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Accounting System: - consist of the personnel, procedure, technology and

records used by an organization

 Develop accounting information

 To communicate these information to decision maker

Basic functions of an Accounting system

1. Interpret and record the effect of business transactions

2. Classify the effect of similar transaction in a manner that permits determination
of the various totals and subtotals useful to management and used in
accounting report.
3. Summarize and communicate the information.

Integrity of Accounting Information

The word integrity refers to the following qualities: complete, unbroken,

unimpaired, sound, honest, and sincere.

General Accepted Accounting Principle

The Generally Accepted Accounting Principles (GAAP) are a set of rules,

guidelines and principles companies of all sizes and across industries in the U.S. adhere
to. In the U.S., it has been established by the Financial Accounting Standards Board
(FASB) and the American Institute of Certified Public Accountants (AICPA).

Irrespective of the type of company, the GAAP is at the core of all of the company’s
accounting transactions. It is used by businesses to organize and summarize the financial
information into accounting records.

Financial Accounting Standard Board: - is an independent rule making body,

consisting of seven members from the accounting profession. The FASB is responsible
to issue statement of Financial Accounting Standard and other authoritative Accounting
Pronouncement, which represent official expressions of generally Accepted Accounting
Principle.
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Accounting Cycle

 Recording cycle: - all transactions should be recorded in the journal or

books of original entry known as subsidiary books as and when they take
place.
 Classifying: - all entries in the journal or books of original entry should be
posted to the appropriate ledger accounts to find out at a glance the total
effect of such transactions in a particular accounts.
 Summarizing: - last stage is to prepare the trail balance and final
accounts with a view to ascertain the profit or loss made during a trading
period and the financial position of the business on a particular date.
 Bookkeeping:-Bookkeeping is the clerical side of accounting, the
recording of routine transactions and day to day record keeping. It is just
recording phase of accounting.

 Closing entries: - Revenue and expenses account showing

credit and debit are closed to concerned owner capital
account, as Revenue shows normally a credit balance it is
posted to credit side of income and summary account, on
the other hand expenses show debit balance, their debit
balances are closed to debit side of income and summary
account. The following necessary entries are made in
respect of the above mentioned causes:-
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Repair Service Revenue

To income summary account
Income summary
To all expenses Cr
When income summary account shows a credit balance it is
shifted to credit side of owner capital, in case of excess
debit over credit, it is recorded to debit side of owner
equity.

 After closing trial Balance: - A trial balance prepared after

all closing entries have been made. Consists only of
accounts for assets, liabilities and owner’s equity.
Permanent Accounts are recorded here. Temporary
Accounts are transferred to Income and Summary Account
at the End of the year to ascertain Profit earned or Loss
suffered during a financial year.

Accounting cycles: -
1. Recording transactions: - in this step every transaction which
brings any change in financial affairs of the business are recorded
on daily basis.
2. Ledger
3. Trial Balance
4. Adjustments
5. Adjusted trial balance
6. Preparation of final account
7. Passing closing entry
8. Passing reverse entry (optional)
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Double entry book keeping system: - the double entry system of book-keeping owes
its origin to an Italian merchant named Lucas Pacilio who wrote the first book on double
entry books keeping system “De-Computis et Scripture” It is published in Venice in
1544.

The double entry book keeping system can be defined as the system of recording
transactions having two fundamental aspects ---- one involving the receiving of a benefit
and the other to giving the benefits in the same set of books.

Accounting concepts

1. Business entity concept: - in accounting, business is treated as a separate entity

from it owner. Accounting gives information about the entity not about the
person who operates the entity.
2. Going concern concept: - according to this concept it is assumed that the
business will exist for a long time to come. Transaction are recorded in the books
keeping in view the going concern aspect of the business unit, the fixed assets are
shown in the balance sheet at a diminishing balance method i.e. going concern
value. There is no need to show assets at their market value because these have
been purchased for used in future and earn revenue as not for sale purpose.
3. Money measurement concept/ the stable Dollar Assumption: - a limitation of
measuring cost is that value of the monetary unit or dollar in not always stable.
Inflation is a termed used to describe a situation where the value of the
monetary unit decreases, likely deflation may occur which distorts the
transactions of the entity.
4. Cost concept: closely related to going concern concept. According to this
concept, an asset is ordinarily recorded in the books at price at which it was
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acquired i.e. cost price. Cost principle has one drawback which ignores the
inflation causes as time passes value of any assets goes on declining due to
inflation factor.
5. Dual aspect concept:- Dual aspects may be stated as for every debit, there is a
credit, every transaction should have two sided effect to the extent of same
amount e.g. Equities= asset
6. Accounting period concept
7. Matching concept: - the aim of every business is to earn profit. In order to
ascertain the profit the cost (expenses) are matched to revenues.
8. Objectivity concept: - this means that the business transactions are recorded on
the basis of supporting documents like vouchers, bills, invoices etc. These
documents are base for accounting record and audit.
9. Realization concept: this concept says that profit should be considered only
when realized. It determines when revenue should be recorded in the accounting
record. Revenue is realized when services are rendered to customers or when
goods sold are delivered to customers.
10. Objectivity: - accountants preference for using dollar amounts that are relatively
factual- as opposed to merely maters of personal opinion.
11.

Accounting conventions
1. Convention of disclosure: -this disclosure of all significant information is one of
the important accounting conventions. It implies that accounts should be
prepared in such a way that all material information is clearly disclosed to the
reader. Adequate disclosure means that users of financial statements are
informed of any facts necessary for the proper interpretation of the statement.
Adequate disclosure may be made either in the body of the financial statements
or in notes accompanying the statements. Adequate disclosure is made in the
body of financial statements and in notes accompanying these statements. Which
assist the reader to interpret the accounting information? It includes lawsuits
against the company, due dates of major liabilities, assets pledged as collateral to
secure loan, account receivables from officers or other outsiders and contractual
commitments requiring large future cash outlays.
2. Conventions of consistency: this convention means that accounting practices
should remain unchanged from one period to another, e.g. if stock is valued at
cost or market price whichever is less; this method should be followed year after
year.
3. Conventions of conservatism: - this convention means caution approach or
policy of safe play. This ensures that uncertainties and risks inherent in business
transactions should be given a proper consideration. It there is a possibility of
loss, it should be taken into account at the earliest. On the other hand, a prospect
of profit should be ignored up to the time it does not materialize.
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4. Materiality Concept: - the term materiality refer to relative importance of an

item or an event. An item is considered material if knowledge of the item might
reasonably influence the decision of users of financial statements. Accountant
must be sure that all material items are properly reported in Financial
Statements. This means this financial reporting process must be cost effective,
that is the value of information should exceed the cost of its preparation. -
According to this convention only those events or items should be recorded
which have a significant bearing and insignificant things should be ignored.
5.

Financial Accounting VS. Cost and Management Accounting

Financial Accounting Cost Accounting

It is primarily for external purpose It is primarily for internal purposes

It records what has happened based on past It provides information which is based to take
transactions in a true and fair manner decision about the future

It is heavily constrained by legal regulation It is relatively free of constraints imposed by

and accounting standard legal regulation and accounting standard

It must comply with stature and generally It is tailored to suit the needs of users
accepted principle

It emphasized on the type of expenses It emphasizes on the product, processes and

departments

It emphasizes on the stewardships of It emphasizes on the control or decision

accounting making aspects of accounting

It provides an overall view of the business It gives detailed analysis of all aspects of the
enterprise business unit

Types of accounts: -
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1. Personal Accounts: - It contains both natural and artificial person. Balance

sheet
2. Real or property Accounts:- accounts of properties and things, are those which
record of properties and things owned by trader e.g. machinery, land and cash
etc balance sheet
3. Nominal Accounts: - expenses and gains are recorded in this accounts, profit
and loss or trading account. Expenses, losses and incomes.

Rules of debit and credit

 Personal account: - debit the receiver and credit the giver of the benefits.
Involves debtors and creditors
 Real accounts: - debit the account of property or thing coming in and credit the
account of that going out.
 Nominal account: - debit the account of all expenses and losses and credit the
account of all gains.

Journal

The word journal has been derived from the French word jour which means day.
So journal means daily. It is a book or original entry to record chronologically in order
of date. It is also termed as day book. Journal is also termed as Original Entry, or prime
entry or primary entry or preliminary entry or first entry.

When carrying forward the total of one page to another, the words carry forward
or carried over is written, it should be written at the bottom of the first page and words
brought forward at the top of the next page is written.

Double Entry and Single entry system: - the system under which both the changes in
a transaction are recorded together- one change is debited; while the other change is
credited with an equal amount- is known as Double entry system.

Single entry system: - the system under which one aspect of the transaction is
recorded; Single entry is faulty, incomplete, inaccurate, unscientific and unsystematic
style of account- keeping.

Double Entry System Single Entry System

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1. Both the aspect are recorded 1. For some transactions both the
aspects are recorded, while for
some other transactions only one
aspect is recorded. Again, some
transactions are not recorded at all.

2. All the different classes of accounts- 2. Only cash and personal accounts
Assets A/C, Liability, Capital, are maintained.
expenses and revenue are
maintained.

3. In this system profit and loss 3. Under this system both aspect are
account can be maintained. not recorded, it is not possible to
prepare trial balance

4. The financial position of the 4. No account is maintained in respect

business can be ascertained of asset and liabilities. So, Balance
through balance sheet sheet cannot be prepared

Distinction between ledger and Journal

 The journal is the book of first entry, original entry; the Léger is the book of
second entry.
 The journal is the book for chronological; the ledger is the book for the analytical
record.
 The journal, as the book of source entry, ordinarily has greater weight as legal
evidence than the ledger.
 Journal is called the book of original entry, and ledger is called book of final
entry.
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 Journal is said to be primary books and ledger is secondary book

 Journal is the subsidiary book and ledger is the main book of account

Ledger: - the book in which accounts are maintained, is called ledger. The goal of every
transaction is ledger. Willian Pickle has said that the destination of every entry made in
the ledger. The record used to keep track of the increase or decreases in financial
statement items is termed a ledger account or simply an account. The entire group of
accounts is kept together in an accounting record called ledger.

Contra entry: -contra entry from the Latin prefix meaning opposite or against.
Balancing: balancing, is an account term which means the difference between the two
sides of account.

If an amount is entered on the debit side of an account, and the exact amount is
again on the credit side of the same account, it is called “Contra Entry”

 Cash is deposited into bank by Office

 Cheque is drawn for office use.

