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What we will study in this chapter: Wewillstudyinthischapter,howfinalaccount(annualaccounts)are preparedforproprietaryandpartnershipfirmsengagedinbusinessandtheadjustmentsrequiredtobemade.
Finalaccountsofnon-corporateentitiesi.e.soleproprietaryconcernsandpartnershipfirms/concernswillbestudied inthischapter.
Final accounts are the end results of the whole accounting process. Final A/c’s or annual accounts includes the following statements:
(1)Trading&Profit&LossAccountand(2)BalanceSheet.
In case of manufacturing concerns the final a/c’s may include the following statements.
(1)ManufacturingA/c.,(2)Trading,Profit&LossA/c.,(3)BalanceSheet.
The above final a/c’s are prepared with the help of trial balance and additional information/adjustments.
TradingandProfit&LossA/c shows the result of the operation (performance) that is profits earned or loss incurred during that year. Therefore all Expenses and Incomes related to that period should come in the P&L A/c, whether it is paid/received or not is not important i.e. expense should be recognized when incurred means services/benefits are received and income should be recognized when earned i.e. when services/benefits are given. This is also referred as Mercantile system of accounting or recognition of accrual principle. Due to this we make adjustments for outstanding expenses, Outstanding Incomes, prepaid expenses, Advance Incomes, closing stock etc.
Balancesheet shows the Assets & Liabilities of the organization as on a particular date. It is not an account. It is not for any period or year. It shows the financial position of the entity as of a particular date (rather at a point of time).
Manufacturingaccount if prepared shows the cost of goods manufactured during that period. This cost is transferred to Trading A/c.
Trading account shows the profit/loss made on a gross basis that is including only the direct cost of the goods. In trading a/c, we credit the trading income like sale and debit the cost of goods sold (opening stock + purchases (-) closing stock).
Alternatively Opening Stock & purchases is debited & Closing stock is credited to trading account.
Other direct expenses related to purchase or manufacture of goods like carriage inward, wages, etc. are also debited here.
Purchase return & Sales returns will be deducted/adjusted from the purchases & sales respectively.
The balance is known as the gross profit or gross loss, which is transferred to profit and loss a/c.
Non-corporate entities usually prepares trading a/c so as to know the gross margin available in its sale.
But at corporate level usually it is not prepared. In those cases the items of trading account gets incorporated in profit & loss account.
Illustration 13.1 : The following is the extract of trial balance as on 31.3.2021 and certain additional information of Shri Tendulkar, who carries on business under the name and style of M/s. Tendulkar and Company at Bombay: 13.1
Additional Information:
1.Value of stock at close of year 44,000
Prepare Trading A/c for the year ended 31.3.2021.
Solution:
M/s Tendulkar and Company Trading a/c
For the year ended 31st March, 2021
It shows the performance of the entity i.e. profit earned or loss suffered considering all indirect expenses and incomes.
Gross profit or gross loss from trading account is transferred to P&L a/c.
Other incomes like discount, interest, etc. are credited.
Administrative expense, selling and distribution expense, financial expense, income tax, losses, etc. are debited to it.
The net profit/net loss is transferred to P&L appropriation a/c (if made) otherwise to capital a/c.
If trading a/c is not prepared then in place of gross profit/gross loss all items of trading a/c will come in P&L a/c itself
Although not necessary, but usually full profit/loss is transferred to proprietor/partners capital account, hence profit & loss account does not appear in balance sheet.
DebitCredit
Reserve for Bad Debt3,000
Salaries11,000
Rent for Godown5,500
Interest on loan from Vishwanath2,700
Rates and Taxes2,100
Discount allowed to Debtors2,400
Discount received from creditors1,600
Carriage Outwards2,000
Printing and Stationary1,800
Additional Information:
2.Depreciate-
(a)Building by 3,000
(b)Furniture and fixture by 2,000
(c)Office equipment by 2,400
(d)Typewriter by 300
(e)Motor Van by 4,000
3.One month’s rent for godown is outstanding.
4.One month’s salary is outstanding.
5.Interest on loan from Vishwanath payable 600
6.Reserve for bad debt is to be maintained at 4,300.
7.Insurance Premium includes 4,000 paid towards proprietor’s L.I.C. policy and the balance of the insurance charges cover the period 1.4.2020 to 30.6.2021.
8.Half of the building is used for residential purposes of Sri. Tendulkar. Prepare Profit and Loss A/c for the year ended 31.3.2021.
The net profit/net loss is transferred to P&L appropriation A/c.
Interest charged on drawings is credited to it.
Interest allowed on capital, salary/commission to proprietor/partner and transfer to reserves are debited to it.
The net balance then left is transferred to capital a/c.
Expenses incurred to earn income is treated as charge against profit and are debited to P&L a/c whereas items which are division of this profit earned are known as appropriation of profit and charged to P&L appropriation a/c.
Trading account, P&L a/c and P&L app. a/c are period statements, showing the result (performance) of that period, usually an accounting year.
In case of corporate organization like companies balance after all appropriations including dividend, remains in P&L/P&L appropriation a/c and hence appears in balance sheet.
Illustration 13.3 : The following is the extract of trial balance as on 31.3.2021 and certain additional information of Shri Tendulkar, in continuation of what is given in Illustrations 13.1 and 13.2:
Additional Information:
9.Salary due to Tendulkar 500 p.m.
10.Interest on capital @5% be provided 8,100.
11.Interest on drawings 2,100
Prepare Profit and Loss Appropriation A/c for the year ended 31.3.2021.
Solution:
M/s Tendulkar and Company Profit and Loss Appropriation a/c
For the year ended 31st March, 2021
ParticularsAmountParticularsAmount
To Salary to Proprietor (500 × 12)6,000 By Profit & loss A/c (Net profit transferred)18,700
To Interest on Capital8,100By Interest on Drawing2,100
To Capital A/c (Balance profit transferred)6,700
20,80020,800
A manufacturing concern may prepare Manufacturing a/c to ascertain cost of goods manufactured.
Raw material consumed (Op. stock + Purchases - Closing stock), carriage inward, wages, power, depreciation of factory building, machinery, etc. and other manufacturing (factory) expense are debited to it.
Opening WIP stock is debited and closing WIP stock credited.
Balance is the cost of goods manufactured and is then transferred to trading account.
When manufacturing a/c is not prepared, these items will come in trading a/c. Sometimes depreciation a/c may be directly taken to P&L a/c instead of trading a/c.
Manufacturing a/c is also a period statement.
A manufacturer is one who purchases raw material and process it into finished goods with the help of labour and machines at his factory and sells the finished goods. Whereas a trader purchases goods and sells it as it is.
Refer Illustration 13.13
Balance sheet shows the financial position of the entity as at a particular point of time.
It shows what and how much entity owns (i.e. its assets) and how much it owes to others (i.e. its liabilities), the balance (i.e. asset - liability) is the owners equity.
It is not an account, hence does not have debit and credit side.
On one side assets like fixed assets (building, machinery, furniture, etc.), current assets (like stock, debtors, cash bank balance, advances, prepared a/c) and investments if any are shown.
On the other side in addition to owners capital and reserves, the outside liabilities like loans taken, creditors, expenses payable etc. are shown.
The two sides total must be same.
On the asset side of balance sheet we start with most permanent to least permanent i.e. fixed assets, investments and then current assets. It is known as permanency preference. In case of manufacturer/trader this sequence is followed hence student will see this in all the chapters.
When asset side starts with most liquid asset to least liquid like cash bank balance and ends with fixed assets is known as liquidity preference generally followed by institutions like banks.
Liability side is mostly same in all cases we have first owner capital and reserves, then loans and thereafter current liabilities and provisions.
Balance sheet is a point of time statement, when stated as at 31.3.2021 it means as at close of that date i.e. after considering all transactions of that day.
Even though balance sheet does not have debit and credit side, student should remember that asset side represent debit and capital and liability side represent credit. It will help in correctly preparing final accounts.
