The Accounting Process: A Case Study

Sunil Bakshi is a business school graduate. He has always been interested in computers and wants to start his own hardware business. As he passed out of the business school, his grandfather funded him Rs 2,00,000 to start his own business. He decided to start a computer parts business and named his firm Sunil Computer Mart. His memory of elementary accounting taken during the first term was somewhat shaky, but he knew that he would need accounting information to manage his business. He remembered the accounting equation (Assets = Liabilities + Owners Equity) and that it always should balance. First Week: During the first week, his diary contained the following items: Event (1) Opened a bank account in business name and transferred Rs 1,00,000 into 1st January it. Event (2) Took a shop on rent in Nehru Place from a person known to his father 02/ 01 Event (3) Gave Rs 10,000 to the shop owner, representing first months rent (Rs 02/ 01 5000) and one months security deposit. Event (4) Spent Rs 500 on cleaning and fixing up the interior of the store. 05/ 01 Event (5) Met a long lost friend, who incidentally was in the same business and 06/ 01 offered to partner in the business. Sunil said he would decide about it later At the end of the week he recorded the effects of these events on the accounting equation as follows: Sunil Computer Mart Financial Position Statement as on the end of first week
Owners Equity Liabilities + Rs. Assets Rs.

Shareholders Equity + 1,00,000 (1)

Liabilities 500 (4) Cash + 1,00,000 (1) - 10,000 (3) 500 (4) + + 5,000 (3) 5,000 (3)

Prepaid Rent Security Deposit

Figures in brackets indicate the event number that the entry refers to. Note that the events (2) and (5) have had no effect on Sunils statement. They did not change the financial position of his business. Taking a shop on rent will have no effect till the time the shop is given to Sunil in usable condition. Sunil was not obliged to take his friend as a partner, his Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.

friend will become partner only when Sunil decides to share his resources with him and the partner brings additional resources to work with Sunil. Also note how Sunil recorded the effect of events (1), (2) and (3) and the reasoning behind such recordings: Effect of (1) Cash in the business has increased by Rs 1,00,000 because Sunil has invested this money into the business. Therefore, it is also reflected in owners equity, which represents Sunils share of the business. Gave Rs 10,000 to the shop owner, representing first months rent (Rs 5000) and one months rent as security deposit (Rs 5,000). This means that the cash goes down by Rs 10,000. One asset (cash) has merely been exchanged for other two (prepaid rent & security deposit). Prepaid rent means the rent paid in advance whose benefit is yet to be taken. Total assets did not change and therefore, total liabilities did not change either. Spent Rs 500 on cleaning and fixing up the interior of the store. Clearly cash must have been given to pay for it. Although future benefits or future cost savings could result from this, the benefits are too uncertain from this intangible asset. With no visible asset increasing and cash reduced by Rs 500, the effect has to be either on liabilities or owners equity. Liabilities are not increasing; therefore the owners equity has to decrease by this amount to maintain the balance. Remember we talked about expenses reducing owners equity. This is a perfect example.

Effect of (3)

Effect of (4)

Second Week: Starting with the second week, Sunil started recording only those events that materially affected his firms financial position. The events recorded during the second week are: Event (6) 07/ 01 Event (7) 08/ 01 Event (8) 09/ 01 Various parts of the computers costing Rs 30,000 were purchased from a wholesale supplier. Other supplies like stationary, packing material, covers, etc. for use in the business was also purchased. Rs 2,000 cash was paid for it. One used display counter and one used computer & printer was purchased for Rs 25,000. Rs 5,000 cash was paid and the rest was payable after three months with 18 per cent annual interest.

Try and record the above events in the financial position format given above on a separate piece of paper. Then match your statement with the one given below: Sunil Computer Mart Financial Position changes in the second week
Owners Equity Liabilities + Rs. Assets Rs.

