UNIT 17 ACCOUNTING CONVENTIONS

AND FINAL ACCOUNTS

Structure
17.1 Introduction
Objectives
17.2 Financial Statements
17.3 Accounting Conventions
17.4 Inter-relationship between P & L Alc and Balance Sheet
17.4.1 Capital and Revenue Expenditure
17.4.2 Capital and Revenue Receipts
17.4.3 Capital Loss and Revenue Loss
17.4.4 Inter-relationship between P&L A/c and Balance Sheet
17.4.5 Matching Principle (Matching Revenue and Expenses)
17.5 Determination of Gross Profit : Trading Account
17.5.1 Purposes of Preparing Trading Alc
17.5.2 Important Items of Trading Account
17.5.3 Gross Profit or Gross Loss
17.6 Manufacturing Account
17.7 Profit and Loss Alc (P & L Alc)
17.7.1 Purposes and Importance of P & L Alc
17.7.2 Contents and Preparation of P & L Alc
17.7.3 Regarding the Contents of P & L A/c
17.7.4 Provisions
17.7.5 Divisible Profits
17.8 P & L A/c (in Common Parlance)
17.9 Explanation of Certain Items in Balance Sheet
17.9.1 Reserves : Classifications
17.9.2 Capital Profits
17.9.3 Marshalling of Assets and Liabilities
17.9.4 More Items in BS Explained
17.10 Some General Information
17.11 Summary
17.12 Answers to SAQs

17.1 INTRODUCTION
To recall the definition advocated by the American Institute of Certified Public
Accountants, "Financial 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 financial character - and interpreting the results thereof'. [In this, the long
hyphens have been introduced only to highlight the aspects emphasised in this definition.]
The earlier units have dealt with the aspects of recording and classifying. The
summarising part will be addressed in this unit.

Objectives
After studying this unit, you should be able to
appreciate the stages of summarising and reporting - through Trial Balance,
Manufacturing Account, Trading Accounting, P & L Alc and Balance Sheet,
recognise the distinctions between the above-mentioned accounting statements
as well as their inter-relationships,
distinguish between capital and revenue aspects of expenditures and incentives,
be aware of the importance and implications of the Matching Principle, the
role of closing stock and several other items of accounting,
ConstructionAccounting put in the constituent entries into P & L A/c and BS comprehensively and
Principles and Practices
appropriately, and
learn, inter alia, on how to arrive at divisible profits.

17.2 FINANCIAL STATEMENTS

Periodically, may be by every six months, and surely by every year, any business
undertaking, and, in general, any organisation dealing inlwith fundslmoney, has to
prepare two statements. The purpose is to know whether the institution has earned
profits or incurred (suffered) losses during the interval; also to know the business
position at the end of the accounting period. For this, the institution prepares "FINAL
ACCOUNTS", also called more commonly as "FINANCIAL STATEMENTS". One sets
out the Income or Revenue earned during the period - an Income Statement - or an
Income and Expenditure Statement, including the expenses or costs incurred for the
purpose as well as any losses suffered during the period. Hence, its name "Income
Statement" (or Income and Expenditure Statement) or "Profit and Loss Account". The
other statement, which is a Position Statement as at the end of the period, also generally
designated as the Balance Sheet, sets out the Assets and Liabilities of the organisation
as at the end of the period.

17.2.1 Transition from Recording/Classifying to

SummarisingfReporting
Profit and Loss Account
The organisation wants to know not only the (total) quantum of profit (or loss) at
the end of the accounting period but also the details of his income and expenses in
order to be able to critically analyse them and thereby to develop future plans of
action for the benefit of all concerned. The Income Statement, being a summary of
all accounts that affect the profit or losses of the firm, accomplishes the purpose.
The Trial Balance contains all the (nominal) accounts in the Ledger. From this, all
such accounts which result either in gains or in losses and expenses are sorted out
and grouped appropriately. Those which contribute to profits are placed on the
Credit side of the P & L A/c; and those which decrease the profits are placed on the
debit side of the P & L Alc. If the two sides are individually summed up and the
net difference of the totals extracted, the overall profit or loss is identified.
Excess on the credit side total indicates profit; and, on the debit side, loss.
This Income Statement is further divided into two parts : one shows the Gross
Profit or Gross Loss; and the other indicates Net Profit or Net Loss. The first is
called the Trading A/c and the latter is called the P & L A/c.
Balance Sheet
After ascertaining the profit or loss of the business, the organisation turns to the
financial position of the business. The Balance Sheet is prepared listing the Assets
and Liabilities at the closing date of the accounting period. The total of the Assets
and Liabilities should be equal; otherwise, there is some error needing
rectification.
Balance Sheet is a classified summary of the balance remaining open in the
Ledger after all the income and expenditure accounts have been closed off by
transfer to P & L A/c. It discloses the amount of capital contributed and how the
same has been invests - the values of assets and liabilities and their nature.
The left hand side, by convention, lists the capital and liabilities of the business.
Assets and other debit balances are shown on the right hand side. [The persistent
and uncorrected irony can be seen : Left side is readable first and the right side
later; however, the nomenclature is : Assets and Liabilities Statement - reversing
the order, right first and left next. Interchange of position is equally in vogue.]
According to Freeman, "Balance Sheet is an itemised list of the assets, liabilities
and proprietorship of a business or an individual at a certain date."
Balance Sheet related to Trial Balance and to P & L A/c
The Trial Balance and Balance Sheet have resemblances and distinctions. The
characteristics are listed in Table 17.1. And comparisons between P & L Alc and
Balance Sheet are listed in Table 17.2.
 Table 17.1 :Characteristics of Trial Balance and Balance Sheet Accounting Conventions
and Final Accounts
) S1. No. ( Detail 1 Trial Balance 1 Balance Sheet I
1 1 Objective To test accuracy of ledger
postings (more of a satisfaction
To know the financial position
of the business.
than rigour).
2. Periodicity Preferably repared every At the end of the accounting
month; a n l i f need, be sooner. period.
3. Titles on the Debits and Credits. Liabilities and Assets.
two sides (L &
R)
Infering P / L
I Does not explicity show Profits
or Losses.
Shows Profits and Losses of
business. I
Closing Stock
p p
No information. Contains information.
Legal utility Not acceptable in Courts;
serves only as an internal basis for paying taxes.
document.
Not compulsory. Legally compulsory.
w 0 Accounts
f All types of accounts are Only Real and Personal
included. accounts are included.
( 9. 1 Content I Cash Book Balances. I Cash Book Balances. I
10. Source I Prepared from Ledger. ) Prepared from Ledger.
11. What is it? Not an account; but is a Not an account; but is a
Statement. Statement.
12. What is Such accounts whose two sides Such accounts whose two sides
missed? are in balance. are in balance.

Table 17.2 :Comparison of P & L Alc and Balance Sheet

1 S1. No. Detail P& LAIC Balance Sheet
Depicts Shows profit or loss the financial position of
the buslness during a given the business on a given date /
period
What is it? It is an account. Not an account, but is a
statement - through prepared
as part of final accounts -
Hence, the nomenclature
"Financial Statements" is
prefered over "Final
Accounts". (cf. 17.2)
3. Titles "Debits" and "Credits" sides The words "To" and "By" are
are implicit in being indicated not relevant and are not used.
by "To" on the left side and The headings are "Liabilities"
"By" on the right side on the left side (together with
(respectively). "Capital"; and "Assets" in the
right side. Interchange of
positions is also in vogue.
Contributions to profit are By showing what the firm
in? placed on credit side; and owes to others (Liabilities) and
decreases in profits are placed what others owe to the firm
on debit side. The overall profit (Assets), the financial position
or loss is identifiable. of the firm is indicated.
Only nominal accounts are It records personal and real
entered. accounts.
5. Prepared from Trial Balance. Trial Balance
Balancing Though balancing may be The totals of Liabilities and
shown by appropriate entry of Assets are always equal.
GrossNet profit, this content
of the difference between the
two sides is the very purpose
of it.
Closure or Accounts transferred to Accounts transferred to BS
carry forward P & L A/c are finally closed. represent those accounts whose
balance is to be carried
forward to-the next vex.
-
Expenditure Revenue Expenditures. Capital Expenditures (on the
8. recorded or Assets side).
entered
Further explanation of S1. No. 8 in Table 17.2 can be seen in subsequent pages.
Construction Accounting : SAQ 1
Principles and Practices
Discuss the essential differences (and similarities) between
(a) Trial Balance and Balance Sheet, and
(b) P & L A/c and Balance Sheet.

17.3 ACCOUNTING CONVENTIONS

Besides the concepts mentioned in Unit 16, as they govern accounting record, there are
Three conventions for preparing financial statements - the full details of which are
available under "International Accounting Standards - Statement of Disclosure of
Accounting Policies" - framed by International Accounting Standards Committee. Those
are as follows :
(a) Materiality in Disclosure;
(b) Consistency; and
(c) Conservatism or Prudence.
(Of these, aspects of the latter two have already been discussed.)
Materiality in Disclosure
The principle is based on that
(a) the P & L A/c should be so drawn up as to give a true and fair picture of
the figure of profit earned or loss suffered during the year; and
(b) the BS should give on its date a true and fair picture of the financial
position of the company.
Both statements must give sufficient analysis offigures, without unnecessary
detail, to enable a person studying them to have knowledge about all the
significant factors which have led to the figure or to the financial position. The real
test is one of materiality : like, if a figure is material, it has to be disclosed. A
figure is material by itselfin the sense that, if it is merged with other figures, it will
cloud the vision or the perspective. An example is : if arrears of salarieslwages,
due since long either because of a dispute or because of pay revision, are added to
current year's salaries and wages (even when the former are large amounts), a
wrong idea of the salarieslwages of the [individual(s) as well as of the] company
gets conveyed. The arrears should, therefore, be shown separately. However, if the
arrears are relatively quite small, it may not be improper (note : it is not yet said to
be "proper") to merge the two series of salarieslwages. Also, materiality may again
arise when there may be a departure from the previous year's practice or some
serious lapse. A penalty or a fine imposed on a firm for, say, mismanagement of the
envqonment, is a material information to be separately shown. Judgement of the
preparing individuals is the only guide and there are no hard and fast rules set up,
except to say that evaluations and decisions should not be let to suffer.
A convention of SUBSTANCE OVER FORM is also mentioned in this context.
Transactions and other events should be accounted for and presented in accordance
with their substance and reality and not merely with their legal form.
Consistency
As is known, depreciation can be provided for by one of several methods. If there
has to be a change in a particular year, in that the method adopted in that year is
different from the one adopted in previous years, such a change adopted must be
indicated. [Note : Materiality referred to amounts of money whereas consistency
refers to procedure(s) adopted]. Valuation of closing stocks is a like example. It is
also important that frequent changes should not be resorted to.
Conservatism, or Prudence
Frauds do get committed by inflating profits and by showing a financial position
much better than what it really is. If two figures are possible, the lower one is to be
 preferably indicated in case of profits and assets valuation; and the higher figure in Accounting CaInventions
and Final Accounts
case of liabilities and costs. [As abiding by materiality convention, the omitted
figure may, if and by whichever manner appropriate, be indicated elsewhere with
proper reference.] However, there is to be read no directive that figures of profits
or assets by deliberately deflated nor of liabilities or costs be inflated. Essentially,
CAUTION IS ADVOCATED. Moreover, "PRUDENCE DOES NOT JUSTIFY
CREATION OF SECRET OR HIDDEN RESERVES.

17.3.1 Certain Difficulties

For reason of caution, asset values in BS are stated depending on the classification : for
fixed assets (i.e. permanent facilities of the organisation that facilitate its operations),
values are given at cost less depreciation; and for current assets (assets intended for
conversion into cash in the process of normal operation), values are given at the lower of
cost or market price. If market costs of fixed assets do rise in the meanwhile, the actual
financial position will be much better than shown. In consequence, profits shown will be
a higher proportion of the asset value shown though, in reality, the profit stated may not
be justified in terms of current values. But, yet, historical costs less depreciation are
shown to avoid later difficulties in revaluing the assets. However, since current assets are
for sale, they being shown at market rates, if such rates are lower, stands justified.

SAQ 2
Whereas materiality refers to the quantum of money, consistency, on the other
hand, emphasises on procedures; and conservatism is dependent on both - write an
informed critique on this with illustrative narrations.

17.4 INTER-RELATIONSHIP BETWEEN P & L A/c AND

BALANCE SHEET
The importance of matching revenue and expenditure has already been mentioned in a
previous context. To advance the discussions on the Final Accounts, i.e. Financial
Statements (i.e. P & L A/c and BS), it is helpful to first clearly understand the nature and
types of different expenditures and receipts. These can be either of the capital category or
the revenue category. Thus, an axpenditure can be either a CAPITAL EXPENDITURE or
a REVENUE EXPEIVDITURE. Likewise, a receipt can be either a CAPITAL RECEIPT
or a REVENUE RECEIPT.

17.4.1 Capital and Revenue Expenditure

In an earlier context, the difference between "expense" and "expenditure" has been
explained. It is emphasised that every expense is an expenditure, but every expenditure is
not necessarily an expense. In accounting parlance, the two words are not synonyms.
Business expenses which affect directly the profits for the accounting period are called
REVENUE expenditure. Expenditure items which do not directly affected the profit (of
the accounting period) but the benefits of which are available over longer periods of
business (ordinarily at least for, say, four to five years) are called CAPITAL expenditure.
Another way of saying these is as under. Payments in respect of which service has
already been obtained and no further service will be available unless further payment is
made are REVENUE expenditures. Telephone bills on a running basis, wageslsalaries,
rents paid - are all examples of revenue expenditure. Payments in respect of which
service will be available for many years to come are CAPITAL expenditures. Installation
charges for a telephone, a machine, electrical fittings, equipment erection - are all
examples of capital expenditure.
Revenue expenses (or expenditure) are to be charged off to the P & L A/c as an expense
relating to the year. Only that portion for which payment is made in advance for the next
year will be shown in the BS.
Capital expenditure is really (the means or transaction of acquiring) an asset. It has to be
shown in the BS after a proper portion out of it, because of wear and tear, is charged as
revenue expense to the P & L Alc.
ConstruetionAccounting : Capital expenditure is characterised by two features. Firstly, barring a few exceptions,
Principles and Practices
cash may be realised through the disposal of the asset concerned, though short of
(occasionally in excess of, e.g. in case of land) the amount originally spent on acquiring
the asset. However, the intention in the acquisition is not for resale. That is to say, all
tangible things (or assets) (and intangible ones too) acquired and kept for use (though
also capable of being sold off) are capital expenditure. Secondly, they increase the
earning capacity of the organisation. This may be by larger production of goods or
lower cost of production. (Note that reducing existing expenses is not the sole result;
existing expenses may or may not be reduced). Put differently, an existing assest may be
improved by increasing its efJiciency (by addition, sustitution, renovation); or there may
result economy in operation of existing assets (e.g. attaching a power-driven motor to a
hand-driven machine).
An extension of the second feature involves an expenditure incurred on a new (or newly
acquired) asset to bring it to workable condition. Examples are : Installation, Electrical
Wiring, Erection of guard frames, etc. after first purchase of a machine. (By "newly
acquired", we include also second-hand purchases.) In other words, all expenses (though
called as expenses - i.e. incurred within the accounting period for specific purposes and
unlikely to be incurred again for the same purpose) incurred in making the asset ready
for operationfor thefirst time will be added to the cost of the asset and thus capitalised.
(a) When buying a building, the deed-writer's fee, the lawyer's fee to verify the
title deed if fully in favour of the seller and to verify no-encumbrances, broker's
commission, etc. will be added to the first, or acquiring, cost of the building.
(b) If a machine is bought second-hand, the cost of overhauling it initially,
renewing the upholstery of the car purchased second-hand, making the platform
for erecting the monoblock pump-motor together with wiring, switch board
panel, guard frames, etc. -will all be capitalised.
(c) Interestpaid on loan taken to acquire an asset, till it is made operational, would
be added to the cost of the asset to set its capitalised value.
Expenses incurred in merely maintaining the assets in proper working conditon are
revenue expenses.
Following are some of the examples of revenue expenses :
(a) Any annual repairs for the building, including painting, white or colour
washing, changing of fittings when damaged (of minor costs) are revenue
expenses.
(b) Operation, maintenance and repair costs (OMR) like diesel, lubricants, etc.
included, constitute revenue expenses.
(c) Interest a f e r the date the asset is ready to operate (no matter if operated or not)
is revenue expense.
Capital expenditure is also called Capital outlay. The portion which is earmarked for a
particular accounting period (because of wear and tear) is called Depreciation.
Depreciation goes to the P & L Arc and is reduced from the capital outlay. The rest is
called cost-residue or written-down value (WDV) and is transferred to BS. Since capital
expenditure (or residual part thereof) is transferred to BS, it is called also as Balance
Sheet expenditure. Like rhe term "expknse" associated with Revenue expenditure, so are
the terms "outlay" and. "residue" w i d capital expenditure.
/
To recall, revenue expenditure is/$ncurred to maintain the earning capacity of the
business, and capital expenditure is incurred to improve the earning capacity of the
business. Acquiring and initiating are also part of improving. Moreover, there is no
discernible intention of reselling in the case of capital expenditure.
The last statement brings in the role and purpose of the business concern in classifying
expenditure as capital or revenue.
(a) Raw material used in manufacture of an asset maintained and kept within the
enterprise is capital expenditure - like, perhaps, BHEL producing transformers
for its own premises. But raw material used by a vessel's manufacturer to
produce Dinner plates is revenue expenditure.
(b) Generally, in shops, establishments and business concerns, furniture, or ceiling
fans, are capital expenditure; but in the case of a dealer in these items, they are
revenue expenditure.
 (c) Wages and salaries are generally revenue expenditure in a going concern; but Accounting Conventions
and Final Accounts
when paid during the construction stage of a building or the manufacturing
stage of, say, the dinner plates mentioned above, they are revenue expenditure.
(d) Installation of a machine is capital revenue expenditure; but moving the
machine trolley, or mount, to respective work sites is revenue expenditure.
(e) Continuing on S1. (d), camage, freight, insurance, etc. are revenue expenditure
in the ordinary course of business; but when incurred to get the machine to the
godown and then to site for erection or mounting is capital expenditure.
(f) Repairs and renewals of an old building or old machine are revenue expenditure
if to maintain in working condition; but if incurred to bring to workable
condition, it is capital expenditure.
Deferred Revenue Expenditure
There is another category of expenditure which is intermediate between capital and
revenue expenditures. By nature they are revenue expenditure but its benefits are
likely to be derived offer a number of further years. Revenue expenditure incurred
during current year but susceptible to be considered as paid as advance
(expenditure) for the coming year(s) is called DEFERRED REVENUE
EXPENDITURE. Examples are : advertising compaigns, major or complete
overhauls of a machine; converting the front room of a house as the consulting
room of a medical practitioner member of the house, etc. The P & L Alc of each
year is charged with its due proportion of the expenditure incurred; and the rest of
the amount is carried forward to the next year and is shown in the balance sheet as
at the end of the year. (Usually, only proportionate values are shown and the
concept of Capital Recovery Factor is not invoked. For example, if the benefits of
the advertisement may continue for five years, one-fifth is charged as Revenue
Expenditure in each year and the unexpired balance is taken in the BS from this
year to next year.) Such expenditure is called also as capitalised expenditure.
Exceptions are also recognised. Extra-ordinary losses, say by Fire, Flooding, other
natural events like Earthquake, due to political disturbances and riots, heavy losses
in trading, etc. however heavy the loss, are not to be camed forward and should be
completely charged against the revenue of the year (even if the net result is not a
profit but a loss).
[Note : Opinions differ in case of Fire and Natural events - some allowing the
losses as deferred revenue expenditure. But the snag is :The unwritten down
portion of the asset value that is camed over is a worthless and fictitious asset and
the information carried in the Final Accounts suffers the stigma of contracdicting
the essential principles, concepts and convention of accounting.]
In short, these are revenue expenditure of a capital nature (no contradiction in
terminology is to be read in this). That the carried overportion of the expenditure
is treated as an asset should be noted.

17.4.2 Capital and Revenue Receipt.

Capital receipts, like capital expenditures, do not affect profit; and are either shown as a
Liability, or, more often, as a reduction from the Assets. Revenue receipts, like revenue
expenditures, affect the P & L A/c and are shown on the credit side.
It shall be noted that any excess realisation over the W. D. V. (or Book Value) of an asset
shall be treated as a revenue receipt (and yet due taxes have to be paid thereon, since the
excess will be considered as capital gains for tax purposes).
Capital receipts include, e.g. capital invested by owners of the business, amounts received
from sale of fixed assets or investments, conversion into cash of any asset EXCEPT
STOCK and any loans (short, or long, term) received (as well as by debentures, bonds,
etc.).
Revenue receipts include, e.g! amount from sale of goods [produced as in the line(s) of
business], amount received from rendering services to other parties, or interest received,
or commisson received.
It must, however, be brought out that categorical distinction between capital receipts and
revenue receipts is hardly possible. At the same time, it must be understood that
distinction is needed for income determination and for taxation purposes. For this
purpose, the fact is recognised that revenue receipts do not need to be returned to anyone.
ConstructionAccounting : 17.4.3 Capital Loss and Revenue Loss
Principles and Practices
Capital loss is the loss that occurs contingent to the sale of some fixed asset. Example is :
Loss due to discount given at the time of issue of shares or debentures. Loss due to
misappropriation of cash from office and forfeiture of security deposits (for the
possibility of securing agencies, contracts, etc. - are also obvious examples of capital
loss.
Revenue losses can occur in the course of sale and purchase of goods. Bad debts, loss due
to fall in prices of goods, etc. are examples here.
Revenue loss is usually accounted for in the current year's P & L N c . Capital loss is
usually spread over a few years.

17.4.4 Inter-relationship between P & L A/c and BS

The two statements between themselves take into record the total expenditure incurred.
An appropriate part of the total amount spent is entered in the P & L N c as expenqe or
cost and the remaining is entered in the BS and (carried forward) as assets.
(a) Stock in hand (taken into the next year) (being goods unsold) is an example of
BS entry in this situation; the balance of the goods purchased during the year
and sold (at profit or loss) will be in the P & L N c as costs incurred for making
the sale.
(b) In respect of wages, salaries, rent, power, etc., these will mostly be incroporated
in the P & L N c except if any part relates, or is relatable, to the next year, like
if service can continue to be obtained in the next year without additional
payment.
(c) In respect of machinery, depreciation will be in the P & L N c and
undepreciated balance will go into the BS.
It must be recalled here that the owner's equity is affected by profit or loss. For this
reason, the P & L N c too, in a way, has implicit information on the changes in the
financial position from one period to the next - though information on financial position
on a date rightly belongs to, and resides in, the BS.
For these reasons, the P & L N c and the BS always go together and should also be read
together.

17.4.5 Matching Principle (Matching Revenue and Expenses)

Perhaps this is easily the most crucial requirement in the operational details and working
procedures in the preparation of Accounts, including Final Accounts. This is to be a
purely internal watchdog guideline for any organisation without which "fair and true"
pictures of the financial status cannot emerge. Errors in the matter, procedures and
operational details of its adoption can, and would, vitiate any external reporting.
The background is : Trading as well as P & L Alcs are prepared by grouping and clubbing
all nominal accounts extracted from the trial balance. In this connection, in practice, all
accounts pertaining to revenue and expenditure are nominal accounts.
The guiding principle is : Given the background, yet, all the expenditures and revenues
do not necessarily affect (or can be taken to contribute to) the profit of the enterprise for
the accounting period. Of the total expenditure incurred in a year and those brought
forward from previous years [Note : "years" - not merely "year"], a certain part is
(eligible to be, and is) treated as an expense, and, accordingly charged against revenues of
the year, i.e. debited to the P & L Alc, and the remaining amount is carried forward to the
next year as an asset and is shown in the Balance Sheet. For calculating correctly the
profits (the term includes "loss", if so) for the accounting period, the PRINCIPLE OF
MATCHING QF REVENUE AND EXPENSES has to be applied. ("Matching does not
imply exact balancing but appropriately relating and comparing.")
In this connection, one important question is as to how much of the amount of
expenditure should be so charged against the P & L A/c and how much is to be carried
forward. Ifthe amounts are not determinedproperly, both the statements will be wrong -
the profit for the year will be wrong and the BS too will be wrong.
This is premised on : all the figures of income (on the Cr. side of P & L A/c) and of those
expenses (on the Dr. side of P & L N c ) are mutually inter-related and have been
adequately and appropriately matched. Such expenses which lead to revenue or sale
during the accounting period have to be matched against such incomes. The Accounting Conventions
operationalisation of this principle requires the following to be adhered to : and Final Accounts

(a) the distinction between capital expenditure and revenue expenditure should be
clearly understood and should dictate the correct allocation of amounts
between the P & L A/c and the BS.
(b) the extent of cost allocated is taken as expense in the P & L Mc.
(c) it would be wrong to consider sales price as revenue of such goods whose cost
has not yet been accounted for.
(d) it would equally be wrong to consider an expendiure as an expense if it will
bring in revenue (only) in future.
(e) based on the correct entries, by mutual comparison between them, the profit or
loss for the period is arrived at.
In other words, the incomes and revenues earned as shown in the P & L A/c should have
relevance to the costs and expenses incurred as shown on the other side of the P & L A/c,
and vice-versa; and such disclosure of revenues and expenditure refer to what can be
properly treated as belonging to the current year. This is the MATCHING PRINCIPLE.
This principle has the following implications :
(a) If an item of revenue or income is entered in the P & L A/c on the creidt side,
then on the debit side all expenses incurred in rendering the service or
producing the goods (after all, it is these goods and services that would have let
earn the revenue) should be entered. It does not matter if any part of the
expenses is yet to be settled in cash. No matter if the payment was made in
(i) previous year or would be made in (ii) following year, the quantum (amount)
of the expense has to be entered in the current year's P & L A/c. [This is the
mercantile system of accounting or the accrual-basis of accounting.] In case it
would be a future payment, then corresponding liability is to be admitted and
shown in the BS. [This is called the treatment (handling) of expenses paid in
advance (or prepaid expense) or outstanding.] [Insurance premium - often to be
paid in advance, house rent paid in advance, are typical, and repetitive,
examples.]
(b) If certain expenses have been incurred but the revenues in respect of them will
be received in future, the amount of the expenses concerned should be carried
forward to the next year and shown in the current year's BS as an asset. This is
underlying reason behind valuation of closing stock (or stock in hand a t
end of accounting period). These are entered on the right side of the P & L A/c
- i.e. same as deducting the amounts from the costs or expenses entered on the
debit side. Such entry in respect of closing stock means that since the sales will
take place next year, the costs in respect of the concerned goods should not be
charged to this year's P & L A/c but, rightly, to the next year's P & L A/c. In
the next year, this closing stock (of the previous year) will be treated as a cost
and debited to the P & L Alc of that year.
The same applies to amounts spent on partially completed products - called
Work-in-Progress at the end of the year. Such amounts (i.e. the value of
W-in-P) will be carried forward to the next year and charged off against the
reveunes of the next year.
(c) [This is almost the opposite of (b) and may be comparable to (a).] If some
revenue has been received but the work in respect of it will be done and
expenses incurred in next year, then the revenue will be canied forward to next
year and treated as income only of the next year and not of this year. An
example is, subscription amounts received for a full year of supply of
journals/magazines, part of the period falling in next year. Part of the amount is
to be shown as next year's income when the issues will be supplied.
Exceptions are realised in practice, but they are only apparent exceptions and, on
informed scrutiny, the course of action to be taken is immediately clear.
(a) If there is any loss (in respect of which no revenue or income has been
received) (e.g. loss due to fire, but without any compensation having been
received from Insurance or Government, loss due to accidents, again without
compensation receivable or received), the loss must still be charged off against
the current year's P & L A/c.
Construction Accounting :
Principles and Practices
(b) If the depreciation of a fixed asset owned by the firm depends on passage of
time, i.e. even if, say, the machine has remained idle and no goods are produced
and (hence) no income received (thereby), the current year's depreciation has to
be charged to the P & L A/c. By the Principle of Conservatism, if factors
already in operation would suggest the incidence of a loss, such loss, though
only likely as yet, is taken into account; but no profit is considered to have been
earned until it actually accrues.

SAQ 3
(a) Explain the concept - "Matching implies relating and comparing but not
balancing." Give examples to convey your explanations forcefully.
(b) What is the difference between capitalised expenditure and deferred revenue
expenditure ? Which one is amortised ? How is the other one treated towards
identifying profits ?
(c) What are the characteristics of capital expenditure ? What components go into
the first cost of a capital asset ?

17.5 DETERMINATION OF GROSS PROFIT :TRADING

ACCOUNT
The Income Statement, or the Profit and Loss Alc, is prepared in two parts; the Trading
Account; followed by the P & L Alc. The Trading Account is designed to assess the
GROSS PROFIT on sale of goods. This it does by showing up the relationship amongst
the broad features of trading, through demonstrating whether the sales revenue covers the
immediate or direct costs substantially so that other expenses can also be covered and,
perhaps, a profit is left. The sales revenue, i.e. net proceeds of the sale, are set against (or
compared with) the cost of goods sold and service(s) rendered.
In the case of a (purely) trading concern, the cost will comprise the purchase price,
freight inwards, octroi duty, etc, - i.e. expenses incurred on the goods till it is received
into the firm'ssales premises.
In the case of a manufacturing concern, the cost will comprise the cost of raw materials,
wages and other manufacturing expenses. "Manufacturing Account" is dealt with in
Section 17.6.
Certain terminology, with self-evident meanings and purport, is used in this context.
Opening stock is the stock left with the concern from the last year. Goods remaining
unsold through the year is called closing stock.
As is only obvious, the Opening Stock is added to the Purchases and Closing Stock is
added to the Sales. [Note : Only additions are permitted in the main columns of accounts,
except on rare occasions where deduction would be in order and would be acceptable -
but then rather implicitly than explicitly - e.g. entries like Gross Tax Payable; paid till
date; now paid at the time of filing the returns.] With these entries, the Trading N c shows
the Gross Profit or Gross Loss.

17.5.1 purposes of Preparing Trading A/c

Besides information of the current period, it is highly rewarding for management to
compare the corresponding details of information in the Trading Accounts of each of
previous years for a chosen length of time in the immediate past for comparison, and
analyses and for planning for growth. Reasons for variation would be the thrust of the
comparisons and analyses so that corrective actions can be taken for future growth.
(a) It provides information on gross profit.
(b) Ratio of gross profit to sale helps to identify needs for and areas of, improving
the administration in the business.
(c) Ratio of direct expenses to sales will help to control and rationalise expenses.
 (d) "Stock in hand" indicates the efficiency of the production floor/shop processes Accounting Conventions
and Final Accounts
and personnel besides the extent of coordination between the purchase units and
the other units of the enterprise. By due comparisons and analyses, steps can be
initiated and effected to improve profitability.
(e) Ratio of goods sold by the firm to the total sale by all similarly engaged
concerns can trigger corrective action for price re-fixation (so as to not lose the
current market share).
(f) Analysis of direct expenses can suggest needed precautionary measures to
avoid possible losses.
The ruling principle throughout shall have to be that the Gross Profit disclosed by the
Trading A/c is the very upper limit within which the operating expenses should be kept
whereby the concern can look for savings for itself. And, in the case of new products
under introduction to the market, the business concern can add the cost of purchases,
production expenses and the gross profit margin desired and thereby fix up the selling
price of the product(s).

17.5.2 Important Items of Trading Account

Opening Stock
Unsold goods of last year, taken on the debit side at the beginning of the year.
Closing Stock
Goods remaining unsold at the end of the year, shown on the credit side.
Note :Opening Stock is given in the Trial Balance but closing stock is given
below the Trial Balance - generally because closing stock is valued after the
accounts have been closed. Goods and components of Closing Stock and also
valuation of closing stock are described later on.
Purchases and Purchase Returns
These, as also Discounts on Purchases, are given under the debit side.
All Direct Expenses
These are shown on the debit side. These iclude the expenses in the manufacture of
the goods and expenses incurred in procuring/importing the goods and getting
them to the godown.
(a) Wages are shown on the debit side of the Trading A/c and show the wages paid
in the production of goods. [Note : If a new (or newly bought, though on
second-hand) machine is to be brought in and installed, the wages paid in this
instance will be treated as part of the cost of the machine and will be shown in
Assets and not in the Trading A/c.] [Note : The term Wages is often used in the
context of specific jobs whereas the term Salaries is used when a range of
jobs with continuing responsibility is implied on the receiver. Accordingly,
convention exists that an expense recorded as "Wages" or as "Wages and
Salaries" would go to the Trading A/c; but if recorded as "Salaries and Wages"
it would go to the P & L A/c.]
(b) Carriage Inward refers to the camage (charges along with any incidentals)
paid to get the goods to the godown, inclusive of minor expenses called
"Cartages", etc. and this too is shown on the debit side of the Trading A/c.
Manufacturing Expenses
Besides what are included under Direct Expenses, there are other expenses
involved in any manufacturing process. Items of expense such as
(a) Coal, Water and Gas,
(b) Factory Lighting,
(c) Fuel and Power, and
(d) Other Motive Powers
are included in this. These too belong to the debit side.
Carriage and Freight
This is to be distinguished from what is given under carriage inward (or can+ge
and cartage) under Direct Expenses. Whereas Direct Expenses refer to the
Construction Accounting : expenses that are incurred in bringing the goods to saleable conditions, carriage
Principles and Practices
and freight refer to such costs incurred thereafter to transport the goods for
purposes of sale - shown under debit side.
Wages and Salaries
These include such costs incurred in the sales of the goods beyond their
manufacture (e.g. allowances to travelling sales persons, their special attire and
special baggages) - shown under debit side.
Other Items
These are like Octroi, Rents and Rates for Factories, Duty on the import content of
the goods sold, and are also shown on debit side.
Sales
Sales are shown on the credit side.
Sales Returns
Sales returns are also shown on the credit side, and are to be deducted from sales.
More on Closing Stock
(a) Goods to be included in Closing Stock
(i) Goods remaining unsold at the end of the year.
(ii) Closing Stock of all branches, wherever branches exist.
(iii) In case of goods sent on consignment, stock remaining unsold with
consignee.
(iv) Purchases Returns and Sales Returns (as well as discounts on Purchases).
(b) Components of Closing Stock
(i) Raw materials left untouched.
(ii) Stock of finished goods - the unsold part of.
(iii) Stock of Work-in-Progress - Stock of W-in-P is goods in the process of
being made ready, i.e. not ready but expected to be ready shortly.
(iv) Stores : Such additional goods as are required for converting raw material
into finished goods - e.g. chemicals, coal, gas, machine oil, welding
rods, foundry sand, etc.
(c) Valuation of Closing Stock
It is not hard to see that any change in the value of the closing stock (the
valuation being subject to human judgement) will automatically change the
gross profit - not only of the current year but also of the ensuing year.
Stock valuation is done either at cost or then-current market price, whichever is
lower. The underlying idea is that anticipated profit, which may arise if the selling
price is higher than cost, should not be brought into books till actual sales takes
place. But, if due to a fall in selling price, there is a loss in respect of goods on
hand, then that 1oss.should be considered when drawing up the P & L A/c even
though the sale has not yet taken place. These only reaffirm the proposition that
expected gain is no gain but expected loss is a loss.
Besides the unit price, the physical quantities listed in the stock sheet should also
be correct. There should be neither double counting not any omission. Cut-off
dates for the transactions for this purpose can be stipulated. Also during a fixed
duration, say, two days, around the cut-off date, issues and taking delivery of
supplies can be suspended.
Goods that have gone out are checked up against sale invoices and if, in respect of
any quantity, a sale invoice has not been raised, then, either that invoice should be
raised or that quantity of goods should be included in the closing stock. The sale
invoice can be raised only ifthe customer has legally become liable to accept the
goods, even ifthe goods may yet be with the seller.
In respect of goods received in the business premises, including all its branches, if
any, purchase entry must be made for all such goods; if not made, the goods should
not be included in the closing stock. Same applies for goods received back from
customers as returns or return to supplier.
 Goods received on agency basis on behalf of, or from, somebody, should not be Accounting Conventions
and Final Accounts
included in the stock. But goods sent to some agents for sale on behalf of the firm,
even if unsold and lying with the agent, should be included in closing stock. Goods
lying with the customers on sale or return basis should also be included in the
stock unless the customer has adopted the goods and a sale invoice has accordingly
been raised on him.

17.5.3 Gross Profit or Gross Loss

When the Trading Alc is completed, both sides must be in balance. If without the Gross
Profit or Gross Loss, the entries on the two sides will not respectively sum up to be equal.
Gross Profit to be entered on the debit side or Gross Loss to be entered on the credit side
will lead to balancing the two sides. The appropriate amount should accordingly be
entered as Gross Profit or Gross Loss in the debit or credit side respectively so as to
finally balance the sides. These will be noted as carried down (cld) to or by P & L Alc.

SAQ 4
(a) What items are included in Direct Expenses ?
(b) How do you distinguish between Wages and Salaries ?
(c) How do you envisage that the purposes of preparing Trading Account can be
pursued to the organisation's long-term advantages ?

17.6 MANUFACTURING ACCOUNT

Traders who are busy in manufacturing would want to know the cost of production of
goods produced. The Trading Alc cannot reveal this. Items indicated under "More on
Closing Stock : (b)", particularly (iii) and (iv), are generally missed in Trading A/c.
Besides this minor reason, a major reason why Trading A/c is not helpful for the purpose
of knowing the cost of production is that Trading A/c, per se, does not include expenses
like repair and depreciation of machinery, etc.

17.6.1 Main Items of Manufacturing Account

Debit Items
(a) Raw Materials Consumed : In this Alc, opening and closing stock of raw
materials are not shown separately but for the purpose of deriving the
consumption of raw materials. The entries go like as under :
To Opening Stock of Raw Materials
Add Purchases of Raw Materials
Less Purchases Returns
Less Closing Stock of Raw Materials
= Raw Materials Consumed.
(b) Direct Expenses : Those wages and expenses that are directly spent in the
process of manufacturing are included.
The term "PRIME COST" is used to denote the sum bf costs of Materials
Consumed and Direct Expenses.
(c) Factory Expenses, or Manufacturing Overheads or Factory Overheads or Field
Overheads (in Construction Organisation), or Indirect Expenses of
Manufacture : Included in this item are : Power, Rent, Rates, Lighting as in
other cases; but also Depreciation on Machinery used, Internal transport directly
relatable to the works including all multiple handling occasions of materials of
all descriptions, Works Manager's Salary, Site Supervisors and Work-charged
Establishment Salary, Salaries of Factory Workers and other labour (skilled and
unskilled) employed, sundry expenses including packaging of finished products
and cleaning up of works site, Insurance paid for Premises and on behalf of
labour and other empolyels, and also proportion of any costs of development
Construction Accounting : activities - like trials and experiments in pharmaceuticals, tyre manufacture,
Principles and Practices loading strength determination, etc. Of these, only when explicitly determined
as policy, expenses on supervisors' salary, Insurance and Depreciation would
be taken into P & L A/c rather than in the Manufacturing A/c.
(d) Semi-finished Goods, i.e. Work-in-Progress : Since information on this would
be both on debit and credit sides, this item is taken up later.
Credit Items
(a) Sale of Scrap : Receipts by sale of scrap (less any handling, storage charges,
etc.) are indicated.
(b) Closing Stock and Work-in-Progress : Raw materials unused and unconsumed
and untransformed by the production processes q e valued and indicated. The
principles of valuation are the same as mentioned earlier under other contexts.
Work-in-Progress is dealt with subsequently - since, as said before, this occurs
on both sides of the A/c.
(c) Cost of Finished Goods : This is determined by difference between debit and
credit sides of the Manufacturing AJc. This shows the cost of production and is
TRANSFERRED TO THE TRADING A/C.
Work-in-Progress
This is called also as Semi-finished Goods or Partly Manufactured Goods. Those
units or articles or job pieces which have not been completed as per drawings,
specifications and descriptions but on and for which some work has been done fall
under this category of goods. These are the ASSETS of the business and should be
VALUED. Proportionate cost of materials inputs and proportionate expenses in
terms of all other inputs must be included in such valuation. As an illustration : if
the total wages paid in the year were Rs. 1,00,000 and other direct expenses were
Rs. 56,000, it is seen that the latter are 56% of the former. This percentage should
be taken into consideration while valuing the semi-finished goods. The purpose of
taking "Wages" as the basis of computation is that it is the most clearly identifiable
aspect of the costs that can be unambiguously and indisputably isolated and other
costs can then be apportioned in the same proportion. Continuing with the
illustration, if, at the end of the year, the materials used (locked up) in
semi-finished goods were worth Rs. 36,000 and the wages thereon were Rs. 25,000
(within the total of Rs. 1,00,000), then the manufacturing (i.e. direct) expenses to
be attributed to these semi-finished goods would be taken as 56% of the attributed
wages (this being Rs. 25,000) and would thus be Rs. 14,000. Then the value of the
semi-finished goods will be Rs. 75,000 = (Rs. 36,000 + Rs. 25,000 + Rs. 14,000).
Opening stock of semi-finished goods is shown on the debit side of the
Manufacturing A/c and Closing Stock on the credit side. Closing Stock is also
shown on the Assets side of the BS.
Unit Cost
The cost of production per unit is also computed at this stage simply by dividing
the total cost by the number of total units produced. Defective and unsaleable
goods are to be discarded for purposes of conservatism unless policies are evolved
for them. Generally, they are preferably clubbed with scrap intended for sale.
Trading A/c vs Manufacturing A/c
The essential differences between these two types of accounts are as follows :

S1. No. Comparison for Trading Alc Manufacturing Alc

1. Purpose To find out Gross To find out the cost of

Profit or Gross Loss production of goods
2. Sale of Scrap Not considered Shown on credit side

3. Contents Stock of finished Stock and Purchase of

goods and its cost raw materials and
semi-finished goods
inclusive
4' Transferring the ToP&LA/c To Trading Alc
Balance
4.A Is a part of P & LAIC Trading Alc
112
 SAQ 5 AccountingConventions
and Final Accounts
(a) How are inventories treated in aManufacturing A/c as compared to in a
Trading A/c and as compared to in the P & L A/c ?
(b) What constitute "overheads" and how are they handled in the process of
assessing the gross profit ?

17.7 PROFIT AND LOSS A/c (P & L A/c)

The management of any business is most interested in knowing the net income or net
profit, as this will increase owners' equity. If the business incurs a loss, owners' equity
will be decreased. However, it is a business practice, that no company shows gross and
- net profit separately, but shows them in a continuing computation, vide "Divisible
Profits" later on.
The Trading Alc reveals gross profit. The excess of gross profit and other revenue gains
over sales expense including sales costs and other expenses and any losses gives the
figure of net profit. Other expenses considered are to be the ones that are essential to the
conduct of the business. These are called INDIRECT EXPENSES and are not shown in
the Trading Alc. These revenue gains and indirect expenses (which do not get a place in
the Trading A/c) are (now) shown in the P & L A/c.
The debit side shows various expenses and losses as shown in the Trial Balance. The
credit side shows the gross profit transfered from the Trading A/c and other incomes like
commission, interest received, dividend received, discount earned from suppliers, etc.
which will be found in the Trial Balance with (or, through) respective credit balance.
As in every other case, if the total on the debit side happens to be more, it would be net
loss by the amount of the excess, and if the total on the credit side is more, this excess
shows the net profit.
In respect of both incomes and expenses, the matching principle must invariably be kept
in mind. In this respect, the following two points are highlighted :
(a) Only the incomes and expenses relating to the period concerned are to be
shown. Items relating to past or future periods are excluded. This necessitates
separation of pre-paid expenses as well as expenses relating to the previous year
from expenses relating to the current year. Likewise, income received in
. advance (but due only next year) and income received in respect of previous
year (but received late and thus in this year) too are to be separated from that
.-
relating to the current year.
(b) All the expenses and incomes relating to the current year will have to be
brought into books even if settlement in cash is yet to be made. For this,
outstanding or accrued expenses on @eone hand and incomes not yet received
have to be considered and added, respectively, to expenses or'incomes already
settled in cash.
Instances of losses need some deliberation. Any loss resulting from trading operations,
and speculation in particular, must be wholly charged to the current year's P & L A/c.
Other types of losses are called accidental. Small amounts of accidental losses may be
absorbed into the year's P & L A/c. If accidental loss is heavy, only a part of it may be
charged as a loss in this year's P & L A/c and the balance may be canied forwared to be
charged off in future years.
An essental adjustment is occasionally needed and will be inevitable. Often clauses
exist in business agreements for revision of prices with retrospective effect; these may
affect prices payable for raw materials, salaries payable to staff, amounts receivable for
finished goods, etc. The current year's transactions may thereby include amounts paid or
received which should in fact be related to respective previous years. Such items should
be bifurcated and shown explicitly separately in the P & L A/c and not lumped with
current year's figures. "Arrears", "Adjustments due to pricelsalary refixation", or any
such terminology should be inserted to highlight the same. If not done so, the current
year's profit or loss (or gross income) will stand out quite differently from that of the
Construction Accounting : previous year(s) (and may be, also future years), It is to be remembered that profits
Principles and Practices should be arrived at on a comparable basis with the figures of the previous year.
Expenditure not to be shown in P & L A/c
(a) Expenses relating to the owner or partners are not to be accounted for in the
P & L A/c of the company. Being personal expenses and not business expenses,
these are transferred to the DRAWINGS A/c of the owner or partners. They
include : Life Insurance premia, Income tax, Household and personal expenses.
These should be deducted from Capital at the Liabilities side of the BS.
(b) Income tax charged from salaries of employees as "Tax Deducted at Source"
(TDS) is neither an income nor an expense. Hence, it is neither debited or
credited to the P & L A/c. This amount will be debited with the full salary
amount paid to them.
(c) All expenditure incurred in acquiring fixed assets, or improving the existing
ones by increasing their efficiency or effecting economy in operation of existing
assets, being capital expenditure, should go to the Assets side of the BS and
should not be included on the Debit side of P & L A/c.
(d) Direct Expenses : All direct expenses (are said to) add to the cost of goods
purchased or manufactured. Thus, they belong to the Debit side of the Trading
A/c. They shall not be debited to the P & L A/c.
17.7.1 Purposes and Importance of P & L A/c
Before detailing the contents of the P & L A/c, it is worthwhile to look at the purposes
and importance of P & L A/c.
The purposes of P & L A/c are as follows :
(a) Providing information about net profit.
(b) Enabling P & L A/c of successive years to be compared.
(c) Provoking for steps to be taken to imporve net profit in future through analysis
of expenses.
(d) Initiating the process of allocation of net profits among partners and for
reserves and contingencies and also for R & D programmes towards going for
new product lines and to improve present lines of business.
Through well-informed deliberations in respect of these purposes, effective control of
expenses, improving the net profit ratio, reducing the expenses ratio, optimal allocation
of the net profit towards future contigencies and reserves and R & D activities, decisions
on future lines of action, identification of weaknesses and working towards their removal
- can be attended to.
17.7.2 Contents and Preparation of P & L A/c
All nominal accounts that are to be accounted for are closed by transferring them to
P & L A/c through closing entries in the nominal accounts. These include typically on
Debits and Credits sides :
Debits
To Gross Loss brought down.
Selling and Distribution Expenses
Advertisement
Travellers' Expenses, Salaries, Commissions (for collections)
Salesmen's Expenses, Salaries and Commissions
Unproductive wages
Bad debts
Godown Rents
Export Expenses - Documents preparation inclusive
Packing charges
Carriage outward, Deumrrages, Dock Dues
Insurance
Agents' commissions
Vehicles Maintenance
Other Trade Expenses
 Management Expenses Accounting Conventions
and Final Accounts
Rents, Rates, Taxes
Office Salaries and Wages - [Managerial and assistances]
Office Establishment
Heating and Lighting
Entertainment and Hospitality
Printing and Stationery
Postage, Telegrams, Telephones, Messengers
Legal expenses
Auditing fees
Insurance
Vehicles : Maintenance and Staff
Miscellaneous and General, Sundries
Provisions
I Depreciation and Maintenance
Depreciation of machinery
Repairs and Maintenance
Special Repairs [Excluded categories not to be taken]
Operational Expenses
Financial Expenses
Interest on Capital (of categories)
Interest on Loans (of categories)
Discounts allowed
Cost of Discounting Bills
Other Bank Charges
Brokerage
Extra-ordinary Expenses
Loss by natural occurrences and fire (not covered by insurance)
Cashier embezzlement/defalcations.
- -
To Net Profit transferred to Capital A/c
' Credits
By Gross Profit brought down
Interest receipts
Discounts received
Commissions recevied
Rents recieved
Income from Investments
Dividends received on shares held
Interest received on Debentures
Provision for discount on creditors
Interest on renewal of bills
Interest from other sources
Differences in expenses (of previous years) -receipts
Training and other fees received
Miscellaneous receipts.
By Net Loss transferred to Capital Alc.

L 17.7.3 Regarding the Contents of P & L A/c

A few of the entries of the Profit and Loss Account (P & L A/c) are explained in some
detail in subsequent paragraphs.
Depreciation
Depreciation of fixed assets for the year is a very important item to be charged
against gross profit. Because of use, there is wear and tear on any asset and its
value goes on diminishing with continued use, i.e. over time. The same may
happen without being continuously used also; loss in value of asset over time is yet
a reality. Not only to ascertain the profit but also to reflect the correct financial
position, a proper amount for this reduction In value, called depreciation, should be
r a l r ~ i l n t ~(nr
d e c t i m a t ~ r l and
) treated as an exnense
Construction Accounting : Moreover, to keep the capital of the firm conserved, thefirm must accumulate
Principles and Practices enoughfunds to enable the firm to replace the fixed assets at the end of their life.
By debiting an amount (the depreciation amount) to the P & L A/c, the firm
manages to keep aside that sum of money and does not allow it to be distributed to
shareholders as dividend. The accumulated funds (through setting aside
depreciation) will enable the firm to buy a new asset when the life of the old one is
over. These considerations are summed up as under : The purpose of charging
depreciation to the P & L A/c is three-fold : namely, to ascertain the true profit,
to correctly state the financial position and to accumulate funds to replace the asset
at the end of its useful life.
The policies or the methodologies to compute depreciation and its effects on tax
liability of the firm and other details are deferred to later sections.
Interest Liabilities
Firms raise loans for improving the scope of their business. Loans can be
unsecured (though unusual), or secured. Loans can be lumpsum amounts or by
uninformly-divided parts offered to the public for their subscription. The former
approach results simply in a "loan" whereas the latter approach results in
"debentures". Debentures are usually secured, i.e. some specific asset is mortgaged
in favour of debenture holders or there may be a charge on the assets of the firm in
general. Loans and debentures must be shown in the BS along with the particulars
of the security given by or on behalf of the firm.
Interest on loan or debentures is payable at a fixed rate irrespective of profits or
losses to the firm. Interest on debentures is paid usually on half-yearly basis.
Interest on loans in paid as per terms settled between the firm and the lender.
Managerial Remuneration
Section 198 of the Companies Act prescribes the maximum limit (usually 11% of
the net profit) of remuneration payable by the firm to its Directors or its Manager.
In years when the profits are low, upto a prescribed maximum amount (generally
Rs. 50000) may be paid as total managerial remuneration, with government's
approval. More too can be paid with government's approval for whole-time
Directors and Manager.
Managerial remuneration includes rent-free accommodation (and/or any amenity in
the accommodation), any other amenity free to charge, life insurance, pension,
gratuity, etc., payable also to spouse or child as per law.
Several other Sections (e.g. 200, 309, 3 10, 349, 350) also govern managerial
remuneration. Detailed information is beyond the scope of this text.
17.7.4 Provisions
By definition, provision is any amount written off or retained by way of providing for
depreciation, renewals or diminution in value of assets or retained by way of providing
for any known liability of which the amount cannot be determined with substantial
accuracy.
Often it is known that, in respect of some expense, a payment will have to be made in
future, or that a loss will occur but the exact amount is not certain. If the amount were
known with certainty, appropriate liability could be created by debiting the concerned
expense or loss account. But since the amount is not certain and since it is only proper
(and needful) that, before ascertaining the current year's profit, the likely expenses or loss
should be taken into account, the amount is estimated (call it guesstimated if it be so) and
it is, by practice, set aside out of the current y e a ' s revenues. When the actual amount of
expense or loss is known, it can be met out of this set-aside amount (with, if need be,
plus/minus adjustments). Such an amount, by defintion, is a provision.
It is re-emphasised that Provisions are part of P & L Alc.
Depreciation
In fact, the amount of depreciation is also a provision since the exact amount of
depreciation (loss in asset value due to wear and tear and even simply because of
passage of time and the attendant inevitable exposure to weather and elements). By
such a reasoning, the amount of depreciation is, it may be argued, to be debited to
the P & L A/c and credited an account called PROVISION for DEPRECIATION
Alc, bearing the asset intact. [Such practice can be seen in the publication of
 UNAUDITED FINANCIAL RESULTS (PROVISIONAL) for period ended (date) Accounting Conventions
for wide ciculation and public information (as in Newspapers).] (But once audited) and Final Accounts
in the BS, the asset is shown at cost less amount of the provision already created
in respect of depreciation.
Other Examples of Provisions are as under
Provision for Gratuity
Gratuity is to be paid to retiring staff depending on the length of service
completed. On any date, who would in future qualify or be entitled cannot be
known as well as what would be the entitlement payable to them. Since gratuity
is to be paid for past service (at the date of retirement), the amount thereof
cannot, rightly, be debited to the P & L A/c (of that year), but the profits of.
the previous years should have been ascertained only after taking into account
the amount payable (in future) in respect of gratuity. Obviously, this
"ascertaining" can be done only "on an estimated basis", and then, the amount
is credited to "Provision for Gratuity A/c" through an equal debit to the P & L
Alc, year after year. When actual gratuity is paid, it is charged (debited to)
against the "Provision . . ." and not against the "Revenues" of the year
concerned.
If, however, insurance policy is taken up for gratu'ity eventually payable, the
premia thereof will be "expenses". This practice is gaining vogue.
Provision for Taration
For reasons of uncertain revenues, the several adjustments, deductions and
exemptions applicable while computing taxes due, and the rates (inclusive of
surcharges, etc.) applicable, the amount payable as income tax and other taxes
in respect of current year's income cannot be ascertained exactly. Hence, only
an estimate is made (can be made) in respect of taxes; the amount is debited to
the P & L A/c and credited to the "Provisions A/c7'. If there is, eventually, a
substantial difference between the amount of the provision and the acutal tax,
the difference is transferred to the P & L A/c as a separate item. This ensures
that those who study the P & L A/c can distinguish the tax payable in respect of
current year's income and the adjustment for previous years. Tax payment can
be made also by "Advance Tax" on estimated income basis; once the actual
liability is determined, advance tax paid and provision for taxation will be set
against each other.
Provision for Bad and Doubtful Debts
Possibilities come up when customers may not be in a position to pay the
amount due from them. The firm must, however, take all efforts to collect the
amounts; therefore, the amount is not usually written off till all efforts are
unsuccessful. In the process, no sooner have doubts arisen regarding the
recovery of an amount due to the firm, than it would be incumbent on the firm
to recognise the possible loss and reduce the current year's profit accordingly.
For the estimated amount of the doubtful (or bad) debt, a provision is made by
suitable credit, the P & L A/c being debited. When all efforts have failed to
recover the dues (and normally this is decided by the next year), at that time
(that year) the actual amount of bad debt is set against the provision and the
provision will again be made up to the appropriate figure by a debit to the
P&LA/c.
In the same manner, firms may, occasionally, also deal with discounts allowed
to customers.
Provision for Maintenance and Repairs
Cost of production, besides material costs and depreciation, must include OMR
costs also, i.e. operation, maintenance and repairs. Operation costs are known
through wages paid and supervising costs.
The amounts spent on maintenance repairs on assets through their life, for
letting them render the same service throughout their life, generally increases
with time. For this reason, the costs in these respects through the life are
estimated year after year and through computation of equivalence (through
Interest Factors), a uniform Annual (Equivalent) cost is ascertained. This is, by
the nature and process of the data and computations thereon, unequal to the
Construction Accounting : actual amount spent in any year. These amounts are debited to the P & L Alc
Principles and Practices and are credited to the "Provisions for Repairs Nc". In the early years, the
provisions will increase (as is evident from the above statements) but will
reduce later on. When the asset is retired, any balance in the Provisions is
transferred to P & L N c .
Purpose of Provisions
Since estimatable losses, liabilities and costs are taken into consideration in
making the provisions, it is ensured the profit is not overstated (except, if so,
marginally). Of course, the actual amounts to be incurred may be different from
the amount of the provision; in that case, the P & L Alc will have to receive a debit
or credit, which, except if it is immaterial, should be shown as a separate item in
the (relevant year's) P & L Alc.
17.7.5 Divisible Profits
Reference to public announcements (in Newspapers, for example) will indicate the order
in which the financial results of the period's operation by a firm are given. The sequence
indicates, wherever implicit, the priority among the charges on the incomes and
revenues. A typical listing will be in the order as indicated (admitting for minor
variations).
(a) Sales and Other Revenues (including Profits/Revenues from sale of
Manufacturing Units)
(b) Other Income
(c) Total (Income) = (a) + (b)
(d) Total Expenditure (Before Amortisation, Interest and Depreciation)
(e) Gross Profit before Amortisation, Interest and Depreciation = (c) - (d)
(f) Amortisation of Deferred Revenue Expenditure
(g) Gross Profit Before Interest and Financing Charges, Depreciation and
Taxation = (e) - (f).
[Also called Operating Profit] [PBIDT]
(h) Interest and Financing charges (Net)
(i) Gross Profit/Loss after Interest but before Depreciation and
Taxation = (g) - (h)
Cj) Depreciation (Net)
(k) Profit before Tax = (i) - Cj) = (PBT)
(1) Provision for Taxes
(m) Net Profit after Tax = (k) - (1) = (PAT)
(n) Reserves excluding Revaluation Reserves
(0) Revaluation Reserves
(p) PAT less Reserves = (m) - [(n) + (o)]
(q) (Paid-up) Equity Share Capital.
[(o) and (p) may be omitted; in that case, (n) and (q) may be interchanged.]
The part of the profit available to shareholders is called divisible profits. [Note that it is
called "divisible" implying that the whole of this need not be divided.] Strictly, legally,
dividends should be declared, unless there are compelling reasons otherwise, only if
profits remain after meeting all expenses [SI. (d)], and [Sl. (f)], also [Sl. (h)], depreciation
on fixed as well as fluctuating assets [Sl. (j)], taxation [Sl. (I)], writing off past losses
[not indicated - to be between S1. (m) and (n)] and after transfening a reasonable amount
to reserves [Sls. (n) and (o)]. Profits of extra-ordinary nature, that is non-recurring profits
arising from sale of fixed assets or redemption of long-term liabilities [indicated within
brackets in S1. (a)], should not be distributed as dividend. The amount so derived, as will
be seen at S1. (p) (subject to the statement in the previous sentence) divided by the
number of ordinary shares implied in S1. (q) will be the maximum dividend payable
(Earnings) per share (EPS). In this connection, prudence demands assets should not be
revalued, at least not for the purpose of declaring a dividend though S1. (0) should be
provided for as indicated hereinabove.
 Dividends cannot be declared except out of profit. If a company declares and pays Accounting Conventions
a dividend when without profits, the Directors will have to reimburse the amount and Final Accounts
to the company from their own sources.
It is re-emphasised that Dividends (Proposed) are part of contents of P & L N c .
The large body of legal provisions in the matter of dividends is beyond the scope
of this text.
Reserves
The term "Reserve" indicates a portion of profit (not when a loss is realised) set
aside for any particular purpose. Thus, reserves reduce the divisible profits
available for distribution as dividends. Whereas reserves are undistributed profit,
provision, on the other hand, is an estimated expense or loss which must be taken
into consideration before profit is ascertained. If the amount put to a provision is
in excess of requirement, the excess will be treated as reserve. In the terminology
in USA, "reserves" are called "Retained Earnings". More discussions on
"reserves" are deferred to a later section.
It is re-emphasised that providing for Reserves is part of contents of P & L Alc.
Charges against Profits and Appropriation of Profits
The term "charges" has been used in Section 17.7.5. Items of expenses or losses
that must be considered before profit is ascertained are called "charges against
profit".
.
After ascertaining profits, the question of their distribution arises. This is called
"appropriation of profits". The prominent items of appropriation are provision [a
misuse of this term in the context of "Reserves" (discussed above), but quite in
vogue irrespectively] for payment of dividends to shareholders and transfers to
reserves. The section of the P & L Alc showing the appropriation is called P& L
Appropriate A/c (again, the use of the words "and Loss" is well inappropriate), or
just "Below the Line".

17.8 P & L A/c (IN COMMON PARLANCE)

Notwithstanding the separate discussions on them, it is a practice to show the Trading Alc
(along with the Manufacturing Alc wherever appropriate), the Profit and Loss Alc and the
Profit and Loss Appropriation Alc together as "Profit and Loss Account", the justification
being their being inter-related and almost one feeding to the next.

SAQ 6
(a) What are financial expenses ?
(b) Which types of expenses or revenue do not belong to P & L N c ?
I

(c) What is a "provision" ? What are the provisions made in a P & L N c ? How are
they reflected, if at all, "below the line" ?

17.9 EXPLANATION ON CERTAIN ITEMS IN

BALANCE SHEET
What is a BS and how it differs from Trial Balance as well as from P & L N c have been
discussed earlier in Section 17.2.1 and in the tables thereunder, However, even on the cost
of slight repetition, the definitions of Balance Sheet go as follows :
(a) Freeman : An itemised list of the assets, liabilities and proprietorship of a
business or an individual at a certain date.
(b) American Institute of Certified Public Accountants (AICPA) : A list of balances
in the assets and liabilities accounts - of a specific business at a specific point
of time.
Constru.ctionAccounting : (c) Palmer : Statement at a given date showing, on one side, the firm's (trader's)
Princigles and Practices property and, on the other side, possessions and liabilities. (Note the distinction
between "property" and "possessions".)
Following on this, certain important items in BS are discuhed here besides its format
(sequence of contents).

17.9.1 Reserves :Classifications

If the amount of Reserve is invested in the business itself, it will be simply called
"Reserve", but if invested in outside securities and such securities are appropriated
(devoted to a specified purpose) for the reserve, it is called "Reserve Fupd".
Reserves may be "general" or "specific". General reserve is meant for the purpose of
strengthening the financial position of the company so as to enable it to meet any
contingency that may arise. Specific reserves (note the word used in plural) are meant for
specific purposes. One important purpose is Dividend Equalisation. Dividend
Equalisation Reserve helps to so manage that the dividends that the company may pay in
future are as far as possible uniform. In years of low profits, this Reserve can allow
maintaining the dividend at the desired level.
Reserve may be Revenue Reserve or Capital Reserve. Capital Reserves shall not include
any amount regarded as freely utilisable for distribution through the P & L A/c; any other
reserve amount is Revenue Reserve. However, mutual reallocation is possible. On the
occurrence of certain events, profits which were previously treated as Capital Reserve
may become available for dividend payments; they will thereafter be Revenue Reserve.
Following three such eventualities are prominently recognised :
(a) Debenture Redemption Reserve is built up of Revenue profits for the purpose of
collecting funds for the redemption of debentures or repayment of any other
fixed liability. On completing the redemption, the balance can be used for
dividend payments. Any further balance will be converted to Capital Reserve or
General Reserve.
(b) Plant Replacement Reserve is meant to come in handy for the indicated
purpose. Amount of depreciation based on cost for the current asset may not
meet the price to be paid to replace the asset on the expiry of its life. This
Reserve, together with the amounts under depreciation pooling, is intended to
effect the replacement at the proper time. Once the replacement is effected, any
balance will be converted to Capital Reserve or General Reserve.
(c) Development Rebate Reserve is governed by elaborate set of legal conditions
and is, as permitted under such conditions, available for new acquisition of
productive assets, setting up plants and industries in designated areas (for the
industrial growth of such areas), and so on. (Investment Allowance is another
legally governed opportunity for the same purposes. This is managed by
debiting the P & L A/c and crediting an "Investment Allowance Reserve
Account".)
The Reserves discussed under generalhpecific classification and RevenueICapital
classification above do not affect the Share Capital (discussed further on). In a different
category of Reserve, the amount transferred from profits into it are never (to be) available
for dividends. Companies issue what are called Redeemable Preference Shares. When the
company eventually carries out the Redemption of these shares out of profits, they have
to do so by transfer of an amount equal to the face value of the shares (to be) so redeemed
from out of their P & L A/c or general reserve into an account designated as "Capital
Redemption Reserve Account". This can be utilised only for the issue of fully-paid bonus
shares. For any other use, Court sanctions have to be obtained; such reductions in this
Account will be treated as reduction in Share Capital.

17.9.2 Capital Profits

Vide discussions under "Reserves" under Section 17.7.5, and also 17.9.1, the capital
reserves discussed therein are created out of ordinary or revenue profits. There is
another aspect of profits called Capital Profits and they cannot be utilised for declaration
of dividend. Capital Profits are extra-ordinary profits. The following pertain here :
( a ) Excess of Sale Proceeds of a Fixed Asset over its Book Value
If a fixed asset is sold, with the sale proceeds being less than its book value
(BKV) (which is cost less depreciation write off), the loss must be written off to
 the P & L A/c (thereby reducing the profit in the period by this debited loss, Accountiog Conventions
resulting in savings in tax otherwise payable). If the sale proceeds exceed the and Final Accounts
BKV, but less than the original cost, the profit is treated as a Revenue Profit
(i.e. as recoupment of depreciation) and has to be credited to the P & L A/c;
nominal rates of tax will have to be paid on this profit. The excess of sale
proceeds over the original cost only is treated as capital profit (or gain) on
which capital gains tax must be paid.
(b) Profits arising from Revaluation of Fixed Assets
(These are not by sale as in (a) but by revaluation.) (For this reason,) these are
merely book (or national) profits and not realised (in cash) profits and, as such,
are not available for dividend.
(c) Profit on Redemption of Debenture or Other Long-term Liabilities
If debentures sell in the market below their nominal value and the comapany
has gone in to purchase those debentures and cancel them, the resulting profit
will be a capital profit.
( d ) Profits Prior to Incorporation
. When a company acquires an ongoing (or running) business but the
incorporation of the company is delayed thereafter, any profit in the intervening
period, as may belong to the company, is treated as profit prior to incorporation
and will not be available for dividend.
(e) Premium Received on Issue of Debentures
When the issue price of debentures is more than the face value, the difference,
called PREMIUM, is treated as Capital Profit.
(f) Profit Remaining after Re-issue of F o ~ e i t e dShares
This is explained under S1. No. (e), namely "Forfeiture of Shares" under
Section 17.9.4 later.
Note :Capital Profits can be available for dividend if
(a) the profit is realised in cash (note that (b) is eliminated),
I (b) the profit has remained after fair re-evaluation of all assets AND liabilities,
and
(c) the Articks of the Company have permitted so.
Share Premium
Premium received on issue of shares, i.e. excess amount collected over and above
capital called for from the shareholders, called Share Premium, has to be credited
I to a "Share Premium A/c". It cannot be used for distribution as dividend. It can be
used, being Capital Profit, only for :
(a) issuing fully-paid bonus shares to shareholders [i.e. returning to the
(subscribing) shareholders];
(b) writing off preliminary expenses of the company (which are
contemporary to the inflow of this premium);
(c) writing off expenses incurred, commission paid or discount allowed on any
issue of shares or debentures of the company (i.e. for outgoes in
corresponding/comparabletransactions);and
(d) providing for the premium payable on the redemption of any redeemable
preference shares or debentures of the company [i.e. as in (c)].
Sanction of Court of Law would be needed for any other use.
17.9.3 Marshalling of Assets and Liabilities
Marshalling refers to arranging in due order. There are two mutually exactly opposite
sequencing orders that are possible. They are as follows :
(a) In Order of Liquidity : Assets are listed in decreasing order of convertibility into
cash, the most liquid, viz, cash in hand, being listed first and perhaps, goodwill,
last. Liabilities will be shown in the order in which they are payable, the most
pressing liability being listed first. Accordingly, Bills payable may be listed first
and Ca~itallast.
Construction Accounting (b) In Order of Permanence : This is just the reverse of the previous one. As for
Principles and Practices adopting the order, Sole Traders and Partnership F i m s prefer the order of
liquidity and Joint Stock Companies prefer the order of permanence.
Major component entries, as generally recognised and often occurring, are now listed by
order of permanence - though slight re-ordering, depending on the individual company,
its finanical advisors and auditors, may be seen in certain instances.

ASSETS
Fixed Assets
Land, Buildings, Freehold Premises, Plants, Machinery, Tools, Furniture,
Livestock, Railway Sidings, etc.
Less
Depreciation : (If in respect of each of the above, to be given for each; or
accumulated basis).
Goodwill, Patents, T e c ~ ,ical Services and Consultations rendered.
Investments (at cost)
[To be listed.]
Current Assets
Interests Receivable
Inventory (or Stores)/(Closing) StocWStock-in-Trade (or) Work-in-Progress1
Finished Goods, etc.
Sundrymrade Debtors and Account/Bills Receivable
Cash in hand and in Bank Balance
Marketable Securities
Pre-paid (or Unexpired) Expenses, Pre-payments, Loans, Advances, Deposits,
etc. (given out) - including Tax-pre-payments and Tax-deducted at source.
Less
Current Liabilities and Provisions and Bills Payable (If not given under
Liabilities)
Other Assets
Other Long-Tern Investments
Unexpired Insurance
Accrued Income
Unamortised discounts on debentures
Equity Shares in, and Loans to Subsidiary Companies
Rights owned, e.g. Mining, etc.
Subsidises received.
(Others)

LIABILITIES (and CAPITAL or OWNERS' EQUITY)

Share Capital
Equity
(with further details as appropriate)
Preference
Reserves and Surpluses (Retained Earnings)
Contingent Liabilities
[To be listed.]
Others
Long-term LoansIDebt - Secured, Unsecured, and Deposits (received)
Debentures and Premiums thereon
 Mortgages Accounting Conventions
and Final Accounts
Deferred Payment Credits
Bad Debts and Doubtful A/c
Current Liabilities and Provisions
Accrued Expenses
Accrued Interest
Accumulated Depreciation, (if not shown under Assets)
Bills Payable (Notes and Accounts)
Sundry CreditorsITrade Creditors
For goodslpurchases
For expenses
For outstanding wageslsalaries
Customers' advances
Unclaimed Dividends
Provision for Dividend
Provision for Taxation and Accrued Taxes, Income Tax, Social Security Tax,
etc.
Provision for Gratuity
~rovisionsunder dispute (or arrears) : Municipal Taxes, Electricity Tariff, etc.
Bank Overdraft
(Others)
[It is for information that : Wages Alc, or Salaries Alc, is a nominal account and should
accordingly be charged to the P & L Alc, while outstanding Wages (or Salaries) Account
is a personal account - to the person to whom the Wages (or Salaries) have to be paid -
and hence is shown in the BS on the Liabilities side.]

17.9.4 More Items in BS Explained

Liabilities are first explained.
Share Capital
A number of terms relating to Share Capital [more than just the two shown in
"Listing of Liabilities (and Capital)" under Section 17.9.3 ] are employed. These
are discussed in subsequent paragraphs.
(a) Authorised Capital : It is called also as NOMINAL CAPITAL and is the
total amount which a company can have as capital - as mentioned in the
Memorandum of Association though the figure can be changed later.
Usually, the figure is divided into preference and equity (ordinary) shares.
This is the possible capital which can be raised at sometime or the other.
(b) Issued Capital : This is the face value of the shares allotted by a company
for cash and for consideration other than cash. Customarily, the value of all
shares for which approval has been obtained from the Controller of Capital
Issues, though all the shares are not actually allotted.
Both (a) and (b) are shown at the face, or the nominal, value of the shares,
e.g. if the capital is Rs. 7 crores and is divided into 70,000 shares, then the
face value of each share is Rs. 1000. If an individual acquires 40 shares, he
is said have subscribed to a capital of Rs. 40,000.
(c) Subscribed Capital : This is the amount of shares actually taken up by the
public or other shareholders. If the whole of (b) is taken up, then (b) and
(c) are equal and (b) is fully subscribed. (c) cannot exceed (b).
(d) Paid-up Capital : Normally, a company asks the shareholders to pay the
amount due on the shares by instalments. The first instalment is payable
along with the application for shares - called application money - and is
not less than 5% of the face value, as determined by the Directors. In the
ConstructionAccounting : above case, for the forty shares, the applicant will pay application money
Principles and Practices of not less than (40 x 1000 x 5%) = Rs. 2000. Another instalment is
usually payable on the shares being allotted to the applicants -known as
allotment money. Together, both these instalments may, oftentimes, cover
only a part of the face value of the shares, and, in such instances, the
Directors will determine when to ask for the remaining amount. When they
do so, they are said to have made a call. Ordinarily, a call cannot be for
more than 25% of the face value of the shares and there must be at least a
month's time between two calls. If the Directors have not called up the full
amount, the full face value of the subscribed capital will nor actually be
received. Together all the instalments paid by the subscriber is the
called-up amount. It is also possible that some of the shareholders have
not yet paid one or the other calls. The amount concerned is called "call in
arrears". This amount is deducted from the called-up amount and the
balance is "paid-up capital". The BS should clearly show the arrears from
Directors separately - to forestall frauds.
(e) Forfeiture of Shares : Subject to provisons having been made in the
Articles (of the Company), Directors may vote to forfeit shares on which a
shareholder has failed to pay the call made on him - after having given a
clear 14 days' notice to the defaulting shareholders to pay up the amount
due from them, if necessary, with interest as laid down in the Articles. This
means that such shares will thenceforth stand "cancelled" and the amount
already paid by such shareholders will stand forfeited to the Company.
The Directors may vote to re-issue the forfeited shares subject to the
condition that the total amount received on such shares, namely, amount
paid by the original shareholders and that paid by the new shareholders, is
not less than the face value of these shares. Put otherwise, discount
allowable to the new shareholder cannot exceed.the amount previously
paid by the defaulting shareholders. If, however, the discount allowed to
the new shareholder is less than the amount already received, the Company
makes a Capital Profit which is to be transferred to Capital Reserve.
( f ) Bonus Shares : When a Company accumulates profits, it may like to utilise
part of the accumulated profits to increase its equity base (as this facilitates
more loans to be gone for, thereby, again, increasing the business potential
of the firm). This is done by issuing Bonus Shares to equity shareholders
without payment - i.e. the shareholders are not required to pay anything
and they are given additional shares. Bonus shares can be issued only out
of free profits (by cutting down on dividends) or out of share premium
received in cash. If a share has been only partly paid, a company may
decide to make it fully paid -which means that the shareholders will not
be required to pay the balance of the amount; for this purpose, only the
revenue profits can be used. In the BS, the number of bonus shares
issued has to be disclosed through a note indicating the source from
which the bonus shares have been issued.
Classes of Shares
Under the Companies Act of 1956, the shares of a public company are of two
types : (i) preference, and (ii) ordinary or equity. Preference shares carry the
following two preferential rights as against the other shareholders :
(a) referential right to receive a dividend at a fixed rate before any
dividend is paid to the other shareholders; and
(b) A right to receive back the captial amount (of these shares) when the
Company is wound up before the capital contributed by the other
shareholders is refunded.
Note : That if only one of the rights is given, such share will not be a preference
share. Also it is to be noted that it is not compulsory for a Company to pay
dividend on preference shares; it is only the precedence to receive dividend
before the ordinary shareholdeis are paid. The Articles of the Company may grant
additional rights to preference shareholders. Accordingly, preference shares can be
of the following types : (i) Cumulative, (ii) Non-cumulative, (iii) Participating, and
(iv) Redeemable.
 (a) Cumulative Preference Shares : If, in any year, the preference dividend cannot Accounting Conventions
be paid, the arrears will be payable whenever the company earns a profit and and Final Accounts
the Directors choose to declare the preference dividend. If nothing is stated, it is
implied as the cumulative preference share.
(b) Non-cumulative Preference Shares : If, in any year, the dividend cannot be
paid, these preference shareholders will have no right to claim the arrears.
These shareholders can receive a dividend only for the current year and that too
only if the company chooses to pay the dividend, but they will receive the
dividend before the ordinary shareholders can.
(c) Participating Preference Shares : In addition to the fixed rates of dividend
payable on preference shares, the rate of equity dividend is also fixed (at, the
time of issue of these shares). Over and above this, these performance
shareholders have a right to share out of the remaining profit - the procedure
being that, if the equity dividend exceeds a certain figure, then, a certain
proportion of the excess shall have to be paid as additional preference dividend
for these shares. An alternative type of these shares may, instead, have the right
that, when the Company is wound up, if there is a surplus after repayment of all
the capital of the Company, these perference shareholders also have a share in
the surplus.
(d) Redeemable Preference Shares : Generally, sanction of the Courts of Law is
needed for any share capital to be repaid in cases other than winding up of the
Company. But, for redeemable preference shares, which ought to have been so
declared at the time of issue, the money can be returned to the investor
shareholders on or after a certain date (also to have been mentioned at the time
of issue), the important condition being that the shares must have been fully
paid. The redemption can be carried out only out of the proceeds of a new issue
of shares for this specific purpose, or out of profits. Moreover, a sum equal to
the face value of the shares so redeemed must be transferred to "Capital
Redemption Reserve Alc". This account can be used only for the issue of fully
paid bonus shares; for any other purpose, there has to be sanction of the Court
of Law. Yet another important aspect in respect of these shares is : If, at the
time of redemption, any premium is payable to these shareholders (the premium
being the excess of the amount returnable to these shareholders over the face
value of the shares), the premium must be paid either out of profits, or out of
share premium, i.e. extra amount collected on the issue of shares, or out of both.
It is important to note that as per Sachar Committee recommendations, all
preference shares should be cumulative and redeemable within twelve years.
Other Items of Liabilities :A Classification
Under Section 17.9.3, under the listing of Liabilities, Shares, as also Reserves and
Surpluses were listed first. These constitute the CORE LIABILITIES of the
Company. In fact, it is on the assurance that these items may induce in members of
the society, including legally constituted organisations, would they venture to
contribute to the finances and functioning of, and for business support for, the
Company, implied in, or giving rise to, the further listed items of Liabilities.
Accordingly, these CORE liabilities are called FIXED LIABILITIES.
There will be other Liabilities also - BORROWINGS from financial institutions
and banks and by issue of debentures. These may be secured by the Assets of the
Company. The nature of the security must be disclosed in the BS. There may be
unsecured loans obtained from outsiders but mainly from Directors and employees.
Any interest accrued and due on loans should be added to the loan amount.
Borrowing other than from financial institutions, banks, debentures, Directors,
and employees, constitute DEPOSITS. Companies are, since 1974, under the
Companies (Acceptance of Deposits) Rules, restricted from accepting deposits
beyond prescribed percentage.
All Liabilities repayable in the normal course of business are "CURRENT
LIABILITIES". These include : Creditors for purchases, expenses, bills payable,
etc. "~anv'verdraft", though a current liability, is often shown separately to
highlight its incidence.
All provisions created shall have to be shown under the head "PROVISIONS"
except provisions for any loss in assets - e.g. depreciation and bad debts - these
Construction Accounting :
Principles and Practices
loss items may be shown under LIABILITIES or as deductions from the relevant
asset value on the ASSETS side.
Liabilities, which are not liabilities at the moment, but maylwill become a liability
on the occurrence or happening of a certain event, are called "CONTINGENT
LIABILITIES". The payments made out therefor will generally be accompained
by acquisition of a corresponding asset. Examples are :Instalments or final
payment for purchase of office buildings and houses for employees; amounts to be
paid in respect of partly paid shares on a call being made; payment to be made for
having stood as surety when the original party has become insolvent; bills
discounted before maturity; cases pending Courts of Law (like disputed amounts in
Taxes); guarantees undertaken, etc. [Note : Acquisition of asset does not happen
in certain of these examples.]
Items of Assets : Classification
1
Like Liabilities, Assets too are arranged or listed, in recognised order, usually the
order of permanence (in the case of joint stock companies).
FIXED ASSETS are those which are acquired and intended to be retained
permanently for the purpose of carrying on a business. Land, Building, Machinery,
Plants, Tools, Furniture, Livestock, etc., being of (relatively) long life (to be with
the organisation), they are also called LONG-LIFE assets or CAPITAL ASSETS
also, sometimes, called as "BLOCK CAPITAL". Fixed assets are shown at full
cost less depreciation written off. Additions to fixed assets, during the year, are
shown separately.
INVESTMENTS : (In a sense, addition to fixed assets may also be considered an
investment, except for the relatively long life to be with the organisation.)
Investments are duly classified and shown at cost price. [These are not to be,
generally, depreciated.] [These are supposed to be easily convertible to cash -but
should not be confused with Inventories - which are meant for the business.] If the
market price is, at any time as the BS date refers, less than the cost price, the same
should be mentioned by way of information. It is necessary to disclose the method
of valuation of inventories. Long-term investments are preferably to be shown
separately.
CURRENTASSETS indicate those assets through which the business operations
continue day to day. They are closely related to profits. One of the important
constituents of current assets is INVENTORIES. It must be realised that valuation
of inventories impacts on profits. Hence, it is necessary to disclose the method of
valuation of inventories.

I
Any loans, advances, pre-payments made, etc. also belong to the category of assets
- in as much as they have been paid out and are either receivable back or are to be
set against arisinglarisen liabililies.
LIQUID ASSETS are those which are represented by cash or can easily be
converted to money - e.g. Cash in hand, Cash at bank, Bills receivable, marketable
securities, etc. and also certain short-term investmentsldeposits made out.
WASTING ASSETS are generally given at the end except when of primary concern
to the business of the firm. These are assets that getfare consumed through being
worked, e.g. Mines. The term is also used to denote such assets as are liable to
depreciate (or terminate) on account of their use in business (or just in course of
-
time) e.'g. copyright, leasehold land, etc.
FLOATING ASSETS : These are assets acquired either for purpose of resale or held I
temporarily in the course of a business for their subsequent conversion into money.
These are typically - Stock-in-hand, Book Debts, etc.
As mentioned earlier, the division between fixed and floating assets is not
permanent. A fixed asset for one business can be floating asset for another - e.g.
the case of furniture as earlier mentioned - it depends on the nature of the business.
FICTITIOUS ASSETS are not represented by any tangible possession or property :
like preliminary expenses, prepaid expenses, infructuous expenditure, etc. They
may also be recognised incidental losses - like loss on issue of sharesldebentures,
expenses on the formation of the Company, etc. They are not at all assets but are
shown on the assets side just to balance the assets with the liabilities -
registered only for technical reasons.
 INTANGIBLE ASSETS are assets which cannot be seen, touched or felt; e.g. Accounting Conventions
goodwill. and F i a l Accounts
-
SAQ 7
(a) How are Assets and Liabilities classified ? Explain in detail, with examples.
(b) How are shares classified ? What are the distinctions between them ?
(c) How is Paid up Capital collected ?
(d) What are the occasions of issue of bonus shares ? What are the advantages for
the company by such issues ? What are the advantages and disadvantages for
the shareholders by such issues ?
(e) How is the amount of forfeited shares handled ?

17.10 SOME GENERAL INFORMATION

Balance Sheet can be prepared in the horizontal format where Assets and Liabilities are
shown on the left and right sides, respectively, or in the vertical format, where all details
are listed one below the other. No specific advantage can be claimed for any method.
It is also customary to give comparative figures for at least one previous date in all BS.
This helps the user to come to his own judgements.
Sometimes, even long-term liabilities are counted as current liabilities provided its
payment is to be made from current assets. If the current assets are almost double of
current liabilities, the financial position of the business concern is supposed to be good.
Preference shares, loans, deposits, etc. are sometimes called fixed-return capital - since
the dividend or interest payable on them is fixed (whereas dividend rate can vary).
- The difference between current assets and current liabilities is taken as one definition of
WORKING CAPITAL. In case, it is not sufficient, the day-to-day working will become
difficult for the business.
The details out of which the condensed statements in the BS are arrived at are to be given
in SCHEDULES to be attached and should be referred to in the BS.
The BS should be duly audited by approved AUDITORS who should also signify their
satisfaction and also bring out all of the most important points for public information.
BS and P & L A/c of subsidiary companies, if any, should also be appended to the prime
(or holding) company's BS.

17.11 SUMMARY
Materiality in disclosure, consistency and procedure are essential conventions in
summarising and reporting the accounts of any organisation. Summarising and reporting
are achieved through the stages of Trial Balance, Manufacturing A/c, Trading N c ,
P & L A/c and BS. All these are complementary to each other and must be taken as a
single cogent piece of information - though Manufacturing A/c and Trading N c may not
be made available to the public. These financial statements must have to be read with
necessary descriptive reports conforming to, and confirming, the conventions. Valuation
of closing stock and also the several provisions are important aspects of the financial
statements. The nature and classificated of components of Liabilities and Assets, as fully
explained, must be appreciated. Valuation of closing stock and provision for depreciation
are to be studied in the next unit.

17.12 ANSWERS TO SAQs

Refer the relevant preceding text in the unit or other useful books on the topics listed in
the section "Further Reading" given at the end of the block to get the answers of the
self-assessment questions.