MB-107: FINANCIAL ACCOUNTING (Faculty: Anupam De)

1.

Introduction to Financial Accounting: Conventions, Concepts and Principles

Definition of Accounting: Accounting is said to be the art of Recording, art of Classifying and art of Summarizing of the business transactions in a significant manner. Difference between Events and Transactions: All Transactions are events but all Events are not transactions. To become transactions, an event have to pass first and any one of the rest of the following tests: i) Financial elements which can be measured in terms of money are involved. ii) There is a flow of financial elements from one party to another. iii) There is a change in financial position.

Accounting and Economics: Economics is the science which studies human behaviour as a relationship between scarce means and resources which have alternative uses. When the individual buyer and sellers have to take economic decision for purchase and sale, they are to depend mainly upon accounting information. A person dealing with accounts is concerned with economic problems of an enterprise only, whereas an Economist is concerned with the problems of an industry and the economy. Much of the statistical data used by the Economists are available from the accounting records and interpretations. Thus Economics and Accounting are closely related subjects. Accounting is the language of a business because accounting provides the principal means by which information about a business is communicated to the others i.e. the users of accounts. Doctrine of Consistency: Accounting principles once used should be used consistently during the year and also from one year to another. Example if accrual basis is followed in

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a certain year, cash basis should not be followed in the next year.

Doctrine of Disclosure: The doctrine of disclosure requires that all the material facts should be disclosed in the accounting statements and reports. For example, notes regarding contingent liability (a liability which may or may not become liability depending upon the occurrence and non-occurrence of future event or events), market price of investments etc are often given which is the result of following the Doctrine of Disclosure. Doctrine of Conservatism: The doctrine of conservatism suggests that no profit should be anticipated unless it actually takes place but provision should be made for all possible losses and expenses. For example valuation of inventory is done at cost or market price whichever is lower. If inventories are valued at market price, profit is anticipated beforehand i.e. even before the actual sale of those inventories. Again provision for bad debts are made in anticipation of debts which may become bad in future ( e.g. debtor being an individual died before paying money due or debtor as a company gone into liquidation before repaying the debt) though actual amount of bad debts may always differ from the provision made for it. Doctrine of Materiality: The doctrine of materiality suggests all the material facts and information should be disclosed properly. Matters which are significant require accounting in greater details than the matters which are much less significant or insignificant. For example while preparing accounts of a big company paise is not material and hence all the figures may be shown in the nearest rupees. Business Entity Concept: A business entity and its owners are regarded as separate entity in accounting. This distinction between a firm and its owners makes it possible to i) record the transactions between the firm and the owner (e.g. investment made by the owner is called capital and withdrawal from the business is called drawing) ii) reveal the true picture of the affairs of the firm, because without this distinction the transaction of the

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firm and private transactions of the owners would be mixed and the clear and fair picture of the affairs of the firm would not be known.

Cost Concept: A business transaction is recorded in terms of the amount actually passing through the transaction i.e. the historical cost. For example, a building is constructed and total expenditure incurred for it is Rs. 10.00 lacs, however market price of this building is Rs. 12.00 lacs. As per the cost concept the building will be recorded in the books of accounts at Rs. 10.00 lacs i.e. the historical cost of the building. Money Measurement Concept: Accounting is only concerned with those events which can be measured in terms of money. For example a court case is pending against a concern for some business disputes and it may face a huge loss if the verdict of the case goes against it. However this probable loss can not be considered in the accounts until and unless it can be measured in terms of money. Going Concern Concept: A business, unless otherwise known, will be assumed to operate for an indefinitely long period of time. According this concept assets are shown in the accounts at their historical cost not at the Net Realisable Value (market price less relevant expenses for selling) or at the Current Replacement Cost (cost which may be incurred to replace the assets in its present condition by a new asset). However when a business is supposed to operate for a short period i.e. for a venture business, the assets is shown in the accounts in its Net Realisable Value (NRV). Dual Aspect Concept: This concept recognizes two aspects of accountingone representing the assets and the other representing the claims against the assets. These two aspects are always equal to each other. The accounting equation for it: i) Assets = Capital ii) Assets = Capital + Liabilities

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Dual aspect concept, therefore, explains the sources of funds for the business on the one hand and application of funds on the other hand.

