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COMMON PROFICIENCY TEST

FUNDAMENTALS
OF
ACCOUNTING

The Institute of Chartered Accountants of India


The objective of the study material is to provide teaching material to the students to enable them to
obtain knowledge and skills in the subject. In case students need any clarifications or have any suggestions
to make for further improvement of the material contained herein they may write to the Director of
Studies.

All care has been taken to provide interpretations and discussions in a manner useful for the students.
However, the study material has not been specifically discussed by the Council of the Institute or any of
its Committees and the views expressed herein may not be taken to necessarily represent the views of
the Council or any of its Committees.

Permission of the Institute is essential for reproduction of any portion of this material.

© The Institute of Chartered Accountans of India

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ISBN : 978-81-8441-033-4

Published by The Publication Department on behalf of The Institute of Chartered Accountants


of India, A94/4, Sector-58, Noida - 201 301, India.

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PREFACE

The paper on Fundamentals of Accounting at CPT Level develops conceptual understanding of


fundamentals of accounting. This Study Material endeavouring towards accounting education, is
committed to provide a framework for understanding accounting discipline and describing the fundamental
accounting concepts and conventions of the basic accounting system. An attempt has been made to provide
a solid foundation on which students can successfully build and enhance their studies.

The book is divided into nine chapters, each addressing to a special aspect of accounting. Chapters 1 to 5
lay emphasis on bookkeeping aspect of accounting whereas chapter 6 deals with preparation of financial
statements of sole proprietors. Chapter 7 covers accounting for special transactions like consignment,
joint ventures, bills of exchange and sale of goods on approval basis which can be entered into by different
forms of business entities viz., sole proprietary concerns, partnership firms or companies. Chapter 8 discusses
accounting of partnership firms and chapter 9 explains basic concepts of company accounts. Learning
objectives have been incorporated at the beginning of each chapter/unit to guide students as to the knowledge
they should acquire after studying the chapters. Small illustrations have been incorporated in each chapter/
unit to explain the concepts/principles dealt with in the chapter/unit. Lot of multiple choice questions have
been provided at the end of each chapter/unit which will help students in appearing Common Proficiency
Test Examination.

The sincere efforts taken by CA. (Dr.) P.C. Tulsion, Additional Director, Ms. Seema Gupta, Assistant Director
and CA. Shilpa Agrawal, Assistant Secretary (Faculty) in preparing this study material and incorporating these
features which would help the students to quickly grasp the essence of the subject, are highly appreciated. These
features would add value to the Study Material and aid the students in the learning process. The contribution of
CA. Alok Agarwal, CA. Rajat Roy, CA. Yash Arya, Mr. R. N. Singh towards various multiple choice questions
has also increased the utility of the study material.
SYLLABUS
Fundamentals of Accounting (60 Marks)
Objective :
To develop conceptual understanding of the fundamentals of financial accounting system.
Contents
1. Theoretical Framework
(i) Meaning and Scope of accounting
(ii) Accounting Concepts, Principles and Conventions
(iii) Accounting Standards – concepts, objectives, benefits
(iv) Accounting Policies
(v) Accounting as a measurement discipline – valuation principles, accounting estimates
2. Accounting Process
Books of Accounts leading to the preparation of Trial Balance, Capital and revenue expen-
ditures, Capital and revenue receipts, Contingent assets and contingent liabilities, Funda-
mental errors including rectifications thereof.
3. Bank Reconciliation Statement
4. Inventories
Basis of inventory valuation and record keeping.
5. Depreciation accounting
Methods, computation and accounting treatment of depreciation, Change in depreciation
methods.
6. Preparation of Final Accounts for Sole Proprietors
7. Accounting for Special Transactions
(a) Consignments
(b) Joint Ventures
(c) Bills of exchange and promissory notes
(d) Sale of goods on approval or return basis.
8. Partnership Accounts
Final accounts of partnership firms – Basic concepts of admission, retirement and death of
a partner including treatment of goodwill.
9. Introduction to Company Accounts
Issue of shares and debentures, forfeiture of shares, re-issue of forfeited shares, redemption
of preference shares.
CONTENTS

Chapter 1 - Accounting : An Introduction


Unit 1 : Meaning and Scope of Accounting
1. Introduction 1.2
2. Meaning of Accounting 1.4
2.1 Procedural Aspects of Accounting 1.5
3. Evolution of Accounting as a Social Science 1.8
4. Objectives of Accounting 1.9
5. Functions of Accounting 1.10
6. Book-keeping 1.10
6.1 Objectives of Book-Keeping 1.11
7. Distinction between Book-Keeping and Accounting 1.11
8. Sub-fields of Accounting 1.13
9. Users of Accounting Information 1.13
10. Relationship of Accounting with Other Disciplines 1.14
11. Limitations of Accounting 1.18
12. Role of Accountant in the Society 1.19
Unit 2 : Accounting Concepts, Principles and Conventions
1. Introduction 1.26
2. Accounting Concepts 1.27
3. Accounting Principles 1.27
4. Accounting Conventions 1.27
5. Concepts, Principles and Conventions - an Overview 1.27
6. Fundamental Accounting Assumptions 1.39
7. Financial Statements 1.39
7.1 Qualitative Characteristics of Financial Statements 1.39
Unit 3 : Accounting Standards – Concepts, Objectives, Benefits
1. Introduction 1.48
2. Concepts 1.48
3. Objectives 1.49
4. Benefits and Limitations 1.49
5. Overview of Accounting Standards in India 1.49
Unit 4 : Accounting Policies
1. Meaning 1.61
2. Selection of Accounting Policies 1.62
3. Change in Accounting Policies 1.63
Unit 5 : Accounting as a Measurement Discipline - Valuation Principles, Accounting Estimates
1. Meaning of Measurement 1.66
2. Objects or Events to be Measured 1.67
3. Standard or Scale of Measurement 1.67
CONTENTS

4. Dimension of Measurement Scale 1.68


5. Accounting as a Measurement Discipline 1.68
6. Valuation Principles 1.69
7. Measurement and Valuation 1.72
8. Accounting Estimates 1.73

Chapter 2 - Accounting Process


Unit 1 : Basic Accounting Procedures - Journal Entries
1. Double Entry System 2.4
2. Advantages of Double Entry System 2.4
3. Account 2.4
4. Debit and Credit 2.5
5. Transactions 2.8
6. Accounting Equation Approach 2.9
7. Traditional Approach 2.13
7.1 Classification of Accounts 2.13
7.2 Golden Rules of Accounting 2.14
8. Journal 2.14
8.1 Journalising Process 2.14
8.2 Points to be taken into care while recording a transaction in the journal 2.15
9. Advantages of Journal 2.27
Unit 2 : Ledgers
1. Introduction 2.30
2. Specimen of Ledger Accounts 2.30
3. Posting 2.30
3.1 Rules regarding posting of entries in the Ledger 2.30
4. Balancing an Account 2.31
Unit 3 : Trial Balance
1. Introduction 2.38
2. Objectives of preparing the Trial Balance 2.38
3. Limitations of Trial Balance 2.39
4. Methods of preparation of Trial Balance 2.39
5. Adjusted Trial Balance 2.44
6. Rules of preparing the Trial Balance 2.44
Unit 4 : Subsidiary Books
1. Subsidiary Books and their advantages 2.50
2. Distinction between Subsidiary Books and Primary Books 2.51
3. Purchases Book 2.52
3.1 Posting the Purchases Book 2.55
4. Sales Book 2.55
4.1 Posting the Sales Book 2.57
4.2 Sales Book with Sales Tax column 2.57
CONTENTS

5. Sales Returns Book or Returns Inward Book 2.60


6. Purchases Returns or Returns Outward Book 2.61
6.1 Posting the Return Books 2.61
6.2 Bills Receivable Books and Bills Payable Books 2.62
7. Importance of Journal 2.62
Unit 5 : Cash Book
1. Cash Book-a Subsidiary Book and a Principal Book 2.68
2. Kinds of Cash Book 2.68
2.1 Simple Cash Book 2.68
2.2 Double-column Cash Book 2.70
2.3 Three-column Cash Book 2.71
3. Posting the Cash Book entries 2.75
4. Petty Cash Book 2.75
4.1 Imprest System of Petty Cash 2.76
4.2 Advantages of Petty Cash Book 2.80
4.3 Posting the Petty Cash Book 2.80
5. Entries for Sale through Credit/Debit Cards 2.81
5.1 Accounting for Credit/Debit Card Sale 2.82
Unit 6 : Capital and Revenue Expenditures and Receipts
1. Introduction 2.87
2. Considerations in determining Capital and Revenue Expenditures 2.88
3. Capital Expeditures and Revenue Expenditures 2.88
4. Deferred Revenue Expenditures 2.89
5. Capital Receipts and Revenue Receipts 2.91
Unit 7 : Contingent Assets and Contingent Liabilities
1. Contingent Assets 2.98
2. Contingent Liabilities 2.98
3. Distinction between Contingent Liabilities and Liabilities 2.99
4. Distinction between Contingent Liabilities and Provisions 2.99
Unit 8 : Rectification of Errors
1. Introduction 2.103
2. Stages of Errors 2.106
3. Types of Errors 2.107
4. Steps to locate Errors 2.109
5. Rectification of Errors 2.109
5.1 Before preparation of Trial Balance 2.110
5.2 After Trial Balance but before Final Accounts 2.116
5.3 Correction in the next accounting period 2.134
CONTENTS

Chapter 3 - Bank Reconciliation Statement


1. Introduction 3.2
2. Bank Pass Book 3.3
3. Bank Reconciliation Statement 3.3
4. Importance of Bank Reconciliation Statement 3.4
5. Ascertaining the causes of difference of Bank Balance in bank
column of the Cash-Book and in Pass-Book 3.4
5.1 Timing differences 3.4
5.2 Differences arising due to Errors in Recording the Entries 3.6
6. Procedure for reconciling the Cash-Book balance with the Pass-Book balance 3.9
7. Methods of Bank Reconciliation 3.9
7.1 Bank Reconciliation Statement without Preparation of Adjusted
Cash-book 3.9
7.2 Bank Reconciliation Statement after the Preparation of Adjusted
Cash-book 3.11
7.3 Presentation 3.11

Chapter 4 - Inventories
1. Meaning 4.2
2. Inventory Valuation 4.3
3. Basis of Inventory Valuation 4.4
4. Techniques of Inventory Valuation 4.5
4.1 Historical Cost Methods 4.6
4.2 Non-Historical Cost Methods 4.10
5. Inventory Record Systems 4.12
5.1 Periodic Inventory System 4.12
5.2 Perpetual Inventory System 4.12
5.3 Distinction between Periodic Inventory System and
Perpetual Inventory System 4.13
6. Stock Taking 4.13
Chapter 5 - Depreciation Accounting
1. Introduction 5.2
1.1 Concept of Depreciation 5.2
1.2 Objectives for providing Depreciation 5.3
2. Factors in the Measurement of Depreciation 5.4
3. Methods for providing depreciation 5.5
3.1 Straight Line Method 5.5
3.2 Reducing Balance Method 5.6
3.3 Sum of Years of Digits Method 5.8
CONTENTS

3.4 Annuity Method 5.9


3 5 Sinking Fund Method 5.12
3.6 Machine Hour Method 5.16
3.7 Production Units Method 5.17
3.8 Depletion Method 5.18
4. Profit or Loss on the Sale/Disposal of depreciable assets 5.19
5. Change in the Method of Depreciation 5.25
6. Revision of the estimated useful life of the depreciable asset 5.29
7. Revaluation of depreciable assets 5.31
8. Provision for repairs and renewals 5.32

Chapter 6 - Preparation of Final Accounts of Sole Proprietors


Unit 1 : Final Accounts of Non-Manufacturing Entities
1.Introduction 6.4
2.Preparation of Final Accounts 6.5
2.1 Inter-relationship of the two statements 6.6
2.2 Matching Principle 6.7
2.3 An exception 6.8
3. Trading Account 6.8
3.1 Trading Account Items 6.9
3.2 Closing entries in respect of Trading Account 6.11
4. Profit and Loss Account 6.14
4.1 Closing entries 6.16
4.2 Adjustments 6.19
5. Certain adjustment and their treatments 6.21
6. Balance Sheet 6.26
6.1 Characteristics 6.27
6.2 Arrangements of Assets and Liabilities 6.27
6.3 Classification of Assets and Liabilities 6.28
7. Sequence of Accounting procedure or the Accounting cycle 6.32
8 Opening Entry 6.32
8.1 Posting the Opening Entry 6.33
9. Provisions and Reserves 6.40
10. Limitations of Financial Statements 6.42
Unit 2 : Final Accounts of Manufacturing Entities
1. Introduction 6.45
2. Purpose 6.45
3. Manufacturing Costs 6.45
3.1 Direct Manufacturing Expenses 6.46
3.2 Indirect Manufacturing Expenses 6.46
CONTENTS

3.3 By-Products 6.46


4. Design of a Manufacturing Account 6.47

Chapter 7 - Accounting for Special Transactions


Unit 1 : Consignment
1. Meaning of Consignment Account 7.2
2. Distinction between Consignment and Sale 7.3
3. Accounting for Consignment Transactions and Events in
the books of the Consignor 7.3
4. Valuation of Stock 7.7
5. Goods Invoiced above Cost 7.7
6. Abnormal Loss 7.10
7. Normal Loss 7.11
8. Commission 7.11
9. Return of Goods from the Consignee 7.11
10. Account Sales 7.12
11. Accounting Books of the Consignee 7.12
12. Advance by the Consignee vs security against the Consignment 7.13
Unit 2 : Joint Ventures
1. Meaning of Joint Venture 7.34
2. Features of Joint Venture Account 7.35
3. Distinction of Joint Venture Account with Partnership 7.35
4. Methods of maintaining Joint Venture Accounts 7.36
4.1. When separate set of books are maintained 7.37
4.2 When no separate set of books are maintained 7.40
Unit 3 : Bills of Exchange and Promissory Notes
1. Bills of Exchange 7.64
2. Promissory Notes 7.66
3. Record of Bills of Exchange and Promissory Notes 7.67
4. Term of a Bill 7.69
5. Due date of a Bill 7.69
6. Days of Grace 7.69
7. Date of Maturity of Bill 7.69
8. Bill at Sight 7.69
9. Bill after Date 7.69
10. How to calculate due date of a bill 7.70
11. How to calculate date of maturity in case of time bills 7.70
12. Noting Charges 7.71
13. Renewal of Bill 7.71
14. Accommodation Bills 7.78
15.. Insolvency 7.79
CONTENTS

16. Bills of Collection 7.85


17. Retirement of Bills of Exchange 7.86
18. Bills Receivable and Bills Payable Books 7.87
Unit 4 : Sale of Goods on Approval or Return Basis
1. Introduction 7.97
2. Accounting Records 7.97
2.1 When the business sends goods casually on sales or return 7.98
2.2 When the business sends goods frequently on sale or return basis 7.104
2.3 When the business sends goods numerously on sale or return 7.106

Chapter 8 - Partnership
Unit 1 : Introduction to Partnership Accounts
1. Introduction 8.2
2. Definition and Features of Partnership 8.2
3. Powers of Partners 8.3
4. Accounts 8.4
4.1 Profit and Loss Appropriation 8.4
4.2 Fixed and Fluctuating Capital 8.8
Unit 2 : Treatment of Goodwill in Partnership Accounts
1. Goodwill 8.23
2. Methods for Goodwill valuation 8.23
3. Need for Valuation of Goodwill 8.28
4. Valuation of Goodwill in case of admission of a Partner 8.28
5. Accounting treatment of Goodwill in case of admission of a Partner 8.30
6. Accounting treatment of Goodwill in case of change in profit sharing ratio 8.35
7. Accounting treatment of Goodwill in case of retirement or death of a Partner 8.37
Unit 3 : Admission of New Partner
1. Introduction 8.46
2. Revaluation Account or Profit and Loss Adjustment Account 8.46
3. Reserves in the Balance Sheet 8.51
4. Computation of new profit sharing ratio 8.54
5. Proportionate capital and inference of Goodwill 8.59
Unit 4 : Retirement of a Partner
1. Introduction 8.67
2. Calculation of Gaining Ratio 8.67
3. Revaluation of Assets and Liabilities on retirement of a Partner 8.68
4. Reserve 8.69
5. Final payment to retiring Partner 8.70
6. Paying a Partner’s loan in instalment 8.85
CONTENTS

Unit 5 : Death of Partner


1. Introduction 8.96
2. Special transactions in case of death : Payment of deceased Partner's share 8.96

Chapter 9 - Company Accounts


Unit 1 : Introduction to Company Accounts
1. Introduction 9.2
2. Meaning of Company 9.2
3. Salient Features of a Company 9.3
4. Types of Companies 9.4
5. Books of Account 9.7
6. Preparation of Financial Statements 9.7
Unit 2 : Issue, Forfeiture and Reissue of Shares
1. Introduction 9.10
2. Share Capital 9.10
3. Types of Shares 9.13
4. Issue of Shares for Cash 9.14
4.1 Journal Entries for issue of shares for cash 9.16
5. Subscription of Shares 9.16
5.1 Full Subscription 9.17
5.2 Under Subscription 9.18
5.3 Over Subscription 9.19
6. Shares issued at Discount 9.23
6.1 Accounting Treatment 9.23
7. Shares issued at Premium 9.25
7.1 Accounting Treatment 9.25
8. Over Subscription and Pro-rata Allotment 9.29
9. Calls-in-arrears and Calls-in-advance 9.32
10. Interest on Calls-in arrears and Calls-in-advance 9.34
11. Forfeiture of Shares 9.36
11.1 Forfeiture of Shares which were issued at par 9.37
11.2 Forfeiture of Shares which were issued at a discount 9.38
11.3 Forfeiture of Shares which were issued at a premium 9.39
11.4 Forfeiture of fully paid-up shares 9.40
12. Re-issue of Forfeited Shares 9.40
12.1 Points for Consideration 9.41
CONTENTS

12.2 Calculation of profit on re-issue of forfeited shares 9.41


13. Issue of Shares for Consideration other than Cash 9.48
Unit 3 : Redemption of Preference Shares
1. Introduction 9.64
2. Purpose of issuing Redeemable Preference Shares 9.64
3. Provisions of the Companies Act (Section 80) 9.65
4. Redemption of Irredeemable Preference Shares (Section 80-A) 9.65
5. Methods of Redemption of fully paid-up shares 9.66
5.1 Redemption of Preference Shares by Fresh Issue of Shares 9.67
5.2 Redemption of Preference Shares by Capitalisation of
Undistributed Profits 9.76
5.3 Redemption of Preference Shares by combination of fresh issue
and capitalisation of undistributed profits 9.78
5.4 Sale of Investments to provide sufficient funds for Redemption 9.84
6. Redemption of Partly Called-Up Preference Shares 9.84
7. Redemption of Fully Called but Partly Paid-Up Preference Shares 9.87
7.1 When Calls in Arrears is received by the Company 9.87
7.2 In case of Forfeited Shares 9.87
Unit 4 : Issue of Debentures
1. Introduction 9.95
2. Meaning 9.95
3. Features of a Debentures 9.96
4. Distinction between Debentures and Shares 9.96
5. Types of Debentures 9.97
6. Issue of Debentures 9.99
6.1 Accounting entries for issue of Redeemable Debentures 9.99
6.2 Accounting for issue of Debentures payable in instalments 9.107
7. Issue of debentures as collateral security 9.112
8. Issue of Debentures in consideration other than for cash 9.114
9. Treatment of discount on issue of Debentures 9.115
10. Interest on Debentures 9.117
CHAPTER - 1

ACCOUNTING :
AN
INTRODUCTION

Unit 1

Meaning
and
Scope of Accounting
MEANING AND SCOPE OF ACCOUNTING

Learning Objectives :
After studying this unit, you will be able to :
 Understand the meaning and significance of accounting.
 Understand the meaning of book-keeping and the distinction of accounting with book-
keeping.
 Appreciate the evolutionary process of accounting as a social science.
 Explain sub-fields of accounting.
 Identify the various user groups for whom accounting information is to be generated.
 Describe the various functions or purposes of accounting data.
 Understand the relationship of accounting with Economics, Statistics, Mathematics,
Law and Management.
 Explain the limitations of accounting.
 Appreciate the enlarged boundary of accounting profession and the areas where in a
chartered accountant plays an important role of rendering useful services to the society.

1. INTRODUCTION
Every individual performs some kind of economic activity. A salaried person gets salary and
spends to buy provisions and clothing, for children’s education, construction of house, etc. A
sports club formed by a group of individuals, a business run by an individual or a group of
individuals, a local authority like Calcutta Municipal Corporation, Delhi Development
Authority, Governments, either Central or State, all are carrying some kind of economic activities.
Not necessarily all the economic activities are run for any individual benefit; such economic
activities may create social benefit i.e. benefit for the public, at large. Anyway such economic
activities are performed through ‘transactions and events’. Transaction is used to mean ‘a
business, performance of an act, an agreement’ while event is used to mean ‘a happening, as
a consequence of transaction(s), a result.’
An individual invests Rs. 2,00,000 for running a stationery business. On 1st January, he purchases
goods for Rs. 1,15,000 and sells for Rs. 1,47,000 during the month of January. He pays shop
rent for the month Rs. 5,000 and finds that still he has goods worth Rs. 15,000 in hand. The
individual performs an economic activity. He carries on a few transactions and encounters
with some events. Is it not logical that he will want to know the result of his activity?
We see that the individual, who runs the stationery business, earns a surplus of Rs. 42,000.

1.2 COMMON PROFICIENCY TEST


Rs.
Goods sold 1,47,000
Goods in hand 15,000
1,62,000
Less : Goods purchased 1,15,000
Shop rent paid 5,000 1,20,000
Surplus 42,000
Earning Rs. 42,000 surplus is an event; also having the stock in hand is another event, while
purchase and sale of goods, investment of money and payment of rent are transactions.
Similarly, a municipal corporation got government grant Rs. 500 lakhs for adult education; it
spent Rs. 250 lakhs for purchasing literacy kits, paid Rs. 200 lakhs to the tutors and is left with
a balance of Rs. 50 lakhs. These are also transactions and events.
Similarly, the Central Government raised money through taxes, paid salaries to the employees,
and spent on various developmental activities. Whenever receipts of the Government are more
than expenses it has surplus, but if expenses are more than receipts it runs in deficit. Here
raising money through various sources can be termed as transaction and surplus or deficit at
the end of the accounting year can be termed as an event.
So, everybody wants to keep records of all transactions and events and to have adequate
information about the economic activity as an aid to decision-making. Accounting discipline
has been developed to serve this purpose as it deals with the measurement of economic activities
involving inflow and outflow of economic resources, which helps to develop useful information
for decision-making process.
Accounting has universal application for recording transactions and events and presenting
suitable information to aid decision-making regarding any type of economic activity ranging
from a family function to functions of the national government. But hereinafter we shall
concentrate only on business activities and their accounting because the objective of this study
material is to provide a basic understanding on accounting for business activities. Nevertheless,
it will give adequate knowledge to think coherently of accounting as a field of study for universal
application.
The growth of accounting discipline is closely associated with the development of the business
world. Thus, to understand accounting as a field of study for universal application, it is best
identified with recording of business transactions and communication of financial information
about business enterprise to facilitate decision-making. The aim of accounting is to meet the
information needs of the rational and sound decision-makers, and thus, called the language of
business.

FUNDAMENTALS OF ACCOUNTING 1.3


MEANING AND SCOPE OF ACCOUNTING

2. MEANING OF ACCOUNTING
The Committee on Terminology set up by the American Institute of Certified Public Accountants
formulated the following definition of accounting in 1961:
“Accounting is the art of recording, classifying, and summarising in a significant manner and
in terms of money, transactions and events which are, in part at least, of a financial character,
and interpreting the result thereof.”
As per this definition, accounting is simply an art of record keeping. The process of accounting
starts by first identifying the events and transactions which are of financial character and then
be recorded in the books of account. This recording is done in Journal or subsidiary books, also
known as primary books. Every good record keeping system includes suitable classification of
transactions and events as well as their summarisation for ready reference. After the transactions
and events are recorded, they are transferred to secondary books i.e. Ledger. In ledger
transactions and events are classified in terms of income, expense, assets and liabilities according
to their characteristics and summarised in profit & loss account and balance sheet. Essentially
the transactions and events are to be measured in terms of money. Measurement in terms of
money means measuring at the ruling currency of a country, for example, rupee in India,
dollar in the U.S.A. and like. The transactions and events must have at least in part, financial
characteristics. The inauguration of a new branch of a bank is an event without having financial
character, while the business disposed of by the branch is an event having financial character.
Accounting also interprets the recorded, classified and summarised transactions and events.
However, the above-mentioned definition does not reflect the present day accounting function.
The dimension of accounting is much broader than that described in the above definition.
According to the above definition, accounting ends with interpretation of the results of the
financial transactions and events but in the modern world with the diversification of
management and ownership, globalisation of business and society gaining more interest in the
functioning of the enterprises, the importance of communicating the accounting results has
increased and therefore, this requirement of communicating and motivating informed judgement
has also become the part of accounting as defined in the widely accepted definition of accounting,
given by the American Accounting Association in 1966 which treated accounting as
“The process of identifying, measuring and communicating economic information to permit
informed judgments and decisions by the users of accounts.”
In 1970, the Accounting Principles Board (APB) of American Institute of Certified Public
Accountants (AICPA) enumerated the functions of accounting as follows:
“The function of accounting is to provide quantitative information, primarily of financial nature,
about economic entities, that is needed to be useful in making economic decisions.”
Thus, accounting may be defined as the process of recording, classifying, summarising, analysing
and interpreting the financial transactions and communicating the results thereof to the persons
interested in such information.

1.4 COMMON PROFICIENCY TEST


2.1 PROCEDURAL ASPECTS OF ACCOUNTING
On the basis of the above definitions, procedure of accounting can be basically divided into
two parts:
(i) Generating financial information and
(ii) Using the financial information.
The procedural aspects of accounting can be explained with the help of the following chart :

Procedure of Accounting

Generating Financial Using the Financial


Information Information

Recording Classifiying Summarising Analysing Interpreting Communicating

2.1.1 Generating Financial Information


1. Recording – This is the basic function of accounting. All business transactions of a financial
character, as evidenced by some documents such as sales bill, pass book, salary slip etc.
are recorded in the books of account. Recording is done in a book called “Journal.” This
book may further be divided into several subsidiary books according to the nature and
size of the business. Students will learn how to prepare journal and various subsidiary
books in chapter 2.
2. Classifying – Classification is concerned with the systematic analysis of the recorded
data, with a view to group transactions or entries of one nature at one place so as to put
information in compact and usable form. The book containing classified information is
called “Ledger”. This book contains on different pages, individual account heads under
which, all financial transactions of similar nature are collected. For example, there may
be separate account heads for Salaries, Rent, Printing and Stationeries, Advertisement
etc. All expenses under these heads, after being recorded in the Journal, will be classified
under separate heads in the Ledger. This will help in finding out the total expenditure
incurred under each of the above heads. Students will learn how to prepare ledger books
in chapter 2.
3. Summarising – It is concerned with the preparation and presentation of the classified
data in a manner useful to the internal as well as the external users of financial statements.
This process leads to the preparation of the following financial statements:
(a) Trial Balance (b) Profit and Loss Account (c) Balance Sheet (d) Cash-flow Statement.

FUNDAMENTALS OF ACCOUNTING 1.5


MEANING AND SCOPE OF ACCOUNTING

Students will learn how to prepare Trial Balance in chapter 2 and Financial Statements in
chapter 6 while Cash-flow Statement will be discussed in the Professional Competence
Course.
4. Analysing – The term ‘Analysis’ means methodical classification of the data given in the
financial statements. The figures given in the financial statements will not help anyone
unless they are in a simplified form. For example, all items relating to fixed assets are put
at one place while all items relating to current assets are put at another place. It is concerned
with the establishment of relationship between the items of the Profit and Loss Account
and Balance Sheet i.e. it provides the basis for interpretation. Students will learn this
aspect of financial statements in the later stages of the Chartered Accountancy Course.
5. Interpreting – This is the final function of accounting. It is concerned with explaining the
meaning and significance of the relationship as established by the analysis of accounting
data. The recorded financial data is analysed and interpreted in a manner that will enable
the end-users to make a meaningful judgement about the financial condition and
profitability of the business operations. The financial statement should explain not only
what had happened but also why it happened and what is likely to happen under specified
conditions. Students will learn this aspect of financial statements in the later stages of the
Chartered Accountancy Course.
6. Communicating – It is concerned with the transmission of summarised, analysed and
interpreted information to the end-users to enable them to make rational decisions. This is
done through preparation and distribution of accounting reports, which include besides
the usual profit and loss account and the balance sheet, additional information in the
form of accounting ratios, graphs, diagrams, fund flow statements etc. Students will
learn this aspect of financial statements in the later stages of the Chartered Accountancy
Course.
The first two procedural stages of the process of generating financial information along with
the preparation of trial balance are covered under book-keeping while the preparation of financial
statements and its analysis, interpretation and also its communication to the various users are
considered as accounting stages. Students will learn the term book-keeping and its distinction
with accounting, in the coming topics of this unit.
2.1.2 Using the Financial Information
There are certain users of accounts. Earlier it was viewed that accounting is meant for the
proprietor or owner of the business, but changing social relationships diluted the earlier thinking.
It is now believed that besides the owner or the management of the business enterprise, users
of accounts include the investors, employees, lenders, suppliers, customers, government and
other agencies and the public at large. Accounting provides the art of presenting information
systematically to the users of accounts. Accounting data is more useful if it stresses economic
substance rather than technical form. Information is useless and meaningless unless it is relevant
and material to a user’s decision. The information should also be free of any biases. The users
should understand not only the financial results depicted by the accounting figures, but also
should be able to assess its reliability and compare it with information about alternative
opportunities and the past experience. The owners or the management of the enterprise,

1.6 COMMON PROFICIENCY TEST


commonly known as internal users, use the accounting information in an analytical manner to
take the valuable decisions for the business. So the information served to them is presented in
a manner different to the information presented to the external users. Even the small details
which can effect the internal working of the business is given in the management report while
financial statements presented to the external users contains key information regarding assets,
liabilities and capital are summarised in a logical manner that helps them in their respective
decision-making. Students can study in detail about the different users of financial statements
in para 9 of this chapter.
The entire procedure of accounting can be explained with the help of chart given below :

PROCESS OF ACCOUNTING

Identification of
Input transaction

Economic Accounting Cycle Output


events
measured
in financial
terms Communicating
Information to
Recording Posting Preparation Preparation
users
transactions to of trial of final
in the books ledger balance accounts
of original
entry

Internal users External users


 Board of  Investors
Directors  Lenders
 Partners  Suppliers
 Managers  Govt.
 Officers agencies
 Employees
 Customers

FUNDAMENTALS OF ACCOUNTING 1.7


MEANING AND SCOPE OF ACCOUNTING

3. EVOLUTION OF ACCOUNTING AS A SOCIAL SCIENCE


In its oldest form accounting aided the stewards to discharge their stewardship function. The
wealthy men employed stewards to manage their property; the stewards in turn rendered an
account periodically of their stewardship. This ‘Stewardship Accounting’ was the root of
financial accounting system. The presently followed system of double-entry book-keeping has
been developed only in the 15th Century. However, historians found records of debit and
credit dating back to the 12th Century. Although double-entry system was followed,
‘stewardship accounting’ served the purpose of businessmen and wealthy persons at that time.
In India too, stewardship accounting was prevalent till the emergence of large-scale enterprises
in the form of public limited companies.
In the second phase, the idea of financial accounting emerged with the concept of joint stock
company and divorce of ownership from the management. To safeguard the interest of the
shareholders and investors, disclosure of financial statements (mainly, profit and loss account
and balance sheet) and other accounting information was moulded by law. Financial statements
give periodic performance report by way of profit and loss account and financial position at
the end of the period by way of Balance Sheet. It got the legal status due to changing relationships
between the owners, economic entity and the managers. With the democratisation of society,
the relationships between the enterprise on the one hand, the investors, employees, managers
and governments on the other, have also undergone a sea-change. Also the prospective investors
and other business contact groups want to know a lot about the business before entering into
transactions. Thus financial accounting emerged as an information system to identify, measure
and communicate useful information for informed judgements and decisions by a broad group
of users. In the third phase, accounting information was generated to aid management decision-
making in particular. It contributed a lot to improve the quality of management decisions. This
new dimension of accounting is called Management Accounting and it is the development of
20th Century only. It is pervasive enough to cover all spheres of management decisions.
Lastly, Social Responsibility Accounting is in the formative process, which aims at accounting
for the social cost incurred by business as well as the social benefit, created by it. It emerges
from the growing social awareness about the undesirable by-products of economic activities.
While earning profit, an enterprise incurs numerous social costs like pollution, using the resources
of society like materials, land, labour etc. To compensate for this social cost, in today’s world,
an enterprise is expected to generate some social benefits also like employment opportunities,
recreation activities, more choice to customers at reasonable price, better quality products etc.
Therefore it is demanded that the accounting system is to produce a report measuring the
social cost incurred and social benefits generated.
Social Sciences study man as a member of society; they concern about social processes and the
results and consequences of social relationships. The usefulness of accounting to society as a
whole is the fundamental criterion to treat it as a social science. Although individuals may
benefit from the availability of accounting information, the accounting system generates
information for social good. It serves social purposes, it contributes for social progress; also it is
being adapted to keep pace with social progress. So, accounting is treated as a social science.

1.8 COMMON PROFICIENCY TEST


4. OBJECTIVES OF ACCOUNTING
The objectives of accounting can be given as follows:
1. Systematic recording of transactions – Basic objective of accounting is to systematically
record the financial aspects of business transactions i.e. book-keeping. These recorded
transactions are later on classified and summarised logically for the preparation of financial
statements and for their analysis and interpretation.
2. Ascertainment of results of above recorded transactions – Accountant prepares profit
and loss account to know the results of business operations for a particular period of time.
If revenues exceed expenses then it is said that business is running profitably but if expenses
exceed revenue then it can be said that business is running under loss. The profit and loss
account helps the management and different stakeholders in taking rational decisions.
For example, if business is not proved to be remunerative or profitable, the cause of such a
state of affair can be investigated by the management for taking remedial steps.
3. Ascertainment of the financial position of the business – Businessman is not only
interested in knowing the results of the business in terms of profits or loss for a particular
period but is also anxious to know that what he owes (liability) to the outsiders and what
he owns (assets) on a certain date. To know this, accountant prepares a financial position
statement popularly known as Balance Sheet. The balance sheet is a statement of assets
and liabilities of the business at a particular point of time and helps in ascertaining the
financial health of the business.
4. Providing information to the users for rational decision-making – Accounting as a
‘language of business’ communicates the financial results of an enterprise to various
stakeholders by means of financial statements. Accounting aims to meet the information
needs of the decision-makers and helps them in rational decision-making.
5. To know the solvency position: By preparing the balance sheet, management not only
reveals what is owned and owed by the enterprise, but also it gives the information
regarding concern’s ability to meet its liabilities in the short run (liquidity position) and
also in the long-run (solvency position) as and when they fall due.

FUNDAMENTALS OF ACCOUNTING 1.9


MEANING AND SCOPE OF ACCOUNTING

An overview of objectives of accounting is depicted in the chart given below :

Objectives of Accounting

Systematic Ascertainment Ascertainment Communicating


Recording of of of Financial Information to
Transactions Results Position Various Users

Book-
keeping :
Journal, Manufacturing Balance Financial
Ledger and Trading, Profit Sheet Reports
Trial Balance and Loss
Account

5. FUNCTIONS OF ACCOUNTING
The main functions of accounting are as follows:
(a) Measurement: Accounting measures past performance of the business entity and depicts
its current financial position.
(b) Forecasting: Accounting helps in forecasting future performance and financial position
of the enterprise using past data.
(c) Decision-making: Accounting provides relevant information to the users of accounts to
aid rational decision-making.
(d) Comparison & Evaluation: Accounting assesses performance achieved in relation to targets
and discloses information regarding accounting policies and contingent liabilities which
play an important role in predicting, comparing and evaluating the financial results.
(e) Control: Accounting also identifies weaknesses of the operational system and provides
feedbacks regarding effectiveness of measures adopted to check such weaknesses.
(f) Government Regulation and Taxation: Accounting provides necessary information to
the government to exercise control on the entity as well as in collection of tax revenues.

6. BOOK-KEEPING
Book-keeping is an activity concerned with the recording of financial data relating to business
operation in a significant and orderly manner. It covers procedural aspects of accounting work

1.10 COMMON PROFICIENCY TEST


and embraces record keeping function. Obviously book-keeping procedures are governed by
the end product, the financial statements. In India, the term ‘financial statements’ means Profit
and Loss Account and Balance Sheet including Schedules and Notes Forming part of Accounts.
As discussed earlier, Profit and Loss Account gives result of economic activities for a period
and Balance Sheet states the financial position at the end of the period. Book-keeping also
requires suitable classification of transactions and events. This is also determined with reference
to the requirement of financial statements. A book-keeper may be responsible for keeping all
the records of a business or only of a minor segment, such as position of the customers’ accounts
in a departmental store. A substantial portion of the book-keeper’s work is of a clerical nature
and is increasingly being accomplished through the use of a mechanical and electronic devices.
Accounting is based on a careful and efficient book-keeping system.
The essential idea behind maintaining book-keeping records is to show correct position regarding
each head of income and expenditure. A business may purchase goods on credit as well as in
cash. When the goods are bought on credit, a record must be kept of the person to whom
money is owed. The proprietor of the business may like to know, from time to time, what
amount is due on credit purchase and to whom. If proper record is not maintained, it is not
possible to get details of the transactions in regard to the expenses. At the end of the accounting
period, the proprietor wants to know how much profit has been earned or loss has been incurred
during the course of the period. For this lot of information is needed which can be gathered
from a proper record of the transactions. Therefore, in book-keeping, the proper maintenance
of books of account is indispensable for any business.
At CPT level, the major concern of the curriculum is with book-keeping and preparation of
financial statements. It seems important to mention at this point that book-keeping and
preparation of financial statements have legal implications also. Maintenance of books of
accounts and the preparation of financial statements of a company are guided by the Companies
Act, 1956, of a co-operative society by Co-operative Societies Act, of banks and insurance
companies by special Acts governing these institutions and so on. However, for sole-
proprietorship and partnership business, there is no specific legislation regarding maintenance
of books of accounts and preparation of financial statements. The Income-tax Act, 1961 requires
maintenance of books of accounts in some cases.
6.1 OBJECTIVES OF BOOK-KEEPING
1. Complete Recording of Transactions – It is concerned with complete and permanent
record of all transactions in a systematic and logical manner to show its financial effect on
the business.
2. Ascertainment of Financial Effect on the Business – It is concerned with the combined
effect of all the transactions made during the accounting period upon the financial position
of the business as a whole.

7. DISTINCTION BETWEEN BOOK-KEEPING AND ACCOUNTING


Some people mistake book-keeping and accounting to be synonymous terms, but in fact they
are different from each other. Accounting is a broad subject. It calls for a greater understanding
of records obtained from book-keeping and an ability to analyse and interpret the information

FUNDAMENTALS OF ACCOUNTING 1.11


MEANING AND SCOPE OF ACCOUNTING

provided by book-keeping records. Book-keeping is the recording phase while accounting is


concerned with the summarising phase of an accounting system. Book-keeping provides
necessary data for accounting and accounting starts where book-keeping ends.
S.No. Book-keeping Accounting
1. It is a process concerned with It is a process concerned with summarising
recording of transactions. of the recorded transactions.
2. It constitutes as a base for accounting. It is considered as a language of the
business.
3. Financial statements do not form part Financial statements are prepared in this
of this process. process on the basis of book-keeping records.
4. Managerial decisions cannot be taken Management takes decisions on the basis of
with the help of these records. these records.
5. There is no sub-field of book-keeping. It has several sub-fields like financial
accounting, management accounting etc.
6. Financial position of the business Financial position of the business is
cannot be ascertained through book- ascertained on the basis of the accounting
keeping records. reports.

Relationship of Accounting and Book-Keeping can be depicted in the following chart as :

Accountancy

Accounting

Book Keeping

1.12 COMMON PROFICIENCY TEST


8. SUB-FIELDS OF ACCOUNTING
The various sub-fields of accounting are:
(i) Financial Accounting – It covers the preparation and interpretation of financial statements
and communication to the users of accounts. It is historical in nature as it records
transactions which had already been occurred. The final step of financial accounting is
the preparation of Profit and Loss Account and the Balance Sheet. It primarily helps in
determination of the net result for an accounting period and the financial position as on a
given date.
(ii) Management Accounting – It is concerned with internal reporting to the managers of a
business unit. To discharge the functions of stewardship, planning, control and decision-
making, the management needs variety of information. The different ways of grouping
information and preparing reports as desired by managers for discharging their functions
are referred to as management accounting. A very important component of the
management accounting is cost accounting which deals with cost ascertainment and cost
control.
Management Accounting will be dealt with at Final level of the Chartered Accountancy
Course.
(iii) Cost Accounting – The terminology of Cost Accounting published by the Institute of
Cost and Management Accountants of England defines cost accounting as:
“the process of accounting for cost which begins with the recording of income and
expenditure or the bases on which they are calculated and ends with the preparation
of periodical statements and reports for ascertaining and controlling costs.”
Cost Accounting will be covered at Professional Competence level and Final level of the
Chartered Accountancy Course.
(iv) Social Responsibility Accounting – The demand for social responsibility accounting stems
from increasing social awareness about the undesirable by-products of economic activities.
As already discussed earlier, social responsibility accounting is concerned with accounting
for social costs incurred by the enterprise and social benefits created.
Social Responsibility Accounting will be discussed in the curriculum of Final level of the
Chartered Accountancy Course.
(v) Human Resource Accounting – Human resource accounting is an attempt to identify,
quantify and report investments made in human resources of an organisation that are not
presently accounted for under conventional accounting practice.
Human Resource Accounting will be discussed in the curriculum of Final level of the
Chartered Accountancy Course.

9. USERS OF ACCOUNTING INFORMATION


Generally users of accounts are classified into two categories, (a) internal management and
owners; and (b) external users or outsiders. Management accounting is concerned with

FUNDAMENTALS OF ACCOUNTING 1.13


MEANING AND SCOPE OF ACCOUNTING

identifying information requirements as well as methods of providing such information to


management while information requirements of the outside users are generally served by
financial statements. Following are the various users of accounting information:
(i) Investors: They provide risk capital to the business. They need information to assess whether
to buy, hold or sell their investment. Also they are interested to know the ability of the
business to survive, prosper and to pay dividend. In non-corporate sector, where ownership
and management are not essentially separated, the owners still need information about
performance of the business and its financial position to decide whether to continue or
shut down.
(ii) Employees: Growth of the employees is directly related to the growth of the organisation
and therefore, they are interested to know the stability, continuity and growth of the
enterprise and its ability to provide remuneration, retirement and other benefits and to
enhance employment opportunities.
(iii) Lenders: They are interested to know whether their loan-principal and interest will be
paid when due.
(iv) Suppliers and Creditors: They are also interested to know the ability of the enterprise to
pay their dues, that helps them to decide the credit policy for the relevant concern, rates to
be charged and so on. Sometimes, they also become interested in long-term continuation
of the enterprise if their existence becomes dependent on the survival of that business.
Suppose, small ancillary units supply their products to a big enterprise, if the big enterprise
collapses, the fate of the small units also becomes sealed.
(v) Customers: Customers are also concerned with the stability and profitability of the
enterprise because their functioning is more or less dependent in a vertical chain, suppose,
a company produces some chemicals used by pharmaceutical companies. It supplies
chemicals on three month’s credit. If all of a sudden it faces some trouble and is unable to
supply the chemical, the customers will also be in trouble.
(vi) Government and their agencies: They regulate the functioning of business enterprises for
public good, allocate scarce resources among competing enterprises, control prices, charge
excise duties and taxes, and so they have continued interest in the business enterprise.
(vii) Public: The public at large is interested in the functioning of the enterprise because it may
make a substantial contribution to the local economy in many ways including the number
of people employed and their patronage to local suppliers.
Management as whole is also interested in the accounts for various managerial decisions.
On the basis of the accounts, management determines the effects of their various decisions and
their effects on the functioning of the organisation. This helps them to make further managerial
decisions.

10. RELATIONSHIP OF ACCOUNTING WITH OTHER DISCIPLINES


Accounting is closely related with several other disciplines and thus to acquire a good knowledge
in accounting one should be conversant with the relevant portions of such disciplines. In many
cases they overlap accounting. The Accountant should have a working knowledge of the related

1.14 COMMON PROFICIENCY TEST


disciplines so that he can understand such overlapping areas and apply the knowledge of
other disciplines in his own work wherever possible, or he can take the expert advice.
(a) Accounting and Economics: Economics is viewed as a science of rational decision-making
about the use of scarce resources. It is concerned with the analysis of efficient use of scarce
resources for satisfying human wants. This may be viewed either from the perspective of
a single firm or of the country as a whole.
Accounting is viewed as a system, which provides data to the users to permit informed
judgement and decisions. Some non-accounting data are also relevant for decision-making.
Still, accounting provides a major database.
Accounting overlaps economics in many respects. 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.
However, there exists a wide gulf between economists’ and accountants’ concepts of income
and capital. Accountants got the ideas of value, income and capital maintenance from
economists, but brushed suitably to make them usable in practical circumstances.
Accountants developed the valuation, measurement and decision-making techniques which
may owe to the economic theorems for origin but these are moulded in the work
environment and suitably tempered with reference to relevance, verifiability, freedom from
bias, timeliness, comparability, reliability and understandability.
An example may be given to explain the nexus between accounting and economics.
Economists think that value of an asset is the present value of all future earnings which
can be derived from such assets. Now think about a plant whose working life is more than
one hundred years. How can you estimate future stream of earnings? So accountants
developed the workable valuation base – the acquisition cost i.e., the price paid to acquire
the assets.
At the macro-level, accounting provides the database over which the economic decision
models have been developed; micro-level data arranged by the accounting system is summed
up to get macro-level database.
Non-overlapping zones of accounting are not negligible. Development of the systems of
recording, classifying and summarising transactions and events, harmonising the systems
by uniform rules and communicating the data is essentially a non-overlapping area of
accounting.
(b) Accounting and Statistics: The use of statistics in accounting can be appreciated better in
the context of the nature of accounting records. Accounting information is very precise; it
is exact to the last paisa. But, for decision-making purposes such precision is not necessary
and hence, the statistical approximations are sought.
In accounts, all values are important individually because they relate to business
transactions. As against this, statistics is concerned with the typical value, behaviour or
trend over a period of time or the degree of variation over a series of observations. Therefore,
wherever a need arises for only broad generalisations or the average of relationships,
statistical methods have to be applied in accounting data.

FUNDAMENTALS OF ACCOUNTING 1.15


MEANING AND SCOPE OF ACCOUNTING

Further, in accountancy, the classification of assets and liabilities as well as the heads of
income and expenditure has been done as per the needs of financial recording to ascertain
financial results of various operations. Other types of classification like the geographical
and historical ones and ad hoc classification are done depending on the purpose to make
such classification meaningful.
Accounting records generally take a short-term view of events and are confined to a year
while statistical analysis is more useful if a longer view is taken for the purpose. For example,
to fit the trend line a longer period will be required. However, statistical methods do use
past accounting records maintained on a consistent basis.
Accounting records are based on historical costs of fixed assets, while the current assets
are valued at the current values. This creates some anomalous situations when prices are
not stable over a period of time. The new methods of inflation accounting are an attempt
to correct this situation. The correction of values is made on the basis of the current
purchasing power of money or the current value of the concerned assets revalued from
the data of purchase till the day of recording, charging depreciation on the current value,
so that the present value of the asset is in line with the current value of money. All this
would require the use of price indices or the price deflators, which are based on statistical
calculations of price changes.
The functional relations showing mathematical relations of one variable with one or more
other variables are based on statistical work. These relations are used widely in making
cost or price estimates for some estimated future values assigned to the given independent
variables. For example, given the functional relation of total cost to the price of an input,
the effect of changes in future prices on the cost of production can be calculated.
In accountancy, a number of financial and other ratios are based on statistical methods,
which help in averaging them over a period of time. Several accounting and financial
calculations are based on statistical formulae.
Statistical methods are helpful in developing accounting data and in their interpretation.
For example, time series and cross-sectional comparison of accounting data is based on
statistical techniques. Now-a-days multiple discriminant analysis is popularly used to
identify symptoms of sickness of a business firm. Therefore, the study and application of
statistical methods would add extra edge to the accounting data.
(c) Accounting and Mathematics: Double Entry book-keeping can be converted in algebraic
form; in fact the first known book on this subject was part of a treatise on algebra. The
fundamental accounting equation will be discussed in detail under ‘Dual Aspect Concept’
of this chapter.
Knowledge of arithmetic and algebra is a pre-requisite for accounting computations and
measurements. Calculations of interest and annuity are the examples of such fundamental
uses. While computing depreciation, finding out installments in hire-purchase and
instalments payment transactions, calculating amount to be set aside for repayment of
loan and replacement of assets and calculating lease rentals, mathematical techniques are
frequently used. Accounting data are also presented in ratio form.

1.16 COMMON PROFICIENCY TEST


With the advent of the computer, mathematics is becoming a vital part of accounting.
Instead of writing accounts in traditional fashion, the transactions and events can be
recorded in the matrix form and the rules of matrix algebra can be applied for classifying
and summarising data.
Now-a-days statistics and econometric models are largely used for developing decision
models for the users of accounts. Also, Operations Research Techniques provide lot of
decision models. Since accounting is meant for providing information to the users, to be
effective, accounting data should feed the information requirements of such statistical,
econometric and operations research models. Understanding mathematics has become a
must to grasp the decision models framed by statisticians, econometricians and the O.R.
experts.
Presently graphs and charts are being extensively used for communicating accounting
information. In addition to statistical knowledge, knowledge in geometry and trigonometry
seems to be essential to have a better understanding about the accounting communications
system.
(d) Accounting and Law: An economic entity operates within a legal environment. All
transactions with suppliers and customers are governed by the Contract Act, the Sale of
Goods Act, the Negotiable Instruments Act, etc. The entity itself is created and controlled
by laws. For example, a partnership business is controlled by Partnership Act. A company
is created by the Companies Act and also controlled by Companies Act.
Similarly, every country has a set of economic, fiscal and labour laws. Transactions and
events are always guided by laws of the land. Very often the accounting system to be
followed has been prescribed by the law. For example, the Companies Act has prescribed
the format of financial statements.
Banking, insurance and electric supply undertakings also have to produce financial
statements as prescribed by the respective legislations controlling such entities.
However, legal prescription about the accounting system is the product of developments
in accounting knowledge. That is to say, legislation about accounting system cannot be
enacted unless there is a corresponding development in the accounting discipline. In that
way accounting influences law and is also influenced by law.
(e) Accounting and Management: Management is a broad occupational field, which comprises
many functions and encompasses application of many disciplines including those
mentioned above. Accountants are well placed in the management and play a key role in
the management team. A large portion of accounting information is prepared for
management decision-making. Although management relies on other data sources,
accounting data are used as basic source documents. In the management team, an
accountant is in a better position to understand and use such data. In other words, since
an accountant plays an active role in management, he understands the data requirements.
So the accounting system can be moulded to serve the management purpose.

FUNDAMENTALS OF ACCOUNTING 1.17


MEANING AND SCOPE OF ACCOUNTING

11. LIMITATIONS OF ACCOUNTING


There are certain misconceptions regarding financial statements. A common man presumes
that an income statement shows the correct income or loss of the enterprise and that a balance
sheet depicts a perfectly true and fair picture of financial standing of that enterprise. It must be
recognised that the accounting as a language has its own limitations. The figures of profit or
loss generated by the accounting process are subject to various constraints within which the
accounting works. The assumptions and conventions, on which the accounting is based, become
the limitations of accounting. The financial statements are never free from subjectivity factor
as these are largely the outcome of personal judgement of the accountant with regard to the
adoption of the accounting policies. Following are certain instances :
1. The factors which may be relevant in assessing the worth of the enterprise don’t find
place in the accounts as they cannot be measured in terms of money. The Balance sheet
cannot reflect the value of certain factors like loyalty and skill of the personnel which may
be the most valuable asset of an enterprise these days.
2. Balance Sheet shows the position of the business on the day of its preparation and not on
the future date while the users of the accounts are interested in knowing the position of
the business in the near future and also in long run and not for the past date. The time it
takes for the annual reports to reach the users, business dynamics change. To resolve this,
auditors disclose the events occurring after the balance sheet date but before approval of
financial statements in the financial reports.
3. Though with the emergence of some accounting standards like AS 11, AS 26, AS 28 etc.,
market/fair value of assets is taken into consideration but still there remains some
subjectivity. Accounting ignores changes in some money factors like inflation etc.
4. There are occasions when accounting principles conflict with each other.
5. Certain accounting estimates depend on the sheer personal judgement of the accountant,
e.g., provision for doubtful debts, method of depreciation adopted, recording certain
expenditure as revenue expenditure or capital expenditure, selection of method of valuation
of stock-in-hand, period for writing off intangible assets, and the list is quite long.
6. Financial statements only consider those assets which can be expressed in monetary terms.
Human resources although the very important asset of the enterprise are not shown in the
balance sheet. There is no generally accepted formula for the valuation of human resources
in money terms.
7. Different accounting policies for the treatment of same item adds to the probability of
manipulations. Though through various laws and Accounting Standards, efforts are made
to reduce these options to minimum but certainly could not be reduced to one.
In nutshell, it can be said that the language of accounting has certain practical limitations and,
therefore, the financial statements should be interpreted carefully keeping in mind all various
factors influencing the true picture.

1.18 COMMON PROFICIENCY TEST


12. ROLE OF ACCOUNTANT IN THE SOCIETY
There are only a few types of profession in the world which are held in high esteem in public
eyes and there is no denying the fact that the accounting profession is one of them. Goethe had
called the accountant’s profession as ‘the fairest invention of the human mind’. At the core of
all types of learned profession, there is the desire of public good and of finding the best way to
serve society. By the use of the science of accountancy and under the spell of its art, a dynamic
pattern which assists business in planning its future is woven by accountants out of the inert
mass of non-speaking silent figures. This is what makes their profession an instrument of socio-
economic change and welfare of the society.
An accountant with his education, training, analytical mind and experience is best qualified to
provide multiple need-based services to the ever growing society. The accountants of today
can do full justice not only to matters relating to taxation, costing, management accounting,
financial lay-out, company legislation and procedures but they can delve deep into the fields
relating to financial policies, budgetary policies and even economic principles. The area of
activities which can be undertaken by the accountants is not limited but it can also cover many
additional facets.
12.1 AREAS OF SERVICE
The practice of accountancy has crossed its usual domain of preparation of financial statements,
interpretation of such statements and audit thereof. Accountants are presently taking active
role in company laws and other corporate legislation matters, in taxation laws matters (both
direct and indirect) and in general management problems. Some of the services rendered by
accountants to the society are briefly mentioned hereunder:
12.1.1 Maintenance of Books of Accounts : An accountant is able to maintain a systematic
record of financial transactions in order to establish the net result of the transactions entered
into during a period and to state the financial position of the concern as at a particular date.
For the fulfillment of the twin objective of ascertaining the profit earned or loss suffered and
the financial position, it is necessary that all transactions be recorded in a systematic manner,
which can be done only by an accountant. Proper maintenance of books of accounts assists
management in planning, decision-making, controlling functions.
12.1.2 Statutory Audit : Every limited company is required to appoint a chartered accountant
as an auditor who is statutorily required to report each year whether in his opinion the balance
sheet shows a true and fair view of the state of affairs on the balance sheet date, and the profit
and loss account shows a true and fair view of the profit or loss for the year.
Auditing is not confined to the accounts of companies; other organisations may also have their
accounts audited, either because the law so requires (for example, the Co-operative Societies
Act, the Income-tax Act, etc. or because the proprietors wisely decided so (for example, a
partnership firm or an individual trader).
12.1.3 Internal Audit : It is a management tool whereby an internal auditor thoroughly
examines the accounting transactions and also the system, according to which these have
been recorded with a view to ensure the management that the accounts are being properly
maintained and the system contains adequate safeguards to check any leakage of revenue or

FUNDAMENTALS OF ACCOUNTING 1.19


MEANING AND SCOPE OF ACCOUNTING

misappropriation of property or assets and the operations have been carried out in conformity
with the plans of management.
Now-a-days internal auditing has developed as a service to management. The internal auditor
constructively contributes in improving the operational efficiency of the business through an
independent review and appraisal of all business operations.
12.1.4 Taxation : An accountant can handle taxation matters of a business or a person and he
can represent that business or person before the tax authorities and settle the tax liability under
the statute prevailing. He can also assist in avoiding or reducing tax burden by proper planning
of tax affairs.
Accountants also have a social obligation to express their views on broad tax policy, on the
effect of tax rate on business and the economy in general and on all other aspects of taxation in
which they have knowledge superior to that of the general public.
12.1.5 Management Accounting and Consultancy Services : Management accountant
performs an advisory function. He is largely responsible for internal reporting to the management
for planning and controlling current operations, decision-making on special matters and for
formulating long-range plans. His job is to collect, analyse, interpret and present all accounting
information which is useful to the management. Accountant provides management consultancy
services in the areas of management information system, expenditure control and evaluation
of appraisal techniques for new investments and divestments, working capital management,
corporate planning etc.
12.1.6 Financial Advice : Many people need help and guidance in planning their personal
financial affairs. An accountant who knows about finances, taxation and family problems is
well placed to give such advice. Some of the areas in which an accountant can render financial
advice are:
(a) Investments: An accountant can explain the significance of the formidable documents
which shareholders receive from companies and help in making decisions relating to their
investments.
(b) Insurance: An accountant can provide information to his clients on various insurance
policies and helps in choosing appropriate policy.
(c) Business Expansion: As businesses grow in size and complexity and mergers are being
considered, accountants are in the forefront in interpreting accounts, making suggestions
as to the form of schemes and the fairness of proposals considering cost and financial
consequences and generally advising their clients. They also advise on how to set about
the problem of borrowing money or whether this is an appropriate method of finance.
Accountants can render extremely useful service in connection of negotiations with foreign
collaborators.
(d) Investigations: Financial investigations are required for a variety of purposes. Examples
are:
(i) To ascertain the financial position of a business, for the information of interested
parties in connection with an issue of capital, the purchase or sale of the business or
a reconstruction or amalgamation.

1.20 COMMON PROFICIENCY TEST


(ii) To help the management to decide whether it is cheaper to manufacture an article or
to buy out.
(iii) To ascertain why profits have fallen.
(iv) To achieve greater efficiency in management.
(v) To ascertain whether fraud has occurred and if so, its nature and extent and to make
suggestions which will help to prevent a recurrence.
(vi) To value businesses and shares in private companies for purposes such as purchase,
sale, estate duty or wealth tax etc.
For such problems requiring financial investigation, you need an accountant. His
task as an independent professional is to establish the facts fairly and clearly for the
benefit of those who have to make decisions and to give advice in many areas in
which he has competence and experience.
(e) Pension schemes: Specialist advice from actuaries, insurance agents or insurance company
is needed before launching or amending a provident fund or pension scheme in a business.
But before making a final decision, an accountant has to be consulted. Later on his help
may be needed for managing the scheme or obtaining tax relief.
12.1.7 Other Services
(a) Secretarial Work : Companies, clubs, and associations indeed, virtually all organisations
involve secretarial work. Accountants frequently do this work.
(b) Share Registration Work : Accountants are often used by many companies to undertake the
work involved in registering share transfers and new issues.
(c) Company Formation : In conjunction with legal advisers, accountants help in the formation
of a company or advise against doing so.
(d) Receiverships, Liquidations, etc. : An unpleasant subject. But someone has to take on the
onerous duties of liquidator when a company is being wound up or receiver when a
debenture holder exercises a right to recover a loan on which the borrower has defaulted.
Accountant is just the man for the job. He is also just the man to help you to keep insolvency
away if you consult him in time.
(e) Arbitrations : At times, accountants are invited by parties to act as arbitrators in a dispute
or settle disputes of various kinds.
(f) As Regards the Cost Accounts : A cost accountant’s job is to continuously report cost data
and related information at frequent intervals to the management.
(g) Accountant and Information Services : An accountant will be effective in his role if he supplies
the information promptly and in an unambiguous language. He should develop a system
by which there is a regular flow of information both horizontally and vertically.
The information system should be such that comparability of financial statement is possible
both business-wise and year-wise so that it benefits both the management and the investors.
Dependence on data from the computerised information system will put new responsibilities
on an accountant but his product will command greater attention and respect.

FUNDAMENTALS OF ACCOUNTING 1.21


MEANING AND SCOPE OF ACCOUNTING

12.2 CHARTERED ACCOUNTANT IN INDUSTRY


An accountant, though he is a part of the highest planning team is not a planner in an industry.
He works with the functional departments and translates the organisation’s aims in terms of
financial expectations. Therefore, he has to make a thorough study of the business and of
individuals in the functional departments, whether they are engineers or salesmen. A qualified
accountant will be able to play an important role in performing important functions of a business
relating to accounting, costing and budgetary control, estimating and treasury.
12.3 CHARTERED ACCOUNTANT IN PUBLIC SECTOR ENTERPRISES
Both in the developed and developing countries, public sector enterprises have become a special
feature of the national economy. The system of financial and budgetary control and of
accounting, auditing and reporting has, therefore, become a matter of interest and concern to
the nation, and does not remain confined merely to a limited number of shareholders. The
form of accounting followed by these corporations or companies is different from that of
ordinary government accounting. It is the duty of the accountants to prepare the accounts and
reports of these public corporations in such a way that they enable the general public to know
how far the items appearing in the various types of records and financial statements justify
their existence.
12.4 CHARTERED ACCOUNTANT IN FRAMING FISCAL POLICIES
Accountants have a positive role to play in the determination of proper fiscal policies and
advancement of trade, commerce and industry. They should develop new techniques and
prepare themselves for new fields of service towards their commitment to the concept of the
public good and service. A business enterprise can be successful in the commercial sense only
if accounting and business knowledge are pooled together. It is a social obligation for both
accountants in industry and in practice to disclose greater information regarding the corporate
results. The state of affairs of the economy can be ascertained only when such consolidated
corporate information is disclosed.
12.5 CHARTERED ACCOUNTANT AND ECONOMIC GROWTH
In the present times accountants should conceive their duties as broadly as the conditions
might require and do not restrict them to only literal compliance of the law. Their aim should
be not to allow any individual to gain at the cost of the nation. Accountants have to accept a
positive role and do their best to encourage efficiency in individual business units and encourage
those social objectives which form the main foundation of a welfare state.

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
1. (i) Which of the following is not a subfield of accounting?
(a) Management accounting. (b) Cost accounting.
(c) Financial accounting. (d) Book-keeping.
(ii) Purposes of an accounting system include all the following except
(a) Interpret and record the effects of business transaction.

1.22 COMMON PROFICIENCY TEST


(b) Classify the effects of transactions to facilitate the preparation of reports.
(c) Summarize and communicate information to decision makers.
(d) Dictate the specify types of business enterprise transactions that the enterprises
may engage in.
(iii) Financial accounting information is characterized by all of the following except
(a) It is historical in nature.
(b) It is factual, so it does not require judgement to prepare.
(c) It results from inexact and appropriate measures.
(d) It is enhanced by management’s explanation.
(iv) Book-keeping is mainly concerned with
(a) Recording of financial data.
(b) Designing the systems in recording, classifying and summarising the recorded
data.
(c) Interpreting the data for internal and external users.
(d) None of the above.
(v) All of the following are functions of Accounting except
(a) Decision making. (b) Measurement.
(c) Forecasting. (d) Ledger posting.
2. (i) Financial statements are part of
(a) Accounting. (b) Book-Keeping.
(c) All of the above. (d) None of the above.
(ii) Financial position of the business is ascertained on the basis of
(a) Records prepared under book-keeping process.
(b) Trial balance.
(c) Accounting reports.
(d) None of the above.
(iii) Users of accounting information include
(a) Creditors. (b) Lenders.
(c) Customers. (d) All of the above.
(iv) Financial statements do not consider
(a) Assets expressed in monetary terms.
(b) Liabilities expressed in monetary terms.

FUNDAMENTALS OF ACCOUNTING 1.23


MEANING AND SCOPE OF ACCOUNTING

(c) Assets expressed in non-monetary terms.


(d) Assets and liabilities expressed in non-monetary terms
(v) On January 1, Sohan paid rent of Rs. 5,000. This can be classified as
(a) An event. (b) A transaction.
(c) A transaction as well as an event. (d) Neither a transaction nor an event.
(vi) On March 31, 2006 after sale of goods worth Rs. 2,000, he is left with the closing
stock of Rs. 10,000. This is
(a) An event. (b) A transaction.
(c) A transaction as well as an event. (d) Neither a transaction nor an event.

[Ans. 1.(i) (d), (ii) (d) , (iii) (b), (iv) (a), (v) (d)
2. (i) (a), (ii) (c), (iii) (d), (iv) (d), (v) (b), (vi) (a)]

II Match the following items from column A with column B


S. No. Column A Column B
1. Financial statements (a). Is the language of business.
2. Accounting (b). Includes Profit and Loss account, Balance Sheet
and Cash-flow statement
3. Book keeping (c). Are the business performance of trading activities.
4. Transactions (d). Constitutes as a base for accounting.

[Ans : 1(d), 2(a), 3(d), 4(c)]


S. No. Column A Column B
1. Events (a) Are the internal users of financial
statements.
2. Government and their agencies (b) Are the end result of the transaction
3. Management of the business enterprise (c) Is a transaction
4. Purchase of goods worth Rs. 1,000 (d) Are one of the external users of the
financial statements.
[Ans : 1(b), 2(d), 3(d), 4(c)]

1.24 COMMON PROFICIENCY TEST


CHAPTER - 1

ACCOUNTING :
AN
INTRODUCTION

Unit 2

Accounting
Concepts, Principles
and Conventions
ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

Learning Objectives
After studying this unit, you will be able to :
 Grasp the basic accounting concepts, principles and conventions and observe their
implications while recording transactions and events.
 Identify the three fundamental accounting assumptions:
 Going Concern
 Consistency
 Accrual

If these assumptions are followed, no disclosure is essential. If these are not followed
specific disclosure is essential to highlight the deviations.
 Understand the qualitative characteristics that will help to develop the skill in course of
time to prepare financial statements.

1. INTRODUCTION
Let us imagine a situation where you are a proprietor and you take copies of your books of
account to five different accountants. You ask them to prepare the financial statements on the
basis of the above records and to calculate the profits of the business for the year. After few
days, they are ready with the financial statements and all the five accountants have calculated
five different amounts of profits and that too with very wide variations among them. Guess in
such a situation what impact would it leave on you about accounting profession. To avoid
this, a generally accepted set of rules have been developed. This generally accepted set of rules
provides unity of understanding and unity of approach in the practice of accounting and also
in better preparation and presentation of the financial statements.
Accounting is a language of the business. Financial statements prepared by the accountant
communicate financial information to the various stakeholders for decision-making purpose.
Therefore, it is important that financial statements prepared by different organizations should
be prepared on uniform basis. Also there should be consistency over a period of time in the
preparation of these financial statements. If every accountant starts following his own norms
and notions for accounting of different items then there will be an utter confusion.
To avoid confusion and to achieve uniformity, accounting process is applied within the
conceptual framework of ‘Generally Accepted Accounting Principles’ (GAAPs). The term
GAAPs is used to describe rules developed for the preparation of the financial statements and
are called concepts, conventions, postulates, principles etc. These GAAPs are the backbone of
the accounting information system, without which the whole system cannot even stand erectly.
These principles are the ground rules, which define the parameters and constraints within
which accounting reports are generated. Accounting principles are basic norms and
assumptions on which the whole accounting system has been developed and established.
Accountant also adheres to various accounting standards issued by the regulatory authority
for the standardization of accounting policies to be followed under specific circumstances.
These conceptual frameworks, GAAPs and accounting standards are considered as the theory
base of accounting.

1.26 COMMON PROFICIENCY TEST


2. ACCOUNTING CONCEPTS
Accounting concepts define the assumptions on the basis of which financial statements of a
business entity are prepared. Certain concepts are perceived, assumed and accepted in
accounting to provide a unifying structure and internal logic to accounting process. The word
concept means idea or notion, which has universal application. Financial transactions are
interpreted in the light of the concepts, which govern accounting methods. Concepts are
those basic assumptions and conditions, which form the basis upon which the accountancy
has been laid. Unlike physical science, accounting concepts are only result of broad consensus.
These accounting concepts lay the foundation on the basis of which the accounting principles
are formulated.

3. ACCOUNTING PRINCIPLES
“Accounting principles are a body of doctrines commonly associated with the theory and
procedures of accounting serving as an explanation of current practices and as a guide for
selection of conventions or procedures where alternatives exits.”
Accounting principles must satisfy the following conditions:
1. They should be based on real assumptions;
2. They must be simple, understandable and explanatory;
3. They must be followed consistently;
4. They should be able to reflect future predictions;
5. They should be informational for the users.

4. ACCOUNTING CONVENTIONS
Accounting conventions emerge out of accounting practices, commonly known as accounting
principles, adopted by various organizations over a period of time. These conventions are
derived by usage and practice. The accountancy bodies of the world may change any of the
convention to improve the quality of accounting information. Accounting conventions need
not have universal application.
In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting
conventions’ have been used interchangeably to mean those basic points of agreement on which
financial accounting theory and practice are founded.

5. CONCEPTS, PRINCIPLES AND CONVENTIONS - AN OVERVIEW


Now we shall study in detail the various accounting concepts on which accounting is based.
The following are the widely accepted accounting concepts:
(a) Entity concept : Entity concept states that business enterprise is a separate identity apart
from its owner. Accountants should treat a business as distinct from the its owner. Business
transactions are recorded in the business books of accounts and owner’s transactions in his
personal books of accounts. The practice of distinguishing the affairs of the business from the

FUNDAMENTALS OF ACCOUNTING 1.27


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

personal affairs of the owners originated only in the early days of the double-entry book-
keeping. This concept helps in keeping business affairs free from the influence of the personal
affairs of the owner. This basic concept is applied to all the organizations whether sole
proprietorship or partnership or corporate entities.
Entity concept means that the enterprise is liable to the owner for capital investment made by
the owner. Since the owner invested capital, which is also called risk capital he has claim on
the profit of the enterprise. A portion of profit which is apportioned to the owner and is
immediately payable becomes current liability in the case of corporate entities.
Example: Mr. X started business investing Rs. 7,00,000 with which he purchased machinery
for Rs. 5,00,000 and maintained the balance in hand. The financial position of the business
(which is shown by Balance Sheet) will be as follows:
Balance Sheet
Liability Assets
Rs. Rs.
Capital 7,00,000 Machinery 5,00,000
Cash 2,00,000
7,00,000 7,00,000
This means that the enterprise owes to Mr. X Rs. 7,00,000. Now if Mr. X spends Rs. 5,000 to
meet his family expenses from the business fund, then it should not be taken as business expenses
and would be charged to his capital account (i.e., his investment would be reduced by
Rs. 5,000. Following the entity concept the revised financial position would be
Balance Sheet
Liability Assets
Rs. Rs.
Capital 7,00,000 Machinery 5,00,000
Less : Drawings 5,000 6,95,000 Cash 1,95,000
6,95,000 6,95,000
(b) Money measurement concept : As per this concept, only those transactions, which can be
measured in terms of money are recorded. Since money is the medium of exchange and the
standard of economic value, this concept requires that those transactions alone that are capable
of being measured in terms of money be only to be recorded in the books of accounts.
Transactions, even if, they affect the results of the business materially, are not recorded if they
are not convertible in monetary terms. Transactions and events that cannot be expressed in
terms of money are not recorded in the business books. For example; employees of the
organization are, no doubt, the assets of the organizations but their measurement in monetary
terms is not possible therefore, not included in the books of account of the organization.
Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency
of a country provides a common denomination for the value of material objects. The monetary
unit though an inelastic yardstick, remains indispensable tool of accounting.

1.28 COMMON PROFICIENCY TEST


It may be mentioned that when transactions occur across the boundary of a country, one may
see many currencies. Suppose an Indian businessman sells goods worth Rs. 50 lakhs at home
and he also sells goods worth of 1 lakh Euro in the United States. What is his total sales? Rs. 50
lakhs plus 1 lakh Euro.
These are not amenable to even arithmetic treatment. So transactions are to be recorded at
uniform monetary unit i.e. in one currency. Suppose EURO 1 = Rs. 55.
Total Sales = Rs. 50 lakhs plus 55 lakhs = Rs. 105 lakhs. Money Measurement Concept imparts
the essential flexibility for measurement and interpretation of accounting data.
This concept ignores that money is an inelastic yardstick for measurement as it is based on the
implicit assumption that purchasing power of the money is not of sufficient importance as to
require adjustment. Also, many material transactions and events are not recorded in the books
of accounts just because it cannot be measured in monetary terms. Therefore it is recognized
by all the accountants that this concept has its own limitations and inadequacies. Yet it is
used for accounting purposes because it is not possible to adopt a better measurement scale.
Entity and money measurement are viewed as the basic concepts on which other procedural
concepts hinge.
(c) Periodicity concept : This is also called the concept of definite accounting period. As per
‘going concern’ concept an indefinite life of the entity is assumed. For a business entity it causes
inconvenience to measure performance achieved by the entity in the ordinary course of business.
If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as
financial position only at the end of its life.
So a small but workable fraction of time is chosen out of infinite life cycle of the business entity
for measuring performance and looking at the financial position. Generally one year period is
taken up for performance measurement and appraisal of financial position. However, it may
also be 6 months or 9 months or 15 months.
According to this concept accounts should be prepared after every period & not at the end of
the life of the entity. Usually this period is one calendar year. In India we follow from 1st April
of a year to 31st March of the immediately following year.
Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an
unduly long time-frame. This concept makes the accounting system workable and the term
‘accrual’ meaningful. If one thinks of indefinite time-frame, nothing will accrue. There cannot
be unpaid expenses and non-receipt of revenue. Accrued expenses or accrued revenue is only
with reference to a finite time-frame which is called accounting period.
Thus, the periodicity concept facilitates in :
(i) Comparing of financial statements of different periods
(ii) Uniform and consistent accounting treatment for ascertaining the profit and assets of the
business
(iii) Matching periodic revenues with expenses for getting correct results of the business
operations

FUNDAMENTALS OF ACCOUNTING 1.29


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

(d) Accrual concept : Under accrual concept, the effects of transactions and other events are
recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is
received or paid) and they are recorded in the accounting records and reported in the financial
statements of the periods to which they relate. Financial statements prepared on the accrual
basis inform users not only of past events involving the payment and receipt of cash but also of
obligations to pay cash in the future and of resources that represent cash to be received in the
future.
To understand accrual assumption knowledge of revenues and expenses is required. Revenue
is the gross inflow of cash, receivables and other consideration arising in the course of the
ordinary activities of an enterprise from sale of goods, from rendering services and from the
use by others of enterprise’s resources yeilding interest, royalties and dividends. For example,
(1) Mr. X started a cloth merchandising. He invested Rs. 50,000, bought merchandise worth
Rs. 50,000. He sold such merchandise for Rs. 60,000. Customers paid him Rs. 50,000 cash and
assure him to pay Rs. 10,000 shortly. His revenue is Rs. 60,000. It arose in the ordinary course
of cloth business; Mr. X received Rs. 50,000 in cash and Rs. 10,000 by way of receivables.
Take another example; (2) an electricity supply undertaking supplies electricity spending
Rs. 16,00,000 for fuel and wages and collects electricity bill in one month Rs. 20,00,000 by way
of electricity charges. This is also revenue which arose from rendering services.
Lastly, (3) Mr. A invested Rs. 1,00,000 in a business. He purchased a machine paying
Rs. 1,00,000. He hired it out for Rs. 20,000 annually to Mr. B. Rs. 20,000 is the revenue of Mr. A;
it arose from the use by others of the enterprise’s resources.
Expense is a cost relating to the operations of an accounting period or to the revenue earned
during the period or the benefits of which do not extend beyond that period.
In the first example, Mr. X spent Rs. 50,000 to buy the merchandise; it is the expense of generating
revenue of Rs. 60,000. In the second instance Rs. 16,00,000 are the expenses. Also whenever
any asset is used it has a finite life to generate benefit. Suppose, the machine purchased by
Mr. A in the third example will last for 10 years only. Then Rs. 10,000 is the expense he met.
For the time being, ignore the idea of accounting period.
Accrual means recognition of revenue and costs as they are earned or incurred and not as
money is received or paid. The accrual concept relates to measurement of income, identifying
assets and liabilities.
Example: Mr. J D buys clothing of Rs. 50,000 paying cash Rs. 20,000 and sells at Rs. 60,000 of
which customers paid only Rs. 50,000.
His revenue is Rs. 60,000, not Rs. 50,000 cash received. Expense (i.e., cost incurred for the
revenue) is Rs. 50,000, not Rs. 20,000 cash paid. So the accrual concept based profit is
Rs. 10,000 (Revenue – Expenses).
As per Accrual Concept : Revenue – Expenses = Profit
Accrual Concept provides the foundation on which the structure of present day accounting
has been developed.

1.30 COMMON PROFICIENCY TEST


Alternative as per Cash basis
Cash received in ordinary course of business – Cash paid in ordinary course of business =
profit.
Revenue may not be realised in cash. Cash may be received simultaneously or
(i) before revenues is created (A. 1)
(ii) after revenue is created (A. 2)
Expenses may not be paid in cash. Cash may be paid simultaneously or (i) before expense is
made (B. 1) (ii) after expense is made (B. 2)
A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Receivables
or Trade Debtors. B. 1 creates an asset called Trade Advance when cash is paid in advance
while B. 2 creates a liability called payables or Trade Creditors or outstanding liabilities. If the
expenses remain unpaid in respect of goods, it is called Trade creditors, if it remains unpaid for
other expenses, it is called Expense Creditors.
Accrual Concept provides the foundation on which the structure of present day accounting
has been developed.
(e) Matching concept : In this concept, all expenses matched with the revenue of that period
should only be taken into consideration. In the financial statements of the organization if any
revenue is recognized then expenses related to earn that revenue should also be recognized.
This concept is based on accrual concept as it considers the occurrence of expenses and income
and do not concentrate on actual inflow or outflow of cash. This leads to adjustment of certain
items like prepaid and outstanding expenses, unearned or accrued incomes.
It is not necessary that every expense identify every income. Some expenses are directly related
to the revenue and some are time bound. For example:- selling expenses are directly related to
sales but rent, salaries etc are recorded on accrual basis for a particular accounting period. In
other words periodicity concept has also been followed while applying matching concept.
Mr. P K started cloth business. He purchased 10,000 pcs. garments @ Rs. 100 per piece and
sold 8,000 pcs. @ Rs. 150 per piece during the accounting period of 12 months Ist January to
31st December, 2005. He paid shop rent @ Rs. 3,000 per month for 11 months and paid
Rs. 8,00,000 to the suppliers of garments and received Rs. 10,00,000 from the customers.
Let us see how the accrual and periodicity concepts operate.
Periodicity Concept fixes up the time-frame for which the performance is to be measured and
financial position is to be appraised. Here, it is January 2005-December, 2005. So revenues and
expenses are to be measured for the year 2005 and assets and liabilities are to be ascertained as
on 31st December, 2005.
Accrual Concept operates to measure revenue of Rs. 12,00,000 (arising out of sale of garments
8,000 Pcs × Rs. 150) which accrued during 2005, not the cash received Rs. 10,00,000 and also
the expenses correctly. Shop rent for 12 months is an expense item amounting to Rs. 36,000,
not Rs. 33,000 the cash paid.

FUNDAMENTALS OF ACCOUNTING 1.31


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

Should the accountant treat Rs. 10,00,000 as expenses for purchase of merchandise ? And
should he treat Rs. 1,64,000 as profit? (Revenue Rs. 12,00,000-Merchandise Rs. 10,00,000.
Shop Rent Rs. 36,000). Obviously the answer is No. Matching links revenue with expenses.
Revenue – Expenses = Profit
But this unqualified equation may create misconception. It should be defined as :
Periodic Profit = Periodic Revenue – Matched Expenses
From the revenue of an accounting period such expenses are deducted which are expended to
generate the revenue to determine profit of that period.
In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000
pcs of garments should be treated as expenses.
Thus, Profit = Revenue Rs. 12,00,000
Less : Expenses:
Merchandise Rs. 8,00,000
Shop Rent Rs. 36,000 Rs. 8,36,000
Rs. 3,64,000
Assets
Stock (2,000 pcs × Rs. 100) Rs. 2,00,000
Debtors Rs. 2,00,000
Cash (Cash Receipts Rs. 10,00,000 – cash payments Rs. 8,33,000) Rs. 1,67,000
Rs. 5,67,000
Liabilities :
Trade Creditors Rs. 2,00,000
Expense Creditors Rs. 3,000
Capital (for Profit) Rs. 3,64,000
Rs. 5,67,000
Thus, accrual, matching and periodicity concepts work together for income measurement and recognition
of assets and liabilities.
(f) Going Concern concept : The financial statements are normally prepared on the assumption
that an enterprise is a going concern and will continue in operation for the foreseeable future.
Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or
curtail materially the scale of its operations; if such an intention or need exists, the financial
statements may have to be prepared on a different basis and, if so, the basis used is disclosed.
The valuation of assets of a business entity is dependent on this assumption. Traditionally,
accountants follow historical cost in majority of the cases.

1.32 COMMON PROFICIENCY TEST


Suppose Mr. X purchased a machine for his business paying Rs. 5,00,000 out of Rs. 7,00,000
invested by him. He also paid transportation expenses and installation charges amounting to
Rs. 70,000. If he is still willing to continue the business, his financial position will be as follows:
Balance Sheet
Liability Rs. Assets Rs.
Capital 7,00,000 Machinery 5,70,000
Cash 1,30,000
7,00,000 7,00,000

Now if he decides to back out and desires to sell the machine, it may fetch more than or less
than Rs. 5,70,000. So his financial position should be different. If going concern concept is
taken, increase/decrease in the value of assets in the short-run is ignored. The concept indicates
that assets are kept for generating benefit in future, not for immediate sale; current change in
the asset value is not realisable and so it should not be counted.
(g) Cost concept : By this concept, the value of an asset is to be determined on the basis of
historical cost, in other words, acquisition cost. Although there are various measurement bases,
accountants traditionally prefer this concept in the interests of objectivity. When a machine is
acquired by paying Rs. 5,00,000, following cost concept the value of the machine is taken as
Rs. 5,00,000. It is highly objective and free from all bias. Other measurement bases are not so
objective. Current cost of an asset is not easily determinable. If the asset is purchased on 1.1.82
and such model is not available in the market, it becomes difficult to determine which model is
the appropriate equivalent to the existing one. Similarly, unless the machine is actually sold,
realisable value will give only a hypothetical figure. Lastly, present value base is highly subjective
because to know the value of the asset one has to chase the uncertain future.
However, the cost concept creates a lot of distortion too as outlined below :
(a) In an inflationary situation when prices of all commodities go up on an average, acquisition
cost loses its relevance. For example, a piece of land purchased on 1.1.82 for Rs. 2,000
may cost Rs. 1,00,000 as on 1.1.2006. So if the accountant makes valuation of asset at
historical cost, the accounts will not reflect the true position.
(b) Historical cost-based accounts may lose comparability. Mr. X invested Rs. 1,00,000 in a
machine on 1.1.82 which produces Rs. 50,000 cash inflow during the year 2006, while
Mr. Y invested Rs. 5,00,000 in a machine on 1.1.92 which produced Rs. 50,000 cash inflows
during the year. Mr. X earned at the rate 20% while Mr. Y earned at the rate 10%. Who is
more-efficient ? Since the assets are recorded at the historical cost, the results are not
comparable. Obviously it is a corollary to (a).
(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example.
The cost concept fails to recognise such asset although it is a very important asset of any
organization.
Many other controversial issues have arisen in financial accounting that revolves around the
cost concept which will be discussed at the advanced stage. However, later on we shall see

FUNDAMENTALS OF ACCOUNTING 1.33


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

that in many circumstances, the cost convention is not followed. See conservatism concept for
an example, which will be discussed later on in this unit.
(h) Realisation concept : It closely follows the cost concept. Any change in value of an asset is
to be recorded only when the business realises it. When an asset is recorded at its historical cost
of Rs. 5,00,000 and even if its current cost is Rs. 15,00,000 such change is not counted unless
there is certainty that such change will materialise.
However, accountants follow a more conservative path. They try to cover all probable losses
but do not count any probable gain. That is to say, if accountants anticipate decrease in value
they count it, but if there is increase in value they ignore it until it is realised. Economists are
highly critical about the realisation concept. According to them, this concept creates value
distortion and makes accounting meaningless.
Example : Mr. X purchased a piece of land on 1.1.82 paying Rs. 2000. Its current market value
is Rs. 1,02,000 on 31.12.2006. Should the accountant show the land at Rs. 2000 following cost
concept and ignoring Rs. 1,00,000 value increase since it is not realised ? If he does so, the
financial position would be :
Balance Sheet
Liability Rs. Assets Rs.
Capital 2,000 Land 2,000
2,000 2,000

Is it not proper to show it in the following manner?

Balance Sheet
Liabilities Rs. Asset Rs.
Capital 2,000 Land 1,02,000
Unrealised Gain 1,00,000
1,02,000 1,02,000

Now-a-days the revaluation of assets has become a widely accepted practice when the change
in value is of permanent nature. Accountants adjust such value change through creation of
capital reserve.
Thus the going concern, cost concept and realization concept gives the valuation criteria.
(i) Dual aspect concept : This concept is the core of double entry book-keeping. Every
transaction or event has two aspects:
(1) It increases one Asset and decreases other Asset;
(2) It increases an Asset and simultaneously increases Liability;
(3) It decreases one Asset, increases another Asset;
(4) It decreases one Asset, decreases a Liability.

1.34 COMMON PROFICIENCY TEST


Alternatively:
(5) It increases one Liability, decreases other Liability;
(6) It increases a Liability, increases an Asset;
(7) It decreases Liability, increases other Liability;
(8) It decreases Liability, decreases an Asset.
Example :
Balance Sheet
Liabilities Rs. Asset Rs.
Capital 1,50,000 Machinery 2,00,000
Bank Loan 75,000 Cash 1,00,000
Other Loan 75,000
3,00,000 3,00,000

Transactions :
(a) A new machine is purchased paying Rs. 50,000 in cash
(b) A new machine is purchased for Rs. 50,000 on credit, cash is to be paid later on
(c) Cash paid to repay bank loan to the extent of Rs. 50,000
(d) Raised bank loan of Rs. 50,000 to pay off other loan
Effect of the Transactions :
(a) Increase in machine value and decrease in cash balance by Rs. 50,000.
Balance Sheet (1 & 3)
Liabilities Rs. Assets Rs.
Capital 1,50,000 Machinery 2,50,000
Bank Loan 75,000 Cash 50,000
Other Loan 75,000
3,00,000 3,00,000
(b) Increase in machine value and increase in creditors by Rs. 50,000.
Balance Sheet (2 & 6)
Liabilities Rs. Assets Rs.
Capital 1,50,000 Machinery 2,50,000
Creditors for machinery 50,000 Cash 1,00,000
Bank Loan 75,000
Other Loan 75,000
3,50,000 3,50,000

FUNDAMENTALS OF ACCOUNTING 1.35


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

(c) Decrease in bank loan and decrease in cash by Rs. 50,000:


Balance Sheet (4 & 8)
Liabilities Rs. Assets Rs.
Capital 1,50,000 Machinery 2,00,000
Bank Loan 25,000 Cash 50,000
Other Loan 75,000
2,50,000 2,50,000

(d) Increase in bank loan and decrease in other loan by Rs. 50,000:
Balance Sheet (5 & 7)
Liabilities Rs. Assets Rs.
Capital 1,50,000 Machinery 2,00,000
Bank Loan 1,25,000 Cash 1,00,000
Other Loan 25,000
3,00,000 3,00,000

So every transaction and event has two aspects.


This gives basic accounting equation :
Equity (E) + Liabilities (L) = Assets (A)
or
Equity (E)= Assets (A) – Liabilities(L)
Or, Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets
Or, Equity + Long Term Liabilities = Fixed Assets + (Current Assets – Current Liabilities)
Or, Equity = Fixed Assets + Working Capital – Long Term Liabilities
Whatever is received as funds is either expended (Expenses) – Debited to Profit & Loss Account
Or Lost – Losses are transferred to Capital Account
Or saved – Shown on the Assets side of the Balance Sheet
Therefore, Capital + Income/Profits + Liabilities = Expenses + Net Loss + Assets
Or, Capital + Income – Expenses + Net Profits = Assets – Liabilities
Since the net profit / loss is transferred to equity, the net effect is
Equity + Liabilities = Assets

1.36 COMMON PROFICIENCY TEST


Illustration :
Develop the accounting equation from the following information: -

April 01, 2005 March 31, 2006


Particulars Rs. Rs.
Capital 1,00,000 ?
12% Bank Loan 1,00,000 1,00,000
Creditors 75,000 70,000
Fixed Assets 1,25,000 1,10,000
Debtors 75,000 80,000
Stock 70,000 80,000
Cash & Bank 5,000 6,000

Find the profit for the year & the Balance sheet as on 31/3/06.
Solution :
For the year ended April 01, 2005 :
Equity = Capital Rs. 1,00,000
Liabilities = Bank Loan + Creditors
Rs. 1,00,000 + Rs. 75,000 = Rs. 1,75,000
Assets = Fixed Assets + Debtors + Stock + Cash & Bank
Rs. 1,25,000 + Rs. 75,000 + Rs. 70,000 + Rs. 5,000 = Rs. 2,75,000
Equity + Liabilities = Assets
Rs. 1,00,000 + Rs. 1,75,000 = 2,75,000

For the year ended April 01, 2006 :


Assets = Rs. 1,10,000 + Rs. 80,000 + Rs. 80,000 + Rs. 6,000 = Rs. 2,76,000
Liabilities = Rs. 1,00,000 + Rs. 70,000 = Rs. 1,70,000
Equity = Assets - Liabilities = Rs. 2,76,000 – Rs. 1,70,000 = Rs. 1,06,000
Profits = New Equity - Old Equity = Rs. 1,06,000 – Rs. 1,00,000 = Rs. 6,000
(j) Conservatism : Conservatism states that the accountant should not anticipate income
and should provide for all possible losses. When there are many alternative values of an asset,
an accountant should choose the method which leads to the lesser value. Later on we shall see
that the golden rule of current assets valuation - ‘cost or market price’ whichever is lower
originated from this concept.

FUNDAMENTALS OF ACCOUNTING 1.37


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

The Realisation Concept also states that no change should be counted unless it has materialised.
The Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain
but it is desirable to guard against all possible losses.
For this concept there should be atleast three qualitative characteristics of financial statements,
namely,
(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as well
as gains which are uncertain.
(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as
well as to exclude uncertain gains,
(iii) Faithful representation of alternative values.
Many accounting authors, however, are of the view that conservatism essentially leads to
understatement of income and wealth and it should not be the basis for the preparation of
financial statements.
(k) Consistency : In order to achieve comparability of the financial statements of an enterprise
through time, the accounting policies are followed consistently from one period to another; a
change in an accounting policy is made only in certain exceptional circumstances.
The concept of consistency is applied particularly when alternative methods of accounting are
equally acceptable. For example a company may adopt any of several methods of depreciation
such as written-down-value method, straight-line method, etc. Likewise there are many methods
for valuation of stocks-in-hand. But following the principle of consistency it is advisable that
the company should follow consistently over years the same method of depreciation or the
same method of valuation of stocks which is chosen. However in some cases though there is no
inconsistency, they may seem to be inconsistent apparently. In case of valuation of stocks if the
company applies the principle ‘at cost or market price whichever is lower’ and if this principle
accordingly results in the valuation of stock in one year at cost price and the market price in
the other year, there is no inconsistency here. It is only an application of the principle.
But the concept of consistency does not imply non-flexibility as not to allow the introduction of
improved method of accounting.
An enterprise should change its accounting policy in any of the following circumstances only:
a. To bring the books of accounts in accordance with the issued Accounting Standards.
b. To compliance with the provision of law.
c. When under changed circumstances it is felt that new method will reflect more true and
fair picture in the financial statement.
(l) Materiality: Materiality principle permits other concepts to be ignored, if the effect is not
considered material. This principle is an exception of full disclosure principle. According to
materiality principle, all the items having significant economic effect on the business of the
enterprise should be disclosed in the financial statements and any insignificant item which
will only increase the work of the accountant but will not be relevant to the users’ need should
not be disclosed in the financial statements.

1.38 COMMON PROFICIENCY TEST


The term materiality is the subjective term. It is on the judgement, common sense and discretion
of the accountant that which item is material and which is not. For example stationary
purchased by the organization though not used fully in the accounting year purchased still
shown as an expense of that year because of the materiality concept. Similarly depreciation on
small items like books, calculators etc. is taken as 100% in the year of purchase though used by
the company for more than a year. This is because the amount of books or calculator is very
small to be shown in the balance sheet though it is the asset of the company.
The materiality depends not only upon the amount of the item but also upon the size of the
business, nature and level of information, level of the person making the decision etc. Moreover
an item material to one person may be immaterial to another person. What is important is that
omission of any information should not impair the decision-making of various users.

6. FUNDAMENTAL ACCOUNTING ASSUMPTIONS


There are three fundamental accounting assumptions :
(i) Going Concern
(ii) Consistency
(iii) Accrual
All the above three fundamental accounting assumptions have already been explained in this
unit.
If nothing has been written about the fundamental accounting assumption in the financial
statements then it is assumed that they have already been followed in their preparation of
financial statements. However, if any of the above mentioned fundamental accounting
assumption is not followed then this fact should be specifically disclosed.

7. FINANCIAL STATEMENTS
The aim of accounting is to keep systematic records to ascertain financial performance and
financial position of an entity and to communicate the relevant financial information to the
interested user groups. The financial statements are basic means through which the management
of an entity makes public communication of the financial information along with selected
quantitative details. They are structured financial representations of the financial position and
the performance of an enterprise. To have a record of all business transactions and also to
determine whether all these transactions resulted in either ‘profit or loss’ for the period, all the
entities will prepare financial statements viz., balance sheet, profit and loss account, cash flow
statement etc. by following various accounting concepts, principles, and conventions which
have been already discussed in detail in para 5.
7.1 QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS
Qualitative characteristics are the attributes that make the information provided in financial
statements useful to users. The following are the important qualitative characteristics of the
financial statements:
1. Understandability : An essential quality of the information provided in financial statements
is that it must be readily understandable by users. For this purpose, it is assumed that

FUNDAMENTALS OF ACCOUNTING 1.39


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

users have a reasonable knowledge of business and economic activities and accounting
and study the information with reasonable diligence. Information about complex matters
that should be included in the financial statements because of its relevance to the economic
decision-making needs of users should not be excluded merely on the ground that it may
be too difficult for certain users to understand.
2. Relevance : To be useful, information must be relevant to the decision-making needs of
users. Information has the quality of relevance when it influences the economic decisions
of users by helping them evaluate past, present or future events or confirming, or correcting,
their past evaluations.
The predictive and confirmatory roles of information are interrelated. For example,
information about the current level and structure of asset holdings has value to users
when they endeavour to predict the ability of the enterprise to take advantage of
opportunities and its ability to react to adverse situations. The same information plays a
confirmatory role in respect of past predictions about, for example, the way in which the
enterprise would be structured or the outcome of planned operations.
Information about financial position and past performance is frequently used as the basis
for predicting future financial position and performance and other matters in which users
are directly interested, such as dividend and wage payments, share price movements and
the ability of the enterprise to meet its commitments as they fall due. To have predictive
value, information need not be in the form of an explicit forecast. The ability to make
predictions from financial statements is enhanced, however, by the manner in which
information on past transactions and events is displayed. For example, the predictive value
of the statement of profit and loss is enhanced if unusual, abnormal and infrequent items
of income and expense are separately disclosed.
3. Reliability : To be useful, information must also be reliable, Information has the quality of
reliability when it is free from material error and bias and can be depended upon by users
to represent faithfully that which it either purports to represent or could reasonably be
expected to represent.
Information may be relevant but so unreliable in nature or representation that its recognition
may be potentially misleading. For example, if the validity and amount of a claim for
damages under a legal action against the enterprise are highly uncertain, it may be
inappropriate for the enterprise to recognise the amount of the claim in the balance sheet,
although it may be appropriate to disclose the amount and circumstances of the claim.
4. Comparability : Users must be able to compare the financial statements of an enterprise
through time in order to identify trends in its financial position, performance and cash
flows. Users must also be able to compare the financial statements of different enterprises
in order to evaluate their relative financial position, performance and cash flows. Hence,
the measurement and display of the financial effects of like transactions and other events
must be carried out in a consistent way throughout an enterprise and over time for that
enterprise and in a consistent way for different enterprises.
An important implication of the qualitative characteristic of comparability is that users be
informed of the accounting policies employed in the preparation of the financial statements,

1.40 COMMON PROFICIENCY TEST


any changes in those polices and the effects of such changes. Users need to be able to
identify differences between the accounting policies for like transactions and other events
used by the same enterprise from period to period and by different enterprises. Compliance
with Accounting Standards, including the disclosure of the accounting policies used by
the enterprise, helps to achieve comparability.
The need for comparability should not be confused with mere uniformity and should not
be allowed to become an impediment to the introduction of improved accounting standards.
It is not appropriate for an enterprise to continue accounting in the same manner for a
transaction or other event if the policy adopted is not in keeping with the qualitative
characteristics of relevance and reliability. It is also inappropriate for an enterprise to
leave its accounting policies unchanged when more relevant and reliable alternatives exist.
Users wish to compare the financial position, performance and cash flows of an enterprise
over time. Hence, it is important that the financial statements show corresponding
information for the preceding period(s).
The four principal qualitative characteristics are understandability, relevance, reliability
and comparability.
5. Materiality : The relevance of information is affected by its materiality. Information is
material if its misstatement (i.e., omission or erroneous statement) could influence the
economic decisions of users taken on the basis of the financial information. Materiality
depends on the size and nature of the item or error, judged in the particular circumstances
of its misstatement. Materiality provides a threshold or cut-off point rather than being a
primary qualitative characteristic which the information must have if it is to be useful.
6. Faithful Representation : To be reliable, information must represent faithfully the
transactions and other events it either purports to represent or could reasonably be expected
to represent. Thus, for example, a balance sheet should represent faithfully the transactions
and other events that result in assets, liabilities and equity of the enterprise at the reporting
date which meet the recognition criteria.
Most financial information is subject to some risk of being less than a faithful representation
of that which it purports to portray. This is not due to bias, but rather to inherent difficulties
either in identifying the transactions and other events to be measured or in devising and
applying measurement and presentation techniques that can convey messages that
correspond with those transactions and events. In certain cases, the measurement of the
financial effects of items could be so uncertain that enterprises generally would not recognise
them in the financial statements; for example, although most enterprises generate goodwill
internally over time, it is usually difficult to identify or measure that goodwill reliably. In
other cases, however, it may be relevant to recognise items and to disclose the risk of error
surrounding their recognition and measurement.
7. 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 their substance and economic reality and not merely their legal form.
The substance of transactions or other events is not always consistent with that which is
apparent from their legal or contrived form. For example, where rights and beneficial

FUNDAMENTALS OF ACCOUNTING 1.41


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

interest in an immovable property are transferred but the documentations and legal
formalities are pending, the recording of acquisition/disposal (by the transferee and
transferor respectively) would in substance represent the transaction entered into.
8. Neutrality : To be reliable, the information contained in financial statements must be
neutral, that is, free from bias. Financial statements are not neutral if, by the selection or
presentation of information, they influence the making of a decision or judgement in order
to achieve a predetermined result or outcome.
9. Prudence : The preparers of financial statements have to contend with the uncertainties
that inevitably surround many events and circumstances, such as the collectability of
receivables, the probable useful life of plant and machinery, and the warranty claims that
may occur. Such uncertainties are recognised by the disclosure of their nature and extent
and by the exercise of prudence in the preparation of the financial statements. Prudence is
the inclusion of a degree of caution in the exercise of the judgments needed in making the
estimates required under conditions of uncertainty, such that assets or income are not
overstated and liabilities or expenses are not understated. However, the exercise of prudence
does not allow, for example, the creation of hidden reserves or excessive provisions, the
deliberate understatement of assets or income, or the deliberate overstatement of liabilities
or expenses, because the financial statements would then not be neutral and, therefore,
not have the quality of reliability.
10. Full, fair and adequate disclosure : The financial statement must disclose all the reliable
and relevant information about the business enterprise to the management and also to
their external users for which they are meant, which in turn will help them to take a
reasonable and rational decision. For it, it is necessary that financial statements are prepared
in conformity with generally accepted accounting principles i.e the information is accounted
for and presented in accordance with its substance and economic reality and not merely
with its legal form. The disclosure should be full and final so that users can correctly
assess the financial position of the enterprise.
The principle of full disclosure implies that nothing should be omitted while principle of
fair disclosure implies that all the transactions recorded should be accounted in a manner
that financial statement purports true and fair view of the results of the business of the
enterprise and adequate disclosure implies that the information influencing the decision
of the users should be disclosed in detail and should make sense.
This principle is widely used in corporate organizations because of separation in
management and ownership. The Companies Act, 1956 in pursuant of this principle has
came out with the format of balance sheet and profit and loss account. The disclosures of
all the major accounting policies and other information are to be provided in the form of
footnotes, annexes etc. The practice of appending notes to the financial statements is the
outcome of this principle.
11. Completeness : To be reliable, the information in financial statements must be complete
within the bounds of materiality and cost. An omission can cause information to be false
or misleading and thus unreliable and deficient in terms of its relevance.

1.42 COMMON PROFICIENCY TEST


Thus, if accounting information is to present faithfully the transactions and other events
that it purports to represent, it is necessary that they are accounted for and presented in
accordance with their substance and economic reality, not by their legal form. For example,
if a business enterprise sells its assets to others but still uses the assets as usual for the
purpose of the business by making some arrangement with the seller, it simply becomes a
legal transaction. The economic reality is that the business is using the assets as usual for
deriving the benefit. Financial statement information should contain the substance of this
transaction and should not only record going by legality. In order to be reliable the financial
statements information should be neutral i.e., free from bias. The preparers of financial
statements however, have to contend with the uncertainties that inevitably surround many
events and circumstances, such as the collectability of doubtful receivables, the probable
useful life of plant and equipment and the number of warranty claims that many occur.
Such uncertainties are recognised by the disclosure of their nature and extent and by
exercise of prudence in the preparation of financial statements. Prudence is the inclusion
of a degree of caution in the exercise of judgement needed in making the estimates required
under condition of uncertainty such that assets and income are not overstated and loss
and liability are not understated.

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES :
1. (i) All the following items are classified as fundamental accounting assumptions except
(a) Consistency. (b) Business entity. (c) Going concern. (d) accrual.
(ii) Two primary qualitative characteristics of financial statements are
(a) Understandability and materiality. (b) Relevance and reliability.
(c) Relevance and understandability. (d) Materiality and reliability
(iii) Kanika Enterprises follows the written down value method of depreciating machinery
year after year due to
(a) Comparability (b) Convenience. (c) Consistency. (d) All of the above.
(iv) A purchased a car for Rs.5,00,000, making a down payment of Rs.1,00,000 and signing
a Rs.4,00,000 bill payable due in 60 days. As a result of this transaction
(a) Total assets increased by Rs.5,00,000.
(b) Total liabilities increased by Rs.4,00,000.
(c) Total assets increased by Rs.4,00,000.
(d) Total assets increased by Rs.4,00,000 with corresponding increase in liabilities
by Rs.4,00,000.
(v) Mohan purchased goods for Rs.15,00,000 and sold 4/5th of the goods amounting
Rs.18,00,000 and met expenses amounting Rs.2,50,000 during the year, 2005. He
counted net profit as Rs.3,50,000. Which of the accounting concept was followed by
him?
(a) Entity. (b) Periodicity. (c) Matching. (d) Conservatism.

FUNDAMENTALS OF ACCOUNTING 1.43


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

(vi) A businessman purchased goods for Rs.25,00,000 and sold 80% of such goods during
the accounting year ended 31st March, 2005. The market value of the remaining goods
was Rs.4,00,000. He valued the closing stock at cost. He violated the concept of
(a) Money measurement. (b) Conservatism.
(c) Cost. (d) Periodicity.
(vii) Capital brought in by the proprietor is an example of
(a) Increase in asset and increase in liability.
(b) Increase in liability and decrease in asset.
(c) Increase in asset and decrease in liability.
(d) Increase in one asset and decrease in another asset.
[Ans. 1. (i) (b), (ii) (b), (iii) (c), (iv) (d), (v) (c), (vi) (b), (vii) (a)]
2. (i) Assets are held in the business for the purpose of
(a) Resale. (b) Conversion into cash.
(c) Earning revenue. (d) None of the above.
(ii) Revenue from sale of products, is generally, realized in the period in which
(a) Cash is collected. (b) Sale is made.
(c) Products are manufactured. (d) None of the above.
(iii) The concept of conservatism when applied to the balance sheet results in
(a) Understatement of assets. (b) Overstatement of assets.
(c) Overstatement of capital. (d) Understatement of capital.
(iv) Decrease in the amount of creditors results in
(a) Increase in cash. (b) Decrease in cash.
(c) Increase in assets. (d) No change in assets.
(v) The determination of expenses for an accounting period is based on the principle of
(a) Objectivity. (b) Materiality. (c) Matching. (d) Periodicity.
(vi) The ‘going concern concept’ is the underlying basis for
(a) Stating fixed assets at their realizable values.
(b) Disclosing the market value of securities.
(c) Disclosing the sales and other operating information in the income statement.
(d) None of the above.
(vii) Economic life of an enterprise is split into the periodic interval as per
(a) Periodicity. (b) Matching. (c) Going concern. (d) Accrual.
[Ans. 2.(i) (c),(ii) (b), (iii) (a), (iv) (b), (v) (c), (vi) (a), (vii) (c)

1.44 COMMON PROFICIENCY TEST


3. (i) If an individual asset is increased, there will be a corresponding
(a) Increase of another asset or increase of capital.
(b) Decrease of another asset or increase of liability.
(c) Decrease of specific liability or decrease of capital.
(d) Increase of drawings and liability.
(ii) Purchase of machinery for cash
(a) Decreases total assets. (b) Increases total assets.
(c) Retains total assets unchanged. (d) Decreases total liabilities.
(iii) Consider the following data pertaining to Alpha Ltd.:
Particulars Rs.
Cost of machinery purchased on 1 April, 2005
st
10,00,000
Installation charges 1,00,000
Market value as on 31 March,2006
st
12,00,000
While finalizing the annual accounts, if the company values the machinery
At Rs. 12,00,000. Which of the following concepts is violated by the Alpha Ltd.?
(a) Cost (b) Matching. (c) Realisation. (d) Periodicity.
[Ans. 3.(i) (b), (ii) (c), (iii) (a)]
II. Match the following items from column A with column B
S. No. Column A Column B
1. Entity concept assumptions. (a) Are the fundamental accounting
2. Accrual concept (b) Gives the valuation criteria.
3. Going concern, consistency and (c) Is the basic accounting concept.
accrual
4. Going concern, cost and realization (d) Is the procedural accounting concept.
concept
[Ans : 1(c), 2(d), 3(a), 4(b)]
S. No. Concepts Statements
1. Consistency (a) Affairs of business are distinguished
from personal affairs of the proprietor.
2. Money measurement (b) Accounting policies are not changed
frequently.
3. Entity (c) Anticipated income should not be
recognized in the financial statements.
4. Conservatism (d) Loyalty of the management team is not
disclosed in the financial statements.
[Ans : 1(b), 2(d), 3(a), 4(c)]

FUNDAMENTALS OF ACCOUNTING 1.45


ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

S. No. Concepts Statements


1. Accrual (a) Advance received from the suppliers is not taken as income
or sale.
2. Going concern (b) Value of an asset is determined on the basis of the
acquisition cost.
3. Matching (c) Provision is made for the amount outstanding for the
electricity consumed during the accounting period.
4. Cost (d) Fixed assets are kept in the business for generating benefits
in the future and not for immediate sale.
[Ans : 1(c), 2(d), 3(e), 4(b)]
III.
A proprietor, Mr. A has reported a profit of Rs. 1,25,000 at the end of the financial year after
taking into consideration the following amount:
(i) The cost of an asset of Rs. 25,000 has been taken as en expense.
(ii) Mr. A is anticipating a profit of Rs. 10,000 on the future sale of a car shown as an asset in
his books.
(iii) Salary of Rs. 7,000 payable in the financial year has not been taken into account.
(iv) Mr. A purchased an asset for Rs. 75,000 but its fair value on the date of purchase was
Rs. 85,000. Mr. A recorded the value of asset in his books by Rs. 85,000.
On the basis of the above facts answer the following questions from the given choices:
(i) What is the correct amount of profit to be reported in the books?
(a) Rs. 1,25,000, (b) Rs. 1,35,000, (c) Rs. 1,50,000, (d) Rs. 1,33,000,
(ii) Which measurement base should be followed in the statement (iv)?
(a) Historical cost, (b) Current cost (c) Replacement cost (d) Present value
(iii) Which concept should be followed in the statement (ii)?
(a) Conservatism, (b) Materiality, (c) Historical cost, (d) Accrual,
(iv) Which concept should be followed in the statement (iii)?
(a) Materiality, (b) Historical cost, (c) Current cost, (d) Accrual,
[Ans. (i)-(d), (ii)-(a), (iii)-(b), (iv)- (d),]

1.46 COMMON PROFICIENCY TEST


CHAPTER - 1

ACCOUNTING :
AN
INTRODUCTION

Unit 3

Accounting
Standards-
Concepts,
Objectives, Benefits
ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS

Learning objectives
After studying this unit you will be able to :
 Understand the Concept of Accounting Standards.
 Grasp the objectives, benefits and limitations of Accounting Standards.
 Learn the system of evolution of Accounting Standards by the Council of the Institute
of Chartered Accountants of India.
 Familiarise with the brief overview of Accounting Standards in India.

(Note : The text of the Accounting Standards does not form part of the CPT curriculum. An overview
of Accounting Standards has been given here for knowledge of the students only. The full text of all
Accounting Standards will be dealt with in later stages of the Chartered Accountancy Course).

1. INTRODUCTION
Accounting as a ‘language of business’ communicates the financial results of an enterprise to
various stakeholders by means of financial statements. If the financial accounting process is
not properly regulated, there is possibility of financial statements being misleading, tendentious
and providing a distorted picture of the business, rather than the true state of affairs. In order
to ensure transparency, consistency, comparability, adequacy and reliability of financial
reporting, it is essential to standardise the accounting principles and policies. Accounting
Standards (ASs) provide framework and standard accounting policies so that the financial
statements of different enterprises become comparable.

2. CONCEPTS
Accounting standards are written policy documents issued by expert accounting body or by
government or other regulatory body covering the aspects of recognition, treatment,
measurement, presentation and disclosure of accounting transactions and events in the financial
statements. The ostensible purpose of the standard setting bodies is to promote the dissemination
of timely and useful financial information to investors and certain other parties having an
interest in the company’s economic performance. The accounting standards deal with the
issues of-
(i) recognition of events and transactions in the financial statements;
(ii) measurement of these transactions and events;
(iii) presentation of these transactions and events in the financial statements in a manner that
is meaningful and understandable to the reader; and
(iv) the disclosure requirements which should be there to enable the public at large and the
stakeholders and the potential investors in particular, to get an insight into what these
financial statements are trying to reflect and thereby facilitating them to take prudent and
informed business decisions.

1.48 COMMON PROFICIENCY TEST


3. OBJECTIVES
The whole idea of accounting standards is centered around harmonisation of accounting policies
and practices followed by different business entities so that the diverse accounting practices
adopted for various aspects of accounting can be standardised. Accounting Standards
standardise diverse accounting policies with a view to:
(i) eliminate the non-comparability of financial statements and thereby improving the
reliability of financial statements; and
(ii) provide a set of standard accounting policies, valuation norms and disclosure requirements.
Accounting standards reduce the accounting alternatives in the preparation of financial
statements within the bounds of rationality, thereby ensuring comparability of financial
statements of different enterprises.

4. BENEFITS AND LIMITATIONS


Accounting standards seek to describe the accounting principles, the valuation techniques
and the methods of applying the accounting principles in the preparation and presentation of
financial statements so that they may give a true and fair view. By setting the accounting
standards, the accountant has following benefits:
(i) Standards reduce to a reasonable extent or eliminate altogether confusing variations in
the accounting treatments used to prepare financial statements.
(ii) There are certain areas where important information are not statutorily required to be
disclosed. Standards may call for disclosure beyond that required by law.
(iii) The application of accounting standards would, to a limited extent, facilitate comparison
of financial statements of companies situated in different parts of the world and also of
different companies situated in the same country. However, it should be noted in this
respect that differences in the institutions, traditions and legal systems from one country
to another give rise to differences in accounting standards adopted in different countries.
However, there are some limitations of setting of accounting standards:
(i) Alternative solutions to certain accounting problems may each have arguments to
recommend them. Therefore, the choice between different alternative accounting
treatments may become difficult.
(ii) There may be a trend towards rigidity and away from flexibility in applying the accounting
standards.
(iii) Accounting standards cannot override the statute. The standards are required to be framed
within the ambit of prevailing statutes.

5. OVERVIEW OF ACCOUNTING STANDARDS IN INDIA


In India, the Institute of Chartered Accountants of India (ICAI), being a premier accounting
body in the country, took upon itself the leadership role by constituting the Accounting
Standards Board (ASB) on 21st April, 1977. The main function of ASB is to formulate accounting
standards so that such standards may be established in India by the council of the ICAI. The
council of the Institute of Chartered Accountants of India has, so far, issued thirty one

FUNDAMENTALS OF ACCOUNTING 1.49


ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS

Accounting Standards. However, AS 8 on ‘Accounting for Research and Development’ has


been withdrawn consequent to the issuance of AS 26 on ‘Intangible Assets’. Thus effectively,
there are 30 Accounting Standards at present. The ‘Accounting Standards’ issued by the
Accounting Standards Board establish standards which have to be complied by the business
entities so that the financial statements are prepared in accordance with generally accepted
accounting principles.
Following is the list of Accounting Standards with their respective date of applicability.
List of Accounting Standards
Sl. Number of the TITLE OF THE ACCOUNTING STANDARD
No. Accounting
Standard (AS)
1. AS 1 Disclosure of Accounting Policies
2. AS 2 (Revised) Valuation of Inventories
3. AS 3 (Revised) Cash Flow Statements
4. AS 4 (Revised) Contingencies and Events Occurring after the Balance Sheet
Date
5. AS 5 (Revised) Net Profit or Loss for the Period, Prior Period Items and
Changes in Accounting Policies
6. AS 6 (Revised) Depreciation Accounting
7. AS 7 (Revised) Accounting for Construction Contracts
8. AS 8 (withdrawn Accounting for Research and Development
pursuant to AS 26
becoming mandatory)
9. AS 9 Revenue Recognition
10. AS 10 Accounting for Fixed Assets
11. AS 11 (Revised) The Effects of Changes in Foreign Exchange Rates
12. AS 12 Accounting for Government Grants
13. AS 13 Accounting for Investments
14. AS 14 Accounting for Amalgamations
15. AS 15 (Revised) Employee Benefits
16. AS 16 Borrowing Costs
17. AS 17 Segment Reporting
18. AS 18 Related Party Disclosures
19. AS 19 Leases
20. AS 20 Earnings Per Share
21. AS 21 Consolidated Financial Statements
22. AS 22 Accounting for Taxes on Income

1.50 COMMON PROFICIENCY TEST


Sl. Number of the TITLE OF THE ACCOUNTING STANDARD
No. Accounting
Standard (AS)
23. AS 23 Accounting for Investments in Associates in Consolidated
Financial Statements
24. AS 24 Discontinuing Operations
25. AS 25 Interim Financial Reporting
26. AS 26 Intangible Assets
27. AS 27 Financial Reporting of Interests in Joint Ventures
28. AS 28 Impairment of Assets
29 AS 29 Provisions, Contingent Liabilities & Contingent Assets
30. AS 30 Financial Instruments: Recognition & Measurement
31. AS 31 Financial Instruments: Presentation
A brief overview of the above mentioned accounting standards is given below:
AS 1 Disclosure of Accounting Policies (Issued 1979)
This Standard is related with presentation/disclosure requirements of the significant accounting
policies (specific accounting policies and the methods of applying those principles) followed in
preparing financial statements. The true and fair state of affairs and the financial results of an
entity is significantly affected by the accounting policies followed in accounting. The areas in
which different accounting policies can be followed are accounting for depreciation, revaluation
of inventories, valuation of fixed assets etc. The disclosure of the significant accounting policies
should form part of the financial statement and any change in the accounting policies which
has a material effect in the current period or which is reasonably expected to have a material
effect in the later periods should be disclosed. If any of the fundamental accounting assumptions
viz. going concern, consistency and accrual is not followed in financial statements, the fact
should be specifically disclosed.
AS 2 Valuation of Inventories (Revised 1999)
AS 2 is a measurement related standard and specifies the methods of computation of cost of
inventories and the method of determination of the value of inventory to be shown in the
financial statements. As per the standard, the cost of inventories should comprise costs of
purchase, costs of conversion and other costs incurred in bringing the inventories to their
present location and condition. Inventory is valued by following conservatism principle i.e., at
lower of the cost or the market price. With a view to bring about uniformity in inventory
valuation practices, the revised AS 2 drastically reduces the alternative choices. The revised
standard permits the use of only FIFO or weighted average cost formula for determining the
cost of inventories where the specific identification of cost of inventories is not possible. The
standard also dispenses with the direct costing method and permits only the absorption costing
method for arriving at the cost of finished goods.
AS 3 Cash Flow Statements (Revised 1997)
This standard deals with the provision of information about the historical changes in cash and
cash equivalents of an enterprise by means of a cash flow statement which classifies cash flows
FUNDAMENTALS OF ACCOUNTING 1.51
ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS

during the period into operating, investing and financing activities. The cash flow statement is
an important part of financial statement and helps in assessing the ability of the enterprise to
generate cash and cash equivalents and enables users to develop models to assess and compare
the present value of future cash flows of different enterprises. The requirement of presentation
of cash flow statement would force the management to strive to improve the actual cash flows
rather than the profits, which is ultimate goal of any business entity.
AS 4 Contingencies and Events occurring after the Balance Sheet date (Revised 1995)
Pursuant to AS 29 ‘Provisions, Contingent Liabilities and Contingent Assets, becoming
mandatory in respect of accounting periods commencing on or after 1st April, 2004, all
paragraphs of AS 4 dealing with contingencies stand withdrawn except to the extent they
deal with impairment of assets not covered by any other Indian AS. The project of revision of
this standard by ASB in the light of newly issued AS 29 is under progress. Thus, the present
standard (AS 4) deals with the treatment and disclosure requirements in the financial statements
of events occurring after the balance sheet. Events occurring after the balance sheet date are
those significant events (favourable as well as unfavourable) that occur between the balance
sheet date and the date on which financial statements are approved by the approving authority
(i.e. board of directors in case of a company) of any entity. The concept of events occurring
after the balance sheet date with their treatment and disclosure in the financial statements
have been discussed in detail under Unit 8 of Chapter 5.
AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting
Policies (Revised 1997)
This statement should be applied by an enterprise in presenting profit and loss from ordinary
activities, extraordinary items and prior period items in the statement of profit and loss, in
accounting for changes in accounting estimates, and disclosure of changes in accounting
policies. As per AS 5, prior period items are income or expenses which arise in the current
period as a result of errors or omissions in the preparation of financial statements of one or
more prior periods. Extraordinary items are income or expenses that arise from events or
transactions that are clearly distinct from the ordinary activities of the enterprise and, therefore,
are not expected to recur frequently or regularly. The prior period and extraordinary items are
required to be disclosed in the profit and loss statement as part of the net profit for the period
with separate disclosure of the nature and amount to show its impact on current year’s profit
or loss.
AS 6 Depreciation Accounting (Revised 1994)
This standard requires that the depreciable amount of a depreciable asset should be allocated
on a systematic basis to each accounting period during the useful life of the asset and the
depreciation method selected should be applied consistently from period to period. If there is a
change in the method of providing depreciation, such a change should be treated as a change
in accounting policy and its effect (deficiency or surplus arising from retrospective recomputation
of depreciation as per new method) should be quantified and disclosed. In case any depreciable
asset is disposed off, discarded or demolished, the net surplus/deficiency, if material, should
be disclosed separately. The depreciation method used and depreciation rates are also required
to be disclosed in the financial statements.

1.52 COMMON PROFICIENCY TEST


AS 7 Construction Contracts (Revised 2002)
The standard prescribes the accounting treatment of revenue and costs associated with
construction contracts by laying down the guidelines regarding allocation of contract revenue
and contract costs to the accounting periods in which the construction work is performed,
since the construction activity is generally contracted and completed in more than one
accounting period. An enterprise is required to disclose the amount of recognised contract
revenue with the methods used to determine that revenue and the methods applied in
determining the stages of completion of contracts in progress. As per the standard, the gross
amount due from and to customers for contract work are shown as asset and liability
respectively.
AS 8 Accounting for Research and Development
This standard stands withdrawn w.e.f. 1st April, 2003 i.e. the date from which AS 26 on
Intangible Assets becomes mandatory.
AS 9 Revenue Recognition (Issued 1985)
The standard deals with the basis for recognition of revenue arising in the course of ordinary
activities, from the sale of goods; rendering of services; and income from interest, royalties and
dividends in the profit and loss statement of an enterprise. According to the standard, revenue
is the gross inflow of cash, receivables or other consideration arising in the course of the ordinary
activities of an enterprise from the sale of goods, from the rendering of services, and from the
use by others of enterprise resources yielding interest, royalty and dividends. The revenue
arising from construction contracts, hire purchase and lease agreements, government grants
and subsidies and revenue of insurance companies from insurance contracts are outside the
purview of AS 9. In addition to disclosures required by AS 1, AS 9 requires an enterprise to
disclose the circumstances in which revenue recognition has been postponed pending the
resolution of significant uncertainties.
AS 10 Accounting for Fixed Assets (Issued 1985)
The standard deals with the disclosure of the status of the fixed assets in terms of value. The
standard does not take into consideration the specialised aspect of accounting for fixed assets
reflected with the effects of price escalations but applies to financial statements on historical
cost basis. It is important to note that from the date of AS 26 on Intangible Assets, becoming
applicable, the relevant paragraphs of this standard (AS 10) dealing with patents and know-
how have been withdrawn. An entity should disclose the following information relating to (i)
the gross and net book values of fixed assets at beginning and end of an accounting period
showing additions, disposals, acquisitions and other movements, (ii) expenditure incurred on
account of fixed assets in the course of construction or acquisition, and (iii) revalued amounts
substituted for historical costs of fixed assets with the method applied in computing the revalued
amount in the financial statements:
AS 11 Effects of Changes in Foreign Exchange Rates (Revised 2003, Applicable w.e.f.
1st April, 2004)
An enterprise may carry on activities involving foreign exchange in two ways – by transacting
in foreign currencies or by indulging in foreign operations. In order to include foreign currency

FUNDAMENTALS OF ACCOUNTING 1.53


ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS

transactions and foreign operations in the financial statements of an enterprise, transactions


must be expressed in the enterprise’s reporting currency and the financial statements of foreign
operations must be translated into the enterprise’s reporting currency. The standard deals
with the issues involved in accounting for foreign currency transactions and foreign operations
i.e., to decide which exchange rate to use and how to recognize the financial effects of changes
in exchange rates in the financial statements. The standard requires the enterprises to disclose
(i) the amount of exchange differences included in the net profit or loss for the period (ii) the
amount of exchange differences adjusted in the carrying amount of fixed assets, (iii) the amount
of exchange differences in respect of forward exchange contracts to be recognised in the profit
or loss in one or more subsequent accounting periods (over the life of the contract).
AS 12 Accounting for Government Grants (Issued 1991)
AS 12 deals with accounting for government grants and specifies that the government grants
should not be recognised until there is reasonable assurance that the enterprise will comply
with the conditions attached to them, and the grant will be received. The standard also describes
the treatment of non-monetary government grants; presentation of grants related to specific
fixed assets, related to revenue, related to promoters’ contribution; treatment for refund of
government grants etc. The enterprises are required to disclose (i) the accounting policy adopted
for government grants including the methods of presentation in the financial statements; (ii)
the nature and extent of government grants recognised in the financial statements, including
non-monetary grants of assets given either at a concessional rate or free of cost.
AS 13 Accounting for Investments (Issued 1993)
The statement deals with accounting for investments in the financial statements of enterprises
and related disclosure requirements. The enterprises are required to disclose the current
investments (realisable in nature and intended to be held for not more than one year from the
date of its acquisition) and long terms investments (other than current investments) distinctly
in their financial statements. An investment property should account for as long-term
investments. The cost of investments should include all acquisition costs (including brokerage,
fees and duties) and on disposal of an investment, the difference between the carrying amount
and net disposal proceeds should be charged or credited to profit and loss statement.
AS 14 Accounting for Amalgamations (Issued 1994)
AS 14 deals with accounting for amalgamation and the treatment of any resultant goodwill or
reserves and is directed principally to companies although some of its requirements also apply
to financial statements of other enterprises. An amalgamation may be either in the nature of
merger or purchase. The standard specifies the conditions to be satisfied by an amalgamation
to be considered as amalgamation in nature of merger. An amalgamation in nature of merger
is accounted for as per pooling of interests method and in nature of purchase is dealt under
purchase method. The standard also describes the disclosure requirements for both types of
amalgamations in the first financial statements.
AS 15 Employee Benefits (Revised 2005)
The standard requires enterprises to recognise (i) a liability when an employee has provided
services in exchange for employee benefits to be paid in future, and (ii) an expense when
enterprise consumes the economic benefit arising from services provided by an employee in

1.54 COMMON PROFICIENCY TEST


exchange for employee benefits. Employee benefits can be classified under (i) short-term
employee benefits (e.g. wages, salaries etc.), (ii) post-employment benefits (e.g. gratuity, pension
etc.), (iii) long-term employee benefits (e.g. long-term leave, long-term disability benefits etc.),
and (iv) termination benefits (e.g. VRS payments). The standard lays down recognition and
measurement criteria and disclosure requirement for all the four types of employee benefits.
AS 16 Borrowing Costs (Issued 2000)
The standard prescribes the accounting treatment for borrowing costs (i.e. interest and other
costs) incurred by an enterprise in connection with the borrowing of funds. This standard
deals with the issues related to identification of asset which qualifies for capitalisation of interest,
determination of the period for which interest can be capitalized and determination of the
amount that can be capitalised. The amount of borrowing costs eligible for capitalisation should
be determined in accordance with provisions of AS 16 and other borrowing costs (not eligible
for capitalisation) should be recognised as expenses in the period in which they are incurred.
AS 17 Segment Reporting (Issued 2000)
This standard requires that the accounting information should be reported on segment basis.
AS 17 establishes principles for reporting financial information about different types of products
and services an enterprise produces and different geographical areas in which it operates. The
information helps users of financial statements, to better understand the performance and
assess the risks and returns of the enterprise and make more informed judgements about the
enterprise as a whole. The standard is more relevant for assessing risks and returns of a
diversified or multilocational enterprise which may not be determinable from the aggregated
data.
AS 18 Related Party Disclosures (Issued 2000)
This standard prescribes the requirements for certain disclosures which must be made in the
financial statements of reporting enterprise for transactions between the reporting enterprise
and its related parties. The requirements of the standard apply to the financial statements of
each reporting enterprise as also to consolidated financial statements presented by a holding
company. Since the standard is more subjective, particularly with respect to identification of
related parties, obtaining corroborative evidence becomes very difficult for the auditors. Thus
successful implementation of AS 18 is dependent upon how transparent the management is
and how vigilant the auditors are.
AS 19 Lease (Issued 2001)
AS 19 prescribes the accounting and disclosure requirements for both finance leases and
operating leases in the books of the lessor and lessee. The classification of leases adopted in this
standard is based on the extent to which risks and rewards incident to ownership of a leased
asset lie with the lessor and the lessee. A lease is classified as a finance lease if it transfers
substantially all the risks and rewards incident to ownership. An operating lease is a lease
other than finance lease. At the inception of the lease, assets under finance lease are capitalised
in the books of lessee with corresponding liability for lease obligations as against the operating
lease, wherein lease payments are recognised as an expense in profit and loss account on a
systematic basis (i.e. straight line) over the lease term without capitalizing the asset. The lessor
should recognize receivable at an amount equal to net investment in the lease in case of finance

FUNDAMENTALS OF ACCOUNTING 1.55


ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS

lease, whereas under operating lease, the lessor will present the leased asset under fixed assets
in his balance sheet besides recognizing the lease income on a systematic basis (i.e. straight
line) over the lease term. The person (lessor/lessee) presenting the leased asset in his balance
sheet should also consider the additional requirements of AS 6 and AS 10.
AS 20 Earnings Per Share (Issued 2001)
The objective of this standard is to describe principles for determination and presentation of
earnings per share which will improve comparison of performance among different enterprises
for the same period and among different accounting periods for the same enterprise. Earnings
per share (EPS) is a financial ratio indicating the amount of profit or loss for the period attributable
to each equity share and AS 20 gives computational methodology for determination and
presentation of basic and diluted earnings per share.
AS 21 Consolidated Financial Statements (Issued 2001)
AS 21 deals with preparation and presentation of consolidated financial statements with an
intention to provide information about the activities of group (parent company and companies
under its control referred to as subsidiary companies). Consolidated financial statements are
presented by a parent (holding company) to provide financial information about the economic
activities of the group as a single economic entity. A parent which presents consolidated financial
statements should present their statements in accordance with this standard but in its separate
financial statements, investments in subsidiaries should be accounted as per AS 13.
AS 22 Accounting for Taxes on Income (Issued 2001)
AS 22 seeks to reconcile the taxes on income calculated as per the books of account with the
actual taxes payable on the taxable income as per the provisions applicable to the entity for the
time being in force. This standard prescribes the accounting treatment of taxes on income and
follows the concept of matching expenses against revenue for the period. The concept of
matching is more peculiar in cases of income taxes since in a number of cases, the taxable
income may be significantly different from the income reported in the financial statements due
to the difference in treatment of certain items under taxation laws and the way it is reflected in
accounts.
AS 23 Accounting for Investments in Associates in Consolidated Financial Statements
(Issued 2001)
AS 23 describes the principles and procedures for recognising investments in associates (in
which the investor has significant influence, but not a subsidiary or joint venture of investor)
in the consolidated financial statements of the investor. An investor which presents consolidated
financial statements should account for investments in associates as per equity method in
accordance with this standard but in its separate financial statements, AS 13 will be applicable.
AS 24 Discontinuing Operations (Issued 2002)
The objective of this statement is to establish principles for reporting information about
discontinuing operations, thereby enhancing the ability of users of financial statements to make
projections of an enterprise’s cash flows, earnings, generating capacities, and financial position
by segregating information about discontinuing operations from information about continuing
operations. This standard is applicable to all discontinuing operations, representing separate
major line of business or geographical area of operations of an enterprise.

1.56 COMMON PROFICIENCY TEST


AS 25 Interim Financial Reporting (Issued 2002)
An enterprise may be required or may elect to present information at interim dates as compared
with its annual financial statements due to timeliness and cost considerations. The standard
prescribes the minimum contents of an interim financial report and requires that an enterprise
which elects to prepare and present an interim financial report, should comply with this
standard. It also lays down the principles for recognition and measurement in a complete or
condensed financial statements for an interim period. Timely and reliable interim financial
reporting improves the ability of investors, creditors and others to understand an enterprise’s
capacity to generate earnings and cash flows, its financial condition and liquidity.
AS 26 Intangible Assets (Issued 2002)
The standard prescribes the accounting treatment for intangible assets that are not dealt with
specifically under other accounting standards, and requires an enterprise to recognise an
intangible asset if, and only if, certain criteria are met. The standard specifies how to measure
the carrying amount of intangible assets and requires certain disclosures about intangible assets.
This standard should be applied by all enterprises in accounting intangible assets, except (a)
intangible assets that are covered by another AS, (b) financial assets, (c) rights and expenditure
on the exploration for or development of minerals, oil, natural gas and similar non-regenerative
resources, (d) intangible assets arising in insurance enterprise from contracts with policy holders,
(e) expenditure in respect of termination benefits.
AS 27 Financial Reporting of Interests in Joint Ventures (Issued 2002)
AS 27 set out principles and procedures for accounting of interests in joint venture and reporting
of joint venture assets, liabilities, income and expenses in the financial statements of venturers
and investors regardless of the structures or forms under which the joint venture activities take
place. The standard deals with three broad types of joint ventures – jointly controlled operations,
jointly controlled assets and jointly controlled entities. An investor in joint venture, which does
not have joint control, should report its interest in a joint venture in its consolidated financial
statements in accordance with AS 13, AS 21 and AS 23.
AS 28 Impairment of Assets (Issued 2002)
AS 28 prescribes the procedures to be applied to ensure that the assets of an enterprise are
carried at an amount not exceeding their recoverable amount (amount to be recovered through
use or sale of the asset). The standard also lays down principles for reversal of impairment
losses and prescribes certain disclosures in respect of impaired assets. An enterprise is required
to assess at each balance sheet date whether there is an indication that an enterprise may be
impaired. If such an indication exists, the enterprise is required to estimate the recoverable
amount and the impairment loss, if any, should be recognised in the profit and loss account.
This standard should be applied in accounting for impairment of all assets except inventories
(AS 2), assets arising under construction contracts (AS 7), financial assets including investments
covered under AS 13, and deferred tax assets (AS 22). There are chances that the provision on
account of impairment losses may increase sickness of companies and potentially sick companies
may actually become sick.

FUNDAMENTALS OF ACCOUNTING 1.57


ACCOUNTING STANDARDS-CONCEPTS, OBJECTIVES, BENEFITS

AS 29 Provisions, Contingent Liabilities and Contingent Assets (Issued 2003)


The objective of AS 29 is to ensure that appropriate recognition criteria and measurement
bases are applied to provisions and contingent liabilities and sufficient information is disclosed
in the notes to the financial statements to enable users to understand their nature, timing and
amount. This standard applies in accounting for provisions and contingent liabilities and
contingent assets resulting from financial instruments (not carried at fair value) and insurance
enterprises (other than those arising from contracts with policyholders). The standard will not
apply to provisions/liabilities resulting from executing controls and those covered under any
other accounting standard.
AS 30 Financial Instruments: Recognition and Measurement (Issued 2008)
Accounting Standard 30 is issued by the Council of the Institute of Chartered Accountants of
India, which comes into effect in respect of accounting periods commencing on or after 1.4.2009
and will be recommendatory in nature for an initial period of two years. This Accounting
Standard will become mandatory in respect of accounting periods commencing on or after
1.4.2011 for all commercial, industrial and business entities except to a Small and Medium-
sized Entity, as defined in the standard.

The objective of this Standard is to establish principles for recognising and measuring financial
assets, financial liabilities and some contracts to buy or sell non-financial items.

AS 31 Financial Instruments: Presentation (Issued 2008)


Accounting Standard 31 is issued by the Council of the Institute of Chartered Accountants of
India, which comes into effect in respect of accounting periods commencing on or after 1-4-
2009 and will be recommendatory in nature for an initial period of two years. This Accounting
Standard will become mandatory in respect of accounting periods commencing on or after 1-
4-2011 for all commercial, industrial and business entities except to a small and medium-sized
entity, as defined in the standard.

The objective of this Standard is to establish principles for presenting financial instruments as
liabilities or equity and for offsetting financial assets and financial liabilities. It applies to the
classification of financial instruments, from the perspective of the issuer, into financial assets,
financial liabilities and equity instruments; the classification of related interest, dividends,
losses and gains; and the circumstances in which financial assets and financial liabilities should
be offset.

1.58 COMMON PROFICIENCY TEST


SELF EXAMINATION QUESTIONS
I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
1. (i) Accounting Standards in India are issued by
(a) Central Govt.
(b) State Govt.
(c) Institute of Chartered Accountants of India.
(d) Reserve Bank of india.
(ii) Accounting Standards
(a) Harmonise accounting policies.
(b) Eliminate the non-comparability of financial statements.
(c) Improve the reliability of financial statements.
(d) All of the above.
(iii) How many Accounting Standards have been issued by ICAI ?
(a) 25.
(b) 20.
(c) 31.
(d) 2.
(iv) It is essential to standardize the accounting principles and policies in order to ensure
(a) Transparency.
(b) Consistency.
(c) Comparability.
(d) All of the above.
(v) All of the following are limitations of Accounting Standards except
(a) The choice between different alternative accounting treatments is difficult.
(b) There may be trend towards rigidity.
(c) Accounting Standards cannot override the statute.
(d) All of the above.
[Ans. 1. (i) (c),(ii) (d), (iii) (c), (iv) (d), (v) (d)]

FUNDAMENTALS OF ACCOUNTING 1.59


CHAPTER - 1

ACCOUNTING :
AN
INTRODUCTION

Unit 4

Accounting
Policies
1.60
Learning Objectives
After studying this unit, you will be able to:
 Understand the meaning of ‘Accounting Policies’.
 Familiarise with the situations under which selection from different accounting policies
is required.
 Grasp the conditions where change in accounting policy can be made and the
consequences arising from such changes.

1. MEANING
Accounting Policies refer to specific accounting principles and methods of applying these
principles adopted by the enterprise in the preparation and presentation of financial statements.
Policies are based on various accounting concepts, principles and conventions that have already
been explained in Unit 2 of Chapter 1. There is no single list of accounting policies, which are
applicable to all enterprises in all circumstances. Enterprises operate in diverse and complex
environmental situations and so they have to adopt various policies. The choice of specific
accounting policy appropriate to the specific circumstances in which the enterprise is operating,
calls for considerate judgement by the management. ICAI has been trying to reduce the number
of acceptable accounting policies through Guidance Notes and Accounting Standards in its
combined efforts with the government, other regulatory agencies and progressive managements.
Already it has achieved some progress in this respect.
The areas wherein different accounting policies are frequently encountered can be given as
follows:
(1) Methods of depreciation, depletion and amortisation;
(2) Valuation of inventories;
(3) Treatment of goodwill;
(4) Valuation of investments;
(5) Valuation of fixed assets.
This list should not be taken as exhaustive but is only illustrative. As the course will progress,
students will see the intricacies of the various accounting policies.
Suppose an enterprise holds some investments in the form of shares of a company at the end of
an accounting period. For valuation of shares, the enterprise may adopt FIFO, LIFO, average
method etc. The method selected by that enterprise for valuation is called an accounting policy.
Different enterprises may adopt different accounting policies. Likewise, different methods of
providing depreciation on fixed assets, i.e. Straight line, written down, etc. are available to the
business enterprises which will lead to different depreciation amounts.

FUNDAMENTALS OF ACCOUNTING 1.61


ACCOUNTING POLICIES

2. SELECTION OF ACCOUNTING POLICIES


Choice of accounting policy is an important policy decision which affects the performance
measurement as well as financial position of the business entity. Selection of inappropriate
accounting policy may lead to understatement or overstatement of performance and financial
position. Thus, accounting policy should be selected with due care after considering its effect
on the financial performance of the business enterprise from the angle of various users of
accounts.
It is believed that no unified an exhaustive list of accounting policies can be suggested which
has universal application. Three major characteristics which should be considered for the
purpose of selection and application of accounting policies. viz.,Prudence, Substance over form,
and Materiality. All these three characteristics have already been explained in Unit 2 of Chapter
1. The financial statements should be prepared on the basis of such accounting policies, which
exhibit true and fair view of state of affairs of Balance Sheet and the Profit & Loss Account.
The basis for selecting accounting policies can be shown in the following chart as :

Selection of Accounting Policies

Based
on

Prudence Substance over Form Materiality

Examples wherein selection from a set of accounting policies is made, can be given as follows:–
1. Inventories are valued at cost except for finished goods and by-products. Finished goods
are valued at lower of cost or market value and by-products are valued at net realisable
value.
2. Investments (long term) are valued at their acquisition cost. Provision for permanent
diminution in value has been made wherever necessary.
Sometimes a wrong or inappropriate treatment is adopted for items in Balance Sheet, or Profit
& Loss Account, or other statement. Disclosure of the treatment adopted is necessary in any
case, but disclosure cannot rectify a wrong or inappropriate treatment.

1.62 COMMON PROFICIENCY TEST


3. CHANGE IN ACCOUNTING POLICIES
A change in accounting policies should be made in the following conditions:
(a) It is required by some statute or for compliance with an Accounting Standard.
(b) Change would result in more appropriate presentation of financial statement.
Change in accounting policy may have a material effect on the items of financial statements.
For example, if depreciation method is changed from straight-line method to written-down
value method, or if cost formula used for inventory valuation is changed from weighted average
to FIFO, or if interest is capitalised which was earlier not in practice, or if proportionate amount
of interest is changed to inventory which was earlier not the practice, all these may increase or
decrease the net profit. Unless the effect of such change in accounting policy is quantified, the
financial statements may not help the users of accounts. Therefore, it is necessary to quantify
the effect of change on financial statement items like assets, liabilities, profit/loss.
The examples in this regard may be given as follows:
1. Omega Enterprises revised its accounting policy relating to valuation of inventories to
include applicable production overheads. The change has resulted in an increase in value
of inventory and consequently profit before tax by Rs. 58.43 lakhs.
2. Alpha Enterprises changed the method of depreciation from straight-line method to
written-down value method, with effect from 1.4.2005. The depreciation has been
recomputed from the date of commissioning of these assets at WDV rates applicable to
those years. Consequent to this there has been an additional charge for depreciation during
the year of Rs. 350.12 crore due to said change which relates to the previous years and an
equal amount has been withdrawn from the General Reserve and credited to Profit &
Loss Account. Had there been no change in the method of depreciation, the charge for the
year would have been lower by Rs. 95.42 crore excluding the charge relating to the previous
years. Consequently, the Net Block of Fixed Assets and Reserves and Surplus are lower by
Rs. 445.54 crore.

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
(i) A change in accounting policy is justified
(a) To comply with accounting standard.
(b) To ensure more appropriate presentation of the financial statement of the
enterprise.
(c) To comply with law.
(d) All of the above.
(ii) Accounting policy for inventories of Xeta Enterprises states that inventories are valued
at the lower of cost determined on weighted average basis or not realizable value.
Which accounting principle in followed in adopting the above policy?
(a) Materiality.

FUNDAMENTALS OF ACCOUNTING 1.63


ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

(b) Prudence.
(c) Substance over form.
(d) All of the above.
(iii) The areas wherein different accounting policies can be adopted are
(a) Providing depreciation.
(b) Valuation of inventories.
(c) Valuation of investments.
(d) All of the above.
(iv) Selection of an inappropriate accounting policy decision may
(a) Overstate the performance and financial position a business entity.
(b) Understate/overstate the performance and financial position a business entity.
(c) Overstate the performance a business entity.
(d) Understate financial position a business entity.
(v) Accounting policies refer to specific accounting
(a) Principles.
(b) Methods of applying those principles.
(c) Both (a) and (b).
(d) None of the above.
[Ans. 1. (i) (d), (ii) (b), (iii) (d), (iv) (b), (v) (c)]

1.64 COMMON PROFICIENCY TEST


CHAPTER - 1

ACCOUNTING :
AN
INTRODUCTION

Unit 5

Accounting as a
Measurement
Discipline - Valuation
Principles,
Accounting Estimates
ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

Learning Objectives
After going through this unit, you will be able to :
 Understand the meaning of measurement and its basic elements.
 Know how far accounting is a measurement discipline if considered from the standpoint
of the basic elements of measurement.
 Distinguish measurement with valuation.
 Learn the different measurement bases namely historical cost, realisable value and
present value.
 Understand the measurement bases which can give objective valuation to transactions
and events.
 Understand that the traditional accounting system mostly uses historical cost as
measurement base although in some cases other measurement bases are also used.

1. MEANING OF MEASUREMENT
Measurement is vital aspect of accounting. Primarily transactions and events are measured in
terms of money. Any measurement discipline deals with three basic elements of measurement
viz., identification of objects and events to be measured, selection of standard or scale to be
used, and evaluation of dimension of measurement standards or scale.
Prof. R. J. Chambers defined ‘measurement’ as “assignment of numbers to objects and events
according to rules specifying the property to be measured, the scale to be used and the dimension
of the unit”. (R.J. Chambers, Accounting Evaluation and Economic Behaviour, Prentice Hall,
Englewood Cliffs, N.J. 1966, P.10).
Kohler defined measurement as the assignment of a system of ordinal or cardinal numbers to
the results of a scheme of inquiry or apparatus of observations in accordance with logical or
mathematical rules’ – [A Dictionary of Accountant].
Ordinal numbers, or ordinals, are numbers used to denote the position in an ordered sequence:
first, second, third, fourth, etc., whereas a cardinal number says ‘how many there are’: one,
two, three, four, etc.
Chambers’ definition has been widely used to judge how far accounting can be treated as a
measurement discipline.
According to this definition, the three elements of measurement are:
(1) Identification of objects and events to be measured;
(2) Selection of standard or scale to be used;
(3) Evaluation of dimension of measurement standard or scale.

1.66 COMMON PROFICIENCY TEST


Elements of Measurement

Identification Selection of Evaluation of


of Objects and Standards or Dimension of
Events Scale Measurement
Standards or Scale

2. OBJECTS OR EVENTS TO BE MEASURED


We have earlier defined Accounting as the process of identifying, measuring and communicating
economic information to permit informed judgements and decisions by the users of the
information. So accounting essentially includes measurement of ‘information’.
Decision makers need past, present and future information. For external users, generally the
past information is communicated.
There is no uniform set of events and transactions in accounting which are required for decision
making. For example, in cash management, various cash receipts and expenses are the necessary
objects and events. Obviously the decision makers need past cash receipts and expenses data
along with projected receipts and expenses. For giving loan to a business one needs information
regarding the repayment ability (popularly called debt servicing) of principal and interest.
This also includes past information, current state of affairs as well as future projections. It may
be mentioned that past and present objects and events can be measured with some degree of
accuracy but future events and objects are only predicted, not measured. Prediction is an
essential part of accounting information. Decision makers have to take decisions about the
unseen future for which they need suitable information.

3. STANDARD OR SCALE OF MEASUREMENT


In accounting, money is the scale of measurement (see money measurement concept), although
now-a-days quantitative information is also communicated along with monetary information.
Money as a measurement scale has no universal denomination. It takes the shape of currency
ruling in a country. For example, in India the scale of measurement is rupee, in the U.K. Pound-
Sterling, in Germany Deutschmark (DM), in the United States Dollar and so on. Also there is
no constant exchange relationship among the currencies.
If one businessman in India took loan $5,000 from a businessman of the U.S.A., he would enter
the transaction in his books in terms of rupees. Suppose at the time of loan agreement exchange
rate was US $ = Rs. 50. Then loan amounted to Rs. 2,50,000. Afterwards the exchange rate has
been changed to $ 1 = Rs. 55. At the changed exchange rate the loan amount becomes
Rs. 2,75,000. So money as a unit of measurement lacks universal applicability across the boundary
of a country unless a common currency is in vogue. Since the rate of exchange fluctuates between
two currencies over the time, money as a measurement scale also becomes volatile.

FUNDAMENTALS OF ACCOUNTING 1.67


ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

4. DIMENSION OF MEASUREMENT SCALE


An ideal measurement scale should be stable over time. For example, if one buys 1 kg. cabbage
today, the quantity he receives will be the same if he will buy 1 kg. cabbage one year later.
Similarly the length of 1 metre cloth will not change if it is bought a few days later. That is to
say a measurement scale should be stable in dimension. Money as a scale of measurement is
not stable. There occurs continuous change in the input output prices. The same quantity of
money may not have the ability to buy same quantity of identical goods at different dates.
Thus information of one year measured in money terms may not be comparable with that of
another year. Suppose production and sales of a company in two different years are as follows:
Year 1 Year 2
Qty Rs. Qty Rs.
5,000 pcs 5,00,000 4,500 pcs 5,40,000
Looking at the monetary figures one may be glad for 8% sales growth. In fact there was 10%
production and sales decline. The growth envisaged through monetary figures is only due to
price change. Let us suppose further that the cost of production for the above mentioned two
years is as follows:
Year 1 Year 2
Qty Rs. Qty Rs.
5,000 pcs 4,00,000 4,500 pcs 4,50,000
Take Gross profit = Sales – Cost of Production. Then in the first year profit was Rs. 1,00,000
while in the second year the profit was Rs. 90,000. There was 10% decline in gross profit.
So money as a unit of measurement is not stable in the dimension.
Thus Accounting measures information mostly in money terms which is not a stable scale
having universal applicability and also not stable in dimension for comparison over the time.
So it is not an exact measurement discipline.

5. ACCOUNTING AS A MEASUREMENT DISCIPLINE


How do you measure a transaction or an event? Unless the measurement base is settled we
cannot progress to the record keeping function of book-keeping. It has been explained that
accounting is meant for generating information suitable for users’ judgments and decisions.
But generation of such information is preceded by recording, classifying and summarising
data. By that process it measures performance of the business entity by way of profit or loss
and shows its financial position. Thus measurement is an important part of accounting discipline.
But a set of theorems governs the whole measurement sub-system. These theorems should be
carefully understood to know how the cogs of the ‘accounting-wheel’ work. Now-a-days
accounting profession earmarked three theorems namely going concern, consistency and accrual
as fundamental accounting assumptions, i.e. these assumptions are taken for granted. Also
while measuring, classifying, summarising and also presenting, various policies are adopted.
Recording, classifying summarising and communication of information are also important

1.68 COMMON PROFICIENCY TEST


part of accounting, which do not fall within the purview of measurement discipline. Therefore
we cannot simply say that accounting is a measurement discipline.
But in accounting money is the unit of measurement. So, let us take one thing for granted that
all transactions and events are to be recorded in terms of money only. Quantitative information
is also required in many cases but such information is only supplementary to monetary
information.

6. VALUATION PRINCIPLES
There are four generally accepted measurement bases or valuation principles. These are:
(i) Historical Cost: It means acquisition price. For example, the businessman paid Rs. 7,00,000

Valuation Principles

Historical Current Realisable Present


Cost Cost Value Value

to purchase the machine, its acquisition price including installation charges is Rs. 8,00,000.
The historical cost of machine would be Rs. 7,00,000.
According to this base, assets are recorded at an amount of cash or cash equivalent paid
or the fair value of the asset at the time of acquisition. Liabilities are recorded at the amount
of proceeds received in exchange for the obligation. In some circumstances a liability is
recorded at the amount of cash or cash equivalent expected to be paid to satisfy it in the
normal course of business.
When one Mr. X a businessman, takes Rs. 5,00,000 loan from a bank @ 10% interest p.a.,
it is to be recorded at the amount of proceeds received in exchange for the obligation. Here
the obligation is the repayment of loan as well as payment of interest at an agreed rate i.e.
10%. Proceeds received are Rs. 5,00,000 - it is historical cost of the transactions. Take
another case regarding payment of income tax liability. You know every individual has to
pay income tax on his income if it exceeds certain minimum limit. But the income tax
liability is not settled immediately when one earns his income. The income tax authority
settles it some time later, which is technically called assessment year. Then how does he
record this liability? As per historical cost base it is to be recorded at an amount expected
to be paid to discharge the liability.
(ii) Current Cost: Take that Mr. X purchased a machine on 1st January, 1995 at Rs. 7,00,000.
As per historical cost base he has to record it at Rs. 7,00,000 i.e. the acquisition price. As
on 1.1.2006, Mr. X found that it would cost Rs. 25,00,000 to purchase that machine. Take
also that Mr. X took loan from a bank as on 1.1.95 Rs. 5,00,000 @ 18% p.a repayable at the
end of 15th year together with interest. As on 1.1.2006 the bank announces 1% prepayment

FUNDAMENTALS OF ACCOUNTING 1.69


ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

penalty on the loan amount if it is paid within 15 days starting from that day. As per
historical cost the liability is recorded at Rs. 5,00,000 at the amount or proceeds received
in exchange for obligation and asset is recorded at Rs. 7,00,000.
Current cost gives an alternative measurement base. Assets are carried out at the amount
of cash or cash equivalent 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 be required to settle the obligation currently.
So as per current cost base, the machine value is Rs. 25,00,000 while the value of bank
loan is Rs. 5,05,000.
(iii) Realisable Value: Suppose Mr. X found that he can get Rs. 20,00,000 if he would sell the
machine purchased, on 1.1.95 paying Rs. 7,00,000 and which would cost Rs. 25,00,000 in
case he would buy it currently. Take also that Mr. X found that he had no money to pay
off the bank loan of Rs. 5,00,000 currently.
As per realisable value, assets are carried at the amount of cash or cash equivalents that
could currently be obtained by selling the assets in an orderly disposal. Haphazard disposal
may yield something less. Liabilities are carried at their settlement values; i.e. the
undiscounted amount of cash or cash equivalents expressed to be paid to satisfy the
liabilities in the normal course of business.
So the machine should be recorded at Rs. 20,00,000 the realisable value in an orderly sale
while the bank loan should be recorded at Rs. 5,00,000 the settlement value in the normal
course of business.
(iv) Present Value: Suppose we are talking as on 1.1.2003 - take it as time for reference. Now
think the machine purchased by Mr. X on 1.1.93 can work for another 10 years and is
supposed to generate cash @ Rs. 1,00,000 p.a. Also take that bank loan of Rs. 5,00,000
taken by Mr. X is to be repaid as on 31.12.2007. Annual interest is Rs. 90,000.
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 future net cash outflows that are expected to be
required to settle the liabilities in the normal course of business.
The term ‘discount’, ‘cash inflow’ and ‘cash outflow’ need a little elaboration. Rs. 100 in hand
as on 1.1.2003. is not equivalent to Rs. 100 in hand as on 31.12.2003. There is a time gap of one
year. If Mr. X had Rs. 100 as on 1.1.03 he could use it at that time. If he received it only on
31.12.2003, he had to sacrifice his use for a year. The value of this sacrifice is called ‘time value
of money’. Mr. X would sacrifice i.e. he would agree to take money on 31.12.2003 if he had
been compensated for the sacrifice. So a rational man will never exchange Rs. 100 as on 1.1.2003
with Rs. 100 to be received on 31.12.2003 Then Rs. 100 of 1.1.2003 is not equivalent to Rs. 100
of 31.12.2003. To make the money receivable at a future date equal with the money of the
present date it is to be devalued. Such devaluation is called discounting of future money.
Perhaps you know the compound interest rule: A = P (1+ i)n

1.70 COMMON PROFICIENCY TEST


A = Amount
P = Principal
i = interest / 100
n = Time
This equation gives the relationship between present money, principal and the future money
amount. If A, i and n are given, to find out P, the equation is to be changed slightly.

A
P=
(1 + i) n
Using the equation one can find out the present value if he knows the values of A, i and n.
Suppose i = 20%, now what is the present value of Rs. 1,00,000 to be received as on 31.12.2003
(Take 1.1.2003 as the time of reference).

1,00,000
P = (1 + .2)1
= Rs. 83,333
Similarly,
Time of Receipt Money Value Present Value
Rs. Rs.
31.12.2004 1,00,000 69,444
31.12.2005 1,00,000 57,870
31.12.2006 1,00,000 48,225
31.12.2007 1,00,000 40,188
31.12.2008 1,00,000 33,490
31.12.2009 1,00,000 27,908
31.12.2010 1,00,000 23,257
31.12.2011 1,00,000 19,381
31.12.2012 1,00,000 16,150
Total of all these present values is Rs. 4,19,246. Since the machine purchased by Mr. X will
produce cash equivalent to Rs. 4,19,246 in terms of present value, it is to be valued at such
amount as per present value measurement basis.
Here, Mr. X will receive Rs. 1,00,000 at different points of time-these are cash inflows. In the
other example, he has to pay interest and principal of bank loan-these are cash outflows.

