Financial Accounting - Quick Guide

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Financial Accounting - Rectification of Errors

Financial accounting deals with recording and maintaining every monetary transaction of an organization. However, sometimes, a few entries might be either incorrect or used at the wrong place. In financial accounting, the process of correcting such mistakes is known as Rectification of Errors.

Types of Errors

Two most common types of errors, which are usually occurred at the time of preparation of Financial Statements are discussed below.

Error which Effect only One Account

• Omission of posting of balance in a Trial Balance.
• Error of carried forward of balance.
• Error of casting and posting.

Error which Effect Two or more Accounts

The nature of errors, which occur during the preparation of Financial Statements are −

• Error of posting in wrong account.
• Error of principle.
• Error of omission.

Methods of Rectification of Errors

There are three types of methods used in rectification of Errors −

Replacing Correct Figure by Striking Off the Wrong Figure

For example, cash payment of Rs. 989 on the account of stationery purchased written as Rs. 998, will be corrected as −

Cash Book

By Stationery A/c

998 989

Through Journal Entry

Normally, there are three types of errors, which can be rectified by passing Journal Entries −

• Short credited or debit in one account and excess debit or credit in another account. For example, purchase of stationery for Rs. 989 wrongly debited to purchase of raw material account will be corrected as follows −

Journal Entry

Stationery AccountDr. To Purchase Account (Being Cash purchase of stationery wrongly debited to Purchase account, now rectified)

989

989

• If, by mistake one account is debited as well as credited with wrong amount simultaneously. For example, Cash purchase of stationery of Rs. 989 booked with an amount of Rs. 489 will be corrected as follows −

Journal Entry

Stationery AccountDr. To Purchase Account (Being purchase of stationery for Rs. 989 wrongly written as Rs. 489 now rectified)

500

500

• If there is an omission of recording a transaction, it can be rectified by passing journal entry to book that omitted transaction. For example, omission of recording transaction of purchase of raw material for Rs. 5000 from Mr. X will be recorded and corrected by passing the following journal Entry −

Journal Entry

Stationery AccountDr. To X Account (Being omitted entry of purchase of Rs. 5000 from Mr. X now recorded and rectified)

5000

5000

If there is a Mistake that Effects Trial Balance

• Before closing the books and transferring the difference in suspense account and

• After the agreed difference is transferred into the suspense account, following accounting treatment will be done −

  • Earlier entry debited or credited with fewer amount will be rectified by repeating that entry with difference amount to complete that amount. For example, entry done with Rs. 500 instead of Rs. 5000 will be rectified by doing same entry with an amount of Rs. 4500. In case, where entry wrongly debited or credited to other account may be rectified by doing reversal of old entry to nullify earlier effect.

If expense booked with less amount entry then −

Particular Expense Account To Cash/Personal Account (Being wrong amount of posting, rectified with Difference amount Rs. 4,500 (5000-500)

Dr

4,500 4,500

If income is booked with less amount, it will be rectified as −

Cash/Personal account To Income Account (Being wrong amount of posting now Rectified. 4500 (5000-500)

Dr

4,500 4,500

If posting done in wrong account that will be rectified as follows −

Stationery AccountDr.** To Office Expenses Account** (Being wrongly debited earlier in office account, now Rectified and posted in stationery account)

In case (ii) where difference has already been transferred to suspense account, further amount will be debited or credited to respective account and correspondingly suspense account will be debited or credited. Thus, these entries would reduce/nil the balance of suspense account.

Effect of Errors on Agreement of Trial Balance

The errors by which there is no change on both side of trial balance or wrong effect on trial balance with same amount will not lead to effect on agreement of Trial Balance. Errors of omission, error of posting with wrong amount on both side, or Error of principles are the example of such errors. To find out such errors is a challenging job for any book keeper or an accountant.

Effects of Errors on Financial Statements

Effect of error depends on the nature of effected accounts. If errors relate to nominal account, it will either increase or reduce the profit and rectification will reduce excess profit or Loss. Effect of error on Trading and Profit account ultimately effect the Balance-Sheet of a company too, because reduced profit or excess profit ultimately transferred to capital account, which is a part of the Balance Sheet.

There are some errors, which effect Trading or Profit and Loss account and Balance sheet simultaneously, like entry of depreciation will affect profit as well as value of the Fixed Assets.

Some entry may effect on Balance sheet only like, for instance omission of entry of cash paid to purchase fixed assets will affect Balance Sheet of a firm only.

Rectification of Errors after Preparation of Final Accounts

To remain unaffected Profit or Loss of the current financial year, the errors, which took place in last financial years are adjusted and rotated through a Profit & Loss adjustment account. Balance of this account directly transferred to capital account of firm without affecting the current year profit or loss.

Financial Accounting - Capital and Revenue

One of the major aspects of preparing a correct financial statement is to distinguish revenue and capital in regard to revenue income, revenue expenditure, revenue payments, revenue profits, and revenue losses of the company with capital income, capital receipts, capital profit, or capital losses.

In fact, without differentiating, we cannot think of correctness of a financial statement. Ultimately, it will mislead the end results where no one can conclude anything. As per this principle, a revenue item should be recorded in the Trading and Profit & Loss account and a capital item should be recorded in the Balance-Sheet of respective firm.

Capital Expenditure

Capital expenditure is the expenditure incurred to acquire fixed assets, capital leases, office equipment, computer equipment, software development, purchase of tangible and intangible assets, and such kind of any value addition in business with the purpose to enhance the income. However, to decide nature of the capital expenditure, we need to pay attention on −

• The expenditure, which benefit cannot be consumed or utilized in the same accounting period, should be treated as capital expenditure.

• Expenditure incurred to acquire Fixed Assets for the company.

• Expenditure incurred to acquire fixed assets, erection and installation charges, transportation of assets charges, and travelling expenses directly relates to the purchase fixed assets, are covered under capital expenditure.

• Capital addition to any fixed assets, which increases the life or efficiency of those assets for example, an addition to building.

Revenue Expenditure

Revenue expenditure is the expenditure incurred on the fixed assets for the ‘maintenance’ instead of increasing the earning capacity of the assets. Examples of some of the important revenue expenditures are as follows −

• Wages/Salary

• Freight inward & outward

• Administrative Expenditure

• Selling and distribution Expenditure

• Assets purchased for resale purpose

• Repairs and renewal expenditure which are necessary to keep Fixed Assets in good running and efficient conditions

Revenue Expenditure Treated as Capital Expenditure

Following are the list of important revenue expenditures, but under certain circumstances, they are treated as a capital expenditure −

• Raw Material and Consumables − If those are used in making any fixed assets.

• Cartage and Freight − If those are incurred to bring Fixed Assets.

• Repairs & Renewals − If incurred to enhance life of the assets or efficiency of the assets.

• Preliminary Expenditures − Expenditure incurred during the formation of a business should be treated as capital expenditure.

• Interest on Capital − If paid for the construction work before the commencement of production or business.

• Development Expenditure − In some businesses, long period of development and heavy amount of investment are required before starting the production especially in a Tea or Rubber plantation. Usually, these expenditure should be treated as the capital expenditure.

• Wages − If paid to build up assets or for the erection and installation of Plant and Machinery.

Deferred Revenue Expenditure

Some non-recurring and special nature of expenditure for which heavy amount incurred and benefit for the same will spread in up-coming years, to be treated as capital expenditure and will be shown as the assets of the firm. Part of the expenditure should be debited to Profit & Loss account every year. For example, if heavy amount paid for the advertisement of a product, which benefits are expected to be received in next four years, then it should be debited as ¼ of the part in Profit & Loss account as the revenue expenses and balance ¾ will be shown as the assets in the Balance-Sheet.

Capital and Revenue Profit

The premium received on issue of shares, and the profit on sale of fixed assets are the major examples of capital profit and should not be treated as revenue profit. Capital profit should be transferred to the capital reserve account, which is used to set off capital losses in future if any.

Capital and Revenue Receipts

Sale of fixed assets, capital employed or invested, and loans are the example of capital receipts. On the other hand, sale of stock, commission received, and interest on investment received are the main examples of revenue receipts. Revenue receipts will be credited to the profit and loss account and on the other hand, capital receipts will affect the Balance-sheet.

Capital and Revenue Losses

Discount on issue of shares and losses on sale of fixed assets are the capital loss and would be set off against the capital profits only. Revenue losses on normal business activity are part of the profit and loss account.

Financial Accounting - Final Accounts

Final Accounts are the accounts, which are prepared at the end of a fiscal year. It gives a precise idea of the financial position of the business/organization to the owners, management, or other interested parties. Financial statements are primarily recorded in a journal; then transferred to a ledger; and thereafter, the final account is prepared (as shown in the illustration).

Usually, a final account includes the following components −

• Trading Account
• Manufacturing Account
• Profit and Loss Account
• Balance Sheet

Now, let us discuss each of them in detail −

Trading Account

Trading accounts represents the Gross Profit/Gross Loss of the concern out of sale and purchase for the particular accounting period.

Study of Debit side of Trading Account

• Opening Stock − Unsold closing stock of the last financial year is appeared in debit side of the Trading Account as “To Opening Stock“ of the current financial year.

• Purchases − Total purchases (net of purchase return) including cash purchase and credit purchase of traded goods during the current financial year appeared as “To Purchases” in the debit side of Trading Account.

• Direct Expenses − Expenses incurred to bring traded goods at business premises/warehouse called direct expenses. Freight charges, cartage or carriage charges, custom and import duty in case of import, gas, electricity fuel, water, packing material, wages, and any other expenses incurred in this regards comes under the debit side of Trading Account and appeared as “To Particular Name of the Expenses”.

• Sales Account − Total Sale of the traded goods including cash and credit sales will appear at outer column of the credit side of Trading Account as “By Sales.” Sales should be on net releasable value excluding Central Sales Tax, Vat, Custom, and Excise Duty.

• Closing Stock − Total Value of unsold stock of the current financial year is called as closing stock and will appear at the credit side of Trading Account.

  closing Stock = Opening Stock + Net Purchases - Net Sale

• Gross Profit − Gross profit is the difference of revenue and the cost of providing services or making products. However, it is calculated before deducting payroll, taxation, overhead, and other interest payments. Gross Margin is used in the US English and carries same meaning as the Gross Profit.

  Gross Profit = Sales - Cost of Goods Sold

• Operating Profit − Operating profit is the difference of revenue and the costs generated by ordinary operations. However, it is calculated before deducting taxes, interest payments, investment gains/losses, and many other non-recurring items.

  Operating Profit = Gross Profit - Total Operating Expenses

• Net Profit − Net profit is the difference of total revenue and the total expenses of the company. It is also known as net income or net earnings.

  Net Profit = Operating Profit - (Taxes + Interest)

Format of Trading Account

Trading Account of M/s ABC Limited (For the period ending 31-03-2014)
Particulars	Amount	Particulars	Amount
To Opening Stock	XX	By Sales	XX
To Purchases	XX	By Closing Stock	XX
To Direct Expenses	XX	By Gross Loss c/d	XXX
To Gross Profit c/d	XXX
Total	XXXX	Total	XXXX

Manufacturing Account

Manufacturing account prepared in a case where goods are manufactured by the firm itself. Manufacturing accounts represent cost of production. Cost of production then transferred to Trading account where other traded goods also treated in a same manner as Trading account.

Important Point Related to Manufacturing Account

Apart from the points discussed under the section of Trading account, there are a few additional important points that need to be discuss here −

• Raw Material − Raw material is used to produce products and there may be opening stock, purchases, and closing stock of Raw material. Raw material is the main and basic material to produce items.

• Work-in-Progress − Work-in-progress means the products, which are still partially finished, but they are important parts of the opening and closing stock. To know the correct value of the cost of production, it is necessary to calculate the correct cost of it.

• Finished Product − Finished product is the final product, which is manufactured by the concerned business and transferred to trading account for sale.

• Raw Material Consumed (RMC) − It is calculated as.

RMC = Opening Stock of Raw Material + Purchases - Closing Stock

• Cost of Production − Cost of production is the balancing figure of Manufacturing account as per the format given below.

Manufacturing Account (For the year ending……….)
Particulars	Amount	Particulars	Amount
To Opening Stock of Work-in-Progress	XX	By Closing Stock of Work-in-Progress	XX
To Raw Material Consumed	XX	By Scrap Sale	XX
To Wages	XXX	By Cost of Production	XXX
To Factory overheadxx		(Balancing figure)
Power or fuelxx
Dep. Of Plantxx
Rent- Factoryxx
Other Factory Exp.xx	xxx
Total	XXXX	Total	XXXX

Profit and Loss Account

Profit & Loss account represents the Gross profit as transferred from Trading Account on the credit side of it along with any other income received by the firm like interest, Commission, etc.

Debit side of profit and loss account is a summary of all the indirect expenses as incurred by the firm during that particular accounting year. For example, Administrative Expenses, Personal Expenses, Financial Expenses, Selling, and Distribution Expenses, Depreciation, Bad Debts, Interest, Discount, etc. Balancing figure of profit and loss accounts represents the true and net profit as earned at the end of the accounting period and transferred to the Balance Sheet.

Profit & Loss Account of M/s ……… (For the period ending ………..)
Particulars	Amount	Particulars	Amount
To Salaries	XX	By Gross Profit b/d	XX
To Rent	XX
To Office Expenses	XX	By Bank Interest received	XX
To Bank charges	XX	By Discount	XX
To Bank Interest	XX	By Commission Income	XX
To Electricity Expenses	XX	By Net Loss transfer to Balance sheet	XX
To Staff Welfare Expenses	XX
To Audit Fees	XX
To Repair & Renewal	XX
To Commission	XX
To Sundry Expenses	XX
To Depreciation	XX
To Net Profit transfer to Balance sheet	XX
Total	XXXX	Total	XXXX

Balance Sheet

A balance sheet reflects the financial position of a business for the specific period of time. The balance sheet is prepared by tabulating the assets (fixed assets + current assets) and the liabilities (long term liability + current liability) on a specific date.

Assets

Assets are the economic resources for the businesses. It can be categorized as −

• Fixed Assets − Fixed assets are the purchased/constructed assets, used to earn profit not only in current year, but also in next coming years. However, it also depends upon the life and utility of the assets. Fixed assets may be tangible or intangible. Plant & machinery, land & building, furniture, and fixture are the examples of a few Fixed Assets.

• Current Assets − The assets, which are easily available to discharge current liabilities of the firm called as Current Assets. Cash at bank, stock, and sundry debtors are the examples of current assets.

• Fictitious Assets − Accumulated losses and expenses, which are not actually any virtual assets called as Fictitious Assets. Discount on issue of shares, Profit & Loss account, and capitalized expenditure for time being are the main examples of fictitious assets.

• Cash & Cash Equivalents − Cash balance, cash at bank, and securities which are redeemable in next three months are called as Cash & Cash equivalents.

• Wasting Assets − The assets, which are reduce or exhausted in value because of their use are called as Wasting Assets. For example, mines, queries, etc.

• Tangible Assets − The assets, which can be touched, seen, and have volume such as cash, stock, building, etc. are called as Tangible Assets.

• Intangible Assets − The assets, which are valuable in nature, but cannot be seen, touched, and not have any volume such as patents, goodwill, and trademarks are the important examples of intangible assets.

• Accounts Receivables − The bills receivables and sundry debtors come under the category of Accounts Receivables.

• Working Capital − Difference between the Current Assets and the Current Liabilities are called as Working Capital.

Liability

A liability is the obligation of a business/firm/company arises because of the past transactions/events. Its settlement/repayments is expected to result in an outflow from the resources of respective firm.

There are two major types of Liability −

• Current Liabilities − The liabilities which are expected to be liquidated by the end of current year are called as Current Liabilities. For example, taxes, accounts payable, wages, partial payments of long term loans, etc.

• Long-term Liabilities − The liabilities which are expected to be liquidated in more than a year are called as Long-term Liabilities. For example, mortgages, long-term loan, long-term bonds, pension obligations, etc.

Grouping of Assets and Liabilities

There may be two types of Marshalling and grouping of the assets and liabilities −

• In order of Liquidity − In this case, assets and liabilities are arranged according to their liquidity.

• In order of Permanence − In this case, order of the arrangement of assets and liabilities are reversed as followed in order of liquidity.

Financial Statements with Adjustments Entries and their Accounting Treatment

In order to prepare a true and fair financial statement, there are some very important adjustments those have to be done before finalization of the accounts (as shown in the following illustration) −

Sr.No.	Adjustments	Accounting Treatments
1	Closing Stock Unsold stock at the end of Financial year called Closing stock and valued at “Cost or market value whichever is less”	First Treatment Where an opening and closing stock adjusted through a purchase account and the value of Closing Stock given in Trial Balance − Closing stock will be shown as adjusted purchase account on the debit side of Trading account and will appear in the Balance Sheet under current Assets.
2	Outstanding Expenses Expenses which are due or not paid called as outstanding expenses.	Accounting Treatment Outstanding expenses will be added in Trading or Profit & Loss account in particular expense account and will appear in liabilities side of the Balance Sheet under the current liabilities.
3	Prepaid Expenses Expenses which are paid in advance are called as Prepaid Expenses.	Accounting Treatment Prepaid Expenses will be deducted from the particular expenses as appear in Trading & Profit & Loss account and will be shown in the Balance Sheet under the current assets.
4	Accrued Income The income, which is earned during the year, but not yet received at the end of the Financial Year is called as Accrued Income.	Accounting Treatment Accrued income will be added to a particular income under the Profit & Loss account and will be shown in the Balance Sheet as current assets.
5	Income Received in Advance An income received in advance, but not earned like advance rent etc.	Accounting Treatment An income to be reduced by the amount of advance income in profit & loss account and will appear as current liabilities in the Balance Sheet.
6	Interest on Capital Where an interest paid on the capital introduced by the proprietor or partner of the firm.	Accounting Treatment Debit Side of Profit & Loss account Add to capital account (Credit side of Capital account).
7	Interest on Drawing Where an interest paid on the capital introduced by the proprietor or partner of the firm.	Accounting Treatment Credit Side of Profit & Loss account Reduced from capital account (Debit side of Drawing account).
8	Provision for Doubtful Debts If there is any doubt on the recovery from Sundry Debtors.	Accounting Treatment Debit Side of Profit & Loss Account In a Balance Sheet, provision for the Doubtful will be deducted from the Sundry Debtors’ Account.
9	Provision for Discount on Debtors If there is any offer of discount to pay the debtors within certain period.	Accounting Treatment Debit Side of Profit & Loss Account In a Balance Sheet, provision for the Discount on Debtors will be deducted from the Sundry Debtors Account.
10	Bad Debts Unrecovered debts or irrecoverable debts	Accounting Treatment Debit Side of Profit & Loss Account In a Balance Sheet, Sundry debtors will be shown after deducting the Bad Debts.
11	Reserve for Discount on Creditors If there is any chance to get discount on the payment of sundry creditors within certain period.	Accounting Treatment Credit Side of Profit & Loss Account In a Balance Sheet, Sundry Creditors will be shown after deducting the Reserve for Discount.
12	Loss of Stock by fire There may be three conditions in this case	Accounting Treatment 1. If Stock is fully insured Credit Side of Trading Account Assets side of Balance Sheet (With full value of loss) 2. If Stock is partially insured Credit side of Trading Account (With Total value of Loss) Debit side of Profit & Loss a/c (With value of loss unrecoverable) Asset Side of Balance Sheet ( With value recoverable) 3. If Stock is not insured Credit Side of Trading Account Debit side of Profit & Loss Account
13	Reserve Fund	Accounting Treatment Debit side of Profit & Loss Account Liabilities side of Balance Sheet
14	Free Sample to Customers	Accounting Treatment Credit side of Trading Account Debit Side of Profit & Loss Account
15	Managerial Commission	Accounting Treatment Debit side of Profit & Loss Account Liabilities side of Balance Sheet as commission payable
16	Goods on Sale or Approval Basis If there is any un-approved stock lying with the customers at the end of financial year.	Accounting Treatment Sales AccountDr To Debtors A/c (With Sale Price) Stock AccountDr To Trading Account (with cost price)

Provision and Reserves

Meaning of Provisions

“Any amount written off or retained by the way of providing depreciation or diminution in the value of assets or for providing any known liability of which the amount cannot be determined with substantial accuracy.”

- The Institute of Chartered Accountants of India

“Liabilities which can be measured only by using a substantial degree of estimation.”

- AS-29 issued by Institute of Chartered Accountants of India

AS 29 also defines liabilities as “a present obligation of the enterprises arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”

Debiting Profit and Loss account, provisions are created and shown either deducting assets side or on the liabilities side under relevant sub-head of Balance Sheet.

Provision for bad and doubtful debts, Provisions for Repair & Renewals, and Provision for discounts & depreciation are the most common examples.

Meaning of Reserves

“That portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for general or a specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability.”

-ICAI

Reserve is an appropriation of profits; on the other hand, Provision is a charge against profit. Reserves are not meant to meet out contingencies or liabilities of a business. Reserve increases working capital of a company to strengthen the financial position.

There are two types of reserves −

• Capital Reserve − Capital reserve is not readily available for distribution as the dividends among the shareholders of the company, and it creates only out of capital profit of the company. It is like Premium on issue of shares or debentures and Profit prior to incorporation.

• Revenue Reserve − Revenue reserves are readily available for the distribution of profit as dividend to the shareholders of the company. Some of the examples of this are general reserve, staff welfare fund, dividend equalization reserve, debenture redemption reserve, contingency reserve, and investment fluctuation reserves.

Distinction between Provisions and Reserves

• Reserve can be made only out of profit and provisions are the charge to profit.

• Reserves reduce divisible profits and provisions reduce the profit.

• Reserves, if remain un-utilized for some period can be distributed as dividends, but provisions cannot be transferred to General Reserve for the distribution.

• Purpose of provision is very specific, but reserve is created to meet out any probable future liabilities or losses.

• Creation of provisions is legally necessary, but reserves are created to save a concern from the future losses and liabilities.

Secret Reserves

Banking Company, Insurance Company, and Electricity Companies create secret reserves, where the public confidence is required. In this case, to create secret reserve, assets showed at lower cost or liabilities at higher value. Some of the examples of it are as follows −

• By undervaluing goodwill or stock
• By excessive depreciation
• By creating excessive provisions
• Showing free reserves as creditors
• By charging capital expenditure to profit and loss account

Advantages of Secret Reserves

Some of the important advantages are given below −

• Without disclosing to its shareholders, it increases working capital of a concern, which is a clear indication of the sound financial position.

• With the help of secret reserves, directors can maintain the rate of dividends during the unfavorable time.

• Non-disclosure of a big profit is useful to avoid an un-due competition.

Limitations of Secret Reserves

Major limitations or objections of secret reserves are as follows −

• Due to non-disclosure of actual profit, financial statements do not presents true and fair view of the state of affairs.

• There are lots of chances of misuse of reserves by the directors for their personal benefits.