Realisation Concept: According to this concept revenue should be recognized in the accounts when there is no uncertainty regarding the ultimate collection (i.e. when the goods or services are passed to the buyer and the later accepts the liability). However the expenses and losses should be realized in the accounts when those are incurred or it is probable to incur them. For example a sales order received by a company is not recognized as sale until and unless the goods are supplied against this order and the customer has accepted it. However any expenses incurred or probable to be incurred for the production of the goods for that sales order, is recognized immediately. Matching Concept: According to this concept only relevant cost should be deducted from the revenue of a period for periodical income measurement. For example suppose 100 units are purchased, and out of this 100 units only 80 units are sold, then for matching expenses against the revenue from the sale of 80 units, only expenses incurred for purchasing the 80 units will be considered. Accrual Concept: Sometimes goods and services may be purchased without any actual inflow or outflow of money (i.e. on credit). According to this concept income is assumed to accrue even if there have been no actual cash inflows and cost is supposed to be incurred even if there have been no actual cash outflows. For example if sales has taken place though portion of the sales proceed has been received and portion of it is due, the total amount of sales irrespective of the actual amount received will considered as sales for an accounting period. Periodic Concept: Although an enterprise is supposed to continue forever, for the purpose of accounting its life is divided into small time spans of equal duration, and each of these time span is called the accounting period. For example 01-04-2005 to 31-03-2006 is an accounting period.

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Importance & Scope of Accounting

Objectives of Accounting:
Accounting Objectives To provide useful financial information Realisation of Objectives By providing useful financial information

Doctrines Materiality, Consistency, Compatibility, Objectivity, Disclosure etc.

Financial Reports Profit and Loss Account, Balance Sheet, Fund Flow Statements, Supplementary Statements

Assumptions On Entity, Going Concern, Historical Cost, Financial Period etc.

GAAP (Generally Accepted Accounting Principles

Accounting Procedures

Procedures applied to Real world.

Importance of Accounting: Importance of accounting is

different to internal and external users of it. Importance to Internal Users: accounts are mainly Owners, Internal users of Management and

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Employees. Owners and Managements need accounting information for o calculating profit or loss (through Profit & Loss Accounting or Income & Expenditure Accounting) o ascertaining financial health (through Balance Sheet) o comparing the results with the past records or with the different branches and departments of a same concern or with the competitors to improve performance and for overall betterment of the concern o controlling expenses and increasing productivity o preventing fraud and misuse of funds o satisfying the external users o sustaining growth and future prospect Employees are mainly interested in the growth and prospect of the concern to satisfy their career goal. Importance to External Users: o Governments Authorities (like Income tax Department, Sales Tax Departments, Excise and Custom Department etc.) are interested in accounting for proper ascertainment of taxes, duties and cess to increase governmental revenue o Suppliers and Lenders (like Sundry Creditors and Bankers) is interested to know the repayment capacity of the concern and their credit rating o Customers or prospective buyers (like Sundry Debtors) is interested to know the survival capacity of the concern for future services and after-sale services o Prospective Investors in the concern will be interested to know the future income growth and future dividend paying capacity of the concern o Researchers and Analysts are interested to get financial information for their research and analysis purpose