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Shareholders Equity
Equipment Liabilities Accounts Payable Loan Payable + + 30,000 (6) 20,000 (8) Inventory Supplies + + 30,000 (6) 2,000 (7) Cash + 25,000 (8) 2,000 (7) 5,000 (8)

Note that the effect of each event is recorded separately. Also, we have not included the figures of the first weeks events shown above so as to clearly bring out the effect of the transactions and we are not accumulating the various effects. Another point that should be noted is that certain increases and decreases in the owners equity are separately identified and recorded for income measurement purposes but at this moment let us only record the changes in owners equity. We will see later how to use this information to draw up an income statement. Effect of (6) Assets (inventory) increase by Rs 30,000. Inventory is the term given to goods and material in hand, which is either ready for sale or will be manufactured for sale to customers. The corresponding effect is felt on the liabilities (accounts payable), which also increase by Rs 30,000. Accounts payable is term given to liabilities that represent obligations to the creditors for goods and services purchased. A simple exchange of assets where supplies increase by Rs 2,000 and cash decreases by Rs 2,000. Assets (equipment) increase by Rs 25,000. There are two corresponding entries; one that affects cash and other one affects loan payable. Cash decreases by Rs 5,000 and loan payable increases by Rs 20,000.

Effect of (7) Effect of (8)

Third Week: Sunil was now ready to do business and he opened his shop at the start of the third week. On advice of other businesspersons, he adopted the following policies: a) All sales of the computer parts would be on cash and carry basis. b) When he will provide extra services like assembling a computer, etc. he would charge extra for his time and send a bill (invoice) to the customer. c) As the sales of the parts would be for cash only, he would not attempt to record the outflow of parts (inventory) sold to the customers. He would only record the cash coming in as sales and accounts receivables based on the invoices written. Accounts receivables could be defined as an asset representing claims against customers for goods or services sold on account. The events recorded during the third week are: Event (9) Total sales for the week was Rs 9,600.

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15/ 01 Event (10) 15/ 01 22/ 01 Event (11) 18/ 01

Total invoices for assembling and servicing (credit sales) for the week were Rs 2,200. Quantities of small screws, wires, switches and connectors costing Rs 5,000 were purchased on account as customers were asking for them along with the computer parts.

Try and record the above events in the format given above on a separate piece of paper. Then match your statement with the statement given below: Sunil Computer Mart Financial position changes in the third week
Owners Equity Liabilities + Rs. Assets Rs.

Shareholders Equity
+ + Liabilities Accounts Payable + 5,000 (11) 9,600 (9) 2,200 (10) Cash Inventory + + + 9,600 (9) 5,000 (11) 2,200 (10)

Accounts Receivables

Effect of (9)

Effect of (10) Effect of (11)

Cash (Assets) increased by Rs 9,600. There was no other effect on the assets (as it was decided to record the outflow of parts later). Liabilities were not affected. Therefore, the owners equity increased by the amount of revenues generated, i.e. Rs 9,600. Accounts receivables (Assets) increased by Rs 2,200. Liabilities were unchanged. Therefore, the same effect as in event (9) would be there. Inventory (Assets) increased by Rs 5,000. Accounts payable (liabilities) increased by Rs 5,000.

Fourth Week: The diary showed the following entries: Event (12) Cash sales for the week were Rs 10,400. 23/ 01 30/ 01 Event (13) Credit sales for the week were Rs 2,800. 23/ 01 30/ 01 Event (14) Purchase of parts on account, cost Rs 4,000. Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.

25/ 01 Event (15) Some of the customers previously invoiced paid Rs 1,500 on their 23/ 01 30/ accounts. 01 Event (16) Sunil paid the wholesaler Rs 25,000 on his account. 28/ 01 Try and record the above events in the financial position format given above on a separate piece of paper. You would find that the effect of the events, (12), (13) and (14), is the same (although with different rupee amounts) as the events (9), (10) and (11) respectively. Sunil Computer Mart Financial Position changes in the fourth week
Owners Equity Liabilities + Rs. Assets Rs.