Types of ledger
 Sales or Debtors Ledger
 Purchase or creditor Ledger
 Impersonal ledger:- it contains all real, and nominal accounts

Trial Balance: - trial balance is used to find out arithmetical accuracy of the
transactions. It mainly contains five columns. These are as follows: -

S. Number Head of Ledger Folio Debit Credit

Account

Limitation of Trial Balance: trial balance is maintained to discover errors and

find out mistakes committed. Some of the errors are not disclosed by trail balance these
are as follows:
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1. Errors of principle
2. Errors or omissions
3. Errors of commission( wrong amount, wrong side
4. Compensatory errors
5. Posting errors

Types of errors

Bank reconciliation statement: if there is any discrepancy between the balance

of cash book and that of pass book, the depositor prepares a statement to explain the
causes of discrepancies and to reconcile the two balances. This statement of explanation
is called Bank Reconciliation Statement.
Not Sufficient Fund:-

Bank Reconciliation Format

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Causes of Difference
1. Timing:- there may be time gap between recording transactions in the
customer’s book and bank’s book
2. Transactions: - for some transactions, the bank has earlier knowledge and it
adjusts its record before the business which causes difference.
3. Errors: - some difference in balance may arise owing to errors committed by the
bank or by the person responsible for preparing the cash book.

Reasons of disagreement of Cash book and Pass Book

1. Un presented Cheque:- it may presented to bank after some time which causes
disagreement
2. Deposit in Transit
3. Un- Collected Cheque, Un credited cheque:- recorded in cash book debit
side but bank has not credited the account of customer which cause
disagreement
4. Dishonor Cheque
5. Service Charges
6. Misc Charges and incomes
7. Amount deposited directly by customer
8. Dividend collected by Bank
9. Insurance premium paid by Bank on standing order of customer.
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Summary of Causes of Difference

Causes due to which Causes due to which

 Cash book shows more balance  Pass book shows more balance
 Pass book shows less balance  Cash book shows less balance

Cheque deposited but not yet credited Cheque issued but not yet paid by bank
by Bank in Pass Book

Various expenses paid by bank upon Amount directly deposited by customer

standing order of customer in the bank

Bank charges and interest on overdraft Dividend collected by bank directly

charged by bank

Cheque received but not send to bank Interest on deposit credited by bank
for collection

Cheque received and deposited in the Cheque received and deposited but
bank but bank record in wrong side; omitted to record in the cash book or
debit side of pass book recorded on credit side of cash book

Chequed issued and recorded in cash

book and bank paid the amount but
forgot it to record in debit side of cash
book

System of petty cash

1. Open system: - under this system the petty cashier at first receives from the
chief cashier a fixed sum of money for meeting petty expenses. As soon as the
said amount is spent the chief cashier again pays the required sum to the petty
cashier.
2. Fixed advance system:- under this system a person receives fixed sum of
money for a fixed period of time, the chief cashier will pay that sum of money to
petty cashier every month
3. Imprest system:-most followed system used by many organizations, under this
system fixed the petty expenses are estimated and then said amount for meeting
required expenses are paid to petty cashier. This amount is called as impress
cash.

Division of Journal / Subsidiary journal

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 Cash book
 Purchase book
 Sales Book
 Purchase return Book
 Sales Return Book
 Bill receivable book
 Bill payable book
 Journal Proper Book: - it is used for recording those transactions for which
there is no separate book.
 Subsidiary ledger: - subsidiary ledger contains a separate account for each of
the items included in the balance of general ledger account e.g. account
receivable 500 subsidiary ledgers for each.

Purchase book/ Posting: - the total of the purchase book is posted to the debit of
purchase Account. It used to record all credit purchase of the entity.

Date Particulars/ Account Invoice L.F Amount

credited Number

Farooq

Rasool

Iqbal

Purchase Return Book: - it is a book in which goods returned to suppliers are recorded
also called as purchase outward book. The total of the return outwards book is credited
to returns outwards Account. Individual suppliers to whom goods are returned are
debited (Because they receive the goods)

Note: - in purchase book of account, an inward invoice received from vendor is written,
as company gets invoice regarding payment from creditors.

Debit Note: - When the goods are returned to the supplier’s intimation is sent to them
through what is known as debit note. This debit note serves as vouchers for these
entries. A debit note is a statement sent by a business to another person, showing the
amount debited to the account of the later, it is prepared as invoice is prepared.

Sales Return Book: - It is called inwards book. It is used for recording goods returned
to us by our customers. The total of the Return inward book is debited to returns
inwards Account or sales returns Account. The customers who have returned the goods
are credited with the amount shown against their names.
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Credit Note: - customers who return goods should be sent a credit note, it is statement
sent by a business to another person showing the amount credited to the account of
latter.

Balancing Cash Book: - in order to find out cash in hand at the end of the month, the
cash book is balanced like an ordinary account.

Contra Entries: - The term Contra refers to the opposite side. Contra is an entry in a
double entry account representing the reversal or cancellation of an entry on the other
side. For example cash deposited into the bank, or cash withdraw from bank for office
use.

Trade Discount: - Trade Discount represents an allowance which is made by the

manufacturers to the wholesalers or by the wholesalers to retailers and it is calculated
as a percentage of list or catalogue prices of goods supplied.

Cash Discount: - Cash Discount is allowed to encourage a debtor to pay off his debt
within a specified period. If the Debtor settles his account within given period, he is
entitled to reduce his bill by agreed amount.

Cash discount is allowed for the following purposes

1. To improve the cash flow of the business for investing the fund elsewhere and
2. To reduce the possibility of bad debt

DEBIT NOTE VS. CREDIT NOTE

Journal proper: - the book of account where all the transactions for which there are
no special journals, are primarily recorded is known as “journal proper or General
Journal”.
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 Opening entry
 Transfer entry
 Adjustment entry
 Rectification entry
 Entries there is not special entry
 Entry for rare transaction

Special Journal:- is an Accounting Record to device designated to record a specific type

of routine Transaction quickly and effectively.

Final accounts

 Financial statement – Statement of Operations

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Balance sheet:- financial position of the business

The history of Balance Sheet:- in the early sixteenth century, Simon of Burges first
devised, what he called statement of affairs of a business using the data provided by
the residue of the trial Balance.

Note: - publicly owned companies___ those with shares listed on Stock Exchange
have obligation to release annual and quarterly information to their stockholders
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and to the general public. Annual Report includes comparative financial statements
for several years and wealth of other information about the company’s financial
position, business operation and future prospect. Publicly owned enterprises must
file their audited financial statements and detailed supporting schedule with
Securities and Exchange Commission.

Formats of Balance Sheet

 Horizontal or Traditional Format

 Vertical Format

 Cash flow statement :- records actual cash received and paid by the business
during one
 Year
Purpose of Cash flow statement:- the basic purpose of a statement of cash flows to
provide information about the cash receipt and cash payment of a business entity
during the accounting period.
Classification of cash flows:-
1. Operating activities: - the operating activities section shows the cash effects
of revenue and expenses transactions. Stated another way, the operating
activities selection of the statement of cash flows includes the cash effects of
those transactions reported in the income statement.
2. Investing activities:- cash flows relating to investing activities present the
cash effects of transactions involving plant assets, intangible assets, and
investment These includes :- cash proceeds from selling investment or plant
assets, payment to acquire investments or plant assets, cash proceeds from
collecting principal amounts on loans etc.
3. Financing activities:- cash flows classified as financing activities include the
following items that result from debt and equity financing transactions:
Proceeds from both short term and long term borrowing, repayment of
amounts borrowed( excluding interest payment), cash received form
owner( as, for example from issuing stock, and repayment to owners , such as
cash dividend

Critical importance of cash flows from operating activities: - in the long run, a
business must generate positive net cash flow from operating activities if it is to survive.
An entity with negative cash flows from operating operations will not be able to raise
cash from other sources. Neither a company expects to survive indefinitely on cash
provided by investing activities. At some point, plant assets, investments, and other
assets available from sale will be depleted.
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Note: - Basically, a statement of cash flows can be prepared from data contained in an
income statement and comparative balance sheet at the beginning and end of the
period.

Methods of Preparing Cash Flow

 Direct Method
 Indirect method: - computation of net cash flows from operating activities by
indirect method looks quite different from the direct method. Both methods give
the same figure of net cash flow. Under indirect method begins with accrual
based net income and then shows the various adjustments necessary to reconcile
net income with net cash flow from operating activities.

Adjustments for Non-Cash Expenses

 Depreciation: -Depreciation is an example of a non-cash expenses, this
reduces net income but does not outlay during the period. To reconcile
net income with net cash flow, we add back to net income the amount of
depreciation and may other non-cash expenses, other non-cash expense
are; unfunded pension, amortization of intangible assets, depletion of
natural resources, and amortization of bond discount.
 Changes in Account Receivable: - receivable increase as revenue is
earned and decrease as cash is collected from customers. A net increase in
Account Receivable over the period indicates that revenue from credit
sales exceeds collection form customers. Part of Revenue recognized
increased Receivable rather than cash.
 Peak pricing: -the strategy of charging a higher price during periods of
high demand, and lower price during period of slack demand. Intended to
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both maximize revenue and shift excess demand periods in which it can
be more easily accommodated.

Statement in change of owner equity


 Noted to accounts:- it includes policies, disclosure, and other explanatory
information about the financial statement of the business, these notes provide
users with various types of information considering necessary for the proper
interpretation of the statements.

Trading and profit and loss account

All direct expenses are recorded in trading account in order to know the
operation of the business. List of direct expenses:-

 Wages
 Carriage inward: - conveyance charges of goods by land. Carriage
inward are the expenses incurred to bring the goods purchased in
the go down or shop
 Cartage
 Freight:- is the charge made for conveyance of goods by sea or rail
 Custom duty, Octroi duty:- when goods are purchased within
municipality limits, generally octroi duty has to be paid on it. It is debited
to Trading Account.
 Excise duty
 Closing stock: - the closing stock is valued at cost or market price
whichever is lower according to the concept of conservatism.

Direct, Operational Sources or Major Sources: - the revenue earned out of normal
business activity belongs to this source. For example, for a trader, sale proceeds of
goods are a major source of revenue.

Financial source or minor source or indirect sources of revenue:- any revenue

arising from sources other than normal business activates belongs to this category e.g.
interest, dividend, profit on sale of fixed assets etc.
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Direct expenses: - Expenses connected with purchases of goods are known as “Direct
expenses” for example, freight in, insurance in transit, carriage, wages, custom import
duty etc. such sort of expenses are recorded in Trading Account.

Indirect expenses: - All the expenses other than direct expenses are assumed as
indirect expenses. Such expenses have no relationship with purchases of goods. For
example, rent, salaries, legal charges, insurance of building, deprecations, and printing
charges. All indirect expense will be recorded in Profit and loss account.

Two Systems of Ascertaining profit or loss: - there are two systems of ascertaining
profit or loss.

 Cash System:- the system under which the annual results (profit or loss) of the
concern is ascertained on the basis of only items of revenue received in cash and
the items of expenses paid in cash whether the relate to the current accounting
year or not_____is called cash basis.
 Accrual or mercantile systems:- the system under which all items of revenue
and expenses relating to the current year whether received/ paid in cash or
not……. Are taken into consideration while determining the profit or loss of the
business is called Accrual or Mercantile system.
All revenue items relating to 2005 received+ receivable VS all items of
expenses relating to 2005 paid +payable

Parts of trading/ profit and loss account

1. Revenue earned
2. Operating expenses
3. Income from operation
4. Other income/ expenses
5. Net income

Income from sales

Less: - sales return and allowance
Sales discount
Net sales
Cost of goods sold
Opening inventory
Less purchase return
Net purchases
Cost of goods available for sales
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Less closing inventory

Cost of goods sold
Gross profit
Operating expenses
Selling and administrative expense
Net profit from operation
Other income
Rent incomes
Other expense
Interest expense
Net profit

Balance sheet Grouping and Marshalling: - in a balance sheet assets and liabilities
should be properly grouped and classified under appropriate headings. The term
marshalling means order in which assets and liabilities are stated on the balance sheet.

 The order of liquidity or realizability : - current assets are recorded first same
rules are used for liabilities;
 The order of permanence: - this method is the reverse of the stated method
 Mixed order of arrangement: - is the combination of the order of the
realisability and the order of permanence. Assets are arranged in order of
realisability and liability in order of permanence.

Classification of assets

 Real ASSETS:- Assets which have some market value are called real
assets e.g. building, machinery, stock, Debtors, cash and Goodwill
 Fictitious assets: - assets which have no market value are called
factious assets e.g. preliminary expenses, loss on issue of shares or
debenture etc. They also called as nominal assets
 Fixed assets : - long term
 Current or circulating or floating assets: - which are held for resale or to be
converted into cash after some time e.g. sundry debtors, bill receivable, stock or
goods.
 Wasting assets: - the asset that depreciate through wear and tear whose value
expires with lapse of time or that become exhausted through working are known
as wasting assets. Mine, forest etc.
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 Intangible assets or fictitious assets: - which don’t possess physical existence.

Debit balance of profit and loss, insurance prepaid , goodwill, trade mark
 Contingent assets: - which comes into existence upon the happening of a certain
event, uncalled capital of limited company.
 Outstanding assets: - expense paid in advance is called as outstanding asset for
example income from earned but not received are known as outstanding assets.
 Quick Assets: - out of the current assets which can be converted into cash very
quickly or which are already in the form of cash are called “Liquid or Quick
Assets”. E.g. debtors, cash in hand, cash at bank etc.

Ratio Analysis: - a ratio is a simple mathematical expression of the relationship of

one item to another. Every percentage may be viewed as a ratio____ that is, one number
expressed as a percentage to another.
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Consolidated financial statement: - consolidated financial statements present the

financial position and operating results of the parent company and its subsidiary as if
they were single business organization.

Gross Profit Margin: - Gross profit expressed as a percentage of net sale. Also called
gross profit rate.

Comparative financial statement: - the financial statement amounts for several years
appear side by side in vertical columns. This consists investors in identifying and
evaluation significant changes and trends.

Trend percentage: - the changes in financial statement items from a base year to
following years are often expressed as trend percentage to show the extent and
direction of change.

Measure of liquidity and Credit Risk

Liquidity refers to a company’s ability to meet its continuing obligation as they arise.
E.g. a company may have borrowed money and needs to be repaid in near further along
with the interest payment.

Working capital: - working capital is a measurement often used to express the

relationship between current assets and current liabilities. Working capital is the excess
of current assets to current liabilities.
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Current ratio: - the most widely used measure of short term debt paying ability is
the current ratio. This ratio is computed by dividing total current assets by total
liabilities.

Quick Ratio: - inventory and prepaid expenses are the least liquid of the current assets.
In a business with a long operating cycle, it may take many months to convert inventory
into cash. The quick ratio compares only the most liquid current asset ____called quick
asset with current liabilities. Quick asset includes cash, marketable securities, and
receivables.

Debt Ratio: - one indicator of the amount of leverage used by a business is the debt
ratio. This ratio measures the proportion of the total assets financed by creditors, as
distinguished from stockholders. It is computed by dividing total liabilities by total
assets. A high debt ratio indicates an extensive use of leverage, that is, a large portion of
financing provided by creditor. A low debt ratio indicates that the business is making
little used of leverage.

Return on Investment: -the rate of investment is a measure of management’s

efficiency in using available resources. Regardless of the size of the organization capital
is the scarce and must be used in effective manner. This ratio tells us about the return
on the invested invested by management.

Return on Equity: -net income divided by average total equity. Indicates the rate of
return earned by owner’s equity.

Return on assets:-operating income expressed as a percentage of average total assets.

A measure of the efficiency with which management utilizes the assets of a business.

Multiple –Step Income Statements: - a multiple step income statements its name from
the series in which costs and expenses are deducted from revenue.

 Revenue
 Cost of goods sold
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 Operating expenses
 No operating expenses

Single-step income statements: - many publically owned corporations present their

financial statements in a highly condensed format

Earnings per share:- earnings per share is net income, expressed on a per share basis.
For example, the balance sheet indicates that computer barn has 15000 shares of capital
stock outstanding, and net income is 72000, in this case earning per share is 4.80, large
corporations compute earnings per share and show these amounts at the bottom of
their income statements. For small organization showing of earnings per share is
optional.

Return on investment: - in deciding where to invest money investors or equity

holders want to know how efficiently companies utilize resources. The most common
method of evaluating the efficiency with which financial resources and employed is to
compute the rate of return earned on these resources.

ROI= Return/Average amount invested

Leverage: - leverage means using borrowed money to earn a return greater than the
cost of borrowing, increasing net income and return on common equity holders.

Operating cycle:-the period of time required for a merchandizing company to convert

its inventory into cash is called the operating cycle
 26

Impact of inflation: - during, a period of significant inflation, financial statements

prepared in terms of historical cost do not reflect fully the economic resources or the
real income, (in term of purchasing power). The FASB recommends that companies
include their annual report schedule showing the effects of inflation on their financial
statements.

Reserves
1. Revenue reserve :-
 General reserve: - which is not created for specific purposes but
for strengthening the financial position of the business e.g. G.
Reserve, Reserve fund and contingency reserve.
 Specific Reserve: - created for specific purposes viz Dividend Eq
Reserve, Debenture sinking fund, these funds can be used for
which the reserve has been made.

Financial Assets – Valuation: - Financial Assets describes not just cash but also
financial assets which can be converted into cash in a short period of time. These assets
includes cash, short term investment (also called marketable securities) and receivable

Types of Financial Asset Basis for Valuation in the Balance sheet

Cash ( and Cash Equivalents) Face value

Short term investment( Marketable Current market value

Securities

Receivables Net Realizable value

Cash equivalent: - some short term investment are most liquid as are called cash
equivalent i.e. money market funds, U.S Treasury bills, and high grade commercial
paper. To qualify as a cash equivalent must be very safe, have a very stable market
value, and mature within 90 days of the date of acquisition
 27

Valuation of Financial Assets (Marketable Securities): - in the balance sheet the

financial assets are recorded on current market value, meaning of cash that these assets
represent. Current market value is measured differently for every financial asset. But
current value of financial assets changes due to stock price, interest rate and other
factors. Therefore, short term investments appear in the balance sheet at their current
market value (Notice that the valuation of these investments represents exceptions to
the cost principle). In 1993 FASB changed the rules and now short term investment in
marketable securities appears in balance sheet at their current market value as of the
balance sheet date. This valuation is also referred as Mark to Market method. When
value of marketable securities is adjusted to current value, an offsetting entry is made to
an account entitled Unrealized Holding Gains or Loss on investments. This, account as a
special stockholders’ Equity account in the balance sheet

 Income summary: - the income summary account in the ledger to which

revenue and expenses account are closed at the end of the period. The balance
(credit balance for a net income, debit balance for net loss) is transferred to the
owner’s equity account.
 28

Articulation: - the relationships among financial statement is called articulation

 Statement of Owner Equity: - A financial statement summarizes the increase

and decrease in owner’s equity during an accounting period.
 Factoring Account Receivables:- The term factoring describes transactions in
which a business either sells its accounts receivable to financial
institutions( often called a factor) or borrows money by pledging its accounts
receivable as collateral/ Security for a loan. A/R Usually Converting of 30 to 60 .

 Statement of Retained Earning: - Instead of a statement of owner’s equity,
corporation prepare “a statement of retained earning” summarizing the changes
in the amount of retained earnings over the year.
 29

Contra Assets Account: - An account with a credit balance is offset against or deducted
from an asset account to produce the proper balance sheet for the asset i.e. Accumulated
Depreciation.

Contra Revenue Account: - a debit balance account that is offset against revenue in the
revenue section of the income statement e.g. Sales Discount, and sales return

2. Capital reserve:- Profit may arise from unusual trading activities selling of fixed
assets or issuing of shares on premium etc.

Adjustments: - the purpose of adjusting entries is to allocate revenue and expenses

among accounting periods in accordance with realization and matching principle.

 Outstanding expenses, deferred expenses (entries to record

unrecorded expenses): - expenses incurred but have not been actually
paid are called outstanding expenses. Rent payable, or other expenses
payables.
Salaries expenses Dr
To outstanding salaries Cr
We will record it in profit and loss account as well as in balance sheet as
liability.

 Prepaid expenses: - expenses paid in advance before they have fallen

due are called “prepaid expenses” or a cash expenditure of adjustments or
cost that will benefit more than one accounting period usually recorded
by debiting an asset account for example, Supplies, unexpired insurance
etc.

Rent expenses
Cash
31st Dec: - Prepaid expense
To rent expense
Or
Prepaid Rent Account
Cash
Rent expense
 30

To prepaid expense
Treatment: - we will have to deduct the unexpired expense from the Toto
of the expense and will be shown as current assets in balance sheet.

 Accrued Income: - which has been accrued during the year but has not
been actually received is called as accrued income, earning or incomes
such as interest on loan or investment
Accrued interest Account
To interest account
Treatment: - part of income will be recorded in profit and loss account
and part will be recorded in balance sheet as current asset in Balance
sheet;
 Unearned income: - income received in advance but not earned is called
unearned income, for which services have not been rendered or Revenue
may be earned, or accrue during the current period, but not yet be
collected or recorded in the accounting record.

