Accounting Theory3

8/6/2019 Accounting Theory3

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SPECTRUM STUDY CIRCLE(The Acme of Excellence)

15/22 IInd Floor Ashok Nagar, New Delhi-110018.

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1CHAPTER 1

ACCOUNTINGA systematic record of the daily events of a business leading to presentation to financial picture is known asAccounting or in its elementary stages, as Book keeping. Accounting organizes and summarises economicinformation so that the decision-makers can use it. The information is presented in reports called financialstatements. To prepare these statements, accountants analyze, record, quantify, accumulate, summarize,classify, report, and interpret economic events and their financial effects on the organization.

The series of steps involved in initially recording information and converting it into financial

statements is called the accounting system.

The financial picture mostly has two parts, one showing how much profits has been earned or losssuffered, and other showing assets and liabilities and the proprietors interest in the firm. Eveninstitution which do not have the earning of profit as an objective must know periodically whether thecurrent income is sufficient to meet the current expenditure and what the financial state of affairs.

The American Institute of Certified Public accountants has defined Accounting as:-The art of recording, classifying and summarizing in a significant manner and in term of money

transactions and events which are, in part at least, of a financial character, and the interpreting the

result thereof.

ACCOUNTANCY, ACCOUNTING AND BOOK-KEEPING

ACCOUNTANCY ACCOUNTING BOOK-KEEPING

Accountancy refers to asystematic knowledge ofaccounting. It explains whyto do and how to do ofvarious aspect of accounting.It tells us why and how to

prepare the books of accountsand how to summarize theaccounting information and tocommunicate it to theinterested parties.

Accounting refers to the actualprocess of preparing andpresenting the accounts. It isthe art of putting the academicknowledge of accountancyinto practice.

It covers the following activities:-(i) Identifying the transactions

and event.(ii) Measuring the identified

transactions and events incommon measuring unit.

(iii) Recording the identifiedand measured transactionsand events in Journal.

(iv) Classifying the recordedtransactions and events in

ledger.(v) Summarizing the classified

transactions and events in the

Book-keeping is a part ofaccounting and is concernedwith record keeping ormaintenance of books ofaccounting, which is oftenroutine and clerical in nature.

It only covers the following fouractivities:(i) Identifying the transactions

and events.(ii) Measuring the identified

transactions and events in acommon measuring unit.

(iii) Recording the identifiedand measured transactionsand events in Proper BooksAccounts.

(iv) Classifying the recordedtransactions and events inledger.


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Danger of window dressing.3

QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

1) Understandability:- Financial Statements must be readily understandable by users. However,information about complex matters that should be included in the financial statements because of itsrelevance to the economic decision making needs of user should not be excluded merely on the groundsthat it may be too difficult for certain users to understand.

2) Relevance:- To be useful, information given in financial statement must be relevant to the decision-making needs of users. Any materials fact or figure should not be omitted.

3) Materiality:- The relevance of information is affected by its materiality. Its provides a cut-off pointrather than being a primary qualitative characteristics which information must have if it is to be useful.Information is material if its omission of misstatement could be influence the economic decision of theusers taken on the basis of the financial statements. Materiality depends on the size of the item or error

judged in particular circumstances of its omission or misstatements.4) Reliability:- To be useful, information must also be reliable. Information has the quality of reliability

when it is free from material error and bias. If there is fraud or misrepresentation, the statement will notbe reliable.

5) Faithful Representation:- to be reliable, information must represent faithfully the transaction and otherevents it either purports to represent or could be reasonably be expected to represent.

6) Substance over form:- If information is to represent faithfully the transactions and other events that it

purports to represent, it is necessary that they are accounted for and presented in accordance with theirsubstance and economic reality and not their legal form.

7) Neutrality:- To be reliable, the information contained in the financial statements must be neutral, thatis, free from bias.

8) Prudence:- Prudence is the inclusion of a degree of caution in the exercise of the judgments needed inmaking the estimates required under conditions of uncertainty, such assets or income are not overstatedand liabilities or expenses are not understated. However, the exercise of prudence does not allow, thecreation of hidden reserves or excessive provisions, the deliberate overstatement of liabilities orexpenses, because the financial statements would not be neutral and, therefore, not have the quality ofreliability.

9) Completeness:- To be reliable, the information in financial statements must be complete within thebounds of materiality and cost. An omission can cause information to be false or misleading and thusunreliable and deficient in the term of its relevance.

10) Comparability:- The information provided by the financial statements is compared by the managementfor decision making. Therefore, uniform accounting methods and policies should be followed from yearto year.

Role of Accounts in Society:

The profession of accountant is an instrument of socio-economic change and welfare of the society. Themodern accountancy is not like the old book-keeper. He is now expected to perform multifarious duties and

play a great role than he supposed to play earlier. His area of operation now cover such fields as

productively, taxation, trade and industry, law and integrated information system. They can also act in thefields relating to financial policies, budgetary policies and even economic principles. At present there arenot only financial accountants but highly specialized ones such as Chartered Accountants, Cost Accountants,management Accountants and other specialist accountants who prepare special reports on the various aspect


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of expansion and new developments of the enterprise. The services rendered by them to the society includethe following:

4(i) To maintain the boos of accounts in a systematic manner.(ii) To act as Statutory Auditor.(iii) To act as an Internal Auditor.(iv) To act as Taxation Advisor.(v) To act as Financial Advisor.(vi) To act as Company Law Advisor.(vii) To act as Management Consultants.

(viii) To act as Liquidator, Arbitrator and Receiver.(ix) To act as Management information System Consultants.

BRANCHES OF ACCOUNTING

Financial Accounting:- The purpose of this branch of accounting is to keep systematic record toascertain financial performance and financial position and to communicate the accounting informationto the interested parties.

Cost Accounting:- The purpose of this branch of accounting is to ascertain the cost, to control the costand communicate information for decision making.

Management Accounting:- The purpose of this branch of accounting is to supply any and allinformation that management may need in taking decision and to evaluate the impact of its decisionsand actions.

Social Responsibility Accounting:- It is accounting for social responsibility aspect of a business.Management is held responsible for what it contributes to the social well being and progress.

USERS OF ACCOUNTING DATA

Besides the people of the concerned firm or institution, there are various other parties interested inthe financial statement who must make decisions that have economic consequences. Such decisionmakers include:-

(i) Shareholder

(ii) Investors(iii) Management(iv) Lenders(v) Customers

(vi) Suppliers and other trade creditors

(vii) Employees.(viii) Government and their agencies(ix) Researcher

For example: An investor considering buying stock in either General Motors Ltd. or Volvo Ltd., would consult

published accounting reports to compare the most recent financial results of the companies. Theinformation in the reports helps the buyer to decide which company would be the better investmentchoice.

A lender considering a loan to a company that want to expand would examine the historicalperformance of the company and projections the company provided about how the borrowed funds

are to be used to produce new business.


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Accounting helps decision making by showing where and when money has been spent and commitmentshave been made, but evaluating performance, and by indicating the financial implications of choosing one

plan instead of another. Accounting also helps predict the future effects of decisions, and it helps directattention to current problems, imperfection and in inefficiencies, as well as opportunities.

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FUNCTIONS OF ACCOUNTING DATA

The main functions of Accounting Data are as follows:-a) Measurement of past performance of the entity and depicting its current financial position.b) Forecasting:- On the basis of past date we may forecast future performance as financial position of the

entity.c) Decision-Making:- Accounting data provides relevant information to the users of accounts to aid

decision-making.d) Evaluation:- Assessing performance achieved in relation to target.e) Control:- On the basis of accounting data we can identify weaknesses of the operational system and

feed back the effectiveness of measures adopted to check such weaknesses.f) Stewardship:- Accounting for the users of owners fund where in the management and owners are

separated.g) Government Regulation and Taxation:- Accounting data provides necessary information for

government to exercise control on the entity as well as collection for tax revenues. Relationship of accounting with some other discipline:

(a) Accounting and Economics:

Economics is viewed as a science of rational decision making about the efficient use of scarceresources. This many be viewed either from the relative importance of situations or facts of a singlefirm or of the country as a whole.