FUNDAMENTALS OF ACCOUNTING 1.71


ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

Perhaps you also know the annuity rule:


Present value of an Annuity or Re. A for n periods is
A = Annuity
i = interest
t = time 1, 2, 3, ..........n.

1
1−
(1 + i) n

i
Applying this rule one can derive the present value of Rs. 1,00,000 for 10 years @ 20% p.a.

1
1−
(1 + .2)10 = Rs. 4,19,246
1,00,000 ×
.2
Similarly, the present value of bank loan is

1
1−
(1 + .2) 5 5,00,000
90,000 × +
.2 (1 + .2) 5

= Rs. 2,69,155 + Rs. 2,00,939


= Rs. 4,70,094
Thus we get the four measurements
Historical Current Realisable Present
cost cost value value
Rs. Rs. Rs. Rs.
Asset: Machine 7,00,000 25,00,000 20,00,000 4,19,246
Liability: Bank Loan 5,00,000 4,50,000 5,00,000 4,70,094
The accounting system which we shall discuss in the remaining chapters is also called historical
cost accounting. However, this need not mean that one shall follow only historical cost basis of
accounting. In the later stages of the CA course, we shall see that the accounting system uses
all types of measurement bases although under the traditional system most of the transactions
and events are measured in terms of historical cost.

7. MEASUREMENT AND VALUATION


Value relates to the benefits to be derived from objects, abilities or ideas. To the economist,
value is the utility (i.e; satisfaction) of an economic resource to the person contemplating or
enjoying its use. In accounting, to mean value of an object, abilities or ideas, a monetary

1.72 COMMON PROFICIENCY TEST


surrogate is used. That is to say, value is measured in terms of money. Suppose, an individual
purchased a car paying Rs. 2,50,000. Its value lies in the satisfaction to be derived by that
individual using the car in future. Economists often use ordinal scale to indicate the level of
satisfaction. But accountants use only cardinal scales. If the value of car is taken as Rs. 2,50,000
it is only one type of value called acquisition cost or historical cost. So value is indicated by
measurement. In accounting the value is always measured in terms of money.

8. ACCOUNTING ESTIMATES
Earlier in this unit we have learned how to measure a transaction, which had already taken
place and for which either some value/money has been paid or some valuation principles are
to be adopted for their measurement. But there are certain items, which are not occurred
therefore cannot be measured using valuation principles still they are necessary to record in
the books of account. For example, provision for doubtful debts on debtors. For such items, we
need some value. In such a situation reasonable estimates based on the existing situation and
past experiences are made.
The measurement of certain assets and liabilities is based on estimates of uncertain future
events. As a result of the uncertainties inherent in business activities, many financial statement
items cannot be measured with precision but can only be estimated. Therefore, the management
makes various estimates and assumptions of assets, liabilities, incomes and expenses as on the
date of preparation of financial statements. Such estimates are made in connection with the
computation of depreciation, amortisation and impairment losses as well as, accruals, provisions
and employee benefit obligations. Also estimates may be required in determining the bad debts,
useful life and residual value of an item of plant and machinery and inventory obsolescence.
The process of estimation involves judgements based on the latest information available.
An estimate may require revision if changes occur regarding circumstances on which the
estimate was based, or as a result of new information, more experience or subsequent
developments. Change in accounting estimate means difference arises between certain
parameters estimated earlier and re-estimated during the current period or actual result achieved
during the current period.
Few examples of situations wherein accounting estimates are needed can be given as follows:
(1) A company incurs expenditure of Rs. 10,00,000 on development of patent. Now the
company has to estimate that for how many years the patent would benefit the company.
This estimation should be based on the latest information and logical judgement.
(2) A company dealing in long-term construction contracts, uses percentage of completion
method for recognizing the revenue at the end of the accounting year. Under this method
the company has to make adequate provisions for unseen contingencies, which can take
place while executing the remaining portion of the contract. Since provisioning for unseen
contingencies requires estimation, there may be excess or short provisioning, which is to
be adjusted in the period when it is recognised.
(3) Company has to provide for taxes which is also based on estimation as there can be some
interpretational differences on account of which tax authorities may either accept the
expenditure or refuse it. This will ultimately lead to different tax liability.

FUNDAMENTALS OF ACCOUNTING 1.73


ACCOUNTING AS A MEASUREMENT DISCIPLINE - VALUATION PRINCIPLES, ACCOUNTING ESTIMATES

SELF EXAMINATION QUESTIONS


PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
1. (i) Measurement discipline deals with
(a) Identification of objects and events.
(b) Selection of scale.
(c) Evaluation of dimension of measurement scale.
(d) All of the above.
(ii) All of the following are valuation principles except
(a) Historical cost. (b) Present value.
(c) Future value. (d) Realisable value.
(iii) Cost of machinery purchased on 1st April, 2005 10,00,000
Market value as on 31st March, 2006 11,00,000
As on 31st March, 2006, if the company values the machinery
At Rs. 11,00,000, which of the following valuation principle is being followed?
(a) Historical Cost. (b) Present Value..
(c) Realisable Value. (d) Current Cost.
(iv) Change in accounting estimate means
(a) Differences arising between certain parameters estimated earlier and re-estimated
during the current period.
(b) Differences arising between certain parameters estimated earlier and actual results
achieved during the current period.
(c) Differences arising between certain parameters re-estimated during the current
period and actual results achieved during the current period.
(d) Both (a) and (b).
2. Mohan purchased a machinery amounting Rs. 10,00,000 on 1st April, 2000. On 31st March,
2006 The similar machinery could be purchased for Rs. 20,00,000 but the realizable value
of the machinery (purchased on 1.4.2000) was estimated at Rs. 15,00,000. The present
discounted value of the future net cash inflows that the machinery was expected to generate
in the normal course of business, was calculated as Rs. 12,00,000.
(i) The current cost of the machinery is
(a) Rs. 10,00,000. (b) Rs. 20,00,000.
(c) Rs. 15,00,000. (d) Rs. 12,00,000.

1.74 COMMON PROFICIENCY TEST


(ii) The present value of machinery is
(a) Rs. 10,00,000. (b) Rs. 20,00,000.
(c) Rs. 15,00,000. (d) Rs. 12,00,000.
(iii) The historical cost of machinery is
(a) Rs. 10,00,000. (b) Rs. 20,00,000.
(c) Rs. 15,00,000. (d) Rs. 12,00,000.
(iv) The realizable value of machinery is
(a) Rs. 10,00,000. (b) Rs. 20,00,000.
(c) Rs. 15,00,000. (d) Rs. 12,00,000.
[Ans 1. (i) (d), (ii) (c), (iii) (c), (iv) (d), 2. (i) (b), (ii) (d), (iii) (a), (iv) (d)]

FUNDAMENTALS OF ACCOUNTING 1.75


NOTES
CHAPTER - 2

By this time, you must have understood that


accounting is the process of identifying,
measuring, recording, classifying, summarising,
analysing, interpreting and communicating the
financial transactions and events. Accounting
helps in keeping systematic records to ascertain
financial performance and financial position of
an entity and to communicate the relevant
financial information to the interested user
groups. Transactions and events recorded by
suitable account headings are analysed in term
ACCOUNTING

of debit and credit; and thus assets become equal


to equity and liabilities. Accounts are classified
as personal, real and nominal types. Transactions
and events are first journalised, then posted to
suitable ledgers accounts and all accounts are
balanced at the end of year. Generally balances
PROCESS

of the nominal accounts are transferred to profit


and loss account for determination of profit or
loss and balance of personal and real accounts
are carried to balance sheet.
The process of accounting, depicting how
information flows from the source documents up
to the stage where final accounts are prepared,
can be shown as:
Source Documents Represents all documents in business which contains financial
records and act as evidence of the transactions which have taken
place.

Book of Original Entry These are books which are used in recording the transactions for
the first time. The books are maintained for memorandum purpose
only and will not form part of the double entry system. Examples
include; Purchase day book, Cash book, Sales day book and
purchases return day book

These form part of double entry system and used to record the
Ledger Accounts
transactions for the period. These are accounts where information
relating to a particular asset, liability, capital, income and expenses
are recorded.

Contains the totals from various ledger accounts and act as a


Trial Balance
preliminary check on accounts before producing final accounts.

Financial Statements are produced to show the financial


Final Accounts
performance and financial position of a business entity.

All the above mentioned steps of the accounting process have been discussed in detail in the
subsequent units of this chapter. The students are advised to observe the whole sequence or
cycle of accounting, starting from journal to the preparation of trial balance (units 1 to 5 of
this chapter). The preparation of final accounts will be discussed in chapter 6 of the Study
Material.
CHAPTER - 2

ACCOUNTING
PROCESS

Unit 1

Basic Accounting
Procedures –
Journal Entries
BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

Learning Objectives
After studying this unit, you will be able to :
 understand meaning and significance of Double Entry Systems.
 familiarige with the term 'account' and understand the classification of accounts into
personal, real and nominal.
 note the utility of such classification and sub-classifications,
 understand how debits and credits are determined from transactions and events.
 observe the points to be taken care of while recording a transaction in the journal.

1. DOUBLE ENTRY SYSTEM


Double entry system of book-keeping has emerged in the process of evolution of various
accounting techniques. It is the only scientific system of accounting. According to it, every
transaction has two-fold aspects–debit and credit and both the aspects are to be recorded in
the books of accounts. For example, if a business acquires something then either it must have
been given by someone or it must have been acquired by giving up something. On purchase of
furniture either the cash balance will be reduced or a liability to the supplier will arise. This
has been made clear already, the Double Entry System is so named since it records both the
aspects. We may define the Double Entry System as the system which recognises and records
both the aspects of transactions. This system has proved to be systematic and has been found
of great use for recording the financial affairs for all institutions requiring use of money.

2. ADVANTAGES OF DOUBLE ENTRY SYSTEM


This system affords the under mentioned advantages:
(i) By the use of this system the accuracy of the accounting work can be established, through
the device of the trial balance.
(ii) The profit earned or loss suffered during a period can be ascertained together with details.
(iii) The financial position of the firm or the 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
affords significant information for the purposes of control etc.
(v) Result of one year may be compared with those of previous years and reasons for the
change may be ascertained.
It is because of these advantages that the system has been used extensively in all countries.

3. ACCOUNT
We have seen how the accounting equation becomes true in all cases. A person starts his
business with say, Rs. 10,000; capital and cash are both Rs. 10,000. Transactions entered into
by the firm will alter the cash balance in two ways, one will increase the cash balance and
other will reduce it. Payment for goods purchased, for salaries and rent, etc., will reduce it;
sales of goods for cash and collection from customers will increase it.
2.4 COMMON PROFICIENCY TEST
We can change the cash balance with every transaction but this will be cumbersome. Instead
it would be better if all the transactions that lead to an increase are recorded in one column
and those that reduce the cash balance in another column; then the net result can be ascertained.
If we add all increases to the opening balance of cash and then deduct the total of all decreases
we shall know the closing balance. In this manner, significant information will be available
relating to cash.
The two columns which we reffered above are put usually in the form of an account, called
the 'T' form. This is illustrated below by taking imaginary figures:
CASH
Increase Decrease
Rs. Rs.
Opening Balance 10,000 1,000
2,500 300
2,000 200
50 500
1,350
400 Total 2,000
New or Closing Balance 14,300
16,300 16,300

What we have done is to put the increase of cash on the left hand side and the decrease on the
right hand side; the closing balance has been ascertained by deducting the total of payments,
Rs. 2,000 from the total of the left - hand side. Such a treatment of receipts and payment of
cash is very convenient.
The proper form of an account is as follows:
ACCOUNT
Dr. Cr.
Date Particulars Ref. Amount Date Particulars Ref. Amount
Rs. Rs.
The columns are self-explanatory except that the column for reference (Ref.) is meant to indicate
the sources where information about the entry is available.

4. DEBIT AND CREDIT


We have seen that by deducting the total of liabilities from the total of assets the amount of
capital is ascertained, as is indicated by the accounting equation.
Assets = Liabilities + Capital
or
Assets – Liabilities = Capital

FUNDAMENTALS OF ACCOUNTING 2.5


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

We have also seen that if there is any change on one side of the equation, there is bound to be
similar change on the other side of the equation or amongst items covered by it. This is again
illustrated below:
Transactions Total = Liabilities + Owner's
Assets Capital
Rs. Rs. Rs.
(1) Started business with cash Rs. 10,000 10,000 10,000
(2) Borrowed Rs. 5,000 + 5,000 + 5,000
(3) Withdrew cash from business Rs. 2,000 - 2,000 - 2,000
(4) Loan repaid to the extent of Rs. 1,000 - 1,000 - 1,000
Balance 12,000 4000 + 8,000

As has been seen previously, what has been given above is suitable only if the number of
transactions is small. But if the number is large, a different procedure of putting increases and
decreases in different columns will be useful and this will also yield significant information.
The transactions given above are being shown below according to this method.
Total Assets = Liabilities + Owner's Capital
Increase Decrease Decrease Increase Decrease Increase
Rs. Rs. Rs. Rs. Rs. Rs.
(1) 10,000 10,000
(2) 5,000 5,000
(3) 2,000 2,000
(4) 1,000 1,000
Total 15,000 3,000 1,000 5,000 2,000 10,000
Balance 12,000 = 4,000 + 8,000

It is a tradition that:
(i) increases in assets are recorded on the left-hand side and decreases in them on the right-
hand side; and
(ii) in the case of liabilities and capital, increases are recorded on the right-hand side and
decreases on the left-hand side.
When two sides are put together in T form, the left-hand side is called the 'debit side' and
the right hand side is 'credit side'. When in an account a record is made on the debit or
left-hand side, one says that one has debited that account; similary to record an amount
on the right-hand side is to credit it.
From the above, the following rules can be obtained:

2.6 COMMON PROFICIENCY TEST


(i) When there is an increase in the amount of an asset, its account is debited; the account will be
credited if there is a reduction in the amount of the asset concerned : Suppose a firm purchases
furniture for Rs. 800, the furniture account will be debited by Rs. 800 since the asset has
increased by this amount. Suppose later the firm sells furniture to the extent of Rs. 300,
the reduction will be recorded by crediting the furniture account by Rs. 300.
(ii) If the amount of a liability increases, the increase will be entered on the credit side of the liability
account, i.e. the account will be credited : similarly, a liability account will be debited if there
is a reduction in the amount of the liability. Suppose a firm borrows Rs. 500 from Mohan;
Mohan's account will be credited since Rs. 500 is now owing to him. If, later, the loan is
repaid, Mohan's account will be debited since the liability no longer exists.
(iii) An increase in the owner's capital is recorded by crediting the capital account : Suppose the
proprietor introduces additional capital, the capital account will be credited. If the owner
withdraws some money, i.e., makes a drawing, the capital account will be debited.
(iv) Profit leads to an increase in the capital and a loss to reduction : According to the rule mentioned
in (iii) above, profit may be directly credited to the capital account and losses may be
similarly debited.
However, it is more useful to record all incomes, gains, expenses and losses separately. By
doing so, very useful information will be available regarding the factors which have
contributed to the year's profits and losses. Later the net result of all these is ascertained
and adjusted in the capital account.
(v) Expenses are debited and Incomes are credited : Since incomes and gains increase capital,
the rule is to credit all gains and incomes in the accounts concerned and since expenses
and losses decrease capital, the rule is to debit all expenses and losses. Of course, if there
is a reduction in any income or gain, the account concerned will be debited; similarly, for
any reduction in an expenses or loss the concerned account will be credited.
The rules given above are summarised below:
(i) Increases in assets are debits; decreases are credits;
(ii) Increases in liabilities are credits; decreases are debits;
(iii) Increases in owner's capital are credits; decreases are debits;
(iv) Increases in expenses are debits; decreases are credits; and
(v) Increases in revenue or incomes are credits; decreases are debits.
The terms debit and credit should not be taken to mean, respectively, favourable and
unfavourable things. They merely describe the two sides of accounts.

FUNDAMENTALS OF ACCOUNTING 2.7


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

Illustration 1

2006 Rs.
April
1. R. started business with 10,000
2. He purchased furniture for 2,000
3. Paid salary to his clerk 100
4. Paid rent 50
5. Received interest 20

Solution
2006 Explanation Accounts Nature of How Debit Credit
April Involved Accounts affected Rs. Rs.
1. Rs. 10,000 cash Cash and Asset Increased 10,000
invested in business R's Proprietorship Increased 10,000
2. Purchased furniture Furniture and Asset Increased 2,000
for Rs. 2,000 Cash Asset Decreased 2,000
3. Paid Rs. 100 to clerk Salary & Expense Increased 100
for salary Cash Asset Decreased 100
4. Paid Rent Rs. 50 Rent & Cash Expense Increased 50
Asset Decreased 50
5. Received interest Rs. 20 Cash & Asset Increased 20
Interest Income Increased 20

5. TRANSACTIONS
In the system of book-keeping, students can notice that transactions are recorded in the books
of accounts. A transaction is a type of event, which is generally external in nature and can be
determined in terms of money. In an accounting period, every business has huge number of
transactions which are analysed in financial terms and then recorded individually, followed
by classification and summarisation process, to know their impact on the financial statements.
A transaction is a two way process in which value is transferred from one party to another. In
it either a party receives a value in terms of goods etc. and passes the value in terms of money
or vice versa. Therefore, one can easily make out that in a transaction, a party receives as well
as passes the value to other party. For recording transaction it is very important that they are
supported by a substantial document like purchasing invoices, bills, pay-slips, cash-memos,
passbook etc.
Transactions analysed in terms of money and supported by proper documents are recorded in
the books of accounts under double entry system. To analyse the dual aspect of each transaction,
two approaches can be followed:

2.8 COMMON PROFICIENCY TEST


(1) Accounting Equation Approach.
(2) Traditional Approach.

6. ACCOUNTING EQUATION APPROACH


The relationship of assets with that of liabilities and owners' equity in the equation form is
known as 'Accounting Equation'. Basic accounting equation comes into picture when sum
total of capital and liabilities equalises assets, where assets are what the business owns and
capital and liabilities are what the business owes. Under double entry system, every business
transaction has two-fold effect on the business enterprise where each transaction affects changes
in assets, liabilities or capital in such a way that an accounting equation is completed and
equated. This accounting equation holds good at all points of time and for any number of
transactions and events except when there are errors in accounting process.
Let us suppose that an individual started business by contributing Rs. 5,00,000 and taking
loan of Rs.1,00,000 from a bank to be repayable, after 5 years. He purchased furniture costing
Rs. 1,00,000, and merchandise worth Rs. 5,00,000. For purchasing the merchandise he paid
Rs. 4,00,000 to the suppliers and agreed to pay balance after 3 months. Assume that all these
transactions and events occurred at to, base point of time.
The contribution by the owner is termed as capital; the borrowings are termed as loans or
liabilities. Whenever the loan is repayable in the short-run, say within one year, it is called
short-term loan or liability. On the other hand, if the loan is repayable within 4 or 5 years or
more, it would be termed as long term loan or liability.
Some other short-term liabilities relating to credit purchase of merchandise are popularly called
as trade creditors, and for other purchases and services received on credit as expense creditors.
These short-term liabilities are also termed as current liabilities.
On the other hand, money raised has been invested in two types of assets–fixed assets and
current assets. Furniture is a fixed asset, if it lasts long, say more than one year, and has utility
to the business, while inventory and cash balance will not remain fixed for long as soon as the
business starts to roll-these are current assets.
Often the owner's claim or fund in the business is called equity. Owner's claim implies capital
invested plus any profit earned minus any loss sustained.
Now at to we have an equation:
Equity + Liabilities = Assets
or, Equity + Long-Term Liabilities = Fixed Assets + Current Assets - Current Liabilities

FUNDAMENTALS OF ACCOUNTING 2.9


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

Check : L.H.S.
Equity Rs. 5,00,000
Long – Term Liabilities Rs. 1,00,000
Current Liabilities Rs. 1,00,000
Rs. 7,00,000
R.H.S.
Fixed Assets:
Furniture Rs. 1,00,000
Current Assets:
Inventory Rs. 5,00,000
Cash Rs. 1,00,000
Rs. 7,00,000
Cash = Capital + Loan - Furniture - Payment to Creditors
= Rs. 5,00,000 + Rs. 1,00,000 - Rs. 1,00,000 - Rs. 4,00,000 = Rs. 1,00,000
Let us use Eo, Lo and Ao to mean Equity, Liabilities and Assets respectively at t0. Thus the basic
accounting equation becomes
E0 + L0 = A0
or E0 = A0 - L0 ...(Eq. 1)
Now, let us suppose that at the end of period inventory valuing Rs. 2,50,000 is in hand, cash
Rs. 2,00,000, trade creditors, Rs. 50,000 bank loan Rs. 1,00,000 (interest was properly paid),
furniture Rs. 80,000 (Rs. 20,000 is taken as loss of value due to use). So at t1 -
Assets:
Fixed assets/ Furniture Rs. 80,000
Current assets/ Inventory Rs. 2,50,000
Cash Rs. 2,00,000
Rs. 5,30,000

Liabilities:
Long–Term Liabilities Rs. 1,00,000
Current Liabilities Rs. 50,000
Rs. 1,50,000
Rs. 3,80,000

2.10 COMMON PROFICIENCY TEST


Equity = Assets - Liabilities
i.e., E1 = A1 - L1
or E1 + L1 = A1 ...(Eq. 2)
Let us compare E1 with E0. Equity is reduced by Rs. 1,20,000 (5,00,000 - 3,80,000). Reduction
in equity is termed as loss.
Since the business sustained loss during the period, E2 becomes less than E0.
E1 < E0 implies loss during t01
Similarly, E2 < E1 implies loss during t12 and so on.
On the other hand, E1 > E0 implies profit earned by business during t01, E2 > E1 implies profit
earned during t12 and so on.
So if En > En-1, in general terms, equity has increased, while En < En-1 implies that equity has
declined. Increase in equity is termed as profit while decrease in equity is termed as loss.
Illustration 1: Develop the accounting equation from following information available at the
beginning of accounting period:
Rs.
Capital 1,00,000
Loan 50,000
Trade Creditors 70,000
Fixed Assets 80,000
Stock 60,000
Debtors 50,000
Cash and Bank 30,000
At the end of the accounting period the balances appear as follows :
Rs.
Capital ?
Loan 50,000
Trade Creditors 80,000
Fixed Assets 72,000
Stock 90,000
Debtors 50,000
Cash at Bank 60,000
(a) Reset the equation and find out profit.
(b) Prepare Balance Sheet at the end of the accounting period.

FUNDAMENTALS OF ACCOUNTING 2.11


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

Solution
(a) Accounting equation is given by
Equity + Liabilities = Assets
Let us use E0, L0 and A0 to mean equity, liabilities and assets respectively at the beginning of
the accounting period.
E0 = Rs. 1,00,000
L0 = Loan + Trade Creditors
= Rs. 50,000 + Rs. 70,000
= Rs. 1,20,000
A 0 = Fixed Assets + Stock + Debtors + Cash at Bank
= Rs. 80,000 + Rs. 60,000 + Rs. 50,000 + Rs. 30,000
= Rs. 2,20,000
So, at the beginning of accounting period
E0 + L0 = A0
i.e., Rs. 1,00,000 + Rs. 1,20,000 = Rs. 2,20,000
Let us use E1, L1, A1 to mean equity, liabilities and assets respectively at the end of the accounting
period.
L1 = Loan + Trade Creditors
= Rs. 50,000 + Rs. 80,000
= Rs. 1,30,000
A 1 = Fixed Assets + Stock + Debtors + Cash at Bank
= Rs. 72,000 + Rs. 90,000 + Rs. 50,000 + Rs. 60,000
= Rs. 2,72,000
E1 = A1 - L1 = Rs. 2,72,000 - Rs. 1,30,000 = Rs. 1,42,000
Profit = E1 - E0 = Rs. 1,42,000 - Rs. 1,00,000 = Rs. 42,000
(b) Balance Sheet
Liabilities Rs. Rs. Assets Rs.
Capital Fixed Assets 72,000
Balance 1,00,000 Stock 90,000
Add: Profit 42,000 1,42,000 Debtors 50,000
Loan 50,000 Cash at Bank 60,000
Trade Creditors 80,000
2,72,000 2,72,000

2.12 COMMON PROFICIENCY TEST


7. TRADITIONAL APPROACH
Under traditional approach of recording transactions one should first understand the term
debit and credit and their rules. The term debit and credit have already been explained in
para 4 of this Unit.
Transactions in the journal are recorded on the basis of the rules of debit and credit only. For
the purpose of recording, these transactions are classified in three groups:
(i) Personal transactions.
(ii) Transactions related to assets and properties.
(iii) Transactions related to expenses, losses, income and gains.

7.1 CLASSIFICATION OF ACCOUNTS


(i) Personal Accounts: Personal accounts relate to persons, debtors or creditors. Example
would be; the account of Ram & Co., a credit customer or the account of Jhaveri & Co., a
supplier of goods. The capital account is the account of the proprietor and, therefore, it is

Accounts

Personal Accounts Impersonal Accounts

Real Nominal
Natural Artificial Representative
(legal)

also personal but adjustment on account of profits and losses are made in it. This account
is further classified into three categories:
(a) Natural personal accounts: It relates to transactions of human beings like Ram, Rita, etc.
(b) Artificial (legal) personal account: For business purpose, business entities are treated
to have separate entity. They are recognised as persons in the eye of law for dealing
with other persons. For example: Government, Companies (private or limited), Clubs,
Co-operative societies etc.
(c) Representative personal accounts: These are not in the name of any person or
organisation but are represented as personal accounts. For example: outstanding
liability account or prepaid account, capital account, drawings account.
(ii) Impersonal Accounts: Accounts which are not personal such as machinery account,
cash account, rent account etc. These can be further sub-divided as follows:

FUNDAMENTALS OF ACCOUNTING 2.13


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

(a) Real Accounts: Accounts which relate to assets of the firm but not debt. For example,
accounts regarding land, building, investment, fixed deposits etc., are real accounts.
Cash in hand and Cash at the bank accounts are also real.
(b) Nominal Accounts: Accounts which relate to expenses, losses, gains, revenue, etc.
like salary account, interest paid account, commission received account. The net result
of all the nominal accounts is reflected as profit or loss which is transferred to the
capital account. Nominal accounts are, therefore, temporary.

7.2 GOLDEN RULES OF ACCOUNTING


All the above classified accounts have two rules each, one related to Debit and one related to
Credit for recording the transactions which are termed as golden rules of accounting, as
transactions are recorded on the basis of double entry system.
1. Personal account is governed by the following two rules:
Debit the receiver
Credit the giver
2. Real account is governed by the following two rules:
Debit what comes in
Credit what goes out
3. Nominal account is governed by the following two rules:
Debit all expenses and losses
Credit all incomes and gains.

8. JOURNAL
Transactions are first entered in this book to show which accounts should be debited and
which credited. Journal is also called subsidiary book. Recording of transactions in journal is
termed as journalizing the entries.

8.1 JOURNALISING PROCESS


All transactions are first recorded in the journal as and when they occur; the record is
chronological; otherwise it would be difficult to maintain the records in an orderly manner.
The form of the journal is given below :
JOURNAL

Dr. Cr.
Date Particulars L.F. Amount Amount
Rs. Rs. Rs.
(1) (2) (3) (4) (5)

2.14 COMMON PROFICIENCY TEST


The columns have been numbered only to make clear the following but otherwise they are not
numbered. The following points should be noted:
(i) In the first column the date of the transaction is entered-the year is written at the top,
then the month and in the narrow part of the column the particular date is entered.
(ii) In the second column, the names of the accounts involved are written; first the account to
be debited, with the word "Dr" written towards the end of the column. In the next line,
after leaving a little space, the name of the account to be credited is written preceded by
the word "To" (the modern practice shows inclination towards omitting "Dr." and "To").
Then in the next line the explanation for the entry together with necessary details is
given-this is called narration.
(iii) In the third column the number of the page in the ledger on which the account is written
up is entered.
(iv) In the fourth column the amounts to be debited to the various accounts concerned are
entered.
(v) In the fifth column, the amount to be credited to various accounts is entered.
8.2 POINTS TO BE TAKEN INTO CARE WHILE RECORDING A TRANSACTION
IN THE JOURNAL
1. Journal entries can be single entry (i.e. one debit and one credit) or compound entry
(i.e. one debit and two or more credits or two or more debits and one credit or two or
more debits and credits). In such cases, it is important to check that the total of both
debits and credits are equal.
2. If journal entries are recorded in several pages then both the amount column of each
page should be totalled and the balance should be written at the end of that page and
also that the same total should be carried forward at the beginning of the next page.
An entry in the journal may appear as follows:
Rs. Rs.
May 5 Cash Account Dr. 450
To Mohan 450
(Being the amount
received from Mohan
in payment of the
amount due from him)
We will now consider some individual transactions.
(i) Mohan commences business with Rs. 5000. This means that the firm has
Rs. 5000 cash. According to the rules given above, the increase in an asset has to
be debited to it. The firm also now owes Rs. 5,000 to the proprietor, Mohan as
capital. The rule given above also shows that the increase in capital should be
credited to it. Therefore, the journal entry will be:

FUNDAMENTALS OF ACCOUNTING 2.15


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

Cash Account Dr. Rs. 5,000


To Capital Account Rs. 5,000
(Being capital introduced
by Shri Mohan)

(ii) Out of the above, Rs. 500 is deposited in the bank. By this transaction the cash balance
is reduced by Rs. 500 and another asset, bank account, comes into existence. Since
increase in assets is debited and decrease is credited, the journal entry will be:

Bank Account Dr. Rs. 500


To Cash Account Rs. 500
(Being cash deposited in
Bank)

(iii) Furniture is purchased for cash Rs. 200. Applying the same reasoning as above the
entry will be:
Furniture Account Dr. Rs. 200
To Cash Account Rs. 200
(Being Furniture
purchased vide CM
No....)
(iv) Purchased goods for cash Rs. 400. The student can see that the required entry is:
Purchases Account Dr. Rs. 400
To Cash Account Rs. 400
(Being goods
purchased vide CM
No....)
(v) Purchased goods for Rs. 1,000 credit from M/s.Ram Narain Bros. Purchase of
merchandise is an expense item so it is to be debited. Rs. 1,000 is now owing to the
supplier; his account should therefore be credited, since the amount of liabilities has
increased. The entry will be:
Purchases Account Dr. Rs. 1,000
To M/s Ram Narain Bros. Rs. 1,000
(Being goods purchased
vide Bill No.....)
(vi) Sold goods to M/S Ram & Co. for cash Rs. 600. The amount of cash increases and
therefore, the cash amount should be debited; sale of merchandise is revenue item so
it is to be credited. The entry will be:

2.16 COMMON PROFICIENCY TEST


Cash Account Dr. Rs. 600
To Sales Account Rs. 600
(Being goods sold vide
CM No....)

(vii) Sold goods to Ramesh on credit for Rs. 300. The stock of goods has decreased and
therefore, the goods account has to be credited. Ramesh now owes Rs. 300; that is an
asset and therefore, Ramesh should be debited. The entry is:
Ramesh Dr. Rs. 300
To Sales Account Rs. 300
(Being goods sold vide
Bill No....)

(viii)Received cash from Ramesh Rs. 300. The amount of cash increased therefore the
cash account has to be debited. Ramesh no longer owes any amount to the firm, i.e.,
this particular form of assets has disappeared; therefore, the account of Ramesh should
be credited. The entry is:
Cash Account Dr. Rs. 300
To Ramesh Rs. 300
(Being cash received
against Bill No....)

(ix) Paid to M/s Ram Narain Bros. Rs. 1,000. The liability to M/S Ram Narain Bros. has
been discharged; therefore this account should be debited. The cash balance has
decreased and, therefore, the cash account has to be credited. The entry is:
M/S Ram Narain Bros. Dr. Rs. 1,000
To Cash Account Rs. 1,000
(Being cash paid
against Bill No....)

(x) Paid rent Rs. 100. The cash balance has decreased and therefore, the cash account
should be credited. No asset has come into existence because of the payment; the
payment is for services enjoyed and is an expense. Expenses are debited. Therefore,
the entry should be:
Rent Account Dr. Rs. 100
To Cash Account Rs. 100
(Being rent paid for the
month of .......)

FUNDAMENTALS OF ACCOUNTING 2.17


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

(xi) Paid Rs. 200 to the clerk as salary. Applying the reasons given in (x) above, the
required entry is:
Salary Account Dr. Rs. 200
To Cash Account Rs. 200
(Being salary paid to
Mr..... for the month of
...........)

(xii) Received Rs. 20 interest. The cash account should be debited since there is an increase
in the cash balance. There is no increase in any liability; since the amount is not
returnable to any one, the amount is an income, incomes are credited. The entry is :
Cash Account Dr. Rs. 20
To Interest Account Rs. 20
(Being interest received
from........ for the
period ............)

When transactions of similar nature take place on the same date, they may be combined while
they are journalised. For example, entries (x) and (xi) may be combined as follows:

Rent Account Dr. Rs. 100


Salary Account Dr. Rs. 200
To Cash Account Rs. 300
(Being expenses done as
per detail attached)

When journal entry for two or more transactions are combined, it is called composite journal
entry. Usually, the transactions in a firm are so numerous that to record the transactions for a
month will require many pages in the journal. At the bottom of one page the totals of the two
columns are written together with the words "Carried forward" in the particulars column.
The next page is started with the respective totals in the two columns with the words "Brought
forward" in the particulars column.
Illustration 3
Analyse transactions of M/S Sahil & Co. for the month of March, 2006 on the basis of double
entry system by adopting the following approaches:
(A) Accounting Equation Approach.
(B) Traditional Approach.
Transactions for the month of March, 2006 were as follows:
1. Sahil introduced cash Rs. 40,000.

2.18 COMMON PROFICIENCY TEST


2. Cash deposited in the City Bank Rs. 20,000.
3. Cash loan of Rs. 5,000 taken from Mr. Y.
4. Salaries paid for the month of March, 2006, Rs. 3,000 and Rs. 1,000 is still payable for the
month of March, 2006.
5. Furniture purchased Rs. 5,000.
What conclusions one can draw from the above analysis?
Solution
(A) Analysis of Business Transaction: Accounting Equation Approach

Transaction Analysis Account Affected Rule Entry


and Nature of
Account
Introduction of Cash received Cash – Asset Debit increase in Debit Cash
Rs. 40,000 cash Investment asset
by the Proprietor by owner
Capital – Capital Credit increase Credit Capital
in capital
Cash Bank balance Bank – Asset Debit increase in Debit Bank
deposited increases asset
in bank
Rs. 20,000 Cash balance Cash – Asset Credit decrease Credit Cash
decrease in asset
Loan from Y Cash balance Cash – Asset Debit increase Debit Cash
Rs. 5,000 increases in assets
Creates an Y's Loan Credit increase Credit Y's Loan
obligation to Liability in liabilities
repay Y
Salaries paid Salaries for Salary Temporary Debit increase in Debit Salary
Rs. 3,000 and services received capital (Expense) expenses (Rs. 4,000)
outstanding Rs. 4,000 Cash–Asset
Rs. 1,000 paid Rs. 3,000 Credit decrease Credit Cash
Obligation to pay Salaries in asset (Rs. 3,000)
Rs. 1,000 outstanding Credit increase Credit Salaries
Liability in liabilities outstanding
(Rs. 1,000)
Furniture Increases Furniture–Asset Debit increase Debit Furniture
purchased furniture owned in asset
Rs. 5,000 Cash decreases Cash–Asset Credit decrease Credit Cash
in asset

FUNDAMENTALS OF ACCOUNTING 2.19


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

(B) Analysis of Business Transactions: Traditional Approach

Transaction Analysis Account Affected Rule Entry


and Nature of
Account
Introduction of Cash is received Cash–Real Debit what Debit Cash
Rs. 40,000 cash by business comes in
by the proprietor Owner has given Capital–Personal Credit the giver Credit Capital
cash
Cash deposited Bank receives Bank–Personal Debit the receiver Debit Bank
in bank cash
Rs. 20,000 Cash goes out Cash–Real Credit what
of business goes out Credit Cash
Loan from Y Business gets cash Cash–Real Debit what Debit Cash
Rs. 5,000 Y pays cash Y's Loan–Personal comes in
Credit the giver Credit Y's Loan
Salary paid Cost of services Salary Nominal Debit all expenses Debit Salary
Rs. 3,000 and used Rs. 4,000 (Rs. 4,000)
still payable Cash goes out Cash–Real Credit what Credit Cash
Rs. 1,000 Rs. 3,000 goes out (Rs. 3,000)
Still payable or Salary Outstanding Credit the giver Credit Salary
outstanding for Personal outstanding
services received (Rs. 1,000)
Rs. 1,000
Furniture Furniture is Furniture Real Debit what Debit Furniture
purchased purchased comes in
Rs. 5,000 Cash is paid Cash–Real Credit what
goes out Credit Cash
Conclusion:
It is evident from above analysis that procedure for analysis of transactions, classification of
accounts and rules for recording business transactions under accounting equation approach
and traditional approach are different. But the accounts affected and entries in affected accounts
remain same under both approaches. Thus, the recording of transactions in affected accounts
on the basis of double entry system is independent of the method of analysis followed by a
business enterprise. In other words, accounts to be debited and credited to record the dual
aspect remain same under both the approaches.
Illustration 4
Journalise the following transactions. Also state the nature of each account involved in the
Journal entry.
1. December 1, 2005, Ajit started business with Cash Rs. 40,000.

2.20 COMMON PROFICIENCY TEST


2. December 3, he paid into the Bank Rs. 2,000.
3. December 5, he purchased goods for cash Rs. 15,000.
4. December 8, he sold goods for cash Rs. 6,000.
5. December 10, he purchased furniture and paid by cheque Rs. 5,000.
6. December 12, he sold goods to Arvind Rs. 4,000.
7. December 14, he purchased goods from Amrit Rs. 10,000.
8. December 15, he returned goods to Amrit Rs. 5,000.
9. December 16, he received from Arvind Rs. 3,960 in full settlement.
10. December 18, he withdrew goods for personal use Rs. 1,000.
11. December 20, he withdrew cash from business for personal use Rs. 2,000.
12. December 24, he paid telephone charges Rs. 1,000.
13. December 26, cash paid to Amrit in full settlement Rs. 4,900.
14. December 31, paid for stationery Rs. 200, rent Rs. 500 and salaries to staff Rs. 2,000.
15. December 31, goods distributed by way of free samples Rs. 1,000.
Solution
JOURNAL

Dr. Cr.
Sl. . Date Particulars Nature of L.F. Debit Credit
No Account (Rs.) (Rs.)
1. Dec. 1 Cash Account Dr. Real A/c 40,000
To Capital Account Personal A/c 40,000
(Being commencement
of business)
2. Dec. 3 Bank Account Dr. Personal A/c 2,000
To Cash Account Real A/c 2,000
(Being cash
deposited in the
Bank)
3. Dec. 5 Purchases Account Dr. Real A/c 15,000
To Cash Account Real A/c 15,000
(Being purchase of
goods for cash)
4. Dec. 8 Cash Account Dr. Real A/c 6,000
To Sales Account Real A/c 6,000
(Being goods sold for cash)

FUNDAMENTALS OF ACCOUNTING 2.21


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

5. Dec. 10 Furniture Account Dr. Real A/c 5,000


To Bank Account Personal A/c 5,000
(Being purchase of
furniture, paid by
cheque)
6. Dec. 12 Arvind Dr. Personal A/c 4,000
To Sales Account Real A/c 4,000
(Being sale of goods)
7. Dec. 14 Purchases Account Dr. Real A/c 10,000
To Amrit Personal A/c 10,000
(Being purchase of
goods from Amrit )
8. Dec. 15 Amrit Dr. Personal A/c 5,000
To Purchases
Returns Account Real A/c 5,000
(Being goods returned
to Amrit)
9. Dec. 16 Cash Account Dr. Real A/c 3,960
Discount Account Dr. Nominal A/c 40
To Arvind Personal A/c 4,000
(Being cash received
from Arvind in full
settlement and allowed
him Rs. 40 as discount)
10. Dec. 18 Drawings Account Dr. Personal A/c 1,000
To Purchases Account Real A/c 1,000
(Being withdrawal of
goods for personal use)
11. Dec. 20 Drawings Account Dr. Personal A/c 2,000
To Cash Account Real A/c 2,000
(Being cash withdrawal
from the business for
personal use)
12. Dec. 24 Telephone Expenses Dr. Nominal A/c 1,000
Account
To Cash Account Real A/c 1,000
(Being telephone
expenses paid)
13. Dec. 26 Amrit Dr. Personal A/c 5,000
To Cash Account Real A/c 4,900
To Discount Account Nominal A/c 100
(Being cash paid to
Amrit and he allowed
Rs. 100 as discount)

2.22 COMMON PROFICIENCY TEST


14. Dec. 31 Stationery Expenses Dr. Nominal A/c 200
Rent Account Dr. Nominal A/c 500
Salaries Account Dr. Nominal A/c 2,000
To Cash Account Real A/c 2,700
(Being expenses paid)
15. Dec. 31 Advertisement
Expenses Account Dr. Nominal A/c 1,000
To Purchases Account Real A/c 1,000
(Being distribution of
goods by way of
free samples)
_______ _______
Total 1,03,700 1,03,700
_______ _______

Illustration 5
Show the classification of the following Accounts under traditional and accounting equation
approach:
(a) Building; (b) Purchases; (c) Sales; (d) Bank Deposit; (e) Rent; (f) Rent Outstanding; (g)
Cash; (h) Adjusted Purchases; (i) Closing Stock; (j) Investments; (k) Debtors; (l) Sales Tax
Payable, (m) Discount Allowed; (n) Bad Debts; (o) Capital; (p) Drawings; (q) Provision for
depreciation account, (r) Interest Receivable account; (s) Rent received in advance account; (t)
Prepaid salary account; (u) Provision for Bad & doubtful debts account; (v) Bad debts recovered
account; (w) Depreciation account, (x) Personal income-tax account; (y) Stock reserve account;
(z) Provision for discount on creditors account.
Solution
Nature of Account
Sl. No. Title of Account Traditional Approach Accounting Equation Approach
(a) Building Real Asset
(b) Purchases Real Asset
(c) Sales Nominal (Revenue) Temporary Capital (Revenue)
(d) Bank Deposit Personal Asset
(e) Rent Nominal (Expense) Temporary Capital (Expense)
(f) Rent Outstanding Personal Liability
(g) Cash Real Asset
(h) Adjusted Purchases Nominal (Expense) Temporary Capital (Expense)
(i) Closing Stock Real Asset
(j) Investment Real Asset
(k) Debtors Personal Asset

FUNDAMENTALS OF ACCOUNTING 2.23


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

(l) Sales Tax Payable Personal Liability


(m) Discount Allowed Nominal (Expense) Temporary Capital (Expense)
(n) Bad Debts Nominal (Expense) Temporary Capital (Expense)
(o) Capital Personal Capital
(p) Drawings Personal Temporary Capital (Drawings)
(q) Provision for
depreciation Valuation (Real) Asset
(r) Interest receivable Personal Asset
(s) Rent received in
advance Personal Liability
(t) Prepaid salary Personal Valuation (Asset)
(u) Provision for bad and
doubtful debts Valuation (Personal) Valuation (Asset)
(v) Bad debts recovered Nominal (Gain) Temporary Capital (Gain)
(w) Depreciation Nominal (Expense) Temporary Capital (Expense)
(x) Personal Income Tax Personal (Drawing) Temporary Capital (Drawings)
(y) Stock reserve Valuation (Real) Valuation (Asset)
(z) Provision for discount
on creditors Valuation (Personal) Valuation (Liability)
Illustration 6
Transactions of Ramesh for April are given below Journalise them.
2006 Rs.
April 1 Ramesh started business with 10,000
" 2 Paid into bank 7,000
" 3 Bought goods for cash 500
" 5 Drew cash from bank for credit 100
" 13 Sold to Krishna goods on credit 150
" 20 Bought from Shyam goods on credit 225
" 24 Received from Krishna 145
" Allowed him discount 5
" 28 Paid Shyam cash 215
" Discount allowed 10
" 30 Cash sales for the month 800
Paid Rent 50
Paid Salary 100

2.24 COMMON PROFICIENCY TEST


Solution
JOURNAL
Dr. Cr.
Date Particulars L.F. Amount Date
2006 Rs. Rs.
April 1 Cash Account Dr. 1 10,000
To Capital Account 4 10,000
(Being the amount invested by Ramesh in
the business as capital)
"2 Bank Account Dr. 5 7,000
To Cash Account 1 7,000
(Being the amount paid into bank)
"3 Purchases Account Dr. 7 500
To Cash Account 500
(Being goods purchased for cash)
"5 Cash Account Dr. 1 100
To Bank Account 5 100
(Being cash withdrawn from bank)
" 13 Krishna Dr. 9 150
To Sales Account 7 150
(Being goods sold to Krishna on credit)
" 20 Purchases Account Dr. 7 225
To Shyam 10 225
(Being goods bought from Shyam on credit)
" 24 Cash Account Dr. 1 145
Discount Account Dr. 12 5
To Krishna 9 150
(Being cash received from Krishna and
discount allowed to him)
" 28 Shyam Dr. 10 225
To Cash Account 1 215
To Discount Account 12 10
(Being cash paid to Shyam and discount
allowed by him)
" 30 Cash Account Dr. 1 800

FUNDAMENTALS OF ACCOUNTING 2.25


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

To Sales Account 7 800


(Being goods sold for cash)
" 30 Rent Account Dr. 15 50
Salaries Account Dr. 10 100
To Cash Account 1 150
(Being the amount paid for rent and salary) _____ _____
Total 19,300 19,300
(Ledger Folio imaginary)

Illustration 7
Pass Journal Entries for the following transactions in the books of Gamma Bros.
(i) Employees had taken stock worth Rs. 10,000 (Cost price Rs. 7,500) on the eve of Deepawali
and the same was deducted from their salaries in the subsequent month.
(ii) Wages paid for erection of Machinery Rs. 8,000.
(iii) Provision for discount on creditors is to be made amounting Rs. 1,500.
(iv) Income tax liability of proprietor Rs. 1,700 was paid out of petty cash.
(v) Purchase of goods from Naveen of the list price of Rs. 2,000. He allowed 10% trade
discount, Rs. 50 cash discount was also allowed for quick payment.
Solution
Journal Entries in the books of Gamma Bros.
Particulars Dr. Cr.
Amount Amount
Rs. Rs.
(i) Salaries A/c Dr. 7,500
To Purchase A/c 7,500
(Being entry made for stock taken by employees)
(ii) Machinery A/c Dr. 8,000
To Cash A/c 8,000
(Being wages paid for erection of machinery)
(iii) Provision for discount on creditors A/c Dr. 1,500
To Profit and Loss A/c 1,500
(Being provision for discount made on creditors)
(iv) Drawings A/c Dr. 1,700
To Petty Cash A/c 1,700
(Being the income tax of proprietor paid out of
business money)
(v) Purchase A/c Dr. 1,800
To Cash A/c 1,750
To Discount Received A/c 50
(Being the goods purchased from Naveen for
2.26 COMMON PROFICIENCY TEST
Rs. 2,000 @ 10% trade discount and cash discount
of Rs. 50)

9. ADVANTAGES OF JOURNAL
In journal, transactions recorded on the basis of double entry system, fetch following
advantages:
1. As transactions are recorded on chronological order, one can get complete information
about the business transactions on time basis.
2. Entries recorded in the journal are supported by a note termed as narration, which is a
precise explanation of the transaction for the proper understanding of the entry. One can
know the correctness of the entry through these narrations.
3. Journal forms the basis for posting the entries in the ledger. This eases the accountant in
their work and reduces the chances of error.

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
(i) The rent paid to landlord is credited to
(a) Landlord’s account. (b) Rent account. (c) Cash account. (d) None of the above.
(ii) In case of a debt becoming bad, the amount should be credited to
(a) Debtors account. (b) Bad debts account. (c) Cash account. (d) Sales account.
(iii) Sunset Tours has a Rs.3,500 account receivable from Mohan. On January 20, the Rotary
makes a partial payment of Rs.2100 to Sunset Tours. The journal entry made on January
20 by Sunset Tours to record this transaction includes:
(a) A credit to the cash received account of Rs.2,100.
(b) A credit to the Accounts receivable account of Rs.2,100.
(c) A debit to the cash account of Rs.1,400.
(d) A debit to the Accounts receivable account of Rs.1,400.
(iv) Which financial statement represents the accounting equation, assets = Liabilities + Owner’s
equity:
(a) Income Statement (b) Statement of Cash flows
(c) Balance Sheet (d) None of the above
(v) Which account is the odd one out?
(a) Office furniture & Equipment. (b) Freehold land and Buildings.
(c) Stock of materials. (d) Plant and Machinery.
(vi) The debts written off as bad, if recovered subsequently are
(a) credited to Bad Debts Recovered Account (b) credited to Debtors Account.
(c) debited to Profit and Loss Account (d) None of the above
[Ans: 1:(i)-(c), (ii)-(a), (iii)-(b), (iv)-(c), (v)-(c), (vi)- (a)]

FUNDAMENTALS OF ACCOUNTING 2.27


BASIC ACCOUNTING PROCEDURES – JOURNAL ENTRIES

II From the given information, choose the most appropriate answer.


1. Classify each of the following items under:
(i) Prepaid salary account.
(a) Personal, (b) Real (c) Nominal (d) None of the above
(ii) Bill payable account.
(a) Personal, (b) Real (c) Nominal (d) None of the above
(iii) Rent account.
(a) Personal, (b) Real (c) Nominal (d) None of the above
(iv) Proprietor’s account
(a) Personal, (b) Real (c) Nominal (d) None of the above
(v) Patents account.
(a) Personal, (b) Real (c) Nominal (d) None of the above
[Ans. 1: (i)-(a), (ii)-(a), (iii)-(c), (iv)-(a), (v)-(b)]
2. Classify each of the following items under:
(i) Salaries.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(ii) Equipment.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(iii) Accounts payable.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(iv) Membership fees earned.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(v) Stock.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(vi) Accounts receivable.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(vii) Building.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) liability (L), or
(viii) Profits.
(a) revenue(R), (b) expense (E), (c) asset (A), (d) owner’s capital (OC) item.
[Ans.2: (i)-(b), (ii)-(c), (iii)-(d), (iv)-(a), (v)-(c), (vi)-(c), (vii)-(c), (viii)-(d)]
3. In each of the following, indicate the alternative which you consider to be correct:
(a) In Double Entry System of Book-keeping every business transaction affects:
(i) Two accounts. (ii) two sides of the same account.
(iii) the same account on two different dates. (iv) All of the above
(b) A sale of goods to Ram for cash should be debited to:
(i) Ram (ii) Cash (iii) Sales (iv) Capital
(c) A withdrawal of cash from business by the proprietor should be credited to:
(i) Drawing Account (ii) Capital Account
(iii) Cash Account (iv) Purchase Account
[Ans:3: (a)(i), (b)(ii), (c)(iii)]

2.28 COMMON PROFICIENCY TEST


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 2

Ledgers
LEDGERS

Learning Objectives
After studying this unit, you will be able to :
 Understand the concept of Ledgers.
 Learn the technique of ledger posting sand how to balance an account.
 Learn the technique of opening accounts each year taking closing balances of the previous
year. Note also the use of 'balance c/d' and 'balance b/d'.

1. INTRODUCTION
After recording the transactions in the journal, recorded entries are classified and grouped
into by preparation of accounts and the book, which contains all set of accounts (viz. personal,
real and nominal accounts), is known as Ledger. It is known as principal books of account in
which account-wise balance of each account is determined.

2. SPECIMEN OF LEDGER ACCOUNTS


A ledger account has two sides-debit (left part of the account) and credit (right part of the
account). Each of the debit and credit side has four columns. (i) Date (ii) Particulars (iii) Journal
folio i.e. page from where the entries are taken for posting and (iv) Amount.
Dr. Account Cr.

Date Particulars J.F. Amount (Rs). Date Particulars J.F. Amount (Rs.)

3. POSTING
The process of transferring the debit and credit items from journal to classified accounts in the
ledger is known as posting.
3.1 RULES REGARDING POSTING OF ENTRIES IN THE LEDGER
1. Separate account is opened in ledger book for each account and entries from ledger
posted to respective account accordingly.
2. It is a practice to use words 'To' and 'By' while posting transactions in the ledger. The
word 'To' is used in the particular column with the accounts written on the debit side
while 'By' is used with the accounts written in the particular column of the credit
side. These 'To' and 'By' do not have any meanings but are used to represent the
account debited and credited.
3. The concerned account debited in the journal should also be debited in the ledger but
reference should be of the respective credit account. For example: Rent paid by cash
Rs. 500. The journal entry for this transaction would be.

2.30 COMMON PROFICIENCY TEST


4. BALANCING AN ACCOUNT
At the end of the each month or year or any particular day it may be necessary to ascertain
the balance in an account. This is not a too difficult thing to do; suppose a person has bought
goods worth Rs. 1,000 and has paid only Rs. 850; he owes Rs. 150 and that is balance in his
account. To ascertain the balance in any account, what is done is to total the sides and ascertain
the difference; the difference is the balance. If the credit side is bigger than the debit side, it is
a credit balance. In the other case it is a debit balance. The credit balance is written on the
debit side as, "To Balance c/d"; c/d means "carried down". By doing this, two sides will be
equal. The totals are written on the two sides opposite one another.
Then the credit balance is written on the credit side as "By balance b/d (i.e., brought down)".
This is the opening balance for the new period. The debit balance similarly is written on the
credit side as "By Balance c/d", the totals then are written on the two sides as shown above as
then the debit balance written on the debit side as, "To Balance b/d", as the opening balance
of the new period.
It should be noted that nominal accounts are not balanced; the balance in the end are transferred
to the profit and loss account. Only personal and real accounts ultimately show balances. In
the illustration given above, one will have noticed that the capital account, the purchases
account, sales account, the discount account, the rent account and the salary account have
not been balanced. The capital account will have to be adjusted for profit or loss and that is
why it has not been balanced yet.
Illustration 1
Prepare the Stationery Account of a firm for the year ended 31.12.2005 duly balanced off,
from the following details:
2005 Rs.
Jan. 1 Stock in hand 480
April 5 Purchase of stationery by cheque 800
Nov. 15 Purchase of stationery on credit from Five Star Stationery Mart 1,280
Dec. 31 Stock in hand 240
Solution
Stationery Account
Dr. Cr.
Date Particulars Rs. Date Particulars Rs.
1.1.2005 To Balance b/d 480 31.12.2005 By Profit and loss
5.4.2005 To Bank A/c 800 A/c (Balancing
figure) 2,320
15.11.2005 To Five Star Stationery
Mart A/c 1,280 31.12.2005 By Balance c/d 240
2,560 2,560

FUNDAMENTALS OF ACCOUNTING 2.31


LEDGERS

Illustration 2
Journalise the following transactions in the books of a trader
Debit Balance on January 1, 2006
Cash in Hand Rs. 8,000, Cash at Bank Rs. 25,000, Stock of Goods Rs. 20,000, Building
Rs. 10,000. Sundry Debtors: Vijay Rs. 2,000 and Madhu Rs. 2,000.
Credit Balances on January 1, 2006:
Sundry Creditors: Anand Rs. 5,000.
Following were further transactions in the month of January, 2006:
Jan. 1 Purchased goods worth Rs. 5,000 for cash less 20% trade discount and 5% cash
discount.
Jan. 4 Received Rs. 1,980 from Vijay and allowed him Rs. 20 as discount.
Jan. 8 Purchased plant from Mukesh for Rs. 5,000 and paid Rs. 100 as cartage for
bringing the plant to the factory and another Rs. 200 as installation charges.
Jan. 12 Sold goods to Rahim on credit Rs. 600.
Jan. 15 Rahim became insolvent and could pay only 50 paise in a rupee.
Jan. 18 Sold goods to Ram for cash Rs. 1,000.
Solution

Cash Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
2006 2006
Jan. 1 To Balance b/d 8,000 Jan. 1 By Purchases A/c 3,800
Jan. 4 To Vijay 1,980 Jan. 8 By Plant A/c 300
Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 7,180
Jan. 18 To Sales A/c 1,000
11,280 11,280
Feb. 1 To Balance b/d 7,180
Bank Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 1 To Balance b/d 25,000 Jan. 31 By Balance c/d 25,000
25,000 25,000
Feb. 1 To Balance b/d 25,000
Stock Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 1 To Balance b/d 20,000 Jan. 31 By Balance c/d 20,000
20,000 20,000
Feb. 1 To Balance b/d 20,000

2.32 COMMON PROFICIENCY TEST


Building Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 1 To Balance b/d 10,000 Jan. 31 By Balance c/d 10,000
10,000 10,000
Feb. 1 To Balance b/d 10,000
Vijay
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 1 To Balance b/d 2,000 Jan. 4 By Cash A/c 1,980
By Discount A/c 20
2,000 2,000
Madhu
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 1 To Balance b/d 2,000 Jan. 31 By Balance c/d 2,000
2,000 2,000
Feb. 1 To Balance b/d 2,000
Capital Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 31 To Balance c/d 55,000 Jan. 1 By Balance b/d 55,000
55,000 55,000
Feb. 1 By Balance b/d 55,000
Purchases Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 1 To Cash 3,800
Jan. 1 To Discount 200 Jan. 31 By Balance c/d 4,000
4,000 4,000
Feb. 1 To Balance b/d 4,000
Discount Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 4 To Vijay 20 Jan. 1 By Purchases A/c 200
Jan. 31 To Balance c/d 180
200 200
Feb. 1 By Balance b/d 180

FUNDAMENTALS OF ACCOUNTING 2.33


LEDGERS

Plant Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 8 To Mukesh 5,000 Jan. 31 By Balance c/d 5,300
Jan. 8 To Cash A/c 300 _____
5,300 5,300
Feb. 1 To Balance b/d 5,300
Mukesh
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 31 To Balance c/d 5,000 Jan. 8 By Plant A/c 5,000
5,000 5,000
Feb. 1 By Balance b/d 5,000
Sales Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 31 To Balance c/d 1,600 Jan. 12 By Rahim 600
Jan. 18 By Cash A/c 1,000
1,600 Feb. 1 By Balance b/d 1,600
Rahim
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 12 To Sales A/c 600 Jan. 15 By Cash A/c 300
___ Jan. 15 By Bad Debts A/c 300
600 600
Bad Debts Account
Dr. Cr.
Date Particulars L.F. Rs. Date Particulars L.F. Rs.
Jan. 15 To Rahim 300 Jan. 31 By Balance c/d 300
300 300
Feb. 1 To Balance b/d 300

Illustration 3
The following data is given by Mr. S, the owner, with a request to compile only the two
personal accounts of Mr. H and Mr. R, in his ledger, for the month of April, 2006.
1 Mr. S owes Mr. R Rs. 15,000; Mr. H owes Mr. S Rs. 20,000.
4 Mr. R sold goods worth Rs. 60,000 @ 10% trade discount to Mr. S.
5 Mr. S sold to Mr. H goods prices at Rs. 30,000.

2.34 COMMON PROFICIENCY TEST


17 Record a purchase of Rs. 25,000 net from R, which were sold to H at a profit of
Rs. 15,000.
18 Mr. S rejected 10% of Mr. R's goods of 4th April.
19 Mr. S issued a cash memo for Rs. 10,000 to Mr. H who came personally for this consignment
of goods, urgently needed by him.
22 Mr. H cleared half his total dues to Mr. S, enjoying a ½% cash discount (of the payment
received, Rs. 20,000 was by cheque).
26 R's total dues (less Rs. 10,000 held back) were cleared by cheque, enjoying a cash discount
of Rs. 1,000 on the payment made.
29 Close H's Account to record the fact that all but Rs. 5,000 was cleared by him, by a
cheque, because he was declared bankrupt.
30 Balance R's Account.
Solution
In the books of Mr. S

Mr. H Account
Dr. Cr.
Date Particulars Rs. Date Particulars Rs.
1.4.2006 To Balance b/d 20,000 22.4.2006 By Bank A/c 20,000
5.4.2006 To Sales A/c 30,000 22.4.2006 By Cash A/c (Note 2) 24,775
17.4.2006 To Sales A/c 40,000 29.4.2006 By Discount Allowed A/c 225
29.4.2006 By Bank A/c 40,000
29.4.2006 By Bad Debts A/c 5,000
90,000 90,000

Mr. R Account
Dr. Cr.
Date Particulars Rs. Date Particulars Rs.
18.4. 2006 To Purchase 5,400 1.4.2006 By By Balance b/d 15,000
Returns A/c 4.4.2006 By Purchases A/c 54,000

26.4. 2006 To Bank A/c 77,600 17.4. 2006 By Purchases A/c 25,000
26.4. 2006 To Discount
Received A/c 1,000
30.4. 2006 To Balance c/d 10,000 –
94,000 94,000
1.5.2006 By Balance b/d 10,000

FUNDAMENTALS OF ACCOUNTING 2.35


LEDGERS

Working Notes:
(1) Sale of Rs. 10,000 on 19th April is a cash sales, therefore, it will not be recorded in the
Personal Account of Mr. H; and (2) On 22nd April, Mr. H owes Mr. S Rs. 90,000, amount paid
by Mr. H ½ of Rs. 90,000 less ½% discount i.e. Rs. 45,000– Rs. 225 = Rs. 44,775. Out of this
amount, Rs. 20,000 paid by cheque and the balance of Rs. 24,775 in cash.

SELF EXAMINATION QUESTIONS


I. Pick up the correct answer from the given choices:
(i). The process of transferring the debit and credit items from a Journal to their respective
accounts in the ledger is termed as
(a) posting
(b) purchase
(c) balancing of an account
(d) arithmetically accuracy test
(ii) The technique of finding the net balance of an account after considering the totals of
both debits and credits appearing in the account is known as
(a) posting
(b) purchase
(c) balancing of an account
(d) arithmetically accuracy test.
(iii) Journal and ledger records transactions in
(a) a chronological order and analytical order respectively.
(b) an analytical order and chronological order respectively.
(c) a chronological order only
(d) an analytical order only.
(iv) Ledger book is popularly known as
(a) secondary book of accounts
(b) principal book of accounts
(c) subsidiary book of accounts
(d) none of the above
(v) At the end of the accounting year all the nominal accounts of the ledger book are
(a) balanced but not transferred to profit and loss account
(b) not balanced and also the balance is not transferred to the profit and loss account
(c) balanced and the balance is transferred to the balance sheet
(d) not balanced and their balance is transferred to the profit and loss account.
[Ans: (i)-(a), (ii)-(c), (iii)-(a), (iv)-(b), (v)-(d)]

2.36 COMMON PROFICIENCY TEST


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 3

Trial Balance
TRIAL BALANCE

Learning Objectives
After studying this unit, you will be able to :
 Understand what is trial balance and what purposes it can serve,
 Learn the technique of taking balances from ledger accounts to prepare trial balance.

1. INTRODUCTION
Preparation of trial balance is the third phase in the accounting process. After posting the
accounts in the ledger, a statement is prepared to show separately the debit and credit balances.
Such a statement is known as the trial balance. It may also be prepared by listing each and
every account and entering in separate columns the totals of the debit and credit sides.
Whichever way it is prepared, the totals of the two columns should agree. An agreement
indicates reasonable accuracy of the accounting work; if the two sides do not agree, then
there is simply an arithmetic error(s).
This follows from the fact that under the Double Entry System, the amount written on the
debit sides of various accounts is always equal to the amounts entered on the credit sides of
other accounts and vice versa. Hence the totals of the debit sides must be equal to the totals of
the credit sides. Also total of the debit balances will be equal to the total of the credit balances.
Once this agreement is established, there is reasonable confidence that the accounting work is
free from clerical errors, though is not proof of cent per cent accuracy, because some errors of
principle and compensating errors may still remain. Generally, to check the arithmetic accuracy
of accounts, trial balance is prepared at monthly intervals. But because double entry system is
followed, one can prepare a trial balance any time. Though a trial balance can be prepared
any time but it is preferable to prepare it at the end of the accounting year to ensure the
arithmetic accuracy of all the accounts before the preparation of the financial statements. It
may be noted that trial balance is a statement and not an account.

2. OBJECTIVES OF PREPARING THE TRIAL BALANCE


The preparation of trial balance has the following objectives:
(i) Trial balance enables one to establish whether the posting and other accounting processes
have been carried out without committing arithmetical errors. In other words, the trial
balance helps to establish arithmetical accuracy of the books.
(ii) Financial statements are normally prepared on the basic of agreed trial balance; otherwise
the work may be cumbersome. Preparation of financial statements, therefore, is the second
objective.
(iii) The trial balance serves as a summary of what is contained in the ledger; the ledger may
have to be seen only when details are required in respect of an account.
The form of the trial balance is simple as shown below:

2.38 COMMON PROFICIENCY TEST


TRIAL BALANCE
as at.......................
S. No Ledger Accounts L.F. Dr. Amount Cr. Amount
(Total or Balance) (Total or Balance)
Rs. Rs.
The under mentioned points may be noted:
(i) A trial balance is prepared as on a particular date which should be mentioned at the top
(ii) In the second column the name of the account is written.
(iii) In the fourth column the total of the debit side of the account concerned or the debit
balance, if any is entered.
(iv) In the next column, the total of the credit side or the credit balance is written.
(v) The two columns are totalled at the end.
(vi) The first and third column needs no explanation.

3. LIMITATIONS OF TRIAL BALANCE


One should note that the agreement of Trial Balance is not a conclusive proof of accuracy. In
other words, in spite of the agreement of the trial balance some errors may remain. These may
be of the following types:
(i) Transaction has not been entered at all in the journal.
(ii) A wrong amount has been written in both columns of the journal.
(iii) A wrong account has been mentioned in the journal.
(iv) An entry has not at all been posted in the ledger.
(v) Entry is posted twice in the ledger.
Still, the preparation of the trial balance is very useful; without it, the preparation of financial
statement, the profit and loss account and the balance sheet, would be difficult.

4. METHODS OF PREPARATION OF TRIAL BALANCE


1. TOTAL METHOD
Under this method, every ledger account is totaled and that total amount (both of debit
side and credit side) is transferred to trial balance. In this method, trial balance can be
prepared as soon as ledger account is totaled. Time taken to balance the ledger accounts
is saved under this method as balance can be found out in the trial balance itself. The
difference of totals of each ledger account is the balance of that particular account. This
method is not commonly used as it cannot help in the preparation of the financial
statements.

FUNDAMENTALS OF ACCOUNTING 2.39


TRIAL BALANCE

Illustration 1
Given below is a ledger extract relating to the business of X and Co. as on March, 31, 2006.
You are required to prepare the Trial Balance by the Total Amount Method.

Cash Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Capital A/c 10,000 By Furniture A/c 3,000
To Ram's A/c 25,000 By Salaries A/c 2,500
To Cash Sales 500 By Shyam's A/c 21,000
By Cash Purchases 1,000
By Capital A/c 500
By Balance c/d 7,500
35,500 35,500

Furniture Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Cash A/c 3,000 By Balance c/d 3,000
3,000 3,000

Salaries Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Cash A/c 2,500 By Balance c/d 2,500
2,500 2,500

Shyam's Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Cash A/c 21,000 By Purchases A/c 25,000
To Purchase Returns A/c 500 (Credit Purchases)
To Balance c/d 3,500 –
25,000 25,000

2.40 COMMON PROFICIENCY TEST


Purchases Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Cash A/c (Cash Purchases) 1,000 By Balance c/d 26,000
To Sundries as per Purchases Book
(Credit Purchases) 25,000 –
26,000 26,000
Purchases Returns Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Balance c/d 500 By Sundries as per Purchases
Return Book 500
500 500

Ram's Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Sales A/c (Credit Sales) 30,000 By Sales Returns A/c 100
By Cash A/c 25,000
By Balance c/d 4,900
30,000 30,000

Sales Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Balance c/d 30,500 By Cash A/c (Cash Sales) 500
By Sundries as per Sales Book
(Credit sales) 30,000
30,500 30,500

Sales Returns Account


Dr. Cr.
Particulars Rs. Particulars Rs.
To Sundries as per Sales
Returns Book 100 By Balance c/d 100
100 100

FUNDAMENTALS OF ACCOUNTING 2.41


TRIAL BALANCE

Capital Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Cash A/c 500 By Cash A/c 10,000
To Balance c/d 9,500 –
10,000 10,000
Solution
Trial Balance of X and Co. as at 31.03.2006

Sl. No. Name of Account Total Debit Total of


Items Credit Items
Rs. Rs.
1. Cash A/c 35,500 28,000
2. Furniture A/c 3,000
3. Salaries A/c 2,500
4. Shyam's A/c 21,500 25,000
5. Purchases A/c 26,000
6. Purchases Returns A/c 500
7. Ram's A/c 30,000 25,100
8. Sales A/c 30,500
9. Sales Returns A/c 100
10. Capital A/c 500 10,000
1,19,100 1,19,100

2. BALANCE METHOD
Under this method, every ledger account is balanced and those balances only are carry forward
to the trial balance. This method is used commonly by the accountants and helps in the
preparation of the financial statements. Financial statements are prepared on the basis of the
balances of the ledger accounts.
Illustration 2
Taking the same information as given in Illustration 1, prepare the Trial Balance by Balance
Method.

2.42 COMMON PROFICIENCY TEST


Solution
Trial Balance of X and Co. as at 31.03.2006
Sl. No. Name of Account Debit Balance Credit Balance
Rs. Rs.
1. Cash A/c 7,500
2. Furniture A/c 3,000
3. Salaries A/c 2,500
4. Shyam's A/c 3,500
5. Purchases A/c 26,000
6. Purchases Returns A/c 500
7. Ram's A/c 4,900
8. Sales A/c 30,500
9. Sales Returns A/c 100
10. Capital A/c – 9,500
44,000 44,000

3. TOTAL AND BALANCE METHOD


Under this method, the above two explained methods are combined. Under this method
statement of trial balance contains seven columns instead of five columns. This has been
explained with the help of the following example:
Trial Balance of X as at 31.3.2006
Sl. No. Heads of Account L.F. Debit Credit Debit Credit
Balance Balance Total Total
(Rs.) (Rs.) (Rs.) (Rs.)
1. Cash Account 7,500 35,500 28,000
2. Furniture Account 3,000 3,000
3. Salaries Account 2,500 2,500
4. Shyam's Account 3,500 21,500 25,000
5. Purchases Account 26,000 26,000
6. Purchase Returns Account 500 500
7. Ram's Account 4,900 30,000 25,100
8. Sales Account 30,500 30,500
9. Sale Returns Account 100 100
10. Capital Account 9,500 500 10,000
Total 44,000 44,000 1,19,100 1,19,100

FUNDAMENTALS OF ACCOUNTING 2.43


TRIAL BALANCE

5. ADJUSTED TRIAL BALANCE (THROUGH SUSPENSE ACCOUNT)


If the trial balance do not agree after transferring the balance of all ledger accounts
includingcash and bank balance and also errors are not located timely, then the trial balance
is tallied by transferring the difference of debit and credit side to an account known as suspense
account. This is a temporary account opened to proceed further and to prepare the financial
statements timely.

6. RULES OF PREPARING THE TRIAL BALANCE


While preparing the trial balance from the given list of ledger balances, following rules should
be taken into care:
1. The balances of all (i) assets accounts (ii) expenses accounts (iii) losses (iv) drawings (iv)
cash and bank balances are placed in the debit column of the trial balance.
2. The balances of all (i) liabilities accounts (ii) income accounts (iii) profits (iv) capital are
placed in the credit column of the trial balance.
Illustration 3
From the following ledger balances, prepare a trial balance of Anuradha Traders as on 31st
March, 2006:
Account Head Rs.
Capital 1,00,000
Sales 1,66,000
Purchases 1,50,000
Sales return 1,000
Discount allowed 2,000
Expenses 10,000
Debtors 75,000
Creditors 25,000
Investments 15,000
Cash at bank and in hand 37,000
Interest received on investments 1,500
Insurance paid 2,500

2.44 COMMON PROFICIENCY TEST


Solution
Dr. balance Rs. Cr. balance Rs.
Purchases 1,50,000 Capital 1,00,000
Sales return 1,000 Sales 1,66,000
Discount allowed 2,000 Creditors 25,000
Expenses 10,000 Interest received on investments 1,500
Debtors 75,000
Investments 15,000
Cash at bank and in hand 37,000
Insurance paid 2,500
Total 2,92,500 2,92,500
Illustration 4
One of your clients, Mr. Singhania has asked you to finalise his accounts for the year ended
31st March, 2005.Till date, he himself has recorded the transactions in books of accounts. As a
basis for audit, Mr. Singhania furnished you with the following statement.
Dr. Balance Cr. Balance
Singhania's Capital 1,556
Singhania's Drawings 564
Leasehold premises 750
Sales 2,750
Due from customers 530
Purchases 1,259
Purchases return 264
Loan from bank 256
Creditors 528
Trade expenses 700
Cash at bank 226
Bills payable 100
Salaries and wages 600
Stock (1.4.2004) 264
Rent and rates 463
Sales return 98
5,454 5,454

FUNDAMENTALS OF ACCOUNTING 2.45


TRIAL BALANCE

The closing stock on 31st March, 2005 was valued at Rs. 574. Mr. Singhania claims that he has
recorded every transaction correctly as the trial balance is tallied. Check the accuracy of the
above trial balance.
Solution

Corrected Trial Balance of Mr. Singhania


as on 31st March, 2005
Particulars Dr. Cr.
Amount Amount
Rs. Rs.
Singhania's Capital 1,556
Singhania's Drawings 564
Leasehold premises 750
Sales 2,750
Due from customers 530
Purchases 1,259
Purchases returns 264
Loan from Bank 256
Creditors 528
Trade expenses 700
Cash at Bank 226
Bills payable 100
Salaries and Wages 600
Stock (1.4.2004) 264
Rent and rates 463
Sales return 98
5,454 5,454
Reasons:
1. Due from customers is an asset, so its balance will be a debit balance.
2. Purchases return account always shows a credit balance because assets go out.
3. Creditor is a liability, so its balance will be a credit balance.
4. Bills payable is a liability, so its balance will be a credit balance.
5. Stock (opening) represents assets, so it will have a debit balance.
6. Sales return account always shows a debit balance because assets come in.

2.46 COMMON PROFICIENCY TEST


Illustration 5
An inexperienced bookkeeper has drawn up a Trial Balance for the year ended 30th June,
2006.
Dr. (Rs.) Cr. (Rs.)
Provision For Doubtful Debts 200 –
Bank Overdraft 1,654 –
Capital – 4,591
Creditors – 1,637
Debtors 2,983
Discount Received 252 –
Discount Allowed – 733
Drawings 1,200 –
Office Furniture 2,155 –
General Expenses – 829
Purchases 10,923 –
Returns Inward – 330
Rent & Rates 314 –
Salaries 2,520 –
Sales – 16,882
Stock 2,418 –
Provision for Depreciation on Furniture 364 –
Total 24,983 25,002
Required:
(a) Draw up a 'Corrected' Trial Balance, debiting or crediting any residual errors to a
Suspense Account.
Solution
Trial Balance as on 30th June, 2006
Heads of Accounts Dr. Rs. Cr. Rs.
Provision for Doubtful Debts – 200
Bank overdraft – 1,654
Capital 4,591
Creditors 1,637
Debtors 2,983 –
Discount Received – 252
Discount allowed 733 –
Drawings 1,200 –
Office furniture 2,155 –
General Expenses 829 –
Purchases 10,923 –
Returns Inward 330 –
Rent & Rates 314 –

FUNDAMENTALS OF ACCOUNTING 2.47


TRIAL BALANCE

Salaries 2,520 –
Stock 2,418
Provision for Depreciation on Furniture – 364
Sales 16,882
Suspense Account (Balancing figure) 1,175 –
Total 25,580 25,580

SELF EXAMINATION QUESTIONS


I. Pick up the correct answer from the given choices:
(i) A trial balance will not balance if
(a) correct journal entry is posted twice.
(b) the purchase on credit basis is debited to purchases and credited to cash.
(c) Rs. 500 cash payment to creditors is debited to creditors for Rs. 50 and credited
to cash as Rs. 500.
(d) None of the above.
(ii) Rs. 1500 received from sub-tenant for rent and entered correctly in the cash book is
posted to the debit of the rent account. In the trial balance
(a) The debit total will be greater by Rs. 3000 that the credit total.
(b) The debit total will be greater by Rs. 1500 than the credit total.
(c) Subject to other entries being correct the total will agree.
(d) None of the above.
(iii) After the preparation of ledgers, the next step is the preparation of
(a) trading accounts (b) trial balance
(c) profit and loss account (d) none of the above
(iv) After preparing the trial balance the accountant finds that the total of debit side is
short by Rs. 1,500. This difference will be
(a) credited to suspense account (b) debited to suspense account
(c) adjusted to any of the debit balance account
(d) adjusted to any of the credit balance account
(v) S. No. Account heads Debit (Rs.) Credit (Rs.)
1. Sales 15,000
2. Purchases 10,000
3. Miscellaneous expenses 2,500
4. Salaries 2,500
Total 12,500 17,500
The difference in trial balance is due to
(a) wrong placing of sales account (b) wrong placing of salaries account
(c) wrong placing of miscellaneous expenses account
(d) Wrong placing of all accounts
[Ans: (i)-(c), (ii)-(a), (iii)-(b), (iv)-(b), (v)-(b)]

2.48 COMMON PROFICIENCY TEST


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 4

Subsidiary Books
SUBSIDIARY BOOKS

Learning Objectives
After studying this unit, you will be able to :
 Understand the techniques of recording transactions in Purchase Book, Sales Book; Returns
Inward Book and Returns outward book; Bills Receivable and Bills Payable book.
 Learn the technique of posting from Subsidiary Books to Ledger.
 Understand that even if subsidiary books are maintained, journalisation is required for
many other transactions and events.
 Learn the difference between the subsidiary books and principle books.

1. SUBSIDIARY BOOKS AND THEIR ADVANTAGES


In a Business most of the transactions generally relate to receipts and payments of cash, sale of
goods and their purchase. It is convenient to keep a separate register for each such class of
transactions one for receipts and payments of cash, one for purchase of goods and one for sale
of goods. A register of this type is called a book of original entry or of prime entry. For
transactions recorded in such books there will be no journal entry. The system by which
transactions of a class are first recorded in the book, specially meant for it and on the basis of
which ledger accounts are then prepared is known as the Practical System of Book keeping or
even the English System. It should be noted that in this system, there is no departure from the
rules of the double entry system.
These books of original or prime entry are also called subsidiary books since ledger accounts
are prepared on their basis and, without the further process of ledger posting, a trial balance
cannot be taken out. Normally, the following subsidiary books are used in a business:
(i) Cash book to record receipts and payments of cash, including receipts into and payments
out of the bank.
(ii) Purchases book to record credit purchases of goods dealt in or of the materials and
stores required in the factory.
(iii) Purchase Returns Books to record the returns of goods and materials previously
purchased.
(iv) Sales Book to record the sales of the goods dealt in by the firm.
(v) Sale Returns Book to record the returns made by the customers.
(vi) Bills receivable books to record the receipts of promissory notes or hundies from various
parties.
(vii) Bills Payable Book to record the issue of the promissory notes or hundies to other parties.
(viii) Journal (proper) to record the transactions which cannot be recorded in any of the seven
books mentioned above.
It may be noted that in all the above cases the word "Journal" may be used for the word "book"
Advantages of Subsidiary Books
The use of subsidiary books affords the undermentioned advantages :
(i) Division of work : Since in the place of one journal there will be so many subsidiary books,
the accounting work may be divided amongst a number of clerks.

2.50 COMMON PROFICIENCY TEST


(ii) Specialisation and efficiency : When the same work is allotted to a particular person over a
period of time, he acquires full knowledge of it and becomes efficient in handling it. Thus
the accounting work will be done efficiently.
(iii) Saving of the time : Various acconting processes can be undertaken simultaneously because
of the use of a number of books. This will lead to the work being completed quickly.
(iv) Availability of informations : Since a separate register or book is kept for each class of
transactions, the information relating to each transactions will be available at one place.
(v) Facility in checking: When the trial balance does not agree, the location of the error or
errors is facilitated by the existence of separate books. Even the commission of errors and
frauds will be checked by the use of various subsidiary books.

2. DISTINCTION BETWEEN SUBSIDIARY BOOKS AND PRIMARY BOOKS


The books in which transactions are first recorded to enable processing are called subsidiary
books. The ledger and the cash book are the principle books since they furnish information for
preparation of the trial balance and financial statements. The following chart will help you in
understanding the difference between Subsidiary Books and Primary Books.

Principal Ledger
Books

Simple Cash Book

Cash Book with


Discount Column

Cash Book with


Bank & Dis. Column

Petty Cash Book

Financial Cash
For Credit Purchase Book
Books Book
Purchase

Sales Book
For Credit Sales

For Credit Purchases Purchase Return


Returns Book

For Credit Sales Sales Return Book


Returns
For Bills receivable Bills Receivable
Subsidiary received Book
Books
For Bills Bills Payable
accepted Book
For record of Journal Proper
transactions
not recorded
elsewhere

FUNDAMENTALS OF ACCOUNTING 2.51


SUBSIDIARY BOOKS

3. PURCHASES BOOK
To record the credit purchases of goods dealt in or materials and stores used in the factory, a
separate register called the Purchases Book or the Purchases Journal, is usually maintained by
firms. The ruling is given below:
Date Particulars L.F. Details Amount
Rs. Rs.
It should be remembered that :
(i) Cash purchases are not entered in this book since these will be entered in the cash book;
and
(ii) Credit purchases of things other than goods or materials, such as office furniture or
typewriters are journalised -they also are not entered in the Purchases Book.
The particulars column is meant to record the name of the supplier and name of the articles
purchased and the respective quantities. The amount in respect of each article is entered in
the details column. After totaling the various amounts included in a single purchase, the
amount for packing, or other charges is added and the amount for trade discount is deducted.
The net amount is entered in the extreme right-hand column. The total in this column shows
the total purchase made in a period.
Illustration 1
The Rough Book of M/s. Narain & Co. contains the following :
2006
Feb. 1. Purchased from Brown & Co. on credit :
5 gross pencils @ Rs. 10 per gross,
1 gross registers @ Rs. 24 per doz.
Less : Trade Discount @ 10%
2. Purchased for cash from the Stationery Mart;
10 gross exercise books@ Rs. 3 per doz.
3. Purchased typewriter for office use from M/s. office
Goods Co. on credit for Rs. 800.
4. Purchased on credit from The Paper Co.
5 reams of white paper @ Rs. 10 per ream.
10 reams of ruled paper @ Rs. 15 per ream.
Less : Trade Discount @ 10%
5. Purchased one dozen ink-pots @ Rs. 1.50 each from
M/s. Verma Bros. on credit.
Make out the Purchase Book of M/s. Narain & Co.

2.52 COMMON PROFICIENCY TEST


Solution
PURCHASES BOOK
Date Particulars L.F. Amount
2006 Rs. Rs.
Feb. 1 M/s. Brown & Co.
5 gross pencils @ Rs. 10 per gross 50.00
1 gross registers @ Rs. 24 per doz. 288.00
338.00
Less : 10% trade discount 33.88 304.12
"4 The Paper Co.
5 reams white paper @ Rs. 10 per ream 50.00
10 reams ruled paper @ Rs. 15 per ream 150.00
200.00
Less : 10% trade discount 20.00 180.00
5 M/s. Verma Bros.
1 doz. ink-pots @ Rs. 1.50 each 18.00 18.00
Total 502.12
Note : Purchases of cash and purchase for typewriter cannot be entered in the Purchase Book.
Illustration 2
Enter the following transactions in Purchase Book and post them into ledger.
2006
April 4 Purchased from Ajay Enterprises, Delhi
100 Doz Rexona Hawai Chappal
@ Rs. 120 per Doz.
200 Doz Palki Leather Chappal
@ Rs. 300 per Doz
Less : trade discount @ 10%
Freight charged Rs. 150.
April 15 Purchased from Balaji Traders, Delhi
50 Doz Max Shoes
@ Rs. 400 per Doz
100 pair Sports Shoes.
@ Rs. 140 per paid.
Less : trade discount @ 10%.
Freight charged Rs. 200.
April 28 Purchased from Tripti Industries, Bahadurgarh

FUNDAMENTALS OF ACCOUNTING 2.53


SUBSIDIARY BOOKS

40 pair leather shoes


@ Rs. 400 per pair
100 Doz Rosy Hawai Chappal
@ Rs. 180 per Doz
Less : trade discount @ 10%.
Freight charged Rs. 100.
Purchases are subject to Sales Tax @ 10%.
Solution
Purchase Book
Date Particulars Gross Trade Net Sales Freight Total
2006 Amount Discount Price Tax Amount

April 4 Ajay Enterprises


100 Doz chappal
@ Rs. 120 per Doz - Rs. 12,000
200 Doz Palki Leather Chappal
@ Rs. 300 per Doz - Rs. 60,000
Less trade discount @ 10% 72,000 7,200 64,800 6,480 150 71,430
April 15 Balaji Traders, Delhi
50 Doz Max Shoes
@ Rs. 400 per Doz - Rs. 20,000
100 pair Sports shoes
@ Rs. 140 per pair - Rs. 14,000
Less trade discount @ 10% 34,000 3,400 30,600 3,060 200 33,860
April 28 Tripti Industries, Bahadurgarh
40 pair Leather shoes
@ Rs. 400 per pair - Rs. 16,000
100 DOZ Rosy Hawai Chappal
@ Rs. 180 per DOZ - Rs. 18,000
Less trade discount @ 10% 34,000 3,400 30,600 3,060 100 33,760
1,40,000 14,000 1,26,000 12,600 450 1,39,050

Ledgers
Purchases A/c
Dr. Rs. Cr.
2006
April 30 To amount as per purchase book 1,38,000
Freight A/c
2006 Rs.
April 30 To amount as per purchase book 450

2.54 COMMON PROFICIENCY TEST


Ajay Enterprises
2006 Rs.
April 4 By purchase A/c 71,280
By Freight A/c 150
Balaji Traders
2006 Rs.
April 15 By purchase A/c 33,660
By Freight A/c 200
Tripati Industries
2006 Rs.
April 28 By purchase A/c 33,660
By Freight A/c 100
Purchase Account will be debited by net price and sales tax because sales tax is a part of cost
of goods purchased.
3.1 POSTING THE PURCHASE BOOK
The Purchases Book shows the names of the parties from whom goods have been purchased
on credit. These parties are now creditors. Their accounts have to be credited for the respective
amounts shown in the purchase book. The total of the amounts column shows the total
purchases made in a period. The amount is debited to the Purchase Account to indicate receipt
of goods. In illustration 11, the Purchases Account is debited by Rs. 502.12, M/s. Brown & Co.
is credited by Rs. 304.12, the Paper Company by Rs. 180 and M/s. Verma Bros. by Rs. 18. The
total of the amounts put on the credit side equals the debit. Thus the double entry is completed.

4. SALES BOOK
The Sales Book is a register specially kept to record credit sales of goods dealt in by the firm,cash
sales are entered in the Cash Book and not in the Sales Book. Credit sales of things, other than
the goods dealt in by the firm are not entered in the Sales Book ; they are journalised. The
ruling is the same as for the Purchases Book.
Entries in the sales book are also made in the same manner as in the Purchase Book. The
particulars column will record the name of the customers concerned together with particulars
and quantities of the goods sold. For each item, the amount is entered in the details column ;
after totalling the amounts for one sale, charges for packing etc; are added and the trade
discount, if any is deducted: the net amount is put in the outer column. The total of this
column will show the total credit sales for a period.
Illustration 3
The following are some of the transaction of M/s Kishore & Sons of the year 2006 as per their
Waste Book. Make out their Sales Book.

FUNDAMENTALS OF ACCOUNTING 2.55


SUBSIDIARY BOOKS

Sold to M/s. Gupta & Verma on credit:


30 shirts @ Rs. 8 per shirt.
20 trousers @ Rs. 10 per trouser.
Less : Trade Discount @ 10%
Sold furniture to M/s. Sehgal & Co. on credit Rs. 80.
Sold 50 shirts of M/s. Jain & Sons @ Rs. 8 per shirt.
Sold 13 shirts to Cheap Stores @ Rs. 7.50 each for cash.
Sold on credit to M/s. Mathur & Jain.
100 shirts @ Rs. 7.50 per shirt
10 overcoats @ Rs. 50 per overcoat.
Less: Trade Discount @ 10%
Solution
SALES BOOK
Date Particulars Details L.F. Amount
2006 Rs. Rs.
M/s. Gupta & Verma
30 shirts @ Rs. 8 240.00
20 Trousers @ Rs. 10 .... 200.00

440.00
Less : 10% 40.00

Sales as per invoice no. dated ..... 396.00


M/s. Jain & Sons
50 shirts @ Rs. 8.
Sale as per invoice no. dated ...... 400.00
M/s Mathur & Jain
100 shirts @ Rs. 7.50 750.00
100 overcoats @ Rs. 50 500.00

1,250.00
Less : 10% 125.00

Sales as per invoice no. dated...... 1,125.00

Total 1,9 21.00


Note : Cash sale and sale of furniture are not entered in Sales Book.

2.56 COMMON PROFICIENCY TEST


4.1 POSTING THE SALES BOOK
The names appearing in the Sales Book are of those parties which have received the goods.
The accounts of the parties have to be debited with the respective amounts. The total of the
Sales Book shows the credit sales made during the period concerned; the amount is credited to
the Sales Account. In the illustration 12, Rs. 1,921 is credited to the Sales Account; Rs. 396 is
debited to M/s. Gupta and Verma Rs. 400 to M/s Jain and Sons and Rs. 1,125 to M/s Mathur
& Jain. The amount put on the credit side is equal to the total of the amount put on the debit
side. Thus, the double entry principle is followed correctly.
4.2. SALES BOOK WITH SALES TAX COLUMN
Sales Tax is one levied at the point of sales. Sales tax is collected by the seller from the customers
on sales of goods and deposited the same with the state government. Sales tax is charged at a
fixed percentage on the net price of the goods. It is calculated after giving trade discount, if
any. Generally a separate column is provided in the Sales Book for sales tax so that a proper
record is maintained regarding sales tax collected. Rates of sales tax vary from item to item
and also on local sales and interstate sales (or say central sales). A separate column in sales
book for each rate of sales tax helps the dealer in calculating sales tax liability accurately.
At the end of a certain period, generally quarterly or monthly, the total of sales tax column is
credited to the Sales Tax Account. When sales tax is deposited with the sales tax department,
the Sales Tax Account is debited and Cash/Bank Account is credited. When there is any credit
balance in Sales Tax Account, it shows the amount payable as sales tax and hence be shown
in the Balance Sheet as a liability.
Illustration 4
Record the following transactions in Sales Book.
February 2 : Sold to South Indian Toys 500 toys @ Rs. 60 each; Less:
Trade Discount @ 5%; Sales tax to be charged @ 10%.
February 10 : Sold to Ria Sisters. 100 kg. of wheat @ Rs. 40 per kg.;
Less: 5% Trade Discount; Sales tax charged @ 5% .
February 15 : Sold to Raj Bros. 20 bags of White Cement Powder; @
Rs. 2,000 per bag; Less: 2% Trade Discount; Sales tax @
8%.
February 27 : Sold to Sen & Co. 10 chests of tea @ Rs. 500 per chest
less 10% Trade Discount; Sales tax is charged @ 5%.
Solution Sales Book
Date Particulars Details Amount
February 2 South Indian Toys
500 toys @ Rs. 60 each 30,000
Less: Trade discount @ 5% 1,500
28,500

FUNDAMENTALS OF ACCOUNTING 2.57


SUBSIDIARY BOOKS

Add: Sales tax @ 10%. 2,850 31,350


February 10 Ria Sisters
100 kg. wheat @ Rs. 40 per kg. 4,000
Less: Trade discount @ 5%. 200
3,800
Add: Sales tax @ 5%. 190 3,990
February 15 Raj Bros.
20 bags of cement @ Rs. 2,000 per
bag 40,000
Less: Trade discount @ 2% 800
39,200
Add: Sales tax @ 8%. 3,136 42,336
February 26 Sen & Co.
10 chests of tea @ Rs. 500 per chest. 5,000
Less: Trade discount @ 10%. 500
4,500
Add: Sales tax @ 5% 225 4,725
Total 82,401
Illustration 5
Enter the following transactions in Sales Book of M/s. Pranat Engineers Ltd., Delhi -
2006
Jan. 2. Sold to M/s. Ajanta Electricals, Delhi 5 pieces of colour T.V. @ Rs. 6,000/- each
less trade Discount @10%
8 Sold to M/s. Ajanta Electricals Plaza, 10 pieces of Washing Machines @ Rs.
8,000/- each less trade discount 5%.
15 Sold to M/s. Haryana Traders, 5 pieces of Black & White T.V. @ Rs. 3,500/- each
less trade discount @ 10%.
All sales are subject to 10% Sales Tax and 10% surcharge on sales tax.

2.58 COMMON PROFICIENCY TEST


Solution

Sales Book
Date Particulars Gross Trade Net Sales Total
Amount Discount Price Tax Amount
2006
Jan. 2 Ajanta Electricals 5 pieces of
Colour T.V. @ Rs.6,000/- each
Less 10% discount 30,000 3,000 27,000 2,970 29,970
8 Electronics Plaza 10 pieces of
Washing Machines @ Rs. 8,000/-
each, less 5% trade discount 80,000 4,000 76,000 8,360 84,360
15 Haryana Traders 5 pieces of
Black & White T.V. @ Rs. 3,500/-
each, less 10% trade discount 17,500 1,750 15,750 1,732.50 17,482.50
1,27,500 8,750 1,18,750 13,062.50 1,31,812.50
Posting
If separate column of sales tax is provided then, each individual debtors account will be debited
by the total amount of respective sales bill, Sales Account and Sales Tax Payable Account shall
be credited with the total of column of net sales and sales tax respectively.
Illustration 6
Post into the ledger the entries of Sales Book prepared in illustration 5.
Ledger
Dr. Cr.
Ajanta Electricals
Date Particulars L.F. Amount Date Particulars L.F. Amount
2006 (Rs.) 2006 (Rs.)
Jan. 2 To Sales A/c 27,000
Electronics Plaza
Date Particulars L.F. Amount Date Particulars L.F. Amount
2006 (Rs.) 2006 (Rs.)
Jan. 8 To Sales A/c 76,000
To Sales Tax Payable A/c

FUNDAMENTALS OF ACCOUNTING 2.59


SUBSIDIARY BOOKS

Haryana Traders
Date Particulars L.F. Amount Date Particulars L.F. Amount
2006 (Rs.) 2006 (Rs.)
Jan. 15 To Sales A/c 15,750
To Sales Tax Payable A/c 1,732.50
Sales Account
Date Particulars L.F. Amount Date Particulars L.F. Amount
2006 (Rs.) 2006 (Rs.)
Jan 31 To Sundries 1,18,750
(As per Sales Book)
Sales Tax Payable A/c
Date Particulars L.F. Amount Date Particulars L.F. Amount
2006 (Rs.) 2006 (Rs.)
Jan. 31 To Sundries 13,062.5
(As per Sales Book)

5. SALES RETURNS BOOK OR RETURNS INWARD BOOK


If customers frequently return the goods sold to them, it would be convenient to record the
returns in a separate book, which is named as the Sales Returns Book or the returns Inward
Book. The ruling of the book is similar to the Purchases or the Sales Book and entries are also
made in the same manner. The following, assumed figures, will illustrate this:
RETURNS INWARD BOOK
Date Particulars Details L.F. Amount
2006 Rs.
June 7 Sunil Bank & Co.
6 Copies-Double Entry
Book keeping by T.S. Grewal @ Rs. 7 42.00
Less : Trade Discount 10% 4.20 37.80
(returns as per debit note no.......)
Kailash & Co.
1 Copy-Business Methods
by R.K. Gupta 3.50
(returns as per debit note no.......) Total 41.30

2.60 COMMON PROFICIENCY TEST


6. PURCHASE RETURNS OR RETURNS OUTWARD BOOK
Such a book conveniently records return of goods or material purchased to the suppliers-if
however, the returns are not frequent, it may be sufficient to record the transaction in the
journal. The ruling of the Purchase Returns or Returns Outward Book is similar to that of the
Purchase Book; entries are also similarly made, as the illustration given below shows:
RETURNS OUTWARD BOOK
Date Particulars Amount
2006 Rs. Rs.
June 2 Premier Electric Co. 175.00
One 36" Usha Ceiling Fan
" 28 Mohan Electric Co.
Ten Iron Heaters 150.00
Less : Discount 15.00 135.00
Total 310.00
6.1 POSTING OF THE RETURN BOOKS
The Sales Return Book will show the total of the returns made by customers. Really, the total
of the returns is in reduction of the sales. Properly, therefore, the amount may be debited to
the Sales Account but, usually, a separate account called Returns Inward Account is opened
and the total of the sales returns is debited to this accounts. The customers who have returned
the goods are credited with the respective amounts.
It should be noted that on goods being received and accepted back from the customers, a
credit note is issued to the customers concerned. This shows the amount to be credited to the
customer's account.
Similarly, when goods are returned to suppliers they will issue the necessary credit note; also
the firm returning the goods will issue a debit note to the supplier, indicating the amount for
which the supplier is liable on account of the return.
The total of Returns Outwards Book shows the total returns made. The amount can be credited to
the purchase Account, but in practice, is credited to a separate account called Purchase Returns or
Returns Outward Account. The suppliers whose names appear in the Book have received the
goods, so their accounts have to be debited. This is shown in the illustration given below :
Illustration 7
Post the following into the ledger
RETURNS OUTWARD BOOK
Date Particulars L.F. Details Amount
2006 Rs. Rs.
Nov.20 Rajindra Prakash & Sons
One 36" Usha Ceiling Fan 200.00
Less : Trade Discount @ 10% 20.00 180.00
" 30 Modern Electric Company 100.00
Total 280.00
FUNDAMENTALS OF ACCOUNTING 2.61
SUBSIDIARY BOOKS

Solution

LEDGER
RAJINDRA PARKASH & SONS.
Dr. Cr.
Date Particulars Folio Amount Date Particulars Folio Amount
2006
Nov. 20 To Returns Outward A/c 180.00
MODERN ELECTRIC CO.
Dr. Cr.
Date Particulars Folio Amount Date Particulars Folio Amount
2006
Nov. 30 To Returns Outward A/c 100.00
RETURNS OUTWARD ACCOUNT
Dr. Cr.
Date Particulars Folio Amount Date Particulars Folio Amount
2006
Nov. 30 By Sundries as
per Returns Outward
A/c 280.00
6.2 BILLS RECEIVABLE BOOKS AND BILLS PAYABLE BOOKS
If the firm usually receives a number of promissory notes or hundies, it would be convenient
to record the transaction in a separate book called the Bills Receivable Book. Similarly, if
promissory notes or hundies are frequently issued, the Bills Payable Book will be convenient.
This will be discussed later.

7. IMPORTANCE OF JOURNAL
Students are now familiar with the journal. They also know that :
(i) Cash transactions are recorded in the cash book;
(ii) Credit purchases of goods or materials are recorded in the purchases book;
(iii) Credit sales of goods are recorded in the sales book ;
(iv) Returns from customers are recorded in the sale returns book; and
(v) Returns to suppliers are entered in the purchase returns book.
Bill transactions are entered in the bills receivable books or the bills payable books, if these are
maintained. Apart from the transactions mentioned above, there are some entries also which
have to be recorded. For them the proper place is the journal. In fact, if there is no special book
meant to record a transaction, it is recorded in the journal (proper). The role of the journal is
thus restricted to the following types of entries :

2.62 COMMON PROFICIENCY TEST


(i) Opening entries : When books are started for the new year, the opening balance of assets
and liabilities are journalised.
(ii) Closing entries : At the end of the year the profit and loss account has to be prepared.
For this purpose, the nominal accounts are transferred to this account. This is done through
journal entries called closing entries.
(iii) Rectification entries : If an error has been committed, it is rectified through a journal
entry.
(iv) Transfer entries : If some amount is to be transferred from one account to another, the
transfer will be made through a journal entry.
(v) Adjusting entries : At the end of the year the amount of expenses or income may have to
be adjusted for amounts received in advance or for amounts not yet settled in cash. Such
an adjustment is also made through journal entries. Usually, the entries pertain to the
following:
(a) Outstanding expenses, i.e., expenses incurred but not yet paid;
(b) Prepared expenses, i.e., expenses paid in advance for some period in the future;
(c) Interest on capital, i.e., the interest which the proprietor thinks proper to allow on his
investment; and
(d) Depreciation, i.e., fall in the value of the assets used on account of wear and tear.
For all these, journal entries are necessary.
(vi) Entries on dishonour of Bills : If someone who accepted a promissory note (or bill) and
is not able to pay in on the due date,a journal entry will be necessary to record the non-
payment or dishonour.
(vii) Miscellaneous entries : The following entries will also require journalising:
(a) Credit purchase of things other than goods dealt in or materials required for
production of goods e.g. credit purchase of furniture or machinery will be journalised.
(b) An allowance to be given to the customers or a charge to be made to them after the
issue of the invoice.
(c) Receipt of promissory notes or issue to them if separate bill books have not been
maintained.
(d) On an amount becoming irrecoverable, say, because, of the customer becoming insolvent.
(e) Effects of accidents such as loss of property by fire.
(f) Transfer of net profit to capital account.

Illustration 8
From the following transactions, prepare the Purchases Returns Book of Alpha & Co., a Saree
dealer and post them to ledger :

FUNDAMENTALS OF ACCOUNTING 2.63


SUBSIDIARY BOOKS

Date Debit Note No. Particulars


04.01.2006 101 Returned to Goyal Mills, Surat - 5 polyester sarees @
Rs. 100.
09.01.2006 Garg Mills, Kota - accepted the return of goods (which
were purchased for cash) from us - 5 Kota sarees @
Rs. 40.
16.01.2006 102 Returned to Mittal Mills, Bangalore -5 silk sarees @
Rs. 260.
30.01.2006 Returned one typewriter (being defective) @ Rs. 3,500
to B & Co.
Solution
Purchase Returns Book
Date Debit Note No. Name of supplier L.F. Amount
2006
Jan. 4 101 Goyal Mills, Surat 500
Jan. 16 102 Mittal Mills, Bangalore 1,300
Jan. 31 Purchases Returns Account (Cr.) 1,800

SELF EXAMINATION QUESTIONS


I. In which book of original entry, will you record the following transactions?
(i) The debit note issued are used to prepare
(a) Sales return book. (b) Purchase return book.
(c) Sales book. (d) Purchases book.
(ii) An allowance of Rs. 50 was offered for an early payment of cash of Rs. 1,050.
(a) Sales Book (b) Cash Book
(c) Journal Proper (General Journal) (d) Purchase Book
(iii) A second hand motor car was purchased on credit from B Brothers for Rs. 10,000.
(a) Journal Proper (General Journal) (b) Sales Book
(c) Cash Book (d) Purchase Book
(iv) Goods were sold on credit basis to A Brothers for Rs. 1,000.
(a) Cash Book (b) Journal Proper (General Journal)
(c) Sales Book (d) Bills Receivable Book

2.64 COMMON PROFICIENCY TEST


(v) Accounting for partial recovery from Mr. C of an amount of Rs. 2,000 earlier written
off as bad debt.
(a) Journal Proper (General Journal) (b) Sales Book
(c) Purchase Book (d) Cash Book
(vi) Rectifying the error of a credit purchase of goods worth Rs. 10,000 recorded as credit
sale to Mr. D, discovered two months later.
(a) Journal Proper (General Journal) (b) Sales Book
(c) Cash Book (d) Purchase Book
(vii) Credit purchase of stationery worth Rs. 5,000 by a stationery dealer.
(a) Purchase Book (b) Sales Book
(c) Cash Book (d) Journal Proper (General Journal)
(viii)A bills receivable of Rs. 1,000, which was received from a debtor in full settlement for
a claim of Rs. 1,100, is dishonoured.
(a) Purchases Return Book (b) Bills Receivable Book
(c) Purchases Book (d) Journal Proper (General Journal)
(ix) Purchased goods from E worth Rs. 5,000 on credit basis.
(a) Bills Receivable Book (b) Purchases Book
(c) Journal Proper (General Journal) (d) Purchases Return
(x) Unpaid salary for Rs. 340 is to be provided for in the accounts.
(a) Bills Receivable Book (b) Purchases Book
(c) Journal Proper (General Journal) (d) Purchases Return
(xi) A debit note for Rs. 2,000 issued to Mr. F for goods returned by us is to be accounted
for.
(a) Bills Receivable Book (b) Purchases Book
(c) Journal Proper (General Journal) (d) Purchases Return
(xii) Goods Outward Journal is meant for recording all returns of goods
(a) Sold on credit (b) Purchased on credit
(c) Purchased on cash (d) None of the above
(xiii)Which of the following types of information are found in subsidiary ledgers, but not
in the general ledger?
(a) Total cost of goods sold for the period.
(b) The quantity of a particular product sold during the period.
(c) The amount owed to a particular creditor.
(d) The portion of total current assets that consist of cash.

FUNDAMENTALS OF ACCOUNTING 2.65


SUBSIDIARY BOOKS

(xiv)The total of the purchases day book is posted periodically to the debit of:
(a) Purchases account. (b) Cash book.
(c) Journal proper. (d) None of these.
(xv) Purchases day book records:
(a) All cash purchases. (b) All credit purchases
(c) Credit purchases of goods in trade. (d) None of the above

[Ans 1: (i)-(b), (ii)-(b), (iii)-(a), (iv)-(c), (v)-(d), (vi)-(a), (vii)-(a), (viii)-(d), (ix)-(b), (x)-(c), (xi)-
(d), (xii)-(b), (xiii)-(b), (xiv)-(a), (xv)-(b)]
2. Choose the most appropriate answer from the given options :
(i) In Purchases Book the record is in respect of
(a) cash purchase of goods, (b) credit purchase of goods dealt in,
(c) all purchases of goods.
(ii) The Sales Returns Book records
(a) the return of goods purchased, (b) return of anything purchased,
(c) return of goods sold.
(iii) The Sales Book
(a) is a part of journal, (b) is a part of the ledger,
(c) is a part of the balance sheet.
(iv) The weekly or monthly total of the purchase Book is
(a) posted to the debit of the Purchases Account,
(b) posted to the debit of the Sales Account,
(c) posted to the credit of the Purchases Account.
(v) The total of the Sales Book is posted to
(a) the credit of the Sales Account,
(b) credit of the Purchases Account,
(c) credit of the Capital Account

[Ans: 2: (i), (b); (ii), (c); (iii), (a); (iv), (a); (v), (a)]

2.66 COMMON PROFICIENCY TEST


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 5

Cash Book
CASH BOOK

Learning Objectives
After studying this unit you will be able to :

 Understand that a Cash Book is a type of subsidiary book but treated as a principal book.
 Be familiar with various kinds of Cash Books, viz., Simple Cash Book, Two-column Cash
Book and Three-column Cash Book.
 Learn the technique of preparation of Simple Cash Book and how to balance it.
 See how Double-Column Cash Book is a prepared adding discount column alongwith
cash column.
 Understand the techniques of preparing Three-column Cash Book.
 Understand what is a Petty Cash Book and the Imprest System of Petty Cash.
 Note the advantages of the Petty Cash Book.
 Learn how to maintain a Petty Cash Book and how to post the entries of the Petty Cash
Book in the ledger.
 Understand the accounting of credit/debit sales transactions.

1. CASH BOOK - A SUBSIDIARY BOOK AND A PRINCIPAL BOOK


Cash transactions are straightaway recorded in the Cash Book and on the basis of such a
record, ledger accounts are prepared. Therefore, the Cash Book is a subsidiary book. But the
Cash Book itself serves as the cash account and the bank account; the balances are entered in
the trial balance directly. The Cash Book, therefore, is part of the ledger also. Hence, it has also
to be treated as the principal book. The Cash Book is thus both a subsidiary book and a principal
book.

2. KINDS OF CASH BOOK


The main Cash Book may be of the three types:
(i) Simple Cash Book;
(ii) Two-column Cash Book;
(iii) Three-column Cash Book.
In addition to the main Cash Book, firms also generally maintain a petty cash book but that is
purely a subsidiary book.
2.1 SIMPLE CASH BOOK
Such a cash book appears like an ordinary account, with one amount column on each side.
The left-hand side records receipts of cash and the right hand side the payments.
Balancing of the Cash Book: The cash book is balanced like other accounts. The receipts column
is always bigger than payments column. The difference is written on the credit side as 'By

2.68 COMMON PROFICIENCY TEST


balance c/d'. The totals are then entered in the two columns opposite one another and then on
the debit side the balance is written as "To Balance b/d", to show cash balance in hand in the
beginning of next period.
Illustration 1
Enter the following transactions in a Simple Cash Book:
2006 Rs.
Jan.1 Cash in hand 1,200
"5 Received from Ram 300
"7 Paid Rent 30
"8 Sold goods for cash 300
"10 Paid to Shyam 700
"27 Purchased Furniture 200
"31 Paid Salaries 100
"31 Rent due, not yet paid, for January 30

Solution
CASH BOOK
Dr. Cr.
Date Receipts L.F. Amount Date Payments L.F. Amount
2006 Rs. 2006 Rs.
Jan. 1 To Balance b/d 1,200 Jan. 07 By Rent A/c 30
"5 To Ram A/c 300 " 10 By Shyam A/c 700
"8 To Sales A/c 300 " 27 By Furniture A/c 200
" 31 By Salaries A/c 100
" 31 By Balance c/d 770

1,800 1,800
2006
Feb. 1 To Balance b/d 770

Note: One can see the following:


(i) In the simple cash book only the cash receipts and cash payment are recorded.
(ii) The debit side is always bigger than the credit side since the payment cannot exceed the
available cash.
(iii) The simple cash book is like an ordinary account.

FUNDAMENTALS OF ACCOUNTING 2.69


CASH BOOK

2.2 DOUBLE COLUMN CASH BOOK


If along with columns for amounts to record cash receipts and cash payments another column
is added on each side to record the cash discount allowed or the discount received, or a column
on the debit side showing bank receipts and another column on the credit side showing
payments through bank. It is a double column cash book.
Cash discount is an allowance which often accompanies cash payments. For example, if a
customer owes Rs. 500 but is promised that 2% will be deducted if payment is made within a
certain period, the customer can clear his account by paying promptly Rs. 490. Cash received
will be Rs. 490 and Rs. 10 will be the discount for the firm receiving the payment discount is a
loss; for the person making the payment it is a gain. Since cash discount is allowed only if cash
is paid, it is convenient to add a column for discount allowed on the receipt side of the cash
book and a column for discount received on the payment side of the cash book.
In the cash column on the debit side, actual cash received is entered; the amount of the discount
allowed, if any, to the customer concerned is entered in the discount column. Similarly, actual
cash paid is entered in the cash column on the payments side and discount received in the
discount column. Also the bank column on the debit side records all receipts through bank and
the same column on the credit side shows payment through bank.
Balancing: It should be noted that the discount columns are not balanced. They are merely
totalled. The total of the discount column on the receipts side shows total discount allowed to
customers and is debited to the Discount Account. The total of the column on the payments
side shows total discount received and is credited to the Discount Account. The Cash columns
are balanced, as already shown. The bank columns are also balanced and the balancing figure
is called bank balance. Thus a double column cash book should have two columns on each side
comprising of either cash and discount transaction or cash and bank transactions.
Illustration 2
Ganesh commenced business on 1st April, 2006 with Rs. 2,000 as capital. He had the following
cash transactions in the month of April 2006:
Rs. Rs.
April 1 Purchased furniture April 7 Paid for petty expenses 15
and paid cash 250 " 8 Cash purchases 150
"2 Purchased goods 500
"4 Sold goods for cash 950
13 Paid for Typewriter 1,000
"5 Paid cash to Ram Mohan 560
"6 He allowed discount 10 "" Paid Ali & Sons 400
"6 Received cash from
Krishna & Co. 600 "" They allowed discount 8
Allowed discount 20
Make out the two-column Cash Book (Cash and discount column) for the month of April,
2006.

2.70 COMMON PROFICIENCY TEST


Solution
CASH BOOK
Dr. Cr.
Date Receipts L.F. Discount Amount Date Payments L.F. Discount Amount
2006 Rs. Rs. 2006 Rs. Rs.
April1 To Capital A/c 2,000 April1 By Furniture A/c 250
"4 To Sales A/c 950 "2 By Purchases A/c 500
"6 To Krishna A/c 20 600
"5 By Ram Mohan 10 560
"7 By Petty
Expenses A/c 15
"8 By Purchases A/c 150
"13 By Typewriter A/c 1,000
"13 By Ali & Sons 8 400
"30 By Balance c/d 675
20 3,550 18 3,550
May 1 To Balance b/d 675

To summarise :
(i) the discount columns in the cash book are not accounts;
(ii) they are not balanced; and
(iii) their totals are entered in the discount account in the ledger.
Note : The person who pays, is credited by both the cash paid by him and the discount allowed
to him. Similarly, the person to whom payment is made, is debited with both the amount paid
and the discount allowed by him.
2.3 THREE COLUMN CASH BOOK
A firm normally keeps the bulk of its funds at a bank; money can be deposited and withdrawn
at will if it is current account. Probably payments into and out of the bank are more numerous
than strict cash transactions. There is only a little difference between cash in hand and money
at bank. Therefore, it is very convenient if, on each side in the cash book, another column is
added to record cash deposited at bank (on the receipt side of the cash book) and payments
out of the bank (on the payment side of the cash book).
For writing up the three column cash book the under mentioned points should be noted:
1. While commencing a new business, the amount is written in the cash column if cash is
introduced and in the bank column if it is directly put into the bank with the description
"To Capital Account". If a new cash book is being started for an existing business, the
opening balances are written as : "To Balance b/d".

FUNDAMENTALS OF ACCOUNTING 2.71


CASH BOOK

2. All receipts are written on the receipts side, cash in the cash column and cheques in the
bank column. If any discount is allowed to the party paying the amount, the discount is
entered in the discount column. In the particulars column the name of the account in
respect of which payment has been received is written.
3. All payments are written on the payments side, cash payment in the cash column and
payments by cheques in the bank column. If some discount has been received from the
party receiving the payment, it is entered in the discount column.
4. Contra Entries: Often cash is withdrawn from bank for use in the office. In such a case the
amount is entered in the bank column on the payments side and also in the cash column
on the receipts side. In the reverse case of cash being sent to the bank, the amount is
recorded in the bank column on the receipts side and in cash column on payment side.
Against such entries, the letter "C" should be written in the LF. column, to indicate that
these are contra transaction and no further posting is required for them.
Note : If initially cheques received are entered in the cash column and then sent to the
bank, the entry is as if cash has been sent to the bank.
While recording contra entries, the basic but important rules should be followed -
(a) The Receiver Dr.
The Giver Cr.
(b) All what comes in Dr.
All what goes out Cr.
e.g. where a Cash Book with separate columns for Bank Account is maintained.
(a) If cash is deposited in Bank Account, the Bank will be the Receiver, hence it will be
Debited and as the cash is going out, cash will be credited.
(b) If cash is withdrawn from the Bank Account, the Bank will be the Giver, hence it will
be Credited and, as the cash is coming in, cash will be Debited.
5. If some cheque sent to the bank is dishonoured, i.e., the bank is not able to collect the
amount, it is entered in the bank column on the credit side with the name of the related
party in the particulars column.
6. If some cheque issued by the firm is not paid on presentation, it is entered in the Bank
column on the debit side with the name of the party to whom the cheque was given.
7. In a rare case, a cheque received may be given to some other party, i.e., endorsed. On
receipt, it must have been entered in the bank column on the debit side;on endorsement
the amount will be written in the bank column on the credit side.
The advantages of such type of Cash Book are that -
(a) the Cash Account and the Bank Account are prepared simultaneously, therefore the
double entry is completed in the Cash Book itself. Thus the contra entries can be
easily cross-checked in Cash column in one side and the Bank column in the other
side of the Cash Book. Also the chances of error are reduced.

2.72 COMMON PROFICIENCY TEST


(b) the information regarding Cash in Hand and the Bank Balance can be obtained very
easily and quickly as there is no need to prepare Ledger of the Bank Account.
In case of maintaining more than one Bank Account, separate column can be add for each
Bank Account. Transactions between these two or more Bank Accounts can be recorded and
tallied with a much less effort.
Suppose, there are two Bank Accounts namely PNB Current Account and SBI-Cash Credit
Account. Now, if a cheque is deposited from PNB cheque Book to SBI Account, the receiver -
i.e., PNB Account will be debited and the giver i.e. the SBI Account shall be credited.
Balancing: The discount columns are totalled but not balanced. The cash columns are balanced
exactly in the same manner as indicated for the simple cash book. The process is similar for
balancing the bank columns also. It is possible, however, that the bank may allow the firm to
withdraw more than the amount deposited i.e., to have an overdraft, In such a case, the total
of the bank column on the credit side is bigger than the one on the debit side. The difference is
written on the debit side as "To Balance c/d." Then the totals are written on the two sides
opposite one another, the balance is then entered on the credit side as "By Balance b/d."
However, the usual case is that payments into the bank will exceed the withdrawals or payments
out of the bank. Then the bank columns are balanced just like the cash columns.
Illustration 3
Enter the following transactions in Cash Book with Discount and Bank Columns. Cheques are
first treated as cash receipt.
2006 Rs.
Jan.1 Chandrika commences business with Cash 20,000
"3 He paid into Current A/c 19,000
"4 He received cheque from Kirti & Co. on account 600
"7 He pays in bank Kirty & Co's cheque 600
"10 He pays Rattan & Co. by cheque and is allowed discount Rs. 20 330
"12 Tripathi & Co pays into his Bank A/c 475
"15 He receives cheque from Warshi and allows him discount Rs. 35 450
"20 He receives cash Rs. 75 and cheque Rs. 100 for cash sale
"25 He pays into Bank, including cheques received on 15th and 20th 1,000
"27 He pays by cheque for cash purchase 275
"30 He pays sundry expenses in cash 50

FUNDAMENTALS OF ACCOUNTING 2.73


Solution

2.74
CASH BOOK
Dr. Cr.
CASH BOOK

Date Receipts L.F. Discount Cash Bank Date Payments L.F. Discount Cash Bank
Rs. Rs. Rs. Rs. Rs. Rs.
2006 2006
Jan. 1 To Capital A/c 20,000 Jan. 3 By Bank A/c C 19,000
3 To Cash C 19,000 7 By Bank A/c C 600
4 To Kirti & Co. 600 10 By Ratan & Co. 20 330
7 To Cash C 600 25 By Bank A/c C 1,000
12 To Tripathi & Co. 475 27 By Purchases A/c 275
15 To Warsh 35 450 30 By S. Exp. A/c 50
20 To Sales A/c 175
25 To Cash C 1,000
31 By Balance c/d 300 20,745
35 21,225 21,075 20 21,225 21,075
Feb. 1 To Balance b/d 300 20,745

COMMON PROFICIENCY TEST


3. POSTING THE CASH BOOK ENTRIES
Students would have seen that the cash columns in the cash book is actually the cash account
and the bank column is actually bank account. Also, the discount columns are memorandum
columns, meant only to provide information about the total discount allowed and total discount
received.
The debit side columns for cash and bank indicate receipts. Therefore, the amounts debited in
the cash book should be put to the credit of the account in respect of which cash or cheque has
been received. For instance, in the cash book given above we see that Rs. 175 have been received
for sale of goods. For posting, the amount is credited to the Sales Account as "By Cash Rs. 175."
We also see M/s. Warsi have paid Rs. 450 and also they have been allowed Rs. 35 as discount;
thus they have discharged a debt of Rs. 485. In the account of M/s. Warsi, the posting is on the
credit side as
"By Cash Rs. 450
By Discount Rs. 35"
or as :
By Sundries Rs. 485"
All payments are recorded on the credit side. The particulars columns show on what account
payments have been made. In the ledger accounts concerned the amount in put on the debit
side. For example, the cash book shows that a cheque for Rs. 330 has been issued to
M/s. Ratan & Co. and also that they have allowed a discount of Rs. 20; thus an obligation of
Rs. 350 has been met. In the account of M/s. Ratan & Co. the posting is :
"To Bank Rs. 330
"To Discount Rs. 20"
Or
"To Sundries Rs. 350"
The rule thus develops: From the debit side of the cash book credit the various accounts with
their respective amounts (including any discount that may have been allowed); from the credit
side of cash book the posting will be to the debit of the accounts mentioned in the particular
column with their respective amounts (including the discount which may have been received).
As has been shown already, the total of the discount columns on the debit side is debited to the
discount account ;the total of the column on the credit side is credited to the discount account.
From the cash book given on the previous page Rs. 35 is debited and Rs. 20 be credited to the
discount account.

4. PETTY CASH BOOK


In a business house a number of small payments, such as for telegrams, taxi fare, cartage, etc.,
have to be made. If all these payments are recorded in the cash book, it will become unnecessarily
heavy. Also, the main cashier will be overburdened with work. Therefore, it is usual for firms

FUNDAMENTALS OF ACCOUNTING 2.75


CASH BOOK

to appoint a person as 'Petty Cashier' and to entrust the task of making small payments say
below Rs. 25, to him. Of course he will be reimbursed for the payments made. Later, on an
analysis, the respective account may be debited.
4.1 IMPREST SYSTEM OF PETTY CASH
It is convenient to entrust a definite sum of money to the petty cashier in the beginning of a
period and to reimburse him for payments made at the end of the period. Thus, he will have
again the fixed amount in the beginning of the new period. Such a system is known as the
imprest system of petty cash.
The system is very useful specially if an analytical Petty Cash Book is used. The book has one
column to record receipt of cash (which is only from the main cashier) and other columns to
record payments of various types. The total of the various columns show why payments have
been made and then the relevant accounts can be debited.
(i) The amount fixed for petty cash should be sufficient for the likely small payments for a
relatively short period, say for a week or a fortnight.
(ii) The reimbursement should be made only when petty cashier prepares a statement showing
total payments supported by vouchers, i.e., documentary evidence and should be limited
to the amount of actual disbursements.
(iii) The vouchers should be filed in order.
(iv) No payment should be made without proper authorization. Also, payments above a certain
specified limit should be made only by the main cashier
(v) The petty cashier should not be allowed to receive any cash except for reimbursement.
In the petty cash book the extreme left-hand column records receipts of cash. The money
column towards the right hand shows total payments for various purposes; a column is usually
provided for sundries to record infrequent payments. The sundries column is analysed. At the
end of the week or the fortnight the petty cash book is balanced. The method of balancing is
the same as for the simple cash book.
Illustration 4
Shri Ramaswamy maintains a Columnar Petty Cash Book on the Imprest System. The imprest
amount is Rs. 500. From the following information, show how his Petty Cash Book would
appear for the week ended 12th September, 2005:
7-9-2005 Balance in hand 134.90
Received Cash reimbursement to make up the imprest 365.10
Stationery 49.80
8-9-2005 Miscellaneous Expenses 20.90
9-9-2005 Repairs 156.70
10-9-2005 Travelling 68.50
11-9-2005 Stationery 71.40
12-9-2005 Miscellaneous Expenses 6.30
Repairs 48.30

2.76 COMMON PROFICIENCY TEST


Solution
PETTY CASH BOOK
Date Receipts Amount Date Payments Total Stationery Travelling Misc. Exps. Repairs
Amount
2005 Rs. 2005 Rs. Rs. Rs. Rs. Rs.

Sept. 7 To Balance b/d 134.90 7 By Stationery 49.80 49.80


To Reimbursement 365.10 8 By Misc. Expenses 20.90 20.90
9 By Repairs 156.70 156.70

FUNDAMENTALS OF ACCOUNTING
10 By Travelling 68.50 68.50
11 By Stationery 71.40 71.40
12 By Misc. Expenses 6.30 6.30
By Repairs 48.30 48.30
421.90 121.20 68.50 27.20 205.00
By Balance c/d 78.10
500.00 500.00

13 To Balance b/d 78.10

2.77
CASH BOOK

Illustration 5
Prepare a Petty Cash Book on the imprest System from the following:
2006 Rs.
Jan.1 Received Rs. 100 for petty cash
" 2 Paid bus fare .50
" 2 Paid cartage 2.50
" 3 Paid for Postage & Telegrams 5.00
" 3 Paid wages for casual labourers 6.00
" 4 Paid for stationery 4.00
" 4 Paid tonga charges 2.00
" 5 Paid for the repairs to chairs 15.00
" 5 Bus fare 1.00
" 5 Cartage 4.00
" 6 Postage and Telegrams 7.00
" 6 Tonga charges 3.00
" 6 Cartage 3.00
" 6 Stationery 2.00
" 6 Refreshments to customers 5.00

2.78 COMMON PROFICIENCY TEST


Solution
PETTY CASH BOOK
Receipts Date V. No. Particulars Total Con- Cartage Statio- Postage & Wages Sundries
vetance nery Telegrams
Rs. 2006 Rs. Rs. Rs. Rs. Rs. Rs. Rs.
100 Jan.1 To Cash
2 1 By Conveyance .50 .50
2 By Cartage 2.50 2.50
3 3 By Postage and Telegrams 5.00 5.00

FUNDAMENTALS OF ACCOUNTING
4 By Wages 6.00 6.00
4 5 By Stationery 4.00 4.00
6 By Conveyance 2.00 2.00
5 7 By Repairs to Furniture 15.00 15.00
8 By Conveyance 1.00 1.00
9 By Cartage 4.00 4.00
6 10 By Postage and Telegrams 7.00 7.00
" 11 By Conveyance 3.00 3.00
" 12 By Cartage 3.00 3.00
" 13 By Stationery 2.00 2.00
" 14 By General Expenses 5.00 5.00
60.00 6.50 9.50 6.00 12.00 6.00 20.00
By Balance c/d 40.00
100.00
40.00 To Balance b/d
60.00 8 To Cash

2.79
CASH BOOK

4.2 ADVANTAGES OF THE PETTY CASH BOOK


There are mainly three advantages:
(i) Saving of time of the chief cashier;
(ii) Saving in labour in writing up the cash book and posting into the ledger; and
(iii) Control over small payments.
4.3 POSTING THE PETTY CASH BOOK
In the ledger, a petty cash account is maintained; when an amount is given to the petty cashier,
the petty cash account is debited. Each week or forthnight, the total of the payments made is
credited to this account. The petty cash account will then show the balance in the hand of the
cashier; on demand he should be able to produce it for counting. At the end of the year, the
balance is shown in the balance sheet as part of cash balance.
Of course, the payments must be debited to their respective amounts as shown by the petty
cash book. For this two methods may be used:
(i) From the petty cash book the total of the various columns may be directly debited to the
concerned accounts; or
(ii) A journal entry may first be prepared on the basis of the petty cash book, debiting the
accounts shown by the various analysis columns, and crediting the total of the payment
of the petty cash accounts.
For Illustration 5 the journal entry and relevant accounts are as follows:
2006 Rs. Rs.
Jan. 6 Conveyance Account Dr. 6.50
Cartage account Dr. 9.50
Stationery account Dr. 6.00
Postage and Telegrams account Dr. 12.00
Wages Account Dr. 6.00
Repairs Account Dr. 15.00
General Expenses Account Dr. 5.00
To Petty Cash Account 60.00
(Being the analysis of the Petty Cash Book for
the week ending Jan. 6)
Entry for cash handed over to the Petty Cashier
Petty Cash Account Dr. Rs. 100
To Cash Account Rs. 100
(Being Cash received)

2.80 COMMON PROFICIENCY TEST


Petty Cash Account
Date Particulars Folio Amount Date Particulars Folio Amount
2006 Rs. 2006
Jan.1 To Cash 100.00 Jan.6 By Sundries:
"8 To Cash 60.00 Conveyance 6.50
Cartage 9.50
Stationery 6.00
Postage and Telegrams 12.00
Wages 6.00
Repairs 15.00
General
Expenses 5.00

5. ENTRIES FOR SALE THROUGH CREDIT/DEBIT CARDS


Now-a-days sales through Credit/Debit Cards are issued by almost every Bank in India either
directly or with collaboration of some other agencies. HSBC Card, SBI Card, BOB Card, ICICI
Bank Card, HDFC Card and Andhra Bank Card are some of the popular Cards.
The procedure for issuing Credit/Debit Cards are as follows -
1. A small Plastic Card, called Credit Card is issued by bank to a prospective customer, after
verifying his credibility, which is generally measured by his income sources. Debit Card is
issued by bank to a customer who has an account with the bank, maintaining a minimum
balance. Now a days ATM Card issued by the bank can also be used as Debit Card. This
card would contain an embossed 16 digit number and also the name of the cardholder.
2. Generally Bank charges annual subscription fees from the credit card holder. No fee is
charged in case of Debit Card, though some banks charge a nominal fee on Debit Card.
3. When the Card holder intends to buy some goods or services through Credit or Debit
Card, the seller fills in a form, generally in triplicate, the details of the goods a with the
amount of sales and uses the embossed card with the help of the Credit Card machine to
print the data on that form. Also the customer has to countersign the form. One carbon
copy of the form is given to the customer for the record.
4. The seller sums up the different amounts sold like this and submits, generally everyday, to
his bank all the forms. The amount is credited by the bank to the seller's account and
debited to the account of the Bank or the company issuing the Credit/Debit Card.
5. The bank issuing the Card, charges commission for each such transaction, which varies
between 1% to 4% and is immediately debited to seller's bank account.
6. The bank sends a monthly statement to the card holder. In case of Debit Card the account
is immediately debited to the card holder's account, whereas in case of Credit Card, card

FUNDAMENTALS OF ACCOUNTING 2.81


CASH BOOK

holder has to pay the amount in full or part. However, if not paid in full, the interest is
charged.
5.1 ACCOUNTING FOR CREDIT/DEBIT CARD SALE
From the seller's point of view, this type of sale is equivalent to a cash sale. Commission charged
by the bank will be treated as selling expenses. The following general entries will be made in
the seller's books of accounts
1. Bank A/c Dr.
To Sales Account
(Sales made through Credit/Debit Card)
2. Commission Account Dr.
To Bank Account
(Commission charged by bank)
Illustration 7
Enter the following transaction in Cash Bank with Discount and Bank columns. Cheques are
first treated as cash receipts -
2006 Rs.
March1 Cash in Hand 15,000
Overdraft in Bank 6,000
2 Cash Sales 3,000
3 Paid to Sushil Bros. by cheque 3,400
Discount received 100
5 Sales through credit card 2,800
6 Received cheque from Srijan 6,200
7 Endorsed Srijan's cheque in favour of Adit
9 Deposit into Bank 6,800
10 Received cheque from Aviral and deposited into Bank 3,600
11 Adit informed that Srijan's cheque is dishonoured
15 Sales through Debit Card 3.200
24 Withdrawn from Bank 1,800
28 Paid to Sanchit 3,000
30 Bank charged 1% commission on sales through
Debit/Credit Cards

2.82 COMMON PROFICIENCY TEST


Solution
CASH BOOK
Dr. Cr.
Date Particulars L.F. Discount Cash Bank Date Particulars L.F. Discount Cash Bank
Rs. Rs. Rs. Rs. Rs. Rs.

2006 2006
March 1 To Balance c/d 15,000 March 1 By Balance b/d 6,000
2 To Sales 3,000 3 By Sushil Bros. 100 3,400

FUNDAMENTALS OF ACCOUNTING
5 To Sales 2,800 7 By Adit 6,200
6 To Srijan 6,200 9 By Bank C 6,800
9 To Cash A/c C 6,800 12 By Shijan 6,200
10 To Aviral 50 3,600 24 By Cash A/c C 1,800
12 Adit 6,200 28 By Sanchit 3,000
15 To Sales A/c 3,200 30 By Commisson 60
24 To Bank A/c C 1,800 31 By Balance c/d 13,000 2,140
50 32,200 16,400 100 32,200 16,400

2.83
CASH BOOK

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
1. (i) The total of discounts column on the debit side of the cash book, recording cash
discount deducted by customers when paying their accounts, is posted to the
(a) credit of the discount allowed account.
(b) debit of the discount received account.
(c) credit of the discount received account.
(d) debit of the discount allowed account.
(ii) Which of the following is the kind of a cash-book ?
(a) Simple column cash-book
(b) Double column cash-book
(c) Three column cash-book
(d) All of the above
(iii) Cash book is a type of __________ but treated as a ____________ of accounts.
(a) Subsidiary book, principal book
(b) Principal book, subsidiary book
(c) Subsidiary book, Subsidiary book
(d) Principal book, Principal book
(iv) Which of the following is not a column of a three-column cash-book?
(a) Cash column
(b) Bank column
(c) Petty cash column
(d) Discount column
(v) Salaries due for the month of March will appear
(a) on the receipt side of the cash book
(b) on the payment side of the cash-book
(c) as a contra entry
(d) nowhere in the cash book
(vi) Contra entries are passed only when
(a) double column cash book is prepared
(b) three-column cash book is prepared
(c) simple cash book is prepared
(d) None of the above

2.84 COMMON PROFICIENCY TEST


2. State which of the following correctly complete the sentences given below:
(i) The Cash Book records
(a) all cash receipts
(b) all cash payments
(c) all cash receipts and payments
(d) cash and credit sale of goods.
(ii) The balance in the petty cash book is
(a) an expense
(b) a profit
(c) an asset
(d) a liability.
(iii) If Ram has sold goods for cash, the entry will be recorded
(a) in the Cash Book
(b) in the Sales Book
(c) in the Journal
(d) in the Stock Book.

ANSWERS
I
1
(i) (d) (ii) (d) (iii) (a) (iv) (c) (v) (d) (vi) (b)

2
(i) (c) (ii) (c) (iii) (a)

FUNDAMENTALS OF ACCOUNTING 2.85


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 6

Capital and Revenue


Expenditures
and Receipts
Learning Objectives
After studying this unit you will be able to :

 Learn the criteria for identifying Revenue Expenditure and distinguishing from Capital
Expenditure.
 Be familiar with the term Deferred Revenue Expenditure.
 Learn the distinction between capital and revenue receipts.
 Understand the linkage of such distinction with the preparation of final accounts.

1. INTRODUCTION
Accounting aims in ascertaining and presenting the results of the business for an accounting
period. For ascertaining the periodical business results, the nature of transactions should be
analysed whether they are of capital or revenue nature. The Revenue Expense relates to the
operations of the business of an accounting period or to the revenue earned during the period
or the items of expenditure, benefits of which do not extend beyond that period. Capital
Expenditure, on the other hand, generates enduring benefits and helps in revenue generation
over more than one accounting period. Revenue Expenses must be associated with a physical
activity of the entity. Therefore, whereas production and sales generate revenue in the earning
process, use of goods and services in support of those functions causes expenses to occur.
Expenses are recognised in the Profit & Loss Account through matching principal which tells
us when and how much of the expenses to be charged against revenue. A part of the
expenditure can be capitalised only when these can be traced directly to definable streams of
future benefits.
The distinction of transaction into revenue and capital is done for the purpose of placing them
in Profit and Loss account or in the Balance Sheet. For example: revenue expenditures are
shown in the profit and loss account as their benefits are for one accounting period i.e. in
which they are incurred while capital expenditures are placed on the asset side of the balance
sheet as they will generate benefits for more than one accounting period and will be transferred
to profit and loss account of the year on the basis of utilisation of that benefit in particular
accounting year. Hence, both capital and revenue expenditures are ultimately transferred to
profit and loss account.
Revenue expenditures are transferred to profit and loss account in the year of spending while
capital expenditures are transferred to profit and loss account of the year in which their benefits
are utilised. Therefore we can conclude that it is the time factor, which is the main determinant
for transferring the expenditure to profit and loss account. Also expenses are recognized in
profit and loss account through matching concept which tells us when and how much of the
expenses to be charged against revenue. However, distinction between capital and revenue
creates a considerable difficulty. In many cases borderline between the two is very thin.

FUNDAMENTALS OF ACCOUNTING 2.87


CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

2. CONSIDERATIONS IN DETERMINING CAPITAL AND


REVENUE EXPENDITURES
The basic considerations in distinction between capital and revenue expenditures are:
(a) Nature of business: For a trader dealing in furniture, purchase of furniture is revenue
expenditure but for any other trade, the purchase of furniture should be treated as capital
expenditure and shown in the balance sheet as asset. Therefore, the nature of business is a very
important criteria in separating an expenditure between capital and revenue.
(b) Recurring nature of expenditure: If the frequency of an expense is quite often in an
accounting year then it is said to be an expenditure of revenue nature while non-recurring
expenditure is infrequent in nature and do not occur often in an accounting year. Monthly
salary or rent is the example of revenue expenditure as they are incurred every month while
purchase of assets is not the transaction done regularly therefore, classified as capital expenditure
unless materiality criteria defines it as revenue expenditure.
(c) Purpose of expenses: Expenses for repairs of machine may be incurred in course of normal
maintenance of the asset. Such expenses are revenue in nature. On the other hand, expenditure
incurred for major repair of the asset so as to increase its productive capacity is capital in
nature. However, determination of the cost of maintenance and ordinary repairs which should
be expensed, as opposed to a cost which ought to be capitalised, is not always simple.
(d) Effect on revenue generating capacity of business: The expenses which help to generate
income/revenue in the current period are revenue in nature and should be matched against
the revenue earned in the current period. On the other hand, if expenditure helps to generate
revenue over more than one accounting period, it is generally called capital expenditure.
When expenditure on improvements and repair of a fixed asset is done, it has to be charged to
Profit and Loss Account if the expected future benefits from fixed assets do not change, and it
will be included in book value of fixed asset, where the expected future benefits from assets
increase.
(e) Materiality of the amount involved: Relative proportion of the amount involved is another
important consideration in distinction between revenue and capital. Even, if expenditure does
not increase the productive capacity of an asset, it may be capitalised because the amount is
material or expenditure may increase the asset value and yet to be expensed because the amount
is immaterial.

3. CAPITAL EXPENDITURE AND REVENUE EXPENDITURES


As we have already discussed, capital expenditure contributes to the revenue earning capacity
of a business over more than one accounting period whereas revenue expense is incurred to
generate revenue for a particular accounting period. The revenue expenses either occur in
direct relation with the revenue or in relation with accounting periods, for example cost of
goods sold, salaries, rent, etc. Cost of goods sold is directly related to sales revenue whereas
rent is related to the particular accounting period. Capital expenditure may represent acquisition
of any tangible or intangible fixed assets for enduring future benefits. Therefore, the benefits
arising out of capital expenditure last for more than one accounting period whereas those
arising out of revenue expenses expire in the same accounting period.

2.88 COMMON PROFICIENCY TEST


4. DEFERRED REVENUE EXPENDITURES
Deferred revenue expenditure is that expenditure for which payment has been made or a
liability incurred but which is carried forward on the presumption that it will be of benefit over
a subsequent period or periods. In short, it refers to that expenditure that is, for the time being,
deferred from being charged against income. Such suspension of 'charging of' operation may
be due to the nature of expenses and the benefits expected there from. So, long as deferred
revenue expenditure is not written off, this is shown on the assets side of the balance sheet
under the head "Miscellaneous Expenditure."
Deferred revenue expenditure should be revenue expenditure by nature in the first instance,
for example, advertisement. But its matching with revenue may be deferred considering the
benefits to be accrued in future.
A thin line of difference exists between deferred revenue expenses and prepaid expenses. The
benefits available from prepaid expenses can be precisely estimated but that is not so in case of
deferred revenue expenses. Heavy advertising to launch a new product is a deferred expenditure
since the benefit from it will be available over the next three to five years but one cannot say
precisely how long the benefit would be available and the exact amount of benefit. On the
other hand, insurance premium paid say, for the year ending 30th June, 2006 when the
accounting year ends on 31st March, 2006 will be an example of prepaid expense to the extent
of premium relating to three months' period i.e. from 1st April, 2006 to 30th June, 2006. Thus
the insurance protection will be available precisely for three months after the close of the Year
and the amount of the premium to be carried forward can be calculated exactly.
Illustration 1
State with reasons whether the following statements are 'True' or 'False'.
(1) Overhaul expenses of second-hand machinery purchased are Revenue Expenditure.
(2) Money spent to reduce working expenses is Revenue Expenditure.
(3) Legal fees to acquire property is Capital Expenditure.
(4) Amount spent as lawyer's fee to defend a suit claiming that the firm's factory site belonged
to the plaintiff's land is Capital Expenditure.
(5) Amount spent for replacement of worn out part of machine is Capital Expenditure.
(6) Expense incurred on the repairs and white washing for the first time on purchase of an
old building are Revenue Expenses.
(7) Expenses in connection with obtaining a license for running the cinema is Capital
Expenditure.
(8) Amount spent for the construction of temporary huts, which were necessary for
construction of the Cinema House and were demolished when the cinema house was
ready, is Capital Expenditure.
(9) Heavy advertising to introduce a new product or to explore a new market is Capital
Expenditure.

FUNDAMENTALS OF ACCOUNTING 2.89


CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

Solution
(1) False: Overhaul expenses are incurred to put second-hand machinery in working condition
to derive endurable long-term advantage. So it should be capitalised.
(2) False: It may be reasonably presumed that money spent for reducing revenue expenditure
would have generated long-term benefits to the entity. It becomes part of intangible fixed
assets if it is in the form of technical know-how and tangible fixed assets if it is in the form
of additional replacement of any of the existing tangible fixed assets. So this is capital
expenditure.
(3) True: Legal fee paid to acquire any property is part of the cost of that property. It is
incurred to possess the ownership right of the property and hence a capital expenditure.
(4) False: Legal expenses incurred to defend a suit claiming that the firm's factory site belongs
to the plaintiff is maintenance expenditure of the asset. By this expense, neither any
endurable benefit can be obtained in future in addition to that what is presently available
nor the capacity of the asset will be increased. Maintenance expenditure in relation to an
asset is revenue expenditure.
(5) False: Amount spent for replacement of any worn out part of a machine is revenue expense
since it is part of its maintenance cost.
(6) False: Repairing and white washing expenses for the first time of an old building are
incurred to put the building in usable condition. These are the part of the cost of building.
Accordingly, these are capital expenditure.
(7) True: The Cinema Hall could not be started without license. Expenditure incurred to
obtain the license is pre-operative expense which is capitalised. Such expenses are amortised
over a period of time.
(8) True: Cost of temporary huts constructed which were necessary for the construction of
the cinema house is part of the construction cost of the cinema house. Therefore such costs
are to be capitalised.
(9) False: The effect of heavy advertising with regard to the launching of a new product or to
explore a new market will last generally for more than one accounting period. But it does
not create any property of tangible or intangible nature and so the expenditure is spread
over the period for which its effect would remain. This type of expenditure items are
termed as deferred revenue expenditure.
Illustration 2
State with reasons whether the following are Capital or Revenue Expenditure:
(1) Expenses incurred in connection with obtaining a license for starting the factory for
Rs. 10,000.
(2) Rs. 1,000 paid for removal of stock to a new site.
(3) Rings and Pistons of an engine were changed at a cost of Rs. 5,000 to get fuel efficiency.
(4) Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) Rs. 8,000 for installing telephone
in the office.
(5) A factory shed was constructed at a cost of Rs. 1,00,000. A sum of Rs. 5,000 had been
incurred in the construction of temporary huts for storing building material.

2.90 COMMON PROFICIENCY TEST


Solution
(1) Money paid Rs. 10,000 for obtaining license to start a factory is a capital expenditure. This
is an item of expenditure incurred to acquire the right to carry on business.
(2) Rs. 1,000 paid for removal of stock to a new site is revenue expenditure. This is neither
bringing enduring benefit nor enhancing the value of the asset.
(3) Rs. 5,000 spent in changing Rings and Pistons of an engine to get fuel efficiency is capital
expenditure. This is an expenditure on improvement of a fixed asset. It results in increasing
profit-earning capacity of the business by cost reduction.
(4) Money deposited with MTNL for installation of telephone in office is not expenditure.
This is treated as an asset and the same is adjusted over a period of time against actual
telephone bills.
(5) Cost of construction of building including cost of temporary huts is capital expenditure.
Building is fixed asset which will generate enduring benefit to the business over more than
one accounting period. Construction of temporary huts is incidental to the main
construction. Such cost is also capitalised with the cost of building.

5. CAPITAL RECEIPTS AND REVENUE RECEIPTS


Just as a clear distinction between Capital and Revenue expenditure is necessary, in the same
manner capital receipts must be distinguished from revenue receipts.
Receipts which are obtained in course of normal business activities are revenue receipts (e.g.
receipts from sale of goods or services, interest income etc.). On the other hand, receipts which
are not revenue in nature are capital receipts (e.g. receipts from sale of fixed assets or investments,
secured or unsecured loans, owners’ contributions etc.). Revenue and capital receipts are
recognised on accrual basis as soon as the right of receipt is established. Revenue receipts
should not be equated with the actual cash receipts. Revenue receipts are credited to the Profit
and Loss Account.
On the other hand, Capital receipts are not directly credited to Profit and Loss Account. For
example, when a fixed asset is sold for Rs. 92,000 (cost Rs. 90,000), the capital receipts
Rs. 92,000 is not credited to Profit and Loss Account. Profit/Loss on sale of fixed assets is
calculated and credited to Profit and Loss Account as follows:
Sale Proceeds Rs. 92,000
Cost (Rs. 90,000)
Profit Rs. 2,000
Illustration 3
Good Pictures Ltd., construct a cinema house and incur the following expenditure during the
first year ending 30th June, 2006.
(i) Second-hand furniture worth Rs. 9,000 was purchased; repainting of the furniture costs
Rs. 1,000. The furniture was installed by own workmen, wages for this being Rs. 200.

FUNDAMENTALS OF ACCOUNTING 2.91


CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

(ii) Expenses in connection with obtaining a license for running the cinema worth Rs. 20,000.
During the course of the year the cinema company was fined Rs. 1,000, for contravening
rules. Renewal fee Rs. 2,000 for next year also paid.
(iii) Fire insurance, Rs. 1,000 was paid on 1st January, 2006 for one year.
(iv) Temporary huts were constructed costing Rs. 1,200. They were necessary for the
construction of the cinema. They were demolished when the cinema was ready.
Point out how you would classify the above items.
Solution
1 The total cost of the furniture should be treated as Rs. 10,200 i.e., all the amounts mentioned
should be capitalised since without such expenditure the furniture would not be available
for use. If Rs. 1,000 and Rs. 200 have been respectively debited to the Repairs Account and
the Wages Account, these accounts will be credited to the Furniture Account.
2. License for running the cinema house is necessary, hence its cost should be capitalised.
But the fine of Rs. 1,000 is revenue expenditure. The renewal fee for the next year is also
revenue expenditure but pertains to the next year; hence, it is a prepaid expense.
3. Half of the insurance premium pertains to the year beginning on 1st July, 2006. Hence
such amount should be treated as prepaid expense. The remaining amount is revenue
expense for the current year.
4. Since the temporary huts were necessary for the construction, their cost should be added
to the cost of the cinema hall and thus capitalised.
Illustration 4
State with reasons, how you would classify the following items of expenditure:
1. Overhauling expenses of Rs. 25,000 for the engine of a motor car to get better fuel efficiency.
2. Inauguration expenses of Rs. 25 lacs incurred on the opening of a new manufacturing
unit in an existing business.
3. Compensation of Rs. 2.5 crores paid to workers, who opted for voluntary retirement.
Solution
1. Overhauling expenses are incurred for the engine of a motor car to derive better fuel
efficiency. These expenses will reduce the running cost in future and thus the benefit is in
form of endurable long-term advantage. So this expenditure should be capitalised.
2. Inauguration expenses incurred on the opening of a new unit may help to explore more
customers. This expenditure is in the nature of revenue expenditure, as the expenditure
may not generate any enduring benefit to the business over more than one accounting
period.
3. The amount paid to workers on voluntary retirement is in the nature of revenue expenditure.
Since the magnitude of the amount of expenditure is very significant, it may be better to
defer it over future years.

2.92 COMMON PROFICIENCY TEST


Illustration 5
Classify the following expenditures and receipts as capital or revenue:
(i) Rs. 10,000 spent as travelling expenses of the directors on trips abroad for purchase of
capital assets.
(ii) Amount received from debtors during the year.
(iii) Amount spent on demolition of building to construct a bigger building on the same site.
(iv) Insurance claim received on account of a machinery damaged by fire.
Solution
(i) Capital expenditure.
(ii) Revenue receipt.
(iii) Capital expenditure.
(iv) Capital receipt.
Illustration 6
Are the following expenditures capital in nature?
(i) M/s ABC & Co. run a restaurant. They renovate some of the old cabins. Because of this
renovation some space was made free and number of cabins was increased from 10 to 13.
The total expenditure was Rs. 20,000.
(ii) M/s New Delhi Financing Co. sold certain goods on installment payment basis. Five
customers did not pay installments. To recover such outstanding installments, the firm
spent Rs. 10,000 on account of legal expenses.
(iii) M/s Ballav & Co. of Delhi purchased a machinery from M/s Shah & Co. of Ahmedabad.
M/s Ballav & Co. spent Rs. 40,000 for transportation of such machinery.
(iv) M/s Dogra & Co. spent Rs. 1,00,000 for organising an Inter-school Hockey Tournament
in Delhi. This was for advertising their new school bag and other books and stationery
which they want to market.
(v) M/s Dogra & Co. installed a machinery for Rs. 5,00,000 on 1.1.1999. They were charging
deprecation on straight line basis taking useful life of the machine as 10 years. In December,
2005 they found that the machine became obsolete which could not be used. The machine
can fetch only Rs. 50,000.
Solution:
(i) Renovation of cabins increased the number of cabins. This has an effect on the future
revenue generating capability of the business. Thus the renovation expense is capital
expenditure in nature.
(ii) Expense incurred to recover installments due from customer do not increase the revenue
generating capability in future. It is a normal recurring expense of the business. Thus the
legal expenses incurred in this case is revenue expenditure in nature.
(iii) Expenses incurred on account of transportation of fixed asset is capital expenditure in
nature.

FUNDAMENTALS OF ACCOUNTING 2.93


CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

(iv) The purpose of expenses incurred for organising the Inter-school Hockey Tournament is
to advertise for some new products. This advertisement may have some enduring effect so
far as marketability of the new products. This expense may be treated as deferred revenue
expenditure.
(v) Loss arising out of obsolescence of machinery is revenue expenditure. This loss is to be
charged against revenue of the year in which such loss is recognised. In this case, loss due
to obsolescence is:
Rs.
Cost 5,00,000
Less: Depreciation 1999-2005 3,50,000
Written down value at the end of 2005 1,50,000
Less: Estimated scrap value 50,000
1,00,000
This loss is revenue loss in nature.
Illustration 7
Are the following expenses capital in nature?
(i) Wages paid for installation of fixed assets.
(ii) Expenses of trial run of a newly installed machine.
(iii) Money deposited with the wholesaler as security.
(iv) Money paid to Mahanagar Telephone Nigam Ltd. (MTNL) Rs. 8,000 for installing
Telephone in the office.
(v) Amount spent for inauguration of new selling centre.
(vi) Free gift to customers of a new product.
(vii) Diwali advance to employees.
(viii) Money advanced to suppliers for booking of goods.
Solution:
(i) Expenses incurred including wages for installation of any fixed asset is capital expenditure
in nature.
(ii) Expenses incurred for trial run of a newly installed machinery is capital expenditure in
nature.
(iii) Money deposited as security is not an expenditure item.
(iv) Money deposited with MTNL for installation of telephone is not expenditure item. This is
treated as an asset.
(v) Expenses incurred for inauguration of branch is treated as revenue expenditure. Sometime
heavy expenditures incurred at the inaugural are meant for advertisement purposes,
which have enduring effect on the future revenue generating capability of the business.
Such expenses may be treated as deferred revenue expenditure.

2.94 COMMON PROFICIENCY TEST


(vi) Free gift to customers is an advertisement expense. This is normally treated as a revenue
expenditure. In case the amount involved in such free gift is heavy in relation to the
volume of sales of the business and in case such free gift has an enduring effect on the
future revenue generating capability of the business, it is treated as deferred revenue
expenditure.
(vii) Diwali advance to employees is not an expense item.
(viii) Money advanced to supplies for booking goods is not an expense item.

SELF EXAMINATION QUESTIONS


I. Pick up the correct answer from the given choices:
1. Classify the following expenditures and receipts as capital or revenue:
(i) Money spent Rs. 10,000 as traveling expenses of the directors on trips abroad for
purchase of capital assets is
(a) Capital expenditures (b) Revenue expenditures
(c) Deferred revenue expenditures (d) None of the above
(ii) Amount of Rs. 5,000 spent as lawyers’ fee to defend a suit claiming that the firm’s
factory site belonged to the plaintiff’s land.
(a) Capital expenditures (b) Revenue expenditures
(c) Deferred revenue expenditures (d) None of the above
(iii) Entrance fee of Rs. 2,000 received by Ram and Shyam Social Club.
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures (d) Revenue expenditures
(iv) Subsidy of Rs. 40,000 received from the government by a manufacturing concern.
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures (d) Revenue expenditures
(v) Insurance claim received on account of machinery damaged completely by fire.
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures (d) Revenue expenditures
(vi) Interest on investments received from UTI.
(a) Capital receipt (b) Revenue receipt
(c) Capital expenditures (d) Revenue expenditures
(vii) Amount received from IDBI as a medium term loan for augmenting working capital.
(a) Capital expenditures (b) Revenue expenditures
(c) Capital receipt (d) Revenue receipt

FUNDAMENTALS OF ACCOUNTING 2.95


CAPITAL AND REVENUE EXPENDITURES AND RECEIPTS

(viii) A bad debt recovered during the year.


(a) Capital expenditures (b) Revenue expenditures
(c) Capital receipt (d) Revenue receipt
(ix) A second hand car is purchased for Rs. 10,000, the amount of Rs. 1,000 is spent on its
repairs, Rs. 500 is incurred to get the car registered in owner’s name and Rs. 1,200 is
paid as dealer’s commission. The amount debited to car account will be
(a) Rs. 10,000. (b) Rs. 10,500. (c) Rs. 11,500. (d) Rs. 12,700.
(x) Revenue from sale of products ordinarily is reported as part of the earning in the
period
(a) the sale is made. (b) the cash is collected.
(c) the products are manufactured. (d) the planning takes place.
(xi) If repair cost is Rs. 25,000, whitewash expenses are Rs. 5,000, cost of extension of
building is Rs. 2,50,000 and cost of improvement in electrical wiring system is Rs.
19,000; the amount to be expensed is
(a) Rs. 2,99,000. (b) Rs. 44,000. (c) Rs. 30,000. (d) Rs. 49,000.
[Ans. 1: (i)-(a), (ii)-(b), (iii)-(a), (iv)-(b), (v)-(a), (vi)-(b), (vii)-(c), (viii)-(d), (ix)-(d), (x)-(a), (xi)-(c)]
2. Out of the following which are (1) capital expenditure; (2) revenue expenditure; and (3)
deferred revenue expenditure?
(i) Rs. 1,200 spent on the repairs of machine.
(a) capital expenditure; (b) revenue expenditure;
(c) deferred revenue expenditure? (d) None of the above
(ii) Rs. 2,500 spent on the overhaul of machines purchased second-hand.
(a) capital expenditure; (b) revenue expenditure;
(c) deferred revenue expenditure? (d) None of the above
(iii) White washing expenses.
(a) capital expenditure; (b) revenue expenditure;
(c) deferred revenue expenditure? (d) None of the above
(iv) Paper purchased for use as stationery.
(a) capital expenditure; (b) revenue expenditure;
(c) deferred revenue expenditure? (d) None of the above
(v) Advertising campaign to launch a new product.
(a) capital expenditure; (b) revenue expenditure;
(c) deferred revenue expenditure? (d) None of the above
[Ans: 2: (ii) is a capital expenditure and Item no. (v) is deferred revenue expenditure, and
remaining items are revenue expenditures.]

2.96 COMMON PROFICIENCY TEST


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 7

Contingent Assets
and Contingent
Liabilities
CONTINGENT ASSETS AND CONTINGENT LIABILITIES

Learning Objectives
After studying this unit you will be able to :

 Understand the meaning of the terms 'Contingent Assets' and 'Contingent Liabilities'.
 Distinguish 'Contingent Liabilities' with 'Liabilities' and 'Provisions'.