Cash Dr
To Commission Cr
Commission account Dr
To unearned Commission Cr
 Interest on Capital: - When a person invested any amount in business
he/ she expect something in return which is said to be interest on capital.
It is termed as expenses from business because shareholders and
business are separate entity
Interest expenses Dr
To capital account Cr
Interest on Drawing: - is revenue for the business and its
aggregate is deducted from the capital of the concern.
 Provision for Bad debts
1. When Provision for bad debt not appearing in the Trial Balance

Profit and loss account Dr

To Provision for Bad Debts

2. When provision for Bad Debt appearing in the Trial Balance

If new provision is more than the provision appearing in the trial balance, pass the
following entry
Profit and loss account
To provision for bad debt
2.1. If new provision is less than the provision appearing in the trial balance
pass the following entry
 31

Provision for bad debt

To profit and loss account

Accounting Worksheet

An accounting worksheet is a tool used to help bookkeepers and accountants complete

the accounting cycle and prepare year-end reports like unadjusted trial
balances, adjusting journal entries, adjusted trial balances, and financial statements. A
work sheet is prepared at the end of the period, but before the adjusting entries are
formally recorded in the accounting records.

Format

The accounting worksheet is essentially a spreadsheet that tracks each step of the
accounting cycle. The spreadsheet typically has five sets of columns that start with
the unadjusted trial balance accounts and end with the financial statements. In other
words, an accounting worksheet is basically a spreadsheet that shows all of the major
steps in the accounting cycle side by side.

Each step lists its debits and credits with totals calculated at the bottom. Just like the
trial balances, the work sheet also has a heading that consists of the company name, title
of the report, and times period the report documents.

Normal and Abnormal losses

 Normal loss: - this loss is pertinent to production and cannot be avoided
through proper planning and efficient management it is a part of system.
No need of entry is made in the books of account for this loss, it will
 32

automatically adjusted .e.g. loss on account of handling of goods,

breakage, and shrinkage, rusting, evaporation, weights loss etc. in Cost
accounting is it termed as expected prior to production is a normal loss. It
is also called as standard loss. Provision for such loss is maintained
 Abnormal loss: - it is recorded on the books of account and trading and
profit and loss account is credited with amount of loss as the loss is not
recurring in the business. This loss may occur due to poor management or
poor skill or breakage of machinery of the concern. This loss realized over
normal loss is called as abnormal loss. Abnormal loss in unanticipated
loss or avoidable loss. amount of loss cannot be shifted to the customer it
is born by the management if company do so many customers will shift to
other business.

Accounting entry
Abnormal loss account
To Trading and profit and loss account
Capital and revenue expenditure: - expenditure means the amount spent. Any
expenditure incurred for the following purposes is capital expenditure: -

1. For acquiring fixed assets

2. For making improvement and extensions to the fixed assets e.g. addition to
building
3. For increasing the earning capacity of a business or for reducing the cost of
manufacture, e.g. expenditure incurred in removing the business to a central
locality
4. For rising capital monies for the business such as brokerage paid for arranging
loans, discount on issued of shares and debenture, underwriting commission etc
5. Before using fixed assets every minor or major expense are capitalized and
added with the cost of the assets e.g. legal expenses, brokerage, freight in,
carriage of fixed assets etc.
6. Most companies often purchase plant assets on an installment plan or by
issuing a note payable. Interest charges after the asset is ready for use are
recorded as interest expenses, not a part of the cost of an assets( FASB NO:- 34
Capitalization of interest cost)
7. Land improvement: - improvements to real estate such as driveways, fences,
parking lots, landscaping, and sprinkler system have a limited life and are
therefore subject to Depreciation. For this reason, they should be recorded in a
separate account entitled land improvement.

Capitalized expenditure: - where a certain revenue expenditure incurred is of a such

a nature that its benefits is likely to be spread over a certain number of years or which
is of non-recurring and special nature and large in amount, in such a case, instead of
 33

debiting the entire amount to the profit and loss account of the year in which It has
been incurred, it may be spread over a number of years. These are as follows: -
 Legal charges: - in connection with the purchase of a fixed asset are
capital expenditure as they form an additional cost of the asset acquired
 Repairs: - if an old property or a second had fixed asset is purchased, the
cost of immediate repairs in order to put the asset into an efficient state is
capital expender
 Wages for carrying the asset to office
 Brokerages and stamp duty: - brokerage paid on newly acquired plant is
considered as capital in nature
 Freight and carriage: -
 Development expenses: - mines, tea or rubber plant, all expenses
incurred during the period of development are treated as capital
 Preliminary or formation expenses: -

Capital expenditure Revenue expenditure

Its effect is long term i.e. not exhausted Its effect is for short term, finished in a short
within the current period, long term period of time

It has physical existence It has no physical existence, it cannot been

seen with eyes

It does not occur again and again It occurs repeatedly – it is recurring and
regular

This expenditure improves the position of the This helps to maintain the concern
business

A portion of this is shown in profit and loss Whole amount is shown in profit and loss
account e.g. depreciation or amortization account

It does not reduce the revenue of the concern. It reduces revenue. Payment of salaries to
Purchase of fixed asset does not affect employees.
revenue

It incur before the starting of the business , Incur after the starting of the business
preliminary expenses

Revenue profit and Gains: - the profit earned during the ordinary course of business,
as a result of the business activities are treated as revenue profit. They are as follows: -

 Sale of merchandize
 Commission earned
 34

 Discount received from payment of cash

 Compensation received from insurance company
 Bad debts recovered

Capital and revenue Receipt: - Receipt refers to the actual amounts of cash received.
They can be either of capital nature or revenue in nature: -

1. Capital brought by owner

2. Money borrowed from partners, bankers, private loan
3. Money received by sale of fixed assets
4. Money received on account of capital profit

Capital profit: - means a profit made on the sale of a fixed assets or profit earned on
raising monies for the business, revenue profit is a profit which is made by the business
through ordinary course of activities

 It is not included in the business income,

 It is of rare case, and non-recurring
 Separate law of taxes applies to capital gains as such it is shown separately in the
account of business
Note: - Capital profit of a larger amount is capitalized and used to set off capital losses
of the concern if any. It is transferred to capital reserve account. Capital profit of
a small amount arising out of selling of one asset is taken to profit and loss
account and added with revenue profit with compliance with concept of
materiality.

Uses of capital profit: - capital profit is used to write off capital loss in the course of
business, and it remained unused in the books of account it is usually transferred to
capital reserve.
 35

List of capital profit: -

 Profit earned on the sale of assets
 On sale of investment
 Premium earned on the issue of shares
 Premium earned on the issue of debenture
 Profit earned on the forfeiture of shares

Note: - capital profit is shown in equity side of balance sheet which is not distributed as
divided among shareholders. If the amount is small it is recorded in profit and loss
account according to the concept of materiality

Capital reserve is created when there is capital profit i.e. profit on sale of assets
or upward revaluation of assets. These profits are held under capital reserve heading
and are not for distribution of dividends to shareholder. Capital reserve have very few
uses, one of them is to issue bonus share, which leaves the retained earnings figure
intact and thereby allows for dividends to be paid in future years.

Capital loss: - any loss on account of following reasons is treated as capital loss: -
1. Loss on account of sale of fixed assets
2. Loss on redemption of debenture
3. Discount on issue of shares
4. Loss on sale of investment
5. Loss on sales of shares of the subsidiary company.

Note: - the capital loss is not deducted from the income of the year, but it is usually
shown in the balance sheet as fictitious asset and written off over a number of years.

Revenue Loss: - is shown in profit and loss account as operating expenses

 Loss on sale of goods

 Loss due to bed debts
 Loss of goods due to natural calamities, war or fire
 Loss due to theft or embezzlement

Deferred Revenue Expenditure: - Deferred Revenue Expenditure represents certain

types of an asset whose usefulness does not expire in the year of their occurrence but
generally expire in the near future. These types of expenditure are carrying forward and
are written off in future accounting period.

Errors in the Books of Account: -

1. Errors of Omission: - when any business transaction has not been recorded in
the books of account due to oversight e.g. an invoice for purchase has been
omitted to record in purchase book. These types of errors don’t affect the
agreement of trial balance.
2. Errors of commission :- wrong amount, wrong side, wrong account
 Making wrong journal entry
 36

 Posting the entry to wrong account

 Posting the entry to wrong side of account
 Wrong balancing of ledger.
 Wrong totaling of sales and other subsidiary books of
account.
 Error in carrying forward
 Errors in additions, carry forward in the books of original
entries or ledger
Note: - above mentioned error will affect the agreement of
trial balance
3. Compensating errors: - these are errors, which cancel the effects of each other;
an error on the debit side of one account is compensated with another error of
similar amount on the credit side of any other account. This errors does not
affect the agreement of trail balance
4. Errors of principle: - When the book keeper ignores certain accounting
principle or basic of book keeping while making accounting record, examples
are as follows: -
 Wrong distinction between capital and revenue
expenditure
 Un sufficient reserve for doubtful debts
 Insufficient depreciation on fixed assets.
 Omission of outstanding assets and liabilities
 Incorrect valuation of asset: - Current asset are not valued
at cost or market price whichever is lower. Fixed asset are
not valued at cost less depreciation
Note: - above mentioned errors can only be detected by an intelligent vouching
and a complete verification (including checking of valuations) of assets and
liabilities
 Error of transposition
This error is recording the incorrect amount of an item by reversing numbers.
This can cause overstating or understanding the amount of an item, which is the result
of transposing a number. For example, instead of entering an expense as $946, you
erroneously enter it as $496. This produces $450. An error like this can be costly if it is a
deductible amount that isn't claimed because of the entry error.

Note: - these types of errors have no relation with the trial balance, but affect the net
profit of the business.
The process of adding the amount at the end of the month is called as casting.

Depreciation: - depreciation is the gradual and permanent decrease in the

value of an asset from any cause.
 37

Note: - As per AS (6) Depreciation is charged from the date on which assets has
been put to use. Here put to use means the date on which asset has been put to
working condition i.e. date of installation.
According to AS -06 Depreciation is charged on all depreciation assets on its
depreciable value during its depreciable life.
Note No.2 all fixed assets are called depreciable assets except land (freehold
land) and leasehold premised are depreciable.
According to AS-06 there are only two methods of Depreciation.
 Straight line method/original cost method/fixed installment method
 Written down method/ diminishing/ reducing balance method.

According to AS-10 all first time expenses are included to the cost of Asset, after the
purchase if an expenses in incurred to enhance the earning capacity of asset it will also
be added to the cost assets. Recurring cost are excluded from the cost of assets. Assets
should be recorded on cash basis, it does not matter whether assets has been purchased
on cash or credit basis.

Following two points should be made clear before proceeding further:-

 Depreciation is not a process of valuation: - the book value of any asset

cannot be claimed as its market value. The market value of any asset is cost
of production, trade policy etc.
 Accumulated depreciation does not consist of cash:- it is just a written
down value of assets due to use and wear and tear.

Causes of depreciation: -
 Internal causes: - Deprecation which occurs for certain inherent normal
causes is known as inherent depreciation
1. Wear and tear
2. Depletion: - some assets declines in value
proportionate to quantum of production e.g. mine,
quarry etc. With raising coal from mine the total
deposit reduces gradually and after sometimes it
will be fully exhausted. Then value is reduced to nil.
 External Causes: - Depreciation caused by some external reasons is called
external depreciation. These are as follows: -
1. Obsolescence :- some assets, although in
proper working condition may become
obsolete e.g. old machine become obsolete
when new comes into market
2. Efflux of time: - some assets diminish in
value on account of sheer passage of time,
 38

even though they are not used e.g. lease hold

property, patent, copy right et.
3. Accident: - assets may destroyed by
abnormal reasons such as fire, earthquakes,
flood etc.

Need for Depreciation

1. Ascertain of true profit and loss
2. Ascertain of true cost of production
3. True valuation of Assets:
4. Replacement of Assets:
5. Keeping capital intact

Characteristics of Depreciation

1. Depreciation is charged in case of fixed assets, e.g. building etc

2. Depreciation causes perpetual, gradual and continues fall in the value of asset
3. In rare case depreciation is charged when certain is not used e.g. Patent, Copy
right,
4. Total Depreciation of an asset cannot exceed its depreciable ( Cost less scrap
value)

Basis of deprecation

1. The original cost of an asset

2. The estimated working life of assets
3. Residual or scrap value of asset
4. The amount to be spent on repair and renewal of the asset
5. The possibility of the new invention or innovation

Estimate of Useful life and Residual value: - the estimated lives of plants assets affect
the amount of net income reported each period. The longer the estimated life, the
smaller of cost transferred each period to depreciation expenses and the larger the
amount of net income.

Methods of providing Depreciation

1. Fixed installment or Straight Line or Original Cost Method

 39

Under this method fixed depreciation on assets is charged

Depreciation Dr
To Asset Ac Cr
Profit and Loss
To Depreciation

Merits: -
 Simple methods
 Book value reduced to zero
 Most companies want to be competitive as their competitor, for this purpose
they may use straight line method of depreciation.

Disadvantages
 Repair cost is ignored
 Interest on money locked up in the assets in not taken into consideration
 No provision for the replacement of asset is made
 Difficulty is faced is calculating depreciation on additions made during the
year

Principle of consistency: - with respect to depreciation method, this principle means

that a company should not change from time to time. But company may use different
methods of depreciation according to needs and demand as mentioned already.

Formula:
 40

Diminishing Balance Method

This method is also known as written down value method of reducing balance
method, or fixed percentage of declining balance depreciation, under this method the
asset is depreciated at fixed percentage calculated on the debit balance of the asset
which is diminished year after year on account of depreciation. However this method is
used in income tax return, rather than financial statement.

Merits: -

 Under it the total burden imposed on profit and loss account due to
depreciation and repairs remain more or less equal year after year since
the amount of deprecation goes to diminishing with the passage of time ,
whears the amount of repairs goes on increasing as asset grow older
 Separate calculation are unnecessary for addition and extensions
 This method is helpful for tax purposed as it reduces the taxable income

Demits

 This method ignores the question of interest on capital invested in the

asset and the replacement of the asset
 This method cannot reduce the value of asset to zero
 Very high rate of depreciation would have to be charged otherwise it will
take a very long time to write an asset down to its residual value
 41

Scope of Application: - this method is most suited to plant and machinery where
additions and extensions take place so often and where repair is also important factor.
This method does not suit the case of lease, whose value has to be reduced to zero.

Distinction between Straight line and Diminishing balance method

Straight line Diminishing Balance Method

Fixed amount of depreciation is charged Fixed rate of depreciation is charged

Asset may or may not have a scrape value Assets must have a scrape value

Amount of depreciation remain the same Amount of depreciation goes on decline

Book value of asset become zero Book value of asset never become zero

When new asset is purchased it is required No such calculation is required

to do additional calculation

Annuity method: - according to this method, the purchase of the asset concerned is
considered as investment, earning interest at certain rate. The cost of the asset and also
interest thereon are written annually by equal installments until the book value of the
asset in question is reduced to nil or its breakup value at the end of its effective life. In
this sort of method depreciation expenses might exceed to the value of depreciable
value of the asset in hand. Interest expenses are also added to the value of the assets
and the interest is charged at the end of the year

Merits: -

 This method takes interest into account on the capital invested in the asset into
account.

Demerits

 The burden on profit and loss account increases each year

 When the asset requires frequent additions and extension, the
calculations have to be changed frequently, which is tough.

Scope: - this method is best suited to those assets which require considerable
investment and which do not call for frequent additions e.g. long lease.

Depreciation Fund Method: - this method is also known as sinking fund method,
Amortization Fund Method etc. Under this a fund in the name of Depreciation fund is
created. Each year profit and loss account is debited and the fund account is created
with a sum, which is so calculated that the annual sum credited to the fund account and
 42

accumulating throughout the life of the asset may equal to the amount which would be
required to replace the old asset

Merits

 The most important merit of this method is that it makes available a sum of
money for replacement of the asset, which has become useless

Demits‘
 The burden on profit and loss goes on increasing as year pass by the amount of
depreciation every year remains the same but the amount spent on repairs goes
on increasing

Scope: - the method is found suitable wherever it is desired not only to charge
depreciation but also to replace the asset as happens in the case of plant and machinery
and other wasting asset.

Depletion method
This method is especially suited to mines, quarries’, sand pits etc.

Unit of Output method: - this method advocated on the basis of use. If the asset is used
more or gave more production more depreciation is charged. This method is not
suitable for every asset. This method is based on working hours, production unit,
Mileage covered or period spends. Vehicle is depreciated on the basis of this method.
This method provides excellent matching of expenses with revenue. However, the
method should be used only when the total units of output can be estimated with
reasonable accuracy. Assets such as building, computers and furniture do not have well
defined “unit of output”.

Cost – Residual value/Units of output

Depreciation of various assets

 Freehold land and Building: - Straight line or Reducing Balance method should
be used
 Leasehold Land Building: - if life is Short Straight line method, if long annuity
method
 Plant and Machinery : - diminishing balance method
 Furniture and fixtures: - Diminishing Balance method
 Patent and copy right: - Straight line method
 Mines, Oil wells, quarries etc.: - depletion method

Financial statement Disclosures

 43

A company should indicate/disclose in notes to its financial statements the method used
to depreciate plant asset.

Disposal of Plant and Equipment: - as units of plant and equipment wear out or
become obsolete, they must be scrapped and sold out or traded in on new equipment.
Upon the disposal of asset, asset account is removed from the list of asset and
accumulated depreciation account is also debited.

Entry
Accumulated Depreciation Dr

Particular Assets Account Cr

Gains or loss on Disposals of Plant and Equipment:- when any asset is sold out its
book value and market valued is compared and verified if market value is greater is
greater than book value it is gain and vice versa. These gains or loss, if material in
amount, should be shown in income statement following the computation of income
from operations.

Disposal at price above book value: - machine costing Rs: - 10000 and currently has a
book value of 2000 is sold for Rs: - 3000. Entry is as follow

Cash 3000
Accumulated Depreciation 8000
Gain on disposal 1000
Machinery 10000
Amortization: - Is used to describe the systematic write off to expense of the cost of an
intangible asset over its useful life. Straight line method of depreciation is used to
amortize intangible assets.
Note: - Financial Standard Board, the maximum period for amortization of an intangible
asset is 40 years (Intangible Assets) AICPA (New York 1970) Par 29
Depletion:- A mine or oil reserve is depleted as the natural resource is removed from
the ground, once all of the coal has been removed from a coil mine, for this we said that
the mine is fully depleted and will be abandoned or sold for its residual value.
Entry
Inventory
To Accumulated Depreciation
Note: - accumulated depletion is a contra asset account similar to Accumulated
depreciation account; it represents the portion of the mine that has been used up
(Depleted) to date.
Net identifiable asset: - Total of all assets, except, goodwill minus liabilities

Current liabilities: - current liabilities are obligations that must be paid within one
year or within the operation cycle, whichever is longer. Another requirement for
classification as a current liability is the expectation that the debt will be paid from
 44

current asset or through rendering of service. Liabilities that do not meet these
conditions are classified as long term liability.

PAYROLL LIABILITIES DEFINITION

Definition
any amount withheld from an employee’s pay and payable to another entity, such as a taxing
entity. Most common payroll liabilities include federal and state income tax, Social Security and
Medicare. Employers withhold the proper amounts from an employee’s payroll check and remit
the taxes according to a set schedule.

Deferred income tax: - Deferred income tax occurs as the company postpones
payment of income tax, because company may uses different method of depreciation i.e.
diminishing balance method or considering installment method of sales. Deferred
income tax is reported as current or long term liability depends on the classification of
the asset and liability. If the installment method is used in accounting for reporting
purposes it is shown as current liability, in case of using of accelerated method of
depreciation it will be shown as long term liability in account reporting method.

Income tax expenses

Income tax payable
Deferred income tax
Interest coverage ratio: - Creditors, investors, and managers all fell more comfortable
when a company has enough income to cover it interest payments by wide margin. One
widely used measure of the relationship between the earning and interest expenses is
the interest coverage ratio; is computed by dividing operating income by the annual
interest expenses, higher the ratio, better sign for creditors, it shows a better past
performance.
 45

Junk Bond: - Bonds payable that involves a greater than normal risk of default and
therefore, must pay higher than normal rate of interest in order to attract to investors

Necessary Points: -
 journal is called book of original entry
 Ledger is called book of final entry
 The technique of finding of the net balance of an account after considering the
totals of both debit and credit appearing in the account Is known as balancing of
an account.

Bill of exchange: - bill of exchange has been defined as an unconditional order in

writing addressed by one person to another, signed by the person giving it, requiring
the person to whom it addressed to pay on demand or at fixed or determinable future
time, a certain sum of money to or to the order of a specified person or to bearer

Types of bill of exchange

 Inland bill of exchange

 Foreign bill of exchange

Parties
 Drawer:- a person who makes the bill or creditor
 Drawer: - to whom the bill is presented for acceptance/debtor
 Payee: - to whom the amount of bill is to be paid.

Uses of bill of exchange

1. Retaining the bill
2. Discounting the bill of exchange
3. Endorsement of the bill
4. Bill for collection
5. Dishonor of the bill: -a bill of exchange is said to be dishonored when the drawee
refuses to accept or make payment of amount of bill.
 Dishonor by non-acceptance
 Dishonor by non-payment

Noting charges: - when a bill of exchange is dishonored the holder can get such fact
noted on the bill by notary public. The advantages of noting is that the evidence of
dishonored is secured.

Renewal of a bill: - when the acceptor or debtor of a bill finds himself unable to make
payment of the bill on the due, he may request of the drawer of the bill before it is due,
 46

to cancel the original bill and draw on him a new bill for an extended period. This is
called renewing a bill

Retiring of a bill: -Retiring of a bill means make payment before the date of maturity,
When the acceptor of a bill is prepared to make payment of the bill before the due date,
he may ask the holder to accept the payment, provided he receives some rebate or
discount for the unexpired period. Such rebate is treated is an expense for the drawer or
creditor and will be income for drawee or debtor.

