Regular Study - Accounting & Finance for Bankers

 

Regular Study - Basic Accounting Terms
The understanding of the subject becomes easy when one has the knowledge of a few
important terms of accounting. Let us go through some of them.
Transactions
Transactions are those activities of a business, which involve transfer of money or goods or
services between two persons or two accounts. For example, purchase of goods, sale of
goods, borrowing from bank, lending of money, salaries paid, rent paid, commission
received and dividend received. Transactions are of two types, namely, cash and credit
transactions.
Cash Transaction is one where cash receipt or payment is involved in the transaction. For
example, When You buys goods from a seller paying the price of goods by cash
immediately, it is a cash transaction.
Credit Transaction is one where cash is not involved immediately but will be paid or
received later. In the above example, if You, do not pay cash immediately but promises to
pay later, it is credit transaction.
Proprietor
A person who owns a business is called its proprietor. He contributes capital to the business
with the intention of earning profit.
Capital
It is the amount invested by the proprietor/s in the business. This amount is increased by the
amount of profits earned and the amount of additional capital introduced. It is decreased by
the amount of losses incurred and the amounts withdrawn. For example, if Mr. Ram starts
business with Rs.10,00,000, his capital would be Rs.10,00,000.
Assets
Assets are the properties of every description belonging to the business. Cash in hand, plant
and machinery, furniture and fittings, bank balance, debtors, bills receivable, stock of
goods, investments, Goodwill are examples for assets. Assets can be classified into tangible
and intangible.
Tangible Assets: These assets are those having physical existence. It can be seen and
touched. For example, plant & machinery, cash, etc.
Intangible Assets: Intangible assets are those assets having no physical existence but their
possession gives rise to some rights and benefits to the owner. It cannot be seen and
touched. Goodwill, patents, trademarks are some of the examples.
Liabilities
Liabilities refer to the financial obligations of a business. These denote the amounts which a
business owes to others, e.g., loans from banks or other persons, creditors for goods
supplied, bills payable, outstanding expenses, bank overdraft etc.
Drawings
It is the amount of cash or value of goods withdrawn from the business by the proprietor for
his personal use. It is deducted from the capital.
Debtors
A person (individual or firm) who receives a benefit without giving money or money’s
worth immediately, but liable to pay in future or in due course of time is a debtor. The
debtors are shown as an asset in the balance sheet. For example, Mr. Ravi bought goods on
credit from Mr. Ram for Rs.10,000. Mr. Ravi is a debtor to Mr. Ram till he pays the value
of the goods.
Creditors
A person who gives a benefit without receiving money or money’s worth immediately but
to claim in future, is a creditor. The creditors are shown as a liability in the balance sheet. In
the above example Mr. Ram is a creditor to Mr. Ravi till he receive the value of the goods.
Purchases
Purchases refers to the amount of goods bought by a business for resale or for use in the
production. Goods purchased for cash are called cash purchases. If it is purchased on
credit, it is called as credit purchases. Total purchases include both cash and credit
purchases.
Purchases Return or Returns Outward
When goods are returned to the suppliers due to defective quality or not as per the terms of
purchase, it is called as purchases return. To find net purchases, purchases return is
deducted from the total purchases.
Sales
Sales refers to the amount of goods sold that are already bought or manufactured by the
business. When goods are sold for cash, they are cash sales but if goods are sold and
payment is not received at the time of sale, it is credit sales. Total sales includes both cash
and credit sales.
Sales Return or Returns Inward
When goods are returned from the customers due to defective quality or not as per the terms
of sale, it is called sales return or returns inward. To find out net sales, sales return is
deducted from total sales.
Stock
Stock includes goods unsold on a particular date. Stock may be opening and closing stock.
The term opening stock means goods unsold in the beginning of the accounting period.
Whereas the term closing stock includes goods unsold at the end of the accounting period.
For example, if 5,000 units purchased @ Rs. 30 per unit remain unsold, the closing stock is
Rs. 1,50,000. This will be opening stock of the subsequent year.
Revenue
Revenue means the amount receivable or realised from sale of goods and earnings from
interest, dividend, commission, etc.
Expense
It is the amount spent in order to produce and sell the goods and services. For example,
purchase of raw materials, payment of salaries, wages, etc.
Income
Income is the difference between revenue and expense.
Voucher
It is a written document in support of a transaction. It is a proof that a particular transaction
has taken place for the value stated in the voucher. It may be in the form of cash receipt,
invoice, cash memo, bank pay-in-slip etc. Voucher is necessary to audit the accounts.
Invoice
Invoice is a business document which is prepared when one sell goods to another. The
statement is prepared by the seller of goods. It contains the information relating to name and
address of the seller and the buyer, the date of sale and the clear description of goods with
quantity and price.
Receipt
Receipt is an acknowledgement for cash received. It is issued to the party paying cash.
Receipts form the basis for entries in cash book.
Account
Account is a summary of relevant business transactions at one place relating to a person,
asset, expense or revenue named in the heading. An account is a brief history of financial
transactions of a particular person or item. An account has two sides called debit side and
credit side.
Regular Study - Classification of Accounts
Classification of Accounts
Transactions can be divided into three categories.
i. Transactions relating to individuals and firms
ii. Transactions relating to properties, goods or cash
iii. Transactions relating to expenses or losses and incomes or gains.
Therefore, accounts can also be classified into Personal, Real and Nominal. The
classification may be illustrated as follows
Personal Accounts:
Accounts recording transactions relating to individuals or firms or company are known as
personal accounts. Personal accounts may further be classified as:
(i) Natural Person’s personal accounts: The accounts recording transactions relating to
individual human beings e.g., Anand’s a/c, Ramesh’s a/c, Pankaj a/c are classified as natural
persons’ personal accounts.
(ii) Artificial Persons’ Personal accounts: The accounts recording transactions relating to
limited companies, bank, firm, institution, club, etc., Delhi Cloth Mill; M/s Sahoo & Sahoo;
Hans Raj College; Gymkhana Club are classified as artificial persons’ personal accounts.
(iii) Representative Personal Accounts: The accounts recording transactions relating to
the expenses and incomes are classified as nominal accounts. But in certain cases (due to
the matching concept of accounting) the amount, on a particular date, is payable to the
individuals or recoverable from individuals. Such amount (i) relates to the particular head of
expenditure or income and (ii) represent persons to whom it is payable or from whom it is
recoverable. Such accounts are classified as representative personal accounts e.g., “wages
outstanding account”, pre-paid Insurance account, etc.
The proprietor being an individual his capital account and his drawings account are
also personal accounts.
Impersonal Accounts
All those accounts which are not personal accounts. This is further divided into two types
viz. Real and Nominal accounts.
i. Real Accounts: Accounts relating to properties and assets which are owned by the
business concern. Real accounts include tangible and intangible accounts. For example,
Land, Building, Goodwill, Purchases, etc.
ii. Nominal Accounts: These accounts do not have any existence, form or shape. They
relate to incomes and expenses and gains and losses of a business concern. For example,
Salary Account, Dividend Account, etc.
Rules of debit and credit (classification based)
1. Personal accounts : Debit the receiver - Credit the giver (supplier)
2. Real accounts : Debit what comes in - Credit what goes out
3. Nominal accounts : Debit expenses and losses - Credit incomes and gains

Regular Study - Process of Accounting
Accounting is “the process of identifying, measuring and communicating economic
information to permit informed judgements and decision by users of the information”.
Process of Accounting
The process of accounting as per the above definition is given below:
In order to accomplish its main objective of communicating information to the users,
accounting embraces the following functions.
i. Identifying: Identifying the business transactions from the source documents.
ii. Recording: The next function of accounting is to keep a systematic record of all business
transactions, which are identified in an orderly manner, soon after their occurrence in the
journal or subsidiary books.
iii. Classifying: This is concerned with the classification of the recorded business
transactions so as to group the transactions of similar type at one place. i.e., in ledger
accounts. In order to verify the arithmetical accuracy of the accounts, trial balance is
prepared.
iv. Summarising : The classified information available from the trial balance are used to
prepare profit and loss account and balance sheet in a manner useful to the users of
accounting information.
v. Analysing: It establishes the relationship between the items of the profit and loss account
and the balance sheet. The purpose of analysing is to identify the financial strength and
weakness of the business. It provides the basis for interpretation.
vi. Interpreting: It is concerned with explaining the meaning and significance of the
relationship so established by the analysis. Interpretation should be useful to the users, so as
to enable them to take correct decisions.
vii. Communicating: The results obtained from the summarised, analysed and interpreted
information are communicated to the interested parties.
Regular Study - Objective of accounting
Objective of accounting may differ from business to business depending upon their specific
requirements. We discuss in this section the general objectives of accounting.
Keeping systematic record
It is very difficult to remember all the business transactions that take place. Accounting
serves this purpose of record keeping by promptly recording all the business transactions in
the books of account.
To ascertain the results of the operation
Accounting helps in ascertaining result i.e., profit earned or loss suffered in business during
a particular period. For this purpose, a business entity prepares either a Trading and Profit
and Loss account or an Income and Expenditure account which shows the profit or loss of
the business by matching the items of revenue and expenditure of the some period.
To ascertain the financial position of the business
In addition to profit, a businessman must know his financial position i.e., availability of
cash, position of assets and liabilities etc. This helps the businessman to know his financial
strength. Financial statements are barometers of health of a business entity.
To portray the liquidity position
Financial reporting should provide information about how an enterprise obtains and spends
cash, about its borrowing and repayment of borrowing, about its capital transactions, cash
dividends and other distributions of resources by the enterprise to owners and about other
factors that may affect an enterprise’s liquidity and solvency.
To protect business properties
Accounting provides upto date information about the various assets that the firm possesses
and the liabilities the firm owes, so that nobody can claim a payment which is not due to
him.
To facilitate rational decision – making
Accounting records and financial statements provide financial information which help the
business in making rational decisions about the steps to be taken in respect of various
aspects of business.
To satisfy the requirements of law
Entities such as companies, societies, public trusts are compulsorily required to maintain
accounts as per the law governing their operations such as the Companies Act, Societies
Act, Public Trust Act etc. Maintenance of accounts is also compulsory under the Sales Tax
Act and Income Tax Act.
Regular Study - Steps/Phases of Accounting Cycle
When complete sequence of accounting procedure is done which happens frequently and
repeated in same directions during an accounting period, the same is called an accounting
cycle.
Steps/Phases of Accounting Cycle
The steps or phases of accounting cycle can be developed as under:
a) The opening balances of accounts from the balance sheet & day to day business
transaction of the accounting year are first recorded in a book known as journal.
b) Periodically these transactions are transferred to concerned accounts known as ledger
accounts.
c) At the end of every accounting year these accounts are balanced & the trial balance is
prepared.
d) Then the final accounts such as trading & profit & loss accounts are prepared.
e) Finally, a balance sheet is made which gives the financial position of the business at the
end of the period.
Regular Study - Basic Assumptions
Business Entity Concept
This concept explains that the business is distinct from the proprietor. Thus, the transactions
of business
only are to be recorded in the books of business.
For example, Mr A starts a new business in the name and style of M/s Independent Trading
Company and introduced a capital of Rs 2,00,000 in cash. It means the cash balance of M/s
Independent Trading Company will increase by a sum of Rs 2,00,000/-. At the same time,
the liability of M/s Independent Trading Company in the form of capital will also increase.
It means M/s Independent Trading Company is liable to pay Rs 2,00,000 to Mr A.
Going Concern Concept
This concept assumes that the business has a perpetual succession or continued existence.
For example, a business unit makes investments in the form of fixed assets and we book
only depreciation of the assets in our profit & loss account; not the difference of acquisition
cost of assets less net realizable value of the assets. The reason is simple; we assume that we
will use these assets and earn profit in the future while using them. Similarly, we treat
deferred revenue expenditure and prepaid expenditure. The concept of going concern does
not work in the following cases:
 If a unit is declared sick (unused or unusable unit).
 When a company is going to liquidate and a liquidator is appointed for the same.
 When a business unit is passing through severe financial crisis and going to wind up.