1. CONTINGENT ASSETS
A contingent asset may be defined as a possible asset that arises from past events and whose
existence will be confirmed only after occurrence or non-occurrence of one or more uncertain
future events not wholly within the control of the enterprise. It usually arises from unplanned
or unexpected events that give rise to the possibility of an inflow of economic benefits to the
business entity. For example, a claim that an enterprise is pursuing through legal process,
where the outcome is uncertain, is a contingent asset.
As per the concept of prudence as well as the present accounting standards, an enterprise
should not recognise a contingent asset. These assets are uncertain and may arise from a claim
which an enterprise pursues through a legal proceeding. There is uncertainty in realisation of
claim. It is possible that recognition of contingent assets may result in recognition of income
that may never be realised. However, when the realisation of income is virtually certain, then
the related asset no longer remains as contingent asset.
A contingent asset need not be disclosed in the financial statements. A contingent asset is
usually disclosed in the report of the approving authority (Board of Directors in the case of a
company, and the corresponding approving authority in the case of any other enterprise), if
an inflow of economic benefits is probable. Contingent assets are assessed continually and if it
has become virtually certain that an inflow of economic benefits will arise, the asset and the
related income are recognised in the financial statements of the period in which the change
occurs.

2. CONTINGENT LIABILITIES
The term 'Contingent liability' can be defined as
"(a) a possible obligation1 that arises from past events and the existence of which will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the enterprise; or
(b) a present obligation2 that arises from past events but is not recognised because:
(i) it is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation; or
(ii) a reliable estimate of the amount of the obligation cannot be made."

1
Possible Obligation: An obligation is a possible obligation if, based on the evidence available, its existence at the balance sheet date
is considered not probable.
2
Present Obligation: An obligation is a present obligation if, based on the evidence available, its existence at the balance sheet date
is considered probable, i.e., more likely than not.

2.98 COMMON PROFICIENCY TEST


A contingent liability is a possible obligation arising from past events and may arise in future
depending on the occurrence or non-occurrence of one or more uncertain future events [part
(a) of the definition]. A contingent liability may also be a present obligation that arises from
past events [(part (b) of the definition)].
An enterprise should not recognise a contingent liability. A Contingent liability is required to be
disclosed unless possibility of outflow of a resource embodying economic benefits is remote.
These liabilities are assessed continually to determine whether an outflow of resources
embodying economic benefits has become probable. If it becomes probable that an outflow or
future economic benefits will be required for an item previously dealt with as a contingent
liability, a provision is recognised in financial statements of the period in which the change in
probability occurs except in the extremely rare circumstances where no reliable estimate can
be made.

3. DISTINCTION BETWEEN CONTINGENT LIABILITIES AND


LIABILITIES
The distinction between a liability and a contingent liability is generally based on the judgement
of the management. A liability is defined as the present financial obligation of an enterprise,
which arises from past events. The settlement of a liability results in an outflow from the
enterprises of resources embodying economic benefits. On the other hand, in the case of
contingent liability, either outflow of resources to settle the obligation is not probable or the
amount expected to be paid to settle the liability cannot be measured with sufficient reliability.
Examples of contingent liabilities are claims against the enterprise not acknowledged as debts,
guarantees given in respect of third parties, liability in respect of bills discounted and statutory
liabilities under dispute etc. In addition to present obligations that are recognised as liabilities
in the balance sheet, enterprises are required to disclose contingent liability in their balance
sheets by way of notes.

4. DISTINCTION BETWEEN CONTINGENT LIABILITIES AND


PROVISIONS
Provision means "any amount written off or retained by way of providing for depreciation,
renewal or diminution in the value of assets or retained by way of providing for any known
liability of which the amount cannot be determined with substantial accuracy".
It is important to know the difference between provisions and contingent liabilities. The
distinction between both of them can be explained as follows:

FUNDAMENTALS OF ACCOUNTING 2.99


CONTINGENT ASSETS AND CONTINGENT LIABILITIES

Provision Contingent liability


(1) Provision is a present liability of uncertain A Contingent liability is a possible
amount, which can be measured reliably obligation that may or may not crystallise
by using a substantial degree of estimation. depending on the occurrence or non-
occurrence of one or more uncertain future
events.
(2) A provision meets the recognition criteria. A contingent liability fails to meet the same.

(3) Provision is recognised when (a) an Contingent liability includes present


enterprise has a present obligation arising obligations that do not meet the recognition
from past events; an outflow of resources criteria because either it is not probable that
embodying economic benefits is probable, settlement of those obligations will require
and (b) a reliable estimate can be made of outflow of economic benefits, or the
the amount of the obligation. amount cannot be reliably estimated.

4) If the management estimates that it is If the management estimates, that it is less


probable that the settlement of an obligation likely that any economic benefit will
will result in outflow of economic benefits, outflow the firm to settle the obligation, it
it recognises a provision in the balance discloses the obligation as a contingent
sheet. liability.

Let us take an example to understand the distinction between provisions and contingent
liabilities. The Central Excise Officer imposes a penalty on Alpha Ltd. for violation of a provision
in the Central Excise Act. The company goes on an appeal. If the management of the company
estimates that it is probable that the company will have to pay the penalty, it recognises a
provision for the liability. On the other hand, if the management anticipates that the judgement
of the appellate authority will be in its favour and it is less likely that the company will have to
pay the penalty, it will disclose the obligation as a contingent liability instead of recognising a
provision for the same.

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
1. (i) Contingent asset usually arises from unplanned or unexpected events that give rise to
(a) The possibility of an inflow of economic benefits to the business entity.
(b) The possibility of an outflow of economic benefits to the business entity.
(c) Either (a) or (b)
(d) None of the above.

2.100 COMMON PROFICIENCY TEST


(ii) If an inflow of economic benefits is probable then a contingent asset is disclosed
(a) in the financial statements.
(b) in the report of the approving authority (Board of Directors in the case of a
company, and the corresponding approving authority in the case of any other
enterprise).
(c) In the cash flow statement.
(d) None of the above.
(iii) In the case of ___________, either outflow of resources to settle the obligation is not
probable or the amount expected to be paid to settle the liability cannot be measured
with sufficient reliability.
(a) Liability.
(b) Provision.
(c) Contingent liabilities.
(d) Contingent assets.
(iv) Present liability of uncertain amount, which can be measured reliably by using a
substantial degree of estimation is termed as ________.
(a) Provision.
(b) Liability.
(c) Contingent liability.
(d) None of the above.
(v) In the financial statement, contingent liability is
(a) Recognised
(b) Not recognised.
(c) Adjusted.
(d) None of the above.

ANSWERS
(i) (a) (ii) (b) (iii) (c) (iv) (a) (v) (a)

FUNDAMENTALS OF ACCOUNTING 2.101


CHAPTER - 2

ACCOUNTING
PROCESS

Unit 8

Rectification of
Errors
Learning Objectives
After studying this unit, you will be able to :

 Understand different types of errors which may occur in course of recording transactions
and events.
 Be familiar with the steps involved in locating errors.
 Learn the nature of one-sided errors and two-sided errors.
 Understand why suspense account is opened for rectification of errors.
 Understand the technique of correcting errors of one period in the next accounting period.

1. INTRODUCTION
Unintentional omission or commission of amounts and accounts in the process of recording
the transactions are commonly known as errors. These various unintentional errors can be
committed at the stage of collecting financial information/data on the basis of which financial
statements are drawn or at the stage of recording this information. Also errors may occur as a
result of mathematical mistakes, mistakes in applying accounting policies, misinterpretation of
facts, or oversight. To check the arithmetic accuracy of the journal and ledger accounts, trial
balance is prepared. If the trial balance does not tally, then it can be said that there are errors
in the accounts which requires rectification thereof. Some of these errors may affect the Trial
Balance and some of these do not have any impact on the Trial Balance although such errors
may affect the determination of profit or loss, assets and liabilities of the business.
Illustrative Case of Errors and their Nature
We have seen that after preparing ledger accounts a trial balance is taken out where debit and
credit balances are separately listed and totalled. If the two totals do not agree, it is definite
that there have been some errors. We shall now study the types of errors which may be
committed and how they may be rectified. For this purpose, the working of the following
illustrative cases should be carefully seen.
Illustrative Cases of Errors
(a) Wrong Entry: Let us start from the first phase in the accounting process. Wrong entry of
the value of transactions and events in the subsidiary books, Journal Proper and Cash Book
may occur.
Example 1: Credit purchases Rs. 17,270 are entered in the Purchases Day Book as Rs. 17,720.
Credit sales of Rs. 15,000 gross less 1% trade discount are wrongly entered in Sales Day Book
at Rs. 15,000. Cheque issued Rs. 19,920 are wrongly entered in the credit of bank column in
the Cash Book as Rs. 19,290.
(b) Wrong positing from subsidiary books: Subsidiary books are totalled periodically and
posted to the appropriate ledger accounts. There may arise totalling errors. Totalling errors
may arise due to wrong entry or simply these may be independent errors.
Example 2: For the month of January, 2006 total of credit sales are Rs. 1,75,700, this is wrongly
totalled as Rs. 1,76,700 and posted to sales account as Rs. 1,76,700.

FUNDAMENTALS OF ACCOUNTING 2.103


RECTIFICATION OF ERRORS

(c) Wrong casting of subsidiary book: For example, wrong castings of the Cash Book result
in balancing error.
Example 3: The following cash transactions of M/s Tularam & Co. occurred:
2006
Jan. 1 Balance - cash Rs. 1,200 bank Rs. 16,000;

Jan. 2 Cheque issued to M/s Bholaram & Co., a supplier, for Rs. 22,500;

Jan. 6 Cheque collected from M/s Scindia & Bros. Rs. 42,240 and deposited for clearance;

Jan 7 Cash sales Rs. 27,200 paid wages Rs. 12,400;

Jan. 8 Cash sales Rs. 37,730 cash deposited to bank Rs. 35,000.

The following Cash Book entries are passed:


Cash Book
Dr. Cr.
Date Particulars Cash Bank Date Particulars Cash Bank
Rs. Rs. Rs. Rs.
2006 2006
Jan. 1 To Balance b/d 1,200 16,000 Jan. 2 By M/s Bholaram & Co. A/c 22,500
Jan. 6 To M/s Scindia & Bros A/c 42,420 By Wages A/c 12,200
Jan. 7 To Sales A/c 27,200 By Bank A/c 34,500
Jan. 8 To Sales A/c 37,370 By Balance c/d 19,070 71,420

Jan. 8 To Cash A/c 34,500


65,770 93,920 65,770 93,920

Wrong entries and casting are shown in bold prints. However, errors of cash entries generally
are not carried. Usually cash balances are tallied daily. So errors are identified at an early
stage. But bank balance cannot be checked daily and thus errors may be carried until bank
reconciliation is made. In the above example, there are four wrong entries and one wrong
casting Bank and cash balances are affected by these errors.
(d) Wrong casting of ledger balances: Likewise Cash Book, any ledger account balance may
be cast wrongly. Obviously wrong postings make the balance wrong; but that is not wrong
casting of balances. Whenever there arises independent casting error as in the case of bank
column in the Cash Book of example (4), that is called wrong casting of ledger balances.

2.104 COMMON PROFICIENCY TEST


Example 4: The following are the credit purchases of M/s Ballav Bros.:
2006
Jan. 1 Purchases from M/s Saurabh & Co.- gross Rs. 1,00,000 less 1% trade discount.
Jan. 3 Purchases from M/s Netai & Co.- gross Rs. 70,000 less 1% trade discount.
Jan. 6 Purchases from M/s Saurabh & Co.- gross Rs. 60,000 less 1% trade discount
Let us cast M/s Saurabh & Co.'s Account:
M/s Saurabh & Co. Account
Dr. Cr.
Date Particulars Amount Date Particulars Amount
Rs. Rs.
2006 2006
Jan. 1 To Balance c/d 1,55,000 Jan. 1 By Purchases A/c 99,000
Jan. 6 By Purchases A/c 59,000
1,55,000 1,55,000

While casting the credit side an error has been committed and so the account is wrongly
balanced.
Example 5: Goods are purchased on credit from M/s Saurabh & Co. for Rs. 27,030 and from
M/s Karnataka Suppliers for Rs. 28,050. The following Day Book is prepared:
Purchases Day Book
Date Particulars Amount
Rs.
M/s Saurabh & Co. 27,050
M/s Karnataka Suppliers 28,030
55,080

In the Day Book both the transactions are entered wrongly but the first error has been
compensated by the second. Even if these errors are not rectified Trial Balance would tally.
Trial Balance
Particulars Dr. Cr.
Rs.
M/s Saurabh & Co. 27,050
M/s Karnataka Suppliers 28,030
Purchases Account 55,080
55,080 55,080

FUNDAMENTALS OF ACCOUNTING 2.105


RECTIFICATION OF ERRORS

2. STAGES OF ERRORS
Errors may occur at any of the following stages of the accounting process:
2.1 AT THE STAGE OF RECORDING THE TRANSACTIONS IN JOURNAL
Following types of errors may happen at this stage:
(i) Errors of principle,
(ii) Errors of omission,
(iii) Errors of commission.
2.2 AT THE STAGE OF POSTING THE ENTRIES IN LEDGER
(i) Errors of omission:
(a) Partial omission,
(b) Complete omission.
(ii) Errors of commission:
(a) Posting to wrong account,
(b) Posting on the wrong side,
(c) Posting of wrong amount.
2.3 AT THE STAGE OF BALANCING THE LEDGER ACCOUNTS
(a) Wrong Totalling of accounts,
(b) Wrong Balancing of accounts.
2.4 AT THE STAGE OF PREPARING THE TRIAL BALANCE
(a) Errors of omission,
(b) Errors of commission:
1. Taking wrong account,
2. Taking wrong amount,
3. Taking to the wrong side.
On the above basis, we can classify the errors in four broad categories:
1. Errors of Principle,
2. Errors of Omission,
3. Errors of Commission,
4. Compensating Errors.

2.106 COMMON PROFICIENCY TEST


3. TYPES OF ERRORS
Basically errors are of two types:
(a) Errors of principle: When a transaction is recorded in contravention of accounting
principles, like treating the purchase of an asset as an expense, it is an error of principle. In
this case there is no effect on the trial balance since the amounts are placed on the correct
side, though in a wrong account.
(b) Clerical errors: These errors arise because of mistake committed in the ordinary course of
the accounting work. These are of three types:
(i) Errors of Omission: If a transaction is completely or partially omitted from the books of
account, it will be a case of omission. Examples would be: not recording a credit
purchase of furniture or not posting an entry into the ledger.
(ii) Errors of Commission: If an amount is posted in the wrong account or it is written on
the wrong side or the totals are wrong or a wrong balance is struck, it will be a case of
"errors of commission."
(iii) Compensating Errors: If the effect of errors committed cancel out, the errors will be
called compensating errors. The trial balance will agree.
From another point of view, error may be divided into two categories:
(a) Those that affect the trial balance - because of the errors that trial balance does
not agree; and
(i) Wrong casting of the subsidiary books [see (b) above.]
(ii) Wrong balancing of an account [see (a) above.]
(iii) Posting an amount on the wrong side [see (d) above.]
(iv) Wrong posting, ie., writing the wrong amount [see (d) above.]
(v) Omitting to post an amount from a subsidiary book.
(vi) Omitting to post the totals of subsidiary book.
(vii) Omitting to write the cash book balances in the trial balance.
(viii)Omitting to write the balance of an account in the trial balance.
(ix) Writing a balance in wrong column of the trial balance.
(x) Totalling the trial balance wrongly.
(b) The errors that do not affect the trial balance are the following:
(i) Omitting an entry altogether from the subsidiary book [see (i) above.]
(ii) Making an entry in the wrong subsidiary book [see (ii) above.]
(iii) Posting an amount in a wrong account but on the correct side, e.g., an
amount to be debited to A is debited to B, the trial balance will still agree.
(iv) Errors of principle: Suppose on the purchase of a typewriter, the office expenses account
is debited; the trial balance will still agree.
(v) Compensating errors: If the effect of an error is cancelled by the effect of some other
error, the trial balance will naturally agree. Suppose an amount of Rs. 10 received
from A is not credited to his account and the total of the sales book is Rs. 10 in excess.
The omission of credit to A's account will be made up by the increased credit to the
Sales Account; there will not be any effect on the trial balance.

FUNDAMENTALS OF ACCOUNTING 2.107


A chart of the types of errors is given below:

2.108
ERRORS

Errors of Principle (Treating a Clerical Errors


revenue expense as capital
expenditure or vice versa or
the sale of a fixed asset as
ordinary sale). Trial Balance
RECTIFICATION OF ERRORS

will agree. Errors of Omission Errors of Compensating


Commission Errors. Trial
Balance will
agree.

Omitting an entry Omitting to post the


completely from the ledger account from
subsidiary books. Trial the subsidiary books.
Balance will agree. Trial Balance will not agree.

Writing the wrong Wrong casting Posting the Posting an Wrong


amount in the of subsidiary wrong amount amount on balancing
subsidiary books. books. in the ledger. the wrong side. of an account
Trial Balance
will agree.

Trial Balance will not agree.

COMMON PROFICIENCY TEST


4. STEPS TO LOCATE ERRORS
Even if there is only a very small difference in the trial balance, the errors leading to it must be
located and rectified. A small difference may be the result of a number of errors. The following
steps will be useful in locating errors :
(i) The two columns of the trial balance should be totalled again. If in place of a number of
accounts, only one amount has been written in the trial balance the list of such accounts
should be checked and totalled again. List of debtors is the example from which Sundry
debtors balance is derived.
(ii) It should be seen that the cash and bank balances have been written in the trial balance.
(iii) The exact difference in the trial balance should be established. The ledger should be gone
through; it is possible that a balance equal to the difference has been omitted from the trial
balance. The difference should also be halved; it is possible that balance equal to half the
difference has been written in the wrong column.
(iv) The ledger accounts should be balanced again.
(v) The casting of subsidiary books should be checked again, especially if the difference is
Re. 1, Rs. 100 etc.
(vi) If the difference is very big, the balance in various accounts should be compared with the
corresponding accounts in the previous period. If the figures differ materially the cases
should be seen; it is possible that an error has been committed. Suppose the sales account
for the current year shows a balance of Rs. 32,53,000 whereas it was Rs. 36,45,000 last
year; it is possible that there is an error in the Sales Account.
(vii) Postings of the amounts equal to the difference or half the difference should be checked. It
is possible that an amount has been omitted to be posted or has been posted on the wrong
side.
(viii)If there is still a difference in the trial balance, a complete checking will be necessary. The
posting of all the entries including the opening entry should be checked. It may be better
to begin with the nominal accounts.

5. RECTIFICATION OF ERRORS
Errors should never be corrected by overwriting. If immediately after making an entry it is
clear that an error has been committed, it may be corrected by neatly crossing out the wrong
entry and making the correct entry. If however the errors are located after some time, the
correction should be made by making another suitable entry, called rectification entry. In fact
the rectification of an error depends on at which stage it is detected. An error can be detected
at any one of the following stages:
(a) Before preparation of Trial Balance.
(b) After Trial Balance but before the final accounts are drawn.
(c) After final accounts, i.e., in the next accounting period.

FUNDAMENTALS OF ACCOUNTING 2.109


RECTIFICATION OF ERRORS

5.1 BEFORE PREPARATION OF TRIAL BALANCE


There are some errors which affect one side of an account or which affect more than one
account in such a way that it is not possible to pass a complete rectification entry. In other
words, there are some errors which can be corrected, if detected at this stage, by making
rectification statement in the appropriate side(s) of concerned account(s). It is important to
note here that such errors may involve only one account or more than one account. Read the
following illustrations:
(i) The sales book for November is undercast by Rs. 200. The effect of this error is that the
Sales Account has been credited short by Rs. 200. Since the account is posted by the total
of the sales book, there is no error in the accounts of the customers since they are posted
with amounts of individual sales. Hence only the Sales Accounts is to be corrected. This
will be done by making an entry for Rs. 200 on the credit side: "By undercasting of Sales
Book for November Rs. 200".
(ii) While posting the discount column on the debit side of the cash book the discount of
Rs. 10 allowed to Ramesh has not been posted. There is no error in the cash book, the total
of discount column presumably has been posted to the discount account on the debit side.
The error is in not crediting Ramesh by Rs. 10. This should now be done by the entry "By
omission of posting of discount on ----- Rs. 10".
(iii) Rs. 200 received from Ram has been entered by mistake on the debit side of his account.
Since the cash book seems to have been correctly written, the error is only in th account of
Ram - he should have been credited and not debited by Rs. 200. Not only is the wrong
debit to be removed but also a credit of Rs. 200 is to be given.This can be done now by
entering Rs. 400 on the credit side of his account. The entry will be "By Posting on the
wrong side - Rs. 400".
(iv) Rs. 50 was received from Mahesh and entered on the debit side of the cash book but was
not posted to his account. By the error, which affects only the account of Mahesh, Rs. 50
has been omitted from the credit side of his account. The rectification will be by the entry.
"By Omission of posting on the Rs. 50"
(v) Rs. 51 paid to Mohan has been posted as Rs. 15 to the debit of his account. Mohan has
been debited short by Rs. 36. The rectifying entry is "To mistake in posting on Rs. 36".
(vi) Goods sold to Ram for Rs. 1,000 was wrongly posted from sales day book to the debit of
purchase account. Ram has however been correctly debited. Here the error affects two
accounts, viz., purchases account and sales account but we cannot pass a journal entry
for its rectification because both the accounts need to be credited . The rectification will be
by the entry "By wrong posting on Rs. 1,000" in the credit of purchases account and also
"By omission of posting on - Rs. 1000" in the credit sales account.
(vii) Bills receivable from Mr. A of Rs. 500 was posted to the credit of Bills payable Account
and also credited to A account. Here also although two accounts are involved we cannot
pass a complete journal entry for rectification. The rectification will be by the entry "To
wrong posting on Rs. 500" in debit of Bills payable Account and also "To omission of
posting on Rs. 500" in the debit of Bills Receivable Account.

2.110 COMMON PROFICIENCY TEST


(viii)Goods purchased from Vinod for Rs. 1,000 was wrongly credited to Vimal account by
Rs. 100. Again we cannot pass a complete journal entry for rectification even though two
accounts are involved. The rectification will be done by the entry "To wrong posting on
Rs. 100" in the debit of Vimal account and "By omission of posting on Rs 1,000" in the
credit of Vinod account.
Thus, from the above illustrations we are convinced that the general rule that errors affecting
two accounts can always be corrected by a journal entry is not always valid.
Such errors will be rectified as follows:
(a) To correct the wrong balancing of the bank column, an entry will be made on the debit
side on first November as follows. "To mistake in balancing Rs. 500".
(b) To correct the excess posting in purchases book the entry will be "By Mistake in totalling
the purchases book for October, 2005 Rs 100".
(c) The discount account will be opened and posted as already shown.
(d) In account of G. Norwood we shall first debit Rs. 640 so that the wrong credit of Rs. 320 is
converted into the debit of Rs. 320.
The entry will be "To Wrong posting on October 5, Rs. 640." Then to remove the wrong debit of
Rs. 312 and give the correct credit of Rs. 320 Rs. 632 will be entered on the credit side by the
entry. "By Wrong posting on October 16, Rs. 632. The account of G.Norwood will appear as
shown below:
G. Norwood
Dr. Cr.
2005 Rs. 2005 Rs.
Oct. 16 To Cash Book 312 Oct. 5 By Sales Book 320
" 11 To Wrong posting " 31 By Wrong posting
on Oct. 5 on Oct. 16
(wrong side) 640 (wrong side, wrong amount)
632
952 952

(e) Rs. 36 has to be debited to the Purchases Account since on the 26th October, Rs. 36 was
credited to this account in excess. The entry will be "To Wrong posting on Oct. 26 Rs. 36".
Illustration 2
How would you rectify the following errors in the book of Rama & Co.?
1. The total to the Purchases Book has been undercast by Rs. 100.
2. The Returns Inward Book has been undercast by Rs. 50.
3. A sum of Rs. 250 written off as depreciation on Machinery has not been debited to
Depreciation Account.

FUNDAMENTALS OF ACCOUNTING 2.111


RECTIFICATION OF ERRORS

4. A payment of Rs. 75 for salaries (to Mohan) has been posted twice to Salaries Account.
5. The total of Bills Receivable Book Rs. 1,500 has been posted to the credit of Bills Receivable
Account.
6. An amount of Rs. 151 for a credit sale to Hari, although correctly entered in the Sales
Book, has been posted as Rs. 115.
7. Discount allowed to Satish Rs. 25 has not been entered in the Discount Column of the
Cash Book. It has been posted to his personal account.
Solution
1. The Purchases Account should receive another debit of Rs. 100 since it was debited short
previously :
"To Undercasting of Purchases Book for the month of --- Rs. 100."
2. Due to this error the Returns Inward Account has been posted short by Rs. 50 : the correct
entry will be :
"To Undercasting of Returns Inward Book for the month of --- Rs. 50."
3. The omission of the debit to the Depreciation Account will be rectified by the entry :
"To Omission of posting on Rs. 250".
4. The excess debit will be removed by a credit in the Salaries Account by the entry :
"By double posting on Rs. 75".
5. Rs. 1,500 should have been debited to the Bills Receivable Account and not credited. To
correct the mistake, the Bills Receivable Account should be debited by Rs. 3,000 by the
entry:
"To Wrong posting of B/R received on Rs. 3,000"
6. Hari's personal A/c is debited Rs. 36 short the rectification entry will be :
"To Wrong posting Rs. 36".
7. Due to this error, the discount account has been debited short by Rs. 25. The required
entry is :
"To Omission of discount allowed to Satish on Rs. 25."
So far we have discussed the correction of errors which affected only one Account of more
than one account but for which rectifying entries were not complete journal entries in fact that
rectifying entry is made directly in the account(s) concerned. We shall now take up the correction
of errors which affect more than one account in such a way that complete journal entries are
possible for their rectification. Read the following illustrations :
(i) The purchase of machinery for Rs. 2,000 has been entered in the purchases book. The
effect of the entry is that the account of the supplier has been credited by Rs. 2,000 which
is quite correct. But the debit to the Purchases Account is wrong : the debit should be to
Machinery Account. To rectify the error, the debit in the purchases Account has to be
transferred to the Machinery Account. The correcting entry will be to Credit Purchases
Account and debit the Machinery Account. Please see the three entries made below: the
last entry rectifies the error:
Wrong Entry : Rs. Rs.
Purchases Account Dr. 2,000
To Creditor 2,000

2.112 COMMON PROFICIENCY TEST


Correct Entry :
Machinery Account Dr. 2,000
To Creditor 2,000
Rectifying Entry :
Machinery Account Dr. 2,000
To Purchases Account 2,000
(ii) Rs. 100 received from Kamal Kishore has been credited in the account of Krishan Kishore.
The error is that there is a wrong credit in the account of Krishan Kishore and omission of
credit in the account of Kamal Kishore; Krishan Kishore should be debited and Kamal
Kishore be credited. The following three entries make this clear :
Wrong Entry : Rs. Rs.
Cash Account Dr. 100
To Krishan Kishore 100
Correct Entry :
Cash Account Dr. 100
To Kamal Kishore 100
Rectifying Entry :
Krishan Kishore Dr. 100
To Kamal Kishore 100
(iii) The sale of old machinery, Rs. 1,000 has been entered in the sales book. By this entry the
account of the buyer has been correctly debited by Rs. 1,000. But instead of crediting the
Machinery Account. Sales Account has been credited. To rectify the error this account
should be debited and the Machinery Account credited. See the three entries given below:
Wrong Entry : Rs. Rs.
Buyer's Account Dr. 1,000
To Sales Account 1,000
Correct Entry :
Buyer's Account Dr. 1,00
To Machinery Account 1,000
Rectifying Entry :
Sales Account Dr. 1,000
To Machinery Account 1,000
Illustration 3
The following errors were found in the book of Ram Prasad & Sons. Give the necessary entries
to correct them.
(1) Rs. 500 paid for furniture purchased has been charged to ordinary Purchases Account.
(2) Repairs made were debited to Building Account for Rs. 50.

FUNDAMENTALS OF ACCOUNTING 2.113


RECTIFICATION OF ERRORS

(3) An amount of Rs. 100 withdrawn by the proprietor for his personal use has been debited
to Trade Expenses Account.
(4) Rs. 100 paid for rent debited to Landlord's Account.
(5) Salary Rs. 125 paid to a clerk due to him has been debited to his personal account.
(6) Rs. 100 received from Shah & Co. has been wrongly entered as from Shaw & Co.
(7) Rs. 700 paid in cash for a typewriter was charged to Office Expenses Account.

Solution
JOURNAL
Particulars L.F. Dr. Cr.
Rs. Rs.
(1) Furniture A/c Dr. 500
To Purchases A/c 500
(Correction of wrong debit to Purchases A/c
for furniture purchased)
(2) Repairs A/c Dr. 50
To Building A/c 50
(Correction of wrong debit to building A/c for
repairs made)
(3) Drawings A/c. Dr. 100
To Trade Expenses A/c 100
(Correction of wrong debit to Trade Expenses
A/c for cash withdrawn by the proprietor for
his personal use)
(4) Rent A/c Dr. 100
To Landlord's Personal A/c 100
(Correction of wrong debit to land-lord's A/c
for rent paid)
(5) Salaries A/c Dr. 125
To Clerk's (Personal) A/c 125
(Correction of wrong debit to Cleark's personal
A/c for salaries paid)
(6) Shaw & Co. Dr. 100
To Shah & Co. 100
(Correction of wrong credit to Shaw & Co.
Instead of Shah & Co.)
(7) Typewriter A/c Dr. 700
To Office Expenses A/c 700
(Correction of wrong debit to Office Expenses
A/c for purchase of typewriter)

2.114 COMMON PROFICIENCY TEST


Illustration 4
Give journal entries to rectify the following :
(1) A purchase of goods from Ram amounting to Rs. 150 has been wrongly entered through
the Sales Book.
(2) A Credit sale of goods amounting Rs. 120 to Ramesh has been wrongly passed through
the Purchase Book.
(3) On 31st Dec. 2003 goods of the value of Rs. 300 were returned by Hari Saran and were
taken into stock on the same date but no entry was passed in the books.
(4) An amount of Rs. 200 due from Mahesh Chand, which had been written off as a Bad
Debt in a previous year, was unexpectedly recovered, and had been posted to the personal
account of Mahesh Chand.
(5) A Cheque for Rs. 100 received from Man Mohan was dishonoured and had been posted
to the debit of Sales Returns Account.
Solution
JOURNAL
Particulars L.F. Dr. Cr.
Rs. Rs.

(1) Purchases A/c Dr. 150


Sales A/c Dr. Dr. 150
To Ram 300
(Correction of wrong entry in the sales Book
for a purchases of goods from Ram)
(2) Ramesh Dr. 240
To Purchases A/c 120
To Sales A/c 120
(Correction of wrong entry in the Purchases
Book of a credit sale of goods to Ram)
(3) Returns Inwards A/c Dr. 300
To Hari Saran 300
(Entry of goods returned by him and taken in
stock omitted from records)
(4) Mahesh Chand Dr. 200
To Bad Debts Recovered A/c 200
(Correction of wrong credit to Personal A/c in
respect of recovery of previously written off bad debts
(5) Man Mohan Dr. 100
To Sales Return A/c 100
(Correction of wrong debit to Sales Returns A/c
for dishonour of cheque received from Man Mohan)

FUNDAMENTALS OF ACCOUNTING 2.115


RECTIFICATION OF ERRORS

Thus it can be said that errors detected before the preparation of trial balance can be rectified
either through rectification statements (not entries) or through rectification entries.
5.2 AFTER TRIAL BALANCE BUT BEFORE FINAL ACCOUNTS
The method of correction of error indicated so far is appropriate when the errors have been
located before the end of the accounting period. After the corrections the trial balance will
agree. Sometimes the trial balance is artificially made to agree inspite of errors by opening a
suspense account and putting the difference in the trial balance to the account - the suspense
account will be debited if the total of the credit column in the trial balance exceeds the total of
the debit column; it will be credited in the other case.
One must note that such agreement of the trial balance will not be real. Effort must be made to
locate the errors.
The rule of rectifying errors detected at this stage is simple. Those errors for which complete
journal entries were not possible in the earlier stage of rectification (i.e., before trial balance)
can now be rectified by way of journal entry(s) with the help of suspense account, for it these
errors which gave rise to the suspense account in the trial balance. The rectification entry for
other type of error i.e. error affecting more than one account in such a way that a complete
journal entry is possible for its rectification, can be rectified in the same way as in the earlier
stage (i.e. before trial balance).
In a nutshell, it can be said that each and every error detected at this stage can only be corrected
by a complete journal entry. Those errors for which journal entries were not possible at the
earlier stage will now be rectified by a journal entry(s), the difference or the unknown side is
being taken care of by suspense account. Those errors for which entries were possible even at
the first stage will now be rectified in the same way.
Suppose, the sales book for November, 2005 is cast Rs. 100 short; as a consequence the trial
balance will not agree. The credit column of the trial balance will be Rs. 100 short and a
Suspense Account will be credited by Rs. 100. To rectify the error the Sales Account will be
credited (to increase the credit to the right figure. Since now one error remains, the Suspense
Account must be closed- it will be debiting the Suspense Account. The entry will be :
Suspense Account Dr. Rs. 100
To Sales Account Rs. 100
(Correction of error of undercasting the sales
Book for Nov. 2005)

Illustration 5
Correct the following errors (i) without opening a Suspense Account and (ii) opening a Suspense
Account :
(a) The Sales Book has been totalled Rs. 100 short.
(b) Goods worth Rs. 150 returned by Green & Co. have not been recorded anywhere.
(c) Goods purchased Rs. 250 have been posted to the debit of the supplier Gupta & Co.

2.116 COMMON PROFICIENCY TEST


(d) Furniture purchased from Gulab & Bros, Rs. 1,000 has been entered in Purchases Day
Book.
(e) Discount received from Red & Black Rs. 15 has not been entered in the Discount Column
of the Cash Book.
(f) Discount allowed to G. Mohan & Co. Rs. 18 has not been entered in the Discount Column
of the Cash Book. The account of G. Mohan & Co. has, however, been correctly posted.
Solution
If a Suspense Account is not opened.
(a) Since sales book has been cast Rs. 100 short, the Sales Account has been similarly credited
Rs. 100 short. The correcting entry is to credit the Sales Account by Rs. 100 as "By wrong
totalling of the Sales Book Rs. 100".
(b) To rectify the omission, the Returns Inwards Account has to be debited and the account of
Green & Co. credited. The entry :
Returns Inward Account Dr. Rs. 150
To Green & Co. Rs.150
(Goods returned by the firm, previously
omitted from the Returns Inward Book)
(c) Gupta & Co. have been debited Rs. 250 instead of being credited. This account should
now be credited by 500 to remove the wrong debit and to give the correct debit. The entry
will be on the credit side... "By errors in posting Rs. 500".
(d) By this error Purchases Account has to be debited by Rs. 1,000 whereas the debit should
have been to the Furniture Account. The correcting entry will be :
Furniture Account Dr. Rs. 1,000
To Purchases Account Rs. 1,000
(Correction of the mistake by which
purchases Account was debited instead
of the Furniture Account)
(e) The discount of Rs. 15 received from Red & Black should have been entered on the credit
side of the cash book. Had this been done, the Discount Account would have been credited
(through the total of the discount column) and Red & Black would have been debited.
This entry should not be made :
Red & Black Dr. Rs. 15
To Discount Account Rs. 15
(Rectification of the error by which the discount
allowed by the firm was not entered in Cash Book)

FUNDAMENTALS OF ACCOUNTING 2.117


RECTIFICATION OF ERRORS

(f) In this case the account of the customer has been correctly posted; the Discount Account
has been debited Rs. 18 short since it has been omitted from the discount column on the
debit side of the cash book. The discount account should now be debited by the entry; "To
Omission of entry in the Cash Book Rs. 18."
If a Suspense Account is opened :

Particulars L.F. Dr. Cr.


Rs. Rs.
(a) Suspense Account Dr. 100
To Sales Account 100
(Being the correction arising from under-
casting of Sales Day Book)
(b) Return Inward Account Dr. 150
To Green & Co. 150
(Being the recording of unrecorded returns)
(c) Suspense Account Dr. 500
To Gupta & Co. 500
(Being the correction of the error by
which Gupta & Co. was debited instead
of being credited by Rs. 250).
(d) Furniture Account Dr. 1,000
To Purchases Account 1,000
(Being the correction of recording purchase
of furniture as ordinary purchases)
(e) Red & black Dr. 15
To Discount Account 15
(Being the recording of discount omitted to be recorded)
(f) Discount Account Dr. 18
To Suspense Account 18
(Being the correction of omission of the
discount allowed from Cash Book
customer's account already posted correctly).

2.118 COMMON PROFICIENCY TEST


Suspense Account
Dr. Cr.
Date Particulars Amount Date Particulars Amount
Rs. Rs.
To Sales A/c 100 By Difference in
To Gupta & Co. 500 Trial Balance 582
By Discount A/c 18
600 600

Note :
(i) One should note that the opening balance in the Suspense Account will be equal to the
difference in the trial balance.
(ii) If the question is silent as to whether a Suspense Account has been opened, the student
should make his assumption, state it clearly and then proceed.
Illustration 6
Correct the following errors found in the books of Mr. Dutt. The Trial Balance was out by
Rs. 493 excess credit. The difference thus has been posted to a Suspense Account.
(a) An amount of Rs. 100 was received from D. Das on 31st December, 2005 but has been
entered in the Cash Book on 3rd January, 2006.
(b) The total of Returns Inward Book for December has been cast Rs. 100 short.
(c) The purchase of an office table costing Rs. 300 has been passed through the Purchases
Day Book.
(d) Rs. 375 paid for Wages to workmen for making show-cases had been charged to "Wages
Account".
(e) A purchase of Rs. 67 had been posted to the creditors' account as Rs. 60.
(f) A cheque for Rs. 200 received from P. C. Joshi had been dishonoured and was passed to
the debit of "Allowances Account".
(g) Rs. 1000 paid for the purchase of a motor cycle for Mr. Dutt had been charged to
"Miscellaneous Expenses Account".
(h) Goods amounting to Rs. 100 had been returned by customer and were taken in to stock,
but no entry in respect there of, was made into the books.
(i) A sale of Rs. 200 to Singh & Co. was wrongly credited to their account.
Solution
(a) The following entry should be passed on 31st December, 2005:
Particulars L.F. Rs. Rs.
Bank Account Dr. 100
To D. Das 100
(Being the amount received)

FUNDAMENTALS OF ACCOUNTING 2.119


RECTIFICATION OF ERRORS

The entry already passed in the Cash Book on 3rd January, 2006 will be reversed by entering
on the credit side of the Cash Book : "By D. Das Rs. 100" (to reverse entry wrongly passed
on January 3).
(b) Returns Inward Account Dr. 100
To Suspense Account 100
(Being the mistake in totalling the Returns
Inward Book corrected)
(c) Furniture Account Dr. 300
To Purchases Account 300
(Being the rectification of mistake by which
purchase of furniture was entered in Purchases
book and hence debited to Purchases Account)
(d) Furniture Account Dr. 375
To Wages Account 375
(Being the wages paid to workmen for
making show-cases which should be
capitalised and not to be charged to
Wages Account)
(e) Suspense Account Dr. 7
To Creditor's (personal) Account 7
(Being the mistake in crediting the
Creditors Account less by Rs. 7, now corrected)
(f) P.C. Joshi Dr. 200
To Allowances Account 200
(Being the cheque of P.C. Joshi
dishonoured, previously debited to Alloweances Account)
(g) Drawings Account Dr. 1,000
To Miscellaneous Expenses 1,000
(Being the motor cycle purchased for
Mr. Dutt debited to his Drawings Account
instead of Miscellaneous Expenses Account
as previously done by mistake)
(h) Returns Inward Account Dr. 100
To Customer's (Personal) Account 100
(Correction of the omission to record return
of goods by customers)
(i) Singh & Co. Dr. 400
To Suspense Account 400
(Being the correction of mistake by which
the account of Singh & Co. was credited by
Rs. 200 instead of being debited)

2.120 COMMON PROFICIENCY TEST


Suspense Account
Dr. Cr.
Date Particulars Amount Date Particulars Amount
2005 Rs. 2005
Dec.31 To Difference in Dec. 31 By Returns
Trial Balance 493 "" Inwards A/c 100
"" To Creditor's A/c 7 "" By Singh & Co. 400
500 500

Illustration 7
The following errors, affecting the account for the year 2005 were detected in the books of Jain
Brothers, Delhi:
(1) Sale of old Furniture Rs. 150 treated as sale of goods.
(2) Receipt of Rs. 500 from Ram Mohan credited to Shyam Sunder.
(3) Goods worth Rs. 100 brought from Mohan Narain have remained unrecorded so far.
(4) A return of Rs. 120 from Mukesh posted to his debit.
(5) A return of Rs. 90 to Shyam Sunder posted as Rs. 9 in his account.
(6) Rent of proprietor's residence, Rs. 600 debited to rent A/c.
(7) A payment of Rs. 215 to Mohammad Sadiq posted to his credit as Rs. 125.
(8) Sales Book added Rs. 900 short.
(9) The total of Bills Receivable Book Rs. 1,500 left unposted.
You are required to pass the necessary rectifying entries and show how the trial balance would
be affected by the errors.
Solution
JOURNAL
Particulars L.F. Dr. Cr.
Amount Amount
Rs. Rs.
(1) Sales Account Dr. 150
To Furniture Account 150
(Rectification of sales of furniture treated
as sales of goods)
(2) Shyam Sunder Dr. 500
To Rama Mohan 500
(Rectification of a receipt from Ram Mohan
credited to Shyam Sunder)

FUNDAMENTALS OF ACCOUNTING 2.121


RECTIFICATION OF ERRORS

(3) Purchases Account Dr. 100


To Mohan Narain 100
(Purchases of goods from Mohan
Narain unrecorded)
(6) Drawing Account Dr. 600
To Rent Account 600
(Rectification of Payment of rent of
proprietor's residence treated as payment
of office rent)

N.B. : For 4, 5, 7, 8, 9 no journal entry can be passed as they affect a single account. The
correction will be as under:
(4) Credit Mukesh's Account with Rs. 240.
(5) Debit the account of Shyam Sunder by Rs. 81.
(7) Debit the account of Mohammad Sadiq by Rs. 340.
(8) Credit Sales Account by Rs. 900.
(9) Debit Bills Receivable Account with Rs. 1,500.

Effect of the Errors on Trial Balance


1. No effect
2. No effect
3. No effect
4. Trial Balance credit total short by Rs. 240.
5. Trial Balance debit total short by Rs. 81.
6. No effect
7. Trial Balance debit total short by Rs. 340.
8. Trial Balance credit total short by Rs. 900.
9. Trial Balance debit total short by Rs. 1,500.
Illustration 8
The trial balance of Mr. W & H failed to agree and the difference Rs. 20,570 was put into
suspense pending investigation which disclosed that :
(i) Purchase returns day book had been correctly entered and totalled at Rs. 6,160, but had
been posted to the ledger.
(ii) Discounts received Rs. 1,320 had been debited to discounts allowed.
(iii) The Sales account had been under added by Rs. 10,000.
(iv) A credit sale of Rs. 1,470 had been debited to a cutomer account at Rs. 1,740.
(v) A vehicle bought originally for Rs. 7,000 four years ago and depreciated to Rs. 1,200 had
been sold for Rs. 1,500 in the beginning of the year but no entries, other than in the bank
account had been passed through the books.

2.122 COMMON PROFICIENCY TEST


(vi) An accrual of Rs. 560 for telephone charges had been completely omitted.
(vii) A bad debt of Rs. 1,560 had not been written off and provision for doubtful debts should
have been maintained at 10% of debtors which are shown in the trial balance at
Rs. 23,390 with a credit provision for bad debts at Rs. 2,320.
(viii) Tools bought for Rs. 1,200 had been inadvertently debited to purchases.
(ix) The proprietor had withdrawn, for personal use, goods worth Rs. 1,960. No entries had
been made in the books.
Required :
(i) Pass rectification entries without narration to correct the above errors before preparing
annual accounts.
(ii) Prepare a statement showing effect of rectification on the reported net profit before
correction of these errors.
Solution
Particulars Dr. Cr.
(i) Suspense Account Dr. 6,160
To Return Outward A/c 6,160
(ii) Suspense Account Dr. 2,640
To Discount Allowed Account 1,320
To Discount Received Account 1,320
(iii) Suspense Account Dr. 10,000
To Sale Account 10,000
(iv) Suspense Account Dr. 270
To Customer Account 270
(v) Suspense Account Dr. 1,500
To Vehicle Account 1,200
To Profit on Sale of Vehicle Account 300
(vi) Telephone Charges Account Dr. 560
To Outstanding Expenses Account 560
(vii) Bad Debts Account Dr. 1,560 1

To Sundry Debtors Account 1,560


Provision for Doubtful Debts Account Dr. 164 2

To Profit and Loss Account 164


(viii) Loose Tools Account Dr. 1,200
To Purchases Account 1,200
(ix) Drawing Account Dr. 1,960
To Purchases 1,960

FUNDAMENTALS OF ACCOUNTING 2.123


RECTIFICATION OF ERRORS

1
Bad debts will be debited in the profit and loss account.
2
Provision @ 10% of Rs. 2,156; Excess provision Rs. 164.

Working Notes :
(i) Sundry Debtors as per books 23,390
Deduction vide item (iv) 270
Bad Debts 1,560 1,830
21,560
(ii) Suspense Account
Rs. Rs.
To Return outward Account 6,160 By balance b/d 20,570
To Discount allowed Account 1,320
To Discount Received Account 1,320
To Sales 10,000
To Customers 270
To Vehicles 1,200
To Profit on Sale of Vehicle 300
20,570 20,570
Illustration 9
Show by means of Journal entries how the following matters should be adjusted when preparing
the Annual Accounts of a firm for the year ended 30th September, 2005.
(a) Goods sold and recorded as sales for Rs. 4,000 were packed and the invoice for them sent
to the customers. Stock taking intervened and the parcel of goods was not despatched but
was included in stock-in-hand.
(b) Several employees took their salary in advance in the month of September, 2005 which
was payable to them in October, 2003 amounting to Rs. 2,500.
(c) A cheque of Rs. 2,500 received for a loss of stock sustained by fire has been paid by the
proprietor into his private bank account and not recorded in the business books.
(d) A cheque for Rs. 1,250 received as Insurance claim for loss of goods in transit at the time of
import, was deposited by the proprietor into his private bank account. The full value of
the invoice was passed through the purchase book.
(e) A purchase was made for a staff member of Rs. 1,000 and the cost was included in
purchases. A deduction of similar amount was made from his salary and the net payment
to him posted to salaries account.
(f) Bill received from Mr. Anup for repairs to furniture Rs. 300/- and new furniture supplied
for Rs. 1,000 was entered in the invoice book as Rs. 1,100.

2.124 COMMON PROFICIENCY TEST


(g) Furniture which stood in the books at Rs. 500 was sold for Rs. 275 in part exchange of
new furniture costing Rs. 875 and the new invoice of Rs. 600 was passed through the
purchase book.
Solution
JOURNAL
Adjustment Entries
Date Particulars Dr. Cr.
2005 Rs. Rs.
Sep. 30
(a) Sales Account* Dr. 4,000
To Sundry Debtors Account 4,000
(Entry for credit sales reversed as goods have not been
despatched to the customer)
(b) Prepaid Salaries Account** Dr. 2,500
To Salaries Account 2,500
(Salaries paid in advance for Oct. and debited to Salaries
Account, now transferred to Prepaid Salaries Account)
(c) *** (i) Insurance Company Account Dr. 2,500
(or Loss by Fire Account) 2,500
To Trading Account
(Being the claim admitted by the Insurance
Company for loss of stock due to fire)
(ii) Drawings Account Dr. 2,500
To Insurance Company Account 2,500
(Being the rectification of cheque received for loss of stock
due to fire deposited in the private account of the proprietor)
(d) Drawings Account Dr. 1,250
To Purchases Account 1,250
(Being the rectification of cheque received as insurance claim
for loss of goods in transit deposited into private bank
Account of the proprietor)
(e) Salaries Account Dr. 1,000
To Purchases Account 1,000
(Goods purchased for staff-member recorded as trade
purchases, new charged to Salaries Account)
Note : * Alternatively in (a) goods recorded as sales may not be reversed, instead may be
excluded from closing stock, as the goods have been ascertained and appropriated
according to the contract. This treatment is recommended if the title in the goods
have already passed to customer.

FUNDAMENTALS OF ACCOUNTING 2.125


RECTIFICATION OF ERRORS

** In (b) it has been assumed that advance salary paid was for the month of Oct. 2005
and has been debited to Salaries Account.
*** In (c) it has been assumed that no entry has been passed in respect of the loss.
(f) Repairs Account Dr. 300
Furniture Account Dr. 1,000
To Purchases Account 1,100
To Mr. Anup 200
(Being the rectification of Bill received from Mr. Anup for repairs
to furniture Rs. 300 and new furniture supplied for Rs. 1,000
entered in the purchases book at Rs. 1,100)
(g) Furniture Account Dr. 375
Loss on sale of Furniture Account 225
To Purchases Account 600
(Being the rectification of net exchange of old and new
furniture passed through purchases day book)

Illustration 10
On going through the Trial balance of Ball Bearings Co. Ltd. you find that the debit is in excess
by Rs. 150. This was credited to "Suspense Account". On a close scrutiny of the books the
following mistakes were noticed:
(1) the totals of debit side of "Expenses Account" have beeen cast in excess by Rs. 50
(2) The "Sales Account" has been totalled in short by Rs. 100.
(3) One item of purchase of Rs. 25 has been posted from the day book to ledger as Rs. 250.
(4) The sale return of Rs. 100 from a party has not been posted to that account though the
Party's account has been credited.
(5) A cheque of Rs. 500 issued to the Suppliers' account (shown under Sundry Creditors)
towards his dues has been wrongly debited to the purchases.
(6) A credit sale of Rs. 50 has been credited to the Sales and also to the Sundry Debtors
Account.
(i) Pass necessary journal entries for correcting the above;
(ii) Show how they affect the Profits; and
(iii) Prepare the "Suspense Account" as it would appear in the ledger.

2.126 COMMON PROFICIENCY TEST


JOURNAL ENTRIES
Particulars L.F. Dr. Cr.
Rs. Rs.
Suspense Account Dr. 50
To Expenses Account 50
(Being the mistake in totalling of Expenses Account, rectified)
Suspense Account Dr. 100
To Sales Account 100
(Being the mistake in totalling of Sales Accounts rectified)
Supplier* Dr. 225
To Suspense Account 225
(Being the mistake in posting from Day Book to Ledger rectified)
Sales Returns Account Dr. 100
To Suspense Account 100
(Being the sales return from a party not posted to "Sales
Returns" now rectified)
Sundry Creditors Dr. 500
To Purchases Account 500
(Being the payments made to supplier wrongly posted to
purchases now rectified)
Sundry Debtors Dr. 100
To Suspense Account 100
(Being the sales wrongly credited to Customer's Account
now rectified)

*
It is assumed that the day-book is the Purchase Day Book in which case only the supplier’s account would be posted wrongly
(creditor of Rs. 250 instead of Rs. 25). If however, by day-book is meant a book in which all transactions are recorded and posted
at the ledger therefrom, it would mean that both the Supplier’s Account and Purchases Account are wrongly posted.

FUNDAMENTALS OF ACCOUNTING 2.127


RECTIFICATION OF ERRORS

Suspense Account
Dr. Cr.
Rs. Rs.
To Expenses Account 50 By Difference in Trial Balance 150
To Sales Account 100 By Sundry Creditors 225
To Balance c/d 425 By Sales Returns Account 100
By Sundry Debtors 100
575 575
By Balance b/d 425

Since the Suspense Account does not balance, it is clear that all the errors have not been traced.
As a result of the above corrections the Net Profit will be :
Increased by Decreased by
Rs. Rs.
Mistake in totalling in "Expenses" 50
Mistake in totalling in "Sales" 100
Mistake in posting from day book to Ledger under
"Purchases" 500
Omission in posting under "Sales Returns" 100
650 100
Net Increase 550

As a result of these adjustments, the Profits will be increased by Rs. 550.

Illustration 11
Write out the Journal Entries to rectify the following errors, using a Suspense Account.
(1) Goods of the value of Rs. 100 returned by Mr. Sharma were entered in the Sales Day Book
and posted there from to the credit of his account;
(2) An amount of Rs. 150 entered in the Sales Returns Book, has been posted to the debit of
Mr. Philip, who returned the goods;
(3) A sale of Rs. 200 made to Mr. Ghanshyam was correctly entered in the Sales Day Book but
wrongly posted to the debit of Mr. Radheshyam as Rs. 20;
(4) Bad Debts aggregating Rs. 450 were written off during the year in the Sales ledger but
were not adjusted in the General Ledger; and
(5) The total of "Discount Allowed" column in the Cash Book for the month of September,
2005 amounting to Rs. 250 was not posted.

2.128 COMMON PROFICIENCY TEST


Solution
JOURNAL
Particulars L.F. Dr. Cr.
Rs. Rs.
(1) Sales Account Dr. 100
Sales Returns Account Dr. 100
To Suspense Account 200
(The value of goods returned by Mr. Sharma
wrongly posted to Sales and omission of debt
to Sales Returns Account, now rectified).
(2) Suspense Account Dr. 300
To Mr. Philip 300
(Wrong debit to Mr. Philip for goods
returned by him, now rectified).
(3) Mr. Ghanshyam Dr. 200
To Mr. Radheshyam 20
To Suspense Account 180
(Omission of debit to Mr. Ghanshyam and wrong credit
to Mr. Radhesham for sale of Rs. 200, now rectited)
(4) Bad Debts Account Dr. 450
To Suspense Account 450
(The amount of Bad Debts written off not
adjusted in General Ledger, now rectified)
(5) Discount Account Dr. 250
To Suspense Account 250
(The total of Discount allowed during
September, 2003 not posted from the Cash
Book; error now rectified).

Illustration 12
The Trial balance of Messrs. A, B and C did not agree. A Suspense Account was opened with the
amount of the difference. The following errors were discovered on scrutiny:
(1) The addition of the Analysis Column of the Tabular Purchase Journal posted to Goods
Purchased for Resale Account was found to be short by Rs. 150 though the addition of the
total column was correct.
(2) A dishonoured B/R for Rs. 400 returned to the firm by bank had been credited to Bank
Account for collection of bills and debited to B/R Account. A cheque was later received
from the customer for Rs. 400 and was duly paid into the firm's bank account.

FUNDAMENTALS OF ACCOUNTING 2.129


RECTIFICATION OF ERRORS

(3) An amount of Rs. 450 treated as paid in advance on account of insurance in the previous
year was not brought forward.
(4) Sales on approval amounting to Rs. 2,000 were included in the Sales Account. Half of
these were returned but no entries were passed in respect of these goods. However, the
returned goods have been included in the closing stock at their cost price of Rs. 500.
(5) Of the total amount of Rs. 38,356 shown as Sundry Debtors, Rs. 1,260 represent credits
given to customers when the payments against sales invoices were received. However,
these invoices themselves were not entered in the books. A discount of 10% is allowed on
the selling price in all such invoices.
You are required to pass rectifying entries making use, of the Suspense Account, wherever
necessary.
Solution
Journal of M/s. A, B and C
Particulars L.F. Dr. Cr.
Rs. Rs.
1. Purchase for Resale A/c Dr. 150
To Suspense Account 150
(Short debit to 'purchases for Resale Account' on
account of undercasting on now corrected)
2. Customers A/c Dr. 400
To Bill Receivable A/c 400
(Amount of dishonoured bill receivable previously
debited to Bills Receivable Account, error now rectified)
3. Insurance Account Dr. 450
To Suspense Account 450
(Prepaid insurance in the previous year not brought
forward now debited to the Insurance Account)
4. Sales Accounts Dr. 1,000
To Customer's Account 1,000
(Goods worth Rs. 1,000 returned by a customer on
sale or return basis, previously omitted to be recorded;
error now rectified)
5. Discount Account Dr. 140
Customers Account Dr. 1,260
To sales Account 1,400
(Credit sales of Rs. 1,400 previously omitted from the
books, error now corrected)

2.130 COMMON PROFICIENCY TEST


Note : Payment being equal to 90% of the gross sale is Rs. 1,400, i.e., 1,260 × 100/90. 1/10 of
this amount is discount.
Since the discount of 10% is allowed in all cases, it would be better to treat the sale to be
Rs. 1,260 and not Rs. 1,400, the discount is trade discount for which no account is opened, the
sales being recorded, at the net amount.
Illustration 13
The trial balance of Anil Traders did not agree. The difference was put in the Suspense Account
and the following trial balance was drafted :
Trial Balance as on 31st March, 2006
Dr. Cr.
Capital Account 45,000
Drawing Account 6,500
Purchases Account 92,750
Sales Account 1,07,200
Salaries and Wages Account 12,250
Furniture and Fittings Account 17,500
Sundry Debtors Account 30,250
Sundry Creditors Account 21,250
Stationery Account 1,250
Cash at Bank 5,700
Cash in Hand 2,300
Bills Receivable Account 15,750
Bills Payable Account 9,000
Rent and Rates Account 3,200
Suspense Account 5,000
1,87,450 1,87,450
On scrutiny the following errors were subsequently detected :
(a) Goods drawn by Mr. Anil, the proprietor, for personal consumption of Rs. 1,500 have not
at all been recorded.
(b) Goods sold to Ram for Rs, 1,250 on credit was debited to Rahim account for Rs. 250 only.
(c) Wages paid for fittings Rs. 500 was debited to salaries and wages account.
(d) Goods Purchased from Atul for Rs. 2,500 on credit was wrongly debited to his account.
(e) Bill received from Arun, a debtor, for Rs. 500 was debited to Ajay's account.
(f) A credit sale of Rs. 1,500 was recorded in Purchased Day Book and a credit purchase of
Rs. 2,000 was entered in Sales Day Book.
You are required to pass the rectification entries and redraft the trial balance.

FUNDAMENTALS OF ACCOUNTING 2.131


RECTIFICATION OF ERRORS

Solution
M/s Anil Traders
Journal
Particulars L.F. Dr. Cr.
Rs. Rs.
(a) Drawings Account Dr. 1,500
To Purchases Account 1,500
(Goods withdrawn for personal consumption
by the proprietor, now recorded)
(b) Ram (Debtor) Account Dr. 1,250
To Rahim (Debtor) Account 250
To Suspense Account 1,000
(Goods sold to Ram for Rs. 1,250 wrongly
debited to Rahim account for Rs. 250, now rectified)
(c) Furniture and Fittings Account Dr. 500
To Salaries and Wages Account 500
(Wages paid for fittings wrongly debited to
salaries and wages account, now rectified)
(d) Suspense Account Dr. 5,000
To Atul (Creditor) Account 5,000
(Goods brought on credit from Atul wrongly
debited to his account, now rectified)
(e) Suspense Account Dr. 1,000
To Arun (Debtor) Account 500
To Ajay (Debtor) Account 500
(Bill received from Arun wrongly debited to
Ajay Account, now rectified)
(f) Purchases Account Dr. 500
Sales Account Dr. 500
To Debtors Account* 500
To Creditors Accont* 500
(A credit sale and a credit purchase wrongly
entered in purchases day book and sales day
book respectively, now rectified)
* In the debtors' ledger and creditors' ledger, the affected individual accounts should be rectified
with the full amount. In other words, in the debtors' ledger the concerned debtors account
should be debited by Rs. 1,500 for credit sales and the debtor account wrongly debited for
credit purchase should be credited by Rs. 2,000.

2.132 COMMON PROFICIENCY TEST


Trial Balance of M/s. Anil Traders as on 31.3.2006

Particulars Dr. Cr.


Capital Account 45,000
Drawings Account 8,000
Purchases Account 91,750
Sales Account 1,06,700
Salaries and Wages Account 11,750
Furniture and Fittings Account 18,000
Sundry Debtors Account 29,750
Sundry Creditors Account 26,750
Stationery Account 1,250
Cash at Bank 5,700
Cash in Hand 2,300
Bills Receivable Account 15,750
Bills Payable Account 9,000
Rent and Rates Account 3,200
1,87,450 1,87,450

Working Notes :
1. Suspense Account
Dr. Cr.
Rs. Rs.
To Atul Account (entry 'd') 5,000 By Balance b/d 5,000
To Arun Account [entry 'e'] 500 By Ram Account (entry 'b') 1,000
To Ajay Account [entry 'e'] 500
6,000 6,000

FUNDAMENTALS OF ACCOUNTING 2.133


RECTIFICATION OF ERRORS

2. Corrected Ledger Balances


Balance as per Rectification Reference Rectified
given trial effect (entry no.) balance
balance
Rs. Rs. Rs.
Drawings 6,500 (+) 1,500 (a) 8,000
Purchases 92,750 (-) 1,000 (a) & (f) 91,750
Sundry Debtors 30,250 (-) 500 (b), (e) & (f) 29,750
Furniture & Fittings 17,500 (+) 500 (c) 18,000
Salaries & Wages 12,250 (-) 500 (c) 11,750
Sundry Creditors 21,250 (+) 5,500 (d) & (f) 26,750
Sales 1,07,200 (-) 500 (f) 1,06,700

5.3 CORRECTION IN THE NEXT ACCOUNTING PERIOD


Rectification of errors discussed so far assumes that it was carried out before the books were
closed for the concerned year. However, sometimes, the rectification is carried out in the next
year, carrying forward the balance in the Suspense Account or even transferring it to the
Capital Account. Suppose, the Purchase Book was cast short by Rs. 1,000 in December, 2005
and a Suspense Account was opened with the difference in the trial balance. If the error is
rectified next year and the entry passed is to debit Purchase Account (and credit Suspense
Account), it will mean that the Purchases Account for year 2006 will be Rs. 1,000 more than
the amount relating to year 2006 and thus the profit that year 2006 will be less than the actual
for that year. Thus, correction of errors in this manner will 'falsify' the Profit and Loss Account.
To avoid this, correction of all amounts concerning nominal accounts, i.e., expenses and incomes
should be through a special account styled as "Prior Period Items" or "Profits and Loss
Adjustment Account". The balance in the account should be transferred to the Profits and Loss
Account. However, these Prior Period Items should be charged after deriving net profit of the
current year. 'Prior Period items' are material income or expenses which arise in the current
period as a result of errors or omissions in the preparation of the financial statements of one or
more periods. Prior Period Items should be separately disclosed in the current statement of
profit and loss together with their nature and amount in a manner that their impact on current
profit or loss can be perceived.
Illustration 14
Mr. A closed his books of account on September 30, 2005 inspite of a difference in the trial
balance. The difference was Rs. 830 the credits being short; it was carried forward in a Suspense
Account. In 2006 following errors were located :
(i) A sale of Rs. 2,300 to Mr. Lala was posted to the credit of Mrs. Mala.
(ii) The total of the Returns Inward Book for July, 2003 Rs. 1,240 was not posted in the ledger.
(iii) Freight paid on a machine Rs. 5,600 was posted to the Freight Account as Rs. 6,500.
(iv) White carrying forward the total in the Purchases Account to the next page, Rs. 65,590
was written instead of Rs. 56,950.

2.134 COMMON PROFICIENCY TEST


(v) A sale of machine on credit to Mr. Mehta for Rs. 9.000 was not entered in the books at all.
The book value of the machine was Rs. 7,500. The firm has the practice of writing off
depreciation @10% on the balance at the end of the year.
Pass journal entries to rectify the errors. Have you any comments to make?
Solution
Journal of Mr. A
Date Particulars L.F. Dr. Cr.
Rs. Rs.
2006 (i) Mrs. Mala Dr. 2,300
Mr. Lala Dr. 2,300
To Suspense A/c 4,600
(Correction of error by which a sale of Rs. 2,300
to Mr. Lala was posted to the Credit of Mrs. Mala)
(ii) Profit and Loss Adjustment A/c Dr. 1,240
To Suspense A/c 1,240
(Rectification of omission to post the total of
Returns Inward Book for July, 2005)
(iii) (a) Machinery A/c Dr. 5,600
Suspense A/c Dr. 900
To Profit & Loss Adjustment A/c 6,500
(Correction of error by which freight paid for
a machine Rs. 5,600 was posted to Freight
Account at Rs. 6,500 instead of capitalising it)
(b) Profit & Loss Adjustment A/c Dr. 560
To Plant and Machinery A/c 560
(Depreciation @ 10% charged on freight paid
on a machine capitalised)
(iv) Suspense A/c Dr. 8,640
To Profit & Loss Adjustment A/c 8,640
(Correction of wrong carry forward
of total in the purchase Account to
the next page Rs. 65,590 instead of Rs. 56,950
(v) Mr. Mehta Dr. 9,000
To Plant & Machinery A/c 6,750
To Profit & Loss Adjustment A/c 2,250
(Correction of omission of a sale of machine
on credit to Mr. Mehta for Rs. 9,000 with a
book value of Rs. 7,500 on which depreciation
@ 10% has been charged in 2005)

FUNDAMENTALS OF ACCOUNTING 2.135


RECTIFICATION OF ERRORS

Comments
The Suspense Account will now appear as shown below :
Suspense Account
Dr. Cr.
Date Particulars Amount Date Particulars Amount
Rs. Rs.
2006 To Profit and Loss 2005 By Balance b/d 830
Adjustment A/c 900 Oct. 1 By Sundries
To Profit and Loss Mrs. Mala 2,300
Adjustment A/c 8,640 Mr. Lala 2,300
By Profit and Loss
Adjustment A/c 1,240
By balance c/d 2,870
9,540 9,540

Since the Suspense Account still shows a balance, it is obvious that there are still some errors
left in the books.
Profit & Loss Adjustment A/c
(For Prior Period Items)
Dr. Cr.
Date Particulars Amount Date Particulars Amount
2006 Rs. 2006 Rs.
To Suspense A/c 1,240 By Machinery A/c 5,600
To Plant and By Suspense A/c 900
Machinery A/c 560 By Suspense A/c 8,640
To Balance c/d 15,590 By Mr. Mehta 2,250
17,390 17,390

Illustration 15
A merchant's trial balance as on June 30, 2005 did not agree. The difference was put to a
Suspense Account. During the next trading period, the following errors were discovered :
(i) The total of the Purchases Book of one page, Rs. 4,539 was carried forward to the next
page as Rs. 4,593.
(ii) A sale of Rs. 573 was entered in the Sales Book as Rs. 753 and posted to the credit of the
customer.

2.136 COMMON PROFICIENCY TEST


(iii) A return to a creditor, Rs. 510 was entered in the Returns Inward Book; however, the
creditor's account was correctly posted.
(iv) Cash received from C. Dass, Rs. 620 was posted to the debit of G. Dass.
(v) Goods worth Rs. 840 were despatched to a customer before the close of the year but no
invoice was made out.
(vi) Goods worth Rs. 1,000 were sent on sale or return basis to a customer and entered in the
Sales Book. At the close of the year, the customer still had the option to return the goods.
The sale price was 25% above cost.
You are required to give journal entries to rectify the errors in a way so as to show the current
year's profit or loss correctly.
Solution
JOURNAL
Particulars L.F. Dr. Cr.
(i) Suspense Account Dr. 54
To Profit and Loss Adjustment A/c 54
(Correction of error by which Purchase
Account was over debited last year- Rs. 4,593
carried forward instead of Rs. 4,539.)
(ii) Profit & Loss Adjustment A/c Dr. 180
Customer's Account Dr. 1,326
To Suspense Account 1,506
(Correction of the entry by which (a) Sales
A/c was over credited by Rs. 180 (b)
customer was credited by Rs. 753 instead of
being debited by Rs. 573.)
(iii) Suspense Account Dr. 1,020
To Profit & Loss Adjustment A/c 1,020
(Correction of error by which Returns
Inward Account was debited by Rs. 510
instead of Returns Outwards Account being
credited by Rs. 510)
(iv) Suspense Account Dr. 1,240
To C. Dass 620
To G. Dass 620
(Removal or wrong debit to G. Dass and
giving credit to C. Dass from whom cash
was received).

FUNDAMENTALS OF ACCOUNTING 2.137


RECTIFICATION OF ERRORS

(v) Customer's Account Dr. 840


To Profit & Loss Adjustment A/c 840
(Rectification of the error arising from non-
preparation of invoice for goods delivered)
(vi) Profit & Loss Adjustment A/c Dr. 200
Stock Account Dr. 800
To Customer's Account 1,000
(The Customer's A/c credited with Rs. 1,000
for goods not yet purchased by him; cost of
the goods debited to Stock and "Profit"
debited to Profit & Loss Adjustment Account)
(vii) Profit & Loss Adjustment A/c Dr. 1,534
To Capital Account 1,534
(Transfer of the Profit & Loss Adjustment A/c
balance to the Capital Account)
Will the students find out the difference in the Trial Balance?1
Illustration 16
Mr. Roy was unable to agree the Trial Balance last year and wrote off the difference to the
Profit and Loss Account of that year. Next Year, he appointed a Chartered Accountant who
examined the old books and found the following mistakes :
(1) Purchase of a scooter was debited to conveyance account Rs. 3,000.
(2) Purchase account was over-cast by Rs. 10,000.
(3) A credit purchase of goods from Mr. X for Rs. 2,000 entered as a sale.
(4) Receipt of cash from Mr. A was posted to the account of Mr. B Rs. 1,000.
(5) Receipt of cash from Mr. C was posted to the debit of his account, Rs. 500.
(6) Rs. 500 due by Mr. Q was omitted to be taken to the trial balance.
(7) Sale of goods to Mr. R for Rs. 2,000 was omitted to be recorded.
(8) Payment of Rs. 2,395 for purchase was wrongly posted as Rs. 2,593.
Mr. Roy used 10% depreciation on vehicles. Suggest the necessary rectification entries.

1
Credit side is short by Rs. 808

2.138 COMMON PROFICIENCY TEST


Solution
JOURNAL OF MR. ROY
Date Particulars Dr. Cr.
Rs. Rs.
(1) Motor Vehicles Account Dr. 2,700
To Profit and Loss Adjustment A/c 2,700
(Purchase of scooter wrongly debited to
conveyance account now rectified-capitalisation
of Rs. 2,700, i.e., Rs. 3,000 less 10% depreciation)
(2) Suspense Account Dr. 10,000
To Profit & Loss Adjustment A/c 10,000
(Purchase Account overcast in the previous
year; error now rectified).
(3) Profit & Loss Adjustment A/c Dr. 4,000
To P's Account 4,000
(Credit purchase from P Rs. 2,000, entered
as sales last year; now rectified)
(4) B's Account Dr. 1,000
To A's Account 1,000
(Amount received from A wrongly posted to
the account of B; now rectified)
(5) Suspense Account Dr. 1,000
To C's Account 1,000
(Rs. 500 received from C wrongly debited to
his account; now rectified)
(6) Sundry Debtors (Q) Dr. 500
To Suspense Account 500
(Rs. 500 due by Q not taken into trial
balance; now rectified)
(7) R's Account Dr. 2,000
To Profit & Loss Adjustment A/c 2,000
(Sales to R omitted last year; now adjusted)
(8) Suspense Account Dr. 198
To Profit & Loss Adjustment A/c 198
(Excess posting to purchase account last
year, Rs. 2,593, instead of Rs. 2,395, now adjusted)
(9) Profit & Loss Adjustment A/c Dr. 10,898
To Roy's Capital Account 10,898
(Balance of Profit & Loss Adjustment A/c
transferred to Capital Account)
(10) Roy's Capital Account Dr. 10,698
To Suspense Account 10,698
(Balance of Suspense Account transferred
to the Capital Account)
Note : Entries No. (2) and (8) may even be omitted; but this is not advocated, Entry (6) will not
be posted in Q's Account.

FUNDAMENTALS OF ACCOUNTING 2.139


RECTIFICATION OF ERRORS

Profit and Loss Adjustment Account


(Prior Period Items)
Rs. Rs.
To P 4,000 By Motor Vehicles A/c 2,700
To Roy's Capital (transfer) 10,898 By Suspense A/c 10,000
By R 2,000
By Suspense Account 198
14,898 14,898

Suspense Account
Rs. Rs.
To Profit & Loss Adjustment By Sundry Debtors (Q) 500
Account 10,000 By Roy's Capital Account 10,698
To C 1,000 (Transfer)
To Profit & Loss Adjustment
Account 198
11,198 11,198

SELF EXAMINATION QUESTIONS


I. Pick up the correct answer from the given choices:
1. (i) Goods purchased from A for Rs. 10,000 passed through the sales book. The error will
result in
(a) Increase in gross profit. (b) Decrease in gross profit.
(c) No effect on gross profit. (d) Either (a) or (b).
(ii) If a purchase return of Rs.1,000 has been wrongly posted to the debit of the sales
returns account, but has been correctly entered in the suppliers’ account, the total of
the
(a) trial balance would show the debit side to be Rs.1,000 more than the credit
(b) trial balance would show the credit side to be Rs.1,000 more than the debit.
(c) the debit side of the trial balance will be Rs.2,000 more than the credit side.
(d) the credit side of the trial balance will be Rs.2,000 more than the debit side.
(iii) If the amount is posted in the wrong account or it is written on the wrong side of the
account, it is called
(a) error of omission. (b) error of commission.
(c) error of principle. (d) compensating error.

2.140 COMMON PROFICIENCY TEST


(iv) If a purchase return of Rs.84 has been wrongly posted to the debit of the sales return
account, but had been correctly entered in the suppliers account, the total of the trial
balance would show:
(a) the credit side to be Rs.84 more than debit side.
(b) the debit side to be Rs.84 more than credit side.
(c) the credit side to be Rs.168 more than debit side.
(d) the debit side to be Rs.168 more than credit side.
[Ans 1 : (i)-(a), (ii)-(c), (iii)-(b), (iv)-(d)]

2. State which statements complete correctly the sentences given below :


(i) Rs. 200 paid as wages for erecting a machine should be debited to
(a) Repair account. (b) Machine account.
(c) Capital account. (d) Furniture account
(ii) On purchase of old furniture, the amount of Rs. 1,000 spent on its repair should be
debited to
(a) Repair account; (b) Furniture account;
(c) Cash account; (d) Bank account
(iii) Goods worth Rs. 50 given as charity should be credited to
(a) Charity account; (b) Sales account;
(c) Purchase account. (d) Cash account
(iv) Goods worth Rs. 100 taken by proprietor for domestic use should be credited to
(a) Sales account; (b) Proprietor’s personal expenses;
(c) Purchases account (d) Expenses account.
(v) Errors of commission do not permit;
(a) Correct totalling of the balance sheet;(b) Correct totalling of the trial balance;
(c) The trial balance to agree. (d) None of the above
(vi) The preparation of a trial balance is for:
(a) Locating errors of commission; (b) Locating errors of principle;
(c) Locating clerical errors. (d) All of the above
(vii) Rs. 200 received from Smith whose account, was written off as a bad debt should be
credited to :
(a) Bad Debts Recovered account; (b) Smith’s account;
(c) Cash account. (d) Bad debts account

FUNDAMENTALS OF ACCOUNTING 2.141


RECTIFICATION OF ERRORS

(viii) Purchase of office furniture Rs. 1,200 has been debited to General Expense Account.
It is :
(a) A Clerical error; (b) An error of principle;
(c) An error of omission. (d) Compensating error.
(ix) Goods destroyed by fire should be credited to
(a) Goods lost by fire account; (b) Sales account.
(c) Purchase account (d) Cash account
(x) Sales of office furniture should be credited to
(a) Sales Account; (b) Furniture Account.
(c) Purchase Account. (d) Cash Account
[Ans: 2 : (i) (b) (ii) (b); (iii) (c); (iv) (c); (v) (c) ; (vi) (c) ; (vii) (a) ; (viii) (b) ; (ix) (a) ;(x) (b);]

II From the given information, choose the most appropriate answer.


1. Classify the following errors under (a) Errors of omission, (b) Errors of commission and
(c) Errors of principle, (d) Compensating errors
(i) The total of sales book was not posted to the ledger.
(ii) Sales to Heena Rs. 143 was posted to Meena as Rs. 143.
(iii) Goods taken away by the proprietor for personal use not recorded anywhere.
(iv) The total of a folio in the sales book Rs. 1,000 was carried forward as Rs. 100.
(v) Repairs of newly purchased second-hand machinery debited to repairs accounts.
[Ans: 1: (i)-(b), (ii)-(b), (iii)-(a), (iv)-(b), (v)-(c)]
2. Point out the type of the errors given below: (put 1 against errors of omission, 2 against
errors of commission, 3 against errors principle, 4 if it is not an error).
(a) Sale of Rs. 120 was written in the purchases book.
(b) Salary paid to Ram, has been debited to his account.
(c) Purchase of furniture has been entered in the purchases book.
(d) Rs. 120 received from Ganesh has been debited to his account.
(e) Freight paid on machinery has been debited to the freight account.
(f) The discount columns of the cash book have not been posted.
(g) Repairs to buildings have been debited to the buildings account.
(h) The total of the Sales Book is Rs. 100 short.
(i) The sale of worth Rs. 337 has been posted as Rs. 373.
(j) The amount of a dishonoured bill has been debited to general expenses account.
[ Ans : 2 : - 1 : (f); 2 : (a) (d) (h) (i); 3 : (b) (c) (e) (g) (j)]

2.142 COMMON PROFICIENCY TEST


III. Given below are the questions containing multiple answers. Choose the correct
answer(s).
1 Below some errors are mentioned. State which of these will not be revealed by the Trial
Balance:
(a) compensating errors; (b) errors of principle;
(c) wrong balancing of an account; (d) wrong totalling of an account;
[Ans : 1 : (a) and (b) will not be revealed]
2. Below some errors are mentioned. State which of these will be revealed by the Trial Balance:
(a) compensating errors; (b) errors of principle;
(c) wrong balancing of an account; (d) wrong totalling of an account;
[Ans : (c) and (d) will be revealed]

FUNDAMENTALS OF ACCOUNTING 2.143


NOTES
CHAPTER - 3

BANK
RECONCILIATION
STATEMENT
BANK RECONCILIATION STATEMENT

Learning Objectives
After studying this chapter, you will be able to :

 Learn the design of a Bank Pass Book.


 Understand the reasons for difference between Cash Book balance and Pass Book balance
and try to ascertain the amount of such differences.
 Learn, how to resolve such difference in a systematic manner.
 Try to understand the purpose for preparing the bank reconciliation statement and its
utility.

1. INTRODUCTION
Banks are essential institutions in a modern society. With the increase in volume of trade,
commerce and business, business entities faced difficulty in transacting in cash for each business
activity. They discovered that dealing through bank, on regular basis, would be the better and
safer option and finally large business entities switched over to banking transaction instead of
dealing in cash. Now-a-days, most of the transactions of the business are done through bank
whether it is a receipt or a payment. Rather, it is legally necessary to operate the transactions
through bank after a certain limit.
A Bank accepts from people, in general, deposits in various forms, and lends funds to those
who need; it also invests some funds in profitable investments. Thus money which would have
been otherwise idle is put to use and is made available to those who need it. Those who deposit
the money are able to withdraw it according to the settled terms and conditions. Apart from
receiving deposits from and handling cash transactions on behalf of its customers, the bank
also renders some other useful services as indicated below :
(i) The bank discounts promissory notes or hundies, i.e., it enables a customer to receive the
cash before the due date in consideration of a small charge called discount.
(ii) The bank allows overdraft to its good customers so that they can make payments even
when they do not have sufficient balance at the bank. Of course the overdraft must be
cleared later.
(iii) The bank gives loans for a year or so, to its customers so that they can continue their
operations. Such financial assistance is of great help for business.
(iv) The bank on behalf of the customer collects the amount of dividend warrants or interest
on securities etc.
(v) On instruction of the customer, the bank makes payments of insurance premium, rent etc.
on the due dates.
(vi) The bank sells and purchases shares, debentures or government securities on behalf of its
customers.
(vii) Money can be remitted to another place or persons through the bank at a low cost.

3.2 COMMON PROFICIENCY TEST


(viii)The bank in return, for a consideration, furnishes security or guarantee for its customers
whose credit is good.
(ix) The bank also issues letter of credit or travellers cheque to facilitate commerce or travel.

2. BANK PASS-BOOK
The bank either sends periodical statements of account or gives a pass-book to its customer in
which all deposits and withdrawals made by the customer during the particular period is
recorded. Both represent almost a copy of the ledger account of the customer in the books of
the bank. Thus, it is the bank's way of keeping the customers informed of the entries made in
his account. It is the customer's duty to check the entries and immediately inform the bank of
any error that he may notice. The form of the pass book is given below :
PASS BOOK
Messers .........................................
in account with
Punjab National Bank
Daryaganj, New Delhi-110002

Date Particulars Withdrawals Deposits Dr. or Balance


Dr. Cr. Cr.
Rs. Rs. Rs. Rs.

The bank statement of account also has a similar form except that it is on loose sheets. The
bank itself sends the statements but it is the customer's duty to send the pass-book to the bank
periodically so that it is written upto date. Business houses should also obtain at the end of the
year a certificate from the bank duly stamped with revenue stamps, showing the balance
which the bank has in the account of firm. The bank balance shown in the pass-book is known
as pass-book balance for reconciliation purpose. The credit balance as per pass-book at a
particular point of time is the deposit made by the customer while debit balance as per pass-
book is the overdraft balance for the customer.
Students may note here that the nature of balance shown by pass-book and cash-book is quite
different. The debit balance in the pass-book represents the credit balance as per the cash-book
and vice-versa because the business enterprise treats the bank as a debtor and bank treats the
business enterprise as a creditor.

3. BANK RECONCILIATION STATEMENT


Strictly speaking, there should be no difference between the balance shown by the pass-book
and the cash-book. This is so, if all the entries are recorded in both. However, on a particular
FUNDAMENTALS OF ACCOUNTING 3.3
BANK RECONCILIATION STATEMENT

date it is possible that balances on both the books do not tally i.e., some entries may have been
recorded in the cash-book but not in the pass-book and vice versa. After finding the reasons for
non-agreement of the bank balances of pass-book and cash-book, efforts are made for their
reconciliation. This reconciliation is prepared and presented in the form of a statement commonly
known as Bank Reconciliation Statement.

4. IMPORTANCE OF BANK RECONCILIATION STATEMENT


Bank reconciliation statement is a very important tool for internal control of cash flows. It
helps in detecting errors, frauds and irregularities occurred, if any, at the time of passing entries
in the cash-book or in the pass-book, whether intentionally or unintentionally. Since frauds
can be detected on the preparation of bank reconciliation statement therefore accountants are
careful while preparing and maintaining the records of the business enterprise. Hence it works
as an important mechanism of internal control. Following are the salient features of bank
reconciliation statement :
(i) The reconciliation will bring out any errors that may have been committed either in the
cash-book or in the pass-book;
(ii) Any undue delay in the clearance of cheques will be shown up by the reconciliation;
(iii) A regular reconciliation discourages the staff of the customer or even that of the bank
from embezzlement. There have been many cases when the cashiers merely made entries
in the cash-book but never deposited the cash in the bank; they were able to get away
with it only because of lack of reconciliation.
(iv) It helps in finding out the actual position of the bank balance.

5. ASCERTAINING THE CAUSES OF DIFFERENCE OF BANK


BALANCE IN BANK COLUMN OF THE CASH-BOOK AND IN
PASS-BOOK
The need for reconciliation arises only when there are differences in entries posted in cash-
book and pass-book which in turn leads to difference in balances in the respective books. It
may sometime happen that the balance shown by cash-book and pass-book is same but the
entries posted do not tally with each other. In this case also there is a need to prepare bank
reconciliation statement. Before reconciling the balances, one must ascertain the causes of
differences. The difference in the balances of both the books can be because of the following
two reasons :
1. Timing differences,
2. Differences arising due to errors in recording the entries.
Both of the above mentioned reasons can be explained in detail as follows :
5.1 TIMING DIFFERENCES
When the same entry is recorded in either of the book earlier and in the other book later, it is
termed as timing difference. The timing difference may arise on account of the following :

3.4 COMMON PROFICIENCY TEST


(i) Cheques issued but not yet presented for payment : The entry in the cash book is made
immediately on issue of cheque but naturally entry will be made by the bank only when
the cheque is presented for payment. There will thus be a gap of some days between the
entry in the cash book and in the pass book.
(ii) Cheques paid into the bank but not yet cleared : As soon as cheques are sent to the bank,
entries are made on the debit side of the bank column of the cash book. But usually banks
credit the customer's account only when they have received the payment from the bank
concerned-in other words, when the cheques have been cleared. Again there will be some
gap between the depositing of the cheques and the credit given by the bank.
(iii) Interest allowed by bank : If the bank has allowed interest to the customer, the entry will
normally be made in the customer's account and later shown in the pass book. The customer
usually comes to know the amount of the interest by pursuing the pass book and only
then he makes relevant entry in the cash book.
(iv) Interest and expenses charged by the bank : Like (iii) above, the interest charged by the
bank and the amount of the bank charges are entered in the customer account and later in
the pass book. The customer makes the required entries only after he sees the pass book.
(v) Interest and dividends collected by the bank : Sometimes investments are left with the
bank in the safe custody; the bank itself sees to it that the interest or the dividend is collected
on the due dates. Entries are made as indicated in (iii) above.
(vi) Direct payments by the bank : The bank may be given standing instructions for certain
payments such as for insurance premium. In this case also, the customer may come to
know of the payment only on seeing the pass book. The entries in the pass book and in the
cash book may thus be on different dates.
(vii) Direct payment into the bank by a customer : If such a payment is received by the bank, it
will be entered in the customer's account and also in the pass book; the account holder
may come to know of the amount only when he sees the pass book.
(viii)Dishonour of a bill discounted with the bank : If the bank is not able to receive payment
on promissory notes discounted by it, it will debit the customer's account together with
the charges it may have incurred. The customer will naturally make the entry only when
he sees the pass book.
(ix) Bills collected by the bank on behalf of the customer : If goods are sold, the documents
may be sent through the bank. If the bank is able to collect the amount, it will credit the
customer's account. The customer may make the entry only on receiving the pass book.
All these timing differences will lead to difference in balances as shown by the cash-book and
the pass-book.

FUNDAMENTALS OF ACCOUNTING 3.5


BANK RECONCILIATION STATEMENT

Following is the table summarising in brief the timings of different transactions :

Sl. Transaction Time of recording in Time of recording in


No. cash book pass book

1. Payment done by the account At the time of issuing At the time presenting
holder through issuing a cheque the cheque the cheque to the bank
for payment
2. Receipt by the account holder At the time of depositing At the time of collection
through a cheque the cheque into the bank of amount from the
account of the issuing
party.
3. Collection of bills/cheque When the entry is posted When the amount is
directly on behalf of the in the pass-book collected by the bank
account holder
4. Direct payment to the third When the entry is posted When the amount is
party on behalf of the in the pass-book paid by the bank
account holder
5. Dishonour of cheque/bills When the entry is posted When the cheque is
receivable in the pass-book dishonoured
6. Bank charges levied by When the entry is posted When charges are levied
the bank in the pass-book by the bank
7. Interest credited by the bank When the entry is posted When interest is allowed
in the pass-book by the bank
8. Interest debited by the bank When the entry is posted When interest is charged
in the pass-book by the bank

5.2 DIFFERENCES ARISING DUE TO ERRORS IN RECORDING THE ENTRIES


While recording the entries, errors can occur both in the cash-book and in the pass-book. A
bank rarely commits an error but, if it does, the balance shown in pass-book will naturally
differ from that shown in the cash-book. Similarly, if any error is committed in the cash-book
then too the balance shown in it will differ from that of the pass-book. Errors include omission
of entry, wrong recording of amount, recording of entry on wrong side of the book, wrong
totaling of account or wrong balancing of the book, recording of transactions of other party
To illustrate this, we give below an extract from a pass book and the bank columns in the cash-
book :
Messer's Tall & Short, Faiz Bazar, New Delhi-110002
in accounts with
Punjab National Bank, Daryaganj, New Delhi-110002

3.6 COMMON PROFICIENCY TEST


PASS-BOOK
With- Dr. or
Date Particulars drawals Deposits Cr. Balance
Rs. Rs. Rs.
2006
Jan. 2 By Cash 4,000 Cr. 4,000
" 4 To Furniture Dealers Ltd. 600 Cr. 3,400
" 4 To Das & Co. 1,250 Cr. 2,150
" 10 By J. Johnson & Co.'s cheque 350 Cr. 2,500
" 12 To Roy & James 1,000 Cr. 1,500
" 15 By B. Babu & Co's cheque 760 Cr. 2,260
" 16 By Cash 300 Cr. 2,560
" 20 To Cash 500 Cr. 2,060
" 26 By J. Rai & Bros cheque 430 Cr. 2,490
" 31 To Premium paid as per
standing instructions 250 Cr. 2,240
To Bank Charges 10 Cr. 2,230
By interest collected on
Government Securities 200 Cr. 2,430

CASH-BOOK (Bank column only)


Date Particulars Amount Date Particulars Amount
Rs. Rs.
2006 2006
Jan. 1 To Cash 4,000 Jan. 2 By Furniture
Jan. 2 To J. Johnson & Co. 350 Dealers Ltd. 600
Jan. 8 To B. Babu & Co. 760 Jan. 2 By Roy & Jame 1,000
Jan. 10 To Cash 300 Jan. 2 By Das & Co. 1,250
Jan. 16 To J. Rai & Bros. 430 Jan. 4 By K. Nagpal & Co. 730
Jan. 20 To M. Mohan & Co. 1,050 Jan. 17 By Cash 500
Jan. 22 To N. Nandy & Sons 340 Jan. 20 By B. Babu & Co. 780
Jan. 31 By Balance c/d 2,370
7,230 7,230
Feb. 1 To Balance b/d 2,370

FUNDAMENTALS OF ACCOUNTING 3.7


BANK RECONCILIATION STATEMENT

It will be seen that whereas the pass-book shows a balance of Rs. 2,430, the case-book shows a
balance of Rs. 2,370. We shall compare the two to establish the reasons for the difference.
If we compare the debit side of the cash book with the deposits column of the pass book, we
find that the following cheques have been sent to the bank but not yet credited by the bank :
M. Mohan & Co. Rs. 1,050
N. Nandy & Sons Rs. 340 Total Rs. 1,390
Had these two cheques been entered in the deposits column of the pass book also, the pass
book balance of Rs. 3,820; i.e., Rs. 2430 + Rs. 1,390.
Looking at the withdrawals column of the pass book and the credit side of the cash-book, we
find that under mentioned two cheques have not yet been paid by the bank :
K. Nagpal & Co. Rs. 730
B. Babu & Co. Rs. 780 Total Rs. 1,510
Had these cheques been presented and paid, the balance at the bank would have been
Rs. 2,310, i.e., Rs. 3,820 - Rs. 1,510
In addition to the above, two amounts appear in the withdrawals column of the pass book but
not on the credit side of the cash book; these are Rs. 250 premium, and Rs. 10 bank charges.
Had these amounts been omitted from the withdrawals also, the balance at the bank would
have been Rs. 2,570, i.e., Rs. 2,310 + Rs. 260.
There is one amount Rs. 200, interest collected, which has been entered in the deposit column
of the pass book but not on the debit side of the cash book: Omission of this amount from the
pass book also would reduce the balance to Rs. 2,370, i.e., 2,570 - Rs. 200. This agrees with the
cash book balance.
This process shows that the difference between the two balance arise only because there are
some entries made in the cash-book but not in the pass-book and some entries which are made
in the pass-book but not in the cash book. A comparison of the two shows up such entries and
then, on that basis, the reconciliation is prepared. To illustrate it again, let us proceed from the
cash-book balance to Rs. 2,370. Since cheques totalling Rs. 1,390 have not been entered in the
pass-book, let us assume that they are also omitted from the cash book, this will reduce the
cash-book balance to Rs. 980. Cheques totalling Rs. 1,510 have been entered on the credit side
of the cash book but not in the pass-book their omission from the cash-book will increase the
cash book balance to Rs. 2,490. Amounts totalling Rs. 260 have been entered in the withdrawals
column of the pass book but not in the cash book; an entry on the credit side of the cash-book
for these amounts will reduce the balance to Rs. 2,230. The deposits column shows an entry of
Rs. 200 not found on the debit side of the cash-book; the entry made in the cash-book will
increase balance to Rs. 2,430 as shown in the pass-book.

3.8 COMMON PROFICIENCY TEST


6. PROCEDURE FOR RECONCILING THE CASH-BOOK
BALANCE WITH THE PASS-BOOK BALANCE
Before proceeding further students must understand that 'Dr. balance as per cash book' means
deposits in the bank or cash at bank or Cr. balance as per pass book. Similarly 'Cr. balance as
per cash-book' means excess amount over deposits withdrawn by the account holder or overdraft
balance or Dr. balance as per pass-book.
It means that students can start bank reconciliation from any of the following four balances
given in the question :
1. Dr. balance as per cash-book
2. Cr. balance as per cash-book
3. Dr. balance as per pass-book
4. Cr. balance as per pass-book
When causes of differences are known then students can start reconciliation by taking any of
the balance stated above and proceed further with the causes. Given the causes of disagreement,
the balance of the other book can be either more or less on account of the said causes. If the
balance of the other book is more on account of the said causes then add the amount. If the
balance of the other book is less on account of the said causes then subtract the amount.
For example, if the reconciliation is initiated with Dr. balance as per the cash-book and there is
a cheque deposited in the bank but not cleared, then on account of non-clearance of the cheque,
the Cr. balance of the pass book would be less. In this case, the amount of cheque should be
subtracted from the cash-book balance to arrive at the balance as per the pass-book. Similarly,
after making all the adjustments the balance as per the other book is obtained. It is necessary to
note here that if a student starts from debit balance of cash-book and after all adjustments the
balance arrived is positive then it is known as Cr. balance as per the pass-book and if the
balance is negative then it is said to be Dr. balance as per the pass-book and vice-versa.
But if causes of differences are not known then one has to compare the debit entries of cash-
book with the credit entries of the pass-book and vice-versa. The entries, which do not tally in
the course, are the causes of difference in the balances of both the books. Once the causes are
located their effects on both the books are analysed and then reconciliation statement is prepared
to arrive at the actual bank balance.
In this procedure students should also take into care that whether opening balance of both the
books at particular point of time from where the books are compared, tallies or not. If opening
balances are not same then unticked items are divided into two categories i.e., one relating to
reconciliation of opening balance and other relating to reconciliation of closing balance.

7. METHODS OF BANK RECONCILIATION


There are following two methods of reconciling the bank balances :
7.1 BANK RECONCILIATION STATEMENT WITHOUT PREPARATION OF ADJUSTED
CASH-BOOK
For reconciliation purposes students can take any of the four balances as the starting point and

FUNDAMENTALS OF ACCOUNTING 3.9


BANK RECONCILIATION STATEMENT

can proceed further with the causes of differences. Given the causes of disagreement, the balance
of the other book can be either more or less on account of the said causes. If the balance of the
other book is more on account of the said causes then add the amount. If the balance of the other
book is less on account of the said causes then subtract the amount.
Based on the said explanation the following table has been prepared for student's ready reference.
The final balance, which will come after addition and subtraction, will be the balance as per the
other book.
Causes of differences Favourable Unfavourable Favourable Unfavourable
balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per cash- as per cash- as per pass- as per pass-
book book book book

Cheque deposited but not cleared Subtract Add Add Subtract


Cheque issued but not presented to bank Add Subtract Subtract Add
Cheque directly deposited in bank
by a customer Add Subtract Subtract Add
Income (e.g., interest from UTI) directly
received by bank Add Subtract Subtract Add
Expenses (e.g., telephone bills) directly
paid by bank on standing instructions Subtract Add Add Subtract
Bank charges levied by bank Subtract Add Add Subtract
Locker rent levied by bank Subtract Add Add Subtract
Wrong debit in the cash book Subtract Add Add Subtract
Wrong credit in the cash book Add Subtract Subtract Add
Wrong debit in the pass book Subtract Add Add Subtract
Undercasting of Dr. side of bank account
in the cash book Add Subtract Subtract Add
Overcasting of Dr. side of bank account
in cash book Subtract Add Add Subtract
Undercasting of Cr. side of bank account
in cash book Subtract Add Add Subtract
Overcasting of Cr. side of bank account in
cash book Add Subtract Subtract Add
Bill receivable collected directly by bank Add Subtract Subtract Add

3.10 COMMON PROFICIENCY TEST


Causes of differences Favourable Unfavourable Favourable Unfavourable
balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per cash- as per cash- as per pass- as per pass-
book book book book
Interest on bank overdraft charged Subtract Add Add Subtract
Final Balance If answer is If answer is If answer is If answer is
positive then positive then positive then positive then
favourable unfavourable favourable unfavourable
balance (Cr.) balance (Dr.) balance (Dr.) balance (Cr.)
as per pass- as per pass- as per cash- as per cash-
book and if book and if book and if book and if
negative then negative then negative then negative then
unfavourable favourable unfavourable favourable
balance (Dr.) balance (Cr.) balance (Cr.) balance (Dr.)
as per pass- as per pass- as per cash- as per cash-
book. book book book

7.2 BANK RECONCILIATION STATEMENT AFTER THE PREPARATION OF


ADJUSTED CASH-BOOK
Adjusting the cash-book before preparing the bank reconciliation statement is completely
optional, if reconciliation is done during different months. But if reconciliation is done at the
end of the accounting year or financial year, the cash-book must be adjusted so as to reflect the
correct bank balance in the balance sheet.
While adjusting the cash-book all the errors (like wrong amount recorded in the cash-
book, entry posted twice in the cash-book, over/under casting of the balance etc.) and
omissions (like bank charges recorded in the pass-book only, interest debited by the bank,
direct receipt or payment by the bank, dishonour of cheques/bills etc.) by the cash-book
are taken into care but delay in recording in the pass-book due to difference in timing (like
cheque issued but not presented for payment, cheque deposited but not collected) is taken
to bank reconciliation statement. This adjusted cash-book balance is taken to bank
reconciliation statement.

Errors occurred in the pass-book are not to be adjusted in the cash book. All the
adjustments considered in the adjusted cash-book are not carried again to the bank
reconciliation statement.

7.3 PRESENTATION
It is proper to prepare a neat statement showing the reconciliation of the two balances. Taking
the example given in the para 5.2, the statement may be prepared as follows:

FUNDAMENTALS OF ACCOUNTING 3.11


BANK RECONCILIATION STATEMENT

Bank Reconciliation Statement


as on 31st January, 2006
Particulars Details Amount
Balance as per Pass Book Rs. Rs.
Add : Cheques paid but not yet credited : 2,430
M. Mohan & Co. 1,050
N. Nandy & Sons 340 1,390
Add : Premium paid and bank charges entered in Pass 260
book but not yet entered in the Cash-Book 4,080
Less : Cheques issued but not yet presented :
K. Nagpal & Co. 730
B. Babu & Co. 780
1,510
2,570
Less : Interest credited by bank but not yet entered in
Cash Book. 200
Balance as per Cash Book 2,370
OR
Balance as per Cash Book 2,370
Add : Cheques issued but not yet presented :
K. Nagpal & Co. 730
B. Babu & Co. 780 1,510
Add : Interest entered in Pass Book, but not yet in
the Cash Book 200
4,080
Less : Cheques paid in but not yet credited :
M. Mohan & Co. 1,050
N. Nandy & Sons 340 1,390
2,690
Less : Premium paid and bank charges entered in
Pass Book
not yet in the Cash Book 260
Balance as per Pass Book 2,430

3.12 COMMON PROFICIENCY TEST


Illustration 1
From the following particulars ascertain the balance that would appear in the Bank Pass Book
of A on 31st December, 2006.
(1) The bank overdraft as per Cash Book on 31st December, 2006 Rs. 6,340
(2) Interest on overdraft for 6 months ending 31st December, 2006 Rs. 160 is entered in Pass
Book.
(3) Bank charges of Rs. 30 for the above paid are debited in the Pass Book.
(4) Cheques issued but not cashed prior to 31st December, 2006, amounted to Rs. 1,168.
(5) Cheques paid into bank but not cleared before 31st December, 2006 were for Rs. 2,170.
(6) Interest on investments collected by the bank and credited in the Pass Book Rs. 1,200.
Note : In this illustration the point to note is the opening balance is an overdraft. Hence, items
which increase the balance at bank will be deducted from the overdraft since money deposited
will reduce the overdraft. Similarly, item which reduce the balance at bank will be added to the
overdraft.
Solution
Bank Reconciliation Statement
As on 31st December, 2006
Particular Amount
Rs.
Overdraft as per Cash Book 6,340
Add : Interest debited in Pass Book but not yet entered in Cash Book 160
Add : Bank charges debited in Pass Book but not entered in the
Cash Book 30
Add : Cheques deposited but not yet credited Pass Book 2,170
8,700
Less : Cheques issued but not yet presented 1,168
7,532
Less : Interest collected and credited by bank but not yet
entered in Cash Book 1,200
Overdraft as per Pass Book 6,332

The above illustration can also be presented with the column for "Plus" and "Minus"

FUNDAMENTALS OF ACCOUNTING 3.13


BANK RECONCILIATION STATEMENT

Plus Minus
Particulars Amount Amount
Rs. Rs.
Overdraft as per Cash Book 6,340
Interest debited in Pass Book but not yet in Cash Book 160
Cheque issued but not yet presented 1,168
Cheques paid in but not yet credited by the Bank 2,170
Bank charges 30
Interest collected and credited by the Bank in the Pass
Book but not yet entered in Cash Book 1,200
2,368
Overdraft as per Pass Book (Rs. 8,700 - 2,368) 6,332
Total 8,700 8,700

Illustration 2
On 30th September, 2006, the bank account of X, according to the bank column of the Cash-
Book, was overdrawn to the extent of Rs. 4,062. On the same date the bank statement showed
a balance of Rs. 1,400 in favour of X. An examination of the Cash Book and Bank Statement
reveals the following :
1. A Cheque for Rs. 1,140 deposited on 29th September, 2006 was credited by the bank only
on 3rd October, 2006.
2. A payment by cheque for Rs. 160 has been entered twice in the Cash Book.
3. On 29th September, 2006, the bank credited an amount of Rs. 1,740 received from a
customer of X, but the advice was not received by X until 1st October, 2006.
4. Bank charges amounting to Rs. 58 had not been entered in the Cash Book.
5. On 6th September, 2006, the bank credited Rs. 2,000 to X in error.
6. A bill of exchange for Rs. 1000 was discounted by X with his bank. This bill was dishonoured
on 28th September, 2006 but no entry had been made in the books of X.
7. Cheques issued upto 30th September, 2006 but not presented for payment upto that date
totalled Rs. 3760.
You are required :
(a) to show the appropriate rectifications required in the Cash Book of X, to arrive at the
correct balance on 30th September, 2006 and
(b) to prepare a bank reconciliation statement as on that date.

3.14 COMMON PROFICIENCY TEST


Solution
(a) CASH BOOK (Bank Column)

Date Particulars Amount Date Particulars Amount


2006 Rs. 2006 Rs.
Sept. 30 Sept. 30
To Party A/c 160 By Balance b/d 4,062
" Customer A/c " Bank charges 58
(Direct deposit) 1,740 " Customer A/c
" Balance c/d 3,220 B/R dishonoured) 1,000
5,120 5,120

(b) Bank Reconciliation Statement as on 30th September, 2006


Particulars Rs.
Overdraft as per Cash Book 3,220
Add : Cheque deposited but not collected upto 30th Sept., 2006 1,140
4,360
Less : Cheques issued but not presented for payment
upto 30th Sept., 2006 3,760
Credit by Bank erroneously on 6th Sept. 2,000
Balance as per bank statement 1,400
Note : Bank has credited X by 2,000 in errror on 6th September, 2006. If this mistake is rectified
in the amendment bank statement, this will not be deducted in the above statement along with
Rs. 3,760 resulting in debit balance of Rs. 600 as per pass-book.
Illustration 3
On 30th December, 2006 the bank column of A. Philip's cash book showed a debit balance of
Rs. 461. On examination of the cash book and bank statement you find that :
1. Cheques amounting to Rs. 630 which were issued to creditors and entered in the cash
book before 30th December, 2006 were not presented for payment until that date.
2. Cheques amounting to Rs. 250 had been recorded in the cash book as having been paid
into the bank on 30th December, 2006, but were entered in the bank statement on 1st
January, 2007.
3. A cheque for Rs. 73 had been dishonoured prior to 30 December, 2006, but no record of
this fact appeared in the cash book.
4. A dividend of Rs. 38, paid direct to the bank had not been recorded in the cash book.

FUNDAMENTALS OF ACCOUNTING 3.15


BANK RECONCILIATION STATEMENT

5. Bank interest and charges amounting to Rs. 42 had been charged in the bank statement
but not entered in the cash book.
6. No entry had been made in the cash book for a trade subscription of Rs. 10 paid vide
banker's order in November, 2006.
7. A cheque for Rs. 27 drawn by B. Philip had been charged to A. Philips bank account by
mistake in December, 2006.
You are required :
(a) to make appropriate adjustments in the cash book bringing down the correct balance,
and
(b) to prepare a statement reconciling the adjusted balance in the cash book with the balance
shown in the bank statement.
Solution
(a) A. Phillip
Dr. Cash Book (Bank column) Cr.
Date Particulars Amount Date Particulars Amount
2006 Rs. 2006 Rs.
Dec. 30 To Balance b/d 461 Dec. 30 By Debtor-Cheque 73
To Dividends received 38 dishonoured
By Bank interest
and charges 42
By Trade Subscription 10
Dec. 31 By Balance c/d 374
499 499
2007
Jan., 1 To Balance b/d 374

(b) Bank Reconciliation Statement


as at 30th December, 2006
Particulars Details Amount
Rs. Remarks
Balance per cash book 374 In hand
Add : Cheques not yet presented 630
1,004 In hand
Deduct : Lodgement not yet recorded by bank 250
754
Deduct : Cheque wrongly charged (confirmed with) 27
727

3.16 COMMON PROFICIENCY TEST


Illustration 4
From the following information, prepare a Bank reconciliation statement as at 31st December,
2006 for Messrs New Steel Limited :
Rs.
(1) Bank overdraft as per Cash Book on 31st December, 2006 2,45,900
(2) Interest debited by Bank on 26th December, 2006 but no advice received 27,870
(3) Cheque issued before 31st December, 2006 but not yet presented to Bank 66,000
(4) Transport subsidy received from the State Government directly by
the Bank but not advised to the company 42,500
(5) Draft deposited in the Bank, but not credited till 31st December, 2006 13,500
(6) Bills for collection credited by the Bank till 31st December, 2006 but
no advice received by the company 83,600
(7) Amount wrongly debited to company account by the Bank, for which
no details are available 7,400
Solution
M/s. New Steel Ltd.
Bank Reconciliation Statement as on 31st Dec. 2006
Particulars Rs. Rs.
Overdraft as per Cash Book 2,45,900
Add : Interest charged by the bank 27,870
Draft deposited in bank but not yet credited 13,500
Wrong debit by the bank, under verification 7,400 48,770
2,94,670
Less: Cheque issued but not yet presented 66,000
Transport subsidy not yet recorded in the
Cash Book 42,500
Bills for collection credited in the bank not
yet entered in the Cash Book 83,600 1,92,100
Over draft as per Bank Statement 1,02,570

Illustration 5
The Cash Book of Mr. Gadbadwala shows Rs. 8,364 as the balance at Bank as on 31st December,
2006, but you find that it does not agree with the balance as per the Bank Pass Book. On
scrutiny, you find the following discrepancies :
(1) On 15th December, 2006 the Payments side of the Cash Book was undercast by Rs. 100.
(2) A cheque for Rs. 131 issued on 25th December, 2006 was not taken in the bank column.

FUNDAMENTALS OF ACCOUNTING 3.17


BANK RECONCILIATION STATEMENT

(3) One deposit of Rs. 150 was recorded in the Cash Book as if there is no bank column
therein.
(4) On 18th December, 2006 the debit balance of Rs. 1,526 as on the previous day, was brought
forward as credit balance.
(5) Of the total cheques amounting to Rs. 11,514 drawn in the last week of December, 2006,
cheques aggregating Rs. 7,815 were encashed in December.
(6) Dividends of Rs. 250 collected by the Bank and subscription of Rs. 100 paid by it were not
recorded in the Cash Book.
(7) One out-going Cheque of Rs. 350 was recorded twice in the Cash Book. Prepare a
Reconciliation Statement.
Solution
(If the books are not closed on 31st December, 2006)
Bank Reconciliation Statement of Mr. Gadbadwala as on 31st Dec., 2006
Particulars Details Amount
Rs. Rs.
Balance as per Cash Book 8,364
Add : Mistake in bringing forward Rs. 1,526 debit balance
as credit balance on 18th Dec., 2006 3,052
Cheques issued but not presented : Rs.
Issued 11,514
Cashed 7,815 3,699
Dividends directly collected by bank but not yet
entered in the Cash Book 250
Cheque recorded twice in the Cash Book 350
Deposit not recorded in the Bank column 150 7,501
15,865
Less : Wrong casting in the Cash Book on 15th Dec. 100
Cheques issued but not entered in the Bank column 131
Subscription paid by the bank directly not yet
recorded in the Cash Book 100 331
Balance as per Pass Book 15,534
(If the books are to be closed on 31st December, 2006)
Corrected Balance as per Pass Book :
Balance as given 8,364
Add : Mistake in bringing forward the balance on
18th December 3,052
Dividends collected by the bank 250
Cheques recorded twice in the Cash Book 350
Deposit not recorded in the bank column 150
12,166

3.18 COMMON PROFICIENCY TEST


Less : Wrong casting of the Cash Book on 15th Dec. 100
Cheques issued but not entered in the Bank Column 131
Subscription paid by the Bank 100 331
Correct Balance (for Balance Sheet purposes) 11,835

Bank reconciliation Statement


Particulars Rs.
Balance as per Cash Book (corrected) 11,835
Add: Cheques issued but not yet presented 3,699
Balance as per Pass Book 15,534
Illustration 6
The following are the Cash Book and Pass Book of Jain for the month of March, 2006 and
April, 2006.
Cash Book (Bank Column only)
Dr. Cr.
Date Particulars Amount Date Particulars Amount
Rs. Rs.
01/3/06 To Balance b/d. 6,000 03/3/06 By Cash A/c. 2,000
06/3/06 To Sales A/c. 3,000 07/3/06 By Modi 6,000
10/3/06 To Ram 6,500 12/3/06 By Patil 3,000
18/3/06 To Singhal 2,700 18/3/06 By Suresh 4,000
25/3/06 To Goyal 3,300 24/3/06 By Ramesh 1,500
31/3/06 To Patel 6,500 30/3/06 By Bal. C/d. 11,500
28,000 28,000

Pass Book
Date Particulars Amount Amount Dr. or Cr. Balance
Dr. Cr.
Rs. Rs. Rs.
1/4/06 By Balance b/d 3,200 Cr. 3,200
3/4/06 By Goyal 3,300 Cr. 6,500
5/4/06 By Patel 6,500 Cr. 13,000
7/4/06 To Naresh 2,800 Cr. 10,200
12/4/06 To Ramesh 1,500 Cr. 8,700
15/4/06 To Bank Charges 200 Cr. 8,500
20/4/06 By Usha 1,700 Cr. 10,200
25/4/06 By Kalpana 3,800 Cr. 14,000
30/4/06 To Sunil 6,200 Cr. 7,800
Reconcile the balance of cash book on 31/3/06.

FUNDAMENTALS OF ACCOUNTING 3.19


BANK RECONCILIATION STATEMENT

Solution
On scrutiny of the debit side of the Cash Book of March 2006 and receipt side of the Pass Book
of April, 2006 reveals that :
1. Two cheque deposited in Bank (Goyal Rs. 3,300 and Patel Rs. 6,500) in March were not
credited by the Bank till 31/3/2006 and on scrutiny of the credit side of the cash book and
payment side of the Pass Book reveals that :
2. A cheque issued to Ramesh for Rs.1,500 in March 2006, had not been presented for payment
in Bank till 31/3/2006. Therefore the Bank Reconciliation statement on 31/3/2006 will
appear as follows : -
Bank Reconciliation Statement as on 31/3/2006
Particulars Amount
Rs.
Balance as per Cash Book 11,500
Add : Cheque issued but not presented for payment 1,500
13,000
Less : Cheque deposited but not credited by Bank 9,800
Balance as per Pass Book 3,200

Illustration 7
When Nikki & Co. received a Bank Statement showing a favourable balance of Rs. 10,392 for
the period ended on 30th June, 2006, this did not agree with the balance in the cash book.
An examination of the Cash Book and Bank Statement disclosed the following-
1. A deposit of Rs. 3,092 paid on 29th June, 2006 had not been credited by the Bank until 1st
July, 2006.
2. On 30th March, 2006 the company had entered into hire purchase agreement to pay by
bankers order a sum of Rs. 3,000 on the 10th of each month, commencing from April,
2006. No entries had been made in Cash Book.
3. A customer of the firm, who received a cash discount of 4% on his account of Rs. 4,000
paid the firm a cheque on 12th June. The cashier erroneously entered the gross amount in
the bank column of the Cash Book.
4. Bank Charges amounting to Rs. 300 had not been entered in Cash-Book.
5. On 28th June, a customer of the company directly deposited the amount in the bank
Rs. 4,000, but no entry had been made in the Cash Book.
6. Rs. 1,200 paid into the bank had been entered twice in the Cash Book.
7. A debit of Rs. 100 appeared in the Bank Statement for an unpaid cheque, which had been
returned marked 'out of date'. The cheque had been re-dated by the customer and paid
into Bank again on 5th July, 2006.
Prepare Bank Reconciliation Statement on 30 June, 2006.

3.20 COMMON PROFICIENCY TEST


Solution:
Bank Reconciliation Statement on 30 June, 2006
Particulars Details Amount
Rs. Rs.
Balance as per Pass Book 10,392
Add:
Deposited with bank but not credited 3,092
Payment of Hire Purchase installments
not entered in Cash Book 9,000
Discount allowed wrongly entered in bank column 160
Bank charges not entered in Cash Book 300
Deposit entered in the Cash Book twice 1,200
Cheque returned 'out of date' entered in Cash Book 100 13,852
24,244
Less : Direct deposit by customer not entered in Cash Book 4,000
Balance as per Cash Book 20,244

Illustration 8
The bank account of Mukesh was balanced on 31st March, 2006. it showed an overdraft of
Rs. 5,000. The bank statement of Mukesh showed a credit balance of Rs. 76,750. Prepare a
bank reconciliation statement taking the following into account :
(1) Cheques issued but not presented for payment till 31.3.2006 Rs. 12,000.
(2) Cheques deposited but not collected by bank till 31.3.2006 Rs. 20,000.
(3) Interest on term-loan Rs. 10,000 debited by bank on 31.3.2006 but not accounted in Mukesh's
book.
(4) Bank charges Rs. 250 was debited by bank during March, 2006 but accounted in the
books of Mukesh on 4.4.2006.
(5) An amount of Rs. 1,00,000 representing collection of Murukesh's cheque was wrongly
credited to the account of Mukesh by the bank in their bank statement.

FUNDAMENTALS OF ACCOUNTING 3.21


BANK RECONCILIATION STATEMENT

Solution :
In the books of Mukesh
Bank Reconciliation Statement as on 31.3.2006
Particulars Details Amount
Rs.
Overdraft as per cash book 5,000
Add: Cheques deposited in bank but not collected and
credited by bank till 31.3.2006 20,000
Interest on term loan not accounted in books 10,000
Bank charges not accounted in books 250 30,250
35,250
Less: Cheques issued but not presented for
payment till 31.3.2006 12,000
23,250
Less: Erroneous credit by bank to Mukesh's account 1,00,000
Balance as per bank statement 76,750

Illustration 9
From the following information (as on 31.3.2006), prepare a bank reconciliation statement
after making necessary amendments in the cash book.
Amount (Rs.)
Bank balances as per cash book (Dr.) 3,25,000
Cheques deposited, but not yet credited 4,47,500
Cheques issued but not yet presented for payment 3,56,200
Bank charges debited by bank but not recorded in cash-book 1,250
Dividend directly collected by the bank 12,500
Insurance premium paid by bank as per standing instruction not intimated 15,900
Cash sales wrongly recorded in the Bank column of the cash-book 25,500
Customer's cheque dishonoured by bank not recorded in the cash-book. 13,000
Wrong credit given by bank 15,000
Also show the bank balance that will appear in the trial balance as on 31.3.2006.

3.22 COMMON PROFICIENCY TEST


Solution:
Cash Book as on 31.3.2006
(after making necessary amendments)
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Balance b/d 3,25,000 By Bank charges 1,250
To Dividend 12,500 By Insurance premium 15,900
By Cash sales (wrongly recorded) 25,500
By Debtors (cheque dishonoured) 13,000
By Balance c/d 2,81,850
3,37,500 3,37,500

Bank Reconciliation Statement


as on 31.3.2006
Particulars DetailsRs. AmountRs.
Bank balance as per cash book 2,81,850
Add: Cheques issued but not yet presented for payment 3,56,200
Wrong credit given by bank 15,000 3,71,200
6,53,050
Less: Cheques deposited but not yet credited by bank 4,47,500
Balance as per pass book 2,05,550

The bank balance of Rs. 2,81,850 will appear in the trial balance as on 31st March, 2006

Illustration 10
On 31st March, 2006 the pass-book of a trader showed a credit balance of Rs. 1,565, but the
pass book balance was different for the following reasons from the cash book balance:
1. Cheques issued to 'X' for Rs. 600 and to 'Y' for Rs. 384 were not yet presented for payment.
2. Bank charged Rs. 35 for bank charges and 'Z' directly deposited Rs. 816 into the bank
account, which were not entered in the cash book.
3. Two cheques one from 'A' for Rs. 515 and another from 'B' for Rs. 1,250 were collected in
the first week of April, 2006 although they were banked on 25.03.2006.
4. Interest allowed by bank Rs. 45.
Prepare a bank reconciliation statement as on 31st March, 2006.

FUNDAMENTALS OF ACCOUNTING 3.23


BANK RECONCILIATION STATEMENT

Solution :
Bank Reconciliation Statement
as on 31st March, 2006
Particulars Details Amount
Rs. Rs. Rs.
Credit balance as per pass book 1,565
Add: Cheques deposited into bank but not yet collected A: 515
B: 1,250 1,765
Bank charges debited by the bank 35 1,800
3,365
Less: Cheques issued but not presented for payment X: 600
Y: 384 984
Direct deposit of cash in bank by Z 816
Interest allowed by the bank 45 1,845
Debit balance as per cash book 1,520

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES(only one correct
answer):
1. When the balance as per Cash Book is the starting point, direct deposits by customers are:
a) added b) subtracted;
c) not required to be adjusted d) neither of the two
2. A Bank Reconciliation Statement is a
(a) part of Cash Book; (b) part of Bank Account;
(c) part of financial statements, (d) none of the above.
3. When balance as per Pass Book is the starting point, interest allowed by Bank is
(a) added (b) subtracted
(c) not required to be adjusted. (d) None of the above.
4. A Bank Reconciliation Statement is prepared with the help of:
(a) Bank statement and bank column of the Cash Book.
(b) Bank statement and cash column of the Cash Book
(c) Bank column of the Cash Book and cash column of the Cash Book
(d) None of the above.

3.24 COMMON PROFICIENCY TEST


5. Debit balance as per Cash Book of ABC Enterprises as on 31.3.2006 is Rs. 1,500.Cheques
deposited but not cleared amounts to Rs. 100 and Cheques issued but not presented of Rs.
150. The bank allowed interest amounting Rs. 50 and collected dividend Rs. 50 on behalf
of ABC Enterprises. Balance as per pass book should be
(a) 1,600. (b) 1,450.
(c) 1,850. (d) 1,650.
6. The cash book showed an overdraft of Rs. 1,500 as cash at bank, but the pass book made
up to the same date showed that cheques of Rs. 100,Rs. 50 and Rs. 125 respectively had
not been presented for payments; and the cheque of Rs.400 paid into account had not been
cleared. The balance as per the cash book will be
(a) Rs. 1,100. (b) Rs. 2,175.
(c) Rs. 1,625. (d) Rs. 1,375.
7. When drawing up a Bank Reconciliation Statement, if you start with a debit balance as
per the Bank Statement, the unpresented cheques should be:
a) Added; b) Deducted; c) Not required to be adjusted. d) None of the above.
8. A debit balance in the depositor’s Cash Book will be shown as:
a) a debit balance on the Bank Statement.
b) a credit balance on the Bank Statement.
c) an overdrawn balance on Bank Statement.
d) None of the above.
9. When preparing a Bank Reconciliation Statement, if you start with a debit balance as per
the Cash Book, cheques issued but not presented within the period should be:
a) Added; b) Deducted;
c) not required to be adjusted d) None of the above.
10. When the balance as per Pass Book is the starting point, direct payment by bank are:
a) added in the bank reconciliation statement
b) subtracted in the bank reconciliation statement
c) Not required to be adjusted in the bank reconciliation statement.
d) Neither of the above.
11. When balance as per Cash Book is the starting point, uncollected cheques are:
a) added in the bank reconciliation statement
b) subtracted in the bank reconciliation statement
c) ‘Not required to be adjusted in the bank reconciliation statement
d) neither of the above.

FUNDAMENTALS OF ACCOUNTING 3.25


BANK RECONCILIATION STATEMENT

12. A Bank Reconciliation Statement is prepared to know the causes for the difference between:
a) the balances as per cash column of Cash Book and the Pass Book.
b) the balance as per bank column of Cash Book and the Pass Book.
c) the balance as per bank column of Cash Book and balances as per cash column of
Cash Book
d) Neither of the above.
13. When the balance as per Pass Book is the starting point, uncollected cheques are:
a) added in the bank reconciliation statement
b) subtracted in the bank reconciliation statement
c) not required to be adjusted in the bank reconciliation statement.
d) neither of the above.
14. When balance as per Cash Book is the starting point, interest charged by Bank is:
a) added in the bank reconciliation statement
b) subtracted in the bank reconciliation statement
c) not required to be adjusted in the bank reconciliation statement
d) neither of the above.
[Ans. : 1(a), 2(d), 3(b), 4(a), 5(d), 6(c), 7(a), 8(b), 9(a), 10(a), 11(b), 12(b), 13(a), 14(b)]

II Match the following items from column A with column B


S. No. Column A Column B
1. Debit Balance in the Cash Book means (a) Account holders
2. A Bank Reconciliation is prepared by: (b) Overdraft as per Pass Book
3. A Bank Statement is a copy of: (c) Credit balance as per Pass Book
4. Credit Balance in the cash book means: (d) A customers account in the
Bank’s book.
[Ans. : 1.(c); 2(a), 3(d), 4(b)]

3.26 COMMON PROFICIENCY TEST


III Choose the correct answer (more than one)
1. The difference in the balances of both the cash-book and the pass-book can be because of
(a) errors in recording the entries either in the cash-book or pass-book.
(b) same entry recorded in either of the book earlier and in the other book later.
(c) debit balance of cash book is the credit balance of pass-book.
(d) None of the above.
2. Direct payment to the third party on behalf of the account holder is entered in
(a) the cash-book when the amount is paid by the bank
(b) the cash-book when the entry is posted in the pass-book
(c) the pass-book when the amount is paid by the bank
(d) the pass-book when the entry is posted in the pass-book
3. Payment done by the account holder through issuing a cheque is entered in
(a) the pass-book at the time of issuing the cheque
(b) the cash-book at the time of presenting the cheque to the bank for payment
(c) the pass-book at the time of presenting the cheque to the bank for payment
(d) the cash-book at the time of issuing the cheque
4. Following are the salient features of bank reconciliation statement:
(a) Any undue delay in the clearance of cheques will be shown up by the reconciliation
(b) Reconciliation statement will help in finding the person doing any fraud
(c) Reconciliation is done by the bankers
(d) It helps in finding out the actual position of the bank balance.
[Ans: 1- (a)&(b), 2-(b)&(c), 3-(c)&(d), 4-(a),(b)&(d) ]

FUNDAMENTALS OF ACCOUNTING 3.27


NOTES
CHAPTER - 4

INVENTORIES
INVENTORIES

Learning objectives
After studying this chapter, you will be able to:
 Understand the meaning of Term 'Inventory'.
 Learn the technique of Specific identification, FIFO, Average price, Weighted Average
Price and Adjusted Selling Price methods of inventory valuation.
 Understand the methods of inventory record keeping and comprehend the intricacies
relating to stock taking.

1. MEANING
Inventory can be defined as tangible property held for sale in the ordinary course of business,
or in the process of production for such sale, or for consumption in the production of goods or
services for sale, including maintenance supplies and consumables other than machinery spares.
Inventories are assets: (a) held for sale in the ordinary course of business; (b) in the process of
production for such sale; (c) in the form of materials or supplies to be consumed in the production
process or in the rendering of services. Inventories encompass goods purchased and held for
resale, for example merchandise (goods) purchased by a retailer and held for resale, or land
and other property held for resale. Inventories also include finished goods produced, or work
in progress being produced, by the enterprise and include materials, maintenance supplies,
consumables and loose tools awaiting use in the production progress. However, inventories do
not include machinery spares which can be used only in connection with an item of fixed asset
and whose use is expected to be irregular; such machinery spares are generally accounted for
as fixed assets.
The types of inventories are related to the nature of business. The inventories of a trading
concern consist primarily of products purchased for resale in their existing form. It may also
have an inventory of supplies such as wrapping paper, cartons, and stationery. The inventories
of manufacturing concern consist of several types of inventories: raw material (which will
become part of the goods to be produced), parts and factory supplies, work-in-process (partially
completed products in the factory) and, of course, finished products.
At the year end every business entity needs to ascertain the closing balance of stock which
comprise of stock of raw material, work-in-progress, finished goods and miscellaneous items.
Value of closing stock is put at the credit side of the Trading Account and asset side of the
Balance Sheet. So before preparation of final accounts, the accountant should know the value
of stock of the business entity. However, we shall restrict our discussion on inventory valuation
for raw materials of a manufacturing concern and goods of a trading concern. The valuation
of other types of inventories will be covered in Advanced Accounting and Cost Accounting
subject at Professional Competence Course.

4.2 COMMON PROFICIENCY TEST


Types of Inventories

In case of manufacturing concerns In case of Trading concerns

Raw Materials Work-in- Finished goods Finished goods


progress

Covered in CPT To be covered in Covered in CPT


and PCC PCC and PCC

* CPT – Common Proficiency Test


* PCC – Professional Competence Course

2. INVENTORY VALUATION
A primary issue in accounting for inventories is the determination of the value at which
inventories are carried in the financial statements until the related revenues are recognized.
Inventory is generally the most significant component of the current assets held by a trading or
manufacturing enterprise. It is widely recognised that the major asset that affects efficiency of
operations is inventory. Both excess of inventory and its shortage affects the production activity,
and the profitability of the enterprise whether it is a manufacturing or a trading business.
Proper valuation of inventory has a very significant bearing on the authenticity of the financial
statements. The significance of inventory valuation arises due to various reasons as explained
in the following points.
(i) Determination of Income
The valuation of inventory is necessary for determining the true income earned by a business
entity during a particular period. To determine gross profit, cost of goods sold is matched
with revenue of the accounting period. Cost of goods sold is calculated as follows:
Cost of goods sold = Opening stock + Purchases + Direct expenses - Closing stock.
Inventory valuation will have a major impact on the income determination if merchandise
cost is large fraction of sales price. The effect of any over or understatement of inventory
may be explained as:
(a) When closing inventory is overstated, net income for the accounting period will be
overstated.
(b) When opening inventory is overstated, net income for the accounting period will be
understated.
(c) When closing inventory is understated, net income for the accounting period will be
understated.

FUNDAMENTALS OF ACCOUNTING 4.3


INVENTORIES

(d) When opening inventory is understated, net income for the accounting period will be
overstated.
The effect of misstatement of inventory figure on the net income is always through cost of
goods sold. Thus, proper calculation of cost of goods sold and for that matter, proper
valuation of inventory is necessary for determination of correct income.
(ii) Ascertainment of Financial Position
Inventories are classified as current assets. The value of inventory on the date of balance
sheet is needed to determine the financial position of the business. In case the inventory is
not properly valued, the balance sheet will not disclose the truthful financial position of
the business. 'Inventory' also affects analysis of financial statements as various ratios based
on current assets, net working capital, total assets considering stock as one of the variables
require inventory as its constituents.
(iii) Liquidity Analysis
Inventory is classified as a current asset, it is one of the components of net working capital
which reveals the liquidity position of the business. Current ratio which studies the
relationship between current assets and current liabilities is significantly affected by the
value of inventory.
(iv) Statutory Compliance
Schedule VI of the Indian Companies Act, 1956 requires that the details of quantities of
each class of goods along with method of valuation of raw material, work-in-progress
and finished goods should be disclosed in the financial statements. As per the requirements
of the Accounting Standards, the financial statements should disclose (a) the accounting
policies adopted in measuring inventories, including the cost formula used, and (b) the
total carrying amount of inventories and its classification appropriate to the enterprise.
The common classification of inventories are raw materials; work-in-progress; finished
goods; stores and spares and loose tools.

3. BASIS OF INVENTORY VALUATION


Inventories should be generally valued at the lower of cost or net realizable value. Pricing of
inventory assumes significance when different lots are purchased at varying prices at different
timings. In case of no change in price level, determination of historical cost of inventory shall
not pose any major problem.

Cost The amount of expenditure incurred on acquisition of goods.

This is the estimated selling price in the ordinary course of business


Net realizable value : less the estimated costs of completion and the estimated costs
necessary to make the sale. An assessment is made of net realisable
value as at each balance sheet date. Inventories are usually written down to net realisable
value on an item-by-item basis. In some circumstances, however, it may be approximate to
group of similar or related items.

4.4 COMMON PROFICIENCY TEST


Basis of Inventory Valuation

Cost Net realizable value

Whichever is less

Value of Inventory

4. TECHNIQUES OF INVENTORY VALUATION

Inventory Valuation Techniques

Inventory, not ordinarily Inventory, ordinarily


interchangeable interchangeable

Specific identification
method Historical cost Non-historical cost
methods methods

FIFO LIFO Average Weighted Base Stock


Price Average to be
Price discussed in
PCC

Standard Adjusted Latest


cost to be Selling Purchase Price
discussed in Price to be discussed
PCC in PCC

FUNDAMENTALS OF ACCOUNTING 4.5


INVENTORIES

4.1 HISTORICAL COST METHODS


Under historical cost methods, cost of goods refers to the historical cost of acquisition of goods.
It is the value of resources required to obtain the inventory in its present condition and includes
"cost of purchase and other costs incurred in bringing the inventories up to their present location
and condition".
The purchase price including duties and taxes (other than those
Costs of purchase which are subsequently recoverable by the enterprise from the taxing
authorities), freight inwards and other expenditure directly
attributable to the acquisition of goods. Trade discounts, rebates, duty drawbacks and other
similar items are deducted in determining the costs of purchase.
Other costs are included in the cost of inventories only to the extent that they
are incurred in bringing the inventories to their present location and condition.
Other Costs
While determining cost of inventories, certain costs are excluded and
recognised as expenses in the period in which they are incurred. Examples
are: (i) costs arising due to abnormal amount of wasted materials, labour or other production
costs, and (ii) storage costs are excluded in calculation of cost of inventories unless these costs
are necessary in the production process prior to a further production stage, (iii) administrative
overheads that do not contribute to bring the inventories to their present location and condition;
and (iv) selling and distribution costs. Interest and other borrowing costs are usually considered
as not relating to bringing the inventories to their present location and condition and are,
therefore, usually not included in the cost of inventories.
There is no unique formula for determination of historical cost of inventories. The different
techniques for valuation of inventory have been discussed below:
(i) Specific Identification Method
Pricing under this method is based on actual physical flow of goods. It attributes specific costs
to identified goods and requires keeping different lots purchased separately to identify the lot
out of which units in stock are left. The historical costs of such specific purpose inventories
may be determined on the basis of their specific purchase price or production cost.
This method is generally used to ascertain the cost of inventories of items that are not ordinarily
interchangeable, otherwise it requires the use of FIFO (First in first out) or weighted overage
price/average price formula.
(ii) FIFO (First in first out) Method
The actual issue of goods is usually from the earliest lot on hand. The stock of goods on hand
therefore, consists of the latest consignments. Thus, the closing inventory is valued at the price
paid for such consignments.
Now, let us take an example to understand the application of FIFO method.

4.6 COMMON PROFICIENCY TEST


Illustration 1
A manufacturer has the following record of purchases of a condenser, which he uses while
manufacturing radio sets:
Date Quantity (units) Price per unit
Dec. 4 900 5.00
Dec. 10 400 5.50
Dec. 11 300 5.50
Dec. 19 200 6.00
Dec. 28 800 4.75
2,600
1,600 units were issued during the month of December.
Solution
The closing stock is 1,000 units and would consist of -
800 units received on 28th December; and
200 units received on 19th December as per FIFO
Rs.
The value of 800 units @Rs. 4.75 3,800
The value of 200 units @ Rs. 6.00 1,200
Total 5,000
(iii) LIFO (Last in first out) Method
Though actual issues are made out of the earliest lot on hand to prevent unnecessary deterioration
in value, it is sometimes assumed that the issue to be valued is to be according to the price paid
for the latest consignments on hand. The closing stock then is assumed to consist of earlier
consignments and its value is then calculated according to such consignments. This method of
valuing stock is known as LIFO basis. Under this basis, goods issued are valued at the price
paid for the latest lot of goods on hand which means stock of goods in hand is valued at price
paid for the earlier lot of goods. In the absence of details of issue, the price paid for the earliest
consignments is used for valuing closing stock.
LIFO method is based on an irrational assumption that inventories entering last in the stores
are issued or consumed first. However, the flow of goods which is generally observed in business
entities is contradictory to this assumption. Therefore, LIFO method is no longer adopted for
valuing inventories. Generally, in practice, FIFO and Average Price Method are popular among
the business entities.
(iv) Average Price Method
Average price for computing value of stock is a very simple approach. (All the different prices
are added together and then divided by the number of prices). The closing stock is then valued
according to the price ascertained.

FUNDAMENTALS OF ACCOUNTING 4.7


INVENTORIES

Illustration 2
In the same example of a manufacturer of radio sets given earlier, let us calculate the value of
closing inventory using Average Price Method:
Record of purchases
Date Quantity (units) Price per unit
Dec. 4 900 5.00
Dec. 10 400 5.50
Dec. 11 300 5.50
Dec. 19 200 6.00
Dec. 28 800 4.75
2,600
Record of issues
Date Quantity (units)
Dec. 5 600
Dec. 12 400
Dec. 29 600
Total 1,600
Solution
The simple average in this question is:
[(5.00 + 5.50 + 5.50 + 6.00 + 4.75)/5] = 26.75/5 = Rs. 5.35
1,000 units valued at Rs. 5.35 would be Rs. 5,350.
Let us try to analyse the impact of FIFO and Average price method with the help of following
chart:

Units Received Units issued


10.1.2006 500 units at Rs. 5 20.1.2006 500 units
15.1.2006 500 units at Rs. 6

FIFO Average Cost Method

500 units at 500 units at


Rs. 6 = Rs. 3,000 Rs. 5.50 = Rs. 2,750

4.8 COMMON PROFICIENCY TEST


(v) Weighted Average Price Method
However, it is more logical to compute weighted average price using the quantities purchased
in a lot as weights. Under weighted average price method, cost of goods available for sale
during the period is aggregated and then dividend by number of units available for sale during
the period to calculate weighted average price per unit. Thus
Total cost of goods available for sale during the period
W eighted average price per unit =
Total number of units available for sale during the period
Closing stock = No. of units in stock X Weighted average price per unit
Cost of goods sold = No. of units sold X Weighted average price per unit.
Illustration 3
On the basis of the datas given in illustration 1, calculate the weighted average price and also
the value of closing inventory by weighted average price method.
Solution
The computation of weighted average price in the referred example is shown below:
Quantity Rate Price paid
units Rs. Rs.
900 5.00 4,500
400 5.50 2,200
300 5.50 1,650
200 6.00 1,200
800 4.75 3,800
2,600 Total 13,350
Rs. 13,350
Weighted average price =
2,600
= Rs. 5.135 per unit
Value of closing inventory of 1,000 units = 1,000 x Rs. 5.135 = Rs. 5,135
It should be noted that if a stock ledger is maintained, recording receipts/issues daily, the
average would be different. A new average rate would be calculated on receiving a fresh
consignment. Answer on that basis would be as under:

FUNDAMENTALS OF ACCOUNTING 4.9


INVENTORIES

Date Receipts Issues Balance


Qty. Rate Amount Qty. Rate Amount Qty. Rate Amount
Dec. Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.
4 900 5.00 4,500 900 5.00 4,500
5 600 5.00 3,000 300 5.00 1,500
10 400 5.50 2,200 700 5.28 3,700
11 300 5.50 1,650 1,000 5.35 5,350
12 400 5.35 2,140 600 5.35 3,210
19 200 6.00 1,200 800 5.51 4,410
28 800 4.75 3,800 1,600 5.13 8,210
29 600 5.13 3,078 1,000 5.13 5,132

4.2 NON-HISTORICAL COST METHODS


Non-historical cost methods do not consider the historical cost incurred to acquire the goods.
Non- historical cost methods include Adjusted Selling Price method, Standard Cost and Latest
Purchase Price method. Adjusted Selling Price method can be explained as follows:
(i) Adjusted selling price method
This method is also called retail inventory method. It is used widely in retail business or in
business where the inventory comprises of items, the individual costs of which are not readily
ascertainable. The use of this method is appropriate for measuring inventories of large numbers
of rapidly changing items that have similar margins and for which it is impracticable to use
other costing methods. The cost of the inventory is determined by reducing from the sales
value of the inventory the appropriate percentage of gross margin. The percentage used takes
into consideration inventory which has been marked to below its original selling price. An
average percentage for each retail department is often used. The calculation of the estimated
gross margin of profit may be made for individual items or groups of items or by departments,
as may be appropriate to the circumstances.
Illustration 4
M/s X, Y and Z are in retail business, following information are obtained from their records for
the year ended 31st March, 2006:
Goods received from suppliers
(subject to trade discount and taxes) Rs. 15,75,500
Trade discount 3% and sales tax 11%
Packaging and transportation charges Rs. 87,500
Sales during the year Rs. 22,45,400
Sales price of closing inventories Rs. 2,35,000

4.10 COMMON PROFICIENCY TEST


Find out the historical cost of inventories using adjusted selling price method.
Solution
Determination of cost of purchases-
Goods received from suppliers Rs. 15,75,500
Less : Trade discount 3% Rs. 47,265
Rs. 15,28,235
Add : Sales Tax 11% Rs. 1,68,106
Rs. 16,96,341
Add : Packaging and transportation charges Rs. 87,500
Rs. 17,83,841
Determination of estimated gross profit margin-
Sales during the year Rs. 22,45,500
Closing inventory at the selling price Rs. 2,35,000
Rs. 24,80,500
Less : Purchase Rs. 17,83,841
Gross profit Rs. 6,96,659
Gross profit margin 28.09%
Inventory valuation-
Selling price of closing inventories Rs. 2,35,000
Less : Gross profit margin 28.09% Rs. 66,012
Rs. 1,68,988
Illustration 5
From the following information, calculate the historical cost of inventories using adjusted selling
price method:
Rs.
Sales during the year 2,00,000
Cost of purchases 2,00,000
Opening stock Nil
Closing stock at selling price 50,000

FUNDAMENTALS OF ACCOUNTING 4.11


INVENTORIES

Solution
Calculation of gross margin of profit:
Rs.
Sales 2,00,000
Add: Closing inventory (at selling price) 50,000
Selling price of goods available for sale : 2,50,000
Less : Cost of goods available for sale 2,00,000
Gross margin 50,000
50,000
Rate of gross margin = ×100=20%
2,50,000
Cost of closing stock = 50,000 less 20% of Rs. 50,000= Rs. 40,000
5. INVENTORY RECORD SYSTEMS
There are two principal systems of determining the physical quantities and monetary value of
inventories sold and in hand. One system is known as 'Periodic Inventory System' and the
other as the 'Perpetual Inventory System'. The periodic system is less expensive to use than the
perpetual method. But the useful information obtained from perpetual system eclipses the cost
considerations. These systems are distinguished on the basis of the actual records kept to
ascertain the cost of goods sold and the closing inventory valuations.

5.1 PERIODIC INVENTORY SYSTEM


Periodic inventory system is a method of ascertaining inventory by taking an actual physical
count (or measure or weight) of all the inventory items on hand at a particular date on which
inventory is required. It is because of actual physical count that the system is also called physical
inventory system. The cost of goods sold is determined as shown below:
Opening inventory (known) + Purchases (known) - closing inventory (physically counted) =
Cost of goods sold.
Periodic inventory system is simple and less expensive than the perpetual system. In this system,
stock account is adjusted at the end of the accounting period to determine cost of goods. This
system suffers from various limitations:
(i) Physical stock taking is required more than once a year for preparation of quarterly or
half yearly financial statements thereby making this system more expensive.
(ii) Physical count of goods requires closure of normal operations of business.
(iii) As cost of goods sold is taken as residual figure, it includes loss of goods during the year.
(iv) Inventory control is not possible under this system.

5.2 PERPETUAL INVENTORY SYSTEM


Perpetual inventory system is a system of recoding inventory balances after each receipt and
issue. In order to ensure accuracy of perpetual inventory records, physical stocks should be
checked and compared with recorded balances. Under this system, cost of goods issued is

4.12 COMMON PROFICIENCY TEST


directly determined and stock of goods is taken as residual figure with the help of stock ledger
in which flow of goods is recorded on continuous basis. The basic feature of this system is the
maintenance of stock ledger to have records of goods on continuous basis.
Perpetual inventory system helps to overcome the limitations of periodic system. As stock is
taken as residual figure, it includes loss of goods. However, the main limiting factor is the cost
of using this system.
5.3 DISTINCTION BETWEEN PERIODIC INVENTORY SYSTEM
AND PERPETUAL INVENTORY SYSTEM
Both the systems - Periodic Inventory System and Perpetual Inventory System are not mutually
exclusive and complementary in nature. Distinction between both the systems can be explained
as follows:
S. Periodic Inventory System Perpetual Inventory System
No.
1. This system is based on physical verification. It is based on book records.
2. This system provides information about It provides continuous information about
stock and cost of sales. stock and cost of sales.
3. This system determines inventory and takes It directly determines cost of sales and
cost of goods sold as residual figure. computes stock as balancing figure.
4. Cost of goods sold includes loss of goods Closing inventory includes loss of goods
as goods not in stock are assumed to be sold. as all unsold goods are assumed to be in
inventory.
5. Under this method, inventory control is not Inventory control can be exercised under
possible. this system.
6. This system is simple and less. It is costlier method.
7. Periodic system requires closure of business Inventory can be determined without
for counting of stock. affecting the operations of business.

6. STOCK TAKING
Normally all operations are suspended for one or two days during the financial year and a
physical inventory is taken of everything in the godown or the store periodically. For the year-
end inventory valuation, physical stock taking is done during the last week of the financial
year. If stock taking is finished on 26th March, whereas accounting year ends on 31st March
purchases and sales subsequent to 26th March are then separately adjusted. Later, a value is
put on each item. The principle of cost or market price, whichever is lower, is applied either for
the inventory as a whole or item by item.
Often, stock taking cannot be carried out on the closing day. It is carried out a few days later or
some times even a few days earlier. In such a case, the actual value of the stock must be so
adjusted as to relate it to the end of the year concerned. For doing so, it will be necessary to

FUNDAMENTALS OF ACCOUNTING 4.13


INVENTORIES

take into account the goods that have come in (purchases and sales returns) and those that
have gone out (sales and purchase returns) during the interval between the close of the year
and date of actual stock taking. Further, the adjustment of all goods must be on the basis of
cost. Suppose, a firm that closes its books on 31st December, carried out the stock taking on the
7th January next year and actual stock was of the cost of Rs. 78,500, during the period January
1 to 7 purchases were Rs. 15,300 and sales Rs. 25,000, the mark up being 25% on cost. The
stock on 31st December would be Rs. 83,200 as shown below:
Rs.
Stock ascertained on January 7 78,500
Less : Purchases during the period Jan. 1 to 7 15,300
63,200
Add : Cost of goods sold during the period :
25,000 × (100/125) 20,000
83,200
Illustration 6
From the following particulars ascertain the value of stock as on 31st March, 2006:
Rs.
Stock as on 1.4.2005 14,250
Purchases 76,250
Manufacturing Expenses 15,000
Selling Expenses 6,050
Administrative Expenses 3,000
Financial Charges 2,150
Sales 1,24,500
At the time of valuing stock as on 31st March, 2005, a sum of Rs. 1,750 was written off on a
particular item, which was originally purchased for Rs. 5,000 and was sold during the year of
Rs. 4,500. Barring the transaction relating to this item, the gross profit earned during the year
was 20 percent on sales.

4.14 COMMON PROFICIENCY TEST


Solution
Statement of Stock in Trade as on 31st March, 2006
Rs. Rs.
Stock as on 31st March, 2005 14,250
Less : Book Value of abnormal stock
(Rs. 5,000 - 1,750) 3,250 11,000
Add : Purchases 76,250
Manufacturing Expenses 15,000
1,02,250
Less : Cost of Sales :
Sales as per books 1,24,500
Less : Sales of abnormal item 4,500
1,20,000
Less : Gross Profit @ 20% 24,000 96,000
Stock in trade as on 31st March, 2006 6,250
Illustration 7
A trader prepared his accounts on 31st March, each year. Due to some unavoidable reasons,
no stock taking could be possible till 15th April, 2006 on which date the total cost of goods in
his godown came to Rs. 50,000. The following facts were established between 31st March and
15th April, 2006.
(i) Sales Rs. 41,000 (including cash sales Rs. 10,000)
(ii) Purchases Rs. 5,034 (including cash purchases Rs. 1,990)
(iii) Sales Return Rs. 1,000.
Goods are sold by the trader at a profit of 20% on sales.
You are required to ascertain the value of Inventory as on 31st March, 2006.
Solution
Statement of Valuation of Stock on 31st March, 2006
Rs. Rs.
Value of stock as on 15th April, 2006 50,000
Add : Cost of sales during the period from 31st
March, 2006 to 15th April, 2006
Sales (Rs. 41,000 - Rs. 1,000) 40,000
Less : Gross Profit (20% of Rs. 40,000) 8,000 32,000
82,000
Less : Purchases during the period from 31st
March, 2006 to 15th April, 2006 5,034
76,966

FUNDAMENTALS OF ACCOUNTING 4.15


INVENTORIES

Illustration 8
Stock taking for the year ended 30th September, 2005 was completed by 10th October 2005,
the valuation of which showed a stock figure of Rs. 1,67,500 at cost as on the completion date.
After the end of the accounting year and till the date of completion of stock taking, sales for the
next year were made for Rs. 6,875, profit margin being 33.33 per cent on cost. Purchases for
the next year included in the stock amounted to Rs. 9,000 at cost less trade discount 10 percent.
During this period, goods were added to stock of the mark up price of Rs. 300 in respect of
sales returns. After stock taking it was found that there were certain very old slow moving
items costing Rs. 1,125, which should be taken at Rs. 525 to ensure disposal to an interested
customer. Due to heavy floods, certain goods costing Rs. 1,550 were received from the supplier
beyond the delivery date of customer. As a result, the customer refused to take delivery and
net realisable value of the goods was estimated to be Rs. 1,250 on 30th September. Compute
the value of stock for inclusion in the final accounts for the year ended 30th September, 2005.
Solution
Statement showing the valuation of stock
as on 30th September, 2005
Rs.
A Value of Stock as on 10th October 1,67,500
B Add: Cost of sales after 30th September till stock taking (Rs. 6,875 - Rs. 1,719) 5,156
C Less: Purchases for the next period (net) 8,100
D Less: Cost of Sales Returns 225
E Less: Loss on revaluation of slow moving inventories 600
F Less: Reduction in value on account of default 300
G Value of Stock on September 30 1,63,431
Note: Profit margin of 33.33 per cent on cost means 25 per cent on sale price.
Illustration 9
The following are the details of a spare part of Sriram mills:
1-1-2006 Opening stock Nil
1-1-2006 Purchases 100 units @ Rs. 30 per unit
15-1-2006 Issued for consumption 50 units
1-2-2006 Purchases 200 units @ Rs. 40 per unit
15-2-2006 Issued for consumption 100 units
20-2-2006 Issued for consumption 100 units
Find out the value of stock as on 31-3-2006 if the company follows First in first out basis

4.16 COMMON PROFICIENCY TEST


Solution
First-in-First out basis
Sriram Mills
Calculation of the value of stock as on 31-3-2006
Receipts Issues Balance
Date Units Rate Amount Units Rate Amount Units Rate Amount
Rs. Rs. Rs. Rs. Rs. Rs.
1-1-2006 Balance Nil
1-1-2006 100 30 3,000 100 30 3,000
15-1-2006 50 30 1,500 50 30 1,500
1-2-2006 200 40 8,000 50 30 1,500
200 40 8,000
15-2-2006 50 30 1,500 150 40 6,000
50 40 2,000
20-2-2006 100 40 4,000 50 40 2,000

Therefore, the value of stock as on 31-3-2006: 50 units @ Rs. 40 = Rs. 2,000


Illustration 10
The following are the details of a spare part of Sriram mills:
1-1-2006 Opening stock Nil
1-1-2006 Purchases 100 units @ Rs. 30 per unit
15-1-2006 Issued for consumption 50 units
1-2-2006 Purchases 200 units @ Rs. 40 per unit
15-2-2006 Issued for consumption 100 units
20-2-2006 Issued for consumption 100 units
Find out the value of stock as on 31-3-2006 if the company follows Weighted Average basis.

FUNDAMENTALS OF ACCOUNTING 4.17


INVENTORIES

Solution
Weighted Average basis
Sriram Mills
Calculation of the value of stock as on 31-3-2006
Receipts Issues Balance
Date Units Rate Amount Units Rate Amount Units Rate Amount
Rs. Rs. Rs. Rs. Rs. Rs.
1-1-2006 Balance Nil
1-1-2006 100 30 3,000 100 30 3,000
15-1-2006 50 30 1,500 50 30 1,500
1-2-2006 200 40 8,000 250 38 9,500
15-2-2006 100 38 3,800 150 38 5,700
20-2-2006 100 38 3,800 50 38 1,900
Therefore, the value of stock as on 31-3-2006 = 50 units @ Rs. 38 = Rs. 1,900
Illustration 11
From the following information find out the value of stock as on 31.3.06.
1. Cost of Physical stock on 31.3.06 was Rs. 3,20,000.
2. Cost of stock held as consignee was Rs. 1,60,000.
3. Stock was expected to realize the normal selling price of 150 % of cost expect for the
following goods:-
a) Goods costing Rs. 20,000 were damaged and an expenditure of 10% of normal selling
price was necessary to realise normal selling price of goods.
b) Goods costing Rs. 15,000 were damaged beyond repair and were expected to realise
Rs. 2,000 only.
Solution
Valuation of Stock on 31.3.2006
Rs. Rs.
Stock as on 31.3.2006 3,20,000
Less : Stock held as consignee 1,60,000
Cost of Goods 1,60,000
Less : Reduction in value of Sock
(a) Repairable damaged goods
(10% of 150% of Rs. 20,000) 3,000
(b) Non Repairable damaged goods
(Rs. 15000-2000) 13,000 16,000
Value of Stock 1,44,000

4.18 COMMON PROFICIENCY TEST


SELF EXAMINATION QUESTIONS
I. Pick up the correct answer from the given choices (only one correct answer) :
1. The amount of purchase if
Cost of goods sold is Rs.80,700
Opening stock Rs.5,800
Closing stock Rs.6,000
(a) Rs.80,500 (b) Rs.74,900 (c) Rs.74,700 (d) Rs.80,900.
2. Average Stock = Rs 12,000. Closing stock is Rs 3,000 more than opening stock. The value
of closing stock = ______.
a. Rs 12,000 b. Rs 24,000 c. Rs 10,500 d. Rs 13,500.
3. If the profit is 25% of the cost price then it is
(a) 25% of the sales price (b) 33% of the sales price
(c) 20% of the sales price (d) 15% of the sales price.
4. Goods purchased Rs 1,00,000. Sales Rs 90,000. Margin 20% on cost. Closing Stock = ?
(a) (10,000) (b) 10,000 (c) 25,000 (d) 28,000
5. A company is following weighted average cost method for valuing its inventory. The
details of its purchase and issue of raw-materials during the week are as follows:
1.12.2005 opening stock 50 units value Rs.2,200.
2.12.2005 purchased 100 units @Rs.47.
4.12.2005 issued 50 units.
5.12.2005 purchased 200 units @Rs.48.
The value of inventory at the end of the week and the unit weighted average costs is
(a) Rs.14200 – 47.33 (b) Rs.14300 – 47.67
(c) Rs.14000 – 46.66 (d) Rs.14400 – 48.00
6. The books of T Ltd. revealed the following information:
Particulars Rs.
Opening inventory 6,00,000
Purchases during the year 200302004 34,00,000
Sales during the year 2003-2004 48,00,000
On March 31, 2004, the value of inventory as per physical stock-taking was Rs.3,25,000.
The company’s gross profit on sales has remained constant at 25%. The management of
the company suspects that some inventory might have been pilfered by a new employee.
What is the estimated cost of missing inventory?

FUNDAMENTALS OF ACCOUNTING 4.19


INVENTORIES

(a) Rs. 75,000 (b) Rs. 25,000 (c) Rs.1,00,000 (d) Rs.1,50,000.

7. The books of B Ltd. revealed the following information:


Particulars Rs.
Opening inventory 6,00,000
Purchases during the year 2004-2005 34,00,000
Sales during the year 2004-2005 48,00,000
On March 31, 2005, the value of inventory as per physical stock-taking was Rs.3,25,000.
The company’s gross profit on sales has remained constant at 25%. The management of
the company suspects that some inventory might have been pilfered by a new employee.
What is the estimated cost of missing inventory?
(a) Rs.75,000 (b) Rs.25,000 (c) Rs.1,00,000 (d) Rs.1,50,000.
8. C Ltd. recorded the following information as on March 31, 2005:
Rs.
Stock as on April 01, 2004 80,000
Purchases 1,60,000
Sales 2,00,000
It is noticed that goods worth Rs.30,000 were destroyed due to fire. Against this, the
insurance company accepted a claim of Rs.20,000.
The company sells goods at cost plus 33 1/3 %. The value of closing inventory, after
taking into account the above transactions is,
(a) Rs.10,000 (b) Rs.30,000 (c) Rs.1,00,000 (d) Rs.60,000.
9. If the goods purchased are in transit, then the journal entry at the end of the period will be
(a) Goods-in-transit A/c Dr.
To Supplier’s A/c
(b) Goods-in-transit A/c Dr.
To Purchases A/c
(c) Stock A/c Dr.
To Good-in-transit A/c
(d) Supplier’s A/c Dr.
To Goods-in-transit
10. D Company, a dealer in cosmetics, records its inventory under first-in-first-out method, so
as to minimize accumulation of outdated stock. The opening stock as on September 01,
2005 is 150 units at the rate of Rs.20 per unit. The purchases and sales made during the
month are:

4.20 COMMON PROFICIENCY TEST


Purchases:
Date No. of units Cost price per unit
04-09-2005 200 Rs.25
14-09-2005 100 Rs.22
Sales:
Date No. of units
03-09-2005 100
10-09-2005 150
With effect from September 01, 2005, the company decided to change the method of
inventory valuation from the FIFO method to LIFO method. The change in the value of
inventory consequent upon the change in the method of valuation is
(a) Increase in the value of closing stock by Rs.250.
(b) Decrease in the value of closing stock by Rs.250.
(c) Increase in the value of closing stock by Rs.500.
(d) Decrease in the value of closing stock by Rs.500.
11. E Ltd., a dealer in second-hand cars has the following five vehicles of different models and
makes in their stock at the end of the financial year 2004-2005:
Car Fiat Ambassador Maruti Esteem Maruti 800 Zen
Cost 90,000 1,15,000 2,75,000 1,00,000 2,10,000
Net realizablevalue (Rs.) 95,000 1,55,000 2,65,000 1,25,000 2,00,000
The value of stock included in the balance sheet of the company as on March 31, 2005 was
(a) Rs.7,62,500
(b) Rs.7,70,000
(c) Rs.7,90,000
(d) Rs.8,70,000.
12. On April 07, 2005, i.e, a week after the end of the accounting year 2004-05, a company
undertook physical stock verification. The value of stock as per physical stock verification
was found to be Rs.35,000.
The following details pertaining to the period April 01, 2005 to April 07, 2005 are given:
I. Goods costing Rs.5,000 were sold during the week.
II. Goods received from consignor amounting to Rs.4,000 included in the value of stock.
III. Goods earlier purchased but returned during the period amounted to Rs.1,000.
IV. Goods earlier purchased and accounted but not received Rs.6,000.