Accommodation Bills: -an accommodation bill is a bill of exchange which has been
drawn for the mutual financial accommodation of the parties involved. Generally, it is
drawn not for value received. In order oblige friend, many times bills are drawn,
accepted and endorsed by businessmen without any consideration.

Insolvency: insolvency of a person means that is unable to pay his liabilities. This will
mean that bill accepted by him will be dishonored.

Promissory Note:- A promissory note is a written unconditional promise made by one

person to another, to pay a specific sum of money either on demand or at specified
future date.

Parties to a Promissory Note

 The maker: Who signs the note (Debtor) and agrees to pay the amount on the
due date and
 The payee: to whom the amount is payable (the creditor)

Work Sheet: - the work sheet is an analytical device which accumulates data for the
adjusting and closing entries and working paper for the accountant and for analyzing
the trail balance in order to prepare the financial statements. It is not a part of
accounting record.

Reasons for preparation

 It is prepared to avoid errors in the permanent records of accounting
 It simplifies work to be done at the end of the period
 It may be used for testing ledger accounts, adjusting entries and financial
accounts.

Processes in Work Sheet

1. Trail Balance
2. Adjustments
3. Adjusted trial Balance
4. Income statement
5. Balance Sheet
 47

FIFO AND LIFO METHODS or Cost flow assumptions

1. FIFO Method
2. LIFO Method
3. Average Method
 FIFO
1. Closing inventory is recorded at cost
2. Unrealized profit or gains are not recorded

Disadvantages

1. Current revenue is matched with oldest cost

2. Cost assigned may not reflect the current price
3. This may not use during rising price

LIFO Method

Advantages

1. Matches current revenue and current cost

2. Cost minimizes the distortion of inflation
3. Give lowest possible tax is reduced

Demerits

1. Fluctuation of price cannot used

2. High cost being matched with current revenue
3. Value of inventories in Balance sheet does not reflect the current
price

Average Cost Method:- The Average cost of all units in inventory is computed after
every purchase. It is computed by dividing the total cost of goods available for sale by
the number of unit in inventory. Because the average cost may change after every
purchase.

What Is the Difference Between FIFO and LIFO?

The method a company uses to assess their inventory costs will affect their profits. The
amount of profits a company declares will directly affect their income taxes.

Inventory refers to purchased goods with the intention of reselling, or produced goods
(including labor, material & manufacturing overhead costs).

FIFO and LIFO are assumptions only. The methods are not actually linked to the
tracking of physical inventory, just inventory totals. This does mean a company using
the FIFO method could be offloading more recently acquired inventory first, or vice-
 48

versa with LIFO. However, in order for the cost of goods sold (COGS) calculation to
work, both methods have to assume inventory is being sold in their intended orders.

Which Method Is Better FIFO or LIFO?

FIFO is considered to be the more transparent and trusted method of calculating cost of
goods sold, over LIFO. Here’s why.

By its very nature, the “First-In, First-Out” method is easier to understand and
implement. Most businesses offload oldest products first anyway - since older inventory
might become obsolete and lose value. As such, FIFO is just following that natural flow
of inventory, meaning less chance of mistakes when it comes to bookkeeping.

LIFO allows a business to use the most recent inventory costs first. These costs are
typically higher than what it cost previously to produce or acquire older inventory. As
such, profits are lower. Although this may mean less tax for a company to pay under
LIFO, it also means stated profits with FIFO are much more accurate because older
inventory reflects the actual costs of that inventory. If profits are naturally high under
FIFO, then the company becomes that much more attractive to investors.

The problem with a company switching to the LIFO method is that the older inventory
may stay on the books forever, and that older inventory (if not perishable or obsolete)
will not reflect current market values. It will be understated.

Lastly, under LIFO, financial statements are much easier to manipulate.

It is considered a best practice to go with FIFO.

Initiating Purchase Process:- buying is the function of purchase department.

Whenever, a need to purchase certain material arises, it is communicated to purchase
department by means of a document called “Purchase Requisition”. In contains the
following information:-
 49

 Description
 Code number
 Specification
 Desired date and any other information if desired.

Which is Better - LIFO or FIFO?

First, remember this: Higher-cost inventory = lower taxes. Lower-cost inventory =

higher taxes. To assess the relative value of LIFO and FIFO inventory cost, you need to
look at the way your inventory costs are changing:

If your inventory costs are going up, or are likely to increase, LIFO costing may be
better, because the higher cost items (the ones purchased or made last) are considered
to be sold. This results in higher costs and lower profits.

This will mean that the profitability ratios will be smaller under LIFO than FIFO. The
profitability ratios include profit margin, return on assets, and return on stockholders’
equity.
 50

If the opposite it’s true, and your inventory costs are going down, FIFO costing might be
better. Since prices usually increase, most businesses prefer to use LIFO costing.

If you want a more accurate cost, FIFO is better, because it assumes that older less-
costly items are most usually sold first.

The decision to use LIFO vs. FIFO is complicated, and each business situation is
different. You must conform to IRS regulations and U.S. and international accounting
standards. Get help from your tax professional before you decide on an inventory
valuation method.

IRS Regulations and FIFO vs. LIFO

As you might guess, the IRS doesn't like LIFO valuation, because it usually results in
lower profits (less taxable income). But the IRS does allow businesses to use LIFO
accounting, requiring an application, on Form 970.

The national accounting standards organization, the Financial Accounting Standards

Board (FASB), in its Generally Accepted Accounting Procedures, allows both FIFO and
LIFO accounting. The international accounting standards body (IFRS) doesn't allow
LIFO to be used, so if your company has international locations, you probably won't be
able to use it.

Restrictions on Changing Inventory Methods

If your business decides to change to LIFO accounting from FIFO accounting, you must
file Form 970 with the IRS, and you will not be allowed to go back to FIFO accounting
unless the IRS gives specific permission. 6

Periodic vs. Perpetual Inventory and LIFO or FIFO

Businesses use one of two ways to manage inventory - periodic and perpetual. Periodic
inventory management is tracked manually, counting at the end of an accounting
period. Perpetual inventory is for larger businesses using point-of-sale technology.

Your business can use either LIFO or FIFO with either of these inventory management
systems.

Recordkeeping Issues and Inventory Accounting

LIFO inventory accounting increases record-keeping, because older inventory items

may be kept on hand for several years, while under FIFO those older items are sold first,
so recordkeeping requirements are less.

The decision to change inventory methods or to change back is complicated and has
many tax and accounting implications. This article provides general information, not tax
 51

or legal advice. Talk to your CPA and tax advisor and get opinions on your specific
business situation before you attempt to make a change.

Periodical vs. perpetual inventory recording system

Under this system, a store keeper maintains Bin card to record the material received
issued and balancing. Under this method physically counting is used at the end of the
year in order to find out profit or losses. When management or employees need up to
date information about inventory level there is no substitute for perpetual inventory
system. Almost all manufacturing companies use perpetual systems. These businesses
need recent information to coordinate their inventories of raw materials with
production schedules. Most large merchandising companies- and many small one also
use it.

A perpetual inventory system uses an inventory subsidiary ledger. The ledger provides
company personnel with up to date information about each type of product that the
company buys and sells, including the per unit cost and the number of units purchased,
sold and currently on hand.

Periodic inventory system is used when the need for current information about
inventories and sale does not justify the cost of maintaining a perpetual system. The
foundation of the periodic inventory system is the taking of a complete physical count of
inventory at the year end.

Net Realizable Value: - is the actual/estimated selling price in the ordinary course of
business, less cost of completion and cost necessarily to be incurred in order to make
the sale.

Store keeper uses the ledger card to record increase and decrease in material cost, in
this method cost of goods sold and sales are updated as sale is made.

Periodic Perpetual Method

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Purchases Inventory

Freight paid Inventory

Carriage inward To cash

To cash

Who uses perpetual system?

When management of the organization needs timely information about inventory level
and profit earned on sale of goods usually needs up to date information. Almost all
manufacturing entities use perpetual inventory keeping system

Corporation: - is the only form of business organization recognized under the law as a
legal entity, with rights and responsibilities separate from those of its owners.

Dividend: - Dividend is not an expense for the corporation, and they are not deducted
from revenue in the income statement. They reason why dividend are not viewed as an
expense is that these payment do not serve to generate revenue. Rather, they are a
distribution of profit to the owners of the business.

Double Taxation:-Corporations must pay corporation income tax on their taxable

income. But shareholders must pay income tax on the dividend they receive. This
concept of taxing corporation’s earnings on two separate occasions is often called as
Double Taxation.

Functions of Directors:-

 The primary functions of the board of directors are to set corporate policies and
to protect the interests of the stockholders. Specific duties of the directors
include hiring corporate officers and setting these officers’ salaries declaring
dividend, etc
 Stock Transfer:- publicly owned corporations use an independent stock transfer
agent and stock register to maintain their stockholder records and to establish
strong internal control over issuance of stock certificate. These agents are
usually large banks or trust companies.
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Features of Preferred Stock:

 Preferred as to dividend
 Cumulative dividend rights
 Preferred as to assets in event of the liquation of the company
 Callable at the option of the corporation
 No voting power

Note: - in case of cumulative preference shares arrears of dividend if any will be shown
in footnotes disclosure of dividend in arrears

Donated Capital:-when a corporation receives such a gift, both total assets and total
stockholder’s equity increase by the market value of the asset being given to company,
No profit is recognized when gift is received, the increase in stockholder’s equity is
regarded as paid in capital. Notes is written at the end of the year regarding the subject
matter

Treasury stock: -(Contra Equity Account)- it is defined as shares of the corporation’s

own stock capital that have been issued and later reacquired by the issuing company
but that have not been canceled or permanently retired. It may be held for a long period
or issued from time to time. Shares of capital stock are not entitled to receive dividend,
to vote, or to share assets upon dissolution of the company. In the computation of
earnings per share, shares held in the treasury are not regarded as outstanding shares

Treasury Stock is Not as Asset: - when it is purchased, the corporation is eliminating

part of its stockholder’s equity by a payment to one or more stockholders. The purchase
 54

of it will be regarded as a reduction of stockholders equity, not as the acquisition of an

asset.

Closely held corporation: - A corporation owned by a small group of

stockholders, not publicly owned.