• Due to secret reserves, chances for the concealment of worst position of a company are very high.

• Company will get very lower amount of claim of insurance at the time of loss of stock or other assets, as valuation of the assets are done at very low value to create secret reserve.

General and Specific Reserves

Specific reserves are created and utilized for the purpose only for which they are created, like dividend equalization reserve and debenture redemption reserve.

General reserves are created for any future contingency or to utilize at the time of expansion of a business. Purpose of creation of General reserve is to strengthen the financial position of the company and to increase the working capital.

Sinking Fund

For the purpose to repay of any liabilities or to replace any fixed assets after particular period, sinking funds are created. For this, some amount are charged or appropriated from the profit and loss account every year and invested in any outside securities. Without any extra ordinary burden, replacement of an asset may be done in a systematic manner or pay any known liability on maturity of the sinking fund.

Investment of Reserves

It is a controversial issue, whether a reserve should be invested in outside securities or not. Thus, to decide anything, it is important to study the need and requirement of a firm according to the financial position of a firm. Therefore, investment in outside securities is justified only in a case where company has the extra fund to invest.

Nature of Reserve

In-spite of showing reserves on the liabilities side of a Balance Sheet, reserves are actually not at all any liabilities of a firm. Reserve represents as accumulated profits, which are available to disburse among the shareholders.

Measurement of Business Income

One of the most significant accounting concepts is “Concept of Income”. Similarly, measurement of a business income is also an important function of an accountant.

In General term, payment received in lieu of services or goods are called income, for example, salary received by any employee is his income. There may be different type of incomes like Gross income, Net income, National Income, and Personal income, but we are here more concerned for a business income. Surplus revenue over expenses incurred is called as “Business Income.”

Objectives of Net Income

Following are the important objectives of a net income −

• Historical income figure is the base for future projections.

• Ascertainment of a net income is necessary to give portion of profit to employees.

• To evaluate the activities, which give higher return on scarce resources are preferred. It helps to increase the wealth of a firm.

• Ascertainment of a net income is helpful for paying dividends to the shareholders of any company.

• Return of income on capital employed, gives an idea of overall efficiency of a business.

Definition of Income

The most authentic definition is given by the American Accounting Association as −

“The realized net income of an enterprise measures its effectiveness as an operative unit and is the change in its net assets arising out of a (a) the excess or deficiency of revenue compared with related expired cost, and (b) other gains or losses to the enterprise from sales, exchange or other conversion of assets:”.

According to the American Accounting Association, to be as business income, income should be realized. For example, to be a business income, only appreciation in value of assets of a company is not enough, for this, asset has really been disposed of.

Accounting Period

For the measurement of any income concerns, instead of a point of time, a span of time is required. Creditors, investors, owners, and government, all of them require systematic accounting reports at regular and proper intervals. The maximum interval between reports is one year, as it helps a businessman to take any corrective action.

An accounting period concept is directly related to matching concept and realization concept; in the absence of any of them, we could not measure income of the concerns. On the basis of matching concept, expenses should be determined in a particular accounting period (usually a year) and matched with the revenue (based on realization concept) and the result will be income or loss of the accounting period.

Accounting Concept and Income Measurement

The measurement of accounting income is the subject to several accounting concepts and conventions. Impact of accounting concepts and convention on measurement of the accounting income is given below −

Conservatism

Where an income of one period may be shifted to another period for the measurement of income is called as ‘conservatism approach.’

According to the convention of conservatism, the policy of playing safe is followed while determining a business income and an accountant seeks to ensure that the reported profit is not over stated. Measurement of a stock at cost or market price, whichever is less is one of the important examples as applied to measurement of income. But it must be insured that providing excessive depreciation or excessive provisions for a doubt full debt or excessive reserve should not be there.

Consistency

According to this concept, the principle of consistency should be followed in accounting practice. For example, in the treatment of assets, liabilities, revenues, and expenses to insure the comparison of accounting results of one period with another period.

Therefore, the accounting profession and the corporate laws of most of the counties require that financial statement must be made out on the basis that the figures stated are consistent with those of the preceding year.

Entity Concept

Proprietor and business are the two separate and different entities according to the entity concept. For example, an interest on capital is business expenditure, but for a proprietor, it is an income. Thus, we cannot treat a business income as personal income or vice-versa.

Going Concern Concept

According to this concept, it is assumed that business will continue for a long time. Thus, charging depreciation on a Fixed Asset is based on this concept.

Accrual Concept

According to this concept, an income must be recognized in the period in which it was realized and costs must be matched with the revenue of that period.

Accounting Period

It is desirable to adopt a calendar year or natural business year to know the results of business.

Computation of Business Income

To compute business income, following are the two methods −

Balance Sheet Approach

Comparison of the closing values (Assets minus outsider’s liabilities) of a firm with the values at the beginning of that accounting period is called as Balance Sheet approach. In above value, an addition to capital will be subtracted and addition of drawings will be added while computing the business income of a firm. Since, income is calculated with the help of Balance Sheet hence called as Balance Sheet approach.

Transaction Approach

Transactions are mostly related to production or the purchase of goods and the sale of goods and all these transactions directly or indirectly related to the revenue or to the cost. Therefore, surplus collection of the revenue by selling goods, spent over for production or purchasing the goods is the measure of income. This system is widely followed by the enterprises where double entry system adopted.

Measurement of Business Income

There are following two factors which are helpful in the estimation of an income −

• Revenues − Sale of goods and rendering of services are the way to generate revenue. Therefore, it can be defined as consideration, recovered by the business for rendering services and goods to its customers.

• Expenses − An expense is an expired cost. We can say the cost that have been consumed in a process of producing revenue are the expired cost. Expenses tell us - how assets are decreased as a result of the services performed by a business.

Measurement of Revenue

Measurement of the revenue is based on an accrual concept. Accounting period, in which revenue earned, is the period of revenue accrues. Therefore, a receipt of cash and revenue earned are the two different things. We can say that revenue is earned only when it is actually realized and not necessarily, when it is received.

Measurement of Expenses

• In case of delivery of goods to its customers is a direct identification with the revenue.

• Rent and office salaries are an indirect association with the revenue.

There are four types of events (given below) that need proper consideration about as an expense of a given period and expenditure and cash payment made in connection with those items −

• Expenditure, which are expenses of the current year.

• Some expenditure, which are made prior to this period and has become expense of the current year.

• Expenditure, which is made this year, becomes expense in the next accounting periods. For example, purchase of fixed assets and depreciation in next up-coming years.

• Expense of this year, which will be paid in next accounting years. For example, outstanding expenses.

Matching Concept

It is a problem of recognition of revenue during the year and allocation of expired cost to the period.

Recognition of Revenue

Most frequent criteria, which are used in recognition of the revenue are as follows −

• Point of Sale − Transfer of ownership title to a buyer is point of sale, in case of sale of commodity.

• Receipt of Payment − Criteria of cash basis is widely used by the attorneys, physicians, and other professionals in which revenue is considered to be earned at the time of collection of cash.

• Instalment Method − Instalment method is widely used in retail trading specially in consumer durables. In this system, revenue earned is treated in the same manner as is used in any other credit sale.

• Gold Mines − The accounting period in which gold is mined is the period of revenue earned.

• Contracts − Degree of contract completion, especially in long term construction contracts is based on percentage of completion of a contract in a single accounting year. It is based on total estimated life of the contract.

Allocation of Costs

Matching of expired revenue and expired costs on a periodic time basis is the satisfactory basis of allocation of cost as stated earlier.

Measurement of Costs

Measurement of costs can be determined by −

• Historical Costs − To determine periodic net income and financial status, historical cost is important. Historical cost actually means - outflow of cash or cash equivalents for goods and services acquired.

• Replacement Costs − Replacing any asset at the current market price is called as replacement cost.

Basis of Measurement of Income

Following are the two significant basis of measurement of income −

• Accrual Basis − In an accrual basis accounting, incomes are recognized in a company’s books at the time when revenue is actually earned (however, not essentially received) and expenses is recorded when liabilities are incurred (however, not essentially paid for). Further, expenses are compared with revenues on the income statement when the expenses expire or title has been transferred to the buyer, and not at the time when the expenses are paid.

• Cash Basis − In a cash basis accounting, revenues and expenses are recognized at the time of physical cash is actually received or paid out.

Change in the Basis of Accounting

We have to pass adjustment entries whenever accounting records change from cash basis to accrual basis or vice versa specially in respect of the prepaid expenses, outstanding expenses, accrued income, income received in advance, bad debts & provisions, depreciation, and stock in trade.

Features of Accounting Income

Followings are the main features of accounting income −

• Matching revenue with related cost or expenses is a matter of accounting income.

• Accounting income is based on an accounting period concept.

• Expenses are measured in terms of a historical cost and determination of expenses is based on a cost concept.

• It is based on a realization principal.

• Revenue items are considered to ascertain a correct accounting income.

Bills of Exchange and Promissory Notes

“An Instrument in writing containing an unconditional order, signed by the maker, directing a certain person, to pay a certain sum of money only to, or to the order of a certain person or to the bearer of the instrument.”

Section 5, Negotiable Instrument Act, 1881

Essentials of Bills of Exchange

Following are the essentials of a bill of exchange −

• Bill of exchange should be in written.

• The seller who makes the bill is termed as “Drawer,” the purchaser upon whom the bill is drawn is known as “Drawee” and must be a person.

• Bill of exchange must be carrying certain amount and only in terms of money, and not in terms of goods or services.

• Order to pay the money, should be unconditional.

Specimen of Bill

Apart from all these (given above), we also need to pay attention on the following points −

Parties to Bill of Exchange

Following are the parties of ‘Bill of Exchange −”

• The Drawer − Seller of goods is termed as drawer of “bills of exchange.”

• The Drawee − Drawee or purchaser is a person who accepts the bill of a certain amount to be paid after a specific time.

• The Payee − Payee and drawer may be same person who gets the payment or may be a different person. In case of same parties, will be reduced to two instead of three.

Important Terms

• Stamp − Amount in excess of certain limit should be paid and signed on affixed revenue stamp according to above specimen. In these days, threshold limit is INR 5,000/.

• Amount − Amount of bill must be written in figure as well as in words as shown in above specimen.

• Date − Date on bill will be written on face of it as above.

• Value and Terms − Both are essential part of it and must be written as shown above.

Acceptance of Bills

To make it a legal document, it must be signed by “Drawee.” Acceptance may be general acceptance i.e. Drawee agrees with the full content of the bill without any change and it may be conditional, which is called as qualified acceptance.

Classification of Bills of Exchange

Bill of exchange may be classified as viz…

• Inland Bill − Bill, which is drawn in India, both the Drawer and the Drawee are from India and also payable in India called Inland Bill.

• Foreign Bill − Bill, which is drawn outside India, drawn on a person residing in India, payable in India or vice versa. Due date of foreign bill starts from the date on which Drawee sees it and accepts it.

Definition of Promissory Notes

As per Section 4 of the Indian Negotiable Instrument Act, 1881

“An instrument in writing (not being a Bank note or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to, or the order of a certain person, or to the bearer of the instrument.”

Difference between Promissory Notes and Bills of Exchange

Promissory Note	Bill of Exchange
It is an unconditional promise to pay	Bill of Exchange is unconditional order to pay.
Debtor make the promise to pay to the creditor	Bill of Exchange drawn by a seller of goods or services and he makes an order to debtor to make the payment.
Foreign promissory note make in a set of one only	Foreign Bills of Exchange drawn in a set of three.
Promissory note payable on demand, requires stamp duty	Bill of Exchange payable on demand does not require stamp duty.
Promissory note has only two parties i.e. drawer and payee	Bill of exchange may have three parties, drawer, drawee and may be payee.
Since debtor himself makes the promise to make the payment, hence no acceptance required in this case	To be a legal document, it must be accepted by Drawee.

Advantages of Bills of Exchange and Promissory Notes

Followings are the important advantages of Bills of Exchange and Promissory Notes −

• Facilitation of the credit transactions is helpful in increasing the size of business.

• Both are the proof of purchase of goods or services in credit.

• Being a legal document, both can be produced in a court, in case of its dishonor.

• Since date of payment is fixed, it is helpful for both debtors and creditors; and, they may manage their payment schedule accordingly.

• In case of any urgency of payment, creditor can get the bill discounted from the bank.

• Being a negotiable instrument, promissory note is easily transferable from one person to another.

Accounting Treatment

Bills of exchange and Promissory notes are treated as bills receivable and bills payable in regards to accounting treatment −

• Bills Receivable − If we have to receive the payment against bills of exchange or promissory note, it will be called as “Bills Receivable” and will be shown in the Asset side of Balance-sheet under Current Assets.

• Bills Payable − Bills payable is current liabilities in hand of Drawee.

• Accounting Entries − When the Bill received and retained in possession till due date.

Accounting entries to be done in the books of Drawer and Payee as −

Sr.No.	In the Books of Drawer	Entries in the Books of Acceptor
1	Customer A/cDr To Sales A/c (Being Goods sold on credit)	Goods Purchase A/cDr To Supplier A/c (Being Goods Purchased on credit)
2	Bills Receivable A/cDr To Customer A/c (Being Bill accepted by Customer)	Supplier A/cDr To Bills Payable A/c (Being Bill accepted drawn by supplier of goods)
3	Cash/Bank A/cDr To Bills Receivable A/c (Being Amount of bill received on due date)	Bills Payable A/cDr To Cash/Bank (Being Amount paid on due date and bills payable received back)

When Bill is Discounted with the Bank

• In the Book of Drawer − The drawer of a bill may get the bill discounted from his bank before due date of that bill. In this case, bank charges some interest on bill amount according to waiting time. For example, if bill is drawn on 1st January for 3 months and drawer may get bill discounted on 1^st February, in this case, bank will charge interest for two months at applicable rate say 14% and drawer of bill may pass following entry.

Cash / Bank A/c                      Dr 
Discount A/c                         Dr 
To bills Receivable A/c 
(Being bill discounted with bank @ 14% p.a.  
discount charge debited by bank for 2 months)

• In the book of Drawee − Drawee has no need to pass entry on above, he just needs to pass the entry at the time of payment on maturity of bill as explained earlier.

When Bill of Exchange Endorsed in Favor of a Creditor

If Drawer of the bill of exchange endorsed the bill to his creditor for his own liabilities and bill is met on maturity, following journal entries will be passed −

In the book of Drawer

Creditors A/c                      Dr    
To bills Receivable A/c
(Being bill receivable endorsed to creditor)

Note − Drawer has no need to pass any entry at the time of maturity of a Bill.

In the book of Drawee − Drawee has no need to pass any entry at the time of endorsement of Bill. Entries will remain same as explained earlier.

Dishonor of a Bill of Exchange

In case where the acceptor of a Bill of Exchange failed to pay the bill on due date of maturity or refused to pay, it is called as dishonor of a Bill of Exchange. As a proof of dishonor of a Bill, payee may get a certificate from a Notary Officer appointed by the Government for this purpose. Notary officer charges some fees in this regard called as “Noting Charges.”

Following entries will pass in the books of Drawer and Drawee −

Sr.No	In the Books of Drawer
1	If bill is kept by the Drawer with himself till the date of maturity − Customer/Acceptor A/c Dr (with total Bill amount + Noting Charges) To Bills Receivable A/c(with Bill Receivable amount) To Cash/Bank(Noting Charges paid) (Being Bills receivable dishonor and noting charges paid)
2	If bill is discounted with the bank − Customer/Acceptor A/c Dr (with total Bill amount + Noting Charges) To Bank A/c(with total Bill amount + Noting Charges) (Being discounted Bills receivable dishonor and noting charges paid)
3	If bill is endorsed by the Drawer in favor of a Creditor − Customer/Acceptor A/c Dr (with total Bill amount + Noting Charges) To Creditor A/c(with total Bill amount + Noting Charges) (Being endorsed Bills receivable dishonor and noting charges paid)

Entries in the Books of Acceptor/Debtors
In all above three case acceptor will pass only one journal entry − Bills payable A/cDr(with the bills payable amount) Noting Charges A/cDr(with Noting Charges ) To Drawer/Creditor A/c(with total Bill amount + Noting Charges) (Being Goods Purchase on credit)

Renewal of Bill

There may be a situation when the acceptor of bill may not be in position to pay the bill on due date and he may request drawer to cancel the old bill and draw a new bill on him (i.e. Renewal of Bill). Drawer of bill may charge some interest on mutually agreed terms and that amount of interest may be paid in cash or may be included in the bill amount.

Entries in the Books of Drawer and Drawee

Following accounting entries to be done in the books of Drawer and Drawee −

Sr.No.	In the Books of Drawer	Entries In the Books Acceptor
1	Cancellation of old bill − Customer/Acceptor A/cDr To Bill receivable A/c (Being old bill cancelled)	Cancellation of old bill − Bills Payable A/cDr To Creditor A/c (Being request for cancellation of old bill accepted by Creditor)
2	Interest received in cash − Cash A/cDr To Interest A/c (Being interest received on delayed payment)	Interest paid in cash − Interest A/cDr To Cash A/c (Being Interest paid on renewal of Bill)
3	In case interest not payable in cash − Customer/Acceptor A/cDr To Interest A/c (Being Interest due on renewal of bill)	In case interest not payable in cash − Interest A/cDr To Creditor A/c (Being Interest on renewal of bill due)
4	On renewal of bill − Bills Receivable A/cDr To Customer/Acceptor A/c (Being renewal of bill including amount of interest)	On renewal of bill − Supplier A/cDr To Bills Payable A/c (Being Bill accepted after cancellation of a new bill including interest)

Retiring of a Bill under Rebate

Sometimes, acceptor may approach to drawer of a bill to make early payment before due date of a bill, following journal entries will pass in this case −

Sr.No.	Entry In the Books of Drawer	Entries In the Books of Acceptor
1	Cash/Bank A/cDr Rebate A/cDr To Bills Receivable A/c (Being Amount of bill received before due date and rebate allowed to customer)	Payable A/cDr To Cash/Bank A/c To Rebate A/c (Being Amount paid before due date on rebate)

Bill sent to Bank for Collection

To manage several numbers of bills receivable, drawer sent those bills to the bank for collection and bank gives credit to the customer whenever a bill is collected from a drawee. Following journal entries will be passed −

Sr.No.	Entry In the Books of Drawer
1	When a bill is sent to the bank for collection − Bills sent for Collection A/cDr To Bank A/c (Being bills receivable sent to the bank for collection)
2	On collection of payment by bank − Bank A/cDr To Bills sent for Collection A/c (Being Collection of bills receivable by bank)

Accommodation Bill

A bill of exchange may be accepted to oblige a friend or any known person at the time of his need or to provide him a loan or else to accommodate one or more parties is called as accommodation bill.”

Financial Accounting - Inventory Valuation

The Institute of Chartered Accountant of India as per Accounting Standard-2 (Revised) defines inventory as the assets held −

• For sale in the ordinary course of a business or

• In the process of production for such a sale or

• In the form of materials or supplies to be consumed in the production process or in rendering of the services.

Thus, the term inventory includes −

• Raw Material and supplies,
• Work in progress, and
• Finished goods.

Importance of Inventory Valuation

Proper valuation of inventory is important because of the following three reasons −

• Importance of sufficient Inventory − An inventory represents major current asset investment of any trading or manufacturing concern. Shortage of inventory may close down the business. Realization of profit from resale of an inventory makes valuation of inventory. Therefore, the point is that every business unit has to follow a proper method of inventory valuation.

• To Determine True Financial Position − Proper valuation of an inventory can only give true and fair view of the financial position of a business unit, as it constitutes a significant portion of the current assets.

• For Proper Determination of Income − Proper determination of income and profit depends on correct valuation of the inventories. Over valuation of closing inventory may overstate the profit figure and vice-versa. Therefore, proper valuation of an inventory is necessary to determine the true income and profit by the business concern.

Methods of Taking Inventory

Following are the two important methods of taking inventory −

• Periodic Inventory Method and
• Perpetual Inventory Method

Let’s discuss each of them separately −

Periodic Inventory Method

This method of stock valuation is also known as physical stock taking method or annual stock taking method. Under this system of taking inventories, stock is determined by physical counting at the end of the accounting period i.e. the date of preparation of final accounts. This system is very simple and useful in small business organizations.

Perpetual Inventory Method

This system of inventory valuation records every movement of stock on the receipt and issue of material reflecting running balances of different kind of inventories through preparation of store ledgers for raw material, work-in- progress, and finished goods. To insure the accuracy of store records, a periodic reconciliation of records is done by taking physical inventories.

Valuation of Inventory at Lower Cost or Market Price

An inventory is valued at a cost or market price, whichever is lower to ensure that the anticipated profit should not be accounted for and full provision for anticipated losses should be done.

As per American Institute of Certified Public Accountants −

“A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference should be recognized as loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.”

Methods of Valuation of Inventory

The following illustration shows the methods of Valuation of Inventory −

Let’s discuss each one of the methods in detail.

First in First out (FIFO) Method

FIFO is the most popular method of an inventory valuation, which is based on assumption that the material first received or purchased are the first to be sold or issued. It means, closing stock is out of the last or latest received or manufactured goods.

It will clear with a small and simple example as given below −

Date	No. of Item	Rate	Value
Opening stock	100	10	1000
Purchased on 01-04-13	500	10	5000
Purchased on 01-07-13	500	12	6000
Purchased on 01-01-14	1000	15	15000
Total Purchases	2100		27000
Item Sold	1700
Closing stock	400	15	6000

In above example, it is assumed that closing stock of 400 items was out 1000 items purchased on 01-01-2014.

Last in First out (LIFO) Method

As name suggests, closing stock is valued on the basis of oldest purchased or manufactured items. First time, this method was used by the U.S.A., at the time of Second World War to get the advantage of hike in prices. In the above example, closing stock will be valued at 400 items @ Rs. 10 each = Rs. 4000

Note − Here 100 items from opening stock and 300 items were out of purchases made on 01-04- 2013

Average Cost Method

Average cost method is used where identification of stock with rate or value of stock is not possible. It is of two types Viz…

• Simple Average Price Method
• Weighted Average Price Method

Simple Average Price Method

Simple average price method may be explained as below −

Suppose, four types of items are in stock as follows −

500 units purchased @ Rs. 10 per unit	= Rs. 5000
750 units purchased @ Rs. 12 per unit	= Rs. 9000
600 units purchased @ Rs. 14 per unit	= Rs. 8400
Total Units 1850 for	= Rs. 22400

Simple average method ignored the inventory at cost, therefore the valuation of stock of 1850 units will be = 12 × 1850 = Rs. 22,200 whereas the actual cost is Rs. 22,400

So, if we want to choose average method then weighted price method should be followed under which valuation will be done as hereunder.

Weighted Average Price Method

In the above example, Rs. 22,400 will be divided by 1850 units and the average price will be Rs. 12.1081.