FUNDAMENTALS OF ACCOUNTING 4.21


INVENTORIES

After considering the above, the value of stock held as on March 31, 2005 was
(a) Rs.27,000 (b) Rs.19,000 (c) Rs.43,000 (d) Rs.51,000.
13. While finalizing the current year’s profit, the company realized that there was an error in
the valuation of closing stock of the previous year. In the previous year, closing stock was
valued more by Rs.50,000. As a result
(a) Previous year’s profit is overstated and current year’s profit is also overstated
(b) Previous year’s profit is understated and current year’s profit is overstated
(c) Previous year’s profit is understated and current year’s profit is also understated
(d) Previous year’s profit is overstated and current year’s profit is understated
14. The total cost of goods available for sale with a company during the current year is
Rs.12,00,000 and the total sales during the period are Rs.13,00,000. If the gross profit margin
of the company is 33 1/3% on cost, the closing inventory during the current year is
(a) Rs.4,00,000 (b) Rs.3,00,000 (c) Rs.2,25,000 (d) Rs.2,60,000.
15. A company follows weighted average cost method for the valuation of its inventory. The
details of purchase and issue of raw-materials pertaining to the company during the week
April 01, 2006 to April 07, 2006 are as follows:
Date Particulars Purchases (Units) Issues (Units) Rate per Unit (Rs.)
April 01 Opening stock 50 44
April 02 100 47
April 04 50 -
The value of inventory at the end of the week under weighted average method is
(a) Rs.4,600 (b) Rs.4,550 (c) Rs.4,700 (d) Rs.4,400.
16. Consider the following information pertaining to G & Sons as on March 31, 2005:
Particulars Rs.
Opening inventory 15,00,000
Purchases during the year 2004-05 45,00,000
Sales during the year 2004-05 50,00,000
As per physical inventory taken on March 31, 2005 the closing inventory was Rs.20,90,000.
Gross profit on sales has remained constant at 25%. The management of the firm suspects
that some inventory might have been taken away by a new employee. The estimated cost
of missing inventory on the close of the financial year and the cost of goods sold during
the year, respectively are
(a) Rs.2,65,000; Rs.37,50,000 (b) Rs.2,10,000; Rs.39,10,000
(c) Rs.1,75,000; Rs.50,00,000 (d) Rs.1,60,000; Rs.37,50,000.

4.22 COMMON PROFICIENCY TEST


17. S Ltd. follows perpetual inventory system. On March 31 of every year, the company
undertakes physical stock verification. On March 31, 2004, the value of stock as per the
records differed from the value as per the physical stock. On scrutiny, the following
differences were noticed:
Goods purchased for Rs.10,000 were received and included in the physical stock but no
entry was made in the books.
Goods costing Rs.30,000 were sold and entered in the books but the stock is yet to be
delivered.
Goods worth Rs.5,000 are returned to the suppliers but is omitted to be recorded.
If the inventory is valued in the books at Rs.1,50,000, the value of the physical inventory is
(a) Rs.1,11,000 (b) Rs.1,89,000 (c) Rs.1,85,000 (d) Rs.1,59,000.

18. Consider the following data pertaining to H Ltd. for the month of March 2005:
Particulars As on March 01, 2005 (Rs.) As on March 31, 2005 (Rs.)
Stock 1,80,000 90,000
The company made purchases amounting Rs. 3,30,000 on credit. During the month of
March 2005, the company paid a sum of Rs.3,50,000 to the suppliers. The goods are sold
at 25% above the cost. The sales for the month of March 2005 were
(a) Rs.4,12,500 (b) Rs.5,25,000 (c) Rs.90,000 (d) Rs.3,15,000.
19. Consider the following data pertaining to a company for the month of March 2005:
Particulars Rs.
Opening stock 22,000
Closing stock 25,000
Purchases less returns 1,10,000
Gross profit margin (on sales) 20%
The sales of the company during the month are
(a) Rs.1,41,250 (b) Rs.1,35,600 (c) Rs.1,33,750 (d) Rs.1,28,400.
20. Consider the following data pertaining to N Ltd. for the month of March 2005:
Date Purchases Issues Balance
Quantity Rate Quantity Quantity Rate
(kg.) (Rs.) (Kg.) (Kg.) (Rs.)
01-03-2005 500 22.80
02-03-2005 400 24
10.03-2005 600 25
25-03-2005 1,000

FUNDAMENTALS OF ACCOUNTING 4.23


INVENTORIES

If the company uses weighted average method for inventory valuation, the value of
inventory as on March 31, 2005 is
(a) Rs.11,967 (b) Rs.12,000 (c) Rs.12,500 (d) Rs.11,400.
21. O Ltd. maintains the inventory records under perpetual system of inventory. Consider the
following data pertaining to inventory of O Ltd. held for the month of March 2005:
Date Particulars Quantity Cost Per unit(Rs.)
Mar. 1 Opening Inventory 15 400
Mar. 4 Purchases 20 450
Mar. 6 Purchases 10 460
If the company sold 32 units on March 24, 2005, closing inventory under FIFO method is
(a) Rs.5,200 (b) Rs.5,681 (c) Rs.5,800 (d) Rs.5,950.
22. Consider the following data pertaining to R Ltd. for the month of June 2004:
Particulars Rs.
Opening stock 30,000
Closing stock 40,000
Purchases 5,60,000
Returns outward 15,000
Returns inward 20,000
Carrige inward 5,000
If the gross profit is 20% of net sales, the gross sales for the month of June 2004 is
(a) Rs.6,95,000 (b) Rs.6,75,000 (c) Rs.5,40,000 (d) Rs.6,68,750.
23. Consider the following for Q Co. for the year 2005-06:
Cost of goods available for sale Rs.1,00,000
Total sales Rs. 80,000
Opening stock of goods Rs. 20,000
Gross profit margin 25%
Closing stock of goods for the year 2005-06 was
(a) Rs.80,000 (b) Rs.60,000 (c) Rs.40,000 (d) Rs.36,000.
24. Consider the following data pertaining to credit purchases made by K Ltd., a dealer in
electronic goods, for the month of March 2005:
Date Particulars No. of units Rate per unit Rs. Trade Discount
March 01 Black & White TVs 50 3,000 10%
Colour TVs 10 6,000 10%
March 09 Tape Recorders 10 1,000 10%
Two-in-one 10 1,500 10%
March 19 Audio Cassettes 100 30 5%

4.24 COMMON PROFICIENCY TEST


On March 22, 2005, the company purchased from LM Stationers on credit for office use
10 dozens of carbon papers at the rate of Rs.35 per dozen and 10 dozens of ball pens at
the rate of Rs.25 per dozen.
At the time of making payment on March 31, 2005, the suppliers have allowed a cash
discount of 10% on the above purchases.
The total of purchases for the month of March 2005, was
(a) Rs.2,14,350 (b) Rs.2,38,000 (c) Rs.1,92,915 (d) Rs.2,38,600
II From the given information, choose the most appropriate answer:
1. Hindustan Ltd. has furnished the following details :
Date Particulars Units Rate (Rs.)
01.03.2006 Opening stock 100 1.75
05.03.2006 Purchased 150 1.50
12.03.2006 Purchased 300 1.60
08.03.2006 Issued 200 -
18.03.2006 Issued 250 -
(i) What is the value of closing stock using FIFO method :
(a) Rs 170 (b) Rs 160 (c) Rs 150 (d) Rs 180
(ii) Using the information given in the problem, the value of issues using FIFO method :
(a) Rs 700 (b) Rs 580 (c) Rs 605 (d) Rs 720
(iii) Using the information given in problem, the value of closing stock as per LIFO
method :
(a) Rs 172.50 (b) Rs 225 (c) Rs 160 (d) Rs 167.50
(iv) Using the information given in problem, the value of issues using LIFO method :
(a) Rs 612.50 (b) Rs 515.50 (c) Rs 620 (d) Rs 575.50
(v) Using the information given in problem, the value of closing stock as per weighted
average method :
(a) Rs 160 (b) Rs 175.50 (c) Rs 150 (d) Rs 225.50
(vi) Using the information given in problem, the value of issues using weighted average
method :
(a) Rs 600.50 (b) Rs 580 (c) Rs 620 (d) Rs 720
2. Bharat Indian Oil is a bulk distributor of petrol. A periodic inventory of petrol on hand is
taken when the books are closed at the end of each month. The following summary of
information is available for the month :
Sales Rs.9,45,000

FUNDAMENTALS OF ACCOUNTING 4.25


INVENTORIES

General administration cost Rs.25,000


Opening Stock: 1,00,000 litres @ Rs.3 per litre Rs.3,00,000
Purchases (including freight inward):
June 1 2,00,000 litres @ Rs.2.85 per litre
June 30 1,00,000 litres @ Rs.3.03 per litre
June 30 Closing stock 1,30,000 litres
(i) Compute the value of inventory on June 30 using FIFO method of inventory costing.
(a) Rs 3,88,500 (b) Rs 4,18,500 (c) Rs 2,58,000 (d) Rs 3,60,500
(ii) Using the information given in problem, compute the amount of cost of goods sold
for June using FIFO principle.
(a) Rs 784,500 (b) Rs 685,000 (c) Rs 388,500 (d) Rs 758,000
(iii) Compute the Profit or loss for June using FIFO method of inventory costing.
(a) Rs 160,000 (b) Rs 115,500 (c) Rs 125,000 (d) Rs 135,500
(iv) Compute the value of inventory on June 30 using weighted average method of
inventory costing.
(a) Rs 3,75,000 (b) Rs 3,90,000 (c) Rs 2,80,000 (d) Rs 4,10,000
(v) Using the information given in problem, compute the amount of cost of goods sold
for June using weighted average method.
(a) Rs 8,15,000 (b) Rs 7,52,000 (c) Rs 7,83,000 (d) Rs 6,79,000
(vi) Compute the Profit or loss for June using weighted average method of inventory
costing.
(a) Rs 1,20,000 (b) Rs 2,15,000 (c) Rs 1,37,000 (d) Rs 129,000
(vii) Compute the value of inventory on June 30 using LIFO method of inventory costing.
(a) Rs 3,93,000 (b) Rs 3,69,000 (c) Rs 2,97,000 (d) Rs 4,18,000
(viii)Using the information given in problem, compute the amount of cost of goods sold
for June using LIFO principle.
(a) Rs 7,80,000 (b) Rs 6,75,000 (c) Rs 8,15,000 (d) Rs 7,95,000
(ix) Compute the Profit or loss for June using LIFO method of inventory costing.
(a) Rs 1,95,500 (b) Rs 165,000 (c) Rs 1,40,000 (d) Rs 1,95,000

4.26 COMMON PROFICIENCY TEST


3. The following are the details supplied by Agni Ltd. in respect of its raw materials for the
Month of December, 2005 :
Date Receipts Issues
(Units) Price per unit (Rs.) (Units)
01.12.2005 2,000(Opening) 5.00
07.12.2005 1,000 6.00
10.12.2005 - - 2,500
15.12.2005 2,000 6.50
31.12.2005 - - 2,200
On 31.12.2005, a shortage of 100 units was found.
(i) Find the value of closing stock using LIFO principle.
(a) Rs 1,900 (b) Rs 2,400 (c) Rs 2,000 (d) Rs 1,000
(ii) Using the data given in problem, the value of issues in the month of December 2005
using LIFO principle.
(a) Rs 35,000 (b) Rs 28,000 (c) Rs 20,000 (d) Rs 65,000
(iii) Using the data given in problem, the value of closing stock using FIFO principle.
(a) Rs 1,600 (b) Rs 1,500 (c) Rs 1,300 (d) Rs 2,000
(iv) Using the data given in problem, the value of issues in the month of December 2005
using FIFO method.
(a) Rs 27,700 (b) Rs 35,500 (c) Rs 19,500 (d) Rs 21,300
(v) Using the data given in problem , the value of closing stock using simple average
principle.
(a) Rs 950 (b) Rs 875 (c) Rs 1,000 (d) Rs 1,300
(e) Rs 750
(vi) Using the data given in problem, the value of issues in the month of December 2005
using simple average method.
(a) Rs 15,385 (b) Rs 21,675 (c) Rs 19,750 (d) Rs 28,125
4. X who was closing his books on 31.03.2006 failed to take the actual stock which he did on
9th April, when it was ascertained by him to be worth Rs 25,000.
It was found that sales are entered in the Sales Day Book on the same day of despatch and
the returns inward in the returns book as and when the goods are received back. Purchases
are entered in the Purchase Day Book once the invoices are received. Observations -
i. Sales between 31st March and 9th April as per Sales Book are Rs 1,720. Rate of gross
profit is 33 1/3 % on cost.

FUNDAMENTALS OF ACCOUNTING 4.27


INVENTORIES

ii. Purchases during the same period as per Purchases Book are Rs 120.
iii. Out of above purchases, goods amounting to Rs 50 were not received until after the
stock was taken.
iv. Goods invoiced during the month of March, but goods received only on 4th April,
amounted to Rs 100.
You want to find the value of physical stock on 31st March. You start with the value of
stock on 9th April.
(i) How would you adjust the observation # 1?
(a) 1,720 (Less) (b) 1,290 (Less) (c) 430 (d) 1,290 (Add)
(ii) How would you adjust the observation # 2?
(a) 120 (Less) (b) 170 (Less) (c) 50 (d) 120 (Add)
(iii) How would you adjust the observation # 3?
(a) 70 (Less) (b) 50 (Less) (c) 120 (d) 50 (Add)
(iv) How would you adjust the observation # 4?
(a) 100 (Add) (b) 150 (Less) (c) 100 (Less) (d) 150 (Add)
(v) Value of physical stock on 31st March = _______.
(a) 26,320 (b) 26,120 (c) 6,190 (d) 23,530
5. Physical verification of stock was done on 23rd june. the value of stock was rs 4,80,000.
following transactions took place between 23rd june and 30th june –
1. Out of goods sent on consignment, goods costing Rs 24,000 were unsold.
2. Purchases of Rs 40,000 were made, out of which goods worth Rs 16,000 were delivered
on 5th July.
3. Sales were Rs 1,36,000, which include goods worth Rs 32,000 sent on approval. Half
of these goods were returned before 30th June, but no intimation is available regarding
the remaining goods. Goods are sold at cost plus 25%. However, goods costing Rs24,000
had been sold for Rs12,000.
You want to determine the value of stock on 30th June. You start with physical stock on
23rd June.
(i) What will you do regarding adjustment # 1?
a. 24,000 (Add) b. 24,000 (less)
c. 48,000 (Add) d. 48,000 (Less)
(ii) What will you do regarding adjustment # 2?
a. 24,000 (Add) b. 16,000 (Add)
c. 40,000 (Add) d. 40,000 (Less)

4.28 COMMON PROFICIENCY TEST


(iii) Normal Sales = ______.
a. 1,36,000 b. 1,24,000 c. 1,48,000 d. 92,000
(iv) Cost of Normal Sales = _______.
a. 73,600 b. 80,000 c. 1,08,800 d. 99,200
(v) What will you do regarding adjustment # 3?
a. 73,600 (Add) b. 24,000 (lAdd) c. 97,600 (Less) d. Both (a) and (b)
(vi) Value of stock on 30th June = ________.
a. 4,80,000 b. 5,44,000 c. 4,36,000 d. 4,46,400
III. MATCH THE FOLLOWING ITEMS FROM COLUMN A WITH COLUMN B
S. No. Column A Column B
1. Under FIFO method, in times of (a) valuation of inventory is based on the
rising prices, the cost of goods assumption that costs are charged against
produced is revenue in the order in which they occur
2. Under FIFO method (b) Raw-materials, work-in-process, finished
goods, consumables and loose tools
3. If the opening inventory is (c) Unduly low
understated and closing
inventory is overstated,
4. Inventory consists of (d) The profit will increase and currents asset
will also increase

IV. Choose the correct answer(more than one)


1. Which of the following is false?
(a) The value of ending inventory under simple average price method is realistic
(b) Usually profit or loss will not arise out of pricing the issues on the basis of simple
average price method
(c) The value of stock is shown on the assets side of the balance-sheet as fixed assets
(d) Opening stock plus purchases minus cost of goods sold is the value of closing
stock.
2. Under inflationary conditions, which of the methods will not show highest value of
closing stock?
(a) FIFO (b) LIFO
(c) Weighted Average (d) None of the above

FUNDAMENTALS OF ACCOUNTING 4.29


INVENTORIES

3. Under inflationary conditions, which of the methods will not show lowest value of
closing stock?
(a) FIFO (b) LIFO
(c) Weighted Average (d) All of the above
4. Under inflationary conditions, which of the methods will not show greatest value of
cost of goods sold?
(a) FIFO (b) LIFO
(c) Weighted Average (d) None of the above
5. Under inflationary conditions, which of the methods will not show lowest value of
cost of goods sold?
(a) FIFO (b) LIFO
(c) Weighted Average (d) All of the above

ANSWERS
I.
1. (d) 2. (d) 3. (c) 4. (c) 5. (a) 6. (a) 7. (a)
8. (d) 9. (b) 10. (b) 11. (b) 12. (c) 13. (d) 14. (c)
15. (a) 16. (d) 17. (c) 18. (b) 19. (c) 20. (b) 21. (d)
22. (a) 23. (c) 24. (a)
II.
1.
(i) (b) (ii) (d) (iii) (d) (iv) (a) (v) (a) (vi) (d)
2.
(i) (a) (ii) (a) (iii) (d) (iv) (b) (v) (c) (vi) (c)
(vii) (a) (viii) (a) (ix) (c)
3.
(i) (d) (ii) (b) (iii) (c) (iv) (a) (v) (b) (vi) (d)
4.
(i) (d) (ii) (a) (iii) (d) (iv) (c) (v) (b)
5.
(i) (a) (ii) (c) (iii) (d) (iv) (a) (v) (c) (vi) (d)
III.
1. (c); 2 (a), 3 (d), 4 (b)
IV.
1. (a),(b)&(d), 2. (b)&(c), 3. (a)&(c), 4. (a)&(c), 5. (b)&(c)

4.30 COMMON PROFICIENCY TEST


CHAPTER - 5

DEPRECIATION
ACCOUNTING
DEPRECIATION ACCOUNTING

Learning Objectives
After studying this chapter, you will be able to :

 Grasp the meaning and nature of depreciation.


 Determine the amount of depreciation from the total value of the fixed assets and its
useful life.
 Understand various methods of depreciation and learn advantages and disadvantages
of such methods.
 To calculate the amount of profit or loss resulting from the sale/ disposal of depreciable
assets.
 Familiarize with the accounting treatment for change in the method of depreciation
from Straight Line Method to Reducing Balance method.

1. INTRODUCTION
Fixed assets like plant and machinery etc. are used in the business for the purpose of production
of goods or for providing useful services in the course of production. These fixed assets are
utilized during operations of a business for a number of successive accounting periods. Value
of such fixed assets decreases with passage of time and its utilization i.e. wear and tear. Value
of portion of fixed asset utilized for generating revenue must be recovered during a particular
accounting year to ascertain true income. This portion of cost of fixed asset allocated to a
particular accounting year is called depreciation.
1.1 CONCEPT OF DEPRECIATION
Depreciation has been defined as 'the diminution in the utility or value of an asset, due to
natural wear and tear, exhaustion of the subject-matter, effluxion of time accident, obsolescence
or similar causes'. The words "accident", "obsolescence" and the phrase "effluxion of time"
included in the definition, signify that when an asset held by a business cannot be employed
for even one of the purposes for which it was acquired due to some damage suffered, the assets
having become out of date or due to no occasion having arisen for it to be used, the loss caused
to the business will be depreciation. Depreciation caused by any one of the last mentioned
factors often is described as external depreciation, to distinguish it from the natural wear and
tear of assets which is known as internal depreciation. Commonly, the word "depreciation" is
also employed to represent a fall in the market value of an asset due to fall in the price level in
the country. Since the last-mentioned type of diminution in value is the outcome of a different
set of causes, it is necessary to differentiate it from the others. But a distinction can be possible
only if we decide not to use the term 'depreciation' in two different senses and accept the
suggestion, that some accountants have made in the past to describe the diminution resulting
from the use of assets as "wear and tear or expired capital outlay.”
is a measure of wearing out, consumption or other loss of value of a depreciable
Depreciation asset arising from use, effluxion of time or obsolescence through technology
and market changes. Depreciation is allocated so as to charge a fair proportion
of the depreciable amount in each accounting period during the expected useful life of the

5.2 COMMON PROFICIENCY TEST


asset. Depreciation includes amortisation of assets whose useful life is predetermined'.
‘Depreciable are those which (i) are expected to be used during more than one accounting
Assets’ period; and (ii) have a limited useful life; and (iii) are held by an enterprise for
use in theproduction or supply of goods and services for rental to others or for
administrative purposes and not for the purpose of sale in the ordinary course of business.
The loss in the value of assets employed for carrying on a business being an essential element of
business expenditure, it is necessary to calculate the amount of such loss and to make a provision,
and therefore, arrive at the amount of profit or loss made by the business.
Basically, the cost of an asset used for purposes of business has to be written off over its economic
(not physical) life which necessarily must be estimated. A point to remember is that usually, at
the end of the economic life, an asset has some value as scrap or otherwise. The amount to be
written off in each year should be such as will reduce the book value of the asset, at the end of
its economic life to the firm, to its estimated scrap value.
A pertinent question, of course, is the price likely to prevail at the time of replacement. That is
why some people advocate the calculation of depreciation on the basis of replacement price
rather than cost.
1.2 OBJECTIVES FOR PROVIDING DEPRECIATION
Prime objectives for providing depreciation are:
(1) Correct income measurement: Depreciation should be charged for proper estimation of
periodic profit or loss.
(2) True position statement: Value of the fixed assets should be adjusted for depreciation charged
in order to depict the actual financial position.
(3) Funds for replacement: Generation of adequate funds in the hands of the business for
replacement of the asset at the end of its useful life.
(4) Ascertainment of true cost of production: For ascertaining the cost of the production, it is
necessary to charge depreciation as an item of cost of production.
Further depreciation is a non-cash expense and unlike other normal expenditure (e.g. wages,
rent, etc.) does not result in any cash outflow. Further depreciation by itself does not create
funds it merely draws attention to the fact that out of gross revenue receipts, a certain amount
should be retained for replacement of assets used for carrying on operation.

Objectives of providing
depreciation

To present true and To accumulate funds


To ascertain true To ascertain true
fair view of the for the replacement
results of operations costs of production
financial position of asset

FUNDAMENTALS OF ACCOUNTING 5.3


DEPRECIATION ACCOUNTING

2. FACTORS IN THE MEASUREMENT


Estimation of exact amount of depreciation is not easy. Generally following factors are taken
into consideration for calculation of depreciation.
1. Cost of asset including expenses for installation, commissioning, trial run etc.
2. Estimated useful life of the asset.
3. Estimated scrap value (if any) at the end of useful life of the asset.
The above mentioned factors can be explained, in detail, as follows:

Cost of Cost of a depreciable asset represents its money outlay or its


Historical

asset equivalent in connection with its acquisition, installation and


commissioning as well as for additions to or improvement
thereof.
'Useful Life' is either (i) the period over which a depreciable
Useful life of
asset is expected to be used by the enterprise or (ii) the number
the asset
of production or similar units expected to be obtained from
Estimated

the use of the asset by the enterprise. Determination of the


useful life is a matter of estimation and is normally based on
various factors including experience with similar type of
assets.
Scrap Determination of the residual value is normally a difficult
(residual) matter. If such value is considered as insignificant, it is
value normally regarded as nil. On the other hand, if the residual
Estimated

value is likely to be significant, it is estimated at the time of


acquisition/installation, or at the time of subsequent
revaluation of asset
Several other factors like estimated working hours,
production capacity, repairs and renewals, etc. are also taken
into consideration on demanding situation.
Depreciable amount of a depreciable asset is its historical
Depreciable cost, or other amount substituted for historical cost in the
amount
financial statements, less the estimated residual value.
For example, a machinery is purchased for Rs. 10,000. The residual value is
estimated at Rs. 1,000. it is estimated that the machinery will work for 5
years. The cost to be allocated as depreciation in the accounting periods
will be calculated as:
Rs.
Acquisition cost 11,000
Less: Residual value 1,000
Depreciable amount 10,000
Estimated useful life of the asset 5 years

5.4 COMMON PROFICIENCY TEST


Depreciable Amount
Depreciation =
Estimated useful life

Factors affecting the


amount of depreciation

Cost of asset Expected useful life Estimated residual


value

3. METHODS FOR PROVIDING DEPRECIATION


Generally, methods for providing depreciation are based on formula, developed on a study of
the behaviour of the assets over a period of years for readily computing the amount of
depreciation suffered by different forms of assets. Each of the methods, however, should be
applied only after carefully considering nature of the asset and the conditions under which it
is being used.
The two most common methods for providing depreciation are the Straight Line Method and
the Reducing Balance Method. The Straight Line Method is the most suitable and accurate
method to adopt in most cases. The Income Tax Rules, however, prescribe the Reducing Balance
Method except in the case of assets of an undertaking engaged in generation and distribution
of power.
3.1 STRAIGHT LINE METHOD
According to this method, an equal amount is written off every year during the working life on
an asset so as to reduce the cost of the asset to nil or its residual value at the end of its useful life.
The advantage of this method is that it is simple to apply and gives accurate results especially
in case of leases, patents and copy rights, and also in case of plant and machinery. Calculation
of depreciation for additions to plant and machinery may be a complicated affair unless different
classes of machines are classified separately in a plant register based on year of additions. This
method is also known as Fixed Instalment Method.
Cost of Asset - Scrap V alue
Straight Line Depreciation =
Useful life
Straight Line Depreciation × 100
Straight Line Depreciation Rate =
Cost of Asset

The underlying assumption of this method is that the particular asset generates equal utility
during its lifetime. But this cannot be true under all circumstances. The expenditure incurred
on repairs and maintenance will be low in earlier years, whereas the same will be high as the
asset becomes old. Apart from this the asset may also have varying capacities over the years,

FUNDAMENTALS OF ACCOUNTING 5.5


DEPRECIATION ACCOUNTING

indicating logic for unequal depreciation provision. However, many assets have insignificant
repairs and maintenance expenditures for which straight line method can be applied.
3.2 REDUCING BALANCE METHOD
Under this system, a fixed percentage of the diminishing value of the asset is written off each
year so-as to reduce the asset to its break - up value at the end of its life, repairs and small
renewals being charged to revenue. This method is commonly used for plant, fixtures, etc.
Under this method, the annual charge for depreciation decreases from year to year, so that the
earlier years suffer to the benefit of the later years. Also, under this method, the value of asset
can never be completely extinguished, which happens in the earlier explained Straight Line
Method. However, it is very simple to operate. The other advantage of this method is that the
total charge to revenue is uniform when the depreciation is high, repairs are negligible; and as
the repairs increase, the burden of depreciation gets lesser and lesser. On the other hand,
under the Straight Line Method, the charge for depreciation is constant, while repairs tend to
increase with the life of the asset. Among the disadvantages of this method is the danger that
too low a percentage may be adopted as depreciation with the result that over the life of the
asset full depreciation may not be provided; also if assets are grouped in such a way that
individual assets are difficult to identify, the residue of an asset may lie in the asset account
even after the asset has been scrapped. The last mentioned difficulty could be, however, over
come if a Plant register is maintained.
The rate of depreciation under this method may be determined by the following formula:

Re sidual Value
1− n × 100
Cost of asset
where, n = useful life
Accounting Entries under Straight Line and Reducing Balance Methods :
There are two alternative approaches for recording accounting entries for depreciation.
First Alternative
A provision for depreciation account is opened to accumulate the balance of depreciation and
the assets are carried at historical cost.
Accounting entry
Profit and Loss Account Dr.
To Provision for Depreciation Account
Second Alternative:
Amount of Depreciation is credited to the Asset Account every year and the Asset Account is
carried at historical cost less depreciation.
Accounting entries:
Depreciation Account Dr.
To Asset Account
Profit and Loss Account Dr.
To Depreciation Account

5.6 COMMON PROFICIENCY TEST


Illustration 1
Jain Bros. acquired a machine on 1st July, 2004 at a cost of Rs. 14,000 and spent Rs. 1,000 on its
installation. The firm writes off depreciation at 10% of the original cost every year. The books
are closed on 31st December every year. Show the Machinery Account and Depreciation Account
for the year 2004-2005.
Solution
As per Straight Line Method
Machinery Account
Dr. Cr.
2004 Rs. 2004 Rs.
July 1 To Bank 14,000 Dec. 31 By Depreciation A/c
July 1 To Bank- Installation 10% on Rs. 15,000 for 750
Expenses 1,000 6 Months
Dec. 31 By Balance c/d 14,250
15,000 15,000
2005 2005
Jan. 1 To Balance b/d 14,250 Dec. 31 By Depreciation A/c
10% on Rs. 15,000 1,500
Dec. 31 By Balance c/d 12,750
14,250 14,250

Depreciation Account
2004 Rs. 2004 Rs.
Dec. 31 To Machinery A/c 750 Dec. 31 By Profit & Loss A/c 750
2005 2005
Dec. 31 To Machinery A/c 1,500 Dec. 31 By Profit & Loss A/c 1,500

Illustration 2
Jain Bros. acquired a machine on 1st July, 2004 at a cost of Rs. 14,000 and spent Rs. 1,000 on its
installation. The firm writes off depreciation at 10% every year. The books are closed on 31st
December every year. Show the Machinery Account and calculation of depreciation on
diminishing balance method for the year 2004-2005.

FUNDAMENTALS OF ACCOUNTING 5.7


DEPRECIATION ACCOUNTING

Solution
As per Reducing Balance Method
Machinery Account
2004 Rs. 2004 Rs.
July 1 To Bank 14,000 Dec. 31 By Depreciation A/c 750
To Bank 1,000 Dec. 31 By Balance c/d 14,250
15,000 15,000
2005 2005
Jan. 1 To Balance b/d 14,250 Dec. 31 By Depreciation A/c 1,425
Dec. 31 By Balance c/d 12,825
14,250 14,250

3.3 SUM OF YEARS OF DIGITS METHOD


It is variation of the "Reducing Balance Method". In this case, the annual depreciation is
calculated by multiplying the original cost of the asset less its estimated scrap value by the
fraction represented by :
The number of years (including the present year) of remaining life of the asset
Total of all digits of the life of the asset (in years)
Suppose the estimated life of an asset is 10 years; the total of all the digits from 1 to 10 is 55
i.e.,10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1, or by the formula:

n(n + 1) 10 × 11
=
2 2
= 55
The depreciation to be written off in the first year will be 10/55 of the cost of the asset less
estimated scrap value; and the depreciation for the second year will be 9/55 of the cost of asset
less estimated scrap value and so on.
The method is not yet in vogue in india; and its advantages are the same as those of the Reducing
Balance Method.
Illustration 3
M/s Raj & Co. purchased a machine for Rs. 1,00,000. Estimated useful life and scrap value
were 10 years and Rs. 12,000 respectively. The machine was put to use on 1.1.2000. Show
Machinery Account and Depreciation Account in their books for 2005 by using sum of years
digits method.

5.8 COMMON PROFICIENCY TEST


Solution
In the books of M/s Raj & Co.
Machinery Account
Dr. Cr.
2005 Rs. 2005 Rs.
Jan. 1 To Balance b/d 36,000 Dec. 31 By Depreciation A/c 8,000
Dec. 31 By Balance c/d 28,000
36,000 36,000
2006
Jan.1 To Balance b/d 28,000

Depreciation Account
2005 Rs. 2005 Rs.
Dec. 31 To Machinery A/c 8,000 Dec. 31 By P & L A/c 8,000
8,000 8,000

Working Notes :
(1) Total of sum of digit of depreciation for 2000-2004
10 + 9 + 8 + 7 + 6
= (Rs. 1,00,000 - Rs. 12,000) ×
10(10 + 1)
2
40
= Rs. 88,000 × = Rs. 64,000
55
(2) Written down value as on 1-1-2004
= Rs. 1,00,000 - Rs. 64,000 = Rs. 36,000
(3) Depreciation for 2005
5
= (Rs. 1,00,000 - Rs. 12,000) × = Rs. 8,000.
55
3.4 ANNUITY METHOD
This is a method of depreciation which also takes into account the element of interest on capital
outlay and seeks to write off the value of the asset as well as the interest lost over the life of the
asset. It assumes that the amount laid out in acquiring asset, if invested elsewhere, would have
earned interest which must be reckoned as part of the cost of asset. On that basis, the amount
of depreciation to be annually provided in the accounts is ascertained from the Annuity Tables,

FUNDAMENTALS OF ACCOUNTING 5.9


DEPRECIATION ACCOUNTING

to write off each year interest on the capital outlay as well as part of the capital sum at a rate
that the whole of the capital sum and interest accruing thereon would be written off over the
life of the asset. Though the amount written off annually is constant, the interest in the earlier
years being greater, only small amount of the capital outlay is written off. This proportion is
reversed with the passage of time. This method is eminently suitable for writing off the amounts
paid for long leases which involve a considerable capital outlay. It is not practicable to adopt
this method for considerable capital outlay. It is not practicable to adopt this method for writing
off depreciation of plant and machinery on account of frequent changes in the value of such
an asset which would necessitate the recalculation of the amount of depreciation to be written
off annually.
Relevant Journal entries are:
(1) For charging interest on asset account
Asset Account Dr.
To Interest Account
(2) For charging depreciation on asset
Depreciation Account Dr.
To Asset Account
(3) For transferring depreciation to Profit and Loss Account
Profit and Loss Account Dr.
To Depreciation Account
(4) For transferring interest to Profit and Loss Account
Interest Account Dr.
To Profit and Loss Account
Illustration 4
A lease is purchased on 1st January, 2002 for 4 years at a cost of Rs. 20,000. It is proposed to
depreciate the lease by the annuity method charging 5 percent interest. A reference to the
annuity table shows that to depreciate Re. 1 by annuity method over 4 years charging 5%
interest, one must write off a sum of Rs. 0.282012 [To write off Rs. 20,000 one has to write off
every year Rs. 5,640.24 i.e. 0.282012 × 20,000].
Show the Lease Account for four years and also the relevant entries in the profit and loss
account.

5.10 COMMON PROFICIENCY TEST


Solution
Lease Account
Dr. Cr.
2002 Rs. 2002 Rs.
Jan. 1 To Bank A/c 20,000.00 Dec. 31 By Depreciation A/c 5,640.24
Dec. 31 To Interest A/c By Balance c/d 15,359.76
(5% on Rs. 20,000) 1,000.00
21,000.00 21,000.00
2003 2003
Jan. 1 To Balance b/d 15,359.76 Dec.31 By Depreciation A/c 5,640.24
Dec. 31 To Interest A/c By Balance c/d 10,487.51
(5% on Rs. 15,359.76) 767.99
16,127.75 16,127.75
2004 2004
Jan. 1 To Balance b/d 10,487.51 Dec. 31 By Depreciation A/c 5,640.24
Dec. 31 To Interest A/c 524.38 Dec. 31 By Balance c/d 5,371.65
11,011.89 11,011.89
2005 2005
Jan. 1 To Balance b/d 5,371.65 Dec. 31 By Depreciation A/c 5,640.24
Dec. 31 To Interest A/c 268.59
5,640.24 5,640.24

Profit and Loss Account


2002 Rs. 2002 Rs.
Dec. 31 To Depreciation A/c 5,640.24 Dec. 31 By Interest A/c 1,000.00
2003 2003
Dec. 31 To Depreciation A/c 5,640.24 Dec. 31 By Interest A/c 767.99
2004 2004
Dec. 31 To Depreciation A/c 5,640.24 Dec. 31 By Interest A/c 524.38
2005 2005
Dec. 31 To Depreciation A/c 5,640.24 Dec. 31 By Interest A/c 268.59

FUNDAMENTALS OF ACCOUNTING 5.11


DEPRECIATION ACCOUNTING

3.5 SINKING FUND METHOD


If a large sum of money is required for replacement of an asset at the end of its effective life, it
may not be advisable to leave in the amount of depreciation set apart annually, for it may or
may not be available in the form of the readily realisable assets to the concern at the time it is
required. To safeguard this position, the amount annually provided for depreciation may be
placed to the credit of the Sinking Fund Account, and at the same time an equivalent amount
may be invested in Government securities. The interest on these securities, when received,
would be re-invested and the amount thereof would be credited to the Sinking Fund Account.
The amount of annual provision for depreciation in such a case is calculated after taking into
account interest, that the amounts annually invested shall be earning over the period these
will remain invested. When the asset is due for replacement, the securities are sold and the
new asset is purchased with the proceeds of their sale. The book value of the old asset, at the
time, is transferred to the Sinking Fund Account. Any amount realised on sale of the old asset,
as well as the profit or loss on sale of securities, is transferred to the Sinking Fund Account and
it is closed off by transfer of the balance of the Profit and Loss Account or General Reserve
The amount to be set apart annually be way of depreciation is ascertained from Sinking Fund
tables. They readily show the amount which must be invested each year to accumulate to Re.
1 at a given rate of interest within the stated period.
Relevant Journal entries are:
(1) For transfer of depreciation to Sinking Fund.
Depreciation Account Dr.
To Sinking Fund Account
(2) For charging depreciation to profit and loss account.
Profit and Loss Account Dr.
To Depreciation Account
(3) For investment of amount of depreciaition.
Sinking Fund Investment Account Dr.
To Bank Account
(4) In subsequent years, for interest earned on sinking fund investment and on investment of
the interest and depreciation.
Bank Account Dr.
To Interest on Sinking Fund Investment Account
Interest on Sinking Fund Investment Account Dr.
To Sinking Fund Account
(In addition to these entries, entries (1) and (2) will also be passed in subsequent years for
transfer of depreciation to sinking fund and for charging it to profit and loss account.)

5.12 COMMON PROFICIENCY TEST


Sinking Fund Investment Account Dr.
To Bank Account
(yearly depreciation + interest earned).
(5) For sale of sinking fund investment at the end of useful life of the asset.
Bank Account Dr.
To Sinking Fund Investment Account
If sale is at a profit
Sinking Fund Investment Account Dr.
To Sinking Fund Account
If sales is at loss
Sinking Fund Account Dr.
To Sinking Fund Investment Account
(6) For transfer of the amount to the extent of book value of the asset from asset account to
sinking fund account.
Sinking Fund Account Dr.
To Asset Account
(7) Any surplus in Sinking Fund Account may be transferred to General Reserve Account
and if any deficit, that may be transferred to Profit and Loss Account.
Sinking Fund Account Dr.
To General Reserve Account
OR
Profit and Loss Account Dr.
To Sinking Fund Account
The aforementioned method may also be operated a little differently. The amount set apart on
account of depreciation, instead of being invested annually in the purchase of government
securities may be paid out as premium on a policy maturing at the end of the life of the asset,
for an amount equal to the sum that will be required for its replacement. In that case the
amount of the premium when paid will be debited to the Policy Account instead of the
Investment Account.
Illustration 5
On 1st January, 2002, Z Limited purchased the lease of property for Rs. 10,000. The lease
would expire on 31st December, 2004. Z Ltd., decided to set up a sinking fund. The Sinking
Fund was to be credited (or debited) with an annual contribution from profit, the interest on
the investments and any profits (or losses) made on the realisation of the sinking fund
investments. The sinking fund was to be represented by specific investment, and any sums
made available to the sinking fund were to be immediately invested, except at the termination
of the fund.

FUNDAMENTALS OF ACCOUNTING 5.13


DEPRECIATION ACCOUNTING

During the three years following transactions took place:


2002 31st December: A contribution from profits of Rs. 3,200 was made and this sum was
invested.
2003 13th July: Investments which originally costed Rs. 1,100 were sold for Rs. 1,200 and the
proceeds of sale were re-invested.
2003 31st December: A contribution from profits of Rs. 3,200 was made; interest on investments
of Rs. 160 was received and these amounts were reinvested.
2004 9th May: Investments which originally costed Rs. 2,100 were sold at a profit of Rs. 200
and proceeds of sale were re-invested.
2004 31st December: Interest on investments Rs. 480 was received which was not invested. All
existing investments were sold for Rs. 6,600. A contribution from profit of an amount required
to make up the sinking fund to Rs. 10,000 was made and this amount was not invested.
You are required to prepare Sinking Fund and Sinking Fund Investment Account for the years
2002-2004.
Solution
Sinking Fund Account
2002 Rs. 2002 Rs.
Dec. 31 To Balance c/d 3,200 Dec. 31 By Depreciation A/c 3,200
3,200 3,200
2003 2003
Dec. 31 To Balance c/d 6,660 Jan. 1 By Balance b/d 3,200
July 13 By S.F. Investment A/c 100
Dec. 31 By Interest on
S.F.Investment A/c 160
By Depreciation A/c 3,200
6,660 6,660

2004 2004
Dec.31 To S.F. Investment A/c 260 Jan. 1 By Balance b/d 6,660
To Lease A/c 10,000 May 9 By S.F. Investment A/c 200
Dec. 31 By Interest on S.F. 480
Investment A/c
By Depreciation A/c 2,920
(Balancing Figure)
10,260 10,260

5.14 COMMON PROFICIENCY TEST


Sinking Fund Investment Account
2002 Rs. 2002 Rs.
Dec. 31 To Bank A/c 3,200 Dec. 31 By Balance c/d 3,200
3,200 3,200
2003 2003
Jan. 1 To Balance b/d 3,200 July 13 By Bank (sale) 1,200
July 13 To S.F.A/c 100 Dec. 31 By Balance c/d 6,660
(profit on sale)
July 13 To Bank A/c 1,200
(investment of sale
proceed)
Dec. 31 To Bank A/c 3,360
(investment of
depreciation amount
and interest) 7,860 7,860
2004 2004
Jan. 1 To Balance b/d 6,660 May 9 By Bank 2,300
May 9 To S.F. A/c 200 Dec.31 By Bank 6,600
(profit on sale) Dec. 31 By S.F. A/c
May 9 To Bank A/c (investment 2,300 (loss on sale) 260
of sale proceeds) 9,160 9,160

Illustration 6
On the basis of the data given in the illustration 5, prepare Lease Account and Depreciation
Account for the years 2002-2004.
Solution
Lease Account
2002 Rs. 2002 Rs.
Jan.1 To Bank A/c 10,000 Dec. 31 By Balance c/d 10,000
10,000 10,000
2003 2003
Jan. 1 To Balance b/d 10,000 Dec.31 By Balance c/d 10,000
10,000 10,000
2004 2004
Jan.1 To Balance b/d 10,000 Dec. 31 By Sinking Fund A/c 10,000
10,000 10,000

FUNDAMENTALS OF ACCOUNTING 5.15


DEPRECIATION ACCOUNTING

Depreciation Account
2002 Rs. 2002 Rs.
Dec. 31 To S.F. A/c 3,200 Dec. 31 By P&L A/c 3,200
3,200 3,200
2003 2003
Dec. 31 To S.F. A/c 3,200 Dec. 31 By P&L A/c 3,200
3,200 3,200
2004 2004
Dec. 31 To S.F. A/c 2,920 Dec. 31 By P&L A/c 2,920
2,920 2,920

3.6 MACHINE HOUR METHOD


Where it is practicable to keep a record of the actual running hours of each machine, depreciation
may be calculated on the basis of hours that the concerned machine worked. The machine
hour rate of the depreciation, is calculated after estimating the total number of hours that
machine would work during its whole life; however, it may have to be varied from time to
time, on a consideration of the changes in the economic and technological conditions which
might take place, to ensure that the amount provided for depreciation corresponds to that
considered appropriate in the changed circumstances. It would be observed that the method is
only a slight variation of the Straight Line Method under which depreciation is calculated per
year. Under this method it is calculated for each hour the machine works.
Illustration 7
A machine was purchased for Rs. 3,00,000 having an estimated total working of 24,000 hours.
The scrap value is expected to be Rs. 20,000 and anticipated pattern of distribution of effective
hours is as follows :
Year
1-3 3,000 hours per year
4-6 2,600 hours per year
7 - 10 1,800 hours per year
Determine Annual Depreciation under Machine Hour Rate Method.
Solution
Statement of Annual Depreciation under Machine Hours Rate Method.
Year Annual Depreciation

3, 000
1-3 × (Rs. 3,00,000 - Rs. 20,000) = Rs. 35,000
24, 000

5.16 COMMON PROFICIENCY TEST


2, 600
4-6 × (Rs. 3,00,000 - Rs. 20,000) = Rs. 30,333
24, 000

1,800
7 - 10 × (Rs. 3,00,000 - Rs. 20,000) = Rs. 21,000
24, 000
3.7 PRODUCTION UNITS METHOD
Under this method depreciation of the asset is determined by comparing the annual production
with the estimated total production. The amount of depreciation is computed by the use of
following method :
Production during the period
Depreciation for the period = Depreciable Amount ×
Estimated total production
The method is applicable to machines producing product of uniform specifications.
Illustration 8
A machine is purchased for Rs. 2,00,000. Its estimated useful life is 10 years with a residual
value of Rs. 20,000. The machine is expected to produce 1.5 lakh units during its life time.
Expected distribution pattern of production is as follows:
Year Production
1-3 20,000 units per year
4-7 15,000 units per year
8-10 10,000 units per year
Determine the value of depreciation for each year using production units method.
Solution
Statement showing Depreciation under Production Units Method.
Year Annual Depreciation

20, 000
1-3 × (Rs. 2,00,000 - Rs. 20,000) = Rs. 24,000
1,50, 000

15, 000
4-7 × (Rs. 2,00,000 - Rs. 20,000 ) = Rs. 18,000
1,50, 000

10, 000
8-10 × (Rs. 2,00,000 - Rs. 20,000) = Rs. 12,000
1,50, 000

FUNDAMENTALS OF ACCOUNTING 5.17


DEPRECIATION ACCOUNTING

3.8 DEPLETION METHOD


This method is used in case of mines, quarries etc. containing only a certain quantity of product.
The depreciation rate is calculated by dividing the cost of the asset by the estimated quantity of
product likely to be available. Annual depreciation will be the quantity extracted multiplied by
the rate per unit.
Illustration 9
M/s Jay & Co. took lease of a quarry on 1-1-2003 for Rs. 1,00,00,000. As per technical estimate
the total quantity of mineral deposit is 2,00,000 tonnes. Depreciation was charged on the basis
of depletion method. Extraction pattern is given in the following table:
Year Quantity of Mineral extracted
2003 2,000 tonnes
2004 10,000 tonnes
2005 15,000 tonnes
Show the Quarry Lease Account and Depreciation Account for each year from 2003 to 2005.
Solution
Quarry Lease Account
Dr. Cr.
2003 Rs. 2003 Rs.
Jan. To Bank A/c 1,00,00,000 Dec. 31 By Depreciation A/c 1,00,000
[2,000/2,00,000×
Rs. 1,00,00,000]
Dec,31 By Balance c/d 99,00,000
1,00,00,000 1,00,00,000
2004 2004
Jan. 1 To Balance b/d 99,00,000 Dec. 31 By Depreciation A/c 5,00,000
Dec. 31 By Balance c/d 94,00,000
99,00,000 99,00,000
2005 2005
Jan. 1 To Balance b/d 94,00,000 Dec. 31 By Depreciation A/c 7,50,000
Dec. 31 By Balance c/d 86,50,000
94,00,000 94,00,000

5.18 COMMON PROFICIENCY TEST


Depreciation Account
Dr. Cr.
2003 Rs. 2003 Rs.
Dec. 31 To Quarry lease A/c 1,00,000 Dec. 31 By P & L A/c 1,00,000
1,00,000 1,00,000
2004 2004
Dec. 31 To Quarry lease A/c 5,00,000 Dec. 31 By P & L A/c 5,00,000
5,00,000 5,00,000
2005 2005
Dec. 31 To Quarry lease A/c 7,50,000 Dec. 31 By P & L A/c 7,50,000
7,50,000 7,50,000

4. PROFIT OR LOSS ON THE SALE DISPOSAL OF DEPRECIABLE ASSETS


Whenever any depreciable asset is sold during the year, depreciation is charged on it for the
period it has been used. The written down value after charging such depreciation is used for
calculating the profit or loss on the sale of that asset. The resulting profit or loss on sale of the
asset is ultimately transferred to profit and loss account.
For example: The book value of the asset as on 1 January, 2006 is Rs. 50,000. Depreciation is
charged on the asset @10%. On 1 July 2006, the asset is sold for Rs. 32,000. In such a situation,
profit or loss on the sale will be calculated as follows:
Rs.
Book value as on 1 Jan.,2006 50,000
Less: Depreciation for 6 months @10% (from 1 Jan., 2006 to 30 June, 2006) 2,500
Written down value as on 1 July, 2006 47,500
Less: Sale proceeds as on 1 July, 2006 32,000
Loss on the sale of asset 15,500

Illustration 10
A firm purchased on 1st January, 2005 certain machinery for Rs. 58,200 and spent Rs. 1,800 on
its erection. On July 1, 2005 another machinery for Rs. 20,000 was acquired. On 1st July, 2006
the machinery purchased on 1st January, 2005 having become obsolete was auctioned for
Rs. 38,600 and on the same date fresh machinery was purchased at a cost of Rs. 40,000.
Depreciation was provided for annually on 31st December at the rate of 10 per cent on written
down value. Prepare machinery account.

FUNDAMENTALS OF ACCOUNTING 5.19


DEPRECIATION ACCOUNTING

Solution
Machinery Account
Dr. Cr.
2005 Rs. 2005 Rs.
Jan. 1 To Bank 58,200 Dec. 31 By Depreciation A/c 7,000
Jan. 1 To Bank-erection
charges 1,800 By Balance c/d 73,000
July 1 To Bank 20,000
80,000 80,000
2006 2006
Jan. 1 To Balance b/d 73,000 July 1 By Depreciation on
sold machine 2,700
July 1 To Bank 40,000 By Bank 38,600
By Profit and Loss A/c 12,700
Dec. 31 By Depreciation A/c 3,900
By Balance c/d 55,100
1,13,000 1,13,000

Working Notes:
Book Value of Machines
Machine Machine Machine
I II III
Rs. Rs. Rs.
Cost 60,000 20,000 40,000
Depreciation for 2005 6,000 1,000
Written down value 54,000 19,000
Depreciation for 2006 2,700 1,900 2,000
Written down value 51,300 17,100 38,000
Sale Proceeds 38,600
Loss on Sale 12,700

5.20 COMMON PROFICIENCY TEST


Illustration 11
A company's plant and machinery account at 31st December, 2005 and the corresponding
depreciation provision account, broken down by year of purchase are as follows:
Year of Plant and Machinery Depreciation
Purchase at cost Provision

1989 20,000 20,000


1995 30,000 30,000
1996 1,00,000 95,000
1997 70,000 59,500
2004 50,000 7,500
2005 30,000 1,500
3,00,000 2,13,500

Depreciation is at the rate of 10% per annum on cost. It is the Company's policy to assume that
all purchases, sales or disposal of plant occurred on 30th June in the relevant year for the
purpose of calculating depreciation, irrespective of the precise date on which these events
occurred.
During 2006 the following transaction took place:
1. Purchase of plant and machinery amounted to Rs. 1,50,000
2. Plant that had been bought in 1995 for Rs. 17,000 was scrapped.
3. Plant that had been bought in 1996 for Rs. 9,000 was sold for 500.
4. Plant that had been bought in 1997 for Rs. 24,000 was sold for Rs. 1,500.
You are required to:
Calculate the provision for depreciation of plant and machinery for the year ended 31st
December, 2006. In calculating this provision you should bear in mind that it is the company's
policy to show any profit of loss on the sale or disposal of plant as a completely separate item
in the Profit and Loss Account.

FUNDAMENTALS OF ACCOUNTING 5.21


DEPRECIATION ACCOUNTING

Solution
Calculation of provision for depreciation of plant and machinery for the year ended 31st
December, 2006.
On plant purchased in: Rs. Rs.
1989 nil
1995 nil
1996 5,000
1997 1/2 year at 10% on Rs. 24,000 1,200
1 year at 10% on Rs. 46,000 4,600 5,800
2004 10% on Rs. 50,000 5,000
2005 10% on Rs. 30,000 3,000
2006 1/2 year at 10% on Rs. 1,50,000 7,500
26,300

Illustration 12
Prepare the following ledger accounts during 2006 from the information given in
illustration 11 :
(i) plant and machinery at cost ;
(ii) depreciation provision;
(iii) sales or disposal of plant and machinery.

Solution
(i) Plant and Machinery Account (for 2006) at Cost
Rs. Rs.
To Balance b/d 3,00,000 By Disposals account:
To Purchases A/c 1,50,000 Scrapped 17,000
Sold 33,000
By Balance c/d 4,00,000
4,50,000 4,50,000

5.22 COMMON PROFICIENCY TEST


(ii) Depreciation Provision Account for 2006
Rs. Rs.
To Disposal Account : By Balance b/d 2,13,500
Scrapped-1995 assets 17,000 By Profit and Loss Account 26,300
Sold-1996 assets 9,000
Sold-1997 assets 21,600 47,600
To Balance c/d 1,92,200
2,39,800 2,39,800

(iii) Sale or disposal of Plant and Machinery Account (for 2006)


Rs. Rs.
To Plant and Machinery : By Provision for Depreciation 47,600
Scrapped 17,000 By Cash-Sales Proceeds 2,000
Sold 33,000 By Loss on sales 400
50,000 50,000

Illustration 13
The Machinery Account of a Factory showed a balance of Rs. 1,90,000 on 1st January, 2005. Its
accounts were made up on 31st December each year and depreciation is written off at 10%
p.a. under the Diminishing Balance Method.
On 1st June 2005, a new machinery was acquired at a cost of Rs. 28,000 and installation
charges incurred in erecting the machine works out to Rs. 892 on the same date. On 1st June,
2005 a machine which had cost Rs. 4,374 on 1st January 2003 was sold for Rs. 750. Another
machine which had cost Rs. 437 on 1st January, 2004 was scrapped on the same date and it
realised nothing.
Write a plant and machinery account for the year 2005, allowing the same rate of depreciation
as in the past calculating depreciation to the nearest multiple of a Rupee.

FUNDAMENTALS OF ACCOUNTING 5.23


DEPRECIATION ACCOUNTING

Solution
Plant and Machinery Account
Dr. Cr.
2005 Rs. 2005 Rs.
Jan. 1 To Balance b/d 1,90,000 June 1 By Bank (Sales) 750
June. 1 To Bank By Depreciation (on
(28,000 + 892) 28,892 sold machine) 148
By Loss on sale 2,645
By Loss on scrapping
the machine 377
By Depreciation (on
scrapped machinery) 16
By Depreciation (Note iii) 20,291
By Balance c/d 1,94,665
2,18,892 2,18,892

Working Note :
(i) To find out loss on sale of machine on 1-6-2005
Rs.
Cost on 1-1-2003 4,374
Less : Depreciation @ 10% on Rs. 4,374 437
W.D.V. on 31-12-2003 3,937
Less : Depreciation @ 10% on Rs. 3,937 394
W.D.V. on 31-12-2004 3,543
Less : Depreciation @ 10% on Rs. 3,543 for 5 months 148
3,395
Less : Sale proceeds on 1-6-2005 750
Loss 2,645
(ii) To find out Loss on scrapped machine
Rs.
Cost on 1-1-2004 437
Less : Depreciation @ 10% on Rs. 437 44
W.D.V. on 1-1-2005 393
Less : Depreciation @ 10% on Rs. 393 for 5 months 16
Loss 377

5.24 COMMON PROFICIENCY TEST


(iii) To find out depreciation
Balance of machinery account on 1-1 2005 1,90,000
Less : W.D.V.of machinery sold 3,543
W.D.V. of machinery scrapped 393 3936
W.D.V. of other machinery on 1-1-2005 1,86,064
Depreciation @ 10% on Rs. 1,86,064 for 12 months 18,606
Depreciation @ 10% on Rs. 28,892 for 7 months 1,685
20,291

5. CHANGE IN THE METHOD OF DEPRECIATION


The depreciation method selected should be applied consistently from period to period. A change
from one method of providing depreciation from another should be made only if the adoption
of the new method is required by the statute or for compliance with the accounting standard
or if it is considered that the change would result in the more appropriate preparation and
presentation of the financial statements of the enterprise. Whenever any change in depreciation
method is made, depreciation should be recalculated in accordance with the new method
from the date of asset coming into use. The deficiency or surplus arising from retrospective
recomputation of depreciation should be debited or credited to P&L A/c in the year in which
the method of depreciation is changed. Such change is treated as change in accounting policy.
Its effect needs to be quantified and disclosed.
Example : Cost of Machine Rs. 1,05,000
Residual Value Rs. 5,000
Useful life 10 years
The company charges depreciation on straight line method for the first two years and thereafter
decides to adopt written down value method.
In this case: Rate of WDV depreciation would be;

5, 000
1- 10
= 26.247%
1, 05, 000
Depreciation already charged for the first 2 years as per straight line method is Rs. 20,000.
Retrospective computation of depreciation as per WDV method:
Cost of Machine Rs. 1,05,000
Less : Depreciation for the Ist year @ 26.247% Rs. 27,559
WDV at the beginning of 2nd year Rs. 77,441
Less : Depreciation for the 2nd year @ 26.247% 20,326
WDV at the beginning of 3rd year Rs. 57,115
Less : Depreciation for the 3rd year 14,991
42,124

FUNDAMENTALS OF ACCOUNTING 5.25


DEPRECIATION ACCOUNTING

WDV : Depreciation for first two years Rs. 47,885


Less : Depreciation already charged as per straight line method Rs. 20,000
Shortfall Rs. 27,885
Therefore in the profit and loss account of the 3rd year, the short depreciation due to change in
the method of depreciation of Rs. 27,885 should be debited. In addition, WDV depreciation for
the 3rd year of Rs. 14,991 should also be debited.
Illustration 14
A firm purchased on 1st January, 2003 certain machinery for Rs. 52,380 and spent Rs. 1,620 on
its erection. On January 1, 2003 another machinery for Rs. 19,000 was acquired. On 1st July,
2004 the machinery purchased on 1st Januray, 2003 having become obsolete was auctioned
for Rs. 28,600 and on the same date fresh machinery was purchased at a cost of Rs. 40,000.
Depreciation was provided for annually on 31st December at the rate of 10 per cent on written
down value. In 2005, however, the firm changed this method of providing depreciation and
adopted the method of providing 5 per cent per annum depreciation on the original cost of the
machinery with retrospective effect.
Solution
Machinery Account
2003 Rs. 2003 Rs.
Jan. 1 To Bank 52,380 Dec. 31 By Depreciation A/c 7,300
Jan. 1 To Bank-erection
charges 1,620 By Balance c/d 65,700
Jan. 1 To Bank 19,000
73,000 73,000
2004 2004
Jan. 1 To Balance b/d 65,700 July 1 By Depreciation 2,430
July 1 To Bank 40,000 By Bank 28,600
By Profit and Loss A/c 17,570
Dec. 31 By Depreciation A/c 3,710
By Balance c/d 53,390
1,05,700 1,05,700
2005 2005
Jan. 1 To Balance b/d 53,390 Dec. 31 By Depreciation A/c 2,950
To Profit and Loss A/c By Balance c/d 53,150
(Excess Dep.
written back) 2,710
56,100 56,100

5.26 COMMON PROFICIENCY TEST


Working Notes :
(1) Book Value of Machines:
Machine Machine Machine
I II III
Rs. Rs. Rs.
Cost 54,000 19,000 40,000
Depreciation for 2003 5,400 1,900
Written down value 48,600 17,100
Depreciation for 2004 2,430 1,710 2,000
Written down value 46,170 15,390 38,000
Sale Proceeds in 2005 28,600
Loss on Sale 17,570

(2) Written down value on the basis of 5% depreciation on straight line basis as at 31st Dec.,
2004.
Machine Machine
II III
Rs. Rs.
Cost 19,000 40,000
Depreciation for 2 years 1,900
Depreciation for 1/2 year 1,000
17,100 39,000
Total Rs. 56,100

(3) The book value appearing in the books is Rs. 53,390; Rs. 2,710 has to be written back to
make this figure Rs. 56,100.
Note : The rate of 10% is assumed to be per annum.
Illustration 15
Messers Mill and Wright commenced business on 1st January 2001, when they purchased
plant and equipment for Rs. 7,00,000. They adopted a policy of (i) charging depreciation at
15% per annum on diminishing balance basis and (ii) charging full year's depreciation on
additions.

FUNDAMENTALS OF ACCOUNTING 5.27


DEPRECIATION ACCOUNTING

Over the years, their purchases of plant have been:


Date Amount
Rs.
1-8-2002 1,50,000
30-9-2005 2,00,000
On 1-1-2005 it was decided to change the method and rate of depreciation to 10% on straight
line basis with retrospective effect from 1-1-2001 the adjustment being made in the books of
account.
Calculate the difference in depreciation to be adjusted in the Plant and Equipment being made
in the accounts for the year ending 31st December, 2005.
Solution
Depreciation on written down value basis
Purchased on Purchased on
Jan. 1, 2001 Aug. 1, 2002
2001 Rs. Rs. Rs.
Cost 7,00,000
Depreciation 1,05,000
Written Down Value (WDV) 5,95,000 1,50,000
2002
Depreciation 89,250 22,500
W.D.V. 5,05,750 1,27,500
2003
Depreciation 75,863 19,125
W.D.V. 4,29,887 1,08,375
2004
Depreciation 64,483 16,256
W.D.V. 3,65,404 92,119
Depreciation Charged 3,34,596 57,881
Total Depreciation Charged (A) 3,92,477
Depreciation on straight line basis :
Rs. Rs.
Annual Depreciation (10% of
original cost) 70,000 15,000
No. of years for which
depreciation is to be charged 4 3
Depreciation charged 2,80,000 45,000
Total (B) 3,25,000
Difference :
Excess depreciation charged to be adjusted in 2005 (A) – (B) = Rs. 67,477.

5.28 COMMON PROFICIENCY TEST


Plant and Equipment Account
Dr. Cr.
2005 Rs. 2005 Rs.
Jan. 1 To Balance b/d 4,57,523 Dec. 31 By Depreciation (10%
To Profit and Loss A/c of original cost) 1,05,000
adjustment for
depreciation 67,477 By Balance c/d 6,20,000
Sep. 30 To Bank 2,00,000
7,25,000 7,25,000
2006
Jan. 1 To Balance b/d 6,20,000

6. REVISION OF THE ESTIMATED USEFUL LIFE OF THE


DEPRECIABLE ASSET
There should be a periodical review of the useful life of depreciable assets. Whenever there is a
revision in the estimated useful life of the asset, the unamortised depreciable amount should be
charged to the asset over the revised remaining estimated useful life of the asset.
Illustration 16
M/s. Mayur & Co. purchased a machine on 1.1.2000 for Rs. 20,00,000. Estimated useful life
was 10 years and scrap value at the end was expected to be Rs. 2,00,000. On 1.1.2005, the
written down value of the machine was revalued to be up by 20%, useful life was re-estimated
as 13 years and scrap value as Rs. 2,80,000. The company follows reducing balance method of
charging depreciation. Show Machinery Account and Provision for Depreciation Account for
the year ended 31.12.2005
Solution
Machinery Account
Dr. Cr.
2005 Rs. 2005 Rs.
Jan. 1 To Balance b/d 20,00,000 Dec. 31 By Balance c/d 21,26,492
To Revaluation
Reserve 1,26,492
21,26,492 21,26,492

FUNDAMENTALS OF ACCOUNTING 5.29


DEPRECIATION ACCOUNTING

Provision for Depreciation Account


Dr. Cr.
2005 Rs. 2005 Rs.
Dec.31 To Balance c/d 14,56,480 Jan. 1 By Balance b/d 13,67,538
Dec. 31 By Profit and Loss A/c 88,942
14,56,480 14,56,480

Working Notes:
(1) 2000 : Calculation of rate of WDV depreciation

⎡ ⎤
= ⎢1 − 10 2, 00, 000 ⎥ × 100 = 20.567%
⎣ 20, 00, 000 ⎦

(2) Statement of Depreciation


Rs.
1.1.2000 Cost of the machine 20,00,000
31.12.2000 Less : Depreciation 4,11,340
1.1.2001 W.D.V. 15,88,660
31.12.2001 Depreciation 3,26,740
1.1.2002 W.D.V. 12,61,920
31.12.2002 Depreciation 2,59,539
1.1.2003 W.D.V. 10,02,381
31.12.2003 Depreciation 2,06,160
1.1.2004 W.D.V. 7,96,221
31.12.2004 Depreciation 1,63,759
1.1.2005 W.D.V. 6,32,462
Add : Upward Revulation (20%) 1,26,492
7,58,954
31.12.2005 Depreciation
(11.719%* on Rs. 7,58,954) 88,942
1.1.2006 W.D.V. 6,70,012
(3) *2005 : Calculation of rate of WDV depreciation

⎡ 2,80, 000 ⎤
= ⎢1 − 8 ⎥ × 100 = 11.719%
⎣ 7,58,954 ⎦

5.30 COMMON PROFICIENCY TEST


7. REVALUATION OF DEPRECIABLE ASSETS
Whenever the depreciable asset is revalued, the depreciation should be charged on the revalued
amount on the basis of the remaining estimated useful life of the asset. If there is an upward
revision in the value of asset, then the amount of appreciation is debited to Asset Account and
credited to Revaluation Account. If there is downward revision in the value of asset then Profit
and Loss Account is debited and Asset Account is credited.
Illustration 17
Consider the following details:
Machine A Machine B
Date of Purchase 1.1.2002 1.1.2004
Cost Price (Rs.) 12,25,000 15,75,000
Realisable Value (Rs.) 25,000 75,000
Useful Life 10 years 15 years
The machines were subject to depreciation under straight line basis. Calendar year is followed
as the accounting year. In 2004 Machine A was revalued upward by Rs. 2 lacs. From 1.1.2005,
it is decided to adopt written down value method of depreciation. You are asked to prepare a
statement showing depreciation charged on each machine upto 31.12.2005.
Solution
Statement of Depreciation
Machine A Machine B
Rs. Rs.
1.1.2002 Cost Price 12,25,000
31.12.2002 Less : SLM depreciation 1,20,000
1.1.2003 WDV 11,05,000
31.12.2003 Less : SLM depreciation 1,20,000
1.1.2004 WDV 9,85,000
1.1.2004 Cost Price 15,75,000
Upward Revaluation 2,00,000
11,85,000
31.12.2004 Less : SLM depreciation
11,85, 000 − 25, 000
1,45,000 1,00,000
8
1.1.2005 WDV 10,40,000 14,75,000
31.12.2005 Less : Retrospective effect of change
in the method of depreciation 5,42,450 1,89,800
4,97,550 12,85,200
31.12.2005 Less : WDV depreciation 1,73,147 2,36,477
3,24,403 10,48,723

FUNDAMENTALS OF ACCOUNTING 5.31


DEPRECIATION ACCOUNTING

Working Notes
(1) WDV Rates :
Machine A Machine B
2002 & 2003 2004 onward
1 1
⎡ 25, 000 ⎤ 10 ⎡ 75, 000 ⎤ 15
1- ⎢ ⎥ = 32.2% 1- ⎢ ⎥ = 18.4%
⎣12, 25, 000 ⎦ ⎣15, 75, 000 ⎦
2004 onwards
1
⎡ 25, 000 ⎤ 8
1- ⎢ ⎥ = 34.8 %
⎣ 7, 63,113 ⎦
(2) Retrospective effect of depreciation Machine A Machine B
WDV depreciation for 2002 3,94,450
WDV depreciation for 2003 2,67,437
WDV depreciation for 2004 2,65,563 2,89,800
9,27,450 2,89,800
Less : SLM depreciation already charged 3,85,000 1,00,000
for the above period
Shortfall 5,42,450 1,89,800

8. PROVISION FOR REPAIRS AND RENEWALS


Expenditure incurred for repairs, renewals and maintenance on plant and machinery may
vary over the years during the working life. Thus, for equalising the charge of repairs and
renewals, sometimes a Provision for Repairs and Renewals Account is opened. Total of such
expenses that may be incurred over the working life is estimated before hand. Average of this
expenditure is debited to Profit and Loss Account and credited to Provision for Repairs and
Renewals Account irrespective of actual expenses incurred. Provision for Repairs and Renewals
Account is debited and Repairs Account is credited for actual expenses incurred. The balance
in provision for Repairs and Renewals Account is carried forward and in the end or on sale of
the asset, the account is closed by transfer to the Asset Account for any balance left.
Illustration 18
The following particulars are available from the books of a public company having a large fleet
of vehicles :
Rs.
Balance in Provision for Repairs and Renewals Account as on 31.3.2004 1,15,000
Actual repairs charged/incurred during the year ended
31.3.2004 75,000
31.3.2005 32,000

5.32 COMMON PROFICIENCY TEST


The company makes an annual provision of Rs. 40,000 on repairs and renewals.
Draw up the Provision for Repairs and Renewals Account for the years 2003-2004 and 2004-
2005.
Solution
Provision for Repairs and Renewal Account
Dr. Cr.
Rs. Rs.
31.3.2004 To Repairs A/c 75,000 1.4.2003 By Balance b/d 1,50,000
31.3.2004 To Balance c/d 1,15,000 (Balancing figure)
31.3.2004 By P & L A/c 40,000
1,90,000 1,90,000
31.3.2005 To Repairs A/c 32,000 1.4.2004 By Balance b/d 1,15,000
31.3.2005 To Balance c/d 1,23,000 31.3.2005 By P & L A/c 40,000
1,55,000 1,55,000
1.4.2005 By Balance b/d 1,23,000

SELF EXAMINATION QUESTIONS


I. PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES (only one correct
answer):
1. Amit Ltd. purchased a machine on 01.01.2003 for Rs 1,20,000. Installation expenses were
Rs 10,000. Residual value after 5 years Rs 5,000. On 01.07.2003, expenses for repairs were
incurred to the extent of Rs 2,000. Depreciation is provided @ 10% p.a. under written
down value method. Depreciation for the 4th year = ________.
a. 25,000 b. 13,000 c. 10,530 d. 9,477
2. Original cost = Rs.1,26,000; Salvage value = Nil; Useful life = 6 years. Depreciation for the
first year under sum of years digits method will be
(a) Rs.6,000 (b) Rs. 12,000 (c) Rs. 18,000 (d) Rs. 36,000
3. Obsolescence of a depreciable asset may be caused by
I. Technological changes.
II. Improvement in production method.
III. Change in market demand for the product or service output.
IV. Legal or other restrictions.
(a) Only (I) above (b) Both (I) and (II) above
(c) All (I), (II), (III) and (IV) above (d) Only (IV) above

FUNDAMENTALS OF ACCOUNTING 5.33


DEPRECIATION ACCOUNTING

4. Amit Ltd. purchased a machine on 01.01.2003 for Rs 1,20,000. Installation expenses were
Rs 10,000. Residual value after 5 years Rs 5,000. On 01.07.2003, expenses for repairs were
incurred to the extent of Rs 2,000. Depreciation is provided under straight line method.
Depreciation rate = 10%. Annual Depreciation = _____.
a. 13,000 b. 17,000 c. 21,000 d. 25,000
5. Original cost = Rs.1,26,000; Salvage value = Nil; Useful life = 6 years. Depreciation for the
fourth year under sum of years digits method will be
(a) Rs.6,000 (c) Rs. 12,000 (c) Rs. 18,000 (d) Rs. 24,000
6. Amit Ltd. purchased a machine on 01.01.2003 for Rs 1,20,000. Installation expenses were
Rs 10,000. Residual value after 5 years Rs 5,000. On 01.07.2003, expenses for repairs were
incurred to the extent of Rs 2,000. Depreciation is provided under straight line method.
Annual Depreciation = _____.
a. 13,000 b. 17,000 c. 21,000 d. 25,000
7. Which of the following statements is/are false?
I. The term ‘depreciation’, ‘depletion’ and ‘amortization’ convey the same meaning.
II. Provision for depreciation a/c is debited when provision for depreciation a/c is created.
III. The main purpose of charging the profit and loss a/c with the amount of depreciation
is to spread the cost of an asset over its useful life for the purpose of income
determination.
(a) Only (I) above (b) Only (II) above
(c) Only (III) above (d) All (I) (II) and (III) above
8. Original cost = Rs 1,26,000. Salvage value = 6,000. Depreciation for 2nd year @ Units of
Production Method, if units produced in 2nd year was 5,000 and total estimated production
50,000.
a. 10,800 b. 11,340 c. 12,600 d. 12,000
9. The number of production or similar units expected to be obtained from the use of an asset
by an enterprise is called as
(a) Unit life (b) Useful life
(c) Production life (d) Expected life
10. Which of the following is not true with regard to fixed assets?
(a) They are acquired for using them in the conduct of business operations
(b) They are not meant for resale to earn profit
(c) They can easily be converted into cash
(d) Depreciation at specified rates is to be charged on most of the fixed assets

5.34 COMMON PROFICIENCY TEST


11. Original cost = Rs 1,26,000. Salvage value = 6,000. Useful Life = 6 years. Annual depreciation
under SLM =
(a) 21,000 (b) 20,000 (c) 15,000 (d) 14,000
12. Original cost = Rs 1,26,000. Salvage value = 6,000. Depreciation for 2nd year @ 10% p.a.
under WDV method =
a. 10,800 b. 11,340 c. 15,000 d. 14,000
13. Which of the following expenses is not included in the acquisition cost of a plant and
equipment?
(a) Cost of site preparation (b) Delivery and handling charges
(c) Installation costs
(d) Financing costs incurred subsequent to the period after plant and equipment is put to
use.
14. For charging depreciation, on which of the following assets, the depletion method is
adopted?
(a) Plant & machinery (b) Land & building
(c) Goodwill (d) Wasting assets like mines and quarries
15. If a concern proposes to discontinue its business from March 2005 and decides to dispose
off all its assets within a period of 4 months, the Balance Sheet as on March 31, 2005
should indicate the assets at their
(a) Historical cost (b) Net realizable value
(c) Cost less depreciation (d) Cost price or market value, whichever is lower
16. In the case of downward revaluation of an asset which is for the first time revalued, the
account to be debited is
(a) Fixed Asset (b) Revaluation Reserve
(c) Profit & Loss account (d) General Reserve
17. In which of the following methods, is the cost of the asset written off in equal proportion,
during its useful economic life?
(a) Straight line method (b) Written down value method
(c) Units-of-production method (d) Sum-of-the-years’-digits method
18. The portion of the acquisition cost of the asset, yet to be allocated is known as
(a) Written down value (b) Accumulated value
(c) Realisable value (d) Salvage value

FUNDAMENTALS OF ACCOUNTING 5.35


DEPRECIATION ACCOUNTING

II CHOOSE THE MOST APPROPRIATE ANSWER ON THE BASIS OF THE


INFORMATION GIVEN IN THE FOLLOWING QUESTIONS:
1. Original Cost = Rs 1,00,000. Life = 5 years. Expected salvage value = Rs 2,000.
(i) Depreciation for 3rd year as per straight line method is
a. Rs 12,800 b. Rs 19,600 c. Rs 20,000 d. Rs 20,400
(ii). rate of depreciation p.a. = __________.
a. 20.0% b. 19.8% c. 19.6% d. 19.4%
2. On April 01, 2004 the debit balance of the machinery account of A Ltd. was Rs.5,67,000.
The machine was purchased on April 01, 2002. The company charged depreciation at the
rate of 10% per annum under diminishing balance method. On October 01, 2004, the
company acquired a new machine at a cost of Rs.60,000 and incurred Rs.6,000 for
installation of the new machine. The company decided to change the system of providing
depreciation from the diminishing balance method to the straight-line method with
retrospective effect from April 01, 2002. The rate of depreciation will remain the same.
The company decided to make necessary adjustments in respect of depreciation due to
the change in the method in the year 2004-2005.
(i) Cost of machinery on 01.04.2002 = ________.
a. Rs 5,67,000 b. Rs 6,30,000 c. Rs 7,00,000 d. Rs 7,77,778
(ii) Depreciation provided in 2002-03 = ______.
a. Rs 56,700 b. Rs 63,000 c. Rs 70,000 d. Rs 77,778
(iii) Depreciation provided in 2003-04 = ______.
a. Rs 51,030 b. Rs 56,700 c. Rs 63,000 d. Rs 70,000
(iv) Depreciation under new method for 2002-03 and 2003-04 = _______.
a. Rs 1,33,400 b. Rs 1,26,000 c. Rs 1,40,000 d. Rs 1,55,556
(v) Further depreciation to be provided = ______.
a. Rs 5,670 b. Rs 6,300 c. Rs 7,000 d. Rs 7,778
(vi) Balance in Machinery A/c on 31.03.2004 = _______
a. Rs 5,67,000 b. Rs 6,30,000 c. Rs 7,00,000 d. Rs 7,77,778
(vii) Depreciation for the year 2004-05 = _________.
a. Rs 3,300 b. Rs 7,000 c. Rs 10,300 d. Rs 73,300
(viii) The balance outstanding to the debit of machinery account as on March 31, 2005
after effecting the above changes was
a. Rs.5,45,700 b. Rs.5,52,700 c. Rs.5,46,000 d. Rs.5,49,400
3. The balance in the accumulated provision for depreciation account of a company as at the
beginning of the year 2004-2005 was Rs. 2,00,000 when the original cost of the assets

5.36 COMMON PROFICIENCY TEST


amounted to Rs.10,00,000. The company charges 10%depreciation on a straight line basis
for all the assets including those which have been either purchased or sold during the
year. One such asset costing Rs.5,00,000 with accumulated depreciation as at the beginning
of the year of Rs.80,000 was disposed off during the year.
(i) Depreciation for the year is
a. Rs 40,000 b. Rs 50,000 c. Rs 60,000 d. Rs 1,00,000
(ii) The balance of the accumulated depreciation account at the end of the year considering
the current year’s depreciation charge would be
(a) Rs.2,20,000 (b) Rs.1,70,000 (c) Rs.1,20,000 (d) Rs.2,50,000
4. B Limited has been charging depreciation on the straight line method. It charges a full
year depreciation even if the machinery is utilized only for part of the year. An equipment
which was purchased for Rs.3,50,000 now stands at Rs.2,97,500 after depreciating at the
rate of 5% on a straight line basis. Now the company decides to change the method of
depreciation with retrospective effect. The applicable reducing balance rate for this
machinery would be 8% p.a. Assuming that before the effect of this change could be
accounted, depreciation for the current year is already charged based on straight line
method and is reflected in the depreciated value of Rs.2,97,500.
(i) Straight line depreciation per annum is
a. 15,000 b. 17,500 c. 35,000 d. 52.500
(ii) Number of years for which depreciation has been charged on this basis is
a. 2 b. 3 c. 4 d. 5
(iii) If 8% depreciation was charged by the reducing balance method, WDV at the end of
1st year is
a. Rs 2,72,541 b. Rs 2,96,240 c. Rs 3,22,000 d. Rs 3,60,000
(iv) If 8% depreciation was charged by the reducing balance method, WDV at the end of
2nd year is
a. Rs 2,72,541 b. Rs 2,96,240 c. Rs 3,22,000 d. Rs 3,60,000
(v) If 8% depreciation was charged by the reducing balance method, WDV at the end of
3rd year is
a. Rs 2,72,541 b. Rs 2,96,240 c. Rs 3,22,000 d. Rs 3,60,000
(vi) The extra depreciation to be provided based on the changed method during the year
is
(a) Rs.24,959 (b) Rs.17,500 (c) Rs.10,500 (d) Rs.46,763

FUNDAMENTALS OF ACCOUNTING 5.37


DEPRECIATION ACCOUNTING

5. In the year 2004- 2005, C Ltd. purchased a new machine and made the following payments
in relation to it: Rs. Rs.
Cost as per supplier’s list 5,20,000
Less: Agreed discount 50,000 4,70,000
Delivery charges 10,000
Erection charges 20,000
Annual maintenance charges 30,000
Additional components to increase capacity of the machine 40,000
Annual insurance premium 5,000
(i) The cost of the machine is
(a) Rs.5,40,000 (b) Rs.5,45,000 (c) Rs.4,70,000 (d) Rs.5,50,000
(ii) If depreciation is provided @ 10% p.a. SLM, depreciation for 3rd year is
(a) Rs.54,000 (b) Rs.54,500 (c) Rs.47,000 (d) Rs.55,000
(iii) If depreciation is provided @ 10% p.a. WDV, depreciation for 3rd year is
(a) Rs.43,740 (b) Rs.44,145 (c) Rs.38,070 (d) Rs.44,550
6. A new machine costing Rs.1 lakh was purchased by a company to manufacture a special
product. Its useful life is estimated to be 5 years and scrap value at Rs.10000. The production
plan for the next 5 years using the above machine is as follows:
Year 1 5000 units
Year 2 10000 units
Year 3 12000 units
Year 4 20000 units
Year 5 25000 units
(i) The depreciation expenditure for the 1st year under units-of-production method will
be
(a) Rs.6,250 (b) Rs.12,500 (c) Rs.15,000 (d) Rs.25,000
(ii) The depreciation expenditure for the 2nd year under units-of-production method
will be
(a) Rs.6,250 (b) Rs.12,500 (c) Rs.15,000 (d) Rs.25,000
(iii) The depreciation expenditure for the 3rd year under units-of-production method will
be
(a) Rs.6,250 (b) Rs.12,500 (c) Rs.15,000 (d) Rs.25,000

5.38 COMMON PROFICIENCY TEST


(iv) The depreciation expenditure for the 4th year under units-of-production method will
be
(a) Rs.6,250 (b) Rs.12,500 (c) Rs.15,000 (d) Rs.25,000

(v) The depreciation expenditure for the 5th year under units-of-production method will
be
(a) Rs.6,250 (b) Rs.12,500 (c) Rs.15,000 (d) Rs.31,250.
7. Consider the following information:
I. Rate of depreciation under the written down method = 20%.
II. Original cost of the asset = Rs.1,00,000.
III. Residual value of the asset at the end of useful life = Rs.40,960.
(i) The estimated useful life of the asset, in years, is
(a) 4 (b) 5 (c) 6 (d) 7
(ii) Depreciation for 1st year =
(a) 20,000 (b) 16,000 (c) 12,800 (d) 10,240
(iii) Depreciation for 2nd year =
(a) 20,000 (b) 16,000 (c) 12,800 (d) 10,240
(iv) Depreciation for 3rd year =
(a) 20,000 (b) 16,000 (c) 12,800 (d) 10,240
(v) Depreciation for 4th year =
(a) 20,000 (b) 16,000 (c) 12,800 (d) 10,240
8. On October 1, 2001 two machines costing Rs.20,000 and Rs.15,000 respectively, were
purchased.
On March 31, 2005, both the machines had to be discarded because of damage and had to
be replaced by two machines costing Rs.25,000 and Rs.20,000 respectively.
One of the discarded machine was sold for Rs.10,000 and against the other it was expected
that Rs.5,000 would be realized. The firm provides depreciation @15% on written down
value
(i) Depreciation for the 2003-04 year =
(a) 2,625 (b) 4,856 (c) 4,128 (d) 3,509
(ii) The total amount of depreciation written off on the two machines till they were
discarded is
(a) Rs.21,000 (b) Rs.15,118 (c) Rs.13,595 (d) Rs.18,194

FUNDAMENTALS OF ACCOUNTING 5.39


DEPRECIATION ACCOUNTING

9. In the books of D Ltd. the machinery account shows a debit balance of Rs.60,000 as on
April 1,2003.The machinery was sold on September 30,2004 for Rs.30,000. The company
charges depreciation @20% p.a. on diminishing balance method.
(i) Depreciation for 2003-04 =
a. 6,000 b. 9.000 c. 4,800 d. 12,000
(ii) Depreciation for 2004-05 =
a. 6,000 b. 9.000 c. 4,800 d. 12,000
(iii) Profit / Loss on sale =
a. 13,200 Profit b. 13,200 loss c. 6,800 profit d. 6,800 loss
10. Consider the following data pertaining to M/s. E Ltd. who constructed a cinema house:
Particulars Rs.
Cost of second hand furniture 90,000
Cost of repainting the furniture 10,000
Wages paid to employees for fixing the furniture 2,000
Fire insurance premium 1,000
The amount debited to furniture account is
(a) Rs.90,000 (b) Rs.91,000 (c) Rs.1,00,000 (d) Rs.1,02,000

11. H Ltd. purchased a machinery on April 01, 2000 for Rs.3,00,000. It is estimated that the
machinery will have a useful life of 5 years after which it will have no salvage value. If the
company follows sum-of-the-years’-digits method of depreciation, the amount of
depreciation charged during the year 2004-05 was
(a) Rs.1,00,000 (b) Rs.80,000 (c) Rs.60,000 (d) Rs.20,000.
12. On August 01,2002, K Travels Ltd. bought four Matador vans costing Rs.1,20,000 each.
The company expected to fetch a scrap value of 25% of the cost price of the vehicles after
ten years. The vehicles were depreciated under the fixed installment method up to March
31, 2005. With effect from April 01, 2005, the company decided to introduce the diminishing
balance method of depreciation @ 20% p.a. instead of the fixed installment method. The
company sold one of the vans at Rs.70,000 on March 31, 2005. The rate of depreciation
charged up to March 31, 2005 was
(a) 10.0% (b) 9.0% (c) 8.5% (d) 7.5%
13. Akhil Ltd. imported a machine on 01.07.2002 for Rs 1,28,000, paid customs duty and
freight Rs 64,000 and incurred erection charges Rs 48,000. Another local machinery costing
Rs 80,000 was purchased on 01.01.2003. On 01.07.2004, a portion of the imported
machinery ( value one-third ) got out of order and was sold for Rs 27,840. Another
machinery was purchased to replace the same for Rs 40,000. Depreciation is to be calculated
at 20% p.a.

5.40 COMMON PROFICIENCY TEST


(i) Profit / Loss on sale = ______.
a. 20,160 (Profit) b. 19,600 (Profit) c. 19,600 (Loss) d. 20,160 (Loss)
(ii) Closing balance of Machinery = ___________.
a. 1,32,000 b. 1,64,000 c. 1,96,000 d. 2,28,000
14. On 01.01.2001, a new plant was purchased by Mrs. Shweta Periwal for Rs 1,00,000 and a
further sum of Rs 5,000 was spent on installation. On 01.06.2002, another plant was
acquired for Rs 65,000. On 02.10.2003, the first plant was totally destroyed and the amount
of Rs 2,500 only was realized by selling the scraps. It was not insured. On 20.10.2003, a
second hand plant was purchased for Rs 75,000 and a further sum of Rs 7,500 was spent
for repairs and Rs 2,500 on its erection. It came into use on 15.11.2003. Depreciation has
been provided @ 10% on the original cost annually on 31st December. It was the practice
to provide depreciation for full year on all acquisitions made at any time during the year
and to ignore the depreciation on any time sold during the year.
In December 2003, it is decided to change the method of depreciation and to follow the
rate of 15% on diminishing balance method with retrospective effect in respect of the
existing items of plant and to make necessary adjustments on 31.12.2003.
(i) Closing balance in Plant A/c = ____________.
a. Rs 1,40,000 b. Rs 1,50,000 c. Rs 1,60,000 d. Rs 1,70,000
(ii) Closing balance in Provision for Depreciation A/c = _________.
a. Rs 30,788 b. Rs 25,788 c. Rs 20,788 d. Rs 15,788
(iii) Profit / Loss on Plant sold = _________.
a. Rs 71,500 (Profit) b. Rs 71,500 (Loss) c. Rs 81,500 (Profit) d. Rs 81,500 (Loss)
(iv) Depreciation over / under charged = _________.
a. Rs 8,288 (Under) b. Rs 8,288 (Over) c. Rs 9,288 (Under) d. Rs 9,288 (Over)
15. Glass, Cutlery etc. : Balance on 01.01.2004 is Rs 28,000. Glass, Cutlery, etc. purchased
during the year Rs 16,000. Depreciation is to be charged on the above assets as follows –
1/5th of their values is to be written off in the year of purchase and 2/5th in each of the
next 2 years. Of the stock of Glass, Cutlery, etc. as on 01.01.2004, ½ was one year old and
½ was 2 years old. Purchases are made on 1st January.
(i) Depreciation for 3rd year = ________.
a. Rs 7,000 b. Rs 17,500 c. Rs 20,200 d. Rs 24,200
(ii) Closing Balance in Glass, Cutlery A/c = ________.
a. Rs 18,000 b. Rs 18,500 c. Rs 19,800 d. Rs 20,400

FUNDAMENTALS OF ACCOUNTING 5.41


DEPRECIATION ACCOUNTING

III MATCH THE FOLLOWING ITEMS FROM COLUMN A WITH COLUMN B


S. No. Column A Column B
1. Property, plant and equipment are (a) Fixed installment method
conventionally shown in the Balance
Sheet at
2. Lease hold property is generally depreciated by (b) Profit & Loss account
3. Where the depreciable asset is revalued, the (c) Replacement cost less
provision for depreciation should be based on accumulated depreciation
the estimate of the remaining useful life of such
asset on the
4. In the case of downward revaluation of an asset (d) Revalued amount
which is for the first time revalued, the account to
be debited is
III Choose the correct answer(more than one)
1. Which of the following is correct? Depreciable assets are those assets which –
a. Are expected to be used for more than 1 accounting period
b. Have a limited useful life
c. Are held for use in production of goods and services ( i.e. for the purpose of re-sale )
d. None of the above
2. Which of the following is of a capital nature?
(a) Purchase of a truck
(b) Cost of repair
(c) Wages paid for installation of machinery
(d) Road tax paid
3. In which of the following methods, the cost of the asset is not spread over in equal proportion
during its useful economic life?
(a) Straight line method
(b) Written down value method
(c) Units-of-production method
(d) All of the above
4. Which of the following statements is false?
(a) Depreciation provision is of the discretion of the management
(b) Depreciation is a charge against profit
(c) Depreciation is provided only when there is profit
(d) Depreciation is an appropriation of profit

5.42 COMMON PROFICIENCY TEST


5. Which of the following assets is usually assumed to be not depreciating?
(a) Land (b) Building (c) Plant (d) Cash

ANSWERS
I
1. d 2. d 3. c 4. a 5. c
6. d 7. d 8. d 9. b 10. c
11. b 12. b 13. d 14. d 15. b
16. c 17. a 18. a
II
1. (i) (c) (ii) (c)
2. (i) (c) (ii) (c) (iii) (c) (iv) (c) (v) (c)
(vi) (a) (vii) (d) (viii) (b)
3. (i) (b) (ii) (b)
4. (i) (b) (ii) (b) (iii) (c) (iv) (b) (v) (a)
(vi) (a)
5. (i) (a) (ii) (a) (iii) (a)
6. (i) (a)
(ii) (b) (iii) (c) (iv) (d) (v) (d)
7. (i) (a)
(ii) (a) (iii) (b) (iv) (c) (v) (d)
8. (i) (c) (ii) (b)
9. (i) (d) (ii) (c) (iii) (b)
10. (d)
11. (d)
12. (d)
13. (i) (c) (ii) (b)
14. (i) (b) (ii) (a) (iii) (d) (iv) (c)
15. (i) (d) (ii) (c)
III
1.(c), 2(a), 3(d), 4(b)
IV
1-(a)&(b), 2-(a)&(c), 3-(b)&(c), 4-(a),(c)&(d), 5-(a)&(d)

FUNDAMENTALS OF ACCOUNTING 5.43


NOTES
CHAPTER - 6
FINAL ACCOUNTS OF
SOLE PROPRIETORS
The primary function of accounting is to accumulate
accounting data in a manner that the amount of
PREPARATION OF

profit made or loss suffered during a period can be


determined along with the status of the business in
financial terms. Statements prepared for this purpose
are called final accounts. Final accounts are also
termed as financial statements.
Preparation of final accounts is the last phase of the
accounting process. The process of accounting
starting from recording of source documents in books
of accounts to preparation of trial balance has
already been discussed in units 1 to 5 of chapter 2.
This chapter deals with preparation of final account
of sole proprietors headed by one person only. For
the purpose of final accounts, the sole proprietors
can be classified into non-manufacturing and
manufacturing business entities. Final accounts of
non-manufacturing entities include Trading
account, Profit and Loss Account and Balance Sheet
while final accounts of manufacturing entities
include Manufacturing account, Trading account,
Profit and Loss account and Balance Sheet.
This chapter has been divided into two units :
(i) Final accounts of Non-manufacturing entities
and
(ii) Final accounts of Manufacturing entities for the
purpose of convenience in understanding of
students
An overview of the final accounts of sole proprietors can be explained with the help of the
following chart :

Sole Proprietors

Non-Manufacturing Manufacturing
Business Entities Business Entities

Final Accounts Final Accounts

Trading Accounts Profit & Loss Balalnce Sheet


Accounts

Manufacturing Trading Accounts Profit & Loss Balance Sheet


Accounts Accounts
CHAPTER - 6

PREPARATION
OF FINAL
ACCOUNTS OF
SOLE
PROPRIETORS

Unit 1

Final Accounts of
Non-Manufacturing
Entities
FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Learning Objectives
After studying this unit you will be able to :
o Make out the various accounts, which are the parts of Final Accounts.
o Learn the relationship between Profit and Loss Account and Balance Sheet.
o Understand the Trading Account items. This will help you to learn which of the
transactions and events should be shown in the Trading Account.
o Understand the items shown in the Profit and Loss Account. By that you will learn the
technique of preparing Profit and Loss Account and deriving the Profit and Loss balance.
o Learn how to adjust outstanding and pre-paid expenses, accrued income and income
received in advance.
o Understand the items to be shown in the balance sheet. Also learn the classifications of
assets and liabilities and the order by which they are put in the Balance Sheet.

1. INTRODUCTION
Non-manufacturing entities are the trading entities, which are engaged in the purchase and
sale of goods at profit without changing the form of the goods. In other words, non-
manufacturing entities do not process the goods purchased and sell them in its original form.
Meanwhile it indulges in some liabilities, makes some assets and also incurs some expenses like
salaries, stationary expenses, advertisement, rent etc to run the business. At the end of the
accounting year, the entity must be interested in knowing the results of the business. To ascertain
the final outcome of the business i.e., the income and financial position, they prepare financial
statements at the end of the year.
Financial Statements are the systematically organized summary of all the ledger account heads
presented in such a manner that it gives detailed information about the financial position and
the performance of the enterprise. Performance of the enterprise is judged on the basis of the
income earned/accrued during the year in the form of profit after the adjustments of expenses
related to the enterprise and to the income earned or accrued. In Financial Accounting, profit
is measured at two levels :
(a) Gross Profit
(b) Net Profit
The profit of the enterprise is obtained through the preparation of Income Statement.
The financial position of the business enterprise is judged by measuring the assets, liabilities
and capital of the enterprise and the same is communicated to the users of financial statements.
Financial position of the enterprise can be known through the preparation of the Position
Statement.
From the above explanation, one can conclude that final accounts is the next step after the
preparation of trial balance which is mainly divided into following two parts :
A. Income Statement

6.4 COMMON PROFICIENCY TEST


B. Position Statement
A. Income Statement
The manner in which amount of profit or loss is arrived at is disclosed in the Income
Statement, prepared at the close of the year. The Income Statement discloses net profit of
the business after adjusting from the income earned during the year, all the expenditures
of the business incurred in that year. The various items of income and expenditure, which
arouse during the accounting period, are detailed out therein, and grouped under significant
heads. The primary objective of the Income Statement is to present the details of various
items of income or expenditure which have contributed to the making of the profit or loss.
Income Statement is sub-divided into following two parts for a non-manufacturing concern:
(i) Trading account; and
(ii) Profit and Loss account
Procedure for the preparation of these accounts has been explained separately in this
chapter.
B. Position Statement
Position statement mainly comprises of Balance Sheet, which exhibits assets and liabilities
of the business as at the close of the period. For proper knowledge of the financial position
of the business, sometimes additional statements are also prepared like cash flow statement,
statement showing earnings per share, value added statement etc. which is not mandatory
for non-corporate entities. These additional statements are prepared for the better
understanding of the financial position of the business. You will learn the preparation of
these additional statements in Professional Competency Course and Final.
Here, we will restrict our discussion to Trading account, Profit and Loss account and
Balance Sheet only.

2. PREPARATION OF FINAL ACCOUNTS


The principal function of final statements of account (Trading Account, Profit and Loss Account
and the Balance Sheet) is to exhibit truly and fairly the profitability and the financial position
of the business to which they relate. In order that these may be properly drawn up, it is essential
that a proper record of transactions entered into by the business during a particular accounting
period should be maintained. The basic principles in regard to accumulation of accounting
period data are:
(i) a distinction should be made between capital and revenue, both income and expenditure;
(ii) also income and expenses relating to a period of account should be separated from those
of another period. What is more important is, different items of income and expenditure
should be accumulated under significant heads so as to disclose the sources from which
capital has been procured and the nature of liabilities, which are outstanding for payment.
Having regard to these basic principles, the various matters to which attention should be paid
for determining the different aspects of transactions, a record of which should be kept, and the

FUNDAMENTALS OF ACCOUNTING 6.5


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

different heads of account under which various items of income and expenditure should be
accumulated, are stated below:
(a) Since the final statements of account are intended to show the profitability of the
business and not that of its proprietors, it is essential that all personal income and
expenditure should be separated from business income and expenditure.
(b) A distinction should be made between capital and revenue, both receipts and
expenditure. Different types of income and expenditure should be classified under
separate heads. Assets should be included in the Balance Sheet at a valuation arrived
at on the basis at which these are valued in the preceding year. Likewise, a provision
for income and expenses which have accrued but not paid, should be made by
estimation or otherwise on the same basis as in the previous year.
(c) Every information, considered material for judging the profitability of the business or
its financial position, should be disclosed. For example, when the labour charges have
increased on account of bonus having been paid to workmen, the amount of bonus
paid should be disclosed. Similarly, if some of the items of stock are not readily saleable,
these should be valued at their approximate sale price and the basis of valuation and
value of such stocks should be shown separately.
(d) Though the record of transactions should be maintained continuously, at the end of
each accounting period (accounting year), the transactions of the period which has
closed should be cut off from those of the succeeding period.
(e) It should be seen that only the effect of transactions, which were concluded before
the close of period of account, has been adjusted in the accounts of the year. For
example, when a sale of goods is to take place only after the goods have been inspected
by the purchaser and the inspection had not been made before the close of the year, it
would be incorrect to treat the goods as a sale in the accounts of the year.
2.1 INTER-RELATIONSHIP OF THE TWO STATEMENTS
One of the points to be remembered is that of total expenditure incurred. Some appears in the
Profit and Loss Account and some in the Balance Sheet. Consider few examples, of the total
amount spent on manufacturing goods. That part which is attributable to finished goods in
stock is shown in the Balance Sheet as closing stock and the amount debited to the Trading (or
the Profit and Loss) Account is thereby reduced. When a machine is purchased, that part of it
which is attributable to the year considered as depreciation is debited to the Profit and Loss
Account and the balance is show in the Balance Sheet as an asset. Next year again, part of the
cost will be debited to the Profit and Loss Account and the remaining cost will be shown as an
asset in the Balance Sheet. These illustrations show that the two statements, the Profit and
Loss Account and the Balance Sheet, are thoroughly inter-related. The assets shown in the
Balance Sheet are mostly only the remainder of the expenditure incurred after a suitable amount
has been charged to the Profit and Loss Account or the Trading Account. For preparing the
two statements properly, it is of the greatest importance that the amounts to be charged to the
Profit and Loss Account should be properly determined as otherwise both statements will
show an incorrect position. The principle that governs this is called the Matching Principle.

6.6 COMMON PROFICIENCY TEST


2.2 MATCHING PRINCIPLE
This principle demands that revenue and the expenses incurred to earn the revenue should be
properly matched. This means the following :
(a) If a certain revenue and income is entered in the Trading / Profit and Loss Account all the
expenses relating to it, whether or not payment has been actually made, should be debited
to the Trading / Profit and Loss Account. This is why at the end of the year an entry is
passed to bring into account the outstanding expenses. That is also the reason why the
opening stock of goods is debited to the Trading Account (or the Profit and Loss Account)
since the relevant sale is credited in the same account.
(b) If some expense has been incurred but against it sale will take place in the next year or
income will be received next year, the expense should not be debited to the current year’s
Profit and Loss Account but should be carried forward as an asset and shown in the
Balance Sheet and debited to the Profit and Loss Account when the relevant income will
be also be credited. It is because of this principle that :
(i) at the end of the year inventory of all the stocks in hand is prepared and is valued at
cost. The credit to the Trading Account (or the Profit and Loss Account) has the effect
of reducing the debit in the Trading Account to the extent goods remain unsold or
unutilised, these will be sold or used up next year and the cost will therefore, be
properly debited to the next year’s Trading Account. If the selling or the replacement
price is lower than the cost, stock will be valued at this price and not at cost. This has
the effect of raising the net debit in the Trading Account higher than the cost of goods
sold or utilised in the year, but that is proper. The fall of the selling price below cost
means that the loss has occurred in the year and therefore, the debit properly is to
current year’s Trading and Profit and Loss Account;
(ii) at the end of the year prepaid expenses are brought into the books by debiting prepared
expenses account and crediting the expenses concerned. The effect of this is also to
transfer the debit in respect of prepaid expenses to the next year when the benefit
from such expenses will accrue; and
(iii) at the end of the year, appropriate depreciation of fixed assets is charged to the profit
and loss account (and credited to the assets concerned ). In this manner, that part of
the cost of the assets which has been used up for earning current year’s revenue is
debited to the Profit and Loss Account.
(c) If an income or revenue is received in the current year but the work against it has to be
done and the cost in respect of it has to be incurred next year, the income or the revenue
is considered to be of next years. It should be shown in the Balance Sheet on the liabilities
side as “income received in advance” and should be credited to the Profit and Loss Account
of the next year. Firms, except those, which follow the cash system (and such firms are
usually of specialised personal service nature), do not credit to the Profit and Loss Account
that income or revenue against which service is to be rendered in future. Newspapers or
magazines usually receive subscriptions in advance for a year. The part of subscription
that covers copies to be supplied in the next year is treated as income received in advance.

FUNDAMENTALS OF ACCOUNTING 6.7


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

2.3 AN EXCEPTION
There appears to be one exception to the rule that only such costs as have yielded or is expected
to yield revenue should only be debited to Profit and Loss Account. For example, if a fire has
occurred and has damaged the firm’s property the loss must be debited to the Profit and Loss
Account to the extent it is not covered by insurance. A loss, resulting from the fall of selling
price below the cost or from some debts turning bad, must similarly be debited to the Profit and
Loss Account. If this is not done the profit will be over-stated.

3. TRADING ACCOUNT
At the end of the year, as has been seen above, it is necessary to ascertain the net profit or the
net loss. For this purpose, it is first necessary to know the gross profit or gross loss. Gross Profit
is the difference between the selling price and the cost of the goods sold. For a trading firm, the
cost of goods sold can be ascertained by adjusting the cost of goods still on hand at the end of
the year against the purchases. Suppose, in the first year, the net purchases (that is after
deducting returns) total Rs. 1,00,000 and that Rs. 15,000 worth of goods (at cost) were not sold
at the end of the year. The cost of the goods sold will then be Rs. 85,000. If in the next year
purchases are Rs. 1,50,000 and the cost of goods on hand at the end of the year is Rs. 20,000
the cost of goods sold will be Rs. 1,45,000. Thus:
Rs.
Cost of the stock of goods in the beginning of the year 15,000
Purchases 1,50,000
1,65,000
Less: Cost of the stock of goods at the end of the year 20,000
Cost of goods sold 1,45,000
If net sales, i.e., after adjustment for sales returns, total Rs. 2,00,000 the gross profit will be
Rs. 55,000, i.e., Rs. 2,00,000 – 1,45,000. The Profit is called gross profit since from it expenses
have still to be deducted for knowing the net profit.
Gross profit is usually ascertained by preparing a Trading account. For the figures given above,
the Trading Account will appear as shown below :
Trading Account for the year ending
Dr. Cr.
Rs. Rs.
To Opening Stock 15,000 By Sales Account 2,00,000
To Purchase Account 1,50,000 By Stock in hand 20,000
To Gross Profit carried to P & L A/c 55,000
2,20,000 2,20,000

6.8 COMMON PROFICIENCY TEST


The opening stock and purchases are written on the debit side. Sales and the closing stocks are
entered on the credit side. If there are any direct expenses then they should also be written on
the debit side of the Trading account. If the credit side is bigger, the difference is written on the
debit side as gross profit. This amount will also be written in the Profit and Loss Account on
the credit side. In case of gross loss, i.e., when the debit side of the Trading Account exceeds
the credit side, the amount will be written on the credit side of the Trading Account and the
debit side of the Profit and Loss Account.
3.1 TRADING ACCOUNT ITEMS
(a) In a trading firm like a wholesaler, the main business consists of buying and selling the
same goods. In addition to the amount of the opening stock, the trading account will also
be debited with all expenses incurred in bringing the goods to the godown of the firm and
in making them ready for sale. For example, freight paid on purchases, cartage, octroi,
etc. will all be debited to the Trading Account. The rule is that this account will be debited
with all expenses incurred in bringing the goods to their present location and condition.
We shall now consider individual items :
(1) Opening Stock : Since this was closing stock of the last year, it must have been entered
in the opening stock account, through the opening entry. Therefore, it will be found
in the trial balance. This item is usually put as the first item on the debit side of the
Trading Account. Of course, in the first year of a business there will be no opening
stock.
(2) Purchases and Purchase Returns : The purchases account will be debit balance,
showing the gross amount of purchases made of the materials. The purchase returns
account will be credit balance showing the return of materials to the suppliers. On
the debit side of the trading account the net amount is shown as indicated (with
assumed figures) :
Rs.
To Purchases 3,00,000
Less : Purchase Returns 10,000
2,90,000
It happens sometimes that goods are received but the relevant invoice is not received
from the supplier. On the date of the closing of the account, an entry must be passed
to debit the purchases account and credit the supplier with the cost of goods. One
may also exclude such goods from the closing stock and not pass any entry, but this
course is not recommended.
(3) Carriage or Freight Inwards : This item should also be debited to the Trading Account,
as it is incurred to bring the materials to the firm’s godown and make them available
for use. However, if any freight or cartage it paid on any asset, like machinery, it
should be added to the cost of the asset and not debited to the Trading Account.
(4) Wages : Wages paid to workers in the godown/stores, should be debited to the Trading
Account. If any amount is outstanding, it must be brought into books so that full

FUNDAMENTALS OF ACCOUNTING 6.9


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

wages for the period concerned are charged to the Trading Account. However, if
wages are paid for installation of an asset, it should be added to the cost of the asset.
(5) Sales and Sales Returns : The sales account will be a credit balance indicating the
total sales made during the year. The sales return account will be a debit balance,
showing the total of the amount of goods returned by customers. The net of the two
amounts is entered on the credit side of the Trading Account.
Sometimes, goods which have been sold and for which invoice has been prepared
may not have been dispatched. If the sale is complete, that is if the customer is liable
to pay the amount, such goods should be kept aside and not included in the closing
stock. If however, the sale is not yet complete say, when sent to customers on approval
basis, that is when the customer has the right to return the goods within the stipulated
period, the cost of the goods should be included in the closing stock and, if any entry
was passed to record the “sale”, it should be reversed.
(6) Closing Stock and its valuation : Usually there is no account to show the value of
goods lying in the godown at the end of the year. However, to correctly ascertain the
gross profit, the closing stock must be properly taken and valued.
The entry is
Closing Stock Account Dr.
To Trading Account
Alternatively, Closing stock can be adjusted with purchases :
Closing Stock Account Dr.
To Purchases Account
The effect of this entry is to reduce the debit in the Purchases Account. It will then
appear in the trial balance. The Stock Account is then not entered in the Trading
Account and will be shown only in the Balance sheet.
To ascertain value of the closing stock, it is necessary to make a complete inventory or
list of all the items in the godown together with quantities. Of course, damaged or
obsolete items are separately listed. To the list of finished goods, one should also add
the goods lying with agents sent to them on consignment basis and also the goods
sent on approval to customers.
The valuation principle is cost or market price whichever is lower.
Taking stock is quite a lengthy process. Strictly, immediately at the end of the year the
taking of stock should be completed. Sometimes, however this is done either a few
weeks before or a few weeks after the closing. In such a case the value of the stock
thus taken must be adjusted to relate it to the closing date. The adjustment will be
necessary because, in the meantime, purchases and sales must have been made. The
main point to remember is that in respect of sales their cost has been established. Cost
will be sales less gross profit.
(7) Sales Tax : Sales Tax is an indirect tax in the sense that it is collected by the seller
from the customers and deposited in Government’s Account as per requirements of

6.10 COMMON PROFICIENCY TEST


the Sales Tax Act. Sales tax is generally deducted from gross sales figures and sales
tax liability (net of payments) is shown as current liability in the balance sheet.
The Trading Account is very useful; with its help the firm can see the relationship between the
costs incurred and the revenues earned and also the level of efficiency with which operations
have been conducted. The ratio of gross profit to sales is very significant. It is arrived as

Gross Profit
× 100
Sale
In the illustration given in the preceding pages the rate of gross profit is 27.5%.
3.2 CLOSING ENTRIES IN RESPECT OF TRADING ACCOUNT
The following entries will be required :
(i) For opening stock : Debit Trading Account and Credit Stock Account.
(ii) For purchases returns : Debit Returns Outward Account and Credit Purchases Account.
For returns inward : Debit Sales Account and Credit Returns Inwards Account. (In the
trading account information is usually given both in respect of gross sales; and purchases
and the respective returns).
(iii) For purchases account : Debit Trading Account and Credit Purchases Account, the amount
being the net amount after return.
(iv) For expenses to be debited to the Trading Account, for example wages etc; Debit Trading
Account and credit the concerned expenses accounts individually.
(v) For sales : Debit Sales Account with the net amount after returns, and Credit Trading
Account.
The student will see that all the accounts mentioned above will be closed with the exception
of the Trading Account.
(vi) For closing stock : Debit Stock Account and Credit Trading Account. The Stock Account
will be carried forward to the next year.
After making the entries mentioned in (ii) above, the other entries are usually summarised as
follows :
(1) Trading Account Dr.
To Opening Stock Account
To Purchases Account
To Wages Account
To Freight on Purchases Account, etc.
(2) Sales Account Dr.
Closing Stock Account Dr.
To Trading Account
At this stage Trading Account will reveal the gross profit, it the credit side is bigger, or gross
loss it the credit side is short. The gross profit will be transferred to the Profit and Loss Account
by the entry:

FUNDAMENTALS OF ACCOUNTING 6.11


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Trading Account Dr.


To Profit and Loss Account
The entry for gross loss, if there be any is :
Profit and Loss Account Dr.
To Trading Account
Illustration 1
From the following information, prepare a Trading Account of M/s. ABC Traders for the year
ended 31st March, 2006 :
Rs.
Opening Stock 1,00,000
Purchases 6,72,000
Carriage Inwards 30,000
Wages 50,000
Sales 11,00,000
Returns inward 1,00,000
Returns outward 72,000
Closing stock 2,00,000
Solution
In the books of M/s. ABC Traders
Trading Account for the year ended 31st March, 2006

Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs. Rs. Rs.
To Opening stock 1,00,000 By Sales 11,00,000
To Purchases 6,72,000 Less : Returns
Inward 1,00,000 10,00,000
Less : Returns
outward 72,000 6,00,000 By Closing stock 2,00,000
To Carriage Inwards 30,000
To Wages 50,000
To Gross profit 4,20,000
12,00,000 12,00,000

6.12 COMMON PROFICIENCY TEST


Illustration 2
From the information given in illustration 1, pass necessary closing entries in the journal proper
of M/s. ABC Traders.
Solution
In the Books of M/s. ABC Traders
Journal Proper
Dr. Cr.
Date Particulars Amount Amount
2006 Rs. Rs.
Mar. 31 Returns outward A/c Dr. 72,000
To Purchases A/c 72,000
Being the transfer of returns to purchases
account)
Sales A/c Dr. 1,00,000
To Returns Inward A/c 1,00,000
(Being the transfer of returns to sales
account)
Sales A/c Dr. 10,00,000
To Trading A/c 10,00,000
(Being the transfer of balance of sales
account to trading account)
Trading A/c Dr. 7,80,000
To Opening Stock A/c 1,00,000
To Purchases A/c 6,00,000
To Wages A/c 50,000
To Carriage Inwards A/c 30,000
(Being the transfer of balances of opening
stock, purchases and wages accounts)
Closing stock a/c Dr. 2,00,000
To Trading A/c 2,00,000
(Being the incorporation of value of closing stock)
Trading A/c Dr. 4,20,000
To Gross Profit 4,20,000
(Being the amount of gross profit)
Gross profit Dr. 4,20,000
To Profit and Loss A/c 4,20,000
(Being the transfer of gross profit to Profit
and Loss Account)

FUNDAMENTALS OF ACCOUNTING 6.13


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

4. PROFIT AND LOSS ACCOUNT


The Profit and Loss Account starts with gross profit on the credit side. If there is gross loss, it
will be written on the debit side. After that all those expenses and losses, which have not been
entered in the Trading Account, will be written on the debit side of Profit and Loss Account.
Incomes and gains, other than sales, will be written on the credit side.
If we understand word ‘expenses’ properly, there should be no difficulty in distinguishing
between items that will be debited to the Profit and Loss Account and those that will not be
Assets and personal expenses are not written in this account, revenue expenses and losses, but
only those relating to the current year, are debited.
It is desirable, according to modern thinking that the Profit and Loss Account should be prepared
in such a manner as will enable the reader to form a correct idea about the profit earned or loss
suffered by the firm during the period together with the significant factors. Too many details
will prevent a person from knowing properly the factors leading to the profit earned. Therefore,
items should be according to the various functions, such as administrations, selling and
financing:
(1) Administrative expenses include the following :
(i) Salaries paid to the people working in the general office; salaries of executive officers
should be shown separately.
(ii) Rent and rates for the office premises.
(iii) Lighting in the office.
(iv) Printing and stationery.
(v) Postage, telegrams and telephone charges.
(vi) Legal expenses.
(vii) Audit fees, etc.
(2) The selling and distribution expenses will comprise the following :
(i) Salesmen’s salaries and commission.
(ii) Commission to agents.
(iii) Advertising.
(iv) Warehousing expenses.
(v) Packing expenses.
(vi) Freight and carriage on sales.
(vii) Export duties.
(viii)Sales tax to the extent it cannot be recovered from the customers.
(ix) Maintenance of vehicles for distribution of goods and their running expenses.
(x) Insurance of finished goods stock and goods in transit.
(xi) Bad debts.

6.14 COMMON PROFICIENCY TEST


It will be good idea to either show these expenses in a separate schedule or to indicate the total
of these prominently in the Profit and Loss Account. This rule should be followed wherever
the number of items is rather large.
Financing expenses normally include interest paid on loan, discount on bills discounted and
the discount allowed to customers. It is possible to show only the net amount of interest if it has
been both received and paid. It is however; better to show the two figures separately.
On the income side of the Profit and Loss Account, besides the gross profit, there may be
interest received, discount received, rents from subletting of premises, miscellaneous incomes
such as from sale of junk material etc., It would be desirable to show the totals only under each
of the main categories of income. However, interest on fixed deposits, interests or income from
investments and other interest should be shown separately. Similarly, items which have to be
debited/credited to the proprietor should be segregated from other items. Examples would be
interest charged on drawings, interest allowed on capital and charges for services rendered by
the firm to the proprietor personally.
We shall now consider a few items individually :
(i) Drawings : Drawings are not expenses for the firm and should therefore not be debited to
the Profit and Loss Account. If the proprietor has enjoyed some benefit personally, like
use of the firm’s car, a suitable amount should be treated as drawing and to that extent
the charge to the Profit and Loss Account will be reduced, Drawings are debited to the
proprietor’s capital account.
(ii) Income Tax : In case of companies, the income tax payable is treated like other expenses.
But in the case of sole proprietorship, income tax is treated as a personal expense. It is
debited to the Capital Account and not to the Profit and Loss Account. This is because the
amount of the tax will depend on the total income of the partners or proprietor besides the
profit of the firm. In case of partnership business, firm’s tax liability is to be debited to
profit and loss account of the firm but partners’ tax liability are not to be borne by the firm.
Therefore if the firm pays income tax on behalf of partners, such payment of personal
income tax should be treated as drawings.
(iii) Discount Received and allowed : We have already seen that discount is of two types.
Trade discount and Cash discount. Trade discount is allowed when the order for goods is
not below a certain figure. It is deducted from the invoice. Only the net amount of invoice
is entered in books. There is no further treatment of the trade discount. Cash discount is
allowed to a customer if he makes the payment before a certain date. It is allowance made
to him for prompt payment. Discount received is really in the nature of interest received
and similarly, discount allowed really means interest paid. Discount received is a gain
and is credited to the Profit and Loss Account. Discount allowed is debited to this account.
There is another term - Rebate. It is the allowance given to a customer when his purchases
during a period, say one year, total upto a certain figure. Suppose a firm allows a rebate of
4% to those customers whose purchases during the year are at least Rs. 5,000. One
Customer’s purchases are Rs. 4,500, he will not get any rebate. Another customer’s
purchases total Rs. 5,100, he will get a rebate of Rs. 204. The entry for rebate is made only
at the end of the year. The Rebate Account is debited and is later written in the profit and
Loss Account on the debit side. Various customers who have earned the rebate are credited.

FUNDAMENTALS OF ACCOUNTING 6.15


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

(iv) Bad Debts: When a customer does not pay the amount due from him and all hopes of
recovering the amount are lost, it is said to be a bad debt. It is a loss to the firm. Therefore,
the bad debts account is debited, which is later on written in the Profit and Loss Account
on the debit side. Since it is no use showing the amount due still as an asset, the account of
the customer concerned is closed by being credited. The entry
Bad Debts Account Dr.
To Debtor’s (by name) Account
If later on, the amount is recovered, it should be treated as a gain. It should not be credited to
the party paying it. It should be credited to Bad Debts Recovered Account. It will be entered in
the Profit and Loss Account on the credit side.
4.1 CLOSING ENTRIES
The entries that have to be made in the journal for preparing the Trading and the Profit and
Loss Account that is for transferring the various accounts to these two accounts are known as
closing entries. We have already seen the entries required for preparing the Trading Account
and for transferring the gross profit to the profit and Loss Account. Now to complete the Profit
and Loss Account, the under mentioned three entries will be necessary.
(a) For items to be debited to the Profit and Loss Account this account will be debited and the
various accounts concerned will be credited. For example,
Profit and Loss Account Dr.
To Salaries Account
To Rent Account
To Interest Account
To Other Expenses Account
(b) Items of income or gain such as interest received or miscellaneous income will be debited
and credited to Profit and Loss Account.
Discount Received Account Dr.
Bad debts Recovered Account Dr.
To Profit and Loss Account
(c) At this stage, the Profit and Loss Account will show net profit or net loss. Both have to be
transferred to the Capital Account. In case of net profit, i.e., when the credit side is bigger
than the debit side, the entry is :
Profit and Loss Account Dr.
To Capital Account
In the case of net loss, the entry will be
Capital Account Dr.
To Profit and Loss Account

6.16 COMMON PROFICIENCY TEST


Illustration 3
Revenue, Expenses and Gross Profit Balances of M/s ABC Traders for the year ended on 31st
March 2006 were as follows:
Gross Profit Rs. 4,20,000, Salaries Rs. 1,10,000, Discount (Cr.), Rs. 18,000, Discount (Dr.)
Rs. 19,000, Bad Debts Rs. 17,000, Depreciation Rs. 65,000, Legal Charges Rs. 25,000,
Consultancy Fees Rs. 32,000, Audit Fees Rs. 1,000, Electricity Charges Rs. 17,000, Telephone,
Postage and Telegrams Rs. 12,000, Stationery Rs. 27,000, Interest paid on Loans Rs. 70,000.
Prepare Profit and Loss Account of M/s ABC Traders for the year ended on 31st March,
2006.
Solution
In the Books of M/s. ABC Traders
Profit and Loss Account
For the year ended 31st March, 2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Salaries 1,10,000 By Gross Profit 4,20,000
“ Legal Charges 25,000 By Discount received 18,000
“ Consultancy Fees 32,000
“ Audit Fees 1,000
“ Electricity Charges 17,000
“ Telephone, Postage &
Telegrams 12,000
“ Stationery 27,000
“ Depreciation 65,000
“ Discount Allowed 19,000
“ Bad Debts 17,000
“ Interest 70,000
“ Net Profit 43,000
4,38,000 4,38,000

Illustration 4
From the information given in illustration 3, show necessary closing entries in the Journal
Proper of M/s. ABC Traders.

FUNDAMENTALS OF ACCOUNTING 6.17


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Solution: In the Books of M/s. ABC Traders


Journal Proper
Date Particulars Dr. Cr.
2006 Amount Amount
Rs. Rs.
March 31 Profit & Loss Account Dr. 3,95,000
To Salaries A/c 1,10,000
To Legal Charges A/c 25,000
To Consultancy Fees A/c 32,000
To Audit Fees A/c 1,000
To Electricity Charges A/c 17,000
To Telephone, Postage & Telegrams A/c 12,000
To Stationery A/c 27,000
To Depreciation A/c 65,000
To Discount Allowed A/c 19,000
To Bad Debts A/c 17,000
To Interest A/c 70,000
(Being the transfer of balances of various
expenses accounts)
“ Discount Received A/c Dr. 18,000
To Profit & Loss A/c 18,000
(Being the transfer of discount received
account balance)
“ Gross Profit A/c Dr. 4,20,000
To Profit & Loss A/c 4,20,000
(Being the transfer of gross profit from
Trading Account)
“ Profit & Loss A/c Dr. 43,000
To Net Profit A/c 43,000
(Being the ascertainment of net profit)
Net Profit A/c Dr. 43,000
To Capital A/c 43,000
(Being the transfer of net profit to Capital A/c)

6.18 COMMON PROFICIENCY TEST


4.2 ADJUSTMENTS
The fundamental principle of accounting is that the period to which various items of income
and expenditure pertain should be co-extensive with the period of account. As such before
Final Accounts are drawn up. It must be ensured that the accounts, which require adjustment
on this consideration, have been adjusted, both by providing for expense accrued and including
income outstanding and excluding expenses the benefit of which extends beyond the year of
account as well as the income received in advance. The entries that will have to be passed for
adjusting various accounts of income and expenditure are shown below:
(1) Expenses accrued and accruing, e.g., Rent, Interest, Local Taxes, Wages etc.
Appropriate Expense Account Dr.
To Expenses Accrued Account
(2) Income accrued and accruing, e.g., Interest on Government Loans, Discounts on Bill,
Professional fees, Rents and Premiums on leases, etc.
Interest/Fees etc. Accruing Account Dr.
To Appropriate Income Account
Notes :
(1) The term “accrued” signifies that an amount has been incurred as expense or earned as
income, the due date of payment of which falls in the next trading period. If the due date
of payment occurs in the accounting period the term used should be “Outstanding” or
“accrued and due”.
(2) The expression ‘accrued and accruing’ signifies items which though not due for payment
but pertain to the period of account, a provision for which has been made. Converse is the
position so far as items of income are concerned.
(3) Carrying forward income received in advance e.g., Subscription in the case of a club or
fees in case of professional person.
Appropriate Income Account Dr.
To Income Received in Advance Account
(4) Carrying forward of payments made in advance e.g., Telephone, Rent, Insurance etc.,
amounts where of stand debited to an expense account.
Expenses Prepaid Account Dr.
To Appropriate Expenses Account
(5) Adjustment of stock of materials in hand, e.g., Stationery, Advertisement, Material.
Manufacturing Stores, etc., the cost whereof already has been debited to expense account.
Stock of Materials Dr.
To Appropriate Expenses Account
Note : Next year in the beginning entries No. (1) to (5) should be reversed.

FUNDAMENTALS OF ACCOUNTING 6.19


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

(6) Provision for Bad and doubtful Debts : When it is feared that some of the amount due
from customers will not be collected it is prudent to recognise the expected loss by reducing
the current year’s profit and placing the amount to the credit of a special account called
“Provision for Bad and Doubtful Debts Account”. The entry is;
Profit and Loss Account Dr.
To Provision for Bad and doubtful Debts Account
Note : The accounts of the customers concerned are not affected until the amount is actually
written off for which the entry is,
Bad Debts Account Dr.
To Customer’s A/c
Bad Debts when written off are debited to the provision in this respect where such a
provision exists or directly to the Profit and Loss Account the corresponding credit being
given (ultimately) to the debtor’s account. If, on the other hand, a provision is required to
be created, the amount of provision is also debited to the Profit and Loss Account. Where
an examination problem requires that certain bad debts should be written off and a
provision for doubtful debts made, the amount of bad debts to be written off should be
first debited against the existing balance of the provision and the resulting balance in the
account afterwards should be raised to the required figure. The method is illustrated below :
Illustration 5
On 1st Jan. 2006 provision for Doubtful Debts existed at Rs. 400. Debtors on 31.12.2006 were
Rs. 15,000; bad debts totalled Rs. 1,000. It is required to write off the bad debts and create a
provision equal to 5% of the debtors’ balances. Show how you would compute the amount
debited to the Profit and Loss Account.
Opening Provision (Cr.) 400
Bad Debts written off (Dr.) 1,000
600
Provision required (Dr.) (5% of Rs. 14,000) 700
Additional amount required by debit to the Profit and Loss Account (Dr.) 1,300
Solution
The account will appear as follows:
Provision for Doubtful Debts Account
2006 Rs. 2006 Rs.
Dec. 31 To Bad Debts Account 1,000 Jan. 1 By Balance b/d 400
To Balance c/d (required) 700 Dec. 31. By Profit and Loss A/c
(Balancing Figure) 1,300
1,700 1,700
2007
Jan 1. By Balance b/d 700

6.20 COMMON PROFICIENCY TEST


(7) Provision for Discount : This provision is created in the same manner, as discussed above
but the amount of provision is required to be calculated after deducting the Provision for
Bad Debts from the total debtors.
(8) Provision for Depreciation : It is made either by debiting Depreciation Account and crediting
the asset account concerned and afterwards closing of the Depreciation Account by transfer
to the Profit and Loss Account or by directly debiting the profit and loss Account and
crediting the asset account and explaining the nature of adjustment by recording a detailed
narration in the Journal. More appropriately, the Profit and Loss Account or first the
Depreciation Account may be debited and Provision Account credited by the amount of
annual depreciation.
(9) Other Provisions : Whenever it is expected that a loss, the amount of which is not certain
will occur, the proper course is to create a provision for meeting the loss if and when it
occurs. This would be the case, for example, if compensation has to be paid for the late
delivery of goods. The entry is to debit the Profit and Loss Account and credit an account
suitably named.
All accounts showing provisions may appear in the Balance Sheet but it should be noted
that:
(i) The provision for Bad and Doubtful Debts and the Provision for Discount on Debtors
are deducted from the total book debts; and
(ii) The provision for Depreciation is deducted from the cost of the assets concerned.
(10) Transfers, involving correction of errors, are made by debit or credit to the accounts affected,
the corresponding effect being recorded either in a Suspense Account of some other account.
Transfers in respect of special charges to the Profit and Loss Account e.g., partner’s salaries,
interest, etc., and in respect of appropriation of profits are recorded by debit to the Profit and
Loss Account and credit to the parties concerned.
While making adjustments, it is important to remember that every entry has a two-fold aspect,
debit and credit. For example, if an adjustment is required to be made on account of prepaid
insurance charges, the Insurance Charges Account would be credited, and, to complete the
double entry, Prepaid Expenses Accounts debited with the same amount. The last mentioned
balance would be included on the debit side of the Trial Balance.
Students should, as a matter of course, record on the rough working sheets adjustments in
respect of various items stated in a question and then appropriate their effect in the Trial
Balance, before proceeding to draw up the Final Accounts.

5. CERTAIN ADJUSTMENTS AND THEIR TREATMENTS


1. Abnormal loss of stock by accident or fire : Some times loss of goods occurs due to fire,
theft, etc. If due to accident or fire, a portion of stock is damaged, the value of loss is first
to be ascertained. Thereafter, Abnormal Loss Account is to be debited and Purchase
Account is to be credited.

FUNDAMENTALS OF ACCOUNTING 6.21


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Abnormal Loss Account is to be transferred to Profit & Loss Account. If amount of loss is
recoverable from insurance company, then insurance company is to be debited instead of
Profit & Loss Account. Till the money not received from the insurance company, Insurance
Company’s Account will be shown in the Assets side of the Balance Sheet. If any part of
the loss is recoverable from the insurance company, them the portion not compensated by
the insurance company should be debited to Profit & Loss Account. For example, if goods
worth Rs. 6,000 are destroyed by fire and the insurance company admits the claim for
Rs. 4,500, the Journal entries will be:-
(i) Loss by Fire Account Dr. 6,000
To Purchase Account 6,000
(ii) Insurance Company’s A/c (Insurance Claim) Dr. 4,500
Profit & Loss A/c Dr. 1,500
To Loss by Fire A/c 6,000
2. Goods sent on Approval basis : Sometimes goods are sold to customers on sale or return
basis or on approval basis. It should not be treated as actual sale till the time it is not
approved by the customer. When goods were sold we have passed the entry for actual
sales. Therefore, at the year end, if the goods are still lying with the customers for approval,
following entries are to be passed:
For example -
Goods costing Rs.10,000 sent to a customer on sale or return basis for Rs.12,000. The entry
for such unapproved sale shall be-
(i) Sales A/c Dr. 12,000
To Sundry Debtors A/c 12,000
(ii) Stock with Customers A/c Dr. 10,000
To Trading A/c 10,000
3. Goods used other than for sale : Some times goods are used for some other purposes,
such as distributed as free samples, used in construction of any assets or used by proprietor
for personal use. In such cases the amount used for other purposes is subtracted from
Purchase A/c and depending upon the specific use done, the suitable account head is
debited.
For example :-
When goods are given away as donation-
Donation A/c Dr.
To Purchases A/c
When goods are used by the proprietor for his personal use-
Drawings A/c Dr.
To Purchases A/c

6.22 COMMON PROFICIENCY TEST


When goods are distributed as free samples :-
Free Samples / Advertisement A/c Dr.
To Purchase A/c
When goods are used in business for construction of Building or the Machinery :-
Building A/c / Plant & Machinery A/c Dr
To Purchases A/c
When goods are used for maintenance of business premises/ Machinery : -
Repair & Maintenance A/c Dr.
To Purchases A/c
4. Sales Tax : If Sales Tax is charged from the customers, along with the price of the goods
sold, amount of sales tax should be shown separately in the sales day book. Periodically
this sales tax is to be deposited with the Sales Tax Department of the Government. The
following entries are passed-
(i) At the time of sale-
Cash/Debtors A/c Dr.
To Sales A/c
To Sales Tax Payable A/c
(ii) On payment of sales-
Sales Tax Payable A/c Dr.
To Bank A/c
If any balance remains in the Sales Tax Payable Account, it should be shown in the Balance
Sheet as liability.
5. Commission based on profit : Sometimes commission is payable to manager based on net
profit; in such a case calculation is done as follows:
(i) Commission on net profit before charging such commission =

Rate of commission
Profit before commission ×
100
(ii) Commission on net profit after charging such commission =

Rate of commission
Profit before commission ×
100+ Rate of commission

FUNDAMENTALS OF ACCOUNTING 6.23


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Commission is recorded by following journal entry-


Commission A/c Dr.
To Commission Payable A/c
(Being commission payable to Mr ….. @ …..% on net profit after
charging such commission, net profit before charging commission being Rs ……..)
Commission will be debited in Profit & Loss Account and Commission Payable Account
will be shown in the Balance Sheet on liability side.
Illustration 6
The following is the Trial Balance of C. Wanchoo on 31st Dec. 2006.
Trial Balance on 31st December, 2006
Dr. Cr.
Rs. Rs.
Capital Account 10,000
Stock Account 2,000
Cash in hand 1,440
Machinery Account 7,360
Purchases Account 18,200
Wages Account 10,000
Salaries Account 10,000
Discount Allowed A/c 500
Discount Received A/c 300
Sundry Office Expenses Account 6,000
Sales Account 50,000
Sums owing by customer (Sundry Debtors) 8,500
Sundry Creditors (sums owing to suppliers) 3,700
Total 64,000 64,000
Value of Closing Stock on 31st Dec. 2006 was Rs. 2,700
Prepare closing entries for the above items.

6.24 COMMON PROFICIENCY TEST


Solution
Journal
Date Particulars L.F. Dr. Cr.
2006 Rs. Rs.
Dec. 31 Trading Account Dr. 30,200
To Stock Account 2,000
To Purchase A/c 18,200
To Wages A/c 10,000
(Being the accounts in the Trial Balance
which have to be transferred to the Trading
Account debit side)
Dec. 31 Sales Account Dr. 50,000
To Trading A/c 50,000
(Being the amount of Sales transferred
to the credit of Trading Account)
Dec. 31 Stock (Closing) A/c Dr. 2,700
To Trading A/c 2,700
(Being the value of Stock on hand on
31st Dec. 2006)
Dec. 31 Trading A/c Dr. 22,500
To Profit and Loss A/c 22,500
(Being the transfer of gross profit.)
Dec. 31 Profit and Loss A/c Dr. 16,500
To Discount Allowed Account 500
To Salaries A/c 10,000
To Sundry Office Expenses A/c 6,000
(Being the various expense accounts
transferred to the P & L Account)
Dec. 31 Discount Received A/c Dr. 300
To P & L Account 300
(Being the credit balance of discount received
transferred to Profit and Loss A/c)
Dec. 31 Profit and Loss A/c Dr. 6,300
To Capital A/c 6,300
(Being the transfer to Net Profit to the
Capital Account)
1,28,500 1,28,500

FUNDAMENTALS OF ACCOUNTING 6.25


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Illustration 7
From the data given in illustration 6, prepare Trading and Profit and Loss Account.
Solution
C. WANCHOO
Trading Account of the year ended December 31, 2006
Rs. Rs.
To Stock A/c 2,000 By Sales A/c 50,000
To Purchases 18,200 By Stock (Closing) 2,700
To Wages 10,000
To Gross profit trfd. to P & L A/c 22,500
52,700 52,700

Profit and Loss Account for the year ended December 31, 2006
Rs. Rs.
To Salaries 10,000 By Gross profit trfd. from
To Discount Allowed 500 the Trading Account 22,500
To Sundry Office Expenses 6,000 By Discount Received 300
To Net Profit transferred to
Capital A/c 6,300
22,800 22,800

6. BALANCE SHEET
The balance sheet may be defined as “a statement which sets out the assets and liabilities of a firm
or an institution as at a certain date.” Since even a single transaction will make a difference to
some of the assets or liabilities, the balance sheet is true only at a particular point of time. That
is the significance of the word “as at.”
In the illustration worked out above it will be seen that the under mentioned accounts have
not been closed even after preparation of the Profit and Loss Account and the transfer of the
net profit to the capital account.
Rs.
Cash in Hand 1,440 Debit balance
Capital Accounts (Rs.10,000+ Rs.6,300) 16,300 Credit balance
Machinery Account 7,360 Debit balance
Sundry Debtors 8,500 Debit balance
Sundry Creditors 3,700 Credit balance
Stock Account 2,700 Debit balance

6.26 COMMON PROFICIENCY TEST


Looking at these accounts, one would know that various assets : Cash balance in hand, cash at
bank, machinery, furniture etc. that the firm possesses and the amounts that are owing as
liability to Sundry Creditors and to the proprietor as capital. The capital, of course, will be the
difference between the total of assets and of liabilities. The assets, liabilities and capital are
usually presented in a statement called the Balance Sheet. This is given below for the accounts
mentioned above.
C. WANCHOO
Balance Sheet as at December 31, 2006
Liabilities Rs. Assets Rs.
Sundry Creditors 3,700 Cash in Hand 1,440
Capital 16,300 Sundry Debtors 8,500
Stock 2,700
Machinery 7,360
20,000 20,000

The assets are shown on the right hand side and liabilities and capital on the left hand side.
6.1 CHARACTERISTICS
The balance sheet has certain characteristics, which should be noted. These are the following:
(i) It is prepared at a particular date, rather the close of a day and not for a period. It is true
only on that date and not later. Suppose, in the example given above, a part of the goods
were sold on 1st January, 2007. This will mean that the value of the stock will be reduced,
the cash in hand will increase and the capital account will be reduced.
(ii) The balance sheet is prepared only after the preparation of the Profit and Loss Account.
This is the reason why the Profit and Loss Account (including the Trading Account) and
the Balance Sheet are together called Final Accounts (Of course, the Balance Sheet is not
an account, the two sides are not the debit and the credit sides.) Without being accompanied
by the Profit and Loss Account, the Balance Sheet will not be able to throw adequate light
on the financial position of the firm. For that purpose an appreciation of the profits of the
firm is necessary.
(iii) Since capital always equals the difference between assets and liabilities and since the capital
account will independently arrive at this figure, the two sides of the Balance Sheet must
have the same totals. If it is not so, there is certainly an error somewhere.
6.2 ARRANGEMENTS OF ASSETS AND LIABILITIES
(1) Assets : Assets may be grouped in one of the following two ways :
(i) Liquidity : Under this approach, the asset, which can be converted into cash first, is
presented first. Those assets, which are most difficult in this respect, are presented at
the bottom.

FUNDAMENTALS OF ACCOUNTING 6.27


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

(ii) Permanence: Assets, which are to be used, for long term in the business and are not
meant to be sold are presented first. Assets, which are most liquid, such as cash in
hand, are presented at the bottom.
The various assets in two order will be as follows:
In the order of Liquidity In the order of Permanence
Cash in Hand Goodwill
Cash at Bank Patents
Investments Furniture
Sundry Debtors Machinery
Stock of Finished Goods Stock of Partly Finished goods
Stock of Raw Materials Stock of Raw Materials
Partly Finished goods Stock of Finished goods
Machinery Sundry Debtors
Furniture Investments
Patents Cash at Bank
Goodwill Cash in Hand
Some of the assets may be capable of being sold easily like investment in government
securities or shares of some companies. They should be treated as liquid or permanent
according to the intention of the firm. One should also note that the order in which the
assets of a company are to be shown is described by the Companies Act.
(2) Liabilities : Liabilities may also be shown according to the urgency with which payment
has to be made. One way is to first show the capital, then long-term liabilities and last of
all short term liabilities like amounts due to suppliers of goods or bills payable. The other
way is to start with short-term liabilities and then show long term liabilities and last of all
capital.
6.3 CLASSIFICATION OF ASSETS AND LIABILITIES
Assets are basically of two types. Those that are meant to be used by the firm over a long
period and not sold and those that are meant to be converted into cash as quickly as possible.
Examples of the latter are book debts, stocks of finished goods and materials, etc. The later
types of assets are called current assets. These include cash also. The former type of assets is
called fixed assets. It is desirable that in the balance sheet the two types of assets should be
shown separately and prominently. This would give meaningful and logical information.
The liabilities to outsider will be of two types. Those that must be settled within one year and
those that will be paid after one year. The former type of liability is called current or short-term
liability. The latter type is long term liability. Of course, it will include undistributed profits
also.

6.28 COMMON PROFICIENCY TEST


Sole proprietors generally present Balance Sheet in a horizontal form with “Capital and
Liabilities” on the left hand side and ‘Assets’ on the right-hand side. In the Balance Sheet the
various items should be grouped suitably as indicated below:
Balance Sheet as on…………..
Capital and Liabilities Amount Assets Amount
Rs. Rs.
Capital A/c: Tangible Fixed Assets :
Balance Land and Building
Add : Net Profit/Less: Net Loss Plant and Machinery
Less : Drawings Furniture and Fixture
Long Term Loans : Vehicles
Term Loans Intangibles :
Other Loans Goodwill
Short Term Loans : Patent Rights
Cash Credit Designs and Brand Names
Overdrafts Deferred Advertisement
Other Loans Investments :
Current Liabilities : Long term investments
Sundry Creditors
Bills Payable Current Assets :
Outstanding Expenses Stock In Trade
Advances Taken Sundry Debtors
Provision : Bills Receivable
Provision for Bad debts Prepayments
Provision for Retirement Benefits Advances
Provisions for Taxation Bank Balances
Cash In Hand
Of course, there is no hard and fast rule regarding presentation of assets, liabilities and equities
in the Balance sheet. However, the model presentation shown above has been designed
considering nature of Balance Sheet elements and categorizing them appropriately.
Proper presentation of Balance Sheet items improved understandability of the information
desired to be communicated to the users of account.

FUNDAMENTALS OF ACCOUNTING 6.29


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Illustration 8
Given below Trial Balance of M/s Dayal Bros. as on 31st March, 2006 :
Debit Balances Credit Balances
Rs. Rs.
Capital A/c 7,00,000
Land and Building 3,00,000
14% Term Loan 4,00,000
Loan from M/s. D & Co. 4,60,000
Sundry Debtors 4,20,000
Cash in hand 20,000
Stock In Trade 6,00,000
Furniture 2,00,000
Sundry Creditors 40,000
Advances to Suppliers 1,00,000
Net Profit 1,00,000
Drawings 60,000
17,00,000 17,00,000
Prepare Balance Sheet as on 31st March, 2006.
Solution
In the Books of M/s Dayal Bros.
Balance Sheet
as on 31st March, 2006
Capital and Liabilities Amount Amount
Rs. Rs. Assets Rs.
Capital: Balances 7,00,000 Land & Building 3,00,000
Add: Net Profit 1,00,000 Furniture 2,00,000
8,00,000 Stock in Trade 6,00,000
Less: Drawings 60,000 7,40,000 Sundry Debtors 4,20,000
14% Term Loan 4,00,000 Advances to Suppliers 1,00,000
Loan from M/s D & Co. 4,60,000 Cash in Hand 20,000
Sundry Creditors 40,000
16,40,000 16,40,000

6.30 COMMON PROFICIENCY TEST


Illustration 9
The balance sheet of Thapar on 1st January, 2005 was as follows :
Particulars Rs. Particulars Rs.
Sundry Creditors 15,000 Plant & Machinery 30,000
Expenses Payable 1,500 Furniture & Fixture 3,000
Capital 50,000 Stock 13,000
Sundry Debtors 14,000
Cash at Bank 6,500
66,500 66,500

During 2005, his Profit and Loss Account revealed a net profit of Rs. 15,300. This was
after allowing for the following :
(a) Interest on capital @ 6% p.a.
(b) Depreciation on Plant and Machinery @ 10% and on Furniture and Fixtures @ 5%.
(c) A provision for Doubtful Debts @ 5% of the debtors as at 31st December, 2005.
But while preparing the Profit and Loss Account he had forgotten to provide for (1) outstanding
expenses totaling Rs. 1,800 and (2) prepaid insurance to the extent of Rs. 200.
His current assets and liabilities on 31st December, 2005 were : Stock Rs. 14,500; Debtors,
Rs. 20,000; Cash at Bank, Rs. 10,350 and Sundry Creditors Rs. 11,400.
During the year he withdrew Rs. 6,000 for domestic use. Draw up his Balance Sheet at the
end of the year.
Solution
Profit and Loss Account (Revised)
Particulars Rs. Particulars Rs.
To Outstanding expenses 1,800 By Balance b/d 15,300
To Net profit 13,700 By Prepaid insurance 200
15,500 15,500
Balance Sheet of Thapar
as on 31st December, 2005
Liabilities Rs. Assets Rs. Rs.
Capital 50,000 Cash at Bank 10,350
Add: Net Profit 13,700 Debtors 20,000
63,700 Less: Provision for
doubtful 1,000 19,000

FUNDAMENTALS OF ACCOUNTING 6.31


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Less : Drawings 6,000 Plant and Machinery 30,000


57,700 Less: Depreciation 3,000 27,000
Add: Interest on capital 3,000 60,700 Furniture & Fixtures 3,000
Outstanding expenses 1,800 Less: Depreciation 150 2,850
Creditors 11,400 Stock 14,500
Prepaid insurance 200
73,900 73,900

7. SEQUENCE OF ACCOUNTING PROCEDURE OR THE


ACCOUNTING CYCLE
What has been done so far shows that the accounting process in the following order :
(i) recording the transactions in the journal or journalising;
(ii) preparing ledger accounts on the basis of the journal or posting into the ledger;
(iii) taking out the trial balance to prove arithmetical accuracy;
(iv) preparing the profit and loss account or the income statement for the period concerned;
and
(v) preparing the balance sheet to show the financial position as the end of the period.

8. OPENING ENTRY
We have seen that on commencing a new business one debits the cash account and credits the
capital account with the amount introduced. A firm closes the books of account at the end of
each year and starts new books in the beginning of each year. The first entry in the journal is to
record the closing balances of various assets and liablities at the end of the previous year as the
opening balances in the beginning of the new year. The balance sheet prepared at the end of
the year records these balances and is the basis for this first entry. It is called the opening entry.
The assets shown in the balance sheet are debited and the liabilities and the capital account
credited.
Illustration 10
From the given below balance sheet prepare the relevant opening entry.
BALANCE SHEET
As at 31st December, 2005
Liabilities Rs. Assets Rs.
Mahendra & Sons 5,600 Cash in hand 430
Capital 20,000 Cash at Bank 2,675
Debtors 7,495
Closing Stock 9,000
Machinery and Equipment 6,000
25,600 25,600

6.32 COMMON PROFICIENCY TEST


Solution
The Opening Entry :
Dr. Cr.
Rs. Rs.
Cash A/c Dr. 430
Bank A/c Dr. 2,675
Sundry Debtors Dr. 7,495
Stock A/c Dr. 9,000
Machinery and Equipment A/c Dr. 6,000
To Mahendra & Sons A/c 5,600
To Capital A/c 20,000

(Being the balances brought forward) 25,600 25,600

8.1 POSTING THE OPENING ENTRY

The assets all show debit balance. Such accounts are opened and the relevant amounts written
on the debit side as “To Balance b/d”. We show the cash account arising from the entry given
above.
CASH ACCOUNT
Dr. Cr.
Date Particulars Amount Date Particulars Amount
2006 Rs. P.
Jan. 1 To Balance b/d 430 —
The accounts of liabilities show credit balances. An account for each liability is opened and the
relevant account is written on the credit side as “By Balance b/d”. This is shown below by
opening the accounts of Mahendra & Sons mentioned in the entry given above.
MAHENDRA & SONS
Dr. Cr.
Date Particulars Amount Date Particulars Amount
Rs. P. 2006 Rs. P.
Jan. 1 By Balance b/d 5,600 –

FUNDAMENTALS OF ACCOUNTING 6.33


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

By posting the opening entry completely all the accounts of assets and liabilities in the beginning
are opened. We illustrate below a complete cycle of journalising, posting and trial balance.
Students should work through the following illustration given by way of practice on the method
of making adjustments in some of the accounts contained in a Trial Balance and afterwards
preparing the final Account.
Illustration 11
Shri Mittal gives you the following Trial Balance and some other information :
Trial Balances as on 31st March, 2006
Dr. Cr.
Rs. Rs.
Capital 8,70,000
Purchases and Sales 6,05,000 12,10,000
Opening Stock 72,000
Debtors and Creditors 90,000 1,70,000
14% Bank Loan 2,00,000
Overdrafts 1,12,000
Salaries 2,70,000
Advertisements 1,10,000
Other expenses 60,000
Returns 40,000 30,000
Furniture 4,50,000
Building 8,90,000
Cash in Hand 5,000
25,92,000 25,92,000
Closing stock on 31st March, 2006 was valued at Rs. 1,00,000.
Prepare his final accounts.
Solution
In the books of Shri Mittal
Trading Account
for the year ended 31st March, 2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Opening Stock 72,000 By Sales 12,10,000
To Purchases 6,05,000 Less: Returns 40,000 11,70,000
Less: Returns 30,000 5,75,000 By Closing stock 1,00,000
To Gross Profit 6,23,000
12,70,000 12,70,000

6.34 COMMON PROFICIENCY TEST


Profit and Loss Account
For the year ended 31st March, 2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Salaries 2,70,000 By Gross profit 6,23,000
To Advertisement 1,10,000
To Other expenses 60,000
To Net profit 1,83,000
6,23,000 6,23,000

Balance Sheet as on 31st March, 2006


Liabilities Amount Assets Amount
Rs. Rs. Rs.
Capital 8,70,000 Building 8,90,000
Add: Net profit 1,83,000 10,53,000 Furniture 4,50,000
14% Bank Loan 2,00,000 Debtors 90,000
Creditors 1,70,000 Closing stock 1,00,000
Overdrafts 1,12,000 Cash in hand 5,000
15,35,000 15,35,000

Illustration 12
Mr. Mohan gives you the following trial balance and some other information:
Trial Balance as on 31st March, 2006
Dr. Cr.
Rs. Rs.
Capital 6,50,000
Sales 9,70,000
Purchases 4,30,000
Opening Stock 1,10,000
Freights Inward 40,000
Salaries 2,10,000
Other Administration Expenses 1,50,000
Furniture 3,50,000
Debtors and Creditors 2,10,000 1,90,000
Returns 20,000 12,000
Discounts 19,000 9,000

FUNDAMENTALS OF ACCOUNTING 6.35


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Bad Debts 5,000


Investments in Government Securities 1,00,000
Cash in Hand and Cash at Bank 1,87,000
18,31,000 18,31,000

Other Information :
(i) Closing stock was Rs. 1,80,000;
(ii) Depreciate Furniture @ 10% p.a.
You are required to prepare Trading and Profit and Loss Account for the year ended on 31.3.2006
and Balance Sheet of Mr. Mohan as on that date.
Solution
In the books of Mr. Mohan
Trading Account
for the year ended 31st March, 2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Opening stock 1,10,000 By Sales 9,70,000
To Purchases 4,30,000 Less: Returns 20,000 9,50,000
Less: Returns 12,000 4,18,000 By Closing stock 1,80,000
To Freight Inwards 40,000
To Net profit 5,62,000
11,30,000 11,30,000
Profit and Loss Account
for the year ended 31st March, 2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Depreciation 35,000 By Gross profit 5,62,000
To Salaries 2,10,000 By Discount received 9,000
To Administration expenses 1,50,000
To Discount allowed 19,000
To Bad debts 5,000
To Net profit 1,52,000
5,71,000 5,71,000

6.36 COMMON PROFICIENCY TEST


Balance Sheet
as on 31st March, 2006
Liabilities Amount Assets Amount
Rs. Rs.
Capital 6,50,000 Furniture 3,50,000
Add: Net profit 1,52,000 8,02,000 Less: Depreciation 35,000 3,15,000
Creditors 1,90,000 Closing stock 1,80,000
Debtors 2,10,000
Investment in Govt
securities 1,00,000
Cash in Hand and
Cash at Bank 1,87,000
9,92,000 9,92,000
Illustration 13
From the following Trial Balance prepare a Trading and Profit and Loss Account for the year
ending 31st December, 2006 and a Balance Sheet as on that date:
Rs. Rs.
Debit Balance :
Sundry Debtors 3,500 Salaries 2,200
Stock 1st January, 2006 5,000 Purchases 12,500
Cash in Hand 5,600 Plant and Machinery 15,700
Wages 3,000 Credit Balance:
Bad Debts 500 Capital 25,000
Furniture and Fixtures 1,500 Sundry Creditors 9,000
Depreciation 1,500 Sales 17,000
On 31st December, 2006 the stock was valued at Rs. 10,000.
Solution
Trading and Profit and Loss Account for the year ending 31st Dec., 2006
Rs. Rs.
To Opening Stock 5,000 By Sales 17,000
To Purchases 12,500 By Closing Stock 10,000
To Wages 3,000
To Gross Profit c/d 6,500
27,000 27,000
To Bad Debts 500 By Gross Profit b/d 6,500
To Depreciation 1,500
To Salaries 2,200
To Net Profit trfd. to Capital A/c 2,300
6,500 6,500

FUNDAMENTALS OF ACCOUNTING 6.37


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

Balance Sheet as at 31st Dec., 2006


Liabilities Rs. Rs. Assets Rs. Rs.
Current Liabilities: Current Assets :
Sundry Creditors 9,000 Cash in Hand 5,600
Capital: Sundry Debtors 3,500
Previous Balance 25,000 Closing Stock 10,000 19,100
Add : Net Profit 2,300 27,300 Fixed Assets :
Furniture & Fixtures 1,500
Plant & Machinery 15,700 17,200
36,300 36,300
Illustration 14
Sengupta & Co. employs a team of eight workers who were paid Rs. 3,000 per month each in
the year ending 31st December, 2005. At the start of 2006, the company raised salaries by 10%
to Rs. 3,300 per month each.
On July 1, 2006 the company hired two trainees at salary of Rs. 2,100 per month each. The
work force are paid salary on the first working day of every month, one month in arrears, so
that the employees receive their salary for January on the first working day in February etc.
Calculate:
(i) Amount of salaries which would be charged in the profit and loss for the year ended
31st December, 2006.
(ii) Amount actually paid as salaries during 2006.
Solution
Rs.
(i) Salaries to be charged to profit and loss account for the year
ended 31st December, 2006:
Salaries of 8 employees for full year @ Rs. 3,300 per month each 3,16,800
Salaries of 2 trainees for 6 months @ Rs. 2,100 p.m. 25,200
3,42,000
(ii) Salaries actually paid in 2006
December, 2005 salaries paid in January, 2006 (8 x 3,000) 24,000
Salaries of 8 employees for January to November, 2006 paid in
February-December, 2006 @ Rs. 3,300 for 11 months 2,90,400
Salaries of 2 trainees for July to November paid in August-
December @ Rs. 2,100 for 5 months 21,000
3,35,400

6.38 COMMON PROFICIENCY TEST


(iii) Outstanding salaries as at 31st December, 2006
8 employees @ Rs. 3,300 each for 1 month 26,400
2 trainees @ Rs. 2,100 each for 2 months 4,200
30,600

Illustration 15
Mr. James submits you the following information for the year ended 31.3.2006:
Rs.
Stock as on 1.4.2005 1,50,500
Purchases 4,37,000
Manufacturing expenses 85,000
Expenses on sale 33,000
Expenses on administration 18,000
Financial charges 6,000
Sales 6,25,000
Gross profit is 20% of sales.
Compute the net profit of Mr. James for the year ended 31.3.2006.
Solution
Statement showing Computation of Net Profit of
Mr. James for the year ended 31.3.2006
Rs. Rs.
Gross profit on sales (Rs.6,25,000x 20/100) 1,25,000
Less: Overhead expenses:
Administration expenses 18,000
Selling expenses 33,000
Financial charges 6,000 57,000
Net profit 68,000
Alternatively, trading and profit and loss account for the year ended 31st March, 2006 can be
prepared to compute the amount of net profit.
Trading and Profit & Loss Account of Mr. James
for the year ended 31st March, 2006
Rs. Rs.
To Opening stock 1,50,500 By Sales 6,25,000
To Purchases 4,37,000 By Closing stock 1,72,500
To Manufacturing expenses 85,000 (balancing figure)
To Gross profit c/d 1,25,000
7,97,500 7,97,500

FUNDAMENTALS OF ACCOUNTING 6.39


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

To Administration expenses 18,000 By Gross profit b/d 1,25,000


To Selling expenses 33,000
To Financial charges 6,000
To Net profit 68,000
1,25,000 1,25,000

Illustration 16

The Balance Sheet of Mr. Popatlal, a merchant on 31st December, 2006 stood as below:
Liabilities Amount Assets Amount
Rs. Rs.
Capital 24,000 Fixed Assets 12,560
Creditors 16,400 Stock 20,640
Bank Overdraft 14,600 Debtors 18,800
Less: Provision 620 18,180
Cash 3,620
55,000 55,000

Show opening journal entry on 1st January, 2007 in the books of Mr. Popatlal.
Solution
Opening entry
(Dr.) Rs. (Cr.) Rs.
1.1.2007 Fixed Assets A/c Dr. 12,560
Stock A/c Dr. 20,640
Debtors A/c Dr. 18,800
Cash A/c Dr. 3,620
To Creditors A/c 16,400
To Bank Overdraft A/c 14,600
To Provision for Doubtful Debts A/c 620
To Capital A/c 24,000

9. PROVISIONS AND RESERVES


Provision means “any amount written off or retained by way of providing for depreciation,
renewal or diminution in the value of assets or retained by way of providing for any known
liability of which the amount cannot be determined with substantial accuracy”.
Thus a provision may be either in respect of loss in the value of an asset provided or written off
on the basis of an estimate or the one in respect of a liability for expenses incurred in respect of
a claim which is disputed i.e. when it is a contingent liability. On the occurrence of a diminution

6.40 COMMON PROFICIENCY TEST


in asset values due to some of them having become irrecoverable or stock items are lost as a
result of some natural calamity, amounts contributed or transferred from profit to make good
the diminution also are described as provision.
The following are instances of amount retained in the business out of earning for different
purposes that are described as provisions.
(1) Amount provided for meeting claims which are admissible in principle but the amount
whereof has not been ascertained.
(2) An appropriation made for payment of taxes still to be assessed.
(3) Amount set aside for writing off bad debts or payment of discounts.
The term ‘reserve’ is not defined in Part III of Schedule VI except negatively in the sense that
profit retained in the business not having any of the attribute of a ‘provision’ is to be treated as
a reserve. Also provisions in excess of the amount considered necessary for the purposes these
were originally made, are to be considered as reserves. It is thus evident that provisions are a
charge against profits, while reserve is an appropriation of profits. Also provisions that ultimately
prove be in excess of amounts required or have been made too liberally are reserves. Such a
distinction is essential for disclosing truly in the Balance Sheet the amount by which the equity
of shareholders has increased with the accumulation of undistributed profits.
Reserve Fund : It signifies the amount standing to the credit of the reserve that is invested
outside the business in securities which are readily realisable e.g., when the amounts set apart
for replacement of an asset are invested periodically, in government securities or shares. The
account to which these amounts are annually credited is described as the Reserve Fund.
Illustration 17
Crimpson Ltd.’s profit and loss account for the year ended 31st December, 2006 includes the
following information:
Rs.
(i) Depreciation 57,500
(ii) Bad debts written off 21,000
(iii) Increase in provision for doubtful debts 18,000
(iv) Proposed dividend 15,000
(v) Retained profit for the year 20,000
(vi) Liability for tax 4,000
State which one of the items (i) to (vi) above are – (a) transfer to provisions; (b) transfer to
reserves; and (c) neither related to provisions nor reserves.
Solution
(a) Transfer to provisions - (i), (iii) (vi)
(b) Transfer to reserves - (v)
(c) Neither related to provisions nor reserves - (ii), (iv).

FUNDAMENTALS OF ACCOUNTING 6.41


FINAL ACCOUNTS OF NON-MANUFACTURING ENTITIES

10. LIMITATIONS OF FINANCIAL STATEMENTS


Financial statements suffer from a number of limitations. These must, therefore be studied
with care, in order that correct inferences may be drawn. The limitations are less serious if the
objective is only to appraise the performance of a single company over a period of years. Where,
however, a comparison of the working of different companies for the same period is to be
made. It can be misleading unless the companies concerned have followed the same system
and basis of accounting. On the account, a comparison of the profitability of different industries
on the basis of financial statements, should be undertaken only if it is not practicable to make
such a comparison on any other basis.
The principal limitations affecting financial statements are the following:
(a) Historical Cost : Accounting records and, on that account, the financial statements are
prepared only on the basis of the money value prevailing at the time the transaction were
entered into. Thus, the effect of subsequent changes in the value of money is not taken into
account. At times this has the effect of making the statements of account quite misleading.
Take the obvious example of a house built in 1945, say at the cost of Rs. 15,000, in 2006 the
benefit receivable from its occupation will be as much as that of a house created in 2006,
say at a cost of Rs. 14,50,000. If the house were included in the financial statements at its
original cost, as normally it would not convey a true picture except to a knowledgeable
person.
The limitations can be serious in the case of other fixed assets that have been working over
a long period over which prices have changed radically. It is, however, not easy to get
over this difficulty, since revaluation of fixed assets, apart from being costly is not practicable
when the value of money is continuously falling. On this account, historical cost continues
to be the accepted basis for the preparation of financial statements. Though it may not be
possible to do much to remove the limitation mentioned above, one must always remember
to read the balance sheet and the profit and loss account in the light of what they cannot
reveal as well as what they do.
(b) Intangible strengths and weaknesses : A company may have a number of strengths and
weaknesses which cannot be shown in the balance sheet e.g., the loyalty and calibre of its
staff. These must be kept in mind while judging the financial position of the company.
(c) Perpetual continuity and periodical account : Financial statements ordinarily are drawn
up at the end of each year but the accounting record is maintained on the assumption that
the business undertaking shall continue to exist forever. In consequence, much of the
expenditure other than revenue expenditure has to be distributed arbitrarily over a number
of years during which benefit of the expenditure is expected to arise. As a result, financial
statements of account are not absolutely correct.
The management of a business entity is left with discretion as regard valuation and treatment
of a number of assets, some of which are mentioned below:
(i) Goodwill and other intangible assets;
(ii) Wasting assets like mines, quarries etc.;
(iii) Deferred revenue expenditure; and

6.42 COMMON PROFICIENCY TEST


(iv) Fictitious assets like Preliminary Expenses, Discount on Debentures, etc.
As a result, if one company follows one method as regards valuation of one or more of
these assets and the second another, the financial results shown by the two companies are
not comparable.
(d) Different accounting policies : It is permissible for a company within certain limits to
adopt different policies for the preparation of accounts-valuation of various assets and
distribution of expenditure over different periods of account. For example, a company
may decide to provide annually for payment of pensions and gratuities to staff and thus
build up a ‘fund’ out of which payments will be made ultimately whereas another company
may deal with these only when actual payments are made. Similarly, a company may
decide whether or not to include intangible assets amongst its assets or manner in which
the amounts thereof should be written off over a period of years.
Whatever basis of accounting is decided upon the same must be followed consistently,
from year to year. Whenever it is departed from, the effect of it would be the effect of
obscuring the profit of the year in which the change in the basis of accounting is made.
(e) Management policies : There is general impression that each undertaking endeavours to
earn as much profit as it can. This is not wholly correct. The management often attempts
not to allow its profit to rise above a level that it consider appropriate, in the circumstances
it is functioning, due to a variety of reasons. This may be:
(i) Disinclination to undertake new risks and responsibilities on account of high rates of
taxation;
(ii) Fear of the odium of profiteering a bad reputation that prices charged by the concern
for its goods are not reasonable :
(iii) Fear that larger profits may give rise to demand for higher wages which may throw
the costs and prices relationship out of gear or impression may gain ground that
there has been an increased workload on the workers which may lead to
discontentment amongst them :
(iv) Fear that the concern may be considered to have developed monopolistic tendencies;
(v) Consideration to maintain efficiency; and
(vi) Unwillingness to expand, unduly on account of uncertainty of the future.
To conclude, on these considerations. Financial statements need to be studied with great
care. The information disclosed by them has to be judged in the light of the economic
change, such as inflationary condition over the short period, as well as, over the long
period (like one witnessed in India after 1971) and the nature of management and its
basic motives. Despite the limitations, the financial statements, verified by independent
auditors, often are the only tangible evidence available as regards the profitability and the
financial position of the company. Their importance, therefore, cannot be under-estimated.
If properly analysed, they are capable of yielding a flood of information.

FUNDAMENTALS OF ACCOUNTING 6.43


CHAPTER - 6

PREPARATION
OF FINAL
ACCOUNTS OF
SOLE
PROPRIETORS

Unit 2

Final Accounts of
Manufacturing
Entities
Learning Objectives :
After studying this unit you will be able to :

 Understand the purpose of preparing Manufacturing Account.


 Learn the items to be included in the Manufacturing Account.

1. INTRODUCTION
The manufacturing entities generally prepare a separate Manufacturing Account as a part of
Final accounts in addition to Trading Account, Profit and Loss Account and Balance Sheet.
The objective of preparing Manufacturing Account is to determine manufacturing costs of
finished goods for assessing the cost effectiveness of manufacturing activities. Manufacturing
costs of finished goods are then transferred from the Manufacturing Account to Trading
Account.

2. PURPOSE
A manufacturing account serves the following functions:
(1) It shows the total cost of manufacturing the finished products and sets out in detail, with
appropriate classifications, the constituent elements of such cost. It is, therefore, debited
with the cost of materials, manufacturing wages and expenses incurred directly or indirectly
on manufacture.
(2) It provides details of factory cost and facilitates reconciliation of financial books with cost records
and also serves as a basis of comparison of manufacturing operations from year to year.
(3) The Manufacturing Account may also be used for various other purposes. For example, if
the output is carried to the Trading Account at market prices, it discloses the profit or loss
on manufacture. Similarly, it may also be used to fix the amount of production of profit
sharing bonus when such schemes are in force.

3. MANUFACTURING COSTS
Manufacturing costs are classified into :
Raw Material Consumed .…..….
Direct Manufacturing Wages ………
Direct Manufacturing Expenses ………
Prime Cost ………
Indirect Manufacturing expenses or
Manufacturing Overhead ………
Total Manufacturing Cost ______
Raw Material consumed is arrived at after adjustment of opening and closing stock of raw
materials:
Raw Material Consumed = Opening Stock of Raw Materials
+ Purchases
- Closing Stock of Raw Materials

6.45
FINAL ACCOUNTS OF MANUFACTURING ENTITIES

If there remain unfinished goods at the beginning and at the end of the accounting period, cost
of such unfinished goods (also termed as Work-In-Process) is shown in the Manufacturing
Account – opening stock of Work-in-Process is posted to the debit of the Manufacturing Account
and closing stock of Work-in-Process is posted to the credit of the Manufacturing Account.

3.1 DIRECT MANUFACTURING EXPENSES


Direct manufacturing expenses are costs, other than material or wages, which are incurred for
a specific product or saleable service.
Examples of direct manufacturing expenses are (i) Royalties for using license or technology if
based on units produced, (ii) Hire charge of the plant and machinery used on hire, if based on
units produced, etc.
When royalty or hire charges are based on units produced, these expenses directly vary with
production.
Illustration 1
10,000 units were produced in a factory. Per unit material cost was Rs. 10 and per unit labour
cost was Rs. 5. That apart it was agreed to pay royalty @Rs. 3 per unit to the Japanese collaborator
who supplied technology.
Solution
In this case Prime Cost comprises of –
Raw Material consumed (10,000 × Rs. 10) Rs. 1,00,000
Direct Wages (10,000 × Rs. 5) Rs. 50,000
Direct Expenses (10,000 × Rs. 3) Rs. 30,000
Rs. 1,80,000
3.2 INDIRECT MANUFACTURING EXPENSES
These are also called Manufacturing overhead, Production overhead, Works overhead, etc.
Overhead is defined as total cost of indirect material, indirect wages and indirect expenses.
Indirect material means materials which cannot be linked directly with the units produced, for
example, stores consumed for repair and maintenance work, small tools, fuel and lubricating
oil, etc. Indirect wages are those which cannot be directly linked to the units produced, for
example, wages for maintenance works, holding pay, etc. Indirect expenses are those which
cannot be directly linked to the units produced, for example, training expenses, depreciation
of plant and machinery, depreciation of factory shed, insurance premium for plant and
machinery, factory shed, etc.
Accordingly, indirect manufacturing expenses comprise indirect material, indirect wages and
indirect expenses of the manufacturing division.
3.3 BY-PRODUCT
In most manufacturing operations, the production of the main product is accompanied by the
production of a subsidiary product which has a value on sale. For example, the production of

6.46 COMMON PROFICIENCY TEST


hydrogenated vegetable oil is accompanied by the production of oxygen gas and the production
of steel yields scrap. The subsidiary product is termed as a by-product because its production is
not consciously undertaken but results out of the production of the main product. It is usually
very difficult to ascertain the cost of the product. Moreover, its value usually forms a very
small percentage of the main product.
By-product is a secondary product. This is produced from the same raw materials, which are
used for producing the main product and without incurring any additional expenses from the
same production process in which the main product is produced. Some examples of by-product
are given below:
(i) Molasses is the by-product in sugar manufacturing;
(ii) Butter milk is the by-product of a dairy which produces butter and cheese, etc.
By-products generally have insignificant value as compared to the value of main product.
They are generally valued at net realisable value, if their costs cannot be separately identified.
It is often treated, as “Miscellaneous income but the correct treatment would be to credit the
sale value of the by-product to Manufacturing Account so as to reduce to that extent, the cost
of manufacture of main product.

4. DESIGN OF A MANUFACTURING ACCOUNT


There is no standardized design for the presentation of a Manufacturing Account. Given below
is a format covering various elements:
Manufacturing Account
Dr. Cr.
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Raw Material By By-products at
Consumed: net realisable value
Opening Stock …. “ Closing Work-in-
Process
Add: Purchases ….. “ Trading A/c -
Less: Closing Stock ….. …… Cost of production
“ Direct Wages ……
“ Direct expenses: ……
Prime cost ……
To Factory overheads:
Royalty .….
Hire charges …..
“ Indirect expenses: …..
Repairs & Maintenance .….
Depreciation .…. …….
Factory cost …….
To Opening Work-in-
process .……

FUNDAMENTALS OF ACCOUNTING 6.47


FINAL ACCOUNTS OF MANUFACTURING ENTITIES

Tutorial Note : Frequently, problems are set, in which all the ledger balances are not given.
Instead, details are given regarding the number of items in stocks, quantity manufactured etc.
the figures for stocks, sales etc., would therefore have to be worked out independently from
the data given.
The following general rules may be observed.
(a) The Manufacturing Account should have columns showing the quantities and values.
Frequently, all the quantities are not given and the quantities applicable to one or more of
the items would have to be worked out. For example, if the question does not state the
total number of items sold, the quantity can be worked out by adding opening stock and
units manufactured and deducting closing stock. It is, therefore, useful to have quantity
columns in the account so that it can be seen that both sides balance.
(b) The Manufacturing Account will show the quantity of raw materials in stock at the
beginning and at the end of the year and the purchases during the year. As regards finished
goods, it will only show the quantity manufactured and, as regards work-in-progress, the
opening and closing amounts.
(c) The Trading Account will show the quantities of finished goods manufactured and sold
and the opening and closing stocks. It will not show the quantity of raw materials or
work-in-progress.
(d) For determining the value of closing stock, in the absence of specific instruction to the
contrary, it must be assumed that sales have been on “first in-first out” basis, that is, the
closing stock consists as far as possible of goods produced during the year, the opening
stocks being sold out.
It may be mentioned here that nowadays no manufacturing business entity prepares
manufacturing account as part of its final set of accounts. Even the items of manufacturing
account are shown either in trading account (in case of non-corporate entities) or in profit and
loss account (in case of corporate entities).
The procedure of preparation of Trading Account, Profit and Loss Account and Balance Sheet
have already been explained in Unit 1 of this chapter. Students should refer the earlier unit for
attempting the problems based on the preparation of complete set of final accounts of a sole
proprietor.
Illustration 2
Mr. Vimal runs a factory which produces toilet soaps. Following details were available in
respect of his manufacturing activities for the year ended on 31.3.2006:
Opening Work-in-Process (10,000 units) 16,000
Closing Work-in-Process (12,000 units) 20,000
Opening Stock of Raw Materials 1,70,000
Closing Stock of Raw Materials 1,90,000
Purchases 8,20,000

6.48 COMMON PROFICIENCY TEST


Hire charges of machine @Re. 0.60 per unit manufactured
Hire charges of factory 2,20,000
Direct wages-Contracted @Re. 0.80 per unit manufactured and
@ Re. 0.40 per unit of Closing W.I.P. 1,80,000
Repairs and Maintenance
Units produced – 5,00,000 units

You are required to prepare a Manufacturing Account of Mr. Vimal for the year ended 31.3.2006.
Solution
In the Books of Mr. Vimal
Manufacturing Account for the Year ended 30.6.2006
Dr. Cr.
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Opening Work- 10,000 16,000 By Closing Work- 12,000 20,000
in-Process in-Process
To Raw Materials “ Trading A/c – 5,00,000 19,00,800
Consumed: transfer of
manufacturing
Opening 1,70,000 cost @ Rs. 4.00
Stock per unit
Add:
Purchases 8,20,000
9,90,000
Less: Closing
Stock 1,90,000 8,00,000
To Direct Wages
– W.N.(1) 4,04,800
To Direct
expenses:
Hire charges
on Machinery
– W.N. (3) 3,00,000
To Indirect
expenses:
Hire charges
of Factory
Shed 2,20,000
Repairs &
Maintenance 1,80,000
19,20,800 19,20,800

FUNDAMENTALS OF ACCOUNTING 6.49


FINAL ACCOUNTS OF MANUFACTURING ENTITIES

Working Notes :
(1) Direct Wages – 5,00,000 units @ Rs. 0.80 = Rs. 4,00,000
12,000 units @ Rs. 0.40 = Rs. 4,800
Rs. 4,04,800
(3) Hire charges on Machinery – 5,00,000 units @ Re. 0.60 = Rs. 3,00,000
Illustration 3
Mr. Pankaj runs a factory which produces motor spares of export quality. The following details
were obtained about his manufacturing expenses for the year ended on 31.3.2006.
Rs.
W.I.P. - Opening 3,90,000
- Closing 5,07,000
Raw Materials - Purchases 12,10,000
- Opening 3,02,000
- Closing 3,10,000
- Returned 18,000
- Indirect material 16,000
Wages - direct 2,10,000
- indirect 48,000
Direct expenses - Royalty on production 1,30,000
- Repairs and maintenance 2,30,000
- Depreciation on factory shed 40,000
- Depreciation on plant & machinery 60,000
By-product at
selling price 20,000

You are required to prepare Manufacturing Account of Mr. Pankaj for the year ended on
31.3.2006.

6.50 COMMON PROFICIENCY TEST


Solution
In the Books of Mr. Pankaj
Manufacturing Account
for the year ended on 31.3.2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs. Rs.
To Opening W.I.P. 3,90,000 By Closing W-I-P 5,07,000
To Raw Material Consumed: By By - products 20,000
Opening Stock 3,02,000 By Trading A/c- 17,81,000
Purchases 12,10,000 Cost of
finished goods
15,12,000 transferred
Less: Return 18,000
14,94,000
Less: Closing Stock 3,10,000 11,84,000
To Direct Wages 2,10,000
To Direct expenses:
Royalty 1,30,000
To Manufacturing Overhead:
Indirect Material 16,000
Indirect Wages 48,000
Repairs & Maintenance 2,30,000
Depreciation on
Factory Shed 40,000
Depreciation on Plant &
Machinery 60,000 3,94,000
23,08,000 23,08,000

FUNDAMENTALS OF ACCOUNTING 6.51


FINAL ACCOUNTS OF MANUFACTURING ENTITIES

SELF EXAMINATION QUESTIONS


1. Match the following items from column A with column B
S. No. Column A Column B
1. Goodwill (a) current assets
2. Sundry Debtors (b) are valued at cost price
3. Loose Tools (c) intangible fixed assets,
4. Long term investments (d) tangible fixed assets
[Ans. : 1.(c); 2(a), 3(d), 4(b)]
2. Pick up the correct answer from the given choices(only one correct answer):
(i) The balance of the petty cash is
(a) an expense, (b) income, (c) an asset. (d) liability
(ii) Fixed assets are
(a) kept in the business for use over a long time for earning income
(b) meant for resale
(c) meant for conversion into cash as quickly as possible
(d) All of the above
(iii) Goodwill is
(a) a current asset (b) an intangible fixed asset
(c) a tangible fixed asset (d) an investment.
(iv) Stock is
(a) included in the category of fixed assets
(b) an investment.
(c) a part of current assets
(d) an intangible fixed asset.
(v) The manufacturing account is prepared:
(a) to ascertain the profit or loss on the goods produced
(b) to ascertain the cost of the manufactured goods
(c) to show the sale proceeds from the goods produced during the year
(d) both (b) and (c).
[Ans: 2: (i)-(c), (ii)-(a), (iii)-(b), (iv)-(c),(v)-(b)

6.52 COMMON PROFICIENCY TEST


3. (i) A new firm commenced business on 1st January, 2006 and purchased goods costing
Rs. 90,000 during the year. A sum of Rs. 6,000 was spent on freight inwards. At the
end of the year the cost of goods still unsold was Rs. 12,000. Sales during the year Rs.
1,20,000. What is the gross profit earned by the firm?
(a) Rs. 36,000 (b) Rs. 30,000 (c) Rs. 42,000 (d) Rs. 38,000
(ii) From the following figures ascertain the gross profit:
Rs.
Opening Stock (1.1.2006) 25,000
Goods Purchased during 2006 1,30,000
Freight and packing on above 5,000
Closing Stock (31.12.2006) 15,000
Sales 1,90,000
Selling expenses on sales 9,000
(a) Rs.36,000 (b) Rs. 45,000 (c) Rs. 50,000 (d) Rs.59,000
(iii) A prepayment of insurance premium will appear in the Balance Sheet and in the
Insurance Account respectively as:
(a) a liability and a debit balance. (b) an asset and a debit balance.
(c) an asset and a credit balance. (d) None of the above
(iv) Under-statement of closing work in progress in the period will
(a) Understate cost of goods manufactured in that period.
(b) Overstate current assets.
(c) Overstate gross profit from sales in that period.
(d) Understate net income in that period.
[Ans : 3 : (i)-(a), (ii)-(b), (iii)-(c), (iv)-(d)
4. (i) If sales revenues are Rs. 4,00,000; cost of goods sold is Rs. 3,10,000 and operating
expenses are Rs.60,000, the gross profit is
(a) Rs. 30,000. (b) Rs. 90,000. (c) Rs. 3,40,000. (d) Rs. 60,000
(ii) Sales are equal to
(a) Cost of goods sold – Gross profit. (b) Cost of goods sold + Gross profit.
(c) Gross profit – Cost of goods sold. (d) Cost of goods sold + Net profit.
(iii) A Company wishes to earn a 20% profit margin on selling price. Which of the following
is the profit mark up on cost, which will achieve the required profit margin?
(a) 33%. (b) 25%. (c) 20%. (d) None of the above.

FUNDAMENTALS OF ACCOUNTING 6.53


FINAL ACCOUNTS OF MANUFACTURING ENTITIES

(iv) If sales are Rs. 2,000 and the rate of gross profit on cost of goods sold is 25%, then the
cost of goods sold will be
(a) Rs. 2,000. (b) Rs. 1,500. (c) Rs. 1,600. (d) None of the above.
(v) Sales for the year ended 31st March, 2005 amounted to Rs. 10,00,000. Sales included
goods sold to Mr. A for Rs. 50,000 at a profit of 20% on cost. Such goods are still lying
in the godown at the buyer’s risk. Therefore, such goods should be treated as part of
(a) Sales. (b) Closing stock. (c) Goods in transit. (d) Sales return.
[Ans:4: (i)-(b), (ii)-(b), (iii)-(b), (iv)-(c); (v)-(a)]
5. (i) The capital of a sole trader would change as a result of:
(a) a creditor being paid his account by cheque.
(b) raw materials being purchased on credit.
(c) fixed assets being purchased on credit.
(d) wages being paid in cash.
(ii) Rent paid on 1 October, 2004 for the year to 30 September, 2005 was Rs. 1,200 and
rent paid on 1 October, 2005 for the year to 30 September, 2006 was Rs. 1,600. Rent
payable, as shown in the profit and loss account for the year ended 31 December
2005, would be:
(a) Rs. 1,200. (b) Rs. 1,600. (c) Rs. 1,300. (d) Rs. 1,500.
(iii) A decrease in the provision for doubtful debts would result in:
(a) an increase in liabilities. (b) a decrease in working capital.
(c) a decrease in net profit. (d) an increase in net profit.
[Ans : 5: (i)-(d), (ii)-(c), (iii)- (d)]
II. From the given information, choose the most appropriate answer:
1. Sales Opening Purchases Closing Cost of Gross Trading Net
Stock Stock goods sold Profit Expenses Profit
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
15,000 6,000 10,000 ? 9,000 ? 4,000 ?
(i) The value of closing stock is
(a) Rs. 9,000 (b) Rs.4,000 (c) Rs.8,000 (d) Rs. 7,000
(ii) Gross profit will be
(a) Rs. 6,000 (b) Rs. 5,000 (c) Rs.8,000 (d) Rs. 7,000
(iii) Net profit will be
(a) Rs. 6,000 (b) Rs. 5,000 (c) Rs. 2,000 (d) Rs. 7,000
[Ans : 1 : (i)-(d), (ii)-(a), (iii)-(c)]

6.54 COMMON PROFICIENCY TEST


2. Opening Investment Capital at the Net Profit
Capital By Proprietor Drawing end of the year (Loss)
Rs. Rs. Rs. Rs. Rs.
16,000 Nil 3,000 13,500 ?
(i) The net profit will be
(a) Rs. 600 (b) Rs. 500 (c) Rs. 550 (d) Rs. 700
(ii) If in the given information, Net Loss is Rs. 1,000, then the investment made by
the proprietor during the year will be
(a) Rs.1,500 (b) Rs. 2,000 (c) Rs. 1,200 (d) Rs. 1,700
[Ans : 2 : (i)-(b), (ii)-(a)]
3. Rs.
Rs.
Opening Stock 20,000 Carriage on sales 3,000
Closing Stock 18,000 Rent of Office 5,000
Purchases 85,800 Sales 1,40,700
Carriage on purchases 2,300
(i) Gross profit will be
(a) Rs. 50,000 (b) Rs. 47,600 (c) Rs. 42,600 (d) Rs. 50,600
(ii) Net profit will be
(a) Rs. 42,600 (b) Rs. 50,600 (c) Rs. 45,600 (d) Rs. 47,600
[Ans: 3 : (i)-(d), (ii)-(a)]
4. The Zed Company, a whole seller estimates the following sales for the indicated months:
June July August
2006 2006 2006
Rs. Rs. Rs.
Opening stock 4,08,000 4,34,400 4,60,800
Credit Sales 15,00,000 16,00,000 17,00,000
Cash Sales 2,00,000 2,10,000 2,20,000
Total Sales 17,00,000 18,10,000 19,20,000
Selling price is 125% of the purchase price.
(i) The cost of goods sold for the month of June, 2006 is:
(a) Rs. 15,20,000 (b) Rs. 14,02,500 (c) Rs. 12,75,000 (d) Rs. 13,60,000

FUNDAMENTALS OF ACCOUNTING 6.55


FINAL ACCOUNTS OF MANUFACTURING ENTITIES

(ii) Stock purchased in July, 2006 is :


(a) Rs. 16,05,000 (b) Rs. 14,74,400 (c) Rs. 14,40,000 (d) Rs. 13,82,500
[Ans : 4 : (i)-(d), (ii)-(b)]
5. Considering the following information, answer the question given below:
1st January 31st December
Rs. Rs.
Stock of raw materials 17,400 18,100
Work-in-progress 11,200 11,400
Stock of finished goods 41,500 40,700
During the year manufacturing overhead expenses amounted to Rs. 61,100, manufacturing
wages to Rs. 40,400 and purchase of raw materials to Rs. 91,900. There were no other
direct expenses.
(i) The cost of raw materials consumed, issued and used were:
(a) Rs. 1,09,300 (b) Rs. 91,200 (c) Rs. 91,900 (d) Rs. 92,600.
(ii) The manufacturing cost of finished goods produced were:
(a) Rs. 1,31,600 (b) Rs. 1,93,300 (c) Rs. 1,91,900 (d) Rs. 1,92,500.
(iii) The manufacturing cost of finished goods sold was:
(a) Rs. 1,91,700 (b) Rs. 1,92,500 (c) Rs. 1,94,000 (d) Rs. 1,93,300.
[Ans: 5 : (i) (b), (ii)-(d), (iii)-(d)]
III Match the following items from column A with column B
S. No. Column A Column B
1. Capital is the difference between (a) cost of good sold from sales
2. Gross profit is ascertained by deducting (b) the net profit earned
3. Wages paid for erecting machines are (c) Assets and liabilities
4. The manufacturing account is prepared: (d) debited to machinery account
[Ans. : 1. (c); 2 (a), 3 (d), 4 (b)]

6.56 COMMON PROFICIENCY TEST


CHAPTER - 7

PREPARATION
OF FINAL
ACCOUNTS OF
SOLE
PROPRIETORS

Unit 1

Consignment
CONSIGNMENT

Learning Objectives :
After studying this unit, you will be able to :
 Understand the special features of consignment business, meaning of the terms consignor
and consignee.
 Analyse the difference between the two transactions – sale and consignment and
understand that why consignment is termed as special transaction.
 Practise the accounting treatments for consignment transactions and events in the books
of consignor and consignee.
 Note the variations in accounting when goods are sent at cost and goods are sent above
the cost.
 Learn the technique of computing value of closing stock lying with the consignor and
also the amount of stock reserve in it.
 Learn the technique of computing cost of abnormal loss and treatment of insurance
claim in relation to it.
 Understand the distinction between ordinary commission, del-credere commission and
over-riding commission paid to the consignee.
 See the variation of accounting treatment for bad debts when consignee is paid ordinary
commission and when consignee is paid del-credere commission in addition.
 Understand the reason of including/excluding various expenditures to cost while valuing
the goods returned by the consignee.

1. MEANING OF CONSIGNMENT ACCOUNT


To consign means to send. In Accounting, the term "consignment account" relates to accounts
dealing with a situation where one person (or firm) sends goods to another person (or firm) on
the basis that the goods will be sold on behalf of and at the risk of the former. The following
should be noted carefully:
(i) The party which sends the goods (consignor) is called principal.
(ii) The party to whom goods are sent (consignee) is called agent.
(iii) The ownership of the goods, i.e., the property in the goods, remains with the consignor or
the principal – the agent does not become their owner even though they are in his
possession. On sale, of course, the buyer will become the owner.
(iv) The principal does not send an invoice to the agent. He sends only a proforma invoice, a
statement that looks like an invoice but is really not one. The object of the proforma
invoice is only to convey information to the agent regarding particulars of the goods sent.
(v) Usually, the agent recovers from the principal all expenses incurred by him on the
consignment. This however can be changed by agreement between the two parties.
(vi) It is also usual for the agent to give an advance to the principal in the form of cash or a bill
of exchange. It is adjusted against the sale proceeds of the goods.

7.2 COMMON PROFICIENCY TEST


(vii) For his work the agent receives a commission, calculated on the basis of gross sale. For
ordinary commission the agent is not responsible for any bad debt that may arise. If the
agent is to be made responsible for bad debts, he is to be paid a commission called del-
credere commission. It is calculated on total sales, not merely on credit sales until and
unless agreed.
(viii)Periodically, the agent sends to the principal a statement called Account Sales. It sets out
the sales made by the agent, the expenses incurred on behalf of the principal, the
commission earned by the agent and the balance due to the principal.
(ix) Firms usually like to ascertain the profit or loss on each consignment or consignments to
each agent.
Consignment Account relates to accounts dealing with such business where one person sends
goods to another person on the basis that such goods will be sold on behalf of and at the risk
of the former.

2. DISTINCTION BETWEEN CONSIGNMENT AND SALE


S.No. Consignment Sale
1. Ownership of the goods rests with the The ownership of the goods transfers
consignor till the time they are sold by the with the transfer of goods from the seller
consignee, no matter the goods are to the buyer.
transferred to the consignee.
2. The consignee can return the unsold goods Goods sold are the property of the buyer
to the consignor. and can be returned only if the seller
agrees.
3. Consignor bears the loss of goods held It is the buyer who will bear the loss if
with the consignee. any, after the delivery of goods.
4. The relationship between the consignor The relationship between the seller and
and the consignee is that of a principal the buyer is that of a creditor and a
and agent. debtor.
5. Expenses done by the consignee to receive Expenses incurred by the buyer are to be
the goods and to keep it safely is borne by borne by the buyer itself after the delivery
the consignor. of goods.

3. ACCOUNTING FOR CONSIGNMENT TRANSACTIONS AND


EVENTS IN THE BOOKS OF THE CONSIGNOR
For ascertaining profit or loss on any transaction (or series of transactions) there is one golden
rule; open an account for the transaction (or series of transactions) and (i) put down the cost
of goods and other expenses incurred or to be incurred on the debit side; and (ii) enter the sale
proceeds as also the cost of goods remaining unsold on the right hand or the credit side. The
difference between the total of the two sides will reveal profit or loss. There is profit if the
credit side is more.
We shall illustrate the scheme of entries on the basis of the following information:

FUNDAMENTALS OF ACCOUNTING 7.3


CONSIGNMENT

Illustration 1
Exe sent on 1st July, 2006 to Wye goods costing Rs. 50,000 and spent Rs. 1,000 on packing etc.
On 3rd July, 2006, Wye received the goods and sent his acceptance to Exe for Rs. 30,000
payable at 3 months. Wye spent Rs. 2,000 on freight and cartage, Rs. 500 on godown rent and
Rs. 300 on insurance. On 31st December, 2006 he sent his Account Sales (along with the
amount due to Exe) showing that 4/5 of the goods had been sold for Rs. 55,000. Wye is
entitled to a commission of 10%. One of the customers turned insolvent and could not pay
Rs. 600 due from him. Show the necessary journal entries.
Solution
Scheme of Journal Entries:
Dr. Cr.
1. Open Consignment Account and debit it with the Rs. Rs.
cost of goods and credit it with "Goods sent on Con-
signment Account". In the above case:
1/7/2006 Consignment to Wye A/c Dr. 50,000
To Goods Sent on Consignment A/c 50,000
2. For the expenses incurred by the consignor,
debit Consignment Account and credit cash
(or Bank as the case may be)
1/7/2006 Consignment to Wye A/c Dr. 1,000
To Bank A/c 1,000
3. If the consignee sends an advance, debit Cash
(or Bank) or Bills Receivable and credit the
consignee's personal account
3/7/2006 Bill Receivable A/c Dr. 30,000
To Wye 30,000
(Note: Wye's account has appeared only now, in the
previous two entries his account did not figure
since he is not personally involved)
4. Wye's acceptance will mature on 6/10/2006
Assuming it was met the entry will be:
6/10/2006 Bank A/c Dr. 30,000
To Bills Receivable A/c 30,000
(Note: If such bill is discounted by consignor with the
bank before maturity, pass usual entry for discounting
a bill. The discount on bills may either be treated as
consignment expenses and charged to Consignment A/c
or it may be treated as general financial charges and
charged to Profit & Loss Account)
5. On receipt of Account sale
(a) For sales made by the consignee, debit his personal
account and credit Consignment Account
Wye Dr. 55,000
To Consignment to Wye A/c 55,000

7.4 COMMON PROFICIENCY TEST


(b) For expenses incurred by the consignee as well as
bad debts suffered by him on behalf of the
consignor, debit Consignment Account and credit
Consignee Account
Consignment to Wye A/c Dr. 3,400
To Wye 3,400
(c) For commission due to the consignee, debit
Consignment Account and credit the consignee.
Consignment to Wye A/c 5,500
To Wye 5,500
(10% on Rs. 55,000)
(d) For the remittance that may accompany the
Account Sales, debit Bank and credit the consignee.
Bank A/c Dr. 16,100
To Wye 16,100
6. For the goods that may remain unsold debit the Stock
on Consignment Account and credit Consignment
Account.
Stock on Consignment A/c Dr. 10,600
To Consignment to Wye A/c 10,600
Note: (i) Cost of Stock
1/5 of Cost to consignor Rs. 10,000
1/5 of expense incurred 200
1/5 of freight 400
10,600

(ii) Stock on Consignment Account is an asset; it will


be shown in the balance sheet of the consignor
and next year it will be transferred to the debit of
the Consignment Account.
7. At this stage the Consignment Account will reveal profit or
loss (see the account given below). The profit or loss will
be transferred to the Profit and Loss Account by debit to
the Consignment Account.
Consignment to Wye A/c Dr. 5,700
To P&L A/c 5,700
8. The Goods sent on Consignment Account should
be closed by transfer to the Trading Account debit
the former and credit the latter:
Goods sent on Consignment Account Dr. 50,000
To Trading Account 50,000

FUNDAMENTALS OF ACCOUNTING 7.5


CONSIGNMENT

Important Ledger Accounts


Consignment to Wye Account
2006 Rs. 2006 Rs.
July 1 To Goods sent on Dec. 31 By Wye-sale
Consignment A/c 50,000 proceeds 55,000
July 1 To Bank expenses 1,000 By Stock on
Consignment Account 10,600
Dec. 31 To Wye-expenses
& bad debt 3,400
Dec. 31 To Wye-commission 5,500
Dec. 31 To P&L Account-transfer
of profit 5,700
65,600 65,600

Goods sent on consignment account


2006 Rs. 2006 Rs.
Dec. 31 To Trading A/c 50,000 July 1 By Consignment to
Wye A/c 50,000

Stock on consignment account


2006 Rs. 2006 Rs.
Dec. 31 To Consignment to 10,600 Dec. 31 By Balance c/d 10,600
2007
Jan. 1 To Balance b/d 10,600

Wye's account
2006 Rs. 2006 Rs.
Dec. 31 To Consignment July 3 By Bills Receivable
Wye A/c 55,000 Account 30,000
By Consignment to
Wye A/c –
Expenses & bad debt 3,400
Commission 5,500
By Bank
(balance received) 16,100
55,000 55,000

7.6 COMMON PROFICIENCY TEST


4. VALUATION OF STOCK
The principle is that stock should be valued at cost or net realisable value whichever is lower,
the same principle as is practised for preparing final accounts. In the case of consignment,
cost means not only the cost of the goods as such to the consignor but also all expenses incurred
till the goods reach the premises of the consignee. Such expenses include packaging, freight,
cartage, insurance in transit, octroi, etc. But expenses incurred after the goods have reached
the consignee's godown (such as godown rent, insurance of godown, delivery charges) are
not treated as part of the cost of purchase for valuing stock on hand. That is why in the case
given above, stock has been valued ignoring godown rent and insurance.
(Sometimes an examination problem states only that the consignor's expenses amounted to
such and such amount and that consignee spent so much. If details are not available for
valuing stock the expenses incurred by the consignor should be treated as part of cost while
those incurred by the consignee should be ignored).
If the expected selling price of stock on hand is lower than the cost the value put on the stock
should be expected net selling price only, i.e. expected selling price less delivery expenses, etc.

5. GOODS INVOICED ABOVE COST


Sometimes the proforma invoice is made out at a value higher than the cost and entries in the
books of the consignor are made out on that basis – even the stock remaining unsold will
initially be valued on the basis of the invoice price. It must be remembered, however, that the
profit or loss can be ascertained only if sale proceeds (plus) stock on hand, valued on cost
basis, is compared with the cost of the goods concerned together with expenses. Hence, if
entries are first made on invoice basis, the effect of the loading (i.e., amount added to arrive at
the invoice price) must be removed by additional entries. Suppose in the example given above,
if the invoice is cost plus 20%, i.e., Rs. 60,000 for the goods sent to Wye. The entries will be
initially:

FUNDAMENTALS OF ACCOUNTING 7.7


CONSIGNMENT

Dr. Cr.
Rs. Rs.
(i) Consignment to Wye A/c Dr. 60,000
To Goods sent on Consignment A/c 60,000
(ii) Consignment to Wye A/c Dr. 1,000
To Bank 1,000
(iii) Bill Receivable A/c Dr. 30,000
To Wye 30,000
(iv) Bank A/c Dr. 30,000
To Bills Receivable A/c 30,000
(v) Wye Dr. 55,000
To Consignment to Wye A/c 55,000
(vi) Consignment to Wye A/c Dr. 3,400
To Wye 3,400
(vii) Consignment to Wye A/c Dr. 5,500
To Wye 5,500
(viii) Bank A/c Dr. 16,100
To Wye 16,100
(ix) Stock on Consignment A/c Dr. 12,600
To Consignment to Wye A/c 12,600
[1/5 of 60,000 + 1/5 of (1000 + 2000)]
[Students will see that except for difference in the amounts in entries (i) and (ix), these and
other entries are the same as those already given.]
Additional entries (before ascertaining profit) to remove the effect of loading:
(a) Goods sent on Consignment A/c Dr. 10,000
To Consignment to Wye A/c 10,000
[Entry (i) reversed to the extent of loading in order to debit the Consignment A/c on cost
basis].
(b) Consignment to Wye A/c Dr. 2,000
To Stock Reserve Account 2,000
(The amount of loading included in the value of the closing stock is unrealised profit – hence
reserve created by debit to the Consignment Account).
The Consignment Account will now reveal a profit of Rs. 5,700 the same as before. It will be
transferred to the P&L A/c. Similarly entry given in 8 above will be made to transfer the
balance in the Goods sent on Consignment Account (now against Rs. 5,000) after entry in (a)
above to the credit of Trading Account. The accounts (except for Wye whose account will be
the same as already shown) are given below:

7.8 COMMON PROFICIENCY TEST


Consignment to Wye Account
2006 Rs. 2006 Rs.
July 1 To Goods sent on Dec. 31 By Wye
Consignment A/c 60,000 Sales proceeds 55,000
To Bank A/c – expenses 1,000 By Stock on
Consignment A/c 12,600
Dec.31 To Wye expenses
& bad debt 3,400 " By Goods sent on
" To Wye commission 5,500 Consignment A/c
loading 10,000
" To Stock Reserve A/c 2,000
" To Profit and Loss A/c
transfer of profit 5,700
77,600 77,600

Goods sent on Consignment Account


2006 Rs. 2006 Rs.
Dec. 31 To Consignment to Wye July 1 By Consignment to
A/c loading 10,000 Wye A/c 60,000
To Trading A/c
transfer 50,000
60,000 60,000

Stock Consignment Account


2006 Rs. 2006 Rs.
Dec. 31 To Consignment to 12,600 Dec. 31 By Balance c/d 12,600
Wye A/c
2007
Jan. 1 Balance b/d 12,600

Stock Reserve Account


2006 Rs. 2006 Rs.
Dec. 31 To Balance c/d 2,000 Dec. 31 By Consignment to 2,000
Wye A/c
2007
Jan. 1 By Balance b/d 2,000

FUNDAMENTALS OF ACCOUNTING 7.9


CONSIGNMENT

The last two accounts will be carried forward to the next year and their balance will then be
transferred to the Consignment Account – Rs. 12,600 on the debit side and Rs. 2,000 on the
credit. This year in the balance sheet the net amount of Rs. 10,600 will be shown on the assets
side as shown below:
Rs.
Stock on consignment 12,600
Less: Reserve 2,000
10,600
What would be the situation if the commission to Wye includes del-credere commission also? In that
case Wye would be able to charge the bad debt of Rs. 600 to Exe; he will have to bear the loss
himself. The student can see that then the profit on consignment will be Rs. 6,300.
In this regard it is to be noted that when del – credere commission is paid to the consignee, the
consignee account is debited in the books of consignor for both cash and credit sales. But if no
such del – credere commission is paid then consignee account cannot be debited for credit
sales and in that case the following entry is passed in the books of consignor for credit sales.
Consignment Debtors A/c Dr.
To Consignment A/c

6. ABNORMAL LOSS
If any accidental or unnecessary loss occurs, the proper thing to do is to find out the cost of the
goods thus lost and then to credit the Consignment Account and debit the Profit and Loss
Account – this will enable the consignor to know what profit would have been earned had
the loss not taken place. Suppose 1,000 sewing machines costing Rs. 250 each are sent on
consignment basis and Rs. 10,000 are spent on freight etc. 20 machines are damaged beyond
repair. The amount of loss will be:
Cost = 20 × 250 Rs. 5,000
10,000
Expenses = 2 × Rs. 200
1,000
Rs. 5,200

This amount should be credited to the Consignment Account and debited to the P&L A/c. If
any amount, say, Rs. 4,000 is received from the insurers, then debit to the P&L A/c will be
only Rs. 1,200. But the credit to the Consignment Account will still be Rs. 5,200. Rs. 4,000 will
have been debited to the Bank Account.
Students will have noted that abnormal loss is valued just like stock in hand.
Students should be careful while valuing goods lost in transit and goods lost in consignee's
godown. Both are abnormal loss but in case of former consignee's non-recurring expenses are
not to be included whereas it is to be included in case of latter.

7.10 COMMON PROFICIENCY TEST


7. NORMAL LOSS
If some loss is essential and unavoidable, it would be spread over the entire consignment
while valuing stock. The total cost plus expenses incurred should be divided by the quantity
available after the normal loss to ascertain the cost per unit. Suppose 1,000 kg of apples are
consigned to a wholesaler, the cost being Rs. 3 per kg, plus Rs. 400 of freight. It is concluded
that a loss of 15% is unavoidable. The cost per kg will be Rs. 3,400 ÷ 850 or Rs. 4. If the stock
is 100 kg its value will be Rs. 400.

8. COMMISSION
Commission is the remuneration paid by the consignor to the consignee for the services rendered
to the former for selling the consigned goods. Three types of commission can be provided by
the consignor to the consignee, as per the agreement, either simultaneously or in isolation.
They are:
8.1 ORDINARY COMMISSION
The term commission simply denotes ordinary commission. It is based on fixed percentage of
the gross sales proceeds made by the consignee. It is given by the consignor regardless of
whether the consignee is making credit sales or not. This type of commission does not give any
protection to the consignor from bad debts and is provided on total sales.
8.2 DEL-CREDERE COMMISSION
To increase the sale and to encourage the consignee to make credit sales, the consignor provides
an additional commission generally known as del-credere commission. This additional
commission when provided to the consignee gives a protection to the consignor against bad
debts. In other words, after providing the del-credere commission, bad debts is no more the
loss of the consignor. It is calculated on total sales unless there is any agreement between the
consignor and the consignee to provide it on credit sales only.
8.3 OVER-RIDING COMMISSION
It is an extra commission allowed by the consignor to the consignee to promote sales at higher
price then specified or to encourage the consignee to put hard work in introducing new product
in the market. Depending on the agreement it is calculated on total sales or on the difference
between actual sales and sales at invoice price or any specified price.

9. RETURN OF GOODS FROM THE CONSIGNEE


Consigned goods can be returned by the consignee because of many reasons like poor quality
or not upto the specimen or destroyed in transit etc. In such a situation, the question arises is
the valuation of returned goods. Consigned goods returned by the consignee to the consignor
are valued at the price at which it was consigned to the consignee. Expenses incurred by the
consignee to send those goods back to the consignor are not taken into consideration while
valuing it because only those expenses are included in the cost of goods which help to bring
the goods into present location and condition i.e. the saleable condition.

FUNDAMENTALS OF ACCOUNTING 7.11


CONSIGNMENT

10. ACCOUNT SALES


An account sale is the periodical summary statement sent by the consignee to the consignor. It
contains details regarding –
(a) sales made,
(b) expenses incurred on behalf of the consignor,
(c) commission earned,
(d) unsold stock left with the consignee,
(e) advance payment or security deposited with the consignor and the extent to which it has
been adjusted,
(f) balance payment due or remitted.
It is a summary statement and is different from Sales Account.

11. ACCOUNTING BOOKS OF THE CONSIGNEE


The consignee is not concerned when goods are consigned to him or when the consignor
incurs expenses. He is concerned only when he sends an advance to the consignor, makes a
sale, incurs expenses on the consignment and earns his commission. He debits or credits the
consignor for all these as the case may be.
Illustration 2
Exe sent on 1st July, 2006 to Wye goods costing Rs. 50,000 and spent Rs. 1,000 on packing etc.
On 3rd July, 2006, Wye received the goods and sent his acceptance to Exe for Rs. 30,000
payable at 3 months. Wye spent Rs. 2,000 on freight and cartage, Rs. 500 on godown rent and
Rs. 300 on insurance. On 31st December, 2006 he sent his Account Sales (along with the
amount due to Exe) showing that 4/5 of the goods had been sold for Rs. 55,000. Wye is
entitled to a commission of 10%. One of the customers turned insolvent and could not pay
Rs. 600 due from him. Show the necessary journal entries in the consignee's book.
Solution
1. On sending the acceptance to Exe Dr. Cr.
Rs. Rs.
2006 July 3, Exe Dr. 30,000
To Bills Payable A/c 30,000
2. On meeting expenses on the consignment:
2006 July 3, Exe Dr. 2,000
To Bank 2,000
3. On meeting his acceptance:
2006 Oct. 6, Bills payable Dr. 30,000
To Bank 30,000

7.12 COMMON PROFICIENCY TEST


4. On sales being effected:
Sundry Debtors/Bank Dr. 55,000
To Exe 55,000
5. On there being a bad debt:
Exe Dr. 600
To Sundry Debtors 600
6. On earning the commission:
Exe Dr. 5,500
To Commission Earned A/c 5,500
7. On setting the account to Exe:
Exe Dr. 16,100
To Bank 16,100
If the commission includes del-credere commission also, he would not be able to debit Exe for
the bad debt. In that case the debit should be to the Commission Earned Account whose net
balance will then be Rs. 4,900 and he will have to pay Rs. 16,700 to Exe.

12. ADVANCE BY THE CONSIGNEE VS SECURITY AGAINST


THE CONSIGNMENT
Generally the consignor insist the consignee for some advance payment for the goods consigned
at the time of delivery of goods. This advance payment is adjusted in full against the amount
due by the consignee on account of the goods sold.
But if the advance money deposited by the consignee is in the form of security against the
goods consigned then the full amount is not adjusted against the amount due by the consignee
to the consignor on account of goods sold in case, there is any unsold stock left with the
consignee. In that case proportionate security in respect of unsold goods is carried forward till
the time the respective goods held with the consignee are sold.
An overview of the consignment transaction between consignee and consignor can be depicted
with the help of the following chart :

FUNDAMENTALS OF ACCOUNTING 7.13


CONSIGNMENT

Consignment Account

Goods consigned

Consignor Consignee

Account sales

Stock of
consignor Details of Sales made by the consignee

Expenses incurred on behalf of the consignor

Commission earned

Unsold stock left with the consignee

Advance payment or security deposited

Balance due or remitted

Illustration 3
Miss Rakhi consigned 1,000 radio sets costing Rs. 900 each to Miss Geeta, her agent on 1st
July, 2006. Miss Rakhi incurred the following expenditure on sending the consignment.
Freight Rs. 7,650
Insurance Rs. 3,250
Miss Geeta received the delivery of 950 radio sets. An account sale dated 30th November,
2006 showed that 750 sets were sold for Rs. 9,00,000 and Miss Geeta incurred Rs. 10,500 for
carriage.
Miss Geeta was entitled to commission 6% on the sales effected by her. She incurred expenses
amounting to Rs. 2,500 for repairing the damaged radio sets remaining in the stock.
Miss Rakhi lodged a claim with the insurance company which was admitted at Rs. 35,000.
Show the Consignment Account and Miss Geeta's Account in the books of Miss Rakhi.

7.14 COMMON PROFICIENCY TEST


Solution
In the books of Miss Rakhi
Consignment Account
Rs. Rs. Rs.
To Goods sent on By Miss Geeta 9,00,000
Consignment A/c 9,00,000 By Insurance Co. 35,000
By Profit & Loss A/c
To Cash abnormal loss 10,545
Freight 7,650 By Consignment
Insurance 3,250 10,900 stock 1,84,391
To Miss Geeta
Carriage 10,500
Repairs 2,500
Commission 54,000 67,000
To Profit & Loss A/c 1,52,036
11,29,936 11,29,936
Miss Geeta’s Account
Rs. Rs. Rs.
To Consignment A/c (Sales) 9,00,000 By Consignment A/c
Expenses:
Carriage 10,500
Repairs 2,500
Commission 54,000 67,000
By Bank 8,33,000
9,00,000 9,00,000
Note: It is assumed that the agent has remitted the amount due from her.
Working Notes:
1. Abnormal loss :
Cost to the consignor: 50 sets @ Rs. 900 45,000
Add. Proportionate expenses incurred by the consignor 50 x 10,900 545
1,000
45,545
Less: Insurance claim 35,000
10,545
2. Valuation of Stock
200 sets @ Rs. 900 1,80,000
Add: Proportionate expenses of the consignor 200 x 10,900 2,180
1,000

FUNDAMENTALS OF ACCOUNTING 7.15


CONSIGNMENT

200 x 10,500
Carriage and customs duty paid by the consignee 2,211
950
1,84,391
Illustration 4
Vikram Milk Foods Co. Ltd. of Vikrampur sent to Sunder Stores, Sonepuri 5,000 kgs of baby
food packed in 2,000 tins of net weight 1 kg and 6,000 packets of net weight 1/2 kg for sale on
consignment basis. The consignee's commission was fixed at 5% of sale proceeds. The cost
price and selling price of the product were as under:
1 kg. tin 1/2 kg. packet
Rs. Rs.
Cost Price 10 6
Selling Price 15 7
The consignment was booked on freight "To Pay" basis, and freight charges came to 2% of
selling value. One case containing 501 kg. tins was lost in transit and the transport carrier
admitted a claim of Rs. 450.
At the end of the first half-year, the following information is gathered from the "Account
Sales" sent by the consignee:
(i) Sale proceeds: 1,500 1 kg. tins
4,000 1/2 kg. packets
(ii) Store rent and insurance charges Rs. 600.
Find out the value of closing stock on consignment.
Show the Consignment A/c and the Consignee's A/c in the books of Vikram Milk Food Co.
Ltd. assuming that the consignees had paid the amount due from them.
Solution
Vikram Milk Foods Co. Ltd.
Consignment to Sonepuri Account
Dr. Cr.
Rs. Rs. Rs.
To Goods sent on By Sunder Stores
Consignment A/c 1,500 1 kg. tins 22,500
2,000 1 kg. tins 20,000 4,000 1/2 kg. pkts. 28,000 50,500
6,000 1/2 kg. pkts. 36,000 56,000
To Sunder Stores: By Insurance (Claim) 450
Freight 1,440 By Profit & Loss A/c
Rent and insurance 600 abnormal loss 65
Commission 2,525 4,565 By Stock A/c 16,915
To Profit & Loss A/c Profit 7,365
67,930 67,930

7.16 COMMON PROFICIENCY TEST


Sunder Stores, Sonepuri
Rs. Rs.
To Consignment to Sonepuri By Consignment to
Account - Sales Proceeds 50,500 Sonepuri Account
Freight 1,440
Rent & Insurance 600
Commission 2,525
By Bank 45,935
50,500 50,500

Working Notes:
(i) Sale value of total consignment:
2,000 1- kg tins 30,000
6,000 1/2 kg. pkts. 42,000
72,000
(ii) Freight @ 2% of above 1,440
(iii) Stock at the end:
450 1 kg. tins @ Rs. 10 (Selling Price Rs. 6,750) 4,500
2,000 1/2 kg. pkts. @ Rs. 6 (Selling Price Rs. 14,000) 12,000
16,500
Add: Freight 2% of (Selling Price Rs. 20,750) 415
16,915
(iv) Loss in transit:
Cost of 50 1 kg. tins @ Rs. 10/- 500
Freight @ 2% of Selling Price Rs. 750 15
Less : Claim 515
450
Loss 65

FUNDAMENTALS OF ACCOUNTING 7.17


CONSIGNMENT

Illustration 5
Vandana Traders of Delhi purchased 10,000 pieces of Sarees @ Rs. 100 per Saree. Out of these
Sarees, 6,000 Sarees were sent on consignment to Vastralaya of Jabalpur at the selling price of
Rs. 120 per Saree. The consignors paid Rs. 3,000 for packaging and freight.
Vastralaya sold 5,000 Sarees at Rs. 125 per Saree and incurred Rs. 1,000 for selling expenses
and remitted Rs. 5,00,000 to Delhi on account. They are entitled to a commission of 5% on
total sales plus a further 20% commission on any surplus price realised over Rs. 120 per Saree.
3,000 Sarees were sold at Rs. 110 per Saree.
Owing to fall in market price, the value of the stock of Sarees in hand is to be reduced by 10%.
Prepare the Consignment Account and Trading Account in the books of Vandana Traders
and their account in the books of the agents Messrs Vastralaya of Jabalpur.
Solution
Vandana Traders, Delhi
Consignment Account
Rs. Rs.
To Goods sent on Consignment 7,20,000 By Vastrayala (Sales) 6,25,000
To Bank (expenses) 3,000 By Goods Sent on
To Vastrayala - Expenses 1,000 Consignment (Loading) 1,20,000
- Commission 36,250 By Stock out on
To Stock Reserve 18,000 Consignment 1,08,450
To Net Profit 75,200
8,53,450 8,53,450

Trading Account for the period ending....


Rs. Rs.
To Purchases 10,00,000 By Sales 3,30,000
Less: Goods on By Closing Stock 90,000
Consignment 6,00,000 By Profit on Consignment 75,200
4,00,000
To Net Profit 95,200
4,95,200 4,95,200

7.18 COMMON PROFICIENCY TEST


Vastralaya, Jabalpur
Vandana Traders (Delhi) Account
Rs. Rs.
To Bank (Expenses) 1,000 By Bank/Sundry Debtors 6,25,000
To Commission 36,250
To Bank 5,00,000
To Balance c/d 87,750
6,25,000 6,25,000

Working Notes:
Rs.
(1) Commission payable
5% on Rs. 6,25,000 31,250
20% on Rs. 25,000 5,000
36,250
(2) The closing stock will be
1,000 Sarees @ Rs. 120 = 1,20,000
⎡ 1,000 ⎤
Add : Proportionate expenses ⎢Rs.3,000x 500
⎣ 6,000 ⎥ ⎦
1,20,500
Less : 10% 12,050
Consignment Stock (at loaded amount) 1,08,450
Loading = Rs. 20 × 1,000 - 10% = 20,000 - 2,000 = Rs. 18,000
(3) It is better to transfer profit on consignment to profit and loss account instead of trading
account.
Illustration 6
Shri Mehta of Bombay consigns 1,000 cases of goods costing Rs. 100 each to Shri Sundaram of
Madras.
Shri Mehta pays the following expenses in connection with consignment:
Rs.
Carriage 1,000
Freight 3,000
Loading charges 1,000
Shri Sundaram sells 700 cases at Rs. 140 per case and incurs the following expenses:
Clearing charges 850
Warehousing and storage 1,700
Packing and selling expenses 600
It is found that 50 cases have been lost in transit and 100 cases are still in transit.
Shri Sundaram is entitled to a commission of 10% on gross sales. Draw up the Consignment
Account and Sundaram's Account in the books of Shri Mehta.

FUNDAMENTALS OF ACCOUNTING 7.19


CONSIGNMENT

Solution
In the books of Shri Mehta
Consignment of Madras Account
Dr. Cr.
Rs. Rs.
To Goods sent on By Sundaram (Sales) 98,000
Consignment 1,00,000 By Loss in Transit
To Bank (Expenses) 5,000 50 cases @ Rs. 105 each 5,250
To Sundaram (Expenses) 3,150
To Sundaram (Commission) 9,800 By Consignment Stock
To Profit on Consignment
to Profit & Loss A/c 11,700 In hand 150 @
Rs. 106 each 15,900
In transit 100 @
Rs. 105 each 10,500 26,400
1,29,650 1,29,650

Sundaram's Account
Rs. Rs.
To Consignment to Madras A/c 98,000 By Consignment A/c
(Expenses) 3,150
By Consignment A/c
(Commission) 9,800
By Balance c/d 85,050
98,000 98,000

Working Notes:
(i) Consignor's expenses on 1,000 cases amounts to Rs. 5,000; it comes to Rs. 5 per case. The
cost of cases lost will be computed at Rs. 105 per case.
(ii) Sundaram has incurred Rs. 850 on clearing 850 cases, i.e., Re. 1 per case; while valuing
closing stock with the agent Re. 1 per case has been added to cases in hand with the
agent.
Illustration 7
Ajay of Mumbai consigned to Vijay of Delhi, goods to be sold at invoice price which represents
125% of cost. Vijay is entitled to a commission of 10% on sales at invoice price and 25% of any
excess realised over invoice price. The expenses on freight and insurance incurred by Ajay
were Rs. 10,000. The account sales received by Ajay shows that Vijay has effected sales
amounting to Rs. 1,00,000 in respect of 75% of the consignment. His selling expenses to be
reimbursed were Rs. 8,000. 10% of consignment goods of the value of Rs. 12,500 were destroyed
in fire at the Delhi godown and the insurance company paid Rs. 12,000 net of salvage. Vijay

7.20 COMMON PROFICIENCY TEST


remitted the balance in favour of Ajay. Prepare consignment account and the account of
Vijay in the books of Ajay alongwith the necessary calculations.

Solution
Books of Ajay
Consignment Account
Dr Cr.
Rs Rs
To Goods sent on 1,25,000 By Goods sent on 25,000
Consignment A/c Consignment A/c
To Cash A/c 10,000 By Abnormal Loss 11,000
To Vijay 8,000 By Vijay 1,00,000
(Expenses) (Sales)
To Vijay 10,937.50 By Stock on 20,250
(Commission) Consignment A/c
To Stock Reserve A/c 3,750 By General Profit & Loss A/c 1,437.50
1,57,687.50 1,57,687.50

Vijay's Account
Dr Cr.
Rs. Rs.
To Consignment A/c 1,00,000 By Consignment A/c 8,000.00
To Abnormal Loss A/c 12,000 By Consignment A/c 10,937.50
By Bank A/c 93,062.50
1,12,000 1,12,000.00

Working Notes:
1. Calculation of value of goods sent on consignment:
Abnormal Loss at Invoice price = Rs. 12,500.
Abnormal Loss as a percentage of total consignment = 10%.
Hence the value of goods sent on consignment = Rs. 12,500 X 100/ 10 = Rs. 1,25,000.
Loading of goods sent on consignment = Rs. 1,25,000 X 25/125 = Rs. 25,000.

FUNDAMENTALS OF ACCOUNTING 7.21


CONSIGNMENT

2. Calculation of abnormal loss (10%):


Abnormal Loss at Invoice price = Rs. 12,500.
Abnormal Loss at cost = Rs. 12,500 X 100/125 = Rs. 10,000
Proportionate expenses of Ajay (10 % of Rs 10,000) = Rs. 1,000
Rs. 11,000

3. Calculation of closing stock (15%):


Ajay's Basic Invoice price of consignment = Rs. 1,25,000
Ajay's expenses on consignment = Rs. 10,000
Rs. 1,35,000
Value of closing stock = 15% of Rs. 1,35,000 = Rs. 20,250
Loading in closing stock = Rs. 18,750 X 25/125 = Rs. 3,750
Where Rs. 18,750 (15% of Rs. 1,25,000) is the basic invoice price of the goods sent on
consignment remaining unsold.

4. Calculation of commission:
Invoice price of the goods sold = 75% of Rs. 1,25,000 = Rs. 93,750
Excess of selling price over invoice price = Rs. 6,250 ( Rs. 1,00,000- Rs. 93,750)
Total commission = 10% of Rs. 93,750 + 25% of Rs. 6,250
= Rs. 9,375 + Rs. 1,562.50
= Rs. 10,937.50

Illustration 8
X of Delhi purchased 10,000 metres of cloth for Rs. 2,00,000 of which 5,000 metres were sent
on consignment to Y of Agra at the selling price of Rs. 30 per metre. X paid Rs. 5,000 for
freight and Rs. 500 for packing etc.
Y sold 4,000 metre at Rs. 40 per metre and incurred Rs. 2,000 for selling expenses. Y is entitled
to a commission of 5% on total sales proceeds plus a further 20% on any surplus price realised
over Rs. 30 per metre. 3,000 metres were sold at Delhi at Rs. 30 per metre less Rs. 3,000 for
expenses and commission. Owing to fall in market price, the stock of cloth in hand is to be
reduced by 10%.
Prepare the Consignment Account and Trading and Profit & Loss Account in Books of X.

7.22 COMMON PROFICIENCY TEST


Solution
In the books of Mr. X
Consignment Account
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Goods sent on
Consignment Account 1,50,000 By Y's account: Sales 1,60,000
By Goods sent on consignment 50,000
To Bank account: (cancellation of loading)
Freight and packing etc. 5,500 By Stock on consignment (W.N.2) 27,000
To Y's account:
Selling expenses 2,000
Commission (W.N.1) 16,000
To Stock Reserve (W.N.2) 9,000
To Profit and loss account (profit
on consignment transferred) 54,500
2,37,000 2,37,000

Trading and Profit and Loss Account


for the year ended……..
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To Purchases 2,00,000 By Sales 90,000
To Gross profit c/d 26,000 By Goods sent on consignment 1,00,000
By Stock in hand
Cost Rs. 40,000
Less: 10% 4,000 36,000
2,26,000 2,26,000
To Expenses and commission 3,000 By Gross profit b/d 26,000
To Net profit 77,500 By Consignment A/c
(profit on consignment) 54,500
80,500 80,500

FUNDAMENTALS OF ACCOUNTING 7.23


CONSIGNMENT

Working Notes:
1. Calculation of commission payable to Y: Rs.
Total sale proceeds of Y 1,60,000
Surplus proceeds realised over Rs. 30 per metre
[4,000 x Rs. (40-30)] 40,000
Commission:
5% of total sale proceeds (5% of Rs. 1,60,000) 8,000
20% of surplus (20% of Rs. 40,000) 8,000
16,000
2. Stock on Consignment: Rs.
Cost of consignment stock (1000 mtrs@ Rs. 20) 20,000
Less: Reduction of 10% due to fall in market price 2,000
18,000
Add: Loading 50% 9,000
27,000*

* Proportionate expenses incurred by the consignor have not been added to the cost of
consignment stock as it has been valued at lower of cost or realisable value.

SELF EXAMINATION QUESTIONS


I CHOOSE THE MOST APPROPRIATE ANSWER FROM THE GIVEN OPTIONS:
1. P of Delhi sends out 100 boxes of toothpaste costing Rs 200 each. Each boxes consist of 12
packets. 60 boxes were sold by consignee at Rs 20 per packet. Amount of sale value will
be:
(a) Rs.14400 (b) Rs.12000 (c) Rs.13200 (d) Rs.14200
2. X of Kolkata sends out 2000 boxes to Y of Delhi costing Rs 100 each. Consignor’s expenses
Rs 5000. 1/10th of the boxes were lost in consignee’s godown and treated as normal loss.
1200 boxes were sold by consignee. The value of consignment stock will be:
(a) Rs. 68333 (b) Rs.61500 (c) Rs.60000 (d) Rs.60250
3. Goods costing Rs 2,00,000 sent out to consignee at Cost + 25%. Invoice value of the goods
will be:
(a) Rs.250,000 (b) Rs.2,40,000 (c) Rs.300,000 (d) None
4. Goods costing Rs 1,80,000 sent out to consignee to show a profit of 20% on Invoice Price.
Invoice price of the goods will be:
(a) Rs.2,16,000 (b) Rs.2,25,000 (c) Rs.2,10,000 (d) None

7.24 COMMON PROFICIENCY TEST


5. Goods of the Invoice value Rs 2,40,000 sent out to consignee at 20% profit on cost. The
loading amount will be:
(a) Rs.40,000 (b) Rs.48,000 (c) Rs.50,000 (d) None
6. X sent out certain goods to Y of Delhi. 1/10 of the goods were lost in transit. Invoice value
of goods lost Rs 12,500. Invoice value of goods sent out on consignment will be:
(a) Rs.120,000 (b) Rs.125,000 (c) Rs.140,000 (d) Rs.100,000
7. Rabin consigned goods for the value of Rs 8,250 to Raj of Kanpur paid freight etc. of Rs
650 and insurance Rs 400. Drew a bill on Raj at 3 months after date for Rs 3,000 as an
advance against consignment, and discounted the bill for Rs 2960. Received Account
Sales from Raj showing that part of the goods had realized gross Rs 8,350 and that his
expenses and commission amounted to Rs 870. The stock unsold was valued at Rs 2750.
Consignee wants to remit a draft for the amount due. The amount of draft will be:
(a) Rs.2130 (b) Rs.4480 (c) Rs.5130 (d) Rs.5090
8. X of Kolkata sends out goods costing Rs 1,00,000 to Y of Delhi. 3/5th of the goods were
sold by consignee for Rs 70,000. Commission 2% on sales plus 20% of gross sales less all
commission exceeds cost price. The amount of Commission will be:
(a) Rs.2833 (b) Rs.2900 (c) Rs.3000 (d) Rs.2800
9. X of Kolkata send out 1000 bag to Y of Delhi costing Rs 200 each. Consignor’s expenses Rs
2000. Y’s expenses non-selling Rs 1000, selling Rs 2000. 100 bags were lost in transit.
Value of lost in transit will be:
(a) Rs.20,200 (b) Rs.20,300 (c) Rs.20,000 (d) Rs.23,000
10. X of Kolkata sends out 1000 bags to Y on Delhi costing Rs 2000 each. 600 bags were sold
at 10% above cost price. Sale value will be:
(a) Rs.13,20,000 (b) Rs.13,00,000 (c) Rs.12,00,000 (d) 13,50,000
11. Which of the following statement is not true:
(a) If del-creder’s commission is allowed, bad debt will not be recorded in the books of
consignor
(b) If del-creder’s commission is allowed, bad debt will be debited in consignment account
(c) Del-creder’s commission is allowed by consignor to consignee
(d) Del-creder’s commission is generally relevant for credit sales
12. X of Kolkata sends out 400 bags to Y on Delhi costing Rs 200 each. Consignor expenses Rs
2000. Y expenses non selling Rs 2000, selling 1000. 300 bags were sold by Y. Value of
consignment stock will be:
(a) Rs.20,400 (b) Rs.20,200 (c) Rs.20,000 (d) Rs.21000
13. X of Kolkata sent out 2000 boxes costing 100 each with the instruction that sales are to be
made at cost + 45%. X draws a bill on Y for an amount equivalent to 60% of sales value.

FUNDAMENTALS OF ACCOUNTING 7.25


CONSIGNMENT

The amount of bill will be:


(a) Rs.1,74,000 (b) Rs.2,00,000 (c) Rs.2,90,000 (d) Rs.1,20,000
14. Which of the following statement is wrong:
(a) Consignor is the owner of the consignment stock
(b) Del-credere commission is allowed by consignor to protect himself for bad debt
(c) Proportionate consignor’s expenses is added up with consignment stock
(d) All proportionate consignee’s expenses will be added up for valuation of consignment
stock.
15. X of Kolkata sends out 500 bags to Y costing Rs 400 each at an invoice price of Rs 500
each. Consignor’s A/c expenses Rs 4000 consignee’s expenses, non-selling Rs 1000, selling
Rs. 2000. 400 bags were sold.
The amount of consignment stock at Invoice Price will be:
(a) Rs.50,900 (b)Rs.50,800 (c) Rs.50,000 (d) Rs.51,000
16. X of Kolkata sends out 500 bags to Y costing Rs 400 each at an invoice price of Rs 500
each. Consignor’s A/c expenses Rs 4000 consignee’s expenses, non-selling Rs 1000, selling
Rs. 2000. 400 bags were sold. The amount of Stock Reserve will be
(a) Rs.10,000 (b) Nil (c) Rs.20,000 (d) Rs.20,400
17. Commission will be shared between:
(a) Consignor & Consignee (b) Only Consignee
(c) Only Consignor (d) Third Party
18. X of Kolkata sends out certain goods to Y of Mumbai at cost + 25%. 1/2 of the goods
received by Y is sold at 1,76,000 at 10% above IP. Invoice value of goods send out is:
(a) Rs.300,000 (b) Rs.3,20,000 (c) Rs.180,000 (d) Rs.340,000
19. X of Kolkata sends out goods costing 300,000 to Y of Mumbai at cost + 25%. Consignor’s
expenses Rs 5000. 1/10th of the goods were lost in transit. Insurance claim received Rs
3000. The net loss on account of abnormal loss is:
(a) Rs.27,500 (b) Rs.25,500 (c) Rs.30.500 (d) Rs.27,000
20. Rahim of Kolkata sends out 1000 boxes to Ram of Delhi costing Rs 100 each at an IP of Rs
120 each. Goods send out on consignment to be credited in general trading will be:
(a) Rs.100,000 (b) Rs.120,000 (c) Rs.20,000 (d) None
21. In the books of consignor, the profit of consignment will be transferred to:
(a) General Trading A/c (b)General P/L A/c (c) Drawings A/c (d) None of these
22. Ram of Kolkata sends out 1000 boxes to Y of Delhi, costing Rs 200 each. 1/10th of the
boxes were lost in transit. 2/3rd of the boxes received by consignee is sold at cost + 25%.
The amount of sale value will be:
(a) Rs.1,00,000 (b) Rs.1,50,000 (c) Rs.1,20,000 (d) Rs.1,40,000

7.26 COMMON PROFICIENCY TEST


23. X of Kolkata sends out goods costing Rs 80,000 to Y of Mumbai so as to show 20% profit
on invoice value. 3/5th of the goods received by consignee is sold at 5% above invoice
price. The amount of sale value will be:
(a) Rs.63,000 (b) Rs.60,000 (c) Rs.50,400 (d) Rs.40,000
24. X of Kolkata sends out certain goods at cost + 25%. Invoice value of goods sends out Rs
200,000. 4/5th of the goods were sold by consignee at Rs.1,76,000. Commission 2% upto
invoice value and 10% of any surplus above invoice value.
The amount of commission will be:
(a) Rs.4800 (b) Rs.5200 (c) Rs.3200 (d) Rs.1600
25. Ram of Kolkata sends out goods costing 100,000 to Y of Mumbai at 20% profit on invoice
price. 1/10th of the goods were lost in transit. ½ of the balance goods were sold. The
amount of stock reserve on consignment stock will be:
(a) Rs.4500 (b) Rs.9000 (c) Rs.11250 (d) None
26. C of Bangalore consigned goods costing Rs 3,000 to his agent at Delhi. Freight and insurance
paid by consignor Rs 100. Consignee’s expenses Rs 200. 4/5th of the goods were sold for Rs
3,000. Commission 2% on sales. Consignee want to settle the balance with the help of a
bank draft. The amount of draft will be:
(a) Rs.2740 (b) Rs.2800 (c) Rs.3000 (d) Rs.1800
27. Out of the following at which point the treatment of “Sales” and “Consignment” is same:
(a) Ownership transfer. (b) Money receive. (c) Stock outflow. (d) Risk.
28. If del-credere commission is allowed for bad debt, consignee will debit the bad debt amount
to:
(a) Commission Earned A/c (b) Consignor A/c
(c) Debtors A/c (d) General Trading A/c
29. A proforma invoice is sent by:
(a) Consignee to Consignor (b) Consignor to Consignee
(c) Debtors to Consignee (d) Debtors to Consignor
30. Which of the following statement is correct:
(a) Consignee will pass a journal entry in his books at the time of receiving goods from
consignor.
(b) Consignee will not pass any journal entry in his books at the time of receiving goods
from consignor.
(c) The ownership of goods will be transferred to consignee at the time of receiving the
goods.
(d) Consignee will treat consignor as creditor at the time of receiving goods.

FUNDAMENTALS OF ACCOUNTING 7.27


CONSIGNMENT

31. 1000 kg of apples are consigned to a wholesaler, the cost being Rs 3 per kg plus Rs 400 of
freight, it is known that a loss of 15% is unavoidable. The cost per kg will be:
(a) Rs 5 (b) Rs 4 (c) Rs 3.40 (d) Rs 3
32. A of Mumbai sold goods to B of Delhi, the goods are to be sold at 125% of cost which is
invoice price. Commission 10% on sales at IP and 25% of any surplus realized above IP.
10% of the goods sent out on consignment, invoice value of which is Rs 12,500 were
destroyed. 75% of the total consignment is sold by B at Rs 1,00,000. What will be the
amount of commission payable to B?
(a) Rs.11,562.50 (b) Rs.10,000 (c) Rs.9000 (d) Rs.9700
33. Consignment A/c is prepared in the books of :
(a) Consignor (b) Consignee (c) Third Party (d) None
34. Goods sent on consignment Invoice value 2,00,000 at cost + 331/3 %. 1/5th of the goods
were lost in transit. Insurance claim received Rs 10,000. The amount of abnormal loss to
be transferred to General P/L is:
(a) Rs.30,000 (b) Rs.20,000 (c) Rs.35,000 (d) Rs.20,000
35. X of Kolkata sends out 100 boxes to Y of Delhi costing Rs 200 each. Consignor’s
expenses Rs 4000. Consignee’s expenses non-selling 900, selling 500. 1/10th of the boxes
were lost in transit. 2/3rd of the boxes received by consignee were sold. The amount of
consignment stock will be:
(a) Rs.7200 (b) Rs.7500 (c) Rs.7000 (d) Rs.6000
36. X of Kolkata sends out goods costing 100,000 to Y of Mumbai at cost + 25%. Consignor’s
expenses Rs 2000. 3/5th of the goods were sold by consignee at 85000. Commission 2% on
sales + 20% of gross sales less all commission exceeds invoice value. Amount of commission
will be:
(a) Rs.3083 (b) Rs.3000 (c) Rs.2500 (d) Rs.2000
37. Consignment stock will be recorded in the balance sheet of consignor on asset side at:
(a) Invoice Value (b) At Invoice value less stock reserve
(c) At lower than cost price (d) At 10% lower than invoice value
38. Which of the following expenses of consignee will be considered as non-selling expenses:
(a) Advertisement (b) Insurance
(c) Selling Expenses (d) None of the above
39. The consignment accounting is made on the following basis:
(a) Accrual (b) Realisation (c) Cash Basis (d) None
40. Goods sent on consignment Rs 7,60,000. Opening consignment stock Rs 48,000. Cash
sales Rs 7,00,000. Consignor’s expenses Rs 20,000. Consignee’s expenses Rs 12,000.

7.28 COMMON PROFICIENCY TEST


Commission Rs 20,000. Closing consignment stock Rs 3,00,000. The profit on consignment
is:
(a) Rs.150,000 (b) Rs.140,000 (c) Rs.92,000 (d) None
41. X of Kolkata sends out 100 boxes to Y of Delhi costing Rs 100 each. Consignor’s expenses
Rs 1000. Consignees expenses selling Rs 500. 3/5th of the goods sold by consignee, ½ of the
balance goods were lost in consignee’s godown due to fire. The value of abnormal loss will
be:
(a) Rs.3000 (b) Rs.2200 (c) Rs.4000 (d) None
42. X of Kolkata sends out 1000 boxes costing Rs.2000 each to Y of Delhi. 1/10th of the boxes
were lost in transit. 2/3rd of the remaining boxes sold by consignee at cost + 25%. The sale
value will be:
(a) Rs.1,50,000 (b) Rs.1,40,000 (c) Rs.1,20,000 (d) Rs.1,00,000
43. Which of the following item is not credited to consignment account?
(a) Cash sales made by consignee
(b) Credit sales made by consignee
(c) Consignment Stock
(d) Stock Reserve
44. Goods sent out on consignment Rs 2,00,000. Consignor’s expenses 5,000. Consignee’s
expenses 2000. Cash sales Rs 1,00,000, credit sales Rs 1,10,000. Consignment stock Rs
40,000. Ordinary commission payable to consignee Rs 3,000. Del-credere commission Rs
2000. The amount irrecoverable from customer Rs 2,000. What will be the profit
on consignment?
(a) Rs.38,000 (b) Rs.40,000 (c) Rs.36,000 (d) Rs.43000
45. The commission received from consignor will be transferred to which account?
(a) General Trading (b) General P/L (c) Balance Sheet (d) None of these
46. X of Kolkata sends out 1000 boxes to Y of Delhi costing Rs 20 each. Consignor’s expenses
2000. 4/5th of the boxes were sold at 25 each. The profit on consignment will be:
(a) Rs.2400 (b) Rs.2000 (c) Rs.3000 (d) Rs.3500
47. If del-credere commission is allowed by consignor to consignee the bad debt treatment
will be (In the books of Consignor):
(a) Will not be recorded in consignor’s books
(b) Bad Debt will be debited in Consignor’s A/c
(c) Bad Debt will be charged to General P/L A/c
(d) Bad Debt will be recoverable along with credit sales

FUNDAMENTALS OF ACCOUNTING 7.29


CONSIGNMENT

48. The owner of the consignment stock is:


(a) Consignor (b) Consignee (c) Debtors (d) None
49. The nature of the consignment account is:
(a) Capital in nature (b) Revenue in nature
(c) Realisation A/c in nature (d) Bank A/c in nature
50. Goods sent out on consignment Rs 2,00,000. Consignor’s expenses 5,000. Consignee’s
expenses 2000. Cash sales Rs 1,00,000, credit sales Rs 1,10,000. Consignment stock Rs
40,000. Commission payable to consignee Rs 3,000. The amount irrecoverable from
customer Rs 2,000. What will be the profit on consignment?
(a) Rs.38,000 (b) Rs.40,000 (c) Rs.43,000 (d) None
51. Rahim of Kolkata sends out goods of the invoice value Rs 2,00,000 to Ram of Delhi at cost
+ 25%. The amount of loading will be:
(a) Rs.50,000 (b) Rs.40,000 (c) Rs.30,000 (d) Rs.60,000
52. Goods sent to consignment at cost + 331/3 %. The percentage of loading on invoice price
will be:
(a) 25% (b) 331/3 % (c) 20% (d) None
53. The balance of goods sent out on consignment will be transferred to:
(a) General P/L (b)General Trading (c) Balance Sheet (d) Capital A/c
54. X of Kolkata purchased 1000 boxes costing Rs 100 each. 200 boxes were sent out to Y of
Delhi at cost + 25%. 600 boxes were sold at 120 each. The amount of gross profit to be
recorded in general trading will be:
(a) Rs.12,000 (b) Rs.17,000 (c) Rs. (3,000) (d) None
55. In the books of consignee, the rpfit o consignment will be transferred to:
(a) General Trading A/c (b) General Profit and Loss A/c
(c) Drawings A/c (d) None of the above
56. P of Faridabad sent out goods costing Rs. 45,000 to Y of Delhi at cost + 331/3 %. 1/10th of
goods were lost in transit. 2/3rd of the goods are sold at 20% above IP. The amount of sale
value will be:
(a) Rs.54,000 (b) Rs.43,200 (c) Rs.60,000 (d) Rs.36,000
57. M of Kolkata sent out goods costing Rs. 45,000 to N of Mumbai at cost + 331/3 %. 1/10th of
goods were lost in transit. 2/3rd of the goods are sold at 20% above IP. ½ of the sales are on
credit. The amount of credit sales will be:
(a) Rs.21,600 (b) Rs.18,000 (c) Rs.21,000 (d) Rs.22,500

7.30 COMMON PROFICIENCY TEST


58. A of Ahmedabad sent out certain goods so as to show a profit of 20% on IP. 1/10th of the
goods were lost in transit. The cost price of goods lost is Rs.20,000. The invoice value of
goods sent out is:
(a) Rs.250,000 (b) Rs.2,00,000 (c) Rs.225,000 (d) Rs.2,40,000
59. Ram of Delhi sends out goods costing Rs.2,00,000 to Krishna of Brindaban. Consignor’s
expenses Rs.5000. Consignee’s expenses in relation to sales Rs 2000. 4/5th of the goods
were sold at 20% above cost. The profit on consignment will be:
(a) Rs.26,000 (b) Rs.32,000 (c) Rs.26,200 (d) Rs.(6,000)
60. Overwriting commission is a commission payable to consignee by consignor for:
(a) For protecting himself from bad debt
(b) For making sales above specific price
(c) As good friend
(d) As loyalty payment
61. A of Kolkata sends out 500 boxes to B of Delhi costing Rs 200 each. Consignor’s expenses
Rs 5000. 1/5th of the boxes were still in transit. 3/4th of the goods received by consignee,
were sold. The amount of goods still in transit will be:
(a) Rs.20,000 (b) Rs.21,000 (c) Rs.21,200 (d) None
62. Consignment account is
(a) Real account (b) Personal account
(c) Nominal account (d) None of the above
63. In the books of consignor, the loss on consignment business will be charged to:
(a) Consignee A/c (b) General Trading A/c
(c) General P/L A/c (d) Bank A/c
64. Dravid of Delhi sends out goods to Sourav of Kolkata, goods costing Rs 2,00,000 at cost +
25%, with the instruction to sell it at cost + 50%. If 4/5th of the goods are sold at stipulated
selling price and commission allowable 2% on sales. What will be the profit on consignment
in the books of consignor?
(a) Rs.86,200 (b) Rs.70,000 (c) Rs. 75,200 (d) Rs. 76,800
65. X of Kolkata sends out goods costing Rs 3,00,000 to Y of Delhi. Goods are to be sold at cost
+ 331/3 %. The consignor asked consignee to pay an advance for an amount equivalent to
60% of sales value. The amount of advance will be:
(a) Rs.2,40,000 (b) Rs.2,00,000 (c) Rs.3,00,000 (d) None
66. If consignor draws a bill on consignee and discounted it with the banker the discounting
charges will be debited in:
(a) General P/L (b) Consignment A/c (c) Consignee (d) Debtors

FUNDAMENTALS OF ACCOUNTING 7.31


CONSIGNMENT

67. X of Kolkata sends out goods costing Rs 3,00,000 to Y of Delhi. Commission agreement –
2% on sales + 3% on sales as del-credere commission. The entire goods is sold by consignee
for Rs 4 lacs. However, consignee is able to recover Rs 3,95,000 from the debtors. The
amount of profit to be transferred to P/L as net commission by consignee will be:
(a) Rs.15,000 (b) Rs.22,000 (c) Rs.21,000 (d) Rs.20,000

II MATCH THE FOLLOWING ITEMS FROM COLUMN A WITH COLUMN B


S. No. Column A Column B
1. The relationship between consignor (a) consignor
and consignee is:
2. Entire profit on consignment business (b) is allowed to consignee by consignor
belongs to for protecting consignor from bad debt
3. Account sales (c) Principal & Agent
4. Del-credere commission (d) is rendered by Consignee to Consignor

ANSWERS
I.
1. (a) 2. (a) 3. (a) 4. (b) 5. (a)
6. (b) 7. (b) 8. (a) 9. (a) 10. (a)
11. (b) 12. (d) 13. (a) 14. (d) 15. (d)
16. (a) 17. (b) 18. (b) 19. (a) 20. (a)
21. (b) 22. (b) 23. (a) 24. (a) 25. (c)
26. (a) 27. (c) 28. (a) 29. (b) 30. (b)
31. (b) 32. (a) 33. (a) 34. (b) 35. (b)
36. (a) 37. (b) 38. (b) 39. (a) 40. (b)
41. (b) 42. (a) 43. (d) 44. (a) 45. (b)
46. (a) 47. (a) 48. (a) 49. (b) 50. (a)
51. (b) 52. (a) 53. (b) 54. (a) 55. (d)
56. (b) 57. (a) 58. (a) 59. (a) 60. (b)
61. (b) 62. (c) 63. (c) 64. (c) 65. (a)
66. (a) 67. (a)
II.
1. (c), 2 (a), 3( d), 4 (b)

7.32 COMMON PROFICIENCY TEST


CHAPTER - 7

PREPARATION
OF FINAL
ACCOUNTS OF
SOLE
PROPRIETORS

Unit 2

Joint
Ventures
JOINT VENTURES

Learning Objectives:
After studying this unit, you will be able to :
 Understand special features of joint venture transactions,
 Learn the techniques of preparing Joint Venture Account and also the settlement of
accounts with the co-venturer(s),
 Familiarise with the use of Memorandum Joint Venture Account,
 Learn the technique of deriving venture profit and its allocation among the venturers,
 Distinguish joint venture with partnership.

1. MEANING OF JOINT VENTURE


A Joint Venture is a very short duration "business" (generally, confined to a single transaction,
like, buying some surplus stores and selling them) entered into by two or more persons jointly.
Joint Venture may be described as a temporary partnership between two or more persons
without the use of the firm name, for a limited purpose. In other words, under Joint Venture,
two or more persons agree to undertake a particular venture (e.g. Joint consignment of goods,
Joint construction of a building, Joint underwriting of a particular issue of shares or debentures)
and to share the profits and losses thereof in an agreed ratio (if agreement is silent on this
point, then in equal ratio).
Venture may be for the construction of a building or a bridge, for the supply of certain quantity
of materials or labour and even for the supply of technical services. The persons who have so
agreed to undertake a Joint Venture are known as 'Joint Venturers' or 'Co-Venturers'. If the
co-venturers are in business, then they often supply goods from their regular business for the
venture. This limited partnership automatically expires on the completion of the venture for
which it was formed.
Let us take two examples to appreciate the nature of joint venture business.
Example 1: A and B decided to purchase Assam Teak in Guwahati and send to Delhi. A of
Guwahati purchased Teak of Rs. 1,00,000, spent Rs. 20,000 for transportation and Rs. 8,000
for transit insurance. B of Delhi received the goods. B spent Rs. 2,000 for unloading, Rs. 6,000
for godown rent and Rs. 4,000 for selling expenses. He sold the entire lot for Rs. 1,75,000. They
agreed to share profit of the venture in the ratio of A:B = 3:2.
In the above example, A and B are co-venturers. The venture was for sale of a certain quantity
of Assam Teak. The venture would be over on sale of such Teak. Obviously some accounting
is necessary to find out profit/loss of the venture and settlement of claims of the co-venturers.
Example 2: Mr. Arun and Barun entered into a joint venture for supply of 15,000 pcs. of
Bengal handloom sarees to an exporter of Delhi @ Rs. 520 per piece. Arun and Barun contacted
handloom weavers and paid advance to them. They collected production by lots and delivered
to Delhi in a lot of 1,000 pcs.

7.34 COMMON PROFICIENCY TEST


In this example, Arun and Barun were co-venturers. The venture was for a special purpose of
supplying of 15,000 pcs. of Bengal handloom sarees. The venture was over on supply of such
quantity. Obviously, Arun and Barun had to maintain accounts to book all costs relating to
the venture and revenue received from the exporter for determining profit/loss of the venture
and for settling the claims of co-venturers inter se.

2. FEATURES OF JOINT VENTURE ACCOUNT


Some important features of joint venture business are as follows:
(i) It is short duration special purpose partnership. Parties in venture are called co-venturers.
(ii) Co-venturers may contribute funds for running the venture or supply stock from their
regular business.
(iii) Co-venturers share profit/loss of the venture at an agreed ratio likewise partnership.
(iv) Generally profit/loss of the venture is computed on completion of the venture.
(v) Going concern assumption of accounting is not appropriate for joint venture accounting.
There does not arise problem of distinction between capital and revenue expenditure.
Plant, machinery and other fixed assets when used in venture are first charged to venture
account at cost. On completion of venture such assets are revalued and shown as revenue
of the venture. Thus accounting approach for measurement of venture profit is totally
different.

3. DISTINCTION OF JOINT VENTURE ACCOUNT WITH


PARTNERSHIP
Joint Venture differs from Partnership in the following respects:

Basis of Distinction Joint Venture Partnership


1. Scope It is limited to a specific venture. It is not limited to a specific
venture.
2. Persons involved The persons carrying on business The persons carrying on business
are called co-venturers. are individually called partners.
3. Ascertainment of The profits/losses are ascertained The profits/losses are ascertained
profit/loss at the end of specific venture (if on an annual basis.
venture continues for a short
period) or on interim basis
annually (if venture continues for
a longer period).
4. Act governing No specific Act is there. Partnership firms are governed by
Indian Partnership Act, 1932.
5. Name There is no need for firm name. A partnership firm always has a
name.

FUNDAMENTALS OF ACCOUNTING 7.35


JOINT VENTURES

6. Separate set of There is no need for a separate set Separate set of books have to be
Books of books. The accounts can be maintained.
maintained even in one of the Co-
venturer's books only.
7. Admission of A minor cannot be a co-venturer A minor can be admitted to the
Minor as he is incompetent to contract. benefits of the firm.
8. Accounting Accounting for joint venture is Accounting for partnership is
done on liquidation basis. done on going concern basis.
9. Competition It is a rule rather than exception Partners generally do not involve
that chances of co-venturers in the in competing business.
competing business are very high.

4. METHODS OF MAINTAINING JOINT VENTURE ACCOUNTS


Co-venturers can maintain the accounts for joint venture in the manner that suits them in a
particular situation.
Generally there are two ways to keep records of joint venture:
1. When separate set of books are maintained.
2. When no separate set of books are maintained.

Maintenance of Joint Venture Accounts

Separate set of books are maintained No separate set of books are maintained

Joint bank Joint venture Personal accounts When each When each
account account of co-venturers co-venturer co-venturer keeps
keeps record of record of own
all transactions transactions only

Joint venture Co-venturer’s Memorandum Joint venture


account account joint venture with co-venturer
account account

7.36 COMMON PROFICIENCY TEST


4.1. WHEN SEPARATE SET OF BOOKS ARE MAINTAINED
When size of the venture is fairly big, the co-venturers keep separate set of books of account
for the joint venture. Joint venture transactions are separate from their regular business activities.
In the books of Joint Venture the following accounts are opened:
(i) Joint Bank Account.
(ii) Joint Venture Account.
(iii) Personal Accounts of the Co-venturers or Co-venturers' Accounts.
(i) Joint Bank Account: The co-venturers open a separate bank account for the venture
transactions by making initial contributions. The bank account is generally operated jointly.
Expenses are met from this Joint Bank Account. Also sales or collections from transactions are
deposited to this account. However, sometimes the co-venturers may make direct payments
and direct collections. On completion of the venture the Joint Bank Account is closed by paying
the balance to co-venturers.
(ii) Joint Venture Account: This account is prepared for measurement of venture profit. This
account is debited for all venture expenses and is credited for all sales or collections. Venture
profit/loss is transferred to co-venturers' accounts.
(iii) Co-venturers' Accounts: Personal accounts of the venturers are maintained to keep record
of their contributions of cash, goods or meeting venture expenditure directly and direct payment
received by them on venture transactions. This account is also closed simultaneously with the
closure of joint bank account.
The following journal entries are necessary in the books of joint venture:
Journal Entries
(a) For initial contribution by the co-venturers in Joint Bank Account
Joint Bank A/c Dr.
To Co-venturers' A/c
(b) For expenses paid out of Joint Bank Account
Joint Venture A/c Dr.
To Joint Bank A/c
(c) For material supplied by venturers or direct payment made by venturers
Joint Venture A/c Dr.
To Co-venturers' A/cs
(d) For sale or payment received
Joint Bank A/c Dr.
To Joint Venture A/c
(e) For sale or payment received directly by the venturers
Co-venturers' A/cs Dr.
To Joint Venture A/c
(f) For profit on Joint Venture
Joint Venture A/c Dr.
To Co-venturers' A/cs
or For loss on Joint Venture
Co-venturers' A/cs Dr.
To Joint Venture A/c
(g) For closing the Joint Bank A/c
Co-venturers' A/cs Dr.
To Joint Bank A/c

FUNDAMENTALS OF ACCOUNTING 7.37


JOINT VENTURES

Illustration 1
B and C enter a joint venture to prepare a film for the Government. The Government agrees
to pay Rs. 1,00,000. B contributes Rs. 10,000 and C contributes Rs. 15,000. These amounts are
paid into a Joint Bank Account. Payments made out of the joint bank account were:
Rs.
Purchase of equipment 6,000
Hire of equipment 5,000
Wages 45,000
Materials 10,000
Office expenses 5,000
B paid Rs. 2,000 as licensing fees. On completion, the film was found defective and Government
made a deduction of Rs. 10,000. The equipment was taken over by C at a valuation of Rs.
2,000.
Separate books were maintained for the joint venture whose profits were divided in the ratio
of B 2/5 and C 3/5. Give ledger account.
Solution
Dr. Cr.
Joint Bank Account
Date Rs. Date Rs.
?? To B 10,000 ?? By Joint Venture A/c-
?? To C 15,000 Equipment 6,000
Hire of equipment 5,000
?? To Joint Venture A/c 90,000 Wages 45,000
Materials 10,000
Office expenses 5,000
?? By B 19,600
By C 24,400
1,15,000 1,15,000

7.38 COMMON PROFICIENCY TEST


Dr. Cr.
Joint Venture Account
Date Rs. Date Rs.
?? To Joint Bank A/c: ?? By Joint Bank A/c
Equipment 6,000 (Rs. 1,00,000-10,000) 90,000
Hire of equipment 5,000
Wages 45,000 ?? By C
Materials 10,000 (Equipment taken) 2,000
Off. Expenses 5,000
?? To B - Licensing fee 2,000
?? To Profit to:
B 2/5 7,600
C 3/5 11,400
19,000
92,000 92,000

B’s Account
Date Rs. Date Rs.
?? To Joint Bank A/c ?? By Joint Bank A/c 10,000
- Repayment 19,600
?? By Joint Venture A/c 2,000
- Fees
?? By Joint Venture A/c 7,600
- Profit
19,600 19,600

C’s Account
Date Rs. Date Rs.
?? To Joint Venture A/c ?? By Joint Bank A/c 15,000
- Equipment 2,000
?? To Joint Bank A/c ?? By Joint Venture A/c
- Repayment 24,400 - Profit 11,400
26,400 26,400

FUNDAMENTALS OF ACCOUNTING 7.39


JOINT VENTURES

4.2 WHEN NO SEPARATE SET OF BOOKS ARE MAINTAINED


When no separate set of books of account are maintained for joint venture, each venture
maintains accounts independently for the venture transactions. The standard practice is to
keep full records of own transactions as well as transactions of the co-venturer relating to the
venture. But sometimes the parties to a venture keep record of their own transactions only. In
that case a Memorandum Joint Venture Account is prepared by the parties.
4.2.1 WHEN EACH CO-VENTURER KEEPS RECORDS OF ALL TRANSACTIONS
When venturers maintain full records of joint venture, the following journal entries are necessary:
Journal Entries
(i) For supply of goods to venture out of business stock
Joint Venture A/c Dr.
To Purchase A/c
(ii) For meeting expenses of venture
Joint Venture A/c Dr.
To Bank A/c
(iii) When co-venturer supplies goods and incurs expenses for venture
Joint Venture A/c Dr.
To Co-venturer A/c
(iv) For venture sale
Bank A/c Dr.
To Joint Venture A/c
(v) For venture sale made by the co-venturer
Co-venturer A/c Dr.
To Joint Venture A/c
(vi) For venture profit
Joint Venture A/c Dr.
To Profit and Loss A/c (for own shares)
To Co-venturer A/c (for co-venturer's share)
(vii) For venture loss
Profit and Loss A/c Dr. (for own share)
Co-venturer A/c Dr. (for co-venturer's share)
To Joint Venture A/c
(viii) For settlement of claims
When payment is due to co-venturer
Co-venturer A/c Dr.
To Bank A/c
When payment is due from co-venturer
Bank A/c Dr.
To Co-venturer A/c

7.40 COMMON PROFICIENCY TEST


So two special ledger accounts are necessary for joint venture transactions in the books of a
venturer: (i) Joint Venture Account and (ii) Co-venturer's A/c.
Illustration 2
A and B entered into a joint venture of underwriting the subscription at part of the entire
share capital of the Copper Mines Ltd. consisting of 1,00,000 equity shares of Rs. 10 each and
to pay all expenses upto allotment. The profits were to be shared by them in proportions of
3/5ths and 2/5ths. The consideration in return for this agreement was the allotment of 12,000
other shares of Rs. 10 each to be issued to them as fully paid. A provided funds for registration
fees Rs. 12,000, advertising expenses of Rs. 11,000, for expenses on printing and distributing
the prospectus amounting to Rs. 7,500 and other printing and stationery expenses of Rs. 2,000.
B contributed towards payment of office rent Rs. 3,000, legal charges Rs. 13,750, salary to
clerical staff Rs. 9,000 and other petty disbursements of Rs. 1,750. The prospectus was issued
and applications fell short of the issued by 15,000 shares. A took over these on joint account
and paid for the same in full. The venturers received the 12,000 fully paid shares as underwriting
commission. They sold their entire holding at Rs. 12.50 less 50 paise brokerage per share. The
net proceeds were received by A for 15,000 shares and B for 12,000 shares. Write out the
necessary accounts in the books of A showing the final adjustments.
Solution
In the books of A
Joint Venture Account
Dr. Cr.
Rs. Rs.
To Bank A/c - Registration Fee 12,000 By Bank A/c - sale proceeds of
- Advertising 11,000 15,000 shares Rs. 12.50 each
- Printing & Distribution less 50 paise brokerage 1,80,000
of Prospectus 7,500 By B - sale proceeds of 12,000
- Printing & Stationery 2,000 shares Rs. 12.50 each less 1,44,000
To B - Office Rent 3,000 50 paise per share brokerage
- Legal Charges 13,750
- Clerical Staff 9,000
- Petty Payments 1,750
To Bank - Cost of Shares 1,50,000
Net profit to:
- P & L A/c [3/5] 68,400
- B [2/5] 45,600
3,24,000 3,24,000

FUNDAMENTALS OF ACCOUNTING 7.41


JOINT VENTURES

B's Account
Dr. Cr.
To Joint Venture A/c - Sale By Joint Venture A/c
proceeds of shares 1,44,000 - Office Rent 3,000
- Legal Charges 13,750
- Clerical Staff 9,000
- Petty Payments 1,750
By Joint Venture A/c -
share of profit 45,600
By Bank 70,900
1,44,000 1,44,000

Illustration 3
With the information given in Illustration 2, let us prepare the necessary accounts in the books
of B also.
In the books of B
Joint Venture Account
Rs. Rs.
To Bank - Office Rent 3,000 By Bank (Sale of Investments) 1,44,000
- Legal Charge 13,750
- Clerical Staff 9,000 By A (Sale of Investments) 1,80,000
- Petty Payments 1,750
To A - Registration Fee 12,000
- Advertisement 11,000
- Printing of Prospectus 7,500
- Printing Stationery 2,000
- Cost of Shares 1,50,000
To Net Profit to:
P&L A/c (2/5) 45,600
A (3/5) 68,400
3,24,000 3,24,000

7.42 COMMON PROFICIENCY TEST


A's Account
To Joint Venture A/c Rs. By Joint Venture A/c Rs.
sale proceeds 1,80,000 - Registration Fee 12,000
To Bank A/c 70,900 - Advertisement Charges 11,000
- Printing & Distribution of
- Prospectus 7,500
- Printing & Stationery 2,000
- Cost of Shares 1,50,000
By Joint Venture A/c -
share of profit 68,400
2,50,900 2,50,900

Illustration 4
A and B entered into a joint venture agreement to share the profits and losses in the ratio of
2:1. A supplied goods worth Rs. 60,000 to B incurring expenses amounting to Rs. 2,000 for
freight and insurance. During transit goods costing Rs. 5,000 became damaged and a sum of
Rs. 3,000 was recovered from the insurance company. B reported that 90% of the remaining
goods were sold at a profit of 30% of their original cost. Towards the end of the venture, a fire
occurred and as a result the balance stock lying unsold with B was damaged. The goods were
not insured and B agreed to compensate A by paying in cash 80% of the aggregate of the
original cost of such goods plus proportionate expenses incurred by A. Apart from the joint
venture share of profit, B was also entitled under the agreement to a commission of 5% of net
profits of joint venture after charging such commission. Selling expenses incurred by B totalled
Rs. 1,000. B had earlier remitted an advance of Rs. 10,000. B duly paid the balance due to A by
Draft.
You are required to prepare in A's books:
(i) Joint Venture Account.
(ii) B's Account.
Solution
Books of A
Joint Venture Account
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Purchases (Cost of goods supplied) 60,000 By Bank (Insurance claim) 3,000
To Bank (Expenses) 2,000 By B (Sales) 64,350
To B (Expenses) 1,000 By B (agreed value
To B (Commission - 1/21 of 8,896) 424 for damaged goods) 4,546
To Profit transferred to:
Profit & Loss A/c 5,648
B 2,824
71,896 71,896

FUNDAMENTALS OF ACCOUNTING 7.43


JOINT VENTURES

B's Account
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Joint Venture A/c (Sales) 64,350 By Bank (Advance) 10,000
To Joint Venture A/c (Claim Portion) 4,546 By Joint Venture A/c (Expenses) 1,000
By Joint Venture A/c (Commission) 424
By Joint Venture A/c (Share of Profit) 2,824
By Bank (Balance received) 54,648
68,896 68,896

Working Notes:
1. It has been assumed that the goods damaged in transit have no residual value.
2. Computation of Sales
Rs.
Cost of goods sent 60,000
Less: Cost of damaged goods 5,000
55,000
Less: Cost of goods remaining unsold 5,500
Cost of goods sold 49,500
Add: Profit @ 30% 14,850
Sales 64,350
3. Claim for loss of fire admitted by B
Cost of goods 5,500
Add: Proportionate expenses
(2,000 x 5,500)/60,000 183
5,683
Less: 20% 1,137
4,546
Illustration 5
Ram and Rahim enter into a joint venture to take a building contract for Rs. 24,00,000. They
provide the following information regarding the expenditure incurred by them:
Ram Rahim
Rs. Rs.
Materials 6,80,000 5,00,000
Cement 1,30,000 1,70,000
Wages - 2,70,000
Architect's fees 1,00,000 -
License fees - 50,000
Plant - 2,00,000

7.44 COMMON PROFICIENCY TEST


Plant was valued at Rs. 1,00,000 at the end of the contract and Rahim agreed to take it at that
value. Contract amount Rs. 24,00,000 was received by Ram. Profits or losses to be shared
equally. You are asked to show:
Joint Venture Account and Rahim's Account in the books of Ram.
Solution
In the books of Ram
Joint Venture Account
Dr. Cr.
Rs. Rs.
To Bank A/c: By Bank A/c 24,00,000
Material 6,80,000 By Rahim's A/c (plant) 1,00,000
Cement 1,30,000
Architect's fee 1,00,000 9,10,000
To Rahim's A/c:
Material 5,00,000
Cement 1,70,000
Wages 2,70,000
License fees 50,000
Plant 2,00,000 11,90,000
To Net profit transferred to
Rahim's A/c 2,00,000
Profit & Loss A/c 2,00,000 4,00,000
25,00,000 25,00,000

Rahim's Account
Dr. Cr.
Rs. Rs.
To Joint Venture A/c (plant) 1,00,000 By Joint Venture A/c (sundries) 11,90,000
To Balance c/d 12,90,000 By Joint Venture A/c (profit) 2,00,000
13,90,000 13,90,000

FUNDAMENTALS OF ACCOUNTING 7.45


JOINT VENTURES

Illustration 6
With the information given in illustration 5, prepare Joint Venture Account and Ram's Account
in the books of Rahim.
In the books of Rahim
Joint Venture Account
Dr. Cr.
Rs. Rs.
To Ram’s A/c: By Ram's A/c (contract amount) 24,00,000
Material 6,80,000 By Plant A/c 1,00,000
Cement 1,30,000
Architect's fee 1,00,000 9,10,000
To Bank A/c:
Material 5,00,000
Cement 1,70,000
Wages 2,70,000
License fees 50,000
Plant 2,00,000 11,90,000
To Net profit
transferred to:
Ram's A/c 2,00,000
Profit & Loss A/c 2,00,000 4,00,000
25,00,000 25,00,000

Ram's Account
Dr. Cr.
Rs. Rs.
To Joint Venture A/c (contract 24,00,000 By Joint Venture A/c (sundries) 9,10,000
amount) By Joint Venture A/c (profit) 2,00,000
By Balance c/d* 12,90,000
24,00,000 24,00,000

* It may be taken that Rs. 12,90,000 is settled by way of payment from Ram to Rahim.

7.46 COMMON PROFICIENCY TEST


4.2.2 WHEN EACH CO-VENTURER KEEPS RECORDS OF THEIR OWN TRANSACTIONS
ONLY
Sometimes the venturers find it useless to keep full record of venture transactions. Rather it is
considered convenient to keep record of own transactions only. For this purpose, it is necessary
to open 'Joint Venture with Co-venturer A/c'. All expenses incurred, materials sent, etc. are
debited to this account. Profit earned is also debited to this account while the loss sustained is
credited. Any receipt from joint venture or from co-venturer is credited to this account, while
any payment to the co-venturer is debited to this account, profit/loss on joint venture cannot
be determined from this account. For determination of profit/loss a Memorandum Joint Venture
Account is prepared.
Venturers usually pass the following journal entries:
Journal Entries
(a) For supply of material from stores:
Joint Venture with X A/c Dr.
To Purchases A/c
(b) For payment of expenses
Joint Venture with X A/c Dr.
To Bank/Cash A/c
(c) For sale on venture
Bank A/c Dr.
To Joint Venture with X A/c
(d) For profit on venture
Joint Venture with X A/c Dr.
To Profit & Loss A/c
(e) For final payment to co-venturer
Joint Venture with X A/c Dr.
To Bank A/c
or For final payment made by co-venturer
Bank A/c Dr.
To Joint Venture with X A/c
4.2.2.1 Memorandum Joint Venture Account
It is a rough statement prepared by the venturers for determination of venture profit when
they do not maintain full records of venture transactions in the books of accounts. Unless this
memorandum account is prepared, the venturer cannot compute venture profit.
Let us now take some illustrations to understand the book keeping system of joint venture,
when venturers maintain records of their own transactions only.

FUNDAMENTALS OF ACCOUNTING 7.47


JOINT VENTURES

Illustration 7
Ram and Gautham entered into a joint venture to buy and sell TV sets, on 1st July, 2006.
On 1.7.2006, Ram sent a draft for Rs. 2,50,000 in favour of Gautham, and on 4.7.2006, the
latter purchased 200 sets each at a cost of Rs. 2,000 each. The sets were sent to Ram by lorry
under freight "to pay" for Rs. 2,000 and were cleared by Ram on 15.7.2006.
Ram effected sales in the following manner:
Date No. of sets Sale price Discount
per set sales price
16.7.2006 20 3,000 10%
31.7.2006 100 2,800 -
15.8.2006 80 2,700 5%
On 25.8.2006, Ram settled the account by sending a draft in favour of Gautham, profits being
shared equally. Gautham does not maintain any books. Show in Ram's book:
(i) Joint Venture with Gautham A/c; and
(ii) Memorandum Joint Venture A/c.
Solution
Ram's Books
Joint Venture with Gautham A/c
Dr. Cr.
2006 Rs. 2006 Rs.
July 1 To Bank - draft sent July 16 By Bank-sale proceeds 54,000
on A/c 2,50,000
July 15 To Bank - freight 2,000 July 31 By Bank-sale proceeds 2,80,000
" 25 To Profit and Loss A/c
share of profit 68,600 Aug 14 By Bank-sale proceeds 2,05,200
To Bank - draft sent
in settlement 2,18,600
5,39,200 5,39,200

Memorandum Joint Venture A/c


Rs. Rs.
To Cost of 200 sets 4,00,000 By Sales proceeds (net)
" Freight 2,000 20 sets @ Rs. 2,700 net 54,000
" Profit : 100 sets @ Rs. 2,800 net 2,80,000
Ram 68,600 80 sets @ Rs. 2,565 net 2,05,200
Gautham 68,600
1,37,200
5,39,200 5,39,200

7.48 COMMON PROFICIENCY TEST


Illustration 8
D of Delhi and B of Bombay entered into a joint venture for the purpose of buying and selling
second-hand typewriters, B to make purchases and D to effect sales. The profit and loss was
to be shared equally by D and B. A sum of Rs. 15,000 was remitted by D to B towards the
venture.
B purchased 22 old typewriters for Rs. 15,000 and paid Rs. 9,000 for their reconditioning and
sent them to Delhi. His other expenses were: Buying commission Rs. 1,000; Cartage Rs. 200
and Miscellaneous Rs. 100.
D took delivery of the typewriters and paid Rs. 270 for Octroi and Rs. 100 for Cartage. He sold
12 typewriters at Rs. 2,200 each; 4 typewriters at Rs. 2,100 each and 3 typewriters at Rs. 2,000
each. He retained remaining typewriter for his personal use at an agreed value of Rs. 1,500.
His other expenses – Insurance Rs. 250; Rent Rs. 400; Brokerage Rs. 1,200 and Miscellaneous
Rs. 200.
Each party's ledger contains a record of his own transactions on joint account. Prepare a
statement showing the result of the venture and the account of the venture in D's ledger as it
will finally appear, assuming that the matter was finally settled between the parties.
Solution
Statement showing the results of the venture
Sales Rs. Rs.
12 typewriters @ Rs. 2,200 each 26,400
4"" Rs. 2,100 each 8,400
3"" Rs. 2,000 each 6,000
Taken by D at agreed value 1,500
42,300
Less: Cost:
Paid for purchases 15,000
Repairs 9,000
Expenses – Buying Commission 1,000
Cartage (200 + 100) 300
Misc. Expenses (200 + 100) 300
Octroi 270
Insurance 250
Rent 400
Brokerage 1,200
27,720
Profit on Joint Venture 14,580

FUNDAMENTALS OF ACCOUNTING 7.49


JOINT VENTURES

In the books of D
Joint Venture with B Account
Rs. Rs.
To Cash - remittance to B 15,000 By Cash - Sale proceeds received 40,800
To Cash - expenses
- Octroi 270 By Drawings (Goods taken for
- Cartage 100 personal use) 1,500
- Insurance 250
- Rent 400
- Brokerage 1,200
- Misc. 200
2,420
To Profit and Loss - own
share of profit (1/2) 7,290
To Cash - Balance remitted 17,590
42,300 42,300

Illustration 9
David of Bombay and Khosla of Delhi entered into a joint venture for the purpose of buying
and selling second-hand motor cars: David to make purchases and Khosla to effect sales. The
profit and loss was to be shared equally. Khosla remitted a sum of Rs. 1,50,000 to David
towards the venture.
David purchased 5 cars for Rs. 1,60,000 and paid Rs. 60,000 for their reconditioning and sent
them to Delhi. He also incurred an expense of Rs. 5,000 in transporting the cars to Delhi.
Khosla sold 4 cars for Rs. 2,40,000 and retained the fifth car for himself at an agreed value of
Rs. 50,000. His expenses were: Insurance Rs. 1,000; Garage Rent Rs. 2,000; Brokerage
Rs. 2,000; and Sundry Expenses Rs. 400.
Each party's ledger contains a record of his own transactions on joint account. Prepare a
Statement showing the result of the venture and the joint venture account with David in the
books of Khosla as it will finally appear, assuming that the matter was finally settled between
the parties.

7.50 COMMON PROFICIENCY TEST


Solution
Books of Khosla
Joint Venture Account with David
Rs. Rs.
To Bank - Remittance 1,50,000 By Bank - Sales 2,40,000
" Bank - Insurance 1,000 " Vehicles A/c (Car Purchase) 50,000

" Bank - Garage Rent 2,000


" Bank - Brokerage 2,000
" Bank - Sundry 400
" Profit & Loss A/c
- Share of Profit 29,800
Bank - Final Settlement 1,04,800
2,90,000 2,90,000
Statement showing the results of the venture**
Memorandum Joint Venture Account
To David - cost of cars 1,60,000 By Khosla - Sales 2,40,000
" David - Reconditioning 60,000 " Khosla - car taken 50,000
" David - Transport charges 5,000
" Khosla - Expenses * 5,400*
" Net Profit
- David 29,800
- Khosla 29,800 59,600
2,90,000 2,90,000
* Expenses incurred by Khosla
- Insurance 1,000
- Garage Rent 2,000
- Brokerage 2,000
- Sundry Expenses 400
5,400

** Statement includes an account. Alternatively, it could have been prepared in vertical form.
Illustration 10
A of Delhi and B of Bangalore entered into a joint venture for purchase and sale of one lot of
mopeds. The cost of each moped was Rs. 3,600 and the fixed retail selling price; Rs. 4,500. The
following were the recorded transactions:

FUNDAMENTALS OF ACCOUNTING 7.51


JOINT VENTURES

2006
Jan 1 A purchased 100 mopeds paying Rs. 72,000 in cash on account.
A raised a loan from X Bank for Rs. 50,000 at 18% p.a., interest repayable with
interest on 1.3.2001.
A forwarded 80 mopeds to B incurring Rs. 2,880 as forwarding and insurance
charges.
Jan. 7 B received the consignment and paid Rs. 720 as clearing charges.
A sold 5 mopeds for cash.
B sold 20 mopeds for cash.
B raised a loan of Rs. 1,50,000 from Y Bank, repayable with interest at 18% p.a on
1.3.2006.
B telegraphically transferred Rs. 1,50,000 to A incurring charges of
Rs. 50. A paid balance due for the mopeds.
Feb. 26 A sold the balance mopeds for cash.
B sold balance mopeds for cash.
A paid selling expenses Rs. 5,000.
B paid selling expenses Rs. 20,000.
Mar. 1 Accounts settled between the venturer and loans repaid, profit being appropriated
equally.
You are required to show Memorandum Joint Venture A/c.
Solution
Memorandum Joint Venture Account
for the period Jan. 1 to March 1, 2006
Rs. Rs.
To A : By Sales :
Cost of Mopeds 3,60,000 B
Forwarding & Insurance 2,880 80 × 4,500 3,60,000
Interest (2 months) 1,500 A
Selling Expenses 5,000 20 × 4,500 90,000
To B :
Clearing Charges 720
Interest (1 month) 2,250
Sundry Expenses
(Telegraphic transfer
charges) 50
Selling Expenses 20,000
To Net Profit to
A 28,800
B 28,800
57,600
4,50,000 4,50,000

7.52 COMMON PROFICIENCY TEST


Illustration 11
With the data given in Illustration 10, prepare
(1) Joint Venture with B A/c in A's books; and
(2) Joint Venture with A A/c in B's books.
You have to assume that each venturer recorded only such transactions as concluded by
him.
Solution
Books of A
Joint Venture with B Account
Rs. Rs.
To Bank A/c - (part payment of cost) 72,000 By Bank A/c 22,500
(sales proceeds)
" Bank A/c - (forwarding charges) 2,880 By Bank A/c - (remittance 1,50,000
from B)
" Bank A/c - (balance cost of 2,88,000 By Bank A/c 67,500
purchases) (sales proceeds)
" Bank A/c - (selling exp.) 5,000 By Bank A/c - (cash received
" Interest A/c 1,500 in settlement) 1,58,180
" Profit & Loss A/c -
(share of profit) 28,800
3,98,180 3,98,180

Books of B
Joint Venture with A Account
Dr. Cr.
Rs. Rs.
To Bank A/c - (clearing charges) 720 By Bank A/c - (Sales proceeds
of 20 mopeds) 90,000
" Bank A/c - (remittance 1,50,000 By Bank A/c - (sales proceeds
including charges) of 60 mopeds) 2,70,000
" Bank A/c - (selling exp.) 20,000
" Bank A/c - (interest) 2,250
" Sundry Expenses 50
" P & L A/c
(share of profit) 28,800
" Bank A/c - (paid in
settlement) 1,58,180
3,60,000 3,60,000

FUNDAMENTALS OF ACCOUNTING 7.53


JOINT VENTURES

Illustration 12
K and A of Nagpur entered into a joint venture to trade in silk goods in the ratio 2:1. On
June 1, 2004, K bought goods worth Rs. 7,200 and handed over half of the goods to A. On
July 1, 2004, K bought another lot of goods costing Rs. 2,400 and paid Rs. 180 as expenses. On
September 1, A purchased goods for Rs. 4,500 and on the same day he sent to K a part of these
goods costing Rs. 1,800 and paid Rs. 240 towards expenses. On the same day K remitted
Rs. 1,800 to A. The goods were invariably sold by the venturers at a uniform price of 33.33%
above cost price excluding expenses. Each of the ventures collected cash proceeds on sales
excepting an amount of Rs. 250 owing to K by a customer and this was written off as a loss
relating to the venture. In addition, goods costing Rs. 600 in possession of A were destroyed
by fire and an amount of Rs. 500 was realised by him as compensation from the Insurance
Company. On December 20, unsold goods costing Rs. 1,500 (at cost) were lying with K. Of
these, goods costing Rs. 600 were taken by K for personal use and the balance was purchased
by him at an agreed value of Rs. 1,000. A disposed of all the goods with him on December 31,
excepting some damaged goods costing Rs. 300 which were written off as unsaleable.
Prepare a Memorandum Joint Venture Account to find the amount of profit or loss.
Solution
Memorandum Joint Venture Account
Dr. Cr.
Date Particulars Rs. Date Particulars Rs.
To K: By K:
Cost of goods Sales (Note) 8,400
(Rs. 7,200 + Rs. 2,400) 9,600 Stock taken over 1,600
Expenses 180 By A:
Bad Debts 250 Sales (Note) 7,200
To A: Insurance claim 500
Cost of goods 4,500
Expenses 240
To Net Profit:
K - 2/3rd 1,953
A - 1/3rd 977
17,700 17,700

7.54 COMMON PROFICIENCY TEST


SELF EXAMINATION QUESTIONS
CHOOSE THE MOST APPROPRIATE ANSWER FROM THE GIVEN OPTIONS
1. M and N enter into a Joint venture where M supplies goods worth Rs 6000 and spends Rs
100 on various expenses. N sells the entire lot for Rs 7500 meeting selling expenses
amounting to Rs 200. Profit sharing ratio equal .N remits to M the amount due. The amount
of remittance will be:
(a) Rs. 6700 (b) Rs. 7300 (c) Rs. 6400 (d) Rs. 6100
2. A purchased goods costing 42500. B sold goods costing Rs 40000 at Rs 50000. Balance
goods were taken over by A at same gross profit percentage as in case of sale. The amount
of goods taken over will be:
(a). Rs. 3125 (b). Rs. 2500 (c). Rs. 3000 (d) none
3. Which of the following statement is true?
(a) Only one venturer bears the risk
(b) Only one venturer can sell the goods
(c) Only one venturer can purchase the goods
(d) In joint venture, provisions of partnership act applies
4. Which of the following statement is true:
(a) In case of separate sets of books method of Joint Venture, co-venturer’s contribution
of goods is debited in Joint Bank A/c
(b) Co-venturer’s contribution in cash is debited in Venturer’s personal account
(c) Discount on discounting of B/R is debited to Venturer’s personal account
(d) Contract money received is credited to Joint Venture Account.
5. For opening Joint Bank account, in case of separate sets of books:
(a) Venture A/c will be debited and Venturers A/c will be credited
(b) Joint Bank A/c is debited and Venturers Capital A/c is credited
(c) Joint Venture A/c is debited and Joint Bank A/c will be credited
(d) Joint Bank A/c will be debited and Joint Venture A/c will be credited
6. For purchase of plant from Joint Bank Account, in case separate sets of books are
maintained, the correct journal entry will be:
(a) Plant A/c will be debited and Joint Bank A/c will be credited
(b) Joint Venture A/c will be debited and Joint Bank A/c will be credited
(c) Plant A/c will be debited and Venturers Capital A/c will be credited
(d) Joint Venture A/c will be debited and Plant A/c will be credited

FUNDAMENTALS OF ACCOUNTING 7.55


JOINT VENTURES

7. For material supplied from own stock by any of the venturer, the correct journal entry will
be: (In case of separate sets of books)
(a) Joint Venture A/c will be debited and Venturers Capital A/c will be credited
(b) Joint Venture A/c will be debited and Joint Bank A/c will be credited
(c) Joint Venture A/c will be debited and Material A/c will be credited
(d) Joint Bank A/c will be debited and Joint Venture A/c will be credited
8. A and B enter into a joint venture to underwrite the shares of K Ltd. K Ltd make an equity
issue of 100000 equity shares of Rs 10 each. 80% of the issue are subscribed by the party.
The profit sharing ratio between A and B is 3:2. The balance shares not subscribed by the
public, purchased by A and B in profit sharing ratio. How many shares to be purchased
by A.
(a) 80000 shares (b) 72000 shares (c) 12000 shares (d) 8000 shares
9. A and B enter into a joint venture to underwrite shares of K Ltd. K Ltd make an equity
issue of 200000 equity shares. 80% of the shares underwritten by the venturer. 160000
shares are subscribed by the public. How many shares are to be subscribed by the venturer?
(a) Nil (b) 32000 (c) 36000 (d) None
10. A and B purchased a piece of land for Rs 20,000 and sold it for Rs 60,000 in 2005. Originally
A had contributed Rs 12000 and B Rs 8000. What will be the profit on venture?
(a) Rs. 40,000 (b) Rs. 20,000 (c) Rs. 60,000 (d) Nil
11.. A and B enter into a joint venture sharing profit and losses in the ratio 2:1. A purchased
goods costing Rs 200,000. B sold the goods for Rs 250,000. A is entitled to get 1% commission
on purchase and B is entitled to get 5% commission on sales. The profit on venture will be:
(a) Rs. 35500 (b) Rs. 36000 (c) Rs. 34000 (d) Rs.38000
12. P and Q enter into a Joint Venture sharing profits and losses in the ratio 3:2. P purchased
goods costing Rs 200,000. Other expenses of P Rs 10000. Q sold the goods for 180000.
Remaining goods were taken over by Q at Rs 20000. The amount of final remittance to be
paid by Q to P will be:
(a) 215000 (b) 204000 (c) 210000 (d) None
13. C and D entered into a Joint Venture to construct a bridge. They did not open separate set
of books. They shared profits and losses as 3:2. C contributed Rs 150000 for purchase of
materials. D paid wages amounting to Rs 80000. Other expenses were paid as:
C – 5000 D – 15000
C purchased one machine for Rs 20000. The machine was taken over by C for Rs 10000.
Total contract value of Rs 300000 was received by D. What will be the profit on venture?
(a) Rs. 30000 (b) Rs. 40000 (c) Rs. 20000 (d) Rs. 15000
14. R and M entered into a joint venture to purchase and sell new year gifts. They agreed to
share the profit and losses equally. R purchased goods worth Rs 100,000 and spent Rs

7.56 COMMON PROFICIENCY TEST


10000 in sending the goods to M. He also paid Rs 5000 for insurance. M spent Rs 10000 as
selling expenses and sold goods for 200000. Remaining goods were taken over by him at
Rs 5000. What will be the amount to be remitted by M to R as final settlement?
(a) Rs.155000 (b) Rs.150000 (c) Rs.115000 (d) Rs.80000
15. R and M entered into a joint venture to purchase and sell new year gifts. They agreed to
share the profit and losses equally. R purchased goods worth Rs 100,000 and spent Rs
10000 in sending the goods to M. He also paid Rs 5000 for insurance. M spent Rs 10000 as
selling expenses and sold goods for 200000. Remaining goods were taken over by him at
Rs 5000. Find out profit on venture?
(a) Rs.70000 (b) Rs.75000 (c) Rs.80000 (d) Rs.85000
16. A and B enter into a joint venture sharing profit and losses in the ratio 3:2. A will purchase
goods and B will affect the sale. A purchase goods costing Rs 200,000. B sold it for Rs
300000. The venture is terminated after 3 months. A is entitled to get 10% interest on
capital invested irrespective of utilization period.. The amount of interest received by A
will be
(a) 20000 (b) 10000 (c) 15000 (d) 25000
17. A bought goods of the value of Rs 10000 and consigned them to B to be sold by them on a
joint venture, profits being divided equally. A draws a bill on B for an amount equivalent
to 80% of cost on consignment. The amount of bill will be:
(a) Rs.10000 (b) Rs.8000 (c) Rs.6000 (d) Rs.9000
18. A bought goods of the value of Rs 10000 and consigned them to B to be sold by them on a
joint venture, profits being divided equally, A paid Rs 1000 for freight and insurance. A
draws a bill on B for Rs 10000. A got it discounted at Rs 9500. B sold the goods for Rs
15000. Commission payable to B, Rs 500. Find out the profit on venture?
(a) Rs.3000 (b) Rs.3500 (c) Rs.4000 (d) Rs.3200
19. A bought goods of the value of Rs 10000 and consigned them to B to be sold by them on a
joint venture, profits being divided equally, A paid Rs 1000 for freight and insurance. A
draws a bill on B for Rs 10000. A got it discounted at Rs 9500. B sold the goods for Rs
15000. Commission payable to B, Rs 500. The amount to be remitted by B to A will be:
(a) Rs.12500 (b) Rs.13000 (c) Rs.14500 (d) Rs.13500
20. If any stock is taken over by the venturer, it will be treated as an:
(a). Income of the joint venture, hence credited to Joint Venture Account
(b). Expenses of Joint enture, hence debited to Joint Venture Account
(c). To be ignored from Joint Venture Transaction
(d). It will be treated in the personal book of the venturer and not in the books of Jt Venture.
21. Advise which of the statement is true:
(a). The Joint Venture can be formed by a single person only.

FUNDAMENTALS OF ACCOUNTING 7.57


JOINT VENTURES

(b). A legal deed should be drafted before forming Joint Venture.


(c). The profit to be shared between the venturer in agreed ratio
(d). Joint Venture follows going concern concept.
22. A and B were partners in a joint venture sharing profits and losses in the proportion of 3/
5th and 2/5th respectively. A supplies goods to the value of Rs 80000 and incurs expenses
amounting Rs 6000. B supplies goods to the value of Rs 14000 and his expenses amount to
Rs 2000. B sells goods on behalf of the joint venture and realizes Rs 150000. B entitled to a
commission of 5% on sales. B settles his account by bank draft. Find out A’s share of profit
on venture?
(a) Rs. 24300 (b) Rs. 25000 (c) Rs. 26000 (d) Rs. 20300
23. A and B were partners in a joint venture sharing profits and losses in the proportion of 3/
5th and 2/5th respectively. A supplies goods to the value of Rs 60000 and incurs expenses
amounting Rs 6000. B supplies goods to the value of Rs 16000 and his expenses amount to
Rs 3000. B sells goods on behalf of the joint venture and realizes Rs 120000. B entitled to a
commission of 5% on sales. B settles his account by bank draft. How much amount, B will
pay to A as final settlement?
(a) Rs.83400 (b) Rs.93200 (c) Rs.80000 (d) Rs.66000
24. A and V enter into a joint venture to sell a consignment of biscuits sharing profits and
losses equally. A provides biscuits from stock Rs 10000. He pays expenses amounting to Rs
1000. V incurs further expenses on carriage Rs 1000. He receives cash for sales Rs 15000.
He also takes over goods to the value of Rs 2000. What will be the amount to be remitted
by V to A?
(a) Rs.13500 (b) Rs.15000 (c) Rs.11000 (d) Rs.10000
25. A and V enter into a joint venture to sell a consignment of biscuits sharing profits and
losses equally. A provides biscuits from stock Rs 10000. He pays expenses amounting to Rs
1000. V incurs further expenses on carriage Rs 1000. He receives cash for sales Rs 15000.
He also takes over goods to the value of Rs 2000. Find out profit on venture?
(a) Rs.3000 (b) Rs.5000 (c) Rs.6000 (d) Rs.3500
26. A purchased 1000 kg of rice costing Rs 200 each. Carriage 2000, insurance 3000. 4/5th of
the boxes were sold by B at Rs 250 per boxes. Remaining stock were taken over by B at
cost. The amount of stock taken over will be:
(a) Rs. 40000 (b) Rs.41000 (c) Rs.50000 (d) Rs.50200
27. Goods costing Rs. 10,000 destroyed by an accident, insurance claim nil.
(a) Rs 10000 will be credited to Joint Venture Account.
(b) No Entry will be made in the books of Joint Venture
(c) Rs 10000 will be debited in Joint Venture Account as Loss
(d) Rs 8000 will be credited in Joint Venture Account

7.58 COMMON PROFICIENCY TEST


28. A and B were partners in a joint venture sharing profits and losses in the proportion of 3/
5th and 2/5th respectively. A supplies goods to the value of Rs 60000 and incurs expenses
amounting Rs 6000. B supplies goods to the value of Rs 14000 and his expenses amount to
Rs 1000. B sells goods on behalf of the joint venture and realizes Rs 100000. B entitled to a
commission of 5% on sales. B settles his account by bank draft. Find out the profit on
venture?
(a) Rs. 14400 (b) Rs.14000 (c) Rs.13000 (d) Rs.13200
29. A purchased goods costing 100000. B sold the goods for Rs 150000. Profit sharing ratio
between A and B equal. If same sets of books is maintained, what will be the final
remittance?
(a) B will remit Rs 125000 to A (b) B will remit Rs 150000 to A
(c) A will remit Rs 100000 to B (d) B will remit Rs 25000 to A
30. A purchased goods costing 200000, B sold 4/5th of the goods for Rs 250000. Balance goods
were taken over by B at cost less 20%. If same sets of books is maintained, find out profit
on venture?
(a) Rs. 82000 (b) Rs .90000 (c) Rs. 50000 (d) none
31. A purchased goods costing Rs 2,00,000. B sold the goods for Rs 2,80,000. Unused material
costing Rs 10,000 taken over by A at Rs 8000. A is entitled to get 1% commission on
purchase. B is entitled to get 2% commission on sales. Profit sharing ratio equal. A’s share
of profit on venture will be:
(a) Rs. 40000 (b) Rs. 40400 (c) Rs. 40600 (d) Rs. 40200
32. A and B enter into joint venture sharing profit and loss equally. A purchased 100 kg of
rice @ Rs 20/kg. Brokerage paid Rs 200, carriage paid Rs 300. B sold 90 kg of rice @ Rs 22/
kg. Balance rice were taken over by B at cost. The value of rice taken over to be recorded in
joint venture will be:
(a) Rs. 200 (b) Rs. 250 (c) Rs. 230 (d) Rs. 220
33. A and B enter into a joint venture sharing profit and losses equally. A purchased 5000 kg
of rice @ Rs 50/kg. B purchased 1000 kg of wheat @ Rs 60/kg. A sold 1000 kg of wheat @
Rs 70/kg and B sold 5000 kg of rice @Rs 60/kg. The profit on venture when same sets of
books is maintained will be:
(a) Rs. 110000 (b) Rs.100000 (c) Rs.120000 (d) Rs.60000
34. A and B enter into a joint venture sharing profits and losses equally. A purchased 5000 kg
of rice @ Rs 50/kg. B purchased 1000 kg of wheat @ Rs 60/kg. A sold 1000 kg of wheat @
Rs 70/kg and B sold 5000 kg of rice @Rs 60/kg. What will be the final remittance?
(a) B will remit Rs 210,000 to A
(b) A will remit Rs 210000 to B
(c) A will remit Rs 200000 to B
(d) B will remit Rs 180000 to A

FUNDAMENTALS OF ACCOUNTING 7.59


JOINT VENTURES

35. A and B enter into a Joint Venture by opening a joint bank account contributing Rs
10,00,000. The profit sharing ratio between A and B is 3:2. How much amount to be
contributed by A?
(a) Rs.600000 (b) Rs.400000 (c) Rs.300000 (d) Rs.500000
36. A, B and C are co-venturer. The relative Profit sharing ratio between A and B is 3:2 and
between B and C is also 3:2. Find out the PSR between A, B and C.
(a) 3:2:2 (b) 9:6:4 (c) 4:3:2 (d) 3:2:1
37. A and B entered into a joint venture. They opened a joint bank account by contributing Rs
200000 each. The expenses incurred on venture is exactly equal to Rs. 2,00,000. Once the
work is completed, contract money received by cheque Rs 4,00,000 and in shares Rs 50,000.
The shares are sold for Rs 40,000. What will be the profit on venture?
(a) Rs.2,50,000 (b) Rs.2,40,000 (c) 4,40,000 (d) 4,50,000
38. If a venturer draws a bill on his co-venturer and if the drawer discounts the bill with same
sets of books maintained, the discounting charges will be borne by:
(a) The drawer of the bill (b) The drawee of the bill
(c) The discounting charges will be recorded in memorandum account
(d) The discounting charges will be borne by bank
39. Which of the following statement is not true?
(a) Joint venture is a going concern
(b) Joint venture is terminable in nature
(c) Joint venture does not follow accrual basis of accounting
(d) The co-venturer shares the profit in agreed ratio
40. A and B were partners in a joint venture sharing profits and losses in the proportion of 4/
5th and 1/5th respectively. A supplies goods to the value of Rs 50,000 and incurs expenses
amounting to Rs 5400. B supplies goods to the value of Rs 14000 and his expense amount
to Rs 800. B sells goods on behalf of the joint venture and realizes Rs 92000. B is entitled to
a commission of 5 per cent on sales. B settles his account by bank draft. What will be the
final remittance?
(a) B will remit Rs.69160 to A
(b) A will remit Rs.69160 to B
(c) A will remit Rs.69000 to B
(d) B will remit Rs.69000 to A
41. A and B were partners in a joint venture sharing profits and losses in the proportion of 4/
5th and 1/5th respectively. A supplies goods to the value of Rs 50,000 and incurs expenses
amounting to Rs 5400. B supplies goods to the value of Rs 14000 and his expense amount
to Rs 800. B sells goods on behalf of the joint venture and realizes Rs 92000. B is entitled to

7.60 COMMON PROFICIENCY TEST


a commission of 5 per cent on sales. B settles his account by bank draft. What will be the
profit on venture?
(a) Rs.17200 (b) Rs.17000 (c) Rs.18000 (d) Rs.18200
42. In a Joint venture A contributes Rs 5000 and B contributes Rs 10000. Goods are purchased
for Rs 11200. Expenses amount to Rs 800. Sales amount to Rs 14000 the remaining goods
were taken by B at an agree price of Rs 400. A and B share profit and losses in the ratio of
1:2 respectively. As a final settlement, how much A will receive?
(a) 5800 (b) 6000 (c) 5000 (d) 10800
43. Which of the following statement is true?
(a). There is no difference between Jt Venture and Partnership
(b). Consignment and Jt Venture is same
(c). In case of Jt Venture, none of the act is applicable
(d) In case of Jt Venture, the number of related party is one only.
44. A and B enter into a venture sharing profit and losses in the ratio 2:3. Goods purchased by
A for Rs 45,000. Expenses incurred by A Rs 13500 and by B Rs 5200. B sold the goods for
Rs 85,000. Remaining stock taken over by B at Rs 7200. What will be the final remittance
to be made by B to A:
(a) Rs.69900 (b) Rs.11400 (c) Rs.17100 (d) Rs.7200
45. If separate sets of books is maintained and suppliers grant discount at the time of making
the payment for purchase of goods, such discount received will be treated as:
(a) Income of Joint Venture, hence credited to Joint Venture A/c
(b) Will be credited to Joint Bank A/c
(c) Will be credited to Co-venturer’s Capital A/c
(d) Will be ignored from the books
46. If unsold goods costing Rs 20000 is taken over by Venturer at Rs 15000, the Joint Venture
A/c will be credited by:
(a) Rs.20000 (b) Rs.15000 (c) Rs.5,000l (d) nil
47. A and B enter into a venture sharing profits and losses in the ratio 2:3. Goods purchased
by A for Rs 45,000. Expenses incurred by A, Rs 13500 and by B Rs 5200. B sold the goods
for Rs 85,000. Remaining stock taken over by B at Rs 7200. The profit on venture will be:
(a) Rs. 28500 (b) Rs. 21300 (c) Rs. 35700 (d) Rs. 9800
48. State which of the statement is true?
(a) Memorandum Jt Venture Account is prepared to find out profit on venture
(b) Memorandum Jt Venture Account is prepared to find out amount due from co-venturer
(c) Memorandum Jt Venture Account is prepared when separate sets of books is
maintained

FUNDAMENTALS OF ACCOUNTING 7.61


JOINT VENTURES

(d) In Memorandum Jt Venture Account only one venturer’s transaction is recorded


49. A and B enter into a joint venture for purchase and sale of Type-writer. A purchased
Typewriter costing Rs 100000. Repairing expenses Rs 10000, printing expenses Rs 10000.
B sold it at 20% margin on selling price. The sales value will be:
(a) Rs. 125000 (b) Rs. 150000 (c). Rs. 100000 (d) Rs. 140000
50. Which of the following statement is true?
(a) When separate set of books is maintained, expenses paid by venturer will be credited
to joint bank account.
(b) When separate set of books is maintained, expenses paid by venturer will be credited
to venturer’s capital account.
(c) When separate set of books is maintained, expenses paid by venturer will be credited
to Jt. venture account.
(d) When separate set of books is maintained, expenses paid by venturer will be credited
to Outstanding Expenses Account.
II MATCH THE FOLLOWING ITEMS FROM COLUMN A WITH COLUMN B
S. No. Column A Column B
1. The parties to joint venture is called (a) Is terminable in nature
2. Joint venture (b) Joint Bank account
3. Memorandum Joint Venture Account is
maintained in case of (c) Co-venturers
4. The Bank Account maintains in the same
set of books is called as (d) Same sets of books with own
transactions only

ANSWERS
I.
1. (a) 2. (a) 3.(d) 4. (d) 5.(b) 6. (b) 7. (a) 8. (c) 9. (b) 10. (a) 11. (a) 12.(b)
13. (b) 14. (a) 15. (c) 16. (a) 17. (b) 18. (a) 19. (b) 20. (a) 21.( c) 22. (a) 23. (a) 24. (a)
25. (b) 26.(b) 27. (b) 28 (b) 29. (a) 30. (a) 31. (d) 32. (b) 33. (d) 34. (a) 35. (a) 36. (b)
37. (b) 38. (c) 39. (a) 40. (a) 41. (a) 42. (a) 43. (c) 44. (a) 45. (a) 46. (b) 47.(a) 48. (a)
49. (b) 50. (b)
II.
1. (c), 2(a), 3(d), 4(b)]

7.62 COMMON PROFICIENCY TEST


CHAPTER - 7

PREPARATION
OF FINAL
ACCOUNTS OF
SOLE
PROPRIETORS

Unit 3

Bills of Exchange
and
Promissory Notes
BILLS OF EXCHANGE AND PROMISSORY NOTES

Learning Objectives
After studying this unit, you will be able to :
 Understand the meaning of Bills of Exchange and Promissory Notes and also try to
grasp their underlying features.
 Grasp the accounting treatments relating to issue, acceptance, discounting, maturity
and endorsement of bills and notes in the books of drawer and drawee.
 Learn the technique of accounting relating to accommodation bills.
 Learn the special treatment needed in case of insolvency as well as early retirement of
bill.

1. BILLS OF EXCHANGE
Often when goods are sold on credit, the seller would like that the purchaser should give a
definite promise in writing to pay the amount of the goods on a certain date. Commercial
practice has developed to treat these written promises into valuable instruments of credit so
much so that when a written promise is made in proper form and is properly stamped, it is
supposed that the buyer has discharged his debt and that the seller has received payment.
This is because written promises are often accepted by banks and money is advanced against
them. Otherwise also they can be passed on from person to person. The written promise is
either in the form of a Bill of Exchange or in the form of a promissory note.
A Bill of Exchange has been defined as an "instrument in writing containing an unconditional
order signed by the maker directing 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 in writing on the face of the order itself, it becomes a valid bill of exchange. Suppose
A order B to pay Rs. 500 three months after date and B accepts this order by signing his name,
then it will be a bill of exchange.
The following is a specimen of a properly drawn bill of exchange.
Rs. 1,000 Delhi
June, 2006
Three months after date pay to M/s. Mohanlal & Sons or order the sum of Rs. One thousand
for value received.
G. Nanda
To
Gulab Singh & Co.
Sardar Bazaar.
This is known as draft. This will be sent to M/s. Mohanlal & Sons or order as accepted by
them who will write across the order as under :
Accepted
Gulab Singh
Partner
After acceptance it becomes a proper bill of exchange.

7.64 COMMON PROFICIENCY TEST


The following points should be noted:
1. A Bill of Exchange must be in writing.
2. It must be dated.
3. It must contain an order to pay a certain sum of money.
4. The money must be payable to a definite person or to his order to the bearer.
5. The draft must be accepted for payment by the party whom the order is made.
The party which makes the order is known as the drawer. the party which accepts the order
is known as the acceptor and the party to whom the amount has to be paid is known as the
payee. The drawer and the payee can be the same.
A Bill of Exchange can be passed on to another person by endorsement. Endorsement on a bill
of exchange is made exactly as it is done in the case of a cheque. The primary liability on a bill
of exchange is that of the acceptor. If he does not pay, a holder can recover the amount from
any of the previous endorsers or the drawee.
The meaning of the term Payee, Drawee and Drawer can be explained with the help of following
example :
Sohan sold goods worth Rs. 1,00,000 to Mohan for which the former drew a bill to be paid
3 months after date and sent it to later for acceptance. After acceptance, this bill becomes a bill
of exchange. In the mean time, Sohan bought goods worth Rs. 1,00,000 from Ram Lal & Sons
and directed Mohan to pay the amount to Ram Lal & Sons.

Specimen of a Bill of Exchange

Payee

Rs. 1,00,000/- only Delhi,


June 25, 2006

Three months after pay to M/s. Ram Lal & Sons or order the sum of Rs. One lakh only,
for value received.

To, Stamp
Mohan
Accepted Sd/-
23, Rajasthali Apartments,
(Mohan) (Sohan)
Pitampura, Delhi-110 034.

Drawee Drawer

FUNDAMENTALS OF ACCOUNTING 7.65


BILLS OF EXCHANGE AND PROMISSORY NOTES

A foreign bill of exchange is generally drawn up in triplicate. Each copy is sent by separate
post so that at least one copy reaches the intented party. Of course payment will be made only
on one of the copies and when such payment is made the other copies become useless. A
foreign bill of exchange drawn the like the following :
Rs. 5,000 New Delhi
July, 2005
Ninety days after date of this First Bill of Exchange (Second and Thrid of the same tenure and
date being unpaid) pay to the order of M/s. Ghosh Sons, London the sum of Rs. Five thousand
only, value received.
To Wallis Sons,
M/s. Black White
Birmingham, UK.
Section 12 of the Negotiable Instruments Act provides that all instruments which are not
inland instrument are foreign. The following are examples of foreign bills.
1. A bill drawn in India on a person resident outside India and made payable outside India.
2. A bill drawn outside India on a person resident outside India.
3. A bill drawn outside India and made payable in India.
4. A bill drawn outside India and made payable outside India.

2. PROMISSORY NOTE
A promissory note is an instrument in writing, not being a bank note or currency note containing
an unconditional undertaking signed by the maker to pay a certain sum of money only to or to
the order of a certain person. Under Section 31(2) of the Reserve Bank of India Act a promissory
note cannot be made payable to bearer. 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. 500 as soon as I can” is
not an unconditional promise.
4. The promiser or maker must sign the promissory note.
5. The maker must be a certain person.
6. The payee (the person to whom the payment is promised) must also be certain.
7. The sum payable must be certain. "I promise to pay Rs. 500 plus all fine" is not certain.
8. Payment must be in legal currency of the country.
9. It should not be made payable to the bearer.
10. It should be properly stamped.

7.66 COMMON PROFICIENCY TEST


Specimen of promissory note :
Specimen of a Promissory Note

Rs. 1,00,000/- only Mohan


84, Sector-1, Noida.
June 20, 2006.

Three months after date I promise to pay Sohan or his order the sum of Rs. One lakh only,
for value received

To,
Sohan Stamp
D-14, Pitampura, Delhi-110 034. (Mohan)

Payee Maker

3. RECORD OF BILLS OF EXCHANGE AND PROMISSORY NOTES


A party which receives a Promissory Note or receives an accepted Bill of Exchange will treat
it as a new asset under the name of Bills receivable. A party which issues a Promissory Note or
accepts a Bill of Exchange will treat it as new liability under the heading of Bills Payable. We
shall first deal with the entries in the books of the party which receives promissory notes or
bills. (When we talk of bills, we include promissory notes also).
(1) On receipt of Bill :
Bills Receivable Account ...... Dr.
To Party
Example 1 : A accepts a Bill of exchange drawn on him by B. In the books of B the entry will
be :
Bills Receivable Account Dr.
To A
(2) A sends to B the acceptance of D. In this case also, the entry in the books of B will be :
Bills Receivable Account ..... Dr.
To A
Example 2 : The person who receives the bill has three options. These are :
(i) He can hold the bill till maturity. (Naturally in this case no further entry is necessary until
the date of maturity arrives).

FUNDAMENTALS OF ACCOUNTING 7.67


BILLS OF EXCHANGE AND PROMISSORY NOTES

(ii) The bill can be endorsed in favour of another party. In the case the entry will be to debit
the party which now receives the bill and to credit the Bills Receivable Account.
A ...... Dr.
To Bills Receivable Account
(iii) The Bill of Exchange can be discounted with bank. The bank will deduct a small sum of
money as discount and pay the rest of the money.
Bank Account Dr. (with the amount actually received)
Discount Account Dr. (with the amount of loss or discount)
To Bills Receivable Account
Example 3 : On the date of maturity there will be two possibilities. The first is that the bill will
be paid, that is to say, met or honoured. The entries for this will depend upon what was done
to the bill during the period of maturity. If the bill was kept, the cash will be received by the
party which originally received the bill. In his books, therefore, the entry will be :
Cash Account ... Dr.
To Bills Receivable Account
But if he has already endorsed the bill in favour of his creditor or if the bill has been discounted
with the bank he will not get the amount; it will be the creditor or the bank wich will receive
the money. Therefore, in these two cases, no entry will be made in the books of the party
which originally received the bill.
The second possibility is that the bill will be dishonoured, that is to say, the bill will not be
paid. If the bill is dishonoured, the bill becomes useless and the party from whom the bill was
received will be liable to pay the amount (as also the expenses incurred by the party).
Therefore, the following entires will be made :
1. If the bill was kept till maturity then :
Party (giving the bill) .... Dr.
To Bills Receivable Account
2. If the bill was endorsed in favour of a creditor, the entry is :
Party (giving the bill) .... Dr.
To Creditors
3. If the bill was discounted with the bank :
Party (giving the bill) .... Dr.
To Bank A/c
Thus it will be seen that in case of dishonour, the party which gave the bill has to be debited
(because he has become liable to pay the amount). The credit entry is in Bills Receivable Account
(if it was retained) or the Creditor or the bank (if it was endorsed in their favour).

7.68 COMMON PROFICIENCY TEST


4. TERM OF A BILL
The term of bill of exchange may be of any duration. Usually the term does not exceed 90 days
from the date of the bill. When a bill is drawn after sight, the term of the bill begins to run from
the date of ‘sighting’, i.e., when the bill is accepted. When a bill is drawn ‘after date’, the term
of the bill begins to run from the date of drawing the bill.

5. DUE DATE OF A BILL


The date on which the term of the bill expires is called as ‘Due Date of the bill’.

6. DAYS OF GRACE
Every instrument payable otherwise than on demand is entitled to three days of grace.

7. DATE OF MATURITY OF BILL


The date which comes after adding three days to the due date of a bill, is called the date of
maturity.

8. BILL AT SIGHT
Bill at Sight means the instruments in which no time for payment is mentioned. A cheque is
always payable on demand. A promissory note or bill of exchange is payable on demand-
(a) when no time for payment is specified, or
(b) when it is expressed to be payable on demand, or at sight or on presentment.
Notes:
(i) ‘At sight’ and presentment means on demand.
(ii) An instrument payable on demand may be presented for payment at anytime.
(iii) Days of grace is not to added to calculate maturity for such types of bill.

9. BILL AFTER DATE


Bill after date means the instrument in which time for payment is mentioned. A promissory
note or bill of exchange is a time instrument when it is expressed to be payable-
(a) after a specified period.
(b) on a specific day
(c) after sight
(d) on the happening of event which is certain to happen

FUNDAMENTALS OF ACCOUNTING 7.69


BILLS OF EXCHANGE AND PROMISSORY NOTES

Notes:
(i) The expression ‘after sight’ means-
(a) in a promissory note, after presentment for sight
(b) in a bill of exchange, after acceptance or noting for non-acceptance or protest for
non-acceptance.
(ii) A cheque cannot be a time instrument because the cheque is always payable on demand.

10.HOW TO CALCULATE DUE DATE OF A BILL


The due date of each bill is calculated as follows:

Case Due Date


(a) When the bill is made payable on a (a) That specific date will be the due date.
specific date.
(b) When the bill is made payable at a (b) That date on which the term of the bill shall
stated number of months(s) after date. expire will be the due date.
Note: The term shall expire on that day of the
month which corresponds with the day on
which the bill is dated. If the month in which
the period terminates has no corresponding
day, the period shall be deemed to expire on
the last day of such a month.
(c) When the bill is made payable at a (c) That date which comes after adding stated
stated number of days after date. number of days to the date of bill, shall be
the due date.
Note: The date of Bill is excluded.
(d) When the due date is a public holiday. (d) The preceding business day will be the due
date.
(e) When the due date is an emergency/ (e) The next following day will be the due date.
unforeseen holiday.

Note: The term of a Bill after sight commences from the date of acceptance of the bill whereas
the term of a Bill after date of drawing a bill commences from the date of drawing of bill.

11.HOW TO CALCULATE DATE OF MATURITY IN CASE OF TIME


BILLS
In case of time or tenor bills, three days (called days of grace) are added to the due date to
arrive at the date of maturity.

7.70 COMMON PROFICIENCY TEST


12. NOTING CHARGES
It is necessary that the fact of dishonour and the causes of dishonour should be established. If
the acceptor can prove that the bill was not properly presented to him for payment, he may
escape liability. Therefore, if there is dishonour, or fear of dishonour, the bill will be given to a
public official known as "Notary Public". These officials present the bill for payment and if the
money is received, they will hand over the money to the original party. But if the bill is
dishonoured they will note the fact of dishonuour, and the reasons given and give the bill
back to their client. For this service they charge a small fee. This fee is known as noting charges.
The amount of noting charges is recoverable from the party which is responsible for dishounour.
Suppose X received from Y a bill for Rs. 1,000. On Maturity the bill is dishonoured and Rs. 10
is paid as noting charges. The entry in this case will be
Rs. Rs.
Y Dr. 1,010
To Bills Receivable Account 1,000
To Bank A/c 10
Suppose X had endorsed this bill in favour of Z. In that case entry for dishonoured bill would
have been
Y Dr. 1,010
To Z 1,010
This is because Z will claim Rs. 1,010 from X and X has the right of recovering Rs. 1,010 from
Y. Similarly, if the bill has been discounted with a bank, entry will be :
Y Dr. 1,010
To Bank A/c 1,010

13. RENEWAL OF BILL


Sometimes the acceptor is unable to pay the amount and he himself moves that the should be
given extension of time. In such a case a new bill will be drawn and the old bill will be cancelled.
If this happens entries should be passed for cancellation of the old bill. This is done exactly as
already explained for dishonuour. When the new bill is received entries for the receipt of the
bill will be repeated. These have already been given above.
Illustration 1
Mohan sold goods to Gupta on 1st September, 2005 for Rs. 1,600. Gupta immediately accepted
a three months bill. One due date Gupta requested that the bill be renewed for a fresh period
of two months. Mohan agrees provided interest at 9% was paid immediately in cash. To this
Gupta was agreeable. The second bill was met on due date. Give Journal entries in the books
of Mohan.

FUNDAMENTALS OF ACCOUNTING 7.71


BILLS OF EXCHANGE AND PROMISSORY NOTES

Solution
Books of Mohan
Journal
Dr. Cr.
2005 Rs. Rs.
Sept. 1 Gupta Dr. 1,600
To Sales Account 1,600
(Sales of goods to Gupta as per Invoice No.)
Bill Receivable Account Dr. 1,600
To Gupta 1,600
(3 months acceptance received from Gupta
for the amount due from him)
Dec. 4 Gupta Dr. 1,600
To Bills Receivable Account 1,600
(Gupta's acceptance cancelled because of renewal)
Gupta Dr. 24
To interest 24
(Interest @ 9% on Rs. 1,600 due from Gupta
for 2 months because of renewal)
Bills receivable Account Dr. 1,600
Cash Account Dr. 24
To Gupta 1,624
[New acceptance for 2 months for Rs. 1,600 and
Cash (for interest) received from Gupta]
2006
Feb. 7 Cash Account Dr. 1,600
To Bills receivable Account 1,600
[Cash received against Gupta's second acceptance]
Illustration 2
On 1st July, 2005 G drew a bill for Rs. 80,000 for 3 months on H for mutual accommodation.
H accepted the bill of exchange. G had purchased goods worth Rs. 81,000 from J on the same
date. G endorsed H's acceptance to J in full settlement. On 1st September, 2005 J purchased
goods worth Rs. 90,000 from H. J endorsed the bill of exchange received from G to H and paid

7.72 COMMON PROFICIENCY TEST


Rs. 9,000 in full settlement of the amount due to H. On 1st October, 2005 H purchased goods
worth Rs. 1,00,000 from G. H paid the amount due to G by cheque. Give the necessary Journal
Entries in the books of H.
Solution
In the books of H
Journal Entries
Date Particulars Dr. Cr.
Rs. Rs.
1.7.05 G's account Dr. 80,000
To Bills payable account 80,000
(Acceptance of bill drawn by G)
1.9.05 J's account Dr. 90,000
To Sales account 90,000
(Sales made to J)
1.9.05 Bills receivable account Dr. 80,000
Bank account Dr. 9,000
Discount account Dr. 1,000
To J's account 90,000
(Acceptance received from J's endorsement of bill
received from G for Rs. 80,000 and Rs. 9,000 received
in full settlement of the amount due)
1.9.05 Bills payable account Dr. 80,000
To Bills receivable account 80,000
(Own acceptance received from J's endorsement,
cancelled)

1.10.05 Purchase account Dr. 1,00,000


To G's account 1,00,000
(Purchases made from G)

G's account Dr. 20,000


To Bank account 20,000
(Amount paid to G after adjusting Rs. 80,000 for
accommodation extended to him)

FUNDAMENTALS OF ACCOUNTING 7.73


BILLS OF EXCHANGE AND PROMISSORY NOTES

Illustration 3
On 1st January, 2006, A sells goods for Rs. 10,000 to B and draws a bill at three months for the
amount. B accepts it and returns it to A. On 1st March, 2006, B retires his acceptance under
rebate of 12% per annum. Record these transactions in the journals of A.
Solution
Journal Entries in the books of A
Date Particulars Dr. Cr.
2006 Rs. Rs.
Jan. 1 B's account Dr. 10,000
To Sales account 10,000
(Being the goods sold to B on credit)
Bills receivable account Dr. 10,000
To B's account 10,000
(Being the acceptance of bill received)
March 1 Bank account Dr. 9,900
Rebate on bills account Dr. 100
To Bills receivable account 10,000
(Being retirement of bill by B one month before
maturity, the rebate being given to him at 12% p.a.)
Illustration 4
On 1st January, 2006, A sells goods for Rs. 10,000 to B and draws a bill at three months for the
amount. B accepts it and returns it to A. On 1st March, 2006, B retires his acceptance under
rebate of 12% per annum. Record these transactions in the journals of B.
Solution
Journal Entries in the books of B
Date Particulars Debit Credit
2006 Rs. Rs.
Jan. 1 Purchases account Dr. 10,000
To A's account 10,000
(Being the goods purchased from A on credit)
A's account Dr. 10,000
To Bills payable account 10,000
(Being the acceptance of bill given to A)
March 1 Bills payable account Dr. 10,000
To Bank account 9,900
To Rebate on bills account 100
(Being the bill discharged under rebate @ 12% p.a.)
Working Note :
Calculation of rebate:
10,000 x 12/100 x 1/12 = Rs. 100

7.74 COMMON PROFICIENCY TEST


Illustration 5
A draws upon B three Bills of Exchange of Rs. 3,000, Rs. 2,000 and Rs. 1,000 respectively. A
week later his first bill was mutually cancelled, B agreeing to pay 50% of the amount in cash
immediately and for the balance plus interest Rs. 100, he accepted a fresh Bill drawn by A.
This new bill was endorsed to C who discounted the same with his bankers for Rs. 1,500. The
second bill was discounted by A at 5%. This bill on maturity was returned dishonoured (nothing
charge being Rs. 30). The third bill was retained till maturity when it was duly met.
Give the necessary journal entries recording the above transactions in the books of A.
Solution
Journal of A
Dr. Cr.
Rs. Rs.
Bill Receivable A/c Dr. 6,000
To B 6,000
(Three bills for Rs. 3,000, Rs. 2,000 and Rs. 1,000
drawn on B and duly accepted by him received)
B Dr. 1,500
To Bills Receivable A/c 3,000
(Bills received from B cancelled for renewal)
Cash Account Dr. 1,500
Bills Receivable Account Dr. 1,600
To B 3,000
To Interest Account 100
(Amount received on cancellation of the first bill,
50% along with a new bill for 50% of the amount
plus interest Rs. 100)
C Dr. 1,600
To Bills Receivable A/c 1,600
(A's acceptance endorsed in favour of C)
Bank A/c Dr. 1,900
Discount A/c Dr. 100
To Bills Receivable A/c 2,000
(Second Bill for Rs. 2,000 discounted with the
bank @ 5%)
B Dr. 2,030
To Bank A/c 2,030
(Second Bill for Rs. 2,000 discounted with the
Bank dishonoured, nothing charges Rs. 30 paid
by the Bank)
Bank A/c Dr. 1,000
To Bills Receivable A/c 1,000
(Amount received on maturity of the third bill)
Note : It is assumed that the bill for Rs. 1,600 has not yet fallen due for payment.

FUNDAMENTALS OF ACCOUNTING 7.75


BILLS OF EXCHANGE AND PROMISSORY NOTES

Illustration 6
Journalise the following transactions in K. Katrak's books.
(i) Katrak's acceptance to Basu for Rs. 2,500 discharged by a cash payment of Rs. 1,000 and
a new bill for the balance plus Rs. 50 for interest.
(ii) G. Gupta's acceptance for Rs. 4,000 which was endorsed by Katrak to M. Mehta was
dishonoured. Mehta paid Rs. 20 noting charges. Bill withdrawn against cheque.
(iii) D. Dalal retires a bill for Rs. 2,000 drawn on him by Katrak for Rs. 10 discount.
(iv) Katrak's acceptance to P. Patel for Rs. 5,000 discharged by P. Mody's acceptance to Katrak
for a similar amount.
Solution
Books of K. Katrak
Journal
Dr. Cr.
Rs. Rs.
(i) Bills Payable Account Dr. 2,500
Interest Account Dr. 50
To Cash A/c 1,000
To Bills Payable Account 1,550
(Bills Payable to Basu discharged by cash
payment of Rs. 1,000 and a new bill for
Rs. 1,550 including Rs. 50 as interest)
(ii) (a) G. Gupta Dr. 4,020
To M. Mehta 4,020
(G. Gupta's acceptance for Rs. 4,000
endorsed to M. Mehta dishonoured,
Rs. 20 paid by M. Mehta as noting charges)
(b) M. Mehta Dr. 4,020
To Bank Account 4,020
(Payment to M. Mehta on withdrawal of
bill earlier received from Mr. G. Gupta)
(iii) Bank Account Dr. 1,990
Discount Account Dr. 10
To Bills Receivable Account 2,000
(Payment received from D. Dalal against his
acceptance for Rs. 2,000. Allowed him a
discount of Rs. 10)
(iv) Bills Payable Account Dr. 5,000
To Bills Receivable Account 5,000
(Bills Receivable from M. Mody endorsed to
P. Patel in settlement of bills payable issued
to him earlier)

7.76 COMMON PROFICIENCY TEST


Illustration 7
Journalise the folllowing in the books of Don :
(i) Bob informs Don that Ray's acceptance for Rs. 3,000 has been dishonoured and noting
charges are Rs. 40. Bob accepts Rs. 1,000 cash and the balance as bill at three months at
interest of 10%.
Don accepts from Ray his acceptance at two months plus interest @ 12% p.a.
(ii) James owes Don Rs. 3,200; he sends Don's own acceptance in favour of Ralph for
Rs. 3,160; in full settlement.
(iii) Don meets his acceptance in favour of Singh for Rs. 4,500 by endorsing John's acceptance
for Rs. 4,450 in full settlement.
(iv) Ray's acceptance in favour of Don retired one month before due date, interest is taken at
the rate of 6% p.a.
Solution
Books of Don
Dr. Cr.
Rs. Rs.
(i) (a) Ray Dr. 3,040
To Bob 3,040
(Ray's acceptance endorsed to Bob
dishonoured on due date nothing charges
paid by Bob Rs. 40)
(b) Bob Dr. 3,040
Interest Dr. 51
To Cash 1,000
To Bills Payable A/c 2,091
(Amount payable to Bob Rs. 3,040 settled
by cash payment Rs. 1,000 and issue of
new bill for Rs. 2,091 including interest
Rs. 51 for three months on Rs. 2,040 @ 10% p.a.)
(ii) Bill Receivable A/c Dr. 3,100.80
To Ray 3,040.00
To Interest 60.80
(Bill received from Ray for Rs. 3,040
due against earlier acceptance dishonoured
plus Rs. 60.80 interest for two months @ 12% p.a.)
(iii) Bills payable A/c Dr. 3,160
Discount A/c Dr. 40
To James 3,200
(Cancellation of bills payable to Ralph for
Rs. 3,160 in settlement of Rs. 3,200 due from James)

FUNDAMENTALS OF ACCOUNTING 7.77


BILLS OF EXCHANGE AND PROMISSORY NOTES

(iv) Bills payable A/c Dr. 4,500


To Bills Receivable A/c 4,450
To Discount A/c 50
(Settlement of acceptance issued to
Mr. Singh by endorsement of John's
Acceptance for Rs. 4,450)
(v) Bank A/c Dr. 3085.30
Discount A/c Dr. 15.50
Total Bills Receivable A/c 3,100.80
(Amount received fro Ray in settlement
of Bills Payable, retired one month before
due date)

14. ACCOMMODATION BILLS


Bills of Exchange are usually drawn to facilitate trade transmission, that is, bills are meant to
finance actual purchase and sale of goods. But the mechanism of bill can be utilised to raise
finance also. Suppose Bhalla needs, finance for three months. In that case he may persuade
his friend Kohli to accept his draft. The bill of exchange may then be taken by Bhalla to his
bank and get it discounted there. Thus Bhalla will be able to make use of funds. When the
three months period expires Bhalla will send the requisite amount to Kohli and Kohli will
meet the bill. Thus Bhalla is able to raise money for his use. If both Bhalla and Kohli need
money, the same devise can be used. Either Bhalla accepts a bill of exchange or Kohli does. In
either case, the bill will be discounted with the bank and the proceeds divided between the
two parties according to mutual agreement. The discounting charges must also be borne by
the two parties in the same ratio in which the proceeds are divided. On the due date the
acceptor will receive from the other party his share. The bill will then be met. When bills are
used for such a purpose, they are known as accommodation bills.
Entries are passed in the books of two parties exactly in the way already pointed out for
ordinary bills. The only additional entry to be passed is for sending the remittance to the other
party and also debiting the other party with the requisite amount of discount.

15. INSOLVENCY
Insolvency of a person means that he is unable to pay his liabilities. This means that bills
accepted by him will be dishonoured. Therefore when it is known that a person has become
insolvent, entry for dishonour of his acceptance must be passed. Later something may be
received from his estate. When and if an amount is received cash account will be debited and
the personal account of the debtor will be credited. The remaining amount will be irrecoverable
and, threfore, should be written off as bad debt. The student should be careful to calculate the
amount actually received from an insolvent's estate and amount to be written off only after
preparing his account.
In the books of drawee of the bill, the amount not ultimately paid by him due to insolvency,
should be credited to deficiency account.

7.78 COMMON PROFICIENCY TEST


Illustration 8
R owed Rs. 1,000 to S. On 1st October, 2005, R accepted a bill drawn by S for the amount at
3 months. S got the bill discounted with his bank for Rs. 900 on 3rd October, 2005. Before the due
date, R approached S for renewal of the bill. S agreed on the conditions that Rs. 500 be paid
immediately together with interest on the remaining amount at 12% per annum for 3 months and
for the balance, R should accept a new bill at three months. These arrangements were carried out.
But afterwards, R became insolvent and 40% of the amount could be recovered from his estate.
Pass journal entries (with narration) in the books of S.
Solution
In the books of S
Journal
Particulars L.F. Dr. Cr.
Rs. Rs.
Bills Receivable A/c Dr. 1,000
To R 1,000
(Being a 3 month's bill drawn on R for the amount due)
Bank A/c Dr. 900
Discount A/c Dr. 100
To Bills Receivable A/c 1,000
(Being the bill discounted)
R Dr 1,000
To Bank A/c 1,000
(Being the bill cancelled up due to R's inability to pay it)
R Dr. 15
To Interest A/c 15
(Being the interest due on Rs. 500 @ 12% for 3 months)
Bank A/c Dr. 515
To R 515
(Being the receipt of a portion of the amount due on the
bill together with interest)
Bills Receivable A/c Dr. 500
To R 500
(Being the new bill drawn for the balance)
R Dr. 500
To Bills Receivable A/c 500
(Being the dishonour of the bill due to R's insolvency)
Bank A/c Dr. 200
Bad Debts A/c Dr. 300
To R 500
(Being the receipt of 40% of the amount due on the
bill from R's estate)

FUNDAMENTALS OF ACCOUNTING 7.79


BILLS OF EXCHANGE AND PROMISSORY NOTES

Illustration 9
On 1st July, 2005 G drew a bill for Rs. 80,000 for 3 months on H for mutual accommodation.
H accepted the bill of exchange. G had purchased goods worth Rs. 81,000 from J on the same
date. G endorsed H's acceptance to J in full settlement. On 1st September, 2005 J purchased
goods worth Rs. 90,000 from H. J endorsed the bill of exchange received from G to H and paid
Rs. 9,000 in full settlement of the amount due to H. On 1st October, 2005 H purchased goods
worth Rs. 1,00,000 from G. H paid the amount due to G by cheque. Give the necessary Journal
Entries in the books of H.
Solution
In the books of H
Journal Entries
Date Particulars Dr. Cr.
Rs. Rs.
1.7.05 G's account Dr. 80,000
To Bills payable account 80,000
(Acceptance of bill drawn by G)
1.9.05 J's account Dr. 90,000
To Sales account 90,000
(Sales made to J)
1.9.05 Bills receivable account Dr. 80,000
Bank account Dr. 9,000
Discount account Dr. 1,000
To J's account 90,000
(Acceptance received from J's endorsement of bill
received from G for Rs. 80,000 and Rs. 9,000
received in full settlement of the amount due)
1.9.05 Bills payable account Dr. 80,000
To Bills receivable account 80,000
(Own acceptance received from J's
endorsement, cancelled)
1.10.05 Purchase account Dr. 1,00,000
To G's account 1,00,000
(Purchases made from G)
G's account Dr. 20,000
To Bank account 20,000
(Amount paid to G after adjusting Rs. 80,000
for accommodation extended to him)

7.80 COMMON PROFICIENCY TEST


Illustration 10
For the mutual accommodation of 'X' and 'Y' on 1st April, 2006, 'X' drew a four months' bill on
'Y' for Rs. 4,000. 'Y' returned the bill after acceptance of the same date. 'X' discounts the bill
from his bankers @ 6% per annum and remit 50% of the proceed to 'Y'. On due date 'X' is
unable to send the amount due and therefore 'Y' draws a bill for Rs. 7,000, which is duly
accepted by 'X'. 'Y' discounts the bill for Rs. 6,600 and sends Rs. 1,300 to 'X'. Before the bill is
due for payment 'X' becomes insolvent. Later 25 paise in a rupee received from his estate.
Record Journal entries in the books of 'X'.
Solution
In the books of X
Journal Entries
Date Particulars Debit Credit
2006 Rs. Rs.
April 1 Bills receivable account Dr. 4,000
To Y's account 4,000
(Acceptance received from Y for mutual
accommodation)
April 1 Bank account Dr. 3,920
Discount account Dr. 80
To Bills receivable account 4,000
(Bill discounted for Rs. 3,920)
Y's account Dr. 2,000
To Cash account 1,960
To Discount account 40
(Half of proceeds remitted to Y)
Aug. 4 Y's account Dr. 7,000
To Bills payable account 7,000
(Acceptance given to Y, being unable to remit the
due amount)
Bank account Dr. 1300
Discount account Dr. 200
(2, 000 + 1, 300)
40 ×
660
To Y's account 1500
(Amount received from Y and discount amount
credited to him)
Bills payable account Dr. 7,000
To Y's account 7,000
(Acceptance to Y dishonoured because of insolvency)
Y account Dr. 3,500
To Bank account 875
To Deficiency account 2,625
(Amount paid @ 25 paise in a rupee and balance
credited to deficiency account as being unable to pay)

FUNDAMENTALS OF ACCOUNTING 7.81


BILLS OF EXCHANGE AND PROMISSORY NOTES

Illustration 11
Anil draws a bill for Rs. 9,000 on Sanjay on 5th April, 2005 for 3 months, which Sanjay
returns it to Anil after accepting the same. Anil gets it discounted with the bank for Rs. 8,820
on 8th April, 2005 and remits one-third amount to Sanjay. On the due date Anil fails to remit
the amount due to Sanjay, but he accepts a bill for Rs. 12,600 for three months, which Sanjay
discounts it for Rs. 12,330 and remits Rs. 2,220 to Anil. Before the maturity of the renewed bill
Anil becomes insolvent and only 50% was realized from his estate on 15th October, 2005.
Pass necessary Journal entries for the above transactions in the books of Anil.
Solution
In the books of Anil
Journal Entries
Date Particulars Debit Credit
Amount Amount
2005 Rs. Rs.
April 5 Bills receivable account Dr. 9,000
To Sanjay's account 9,000
(Being acceptance received from Sanjay for mutual
accommodation)
April 5 Bank account Dr. 8,820
Discount account Dr. 180
To Bills receivable account 9,000
(Being bill discounted with bank)
April 5 Sanjay's account Dr. 3,000
To Bank account 2,940
To Discount account 60
(Being one-third proceeds of the bill sent to Sanjay)
July 8 Sanjay's account Dr. 12,600
To Bills payable account 12,600
(Being Acceptance given)
July 8 Bank account Dr. 2,220
Discount account Dr. 180
To Sanjay's account 2,400
(Being proceeds of second bill received from Sanjay)
Oct.11 Bills payable account Dr. 12,600
To Sanjay's account 12,600
(Being bill dishonoured due to insolvency)
Oct.15 Sanjay's account (6,000+2,400) Dr. 8,400
To Bank account 4,200
To Deficiency account 4,200
(Being insolvent, only 50% amount paid to Sanjay)

7.82 COMMON PROFICIENCY TEST


Illustration 12
Bose and Mitra were in need of funds. On 1st May, 2005 Bose accepted Mitra's draft for
Rs. 6,000 at 3 months. After 3 days, Mitra got it discounted at 6% and remitted 1/3 of the proceeds
to Bose. On the due date Mitra was not able to sent the amount instead he accepted to Bose's bill
for Rs. 4,500 at two months. Bose got it discounted for Rs. 4,420 on 7th August, 2005. Out of this
Rs. 280 were sent to Mitra. Early in October Mitra became insolvent. His estate paid 40%.
Give Journal entries in the books of Bose.
Solution
In the books of Bose
Journal Entries
Dr. Cr.
2005 Rs. Rs.
May 1 Mitra Dr. 6,000
To Bills Payable Account 6,000
(Mitra's draft for Rs. 6,000 accepted
for mutal accommodation)
May 4 Bank Account Dr. 1,970
Discount Account Dr. 30
To Mitra 2,000
(One third of the proceeds of bill after
discount received from Mitra)
Aug. 4 Bills Receivable Account Dr. 4,500
To Mitra 4,500
(Acceptance received from Mitra to cover
the amount due from him)
Bank Account Dr. 4,420
Discount Account Dr. 80
To Bills Receivable Account 4,500
(Mitra's acceptance discounted for Rs. 4,420)
Bills Payable Account Dr. 6,000
To Bank Account 6,000
(Own acceptance due on this date met)
Mitra Dr. 357.47
To Bank Account 280.00
To Discount Account* 77.47
(Amount remitted to Mitra after
discounting the bill)
Oct. 7 Mitra Dr. 4,500
To Bank Account 4,500
(Mitra's acceptance dishonoured because of
his insolvency)
Bank Account Dr. 1742.99
Bad Debts Account Dr. 2614.48
To Mitra 4357.47
(Amount received and debts written off in
respect of amount due for Mitra)
FUNDAMENTALS OF ACCOUNTING 7.83
BILLS OF EXCHANGE AND PROMISSORY NOTES

Illustration 13
Mr. David draws two bills of exchange on 1.1.2005 for Rs. 6,000 and Rs. 10,000. The bills of
exchange for Rs. 6,000 is for two months while the bill of exchange for Rs. 10,000 is for three
months. These bills are accepted by Mr. Thomas. On 4.3.2005, Mr. Thomas requests Mr. David
to renew the first bill with interest at 18% p.a. for a period of two months. Mr. David agrees to
this proposal. On 20.3.3005, Mr. Thomas retires the acceptance for Rs. 10,000, the interest
rebate i.e. discount being Rs. 100. Before the due date of the renewed bill, Mr. Thomas becomes
insolvent and only 50 paise in a rupee could be recovered from his estate.
You are to give the journal entries in the books of Mr. David.
Solution
Journal Entries in the books of Mr. David
2005 Dr.(Rs.) Cr.(Rs.)
Jan. 1 Bills receivable (No. 1) A/c Dr. 6,000
Bills receivable (No. 2) A/c Dr. 10,000
To Mr. Thomas's A/c 16,000
(Being drawing of bills receivable No. 1 due
for maturity on 4.3.2005 and bills receivable No. 2
due for maturity on 4.4.2005)
March 4 Mr. Thomas's A/c Dr. 6,000
To Bills receivable (No.1) A/c 6,000
(Being the reversal entry for bill No.1 on
agreed renewal)
March 4 Bills receivable (No. 3) A/c Dr. 6,180
To Interest A/c 180
To Mr. Thomas's A/c 6,000
(Being the drawing of bill of exchange no. 3 due for
maturity on 7.5.2005 together with interest at 18%
p.a. in lieu of the original acceptance of Mr. Thomas)
March 20 Bank A/c Dr. 9,900
Discount A/c Dr. 100
To Bills receivable (No. 2) A/c 10,000
(Being the amount received on retirement of
bills No.2 before the due date)

7.84 COMMON PROFICIENCY TEST


May 7 Mr. Thomas's A/c Dr. 6,180
To Bills receivable (No. 3) A/c 6,180
(Being the amount due from Mr. Thomas on
dishonour of his acceptance on presentation on
the due date)
May 7 Bank A/c Dr. 3,090
To Mr. Thomas's A/c 3,090
(Being the amount received from official
assignee of Mr. Thomas at 50 paise per rupee

against dishonoured bill)


May 7 Bad debts A/c Dr. 3,090
To Mr. Thomas's A/c 3,090
(Being the balance 50% debt in Mr. Thomas's
Account arising out of dishonoured bill written
as bad)

16. BILLS FOR COLLECTION


When a person received a bill of exchange he may decide to receive the total amount by
keeping it till the date of maturity. But in order to ensure safety, he may send it to bank with
instructions that the bill should be retained till maturity and should be realised on that date.
This does not mean discounting because the bank will not credit the client until the amount is
actually realised. If the bill is sent to the bank with such instructions it is known as "Bill sent
for collection".
It is better to make a record of this also in books by passing following entry:
Bills for Collection Account Dr.
To Bills Receivable Account
When the amount is realised the entry will be
Bank Account Dr.
To Bills for Collection Account
When the amount is not honoured, the entry will be
Party (from whom the bill was received) Dr.
To Bills for collections A/c

FUNDAMENTALS OF ACCOUNTING 7.85


BILLS OF EXCHANGE AND PROMISSORY NOTES

17. RETIREMENT OF BILLS OF EXCHANGE


We have seen that renewal of a bill of exchange is made when a person does not have sufficient
funds to pay for the bill of exchange on the due date and he requires a further period of credit.
Many a time instances do arise when the acceptor has spare funds much before the maturity
date of the bill of exchange accepted by him. In such circumstances he approaches the payee
of the bill of exchange and asks him whether the payee is prepared to accept cash before the
maturity date. In such cases the acceptor gets a certain rebate or interest or discount for
premature payment. The interest becomes the income of the acceptor and expense of the
payee. It is a consideration of premature payment.
Illustration 14
On 1st January, 2006, Vilas draws a bill of exchange for Rs. 10,000 due for payment after 3
months on Eknath. Eknath accepts to this bill of exchange. On 4th March, 2006. Eknath retires
the bill of exchange at a discount of 12% p.a. You are asked to show the journal entries in the
books of Vilas.
Solution
Journal entries in the books of Eknath
Date Particulars L.F. Debit Credit
Rs. Rs.
Jan. 1 Vilas A/c Dr. 10,000
To Bills Payable A/c
(Being the bill draws by him accepted)
Mar. 4 Bills Payable A/c Dr. 10,000
To Bank A/c 9,900
To Interest A/c (Discount A/c) 100
(Being retirement of acceptance 1 month before
maturity, interest allowed at 12% p.a.)

Illustration 15
On 1st January, 2006, Vilas draws a Bill of Exchange for Rs. 10,000 due for payment after
3 months on Eknath. Eknath accepts to this bill of exchange. On 4th March, 2006. Eknath
retires the bill of exchange at a discount of 12% p.a. You are asked to show the journal entries
in the books of Eknath,.

7.86 COMMON PROFICIENCY TEST


Solution
Journal entries in the books of Vilas
Date Particulars Debit Credit
2006 Rs. Rs.
Jan. 1 Bills Receivable A/c Dr. 10,000
To Eknath A/c 10,000
(Being bill of exchange no . . . drawn on Eknath
due for payment on 4th April 2001)
Mar. 4 Bank A/c Dr. 9,900
Interest A/c (Discount) A/c Dr. 100
To Bills Receivable A/c 10,000
(Being retirement of bill of exchange no. due for
maturity on 4th April, 2001 by Eknath 1 month
before maturity, the rebate being given to him at
12% p.a.)

18. BILLS RECEIVABLE AND BILLS PAYABLE BOOKS


Bills receivable and bills payable books are journals (Day Books) to record in a chronological
order the details of bills receivable and bills payable. When large number of bill transactions
take place in an organisation, it is convenient to maintain these books. Wherein any bill
transaction takes place, the same is entered in the Day Books in the first instance. Postings to
individual debtors or creditors accounts are made from the Day Books. Also totals of bills
received or accepted are posted periodically to Bills Receivable Account and Bills Payable
Account respectively.
Bills receivable book and bills payable book are very useful for following up the status of
outstanding bills. When there are large number of bills and these bills fall due on different
dates, some of these bills may not be honoured on maturity due to some reason or the other. It
is possible from these Day Books to trace the details of the outstanding bills and to identify the
reasons for not honouring the bills. Given below are forms of Day Books for both bills receivable
and bills payable:

FUNDAMENTALS OF ACCOUNTING 7.87


BILLS OF EXCHANGE AND PROMISSORY NOTES

Bills Receivable Book (Folio No . . .)


Date of Voucher Party Acceptor Date of Due Place of Amt. LF. Mode of
receipt No. from Bill Date Payment Rs. Disposal
whom
Received

Bills Payable Book (Folio No . . .)


Date of Drawer Payee Date of Due Place of Amount L.F. Mode of
Acceptance Bill Date Payment Rs. Disposal

SELF EXAMINATION QUESTIONS


CHOOSE THE MOST APPROPRIATE ANSWER FROM THE GIVEN OPTIONS.
1. On 1.1.05 X draws a bill on Y for Rs 20,000 for 3 months due date of the bill will be :
(a) 1.4.05 (b) 3.4.05 (c) 4.4.05 (d) 4.5.05
2. On 15.8.05 X draws a bill on Y for 3 months for Rs. 20,000. 18th Nov was a sudden holiday,
due date of the bill will be:
(a) 17th Nov (b) 18th Nov (c) 19th Nov (d) 15th Nov
3. On 16.6.05 X draws a bill on Y for Rs 25,000 for 30 days. 19th July is a public
holiday, due date of the bill will be:
(a) 19th July (b) 18th July (c) 17th July (d) 16th July
4. X draws a bill on Y for Rs 30,000 on 1.1.05. X accepts the same on 4.1.05. Period of the
bill 3 months after date. What will be the due date of the bill:
(a) 4.4.05 (b) 3.4.05 (c) 7.4.05 (d) 8.4.05
5. X draws a bill on Y. X endorsed the bill to Z. The payee of the bill will be
(a) X (b) Y (c) Z (d) None
6. A bill of 12,000 was discounted by A with the banker for 11,880. At maturity, the bill
returned dishonoured, noting charges Rs 20. How much amount will the bank deduct
from A’s bank balance at the time of such dishonour?
(a) 12,000 (b) 11,880 (c) 12,020 (d) 11,900
7.88 COMMON PROFICIENCY TEST
7. X draws a bill on Y for Rs 20,000 on 1.7.05 for 3 months after sight, date of
acceptance is 6.1.05. Due date of the bill will be:
(a) 8.1.05 (b) 9.1.05 (c) 10.1.05 (d) 11.1.05
8. X sold goods to Y for Rs 1,00,000. Y paid cash Rs 30,000. X will grant 2% discount on
balance, and Y request X to draw a bill for balance, the amount of bill will be:
(a) 98,000 (b) 68,000 (c) 68,600 (d) 70,000
9. On 1.1.05 X draws a bill on Y for Rs 50,000 for 3 months. X got the bill discounted 4.1.05
at 12% rate. The amount of discount on bill will be:
(a) 1500 (b) 1600 (c) 1800 (d) 1450
10. Mr. A draws a bill on Mr. Y for Rs 30,000 on 1.1.06 for 3 months. On 4.2.06. X got the bill
discounted at 12% rate. The amount of discount will be:
(a) 900 (b) 600 (c) 300 (d) 650
11. X draws a bill on Y for Rs 20,000 for 3 months on 1.1.05. The bill is discounted with banker
at a charge of Rs 100. At maturity the bill return dishonoured. In the books of X, for
dishonour, the bank account will be credited by:
(a) 19,900 (b) 20,000 (c) 20,100 (d) 19,800
12. On 1.1.05 X draws a bill on Y for Rs 10,000. At maturity Y request X to renew the bill for
2 month at 12% p.a. interest. Amount of interest will be:
(a) 200 (b) 150 (c) 180 (d) 190
13. On 1.1.05 X draws a bill on Y for Rs 15000 for 3 months. At maturity Y request X to accept
Rs 5000 in cash and for balance to draw a fresh bill for 2 months together with 12% p.a.
interest, amount of interest will be:
(a) 200 (b) 300 (c) 240 (d) 380
14. On 1.8.05 X draw a bill on Y “for 30 days after sight”. The date of acceptance is
8.8.05. The due date of the bill will be:
(a) 8.9.05 (b) 10.9.05 (c) 11.9.05 (d) 9.9.05
15. On 1.6.05 X draw a bill on Y for Rs. 25,000. At maturity Y request X to accept Rs. 5,000 in
cash and noting charges incurred Rs. 100 and for the balance X draw a bill on Y for 2
months at 12% p.a. Interest amount will be:
(a) 410 (b) 420 (c) 440 (d) 400
16. On 1.1.05 X draw a bill on Y for Rs. 50,000. At maturity, the bill returned dishonoured as
Y become insolvent and 40 paise per rupee is recovered from his estate. The amount
recovered is:
(a) 20,000 (b) Nil (c) 30,000 (d) 40 paise

FUNDAMENTALS OF ACCOUNTING 7.89


BILLS OF EXCHANGE AND PROMISSORY NOTES

17. X draws a bill on Y for Rs 3000. X endorsed to Z. Y will pay the amount of the bill to:
(a) X (b) Z (c) To himself (d) None
18. On 1.1.05 X draw a bill on Y for 3 months for Rs 10,000. On 4.3.05 Y pay the bill to X at
12% discount, the amount of discount will be:
(a) 100 (b) 200 (c) 300 (d) 50
19. Ram draws on Aslam a bill for Rs 60,000 on 1.4.01 for 2 months. Aslam accepts the bill
and sends it to Ram who gets it discounted for Rs 58,800. Ram immediately remits Rs
19,600 to Aslam. On due date, Ram being unable to remit the amount due accepts a bill
for Rs 84,000 for 2 months which is discounted by Aslam for Rs 82,200. Aslam sends Rs
14,800 to Ram out of the same. How much discount will be borne by Ram at the time of
14,800 remittances.
(a) 1200 (b) 1800 (c) 1100 (d) 800
20. Mr Bobby sold goods worth Rs 25,000 to Mr Bonny. Bonny immediately accepted a bill on
1.11.01, payable after 2 months. Bobby discounted this bill @ 18% p.a. on 15.11.01. On the
due date Bonny failed to discharge the bill. Later on Bonny became insolvent and 50 paise
is recovered from Bonny’s estate. How much amount of bad debt will be recorded in the
books of Bobby:
(a) 12,500 (b) 9,437 (c) 11,687 (d) 13,650
21. The purpose of accommodation bill is:
(a) To finance actual purchase or sale of goods
(b) To facilitate trade transmission
(c) When both parties are in need of funds
(d) None of the above
22. M sold goods worth of Rs 50,000 to N. On 1.10.05, N immediately accepted a three month
bill. On due date N requested that the bill be renewed for a fresh period of 3 months. N
agrees to pay interest @ 18% p.a. in cash. How much interest to be paid in cash by N?
(a) 2250 (b) 1800 (c) 2000 (d) 1100
23. On 1.1.05 X draws a bill on Y for Rs 30,000. At maturity Y request X to draw a fresh bill for
2 months together with 12% pa. interest. Noting charges Rs 100. The amount of interest
will be:
(a) 600 (b) 602 (c) 500 (d) 550
24. On 18.2.05 A draw a bill on B for Rs 10,000. B accepted the bill on 21.2.05. The bill is
drawn for 30 days after sight. The due date of the bill will be:
(a) 24.3.05 (b) 22.3.05 (c) 26.3.05 (d) 21.3.05
25. X sold goods to Y for Rs 3,00,000. ½ of the amount will be received in cash and balance in
B/R. For what amount X should draw the bill on Y.
(a) 1,50,000 (b) 3,00,000 (c) 1,00,000 (d) 1,20,000

7.90 COMMON PROFICIENCY TEST


26. A draws a bill on B for Rs 50,000 for 3 months. At maturity, the bill returned dishonoured,
noting charges Rs 500. 40 paise in a rupee is recovered from B’s estate. The amount of
deficiency to be recorded on insolvency in the books of B will be:
(a) Rs.20,200 (b) Rs.30,300 (c) Rs.19,800 (d) Rs.19000
27. A sold goods to B for Rs 20,000. A will grant 5% discount to B. B requested A to draw a
bill. The amount of bills will be:
(a) 20,000 (b) 19000 (c) 19200 (d) Nil
28. Fees paid in cash to Notary Public is charged by:
(a) Drawer (b) drawee (c) Holder of bill of exchange (d) None
29. A draws a bill on B for Rs 50,000. A endorsed it to C in full settlement of Rs 50,500. Noting
charges of Rs 200 as the bill returned dishonoured. A want to pay the amount to C at 2 %
discount. The amount to be paid by A to C will be:
(a) 49,000 (b) 49,490 (c) 49,686 (d) 50,500
30. A draws a bill on B for Rs 1,00,000. A endorsed the bill to C. The bill return dishonoured.
Noting charges Rs 1000. B request A to accept the amount at 2% discount by a single
cheque. The cheque amount will be:
(a) 98,000 (b) 98,980 (c) 99,000 (d) 99,980
31. S draws 2 bills of exchange on 1.1.06 for Rs 3,000 and Rs 5,000 respectively. The bill of
exchange for Rs 3,000 is for 2 months, while the bill of exchange for Rs 5,000 is for 3
months. These bills are accepted by K. On 4.3.06 K requests S to renew the first bill with
interest at 18% p.a. for a period of 2 months. S agrees to this proposal. On 20.3.06 K retires
the acceptance for Rs 5,000 the interest rebate i.e., discount being Rs 50.
Before the due date of the renewed bill K becomes insolvent and only 60 paise in a rupee
can be recovered from his estate. How much bad debt will be recorded in the books of S:
(a) 1236 (b) 1854 (c) 3090 (d) 3000
32. The promissory note should be signed by:
(a) Drawer (b) Drawee (c) Payee (d) Promiser
33. Kuntal draws a bill on Shyam for Rs 3000. Kuntal endorsed it to Ram. Ram endorsed it to
Rahim. The payee of the bill will be:
(a) Kuntal (b) Ram (c) Shyam (d) Rahim
34. A bill is drawn on 29th Jan’ 06 for one month after date. The date of acceptance is 2nd
Feb’06. The bill is drawn on one month after date basis. The due date of the bill will be:
(a) 28th Feb (b) 1st Mar (c) 2nd Mar (d) 3rd Mar
35. Mr. Rex accepted a bill drawn by Mr. Rabin. Mr. Rabin endorsed the bill to Mr Shekar. On
the due date, the bill is dishonored as Mr Rex became insolvent. To record the dishonor of
the bill in the books of Mr. Rabin, which of the following accounts should be credited?

FUNDAMENTALS OF ACCOUNTING 7.91


BILLS OF EXCHANGE AND PROMISSORY NOTES

(a) Mr. Rex’s account (b) Bills Receivable account


(c) Mr Shekar’s account (d) Bills payable account
36. Which of the following statements is true?
(a) A bill cannot be endorsed more than two times
(b) A bill is drawn by purchaser
(c) A bill contains an unconditional promise to pay
(d) Noting charges are borne by the drawee in the event of dishonour of bill.
37. For mutual accommodation of A and B, B accepted a bill drawn on him by A for 2 months
Rs 6000. The said bill is discounted at 12% pa. and remitted 1/3rd of the proceeds to B. The
amount remitted by A to B will be:
(a) 2000 (b) 1960 (c) 1920 (d) 1900
38. Lara draws an accommodation bill on Sachin. The proceeds are to be borne between
Sachin and Lara in the ratio of 3:1. The amount of bill Rs 6000, discounting charges Rs
120. Discount borne by Sachin will be:
(a) 90 (b) 120 (c) 100 (d) None
39. A draws a bill on B for Rs 4500 for mutual accommodation in the ratio 2:1. A got it
discounted at 4230 and remitted 1/3rd of the proceeds to B. At the time of maturity, how
much amount A should remit to B such that B can pay off the bill?
(a) 3000 (b) 2880 (c) 2920 (d) 3010
40.. Suman drew a bill on Sonu for Rs 4500 for mutual accommodation in the ratio 2:1. Sonu
accepted the bill and returned to Suman. Suman discounted the bill for Rs 4230 and remitted
1/3rd proceeds to Sonu. Before the due date, not having funds to meet the bill, Sonu drew
a bill on Suman for Rs 6,300 on the same terms as to mutual accommodation. The second
bill was discounted for Rs 6120. The first bill was honored on the due date and a net
amount of Rs 1080 was remitted to Suman by Sonu. The proportionate discount charge
on both the bills is to be borne by Suman is:
(a) 180 (b) 150 (c) 300 (d) 120
41. Which of the following instrument is not a negotiable instrument:
(a) Bearer cheque (b) Promissory note (c) Bill of exchange (d) Crossed cheque
42. On 1.1.06 Vikas draws a bill of exchange for Rs 10,000 due for payment after 3 months on
Ekta. Ekta accepts to this bill of exchange. On 4.3.06, Ekta retires the bill of exchange at a
discount of 12% p.a. Which of the discount is correct for premature payment in the books
of Ekta?
(a) 120 (b) 100 (c) 140 (d) 160
43. Neelam sold goods to Dhiman for Rs 4,000 on 1.5.06. On the same day, he drew on Dhiman
a bill for the amount for 3 months, which Dhiman duly accepted. Neelam got the bill
discounted with her bank before the due date, Dhiman became insolvent. Later, her estate

7.92 COMMON PROFICIENCY TEST


could pay only 40% of the amount due. What will be the amount of deficiency in the
books of Dhiman.
(a) 3200 (b) 2200 (c) 2400 (d) 2000
44. Which of the following is not a foreign bill:
(a) A bill drawn in India, on a person resident outside India and made payable outside
India.
(b) A bill drawn outside India, on a person resident outside India
(c) A bill drawn outside India, made payable in India
(d) A bill drawn on a person resident in India made payable in India
45. Which of the following is correct for presenting bill to notary public:
(a) To pay fees to notary public
(b) For “ bill for collection”
(c) If the acceptor can prove that the bill was not properly presented to him for payment,
he can escape the liability, hence for dishonour it is produced.
(d) For drawing a fresh bill
46. A drew a bill on B for Rs 50,000 for 3 months. Proceeds are to be shared equally. A got the
bill discounted at 12% p.a. and remits required proceeds to B. The amount of such
remittance will be:
(a) 24250 (b) 25000 (c) 16167 (d) 32333
47. From the following information, find out who can draws the bill if Mr A sold goods to B:
(a) A will draw a bill on B (b) B will draw a bill on A
(c) None (d) Third party will draw a bill on A
48. When the bill are to be produced to notary public:
(a) At the time of drawing the bill (b) At the time of acceptance of the bill
(c) At the time of dishonour of the bill (d) At the time of “bill for collection”
49. Which of the following statement is false:
(a) B/R is a negotiable instrument (b) B/R must be accepted by drawee.
(c) There can be three parties in respect of bills of exchange – drawer, drawee & payee
(d) Oral bill of exchange is also valid.
50. Under which circumstances drawer and payee is same person:
(a) When drawer discounted the bill with banker
(b) When drawer endorse the bill to the third party
(c) When drawer held the bill till maturity
(d) When drawee rejects to accept the bill

FUNDAMENTALS OF ACCOUNTING 7.93


BILLS OF EXCHANGE AND PROMISSORY NOTES

51. Which of the following statement is true:


(a) Noting charge is an expense to be borne by drawer
(b) Noting charge is an expense to be borne by drawee
(c) Noting charge is an expense to be borne by payee
(d) Noting charge is an expense to be borne by bank
52. Which of the following statement is true:
(a) Creditors can draw a bill on Debtors
(b) Debtors can draw a bill on Creditors.
(c) Bank will draw a bill on customer at the time of overdraft.
(d) One can draw the bill on another under any circumstances.
53. Indian currency is a
(a) Bill of exchange (b) Promissory Note (c) Hyundi (d) Cheque
54. Gouri sold goods to Gupta on 1.6.06 for Rs 1600. Gupta immediately accepted a three
months bill. On due date Gupta requested that the bill be renewed for a fresh period of
two months. Gouri agrees provided interest at 9% was paid immediately in cash. What
will be the amount of interest in the books of Gouri?
(a) 20 (b) 25 (c) 24 (d) 28
55. X draws a bill on Y on 1.1.05 for Rs 20,000 for 30 days. What will be the maturity date
of the bill:
(e) 2.2.05 (f) 3.2.05 (g) 1.2.05 (h) 31.1.05
56. Ram’s acceptance to Din for Rs 8,000 renewed at 3 months on the condition that Rs 4,000
be paid in cash immediately and the remaining amount will carry interest @ 12% p.a. The
amount of interest will be:
(a) 120 (b) 80 (c) 90 (d) 160
57. A draws a bill on B for Rs 30,000. A wants to endorse it to C in settlement of Rs 35,000 at
2% discount with the help of B’s acceptance and balance in cash. How much cash A will
pay to B?
(a) 4300 (b) 4000 (c) 4100 (d) 5000
58. Ram gets Ghosh’s acceptance for Rs 12,000 discounted at 2 months at 12% p.a. The amount
of discount will be:
(a) 240 (b) 120 (c) 360 (d) Nil
59. If the due date is a public holiday, what will be the due date of the bill:
(a) Following day (b) Preceding day
(c) The same day only (d) One month later

7.94 COMMON PROFICIENCY TEST


II MATCH THE FOLLOWING ITEMS FROM COLUMN A WITH COLUMN B
S. No. Column A Column B
1. Noting charges (a) is an instrument of negotiable
instrument
2. The bills of exchange (b) following day
3. The fees charged by notary public is known as (c) is an expenses of drawee
4. If due date is a sudden holiday, what will be (d) Noting charges
the due date of the bill:

ANSWERS
I.
1. (c) 2. (c) 3. (b) 4. (a) 5. (c) 6. (c)
7. (b) 8. (c) 9. (a) 10. (b) 11. (b) 12. (a)
13. (a) 14. (b) 15. (d) 16. (a) 17. (b) 18. (a)
19. (a) 20. (a) 21. (c) 22. (a) 23. (b) 24. (c)
25. (a) 26. (b) 27. (b) 28. (c) 29. (c) 30. (b)
31. (a) 32. (d) 33. (d) 34. (d) 35. (c) 36. (d)
37. (b) 38. (a) 39. (a) 40. (c) 41. (d) 42. (b)
43. (c) 44. (d) 45. (c) 46. (a) 47. (a) 48. (c)
49. (d) 50. (c) 51. (b) 52. (a) 53. (b) 54. (c)
55. (b) 56. (a) 57. (a) 58. (a) 59. (b)

II. [Ans. : 1.(c); 2(a), 3(d), 4(b)]

FUNDAMENTALS OF ACCOUNTING 7.95


CHAPTER - 7

PREPARATION
OF FINAL
ACCOUNTS OF
SOLE
PROPRIETORS

Unit 4

Sale of Goods
on Approval
or
Return Basis
Learning Objectives
After studying this unit, you will be able to :
 Understand the nature of goods sent on approval or return basis.
 Learn the accounting treatment of sales on approval or return basis under different
situations.

1. INTRODUCTION
With a view of pushing up the sales or for introducing a new product in the market, goods are
sometimes sent to the customers on sale or approval basis. Here, goods sent on 'approval' or
'on sale or return' basis mean the delivery of the goods to the customers with the option to
retain or return them within a specified period. Generally, these transactions take place between
a manufacturer (or a wholesaler) and a retailer. The goods are transferred from the wholesaler
to the retailer, under a sale or return basis, it implies a change in the possession of goods only
and not a transfer of the ownership of goods. The ownership is passed only when the retailer
gives his approval or if the goods are not returned within that specified period. The retailer
(customer) does not incur any liability when the goods are merely sent to him.
As per the definition given under the Sale of Goods Act, 1893, in respect of such goods, the
sale will take place or the property in the goods pass to the buyer:

(i) When he signifies his approval or acceptance to the seller;

(ii) When he does some act adopting the transaction;

(iii) If he does not signify his approval or acceptance to the seller but retains the goods without
giving notice of rejection, on the expiry of the specified time (if a time has been fixed) or
on the expiry of a reasonable time (if no time has been fixed).

2. ACCOUNTING RECORDS
Accounting entries depend on the fact whether the business sends goods on sale or approval
basis (i) casually; (ii) frequently; and (iii) numerously.
An overview of the accounting treatment for the goods sent on sale or approval basis can be
depicted with the help of the chart given below :

FUNDAMENTALS OF ACCOUNTING 7.97


SALE OF GOODS ON APPROVAL OR RETURN BASIS

Sale of Goods on Approval or Return Basis

Accounting treatment when the business sends goods

Casually Frequently Numerously

Transaction is Sales or Return


treated as Journal is prepared
Ordinary Sale with four main columns Sales or Return Sales or
Day Book Return Ledger

Treated as
Memorandum Books

Goods sent on Goods Goods


Balance
Approval Returned Approved

2.1 WHEN THE BUSINESS SENDS GOODS CASUALLY ON SALES OR RETURN


When the transactions are few, the seller on sending the goods, treats them as an ordinary
sale. If the goods are accepted or not returned or the business receives no intimation within
the specified time limit, no extra entry is required to be passed because the transaction for sale
or return becomes entry after the expiry of the specified period. If the goods are returned
within a specified time limit, a reverse entry is passed to cancel the previous transaction. If, at
the year-end, goods are still lying with the customers and the specified time limit is yet to
expire, the entry for sales made earlier is cancelled and the value of the goods lying with the
customers must be reduced from the selling price to the cost price, and treated as an ordinary
stock for Balance Sheet purposes.
Journal Entries:
1. When goods are sent on approval or on sale or return basis
Sundry Debtors Account Dr. [Invoice price]
To Sales Account
2. When goods are rejected or returned within the specified time
Sales/Return Inwards Account Dr. [Invoice price]
To Customers/Sundry Debtors Account

7.98 COMMON PROFICIENCY TEST


3 When goods are accepted at invoice price
[No entry]
4 When goods are accepted at a higher price than invoice price
Sundry Debtors Account Dr.
To Sales Account [Difference in price]
5 When goods are accepted at a lower price than the invoice price
Sales Account Dr.
To Sundry Debtors Account [Difference in price]
6 (i) At the year-end, when goods are lying with customers and the specified time limit is
yet to expire
Sales Account Dr. [Invoice price]
To Sundry Debtors Account
(ii) These goods should be considered as stock with customers and in addition to the
above, the following adjustment entry is to be passed
Stock with Customers on Sale or Return Account Dr.
To Trading Account [Cost price or market price whichever is less]

No entry is to be passed for goods returned by the customers on a subsequent date.

Illustration 1
CE sends goods to his customers on Sale or Return. The following transactions took place
during 2006:
2006
Sept. 15 Sent goods to customers on sale or return basis at cost plus 33 1/3
% Rs.1,00,000

Oct. 20 Goods returned by customers 40,000

Nov. 25 Received letters of approval from customers 40,000

Dec .31 Goods with customers awaiting approval 20,000

CE records sale or return transactions as ordinary sales. You are required to pass the necessary
Journal Entries in the books of CE assuming that accounting year closes on 31st December,
2006.

FUNDAMENTALS OF ACCOUNTING 7.99


SALE OF GOODS ON APPROVAL OR RETURN BASIS

Solution
In the books of Capital Electronics
Journal

Date Particulars L.F. Dr. (in Rs.) Cr. (in Rs.)


2006
Sept. 15 Sunday Debtors A/c Dr. 1,00,000
To Sales A/c 1,00,000
(Being the goods sent to customers on sale
or return basis )
Oct. 20 Return Inward A/c (Note 1) Dr. 40,000
To Sundry Debtors A/c 40,000
(Being the goods returned by customers to
whom goods were sent on sale or return
basis)
Dec. 31 Sales A/c Dr. 20,000
To Sundry Debtors A/c (Note 3) 20,000
(Being the cancellation of original entry of
sale in respect of goods on sale or
return basis)
Dec. 31 Stock with Customers on Sale or Return A/c Dr. 15,000
To Trading A/c (Note 3) 15,000
(Being the adjustment for cost of goods lying
with customers awaiting approval)

Note: (1) Alternatively, Sales account can be debited in place of Return Inwards account.
(2) No entry is required for receiving letter of approval from customer.
Rs.20, 000 × 100
(3) Cost of goods with customers = = Rs.15, 000
133.33
Illustration 2
S. Ltd. sends out its goods to dealers on Sale or Return. All such transactions are, however,
treated as actual sales and are passed through the Day Book. Just before the end of the
accounting year on 31.12.2005, 200 such goods have been sent to a dealer at Rs. 250 each (cost
Rs. 200 each) on sale or return and debited to his account. Of these goods, on 31.12.2005, 50
were returned and 70 were sold, for the other goods date of return has not yet expired.
Pass necessary adjustment entries on 31.12.2005.

7.100 COMMON PROFICIENCY TEST


Solution
In the books of S. Ltd.
Journal
Dr. Cr.
Date Particulars L.F. Rs. Rs.
2005
Dec. 31 Return Inwards A/c (Rs. 250 X 50) Dr. 12,500
To Sundry Debtors A/c 12,500
(Being the adjustment for 50 units of goods
returned by customers to whom goods were
sent on sale or return basis)
Dec. 31 Sales A/c (Rs. 250 X 80) Dr. 20,000
To Sundry Debtors A/c 20,000
(Being the cancellation of original entry for
sale in respect of 80 units of goods not yet
returned or approved by customers)
Dec. 31 Stock with Customers on Sale or Return A/c Dr. 16,000
To Trading A/c 16,000
(Being the cost of goods sent to customers
on sale or return basis not yet approved,
adjusted)

Illustration 3
Caly Company sends out its gas containers to dealers on Sale or Return. All such transactions
are, however, treated as actual sales and are passed through the Day Book. Just before the end
of the financial year, 100 gas containers, which cost them Rs. 900 each have been sent to the
dealer on 'sale or return' and have been debited to his account at Rs. 1,200 each. Out of this
only 20 gas containers are sold at Rs. 1,500 each.
You are required to pass necessary adjustment entries for the purpose of Profit and Loss Account
and Balance Sheet.

FUNDAMENTALS OF ACCOUNTING 7.101


SALE OF GOODS ON APPROVAL OR RETURN BASIS

Solution
In the books of Caly Company
Journal
Dr. Cr.
Date Particulars L.F. Rs. Rs.
Sundry Debtors A/c Dr. 6,000
To Sales A/c 6,000
(Being the adjustment for excess price of 20 gas
containers @ 300 each)
Sales A/c Dr. 96,000
To Sundry Debtors A/c 96,000
(Being the cancellation of original entry for
sale in respect of 80 gas containers
@ Rs. 1200 each)
Stock with Customers on Sale or Return A/c Dr. 72,000
To Trading A/c 72,000
(Being the adjustment for cost of 80 gas
container lying with customers awaiting
approval)

Illustration 4
E Ltd. sends out its accounting machines costing Rs. 200 each to their customers on Sales or
Return. All such transactions are, however, treated like actual sales and are passed through
the Day Book. Just before the end of the financial year, i.e., on December 24, 2005, 300 such
accounting machines were sent out at an invoice price of Rs. 280 each, out of which only 90
accounting machines are accepted by the customers Rs. 250 each and as to the rest no report
is forthcoming. Show the Journal Entries in the books of the company for the purpose of
preparing Final Accounts for the year ended December 31, 2005.

7.102 COMMON PROFICIENCY TEST


Solution
In the books of E Ltd.
Journal
Dr. Cr.
Date Particulars L.F. Rs. Rs.
2005
Dec. 31 Sales A/cs (30x90) Dr. 2,700
To Sundry Debtors A/c 2,700
(Being the adj. for reduction in the selling price
of 90 accounting machines @ Rs. 30 each)
Dec. 31 Sales A/c (Rs. 280 x 210) Dr. 58,800
To Sundry Debtor A/c 58,800
(Being the cancellation of original entry for sale
in respect of 210 accounting machines sent
to customers not yet returned or approved)
Stock with customers on Sale or Return A/c Dr. 42,000
To Trading A/c 42,000
(Being the cost of 210 accounting machines
@ Rs. 200 each adjusted against Trading
Account)

Illustration 5
A sends out goods on approval to few customers and includes the same in the Sales Account.
On 31.3.2006 the Sundry Debtor balance stood at Rs. 1,00,000 which included Rs. 7,000 goods
sent on approval against which no intimation was received during the year. These goods
were sent out at 25% over and above cost price and were sent to-
Mr. X - Rs. 4,000 and Mr. Y -Rs. 3,000.
Mr. X sent intimation of acceptance on 30th April and Mr. Y returned the goods on 10th
April, 2006.
Make the adjustment entries and show how these items will appear in the Balance Sheet on
31st March, 2006. Show also the entries to be made during April, 2006. Value of closing stock
as on 31st March, 2006 was Rs. 60,000.

FUNDAMENTALS OF ACCOUNTING 7.103


SALE OF GOODS ON APPROVAL OR RETURN BASIS

Solution
In the Books of A
Journal
Dr. Cr.
Date Particulars L.F. Rs. Rs.
2006 Sales A/c Dr. 7,000
March To Sundry Debtors A/c (Note 1) 7,000
31 (Being the cancellation of original entry for
sale in respect of goods lying with customers
awaiting approval)
March Stock with Customers on Sale or Return A/c Dr 5,600
31 To Trading A/c (Note 1) 5,600
(Being the adjustment for cost of goods lying
with customers awaiting approval)
April 30 Sundry Debtors A/c Dr. 4,000
To Sales A/C 4,000
(Being goods costing Rs. 3,200 sent to Mr. X on
sale or return basis has been accepted by him)

Balance Sheet of A & Co. as on 31st March, 2006 (Extracts)


Liabilities Rs. Assets Rs. Rs.
Sundry debtors (Rs. 1,00,000 - Rs. 7,000) 93,000
Stock-in-trade 60,000
Add: Stock with customers on Sale or Return 5,600 65,600
1,58,600

Notes:
(1) Cost of goods lying with customers = 100/125 x Rs. 7,000 = Rs. 5,600
(2) No entry is required on 10th April, 2006 for goods returned by Mr. T. Goods should be
included physically in the stock-in-trade.
2.2 WHEN THE BUSINESS SENDS GOODS FREQUENTLY ON SALE OR RETURN BASIS
When goods are sent out on sale, on approval or return basis, an immediate sale obviously
does not take place. Only when the customer signifies his intention to purchase the goods or
takes some action whereby it is indicated that he has decided to purchase the goods, the
property in the goods passes to the buyer. So long as the property does not pass to the buyer,
the seller should not record it as a sale and, therefore, should not debit the customer with the
sales price.

7.104 COMMON PROFICIENCY TEST


Where a large number of articles are sent out on a sale or return basis, it is necessary to
maintain a specially ruled Sale or Return Journal / Day Book: This Day Book is divided into 4
main columns - (1) Goods sent on Approval; (2) Goods Returned: (3) Goods Approved; and
(4) Balance.
Goods sent on approval Goods returned Goods approved Balance

1 2 3 4 5 6 7 8 9 10 11 12 13

Date Particulars Fol. Amt. Date Particulars Fol. Amt. Date Particulars Fol. Amt. Amt.

When such a Journal is kept the following procedure is adopted for recording transactions
entered into on this basis.
When goods are sent out for sale on approval, entries are made only in column 1 to 4, the sale
price of goods being entered in column 4. The sale price is also posted to the debit of the
customers' account in 'Goods on Approval Ledger', and periodically total of column 4 is posted
to the credit of Goods on Approval Total Account in the same ledger.
If goods are returned, entries are made in columns 5 to 8, the price of goods returned being
entered to column 8. The individual amounts are credited to the Customers' Accounts, in the
'Goods on Approval' Ledger and the total of this column in periodically posted to the Total
Goods on Approval Account.
If the goods are retained by the customer, entries are made in columns 9 to 12. The individual
amounts are then posted to the debit of customer's accounts in the Sales Ledger and their total
is credited to Sales Account in the General Ledger. Further the customer's accounts in the
Goods on Approval Ledger are credited with the individual amounts of goods sold and
periodically, the total of the amount is posted to the debit of Goods on Approval Total Account.
The value of goods sent out but not sold or returned till the close of the year is extended to
column 13. The total of this column, afterwards, will show the value of goods with customers
at the sale price.
The balance amount is calculated as follows:
Balance Value of Goods Sent on Sale or Return Less Value of Goods Returned Less Value of
Goods Approved.
Information relating to goods delivered and goods returned is kept on Memorandum basis.
However, information relating to goods approved and balance is duly accounted for by passing
journal entries relating to sales and stock on approval basis.
(i) At the time of approval
Customer's A/c Dr.
To Sales A/c

FUNDAMENTALS OF ACCOUNTING 7.105


SALE OF GOODS ON APPROVAL OR RETURN BASIS

The amount, after eliminating the element of profit, is included in the Trading Account
representing the value of stock with customers at cost price. Like an ordinary closing stock,
such goods are considered as stock lying with customers on behalf of seller and are valued at
cost or net realisable value whichever is less.
(ii) At the time of preparing of Final Accounts
An adjustment entry is required for balance goods which is as follow:
Goods with Customers on Sale or Return Account Dr. [Cost or net realisable value
To Trading Account whichever is less]

2.3 WHEN THE BUSINESS SENDS GOODS NUMEROUSLY ON SALE OR RETURN


When transactions are numerous, a business maintains the following books: (a) Sale or Return
Day Book; and (b) Sale or Return Ledger. Ledger contains the accounts of the customers and
the 'Sale or Return' Total account. It is important to remember is that both are Memorandum
Books.
In this case, when the goods are sent to the customers on a sale or return basis, they are
recorded in the Sale or Return day Book. Thereafter, in the Sale or Return Ledger, all the
customers are individually debited and the Sale or Return Account is credited with the
periodical total of the Sale or Return Day Book.
When the goods are returned by the customers within the specified time, they are recorded
initially in the Sale or Return Day Book. Thereafter, in the Sale or Return Ledger, the Sale or
Return Account is debited with the periodical total of the Sale or Return Day Book and the
individual customers are credited. The above mentioned records are all memorandum and
hence cannot find a place in the regular books.
When the business receives information about the acceptance of the goods or no intimation is
received within the specified time, they are recognised as sales and are recorded in the Sales
Day Book. Periodically, the total of the Sales Day Book is credit to Sales Account and debited
to the Individual Customers Account. To cancel the earlier entries, individual customers are
credited and the Sale or Return Account is debited. The entries for the approved goods are
shown below:

In the Memorandum Sale or Return Ledger In the regular General ledger


Sale or Return Account Dr. Individual Customer's Account Dr.
To Individual Customer's Account To Sales Account
At the year end, in the Sale or return Ledger, the sum of the debit balances of the Individual
Customers' Account must be equal to the credit balance of the Sale or return Account. It
represents stock with customers waiting for approval at invoice price. To adjust the cost of
such goods with customers in the Final Accounts, the following entry is passed:

7.106 COMMON PROFICIENCY TEST


Stock with Customers on Sale or Return Account Dr. [Cost or net realisable value,
To Trading Account whichever is less]
Illustration 6
A firm sends goods on sale or return basis. Customers having the choice of returning the
goods within a month. During May 2006, the following are the details of goods sent:

Date (May) 2 8 12 18 20 27
Customers P B Q D E R
Value (Rs.) 15,000 20,000 28,000 3,000 1,000 26,000

Within the stipulated time, P and Q returned the goods and B, D, and E signified that they
have accepted the goods.
Show in the books of the firm, the Sale or Return Account and Customer- P for Sale or Return
Account on 15th June, 2006.
Solution
Sale or Return
Dr. Cr.
Date Particulars Rs. Date Particulars Rs.
2006 2006
May 31 To Sundries: Sales 24,000 May 31 By Sundries
June 15 To Sundries: Returned 43,000 (Good sent on sale or
return basis) 93,000
June 15 To Balance c/d 26,000
93,000 93,000
By Balance b/d 26,000

P's Account
Dr. Cr.
Date Particulars Rs. Date Particulars Rs.
2006 2006
May 2 To Sale or Return A/c 15,000 May ? By Sale or Return A/c 15,000

FUNDAMENTALS OF ACCOUNTING 7.107


SALE OF GOODS ON APPROVAL OR RETURN BASIS

Illustration 7
On 31st December, 2005 goods sold at a sale price of Rs. 3,000 were lying with customer, Ritu
to whom these goods were sold on 'sale or return basis' and recorded as actual sales. Since no
consent has been received from Ritu, you are required to pass adjustment entries presuming
goods were sent on approval at a profit of cost plus 20%. Present market price is 10% less than
the cost price.
Solution
Journal entries

Date Particulars Dr. Cr.


Rs. Rs.
2005
31st Dec. Sales A/c Dr. 3,000
To Ritu's A/c 3,000
(Being cancellation of entry for sale of
goods, not yet approved)
Stock with customers* A/c Dr. 2,250
To Trading A/c 2,250
(Being stock with customers recorded at
market price)
Working Note:
Calculation of cost and market price of stock with customer
Sale price of goods sent on approval Rs.3,000
Less: Profit (3,000 x 20/120) 500
Cost of goods Rs.2,500
Market price = 2,500 - (2,500 x 10%) = Rs. 2,250.

SELF EXAMINATION QUESTIONS


1. When a large number of articles are sent on a sale or return basis, it is necessary to maintain
(a) Sale journal (b) Goods returned journal
(c) Sale or return journal (d) None of the above.
2. On 31st December, 2005 goods sold at a sale price of Rs. 30,000 were lying with customer,
Mohan to whom these goods were sold on 'sale or return basis' and recorded as actual
sales. Since no consent was received from Mohan, the adjustment entry was made
presuming goods were sent on approval at a profit of cost plus 20%. In the balance sheet,
the stock with customers account will be shown at Rs.
(a) 30,000. (b) 24,000. (c) 20,000. (d) 25,000.

7.108 COMMON PROFICIENCY TEST


3. A sent some goods costing Rs. 3,500 at a profit of 25% on sale to B on sale or return basis.
B returned goods costing Rs. 800. At the end of the accounting period i.e. on 31st December,
2005, the remaining goods were neither returned nor were approved by him. The stock
on approval will be shown in the balance sheet at Rs.
(a) 2,000. (b) 2,700. (c) 2,700 less 25% of 2,700. (d) 3,500.
4. A merchant sends out his goods casually to his dealers on approval basis. All such
transactions are, however, recorded as actual sales and are passed through the sales
book. On 31-12-2005, it was found that 100 articles at a sale price of 200 each sent on
approval basis were recorded as actual sales at that price. The sale price was made at cost
plus 25%. The amount of stock on approval will be amounting
(a) Rs.16,000. (b) Rs. 20,000. (c) Rs. 15,000. (d) None of the above.
5. Umesh sends goods on approval basis as follows:
Date Customer's Name Sale price of Goods Accepted Goods
January, 2006 Goods Sent Rs. Returned
Rs. Rs.
8 Anna 3,500 3,000 500
10 Babu 2,800 2,800 –
15 Chandra 3,680 – 3,680
22 Desai 1,260 1,000 260
The stock of goods sent on approval basis on 31st January will be
(a) Rs. 500. (b) Nil. (c) Rs. 260. (d) None of the above.
6. A company sends its cars to dealers on 'sale or return' basis. All such transactions are
however treated like actual sales and are passed through the sales day book. Just before
the end of the financial year, two cars which had cost Rs. 55,000 each have been sent on
'sale or return' and have been debited to customers at Rs. 75,000 each, cost of goods lying
with the customers will be
(a) Rs. 1,10,000. (b) Rs. 55,000. (c) Rs. 75,000. (d) None of the above.
7. A trader has credited certain items of sales on approval aggregating Rs. 60,000 to Sales
Account. Of these, goods of the value of Rs. 16,000 have been returned and taken into
stock at cost Rs. 8,000 though the record of return was omitted in the accounts. In respect
of another parcel of Rs. 12,000 (cost being Rs. 6,000) the period of approval did not expire
on the closing date. Cost of goods lying with customers should be
(a) Rs. 12,000. (b) Rs. 54,000. (c) Rs. 6,000. (d) None of the above.
8. Under sales on return or approval basis, the ownership of goods is passed only
(a) when the retailer gives his approval
(b) if the goods are not returned within specified period.
(c) Both (a) and (b) (d) None of the above
9. Under sales on return or approval basis, when transactions are few, the seller, while
sending the goods, treats them as

FUNDAMENTALS OF ACCOUNTING 7.109


SALE OF GOODS ON APPROVAL OR RETURN BASIS

(a) an ordinary sale but no entry is passed in the books


(b) an ordinary sale and entry for normal sale is passed in the books
(c) Approval sale and no entry is passed
(d) None of the above
10. Under sales on return or approval basis, when transactions are few and the seller at the
end of the accounting year reverse the sale entry, then what will be the accounting treatment
for the goods returned by the customers on a subsequent date?
(a) No entry will be passed for such return of goods
(b) Entry for return of goods is passed by the seller
(c) Only the stock account will be adjusted
(d) None of the above
11. Which of the following is not a main column of sales or return journal?
(a) goods sent on approval column (b) goods returned column
(c) goods approved column (d) purchase column
12. Sale or Return Day Book and Sale or Return Ledger are known as
(a) principal books (b) subsidiary books
(c) memorandum books (d) none of the above
13. In the Sale or Return Ledger
(a) all the customers are individually debited and the sale or return account is credited
with the periodical total of the Sale or Return Day Book.
(b) all the customers are debited in total and the sale or return account is credited with
the periodical total of the Sale or Return Day Book.
(c) all the customers are individually debited and the sale or return account is also credited
with the individual total of the Sale or Return Day Book.
(d) None of the above.
14. When the goods are returned by the customers within the specified time, they are recorded
(a) initially in the Sale or Return Ledger. Thereafter, in the Sale or Return Day Book
(b) initially in the Sale or Return Day Book. Thereafter, in the Sale or Return Ledger
(c) only in the Sale or Return Day Book
(d) only in the Sale or Return Ledger

ANSWERS
1. (c) 2. (d) 3. (b) 4. (a) 5. (b)
6. (a) 7. (c) 8. (c) 9. (b) 10. (a)
11. (d) 12. (c) 13. (a) 14. (b)

7.110 COMMON PROFICIENCY TEST


CHAPTER - 8

PARTNERSHIP
ACCOUNTS

Unit 1

Introduction to
Partnership
Accounts
INTRODUCTON TO PARTNERSHIP ACCOUNTS

Learning objectives
After studying this unit, you will be able to :
 Understand the features of a partnership firm and the need for a Partnership Deed.
 Understand the points to be covered in a Partnership Deed regarding accounts.
 Learn the technique of maintaining Profit and Loss Appropriation Account.
 Familiaralize with the two methods of maintaining Partners’ Capital Accounts, namely
Fixed Capital Method and Fluctuating Capital Method.
 Note that Capital Account balance as per Fluctuating Capital method is just equal to the
sum of the balances of Capital Account and Current Account as per Fixed Capital Method.
 Learn how to arrive at the corrected net profit figure which is to be taken to be Profit and
Loss Appropriation Account after rectification of errors. Rectification of errors may be
necessary to arrive at the net profit of the partnership and preparing Profit and loss
Appropriation Account.
 Learn that interest on capital and drawings, salaries/commissions are to be shown in
the Profit and Loss Appropriation Account and not in the Profit and Loss Account. Also
learn that drawings by partners will not appear in the Appropriation Account.

1. INTRODUCTION
An individual i.e., a sole proprietor may not be in a position to cope with the financial and
managerial demands of the present day business world. As a result, two or more individuals
may decide to pool their financial and non-financial resources to carry on a business. The
preparation of final accounts of sole proprietors have already been discussed in chapter 6. The
final accounts of partnership firms including basic concepts of accounting for admission of a
partner, retirement and death of a partner have been discussed in succeeding units of this
chapter.

2. DEFINITION AND FEATURES OF PARTNERSHIP


The Indian Partnership Act defines partnership as “the relationship between persons who
have agreed to share the profit of a business carried on by all or any of them acting for all.” The
essential features of partnership therefore, are :
1. An association of two or more persons;
2. An agreement entered into by all persons concerned;
3. Existence of a business;
4. The carrying on of such business by all or any one of them acting for all; and
5. Sharing of profits of the business (including losses).
The persons who enter into such an agreement are called partners and the business is called a
firm.

8.2 COMMON PROFICIENCY TEST


From the accounting point of view, the main thing is that relations among the partners will be
governed by mutual agreement. The agreement is known as Partnership Deed which is to be
properly stamped. It should be comprehensive to avoid disputes later on. It is usual therefore,
to find the following clauses in a Partnership Deed which may or may not be registered.
1. Name of the firm and the partners;
2. Commencement and duration of business;
3. Amount of capital to be contributed by each partner;
4. Amount to be allowed to each partner as drawings and the timings of such drawings;
5. Rate of interest to be allowed to each partner on his capital and on his loan to the firm,
and to be charged on his drawings;
6. The ratio in which profits or losses are to be shared;
7. Whether a partner will be allowed to draw any salary;
8. Any variations in the mutual rights and duties of partners;
9. Method of valuing goodwill on the occassions of changes in the constitution of the firm ;
10. Procedure by which a partner may retire and the method of payment of his dues;
11. Basis of the determination of the executors of a deceased partner and the method of payment;
12. Treatment of losses arising out of the insolvency of a partner;
13. Procedure to be allowed for settlement of disputes among partners;
14. Preparation of accounts and their audit.
Registration of the firm is not compulsory, but non-registration restricts the partners or the
firm from taking any legal action.
Often there is no written Partnership Deed or, if there is one, it may be silent on a particular
point. In that case the relevant sections of the Partnership Act will apply. If on any point the
Partnership Deed contains a clause, it will hold good; otherwise the provisions of the Act
relating to the questions will apply.

3. POWERS OF PARTNERS
The Partners are supposed to have the power to act in certain matters and not to have such
powers in others. In other words, unless a public notice has been given to the contrary, certain
contracts entered into by a partner on behalf of the partnership, even without consulting other
partners are binding and the provisions of the Act relating to the question will apply. In case of
a trading firm, the implied powers of a partners are the following.
(a) Buying and selling of goods :
(b) Receiving payments on behalf of the firm and giving valid recepit;
(c) Drawing cheques and drawing, accepting and endorsing bills of exchange and promissory
notes in the name of the firm;
(d) Borrowing money on behalf of the firm with or without pledging the stock-in-trade;
(e) Engaging servants for the business of the firm.

FUNDAMENTALS OF ACCOUNTING 8.3


INTRODUCTON TO PARTNERSHIP ACCOUNTS

In certain cases an individual partner has no power to bind the firm. This is to say that third
parties cannot bind the firm unless all the partners have agreed. These cases are :
(a) Submitting a dispute relating to the firm arbitration;
(b) Opening a bank account on behalf of the firm in the name of a parnter;
(c) Compromise or relinquishment of any claim or portion of claim by the firm;
(d) Withdrawal of a suit or proceeding filed on behalf of the firm;
(e) Admission of any liability in a suit or proceedings against the firm;
(f) Acquisition of immovable property belonging to the firm;
(g) Entering into partnership on behalf of the firm.
The rights, duties and power of partners can be changed by mutual consent.
Students should remember that in the absence of any agreement to the contrary;
1. no partner has the right to a salary,
2. no interest is to be allowed on capital,
3. no interest is to be charged on the drawings,
4. interest at the rate of 6% is to be allowed on a partner’s loan to the firm, and
5. profits and losses are to be shared equally.
Note : In the absence of an agreement, the interest and salary payable to a partner will be paid
only if there is profit.

4. ACCOUNTS
There is not much difference between the accounts of a partnership firm and that of sole
proprietorship (provided there is no change in the firm itself). The only difference to be noted
is that instead of one Capital Account there will be as many Capital Accounts as there are
partners. If, for instance, there are three partners A, B, and C there will be a Capital Account
for each one of the partners, A’s Capital Account will be credited by the amount contributed
by him as capital and similarly B’s and C’s Capital Accounts will be credited with the amounts
brought in by them respectively as capital.
When a partner takes money out of the firms for his domestic purpose, either his Capital
Account can be debited or a separate account, named as Drawings Account, can be opened in
his name and the account may be debited. In a Trial Balance of a partnership firm, therefore,
one may find Capital Accounts of partners as well as Drawings Accounts. Finally the Drawings
Account of a Partner may be transferred to his Capital Account so that a net figure is available.
But, often the Drawings Account or Current Account (as it is usually called) remains separate.
4.1 Profit and Loss Appropriation : During the course of business, a partnership firm will
prepare Trading Account and a Profit and Loss Account at the end of every year. This is done
exactly on the lines already given in the chapter 6. This is to say that final accounts of a sole
proprietorship concern will not differ from the accounts of a partnership firm. The Profit and
Loss Account will show the profit earned by the firm or loss suffered by it. This profit or loss
has to be transferred to the Capital Accounts of partners according to the terms of the Partnership

8.4 COMMON PROFICIENCY TEST


Deed or according to the provisions of the Indian Partnership Act (if there is no Partnership
Deed or if the Deed is silent on a particular point). Suppose the Profit and Loss Account reveals
a profit of Rs. 90,000. There are two partners, A and B. A devotes all his time to the firm; B does
not. A’s capital is Rs. 50,000 and B’s is Rs. 20,000. There is no Partnership Deed. In such a case
the profit will be distributed among A and B equally. This is irrespective of the fact that B does
not work as much as A does and B’s capital is much less than that of A. But if the Partnership
Deed lays down that A is to get a salary and interest is to be allowed on the capital, then first
of all, from the profit earned, A’s salary must be deducted and interest on the Capital Accounts
of both partners will be deducted. The remaining profit will be divided equally between A and
B. Further if the Partnership Deed says that profits are to be divided in the ratio of, say, three-
fourth to A and one-fourth to B, then this will be the ratio to be adopted.
The student can see for himself that if a salary is to be allowed to a partner, the Profit and Loss
Account will be debited and the Partner’s Capital Account will be credited. Similarly, if interest
is to be allowed on capital, the Profit and Loss Account will be debited and the respective
Capital Accounts will be credited.
Let us take an illustration to understand how to divide profits among partners.
Illustration 1
A and B start business on 1st January, 2005, with capitals of Rs. 30,000 and Rs. 20,000. According
to the Partnership Deed, B is entitled to a salary of Rs. 500 per month and interest is to be
allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the
partners in the ratio of 5:3. During 2005 the firm earned a profit, before charging salary to B
and interest on capital amounting to Rs. 25,000. During the year A withdrew Rs. 8,000 and B
withdrew Rs. 10,000 for domestic purposes.
Give journal entries relating to division of profit.
Solution
Journal Entries
2005 Dr. Cr.
Rs. Rs.
Dec. 31 Profit and Loss Account Dr. 6,000
To B’s Capital Account 6,000
(Salary due to B @ Rs. 500 per month)
Profit and Loss Account Dr. 3,000
To A’s Capital Account 1,800
To B’s Capital Account 1,200
(Interest due on Capital @ 6% per month)
Profit and Loss Account Dr. 16,000
To A’s Capital Account 10,000
To B’s Capital Account 6,000
(Remaining profit of Rs. 16,000 divided)
between A and B in the ratio of 5:3)

FUNDAMENTALS OF ACCOUNTING 8.5


INTRODUCTON TO PARTNERSHIP ACCOUNTS

Now, let us learn the preparation of profit and loss appropriation account with the help of
same illustration of partnership firm consisting of partners A and B.
Illustration 2
Ram, Rahim and Karim are partners in a firm. They have no agreement in respect of profit-
sharing ratio, interest on capital, interest on loan advanced by partners and remuneration
payable to partners. In the matter of distribution of profits they have put forward the following
claims :
(i) Ram, who has contributed maximum capital demands interst on capital at 10% p.a. and
share of profit in the capital ratio. But Rahim and Karim do not agree.
(ii) Rahim has devoted full time for running the business and demands salary at the rate of
Rs. 500 p.m. But Ram and Karim do not agree.
(iii) Karim demands interest on loan of Rs. 2,000 advanced by him at the market rate of interest
which is 12% p.a.
How shall you settle the dispute and prepare Profit and Loss Appropriation Account after transferring
10% of the divisible profit to Reserve. Net profit before taking into account any of the above claims
amounted to Rs. 45,000 at the end of the first year of their business.
Solution
There is no partnership deed. Therefore, the following provisions of The Indian Partnership
Act are to be applied for settling the dispute.
(i) No interest on capital is payable to any partner. Therefore, Ram is not entitled to interest
on capital.
(ii) No remuneration is payable to any partner. Therefore, Rahim is not entitled to any salary.
(iii) Interest on loan is payable @6% p.a. Therefore, Karim is to get interest @6% p.a. on Rs.2,000
instead of 12%.
(iv) The profits should be distributed equally.
Profit and Loss Appropriation Account for the year ended…
Dr. Cr.
Particulars Rs. Particulars Rs.
To Interest on Karim Loan A/c By Profit and Loss A/c
(Rs. 2,000 x 6/100) 120 (Net profit) 45,000
To Reserve A/c – 10% of
Rs. (45,000-120) 4,488
To Share of Profit A/c :
Ram: Rs. 13,464;
Rahim: Rs. 13,464;
Karim: Rs. 13,464 40,392
45,000 45,000

8.6 COMMON PROFICIENCY TEST


Illustration 3
A and B start business on 1st January, 2005, with capitals of Rs. 30,000 and Rs. 20,000. According
to the Partnership Deed, B is entitled to a salary of Rs. 500 per month and interest is to be
allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the
partners in the ratio of 5:3. During 2005 the firm earned a profit, before charging salary to B
and interest on capital amounting to Rs. 25,000. During the year A withdrew Rs. 8,000 and B
withdrew Rs. 10,000 for domestic purposes.
Prepare Profit and Loss Appropriation Account.
Solution
Profit and Loss Appropriation Account*
Rs. Rs.
To B’s Capital Account-Salary 6,000 By Net Profit 25,000
To A’s Capital Account-interest 1,800
To B’s Capital Account-interest 1,200
To Profit transfer to :
A’s Capital Account (5/8) 10,000
B’s Capital Account (3/8) 6,000
25,000 25,000
Let us also learn the preparation of capital accounts of partners with the help of same illustration
of partnership firm consisting of partners A and B..
Illustration 4
A and B start business on 1st January, 2005, with capitals of Rs. 30,000 and Rs. 20,000. According
to the Partnership Deed, B is entitled to a salary of Rs. 500 per month and interest is to be
allowed on capitals at 6% per annum. The remaining profits are to be distributed amongst the
partners in the ratio of 5:3. During 2005 the firm earned a profit, before charging salary to B
and interest on capital amounting to Rs. 25,000. During the year A withdrew Rs. 8,000 and B
withdrew Rs. 10,000 for domestic purposes.
Prepare Capital Accounts of Partners A and B.

FUNDAMENTALS OF ACCOUNTING 8.7


INTRODUCTON TO PARTNERSHIP ACCOUNTS

Solution
A’s Capital Account
Dr. Cr.
2005 Rs. 2005 Rs.
Dec. 31 To Cash - (Drawings) 8,000 Jan. 1 By Cash 30,000
To Balance c/d 33,800 Dec. 31 By Profit and Loss
A/c - Interest 1,800
By Profit and Loss
A/c - (5/8 Profit) 10,000
41,800 41,800
2006
Jan. 1 By Balance b/d 33,800
B’s Capital Account
Dr. Cr.
2005 Rs. 2005 Rs.
To Cash - (Drawings) 10,000 Jan. 1 By Cash 20,000
To Balance c/d 23,200 Dec. 31 By Profit and Loss A/c
- Salary 6,000
- Interest 1,200
By Profit and Loss A/c 6,000
- (3/8 Profit)
33,200 33,200
2006
Jan. 1 By Balance b/d 23,200
4.2 Fixed and Fluctuating Capital : You have seen in the above example that the Capital
Account of A has changed from Rs. 30,000 at the beginning to Rs. 33,800 and B’s Capital
A/c from Rs. 20,000 to Rs. 23,200. This is because we have made entries in respect of interest,
salary, profit earned during the year and money taken out by the partners in the Capital Account
itself. If the Capital Accounts are prepared on this basis, capitals are said to be fluctuating.
Some firms, however prefer to continue to show the Capital Accounts of the partners at the
same old figure. This means that no entry is to be made in the Capital Account in respect of
interest, salary, profit and drawings etc. A separate account is to be opened for this purpose.
This account is known as the Current Account or even as Drawings Account. Under this
system interest on capital if allowed, should be calculated only on the amount of the fixed
capital.
4.2.1 Interest on Capital : Interest is generally allowed on capitals of the partners. Interest on
capital of partners is calculated for the relevant period for which the amount of capital has
been used in the business. Normally, it is charged for full year on the balance of capital at the

8.8 COMMON PROFICIENCY TEST


beginning of the year unless some fresh capital is introduced during the year. On the additional
capital introduced, interest for the relevant period of utilisation is calculated. For example, A
has Rs. 30,000 capital in the beginning of the year and introduces Rs. 10,000 during the year.
If rate of interest on capial is 20 % p.a., interest on A’s capital is calculated as follows:

⎡ 20 ⎤ ⎡ 20 6 ⎤
⎢30,000 × 100 ⎥ + ⎢10,000 × 100 × 12 ⎥ = Rs. 6,000 + Rs. 1,000 = Rs. 7,000
⎣ ⎦ ⎣ ⎦
In case of fixed capital accounts, interest is calculated on the balance of capital accounts only
and no interest is payable / chargeable on the balance of current accounts.
Net loss and Interest on Capital : Subject to contract between the partners, interest on capitals is
to be provided out of profits only. Thus in case of loss, no interest is provided. But in case of
insufficient profits( i.e., net profit less than the amount of interest on capital), the amount of
profit is distributed in the ratio of capital as partners get profit by way of interest on capital
only.
4.2.2 Interest on Drawings : Sometimes interest is not only allowed on the capitals, but is also
charged on drawings. In such a case, interest will be charged according to the time that elapses
between the taking out of the money and the end of the year. Suppose X, a partner, has drawn
the following sum of money –
Rs.
On 29th February, 2005 500
On 31st March, 2005 400
On 30th June, 2005 600
On 31st October, 2005 800
Accounts are closed on 31st December every year. Interest is chargeable on drawings at 6%
per annum. The interest on X’s drawings will be calculated as shown below :
1. On Rs. 500 for 10 months, i.e. Rs. 25
2. On Rs. 400 for 9 months, i.e. 18
3. On Rs. 600 for 6 months, i.e. 18
4. On Rs. 800 for 2 months, i.e. 8
Total 69
Alternatively, it can be calculated as follows :
Amount Number of months Product
500 10 5,000
400 9 3,600
600 6 3,600
800 2 1,600
2,300 13,800
Interest on Rs. 13,800 for one month at 6% per annum is Rs. 69.

FUNDAMENTALS OF ACCOUNTING 8.9


INTRODUCTON TO PARTNERSHIP ACCOUNTS

If the dates on which amounts are drawn are not given, the student will do well to charge
interest for six months on the whole of the amount on the assumption that the money was
drawn evenly through out the year. In the above example, the total drawings come to Rs.
2,300; and at 6% for 6 months, the interest comes to Rs. 69. The entry to record interest on
drawings is- debit the Capital Account of the partner concerned (or his Current Account if the
capital is fixed) and credit the Profit and Loss Appropriation Account.
If withdrawals are made evenly in the beginning of each month, interest can be calculated
easily for the whole of the amount of 6-1/2 months; if withdrawals are made at the end of
each month, interest should be calculated for 5-1/2 months.
4.2.3 Guarantee of Minimum Profit : Sometimes, one partner can enjoy the right to have
minimum amount of profit in a year as per the terms of the partnership agreement. In such
case, allocation of profit is done in a normal way if the share of partner, who has been guaranteed
minimum profit, is more than the amount of guaranteed profit. However, if share of the partner
is less than the guaranteed amount, he takes minimum profit and the excess of guaranteed
share of profit over the actual share is borne by the remaining partners as per the agreement.
There are three possibilities as far as share of deficiency by other partners is concerned. These
are as follows :
Excess is payable by one of the remaining partners.
Excess is payable by atleast two or all the partners in an agreed ratio.
Excess is payable by remaining partners in their mutual profit sharing ratio.
If the question is silent about the nature of guarantee , the burden of guarantee is borne by the
remaining partners in their mutual profit sharing ratio.
Illustration 5
A and B are partners sharing profits and losses in the ratio of their effective capital. They had
Rs.1,00,000 and Rs. 60,000 respectively in their Capital Accounts as on 1st January, 2005.
A introduced a further capital of Rs.10,000 on 1st April, 2005 and another Rs. 5,000 on 1st
July, 2005. On 30th September, 2005 A withdrew Rs. 40,000.
On 1st July, 2005, B introduced further capital of Rs.30,000.
The partners drew the following amounts in anticipation of profit.
A drew Rs. 1,000 per month at the end of each month beginning from January, 2005. B drew
Rs.1,000 on 30th June, and Rs. 5,000 on 30th September, 2005.
12% p.a. interest on capital is allowable and 10% p.a. interest on drawings is chargeable. Date
of closing 31.12.2005. Calculate: (a) Profit-sharing ratio; (b) Interest on capital; and (c) Interest
on drawings.

8.10 COMMON PROFICIENCY TEST


Solution
A (a) Calculation of Effective Capital B
Rs. 1,00,000 invested for 3 months i.e., Rs. 60,000 invested for 6 months i.e.,
Rs. 3,00,000 invested for 1 month Rs. 3,60,000 invested for 1 month
Rs. 1,10,000 invested for 3 months i.e., Rs. 90,000 invested for 6 months, i.e.,
Rs. 3,30,000 invested for 1 month. Rs. 5,40,000 invested for 1 month
9,00,000
Rs. 1,15,000 invested for 3 months i.e,
Rs. 3,45,000 invested for 1 month.
Rs. 75,000 invested for 3 months, i.e.,
Rs. 2,25,000 invested for 1 month.
12,00,000
(b) Calculation of Interest on Drawings
Rs. 12,00,000 x 12/100 x 1/12 = Rs. 12,000 Rs. 9,00,000 x 12/100 x 1/12 = Rs. 9,000
(c) Calculation of Interest on Drawings
Rs. 12,000 x 10/100 x 5.5/12 = Rs. 550 Rs. 1,000 x 10/100 x 6/12 = Rs. 50
Rs. 5,000 x 10/100 x 3/12 = Rs. 125
Illustration 6
Ram and Rahim start business with capital of Rs. 50,000 and Rs. 30,000 on 1st January, 2005.
Rahim is entitled to a salary of Rs. 400 per month. Interest is allowed on capitals and is charged
on drawings at 6% per annum. Profits are to be distributed equally after the above noted
adjustments. During the year Ram withdrew Rs. 8,000 and Rahim withdrew Rs. 10,000. The
profit for the year before allowing for the terms of the Partnership Deed came to Rs. 30,000.
Assuming the capitals to be fixed, prepare the Profit and Loss Appropriation Account and the
Capital and Current Accounts relating to the partners.

FUNDAMENTALS OF ACCOUNTING 8.11


INTRODUCTON TO PARTNERSHIP ACCOUNTS

Solution
Profits & Loss (Appropriation) Account
Dr. Cr.
2005 Rs. 2005 Rs.
Dec. 31 To Rahim’s Current A/c Dec. 31 By Net Profit 30,000
Salary 4,800 By Sundries-Interest on
To Sundries-Interest on Drawings :
Capitals : Ram’s Current A/c
Ram’s Current A/c 3,000 (6% on Rs. 8,000 for
Rahim’s Current A/c 1,800 6 months) 240
To Profit transferred to Rahim’s Current A/c
Ram’s Current A/c (1/2) 10,470 (6% on Rs. 10,000 for
Rahim’s current A/c (1/2) 10,470 6 months) 300
30,540 30,540
Illustration 7
With the help of same information given in illustration 6, let us prepare the Capital and Current
Accounts of Ram and Rahim.
Solution
Ram’s Capital Account
2005 Rs. 2005 Rs.
Dec. 31 To Balance c/d 50,000 Jan. 1 By Cash 50,000
2006
Jan. 1 By Balance b/d 50,000
Rahim’s Capital Account
2005 Rs. 2005 Rs.
Dec. 31 To Balance c/d 30,000 Jan. 1 By Cash 30,000
2006
Jan. 1 By Balance b/d 30,000
Ram’s Current Account
2005 Rs. 2005 Rs.
Dec. 31 To Cash (Drawings) 8,000 Dec. 31 By Profit and Loss A/c -
To Profit and Loss A/c - Interest 3,000
Interest on Drawings 240 By Profit and Loss A/c -
To Balance c/d 5,230 1/2 profit 10,470
13,470 13,470
2006
Jan. 1 By Balance b/d 5,230

8.12 COMMON PROFICIENCY TEST


Rahim’s Current Account
2005 Rs. 2005 Rs.
? To Cash (Drawings) 10,000 Dec. 31 By Profit and Loss A/c
Dec. 31 To Profit and Loss A/c Salary 4,800
Interest on Drawings 300 Interest 1,800
To Balance c/d 6,770 By Profit and Loss A/c
To Balance c/d Profit 10,470
17,070 17,070
2006
Jan. 1 By Balance b/d 6,770
Illustration 8
Weak, Able and Lazy are in partnership sharing profits and losses in the ratio of 2:1:1. It is
agreed that interest on capital will be allowed @ 10% per annum and interest on drawing will
be charged @ 8 per cent per annum. (No interest will be charged/allowed on Current Accounts).
The following are the particulars of the Capital and Drawings Accounts of the partner:
Weak Able Lazy
Rs. Rs. Rs.
Capital (1.1.2005) 75,000 40,000 30,000
Current Account (1.1.2005) 10,000 5,000 (Dr.) 5,000
Drawings 15,000 10,000 10,000
The draft accounts for 2005 showed a net profit of Rs. 60,000 before taking into account interest
on capitals and drawings and subject to following rectification of errors :
(a) Life Insurance premium of Weak amounting to Rs. 750 paid by the firm on 30th June,
2005 has been charged to Miscellaneous Expenditure A/c.
(b) Repairs of Machinery amounting to Rs. 10,000 has been debited to Plant Account and
depreciation thereon charged @ 20%.
(c) Travelling expenses of Rs. 3,000 of Able for a pleasure trip to U.K. paid by the firm on 30th
June, 2005 has been debited to Travelling Expenses Account.
You are required to prepare the Profit and Loss Appropriation Account for the year ended
31st December, 2005.

FUNDAMENTALS OF ACCOUNTING 8.13


INTRODUCTON TO PARTNERSHIP ACCOUNTS

Solution
WEAK, ABLE & LAZY
Profit and Loss Appropriation Account for the year ended
31st December, 2005
Rs. Rs. Rs. Rs.
To Interest on Capital : By Net Profit (Adjusted) 55,750
Weak 7,500 By Interest on Drawings :
Able 4,000 Weak 630
Lazy 3,000 14,500 Able 520
Lazy 400 1550
To Partner’s Current A/cs :
Share of profit :
Weak 21,400
Able 10,700
Lazy 10,700 42,800
57,300 57,300
Working Notes :
1. Adjusted Profit Rs.
Net Profit as per Profit & Loss A/c 60,000
Add : Drawings by Weak : Life Insurance Premium of Weak charged to
Miscellaneous Expenditure A/c of the Firm. 750
Drawing by Able : Travelling expenses of able in connection with pleasure
trip to U.K. Charged to travelling Expenses A/c of the Firm. 3,000
63,750
Less : Repairs to Machinery wrongly capitalised 10,000
Less : Depreciation charged @ 20% 2,000 8,000
55,750
2. Interest on Drawings :
Weak Able Lazy
Rs. Rs. Rs.
Drawings 15,000 10,000 10,000
Add : Rectificatory adjustments 750 3,000 –
15,750 13,000 10,000
Interest @ 8% p.a. for 6 months 630 520 400

8.14 COMMON PROFICIENCY TEST


Illustration 9
After preparation of Profit and Loss Appropriation Account for the year ended 31st December,
2005 let us prepare Current Accounts of partners Weak, Able and Lazy for the year ended
31st December, 2005.
Solution
Partners’ Current Accounts
Weak Able Lazy Weak Able Lazy
Rs. Rs. Rs. Rs. Rs. Rs.
To Balance b/d – – 5,000 By Balance b/d 10,000 5,000 –
To Drawings 15,000 10,000 10,000 By Profit & Loss
App. A/c 7,500 4,000 3,000
To Life Insurance (Int. on capital)
Premium 750 – – By Profit & Loss
App. A/c 21,400 10,700 10,700
To Travelling Exps. – 3,000 – (Share of profit)
To Profit & Loss App. By Balance c/d
A/c (Int. on drawings) 630 520 400 – – 1,700
To Balance c/d 22,520 6,180
38,900 19,700 15,400 38,900 19,700 15,400
Illustration 10
Ram and Rahim are in partnership sharing profits and losses in the ratio of 3:2. As Ram, on
account of his advancing years, feels he cannot work as hard as before, the chief clerk of the
firm, Ratan, is admitted as a partner with effect from 1st January, 2005, and becomes entitled
to 1/10th of the net profits and nothing else, the mutual ratio between Ram and Rahim
remaining unaltered.
Before becoming a partner, Ratan was getting a salary of Rs. 500 p.m. together with a commission
of 4% on the net profits after deducting his salary and commission.
It is provided in the partnership deed that the share of Ratan’s profits as a partner in excess of
the amount to which he would have been entitled if he had continued as the chief clerk,
should be taken out of Ram’s share of profits.
The net profit for the year ended December 31, 2005 is Rs. 1,10,000. Show the distribution of
net profit amongst the partners.

FUNDAMENTALS OF ACCOUNTING 8.15


INTRODUCTON TO PARTNERSHIP ACCOUNTS

Solution
Amount due to Ratan as a Chief Clerk Rs.
Salary 6,000
Commission 4/104 (Rs. 1,10,000 - Rs. 6,000) 4,000
10,000
Share of Profit as a partner (1/10th of 1,10,000) 11,000
Excess chargeable to Ram 1,000
Profit and Loss Appropriation Account for the year ended 31.12..2005
Dr. Cr.
Particulars Rs. Particulars Rs.
To Share of Profit A/c By Profit and Loss
A/c (Net profit) 1,10,000
Ram 3/5 (Rs. 1,10,000 –
Rs. 10,000) less Rs. 1,000 59,000
Rahim 2/5 (Rs. 1,10,000 –
Rs. 10,000) 40,000
Ratan 1/10 (Rs. 1,10,000) 11,000
1,10,000 1,10,000

SELF EXAMINATION QUESTIONS


I. Pick up the correct answer from the given choices:
1. Following are the essential elements of a partnership firm except:
a. Atleast two persons. b. There is an agreement between all partners.
c. Equal share of profits and losses. d. Partnership agreement is for some business.
2. Following is the difference between partnership deed and partnership agreement.
a. Partnership deed is in writing and partnership agreement is oral.
b. Partnership deed is signed by all the partners but partnership agreement is signed
by majority of the partners.
c. Partnership deed is registered in the court of law whereas partnership agreement
is not registered.
d. Partnership deed is not subject to changes unless all partners agrees to it.
Partnership agreement can be amended with the consent of more than 50%
partners.

8.16 COMMON PROFICIENCY TEST


3. If a firm prefers Partners’ Capital Accounts to be shown at the amount introduced
by the partners as capital in firm then entries for salary, interest, drawings, interest
on capital and drawings and profits are made in
a. Trading Account. b. Profit and Loss Account
c. Balance Sheet d. Partners’ Current Account.
4. In the absence of any agreement, partners are liable to receive interest on their Loans @:
a. 12% p.a. b. 10% p.a.
c. 8% p.a. d 6% p.a.
5. A partner acts as ……… for a firm.
a. Agent. b. Third Party. c. Employee. d. None of the Above.
6. Bill and Monica are partners sharing profits and losses in the ratio of 3:2 having the
capital of Rs. 80,000 and Rs. 50,000 respectively. They are entitled to 9% p.a. interest
on capital before distributing the profits. During the year firm earned Rs. 7,800 after
allowing interest on capital. Profits apportioned among Bill and Monica is:
a. 4,680 and 3,120. b. 4,800 and 3,000.
c. 5,000 and 2,800. d. None of the above.
7. Ram and Shyam are partners with the capital of Rs. 25,000 and Rs. 15,000 respectively.
Interest payable on capital is 10% p.a. Find the interest on capital for both the partners
when the profits earned by the firm is Rs. 2,400.
a. Rs. 2,500 and Rs. 1,500. b. Rs. 1,500 and Rs. 900.
c. Rs. 1,200 and Rs. 1,200. d. None of the above.
8. Seeta and Geeta are partners sharing profits and losses in the ratio 4:1. Meeta was
manager who received the salary of Rs. 4,000 p.m. in addition to a commission of 5%
on net profits after charging such commission. Profits for the year is Rs. 6,78,000
before charging salary. Find the total remuneration of Meeta.
a. Rs. 78,000. b. Rs. 88,000. c. Rs. 87,000. d. Rs. 76,000.
9. The relationship between persons who have agreed to share the profit of a business
carried on by all or any of them acting for all is known as ………
a. Partnership. b. Joint Venture.
c. Association of Persons. d. Body of Individuals.
10. Features of a partnership firm are:
a. Two or more persons carrying common business under an agreement.
b. Sharing profits and losses in the fixed ratio.
c. Business carried by all or any of them acting for all.
d. All of the above.

FUNDAMENTALS OF ACCOUNTING 8.17


INTRODUCTON TO PARTNERSHIP ACCOUNTS

11. Firm has earned exceptionally high profits from a contract which will not be renewed.
In such a case the profit from this contract will not be included in ………
a. Profit sharing of the partners. b. Calculation of the goodwill.
c. Both. d. None.
12. In the absence of an agreement, partners are entitled to
a. Salary. b. Commission.s
c. Interest on Loan and Advances. d. Profit share in capital ratio.
13. Interest on capital will be paid to the partners if provided for in the agreement but
only from …………
a. Current Profits. b. Reserves. c. Accumulated Profits. d. Goodwill.
14. Partners are suppose to pay interest on drawing only when ……… by the ………
a. Provided, Agreement. b. Permitted, Investors.
c. Agreed, Partners. d. Both ‘a’ & ‘c’ above.
15. When a partner is given Guarantee by the other partner, loss on such guarantee will
be borne by
a. Partnership firm. b. All the other partners.
c. Partner who gave the guarantee. d. Partner with highest profit sharing ratio.
16. Guarantee given to a partner ‘A’ by the other partners ‘B & C’ means
a. In case of loss ‘A’ will not contribute towards that loss.
b. In case of insufficient profits ‘A’ will receive only the minimum guarantee amount.
c. In case of loss or insufficient profits ‘A’ will withdraw the minimum guarantee amount.
d. All of the above.
17. What would be the profit sharing ratio if the partnership act is complied with?
a. As per agreement. b. Equally.
c. In Capital Ratio. d. None of the above.
18. Would interest on loan be allowed in the absence of any agreement or when
partnership deed is silent?
a. No interest allowed.
b. Allowed only if agreed by all the other partners.
c. Will be paid only when there are sufficient profits.
d. Allowed @ 6% p.a.
19. When is the Profit & Loss Appropriation Account prepared?
a. For Proprietorship firm. b. For partnership firm.
c. Both ‘a’ and ‘b’ d. None of the above.

8.18 COMMON PROFICIENCY TEST


20. What time would be taken into consideration if equal monthly amount is drawn as
drawings at the beginning of each month?
a. 7 months. b. 6 months. c. 5 months. d. 6.5 months.
21. Where will you record interest on drawings?
a. Debit side of Profit & Loss Appropriation Account.
b. Credit side of Profit & Loss Appropriation Account.
c. Credit side of Profit & Loss Account.
d. Debit side of Capital/Current Account only.
22. What balance does a Partner’s Current Account has?
a. Debit balance. b. Credit balance. c. Either ‘a’ or ‘b’. d. None of the above.
23. Is rent paid to a partner is appropriation of profits?
a. Yes. b. No.
c. If partner’s contribution as capital is maximum.
d. If partner is a working partner?
24. How would you close the Partner’s Drawings Account?
a. By transfer to Capital or Current Account debit side.
b. By transfer to Capital Account credit side.
c. By transfer to Current Account credit side.
d. Either ‘b’ or ‘c’.
25. A, B and C had capitals of Rs. 50,000; Rs. 40,000 and Rs. 30,000 respectively for
carrying on business in partnership. The firm’s reported profit for the year was Rs.
80,000. As per provisions of the Indian Partnership Act, 1932, find out the share of
each partner in the above amount after taking into account that no interest has been
provided on an advance by A of Rs. 20,000, in addition to his capital contribution.
a. Rs. 26,267 for Partner B and C & Rs. 27,466 for partner A.
b. Rs. 26,667 each partner.
c. Rs. 33,333 for A, Rs. 26,667 and Rs. 20,000 for C.
d. Rs. 30,000 each partner.
26. X, Y and Z are partners in a firm. At the time of division of profit for the year there
was dispute between the partners. Profits before interest on partner’s capital was Rs.
6,000 and X wanted interest on capital @ 20% as his capital contributions was Rs.
1,00,000 as compared to that of Y and Z which was Rs. 75,000 and Rs. 50,000
respectively.
a. Profits of Rs. 6,000 will be distributed equally.
b. X will get the interest of Rs. 20,000 and the loss of Rs. 14,000 will be shared equally.
c. All the partners will get interest on capital and the loss of Rs. 39,000 will be shared equally.
d. None of the above.

FUNDAMENTALS OF ACCOUNTING 8.19


INTRODUCTON TO PARTNERSHIP ACCOUNTS

27. X, Y and Z are partners in a firm. At the time of division of profit for the year there
was dispute between the partners. Profits before interest on partner’s capital was Rs.
6,000 and Y determined interest @ 24% p.a. on his loan of Rs. 80,000. There was no
agreement on this point. Calculate the amount payable to X, Y and Z respectively.
a. Rs. 2,000 to each partner.
b. Loss of Rs. 4,400 for X and Z & Y will take home Rs. 14,800.
c. Rs. 400 for X, Rs. 5,200 for Y and Rs. 400 for Z.
d. Rs. 2,400 to each partner.
28. X, Y and Z are partners in a firm. At the time of division of profit for the year there
was dispute between the partners. Profits before interest on partner’s capital was Rs.
6,000 and Z demanded minimum profit of Rs. 5,000 as his financial position was not
good. However, there was no written agreement on this profit. Profits to be distributed
to X, Y and Z will be
a. Other partners will pay Z the minimum profit and will suffer loss equally.
b. Other partners will pay Z the minimum profit and will suffer loss in capital ratio.
c. X & Y will take Rs. 500 each and Z will take Rs. 5000.
d. Rs. 2,000 to each of the partners.
29. Following are the differences between Capital Account and Current Account except:
a. Capital Account is prepared under fixed capital method whereas current account
is prepared under fluctuating capital method.
b. In capital account only capital introduced and withdrawn is recorded, all other
transactions between the firm and partner is recorded in the current account.
c. Interest is sometimes paid on capital account balance but no such interest is payable
on current account balances.
d. ‘b’ and ‘c’ above.
30. Following are the differences between Partnership and Joint Venture except:
a. Joint venture is essentially planned for short term mainly for one transaction.
However, partnerships are normally undertaken as going concerns and are expected
to last for a very long period.
b. The persons involved in a joint venture are called co-venturers whereas persons
involved in a partnership are called partners.
c. Any specific statute of the Government does not govern joint ventures but the
Indian Partnership Act, 1932, governs partnerships.
d. Memorandum of Understanding is mandatory to be drafted to spell the relationship
between the co-venturers whereas the basic relationship between the partners is
defined by the partnership deed.
31. Every partner is bound to attend diligently to his ……… in the conduct of the business.
a. Rights. b. Meetings. c. Capital. d. Duties.

8.20 COMMON PROFICIENCY TEST


II Match the following items from column A with column B
S. No. Column A Column B
1. Partnership deed is the mutual
agreement between (a) Jointly and severely unlimited.
2. The liability of all the partners is (b) To show the distribution of profits among
partners.
3. In the absence of an agreement,
partners shares profits in (c) Partners
4. Profit & Loss Appropriation
Account is prepared to (d) Equal Ratio

ANSWERS
I.
[Ans 1. (c) 2. (c), 3. (d), 4. (d), 5 (a), 6. (a),
7. (b), 8. (a), 9. (a), 10. (d), 11. (b), 12. (c),
13. (a), 14. (d), 15. (c) , 16. (c), 17. (b), 18. (d),
19. (b), 20. (d), 21. (b), 22. (c) , 23. (b) , 24. (a),
25. (a), 26. (a), 27. (c), 28. (d), 29. (a), 30. (d),
31. (d) ]
II.
1. (c), 2(a), 3(d), 4(b)

FUNDAMENTALS OF ACCOUNTING 8.21


CHAPTER - 8

PARTNERSHIP
ACCOUNTS

Unit 2

Treatment of
Goodwill in
Partnership
Accounts
Learning objectives
After studying this unit, you will be able to :
 Understand when does the need for valuation of goodwill arise.
 Learn the accounting of goodwill.

1. GOODWILL
Goodwill is the value of reputation of a firm in respect of profits expected in future over and
above the normal rate of profits. The implication of the term over and above is that there is
always a certain normal rate of profits earned by similar firms in the same locality. The excess
profit earned by a firm may be due to its locational advantage, better customer service, possession
of a unique patent right, personal reputation of the partner or for similar other reasons. The
necessity for valuation of goodwill in a firm arises in the following cases :
a) When the profit sharing ratio amongst the partners is changed;

b) When a new partner is admitted;

c) When a partner retires or dies; and

d) When the business is dissolved or sold.

2. METHOD FOR GOODWILL VALUATION


There are four methods for valuation of goodwill

1) Average profit basis,

2) Super profit basis,

3) Annuity basis, and

4) Capitalisation basis
(1) Average Profit Basis : In this case the profits of the past few years are averaged and
adjusted for any expected change in future. For averaging the past profit, either simple average
or weighted average may be employed depending upon the circumstances. If there exists clear
increasing or decreasing trend of profits, it is better to give more weight to the profits of the
recent years than those of earlier years. But, if there is no clear trend of profit, it is better to go
by simple average.
Let us suppose profits of a partnership firm for the last five years were Rs. 30,000, Rs. 40,000,
Rs. 50,000, Rs. 60,000 and Rs. 70,000. In this case, a clear increasing trend is noticed

FUNDAMENTALS OF ACCOUNTING 8.23


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

and therefore, average profit may be arrived at by assigning appropriate weights as shown
below :
1 2 3 4=2×3
Year Profit Weight Weighted Profit
Rs. Rs.
1 30,000 1 30,000
2 40,000 2 80,000
3 50,000 3 1,50,000
4 60,000 4 2,40,000
5 70,000 5 3,50,000
15 8,50,000
So Weighted Average Profit = Rs. 8,50,000 = Rs. 56,667
If goodwill is valued at three years’ purchase of profit, then in this case the value of goodwill is
Rs. 56,667 × 3 = Rs. 1,70,000.
However, if any such trend is not visible from the figures of past profits, then one should take
simple average profit and calculate goodwill accordingly. Let us suppose, profits of a partnership
firm for five years were Rs. 30,000, Rs. 25,000, Rs. 20,000, Rs. 30,000 and Rs. 28,000. In this
case, there is no clear increasing or decreasing trend of profit. So average profit comes to Rs.
26,600 (arrived at by taking simple average). If the goodwill is valued by taking three years’ of
purchase of profit, then in this case, value of goodwill becomes Rs. 79,800.
(2) Super Profit Basis : In case of average profit basis, goodwill is calculated on the basis of
average profit multiplied by certain number of years. The implication is that such profit will be
maintained for so many number of years and the partner(s) who gains in terms of profit sharing
ratio should contribute for such gains in profit to the partners who make the sacrifice. On the
other hand, super profit means, excess profit that can be earned by a firm over and above the
normal profit usually earned by similar firms under similar circumstances. Under this method,
the partner who gains in terms of profit sharing ratio has to contribute only for excess profit
because normal profit he can earn by joining any partnership. Under super profit method,
what excess profit a partnership firm can earn is to be determined first. The steps to be followed
are given below :
a. Identify the capital employed by the partnership firm;
b. Identify the average profit earned by the partnership firm based on past few years’ figures;
c. Determine normal rate of return prevailing in the locality of similar firms;
d. Apply normal rate of return on capital employed to arrive at normal profit;
e. Deduct normal profit from the average profit of the firm. If the average profit of the firm
is more than the normal profit, there exists super profit and goodwill.

8.24 COMMON PROFICIENCY TEST


Let us suppose, total capital employed by a partnership firm was Rs. 1,00,000 and its average
profit was Rs. 25,000. Normal rate of return is 22% in case of similar firms working under
similar conditions. So normal profit is Rs. 22,000 and average profit is Rs. 25,000. The partnership
firm earns Rs. 3,000 super profit.
Goodwill is generally valued by multiplying the amount of super profit by certain number of
years depending upon the expectation about the maintence of such profit in future. If it is
expected that the super profit can be maintained for another five years in future, then value of
goodwill may be taken as Rs. 3,000 × 5 = Rs. 15,000.
(3) Annuity Method : In the super profit method explained above, time value of money is not
considered. Although it was expected that super profit would be earned in five future years,
still no devaluation was done on the value of money for the time difference. In fact when
money will be received in different points of time, its value should be different depending upon
the rate of interest. If 15% rate of interest is considered appropriate, then discounted value of
super profit to be earned in different future years will be as follows :
Year Super Profit Discount Discounted
Factor @ 15% value of
Super Profit
1 3000 .8696 2,608.80
2 3000 .7561 2,268.30
3 3000 .6575 1,972.50
4 3000 .5718 1,715.40
5 3000 .4972 1,491.60
3.3522 10,056.60
So under the annuity method, discounted value of total super profit becomes Rs. 10,056.60 not
Rs. 15,000 as was done under super profit method.
The word annuity is used to mean identical annual amount of super profit. So for discounting
it is possible to refer to annuity table. As per the annuity table, present value of Re. 1 to be
received at the end of each year for n year @ 15% interest p.a. is 3.3522. So value of goodwill
under annuity method is Rs. 3000 × 3.3522 = Rs. 10,056.60.
(4) Capitalisation Basis : Under this basis, value of whole business is determined applying
normal rate of return. If such value (arrived at by applying normal rate of return) is higher
than the capital employed in the business, then the difference is goodwill. The steps to be
followed under this method are given below :
a. Determine the normal rate of return.
b. Find out the average profit of the partnership firm for which goodwill is to be determined.
c. Determine the capital employed by the partnership firm for which goodwill is to be
determined.

FUNDAMENTALS OF ACCOUNTING 8.25


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

d. Find out normal value of the business by dividing average profit by normal rate of return.
e. Deduct average capital employed from the normal value of the business to arrive at
goodwill.
Let us suppose capital employed by a partnership firm is Rs. 1,00,000. Its average profit is
Rs. 20,000. Normal rate of return is 15%
Normal Value of business = Rs. = 1,33,333
Value of goodwill = 1,33,333 – Rs. 1,00,000 = 33,333
Illustration 1
Lee and Lawson are in equal partnership. They agreed to take Hicks as one-fourth partner. For
this it was decided to find out the value of goodwill. M/s. Lee and Lawson earned profits
during 2002-2005 as follows :
Year Profits
Rs.
2002 1,20,000
2003 1,25,000
2004 1,30,000
2005 1,50,000
On 31.12.2005 capital employed by M/s. Lee and Lawson was Rs. 5,00,000. Rate of normal
profit is 20%.
Find out the value of goodwill following various methods.
Solution
Average Profit :
Year Profit Weight Weighted
Rs. Profit
Rs.
2002 1,20,000 1 1,20,000
2003 1,25,000 2 2,50,000
2004 1,30,000 3 3,90,000
2005 1,50,000 4 6,00,000
10 13,60,000
Weighted Average Profit Rs. = 1,36,000
Method (1) : Average Profit Basis
Assumption : Goodwill is valued at 3 year’s purchase
Value of Goodwill : Rs. 1,36,000 × 3 = Rs. 4,08,000

8.26 COMMON PROFICIENCY TEST


Method (2) : Super Profit Basis
Average Profit Rs. 1,36,000
Less : Normal Profit
20% on Rs. 5,00,000 Rs. 1,00,000
Rs. 36,000
Assumption : Goodwill is valued at 3 years purchase.
Value of Goodwill : Rs 36,000 × 3 = Rs. 1,08,000
Method (3) : Annuity Basis
Assumptions :
(a) Interest rate is equivalent to normal profit rate i.e. 20% p.a.
(b) Goodwill is valued at 3 years’ purchases
Valuation of Goodwill : Rs. 36,000 × 2.1065 = Rs. 75,834
Method (4) : Capitalisation Basis
Normal Value of Capital employed :
1,36,000
X 100
20 = Rs. 6,80,000
Capital Employed in M/s. Lee and Lawson = Rs. 5,00,000
Goodwill = Rs. 1,80,000
Illustration 2
The following particulars are available in respect of the business carried on by Rathore
Rs.
(1) Capital Invested 1,50,000
(2) Trading Results :
2002 Profit 40,000
2003 Profit 36,000
2004 Loss 6,000
2005 Profit 50,000
(3) Market Rate of interest on investment 10%
(4) Rate of risk return on capital
invested in business 2%
(5) Remuneration from alternative
employment of the proprietor Rs. 6000
(if not engaged in business). per annum

FUNDAMENTALS OF ACCOUNTING 8.27


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

You are requested to compute the value of goodwill on the basis of 5 years’ purchase of super
profit of the business calculated on the average profits of the last four years.
Solution
Average maintainable profits : Rs.
Trading profit during 2002 40,000
2003 36,000
2005 50,000
1,26,000
Less : Loss during 2004 6,000
Total 1,20,000
Average Profits (Total ¼) 30,000
Less : Remuneration for the proprietor 6,000
Average maintainable Profit 24,000
Normal Profit (12% on capital employed) 18,000
Super Profit 6,000
Goodwill at 5 year’s purchase of super Profit 30,000

3. NEED FOR VALUATION OF GOODWILL


Whenever there is any change in the existing relationship of the partners inter se, some partners
have to sacrifice their future profit and some others would gain. Those who are sacrificing
future profit should be compensated by the others who are gaining. This adjustment of the
partnership rights may arise due to admission of a new partner, change in the profit sharing
ratio, retirement or death of a partner and a dissolution of the partnership. The partners, who
gain in terms of profit sharing ratio, have to pay for such gain as a proportion to the value of
goodwill. The partners, who lose in terms of profit sharing ratio, receive payments for the
sacrifice as a proportion to the value of goodwill. Dissolution of partnership firms is not covered in
this study material and will be discussed in the Professional Course Study Material.

4. VALUATION OF GOODWILL IN CASE OF ADMISSION OF A PARTNER


When a new partner is admitted into a partnership, certain adjustments in accounts become
necessary. Chiefly, this is because the new partner will acquire a share in the profits of the firm
and because of this, the old partners will stand to lose. Suppose, A and B are partners sharing
profits in the ratio of 3:2. If their profits are Rs. 20,000, A will get Rs. 12,000 and B will get Rs.
8,000. If C is admitted and given one fourth share in profits, then out of Rs. 20,000 he will get
Rs. 5,000. The remaining Rs. 15,000 will be divided between A and B; A will get Rs. 9,000 and
B will get Rs. 6,000. Thus on C’s admission A loses Rs. 3,000 per year and B loses Rs. 2,000 per
year. C will have to compensate A and B for this loss. It is no argument to say that on C’s
admission the profits will not remain at Rs. 20,000; extra profits will arise and therefore, A and

8.28 COMMON PROFICIENCY TEST


B will both get more than what they previously got. But it should be noted that the additional
profits will be earned by the combined efforts of all the partners A, B and C. Therefore, if A
and B get a share of the extra profits they are not particularly obliged to C. Out of the present
profits of Rs. 20,000 they have to give up a share in favour of C and, therefore, they are entitled
to a compensation. The problem of compensation is the chief problem while dealing with
admission of a partner. This is tackled through goodwill.
But one point should be made clear here. Goodwill is a compensation to old partners for their
sacrifice in connection with admission of a new partner. So it is to be credited to the partners
according to their profit sacrificing ratio. Whatever share the new partner is getting, it may be
sacrificed by the old partners in proportion to their old profit sharing ratio or in different
proportion. For example, Nigam and Dhameja are in partnership sharing profits and losses
equally. They agreed to take Ghosh as one-third partner. Now one-third share of Ghosh may
come out of sacrifice made by Nigam and Dhameja equally (i.e. at their old profit sharing
ratio). See the following profit sharing pattern :
Profit Sharing Pattern
Partners OLD NEW
Nigam 1/2 Ghosh 1/3
Dhameja 1/2 Nigam (1/2–1/3×1/2) Dhameja
(1/2–1/3×1/2) 1/3
In other words, one-third share of Ghosh was borne by Nigam and Dhameja at their old profit
sharing ratio. By this process Nigam sacrificed 1/2–1/3=1/6 in share and Dhameja sacrificed
1/2–1/3=/1/6 in share. So the profit sacrificing ratio becomes :
Nigam = Dhameja
1/6 = 1/6
1 = 1
which is the same as old profit sharing ratio.
But if the new profit sharing ratio of Nigam, Dhameja and Ghosh becomes 4:2:3, then profit
sacrificed by Nigam and Dhameja on Ghosh’s admission is not at the old profit sharing ratio.
In this case profit sacrificing ratio is as follows :
Nigam : 1/2–4/9 = 1/18
Dhameja : 1/2–2/9 = 5/18
i.e. 1 : 5
If Ghosh pays goodwill of Rs. 24,000, then in the first case, Nigam and Dhameja should share
it equally; but in second case Nigam should get Rs. 4,000 and Dhameja should get Rs. 20,000.
Take another example : Nigam and Dhameja are equal partners. They agreed to take Ghosh as
one-third partner. The new profit sharing ratio is 4:2:3. Nigam and Dhameja agreed Rs. 27,000
as value of goodwill.

FUNDAMENTALS OF ACCOUNTING 8.29


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

Journal Entries :
Rs. Rs.
Ghosh’s Capial Account Dr. 9,000
To Nigam’s Capital Account 1,500
To Dhameja’s Capital Account 7,500
(Goodwill adjustment in the profit sacrificing ratio –
Nigam - Rs. 27,000 × 1/8
Dhameja - Rs. 27,000 × 5/18)
As per the Accounting Standard, it is not recommended to raise goodwill account but to show
the adjustment of goodwill through partners’ capital accounts.

5. ACCOUNTING TREATMENT OF GOODWILL IN CASE OF


ADMISSION OF A NEW PARTNER
The goodwill should be recorded in the books only when some consideration in money or
money’s worth has been paid for it. Therefore, only purchased goodwill should be recorded in
the books of the firm. In case of admission of a partner, goodwill cannot be raised in the books
of the firm because no consideration in money or money’s worth is paid for it. If the incoming
partner brings any premium over and above his capital contribution at the time of his admission,
such premium should be distributed to other existing partners. When a new partner is admitted
to a firm, the old partners generally sacrifice in favour of the new partner in terms of lower
profit sharing ratio in the future. Therefore, the premium for goodwill brought in by the new
partner shall be given to the existing partners on the basis of profit sacrificing ratio. The profit
sacrificing ratio is computed by deducting the new profit sharing ratio from the old profit
sharing ratio. If the difference is positive, there is a profit sacrifice and in case the difference is
negative, there is a gain in terms of higher future profit sharing ratio. In case of admission of a
partner, only those existing partners are entitled to a share for goodwill who have sacrificed a
part of their profits in favour of the new partner. Sometimes, goodwill may be evaluated in
case of admission of a partner when incoming partner is unable to bring in cash any premium
for goodwill. In that situation also, the value of goodwill should not be raised in the books since
it is inherent goodwill. Rather it is preferable that such value of goodwill should be adjusted
through partners’ capital accounts. It may also be noted that when the incoming partner pays
any premium for goodwill privately to the existing partners, no entry is required in the books
of the firm. In that case, the amount to be paid to each partner should be calculated as per the
profit sacrificing ratio.
Example 1 : A, B & C are in partnership sharing profits and losses in the ratio 2:2:1. They want
to admit D into partnership with one-fifth share. D brings in Rs. 30,000 as capital and
Rs. 10,000 as premium for goodwill.

8.30 COMMON PROFICIENCY TEST


The necessary journal entry will be:
Bank A/c Dr. Rs. 40,000
To A’s Capital A/c Rs. 4,000
To B’s Capital A/c Rs. 4,000
To C’s Capital A/c Rs. 2,000
To D’s Capital A/c Rs. 30,000
(Amount brought in by D, premium for
goodwill credited to existing partners’
capital accounts in profit sacrificing ratio)

Example 2 : A & B are equal partners. They wanted to take C as a third partner and for this
purpose goodwill was valued at Rs. 1,20,000. The journal entry for adjustment of value of
goodwill through partners’ capital accounts will be :
C’s Capital A/c Dr. Rs. 40,000
To A’s Capital A/c Rs. 20,000
To B’s Capital A/c Rs. 20,000
(Adjustment for goodwill)
The net effect in partner capital accounts is shown on the basis of profit sacrificing ratio:
A = 1/6 × Rs. 1,20,000 = Rs. 20,000 (Cr.)
B = 1/6 × Rs. 1,20,000 = Rs. 20,000 (Cr.)
C = 1/3 × Rs. 1,20,000 = Rs. 40,000 (Dr.)

Example 3 : A & B are equal partners. They wanted to admid C as 1/6th partner who brought
Rs. 60,000 as goodwill. The new profit sharing ratio is 3:2:1. Profit sacrificing ratio is to be
computed as follows :
Old Share - New Share = Share Sacrificed
A = 1/2 less 3/6 = 0
B = 1/2 less 2/6 = 1/6
So the entire goodwill should be credited to B’s Capital A/c.
Cash A/c Dr. Rs. 60,000
To B’s Capital A/c Rs. 60,000
(Goodwill brought in by
C credited to B’s Capital A/c)

FUNDAMENTALS OF ACCOUNTING 8.31


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

Example 4 : A, B & C are equal partners. They decided to take D who brought in Rs. 36,000 as
goodwill. The new profit sharing ratio is 3:3:2:2.
Old Share - New Share = Share Sacrificed
A = 1/3 less 3/10 = 1/30
B = 1/3 less 3/10 = 1/30
C = 1/3 less 2/10= 4/30
So goodwill should be shared in the ratio 1:1:4
Cash A/c Dr. Rs. 36,000
To A’s Capital Account Rs. 6,000
To B’s Capital Account Rs. 6,000
To C’s Capital Account Rs. 24,000
(Goodwill brought in by D credited
to old partners’ accounts in their
profit sacrificing ratio 1:1:4)
Instead of adjusting the value of goodwill of the firm through partner’s capital accounts without
raising goodwill account in the books, another practice is also followed. The practice is to first
raise the goodwill account in the books by crediting the value of goodwill to existing partner’s
capital accounts in old profit sharing ratio and then immediately writing off the value of goodwill
by debiting all partner capital accounts in new profit sharing ratio.
Illustration 2
The following is the Balance Sheet of Yellow and Green as at 31st December, 2005 :
Liabilities Rs. Assets Rs.
Creditors 20,000 Cash at Bank 10,000
Capital : Sundry Assets 55,000
Yellow 25,000
Green 20,000
65,000 65,000
The partners shared profit and losses in the ratio 3:2. On the above date, Black was admitted
as partner on the condition that he would pay Rs. 20,000 as Capital. Goodwill was to be
valued at 3 years’ purchase of the average of four years’ profits which were :
Rs. Rs.
2000 9,000 2002 12,000
2001 14,000 2003 13,000

8.32 COMMON PROFICIENCY TEST


The new profit sharing ratio is 6:5:5.
Give journal entries and Balance Sheet if goodwill is adjusted through partner’s capital accounts.
Solution
Rs. Rs.
(i) Bank Account Dr. 20,000
To Black’s Capital Account 20,000
(Amount brought in by Black as capital)
(ii) Black’s Capital Account Dr. 11,250
To Yellow’s Capital Account 8,100
To Green’s Capital Account 3,150
(Black’s share of goodwill adjusted to existing partners’
capital accounts in the profit sacrificing ratio 18:7)
Balance Sheet as on....................
Liabilities Rs. Assets Rs.
Creditors 20,000 Cash at Bank 30,000
Capital : Sundry Assets 55,000
Yellow 33,100
Green 23,150
Black 8,750
65,000
85,000 85,000
Note : Calculation of Profit Sacrificing Ratio
Old Share - New Share = Share Sacrificed
Yellow 3/5 – 6/16 = 18/80
Green 3/5 – 5/16 = 7/80
Illustration 3
With the information given in illustration 2, let us give journal entries and prepare balance
sheet assuming that goodwill is brought in cash.
Solution
Goodwill brought in cash
Bank Account Dr. 31,250
To Black’s Capital Account 20,000
To Yellow’s Capital Account 8,100
To Green’s Capital Account 3,150
(Amount brought in by Black as capital
and as goodwill; goodwill credited to Yellow
and Green in the profit sacrficing ratio)
FUNDAMENTALS OF ACCOUNTING 8.33
TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

Balance Sheet as on....................


Liabilities Rs. Assets Rs.
Creditors 20,000 Cash at Bank 41,250
Capital : Sundry Assets 55,000
Yellow 33,100
Green 23,150
Black 20,000 76,250
96,250 96,250
Illustration 4
Continuing with the same illustration 2, let us give journal entries and prepare balance sheet
assuming that goodwill is brought in cash, but withdrawn.
Solution
Goodwill brought in cash, but withdrawn
In addition to the treatment under case (d) above, the following additional entry will be made:
Yellow’s Capital Account Dr. 8,100
Green’s Capital Account Dr. 3,150
To Bank Account 11,250
(Amount withdrawn by Yellow and Green
in respect of goodwill credited to them)
Balance Sheet as on....................
Liabilities Rs. Assets Rs.
Creditors 20,000 Cash at Bank 30,000
Capital : Sundry Assets 55,000
Yellow 25,000
Green 20,000
Black 20,000 65,000
85,000 85,000
Illustration 5
On the basis of information given in illustration 2, let us give journal entries and prepare
balance sheet assuming that goodwill is paid privately.
Solution
There will be no entry for goodwill but Black will pay Rs. 8,100 to Yellow and Rs. 3,150 to
Green. For capital brought in by Black, the entry is :
Bank Account Dr. 20,000
To Black’s Capital Account 20,000
(Amount brought in by Black as capital)

8.34 COMMON PROFICIENCY TEST


Balance Sheet as on....................
Liabilities Rs. Assets Rs.
Creditors 20,000 Cash at Bank 30,000
Capital : Sundry Assets 55,000
Yellow 25,000
Green 20,000
Black 20,000
65,000
85,000 85,000

6. ACCOUNTING TREATMENT OF GOODWILL IN CASE OF


CHANGE IN THE PROFIT SHARING RATIO
In case of change in profit sharing ratio, the value of goodwill should be determined and
preferably adjusted through capital accounts of the partners on the basis of profit sacrificing
ratio. Another alternative is that goodwill is raised in the books of accounts of the firm crediting
the partners’ capital accounts in their old profit sharing ratio.
Illustration 6
A, B & C are equal partners. They wanted to change the profit sharing ratio into 4:3:2. They
raised the goodwill Rs. 90,000 but they want to immediately write it off. Make the necessary
journal entries.
Solution
Journal Entry
Rs. Rs.
A’s Capital Dr. 10,000
To C’s Capital A/c 10,000
In this case due to change in profit sharing ratio
A’s gain is = 4/9 less 1/3 = 1/9
B’s gain is = 1/3 less 1/3 = 0
C’s loss is = 1/3 less 2/9 = 1/9
So, A should compensate C to the extent of 1/9th of goodwill i.e.
Rs. 90,000 × 1/9 = Rs. 10,000

FUNDAMENTALS OF ACCOUNTING 8.35


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

Illustration 7
A, B and C are in partnership sharing profit and losses in the ratio of 4:3:3. They decided to
change the profit sharing ratio to 7:7:6. Goodwill of the firm is valued at Rs. 20,000. Calculate
the sacrifice/gain by the partners and make the necessary journal entry.
Solution
Partner New Share Old Share Difference

7 4 1
A – = -
20 10 20

7 3 1
B – =
20 10 20

6 3
C – = 0
20 10

Thus B gained 1/20th share while A sacrificed 1/20th share. For C there was no loss no gain.

Illustration 8

A, B, C and D are in partnership sharing profits and losses equally. They mutually agreed to
change the profit sharing ratio to 3:3:2:2. Give necessary journal entry.

Solution

3 1 1
A gains by − =
10 4 20

3 1 1
B gains by − =
10 4 20

1 2 1
C loses by − =
4 10 20

1 2 1
D loses by − =
4 10 20

So if goodwill is valued at Rs. 20,000, A and B should pay @ Rs. 1,000 each (i.e., Rs. 20,000 ×
1/20) as compensation to C and D respectively for their sacrifice.

8.36 COMMON PROFICIENCY TEST


Journal Entry
Rs. Rs.
A’s Capital Account Dr. 1,000
B’s Capital Account Dr. 1,000
To C’s Capital Account 1,000
To D’s Capital Account 1,000

7. ACCOUNTING TREATMENT OF GOODWILL IN CASE OF


RETIREMENT OR DEATH OF A PARTNER
In case of retirement of a partner, the continuing partners will gain in terms of profit sharing
ratio. Therefore they have to pay to retiring partner for his share of goodwill in the firm in the
gaining ratio. Similarly, in case of death of the partner, the continuing partners should bear
the share of goodwill due to the heirs of the deceased partner. For this purpose, the goodwill is
valued on the date of the retirement or death and adjusted through the capital accounts of the
partners.
Example : A, B & C are equal partners. C wanted to retire for which value of goodwill is
considered as Rs. 90,000. The necessary journal entry will be :
A’s Capital A/c Dr. Rs. 15,000
B’s Capital A/c Dr. Rs. 15,000
To C’s Capital A/c Rs. 30,000
(C’s share of goodwill adjusted to existing partners’
capital accounts in profit gaining ratio)

Illustration 9
Wise, Clever and Dull were trading in partnership sharing profits and losses 4:3:3 respectively.
The accounts of the firm are made upto 31st December every year.
The partnership provided, inter alia, that :
On the death of a partner the goodwill was to be valued at three years’ purchase of average
profits of the three years upto the date of the death after deducting interest @ 8 per cent on
capital employed and a fair remuneration of each partner. The profits are assumed to be earned
evenly throughout the year.
On 30th June, 2005, Wise died and it was agreed on his death to adjust goodwill in the capital
accounts without showing any amount of goodwill in the Balance Sheet.
It was agreed for the purpose of valuation of goodwill that the fair remuneration for work
done by each partner would be Rs. 15,000 per annum and that the capital employed would be
Rs. 1,56,000. Clever and Dull were to continue the partnership, sharing profits and losses
equally after the death of Wise.
FUNDAMENTALS OF ACCOUNTING 8.37
TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

The following were the amounts of profits of earlier years before charging interest on capital
employed.
Rs.
2002 67,200
2003 75,600
2004 72,000
2005 62,400
You are requested to compute the value of goodwill and show the adjustment thereof in the
books of the firm.
Solution
Computation of the value of goodwill :
(i) Average Profit for three years, ending 30th June; before death:
Year ending 30th June, 2003 : Rs. Rs.
1/2 of 2002 profits 33,600
1/2 of 2003 Profits 37,800 71,400
Year ending 30th June, 2004 :
1/2 of 2003 37,800
1/2 of 2004 Profits 36,000 73,800
Year ending 30th June, 2005 :
1/2 of 2004 36,000
1/2 of 2005 Profits 31,200 67,200
Total 2,12,400
Average 70,800
(ii) Super Profit :
Average profits earned 70,800
Less : Partner’s remuneration 45,000
Less : 8% on capital employed 12,480 57,480
Super Profits : 13,320

(iii) Goodwill @ three years’ purchase 39,960


Adjustment entries for Goodwill
Journal
Dr. Cr.
Rs. Rs.
Clever’s Capital Account Dr. 7,992
Dull’s Capital Account Dr. 7,992
To Wise’s Capital Account 15,984
(Adjusting entry passed for share of goodwill of wise
through remaining partners’ capital account in gaining
ratio)

8.38 COMMON PROFICIENCY TEST


Working Note:

Partner New Share Old Share Difference

4 4
Wise – - = - 10
10

1 3 2
Clever - =
2 10 10

1 3 2
Dull - =
2 10 10

SELF EXAMINATION QUESTIONS


I. Pick up the correct answer from the given choices:
1. The profits of last five years are Rs. 85,000; Rs. 90,000; Rs. 70,000; Rs. 1,00,000 and
Rs. 80,000. Find the value of goodwill, if it is calculated on average profits of last five
years on the basis of 3 years of purchase.
(a) Rs. 85,000. (b) Rs. 2,55,000. (c) Rs. 2,75,000. (d) Rs. 2,85,000.
2. The profits of last three years are Rs. 42,000; Rs. 39,000 and Rs. 45,000. Find out the
goodwill of two years purchase.
a. Rs. 42,000. b. Rs. 84,000. c. Rs. 1,26,000. d. Rs. 36,000.
3. The capital of A and B sharing profits and losses equally are Rs. 90,000 and Rs. 30,000
respectively. They value the goodwill of the firm at Rs. 84,000, which was not recorded
in the books. If goodwill is be raised now, by what amount each partner’s capital
account will be debited:
a. Rs. 21,000 and Rs. 63,000. b. Rs. 42,000 and Rs. 42,000.
c. Rs. 63,000 and Rs. 21,000. d. None of the above.
4. Find the goodwill of the firm using capitalization method from the following information:
Total Capital Employed in the firm Rs. 8,00,000
Reasonable Rate of Return 15%
Profits for the year Rs. 12,00,000
a. Rs. 82,00,000. b. Rs. 12,00,000. c. Rs. 72,00,000. d. Rs. 42,00,000
5. The capital of B and D are Rs. 90,000 and Rs. 30,000 respectively with the profit
sharing ratio 3:1. The new ratio, admissible after 01.04.2006 is 5:3. Goodwill valued
on 02.04.2006 as Rs. 84,000 will be credited to B and D’s capital by Rs………. and Rs.
…………
a. 63,000 and 21,000. b. 50,000 and 34,000.
c. 52,500 and 31,500. d. 60,000 and 24,000.

FUNDAMENTALS OF ACCOUNTING 8.39


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

6. The capital of B and D are Rs. 90,000 and Rs. 30,000 respectively with the profit
sharing ratio 3:1. The new ratio, admissible after 01.04.2006 is 5:3. The goodwill is
valued Rs. 80,000 as on that date. Amount payable by a gaining partner to a scarifying
partner is:
a. B will pay to D Rs. 10,000. b. D will pay to B Rs. 10,000.
c. B will pay to D Rs. 80,000. d. will pay to B Rs. 80,000.
7. A, B and C are equal partners. D is admitted to the firm for one-fourth share. D
brings Rs. 20,000 capital and Rs. 5,000 being half of the premium for goodwill. The
value of goodwill of the firm is
a. Rs. 10,000 b. Rs. 40,000. c. Rs. 20,000. d. None of the above..
8. The profits for 1998-99 are Rs. 2,000; for 1999-2000 is Rs. 26,100 and for 2000-01 is
Rs. 31,200. Closing stock for 1999-2000 and 2000-01 includes the defective items of
Rs. 2,200 and Rs. 6,200 respectively which were considered as having market value
NIL. Calculate goodwill on average profit method.
a. Rs. 23,700. b. Rs. 17,700. c. Rs. 13,700. d. Rs. 17,300.
9. A and B are partners with capitals of Rs. 10,000 and Rs. 20,000 respectively and
sharing profits equally. They admitted C as their third partner with one-fourth profits
of the firm on the payment of Rs. 12,000. The amount of hidden goodwill is .
a. 6,000. b. 10,000. c. 8,000. d. None of the above.
10. X and Y share profits and losses in the ratio of 2 : 1. They take Z as a partner and the
new profit sharing ratio becomes 3 : 2 : 1. Z brings Rs. 4,500 as premium for goodwill.
The full value of goodwill will be
(a) Rs. 4,500. (b) Rs. 18,000. (c) Rs. 27,000. (d) Rs. 24,000.
11. Under average profit basis goodwill is calculated by:
a. No. of years purchased multiplied with average profits.
b. No. of years purchased multiplied with super profits.
c. Summation of the discounted value of expected future benefits.
d. Super profit divided with expected rate of return.
12. Under super profit basis goodwill is calculated by:
a. No. of years purchased multiplied with average profits.
b. No. of years purchased multiplied with super profits.
c. Summation of the discounted value of expected future benefits.
d. Super profit divided with expected rate of return.
13. Under annuity basis goodwill is calculated by:
a. No. of years purchased multiplied with average profits.
b. No. of years purchased multiplied with super profits.

8.40 COMMON PROFICIENCY TEST


c. Summation of the discounted value of expected future benefits.
d. Super profit divided with expected rate of return.
14. Under capitalisation basis goodwill is calculated by:
a. No. of years purchased multiplied with average profits.
b. No. of years purchased multiplied with super profits.
c. Summation of the discounted value of expected future benefits.
d. Super profit divided with expected rate of return.
15. The following particulars are available in respect of the business carried on by a
partnership firm:
Trading Results:
2001 Loss Rs. 5,000
2002 Loss Rs. 10,000
2003 Profit Rs. 75,000
2004 Profit Rs. 60,000
You are required to compute the value of goodwill on the basis of 5 year’s purchase of
average profit of the business.
a. Rs. 1,25,000. b. Rs.1,50,000. c. Rs. 10,000. d. Rs. 1,20,000.
16. The profits and losses for the last years are 2001-02 Losses Rs. 10,000; 2002-03 Losses
Rs. 2,500; 2003-04 Profits Rs. 98,000 & 2004-05 Profits Rs. 76,000. The average capital
employed in the business is Rs. 2,00,000. The rate of interest expected from capital
invested is 12%. The remuneration of partners is estimated to be Rs. 1,000 per month.
Calculate the value of goodwill on the basis of two years purchase of super profits
based on the average of four years.
a. Rs. 9,000. b. Rs. 8,750. c. Rs. 8,500. d. Rs. 8,250.
17. The profits for the last three years are 2002-03 Rs. 42,500; 2003-04 Profits Rs. 56,000
& 2004-05 Profits Rs. 68,000. The total assets of the firm are Rs. 11,52,500 and the
total liabilities of the firm are Rs. 10,00,000 of which outsiders liabilities is Rs. 5,00,000.
The rate of interest expected from capital invested is 10%. Calculate the value of
goodwill on capitalization basis.
a. Rs. 97,000. b. Rs. 97,250. c. Rs. 97,500. d. Rs. 97,750.
18. The profits and losses for the last years are 2001-02 Losses Rs. 10,000; 2002-03 Losses
Rs. 2,500; 2003-04 Profits Rs. 98,000 & 2004-05 Profits Rs. 76,000. The average capital
employed in the business is Rs. 2,00,000. The rate of interest expected from capital
invested is 12%. The remuneration of partners is estimated to be Rs. 1,000 per month.
Calculate the value of goodwill on the basis of four years purchase of super profits
based on the annuity of the four years. Take discounting rate as 10%.
a. Rs. 13,500. b. Rs. 13,568. c. Rs. 13,668. d. Rs. 13,868.

FUNDAMENTALS OF ACCOUNTING 8.41


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

19. The profits and losses for the last years are 2001-02 Losses Rs. 10,000; 2002-03 Losses
Rs. 2,500; 2003-04 Profits Rs. 98,000 & 2004-05 Profits Rs. 76,000. The average capital
employed in the business is Rs. 2,00,000. The rate of interest expected from capital
invested is 12%. The remuneration of partners is estimated to be Rs. 1,000 per month.
Calculate the value of goodwill on the basis of four years purchase of super profits
based on the annuity of the four years. Take discounting rate as 10%.
a. Rs. 13,500. b. Rs. 13,568. c. Rs. 13,668. d. Rs. 13,868.
20. A, B and C are partners sharing profits and loss in the ratio 3:2:1. They decide to
change their profit sharing ratio to 2:2:1. To give effect to this new profit sharing ratio
they decide to value the goodwill at Rs. 30,000. Pass the necessary journal entry if
Goodwill not appearing in the old balance sheet and should not appear in the new
balance sheet.
a. B’s Capital Account Dr. 2,000
C’s Capital Account Dr. 1,000
To A’s Capital Account 3,000
b. Goodwill Account Dr. 30,000
To A’s Capital Account 15,000
To B’s Capital Account 10,000
To C’s Capital Account 5,000
c. A’s Capital Account Dr. 12,000
B’s Capital Account Dr. 12,000
C’s Capital Account Dr. 6,000
To Goodwill Account 30,000
d. A’s Capital Account Dr. 3,000
To B’s Capital Account 2,000
To C’s Capital Account 1,000
21. Goodwill brought in by incoming partner in cash for joining in a partnership firm is
taken away by the old partners in their ……… ratio.
a. Capital. b. New Profit Sharing. c. Sacrificing. d. Old Profit Sharing.
22. A & B are partners sharing profits and losses in the ratio 5:3. On admission C brings
Rs. 70,000 cash and Rs. 48,000 against goodwill. New profit sharing ratio between A,
B and C are 7:5:4. Find the sacrificing ratio as A:B
a. 3:1. b. 4:7. c. 5:4. d. 2:1.
23. Goodwill bought in by incoming partner in cash for joining in a partnership firm is
taken away by the old partners in:
a. Old Profit Sharing Ratio. b. New Profit Sharing Ratio.
c. Sacrificing Ratio. d. Capital Ratio.

8.42 COMMON PROFICIENCY TEST


24. A and B are partners with the capital Rs. 50,000 and Rs. 40,000 respectively. They share
profits and losses equally. C is admitted on bringing Rs. 50,000 as capital only and nothing
was bought against goodwill. Goodwill in Balance sheet of Rs. 20,000 is revalued as Rs.
35,000. What will be value of goodwill in the books after the admission of C?
a. Rs. 55,000. b. Rs. 35,000. c. Rs. 20,000. d. Rs. 15,000
25. Following are the factors affecting goodwill except:
a. Nature of business. b. Efficiency of management.
c. Technical know how. d. Location of the customers.
26. Weighted average method of calculating goodwill should be followed when:
a. Profits are uneven. b. Profits has increasing trend.
c. Profits has decreasing trend. d. Either ‘b’ or ‘c’.
27. In the absence of any provision in the partnership agreement, profits and losses are
shared
a. In the ratio of capitals. b. Equally.
c. In the ratio of loans given by them to the partnership firm. d.None of the above.
28. X, Y and Z are partners sharing profits and losses in the ratio 5:3:2 decide to share the
future profits in the ratio 2:3:5. What will be the treatment for workmen compensation
fund appearing in the balance sheet on the date if no information is available for the
same?
a. Distributed to the partners in old profit sharing ratio.
b. Distributed to the partners in new profit sharing ratio.
c. Distributed to the partners in capital ratio.
e. Carried forward to new balance sheet without any adjustment.
II Match the following items from column A with column B
S. No. Column A Column B
1. Goodwill is the intangible assets of the (a) is the number of years for which the
concern which helps it to earn goodwill is expected to generate extra
profits to the concern
2. Number of years purchased (b) is the method for calculating goodwill.
3. Change in profit sharing ratio means (c) super profits.
4. Average Profit Method. (d) Purchase of share of profits by one
partner from another

FUNDAMENTALS OF ACCOUNTING 8.43


TREATMENT OF GOODWILL IN PARTNERSHIP ACCOUNTS

ANSWERS

I. 1 (b), 2. (b), 3. (d), 4. (c), 5. (c), 6. (b),


7. (b), 8. (b), 9. (a), 10. (c), 11. (a), 12. (b),
13. (c), 14. (d), 15. (b), 16. (b), 17. (c), 18. (d),
19. (d), 20 (a), 21. (c), 22. (a), 23. (c), 24. (b),
25. (d), 26. (d), 27. (b), 28. (a),

II. 1.(c), 2(a), 3(d), 4(b)

8.44 COMMON PROFICIENCY TEST


CHAPTER - 8

PARTNERSHIP
ACCOUNTS

Unit 3

Admission
of
New Partner
FUNDAMENTALS OF ACCOUNTING 8.45
ADMISSION OF NEW PARTNER

Learning Objectives :
After studying this unit, you will be able to :
 Understand the reasons for which revaluation of assets and recomputation of liabilities
is required in case of admission of a new partner. Also understand the logic of revaluation
of assets and recomputation of liabilities at the time of admission of a partner.
 Learn the accounting treatments under two circumstances :
(a) When revalued assets and recomputed liabilities are shown in the Balance Sheet,
and
(b) When revalued assets and recomputed liabilities are not shown in the Balance Sheet
 Learn the technique of treating reserve balance on admission of a partner.
 See the technique of arriving at new profit-sharing ratio.
 Observe the technique of inferring goodwill although figure of goodwill is not mentioned
clearly.

1. INTRODUCTION
New partners are admitted for the benefit of the partnership firm. New partner is admitted
either for increasing the partnership capital or for strengthening the management of the firm.
When a new partner joins a firm, it is desirable to bring all appreciation or reduction in the
value of assets into accounts as on the date of admission. Similarly, if the books contain any
liability which has not been paid or if the books do not contain a liability which has to be paid,
suitable entries should be passed. The purpose of such entries is to make an updated Balance
Sheet on the date of admission. Also, all profits which have accrued but not yet brought into
books and similarly, all losses which have occurred but not recorded, should now be brought
into books so that the Capital Accounts of the old partners reflect the proper figure. As a result
of passing of such entries, any subsequent profits or losses will be automatically shared by the
incoming partner along with old partners.
Also the value of goodwill is to be assessed and proper accounting treatment is required to
bring the value of goodwill into books accounts. Treatment for goodwill has already been
discussed in unit 2 of this chapter.
2. REVALUATION ACCOUNT OR PROFIT AND LOSS
ADJUSTMENT ACCOUNT
When a new partner is admitted into the partnership, assets are revalued and liabilities are
reassessed. A Revaluation Account (or Profit and Loss Adjustment Account) is opened for the
purpose. This account is debited with all reduction in the value of assets and increase in liabilities
and credited with increase in the value of assets and decrease in the value of liabilities. The
difference in two sides of the account will show profit or loss. This is transferred to the Capital
Accounts of old partners in the old profit sharing ratio. The entries to be passed are :

8.46 COMMON PROFICIENCY TEST


1. Revaluation Account
To Assets Account Dr. with the reduction in the value of the assets
(individually which show a decrease)
To the Liabilities (Individually which with the increase in the liabilities.
have to be increased)
2. Assets Account (Individually) Dr. with the increase in the value of the of assets
Liabilities Accounts with the reduction in the amount liabilities
To Revaluation Acount
3. Revaluation Account Dr. with the profit in the old profit sharing ratio.
To Capital A/cs of the old partners
or,
Capital A/cs of the old partners Dr. with the loss in old profit sharing ratio.
To Revaluation Account
As a result of the above entries, the capital account balances of the old partners will change
and the assets and liabilities will have to be adjusted to their proper values. They will now
appear in the Balance Sheet at revised figures. Alternatively, the partners may agree that
revalued figures will not be shown in the Balance Sheet and Assets and liabilities would appear
in the Balance Sheet at their old values. For this, one additional entry is necessary.
Capital A/cs Dr. with the amount of revaluation
(of all partners including Profit in the new Profit sharing ratio.
newly admitted partner)
To Revaluation A/c
or,
Revaluation A/c Dr. with the amount of revaluation loss
To Capital A/cs in the new profit sharing ratio.
(of all partners including
newly admitted partners)
Alternatively, in case partners desire to disclose assets and liabilities in the balane sheet at
old figures then the change (i.e. increase or decrease) in the value of assets and liabilities
may be adjusted through Partners’ Capital Accounts directly instead of using Revaluation
Account.

FUNDAMENTALS OF ACCOUNTING 8.47


ADMISSION OF NEW PARTNER

Illustration 1
The following is the Balance Sheet of Ram and Mohan (who share Profits in the ratio of 3:2) as
on 1st January, 2006 :
Liabilities Rs. Assets Rs.
Sundry Creditors 15,000 Buildings 18,000
Ram’s Capital 20,000 Plant and Machinery 15,000
Mohan’s Capital 25,000 Stock 12,000
Debtors 10,000
Bank 5,000
60,000 60,000
On this date Shyam was admitted on the following :
1. He is to pay Rs. 25,000 as his capital and Rs. 10,000 as his share of goodwill for one fifth
share in profits.
2. The new profits sharing ratio will be 5:3:2.
3. The assets are to be revalued as under :
Rs.
Building 25,000
Plant and Machinery 12,000
Stock 12,000
Debtors (because of doubtful debts) 9,500
4. It was found that there was a liability for Rs. 1,500 for goods received but not recorded in
books.
Give journal entries to record the above.
Solution
Journal Entries
2006 Dr. Cr.
Jan. 1 Bank Account Dr. 35,000
To Shyam’s Capital Account 35,000
(Amount brought in by Shyam for capital
and goodwill)
Shyam’s Capital Account Dr. 10,000
To Ram’s Capital Account 5,000
To Mohan’s Capital Account 5,000
Shyam’s share of goodwill adjusted
to existing partners’ capital

8.48 COMMON PROFICIENCY TEST


accounts in the profit sacrificing ratio 1:1)
Revaluation Account Dr. 5,000
To Plant and Machinery Account 3,000
To Provisions for Doubtful Debts Account 500
To Sundry Creditors Account 1,500
(Recording of the reduction in the value of
assets and the liability which had been
previously omitted)
Building Account Dr. 7,000
To Revaluation Account 7,000
(Increase in the value of building brought
into account)
Revaluation Account Dr. 2,000
To Ram’s Capital Account 1,200
To Mohan’s Capital Account 800
(Profit on revaluation credited to Ram and
Mohan in the old profit sharing ratio)
Working Note
Profit sacrificing ratio:
3/5 less1/2 = 1/10
2/5 less 3/10 = 1/10
Illustration 2
Continuing with the same illustration 1, let us also give the Balance Sheet of the partnership
firm after Shyam’s admission .
Solution
Balance Sheet of Ram, Mohan and Shyam as at January 1, 2006
Liabilities Rs. Assets Rs.
Sundry Creditors 16,500 Buildings 25,000
Capital Account Plant and Machinery 12,000
Ram 26,200 Stock 12,000
Mohan 30,800 Sundry Debtors 10,000
Shyam 25,000 82,000 Less : Provision for
Doubtful Debts 500 9,500
Bank 40,000
98,500 98,500

FUNDAMENTALS OF ACCOUNTING 8.49


ADMISSION OF NEW PARTNER

Illustration 3
A and B are partners in a firm, sharing profits and losses in the ratio of 3:2. The Balance Sheet
of A and B as on 1.1.2006 was as follows:
Liabilities Amount Assets Amount
Rs. Rs. Rs.
Sundry creditors 12,900 Building 26,000
Bills payable 4,100 Furniture 5,800
Bank overdraft 9,000 Stock-in-trade 21,400
Capital accounts: Debtors 35,000
A 44,000 Less: Provision 200 34,800
B 36,000 80,000 Investment 2,500
Cash 15,500
1,06,000 1,06,000

‘C’ was admitted to the firm on the above date on the following terms:
(i) He is admitted for 1/6 share in the future profits and to introduce a capital of Rs. 25,000.
(ii) The new profit sharing ratio of A, B and C will be 3:2:1 respectively.
(iii) ‘C’ is unable to bring in cash for his share of goodwill, partners therefore, decided to raise
goodwill account in the books of the firm. They further decide to calculate goodwill on the
basis of C’s share in the profits and the capital contribution made by him to the firm.
(iv) Furniture is to be written down by Rs. 870 and stock to be depreciated by 5%. A provision
is required for debtors @ 5% for bad debts. A provision would also be made for outstanding
wages for Rs. 1,560. The value of buildings having appreciated be brought upto Rs. 29,200.
The value of investments is increased by Rs. 450.
(vi) It is found that the creditors included a sum of Rs. 1,400, which is not to be paid off.
Prepare the following:
(i) Revaluation account.
(ii) Partners’ capital accounts.

8.50 COMMON PROFICIENCY TEST


Solution
Revaluation Account
Dr. Cr.
Rs. Rs.
To Furniture 870 By Building 3,200
To Stock 1,070 By Sundry creditors 1,400
To Provision for doubtful debts By Investment 450
(Rs. 1,750-Rs. 200) 1,550
To Outstanding wages 1,560
5,050 5,050

Partners’ Capital Accounts


Dr. Cr.
A B C A B C
Rs. Rs. Rs. Rs. Rs. Rs.
To Balance b/d 71,000 54,000 25,000 By Balance b/d 44,000 36,000 –
By Cash A/c – – 25,000
By Goodwill A/c
(working note) 27,000 18,000 –
71,000 54,000 25,000 71,000 54,000 25,000

Working Note :
Calculation of goodwill:
C’s contribution of Rs. 25,000 consists of only 1/6th of capital.
Therefore, total capital of firm should be Rs. 25,000 x 6 = Rs. 1,50,000
But combined capital of A, B and C amounts Rs. 44,000 + 36,000 + 25,000 = Rs. 1,05,000
Thus, the hidden goodwill is Rs. 45,000 (Rs. 1,50,000 - Rs. 1,05,000).

3. RESERVES IN THE BALANCE SHEET


Whenever a new partner is admitted, any reserve etc. lying in the Balance Sheet should be
transferred to the Capital Accounts of the old partners in the old profit sharing ratio. (In
examination problems it should be done even if there are no instructions on this point).

FUNDAMENTALS OF ACCOUNTING 8.51


ADMISSION OF NEW PARTNER

Illustration 4
Dalal, Banerji and Mallick are a firm sharing profits and losses in the ratio 2:2:1. Their Balance
Sheet as on 31st March, 2006 is as below :
Liabilities Rs. Assets Rs.
Sundry Creditors 12,850 Land and Buildings 25,000
Outstanding Liabilities 1,500 Furniture 6,500
General Reserve 6,500 Stock of goods 11,750
Capital Account : Sundry Debtors 5,500
Mr. Dalal 12,000 Cash in hand 140
Mr. Banerji 12,000 Cash at Bank 960
Mr. Mallick 5,000 29,000
49,850 49,850
The partners have agreed to take Mr. Mistri as a parner with effect from 1st April, 2006 on the
following terms :
(1) Mr. Mistri shall bring Rs. 5,000 towards his capital.
(2) The value of stock should be increased by Rs. 2,500 and Furniture should be depreciated
by 10%.
(3) Reserve for bad and doubtful debts should be provided at 10% of the debtors.
(4) The value of land and buildings should be enhanced by 20% and the value of the goodwill
be fixed at Rs. 15,000.
(5) The value of the goodwill be fixed at Rs. 15,000.
(6) General Reserve will be transferred to the Partner’s Capital Accounts.
(7) The new profit sharing ratio shall be : Mr. Dalal 5/15, Mr. Banerji 5/15,Mr. Mallick 3/15
and Mr. Mistri 2/15.
(8) The goodwill account shall be written back to the partner’s account in accordance with
the new profit sharing proportion.
The outstanding liabilities include Rs. 1,000 due to Mr. Sen which has been paid by Mr. Dalal.
Necessary entries were not made in the books.
Prepare (i) Revaluation Account, and (ii) The Capital Accounts of the partners, and (iii) the
Balance Sheet of the firm as newly constituted (Journal entries are not required)

8.52 COMMON PROFICIENCY TEST


Solution
Revaluation Account
2006 Rs. 2006 Rs.
April1 To Provision for bad and April 1 By Stock in trade 2,500
doubtful debts 550 “ By Land and Building 5,000
“ To Furniture and fittings 650
“ Capital A/cs
Profit on revaluation
transferred
Dalal 2,520
Banerji 2,520
Mallick 1,260 6,300
7,500 7,500
Partners’ Capital Accounts
Dr. Cr.
Particulars Dalal Banerji Mallick Mistri Particulars Dalal Benerji Mallick Mistri
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
To Goodwill 5,000 5,000 3,000 2,000 By Balance b/d 12,000 12,000 5,000 –
To Balance c/d 19,120 18,120 7,560 3,000 By General
Reserve 2,600 2,600 1,300
By Cash – – – 5,000
By Goodwill 6,000 6,000 3,000 –
By Outstanding
Liabilities 1,000 – – –
By Revaluation
A/c
2,520 2,520 1,260 –

24,120 23,120 10,560 5,000 24,120 23,120 10,560 5,000

Illustration 5
With the information given in illustration 4, after preparing revaluation account and partners’
capital accounts, prepare the Balance Sheet of the firm after admission of Mr. Mistri.

FUNDAMENTALS OF ACCOUNTING 8.53


ADMISSION OF NEW PARTNER

Solution
Balance Sheet of M/s. Dalal, Banerji, Mallick and Mistri as on 1-4-2006
Liabilities Rs. Assets Rs.
Sundry Creditors 12,850 Land and Buildings 30,000
Outstanding Liabilities 500 Furniture 5,850
Capital Account of Partners :
Stock of goods 14,250
Mr. Dalal 19,120 Sundry Debtors 5,500
Mr. Banerji 18,120 Less : Provisions 550 4,950
Mr. Mallick 7,560 Cash in hand 140
Mr. Mistri 3,000 47,800 Cash at Bank 5,960
61,150 61,150

4. COMPUTATION OF NEW PROFIT SHARING RATIO


When a new partner is admited and there is no agreement to the contrary, it is supposed that
old partners will continue to have inter se at the old profit sharing ratio.
For example, A and B are in partnership sharing profits and losses at the ratio of 3:2. They
admitted C as 1/5 partner. For computation of new profit sharing ratio.
(i) Firstly, deduct the share offered to new partner from 1.
1 – 1/5 = 4/5
(ii) Divide the balance of share between A and B at the ratio of 3:2.
A – 4/5 x 3/5 = 12/25
B – 4/5 × 2/5 = 8/25
(iii) New profit sharing ratio is
A : B :C
12/25 : 8/25 : 1/5
or 12/25 : 8/25 : 5/25
i.e. 12 : 8 : 5
Illustration 6
A and B are in partnership sharing profits and losses at the ratio 3:2. They take C as a new
partner. Calculate the new profit sharing ratio if -
(i) C Purchases 1/10 share from A
(ii) A and B agree to sacrifice 1/10th share to C in the ratio of 2 : 3

8.54 COMMON PROFICIENCY TEST


(iii) Simply gets 1/10th share of profit.
Solution
(i) New profit sharing ratio :
A 3/5 – 1/10 = 5/10
B 2/5 i.e. 4/10
C 1/10
i.e. 5 : 4 : 1
(ii) A’s sacrifice 1/10× 2/5 = 2/50
B’s sacrifice 1/10 × 3/5 = 3/50
New profit sharing ratio
A 3/5 – 2/50 = 28/50
B 2/5 – 3/50 = 17/50
C 1/10 i.e. 5/50
i.e. 28 : 17 : 5
(iii) Balance of share to be divided between A and B :
1 – 1/10= 9/10
Distribution :
A : 9/10 × 3/5 = 27/50
B: 9/10 × 2/5 = 18/50
C: 1/10. i.e. = 5/50
i.e. 27 : 18 : 5
Illustration 7
A and B are in the partnership sharing profits and losses in the proportion of three-fourth and
one-fourth respectively. Their balance sheet as on 31st March, 2005 was as follows:
Cash Rs. 1,000; sundry debtors Rs. 25,000; stock Rs. 22,000: plant and machinery Rs. 4,000;
sundry creditors Rs. 12,000; bank overdraft Rs. 15,000; A’s capital Rs. 15,000; B’s capital
Rs. 10,000.
On 1st April, 2005, they admitted C into partnership on the following terms:
(i) C to purchase one–third of the goodwill for Rs. 2,000 and provide Rs. 10,000 as capital.
Goodwill not to appear in books.
(ii) Further profits and losses are to be shared by A, B and C equally.
(iii) Plant and machinery is to be reduced by 10% and Rs. 500 is to be provided for estimated
bad debts. Stock is to be taken at a valuation of Rs. 24,940.

FUNDAMENTALS OF ACCOUNTING 8.55


ADMISSION OF NEW PARTNER

(iv) By bringing in or withdrawing cash and capitals of A and B are to be made proportionate
to that of C on their profit-sharing basis.
Set out entries to the above arrangement in the firm’s journal, give the partners’ capital accounts
in tabular form.
Solution
Journal Entries
as on 1st April, 2005
Dr. (Rs.) Cr. (Rs.)
Revaluation Account Dr. 900
To Plant and machinery Account 400
To Provision for bad debts Account 500
(Plant & machinery reduced by 10% and
Rs. 500 provided for bad debts)
Stock Account Dr. 2,940
To Revaluation Account 2,940
(Value of stock increased by Rs. 2,940)
Revaluation Account Dr. 2,040
To A’s capital Account 1,530
To B’s capital Account 510
(Profit on revaluation transferred)
Cash Account Dr. 10,000
To C’s capital Account 10,000
(Cash brought in by C as his capital)
Cash Account Dr. 2,000
B’s capital Account Dr. 500
To A’s capital Account 2,500
(Entry for goodwill purchased by B and C)
A’s capital Account Dr. 9,030
B’s capital Account Dr. 10
To Cash Account 9,040
(Excess amount of capital withdrawn)

8.56 COMMON PROFICIENCY TEST


Partners’ Capital Accounts
Dr. Cr.
A B C A B C
Rs. Rs. Rs. Rs. Rs. Rs.
To A’s capital A/c - 500 By Balance b/d 15,000 10,000 –
To Cash 9,030 10 By Revaluation A/c 1,530 510 –
To Balance b/d 10,000 10,000 10,000 By Cash 2,000 – 10,000
By B’s Capital A/c 500
19,030 10,510 10,000 19,030 10,510 10,000

Working Note:
Calculation of goodwill
C pays Rs. 2,000 on account of goodwill for 1/3rd share of profit/loss. Total goodwill is
Rs. 2,000 x 3 = Rs. 6,000.
Gaining ratio:
B: 1/3-1/4 = 1/12
C: 1/3
Goodwill to be paid to A:
By B Rs. 6,000 x 1/12 = Rs. 500
By C Rs. 6,000 x 1/3 = Rs. 2,000
Total Rs. 2,500
Illustration 8
A and B are partners of X & Co. sharing profits and losses in 3:2 ratio between themselves. On
31st March, 2006, the balance sheet of the firm was as follows:
Balance Sheet of X & Co. as at 31.3.2006
Liabilities Rs. Rs. Assets Rs.
Capital accounts: Plant and machinery 20,000
A 37,000 Furniture and fittings 5,000
B 28,000
65,000 Stock 15,000
Sundry creditors 5,000 Sundry debtors 20,000
Cash in hand 10,000
70,000 70,000

FUNDAMENTALS OF ACCOUNTING 8.57


ADMISSION OF NEW PARTNER

X agrees to join the business on the following conditions as and from 1.4.2006:
(a) He will introduce Rs. 25,000 as his capital and pay Rs. 15,000 to the partners as premium
for goodwill for 1/3rd share of the future profits of the firm.
(b) A revaluation of assets of the firm will be made by reducing the value of plant and machinery
to Rs. 15,000, stock by 10%, furniture and fitting by Rs. 1,000 and by making a provision
of bad and doubtful debts at Rs. 750 on sundry debtors.
Prepare profit and loss adjustment account, capital accounts of partners including the incoming
partner X assuming that the relative ratios of the old partners will be in equal proportion after
admission.
Solution
Profit and Loss Adjustment Account
Dr. Cr.
2006 Rs. 2006 Rs.
April 1 April 1
To Plant and machinery A/c 5,000 By Partners’ capital
accounts
To Stock A/c 1,500 - Loss on revaluation
To Furniture and fitting A/c 1,000 A (3/5) 4,950
Provision for bad and doubtful debts 750 B (2/5) 3,300 8,250
8,250 8,250

Partners’ Capital Accounts


Dr. Cr.
A B X A B X
Rs. Rs. Rs. Rs. Rs. Rs.
To Profit & loss
adjustment A/c 4,950 3,300 – By Balance b/d 37,000 28,000 –
By Cash A/c – – 40,000
To A’s & B’s capital – – 15,000 By X’s capital
A/cs A/c 12,000 3,000 –
To Balance c/d 44,050 27,700 25,000 [W. N.(ii)]
49,000 31,000 40,000 49,000 31,000 40,000

8.58 COMMON PROFICIENCY TEST


Working Notes:
(i) New profit sharing ratio :
On admission of X who will be entitled to 1/3rd share of the future profits of the firm. A
and B would share the remaining 2/3rd share in equal proportion i.e. 1:1.
A: 2/3 x 1/2 = 1/3
B: 2/3 x 1/2 = 1/3
X:1/3
A, B and X would share profits and losses in equal ratio.
(ii) Adjustment of goodwill :
X pays Rs. 15,000 as premium for goodwill for 1/3rd share of the future profits.
Thus, total value of goodwill is Rs. 15,000 x 3 i.e. Rs. 45,000
Sacrificing ratio:
A: 3/5 - 1/3 = 4/15
A: 2/5 - 1/3 = 1/15
Hence, sacrificing ratio is 4:1
Adjustment of X’s share of goodwill through existing partners’ capital accounts in the
profit sacrificing ratio:
Rs.
A: 15,000 x 4/5 = 12,000
B: 15,000 x 1/5 = 3,000
15,000

5. PROPORTIONATE CAPITAL AND INFERENCE OF GOODWILL


‘Proportionate Capital’ means Capital Account balances of partners in accordance with the
profit sharing ratio. In other words, ratio of Capital Account balances is equal to profit sharing
ratio. Proportionate capital is maintained generally following ‘fixed capital method’ (Unit 1).
For example, A and B are in partnership, sharing profit or loss in the ratio of 3:2.
If total capital is Rs. 1,00,000. A should contribute Rs. 1,00,000 × 3/5 i.e. Rs. 60,000 and B
should contribute Rs. 1,00,000 × 2/5 i.e. Rs. 40,000.
The question of inferring goodwill arises only in case of proportionate capital. If the newly
admitted partner brings capital more than what is required as per profit sharing ratio, then it
is to be presumed that he has contributed the excess for goodwill. For example, A and B are in
partnership who contributed proportionate capital of Rs. 60,000 and Rs. 40,000. Now they
want to admit C giving him 1/5th share for which C agrees to bring Rs. 30,000. Since total
capital is Rs. 1,00,000, C should contribute Rs. 20,000 (Rs. 1,00,000 x 1/5) for1/5th share.

FUNDAMENTALS OF ACCOUNTING 8.59


ADMISSION OF NEW PARTNER

Instead he agrees to pay Rs. 30,000. So for 1/5th share he is paying Rs. 10,000, for goodwill.
Thus total value of goodwill is Rs. 10,000 × 5 i.e. Rs. 50,000.
Illustration 9
A and B are in partnership sharing profits and losses equally. The Balance Sheet M/s. A and B
as on 31.12.2005, was as follows :
Liabilities Rs. Assets Rs.
Capital A/cs Sundry Fixed Assets 60,000
A 45,000 Stock 30,000
B 45,000 Bank 20,000
Sundry Creditors 20,000
1,10,000 1,10,000
On 1.1.2006 they agreed to take C as 1/3rd partner to increase the capital base to Rs. 1,35,000.
C agrees to pay Rs. 60,000. Show the necessary journal entries and partners’ capital accounts.
Solution
In the Books of M/s. A, B and C
Journal Entries
Rs. Rs.
Bank A/c Dr. 60,000
To C’s Capital A/c 60,000
(Cash brought in by C for 1/3rd share)
Goodwill A/c Dr. 45,000
To A’s Capital A/c 22,500
To B’s Capital A/c 22,500
(Inferred value of goodwill raised in the books)
A’s Capital A/c Dr. 15,000
B’s Capital A/c Dr. 15,000
C’s Capital A/c Dr. 15,000
To Goodwill A/c 45,000
(Value of goodwill written off in the new profit sharing ratio)
A’s Capital A/c Dr. 7,500
B’s Capital A/c Dr. 7,500
To Bank 15,000
(Amount of goodwill due to A and B withdrawn)

8.60 COMMON PROFICIENCY TEST


Workings :
(1) Old Profit Sharing Ratio : 1 : 1
(2) New Profit Sharing Ratio : 1:1:1
(3) C’s share of capital Rs. 1,35,000 × 1/3 = Rs. 45,000
(4) Goodwill Rs. 60,000 – Rs. 45,000 = Rs. 15,000 for 1/3rd share.
Total Goodwill : Rs. 15,000 × 3 = Rs. 45,000
Partners Capital A/cs
Dr. Cr.
Particulars A B C Particulars A B C
Rs. Rs. Rs. Rs. Rs. Rs.
To Goodwill 15,000 15,000 15,000 By Balance b/d 45,000 45,000 –
To Bank 7,500 7,500 – By Bank – – 60,000
To Balance c/d 45,000 45,000 45,000 By Goodwill A/c 22,500 22,500 –
67,500 67,500 60,000 67,500 67,500 60,000

SELF EXAMINATION QUESTIONS


PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES :
1. A and B are partners sharing profits and losses in the ratio 5:3. They admitted C and
agreed to give him 3/10th of the profit. What is the new ratio after C’s admission?
a. 35:42:17. b. 35:21:24. c. 49:22:29. d. 34:20:12.
2. A and B are partners sharing profits in the ratio 5:3, they admitted C giving him 3/10th
share of profit. If C acquires 1/5th share from A and 1/10th from B, new profit sharing
ratio will be:
a. 5:6:3. b. 2:4:6. c. 18:24:38. d. 17:11:12
3. C was admitted in a firm with 1/4 share of the profits of the firm. C contributes Rs.
th

15,000 as his capital, A and B are other partners with the profit sharing ratio as 3:2. Find
the required capital of A and B, if capital should be in profit sharing ratio taking C’s as
base capital:
a. Rs. 27,000 and Rs. 16,000 for A and B respectively.
b. Rs. 27,000 and Rs. 18,000 for A and B respectively.
c. Rs. 32,000 and Rs. 21,000 for A and B respectively.
d. Rs. 31,000 and Rs. 26,000 for A and B respectively.
4. A, B and C are partners sharing profits and losses in the ratio 6:3:3, they agreed to take D
into partnership for 1/8th share of profits. Find the new profit sharing ratio.
a. 12:27:36:42. b. 14:7:7:4. c. 1:2:3:4. d. 7:5:3:1.

FUNDAMENTALS OF ACCOUNTING 8.61


ADMISSION OF NEW PARTNER

5. X and Y are partners sharing profits in the ratio 5:3. They admitted Z for 1/5th share of
profits, for which he paid Rs. 1,20,000 against capital and Rs. 60,000 against goodwill.
Find the capital balances for each partner taking Z’s capital as base capital.
a. 3,00,000; 1,20,000 and 1,20,000. b. 3,00,000; 1,20,000 and 1,80,000.
c. 3,00,000; 1,80,000 and 1,20,000. d. 3,00,000; 1,80,000 and 1,80,000.
6. A and B are partners sharing profits and losses in the ratio of 3:2 (A’s Capital is Rs. 30,000
and B’s Capital is Rs. 15,000). They admitted C agreed to give 1/5th share of profits to him.
How much C should bring in towards his capital?
a. Rs. 9,000. b. Rs. 12,000. c. Rs. 14,500. d. Rs. 11,250.
7. A and B are partners sharing the profit in the ratio of 3:2. They take C as the new partner,
who brings in Rs. 25,000 against capital and Rs. 10,000 against goodwill. New profit sharing
ratio is 1:1:1. In what ratio will this amount will be shared among the old partners A & B.
a. 8,000:2,000. b. 5,000:5,000.
c. Old partners will not get any share in the goodwill bought in by C.
d. 6,000:4,000.
8. A and B are partners sharing the profit in the ratio of 3:2. They take C as the new partner,
who is supposed to bring Rs. 25,000 against capital and Rs. 10,000 against goodwill. New
profit sharing ratio is 1:1:1. C is able to bring Rs. 30,000 only. How this will be treated in
the books of the firm.
a. A and B will share goodwill bought by C as 4,000:1,000.
b. Goodwill will be raised to Rs. 15,000 in old profit sharing ratio.
c. Both. d. None.
9. A and B are partners sharing the profit in the ratio of 3:2. They take C as the new partner,
who is supposed to bring Rs. 25,000 against capital and Rs. 10,000 against goodwill. New
profit sharing ratio is 1:1:1. C is able to bring only his share of Capital. How this will be
treated in the books of the firm.
a. A and B will share goodwill bought by C as 4,000:1,000.
b. Goodwill will be raised to Rs. 30,000 in old profit sharing ratio.
c. Both. d. None.
10. A and B are partners sharing the profit in the ratio of 3:2. They take C as the new partner,
who is supposed to bring Rs. 25,000 against capital and Rs. 10,000 against goodwill. New
profit sharing ratio is 1:1:1. C bought cash for his share of Capital and agreed to compensate
to A and B outside the firm. How this will be treated in the books of the firm.
a. Cash bought in by C will only be credited to his capital account.
b. Goodwill will be raised to full value in old ratio.
c. Goodwill will be raised to full value in new ratio.

8.62 COMMON PROFICIENCY TEST


d. Cash bought by C will be credited to his account and debited with his share of goodwill,
which will be debited to A and B’s account in sacrificing ratio.
11. Profit or loss on revaluation is shared among the partners in ……… ratio.
a. Old Profit Sharing. b. New Profit Sharing.
c. Capital. d. Equal.
12. Amit and Anil are partners of a partnership firm sharing profits in the ratio of 5:3
respectively. Atul was admitted on the following terms: Atul would pay Rs. 50,000 as
capital and Rs. 16,000 as Goodwill, for 1/5 th share of profit. Machinery would be
appreciated by 10% (book value Rs. 80,000) and building would be depreciated by 20%
(Rs. 2,00,000). Unrecorded debtors of Rs. 1,250 would be bought into books now and a
creditors amounting to Rs. 2,750 died and need not to pay anything to its estate. Find the
distribution of profit/loss on revaluation between Amit, Anil and Atul.
a. Loss – 17,500:10,500:0. b. Loss – 14,000:8,400:5,600.
c. Profits – 17,500:10,500:0. d. Profits – 14,000:8,400:5,600.
13. A and B, who share profits and losses in the ratio of 3:2 has the following balances: Capital
of A Rs. 50,000; Capital of B Rs. 30,000; Reserve Fund Rs. 15,000. They admit C as a
partner, who contributes to the firm Rs. 25,000 for 1/6th share in the partnership. If C is to
purchase 1/6th share in the partnership from the existing partners A and B in the ratio of
3:2 for Rs. 25,000, find closing capital of C.
a. Rs. 25,000. b. Rs. 19,000. c. Rs. 20,000. d. Rs. 18,000.
14. Amit and Anil are partners of a partnership firm sharing profits in the ratio of 5:3 with
capital of Rs. 2,50,000 & Rs. 2,00,000 respectively. Atul was admitted on the following
terms: Atul would pay Rs. 50,000 as capital and Rs. 16,000 as Goodwill, for 1/5th share of
profit. Find the balance of capital accounts after admission of Atul.
a. 2,60,000:2,06,000:50,000. b. 2,20,000:1,82,000:66,000.
c. 2,92,500:2,25,500:50,000. d. 2,82,500:2,19,500:66,000.
15. A and B shares profit and losses equally. They admit C as an equal partner and assets
were revalued as follow: Goodwill at Rs. 30,000 (book value NIL). Stock at Rs. 20,000
(book value Rs. 12,000); Machinery at Rs. 60,000 (book value Rs. 55,000). C is to bring in
Rs. 20,000 as his capital and the necessary cash towards his share of Goodwill. Goodwill
Account will not remain in the books. Find the profit/loss on revaluation to be shared
among A, B and C.
a. 21,500:21,500:0. b. 6,500:6,500:0. c. 14,333:14,333:14,333. d. 4,333:4,333:4,333.
16. A and B shares profit and losses equally. They admit C as an equal partner and goodwill
was valued as Rs. 30,000 (book value NIL). C is to bring in Rs. 20,000 as his capital and the
necessary cash towards his share of Goodwill. Goodwill Account will not remain in the
books. What will be the final effect of goodwill in the partner’s capital account?
a. A & B’s account credited with Rs. 5,000 each.

FUNDAMENTALS OF ACCOUNTING 8.63


ADMISSION OF NEW PARTNER

b. All partners’ account credited with Rs. 10,000 each.


c. Only C’s account credited with Rs. 10,000 as cash bought in for goodwill.
d. Final effect will be nil in each partner.
17. A and B shares profit and losses equally. They admit C as an equal partner and goodwill
was valued as Rs. 30,000 (book value NIL). C is to bring in Rs. 20,000 as his capital and the
necessary cash towards his share of Goodwill. Goodwill Account will not remain in the
books. If profit on revaluation is Rs. 13,000, find the closing balance of the capital account.
a. 31,500:31,500:20,000. b. 31,500:31,500:30,000.
c. 26,500:26,500:30,000. d. 20,000:20,000:20,000.
18. Balance sheet prepared after the new partnership agreement, assets and liabilities are
recorded at:
a. Original Value. b. Revalued Figure.
c. At realisable value. d. At current cost.
19. P and Q are partners sharing Profits in the ratio of 2:1. R is admitted to the partnership
with effect from 1st April on the term that he will bring Rs. 20,000 as his capital for 1/4th
share and pays Rs. 9,000 for goodwill, half of which is to be withdrawn by P and Q. How
much cash can P & Q withdraw from the firm (if any).
a. 3,000:1,500. b. 6,000:3,000.
c. NIL. d. None of the above.
20. P and Q are partners sharing Profits in the ratio of 2:1. R is admitted to the partnership
with effect from 1st April on the term that he will bring Rs. 20,000 as his capital for 1/4th
share and pays Rs. 9,000 for goodwill, half of which is to be withdrawn by P and Q. If
profit on revaluation is Rs. 6,000 and opening capital of P is Rs. 40,000 and of Q is Rs.
30,000, find the closing balance of each capital.
a. 47,000:33.500:20,000. b. 50,000:35,000:20,000.
c. 40,000:30,000:20,000. d. 41,000:30,500:29,000.
21. Adam, Brain and Chris were equal partners of a firm with goodwill Rs. 1,20,000 shown in
the balance sheet and they agreed to take Daniel as an equal partner on the term that he
should bring Rs. 1,60,000 as his capital and goodwill, his share of goodwill was evaluated
at Rs. 60,000 and the goodwill account is to be written off before admission. What will be
the treatment for goodwill?
a. Write off the goodwill of Rs. 1,20,000 in old ratio.
b. Cash bought in by Daniel for goodwill will be distributed among old partners in
sacrificing ratio.
c. Both.
d. None.

8.64 COMMON PROFICIENCY TEST


22. Which of the following asset is compulsory to revalue at the time of admission of a new
partner:
a. Stock. b. Fixed Assets. c. Investment. d. Goodwill.
23.X and Y are partners sharing profits in the ratio of 3 : 1. They admit Z as a partner who pays
Rs. 4,000 as Goodwill the new profit sharing ratio being 2 : 1 : 1 among X, Y and Z
respectively. The amount of goodwill will be credited to :
a. X and Y as Rs. 3,000 and Rs. 1,000 respectively.
b. X only
c. Y only.
d. None of the above.

ANSWERS
1. (b), 2. (d), 3. (b), 4. (b), 5. (c),

6. (d), 7. (a), 8. (c), 9. (b), 10. (a),

11. (a), 12. (a), 13. (b), 14. (a), 15. (b),

16. (a), 17. (a), 18. (b), 19. (a), 20. (a),

21. (c), 22. (d), 23. (b)

FUNDAMENTALS OF ACCOUNTING 8.65


CHAPTER - 8

PARTNERSHIP
ACCOUNTS

Unit 4

Retirement
of a Partner
Learning objectives
After studying this unit, you will be able to :
 Learn how to compute the gaining ratio and observe the use of such gaining ratio,
 Be familiar with the accounting treatment in relation to revaluation of assets and liabilities,
 Learn the accounting entries to be passed for transfer of reserves standing in the balance
sheet to partners’ capital accounts in a manner already discussed for admission of a
partner in unit 3 of the chapter,
 Learn the technique of keeping records if the balance due to the retiring partner is
transferred to loan account,

1. INTRODUCTION
A partner may retire from the partnership firm because of old age, illness, etc. Generally, the
business of the partnership firm may not come to an end when one of the partners retires.
Other partners may continue to run the business of the firm. Readjustment takes place in case
of retirement of a partner likewise the case of admission of a partner. Whenever a partner
retires, the continuing partners make gain in terms of profit sharing ratio. Therefore, the
remaining arrange for the amount to be paid to discharge the claims of the retiring partners.
Assets and liabilities are revalued, value of goodwill is raised and revaluation profit and reserves
are transferred to capital and current accounts of partners’ accounts. Lastly, final amount due
to the retiring partner is determined and discharged.

2. CALCULATION OF GAINING RATIO


On retirement of a partner, the continuing partners will gain in terms of profit sharing ratio.
For example, if A, B and C were sharing profits and losses in the ratio of 5 : 3 : 2 and B retires,
then A and C have to decide at which ratio they will share profits and losses in future. If it is
decided that the continuing partners will share profits and losses in future at the ratio of 3:2,
then A gains 1/10th [(3/5)-(5/10)] and C gains 2/10 [(2/5)-(2/10)]. So the gaining ratio
between A and C is 1:2. If A and C decide to continue at the ratio 5:2, this indicates that they
are dividing the gained share in the previous profit sharing ratio.
Example.: Amir, Jamir and Samir are in partnership sharing profits and losses at the ratio of
3:2:1. Now Amir wants to retire and Jamir and Samir want to continue at the ratio of 3:2. In
this case, Jamir gains 8/30th of share of partnership (3/5 less 2/6) whereas Samir gains
7/30th (2/5 less 1/6) share of the partnership. So gaining ratio between Jamir and Samir is
8:7. On the other hand, if Jamir and Samir would decide to continue sharing profits and losses
at the ratio of 2:1, then Jamir would gain 2/6th share of partnership i.e. [(2/3)–(2/6)], and Samir
would gain 1/6th share of partnership i.e. [(1/3)–(1/6)]. So it appears that in such a case gaining
ratio of Jamir and Samir would be 2:1. i.e., the existing profit sharing ratio between them.

FUNDAMENTALS OF ACCOUNTING 8.67


RETIREMENT OF A PARTNER

3. REVALUATION OF ASSETS AND LIABILITIES ON RETIREMENT


OF A PARTNER
On retirement of a partner, it is required to revalue assets and liabilities just as in the case of
admission of a partner. If there is revaluation profit, then such profit should be distributed
amongst the existing partners including the retiring partner at the existing profit sharing ratio.
On the other hand, if there is loss on revaluation that is also to be distributed to all the partners
including the retiring partner at the existing profit sharing ratio. To arrive at, profit or loss on
revaluation of assets and liabilities, a Revaluation Account or Profit and Loss Adjustment
Account is opened. Revaluation Account or Profit and Loss Adjustment Account is closed
automatically by transfer of profit or loss balance to the Partners’ Capital Accounts.
If it is decided that revalued figures of assets and liabilities will not appear in the balance sheet
of the continuing partners, then a journal entry should be passed only continuing the amount
payable or chargeable to the retiring partner which the continuing partners will share at the
ratio of gain. In the first instance, the journal entry for distribution of profit or loss on revaluation
which will appear in the balance sheet also is as follows :
Revaluation A/c Dr.
To Partners’ Capital A/c
(For profit on revaluation)
Or
Partners’ Capital A/c Dr.
To Revaluation A/c
(For loss on revaluation)
Now see how to deal with a situation where revaluation profit will not appear in the Balance
Sheet.
If A, B & C share profits and losses equally and there is a revaluation profit of Rs. 30,000
calculated on A’s retirement, then Rs. 10,000 becomes due to A which is to be borne by B and
C equally. So the journal entry will be as follows :

Rs. Rs.
B’s Capital A/c Dr. 5,000
C’s Capital A/c Dr. 5,000
To A’s Capital A/c 10,000
Alternatively it is possible to account for the increase in the value of assets or decrease in the
value of liabilities by debiting the appropriate asset account or liability account and crediting
partners’ capital account at the existing profit sharing ratio. Simultaneously the partners capital

8.68 COMMON PROFICIENCY TEST


accounts are to be debited for such gain at the new profit sharing ratio and the respective
assets and liabilities account is to be credited again. So the following journal entries are necessary
for Rs. 10,000 increase in sundry fixed assets and Rs. 2,000/- decrease in sundry creditors:
1) Sundry Fixed Assets A/c Dr. 10,000
Sundry Creditors A/c Dr. 2,000
To A’s Capital A/c 4,000
To B’s Capital A/c 4,000
To C’s Capital A/c 4,000
(Distribution of Revaluation Profit amongst the existing partners at the old profit sharing
ratio)
2) B’s Capital A/c Dr. 6,000
C’s Capital A/c Dr. 6,000
To Sundry Fixed Assets A/c 10,000
To Sundry Creditors A/c 2,000
In this case it is not necessary to open a separate Revaluation Account.

4. RESERVE
On the retirement of a partner any undistributed profit or reserve standing at the Balance
Sheet is to be credited to the Partners’ Capital Accounts in the old profit sharing ratio.
Alternatively, only the retiring partner’s share may be transferred to his Capital Account if the
other continue at the same profit sharing ratio.
For example, A, B and C were in partnership sharing profits and losses at the ratio 5 : 3 : 2. A
retired and B and C agreed to share profits and losses at the ratio of 3:2. Reserve balance was
Rs. 10,000. In this case either of the following journal entries can be passed :

Rs. Rs.
(1) Reserve A/c Dr. 10,000
To A’s Capital A/c 5,000
To B’s Capital A/c 3,000
To C’s Capital A/c 2,000
(Transfer of reserve to partner’s Capital A/c at
5 : 3 : 2 on A’s retirement)
or
(2) Reserve A/c Dr. 5,000
To A’s Capital A/c 5,000
(Transfer of A’s share of Reserve to the Capital
Account on his retirement)

FUNDAMENTALS OF ACCOUNTING 8.69


RETIREMENT OF A PARTNER

Note that alternative (2) has the same implications because B and C continued at the same
ratio 3 : 2 as they did before A’s retirement.
Take another example : X, Y and Z were equal partners. Z decided to retire. X and Y decided
to continue at the ratio of 3 : 2. Reserve standing at the date of retirement of Z was Rs. 9,000.
In this case adjustment of Z’s share was not sufficient since the relationship between X and Y
was also changed.

3 1 9-5 4
X’s gain : - = =
5 3 15 15

2 1 6-5 1
Y’s gain : - = =
5 3 15 15
Gaining Ratio : X:Y
4:1
This is different from 1 : 1. So alternative (1) is to be followed in this case.

Rs.
Reserve A/c Dr. 9000 Rs.
To X’s Capital A/c 3000
To Y’s Capital A/c 3000
To Z’s Capital A/c 3000
(Transfer of Reserve on Z’s retirement)
If the continuing partners want to show reserve in the Balance Sheet, the journal entry will be.
Rs. Rs.
X’s Capital A/c Dr. 2400
Y’s Capital A/c Dr. 600
To Z’s Capital A/c 3,000
(Adjustment entry for Z’s share reserve).

5. FINAL PAYMENT TO RETIRING PARTNER


The following adjustments are necessary in the Capital A/cs :
(i) Transfer of reserve,
(ii) Transfer of goodwill,
(iii) Transfer of profit/loss on revaluation.
After adjustment of the above mentioned items, the Capital Account balance standing to the
credit of the retiring partner represents amount to be paid to him.

8.70 COMMON PROFICIENCY TEST


The continuing partners may discharge the whole claim at the time of retirement. Then the
journal entry will appear as follows :
Retiring Partners’ Capital A/cs Dr.
To Bank A/c
Sometimes the retiring partner agrees to retain some portion of his claim in the partnership as
loan. The journal entry will be as follows :
Retiring partner’s Capital A/c Dr.
To Retiring Partner’s Loan A/c
To Bank A/c
Illustration 1
A and B partners in a business sharing profit and losses as A 3/5ths and B 2/5ths. Their
balance sheet as on 1st January, 2006 is given below :
Liabilities Rs. Assets Rs.
Capital Accounts Plant and Machinery 20,000
A 20,000 Stock 16,000
B 15,000 35,000 Debtors 15,000
Reserve Account 15,000 Balance at Bank 6,000
Sundry Creditors 7,500 Cash in hand 500
57,500 57,500
B retires from the business owing to illness and A takes it over. The following revaluation
was made:
(1) The goodwill of the firm is valued at Rs. 25,000.
(2) Depreciate Plant & Machinery by 7.5% and stock by 15%.
(3) Doubtful debts provision is raised against debtors at 5% and a discount reserve against
creditors at 2%.
You are asked to journalise the above transactions in the books of the firm and close the Partners’
Accounts as on 1st January 2006. Give also the opening Balance Sheet of A.
Solution
Journal
2006 Dr. Cr
Rs. Rs.
Jan 1. A’s Capital Account Dr. 10,000
To B’s Capital Account 10,000
(The amount of share of goodwill adjusted on
B’s retirement)

FUNDAMENTALS OF ACCOUNTING 8.71


RETIREMENT OF A PARTNER

Reserve Account Dr. 15,000


To A’s Capital Account 9,000
To B’s Capital Account 6,000
(Transfer of reserve to A’s
Capital Account and B’s Capital
Account in the profit sharing ratio.)
Profit and Loss Adjustment Account Dr. 4,650
To Plant and Machinery Account 1,500
To Stock Account 2,400
To Provision for Doubtful Debts Account 750
(Reduction in the values, assets
and creation of provision for doubtful
debts as per agreement with B)
Reserve for Discount on Creditors A/c Dr. 150
To Profit and Loss Adjustment Account 150
(Creation of reserve for discount on creditors at 2%)
A’s Capital Account Dr. 2,700
B’s Capital Account Dr. 1,800
To Profit and Loss Adjustment Account 4,500
(Transfer of loss on revaluation of assets
and liabilities to Capital Accounts of A and B
in the profit sharing ratio)
B’s Capital Account Dr. 29,200
To B’s Loan Account 29,200
(Transfer of B’s Capital Account to his Loan A/c)

Balance Sheet of A as on 1st January, 2006


Liabilities Rs. Rs. Assets Rs.
A’s Capital Account 16,300 Plant and Machinery 18,500
B’s Loan Account 29,200 Stock 13,600
Sundry Creditors 7,500 Debtors 15,000
Less : Reserve for Discount 150 7,350 Less : Prov for Bad Debts 750 14,250
Balance at Bank 6,000
Cash 500
52,850 52,850

8.72 COMMON PROFICIENCY TEST


Illustration 2
F, G and K were partners sharing profit and losses at the 2 : 2 : 1. K wants to retire on 31.12.2005.
Given below is the Balance Sheet of the partnership as well as other information :
Balance Sheet as on 31.12.2005
Liabilities Rs. Assets Rs.
Capital A/cs Sundry Fixed Assets 1,50,000
F 1,20,000 Stock 50,000
G 80,000 Debtors 50,000
K 60,000 Bills Receivable 20,000
Reserve 10,000 Bank 50,000
Sundry Creditors 50,000
3,20,000 3,20,000
F and G agree to share profits and losses at the ratio of 3 : 2 in future. Value of Goodwill is
taken to be Rs. 50,000. Sundry Fixed Assets are revalued upward by Rs. 30,000 and stock by
Rs. 10,000. Bills Receivable dishonoured Rs. 5,000 on 31.12.2005 but not recorded in the books.
Dishonour of bill was due to insolvency of the customer. F and G agree to bring sufficient cash
to discharge claim of K and to make their capital proportionate. Also they wanted to maintain
Rs. 75,000 bank balance for working capital. However they did not want to show goodwill in
the books of accounts. Pass necessary journal entries and draft the Balance Sheet of Ms/ F & G.
Solution
Journal Entries
Rs. Rs.
(1) F’s Capital A/c Dr. 10,000
To K’s Capital A/c 10,000
(Being the adjustment for goodwill on K’s retirement) - Refer W.N.
(2) Reserve A/c Dr. 10,000
To F’s Capital A/c 4,000
To G’s Capital A/c 4,000
To K’s Capital A/c 2,000
(Transfer of Reserve to Partners’ Capital A/cs on K’s
retirement)
(3) Sundry Fixed Assets A/c Dr. 30,000
Stock A/c Dr. 10,000
To Profit and Loss Adjustment A/c 40,000
(Increase in the value of Sundry Fixed Assets and
Stock recorded).

FUNDAMENTALS OF ACCOUNTING 8.73


RETIREMENT OF A PARTNER

(4) Profit and Loss Adjustment A/c Dr. 5,000


To Bills Receivable A/c 5,000
(Loss arising out of dishonoured bill recorded)
(5) Profit and Loss Adjustment A/c Dr. 35,000
To F’s Capital A/c 14,000
To G’s Capital A/c 14,000
To K’s Capital A/c 7,000
(Profit on revaluation transferred to Partners’
Capital A/cs on K’s retirement)
(7) Bank A/c Dr. 1,04,000
To F’s Capital A/c 70,000
To G’s Capital A/c 34,000
(Cash brought in by F and G as per agreement)
(8) K’s Capital A/c Dr. 79,000
To Bank A/c 79,000
(Payment made to K on retirement)

Working Note:
Adjusting entry for goodwill
Partner Old Share New Share Gain Sacrifice

2 3 1
F –
5 5 5
2 2
G – –
5 5
1 1
K – –
5 5

Adjusting entry:
F’s Capital A/c (50,000 X 1/5) Dr. 10,000
To K’s Capital A/c 10,000

8.74 COMMON PROFICIENCY TEST


Illustration 3
With the illustration 2, prepare capital accounts of partners and draft the Balance Sheet of
Ms/ F & G after K’s retirement.
Solution
Balance Sheet
(after K’s retirement)
Liabilities Rs. Assets Rs.
Capital A/cs Sundry Fixed Assets 1,80,000
F 1,98,000 Stock 60,000
G 1,32,000 Debtors 50,000
Sundry Creditors 50,000 Bills Receivable 15,000
Bank 75,000
3,80,000 3,80,000
Partners’ Capital Accounts
F G K F G K
Rs. Rs. Rs. Rs. Rs. Rs.
To K’s Capital A/c 10,000 – – By Balance b/d 1,20,000 80,000 60,000
To Balance c/d 1,28,000 98,000 79,000 By F’s Capital A/c 10,000
By P & L Adj. A/c 14,000 14,000 7,000
By Reserve 4,000 4,000 2,000
1,38,000 98,000 79,000 1,38,000 98,000 79,000
To Bank – – 79,000 By Balance b/d 1,28,000 98,000 79,000
To Balance c/d 1,98,000 1,32,000 – By Bank 70,000 34,000 –
1,98,000 1,32,000 79,000 1,98,000 1,32,000 79,000
Working Notes :
1. Total Capital Rs.
Sundry Fixed Assets (Rs. 1,50,000 + 30,000) 1,80,000
Stock (Rs. 50,000 + Rs. 10,000) 60,000
Debtors 50,000
Bills Receivable (Rs. 20,000 – Rs. 5,000) 15,000
Bank 75,000
3,80,000
Less Sundry Ceditors 50,000
3,30,000
F’s share (3,30,000 × 3/5) 1,98,000
G’s share (3,30,000 × 2/5) 1,32,000

FUNDAMENTALS OF ACCOUNTING 8.75


RETIREMENT OF A PARTNER

2. Bank Account
To Balance b/d 50,000 By K’s Capital A/c 79,000
To F’s Capital A/c 70,000 By Balance c/d 75,000
To G’s Capital A/c 34,000
1,54,000 1,54,000
Illustration 4
A, B & C were in partnership sharing profits in the proportions of 5:4:3. The balance sheet of
the firm as on 31st March, 2006 was as under :
Liabilities Rs. Assets Rs.
Capital accounts: Goodwill 40,000
A 1,35,930 Fixtures 8,200
B 95,120 Stock 1,57,300
C 61,170 Sundry Debtors 93,500
Sundry creditors 41,690 Cash 34,910
3,33,910 3,33,910
A had been suffering from ill-health and gave notice that he wished to retire. An agreement
was, therefore, entered into as on 31st March, 2006, the terms of which were as follows:
(i) The profit and loss account for the year ended 31st March, 2006 which showed a net
profit of Rs. 48,000 was to be re-opened. B was to be credited with Rs. 4,000 as bonus, in
consideration of the extra work which had devolved upon him during the year. The profit
sharing was to be revised as from 1st April, 2005, to 3:4:4.
(ii) Goodwill was to be valued at two years’ purchase of the average profits of the preceding
five years. The fixtures were to be valued by an independent valuer. A provision of 2%
was to be made for doubtful debts and the remaining assets were to be taken at their book
values.
The valuations arising out of the above agreement were goodwill Rs. 56,800 and fixtures
Rs. 10,980.
B and C agreed, as between themselves, to continue the business, sharing profits in the ratio of
3:2 and decided to eliminate goodwill from the balance sheet, to retain the fixtures on the
books at the revised value, and to increase the provision for doubtful debts to 6%.
You are required to submit the journal entries necessary to give effect to the above arrangements
and to draw up the capital account of the partners after carrying out all adjusting entries as
stated above.

8.76 COMMON PROFICIENCY TEST


Solution
Journal Entries
Particulars Dr. Cr.
Rs. Rs.
A’s Capital Account Dr. 20,000
B’s Capital Account Dr. 16,000
C’s Capital Account Dr. 12,000
To Profit and Loss Adjustment Account 48,000
(Profit written back for making adjustments)
Profit and Loss Adjustment Account Dr. 4,000
To B’s Capital account 4,000
(Bonus Credited to B’s Capital Account)
Profit and Loss Adjustment Account Dr. 44,000
To A’s Capital Account 12,000
To B’s Capital Account 16,000
To C’s Capital Account 16,000
(Distribution of profits in the new ratio)
Fixtures Account Dr. 2,780
To Provision for Doubtful debts Account @ 2% 1,870
To A’s Capital Account 248
To B’s Capital Account 331
To C’s Capital Account 331
(Revaluation of assets on A’s retirement)
A’s Capital Account Dr. 10,909
B’s Capital Account Dr. 14,545
C’s Capital Account Dr. 14,546
To Goodwill 40,000
(Old goodwill shown in the balance sheet has been written off)
A’s Capital Account Dr. 1,32,760
To A’s Loan Account 1,32,760
(Transfer of A’s Capital Account to his Loan Account)
B’s Capital Account Dr. 2,244
C’s Capital Account Dr. 1,496
To Provision for Doubtful Debts Account 3,740
(Raising provision for bad debts)

FUNDAMENTALS OF ACCOUNTING 8.77


RETIREMENT OF A PARTNER

B’s Capital Account Dr. 13,425


C’s Capital Account Dr. 2,066
To A’s Capital Account 15,491
(Adjusting entry of goodwill passed through partners’
capital accounts in gaining/sacrificing ratio)
Partners’ Capital Accounts
Dr. Cr.
A B C A B C
Rs. Rs. Rs. Rs. Rs. Rs.
To Profit and Loss
Adjustment A/c 20,000 16,000 12,000 By Balance b/d 1,35,930 95,120 61,170
By Profit and Loss – 4,000 –
To Goodwil 10,909 14,545 14,546 Adjustment A/c
To A’s Loan A/c 1,32,760 – –
To Provision for – 2,244 1,496 By Profit and loss 12,000 16,000 16,000
Doubtful Adjustment A/c
Debts A/c By Fixtures Less 248 331 331
To A – 13,425 2,066 provision for
To Balance c/d – 69,237 47,393 DD A/c
By B 13,425
By C 2,066
1,63,669 1,15,451 77,501 1,63,669 1,15,451 77,501

Notes : The balance of A’s Capital Account has been transferred to A’s Loan Account.
Working Note:
Calculation for adjustment of Amount of Goodwill
Partner Old Share New Share Gain Sacrifice

3 3
A – –
11 11
4 3 13
B –
11 5 55
4 2 2
C –
11 5 55

Illustration 5
K, L & M are partners sharing profits and losses in the ratio 5:3:2. Due to illness, L wanted to
retire from the firm on 31.3.2006 and admit his son N in his place.

8.78 COMMON PROFICIENCY TEST


Balance Sheet of K, L and M as on 31.3.2006
Liabilities Rs. Rs. Assets Rs.
Capital: Goodwill 30,000
K 40,000 Furniture 20,000
L 60,000 Sundry Debtors 50,000
M 30,000 1,30,000 Stock in Trade 50,000
Reserve 50,000 Cash and Bank balances 50,000
Sundry Creditors 20,000
2,00,000 2,00,000

On retirement of L assets were revalued : Goodwill Rs. 50,000, furniture Rs. 10,000, Stock in
trade Rs. 30,000. 50% of the amount due to L was paid off in cash and the balance was retained
in the firm as capital of N. On admission of the new partner, goodwill has been written off. M
is paid off his extra balance to make capital proportionate.
Pass necessary journal entries. Prepare balance sheet of M/s K, M and N as on 1.4.2006. Show
necessary workings.
Solution
Journal Entries
Date Particulars Dr. Cr.
Rs. Rs.
31.3.06 K’s Capital A/c Dr. 15,000
L’s Capital A/c Dr. 9,000
M’s Capital A/c Dr. 6,000
To Goodwill A/c 30,000
(Being old goodwill of balance sheet written off)
Profit and Loss Adjustment A/c Dr. 30,000
To Furniture A/c 10,000
To Stock in Trade A/c 20,000
(Being revaluation of furniture and stock in
trade recorded)
K’s Capital A/c Dr. 15,000
L’s Capital A/c Dr. 9,000
M’s Capital A/c Dr. 6,000
To Profit and Loss Adjustment A/c 30,000
(Being net revaluation loss debited to capital
accounts of K, L and M in the ratio 5:3:2)

FUNDAMENTALS OF ACCOUNTING 8.79


RETIREMENT OF A PARTNER

Reserve A/c Dr. 50,000


To K’s Capital A/c 25,000
To L’s Capital A/c 15,000
To M’s Capital A/c 10,000
(Being reserve transferred to capital accounts, K, L and M)
L’s Capital A/c Dr. 72,000
To Cash A/c 36,000
To N’s Capital A/c 36,000
(Being 50% of the amount due to L was paid off in cash
and balance was retained in the firm as capital of N)
N’s Capital A/c Dr. 15,000
To L’s Capital A/c 15,000
(Being adjusting entry for goodwill passed in
gaining/sacrificing ratio)
M’s Capital A/c Dr. 14,000
To Bank A/c 14,000
(Being amount paid to M to make his capital proportionate)

Working Note:
1. Calculation for adjustment of Amount of Goodwill
Partner Old Share New Share Gain Sacrifice
5 5
K – –
10 10
3 3
L – –
10 10
2 2
M – –
10 10
3 3
N – –
10 10

2. Calculation of excess capital paid off to M to make capital proportionate.


Partner Capital Balance Capital Ratio P/L Ratio Excess Capital
(After all Paid Off
Adjustments)
K 35,000 5 5 –
N 21,000 3 3 –
28,000
M 28,000 4 2 x 2 = 14,000
4

8.80 COMMON PROFICIENCY TEST


Illustration 6
With the information given in illustration 5, prepare capital accounts of partners and prepare
balance sheet of M/s K, M and N as on 1.4.2006. Show necessary workings.
Solution
Partners’ Capital Accounts
Dr. Cr.
K L M N K L M N
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
To Goodwill 15,000 9,000 6,000 - By Balance b/d 40,000 60,000 30,000 -
To Profit and 15,000 9,000 6,000 - By Reserve 25,000 15,000 10,000 -
Loss adjustment By L’s Capital A/c - - - 36,000
A/c By N’s Capital A/c - 15,000 -
To Cash A/c - 36,000 - -
To N’s capital A/c - 36,000 - -
To L’s Capital A/c - - - 15,000
To Bank A/c
(Balancing figure) - - 14,000 -
To Balance c/d 35,000 - 14,000 21,000
65,000 90,000 40,000 36,000 65,000 90,000 40,000 36,000
By Balance b/d 35,000 – 14,000 21,000

Balance Sheet of M/s K, M & N


as on 1st April, 2006
Liabilities Rs. Rs. Assets Rs.
Capital Accounts: Furniture 10,000
K 35,000 Sundry Debtors 50,000
M 14,000 Stock in Trade 30,000
N 21,000 70,000
Sundry Creditors 20,000
90,000 90,000

FUNDAMENTALS OF ACCOUNTING 8.81


RETIREMENT OF A PARTNER

Illustration 7
Dowell & Co. is a partnership firm with partners Mr. A, Mr. B and Mr., C, sharing profits
and losses in the ratio of 10:6:4. The balance sheet of the firm as at 31st March, 2006 is as
under:
Rs. Rs.
Capital : Land 10,000
Mr. A 80,000 Buildings 2,00,000
Mr. B 20,000 Plant and machinery 1,30,000
Mr. C 30,000 1,30,000 Furniture 43,000
Reserves Investments 12,000
(unappropriated profit) 20,000 Stock 1,30,000
Long Term Debt 3,00,000 Debtors 1,39,000
Bank Overdraft 44,000
Trade Creditors 1,70,000
6,64,000 6,64,000

It was mutually agreed that Mr. B will retire from partnership and in his place Mr. D will be
admitted as a partner with effect from 1st April, 2006. For this purpose, the following
adjustments are to be made:
(a) Goodwill is to be valued at Rs. 1 lakh but the same will not appear as an asset in the books
of the reconstituted firm.
(b) Buildings and plant and machinery are to be depreciated by 5% and 20% respectively.
Investments are to be taken over by the retiring partner at Rs. 15,000. Provision of 20% is
to be made on debtors to cover doubtful debts.
(c) In the reconstituted firm, the total capital will be Rs. 2 lakhs which will be contributed by
Mr. A, Mr. C and Mr. D in their new profit sharing ratio, which is 2:2:1.
(a) The surplus funds, if any, will be used for repaying bank overdraft.
(b) The amount due to retiring partner shall be transferred to his loan account.
Prepare
(a) Revaluation account;
(b) Partners’ capital accounts;
(c) Bank account; and
(d) Balance sheet of the reconstituted firm as on 1st April, 2006.

8.82 COMMON PROFICIENCY TEST


Solution
Revaluation Account
Dr. Cr.
Rs. Rs.
To Buildings A/c 10,000 By Investments A/c 3,000
To Plant and Machinery A/c 26,000 By Loss to Partners:
To Provision for Doubtful Debts A/c 27,800 A 30,400
B 18,240
C 12,160 60,800
63,800 63,800
A’s Capital Account
Dr. Cr.
Rs. Rs.
To Revaluation A/c 30,400 By Balance b/d 80,000
To Balance c/d 80,000 By Reserves A/c 10,000
By C and D’s Capital A/c 10,000
By Bank A/c (balancing figure) 10,400

1,10,400 1,10,400

B’s Capital Account


Dr. Cr.
Rs. Rs.
To Revaluation A/c 18,240 By Balance b/d 20,000
To Investments A/c 15,000 By Reserves A/c 6,000
To B’s Loan A/c 22,760 By C and D’s Capital A/c 30,000
56,000 56,000

C’s Capital Account


Dr. Cr.
Rs. Rs.
To Revaluation A/c 12,160 By Balance b/d 30,000
To A and B’s Capital A/c 20,000 By Reserves A/c 4,000
To Balance c/d 80,000 By Bank A/c (balancing figure) 78,160
1,12,160 1,12,160

FUNDAMENTALS OF ACCOUNTING 8.83


RETIREMENT OF A PARTNER

D’s Capital Account


Dr. Cr.
Rs. Rs.
To A and B’s Capital A/cs 20,000 By Bank A/c 60,000
To Balance c/d 40,000
60,000 60,000

Illustration 8
After preparing revaluation account and partners’ capital accounts, let us prepare Bank account
and Balance Sheet of the reconstituted firm as on 1st April, 2006 from the information given in
illustration 7.
Solution
Bank Account
Dr. Cr.
Rs. Rs.
To A’s capital A/c 10,400 By Bank Overdraft A/c 44,000
To C’s capital A/c 78,160 By Balance c/d 1,04,560
To D’s capital A/c 60,000
1,48,560 1,48,560

Balance Sheet of Dowell Co.


as at 1st April, 2006
Liabilities Rs. Assets Rs.
Capital Accounts: Land 10,000
A 80,000 Buildings 1,90,000
B 80,000 Plant and Machinery 1,04,000
C 40,000 2,00,000 Furniture 43,000
Long Term Debts 3,00,000 Stock 1,30,000
Trade Creditors 1,70,000 Debtors 1,39,000
B’s Loan Account 22,760 Less: Provision for
Doubtful Debts 27,800 1,11,200
Balance at Bank 1,04,560
6,92,760 6,92,760

8.84 COMMON PROFICIENCY TEST


6. PAYING A PARTNER’S LOAN IN INSTALMENT
Strictly speaking, paying a partner’s loan is only a matter of arranging finance. However,
sometimes it is stated that the loan is to be paid off in so many equal instalments and that the
balance is to carry interest. In such case what should be done is that the loan should be divided
into equal parts. The interest for the period should be calculated and the payment should
consist of the instalment on account of the loan plus interest for the period. Suppose a partner’s
loan stands at Rs. 30,000 and that it has to be paid in four annual equal instalments and that
the loan is to carry interest at 6% per annum. The annual instalment on account of loan comes
to Rs. 7,500. For the first year the first interest is Rs. 1,800 i.e. 6% on Rs. 30,000. In the first year
the amount to be paid will be Rs. 9,300. Balance of Rs. 22,500 will now be left. Next year the
interest will be Rs. 1,350. The amount to be paid therefore will be Rs. 7,500 plust interest viz.,
Rs. 8,850. The loan account will appear in the books as under.

Retiring Partner’s loan Account


Dr. Cr.
Rs. Rs.
I Year To Cash (7,500 + 1,800) 9,300 I year By Capital Account 30,000
To Balance c/d 22,500 By Interest Account 1,800
31,800 31,800
II Year To Cash (7,500 + 1,350) 8,850 II Year By Balance b/d 22,500
To Balance c/d 15,000 By Interest A/c 1,350
(6% on Rs. 22,500)
23,850 23,850
III Year To Cash 8,400 III Year By Balance b/d 15,000
To Balance c/d 7,500 By Interest Account 900
15,900 15,900
IV Year To Cash 7,950 IV Year By Balance b/d 7,500
450
7,950 7,950

FUNDAMENTALS OF ACCOUNTING 8.85


RETIREMENT OF A PARTNER

Illustration 9
M/s X and Co. is a partnership firm with the partners A, B and C sharing profits and losses in
the ratio of 3:2:5. The balance sheet of the firm as on 30th June 2005, was as under :
Balance Sheet of X and Co.
as on 30.06.2005
Liabilities Rs. Assets Rs.
A’s Capital A/c 1,04,000 Land 1,00,000
B’s Capital A/c 76,000 Building 2,00,000
C’s Capital A/c 1,40,000 Plant and Machinery 3,80,000
Long Term Loan 4,00,000 Investments 22,000
Bank Overdraft 44,000 Stock 1,16,000
Trade Creditors 1,93,000 Sundry Debtors 1,39,000
9,57,000 9,57,000

It was mutually agreed that B will retire from partnership and in his place D will be admitted
as a partner with effect from 1st July, 2005. For this purpose, the following adjustments are to
be made:
(a) Goodwill of the firm is to be valued at Rs. 2 lakhs due to the firm’s locational advantage
but the same will not appear as an asset in the books of the reconstituted firm.
(b) Buildings and plant and machinery are to be valued at 90% and 85% of the respective
balance sheet values. Investments are to be taken over by the retiring partner at Rs. 25,000.
Sundry debtors are considered good only upto 90% of balance sheet figure. Balance be
considered bad.
(c) In the reconstituted firm, the total capital will be Rs. 3 lakhs, which will be contributed by
A, C and D in their new profit sharing ratio, which is 3:4:3.
(d) The amount due to retiring partner shall be transferred to his loan account.
You are required to prepare Revaluation Account and Partners’ Capital Accounts

8.86 COMMON PROFICIENCY TEST


Solution
Revaluation Account
Dr. Cr.
2005 Rs. 2005 Rs.
July 1 To Building 20,000 July 1 By Investments 3,000
To Plant and Machinery 57,000 (25,000-22,000)
To Bad Debts 13,900 By Partners’ Capital A/cs
(loss on revaluation)
A (3/10) 26,370
B (2/10) 17,580
(5/10) 43,950 87,900
90,900 90,900

Partners’ Capital Accounts


Dr. Cr.
A B C D A B C D
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
To Revaluation
A/c 26,370 17,580 43,950 – By Balance b/d 1,04,000 76,000 1,40,000 –
To B’s and C’s By D’s Capital A/c
capital A/cs – – – 60,000 (W.N.1) – 40,000 20,000 –
To Investments A/c – 25,000 – – By Bank A/c 12,370 – 3,950 1,50,000
To B’s loan A/c – 73,420 – –
To Balance c/d
(W.N. 2) 90,000 - 1,20,000 90,000

1,16,370 1,16,000 1,63,950 1,50,000 1,16,370 1,16,000 1,63,950 1,50,000

Working Notes :
1. Adjustment of goodwill
Goodwill of the firm is valued at Rs. 2 lakhs
Sacrificing ratio:
A 3/10-3/10 = 0
B 2/10-0 = 2/10
C 5/10-4/10 = 1/10
Hence, sacrificing ratio of B and C is 2:1. A has not sacrificed any share in profits after
retirement of B and admission of D in his place.

FUNDAMENTALS OF ACCOUNTING 8.87


RETIREMENT OF A PARTNER

Adjustment of D’s share of goodwill through existing partners’ capital accounts in the
profit sacrificing ratio:
Rs.
B : Rs. 60,000 x 2/3 = 40,000
C : Rs 60,000 x 1/3 = 20,000 60,000

2. Capital of partners in the reconstituted firm :


Rs.
Total capital of the reconstituted firm (given) 3,00,000
A (3/10) 90,000
B (4/10) 1,20,000
C (3/10) 90,000

Illustration 10
A, B and C are in partnership sharing profits and losses at the ratio of 5 : 3 : 2. The balance
sheet of the firm on 31.12.2005 was as follows :
Balance Sheet
Liabilities Rs. Assets Rs.
Capital A/cs Sundry Fixed Assets 80,000
A 50,000 Stock 50,000
B 40,000 Debtors 30,000
C 30,000 Joint Life Policy 20,000
Bank Loan 40,000 Bank 10,000
Sundry Creditors 30,000
1,90,000 1,90,000

On 1.1.2006, A wants to retire, B and C agreed to continue at 2:1. Joint Life Policy was taken
on 1.1.2000 for Rs. 1,00,000 and its surrender value as on 31.12.2005 was Rs. 25,000. For the
purpose of A’s retirement goodwill was raised for Rs. 1,00,000. Sundry Fixed Assets was revalued
for Rs. 1,10,000. But B and C did not prefer to show such increase in assets in the Balance
Sheet. Also they agreed to bring necessary cash to discharge 50% of the A’s claim, to make the
bank balance Rs. 25,000 and to make their capital proportionate.
Prepare necessary journal entries.

8.88 COMMON PROFICIENCY TEST


Solution
Journal Entries
Rs. Rs.
1. B’s Capital A/c Dr. 49,500
C’s Capital A/c Dr. 18,000
To A’s Capital A/c 67,500
(Share of revaluation profit Rs. 67,500 including good
will due to A borne by B and C at the gaining ratio 11 : 4)
2. A’s Capital A/c Dr. 1,17,500
To A’s Loan A/c 58,750
To Bank A/c 58,750
(Settlement of A’s claim on his retirement by payment of
50% in case and transferring the balance to his Loan A/c).
3. Bank A/c Dr. 73,750
To A’s Capital A/c 60,333
To A’s Capital A/c 13,417
(Cash brought in by the continuing partners).

Working Notes :
1. Revaluation Profit Rs.
Goodwill 1,00,000
Sundry Fixed Assets 30,000
Joint Life Policy 5,000
1,35,000
A’s Share Rs. 1,35,000 × 5/10 = Rs. 67,500.

2. Gaining Ratio
B : 2/3 - 3/10 = 11/30
C : 1/3 - 2/10 = 4/30
Gaining Ratio : B : C
11 : 4

FUNDAMENTALS OF ACCOUNTING 8.89


RETIREMENT OF A PARTNER

3. Total Capital
Rs.
Assets as per Balance Sheet 1,90,000
Additional Bank Balance 15,000
2,05,000
Less : Bank Loan 40,000
Sundry Crs. 30,000
A’s Loan 58,750 1,28,750
76,250
B’s Share 50,833
C’s Share 25,417

SELF EXAMINATION QUESTIONS


PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES :
1. Retiring or outgoing partner:
a. To be liable for firm’s liabilities. b. Not liable for any liabilities of the firm.
c. Is liable for obligations incurred before his retirement.
d. Is liable for obligations incurred with his consent only.
2. A, B and C are partners with profits sharing ratio 4:3:2. B retires and Goodwill Rs. 10,800
shown in books of account. If A & C shares profits of B in 5:3, then find the new profit
sharing ratio.
a. 13:11. b. 17:11. c. 31:11. d. 14:21.
3. A, B and C are partners with profits sharing ratio 4:3:2. B retires and Goodwill Rs. 10,800
was shown in books of account. If A & C shares profits of B in 5:3, then find the value of
goodwill shared between A and C.
a. Rs. 1,850 and Rs. 1,950. b. Rs. 1,650 and Rs. 1,750.
c. Rs. 2,000 and Rs. 1,600. d. Rs. 1,950 and Rs. 1,650.
4. C, D and E are partners sharing profits and losses in the proportion of ½, 1/3 and 1/6. D
retired and the new profit sharing ratio between C and E is 3:2 and the Reserve of Rs.
12,000 is divided amount the partners in the ratio:
a. 2000:4000:6000. b. 5000:5000:2000.
c. 4000:6000:2000. d. 6000:4000:2000.
5. The capitals of A, B and C are Rs. 1,00,000; Rs. 75,000 and Rs. 50,000, profits are shared
in the ratio of 3:2:1. B retires on the basis that his shares is purchased by other partners
keeping the total capital intact. The new ratio between A and C is 3:1. Find the capital of
A and C after purchasing B’s share..
8.90 COMMON PROFICIENCY TEST
a. Rs. 1,50,000 and Rs. 1,00,000. b. Rs. 1,46,250 and Rs. 42,000.
c. Rs. 1,56,250 and Rs. 68,750. d. Rs. 86,250 and Rs. 46,250.
6. Outgoing partner is compensated for parting with firm’s future profits in favour of remaining
partners. In what ratio do the remaining partners contribute to such compensation amount?
a. Gaining Ratio. b. Capital Ratio. c. Sacrificing Ratio. d. Profit Sharing Ratio.
7. Joint Life Policy is taken by the firm on the life(s) of ………
a. All the partners jointly. b. All the partners severely.
c. On the life of all the partners and employees of the firm. d. ‘a’ and ‘b’.
8. At the time of retirement of a partner, firm gets ……… from the insurance company
against the Joint Life Policy taken jointly for all the partners.
a. Policy Amount. b. Surrender Value.
c. Policy Value for the retiring partner and Surrender Value for the rest.
d. Surrender Value for all the partners.
9. At the time of retirement of a partner, firm gets ……… from the insurance company
against the Joint Life Policy taken severely for each partner.
a. Policy Amount. b. Surrender Value.
c. Policy Value for the retiring partner and Surrender Value for the rest.
d. Surrender Value for all the partners.
10. A, B and C takes a Joint Life Policy, after five years B retires from the firm. Old profit
sharing ratio is 2:2:1. After retirement A and C decides to share profits equally. They had
taken a Joint Life Policy of Rs. 2,50,000 with the surrender value Rs. 50,000. What will be
the treatment in the partner’s capital account on receiving the JLP amount if joint life
premium is fully charged to revenue as and when paid?
a. Rs. 50,000 credited to all the partners in old ratio.
b. Rs. 2,50,000 credited to all the partners in old ratio.
c. Rs. 2,00,000 credited to all the partners in old ratio.
d. No treatment is required.
11. A, B and C takes a Joint Life Policy, after five years, B retires from the firm. Old profit
sharing ratio is 2:2:1. After retirement A and C decides to share profits equally. They had
taken a Joint Life Policy of Rs. 2,50,000 with the surrender value Rs. 50,000. What will be
the treatment in the partner’s capital account on receiving the JLP amount if joint life
policy is maintained at the surrender value?
a. Rs. 50,000 credited to all the partners in old ratio.
b. Rs. 2,50,000 credited to all the partners in old ratio.
c. Rs. 2,00,000 credited to all the partners in old ratio.
d. No treatment is required.

FUNDAMENTALS OF ACCOUNTING 8.91


RETIREMENT OF A PARTNER

12. A, B and C takes a Joint Life Policy, after five years B retires from the firm. Old profit
sharing ratio is 2:2:1. After retirement A and C decides to share profits equally. They had
taken a Joint Life Policy of Rs. 2,50,000 with the surrender value Rs. 50,000. What will be
the treatment in the partner’s capital account on receiving the JLP amount if joint life
policy is maintained at surrender along with the reserve?
a. Rs. 50,000 credited to all the partners in old ratio.
b. Rs. 2,50,000 credited to all the partners in old ratio.
c. Rs. 2,00,000 credited to all the partners in old ratio.
d. Distribute JLP Reserve Account in old profit sharing ratio.
13. A, B and C are partners sharing profits in the ratio 2:2:1. On retirement of B, goodwill was
valued as Rs. 30,000. Find the contribution of A and C to compensate B.
a. Rs. 20,000 and Rs. 10,000. b. Rs. 8,000 and Rs. 4,000.
c. They will not contribute any thing.
d. Information is insufficient for any comment.
14. Claim of the retiring partner is payable in the following form.
a. Fully in cash.
b. Fully transferred to loan account to be paid later with some interest on it.
c. Partly in cash and partly as loan repayable later with agreed interest.
d. Any of the above method.
15. A, B and C were partners in a firm sharing profits and losses in the ratio of 2:2:1 respectively
with the capital balance of Rs. 50,000 for A and B, for C Rs. 25,000. B declared to retire
from the firm and balance in reserve on the date was Rs. 15,000. If goodwill of the firm
was valued as Rs. 30,000 and profit on revaluation was Rs. 7,050 then what amount will
be transferred to the loan account of C.
a. Rs. 70,820. b. Rs. 50,820. c. Rs. 25,820. d. Rs. 58,820.
16. A, B and C are partners sharing profits and losses in the ratio of 3:2:1. C retires on a
decided date and Goodwill of the firm is to be valued at Rs. 60,000. Find the amount
payable to retiring partner on account of goodwill.
a. Rs. 30,000. b. Rs. 20,000. c. Rs. 10,000. d. Rs. 60,000.
17. A, B and C were partners sharing profits and losses in the ratio of 3:2:1. A retired and
Goodwill of the firm is to be valued at Rs. 24,000 and Goodwill Account is to be raise
which is not appearing in the balance sheet. What will be the treatment for goodwill?
a. Credited to Revaluation Account at Rs. 24,000.
b. Credited to partners capital account Rs. 24,000 in profits sharing ratio.
c. Only A’s capital account credited with Rs. 12,000.
d. Only A’s capital account credited with Rs. 24,000.

8.92 COMMON PROFICIENCY TEST


18. A, B and C were partners sharing profits and losses in the ratio of 3:2:1. A retired and firm
received the joint life policy as Rs. 7,500 appearing in the balance sheet at Rs. 10,000. JLP
is credited and cash debited with Rs. 7,500, what will be the treatment for the balance in
Joint Life Policy?
a. Credited to partner’s current account in profit sharing ratio.
b. Debited to revaluation account.
c. Debited to partner’s capital account in profit sharing ratio.
d. Either ‘b’ or ‘c’.
19. Balances of M/s. Ram, Rahul and Rohit sharing profits and losses in proportionate to
their capitals, stood as follows: Capital Accounts: Ram Rs. 3,00,000; Rahul Rs. 2,00,000
and Rohit Rs. 1,00,000. Ram desired to retire form the firm and the remaining partners
decided to carry on, Joint life policy of the partners surrendered and cash obtained Rs.
60,000. What will be the treatment for JLP?
a. Rs. 60,000 credited to Revaluation Account.
b. Rs. 60,000 credited to Joint Life Policy Account.
c. Rs. 30,000 debited to Ram’s Capital Account.
d. Either ‘a’ or ‘b’.
20. Balances of A, B and C sharing profits and losses in proportionate to their capitals, stood
as follows: Capital Accounts: A Rs. 2,00,000; B Rs. 3,00,000 and C Rs. 2,00,000; JLP Reserve
Rs. 80,000 and JLP Rs. 80,000. A desired to retire form the firm and the remaining partners
decided to carry on in equal ratio, Joint life policy of the partners surrendered and cash
obtained Rs. 80,000. What will be the treatment for JLP?
a. Cash received credited to Revaluation Account.
b. JLP Reserve balance credited to Partner’s Capital Account in old profit sharing ratio.
c. JSP Reserve balance credited to Partner’s Capital Account in new profit sharing ratio.
d. Cash received credited to Partner’s Capital Account in old profit sharing ratio.
21. Balances of A, B and C sharing profits and losses in proportionate to their capitals, stood
as follows: Capital Accounts: A Rs. 2,00,000; B Rs. 3,00,000 and C Rs. 2,00,000. A desired
to retire form the firm, B and C share the future profits equally, Goodwill of the entire firm
be valued at Rs. 1,40,000 and no Goodwill account being raised.
a. Credit Partner’s Capital Account with old profit sharing ratio for Rs. 1,40,000.
b. Credit Partner’s Capital Account with new profit sharing ratio for Rs. 1,40,000.
c. Credit A’s Account with Rs. 40,000 and debit B’s Capital Account with Rs. 10,000
and C’s Capital Account with Rs. 30,000.
d. Credit Partner’s Capital Account with gaining ratio for Rs. 1,40,000.
22. Balances of A, B and C sharing profits and losses in proportionate to their capitals, stood
as follows: Capital Accounts: A Rs. 2,00,000; B Rs. 3,00,000 and C Rs. 2,00,000. JLP Reserve

FUNDAMENTALS OF ACCOUNTING 8.93


RETIREMENT OF A PARTNER

and JLP at Rs. 80,000. A desired to retire form the firm, B and C share the future profits
equally. Joint life policy of the partners surrendered and cash obtained Rs. 80,000. Goodwill
of the entire firm be valued at Rs. 1,40,000 and no Goodwill account being raised.
Revaluation Loss was Rs. 10,000. Amount due to A is to be settled on the following basis:
50% on retirement and the balance 50% within one year. The total capital of the firm is to
be the same as before retirement. Individual capitals in their Profit sharing ratio. Find the
balances of Partner’s Capital Account.
a. Rs. 3,50,000 each b. Rs. 3,20,000 each.
c. Rs. 1,90,000 each. d. Rs. 1,30,000 each.
23. Balances of Ram, Hari & Mohan sharing profits and losses in the ratio 2:3:2 stood as
follows: Capital Accounts: Ram Rs. 10,00,000; Hari Rs. 15,00,000; Mohan Rs. 10,00,000;
Joint Life Policy Rs. 3,50,000. Hari desired to retire from the firm and the remaining partners
decided to carry on with the future profit sharing ratio of 3:2. Joint Life Policy of the
partners surrendered and cash obtained Rs. 3,50,000. What would be the treatment for
JLP?
a. Rs. 3,50,000 credited to partner’s capital account in new ratio.
b. Rs. 3,50,000 credited to partner’s capital account in old ratio.
c. Rs. 3,50,000 credited to partner’s capital account in capital ratio.
d. Rs. 3,50,000 credited to JLP account.

ANSWERS
1. (c), 2. (a), 3. (d), 4. (d), 5. (c),
6. (a), 7. (d), 8. (b), 9. (d), 10. (a),
11. (d), 12. (d), 13. (b), 14. (d), 15. (a),
16. (c), 17. (b), 18. (d), 19. (b), 20. (b),
21. (c), 22. (a), 23. (d)

8.94 COMMON PROFICIENCY TEST


CHAPTER - 8

PARTNERSHIP
ACCOUNTS

Unit 5

Death
of
Partner
DEATH OF PARTNER

Learning Objectives
After studying this unit you will be able to:
 Understand the implication of the excess money received on death of a partner from a
joint life policy from the insurance company in the accounts of the partnership. Learn
the journal entries required to record this transaction.
 Understand the accounting implications if death of a partner takes place at any date
during the accounting period. Learn to record this transaction and how to record
payment of profit to the Executor of the deceased partner for part of the accounting
year.
 Be familiar with other accounting treatments in case of death of partner which are
similar to the explained in case of retirement of a partner.

1. INTRODUCTION
Business of a partnership firm may not come to an end due to death of a partner. Other partners
shall continue to run the business of the firm. The problems arising on the death of a partner
are similar to those arising on retirement. Assets and liabilities have to be revalued and the
resultant profit or loss has to be transferred to the capital accounts of all partners including the
deceased partner. Goodwill is dealt with exactly in the way already discussed in the case of
retirement in the earlier unit. Treatment of joint life policy will also be same as in the case of
retirement. However, in case of death of a partner, the firm would get the joint policy value.
The only additional point is that as death may occur on any day, the representatives of the
deceased partner will be entitled to the partner's share of profit from the beginning of the year
to the date of death. After ascertaining the amount due to the deceased partner, it should be
credited to his Executor's Account.
The amount due to the deceased partner carries interest at the mutually agreed upon rate. In
the absence of agreement, the representatives of the deceased partner can receive, at their
option, interest at the rate of 6% per annum or the share of profits earned for the amount due
to the deceased partner.

2. SPECIAL TRANSACTIONS IN CASE OF DEATH : PAYMENT


OF DECEASED PARTNER'S SHARE
The basic distinction between retirement and death of a partner relates to finalisation of amount
payable to the Executor of the deceased partner. Although, revaluation of goodwill is done in
the same way as it has been done in case of retirement, in addition, the executor of the deceased
partner is entitled to share of profit upto the date of death.
For example, A, B and C are in partnership sharing profits and losses at the ratio of 2:2:1. A
died on 15th April, 2006. The firm closes its books of account as on 31st December every year.
So the executor of A is entitled for 3½ months profit. If A's share is immediately paid off then
profit for 2000 can be taken as base for calculating 3½ months profits in, 2006. If M/s. A, B &
C earned Rs. 96,000 in year 2005, then 3½ months profit is Rs. 28,000. A's share comes to
Rs. 28,000 × 2/5 i.e. Rs. 11,200.

8.96 COMMON PROFICIENCY TEST


Journal entry is :
Profit and Loss Suspense A/c * Dr. Rs.11,200
To A's Capital A/c Rs. 11,200
(Share of A 3½ months profit in 2001
is transferred to his Capital Account on death)
* At the end of the year 2006, the Profit & Loss Suspense A/c will be transferred to Profit and
Loss A/c.
Illustration 1
The Balance Sheet of Seed, Plant and Flower as at 31st December, 2005 was as under :
Liabilities Rs. Assets Rs.
Sundry Creditors 20,000 Fixed Assets 40,000
General Reserve 5,000 Sundry Debtors 10,000
Capital : Bill Receivable 4,000
Seed 25,000 Stock 16,000
Plant 15,000 Cash at Bank 10,000
Flower 15,000 55,000
80,000 80,000

The profit sharing ratio was: Seed 5/10, Plant 3/10 and Flower 2/10. On 1st May, 2006 Plant
died. It was agreed that:
(a) Goodwill should be valued at 3 years purchase of the average profits for 4 years. The
profits were :
2002 Rs. 10,000 2004 Rs. 12,000
2003 Rs. 13,000 2005 Rs. 15,000
(b) The deceased partner to be given share of profits upto the date of death on the basis of the
previous year.
(c) Fixed Assets were to be depreciated by 10%. A bill for Rs. 1,000 was found to be worthless.
These are not to affect goodwill.
(d) A sum of Rs. 7,750 was to be paid immediately, the balance was to remain as a loan with
the firm at 9% p.a. as interest.
Seed and Flower agreed to share profits and losses in future in the ratio of 3 : 2. They also
agreed that goodwill should not continue to appear in the books.
Give necessary journal entries.

FUNDAMENTALS OF ACCOUNTING 8.97


DEATH OF PARTNER

Solution
Journal
2006 Dr. Cr.
Rs. Rs.
May 1 General Reserve Account Dr. 5,000
To Seed's Capital Account 2,500
To Plant's Capital Account 1,500
To Flower's Capital Account 1,000
(General Reserve transferred to Capital Account
on the death of Plant)
Seed's Capital Account Dr. 3,750
Flower's Capital Account Dr. 7,500
To Plant's Capital Acco0unt 11,250
(Adjustment for goodwill on the death
of Plant on the basis of gaining ratio)
Value = 3 × (10,000 + 13,000 + 12,000 + 15,000)/4]
Revaluation Account Dr. 5,000
To Fixed Assets Account 4,000
To Bills Receivable Account 1,000
(Depreciation of fixed assets @ 10% and
Writing off of one bill for Rs. 1,000 on Plant's death)
Seed's Capital Account Dr. 2,500
Plant's Capital Account Dr. 1,500
Flower's Capital Account Dr. 1,000
To Revaluation Account 5,000
(Loss on Revaluation transferred to capital accounts.)
Profit and Loss Suspense Account Dr. 1,500
To Plant's Capital Account 1,500
(Plant's share of four month's profit based on 2000)
Plant's Capital Account Dr. 27,750
To Plant's Executor's Account 27,750
(Amount standing to the credit of Plant's
Capital Account transferred to the credit of his
Executor's Account)
Plant's Executor's Account Dr. 7,750
To Bank Account 7,750
(Amount paid to Plant's Executors.)

8.98 COMMON PROFICIENCY TEST


Illustration 2
The following was the Balance Sheet of Om & Co. in which X, Y, Z were partners sharing
profits and losses in the ratio of 1:2:2 as on 31.3.2005. Mr. Z died on 31st December, 2005. His
account has to be settled under the following terms.
Balance Sheet of Om & Co. as on 31.3.2005
Liabilities Rs. Rs. Assets Rs.
Sundry creditors 20,000 Goodwill 30,000
Bank loan 50,000 Building 1,20,000
General reserve 30,000 Computers 80,000
Capital accounts: Stock 20,000
X 40,000 Sundry debtors 20,000
Y 80,000 Cash at bank 20,000
Z 80,000 2,00,000 Investments 10,000
3,00,000 3,00,000

Goodwill is to be calculated at the rate of two years purchase on the basis of average of three
years' profits and losses. The profits and losses for the three years were as detailed below:
Year ending on profit/loss
31.3.2005 30,000
31.3.2004 20,000
31.3.2003 (10,000) Loss
Profit for the period from 1.4.2005 to 31.12.2005 shall be ascertained proportionately on the
basis of average profits and losses of the preceding three years.
During the year ending on 31.3.2005 a car costing Rs. 40,000 was purchased on 1.4.2004 and
debited to traveling expenses account on which depreciation is to be calculated at 20% p.a.
This asset is to be brought into account at the depreciated value.
Other values of assets were agreed as follows:
Stock at Rs. 16,000, building at Rs. 1,40,000, computers at Rs. 50,000; investments at Rs. 6,000.
Sundry debtors were considered good.
You are required to:
(i) Calculate goodwill and Z's share in the profits of the firm for the period 1.4.2005 to
31.12.2005.
(ii) Prepare revaluation account assuming that other items of assets and liabilities remained
the same.

FUNDAMENTALS OF ACCOUNTING 8.99


DEATH OF PARTNER

Solution
(i) Calculation of goodwill and Z's share of profit:
(a) Adjusted profit for the year ended 31.3.05: Rs. Rs.
Profit (Given) 30,000
Add: Cost of car wrongly written off 40,000
Less: Depreciation for the year 2004-05 8,000 32,000
(20% on Rs. 40,000)
62,000
(b) Average of last three year's profits and losses
Year ended on profit/(loss)
Rs.
31.3.2003 (10,000)
31.3.2004 20,000
31.3.2005 62,000
72,000
Average profit (72,000/3) 24,000

(c) Goodwill at 2 years' purchase


Rs. 24,000 x 2 = Rs. 48,000
(d) Z's share of profits from the period 1.4.2005 to 31.12.2005
Rs. 24,000 x 9/12 x 2/5 = Rs. 7,200
(ii) Revaluation Account
Dr. Cr.
Rs. Rs.
To Stock account 4,000 By Building account 20,000
To Computers account 30,000 By Loss transferred to
To Investments account 4,000 X 3,600
Y 7,200
Z 7,200 18,000
38,000 38,000

8.100 COMMON PROFICIENCY TEST


Illustration 3
On the basis of illustration 2, prepare partners' capital accounts and balance sheet of the firm
Om & Co. as on 31.12.2005.
Solution
Partners' Capital Accounts
Dr. Cr.
X Y Z X Y Z
Rs. Rs. Rs. Rs. Rs. Rs.
To Revaluation A/c 3,600 7,200 7,200 By Balance b/d 40,000 80,000 80,000
To Z's Executor's A/c 1,12,000 By General reserve 6,000 12,000 12,000
To Goodwill A/c 6,000 12,000 12,000 By X and Y – – 19,200
To Z 6,400 12,800 – By Car A/c 6,400 12,800 12,800
To Balance c/d 36,400 72,800 By Profit and Loss
suspense A/c – – 7,200
52,400 1,04,800 1,31,200 52,400 1,04,800 1,31,200

Balance Sheet of Om & Co. as 31.12.2005


Liabilities Rs. Assets Rs.
Sundry creditors 20,000 Building 1,40,000
Bank loan 50,000 Car 32,000
Capital accounts: Stock 16,000
X 36,400 Computers 50,000
Y 72,800 Investments 6,000
Z's Executor's account 1,12,000 Sundry debtors 20,000
Cash at bank 20,000
Profit and Loss suspense Account 7,200
2,91,200 2,91,200
Goodwill calculated at the time of death of partner Z (See W.N.c of solution 2) Rs. 48,000

Partner Old Share New Share Gain Sacrifice

1 1 2
X –
5 3 15
2 2 4
Y –
5 3 15
2 2
Z – –
5 5

FUNDAMENTALS OF ACCOUNTING 8.101


DEATH OF PARTNER

Adjusting entry :
X's Capital Account Dr. 6,400
Y's Capital Account Dr. 12,800
To Z's Capital Account 19,200
(Adjustment for goodwill on the death
of Z on the basis of gaining ratio)

Illustration 4

The partnership agreement of a firm consisting of three partners - A, B and C (who share
profits in proportion of ½, ¼ and ¼ and whose fixed capitals are Rs. 10,000; Rs. 6,000 and
Rs. 4,000 respectively) provides as follows:
(a) That partners be allowed interest at 10 per cent per annum on their fixed capitals, but no
interest be allowed on undrawn profits or charged on drawings.
(b) That upon the death of a partner, the goodwill of the firm be valued at two years' purchase
of the average net profits (after charging interest on capital) for the three years to 31st
December preceding the death of a partner.
(c) That an insurance policy of Rs. 10,000 each to be taken in individual names of each partner,
the premium is to be charged against the profit of the firm.
(d) Upon the death of a partner, he is to be credited with his share of the profits, interest on
capitals etc. calculated upon 31st December following his death.
(e) That the share of the partnership policy and goodwill be credited to a deceased partner as
on 31st December following his death.
(f) That the partnership books be closed annually on 31st December.
A died on 30th September 2006, the amount standing to the credit of his current account on
31st December, 2005 was Rs. 450 and from that date to the date of death he had withdrawn
Rs. 3,000 from the business.
An unrecorded liability of Rs. 2,000 was discovered on 30th September, 2006. It was decided
to record it and be immediately paid off.
The trading result of the firm (before charging interest on capital) had been as follows: 2003
Profit Rs. 9,640; 2004 Profit Rs. 6,720; 2005 Loss Rs. 640; 2006 Profit Rs. 3,670.
Assuming the surrender value of the policy to be 20 percent of the sum assured, you are required
to prepare an account showing the amount due to A's legal representative as on 31st December,
2006.

8.102 COMMON PROFICIENCY TEST


Solution
A's Capital Account
2006 Rs. 2006 Rs.
Sep. 30 To Current A/c 2,550 Jan. 1 By Balance b/d 10,000
(3,000 - 450) Dec. 31 By Profit and Loss A/c :
Dec. 31 To Profit and Loss Adjt. 1,000 Interest on Capital 1,000
(Unrecorded Liability) Share of Profit 835
To Balance Transferred to B & C (Goodwill) 3,240
A's Executor's A/c 18,525 Insurance Policies A/c 7,000
22,075 22,075

Working Notes :
(i) Valuation of Goodwill
Year Profit before Interest Interest Profit after
on fixed capital interest
Rs. Rs. Rs.
2003 9,640 2,000 7,640
2004 6,720 2,000 4,720
2005 (-) 640 2,000 (-) 2,640
15,720 6,000 9,720
Rs.
Average 3,240
Goodwill at two years purchase of average net profits 6,480
Share of A in the goodwill 3,240
(ii) Profit on Separate Life Policy :
A's policy 10,000
B and C's policy @ 20% 4,000
14,000
Share of A (1/2) 7,000
(iii) Share in Profit for 2006 :
Profit for the Year 3,670
Less : Interest on Capitals 2,000
1,670
A's share in Profit (1/2) 835
(iv) As unrecorded liability of Rs. 2,000 has been charged to Capital Accounts through Profit
and Loss Adjustment Account, no further adjustment in current year's profit is required.

FUNDAMENTALS OF ACCOUNTING 8.103


DEATH OF PARTNER

(v) Profits for 2003, 2004 and 2005 have not been adjusted (for valuing goodwill) for
unrecorded liability for want of precise information.
Illustration 5
The following is the Balance Sheet of M/s. ABC Bros as at 31st December, 2005.
Balance Sheet as at 31st December, 2005
Liabilities Rs. Assets Rs.
Capital A 4,100 Machinery 5,000
B 4,100 Furniture 2,800
C 4,500 Fixture
General Reserve 1,500 Cash 2,100
Creditors 2,350 Stock 1,500
Debtors 4,500
Less: Provision for DD 300 950
4,200
16,550 16,550

C died on 3rd January, 2006 and the following agreement was to be put into effect.
(a) Assets were to be revalued : Machinery to Rs. 5,850; Furniture to Rs. 2,300; Stock to
Rs. 750.
(b) Goodwill was valued at Rs. 3,000 and was to be credited with his share, without using a
Goodwill Account
(c) Rs. 1,000 was to be paid away to the executors of the dead partner on 5th January, 2006.
You are required to show:
(i) The Journal Entry for Goodwill adjustment.
(ii) The Revaluation Account and Capital Accounts of the partners.
(iii) Which account would be debited and which account credited if the Provision for bad
debts in the Balance Sheet was to be found unnecessary to maintain at the death of C.
Solution
(i) Journal Entry in the Books of the firm
Dr. Cr.
Date Particulars Rs. Rs.
Jan 3 A’s Capital A/c Dr. 500
2006 B’s Capital A/c Dr. 500
To C’s Capital A/c 1,000
(Being the required adjustment for goodwill through
the partner's Capital Accounts)

8.104 COMMON PROFICIENCY TEST


(ii) Revaluation Account
Dr. Cr.
Particulars Rs. Particulars Rs.
To Furniture A/c (Rs. 2,800 -2,300) 500 By Machinery A/c (Rs. 5,850 - 5,000) 850
To Stock A/c (Rs. 950-750) 200
To Partners' Capital A/cs 150
(A, - Rs. 50, B - Rs. 50, C - Rs 50)
850 850

Particulars' Capital Accounts


Particulars A B C Particulars A B C
To Capital A/cs (Goodwill) 500 500 – By Balance b/d 4100 4100 4500
To Cash A/c – – 1000 By General Reserve A/c 500 500 500
To Executors A/c – – 5050 By Revaluation A/c (Profit) 50 50 50
To Balance C/d 4150 4150 – By A, Capital A/c (Goodwill) – – 500
By B, Capital A/c (Goodwill) – – 500
4650 4650 6050 4650 4650 6050

(iii) Provision for Doubtful Debts Account is a credit balance. To close, this account is to be
debited. It becomes a gain for the partners. Therefore, either Partners' Capital Accounts
(including C) or Revaluation Account is to be credited.
Working Note :
Statement showing the Required Adjustment for Goodwill
Particulars A B C
Right of goodwill before death 1/3 1/3 1/3
Right of goodwill after death 1/2 1/2 –
Gain / (Sacrifice) (+) 1/6 (+) 1/6 (-) 1/3

Profit sharing ratio is equal before or after the death of C because nothing has been mentioned
in respect of profit-sharing ratio.
Illustration 6
B and N were partners. The partnership deed provides inter alia:
(i) That the accounts be balanced on 31st December each year.
(ii) That the profits be divided as follows:
B : One-half; N : One-third; and carried to Reserve Account : One-sixth

FUNDAMENTALS OF ACCOUNTING 8.105


DEATH OF PARTNER

(iii) That in the event of death of a partner, his executor will be entitled to the following:
(a) the capital to his credit at the date of death; (b) his proportion of profit to date of
death based on the average profits of the last three completed years; (c) his share of
goodwill based on three years' purchases of the average profits for the three preceding
completed years.
Trial Balance on 31st December, 2005
Particulars Dr. (Rs) Cr. (Rs)
B's Capital 90,000
N's Capital 60,000
Reserve 30,000
Bills receivable 50,000
Investments 40,000
Cash 1,10,000
Creditors 20,000
Total 2,00,000 2,00,000

The profits for the three years were 2003 : Rs. 42,000; 2004 : Rs. 39,000 and 2005 : Rs, 45,000.
N died on 1st May, 2006. Show the calculation of N (i) Share of Profits; (ii) Share of Goodwill;
(iii) Draw Up N's Executors Account as would appear in the firms' ledger transferring the
amount to the Loan Account.
Solution
(i) Ascertainment of N's Share of Profit (ii) Ascertainment of Value of Goodwill
2003 42,000 2003 42,000
2004 39,000 2004 39,000
2005 45,000 2005 45,000
Total Profit 1,26,000 Total Profit for 3 years 1,26,000
Average Profit 42,000 Average Profit 42,000
4 months' Profit 14,000 Goodwill - 3 years
Purchase of Average Profit 1,26,000
N's Share in Profit
(2/5th* of Rs.14,000 5600 N's Share of goodwill
(2/5 of Rs. 1,26,000) 50,400
* Profit sharing ratio between B and N = 1/2; 1/3; = 3 : 2, Therefore N's share of Profit = 2/5

8.106 COMMON PROFICIENCY TEST


N’s Executors Account
Date Particulars Rs. Date Particulars Rs.
2006 2006
May 1, - To N's Loan A/c 1,28,000 Jan. 1 By Capital A/c 60,000
May 1 By Reserves
(2/5th of Rs. 30,000) 12,000
May 1 By B’s Capital A/c
(Share of goodwill) 50,400
May 1 By P/L Suspense A/c
(Share of Profit) 5,600
1,28,000 1,28,000

SELF EXAMINATION QUESTIONS


PICK UP THE CORRECT ANSWER FROM THE GIVEN CHOICES:
1. On death of a partner, his executor is paid the share of profits of the dying partner for the
relevant period. This payment is recorded in Profit & Loss ……… Account.
a. Adjustment. b. Appropriation. c. Suspense. d. Reserve.
2. Revaluation account is prepared at the time of
a. Admission of a partner b. Retirement of a partner
c. Death of a partner d. All of the above
3. In the absence of proper agreement, representative of the deseased partner is entitled to
the Dead partner’s share in the following items.
a. Profits till date, goodwill, joint life policy, interest on capital, share in revalued assets
and liabilities.
b. Capital, goodwill, joint life policy, interest on capital, share in revalued assets and
liabilities.
c. Capital, profits till date, goodwill, interest on capital, share in revalued assets and
liabilities.
d. Capital, profits till date, goodwill, joint life policy, share in revalued assets and
liabilities.
4. As per Section 37 of the Indian Partnership Act, 1932, the executors would be entitled at
their choice to the interest calculated from the date of death till the date of payment on
the final amount due to the dead partner at …… percentage per annum.
a. 7. b. 4. c. 6. d. 12.
5. A, B and C are the partners sharing profits and losses in the ratio 2:1:1. Firm has a joint
life policy of Rs. 1,20,000 and in the balance sheet it is appearing at the surrender value

FUNDAMENTALS OF ACCOUNTING 8.107


DEATH OF PARTNER

i.e. Rs. 20,000. On the death of A, how this JLP will be shared among the partners.
a. 50,000:25,000:25,000. b. 60,000:30,000:30,000.
c. 40,000:35,000:25,000. d. Whole of Rs. 1,20,000 will be paid to A.
6. R, J and D are the partners sharing profits in the ratio 7:5:4. D died on 30th June 2006. It
was decided to value the goodwill on the basis of three year’s purchase of last five years
average profits. If the profits are Rs. 29,600; Rs. 28,700; Rs. 28,900; Rs. 24,000 and Rs.
26,800. What will be D’s share of goodwill?
a. Rs. 20,700. b. Rs. 27,600. c. Rs. 82,800. d. Rs. 27,000.
7. R, J and D are the partners sharing profits in the ratio 7:5:4. D died on 30th June 2006 and
profits for the accounting year 2005-2006 were Rs. 24,000. How much share in profits for
the period 1st April 2006 to 30th June 2006 will be credited to D’s Account.
a. Rs. 6,000. b. Rs. 1,500. c. Nil. d. Rs. 2,000.
8. If three partners A, B & C are sharing profits as 5:3:2, then on the death of a partner A,
how much B & C will pay to A’s executer on account of goodwill. Goodwill is to be
calculated on the basis of 2 years purchase of last 3 years average profits. Profits for last
three years are: Rs. 3,29,000; Rs. 3,46,000 and Rs. 4,05,000.
a. Rs. 2,16,000 & Rs. 1,42,000. b. Rs. 2,44,000 & Rs. 2,16,000.
c. Rs. 3,60,000 & Rs. 3,60,000. d. Rs. 2,16,000 & Rs. 1,44,000.

ANSWERS

1. (c), 2. (d), 3. (d), 4. (c), 5. (a), 6. (a), 7. (b),


8. (d)

8.108 COMMON PROFICIENCY TEST


CHAPTER - 9

COMPANY
ACCOUNTS

Unit 1

Introduction
to Company
Accounts
INTRODUCTION TO COMPANY ACCOUNTS

Learning Objectives
After studying this unit you will be able to
 Understand the reason for the existence and survival of a company.
 Learn the nature and types of companies.
 Explain the salient features of a company
 Understand the purpose of preparing the financial statements of the company

1. INTRODUCTION
The never-ending human desire to grow and grow further has given rise to the expansion of
business activities, which in turn has necessitated the need to increase the scale of operations
so as to provide goods and services to the ever increasing needs of the growing population of
consumers. Large amount of money, modern technology, large human contribution etc. is
required for it, which is not possible to arrange under partnership or proprietorship. To overcome
this difficulty, the concept of ‘Company’ or ‘Corporation’ came into existence.
While the invention of steam power ignited the human imagination to build big machines for
the mass production of goods, the need to separate the management from ownership gave
birth to a form of organisation today known as ‘company’.
Company form of organisation is one of the ingenious creations of human mind, which has
enabled the business to carry on its wealth creation activities through optimum utilisation of
resources. In course of time, company has become an important institutional form for business
enterprise, which has carved out a key place for itself in the field of business operations as well
as in the wealth-generating functions of society.

2. MEANING OF COMPANY
The word ‘Company’, in everyday usage, implies an assemblage of persons for social purpose,
companionship or fellowship. As a form of organisation, the word ‘company’ implies a group
of people who voluntarily agree to form a company.
The word ‘company’ is derived from the Latin word ‘com’ i.e. with or together and ‘panis’ i.e.
bread. Originally the word referred to an association of persons or merchant men discussing
matters and taking food together. However, in law ‘company’ is termed as company which is
formed and registered under The Companies Act, 1956, or an existing company formed and
registered under any of the previous laws (Act or Acts relating to companies before the Indian
Companies Act, 1956, The Companies Act, 1882, The Indian Companies Act, 1913 or any law
governing companies in the State of Jammu and Kashmir before the commencement of Central
Laws Act, 1968 and Portuguese Commercial Code). As per this definition of law, there must
be group of persons who agree to form a company under the law and once so formed, it
becomes a separate legal entity having perpetual succession with a distinct name of its own
and a common seal. Its existence is not affected by the change of members.

9.2 COMMON PROFICIENCY TEST


Company begs its origin in law. It is an organisation consisting of individuals, called shareholders
by virtue of holding the shares of a company, who are authorised by law to elect a board of
directors and, through it, to act as a separate legal entity as regards its activities. Generally, the
capital of the company consists of transferable shares, and members have limited liabilities.
To get to the heart of the nature of the company, let us examine the concept of company
propounded under corporate jurisprudence.
According to Justice Marshal. “A corporation is an artificial being, invisible, intangible and existing
only in the contemplation of law”.
In the same manner, Lord Justice Hanay has defined a company as “an artificial person created
by law with a perpetual succession and a common seal”.
A common thread running through the various definitions of ‘company’ is that it is an association
of persons created by law as a separate body for a special purpose. At the same time, definitions
have laid down certain characteristics of a corporate organisation, which make it out as a
separate and unique organisation which enables the people to contribute their wealth to the
capital of the company by subscribing to its shares and appointing elected representatives to
carry out the business.

3. SALIENT FEATURES OF A COMPANY


Following are the salient features of a company:
1. Incorporated Association : A company comes into existence through the operation of law.
Therefore, incorporation of company under The Companies Act is must. Without such
registration, no company can come into existence. Being created by law, it is regarded as
an artificial legal person.
2. Separate Legal Entity : A company has a separate legal entity and is not affected by changes
in its membership. Therefore, being a separate business entity, a company can contract,
sue and be sued in its incorporated name and capacity.
3. Perpetual Existence : Since company has existence independent of its members, it continues
to be in existence despite the death, insolvency or change of members.
4. Common Seal : Company is not a natural person, therefore, it cannot sign the documents
in the manner as a natural person would do. In order to enable the company to sign its
documents, it is provided with a legal tool called ‘Common Seal’. The common seal is
affixed on all documents by the person authorised to do so who in turn puts his signature
for and on behalf of the company.
5. Limited Liability : The liability of every shareholder of a company is limited to the amount
he has agreed to pay to the company on the shares allotted to him. If such shares are fully
paid-up, he is subject to no further liability.
6. Distinction between Ownership and Management : Since the number of shareholders is very
large and may be distributed at different geographical locations, it becomes difficult for
them to carry on the operational management of the company on a day-to-day basis. This

FUNDAMENTALS OF ACCOUNTING 9.3


INTRODUCTION TO COMPANY ACCOUNTS

gives rise to the need of separation of the management and ownership.


7. Not a citizen : A company is not a citizen in the same sense as a natural person is, though
it is created by the process of law. It has a legal existence but does not enjoy the citizenship
rights and duties as are enjoyed by the natural citizens.
8. Transferability of Shares : The capital is contributed by the shareholders through the
subscription of shares. Such shares are transferable by its members except in case of a
private limited company, which may have certain restrictions on such transferability.
9. Maintenance of Books : A limited company is required by law to keep a prescribed set of
account books and any failure in this regard attracts penalties.
10. Periodic Audit : A company has to get its accounts periodically audited through the chartered
accountants appointed for the purpose by the shareholders on the recommendation of
board of directors.
11. Right of Access to Information : The right of the shareholders of a company to inspect its
books of account, with the exception of books open for inspection under the Statute, is
governed by the Articles of Association. The shareholders have a right to seek information
from the directors by participating in the meetings of the company and through the periodic
reports.

4. TYPES OF COMPANIES
1. STATUTORY COMPANY

COMPANY

STATUTORY GOVERNMENT FOREIGN HOLDING REGISTERED


COMPANY COMPANY COMPANY AND COMPANY
SUBSIDIARY
COMPANY

LIMITED UNLIMITED
COMPANY COMPANY

PUBLIC PRIVATE PUBLIC PRIVATE


COMPANY COMPANY COMPANY COMPANY

9.4 COMMON PROFICIENCY TEST


All those companies, which operate under the special act passed by the State Legislature or
Parliament, are called statutory companies. They are formed for special purpose by a special Act
of Parliament. Included in this category are the Unit Trust of India, Life Insurance Corporation,
Reserve Bank of India, State Bank of India and so on. Such companies are not required to use
the word ‘limited’ as part of their name. For example, Reserve Bank of India. Such companies
are required to get their accounts audited by Comptroller and Auditor General of India and
are publicly accountable to the State Legislature/Parliament.
2. GOVERNMENT COMPANY
According to Section 617 of The Companies Act, 1956. “a Government company means any
company in which not less than 51% of the paid-up capital is held by the Central Government,
or by any State Government or Governments, or partly by the Central Government and partly
by one or more State Governments and includes a company which is a subsidiary of a
government Company”.
3. FOREIGN COMPANY
A foreign company is one that is incorporated outside India but has place of business or business
operations in India.
4. HOLDING COMPANY
Under Section 4(4) of The Companies Act, 1956, a company is deemed to be a holding company
if the other company is its subsidiary company. A company becomes a subsidiary company
when other company controls 51% or more of its paid-up share capital, has right to appoint
directors on its board, or is a subsidiary of another subsidiary company.
5. SUBSIDIARY COMPANY
According to Section 4(1), a company is deemed to be a subsidiary of another company if and
only if –
(a) That other company controls the composition of its board of directors, it implies that the
controlling company (holding company) has the right to exercise the power of appointing
or removing any person or a majority of persons from the directorship at its own discretion;
or
(b) That other company holds more than half in its nominal value of its equity share capital;
or
(c) That other company is a subsidiary of any company, which is that other’s subsidiary. For
example, Company B is a subsidiary of Company A, and Company C is a subsidiary of
Company B. Since, Company B is a subsidiary of Company A, Company C becomes the
subsidiary of Company A as well.
(d) In case of a body corporate which is incorporated in a country outside India, a subsidiary
or holding company of the body corporate under the law of such country shall be deemed
to be a subsidiary or holding company within the meaning and for the purpose of this act
whether the requirements of this section are fulfilled or not. It implies that if a company
operating in India is a subsidiary of a foreign company, it will be treated as such irrespective
of the fact whether in India, if it fulfills conditions (a), (b) and (c) listed above or not.

FUNDAMENTALS OF ACCOUNTING 9.5


INTRODUCTION TO COMPANY ACCOUNTS

6. REGISTERED COMPANY
All those companies that are registered under The Companies Act, 1956, are called Registered
Companies.
7. LIMITED LIABILITY COMPANY
A company in which the liability of shareholders is restricted to the amount of unpaid calls on
shares is known as limited company.
8. UNLIMITED LIABILITY COMPANY
A company in which the liability of shareholders is not restricted only to the value unpaid
shares is known as unlimited company
9. PUBLIC COMPANY
According to Section 3(1)(iv) of the Act, ‘public company’ means a company which (a) is not a
private company; (b) has a minimum paid-up capital of Rs.5 lakhs or such higher paid-up
capital; and (c) is a private company which is a subsidiary of a company which is not a private
company. After Companies (Amendment) Act, 2000, a public company cannot be registered
with a capital of less than Rs. 5 lakhs. Public companies invite the public at large to participate
and subscribe for the shares in, or debentures of, the company and there are no restrictions on
transfer of shares.
10. PRIVATE COMPANY
According to Section 3(1)(iii), a private company means a company which has a minimum
paid-up capital of one lakh rupees or such higher paid-up capital as may be prescribed, and by
its articles:
(a) Restricts the rights of members to transfer its shares.
(b) Limits the number of its member to 50 excluding: (i) persons who are in employment of
the company; and (ii) persons who, having been formerly in the employment of the
company, were members of the company while in that employment and have continued
to be members after the employment ceased. For this purpose joint holders of shares will
be counted as single members.
(c) Prohibits any invitation to the public to subscribe to any shares in, or debentures of, the
company.
(d) Prohibits any invitation or acceptance of deposits from persons other than its member,
directors, and relatives.
Private companies do not involve participation of public in general.
Companies (Amendment) Bill, 2003 states that if a company, private or public, fails to
enhance its minimum paid-up capital (i.e., one lakh rupees or five lakh rupees, as the case
may be) each director or manager or shareholder will have unlimited liability.
A public company may be a listed company or an unlisted company.

9.6 COMMON PROFICIENCY TEST


11. LISTED COMPANY
A listed company is a public company which has any of its securities listed in any recognised
stock exchange.
12. UNLISTED COMPANY
An unlisted company is one whose securities are not listed on any recognised stock exchange
for trading.
In the case of private companies shares are not listed in any stock exchange.

5. BOOKS OF ACCOUNT
Section 209 of the Companies Act, 1956 requires that:
(a) Such books, as are necessary to give a true and fair view of the state of affairs of the
company and to explain its transactions, are kept on accrual basis and according to the
double-entry system of book-keeping.
(b) Every company maintains proper books of account with respect to:
(i) all sums of money received and expanded by the company and the matters in respect
of which receipts and expenditure take place;
(ii) all sales and purchases of goods by the company;
(iii) all assets and liabilities of the company; and
(iv) utilisation of material or labour or other items of costs in cost accounting records, in
case of manufacturing companies.

6. PREPARATION OF FINANCIAL STATEMENTS


Under Section 210 of the Companies Act, at the annual general meeting of a company, the
Board of Directors of the company shall lay before the company:
(a) a balance sheet as at the end of the period;
(b) a profit & loss account for that period.
In case of a company not carrying on business for profit, an income and expenditure account
shall be laid before the company at its annual general meeting instead of profit and loss account.
Section 211 along with Schedule VI of the Companies Act, 1956 deals with the preparation
and presentation of profit and loss account and the balance sheet. It requires that final accounts
of a company shall give a true and fair view of the state of affairs of the company. Schedule VI
does not prescribe any form in which profit and loss account should be prepared. However, it
requires that profit and loss should give a true and fair view of the profit and loss of the
company for the financial year and should comply with the requirements of Part II of
Schedule VI.
Balance sheet of a company should be in form set out in Part I of Schedule VI. It prescribes two
alternative forms in which balance sheet can be prepared, namely, horizontal and vertical (for
details see chapter on ‘Final Accounts of Companies’). Main heads in balance sheet in the
prescribed order are given below in horizontal form:

FUNDAMENTALS OF ACCOUNTING 9.7


INTRODUCTION TO COMPANY ACCOUNTS

Balance Sheet of M/s…..as at……..


Liabilities Amount Assets Amount
Share Capital Fixed Assets
Reserves & Surplus Investments
Secured Loans Current Assets, Loans and
Unsecured Loans Advances :
Current Liabilities and Provisions : a. Current Assets
a. Current Liabilities b. Loans and Advances
b. Provisions Miscellaneous Expenditure
Profit and Loss Account

SELF EXAMINATION QUESTIONS


1. The following list of accounts with their balances was taken from the general ledger of D
Ltd. as on March 31, 2006:
Particulars Rs.
Discount on issue of debentures 8,500
Cash 73,500
Equity Share Capital Rs.100 each 6,80,000
General Reserve 2,31,500
Securities premium 3,95,000
Dividends Payable 22,000
Profit and Loss appropriation account 80,000
10% Debentures Rs.100 each 1,00,000
The Shareholders equity as on March 31, 2006 is:
a. Rs.13,78,000
b. Rs.13,86,500
c. Rs.14,00,000
d. Rs.14,08,500
2. The item ‘Interest Accrued on Investments’ appears in the Balance Sheet of a company
under the category of _____________.
(a) Secured loans (b) Current assets, loans and advances
(c) Investments (d) Current liabilities

ANSWERS
1. (a), 2. (b)

9.8 COMMON PROFICIENCY TEST


CHAPTER – 9

COMPANY
ACCOUNTS

Unit 2

Issue, Forfeiture
and Reissue
of Shares
ISSUE, FORFEITURE AND REISSUE OF SHARES

Learning objectives
After studying this unit you will be able to :
 Appreciate various types of shares and share capital
 Learn the accounting treatment if shares issued under different circumstances like at
par, at discount and at premium.
 Differentiate the accounting treatment for under-subscription and over-subscription of
shares.
 Understand the concept and accounting treatment of call-in-arrears and call-in-advance.
 Deal with the forfeiture of shares issued with different conditions.
 Journalise the entry for re-issue of shares whether at discount or at premium.
 Learn the various phases of share capital i.e. alteration or conversion of shares into
stock and vice-versa.
 Know the concept and accounting treatment of bonus shares.

1. INTRODUCTION
Funds provided by the owner(s) into a business are recorded as capital. Capital of the business
depends upon the form of business organisation. Proprietor provides capital in a sole-
proprietorship business. In case of a partnership, there is more than one proprietor, called
partners. Partners introduce capital in a partnership firm. As the maximum number of members
in a partnership firm is restricted, therefore only limited capital can be provided in such form
of businesses. Moreover, the liability of the proprietor(s) is unlimited in case of non-corporate
business, namely, sole-proprietorship and partnership.
With the onset of industrial revolution, requirement of capital investment soared to a new
height and the attached risk of failure increased due to pace of technological developments.
Non-corporate entities could not cope with the pressure of increased capital and degree of risk
involved. This led to the emergence of corporate form of organisation.

2. SHARE CAPITAL
Total capital of the company is divided into a number of small indivisible units of a fixed
amount and each such unit is called a share. The fixed value of a share, printed on the share
certificate, is called nominal/par/face value of a share. However, a company can issue shares
at a price different from the face value of a share. The liability of holder of shares (called
shareholders) is limited to the issue price of shares acquired by them.
As per SEBI guidelines, a company is free to price its issue, if it has a three years track record of
consistent profitability and in case of new company, if it is promoted by a company with a five
years track record of consistent profitability. As the total capital of the company is divided into
shares, the capital of the company is called ‘Share Capital’.

9.10 COMMON PROFICIENCY TEST


Share capital of a company is divided into following categories:
(i) Authorised Share Capital : A company estimates its maximum capital requirements. This
amount of capital is mentioned in ‘Capital Clause’ of the ‘Memorandum of Association’
registered with the Registrar of Companies. It puts a limit on the amount of capital, which
a company is authorised to raise during its lifetime and is called ‘Authorised Capital’. It is
also referred to as ‘Registered Capital’ or ‘Nominal Capital’. It is shown in the balance
sheet at face value.
(ii) Issued Share Capital : A company need not issue total authorised capital. Whatever portion
of the share capital is issued by the company, it is called ‘Issued Capital’. Issued capital
means and includes the nominal value of shares issued by the company for:
1. Cash, and
2. Consideration other than cash to:
(i) Promoters of a company; and
(ii) Others.
It is also shown in the balance sheet at nominal value.
The remaining portion of the authorised capital which is not issued either in cash or
consideration may be termed as ‘Un-issued Capital’. It is not shown in the balance sheet.
(iii) Subscribed Share Capital : It is that part of the issued share capital, which is subscribed by
the public i.e., applied by the public and allotted by the company. It also includes the face
value of shares issued by the company for consideration other than cash.
(iv) Called-up Share Capital : Companies generally receive the issue price of shares in installments.
The portion of the issue price of shares which a company has demanded or called from
shareholders is known as ‘Called-up Capital’ and the balance, which the company has
decided to demand in future may be referred to as Uncalled Capital.
(v) Paid-up Share Capital : It is the portion of called up capital which is paid by the shareholders.
Whenever a particular amount is called by the company and the shareholder(s) fails to
pay the amount fully or partially, it is known as ‘unpaid calls’ or ‘installments (or Calls)
in Arrears’. Thus, installments in arrears mean the amount not paid although it has been
demanded by the company as payment towards the issue price of shares. To calculate
paid-up capital, the amount of installments in arrears is deducted from called up capital.
In balance sheet, called-up and paid-up capital are shown together.
(vi) Reserve Share Capital : As per Section 99 of the Companies Act, 1956, a company may
decide by passing a special resolution that a certain portion of its subscribed uncalled
capital shall not be called up except in the event of winding up of the company. Portion of
the uncalled capital which a company has decided to call only in case of liquidation of the
company is called Reserve Liability/Reserve Capital.
Reserve Capital is different from Capital reserve, Capital reserves are part of ‘Reserves and
Surplus’ and refer to those reserves which are not available for declaration of dividend. These
reserves may be used to write off capital losses such as discount on issue of shares. These can

FUNDAMENTALS OF ACCOUNTING 9.11


ISSUE, FORFEITURE AND REISSUE OF SHARES

also be used to issue bonus shares, subject of the condition, that reserve is realized in cash.
Thus, reserve capital which is portion of the uncalled capital to be called up in the event of
winding up of the company is entirely different in nature from capital reserve which is created
out of profits only.
Illustration 1
A company had a registered capital of Rs.1,00,000 divided into 10,000 equity shares of Rs.10
each. It decided to issue 6,000 shares for subscription and received applications for 7,000 shares.
It allotted 6,000 shares and rejected remaining applications. Upto 31-12-2005, it has demanded
or called Rs.9 per share. All shareholders have duly paid the amount called, except one
shareholder, holding 500 shares who has paid only Rs.7 per share.
Prepare a balance sheet assuming there are no other details.
Solution
Balance Sheet as at December 31, 2005
Liabilities Amount Assets Amount
Share Capital
Authorised share capital Fixed Assets Nil
10,000 equity shares of Rs.10 each 1,00,000 Investments Nil
Issued Capital : Current Assets loans and
6,000 equity shares of Rs.10 each 60,000 Advances:
Subscribed Capital: 6,000 equity A. Current Assets:
shares of Rs.10 each 60,000 Bank 53,000
Called-up and paid up capital: B. Loans and Advances Nil
6,000 shares of Rs.10 each Rs.9 Miscellaneous Expenditure Nil
called-up 54,000 Profit and Loss Account Nil
Less : calls in arrears (unpaid
calls) on 500 shares @Rs.2
per share 1,000 53,000
Reserves and Surplus Nil
Secured loans Nil
Current liabilities and Provisions Nil
53,000 53,000

It is clear from above, that details of authorised, issued and subscribed capital are given in the
balance sheet but are not counted. It is only the paid-up capital i.e., the portion of the issued
capital subscribed by shareholders which is taken into account while totalling the liabilities
side of the balance sheet.

9.12 COMMON PROFICIENCY TEST


3. TYPES OF SHARES
Share issued by a company can be divided into following categories :
(i) Preference Shares: According to section 85 of the Companies Act, 1956, persons holding
preference shares, called preference shareholders, are assured of a preferential dividend
at a fixed rate during the life of the company. They also carry a preferential right over
other shareholders to be paid first in case of winding up of the company. Thus, they enjoy
preferential rights in the matter of :
(a) Payment of dividend, and
(b) Repayment of capital
Generally, holders of these shares do not get voting rights. Companies use this mode of
financing as it is cheaper than raising debt. Dividend is generally cumulative in nature
and need not be paid every year in case of deficiency of profits. The Companies Act, 1956,
prohibits the issue of any preference share which is irredeemable. Preference shares are
cumulative and non-participating unless expressly stated otherwise.
Types of Preference Shares
Preference shares can be of various types, which are as follows :
(a) Cumulative Preference Shares : A cumulative preference share is one that carries
the right to a fixed amount of dividend or dividend at a fixed rate. Such a dividend is
payable even out of future profit if current year’s profits are insufficient for the purpose.
This means that dividend on these shares accumulates unless it is paid in full and,
therefore, the shares are called Cumulative Preference Shares. The arrears of dividend
are then shown in the balance sheet as a contingent liability. In India, a preference
share is always cumulative unless otherwise stated. In case, the dividend remains in
arrears for a period of not less than two years, holders of such shares will be entitled
to take part and vote on every resolution on every matter in the general body meeting
of the shareholders.
(b) Non-cumulative Preference Shares : A non-cumulative preference share carries with
it the right to a fixed amount of dividend. In case no dividend is declared in a year
due to any reason, the right to receive such dividend for that year expires. It implies
that holder of such a share is not entitled to arrears of dividend in future. In case, the
dividend remains in arrears for a period of not less than two years or an aggregate
period of not less than three years comprised in the six years ending with the expiry
of the financial year, holders of such shares will be entitled to take part and vote on
every resolution at any meeting of the shareholders.
(c) Participating Preference Shares : Notwithstanding the right to a fixed dividend, this
category of preference share confers on the holder the right to participate in the surplus
profits, if any, after the equity shareholders have been paid dividend at a stipulated
rate. Similarly, in the event of winding up of the company, this type of share carries
the right to receive a pre-determined proportion of surplus as well once the equity
shareholders have been paid off.

FUNDAMENTALS OF ACCOUNTING 9.13


ISSUE, FORFEITURE AND REISSUE OF SHARES

(d) Non-participating Preference Shares : A share on which only a fixed rate of dividend
is paid every year, without any accompanying additional rights in profits and in the
surplus on winding-up, is called ‘Non-participating Preference Shares.’ Unless
otherwise specified, the preference shares are generally non-participating.
(e) Redeemable Preference Shares : These are shares that a company may issue on the
condition that the company will repay after the fixed period or even earlier at
company’s discretion. The repayment on these shares is called redemption and is
governed by Section 80 of The Companies Act, 1956. In India, companies can now
issue only this category of preference shares.
(f) Non-redeemable Preference Shares : The preference shares, which do not carry
with them the arrangement regarding redemption, are called Non-redeemable
Preference Shares. According to Section 80(5A), no company limited by shares shall
issue irredeemable preference shares or preference shares redeemable after the expiry
of 20 years from the date of issue.
(g) Convertible Preference Shares : These shares give the right to the holder to get them
converted into equity shares at their option according to the terms and conditions of
their issue.
(h) Non-convertible Preference Shares : When the holder of a preference share has not
been conferred the right to get his holding converted into equity share, it is called
Non-convertible Preference Shares. Preference shares are non-convertible unless
otherwise stated.
(ii) Equity Shares : Equity shares are those shares, which are not preference shares. It means
that they do not enjoy any preferential rights in the matter of payment of dividend or
repayment of capital. The rate of dividend on equity shares is recommended by the Board
of Directors and may vary from year to year. Rate of dividend depends upon the dividend
policy and the availability of profits after satisfying the rights of preference shareholders.
These shares carry voting rights. Companies (Amendment) Act, 2000 permits issue of
equity share capital with differential rights as to dividend, voting or otherwise.
The shares can be issued by a company either
(1) for cash or
(2) for consideration other than cash.

4. ISSUE OF SHARES FOR CASH


To issue shares, private companies depend upon ‘Private Placement’ of shares. Public companies
issue a ‘Prospectus’ and invite general public to subscribe for shares. To discuss accounting
treatment, we shall concentrate on public companies who invite general public to subscribe for
equity shares. Similar accounting treatment is applicable in other cases. However, in case of
issue of preference shares, the word ‘Equity’ is replaced with the word ‘Preference’.
A public company issues a prospectus inviting general public to subscribe for its shares. On the
basis of prospectus, applications are deposited in a scheduled bank by the interested parties

9.14 COMMON PROFICIENCY TEST


alongwith the amount payable at the time of application, in cash. First installment paid alongwith
application is called ‘Application Money’. As per Companies Act 1956, Application money must
be atleast 5% of the face value of shares. After the closing date of the issue (the last date for filing
applications), company decides about allotment of shares in consultation with the SEBI and
stock exchange concerned. According to the Companies Act, 1956, a company cannot proceed
to allot shares unless minimum subscription is received by the company.
Minimum Subscription : A public limited company cannot make any allotment of shares
unless the amount of minimum subscription stated in the prospectus has been subscribed and
the sum payable as application money for such shares has been paid to and received by the
company. The amount of minimum subscription to be disclosed in prospectus by the Board of
Directors taking into account the following:
(a) Preliminary expenses of the company,
(b) Commission payable on issue of shares,
(c) Cost of fixed assets purchased or to be purchased,
(d) Working capital requirements of the company, and
(e) Any other expenditure for the day to day operation of the business.
As per guidelines of the Securities Exchange Board of India (SEBI), a company must receive a
minimum of 90% subscription against the entire issue (including devolvement on underwriters
in case of underwritten issue) before making any allotment of shares or debentures to the
public. It is applicable for public and right issue, and not in case of offer for sale of securities. If
the Company does not receive the minimum subscription of 90% of the issue, the entire
subscription shall be refunded to the applicants within 42 days from the date of closure of
issue. In case of delayed refund, interest for the delayed period as per section 73 of the Companies
Act shall be payable. SEBI guidelines dated 27-1-2000 also require that in case of public issue at
par the minimum number of shares for which an application is to be made shall be fixed at 200
shares of face value of Rs.10 each.
The company reserves the right to reject or accept an application fully or partially. Successful
applicants become shareholders of the company and are required to pay the second instalment
which is known as ‘Allotment Money’ and unsuccessful applicants get back their money.
However, in case of delay in refunding the money, the Company becomes liable to pay interest
@ 15% p.a. on the amount of refund. Subsequent instalments, if any, to be called by the company
are known as ‘Calls’. The Companies Act, 1956, requires that the period of at least one month
must be there between two calls. The Securities and Exchange Board of India (SEBI) Guidelines,
dated 27-1-2000 require the shares issued are made fully paid up within twelve months of the
date of allotment if size of the issue is upto 500 crores. The minimum application money to be
paid by an applicant alongwith the application money shall not be less than 25% of the issue
price. Companies (Amendment) Bill, 2003 require application money to be not less than 25%
of the nominal value of security. Thus, the issue price of shares is generally received by the
company in instalments and these instalments are known as under :

FUNDAMENTALS OF ACCOUNTING 9.15


ISSUE, FORFEITURE AND REISSUE OF SHARES

First instalment ………….. Application Money


Second Instalment ………….. Allotment Money
Third Instalment ………….. First Call Money
Fourth Instalment ………….. Second Call Money and so on.
Last Instalment Final Call Money

4.1 JOURNAL ENTRIES FOR ISSUE OF SHARES FOR CASH


Upon the issue of share capital by a company, the undermentioned entries are made in the
financial books:
(1) On receipt of the application money
Bank Account Dr. (With the actual amount received.)
To Shares Application Account
(2) On allotment of share
Share Allotment Account Dr. (With the amount due on allotment.)
Share Application Account Dr. (With the application amount received on allotted
shares.)
To Share Capital Account (With the amount due on allotment and application.)
(3) On receipt of allotment money
Bank Account Dr. (With the amount actually received on allotment.)
To Share Allotment Account

Sometimes separate Application and Allotment Accounts are not prepared and entries
relating to application and allotment monies are passed through a combined Application
and Allotment Account.
(4) On a call being made
Share Call Account Dr. (With the amount due on the call.)
To Share Capital Account
(5) On receipt of call money
Bank Account Dr. (with the due amount actually received on call)
To Share Call Account

5. SUBSCRIPTION OF SHARES
Accounting for issue of shares depends upon the type of subscription. Whenever a company
decides to issue shares to public, it invites applications for subscription by issuing a prospectus.
It is not necessary that company receives applications for the number of shares to be issued by
it. There are three possibilities :

9.16 COMMON PROFICIENCY TEST


5.1 FULL SUBSCRIPTION
Issue is fully subscribed if the number of shares offered for subscription and the number of
shares actually subscribed by the public are same. To start discussion on accounting treatment
for issue of shares, let us assume that the issue is fully subscribed.
Illustration 2
A company invited applications for 10,000 equity shares of Rs. 50 each payable on application
Rs. 15, on Allotment Rs. 20, on first and final call Rs. 15. Applications are received for 10,000
shares and all the applicants are allotted the number of shares they have applied for and
installment money was duly received by the company. Show Journal entries in the books of the
company.
Solution
Journal entries in the books of a company
For application money received: Amount received alongwith application is accounted as follows:
Bank A/c Dr. (Application money on allotted share i.e.,
To Equity Share Application A/c 10,0000 × 15 = 1,50,000)
At the time of allotment: Application money received from successful applicants become part of
share capital and is transferred to share capital as under:
Equity Share Application A/c Dr. (Application money on allotted share i.e.,
To Equity Share Capital A/c 10,0000 × 15 = 1,50,000)
To record amount due on allotment: When the decision is taken to allot shares, allotment money
on allotted shares falls due and is recorded as follows:
Equity Share Allotment A/c Dr. (Application due at the allotted share i.e.,
To Equity Share Capital A/c 10,0000 × 20 = 2,00,000)
For allotment money received: Allotment money received from shareholders is recorded as follows:
Bank A/c Dr. (Allotment money received from shareholders i.e.
To Equity Share Allotment A/c 10,000 × 20 =2,00,000)
When decision to demand first call is made: After allotment of share, when the Board of Directors
decide to demand the next instalment from shareholders, first call money falls due and is
accounted for, as under:
Equity Share First Call A/c Dr. (No. of shares × first call money per share i.e.,
To Equity Share Capital A/c 10,000 × 15 = 1,50,000)
On receiving first and final call money: The journal entry passed to record the money received on
account of first call is as under:
Bank A/c Dr. (Amount actually received on account of first call
To Equity Share Capital A/c i.e., Rs.10,000 × 15 = 1,50,000)

FUNDAMENTALS OF ACCOUNTING 9.17


ISSUE, FORFEITURE AND REISSUE OF SHARES

5.2 UNDER SUBSCRIPTION


It means the number of shares offered for subscription is more than the number of shares
subscribed by the public. In this case, the journal entries as discussed above are passed but
with one change i.e., calculation of application, allotment and for that matter, the call money
is based on number of shares actually applied and allotted. It must be remembered that shares
can be allotted, in this case, only when the minimum subscription is received.
Illustration 3
On 1st April, 2005, A Ltd. issued 43,000 shares of Rs. 100 each payable as follows:
Rs. 20 on application;
Rs. 30 on allotment;
Rs. 25 on 1st October, 2005; and
Rs. 25 on 1st February, 2006.
By 20th May, 40,000 shares were applied for and all applications were accepted. Allotment
was made on 1st June. All sums due on allotment were received on 15th July; those on 1st call
were received on 20th October. Journalise the transactions when accounts were closed on 31st
March, 2006.
Solution
A Ltd.
Journal
Dr. Cr.
2005 Rs. Rs.
May 20 Bank Account Dr. 8,00,000
To Share Application & Allotment A/c 8,00,000
(Application money on 40,000 shares at
Rs. 20 per share.)
June 1 Share Application & Allotment A/c Dr. 20,00,000
To Share Capital A/c 20,00,000
(The amount transferred to Capital Account
on 40,000 shares at Rs. 50 per share-Rs. 20
on application and Rs. 30 on allotment.
Directors’ resolution no...... dated ......)
July 15 Bank Account Dr. 12,00,000
To Share Application and Allotment A/c 12,00,000
(The sums due on allotment received.)
Oct. 1 Share First Call Account Dr. 10,00,000
To Share Capital Account 10,00,000
(Amount due from members in respect of

9.18 COMMON PROFICIENCY TEST


first call-on 40,000 shares at Rs. 25 as per
Directors, resolution no... dated...)
Oct. 20 Bank Account Dr. 10,00,000
To Share First Call Account 10,00,000
(Receipt of the amounts due on first call.)
2006
Feb. 1 Share Second and Final Call A/c Dr. 10,00,000
To Share Capital A/c 10,00,000
(Amount due on 40,000 share at Rs. 25
per share on second and final call, as per
Directors resolution no... dated...)
Mar. 31 Bank Account Dr. 10,00,000
To Share Second & Final Call A/c 10,00,000
(Amount received against the final call on
40,000 shares at Rs. 25 per share.)
5.3 OVER SUBSCRIPTION
In actual practice, issue of shares is either under or over subscribed. If an issue is over-subscribed,
some applications may be rejected and application money refunded and in respect of others,
only a part of the shares applied for may be allotted and the excess amount received can be
utilised towards allotment or call money which has fallen or will soon fall due for payment.
The entries are:
(1) On refund of application money to applicants to whom shares have not been allotted :
Share Application A/c Dr.
To Bank Account
(2) When only a part of shares applied for are allowed:
Share Application A/c Dr. (With the amount received in advance for allotment)
To Share Allotment A/c
To Share Calls-in-Advance Account
Illustration 4
The Delhi Artware Ltd. issued 500 equity shares of Rs. 100 each and 1,000 preference shares of
Rs. 100 each. The Share Capital was to be collected as under:
Equity Shares Preference Shares
Rs. Rs.
On Application 25 20
On Allotment 20 30
First Call 30 20
Final Call 25 30

FUNDAMENTALS OF ACCOUNTING 9.19


ISSUE, FORFEITURE AND REISSUE OF SHARES

All these shares were subscribed. Prepare the cash book and journalise the remaining
transactions in the books of the company.
Solution
Delhi Artware Ltd.
Cash Book
Dr. Cr.
Rs. Rs.
To Equity Shares Applications & By Balance c/d 1,44,400
Allotment Account (application
money on 500 shares at Rs. 25) 12,500
To Preference Share Application &
Allotment A/c (application money
on 1,000 shares at Rs. 20) 20,000
To Equity Share Applications &
Allotment A/c (allotment money
on 500 shares at Rs. 20) 10,000
To Preference Share Application &
Allotment A/c (allotment money
on 1,000 shares at Rs. 30) 30,000
To Equity Shares First Call A/c
(Rs. 30 on 500 shares) 15,000
To Preference Share First Call A/c
(Rs. 20 on 1,000 shares) 20,000
To Equity Shares Final Call A/c
(Rs. 25 on 420 shares) 10,500
To Preference Share Final A/c
(Rs. 30 on 880 shares) 26,400
1,44,400 1,44,400
To Balance b/d 1,44,400

9.20 COMMON PROFICIENCY TEST


Journal
Dr. Cr.
Rs. Rs.
Equity Share Application & Allotment A/c Dr. 22,500
To Equity Share Capital A/c 22,500
[The Credit to share capital on allotment of 500 equity
shares at Rs. 45 per share (Rs. 25 on application and
Rs. 20 on allotment) allotted as per Directors resolution
no.... dated.....]
Preference Share Application & Allotment A/c Dr. 50,000
To Preference Share Capital A/c 50,000
[The credit to Preference Share Capital on allotment
of 1,000 preference shares at Rs. 50 per share (Rs. 20
on application and Rs.30 on allotment), allotted as per
Directors’ resolution no... dated...]
Equity Share First Call A/c Dr. 15,000
To Equity Share Capital A/c 15,000
(Amount due on 500 equity shares at Rs. 30 per share as
per Directors’ resolution no... dated...)
Preference Share First Call A/c Dr. 20,000
To Preference Share Capital A/c 20,000
(Amount due on 1,000 preference shares at Rs.20
per share, as per Directors’ resolution no...dated...)
Equity Share Final Call A/c Dr. 12,500
To Equity Share Capital A/c 12,500
(Amount due on final call on 500 equity shares at
Rs. 25 per share, as per Directors’ resolution no... dated...)
Preference Share Final Call A/c Dr. 30,000
To Preference Share Capital A/c 30,000
(Amount due on final call on 1,000 preference shares
at Rs. 30 per share, as per Directors’ resolution no... dated...)
Note: Students may note that cash transactions have not been journalised as these have been
entered in the Cash Book.

FUNDAMENTALS OF ACCOUNTING 9.21


ISSUE, FORFEITURE AND REISSUE OF SHARES

An overview of the procedure for raising funds through equity can be depicted with the help
of following chart :

9.22 COMMON PROFICIENCY TEST


6. SHARES ISSUED AT DISCOUNT
There are instances when the shares of a company can also be issued at a discount, i.e., at an
amount less than the nominal or par value of shares. The excess of the nominal value over the
issue price represents discount on the issue of shares. For example, when a share of the nominal
value of Rs. 100 is issued at Rs. 98, it is said to have been issued at a discount of 2 per cent.
According to Section 79, a company is permitted to issue shares at a discount provided the
following conditions are satisfied:
(a) The issue of shares at a discount is authorised by an ordinary resolution passed by the
company at its general meeting and sanctioned by the Company Law Board.
(b) The resolution must specify the maximum rate of discount at which the shares are to be
issued but the rate of discount must not exceed 10 per cent of the nominal value of shares.
The rate of discount can be more than 10 per cent of the board is convinced that a higher
rate is called for under special circumstances of the case.
(c) At least one year must have elapsed since the company was entitled to commence the
business.
(d) The shares are of a class, which has already been issued.
(e) The shares are issued within two months from the date of receiving sanction for the same
from the Government.
The clear implications of the restrictions placed on the issues of shares at a discount are
that
– a new company cannot issue shares at a discount; and
– a new class of shares cannot be issued at a discount.
In case a company issues shares at a discount, its every prospectus concerning the public issue
of shares must clearly state the amount of discount allowed on the issue of shares or of the
balance of discount not written off at the date of the prospectus.
6.1 ACCOUNTING TREATMENT
Whenever shares are issued at a discount the amount of discount is brought into the books at
the time of allotment by debiting an account called “Discount on the issue of shares account”.
Therefore, the journal entry to record discount on the issue of shares is as given below:
Share Allotment A/c Dr.
Discount on the issue of Shares A/c Dr.
To Share Capital A/c
(Amount due on allotment of ____Shares @Rs.____
per share and discount on issue brought into account)
“Discount on the Issue of Shares Account”, showing a debit balance, denotes a loss to the company,
which is in the nature of capital loss. Therefore, the account is presented on the asset side of
the company’s balance sheet under “Miscellaneous Expenditure”. It is written off by charging
it to the Securities Premium Account of any, and, in its absence, by charging to the Profit and
Loss Account over a period of time.

FUNDAMENTALS OF ACCOUNTING 9.23


ISSUE, FORFEITURE AND REISSUE OF SHARES

Illustration 5
DM Limited issued 25,000 Equity Shares of Rs.20 each, at a discount of 10 per cent, payable as
follows:
On Application Rs.5 per share
On Allotment Rs.6 per share
On First Call Rs.7 per share
Applications were received for 37,500 shares and the Directors made pro-rata allotment to the
applicants for 30,000 shares.
Record journal entries for above transactions in the books of the Company.
Solution
Books of DM Limited
Journal
Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)
Bank A/c Dr. 1,87,500
To Equity Share Application A/c 1,87,500
(Money received on applications for 37,500 shares
@ Rs.5 per share)
Equity Share Application A/c Dr. 1,87,500
To Equity Share Capital A/c 1,25,000
To Equity Share Allotment A/c 25,000
To Bank A/c 37,500
(Transfer of application money on shares allotted
to share capital, excess application amount adjusted
to allotment and money refunded on rejected
applications)
Equity Share Allotment A/c Dr. 1,50,000
Discount on Issue of Shares A/c Dr. 50,000
To Equity Share Capital A/c 2,00,000
(Amount due on the allotment of 25,000 shares
@ Rs. 6 per share and discount on issue brought
into account)
Bank A/c Dr. 1,25,000
To Equity Share Allotment A/c 1,25,000
(Money received consequent upon allotment)
Equity Share First call A/c Dr. 1,75,000
To Equity Share Capital A/c 1,75,000
(First call money due on 25,000 shares @ Rs. 4 per share)
Bank A/c Dr. 1,75,000
To Equity Share First Call A/c 1,75,000
(Money received on first call)

9.24 COMMON PROFICIENCY TEST


Working Notes :
(i) Application Money received = 37,500 shares x 5 = Rs. 1,87,500
(ii) Amount refunded for 7,500 shares = Rs. 5 x 7,500 = 37,500
(iii) Amount to be adjusted on allotment = (30,000 – 25,000) x Rs.5
= 5,000 x Rs. 5 = Rs. 25,000
A company can issue shares at a discount subject to the provision contained in sub-section (3) of
Section 79. Whenever shares are issued at a discount, Application and Allotment of Call Account is
debited only with the net amount due and the discount allowed is debited to the Discount on Issue
of Shares Account and credited to Share Capital Account to make up the nominal amount of shares
subscribed. The discount on shares, till the same is written off, is shown as a separate item in the
Balance Sheet.

7. SHARES ISSUED AT PREMIUM


When a company issues its securities at a price more than the face value, it is said to be an issue
at a premium. Premium is the excess of issue price over face value of the security. It is quite
common for the financially strong, and well-managed companies to issue their shares at a
premium, i.e. at an amount more than the nominal or par value of shares. Thus, where a share
of the nominal value of Rs. 100 is issued at Rs. 105, it is said to have been issued at a premium
of 5 per cent.
When the issue is at a premium, the amount of premium may technically be called at any stage
of share capital transactions. However, premium is generally called with the amount due on
allotment, sometimes with the application of money and rarely with the call money.
7.1 ACCOUNTING TREATMENT
When shares are issued at a premium, the premium amount is credited to a separate account
called “Securities Premium Account” because it is not a part of share capital. Rather, it represents
a gain of a capital nature to the company.
Being a credit balance, Securities premium Account is shown on the liabilities side of the
company’s Balance Sheet under the heading “Reserves and Surplus”. According to Section 78
of The Companies Act, 1956, Securities Premium Account may be used by the company:
(a) In paying up un-issued securities of the company to be issued to members of the company
as fully paid bonus securities.
(b) To write off preliminary expenses of the company.
(c) To write off the expenses of, or commission paid, or discount allowed on any of the securities
or debentures of the company.
(d) To pay premium on the redemption of preference securities or debentures of the company.
When shares are issued at a premium, the journal entries are as follows:
(a) Premium amount called with Application money

FUNDAMENTALS OF ACCOUNTING 9.25


ISSUE, FORFEITURE AND REISSUE OF SHARES

(i) Bank A/c Dr. [Total Application money + Premium


Amount]
To Share Application A/c [Amount received]
[Money received on applications
for_____Shares @ Rs._______ per
share including premium
(ii) Share Application A/c Dr. [No. of Shares Applied for x Application
Amount per share]
To Securities Premium A/c [No. of Shares allotted x Premium Amount
per share]
To Share capital A/c [No. of Shares allotted x per share for
capital]
(b) Premium Amount called with Allotment
Money
(i) Share Allotment A/c Dr. [No. of Shares Allotted x Allotment and
Premium Money per share]
To Share Capital A/c [No. of Shares Allotted x Allotment
Amount per share]
To Securities Premium A/c [No. of Share Allotted x Premium Amount
per share]
(Amount due on allotment of
shares @ Rs.____ per share
including premium)
(ii) Bank A/c Dr.
To Share Allotment A/c
(Money received including
premium consequent upon
allotment).
Illustration 6
Pioneer Equipment Limited received on October 1, 2005 applications for 25,000 Equity Shares
of Rs. 100 each to be issued at a premium of 25 per cent payable at thus:
On Application Rs. 25
On Allotment Rs. 75 (including premium)
Balance Amount on Shares As and when required
The shares were allotted by the Company on October 20, 2005 and the allotment money was
duly received on October 31, 2005.
Record journal entries in the books of the company to record the transactions in connection
with the issue of shares.

9.26 COMMON PROFICIENCY TEST


Solution
Pioneer Equipment Limited
Journal
Date Particulars L.F. Debit Credit
Amount Amount
2005 (Rs.) (Rs.)
Oct. 1 Bank A/c Dr. 6,25,000
To Equity Share Application A/c 6,25,000
(Money received on applications for
25,000 shares @ Rs. 25 per share)
Oct. 20 Equity Share Application A/c Dr. 6,25,000
To Equity Share Capital A/c 6,25,000
(Transfer of application money on
allotment to share capital)
Oct. 20 Equity Share Allotment A/c Dr. 18,75,000
To Equity Share Capital A/c 12,50,000
To Securities Premium A/c 6,25,000
(Amount due on allotment of 25,000
shares @ Rs. 75 per share including premium)
Oct. 31 Bank A/c Dr. 18,75,000
To Equity Share Allotment A/c 18,75,000
(Money received including premium
consequent upon allotment)
Illustration 7
X Ltd. invited applications for 10,000 shares of Rs. 100 each payable as follows :
Rs.
On Application 20
On Allotment (on 1st May, 2005) 30
On First Call (on 1st Oct., 2005) 30
On Final Call (on 1st Feb., 2006) 20
All the shares were applied for and allotted. A shareholder holding 200 shares paid the whole
of the amount due along with allotment. Journalise the transactions, assuming all sums due
were received. Interest was paid to the shareholder concerned on 1st February, 2006.

FUNDAMENTALS OF ACCOUNTING 9.27


ISSUE, FORFEITURE AND REISSUE OF SHARES

Solution :
Journal of X Ltd.
Dr. Cr.
2005 Rs. Rs.
May 1 Bank A/c Dr. 2,00,000
To Shares Application & Allotment A/c 2,00,000
(Receipt of applications for 10,000 shares along
with application money of Rs. 20 per share.)
May 1 Share Application and Allotment A/c Dr. 5,00,000
To Share Capital A/c 5,00,000
(The allotment of 10,000 shares : payable on
application Rs. 20 and on allotment Rs. 30 per
share, as per Directors’ resolution no... dated...)
May 1 Bank A/c Dr. 3,10,000
To Shares Application & Allotment A/c 3,00,000
To Calls in Advance A/c 10,000
[Receipt of money due on allotment, also the
two calls (Rs. 30 and Rs. 20) on 200 shares.]
Oct. 1 Share First Call A/c Dr. 3,00,000
To Share Capital A/c 3,00,000
(The amount due on 10,000 shares @ Rs. 30 on
first call, as per Directors, resolution no... dated...)
Bank A/c Dr. 2,94,000
Calls in Advance A/c Dr. 6,000
To Share First Call A/c 3,00,000
(Receipt of the first call on 9,800 shares, the
balance having been previously received
and now debited to call in advance account.)
2006
Feb. 1 Share Final Call A/c Dr. 2,00,000
To Share Capital A/c 2,00,000
(The amount due on Final Call on 10,000 shares
@ Rs. 20 per share, as per Directors’ resolution
no... dated...)
Feb. 1 Bank A/c Dr. 1,96,000
Calls in Advance A/c Dr. 4,000
To Share Final Call A/c 2,00,000
(Receipt of the moneys due on final call on
9,800 shares, the balance having been previously
received.)
Feb. 1 Interest A/c Dr. 330
To Bank A/c 330
The interest on calls in advance paid @ 6% on :
Rs. 6,000 (first call) from 1st May to 1st Oct., 2005–5 months 150
Rs. 4,000 (final call) from 1st May to 1st Feb., 2006–9 months 180
330

9.28 COMMON PROFICIENCY TEST


Thus shares can be issued either at face value or at premium or at discount. The following
chart depicts the three categories as follows :

Shares issued at
Discount

8. OVER-SUBSCRIPTION AND PRO-RATA ALLOTMENT


Over subscription is the application money received for more than the number of shares offered
to the public by a company. It usually occurs in the case of good issues and depends on many
other factors like investors confidence in the company, general economic conditions, pricing of
the issue etc. When the shares are oversubscribed, the company cannot satisfy all the applicants.
It means that a decision is to be made on how the shares are going to be allotted. Shares can be
allotted to the applicants by a company in any manner it thinks proper. The company may
reject some applicants in full, i.e., no shares are allotted to some applicants and application
money is refunded. Usually, multiple applications by the same persons are not considered.
Allotment may be given to the rest of the applicants in full, i.e., for the number of shares they
have applied for. A third alternative is that a company may allot shares to the applicants on
pro-rata basis. ‘Pro-rata allotment’ means allotment in proportion of shares applied for.
For example, a company offers to the public 10,000 shares for subscription. The company
receives applications for 12,000 shares. If the shares are to be allotted on pro-rata basis, applicants
for 12,000 shares are to be allotted 10,000 shares, i.e., on the 12,000 : 10,000 or 6:5 ratio. Any
applicant who has applied for 6 shares will be allotted 5 shares.
Under pro-rata allotment, the excess application money received is adjusted against the amount
due on allotment or calls. Surplus money after making adjustment against future calls is returned
to the applicants. The applicants are informed about the allotment procedure through an
advertisement in leading newspapers.
There is no separate journal entry for forfeiture of shares when there is a pro-rata allotment.
But it requires to calculate the net amount due on allotment or any other call, and also the total
amount forfeited. When there is a pro-rata allotment, the total application money paid by an
applicant is more than the exact amount due on application. The excess amount is treated as

FUNDAMENTALS OF ACCOUNTING 9.29


ISSUE, FORFEITURE AND REISSUE OF SHARES

an advance against allotment or any other future calls. The net amount due on allotment or
any other calls is the difference between the amount due on allotment or any other calls and
the excess amount received in application.
Accounting Entries
(a) For rejected application:
Share Application Account Dr.
To Bank Account
(b) For pro-rata allotment
Share Application Account Dr.
To Share Allotment Account
(Being excess application money adjusted against allotment money as per Board’s Resolution
No….dated….)
Illustration 8
JHP Limited is a company with an authorised share capital of Rs. 10,00,000 in equity shares of
Rs. 10 each, of which 6,00,000 shares had been issued and fully paid on 30th June, 2005. The
company proposed to make a further issue of 1,00,000 of these Rs. 10 shares at a price of Rs.14
each, the arrangements for payment being:
(a) Rs. 2 per share payable on application, to be received by 1st July, 2005;
(b) Allotment to be made on 10th July, 2005 and a further Rs. 5 per share (including the
premium) to be payable;
(c) The final call for the balance to be made, and the money received by 30th April, 2006.
Applications were received for 3,55,000 shares and were dealt with as follows:
(i) Applicants for 5,000 shares received allotment in full;
(ii) Applicants for 30,000 shares received an allotment of one share for every two applied for;
no money was returned to these applicants, the surplus on application being used to
reduce the amount due on allotment;
(iii) Applicants for 3,20,000 shares received an allotment of one share for every four applied
for; the money due on allotment was retained by the company, the excess being returned
to the applicants; and
(iv) the money due on final call was received on the due date.
You are required to record these transactions (including cash items) in the Journal of JHP
Limited.

9.30 COMMON PROFICIENCY TEST


Solution
Journal of JHP Limited
Date Dr. Cr.
2005 Particulars Rs. Rs.
Bank A/c (Note 1 – Column 3) Dr. 7,10,000
July 1 To Equity Share Application A/c 7,10,000
(Being application money received on 3,55,000
shares @ Rs. 2 per share)
July 10 Equity Share Application A/c Dr. 7,10,000
To Equity Share Capital A/c 2,00,000
To Equity Share Allotment A/c
(Note 1 Column 5) 4,30,000
To Bank A/c (Note 1 – Column 6) 80,000
(Being application money on 1,00,000 shares
transferred to Equity Share Capital Account;
on 2,15,000 shares adjusted with allotment and
on 40,000 shares refunded as per Board’s
Resolution No…..dated…)
Equity Share Allotment A/c Dr. 5,00,000
To Equity Share Capital A/c 1,00,000
To Securities Premium a/c 4,00,000
(Being allotment money due on 1,00,000 shares
@ Rs. 5 each including premium as per Board’s
Resolution No….dated….)
Bank A/c (Note 1 – Column 8) Dr. 70,000
To Equity Share Allotment A/c 70,000
(Being balance allotment money received)
2006 Equity Share Final Call A/c Dr. 7,00,000
? To Equity Share Capital A/c 7,00,000
(Being final call money due on 1,00,000
shares @Rs. 7 per share as per Board’s
Resolution No…..dated….)
April 30 Bank A/c Dr. 7,00,000
To Equity Share Final Call A/c 7,00,000
(Being final call money on 1,00,000 shares
@ Rs. 7 each received)

FUNDAMENTALS OF ACCOUNTING 9.31


ISSUE, FORFEITURE AND REISSUE OF SHARES

Working Notes:
(1) Calculation for Adjustment and Refund
Category No. of No. of Amount Amount Amount Refund Amount Amount
Shares Shares Received Required adjusted [3 - 4 + 5] due on received
Applied for Allotted on on on Allotment on
Application Application Allotment Allotment
(1) (2) (3) (4) (5) (6) (7) (8)
(i) 5,000 5,000 10,000 10,000 – Nil 25,000 25,000
(ii) 30,000 15,000 60,000 30,000 30,000 Nil 75,000 45,000
(iii) 3,20,000 80,000 6,40,000 1,60,000 4,00,000 80,000 4,00,000 –

TOTAL 3,55,000 1,00,000 7,10,000 2,00,000 4,30,000 80,000 5,00,000 70,000

9. CALLS-IN-ARREARS AND CALLS-IN-ADVANCE

CALLS-IN-ARREARS
Sometimes shareholders fail to pay the amount due on allotment or calls. The total unpaid
amount on one or more instalments is known as Calls-in-Arrears or Unpaid Calls. Such amount
represents the uncollected amount of capital from the shareholders; hence, it is shown by way
of deduction from ‘called-up capital’ to arrive at paid-up value of the share capital to be shown
in the balance sheet.
For recording ‘Calls-in-Arrears’, the following journal entry is recorded :
Calls-in-Arrears A/c Dr. [Amount of Unpaid Calls]
To Share Allotment A/c
To Share Calls A/c

9.32 COMMON PROFICIENCY TEST


The Articles of Association of a company usually empower the directors to charge interest at a
stipulated rate on calls-in-arrears. According to Table A interest at the rate of 5 per cent per
annum is to be charged on unpaid calls for the period intervening between the due date of the
call and the time of actual payment. However, the directors have the authority to waive the
application of this rule in individual cases at their discretion or charge at a higher rate of
interest.
The journal entries for calls-in-arrears are as follows :
(i) For interest receivable on calls-in-arrears
Shareholders’ A/c Dr.
To Interest on calls-in-arrears A/c
(ii) For receipt of interest
Bank A/c Dr.
To Shareholders’ A/c
CALLS-IN-ADVANCE
Some shareholders may sometimes pay a part, or whole, of the amount not yet called up, such
amount is known as Calls-in-advance. According to Table A, interest at the rate of 6 per cent is
to be paid on such advance call money. This amount is credited in Calls-in-Advance Account.
The following entry is recorded:
Bank A/c Dr.
To Call-in-Advance A/c
When calls become actually due, calls-in-advance account is adjusted at the time of the call.
For this the following journal entry is recorded:
Calls-in-Advance A/c Dr. [Call amount due]
To Particular Call A/c
The balance in Calls-in-Advance account is shown as a separate item on the liabilities side of
the company’s balance sheet under the heading ‘Share Capital’ but is not added to the amount
of paid-up capital.
The accounting treatment of interest on Calls-in-Advance is as follows:
(i) Interest Due
Interest on Calls-in-Advance A/c Dr. [Amount of interest due for payment]
To Shareholder’s A/c
(ii) Payment of Interest
Shareholder’s A/c Dr. [Amount of interest paid]
To Bank A/c
(Interest paid on calls-in-advance)

FUNDAMENTALS OF ACCOUNTING 9.33


ISSUE, FORFEITURE AND REISSUE OF SHARES

10. INTEREST ON CALLS-IN-ARREARS AND CALLS-IN-ADVANCE


Interest on calls in arrear is recoverable and that in respect of calls in advance is payable,
according to provisions in this regard in the articles of the company, at the rates mentioned
therein or those to be fixed by the directors, within the limits prescribed by the Articles. Table A
prescribes 5% and 6% p.a. as the maximum rates respectively for calls in arrears and those in
advance.
Directors, however, have the right to waive the payment of interest on calls in arrear. Calls
received in advance are not entitled to any dividend. The book entries to be passed for the
adjustment of such interest are much the same as those in case of temporary borrowings or
loans raised, the only difference being that debits are raised and credits are given to Sundry
Members Account (and not the individual accounts of shareholders) in respect of interest
recoverable on calls in arrear or that payable on call received in advance, the corresponding
entries being made in the Interest Receivable on Calls in Arrears and Interest Payable on Calls
in Advance, respectively.
Illustration 9
Rashmi Limited issued at par 10,000 Equity shares of Rs. 10 each payable Rs. 2.50 on application;
Rs. 3 on allotment; and balance on the final call. All the shares were fully subscribed and paid
except a shareholder having 100 shares could not pay the final call. Give journal entries to
record these transactions.
Solution
Book of Rashmi Limited
Journal
Date Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)

Bank A/c Dr. 25,000


To Equity Share Application A/c 25,000
(Money received on applications for
10,000 shares @Rs. 2.50 per share)
Equity Share Application A/c Dr. 25,000
To Equity Share Capital A/c 25,000
(Transfer of application money on 10,000
shares to share capital)
Equity Share Allotment A/c Dr. 30,000
To Equity Share Capital A/c 30,000
(Amount due on the allotment of 10,000
shares @ Rs. 3 per share)

9.34 COMMON PROFICIENCY TEST


Date Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)
Bank A/c Dr. 30,000
To Equity Share Allotment A/c 30,000
(Allotment money received)
Share Final Call A/c Dr. 45,000
To Equity Share Capital A/c 45,000
(Final call money due)
Bank A/c Dr. 44,750
Cash-in-Arrears A/c Dr. 250
To Share Final Call A/c 45,000
(Final call money received and arrears
on 100 shares
Illustration 10
A limited Company, with an authorized capital of Rs. 2,00,000 divided into shares of Rs. 100
each, issued for subscription 1,000 shares payable at Rs. 25 per share on application, Rs. 30 per
share on allotment, Rs.20 per share on first call three months after allotment and the balance
as and when required.
The subscription list closed on January 31, 2006 when application money on 1,000 shares was
duly received and all9otment was made on March 1, 2006.
The allotment amount was received in full but, when the first call was made, one shareholder
failed to pay the amount on 100 shares held by him and another shareholder with 50 shares
paid the entire amount on his shares.
Give journal entries in the books of the Company to record these share capital transactions
assuming that all amounts due were received within one month of the date they were called.
Solution
Books of the Company
Journal
Date Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)

Jan. 31 Bank A/c Dr. 25,000


To Equity Share Application A/c 25,000
(Money received on applications for 1,000
shares @ Rs. 25 per share)

FUNDAMENTALS OF ACCOUNTING 9.35


ISSUE, FORFEITURE AND REISSUE OF SHARES

March 1 Equity Share Application A/c Dr. 25,000


To Equity Share Capital A/c 25,000
(Transfer of application money on
1,000 shares to share capital)
March 1 Equity Share Allotment A/c Dr. 30,000
To Equity Share Capital A/c 30,000
(Amount due on the allotment of 1,000
shares @ Rs. 30 per share)
April 1 Bank A/c Dr. 30,000
To Equity Share Allotment A/c 30,000
(Allotment money received)
June 1 Equity Share First Call A/c Dr. 20,000
To Equity Share Capital A/c 20,000
(First call money due on 1,000 shares
@ Rs. 20 per share)
July 1 Bank A/c Dr. 19,250
Calls-in-Arrears A/c Dr. 2,000
To Equity Share First Call A/c 20,000
To Calls-in-Advance A/c 1,250
(First call money received on 900
shares and calls-in-advance on 50 shares
@ Rs. 25 per share)

11. FORFEITURE OF SHARES


The term ‘forfeit’ actually means taking away of property on breach of a condition. It is very
common that one or more shareholders fail to pay their allotment and/or calls on the due
dates. Failure to pay call money results in forfeiture of shares. Forfeiture of shares is the action
taken by a company to cancel the shares. The directors are usually empowered by the Articles
of Association to forfeit those shares by serving proper notice to the defaulting shareholder(s).
When shares are forfeited, the title of such shareholder is extinguished but the amount paid to
date is not refunded to him. The shareholder then has no further claim on the company. The
power of forfeiture must be exercised strictly having regard to the rules and regulations provided
in the Articles of Association and it should be bonafide in the interests of the company.
The Articles of a company usually authorise the Directors to forfeit shares of a member on
account of non-payment of a call or interest thereon after serving him a prior notice as prescribed
by the Articles. Directors also have the right to cancel such forfeiture before the forfeited shares
are re-allotted.