Money Measurement Concept
According to this concept only those transactions which are expressed in money terms are
to be
recorded in accounting books.
Example
Determine and book the value of stock of the following items:
Shirts Rs 5,000/-
Pants Rs 7,500/-
Coats 500 pieces
Jackets 1000 pieces
Value of Stock = ?
Here, if we want to book the value of stock in our accounting record, we need the value of
coats and jackets in terms of money. Now if we conclude that the values of coats and
jackets are Rs 2,000 and Rs 15,000 respectively, then we can easily book the value of stock
as Rs 29,500 (as a result of 5000+7500+2000+15000) in our books. We need to keep
quantitative records separately.
The Accounting Period Concept
Businesses are living, continuous organisms. The splitting of the continuous stream of
business events into time periods is thus somewhat arbitrary. There is no significant change
just because one accounting period ends and a new one begins. This results into the most
difficult problem of accounting of how to measure the net income for an accounting period.
One has to be careful in recognizing revenue and expenses for a particular accounting
period. Subsequent section on accounting procedures will explain how one goes about it in
practice.
The Accrual Concept
The accrual concept is based on recognition of both cash and credit transactions. In case of a
cash transaction, owner’s equity is instantly affected as cash either is received or paid. In a
credit transaction, however, a mere obligation towards or by the business is created. When
credit transactions exist (which is generally the case), revenues are not the same as cash
receipts and expenses are not same as cash paid during the period.
Today’s accounting systems based on accrual concept are called as Accrual system or
mercantile system of accounting.
Regular Study - Basic Concepts of Accounting
These concepts guide how business transactions are reported. On the basis of the four
assumptions the following concepts (principles) of accounting have been developed.
Dual Aspect Concept
Dual aspect principle is the basis for Double Entry System of book-keeping. All business
transactions recorded in accounts have two aspects - receiving benefit and giving benefit.
For example, when a business acquires an asset (receiving of benefit) it must pay cash
(giving of benefit).
For example, if we buy some stock, then it will have two effects:
 the value of stock will increase (get benefit for the same amount), and
 it will increase our liability in the form of creditors.
Transaction Effect
Purchase of Stock for Rs
25,000
Stock will increase by Rs 25,000 (Increase in debit balance)
Cash will decrease by Rs 25,000 (Decrease in debit balance)
Or
Creditor will increase by Rs 25,000 (Increase in credit balance)
Revenue Realisation Concept
According to this concept, revenue is considered as the income earned on the date when it is
realised. Unearned or unrealised revenue should not be taken into account. The realisation
concept is vital for determining income pertaining to an accounting period. It avoids the
possibility of inflating incomes and profits.
Historical Cost Concept
Under this concept, assets are recorded at the price paid to acquire them and this cost is the
basis for all subsequent accounting for the asset. For example, if a piece of land is
purchased for Rs.5,00,000 and its market value is Rs.8,00,000 at the time of preparing final
accounts the land value is recorded only for Rs.5,00,000. Thus, the balance sheet does not
indicate the price at which the asset could be sold for.
Matching Concept
Matching the revenues earned during an accounting period with the cost associated with the
period to ascertain the result of the business concern is called the matching concept. It is the
basis for finding accurate profit for a period which can be safely distributed to the owners.
Full Disclosure Concept
Accounting statements should disclose fully and completely all the significant information.
Based on this, decisions can be taken by various interested parties. It involves proper
classification and explanations of accounting information which are published in the
financial statements.
Verifiable and Objective Evidence Concept
This principle requires that each recorded business transactions in the books of accounts
should have an adequate evidence to support it.
For example, cash receipt for payments made. The documentary evidence of transactions
should be free from any bias. As accounting records are based on documentary evidence
which are capable of verification, it is universally acceptable.
Regular Study - Modifying Principles
The Concept of Materiality
The materiality could be related to information, amount, procedure and nature. Error in
description of an asset or wrong classification between capital and revenue would lead to
materiality of information. Say, If postal stamps of ` 500 remain unused at the end of
accounting period, the same may not be considered for recognizing as inventory on account
of materiality of amount. Certain accounting treatments depend upon procedures laid down
by accounting standards. Some transactions are by nature material irrespective of the
amount involved. e.g. audit fees, loan to directors.
Consistency Concept
This Concept says that the Accounting practices should not change or must remain
unchanged over a period of several years.
Conservatism Concept
Conservatism concept states that when alternative valuations are possible, One should select
the alternative which fairly represents economic substance of transactions but when such
choice is not clear select the alternative that is least likely to overstate net assets and net
income.
It provides for all known expenses and losses by best estimates if amount is not known with
certainty, but does not recognizes revenues and gains on the basis of anticipation.
Timeliness Concept
Under this principle, every transaction must be recorded in proper time. Normally, when the
transaction is made, the same must be recorded in the proper books of accounts. In short,
transaction should be recorded date-wise in the books. Delay in recording such transaction
may lead to manipulation, misplacement of vouchers, misappropriation etc. of cash and
goods. This principle is followed particularly while verifying day to day cash balance.
Principle of timeliness is also followed by banks, i.e. every bank verifies the cash balance
with their cash book and within the day, the same must be completed.
Industry Practice
As that are different types of industries, each industry has its own characteristics and
features. There may be seasonal industries also. Every industry follows the principles and
assumption of accounting to perform their own activities. Some of them follow the
principles, concepts and conventions in a modified way. The accounting practice which has
always prevailed in the industry is followed by it. e.g Electric supply companies, Insurance
companies maintain their accounts in a specific manner.
Insurance companies prepare Revenue Account just to ascertain the profit/loss of the
company and not Profit and Loss Account. Similarly, non trading organizations prepare
Income and Expenditure Account to find out Surplus or Deficit.
Regular Study - Single Entry System
Business transactions are recorded in two different ways, one is double entry system and
another one is single entry system.
All business transactions are has two aspects namely Debit and Credit, If these two aspects
of a transaction are recorded, which system is known as the Double entry system.
The term single entry is vaguely used to refer to any method of maintaining accounts which
does not conform to strict principles of double entry system, under single entry method only
one aspect of a transaction is recorded, it may be debit without a corresponding credit and
vice versa. This system is not based on any scientific system therefore it cannot be termed
as a system, It is incomplete and unsatisfactory system and it is clear that accurate
information of the operations of the business is entirely lacking.
SALIENT FEATURES OF SINGLE ENTRY SYSTEM
Some features of single entry system.
i) The system is suitable for sole trader, partnership firms and professionals.
ii) In this system, usually personal accounts are fully written and cash book is also
maintained and ignore all other accounts.
iii) This system does not follow uniformity .It is highly flexible accounting to the
capabilities of individuals maintaining the records.
iv)This system needs very few numbers of account books and it gives only partial
information.
v) When preparing cash book under this system both personal and business transactions are
recorded.
vi) In this system to know the total purchases and sales, one has to depend on original
vouchers.
DEFECTS OF SINGLE ENTRY SYSTEM
Some of the defects of single entry system.
i) It is not a scientific method of accounting.
ii) Frauds can be committed easily
iii) It is difficult to ascertain the value of the business
iv) It is very difficult to say whether the business is making progress or working at a loss
v) The Trading and profit and loss account and balance sheet cannot be prepared in a
scientific manner
vi) The trading results of one period cannot be compared with those of the other period.
vii) Impersonal accounts such as sales account, purchases account as well as assets account
are not available.
METHODS OF ASCERTAINMENT OF PROFIT OR LOSS UNDER SINGLE
ENTRY SYSTEM:
There are two methods of ascertaining profit or loss under the single entry system, they are:
(a) Comparison method (or) Net worth Method (or) statement of affair method (b)
Conversion Method.
Comparison method (or) statement of affair method
Under this method the profit or loss is ascertained by comparing the capital at the beginning
with the capital at the end of the period. The closing capital is taken; drawings should be
added to this; from this total the additional capital if any introduced should be subtracted;
from this total the opening capital should be subtracted. The answer so obtained will be the
profit or loss (before adjustment) earned during the year.
Conversion Method
The process of collecting, computing and recording missing information along with the
available data in the incomplete books of a business is called “conversion method”. Once
the books are “converted”, all future transactions can be recorded as per “double entry
system”. Conversion to double entry system enables a business to avoid the harassment of
taxation authorities and ensures better management of the business.
Procedure for conversion
The following are the steps to be followed for conversion of incomplete records to complete
record system (Double entry system)
1. A statement of affairs at the beginning of the year should be prepared. The balance in the
statement represents opening capital.
2. Single or double column cash book should be prepared to find out missing items like
opening cash, closing cash, cash sales, cash purchase, additional capital and drawings etc.
Any shortage on the debit side can be cash sales or additional capital introduced or opening
cash. Shortage on the credit site can be cash purchase or drawings or sundry expenses or
closing cash balance.
3. Impersonal accounts like total debtors account ,total creditors account , Bills receivables
account and Bills payable account should be prepared .preparation of these accounts can
help in finding any missing items like opening or closing debtors, opening or closing
creditors, credit sales and credit purchases
4. Appropriate journal entry should be passed in respect of assets and liabilities included in
the opening statement of affairs.
5. Real and nominal accounts must be written from the information recorded in the cash
book, total debtors account, total creditors account, etc. The double effect of every entry
must be posted to the ledger, opening new accounts wherever necessary.
6. From all the accounts balance in the ledger and any other additional details trading
account, profit and loss account and balance sheet must be prepared.
Regular Study - Double Entry System
There are numerous transactions in a business concern. Each transaction, when closely
analysed, reveals two aspects. One aspect will be “receiving aspect” or “incoming aspect”
or “expenses/loss aspect”. This is termed as the “Debit aspect”. The other aspect will be
“giving aspect” or “outgoing aspect” or “income/gain aspect”. This is termed as the “Credit
aspect”. These two aspects namely “Debit aspect” and “Credit aspect” form the basis of
Double Entry System. The double entry system is so named since it records both the aspects
of a transaction.
In short, the basic principle of this system is, for every debit, there must be a corresponding
credit of equal amount and for every credit, there must be a corresponding debit of equal
amount.
According to J.R.Batliboi “Every business transaction has a two-fold effect and that it
affects two accounts in opposite directions and if a complete record were to be made of each
such transaction, it would be necessary to debit one account and credit another account. It is
this recording of the two fold effect of every transaction that has given rise to the term
Double Entry System”.
Features of Double Entry System
i. Every business transaction affects two accounts.
ii. Each transaction has two aspects, i.e., debit and credit.
iii. It is based upon accounting assumptions concepts and principles.
iv. Helps in preparing trial balance which is a test of arithmetical accuracy in accounting.
v. Preparation of final accounts with the help of trial balance.
Approaches of Recording
There are two approaches for recording a transaction.
I. Accounting Equation Approach
II. Traditional Approach
I. Accounting Equation Approach
This approach is also called as the American Approach. Under this method transactions
are recorded based on the accounting equation, i.e.,
Assets = Liabilities + Capital
II. Traditional Approach
This approach is also called as the British Approach. Recording of business transactions
under this method are formed on the basis of the existence of two aspects (debit and credit)
in each of the transactions. All the business transactions are recorded in the books of
accounts under the ‘Double Entry System’.
Advantages
The advantages of this system are as follows:
i. Scientific system: This is the only scientific system of recording business transactions. It
helps to attain the objectives of accounting.
ii. Complete record of transactions: This system maintains a complete record of all
business transactions.
iii. A check on the accuracy of accounts: By the use of this system the accuracy of the
accounting work can be established by the preparation of trial balance.
iv. Ascertainment of profit or loss: The profit earned or loss occurred during a period can
be ascertained by the preparation of profit and loss account.
v. Knowledge of the financial position : The financial position of the concern can be
ascertained at the end of each period through the preparation of balance sheet.
vi. Full details for control: This system permits accounts to be kept in a very detailed
form, and thereby provides sufficient information for the purpose of control.
vii. Comparative study : The results of one year may be compared with those of previous
years and the reasons for change may be ascertained.
viii. Helps in decision making: The management may be able to obtain sufficient
information for its work, especially for making decisions. Weaknesses can be detected and
remedial measures may be applied.
ix. Detection of fraud: The systematic and scientific recording of business transactions on
the basis of this system minimizes the chances of fraud.
