Accounting
Notes
What is accounting?
Accounting is the process of recording, reporting and interpreting financial
information pertaining to an organization.
According to American Institute of Certified Public Accountants:
Accounting is the art of recording, classifying and summarizing in a significant
manner and in terms of money, transactions and events, which are, in part at
least of a financial character, and interpreting the results thereof.
If we analyze this definition, we get the following components:

It is about recording transactions

Transactions should be only of financial nature

The recorded transactions are then classified according to set rules

Results are then interpreted for people who are interested in this information
Difference between Book-keeping and Accounting



Book keeping is mainly concerned with record keeping or maintenance of books of
account. It includes identifying the financial transactions, measuring them in terms of
money, recording them in the books of original entry and then classifying them into
ledger.
Accounting is more than Book-keeping. Apart from the standard practices of Bookkeeping it involves summarizing the classified information in the form of Profit and Loss
Account and Balance Sheet, drawing meaningful information from them and
communicating this information with the interested parties i.e. stakeholders.
„Booking keeping‟ is a part of accounting as it only involves recording of economic
events.
Purpose of Accounting
The main purpose of accounting is

To keep a systematic record of business transactions

To calculate Profit and Loss

To ascertain the financial position of the business

To provide financial information to different users of this information.
Who are users of accounting
information?
These stakeholders or users might include

Owner/Shareholders: How much profit?

Managers: How business performed and how they can improve the performance in future

Employees: To know the profits so that they could demand better wages?

Investors: Is it safe and profitable to invest in the business?

Suppliers: Will the business be able to pay for their supplies?

Government: How much tax should be collected?

Lenders: It is safe to lend money to the business?
Types of Accounting
Financial Accounting: It is about recording business transactions in a systematic manner, to
ascertain the profits or losses of the business by preparing Profit and Loss Account and Balance
Sheet.
Cost Accounting: It involves finding out the total cost and unit cost of goods and services
produced by the business.
Management accounting: Accounting table and formats may not make sense to a person other
than an accounting. This is where Management accounting comes in. It is presenting the
accounting information in a manner which a layman manager could understand. It involves ratio
analysis, budgets, cash flows etc.
We will be covering some parts of Management accounting in Analysis of Final Accounts section.
Basic Accounting Concepts
Business Entity Concept/Accounting Entity
Concept
According to this concept, the business is considered as a separate business entity from its
owner(s). Thus the financial information of the business will be recorded and reported separately
from its owner‟s personal financial information.
Going Concern
For accounting purposes, it is assumed that the business will operate for an indefinite period of
time and thus considered as „going concern‟. For this reason, the realizable value of the property
owned by business will not be relevant.
Money Measurement
Only those transactions will be recorded in the financial books which can be measured in terms of
money. Anything which cannot be measured in monetary terms will not be considered as a part of
the accounting data.
Historical Cost
All assets will be recorded at their cost price. This means that machinery purchased years ago
will be recorded at its original cost of purchase even though its value is lower now.
The reason for doing so is because the business is considered as a going concern and we need
not be worried about the saleable value of the asset.
Accounting Period
The life a business is considered to be indefinite. But for accounting purposes, the life of the
business is divided into specified periods of time. The period may be a month, a half year, a full
year or any length of time.
Accrual Concept
Accrual concept states that revenue is recognized when it is earned and expenses when they are
incurred.
Any income or revenue generated must be recorded in the books of accounts whether the
payment for it is received or not. Similarly, any expense done by the business should be recorded
irrespective of the fact that the business has paid for it or not.
Objectivity
Any transaction which is recorded in the accounting books should be verifiable. In other words,
the transaction should backed by some proof in the form of a receipt, invoice, cheque, voucher
etc.
Accounting Conventions
Consistency
According to this concept, the same accounting method should be applied in each accounting
period when preparing financial reports. This makes it easy to compare results of one period with
another period and the stakeholders can get a more realistic idea about the performance of the
business.
Prudence
It involves being cautious while reporting accounting information. The assets should not be
overstated and the liabilities should not be understated.
This is why closing stock is always valued at the lower of cost or market value so that the profits
are not overstated.
Matching Principle
This principle is based on accrual concept of accounting. It states that revenue earned during a
specific period has to be matched with the expenses incurred with earning that revenue. The
following point should be considered:

If an item of revenue is shown in the Profit and Loss account, all expenses incurred on it, whether
paid or not, should be shown as expenses in the Profit and Loss account.

An expense will be recorded in the books of accounts if the revenue associated with it has not
been realized.

Incomes received in advance should not be shown in Profit and Loss account.

All the cost and expenses incurred on good remaining unsold at end of the year must be carried
forward to next year as these goods will be sold in the next accounting period.
Accounting Procedures
Provision for Doubtful Debts
Even after deducting the amount of actual bad-debts from the Debtors, there may still be some
debts which may be regarded as bad or doubtful. Thus a business might make an estimate of the
amount of such doubtful debts, that is, debts that are likely to become bad, and charge them as
an expense against the current period‟s revenue.
When Provision for Doubtful Debts is
set up for the first time
Accounting Entries
Doubtful Debts Account
Dr.
Provision for doubtful debts
(Being creation of provision for doubtful debts)
Closing Entries
Doubtful Debts Account is an expense for the business and thus it will be debited to the Profit and
Loss account
Profit and Loss Account
Dr.
Doubtful debts Account
(Being transfer of doubtful debts expense to the Profit and Loss Account)
It will be deducted from the Sundry Debtors in the Balance Sheet.
Increasing the Existing Provision for
Doubtful Debts
Adjusting Entry
Doubtful debts Account
Dr.
Provision for doubtful debts Account
(Being increase of provision for doubtful debts)
Closing Entry
Being a loss for the business the Doubtful Debts Account is transferred to the debit side of Profit
and Loss Account.
Profit and Loss Account
Dr.
Doubtful Debts
(Being transfer of doubtful debts expense to the Profit and Loss Account)
Decreasing the Existing Provision for
Doubtful Debts
Adjusting Entry
Provision for doubtful debts Account
Doubtful debts Account
(Being decrease of provisions for doubtful debts)
Dr.
Closing Entry
Being a gain for the business the Doubtful Debts Account is transferred to the Credit side of Profit
and Loss Account.
Doubtful Debts Account
Dr.
Profit and Loss Account
(Being transfer of doubtful debts expense to the Profit and Loss Account)
In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts.
Closing Stock
Closing stock refers to the goods remaining unsold during the year.
They are valued at Cost price or Market Price whichever is lower.
Closing entries
Closing Stock Account
Dr.
Trading Account
(For closing Stock transferred to trading
account)
Treatment in Final Accounts
When closing stock is given outside the Trial
Balance
It will appear on

The credit side of the Trading Account

Under Current Assets in the Balance Sheet.
When closing stock appears inside the Trail
Balance
This means that the Closing stocks have already been deducted from the Purchases and thus it
will ONLY appear in the Balance Sheet under Current Assets.
Writing off Bad Debts
There may be occasions when the business might not be able to collect its debts. This may be
due to the dishonesty of a debtor or may be due to the death or insolvency of a debtor.
Bad Debts Account
Dr.
Debtors Account
(Bad debts written off)
This amount is then written off the books as „Bad debts‟. It is a loss for the business and thus it is
written on the debit side of the Profit and Loss account.
Closing Entry
Profit and Loss Account
Dr.
Bad Debts Account
(Transfer of bad debts to Profit and
loss Account)
Accounting Treatment
Bad debts appear on the debit side of the Profit and Loss account because it is a loss.
Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet.
Recovery of Bad Debts
Sometime a debts written off as Bad debts may be recovered later on. Cash is coming in thus
Cash account is debited whereas „Recovery of bad debts‟ is credited because it a gain.
Accounting Entries
Cash Account
Dr.
Recovery of bad
debts
(Being bad debts
recovered)
Recovery of bad debts
Dr.
Profit and Loss account
(Being transfer of recovery of bad debts to
Profit and Loss Account)
Partial Settlement of Debtors
Sometimes, a business might only be able to recover a part of the debts. This means the rest of
the unrecovered debts will be written off as bad debts.
Accounting Entries
Cash Account
Dr.
Bad Debts Account
Dr.
Debtor‟s Account
(Being partial recovery of debts)
Depreciation

Depreciation may be defined as the permanent and continuing diminution in the quality or
the value of an asset. William Pickles
Depreciation is the gradual and permanent decrease in the value of an asset from any
cause. R.N. Carter.
Depreciation is fall in the value of the fixed assets (except Land).

Depreciation is charged as an expense in the Profit and Loss Account in order to spread the cost
of a fixed asset over the asset‟s useful life.

Depreciation is charged on a continuous basis. Once the depreciation is charged, it must be
charged on regular basis in the succeeding period also.
Calculation of Depreciation
Straight line or Fixed Installment Method
A fixed or equal amount is to be charged as depreciation every year during the life time of the
asset. The amount of depreciation remains equal from year to year. The expected lifetime of the
asset is calculated and the cost of the asset is spread over its lifetime.
Depreciation expense per annum=Original cost/number of years of useful life
If the fixed asset is expected to have a scarp value at the end of its useful life, then
Depreciation expense per annum= (Original cost-Estimated scrap value)/Number of years
of useful life
Reducing Balance or Diminishing Balance
Method
The value of asset goes on diminishing year after year, the amount of depreciation charged every
year also goes on declining. Every year a fixed percentage of the net book value of the asset is
reduced. For example 20% depreciation is charged. If the asset has a value of $10000, the
depreciation for the first year will be 20% of $10000 i.e. $4000. The book value for the next year
will be now $6000. This year the depreciation will be again 20% of the remaining value i.e. 20% of
6000=$1200. So the remaining value of the asset is now $6000-$1200=$4800.
Revaluation Method
Under this method, the fixed asset is valued at the end of every accounting period. The difference
between its value at the end of the period and the beginning of the period will be the depreciation
for that period.
Depreciation expense=Value of asset at the end-Value of asset at the beginning + Any new
purchase
Recording Depreciation in the Books
Once the depreciation expense is calculated, the adjusted entry would be:
Method 1
Depreciation Account
Dr.
Provision for Depreciation Account
The nominal account is closed and the balance transferred to the Profit and Loss Account by:
Profit and Loss Account
Depreciation Account
Dr.
The Provision for Depreciation Account shows the accumulated depreciation on the fixed asset.
Like other liability accounts, it is closed by bringing its balance down. The Fixed Assets account is
always maintained at its original cost. In the Balance Sheet, the fixed asset is shown at it book
value, thus is, cost minus the provision for depreciation.
Method 2
In this method, depreciation expense is directly credited into the fixed asset itself. In this case, the
book value of the fixed asset is the balance in the Asset Account.
The entries are:
Depreciation account
Fixed asset Account
Dr.
Depreciation account is closed and its balance is transferred to the Profit and Loss account.
Profit and Loss Account
Depreciation Account
Dr.
The effect on the Profit and Loss account and the Balance Sheet remains unchanged.
When no Provision for Depreciation Account is set up to record all the accumulated depreciation,
the Fixed asset is brought down to its book value at the close of each accounting period after
depreciation is written off.
Capital Expenditure
Capital expenditure occurs when a business gets a long term advantage due to that expenditure.
It is usually incurred for accusation of an asset. These expenditures do not occur in the regular
day to day transactions of the business.
Common examples

Purchase of furniture, office building etc.

Purchase of additional furniture or machinery

Expenditure incurred in connection with the purchase of a fixed asset. For example, carriage paid
of machinery purchased.

Purchase of patent right, copy rights etc.
Revenue Expenditure
Expenditure which is not for increasing the value of fixed assets, but for running the business on
a day to day basis, is known as revenue expenditure.
Difference between Capital and
Revenue expenditure
Buy a car is capital expenditure because its benefit to the business will be spread over a long
time.
Fuel cost for running this care is revenue expenditure and it will be used up in few days and does
not add to the value of the fixed asset.
Capital receipts
Capital receipts consist of

additional payments made to the business either by owner or shareholder of the business; or

from sale of fixed assets of the business.
Revenue receipts

Any receipt in the normal running or through day to day transactions of the business is
categorized as Revenue receipt.

Sales receipts of the business are revenue receipts.
Verification of accounting
records
Bank Reconciliation Statement
Bank reconciliation statement is a statement prepared mainly to reconcile the
difference between the ‘Bank Balance’ shown by the Cash book and Bank
statement.
Usually, the trader maintains a Bank Column in the Cash book and does all the entries related
with bank. At the end of the month, when he receives a Bank statement from the bank he might
find some differences between bank balance shown by Bank Statement and his Cash book.
These differences might arise due to many reasons. In order to reconcile and tally the differences
he will prepare a Bank Reconciliation Statement.
Now the question arise,
What are the reasons for difference in
Bank Statement and Cash Book?
These can be summarized as follows:

Cheque issued by the trader but the customer has not yet presented it to the bank for
encashment.

This will show a less bank balance in the trader‟s Cash book as he has already issued the
cheque, but the bank will not reduce the amount till the cheque is presented to it.

Cheque received by the trader was deposited into the bank for collection but the bank did not
realize the funds and did not credit the Trader‟s account.

Trader deposited a cheque into bank but it was dishonored by the bank. The reason may be the
customer does not have sufficient cash in his bank account.

Bank pays interest to the trader on his deposit but the trader will not come to know this till he
receives the Bank statement and thus his cash book will show less balance as compared to bank
statement.

Bank might receive direct payment of interest or dividends on behalf of the trader for any
investments made by the trader. The trader will not come to know the details till he gets a bank
statement and thus his Cash book will be understated.

Bank might charge transaction fees or Bank charges or interest on any overdraft which the trader
will only know when he receives the bank statement.

A customer or debtor might directly pay into the trader‟s bank account and the trader might not be
aware of this.

A Bank may pay bills, insurance premiums or some payment based on the standing instruction of
the trader. The details of these transactions will only be available to the trader once he receives
the bank statement.
A bank reconciliation statement can be prepared by taking the balance either as per cash book or
as per pass book as a starting point.
If the statement is started with the balance as per bank column of the cash book, the answer
arrived at the end will be balance as per pass book.
Alternatively, if the statement is started with the balance as per pass book, the answer arrived at
in the end will be the balance as per cash book.
A debit balance as per cash book shows the amount of the money in the bank, whereas, a credit
balance means that the business has taken an overdraft. In the same way, a credit balance as
per pass book shows a positive bank balance whereas debit balance as per pass book shows an
Overdraft.
Method 1: Bank reconciliation
statement by Debit balance of Bank
Column of Cash Book.
Method 2: Bank reconciliation
statement by Credit balance as Cash
Book (Overdraft).
Method 3: Bank reconciliation
statement by Credit balance as per
Bank Statement .
Method 4: Bank reconciliation
statement by Debit balance as per
Bank Statement (Overdraft).
Control Accounts
Not all the transactions done in a business are in cash. Now days, businesses do a lot more
transactions in credit and thus there is a long list of debtors and creditors. Since the bulk of
entries are made in the accounts of debtors and creditors, these two classes of accounts are
taken out of the General Ledger and put in a subsidiary ledger.
Subsidiary ledgers include
Sales Ledger: Which contains all debtors accounts
Purchases Ledger: contains all creditors‟ accounts.
This is where control account comes in…
Control account is a summary of all the accounts in the subsidiary ledgers.
The summary of all accounts in the Sales ledger make up the Debtors control
account and the summary of all accounts in the Purchase Ledger is known as
the Creditors control account.
How to make Debtors Control
Account

Sales transaction takes place

It is recorded in the Sales Journal

From the Sales Journal entry is posted to the Sales Ledger.
From where do you get information to
draw Debtors Control Accounts?
Information
Source
Total Opening Balance
Trial Balance at close of
previous period
Total Sales
Sales Journal
Dishonoured Cheques
Cash Book
Discount allowed withdrawn
General Journal
Any charges to debtors
General Journal
Total cash and cheques received from debtors
Cash book
Discount allowed
Cash Book
Returns inwards and allowances
Returns Inwards journal
Bad Debts
General Journal
How do we prepare Creditors Control
Account?
Also known as Purchases Ledger Control Account
It accounts for all Creditors appearing in the Purchases Ledger.
From where do you get information to
draw Creditors Control Accounts?
Information
Sources
Total cash and cheques paid to creditors
Cash Book
Discount received
Cash Book
Returns outwards and allowances
Returns Outwards Journals
Total opening balances
Trial Balance at close of previous period
Total purchases
Purchases Journal
Any charges by creditors
Journal
Minority balances in Control Accounts
Normally, debtors accounts have debit balances
Creditors accounts contain credit balances.
There may instances when debtors might return some goods after their accounts have been
settled and this may lead them to have a credit balance.
What to do?
The Debtors control Account will have both the debit and credit balances brought down.
Same procedure will take place for Creditors Control Account.
Through this the true financial position is shown i.e. the exact amount owing by debtors as well as
the amount owing to them.
Trial Balance
Trial Balance is a statement prepared with the debit and credit balances of
ledger accounts to verify the arithmetical accuracy of the book.
The Trial Balance checks the equality of debits and credits in the ledger by listing each account
along with its ending balance.
Accounts to
be placed on
debit side
Accounts to be
placed on
credit side
Assets
Expenses
Drawings
Liabilities
Capital
Revenue
Errors revealed by Trial Balance
Errors in calculation
Any calculation mistake, especially totaling mistake or balancing mistake will be revealed by Trial
Balance as both the side will not match.
Errors of omission of one entry
If by mistake only one entry is made for a transaction, Trial Balance will not balance.
Posting to the wrong side of an
account
In case any entry is made on the wrong side of the account, it will be revealed by the Trial
Balance. For example Credit sale of $100 was debited to Sales account.
Posting of wrong amount
When two different amounts are entered for the same entry, both the sides of the Trial balance
will not match. For example, Credit sales of $123 to James. James was debited with $123 but
Sales was wrongly credited as $132.
Limitation of Trial Balance
Though Trial Balance is prepared to check the arithmetical accuracy of double entries, there are
still some mistakes which cannot be identified by Trial Balance. These are:
Errors of omission
These are errors where the transactions are totally omitted. They are neither recorded in the
Journal or Ledge and thus do not appear in the Trial Balance.
Errors of commission
This means that a wrong amount is entered from the very starting in the Journal or Ledger and
thus a Trial Balance based on this amount may not show any mistake at all.
Errors of principle
These errors occur when the classification of accounts is wrongly done. For example revenue
expenditure may be considered as capital expenditure. Repairs of machinery $200 was debited to
Machinery account whereas it should have been debited to „Repairs of machinery account‟.
Complete reversal of entries
Complete reversal of entries cannot be revealed by Trial Balance. This is when entries have been
made to both the sides and thus there is no arithmetical mistake. Good sold to Raman were
entered as Sales debited and Raman Credited, whereas, it should have been vice versa.
Compensating errors
These errors are those which cancel themselves because the same error is committed on both
sides. For example, Purchases were debited by $100 more and at the same time Sales were also
credited by $100. This will neutralize the effect of both the entries.
Final Accounts
Accounts of clubs and societies
What are Non Profit
Organizations?
Sole trader, Partnership and Limited companies have Profit as their main objective. However,
Clubs, societies and associations does not only exist to make profit. They may be formed to
promote cultural and recreational interest. Thus their final accounts are different from those
organizations which solely exist to earn profit.
The final accounts of a non-profit organization includes of
1. Trading Accounts (only if there is a restaurant or canteen)
2. Receipts and Payments Accounts
3. Income and Expenditure Account
4. Balance Sheet
What can be classified as Revenue
receipts & revenue expenditure?
Revenue receipts
Revenue
expenditure
Subscription
Entertainment expenses
Competition fees
Rent of club premises
Income from Socials
Competition prizes
Rental fees
Cost of fund raising projects
Donation (if not capitalized)
Repairs and maintenance of property
Proceeds from fund-raising projects (not
capitalized)
Sundry expenses to run the activities of
club
Interest on bank deposits
Staff wages
Receipts from sale of food in club
restaurant
Postage & Stationery expenses
Electricity and water expenses
Depreciation
What can be classified as Capital
receipts and Capital Expenditure?
Capital receipts
Legacies
Building funds
Entrance fees
Life membership fees (if capitalized)
Capital Expenditure
Purchase of fixed assets
Receipts and Payments Account
Format for Receipts and Payments Account
Receipt and Payments Account
for the year ended 31 December 2010
Dr.
Cr.
Receipts
Balance b/d (Opening
balance)
All Cash
receipts
Amount
XXXX
Payments
All cash
payments
Amount
xxxxx
XXXX
XXXX
Balance c/f (closing
balance)
XXXXX
Cash (beginning)
+ all cash receipts (revenue receipts and capital
receipts) - All Cash payments (revenue expenditure
and capital expenditure)
Cash (end)
Features

Similar to Cash Book

Cash receipts are on Debit side and Cash payments are on Credit side

All cash receipts and payments are recorded irrespective of their relation to current year.

There is an opening balance and a closing balance
xxxxx
XXXXX
Income and Expenditure Account
Income and Expenditure Account
for the year ended 31 December 2010
Dr.
Cr.
Expenditure
Revenue expenses only
Surplus
(when income is more than
expenditure)
Amount
XXXX
XXXX
Income
Amount
Trading Profit (if any)
XXXX
Revenue Incomes only
XXXX
Deficit
(when expenditure is more than
income)
xxxxx
XXXXX
Step in constructing an Income and
Expenditure Account
1. If there is a Trading Profit put it on the Credit side.
2. Put all the revenue incomes on the Credit side.
3. Put all the revenue expenses on Debit side.
4. Balance both the sides.
5. If the Income side is more than the expenditure side then we get a SURPLUS.
6. If the Expenditure side is more than the income side we get a DEFICIT.
Note

Only revenue receipts and expense are posted in this account

Only incomes and expenses pertaining that particular year are recorded. Incomes and expenses
pertaining to previous year or future year are adjusted for.
XXXXX
Distinction between Receipts and
Payments Accounts and Income
and Expenditure Accounts
Receipts and Payments Accounts
Income and Expenditure Account
Similar to a cash account showing total
cash receipts and total cash payments
during a particular period.
Similar to Profit and Loss account showing
incomes and expenses arising during a
particular period.
There is an opening balance representing
cash or bank balance
No opening balance
Records all cash receipts and cash
payments whether capital or revenue in
nature.
Only records income and expenses of
revenue nature
Records all receipts and payments
irrespective of their relation to this year,
previous year or next year.
Records only receipts and expenses
relating to the current year.
At the end of the year excess of receipts
over payments shows a positive cash
balance whereas a negative balance
signifies an overdraft
Excess of income over expenditure
represents net income whereas vice versa
represents a net loss.
Adjustments in Final Accounts
(Non-trading concerns)
Subscription Account
Subscriptions are paid by members as charges for using the facilities of a club or society for a
particular period of time. Usually it is on a yearly basis.
Receipt and Payment account records the actual subscription received. It may pertain to any
year.
However, In order to post it to the Income and Expenditure Account adjustments have to be made
to the subscription as only subscription pertaining to that particular year is recorded in I/E
account.
How to calculate e.g. for Year 2009
Total subscription received
1000
Less Subscription in arrears, at the starting of the year
200
Add Subscription received in advance for 2009, in previous years.
100
Add Subscription in arrears, at the end of 2009
300
Less Subscription received in advance (for next year), at the end of
the year
100
Subscription revenue for Year 2010
1100
You can also make a separate
Subscription Account and then post
the final subscription amount in the
Income and Expenditure Account
Dr.
Subscription Account
Amount
Subscription in arrears
(b/d)
Amount
XXXX
Subscription received in
advance b/d (collected
during previous year)
XXXX
XXXX
Total Cash received as
subscription during the
current year
XXXX
(not collected during the
previous year)
Subscription received
during current year (from
Income & Expenditure
Account)
Cr.
Subscription in advance
c/d
XXXX
Subscription in arrears c/d
(not yet collected for
current year)
(collected for subsequent
year)
XXXX
Subscription in arrears b/d
XXXX
XXXX
XXXX
Subscription in advance b/d
XXXX
'Subscription Account Format'
Note:

Subscription in arrears appears as Current Assets in the Balance Sheet.

Subscription received in advance appears as Current Liability in the Balance Sheet.
Other adjustments
Donations: Donations for general purpose unless specifically mentioned appear in Income and
Expenditure Account. However, Donations for specific purpose such as construction of building
and mentioned as „capitalized‟ will appear in Receipt & Payment Account and Balance Sheet.
Similarly, all other receipts, unless mentioned, as „capitalized‟ will appear Receipts and Payments
Account and Income and Expenditure Account. If they are „capitalized‟ then they will appear in
Receipts and Payments Account and Balance Sheet
What are Final Accounts?
Final Accounts consists of

Trading Account

Profit and Loss Account

Balance Sheet
Trading Account
It is a Nominal Account and is prepared for calculating the GROSS PROFIT or GROSS LOSS
arising as a result of trading activities of a business.
According to J.R.Batliboi:-
„The Trading Account shows the results of buying and selling of goods. In preparing, this
account, the general establishment charges are ignored and only the transactions in
goods are included‟
Importance of Trading Account
Trading Account is prepared for the following reasons

To know the Gross Profit or Gross loss arising due to trading activities of the business.

To find out the direct expenses incurred by the business for the goods sold during the year.

Find out how much closing stock is left as compared to previous years and thus find out the
performance of the business.

Gives the trader an idea of the increase/decrease in Gross Profit /Gross Loss and to assess the
performance of the business and take corrective measures, if needed.
Preparation of Trading Account
The following items usually appear in a Trading Account
Sales turnover
Both Cash and Credit sales are included. Net Sales is recorded after deducting Sales returns
(Return inwards).
Opening Stock
The closing stock of the previous accounting year is taken as the Opening stock for the present
year. If there is no Opening Stock then no entry is made. Opening stock is derived by balancing
the Stock Account and bringing down its balance to the next period.
Purchases
Purchases include all the Cash and Credit purchases of goods made by the business during the
year.
Purchase returns (Return outwards) is deducted from the Purchases to arrive at Net Purchases.
Direct Expenses
All expenses which are incurred in purchasing the goods and bringing them to the trading place
are recorded under this category.
These include:

Wages e.g. Warehouse worker wages.

Carriage Inwards i.e. the cost of transport of goods to the trading place. The expense is usually
borne by the buyer.

Duty on purchases, for example, Import duty or excise duty.
Closing Stock
All the goods which remain unsold at the end of the year are known as „Closing stock‟.
The closing is stock is valued at Cost price or Market price, whichever is lower.
The reason for taking the lower value of the two is in accordance with the „Prudence Principle‟.
Normally, „Closing stock‟ is given outside the Trial Balance. This is so because its valuation is
made after the accounts have been closed.
Note: Sometimes, the „Closing Stock‟ may be given inside the Trail Balance. This means that the
entry to incorporate the closing stock in the books has already been passed and it has already
been deducted from the Purchases Account. In this case, „Closing Stock‟ will not be shown in the
Trading Account will only appear in the Asset side of Balance Sheet‟.
Cost of goods sold
This means the finding the cost of only those goods which have been sold during the year. It can
be calculated as follows:
(Net Purchases+Opening Stock) - Closing Stock
Profit and Loss Account
According to Prof. Carter:
„A Profit and Loss Account is an account into which all gains and losses are collected, in
order to ascertain the excess of gains over the losses or vice-versa‟.
Why Profit and loss account is made?

To find out the Net Profit or Net Loss

Compare the net profit of the business with previous years and to assess the performance of the
business.

Find out the amount of overheads of a business.
Items appearing on a Profit and
Loss account
Any Incomes or gains
Any income or gains of the business from sources other than sales are recorded on the Credit
side of Profit and loss account.
Gross Profit or Loss
It is transferred to the P/L account from the Trading Account. Gross Profit is transferred to the
Debit side whereas Gross Loss is transferred to the Credit side.
Office and Administrative expenses
Example include salaries, office rent, lighting, stationery etc.
Selling and Distribution expenses
Include advertising expense, commission, carriage outwards, bad-debts etc.
Miscellaneous expenses
Such as, interest on loan, interest on capital, depreciation etc.
Balance Sheet
Balance Sheet is a statement which shows the financial position of the business on a particular
day.
According to A. Palmer
“The Balance Sheet is a statement at a particular date showing on one side the trader‟s
property and possessions and on the other hand the liabilities”.

Thus we can say that
Balance sheet is a statement not an account.

It is prepared to show the financial position of the business.

It records all the assets and liabilities of the business.

It shows the financial position on a particular day not for a period of time.
Need and Importance of Preparing a
Balance Sheet
A Balance Sheet serves the following purposes:

The true financial position of the business can be ascertained at a particular point of time.

Reveals the amount of assets owned by the business for example machinery, cash, debtors and
so on.

Show the liabilities of the business such as total creditors, share capital etc.

To adjudge weather the firm is solvent or not.