Shareholders Equity
+ 10,400 (12) + 2,800 (13) Cash + 10,400 (12) + 1,500 (15) - 25,000 (16) + + 4,000 (14) 2,800 (13) 1,500 (15)

Liabilities Accounts Payable + 4,000 (14) - 25,000 (16)

Inventory Accounts Receivables

Effect of (15)

Collection of receivables means that cash has come in and the balance shown against the accounts receivables reduces. This means that only the asset side is affected. Effect of (16) The effect is just the opposite of the above transaction. Cash is used to pay the accounts payable. Both the accounts payable and cash reduces by the same amount. We showed the financial position effect of each weeks events separately in order to focus on the effect of each distinct event. The effect of all these events is cumulative. The financial position statement below shows the effect of all events recorded in the dairy during the month that changed the firms financial position. Sunil Computer Mart Effect of First Months Events on the financial Position at the end of the month
Owners Equity Liabilities + Rs. Assets Rs.

Shareholders Equity
+ 1,00,000 (1) 500 (4) + 9,600 (9) Cash +1,00,000 (1) - 10,000 (3) 500 (4)

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+ 2,200 (10) + 10,400 (12) + 2,800 (13)

2,000 (7) 5,000 (8) + 9,600 (9) + 10,400 (12) + 1,500 (15) - 25,000 (16) Equipment + 25,000 (8) + 5,000 (3)

Liabilities Loan Payable Accounts Payable + 20,000 (8) + 30,000 (6) + 5,000 (11) + 4,000 (14) - 25,000 (16)

Prepaid Rent Inventory

+ 30,000 (6) + 5,000 (11) + 4,000 (14) + + + + 2,200 (10) 2,800 (13) 1,500 (15) 2,000 (7)

Accounts Receivables

Supplies Security Deposit

5,000 (3)

Assume that you are in the position of Sunil Bakshi. As owner you would be interested to know where the business stands today and whether you have made any profits from the business transactions in the first month. From the transactions above compile a month-end financial position (hint: add all the items under a particular category to get the closing balance). Check your results against the financial position given below. Sunil Computer Mart Financial position at the end of the month
Owners Equity Liabilities + Rs. 1,24,500 Equipment Liabilities Loan Payable Accounts Payable 20,000 14,000 Cash Inventory Accounts Receivables Supplies 25,000 79,000 39,000 3,500 2,000 5,000 5,000 1,58,500 Assets Rs.

Shareholders Equity

Total Liabilities

34,000 Prepaid Rent

Security Deposit
Total Liabilities Owners Equity + 1,58,500 Total Assets

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Do you think that this statement accurately represents the firms financial position? Do you need any more facts before you could complete the preparation of a proper month-end financial position? Refer back to the accounting process. We have just taken all the balances in the individual accounts and have not done any adjustments till now. For example, as we have not taken any inventory and have recorded sales against it, a physical verification would be required to know how much value of inventory has been sold out. This will also reduce the owners equity by a proportionate amount. Therefore, this unadjusted financial position statement can at best serve as a starting point to reach the exact position at the end of the period. There are basically four improperly recorded asset measurements in the above statement. Can you identify them? Required Month-end Adjustments to Reach Final Financial Position Statement The four improperly reported asset measurements concern inventory, supplies, prepaid rent and equipment. We saw above why decrease in inventory is not properly recorded. To rectify this error, Sunil will have to count the items and their cost to find the actual value. In manual accounting systems the inventory is physically verified at least once a year. For computerised accounting systems, the inventory is automatically updated as the transactions take place, making it easier to keep a track of the positions. For the sake of ease, let us make some assumptions. The first assumption is of inventory. Let us assume that physical verification resulted in Rs 28,500 worth of inventory and Rs 750 worth of unused supplies at the end of the first month. Another assumption that we make is that the equipment has a useful remaining life of four years and it can be sold for Rs 1000 at the end of fourth year. What about the telephone & power costs incurred during the month? Neither bill has arrived and therefore nothing was recorded in the dairy. Let us assume that Rs 1400 could be earmarked for both the bills together. Sunil also owns the interest for the loan taken which would be paid at the end of three months along with the loan amount. It works out to Rs 300 for one month. You now have all the necessary information to adjust the unadjusted financial position figures. Try and do it before you proceed. Adjustment (17) 31/ 01 We assumed that Sunil found the total inventory to be worth Rs 28,500 after verification. As the total amount of parts bought were worth Rs 39,000 and there was no beginning inventory, a consumption of inventory worth Rs 10,500 (i.e. Rs 39,000 28,500) has taken place. Note that the consumption could be in any form: sales, stolen, broken or perished. Inventory is therefore reduced by Rs 10,500 and as no other asset or liability is involved, owners equity is also reduced by the same amount. Similarly, supplies and owners equity are both reduced by Rs 1,250 each to record supplies used.