Highest in First out (HIFO) Method

This method is based on the assumption that the highest value of material always consumed first and closing stock will be valued at the lowest cost of purchased or manufactured material. This method is not a popular method of valuation of inventory and so, used only by the business units having monopoly products or who are dealing with the cost + contract.

Base Stock Method

Base stock means — minimum level of stock maintained by a business unit to run his business without any interruption or which is according to AS-2 issued by The Institute of Chartered Accountants of India as “the base stock formula proceeds on the assumption that a minimum quantity of inventory (base stock) must be held at all times in order to carry on business.”

Note − This method can be followed only when LIFO method is used.

Inflated Price Method

This method of valuation covers normal losses, increasing price of purchases to calculate closing value of an inventory. For example, if 550 units purchased for Rs. 2000 and due to normal loss units, remain 500 then the cost per unit will be 2000/500 = Rs. 4 per unit, and while calculating closing stock value for 100 unit, cost will be Rs. 400 (100 × 4).

Specific Identification Method

Under this method, where identification of items with price is possible, then closing stock will be valued accordingly.

Market Price Method

Under this method of valuation, stock is valued at current market price. It is also called replacement price or realizable price method.

Method of Valuation of Closing Stock when it is not given

In case, where the value of closing stock is not given, we may calculate it as −

Opening stock	xx
Add: Net Purchases	xx
Less: Cost of Sales	xx
Less: Gross Profit	xx
Value of Closing stock	xx

Putting value in above formula, we may also calculate the value of opening stock.

Analysis of Changes in Income

The purpose of preparing a financial statement is not only to know the net income or losses of concern for the current year, but also to know the change in net income or losses of a firm in comparisons to the preceding years.

There are two types of financial statements, which reflect two types of profits i.e. trading account shows the gross profit and Profit & Loss accounts shows the net profit of the concern for a specific accounting period. Under this chapter, we will discuss the reasons for changes in Gross Profit Ratio.

Gross Profit Ratio (GPR)

Gross profit means, excess of sales over cost of goods sold. This ratio also indicates the losses due to damage or mismanagement. More the ratio is high more it is good for a financial health of a concern. Chances of higher net income are more in an organization where ratio of gross profit is high (formula is given below) −

$$\normalsize Gross\:Profit\:Ratio = \frac{Gross\:Profit}{Net\:Sales}$$

Higher gross profit provides leverage to the management to meet their indirect expenses and to spare net income for the distribution of profit and to increase the reserves.

Gross Profit Margin

When Gross profit margin is presented in percentage, it is called as Gross profit margin (formula is given below) −

$$\normalsize Gross\:Profit\:Margin = \frac{Gross\:Profit}{Net\:Sales} \times 100$$

Chances of Increase in GPR may be due to following Reasons −

• Without increase in corresponding costs, if there is an increase in selling price.

• Without decrease in selling price, if there is decrease in cost of production of products.

• There may be equal decrease or increase in selling price and cost of production without affecting gross profit of the current year.

• There may be chances that the valuations of closing stocks are done with higher price.

• It is also possible that the opening stock of a concern is valued at very lower rate.

• There is a possibility that given sales are inclusive of consignment sale due to any mistake or otherwise.

• Omission of purchase invoices in the books of accounts may also be one of the reasons for higher gross profit.

Chances of Decrease in GPR may be due to following Reasons −

• If cost price remains same, but decrease in selling price.
• Sale price remains same, but increase in cost of production.
• Personal used goods debited to purchase account.
• Closing stock may be valued at very low price.
• Opening stock may be valued at very high price.
• Any omission or mistake while valuation of closing stock.

It is necessary for survival and progress of any business to keep its margin of gross profit high as much as possible to enable it to cover its operative expenses as well as indirect expenses.

Analysis of Gross Profit

Analysis of changes in gross profit is the first step in determination of a net income. Change of gross profit in current year may be due to the following reasons −

• Change in sale amount may be due to following three reasons −
  • Change in selling price.
  • Change in quantity sold without change in sale price.
  • Change in sale price as well as quantity of goods sold.
• Change in cost of goods sold may be due to following reasons −
  • Change in cost of production.
  • Change quantity of goods sold.
  • Change in quantity as well as cost of goods sold.

Example

Make an analysis of changes from the information given below −

Particulars	Year 2012 (Rs.)	Year 2013 (Rs.)	Changes (Increase or decrease)
Sales	3,50,000	4,80,000	1,30,000
Number of Unit sold	5,000	6,000	1,000
Selling Price per Unit	70	80	10

Solution

Increase in sales amount due to price −

Increase in price per unit × Number of unit sold in current year

= 10 × 6000 = 60,000

Increase in sales amount due to Quantity −

Increase in number of unit sold × price of last year

= 1,000 × 70 = 70,000

Combined effect of change in quantity and price (A+B)

= 1, 30,000

Accounting for Consignment

Due to increasing size of market, it is quite obvious that manufacturers or whole sellers cannot approach directly to every customer around the state or nation. To overcome this limitation, manufacturers normally appoint reliable agents at every desired location to reach the customers directly. He makes an agreement with local traders who can sell goods on his behalf on commission basis.

Meaning and Features of Consignment

Consignment is a process under which the owner consigns/handovers his materials to his agent/salesman for the purpose of shipping, transfer, sale etc.

Following are the points that throw more light on the nature and scope of a consignment −

• Here, ultimate ownership of the goods remains with the manufacturer or whole seller who handovers goods to his agent for sale on commission basis. Consignment is merely a transfer of possession of goods not an ownership.

• Since ownership of goods remain with the manufacturer (consignor), consignee (agent) is not responsible for any loss or destruction of goods.

• The goods are sold on owner’s risk and hence, profit/loss goes to owner.

• Consignee only gets re-imbursement of expenses incurred by him and commission on sale made by him, because sale that proceeds, belongs to owner (consignor).

Why is Consignment not a Sale?

Following are the reasons that explain why consignment is not a sale −

• Ownership − Ownership of goods need to be transferred from seller to buyer in case of sale, but ownership of goods remains with the consignor, till the goods are sold by the consignee.

• Risk − In case of a consignment, normally, risk remains with the consignor in the event of goods being lost or destroyed.

• Relationship − The relation between a seller and a buyer will be of debtor and creditor in case where goods are sold on credit basis. On the other hand, the relationship between a consignor and a consignee is that of principal and agent.

• Goods Return − Usually, the sold goods cannot be returned back; however, if there is any manufacturing defect or any other technical fault, seller is obliged to take them back. On the other hand, consignee may return the unsold stock of goods to consignor anytime.

Important Terms

Pro-forma Invoice

Invoice implies that the sale has taken place, but pro-forma invoice is not an invoice. Proforma invoice is a statement prepared by the consignor of goods showing quantity, quality, and price of the goods. Such pro-forma invoice is issued by the consignor to consignee regarding the goods before the sale actually takes place.

Account Sale

Statement showing the details of goods received, goods sold, expenses incurred, commission charged, remittances made, and due balance is called Account Sale and it is remitted by the consignee to the consignor of goods on a periodic basis.

Commission

There are three types of commission payable to consignee on sale of the goods −

• Simple Commission − This is usually a fixed percentage on the total sale, calculated as per mutually agreed terms.

• Over-riding Commission − In case of an extra-ordinary sale of the goods, some specific amount is payable to consignee in the form of an incentive is called overriding commission. Over-riding commission is also calculated on the total sales.

• Del-credere Commission − “An agreement by which an agent or factor, in consideration of an additional premium or commission (called a del credere commission), engages, when he sells goods on credit, to insure, warrant, or guarantee to his principal the solvency of the purchaser, the engagement of the factor being to pay the debt himself if it is not punctually discharged by the buyer when it becomes due.”

  C. & G. Merriam Co.

A del credere commission is paid by the consignor to his agent for taking additional risk of recovery of debts from the consignee on an account of credit sales made by him (agent) on consignor's behalf.

Direct Expenses

Expenses, which increases the cost of the goods and are of non-recurring nature and incurred till the goods reach the warehouse of consignee may called direct expenses.

Indirect Expenses

Warehouse rent, storage charges, advertisement expenses, salaries, etc. comes under the category of the indirect expenses. The distinctions between direct and indirect expenses are important especially at the time of valuation of the unsold closing stock.

Advance

Amount paid in advance by a consignee to consigner as security called as advance.

Valuation of unsold Consignment

Valuation of unsold stock will be done like a closing stock of a Trading concern and should be valued at the cost or the market price whichever is low. This stock will be valued at −

• Proportionate cost price and
• Proportionate direct expenses.

Here, proportionate direct expenses mean — all expenses incurred by the consignor and the expenses of consignee, which are incurred by him till the goods reach the warehouse.

Invoicing Goods higher than Cost

Under this method, goods are charged at the cost + profit and the pro-forma invoice also shows this higher price of such goods. To know the actual profit, at the end of an accounting period, consignment account will be credited with excess price so charged. Value of the stock will also be adjusted to the extent of profit element. Main reason to adopt this policy by consignor is −

• To hide actual profit from consignee.

• Valuation of a stock at the consignor’s warehouse is comparatively easy in this case.

• In this case, consignor usually directs consignee to sale goods on invoice price only. It prevents different sale price to different customers.

Loss of Goods

There may be two types of losses as explained below −

Normal Loss − Normal loss may occur due to inherent characteristics of goods like evaporation, drying up of goods, etc. It is not separately shown in the consignment account, but included in the cost of goods sold and the closing stock by inflating the rate per unit. To calculate the value of unsold stock, following formula is used.

$$\small Value\:of\:closing\:stock = \frac{Total\:value\:of\:goods\:sent}{Net\:quantity\:received\:by\:consignee} \times Unsold\:quantity$$

$$\small Net\:quantity\:received = Goods\:consigned\:quantity - Normal\:loss\:quantity$$

Abnormal Loss − An abnormal loss may occur due to any accidental reason. It is credited to the consignment account to calculate actual profitability. Valuation of closing stock is done on the same basis as explained earlier i.e. proportionate cost + proportionate direct expenses.

Abnormal Loss and Insurance

If, there is an insurance policy in respect of the consigned goods; following entries will be passed in the books of a consignor −

Sr.No.	In the Books of Consignor	In the Books of Consignee
1	Payment of Insurance Premium (a) If insurance premium is paid by the consignor, then cash will be credited. (b) If Insurance premium is paid by the consignee, then consignee’s A/c will be credited.	Consignment A/cDr To Cash A/c Or To Consignee A/c (Being Insurance premium paid)
2	At the time of Abnormal Loss	Abnormal Loss A/cDr To Consignment A/c (Being Loss Incurred)
3	Acceptance of Claim by Insurance Company	Insurance Company (Name of the insurer) A/cDr To Abnormal Loss A/c (Being claim admitted)
4	On receipt of Claim	Bank A/cDr To Insurance Company A/c (Being amount of claim received)
5	In Case of Loss	Profit & Loss A/cDr To Abnormal Loss A/c (Being amount of Abnormal Loss transferred)

Summary of Accounting Entries

Following Accounting Entries (Except for Loss) will be done in the books of consignor and consignee for transactions related to the consignment −

Sr.No.	In the Books of Consignor	In the Books of Consignee
1	When goods are sent to the consignee Consignment A/cDr To Goods Sent on Consignment A/c (Being Goods Sent on Consignment)	No need to do any Entry in this case
2	Expenses Incurred by Consignor Consignment A/cDr To Cash/Bank A/c (Being Expenses incurred on consignment)	Not Applicable
3	Advance given by consignee Cash/Bank A/cDr To Consignee’s A/c (Being advance received from consignee)	Consigner A/cDr To Bank/Cash A/c (Being Advance amount paid to Consignor)
4	Expenses Incurred by Consignee Consignment A/cDr To Consignee’s A/c (Being Expenses incurred by consignee)	Consigner A/cDr To Bank/Cash A/c (Being Expenses incurred on goods received on consignment)
5	Sale by Consignee Consignee’s A/cDr To Consignment A/c (Being Expenses incurred by consignee)	Cash (for cash sale) A/cDr Debtors (for Credit Sale) A/c Dr To Consignor A/c (Being goods sold)
6	Commission to Consignee Consignment A/cDr To Consignee’s A/c (Being Commission on sale due to consignee)	Consigner A/cDr To Commission A/c (Being Commission earned)
7	Remittance from Consignee Cash/Bank A/cDr To Consignee’s A/c (Being due amount received from consignee)	Consigner A/cDr To Bank/Cash A/c (Being Balance due Payment made to consignor)
8	Entry for Profit on Consignment Profit & Loss A/cDr To Consignment A/c (Being Profit earned on consignment)	Not Applicable
9	Loss on Consignment Consignment A/cDr To Profit & Loss A/c (Being Loss incurred on Consignment transferred to the profit & Loss Account)	Not Applicable

Note − The goods sent on consignment account will be closed by transferring balance into the Purchase account or the Trading account.

Financial Accounting - Joint Venture

An association of two or more persons or we may say temporary partnership combined for the carrying out a specific business, and divide profit or loss thereof in agreed ratio is called a Joint Venture. Concerned parties to joint venture are known as co-venturers. The liabilities of co-venturers are limited to their profit sharing ratio or as per agreed terms −

Suppose ‘A’ and ‘B’ undertake the job to develop a park for a consideration of Rs. 50,000/- Lacs. Since they come together for a work on a specific project, it will termed as joint venture and each of them (A and B) will be called as a co-venturer. Further, this venture will automatically terminate once the project is completed.

Major Features and Characteristics of Joint Venture

Following are the major features of a joint venture −

• There is an agreement between two or more persons.

• Joint venture is made for the specific execution of a business plan/project.

• It is a temporary partnership without the use of a firm name.

• Agreement for joint ventures is automatically dissolved as soon as specific project is over.

• Profit & Share are shared on the same terms and conditions agreed upon. However, in the absence of any agreement, profit & share will be divided equally.

Partnership and Joint Venture

There are following differences between partnership and joint venture −

• Partnership always carried on with firm’s name, but for the joint venture, no such firm’s name is required.

• The persons who run the business on partnership are called as partners and the persons who agreed to take the project as joint venture are called as co-venturers.

• Normally, a partnership is constituted for a long period (including various projects), whereas joint venture is formed to complete a specific job/project.

• Partnership is governed under the Partnership Act, 1932, whereas there is no enactment of such kind for the joint ventures. However, as a matter of fact in law, a joint venture is treated as a partnership.

• There is no limit specified for the numbers of co-venturers, but the number of partners is limited to 10 under banking business and 20 for any other trade or business.

• Liability of a partner is unlimited and may extent of his business and personal estate, whereas under joint venture, liabilities of co-venturers are limited to the particular assignment or project agreed upon.

Joint Venture and Consignment

Major differences between joint venture and consignment may be summarized as −

• Relationship − The co-venturers of a Joint venture are the owners of a Joint venture, whereas relationship of a consignor and consignee is of owner and Agent.

• Sharing of Profits − There is no distribution of profit between a consignor and consignee, consignee only gets commission on sale made by him. On the other hand, the co-venturers of a joint venture share profits as per the agreed profit sharing ratio.

• Ownership of Goods − Ownership of the goods remains with the consignor. Consignor transfers only possession to the consignee, but every co-venturer of a joint venture is the co-owner of the goods/project.

• Contribution of Funds − Investment is done by the consignor only. On the other hand, funds are contributed by all co-ventures in a certain agreed proportion.

• Continuity of Business − In case of a joint venture, there is no continuity of the business once project is completed. On the other hand, if, everything goes smooth, consignment is a continuous process.

Accounting Records

To keep a record of the joint venture transactions, there are three following types of accounting methods −

• When one of the Venturers keeps Accounts,
• When Separate Books of Accounts are kept for the Joint Venture, and
• When Separate Books of Accounts are not kept for the Joint Venture.

Let’s discuss each of them separately −

When one of the Venturers keeps Accounts

If one of the co-venturers is appointed to manage the joint venture, he is awarded an extra commission or remuneration out of the profit for his services.

Journal Entries

When share of investment received from other co-venturers	Cash/Bank A/cDr To Co-venturers A/c
When goods are purchased	Joint Venture A/cDr To Cash A/c (in case of cash purchase) Or To Creditors A/c (for credit purchase)
When expenses incurred	Joint Venture A/cDr To Cash A/c
When goods are sold	Cash A/cDr Or Debtors A/cDr To Joint Venture A/c
When commission allowed to working co-venturer	Joint Venture A/cDr To Commission A/c
In case of Profit balance of joint venture, account will be transferred to profit & Loss (own share of working co-venturer) and other co-venture’s personal accounts	Joint Venture A/cDr To Profit & Loss A/c To Co-venturers personal A/c
In case of Loss	Profit & Loss A/cDr To Joint Venture A/c
On settlement of accounts	All Co-venturer A/cDr To Cash/Bank A/c

When Separate Books of Accounts are kept for the Joint Venture

Under this method, all co-venturers contribute their share of investment and deposit their shares in a Joint Bank account — newly opened for the specific purpose of the Joint Venture. They may use this bank account to make any kind of payments and to deposit sale proceeds or any other kind of receipts.

In addition to Bank account, a Joint venture account is also opened in the books to keep records of all transactions routed through this account.

This category of accounts is a personal account of the each co-venturer. Thus following three accounts are opened −

• Joint Bank Account
• Joint Venture Account
• Personal account of co-venturers

When Separate Books of Accounts are not kept for the Joint Venture

It is of two types −

• When all venturers keep separate accounts
• Memorandum joint venture method

When all Venturers keep Separate Accounts −

• Separate Joint venture account and personal accounts of other co-venturers are opened under this method of accounting.

• Joint venture account is debited and bank account or creditor account is credited on the account of goods purchased or expensed.

• Joint venture account is credited and a bank account or debtor account is debited in case of either cash sale or credit sale.

• Each co-venturer debits joint venture account and credits personal accounts of other co-venturer on the account of either goods purchased or expensed by other co-venturers.

• Joint venture account is credited and personal account of others co-venturer account is debited in case of sale made by other co-venturers.

• Joint venture account is debited and commission account is credited if, commission is receivable, but if commission is receivable by other co-venturer, then the concerned co-venturer account will be credited instead of the commission account.

• If unsold stock is taken, then goods account will be debited by crediting Joint venture account. On the other hand, if unsold stock is taken by any other co-venturer, then personal account of the co-venturer will be debited.

• Balance in the joint venture accounts represents profit or loss and later that amount of profit or loss will be transferred to the personal accounts of co-venturers.

Note − Above transactions are possible only when all the co-venturers exchange information’s on regular basis.

Memorandum Joint Venture Method

Important features of memorandum method are given as hereunder −

• Only one personal account is opened by each co-venturer in his book named Joint Venture account with…………… (Name of other co-venturer). Same process will be followed by other co-venturer in his books of accounts.

• Only one personal account will be opened by each co-venturer irrespective of the fact, how many other co-venturers are exists. For example, there is a joint venture of 4 person A,B,C, & D; now, A in his books will open only one personal account named as Joint venture with B,C, & D account.

• Each party will record only those transactions in his book, which are done by him; the transactions done by other co-venturers will be ignored.

• In addition to above said personal account, a combined account named as “memorandum joint venture account” will also be opened.

• Memorandum account is merely a combined account of personal accounts opened by each co-venturer. Debit side of personal account will be transferred to the memorandum account and the credit side of personal account will be transferred to the credit side of memorandum account.

• Transactions done by co-venturers among themselves including cash received or paid by one co-venturer to other will be ignored at the time of preparation of a memorandum account.

• Balance of memorandum joint venture account will represent profit or loss of the particular business. Further, the profit or loss will be transferred to the individual co-venturer account in their profit sharing ratio.

Financial Accounting - Non-Trading Accounts

Some of the organizations or institutions are constituted to provide valuable services to the society with the objective not to earn profit. These organizations normally offer the services such as education, medical, social clubs, charitable trusts, trade unions, etc.

However, we can summarize these organizations in the following three types of categories −

• Clubs, associations, or society’s works for the welfare of their members.

• Charitable institutions like hospitals, students’ hostels, and other educational institutions providing education to poor children as well as illiterate young and old groups.

• Professional firms of lawyers, chartered accountants, architects, doctors, solicitors, etc.

What is Non-Trading Account?

Maintenance of proper books of accounts is necessary to safeguard the money of its members and general public from any kind of misuse or misappropriations. It is important to know the total receipts, total payments, and also to know financial status of an institution. Hence, the account opened and maintained for and by the organizations discussed above is known as Non-trading account.

Normally, registration of members, minute book, cash receipt journal, cash payment journal, etc. are main record which is maintained by these organizations/ institutions in their non-trading accounts. At the end of an accounting period, these institutions prepares its final accounts, which include the following −

• Receipt and Payment Account
• Income and Expenditure Account
• Balance-Sheet

Let’s discuss each of these in detail.

Receipt and Payment Account

It is a real account. Basic rule of double entries is followed to prepare this account. It is prepared from a cash book at the end of the accounting period. Every transaction regarding the cash transactions is recorded in the Cash Book in a chronological order. We may say that the Receipt and Payment account is a summary of cash payment and cash receipts during the current year.

For example, if rent and salary paid on monthly basis all over the accounting period, and donation or subscription received during the current year recorded in a cash book date wise, but at the end of the accounting period, the Receipt and Payment account will contain total amount of rent paid, salary paid, subscription received and donation received. All cash receipt will be recorded on the debit side and all cash payment will be recorded on the credit side.

Income and Expenditure Account

Income and expenditure account is a nominal account and as an equivalent to Profit and Loss account.

The essential features of an income and expenditure account are as follows −

• Expenses and losses are recorded in the debit side of it and all incomes and gains are recorded on the credit side.

• Capital income and expenditure are excluded and revenue income and expenses are included in it.

• It is based on a mercantile system of accounting, therefore, the income and expenses related to preceding years or subsequent years are excluded while preparing the income and expenditure account.

• The credit balance of an income and expenditure account shows surplus. Further, excess of income over the expenditure and the debit balance of it show deficit i.e. excess of the expenditure over income.

• Only nominal accounts are considered in preparation of this account.

Balance Sheet

The date on which a balance sheet is prepared, particulars of all the assets and liabilities are recorded in the same manner as we do in any other profit making firms. Its capital fund is made up of surplus income over expenditure and other incomes capitalized in the given period of time. Sometimes, two balance sheets need to be prepared viz…

• At the beginning of the accounting year to know the opening capital fund and
• At the end of the financial year to know the financial position of the organization.

Conversion of Receipt and Payment Account into Income and Expenditure Account

Following are the steps required to convert receipt and payment account into income & expenditure account −

• Opening balance and closing balance of a receipt and payment account representing opening cash in hand, opening cash at bank, closing cash in hand, and closing cash at bank need to be ignored.

• Items of capital receipts and capital payment will be excluded while preparing an income and expenditure account.

• Revenue items of an income and expenditure will be considered only at the time of preparation of an income & expenditure account from the receipt and payment account.