In General Mercantile/accrual system is followed, as it is the proper and complete system to measure the performance of entity. In your syllabus every where this is considered. Under this system, incomes are recognized when these are earned irrespective of whether amount is received or not. Similarly expenses are recognized when these are incurred or accrued irrespective of whether amount is paid or not. As a result we have to make adjustment for expenses outstanding (payable), prepaid, income outstanding (receivable) and advance-received etc.
Illustration 13.4 : The following is the extract of trial balance as on 31.3.2021 and certain additional information of Shri Tendulkar, in continuation of what is given in Illustrations 13.1, 13.2 and 13.3:
DebitCredit
Cash in hand1,400
Cash at Bank2,600
Sundry Debtors86,000
Furniture and Fixture20,000
Office Equipment16,000
Typewriter purchased on 1.10.20204,000
Buildings60,000
Motor Car20,000
Sundry Creditors43,000
Loan from Vishwanath30,000
Drawings12,000
Capital A/c
Prepare Balance Sheet as on 31.3.2021.
1,62,000
Trial balance is a statement containing the balances of all accounts as at the end of certain period usually classified into debit and credit.
The total of debit and credit side must tally because whole accounting is done by double entry principle, otherwise it indicates arithmetical inaccuracies.
It has balance of expenses, incomes, assets and liabilities.
With the help of trial balance and adjustments the final accounts are prepared. All expenses and incomes will go into Manufacturing, Trading, P&L and P&L app. a/c depending upon its nature and all assets and liabilities will go into balance sheet.
When the trial balance is prepared, there may still be some accounts which are not yet final and may need some adjustments, some corrections etc.
Such information is given together with trial balance and commonly referred as adjustment/additional information/other information etc.
It is basically a transaction which needs to be entered in the account books or some errors which needs to be rectified, hence we give double entry effect i.e. Debit & Credit both for such adjustments.
Some times indirect information is contained, in the trial balance, which when interpreted results into an adjustment (known as adjustment derived).
Place where information is given is irrelevant. Hence adjustment though commonly given below the trial balance, can be given in the trial balance or above the trial balance.
(1) Outstanding Expenses/Expenses payable/Expense accrued (i.e. services/benefits have been received during the year, but payment not yet made.)
Expenses a/cDr.
To Expenses Payable a/c (Liability)
(2) Prepaid expenses/Advance payment. (i.e. payment has been made but services/benefits have not been received during the year.)
Prepaid Expenses a/cDr. (Assets)
To Expenses a/c
(3) Outstanding Income/Income receivable/Accrued income. (i.e. services/benefits have been rendered during the year, but payment not yet received.)
Income receivable a/cDr. (Assets)
To Income a/c
(4) Incomes received in advance (i.e. payment has been received but services/benefits have not been rendered during the year.)
Income a/cDr.
To Advance Income a/c (Liability)
(5) Depreciation: Following are the two ways of accounting for Depreciation.
(
(
a)Depreciation a/cDr.
To Assets a/c
b)Depreciation a/cDr.
To Depreciation reserve/Depreciation fund/Depreciation provision a/c (Depreciation a/c is an expense which will be transferred to P&L a/c)
(6) Closing Stock adjusted/accounted.
Stock a/cDr. (Assets)
To Trading a/c
Refer Illustration 13.9
Any or all of the adjustments mentioned above can be recorded in the books of account and then trial balance can be prepared.
Similarly stocks can also be adjusted before preparing trial balance as follows:
Transfer Opening stock account to Purchases account i.e. Debit purchase a/c and Credit Opening stock a/c. Record closing stock in the books i.e. Debit Closing stock account and Credit Purchases account.
Now in the Trial balance opening stock will not appear instead closing stock will appear which will be shown as asset in the balance sheet.
The balance in Purchases account is the cost of goods sold also known as adjusted purchases which will be debited to trading account.
Illustration 13.5: Below is the trial balance of Shah as December 31, 2020 DebitBalanceCreditBalance
Cash on Hand250
Cash at Bank1,500
Stock (31st December, 2020)61,250
8,10,5008,10,500
Additional information:
1.Rates have been prepaid to the extent of 175.