Adjustment (18) 31/ 01

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Adjustment (19) 31/ 01

As the shop has already been used for one month, Rs 5,000 rent paid in advance for the month ceases to be an asset and becomes an expense. Therefore prepaid rent is reduced by this amount (which now becomes zero) as also the owners equity to keep the balance as no other asset or liability is affected. As the usefulness of the asset is spread over four years and some future usefulness of the asset is used in the first month; some part of the assets value should be shown as an expense. As the equipment was bought for Rs 25,000 and the scrap value is Rs 1,000 at the end of four years; the question arises how to treat the loss in value. Whether the loss in value should be treated as an expense in the first month itself, over the life of the asset or at the end of the four years? Logically the loss in value should be written off over the life of the asset as the asset is used gradually over its useful life. This means that the cost of Rs 24,000 is best spread over four years. What should be the per month cost to be written off? (Rs.500 per month which comes from Rs 24,000/4 = Rs 6,000 per year). This is known as depreciating the asset over its useful life. The accumulated depreciation is written below the asset value and then the net asset value is shown. Recording a depreciation of Rs 500 means that the asset value is reduced by that amount and to balance the owners equity is also reduced by the same amount. The point to be noted here is that inspite of being mentioned on the asset side, the accumulated depreciation in effect reduces the asset value when it increases in value. This type of account is called a contra account.

Adjustment (20) 31/ 01

Adjustment (21) 31/ 01

The firm has an additional liability of Rs 1,400 for services performed by power & telephone companies and this must be added to accounts payable as the company is liable to pay whenever the bills come. There is no new asset as the services have already been consumed and therefore the owners equity must reduce by this amount. Interest payable is a short-term liability as it is going to be paid after three months when the money is returned but the amount has been used for a month so the monthly cost (interest) has to be accounted for a business expense. Owners equity decreases to balance, as there is no change in any other asset or a liability.

Adjustment (22) 31/ 01

Note that all the six transactions reduced the amount of owners equity, which should now reflect the true picture of the increases due to the business operations. Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.

Sunil Computer Mart Financial Statement changes due to month-end adjustments

Owners Equity Liabilities + Rs. Assets Rs.

Shareholders Equity
Liabilities Accounts Payable Interest Payable + + 1,400 (21) 300 (22) 10,500 (17) 1,250 (18) 5,000 (19) 500 (20) 1,400 (21) 300 (22) Accumulated Depreciation on Equipment 500 (20)

Prepaid Rent Supplies Inventory

5,000 (19) 1,250 (18) 10,500 (17)

The financial position statement below gives the final position of Sunil Computer Mart as at end of the month.

Sunil Computer Mart Final financial position at the end of the month
Owners Equity Liabilities + Rs. 1,05,550 Equipment 25,000 Less Accumulated Depreciation (500) Net Equipment Liabilities Accounts Payable Interest Payable Loan Payable 15,400 300 Accounts Receivables 20,000 Supplies 750 5,000 1,41,250 35,700 Security Deposit Owners Equity Liabilities + 1,41,250 Total Assets 3,500 Cash Inventory Assets Rs.

Shareholders Equity

24,500 79,000 28,500

Total Liabilities

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So at the end of first month Sunils Rs 1,000,000 became Rs 1,05,550 i.e. an increase of Rs 5,550. Not bad considering that Sunil is new to the market and has only been operating for two weeks.

How Accountants Do It
So far we have tracking changes in the accounting equation only and this is great as far as understanding the basic process goes, but the process that the accountants use (and discussed before) is slightly different. Let us now glance back and see how the accountant would record these transactions. Let us take three of the above mentioned events [(1), (4) and (6)] for illustration purposes.