Regular Study - Differences between Single entry system and Double entry
system
Differences between Single entry system and Double entry system
Single entry system Double entry system
1 Personal account and cash account
alone are maintained.
Personal account, real account and nominal
accounts are maintained properly.
2 It involves less clerical labour. It involves more clerical labour.
3 Only one aspect of a transaction is
recorded.
Two aspect of a transaction are recorded.
4 There may be debit without a
corresponding credit and vice versa.
For every debit there is a corresponding
equal credit.
5 Trading account, Profit and loss
account and Balance sheet cannot be
prepared as it has incomplete record.
They can be prepared.
6 It is an imperfect way of bookkeeping. It is a perfect and scientific system.
7 Approximate net profit can be
indirectly calculated.
Accurate net profit can be calculated
directly.
8 As the ledger does not contain all
accounts, trial balance cannot be
prepared.
To test the arithmetical accuracy a trial
balance can be prepared.
9 Tax authorities do not accept it as such Tax authorities accept this method.
10 Internal check is not possible It is possible in this system.
11 Balance sheet cannot prepare. So,
financial position is difficult to ascertain.
Reliable financial position can be found
through balance sheet.
12 The Accounting records are not
acceptable as evidence.
In case of disputes, accounting records can
be produced in courts of law
13 It is suitable for small businessmen It is suitable for any type of businessmen.
Regular Study - Types of Transactions
There are 2 types of Transaction
1. Capital
2. Revenue
The concepts of capital and revenue are of fundamental importance to the correct
determination of accounting profit for a period and recognition of business assets at the end
of that period.
• Capital Transactions:
Transactions having long-term effect are known as capital transactions.
• Revenue Transactions:
Transactions having short-term effect are known as revenue transactions.
• Capital Expenditure
Capital expenditure can be defined as expenditure incurred on the purchase, alteration or
improvement of fixed assets. For example, the purchase of a car to be use to deliver goods is
capital expenditure. Included in capital expenditure are such costs as:
• Delivery of fixed assets;
• Installation of fixed assets;
• Improvement (but not repair) of fixed assets;
• Legal costs of buying property;
• Demolition costs;
• Architects fees;
• Revenue Expenditures
Revenue expenditure is expenditure incurred in the running / management of the business.
For example, the cost of petrol or diesel for cars is revenue expenditure. Other revenue
expenditure:
• Maintenance of Fixed Assets;
• Administration of the business;
• Selling and distribution expenses.
Capitalized Expenditure
Expenditure connected with the purchase of fixed asset are called capitalized expenditure
e.g. wages paid for the installation of machinery.
The Treatments of Capital and Revenue Expenditures
Capital expenditures are shown in the Balance Sheet Assets Side while Revenue
Expenditures are shown in the Trading and Profit And Loss Account debit side.
Revenue Receipts
Amount received against revenue income are called revenue receipt.
Capital Receipts
Amount received against capital income are called capital receipts.
Capital Profits
Capital profit which is earned on the sale of the fixed assets.
Revenue Profit
The profit which is earned during the ordinary course of business is called revenue profit.
Capital Loss
The loss suffered by a company on the sale of fixed assets.
Revenue Loss
The loss suffered by the business in the ordinary course of business is called revenue loss.
Rules for Determining Capital Expenditure
An expenditure can be recognised as capital if it is incurred for the following purposes :
• An expenditure incurred for the purpose of acquiring long term assets (useful life is at
least more than one accounting period) for use in business to earn profits and not meant for
resale, will be treated as a capital expenditure. For example, if a second hand motor car
dealer buys a piece of furniture with a view to use it in business; it will be a capital
expenditure. But if he buys second hand motor cars, for re-sale, then it will be a revenue
expenditure because he deals in second hand motor cars.
• When an expenditure is incurred to improve the present condition of a machine or putting
an old asset into working condition, it is recognised as a capital expenditure. The
expenditure is capitalized and added to the cost of the asset. Likewise, any expenditure
incurred to put an asset into working condition is also a capital expenditure.
• For example, if one buys a machine for ` 5,00,000 and pays ` 20,000 as transportation
charges and ` 40,000 as installation charges, the total cost of the machine comes upto `
5,60,000. Similarly, if a building is purchased for ` 1,00,000 and ` 5,000 is spent on
registration and stamp duty, the capital expenditure on the building stands at ` 1,05,000.
• If an expenditure is incurred, to increase earning capacity of a business will be considered
as of capital nature. For example, expenditure incurred for shifting ‘the ‘factory for easy
supply of raw materials. Here, the cost of such shifting will be a capital expenditure.
• Preliminary expenses incurred before the commencement of business is considered capital
expenditure. For example, legal charges paid for drafting the memorandum and articles of
association of a company or brokerage paid to brokers, or commission paid to underwriters
for raising capital.
• Thus, one useful way of recognising an expenditure as capital is to see that the business
will own something which qualifies as an asset at the end of the accounting period.
Some examples of capital expenditure:
(i) Purchase of land, building, machinery or furniture
(ii) Cost of leasehold land and building
(iii) Cost of purchased goodwill
(iv) Preliminary expenditures
(v) Cost of additions or extensions to existing assets
(vi) Cost of overhauling second-hand machines
(vii) Expenditure on putting an asset into working condition and
(viii) Cost incurred for increasing the earning capacity of a business.
Rules for Determining Revenue Expenditure
Any expenditure which cannot be recognised as capital expenditure can be termed as
revenue expenditure. A revenue expenditure temporarily influences only the profit earning
capacity of the business. An expenditure is recognised as revenue when it is incurred for the
following purposes :
Expenditure for day-to-day conduct of the business, the benefits of which last less than one
year.
Examples are wages of workmen, interest on borrowed capital, rent, selling expenses, and
so on.
Expenditure on consumable items, on goods and services for resale either in their original or
improved form. Examples are purchases of raw materials, office stationery, and the like. At
the end of the year, there may be some revenue items (stock, stationery, etc.) still in hand.
These are generally passed over to the next year though they were acquired in the previous
year.
Expenditures incurred for maintaining fixed assets in working order.
For example, repairs, renewals and depreciation.
Some examples of revenue expenditure
(i) Salaries and wages paid to the employees;
(ii) Rent and rates for the factory or office premises;
(iii) Depreciation on plant and machinery;
(iv) Consumable stores;
(v) Inventory of raw materials, work-in-progress and finished goods;
(vi) Insurance premium;
(vii) Taxes and legal expenses; and
(viii) Miscellaneous expenses.
Deferred Revenue Expenditures
Deferred revenue expenditures represent certain types of assets whose usefulness does not
expire in the year of their occurrence but generally expires in the near future. These type of
expenditures are carried forward and are written off in future accounting periods.
Sometimes, we make some revenue expenditure but it eventually becomes a capital asset
(generally of an intangible nature). If one undertake substantial repairs to the existing
building, the deterioration of the premises may be avoided. We may engage our own
employees to do that work and pay them at prevailing wage-rate, which is of a revenue
nature. If this expenditure is treated as a revenue expenditure and the current year’s-profit is
charged with these expenses, we are making the current year to absorb the entire expenses,
though the benefit of which will be enjoyed for a number of accounting years. To overcome
this difficulty, the entire expenditure is capitalised and is added to the asset account.
Another example is an insurance policy. A business can pay insurance premium in advance,
say, for a 3 year period. The right does not expire in the accounting period in which it is
paid but will expire within a fairly short period of time (3 years). Only a portion of the total
premium paid should be treated as a revenue expenditure (portion pertaining to the current
period) and the balance should be carried forward as an asset to be written off in subsequent
years.
Regular Study - Types of Transactions - Illustrations
Illustration1.
State whether the following are capital, revenue or deferred revenue expenditure.
(i) Carriage of 7,500 spent on machinery purchased and installed.
(ii) Heavy advertising costs of 20,000 spent on the launching of a company’s new product.
(iii) 200 paid for servicing the company vehicle, including ` 50 paid for changing the oil.
(iv) Construction of basement costing 1,95,000 at the factory premises.
Solution :
(i) Carriage of 7,500 paid for machinery purchased and installed should be treated as a
Capital Expenditure.
(ii) Advertising expenses for launching a new product of the company should be treated as a
Revenue Expenditure. (As per AS-26)
(iii) 200 paid for servicing and oil change should be treated as a Revenue Expenditure.
(iv) Construction cost of basement should be treated as a Capital Expenditure.
Illustration 2.
State whether the following are capital or revenue expenditure.
(i) Paid a bill of 10,000 of Mr. Kumar, who was engaged as the erection engineer to set up a
new automatic machine costing 20,000 at the new factory site.
(ii) Incurred 26,000 expenditure on varied advertisement campaigns under taken yearly, on
a regular basis, during the peak festival season.
(iii) In accordance with the long-term plan of providing a well- equipped Labour Welfare
Centre, spent 90,000 being the budgeted allocation for the year.
Solution :
(i) Expenses incurred for erecting a new machine should be treated as a Capital
Expenditure.
(ii) Advertisement expenses during peak festival season should be treated as a Revenue
Expenditure.
(iii) Expenses incurred for Labour Welfare Centre should be treated as a Capital
Expenditure.
Illustration 3.
Classify the following items as capital or revenue expenditure :
(i) An extension of railway tracks in the factory area;
(ii) Wages paid to machine operators;
(iii) Installation costs of new production machine;
(iv) Materials for extension to foremen’s offices in the factory;
(v) Rent paid for the factory;
(vi) Payment for computer time to operate a new stores control system,
(vii) Wages paid to own employees for building the foremen’s offices.
Solution :
(i) Expenses incurred for extension of railway tracks in the factory area should be treated as
a Capital Expenditure because it will yield benefit for more than one accounting period.
(ii) Wages paid to machine operators should be treated as a Revenue Expenditure as it will
yield benefit for the current period only.
(iii) Installation costs of new production machine should be treated as a Capital Expenditure
because it will benefit the business for more than one accounting period.
(iv) Materials for extension to foremen’s offices in the factory should be treated as a Capital
Expenditure because it will benefit the business for more than one accounting period.
(v) Rent paid for the factory should be treated as a Revenue Expenditure because it will
benefit only the current period.
(vi) Payment for computer time to operate a new stores control system should be treated as
Revenue Expenditure because it has been incurred to carry on the normal business.
(vii) Wages paid for building foremen’s offices should be treated as a Capital Expenditure
because it will benefit the business for more than one accounting period.
Illustration 4.
For each of the cases numbered below, indicate whether the income/expenditure is capital
or revenue.
(i) Payment of wages to one’s own employees for building a new office extension.
(ii) Regular hiring of computer time for the preparation of the firm’s accounts.
(iii) The purchase of a new computer for use in the business.
(iv) The use of motor vehicle, hired for five years, but paid at every six months.
Solution :
(i) Payment of wages for building a new office extension should be treated as a Capital
Expenditure.
(ii) Computer hire charges should be treated as a Revenue Expenditure.
(iii) Purchase of computer for use in the business should be treated as a Capital Expenditure.
(iv) Hire charges of motor vehicle should be treated as a Revenue Expenditure.
Illustration 5.
State with reasons whether the following are capital or revenue expenditure :
(i) Freight and cartage on the new machine 150, and erection charges 500.
(ii) Fixtures of the book value of 2,500 sold off at 1,600 and new fixtures of the value of
4,000 were acquired. Cartage on purchase 100.
(iii) A sum of 400 was spent on painting the factory.
(iv) 8,200 spent on repairs before using a second hand car purchased recently, to put it in
usable condition.
Solution :
(i) Freight and cartage totaling 650 should be treated as a Capital Expenditure because it
will benefit the business for more than one accounting year.
(ii) Loss on sale of fixtures (2,500 – 1,600) = 900 should be treated as a Capital Loss. The
cost of new fixtures and carriage thereon should be treated as a Capital Expenditure because
the fixture will be used for a long period. So (4,000+1,000)the cost of new fixture will be
4,100.