Issue of shares
1 Issues of shares at Par
2 Issue at premium
3 Issue at discount

Types of Shares

1. Preference Share:- preference share are those which satisfy the following two
conditions as

 As regard to dividends, it must carry a preferential right to a fixed amount and

 55

 As regard to capital, in the event of winding up there must be a preferential

right to be paid for the amount of capital on such shares
 Cumulative preference share
 Non-cumulative preference shares.
2. EQUITY SHARE: - Equity shares are those, which are not preference share. Every
company must have some equity shares. Equity shares are the risk capital of a
business. Equity shareholders have both higher expected returns and higher
expected risk than preference shareholders.
3. Deferred Shares:- A deferred share is a share that does not have any rights to the
assets of a company undergoing bankruptcy until all common and preferred
shareholders are paid. It may also be a share that is issued to company founders that
restricts their receipt of dividends until dividends have been distributed to all other
classes of shareholders. Deferred shares can also be awarded to venture capital and
other private investor groups as part of a long-term investment in a company.

Issue of shares at Par

Issue of shares at pat means that shares are issued at face value

Issue of shares at Premium: - are issued at higher price than book value or par value
e.g. shares of Rs:-10 are issued at 12, 2 will be considered as premium. The amount
received by issuing shares at a premium is not business profit thus should not be
transferred to profit and loss account. This should be treated as capital profit. This will
be shown as a separate item on the liability side of the balance sheet under the heading
Reserve. Share premium account is recorded on the equity side of Balance sheet.
Amount of share premium cannot be used to set off operating loss because it belongs to
equity side. Company can’t pay dividend out of share premium account, it is used to pay
off equity expenses or capital loss i.e. underwriter fee or capital loss on selling of fixed
assets.

Uses of Shares Premium

 In writing off the preliminary expenses of the company.

 In writing off the expenses of or the commission paid or discount allowed on any
issue of shares or debenture.
 Discount on issue of shares
 Paying bonus shares
 Providing for the premium payable on the redemption of any redeemable
preference shares or debentures of the company

Issues of shares at Discount: - when a share is issued at a price which is less than
its par value it is said that it has been issued at discount.

A company can issue shares at a discount subject to the following conditions laid down
by section 84 of the company ordinance. It is considered as capital loss and will be
shown in asset side of balance sheet and write off against the profit of the every year.
 56

 The issue of shares at a discount must be authorized by resolution passed in

general meeting of the company and must be sanctioned by the authority.
 The resolution must specify the maximum rate of discount not exceeding ten
percent, or higher rate fixed by the authority

NPO: - Not for Profit organization: - which is operated to give assistance to

needy people of the society and works during natural calamity i.e. earthquakes, food
etc., Profit earning in not the main objectives of the entity. Following necessary books
are maintained to ascertain the surplus or deficit.

1 Cash Book: - in this book the receipt of cash from all sources are entered
on debit side and payments of cash for various expenditures on credit
side.
2 Receipt and payment Account: - it is used to record each and every
transactions being made in the entity i.e. capital and revenue transaction
are recorded. It is the summarized form of cash book; it does not fall
under double entry book keeping system. It is in the nature of Real
account.
3 Income and expenditure account: - it takes the place of income
statement. As the non-trading concerns have not motive for earning
profits, therefore, they do not prepare income statement. They usually
prepare Income and Expenditure Account.

Receipt Payment Side

 Capital receipt:- loan receipt  Capital payment:- Machinery

 Revenue receipt:- interest or purchased, or any other fixed asset
commission etc. purchased
 Revenue payment :- Rent, Salaries
etc.

Note: - Reasons of the above mentioned transactions are recorded in Income and
expenditure account and balance sheet. If transactions are in the nature of revenue
receipt and revenue payment these are recorded in income and expenditure account. In
case of Capital Receipt and Capital Payment will be recorded in Balance Sheet.

Revenue expenditure Capital Expenditure

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Recurring : - Rent, Salaries Non recurring:- loan, Machinery etc

Small payment Big Payment

General Purposes : - Revenue Specific Purpose

Note: - Organization cannot accept small

payment as special purposes

Income and expenditure Account: - Nominal Account: - it is used to record all

expenses and gains during the operation of the entity. It acts just like profit and loss
account, where all the income of the period is recorded on the credit side and expenses
on the debit side. The surplus or deficit is derived from this statement which is added or
deducted from accumulated surplus in Balance Sheet.

Difference between Receipt and Payment Account and income and

expenses Account

Consignment: - Is a sort of business where one person consignor send goods to other
person conginee to sell goods on behalf of the former. In this form of business limited
account of books are maintained to ascertain profit and loss account of the concern. It is
just expansion of the business.

Proforma invoice: - consignor sends goods to consignee along with a proforma invoice.
An invoice is documents sent to consignee about price of goods and provide guideline to
consignee about the items being shift or placed.
 58

Account sale: - is a statement which is periodically rendered by a consignee to the

consignor showing details about the goods sold, price realized, his own commission, and
the expenses incurred in connection with sale.
Consignment account: - Nominal account- used to know the profit and loss account of
the business. It is combined trading and profit and loss account.

Benefits of Consignments

1. Cost saving
2. The manufacturer may not have the capacity to open branches while he intends
to tap distant market

Concept of Commission in Consignment

The commission of the consignee is calculated on gross sales made by the consignee. It
is the percentage of a sale that the person who sells a product receives. It is a reward to
the consignee by the consignor for selling the goods of the former. The commission may
take different forms depending on the agreement between the consignor and consignee.
 59

The rate of commission is fixed considering the prevailing market practices and with
the due agreement between the consignor and consignee.

Types of Commission

1. Ordinary commission/Simple Commission

The Commission charged by the consignee on the gross sale proceeds is known as
ordinary or simple commission. It is the fee payable by the consignor to the
consignee for the sale of goods when there is no guarantee for the collection of
money from the consumer. It is calculated at a fixed percentage of total sales.

2. Del- Credere

This type of commission is an additional commission for an endeavor of magnifying

sales in the form of credit. It is the additional amount that the consignor pays to the
consignee for taking the responsibly of the collection of debt from the customers. It
is calculated at certain predetermined rate of gross sales. When customers make
default in payment, the consignee charges the amount of loss of bad debts in his
books.

3. Special/Extra/Over- Riding commission

In normal practice, if a consignee sells the goods at price higher than the normal
selling price, he will entitle a commission for excess amount realized over the
normal selling price. The consignee or agent is the person to which such goods are
sent. The commission provided on the excess amount realized over the normal
selling price is known as a special commission.

Concept Building Question

Mahesh consigned 400 tins of vegetable oil (One tin contains 10 KG of Oil) to Dinesh
costing Rs. 50 per Kg. The consignors paid R. 16000 for forwarding charges and Rs.
24000 for freight. 10 tins of oil were totally damaged during transit. Dinesh took
delivery of the oil and sent Account sales showing that 300 tins were sold for Rs.
240000. The expenses incurred by them were custom duty and clearing charges Rs.
14320 and selling expenses Rs. 4000. They are entitled to a commission of 5% on
sales. Dinesh also reported that 20 Kg. of oil were lost due to leakage which was
considered to be normal. Showing the necessary ledger accounts in the books of
Mahesh and Dinesh.

Profit. 32000
Dinesh Balance Rs. 209680
Abnormal Loss. Rs. 6000
Commission. 12000
Closing Stock. 56320
Joint venture
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A Joint Venture is the combination of two or more persons into a single activity. Its
form of partnership which is limited to a specific venture. It may seem to be exactly the
same as partnership, with the exception that it is one of a business that is to be
terminated.

Features

1. It is a specific partnership
2. It does not entail a continuing partnership since termination is certain
3. The business is dissolved after the venture is terminated
4. Many accounting concepts are not applicable such as going concern concept
5. All the assets are ultimately received in cash and all liabilities are paid in cash
6. It does not use a firm name generally

Partnership Joint Venture

Partnership act 1932 No law

Members, Partners Con venture

Long term Short term

Proper record Limited record

We maintain limited record in case of joint venture to find out profit of the
concern. Three main books of accounts are kept i.e. joint venture
account(nominal account), Co venture account( personal account) and joint bank
account ( real account)
 61

Types of book typing

1. When a separate set of book is kept for the joint venture

2. When no separate set of books is kept for the joint venture

When a separate set of books are kept:- when the size of the venture is large the
duration of the venture is protracted, then a complete separate set of books of account
may be maintained under the double entry system for recording all joint venture
transactions.

1. Joint Bank Account:- for better financial control, joint bank account is opened
specially for the venture.
2. Co-venture Account:- personal account ventures
3. Joint venture Account:- Nominal Account:- it is the nature of a trading and profit
and loss account and it is prepared to ascertain profit or loss account on joint
venture account.

When No separate Set of Books is kept: - when concern is small and co ventures are
residing at distant place, each con venture may record joint venture transactions in his
own books of account without inaugurating a complete set of double entry books for the
venture. In such a case, each co venture will record in his own books of account all
transactions own+conventurer

1. Joint venture account :- it is a nominal account and may be treated as a special

profit and loss account which discloses profit or loss on venture
2. Personal Account of Co Ventures :- these accounts are credited with cash,
goods and services supplied b co ventures and debited with goods, sale proceeds
take over, remittance, and the like

Normal and Abnormal Losses

Normal Losses:- Normal losses are inevitable or unavoidable. These may arise due to
natural causes like breaking in bulk, evaporation, leakages, drying and the like. No effort
can prevent these losses. When there is not stock remaining unsold, there will be no
treatment for normal loss. When there is some stock remaining unsold, then value of
stock is find out.

Abnormal loss:- Abnormal loss may arise owing to causes such as theft, fire and the like.
For calculating the profit of the joint venture abnormal losses are ignored. It is ignored
on the ground that joint venture account itself represents trading as well as profit and
loss Account.

Valuation of Unsold Stock: - The unsold stock should be valued by the principle of Cost
price or Market price, whichever is lower. The cost should include:-
 62

 Cost of unsold goods and

 Proportionate non-recurring expenses such as freight, insurance, carriage
inward and the like, but not selling or distribution cost.

Partnership

Admission of Partner: - According to Section (32) and 31 of Accounting standard no

partner will be entered into the business without the assent of the old or existing
partners.

Note: - Any business that is not organized as a corporation. Includes both sole
proprietorship and partnerships.

Statement of partner’s Equity: - a financial statement for a partnership shows the

changes during the accounting period in each partner’s capital account.