Event (1) Event (1) Opened a bank account in business name and transferred Rs 1,00,000 into it. Effect of (1) Cash in the business has increased by Rs 1,00,000 because Sunil has invested this money into the business. The dual-entry effect it is reflected in owners equity, which represents Sunils share of the business. Debit-Credit Increases in assets (cash) are recorded by debits (remember!). Rules Increases in owners equity are recorded by credits. (Refer back to the debit-credit rules if you have forgotten them) Journal Dr. Cr. Entry 01/ 01 Cash Rs 1,00,000 Owners Equity Rs 1,00,000 Entries in Ledger Accounts Cash 31/ 12 Bal. 01/ 01 Owners

Rs 0 Rs 1,00,000

Equity 31/ 12 Bal. 01/ 01

Rs 0 Rs 1,00,000

The first figure represents the closing balance of the last period. As there was no closing balance (can you tell why?) the starting balance is zero.

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 Event (4) Event (4) Spent Rs 500 on cleaning and fixing up the interior of the store. 05/ 01 Effect of (4) This is a business expense and therefore, should be recorded as such. Clearly cash must have been given to pay for it. Debit-Credit Rules Journal Entry Decreases in assets (cash) are recorded by credits. Expenses decrease owners equity and are recorded by debits. Dr. 500 Rs Cr. 500

05/ 01 Maintenance Expense Cash

Rs

Entries in Ledger Accounts Cash 31/ 12 Bal. 01/ 01 Maintenance 05/ 01

Rs 0 Rs 1,00,000

02/ 01 05/ 01 Expense

Rs 10,000 Rs 500

Rs

500

Can you explain the figure of Rs 10,000 in the cash account above? It comes from prepaid rent, event (3). Notice that in maintenance expense account no starting balance mentioned as the expense accounts are started afresh every time a new accounting period starts. If you remember when we recorded the effect of event (4) in the accounting equation above, we simply decreased the owners equity. Accountants do not do that. For different types of revenue and expense activities, they open separate accounts so that it is easier for them to compile these account figures into the financial statements.

Event (6) Event (6) Various parts of the computers costing Rs 30,000 were purchased from a 07/ 01 wholesale supplier Effect of (6) Assets (inventory) increase by Rs 30,000. The corresponding effect is felt on the liabilities (accounts payable) which also increase by Rs 30,000. Debit-Credit Increases in assets (inventory) are recorded by debits. Rules Increases in liabilities (accounts payable) are recorded by credits. Journal Dr. Cr. Entry Date Inventory Rs 30,000 Accounts Payable Rs 30,000 Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.

Entries in Ledger Accounts Inventory 31/ 12 Bal. 07/ 01 Accounts

Rs 0 Rs 30,000 Payable 07/ 01

Rs

30,000

Other events can also be recorded in the same manner. All this would result in accounts, which would show the balances as given in the trial balance given below:

Sunil Computer Mart Unadjusted trial balance at the end of the month
Dr.

Shareholders Equity
Loan Payable Event (8) Accounts Payable Event (6), (11), (14) & (16) Equipment Event (8) Cash Event (1), (3), (4), (7), (8), (9), (12), (15) & (16) Inventory Event (6), (11) & (14) Accounts Receivables Event (10), (13) & (16) Supplies

Cr. 1,00,000 20,000 14,000

25,000 79,000

39,000 3,500 2,000 5,000 5,000 20,000 5,000 500

Event (7)
Prepaid Rent Event (3) Security Deposit Event (3) Cash Sales Event (9) & (12) Credit Sales Event (10) & (13) Maintenance Expense Event (4)