Scope of Accounting: Accounting is the language of a business. Accounting departments, is an extremely important department of an organization and it holds
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most important, vital and sensitive records and documents of a concern and it supplies most essential information to run and sustain an organization efficiently and effectively. It is vital for survival of any organization. Not only the internal users (i.e. management, owners) are very much dependant on it, the external users (like bankers, lenders, govt. authorities.) also are very much dependant on the accounting records, reports, statements to satisfy their various information needs. Accounting system acts a bridge between them. Revenue Recognition Principles of revenue recognition deal with the timing and extent (i.e. amount) of revenue to be recognized in an accounting year. Indian Accounting Standard-9 is relevant for this purpose. The following principles are followed for revenue recognition: i) The amount of income must be capable of being measured objectively ii) The revenue must have been earned i.e. substantial amount of goods have been delivered or services have been rendered and the buyer of goods or service has accepted the liability towards it. iii) There is no significant uncertainty towards the ultimate collection Revenue can be recognized either on cash basis or accrual basis. If revenue is recognized only upon collection of the amount of sales, it is called cash basis of accounting. If revenue is recognized at the point of sale (i.e. goods and services have been delivered or rendered and buyer has accepted the liability) rather than at the time of collection of cash, it is called accrual basis of accounting. Double Entry System of Accounting Under this system every transaction has always dual aspect, one is called Debit (Dr.) and other is called Credit (Cr.) And both will be equal always. For example owner

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invest cash of Rs. 1,00,000 into the business. As per double entry concept it can be written as: Assets (here Cash) = Equity (i.e Capital) = Rs. 1,00,000 If a machinery of Rs. 50,000 is purchased out of that cash, the same equation can be written as: Assets (here Fixed Assets +Cash) = Equity (i.e Capital) = Rs. 1,00,000 If a stock of goods of Rs. 20,000 is purchased on credit from a supplier, the same equation can be written as: Assets (here Fixed Assets +Stock of Goods +Cash) = 1,20,000 and Equity (i.e. Capital) + Liability (here Sundry Creditors) = Rs. 1,20,000 i.e. Assets (A) = Equity(E) + Liability (L) = 1,20,000
2.

Recording System: Transaction: Accounting system records the transactions only. An event becomes a transaction if i) financial element is involved ii) there is a flow of financial elements from one party to another and or iii) there is a change in financial position of any one party. For example: Machinery purchased worth Rs. 10.00 lacs on credit from International Suppliers is a transaction. Journal Transactions are recorded in the books (i.e primary books of entry e.g. Cash Book, Journal Proper) systematically by following the Golden Rules.

Credit)

Golden Rule of Accountancy (Rules of Debit and Real Account: Debit what comes in and Credit

a) what goes out

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c)

Nominal Account: Debit all the expenses & losses and Credit all the incomes and gains Personal Account: Debit the receiver and Credit the giver b)
Simplification of Golden Rule: Debit Assets & Expenses, Credit

Books of .. Dr. Dat e ?? Particulars Machinery A/cDr. To International Suppliers A/c (Being machinery purchased on credit)
Incomes & Liabilities

Cr. Amount (Rs.) 10,00,000. 00

LF ??

V. No.

Amount (Rs.) 10,00,000 .00

Examples of Real Account: Cash, Building, Machinery, Stocks etc. Examples of Nominal Account: Expenses like Rent, Salary, Traveling & Conveyance, Advertisement & Publicity etc. and Incomes e.g. Sales, Miscellaneous Income, Discounted Received etc. Examples of Personal Account: Sundry Debtors, Sundry Creditors, Bank, Capital etc. The Transaction Machinery purchased worth Rs. 10.00 lacs on credit from International Suppliers may be recorded in the Journal Proper in this way:

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LF: Ledger Folio, V No.: Voucher No.

Cash & Bank transactions are recorded in Cash Book, credit Sales & Purchases are recorded in Sales Day Book & Purchase Day Book respectively, sale & purchase returns are recorded in Sales Return Book & Purchases Return Book respectively, in this way transactions are recorded in all the primary books of entry and residual transactions are recorded in Journal Proper (which is also a primary book of entry). Ledger: After the transactions are recorded in a systematic manner, they are classified on the basis of different Account Heads. All these Accounting heads are called Ledger and this act is called posting. For example, the above journal entry may posted into following ledger heads Dr. Cr.
Dat e
?? To, International Suppliers A/c ??