• All adjustment regarding the outstanding expenses, prepaid expenses, provision for bad debts, provision for depreciation, income received in advance, and income receivable will be done.

• An income and expenditure relating to preceding year or subsequent year will be ignored, and the items only related to the current year will be considered.

Method to Calculation

With the help of ledger accounts, we may calculate the value of income or expenses.

The following two examples describe the method of calculation −

Example (1) − to calculate the amount of expenses of the current year, we need to prepare a ledger account of a particular expense and then the balancing figure of it will represent the amount of expense for the current year.

From the following particulars, please find out the amount of rent need to be shown in income & expenditure account −

Particulars	Amount (in Rs.)
Outstanding Rent at the beginning of the year (as on 01-04-2013)	6,000
Amount as shown in the receipt and payment account	26,000
Outstanding Rent at the end of the year (31-03-14)	4,000

Solution −

Rent Account

Date	Particulars	Amount	Date	Particulars	Amount
			01-04-13	By Balance b/d	6,000
	To Cash Paid (As per receipt and payment account)	26,000	31-03-14	By Income and expenditure a/c (Balancing Figure)*	24,000
31-03-14	To Balance C/d	4,000
	Total	30,000	Total		30,000

It is very clear from the above example that the balancing figure represents rent for the current year i.e. to be transferred and shown in the debit side of the income & expenditure account. Following the same method, we can calculate the amount of any other expenses.

Items Peculiar to Non-Trading Concern

There are certain peculiar items in the case of non-trading concerns, which require a special treatment −

Donations

Non-trading concerns may receive donations time to time. The treatment of donation depends upon nature of donation.

There are two types of donation as explained below −

• Specific Donation − Some donation may be received for any specific purpose, for example, for the construction of a room or building and then donation is termed as specific donation. The amount of such donation cannot be used for any other purpose. It should be shown on liabilities side of the Balance-sheet and used only for the same purpose it is meant for.

• General Donation − When a donation is received for a common purpose is termed as General Donation. If the amount of donation is small, it will be treated as recurring income and will be recorded in the credit side of income & expenditure account.

  Donation of the big amount should be fairly treated as capital receipts and will be shown in the liabilities side of the Balance sheet. However, donation is of a small amount or a big amount may depend upon the size of a concern and amount.

Legacy

Sometimes, as per the will of a person, an amount received is called as legacy. It is as good as donation. It is of a non-recurring nature, therefore should be treated as a capital receipt, and hence will be appeared in the liabilities side of a Balance sheet. However, it may also be treated as an income and may be taken to income & expenditure account.

Entrance Fees

A club or society usually charge admission fees or entrance fees for the membership. In case of club etc., admission fees or entrance fees usually charged as capital receipts, but in case of a hospital or educational institution, it is treated as a recurring income.

Life Membership Fees

The life membership fees may be taken from the members of institution only once in their lifetimes. On the basis of lifetime membership, members may enjoy certain benefits. Amount received as the Life Membership might be transferred to the “Life Membership Fees Account” of the institution and can be dealt in the accounts by any of the following methods −

• May be taken as liabilities side of a Balance sheet as Life Membership Fees.”

• Normal subscriptions of the members may be transferred from the Life Membership Fees account to the subscription account as an income and the balance may be carried forward to the following years.

• On the basis of average life of a member, the amount may be transferred to the income and expenditure account annually and rest will be carried forward towards the following years.

Sale of Scrap or Old Newspapers

Without any dispute, it will be treated as recurring income and will appear in the credit side of an income and expenditure account.

Subscription

Subscription is the major source of an income for the non-trading concerns. Subscriptions are received from the members of a club or institution. A receipt and payment account records all the actual subscription received during the current year and an income & expenditure account shows the subscriptions, which relates to the current accounting period. Therefore, some adjustments require to calculate the subscription of the current year.

Example (1) − to calculate the amount of Subscription for the current year, the ledger account of a subscription account needs to be drawn and the balancing figure of this will represent the amount of subscription of the current year.

With the following particulars, please find out the amount of subscription to be shown in an income & expenditure account −

Particulars	Amount (in Rs.)
Outstanding subscription at the beginning of the year (as on 01-04-2013)	6,000
Amount as shown in the receipt and payment account	26,000
Outstanding subscription at the end of the year (31-03-14)	4,000
Subscription received in advance for the next year	2,000

Solution −

Subscription Account

Date	Particulars	Amount	Date	Particulars	Amount
01-04-13	To balance b/d	6,000	31-03-14	By Cash	28,000
31-03-14	To Advance Subscription (to be shown as Liabilities in Balance Sheet)	2,000
31-03-14	To Income & Expenditure Account (Balancing Figure)*	24,000	31-03-14	By balance c/d	4,000
	Total	32,000	Total		32,000

It is very clear from the above example that the balancing figure represents subscription for the current year, which needs to be transferred to the income & expenditure account as an income.

Special Funds

Some special funds are created by the respective institutions for specific purpose. For example, a prize fund may be created to give the best player of the year award. Any income relating to those funds should be added to the funds and deficit, if any may be charged from the income & expenditure account.

Example (2) − to calculate the amount of an income related to the current year, we need to prepare a ledger account of the particular income. Further, the balancing figure of this account will represent the amount of an income for the current year.

From the following particulars, please find out the amount of Subscription that needs to be shown in the Income & Expenditure account −

Particulars	Amount (in Rs.)
Outstanding Subscription at the beginning of the year (as on 01-04-2013)	6,000
Amount as shown in the receipt and the payment account	26,000
Outstanding subscription at the end of the year (31-03-14)	4,000

Solution −

Subscription Account

Date	Particulars	Amount	Date	Particulars	Amount
01-04-13	To balance b/d	6,000
	By Income and expenditure a/c (Balancing Figure)*	24,000	31-03-14	By Cash (As per receipt and payment account)	26,000
			31-03-14	By balance c/d	4,000
	Total	30,000	Total		30,000

It is very clear from the above example that balancing figure represents Subscription for the current year i.e. to be transferred and shown in the credit side of the income & expenditure account.

It is very clear from the above example that balancing figure represents Subscription for the current year i.e. to be transferred and shown in the credit side of the income & expenditure account.

Financial Accounting - Single Entry

As we know, there are two systems of recording transactions in our books of accounts. In the previous chapters, we have learned about the double entry system, now let’s discuss another system of accounting i.e. Single Entry System (SES).

Meaning and Silent Features of SES

For every accounting transaction, everyone does not follow the principle of double entry system of accounts. Some of the small business units do not keep their books of accounts as per double entry system. In simple words, single entry system of accounts mean — the business unit, which does not follow the principle of double entry system.

There are following two types of SES of accounts −

• Pure Single Entry System − Personal accounts like sundry debtors and sundry creditor’s accounts are maintained, but real and nominal accounts are not opened under this system.

• Popular Sense − Under this system, three types of treatment are done.

  • Double entry system followed for cash received from the debtors and the cash paid to the creditors.

  • Single entry system followed for expenses paid, purchases of goods, purchases of fixed assets etc.

  • Provisional entries like bad debts, depreciation, etc. are not done.

Difference between SES and DES

• Single entry is an in-complete system of accounting, whereas double entry system (DES) is a complete system of accounting transactions.

• There is no reliability on books in a single entry system, whereas double entry system is a reliable accounting system.

• Checking of the arithmetical accuracy is possible in a double entry system through preparation of trial balance, whereas it is not possible under a single entry system.

• Since, single entry system does not maintain Trading, and Profit & Loss Account, and Balance Sheet; hence, ascertainment of the actual profit and exact financial position of the firms is not possible, on the other hand, all above is quite possible under the double entry system of accounting.

Limitations of SES

• Single entry system of accounts do not record two-fold aspects of each and every transactions, hence, it is not a scientific system of keeping accounting records.

• Checking of the arithmetical accuracy is not possible due to non-preparation of a trial balance. Preparation of a trial balance is not possible, because the method of double entry system is not followed for each business transaction.

• Ascertainment of the actual profit of a concern is not possible, as nominal accounts are kept under single entry system. In the absence of nominal accounts, Trading and Profit & Loss account cannot be prepared.

• It is not possible to find the exact financial position of a firm in the absence of real accounts, because without real accounts, it is not possible to prepare the Balance sheet of a firm on a particular day.

• Outsiders never rely on the books of accounts of a firm.

• In case where owner of the business wants to sell his business, ascertainment of exact value of the business is not possible, especially goodwill value of the firm.

• Single entry system is practiced only by the small business units.

Preparation of Statement of Affairs

To know the financial position of a business, the list of assets & liabilities and statement of affairs are prepared on the last date of accounting period. As stated earlier, in the absence of real accounts, it is not possible to prepare a Balance sheet.

Following points are required to prepare the statement of affairs −

• With the help of personal accounts, a list of debtors and creditors should be prepared.

• Stock valuation method will be either on cost or market price, whichever is lower.

• Cash book balance should be physically verified with the cash book.

• Bank balance should also be reconciled with the Bank statements.

• Statement of affairs should contain the income received in advance and the expenses paid in advance.

• Excess of assets over liabilities will be capital of the proprietor or firm.

• Basis for the valuation of fixed assets will be the purchased voucher and any other available evidence.

How does the Statement of affairs Differ from Balance-Sheet?

Main difference between the statement of affairs and the Balance sheet is —reliability on first is prepared through incomplete information and on later is based on the scientific method of the double entry system of accounts.

Ascertainment of Profit under SES

We have the following two methods to ascertain the profit under single entry system −

• Statement of Affairs or Net worth Method and
• Conversion Method

Net worth Method

Under the single entry system, the ascertainment of the profit can be done without preparing a Trading and Profit & Loss account. For example,

1	To know the capital at the beginning of the year or at the last date of the preceding accounting year, first step is to prepare the statement of affairs at the beginning of the year.
2	One statement of affairs should be prepared on the last date of accounting year to ascertain.
3	Drawing should be added to the amount of capital as ascertained at the end of the year and the capital introduced if, any, during the year will be subtracted.
4	Capital introduced if, any, during the year will be subtracted.
5	Difference of (3) – (1) will be the profit or loss for the year. If, (3) is more than (1), then it is a profit or vice versa.
6	The amount of profit or loss as calculated by the step No. (4) above, will be adjusted by the interest on capital and the interest on drawing (to ascertain Net Profit of the firm).

Conversion Method

Under the conversion method system of accounting, change from the single entry system to the double entry system on a particular date can be done by the following procedure −

• Statement of affairs should prepare on the date on which the change need to be made. After the proper checking and verification of such balances from available records, all the balances like cash balance, bank balance, assets, liabilities, debtors, and creditors should appear in the statement of affairs.

• An opening journal entry should be made to bring into the books as −

Journal Entry

AssetAA/cDr AssetBA/cDr AssetCA/cDr

LiabilitiesAA/c LiabilitiesBA/c LiabilitiesCA/c

Being all assets and all liabilities brought forward from the statement of affairs a/c.

Above entry will be a base entry to open all new books under the double entry system of accounts and all the future transactions will be booked according to the double entry system as explained earlier.

Conversion of Books of Last Year from SES into DES

To convert books of the last year from single entry to double entry system, it will be assumed that all the subsidiary books are maintained properly under the single entry system. However, following procedures need to be followed −

Where Cash Book, Personal Books, and Subsidiary Books are Maintained −

• Opening statement of the affairs should be prepared at the beginning of the period.

• All the impersonal accounts as appeared in the cash book should be posted in the respective impersonal accounts, if it has not been done earlier.

• New impersonal accounts need to be opened through total of the subsidiary books. For example, with the total of sales book and purchase book, sale account will be credited and purchase account will be debited, vice versa in case of returns.

• All the new account should be opened for the entries relating to discount, rebates, bad debts, etc. which are not passed through the subsidiary books. This procedure will give two-folds effect of such transaction as appeared in the personal accounts.

• Month-wise positing should be done to the ledger accounts through petty cash book, if, maintained by the firm.

• After completion of the above procedure, a trial balance should be prepared to confirm the arithmetical accuracy of the books of accounts.

• After completion of the above procedure of trial balance, Trading and Profit & Loss account and Balance sheet should be prepared (after considering all the adjustments like prepaid expenses, outstanding expenses, income received in advance, or receivables as well as the provisions for depreciations, doubtful debts etc.

Where only Cash Book and Personal Books are Maintained

In this case, a different procedure of conversion will be followed −

• As described earlier, an opening statement of the affairs should be prepared at the beginning of the period.

• All the real and nominal accounts as appeared in the cash book and not posted earlier in any account, should be posted in respective accounts.

• An analysis of debit and credit side of personal accounts like debtors accounts and creditors accounts will be done as per the method given below −

Summary of Analysis to be Done

Sr.No.	Debit side of Creditors’ Accounts	Debit side of Debtors’ Accounts
1	Bills payables	Opening balance as appeared in opening Statement of Affairs
2	Discounts and rebates received	Sale (Credit)
3	Return inward (Purchase returns)	Transfers
4	Transfers	Bills receivables (Dishonored)
5	Cash paid to Creditors
6	Endorsement of Bills Receivables in favor of Creditors

Sr.No.	Credit side of Debtors’ Accounts	Credit side of Creditors’ accounts
1	Cash received	Opening balance as appeared in opening Statement of Affairs
2	Discount Allowed	Purchases (Credit)
3	Bills receivables received	Transfers
4	Discount and allowances	Bills payables (dishonored)
5	Transfers
6	Goods returned (Sales returns)
7	Bad Debts

Financial Accounting - Leasing

In the field of real estate, leasing is a popular term because it is advantageous to own land and building. Today, most of the businesses run their offices on the leased premises.

A Lease is an agreement under which lessee (the person/entity, who takes possession of the property) get the right to use the premises for the agreed period of time in lieu of the rent as agreed between both Lessor (owner) and lessee. Lessor has an ownership right of assets, but still lessee has an unrestricted right to use that asset.

Every lease contract should cover the following terms −

• Period of lease.

• Timing of the payment to be made along with the amount of rent.

• About maintenance expenses, taxes, insurance, provision for renewal of lease agreement.

The Accounting Standard 19, issued by the Council of the Institute of Chartered Accountants of India, covers the disclosure of appropriate accounting policies in the financial statements.

Standards 19 are mandatory in nature and applicable to all lease agreements except some given below −

• Lands to be used under the lease agreement.
• For use of natural resources like oil, gas, timber, metal, etc.
• Video recording, films, motion picture, patents, and copyrights.

Important Terms in Leasing

Following important terms are commonly used in lease accounting −

• Lessee − Lessee is a person who possess the right to use the asset in lieu of agreed rent for a certain period of time (as per the lease agreement).

• Lessor − Lessor is the owner who gives right to the lessee to use his asset/property in lieu of rent for a certain period of time.

• Lease Term − Usually, lease agreement is contracted for a fixed and non-cancellable period called as lease term. It is also known as ‘Lease Period.’ Lease term may be further extended as agreed with or without further amendment/s.

• Fair Value − Fair value is an amount on which an asset can be exchanged or it may be the value of liability settled.

• Useful Life − It can be

  • A period over which an asset could be used by the lessee.

  • Expected number of units that can be produced by that asset.

• Inception of Lease − It is the date on which principal provision of the lease are committed to.

• Residual Value − An estimated fair value of an asset at the end of the lease term is called as residual value.

• Minimum Lease Payment − Total payment to be made by lessee to lessor during the lease terms excluding taxes, insurance, maintenance charges, contingent rent, etc.

• Contingent Rent − It is based on a factor other than passage of time, lease payments i.e. percentage of sale, etc.

• Unguaranteed Residual Value − An expected fair value at the end of the lease period is called as Unguaranteed Residual Value.

Popularity of Leasing

One of the main reasons behind the popularity of leasing is its simplicity to both the parties i.e. lessor as well as lessee. It is beneficial in terms of its documentation and also provides tax advantage. Selection and purchase of asset come under the purview of leasing company, and use and rent payment of the assets are the part of lessee.

Since lessor remains owner of the assets, so he can claim for the depreciation in his books. Interestingly, he can enjoy the tax benefit against the depreciation. Similarly, lessee pays the rent and records such rent in his books as expenses for the purpose of tax benefit.

Advantages of Leasing

Main advantage of leasing is given hereunder −

• Lessee can use the asset without actually purchasing it, means full finance without any margin money.

• It provides flexibility in fixation of the rent and the lease period as per the requirements.

• In the Balance sheet of a lessee, leased assets are not shown as asset or liability of the company, hence the credit capacity of the lessee remains un-affected.

• Leasing provides an opportunity to lessee to earn additional profit and to improve earnings per share.

• Deduction of a rent is eligible to claim tax benefit (as business expenditure).

• Without heavy investment, lease rent can be paid out from the income generated by the use of the assets.

• Tax benefit of the depreciation may be claimed by lessor according to the Income Tax Act.

• Taking advantage of the full utilization of the asset is possible under a lease agreement; chances of ignorance are high, where company purchases asset as its own.

• In case of a closely held company, it provides better wealth planning solutions.

• It provides protection to lessee against the inflation.

• Strict provisions of the financial institutions for acquiring an asset can be avoided through a lease agreement.

Disadvantages of Leasing

Some of the disadvantages of leasing are −

• Leasing is not very much useful for some of the new businesses, as earning through the business comes much after the investment.

• Some of the incentives as provided by the state and the central government, cannot be enjoyed due to lease agreement.

• The assets, whose values are likely to appreciate, should be purchased instead of leasing.

• In case of variation clause in a lease agreement, rental structure can be changed due to change in the rate of interest, rate of depreciation, etc.

Classification of Lease

According to AS-19, following are the two categories of Leasing −

• Operating lease
• Finance Lease

Operating Lease

Operating lease is an agreement wherein the lessor (owner) allows the renter (lessee) to use the agreed asset for a particular period. Usually, the lease period is shorter than the economic life of the asset. Further, lessor does not actually transfer the ownership rights. The Lessor gives the right to the lessee to use the asset in return of regular payments for an agreed period of time.

Accounting Treatment

As per AS-19, following are the accounting treatment in the books of lessor and lessee −

In the books of Lessor −

• Assets should be treated as the fixed assets in the Balance sheet of a lessor.

• Rental income should be treated as an income in the Profit and Loss account.

• Depreciation should be treated as expenses and should be debited from the Profit & Loss account.

• An initial cost can be deferred to the lease period of the asset or may be booked as expenses in the year, in which actually incurred.

• Depreciation will be charged as per AS-6.

In the books of Lessee −

• Lessee should treat a rental payment as expenses in the profit and loss account.

Finance Lease

In case where lease is able to secure for lessor the recovery of his capital outlays plus a reasonable return on the fund invested during the lease period is called financing lease. Finance lease in non-cancellable contract and also, lessor is not responsible for any expenses and taxes of the leased asset.

Accounting Treatment

In the books of Lessor −

• Total value of the investment plus income receivable on it will be treated as receivables in the Balance sheet.

• Direct expenses may be directly debited from the profit and Loss account in the year of expenses incurred or may be deferred up to the lease period.

In the books of Lessee −

• Initial direct cost will be treated as an asset.

• Fair value of the leased assets should be considered as an asset and a liability in the finance lease.

• It is an appropriate to show liability separately in the Balance sheet.

Financial Accounting - Investment Account

Anyone can buy and sell securities from a stock exchange with the purpose to increase his/her (monetary) assets. Sale and purchase of the securities is done through banks. The stockbrokers help people in trading by paying the amount of commission, stamp duty, and brokerage on it, which are the essential parts of security trading.

At the time of selling of these securities, charges should be deducted from the sale, as proceeds to get the actual sale price. Most of the time, market price is different from the face value of securities, which depends upon different regulating factors. If market value of the securities is equal to face value, it is called as at par; if market value is less than face value, it is called as on discount; and if market value is higher than face value, it is said to be on premium.

Meaning of Investment

Investment means either buying or creating an asset with the future expectation of capital appreciation, dividends (profit), rents, interest earnings, or some combination of these returns. However, normally, investment inherent with some form of risk, such as investment in equities, property, and even fixed interest securities, among other things, are the subject to inflation risk.

Further, among all these, securities are held as long term investment to earn income. It is said to be fixed assets, but where objective of an organization is to sell and buy securities in short term fund to utilize its surplus fund, would come under the category of current assets.

There may be two types of securities −

• Fixed Interest Securities − Holders of fixed interest securities get fixed rate of interest.

• Variable Yield Securities − Under this category, return on investment may differ from year to year.

Investment Account

Investment account is an account opened for the purpose of the investment. Further, if the number of investment is large, a separate account for each investment should be opened.

Accounting entry on the purchase of any investments are given as hereunder −

On purchase of investment	Investment A/cDr To Cash/Bank A/c (Being Investment made) Note − Investment account is inclusive of purchase expenses like stamp duty, Commission, and brokerage.
On Sale of investments	Cash/Bank A/cDr To Investment A/c (Being Investment made) Note − Investment account will be credited with net realized value of investment.
Interest and dividend account	Cash/Bank/Investment A/cDr To Dividend/Interest A/c (Being Interest/dividend received on investments) Note − Investments account will be credited in case, interest/dividend accrue and cash/bank account will be debited (in case) with net realized value of investment.

Investment Transactions

We normally have the following two types of investments transactions −

• Cum Dividend or Cum Interest Quotations and
• Ex-Dividend or Ex-Interest Quotations

Let’s discuss these two types of investment transactions in detail.

Cum Dividend or Cum Interest Quotations

Interest and dividend on the fixed investments accrued on regular interval, but payment of those are made only on fixed dates. Dividends are always paid to the persons, who are shareholder at the time of payouts. Suppose a shareholder sold his shares after keeping those shares in his hand up to ten months, then dividends on those shares will be paid to the buyer or we can say, to new shareholder.

So, a seller at the time of selling shares normally charge value of the accrued dividends up to the date of sale, and this is called ‘CUM DIVIDEND” or “CUM INTEREST”. Since, the sale price is inclusive of the value of a share and interest or dividend, therefore at the time of entry in the books of accounts, normal price of share should be booked in the investment account and the value of dividend or interest should be debited to dividend or interest account.

At the time of receiving dividend or interest, dividend or interests account will be credited, debiting cash or bank account. On the other hand, in the books of seller, normal price of the share should be credited to Investment account and the price of accrued dividend or interest should be credited to the dividend or interest account as the case may be.

Accounting Entries − It can be understand through the following table.

In the Books of Buyer

On purchase of investment	Investment A/cDr Dividend or Interest A/c To Cash/Bank A/c (Being Investment made)
On receipt of dividend or interest	Cash/Bank A/cDr To Dividend or Interest A/c (Being dividend or interest received)
for Accrued Interest	Accrued Interest A/cDr To Interest A/c (Being interest accrued)

In the Books of Seller

On Sale of investments	Cash/Bank A/cDr To Investment A/c To Dividend or Interest A/c (Being Investment Sold )
On receipt of dividend or Interest	Cash/Bank A/cDr To Dividend or Interest A/c (Being dividend or interest received)

Ex-Dividend or Ex-Interest Quotations

The buyer of shares when he is quoted ex-dividend is not entitled to receive the payment. It is the interval between the record date and the payment date during which the stock trades without its dividend. Therefore, the person who owns the security on the ex-dividend date will be awarded the payment, regardless of who currently holds the stock.