Account is viewed as a system, which provide data to the users to permit informed judgment anddecisions. It contributed a lot in improving the management decision making process.

But, economic theories influenced the development of the decision making tools used in accounting.At the macro level:-

Accounting provides the data base over which the economic decision models have been developed;

micro level data arranged by the accounting system is summed up to get macro level data base.(b) Accounting and Statistics:

Accounting records generally take a short-term view of events and are confined to a year whilestatistical analysis is more useful if a longer view is taken for the purpose. For example, to fit thetrend line a longer period will be required.However, statistical method does use past accounting record maintained on a consistent basis.In account, all values are important individually because they relate to business transactions, whilestatistics is concerned with the typical value, behaviour or trend over a period or the degree ofvariation over a series of observations. Accounting records are based on historical cost of permanentassets, while the current assets are automatically valued at the current value. However, when prices

are not stable over a period of time, inflation accounting method are used which require the use ofprice indices or price deflator which are based on statistical calculations of price changes. Inaccounting, a number of financial and other ratios are based on statistical method and severalfinancial calculations are based on statistical framework.


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In Some circumstances a liabilities

2. Current Cost:- Under current cost measurement base:- Assets are carried at the amount cash or cash equivalents that would have to be paid if the same

or an equivalent asset was acquired currently. Liabilities are carried at the undiscounted amount of cash or cash equivalents that would required

to be settle the obligation currently.7

3. Realisable value :- As per realisable value:- Assets are carried at the amount of cash or equivalents that could currently be obtained by selling

the assets in an orderly disposal Liabilities are carried at their settlement values; i.e. the undiscounted amounts of cash or cash

equivalents expressed to be paid to satisfy the liabilities in the normal course of business.4. Present Value:- As per present value:- An asset is carried at the present discounted value of the future net cash inflows that the item is

expected to generate in the normal course of business. Liabilities are carried at the present discounted value of further net cash outflows that are

expected to be required to settle the liabilities in the normal course of business.

ACCOUNTING CONCEPTThe following are the accounting concepts:(i) Business entity concept.(ii) Money measurement concept(iii) Cost concept(iv) Going concern concept(v) Dual aspect concept(vi) Realization concept.(vii) Accrual concept.

(i) Business entity concept:- Treat a business as distinct from the person who owns it.

(ii) Money measurement concept:- Accounting records only those transactions, which are expressed inmonetary term.(iii) Cost Concept:- Transactions is entered in the books of account at the amount actually involved.(iv) Going concern Concept:- It is assumed that business will exist for a long time and transactions are

recorded from that point of view.(v) Dual Aspect concept:- Each transaction has two aspects; if a business has acquired assets, it must

have resulted in one of the following:-(a) Some other assets have been given up.(b) The obligation to pay for it has arisen; or rather,(c) There has been a profit, leading to an increase in the amount that the business owes to the

proprietors, or

(d) The proprietor has contributed money for the acquisition of assets.ACCOUNTING EQUATIONS

ASSETS = Liabilities + Capital or CAPITAL = Asset Liabilities


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(vi) Realization Concept:- Accounting is a historical record of transactions; it records what hashappened. It does not anticipated events though anticipated adverse effects of events that havealready occurred are usually recorded.This concept stops the business firms form inflating their profits by recording sales and income thatare likely to accrue. Unless the money has been realized either cash has been received or a legalobligation to pay has been assumed by the customers no sale can be said to have taken place and no

profit or income can be said to have arisen.

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(vii) Accrual Concept:- If an event has occurred or a transaction has been interred into, its consequenceswill follow. Normally, all transactions are settled in cash but even if cash settlement has not takenplace, it is proper to bring the transaction or the event concerned in to the books.

FUNDAMENTAL ACCOUNTING ASSUMPTION

The following are the fundamental accounting assumptions:-(a) Going Concern:- The enterprise is normally viewed as a going concern, that is, as continuing

in operation for the foreseeable future. It is assumed that the enterprise has neither theintention nor the necessity of liquidation or of curtailing materially the scale of theoperations.

(b) Consistency:- It is assumed that accounting policies are consistent from one period toanother. A change in an accounting policy is made only in certain exceptional circumstances.

(c) Accrual:- Revenue and costs are accrued, i.e., recognized as they are earned or incurred (andnot as money is received or paid) and recorded in the financial statements of the period towhich they relate.

ACCOUNTING CONVENTIONS REGARDING FINANCIAL STATEMENTS

In order to make the information contained in the financial statements clear and meaningful, these are drawnup according to the following convention:-(i) Consistency:- The accounting practices should remain the same from one year to another. If a

change become necessary, the change and its effects should be stated clearly.(ii) Disclosure: Apart from legal requirements good accounting practices also demand that all

significant information should be disclosed.(iii) Conservatism: Financial Statements are usually drawn up on rather a conservation basis. Window-

dressing i.e. showing a position better than what is not permitted. It is also not proper to show aposition substantially worse than what it is. In other words secret reserve are not permitted.

Question: Elucidate accounting convention of conservatism.Ans.: Conservatism convention states that the accountants should not anticipate income and should

provide for all possible losses. The underlying principle is that revenues should only be recognized whenthere is reasonable certainly about their realization. At the same time television must be made for all

possible liabilities, whether the amount is known with certainly or is based on lesser value must be selected.To illustrate, inventories are recorded at the cost or market value whichever is less or if there a possibilitythat a debt may not be realized, a specific amount is charged against profits as a provision for doubtful debts.

ACCOUNTING POLICIES

The accounting policy refer to specific accounting principles and the methods of applying thoseprinciples adopted by the enterprise in the preparation and presentation of financial statements.


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There is no single list of accounting policies, which is applicable to all enterprise in allcircumstances. The choice of the appropriate accounting principles in specific circumstances of eachenterprise calls for considerable judgment by the management of the enterprise.

The area where in different accounting policies are frequently encountered:-

(1) Method of depreciation, depletion and amortization;(2) Treatment of expenditure during construction;(3) Conversion or translation of foreign currency items;(4) Valuable of inventories;(5) Treatment of Goodwill;

9(6) Valuation of investments;(7) Treatment of retirement benefits;(8) Recognition of profit on long term contracts;(9) Valuation of fixed assets;(10)Treatment of contingent liabilities.

CONSIDERATION IN THE SELECTION OF ACCOUNTING POLICIES:

The primary consideration in selection of Accounting Policies by an enterprise is that the financial statementis prepared and presented on the basis of such accounting policies should represent a true and fair view ofthe state of affairs of the enterprise as the Balance Sheet date and of the profit or loss for the period ended on

that date.The major considerations governing the selection and application of accounting policies are the following:-(a) Prudence:- In view of uncertainty attached to future events, profits are not anticipated but

recognized only when realised through not necessarily in cash. Provision is made for all knownliabilities and losses even though the amount cannot be determined with certainty and represent onlya best estimate in the light available information.

(b) Substance over form:- The accounting treatment and presentation in financial statements oftransactions and events should be governed by their substance and not merely by the legal form. Forexample:

(i) Where rights and interest in a property stands transferred while legal documentation forthe transfer is yet to be completed, the transaction should be recorded as a sale in the books oftransferor and acquisition in the books of transferee.

(c) Materiality: - Financial statement should disclose all material items, i.e. items the knowledge ofwhich might influence the decisions of the user of the financial statements.

Disclosure of Accounting Policy:

(a) All significant accounting policies adopted in preparation and presentations of financialstatement should be disclosed.

(b) The disclosure of the significant accounting policies as such should form a part of the financialstatements and the significant accounting policies should normally be disclosed in one place.

Change in Accounting Policies:

The change in Accounting Policy is recommended only in the following circumstances:(i) If it is required by statute for compliance with an accounting standard.(ii) If it is considered that the change would result in a more appropriate presentation of the

financial statements of an enterprise.


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Disclosure in case of change in accounting policy:

Case Disclosure Requirement

(i) If change has a material effect in currentperiod and the effect of change isascertainable.

(ii) If change has a material effect in currentperiod and the effect of change in notascertainable, wholly or in part.

