This chapter will help the readers to:
Financial statements—the profit and loss account and the balance sheet—convey useful information about the financial health of a business enterprise. Every manager is expected to have the necessary skills to be able to read, understand and analyze the information contained in these statements. These statements are the end result of a well-structured accounting process, which is the responsibility of the accounts department of the enterprise. However, to fully appreciate the information contents of these financial statements, it is important for other functional managers also to have a basic understanding of accounting cycle. In this chapter we will discuss the process of accounting that culminates into preparation of financial statements.
As discussed in Chapter 2, the modern day accounting is based upon the dual aspect concept, i.e., each transaction affects at least two accounts in such a way that the basic accounting equation,
is always true. The accounting system based upon the dual aspect concept is called double-entry book keeping system.
Various steps in the accounting process are depicted in Figure 3.1:
Figure 3.1 Accounting Cycle
The various steps in the accounting cycle have been discussed in detail in the following sections.
Accounting entries are recorded by a system of debits and credits. As a rule, every accounting transaction affects atleast two accounts, one or more of which are debited and the others credited in such a way that sum of amounts debited is equal to amounts credited. This process of recording is called the journal entry.
Journal entry—all accounting transactions are originally recorded by way of journal entries in a chronological order.
For this purpose, accounts are classified under three heads:
To determine whether an account has to be debited or credited, we follow certain rules for each category of accounts. Rules for the same are described in Table 3.1.
Table 3.1 Rules for Debits and Credits
The expressions ‘debit’ or ‘credit’ have no definitive meaning—it is just a way of recording accounting transactions.
Once an accounting transaction has taken place, the same is analysed to pass the necessary journal entry. The following questions need to be answered by the accountant:
To illustrate: On 1st April 2017, an amount of ₹ 5,000 was paid to the watchman in cash towards his salary. The transaction will be analysed and journalized as follows:
After having analysed the transaction, the following journal entry will be passed:
As a convention, account to be debited is shown first and a prefix ‘To’ is added before the account head to be credited. A brief narration is added along with the journal entry about the nature of the transaction.
Analyse the following transactions and pass the necessary journal entries:
The transactions will be analysed as follows:
Rent A/c | Dr. | ₹60,000 |
To Cash A/c | ₹60,000 |
Ramesh A/c | Dr. | ₹ 100,000 |
To Sales A/c | ₹ 100,000 |
Cash A/c | Dr. | ₹ 35,000 |
To Bank A/c | ₹ 35,000 |
Journal entries as aforesaid are recorded in a chronological order, i.e., as and when they occur. In an accounting period, a number of transactions affecting the same head of account might take place. On the basis of journal entries alone, it is not readily possible to know all the transactions that might have affected a particular account during an accounting period. Therefore, we need to classify these transactions under suitable heads called ‘ledger accounts’ or simply ‘accounts’. An account is a T-shaped statement in which the left-hand side is called the debit side and the right-hand side is called the credit side. For example, all the journal entries where Cash Account has been debited will be shown on the left-hand (Debit) side of the Cash Account and wherever cash has been credited will be shown on the right-hand (Credit) side of Cash Account. So by looking at the Cash Account, one can easily ascertain all the transactions affecting cash that have taken place in an accounting period. The process of classification is called ‘ledger posting’. It may be noted that no new entries are recorded at this stage. Transaction recorded earlier by way of journal entries only are posted in the accounts.
Ledger posting—is a process by which a journal entry is transferred to a ledger.
Classify the transactions in Illustration 3.1 under relevant accounts.
There are five different accounts to be opened—Rent Account, Cash Account, Sales Account, Ramesh’s Account and Bank Account. The entries will be posted as follows:
The first journal entry has been posted in two accounts—debit side of Rent Account and credit side of Cash Account. While posting in the rent account, cross reference to other account affected (i.e. Cash Account) is made. Likewise, while posting in the Cash Account, cross reference to Rent Account is made. As a convention, while posting on the debit side of the account, a prefix ‘To’ is added whereas on the credit side posting, a prefix ‘By’ is added. It may also be noted that both the entries affecting cash have been posted in the same Cash Account. By looking at the Cash Account, one can observe all the transactions affecting cash and by comparing the two sides, it is also possible to ascertain the cash balance at any point of time.