(iii) Painting of the factory should be treated as a Revenue Expenditure because it has been
incurred to maintain the factory building.
(iii) Repairing cost of second hand car should be treated as a Capital Expenditure because it
will benefit the business for more than one accounting year.
Illustration 6.
State the nature (capital or revenue) of the following expenditure which were incurred by
Vedanta & Co. during the year ended 30th June, 2016 :
(i) 350 was spent on repairing a second hand machine which was purchased on 8th May,
2016 and 200 was paid on carriage and freight in connection with its acquisition.
(ii) A sum of 30,000 was paid as compensation to two employees who were retrenched.
(iii) 150 was paid in connection with carriage on goods purchased.
(iv) 20,000 customs duty is paid on import of a machinery for modernisation of the factory
production during the current year and ` 6,000 is paid on import duty for purchase of raw
materials.
(v) 18,000 interest had accrued during the year on term loan obtained and utilised for the
construction of factory building and purchase of machineries; however, the production has
not commenced till the last date of the accounting year.
Solution :
(i) Repairing and carriage totaling 550 for second hand machine should be treated as a
Capital Expenditure.
(ii) Compensation paid to employees shall be treated as a Revenue Expenditure.
(iii) Carriage paid for goods purchased should be treated as a Revenue Expenditure.
(iv) Customs duty paid on import of machinery to be treated as a Capital Expenditure.
However, import
duty paid for raw materials should be treated as a Revenue Expenditure.
(v) Interest paid during pre-construction period to be treated as a Capital Expenditure.
Illustration 7.
State with reasons whether the following items relating to Parvati Sugar Mill Ltd. are capital
or revenue :
(i) 50,000 received from issue of shares including ` 10,000 by way of premium.
(ii) Purchased agricultural land for the mill for ` 60,000 and ` 500 was paid for land revenue.
(iii) 5,000 paid as contribution to PWD for improving roads of sugar producing area.
(iv) 40,000 paid for excise duty on sugar manufactured.
(v) 70,000 spent for constructing railway siding.
Solution :
(i) 40,000 (50,000 – 10,000) received from issue of shares will be treated as a Capital
Receipt. The premium of 10,000 should be treated as a Capital Profit.
(ii) Cost of land 60,000 to be treated as Capital Expenditure and land revenue of 500 to be
treated as Revenue Expenditure.
(iii) Contribution paid to PWD should be treated as a Revenue Expenditure.
(iv) Excise duty of 40,000 should be treated as a Revenue Expenditure.
(v) 70,000 spent for constructing railway siding to be treated as a Capital Expenditure.
Illustration 8.
State with reasons whether the following are Capital Expenditure or Revenue Expenditure :
(i) Expenses incurred in connection with obtaining a licence for starting the factory were
10,000.
(ii) 1,000 paid for removal of stock to a new site.
(iii) Rings and Pistons of an engine were changed at a cost of ` 5,000 to get full efficiency.
(iv) 2,000 spent as lawyer’s fee to defend a suit claiming that the firm’s factory site
belonged to the Plaintiff. The suit was not successful.
(v) 10,000 were spent on advertising the introduction of a new product in the market, the
benefit of which will be effective during four years.
(vi) A factory shed was constructed at a cost of 1,00,000. A sum of 5,000 had been incurred
for the construction of the temporary huts for storing building materials.
Solution :
(i) 10,000 incurred in connection with obtaining a license for starting the factory is a Capital
Expenditure. It is incurred for acquiring a right to carry on business for a long period.
(ii) 1,000 incurred for removal of stock to a new site is treated as a Revenue Expenditure
because it is not enhancing the value of the asset and it is also required for starting the
business on the new site.
(iii) 5,000 incurred for changing Rings and Pistons of an engine is a Revenue Expenditure
because, the change of rings and piston will restore the efficiency of the engine only and it
will not add anything to the capacity of the engine.
(iv) 2,000 incurred for defending the title to the firm’s assets is a Revenue Expenditure.
(v) 10,000 incurred on advertising is to be treated as a Revenue Expenditure (As per AS-
26).
(vi) Cost of construction of Factory shed of 1,00,000 is a Capital Expenditure, similarly cost
of construction of small huts for storing building materials is also a Capital Expenditure.
Illustration 9.
State clearly how you would deal with the following in the books of a Company :
(i) The redecoration expenses 6,000.
(ii) The installation of a new Coffee-making Machine for 10,000.
(iii) The building of an extension of the club dressing room for 15,000.
(iv) The purchase of Snacks & food stuff 2,000.
(v) The purchase of V.C.R. and T.V. for the use in the club lounge for 15,000.
Solution :
(i) The redecoration expenses of 6,000 shall be treated as a Deferred Revenue Expenditure.
(ii) The installation of a new Coffee - Making Machine is a Capital Expenditure because it
is the acquisition of an asset.
(iii) 15,000 spent for the extension of club dressing room is a Capital Expenditure because it
creates an asset of a permanent nature.
(iv) The purchase of snacks & food stuff of 2,000 is a Revenue Expenditure.
(v) The purchase of V.C.R. and T.V. for 15,000 is a Capital Expenditure, because it is the
acquisition of assets.
Regular Study - Accounting Equation
The source document is the origin of a transaction and it initiates the accounting process,
whose starting point is the accounting equation.
Accounting equation is based on dual aspect concept (Debit and Credit). It emphasizes on
the fact that every transaction has a two sided effect i.e., on the assets and claims on assets.
Always the total claims (those of outsiders and of the proprietors) will be equal to the total
assets of the business concern. The claims are also known as equities, are of two types: i.)
Owners equity (Capital); ii.) Outsiders’ equity (Liabilities).
Assets = Equities
Assets = Capital + Liabilities (A = C+L)
Capital = Assets – Liabilities (C = A–L)
Liabilities = Assets – Capital (L = A–C)
Effect of Transactions on Accounting Equation :
Illustration 1
If the capital of a business is Rs.3,00,000 and other liabilities are Rs.2,00,000, calculate the
total assets of the business.
Solution
Assets = Capital + Liabilities
Capital + Liabilities = Assets
Rs. 3,00,000 + Rs.2,00,000 = Rs.5,00,000
Illustration 2
If the total assets of a business are Rs.3,60,000 and capital is Rs.2,00,000, calculate
liabilities.
Solution
Assets = Capital + Liabilities
Liabilities = Assets – Capital
Assets – Capital = Liabilities
Rs. 3,60,000 – Rs. 2,00,000 = Rs. 1,60,000
Illustration 3
If the total assets of a business are Rs.4,50,000 and outside liabilities are Rs.2,50,000,
calculate the capital.
Solution:
Capital = Assets – Liabilities
Assets – Liabilities = Capital
Rs. 4,50,000 – Rs. 2,50,000 = Rs.2,00,000
Illustration – 4
Transaction 1: Murugan started business with Rs.50,000 as capital.
The business unit has received assets totalling Rs.50,000 in the form of cash and the claims
against the firm are also Rs.50,000 in the form of capital. The transaction can be expressed
in the form of an accounting equation as follows:
Assets = Capital + Liabilities
Cash = Capital + Liabilities
Rs. 50,000 = Rs. 50,000 + 0
Transaction 2: Murugan purchased furniture for cash Rs.5,000.
The cash is reduced by Rs,5,000 but a new asset (furniture) of the same amount has been
acquired. This transaction decreases one asset (cash) and at the same time increases the
other asset (furniture) with the same amount, leaving the total of the assets of the business
unchanged. The accounting equation now is as follows:
Assets = Capital + Liabilities
Cash + Furniture = Capital + Liabilities
Transaction 1 50,000 + 0 = 50,000 + 0
Transaction 2 (–) 5,000 + 5,000 = 0 + 0
Equation 45,000 + 5,000 = 50,000 + 0
Transaction 3: He purchased goods for cash Rs.30,000.
As a result, cash balance is reduced by the goods purchased, leaving the total of the assets
unchanged.
Assets = Capital +Liabilities
Cash + Furniture + Stock = Capital +Liabilities
(Goods)
Transaction 1&2 45,000 + 5,000 + 0 = 50,000 + 0
Transaction 3 (–) 30,000 + 0 + 30,000 = 0 + 0
Equation 15,000 + 5,000 + 30,000 = 50,000 + 0
Transaction 4: He purchased goods on credit for Rs.20,000.
The above transaction will increase the value of stock on the assets side and will create a
liability in the form of creditors.
Assets = Capital +Liabilities
Cash + Furniture + Stock = Capital +Creditors
Transaction 1-3 15,000 + 5,000 + 30,000 = 50,000 + 0
Transaction 4 0 + 0 + 20,000 = 0 + 20,000
Equation 15,000 + 5,000 + 50,000 = 50,000 + 20,000
Transaction 5: Goods costing Rs.25,000 sold on credit for Rs.35,000.
The above transaction will give rise to a new asset in the form of Debtors to the extent of
Rs.35,000. But the stock of goods will be reduced by Rs.25,000 i.e., the cost of goods sold.
The net increase of Rs.10,000 is the amount of revenue which will be added to the capital.
Assets = Capital + Liabilities
Cash + Furniture + Stock + Debtors = Capital + Creditors
+
Revenue
Transaction 1-4 15,000 + 5,000 + 50,000 + 0 = 50,000 + 20,000
Transaction 5 0 + 0 +(-)25,000 + 35,000 = 10,000 + 0
Equation 15,000 + 5,000 + 25,000 + 35,000 = 60,000 + 20,000
Transaction 6: Rent paid Rs.3,000.
It reduces cash and the rent is an expense, it results in a loss which decreases the capital.
Assets = Capital + Liabilities
Cash + Furniture + Stock + Debtors = Capital + Creditors
Transaction 1-5 15,000 + 5,000 + 25,000 + 35,000 = 60,000 + 20,000
Transaction 6 – 3,000 + 0 + 0 + 0 = –3,000 + 0
Equation 12,000 + 5,000 + 25,000 + 35,000 = 57,000 + 20,000
77,000 = 77,000
From the above transactions, it may be concluded that every transaction has a double effect
and in each case - Assets = Capital + Liabilities, i.e., ‘Accounting equation is true in all
cases’. The last equation appearing in the books of Mr.Murugan may also be presented in
the form of a statement called Balance Sheet.
Regular Study - Journal
The books in which a transaction is recorded for the first time from a source document are
called Books of Original Entry or Prime Entry. Journal is one of the books of original entry
in which transactions are originally recorded in a chronological (day-to-day) order
according to the principles of Double Entry System.
Journal is a date-wise record of all the transactions with details of the accounts debited and
credited and the amount of each transaction.
Format - Journal
Date Particulars L.F. Debit Amount
Rs.
Credit Amount
Rs.
Explanation:
1. Date : In the first column, the date of the transaction is entered. The year and the month
is written only once, till they change. The sequence of the dates and months should be
strictly maintained.
2. Particulars : Each transaction affects two accounts, out of which one account is debited
and the other account is credited. The name of the account to be debited is written first, very
near to the line of particulars column and the word Dr. is also written at the end of the
particulars column. In the second line, the name of the account to be credited is written,
starts with the word ‘To’, a few space away from the margin in the particulars column to the
make it distinct from the debit account.
3. Narration : After each entry, a brief explanation of the transaction together with
necessary details is given in the particulars column with in brackets called narration. The
words ‘For’ or ‘Being’ are used before starting to write down narration. Now, it is not
necessary to use the word ‘For’ or ‘Being’.
4. Ledger Folio (L.F): All entries from the journal are later posted into the ledger accounts.
The page number or folio number of the Ledger, where the posting has been made from the
Journal is recorded
in the L.F column of the Journal. Till such time, this column remains blank.
5. Debit Amount : In this column, the amount of the account being debited is written.
6. Credit Amount : In this column, the amount of the account being credited is written.
Steps in Journalising
The process of analysing the business transactions under the heads of debit and credit and
recording them in the Journal is called Journalising. An entry made in the journal is called
a ‘Journal Entry’.
Step 1 - Determine the two accounts which are involved in the transaction.
Step 2 - Classify the above two accounts under Personal, Real or Nominal.