(iii) If change has no material effect in currentperiod but which is reasonably expected to

have a material effect in later period.

(i) The amount of change should bedisclosed . The fact should disclosed.

(ii) The fact of such change should beappropriately disclosed.

SYSTEM FOR RECORDING THE TRANSACTIONS:

There are two systems for recording the transactions:(i) Single Entry System.(ii) Double Entry System.

DOUBLE ENTRY SYSTEM

The Double Entry system of accounting is the only real system of accounting. This system recognizes thatevery transaction is a double-sided affair. If one receives something then eithera) some other person has given it, or

b) Stock of something else has diminished, orc) Some service has been rendered.Is one losses something in the sense that either cash (or its equivalent) has to be given up (or is irretrievablelost), then a corresponding benefit must have been received. For good and accurate results a transactionshould be recorded in both aspects.Advantages of double entry system:

(i) The accuracy of the accounting work can be ensured, through the devices of the trial balances.(ii) The profit earned or loss suffered during a period can be ascertained together with details.(iii) The financial position of the firm or institution concerned can be ascertained at the end of each

period through preparation of the balance sheet.(iv) The system permits accounts to be kept in as much details as necessary and therefore afford

significant information for the purpose of control etc.(v) Result of one year may be compared with those of the previous years and reasons for the changemay be ascertained.

CASH AND MERCANTILE SYSTEM OF ACCOUNTING:

Cash system:- In this system, entries are made only when cash is received or paid, no entry beingmade when payment or receipt. The mercantile system is better normally since it takes into accountthe amounts that become due.Mercantile / Accrual system:- Under this system, a record is made on the basis of amounts having

become due for payment or receipt. The mercantile system is better normally since it takes intoaccount the amounts the become due.

Distinguish between Accrual Basis of Accounting and Cash Basis of Accounting:

Accrual Basis Cash Basis


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(i) Under this system, there may be prepaid /outstanding expenses and accrued /unaccrued income in the balance sheet.

(ii) Income Statement will show a relativelyhigher income in case of prepaid expensesand accrued income.

(iii) Income statement will show a relativelylower income in case of outstanding expensesand unaccrued income .

(iv) The basis is recognized under the

Companies Act. 1956.

(i) Under this, there is no prepaid /outstanding expenses or accrued / unaccruedincome.

(ii) Income statement will show lowerincome.

(iii) Income statement will show higherincome.

(iv) The basis is not recognized under theCompanies Act.1956.

The Elements of Financial Statements:

The elements directly related to the measurement of financial position are assets, liabilities andequity. These are defined as follows:-

a) An Assets is a resource controlled by the enterprise as a result of past events and from which futureeconomic benefits are expected to flow to the enterprise. These assets may be classified as follows:-

(i) Current Assets(ii) Fixed Assets:

(a) Tangible fixed assets(b) Intangible fixed assets.

b) A Liability is a present obligation of the enterprise arising from past events, the settlement of which isexpected to result in an outflow from the enterprise or resources embodying economic benefits.Liabilities may be broadly classified as follows:

(a) current Liabilities(b) Long-Term Liabilities

c) Equity is the residual interest in our remaining claim against the assets of the enterprise after deductingall its liabilities. When the business is first started, the owners equity is measured the total amountinvested by the owners.Owners equity = Assets Liabilities

The rule for writing up accounts of various types are as follows:-

Assets: Increase on the left hand or the debit side and decrease on the right hand or credit side.Ex.: When cash is received, cash account should be debited and when it is paid, the accountshould be credited.

Liabilities: Increase on the credit side and decrease on the debit side. Capital: Increase on the credit side and decrease on the debit side. Expenses: Increase on the debit side and decrease on the credit side. Income or Gains: Increase on the credit side and decrease on the debit side.

IMPORTANT TERMS USED IN FINANCIAL STATEMENTS

S.No. Terms Definitions


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1. Accrual Recognition of revenues and costs as they are earned or incurred (and not as money is received or paid). Itincludes recognition of transactions relating to assets andliabilities as they occur irrespective of the actual receiptsor payments.

2. Accrual Basis of Accounting The method of recording the transactions by whichrevenues, cost, assets and liabilities are reflected in theaccounts in the period in which they accrue.

3. Accrued Assets A developing but not yet enforceable claim againstanother person which accumulates with the passage of

time or the rendering of service or otherwise. It mayarise from the rendering of services (including the use ofmoney) which at the date of accounting have been only

partly performed, and yet are not billable.4. Accrued Expenses An expenses which has been incurred in an accounting

period but for which no enforceable claim has becomedue in that period against the enterprise. It may also fromthe purchase of services which at the date of accountinghave been partly performed, and are not yet billable.

5. Accrued Liability A developing but not yet enforceable claim by another person which accumulates with the passage of time or the

receipt of service or otherwise. It may arise from thepurchase of services which at the date of accountinghave been only partly performed, and are not yet billable.

6. Accrued Revenue Revenue which has been earned in an accounting periodbut in respect of which no enforceable claim has becomedue in that period by the enterprise. It may arise from therendering of services which at the date of accountinghave been partly performed, and are not yet billable.

7. Accumulated Depreciation Is the cumulative sum of all depreciation recognisedsince the date of acquisition of the particulars assets

described.8. Advance Payment made on account of, but before completion of, acontract, or before acquisition of goods or receipt ofservices.

9. Amortisation The gradual and systematic writing off of an assets or anaccount over an appropriate period. The amount onwhich amortisation is provided is referred to asamortizable amount. Amortisation also refers to gradualextinction or provision for extinction of a debt by gradualredemption or sinking fund payments or the gradualwriting off to revenue of miscellaneous expenditure

carried forward, e.g., share issue expenses, preliminaryexpenses, etc.10. Appropriation Account An account sometimes included as a separate section of

the profit and loss statement showing application of


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profits towards dividends, reserves, etc.11. Assets Assets are economic resources that are expected to help

generate future cash in flow or reduce or prevent futurecash outflows. Example are cash, inventories, equipmentetc.

12. Bad Debts Debts owed to an enterprise which are considered to bean irrecoverable.

13. Book Value The amount at which an item appears in the books of anaccount or financial statements. It does not refer to any

particular basis on which the amount is determined e.g.,

cost, replacement value, etc.14 Capital Generally refers to the amount invested in an enterpriseby its owners e.g. paid up share capital in a corporateenterprise. It is also used to refer to the interest of ownersin the assets of an enterprise.

15 Capital Assets Assets, including investments not held for sale,conversion or consumption in the ordinary course of

business.16 Capital Employed The finances deployed by an enterprise in its net fixed

assets, investments and working capital. Capitalemployed in an operation may, however, excludeinvestments made outside that operation.

17 Capital Profit and Capital Loss Excess of proceeds realised from the sale, transfer, orexchange of the whole or a part of a capital assets over itscost. When the result of this computation is negative, itis referred to as capital loss.

18 Capital Reserve A reserve of a corporate enterprise which is not availablefor distribution.

19 Capital Work in Progress Expenditure on capital assets which are in the process ofconstruction or completion.

20 Cash Basis of Accounting The method of recording transactions by which revenues

and costs and assets and liabilities are reflected in theaccounts in the period in which actual receipts or actualpayments are made.

21 Cash Discount A reduction granted by a supplier from the invoiced pricein consideration of immediate payment within astipulated period

22 Cash Profit The net profit as increased by non-cash costs, such asdepreciation, amotisation, etc when the result of thecomputation is negative, it is termed as cash loss.

23 Security Security which is given in addition to the principalagainst the same liability or obligation.

24 Contingent Assets An assets the existence, ownership or value of which maybe known or determined only on the occurance or non-occurance of one or more uncertain future events.


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25 Contingent Liabilities An obligation relating to an existing condition or situation which may arise in future depending on theoccurance or non-occurance of one or more uncertainfuture events.

26 Cost of purchase The purchase price including duties and taxes, freightinward and other expenditure directly attributable toacquisition, less trade discounts, rebates duty drawbacks,and subsidies in respect of such purchase.