Difference between Cum-dividend and Ex-Dividend

Major differences between them are given as hereunder −

• Cum interest or dividend prices are inclusive of the interest or dividend accrued at the date of purchase, whereas in case of the ex-dividend, prices are excluding value of the dividend or interest.

• The purchase price is higher than normal purchase price in case of Cum-dividend, whereas purchase price is the real price in case of ex-dividend.

• Nothing is payable additional in case of Cum-Interest, whereas separate amount of the dividend or interest has to be paid in case of the ex-dividend or ex-interest.

Balancing the Investment Account

Difference of debit and credit side of the investment account is Profit or Loss in case where all the investments are sold.

In case where part of the investments are sold and the balance investments stand unsold, it should be carried forward to the next accounting period and remaining balance of the two sides (debit and credit) will represent profit or loss on the sale of investment.

In case where investments are the fixed assets, then the profit or loss will be of capital revenue or capital loss and should be treated accordingly.

Equity Share Accounts

Main features of investment account regarding the equity shares are given as hereunder −

• Bonus Shares − Bonus shares are issued by the profitable companies to the existing shareholders of the company without any additional amount. Purpose of the bonus share is to capitalize reserves of the company. Only number of the shares will be added in face value column, and principle or capital column will remain unchanged.

• Right Shares − Right shares are first offered to the existing shareholders of the company as a matter of the right, hence called as right shares. As per Companies Act, right shares can be issued after two years of the establishment of a company or after one year of first issue.

Financial Accounting - Insolvency Accounts

Insolvency is a financial stringency i.e. when an individual or an organization/company is no longer capable to pay the debts he/it owes. Insolvency usually leads to insolvency proceedings, in which legal action can be taken against the insolvent, and assets may be liquidated to pay off the outstanding debts.

When a Person / Entity can be Declared Insolvent

Before declaring an entity or a person as insolvent, a competent court defines two conditions −

• A person or entity should be debtor and
• He/it should had done any act of insolvency.

Act of insolvency means, when a person (debtor) shows that he is not able to pay his liabilities.

An order of adjudication must be passed by the court of law, before legally declaring any person insolvent. To pass an order of adjudication by the court of law, a petition should be filed by any of the creditor or creditors or by the debtor himself. Petition by the creditor may be filled only in following conditions;

• Debt should be at least for Rs. 500/- or more

• Within three months of petition, an act of insolvency should be done by debtors.

After filing the petition, the competent court will fix date of hearing and then it may declares that the debtor is insolvent or not. If insolvency of a person starts from an earlier date, and not from the date of adjudication passed by the court. This is known as Doctrine of Relation Back.

Under Presidency Towns Act, to conduct the insolvency proceedings, an official is appointed by the court is known as Official Assignee and in case of Provincial Insolvency Act, known as Official Receiver. The property of the insolvent vests in the official assignee or receiver to realize the assets and distribute the sale proceeds of the assets in the manner given below −

• Secured creditors will be paid in full.

• Remuneration and expenses of the official receiver.

• To Preferential Creditors.

• To unsecured creditors + partly secured creditors to the extent remain un-secured.

The Order of Discharge

Order of discharge is an order issued by the court of law to the insolvent. Normally, this order releases the insolvent from all current and provable debts and liberates him from the legal obligations imposed on as insolvent. The order of discharge is issued on the basis of the report submitted by the official receiver and on the application of the insolvent.

Interest

An interest @ 6% pa will be paid to the creditors for the period, after the order of adjudication, if, any surplus remains, after full payment to the creditors.

Voluntary Transfer

As per the Presidency Towns Insolvency Act, any property transferred by the insolvent without any consideration during the two years preceding the order of adjudication shall be void. Under the Provincial Insolvency Act, such transfer became inoperative, if made with two years of petition of the insolvency except followings −

• For consideration of marriage and made before and
• To purchase valuable consideration in good faith.

Insolvency Law

The Insolvency Act in India is based on English Bankruptcy Act and following two acts are applicable on the Indian Territory −

• The Presidency Towns Insolvency Act, 1909 − Applicable to Mumbai, Kolkata, and Chennai.

• The Provisional Insolvency Act, 1920 − Applicable to the rest of India except Mumbai, Kolkata, and Chennai.

Above Insolvency Acts are applicable to any Individual, Partnership Firm, and Hindu Undivided Family only. Companies Act, 1956 applies to Joint stock companies and the term liquidation is used instead of Insolvency. In case of insolvency, a person is not able to pay his liabilities but in case of liquidation, company may be liquidated even it has the sufficient amount to pay its liabilities.

Insolvency Accounts

Under the Presidency Towns Insolvency Act, insolvent has to submit following documents to the court of law −

• Statement of Affairs as on date of order and
• Deficiency Account.

No provision, for the submission of a Statement of Affairs under Provincial Insolvency Act. The form of Statement of Affairs as prescribed by the rule made under Presidency Towns Act is given below −

Statement of Affairs

(As required by the Indian Insolvency Act)

In the Court of Justice

In insolvency

To the insolvent – you are required to fill up carefully and accurately, this sheet and the several sheets, A,B,C,D,E,F,G, and H, showing the state of your affairs on the day on which the order of adjudication was made against you viz. the …………day of …………..20…….

Such sheets, when filled up will constitute your Schedule and must be verified by Oath or Declaration.

Gross Liabilities (Rs.)	Liabilities (as stated and estimated by the debtor)	Expected To rank	Assets (as stated and estimated by the debtors)	Estimated to produce
	Unsecured Creditors as per List A Fully Secured Creditors as per list B Less: Estimated value of Securities Less: Amount thereof carried to List C Balance thereof contra Partly secured creditors as per List C Less: Estimated value of Securities Preferential Creditors as per List D (Creditors for rent, taxes, salaries and wages, etc.) payable in full as per contra		Property as per List E, viz. Cash at Bank Cash in hand Cash deposited with solicitor for cost of petition Stock in trade Machinery Trade Fixture, Fitting, Utensils, etc. Furniture Life Insurance Policies Other property Book debts as per list F, viz. Good Doubtful Bad Estimated to produce Bills of exchange or other similar Securities on hand as per List G Estimated to produce Surplus from securities in the hands of creditors fully secured (per contra) Deduct: Creditors for preferential rent, rates, taxes, wages, etc. (per contra) Deficiency as per explained in list H

I /We ………………make oath, solemnly affirm, and say, that the above statement and the several lists hereunto annexed marked A,B,C,D,E,F,G, and H are to the best of my/our knowledge and belief, a full and complete of my/our affairs on the date of the abovementioned order of adjudication made against me/us.

Affirmed------------------ at. ………….this……………day of Sworn Before me.

……………………

(Signature)

Commissioner

Just like Balance sheet, the statement of affairs is divided in to two part of Assets and Liabilities and liabilities of the insolvent are classified as −

Unsecured Creditors as per List A

Trade creditors, stridhan ornament and personal belongings etc. of lady) of Mrs., bills payable, bank overdraft, partly paid shares held, uncompleted contracts guarantees given for others, etc., wages, rent, salaries, etc.

Loan from Wife

Loan taken from wife is usually treated like any other loan taken and makes wife creditor of the insolvent. In case, it is proved that loan is paid by wife out of amount received from insolvent, then be treated as the capital of insolvent.

Interest

@ 6% interest will be paid to the creditors after the date of adjudication, if there is a sufficient balance left after the payments to creditors.

Fully Secured Creditors as per List B

The creditors who have sufficient securities against their claims will be included in this list and after paying these creditors, balance amount will be shown on the asset side of the statement of affairs as available balance to distribute among other creditors.

Partly Un- secured Creditors as per List C

Un-paid or unsatisfied amount of the partly secured creditors will be shown as expected to rank column as unsecured creditors, to be divided for unpaid amount.

Preferential Creditors as per List D

Following creditors comes under the category of preferential creditors and such creditors get preference over the un-secured creditors.

As per the law, following creditors come under category of the preferential creditors −

• Government and local authority.

• Salary and wages for the service rendered for four months preceding the date of the presentation of the insolvency petition.

• Under Presidency Town Insolvency Act, one month rent comes under the category of preferential creditors, but rent is not at all comes under the preferential creditors category as per the Provincial Insolvency Act.

The assets as shown in the statement of affairs of insolvent are classified into the four categories as follows −

• Property as per List E − Other than the bills receivable in hand and the assets as kept by creditors as fully and partly secured debts are comes under this list.

• Property as per List F − Following are the three categories of book debts −

  • Good

  • Doubtful Debts

  • Bad

• Assets as per List G − Bills of exchange and other similar securities comes under this list.

• Deficiency Account as per List H − As name suggests, deficiency account means the deficiency, which the insolvent debtor is not able to pay.

Important Points in Preparation of Statement of Affairs

• In case of an individual insolvent, no distinction will be made between the private assets and the business assets while preparing a Statement of Affairs. Personal assets are included in the Statement of Affairs to pay the business liabilities. In case of partnership firm, after paying personal liabilities from the personal assets of the partner, surplus if any, may be included in the statement of affairs of Partnership firm to pay the business liabilities.

• Value exceeding Rs. 300/- of tools, wearing apparel, bedding, cooking utensils, etc. will be included in the statement of affairs under the Presidency Towns Insolvency Act. Assets, as pledged against secured and partly secured creditors, may be shown in the statement of affairs only, if, became surplus after paying the fully and partly secured creditors.

• Fully secured assets are not shown in the ‘expected to rank’ column.

• Partly secured assets after paying partly secured debts will be shown in the column of ‘expected to rank.’

• The bills discounted to be dishonored are included in the un-secured creditors as per the list A.

Difference between Balance Sheet and Statement of Affairs

Following are the main differences between Balance Sheet and Statement of Affairs −

• The value of assets is shown as books value as well as releasable value in the statement of affairs; however, it is shown as only book value as in the case of Balance sheet.

• In the Statement of Affairs, prepaid expenses and goodwill are not included, whereas all fictitious assets are included in the Balance sheet.

• Statement of Affairs does not include capital, drawings, profit, or loss, interest on capital, whereas Balance sheet includes all such items.

• Balance sheet does not show the amount of deficiency as shown in the Statement of Affairs.

• Balance sheet is prepared at the end of accounting period, whereas Statement of Affairs is prepared on the date on which order of adjudication is passed.

• Statement of affairs is prepared as per the rule of Insolvency Act, whereas Balance sheet is a routine work to maintain the accounting record.

• Balance sheet of a firm does not include personal assets and liabilities, whereas Statement of Affairs includes the same as discussed above in this chapter.

• Statement of Affairs includes contingent liabilities, whereas in the Balance sheet, contingent liabilities are shown as footnote only.

Deficiency Account (List H)

Specimen of Deficiency Account List H

	Amount (Rs.)		Amount (Rs.)
Excess of Assets over liabilities i.e. capital on …….. Net profit arising from carrying on business after deducting usual trade expenses, income or profit from other source i.e. Interest on capital Excess of private assets over private liabilities Profit on realization of any assets Deficiency as per statement of Affairs		Excess of Liabilities over assets Net Loss arising from carrying on business after deduction from profit, usual trade expenses Bad debts as per list F Expenses incurred since……. Other than usual trade expenses, viz. House hold expenses (Drawings) Other Losses − Loss on realization of Assets Loss through dishonor of discounted bills Speculation losses Losses through betting Excess of private liabilities over private assets, etc.

From the above, it is clear that debit side of the deficiency account shows capital account and credit side of the deficiency accounts shows losses and drawing and the difference of two sides is a deficiency as shown in the Statement of affairs Account.

Insolvency of Partnership Firm

Insolvency of the partnership firm differs from the insolvency of any individual or HUF (Hindu undivided family). The assets of an individual are used to pay the business liabilities, but in case of partnership firm, assets of the partners are used to pay his personal liabilities first, and then balance, if any, may be utilized to pay the business debts. After paying the personal debts of a partner, surplus assets will appear in the Statement of Affairs and will be shown as “Property as per List E.”

In case, if personal asset of a partner is in possession of any creditor as security, still such creditor will get his dues first as unsecured creditor from the firm and then for the balance amount, he may sell the property, owned by him to recover his dues.

Stock Exchange Transactions

Stock exchange is an organized market where sale and purchase of listed securities of all description i.e. shares, stocks, debentures, government securities, etc. are done. It is a government approved market place where buyer and seller of securities of all kind find each other to buy and sell securities on the market price.

Meaning of Stock Exchange

“ An association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities.”

- The Securities Contracts (Regulation) Act, 1956

A stock exchange is a common and authorized point of exchange, which offers the services for stock brokers and traders to buy or sell stocks, bonds, and other securities of such kind. Further, it also provides facilities for issue and redemption of securities, other financial instruments, and capital events. For example, payment of income and dividends.

Features and Characteristics of Stock Exchange

Following are the main features and characteristics of a stock exchange −

• Stock exchange is the market place where trading of listed securities can be done.

• Trading of un-listed securities is not allowed.

• There are certain rules and regulations that need to be followed while trading.

• Stock exchange is an association of persons, whether incorporated or not.

• Anyone can buy or sell securities whether he is investor or speculator.

• For doing business transaction i.e. sale & purchase of securities, membership is compulsory. Non-members are not allowed to do business transactions. Membership can be applied only when there is a vacancy in any stock exchange and after paying the prescribed fees of respective stock exchange, membership can be acquired. Members of stock exchange are called as brokers and commission charged by them for the transaction done is called as brokerage.

• Only a broker (member) can buy or sell securities, therefore, investors or speculators can do transaction through members only.

Functions and Services of Stock Exchange

Followings functions are performed by Stock Exchange −

• Anyone can sell and buy any industrial, financial, and Government securities. Stock Exchange is an organized ready market to do all this.

• Liquidity is provided by the stock exchange. Investors and speculators can buy and sell their securities at any time.

• Stock exchange provides collateral value to the securities that is helpful in borrowing from the bank on easy terms.

• Capital for the industrial growth is provided by the stock exchange that is helpful for the investor to participate in the industrial development.

• Price list and reports are prepared and published in the newspapers and broadcasted through the TV channels by stock exchange. It is helpful in knowing the true value of the investments. With the help of this, an investor or speculator can get to know the fair market value of his securities as per the latest market trend.

• Listing of securities is encouraged by the stock exchange. Listing of securities means — “a permission to trade” that is given by the stock exchange only after fulfillment of the prescribed standards.

• Listed companies have to provide the financial statements, reports, and other statements time to time to stock exchange — necessary for the maintaining the record and deciding the value of securities.

Thus, stock exchange works as the center of providing business information at one platform.

Procedures for Dealing at Stock Exchange

Following procedures are normally followed for dealing at stock exchange −

• No one can directly deal in stock exchange, therefore, any person who wants to sell or buy securities, requires a broker through whom selling or buying of securities can be done.

• After finalization of a member or a broker, intending buyer or seller of the securities, places an order according to his choice, mentioning tentative quantity, and price. Thereupon, broker opens a new account for each client and start trading in the best possible way.

• After getting an order, broker tries to finalize the deal between seller and buyer. After finalization of deal, seller and buyer of securities send a selling and buying note respectively mentioning the detail of traded securities.

• Finally, settlement of account may be done in the following three manners −

  • When the settlement of account is done as per the fixed and agreed date, it is called as “liquidation in full.”

  • When only difference of agreed price and ruling price is settled on the fixed date, it is called as “liquidation by payment of difference.”

  • When a settlement is carried forward to the next settlement period, it is known as “carried over to next settlement period”.

In case, when purchase is delayed and charge debited by the broker to purchaser is known as “contango” (Contango charge is also known as “Badla” Charge) and in case, where sale is delayed by the seller and charge debited by the broker is known as “backwardation.”

Operators at Stock Exchange

The following figure shows the three operators at the Stock Exchange −

Broker

As studied earlier, no one can deal directly in stock exchange and every intended seller or buyer, who wants to sell or buy securities has to deal through members known as brokers. Broker is duly certified by SEBI (Stock and Exchange Board of India) under its 1992 rule. Membership of the stock exchange is restricted to prescribed numbers of members, to financially sound persons who have sufficient experience in dealing in securities.

A broker cannot buy or sell securities on his personal capacity. He charges commission from the parties, sellers, and buyers and deals on the behalf of his non-member clients.

Sub-broker

Sub-brokers are non-members of the stock exchange and deal only on behalf of the members or registered brokers. Commission is received by sub-brokers on the business procured by them out of total commission received by the brokers. Sub brokers are known as “half commission men” and “remisiers” too.

Jobbers

Jobbers are the independent dealers, who deal in securities at their own. A jobber cannot sell or buy securities on the behalf of others, but he deals in securities for his own profit through fluctuation of the prices. Difference between sale price and purchase price of securities is the profit of a jobber.

Important Terms used in Stock Exchange

Following are the significant terms more commonly used in stock exchange −

• Bull − Bulls are those brokers who strongly expect price hike of securities and with this hope, they buy shares to sell them at later stage (when price gets increased). Thus bull market means when buying of the securities are on much higher side instead of selling of the securities. Bulls first buy securities and sell when the price of securities is high.

• Bear − Bear is pessimist, who expect fall in the price of certain securities. A Bear first sells his securities and purchases at later stage when the price of securities are low and the difference of both is his profit.

• Stag − A cautious investor or speculator is known as a stag. Stag doesn’t sell or buy shares in his hand, but he tries to buy shares of new company with a hope that price of those shares will increase in the future.

• Blue Chips − Shares of well-recognized, well-renowned, financially strong, and well-established companies.

• Cash Shares − Settlement of some of the transactions are completed in cash are known as cash shares. These transactions are done by real and genuine investors who want to buy or sell shares for the actual investment purpose.

• Cleared Shares − Speculators are normally deals in such type of shares. In these types of shares, settlement of the payments are done by the differential amounts only; however, actual delivery of the securities may not be done.

• Carry Over or Badla System − Speculator earns money by foreseeing the future. If their expectations come true, they earn profit and if not, they lose money. Speculator mostly does transactions on forward basis, when any speculator forwards his transactions from one settlement date to another, he has to pay charges called “Badla charge.” Transaction of these natures is called as Badla System.

• Kerb Market − Transactions that done before and after the official hours are known as kerb market.

• Short Selling − Short selling means where the large volumes of securities are sold by the bear speculator without actually possessing.

• Arbitrage − Securities are traded at the different stock exchanges and there is normally a little difference in prices (among different stock exchanges). Therefore, arbitrage is practiced to take advantage of different rates.

• Primary Market − Primary market is the market where new securities are issued for the capital formation in the form of a new issue or in the form of a right issue to the existing shareholders.

• Secondary Market − Secondary market is the market where subsequent trading (sale and purchase) of securities are done called as secondary market and the transactions are known as secondary transactions.

• Group A Shares − Actively traded shares of the reputed companies are called a Group A shares.

• Group B Shares − Not actively traded shares or the shares of different stock exchanges are called as Group B shares.

SEBI

The Securities and Exchange Board of India (SEBI) is the regulatory board. It regulates affairs of stock exchange in India, similar to Securities Exchange Commission of the United States. To protect the rights of investors and to enforce an orderly growth of securities market, SEBI came into existence by an Act of Parliament known as “Securities and Exchange Board of India Act, 1992”.

OTCEI

The Over the Counter Exchange of India (OTCEI) was established in India in 1990. It is the latest concept and a new way to do securities business in India similar to Electronic Exchange in the United States. Brokers located at the different regions, communicate through latest means of technologies such as Telephones, Faxes, Mobile phones, and Computers.

Selectors are allowed to select the prices as shown on the computer screen among the competitive markets, without the floor meeting of brokers. It is the most efficient, economic, and courageous way of the trading of securities. The latest market prices of the securities are displayed on the computer screens. Since, listing of the securities is not required on OTCEI, hence it is the most suitable way for the small and medium size companies.

Over-the-Counter Exchange of India

Brokers require and maintain following books of accounts as per the SEBI rules, 1992 −

• Cash Book

• Bank Book (Pass Book)

• General Ledger

• Client Ledger

• Register of Transaction

• Journal

• Document Register (Showing Particulars of the Securities received and delivered)

• Members Contract Book

• Duplicates of Contract Notes issued to clients

• Written consent of clients

• Margin Deposit Books

• Register of accounts of Sub Brokers

• An agreement with a Sub-Broker.

Accounts of Private Individuals

Most of the private individuals never keep their accounts to record earned income or expenditure incurred by them. It is advisable for everyone to maintain an account to know what he has earned during a particular period, what he spent, and what was his saving out of that income. It is helpful to track the record of income and expenditure. It also helps to increase the income (as need arises) and control on the expenditure.

Maintenance of Accounts by Private Individuals

Private individual should keep his books on cash basis system, ignoring accrued system in different heads like insurance premium paid, medical insurance, school fees, taxes, household expenses, medical expenses, clothing, salary received, bank interest, income from mutual fund, rent received, and other income received.

For all these, one should keep a cash book, which can be summarized on monthly basis as per the abstract of cash Book given below −

Abstract Cash Book

Particulars (of Income)	Amount	Particulars (of Expenditure)	Amount
To Balance b/d To Salary To Rent received To Saving Bank Interest To Interest on FDR To Income from Investment To Income from profession or Business Total	xx xx xx xx xx xx xx xxxx	By Kitchen Expenses By Electricity Expenses By School/College fees By Clothing By Insurance Premium (Life insurance, medi-claim, accidental insurance, other Insurance like fire, theft etc.) Total	xx xx xx xx xx xxxx

In case of professional individual, one more column can be added in the cash book to show professional transaction and personal transaction separately. In addition to above, an individual may keep a register to maintain the record for his assets including car, building, investments, etc.

Maintenance of Accounts by Professionals

A cash basis of accounting is the most suitable system for any professional including doctor, accountant, or solicitor instead of a mercantile system to fulfill the following purposes −

• To ascertain the professional income earned by him correctly for a specific accounting period, and also to calculate the net professional income after deducting the related expenses from the professional income.

• To correctly record all items of income and expenditure.

Following records should be maintained by a professional −

Cash Book

All receipts and payments should be recorded in a cash book, and a memorandum book should be maintained to keep record of credit transactions. The credit transactions will be scored off at the time of actually cash receipt or at the time of payment made and should be entered in the cash book.

A cash book can be summarized under various heads on monthly, quarterly, half yearly, or annual basis as per the suitability and requirements.

Stock Register

Two separate stock registers should be maintained, one for resale items and other to keep record of the items of personal use. Resale items may be medicine, surgical items, the stationery items, electrical items, computers, and any other items or asset.

Receipt and Expenditure Account

A receipt and expenditure account is similar to a profit and loss account; therefore, it is prepared by the professionals to know the professional income and expenditure for a specific period. Outstanding incomes are ignored to prepare it, but outstanding expenses are included in it. Therefore, it is known as Receipt & Expenditure account instead of Receipt & Payment account. It means, incomes are recorded on a cash basis and expenditure on an accrual basis.

Maintenance of Accounts by Doctors

Doctors usually maintain a register that may also be known as diary or note book in which all the particulars of the patients including charges, fees, physical conditions of patient, etc. are recorded. After grouping, the extracted entries of diary are recorded in the cash book under different heads of income. Similarly, expenses are also recorded under various heads.

In case, where the number of doctors is two or more than two and they run their clinic in the partnership, income may be recorded in the cash book under various heads (Doctor Wise), similar to a petty cash book pattern. Similarly, the expenses relating to each doctor may be recorded under various heads of the expenses.

Thus, cash book, stock register, memorandum book, Receipt and expenditure account, and Balance sheet are prepared by the doctors.

Illustration

Dr. Ortho starts his medical practice on 1st January 2013 and introduced a capital of Rs. 300,000/. Receipt and payment account as on 31-12-2013.

Receipt	Amount (Rs.)	Payment	Amount (Rs.)
To Consultation Charges To Capital Introduced	2,500,000 300,000	By Clinic Rent By Salary to Staff By Books & Periodicals By Medical Equipment By Other expenses By Balance c/d Cash in hand Cash at Bank	240,000 300,000 15,000 450,000 38,000 57,000 1,700,000
Total	28,00,000	Total	28,00,000

• Outstanding salary Rs. 50,000
• Medical equipment was purchased on 01-04-2013
• Depreciation on Equipment is Rs. 15%

Solution −

Receipt & Expenditure Account of Dr. Ortho

For the year ended 31-12-2013

Expenditure	Amount	Receipt	Amount
To Clinical Rent To Salary to Staff300,000 Add: Outstanding Salary50,000 ------------ To Books & Periodicals To Other Expenses To Depreciation on Equipment To Surplus – Excess of Receipt over Expenditure	2,40,000 350,000 15,000 38,000 50,625 1806,375	By Consultation Charges	25,00,000
Total	25,00,000	Total	25,00,000

Dr. Ortho

Balance Sheet

As on 31-12-2013

Expenditure	Amount	Receipt	Amount
Capital Introduced300,000 Add: Surplus1,806,375 _________ Outstanding Salary	2,106,375 50,000	Cash in hand Cash at Bank Medical Equipment450,000 Less: Depreciation50,625 _______	57,000 1,700,000 399,375
Total	2,156,375	Total	2,156,375

Maintenance of Accounts of Educational Institutions

Most of the educational institutions are registered under Indian Society Registration Act, 1860. The core purpose of formation of the educational institutions is to educate people at large and not to earn profit.

Generally, following financial transactions are being incurred by the educational institutions −

Main Sources of Collection

Types of Expenses/Payments

Admission fees, tuition fees, Examination fees, fines etc. Security deposit by students Donations from public Grants from Government for building, prizes, maintenance, etc.

Salary, allowances, and provident fund contribution to teaching and nonteaching staffs. Examination expenses Stationery & printing expenses Distribution of scholarships and stipends Purchase and repair of furniture & fixture. Prizes Expenses on sports and games Festival and function expenses Library books, newspaper, magazines, etc. Medical expenses- medicine and examination Audit fees and audit expenses Electricity expenses Telephone expenses Laboratory running & maintenance Laboratory equipment Building Repair & maintenance

Separate collection register should be maintained to record these collections from the above mention sources. Separate ledger for students should also be maintained for each student to record the fees — due, received, and outstanding if any.

Normally, all accounting records are maintained on the basis of financial year i.e. from 1^st April to 31^st March in most of the educational institutions. Educational institutions maintain income and expenditure account to keep the records of surplus or deficiency and also to prepare a Balance sheet to know the financial position of the institution.

Consolidation of Accounts of various Educational Institutions

Consolidation of accounts is done step by step, where various institutions are run under one society.

The given example is an illustration of the simplified procedures −

Consolidation of Fees

Institute wise consolidation will be done as hereunder −

Opening Balance of Fees Due Add: Fees due during the current financial year Less: Fees collected during the current Financial Year Outstanding Fees at the end of the year
	XXX XXX
	XXXXX XXX
	XXX

Illustration

Trial Balance of the Brilliant education society as on 31st March, 2013 is given as here under, please prepare an Income and Expenditure Account and a Balance sheet on that date −

Particulars	Amount (Debit)	Amount (Credit)
Cash in Hand	68,000
Cash at Bank	802,000
Scholarship Fund Investment	800,000
Miscellaneous Expenses	420,000
Interest received on Scholarship Fund		80,000
Interest Received on Investment		55,000
Investment	550,000
Sundry Creditors		236,000
Building	1,700,000
Furniture & Fixture	200,000
Addition to Furniture & Fixture	25000
Vehicles	280,000
Sundry Debtors	260,000
Capital Fund		2,400,000
Donation for Capital Fund		500,000
Entrance Fees		40,000
Course Fees		1,600,000
Examination Fees		70,000
Auditorium Rent Received		850,000
Salary	1,100,000
Printing & Stationery	50,000
Scholarship Awarded	36,000
Scholarship Fund Reserve		360,000
Government Grant Received		100,000
Total	6,291,000	6,291,000

Additional Information

• Salary for one month is outstanding.

• Outstanding Auditorium is Rs, 50,000/- and Rs. 25,000 received in advance.

• Depreciation is to be provided at 5% on building, 10% on Furniture & Fixture, and 15% on vehicles.

Solution

In the Books of Brilliant Education Society

Income & Expenditure Account

For the Year ended 31^st March, 2013

Expenditure	Amount	Income	Amount
To Printing & Stationery To Salary1,100,000 (+) Outstanding Salary100,000 -------------- To Miscellaneous Expenses To Scholarship awarded To Depreciation: Building @ 5%85,000 Furniture & Fixture22,500 Vehicles @ 15%42,000 -------------- To Surplus of Income over Expenditure	50,000 1,200,000 420,000 36,000 149,500 964,500	By Entrance Fees By Examination Fees By Course Fees By Auditorium Rent850,000 (+) Outstanding Rent50,000 -------------- 900,000 (-) Advance Rent Received25,000 -------------- By Government Grants By Interest received on scholarship fund	40,000 70,000 1,600,000 875,000 100,000 80,000 55,000
Total	2,820,000	Total	2,820,000

Balance Sheet

As on 31-03-2013

Liabilities	Amount	Assets	Amount
Capital Fund2,400,000 Add: Donation500,000 --------------- 2,900,000 Add: Surplus964,500 --------------- Scholarship Fund Sundry Creditors Salary outstanding Rent received in advance	3,864,500 360,000 236,000 100,000 25,000	Building1,700,000 (-) Depreciation@ 5%85,000 -------------- Furniture & Fixture200,000 (+) Addition25,000 -------------- 225,000 (-) Depreciation @10%22,500 -------------- Vehicles280,000 (-) Depreciation @15%42,000 -------------- Investments Scholarship Fund Investment Sundry Debtors Rent receivable Cash in hand Cash at Bank	1,615,000 202,500 238,000 550,000 800,000 260,000 50,000 68,000 802,000
Total	4,585,500	Total	4,585,500

Maintenance of Accounts of Student Hostels

Hostels are run by most of the educational institutions to provide boarding facility to the students, coming from remote places, for their education. Hostels are usually run on no profit basis. Government also grants some fund to these hostels to provide cheaper living space to the students.

Like any other non-profit organization, hostels also have accountants who record and maintain their financial transactions as −

• Receipt & Payment Account
• Income & Expenditure Account
• Balance Sheet

Following are the common lists of incomes and expenditures incurred by Hostels −

Main Source of Collection	Types of Expenses/Payments
Admission fees Security (refundable at the time of entering into the hostel) Room rent Electricity, water, fans, coolers, heaters & geysers charges etc. Government grants Fees for reading room & common room. Mess charges Medical Fee.	Electricity expenses Water charges Building repair & maintenance Grocery & provisions for mess Rent for hostel Accommodation (In case or rented premises) Salary (Warden, watchman, sweeper etc.) Telephone expenses Newspaper and magazines

Illustration

From the given information and Trial Balance, please prepare an Income & Expenditure account and Balance sheet of Divya Jyoti hostels (for the girls) for the year ending 31-03-2014 −

Particulars	Amount (Debit)	Amount (Credit)
Opening Stock − Food Fuel Drinks Sundries	31,500 4,500 3,000 6,000
Purchases − Food Fuel Drinks Sundries	1,065,000 90,000 135,000 15,000
Wages − Mess Others	337,500 97,500
Annual Day Collection		10,500
Building	6,300,000
Capital Fund		7,050,000
Cash at Bank	466,500
Common Room Expenses	24,000
Electricity and Water Charges		28,500
Electricity and Water Charges	42,000
Fans	75,000
Furniture & Fixture	225,000
General Fund		450,000
Grants-Youth welfare Departments		300,000
Heaters	7,500
Income From Investments		82,500
Indoor Games Material	22,500
Investments	750,000
Land	750,000
Medical Expenses	19,500
Mess Charges (for guests)		30,000
Mess Fees		1,770,000
Rent for fan Heater etc.		16,500
Repair & Maintenance	33,000
Room Rent		352,500
Room Service Charges		9,000
Security Deposits		400,500
Total	10,500,000	10,500,000

Additional Information

• Depreciation to be provided @ 5% on Building, Furniture, & Fixture; and 15% on heater and Fans.

• Closing stock: Food Rs. 22,500, Fuel Rs. 7,500, Drinks Rs. 4,500, and sundries Rs. 3,000.

Solution −

In the Books of Divya Jyoti Hostels

Income & Expenditure Account

For the Year ended 31^st March, 2014

Expenditure	Amount	Income	Amount
To Mess Expenses Food: Opening Stock31,500 Add: Purchases1,065,000 -------------- 1,096,500 Less: Closing Stock22,500 -------------- Fuel: Opening Stock4,500 Add: Purchases90,000 -------------- 94,500 Less: Closing Stock7,500 -------------- Drinks: Opening Stock3,000 Add: Purchases135,000 -------------- 138,000 Less: Closing Stock4,500 -------------- Sundries: Opening Stock6,000 Add: Purchases15,000 -------------- 21,000 Less: Closing Stock3,000 -------------- To Wages : Mess337,500 Others97,500 -------------- To Electricity & Water Charges To Repair & Maintenance To Indoor Games Material To Common Room Expenses To Medical Expenses To Depreciation: Building5%315,000 Furniture10%22,500 Heaters15%1,125 Fans15%11,250 -------------- To Excess of Income Over Expenditure	1,074,000 87,000 133,500 18,000 435,000 42,000 33,000 22,500 24,000 19,500 3,49,875 3,61,125	By Room Rent By Rent for Heater, Fans, etc. By Grants-Youth Welfare By Income From Investments By Annual Day Collection By Mess Fees By Mess Charges for Grants By Room Service Charges By Electricity & Water Charges	352,500 16,500 300,000 82,500 10,500 1,770,000 30,000 9,000 28,500
Total	2,599,500	Total	2,599,500

Balance Sheet

As on 31-03-2014

Liabilities	Amount	Assets	Amount
Capital Fund General Fund450,000 Add: Surplus361,125 ------------ Security Deposits	7,050,000 811,125 400,500	Land Building6,300,000 (-) Depreciation@ 5%315,000 ------------ Furniture & Fixture225,000 (-) Depreciation @10%22,500 ------------ Heaters7,500 (-) Depreciation @15%1,125 ------------ Fans75,000 (-) Depreciation @15%11,250 ------------ Investments Closing Stocks: Food22,500 Fuel7,500 Drinks4,500 Sundries3,000 ------------ Cash at Bank	750,000 5,985,000 202,500 6,375 63,750 750,000 37,500 466,500
Total	8,261,625	Total	8,261,625

Maintenance of Accounts of Hospitals

Being a non-profit organization, hospitals also maintain Receipt & Payment accounts, Income & Expenditure account, and Balance Sheet.

An illustration of the income and expenditure of a hospital is shown below −

Main Items of Income	Types of Expenses/Payments
Room Rent Medical Care Dentistry Charges Delivery Room Charges Anesthesia Charges Laboratory Charges Grants for operating needs of Hospital Grants for fixed Assets Donations Miscellaneous Income Interest on Investments Fees from Nursing & Training School Bed Charges Operating Room Charges X-ray Charges Pharmacy Charges Physiotherapy Charges	Electricity & Water Charges Pharmacy Charges Salaries and Wages Pharmacy Expenses Building repair & Maintenance Laundry Charges Rent for Nursing Hostel Accommodation (In case or rented premises) Telephone Expenses Laboratory Expenses Surgery Expenses Operation Tools and Equipment Expenses Depreciation

Illustration

A charitable hospital and pharmacy are run by Rehmat Ali trust; following are the balances as extracted from its books for the year ended 31-03-2014 −

Particulars	Amount (Debit)	Amount (Credit)
Consumption of Medicines Foodstuff Drugs and Chemicals Closing Stock of Medicines Foodstuff Drugs and Chemicals	360,000 270,000 90,000 60,000 12,000 3,000
Salary	540,000
Electricity	315,000
Pharmacy − Opening Stock Purchase Sale Salary Electricity	165,000 900,000 45,000 6,000	930,000
Furniture & Fixture	240,000
Ambulance	90,000
Telephone Expenses	78,000
Subscription	63,000
Ambulance Charges		2,400
Consumption of Housekeeping Items	2,70,000
Bank Deposits @ 15%	1,500,000
Cash in hand	105,000
Cash at Bank	720,000
Sundry Debtors	181,500
Sundry Creditors		824,100
Remuneration to Trustees	63,000
Capital Fund		2,700,000
Donation		1,800,000
Fees		900,000
Rent		825,000
Food Supply		420,000
Building	960,000
Equipment	1,365,000
Total	8,401,500	8,401,500

Additional Information

• Depreciation to be provided @ 5% on Building; 10% on Furniture; 15% on Equipment; and 30% on Ambulance.

• Closing stock of medicine at pharmacy Rs. 120,000

• 15% of the fees received from patients to be paid to specialist doctors.

• Supply of medicines from pharmacy to the hospital Rs. 180,000 for which no adjustment has been made in the books of accounts.

Solution −

In the Books of Rehmat Ali Trust

Income & Expenditure Account of the Pharmacy

For the Year ended 31^st March, 2014

Expenditure	Amount	Income	Amount
To Opening Stock (Medicines) To Purchase of Medicine To Salaries To Electricity Expenses To Surplus of Income over Expenditure	165,000 900,000 45,000 6,000 114,00	By Sale (Medicines) By Medicine to Hospital By Closing Stock	930,000 180,000 120,000
Total	1,230,000	Total	1,230,000

Income & Expenditure Account of the Hospital

For the Year ended 31^st March, 2014

Expenditure	Amount	Income	Amount
To Consumption of Medicines360,000 Add: Medicine from Pharmacy180,000 ------------ To Consumption of Food Stuff To Consumption of Drugs & Chemicals To Consumption of House Keeping To Salaries To Electricity Expenses To Subscription To Fees to specialist 15% of fees To Telephone Expenses To Depreciation: Building5%48,000 Furniture10%24,000 Equipment 15%204,750 Ambulance 30%27,000 ------------	540,000 270,000 90,000 270,000 540,000 315,000 63,000 135,000 78,000 303,750	By Fees By Rent By Recovery of Food supply By Ambulance Charges By Deficit (Excess of expenditure Over Income)	900,000 825,000 420,000 2,400 457,350
Total	2,391,750	Total	2,391,750

Income & Expenditure Account of Trust

For the Year ended 31^st March, 2014

Expenditure	Amount	Income	Amount
To Deficit (Hospital A/c) To Remuneration to Trustee	457,350 63,000	By Surplus (Pharmacy) By Interest due on fixed deposit By Net Deficit	114,000 225,000 181,350
Total	520,350	Total	520,350

Statement of Affairs of Rehmat Ali Trust

As on 31-03-2014

Liabilities	Amount	Assets	Amount
Capital Fund2,700,000 Add: Donation1,800,000 ---------------- 4,500,000 Less: Net Deficit (-)181,350 ---------------- Sundry Creditors Fees Payable to specialist	4,318,650 824,100 135,000	Building960,000 (-) Depreciation@ 5%48,000 --------------- Furniture & Fixture240,000 (-) Depreciation @10%24,000 ------------- Equipment1,365,000 (-) Depreciation @15%204,750 ------------- Ambulance90,000 (-) Depreciation @30%27,000 ------------- Bank Deposits1,500,000 Add: Interest Due225,000 ------------- Closing Stocks: Medicine60,000 Foodstuff12,000 Drugs & Medicine3,000 Pharmacy120,000 ------------- Sundry Debtors Cash in hand Cash at Bank	912,000 216,000 1,160,250 63,000 1,725,000 195,000 181,500 105,000 720,000
Total	5,277,750	Total	5,277,750

Financial Accounting - Co-Operative Societies

Any ten persons who are competent to contract may file an application to the Registrar of Co-operative Societies as per Section 6 of the Co-operative Societies Act, 1912. By law, may be framed by each society and should be registered with the Co-operative Societies.

Effectiveness of change by the law of societies is applicable only when changes are approved by the Registrar of Society.

Types of Society

There are two types of society −

• Limited liabilities society
• Unlimited liabilities society

Any member is not liable to pay more than the nominal value of the share held by him and no member can own more than 20% of the shares of society.

Today, government is encouraging co-operative societies to help society at large. Cooperative societies are operative in various sectors like consumer, industrial, services, marketing, etc.

Under accounting system of Co-operative societies, the term Receipt and Payment is used for two fold aspects of double entry system.

Accounts

Following accounts usually maintained by the Co-operative societies −

• Day Book (Journal)
• Day Book (Cash Account)
• Day Book (Cash Book with Adjustment Column)

Day Book (Journal)

Day book is a book of original entries. In a day book, all types of cash or non-cash transactions are recorded, according to the principle of double entry system.

As per the practice followed in the co-operative societies, a separate journal book is not prepared rather all transactions are directly recorded in the day book. Day book has two sides Receipt (debit) and payment (credit) and there are two columns in each side of a day book, one for the cash transactions and second for the adjustment.

Transaction for the cash receipt and cash payment are recorded in cash column and payment side respectively. Similarly, entries are done in debit and credit side of a day book in the adjustment column.

Day Book (Ledger for Cash Account)

Since, all the cash transactions are recorded directly in a day book, it might be called as ledger account of cash book.

Day Book with Cash and Adjustment Columns

Specimen

Day Book with Cash and Adjustment Columns
Date	Particular	R.No.	Cash	Adjustment	Date	Particular	R.No.	L.F	Cash	Adjustment

Ledger

In the co-operative societies, posting of ledger is not done on the double entry system. Receipt side of the day book on debit side of the ledger account and payment side of the day book posted on the credit side of the ledger account.

Closing of Ledgers

In the co-operative societies, balancing of a personal account is done at the time when any member clear his account or a new account is opened. Totals of all other accounts (receipt and payments) are kept as it is. Balancing of receipt and payment accounts are not required.

Receipt and Payment Account

A receipt and payment account is the summary of a day book and prepared for a specified period. Receipt and payment account is prepared from the totals of receipts and payment sides of the ledger accounts.

Final Accounts

Trading & Profit and Loss account and Balance sheet are prepared from the receipt and payment accounting after consideration of the adjustment entries. Items appear under the receipt side are treated as income, and items of the payment side are as expenditure.

Rules Appropriated as −

• First 25% of the net profit should be transferred to the reserve fund account.

• As per section 35 of Co-operative Societies Act, 1912, distribution of the profit should not be more than 6.25%.

• Contribution to charitable funds as defined in section 2 of Charitable Endowment Act, 1890, which says that contribution may be done with the prior permission of the Registrar. Maximum contribution is restricted to 10% of the available profit, after transferring profit to reserve account.

• Unlimited liabilities, co-operative society may distribute profit only after general or special order of the State Government.

Financial Accounting - Insurance Claims

Every business entity keeps sufficient stock as per the need and size of its respective business for smooth running of the business, but at the same time risk of loss by fire or by means is also there. To safeguard the businesses from any unforeseen circumstantial loss, most of the business entities buy insurance policy, which covers loss of stock (by fire) — is known as stock policy.

In consideration of the premium, insurance company takes the responsibility to compensate — if any loss occurs by fire or by other means, applicable under the insurance terms. It is in the best interest of the firm to take fire insurance policy because it covers wide range of losses (by fire) including Building damage, Furniture and Fixture loss, Plant & Machinery destruction, etc.

Following are the important points to be considered for the estimation of stock −

Gross Profit on Sale

Gross profit is calculated by deducting net sales from the cost of goods sold. To know the gross profit of the last year, “Trading” account of the last year should be referred.

Memorandum Trading Account (for Current Year)

In case of fire, Memorandum Trading account is required to find the value of estimated Stock. It is prepared with the help of Gross Profit ratio of the last year, Opening Stock, Purchase, Sale, and Direct Expenses.

Value of Salvaged Stock

Value of stock as calculated at step-2 will be reduced by the value of salvaged stock to arrive at the value of Insurance Claim.

Other Important Points

• In case, where stock is not valued at the cost, first it will be valued at the cost in the last year trading account and then in the memorandum account of the current year. For example, if it is given that stock of Rs. 80,750 is valued at 85% of the cost in the last year, then first it should be valued as $\small (\frac{80,750}{85} \times 100) = 95,000$ in the last year and then in the current year memorandum Trading account.

• Cost of the sample given free of cost or withdrawal of stock by proprietor or partner of the firm for personal use, it should be adjusted in the Trading Account of the last year as well as in the current year’s memorandum trading account.

• In case, where gross profits of the last several years are given, average gross profit should be taken to determine the gross profit of the current year. However, in case where clear upward trend of the gross profit or downward trend of the gross profit is identified, weighted average gross profit or reasonable trend of upward or downward trend should be applied to determine the gross profit of the current year.

• To find out the gross profit on normal sales, poor selling sale should be eliminated from the sale of the current year. Similarly, poor selling items should be eliminated from the opening and closing stock of the last years to prepare the trading account of the current year.

Average Clause

An average clause is applied to find out the value of a claim where value of the stock on the date of fire is more than the value of insured stock. Average clause is applied by the insurance companies to discourage the under insurance of stock or any other assets.

Following illustration help you to understand it in a better way −

Suppose, value of insurance policy is Rs. 1,500,000 and at the date of fire, value of stock in hand is Rs1,800,000, out of which approx. worth of 1,200,000 stock is destroyed, then the value of the claim admitted will be −

$$\small Value\:of\:Claim = \frac{1,500,000}{1,800,000} \times 1,200,000 = 1,000,000$$

Value of stock of Rs. 1,200,000 will not be admissible to the insured, rather admissible claim will be Rs. 1,000,000.