Step 3 - Find out the rules of debit and credit for the above two accounts.
Step 4 - Identify which account is to be debited and which account is to be credited.
Step 5 - Record the date of transaction in the date column. The year and month is written
once, till they change. The sequence of the dates and months should be strictly maintained.
Step 6 - Enter the name of the account to be debited in the particulars column very close to
the left and side of the particulars column followed by the abbreviation Dr. in the same line.
Against this, the mount to be debited is written in the debit amount column in the same line.
Step 7 - Write the name of the account to be credited in the second line starts with the word
‘To’ a few space away from the margin in the particulars column. Against this, the amount
to be credited is written in the credit amount column in the same line.
Step 8 - Write the narration within brackets in the next line in the particulars column.
Step 9 - Draw a line across the entire particulars column to separate one journal entry from
the other.
Regular Study - Ledger
A Ledger is a book which contains all the accounts whether personal, real or nominal, which are
first entered in journal or special purpose subsidiary books.
According to L.C. Cropper, ‘the book which contains a classified and permanent record of all
the transactions of a business is called the Ledger’.
Format – Ledger
Name of Account
Dr.
Cr.
Date
Particulars J.F Amount
Rs. P.
Date Particulars J.F Amount
Rs. P.
Year
Month
Date
To (Name of
Credit Account
in Journal)
Year
Month
Date
To (Name of
Debit Account
in Journal)
Explanation:
i. Each ledger account is divided into two parts. The left hand side is known as the debit side and
the right hand side is known as the credit side. The words ‘Dr.’ and ‘Cr.’ are used to denote
Debit and Credit.
ii. The name of the account is mentioned in the top (middle) of the account.
iii. The date of the transaction is recorded in the date column.
iv. The word ‘To’ is used before the accounts which appear on the debit side of an account in the
particulars column. Similarly, the word ‘By’ is used before the accounts which appear on the
credit side of an account in the particulars column.
v. The name of the other account which is affected by the transaction is written either in the debit
side or credit side in the particulars column.
vi. The page number of the Journal or Subsidiary Book from where that particular entry is
transferred, is entered in the Journal Folio (J.F) column.
vii. The amount pertaining to this account is entered in the amount column.
Regular Study - Balancing an Account
Balance is the difference between the total debits and the total credits of an account. When
posting is done, many accounts may have entries on their debit side as well as credit side.
The net result of such debits and credits in an account is the balance.
Balancing means the writing of the difference between the amount columns of the two
sides in the lighter (smaller total) side, so that the grand totals of the two sides become
equal.
Significance of balancing
There are three possibilities while balancing an account during a given period. It may be a
debit balance or a credit balance or a nil balance depending upon the debit total and the
credit total.
i. Debit Balance : The excess of debit total over the credit total is called the debit balance.
When there is only debit entries in an account, the amount itself is the balance of that
account, i.e., the debit balance. It is first recorded on the credit side, above the total. Then it
is entered on the debit side, below the total, as the first item for the next period.
ii. Credit Balance : The excess of credit total over the debit total is called the credit
balance. When there is only credit entries in an account, the amount itself is the balance of
that account i.e., the credit balance. It is first written in the debit side, as the last item, above
the total. Then it is recorded on the credit side, below the total, as the first item for the next
period.
iii. Nil Balance : When the total of debits and credits are equal, it is closed by merely
writing the total on both the sides. It indicates the equality of benefits received and given by
that account.
Balancing of different accounts
Balancing is done periodically, i.e., weekly, monthly, quarterly, half-yearly or yearly,
depending on the requirements of the business.
i. Personal Accounts : These accounts are generally balanced regularly to know the
amounts due to the persons (creditors) or due from the persons (debtors).
ii. Real Accounts : These accounts are generally balanced at the end of the financial year,
when final accounts are being prepared. However, cash account is frequently balanced to
know the cash on hand.
A debit balance in an asset account indicated the value of the asset owned by the business.
Assets accounts always show debit balances.
iii.Nominal Accounts : These accounts are in fact, not to be balanced as they are to be
closed by transfer to final accounts. A debit balance in a nominal account indicates that it is
an expense or loss. A credit balance in a nominal account indicates that it is an income or
gain.
All such balances in personal and real accounts are shown in the Balance Sheet and the
balances in nominal accounts are taken to the Profit and Loss Account.
Procedure for Balancing
While balancing an account, the following steps are involved:
Step 1 - Total the amount column of the debit side and the credit side separately and then
ascertain the difference of both the columns.
Step 2 - If the debit side total exceeds the credit side total, put such difference on the
amount column of the credit side, write the date on which balancing is being done in the
date column and the words “By Balance c/d” (c/d means carried down) in the particulars
column.
OR
If the credit side total exceeds the debit side total, put such difference on the amount column
of the debit side, write the date on which balancing is being done in the date column and the
words “To Balance c/d” in the particulars column.
Step 3 - Total again both the amount columns, put the total on both the sides and draw a line
above and a line below the totals.
Step 4 - Enter the date of the beginning of the next period in the date column and bring
down the debit balance on the debit side along with the words “To Balance b/d” (b/d
means brought down) in the particulars column and the credit balance on the credit side
along with the words “By balance b/d” in the particulars column.
Note: In the place of c/d and b/d, the words c/f or c/o (carried forward or carried over) and
b/f or b/o (brought forward or brought over) may also be used. When the balance is carried
down in the same page, the words c/d and b/d are used, while balance is carried over to the
next page, the term c/o and b/o are used. When balance is carried forward to some other
page either in same book or some other book, the abbreviations c/f (carried forward) and b/f
(brought forward) are used.
Regular Study - Distinction between Journal and Ledger
Books of original entry (Journal) and Ledger can be distinguished as follows:
Regular Study - Trial balance
Trial balance is a statement prepared with the balances or total of debits and credits of all
the accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the
name indicates it is prepared to check the ledger balances. If the total of the debit and credit
amount columns of the trail balance are equal, it is assumed that the posting to the ledger in
terms of debit and credit amounts is accurate. The agreement of a trail balance ensure
arithmetical accuracy only, A concern can prepare trail balance at any time, but its
preparation as on the closing date of an accounting year is compulsory.
According to M.S. Gosav (The Substance of Accountancy) “Trail balance is a statement
containing the balances of all ledger accounts, as at any given date, arranged in the form of
debit and credit columns placed side by side and prepared with the object of checking the
arithmetical accuracy of ledger postings”.
OBJECTIVES OF PREPARING A TRAIL BALANCE
Trial balance is prepared to check arithmetic accuracy.
(i) It gives the balances of all the accounts of the ledger. The balance of any account can be
found from a glance from the trail balance without going through the pages of the ledger.
(ii) It is a check on the accuracy of posting. If the trail balance agrees, it proves that both the
aspects of each transaction are recorded and that the books are arithmetically accurate.
(iii) It facilitates the preparation of profit and loss account and the balance sheet.
(iv) Important conclusions can be derived by comparing the balances of two or more than
two years with the help of trail balances of those years.
Basis of
Distinction
Journal Ledger
1. Book It is the book of prime entry. It is the main book of account.
2. Stage Recording of entries in these books is the
first stage.
Recording of entries in the ledger is the
second stage.
3. Process The process of recording entries in these
books is called “Journalising”.
The process of recording entries in the
ledger is called “Posting”.
4.Transactions Transactions relating to a person or property
or expense are spread over.
Transactions relating to a particular
account are found together on a
particular page.
5. Net effect The final position of a particular account
cannot be found.
The final position of a particular
account can be ascertained just at a
glance.
6. Next Stage Entries are transferred to the ledger. From the Ledger, first the Trial Balance
is
drawn and then final accounts are
prepared.
7. Tax authorities Do not rely upon these Rely on the ledger for books assessment
purpose.
FEATURES OF TRIAL BALANCES
(i) A trial balance is prepared as on a specified date.
(ii) It contains a list of all ledger accounts including cash account.
(iii) It may be prepared with the balances or totals of Ledger accounts.
(iv) Total of the debit and credit amount columns of the trial balance must tally.
(v) It the debit and credit amounts are equal, we assume that ledger accounts are
arithmetically accurate.
(vi) Difference in the debit and credit columns points out that some mistakes have been
committed.
(vii) Tallying of trail balance is not a conclusive proof of accuracy of accounts.
LIMITATIONS OF TRAIL BALANCE
(i) The trail balance can be prepared only in those concerns where double entry system of
book- keeping is adopted. This system is too costly.
(ii) A trail balance is not a conclusive proof of the arithmetical accuracy of the books of
account. It the trail balance agrees, it does not mean that now there are absolutely no errors
in books. On the other hand, some errors are not disclosed by the trail balance.
(iii) It the trail balance is wrong, the subsequent preparation of Trading, P&L Account and
Balance Sheet will not reflect the true picture of the concern.
METHODS OF PREPARING TRAIL BALANCE
A trail balance refers to a list of the ledger balances as on a particular date. It can be
prepared in the two manners. In this section we present the important methods of preparing
Trial balance
Total method
According to this method, debit total and credit total of each account of ledger are recorded
in the trail balance.
Balance Method
According to this method, only balance of each account of ledger is recorded in trail
balance. Some accounts may have debit balance and the other may have credit balance. All
these debit and credit balances are recorded in it. This method is widely used.
Note: Accounts of all assets, expenses, losses and drawings are debit balances. Accounts of
incomes, gains, liabilities and capital are credit balances
Regular Study - Annuities
Annuities
Many of the most common financial arrangements are structured as annuities, including
mortgage and rent payments, insurance premiums, retirement benefits -- even a salaried
worker's pay. An annuity will be either an ordinary annuity or an annuity due. The
difference lies in the timing of each payment relative to the period the payment covers.
In finance, an annuity is any series of equal payments that are made at regular intervals.
Though the word "annuity" comes from the Latin for "yearly," the periods between
payments in an annuity can be just about anything -- years, months, weeks; it doesn't matter
as long as the interval is consistent. An annuity can also last for a short period -- say a few
months -- or for decades.
Ordinary Annuity
With an ordinary annuity, the payment comes at the end of the covered term. The typical
home mortgage is an example of an ordinary annuity. When you pay your mortgage on
Sept. 1, for example, you're actually paying for the use of your home (and the use of the
lender's money) for August. You'll pay for September on Oct. 1, and so on. Most annuities
are ordinary annuities, which is why they're called "ordinary." Other common examples
include interest payments from bonds and payments on installment loans.
Annuity Due
In an annuity due, the payment comes at the beginning of the term. The most familiar
application of the annuity due is rent. When you pay apartment rent on Sept. 1, you're
paying for the use of the apartment in September. Unlike with a mortgage, when your first
payment typically isn't due until after your first full month in the home, your first rent
payment is due when you move in. Insurance premiums are another common example of an
annuity due; you pay today for coverage in the future.
Comparison / Distinction between an Ordinary Annuity and an Annuity-Due
In general, if you're the one making the payments, you're better off with an ordinary
annuity. If you're the one receiving the payments, you're better off with an annuity due. The
reason lies in a basic principle of finance known as the "time value of money": Because of
inflation and the ability to earn interest on invested or banked money, a sum of money today
is worth more than the same sum in the future. The longer you can delay making your first
fixed payment, the less that payment costs you.
On the flip side, the earlier you can receive the first payment of an annuity, the more it's
worth. Practically speaking, though, once an annuity begins, the cash flows occur on the
same schedule, and there's little noticeable difference between an ordinary annuity and an
annuity due.
Each payment of an ordinary annuity belongs to the payment period preceding its date,
while the payment of an annuity-due refers to a payment periodfollowing its date.
The meaning of the above statement may not be immediately obvious until we look at it
graphically...
A more simplistic way of expressing the distinction is to say that payments made under an
ordinary annuity occur at the end of the period while payments made under an annuity due
occur at the beginning of the period.
A third possibility is to define an annuity due in terms of an ordinary annuity: an annuitydue
is an ordinary annuity that has its term beginning and ending one period earlier than
an ordinary annuity. This definition is useful because this is how we will compute an
annuity due; i.e., in relation to an ordinary annuity (discussed further in "Calculating the
Value of an Annuity Due" below).