27 Cost of goods sold The cost of goods and sold during an accounting period.In manufacturing operation, it includes (a) cost of

material (b) labour and factory over heads; selling andadministrative expenses are normally excluded.28 Cost of Sales The cost of goods sold plus selling and administrative

expenses.29 Conversion cost Cost incurred to convert raw materials or components

into finished or semi-finished products. This normallyincludes costs which are specifically attributable to unitsof production, i.e., direct labour, direct expenses and subcontracted work, and production overheads as applicablein accordance with either the direct costing or absorptioncosting method. Production overheads exclude expenses

which relate to general administration, finance, sellingand distribution.

30 Current Assets Cash and other assets that are expected to be convertedinto cash or consumed in the production of goods orrendering of services in the normal course of business.

31 Current Liability Liability including loans, deposits and bank overdraftwhich fall due for payment in a relatively short period,normally not more than twelve months.

32 Defferal Postponement of recognition of a revenue or expenseafter its related receipt or payment (or incurrence of a

liability) to a subsequent period to which it applies.Common examples of deferrals include pre-paid rent andtaxes, unearned subscriptions received in advance bynewspaper and magazine selling companies, etc.

33 Deferred expenditure Expenditure for which payment has been made or aliability incurred but which is carried forward on the

presumption that it will be of benefit over a subsequentperiod or periods. This is also referred to as deferredrevenue expenditure.

34 Deferred Revenue Revenue or income received or recorded before it isearned and carried forward to a subsequent period or

periods to which it relates.35 Deficiency The excess of liabilities over assets of an enterprise at agiven date. The debit balance in the profit and lossstatement.


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36 Depreciable amount The historical cost, or other amount subsituated for historical cost of a depreciable asset in the financialstatements, less the estimated residual value.

37 Depreciable asset Asset which is expected to be used during more than oneaccounting period, has a limited useful life, and is held byan enterprise for use in production or supply of goods andservices, for rental to others, or for administrative

purposes and not for the purpose of sale in the ordinarycourse of business.

38 Depreciation A measure of the wearing out, consumption or other loss

of value of a depreciable asset arising from use, effluxionof time or obsolescence through technology and marketchanges. It is allocated so as to charge a fair proportionin each accounting period during the useful life of theasset. It includes amortisation of asset whose useful life is

predetermined and depletion of wasting assets.39 Depreciation Method Any method of calculating deprecation for an accounting

period.40 Depreciation Rate A percentage applied to the historical cost or the

substituted amount of a depreciable asset (or in case ofdiminishing balance method, the historical cost or the

substituted amount less accumulated deprecation.)41 Diminishing Balance Method A method under which the periodic charge for

depreciation of an asset is computed by applying a fixedpercentage to its historical cost or substituted amountless accumulated depreciation (net book value). This isalso referred to as written down value method.

42 Direct Cost An item of cost that can be reasonable identified with aspecific unit of product or with a specific operation orother cost centre.

43 Direct costing A method whereby the cost is determined so as to include

the appropriate share of variable costs only, all fixedcosts being charged against revenue in the period inwhich they are incurred.

44 Discount A reduction from the list price, quoted price or invoicedprice. It also refers to the price for obtaining payment ona bill before its maturity.

45 Expenditure Incurring a liability, disbursement of cash or transfer of property for the purpose of obtaining assets, goods orservices.

46 Expense A cost relating to the operations of an accounting periodor to the revenue earned during the period or the benefit

of which do not extend beyond the period.47 Expired Cost The proportion of an expenditure from which no further benefit is expected. Also termed as expense.

48 Ordinary Item Gain or loss which arises from events or transactions that


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are distinct from ordinary activities of the enterprise andwhich are both material and expected not to recurfrequently or regularly. This would also includematerial adjustment necessitated by circumstances,which, though related to previous periods, are determinedin the current period.

49 Fair Market Value The price that would be agreed to in an open andunrestricted market between knowledge and wiling

parties dealing at arms length who are fully informedand not under any compulsion to transact. Arms length

is a term applied to any transaction on the assumptionthat the parties to the transactions would act withoutbeing influenced by each other or by any other person.

50 Fictitious Asset Item grouped under assets in a balance sheet which hasno real value (e.g. the debit balance of the profit and lossstatement.)

51 Fixed asset Asset held for the purpose of providing or producinggoods or services and that is not held for resale in thenormal course of business.

52 Fixed cost The cost of production which by its very nature remainsrelatively unaffected in a defined period of time by

variations in the volume of production.53 Free Reserve A reserve the utilisation of which is not restricted in any

manner.54 Franchises and Licenses: Franchises and licenses are legal contract that grant the

buyer the right to sell a product or service. An exampleis a local McDonalds name, to acquire branded productssuch as cups and bags, and to share in advertising andspecial promotions. In exchange, the franchisee promiseto follow McDonaldss procedures and maintainstandards of quality, cleanliness, and pricing. The

acquisition costs of franchises and licenses are amortizedover their economic lives.55 Gain A monitary benefit, profits or advantage resulting from a

transition or group of transations.56 Reserve A revenue reserve which is not earmarked for a specific

purpose.57 Goodwill An intangible asset arising from business connections or

trade name or reputation of an enterprise.58 Intangible Asset Asset which does not have a physics identity e.g.

Goodwill, Patents, Copyright etc.59 Investment Expenditure on assets held to earn interest, income,

profit, or other benefits.60 Investments Assets held not for operational purposes or for renderingservices i.e. assets other than fixed assets or currentassets (e.g. securities, shares, debentures, immovable


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properties). The financial obligation of an enterpriseother than owners funds.

61 Liabilities Liabilities are economic obligations of the organizationto outsiders, or claim against its assets by outsides. Anexample is debt to bank.

62 Lien Right of one person to satisfy a claim against another byholding or retaining possession of the othersassets/property.

63 Long-term Liability Liability which does not fall due for payment in arelatively short period, i.e., normally a period not more

than twelve months.64 Materiality An accounting concept according to which all relativelyimportant and relivant items, ie., items the knowledge ofwhich might influenced the decisions of the user of thefinancial statements are disclosed in the financialstatements.

65 Mortgage A transfer of interest in specific immovable property for the purpose of securing a loan advanced or to beadvanced, an existing or further debt or the performanceof an engagement which may give rise to a pecuniaryliability. The security is redeemed when the loan is

repaid or the debt discharged or the obligationsperformed.

66 Net Assets The excess of the book value of assets (other thanfictitious assets) of an enterprise over its liabilities. Thisis also referred to as net worth or shareholdes funds.

67 Operating profit The net profit arising from the normal operations andactivities of an enterprise without taking account ofextraneous transactions and expenses of a purelyfinancial nature.

68 Operating cycle The time span during which cash is used to acquire goods

and services, which cash is used to acquired goods andservices, which in term are sold to customers, who is ternpay for their purchases with cash.

69 Preliminary Expenses Expenses relating to the formation of an enterprise.These include legal, accounting and share issuedexpenses incurred for formation of the enterprise.

70 Pre-paid Expenses Payment for expense in an accounting period, the benefitfor which will accrue in the subsequent accounting

period(s).71 Prior Period Item A material charge or credit which arises in the current

period as a result of errors or omissions in the preparation

of the financial statements of one or more prior periods.72 Provision An amount written off or retained by way of providingfor deprecation of diminution in value of assets orretained by way of providing for any known liability the


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for prompt payment.83 Trade Mark Trademarks are distinctive identifications of a

manufactured product or of service, taking the form of aname, a sign, a slogan, a logo, or an emblame. Anexample is an emblem for Coco-Cola. Trademark, tradenames, trade brands, secret formulas, and similar itemsare property rights with economic lives depending ontheir length of use.

84 Transaction A transaction is any event that both affects the financialposition of an entity and can reliably recorded in money

terms. Each transaction has counterbalancing entries onthe balance sheet so that the total assets always equal thetotal liabilities and owners equity.

85 Unexpired Cost That portion of an expenditure whose benefit has not yetbeen exhausted.

86 Variable Cost That cost which varies directly, or nearly directly, withthe volume of activity.

87 Work-in-Progress Work in process includes all materials which haveundergone manufacturing or processing operations, butupon which further operations are necessary before the

product is ready for sale.