2.Bad debts 500 have to written off. A provision for doubtful debts @ 5% on debtors is necessary.
3.Building has to be depreciated at 2% and Furniture @ 10%.
4.The manager is entitled to a commission of 5% of net profits before charging such commission. Solution:
To
To Rates & Insurance: Paid400
Less: Prepaid175225
To Bad Debts written off500
To Provision for Doubtful Debts (5% of 7,500)375
To Depreciation: Buildings (2%)540
Furniture (10%)6001,140
To Interest1,800
To Commission payable to manager (5% of 11,860*)593
To Net Profit11,267
20,90020,900
* 20,900 less 9,040 (the total of all expenses so far), Manager is entitled to 5% of this figure.
(1) The trial balance gives “Adjusted Purchases”. It means that the opening stock has already been transferred to the Purchases Account and thus been closed. Further, entry for closing stock has already been passed by debiting the Closing Stock Account and crediting Purchases Account. That is why closing stock appears inside the trial balance. It will now be shown in the Balance Sheet and not in the Trading Account since purchases already stand reduced.
(2) There is a Loan of Desai @ 9% taken in 2019 i.e. in last accounting year. As per mercantile system interest up to 31.12.19 must have been provided in the last years a/c itself. The trial balance makes no mention of any interest being paid to him. Hence, interest @ 9% must be provided for the whole of current year only.
Balance Sheet of Shah as at December 31, 2020
Although there is nothing wrong in either.
But as a student our objective should be to improve our knowledge of accounting.
Debit credit is the language of accounting and not add-less, hence it is advisable to use your debit-credit (i.e. accounting) knowledge everywhere.
Formulate a double entry for every transaction/adjustment and then give its effect to same accounts if appearing in trial balance and the final figure then will appear in final account.
There is no point in memorising a long list of adjustment with there add less effects. Entry should be formed using basic accounting knowledge as studied in Chapter 1.
In any case in a real situation every adjustment is required to be accounted in the books of account then only profit and loss a/c and balance sheet will be as per the books of account (or in agreement with books of account) as is certified by an auditor.
After all adjustment are duly accounted.
The individual expenses accounts are closed by debiting into trading or P&L a/c etc. as the case may be. Similarly all incomes a/c are closed by crediting it to Trading & P&L a/c.
Such entries are known as closing entries.
Balance of trading account (gross profit) is transferred to P&L a/c.
Balance of P&L a/c (net profit) is transferred to capital a/c.
Thus we are left with only the balances of assets and liabilities (including capital) which are shown in the balance sheet and carried forward to next years books of account by writing the balance on the other side of the account and thus account is shown as closed i.e. total on both debit and credit side gets equalized.
When the books of account have been audited and final accounts have been prepared, then the closing entries as above are passed.
All assets and liabilities accounts are balanced, shown in the balance sheet and carried forward to next years account book.
It is a accepted norm, not to make any changes once the account books are audited and closed.
(1)All debit balances will be either expenses or assets & all credit balances will be either incomes or Liabilities.
(2)All expenses and incomes accounts are transferred to trading and profit and loss a/c and are thus closed.
(3)All assets & liabilities as shown in the Balance sheet are carried forward to next years books as opening balance. Refer
When goods are sold on credit it creates a debt (debtor) to be collected in future.
Debtors will include a number of parties from whom money has to be collected.
If amount can’t be collected from any party it is said to be a bad debt (a loss).
If we are sure that amount can’t be collected and wants to close that party’s account i.e., wants to write off the Bad debt then entry will be-
(1) Bad debt a/c Dr. .....
To Concerned party A/c (Debtors a/c) .....
But if we don’t want to close the party account and still want to account the Bad debt loss i.e., want to provide for the Bad debts or create provision for Bad debts, then entry will be:
(2) Bad debts a/c Dr. .....
To Provision/Reserve for Bad & doubtful debt a/c .....
Entry for writing off the Bad debts (Entry No.1 in above question) may be passed any time during the year.