Most annuities are ordinary annuities. Installment loans and coupon bearing bonds are
examples of ordinary annuities. Rent payments, which are typically due on the day
commencing with the rental period, are an example of an annuity-due.
2. Calculating the Value of an Annuity Due
An annuity due is calculated in reference to an ordinary annuity. In other words, to calculate
either the present value (PV) or future value (FV) of an annuity-due, we simply calculate
the value of the comparable ordinary annuity and multiply the result by a factor of (1 + i) as
shown below...
AnnuityDue = AnnuityOrdinary x (1 + i)
This makes sense because if we go back to our earlier definitions we see that the difference
between the ordinary annuity and the annuity due is one compounding period.
Note also that the above formula implies that both the PV and the FV of an annuity due will
be greater than their comparable ordinary annuity values. This is illustrated graphically in
the section that follows, "Visual Comparison of Cash Flows." It can also be clearly seen in
the discount and accumulation schedules constructed in the "Excel" section.
The following examples illustrate the mechanics of the ordinary annuity calculation and
subsequent annuity due calculation.
a. Present Value of an Annuity
Using the example problem from the Present Value of an Annuity, we calculate the PV of
an ordinary annuity of 50 per year over 3 years at 7% as...
...and the present value of an annuity due under the same terms is calculated as...
...and just as we thought, the PV of the annuity due is greater than the PV of the ordinary
annuity; by 9.18 in this example.
b. Future Value of an Annuity
Using the example problem from the Future Value of an Annuity, we calclate the FV of
an ordinary annuity of 25 per year over 3 years at 9% as...
...and the future value of an annuity due under the same terms is calculated as...
...and again the FV of the annuity due is greater than the FV of the ordinary annuity; in this
example by 7.38.
3. Visual Comparison of Cash Flows
The distinction between an ordinary annuity and an annuity-due can be easily grasped by
visualizing the timing of the payments.
a. Present Value of an Annuity:
Ordinary Annuity. Continuing with the same example from the Present Value of an
Annuity, the following illustration shows how payments are applied in the case of an
ordinary annuity:
Annuity-Due. With an annuity-due the payments are made at the beginning rather than the
end of the period...
Note that the PV of the ordinary annuity is 131.22 and the PV of the annuity-due is 140.40
(calculated as 131.22 x 1.07).
The fact that the value of the annuity-due is greater makes sense because all the payments
are being shifted back (closer to the start) by one period. This means the PV should be
larger under the annuity due because all the payments are made earlier. In other words, they
are all closer to the "present" so they are subject to less discounting. Note that there is no
need to discount the first payment under the annuity due at all; since it is made at the very
outset, its PVis its face value.
b. Future Value of an Annuity:
Continuing with the same example from the Future Value of an Annuity, the following
illustration shows how payments are applied in the case of an ordinary annuity...
Annuity-Due. With an annuity-due the payments are made at the beginning rather than the
end of the period.
Note that the FV of the ordinary annuity is 81.95 and the FV of the annuity-due is 89.33
(calculated as 81.95 x 1.09).
The fact that the value of the annuity-due is greater makes sense because all the payments
are being shifted back (closer to the start) by one period. Moving the payments back means
there is an additional period available for compounding. Note the under the annuity due the
first payment compounds for 3 periods while under the ordinary annuity it compounds for
only 2 periods. Likewise for the second and third payments; they all have an additional
compounding period under the annuity due. The additional compounding generates a
larger FV.
Present Value and Future Value of an Annuity - Example
1. For calculating PV of Annuity, PV of each payment is calculated and added. E.g. if
Rs 100 is paid at the end of each year for 10 years, we calculate PV of each of these
10 payments of Rs 100 separately and add these 10 values.
2. Similarly, for calculating FV of Annuity, FV of each payment is calculated and
added. E.g. if Rs 100 is paid at the end of each year for 10 years, we calculate fv of
each of these 10 payments of Rs 100 separately and add these 10 values.
The present value an annuity is the sum of the periodic payments each discounted at the
given rate of interest to reflect the time value of money.
PV of an Ordinary Annuity = R (1 − (1 + i)^-n)/i
PV of an Annuity Due = R (1 − (1 + i)^-n)/i × (1 + i)
Where,
i is the interest rate per compounding period;
n are the number of compounding periods; and
R is the fixed periodic payment.
In the formulae, given, we have to correctly arrive at r, i.e.the interest rate. E.g.the given intt
rate is 12%p.a.If the payment is received yearly, r will be equal to 12/100=0.12.But if
payment is received monthly, it will be 12/100*12=0.01.For quarterly payment, it will be
0.03 and for half yearly payment, it will be 0.06
Example :
1. Calculate the present value on Jan 1, 2015 of an annuity of 5,000 paid at the end of each
month of the calendar year 2015. The annual interest rate is 12%.
Solution
We have,
Periodic Payment R = 5,000
Number of Periods n = 12
Interest Rate i = 12%/12 = 1%
Present Value
PV = 5000 × (1-(1+1%)^(-12))/1%
= 5000 × (1-1.01^-12)/1%
= 5000 × (1-0.88745)/1%
= 5000 × 0.11255/1%
= 5000 × 11.255
= 56,275.40
2. A certain amount was invested on Jan 1, 2015 such that it generated a periodic payment
of 10,000 at the beginning of each month of the calendar year 2015. The interest rate on the
investment was 13.2%. Calculate the original investment and the interest earned.
Solution
Periodic Payment R = 10,000
Number of Periods n = 12
Interest Rate i = 13.2%/12 = 1.1%
Original Investment = PV of annuity due on Jan 1, 2015
= 10,000 × (1-(1+1.1%)^(-12))/1.1% × (1+1.1%)
= 10,000 × (1-1.011^-12)/0.011 × 1.011
= 10,000 × (1-0.876973)/0.011 × 1.011
= 10,000 × 0.123027/0.011 × 1.011
= 10,000 × 11.184289 × 1.011
= 1,13,073.20
Interest Earned = 10,000 × 12 − 1,13,073.20
= 1,20,000 – 1,13,073.20
= 6926.80
Regular Study - YTM
Yield To Maturity (YTM)
The total return anticipated on a bond if the bond is held until the end of its lifetime. Yield
to maturity is considered a long-term bond yield, but is expressed as an annual rate. In other
words, it is the internal rate of return of an investment in a bond if the investor holds the
bond until maturity and if all payments are made as scheduled.
Calculating 'Yield To Maturity (YTM)'
Calculations of yield to maturity assume that all coupon payments are reinvested at the
same rate as the bond’s current yield, and take into account the bond’s current market price,
par value, coupon interest rate and term to maturity. YTM is a complex but accurate
calculation of a bond’s return that can help investors compare bonds with different
maturities and coupons.
Because of the complex means of determining yield to maturity, it is often difficult to
calculate a precise YTM value. Instead, one can approximate YTM by using a bond yield
table. Because of the price value of a basis point, yields decrease as a bond’s price
increases, and vice versa. For this reason, yield to maturity may only be calculated through
trial-and-error, by using a business or financial calculator or by using other software.
Though yield to maturity represents an annualized rate of return on a bond, coupon
payments are often made on a semiannual basis, so YTM is often calculated on a six-month
basis as well.
Yield to maturity is also often known as “book yield” or “redemption yield.”
Yield to maturity is very similar to current yield, which divides annual cash inflows from
holding a bond by the market price of that bond, to determine how much money one would
make by buying a bond and holding it for one year. Yet, unlike current yield, YTM accounts
for the present value of a bond’s future coupon payments. In other words, it factors in the
time value of money, whereas a simple current yield calculation does not. As such, it is
often considered a more thorough means of calculating the return from a bond.
Because yield to maturity is the interest rate an investor would earn by reinvesting every
coupon payment from the bond at a constant interest rate until the bond’s maturity date, the
present value of all of these future cash flows equals the bond’s market price.
Bonds can be priced at a discount, at par and at a premium. When the bond is priced at par,
the bond’s interest rate is equal to its coupon rate. A bond priced above par (called
a premium bond) has a coupon rate higher than the interest rate, and a bond priced below
par (called a discount bond) has a coupon rate lower than the interest rate. So if an investor
were calculating YTM on a bond priced below par, he or she would solve the equation by
plugging in various annual interest rates that were higher than the coupon rate until finding
a bond price close to the price of the bond in question.
Calculating Yield to Maturity
Imagine you are interested in buying a bond, at a market price that's different from the
bond's par value. There are three numbers commonly used to measure the annual rate of
return you are getting on your investment:
Coupon Rate : Annual payout as a percentage of the bond's par value
Current Yield : Annual payout as a percentage of the current market price you'll actually
pay
Yield-to-Maturity : Composite rate of return off all payouts, coupon and capital gain (or
loss)
(The capital gain or loss is the difference between par value and the price you actually pay.)
The yield-to-maturity is the best measure of the return rate, since it includes all aspects of
your investment. To calculate it, we need to satisfy the same condition as with all composite
payouts:
Whatever r is, if you use it to calculate the present values of all payouts and then add up
these present values, the sum will equal your initial investment.
In an equation,
c(1 + r)-1 + c(1 + r)-2 + . . . + c(1 + r)-Y + B(1 + r)-Y = P, where
c = annual coupon payment (in dollars, not a percent)
Y = number of years to maturity
B = par value
P = purchase price
You should try to form a mental picture of what this equation is saying. The left side
representsY+1 different compound interest curves, all starting out now, and each one ending
at the moment that the payout it corresponds to takes place. Most of these curves will lie
pretty low to the axis, because they only grow to a value of c, the coupon payment. The very
last curve will be a lot taller, and end up at the par value B. And if you add up the present
values of all these curves (that's the left side of the equation), the sum will exactly equal the
purchase price of the bond (that's the right side).
As with most composite payout problems, equation 1 can't be solved exactly, in general.
The nice part is that all yield-to-maturity problems have basically the same form, so people
have been able to create programmable calculators and computer programs (and even tables
back in the old days) to help you find r.
YTM Examples :
Suppose your bond is selling for 950, and has a coupon rate of 7%; it matures in 4 years,
and the par value is 1000. What is the YTM?
The coupon payment is 70 (that's 7% of 1000), so the equation to satisfy is
70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)-3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950
Of course you aren't really going to solve this, so you just use any calculator instead, and
find that r is 8.53%. If you want, you can plug this number back into equation, just to make
sure it checks out.
One thing to notice is that the YTM is greater than the current yield, which in turn is greater
than the coupon rate. (Current yield is 70/950 = 7.37%). This will always be true for a bond
selling at a discount. In fact, you will always have this:
One more basic formula for calculating yield to maturity looks like this:
Approximate YTM=(C+(F-P)/n)/((F+P)/2)
Where...
YTM = Yield to Maturity
C = Coupon/Interest Payment
F = Face Value
P = Price
n = Years to maturity
This calculation can only approximate what the yield or actual interest rate will be because
prices change in the actual bond market on a daily basis.
If a bond has a face value of 100 at 8% interest with a 15 year maturity and the coupon or
interest payment each year is 8 (8% x 100). The yield for the bond at its current price is 92.
The equation to find the yield looks like this:
Approximate YTM=(8+(100-92)/15)/((100+92)/2)
This looks like a lot of complex math but it's not as difficult as it may seem. We can break it
down into parts and solve it.
= 8+(100-92)/15
= 8+8/15
= 8+0.533
= 8.533
= (100+92)/2
= 192/2
= 96
= 8.533/96
= 0.088
= 8.8%
Yield to Maturity Calculation
Remember this is still only an approximation as the yield will change as the price of the
bond changes. The bonds interest rate (8%) is less than its yield to maturity (8.8%) so it is
selling at a discount.