Illustration

Fire occurred on the business premises of ‘Style India’ on 1^st April, 2014 and most of the stock destroyed. Please ascertain the insurance claim from the following given particulars −

Particulars	Amount (Year 2013)	Amount (01 Jan to 31st March 2014)
Sale	2,500,000	750,000
Purchases	1,800,000	350,000
Opening Stock (01-01-2013)	270000
Closing Stock (31-12-2013)	498,750
Direct Expenses (Freight & wages)	150,000	30,000

• Stock as on 01-01-2013, valued 10% less at the cost.
• Stock as on 31-12-2013 value 5% more at the cost.
• Value of stock salvaged Rs. 45,000.
• Insurance policy (for fire) was for Rs. 300,000.

Solution

Trading Account of M/s Style India

(For the year ending on 31st December, 2013)

Particulars	Amount	Particulars	Amount
To Opening Stock $\small \left \{ \frac{270,000}{90} \times 100 \right \}$ To Purchases To Direct Expenses To Gross Profit (29%)	300,000 1,800,000 150,000 725,000	By Sales $\small By\:Stock = \frac{500,000}{105} \times 100$	2,500,000 475,000
	2,975,000		2,975,000

Memorandum Trading Account of M/s Style India

(Up to 01-4-2014)

Particulars	Amount	Particulars	Amount
To Opening Stock To Purchases To Direct Expenses To Gross Profit (29% of 750,000)	475,000 350,000 30,000 217,500	By Sales By Stock (Balancing Figure)	750,000 322,500
	1,072,500		1,072,500

Value of Stock= Rs. 322,500

Less: Stock Salvage= Rs.45,000

Insurance Claim to be lodged will be −

$$\small Value\:of\:Claim = \frac{300,000}{322,500} \times 277,500 = 258,140$$

Here an average clause will be applied because the value of insurance policy (Rs.300,000) is less than the value of stock (Rs. 322,500) on the date of fire.

Consequential Loss Insurance

A normal fire policy only indemnifies loss of stock or assets, and fails to insure any loss of profit suffered by the concerned business. Therefore, a consequential loss policy should be taken to cover the Loss of profit, Loss of Fixed expenditure, etc.

Following are the important terms used in loss of profit policy −

• Insured Standing Charges − Salaries to staff, Rent rates & Taxes, Wages to skilled workers, Auditors’ fees, Directors’ fees, Advertisement Expenses, Travelling Expenses, Interest on debentures, and unspecified expenses (not more than 5% of the specified expenses) are the charges that have to mention on the policy form at the time of buying policy (so that all charges get insured).

• Turnover − Turnover includes sold goods or services for which amount is payable; it also needs to be insured.

• Annual Turnover − Turnover for the last 12 months, immediately preceding to the date of fire.

• Standard Turnover − Standard turnover means, turnover for the period corresponding with the indemnity period during the preceding accounting year. It also needs to be adjusted to notice the trend during the accounting year, in which incident took place.

• Gross Profit − It is calculated as

  Gross profit = Net profit + Insured standing charges

• Net Profit − To calculate net profit — profit (excluding tax), insured standing charges, other charges, depreciation, and other provisions of such kind need to be adjusted.

• Indemnity Period − Maximum twelve months (from the date of damage), during which the result of the business affected due to damage. Period of indemnity is selected by the insured person.

Computation of Claim

Following steps need to be taken to compute insurance claim on the loss of the profit, which is occurred due to dislocation of the business −

Short Sale − Short sale means loss of sale due to the incident of fire and subsequent dislocation of the business. The difference of standard turnover and the actual turnover during the period of indemnity is called short sale. It is illustrated in the following example.

Example

Calculate short sale according to the particulars given below −

Date of Fire occurs	01-06-2013
Period of dislocation of business	4 months
Standard Sale	500,00
Increased trend	15%
Actual Sale	300,000

Solution

Computation of Short Sale

Standard turnover (Rs. 50,000 + 15%)(A)	575,000
Less: Actual Sale(B)	300,000
Short Sale(A-B)	275,000

Rate of Gross Profit − It is calculated as

$$\small\:Rate\:of\:Gross\:Profit = \frac{Net\:Profit + Insured\:Standing\:Charges}{Turnover} \times 100$$

Note − All figures given above are related to the last accounting year.

$$\small In\:Case\:of\:Loss = \frac{Insured\:Standing\:Charges − Net\:Loss}{Turnover} \times 100$$

Note − All figures given above are related to the last accounting year.

In case where all the standing charges are not insured, amount of net loss need to reduce as −

$$\small = \frac{Insured\:Standing\:Charges}{All\:standing\:Charges} \times Net\:Loss$$

Loss Due to Short Sale − It is calculated as

$$\small Loss\:due\:to\:Short\:Sale = Short\:Sale \times Rate\:of\:Gross\:profit$$

Increased Cost of Working − Increased cost of working means, certain additional expenses those have to be incurred by insured person to keep the business in running condition during the indemnity period.

Least of following figures will be considered as increased cost of working −

$$\small = \frac{Net\:Profit + Insured\:Standing\:Charges}{Net\:Profit + All\:standing\:Charges} \times Increased\:Cost\:of\:Working$$

Illustration

Calculate permissible increased cost of working with following given particulars −

Net Profit	45,000
Insured Standing Charges	25,000
Uninsured Standing Charges	25,000
Short Sale	100,000
Rate of Gross Profit	15%
Increased Working Expenses	10,000
Short sale avoided through Increased Cost of Working	50,000

Solution

Least of the following will be permissible increased cost of working −

$$\small =\frac{Net\:Profit + Insured\:Standing\:Charge}{Net\:Profit + All\:standing\:Charges} \times Increased\:Cost\:of\:Working$$

$\small =\frac{45,000 + 25,000}{45,000 + 50,000} \times 10,000 \small =7,368$

$\small Short\:sale\:avoided \times Rate\:of\:Gross\:profit = 50,000 \times 15\% = 7,500$

So, Rs. 7,368 will be permissible claim of the increased cost of working.

Note − Overall permissible limit of claim for short sale + increased cost of working cannot exceed the following limit.

$$\small Maximum\:permissible\:limit\:of\:claim = Standard\:Sale \times\:Rate\:of\:Gross\:profit$$

Saving in Expenses − Saving in expenses due to fire will be deducted from the amount calculated as above.

Average Clause − In case where the value of sum insured is less than the value of policy for which policy have been taken, average clause will be applied as applied for the stock insurance (above).

Accounting Entries

In case of loss of stock

Insurance company A/cDr To Stock Damaged A/c To Stock Destroyed A/c (Being Claim admitted for stock destroyed and stock damaged)

Stock destroyed A/cDr Stock Damaged A/cDr To Trading A/c (Being actual cost of stock destroyed and stock damaged to trading account)

Bank A/cDr To Stock Damaged A/c (Being realization made on sale of damaged Stock)

Note − Difference of stock destroyed account and damaged account will be transferred to Profit & Loss account)

In case of loss of Profit

Insurance company A/cDr To Profit & Loss A/cDr To Profit & Loss Suspense A/c (Being Loss of profit for next year)

Bank A/cDr To Insurance Company A/c

Government Accounting

Government accounting is a scientific procedure of collecting, classifying, recording, summarizing, and interpreting all the financial transactions including revenues and expenditures of all the government offices. It keeps the record of public funds.

Followings are the main objectives of the Government Accounting −

• Information about Revenues − One of the most important functions of the Government accounting is to maintain the transactions of generation and collection of revenues during the financial year (and maintain all the past years’ financial data). Under the ‘Right to Information Act,’ if someone asks to have the information regarding the financial transactions of a government office, it is oblige to provide that.

• Information about Expenditures − One of the most important objectives of the Government accounting is to provide information about the expenditures incurred on various heads. It is checked by the Parliament in case of Central Government and state legislature in case of the State Government.

• Information about Deposits and Loans − Government has to provide information about the loan granted by the Government to others and repayment of the deposits.

• Information about Availability of Cash − It has to provide information about the present and the future cash availability.

Difference between Government and Commercial Accounting

There are following notable differences between the Government accounting and the commercial accounting −

Headings	Govt. Accounting	Comm. Accounting
Objective	Administration and management of all the financial activities of the government.	Maintain the records of trading and manufacturing of goods or to provide services to calculate profits.
Date Entry System	It has single entry system — Govt. does not work to earn profit; so, it does not need cross-check the accounting records.	Normally, it has double entry system — need to prepare Trading & Profit & Loss account and Balance Sheet at the end of the accounting period.
Basis of Accounting statements	Accounting statements are also prepared on the basis of single entry system. Most of the statements are merely statements of collections of revenue and expenditures done, except where the Government acts like a banker or lender or borrower.	Accounting statements are prepared on the basis of double entry system.

Important Terms and Expressions of Government Finance

Following are the important terms and expressions used in Government accounting −

• Demand for Grant − Without sanction from the Parliament, no expenditure can be incurred by any Government Authority. Public Authority can request for the grant of expenditure to the Government, this request is called “Demand for Grant”.

• Supplementary Grant − Sometimes, grants are sanctioned before the end of the financial year, in case where annual budget might be inadequate. Supplementary demand can be made, if need arises to meet the expenditure. For example, amount granted for the Natural Disaster Relief fund, may be found inadequate due to extraordinary disaster by the flood; in such a condition, an additional grant may be asked by the concerned state or ministry.

• Treasuries − Treasuries are the units of fiscal system in India. Every Indian States and Union Territory is divided into different districts’ headquarters and every district headquarters has one or more than one treasury. Treasuries are conducted by the State Bank of India as an agent of the Reserve Bank of India. Central Government and State Government keep their separate accounts and differences of Central and State Govt. are adjusted by the Reserve Bank of India.

• Votable and Non-votable Items − To incur some expenditures, Parliamentary approval is not required; so, these expenditures may be charged from the Consolidated fund or the Public account, these items are known as Non-votable items. Some items of expenditure require sanction of the Parliament and cannot be incurred without its grant. Thus, demand for grant for that expenditure may be placed to the government, such items are called as Votable Items.

• Appropriation Act − After the approval of the budget proposal in the Parliament or Legislature, an Appropriation Bill has to be introduced, when this Bill is passed, it becomes Appropriation Act. Now, money can be withdrawn from the Consolidated Fund of India or the concerned State to meet the grants.

• Vote on Account − In certain condition, when government has no time to place full budget in the Parliament, then it uses the special provision of ‘Vote on Account.’ Under this provision, government obtains the vote of the Parliament for the amount required to incur the expenditure of the items in demand. After sanction obtained in the Parliament, government obtains money from the Consolidated Fund of India.

• Public Accounts Committee (PAC) − Public Account Committee is formed by the Parliament and each Legislature to scrutinize the Appropriation account and Audit the report thereon. All the reports on financial statements those are to be submitted to the President of Indian and in the Parliament are examined by the Public Accounts Committee (PAC). Examination by the PAC is similar to post-mortem of the reports. Members of the PAC are appointed from the Opposition Parties of the Parliament. Member of the ruling party cannot be part of this committee, as this committee is working as a watchdog to look after the affairs of ruling party.

• Local Government Accounting − Accounting of the Local government is based on the concept of “fund accounting” and on the budget. Urban local government entities and rural local government entities are two types of local government entities. Accounting of the Local Government in India comprises budget, Receipt, and payment accounts.

Government Fund

Government of India has following three types of Funds for marinating the records of all sorts of financial transactions −

• Consolidated Funds of India
• Contingency Funds of India
• Public Account

Let’s discuss each of them succinctly −

Consolidated Funds of India

As per the Clause 1 of the Article 266 of the Indian Constitution −

“All revenues received by the Government by way of taxes like Income Tax, Central Excise, Customs and other receipts flowing to the Government in connection with the conduct of Government business i.e. Non-Tax Revenues are credited into the Consolidated Fund constituted. Similarly, all loans raised by the Government by issue of Public notifications, treasury bills (internal debt) and loans obtained from foreign governments and international institutions (external debt) are credited into this fund. All expenditure of the government is incurred from this fund and no amount can be withdrawn from the Fund without authorization from the Parliament.”

Contingency Funds of India

As per the Article 267 of the Indian Constitution −

“The Contingency Fund of India records the transactions connected with Contingency Fund set by the Government of India. The corpus of this fund is Rs. 50 crores. Advances from the fund are made for the purposes of meeting unforeseen expenditure which are resumed to the Fund to the full extent as soon as Parliament authorizes additional expenditure. Thus, this fund acts more or less like an imprest account of Government of India and is held on behalf of President by the Secretary to the Government of India, Ministry of Finance, and Department of Economic Affairs.”

Public Account

The Public Account is constituted under Clause 2 of Article 267 of the Indian Constitution, which says −

“The transactions relate to debt other than those included in the Consolidated Fund of India. The transactions under Debt, Deposits and Advances in this part are those in respect of which Government incurs a liability to repay the money received or has a claim to recover the amounts paid. The transactions relating to ‘Remittance’ and `Suspense’ shall embrace all adjusting heads. The initial debits or credits to these heads will be cleared eventually by corresponding receipts or payments. The receipts under Public Account do not constitute normal receipts of Government. Parliamentary authorization for payments from the Public Account is therefore not required.”

Similarly, all 29 states of India has the same structure as described above.

General Structure of Government Accounts

The general structure of the government accounts is illustrated below −

Compilation of Accounts

Treasury and other government departments, initially compile their receipt and payment accounts on monthly basis for central government and state government separately and then send to respective Accountant General of India.

Collection of revenue and disbursement are directly made by Railway, Defense, Post & Telegraphs, Forest, and public departments and lump sum payments are made by treasury through the departmental officers. Detail of accounts on monthly basis is maintained by the departmental Accounts officers.

Monthly accounts submitted by the treasury and account officer are compiled by the Accountant General, for the central government as a whole and for each state separately. The compiled report shows progressive figure of each month from 1st April to 31st March of every year. Complied accounts along with appropriation accounts are submitted by Comptroller and Auditor General of India to the President of India, to the Governor of each state, or to the Administrator of the Union Territory accordingly.

Principles of Government Accounting

• Charges or expenditure on a new project like constructions, new equipment, plant & machinery installation, maintenance, improvement, and service should be allocated to the capital account as per the rule made by competent authority.

• Working charges of the project should be allocated to the revenue account.

• In case of renewal and replacement and cost of the genuine replacement should be charged to capital account.

• In case of damage due to extraordinary calamities, charged should be debited from the capital account or revenue account or from both. However, it will be determined by the government according to the case and circumstances.

• Capital receipts during the new project should be credited to the capital account to reduce the capital expenditure of the project.

CAG

Comptroller and Audit General (CAG) is an independent Constitutional body. Special status has been given to safeguard his independence and enable him to discharge his duty without fear or favor.

As per the Article 148 of the Constitution of India, the comptroller and Auditor-General will be appointed by the President of India. The provision of removal of CAG is the same as of the judges of the Supreme Court. He can be removed only on the basis of proven misbehavior or incapacity.

As per the Article 150 of the Constitution of India — the accounts of the Union and of the States shall be kept in such form as the President may prescribed, on the advice of the Comptroller & Auditor General.

Article 151 of the Constitution provides that the audit reports of the Comptroller & Auditor General relating to the accounts of the Union shall be submitted to the President, who shall cause them to be laid before each House of Parliament.

Financial Accounting - Contract Account

Contracts are undertaken to customer’s requirements, which is generally of constructional. For example, construction of buildings, ships, Bridges, Roads, etc. In all the above cases, contract account is opened. A unique number is allotted to each contract and a separate account is maintained for each individual contract.

Features of Contract Accounting

Following are the important features of a contract accounting −

• Direct Costs − Direct cost is the main proportion of expenses in a contract account. However, indirect nature of expenses is also treated as direct expenses in a contract account.

• Indirect Costs − Proportion of the indirect cost is very low in a contract accounting such as expenses related to the head office in case of various contracts.

• Cost Control − Cost control is the main challenge in a contract account especially in the large scale contracts. For example, control over the material cost, labor cost, loss, damages, etc. are difficult to regulate.

• Surplus Material − After completion of the constructional project, if any material such as cement, iron and steel, marbles, etc. is remained unused, is known as surplus material. Surplus materials are normally disposed of to get back the invested amount.

Types of Contract

There are three types of contracts, as depicted in the following figure.

Recording of Costs, Value, and Profit on Contract

Recording of each contract will be done as under −

Material

Cost of “Material” will be debited from the contract account in the following manners −

• Direct purchase
• Supplied from stores
• Transfer from other project/contract

Contract account will be credited −

• Material returned to stores
• Sale proceed of surplus material

Amount will be transferred to Profit & Loss account −

• Profit or Loss on sale of surplus of material

• Damaged, Lost, or stolen material (except normal wastage of material that will be charged directly to concerned contract account).

Labor

Labor or wages directly charged to concerned contract account and outstanding wages should be debited from the contract account.

Direct Expenses

In addition to material and labor, all other expenses, which are directly attributable to the specific contract account are called direct expenses and will be debited from the contract account.

Plant and Machinery

Following are the two methods for charging value of Plant & machinery to a contract account −

a) Contract account will be debited with the full value of Plant & Machinery − Contract A/cDr(With full value) To Plant & Machinery A/c(With Full Value) Contract account will be credited with the depreciated value of Plant & Machinery at the end of the contract − Plant & Machinery A/cDr(with Depreciated Value) To Contract A/c

b) Contract account will be debited with hourly rate of Depreciation − This is much better and scientific approach as compared to the first method. On the basis of time, contract will be debited with hourly rate of depreciation.

Indirect Expenses

The expenses, which cannot be directly charged to such contract are known as indirect expenses.

On the basis of some percentage, these expenses may be distributed among several contracts. For example, charges of supervisor, engineer, administrative expenses etc.

Sub Contract

When a main or prime contractor assigns some specific work to another contractor as part of the main contract called as sub contract. Sub-contractors are paid by the main contractor. Sub-contractors normally do some specialized work, in which they are specialized. Charges paid to the sub-contractor will be shown in the debit side of the contract account.

Extra Work Charges

Any additional works in addition to the main contract, done by contractor as per the requirement of the Contractee, may be charged to same contract account. However, in case where volume of the extra work is not substantial; so, the amount received in lieu of that extra work should be added to the contract price.

In case where extra work is of substantial amount, a separate contract account should be prepared, as explained above.

Recording of Value and Profit on Contracts

Certification of Work Done

During the period of contract, Contractee has to pay sums of amount to contractor especially where a contractor is engaged in a big and long term contract. This amount is paid on the basis of certification of work done by surveyors or architects on behalf of the Contractee, who certified the value of the work done by the contractor.

Usually, some percentage of the certified amounts is paid by Contractee and the balance amount called as “retention money.” The retention amount remains with the Contractee until the work is completed to safeguard and keep in favorable position. Completed work, which is not certified is called “uncertified work.”

Following accounting procedure should be followed after getting certificate −

a) Contractee personal A/cDr

To Contract A/c

Note −

• 1. Above entry will be done with certified value

• 2. Balance amount in personal account will represent retention money as debtors.

b) Contractee personal A/cDr

Retention Money A/cDr

To Contract A/c

c) Under this method, any amount received from the Contractee till the completion of contract will be crediting to Contractee’s personal account debiting cash/bank. Amount so received will represent advance received from Contractee and will be shown as (work in progress less advance received) in the Balance sheet.

Profit on Incomplete Contract

Actual ascertainment of the cost is possible only after fully completion of the contract. Therefore, it is not possible to know the profit or loss on contract till it is completed.

However, following principles are adopted to estimate profit on uncompleted contracts −

• No profit is ascertained and transferred to profit and loss account where work is completed up to 25% of the total contract.

• In case where contract is completed from 33.33% to approximately 75%, one-third amount of the notional profit may retain to suspense account as a provision for future loss and balance; two third is transferred to the profit and loss account. Sometime notional profit is further reduced in the ratio of the cash received and the work certified, the formula is −

  $$\small Notional\:Profit \times \frac{2}{3} \times \frac{Cash\:Received}{Work\:Certified}$$

• In case where a contract is almost completed, proportion of an estimated profit is transferred to the profit & loss account by one of the most popular formula as given below −

  $$\small Estimated\:Profit \times \frac{Work\:Certified}{Contract\:Price}$$

Note − In case of any loss that should be transferred to Profit & Loss account.

Work in Progress

Uncompleted contracts at the end of the financial year, which are known as work-inprogress will be accounted as −

• Work-in-progress will be shown at the asset side of the Balance sheet on the account of expenses incurred the un-completed contracts.

• Value of the work-in-progress will be inclusive of Profit.

• Cash received from the Contractee will be deducted from the value of work-inprogress.

• Contractee will be treated as a debtor only after completion of the contract.

• Contractee will not be shown as creditor on account of cash received from him.

• Cost of plant and material at the site will be shown separately as “Plant at site” and “Material at site” on the asset side of the Balance sheet.

Illustration

Please prepare a Contract Account, Contractee Account and Extract of Balance sheet from the following information as received from M/s “Solid Building Contractor’ for the period 01-04-2013 to 31-03-2014.

Particulars	Amount
Contract Price	18,000,000
Material Issued to contract	3,060,000
Wages & Salary	4,800,000
Plant used for Contract	900,000
Other Miscellaneous Expenses	300,000
Cartage paid on Material	60,000
Loss of Plant at site	180,000
Plant returned to store on 31-03-2014	120,000
Loss of Material at site	150,000
Material in hand at site on 31-03-2014	138,000
Cash received 80% of work certified	7,680,000
Uncertified work	60,000
Depreciation on Plant	15%
Profit transferred to Profit & loss account	$\frac{2}{3^{rd}}$

Solution

M/s Solid Building Contractor

Contract Account

(For the period 01-04-2013 to 31-03-2014)

Particulars	Amount	Particulars	Amount
To Material To Wages & Salary To Plant To Cartage To Misc. Expenses To Notional Profit c/d	3,060,000 4,800,000 900,000 60,000 300,000 1,620,000	By Material at site By Profit & Loss A/c Material Lost150,000 Plant Lost180,000 ----------- By Plant return to store120,000 Less: Dep.18000 ----------- By Plant at site600,000 Less: Dep.90,000 ----------- By Work In progress A/c Work certified9,600,000 Work uncertified60,000 -----------	138,000 330,000 102,000 510,000 9,660,000
Total	107,400,000	Total	107,400,000
To Profit & Loss A/c $\small 1,620,000 \times \frac{2}{3} \times \frac{4}{5}$ To Work in Progress A/c (Reserve)	864,000 756,000	By Notional Profit b/d	1,620,000
Total	1,620,000	Total	1,620,000

Contractee Account

Particulars	Amount	Particulars	Amount
To Balance c/d	7,680,000	By Cash Received	7,680,000
Total	7,680,000	Total	7,680,000

Balance-Sheet

(As on 31-03-2014)

Particulars	Amount	Particulars	Amount
Profit & Loss A/c864,000 Less: Loss of330,000 Plant & Material-----------	534,000	Plant720,000 Less: Dep. 15%108,000 ------------ Material at site Work-in-progress Work Certified9,600,000 Uncertified work60,000 ------------ 9,660,000 Less: Reserve756,000 ------------ 8,904,000 Less: Cash Received7,680,000 ------------	612,000 138,000 1,224,000

Modern Approach on Profit on Uncompleted Record

Following are the two methods of calculating the profits on uncompleted contracts −

• Where profit is ascertained only after completion of the contract or after substantially completion of the contract is called ‘completion contract method.’