Opening entries for the next financial year are based on the Balance Sheet of the previous year.
Items appearing on a Balance
Sheet
Assets
Assets of a business are what it owns. They can be classified as:
Fixed assets: All those assets which are owned by the business and last for more than an
accounting year. Examples include Land, building, machinery, vehicle, furniture and fixtures and
the like.
Current assets: It includes all those assets which either in the form of cash or can be easily
converted into cash within one accounting period. Current Assets include Cash, Debtors and
Stock.
Liabilities
Liabilities represents what the business owes to outside persons other than owners. These
liabilities are classified on basis of time period of repayment.
Long term liabilities: These are liabilities which the business owes for more than one
accounting period, e.g. long term bank loans, debentures etc.
Current liabilities: These are short term debts of the business that are to be repaid within one
accounting period, e.g. creditors and bank overdraft.
Owner’s Equity
Owner‟s equity represents what the business owes its owner.
It is equal to total assets minus total liabilities.
Important points regarding Balance
Sheet

The Balance Sheet is not an account but a statement.

It does not have debit or credit side but has two sections i.e. assets and liabilities.

The heading of Balance Sheet is „as on a particular date‟. Thus a Balance Sheet may have
different figure on different dates.

The balances shown in the Balance Sheet act as Opening Balances for the next accounting
period.

Balance Sheet is based on the accounting equation
Assets= Owner’s Equity + Liabilities
Difference between Trial Balance
and Balance Sheet
Objective
Trial Balance is prepared to verify the arithmetical accuracy of the books of account whereas
Balance Sheet shows the financial position of the business.
Headings
Trial Balance is two sides i.e. Debit and Credit whereas Balance Sheet has Assets and
Liabilities.Profit and LossTrial Balance does not show any information about the profit or loss of a
business, whereas Balance Sheet records the Profit or Loss of the business.
Closing stock
The valuation of closing stock is not necessary to prepare a Trial Balance whereas Balance
Sheet cannot be prepared unless the Closing stock for that particular accounting year is not
ascertained.
Types of Accounts
Balances of all types of accounts are recorded in a Trial Balance i.e. Personal, real and nominal.
Balance Sheet records balances of personal and real accounts only.
Adjustments
Adjustment for outstanding expenses, prepaid expenses and accrued incomes are not required
for the preparation of Trial Balance. A Balance sheet is only complete after all the necessary
adjustments are made.
Closing Stock
Closing stock refers to the goods remaining unsold during the year.
They are valued at Cost price or Market Price whichever is lower.
Closing entries
Closing Stock Account
Dr.
Trading Account
(For closing Stock transferred to trading
account)
Treatment in Final Accounts
When closing stock is given outside the Trial
Balance
It will appear on

The credit side of the Trading Account

Under Current Assets in the Balance Sheet.
When closing stock appears inside the Trail
Balance
This means that the Closing stocks have already been deducted from the Purchases and thus it
will ONLY appear in the Balance Sheet under Current Assets.
Accrued expenses or outstanding
expenses
Expenses which have been incurred but not been paid for till the end of the accounting year are
known as Accrued expenses or outstanding expenses.
For example,
Total salaries to be paid for the year were $10,000, but by the end of the year $1000 were not
paid and will be treated as outstanding salary.
Adjusting Entry
Salaries Account
Dr.
Outstanding Salaries Account
(Being salaries outstanding)
Accounting treatment
Outstanding expense amount is added to that particular expense account in the Profit and loss or
Trading Account because it was the expense for that year. (Based on the matching principle)
Outstanding expenses are liabilities for the business. Thus they will appear under the Current
Liabilities in the Balance Sheet.
Note: If the Outstanding expense appears in the Trial Balance then it will only be recorded in the
Liabilities side of the Balance Sheet.
Prepaid Expenses
All those expenses which are due next year but paid for in advance during the current year are
termed as Prepaid Expenses.
Adjustment Entries
Prepaid Expense Account
Dr.
Expense Account
(For expense paid in advance)
Accounting Treatment
The concerned expense will be deducted by the prepaid amount in the Trading Account or Profit
& Loss account.
Prepaid expenses are assets for the business thus it will appear under the Current Assets in the
Balance Sheet.
Note: If the Prepaid expense is given inside the Trial Balance, then the prepaid expense will only
appear in the Current Asset of the Balance Sheet.
Depreciation
Depreciation is the fall in the value of fixed assets over a period of time.
Adjustment Entries
Depreciation Account
Assets Account
(Being depreciation charged)
Dr.
Accounting Treatment
Depreciation amount is entered as expense on the Debit Side of Profit and Loss account.
Depreciation is deducted from the value of the concerned asset in the Balance Sheet.
Accrued Income
Incomes which are earned during the year but not received till the end of the accounting year are
termed as Accrued Income / Earned Incomes/ Income Receivable.
Adjustment Entries
Accrued Income Account
Dr.
Income Account
(Being income received in advance)
Accounting treatment
Accrued income will be added to the concerned income account in the Profit and Loss account
because it the income for that particular year (matching principle)
Accrued incomes are asset for the business and appear under the Current Assets in the Balance
Sheet.
Note: If Accrued Incomes appear inside the Trial Balance then it will ONLY appear under the
Current Assets in the Balance Sheet.
Unearned Income/Revenue
All incomes or revenues which are received in advance but not earned during the year are treated
as unearned revenue. There may be times when a certain income is received in the current year
but the whole amount of it does not belong to the current year.
Adjusting Entries
Revenue Account
Dr.
Revenue received in advance Account
(For revenue received in advance)
Accounting Treatment
Unearned incomes/revenues are not the actual income for that particular year and thus deducted
from that particular revenue account in the Profit and Loss Account.
Unearned incomes/revenues are treated as liability for the business and thus appear under the
Current Liabilities in the Balance Sheet.
Note: If unearned income/revenue appears inside the Trial balance then it will ONLY appear
under the Liabilities in the Balance Sheet.
Interest on Capital
Usually the owner gets an Interest on his investment the business. According to the principle of
separate entity, Capital is considered as Liability for the business and the owner is paid a certain
amount of interest on the capital employed.
Accounting Entries
Interest on Capital
Dr.
Capital Account
(Interest allowed on Capital)
Accounting Treatment in Final
Accounts
Interest on Capital is an expense for the business and thus appears on the Debit side of the Profit
and Loss account.
It is a gain for the owner and thus it is added to the Capital in the Balance Sheet.
Interest on Drawings
Many times during the operation of business, the owner may take out some cash from the
business for his personal use. These withdrawals from the business are considered as
Drawings. Considering the fact that the business is a separate accounting entity, it charges an
interest on the drawings to the owner.
Adjusting Entries
Drawing Account
Interest on drawings account
(Being interest charged on drawings)
Dr.
Accounting Treatment
Interest on drawings is an income for the business and appears on the Credit side of the Profit
and Loss Account.
Interest on drawings is an expense for the proprietor and thus it is deducted from the Capital
Account in the Balance Sheet.
Interest on Loan
Interest paid on loans taken by the business is treated as expense and will appear on the Debit
side of the Profit and loss account.
Sometimes the interest on loan may not be fully paid and may be outstanding when the final
account is prepared. In this case, the Interest on loan account will be debited by the outstanding
interest amount.
Adjusting Entries
Interest on Loan account
Dr.
Outstanding Interest account
(Being outstanding interest on loan)
Accounting treatment
Interest on loan is an expense for the business and appears on the Debit side of the Profit and
Loss account.
Interest on loan is a liability for the business and is added to the Loan Account in the Liabilities
section of the Balance Sheet.
Writing off Bad Debts
There may be occasions when the business might not be able to collect its debts. This may be
due to the dishonesty of a debtor or may be due to the death or insolvency of a debtor.
Bad Debts Account
Dr.
Debtors
Account
(Bad debts written off)
This amount is then written off the books as „Bad debts‟. It is a loss for the business and thus it is
written on the debit side of the Profit and Loss account.
Closing Entry
Profit and Loss Account
Dr.
Bad Debts Account
(Transfer of bad debts to Profit and
loss Account)
Accounting Treatment
Bad debts appear on the debit side of the Profit and Loss account because it is a loss.
Bad debts are deducted from the Debtors in the Current assets in the Balance Sheet.
Recovery of Bad Debts
Sometime a debts written off as Bad debts may be recovered later on. Cash is coming in thus
Cash account is debited whereas „Recovery of bad debts‟ is credited because it a gain.
Accounting Entries
Cash Account
Recovery of bad
debts
(Being bad debts
recovered)
Dr.
Recovery of bad debts
Dr.
Profit and Loss account
(Being transfer of recovery of bad debts to
Profit and Loss Account)
Partial Settlement of Debtors
Sometimes, a business might only be able to recover a part of the debts. This means the rest of
the unrecovered debts will be written off as bad debts.
Accounting Entries
Cash Account
Dr.
Bad Debts Account
Dr.
Debtor‟s Account
(Being partial recovery of debts)
Provision for Doubtful Debts
Even after deducting the amount of actual bad-debts from the Debtors, there may still be some
debts which may be regarded as bad or doubtful. Thus a business might make an estimate of the
amount of such doubtful debts, that is, debts that are likely to become bad, and charge them as
an expense against the current period‟s revenue.
When Provision for Doubtful Debts is
set up for the first time
Accounting Entries
Doubtful Debts Account
Dr.
Provision for doubtful debts
(Being creation of provision for doubtful debts)
Closing Entries
Doubtful Debts Account is an expense for the business and thus it will be debited to the Profit and
Loss account
Profit and Loss Account
Dr.
Doubtful debts Account
(Being transfer of doubtful debts expense to the Profit and Loss
Account)
It will be deducted from the Sundry Debtors in the Balance Sheet.
Increasing the Existing Provision for
Doubtful Debts
Adjusting Entry
Doubtful debts Account
Dr.
Provision for doubtful debts Account
(Being increase of provision for doubtful debts)
Closing Entry
Being a loss for the business the Doubtful Debts Account is transferred to the debit side of Profit
and Loss Account.
Profit and Loss Account
Dr.
Doubtful Debts
(Being transfer of doubtful debts expense to the Profit and Loss Account)
Decreasing the Existing Provision for
Doubtful Debts
Adjusting Entry
Provision for doubtful debts Account
Dr.
Doubtful debts Account
(Being decrease of provisions for doubtful debts)
Closing Entry
Being a gain for the business the Doubtful Debts Account is transferred to the Credit side of Profit
and Loss Account.
Doubtful Debts Account
Dr.
Profit and Loss Account
(Being transfer of doubtful debts expense to the Profit and Loss Account)
In the Balance Sheet the debtors will appear net of the Provision for Doubtful debts.
Provision for Discount on Debtors
A provision for discounts to debtors who pay early is created in the current year itself.
Accounting Entries
Profit and Loss Account Dr.
Provision for Discount on Debtors Account
(For provision for discount created on Debtors)
It is shown on the Debit side of the Profit and Loss Account.
Provision for Discount on Debtors is deducted from the Debtors in the Balance Sheet.
Note: Provision for discount on debtors will be deducted after „Further bad debts‟ and „Provision
for doubtful debts‟ are deducted from the Debtors.
Provision for Discount on
Creditors
When the business makes prompt payments of its debts, it is bound to receive Discounts from its
creditors.
Although the discounts will be earned in the next year, the discounts so earned are an income of
the current year. A Provision for such discount is made in the current year itself so that that the
discounts thus earned may be credited to the Profit and Loss Account of the current year.
Provision for Discount on Creditors Account
Dr.
Profit and Loss Account
(For provision for discount on Creditors)
Accounting Treatment
Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss
Account.
It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.
Provision for Discount on
Creditors
When the business makes prompt payments of its debts, it is bound to receive Discounts from its
creditors.
Although the discounts will be earned in the next year, the discounts so earned are an income of
the current year.
A Provision for such discount is made in the current year itself so that that the discounts thus
earned may be credited to the Profit and Loss Account of the current year.
Provision for Discount on Creditors Account
Dr.
Profit and Loss Account
(For provision for discount on Creditors)
Accounting Treatment
Provision for Discount on Creditors will be shown on the Credit side of the Profit and Loss
Account.
It is deducted from Sundry Creditors on the Liabilities side of the Balance Sheet.
Manufacturing Account
It is prepared to ascertain the cost of goods manufactured during an accounting period.
This account is prepared only by a business which is manufacturing goods.
Items appearing on the debit side
Stock
It is of three types:

Raw materials: raw material purchased but not yet consumed.

Work in progress: Goods which are still semi-finished.

Finished goods: Completed goods but yet unsold and laying in warehouse waiting to be sold.
Raw materials consumed during the period is calculated as follows
Opening Stock of Raw material
xxxx
Add: Purchase of Raw Materials
xxxx
xxxx
Less: Closing Stock of Raw Materials
xxxx
xxxx
Carriage Inwards
All expenses incurred for bringing the raw materials to the factory e.g. custom duty, excise etc.
Factory overheads

All indirect expenses related to the operation of factory such as
indirect materials (not direct raw material used in manufacturing) e.g. lubricants for machinery

indirect labour (not direct labour) e.g. supervisor wages

indirect expenses such as factory insurance, rent, depreciation of machinery
Items appearing on Credit Side
Sale of Scrap
Scrap is the waste products during the process of manufacturing. Money realized by their sales
(an income!)
Any Work in Progress
Any unfinished goods left with the manufacturer at the end of the accounting period.
How to calculate the Cost of
Production?
Total Debit Side – Total Credit Side
This balance is known as the Cost of Production
It is transferred to the Trading Account.
Format of Manufacturing Account
What is Single entry system?
According to Carter ‘Single Entry system is a method or a variety of methods, employed for the
recording of transactions, which ignore the two-fold aspect and consequently fails to provide the
businessman with the information necessary for him to be able to ascertain the position’
Features

Usually, only Personal Accounts are prepared.

Cash Book records both business and personal transactions.

Too much dependence on Source documents to ascertain final status of the business.

There is no standard procedure in maintaining records and vary from firm to firm.

Usually found in a sole trader or a partnership firm.
Advantages

It is easy and simple method of recording business transactions.

Less expensive as qualified staff is not required.

Suitable for small businesses where cash transactions occur and very few assets and liabilities
exists.

Flexible method as there are no set procedures and principles followed.
Disadvantages

No double entry, thus Trial Balance cannot be prepared to check the arithmetical accuracy of
books of accounts.

Information related to assets and liabilities cannot be reliable because respective accounts have
not been maintained.

True Profit and Loss cannot be ascertained.

Comparison of accounting performance with previous year or other firms not possible as any
standard principle or procedure is not followed.
Finding Profit or Loss from
Incomplete Records
Two methods to find out the Profit or loss from incomplete records

Statement of Affairs methods

Conversion into Double entry method
FIRST METHOD-Statement of Affairs
method
In this method the capital of the business in the beginning of the period is compared with its
capital at the end of the period. The difference represents profit or loss during the period.

If the closing capital is more than opening capital, it shows a profit for the business.

If the closing capital is less than opening capital, the business had a loss.
Opening balance of capital can be ascertained by preparing an „Opening Statement of Affairs‟.
Statement of Affairs is quite similar to a Balance Sheet (NOT exactly).
Click here to download FORMAT-STATEMENT OF AFFAIRS (pdf)
The difference between the assets and liabilities of the business is the OPENING CAPITAL of the
business.
Capital = Assets – Liabilities
Similarly, prepare a „Closing Statement of Affairs‟ to get the CLOSING CAPITAL of the business.
Adjustments in the Closing Capital

Drawings are added to the Closing Capital.