But entry for creating provision for Bad debts (Entry No.2) is passed at the end of year only.
The total debtors at the end of the year is ascertained and how much of it is doubtful of recovery is estimated. This will give the amount of total provision required or to be maintained.
If already we don’t have any provision in the books then entry as per (2) above will be passed for full amount.
But if we have opening balance of provision then entry will be passed only for the difference amount known as additional provision (i.e. New Provision (i.e. total provision required) (-) Opening balance of Provision). Alternatively opening provision is reversed and entry for closing provision (New provision) is passed by full amount.
If the opening balance of provision is more than the provision required at the end of the year, then the excess provision will have to be written back as follows:
(3) Provision for Bad & Doubtful debt a/c Dr. .....
To Bad debts a/c .....
This may be mentioned in adjustment as ‘provision to be decreased/reduced by……..
The total of Bad debt is debited in profit & loss a/c. Total bad debt loss is:
(1) bad debt written off + additional provision or
(2) bad debt written off + new provision (-) old provision.
The closing balance of provision (Final Provision/new provision) will be shown as deduction from Debtors in Balance Sheet.
Interpretation of adjustment given in the question as to whether it is Total Provision or Additional Provision can be made as follows:
Sentence GivenMeaning
(i) Provision to be maintained/createdTotal Provision (New R.D.D.)
(ii) Provision to be raised/increased toTotal Provision (New R.D.D.)
(iii) Provision to be increased byAdditional Provision
(iv) Additional Provision to be made/createdAdditional Provision } (New RDD- Old RDD)
Entry as per (2) above should always be passed for additional provision. Whenever total provision is given, from this opening provision should be deducted to get the amount of additional provision.
Alternatively old provision should be reversed (entry No.3) and then create full new provision (entry No.2).
When Bad debt already written off is recovered later on, the entry will be: (4) Cash/Bank a/c Dr. .....
To Bad debt a/c OR Bad debt recovered a/c .....
Dr.Bad Debt A/cCr.
ParticularsParticulars
To Debtors a/cBy Provision for B & D a/c
(Bad debt written Off)xxx (1)(excess provision written back)xxx (3)
To Provision for B&D a/cBy Cash/Bank a/c
(Additional provision created)xxx (2)(Bad debt recovered)xxx (4) By P & L a/c
(Balance Transferred )xxx
TotalxxxTotalxxx
Dr.Provision
for Bad
& Doubtful Debt A/C (RDD A/C)Cr.
ParticularsParticulars
To Bad debt a/cBy Opening Balance b/f
(excess provision written back)xxx (3)(old RDD)xxx
To Closing BalanceBy Bad debt a/c
(Final provision at the end)xxx(Additional provision created)xxx (2) (New RDD)
TotalxxxTotalxxx
Number (1) to (4) refers to entries given above.
Some people suggest that provision when created should be directly debited to Profit & loss a/c.
In the Author’s opinion all nominal accounts should be created in the books of account and then transferred to Profit and Loss a/c.
When any accounting standard or guidance note etc. refers debit/credit to P&L a/c, it is giving recognition principle that is what should be the ultimate treatment, it should not be construed as requiring direct charge to P&L a/c.
Illustration 13.6 :
On 1-1-2021 M/s A & Co. had a provision for bad debts of 10,880.
The bad debts during the year 2021 amounted to 9,040.
The debtors as at 31-12-2021 were 2,24,000.
Provision for bad debts @ 5% is maintained by the business.
Bad debts during 2022 and 2023 were 11,680 and 14,160 respectively.
The sundry debtors as at 31-12-22 and 31-12-23 were 2,88,000 and 1,36,000 respectively.
Prepare necessary Ledger Accounts in the books of M/s. A & Co. Also show how these would appear in the Profit and Loss Account and Balance Sheet for the years 2021 to 2023.
a. There was a further bad debt of 1,000.
b During the year sales of 8,000 omitted to be recorded.
c. Make a Provision for bad debts @ 5% on debtors.
d. Make a Provision for discount @ 2%.