Books of .. Machinery Account

Particulars JF Amount (Rs.) Dat e
By, Balance c/d

Particulars

JF Amount (Rs.)

10,00,000 ?? .00 10,00,00

10,00,000. 00 10,00,00 0.00

??

To, b/d

Balance

0.00 10,00,000 .00

Dr.

International Suppliers A/c

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Cr.
Dat e
?? To, c/d Balance ??

Particulars

JF

Amount (Rs.)

Dat e

Particulars
By, Machinery A/c

JF Amount (Rs.)

10,00,000 ?? .00 10,00,00 0.00

??

10,00,000. 00 10,00,00

By, Balance b/d

0.00 10,00,000. 00

JF: Journal Folio

Trial Balance All the debit and credit balances of the different Ledger heads are periodically tabulated in a separate statement or sheet to ascertain whether total of all debits are equal to total of all credits. This statement or sheet is called Trial Balance. If Trail Balance is tallied both sides (i.e. debit side and credit side) we can say that there is no apparent mathematical error. However it can not be said that as the Trial Balance is tallied the accounts is correct in all respect. Because certain errors can not be detected by Trial Balance which are namely compensating errors (one error is compensated by others), error of omission (one total transaction omitted to be posted), error of mis-posting (posted under wrong account heads without violating debit and credit), error of principles (wrong entry of journal due to lack of knowledge in accounting principles) etc. When the Trial Balance is not tallied both sides, temporarily a suspense account is created and subsequently errors are rectified by passing appropriate journal entry. This method is followed in manual accounting system only. A small Trail Balance will look like this:

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Books of .. Trail Balance As on ..

Sl. No. Name of Accounts 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17 18. Cash in Hand Bank Overdraft Capital Building Purchases Sales Sundry Debtors Sundry Creditors Salary Drawings Printing Stationery Advertising & Publicity Opening Stock Carriage Inwards Drawings Discount Allowed Depreciation Miscellaneous Income Total LF Dr. Cr. Amount Amount (Rs.) (Rs.) XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXX XXXXXX XXXXXX

Trading Account

and Profit & Loss Account

Accounting means RCS i.e Recording, Classification and Summarising. Recording and classification is done through journal and ledger. After this stage, Summarising stage starts which is the most challenging and analytical stage, and a business manager is supposed to handle this stage very efficiently and effectively. Summarising stage starts at
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the preparation of Trial Balance. After preparation of Trial Balance all the nominal accounts (refer second Golden Rules of Accountancy) are transferred to Trading A/c and Profit & Loss A/c. If no separate manufacturing account is created, all the manufacturing expenses and all other direct expenses (i.e. expenses which are required to be incurred for making the purchased or manufactured goods ready for sale) are transferred to Trading A/c and remaining nominal accounts heads are transferred to profit & Loss A/c. If there is surplus of income over all expenditures it is called profit and if there is deficit it is called loss. Both are adjusted with capital. A small Trading and Profit & Loss A/c will look like this.

Dr. Cr.
Particulars

Books of .. Trading Account for the period from to

Amount Particulars (Rs.) Amount (Rs.)
XXXXX XXXXX

To, Opening Stock A/c To, Purchase To,. Carriage Inwards To, Gross Profit c/d

XXXXX By, Sales XXXXX By, Closing Stock XXXXX XXXXX XXXXXX

XXXXXX

Dr. Cr.

