BAB 33201: AGRICULTURAL RECORDS, ACCOUNTING AND

ANALYSIS
Instructor: Mr. Ddungu Stanley Peter
+256786070300/0700953961, ddungustanley@gmail.com

COUR SE DESCRIPTION
This course introduces the student to basic principles of accounting theory and practice, Primary areas of
study include, branches of accounting the theory of debit and credit, accounts, and special journals and
books of accounts, the accounting cycle, and the preparation of financial statements. The main aim of this
course is to enable students to apply accounting principles in the preparation of the books of accounts and
financial statements and interpret the results.
OBJECTIVES
Upon completion of this course the student will be able:
a. To describe various accounting principles and concepts
b. To prepare the basic accounts, complete the double entry and balance the accounts
c. To present the financial statements of an agricultural or agribusiness firm as per IAS 1 and interpret
the results.
d. To assess the performance and financial position of an agribusiness enterprise

REFERENCES RECOMMENDED FOR READING

• Wheeling Barbara M. (2007): Introduction to Agricultural Accounting. 1 edition. Delmar Cengage
st

Learning
• Frank Wood and Allan Sangster (2011): Business Accounting1 Volume 1. 12 Edition. Pearson
th

Education Ltd
•
Omonuk Joseph Ben (1999): Fundamentals of Accounting for Business Uganda. Printing and
publishing Corporation. Entebbe Uganda.
OTHER REFERENCES:
• Weygandt Jerry J., Kieso Donald E. and Kimmel Paul D. (2008) Financial Accounting. Eighth
edition, Wiley publishers
• N.A. Saleemi (1998) Advanced Financial Accounting Simplified. Publisher: Pitman
(London,U.K.)

OUTLINE TOPICS
1. Introduction to accounting concepts and Principles
• The Nature of Accounting, Qualitative characteristics of accounting information
• Users of accounts, branches of accounting
• Comparison of financial and management accounting
• Underlying assumptions and Constraints
• Accounting Principles and concepts
2. Accounting equation and double entry
• What is bookkeeping? , The Development of Bookkeeping
• Significance of keeping records, Bookkeeping Conventions
• Meaning of the accounting equation
• History of Double Entry, Meaning of Double entry
• An explanation of debits and credits
• Classification of Accounts

3. Books of prime entry (Journal)

• Journal , Characteristics of Journal
• Advantages of Journal
 • Types of journals. Rules of Journalising(Journal proper)
4. Ledger accounts preparation
• Meaning, Features of Ledger
• Form of Ledger
• Method of Posting, Folioing
• Difference between Ledger and Journal
• Advantages of Ledger
• Balancing up the Ledger

5. Trial balance
• Nature of Trial Balance
• Objectives and Advantages of Preparing a Trial Balance
• Preparing the Trial Balance, Steps to Prepare the Trial Balance
• Unbalanced Trial Balance, Balanced Trial Balance
• Trial balance limitations
6. Cash book
• Introduction to Cash Book, Types of Cash Book
• Balancing the Cash Book, Contra Entries
• Petty Cash Book, Imprest System of Petty Cash Book.
• Advantages of Petty Cash Book
7. Errors & Omissions in Accounting

8. Banking transactions
• Bank Statement, Bank Reconciliation Statement
• Causes for Differences
• Need and Importance of Bank Reconciliation Statement
9. Presentation of Financial statements
• Components of Financial Statements
• The Elements of Financial Statements
• Measurement of the elements of financial statements
10. Analysis and Interpretation of Financial Statements
• Financial Statement Analysis
• Methods of Financial Statement Analysis
• Classification of ratios
• Limitations of Financial statement analysis

OVERALL COURSE ASSESSMENT

The student will be assessed based on
Continuous Assessment tests 30%
Final examination 70%
 ACCOUNTING

Introduction

Whenever your mother asks you to go to the nearby grocery store to buy from it items of daily
use like match box, candle stick, soap cake, coffee, spices etc. you need not pay for these items
immediately. When you buy these items, the store owner immediately opens the page of a note
book on which your father’s name is written. He records the value of items purchased. At the end
of the month, your father goes to him. He again opens the same page tells the total amount to be
paid and record when your father makes the payment. In a similar manner, he keeps the record of
other customers also. Whenever he gets commodities from supplier, he records it and also records
the payment he makes to them. Similarly, every business small or big, sole proprietor or a firm
keeps the record of the business transactions. Have you ever thought why do they keep record of
business transactions? If they do not keep the record, how will they know how much, when and
to whom they are to make payments or from whom how much and when they are to receive
payments or what they have earned after a particular period and so on. Recording of transactions
by a businessman in proper books and in a systematic manner is known as accounting. In this
lesson you will learn about it in detail.

OBJECTIVES
After studying this lesson, you will be able to:
Explain the meaning of Book-Keeping; - state the meaning, nature and significance of accounting;
- distinguish between book keeping and accounting; - explain the limitations of accounting; l-
explain the branches of accounting; -state the functions and objectives of financial accounting; -
explain accounting as an information system for decision making by the interested users; - explain
various accounting terms to used.
1.1 BOOK KEEPING AND ACCOUNTING
A business undertakes number of transactions. Can you estimate the number of transactions a
business undertakes? It depends upon the size of a business entity. Every day business transactions
may be around hundreds/thousands. Can a businessman remember all these transactions in every
respect? Not at all. So, it becomes necessary to record these business transactions in details and in
a systematic manner. Recording of business transactions in a systematic manner in the books of
account is called book-keeping. BookKeeping is concerned with recording of financial data. This
may be defined as.

“The art of keeping a permanent record of business transactions is book keeping”.

From book keeping important details such as total sales, total purchases, total cash receipts, total
payments, etc. may be ascertained. As you know the main objective of business is to earn profits.
In order to achieve this objective, mere recording of business transactions is not enough.
Accounting involves not only book keeping but also many other activities. In 1941, the American
Institute of Certified Public Accountants (AICPA) defined as
 “The art of recording, classifying, summarising, analysing and interpreting the business
transactions systematically and communicating business results to interested users is
accounting”
Accounting is identified with a system of recording of business transactions that creates economic
information about business enterprises to facilitate decision making. The function of accounting is
to provide quantitative information, primarily financial in nature, about economic entities, that is
intended to be useful in making economic decisions.
The American Accounting Association defined accounting as:
“It is the process of identifying, measuring, recording and communicating the required
information relating to the economic events of an organization to the interested users of such
information.
In order to appreciate the nature of accounting it is necessary to understand the following relevant
aspects of the definition of accounting:
Economic events: It is the occurring of the consequence to a business organization which consists
of transactions that are measurable in monetary terms. Purchase of a Machinery, installing and
keeping it ready for manufacturing is an economic event which consists of a number of financial
transactions. These transactions are (a) buying the machine, (b) transporting the same, (c)
preparing the site for its installation and (d) incurring expenditure on installing the same.
Identification, Measurement, Recording and Communication:
Identification implies determining what transactions are to be recorded i.e., items of financial
character are to be recorded. For example, goods purchased for cash or on credit will be recorded.
Items of non-financial character such as changes in managerial policies, etc. are not recorded in
the books of accounts.
Measurement means quantification of business transactions into financial terms by using
monetary unit. If an event cannot be quantified in monetary terms, it is not considered fit for
recording in the books of the firm. That is why important items like appointment, signing of
contracts, etc. are not shown in the books of accounts.
Recording: Having identified and measured the economic events in financial terms, these are
recorded in the books of accounts in monetary terms and date wise. The recording of the business
transactions is done in such a manner that the necessary financial information is summarized as
per well-established accounting practice.
Communication: The economic events are identified, measured and recorded in such a manner
that the necessary relevant information is generated and communicated in a certain form to the
management and other internal and external users of information. The financial information is
regularly communicated through accounting reports.
Organization: refers to a business enterprise whether for profit or not for profit motive.
Interested users of information. Many users need financial information to make important
decisions. These users can be investors, creditors, labour unions, Trade Associations, etc.
 Evolution of Accounting
Evolution of Accounting as per Indian mythology Chitra Gupta is responsible for maintaining
accounts in God’s court.
A book on Arthashasthra written by Kautilya who was a minister in Chandra Gupta’s kingdom
twenty-three centuries ago mentions about the accounting practices in India. It describes how
accounting records have to be maintained. In China and in Egypt accounting was used for
maintaining revenue records of the government treasury.
A book on Arithmetica Geometrica, Proportion at Proportionality (Review of Arithmetic and
Geometric proportion) by an Italian Luca Pacioli is considered as the first authentic book on
double entry book keeping. In his book he used the present-day popular terms of accounting
Debit (Dr.) and Credit (Cr). He also discussed the details of memorandum, journal, ledger and
specialised accounting procedures. He also stated that, “all entries have to be double entries, i.e.
if you make one creditor you must make some debtor.
Accounting process can be summarized as

Difference between book keeping and accounting: Book keeping and accounting can be
differentiated on the basis of nature, objective, function, basis, level of knowledge, etc.
Basis of Book-keeping Accounting
Difference

Nature It is concerned with identifying financial

transactions; measuring them in monetary
terms; recording and classifying them.
It is concerned with summarizing the recorded
It is to maintain systematic records of financial transactions, interpreting them and communicating
Objective transactions. the results.

It aims at ascertaining business income and financial

It is to record business transactions. So, its position by maintaining records of business
Function scope is limited. transactions.
It is the recoding, classifying, summarizing,
interpreting business transactions and
Vouchers and other supporting documents are communicating the results. Thus, its scope is quite
necessary as evidence to record the business wide.
Basis
transactions.
Book-keeping works as the basis for accounting
It is enough to have elementary knowledge of information.
accounting to do bookkeeping.
Level of
Knowledge Book-keeping is the first step to accounting. For accounting, advanced and indepth knowledge
and understanding is required.

Relation Accounting begins where bookkeeping ends.

INTEXT QUESTIONS 1.1

I.Fill in the blanks with suitable word/words:

1. Keeping systematic record of business transactions is known as

2. The next step after classification of recorded transactions is
3. The whole process of recording, classifying, summarizing and interpreting the business transactions
systematically and communicating business results to the interested users of financial information is known
as ...................................

4. Interested users of accounting information are ................................

II.Identify transactions related to book-Keeping or accounting and write B for book-keeping and A for accounting
against the space provided:
1. Credit Sales/Purchases
2. Cash Purchases/Sales
3. Calculation of business profits
4. Find out total debtors
5. Find out financial position of the business enterprise
1.2 BRANCHES AND OBJECTIVES OF ACCOUNTING
Branches of accounting
The changing requirements of the business over the centuries have given rise to specialized
branches of accounting and these are:
Financial accounting
It is concerned with recording the transactions of financial character, summarizing and interpreting
them and communicating the results to the users. It ascertains profit earned or loss incurred during
a period (usually one year as accounting year) and the financial position as on the date when the
accounting period ends. It can provide financial information required by the management and other
parties. The word accounting and financial accounting are used interchangeably. At present we are
concerned with financial accounting only.
Cost accounting
It analyses the expenditure so as to ascertain the cost of various products manufactured by the firm
and fix the prices. It also helps in controlling the costs and providing necessary costing information
to management for decision making.
Management accounting
It is concerned with generating information relating to funds, cost and profits etc. This enables the
management in decision making. Basically, it is meant to assist the management in taking rational
policy decisions and to evaluate the impact of its decisions and actions and the performance of
various departments.
Tax accounting
This branch of accounting has grown in response to the difficult tax laws such as relating to income
tax, sales tax etc. An accountant is required to be fully aware of various tax legislations.
Social accounting
This branch of accounting is also known as social reporting or social responsibility accounting. It
discloses the social benefits created and the costs incurred by the enterprise. Social benefits include
such facilities as medical, housing, education, canteen, provident fund and so on while the social
costs may include such matters as exploitation of employees, industrial interest, environment
pollution, unreasonable terminations, social evils resulting from setting up industries etc.
Human resource accounting
It is concerned with human resource of an enterprise. Accounting methods are applied to evaluate
the human resources in money terms. It is, therefore, an accounting for the people of the
organisation.
National resource accounting
It means the accounting for the resources of the nation as a whole such as water resources, mining,
forests etc. It is generally not concerned with the accounting of individual business entities and is
not based on generally accepted accounting principles. It has been developed by the economists.
You will study about financial accounting in details.
Objectives and Functions of financial accounting
The main objectives of financial accounting are as under:
Finding out various balances
Systematic recording of business transactions provides vital information about various balances
like cash balance, bank balance, etc.
Providing knowledge of transactions
Systematic maintenance of books provides the details of every transactions. Ascertaining net
profit or loss
Summarisation in form of Profit and Loss Account provides business income over a period of time.
Depicting financial position
Balance sheet is prepared to depict financial position of business means what the business owns
and what owes to others.
Information to all interested users
After analysis and interpretation, business performance and position are communicated to the
interested users.
Fulfilling legal obligations
Vital accounting information helps in fulfilling legal obligations e.g. sales tax, income tax etc.
Functions of accounting
The function of accounting is to provide quantitative information primarily financial in nature
about economic entities, which is intended to be useful in making economic decisions. Financial
accounting performs the following major functions:
Maintaining systematic records
Business transactions are properly recorded, classified under appropriate accounts and summarized
into financial statements.
Communicating the financial results
It is used to communicate financial information in respect of net profits (or loss), assets, liabilities
etc. to the interested parties.
Meeting Legal Requirements
The provisions of various Laws such as Companies Act, 1956 Income Tax and Sales/VAT Tax
Acts, require the submission of various statements i.e.
Annual accounts, Income Tax returns, Returns for VAT etc.
 Fixing responsibility
It helps in computation of profits of different departments of an enterprise. This facilitates the
fixing of the responsibility of departmental heads.
Decision making
It provides the users the relevant data to enable them make appropriate decisions in respect of
investment in the capital of the business enterprise or to supply goods on credit or lend money etc.

Limitations of Accounting
1. Accounting information is expressed in terms of Money : Nonmonetary events or
transactions are completely omitted.
2. Fixed assets are recorded in the accounting records at the original cost : Actual amount
spent on the assets like building, machinery, plus all incidental charges is recorded. In this
way the effect of rise in prices not taken into consideration. As a result the Balance Sheet
does not represent the true financial position of the business.
3. Accounting information is sometimes based on estimates: Estimates are often
inaccurate. For example, it is not possible to predict the actual life of an asset for the
purpose of depreciation.
4. Accounting information cannot be used as the only test of managerial performance
on the basis of mere profits : Profit for a period of one year can readily be manipulated
by omitting certain expenses such as advertisement, research and development,
depreciation etc. i.e. window dressing is possible.
5. Accounting information is not neutral or unbiased : Accountants ascertain income as
excess of revenue over expenses. But they consider selected revenue and expenses for
calculating profit of the concern. They also do not include cost of such items as water, noise
or air pollution i.e. social cost they may use different methods of valuation of stock or
depreciations.

INTEXT QUESTIONS 1.2

I.Following are the statements relating to various branches of accounting. Write against each branch
of accounting.

1. It analyses the expenditure so as to ascertain the cost of products manufactured by the

concern.
2. Accounting that discloses the social benefits and the costs incurred by the business
enterprises.