CHAPTER 2

JOURNALIZING, POSTING & BALANCING

TRADITIONAL CLASSIFICATION OF ACCOUNTS:

a) Personal Accounts:- These accounts relate to natural persons, artificial persons, and representativepersons. (creditors, customers, etc)

b) Impersonal Accounts:

i) Real Accounts:- These accounts relate to the tangible or intangible real assets. (i.e. accountsof properties and assets); and

ii) Nominal Accounts:- These accounts relate to incomes, expenses or losses.RULES:- The following three are the basic rules for recording the transaction:-1) Personal Accounts:- Debit the receiver and Credit the giver.2) Real Accounts:- Debit what comes in and credits what goes out.3) Nominal Accounts:- Debit all exp. (and loses) and credit all incomes and gains.The left hand side of an account is called the debit side and the right-hand side of an account is calledcredit side.

ACCOUNTING EQUATION BASED CLASSIFICATION:

1. Assets Accounts These accounts relate to tangible or intangible real assets. Eg. Land A/c, BuildingA/c, cash A/c, Patents, Goodwill, Trademark etc.

2. Liabilities Accounts These accounts relate to the financial obligations of an enterprise towardsoutsiders. Eg Trade creditors, Bills Payable , Bank Overdraft, Loans, Outstanding


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Exp. etc.3. Capital Accounts These accounts relate to owners of an enterprise. Eg. Capital A/c, Drawings A/c.4. Revenue Accounts These accounts relate to the amount charged for goods sold or services rendered

or permitting others to use enterprises resources yielding interest, royalty ordividend. Eg. Sales A/c, Discount Received A/c, Dividend Received A/c, InterestReceived A/c.

5. Expenses Accounts These accounts relate to the amount incurred or lost in the process of earningrevenue. Eg. Purchase A/c, Discount allowed A/c, Royalty paid A/c, Interest

payable A/c, Loss by Fire A/c etc.

DISTINCTION BETWEEN REAL ACCOUNT AND NOMINAL ACCOUNTReal Account Nominal Account

These accounts relate to properties of thebusiness.

These accounts are shown in Balance Sheet. Closing balances of these accounts are carried

over to the next year as opening balances. These accounts indicate financial position of

the business. As per double entry rule, property received is

debited and property given is credited.

These accounts relate to expenses, losses,income and gains.

These accounts are shown in profit and lossaccount.

Closing balance of these accounts are closed bytransfer to profit and loss account.

These accounts assist in calculating profit andloss of the business.

As per double entry rule, expenses and lossesare debited and income and gains are credited.

JOURNAL

A Journal is a book in which transactions are recorded in the order in which they occur i.e., in chronologicalorder. A journal is the primary books of account under which all the transactions are recorded withcomplete narration on the basis of the three basic rules given for recording the transactions. The process ofrecording a transaction in a journal is called Journalizing. An entry made in the journal is called a JournalEntry.A journal entry is an analysis of all the effect of a single transaction on the various accounts, usuallyaccompanied by an explanation. For each transaction, this analysis identifies the accounts to be debited or

credited.FORMAT:

Date Particulars L.F. Amount (Dr.) Amount (Cr.)

Note:- The Ledger Folio column is filled in at the time of posting into the ledger and not at the time ofjournalizing. ADVANTAGES OF JOURNAL

Chronological record:- It records the transactions in the order in which they occur. Explanation of transaction:- Eachjournal entry in the journal carries narration which gives a brief

explanations of the transaction. Recording the both aspects:- Both the aspect (i.e., debit and credit) of a transaction are recorded in

the journal. Since the amounts recorded in both debit amount column and credit amount column


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must be equal, the possibility of accounting error is reduced and the detection of errors, if any,committed becomes easy.

LIMITATIONS OF JOURNAL:

When the number of transactions is large, it is practically impossible to record all the transactionsthrough one journal because of the following reasons:(i) The system of recording all the transactions in a journal required (a) the writing down of the

name of account involved as many times as the transactions occur; and (b) an individual postingof each account debited and credited and hence involves the repetitive journalizing and postinglabour.

(ii) Such system does not provide the information on prompt basis.(iii) Such a system does not facilitate the installation of an internal check system since, the journalcan be handled by only one person.

(iv) The journal becomes bulky and voluminous.To overcome and shortcomings of the use of the journal only as a book of original entry, the journal issubdivided into special journal.

NARRATION:

The narration is the explanation of the entry and facilitates quick understanding. The length of thenarration depends on the complexity of the transaction and whether management wants the journal itselfto contain all relevant information. Most often narration are in brief.S.No. Particulars Amount (Dr.) Amount (Cr.)

1. On bringing of Capital in Cash:Cash Account ...................... Dr.

To Capital Account(Being cash brought as capital in to business)

2. On brining of capital in the mode of cheque:Bank Account ...................... Dr.

To Capital Account(Being capital brought into business)

3. On deposit of cash into bank:

Bank Account ...................... Dr.To Cash Account(Being Cash deposited into bank)

4. On purchase of assets for cash.Assets (name of assets) Account ............ Dr.

To Cash Account.(Being assets purchase for cash)

5. On purchase of assets on credit:Assets Account ....................... Dr.

To Supplier Account(Being assets purchased on credit from .............)

6. On sale of goods for cash.Cash Account ...................... Dr.To Sales Account

(Being goods sold for cash)


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7. On sale of goods on credit.Sundry Debtors Account ........... Dr.

To Sales Accounts(Being goods sold to Mr. ............. on credit)

8. On return of goods from customer:Sales Account ...................... Dr.

To Sundry Debtors / Cash A/c(Being goods return from Mr. ...........)

9. On payment received from debtors:(i) Received in cash:

Cash Account ...................... Dr.To Sundry Debtors Account(Being cash received from .............)

(ii) Received by cheque and the same isdeposited into bank:

Bank Account ...................... Dr.To Sundry Debtors Account

(Being cheque received from customer depositedinto bank)

10. On Dishonour of cheque deposited into Bank:

Sundry Debtors A/c ...................... Dr.To Bank A/c

(Being dishonour of cheque received from customer)11 On Payment received from debtors:

Cash / Bank Account ........................ Dr.Discount Account ......................... Dr.

To Sundry Debtors Account(Being amount received from ............. after giving adiscount @%)

12 For bad debts:Bad Debts Account ........................ Dr.

To Sundry Debtors Account(Being amount due from Mr............. is confirmed as baddebts)

13 For provision for bad and doubtful debt:Profit and Loss Account ........................ Dr.

To Provision for doubtful debt Account(Being prov. made for doubtful debts @ ..% of Sundrydebtors)

14 For transfer of Bad Debts of provision for doubtful debtsaccount (if prov. for doubtful debts account maintained)

Provision for doubtful debts account ............. Dr.To Bad Debts Account(Being amt. of bad dents trad. to prove for doubtfuldebts account)


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15 On purchase of raw material / trading goods for cash:Purchase/Goods Account ........................ Dr.

To Cash Account(Being goods purchased for cash)

16. On purchase of raw material/trading goods on credit:Purchase / Goods Account ........................ Dr.

To Sundry Creditors Account(Being goods purchased on credit)

17. On return of purchased goods to the supplier:Sundry Creditors Account ........................ Dr.

To Purchase / Goods A/c(Being goods return to Mr. ...........)18. On Payment made to supplier/creditor:

Sundry Creditor Account ........................ Dr.To cash/Bank account

(Being cash / cheque no......paid to Mr.............)19 On payment made to creditors after availing cash

discountSundry Creditors Account ........................ Dr.

To cash/bank A/cTo Discount A/c

(being cash/cheque no..paid to Mr. .... after discount@%)

20 On payment of expenses:Expenses Account ...................... Dr.

To cash/Bank A/c(Being cash paid for .............)

21 On expenses due but no paid:Expenses Account ........................ Dr.

To Expenses outstanding/payable account(Being expenses for the month of .............due but not

paid)22 On income accrue but not received:Income Accrue/Received A/c ............ Dr.

To respective Income A/c(Being Income accrues but not received during the year.)