Bond Selling At ... Satisfies This Condition
Discount Coupon Rate < Current Yield
< YTM
Premium Coupon Rate > Current Yield
> YTM
Par Value Coupon Rate = Current Yield
= YTM
Bond Yields and Prices
Once a bond has been issued and it's trading in the bond market, all of its future payouts are
determined, and the only thing that varies is its asking price. If you buy such a bond the
yield to maturity you'll get on your investment naturally increases if you can buy it at a
lower price: as they say, bond prices and yields "move" in opposite directions. That can be
confusing since people aren't always consistent in the way they talk about bond
performance. If somebody says "10 year treasuries were down today", they probably mean
that the asking price was down (so it was a bad day for bond holders); but they sometimes
mean that the yield to maturity was down because the asking price was up (a good day for
bond holders).
Uses of Yield to Maturity (YTM)
Yield to maturity can be quite useful for estimating whether or not buying a bond is a good
investment. An investor will often determine a required yield, or the return on a bond that
will make the bond worthwhile, which may vary from investor to investor. Once an investor
has determined the YTM of a bond he or she is considering buying, the investor can
compare the YTM with the required yield to determine if the bond is a good buy.
Yet, yield to maturity has other applications as well. Because YTM is expressed as an
annual rate regardless of the bond’s term to maturity, it can be used to compare bonds that
have different maturities and coupons since YTM expresses the value of different bonds on
the same terms.
Variations of Yield to Maturity (YTM)
Yield to maturity has a few common variations that are important to know before doing
research on the subject.
One such variation is Yield to call (YTC), which assumes that the bond will be “called”
(repurchased by issuer before it reaches maturity) and thus has a shorter cash flow period.
Another variation is Yield to put (YTP). YTP is similar to YTC, except for the fact that the
holder of a put bond can choose to sell back the bond with a fixed price and on a particular
date.
A third variation on YTM is Yield to worst (YTW). YTW bonds can be called, put or
exchanged, and YTW bonds generally have the lowest yields out of YTM and its variants.
Limitations of Yield to Maturity (YTM)
Like any calculation that attempts to determine whether or not an investment is a good idea,
yield to maturity comes with a few important limitations that any investor seeking to use it
would do well to consider.
One limitation of YTM is that YTM calculations usually do not account for taxes that an
investor pays on the bond. In this case YTM is known as the “gross redemption yield.”
YTM calculations also do not account for purchasing or selling costs.
Another important limitation of both YTM and current yield is that these calculations are
meant as estimates and are not necessarily reliable. Actual returns depend on the price of the
bond when it is sold, and bond prices are determined by the market and can fluctuate
substantially. Though this limitation generally has a more noticeable effect on current yield,
because it is for a period of only one year, these fluctuations can affect YTM significantly
as well.
Regular Study - Depreciation
Depreciation
Depreciation is a systematic and rational process of distributing the cost of tangible assets
over the life of assets.
Depreciation is a process of allocation.
Cost to be allocated = acquisition cot - salvage value
Allocated over the estimated useful life of assets.
Allocation method should be systematic and rational.
Depreciation methods based on time
Straight line method
Depreciation = (Cost - Residual value) / Useful life
Example
Company A purchased an equipment at the cost of 140,000 in 2015. This equipment is
estimated to have 5 year useful life. At the end of the 5th year, the salvage value (residual
value) will be 20,000. Calculate the depreciation expenses for 2015, 2016 and 2017 using
straight line depreciation method.
Depreciation for 2015
= (140,000 - 20,000) x 1/5 = 24,000
Depreciation for 2016
= (140,000 - 20,000) x 1/5 = 24,000
Depreciation for 2017
= (140,000 - 20,000) x 1/5 = 24,000
Declining balance method or Reducing Balance or Diminishing Balance Method
Depreciation = Book value x Depreciation rate
Book value = Cost - Accumulated depreciation
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. 2000. The book value for the next year will be
now 8000. This year the depreciation will be again 20% of the remaining value i.e. 20% of
8000=1600. So the remaining value of the asset is now 8000-1600=6400.
Depreciation rate for double declining balance method
= Straight line depreciation rate x 200%
Sum-of-the-years'-digits method
Depreciation expense = (Cost - Salvage value) x Fraction
Fraction for the first year = n / (1+2+3+...+ n)
Fraction for the second year = (n-1) / (1+2+3+...+ n)
Fraction for the third year = (n-2) / (1+2+3+...+ n)
...
Fraction for the last year = 1 / (1+2+3+...+ n)
n represents the number of years for useful life.
Example
Company A purchased the following asset on January 1, 2015.
What is the amount of depreciation expense for the year ended December 31, 2015
Acquisition cost of the asset --> 100,000
Useful life of the asset --> 5 years
Residual value (or salvage value) at the end of useful life --> 10,000
Depreciation method --> sum-of-the-years'-digits method
Calculation of depreciation expense
Sum of the years' digits = 1+2+3+4+5 = 15
Depreciation for 2015 = (100,000 - 10,000) x 5/15 = 30,000
Depreciation for 2016 = (100,000 - 10,000) x 4/15 = 24,000
Depreciation for 2017 = (100,000 - 10,000) x 3/15 = 18,000
Depreciation for 2018 = (100,000 - 10,000) x 2/15 = 12,000
Depreciation for 2019 = (100,000 - 10,000) x 1/15 = 6,000
Regular Study - Understanding Foreign Exchange Arithmetic
Understanding Foreign Exchange Arithmetic
Forces of demand and supply in the local interbank market drive the exchange rate.
Direct and Indirect Quote
A foreign exchange quotation can be either a direct quotation and or an indirect quotation,
depending upon the home currency of the person concerned. For example, $ 1 = Rs. 67.00,
means that one dollar can be exchanged for Rs. 67.00. Alternatively, we maypay Rs. 67.00
to buy one dollar. A direct quote is the home currency price of one unit of the foreign
currency.
Thus, in the aforesaid example, the quote$ 1 = Rs. 67.00 is a direct quote for an Indian
national.
An indirect quote is the foreign currency price of one unit of the home currency. The quote
Re. 1 = $ 0.0149 is an indirect quote
Basic Exchange Rate Arithmetic
(a) Cross rate
If a person wants to remit Euros from India, and as a banker, and for argument sake,
rupees/Euros are not normally quoted and therefore, we have to first buy dollars against the
rupees and the same dollars will be disposed off overseas to acquire the Euros.
(b) Chain rule
Calculation of the cross rate is based on a commonsense approach. However, it can be
reduced to a rule known as the chain rule with similar steps.
(c) Value date
The value date is a date on which the exchange of currencies actually takes place. Based on
this concept, we have the following types of exchange rates.
(i) Cash/ready: It is the rate when an exchange of currencies takes place on the date of the
deal.
(ii) TOM: When the exchange of currencies takes place on the next working day, i.e.
tomorrow it is called the TOM rate.
(iii) SPOT: When the exchange of currencies takes place on the second working day after
the date of the deal, it is called the spot rate.
(iv) Forward rate: If the exchange of currencies takes place after a period of spot date, it is
called the forward rate. Forward rates generally are expressed by indicating a
premium/discount for the forward period.
(v) Premium: When a currency is costlier in forward or say, for a future value date, it is
said to be at a premium. In the case of the direct method of quotations, the premium is
added to both the selling and buying rate.
(vi) Discount: If currency is cheaper in the forward or for a future value date, it is said to be
at a discount. In the case of a direct quotation, the discount is (deducted) subtracted from
both the rates, i.e. buying and selling rates.
The forward rates are quoted in terms of forward margins or forward differentials. For
example:
Spot Euro 1 = US$ 1.3180/90
1 month forward 35-32
2 month forward 72-70
3 month forward 110-107
It is understandable that if a currency is at a premium vis-a-vis another currency, the natural
consequence is that the later will be at a discount vis-a-vis the former currency.
In the above exchange rate quotations Euro is at a discount and hence US $ is at a premium.
We can buy US $, one month forward at
Euro 1 = US$ 1.3190 (-) 0.0032 = 1.3158
Similarly, we can sell
Euro 1 = US$ 1.3180 (-) 0.0035 = 1.3145
If the rates in Mumbai market are US$ 1 = Rs. 66.8450/545 and rates in London market are
US$ 1 = Euros 0.7587 we will get US$ 1 for Rs. 66.8545 and for one US$ we will get Euro
0.7587. Thus, we can form a sort of chain rule as under:
0.7587 Euro = US$ 1
Rs. 66.8545 = US$ 1
1 Euro = Rs. 66.8545 / 0.7587
1 Euro = Rs. 88.1172
If an export customer has a bill for £100,000, the bank has to purchase the £(Pound
Sterling) from him and give an equivalent amount in rupees to the customer. Presuming the
inter-bank market quotations for spot delivery are as follows:
US$ 1 = Rs. 66.8450/545
The London market is quoting cable (STG/DLR) as
£ 1 = US$ 1.9720/40
The bank has to sell £'s in the London market at US$ 1.9720, i.e. the market's buying rate
for £ 1. The US dollars so obtained have to be disposed off in the local inter-bank market at
US$ 1 = Rs. 66.8450 (market's buying rate) for US$.
By chain rule, we get:
£ 1 = 1.9720 x 66.8450
= Rs. 131.8183
The precaution which should be taken is that one should know who is the quoting party and
who is facing the quote. The thumb rule of the market is that if you ask for a quote, the
quoting party will give you a quote and it is for you to do the deal or not to do a deal on the
prices quoted. You cannot dictate prices. However, you can ask for a fresh quote.
Regular Study - Trial balance
Trial balance is a statement prepared with the balances or total of debits and credits of all
the accounts in the ledger to test the arithmetical accuracy of the ledger accounts. As the
name indicates it is prepared to check the ledger balances. If the total of the debit and credit
amount columns of the trail balance are equal, it is assumed that the posting to the ledger in
terms of debit and credit amounts is accurate. The agreement of a trail balance ensure
arithmetical accuracy only, A concern can prepare trail balance at any time, but its
preparation as on the closing date of an accounting year is compulsory.
According to M.S. Gosav (The Substance of Accountancy) “Trail balance is a statement
containing the balances of all ledger accounts, as at any given date, arranged in the form of
debit and credit columns placed side by side and prepared with the object of checking the
arithmetical accuracy of ledger postings”.
OBJECTIVES OF PREPARING A TRAIL BALANCE
Trial balance is prepared to check arithmetic accuracy.
(i) It gives the balances of all the accounts of the ledger. The balance of any account can be
found from a glance from the trail balance without going through the pages of the ledger.
(ii) It is a check on the accuracy of posting. If the trail balance agrees, it proves that both the
aspects of each transaction are recorded and that the books are arithmetically accurate.
(iii) It facilitates the preparation of profit and loss account and the balance sheet.
(iv) Important conclusions can be derived by comparing the balances of two or more than
two years with the help of trail balances of those years.
FEATURES OF TRIAL BALANCES
(i) A trial balance is prepared as on a specified date.
(ii) It contains a list of all ledger accounts including cash account.
(iii) It may be prepared with the balances or totals of Ledger accounts.
(iv) Total of the debit and credit amount columns of the trial balance must tally.
(v) It the debit and credit amounts are equal, we assume that ledger accounts are
arithmetically accurate.
(vi) Difference in the debit and credit columns points out that some mistakes have been
committed.
(vii) Tallying of trail balance is not a conclusive proof of accuracy of accounts.
LIMITATIONS OF TRAIL BALANCE
(i) The trail balance can be prepared only in those concerns where double entry system of
book- keeping is adopted. This system is too costly.
(ii) A trail balance is not a conclusive proof of the arithmetical accuracy of the books of
account. It the trail balance agrees, it does not mean that now there are absolutely no errors
in books. On the other hand, some errors are not disclosed by the trail balance.
(iii) It the trail balance is wrong, the subsequent preparation of Trading, P&L Account and
Balance Sheet will not reflect the true picture of the concern.
METHODS OF PREPARING TRAIL BALANCE
A trail balance refers to a list of the ledger balances as on a particular date. It can be
prepared in the two manners. In this section we present the important methods of preparing
Trial balance
Total method
According to this method, debit total and credit total of each account of ledger are recorded
in the trail balance.
Balance Method
According to this method, only balance of each account of ledger is recorded in trail
balance. Some accounts may have debit balance and the other may have credit balance. All
these debit and credit balances are recorded in it. This method is widely used.