• Under the second approach, it is ascertained at the end of each and every accounting period on percentage basis, which comes before completion of the entire contract.

Work-in-Progress

Work-in-progress means total expenditure incurred up to the end of financial or accounting year known as work-in-progress account.

Following example is described for better understanding −

Illustration

Please evaluate the profit of the period by using both of the given methods −

• Percentage of completion method and
• The completed contract method.

Please also find the value of work-in-progress in the Balance sheet by assuming, the contractor received Rs. 460,000 on completion of the first stage.

Stages	Estimates		Actual Cost	Contract Price
	Original (Rs.)	Revised (Rs.)
Certified Completed but not certified Completed 75% Completed 25% Incomplete	345,000 115,000 115,000 230,000 138,000	368,000 126,500 126,500 276,000 172,500	356,500 120,750 95,450 71,300 --	460,000 172,500 149,500 345,000 161,000
	943,000	1,069,500	644,000	1,288,000

Solutions −

On the Basis of Percentage of Completion Method −

Stages	Actual Cost	% of completion	Balance estimates (Rs.)	Total Rs.	Contract Price	Profit or Loss
1 2 3 4 5	356,500 120,750 95,450 71,300 --	25% 75% 100%	31,625 207,000 172,500	356,500 120,750 127,075 278,300 172,500	460,000 172,500 149,500 345,000 161,000	103,500 51,750 -- -- (11,500)
	644,000		411,125	1,055,125	1,288,000	143,750

Balance Sheet

Particulars	Amount	Particulars	Amount
Advances	460,000	Work in Progress (Actual cost + Profit) 644,000 + 143,750	787,750

On the Basis of Completion Contract Method −

No profit will be ascertained before the completion of contract −

Balance Sheet

Particulars	Amount	Particulars	Amount
Advances	460,000	Work in Progress	644,000

Cost Plus Contract

In some cases, it is not possible in advance to know the exact cost of contracts; therefore, cost plus contract clause need to be applied, in which the value of contract is ascertain by adding certain percentage of the profit in cost.

Escalation Clause

An Escalation clause is applied to cover up the changes in price due to change in prices of the raw material or change in utilization of the production capacity. Escalation clause safeguards both the contractor and the contractee against any unfavorable change in the cost or the price.

Target Costing

Under this method of a contract, contractee gives target of the production with target of the expenditure. Contractor cannot increase the cost of contract without increasing the production. It means, expenditure is fixed with the target of the production.

Departmental Accounting

Departmental stores have many types of stores under a single roof, for example one departmental store may have a cosmetic store, shoe store, stationery store, readymade departmental store, grocery stores, medicines, and many more.

It is essential to know the profit and loss account of each departmental store at the end of the accounting year. However, it can be done by maintaining the department wise Trading & Profit and Loss account.

Objectives of Departmental Accounting

Following are the main objectives of the departmental accounting −

• To know the financial position of each and every department separately, it is helpful to make a comparison.

• Calculate commission of the managers department wise.

• Evaluate performance, planning, and control.

Advantages of Departmental Accounting

Following are the advantages of a department accounting −

• It is helpful in evaluating the result of each department.

• It helps to know the profitability of each department.

• Investors and outsiders may know the detailed information.

• It is helpful in making comparison of each expenses (same department) of the different accounting years and different expenses (other departments) of the same accounting year.

Methods of Departmental Account

There are two methods of keeping Departmental Accounts −

• Separate Set of Books for each department
• Accounting in Columnar Books form

Separate Set of Books for each Department

Under this method of accounting, each department is treated as a separate unit and separate set of books are maintained for each unit. Financial results of each unit are combined at the end of accounting year to know the overall result of the store.

Due to high cost, this method of accounting is followed only by very big business houses or where to do so is compulsory as per the law. Insurance business is one of the best examples, where to follow this system is compulsory.

Accounting in Columnar Books Form

Small trading unit generally uses this system of accounting, where accounts of all departments are maintained together by central accounts department in the columnar books form. Under this method, sale, purchase, stock, expenses, etc. are maintained in a columnar form.

It is necessary that to prepare a departmental Trading and Profit and Loss Account, preparation of subsidiary books of accounts having different columns for the different department is required. Purchase Book, Purchase Return Book, Sale Book, Sales return books etc. are the examples of the subsidiary books.

Specimen of a Sale Book is given below −

Sales Book

Date	Particulars	L.F.	Department A	Department B	Department C	Department D

A Trading account in columnar form is prepared to know the department wise gross profit of the concern.

Function wise classification may also be done in a business unit like Production department, Finance department, Purchase department, Sale department, etc.

Allocation of Department Expenses

• Some expenses, which are specially incurred for a particular department may be charged directly to the respective department. For example, hiring charges of the transport for delivery of goods to customer may be charged to the selling and distribution department.

• Some of the expenses may be allocated according to their uses. For example, electricity expenses may be divided according to the sub meter of each department.

Following are the examples of some expenses, which are not directly related to any particular department may be divide as −

• Cartage Freight Inward Account − Above expenses may be divided according to purchase of each department.

• Depreciation − Depreciation may be divided according to the value of assets employed in each department.

• Repairs and Renewal Charges − Repair and renewal of the assets may be divided according to the value of the assets used by each department.

• Managerial Salary − Managerial salary should be divided according to the time spent by the manager in each department.

• Building Repair, Rents & Taxes, Building Insurance, etc. − All the expenses related to the building should be divided according to the floor space occupied by each department.

• Selling and Distribution Expenses − All the expenses relating to selling and distribution expenses should be divided according to the sales of each department, such as freight outward, travelling expenses of sales personals, salary and commission paid to salesmen, after sales services expenses, discount and bad debts, etc.

• Insurance of Plant & Machinery − The value of such Plant & Machinery in each department is the basis of the insurance.

• Employee/worker Insurance − Charges of a group insurance should be divided according to the direct wage expenses of each department.

• Power & Fuel − Power & fuel will be allocated according to the working hours and power of the machine (i.e. Hours worked x Horse power).

Inter-Department Transfer

An inter-department analysis sheet is prepared at a regular interval such as weekly or monthly basis to record all the inter-departmental transfers of goods and services. It is necessary, as each department is working as a separate profit center. Transfer of the prices of such transactions can be cost base, market price, or duel basis.

Following Journal entry will pass at the end of that period (weekly or monthly) −

Journal Entry

Receiving Department A/c                      Dr 
To Supplying Department A/c

Inter-Department Transfer Price

There are three types of transfer prices −

• Cost based transfer price − Where the transfer price is based on standard, actual, or total cost, or marginal cost is called cost based transfer price.

• Market based transfer price − Where the goods are transferred at selling price from one department to another is known as market based price. Therefore, unrealized profit on the goods sold is debited from the selling department in the form of a stock reserve for both the opening and the closing stock.

• Dual pricing system − Under this system, the goods are transferred on the selling price by the transferor department and booked at the cost price by the transferee department.

Illustration

Please prepare a Departmental Trading and Profit and Loss Account & General Profit and Loss Account for the year ended 31-12-2014 of M/s Andhra & Company where department A sells goods to department B on Normal selling price.

Particulars	Dept. A	Dept. B
Opening stock	175,000	-
Purchases	4,025,000	350,000
Inter Transfer of Goods	-	1,225,000
Wages	175,000	280,000
Electricity Expenses	17,500	245,000
Closing Stock (at cost)	875,000	315,000
Sales	4,025,000	2,625,000
Office Expenses	35,000	28,000
Combined Expenses for both Department
Salaries (2:1 Ratio)	472,500
Printing and Stationery Expenses (3:1 Ratio)	157,500
Advertisement Expenses ( Sale Ratio)	1,400,000
Depreciation (1:3 Ratio)	21,000

Solution

M/s Andhra & Company

Departmental Trading and Profit and Loss Account

For the year ended 31-12-2014

Particulars	Dept. A	Dept. B	Particulars	Dept. A	Dept. B
To Opening Stock To Purchases To Transfer from A To Wages To Gross Profit c/d	175,000 4,025,000 175,000 1,750,000	-- 350,000 1,225,000 280,000 1,085,000	By Sales By Transfer to B By Closing Stock	4,025,000 1,225,000 875,000	2,625,000 ---- 315,000
Total	6,125,000	2,940,000	Total	6,125,000	2,940,000
To Electricity Expenses To Office Expenses To Salaries (2:1 ratio) To Printing & Stationery (3:1 Ratio) To Advertisement Exp. ( Sales Ratio 40.25 :26.25) To Depreciation (1:3 Ratio) To Net Profit	17,500 35,000 315,000 118,125 847,368 5,250 411,757	245,000 28,000 157,500 39,375 552,632 15,750 46,743	By Gross Profit b/d	1,750,000	1,085,000
Total	1,750,000	1,085,000	Total	1,750,000	1,085,000

General Profit and Loss Account

For the year ended 31-12-2014

Particulars	Dept. A	Particulars	Dept. B
To Stock reserve (Dept. B) To Net Profit c/d	81,667 376,833	By Departmental Net Profit b/d Dept. A411,757 Dept. B46,743 -------------	458,500
Total	458,500	Total	458,500

Financial Accounting - Voyage Accounting

To know the financial results of a marine business, voyage accounting is prepared. Voyage account is similar to a Profit and Loss account; all expenses are debited to Voyage account and all incomes are credited to Voyage account. Voyage account is prepared to ascertain the profit or Loss of voyage. It covers both inward and outward travelling. It is very important that separate Voyage account should be prepared for each vessel.

Income

Following are the main sources of income of a Voyage −

• Freight − Freight charges are the main income collected against the transportation of the goods.

• Passage Money − Passage money is collected from the passengers, in case it is passengers’ vessel.

• Primage − Primage is an additional freight in the form of surcharge on the freight.

Expenses

Following are the various ways of expenses of a vessel −

• Brokerage & Commission − Brokerage and commission is calculated on the freight charges including primage and it is paid to the charters agent. Address commission is payable to the brokers on procurements of freight from the different parties.

• Insurance − The insurance charges on proportionate basis might be debited from the voyage account. For example, if insurance is for one year and journey of voyage is for three month, insurance charges will be debited from the voyage account on $\frac{1}{4^{th}}$ ratio.

• Stores − Stores, which are purchased for voyage are debited from the voyage account on consumption basis i.e. opening stock + purchases – closing stock.

• Depreciation − Depreciation on ship is charged from the voyage account in the proportion of the period of a journey.

• Bunker Cost − Cost of water, coal, diesel, fuel, etc. used for the purpose of voyage is called bunker cost and may debited from the voyage account.

• Port Charges − Port authorities charge fees for allowing ships to use port for the loading/unloading the cargo. This fee amount is debited from the voyage account.

• Stevedoring Charges − Loading and unloading of cargo called stevedoring charges and should be debited from the voyage account.

Voyage in Progress

At the end of the accounting year where voyage is not completed and is still in progress, following accounting treatments are required −

Freight Received

Total freight received credited to the voyage account and the provision for incomplete voyage is debited from the voyage account. Provision is created for the voyage-in-progress in proportion of the incomplete journey.

Expenses

To complete matching concept, an income as well as expenses related to the incomplete voyage might be carried forward to the next accounting year on the respective account. Provision for the income earned should be debited from the voyage account and provision for the expenses should also be credited to the voyage account.

Basis of the expenses to be carried forward is as hereunder −

• Expenses which are related to the freight, need to be carried forward in a proportion to return freight. For example, if total freight is Rs. 2,500,000 out of which return freight is Rs. 1,200,000 and total expenses are Rs. 500,000, then expenses to be carried forward to the next accounting year — will be Rs. 240,000.

  $$\small = \frac{1,200,000}{2,500,000} \times 500,000$$

• In case of the standing expenses, if return journey is incomplete, ½ of the standing charges to be carried forward.

• In case where return journey is halfway back and the total expenses of voyage given $\frac{1}{2}$ of the total expenses to be carried forward.

• When the return journey is halfway back and the expenses till date are given $\frac{1}{3^{rd}}$ of the expense are to be carried forward.

• When one round of the trip is completed and on his half way back for single way and total expenses of voyage are given, then $\frac{1}{3^{rd}}$ expenses are to be carried forward.

• When one round trip is completed and on his half way back for single way and expenses till date are given, then $\frac{1}{5^{th}}$ expenses are to be carried forward.

Pro-forma

In the books of M/s Titanic Shipping Company

Voyage Account

For the period ending 31-12-2014

Particulars	Amount	Particulars	Amount
To Coal Opening Stockxx Add: Purchasesxx --------- xxxx Less: Closing Stockxx --------- To Port Charges To Captain Expenses To Harbor Wages To Address Commission To Brokerage To Insurance Premium To Salary & Wages To Stores To Deprecation To Provision for Incomplete Voyage To Net Profit (trf. To Profit & Loss A/c)	xx xx xx xx xx xx xx xx xx xx xx xx --------- XXXX	By Freight By Primage	Xx Xx --------- XXXX

Financial Accounting - Royalty Accounts

Royalty is payable by a user to the owner of the property or something on which an owner has some special rights. A royalty agreement is prepared between the owner and the user of such property or rights. If payment is made to purchase the right or property that will be treated as capital expenditure instead of a Royalty.

Payment made by the lessee on account of a royalty is normal business expenditure and will be debited to the Royalty account. It is a nominal account and at the end of the accounting year, balance of Royalty account need to be transferred to the normal Trading and Profit & Loss account. Royalty, based on the production or output, will strictly go to the Manufacturing or Production account. In case, where the Royalty is payable on sale basis, it will be part of the selling expenses.

Types of Royalties

There are following types of Royalties −

• Copyright − Copyright provides a legal right to the author (of his book/s), the photographer (on his photographs), or any such kind of intellectual works. Copyright royalty is payable by the publisher (lessee) of a book to the author (lessor) of that book or to the photographer, based on the sale made by the publisher.

• Mining Royalty − Lessee of a mine or quarry pays royalty to lessor of the mine or quarry, which is generally based on the output basis.

• Patent Royalty − Patent royalty is paid by the lessee to lessor on the basis of output or production of the respective goods.

Basis of Royalty

In case of the patent, publisher of the book pays royalty to the author of the book on the basis of number of books sold. So, holder of patent gets royalty on the basis of output and the mine owner gets royalty on the basis of production.

Important Terms

Following are the important terms, which are used in Royalty agreements −

Royalty

A periodic payment, which may be based on a sale or output is called Royalty. Royalty is payable by the lessee of a mine to the lessor, by publisher of the book to the author of the book, by the manufacturer to the patentee, etc.

Landlord

Landlords are the persons who have the legal rights on mine or quarry or patent right or copybook rights.

Tenet

An Author or publisher; lessee or patentor who takes out rights (usually commercial or personal rights) from the owner on lease against the consideration is called tenet..

Minimum Rent

According to the lease agreement, minimum rent, fixed rent, or dead rent is a type of guarantee made by the lessee to the lessor, in case of shortage of output or production or sale. It means, lessor will receive a minimum fix rent irrespective of the reason/s of the shortage of production.

Payment of royalty will be minimum rent or actual royalty, whichever is higher for example −

M/s Hyderabad publication printed a book on Java on the minimum rent of Rs. 1,000,000/- per annum royalty being payable @ Rs. 20 per book sold. In the first year of publication, Hyderabad publication sold 75,000 copy of the books and in the second year, number of sold books fell down to 45,000 only. Amount of royalty will be payable as under −

	Minimum Rent	Royalty Payable
Ist Year 75,000 Books X Rs. 20 per book = Rs. 1,5,00,000	1,0,00,000	Rs. 1,5,00,000
IInd Year 45,000 Books X Rs. 20 per book = Rs. 9,00,000	1,0,00,000	Rs. 1,0,00,000

Shortworkings

Difference of minimum rent and actual royalty is known as shortworkings where payment of Royalty is payable on the basis of minimum rent due to shortage in the production or sale. For example, if calculated royalty is Rs. 900,000/- as per sale of books based on the above example, but royalty payable is Rs. 1000,000 as per minimum rent, shortworking will be Rs. 100,000 (Rs. 1,000,000 – Rs. 9,00,000).

Ground Rent

The rent, paid to the landlord for the use of land or surface on the yearly or half yearly basis is known as Ground Rent or Surface Rent.

Right of Recouping

It may contain in the royalty agreement that excess of minimum rent paid over the actual royalty (i.e. shortworkings), may be recoverable in the subsequent years. So, when the royalty is in excess of the minimum rent is called the right of recoupment (of shortworkings).

Right of recoupment will be decided for the fixed period or for the floating period. When the right of recoupment is fixed for the certain starting years from the date of royalty agreement, it is said to be fixed or restricted. On the other hand, when the lessee is eligible to recoup the shortworkings in next 2 or 3 years from the year of its commencement, it is said to be floating.

Shortworking will be shown on the asset side of Balance sheet up to allowable year of recouping after that it will be transferred to profit & loss account (after expiry of allowable period).

Lease Premium

An Extra payment in addition to royalty, if any, paid by lessee to lessor is called Lease premium and will be treated as capital expenditure and it will be written off on yearly basis through profit and loss account as per the suitable method.

TDS (Tax Deducted at sourceSource)

If there is an applicability of TDS (Tax deducted at source) as per Income Tax Act, lessee will make the payment to lessor after deducting TDS as per applicable rate and lessee is liable to deposit it to the credit of Central Government. Amount of royalty will be gross amount of royalty (inclusive of TDS), that will be charged to profit and loss account.

For example, if royalty amount is 1,000,000/-& rate of TDS is 10%, then lessee will pay Rs. 900,000/- to lessor. Amount of royalty charge to profit and loss account will be Rs. 1,000,000/- and balance amount of Rs. 100,000/- will be deposited in the credit of central Government account.

Stoppage of Work

Sometime, there may be stoppage of work due to conditions beyond control like strike, flood, etc. in this case, minimum rent is required to be revised as provided in the agreement.

Revision of the minimum rent will be −

• Reduction of minimum rent in the proportion of the stoppage of work;
• On the basis of fixed percentage; or
• By a fixed amount in the year of stoppage.

Sub Lease

Sometime, landlord or lessor allows lessee to sublet some part of the mine or land as a sub-lessee. In this case, lessee will become lessor for sub lessee and lessee for main landlord.

In such a case, as Lessee, he will maintain the following books of accounts −

As a Lessee Landlord accountAccount Minimum Rent Account Royalty Account Shortworkings Recoupable Accounts

As a Sub Lessor Royalties receivable Receivable accountAccount Sub lessee Lessee accountAccount Shortworkings allowable Allowable Account

Accounting Entries

When there is no royalty in the year	(a) Minimum Rent A/cDr To Landlord A/c (b) Shortworking A/cDr To Minimum Rent A/c
Where Royalties are less than minimum rent and shortworkings are recoverable in next years.	(c) Minimum Rent A/cDr To Landlord A/c (d) Royalties A/cDr Shortworkings A/cDr To Minimum Rent A/c (e) Landlord A/cDr To Bank A/c (f) Profit & Loss A/cDr To Royalty A/c
When Short workings are recouped	(g) Royalties A/cDr To short workings A/c To Landlord A/c (h) Landlord A/cDr To Bank A/c
Transfer of irrecoverable Short workings	(i) Profit & Loss A/cDr To Short workings A/c

Illustration

From the below given information’s, please open prepare the necessary accounts in the books of M/s Black Diamond Limited.

• Company leased a colliery on 01-01-2010 at a minimum rent of Rs. 75,000.

• Royalty Rate@ Rs. 1/- per ton.

• Right of recouping of shortworkings is restricted to first 3 years.

• Output for the first four years of the lease was 40,000, 65,000, 1,05,000, and 90,000 tons respectively.

Solution −

Analytical Table

Year	Output (Tons)	Royalties @ Rs. 1 Per ton	Shortworkings	Surplus	Recoupment	Unrecoupable Short workings	Payable to Landlord
2010 2011 2012 2013	40,000 65,000 105,000 90,000	40,000 65,000 105,000 90,000	35,000 10,000 --	30,000 15,000	-- -- 30,000	15,000	75,000 75,000 75,000 90,000
	300,000	300,000	45,000	45,000	30,000	15,000	315,000

In the books Books of M/s Black Diamonds Ltd

Royalties Account

Date	Particulars	Amount	Date	Particulars	Amount
31-12-2010 31-12-2011 31-12-2012 31-12-2013	To Landlord A/c To Landlord A/c To Landlord A/c To Landlord A/c	40,000 ======= 65,000 ======= 105,000 ======= 90,000 =======	31-12-2010 31-12-2011 31-12-2012 31-12-2013	By Production A/c By Production A/c By Production A/c By Production A/c	40,000 ======= 65,000 ======= 105,000 ======= 90,000 =======

Landlord Account

Date	Particulars	Amount	Date	Particulars	Amount
31-12-2010 31-12-2011	To Bank A/c To Bank A/c	75,000 ---------- 75,000 ---------- 75,000 ---------- 75,000 ----------	31-12-2010 31-12-2011	By Royalties A/c By Shortworkings A/c By Royalties A/c By Shortworkings A/c	40,000 35,000 ---------- 75,000 ---------- 65,000 10,000 ---------- 75,000 ----------
31-12-2012 31-12-2012 31-12-2013	To Shortworkings A/c To Bank A/c To Bank A/c	30,000 75,000 ---------- 105,000 ---------- 90,000 ---------- 90,000 ----------	31-12-2012 31-12-2013	By Royalties A/c By Royalties A/c	105,000 ---------- 105,000 ---------- 90,000 ---------- 90,000 ----------

Shortworkings Account

Date	Particulars	Amount	Date	Particulars	Amount
31-12-2010 01-01-2011 01-01-2012	To Landlord A/c To Balance b/d To Landlord A/c To Balance b/d	35,000 ---------- 35,000 ---------- 35,000 10,000 ---------- 45,000 ---------- 45,000 ---------- 45,000 ----------	31-12-2010 31-12-2011 31-12-2012 31-12-2010	By Balance C/d By Balance C/d By Landlord A/c By Profit & Loss A/c	35,000 ---------- 35,000 ---------- 45,000 ---------- 45,000 ---------- 30,000 15,000 ---------- 45,000 ----------