1,59,000

1,59,000

Total

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Events mentioned below the account name are put in there to help you relate these figures to the financial position and transactions. Accountants do not write them, they only write the account name. There are two points that you must note out here. The shareholders equity here does not show the effect of revenues and expenses events, which are shown separately. For example, look at the cash sales and credit sales. If you club the both the sales figures into the shareholders equity and subtract maintenance expenses you would get the same figure (Rs 1,24,500) as was reported in the unadjusted financial position figure before. Many other items also have the same balance, but note the different way of presentation. Accountants take the ending balances of accounts and write it on the respective sides of debit and credit. This makes it easier for them to compile the figures later into the financial statements. Before we go on and compile these figures into financial statements dont you think that we also need to do the adjustments that we did before? Yes, we have to. Let us see how the above mentioned adjustments are recorded in the trial balance. The adjustments are reproduced below for easier reference. Why dont you try to do these adjustments in the trial balance yourself before taking a look at the final trial balance? Adjustment (17) 31/ 01 We assumed that Sunil found the total inventory to be worth Rs 28,500 after verification. As the total amount of parts bought were worth Rs 39,000 and there was no beginning inventory, a consumption of inventory worth Rs 10,500 (i.e. Rs 39,000 28,500) has taken place. Inventory is therefore reduced by Rs 10,500, and Rs 10,500 is also shown as inventory consumption. Similarly, supplies are reduced by Rs 1,250 and Rs 1,250 is also shown as supplies consumption. As the shop has already been used for one month, Rs 5,000 rent paid in advance for the month ceases to be an asset and becomes an expense. Therefore prepaid rent is reduced by Rs 5,000 (which makes it zero), which is also shown as the rent expense for the month. As the usefulness of the asset is spread over four years and some future usefulness of the asset is used in the first month; some part of the assets value should be shown as an expense. This depreciation expense for the first month works out to Rs 500. This would affect two accounts: accumulated depreciation account, which would increase by Rs 500 and depreciation expense account, which would show an expense of Rs 500. Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.

Adjustment (18) 31/ 01 Adjustment (19) 31/ 01

Adjustment (20) 31/ 01

Adjustment (21) 31/ 01

The firm has an additional liability of Rs 1,400 for services performed by power & telephone companies and this must be added to accounts payable as the company is liable to pay whenever the bills come. There is no new asset as the services have already been consumed and therefore the owners equity must reduce by this amount. Interest payable is a short-term liability as it is going to be paid after three months when the money is returned but the amount has been used for a month so the monthly cost (interest) has to be accounted for a business expense. Interest payable account is created to represent unpaid interest.

Adjustment (22) 31/ 01

Note that when we were making the adjustments in the financial position, all the six transactions reduced the amount of owners equity. Here the effect is not on the owners equity as none of the adjustments has resulted in the increase or decrease in it. All the changes due to these adjustments have been italicised for easy understanding.

Sunil Computer Mart Adjusted trial balance at the end of the month
Dr.

Shareholders Equity
Loan Payable Event (8) Accounts Payable Event (6), (11), (14), (16) & Adjustment (21) Interest Payable Adjustment (22) Equipment Event (8) Accumulated Depreciation: Equipment Adjustment (20) Cash Event (1), (3), (4), (7), (8), (9), (12), (15) & (16) Inventory Event (6), (11) & (14) & Adjustment (17) Accounts Receivables Event (10), (13) & (16) Supplies Event (7) &

Cr. 1,00,000 20,000 15,400

300 25,000 500

79,000

28,500

3,500 750

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Adjustment (18) Prepaid Rent Event (3) & Adjustment (19) Security Deposit Event (3) Cash Sales Event (9) & (12) Credit Sales Event (10) & (13) Maintenance Expense Event (4) Inventory Consumed Expense Adjustment (17) Supplies Consumed Expense Adjustment (18) Rent Expense Adjustment (19) Depreciation Expense Adjustment (20) Power & Telephone Expense Adjustment (21) Interest Expense Adjustment (22)

5,000 20,000 5,000 500 10,500 1,250 5,000 500 1,400 300

1,61,200

1,61,200

Total

Transforming Trial Balance Information into Financial Statements

Now we are ready to utilise the trial balance information for developing the financial statements. Can you guess which of the accounts below will go into balance sheet and which ones will go into the income statement? (Hint: The trial balance below shows some figures in bold and some in Italics for ease of identification). Sunil Computer Mart Adjusted trial balance at the end of the month
Dr.