23 On amount withdrawn from bank:Cash Account ....................... Dr.

To Bank A/c(Being amount withdrawn from bank for business use)

24 On amount withdrawn from bank for private use:Capital / Drawing Account ........... Dr.

To Bank A/c(Being amount withdrawn from bank for personal use.)25 On withdrew of trading gods for private use:

Capital / Drawing Account .................... Dr.


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To Purchase / Goods A/c(Being goods withdrew from business for personal use.)

26 For distribution of trading goods free as a sample:Advertisement A/c ........................ Dr.

To Purchase A/c.(Being distribution of trading goods free as a sampledebited to advertisement A/c and credited to purchasesA/c)

COMPOUND ENTRY:

When more than two accounts are involved in a transaction and the transaction is recorded by means ofsingle journal entry instead of passing several journal entries, such single journal entry is termed asCompound Journal Entry. A compound journal may also be passed if there are more transactions ofthe same nature, taking place on the same date. It may be recorded in the following three way:(i) by debiting one account and crediting two or more accounts; or(ii) by debiting two or more accounts and crediting one account; or(iii) by debiting several accounts and crediting several accounts.Example:-Paid Rs. 920 to Mr. Gopal in full settlement of his account of Rs. 1,000.Gopal A/c ........... Dr. 1000

To Cash a/c 980

To discount received A/c 20(Being cash paid to Gopal in full settlement of his account)

OPENING ENTRY

A Journal entry by means of which the balances of various assets, liabilities and capital appearing in thebalance sheet of previous accounting period are brought forward in the books of current accountingperiod, is known as Opening Entry.While passing an opening entry. All those accounts which denote what the business possesses (assets)are debited and all the accounts showing amounts due by the business (liabilities) are credited. If Capital is not given, it can be easily found out by deducting liabilities from assets.

Opening entries are the following:Cash Account ............. Dr.Cash at Bank Account ............. Dr.Sundry Debtors Account ............. Dr.Stock Account ............. Dr.Fixed Assets Account ............. Dr.

To Sundry Creditors AccountTo Capital Account

The opening entry is made in the journal. At the end of the trading period, closing entries are made,the object being to close the books.

LEDGER:A ledger is a principal book, which contains all the accounts to which the transactions recorded in the

books of original entry are transferred. As the ledger is the ultimate destination of all transactions, theledger is called the Book of Final Entry.


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The ledger may be kept in the form of a bound book, a loose-leaf set of pages, or some kind of electronicstorage device such as magnetic tape or floppy diskettes or CDs, but it is always kept current in asystematic manner.Utility of the ledger:

It provides complete information about all the accounts in one book. It enables to ascertain what the main item of revenues are. It enables to ascertain what the main item of expenses are. It enables to ascertain what the assets are and of what value. It enables to ascertain what the liabilities are and of what amounts. It facilitate (i.e. make easy) the preparation of Final Accounts.

DISTINCTION BETWEEN JOURNAL AND LEDGER:

Journal Ledger

It is a book of primary entry. It is prepared on the basis of source documents

of transactions. Recording of transactions in the journal is

It is book of final or secondary entry. It is prepared on the basis of journal.

Recording in the Journal is second stage.


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25CHAPTER 3

SUBSIDIARY BOOKSWhen number of transactions is numerous, it is practically impossible to record all the transactions throughone journal because of a its limitations. To overcome the shortcomings of the use of the journal entry, the

journal is divided into special journals.The journal is subdivided in such a way, that a separate book is used for each category of transactions,which are repetitive in nature and are sufficiently large in number.Special journal, refer to the journals meant for specific transactions of similar nature. Special journals arealso known as subsidiary books or day-book.

In any large business organization, the following special journal (or subsidiary books) are generally used:Name of Books Transactions to be recorded

[I] Cash Journals:

(a) Cash Book (simple)(b) Cash book with discount column(c) Cash Book with bank and(d) Petty Cash Book[II] Goods Journals:

(a) Purchase book(b) Sales book.(c) Sales return book

(d) Purchase returns book

[III] Bills of Journals:

(a) Bills receivable book.(b) Bills payable

book.

Cash transactions Cash and discount transactions Cash, Bank and discount transactions Petty Cash transactions

Credit purchase of goods. Credit sales of goods

Goods returned by those customers to whomgoods were sold on credit.

Goods returned to those suppliers from goodswere purchased on credit

Bills receivable Drawn Bills payable accepted.

Advantages of subsidiary Books:-(i) Division of work.(ii) Specialization and efficiency.

(iii) Saving the time.(iv) Availability of informations.(v) Facility in checking.

Cash Book:

A cash Book is special journal which is used for recording all cash receipts and cash payments. It is abook of original entry, since transactions are recorded for the first time from the source documents. TheCash-Book is a ledger in the sense that it is designed in the form of a Cash Account and records cashreceipts on the debit side and cash payment on the credit side. Thus, Cash-book is both a journal andledger.

Single Column Cash Bookhas one amount column on each side. Double Column Cash Book(i.e. Cash book with discount Column) has two amount columns. One for

cash and another fro discount. All cash receipts and cash discount allowed are recorded on the debit sideand all cash payments and cash discount received are recorded on the credit side.


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1. Three Column Cash Bookhas three amount columns (one for cash, one for bank and one for discount)on each side. All cash receipts, deposits into bank and discount allowed are recorded on debit side andall cash payments, withdrawals from bank and discount received are recorded on the credit side. A three

26

column cash book serves the purpose of Cash Account and Bank Account. Hence, there is no need to openthese two accounts in ledger.

Petty Cash Book:

Petty cash book is the book which is used for the purposes of recording the payment of petty cashexpenses.

Features of Petty Cash Book:(i) The amount of cash received from the main cashier is recorded on the left hand side column.(ii) The payments of petty cash expenses are recorded on the right hand side in the respective

columns.(iii) It can never show a credit balance because the cash payments can never exceed the cash receipts.(iv) Its balance represents unspent petty cash in hand.(v) All the columns of expenses are totaled periodically and such periodic totals are individually

posted to the debit side of the respective expenses accounts in the ledger by writing To Sundriesas per petty Cash Book.

Advantages:

(i) Saving of chief cashiers time.

(ii) Saving labour in posting.(iii) Control over mistakes(iv) Control over petty expenses(v) Control over fraud(vi) Benefits of specialization

Imprest System of Petty Cash Book

The amount which the man cashier hands over to the petty cashier in order to meet the petty cashexpenses of a given period in known as IMPREST OR FLOAT.Features of imprest system of petty cash:(i) Estimation by chief cashier(ii) Advances by chief cashier(iii) Submission of petty cash book by petty cashier(iv) Examination of petty cash book by chief cashier(v) Reimbursement of amount spent(vi) Availability of same amount of petty cash.Advantages:(i) Control over mistakes(ii) Control over petty expenses(iii) Control over fraud

TRADE DISCOUNT

It is reduction granted by a supplier from the list price of goods or services on business considerations (suchas quantity bought, trade practices, etc.) other than for prompt payment. List price is the selling price asprinted on the product or in the List/Catalogue of product.


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CASH DISCOUNT

A reduction granted by a supplier from the invoice price in consideration of immediate payment within astipulated period.

27 DISTINCTION BETWEEN TRADE DISCOUNT

Trade Discount Cash Discount

It is a reduction granted by a supplier from thelist price of goods or services.

It is allowed to promote the sales or as a tradepractices.

It is allowed on purchase of goods.

It is shown by way of deduction in the invoiceitself.

Trade discount account is not opened in theledger.

It may vary with the quantity purchased

A reduction granted by a supplier from theinvoice price in consideration of immediate

payment or payment within stipulated period It is allowed to encourage the prompt payment.

It is allowed on immediate payment or paymentwithin a specified period.

It is not shown in the invoice.

Cash discount Account is opened in the ledger.

It may vary with the period within which the

payment is madeQuestion:

(1) What is debit note? Name the book in which entries are recorded on the basis of debit note?

Ans.: A Debit note is a document prepared by the purchases to inform the supplier that his account hasbeen debited with the amount mentioned and for the reasons stated therein. Debit note contains the date ofreturn, name of the supplier to whom the goods have been returned, details of the goods returned, reasonsfor returning the goods. Each debit note is serially numbered.