The classification or ledger posting is a mechanical process requiring no analysis at all. In computerized accounts this mapping is done by the accounting software using the codification system used to identify various accounts.
Steps described above—recording and classification—are followed for all accounting transactions throughout the accounting period. At the end of the accounting period, each of these ledger accounts are summarized by ascertaining the balance in each account and putting balance in a statement called the Trial Balance.
As discussed earlier, each account has a debit side and a credit side and may have entries posted on both sides. At the end of the accounting period, these accounts are required to be balanced. For balancing an account, the totals of debit side and credit side are ascertained. If the sum of the entries on the debit side is greater than the credit side, the difference is posted on the credit side as the balancing figure. Such a balance representing excess of debit side over credit side is called a ‘debit balance’ though posted on the credit side of the account. If the sum of the entries on the credit side is greater than the debit side, the difference is posted on the debit side as the balancing figure. Such a balance representing excess of credit side over debit side is called a ‘credit balance’ though posted on the debit side of the account. This process is repeated for all the accounts.
Debit balance—excess of the total of debit side of an account over credit side.
Credit balance—excess of the total of credit side of an account over debit side.
The Cash Account of Strong Bull Limited for the month of December 2017 is given below. You are required to ascertain the balance is cash account as on 31st December 2017.
The total of the debit side of the Cash Account ( ₹ 261,000) is more than the total of the credit side ( ₹ 128,000) by ₹ 133,000 so the Cash Account has a debit balance (excess of debit over credit) of ₹ 133,000. The closing balance will be shown as follows:
The balancing figure in the Cash Account (₹ 133,000) is also called the closing balance. In the next accounting period, the same balance will appear on the debit side as the Opening Balance or Balance brought down.
Once balances of all accounts have been ascertained, they are placed in a Trial Balance. The Trial Balance is again a T-shaped statement with the left-hand side called the Debit side and the right-hand side being called the Credit side. All accounts with debit balances are placed on the debit side of the Trial Balance with the closing balance amount. Accounts with credit balances are placed on the credit side of the Trial Balance. The total of the debit side of the Trial Balance and the total of credit side must tally, reflecting the nature of the double entry book keeping system. Because of the accounting rules discussed earlier, all real accounts (assets) and expenses and losses will necessarily have debit balances, whereas income and gains will always have credit balances. The personal accounts may have either a debit or credit balance. A personal account with debit balance represents a receivable and a personal account with credit balance represents a payable. The format of Trial Balance is given in Table 3.2.
Trial balance—T-shaped statement separately showing all the debit and credit balances at the end of the accounting period.
The Trial Balance serves three basic purposes.
Table 3.2 Format of Trial Balance
Satya Paul started a new business on 1st April 2017. For the first quarter, his transactions are listed below.
You are required to do the following:
Trial Balance as on 30th June 2017
Journal entries as discussed above are recorded on a continuous basis throughout the accounting period. The trial balance prepared reflects the effect of all those accounting transactions. At the end of the accounting period, some adjustment entries may be required to be made to give effect to accrual principle and matching principle. These adjustments entries are again recorded by way of journal entries. As a result of these adjustments, balances appearing in the trial balance get altered. Some of the common adjustments that are made at the end of accounting periods are discussed below.
Adjustment entries are passed at the end of accounting period to give effect to accrual and matching principles and for rectifying errors that might have happened earlier.