Shareholders Equity
Loan Payable Accounts Payable Interest Payable Equipment 25,000

Cr. 1,00,000 20,000 15,400 300

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Accumulated Depreciation: Equipment Cash Inventory Accounts Receivables Supplies Security Deposit Cash Sales Credit Sales Maintenance Expense Inventory Consumed Expense Supplies Consumed Expense Rent Expense Depreciation Expense Power & Telephone Expense Interest Expense 500 10,500 1,250 5,000 500 1,400 300 1,61,200 79,000 28,500 3,500 750 5,000

500

20,000 5,000

1,61,200

Total

As you would have guessed by now (I sincerely hope that you have) the accounts in bold would go into the balance sheet and the accounts in italics would go into the income statement. Let us first look at the income statement. The Income Statement We already know that Profit = Sales Expenses, now let us see which are the expense items for Sunil Computer Mart. Rs. 500 10,500 1,250 5,000 500 Spent on cleaning and fixing up the interior of the shop Worth of inventory sold to the customers Worth of supplies used Worth of prepaid rent expired due to the end of the month Depreciation charged on equipment

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1,400 300 Rs. 19,450

Commitment to pay for power and telephone already used Interest liability for the amount used for the month Total Expenses

Since total revenues (or sales) during the month was to the tune of Rs 25,000, the profit for the month can be calculated by subtracting the above-mentioned amount of the expenses. It comes to Rs 5,550. The income statement that an accountant would draw up is shown below: Sunil Computer Mart Income Statement for the month of January Revenue
Cash Sales Credit Sales Total Revenue Less: Expenses Raw Material & Supplies Maintenance Expense Rent Power & Telephone Total Expenses Gross Profit Depreciation Interest Net Profit 20,000 5,000 25,000 Rs.

11,750 500 5,000 1,400 18,650 6,350 500 300 5,550

Note that by taking the expenses, which are due but not yet paid, we are following the conservatism principle. Also by taking sales on credit for which the payment has not come in this month, we are following the accrual system of accounting.

The Profit & Loss a/c shown above has certain limitations. Remember that the depreciation expenses are based on estimates of the useful lives of the firms equipment. Also, the income statement includes only those events that are evidenced by business transactions. Perhaps, during the month Sunils shop has caught the attention of many potential customers. A good customer base is certainly beneficial to Sunil in the long run; however, it cannot be recorded, as it cannot be measured objectively until the actual transactions take place. Despite these limitations, income statement is of vital importance and indicates that the firm has been profitable in the first month of operations. Alter-native titles for the income statement include earnings statement, profit & loss statement, etc. In India the term profit & loss account is used. As internationally income statement is the most popular term we will continue to use this term throughout the text. The Balance Sheet Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.

As you already know the balance sheet lists the amounts of owners equity, liabilities and assets at the end of the accounting period. The balances of the owners equity, asset and liability accounts are taken directly from the adjusted trial balance figures given above. Sunil Computer Mart Balance Sheet as on 31st January
Owners Equity Liabilities + Rs. 1,00,000 5,550 Assets Rs.

Shareholders Equity
Reserves & Surplus

Fixed Assets
Gross Block Less Accumulated Depreciation 25,000 (500) 24,500

Net Block
Liabilities Accounts Payable Interest Payable 15,400 300

Current Assets
Cash Inventory Accounts Receivables 79,000 28,500 3,500 750 5,000 1,41,250

Loan Payable

20,000 Supplies 35,700 Security Deposit

Total Liabilities
Total Owners Equity + Liabilities

1,41,250

Total Assets

The balance sheet has a striking resemblance to the final financial position that we made using the accounting equation. This had to be as the accounting equation represents the balance sheet. There are two things that need explanation here: 1) Reserves & Surplus and 2) Bifurcation of Assets into fixed and current. Reserves & Surplus represent the earnings that accumulate in the owners account. One of the several entries in it comes from the income statement. Can you tell me which figure from the income statement comes here? Simply looking at the figures you can guess that it is the net profit figure that gets added up in the Reserves & Surplus Account. As the opening balance was zero and there were no other entries, it is the only figure that is shown here. Assets are bifurcated into fixed and current. Current assets represent those assets that will be quickly converted to cash or used up in operations. Current assets include cash, marketable securities, accounts receivables, inventory, etc. Fixed assets are those assets, which are not meant to be sold or converted into finished products themselves, but are used for business operations.

Proprietary information of Dr. Anjala Kalsie, Faculty at Faculty of Management Studies University of Delhi, Delhi 110007. No part of this document can be produced or published without her consent.