3. Accounting for the resources of the water as a whole.

4. Accounting that is concerned with generating information that will enable the
management in decision making.
II.Write against each statement which explains how it is a limitation of accounting.
1. Fixed assets are recorded in the accounting records at the original cost.
2. Accounting information is sometimes based on estimates

3. Accounting information cannot be used as the only test of managerial performance on the basis
of mere profit

4. Accounting information is expressed in terms of money

Accounting terms Business Entity

Business entity means a specific identifiable business enterprise like Big bazaar, Super Bazaar,
Your father’s shop, Transport limited, etc. An accounting system is always devised for specific
business entity (may be called an accounting entity). For accounting, it is assumed that business
has separate existence and its entity is different from that of its owner(s). Every transaction is
analysed from the point of view of a business enterprise and not that of the person(s) who are
associated with it. For example, when the owner of the business introduces cash in the business,
accounting records show that business has more cash although it does not affect the overall cash
(personal plus business) position of the owner. At the same time, business enterprise records that
an equivalent amount is payable by the business enterprise to the owner of the business i.e. capital.
Transaction
It is an event which involves exchange of some value between two or more entities. It can be
purchase of stationery, receipt of money, payment to a supplier, incurring expenses, etc. It can be
a cash transaction or a credit transaction.
Purchases
This term is used for goods to be dealt-in i.e. goods are purchased for resale or for producing the
finished products which are meant for sale. Goods purchased may be Cash Purchases or Credit
Purchases. Thus, Purchase of goods is the sum of cash purchases and credit purchases.
Sundry creditors
Creditors are persons who have to be paid by an enterprise an amount for providing goods and
services on credit.
Sales
Sales are total revenues from goods or services provided to customers. Sales may be in cash or in
credit.
Sundry debtors
Persons who are to pay for goods sold or services rendered or in respect of contractual obligations.
It is also termed as debtor, trade debtor, and accounts receivable.
Revenue (Sales)
Sales revenue is the amount by selling its products or providing services to customers.
Other items of revenue common to many businesses are: Commission, Interest, Dividends,
Royalties, and Rent received, etc. Revenue is also called Income.
Expenses
Costs incurred by a business in the process of earning revenue are called expenses. In general,
expenses are measured by the cost of assets consumed or services used during the accounting
period. The common items of expenses are: Depreciation, Rent, Wages, Salaries, Interest, Cost of
Heating, Light and water and Telephone, etc.
Income
The difference between revenue and expense is called income. For example, goods costing
Ugxs.25000 are sold for Ugxs.35000, the cost of goods sold, i.e. Ugxs.25000 is expense, the sale
of goods, i.e. Ugxs.35000 is revenue and the difference. i.e. Ugxs.10000 is income. In other words,
we can state that income = Revenue - Expense.
Gain
Usually this term is used for profit of an irregular nature, for example, capital gain.
Loss
It means something against which the firm receives no benefit. It is a fact that expenses lead to
revenue but losses do not, such as theft.
Profit
It is the excess of revenue of a business over its costs. It may be gross profit and net profit. Gross
profit is the difference between sales revenue or the proceeds of goods sold and/or services
provided over its direct cost of the goods sold. Net profit is the profit made after allowing for all
types of expenses. There may be a net loss if the-expenses exceed the revenue.
Expenditure

Spending money or incurring a liability for some benefit, service or property received is called
expenditure. Payment of rent, salary, purchase of goods, purchase of machinery, etc. are some
examples of expenditure. If the benefit of expenditure is exhausted within a year, it is treated as
revenue expenditure. In case the benefit of expenditure lasts for more than one year, it is treated
as an asset also known as capital expenditure. Expenditure is usually the amount spent for the
purchase of assets. It increases the profit earning capacity of the business. Expense, on the other
hand, is an amount to earn revenue. Expenditure is considered as capital expenditure unless it is
qualified with words like revenue expenditure on rent, salaries etc., while expenses is always
considered as a revenue expense because it is always incurred to earn revenue.

Drawings

It is the amount of money or the value of goods which the proprietor takes away from business for
his/her household or private use.
Capital

It is the amount invested in an enterprise by its owners e.g. paid up share capital in a corporate
enterprise. It also refers to the interest of owners in the assets of an enterprise. It is the claim against
the assets of the business. Any amount contributed by the owner towards the business unit is a
liability for the business enterprise. This liability is also termed as capital which may be brought
in the form of cash or assets by the owner.

Assets

These are tangible objects or intangible rights owned by the enterprise and carrying probable future
benefits. Tangible items are those which can be touched and their physical presence can be
noted/felt e.g. furniture, machine etc. Intangible rights are those rights which one possesses but
cannot see e.g. patent rights, copyrights, goodwill etc. Assets are purchased for business use and
are not for sale. They raise the profit earning capacity of the business enterprise.

Assets are broadly categorized as current assets and non-current assets/fixed assets. Current assets
are those assets which are held for a short period generally one year’s time. The balance of such
items goes on fluctuating i.e. it keeps on changing throughout the year. The balance of cash in
hand may change so many times in a day. Various current assets are cash in hand/ at bank, debtors,
bills receivable, stock, pre-paid expenses.

Non-current assets : Those assets are acquired for long term use in the business. Such assets raise
the profit earning capacity of the business enterprise. Expenditure on such assets is non-recurring
and of capital nature. Expenses incurred on acquiring these assets are added to the value of the
assets.

Liability
It is the financial obligation of an enterprise other than owners’ funds. cost, stock, voucher,
discount.

ACCOUNTING CONCEPTS
In the previous lesson, you have studied the meaning and nature of business transactions and
objectives of financial accounting. In order to maintain uniformity and consistency in preparing
and maintaining books of accounts, certain rules or principles have been evolved. These
rules/principles are classified as concepts and conventions. These are foundations of preparing and
maintaining accounting records. In this lesson we shall learn about various accounting concepts,
their meaning and significance.

OBJECTIVES
After studying this lesson, you will be able to :
Explain the term accounting concept;
Explain the meaning and significance of various accounting concepts : Business Entity, Money
Measurement, Going Concern, Accounting Period, Cost Concept, Duality Aspect concept,
Realisation Concept, Accrual Concept and Matching Concept.

2.1 MEANING AND BUSINESS ENTITY CONCEPT

Let us take an example. In India there is a basic rule to be followed by everyone that one should
walk or drive on his/her left hand side of the road. It helps in the smooth flow of traffic. Similarly,
there are certain rules that an accountant should follow while recording business transactions and
preparing accounts. These may be termed as accounting concept. Thus, this can be said that :
Accounting concept refers to the basic assumptions and rules and principles which work as
the basis of recording of business transactions and preparing accounts.
The main objective is to maintain uniformity and consistency in accounting records. These
concepts constitute the very basis of accounting. All the concepts have been developed over the
years from experience and thus they are universally accepted rules.

Following are the various accounting concepts that have been discussed in the following
sections

Business entity concept; Money measurement concept;

Going concern concept; Accounting period concept;

Accounting cost concept; Duality aspect concept;

Realisation concept; Accrual concept; Matching

concept

Business entity concept

This concept assumes that, for accounting purposes, the business enterprise and its owners are two
separate independent entities. Thus, the business and personal transactions of its owner are
separate. For example, when the owner invests money in the business, it is recorded as liability of
the business to the owner. Similarly, when the owner takes away from the business cash/goods for
his/her personal use, it is not treated as business expense. Thus, the accounting records are made
in the books of accounts from the point of view of the business unit and not the person owning the
business. This concept is the very basis of accounting.
Let us take an example. Suppose Mr. Sahoo started business investing Ugxs 100000. He purchased
goods for Ugxs 40000, Furniture for Ugxs 20000 and plant and machinery of Ugxs 30000. Ugxs
10000 remains in hand. These are the assets of the business and not of the owner. According to the
business entity concept Ugxs 100000 will be treated by business as capital i.e. a liability of business
towards the owner of the business.
 Now suppose, he takes away Ugxs 5000 cash or goods worth Ugxs 5000 for his domestic purposes.
This withdrawal of cash/goods by the owner from the business is his private expense and not an
expense of the business. It is termed as Drawings. Thus, the business entity concept states that
business and the owner are two separate/distinct persons. Accordingly, any expenses incurred by
owner for himself or his family from business will be considered as expenses and it will be shown
as drawings.

Significance
The following points highlight the significance of business entity concept :
This concept helps in ascertaining the profit of the business as only the business expenses and revenues
are recorded and all the private and personal expenses are ignored.
This concept restraints accountants from recording of owner’s private/ personal transactions.
It also facilitates the recording and reporting of business transactions from the business point of
view l It is the very basis of accounting concepts, conventions and principles.
2.2 MONEY MEASUREMENT CONCEPT
This concept assumes that all business transactions must be in terms of money, that is in the
currency of a country. In our country such transactions are in terms of shillings.
Thus, as per the money measurement concept, transactions which can be expressed in terms of
money are recorded in the books of accounts. For example, sale of goods worth Ugxs.200000,
purchase of raw materials Ugxs.100000, Rent Paid Ugxs.10000 etc. are expressed in terms of
money, and so they are recorded in the books of accounts. But the transactions which cannot be
expressed in monetary terms are not recorded in the books of accounts. For example, sincerity,
loyality, honesty of employees are not recorded in books of accounts because these cannot be
measured in terms of money although they do affect the profits and losses of the business concern.
Another aspect of this concept is that the records of the transactions are to be kept not in the
physical units but in the monetary unit. For example, at the end of the year 2006, an organisation
may have a factory on a piece of land measuring 10 acres, office building containing 50 rooms, 50
personal computers, 50 office chairs and tables, 100 kg of raw materials etc. These are expressed
in different units. But for accounting purposes they are to be recorded in money terms i.e. in rupees.
In this case, the cost of factory land may be say Ugxs.12 crore, office building of Ugxs.10 crore,
computers Ugxs.10 lakhs, office chairs and tables Ugxs.2 lakhs, raw material Ugxs.30 lakhs. Thus,
the total assets of the organisation are valued at Ugxs.22 crore and Ugxs.42 lakhs. Therefore, the
transactions which can be expressed in terms of money is recorded in the accounts books, that too
in terms of money and not in terms of the quantity.

Significance
The following points highlight the significance of money measurement concept : This concept
guides accountants what to record and what not to record. It helps in recording business
transactions uniformly.
If all the business transactions are expressed in monetary terms, it will be easy to understand the
accounts prepared by the business enterprise.
It facilitates comparison of business performance of two different periods of the same firm or of the
two different firms for the same period.

2.3 GOING CONCERN CONCEPT

This concept states that a business firm will continue to carry on its activities for an indefinite
period of time. Simply stated, it means that every business entity has continuity of life. Thus, it
will not be dissolved in the near future. This is an important assumption of accounting, as it
provides a basis for showing the value of assets in the balance sheet; For example, a company
purchases a plant and machinery of Rs.100000 and its life span is 10 years. According to this
concept every year some amount will be shown as expenses and the balance amount as an asset.
Thus, if an amount is spent on an item which will be used in business for many years, it will not
be proper to charge the amount from the revenues of the year in which the item is acquired. Only
a part of the value is shown as expense in the year of purchase and the remaining balance is shown
as an asset.

Significance
The following points highlight the significance of going concern concept; This concept facilitates

preparation of financial statements. On the basis of this concept, depreciation is charged on the

fixed asset.

It is of great help to the investors, because, it assures them that they will continue to get income on
their investments.
In the absence of this concept, the cost of a fixed asset will be treated as an expense in the year of
its purchase.
A business is judged for its capacity to earn profits in future.
2.4 ACCOUNTING PERIOD CONCEPT
All the transactions are recorded in the books of accounts on the assumption that profits on these
transactions are to be ascertained for a specified period. This is known as accounting period
concept. Thus, this concept requires that a balance sheet and profit and loss account should be
prepared at regular intervals. This is necessary for different purposes like, calculation of profit,
ascertaining financical position, tax computation etc.
Further, this concept assumes that, indefinite life of business is divided into parts. These parts are
known as Accounting Period. It may be of one year, six months, three months, one month, etc. But
usually one year is taken as one accounting period which may be a calender year or a financial
year.
Year that begins from 1 of January and ends on 31 of December, is known as Calendar
st st

Year. The year that begins from 1 of April and ends on 31 of March of the following year,
st st

is known as financial year.

 As per accounting period concept, all the transactions are recorded in the books of accounts for a
specified period of time. Hence, goods purchased and sold during the period, rent, salaries etc. paid
for the period are accounted for and against that period only.

Significance
It helps in predicting the future prospects of the business.
It helps in calculating tax on business income calculated for a particular time period.
It also helps banks, financial institutions, creditors, etc to assess and analyse the performance of
business for a particular period.
It also helps the business firms to distribute their income at regular intervals as dividends.
2.5 ACCOUNTING COST CONCEPT
Accounting cost concept states that all assets are recorded in the books of accounts at their purchase
price, which includes cost of acquisition, transportation and installation and not at its market price.
It means that fixed assets like building, plant and machinery, furniture, etc are recorded in the
books of accounts at a price paid for them. For example, a machine was purchased by XYZ Limited
for Ugxs.500000, for manufacturing shoes. An amount of Ugxs.1,000 were spent on transporting
the machine to the factory site. In addition, Ugxs.2000 were spent on its installation. The total
amount at which the machine will be recorded in the books of accounts would be the sum of all
these items i.e. Ugxs.503000. This cost is also known as historical cost. Suppose the market price
of the same is now Ugxs. 90000 it will not be shown at this value. Further, it may be clarified that
cost means original or acquisition cost only for new assets and for the used ones, cost means
original cost less depreciation. The cost concept is also known as historical cost concept. The effect
of cost concept is that if the business entity does not pay anything for acquiring an asset this item
would not appear in the books of accounts. Thus, goodwill appears in the accounts only if the entity
has purchased this intangible asset for a price.

Significance
This concept requires asset to be shown at the price it has been acquired, which can be verified
from the supporting documents. It helps in calculating depreciation on fixed assets.
The effect of cost concept is that if the business entity does not pay anything for an asset, this item
will not be shown in the books of accounts.

2.6 DUAL ASPECT CONCEPT

Dual aspect is the foundation or basic principle of accounting. It provides the very basis of
recording business transactions in the books of accounts. This concept assumes that every
transaction has a dual effect, i.e. it affects two accounts in their respective opposite sides.
Therefore, the transaction should be recorded at two places. It means, both the aspects of the
transaction must be recorded in the books of accounts. For example, goods purchased for cash has
two aspects which are (i) Giving of cash (ii) Receiving of goods. These two aspects are to be
recorded.
Thus, the duality concept is commonly expressed in terms of fundamental accounting equation :
Assets = Liabilities + Capital
 The above accounting equation states that the assets of a business are always equal to the claims
of owner/owners and the outsiders. This claim is also termed as capital or owners equity and that
of outsiders, as liabilities or creditors’ equity.
The knowledge of dual aspect helps in identifying the two aspects of a transaction which helps in
applying the rules of recording the transactions in books of accounts. The implication of dual aspect
concept is that every transaction has an equal impact on assets and liabilities in such a way that
total assets are always equal to total liabilities.
Let us analyse some more business transactions in terms of their dual aspect :
1. Capital brought in by the owner of the business The two aspects in this transaction are :
1. Receipt of cash
2. Increase in Capital (owners equity)
2. Purchase of machinery by cheque
The two aspects in the transaction are

i.Reduction in Bank Balance

ii.Owning of Machinery
3. Goods sold for cash
The two aspects are

i.Receipt of cash
ii.Delivery of goods to the customer
4. Rent paid in cash to the landlord
The two aspects are

i.Payment of cash
ii.Rent (Expenses incurred).
Once the two aspects of a transaction are known, it becomes easy to apply the rules of accounting and
maintain the records in the books of accounts properly.
The interpretation of the Dual aspect concept is that every transaction has an equal effect on assets and
liabilities in such a way that total assets are always equal to total liabilities of the business.

Significance
This concept helps accountant in detecting error.
It encourages the accountant to post each entry in opposite sides of two affected accounts.
2.7 REALISATION CONCEPT
This concept states that revenue from any business transaction should be included in the accounting
records only when it is realised. The term realisation means creation of legal right to receive
money. Selling goods is realisation, receiving order is not.
In other words, it can be said that :
Revenue is said to have been realised when cash has been received or right to receive cash
on the sale of goods or services or both has been created.
Let us study the following examples :
i.N.P. Jeweller received an order to supply gold ornaments worth Ugxs.500000. They supplied
ornaments worth Ugxs.200000 up to the year ending 31 December 2005 and rest of the
st

ornaments were supplied in January 2006.

ii.Bansal sold goods for Ugxs.1,00,000 for cash in 2006 and the goods have been delivered during
the same year.
iii.Akshay sold goods on credit for Ugxs.50,000 during the year ending 31 December 2005. The
st

goods have been delivered in 2005 but the payment was received in March 2006.
Now, let us analyse the above examples to ascertain the correct amount of revenue realised for the
year ending 31 December 2005.
st

i.The revenue for the year 2005 for N.P. Jeweller is Ugxs.200000. Mere getting an order is not
considered as revenue until the goods have been delivered.
ii.The revenue for Bansal for year 2005 is Ugxs.1,00,000 as the goods have been delivered in the
year 2005. Cash has also been received in the same year.
iii.Akshay’s revenue for the year 2005 is Ugxs.50,000, because the goods have been delivered to
the customer in the year 2005. Revenue became due in the year 2005 itself. In the above
examples, revenue is realised when the goods are delivered to the customers.

The concept of realisation states that revenue is realized at the time when goods or services
are actually delivered.
In short, the realisation occurs when the goods and services have been sold either for cash or on
credit. It also refers to inflow of assets in the form of receivables.
Significance
It helps in making the accounting information more objective.
It provides that the transactions should be recorded only when goods are delivered to the buyer.

2.8 ACCRUAL CONCEPT

The meaning of accrual is something that becomes due especially an amount of money that is yet
to be paid or received at the end of the accounting period. It means that revenues are recognised
when they become receivable. Though cash is received or not received and the expenses are
recognised when they become payable though cash is paid or not paid. Both transactions will be
recorded in the accounting period to which they relate. Therefore, the accrual concept makes a
distinction between the accrual receipt of cash and the right to receive cash as regards revenue and
actual payment of cash and obligation to pay cash as regards expenses.
The accrual concept under accounting assumes that revenue is realised at the time of sale of goods
or services irrespective of the fact when the cash is received. For example, a firm sells goods for
Ugxs 55000 on 25th March 2005 and the payment is not received until 10th April 2005, the amount
is due and payable to the firm on the date of sale i.e. 25th March 2005. It must be included in the
revenue for the year ending 31st March 2005. Similarly, expenses are recognised at the time
services provided, irrespective of the fact when actual payment for these services are made. For
example, if the firm received goods costing Ugxs Ugxs.20000 on 29th March 2005 but the payment
is made on 2nd April 2005 the accrual concept requires that expenses must be recorded for the year
ending 31st March 2005 although no payment has been made until 31st March 2005 though the
service has been received and the person to whom the payment should have been made is shown
as creditor.
In brief, accrual concept requires that revenue is recognised when realised and expenses are
recognised when they become due and payable without regard to the time of cash receipt or cash
payment.

Significance
It helps in knowing actual expenses and actual income during a particular time period.
It helps in calculating the net profit of the business.

2.9 MATCHING CONCEPT

The matching concept states that the revenue and the expenses incurred to earn the revenues must
belong to the same accounting period. So once the revenue is realised, the next step is to allocate
it to the relevant accounting period. This can be done with the help of accrual concept.
Let us study the following transactions of a business during the month of
December, 2006
i.Sale : cash Ugxs.2000 and credit Ugxs.1000
ii.Salaries Paid Ugxs.350
iii.Commission Paid Ugxs.150
iv.Interest Received Ugxs.50
v.Rent received Ugxs Ugxs.140, out of which Ugxs.40 received for the year 2007
vi.Carriage paid Ugxs.20
vii.Postage Ugxs.30
viii.Rent paid Ugxs Ugxs.200, out of which Ugxs.50 belong to the year 2005
ix.Goods purchased in the year for cash Ugxs.1500 and on credit Ugxs.500 (x) Depreciation on
machine Ugxs.200
Let us record the above transactions under the heading of Expenses and Revenue.
Expenses Amount Revenue Amount

Ugxs Ugxs
1. Salaries 350 1. Sales

2. Commission 150 Cash 2000

3. Carriage 20 Credit 1000 3000
4. Postage 30 2. Interest received 50
5. Rent paid 200 3. Rent received 140
 Less for 2005 (50) 150 Less for 2007 (40) 100
6. Goods purchased 2000
Cash 1500
Credit 500
7. Depreciation on machine 200

Total 2900 Total 3150

In the above example expenses have been matched with revenue i.e (Revenue Ugxs.3150-Expenses
Ugxs.2900) This comparison has resulted in profit of Ugxs.250. If the revenue is more than the
expenses, it is called profit. If the expenses are more than revenue it is called loss. This is what
exactly has been done by applying the matching concept.
Therefore, the matching concept implies that all revenues earned during an accounting year,
whether received/not received during that year and all cost incurred, whether paid/not paid during
the year should be taken into account while ascertaining profit or loss for that year.

Significance
It guides how the expenses should be matched with revenue for determining exact profit or loss for a
particular period.
It is very helpful for the investors/shareholders to know the exact amount of profit or loss of the
business.

ACCOUNTING CONVENTIONS AND

STANDARDS
In the previous lesson, you have studied the accounting concepts like business entity, money
measurement, going concern, accounting period, cost, duality, realisation, accrual and matching.
These concepts or assumptions or principles are working rules for all accounting activities.
You may visit some business units. Enquire them and find out how unsold goods are being valued.
You will find that they follow the same method of valuation of unsold stock of goods. If you ask
them, why do they value the unsold goods at cost or market price, whichever is lower, even though
the market price is higher than the cost price, the businessman may answer that it is the convention,
tradition or practice or custom of the business, that business is following year after year. In
 accounting, there are many conventions or practices which are used while recording the
transactions in the books of accounts. Apart from these, the Institute of Chartered Accountants of
India (ICAI), which is the main regulatory body for standardisation of accounting policies in the
country has issued a number of accounting standards from time to time to bring consistency in the
accounting practices. We shall study about accounting conventions and standards in detail in this
lesson.

OBJECTIVES
After studying this lesson, you will be able to : l explain the meaning of
accounting convention;
Explain the meaning and significance of accounting conventions like consistency of full disclosure,
materiality and convservatism;
State the meaning of the term Generally Accepted Accounting Principles
(GAAP); l explain the concept of accounting standard and enumerate the various accounting
standards issued by the Institute of Chartered Accountants of India.
3.1 MEANING AND CONVENTION OF CONSISTENCY
An accounting convention refers to common practices which are universally followed in recording
and presenting accounting information of the business entity. They are followed like customs,
tradition, etc. in a society. Accounting conventions are evolved through the regular and consistent
practice over the years to facilitate uniform recording in the books of accounts. Accounting
Conventions help in comparing accounting data of different business units or of the same unit for
different periods. These have been developed over the years. The most important conventions
which have been used for a long period are : l Convention of consistency. l Convention of full
disclosure. l Convention of materiality. l Convention of conservatism.

Convention of consistency
The convention of consistency means that same accounting principles should be used for preparing
financial statements year after year. A meaningful conclusion can be drawn from financial
statements of the same enterprise when there is comparison between them over a period of time.
But this can be possible only when accounting policies and practices followed by the enterprise
are uniform and consistent over a period of time. If different accounting procedures and practices
are used for preparing financial statements of different years, then the result will not be
comparable.
Generally a businessman follows the undermentioned general practices or methods year after year.
(i) While charging depreciation on fixed assets or valuing unsold stock, once a particular method is used
it should be followed year after year so that the financial statements can be analysed and compared
provided the depreciation on fixed assets is charged or unsold stock is valued by using particular
method year after year. This can be further clarified as : in case of charging depreciation on fixed
assets accountant can decide to adopt any one of the methods of depreciation such as diminishing
value method or straight line method.
 Similarly, in case of valuation of closing stock it can be valued at actual cost price or market
price or whichever is less. However precious metals like gold, diamond, minerals are
generally valued at market price only.
Types of consistency : There are three types of consistency namely :
i.Vertical consistency (Same organisation) : It is to be found within the group of inter-related
financial statements of an organisation on the same date. It occurs when fixed assets have been
shown at cost price and in the interrelated income statement depreciation has also been charged
on the historical cost of the assets.

ii.Horizontal consistency (Time basis): This consistency is to be found between financial statements of
one entity from period to period. Thus, it helps in comparing performance of the business between two
years i.e. current year with past year.

iii.Dimensional consistency (Two organisations in the same trade): This consistency is to be found in the
statements of two different business entities of the same period. This type of consistency assists in
making comparison of the performance of one business entity with the other business entity in the same
trade and on the same date.
Therefore, as per this convention the same accounting methods should be adopted every year in preparing
financial statements. But it does not mean that a particular method of accounting once adopted can never
be changed. Whenever a change in method is necessary, it should be disclosed by way of footnotes in the
financial statements of that year.

Significance
It facilitates comparative analysis of the financial statements.
It ensures uniformity in charging depreciation on fixed assets and valuation of closing stock.
3.2 CONVENTION OF FULL DISCLOSURE
Convention of full disclosure requires that all material and relevant facts concerning financial
statements should be fully disclosed. Full disclosure means that there should be full, fair and
adequate disclosure of accounting information. Adequate means sufficient set of information to
be disclosed. Fair indicates an equitable treatment of users. Full refers to complete and detailed
presentation of information. Thus, the convention of full disclosure suggests that every financial
statement should fully disclose all relevant information. Let us relate it to the business. The
business provides financial information to all interested parties like investors, lenders, creditors,
shareholders etc. The shareholder would like to know profitability of the firm while the creditor
would like to know the solvency of the business. In the same way, other parties would be interested
in the financial information according to their requirements. This is possible if financial statement
discloses all relevant information in full, fair and adequate manner.
Let us take an example. As per accounts, net sales are Ugxs.150,000, it is important for the
interested parties to know the amount of gross sales which may be Ugxs.200,000 and the sales
return Ugxs.50,000. The disclosure of 25% sales returns may help them to find out the actual sales
position. Therefore, whatever details are available, that must be honestly provided. Additional
information should also be given in the financial statement. For example, in a balance sheet the
basis of valuation of assets, such as investments, inventories, land and building etc. should be
clearly stated. Similarly, any change in the method of depreciation or in making provision for bad
 debts or creating any reserve must also be shown clearly in the Balance Sheet. Therefore, in order
to achieve the purpose of accounting, all the transactions of a business and any change in
accounting policies, methods and procedures are fully recorded and presented in accounting.
To ensure proper disclosure of material accounting information, the Companies Act 1956, under
schedule VI has provided a format for the preparation of Profit and Loss account and Balance
Sheet of a company. It is necessary for every company to follow this format. The regulatory bodies
like Securities and Exchange Board of India (SEBI) has also made compulsory for complete
disclosures by registered companies.

Significance
It helps in meaningful comparison of financial statements of the different business units.
This can also help in the comparison of financial statements of different years of the same business
unit.
This convention is of great help to investor and shareholder for making investment decisions. l The
convention of full disclosure presents reliable information.

3.3 CONVENTION OF MATERIALITY

The convention of materiality states that, to make financial statements meaningful, only material
fact i.e. important and relevant information should be supplied to the users of accounting
information. The question that arises here is what is a material fact. The materiality of a fact
depends on its nature and the amount involved. Material fact means the information of which will
influence the decision of its user.
For example, a businessman is dealing in electronic goods. He purchases T.V., Refrigerator,
Washing Machine, Computer etc. for his business. In buying these items he uses larger part of his
capital. These items are significant items; thus should be recorded in books of accounts in detail.
At the same time to maintain day to day office work he purchases pen, pencil, match box, scented
stick, etc. For this he will use very small amount of his capital. But to maintain the details of every
pen, pencil, match box or other small items is not considered of much significance. These items
are insignificant items and hence they should be recorded separately. Thus, the items that are
significantly important in recording the details are termed as material facts or significant items.
The items that are of less significance are immaterial facts or insignificant items.
Thus according to this convention important and significant items should be recorded in their
respective heads and all immaterial or insignificant transactions should be clubbed under a
different accounting head.

Significance l It helps in minimising errors in calculation. l It helps in making

financial statements more meaningful. l It saves time and resources.

3.4 CONVENTION OF CONSERVATISM

This convention is based on the principle that “Anticipate no profit, but provide for all possible
losses”. It provides guidance for recording transactions in the books of accounts. It is based on the
policy of playing safe in regard to showing profit. The main objective of this convention is to show
minimum profit. Profit should not be overstated. If profit shows more than actual, it may lead to
distribution of dividend out of capital. This is not a fair policy and it will lead to the reduction in
the capital of the enterprise.
Thus, this convention clearly states that profit should not be recorded until it is realised. But if the
business anticipates any loss in the near future, provision should be made in the books of accounts
for the same. For example, valuing closing stock at cost or market price whichever is lower,
creating provision for doubtful debts, discount on debtors, writing off intangible assets like
goodwill, patent, etc. The convention of conservatism is a very useful tool in situation of
uncertainty and doubts.

Significance l It helps in ascertaining actual profit. l It is useful in the situation of

uncertainties and doubts. l It helps in maintaining the capital of the enterprise.
3.5 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
(GAAP) AND ACCOUNTING STANDARDS
In order to maintain uniformity and consistency in accounting records throughout the world, certain
rules and principles have been developed which are generally accepted by the accounting
profession. These rules/ principles are called by different names such as principles, concepts,
conventions, postulates, assumptions. These rules/principles are judged on their general
acceptability rather than universal acceptability. Hence, they are popularly called Generally
Accepted Accounting Principles (GAAP). The term “generally accepted” means that these
principles must have support, that generally comes from the professional accounting bodies. Thus,
Generally Accepted Accounting Principles (GAAP) refer to the rules or guidelines adopted for
recording and reporting of business transactions of financial statements. These principles have
evolved over a long period of time on the basis of past experiences, usages or customs, etc. These
principles are also referred as concepts and conventions, which have already been discussed.

Accounting standards
The term standard denotes a discipline, which provides both guidelines and yardsticks for
evaluation. As guidelines, accounting standard provides uniform practices and common
techniques of accounting. As a general rule, accounting standards are applicable to all corporate
enterprises. They are made operative from a date specified in the standard. The Institute of
Chartered Accountant of India (ICAI) constituted the Accounting Standards Board (ASB) in
April, 1977 for developing accounting standards. However, the International Accounting
Standards Committee (IASC) was set up in 1973, with its headquarter in London (U.K.).
The Accounting Standards Board is entrusted with the responsibility of formulating standards on
significant accounting matters keeping in view the international developments, and legal
requirements in India.
 The main function of the ASB is to identify areas in which uniformity in standards is required and
to develop draft standards after discussions with representatives of the Government, public sector
undertaking, industries and other agencies.
In the initial years the standards are of recommendatory in nature. Once an awareness is created
about the benefits and relevance of accounting standards, steps are taken to make the accounting
standards mandatory for all companies. In case of non compliance, the companies are required to
disclose the reasons for deviations and its financial effect :
Till date, the IASC has brought out 40 accounting standards. However, the ICAI has so far issued
29 accounting standards. These are :

AS-1 Disclosure of accounting policies (January 1979). This standard deals with the disclosure of
significant accounting policies in the financial statements.

AS-2 Valuation of Inventories (June 1981). This standard deals with the principles of valuing inventories
for the financial statements.
AS-3 (Revised) Cash flow statement (June 1981, Revised in March 1997). This standard deals with the
financial statement which summaries for a given period the sources and applications of an
enterprise.
AS-4 Contingencies and events occurring after the Balance Sheet date (November 1982, Revised in April,
1995) This standard deals with the treatment of contingencies and events occurring after the
balance sheet date.
AS-5 Net profit or loss for the period, prior period (period before the date of balance sheet) items and
changes in accounting policies (November 1982, Revised in February 1997). This standard deals
with the treatment in financial statement of prior period and extraordinary items and changes in
accounting policies.
AS-6 Depreciation Accounting (November 1982). This standard applies to all depreciable assets. But this
standard does not apply to assets in the category of forests, plantations and similar natural resources
and wasting assets.
AS-7 Accounting for construction contracts (December 1983, revised in April 2003). This standard deals
with accounting for construction contracts in the financial statements of contractors.
AS-8 Accounting for Research and Development (January 1985). This standard deals with the treatment of
costs of research and development in financial statements.
AS-9 Revenue Recognition (November 1985). This standard deals with the bases for recognition of revenue
in the statement of profit and loss of an enterprise.
AS-10 Accounting for fixed assets (November 1991). This standard deals with recognition of fixed assets
grouped into various categories, such as land, building, plant and machinery, vehicles, furniture
and gifts, goodwill, patents, trading and designs.
AS-11 Accounting for the effects of change in foreign exchange Rates. (August 1991 and Revised in 1993).
This standard deals with the issues relating to accounting for effect of change in foreign exchange
rates.
AS-12 Accounting for Government grants (April 1994). This standard deals with the accounting for
government grants.
AS-13 Accounting for investments (September 1994). This standard deals with accounting aspect
concerning investments in the financial statements. These include classification, determination of
cost for initial recognition, disposal and re-classification of investment.
AS-14 Accounting for amalgamation (October 1994). This standard deals with accounting treatment of any
resultant goodwill or reserves in amalgamation of companies.

AS- Accounting for retirement Benefits in the financial statements of employers (January 1995).
15 This standard deals with accounting for retirement benefits in the financial statements of
employers.
AS- Borrowing Costs (April 2000). This standard deals with the uses involved relating to
16 capitalization of interest on borrowing for purchase of fixed assets.

AS- Segment reporting (October 2000). This standard applies to companies which have an annual
17 turnover of Rs 50 crores or more. These companies have to present financial statements and
consolidated financial statements.

AS- Related party disclosures (October 2000 revised 1st July 2003). This standard requires
18 certain disclosure which must be made for transactions between the enterprise and related
parties.
AS- Leases (January 2001). This standard deals with the accounting treatment of transactions
19 related to lease agreements.
AS- Earning per share (April 2001). This standard deals with the presentation and computation
20 of earning per share (EPS).
AS-
21 Consolidated financial statements (April 2001). This standard deals with the preparation of
consolidated financial statements with an intention to provide information about the activities
of a group.

AS- Accounting for taxes on Income (April 2001). This standard deals with determination of the
22 account of tax expenses for the related revenue.
AS- Accounting for investments in Associates in consolidated financial statements (July 2001).
23 This standard deals with the principles and procedures to be followed for recognising, in the
consolidated financial statement.

AS- Discontinued operations (February 2002). This standard deals with the principles of
24 discontinuing operations of an enterprise with the activities which are continuing.
 AS- Interim financial reporting (February 2002). This standard deals with the minimum content
25 of interim financial report.
AS- Intangible Assets (February 2002). This standard prescribed the accounting treatment for
26 intangible assets which are not covered by any other specific accounting standard.

AS- Financial reporting of interest for joint venture (February 2002). This standard sets principles
27 and procedure for accounting for interest in joint venture.

AS-28 Impairment of Assets (2004). This standard prescribed procedure to ensure that an asset is carried at
no more than its carrying amount and procedures as to when to recognise an asset as impaired.
AS-29 Provision for contingent labilities and contingent assets (2004). This standard deals with
measurement and recognition criteria in three areas, namely provisions, contingent liabilities and
contingent assets.
All the above standards issued by the Accounting Standards Board are recommended for use by
companies listed on a recognized stock exchange and other large commercial, industrial and
business enterprises in the public and private sectors.

Book Keeping

1. What is single entry bookkeeping?

Single entry bookkeeping means that all transactions are entered only once on to the accounts
system. For instance, buying a vehicle for £15,000 would be entered as a payment in a cashbook.

Single entry bookkeeping can be used to account for cash (and bank) based systems. It has the
advantage of being simple, and intuitive to use. However, it will not account for “non-cash” (or
“non-bank”) transactions. These are transactions that will have a significant effect on the accounts,
but do not immediately cause a change on the cash or bank accounts.

An example of a non-cash transaction is ordering a vehicle for £15,000. The vehicle might take a
month to arrive. During that month, a single entry system would not record the transaction on the
formal accounts. This would mean that the accounts showed you as having £15,000 more than you
do: a dangerous situation.

2. What is double entry bookkeeping?

Double entry bookkeeping means that all transactions are entered twice on to the accounts system.
For instance, buying a vehicle for £15,000 would be entered as a decrease in the cash account, and
as an increase in the ‘vehicle’ account. (The decrease in the cash account would be shown as an
entry in a cashbook, like in a single entry system.)
A double entry system will have a separate ‘account’ for each budget line. The system also uses a
few accounts that are not found on the budget. These are the accounts that allow you to track non-
cash expenditure, and which make the double entry system so powerful.

For instance, you might have an account called ‘Goods ordered’. Then, if the vehicle above was
ordered, the cash account would decrease by £15,000, and the ‘Goods ordered’ account would
increase by £15,000. This is just a transfer in the accounts: no real money would have moved.

But it would show you that you have put aside £15,000 for something. When the vehicle arrives,
and you have to pay the bill for it, then the double entry that you make would be to decrease the
‘Goods ordered’ account by £15,000, and increase the ‘vehicles’ account by £15,000.

So, the advantage of a double entry system is that it is comprehensive. It will give you an accurate
picture of your true financial position, not just your cash position. As non-cash transactions can be
huge, this is extremely important for robust financial management.

For example, in the 1994/95 response to the Rwanda crisis, a major international NGO flew a very
large amount of relief equipment into Central Africa. When the response was completed, the NGO
drew up its accounts, from its single entry, cash-based accounting system, and submitted them to
its donor. The donor paid up, and the project was closed.

Unfortunately, some time later, a bill for freight insurance was received. It came to over £50,000.
The donor said that they could not pay more, after the accounts had been settled, and the NGO had
to meet the bill out of its own resources. If a full double entry accounts system had been used, then
this sort of vicious surprise would have been almost impossible.

However, the disadvantage of double entry bookkeeping is that it is complicated, and not always
easy to use. It generally needs a qualified accountant to run it for the entire life of the project. On
large international projects, it may need two or three. This may not always be possible for an NGO.

The Accounting Equation

The resources controlled by a business are referred to as its assets. For a new business, those assets
originate from two possible sources:

• Investors who buy ownership in the business

• Creditors who extend loans to the business

Those who contribute assets to a business have legal claims on those assets. Since the total assets
of the business are equal to the sum of the assets contributed by investors and the assets contributed
by creditors, the following relationship holds and is referred to as the accounting equation :

Assets = Liabilities + Owners' Equity

 Resources Claims on the Resources

Initially, owner equity is affected by capital contributions such as the issuance of stock. Once
business operations commence, there will be income (revenues minus expenses, and gains minus
losses) and perhaps additional capital contributions and withdrawals such as dividends. At the end
of a reporting period, these items will impact the owners' equity as follows:

Assets = Liabilities + Owners' Equity

+ Revenues
- Expenses
+ Gains
- Losses
+ Contributions
- Withdrawals

These additional items under owners' equity are tracked in temporary accounts until the end of the
accounting period, at which time they are closed to owners' equity.

The accounting equation holds at all times over the life of the business. When a transaction occurs,
the total assets of the business may change, but the equation will remain in balance. The accounting
equation serves as the basis for the balance sheet, as illustrated in the following example.

The Accounting Equation - A Practical Example

To better understand the accounting equation, consider the following example. Mike Peddler
decides to open a bicycle repair shop. To get started he rents some shop space, purchases an initial
inventory of bike parts, and opens the shop for business. Here is a listing of the transactions that
occurred during the first month:

Date Transaction
Sep 1 Owner contributes $7500 in cash to capitalize the business.
Sep 8 Purchased $2500 in bike parts on account, payable in 30 days.
Sep 15 Paid first month's shop rent of $1000.
Sep 17 Repaired bikes for $1100; collected $400 cash; billed customers for the $700 balance.
Sep 18 $275 in bike parts were used.
Sep 25 Collected $425 from customer accounts.
Sep 28 Paid $500 to suppliers for parts purchased earlier in the month.

These transactions affect the accounting equation as shown below.

Assets = Liabilities + Owner's Equity

Bike Accounts Accounts Peddler, Revenue
Cash + + = + +
Parts Receivable Payable Capital (Expenses)
Sep 1 7500 = 7500
Sep 8 2500 = 2500
Sep 15 (1000) = (1000)
Sep 17 400 700 = 1100
Sep 18 (275) = (275)
Sep 25 425 (425) =
Sep 28 (500) = (500)
Totals: 6825 + 2225 + 275 = 2000 + 7500 + (175)
$9325 = $9325

Note that for each date in the above example, the sum of entries under the "Assets" heading is
equal to the sum of entries under the "Liabilities + Owner's Equity" heading. In most of these
cases, the transaction affected both sides of the accounting equation. However, note that the Sep
25 transaction affected only the asset side with an increase in cash and an equal but opposite
decrease in accounts receivable.

At the end of the month of September, the net income (revenues minus expenses) is closed to
capital and the balance sheet for the business would appear as follows:

Peddler's Bikes
Balance Sheet
September 30, 20xx
Liabilities &
Assets
Owner's Equity
Cash 6825 Accounts Payable 2000
Accounts Receivable 275 Peddler, Capital 7325
Bike Parts 2225

Total Assets $9325 Total Liabilities $9325

The bike parts are considered to be inventory, which appears as an asset on the balance sheet. The
owner's equity is modified according to the difference between revenues and expenses. In this case,
the difference is a loss of $175, so the owner's equity has decreased from $7500 at the beginning
of the month to $7325 at the end of the month.

Debits and Credits

The above example illustrates how the accounting equation remains in balance for each
transaction. Note that negative amounts were portrayed as negative numbers. In practice, negative
numbers are not used; in a double-entry bookkeeping system the recording of each transaction is
made via debits and credits in the appropriate accounts.

JOURNAL

Learning Objectives:

1. Define and explain journal.

2. What are characteristics of journal? What are its advantages and how a journal is prepared?

Definition and Explanation:

The word "journal" has been derived from the French word "jour". Jour means day. So journal
means daily. Transactions are recorded daily in journal and hence it has been named so. It is a
book of original entry to record chronologically (i.e. in order of date) and in detail the various
transactions of a trader. It is also known Day Book because it contains the account of every day's
transactions.

Characteristics of Journal:

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 the journal is called the book of original entry.
2. A transaction is recorded on the same day it takes place. So, journal is called 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 in two 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 arte 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 debits of transaction 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.

Objective of an Entry:

While recording transactions in journal the following two objects must be aimed at:

1. That each entry in the journal should be so clear that at any future time we may, without
the aid of memory, perceive the exact nature of the transactions.
2. That each transaction should be so classified that we may easily obtain the aggregate effect
of such transactions at the end of a certain period.

Narration of an Entry:

It is the remark or explanation put below each entry in the journal. The journal is a book of original
entry and all possible details have to recorded in connection with each and every transaction
entered there. The details are laid out in the form of a remark at the end of each journal entry,
which is called narration.

Form of Journal:

Date Particulars L.F.

Dr. Amount Cr. Amount
(1) (2) (3)
Column is meant for writing the date of the transaction.
(1)
Column is used for recording the names of the two accounts affected by transactions.
(2)
Column is meant for noting the number of the page of the ledger on on which the particular
(3) account appears in that book.
Column shows the amount to be debited to the account named.
(4)
Column shows the amount to be credited to the account stated.
(5)

Rules of Journalising:

The act of recording transactions in journal is called journalizing. The rules may be summarized
as follows:

1. Use two separate lines for writing the names of the two accounts concerned in each
transaction.
2. write the name of the debtor or account to be debited in the first line and the name of the
creditor or the account to be credited in the next line
3. Write the name of the account to be debited close to the line starting the particulars column
and that of the account to be credited at a short distance from this line.
4. Use "Dr" after each debit item and "To" before each credit. The term "Cr." after a credit
item is unnecessary, as if one account is debtor, the other must be creditor.
5. To separate one entry from another a line is drawn below every entry to cover particulars
column only. The line does not extend to amount column.

Example 1:

On first January, 1991 A started business with capital of $20,000 and his transactions of the month
were as follows:

Jan.2 Purchased building for cash 8,000

Jan.8 Purchased goods from C 1,000
Jan.15 Sold goods for cash 500
Jan.20 Goods returned to C 100
Jan.22 Sold goods to R 400
Jan.25 R returned goods 25
Jan.31 Salaries paid for the month 200
Jan.31 Rent paid for the month 150

Solution:
Journal of A

Date Particulars L.F Debit Credit

Jan. 1 Cash Account ...Dr. 20,000
To Capital Account 20,000
(Capital introduced)

Jan 2. Building Account ...Dr. 8,000

To Cash Account 8,000
(Building purchased for cash)
Jan. 8 Purchases Account ...Dr. 1,000
To cash Account 1,000
(Goods purchased on credit form C)
Jan. 15 Cash Account ...Dr. 500
To Sales Account 500
(Goods sold for cash)

Jan. 20 C ...Dr. 100

To purchases Returns Account 100
(Goods returned to C)

Jan. 22 R ...Dr. 400

To Sales Account 400
(Goods sold on credit)
Jan. 25 Sales returns Account .Dr. 25
To R 25
(Goods returned by him)
Jan. 31 Salaries Account ...Dr. 200
To Cash Account 200
(Salaries paid)
Jan. 31 Rent Account ...Dr. 150
To Cash Account 150
(Rent paid in cash)
Total 30,375 30,375

Capital Account:
The proprietor's account in the business books is called "capital account". Whenever the proprietor
invests money in the business, instead of giving credit to his name, capital account should be
credited.

Drawings Account:

Any cash or goods taken away by the proprietor for his personal use are called his drawings and
are debited to "Drawings Account". Drawings account like the capital account is personal account
of the proprietor.

Casts and Carry Forwards:

In bookkeeping casting means totaling. The first page of the journal will be cast by drawing a line
across the money column. The total of this page will be carried forward to the top of second page.
The total of the second page will be carried forward to the third page and so on until the last page
gives the final total.

When carrying forward the total of the one page to another, the words "carried forward" or "carried
over" should be written at the bottom of the first page and words "brought forward" the top of the
next page. The abbreviations c/f or c/o and b/f can also be used.

Compound Journal Entries:

When two or more transactions of the same nature take place on the same date, a compound journal
entry may be made instead of making separate entries for each transaction.

Trade Discount:

No entry is passed for trade discount. The purchases or sales should be recorded at net price i.e.,
after deducting the trade discount from the list price.

Goods Given Away:

Sometimes goods are (a) given away as charity (b) taken by the proprietor for his private use (c)
distributed free as samples. Such goods are not sales. Therefore they are not credited to sales
account but are credited to purchases account because they reduce the amount of goods purchased.

Example 2:

On first April 1991 a merchant started business with a capital of $15,000 and his transactions of
the month were as follows:

April 2 Purchased machinery for $7,000.

April 3 Bought furniture from S $300.
April 7 Purchased goods for cash $2,500
April 8 Sold goods to R & Sons $1,500
April
Bought goods from B, $1,000 and from C $2,000
10
April
Received cash from R & Sons $1,450, allowed him discount of $50.
12
April
Paid B cash $975, discount received $25.
15
April
Returned goods to C $500
16
April
Sold goods to Din Mohammad $800
17
April
Goods returned by Din Mohammad $200
20
April Purchased from K goods of the list price of $600 subject to a 10 percent trade discount.
21
April
Paid C cash $1,500
22
April
Gave away a charity cash $50 and goods worth $30.
25
April Distributed goods worth $200 as free samples and goods taken away by the proprietor for
27 personal use $100
April
Amount withdrawn by the proprietor for private use $200
28
April
Salaries paid for the month $500
31

Record these transactions in the journal.

Solution:

Journal

Date Particulars L.F Debit Credit

April 1 Cash Account ...Dr. 15,000
To Capital Account 15,000
(Capital introduced)

April 2 Machinery Account 7,000

To Cash Account 7,000
(Machinery purchased)
April 3 Furniture Account 2,500
 To Cash Account 2,500
(Goods purchased for cash C)
April 7 Purchases Account 3,000
To Cash Account 3,000
(Goods purchased for cash)

April 8 R & Sons 1,500

To Sales Account 1,500
(Goods sold on credit)

April 10 Purchases Account 3,000

To B 1,000
To C 2,00
(Goods purchased on credit)
Cash Account 1,450
April 12
Discount 50
To R & Sons 1,500
(Cash received and discount allowed)
April 15 B 1,000
To Cash Account 975
To Discount account 25
(Salaries paid)
April 16 C 500
To Purchases Return Account 500
(Goods returned to C)
April 17 Din Mohammad 800
To Sales Account 800
(Goods sold on credit)

April 20 Sales Returns Account 200

To Din Mohammad 200
(Goods returned by him)

April 21 Purchases Account 540

To K 540
(Goods purchased on credit)

April 22 C 1,500
To Cash Account 1,500
(Cash paid to C)
 April 25 Charity Account 80
To Cash Account 50
To Purchases Account 30
(Cash and goods given in charity)

April 27 Free samples Account 200

Drawings Account 100
To Purchases Account 300
(Goods distributed free and taken by the proprietor for private use)

April 28 Drawings Account 200

To Cash 200
(Cash drawn by the proprietor)

April 31 Salaries Account 500

To Cash Account 500
(Salaries paid in cash)

Note:

(a) In actual practice even the word "Dr." is not written after the name of the account to be debited,
because it is also implied.

(b) When writing the name of a personal account, it is not considered necessary to add the word
"account" after the name of the person.

LEDGER
You have learnt that business transactions are recorded in various special purpose books and
journal proper. The accounting process does not stop here. The transactions are recorded in number
of books in chronological order. Such recording of business transactions serves little purpose of
accounting. Items of same title in different books of accounts need to be brought at one place under
one head called an account. There are numerous account titles of items/persons or accounts. All
the accounts, if brought in one account book, will be more informative and useful. The account
book so maintained is called Ledger.

In this lesson, you will learn about Ledger and posting of items entered in various books of
accounts to ledger.

LEDGER: MEANING, IMPORTANCE AND TYPES

You have already learnt about accounts. Each transaction affects two accounts. In each account
transactions related to that account are recorded.
For example, sale of goods taking place number of times in a year will be put under one Account
i.e. Sales Account

All the accounts identified on the basis of transactions recorded in different journals/books such
as Cash Book, Purchase Book, Sales Book etc. will be opened and maintained in a separate book
called Ledger. So a ledger is a book of account; in which all types of accounts relating to assets,
liabilities, capital, expenses and revenues are maintained. It is a complete set of accounts of a
business enterprise.

Ledger is bound book with pages consecutively numbered. It may also be a bundle of sheets.

Thus, from the various journals/Books of a business enterprise, all transactions recorded
throughout the accounting year are placed in relevant accounts in the ledger through the process
of posting of transactions in the ledger. Thus, posting is the process of transfer of entries from
Journal/Special Journal Books to ledger.

Features of ledger
• Ledger is an account book that contains various accounts to which various business
transactions of a business enterprise are posted.
• It is a book of final entry because the transactions that are first entered in the journal or
special purpose Books are finally posted in the ledger.
• It is also called the Principal Book of Accounts.
• In the ledger all types of accounts relating to assets, liabilities, capital, revenue and
expenses are maintained.
• It is a permanent record of business transactions classified into relevant accounts.
• It is the ‘reference book of accounting system and is used to classify and summarise
transactions to facilitate the preparation of financial statements.

POSTING OF JOURNAL PROPER INTO LEDGER

You know that the purpose of opening an account in the ledger is to bring all related items of this
account which might have been recorded in different books of accounts on different dates at one
place. The process involved in this exercise is called posting in the ledger. This procedure is
adopted for each account.
To take the items from the journal to the relevant account in the ledger is called posting of journal.
Following procedure is followed for posting of journal to ledger:

1. Identify both the accounts ‘debit’ and credit of the journal entry. Open the two accounts in the
ledger.
2. Post the item in the first account by writing date in the date column, name of the account to be
credited in the particulars column and the amount in the amount column of the ‘debit’ side of the
account.
3. Write the page number of the journal from which the item is taken to the ledger in Folio column
and write the page number of the ledger from which account is written in L.F. column of the
journal.
4. Now take the second Account and give the similar treatment. Write the date in the ‘date’ column,
name of the account in the ‘amount’ column of the account on its credit side in the ledger.
5. Write page number of journal in the ‘folio’ column of the ledger and page number of the ledger
in the ‘LF’ of column of the journal.

Illustration 1
Journalize the following transactions and post them in the ledger

January 1 Commenced business with cash 50000

January 3 Paid into bank 25000
January 5 Purchased furniture for cash 5000
January 8 Purchased goods and paid by cheque 15000
January 8 Paid for carriage 500
January 14 Purchased Goods from K. Murthy 35000
January 18 Cash Sales 32000
January 20 Sold Goods to Ashok on credit 28000
January 25 Paid cash to K. Murthy in full settlement 34200
January 28 Cash received from Ashok 20000
January 31 Paid Rent for the month 2000
January 31 Withdrew from bank for private use 2500

JOURNALIZING THE TRANSACTIONS (UGXS IS THE MONEY UNIT )

POSTING TO THE LEDGER
BALANCING OF AN ACCOUNT
Balancing of an account is the difference between the total of debits and total of credits of an
account. If debit side total is more than the credit side, the account shows a debit balance. Similarly,
the balance will be credit if the credit side total of an account is more than the debit side total. This
process of ascertaining and writing the balance of each account in the ledger
is called balancing of an account. An account has two sides: debit and credit. Items by which this
account is debited are entered on its debit side with their amounts and items by which this account
is credited are entered on its credit side with their amounts so all items related to an account are
shown at one place in the ledger. But then you would like to know the net effect of this account
i.e. the balance between its debit amount and credit amount. The following steps are to be followed
in Balancing the Ledger Account:
• Total up the two sides of an Account on a rough sheet.
• Determine the difference between the two sides. If the credit side is morethan the debit
side, the balance calculated is a credit balance.
• Put the difference on the ‘Shorter side’ of the account such that the totals of the two sides
of the account are equal.
• If the difference amount is written on debit side (i.e., if credit. side is bigger) then write as
“Balance c/d” (c/d stands for carried down). If difference is written on the credit side (i.e.,
if debit side is bigger) then write it as “Balance c/d.
• Finally at the end of the year all the ledger accounts are closed by taking out the balance of
each account.
The Balance then should be brought down or carried forward to the next period. If the difference
was put on credit side as “Balance c/d” it should now be written on the debit side of the account
as “Balance b/d” (b/d stands for brought down) and vice-a-versa. Thus debit balance will
automatically be brought down on the debit side and a credit balance on the credit side.

Balancing of different types of Accounts

Assets: All asset accounts are balanced. These accounts always have a debit balance.
Liabilities: All Liability accounts are balanced. All these accounts have a credit balance.
Capital: This account is always balanced and usually has a credit balance.
Expense and Revenue: These Accounts are not balanced but are simply totalled up. The debit
total of Expense/Loss will show the expense/Loss. In the same manner, credit total of Revenue/
Income will show increase in income. At the time of preparing the Trial Balance, the totals of these
are taken to the Trial Balance.
The Balance of Assets, Liabilities and Capital Accounts will be shown in Balance Sheet whereas
total of Expense/Loss and Revenue/Income will be taken to the Trading and Profit and Loss
Account. These Accounts are, thus, closed.
If two sides of an Account (usually Assets, Liabilities and Capital) are equal there will be no
balance. The Account is then simply closed by totaling up of the two sides of the account.

Illustration 2
Take ledger accounts of illustration 1
Solution.
 TRIAL BALANCE

A trial balance is a list of all the nominal ledger (general ledger) accounts contained in the ledger
of a business. This list will contain the name of the nominal ledger account and the value of that
nominal ledger account. The value of the nominal ledger will hold either a debit balance value or
a credit value balance. The debit balance values will be listed in the debit column of the trial
balance and the credit value balance will be listed in the credit column. The profit and loss
statement and balance sheet and other financial reports can then be produced using the ledger
accounts listed on the trial balance.

The trial balance is usually prepared by a bookkeeper who has used day books to record financial
transactions and then post them to the nominal ledgers and personal ledger accounts. The trial
balance is a part of the double-entry bookkeeping system and uses the classic 'T' account format
for presenting values.

If the journal entries are error-free and were posted properly to the general ledger, the total of all
of the debit balances should equal the total of all of the credit balances. If the debits do not equal
the credits, then an error has occurred somewhere in the process. The total of the accounts on the
debit and credit side is referred to as the trial balance.

To calculate the trial balance, first determine the balance of each ledger account as shown in the
following example:

Ledger Accounts Cash

Accounts Receivable
Sep 1 7500
Sep 15 1000
17 400 Sep 17 700 Sep 25 425
28 500
25 425 Bal. 275

Bal. 6825

Parts Inventory Accounts Payable

Sep 8 2500 Sep 18 275 Sep 28 500 Sep 8 2500

Bal. 2225 Bal. 2000

 Capital Revenue

Sep 1 7500 Sep 17 1100

Bal. 7500 Bal. 1100

Expenses

Sep 15 1000

Sep 18 275

Bal. 1275

Once the account balances are known, the trial balance can be calculated as shown below:

Steps to prepare Trial Balance

(i) At first ascertain the balance account wise of all the ledger accounts.
(ii) Write the name of the ledger account in the ledger account column.
(iii) Write against the name of the ledger account, the balance amount/total amount, debit
balance/total in the debit column; and credit balance/total in the credit column.
(iv) Add the debit balance/total amount column and credit balance/total amount column.

Trial Balance- Balance Method

In this method the total of both sides of every account in the ledger is written against the name of
the respective account without balancing them in the form of debit and credit balances
respectively.

Account Title Debits (‘000s Shs) Credits (‘000s Shs)

Cash Account 6825

Accounts Receivable Account 275

Goods Inventory Account 2225

Accounts Payable Account 2000

Capital Account 7500

Revenue Account 1100

Expenses Account 1275

Totals 10600 10600

In this example, the debits and credits balance. This result does not guarantee that there are no
errors. For example, the trial balance would not catch the following types of errors:

• Transactions that were not recorded in the journal

• Transactions recorded in the wrong accounts
• Transactions for which the debit and credit were transposed
• Neglecting to post a journal entry to the ledger

If the trial balance is not in balance, then an error has been made somewhere in the accounting
process. The following is listing of common errors that would result in an unbalanced trial balance;
this listing can be used to assist in isolating the cause of the imbalance.

• Summation error for the debits and credits of the trial balance
• Error transferring the ledger account balances to the trial balance columns
o Error in numeric value
o Error in transferring a debit or credit to the proper column
o Omission of an account
• Error in the calculation of a ledger account balance
• Error in posting a journal entry to the ledger
o Error in numeric value
o Error in posting a debit or credit to the proper column
• Error in the journal entry
o Error in a numeric value
o Omission of part of a compound journal entry

The more often that the trial balance is calculated during the accounting cycle, the easier it is to
isolate any errors; more frequent trial balance calculations narrow the time frame in which an error
might have occurred, resulting in fewer transactions through which to search.

Trial Balance -Totals Method

In this method the total of both sides of every account in the ledger is written against the name of
the respective account without balancing them in the form of debit and credit balances respectively.

Account title Debits (‘000s Shs) Credits (‘000s Shs)

 Cash Account 8325 1500

Accounts Receivable Account 700 425

Goods Inventory Account 2500 275

Accounts payable 500 2500

Capital Account 7500

Revenue Account 1100

Expenses Account 1275

Total 13300 13300

Trial balance limitations

A trial balance only checks the sum of debits against the sum of credits. That is why it does not
guarantee that there are no errors. The following are the main classes of error that are not detected
by the trial balance:

• An error of original entry is when both sides of a transaction include the wrong amount.
For example, if a purchase invoice for £21 is entered as £12, this will result in an incorrect
debit entry (to purchases), and an incorrect credit entry (to the relevant creditor account),
both for £9 less, so the total of both columns will be £9 less, and will thus balance.
• An error of omission is when a transaction is completely omitted from the accounting
records. As the debits and credits for the transaction would balance, omitting it would still
leave the totals balanced. A variation of this error is omitting one of the ledger account
totals from the trial balance.
• An error of reversal is when entries are made to the correct amount, but with debits instead
of credits, and vice versa. For example, if a cash sale for £100 is debited to the Sales
account, and credited to the Cash account. Such an error will not affect the totals.
• An error of commission is when the entries are made at the correct amount, and the
appropriate side (debit or credit), but one or more entries are made to the wrong account of
the correct type. For example, if fuel costs are incorrectly debited to the postage account
(both expense accounts). This will not affect the totals.
• An error of principle is when the entries are made to the correct amount, and the
appropriate side (debit or credit), as with an error of commission, but the wrong type of
account is used. For example, if fuel costs (an expense account), are debited to stock (an
asset account). This will not affect the totals.
• Compensating errors are multiple unrelated errors that would individually lead to an
imbalance, but together cancel each other out.
• A Transposition Error is a Computing error caused by switching the position of two
adjacent digits. Since the resulting error is always divisible by 9, accountants use this fact
 to locate the misentered number. For example, a total is off by 72, dividing it by 9 gives 8
which indicates that one of the switched digit is either more, or less, by 8 than the other
digit. Hence the error was caused by switching the digits 8 and 0 or 1 and 9. This will also
not affect the totals.

CASH BOOK

A person after passing his/her senior secondary examination started a grocery store. The
transactions were limited in number and he/she maintained only one register to record them i.e.,
Journal. As the business grows, the number of business transactions increases. Recording all the
transactions only in the Journal becomes very inconvenient and cumbersome. It needs to be divided
into many books. There are various kinds of books that are maintained where the transactions will
be recorded in these books according to their nature, such as Cash book for cash transactions, Sales
Book for credit sales; Purchases Book for credit Purchases and so on. Out of these books, Cash
Book plays a significant role because it records large number of cash items of a business concern.
In this lesson you will learn about Cash Book, its meaning and preparation.

OBJECTIVES
After studying this lesson, you will be able to:
State the meaning of Cash Book; enumerate the types of Cash Book; state the meaning and draw

Simple Cash Book as per format; state the meaning and draw Cash Book with Bank Column as per

format; prepare Simple Cash Book and Cash Book with Bank column; posting of Cash Book in

the ledger; describe the meaning and need of Petty Cash Book; prepare the Petty Cash Book.

7.1 CASH BOOK : MEANING AND SIMPLE CASH BOOK

On your birthday you got gift in the form of cash from your parents, grand parents and some of
your relatives. In the meantime, you got back some money that you have given to your friend as a
loan. You spent this money in buying books and clothes. You went to see movies with your friends.
You purchased some toys for your niece. As per habit you noted down all receipts and payments
in your note book. At the end of the month, you calculated the balance of cash in hand and tallied
it with the actual cash balance with you. You may maintain separate book to record these items of
receipts and payments, this book is known as Cash Book.
Cash Book is a Book in which all cash receipts and cash payments are recorded. It is also one of
the books of original entry. It starts with the cash or bank balance at the beginning of the period.
In case of new business, there is no cash balance to start with. It is prepared by all organisations.
When a cash book is maintained, cash transactions are not recorded in the Journal, and no cash or
bank account is required to be maintained in the ledger as Cash Book serves the purpose of Cash
Account.
Cash Book : Types and Preparation Cash Books may be of the
following Types:
Simple Cash Book, Bank Column Cash Book,
Petty Cash Book

Simple Cash Book

A Simple Cash Book records only cash receipts and cash payments. It has two sides, namely debit
and credit. Cash receipts are recorded on the debit side i.e. left hand side and cash payments are
recorded on the credit side i.e. right hand side. In this book there is only one amount column on its
debit side and on the credit side. The format of a Simple Cash Book is as under:
Format of a Simple Cash Book
Dr Cr
Date Particulars L.F. Amount Date Particulars L.F. Amount
(Ugxs) (Ugxs)

Column-wise explanation is as follows :

Date

In this column Year, Month and Date of transactions are recorded in chronological order.
Particulars
In this column, the name of the account in respect of which cash has been received or payment has
been made is written. Account pertaining to the receipts of cash is recorded on the debit side and
those pertaining to cash payments on the credit side.

Ledger Folio
In this column, it records the page number of the ledger book on which relevant account is
prepared.

Amount
In this column, it records the amount received on debit side and cash paid on its credit side.

Preparation of Simple Cash Book

Cash Book is in a way, a cash account with debit and credit side and Cash account is an asset
account, so the rule followed is Increase in assets to be debited and Decrease in asset is to be
credited. This implies that Cash Book is a book where all the receipts in terms of cash are recorded
on the debit side of the Cash Book and all the payments in terms of cash are recorded on its credit
side. This means :
Cash Book records all transactions related to receipts and payments in terms of Cash only.
On the debit side in the particulars column, the name of the account, for which cash is received is
recorded. Similarly, on the credit side, the name of account for which cash is paid, is recorded. In
the amount column the actual cash paid or received is recorded. At the end of the month, cash book
is balanced. The cash book is balanced in the same manner an account is balanced in the ledger.
The total of the debit side of the cash book is compared with the total of the credit side and the
difference if any is entered on the credit side of the cash book under the particulars column as
balance c/d. In case of Simple Cash Book, the total of debit side is always more than the total of
the credit side, since the payment can never exceed the available cash. The difference is written in
the amount column and total of the both sides of the cash book becomes equal. The closing balance
of the credit side becomes the opening balance for the next period and is written as Balance b/d on
the Debit side of the Cash Book for the following period.
Recording of cash transactions in the Simple Cash Book and its balancing is illustrated with the
help of the following illustrations :

Illustration 1
Enter the following transactions in the cash book of M/s. Rohan Traders:
Date Details Amount (Ugxs.)
2005
December 01 Cash in Hand 27,500
December 05 Cash received from Nitu 12,000
December 08 Insurance Premium paid 2,000
December 10 Furniture purchased 6,000
December 14 Sold Goods for cash 16,500
December 18 Purchased Goods from Naman for cash 26,000
December 22 Cash paid to Rohini 3,200
December 25 Sold Goods to Kanika for cash 18,700
December 28 Cash Deposited into Bank 5,000
December 30 Rent paid 4,000
Solution

Books of M/s. Rohan Traders

Cash Book

Date Particulars L.F Amount Date Particulars L.F Amount

(Ugxs) (Ugxs)
2005 2005
Dec.01 Balance b/d 27,500 Dec.08 Insurance premium 2,000
Dec.05 Nitu 12,000 Dec.10 Furniture 6,000
Dec.14 Sales 16,500 Dec.18 Purchases 26,000
Dec.25 Sales 18,700 Dec.22 Rohini 3,200

Dec.30 Rent 4,000

Dec.31 Salary 7,000
2006 Jan. 01 Balance b/d Dec.31 Balance c/d 21,500
74,700 74,700
21,500

3 PETTY CASH BOOK : MEANING AND NEED

In big business organisations, a large number of repetitive small payments such as, for conveyance,
cartage, postage, telegrams, courier and other expenses are made. These organisations appoint an
assistant to the Head Cashier. The appointed cashier is known as petty cashier. He makes payments
of these expenses and maintains a separate cash book to record these transactions. Such a cash
book is called Petty Cash Book. The petty cashier works on the imprest system. Under this system,
a definite sum, say Ugxs. 4000/- is given to the petty cashier at the beginning of the period. This
amount is called imprest money. The petty cashier meets all small payments out of this imprest
amount, At the end of the period say one month he presents the account to the Head Cashier and
gets reimbursed from the Head Cashier. Suppose out of Ugxs.4,000 he has spent Ugxs.3,850 by
the end of the month. He will get Ugxs.3,850 from the head cashier. Thus, again he has the full
imprest amount in the beginning of the next period. The process of reimbursement can be weekly,
fortnightly or monthly depending upon the frequency of small payments. The Petty Cashier is
authorised to sanction and disburse small payments. Assignment of the task of making of petty
expenses to a person and the maintenance of petty cash book by him reduces the burden of the
Head Cashier.
The petty cash book has a number of columns for the amount on the payment side. Each of the
amount columns is allotted to items of specific payments, which are common. The last column is
allotted for miscellaneous payments. At the end of the period, all amount columns are totalled. The
total of the amount paid shown in column 5 is deducted from the column 1. At the opening of the
month the total amount paid in the previous month is reimbursed by the Head Cashier.
Format of a Petty Cash Book is given as under:

Petty Cash Book (Format)

Amount Date Particulars Voucher Amount Analysis of Payments
Received No, paid (Ugxs)
Postage Teleph Convey Station Miscell

one & ance ery aneous

Telegr Expenses
am

1 2 3 4 5 6 7 8 9 10

ACCOUNTING ERRORS AND THEIR LOCATION

In life we make many mistakes. As soon as these are detected, he/she corrects them. In the similar
manner, an accountant can also make mistakes or commit errors while recording and posting
transactions. These are called ‘Accounting Errors’. So accounting errors are the errors committed
by persons responsible for recording and maintaining accounts of a business firm in the course of
accounting process. These errors may be in the form of omitting the transactions to record,
recording in wrong books, or wrong account or wrong totalling and so on.

Accounting errors can take the following forms:

• Omission of recording a business transaction in the Journal or Special purpose Books
• Not posting the recorded transactions in various books of accounts to the respective
accounts in ledger
• Mistakes in totalling or in carrying forward the totals to the next page
• Mistake in recording amount wrongly, writing it in a wrong account or on the wrong side
of the account.
Again there may be two types of accounting errors
(i) That cause the disagreement of trial balance,
(ii) That do not affect the agreement of Trial Balance.

Locating Errors
It is obvious that if there are errors they must be located at the earliest. After locating the errors,
they are to be rectified. In accounting also once it is established there are some accounting errors
these need to be located and detected as early as possible. How to locate the errors?
Steps to be taken to locate the accounting errors can be stated as follows:

(A) When the Trial Balance does not agree

(i) Check the columnar totals of Trial Balance
(ii) Check that the balances of all accounts (including cash and bank balances) in the ledger have
been written and are written in the correct column of trial balance i.e. debit balance in the debit
column and credit balance in the credit column.
(iii) Find the exact figure of difference with trial balance and see that:
a. No account of a similar balance has been omitted to be shown
in the Trial Balance or
b. A balance amount which is half of the amount of difference
amount but is written on the wrong side of the trial Balance.
(iv) Recheck the totals of Special Purpose Books.
(v) Check the balancing of the various accounts in the ledger.
(vi) If difference is still not traced, check each and every posting from the
Journal and various Special Purpose Books, one by one in the ledger.

(B) When the Trial Balance agrees.

You have already learnt that if the totals of the two amount columns of trial balance tally it is no
conclusive proof of the accuracy of accounts. There may still be some accounting errors. These
errors may not be immediately traced but may be detected at much later stage. These are rectified
as and when detected.

Following are the errors which don’t affect the trial balance:
(i) Omission to record a transaction in a journal or in a Special Purpose Book. For example, goods
purchased on credit but are not recorded in the Purchases Book at all.
(ii) Recording a wrong amount of an item in journal or in a Special Purpose Book. For example,
sale of U Shs 255,000 on credit entered in the Sales Book as U Shs.525,000.
(iii) Posting the correct amount on the correct side but in wrong account. For example, cash
received from Musoke was credited to Kato.
(iv) An item of Capital Expenditure recorded as an item of Revenue Expenditure and vice-a-versa.
For example, Repairs to Building was debited to Building A/c.

CLASSIFICATION OF ACCOUNTING ERRORS

Various accounting errors can be classified as follows:

A. On the basis of their nature
(a) Errors of omission
(b) Errors of commission
(c) Errors of principle
B. On the basis of their impact on ledger accounts
(a) One sided errors
(b) Two sided errors.

A. On the basis of their nature

(a) Errors of omission
As a rule, a transaction is first recorded in books of accounts. However, an accountant may not
record it at all or record it partially. It is called an error of omission. For example, goods purchased
on credit are not recorded in Purchases Book or discount allowed to a customer was not posted to
Discount A/c in the ledger.
In the first case it is a complete omission. Therefore, both debit and credit are affected by the same
amount. Therefore, it does not affect the Trial Balance.
The second example is the example of partial omission. It affects only one account i.e. Discount
A/c. Therefore it affects Trial Balance.

(b) Errors of commission

When the transaction has been recorded but an error is committed in the process of recording, it is
called an error of commission. Error of commission can be of the following types:

(i) Errors committed while recording a transaction in the Special Purpose books. It may be:
• Recording in the wrong book for example purchase of goods from Musoke on credit is
recorded in the Sales Book and not in the Purchases Book.
• Recording in the book correctly but wrong amount is written. For example, goods sold to
Kato of U Shs 420000 was recorded in the Sales Book as U Shs .240000
In the above two cases two accounts are affected by the same amount, debit of one and the credit
of the other. Therefore, trial balance will not be affected.

(ii) Wrong totalling: There may be a mistake in totalling Special Purpose Book or accounts. The
totalled amounts may be less than the actual amount or more than the actual amount. First is a case
of under casting and the other of overcasting. For example, the total of Purchases Book is written
as U shs 44800 while actual total is U Shs. 44300, the total of Sales Day Book is written as U Shs
52500 while it is U Shs .52900. It is a case of an error affecting one account hence it affects trial
balance.

(iii) Wrong balancing: While closing the books of accounts at the end of the accounting period,
the ledger accounts are balanced. Balance is calculated of the totals of the two sides of the account.
It may be wrongly calculated. For example, the total of the debit column of Mohan’s A/c is
Ugxs.8600 and that of credit column is Ugxs.6800. The balance calculated is as Ugxs.1600 while
the actual balance is Ugxs.1800. It has affected one account only, therefore, the Trial Balance gets
affected.

(iv) Wrong carry forward of balances or totals: Totals or balances are carried forward to the next
page. These may be carried forward incorrectly. For example, the total of one page of the Purchases
Book. of Ugxs.35,600 is carried to next page as Ugxs.36500. Again the error affects one account
only. Therefore, Trial Balance gets affected.

(v) Wrong Posting : Transactions from the journal or special purpose books are posted to the
respective accounts in the ledger. Error may be committed while carrying out posting. It may take
various forms such as, posting to wrong account, to the wrong side of the account or posted twice
to the same account. For example goods purchased of Rs.5400 from Rajesh Mohanti was posted
to the debit of Rajesh Mohanti or posted twice to his account or posted to the credit of Rakesh
Mohanti. In the above examples, only one account is affected because of the error therefore, Trial
Balance is also affected.

Compensating Errors
Two or more errors when committed in such a way that there is increase or decrease in the debit
side due to an error, also there is corresponding decrease or increase in the credit side due to another
error by the same amount. Thus, the effect on the account is cancelled out. Such errors are called
compensating errors. For example, Sohan’s A/c is debited by U Shs 250000 while it was to be
debited by U Shs 350000 and Mohan’s A/c is debited by U Shs 350000 while the same was to be
debited by U Shs 250000 Thus excess debit of Mohan’s A/c by U Shs.100000 is compensated by
short credit of Sohan’s A/c by U Shs.100000.
As the debit amount and the credit amount are equalised, such errors do not affect the agreement
of Trial Balance, but the fact remains that there is still an error.

(c) Error of Principle

Items of income and expenditure are divided into capital and revenue categories. This is the basic
principle of accounting that the capital income and capital expenditure should be recorded as
capital item and revenue income and revenue expenditure should be recorded as revenue item. If
transactions are recorded in violation of this principle, it is called error of principle i.e. the capital
item has been recorded as revenue item and revenue item is recorded as capital item. For example,
U Shs. 5000 spent on the repairs of building is debited to Building A/c while it should have been
debited to Repair to Building A/c. It is a case of error of principle because expenditure on repairs
of building is a revenue expenditure, while it has been debited to Building A/c taking it as an item
of capital expenditure.
As both the sides i.e. credit as well as debit remain affected, the trial Balance also is not affected
by such errors.

B. On the basis of impact on ledger accounts

Errors may affect one side i.e. either debit or credit side of an account or its two sides i.e. both
debit and credit thus errors may be divided as:
(a) One sided errors
(b) Two sided errors
(a) One sided errors
Accounting errors that affect only one side of an account which may be either its debit side or
credit side, is called one sided error. The reason of such error is that while posting a recorded
transaction one account is correctly posted while the corresponding account is not correctly posted.
For example, Sales Book is overcast by U shs.1000. In this case only Sales A/c is wrongly credited
by excess amount of U Shs.1000 while the corresponding accounts of the various debtors have
been correctly debited. Another example of one sided error is U Shs. 2500 received from Ishita is
wrongly debited to her account. In this case, only Ishita’s account is affected, amount in the cash-
book is correctly written. This type of mistake does affect the trial balance.

(b) Two sided errors

The error that affects two separate accounts, debit side of the one and credit side of the other is
called two sided error. Example of such error is purchase of machinery for U Shs.1000 has been
entered in the Purchases Book. In this case, Purchases A/c is wrongly debited while Machinery
A/c has been omitted to be debited. So two accounts i.e. Purchases A/c and the Machinery A/c are
affected.

BANK RECONCILIATION STATEMENT

You operate a bank account in which you deposit money and withdraw money from time to time.
You maintain a record with yourself of these deposits and withdrawals. One day you get your pass-
book (statement issued by the bank) updated but are surprised to find that the balance shown by
the pass book was different from what it should have been as per your records. What will you do
in this case? It is obvious that you will compare the two sets of records and find out items which
are recorded in one but not in the other. Similar situation may arise in case of a business concern
which operates a bank account. These business concerns maintain record of all of their banking
transactions in their bank column of the cash book. On any particular date the bank balance shown
by the bank column cash book and that shown by the pass book should be the same. But if there is
difference between the two, the business concern will find out the reasons to reconcile the balance.
In this lesson you will learn about reasons for difference and prepare the reconciliation statement
called Bank Reconciliation Statement.

OBJECTIVES
After studying this lesson, you will be able to:
State the meaning and need of Bank Reconciliation Statement; explain the reasons for difference
between the balances of Cash Book and Pass Book; prepare the Bank Reconciliation Statement.
BANK RECONCILIATION STATEMENT - MEANING AND NEED
Business concern maintains the cash book for recording cash and bank transactions. The Cash
book serves the purpose of both the cash account and the bank account. It shows the balance of
both at the end of a period. Bank also maintains an account for each customer in its book. All
deposits by the customer are recorded on the credit side of his/her account and all withdrawals are
recorded on the debit side of his/her account. A copy of this account is regularly sent to the
customer by the bank. This is called ‘Pass Book’ or Bank statement. It is usual to tally the firm’s
bank transactions as recorded by the bank with the cash book. But sometimes the bank balances
as shown by the cash book and that shown by the pass book/bank statement do not match. If the
balance shown by the pass book is different from the balance shown by bank column of cash book,
the business firm will identify the causes for such difference. It becomes necessary to reconcile
them. To reconcile the balances of Cash Book and Pass Book a statement is prepared. This
statement is called the ‘Bank Reconciliation Statement. It can be said that :
Bank Reconciliation Statement is a statement prepared to reconcile the difference between
the balances as per the bank column of the cash book and pass book on any given date.

Need of preparing Bank Reconciliation Statement

It is neither compulsory to prepare Bank Reconciliation Statement nor a date is fixed on which it
is to be prepared. It is prepared from time to time to check that all transactions relating to bank are
properly recorded by the businessman in the bank column of the cash book and by the bank in its
ledger account. Thus, it is prepared to reconcile the bank balances shown by the cash book and by
the bank statement. It helps in detecting, if there is any error in recording the transactions and
ascertaining the correct bank balance on a particular date.

INTEXT QUESTIONS
Fill in the blanks with suitable word/words :

1. The copy of customer’s account with the Bank is called ....................

2. The cheques deposited are entered on the .................... of the bank column of cash book.

3. Bank Reconciliation statement is prepared to .................... the bank balance as shown by the
cash book and the bank statement.
4. Cheques issued are posted on the .................... side of the bank column of Cash Book.

5. The credit column of pass book should be equal to .................... column of cash book and debit
column of pass book should equal to ................... column of cash book, if there are no
differences.

REASONS FOR DIFFERENCE

When a businessman compares the Bank balance of its cash book with the balance shown by the
bank pass book, there is often a difference. As the time period of posting the transactions in the
bank column of cash book does not correspond with the time period of posting in the bank pass
book of the firm, the difference arises. The reasons for difference in balance of the cash book and
pass book are as under :

1. Cheques issued by the firm but not yet presented for payment
When cheques are issued by the firm, these are immediately entered on the credit side of the bank
column of the cash book. Sometimes, receiving person may present these cheques to the bank for
payment on some later date. The bank will debit the firm’s account when these cheques are
presented for payment. There is a time period between the issue of cheque and being presented in
the bank for payment. This may cause difference to the balance of cash book and pass book.

2. Cheques deposited into bank but not yet collected

When cheques are deposited into bank, the firm immediately enters it on the debit side of the bank
column of cash book. It increases the bank balance as per the cash book. But, the bank credits the
firm’s account after these cheques are actually realised. A few days are taken in clearing of local
cheques and in case of outstation cheques few more days are taken. This may cause the difference
between cash book and pass book balance.

3. Amount directly deposited in the bank account

Sometimes, the debtors or the customers deposit the money directly into firm’s bank account, but
the firm gets the information only when it receives the bank statement. In this case, the bank credits
the firm’s account with the amount received but the same amount is not recorded in the cash book.
As a result the balance in the cash book will be less than the balance shown in the Pass book.
4. Bank Charges
The bank charge in the form of fees or commission is charged from time to time for various services
provided from the customers’ account without the intimation to the firm. The firm records these
charges after receiving the bank intimation or statement. Example of such deductions is : Interest
on overdraft balance, credit cards’ fees, outstation cheques, collection charges, etc. As a result, the
balance of the cash book will be more than the balance of the pass book.

5. Interest and dividend received by the bank

Sometimes, the interest on debentures or dividends on shares held by the account holder is directly
deposited by the company through Electronic Clearing System (ECS). But the firm does not get
the information till it receives the bank statement. As a consequence, the firm enters it in its cash
book on a date later than the date it is recorded by the bank. As a result, the balance as per cash
book and pass book will differ.

6. Direct payments made by the bank on behalf of the customers

Sometimes, bank makes certain payments on behalf of the customer as per standing instructions.
Telephone bills, rent, insurance premium, taxes, etc are some of the expenses. These expenses are
directly paid by the bank and debited to the firm’s account immediately after their payment. but
the firm will record the same on receiving information from the bank in the form of Pass Book or
bank statement. As a result, the balance of the pass book is less than that of the balance shown in
the bank column of the cash book.

7. Dishonour of Cheques/Bill discounted

If a cheque deposited by the firm or bill receivable discounted with the bank is dishonoured , the
same is debited to firm’s account by the bank. But the firm records the same when it receives the
information from the bank. As a result, the balance as per cash book and that of pass book will
differ.

8. Errors committed in recording transactions by the firm

There may be certain errors from firm’s side, e.g., omission or wrong recording of transactions
relating to cheques deposited, cheques issued and wrong balancing etc. In this case, there would
be a difference between the balances as per Cash Book and as per Pass Book.
9. Errors committed in recording transactions by the Bank
Sometimes, bank may also commit errors, e.g., omission or wrong recording of transactions
relating to cheques deposited etc. As a result, the balance of the bank pass book and cash book will
not agree.

INTEXT QUESTIONS
Given below are statements. Some of these statements are true statements and some of these are
false statements. Write ‘T’ for True and ‘F’ for false statements.
1. Bank credits firm’s account as soon as it receives cheques from the firm.
 2. Bank charges are never entered in the Cash Book.
3. Banks make certain payments on behalf of the customer under his standing instructions.
4. In case of cheques issued but not encashed, the balance of pass book will be less than the
balance of Cash Book.
5. Direct deposits in the bank by a customer would increase the balance shown by the Pass Book.

9.3 PREPARATION OF BANK RECONCILIATION STATEMENT

To reconcile the bank balance as shown in the pass book with the balance shown by the cash book,
Bank Reconciliation Statement is prepared. After identifying the reasons of difference, the Bank
Reconciliation statement is prepared without making change in the cash book balance.
We may have the following different situations with regard to balances while preparing the Bank
Reconciliation statement. These are:

1. Favourable balances
a. Debit balance as per cash book is given and the balance as per pass book is to be
ascertained.
b. Credit balance as per pass book is given and the balance as per cash book is to be
ascertained.

2. Unfavourable balance/overdraft balance

a. Credit balance as per cash book (i.e. overdraft) is given and the balance as per pass book
is to be ascertained.
b. Debit balance as per pass book (i.e. overdraft) is given and the balance as per cash book is
to be ascertained.
The following steps are taken to prepare the bank reconciliation statement:

(i) Favourable balances : When debit balance as per cash book or credit balance as per pass book is
given :

a. Take balance as a starting point say Balance as per Cash Book.

b. Add all transactions that have resulted in increasing the balance of the pass book.

c. Deduct all transactions that have resulted in decreasing the balance of pass book.

d. Extract the net balance shown by the statement which should be the same as shown in the
pass book.

In case balance as per pass book is taken as starting point all transactions that have resulted in
increasing the balance of the Cash book will be added and all transactions that have resulted in
decreasing the balance of Cash book will be deducted. Now extract the net balance shown by the
statement which should be the same as per the Cash book.

FINANCIAL STATEMENTS – AN INTRODUCTION

In the previous lessons you have learnt how to record the business transactions in various books
of accounts and posting into ledger. You have also learnt about balancing the account and
preparing the trial balance. One of the most important purposes of accounting is to ascertain
financial results, i.e., profit or loss of the business operations of a business enterprise after a certain
period and the financial position of it on a particular date. For this certain financial statements are
prepared which are termed as income statement (i.e. Trading and Profit & Loss Account) to know
what the business has earned during a particular period and the Position Statement (i.e. Balance
Sheet) to know the financial position of the business enterprise on a particular date.
In this lesson you will learn about the financial statements that are prepared by a business unit for
profit.

OBJECTIVES

After studying this lesson you will be able to:

Explain the meaning and the objectives of financial statements; classify the financial statements
into Trading and Profit & Loss Account and Balance Sheet; distinguish between capital
expenditure and revenue expenditure, capital receipts and revenue receipts; explain the purpose of
preparing Trading Account and Profit and Loss Account; draw the format of Trading Account and
Profit and Loss Account; l explain the Balance Sheet.

13.1 FINANCIAL STATEMENTS : MEANING AND OBJECTIVES

When a student has studied for a year, he/she wants to know how much he/she has learnt during
that period. Similarly, every business enterprise wants to know the result of its activities of a
particular period which is generally one year and what is its financial position on a particular date
which is at the end of this period. For this, it prepares various statements which are called the
financial statements.

Objectives of financial statements

Financial statements are prepared to ascertain the profits earned or losses incurred by a business
concern during a specified period and also to ascertain its financial position at the end of that
specified period.

Financial statements are generally of two types (a) Income statement which comprises of Trading
Account and Profit & Loss Account, and (b) Position Statement i.e., the Balance Sheet.

Following are the objectives of preparing financial statements: -

Ascertaining the results of business operations

Every businessman wants to know the results of the business operations of his enterprise during a
particular period in terms of profits earned or losses incurred. Income statement serves this
purpose.

Ascertaining the financial position

Financial statements show the financial position of the business concern on a particular date which
is generally the last date of the accounting period. Position statement i.e. Balance Sheet is prepared
for this purpose.

Source of information

Financial statements constitute an important source of information regarding finance of a business

unit which helps the finance manager to plan the financial activities of the business and making
proper utilisation of the funds.

Helps in managerial decision making

The Manager can make comparative study of the profitability of the concern by comparing the
results of the current year with the results of the previous years and make his/her managerial
decisions accordingly.
An index of solvency of the concern

Financial statements also show the short term as well as long term solvency of the concern. This
helps the business enterprise in borrowing money from bank and other financial institutions and/or
buying goods on credit.

Capital Expenditure and Revenue Expenditure, Capital Receipts and Revenue Receipts

The preparation of Trading Account and Profit and Loss Account requires the knowledge of
revenue expenditure, revenue receipts and capital expenditure and capital receipts. The knowledge
shall facilitate the classification of revenue items and put them in the Trading account and Profit
and Loss Account on one hand and prepare Balance Sheet based on capital items (expenditure as
well as receipts) on the other hand.
Capital Expenditure refers to the expenditure incurred for acquiring fixed assets or assets which
increase the earning capacity of the business. The benefits of capital expenditure to the firm extend
to number of years. Examples of capital expenditure are expenditure incurred for acquiring a fixed
asset such as building, plant and machinery etc.
Revenue expenditure, on the other hand, is an expenditure incurred in the course of normal
business transactions of a concern and its benefits are availed of during the same accounting year.
Salaries, carriage etc. are examples of revenue expenditure.
There is another category of expenditure called deferred revenue expenditure. These are the
expenses incurred during one accounting year but are applicable wholly or in part in future periods.
These expenditures are otherwise of a revenue nature. Example of deferred revenue expenditure
are heavy expenditure on advertisement say for introducing a new product in the market,
expenditure incurred on research and development, etc.

Differences between Capital expenditure and Revenue Expenditure

Basis of Capital Revenue

Difference Expenditure Expenditure
1. Purpose It is incurred for It is incurred for the
acquiring of fixed maintenance of fixed assets.
assets.
2. Earning It increases the It helps in maintaining
earning
Capacity capacity of the the earning capacity of the business intact.
business.
3. Periodicity Its benefits are spread Its benefits accrue only in
of benefit over a number of one accounting year.
years.
4. Placement in It is an item of It is an item of Trading
Balance
Financial Sheet and is shown as and Profit and Loss
Statements an item of asset. Account and is shown on the debit side of either of
the two.
5. Occurrence It is non-recurring It is usually a recurring
of
expenditure in nature. expenditure.

Capital and Revenue Receipts

Capital receipts are receipts which do not arise out of normal course of business. Examples of such
receipts are sale of fixed assets, and raising of loans etc. Such receipts are not treated as income of
the enterprise.
Revenue receipts are receipts which arise during the normal course of business, Sale of goods, rent
from tenants, dividend received, etc. are some of the examples of revenue receipts. They are the
items of incomes of the business entity.
 Distinction between Capital Receipts and Revenue Receipts
Basis of Capital Receipts Revenue Receipts
difference
Source Receipts that do not arise during Receipts that do arise during the
normal course of business normal course of business

Nature These are of capital nature and hence are These are of revenue nature and
not treated as items of income of the hence are treated as items of income
business. of the business.

Occurrence These are of non-recurring in nature. These are recurring in nature.

TRADING ACCOUNT

Income statement consists of Trading and Profit and Loss Account. Let us first study the Trading
Account. A business firm either purchases goods from others and sells them or manufactures and
sells them to earn profit. This is known as trading activities. A statement is prepared to know the
results in terms of profit or loss of these activities. This statement is called Trading Account.
Trading Account is prepared to ascertain the results of the trading activities of the business
enterprise. It shows whether the selling of goods purchased or manufactured has earned profit or
incurred loss for the business unit. Cost of goods sold is subtracted from the net sales of the
business of that accounting year. In case the total sales value exceeds the cost of goods sold, the
difference is called Gross Profit. On the other hand, if the cost of goods sold exceeds the total net
sales, the difference is Gross Loss. All accounts related to cost of goods sold such as opening stock,
net purchases i.e. purchase less returns outward, direct expenses such as wages, carriage inward
etc. and closing stock with net sales (i.e. Sales minus Sales returns) are taken to the Trading
Account. Then this account is balanced. Credit balance shows the gross Profit and debit balance
shows the gross loss.
It is necessary to understand the meaning of cost of goods sold before preparing Trading Account.
Cost of goods sold and gross profit
A business enterprise either purchases goods or manufactures goods to sell in the market. Cost of
goods sold is computed to know the profit earned (Gross Profit) or loss incurred (Gross Loss) from
the trading activities of a business unit for a particular period.
Cost of goods sold = the amount of goods purchased + expenses incurred in bringing the goods to
the place of sale or expenses incurred on manufacturing the goods (called direct expenses).
In case there is a stock of goods to be sold in the beginning of the year or at the end of the year,
the cost of goods is calculated as follows:
Cost of goods sold = Opening stock + Net purchases + All direct expenses – Closing stock

Gross Profit = Net sales – Cost of goods sold

Illustration 1
Calculate the cost of goods sold from the following information, amounts in shillings:
Opening stock 10000
Closing stock 8000
Purchases 80000
Carriage on purchases 2000
Wages 6600

Solution:
Cost of goods sold = opening stock + purchases + direct expenses (carriage on purchases +
wages) – closing stock
= Ugx. [10000 + 80000 + 8600 (i.e. 2000 + 6600) – 8000]

= Ugx. 90600

Illustration 2
Calculate cost of goods sold and gross profit from the following information.
Sales 62500
Sales Returns 500
Opening Stock 6400
Purchases 32000
Direct Expenses 4200
Closing Stock 7200
Solution :
Net sales Ugxs.
(Sales-Sales Returns i.e. 62500 – 500) 62000
Less : Cost of goods sold Ugxs.
Opening Stock 6400
Add Purchases 32000
Add Direct Expenses 4200
Less Closing Stock (7200) 35400
26600
 Gross profit = Net sales – cost of goods sold
= 62000 – 35400 = 26600

Illustration 3 (try it out)

From the following information for the year ending 31st March, 2006 furnished by Mr.
Vikram, a trader, calculate cost of goods sold and also calculate Gross Profit/Gross Loss
of business.
Ugxs
Sales 120000
Purchases 80000
Octroi 1600
Carriage on purchases 4500
Purchase Returns 2400
Opening Stock 27600
Closing Stock 32400

Need of Trading Account

Trading Account serves the following purposes:
Knowledge of Gross Profit
Trading Account gives information about Gross Profit. It is the profit earned by a business
enterprise from its trading activities. The percentage of gross profit on sales reflects the
degree of success of business.
Knowledge of All Direct expenses
All direct expenses are taken to trading Account. Direct expenses are the expenses that
can be directly attributed to purchase or manufacturing of goods for sale. Percentage of
Direct expenses on sales of current year when compared with the same of previous years,
helps the manager to exercise control over direct expenses.
Precaution against future losses
Trading Account, if shows gross loss, reasons for this loss can be found out and necessary
corrective steps can be taken.
Format of Trading Account: Trading Account for the year ending …………..
 Particulars Amount Particulars Amount
Rs Rs
Opening Stock Sales
Purchases Less: Sales Returns
Less Purchase Returns Closing stock
Direct Expenses : Gross loss transferred to
Carriage Inward Profit & Loss Account
Freight
Wages
Fuel & Power
Excise Duty
Factory Rent
Heating & Lighting
Factory Rent & Insurance
Work Managers Salary
Gross Profit transferred to Profit & Loss Account

Important items of Trading account

Important items of Trading account are:

Stock refers to the goods lying unsold on a particular date. It can be of two types:

(a) Opening stock and (b) Closing stock

a. Opening stock
Opening stock refers to the value of goods lying unsold at the beginning of the accounting year. It
is shown on the debit side of the Trading Account. In the first year of business there is no opening
stock
 b. Closing Stock
It is the value of goods lying unsold at the end of the accounting year. It is valued at the cost price
or market price whichever is less. It is shown on the credit side of the Trading Account.
Purchases
Purchases mean total items purchased for resale during the year. It can be both in cash and on
credit. Purchases are shown on the debit side of the Trading account. These are always shown as
net purchases i.e. amount of purchases returned (Purchase returns or return outwards) is deducted
from the total amount of purchases made. Goods received on consignment basis are never treated
as purchases. Similarly, goods received on ‘sale or return’ basis are never treated as purchases.
Sales
Sales refer to the total revenue from sale of goods of the business enterprise for which the Trading
account is being prepared. It includes both cash sales and credit sales. These are recorded on the
credit side of the Trading Account. Sales are shown at their net value i.e. sales return or returns
inward is deducted from the total sales. Cash sales plus credit sales minus sales returns constitute
net sales. Goods sent on ‘sale or approval’ are not part of sales until approval is received.
Direct Expenses
Direct expenses are the expenses that can be attributed directly to the purchase of goods or goods
manufactured. These are shown on the debit side of the Trading Account. These are shown at the
amount as shown in the Trial balance. For example, wages are recorded on the debit side of Trading
Account at the amount shown in the Trial balance.

Important items of direct expenses

1. Wages i.e. wages relate to production. If amount under this head includes
wages paid for construction of building or manufacturing of furniture for office
it will be subtracted from the amount of wages.
2. Carriage Cartage Freight i.e. amount paid for carriage of goods purchased for
sale or raw material purchased for manufacturing.
3. Other such direct expenses are customs and import duty, packing materials,
gas, electricity water, fuel, oil, gas greese, heating and lighting, factory rent
and insurance and many more such items.

Gross Profit/Gross Loss

It is the excess of net sales revenue over cost of goods sold. Gross Profit is equal to net
sales minus cost of goods sold. If total of the credit side exceeds the total of debit side, the
excess amount is termed as ‘gross profit’ and is shown on the debit side of Trading
Account. On the other hand if debit side is more than the credit side, the difference in
amount is called gross loss and is shown on the credit side of the Trading Account.
 Gross profit = Net sales – Cost of goods sold
Gross loss = Cost of goods sold – Net sales

PROFIT & LOSS ACCOUNT

As stated earlier, income statement consists of two accounts: Trading Account and Profit & Loss
Account. You have seen that Trading account is prepared to ascertain the Gross profit or Gross
loss of the trading activities of the business. But these are not the final results of business
operations of an enterprise. Apart from direct expenses, there are indirect expenses also. These
may be conveniently divided into office and administrative expenses, selling and distribution
expenses, financial expenses, depreciation and maintenance charges etc
Similarly, there can be income from sources other than sales revenue. These may be interest on
investments, discount received from creditors, commission received, etc. Another account is
prepared in which all indirect expenses and revenues from sources other than sales are written.
This account when balanced shows profit (or loss). This account is termed as Profit and Loss
Account. The profit shown by this account is called ‘net profit’ and if it shows loss it is known as
‘net loss.
Format of Profit and Loss Account
Profit and Loss A/c of M/s ................…..
for the year ended ...............

Particulars Amount Particulars Amount

Rs Rs
Gross loss b/d — Gross Profit b/d —

Salaries — Discount Received —

Rent, Rates & taxes — Commission Received —
Insurance Premium — Dividend Received —
Advertising — Interest on Investment —
Commission paid — Rent Received —
Discount Allowed — Net Loss transferred to capital account —

Repairs & Renewals —

Bad Debts —
Establishment charges —
Travelling Expenses —
Bank Charges —
Sales Tax/Value added Tax —
Depreciation on fixed assets —
Net Profit transferred to —
Capital Account

Some important items of Profit and Loss Account

As stated earlier Indirect expense are written on the debit side of Profit and Loss A/c. These
can be classified under the following heads:

Debit items
1. Selling and distribution expenses
To materialise sales, the expenses incurred are called selling and distribution expenses. Examples
are:
Carriage on sales/carriage outwards, advertisement, selling expenses, travelling expenses
and salesman commission, depreciation of delivery van, salary of driver of the delivery
van, etc.
2. Office and administration expenses
These are the expenses incurred on establishment and maintenance of office. Some of the
expenses that may be under this head are: rent, rates and taxes, postage, printing and
stationery, insurance, legal charges, audit fees, office salaries, etc.
3. Financial expenses
Finances are to be arranged for business. Expenses that are incurred in this connection are
called financial expenses. Some of the financial expenses are: interest on loan, interest on
capital, discount on bills, etc.
4. Depreciation and maintenance charges
The total value of a fixed asset like machinery, building, furniture, etc. is not charged to
profit and loss account in the year in which it is purchased. Such assets help running
business for a number of years to come. Therefore, only a part of the value of such assets
is treated as an expense and is charged to Profit and Loss A/c as depreciation. Depreciation
means decline in the value of fixed asset due to wear and tear, lapse of time, obsolescence,
etc. Expense incurred on repairs and renewals and maintenance of assets are expenses
other than depreciation under this category.
5. Other expenses
These are the expenses which are not included under the above mentioned heads of
expenses for example, losses and expenses due to fire, theft etc.

Credit items
On the credit side of Profit and Loss Account, items of revenue and incomes are written. The
first item on this side of Profit and Loss Account is the gross profit transferred from trading
account. Other items of the credit side are: ( i) Interest on investment, fixed deposits etc. Rent
Received, Commission Received, Discount Received, Dividend on shares.

Need of preparing Profit and Loss Account

Need of preparing profit and loss account by a business concern may be Notes stated as follows :
(i) Knowledge of the net profit or net loss of a business for an accounting year.
(ii) Net profit of one year can be compared with net profits of previous year or years. It helps
in ascertaining whether the business is being conducted efficiently or not.
(iii) Different expenses which are taken to Profit & Loss A/c in one year can be compared with
the amounts incurred in previous year or years. This helps in ascertaining the need of applying
control over such expenses.

BALANCE SHEET
Apart from Trading Account and Profit and Loss Account, Balance Sheet is another financial
statement that is prepared by the every business firm.
This is prepared in order to measure the true financial position of the business organization on a
particular date which is usually the last date of the accounting year.
Financial position of a business unit is the amount of claims against the resources of the business.
Resources are cash, Stock of goods, furniture, machines etc.
It thus shows the assets owned by a business and liabilities owed by it on a particular date. It has
two sides Assets and liabilities.
Assets refer to the financial resources of the business and can be divided broadly into current assets
and Fixed Assets.
 Liabilities show the claims against those assets and can be of two types
Owner’s liability – Capital
Out sider’s liabilities – Creditors, loans etc.
Note that
1. Balance Sheet is prepared to measure the true financial position of a business entity at a
particular point of time.
2. It is a systematic presentation of what a business unit owns and what it owes.
3. Balance Sheet shows the financial position of the concern at a glance.
4. Creditors, financiers are particularly interested in the Balance Sheet of a concern so that they
can decide whether to deal with the concern or not.

There is no prescribed form of a Balance Sheet in which it should be prepared by a sole proprietary
business or a partnership firm. However, an order is generally maintained in which assets and
liabilities are written. This is to maintain uniformity/consistency which facilitates comparative
analysis for decision making. Balance sheet may be prepared in any of the following orders:
(a) Liquidity order (b) Permanency order
(a) Liquidity order
Liquidity means convertibility of assets into cash. Every asset cannot be converted into cash at the
same degree of ease and convenience. Assets are written in the order of their liquidity. Assets of
highest liquidity are written first and next highest follows and so on. Similarly, liabilities are also
written in this very order. Short term liabilities are written first and then long term liabilities and
lastly the capital.A specimen of the balance sheet prepared on the basis of liquidity order is given
below:

Liabilities Assets
Bank overdraft xxxx Cash in hand xxxx
Outstanding Expenses xxxx Cash at Bank xxxx
Bill payables xxxx Prepaid expenses xxxx
Creditors xxxx Investments(short term) xxxx
Bills receivable xxxx
Debtors
Closing Stock
Loans xxxx Investments
Capital xxxx Furniture
Add Net Profit xxxx Plant and Machinery
Less drawings xxxx Land & Buildings
Good Will

Permanency order
While following the order of permanency, assets, which are to be used permanently i.e. for a long
time and not meant for resale are written first. For example, Land and building, Plant and
Machinery, furniture etc. are written first. Assets which are most liquid such as cash in hand is
written in the last. Order of liabilities is similarly changed. Capital is written first, then the long
term liabilities and lastly the short term liabilities and provisions and Specimen of a Balance Sheet
that can be prepared in the order of permanency is as follows:

Liabilities Assets
Capital xxxx xxxx Good Will xxxx
Add Net Profit xxxx xxxx Land & Buildings xxxx
Less drawings xxxx xxxx Plant and Machinery xxxx
Loans xxxx Furniture xxxx
Creditors xxxx Investments xxxx
Bill payables xxxx Closing Stock
Outstanding Expenses xxxx Debtors
Bank overdraft xxxx Bills receivable
Investments(short term)
Prepaid expenses
Cash in hand
Cash at Bank

CLASSIFICATION OF ASSETS AND LIABILITIES

Assets and Liabilities are of various types. These can be classified as under:
(a) Fixed Assets
These are the assets that are purchased for permanent i.e. long term use and these help the business
to earn revenue. Examples of such assets are Building, Machinery, Motor Vehicle, etc. These
assets are not for sale in ordinary course of business but can be disposed off, if no more needed for
business use.
(b) Current Assets
These are the assets which are acquired by the business either for resale or for converting them
into cash. These are normally realised within a period of one year. Examples of such assets are:
cash in hand, cash at bank, bill receivable, debtors, stock etc.

(c) Tangible Assets

These are the assets that can be seen, touched and have certain volume. Building, Machinery,
goods etc. are tangible assets.

(d) Intangible Assets

Assets which can neither be seen nor touched, have no volume are called intangible assets. Patents,
trademark, goodwill etc are the examples of such assets.

(e) Liquid Assets

These are the assets which are either in cash or can be easily converted into cash. For example
cash, stock, marketable securities etc.

(f) Wasting Assets

These are the assets which exhaust or reduce in value by their use. Mines, quarries etc come under
this category.
(g) Fictitious Assets
These are not the real assets. These are the items of such expenses and losses which have not been
written off in full. For example, preliminary expenses, under writing commission, etc.

Liabilities
Liabilities can be classified as follows:

(a) Long term Liabilities

These are the liabilities which are not payable during the current accounting year. Generally, the
funds raised through such means are used for purchase of fixed assets. Examples of such liabilities
are loan on mortgage, loan from financial institutions.

(b) Current Liabilities

These are the liabilities which are payable during the current year. These include Bank overdraft,
trade creditors, bill payable etc.

PREPARATION OF BALANCE SHEET

Balance sheet has two sides: Assets and Liabilities. On the assets side we write all types of assets
such as Cash, Bills Receivable, Stock, Building etc. On the liabilities side all liabilities, are written
both long term liabilities and current liabilities, such as Bills Payable, trade creditors, bank loan
etc.
Next we write owners’ capital. Net profit is added to it. If there is net loss it is deducted from the
capital. Amount of drawings is also deducted from the capital. Finally the two sides are totaled
and the totals should agree.

Illustration
From the following Trial Balance of M/s Vikram Brothers prepare Trading and Profit and Loss
Account for the year ended 31st March 2011 and Balance Sheet as on that date.

Dr. Cr
Particulars Balances Particulars Balance
‘000s ‘000s
Cash in hand 500 Capital 70000
Motor car 25,000 Discount Received 2000
Drawings 48,000 Sales 230000
Legal charges 1,500 Creditors 46000
Plant & Machinery 60,000 Interest on investment 5200
Investments 40,000 Purchases Return 3800
Opening stock 35,000 Bills payable 34000
Sales Returns 2,500
Salaries 12,000
Discount allowed 600
Carriage Inward 1,800
Wages 21,000
Postage 400
Debtors 60,000
Interest 1,500
 Insurance Premium 1,200
Purchases 80,000
391000 391000
Closing stock as on 31.3.2006 Ugxs 2800

Trading A/C for the year

Ended 31 March 2011
st

Particulars Balances Particulars Balance

‘000s ‘000s
Opening stock 35,000 Sales 230,000
Less Sales Returns 2,500 227,500
Purchases 80,000
Less Purchases Returns 3,800 76200 Closing stock 28,000
Wages 21,000
Carriage Inward 1,800
Gross Profit transferred to
Profit & Loss A/C 121,500

255,500 255,500

Profit and loss A/C

For the Year Ended 31 March 2011
st

Insurance Premium 1,200 Gross Profit transferred

Discount allowed 600 from Trading A/C 121,500
Postage 400 Discount received 2000
Interest 1,500 Interest on investment 5200
Legal charges 1,500

Net Profit transferred to Capital

A/C

BALNCE SHEET

LIABILITIES AMOUNT ASSETS AMOUNT

‘000s SHS ‘000s Shs
Bills payable 34,000 Cash in Hand
Capital 70000 Debtors 227,500
Add Net Profit 115000 Closing stock
181500 Investments 28,000
Less Drawings 48000 133,500 Motor Car
Creditors 46,000 Plant and Machinery
 255,500 255,500

Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios
can be calculated from information provided by the financial statements. Financial ratios can be
used to analyze trends and to compare the firm's financials to those of other firms. In some cases,
ratio analysis can predict future bankruptcy.

Financial ratios can be classified according to the information they provide. The following types
of ratios frequently are used:

• Liquidity ratios
• Asset turnover ratios
• Financial leverage ratios
• Profitability ratios
• Dividend policy ratios

Liquidity Ratios

Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

The current ratio is the ratio of current assets to current liabilities:

Current Assets
Current Ratio =

Current Liabilities

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer
a lower current ratio so that more of the firm's assets are working to grow the business. Typical
values for the current ratio vary by firm and industry. For example, firms in cyclical industries
may maintain a higher current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that are difficult to
liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative
measure of liquidity that does not include inventory in the current assets. The quick ratio is defined
as follows:

Quick Ratio =
 Current Assets - Inventory

Current Liabilities

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These
assets essentially are current assets less inventory. The quick ratio often is referred to as the acid
test.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except
the most liquid: cash and cash equivalents. The cash ratio is defined as follows:

Cash + Marketable Securities

Cash Ratio =

Current Liabilities

The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason
immediate payment were demanded.

Asset Turnover Ratios

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are
referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly
used asset turnover ratios are receivables turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collects its accounts receivables and
is defined as follows:

Annual Credit Sales

Receivables Turnover =

Accounts Receivable

The receivables turnover often is reported in terms of the number of days that credit sales remain
in accounts receivable before they are collected. This number is known as the collection period. It
is the accounts receivable balance divided by the average daily credit sales, calculated as follows:

Average Collection Period = Accounts Receivable

 Annual Credit Sales / 365

The collection period also can be written as:

365
Average Collection Period =

Receivables Turnover

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time
period divided by the average inventory level during that period:

Cost of Goods Sold

Inventory Turnover =

Average Inventory

The inventory turnover often is reported as the inventory period, which is the number of days
worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods
sold:

Average Inventory
Inventory Period =

Annual Cost of Goods Sold / 365

The inventory period also can be written as:

365
Inventory Period =

Inventory Turnover

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Financial Leverage Ratios

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the firm is using long term debt.

The debt ratio is defined as total debt divided by total assets:

Total Debt
Debt Ratio =

Total Assets

The debt-to-equity ratio is total debt divided by total equity:

Total Debt
Debt-to-Equity Ratio =

Total Equity

Debt ratios depend on the classification of long-term leases and on the classification of some items
as long-term debt or equity.

The times interest earned ratio indicates how well the firm's earnings can cover the interest
payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:

EBIT
Interest Coverage =

Interest Charges

where EBIT = Earnings Before Interest and Taxes

Profitability Ratios

Profitability ratios offer several different measures of the success of the firm at generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin
considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:

Gross Profit Margin =

Sales - Cost of Goods Sold
 Sales

Return on assets is a measure of how effectively the firm's assets are being used to generate profits.
It is defined as:

Net Income
Return on Assets =

Total Assets

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for
each dollar invested in the firm's stock. Return on equity is defined as follows:

Net Income
Return on Equity =

Shareholder Equity

Dividend Policy Ratios

Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for
future growth. Two commonly used ratios are the dividend yield and payout ratio.

The dividend yield is defined as follows:

Dividends Per Share

Dividend Yield =

Share Price

A high dividend yield does not necessarily translate into a high future rate of return. It is important
to consider the prospects for continuing and increasing the dividend in the future. The dividend
payout ratio is helpful in this regard, and is defined as follows:

Payout Ratio = Dividends Per Share

 Earnings Per Share

Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:

• A reference point is needed. To be meaningful, most ratios must be compared to historical

values of the same firm, the firm's forecasts, or ratios of similar firms.
• Most ratios by themselves are not highly meaningful. They should be viewed as indicators,
with several of them combined to paint a picture of the firm's situation.
• Year-end values may not be representative. Certain account balances that are used to
calculate ratios may increase or decrease at the end of the accounting period because of
seasonal factors. Such changes may distort the value of the ratio. Average values should
be used when they are available.
• Ratios are subject to the limitations of accounting methods. Different accounting choices
may result in significantly different ratio values.

Accounting ratios are very significant in analysing the financial statements. Through accounting
ratios, it will be easy to know the true financial position and financial soundness of a business
concern. However, despite the advantages of ratio analysis, it suffers from a number of
disadvantages. The following are the main limitations of accounting ratios.
Ignorance of qualitative aspect
The ratio analysis is based on quantitative aspect. It totally ignores qualitative aspect which is
sometimes more important than quantitative aspect.
Ignorance of price level changes
Price level changes make the comparison of figures difficult over a period of time. Before any
comparison is made, proper adjustments for price level changes must be made.
No single concept
In order to calculate any ratio, different firms may take different concepts for different
purposes. Some firms take profit before charging interest and tax or profit before tax but after
interest tax. This may lead to different results.
Misleading results if based on incorrect accounting data
Ratios are based on accounting data. They can be useful only when they are based on reliable
data. If the data are not reliable, the ratio will be unreliable.
No single standard ratio for comparison
There is no single standard ratio which is universally accepted and against which a comparison
can be made. Standards may differ from Industry to industry.

Difficulties in forecasting
Ratios are worked out on the basis of past results. As such they do not reflect the present and future
position. It may not be desirable to use them for forecasting future events.