Additional Capital is deducted from the Closing Capital
Once the Closing Capital is calculated, the Opening Capital is deducted from it.

If Closing Capital is MORE than Opening Capital, it is a PROFIT.

If Closing Capital is LESS than Opening Capital, it is a LOSS.
Net Formula
Profit = Closing Capital + Drawings – Additional Capital – Opening Capital
Some Adjustment
The profit achieved from this method is not the final net profit.
Adjustments which result in increase in expenses or losses must be deducted from the Profit
figure to get the accurate net profit. These are

Depreciation

Outstanding expenses

Interest on Capital

Interest on Loans

Provisions for Doubtful debts
Adjustments which result in increase in incomes and gains must be added to the Profit figure.
These are

Prepaid expenses

Interest on investments
At the end a final Statement of Affairs is prepared after these adjustments are done.
Note: When the Opening Capital is more than the Closing Capital, it shows a LOSS.
In this case, the adjustments which result in an increase in expense are added to the loss amount
and the adjustments which result in increase income are deducted.
SECOND METHOD-Conversion
into Double entry methods by
finding missing information
Following steps have to be taken

Opening Capital is calculated by preparing an Opening Statement of Affairs.

Cash Book is updated by adding all the missing information. Opening and closing cash balance
has to be ascertained.

Total Debtors Account has to be prepared.

Total Creditors Account has to be prepared.

Final Accounts are prepared i.e. Trading and Profit & Loss Account and Balance Sheet from the
information collected in Steps 1 to 4.
Finding Missing information using
Accounting Ratios
If Gross Profit is expressed as a percentage
of the cost price. In order words, Mark up is
given.
Mark up = Gross Profit/Cost price
Example
Calculate the Gross profit if the Sales = $54,000, Mark up is 20%.
Goods costing $100 has been sold at $120.
If sales are $54000 then the Gross Profit = 20/120 * 54,000= $9000
If Gross Profit is expressed as a percentage
of selling price i.e. Gross profit margin.
Gross profit margin = Gross profit/ Selling price
If Stock turnover ratio is stated
Stock turnover is the rate at which the stock of goods is sold.
Stock turnover= Cost of goods sold/ Average stock
Example
Cost of goods sold= $3000
Opening Stock= $400
Closing Stock = $600
AVERAGE
$400+$600
=
STOCK =
2
$500
Therefore, Stock turnover = $3000/$500 = 6 times per year or 2 months
What is partnership form of business?
A partnership is the relationship existing between two or more persons who join to carry on a
trade or business. Each person contributes money, property, labor or skill, and expects to share
in the profits and losses of the business.
A partnership must file an annual information return to report the income, deductions, gains,
losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any
profits or losses to its partners. Each partner includes his or her share of the partnership's income
or loss on his or her tax return.
Advantages of forming a partnership
The following are often seen as being positive attributes of being in a partnership:

Partners may possess complimentary skills, which can be very cost-effective. Partners may
specialise and become more efficient in certain aspects of their creative business. One partner
might be good at selling work and presenting to clients, while another is better at bookkeeping.

Partners have access to a wider pool of knowledge, skills and contacts.

Partnerships provide moral support and will allow for more creative brainstorms
Partnerships have access to large amount of capital and find it easier to expand as compared to
sole proprietor.

Partnerships have better administration and financial systems in place than sole traders.
Disadvantages

A partnership is for the long term, and expectations and situations can change, which can lead to
dramatic split ups. You might spend more time with your business partner than with anybody
else, so losing that very intimate and personal business relationship can lead to major problems
when splitting up.

You have to consult your partner and negotiate more as you cannot take decisions by yourself.
So you need to be more flexible.

You both are responsible for the business debts and errors of others. So if the business fails and
incurs debts, and your partner doesn‟t pay his or her share, you will still be required to pay. This
is even the case if debts were incurred by your partner‟s dishonesty or mismanagement without
your knowledge.

You have to share your profits and decide on how you value each other‟s time and skills. What is
more valuable to the company - a fantastic creative idea generator or somebody who can sell this
idea to a customer? What happens if one person puts in 60 hours a week and the other one turns
up late very regularly? What happens if one partner can put in less time due to personal
circumstances, such as caring responsibilities or illness?
Partnership Deed/ Agreement
Before starting a partnership business, the partners need to come to a common understanding. A
typical partnership agreement would include

Capital - the amount of capital put in by each partner, which will include both money and equipment
and other capital goods.

The role and responsibilities of each partner.

The apportionment of profits and losses. Is this equal (50/50) and if not how is this split and why?

The amount of drawing allowed to each partner.

The salary, if nay, to be paid to any partner.

There interest, if any, to be allowed on capital and charged on drawing.

What are the arrangements in case of dissolving the company, including the retirement, death or
long-term illness of a partner.

Management of the finances, bank account, signing of cheques and orders

Hours of work and holidays allocated.

Arrangement for arbitration in the event of disagreement.
Click here to download Sample of Partnership Agreement (PDF)
Capital account
Each partner in the business has a Capital account. It carries the record of initial capital and any
additional capital contributed by the partner. It is fixed and is not affected by any entry other than
contribution of capital.
Current account
This account records the share of profits and losses and drawing of a partner. Credit balances in the
Current Accounts at the end of the accounting year represents undrawn profits whereas debit balance
indicates that the partner has overdrawn from his account and owes to the firm.
Profit and Loss Appropriation Account
This account is prepared to show the division of profit or loss among the partners
Balance Sheet
Balance Sheet of a Partnership firm carries the following information:

Capital Account of all the partners

Current Account of all the partners
Interest on Capital
Partners who contribute more capital than other partners are granted interest on capital. It is
calculated on the capital at the beginning of the trading period. If the partner brings in additional
capital, interest will be calculated for the period beginning from the date the capital is injected into the
business.
Interest is deducted from the profit and the remaining profit is divided among the partners.
Interest on Drawings
Withdrawals made by partners from the firm are known as drawings. These drawings may be in cash
or in form of goods. The firm charges interest on these drawings. The interest is calculated for the
period beginning from the date of withdrawal to the end of the trading period.
Interest on drawing is debited to the Current Account of the partner who makes the drawings.
Loans from Partners
When a partner makes a cash loan separate from the capital, it is credited to the partner‟s Capital
Account. A separate Loan Account is created and credited with the loan amount. The amount
received by the firm is debited to the Cash account.
Interest is payable to the partner who makes the loan. The interest amount is

Credited to the partner‟s Current Account.