Note: Accounts of all assets, expenses, losses and drawings are debit balances. Accounts of
incomes, gains, liabilities and capital are credit balances
Regular Study - Classification of Accounts
Classification of Accounts
Transactions can be divided into three categories.
i. Transactions relating to individuals and firms
ii. Transactions relating to properties, goods or cash
iii. Transactions relating to expenses or losses and incomes or gains.
Therefore, accounts can also be classified into Personal, Real and Nominal. The
classification may be illustrated as follows
Personal Accounts:
Accounts recording transactions relating to individuals or firms or company are known as
personal accounts. Personal accounts may further be classified as:
(i) Natural Person’s personal accounts: The accounts recording transactions relating to
individual human beings e.g., Anand’s a/c, Ramesh’s a/c, Pankaj a/c are classified as natural
persons’ personal accounts.
(ii) Artificial Persons’ Personal accounts: The accounts recording transactions relating to
limited companies, bank, firm, institution, club, etc., Delhi Cloth Mill; M/s Sahoo & Sahoo;
Hans Raj College; Gymkhana Club are classified as artificial persons’ personal accounts.
(iii) Representative Personal Accounts: The accounts recording transactions relating to
the expenses and incomes are classified as nominal accounts. But in certain cases (due to
the matching concept of accounting) the amount, on a particular date, is payable to the
individuals or recoverable from individuals. Such amount (i) relates to the particular head of
expenditure or income and (ii) represent persons to whom it is payable or from whom it is
recoverable. Such accounts are classified as representative personal accounts e.g., “wages
outstanding account”, pre-paid Insurance account, etc.
The proprietor being an individual his capital account and his drawings account are
also personal accounts.
Impersonal Accounts
All those accounts which are not personal accounts. This is further divided into two types
viz. Real and Nominal accounts.
i. Real Accounts: Accounts relating to properties and assets which are owned by the
business concern. Real accounts include tangible and intangible accounts. For example,
Land, Building, Goodwill, Purchases, etc.
ii. Nominal Accounts: These accounts do not have any existence, form or shape. They
relate to incomes and expenses and gains and losses of a business concern. For example,
Salary Account, Dividend Account, etc.
Rules of debit and credit (classification based)
1. Personal accounts : Debit the receiver - Credit the giver (supplier)
2. Real accounts : Debit what comes in - Credit what goes out
3. Nominal accounts : Debit expenses and losses - Credit incomes and gains
Regular Study - Capital and Revenue Expenditure/Receipts
Capital and Revenue Expenditure/Receipts
A capital expenditure is an amount spent to acquire or improve a long-term asset
such as equipment or buildings. Usually the cost is recorded in an account classified as
Property, Plant and Equipment. The cost (except for the cost of land) will then be charged to
depreciation expense over the useful life of the asset.
A revenue expenditure is an amount that is expensed immediately—thereby being matched
with revenues of the current accounting period. Routine repairs are revenue expenditures
because they are charged directly to an account such as Repairs and Maintenance Expense.
Even significant repairs that do not extend the life of the asset or do not improve the asset (the
repairs merely return the asset back to its previous condition) are revenue expenditures.
Difference between Capital and Revenue Expenditure
CAPITAL REVENUE
Large amount Relatively small
Improve or enhance earning capacity Maintain asset
Long duration benefit Short duration
Non- recurring Recurring
Balance sheet item Trading /P & L A/c item
Capital Receipt
Capital receipts are the income received by the company which is non recurring in nature.
They are generally part of financing and investing activities rather than operating activities.
The capital receipts either reduces an asset or increases a liability. The receipts can be
generated from the following sources:
Issue of Shares
Issue of debt instruments such as debentures.
Loan taken from a bank or financial institution.
Government grants.
Insurance Claim.
Additional capital introduced by the proprietor.
Revenue Receipt
Revenue Receipts are the receipts which arises through the core business activities. These
receipts are a part of normal business operations that is why they occur again and again
however its benefit can be enjoyed only in the current accounting year as its effect is short
term. The income received from the day to day activities of business includes all the operations
that bring cash into the business like:
Revenue generated from the sale of inventory
Services Rendered
Discount Received from the creditors or suppliers
Sale of waste material/scrap.
Interest Received
Receipt in the form of dividend
Rent Received
Key Differences Between Capital Receipt and Revenue Receipt
Receipts generated from investing and financing activities are capital receipts, on the other
hand, receipts from operating activities are revenue receipt.
Capital Receipts do not occur frequently as opposed to Revenue Receipts which do occur
frequently.
The benefit of capital receipt can be enjoyed in more than one year but the benefit of revenue
receipt can be enjoyed only in the current year.
Capital Receipts appears in the liabilities side of the Balance Sheet whereas Revenue Receipts
appears in the credit side of the Profit and Loss Account.
Similarities
Both receipts are a part of business activities.
Both are important for the survival and growth of the company.
Source of business income.
Capital Receipts Revenue Receipts
Receipts derived from sources which are not part of
the normal trading activities of the business such as
loans and capital injection by owners
Receipts related to normal activities of the
business, such as sales of goods and that
are added to Gross Profit
Example of capital receipts in a business
Capital paid by partners, or in case of a joint stock
company, sums received from shareholders or
debenture holders
Loan
Income from the sale of assets
Example of capital receipts by clubs and societies
Entrance fees
Donations received for the purpose of purchasing a
Example of revenue receipts in a business
Sales
Discount received
Commission received
Rent received
Interest received, etc
Example of capital receipts by clubs and
societies
Annual subscriptions
new assets or improving an existing asset
Legacies
Donations
Gains from sale of an asset
Appear as capital or liabilities in the Balance Sheet As revenue to Trading and Profit and Loss
Account
Capital and Revenue Expenditure : Examples
1. Cost of replacement of defective parts of the machinery is ……
1. Capital expenditure
2. Revenue expenditure
3. Deferred revenue expenditure
2. Loss of goods due to fire Rs.8000 is a revenue expenditure because……
1. It is recurring
2. Amount involved is small
3. Loss is arising out of business operations
3. Preliminary expenses , discount allowed on issue of shares are the examples of
1. Capital expenditure
2. Deferred revenue expenditure
3. Revenue expenditure
4. Expenditure incurred in acquiring the patents rights for the business is an example of ---
-
1. Capital expenditure
2. Deferred revenue expenditure
3. Revenue expenditure
S.No Item of Expenditure Nature Reason for Classification
1. Expenses on a Foreign Tour to
purchase a machinery
Capital These are incurred to acquire
a capital asset
2. Cost of Machinery Purchased Capital These are to acquire a capital
asset
3. Insurance & Freight on
Machinery purchased
Capital These are incurred to acquire
a capital asset.
4. Custom Duty on Imported Capital These are incurred to acquire
Machinery a capital asset
5. Wages for erection of Machinery Capital These are incurred to put the
Capital Asset to use.
6. Installation Charges of a
Machinery Purchased
Capital These are incurred to put the
capital asset to
7. Expenses incurred on trial before
the asset is put
Capital These are incurred Run to use
8. Cost of a Second hand Machinery
Purchased
Capital These are incurred to acquire
a capital asset.
9. Repair of a second hand
machinery before put to use
Capital These are incurred to put the
capital asset to use
10. Interest on a term loan for the
purchase of machinery. The
commercial production has not
begun till the last day of the
accounting year.
Capital These are incurred to acquire
capital asset & the
commercial production has
not yet begun.
11. Interest on a term-loan for the
purchase of machinery. The
commercial production has
already begun.
Revenue The commercial production
has already begun.
12. Repairs of Machine after the
machine is put to use
Revenue These are incurred to
maintain the capital asset
13. Amount spent for replacement of
worn out part of machine
Revenue These are incurred to
maintain the capital asset.
14. Annual Maintenance fee of a
machine
Revenue These are incurred to
maintain the capital asset.
15. Money spent to reduce working
expenses
Capital These are incurred to acquire
long term benefits.
16. Amount spent for replacement of
a petrol driven origin by CNG
Kits
Capital These are incurred to reduce
the operating costs and
thereby increasing the profits
17. Cost of Rings & Pistons of an
engine changed to get fuel
efficiency
Capital These are incurred to reduce
the operating costs and
thereby increasing the profits
18. Overhauling expenses for the
engine of a motor car to get better
fuel efficiency
Capital These are incurred to reduce
the operating costs and there
by increasing the profits
19. Legal expenses to acquire a
building
Capital These are incurred to acquire
ownership rights of the
capital asset.
20 Legal Expenses to defend a suit
claiming that firm’s factory site
Revenue These are incurred to
maintain the capital asset.
belongs to plaintiff
21. Amount spent on repainting an
old building for the first time on
purchase
Capital These are incurred to put the
capital assets to use.
22. Amount spent on annual
repainting of building
Revenue These are incurred to
maintain the capital asset.
23. Expenses to obtain a license for
starting a factory
Capital These are incurred to
maintain the capital asset. (i.e.
right to carry on business)
24. Annual Renewal fee of Licence
for next year
Revenue These are incurred for the
construction of building and
hence to be capitalized with
the cost of building
25. Amount spent for the
construction of temporary huts
for storing building material
while constructing a building
Capital These are incurred for the
construction of building and
hence to be capitalized with
the cost of building
26. Deposit with Mahanagar
Telephone Nigam Ltd. for
installing telephone.
Capital The amount us adjusted over
a period of time against
telephone bills.
27. Expenses for removal of stock to
a new site
Revenue Such expenditure in neither
bringing enduring benefit nor
enhancing the value of capital
asset.
28. Fines Imposed Revenue Such expenditure is neither
bringing enduring benefit nor
enhancing the value of capital
asset.
29. Annual Fire Insurance Rs. 12,000
paid on 1stJanuary 2006 during
accounting year ending on
31.3.2006
Revenue Rs. 3,000 as current year’s
revenue expenses Rs. 9,000
as prepaid expenses for next
year.
30. Inauguration Expense on opening
of a new branch of an existing
business Free gift to customers
Or
Tournament Sponsoring Exp.
Or
Advertisement campaign to lunch
a new product.
Deferred
Revenue
Such expenditure is not
enhancing value of capital
asset. Since it has an enduring
effect on the future revenue
generating capability of
business, it may be treated
deferred revenue expenses.
31. Compensation for breach of stock
to a new site
Revenue Such expenditure in neither
benefit nor enhancing the
value of capital asset.
32. Compensation paid to workers
under Voluntary Retirement
Scheme (VRS)
Revenue Such expenditure is not
enhancing value of capital
asset. Having regarded to the
large amount, it may be better
to treat it as deferred revenue
expenditure which may be
w/o of over future years.
33. Amount spent on demolition of
Building to construct bigger
building on the same site
Capital These are incurred for the
construction of new building
34. Loss Sale of Machine Revenue Such expenditure is neither
brining enduring benefit nor
enhancing the value of capital
asset.
35. Legal Expenses to recover dues
from customers
Revenue These are incurred to
maintain present revenue
generating capability
36. Festival Advance to employees Not an Exp. It is an item of loan &
advances
37. Advance to Suppliers of Goods Not an exp. It is an item of loan &
advances.
38. Cost of Improvement in Electric
wiring system
Capital This is incurred to acquire
capital asset.
39. Purchase of a Patent Right Capital This is incurred to acquire
capital asset.
40. Purchase of a Goodwill Capital This is incurred to acquire
capital asset.
41. Purchase of a Technical Know
how
Capital This is incurred to acquire
capital asset.
42. Purchase of a Live Stock by a
farmer
Capital This is incurred to acquire
capital asset.
43. Amount spent on Neon Sign
Board
Capital This is incurred to acquire
capital asset.
44. Import Duty on purchase of
Materials
Revenue This is incurred on operating
activities in the normal course
of business.
45. Compensation paid to employees
who were retireched
Revenue Such expenditure is neither
bringing enduring benefit nor
enhancing the value of capital
asset.
46. Imported Goods forfeited by
custom authorities
Revenue Loss Such expenditure is neither
bringing enduring benefit nor
enhancing the value of capital
asset.
…………………………………………………………………………………………………….