Profit & Loss Account for the period from to

XXXXX By, Gross Profit b/d XXXXX By, Misc. Income XXXXX & XXXXX XXXXX XXXXX profit
XXXXXX XXXXXX XXXXX XXXXX

To, Printing Stationery

To, Salary To, Discount Allowed To, Advertising Publicity To, Depreciation To. Net (transferred to

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capital)

This presentation of Profit and Loss A/c is called horizontal presentation. There are may be vertical presentation also. Balance Sheet: Balance Sheet is prepared by transferring all the real account (refer fist rule of Golden Rules) and personal account (refer third rule of Golden Rules) to a separate sheet. One side of this statement accumulates all the Liabilities and other side accumulates all the assets. Actually assets side contains debit accounting heads and liabilities sides contains the credit accounting heads. Liabilities side is also called sources of fund and assets side is called application of fund. A small Balance Sheet will look like this. Books of ..
Liabilities Balance Sheet As At . Amount Assets Amount (Rs.) (Rs.) Capital Opening Add: Profit (or less: Loss) Less: Drawings Building (less XXXXX deprecation) XXXXX XXXXX Sundry Debtors XXXXX (less bad debt XXXXX provision)
XXXXX Closing Stock XXXXX XXXXX

XXXXX XXXXX

Sundry Creditors Bank Overdraft

XXXXX Cash in Hand XXXXXX

XXXXXX

This presentation of Balance Sheet is called horizontal presentation. There may be vertical presentation also.
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A standard format of Balance Sheet will look like this:

Balance Sheet as at Rs. Rs. SOURCES OF FUNDS Owners Fund Capital XXXX Reserve and Surplus (P/L A/c, Share XXXX XXXX Premium, Capital Reserve etc.) Loan Fund Secured Loan (Debenture, Term Loan from Bank etc.) Unsecured Loan (Unsecured loan form Directors, Relatives) APPICATION OF FUNDS Fixed Assets Gross Block Less: Depreciation Net Block Investments (investment in shares, debenture & bond, investment in other business, etc.) Current Assets, Loans & Advances Current Assets Inventories Sundry Debtors Cash & Bank Balances Loans & Advances Bills Receivables Other Advances Less: Current Liabilities & Provision Sundry Creditors XXXX XXXX XXXX XXXXXX XXXX XXXX XXXX XXXX

XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX

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Tax Provision Net Current Assets Miscellaneous Expenditures (Preliminary Expenses, Preoperative Expenses, etc.)

XXXX XXXX XXXX XXXX XXXXXX

3.

Financial Statements Income Statement: The statement which represents the different categories of income earned and the expenditures and losses incurred to earn it (Matching Concept, discussed earlier, has to be kept into mind) is called Income Statement. Profit & Loss Account (prepared for organization running for profit making purposes) and Income & Expenditure Account (prepared for organization running for non-profit making purposes) are examples of Income Statement.
A standard format of Profit & Loss Account will look like this: Profit & Loss Account for the period from. Rs. Rs. Sales XXXX Less: Cost of Goods Sold XXXX Gross Profit XXXX Less: Operating Expenses: Office & Administrative XXXX Expenses Selling & Distribution XXXX Expenses Depreciation XXXX Operating Profit XXXX Less: Interest XXXX Add: Other Non-operating Income XXXX Less: Non-operating Expenses XXXX XXXX Profit Before Tax XXXX Less: Provision for Tax XXXX Profit After Tax XXXX Appropriation of Profit Provision for Dividend XXXX
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Reserves and Surplus

XXXX

Fund Flow Statement:

and

Cash Flow Statement

Fund Flow Statement is to reveal how much of fund is earned from the normal business activities and how much of fund earned from other business activities like sale of fixed assets (i.e assets hold for long-term purpose not for resale), issues of shares or from accepting loans etc. It is also supposed to reveal what portion of collected fund is utilised for acquisition of fixed assets, loan payment, tax and dividend payment etc. One side of this called sources of fund, other side is called application of fund. Cash Flow Statement is a statement which presents detail information on annual cash inflows and cash outflows of an entity separately under the heading of sources and their uses. Sources of cash flow may be analysed into mainly two broad categories: one is cash from operations (i.e money earned from normal business activities which are production and trading of goods and rendering of services) and the other is cash from other sources (examples are sale of fixed assts, issue of shares, accepting business loan etc.). Use of cash may be due to acquisition of fixed assets, payment of loan, payment of taxes and dividend etc. As per Indian Accounting Standard-3, various components of Cash Flow Statement is presented as operating activities (i.e. normal business operation), investing activities (example: sale and purchase of fixed assets) and financing activities (example: issue of share capital, acceptance of loan etc.). Interpretation and Importance Growth of a business depends on its money earning capacity and effective and effective use of this money or funds for future growth, survival. Information regarding the inflows of cash or funds and outflows of cash or funds is derived by preparing Cash Flow Statement and Fund Flow Statement.
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4.

Ratio Analysis Computation of different Accounting Ratio Quotients used to express the comparative relation between the two accounting figures are called accounting ratios. For example if Return on Capital Invested (ROI) of a concern is 25%, it means if Rs 1oo is invested in that concern, Rs. 25 will be its return. Important Accounting Ratios o Short Term Solvency or Short Term Liquidity Ratio
Current Assets Current Ratio = Current Liabilities Liquid Assets
(i.e. stock, debtor, loans, cash etc.) (i.e. creditors, bank overdraft, provisions)

Liquid Ratio
(Quick Assets Ratio)

(i.e C.A. less Stock) overdraft

= Liquid Liabilities (i.e. C.L. minus bank

o Long Term Solvency or Long Term Liquidity Ratio Debt Equity Ratio
(i.e. Debenture, Term Loan from Bank etc.) Proprietors (i.e. Share Capital+ = Reserve SurplusFund/Equity Fictitious Assets ) (Fictitious assets means assets having no productivity)

Long Term Debt

Proprietar = y Ratio

Proprietors Fund Total Assets

(i.e. Total AssetsFictitious Assets)

o Capital Gearing or Leverage Ratio Capital Gearing = Preference Shareholders Equity + Debentures

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Ratio Debentur e Capital Ratio

Equity Shareholders Equity (i.e. Equity Share Capital +Reserve & Surplus) Debentures = Net Worth + Debentures
(Net Worth means Shareholders Fund)

o Profitability or Earning Ratio Gross Profit/Margin/ Turnover Ratio Net Profit Ratio Return on Investment/R
OI

Gross Profit = Net Sales Net Profit Net Sales Net Profit i.e. PAT Capital Employed Net Profit

(i.e. Net Sales Cost of Sales.) (i.e. Sales Sales Return ) Net Sales All Expenses

PAT means profit after tax (i.e. Proprietors Fund + Long Term Debt) Net Sales All Expenses

Return on Equity

Proprietors Fund/ Net Worth

o Turnover Ratio Cost of Stock Sales Turnover/Velo = city Average Stock Debtor Turnover /Velocity Creditor Turnover /Velocity Net Credit Sales Accounts Receivables Net Credit Purchases Accounts Payable or

(i.e. Net Sales Margin.) (i.e. [Op. stock + Cl. Stock]/2 ) Accounts Receivables X 365 days Net Credit Sales

or

Accounts Payable X 365 days Net Credit Purchases

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o Operating Ratio
Operating Ratio =

Cost of Sales & Other Expenses Net Sales Cost of Sales

Operating

Administrative Exp.

Expenses Ratio

, = Net Sales Net Sales

Sellin g & Dist. , Exp.

etc.

Net Sales

o Debt Service & Ratio Dividend Ratio Interest Coverage Ratio EBIT = Interest Expenses PAT + Depreciation + Interest Interest + Principle Repayment of Loan
(EBIT means Earnings before Interest and Tax)

PAT Tax

means Profit after

Debt Service Ratio (DSCR)

Dividend Coverage Ratio

Net Profit - Income Tax Dividend on =

Preference Shares

Dividend on Equity Shares paid or proposed

o Market Price Ratio

Dividend Yield Dividend per Equity Shares = Market Value per Equity Share EPS = Market Value per Equity Share
EPS means Earning Per Share

Earning Price Ratio/ Earning Yield

Interpretation & Importance of Ratio:

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Different Ratio has got different interpretation. A ratio should be interpreted by the items used for calculating it. For example, industry standard of Current Ratio & Liquid Ratio is 2:1 and 1:1 respectively. It means if a concern has C.R. and L.R. less than that, it can be said that the concern may be not be able to meet its short term liabilities (like bank overdraft, trade creditors) on timely basis. Ratios are very important indicators of performance, short run and long run liquidity, debt servicing capacity and financial health of a concern. These are the best tools to compare a particular concern with its competitors. Limitations: Ratios are generally calculated by the historical data which sometimes lead to wrong and misleading decision making. Ratios are basically problem indicators not the problem solvers. Sometimes based on one single ratio may again leads to wrong decision making. Proper diagnosis is possible when implications of all ratios are examined together.

5.

Inventories Pricing: &

Valuation:

Stock pricing and valuation is very much important for profit calculation. Indian Accounting Standard-2 deals with it. Normally we value stock cost and market price whichever is lower. Calculation of the value of stock lying on hand is a critical a job because purchase price may vary with each lot of purchase and it is virtually impossible to identify which lots of the stock is lying in hand. To remove this practical difficulty various stock valuation methods are used. Those are FIFO (means First In First Out, here it is assumed that materials received first is used first), LIFO (means Last In First Out, here it is assumed that materials received last is used first), Weighted Average Cost (weighted average cost of materials used where both quantity and price of materials are taken into consideration), Simple Average Cost, Base Stock Methods, Specific Identification Methods etc. However FIFO, LIFO and Weighted Average Cost are the most commonly used methods. Indian Accounting Standard-2 recommends FIFO and Weighted Average Cost only for stock valuation.

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Accounting & Recording While accounting the stock all the cost is incurred to bring the materials into present location is included. Stock ledgers are maintained item wise to record stock receipts, issue and balances. For valuation of closing stock certain items are included e.g. goods-in-transit (Goods dispatched by the suppliers but still in transit), goods sold on consignment basis etc. and certain items are excluded e.g. goods already sold awaiting delivery. 6. Depreciation Depreciation means wear and tear of a depreciable asset due to use and efflux of time, fall in the value and quality due to obsolescence, accidents and change in market condition. Depreciation is popularly know as a non cash expenditure, because though it is considered as expenses in the profit & loss account, there is no cash outflow for it as an expense. India Accounting Standard-6 deals with depreciation. Methods: Various methods may be used for calculating depreciation. Which are Straight Line Method (annual depreciation remains same year to year;, amount of annual depreciation = (Cost of the Asset Estimated Residual Value at the end of useful life)/Expected years of use), Diminishing Balance Method (Annual depreciation diminishes as the useful life diminishes; rate of annual depreciation = 1 Residual Value/Cost of Asset), Sums of Years Digit Method (annual depreciation is calculated considering diminishing effectiveness of the remaining life of the asset), Machine Hour Rate method (annual depreciation, e.g. machinery = (Cost of the Asset Estimated Residual Value)/expected no of machine hours produced), Replacement Cost Methods, Annuity Methods etc. Accounting: Depreciation may be accounted by charging depreciation against the asset itself or by application of fund. In the first

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case, the value of asset shown in accounts goes on decreasing year after year. In the second case method the asset value is kept intact and a different fund named depreciation fund is created. The effect of depreciation accounting is the amount of depreciation is charged i.e. debited to P/L A/c as expenses and by the same amount asset value is decreased or for the same amount fund is created. Importance: A business is supposed to run forever (if it is not a venture business which is operated for specific purpose only). Survival of the business depends mainly how its capital base is kept intact and how fund is created for replacing assets and meeting contingencies. Depreciation is charged to account so that an amount is kept aside from profit every year and after the end of useful life similar asset can be purchased from that fund. If depreciation is not charged cost of production will not be the actual, it will be lower and consequently the profit will be overstated.
7.