Rules Applicable in absence of an agreement among the partners

1 The partners shall share equally the profits and losses
 63

2 A partners shall be entitled to interest at the rate of six percent per annum on the
loan advanced by him to the firm
3 A partner is not entitled to any salary for taking partner in the conduct of the
business
4 No partner is entitled to interest on the capital
5 No interest on drawing is to be charged by firm

Reasons for admission of Partner

 For want of capital

 Business expansion
 Expertise knowledge
 Faithful hand
 For want of goodwill

When new partner gets admission in the business the following necessary adjustments
are made in the books of account:-

1. Revaluation of assets and liabilities

2. Adjustment in capital of partners
3. Profit and loss sharing ratio
4. Treatment of reserve.
5. Goodwill

Adjustment with regard to Goodwill

1. Premium Method:- when new partner brings amount of goodwill in cash

Entry

Bank account
To premium for Goodwill Cr
Goodwill account Dr
To Remaining Partners Capital account (In sacrificing Ratio)
2. Revaluation method:- as new partner doesn’t bring amount of goodwill

Goodwill Dr

To old partners’ capital account (Old Ratio)

NOTE: - Goodwill account as intangible asset will be shown in balance sheet

3. Memorandum Revaluation method

Entry:-
Goodwill account
To capital of old partner account
 64

All partners’ Capital Account New Ratio

To Goodwill Account
Note: - When new partner is got admission in the business, old partners will have to
sacrifice their share of profit, and in future they will not get profit as they were getting
before.

Goodwill has been very ably divided into three type’s _____ cat, dog and rat____ in view of
the peculiar habits of these three animals. The cat tends to sticks to the abode, cat
goodwill is therefore that which will adhere to the business which is being transferred
and is corresponding less valuable.

 Dog-Goodwill
Dogs represent a loyal and faithful customer base that is more attached to the
persons conducting the business rather than the place of the business. These
types of customers follow the person if he has not gone too far. These types of
customers are more of a brand loyal type.
 Cat-Goodwill:
Cats are normally attached to the home irrespective of the owner of the
house. Even if he leaves the house and somebody else comes to occupy it,
they keep on visiting the same home. Cats represent those customers who go
to the same shop or place of business whoever is the owner of the shop. It
provides local goodwill to the business.
 Rat-Goodwill:
the other variety of customer does not have attachment to the person nor to
the place, which, in other words, is known as fugitive goodwill. The rats are
not attached to person or place and are casual in their behavior.
 Rabbit-Goodwill
Rabbits are more concerned about the nearness of the place as it would be
troublesome to go somewhere far away.

Recording of the Investment

1. By Making Investment:- when incoming partner brings assets and cash, entity’s
cash and partner’s capital account will increase
2. Purchase of interest Method: - it means the new partner does not invest
anything but purchases the share of existing partners and pays to them privately.
It does not bring any change in the business. No entry will be made, Assets of the
firm don’t change and partner’s equity will not change. A general entry is passed
as follows:-
Selling Partner Capital Account
To incoming partner Capital Account Cr

Purchase and None purchase Goodwill

 65

1. Purchase Goodwill: - purchase goodwill arises when one business pays more
than purchase consideration. Goodwill is recorded on asset side of balance sheet.
Good will is recorded for which money has been used to acquire it. Only
purchase good will is recorded, purchase goodwill is recorded in books of
account up to 5 years according to the rules and write off from time to time.
Features:-
 It is arise on requisition
 It is demonstrated by P. Consideration
 It is recognized in financial statement
2. Non- purchase Goodwill: - inherent goodwill is referred, and internally
generated goodwill. Its valuation depends on subjective judgment of valuer. It is
never recognized in financial statement. In case of retirement, admission or
death of partner, goodwill is not raised in the books of account as not
consideration has been paid against goodwill. Good will account may be adjusted
through capital account of the partners or goodwill account is opened and
immediately closed.

Valuation of goodwill: - The necessity of valuation of goodwill arises in the following

cases

1. Upon the introduction of new partner

2. Upon retirement or death of Partners
3. Upon dissolution or sale of firm’s business
4. Upon amalgamation of two business
5. Upon an agreed change in the profit sharing ratio

Method of valuation of goodwill

1. Average profit method

2. Super profit method
3. Capitalization method
 66

Summary regarding Demand of Goodwill for incoming partner: - old partners

may demand for goodwill from incoming partner for two things
1. For hardworking in the past
2. Future loss of profit due to admission of new partner

Memorandum Revaluation Method is used in accounting to record goodwill in the

books of account, as goodwill in not purchase form vendor it is just inherent or
internally generated goodwill. Business can record the purchased goodwill in the books
of account up to five years and writes off according to accounting standards, it against
the income of the business.

Profit and loss appropriation Account Format

Types of partners
 Active Partner
 Dormant or Sleeping Partner: One who retain his capital but refrain from the
work in the organization
 Nominal Partner:- One who neither contributes any capital nor takes any part
in the management but merely lend his name and credit to the firm and thereby
incurs the liability of a partner between himself and a credits dealing with firm
 Holding Out partner: - A partner by holding out means a person who is not a
member of firm but allows him/her to be represented as a partner. Such person
is responsible to person who has given loan to firm on his representation
because loan has been given by assuming that he/she is member.

Types of Ratios
 Sacrificing Ratio= Old – New (at the time of admission)
 Gaining Ratio= New- Old (at the time of retirement)
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Revaluation (Nominal account) of assets and liabilities: - when a new partner is

admitted into partnership concern, he acquires the ownership rights of the assets and
also makes himself responsible for the liabilities of the firm. It is, therefore, desirable
both from the point of view of incoming partner as well as the existing partners that the
assets and the liabilities as appearing in the balance sheet on the date of admission of
the new partner should be properly valued.

 For increase in the value of asset

Debit respective asset account

To revaluation account Cr

 For decrease in the value of assets

Revaluation account

To assets account Cr

 For an decrease in the value of liabilities

Debit Particular liability account

To revaluation account Cr

 For an increase in the value of liabilities

Revaluation account

To liabilities account Cr

Note: - if there is the excess of debits over credits i.e. it shows loss and will be shifted to
partners’ capital account vice versa

Partnership- Dissolution

According to partnership Act, Section 39, “The Dissolution of a partnership between all
the partners of a firm is called the dissolution of the firm” it simply means the
discontinuance of business of the partnership. The Dissolution involves the termination
of business; sale of assets, payment of liabilities and return of capital to the partners. All
this process of dissolution is called as liquidation of firm.

Modes of Dissolution

1. Voluntary dissolution: A partnership firm is dissolved in any of the following

ways
i) If all the partners mutually decide to dissolve the firm
ii) If the partnership was formed for specific project, at the completion of that
project
iii) If any of the partner become insolvent
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iv) Any event which makes the business of the firm as unlawful
2) Compulsory Dissolution
1.1. If any partner has become insolvent
1.2. If any partner has become unsound mind or due to any other reason has
1. When any of the partner is insolvent
2. When all the partners are insolvent
When all the partners are solvent:- under this method all the partners have
surplus of capital. There is no deficiency in the capital of any partner. The firm is
in a position to pay all the liability in full either from its own sources or from the
private sources of the partners.
 Preparation of Realization account: - This account is prepared to record the
amount realized from sale of assets and payment of liabilities. Profit or loss on
account of realization of assets and payment of liabilities is transferred to
partners’ capital account. A format of realizations account is as under:-


 When one of the partner is insolvent: - By the insolvency, we mean the

incapability of any person to pay his creditors in full. In partnership, if any of the
partners is not in a position to pay his capital deficiency from his private estate,
he called insolvent. In such a case, the capital account of insolvent will show a
debit balance. We know that the liability of all partners in partnership in
unlimited. This means that until and unless any one of the partner in partnership
is solvent, the creditor will be paid in full. Therefore, the capital deficiency of
insolvent is born by the insolvent partners. This loss is born by solvent partners
in any of the following methods:-
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1 According to their profit sharing ratio(American Approach)

2 According to Garner VS Murray Rolling( British Approach)
 According to profit sharing ratio: - this principle is followed in USA and in
many other countries in the world associated in America Accounting Approach.
According to this principle, the capital deficiency of the insolvent partner is
divided among the solvent partner in their profit sharing ratio.
 According to Garner VS Murray Rolling:- this principle is based upon the
decision of United Kingdom Court in 1903 in a case titled as Garner VS Murray.
According to the decision of the court, the deficiency of the insolvent partners’
capital is divided among the solvent partners in the ratio of their capital balances
as stood just before dissolution. Therefore, the solvent partners will first bring
cash equal to their respective share of loss on realization. Then, the deficiency of
the insolvent partner capital will be divided according to capital ratio. For this
purpose, following General journal entries are passed in the books of account:-
 When the cash is brought in by the solvent partners to make good their
share of loss on realization

Cash

To partners capital

 When the deficiency of insolvent partners is transferred to solvent

partners

Capital of solvent partners

To Capital of insolvent partner

 When all the partners are insolvent: - when all partners are insolvent, it
means that no one of the partner is able to contribute sufficient amount for
payment of liabilities of the firm in full. Therefore, the creditors of the firm don
not receive full amount. The procedure under such case is explained below:
1 All the assets of the firm are transferred to Realization account
2 The liabilities are not transferred to realization account
3 The assets are sold and all the available cash is utilized to pay the claims
of the outsiders. If the creditors are not paid in full, the difference is
transferred to expenses and revenue account.

Corporation: - Corporation in Pakistan is generally called as Joint Stock Company. Joint

Stock Company or corporation is governed by company ordinance 1984.

A corporation can be defined as “an artificial person created by law to carry on business
activities under its own name and common seal”
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Kinds of company

 Chartered company: - this is the oldest form of company. It was incorporated

under Royal Charter (Order of King or Queen) in Great Britain. The example of
such company East India Company, Chartered Bank of England.
 Statutory company: - the companies incorporated by the orders of president,
prime minister, and Governor General or by special act of parliament or
legislature are called statutory companies. The state accepts the liability of such
company; therefore these companies do not used limited with their names. The
example of such companies are state Bank of Pakistan, Utility Stories etc.
 Registered company: - the companies registered under company’s ordinance
1984 or any earlier Act or Ordinance is called registered companies. Registered
companies are further divided into following types:-
i) Private limited company
ii) Public Limited company

Qualification Shares: - these are the minimum number of shares, which are necessary
to be purchased by a person who wants to become the director of a company. The
number of qualification shares is stated in the article of Association.

Share capital: - the amount invested by the owners of the company is called as share
capital. In other words the total paid up value of the shares purchased by the owners of
a company. Categories of share capital:-
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Shares Value: - the value assigned to shares is called share value. These values may be
of the following types:-

 Par Value: - this is the value assigned to the shares in the memorandum of
association. It is the original value of the share.
 Book value: - it is the value of the share according to the books of account. The
book value is determined by dividing the total owner’s equity by number of
shares, e.g.

Paid up capital 100000

Reserve funds 10000

Retained Earnings 20000

Total owner’s Equity 130000/1000=130 BOOK VALUE OF

SHARE

 Market value: - this is the value of a share as quoted in the stock exchange. In
other words, it is the price at which the buyer is willing to purchase and seller is
willing to sell the share.

Note: - The people to whom shares are not allotted are also informed. According to
section 71 of the company ordinance 1984, the company should take decision within
ten days of the closure of subscription list as to what applications have been accepted
and refunded money to un-accepted applicants within ten days of the date of such
decision.