The entries in the purchases returns book are usually made on the basis of debit notes issued to thesuppliers or credit notes received from the suppliers.(2) What is credit note? Name the book in which entries are recorded on the basis of credit note?

Ans.: A Credit note is a document prepared by the seller to inform the buyer that his account has beencredited with the amount mentioned and for the reasons stated therein. Credit note contains the date ofreturn of goods, the name of the customer who has returned the goods, details of goods received back andthe amount of such goods. Each credit note in serially numbered.

The entries in the sales returns book are usually on the basis of credit notes issued to customers ordebit notes issued by the customers.


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CHAPTER 4

RECTIFICATION OF ERRORSThe term error refers to unintentional mistakes in financial information, e.g. mathematical or clericalmistakes, oversight or misinterpretation of facts, or unintentional misapplication of accounting policies.While recording transactions and events various errors may be committed unintentionally. When a journalentry contains an error, the entry can be erased or crossed out and corrected if the error is discoveredimmediately. However, if the errors are detected after posting to ledger accounts, the correcting entries aremade. The correcting entry is recorded in journal and posted to the general ledger exactly as regular entriesare.Example:

28

(i) A repair expenses was erroneously debited to plant and machinery on November 25, the error isdiscovered on December 31:Corrective Entry: 31st Dec.: Repair Expenses A/c ............. Dr.

To Plant and Machinery A/cThe corrective entry shows a credit to Plant and Machinery to cancel or offset the erroneous debit toPlant and Machinery.

(ii) A collection on account was erroneously credited to Sales on Jan. 1. The error is discovered onMarch 26.Corrective Entry: March 26. Sales Account ............ Dr.

To Sundry Debtor A/cThe debit to Sales in the correcting entry offset the incorrect credit to sales in the erroneous entry. Thecredit to Accounting Receivable in the correcting entry places the collected amount where it belongs.

Some Errors are Counter Balanced:

Accounting errors that are undetected can affect a variety of items, including revenues and expenses for agiven period. Some errors are counterbalanced by offsetting errors in the ordinary accounting process in thegiven period. Such errors are misstate net income in both periods, but by the end of the second period theerrors counterbalance or cancel each other out, and they affect the balance sheet of only first period, not thesecond period.

Example: A payment of Rs. 10,000 in March 2003 for Rent for the month April 2003. Instead of recordingit as prepaid rent, the payment was recorded as Rent Expenses.The effect of this recording error would be to:(1) Overstate rent expenses for the year 2002-2003 and understate year-end assets by Rs. 10,000 for the first

year end; and(2) Understate rent expense for the second year.The errors have no effect on the second years ending assets because the same total assets exist whether therent is recorded as used in April of that year or recorded as used in full the previous year. The total of theincorrect pretax income for the 2 years would be same with the total of the correct pretax income for the 2year because the first years understatement of pretax income by Rs. 10,000 would counterbalance thesecond years overstatement of Rs. 10,000. The retained income balance at the end of second year would

thus be correct on a pretax basis.

Errors that are not counterbalanced in the ordinary book-keeping process will keep subsequent

balance sheets in error until specific correcting entries are made.


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A Trial Balance is very good way of giving a clear indication of some mistakes that may be there. This willbe shown immediately , if the total of the two columns of the trial balance differ. Thus, trial balance isessential to ensure that mistakes do not remain unearthed. However, the agreement to trial balance does notshow conclusively that no mistakes have remain undetected. Some errors will not be disclosed by the trial

balance whereas some will be. An agreed trial balance, therefore, is only a reasonable proof ofarithmetic accuracy of books.

DIFFERENCE IN TRIAL BALANCE:- ERRORS

Apart from error in totaling the two columns of trial balance, the following mistakes will be shown up by

the trial balance, because then the trial balance will not agree:a) mistake in transferring the balance of an account to trial balance.29

b) Omitting to write the balance of an account in the trial balance.c) Mistake in balancing.d) Mistake an entry on the wrong side.e) A mistake in the casting of subsidiary books.f) Omitting to post the discount columns of the cash book.

Inspite of the agreement of the trail balance, the following types of error will not be disclosed because

they do not upset the equation: DEBIT = CREDIT.

(i) Omitting to record a transaction entirely in subsidiary books.

(ii) A wrong entry in the subsidiary books.(iii) Posting an entry on the correct side but in the wrong account head.(iv) An error of principle where by an assets is transferred as an expense or liability is treated as an

income.(v) Compensating errors.

CLASSIFICATION OF ERRORS

(a) Error of Omission A transaction entirely omitted to record in originalbooks or partially omitted while posting.

(b) Error of commission Wrong posting either of amount, or on the wrong

side, or in the wrong account.(c) Error of Principle Wrong classification of expenditure or receipt.(d) Compensating error One error compensated by the another error i.e. an

error which cancel themselves out.

STEPS TO LOCATE A MISTAKES

THE FOLLOWING STEPS ARE SUGGESTED TO FIND OUT ERRORS:1) Total the debit and credit columns of trial balance again.2) See the balances of all accounts, including the cash and bank balances, have been written in the trial

balance.3) Find our the difference in the trial balance. Look for such accounts as show this account. It is

possible that the balance of the particular account has been omitted from the trial balance. Accountshowing equal to half the difference should also be checked; the amount may have been written onthe wrong side of the trail balance.

4) See that there are no mistakes in the balancing of the various accounts.


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5) Recheck the totals of the subsidiary books, especially if the mistake is of 1,10,100 and so on.6) If the difference is a large one, compare the figure with the trial balance of the corresponding date of

the previous year. Any account showing rather large difference over the figure in the correspondingtrial balance of the previous year, should be rechecked.

7) Posting of all amounts corresponding to the differences or half the difference should be checked.8) If the differences are still not traced posting of all accounts will have to be checked.

RECTIFICATION OF ERRORS

Correction of errors, if located after some time, is always made by a proper journal entry and not bysimply crossing the wrong amount and inserting the right one. A complete explanation for the correction

made should be given so that no difficulty is experienced later when accounts are checked.From the point of view of rectification, errors are of two type:-(i) Error that affect the trial balance; and

30

(ii) Errors that do not affect the trial balance.

Correction of such error as affect the trial balance would not be through journal entry; only a

corrective amount placed on the proper side will suffice. Some of the examples of such types oferrors are as follows:-

1) An amount of Rs. 150 for a credit sale to Mr X correctly entered in the sales book, has been debited tohis account as Rs. 105.In this case the amount has been correctly entered in the sales book and, therefore, the sales account has

been correctly posted. The mistakes lies only in the account of Mr. X, who should have been debitedwith Rs. 150 and has been debited, instead, with Rs 105. The correcting entry is to:-

Mr. X Account Dr. Rs. 45.00To mistakes in posting on ............. Rs. 45.00

(Being amount wrongly posted in Mr. X A/c for Rs. 105 instead of Rs. 150)2) An amount of Rs. 150 for a credit sale to D.K.Kapoor, correctly entered in sales book, has been credited

to him.In this case also the sales account has been correctly posted and the mistakes lies only in the account ofD.K.Kapoor, who has been credited instead of debited.The correcting entry is to debit him with Rs. 300, Rs. 150 to remove the wrong credit and Rs. 150 for therightful debit. The caption will be To mistake in posting on...........

SUSPENSE ACCOUNT:

If the difference in the trial balances is not quickly located, it is usual to put the difference to

suspense account in order to make the trial balance balanced.

If the debit side is short, the suspense account will be debited saying To differences in trial balanceand

Similarly, the suspense account will be credited if the credit side is short.The difference in the trial balance is due only to type of mistakes which affect only one account such aswrong posting of an account, mistake in totaling a subsidiary book, etc. Such types of mistakes are onlyreflected in suspense account.

When the difference in trial balance is put to suspense account, the account to be corrected will bedebited or credit as the case may be, and the journal entry will be completed by crediting or debiting thesuspense account. When all the mistakes have been corrected, the suspense account will show no

balance.