Provisions: Provisions: & Reserves: A provision is a charge against profit (i.e. profit is deducted) for either i) for a known reduction in the value of an asset or ii) for a known liability. Provision is created, out profit available before distribution, for known future contingencies so that amount is available in the business itself for meeting that contingencies whenever it arise. A reserve is profits retained in the business (not distributed to the owners) for unknown liability and contingencies which may crop up in the future. It is actually an allocation of profit made to strengthen the financial position and general health of a business entity. Doubtful Debt: Doubtful debts are debts which are doubtful to be recovered. In every types of business it is a common phenomenon. To ensure future survival of business,

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provision are created (i.e. it is charged against profit) for future estimated (normally as a percentage on total debts and this percentage may vary business to business) doubtful debts. Bad Debt: When a claim against a debtor becomes irrecoverable (e.g. death or insolvency of an individual debtor or winding up of a debtor being a company etc.) owing to various reasons it is called bad debts. It is quite natural to happen to any business. Importance: In order to measure net profit or net loss for an accounting period, it is proper that expenses and losses of the period must be matched against the revenues of that period (refer Matching Concept), which (revenues) the expenses has helped to generate. Normally bad debts do not happen in the year of sale, it normally happens after the sale. Hence as per the Matching Concept the provision (though it is an estimated bad debts) must be created against the profit of the year only in which the sales (debtors of which have been proved bad later on) have taken place. Accounting Treatments: Provision for bad and doubtful debts are created as a charge against profit i.e. it is debited to P/L A/c and credited to Provision for Bad and Doubtful Debt A/c. Every year it is estimated normally as a percentage of the total amount of debts lying at the end of an accounting period and adjusted every year if it is required so. If there is actual bad debts in any year, it is first charged against the provision created for it, if any, and the remaining portion or the total amount (if provision is not created) of the bad debt is charged to profit and loss account as a loss. 8. Corporate Accounting Preparation of Corporate Final Accounts as per Companies act 1956:

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Indian Companies Act has certain provision for charging depreciation before dividend distribution, calculating managerial remuneration, presentation of Profit & Loss Account and Balance Sheet, following of Indian Accounting Standards etc. Final accounts of a company are prepared as per these provisions of Companies Act.

Issues and buyback of Equity Share- Issue and Redemption of Preference Share and Debentures Shares of a company is floated in the market, in case of public limited company, by issuing prospectus (a documents of all relevant details of a company) to public or in case of private limited company, through private channels. All the transactions of process of application & allotment of share and calls (calling the amount due on shares from shareholders), treatment of issue on discount or at premium (i.e higher price than the face value) and subsequent forfeiture of shares due to non payment of allotment and call money are recorded in books of accounts. Shares may be bought back by the company itself (companies act has a provision of buy back of own shares by a company) after floating in the market. Objective of share buy back may be reconstitution of share capital or it may be sheer investment. Preference share is a particular category of share, shareholders of which generally does not have any voting rights except in some special situations. However preference share holders are supposed to get fixed percentage of dividend (which may be cumulative dividend or non-cumulative dividend) and they will have a preferential claim of their dividend (i.e. they should get preference in getting dividend) before the equity shareholders. There is no tax benefit on preference dividend as it is not an expense. Procedure of issue and its accounting of preference share are almost similar to that of equity shares. Preference shares are normally redeemed (i.e. repaid) within a certain period. Redemption may be at

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par (i.e. face value repaid) or at premium (higher than the face value is repaid). Debentures are fixed interest bearing securities. Interest on debentures is a legal obligation to a company and has to be paid out even in case of loss also. Interest of debentures is allowable expenses in Income Tax. Debentures also are redeemed within a certain period as mention the debenture document.

-:End:-

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