9.36 COMMON PROFICIENCY TEST


Accounting Entries
At the time of passing entry for forfeiture of shares, students must be careful about the following
matters:

(i) Amount called-up (i.e., amount credited to capital) in respect of forfeited shares.

(ii) Amount already received in respect of those shares.

(iii) Amount due but has not been received in respect of those shares.

We know that shares can be issued at par or at a discount or at a premium. Accounting entries
for forfeiture will vary according to situations.
11.1 FORFEITURE OF SHARES WHICH WERE ISSUED AT PAR
In this case, Share Capital Account will be debited with the called-up value of shares forfeited.
Allotment or Calls Account will be credited with the amount due but not paid by the
shareholder(s). (Alternatively, Calls-in-Arrears Account can be credited for all amount due, if
it was transferred to Calls-in-Arrears Account). Forfeited Shares Account or Shares Forfeiture
Account will be credited with the amount already received in respect of those shares.
Share Capital Account Dr. [No. of shares õ called-up value per share]
To Forfeited Shares Account [Amount already received on forfeited shares]
To Share Allotment Account [If amount due, but not paid]
To Share First Call Account [If amount due, but not paid]
To Share Final Call Account [If amount due, but not paid]
Where all amounts due on allotment, first call and final call have been transferred to Calls-in-
Arrears Account, the entry will be :
Share Capital Account Dr. [No. of shares õ called-up value per share]
To Calls-in-Arrear Account [Total amount due, but not paid]
To Forfeited Shares Account [Amount received]
Illustration 11
A Ltd forfeited 300 equity shares of Rs.10 fully called-up, held by Mr. X for non-payment of
final call @ Rs. 4 each. However, he paid application money @ Rs. 2 per share and allotment
money @ Rs. 4 per share. These shares were originally issued at par. Give Journal Entry for the
forfeiture.

FUNDAMENTALS OF ACCOUNTING 9.37


ISSUE, FORFEITURE AND REISSUE OF SHARES

Solution
In the books of A Ltd.
Journal Dr. Cr.
Date Particulars Rs. Rs.
Equity Share Capital A/c (300 x Rs. 10) Dr. 3,000
To Equity Share Final Call A/c (300 x Rs. 4) 1,200
To Forfeited Shares A/c (300 x Rs. 6) 1,800
(Being the forfeiture of 300 equity shares of Rs.10 each
fully called-up for non-payment of final call money
@ Rs. 4 each as per Board’s Resolution No…. dated….)

Illustration 12
X Ltd forfeited 200 equity shares of Rs. 10 each, Rs. 8 called-up for non-payment of first call
money @ Rs. 2 each. Application money @ Rs. 2 per share and allotment money @ Rs. 4 per
share have already been received by the company. Give Journal Entry for the forfeiture (assume
that all money due is transferred to Calls-in-Arrears Account).
Solution
In the books of X Ltd
Journal Dr. Cr.
Date Particulars Rs. Rs.
Equity Share Capital A/c (200 x Rs. 8) Dr. 1,600
To Calls-in-Arrears A/c (200 x Rs. 2) 400
To Forfeited Shares A/c (200 x Rs. 6) 1,200
(Being the forfeiture of 200 equity shares of Rs. 10
each, Rs. 8 called-up for non-payment of first call
money @ Rs. 2 each as per Board’s Resolution
No……dated….. )
11.2 FORFEITURE OF SHARES WHICH WERE ISSUED AT A DISCOUNT
In this case also Share Capital Account will be debited with the called-up value of shares
forfeited, Allotment or Calls Account will be credited with the amount due but not paid by the
shareholder(s). (Alternatively, Calls-in-Arrears Account can be credited). Forfeited Shares
Account will be credited with the amount already received in respect of those shares.
When shares are issued at a discount, the Discount Account is debited. Therefore, at the
time of forfeiture of such share, Discount Account will be credited to cancel it.

9.38 COMMON PROFICIENCY TEST


Share Capital Account Dr. [No. of shares x called-up value per share]
To Share Allotment Account [If amount due, but not paid]
To Share First Call Account [If amount due, but not paid]
To Share Final Call Account [If amount due, but not paid]
To Forfeited Shares Account [Amount received on forfeited shares]
To Discount on Issue of Shares Account [No. of shares x discount per share]
(Being the forfeiture of….shares for non-payment of allotment and call(s) money as per Board’s
Resolution No…..dated….)
Illustration 13
H.P. Ltd. forfeited 200 equity shares of Rs. 10 each fully called-up for non-payment of final call
@ Rs. 2 per share. These shares were originally issued at a discount of 10%. Application, allotment
and first call money per share @ Rs. 2, Rs. 3 and Rs. 2 respectively were received in time. Give
Journal Entry for the forfeiture.
Solution
In the books of H.P Ltd
Journal
Dr. Cr.
Date Particulars Rs. Rs.
Equity Share Capital A/c (200 x Rs.10) Dr. 2,000
To Equity Share Final Call A/c (200 x Rs. 2) 400
To Forfeited Shares A/c (200 x Rs. 7) 1,400
To Discount on Issue of Shares A/c (200 x Re1) 200
(Being the forfeiture of 200 equity shares of Rs. 10 each
fully called-up for non-payment of final call money
@ Rs. 2 each as per Board’s Resolution No…… dated….)

11.3 FORFEITURE OF SHARES WHICH WERE ISSUED AT A PREMIUM


In this case, Share Capital Account will be debited with the called-up value of shares forfeited.
If the premium on such shares has not been paid by the shareholder, the Securities Premium
Account will be debited to cancel it (if it was credited earlier). Allotment, Calls and Forfeited
Accounts will be credited in the usual manner.
If the premium has already received by the company, it cannot be cancelled even if the
shares are forfeited in the future

FUNDAMENTALS OF ACCOUNTING 9.39


ISSUE, FORFEITURE AND REISSUE OF SHARES

Illustration 14
X Ltd. forfeited 500 equity shares of Rs.10 each fully called-up which were issued at a premium
of 20%. Amount payable on shares were: on application Rs.2; on allotment Rs.5 (including
premium) on First and Final call Rs.5. Only application money was paid by the shareholders in
respect of these shares. Pass Journal Entries for the forfeiture.
Solution
In the books of X Ltd.
Journal Dr. Cr.
Date Particulars Rs. Rs.
Equity Share Capital A/c (500 x Rs. 10) Dr. 5,000
Securities Premium A/c (See Note) Dr. 1,000
To Equity Share Allotment A/c (500 x Rs. 2) 2,500
To Equity Share First and Final Call A/c
(500 x Rs. 5) 2,500
To Forfeited Shares A/c (500 x Rs. 2) 1,000
(Being the forfeiture of 500 equity shares of Rs. 10
each fully called-up, issued at a premium of 20%,
for non-payment of allotment and call money as per
Board’s Resolution No…..dated….)

Tutorial Note: Share premium @ Rs.2 on 500 shares has not been received by the company.
Therefore, at the time of forfeiture, Securities Premium Account will be debited to cancel it
(because Securities Premium Account was credited at the time of allotment).
11.4 FORFEITURE OF FULLY PAID-UP SHARES
Forfeiture for non-payment of calls, premium, or the unpaid portion of the face value of the
shares is one of the many causes for which a share may be forfeited. But fully paid-up shares
may be forfeited for realization of debts of the shareholder if the Articles specifically provide it.

12. RE-ISSUE OF FORFEITED SHARES


A forfeited share is merely a share available to the company for sale and remains vested in the
company for that purpose only. Reissue of forfeited shares is not allotment of shares but only a
sale. When shares are re-issued, return of the forfeited shares need not be filed under Section
75(1) of the Companies Act, 1956.
The share, after forfeiture, in the hands of the company is subject to an obligation to dispose it
of. In practice, forfeited shares are disposed off by auction. These shares can be re-issued at
any price so long as the total amount received (from the original allottee and the second
purchaser) for those shares is not less than the amount in arrear on those shares.

9.40 COMMON PROFICIENCY TEST


Accounting Entries :
(a) Bank Account Dr. [Actual amount received]
Forfeited Shares Account Dr. [Loss on re-issue]
To Share Capital Account
(Being the re-issue of….shares @ Rs…. each as per Board’s Resolution No…. dated.)
(b) Forfeited Shares Account Dr.
To Capital Reserve Account
(Being the profit on re-issue, transferred to capital reserve).
12.1 POINTS FOR CONSIDERATION
In connection with re-issue, the following points are important:
1. Loss on re-issue should not exceed the forfeited amount.
2. If the loss on re-issue is less than the amount forfeited, the surplus should be transferred to
Capital Reserve.
3. The forfeited amount on shares not yet reissued should be shown in the Balance Sheet as
an addition to the share capital.
4. When only a portion of the forfeited shares are re-issued, then the profit made on reissue
of such shares must be transferred to Capital Reserve.
5. When the shares are re-issued at a loss, such loss is to be debited to “Forfeited Shares
Account”.
6. If the shares are re-issued at a price which is more than the face value of the shares, the
excess amount will be credited to Securities Premium Account.
7. If the re-issued amount and forfeited amount (taken together) exceeds the face value of
the shares re-issued, it is not necessary to transfer such amount to Securities Premium
Account.
8. When shares, originally issued at a discount, are reissued at a loss, the loss to the extent of
original discount is debited to Discount on Issue of Shares Account and the balance loss is
debited to Forfeited Shares Account.
12.2 CALCULATION OF PROFIT ON RE-ISSUE OF FORFEITED SHARES
Students will appreciate that the credit balance of forfeited shares account cannot be considered
a surplus until the shares forfeited have been re-issued, because the company may, on re-issue,
allow the discount to the new purchaser equivalent to the amount held in credit in this regard
in the forfeited shares Account. Suppose 120 shares of a nominal value of Rs. 10 have been
forfeited upon which Rs. 5 per share was paid up and transferred to Forfeited Share Account.
Afterwards, 50 shares are re-issued, Rs. 6 per share being collected to make them fully paid up;
Rs. 200 out of shares forfeited will be credited to Share Capital Account to make up the deficiency

FUNDAMENTALS OF ACCOUNTING 9.41


ISSUE, FORFEITURE AND REISSUE OF SHARES

on re-issued shares, and Rs. 50 will be transferred to the Capital Reserve Account being the
surplus on re-issue of the 50 shares. It would have in the Forfeited shares Account balance
equivalent to the amount collected on the remaining 70 forfeited shares which will be carried
forward till these are re-issued.
In the above case, it has been assumed that the amount paid up on all the 120 forfeited shares
was Rs. 5 per share. But in practice, shares may be forfeited on which varying amounts are
out-standing. For instance, if in the above case 70 shares were forfeited with Rs. 5 paid up
thereon and 50 shares with Rs. 7.50 was paid up thereon, the credit in the forfeited Shares
Account would be Rs. 725. The amount to be credited to Capital Reserve will depend on the lot
of shares re-issued; it will be Rs. 175 if the shares are those on which Rs. 7.50 was originally
paid.
Illustration 15
X Ltd. reissued 200 equity shares of Rs. 10 each @ Rs. 7 per share. These shares were issued
originally at a discount of 10%. Give Journal Entries for re-issue only.
Solution
In the books of X Ltd.
Journal Dr. Cr.
Date Particulars Rs. Rs.
Bank A/c (200 x 7) Dr. 1,400
Discount on Issue of Shares A/c (200 x Re. 1) Dr. 200
Forfeited Shares A/c (200 x Rs. 2) Dr. 400
To Equity Share Capital A/c 2,000
(Being the re-issue of 200 equity shares of Rs. 10
each @ Rs.7 per share. Loss equal to original
discount is debited to Discount on Issue of Shares
Account and the balance of loss is transferred
to Forfeited Shares Account as per Board’s
Resolution No…..dated…..)

Illustration 16
Mr. Long who was the holder of 200 preference shares of Rs. 100 each, on which Rs. 75 per
share has been called up could not pay his dues on Allotment and First call each at Rs. 25 per
share. The Directors forfeited the above shares and reissued 150 of such shares to Mr. Short at
Rs. 65 per share paid-up as Rs.75 per share.
Give Journal Entries to record the above forfeiture and re-issue in the books of the company.

9.42 COMMON PROFICIENCY TEST


Solution
Journal Dr. Cr.
Rs. Rs.
Preference Share Capital A/c (200 x Rs.75) Dr. 15,000
To Preference Share Allotment A/c 5,000
To Preference Share First Call A/c 5,000
To Forfeited Share A/c 5,000
Being the forfeiture of 200 preference shares
Rs.75 each being called up for non-payment of
allotment and first call money as per Board’s
Resolution No….. dated….)
Bank A/c (Rs.65 x 150) Dr. 9,750
Forfeited Shares A/c (Rs.10 x 150) Dr. 1,500
To Preference Share Capital A/c 11,250
(Being re-issue of 150 shares at Rs. 65 per share
paid-up as Rs. 75 as per Board’s Resolution
No…..dated….)
Forfeited Shares a/c Dr. 2,250
To Capital Reserve A/c (Note 1) 2,250
(Being profit on re-issue transferred to
Capital/Reserve)

Working Note:
(1) Calculation of amount to be transferred to Capital Reserve
Forfeited amount per share = Rs. 5,000/200 = Rs. 25
Loss on re-issue = Rs. 75 – Rs. 65 = Rs. 10
Surplus per share re-issued Rs. 15
Transferred to capital Reserve Rs. 15 x 150 = Rs. 2,250. Rs. 25 x 50 = Rs. 1,250 should be shown
as an addition to share capital.
Illustration 17
Beautiful Co. Ltd issued 3,000 equity shares of Rs.10 each payable as Rs. 3 per share on
Application, Rs. 5 per share (including Rs. 2 as premium) on Allotment and Rs. 4 per share on
Call. All the shares were subscribed. Money due on all shares was fully received excepting
Ram, holding 50 shares, failed to pay the Allotment and Call money and Shyam, holding 100
shares, failed to pay the Call Money. All those 150 shares were forfeited. Of the shares forfeited,
125 shares (including whole of Ram’s shares) were subsequently re-issued to Jadu as fully paid
up at a discount of Rs. 2 per share.

FUNDAMENTALS OF ACCOUNTING 9.43


ISSUE, FORFEITURE AND REISSUE OF SHARES

Pass the necessary entries in the Journal of the company to record the forfeiture and re-issue of
the share. Also prepare the Balance Sheet of the company.
Solution
In the books of Beautiful Co. Ltd.
Journal
Dr. Cr.
Date Particulars Rs. Rs.
Equity Share Capital A/c (150 x Rs. 10) Dr. 1,500
Securities Premium A/c (50 x Rs. 2) Dr. 100
To Equity Share Allotment A/c (50 X Rs. 5) 250
To Equity Share Call A/c (150 X Rs. 4) 600
To Forfeited Shares A/c 750
(Being forfeiture of 150 equity shares for non-
payment of allotment and call money on 50 shares
and for non-payment of call money on 100 shares
as per Board’s Resolution No…..dated ….)
Bank A/c Dr. 1,000
Forfeited Shares A/c Dr. 250
To Equity Share Capital A/c 1,250
(Being re-issue of 125 shares @Rs.8 each as per
Board’s Resolution No…..dated….)
Forfeited Shares A/c Dr. 350
To Capital Reserve A/c 350
(Being profit on re-issue transferred to
Capital Reserve)

9.44 COMMON PROFICIENCY TEST


Balance Sheet of Beautiful Limited as at……
Liabilities Rs. Assets Rs.
Share Capital Fixed Assets ?
Authorised Capital Investments ?
….Share of…each *** Current Assets, Loans & Advances
Issued Capital (A) Current Assets
3,000 Equity Shares of Rs.10 each 30,000 Bank Balances 36,150
Subscribed Capital (B) Loans & Advances
2,975 Equity shares of Rs.10 each 29,750
Add : Forfeited Shares 150
29,900
Reserve & Surplus
Securities Premium 5,900
Capital Reserve 350
Current Liabilities and Provisions ?
36,150 36,150

Working Note : (1) Calculation of Amount to be Transferred to Capital Reserve


Amount forfeited per share of Ram Rs. 3 Amount forfeited per share of Shyam Rs. 6
Less: Loss on re-issue per share Rs. 2 Less: Loss on re-issue per share Rs. 2
Surplus Re. 1 Surplus Rs. 4
Transferred to Capital Reserve: Ram share (50 x Re 1) = Rs. 50;
Shyam’s Share (75 x Rs. 4) = Rs. 300.
Total Rs. 350
Illustration 18
A holds 200 shares of Rs.10 each on which he has paid Rs. 2 as application money. B holds 400
shares of Rs. 10 each on which he has paid Rs. 2 per share as application money and Rs. 3 per
share as allotment money. C holds 300 shares of Rs.10 each and has paid Rs. 2 on application,
Rs. 3 on allotment and Rs.3 for the first call. They all fail to pay their arrears on the second and
final call of Rs. 2 per share and the directors, therefore, forfeited their shares. The shares are re-
issued subsequently for Rs. 12 per share fully paid-up. Journalise the transactions relating to
the forfeiture and re-issue.

FUNDAMENTALS OF ACCOUNTING 9.45


ISSUE, FORFEITURE AND REISSUE OF SHARES

Solution
Journal
Dr. Cr.
Date Particulars Rs. Rs.
Share Capital A/c (900 x Rs.10) Dr. 9,000
To Share Allotment A/c 600
To Share First Call A/c 1,800
To Share Final Call A/c 1,800
To Forfeited Shares A/c 4,800
(Being forfeiture of 900 shares of Rs.10 each for
non-payment of allotment, first and final call
money as per Board’s Resolution No…..dated….)
Bank A/c (900 x Rs. 12) Dr. 10,800
To Share Capital A/c 9,000
To Securities Premium A/c 1,800
(Being the re-issue of 900 shares of Rs.10 each
@ Rs.12 as per Board’s Resolution No…..dated…)
Forfeited Shares A/c Dr. 4,800
To Capital Reserve A/c 4,800
(Being profit on re-issue transferred to Capital Reserve).

Working Note :
Shareholders Money Received Money Not Received On
Application Allotment First Call Final Call Allotment First Call Final Call
A 200 - - - 200 200 200
B 400 400 - - - 400 400
C 300 300 300 - - - 300
TOTAL 900 700 300 - 200 600 900
Money
Receivable Rs. 2 Rs. 3 Rs. 3 Rs. 2 Rs. 3 Rs. 3 Rs. 2
Rs. 1,800 Rs. 2,100 Rs. 900 - Rs. 600 Rs. 1,800 Rs. 1,800
Illustration 19
B. Ltd. issued 20,000 equity shares of Rs.10 each at a premium of Rs.2 per share payable as
follows: on application Rs.5; on allotment Rs.5 (including premium); on final call Rs.2.
Applications were received for 24,000 shares. Letters of regret were issued to applicants for
4,000 shares and were allotted to all the other applicants. Mr. A, the holder of 150 shares,
failed to pay the call money, the shares were forfeited. Show the Journal Entries and Cash
Book in the books of B. Ltd.

9.46 COMMON PROFICIENCY TEST


Solution
In the Books of B Ltd.
Dr. Cash Book (Bank column only) Cr.
Date Particulars Rs. Date Particulars Rs.
To Equity Share By Equity Share
Application A/c 1,20,000 Application A/c 20,000
(Being application money (Being excess
received on 24,000 shares money refunded on
@ Rs. 5 each) 4,000 shares @ Rs.5
each as per Board’s
Resolution No…dated….)
To Equity Share Allotment
A/c 99,250 By Balance c/d 2,38,950
(Being allotment money
received on 19,850 shares
@Rs. 5 each)
To Equity Share Final Call
A/c 39,700
(Being final call money
received on 19,850 shares
@ Rs. 2 each)
2,58,950 2,58,950

Date Journal Dr. Cr.


Particulars Rs. Rs.
Equity Share Application A/c Dr. 1,00,000
To Equity Share Capital A/c 1,00,000
(Being application money on 20,000 shares
@Rs. 5 each transferred to Equity Share
Capital Account as per Board’s Resolution
No…..dated…)
Equity Share Allotment A/c Dr. 1,00,000
To Equity Share Capital A/c 60,000
To Securities Premium A/c 40,000
(Being final call money due on 20,000 shares
@Rs. 2 each as per Board’s Resolution
No……dated….)
Equity Share Capital A/c (150 x Rs.10) Dr. 1,500
Securities Premium A/c (150 x Rs. 2) Dr. 300
To Equity Share Allotment A/c 750
To Equity Share Final Call A/c 300
To Forfeited Shares A/c 750
(Being forfeiture of 150 shares for non-
payment of allotment money and final call
money as per Board’s Resolution No….dated…)

FUNDAMENTALS OF ACCOUNTING 9.47


ISSUE, FORFEITURE AND REISSUE OF SHARES

Tutorial Note : Here, securities premium on forfeited shares has not been realised, so Securities
Premium Account will be debited at the time of forfeiture of these shares.

13. ISSUE OF SHARES FOR CONSIDERATION OTHER THAN CASH


Public limited companies, generally, issue their shares for cash and use such cash to buy the
various types of assets needed in the business. Sometimes, however, a company may issue
shares in a direct exchange for land, buildings or other assets. Shares may also be issued in
payment for services rendered by promoters, lawyers in the formation of the company. In the
Balance Sheet, these shares should be shown separately.
Within one month of allotment, the company must produce before the Registrar a written
contract of sale of service in respect of which shares have been allotted.
Accounting Entries
(a) When assets are purchased in exchange of shares
Assets Account Dr.
To Share Capital Account
(b) When shares are issued to promoters
Goodwill Account Dr.
To Share Capital Account
Illustration 20
X Co. Ltd. was incorporated with an authorized share capital of 1,00,000 equity shares of
Rs. 10 each. The directors decided to allot 10,000 shares credited as fully paid to the promoters
for their services.
The company also purchased land and buildings from Y Co. Ltd for Rs. 4,00,000 payable in
fully paid-up shares of the company. The balance of the shares were issued to the public,
which were fully subscribed and paid for.
You are required to pass Journal Entries and to prepare the Balance Sheet.
Solution
Journal
Dr. Cr.
Date Particulars Rs. Rs.
Goodwill A/c Dr. 1,00,000
To Equity Share Capital A/c 1,00,000
(Being the issue of 10,000 shares of
Rs.10 each fully paid to the promoters
for their services as per Board’s
Resolution No….. dated…..)
Land and Buildings A/c Dr. 4,00,000

9.48 COMMON PROFICIENCY TEST


To Y Co. Ltd A/c 4,00,000
(Being the land and buildings purchased from
Y Co. Ltd as per agreement dated…).
Bank A/c Dr. 5,00,000
To Equity Share Capital A/c 5,00,000
(Being the issue of 50,000 shares of
Rs.10 each as per Board’s Resolution
No…..dated…)
Balance Sheet of X Company Limited as at….
Liabilities Rs. Assets Rs.
Share Capital Fixed Assets
Authorised Capital Goodwill 1,00,000
1,00,000 Shares of Rs.10 each 10,00,000 Land and Building 4,00,000
Issued Capital Current Assets
1,00,000 Equity shares of
Rs. 10 each 10,00,000 Bank 5,00,000
(Of the above, 50,000 shares have
been allotted for consideration
other than cash)
10,00,000 10,00,000

SELF EXAMINATION QUESTIONS


1. The excess price received over the par value of shares, should be credited to __________.
(a) Calls-in-advance account (b) Share capital account
(c) Reserve capital account (d) Share premium account
2. Which of the following statements is false?
(a) The forfeited shares should not be issued at a premium
(b) At the time of forfeiture of shares, share premium should not be debited with the
amount of premium already received
(c) Shares can be issued at a discount only after one year from the commencement of
business
(d) Share premium cannot be utilized to redeem preference shares
3. When shares are issued to promoters for the services offered by them, the account that
will be debited with the nominal value of shares is ____________.
(a) Preliminary expenses (b) Goodwill
(c) Asset account (d) Share capital

FUNDAMENTALS OF ACCOUNTING 9.49


ISSUE, FORFEITURE AND REISSUE OF SHARES

4. The directors of E Ltd. made the final call of Rs.30 per share on May 15, 2004 indicating
the last date of payment of call money to be May 31, 2004. Mr.F, holding 5,000 shares paid
the call money on July 15, 2004.
If the company adopts Table A, the amount of interest on calls-in-arrear to be paid by
Mr.F = ?
(a) Rs.625.00 (b) Rs.937.50 (c) Rs.750.00 (d) Rs.1,125.00
Use the following information for questions 5 to 9
B Ltd. was registered with a share capital of Rs 1,00,00,000 divided into equity shares of Rs 10
each. It issued 9,00,000 equity shares to the general public at par payable as to Rs 3 on application,
Rs 3 on allotment and balance in 2 equal calls. The public had subscribed for 8,50,000 shares.
Till 31st March, 2006, only first call had been made. All the shareholders had paid up except
Mr. C, a holder of 25,000 shares, who did not pay the call money.
5. How much is B Ltd.’s authorized share capital?
a. Rs 1,00,00,000 b. Rs 90,00,000 c. Rs 85,00,000 d. Rs 68,00,000
6. How much is B Ltd.’s Issued Capital?
a. Rs 1,00,00,000 b. Rs 90,00,000 c. Rs 85,00,000 d. Rs 68,00,000
7. How much is B Ltd.’s Subscribed Capital?
a. Rs 1,00,00,000 b. Rs 90,00,000 c. Rs 85,00,000 d. Rs 68,00,000
8. How much is B Ltd.’s Called Up Capital?
a. Rs 1,00,00,000 b. Rs 90,00,000 c. Rs 85,00,000 d. Rs 68,00,000
9. How much is B Ltd.’s Paid Up Capital?
a. Rs 1,00,00,000 b. Rs 90,00,000 c. Rs 85,00,000 d. Rs 67,50,000
Use the following information for questions 10 to 23
D Ltd. issued 2,00,000 shares of Rs.100 each at a premium of Rs.20 per share payable as
follows:
On application Rs.20
On allotment Rs.50 (including premium)
On first call Rs.30
On second and final call Rs.20
Applications were received for 3,00,000 shares and pro rata allotment was made to applicants
of 2,40,000 shares. Money excess received on application was employed on account of sum
due on allotment as part of share capital. E, to whom 4,000 shares were allotted, failed to pay
the allotment money and on his subsequent failure to pay the first call, his shares were forfeited
and F, the holder of 6,000 shares failed to pay the two calls and his shares were forfeited after
the second call. Of the forfeited shares, 8,000 shares were reissued to G at a discount of 10%, the
whole of E’s forfeited shares being reissued.

9.50 COMMON PROFICIENCY TEST


10. Amount received on application = ___________.
a. Rs 40,00,000 b. Rs 60,00,000 c. Rs 48,00,000 d. Rs 2,40,00,000
11. Application money adjusted against allotment = __________.
a. Rs 20,00,000 b. Rs 16,00,000 c. Rs 12,00,000 d. Rs 8,00,000

12. Amount refunded to shareholders = __________.


a. Rs 20,00,000 b. Rs 16,00,000 c. Rs 12,00,000 d. Rs 8,00,000
13. Total amount paid by E = _________.
a. Rs 80,000 b. Rs 1,00,000 c. Rs 1,44,000 d. Rs 96,000
14. Total amount paid by F = ________.
a. Rs 80,000 b. Rs 3,00,000 c. Rs 4,20,000 d. Rs 1,44,000
15. Total amount paid by G = __________.
a. Rs 7,20,000 b. Rs 8,00,000 c. Rs 8,80,000 d. Rs 8,64,000
16. Amount transferred to Share forfeiture account at the time of forfeiting E’s
shares = _________.
a. Rs 80,000 b. Rs 1,00,000 c. Rs 3,00,000 d. Rs 96,000
17. Amount transferred to Share forfeiture account at the time of forfeiting F’s
shares = _________.
a. Rs 80,000 b. Rs 3,00,000 c. Rs 4,20,000 d. Rs 1,44,000
18. Net balance in Share Capital Account = ________.
a. Rs 2,00,00,000 b. Rs 2,08,00,000 c. Rs 2,04,00,000 d. Rs 1,98,00,000
19. Net balance in Securities Premium Account = ________.
a. Rs 39,20,000 b. Rs 39,28,000 c. Rs 39,36,000 d. Rs 39,44,000
20. Net balance in Share Forfeiture Account = ________.
a. Rs 1,00,000 b. Rs 3,00,000 c. Rs 96,000 d. Rs 3,96,000
21. Net balance in Capital Reserve Account = ________.
a. Rs 2,96,000 b. Rs 80,000 c. Rs 2,10,000 d. Rs 2,16,000
22. Net balance in Bank Account = ________.
a. Rs 2,40,00,000 b. Rs 2,40,12,000 c. Rs 2,40,24,000 d. Rs 2,40,36,000
23. Balance Sheet Total = _________.
a. Rs 2,40,00,000 b. Rs 2,40,12,000 c. Rs 2,40,24,000 d. Rs 2,40,36,000
24. When shares are forfeited, the share capital account is debited with ________ and the
share forfeiture account is credited with __________.

FUNDAMENTALS OF ACCOUNTING 9.51


ISSUE, FORFEITURE AND REISSUE OF SHARES

(a) Paid-up capital of shares forfeited; Called up capital of shares forfeited


(b) Called up capital of shares forfeited; Calls in arrear of shares forfeited
(c) Called up capital of shares forfeited; Amount received on shares forfeited
(d) Calls in arrears of shares forfeited; Amount received on shares forfeited
Use the following information for the questions 25 to 29
B Ltd. issued 80,000 equity shares of Rs.10 each, payable as under:
On application Rs.3
On allotment Rs.4
On first call Rs.2
On final call Rs.1
The applications received for 1,20,000 shares were dealt with as under:
 Applicants of 20,000 shares were allotted in full.
 Applicants of 80,000 shares were allotted 60,000 shares pro-rata.
 Applications for 20,000 shares were rejected.
25. Amount received on application is _____________.
a. Rs 2,40,000 b. Rs 3,60,000 c. Rs 5,60,000 d. Rs 8,00,000
26. Total excess money received as compared to the number of shares allotted = ?
a. Rs 3,00,000 b. Rs 2,40,000 c. Rs 3,60,000 d. Rs 1,20,000
27. Amount to be refunded = ?
a. Nil b. Rs 60,000 c. Rs 1,20,000 d. Rs 1,80,000
28. Amount of excess application money available for adjustment against allotment
money = ?
a. Nil b. Rs 60,000 c. Rs 1,20,000 d. Rs 1,80,000
29. Amount of excess application money available for adjustment against call money = ?
a. Nil b. Rs 60,000 c. Rs 1,20,000 d. Rs 1,80,000
30. Which type of the following shares have the right to receive dividends unpaid in prior
years, whenever earnings become adequate?
(a) Cumulative preference shares (b) Participating preference shares
(c) Convertible preference shares (d) Callable preference shares
31. Which of the following statements is false?
(a) Interest on calls-in-advance is paid from the date of receipt of advance to the date of
relevant call
(b) Interest on calls-in-advance is paid from the date of receipt of advance to the date of
appropriation to the relevant call
(c) Interest on calls-in-advance is paid at the rate of 6% p.a.
(d) Payment of interest on calls-in-advance is at the discretion of the company

9.52 COMMON PROFICIENCY TEST


32. T Ltd. proposed to issue 6,000 equity shares of Rs.100 each at a premium of 40%. The
minimum amount of application money to be collected per share = ?
(a) Rs.5.00 (b) Rs.6.00 (c) Rs.7.00 (d) Rs.8.40.
33. The directors of B Ltd. made the final call of Rs.30 per share on January 15, 2004 indicating
the last date of payment of call money to be January 31, 2004. Mr. C, holding 7,500 shares
paid the call money on March 15, 2004.
If the company adopts Table A, of the Companies Act the amount of interest on calls-in-
arrear to be paid by Mr. C = ?
(a) Rs.937.50 (b) Rs.1,406.25 (c) Rs.1,125.00 (d) Rs.1,687.50.
34. Dividends are usually paid as a percentage of ______.
(a) Authorized share capital (b) Net profit
(c) Paid-up capital (d) Called-up capital
35. E Ltd. had allotted 10,000 shares to the applicants of 14,000 shares on pro rata basis. The
amount payable on application is Rs.2. F applied for 420 shares. The number of shares
allotted and the amount carried forward for adjustment against allotment money due from
F=?
(a) 60 shares; Rs.120 (b) 340 shares; Rs.160
(c) 320 shares; Rs.200 (d) 300 shares; Rs.240
36. O Ltd. issued 10,000 equity shares of Rs.10 each at a premium of 20% payable Rs.4 on
application (including premium), Rs.5 on allotment and the balance on first and final call.
The company received applications for 15,000 shares and allotment was made pro-rata. P,
to whom 3,000 shares were allotted, failed to pay the amount due on allotment. All his
shares were forfeited after the call was made. The forfeited shares were reissued to Q at par.
Assuming that no other bank transactions took place, the bank balance of the company
after effecting the above transactions = ?
a. Rs.1,14,000 b. Rs.1,32,000 c. Rs.1,20,000 d. Rs.1,00,000
37. A company forfeited 2,000 shares of Rs.10 each (which were issued at par) held by Mr.
John for non-payment of allotment money of Rs.4 per share. The called-up value per share
was Rs.9. On forfeiture, the amount debited to share capital = ?
(a) Rs.10,000 (b) Rs.8,000 (c) Rs.2,000 (d) Rs.18,000.
38. If forfeited shares (which were originally issued at a discount) are reissued at a premium,
the amount of such premium will be credited to ________.
(a) Share forfeiture account (b) Share premium account
(c) Capital reserve account (d) Discount on issue of shares account
39. The maximum amount beyond which a company is not allowed to raise funds, by issue
of shares is its’ _____.
a. Issued capital b. Reserve capital
c. Nominal capital d. Subscribed capital
FUNDAMENTALS OF ACCOUNTING 9.53
ISSUE, FORFEITURE AND REISSUE OF SHARES

40. On issue of shares, the application money should not be less than
a. 2.5% of the nominal value of shares
b. 2.5% of the issue price of shares
c. 5.0% of the nominal value of shares
d. 5.0% of the issue price of shares
41. G Ltd. acquired assets worth Rs.7,50,000 from H Ltd. by issue of shares of Rs.100 at a
premium of 25%. The number of shares to be issued by G Ltd. to settle the purchase
consideration = ?
(a) 6,000 shares (b) 7,500 shares (c) 9,375 shares (d) 5,625 shares
42. B Ltd., a listed company, proposed to issue 1,00,000 equity shares of Rs.10 each at par by
way of private placement. The maximum amount of brokerage that can be paid by the
company = ?
(a) Rs.5,000 (b) Rs.10,000 (c) Rs.50,000 (d) Rs.25,000.
43. D Ltd. issued 5,000 equity shares of Rs.20 each at a premium of 20% payable Rs.8 on
application (including premium), Rs.10 on allotment and the balance on first and final
call. The company received applications for 7,500 shares and allotment was made pro-
rata. E, to whom 1,500 shares were allotted, failed to pay the amount due on allotment.
All her shares were forfeited after the call was made. The forfeited shares were reissued to
F at par. Assuming that no other bank transactions took place, the bank balance of the
company after affecting the above transactions = ?
(a) Rs.1,14,000 (b) Rs.1,32,000 (c) Rs.1,20,000 (d) Rs.1,00,000.
44. Declared dividend should be classified in the Balance Sheet as a _______.
(a) Provision (b) Current liability (c) Reserve (d) Current asset
45. The interest on calls-in-advance is paid for the period from the _______.
a. Date of receipt of application money to the date of appropriation
b. Date of receipt of allotment money to the date of appropriation
c. Date of receipt of advance to the date of appropriation
d. Date of appropriation to the date of dividend payment
46. As per Schedule VI of the Companies Act, 1956, under which of the following heads is
‘Premium on issue of Preference Shares’ shown in the balance sheet of a company?
(a) Miscellaneous expenditure (b) Debentures
(c) Reserves and surplus (d) Current liabilities and provisions
47. Which of the following signifies the difference between par value and an issue price below
par?
a. Securities premium b. Discount on issue of shares
c. Calls in arrear d. Calls in advance

9.54 COMMON PROFICIENCY TEST


48. The excess price received over the par value of shares, should be credited to
a. Calls-in-advance account b. Share capital account
c. Reserve capital accountd. Securities premium account
49. On approval from the Central Government, the rate of discount on issue of shares can be
———percent of the nominal value of the shares.
(a) 10 (b) 20 (c) 15 (d) 5
50. The Share Premium Account should be shown under
a. Share Capital b. Current Liabilities
c. Current Assets d. Reserves and Surplus
Use the following information for questions 51 and 52
Consider the following data pertaining to W Ltd. as on March 31, 2006
Share Capital
Issued, Subscribed Called-up (20,000 shares of Rs.100 each) Rs.20,00,000
Calls in arrear Rs. 10,000
Profit and loss account (Cr.) as on April 01, 2005 Rs. 67,000
Profit for the year Rs. 1,90,610
 The company wants to create a Debenture Redemption Reserve and to transfer Rs.50,000
every year out of profits to redeem the debentures.
 The company declared 10% dividends.
51. The amount of dividend declared = ?
a. Rs.1,00,700 b. Rs.2,25,761 c. Rs.1,99,000 d. Rs.2,00,000
52. The balance of Profit and Loss Appropriation account transferred to Balance Sheet after
effecting the above transactions = ?
a. Rs.6,000 b. Rs.68,100 c. Rs.8,610 d. Rs.6,810
53. If the forfeited shares are issued at a premium, the amount of the premium shall be credited
to
a. Profit and loss account b. Capital reserve account
c. Share forfeiture account d. Share premium account
54. IJK Ltd. issued 20,000 shares of Rs.10 each at a premium of 20% on May 01, 2004, payable
as follows:
On application Rs.4.50 (inclusive of premium)
On allotment Rs.2.50
On first and final call Rs.5.00

FUNDAMENTALS OF ACCOUNTING 9.55


ISSUE, FORFEITURE AND REISSUE OF SHARES

Mrs. M, to whom 1,000 shares were allotted, has paid Rs.5,000 on June 01, 2004. At the
time of remitting the allotment money, she indicated that the excess money should be
adjusted towards the call money. The directors of the company made the first and final
call on October 31, 2004. The company has a policy of paying interest on calls-in-advance.
The amount of interest paid to Mrs. M on calls-in-advance = ?
(a) Rs.62.50 (b) Rs.52.08 (c) Rs.125.00 (d) Rs.150.00
55. The following information pertains to X Ltd.
i. Equity share capital called up Rs.5,00,000 ii. Calls in arrear Rs. 40,000
iii. Calls in advance Rs. 25,000 iv. Proposed dividend 15%
The amount of dividend payable = ?
a. Rs.75,000 b. Rs.72,750 c. Rs.71,250 d. Rs.69,000
56. Z Ltd. issued 10,000 shares of Rs.10 each. The called up value per share was Rs.8. The
company forfeited 200 shares of Mr. A for non-payment of 1st call money of Rs.2 per
share. He paid Rs.6 for application and allotment money. On forfeiture, the share capital
account will be _________.
a. Debited by Rs.2,000 b. Debited by Rs.1,600
c. Credited by Rs.1,600 d. Debited by Rs. 1,200
57. B Ltd. issued shares of Rs.10 each at a discount of 10%. Mr. C purchased 30 shares and
paid Rs.2 on application but did not pay the allotment money of Rs.3. If the company
forfeited his entire shares, the forfeiture account will be credited by ______.
a. Rs.90 b. Rs.81 c. Rs.60 d. Rs.54
Use the following information for questions 58 and 59
B Ltd. invited applications for 5,000 shares of Rs.10 each at a premium of Rs.2 per share payable
as follows:
On application – Rs.5 (including premium)
On allotment – Rs.4
On final call – Rs.3
Allotment was made on pro rata basis to the applicants of 6,000 shares. Mr. C to whom 60
shares were allotted, failed to pay allotment money and call money. Mr. D the holder of 100
shares, failed to pay call money. All these shares were forfeited after proper notice.
58. On forfeiture, the amount credited to share allotment account = ?
a. Rs.480 b. Rs.640 c. Rs.180 d. Rs.400
59. On forfeiture, the amount credited to share forfeiture account = ?
a. Rs.300 b. Rs.880 c. Rs.320 d. Rs.940.

9.56 COMMON PROFICIENCY TEST


60. Which of the following statements is false?
a. Shares can be issued for cash or any other consideration
b. In the event of over subscription, excess amount has to be refunded or a pro rata
allotment is to be made
c. SEBI guide lines are applicable not only for the first issue of shares but also to subsequent
issue of shares
d. The share application money is automatically converted to share capital.
61. A company invited applications for 25,000 equity shares of Rs10 each and received 30,000
applications along with the application money of Rs.4 per share. Which of the following
alternatives can be followed?
I. Refund the excess applications.
II. Make pro rata allotment to all the applicants, and refund the excess application money.
III. Not to allot any shares to some applicants, full allotment to some of the applicants
and pro rata allotment to the rest of the applicants.
IV. Not to allot any shares to some applicants and make pro rata allotment to other
applicants.
V. Make pro rata allotment to all the applicants and adjust the excess money received
towards call money.
a. Only (II) above b. Both (I) and (IV) above
c. All (I), (II), (III), (IV) and (V) above d. Only (III) above
62. The document inviting offers from public to subscribe for the debentures or shares or
deposits of a body corporate is a _____.
a. Share certificate b. Stock invest
c. Fixed deposit receipt d. Prospectus
63. As per Schedule VI of the Companies Act, 1956, forfeited shares account will be ______.
a. Added to paid-up capital b. Deducted from paid-up capital
c. Shown as a capital reserve d. Shown as a revenue reserve
64. The authorized capital of M Ltd. consists of both cumulative preference shares and equity
shares. Each 5% cumulative preference share has a par value Rs.100. Each equity share
has a par value Rs.10. During the year April 01, 2005 to March 31, 2006, the cumulative
preference share capital balance was Rs.2,00,000 and the equity share capital balance was
Rs.5,00,000.
If dividend declarations totalled Rs.8,000 and Rs.15,000 in the year 2004-05 and 2005-06
respectively, the dividends allocated to the equity share holders in the year 2005-06 = ?
a. Rs.3,000 b. Rs.5,000 c. Rs.10,000 d. Rs.12,000

FUNDAMENTALS OF ACCOUNTING 9.57


ISSUE, FORFEITURE AND REISSUE OF SHARES

65. Which of the following statements is true?


a. Par value must be separately reported in the balance sheet because it represents the
market value of the shares when it was first issued
b. Selling common shares for more than par value results in gain that is reported in the
income statement
c. Common shareholders assume a higher investment risk than long-term creditors
d. Non-convertible debentures cannot be issued by companies
66. F Ltd. issued 10,000 equity shares of Rs.10 each at a premium of 20% payable Rs.4 on
application (including premium), Rs.5 on allotment and the balance on first and final call.
The company received applications for 15,000 shares and allotment was made pro-rata. G,
to whom 3,000 shares were allotted, failed to pay the amount due on allotment. All his
shares were forfeited after the call was made. The forfeited shares were reissued to H at par.
Assuming that no other bank transactions took place, the bank balance of the company
after effecting the above transactions = ?
(a) Rs.1,14,000 (b) Rs.1,32,000 (c) Rs.1,20,000 (d) Rs.1,00,000
67. At the time of forfeiture of shares which were originally issued at a discount, the accounting
entry involves __________.
I. A debit to Share capital account with the called-up value of shares forfeited
II. A credit to Share forfeiture account with the amount received on forfeited shares
III. A credit to Discount on issue of shares with the amount of discount allowed on forfeited
shares
IV. A credit to Calls-in-arrears with the amount due but not paid on forfeited shares
(a) Both (I) and (IV) above (b) Both (IV) and (III above
(c) Both (I) and (II) above (d) (I), (II), (III) and (IV) above.
68. When shares are forfeited, the share capital account is debited with______ and the share
forfeiture account is credited with_________
a. Paid-up capital of shares forfeited; Called up capital of shares forfeited
b. Called up capital of shares forfeited; Calls in arrear of shares forfeited
c. Called up capital of shares forfeited; Amount received on shares forfeited
d. Calls in arrears of shares forfeited; Amount received on shares forfeited
69. Capital Reserves are created out of ______.
a. Balance in Profit and loss Account b. Capital Profits
c. Revenue Profits d. Provisions
70. As per The Companies Act, only preference shares, which are redeemable within ____ can
be issued.
a. 24 years b. 22 years c. 30 years d. 20 years

9.58 COMMON PROFICIENCY TEST


71. Which of the following is not true?
a. Loss on reissue of shares cannot be more than the gain on forfeiture of those shares
b. Where all the forfeited shares are not reissued the share forfeited account will show a
credit balance equal to gain on forfeiture of shares not yet issued
c. When the shares are forfeited, share premium is debited along with share capital where
premium has not been received
d. Where forfeited shares are issued at premium, the amount of such premium is credited
to capital reserve account.
72. The subscribed share capital of S Ltd. is Rs.80,00,000 of Rs.100 each. There were no calls in
arrear till the final call was made. The final call made was paid on 77,500 shares. The calls
in arrear amounted to Rs.62,500. The final call on share = ?
a. Rs.25 b. Rs.7.80 c. Rs.20 d. Rs.62.50
73. Dividends are usually paid on _________.
(a) Authorized capital (b) Issued capital
(c) Called-up capital (d) Paid-up capital
74. The maximum amount beyond which a company is not allowed to raise funds, by issue of
shares is known as _______.
(a) Issued capital (b) Reserve capital (c) Nominal capital (d) Subscribed capital
75. Which of the following should be deducted from the share capital to find out paid-up
capital?
(a) Calls-in-advance (b) Calls-in-arrears
(c) Share forfeiture (d) Discount on issue of shares
76. If a shareholder does not pay his dues on allotment, for the amount due, there will be a
________.
(a) Credit balance in the share allotment account
(b) Debit balance in the share forfeiture account
(c) Credit balance in the share forfeiture account
(d) Debit balance in the share allotment account
77. The discount allowed on re-issue of forfeited shares is debited to __________.
(a) General reserve account (b) Capital reserve account
(c) Revaluation reserve account (d) None of these.
78. Maximum amount that can be collected as premium as a percentage of face value = ?
a. 20%. b. 30% c. 40%. d. Unlimited
79. Consider the following information pertaining to the issue of shares of a company. The
company issued shares of Rs.10 each at a premium of Rs.2 payable as:

FUNDAMENTALS OF ACCOUNTING 9.59


ISSUE, FORFEITURE AND REISSUE OF SHARES

On application –– Rs.3
On allotment –– Rs.4 (including premium)
On first call –– Rs.3
On second and final call –– Rs.2
Mr. E who holds 100 shares failed to pay the first call money. The company has forfeited
the 100 shares after the first call. On forfeiture, the amount debited to share capital account
=?
(a) Rs.1,200 (b) Rs.1,000 (c) Rs.800 (d) Rs.700
Use the following information for questions 80 and 81
D Ltd. issued 10,000 equity shares of Rs.10 each at a premium of 20%. The share amount was
payable as:
On application Rs.2
On allotment (including premium) Rs.5
On first call Rs.3
On second and final call Rs.2
Applications were received for 14,000 shares and the shares were allotted to applicants on
pro-rata basis. E, who was allotted 300 shares, failed to pay the first call. On his subsequent
failure to pay the second and final call, all his shares were forfeited. Out of the forfeited
shares, 200 shares were re-issued @ Rs.9 per share.
80. The amount transferred to capital reserve = ? and the balance in share forfeiture accounts
respectively, are
(a) Rs.200 (b) Rs.1,100 (c) Rs.800 (d) Rs.1,300
81. Balance in share forfeiture accounts = ?
(a) Rs.Nil (b) Rs.700 (c) Rs.500 (d) Rs.400
82. The following statements apply to equity/preference shareholders. Which one of them
applies only to Preference Shareholders?
(a) Shareholders risk the loss of investment
(b) Shareholders bear the risk of no dividends in the event of losses
(c) Shareholders usually have the right to vote
(d) Dividends are usually a set amount in every financial year
83. The Securities Premium amount may be utilized by a company for __________.
(a) Writing off any loss on sale of fixed asset
(b) Writing off any loss of revenue nature
(c) Payment of dividends
(d) Writing off the expenses/discount on the issue of debentures

9.60 COMMON PROFICIENCY TEST


II Match the following items from column A with column B
S. No. Column A Column B
1. The amount of capital, to describe the shares (a) Financial statements
offered to public for subscription is
2. The primary means of communicating (b) Par value
important accounting information to users is
3. The equity shareholders are entitled to (c) Issued Capital
4. The value that is placed on the share at the (d) One vote for each equity share
time of its original issue, is called held
[Ans. : 1.(c); 2(a), 3(d), 4(b)]
III Choose the correct answer (more than one)
1. Which of the following is not correct?
(a) Nominal capital is the maximum amount that a company is authorized to issue to the
public without altering the memorandum of association
(b) Subscribed capital is that part of nominal capital that is offered to the public for
subscription
(c) Subscribed capital will not be equal to the issued capital, when all the shares offered
to the public are taken up by the public
(d) Called up capital is that part of the subscribed capital, that has been called up
2. Which of the following statements is true regarding Calls in Arrears?
a. Calls in arrear is that part of called up capital remaining unpaid
b. It is shown in the Balance Sheet until the defaulted shares are forfeited
c. The rate of interest on calls in arrear is chargeable at 9% p.a if a company adopts Table
A
d. Charging of interest on calls in arrear need not be permitted by the Articles of Association
3. Which of the following is not a condition for issue of shares at a discount?
a. The Memorandum of Association must authorize the company for issue of shares at a
discount
b. The issue must be authorized by passing an ordinary resolution in the General Meeting
and must be confirmed by the Central Government
c. The shares need not be a class of shares already issued
d. At least one year must have elapsed since the company was entitled to commence
business
4. Which of the following does not appear under the head ‘share capital’ of a balance sheet?
a. Preference share capital b. Minority interest in subsidiaries
c. Equity share capital d. Capital Reserve account.

FUNDAMENTALS OF ACCOUNTING 9.61


ISSUE, FORFEITURE AND REISSUE OF SHARES

5. Which of the following statements is true with regard to issue of shares by a joint stock
company?
a. Shares can be issued for consideration other than cash
b. In the event of over-subscription, the company can allot more number of shares than
those specified in the prospectus
c. As per the SEBI guidelines, the minimum subscription clause is applicable only to the
first issue of shares by the company
d. The share application money is converted into share capital only after the board of
directors approve the allotment of shares
[Ans : 1 : (b) & (c), 2 : (a)&(b), 3 : (a)&(c), 4 : (b)&(d), 5 : (a)&(d)]

ANSWERS
1. (d) 2. (a) 3. (b) 4. (b) 5. (a)
6. (b) 7. (c) 8. (d) 9. (d) 10. (b)
11. (b) 12. (c) 13. (d) 14. (c) 15. (a)
16. (d) 17. (b) 18. (d) 19. (a) 20. (a)
21. (d) 22. (d) 23. (d) 24. (c) 25. (b)
26. (d) 27. (b) 28. (b) 29. (a) 30. (a)
31. (d) 32. (a) 33. (b) 34. (c) 35. (d)
36. (b) 37. (d) 38. (b) 39. (c) 40. (c)
41. (a) 42. (a) 43. (b) 44. (b) 45. (c)
46. (c) 47. (b) 48. (d) 49. (b) 50. (d)
51. (c) 52. (c) 53. (d) 54. (a) 55. (d)
56. (b) 57. (c) 58. (c) 59. (b) 60. (d)
61. (c) 62. (d) 63. (a) 64. (a) 65. (c)
66. (b) 67. (d) 68. (c) 69. (b) 70. (d)
71. (d) 72. (a) 73. (d) 74. (c) 75. (b)
76. (d) 77. (d) 78. (d) 79. (c) 80. (c)
81. (c) 82. (d) 83. (d)

9.62 COMMON PROFICIENCY TEST


CHAPTER – 9

COMPANY
ACCOUNTS

Unit 3

Redemption
of Preference
Shares
REDEMPTION OF PREFERENCE SHARES

Learning Objectives
After studying this unit, you will be able to:
 understand the meaning of redemption and the purpose of issuing redeemable preference
shares,
 learn various provisions of the Companies Act regarding preference shares and their
redemption,
 familiarise yourself with various methods of redemption of fully paid-up preference
shares: (i) Fresh issue of shares; (ii) Capitalisation of undistributed profits; (iii)
Combination of (i) and (ii); and (iv) Raising funds through sale of investments,
 understand the logic behind the creation of capital redemption reserve account,
 learn the accounting treatment for redemption of partly called-up and fully called-up
but partly paid-up preference shares.

1. INTRODUCTION
Redemption is the process of repaying an obligation, at prearranged amounts and timings.
The conditions of the issue of preference shares include a call provision, i.e. a contract giving
the right to redeem preference shares within or at the end of a given time period at an agreed
price. These shares are issued on the terms that share holders will at a future date be repaid the
amount which they invested in the company. The redemption date is the maturity date, which
specifies when repayment takes place and is usually printed on the preference share certificate.
Through the process of redemption, a company can also adjust its financial structure, for
example, by eliminating preference shares and replacing those with other securities if future
growth of the company makes such change advantageous.

2. PURPOSE OF ISSUING REDEEMABLE PREFERENCE SHARES


A company may issue redeemable preference shares because of the following:
1 It is a proper way of raising finance in a dull primary market.
2. A company may face difficulty in raising share capital, as its shares are not traded on the
stock exchange. Potential investors, hesitant in putting money into shares that cannot
easily be sold, may be encouraged to invest if the shares are redeemable by the company.
3 The preference shares may be redeemed when there is a surplus of capital and the surplus
funds cannot be utilised in the business for profitable use.
4. A company may require additional capital in the medium term for a project, but the
project is expected to generate sufficient funds to enable the preference shares to be reduced.
In India the issue and redemption of preference shares is governed by Section 80 of the
Companies Act, 1956.

9.64 COMMON PROFICIENCY TEST


3. PROVISIONS OF THE COMPANIES ACT (SECTION 80)
A company limited by shares if so authorised by its Articles, may issue preference shares which
at the option of the company, are liable to be redeemed. It should be noted that:
(a) no shares can be redeemed except out of profit of the company which would otherwise be
available for dividend or out of proceeds of fresh issue of shares made for the purpose of
redemption;
(b) no such shares can be redeemed unless they are fully paid;
(c) the premium, if any, payable on redemption must be provided for out of the profits of the
company or out of the company's share premium account before the shares are redeemed.
(d) where any such shares are redeemed, otherwise than out of the proceeds of a fresh issue,
there shall, out of profits which would otherwise have been available for dividends, be
transferred to a reserve account to be called Capital Redemption Reserve Account, a sum
equal to the nominal amount of the shares redeemed; and the provisions of the Act relating
to the reduction of the share capital of a company shall, except as provided in the section,
apply as if the Capital Redemption Reserve Account were the paid-up share capital of the
company.
From the legal provision outlined above, it is apparent that on the redemption of redeemable
preference shares out of accumulated profits it will be necessary to transfer to the Capital
Redemption Reserve Account an amount equal to the amount repaid on the redemption of
preference shares on account of face value less proceeds of a fresh issue of capital made for the
purpose of redemption. The object is that with the repayment of redeemable preference shares,
the security for creditors should not be reduced. At times, a part of the preference share capital
may be redeemed out of accumulated profits and the balance out of a fresh issue. The entries
which have to be made on the redemption of preference shares are shown in the illustration
that follows:
After the commencement of the Companies (Amendment) Act, 1996, a company cannot issue
any preference share, which is irredeemable or is redeemable after the expiry of a period of
twenty years from the date of its issue.

4. REDEMPTION OF IRREDEEMABLE PREFERENCE SHARES


(SECTION 80-A)
Section 80-A states that:
1. Notwithstanding anything contained in the terms of issue of any preference shares, every
preference share issued before the commencement of the Companies (Amendment) Act,
1988.
(a) which is irredeemable, shall be redeemed by the company within a period not
exceeding five year from such commencement, or
(b) which is not redeemable before the expiry of ten years from the date of issue thereon
in accordance with the terms of its issue and which had not been redeemed before

FUNDAMENTALS OF ACCOUNTING 9.65


REDEMPTION OF PREFERENCE SHARES

such commencement, shall be redeemed by the company on the date on which such
share is due for redemption or within a period not exceeding ten years from such
commencement, whichever is earlier.
Provided that where a company is not in a position to redeem any such share within the
period aforesaid and to pay the dividend, if any, due thereon (such shares being hereinafter
referred to as unredeemed preference shares), it may, with the consent of the Company
Law Board, on a petition made by it in this behalf and notwithstanding anything contained
in the Act, issue further redeemable preference shares equal to the amounts due (including
the dividend thereon), in respect of the unredeemed preference shares, and on the issue of
such further redeemable preference shares, the unredeemed shares shall be deemed to
have been redeemed.
2. Nothing contained in other section of the Companies Act, shall be deemed to confer power
on any class of shareholders by resolution or on any court or the Central Government or
vary or modify the provisions of this section.

5. METHODS OF REDEMPTION
Redemption of preference shares means repayment by the company of the obligation on account
of shares issued. According to the Companies Act, 1956, preference shares issued by a company
must be redeemed within the maximum period allowed under the Act. Thus, a company cannot
issue irredeemable preference shares. Section 80 of the Companies Act, 1956, deals with rules
relating to redemption of preference shares. It ensures that there is no reduction in shareholders'
funds due to redemption and thus the interest of outsiders is not impaired. For this, it requires
that either fresh issue of shares is made or distributable profits are retained and transferred to
'Capital Redemption Reserve Account'.
The rationale behind these provisions is to protect the interest of outsiders to whom the amount
is payable before redemption of preference share capital. The interest of outsiders is protected
if the nominal value of capital redeemed is subsituted, thus, ensuring the same amount of
shareholders fund. In case of redemption of preference shares out of proceeds of a fresh issue
of shares, replacement of capital and tangible assets is obvious. But, if redemption is done out
of distributable profits, replacement of capital is ensured in an indirect manner by retention of
profit by transfer to Capital Redemption Reserve. In this case, the amount which would have
gone to shareholders in the form of dividend is retained in the business and is used for settling
the claim of preference shareholders. Thus, there is no additional claim on net assets of the
Company. The transfer of divisible profits to Capital Redemption Reserve makes them non-
distributable profits. As Capital Redemption Reserve can be used only for issue of fully paid
bonus shares, profits retained in the business ultimately get converted into share capital.
Security cover available to outside stakeholders depends upon called-up capital as well as
uncalled capital to be demanded by the company as per its requirements. To ensure that the
interests of outsiders are not reduced, Section 80 provides for redemption of only fully paid-up
shares.

9.66 COMMON PROFICIENCY TEST


From the above paras, it can be concluded that the 'gap' created in the company's capital by
the redemption of redeemable preference shares much be filled in by:
(a) the proceeds of a fresh issue of shares;
(b) the capitalisation of undistributed profits; or
(c) a combination of (a) and (b).

5.1 REDEMPTION OF PREFERENCE SHARES BY FRESH ISSUE OF SHARES


One of the methods for redemption of preference shares is to use the proceeds of a fresh issue
of shares. A company can issue new shares (equity share or preference share) and the proceeds
from such new shares can be used for redemption of preference shares.
The proceeds from issue of debentures cannot be utilised for the purpose.
A problem arises when a fresh issue is made for the purpose of redemption of preference
shares, at a premium. The point to ponder is that whether the proceeds of a fresh issue of
shares will include the amount of securities premium for the purpose of redemption of preference
shares.
For security premium account, Companies Act provides that:
The securities premium account may be applied by the company;
(a) in paying up un-issued shares of the company to be issued to members of the company as
fully paid bonus shares;
(b) in writing off the preliminary expenses of the company;
(c) in writing off the expenses of, or the commission paid or discount allowed on, any issue of
shares or debentures of the company; or
(d) in providing for the premium payable on the redemption of any redeemable preference
shares or of any debentures of the company.
Any other way, except the above four prescribed ways, in which securities premium account
is utilised will be in contravention of law. It is interesting to note that clause (d) above allows
premium on redemption of preference shares to be adjusted against Securities Premium Account
but the redemption itself cannot be financed out of the Securities Premium Account.
Again, a problem may arise when the fresh issue is made at a discount. Proceeds in connection
with issue of shares at a discount would mean only the net amount received that is, face value
less the discount. Suppose a share of Rs. 100 (face value) is issued at a discount of 5% money
available from the proceeds of a fresh issue is Rs. 95 and not Rs. 100. Hence, the company can
redeem only Rs. 95. Therefore, when the shares are issued at a discount, then the number of
shares to be issued at a discount should be manipulated to ensure that at least the face value of
the shares to be redeemed has been procured in money out of the proceeds of the fresh issue at
a discount.

FUNDAMENTALS OF ACCOUNTING 9.67


REDEMPTION OF PREFERENCE SHARES

5.1.1 Reasons for issue of New Equity Shares


A company may prefer issue of new equity shares for the following reasons:
(a) When the company has come to realise that the capital is needed permanently and it
makes more sense to issue Equity Shares in place of Redeemable Preference Shares which
carry a fixed rate of dividend.
(b) When the balance of profit, which would otherwise be available for dividend, is insufficient.
(c) When the liquidity position of the company is not good enough.
5.1.2 Advantages of redemption of preference shares by issue of fresh equity shares
Following are the advantages of redemption of preference shares by the issue of fresh equity
shares:
(1) No cash outflow of money – now or later.
(2) New equity shares may be valued at a premium.
(3) No capital gains tax for shareholders.
(4) Shareholders retain their equity interest.
5.1.3 Disadvantages of redemption of preference shares by issue of fresh equity shares
The disadvantages are:
(1) There is a possibility of dilution of further earnings;
(2) Share holdings in the company are changed.
5.1.4 Accounting Entries
1 When new shares are issued at par
Bank Account Dr.
To Share Capital Account
(Being the issue of …….shares of Rs……each for the
purpose of redemption of preference shares, as per Board's
Resolution No…… dated……. ) .
2. When new shares are issued at a premium.
Bank Account Dr.
To Share Capital Account
To Securities Premium Account
(Being the issue of ……..shares of Rs……each at a premium of
Rs……each for the purpose of redemption of preference shares
as per Board's Resolution No….. dated……)

9.68 COMMON PROFICIENCY TEST


3 When new shares are issued at a discount
Bank Account Dr.
Discount on Issue of Shares Account Dr.
To Share Capital Account
(Being the issue of ……..shares of Rs…….each at a discount of
Rs……..each for the purpose of redemption of preference
shares, as per Board's Resolution No…….dated…….)
4 When preference shares are redeemed at par
Redeemable Preference Share Capital Account Dr.
To Preference Shareholders Account
5 When preference shares are redeemed at a premium
Redeemable Preference Share Capital Account Dr.
Premium on Redemption of Preference Shares Account Dr.
To Preference Shareholders Account
6 When payment is made to preference shareholders
Preference Shareholders Account Dr.
To Bank Account
7 For adjustment of premium on redemption
Profit and Loss Account Dr.
Securities Premium Account Dr.
To Premium on Redemption of Preference Shares Account
Illustration 1
Hinduja Company Ltd. had 5,000 8% Redeemable Preference Shares of Rs. 100 each, fully
paid up. The company decided to redeem these preference shares at par by the issue of sufficient
number of equity shares of Rs. 10 each fully paid up at par. You are required to pass necessary
Journal Entries including cash transactions in the books of the company.
Solution
In the books of Hinduja Company Ltd.
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
Bank A/c Dr. 5,00,000
To Equity Share Capital A/c 5,00,000
(Being the issue of 50,000 Equity Shares of Rs. 10 each at
par for the purpose of redemption of preference shares,
as per Board Resolution No ……..dated……..)
8% Redeemable Preference Share Capital A/c Dr. 5,00,000

FUNDAMENTALS OF ACCOUNTING 9.69


REDEMPTION OF PREFERENCE SHARES

To Preference Shareholders A/c 5,00,000


(Being the amount payable on redemption of
preference shares transferred to Preference
Shareholders Account)
Preference Shareholders A/c Dr. 5,00,000
To Bank A/c 5,00,000
(Being the amount paid on redemption of
preference shares)

Illustration 2
C. Ltd. had 10,000 10% Redeemable Preference Shares of Rs. 100 each, fully paid up. The
company decided to redeem these preference shares at par, by issue of sufficient number of
equity shares of Rs. 10 each at a premium of Rs. 2 per share as fully paid up. You are required
to pass necessary Journal Entries including cash transactions in the books of the company.
Solution
In the books of C Limited
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
Bank A/c Dr 12,00,000
To Equity Share Capital A/c 10,00,000
To Securities Premium A/c 2,00,000
(Being the issue of 1,00,000 Equity Shares of Rs. 10
each at a premium of Rs. 2 per share as per Board's
Resolution No….. dated……….)
10% Redeemable Preference Share Capital A/c Dr 10,00,000
To Preference Shareholders A/c 10,00,000
(Being the amount payable on redemption of
preference shares transferred to Preference
Shareholders A/c)
Preference Sharesholders A/c Dr 10,00,000
To Bank A/c 10,00,000
(Being the amount paid on redemption of
preference shares)

Note: Amount required for redemption is Rs. 10,00,000. Therefore, face value of equity shares
to be issued for this purpose must be equal to Rs. 10,00,000. Premium received on new issue
cannot be used to finance the redemption.

9.70 COMMON PROFICIENCY TEST


Illustration 3
G India Ltd. had 9,000 10% redeemable Preference Shares of Rs. 10 each, fully paid up. The
company decided to redeem these preference shares at par by the issue of sufficient number of
equity shares of Rs. 10 each fully paid up at a discount of 10%.
You are required to pass necessary Journal Entries including cash transactions in the books of
the company.
Solution
In the books of G India Limited
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
Bank A/c Dr. 90,000
Discount on Issue of Shares A/c Dr. 10,000
To Equity Share Capital A/c 1,00,000
(Being the issue of 10,000 Equity Shares of Rs. 10
each at a discount of 10%, as per Board's
Resolution No…….Dated…..)
10% Redeemable Preference Shares Capital A/c Dr. 90,000
To Preference Shareholders A/c 90,000
(Being the amount payable on redemption of
preference shares transferred to Preference
Shareholders A/c)
Preference Shareholders A/c Dr. 90,000
To Bank A/c 90,000
(Being the amount paid on redemption of
preference shares)

Note: When shares are redeemed by issuing shares at a discount, the proceeds from new issue
must be sufficient to cover the face value of shares redeemed. Here, face value of shares to be
redeemed is Rs. 90,000. Proceeds from each new share is Rs. 9 (Rs. 10 – 10x10% discount).
Therefore, the number of new shares to be issued = Rs. 90,000/Rs. 9 = 10,000 shares.
5.1.5 Calculation of Minimum Fresh Issue of Shares
Sometimes, examination problem does not specify the number of shares to be issued for the
purpose of redemption of preference shares and requires that the minimum number of shares
should be issued to ensure that provisions of Section 80 of the Companies Act, 1956, are not
violated. This is done in four steps as given below:

FUNDAMENTALS OF ACCOUNTING 9.71


REDEMPTION OF PREFERENCE SHARES

(1) In such cases, the maximum amount of reserves and surplus available for redemption is
ascertained taking into account the balances appearing in the balance sheet before
redemption and the additional information provided in the problem. For example, if balance
of general reserve in the balance sheet is Rs. 1,00,000 and additional information provides
that the Board of Directors have decided that the balance of general reserve should not be
less than Rs. 40,000 under any circumstances, then, the maximum amount of general
reserve available for redemption is Rs. 60,000.
(2) After ascertaining the maximum amount of reserves and surplus available for redemption,
adjustment for premium on redemption payable out of profits is made and then it is
compared with the nominal value of shares to be redeemed. By comparison, one gets the
minimum proceeds of fresh issue as Section 80 permits redemption either out of proceeds
of fresh issue or out of divisible profits. Thus,
Minimum Proceeds of Fresh Issue of shares :
Nominal value of preference shares to be redeemed – Maximum amount of reserve and
surplus available for redemption.
(3) After computation of minimum proceeds, the minimum number of shares to be issued are
determined by dividing minimum proceeds by the proceeds of one share. This is done as
follows:
Minimum proceeds to comply with Section 80
Minimum Number of Shares =
Proceeds of one share
Proceeds of one share mean the par value of a share issued, if it is issued at par or premium.
However, in case of issue of share at a discount, it refers to the discounted value.
(4) Minimum number of shares calculated as per (3) above, needs to be adjusted due to various
reasons. Firstly, shares fractions cannot be issued. Thus, if minimum number of shares as
per (3) above includes a fraction, it must be approximated to the next higher figure to
ensure that provisions of Section 80 are not violated. Secondly, if the examination problem
states that the proceeds/number of shares should be a multiple of say, 10 or 50 or 100,
then again the next higher multiple should be considered.
Illustration 4
The Board of Directors of a Company decide to issue minimum number of equity shares of
Rs. 10 each at 10% discount to redeem Rs. 5,00,000 preference shares. The maximum amount
of divisible profits available for redemption is Rs. 3,00,000. Calculate the number of shares to
be issued by the company to ensure that provisions of Section 80 are not violated. Also determine
the number of shares if the company decides to issue shares in multiples of Rs. 50 only.
Solution
Nominal value of preference shares Rs. 5,00,000
Maximum possible redemption out of profits Rs. 3,00,000
Minimum proceeds of fresh issue Rs. 5,00,000 - 3,00,000 Rs. 2,00,000

9.72 COMMON PROFICIENCY TEST


Proceed of one share = Nominal value - Discount = 10-1=Rs. 9

2,00,000
Minimum number of shares = = 22,222.22
9
shares

As fractional shares are not permitted, the minimum number of shares to be issued is 22,223
shares.
If shares are to be issued in multiples of 5-, then the next higher figure which is a multiple of 50
is 22,250. Hence, minimum number of shares to be issued in such a case is 22,250 shares.
Illustration 5
The Balance Sheet of a Company on 30-6-2006 is as follows:
Liabilities Amount Assets Amount
Equity Share Capital (Rs. 10) 5,00,000 Sundry Assets 10,00,000
Preference Share Capital (Rs. 100) 2,00,000
Securities Premium 10,000
Profit and Loss Account 90,000
Liabilities 2,00,000
10,00,000 10,00,000

Compute the minimum number of equity shares of Rs. 10 each that the company must issue at
par to redeem preference shares at a premium of 10%.
Solution
Nominal value of preference shares Rs. 2,00,000
Premium on redemption 10% of Rs. 2,00,000 = Rs. 20,000
Securities premium Rs. 10,000
∴ Premium on redemption payable out of profits 20,000-10,000 = Rs. 10,000
Profits available for redemption 90,000-10,000 = Rs. 80,000
Minimum proceeds 2,00,000-80,000 = Rs. 1,20,000
Minimum number of shares 1,20,000/10 = 12,000 shares

5.1.6 Fresh Issue at a Premium and Minimum Fresh Issue


The calculation of minimum number of shares, when fresh issue is at a premium should be
handled very carefully because premium of fresh issue of shares is available for writing off
premium on redemption also. Minimum fresh issue cannot be calculated unless one knows the
profits available for replacement of capital and profit available for replacement cannot be
determined unless one knows the portion of profit available for redemption which is required

FUNDAMENTALS OF ACCOUNTING 9.73


REDEMPTION OF PREFERENCE SHARES

for paying premium on redemption. To tackle this, assume that profits available for redemption
is not required for paying premium on redemption of preference shares. In other words, it
means that securities premium including premium on fresh issue is comparantively more than
premium on redemption.
If the above assumption holds good, minimum number of shares can be calculated in a simple
manner without use of equation. But, if above condition does not hold good, then an equation
is used to determine the minimum number of shares.
5.1.7 Minimum Fresh Issue to Provide Funds for Redemption
Besides, ensuring compliance with Section 80, the fresh issue of shares is made to provide
funds for making payment to preference shareholders. To calculate minimum number of fresh
shares to be issued to provide funds, amount payable to preference shareholders is compared
with funds available for redemption and the balance of funds to be raised by fresh issue of
shares are calculated. The amount to be raised is divided by the issue price of a share (amount
payable by shareholder including premium, if any, on fresh issue) to compute the minimum
number of shares to be issued.
Illustration 6
The Balance Sheet of X Ltd. as on 31st March, 2006 was as follows:
Liabilities Amount Assets Amount
Share Capital: Fixed Assets 3,45,000
Preference Shares of Rs. 100 each Investments 18,500
fully paid 65,000 Balance at Bank 31,000
Equity Shares of Rs. 50 each
fully paid 2,25,000
2,90,000
Profit and Loss Account 48,000
Creditors 56,500
3,94,500 3,94,500

In order to facilitate the redemption of preference shares at a premium of 10%, the Company
decided:
(a) to sell all the investments for Rs. 15,000.
(b) to finance part of redemption from company funds, subject to, leaving a bank balance of
Rs. 12,000.
(c) to issue minimum equity share of Rs. 50 each at a premium of Rs. 10 per share to raise the
balance of funds required.
You are required to pass:
The necessary Journal Entries to record the above transactions and prepare the balance
sheet as on completion of the above transactions.

9.74 COMMON PROFICIENCY TEST


Solution
Journal
Bank A/c Dr. 37,500
To Share Application A/c 37,500
(For application money received on 625 shares
@ Rs. 60 per share)
Share Application A/c Dr. 37,500
To Equity Share Capital A/c 31,250
To Securities Premium A/c 6,250
(For disposition of application money received)
Preference Share Capital A/c Dr. 65,000
Premium on Redemption of
Preference Shares A/c Dr. 6,500
To Preference Shareholders A/c 71,500
(For amount payable on redemption of
preference shares)
Securities Premium A/c Dr. 6,250
Profit and Loss A/c Dr. 250
To Premium on Redemption of
Preference Shares A/c 6,500
(For writing off premium on redemption firstly
out of securities premium and balance out
of profits)
Bank A/c Dr. 15,000
Profit and Loss A/c (loss on sale) A/c Dr. 3,500
To Investment A/c 18,500
(For sale of investments at a loss of Rs. 3,500)
Profit and Loss A/c Dr. 33,750
To Capital Redemption Reserve A/c 33,750
(For transfer to CRR out of divisible profits an
amount equivalent to excess of nominal
value over proceeds i.e., Rs. 65,000 - Rs. 31,250)
Preference Shareholders A/c Dr. 71,500
To Bank A/c 71,500
(For payment of preference shareholders)
Capital Redemption Reserve A/c Dr. 25,000
To Bonus to Shareholders A/c 25,000
(For making provision for issue of 500
bonus shares)
Bonus to Shareholders A/c Dr. 25,000
To Equity Share Capital A/c 25,000
(For issue of bonus shares)

FUNDAMENTALS OF ACCOUNTING 9.75


REDEMPTION OF PREFERENCE SHARES

Balance Sheet (after redemption)


Liabilities Amount Assets Amount
Equity Share Capital 2,56,250 Fixed Assets 3,45,000
Capital Redemption Reserve 33,750 Bank
Profit and Loss Account (31,000 + 37,500 + 15,000 - 1,500) 12,000
(48,000 - 250 - 3,500 - 33,750) 10,500
Creditors 56,500
3,57,000 3,57,000

Working Note:
Calculation of Number of Shares: Rs.
Amount payable on redemption 71,500
Less: Sale price of investment 15,000
56,500
Less: Available bank balance (31,000 - 12,000) 19,000
Funds from fresh issue 37,500
∴ No. of shares = 37500/60 = 625 shares

5.2 REDEMPTION OF PREFERENCE SHARES BY CAPITALISATION OF


UNDISTRIBUTED PROFITS
Another method for redemption of preference shares, as per the Companies Act, is to use the
distributable profits in place of issuing new shares. When shares are redeemed by utilising
distributable profit, an amount equal to the face value of shares redeemed is transferred to
Capital Redemption Reserve Account by debiting the distributable profit. In other words, some
of the distributable profits are kept aside to ensure that it can never be distributed to shareholders
as dividend.
In this connection, the provisions of the Companies Act state that 'When any such shares are
redeemed otherwise than out of the proceeds of a fresh issue, there shall out of profits which
would otherwise have been available for dividend, be transferred to a reserve fund to be called
the Capital Redemption Reserve Account sum equal to the nominal amount of the shares
redeemed'.
5.2.1 Advantages of redemption of preference shares by capitalisation of undistributed
profits
The advantages of redemption of preference shares by capitalisation of undistributed profits
are:
(1) No change in the percentage share holdings of the company;
(2) Future earnings are not diluted;

9.76 COMMON PROFICIENCY TEST


(3) Surplus funds can be used.
5.2.2 Disadvantages of redemption of preference shares by capitalisation of undistributed
profits
The disadvantages of redemption of preference shares by capitalisation of undistributed profits
are:
(1) There may be a reduction in liquidity;
(2) Capital gains tax liability for preference shareholders.
Accounting Entries
1 When shares are redeemed at par
Redeemable Preference Share Capital Account Dr.
To Preference Shareholders Account
(Being the amount payable on redemption of preference shares transferred to Preference
Shareholders Account)
2. When shares are redeemed at a premium
Redeemable Preference Share Capital Account Dr.
Premium on Redemptions of Preference Shares Account Dr.
To Preference Shareholders Account
(Being the amount payable on redemption transferred to Preference Shareholders Account)
3. When payment is made to preference shareholders
Preference Shareholders Account Dr.
To Bank Account
(Being the payment to preference shareholders as per terms)
4 For adjustment of premium of redemption
Profit and Loss Account Dr.
Securities Premium Account Dr.
To Premium on Redemption of Preference Shares Account
(Being the premium on redemption adjusted against Profit and Loss Account and Securities
Premium Account)
5 For transferring nominal amount of shares redeemed to Capital Redemption Reserve Account
General Reserve Account Dr.
Profit and Loss Account Dr.
To Capital Redemption Reserve Account
(Being the amount transferred to Capital Redemption Reserve Account as per the requirement
of the Act).

FUNDAMENTALS OF ACCOUNTING 9.77


REDEMPTION OF PREFERENCE SHARES

Illustration 7
The following are the extracts from the Balance Sheet of ABC Ltd. as on 31st December, 2004.
Share capital: 40,000 Equity shares of Rs. 10 each fully paid - Rs. 4,00,000; 1,000 10% Redeemable
preference shares of Rs. 100 each fully paid – Rs. 1,00,000.
Reserve & Surplus: Capital reserve – Rs. 50,000; Securities premium – Rs. 50,000; General reserve
– Rs. 75,000; Profit and Loss Account – Rs. 35,000
On 1st January 2005, the Board of Directors decided to redeem the preference shares at par by
utilisation of reserve.
You are required to pass necessary Journal Entries including cash transactions in the books of
the company.
Solution
In the books of ABC Limited
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
2005
Jan 1 10% Redeemable Preference Share Capital A/c Dr. 1,00,000
To Preference Shareholders A/c 1,00,000
(Being the amount payable on redemption
transferred to Preference Shareholders Account)
Preference Shareholders A/c Dr. 1,00,000
To Bank A/c 1,00,000
(Being the amount paid on redemption of
preference shares)
General Reserve A/c Dr. 75,000
Profit & Loss A/c Dr. 25,000
To Capital Redemption Reserve A/c 1,00,000
(Being the amount transferred to Capital Redemption
Reserve Account as per the requirement of the Act)
Note: Securities premium cannot be utilised for transfer to Capital Redemption Reserve because
dividend cannot be paid out of Securities Premium Account.
5.3 REDEMPTION OF PREFERENCE SHARES BY COMBINATION OF FRESH ISSUE AND
CAPITALISATION OF UNDISTRIBUTED PROFITS
A company can redeem the preference shares partly from the proceeds from new issue and
partly out of profits. In order to fill in the 'gap' between the face value of shares redeemed and
the proceeds of new issue, a transfer to be made from distributable profits (Profit & Loss Account,
General Reserve and other Free Reserves) to Capital Redemption Reserve Account.

9.78 COMMON PROFICIENCY TEST


Formula:
(i) Amount to be Transferred to Capital Redemption Reserve
Rs.
Face value of shares redeemed ***
Less: Proceeds from new issue ***
***
(ii) Proceeds to be collected from New Issue
Rs.
Face value of shares redeemed ***
Less: Profits available for distribution as dividend ***
***
Illustration 8
C Limited had 3,000, 12% Redeemable Preference Shares of Rs. 100 each, fully paid up. The
company had to redeem these shares at a premium of 10%.
It was decided by the company to issue the following:
(i) 25,000 Equity Shares of Rs. 10 each at par,
(ii) 1,000 14% Debentures of Rs. 100 each.
The issue was fully subscribed and all amounts were received in full .The payment was duly
made. The company had sufficient profits. Show Journal Entries in the books of the company.
Solution
In the books of C Limited
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
Bank A/c Dr 2,50,000
To Equity Share Capital A/c 2,50,000
(Being the issue of 25,000 equity shares of Rs. 10 each
at par as per Board's resolution No……dated…..)
Bank A/c Dr. 1,00,000
To 14% Debenture A/c 1,00,000
(Being the issue of 1,000 Debentures of Rs. 100 each
as per Board's Resolution No…..dated……)
12% Redeemable Preference Share Capital A/c Dr. 3,00,000

FUNDAMENTALS OF ACCOUNTING 9.79


REDEMPTION OF PREFERENCE SHARES

Premium on Redemption of Preference Shares A/c Dr. 30,000


To Preference Shareholders A/c 3,30,000
(Being the amount payable on redemption transferred
to Preference Shareholders Account)
Preference Shareholders A/c Dr. 3,30,000
To Bank A/c 3,30,000
(Being the amount paid on redemption of
preference shares)
Profit & Loss A/c Dr. 30,000
To Premium on Redemption of 30,000
Preference Shares A/c
(Being the adjustment of premium on redemption
against Profits & Loss Account)
Profit & Loss A/c Dr. 50,000
To Capital Redemption Reserve A/c (Note 1) 50,000
(Being the amount transferred to Capital Redemption
Reserve Account as per the requirement of the Act)
Working Note:
(1) Amount to be transferred to Capital Redemption Reserve Account
Face value of shares to be redeemed Rs. 3,00,000
Less: Proceeds from new issue Rs. 2,50,000
Total Balance Rs. 50,000

Illustration 9
The capital structure of a company consists of 20,000 Equity Shares of Rs. 10 each fully paid
up and 1,000 8% Redeemable Preference Shares of Rs. 100 each fully paid up.
Undistributed reserve and surplus stood as: General Reserve Rs. 80,000; Profit and Loss Account
Rs. 10,000; Investment Allowance Reserve out of which Rs. 5,000, (not free for distribution as
dividend) Rs. 10,000; Securities Premium Rs. 12,000, Cash at bank amounted to Rs. 98,000.
Preference shares are to be redeemed at a Premium of 10% and for the purpose of redemption,
the directors are empowered to make fresh issue of Equity Shares at par after utilising the
undistributed reserve and surplus, subject to the conditions that a sum of Rs. 20,000 shall be
retained in general reserve and which should not be utilised.
Pass Journal Entries to give effect to the above arrangements and also show how the relevant
items will appear in the Balance Sheet of the company after the redemption carried out.

9.80 COMMON PROFICIENCY TEST


Solution
In the books of ……….
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
Bank A/c Dr. 25,000
To Equity Share Capital A/c 25,000
(Being the issue of 2,500 Equity Shares of Rs. 10 each
at a premium of Re. 1 per share as per Board's
Resolution No…..dated…….)
8% Redeemable Preference Share Capital A/c Dr. 1,00,000
Premium on Redemption of Preference Shares A/c Dr. 10,000
To Preference Shareholders A/c 1,10,000
(Being the amount paid on redemption transferred to
Preference Shareholders Account)
Preference Shareholders A/c Dr. 1,10,000
To Bank A/c 1,10,000
(Being the amount paid on redemption of preference
shares)
Securities Premium A/c Dr. 10,000
To Premium on Redemption of
Preference shares A/c 10,000
(Being the premium payable on redemption provided
out of Securities Premium Account)
General Reserve A/c Dr. 60,000
Profit & Loss A/c Dr. 10,000
Investment Allowance Reserve A/c Dr. 5000
To Capital Redemption Reserve A/c 75,000
(Being the amount transferred to Capital Redemption
Reserve Account as per the requirement of the Act)

FUNDAMENTALS OF ACCOUNTING 9.81


REDEMPTION OF PREFERENCE SHARES

Balance Sheet as on ………[Extracts]


Liabilities Amount Assets Amount
Share capital Fixed Assets
22,500 Equity Shares of Investment
Rs. 10 each fully paid-up 2,25,000 Current Assets
Reserve and Surplus Cash 13,000
General Reserve 20,000
Securities Premium:
(Rs. 12,000-10,000) 2,000
Capital Redemption Reserve 75,000
Investment Allowance Reserve 5,000

Working Note:
(1) No of Shares to be issued for redemption of Preference Shares:
Face value of shares redeemed Rs. 1,00,000
Less: Profit available for distribution as dividend:
General Reserve : Rs. (80,000-20,000) Rs. 60,000
Profit and Loss Rs. 10,000
Investment Allowance Reserve: (Rs. 10,000-5,000) Rs. 5,000 Rs. 75,000
Rs. 25,000
Therefore, No. of shares to be issued = 25,000/Rs. 10 = 2,500 shares.
Illustration 10
The books of B Ltd. showed the following balance on 31st December, 2005:
30,000 Equity Shares of Rs. 10 each fully paid; 18,000 12% Redeemable Preference Shares of
Rs. 10 each fully paid; 4,000 10% Redeemable Preference Shares of Rs. 10 each, Rs. 8 paid up.
Undistributed Reserve and Surplus stood as: Profit and Loss Account Rs. 80,000; General Reserve
Rs. 1,20,000; Securities Premium Account Rs. 15,000 and Capital Reserve Rs. 21,000.
Preference shares are redeemed on 1st January, 2006 at a premium of Rs. 2 per share. The
whereabouts of the holders of 100 shares of Rs. 10 each fully paid are not known.
For redemption, 3,000 equity shares of Rs. 10 each are issued at 10% premium. At the same
time, a bonus issue of equity share was made at par, two shares being issued for every five held
on that date out of the Capital Redemption Reserve Account.
Show the necessary Journal Entries to record the transactions.

9.82 COMMON PROFICIENCY TEST


Solution
In the books of B Limited
Journal
Date Particulars Dr. (Rs.) Cr. (Rs.)
2006 12% Redeemable Preference Share Capital A/c Dr. 1,80,000
Jan 1 Premium on Redemption of Preference Shares A/c Dr. 36,000
To Preference Shareholders A/c 2,16,000
(Being the amount payable on redemption of 18,000
12% Redeemable Preference Shares transferred to
Shareholders Account)
Preference Shareholders A/c Dr. 2,14,800
To Bank A/c 2,14,800
(Being the amount paid on redemption of 17,900
preference shares)
Bank A/c Dr. 33,000
To Equity Shares Capital A/c 30,000
To Securities Premium A/c 3,000
(Being the issue of 3,000 Equity Shares of Rs. 10 each
at a premium of 10% as per Board's
Resolution No……. Dated……)
General Reserve A/c Dr. 1,20,000
Profit & Loss A/c Dr. 30,000
To Capital Redemption Reserve A/c 1,50,000
(Being the amount transferred to Capital Redemption
Reserve A/c as per the requirement of the Act.)
Capital Redemption Reserve A/c Dr. 1,20,000
To Bonus to Shareholders A/c 1,20,000
(Being the amount appropriated for issue of bonus
share in the ratio of 5:2 as per shareholders
Resolution No.….. dated…)

FUNDAMENTALS OF ACCOUNTING 9.83


REDEMPTION OF PREFERENCE SHARES

Bonus to Shareholders A/c Dr. 1,20,000


To Equity Share Capital A/c 1,20,000
(Being the utilisation of bonus dividend for issue of
12,000 equity shares of Rs. 10 each fully paid)
Securities Premium A/c (Note 2) Dr. 15,000
Profit & Loss A/c Dr. 21,000
To Premium on Redemption of 36,000
Preference Shares A/c
(Being premium on redemption of preference shares
adjusted against Securities Premium Account and the
balance charged to Profit & Loss Account)

Working Notes:
(1) Partly paid-up preference shares cannot be redeemed.
(2) Premium on redemption of preference shares is payable only from Securities Premium
and Profit & Loss Account balance before redemption, i.e. current securities premium of
Rs. 3,000 cannot be utilised for this purpose.
(3) Amount to be Transferred to Capital Redemption Reserve Account
Face value of share to be redeemed Rs. 1,80,000
Less: Proceeds from fresh issue (excluding premium) Rs. 30,000
Rs. 1,50,000

5.4 SALE OF INVESTMENTS TO PROVIDE SUFFICIENT FUNDS FOR REDEMPTION


Companies may have sufficient investments, which can be sold, in the market to arrange funds
for redemption of preference shares.

6. REDEMPTION OF PARTLY CALLED-UP PREFERENCE SHARES


One of the conditions of redemption is that only fully paid up preference shares can be redeemed
by a company. If the examination problem states that it is decided to redeem preference shares
which are partly called up, then it is assumed that final call on these shares is demanded and
received before proceeding with redemption of these shares. If information about both fully
paid and partly paid preference shares is provided, then, only fully paid shares are redeemed.

9.84 COMMON PROFICIENCY TEST


Illustration 11
The Balance Sheet of XYZ as at 31st December, 2005 inter alia includes the following:
Rs.
50,000, 8% Preference Shares of Rs. 100 each, Rs. 70 paid up 35,00,000
1,00,000 Equity Shares of Rs. 100 each fully paid up 1,00,00,000
Securities Premium 5,00,000
Capital Redemption Reserve 20,00,000
General Reserve 50,00,000
Under the terms of their issue, the preference shares are redeemable on 31st March, 2006 at
5% premium. In order to finance the redemption, the company makes a rights issue of 50,000
equity shares of Rs. 100 each at Rs. 110 per share, Rs. 20 being payable on application, Rs. 35
(including premium) on allotment and the balance on 1st January, 2007. The issue was fully
subscribed and allotment made on 1st March, 2006. The money due on allotment were received
by 31st March, 2006. The preference shares were redeemed after fulfilling the necessary
conditions of Section 80 of the Companies Act, 1956. The company decided to make minimum
utilisation of general reserve.
You are asked to pass the necessary Journal Entries and show the relevant extracts from the
balance sheet as on 31st March, 2006 with the corresponding figures as on 31st December,
2005.
Solution
Journal
Rs. Rs.
8% Preference Share Final Call A/c Dr. 15,00,000
To 8% Preference Share Capital A/c 15,00,000
(For final call made on preference shares
@ Rs. 30 each to make them fully paid up)
Bank A/c Dr. 15,00,000
To 8% Preference Share Final Call A/c 15,00,000
(For receipt of final call money on preference shares)
Bank A/c Dr. 10,00,000
To Equity Share Application A/c 10,00,000
(For receipt of application money on 50,000 equity
shares @ Rs. 20 per share)
Equity Share Application A/c Dr. 10,00,000
To Equity Share Capital A/c 10,00,000
(For capitalisation of application money received)

FUNDAMENTALS OF ACCOUNTING 9.85


REDEMPTION OF PREFERENCE SHARES

Equity Share Allotment A/c Dr. 17,50,000


To Equity Share Capital A/c 12,50,000
To Securities Premium A/c 5,00,000
(For allotment money due on 50,000 equity shares
@ Rs. 35 per share including a premium of
Rs. 10 per share)
Bank A/c Dr. 17,50,000
To Equity Share Allotment A/c 17,50,000
(For receipt of allotment money on equity shares)
8% Preference Share Capital A/c Dr. 50,00,000
Premium on Redemption of Preference Shares A/c Dr. 2,50,000
To Preference Shareholders A/c 52,50,000
(For amount payable to preference shareholders
on redemption at 5% premium)
Securities Premium A/c Dr. 2,50,000
To Premium on Redemption A/c 2,50,000
(For writing off premium on redemption of
preference shares)
General Reserve A/c Dr. 27,50,000
To Capital Redemption Reserve A/c 27,50,000
(For transfer of CRR the amount not covered by
the proceeds of fresh issue of equity shares i.e.,
50,00,000 - 10,00,000 - 12,50,000)
Preference Shareholders A/c Dr. 52,50,000
To Bank A/c 52,50,000
(For amount paid to preference shareholders)

Balance Sheet (extracts)


As at As at
31.3.2006 31.3.2005
Share Capital:
Issued, Subscribed and Paid up:
1,00,000 Equity Shares of Rs. 100 each fully paid up 1,00,00,000 1,00,00,000
50,000 Equity Shares of Rs. 100 each Rs. 45 paid up 22,50,000 –
50,000 8% Preference Shares of Rs. 100 each, Rs. 70 called up – 35,00,000

9.86 COMMON PROFICIENCY TEST


Reserves and Surplus :
Capital Redemption Reserve 47,50,000 20,00,000
Securities Premium 7,50,000 5,00,000
General Reserve 22,50,000 50,00,000

Note: Amount received (excluding premium) on fresh issue of shares till the date of redemption
should be considered for calculation of proceeds of fresh issue of shares. Thus, proceeds
of fresh issue of shares are Rs. 22,50,000 (Rs. 10,00,000 application money plus
Rs. 12,50,000 received on allotment towards share capital).
7. REDEMPTION OF FULLY CALLED BUT PARTLY PAID-UP
PREFERENCE SHARES
The problem of unpaid calls on fully called up shares may be studied under following categories:
7.1 WHEN CALLS IN ARREAR IS RECEIVED BY THE COMPANY
If the amount of unpaid calls is received by the Company before redemption, the entry passed
is as under:
Bank A/c Dr.
To Calls-in-Arrears A/c
After receipt of calls in arrears, the shares become fully paid up and, then, company can
proceed with redemption in the normal course.
7.2 IN CASE OF FORFEITED SHARES
If, on getting a proper notice from the company, the shareholders fail to pay the unpaid calls,
the Board of Directors may decide to forfeit the shares and cancel these shares instead of
reissuing the forfeited shares because redemption of these share is due immediately or in near
future. In this case, entry for forfeiture is passed as usual.
It is worth noting that to ensure replacement of capital out of proceeds of a fresh issue or
out of divisible profits, total preference share capital (including the shares forfeited and
cancelled) should be considered. However, while arranging funds for redemption, amount
actually payable to shareholders is taken into consideration.

Illustration 12
A company invited application for issue of 10,000 14% Redeemable preference shares of
Rs. 100 each at 10% discount. The amount was payable in three equal installments. Applications
were received for 16,000 shares. Incomplete applications for 1,000 shares were rejected and
the remaining applicants were allotted shares on pro rata basis.
Mr. X, to whom 100 shares were allotted, failed to pay the allotment and call money. Another
shareholder Mr. Y, who had applied for 300 shares, failed to pay the call money.
Before redemption of preference shares, both Mr. X and Mr. Y were issued reminders to pay
the unpaid amount. On getting the reminder, Mr. X paid the amount in arrear but Mr. Y failed
FUNDAMENTALS OF ACCOUNTING 9.87
REDEMPTION OF PREFERENCE SHARES

to pay the arrears. On Mr. Y's failure to pay the arrears his shares were forfeited and cancelled.
Remaining preference shares were redeemed at premium of 5%. On the date of redemption,
following balances appeared in the books of the Company:
Rs.
Securities Premium 1,40,000
General Reserve 3,50,000
Share Discount 1,00,000
For the purpose of redemption, it was decided to issue minimum number of equity shares of
Rs. 10 each at Rs. 9 per share. Shares were issued in multiples of 100. Fresh issue of share was
fully subscribed and preference shares were redeemed.
Pass Journal Entries to record the above transactions.
Solution
Journal
Dr. (Rs.) Cr. (Rs.)
Bank A/c Dr. 4,80,000
To Share Application A/c 4,80,000
(For application money received)
Share Application A/c Dr. 4,80,000
To 14% R. Preference Share Capital A/c 3,00,000
To Share Allotment A/c 1,50,000
To Bank A/c 30,000
(For disposition of application money received)
Share Allotment A/c Dr. 3,00,000
Share Discount A/c Dr. 1,00,000
To 14% R. Preference Share Capital A/c 4,00,000
(For allotment money due)
Bank A/c Dr. 1,48,500
To Share Allotment A/c 1,48,500
(For amount received allotment instalment)
Share First and Final Call A/c Dr. 3,00,000
To 14% R. Preference Share Capital A/c 3,00,000
(For call money due)
Bank A/c Dr. 2,91,000
Calls-in-Arrears A/c Dr. 9,000
To Share First and Final Call A/c 3,00,000
(For call money received and the amount not
paid by shareholders)

9.88 COMMON PROFICIENCY TEST


Bank A/c Dr. 4,500
To Share Allotment A/c 1,500
To Calls-in-Arrears A/c 3,000
(For arrears received on issue of a reminder)
14% R. Preference Share Capital A/c Dr. 20,000
To Shares Forfeited A/c 12,000
To Calls-on-Arrears A/c 6,000
To Share Discount A/c 2,000
(For forfeiture of shares due on non-payment
of arrears)
Shares Forfeited A/c Dr. 12,000
To Capital Reserve A/c 12,000
(For transfer of amount forfeited to capital
reserve on cancellation of shares for redemption)
Bank A/c Dr. 6,50,700
To Share Application A/c 6,50,700
(For application money received on 72,300
shares @ Rs. 9 per share)
Share Application A/c Dr. 6,50,700
Share Discount A/c 72,300
To Equity Share Capital A/c 7,23,000
(For disposition of application money received
and recording of share discount)
Securities Premium A/c Dr. 1,00,000
To Share Discount A/c 1,00,000
(For writing off discount on issue of preference
shares before their redemption)
14% R. Preference Share Capital A/c Dr. 9,80,000
Premium on Redemption of Preference Shares A/c Dr. 49,000
To Preference Share holders A/c 10,29,000
(For writing off premium payable on redemption of
preference shares)
General Reserve A/c Dr. 3,49,300
To Capital Redemption Reserve A/c 3,49,300
(For transfer to CRR out of divisible profits an amount
equivalent to the excess of nominal value of shares
redeemed (including by cancellation) over the proceeds
of fresh issue of shares i.e., 10,00,000 - 6,50,700).
Preference Shareholders A/c Dr. 10,29,000
To Bank A/c 10,29,000
(For making payment to preference shareholders)

FUNDAMENTALS OF ACCOUNTING 9.89


REDEMPTION OF PREFERENCE SHARES

Working Notes:
1. Calculation of Minimum Number of shares: Rs.
Nominal value of Preference Shares Capital 10,00,000
Less: Divisible profits 3,50,000
Minimum Proceeds 6,50,000
Proceed of one share = 10 - 10% of Rs. 10 = Rs. 9
Number of shares = 6,50,000/9 = 72,223 (Approx.)
Number of shares in next multiple of 100 = 72,300 shares.
2. Capital reserve realised in cash is available for paying premium on redemption of
debentures. Therefore, out of Rs. 12,000 capital reserve on cancellation of shares forfeited
Rs. 9,000 is utilised for writing off premium on redemption of preference shares.

SELF EXAMINATION QUESTIONS


1. Which of the following statements is false?
(a) A company can redeem its preference shares
(b) Preference shareholders are creditors of a company
(c) The part of the authorized capital which can be called up only in the event of
liquidation of a company is called reserve capital
(d) Capital redemption reserve can be utilized for issuing fully paid bonus shares
Use the following information for questions 2 and 3
The Balance Sheet of A Ltd. as on March 31, 2006 is as under:
Liabilities Rs. Assets Rs.
Share capital: Land and building 4,00,000
Equity shares of Rs.100 each 5,00,000 Plant and machinery 3,00,000
12% Preference shares of Rs.10 each 3,00,000 Furniture and fixtures 2,50,000
Reserves and surplus: Investments 2,25,000
General reserve 1,50,000 Sundry debtors 1,00,000
Profit and loss account 2,50,000 Inventories 1,50,000
18% Debentures 2,00,000 Cash 50,000
Sundry creditors 50,000
Bank overdraft 25,000
14,75,000 14,75,000
The 12% preference shares are redeemable at a premium of 10%. The company wishes to
maintain the cash balance at Rs.25,000. For the purpose of redemption of preference shares, it
proposed to sell the investments for Rs.2,00,000. The company proposes to issue sufficient
number of equity shares of Rs.100 each at a premium of 5% to raise required cash resources.
2. Cash required to effect the above decisions is __________.
a. Rs 3,30,000 b. Rs 3,55,000 c. Rs 25,000 d. Rs 1,05,000

9.90 COMMON PROFICIENCY TEST


3. Number of equity shares to be issued is __________.
a. 1,500 b. 1,000 c. 950 d. 1,500
Use the following information for questions 4 and 5
The following is the balance sheet of G Ltd. as on March 31, 2006:
Liabilities Rs. Assets Rs.
Equity shares of Rs.10 each fully paid-up 10,00,000 Sundry assets 19,50,000
12% Redeemable preference shares of
Rs.100 each fully paid-up 8,00,000 Investments 4,50,000
General Reserve 4,00,000 Cash at bank 2,00,000
Profit & Loss account 2,50,000
Share premium 25,000
Sundry creditors 1,25,000
26,00,000 26,00,000

The Board of Directors of the company decided to redeem the preference shares at a premium
of 10%. In order to facilitate the redemption, the Board has taken the following decisions:
 To sell the investments for Rs.4,00,000.
 To issue sufficient equity shares at a premium of Rs.2 per share to raise the balance of
funds needed.
 To maintain minimum bank balance of Rs.50,000.
The Board of Directors initiated the above course of action during the month of April, 2006
and redeemed all the preference shares.
4. Premium on issue of fresh equity shares = ?
a. Rs 55,000 b. Rs 60,000 c. Rs 65,000 d. Rs 66,000
5. The amount to be transferred to Capital Redemption Reserve = ?
a. Rs.70,000 b. Rs.5,25,000 c. Rs.1,25,000 d. Rs.8,00,000
6. S Ltd. issued 2,000, 10% Preference shares of Rs.100 each at par, which are redeemable at
a premium of 10%. For the purpose of redemption, the company issued 1,500 Equity
Shares of Rs.100 each at a premium of 20 % per share. At the time of redemption of
Preference Shares, the amount to be transferred by the company to the Capital Redemption
Reserve Account = ?
a. Rs.50,000 b. Rs.40,000 c. Rs.2,00,000 d. Rs.2,20,000
7. During the year 2000-2001, T Ltd. issued 20,000, 12% Preference shares of Rs.10 each at a
premium of 5%, which are redeemable after 4 years at par. During the year 2005-2006, as
the company did not have sufficient cash resources to redeem the preference shares, it
issued 10,000, 14% debentures of Rs.10 each at a premium of 10%. At the time of redemption
of 12% preference shares, the amount to be transferred to capital redemption reserve = ?
a. Rs.90,000 b. Rs.1,00,000 c. Rs.2,00,000 d. Rs.1,10,000
8. According to section 78 of the Companies Act, the amount in the Securities Premium A/
c cannot be used for the purpose of
a. Issue of fully paid bonus shares
b. Writing off losses of the company

FUNDAMENTALS OF ACCOUNTING 9.91


REDEMPTION OF PREFERENCE SHARES

c. Writing off preliminary expenses


d. Writing off commission or discount on issue of shares
9. Which of the following can be utilized for redemption of preference shares?
a. The proceeds of fresh issue of equity shares b. The proceeds of issue of debentures
c. The proceeds of issue of fixed deposit d. The sale proceeds of investments
10. Which of the following can be utilized for redemption of preference shares?
a. The proceeds of fresh issue of equity shares b. The proceeds of issue of debentures
c. The proceeds of issue of fixed deposit d. The sale proceeds of investments
e. Both (a) and (b) above.
11. Which of the following statements is false?
a. Capital redemption reserve cannot be used for writing off miscellaneous expenses
and losses
b. Capital profit realized in cash can be used for payment of dividend
c. Reserves created by revaluation of fixed assets are not permitted to be capitalized
d. Dividend is payable on the calls paid in advance by shareholders.
12. Consider the following information pertaining to E Ltd.
On September 4, 2005, the company issued 12,000 7% Debentures having a face value of
Rs.100 each at a discount of 2.5%. On September 12, the company issued 25,000, 8%
Preference share of Rs.100 each. On September 29,the company redeemed 30,000, 6%
Preference shares of Rs.100 each at a premium of 5% together with one month dividend
thereon. Bank balance as on August 31, 2005 was Rs.29,25,000.
After effecting the above transactions, the Bank balance as on September 30, 2005 = ?
a. Rs.33,15,000 b. Rs.33,30,000 c. Rs.33,45,000 d. Rs.34,30,000
13. O Ltd has redeemed its 12% preference shares of Rs. 2,00,000 at a premium of 4% . To
meet the redemption it has issued Rs. 1,98,084 worth of shares of Rs. 20 each at a premium
of 5%. The balance outstanding to the credit of share premium account after adjusting
premium on redemption of preference shares = ?
a. Rs.Nil b. Rs.1,904 c. Rs.1,432 d. Rs.8,000
14. Which of the following accounts can be transferred to capital redemption reserve account?
a. General reserve account b. Forfeited shares account
c. Profit prior to incorporation d. Share premium account
15. Preference shares amounting to Rs.2,00,000 are redeemed at a premium of 5%, by issue of
shares amounting to Rs.1,00,000 at a premium of 10%. The amount to be transferred to
capital redemption reserve = ?
a. Rs.1,05,000 b. Rs.1,00,000 c. Rs.2,00,000 d. Rs.1,11,000
16. Share premium cannot be used to _______.
(a) Issue bonus shares (b) Redeem preference shares
(c) Write-off preliminary expenses (d) Write-off discount on issue of shares

9.92 COMMON PROFICIENCY TEST


17. A company cannot issue redeemable preference shares for a period exceeding
_____________.
(a) 6 years (b) 7 years (c) 8 years (d) 20 years (e) 25 years.
18. Which of the following cannot be used for the purpose of creation of capital redemption
reserve account?
(a) Profit and loss account (credit balance) (b) General reserve account
(c) Dividend equalization reserve account (d) Unclaimed dividends account

ANSWERS
1. (b) 2. (b) 3. (b) 4. (a) 5. (b)
6. (a) 7. (c) 8. (b) 9. (d) 10. (a)
11. (d) 12. (d) 13. (c) 14. (a) 15. (b)
16. (b) 17. (d) 18. (d)

FUNDAMENTALS OF ACCOUNTING 9.93


CHAPTER – 9

COMPANY
ACCOUNTS

Unit 4

Issue
of
Debentures
Learning Objectives
After studying this unit, you will be able to :
 Understand the meaning and basic purpose for raising debentures by the company
 Differentiate between shares and debentures of a company
 Understand various types of debentures
 Pass entries for issue of debentures payable in installments
 Make entries for issue of debentures considering the conditions of redemption
 Pass entries for issue of debentures as collateral security
 Pass entries for debentures issued for consideration other than for cash
 Write off discount on issue of debentures.
 Calculate interest on debentures

1. INTRODUCTION
In the earlier units of this chapter, we have studied the issue of share capital as a means of
raising funds for financing the business activities. But with increasing and ever growing needs
of the corporate expansion and growth, equity source of financing is not sufficient. Hence
corporates turn to debt financing through various means. Issuing debt instruments by offering
the same for public subscription is one of the sources of financing the business activities. Debt
financing does not only helps in reducing the cost of the capital but also helps in designing
appropriate capital structure of the company. Debenture is one of the most commonly used
debt instrument issued by the company to raise funds for the business.

2. MEANING
The most common method of supplementing the capital available to a company is to issue
debentures which may either be simple or naked carrying no charge on assets, or mortgage
debentures carrying either a fixed or a floating charge on some or all of the assets of the company.
A debenture is a bond issued by a company under its seal, acknowledging a debt and containing
provisions as regards repayment of the principal and interest. If a charge* has been created on
any or on the entire asset of the company, the nature of the charge and the assets charged are
described therein. Since the charge is not valid unless registered with the Registrar, and the
certificate registering the charge is printed on the bond. It is also customary to create a trusteeship
in favour of one or more persons in the case of mortgage debentures. The trustees of debenture
holders have all powers of a mortgage of a property and can act in whatever way they think
necessary to safeguard the interest of debenture holders.

Charge is an incumbrance to meet the obligation under the Trust Deed, whereby the company agrees to mortgage
specific portion either by way of a first or second charge. Such charge implies right of lenders to secure their payment
from such asset(s) or from the liquidator in the event of winding up or from the company when the charge becomes
void.

FUNDAMENTALS OF ACCOUNTING 9.95


ISSUE OF DEBENTURES

3. FEATURES OF DEBENTURES
1. It is a document which evidences a loan made to a company.
2. It is a fixed interest-bearing security where interest falls due on specific dates.
3. Interest is payable at a predetermined fixed rate, regardless of the level of profit.
4. The original sum is repaid at a specified future date or it is converted into shares or other
debentures.
5. It may or may not create a charge on the assets of a company as security.
6. It can generally be bought or sold through the stock exchange at a price above or below its
face value.

4. DISTINCTION BETWEEN DEBENTURES AND SHARES


Debentures Shares
1. Debentureholders are the creditors of 1. Shareholders are the owners of the
the company. company.
2. Debentureholders have no voting 2. Shareholders have voting rights and
rights and consequently do not pose consequently control the total affairs of the
any threat to the existing control of company.
the company.
3. Debenture interest is paid at a pre- 3. Dividend on equity shares is paid at a variable
determined fixed rate. It is payable, rate which is vastly affected by the profits of
whether there is any profit or not. the company (however, dividend on
Debentures rank ahead of all types preference shares is paid at a fixed rate).
of shares for payment of the interest
due on them.
4. Interest on debentures are the charges 4. Dividends are appropriation of profits and
against profits and they are deductible these are not deductible in determining
as an expense in determining taxable taxable profit of the company.
profit of the company.
5. There are different kinds of 5. There are only two kinds of shares – Equity
debentures, such as Secured/ Shares and Preference Shares.
Unsecured; Redeemable/
Irredeemable; Registered/Bearer;
Convertible /Non-convertible, etc.
6. In the Company Balance Sheet, 6. In the Company Balance Sheet, shares are
Debentures are shown under shown under “Share Capital”.
“Secured Loans”.
7. Debentures can be converted into 7. Shares cannot be converted into debentures
shares as per the terms of issue of in any circumstances.
debentures.

9.96 COMMON PROFICIENCY TEST


Debentures Shares
8. Debentures cannot be forfeited 8. Shares can be forfeited for non-payment of
for non-payment of calls money. allotment and calls moneys.
9. At maturity, debentureholders get 9. Equity shareholders cannot get back their
back their money as per the terms money before the liquidation of the company
and conditions of redemption. (however, preference shareholders can get
back their money before liquidation).
10. At the time of liquidation, 10. At the time of liquidation shareholders are
debentureholders are paid-off paid at last, after paying debentureholders,
before the shareholders. creditors, etc.

5. TYPES OF DEBENTURES
The following are the types of debentures issued by a company. They can be classified on the
basis of: (1) Security; (2) Convertibility; (3) Permanence; (4) Negotiability; and (5) Priority.

Types of Debentures

Security Convertibility Permanence Negotiability Priority

Secured Unsecured Redeemable Irredeemable First Second


Debentures Debentures Debentures Debentures Mortgage Mortgage
Debentures Debentures

Convertible Non-convertible Registered Non-registered


Debentures Debentures Debentures Debentures

1. Security
(a) Secured Debentures : These debentures are secured by a charge upon some or all assets
of the company. There are two types of charges: (i) Fixed charge; and (ii) Floating
charge. A fixed charge is a mortgage on specific assets. These assets cannot be sold
without the consent of the debentureholders. The sale proceeds of these assets are

FUNDAMENTALS OF ACCOUNTING 9.97


ISSUE OF DEBENTURES

utilized first for repaying debentureholders. A floating charge generally covers all the
assets of the company including future one.
(b) Unsecured or “Naked” Debentures : These debentures are not secured by any charge
upon any assets. A company merely promises to pay interest on due dates and to
repay the amount due on maturity date. These types of debentures are very risky
from the view point of investors.
2. Convertibility
(a) Convertible Debentures : These are debentures which will be converted into equity
shares (either at par or premium or discount) after a certain period of time from the
date of its issue. These debentures may be fully or partly convertible. In future, these
debentureholders get a chance to become the shareholders of the company.
(b) Non-Convertible Debentures : These are debentures which cannot be converted into
shares in future. As per the terms of issue, these debentures are repaid.
3. Permanence
(a) Redeemable Debentures : These debentures are repayable asper the terms of issue, for
example, after 8 years from the date of issue.
(b) Irredeemable Debentures : These debentures are not repayable during the life time of
the company. These are also called perpetual debentures. These are repaid only at the
time of liquidation.
4. Negotiability
(a) Registered Debentures : These debentures are payable to a registered holder whose
name, address and particulars of holding recorded in the Register of Debentureholders.
They are not easily transferable. The provisions of the Companies Act, 1956 are to be
complied with for effecting transfer of these debentures. Debenture interest is paid
either to the order of registered holder as expressed in the warrant issued by the
company or the bearer of the interest coupons.
(b) Bearer Debentures : These debentures are transferable by delivery. These are negotiable
instruments payable to the bearer. No kind of record is kept by the company in respect
of the holders of such debentures.
5. Priority
(a) First Mortgage Debentures : These debentures are payable first out of the property
charged.
(b) Second Mortgage Debentures : These debentures are payable after satisfying the first
mortgage debentures.

9.98 COMMON PROFICIENCY TEST


6. ISSUE OF DEBENTURES
6.1 ACCOUNTING ENTRIES FOR ISSUE OF REDEEMABLE DEBENTURES
Issue of redeemable debentures can be categorized into the following:
1. Debenture issued at a par and redeemable at par or at a discount;
2. Debenture issued at a discount and redeemable at par or at discount;
3. Debenture issued at premium and redeemable at par or at discount;
4. Debenture issued at par and redeemable at premium;
5. Debenture issued at a discount and redeemable at premium.
Journal entries in each of the above cases are discussed below:
1. Debenture issued at par redeemable at par : When debenture are issued at par, the issue
price is equal to par value, in this regard the following entries are recorded:
(a) For receipt of application money :
Bank A/c Dr.
To Debenture Application A/c
(b) For transfer of application money to debentures account :
Debenture Application A/c Dr.
To …% Debenture A/c
Illustration 1
Amol Ltd. Issued 40,00,000, 9% debenture of Rs. 50 each, payable on application as per term
mentioned in the prospectus and redeemable at par any time after 3 years from the date of
issue. Record necessary entries for issue of debenture in the books of Amol Ltd.
Solution
Books of Amol Ltd.
Journal
Date Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)
Bank A/c Dr. 20,00,00,000
To Debenture Application A/c 20,00,00,000
(Debenture application money received)
Debenture Application A/c Dr. 20,00,00,000
To 9% Debenture A/c 20,00,00,000
(Application money transferred to 9%
debentures account consequent upon
allotment)

FUNDAMENTALS OF ACCOUNTING 9.99


ISSUE OF DEBENTURES

Illustration 2
Country Crafts Ltd. Issued 20,00,000, 8% debenture of Rs.100 each at par payable as Rs.40 on
application a nd Rs.60 allotment, redeemable at par after 5 years from the date of issue of
debenture. Record necessary entries in the books of Country Crafts Ltd.
Solution
Books of Country Crafts Ltd.
Journal
Date Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)
(a) Bank A/c Dr. 8,00,00,000
To Debenture Application A/c 8,00,00,000
(Debenture application money received)
(b)* Debenture Application A/c Dr. 8,00,00,000
Debenture Allotment A/c Dr. 12,00,00,000
To 8% Debentures A/c 20,00,00,000
(Debenture application and call made
consequent upon allotment money
transferred to debenture account)
(c) Bank A/c Dr. 12,00,00,000
To Debenture Allotment A/c 12,00,00,000
(Call made on allotment received)
*Alternatively, for entry (b) above,
the following two entries can be made :
(i) Debenture Application A/c Dr. 8,00,00,000
To 8% Debenture A/c 8,00,00,000
(Transfer of application money to 8%
debenture account on consequent
upon allotment)
(ii) Debenture Allotment A/c Dr. 12,00,00,000
To 8% Debenture A/c 12,00,00,000
(Call made consequent upon allotment)

2. Debenture issued at Discount and Redeemable at par or at discount : When debentures


are issued at discount, issue price will be less than par value. The difference between the
two is considered as loss on issue on debentures and is to be written-off over the life of
debentures. The entries with regards to issue are given below :

9.100 COMMON PROFICIENCY TEST


(a) For receipt of application money
Bank A/c Dr.
To Debenture Application A/c
(b) At the time of making allotment
(i) Debenture Application A/c Dr.
Discount on issue of debenture A/c Dr.
To …% Debenture A/c
Illustration 3
Atul Ltd. issued 1,00,00,000, 8% debenture of Rs. 100 each at a discount of 10% redeemable at
par at the end of 10th year. Money was payable as follows :
Rs. 30 on application
Rs. 60 on allotment
Record necessary journal entries regarding issue of debenture.
Solution
Books of Atul Ltd.
Journal
Date Particulars L.F. Debit Credit
Amount Amount
(Rs.) (Rs.)
Bank A/c Dr. 30,00,00,000
To Debenture Application A/c 30,00,00,000
(Debenture application money received)
Debenture Application A/c Dr. 30,00,00,000
To 8% Debenture A/c 30,00,00,000
(Application money transferred to 8%
debenture account consequent upon
allotment)
Debenture allotment A/c Dr. 60,00,00,000
Discount on issue of debenture A/c Dr. 10,00,00,000
To 8% Debenture A/c 70,00,00,000
(Amount due on allotment)
Bank A/c Dr. 60,00,00,000
To Debenture Allotment A/c 60,00,00,000
(Money received consequent upon
allotment)

FUNDAMENTALS OF ACCOUNTING 9.101


ISSUE OF DEBENTURES

3. Debenture Issued at Premium and Redeemable at par or at discount


When debenture are issued at premium, the issue price is more than the par value. The
premium is transferred to securities premium account. In this regard, the following journal
entries are recorded:
When premium amount is received at the time of application;
(a) For receipt of application money
Bank A/c Dr.
To Debenture Application A/c
(b) For transfer of application of money at the time of allotment
Debenture application A/c Dr.
To …% Debentures A/c
To Securities Premium A/c
Illustration 4
Koinal Chemicals Ltd. issued 15,00,000, 10% debenture of Rs. 50 each at premium of 10%,
payable as Rs. 20 on application and balance on allotment. Debentures are redeemable at par
after 6 years. All the money due on allotment was called up and received. Record necessary
entries when premium money is included in application money
Solution
Books of Koinal Chemicals Ltd.
Journal
When premium money is received alongwith application money :
Date Particulars L.F. Debit Credit
Amount (Rs.) Amount (Rs.)
Bank A/c Dr. 3,00,00,000
To Debenture Application A/c 3,00,00,000
(Debenture application money received)
Debentures Application A/c Dr. 3,00,00,000
To 10% Debenture A/c 2,25,00,000
To Securities Premium A/c 75,00,000
(Application money transferred to 10%
debenture and securities premium
account consequent upon allotment)
Debenture Allotment A/c Dr. 5,25,00,000
To 10% Debenture A/c 5,25,00,000
(Call made consequent upon allotment)
Bank A/c Dr. 5,25,00,000
To Debenture Allotment A/c 5,25,00,000
(Call made consequent upon
allotment money received)

9.102 COMMON PROFICIENCY TEST


Illustration 5
Koinal Chemicals Ltd. issued 15,00,000, 10% debenture of Rs. 50 each at premium of 10%,
payable as Rs.20 on application and balance on allotment. Debentures are redeemable at par
after 6 years. All the money due on allotment was called up and received. Record necessary
entries when premium money is included in allotment money
Solution
Books of Koinal Chemicals Ltd.
Journal
When premium money is called on allotment :
Bank A/c Dr. 3,00,00,000
To Debenture Application A/c 3,00,00,000
(Debenture application money received)
Debentures Application A/c Dr. 3,00,00,000
To 10% Debenture A/c 3,00,00,000
(Debenture application money transferred to 10%
debenture account consequent upon allotment)
Debenture allotment A/c Dr. 5,25,00,000
To 10% Debenture A/c 4,50,00,000
To Securities Premium A/c 75,00,000
(Call made on allotment of debenture
including premium)
Bank A/c Dr. 5,25,00,000
To Debenture Allotment A/c 5,25,00,000
(Money received consequent upon allotment)

Where debentures are to be redeemed at premium, an extra entry is to be made at the time of
issue and allotment of debentures. This extra entry is to be passed for providing premium
payable on redemption.
4. Debenture issued at par and redeemable at a premium
In this case, the issue price is same as par value but the redemption value is more than the par
value, therefore redemption premium is recorded as a loss on issue of debenture at the time of
allotment of debenture. Following journal entries are recorded in this regard:
(a) For receipt of application money
Bank A/c Dr.
To Debenture application A/c
(b) At the time of making allotment
(i) Transfer of application money to debenture account

FUNDAMENTALS OF ACCOUNTING 9.103


ISSUE OF DEBENTURES

Debenture Application A/c Dr.


To …% Debenture A/c
(ii) Call made consequent upon allotment.
Debenture Allotment A/c Dr.
Loss on issue of debenture A/c Dr. [Equal to Debenture Redemption
Premium]
To …% Debenture A/c
To Debenture redemption premium A/c
Students can note that instead of passing the separate entries, a compound entry can be passed:
Bank A/c Dr.
Loss on issue of debenture A/c Dr.
To …% Debenture A/c
To Debenture redemption premium A/c

Illustration 6
Modern Equipments Ltd. issued 2,00,000, 12% debenture of Rs. 1,000 payable as follows :
On application Rs. 300
On allotment Rs. 700
The debenture were fully subscribed and all the money was duly received. As per terms of
issue, the debenture are redeemable at Rs. 1,100 per debenture. Record necessary entries
regarding issue of debenture.
Solution
Books of Modern Equipments Ltd.
Journal
Date Particulars L.F. Debit Credit
Amount (Rs.) Amount (Rs.)
Bank A/c Dr. 6,00,00,000
To Debenture application A/c 6,00,00,000
(Debenture application money received)
Debentures Application A/c Dr. 6,00,00,000
To 12% Debenture A/c 6,00,00,000
(Application money transferred to 12%
debenture account consequent to allotment)
Debenture Allotment A/c Dr. 1400,00,000
Loss on issue of debenture A/c Dr. 2,00,00,000
To 12% Debenture A/c 14,00,00,000

9.104 COMMON PROFICIENCY TEST


To Debenture redemption premium A/c 2,00,00,000
(Call made on allotment of debenture at
par and redeemable at premium)
Bank A/c Dr. 14,00,00,000
To 12% Debenture allotment A/c 14,00,00,000
(Call made consequent upon allotment
money received)

5. Debenture Issued at discount and redeemable at premium


In this situation the issue price is less than par value but redemption value is more than
par value. The difference between the redemption price and the issue price is treated as
discount/loss on issue of debenture. Suppose, a 10% debenture of Rs. 1,000 is issued at a
discount of Rs. 100 and redeemable at a premium of Rs. 5 per debenture, the amount of
loss will be equal to Rs.900 – Rs. 1,005 = Rs. 105. This is to be treated as loss on issue. It is
to be noted that premium on redemption of debentures is also credited by Rs. 5.
(a) For the receipt of application money
Bank A/c Dr.
To Debenture Application A/c
(b) At the time of making allotment
(i) Transfer of application money to debenture account
Debenture Application A/c Dr.
To % Debenture A/c
(ii) Call made consequent upon allotment of debenture at discount and redeemable
at premium
Debenture Allotment A/c Dr.
Discount/Loss on issue of debenture A/c Dr. [Amount equal to the discount on
issue of debenture plus Premium on
redemption]
To …% Debenture A/c
To Debenture Redemption Premium A/c
(c) For receipt of call made on allotment
Bank A/c Dr.
To Debenture Allotment A/c
Students can note that instead of passing the separate entries, a compound entry can be passed:
Bank A/c Dr.
Discount/Loss on issue of debenture A/c Dr.
To …% Debenture A/c
To Debenture redemption premium A/c

FUNDAMENTALS OF ACCOUNTING 9.105


ISSUE OF DEBENTURES

Illustration 7
Agrotech Ltd. issued 1,40,00,000, 9% debentures of Rs. 100 each at a discount of 6%, redeemable
at a premium of 5% after 3 years payable as : Rs. 50 on application and Rs. 44 on allotment.
Record necessary journal entries for issue of debentures.
Solution
Books of Agrotech Ltd.
Journal
Date Particulars L.F. Debit Credit
Amount (Rs.) Amount (Rs.)
Bank A/c 70,00,00,000
To Debenture Application A/c 70,00,00,000
(Debentures application money received)
Debenture Application A/c Dr. 70,00,00,000
To 9% Debenture A/c 70,00,00,000
(Application money transferred to 9%
debenture account)
Debenture Allotment A/c Dr. 61,60,00,000
Discount on issue of debenture A/c Dr. 15,40,00,000
To 9% Debenture A/c 70,00,00,000
To Debenture redemption premium A/c 7,00,00,000
(Call made consequent upon allotment of
debenture issued at discount and
redeemable at premium)
Bank A/c Dr. 61,60,00,000
To Debenture Allotment A/c 61,60,00,000
(Allotment amount received)

Working Notes :
Discount/Loss on issue of debenture =
Amount of discount on issue + Premium payable on redemption
= 6% of Rs. 1,40,00,00,000 + 5% of Rs. 1,40,00,00,000
= Rs. 8,40,00,000 + Rs. 7,00,00,000
= Rs. 15,40,00,000
6. Debenture Issued at premium and redeemable at premium
In this situation the issue price is more than par value and also redemption value is more
than par value. The premiuim received at the time of issue of debentures is credited to
Debenture premium account and premium paid at the time of redemption is loss to be

9.106 COMMON PROFICIENCY TEST


provided at the time of issue of debentures. Suppose, a 10% debenture of Rs. 1,000 is
issued at a premium of Rs. 100 and redeemable at a premium of Rs. 5 per debenture. In
the given case Rs. 100 is to be credited tp Debenture premium account and Rs. 5 will be
the loss to be provided at the time of issue of debentures. It is to be noted that premium on
redemption of debentures is also credited by Rs. 5.
(a) For the receipt of application money
Bank A/c Dr.
To Debenture Application A/c
(b) At the time of making allotment
(i) Transfer of application money to debenture account
Debenture Application A/c Dr.
To % Debenture a/c
(ii) Call made consequent upon allotment of debenture at premium and redeemable
at premium
Debenture Allotment A/c Dr.
Loss on issue of debenture A/c Dr. [Amount equal to the premiuim on
redemption]
To …% Debenture A/c
To Debenture Premium A/c
To Debenture Redemption Premium A/c
Students can note that instead of passing the separate entries, a compound entry can be passed:
Bank A/c Dr.
Loss on issue of debenture A/c Dr.
To …% Debenture A/c
To Debenture Premium A/c
To Debenture redemption premium A/c

6.2 ACCOUNTING FOR ISSUE OF DEBENTURES PAYABLE IN INSTALMENTS


Just like shares, money payable on debentures may be paid either in full with application or by
instalments. Accounting entries will differ to some extent in either case.
6.2.1 Debentures Payable in Full on Application
Where the amount due on debentures are payable in full on application, it is usual to open a
separate Debentures Application Account for each class of debentures, such as 10% Debentures
Application Account or 12% Debentures Application Account. These accounts record moneys
received from the applicants of debentures. If an issue is over-subscribed, these accounts can
be used to record the refund of moneys to the unsuccessful applicants. At the time of allotment
of debentures, the amount in Debentures Application Account is transferred to the respective
Debentures Account.
As in case of shares, debentures may also be issued at par, at a premium, or at a discount.

FUNDAMENTALS OF ACCOUNTING 9.107


ISSUE OF DEBENTURES

6.2.2 Debentures Issued at Par


The debentures which are issued at par are issued at the same price as their nominal value;
that is, if a debt with a nominal value of Rs. 100 is issued at par, the company receives Rs. 100.
The accounting entries would be as follows:
(a) When cash is received
Bank Account Dr.
To Debentures Application Account
(Being money received on…. debentures @Rs….each)
(b) When excess money is refunded
Debentures Application Account Dr.
To Bank Account
(Being excess money…debentures refunded as per Board’s Resolution
No….dated…..)
(c) When the debentures are allotted
Debentures Application Account Dr.
To Debentures Account
(Being the allotment of…debentures of Rs….each as per Board’s Resolution
No….dated….)

Illustration 8
Simmons Ltd. issued 10,000, 12% Debentures of Rs. 100 each at par payable in full on application
by 1st April, Application were received for 11,000 Debentures. Debentures were allotted on
7th April. Excess money refunded on the same date.
You are required to pass necessary Journal Entries (including cash transactions) in the books of
the company.
Solution
In the books of Simmons Limited
Date Particulars Rs. Rs.
April 1 Bank A/c Dr. 11,00,000
To 12% Debentures Application A/c 11,00,000
(Being money received on 11,000 debentures)
April 7 12% Debentures Application A/c Dr. 1,00,000
To Bank A/c 1,00,000
(Being money on 1,000 debentures refunded as per
Board’s Resolution No…..dated…)
April 7 12% Debentures Application A/c Dr. 10,00,000
To 12% Debentures A/c 10,00,000
(Being the allotment of 10,000 debentures of
Rs.100 each at par, as per Board’s Resolution
No….dated…)

9.108 COMMON PROFICIENCY TEST


6.2.3 Debentures Issued at a Premium
Debentures are rarely issued at a premium. A company issues debentures at a premium when
the market rate of interest is lower than the debentures interest rate. The debentures, which are
issued at a premium, are issue at a higher price than their nominal value; that is, if a debenture
with a nominal value of Rs. 100 is issued; 10% premium, the company receives Rs. 110 where
the investor gets slightly less interest than stated in the debenture. For example, 12% Debentures
of Rs. 100 issued at a premium of 10%. The investor will get Rs. 1 p.a. for his investment of 110.
Therefore, the effective rate of interest on investment is (12/111x 100) = 10.91%.
There is no restriction in the Companies Act 1956 regarding the utilization of Debenture
Premium. This is different from Share Premium. It can be used to write-off: (a) discount on
issue of shares or debentures; (b) premium on redemption of shares or debentures; (c) capital
losses; and (d) intangible assets, such as goodwill, etc. Any balance left in the Debenture
Premium Account should be transferred to Capital Reserve Account.
The accounting entries would be as follows:
(a) When cash is received
Bank Account Dr. [Nominal value plus premium]
To Debentures Application Account
(Being money received on….debentures @ Rs…..
each including premium of Rs…
(b) When excess money is refunded
Debentures Application Account Dr.
To Bank Account
(Being refund of money on….debentures
@ Rs….each, as per Board’s Resolution No…..dated….)
(c) When the debentures are allotted
Debentures Application Account Dr.
To Debentures Account
To Debentures Premium Account
(Being the allotment of….debentures, premium
transferred to Debentures Premium Account,
as per Board’s Resolution No….dated….)
(d) When debentures premium is transferred
Debentures Premium Account Dr.
To Capital Reserve Account
(Being the amount transferred to capital reserve)
Illustration 9
Kapil Ltd. issued 10,000. 12% Debentures of Rs. 100 each at a premium of 10% payable in full
on application by 1st March, 2006. The issue was fully subscribed and debentures were allotted
on 9th March, 2006.
Pass necessary Journal Entries (including cash transactions).

FUNDAMENTALS OF ACCOUNTING 9.109


ISSUE OF DEBENTURES

Solution
In the books of Kapil Limited
Journal Dr. Cr.
Date Particulars Rs. Rs.
2006
March 1 Bank A/c Dr. 11,00,000
To 12% Debentures Application A/c 11,00,000
(Being the money received on 10,000
debentures @ Rs.110 each including
premium of Rs.10 each)
March 9 12% Debentures Application A/c Dr. 11,00,000
To 12% Debentures A/c 10,00,000
To Debentures Premium A/c 1,00,000
(Being the allotment of 10,000 debentures
of Rs.100 each, premium @ Rs.10 each
transferred to Debenture Premium
Account as per Board’s Resolution
No….dated….)
Debenture Premium A/c Dr. 1,00,000
To Capital Reserve A/c 1,00,000
(Being the debenture premium transferred
to capital reserve)
6.2.4 Debentures Issued at a Discount
The Companies Act does not impose any restriction on the price at which debentures can be
issued. Unlike shares, there is no maximum limit for discount on issue of debenture. This is
why it is very common for debentures to be issued at a discount. The debentures which are
issued at a discount are issued at a lower price than nominal value, that is, if a debenture with
a nominal value of Rs. 100 is issued at 10% discount, the company receives Rs. 90 only. The
issue of debentures at a discount slightly increases the true rate of interest payable. For example,
12% Debentures of Rs.100 issued at a discount of 10%. The Company will have to pay Rs. 1 for
a loan of Rs. 90. Therefore, the true rate of interest is (12/90 x 100) = 13.33%.
The company issues debentures at a discount when the market rate of interest is higher than
the debenture interest rate. Like shares, Debentures Account is credited with the nominal
value. The difference between the nominal value of debentures and cash received is transferred
to “Discount on Issue of Debentures Account. In the Balance Sheet, “Discount on Issue of
Debentures” is shown on the Assets side under “Miscellaneous Expenditure”. In the subsequent
years, Discount on Issue of Debentures is written-off proportionately by charging to the Profit
and Loss Account.
The accounting entries would be as follows :
(a) When Cash is received

9.110 COMMON PROFICIENCY TEST


Bank Account Dr. [Actual cash received]
To Debentures Application Account
(Being money received on….debentures @Rs……each)
(b) When excess money is refunded
Debentures Application Account Dr.
To Bank Account
(Being excess money on…debentures refunded as per
Board’s Resolution No…..dated….)
(c) When the debentures are allotted
Debentures Application Account Dr. [Actual cash received]
Discount on Issue of Debentures Account Dr. [Discount on debentures]
To Debentures Account [Nominal value of debentures]
(Being the allotment of…debentures of Rs….each
@ Rs…..eachasper Board’s Resolution No…..dated….
In fact, the discount on issue of debentures is considered as incremental interest expense.
The true expense (net borrowing cost) for a particular accounting period is, therefore, the
total interest payment plus the discount written off.
Illustration 10
X Ltd. issued 10,000 12% Debentures of Rs. 100 each at a discount of 10% payable in full on
application by 31st March, 2006. Applications were received for 12,000 debentures. Debentures
were allotted on 9th June, 2006. Excess monies were refunded on the same date. Pass necessary
Journal Entries.
Solution
In the books of X Limited
Journal
Date Dr. Cr.
2006 Particulars Rs. Rs.
May 31 Bank A/c Dr. 10,80,000
To 12% Debentures Application A/c 10,80,000
(Being money received for 12,000 debentures
@ Rs. 90 each)
June 9 12% Debentures Application A/c Dr. 1,80,000
To Bank A/c 1,80,000
(Being excess money on 2,000 debentures
@ Rs. 90 refunded as per Board’s Resolution
No….dated….)
June 9 12% Debentures Application A/c Dr. 9,00,000
Discount on Issue of Debentures A/c Dr. 1,00,000
To 12% Debentures A/c 10,00,000
(Being the allotment of 10,000 debentures of
Rs.100 each at a discount of Rs. 10 per
debenture as per Board’s Resolution No…..dated…)

FUNDAMENTALS OF ACCOUNTING 9.111


ISSUE OF DEBENTURES

Dr. Bank Account Cr.


Date Particulars Rs. Date Particulars Rs.
31.5.2006 To 12% Debentures 9.6.2006 By 12% Debentures
Application A/c 10,80,000 Application A/c 1,80,000
9.6.2006 By Balance c/d 9,00,000
10,80,000 10,80,000
Dr. 12% Debentures Account Cr.
Date Particulars Rs. Date Particulars Rs.
9.6.2006 To Balance c/d 10,00,000 9.6.2006 By 12% Debentures
Application A/c 9,00,000
9.6.2006 By Discount on
Issue of Debentures
A/c 1,00,000
10,00,000 10,00,000
Dr. 12% Debentures Application Account Cr.
Date Particulars Rs. Date Particulars Rs.
9.6.2006 To Bank A/c 1,80,000 31.5.2006 By Bank A/c 10,80,000
9.6.2006 To 12% Debentures 9.6.2006
A/c 9,00,000
10,80,000 10,80,000
Dr. Discount on Issue of Debentures Account Cr.
Date Particulars Rs. Date Particulars Rs.
9.6.2006 To 12% Debentures 9.6.2006 By Balance c/d
A/c 1,00,000 1,00,000
Balance Sheet of X Limited as on 09.06.2006 (includes)
Liabilities Rs. Assets Rs.
Secured Loan Current Assets 9,00,000
12% Debentures 10,00,000 Cash at Bank
Miscellaneous Expenditure
Discount on Issue of Debentures 10,00,000
1,00,000 10,00,000

7. ISSUE OF DEBENTURES AS COLLATERAL SECURITY


Collateral security means secondary or supporting security for a loan, which can be realised
by the lender in the event of the original loan not being repaid on the due date. Under this

9.112 COMMON PROFICIENCY TEST


arrangement, the borrower agrees that a particular asset or a group of assets will be realized
and the proceeds there from will be applied to repay the loan in the event that the amount due,
cannot be paid.
Sometimes companies issue their own debentures as collateral security for a loan or a fluctuating
overdraft. When the loan is repaid on the due date, these debentures are at once released with
the main security. In case, the company cannot repay its loan and the interest thereon on the
due date, the lender becomes the debentureholder who can exercise all the rights of a
debentureholder. The holder of such debentures is entitled to interest only on the amount of
loan, but not on the debentures.
Accounting Entries
There are two methods of showing these types of debentures in the accounts of a company.
Method 1
Under this method, no entry is made in the books of account of the company at the time of
making issue of such debentures. In the Balance Sheet, the fact of the debentures being issued
and outstanding is shown by a note under the liability secured.
Illustration 11
X Ltd. obtains a loan from IDBI of Rs.10,00,000, giving as collateral security of Rs.15,00,000,
14%, First Mortgage Debentures. In the Balance Sheet of X Ltd., it is shown as follows:
Balance Sheet of X Limited as at…(includes)
Liabilities Rs. Assets Rs.
Secured Loan
IDBI Loan 10,00,000
(Collaterally secured by issue of Rs. 15,00,000
14% First Mortgage Debentures)
Method 2
Under this method, the following entry is made to record the issue of such debentures:
Debentures Suspense Account Dr.
To Debentures Account
(Being the issue of…debentures collaterally…as per
Board’s Resolution No…..dated)
The Debentures Suspense Account will appear on the assets side of the Balance Sheet and
Debentures on the liabilities side of the Balance Sheet. When the loan is repaid, the entry is
reversed in order to cancel it.
Illustration 12
Taking the same information of the above example, the entry on issue will be as follows :

FUNDAMENTALS OF ACCOUNTING 9.113


ISSUE OF DEBENTURES

In the Books of X Ltd.


Journal Dr. Cr.
Date Particulars Rs. Rs.
Debentures Suspense A/c Dr. 15,00,000
To 14% First Mortgage Debentures A/c 15,00,000
(Being the issue of Rs. 15,00,000 debentures
collaterally as per Board’s Resolution
No…dated…)
Balance Sheet of X Limited as at….(includes)
Liabilities Rs. Assets Rs.
Secured Loan: Debentures Suspense Account 15,00,000
IDBI Loan 10,00,000 (issue of Rs. 15,00,000 14%
First Mortgage Debentures
as collateral security
Unsecured Loan: as per contra)
14% First Mortgage Debentures 15,00,000

Students should note that the Method 1 is much more logical from the accounting point
of view. Therefore we advice to follow Method 1.

8. ISSUE OF DEBENTURES IN CONSIDERATION OTHER THAN


FOR CASH
Just like shares, debentures can also be issued for consideration other than for cash, such as for
purchase of land, machinery, etc. In this case, the following entries are passed :
(a) Sundry Assets Account Dr. [Assets taken over]
To Sundry Liabilities Account [Liabilities assumed]
To Vendors Account [Purchase consideration]
(Being the assets and liabilities are taken over)
(b) Vendors Account Dr.
To Debentures Account
(Being the issue of….debentures to satisfy purchase consideration)
Illustration 13
X Company Limited issued 14% Debentures of the nominal value of Rs. 10,00,000 as follows:
(a) To sundry persons for cash at 90% Rs. 5,00,000 nomonal.
(b) To a vendor for Rs. 2,00,000 for purchase of fixed assets – Rs. 2,50,000 nominal.
(c) To the banker as collateral security for a loan of Rs. 1,00,000 – Rs. 2,50,000 nominal.
Pass necessary Journal Entries.

9.114 COMMON PROFICIENCY TEST


Solution
In the books of X Company Ltd.
Journal Dr. Cr.
Date Particulars Rs. Rs.
(a) Bank A/c Dr. 4,50,000
To Debentures Application A/c 4,50,000
(Being the application money received on 5,000
debentures @ Rs.90 each)
Debentures Application A/c Dr. 4,50,000
Discount on issue of Debentures A/c Dr. 50,000
To 14% Debentures A/c 5,00,000
(Being the issue of 5,000, 14% Debentures
@ 90% as per Board’s Resolution No….dated….)
(b) Fixed Assets A/c Dr. 2,00,000
To Vendor A/c 2,00,000
(Being the purchase of fixed assets from vendor)
Vendor A/c Dr. 2,00,000
Discount on Issue of Debentures A/c Dr. 50,000
To 14% Debentures A/c 2,50,000
(Being the issue of debentures of Rs.2,50,000 to
vendor to satisfy his claim)
(c) Bank A/c Dr. 1,00,000
To Bank Loan A/c (See Note) 1,00,000
(Being a loan of Rs. 1,00,000 taken from bank by
issuing debentures of Rs. 2,50,000 as collateral
security)
Note : No entry is made in the books of account of the company at the time of making issue of
such debentures. In the Balance Sheet the fact that the debentures being issued and outstanding
are shown under the respective liability.

9. TREATMENT OF DISCOUNT ON ISSUE OF DEBENTURES


The Discount on issue of debentures is amortised over a period between the issuance date and
redemption date. It should be written-off in the following manner depending upon the terms
of redemption:
(a) If the debentures are redeemable after a certain period of time, say at the end of 5 or 10
years, the total amount of discount should be written-off equally throughout the life of
the debentures (applying the straight line method). The main advantage of this method is
that it spreads the burden of discount equally over the years.
(b) If the debentures are redeemable at different dates, the total amount of discount should be

FUNDAMENTALS OF ACCOUNTING 9.115


ISSUE OF DEBENTURES

written-off in the ratio of benefit derived from debenture loan in any particular year
(applying the sum of the year’s digit method). This method is suitable when debentures
are redeemed by unequal instalments.
(c) If the debentures are irredeemable, the discount should be written-off gradually over a
long period.
The accounting entries would be as follows :
Profit and Loss Account Dr.
To Discount on Issue of Debentures Account
(Being the amount of discount on issue of debentures written-off)
Illustration 14
HDC Ltd issues 10,000. 12% debentures of Rs. 100 each at Rs. 94 on 1st January, 2006. Under
the terms of issue, the debentures are redeemable at the end of 8 years from the date of the
issue. Calculate the amount of discount to be written-off in each of the 8 years.
Solution
Total amount of discount comes to Rs. 60,000 (Rs. 6 X 10,000). The amount of discount to be
written-off in each year is calculated as under :
Year end Debentures Ratio in which discount Amount of discount to be
outstanding to be written-off written-off
1st Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
2nd Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
3rd Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
4th Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
5th Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
6th Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
7th Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500
8th Rs. 10,00,000 1/8 1/8th of Rs. 60,000 = Rs. 7,500

Illustration 15
HDC Ltd. issues 10,000. 12% debentures of Rs. 100 each at Rs. 94 on 1st January, 2006. Under
the terms of issue, 1/5th of the debentures are annually redeemable by drawings, the first
redemption occurring on 31st December, 2006. Calculate the amount of discount to be written-
off in 2006 to 2010.
Solution
Calculation of amount of discount to be written-off
At the Debentures Ratio of benefit Amount of discount to be
Year end outstanding derived written-off
2006 Rs. 10,00,000 5 5/15th of Rs. 60,000 = Rs. 20,000
2007 Rs. 8,00,000 4 4/15th of Rs. 60,000 = Rs. 16,000
2008 Rs. 6,00,000 3 3/15th of Rs. 60,000 = Rs. 12,000
2009 Rs. 4,00,000 2 2/15th of Rs. 60,000 = Rs. 8,000
2010 Rs. 2,00,000 1 1/15th of Rs. 60,000 = Rs. 4,000
TOTAL 15 Rs. 60,000

9.116 COMMON PROFICIENCY TEST


Tutorial Note : The debentures are to be redeemed in 5 annual instalments, i.e., Rs. 2,00,000
every year. At the end of 1998, the company redeemed Rs. 2,00,000. Tthe company enjoyed
benfit in 2006 Rs. 10,00,000 and in 1999 for Rs. 8,00,000 and so on.

10. INTEREST ON DEBENTURES


Interest payable on coupon debenture is treated as a charge against the profits of the company.
Interest on debenture is paid periodically and is calculated at coupon rate on the nominal
value of debenture. The company will pay interest net of tax to the debenture holders because
the company is under obligation to deduct tax at source at the rates applicable under tax rules
from time to time. The companies will deposit the tax so deducted with income tax authorities.
Following accounting entries are to be recorded in this regard:
1. For making interest due
Interest A/c Dr.
To Debenture holders’ A/c
2. For making payment of interest and deduction of tax at source (TDS)
Debenture holders A/c Dr.
To TDS Payable A/c
To Bank A/c
3. For making payment of tax deducted at source
TDS payable A/c Dr.
To Bank A/c
4. For transferring interest to profit and loss account
Profit and Loss A/c Dr.
To Interest A/c
Illustration 16
A company issued 12% debentures of the face value of Rs. 2,00,000 at 10% discount on
1-1-2005. Debenture interest after deducting tax at source @ 10% was payable on 30th June
and 31st of December every year. All the debentures were to be redeemed after the expiry of
five year period at 5% premium.
Pass journal entries for the accounting year 2005.
Solution
Journal
Dr. (Rs) Cr. (Rs.)
1-1-2005 Bank A/c Dr. 1,80,000
Debenture Discount A/c Dr. 20,000
Loss on Issue of Debentures A/c Dr. 10,000
To 12% Debentures A/c 2,00,000
To Premium on Redemption of Debentures A/c 10,000
(For issue of debentures at discount redeemable at
premium)
30-6-2005 Debenture Interest A/c Dr. 12,000
To Debentureholders A/c 10,800
To Tax Deducted at Source A/c 1,200
(For interest payable)
FUNDAMENTALS OF ACCOUNTING 9.117
ISSUE OF DEBENTURES

Debentureholders A/c Dr. 10,800


Tax Deducted at Source A/c Dr. 1,200
To Bank A/c 12,000
(For payment of interest and TDS)
31-12-2005 Debenture Interest A/c Dr. 12,000
To Debentureholders A/c 10,800
To Tax Deducted at Source A/c 1,200
(For interest payable)
Debentureholder A/c Dr. 10,800
Tax Deducted at Source A/c Dr. 1,200
To Bank A/c 12,000
For payment of interest and tax)
Profit and Loss A/c Dr. 24,000
To Debenture Interest A/c 24,000
(For transfer of debenture interest to
profit and loss account)
Profit and Loss A/c Dr. 4,000
To Debenture Discount A/c 4,000
(For proportionate debenture discount written
off, i.e., 20,000 x 1/5)
Profit and Loss A/c Dr. 2,000
To Loss on Issue of Debenture A/c 2,000
(For proportionate loss on issue written off,
i.e., 1/5 x 10,000)
It may be noted that loss on issue of debenture is also written off in the ratio of debentures
outstanding during different accounting years.

SELF EXAMINATION QUESTIONS


1. Which of the following statements is true?
a. A debenture holder is an owner of the company
b. A debenture holder can get his money back only on the liquidation of the company
c. A debenture issued at a discount can be redeemed at a premium
d. A debenture holder receives interest only in the event of profits
2. Premium on redemption of debentures account is _______.
(a) A real account (b) A nominal account - income
(c) A personal account (d) A nominal account - expenditure
3. Which of the following statements is false?
a. At maturity, debenture holders get back their money as per the terms and conditions
of redemption
b. Debentures can be forfeited for non payment of call money
c. In company’s balance sheet, debentures are shown under secured loans
d. Interest on debentures is charged against profits

9.118 COMMON PROFICIENCY TEST


4. Which of the following statements is false?
a. A company can issue convertible debentures
b. Debentures cannot be secured
c. A company can issue redeemable debentures
d. Debentures have no right to participate in profits over and above their fixed interest
5. Debenture premium cannot be used to _____.
a. Write off the discount on issue of shares or debentures
b. Write off the premium on redemption of shares or debentures
c. Pay dividends d. Write off capital loss
6. F Ltd. purchased Machinery from G Company for a book value of Rs.4,00,000. The
consideration was paid by issue of 10% debentures of Rs.100 each at a discount of 20%.
The debenture account was credited with ______.
a. Rs.4,00,000 b. Rs.5,00,000 c. Rs.3,20,000 d. Rs.4,80,000
7. Loss on issue of debentures is treated as ____________.
a. Intangible asset b. Current asset
c. Current liability d. Miscellaneous expenditure
8. T Ltd. has issued 14% Debentures of Rs.20,00,000 at a discount of 10% on April 01, 2004
and the company pays interest half-yearly on June 30, and December 31 every year. On
March 31, 2006, the amount shown as “interest accrued but not due” in the Balance Sheet
will be
a. Rs.70,000 shown along with Debentures b. Rs.2,10,000 under current liabilities
c. Rs.1,40,000 shown along with Debentures d. Rs.2,80,000 under current liabilities
9. On May 01, 2004 U Ltd. issued 7% 10,000 convertible debentures of Rs.100 each at a
premium of 20%. Interest is payable on September 30 and March 31 every year. Assuming
that the interest runs from the date of issue, the amount of interest expenditure debited to
profit and loss account for the year ended March 31, 2005 = ?
a. Rs.70,000 b. Rs.58,333 c. Rs.84,000 d. Rs.64,167
10. Which of the following is/are true with respect to debentures?
(a) They can be issued for cash
(b) They can be issued for consideration other than cash
(c) They cannot be issued as collateral security
(d) Both (a) and (b) above
11. W Ltd. issued 20,000, 8% debentures of Rs.10 each at par, which are redeemable after 5
years at a premium of 20%. The amount of loss on redemption of debentures to be written
off every year = ?
a. Rs.40,000 b. Rs.10,000 c. Rs.20,000 d. Rs.8,000
12. When debentures are issued as collateral security, the final entry for recording the
transaction in the books is __________.
(a) Credit debentures a/c. and debit cash a/c.
(b) Debit debenture suspense a/c. and credit cash a/c.

FUNDAMENTALS OF ACCOUNTING 9.119


ISSUE OF DEBENTURES

(c) Debit debenture suspense a/c. and credit debentures a/c.


(d) Debit cash a/c. and credit the loan a/c. for which security is given
13. Which of the following is false?
(a) A company can issue redeemable debentures
(b) A company can issue debentures with voting rights
(c) A company can buy its own shares
(d) A company can buy its own debentures
14. Which of the following is false with respect to debentures?
(a) They can be issued for cash
(b) They can be issued for consideration other than cash
(c) They can be issued as collateral security
(d) They can be issued in lieu of dividends
15. Debentures can be _________.
I. Mortgage Debentures or Simple Debentures.
II. Registered Debentures Or Bearer Debentures.
III. Redeemable Debentures or Irredeemable Debentures.
IV. Convertible Debentures or Non-convertible Debentures.
(a) Both (I) and (II) above (b) Both (I) and (III) above
(c) Both (II) and (III) above (d) All of (I), (II), (III) and (IV) above.
16. Which of the following statements is false?
(a) Debenture is a form of public borrowing
(b) It is customary to prefix debentures with the agreed rate of interest
(c) Debenture interest is a charge against profits
(d) The issue price and redemption value of debentures cannot differ.
17. As per the Companies Act, “Interest accrued and due on debentures” should be shown
(a) Under Debentures (b) As Current Liabilities
(c) As Provisions (d) As a reduction of bank balance
18. T Ltd. purchased land and building from U Ltd. for a book value of Rs.2,00,000. The
consideration was paid by issue of 12% Debentures of Rs.100 each at a discount of 20%.
The debentures account is credited with _____________.
(a) Rs.2,60,000 (b) Rs.2,50,000 (c) Rs.2,40,000 (d) Rs.1,60,000
19. P Ltd. issued 5,000, 12% debentures of Rs.100 each at a premium of 10%, which are
redeemable after 10 years at a premium of 20%. The amount of loss on redemption of
debentures to be written off every year = ?
(a) Rs.80,000 (b) Rs.40,000 (c) Rs.10,000 (d) Rs. 8,000
20. Which of the following is true with regard to 10% Debentures issued at a discount of
20%?
(a) The carrying amount of debentures gets reduced each year at a rate of 20%
(b) Issue price and the carrying amount of debentures are equal
(c) At the time of redemption, the debenture holder will be paid the issue price

9.120 COMMON PROFICIENCY TEST


(d) The face value and the carrying amount of debentures are equal.
21. Which of the following is false?
(a) Equity is owners’ stake and the debenture is a debt
(b) Rate of interest on debentures is fixed
(c) Debenture holders get preferential treatment over the equity holders at the time of
liquidation
(d) Interest on debentures is an appropriation of profits.
22. Discount on issue of debentures is a ____________.
(a) Revenue loss to be charged in the year of issue
(b) Capital loss to be written off from capital reserve
(c) Capital loss to be written off over the tenure of the debentures
(d) Capital loss to be shown as goodwill
23. On May 01, 2003, Y Ltd. issued 7% 40,000 convertible debentures of Rs.100 each at a
premium of 20%. Interest is payable on September 30 and March 31, every year. Assuming
that the interest runs from the date of issue, the amount of interest expenditure debited to
profit and loss account for the year ended March 31, 2004 = ?
(a) Rs.2,80,000 (b) Rs.2,33,333 (c) Rs.3,36,000 (d) Rs.2,56,667
24. Which of the following is false with respect to debentures?
(a) They can be issued for cash
(b) They can be issued for consideration other than cash
(c) They can be issued as collateral security
(d) They can be issued in lieu of dividends
25. Which of the following is false?
(a) A company can issue irredeemable debentures
(b) A company can issue debentures with voting rights
(c) A company can buy its own shares
(d) A company can buy its own debentures
26. Which of the following is not a characteristic of Bearer Debentures?
(a) They are treated as negotiable instruments
(b) Their transfer requires a deed of transfer
(c) They are transferable by mere delivery
(d) The interest on it is paid to the holder irrespective of identity

ANSWERS
1. (c) 2. (d) 3. (b) 4. (b) 5. (c) 6. (b)
7. (d) 8. (a) 9. (d) 10. (d) 11. (d) 12. (c)
13. (b) 14. (d) 15. (d) 16. (d) 17. (a) 18. (b)
19. (c) 20. (d) 21. (d) 22. (c) 23. (d) 24. (d)
25. (b) 26. (b)

FUNDAMENTALS OF ACCOUNTING 9.121


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