Show the extract of Profit & Loss Account & Balance Sheet for the above adjustments.
Drawings are the amount (cash or goods) withdrawn from business concern by owners for personal use. If it is required to charge interest on such drawings, following points be considered:
1.Interest zon drawing should be calculated from the date of drawing to the end of year.
2.When the date of drawing is not given we take interest for half year (6 month) assuming that drawings are made evenly (i.e. in equal amount) throughout the year.
3.If it is mentioned that drawings are made evenly at the beginning of each month then interest will be charged for 6.5 month (on an average basis) on the full amount of drawing.
4.If drawings are made evenly at the end of each month then interest is calculated for 5.5 month on an average basis.
Interest on drawing is income for the concern and interest on capital is expense.
Illustration 13.8:
Calculate interest on drawings @ 12 %, under following situation for the year ended 31.12.2021:
(1)Partner A withdrew 12,000 during the year, 5,000 on 31.3.2021, 4,000 on 30.6.2021 & 3,000 on 30.9.2021.
(2)Partner B withdrew 12,000 during the year.
(3)Partner C withdrew 12,000 during the year, 1,000 at the beginning of each month.
(4)Partner D withdrew 12,000 during the year, 1,000 at the end of each month.
Solution:
(1)Interest to be charged to Partner A:
5,000 × 12% × 9/12 + 4,000 × 12% × 6/12 + 3,000 × 12% × 3/12 = 450 + 240 + 90 = 780
(2)Interest to be charged to Partner B:
12,000 × 12% × 6/12 = 720
(3)Interest to be charged to Partner C:
12,000 × 12% × 6.5/12 = 780
(4)Interest to be charged to Partner D:
12,000 × 12% × 5.5/12 = 660
Actually profit is a very vague term. Because profit can have or rather should have different components depending upon the purpose for which we need that information.
Like trading account gives us the gross margin i.e. the difference between selling price and the cost of Goods purchased/manufactured, it does not have effect of further administrative and selling expenses.
We get net profit when we have adjusted all administrative expenses, selling expenses, financial expenses, other incomes, abnormal profit/loss etc.
But if we want to know trading/operating profit (i.e. the result of the operating activity) then from gross profit we will deduct administrative and selling expenses only.
The financial expenses, income tax, other incomes like investment income, profit/loss on sale of fixed assets/ investments will not be considered while ascertaining trading/operating profit. Trading/operating profit can be before depreciation or after depreciation.
After adjusting the above items what we get is the net profit.
Similarly we have other terms like normal profit, profit before tax, profit after tax, etc.
Liability is defined as the financial obligation of an enterprise other than owners’ fund.
They may be classified into current liabilities and long-term liabilities.
Creditors, bills payable and outstanding expenses are examples of current liabilities whereas debentures and term loans from banks and financial institutions are examples of long-term liabilities.
Guidance Note on Terms Used in Financial Statements defines contingent liability as “an obligation relating to an existing condition or situation which may arise in future depending on the occurrence or non-occurrence of one or more uncertain future events”.
Contingent liability may be in respect of bills discounted, pending suits etc.
Thus it is not an actual liability and as such it is not recorded in account books and hence does not appear in the balance sheet.
It is simply mentioned (disclosed) by way of foot note to the balance sheet.
As per Schedule III fund word should be used only when such reserve is specifically represented by earmarked investment.
Although in exam problems this restriction is not strictly followed & the words Reserve & Fund & the word Reserves & Provisions are interchangeably used.
Current Assets are the assets which in the normal course of business are used or realized within an accounting year.
Example: Stock/Inventory, Debtors/Receivables, Prepaid/Advances, Cash Bank etc.
Current Liabilities are the liabilities which in the normal course of business are paid/settled within an accounting year.
Example: Creditor, Payables/Outstandings, Provisions etc.
Current Assets (-) Current Liability is known as working capital.
Long term liabilities are liabilities which are due/payable beyond one year.
Example : Loans, Debentures etc.
Fixed Assets are assets held for use in the business or for giving on rent etc.
