Accurate Profit Measurement: The value of inventory impacts the COGS. Higher
closing inventory reduces COGS and increases profit, while lower inventory increases COGS
and reduces profit.
2. Financial Reporting: Proper inventory valuation ensures the balance sheet reflects the
company’s true financial position.
3. Taxation: Valuation impacts taxable income. For example, under higher inventory valuations,
a company’s taxable profit might increase.
4. Business Decision-Making: Knowing the value of inventory helps management in making
purchasing, production, and pricing decisions.

Methods of Computing Inventory Valuation:

1. FIFO (First In, First Out):
• Under FIFO, it is assumed that the oldest inventory is sold first, meaning the costs of the
earliest goods purchased are used to calculate COGS.
• In periods of rising prices, FIFO results in lower COGS and higher profits because older,
cheaper inventory is matched with revenues.
• Example: If a business purchased goods at $10, $12, and $14, and sells the first batch,
the cost of goods sold would be $10.
2. LIFO (Last In, First Out):
• LIFO assumes the most recent inventory is sold first, meaning the cost of the newest
purchases is used to calculate COGS.
• In times of rising prices, LIFO results in higher COGS and lower profits because the
cost of recent, more expensive inventory is matched with revenue.
 • Example: Using the same prices as FIFO, under LIFO, the cost of goods sold would be
$14 for the first batch sold.

(c) Accounting for Non-Corporate Business

Entities
Preparation of Final Accounts with Adjustments: Non-corporate business
entities such as sole proprietorships and partnerships prepare financial statements to determine their
financial performance (profit or loss) and position at year-end. These include:

1. Trading Account: Shows the gross profit or loss from core trading activities.
2. Profit and Loss Account: Summarizes the net profit or loss by including other income and
expenses.
3. Balance Sheet: A snapshot of the company’s financial position, including assets, liabilities,
and capital, at a specific date.

Accounting for Non-Profit Organizations: Non-profit organizations aim to

serve the public good rather than generate profits. Their accounting follows slightly different
principles:

1. Receipts and Payments Account: A summary of all cash receipts and payments made
during the year. It doesn’t distinguish between capital and revenue items.
2. Income and Expenditure Account: Similar to a profit and loss account, this account
shows the surplus or deficit for the period, including both revenue and capital items.
3. Balance Sheet: Lists assets, liabilities, and capital funds. It shows the financial position of
the organization at the end of the accounting period.

Accounting Under the Single Entry System: The single-entry system records
only one side of transactions, either debit or credit. Unlike double-entry, it lacks a complete record of
all aspects of transactions.

Computation of Profit & Loss: Profit is calculated by comparing the closing capital
with the opening capital, adjusting for any withdrawals and additional capital introduced during the
year:
Profit=Closing Capital−Opening Capital+Drawings−Additional Capital Introduced
3.
Accounting for Hire purchase,
Installment and Royalty

(a) Hire Purchase System

Concept: The hire purchase system allows a buyer to acquire an asset by paying an initial deposit
followed by regular installments. Ownership of the asset transfers to the buyer only after the final
installment is paid. If the buyer defaults on payments, the seller has the right to repossess the asset.

Transactions:
1. Initial Deposit: The buyer pays a percentage of the total asset cost.
2. Installment Payments: Regular payments are made over an agreed period.
3. Interest: The total cost includes interest on the outstanding balance.

Journal Entries in the Books of Hire Vendor:

1. At the time of sale:
• Debit: Hire Purchase Debtors Account (Asset)
• Credit: Sales Account (Revenue)

Entry:
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Hire Purchase Debtors A/c Dr. xxx
To Sales A/c xxx

2. Receiving initial deposit:

• Debit: Bank Account
• Credit: Hire Purchase Debtors Account

Entry:
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Bank A/c Dr. xxx
To Hire Purchase Debtors A/c xxx

3. Receiving installments:
• Debit: Bank Account
• Credit: Hire Purchase Debtors Account
• Credit: Interest Account (if applicable)

Entry:
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Bank A/c Dr. xxx
To Hire Purchase Debtors A/c xxx
To Interest A/c xxx

Journal Entries in the Books of Hire Purchaser:

1. At the time of purchase:
• Debit: Asset Account
• Credit: Hire Purchase Creditors Account

Entry:
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Asset A/c Dr. xxx
To Hire Purchase Creditors A/c xxx

2. Paying deposit:
• Debit: Hire Purchase Creditors Account
• Credit: Bank Account

Entry:
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Hire Purchase Creditors A/c Dr. xxx
To Bank A/c xxx

3. Paying installments:
• Debit: Hire Purchase Creditors Account
• Debit: Interest Account (if applicable)
• Credit: Bank Account
 Entry:
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Hire Purchase Creditors A/c Dr. xxx
Interest A/c Dr. xxx
To Bank A/c xxx

Default and Repossession:

• If the purchaser defaults on payments, the vendor can repossess the asset.

• Journal Entry for Repossession in Vendor’s Books:

• Debit: Asset Account
• Credit: Hire Purchase Debtors Account

Entry:
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Asset A/c Dr. xxx
To Hire Purchase Debtors A/c xxx

(b) Installment Payment System

Concept: In an installment payment system, the buyer agrees to pay the seller the price of an asset
in installments over a period. Unlike hire purchase, ownership of the asset is transferred immediately,
but payment obligations remain.

Transactions:
1. Initial Payment: The buyer may pay a portion upfront.
2. Regular Installments: The buyer pays the balance over time.

Journal Entries in the Books of Seller:

1. At the time of sale:
• Debit: Installment Debtors Account
• Credit: Sales Account

Entry:
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Installment Debtors A/c Dr. xxx
To Sales A/c xxx

2. Receiving initial payment:

• Debit: Bank Account
• Credit: Installment Debtors Account

Entry:
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Bank A/c Dr. xxx
To Installment Debtors A/c xxx

3. Receiving installment payments:

• Debit: Bank Account
• Credit: Installment Debtors Account

Entry:
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Bank A/c Dr. xxx
To Installment Debtors A/c xxx

Journal Entries in the Books of Buyer:

1. At the time of purchase:
• Debit: Asset Account
• Credit: Installment Creditors Account

Entry:
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Asset A/c Dr. xxx
To Installment Creditors A/c xxx

2. Paying initial payment:

• Debit: Installment Creditors Account
• Credit: Bank Account

Entry:
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Installment Creditors A/c Dr. xxx
 To Bank A/c xxx

3. Paying installment:
• Debit: Installment Creditors Account
• Credit: Bank Account

Entry:
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Installment Creditors A/c Dr. xxx
To Bank A/c xxx

(c) Royalty
Concept: Royalty refers to the payment made by one party (the lessee) to another party (the
lessor) for the right to use an asset, such as land, patents, or trademarks. Royalties are typically
calculated based on a percentage of revenue or production.

Journal Entries in the Books of Lessor:

1. Recording royalty income:
• Debit: Royalty Receivable Account
• Credit: Royalty Income Account

Entry:
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Royalty Receivable A/c Dr. xxx
To Royalty Income A/c xxx

2. Receiving royalty payment:

• Debit: Bank Account
• Credit: Royalty Receivable Account

Entry:
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Bank A/c Dr. xxx
To Royalty Receivable A/c xxx
Journal Entries in the Books of Lessee:
1. Recording royalty expense:
• Debit: Royalty Expense Account
• Credit: Royalty Payable Account

Entry:
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Royalty Expense A/c Dr. xxx
To Royalty Payable A/c xxx

2. Paying royalty:
• Debit: Royalty Payable Account
• Credit: Bank Account

Entry:
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Royalty Payable A/c Dr. xxx
To Bank A/c xxx
4.
Accounting for Inland Branches /
Departments

(a) Accounting for Inland Branches

Concepts of Branch System: A branch system is an arrangement in which a business
operates multiple locations (branches) in different areas but is managed under a single legal entity.
Each branch may perform the same functions as the main office or serve a distinct purpose, depending
on the company’s operations.

Different Types of Branches:

1. Dependent Branches:
• These branches do not maintain a separate set of books. All transactions are recorded in
the head office's books, and the branch merely acts as an extension of the main office.
• Example: A retail store where inventory and sales records are maintained at the head
office.
2. Independent Branches:
• These branches maintain their own set of books and records. They operate semi-
autonomously, with some degree of independence in financial reporting.
• Example: A regional office that handles its own purchases, sales, and cash transactions.

Accounting Aspects:
1. Stock and Debtor System:
• Stock System: In dependent branches, stock is often valued and recorded at the head
office. In independent branches, stock records are maintained separately.
 • Debtor System: For dependent branches, debtors are accounted for at the head office.
Independent branches maintain their debtor accounts and are responsible for collections.
2. Final Accounts System:
• Dependent Branches: Final accounts are prepared only for the head office,
incorporating branch data as necessary.
• Independent Branches: Each branch prepares its own final accounts, which include
profit and loss statements and balance sheets. These accounts are then consolidated into
the head office’s accounts.
3. Wholesale Basis System:
• In this system, branches operate like wholesalers. They purchase goods from the head
office at a wholesale price and sell them at retail prices. The profit from these sales
contributes to the overall profit of the business.

(b) Departmental Accounts

Concept of Departmental System: Departmental accounts are used to assess the
financial performance of different departments within a single entity. This system allows for better
performance evaluation, as it segregates revenues and expenses associated with each department.

Preparation of Final Accounts of Departmental Accounts:

1. Final Accounts: Each department's financial results are recorded separately, leading to
individual profit and loss statements for each department. These statements are then
consolidated into a single profit and loss account for the entire entity.

2. Adjustments:
• Inter-departmental Transfers: When goods are transferred from one department to
another, proper records must be maintained. The transfer price may be at cost or at a
profit margin.
• Common Expenses: Expenses incurred for the entire business must be allocated among
departments based on an appropriate basis (e.g., square footage, sales volume).
3. Various Methods:
• Direct Allocation Method: Each expense is directly charged to the department that
incurred it.
 • Step-down Method: Common costs are allocated to departments in a sequential manner,
recognizing the interdependencies among departments.
• Reciprocal Method: This more complex method considers the mutual services provided
between departments, ensuring that all costs are accurately allocated.

Example of Final Accounts Preparation for a Departmental

Store:
1. Prepare Individual Profit and Loss Statements:
• Revenue from sales for each department
• Direct costs associated with sales (cost of goods sold)
• Allocation of common expenses
• Calculation of departmental profit or loss
2. Consolidate Final Accounts:
• Combine departmental profits to form an overall profit figure for the business.
• Prepare a consolidated balance sheet reflecting the financial position of the entire entity.
5.
Accounting for Dissolution of
Partnership Firm and Insolvency:

(a) Concept of Dissolution of Firm

Dissolution of Partnership vs. Dissolution of Firm:
• Dissolution of Partnership: This refers to the end of a partnership agreement between
partners while allowing for the continuation of the business by remaining partners or new
partners. The partnership can dissolve due to various reasons, such as retirement, death, or
mutual agreement of the partners, but the business may still continue.

• Dissolution of Firm: This signifies the complete cessation of all business operations and
the legal entity of the firm. This occurs when all partners agree to wind up the business, or when
a legal requirement mandates it (such as insolvency). At this stage, all assets are sold off,
liabilities are settled, and the business entity itself ceases to exist.

Accounting for Dissolution of Partnership Firm:

1. Settlement of Accounts:
• Upon dissolution, the firm must realize its assets (sell or collect debts) and pay off its
liabilities. This includes paying off creditors and other debts. Any remaining assets after
settling liabilities are then distributed among the partners. The distribution of assets
should follow the profit-sharing ratio established in the partnership agreement or, if no
ratio is specified, according to their capital contributions.

2. Insolvency of Partners:
• If a partner is found to be insolvent during the dissolution process, this can complicate
matters. The losses that result from the insolvent partner's inability to contribute to
settling debts will need to be covered by the solvent partners. For example, if one partner
cannot pay their share of the losses, the other partners must absorb those losses based on
 their respective profit-sharing ratios. This ensures that the remaining partners are treated
fairly while protecting the interests of creditors.
3. Accounting Entries:
• The accounting for the dissolution of a firm involves several key entries:
• Realization of Assets: When assets are sold or collected, the following entries
are made:
• Debit: Bank Account (or other assets realized)
• Credit: Asset Accounts (e.g., Debtors, Stock) to remove the assets from
the books.
• Settlement of Liabilities: When liabilities are paid, the entries would be:
• Debit: Liabilities Accounts (e.g., Creditors)
• Credit: Bank Account (or other assets used for payment) to record the
outflow of cash or other assets.
• Distribution of Remaining Assets: Once all liabilities are settled, the remaining
assets are distributed to the partners:
• Debit: Partners' Capital Accounts for each partner’s share
• Credit: Bank Account (or other assets distributed) to reflect the reduction
in assets.
• Losses due to Insolvency: If a partner is unable to meet their obligations, the
amount of loss attributable to that partner will be charged to the solvent partners.
This may involve the following entry:
• Debit: Remaining Partners' Capital Accounts based on their profit-sharing
ratio
• Credit: Insolvent Partner's Capital Account to reflect the loss allocation.

(b) Concept of Insolvency of an Individual

Definition of Insolvency: Insolvency is a financial state where an individual or entity is
unable to meet their debts as they come due. The insolvency process allows individuals to resolve their
debts legally.

Process of Declaration of Insolvency:

1. Filing for Insolvency: An individual or their creditors can initiate insolvency proceedings
through a legal declaration.
2. Appointment of Insolvency Practitioner: A professional is appointed to oversee the
insolvency process, including the sale of assets and distribution of funds to creditors.
3. Creditors' Meeting: A meeting is convened where creditors discuss the insolvency case and
agree on the course of action.
 4. Court Proceedings: The insolvency case may require court intervention for resolution.

Preparation of Statement of Affairs:

• This is a financial statement prepared at the time of declaring insolvency. It lists all assets,
liabilities, and the net worth of the individual.
Format:

• Assets:
• Cash in hand
• Bank balance
• Debtors
• Inventory
• Fixed assets
• Liabilities:
• Current liabilities (e.g., creditors)
• Long-term debts (e.g., loans)
• Net Worth:
• Total assets - Total liabilities

Preparation of Deficiency Account:

• This account is prepared to show the shortfall of assets against liabilities, detailing how much
creditors will lose.
Format:

• Deficiency Account:
• Debits: Total liabilities
• Credits: Total assets
• Balance: Deficiency amount (if liabilities exceed assets)

Revised Statement of Affairs:

• This is an updated statement prepared if there are significant changes in the asset and liability
values during the insolvency process. It reflects the current financial position and assists in
determining the accurate amount available for distribution to creditors.