Loan Interest Account is debited as it is an expense for the firm.
Partners’ Salaries
Salaries paid to the partners is Credited to their respective Current Account
If Salary is paid in Cash, then Cash Book is credited instead of Partner‟s Current Account, Debited to
Partnership Salaries Account which is later on transferred to the Profit and Loss Appropriation
Account.
Analysis and Interpretation
Ratio Analysis
Accounts make little sense to Managers and people who don‟t have the technical knowledge.
This has resulted in the evolvement of a new stream in Accounting known as Management
Accounting.
Ratio analysis is a part of management accounting, whereby complicated accounting information
can be presented in a more simplified and presentable manner for laymen in accounting to
understand and absorb the information.
A statistics has little value in isolation. The statement „a business earned a profit of $100m‟ does
not make much sense unless it is related to either its sales turnover or its assets.
People who are interested in knowing financial information are known as Stakeholders.
These are
Stakeholders
Owners
Worker
Managers
Consumers
Government
Who are they
Objectives
They invest capital in the business and
get profits from the business
Profits, growth of the business
Employees of the business who give in
their time and effort to make a
business successful
Job security, job satisfaction
and a satisfactory level of
payment for their efforts
Employees of the business who
manage a business. They lead and
control the workers to achieve
organisational goals
High salaries, Job security,
Status and growth of the
business
These are the people who buy the
goods and services of the business.
Safe and reliable products,
value for money, proper after
sales service
Government manages the economy.
Successful businesses,
The
community
The government charges a tax from
the business and also monitors the
working of businesses in the country
employments to be created,
more taxes, follow laws
Community is all the people who are
directly or indirectly affected by the
actions of the business.
They expect more jobs,
environmental protection,
socially responsible products
and actions of the business.
Stakeholders are interested in getting information about business, in order:

To compare the business performance over several financial periods. This is known as Intra-firm
comparison.

To compare the business performance with that of other businesses within the same industry also
known as Inter-firm comparison
Ratios can be broadly classified
as:
Profitability ratios
These ratios measure the profit in relation to sales or capital employed.
Gross profit margin
Gross Profit Margin shows the relationship of gross profit and sales turnover.
Gross Profit
Gross Profit Margin=
X 100
Sales turnover
A lower ratio may be the result of the following factors:

Decrease in selling price of goods sold

Increase in cost of goods sold

Over valuation of opening stock or under valuation of closing stock
Net profit margin
It is an index of efficiency and profitability of a business.
Net Profit
X 100
Net Profit Margin=
Sales turnover
Mark up cost refers to profit expressed as a percentage of cost price.
Gross Profit
Mark Up=
X 100
Cost of goods sold
Rate of return on Capital (ROCE)
It shows the return on the investment made by the owner.
Net Profit
Return on Capital employed=
X 100
Capital
These ratios state how efficiently certain areas of the business are performing.
Stock turnover ratio
It indicates the number of times in a year the average stock can be sold off. The more times the
stock is sold the more efficient the business.
Cost of goods sold
Stock turnover ratio=
Average stock at cost price
Average Stock is calculated as (Opening stock + Closing stock)/2
Asset turnover ratio
Asset turnover is a measure of how effectively the assets are being used to generate sales. It is
one of the ratios that would be considered when interpreting the results of profitability ratio
analyses like ROCE.
Sales turnover
Asset turnover ratio=
Total assets-current liabilities
If the asset turnover is high than its competitors, it shows as an over investment in assets.
However, a new firm may have a higher asset turnover ratio than its competitors as the assets
are newer and have a higher value. Moreover, some firms may use a lower rate of depreciation
than its competitors.
In some cases, firms may purchase assets whereas its competitors firms are leasing assets.
Trade debtor collection period (Debtors
days)
This ratio indicates how efficient the company is at controlling its debtors.
Total Debtors
Debtors days=
X 360
Total Sales turnover
Trade creditor payment period (Creditors
Days)
This ratio indicates how the company uses short term financing to fund its activities.
Total Creditors
Creditors days=
X 360
Cost of sales
Both these ratios are useful for intra-firm comparison.
Liquidity ratios
It measures the availability of cash and other liquid assets to meet the current liabilities of the
firm.
Current Ratio
The current ratio compares total current assets to total current liabilities and is intended to
indicate whether there are sufficient short-term assets to meet the short-term liabilities.
Current assets: Current liabilities
The ratio when calculated may be expressed as either a ratio or 1, with current liabilities being set
to 1, or as „number of times‟, representing the relative size of the amount of total current assets
compared with total current liabilities.
A ratio of 2:1 or current assets as 2 times is considered to be healthy for a business.
Acid test ratio
It is quite similar to Current ratio. The only difference in the items involved between the two ratios
is that the acid test ratio or quick ratio does not include stock.
Current assets-Stock
Acid Test ratio
=
Current liabilities
An acid test ratio 1:1 is considered as healthy. If it is below 1 it suggest the business has
insufficient liquid assets to meet their short term liabilities.
Candidates should be able to recognise the limitations of accounting statements due to such
factors as:
historic cost
difficulties of definition
non-financial aspects
KEY (COMMAND) WORDS IN
ACCOUNTING EXAMINATIONS
ADVISE Write down a suggested course of action in a given situation. Often linked with “Suggest” – see below.
CALCULATE Self-explanatory – “work out”. Often no format specified. Often accompanied by – “show workings”/”show calculations”
COMMENT Make relevant statements, usually on given figures, or results of calculations
COMPARE Write down the differences between two accounting statements/two businesses/methods of recording something etc
COMPLETE Self-explanatory – “Fill in”. Often use in relation to tables/ sentences/ “boxes”.
DEFINE Write down an explanation of the meaning of an accounting term. e.g. “Define depreciation”/“Define current assets”.
DISCUSS Often linked with “Comment” see above. Write down a reasoned explanation of the causes/effects of a course of action/the
difference between two sets of figures/two accounting statements etc.
DRAW UP Sometimes used in place of “Prepare”. Present something in statement or account format etc. Often used in relation to bank
reconciliation, statement of corrected net profit etc.
ENTER Sometimes used in place of “Make entries”. Record given information in specified accounts/ books/ledgers
EXPLAIN Give a written account of what something means/why it is done/ the outcome of it etc. Examples include – “Explain the entries in
an account”/“Explain why a trader ……………..”
GIVE Sometimes used in place of “State”. Write down. Sometimes used as “Give 2 examples ………………”.
LIST Self-explanatory – write down information in a number of points – usually no further explanation is necessary.
MAKE ENTRIES See “Enter” above. Record information in specified accounts etc.
NAME Self-explanatory – write down the title of etc. Often used for short one-word answers e.g. “Name a fixed asset”/“Name an example of
………….”.
OUTLINE Write down. Often linked to “State” – see below. Give a brief written account of something, e.g. “Outline the ways to reduce bad
debts”/“Outline the imprest system of petty cash”.
PREPARE See “Draw up” above. Present some accounting information in a suitable format e.g. “Prepare final accounts”/“Prepare journal
entries”/“Prepare a bank reconciliation statement”.
RECORD Self-explanatory. Used in place of “Enter” or “Write up”. Make the necessary entries in a set of accounting records e.g. “Record a
series of transactions in the cash book/ledger/books of prime entry”
SELECT Self-explanatory – choose relevant information from that given. Often linked to a further instruction e.g. “Select the relevant
information and prepare a Manufacturing Account/Trial Balance”.
SHOW Self-explanatory - write down your workings/calculations or write down how an item will appear in some accounting statement. Often
used when requiring preparation of Balance Sheet extracts/Profit and Loss Account extracts etc.
STATE Self-explanatory – “write down”. Often used instead of “Give” – see above. Used when requiring written explanation of something
e.g. “State 2 ways in which …………….”/“State how the trader can…………….”
STATE AND Usually requires a little more detail than just “State” and often an
EXPLAIN explanation of why/how.
SUGGEST Requiring knowledge to be related to a given situation. Offer explanation why something occurred/how a situation can be
improved/methods available to deal with a situation etc.
USING Refer back to some previous information e.g. using your answer to Part (a), and calculate some figure or make suitable comments.
WRITE UP May be used in place of “Prepare” see above. Often used in connection with ledger accounts, cash books, books of prime entry
etc.