Expenses paid during the year under various heads get recorded during the year and are reflected in the Trial Balance. If however some expense incurred during the year remains outstanding at the end of the period, the same need to be adjusted. The adjustment will lead to an increase in the expense account and recoding the outstanding amount as a liability. For example, Salary Expenses as per trial balance is ₹ 1,250,000. At the year-end, it is realized that salaries amounting to ₹ 150,000 are still to be paid. We need to increase salary expenses by the outstanding amount and also record the same as a liability. The adjustment entry to be made is:
Salary A/c | Dr. | ₹ 150,000 |
To Salary Outstanding A/c | ₹ 150,000 |
As a result of the above adjustment, the Salary A/c will go up by ₹ 150,000 to ₹ 1,400,000 and at the same time a liability of ₹ 150,000 towards outstanding salary will appear in the books. Similar adjustments may be made for other heads of expenses which have been incurred but remain outstanding at the end of the accounting period.
In case a part of the expenses paid during the year actually pertain to the next accounting period, a suitable adjustment needs to be made. For example, insurance on machinery paid during the year amounted to ₹ 600,000. It covers a period of 12 months including three months of the next year. Accordingly, one fourth of the amount paid will be treated as pre-paid expense and the expense for the year will be reduced by the same amount. The adjustment entry will be:
Pre-paid Insurance A/c | Dr. | ₹ 150,000 |
Insurance Expenses A/c | ₹ 150,000 |
As a result of this entry, the insurance expense for the year will get reduced by ₹ 150,000 to ₹ 450,000 and the Pre-paid Insurance will be recorded as a receivable in the books of the company. Similar adjustment may be made for any other head of expenses which has been paid in advance.
It may be possible that an income has been earned but not received by the enterprise during the accounting period. As a result, no entry has been passed in respect of such income. To give effect to the accrual principle, such income needs to be recorded. For example, interest amounting to ₹ 60,000 on investments have accrued but has not been received during the accounting period. The adjustment entry for the same will be:
Interest Receivable A/c | Dr. | ₹ 60,000 |
To Interest Earned A/c | ₹ 60,000 |
As a result of this entry, the Interest Earned will get recorded as an income in accounts and the Interest Receivable will get recorded as a receivable by ₹ 60,000. Similar adjustments may have to be made for other heads of incomes which have accrued but not record.
An enterprise might have received some income in advance, i.e., which pertains to the next accounting period. Due to accrual principle, only the income for the current year should be accounted for in the current accounting period and the advance portion will appear as a liability. For example, an enterprise received an annual fee of ₹ 1,200,000 towards annual maintenance contract which was credited to AMC Fees A/c as an income. The AMC covers a period of 12 months out of which 9 months fall in the next year. The following adjustment entry will be made:
AMC Fees A/c | Dr. | ₹ 900,000 |
To AMC Fees Received in Advance A/c | ₹ 90,000 |
As a result of this entry, the income from AMC Fees to be recognized during the period will get reduced by ₹ 900,000 to ₹ 300,000. At the same time, the advance received amounting to ₹ 900,000 will get recorded as a liability for which services are yet to be rendered.
Fixed assets of an enterprise need to be written off over their useful life by charging depreciation. Depreciation is nothing but the process of appropriating the cost of a fixed asset over its useful life. Depreciation is recorded at the end of the accounting period by suitable adjustment entry. It has two ways affect—firstly, depreciation amount gets recorded as an expense and secondly, the book value of the asset gets reduced to that extent. Accordingly, the adjustment entry for depreciation is passed as follows:
Depreciation Account | Dr. |
To Asset Account |
Alternatively, an enterprise may like to disclose the asset at its gross value (or cost of acquisition) showing depreciation written off separately as a deduction. In that a case, we open another account as ‘Accumulated Depreciation’ or ‘Provision for Depreciation’. The adjustment entry for depreciation accordingly will be:
Depreciation Account | Dr. |
To Accumulated Depreciation A/c |
The ‘Accumulated Depreciation A/c’ is a contra-asset account. While presenting the information about the asset in financial statements, the balance in this account will be shown as a deduction from the gross value of the asset as follows:
Assets—Cost of Acquisition |
Less: Accumulated Depreciation |
Book Value of Asset |
Following conservatism principle, the enterprise may decide to create a provision for anticipated losses due to non-recovery from its customers to whom goods or services have been provided on credit. The adjustment entry for such a provision is done on the same basis as discussed above for accumulated depreciation. The following entry is passed:
Bad Debts Expenses A/c | Dr. |
To Provision for Bad and Doubtful Debts A/c |
The Bad Debts Expenses A/c will be treated as an expense in the profit and loss account of the enterprise and the provision for bad and doubtful debts account will be shown as a deduction from the gross value of debtors or trade receivables in the Balance Sheet as follows:
Sundry Debtors/Accounts Receivables |
Less: Provision for Bad and Doubtful Debts |
At the end of the accounting period, the enterprise may estimate that certain cost or expenses might have to be incurred in the future as a result of past events and it would like to provide for such expenses. The effect of such provisioning will be to record the same as an expense and at the same time create a liability based upon the estimated amount of the expense. For example, the enterprise may like to make a provision for warranty cost in respect of goods sold during the year. The adjustment entry will be:
Warranty Cost A/c | Dr. |
To Provision for Warranty Cost A/c |
The Warranty Cost account will be included with other costs in the profit and loss account, whereas provision for warranty cost will be taken as a liability.
