ACCOUNTING CONCEPTS Basic Accounting Concepts Business Entity Concept/Accounting Entity Concept According to this concept, the business

is considered as a separate business entity from its owner(s). Thus the financial information of the business will be recorded and reported separately from its owners personal financial information. Going Concern For accounting purposes, it is assumed that the business will operate for an indefinite period of time and thus considered as going concern. For this reason, the realizable value of the property owned by business will not be relevant. Money Measurement Only those transactions will be recorded in the financial books which can be measured in terms of money. Anything which cannot be measured in monetary terms will not be considered as a part of the accounting data. Historical Cost All assets will be recorded at their cost price. This means that machinery purchased years ago will be recorded at its original cost of purchase even though its value is lower now. The reason for doing so is because the business is considered as a going concern and we need not be worried about the saleable value of the asset. Accounting Period The life a business is considered to be indefinite. But for accounting purposes, the life of the business is divided into specified periods of time. The period may be a month, a half year, a full year or any length of time. Accrual Concept Accrual concept states that revenue is recognized when it is earned and expenses when they are incurred. Any income or revenue generated must be recorded in the books of accounts whether the payment for it is received or not. Similarly, any expense done by the business should be recorded irrespective of the fact that the business has paid for it or not.

Objectivity Any transaction which is recorded in the accounting books should be verifiable. In other words, the transaction should backed by some proof in the form of a receipt, invoice, cheque, voucher etc.

WHAT IS ACCOUNTING AND ITS PURPOSE What is accounting? Accounting is the process of recording, reporting and interpreting financial information pertaining to an organization. Booking keeping is a part of accounting as it only involves recording of economic events. Purpose of Accounting The main purpose of accounting is to provide financial information to different stakeholders. These stakeholders might include

Owner/Shareholders Managers Employees Investors Suppliers Government Lenders

ACCOUNTING CONVENTIONS Accounting Conventions Consistency According to this concept, the same accounting method should be applied in each accounting period when preparing financial reports. This makes it easy to compare results of one period with another period and the stakeholders can get a more realistic idea about the performance of the business. Prudence

It involves being cautious while reporting accounting information. The assets should not be overstated and the liabilities should not be understated. This is why closing stock is always valued at the lower of cost or market value so that the profits are not overstated. Matching Principle This principle is based on accrual concept of accounting. It states that revenue earned during a specific period has to be matched with the expenses incurred with earning that revenue. The following point should be considered:

If an item of revenue is shown in the Profit and Loss account, all expenses incurred on it, whether paid or not, should be shown as expenses in the Profit and Loss account. An expense will be recorded in the books of accounts if the revenue associated with it has not been realized. Incomes received in advance should not be shown in Profit and Loss account. All the cost and expenses incurred on good remaining unsold at end of the year must be carried forward to next year as these goods will be sold in the next accounting period.

WHAT IS ACCOUNTING AND ITS PURPOSE What is accounting? Accounting is the process of recording, reporting and interpreting financial information pertaining to an organization. Booking keeping is a part of accounting as it only involves recording of economic events. Purpose of Accounting The main purpose of accounting is to provide financial information to different stakeholders. These stakeholders might include

Owner/Shareholders Managers Employees Investors Suppliers Government Lenders

ACCOUNTING EQUATION Assets = Owners Equity + Liabilities The above accounting equation expresses the fact that everything the business owns has been supplied by the owner (owners equity) and by external source (liabilities). Elements of Accounting Equation Assets Assets are items of value owned by the business. Examples include

Building Machinery Motor vehicle Cash at bank Cash in hand Stock Debtors (people who own money to the business)

Liabilities These denote the amounts which the business owes to others. Examples include

Creditors (people to whom the business owes money) Bills payable Bank overdraft Bank loan

Owners equity The funds of a business provided for by its owners. Owners equity = Assets Liabilities

Owners equity increases by Owners equity decreases by Profits Losses

Additional investment into the business RULES OF DEBIT AND CREDIT Rules of Debit and Credit

Drawings

There are two systems or practices of putting the accounts. English system Classification of Accounts Personal Accounts Personal accounts are those which are opened under the NAME of individuals, firms, company, institution etc. For example Johns account, dineshs account, Coca-Cola ltd account, bank account etc. Rule

Debit the Receiver Credit the Giver

Real Accounts All the assets owned by the business can be classified in this account. These can be categorized as Tangible real accounts: All those which can be seen, touched and measured such as

Building Land Cash account Stock account Furniture account

Intangible real accounts Those accounts which cannot be touched or seen. Examples include

Goodwill account Patent accounts

Rule

Debit what comes in Credit what goes out

Nominal Accounts These include all those accounts which are related with incomes/gains and expenses/losses of the business.

Incomes/gains Commission received account Discount received account Interest received account Dividends received account

Expenses/losses Rent paid account Salary paid account Commission paid account Discount allowed account Loss due to theft account Loss due to fire account

Rule
o o

Debit all expense and losses Credit all incomes and gains

SOURCE DOCUMENTS What is a Source document? A source document is a written document that provides details of a transaction and the evidence that the transaction has taken place. Source documents form the bases of accounting entries. Features of Source Documents

Source documents contain the following information: Date of transaction. Names and addresses of parties involved in the transaction. Description of the goods or services. Amount involved. Terms and conditions related to trade discounts, cash discount and other details related to delivery. Signature of the concerned parties.

Types of Source Documents Invoice

Issued by the seller to the buyer. Informs how much to be paid for the goods or services supplied. Original copy is send to buyer and duplicate retained by the seller.

more about Invoice... Credit Note

A credit note is issued by the seller to the buyer. In cases where the goods have been overcharged, or when the buyer returns damaged goods. It informs the buyer about the amount credited do the buyers account. Original copy is send to the buyer and duplicate is retained by the seller.

Debit Note

It is issued by the seller to the buyer. It acts as an additional invoice in case the seller has undercharged his goods or services. It informs the buyer about the extra amount which has to be paid to the seller. Original copy is send to the buyer and duplicate is retained by the seller.

Payment Voucher It records the payment of money to a third party. more about Payment Voucher... Cheque Counterfoil It contains information related to cheques issued by the business. It usually informs about the cheque number, payees name and the amount paid. Receipt It acts as an acknowledgement for the payment received. Some retailers also issue the till slip which is considered as goods as a receipt. The original copy is given to the person paying whereas the duplicate is retained by the receiver.

more about Receipt... Bank Statement This is a report sent by the bank to its current account holder. It contains information related with money deposited into the bank and money withdrawn out of the account during a particular period of time. JOURNALS JOURNALS Journal is a book where the information from source documents is first recorded. It is also known as book of original entry. Journal is a book of prime entry in which transactions are copied in order of date. The entries as they are copied, are classified into debits and credits, so as to facilitate them being correctly posted afterwards in the ledger. Journals can be classified as: General Journals Specialized Journals

Sales Journal Returns Inwards Journal Purchases Journal Returns Outwards Journal

The General Journal Format

Recording into the General Journal The following entries are recorded in the General Journal

Opening Entries

These entries usually arise when the business has just started or a new set of books has been opened. Such entry is made on the basis of accounting equation i.e. debiting all assets and crediting liabilities and capital account. Example Sam is opening a new set of books for the accounting year. He is carrying forward his previous years assets and liabilities. On 1st January 2008, he has the following: Building Furniture Debtors Creditors Bank loan Cash $20,000 $10,000 $2,000 $2,000 $4,000 $500

General Journal Date Particulars 1st Building Jan Furniture 2008 Debtors Cash Creditors Bank Loan Capital [Being assets, liabilities and capital recorded ] Dr.($) 20,000 10,000 2,000 500 Cr.($)

2,000 4,000 26,500

Capital is not given and has to be calculated by as follows: Assets-Liabilities =$32,500-$6,000 =$26,500

Closing Entries.

These are entries at the end of the accounting period.

Purchase and sale of fixed assets on credit.

All assets purchased or sold on credit are posted in the General Journal. Assets purchased or sold in cash are recorded in the Cash Book. Example On 12th May, 2008, Sam purchased a Computer on credit for $1000 from Orion computer ltd. General Journal Date Particulars Office equipment Orion computer Ltd [being purchase of Computer on credit] Dr.($) 1000 Cr.($)

1000

Entries which are not recorded in any other Journal.

Example

goods worth $200 were distributed as free sample on 31st March 2008 On the same date Charity $400 in the form of goods

General Journal Date Particulars 31st Advertisement March Charity 2008 Purchases [being goods distributed for advertisement and charity] Purchases Journal This Journal is used to record all the purchases made on credit. Purchase of fixed assets are recorded in General Journal Cash purchases are recorded in Cash Book. Source document used is Invoice received from the supplier. Format of Purchase Journal Dr.($) 200 400 Cr.($)

600

Particular Date Name of the supplier Less Trade discount Purchases Account Dr. Returns Outwards Journal

Invoice Details of no. Invoice ($)

Total ($)

Also known as Purchases Returns Journal. Goods which are purchased on credit but returned later on to the supplier are recorded in this Journal. Source document used is Credit Note. Format of Returns Outwards Journal Date Particular Invoice no. Details of Credit Note ($) X X Total ($)

Name of the supplier Less Trade discount Returns Outwards Account Cr.

X X

Sales Journal Only sales of goods on credit are recorded in the Sales Journal. Cash sales are recorded in the Cash Book. Source document used is Sales Invoice. Format of Sales Journal Date Particular Invoice no. Details of Credit Note ($) X X Total ($)

Name of the customer Less Trade discount Sales Account Cr.

X X

Trial Balance

Trial Balance is a statement prepared with the debit and credit balances of ledger accounts to verify the arithmetical accuracy of the book. The Trial Balance checks the equality of debits and credits in the ledger by listing each account along with its ending balance.

Accounts to be placed on debit side Assets Expenses Drawings

Accounts to be placed on credit side Liabilities Capital Revenue

Errors revealed by Trial Balance Errors in calculation Any calculation mistake, especially totaling mistake or balancing mistake will be revealed by Trial Balance as both the side will not match. Errors of omission of one entry If by mistake only one entry is made for a transaction, Trial Balance will not balance. Posting to the wrong side of an account In case any entry is made on the wrong side of the account, it will be revealed by the Trial Balance. For example Credit sale of $100 was debited to Sales account. Posting of wrong amount When two different amounts are entered for the same entry, both the sides of the Trial balance will not match. For example, Credit sales of $123 to James. James was debited with $123 but Sales was wrongly credited as $132.

Limitation of Trial Balance

Though Trial Balance is prepared to check the arithmetical accuracy of double entries, there are still some mistakes which cannot be identified by Trial Balance. These are: Errors of omission These are errors where the transactions are totally omitted. They are neither recorded in the Journal or Ledge and thus do not appear in the Trial Balance. Errors of commission This means that a wrong amount is entered from the very starting in the Journal or Ledger and thus a Trial Balance based on this amount may not show any mistake at all. Errors of principle These errors occur when the classification of accounts is wrongly done. For example revenue expenditure may be considered as capital expenditure. Repairs of machinery $200 was debited to Machinery account whereas it should have been debited to Repairs of machinery account. Complete reversal of entries Complete reversal of entries cannot be revealed by Trial Balance. This is when entries have been made to both the sides and thus there is no arithmetical mistake. Good sold to Raman were entered as Sales debited and Raman Credited, whereas, it should have been vice versa. Compensating errors These errors are those which cancel themselves because the same error is committed on both sides. For example, Purchases were debited by $100 more and at the same time Sales were also credited by $100. This will neutralize the effect of both the entries. CASH BOOK Cash Book serves dual role of a ledger as well as journal. Cash book is the account which keeps track of all the cash transactions of the business. It is a part of Ledger. Because of the enormously large amount of cash transactions in a typical business, this Cash Account is maintained as a separate book known as CASH BOOK. Cash book is also a book of original entry. Cash book consists of Cash Account and Bank Account.

Cash Account is an Asset account or Real Account and thus, Any increase in Cash or Bank Account is debited to the account and; Any decrease in Cash or Bank account is credited to the account. Cash Book always shows a debit balance.

Types of Cash Book

Single Column Cash Book

Double Column Cash Book

Triple Column Cash Book

Petty Cash Book

Contra Entries These entries are made to record: When money is withdrawn from the bank for office use: It is recorded in cash column on its debit side by writing Bank account in the column of particulars and in bank column of the same cash book but on its credit side by writing Cash account in the column of particulars. When money is taken from Office cash and deposited into bank: When cash is deposited into bank, it is recorded in the bank column of the cash book on its debit side by writing Cash account in the column of particulars and in the cash column of the same cash book but on its credit side by writing Bank account in the column of particulars. Two entries are made in the Cash Book on the same page at the same time. The double entry for each transaction is complete. There will be no more postings of these entries to the ledger and these contra entries are indicated by a sign c in the folio column.

Cash discount A cash discount is a deduction from the amount due. It is given to encourage prompt payment of debts. Cash discount which is given by the trader to its customers is known as Discount allowed. Cash discount is allowed to the customers to encourage prompt payment of their debts. Discount allowed is recorded in the discount column on the debit side of the triple column Cash Book and posted individually to the credit side of the debtors accounts to which they relate. Cash discount received by the trader from its supplier is known as Discount received. The trader ends up paying less by the amount of discount received. Discount received is recorded in the discount column on the credit side of the triple column Cash Book and posted individually to the debit side of the creditors accounts to which they relate.

BANK RECONCILIATION STATEMENT Why is Bank Reconciliation Statement Prepared? Bank reconciliation statement is a statement prepared mainly to reconcile the difference between the Bank Balance shown by the Cash book and Bank statement. Usually, the trader maintains a Bank Column in the Cash book and does all the entries related with bank. At the end of the month, when he receives a Bank statement from the bank he might find some differences between bank balance shown by Bank Statement and his Cash book. These differences might arise due to many reasons. In order to reconcile and tally the differences he will prepare a Bank Reconciliation Statement. Now the question arise, What are the reasons for difference in Bank Statement and Cash Book? These can be summarized as follows:

Cheque issued by the trader but the customer has not yet presented it to the bank for encashment. This will show a less bank balance in the traders Cash book as he has already issued the cheque, but the bank will not reduce the amount till the cheque is presented to it.

Cheque received by the trader was deposited into the bank for collection but the bank did not realize the funds and did not credit the Traders account. Trader deposited a cheque into bank but it was dishonored by the bank. The reason may be the customer does not have sufficient cash in his bank account. Bank pays interest to the trader on his deposit but the trader will not come to know this till he receives the Bank statement and thus his cash book will show less balance as compared to bank statement. Bank might receive direct payment of interest or dividends on behalf of the trader for any investments made by the trader. The trader will not come to know the details till he gets a bank statement and thus his Cash book will be understated. Bank might charge transaction fees or Bank charges or interest on any overdraft which the trader will only know when he receives the bank statement. A customer or debtor might directly pay into the traders bank account and the trader might not be aware of this. A Bank may pay bills, insurance premiums or some payment based on the standing instruction of the trader. The details of these transactions will only be available to the trader once he receives the bank statement.

A bank reconciliation statement can be prepared by taking the balance either as per cash book or as per pass book as a starting point. If the statement is started with the balance as per bank column of the cash book, the answer arrived at the end will be balance as per pass book. Alternatively, if the statement is started with the balance as per pass book, the answer arrived at in the end will be the balance as per cash book. A debit balance as per cash book shows the amount of the money in the bank, whereas, a credit balance means that the business has taken an overdraft. In the same way, a credit balance as per pass book shows a positive bank balance whereas debit balance as per pass book shows an Overdraft. top Methods of Preparing of Bank reconciliation statement

Method 1: Preparing BRS starting with debit balance as per Cash Book Method 2: Preparing BRS starting with credit balance as per Cash Book Method 3: Preparing BRS starting with Credit balance as per Bank Statement Method 4: Preparing BRS starting with Debit balance as per Bank Statement

Preparing Bank Reconciliation Statement from amended/adjusted Cash Book

Method 1: Bank reconciliation statement by Debit balance of Bank Column of Cash Book.

Method 2: Bank reconciliation statement by Credit balance as Cash Book (Overdraft).

Method 3: Bank reconciliation statement by Credit balance as per Bank Statement .

Method 4: Bank reconciliation statement by Debit balance as per Bank Statement (Overdraft).

Preparation of BRS from Adjusted/ Updated/Amended Cash Book There may be times when Cash Book has to be prepared first and then a Bank Reconciliation Statement is prepared on the basis of the balance of Amended Cash Book. Method Step 1 Cash book will be prepared with Bank Column only. It will be started by writing down the balance of Cash Book. Step 2 All errors committed in the Cash Book will be rectified by passing adjusting entries in the Cash Book.

Example:

Cheques issued to creditors but not recorded in the Cash Book Cheques deposited into bank but not recorded in the Cash Book Over casting or under casting of debit/Credit column of Cash Book. Incorrect amount entered in the Cash Book Any amount recorded twice in the Cash Book Interest allowed by Bank Amount directly deposited by Customers in the Bank. Interest and dividend collected by Bank. Interest charged by Bank on Overdraft. Standing instructions.

Note: Only errors made in the Cash Book will be rectified in the amended Cash Book and any other error committed by the Bank is not recorded. Step 3 The Balance arrived in the Amended Cash Book will be the basis for preparing the Bank Reconciliation Statement. Note: Now all the remaining errors made in the Bank Statement will be recorded in the Bank Reconciliation Statement

Example:

Uncredited Cheques. Unpresented Cheques. Any wrong entry in Bank Statement.

Depreciation Depreciation may be defined as the permanent and continuing diminution in the quality or the value of an asset. William Pickles Depreciation is the gradual and permanent decrease in the value of an asset from any cause. R.N. Carter.

Depreciation is fall in the value of the fixed assets (except Land). Depreciation is charged as an expense in the Profit and Loss Account in order to spread the cost of a fixed asset over the assets useful life.

Depreciation is charged on a continuous basis. Once the depreciation is charged, it must be charged on regular basis in the succeeding period also.

Calculation of Depreciation Straight line or Fixed Instalment Method A fixed or equal amount is to be charged as depreciation every year during the life time of the asset. The amount of depreciation remains equal from year to year. The expected lifetime of the asset is calculated and the cost of the asset is spread over its lifetime. Depreciation expense per annum= Original cost/number of years of useful life If the fixed asset is expected to have a scarp value at the end of its useful life, then Depreciation expense per annum= (Original cost-Estimated scrap value)/Number of years of useful life Reducing Balance or Diminishing Balance Method The value of asset goes on diminishing year after year, the amount of depreciation charged every year also goes on declining. Every year a fixed percentage of the net book value of the asset is reduced. For example 20% depreciation is charged. If the asset has a value of $10000, the depreciation for the first year will be 20% of $10000 i.e. $4000. The book value for the next year will be now $6000. This year the depreciation will be again 20% of the remaining value i.e. 20% of 6000=$1200. So the remaining value of the asset is now $6000-$1200=$4800. Revaluation Method Under this method, the fixed asset is valued at the end of every accounting period. The difference between its value at the end of the period and the beginning of the period will be the depreciation for that period. Depreciation expense=Value of asset at the end-Value of asset at the beginning + Any new purchase Recording Depreciation in the Books Once the depreciation expense is calculated, the adjusted entry would be: Method 1

Depreciation Account Dr. Provision for Depreciation Account Cr. The nominal account is closed and the balance transferred to the Profit and Loss Account by: Profit and Loss Account Depreciation Account Dr.

The Provision for Depreciation Account shows the accumulated depreciation on the fixed asset. Like other liability accounts, it is closed by bringing its balance down. The Fixed Assets account is always maintained at its original cost. In the Balance Sheet, the fixed asset is shown at it book value, thus is, cost minus the provision for depreciation. Method 2 In this method, depreciation expense is directly credited into the fixed asset itself. In this case, the book value of the fixed asset is the balance in the Asset Account. The entries are: Depreciation account Fixed asset Account Dr.

Depreciation account is closed and its balance is transferred to the Profit and Loss account. Profit and Loss Account Dr. Depreciation Account The effect on the Profit and Loss account and the Balance Sheet remains unchanged. When no Provision for Depreciation Account is set up to record all the accumulated depreciation, the Fixed asset is brought down to its book value at the close of each accounting period after depreciation is written off.

Final Accounts

Trading Account Profit and Loss Account Balance Sheet

Difference between Trial Balance and Balance Sheet

Final Account Adjustments

Closing Stock Accrued expenses Prepaid expenses Depreciation Accrued income Unearned revenue Interest on Capital Interest on drawings Interest on loan Writing of Bad Debts Provisions for Doubtful Debts Provision for discounts on debtors Provision for discount on creditors

Final Accounts Final Accounts consists of

Trading Account Profit and Loss Account Balance Sheet

Trading Account It is a Nominal Account and is prepared for calculating the GROSS PROFIT or GROSS LOSS arising as a result of trading activities of a business. According to J.R.Batliboi:The Trading Account shows the results of buying and selling of goods. In preparing, this account, the general establishment charges are ignored and only the transactions in goods are included Importance of Trading Account Trading Account is prepared for the following reasons

To know the Gross Profit or Gross loss arising due to trading activities of the business. To find out the direct expenses incurred by the business for the goods sold during the year.

Find out how much closing stock is left as compared to previous years and thus find out the performance of the business. Gives the trader an idea of the increase/decrease in Gross Profit /Gross Loss and to assess the performance of the business and take corrective measures, if needed.

Preparation of Trading Account The following items usually appear in a Trading Account Sales turnover Both Cash and Credit sales are included. Net Sales is recorded after deducting Sales returns (Return inwards). Opening Stock The closing stock of the previous accounting year is taken as the Opening stock for the present year. If there is no Opening Stock then no entry is made. Opening stock is derived by balancing the Stock Account and bringing down its balance to the next period. Purchases Purchases include all the Cash and Credit purchases of goods made by the business during the year. Purchase returns (Return outwards) is deducted from the Purchases to arrive at Net Purchases. Direct Expenses All expenses which are incurred in purchasing the goods and bringing them to the trading place are recorded under this category. These include:

Wages e.g. Warehouse worker wages. Carriage Inwards i.e. the cost of transport of goods to the trading place. The expense is usually borne by the buyer. Duty on purchases, for example, Import duty or excise duty.

Closing Stock All the goods which remain unsold at the end of the year are known as Closing stock. The closing is stock is valued at Cost price or Market price, whichever is lower.

The reason for taking the lower value of the two is in accordance with the Prudence Principle. Normally, Closing stock is given outside the Trial Balance. This is so because its valuation is made after the accounts have been closed. Note:Sometimes, the Closing Stock may be given inside the Trail Balance. This means that the entry to incorporate the closing stock in the books has already been passed and it has already been deducted from the Purchases Account. In this case, Closing Stock will not be shown in the Trading Account will only appear in the Asset side of Balance Sheet. Cost of goods sold This means the finding the cost of only those goods which have been sold during the year. It can be calculated as follows: (Net Purchases+Opening Stock) -Closing Stock Example

On 31st December 2007, the books of XYZ show the following balances:

$ Opening Stock Purchases Sales Return outwards Return inwards Carriage inwards Warehouse worker wages Closing Stock was valued at $400 1000 2600 9000 200 450 40 200

Trading Account of XYZ for the year ended 31st December 2007

$ Opening stock Purchases 2600

$ 1000 Sales Less Returns inwards

$ 9000 450

Less Returns outwards

200

8550

2400 Add Carriage inwards Worker wages 40

200 2640

Cost of goods available for sale Less Closing stock Cost of goods sold Gross Profit

3640

400 3240 5310 8550 8550

PROFIT AND LOSS ACCOUNT According to Prof. Carter: A Profit and Loss Account is an account into which all gains and losses are collected, in order to ascertain the excess of gains over the losses or vice-versa. Why Profit and loss account is made?

To find out the Net Profit or Net Loss

Compare the net profit of the business with previous years and to assess the performance of the business. Find out the amount of overheads of a business.

Items found in a Profit and Loss account Any Incomes or gains Any income or gains of the business from sources other than sales are recorded on the Credit side of Profit and loss account. Gross Profit or Loss It is transferred to the P/L account from the Trading Account. Gross Profit is transferred to the Debit side whereas Gross Loss is transferred to the Credit side. Office and Administrative expenses Example include salaries, office rent, lighting, stationery etc. Selling and Distribution expenses Include advertising expense, commission, carriage outwards, bad-debts etc. Miscellaneous expenses Such as, interest on loan, interest on capital, depreciation etc. Balance Sheet Balance Sheet is a statement which shows the financial position of the business on a particular day. According to A. Palmer The Balance Sheet is a statement at a particular date showing on one side the traders property and possessions and on the other hand the liabilities. Thus we can say that

Balance sheet is a statement not an account. It is prepared to show the financial position of the business. It records all the assets and liabilities of the business. It shows the financial position on a particular day not for a period of time.

Need and Importance of Preparing a Balance Sheet A Balance Sheet serves the following purposes:

The true financial position of the business can be ascertained at a particular point of time. Reveals the amount of assets owned by the business for example machinery, cash, debtors and so on. Show the liabilities of the business such as total creditors, share capital etc. To adjudge weather the firm is solvent or not. Opening entries for the next financial year are based on the Balance Sheet of the previous year.

Items appearing on a Balance Sheet Assets Assets of a business are what it owns. They can be classified as: Fixed assets: All those assets which are owned by the business and last for more than an accounting year. Examples include Land, building, machinery, vehicle, furniture and fixtures and the like. Current assets: It includes all those assets which either in the form of cash or can be easily converted into cash within one accounting period. Current Assets include Cash, Debtors and Stock. Liabilities Liabilities represents what the business owes to outside persons other than owners. These liabilities are classified on basis of time period of repayment. Long term liabilities: These are liabilities which the business owes for more than one accounting period, e.g. long term bank loans, debentures etc. Current liabilities: These are short term debts of the business that are to be repaid within one accounting period, e.g. creditors and bank overdraft. Owners Equity Owners equity represents what the business owes its owner. It is equal to total assets minus total liabilities. Important points regarding Balance Sheet

The Balance Sheet is not an account but a statement. It does not have debit or credit side but has two sections i.e. assets and liabilities.

The heading of Balance Sheet is as on a particular date. Thus a Balance Sheet may have different figure on different dates. The balances shown in the Balance Sheet act as Opening Balances for the next accounting period. Balance Sheet is based on the accounting equation Assets= Owners Equity + Liabilities

Difference between Trial Balance and Balance Sheet Objective Trial Balance is prepared to verify the arithmetical accuracy of the books of account whereas Balance Sheet shows the financial position of the business. Headings Trial Balance is two sides i.e. Debit and Credit whereas Balance Sheet has Assets and Liabilities. Profit and Loss Trial Balance does not show any information about the profit or loss of a business, whereas Balance Sheet records the Profit or Loss of the business. Closing stock The valuation of closing stock is not necessary to prepare a Trial Balance whereas Balance Sheet cannot be prepared unless the Closing stock for that particular accounting year is not ascertained. Types of Accounts Balances of all types of accounts are recorded in a Trial Balance i.e. Personal, real and nominal. Balance Sheet records balances of personal and real accounts only. Adjustments Adjustment for outstanding expenses, prepaid expenses and accrued incomes are not required for the preparation of Trial Balance. A Balance sheet is only complete after all the necessary adjustments are made. Final Account Adjustments

Closing Stock Closing stock refers to the goods remaining unsold during the year. They are valued at Cost price or Market Price whichever is lower. Closing entries Closing Stock Account Dr. Trading Account (For closing Stock transferred to trading account) Treatment in Final Accounts When closing stock is given outside the Trial Balance It will appear on

Cr.

The credit side of the Trading Account Under Current Assets in the Balance Sheet.

When closing stock appears inside the Trail Balance This means that the Closing stocks have already been deducted from the Purchases and thus it will ONLY appear in the Balance Sheet under Current Assets. Accrued Expenses Accrued expenses or outstanding expenses Expenses which have been incurred but not been paid for till the end of the accounting year are known as Accrued expenses or outstanding expenses. For example, Total salaries to be paid for the year were $10,000, but by the end of the year $1000 were not paid and will be treated as outstanding salary. Adjusting Entry Salaries Account Outstanding Salaries Account (Being salaries outstanding) Accounting treatment Dr. Cr.

Outstanding expense amount is added to that particular expense account in the Profit and loss or Trading Account because it was the expense for that year. (Based on the matching principle) Outstanding expenses are liabilities for the business. Thus they will appear under the Current Liabilities in the Balance Sheet. Note: If the Outstanding expense appears in the Trial Balance then it will only be recorded in the Liabilities side of the Balance Sheet. Prepaid Expenses Prepaid Expenses All those expenses which are due next year but paid for in advance during the current year are termed as Prepaid Expenses. Adjustment Entries

Prepaid Expense Account Expense Account (For expense paid in advance) Accounting Treatment

Dr. Cr.

The concerned expense will be deducted by the prepaid amount in the Trading Account or Profit & Loss account. Prepaid expenses are assets for the business thus it will appear under the Current Assets in the Balance Sheet.

Note: If the Prepaid expense is given inside the Trial Balance, then the prepaid expense will only appear in the Current Asset of the Balance Sheet.

Treatment of Depreciation in Final Accounts Depreciation Depreciation is the fall in the value of fixed assets over a period of time. Adjustment Entries

Depreciation Account Assets Account (Being depreciation charged) Accounting Treatment

Dr. Cr.

Depreciation amount is entered as expense on the Debit Side of Profit and Loss account. Depreciation is deducted from the value of the concerned asset in the Balance Sheet.

Accrued Income Incomes which are earned during the year but not received till the end of the accounting year are termed as Accrued Income / Earned Incomes/ Income Receivable. Adjustment Entries

Accrued Income Account Income Account (Being income received in advance) Accounting treatment

Dr. Cr.

Accrued income will be added to the concerned income account in the Profit and Loss account because it the income for that particular year (matching principle) Accrued incomes are asset for the business and appear under the Current Assets in the Balance Sheet. Note: If Accrued Incomes appear inside the Trial Balance then it will ONLY appear under the Current Assets in the Balance Sheet. Unearned Income/Revenue All incomes or revenues which are received in advance but not earned during the year are treated as unearned revenue. There may be times when a certain income is received in the current year but the whole amount of it does not belong to the current year.

Adjusting Entries

Revenue Account Revenue received in advance Account (For revenue received in advance) Accounting Treatment

Dr. Cr.

Unearned incomes/revenues are not the actual income for that particular year and thus deducted from that particular revenue account in the Profit and Loss Account. Unearned incomes/revenues are treated as liability for the business and thus appear under the Current Liabilities in the Balance Sheet.

Note: If unearned income/revenue appears inside the Trial balance then it will ONLY appear under the Liabilities in the Balance Sheet. Interest on Capital Usually the owner gets an Interest on his investment the business. According to the principle of separate entity, Capital is considered as Liability for the business and the owner is paid a certain amount of interest on the capital employed. Accounting Entries

Interest on Capital Capital Account (Interest allowed on Capital) Accounting Treatment in Final Accounts

Dr. Cr.

Interest on Capital is an expense for the business and thus appears on the Debit side of the Profit and Loss account. It is a gain for the owner and thus it is added to the Capital in the Balance Sheet. Interest on Drawings Many times during the operation of business, the owner may take out some cash from the business for his personal use. These withdrawals from the business are

considered as Drawings. Considering the fact that the business is a separate accounting entity, it charges an interest on the drawings to the owner. Adjusting Entries

Drawing Account Interest on drawings account (Being interest charged on drawings) Accounting Treatment

Dr. Cr.

Interest on drawings is an income for the business and appears on the Credit side of the Profit and Loss Account. Interest on drawings is an expense for the proprietor and thus it is deducted from the Capital Account in the Balance Sheet. Interest on Loan Interest paid on loans taken by the business is treated as expense and will appear on the Debit side of the Profit and loss account. Sometimes the interest on loan may not be fully paid and may be outstanding when the final account is prepared. In this case, the Interest on loan account will be debited by the outstanding interest amount. Adjusting Entries

Interest on Loan account Dr. Outstanding Interest account Cr. (Being outstanding interest on loan) Accounting treatment Interest on loan is an expense for the business and appears on the Debit side of the Profit and Loss account. Interest on loan is a liability for the business and is added to the Loan Account in the Liabilities section of the Balance Sheet. Writing off Bad Debts

There may be occasions when the business might not be able to collect its debts. This may be due to the dishonesty of a debtor or may be due to the death or insolvency of a debtor.

Bad Debts Account Debtors Account (Bad debts written off)

Dr. Cr.

This amount is then written off the books as Bad debts. It is a loss for the business and thus it is written on the debit side of the Profit and Loss account. Closing Entry

Profit and Loss Account Dr. Bad Debts Account Cr. (Transfer of bad debts to Profit and loss Account) Accounting Treatment Bad debts appear on the debit side of the Profit and Loss account because it is a loss. Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet. Recovery of Bad Debts Sometime a debts written off as Bad debts may be recovered later on. Cash is coming in thus Cash account is debited whereas Recovery of bad debts is credited because it a gain. Accounting Entries Cash Account Recovery of bad debts (Being bad debts recovered) Dr. Cr.

Recovery of bad debts Profit and Loss account (Being transfer of recovery of bad debts to Profit and Loss Account) Partial Settlement of Debtors

Dr. Cr.

Sometimes, a business might only be able to recover a part of the debts. This means the rest of the unrecovered debts will be written off as bad debts. Accounting Entries

Cash Account Bad Debts Account Debtors Account (Being partial recovery of debts) Provision for Doubtful Debts

Dr. Dr. Cr.

Even after deducting the amount of actual bad-debts from the Debtors, there may still be some debts which may be regarded as bad or doubtful. Thus a business might make an estimate of the amount of such doubtful debts, that is, debts that are likely to become bad, and charge them as an expense against the current periods revenue. When Provision for Doubtful Debts is set up for the first time Accounting Entries

Doubtful Debts Account Provision for doubtful debts (Being creation of provision for doubtful debts) Closing Entries

Dr. Cr.

Doubtful Debts Account is an expense for the business and thus it will be debited to the Profit and Loss account

Profit and Loss Account Dr. Doubtful debts Account Cr. (Being transfer of doubtful debts expense to the Profit and Loss Account) It will be deducted from the Sundry Debtors in the Balance Sheet. Increasing the Existing Provision for Doubtful Debts Adjusting Entry

Doubtful debts Account Provision for doubtful debts Account (Being increase of provision for doubtful debts) Closing Entry

Dr. Cr.

Being a loss for the business the Doubtful Debts Account is transferred to the debit side of Profit and Loss Account.

Profit and Loss Account Dr. Doubtful Debts Cr. (Being transfer of doubtful debts expense to the Profit and Loss Account) Decreasing the Existing Provision for Doubtful Debts Adjusting Entry

Provision for doubtful debts Account Dr. Doubtful debts Account Cr. (Being decrease of provisions for doubtful debts) Closing Entry

Being a gain for the business the Doubtful Debts Account is transferred to the Credit side of Profit and Loss Account.

Doubtful Debts Account Dr. Profit and Loss Account Cr. (Being transfer of doubtful debts expense to the Profit and Loss Account) In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts. Provision for Discount on Debtors A provision for discounts to debtors who pay early is created in the current year itself. Accounting Entries Profit and Loss Account Dr. Provision for Discount on Debtors Account (For provision for discount created on Debtors) It is shown on the Debit side of the Profit and Loss Account. Provision for Discount on Debtors is deducted from the Debtors in the Balance Sheet. Note: Provision for discount on debtors will be deducted after Further bad debts and Provision for doubtful debts are deducted from the Debtors. Provision for Discount on Creditors When the business makes prompt payments of its debts, it is bound to receive Discounts from its creditors. Although the discounts will be earned in the next year, the discounts so earned are an income of the current year. A Provision for such discount is made in the current year itself so that that the discounts thus earned may be credited to the Profit and Loss Account of the current year.

Provision for Discount on Creditors Account Profit and Loss Account (For provision for discount on Creditors)

Dr. Cr.

Accounting Treatment Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss Account. It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet. Provision for Discount on Debtors A provision for discounts to debtors who pay early is created in the current year itself. Accounting Entries Profit and Loss Account Dr. Provision for Discount on Debtors Account (For provision for discount created on Debtors) It is shown on the Debit side of the Profit and Loss Account. Provision for Discount on Debtors is deducted from the Debtors in the Balance Sheet. Note: Provision for discount on debtors will be deducted after Further bad debts and Provision for doubtful debts are deducted from the Debtors. Provision for Discount on Creditors When the business makes prompt payments of its debts, it is bound to receive Discounts from its creditors. Although the discounts will be earned in the next year, the discounts so earned are an income of the current year. A Provision for such discount is made in the current year itself so that that the discounts thus earned may be credited to the Profit and Loss Account of the current year.

Provision for Discount on Creditors Account Profit and Loss Account (For provision for discount on Creditors)

Dr. Cr.

Accounting Treatment

Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss Account. It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.

Characteristics of a Partnership A partnership is an unincorporated association of two or more individuals to carry on a business for profit. Many small businesses, including retail, service, and professional practitioners, are organized as partnerships. A partnership agreement may be oral or written. However, to avoid misunderstandings, the partnership agreement should be in writing. The agreement should identify the partners; their respective business-related duties and responsibilities; how income will be shared; the criteria for additional investments and withdrawals; and the guidelines for adding partners, the withdrawal of a partner, and liquidation of the partnership. For income tax purposes, the partnership files an information return only. Each partner shares in the net income or loss of the partnership and includes this amount on his/her own tax return. Limited life The life of a partnership may be established as a certain number of years by the agreement. If no such agreement is made, the death, inability to carry out specific responsibilities, bankruptcy, or the desire of a partner to withdraw automatically terminates the partnership. Every time a partner withdraws or is added, a new partnership agreement is required if the business will continue to operate as a partnership. With proper provisions, the partnership's business may continue and the termination or withdrawal of the partnership will be a documentation issue that does not impact ongoing operations of the partnership. Mutual agency In a partnership, the partners are agents for the partnership. As such, one partner may legally bind the partnership to a contract or agreement that appears to be in line with the partnership's operations. As most partnerships create unlimited liability for its partners, it is important to know something about potential partners before beginning a partnership. Although partners may limit a partner's ability to enter into contracts on the company's behalf, this limit only applies if the third party entering into the contract is aware of the limitation. It is the partners' responsibility to notify third parties that a particular partner is limited in his or her ability to enter into contracts.

Unlimited liability Partners may be called on to use their personal assets to satisfy partnership debts when the partnership cannot meet its obligations. If one partner does not have sufficient assets to meet his/her share of the partnership's debt, the other partners can be held individually liable by the creditor requiring payment. A partnership in which all partners are individually liable is called a general partnership. A limited partnership has two classes of partners and is often used when investors will not be actively involved in the business and do not want to risk their personal assets. A limited partnership must include at least one general partner who maintains unlimited liability. The liability of other partners is limited to the amount of their investments. Therefore, they are called limited partners. A limited partnership usually has LLP in its name. Ease of formation Other than registration of the business, a partnership has few requirements to be formed. Transfer of ownership Although it is relatively easy to dissolve a partnership, the transfer of ownership, whether to a new or existing partner, requires approval of the remaining partners. Management structure and operations In most partnerships, the partners are involved in operating the business. Their regular involvement makes critical decisions easier as formal meetings are not required to get approval before action can be taken. If the partners agree on a change in strategy or structure, or approve a purchase of needed equipment, no additional approvals are needed. Relative lack of regulation Most governmental regulations and reporting requirements are written for corporations. Although the number of sole proprietors and partnerships exceeds the number of corporations, the level of sales and profits generated by corporations are much greater. Number of partners The informality of decision making in a partnership tends to work well with a small number of partners. Having a large number of partners, particularly if all are involved in operating the business, can make decisions much more difficult.