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CORRECTION IN THE NEXT TRADING PERIOD:

Since it is necessary to ascertain the profit or loss of each period separately, it would be necessary torectify errors in such a way as not to affect the current years expenses, losses or incomes.To take an example, if an error committed in 2001-2002 is rectified in 2002-2003 by debiting purchaseaccount, it would mean that it would be treated as expenditure for 2002-2003. This would be wrong andthe proper way is to leave the purchase account and all other nominal account for 2002-2003 unaffected

by error in 2001-2002.For this purpose, a separate account, profit and loss adjustment account, should be opened and all debitand credit in respect of nominal accounts for error committed in previous trading period should be

passed through that account. The balance of this account is finally transferred to the capital account.

31 DISTINCTION BETWEEN ERROR OF PRINCIPAL AND ERROR OF OMISSION

Errors of Principal Errors of Omission

This error does not affect Trial Balance This error is due to wrong classification of

Capital and Revenue expenditure or personal andnominal account.

This is not a clerical error. This error affects profit of the business. This error will affect value of asset or liability.

This error may affect Trial Balance. This error is due to complete omission of a

transaction or partial omission.

This is a error may or may not affect profit of thebusiness.

This error may or may not affect value of assetsor liability.

CHAPTER 6

BILLS OF EXCHANGE / PROMISSORY NOTE

BILL OF EXCHANGE:-

A Bill of exchange is an instrument in writing containing an unconditional order signed by the maker,directed a certain person to pay a certain sum of money only to or to the order of, a certain person or to the

bearer of the instrument.When such an order is accepted by writing on the face of the order itself, it becomes a valid Bill ofExchange.The essentials are:

1. A bill of exchange must be in writing .2. It must be dated.3. The bill must be signed by the drawer.4. The drawer, the drawee, and the payee must be certain.5. It must contain an order to pay a certain sum of money.6. The money must be payable to a definite person or to his order to the bearer.7. The draft must be accepted for payment by the party or whom the order is made.


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The party who make the order (i.e. who makes the bill) is known as drawer; the party who accept

the order is known as acceptor and the party to whom the amount has to be paid is known as the

payee. The drawer and payee can be the same.

Specimen of Bill of Exchange.

Rs. 10000 Delhi

October 25, 2004

Three months after the date pay M/s X Brothers to order the sum of Rs. 10,000 for value received.P.K.Singh

ToM/s Nanda Brothers.

Laxmi Nagar, Delhi 110092.

PROMISSORY NOTE:

A Promissory Note is an instrument in writing, not being a bank note or currency note, containing anunconditional undertaking, signed by, the maker, to pay a certain sum of money only to, or to the order of acertain person or to the bearer of the instrument.A Promissory Note has the following characteristics:-

1. It must be in writing.2. It must contain a clear promise to pay, mere acknowledgement of a debt is not a promissory note.

3. The promise to pay must be unconditional. I promise to pay Rs. 5000/- as soon as I can is not anunconditional promise.

4. The promisor or maker must sign the promissory note.5. The maker must be a certain person.6. The payee must also be a certain.7. The sum payable must be certain and must not be capable of contingent addition or subtractions. I

promise to pay Rs. 5000/- plus all fines is not certain.8. Payment must be in legal money of the country.9. It should not be made payable to bearer.10. It should be properly stamped.Specimen of Promissory Note:

Rs. 10000 Delhi

October 25, 2004

Three months after the date we promise to pay M/s Alfa & Co. or order the sum of Rs. 10,000with interest at 6% for value received.

Gopal & Sons.

DISTINGUISH BETWEEN BILLS OF EXCHANGE AND PROMISSORY NOTE:

Bill of Exchange Promissory Note It is an unconditional order directing a certain

person to pay a certain sum of money. Generally, there are three parties in the bill of

It is an unconditional promise to pay a certainsum of money.

There are two parties in a promissory note the

Stamp

Stamp


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exchange the drawer, the drawee and thepayee.

A bill of exchange requires acceptance by thedrawee after if is drawn by the drawer.

Bill of exhange may be payable either on orderor to the bearer.

In case of Bills of Exchange notice of dishonouris given to all parties concerned.

The maker (Drawer) of the Bill is liable onlywhen drawee does not make payment.

In case of foreign bills protest is necessary if it isrequired as per law of the country where bill has

been drawn.

promisor or maker and the payee.

This does not require acceptance. It is written bythe person who will pay the amount.

Promissory note can not be payable to bearer.

In case of promissory note, notice of dishonouris not required.

The maker is primarily liable to pay the amount.

Protest is not required for promissory note.

CHEQUE:

A cheque is a bill of exchange drawn on a specified banker and payable on demand. It includes theelectronic image of a truncated cheque and a cheque in the electronic form.A cheque is a bill of exchange with two additional qualifications:

It is always drawn on a specified bank, and

It is always payable on demand.DISTINGUISH BETWEEN BILLS OF EXCHANGE AND CHEQUE:

Bill of Exchange Cheque

This requires acceptance by the drawee. This can be drawn on any person including bank. Notice of dishonour is necessary. A bill of exchange may be payable either on

demand or after a specified period. A bill of exchange generally requires stamping. Bills of exchange can not be crossed A time bill should be presented on the due date.

This does not require acceptance. This can be drawn on Bank only. Notice of dishonour is not necessary. Cheque is always payable on demand.

This does not require stamping. A cheque may be crossed. A cheque can be presented at any time within six

months from the date of cheque.

NEGOTIABILITY:-

Promissory Notes, Bill of Exchange and Cheque all are negotiable instrument. The holder can claimpayment on them subject to conditions that the holder takes them:-

i) without notice of defect in the title of the transferor, i.e. in good faith,ii) for consideration andiii) Before maturity.

Example:If a steals a bill of exchange and passes it on to B who is not aware of As mode of acquiring the bill andwho takes it for the value and before the due date of the bill, B will be entitled to get payment on the bill.Here B is a holder in due course. A holder in due course always gets a good title in case of forgery.


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Moreover, who ever gets the bill after the holder in due course will also get a good title to it; it has beenpurged of all defects.The instrument may passed on from one person to another by endorsement and delivery. The liability of theendorser or subsequent parties is same as in the case of endorsement of cheque. Thus, if a bill of exchangeis dishonoured, i.e. if payment is not made on the due date by the promisor (drawee in case of bill ofexhange), money can be claimed form any of the previous endorsers, the payee and the maker of theinstrument.

DISCOUNTING OF BILLS:

When the bill is taken to a bank and the necessary cash if received, the act is known as discounting. The

bank will always deduct a small sum depending upon the rate of interest and the period of maturity.

MATURITY OF A PROMISSORY NOTE OR BILL OF EXCHANGE:

The maturity of a promissory note or bill of exchange is the date at which it falls due.A promissory note or bill of exchange may be payable:-

(i) on demand; or (ii) on a specified date, or(iii) after a specified period.

In the first case, the amount is payable on the instrument, when the demand is made. In the second case,payment can be claimed on a specified date. In the third case, date of maturity has to be calculated. Everyinstrument, payable otherwise than on demand, is entitle to three days of grace.

The following instruments are not entitled to days of grace:(a) A cheque,(b) A bill or note payable at sight or on presentment or on demand.(c) A bill or note in which no time is mentioned

The following instruments are entitled to days of grace;

(a) a bill or note payable on a specified day,(b) a bill or note payable after sight,(c) a bill or note payable at a certain period after date,(d) a bill or note payable at a certain period after the happening of a certain event.

Calculation Of date of maturity:

(1) If a promissory note or bill of exchange is made payable a stated number of months after date or aftersight or after a certain event, it becomes payable three days after the corresponding date of the monthsafter the stated number of months. If the month in which the period would terminate has nocorresponding day, the period shall be held to terminate on the last day of such month.

(2) In the above case, the day on which the instrument is drawn, or presented for acceptance or sight or theday on which the event happens is to be excluded.

(3) When the day on which a promissory note or bill of exchange is at maturity is a public holiday, theinstrument shall be deemed to be due on the preceding day. E.g.: A bill falling due for payment onAugust 15 will have to be paid on August 14.

Dishonour:

A bill may be dishonou

Accounting Theory3

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