When goods are purchased, the entire cost is recorded as an expense in the purchase account. If at the end of the period some of these goods are remaining unsold, the cost of inventories need to be adjusted. The closing stock (or ending inventory) will have two affects—firstly, the cost of material consumed will go down to that extent and secondly, the inventory will be treated as an asset to be consumed in the next accounting period. The adjustment inventory for the same will be:
Closing Stock A/c | Dr. |
To Purchases A/c |
As a result, the Closing Stock will get recorded as an asset to be shown in the Balance Sheet and the Purchase account has been adjusted downwards to reflect cost of goods sold.
After making the necessary adjustment entries, the ledger balances get adjusted and a revised trial balance is prepared. The final trial balance will form basis of financial statements.
The updated trial balance after passing the necessary adjustments entries forms the basis of preparing the financial statements. All nominal accounts, i.e., those pertaining to expenses, losses, income and gains are temporary accounts. They are closed out at the end of the accounting period by transferring their respective balances to the profit and loss account. In the next accounting period, these accounts will start with zero balances. Real accounts, i.e., those pertaining to assets and personal accounts are permanent accounts. Balances in these accounts are shown in the Balance Sheet and are carried forward to the next accounting period. In the next accounting period, these accounts will show the Opening Balance, i.e., the balance carried from the earlier period.
Nominal accounts are temporary accounts whereas Real accounts and personal accounts are permanent accounts.
Journal entries at the end of the accounting period for transferring the balances in nominal accounts to the profit and loss account are called transfer entries. As they result in closing the nominal accounts by reducing their balance to zero, they are also referred to as closing entries.
An income or a gain account necessarily has a credit balance. The account balance can be brought to zero by debiting it by equivalent amount and crediting the same to the profit and loss account. This way an income account is ‘closed’ and the balance gets ‘transferred’ to the credit of the profit and loss account. All accounts pertaining to income and gains are closed by debiting them and crediting the same to the profit and loss account at the end of the accounting period.
An expense account by nature will have a debit balance. The account can be closed by crediting it by the balance amount and simultaneously debiting the profit and loss account. All the accounts relating to expenses and losses will get closed by these entries.
As per the Trial Balance of Bright Shine Limited, the Sales Account has a credit balance of ₹ 232.45 million and the Purchase Account has a debit balance of ₹ 163.02 million. Pass the necessary closing entries.