Changes in Partners Partnerships can change with the addition or withdrawal of partners. This section discusses how to account for those changes. New partner Partners may agree to add partners in one or two ways. First, the new partner could buy out all or a portion of the interest of an existing partner or partners. Second, the new partner could invest in the partnership resulting in an increase in the number of partners. The partnership accounts for these changes in partners differently. Buying out existing partner. The capital balances of an existing partnership are: MJM EAM $ 70,000 50,000

Total partnership capital $120,000 If MJM decides to retire and the partners agree to have TLM buy out MJM's partnership interest, the partnership's accounting records must simply reflect the change of ownership. As TLM is buying out MJM's entire interest directly from MJM, the partnership's entry to record the transaction is as follows: General Journal Date 20X0 Mar. 10 MJM, Capital TLM, Capital Buyout of MJM by TLM The cash that MJM receives from TLM is not recorded on the partnership's books as it is an exchange of an investment by individuals with no assets being given to or taken from the partnership. Therefore, it does not matter whether TLM pays $50,000, $70,000, or $100,000 for MJM's partnership interest, the partnership simply records the change in the partner's capital accounts using the current balance in the MJM, capital account. Investment in the partnership. If TLM joins the existing partnership (becoming a third partner) by investing cash of $30,000 in the partnership, the partnership must record the additional cash and establish a capital account for the new partner. The 70,000 70,000 Account Title and Description Ref. Debit Credit

amount recorded as capital for TLM depends on his ownership interest in the partnership. If a difference exists between the cash TLM contributes to the partnership and his ownership interest, the difference is allocated to the existing partners. This difference may increase the existing partners' capital account balances (a bonus to existing partners) or be deducted from the existing partners' capital account balances (a bonus to the new partner). If TLM receives a 20% ownership interest in the partnership for his $30,000 investment, the amount of his initial capital account balance is calculated by adding the $30,000 to the total partnership's capital before his investment and multiplying by 20%, TLM's ownership interest. TLM's capital account would be credited for $30,000 in this case. Existing Capital MJM, Capital EAM, Capital $ 70,000 50,000

Total Existing Capital 120,000 Add: TLM Investment New Capital Balance TLM Ownership % TLM, Capital 30,000 150,000 20% $ 30,000

The entry to record TLM's investment into the partnership would be: General Journal Date 20X0 Mar. 10 Cash TLM, Capital Investment in partnership by TLM If TLM receives a 30% interest for his $30,000 investment, TLM's capital account would be credited for $45,000. Existing Capital MJM, Capital $ 70,000 30,000 30,000 Account Title and Description Ref. Debit Credit

EAM, Capital

50,000

Total Existing Capital 120,000 Add: TLM Investment New Capital Balance TLM Ownership % TLM, Capital 30,000 150,000 30% $ 45,000

The $15,000 difference between his initial capital balance of $45,000 and his cash investment of $30,000 must be deducted from the existing partners' capital account balances according to their sharing of gains and losses. If the current ratio for sharing gains and losses is 60%:40%, the partnership would record TLM's 30% interest with the following entry: General Journal Date 20X0 Mar. 10 Cash 30,000 Account Title and Description Ref. Debit Credit

TLM, Capital Investment in partnership by TLM

45,000

If TLM receives a 15% interest in the partnership for his $30,000 investment, the partnership's cash account would be increased (debited) by $30,000 and TLM's capital account would be increased (credited) by $22,500 (15% $150,000 new capital balance of partnership). Existing Capital MJM, Capital EAM, Capital $ 70,000 50,000

Total Existing Capital 120,000 Add: TLM Investment New Capital Balance TLM Ownership % 30,000 150,000 15 %

TLM, Capital

$ 22,500

The remaining $7,500 would be added (credited) to the two existing partners' capital account balances based on their 60%:40% ratio for sharing gains and losses. MJM's capital account balance would increase $4,500 and EAM's capital account balance would increase $3,000. The entry would look like: General Journal Date 20X0 Mar. 10 Cash MJM, Capital ($7,500 60%) EAM, Capital ($7,500 40%) TLM, Capital Investment in partnership by TLM Retirement or withdrawal of a partner If an existing partner wishes to retire or withdraw from the partnership, the partner may be bought out by an existing partner or may receive assets from the partnership. If an existing partner purchases the interest of the retiring partner, the partnership records an entry to close out the capital account balance of the retiring partner and adds the amount to the capital account balance of the partner who purchased the interest. If the partnership gives assets to the retiring partner in the amount of the partner's capital account balance, an entry is made to reduce the assets and zero out the retiring partner's capital account balance. If the retiring partner receives more assets or fewer assets than the partner's capital account balance, the difference is taken from or added to the capital accounts of the remaining partners according to how they share in gains or losses. Liquidation of a Partnership If the partnership decides to liquidate, the assets of the partnership are sold, liabilities are paid off, and any remaining cash is distributed to the partners according to their capital account balances. If a partner's capital account has a deficit balance, that partner should contribute the amount of the deficit to the partnership. The Statement of Partners' Capital 30,000 4,500 3,000 22,500 Account Title and Description Ref. Debit Credit

The statement of partners' capital shows the changes in each partner's capital account for the year or period being reported on. It has the same format as the statement of owner's equity except that it includes a column for each partner and a total column for the company rather than just one column. The statement starts with the beginning capital balance, followed by the amounts of investments made, share of net income or loss, and withdrawals made during the reporting period to determine the capital balance at the end of the period. The Midland Connection Statement of Partners' Capital For the Year ended December 31, 20X0 Minbiole, CPA Capital balances, January 1, 20X0 Add: Investments Net Income Less: Withdrawals Capital balances, December 31, 20X0 $ 50,000 25,000 40,000 (45,000) $ 70,000 Kaschalk, CPA $ 100,000 10,000 40,000 (30,000) $ 120,000 Total Partnership $ 150,000 35,000 80,000 (75,000) $ 190,000

The $190,000 capital balance for the partnership at December 31, 20X0 would be the amount reported as owners' equity in The Midland Connection's balance sheet as of December 31, 20X0.