The sales account will be closed by debiting it by ₹ 232.45 million and crediting the same amount to the profit and loss account. The purchase account will be closed by crediting it by ₹ 163.02 million and debiting profit and loss account by the same amount. The necessary entries will be as follows:
Sales A/c | Dr. | ₹ 232.45 million |
To Profit and Loss A/c | ₹ 232.45 million | |
Profit and Loss A/c | Dr. | ₹ 163.02 million |
To Purchases A/c | ₹ 163.02 million |
By means of the transfer entries as discussed above, all nominal accounts have been closed and their respective balances transferred to the profit and loss account. The credit side of the profit and loss account will have balances of all accounts pertaining to incomes and gains. The balances of expenses and losses will appear on the debit side of the profit and loss account. If the sum of credit side (incomes) is greater than the debit side (expenses), the balancing figure is profit and is shown on the debit side of the profit and loss account. On the other hand, if the sum of debit side exceeds the credit side, the balancing figure will be shown on the credit side representing the loss for the period.
Profit and loss account is a summary of all the nominal accounts for a particular period. Income and gains are shown on one side and expenses and losses on the other.
The profit and loss account is also a temporary account and is closed down by transferring the balance to the Capital Account. The transfer entries are given below:
In case of a profit:
Profit and Loss A/c | Dr. |
To Capital A/c (By the amount of profit) |
In case of a loss:
Capital A/c | Dr. |
To Profit and Loss A/c (By the amount of loss) |
By this transfer entry, the owner’s capital gets adjusted by the profit or loss for the period and the profit and loss account balance is reduced to zero.
This is the last stage in the accounting cycle. By this time, all nominal or temporary accounts have been closed and we are left with only real accounts and personal accounts. Real accounts pertain to assets and by nature have debit balances. A Personal account may have a debit balance or a credit balance. A personal account with credit balance represents liability or payable whereas a personal account with debit balance represents receivable. Accordingly, permanent accounts with credit balances (capital and payables) will be shown on the Liability side of the Balance Sheet whereas accounts with debit balances (assets and receivables) will appear on the Assets side of the Balance Sheet. Because of the double-entry book keeping system, the total of both the sides of the Balance Sheet will be equal.
Balance sheet is a summary of real accounts (assets) and personal accounts (receivables and payables) at the end of the accounting period.
The relationship between the different types of accounts and the financial statements is depicted in Figure 3.2.
Figure 3.2 Type of Accounts and Financial Statements
Please refer to the Trial Balance in illustration 3.4. After preparing the Trial Balance, Satya Paul identified the following additional information:
You are required to do the following:
Adjustment Entries
As rent has been paid for six months amounting to ₹ 60,000, half of it will be treated as prepaid. Depreciation on Plant and Machinery ( ₹ 4,687) and Furniture ( ₹ 3,750) has been charged.
After passing the above entries, the revised Trial Balance as on 30th June 2017 will appear as follows:
Trial Balance as on 30th June 2017 (₹)
Transfer Entries for Incomes
Transfer Entries for Expenses
Financial Statements
Profit and Loss Account for the Quarter Ended 30th June 2017 (₹)
Transfer Entry for Profit
Profit and Loss A/c | Dr. | ₹ 67,063 |
To Capital A/c | ₹ 67,063 |
Balance Sheet as on 30th June 2017
Classify the following accounts as real, personal or nominal:
Revised Trial Balance
Trial Balance of Snow White & Co as on 31st December 2017
Transfer Entries
Only nominal accounts will be closed by transferring to profit and loss account as follows:
Transferring Nominal Accounts with Credit Balances
Transferring Nominal Accounts with Debit Balances
The profit for the year amount to ₹ 2,326,875 will be transferred to the Capital A/c by the following journal entry:
Profit and Loss A/c | Dr. | ₹ 2,326,875 |
To Capital A/c | ₹ 2,326,875 |
Balance Sheet of Snow White as on 31st December 2017
Trial Balance of Dare Devil & Co as on 31st March 2017
Additional Information
Trial Balance of Seven Wonders & Company as on 31st March 2017
Machinery | 7.5% |
Furniture | 12.5% |
Building | 2.5% |
Please help Roney in making the necessary adjustment entries and also in preparation of the profit and loss account for the year ended 31st March 2017 and the Balance Sheet on that date.
Trial Balance of Eighth Wonder & Company as on 31st March 2017
Additional Information:
Trial Balance of SSS Limited as on 31st March 2017
Additional Information: